UK and European regulators have identified the lack of research coverage for smaller companies as an issue that needs to be addressed.
The number of analysts following small caps has been dwindling for years, a situation not helped by the arrival of Mifid II, which led to a drop in research spending by the buy side.
But Investec sees an opportunity in this under-followed part of the market. The Anglo-South African investment bank has launched a new product that covers 50 stocks with an average market cap of £250 mn ($346 mn).
To make the economics work, the bank has dispensed with buy or sell recommendations and forecasts. Instead, it is applying analysis techniques such as Porter’s five forces and DuPont, alongside discussions with management, to identify stocks worthy of investor attention.
‘We had identified that this part of the market was under-researched,’ says Nathan Piper, head of oil and gas research at Investec, who is leading the new product.
‘We also realized that you couldn’t cover this part of the market in the traditional way where one analyst would cover roughly 10 stocks; it’s too expensive. But this [new technique] is a way [in which] we thought we could bring some in-depth but concise analysis of individual stocks.’
The product, called Investec Searchlight, has been in the works for around 12 months and recently put out some research with a bit more ‘fanfare’ to highlight the new offering, says Piper. There are plans to grow the service, which is supported by three analysts based in Edinburgh, to cover more companies.
European regulators have also been looking at ways to boost research coverage for smaller issuers. Much attention has focused on Mifid II unbundling rules, which forced brokers to separate out the costs of research and trading. As a result, investors largely absorbed the cost of research and cut back their spending.
The EU acted first, making research on companies with a market cap below €1 bn ($1.2 bn) exempt from unbundling rules. In April the UK’s Financial Conduct Authority (FCA) launched its own consultation on Mifid II, proposing an easing of research payment rules for companies under £200 mn.
Piper welcomes the FCA’s focus on small-cap research but notes that Investec’s decision to launch the new service is not a reaction to any regulatory proposals. It’s about the business opportunity, he says: ‘The buy side trawls through that end of the market and tries to pick out what’s good and bad. Through our product we can cover quite a lot of stocks efficiently and highlight the names that have good fundamentals.’
The bank’s approach is sector-agnostic and there is a range of businesses included in the initial 50 stocks. ‘Some of these are high growth with no profits, through to quite well-established businesses that are very profitable but haven’t got that much growth because of the market they happen to be in – and everything in between,’ says Piper.
A common challenge for small-cap companies is the need to boost their research coverage. So how can they make themselves more visible to the Investec team? Alongside simply picking up the phone, Piper says companies should make their investment case ‘as clear as possible’ and maintain a well-run website.
‘The quality of websites across these small-cap companies varies hugely,’ he says. ‘That’s one of the measures we use when we’re trying to choose which ones we’re going to launch coverage on.
‘Check out the website, check out the information you can get straight away, and that will put that company slightly higher up the pecking order than one where you’ve got to look through the IPO prospectus from two years ago to find out anything useful about the market it’s operating in.’