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Feb 08, 2019

No reduction in small-cap coverage in first year of Mifid II

Equity research falls – but not at small caps, says LBS research

One of the many debated consequences of Mifid II was the anticipated reduction in small-cap coverage, but new research reveals this hasn’t been borne out in the first year of the European regulation.

As part of the annual review into performance drivers of the Numis Small Companies Index (NSCI), the London Business School (LBS) finds that, while equity research has fallen by 8 percent since Mifid II came into force, so far there is no disproportionate reduction in small-cap coverage. The LBS also finds no evidence to suggest that Mifid II has impacted the liquidity of small caps.

In an interesting caveat, the report notes that all market caps have seen both higher volumes and greater turnover of trading in the past year.

The authors find that, over the last 16 years, the average number of analysts covering NSCI companies has increased, and ask whether Mifid II might reverse this. After examining a large number of brokers’ recommendations over a 16-year period, they conclude that they are valuable for both small caps and well-followed mid-caps, but less so for large caps.

Explaining the findings, Scott Evans, a researcher at LBS and co-author of the Numis Smaller Companies Index Annual Review 2019, tells IR Magazine: ‘One explanation for the limited impact on small-cap research coverage is that we have been able to look only at supply of research – and not demand.

‘In the transition period from research in effect being offered as a bundled service – which has a low or zero price – demand would meet whatever the level of supply was. Now that research has an explicit price, we may find supply will slowly adjust to a level nearer to actual demand.’

Market dynamics such as trading velocity – measured as the number of times average market cap is turned over in a trailing 12-month period – on the London Stock Exchange before, during and after the financial crisis, and the difference either side of the 2007-2009 bear market, is also evident in the review.

Turnover relative to market cap increased prior to the financial crisis, which the review explains is the general trend in a bull market when trading volumes tend to be higher. It also says the spike in velocity in the immediate aftermath of the crisis is because the market value fell considerably more than trading volume.

The review notes: ‘We know the proportion of total volume accounting for small and mid-caps has been falling as the market has become more concentrated. The concentration of turnover peaked in the 2009-2012 period when as few as 59 companies accounted for 80 percent of total market volume.’

What is interesting is how trading velocity has been subdued since the lowest market point of March 2009, during a sustained period of rising share prices. Quantitative easing then helped to create the early stages of the long bull market.

This saw a much lower velocity of trading in small and mid-cap shares relative to before the financial crisis, when investors engaged in more diverse activities such as long-short hedging, risk arbitrage and event-driven strategies.

Looking at annual data as far back as 1955, the review notes the NSCI has achieved a compound return of 15.2 percent – 3.4 percent per annum above the FTSE All-Share.