TCS Daily

Little Guys Get Some Love

By Kevin Hassett - September 15, 2005 12:00 AM

The analyst industry in the U.S. is undergoing a dramatic reorganization. First, in response to a settlement driven by Eliot Spitzer, millions of dollars are pouring in from the big Wall Street houses to independent research firms. Second, Nasdaq and Reuters are offering firms a new service whereby they can pay for independent analysis of their own firms.

The first development is unlikely to have an impact on U.S. capital markets, but the second might well significantly increase the flow of capital going toward the entrepreneurial sector.

In an efficient stock market, today's price reflects all relevant information. Empirical tests suggest that, while anomalies exist, equity markets often behave quite efficiently. There is, after all, tons of information to go on. Publicly traded firms are required to calculate their books according to a given set of rules, and to make them available to investors.

But the accounting numbers are often not enough. A firm might have been profitable last year, but if they lose their best customer, the story will change. Next year's books will look terrible, but the price today, in an efficient market, will respond immediately. If you find out ahead of time that their customer is unhappy, you can make some money shorting the stock.

Clearly, if you are going to trade in a specific equity, you need to pay a great deal of attention to anything and everything that might affect its price. That is a huge amount of work, however, which is why the analyst industry emerged. Individuals with specific expertise in a relevant area took on the job of watching and reporting to investors.

But there were well documented problems with the system. In particular firms that served as underwriters of specific stocks had an incentive to drum up business for their clients by issuing reports that were excessively optimistic. A recent study for the National Bureau of Economic Research by economists Ulrike Malmendier and Devin Shanthikumar found that these incentives had a big impact. Analysts for underwriters were far more likely to be positive about a stock, and investors who literally followed the advice of these analysts lost money.

Of course, it might well be that very little money followed the advice of analysts. After all, there are countless views about the likely future of any firm, some positive, some negative. The analyst's positive views could easily be adjusted for by rational decision makers, and included in the whole crazy quilt of information available for most equities. Malmendier and Shanthikumar documented that this was indeed mostly the case. Large investors responded to the biased reports of affiliated analysts by ratcheting down their responses to them. The authors found some evidence that small investors were not so smart. The impact of their behavior on the functioning of markets, however, was likely inconsequential.

For most equities, then, the market appears to have been able to sort through the information in an efficient manner. But the scale of the activity of doing analyst work is quite large. Since the market is a fairly efficient place, it takes some serious optimism to want to invest in analyst activity at all. If a share is correctly priced, than what will justify the analyst's salary?

For very large firms like GE or Exxon, it seems that there is enough potential profit to justify hiring an analyst. But the same is not true for many small firms. The real problem with analysts is not that there are too many biased ones out there, but rather, that too many small firms are not covered by analysts at all, which raises their cost of funds. Indeed, in a recent study also published by the National Bureau of Economic Research, my coauthor Alan Auerbach and I used the absence of analyst coverage as a measure of access to capital markets, finding that many firms had no coverage at all, and that this had a big impact on their financial decisions.

One can see why this might be true. A stock with a market cap of $50 million can only deliver so many millions in profit to a Wall Street firm, but figuring out its business prospects might cost as much as it would for a billion dollar company. Small firms that are sure that their business model is a winner might provide their own analysis, but investors would be right to be suspicious of it.

To date, the market has not been able to successfully deliver this product to the public at large. This may be because individuals who can find diamonds in the rough have little incentive to make their information public. Those who do the best work analyzing the little guys probably work privately.

This observation may well explain why the Nasdaq exchange is behind the development of a new research device. When investors sift through small company data and take the best private, they make themselves lots of money if they are able to purchase the firm for pennies on the dollar. When information is scarce for small publicly traded firms, such an outcome is possible. From the exchange's perspective, private equity funds remove volume and revenue. Nasdaq has an incentive to help small investors play ball with the private equity firms, and to do so, they need to get them better information. If small investors know the winners ahead of time, prices of publicly traded shares will be high, and there will be less profit available for those who would acquire firms and take them private.

If this endeavor works, it will help lower the cost of equity capital for small firms and increase the flow of capital into the economy's most entrepreneurial sector.


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