Attention seekers

Small companies may be in vogue, but it is doubtful that they will attract a
larger audience among the research brokerage community. Analysts have always
preferred following the larger, household names that can generate huge trading
revenues.

The status quo is unlikely to change as brokerage houses have slashed their
research budgets in the wake of the Spitzer agreement by which investment banks’
corporate finance departments are now effectively barred from subsidising the
analysts, which now have to pay their way solely by generating share trading
ideas.

Since the analysts now have little incentive to look at the corporate
minnows, the only option open to smaller companies is to pay independent
research houses to analyse and write reports about them. This so-called
independent research is then circulated to other brokerage firms that wouldn’t
otherwise bother to follow the stock.

The popularity of small companies is cyclical, but in the past few years fund
managers have come under increasing pressure to meet their burgeoning
liabilities and are seeking more alpha-generating (risk-adjusted performance)
investment ideas. Small companies can fit the bill and in the two months to the
end of February 2006, the FTSE-AIM All Share index had a burst of activity,
jumping 12.6%. “There is an increase in the number of pension funds and
insurance companies participating in AIM as everyone is looking for the elusive
alpha,” says Andy Edmond, chief executive officer of Equity Development, a
UK-based independent research house, which was recently bought by ADVFN Plc, a
provider of financial information via the internet.

Uphill struggle

The growing interest, however, has not been matched by an increase in
research output. “It is still an uphill struggle for many of these companies to
get research coverage until they reach a certain size. A company with a market
cap of £2.5bn is not even in the FTSE-100. The concentration of research in the
UK continues to be around the large cap stocks and, in many cases, the only
option for a smaller company is to pay for the research if they want to spread
their message,” says Angela Knight, chief executive of the Association of
Private Client Investment Managers and Stockbrokers (APCIMS).

Adam Hart, chairman of the AIM advisory group at the London Stock Exchange
and head of business development at KBC Peel Hunt, a UK-based securities firm
that focuses on the small- to mid-cap sector, echoes these sentiments. “Often,
brokers cannot justify covering a small company because they do not generate
enough trading revenue to make it worth their while.

“The big houses are used to placing £10m orders, rather than 10,000 shares of
a smaller company. As a result, small companies will often turn to the
independent houses.”

Roger Hardman, founder of the independent research company Hardman & Co,
started the company 11 years ago. The six-person team covers information
technology, telecoms, oil, property, mining, leisure and certain areas of the
financials industry such as stockbrokers, sub-prime lending and the independent
financial advisor market. The group plans to strengthen its healthcare offering
by hiring another analyst in the future.

Although few small companies ever register on the radar screen of a large
integrated brokerage house, the situation has become much worse since the stock
market crash in 2001. The ensuing regulations, including the Spitzer agreement
in the US in 2003 and the more recent Financial Services Authority rules, were
intended to 4 raise the research bar. Instead, many market participants believe
that not only has the quantity diminished but also the quality.

Although there are no concrete figures on the UK market, it is thought that
the scenario is the same as in the US, where research budgets at the larger
houses were cut by about 30% over the past three years, according to data from
Sanford C Bernstein, a US-based research firm, which is a subsidiary of
AllianceBernstein. Compensation packages have also shrunk accordingly, which has
made it difficult to attract the best and the brightest into the profession.

A recent Reuters survey in the US revealed that, since January 2002, 690
companies have lost analyst coverage, while data from Nasdaq last year noted
that about 1,200 of its 3,200 listed companies and 35% of all public companies
were not being followed. It also reported that 50% of all publicly-held
companies have two or fewer analysts covering their firms. Market participants
believe that in the UK, the number of analysts employed has dropped by around
8%, while the number of new stocks rose by around 9%.

Poor visibility

This dearth of research particularly impacts the smaller company that is
trying to raise funds for its next stage of development. Without proper
coverage, not only is its brand and visibility dented, but there is also a
greater opportunity for market mis-pricing.

“The net effect of the past three years is that there are fewer analysts with
less experience covering more companies. They are not able to devote enough time
to the research,” says Edmond. “If a company is ignored, it can often be valued
substantially below its true worth. This means it could be taken over too
cheaply or have undervalued currency if it wants to make an acquisition. The
objective for these companies is to have a good supply of research written about
them.”

It is no wonder then, that these so-called orphan companies are increasingly
turning to issuer-paid research to raise their profile. It is ironic, perhaps,
that the Spitzer and FSA rules have created a larger space in this market. The
rules were designed to put a stop to corporate finance departments, in effect,
subsidising the research end of the business. But now, securities firms, more
than ever, can only afford to churn out research on companies where they make a
brokerage commission.

The $1.4bn (£800m) global settlement Spitzer struck with ten investment banks
required them to spend $432.5m over five years for third-party research, while
the FSA rules oblige fund managers to break down their research and execution
costs to their clients. This has yielded an increase in commission-sharing
agreements, where managers pay a single commission to an investment bank for
research and execution, but then instruct the firm to direct a certain portion
of the research spend to an independent firm.

These new regulations are not expected to affect sponsored providers in the
near term as they operate in a different segment of the market. The big
challenge for them, of course, is to convince the market that sponsored reports
are not an extension of the company public relations machine. As one industry
participant put it: “The question is whether the research is truly objective and
independent if the company pays for it?”

Knight of APCIMS does not believe it is in a company’s best interest to pay
for what is in effect a ‘press release’. “I do not think it would benefit the
company if they paid for research that was not substantive and correct,” she
says.

The research firms that provide this service argue that it would not only
hurt the company’s image, but their own status as well if they churned out puff
pieces. “We realised there was a precedent in the market for issuer-paid
research. For many companies, their only coverage comes from their broker, who
does not have an obligation to issue research,” says Peter Molloy, director of
Edison Investment Research, a UK-based independent research house. The firm,
which has a team of 32, covers about 90 stocks, with an average market cap of
£40m.

“However, we always tell our clients that it is of no value to the end-user
if the research is biased. Also, our analysts have their own personal brand and
they do not want to publish something unless it is accurate and credible. They
have to be comfortable with it,” he says.

Wider audience

One of the main benefits for a smaller company in turning to firms such as
Hardman & Co, Equity Development and Edison, is that they can tap into a
wider investor pool. Brokers typically restrict distribution to their clients,
but sponsored research is sent to the private client broker audience, which can
account for as much as 40% of volume on the UK stockmarket. Their research is
also available on portals such as Thomson Financial’s First Call, Bloomberg and
Reuters’ Multex. “For a plc, the main objective is to have a good piece of
research sent to as wide an audience of professional investors as possible,”
says Molloy.

Although sponsored research can help catch a fund manager’s eye, small
companies have to employ a range of proactive techniques to communicate their
virtues to the market and improve their liquidity. For example, investor
relations firms can arrange meetings between company management and existing as
well as potential investors, while a financial public relations firm can write
press releases about the latest development and circulate them in the public
domain. “Research is part of the equation, but it is not the whole answer,” says
Hardman. “In order for companies to raise their profile above the noise level,
they need to spend money and hire specialists, such as a financial public
relations firm, which can promote the company’s activity in the best light to
the right audience.”