New York, NY – In the wake of the tech bubble bursting in March 2000, the number of small and mid cap companies that lost equity research coverage from the investment banking community surged as firms were forced to slash their research budgets. However, this trend started to reverse in recent years as the stock market rose to new highs. Unfortunately, the decline in sell-side research coverage has picked up steam since the third quarter of 2008 as investment banks and brokerage firms have experienced severe financial pressure – a trend that is likely to be bad news for small and mid cap public companies who have traditionally relied on the sell-side to tell their story to buy-side investors.
Post Bubble Trends
According to an academic study most recently published in December 2008 by Professors Kent Womack at Dartmouth College and Ambrus Kecskes at Virginia Tech, they found that sell-side analyst coverage for a typical public company has increased over the past twenty-four years, increasing every year since 2001 and hitting an all-time high in 2007.
Professor’s Womak and Kecskes estimate that sell-side analyst coverage for the typical public company increased from roughly 1.8 to 4.4 analysts per company after accounting for firm characteristics. They explain that this finding should not be surprising as sell-side analysts cater primarily to institutions. Consequently, if institutional ownership increases over time, then so should analyst coverage.
However, recent developments suggest that a turnaround in this trend is clearly taking place. According to data provided by FactSet (and published last week in the Wall Street Journal), between September 2008 and mid-May 2009, more than one quarter (25.7%) of all sell-side research reports on small cap companies announced that a sell-side analyst was formally dropping coverage of the company. This represents more than 2,200 cases. This compares to a mere 6.4% of small cap research reports that announced dropped coverage in the period September 2006 to mid-May 2007.
It is interesting to note that small cap companies have not been the only firms to lose research coverage in recent months. During the same period (September 2008 to mid-May 2009), 17.2% of all mid-cap research reports and 15.5% of all large cap research reports reported that analysts were dropping coverage of the company, compared to 4.9% and 6.9%, respectively that reported this in the September 2006 to mid-May 2007 period.
The Impact of Bear, Lehman and Merrill Lynch
Historically, the number of public companies that have lost research coverage typically rises during bear markets as the number of securities analysts plunge due to Wall Street layoffs or general attrition. However, during the current market cycle, this trend has been exacerbated by the closure of large investment banks like Bear Stearns and Lehman Brothers, and the merger of Merrill Lynch with Bank of America, as these firms provided research coverage to thousands of public companies.
In addition, many other securities firms have decided not to replace equity analysts who have been laid off, or who have left the firm, leaving countless companies with less coverage (or with no research coverage at all).
Companies Lose when Coverage Falls
Of course, the biggest losers of this drop in research coverage are the public companies themselves – particularly if they don’t have a large number of analysts covering them in the first place. According to the study mentioned previously by Professors Womack and Kecskes, the stock price of a company that loses research coverage typically underperforms the industry average in the twelve months after it loses coverage.
It is interesting that according to their study, Professors Womack and Kecskes found that the share price of firms that lose coverage actually outperform their peers in the second twelve month period following a drop in research coverage. They explain that this is due, in large part, to the fact that these companies share price was undervalued as investors sold the shares following being orphaned, rather than for any fundamental reason.
Other Losers and Winners
Another group which might be a loser as a large number of public companies are being orphaned are buy-side investors. Institutional investors typically receive research about the companies they invest in from three sources – the sell-side, alternative research providers, or from internal analysts.
In recent months, a large number of small mid and large cap companies have lost sell-side research coverage. Consequently, if the buy-side wants to continue receiving research on these companies, it will either have to purchase it from third-parties or produce it themselves. Unfortunately, many buy-side firms have been forced to lay off some of their own analytical staff. This means they have less internal analytical resources to produce research themselves.
Some might think that other research firms might be in a position to gain from the loss in sell-side research coverage and the analytical squeeze seen at many buy-side firms. However, many institutional investors have also experienced a 30% to 40% drop in equity commissions in 2009 – a development that will make it extremely difficult for them to pay for research from boutique investment banks, regional brokers, or alternative research providers.
Despite the fact that sell-side research coverage was on the upswing from 2001 to 2007, there has been a severe reversal of this trend in 2008 and 2009, caused in large part by the credit crisis, and the resulting failure and mergers of some large investment banks like Bear Stearns, Lehman Brothers, and Merrill Lynch.
The result of this trend has been that many companies have been orphaned, losing some if not all of their research coverage. If history is a guide, the stock price of these public companies is likely to underperform their peers, at least over the short-term. This will force many company executives to increase the amount of time they spend meeting with investors to tell their companies’ stories. Even investors will lose out as a result of this drop in sell-side research coverage as they will find it extremely difficult to replace this research from either third-party or their own internal analytical resources.