Walk on the Sell Side
(Note: this article was originally published on LinkedIn, March 25, 2021)
Sell side analyst coverage for emerging growth companies (EGCs) has steadily diminished since the tech bubble in 2000. This decline began after regulators took steps to plug holes in the ‘Chinese Wall’, the ethical applied to keep research and investment banking separate. Over the years, changes in the equity research business model have forced middle market and large investment banks to abandon EGCs.
Costs of analyzing the smallest companies cannot be justified for major sell side firms, which focus on large-cap, very liquid stocks. To remain profitable, Wall Street firms depend on them to generate highly lucrative investment banking deals and trade profits.
Across the EGC ecosystem the number of analysts at investment banks and boutique research firms has fallen. An emerging growth company as defined by the SEC has annual revenues of less than $1 billion in its latest fiscal year, which encompasses the small and microcap tiers and a little above. It’s no surprise that coverage dissipates as market capitalization shrinks.
Data indicates smaller companies are in fact under researched. Bloomberg data reveals 35% of companies in the Russell Microcap Index (median market cap: $313 million) have either zero coverage or only one analyst covering the stock. Companies in the index are followed by an average of 2.9 Wall Street analysts. In stark contrast, companies with market caps of at least $50 billion are followed on average by 24.3 analysts.
It’s debatable how the quality of research for EGCs has developed over the years, but anecdotal evidence suggests it has been affected by efforts to cut the cost of production. Analysts appear to cover more companies, leaving them less time to compile detailed research on each.
A team of associates and an analyst will usually cover at least 5 companies and could cover as many as 15, depending on their seniority, the sizes of the companies, and the industry, according to the Corporate Finance Institute.
H.C. Wainwright & Co, one of the most active investment banking firms in the EGC market, recently tweeted that its 18 publishing research analysts cover 480+ public companies. In other words, on average each of their analysts covers 26+ companies.
An alternative platform for EGC analyst coverage is company-sponsored research (CSR), which has grown in size and stature over the past decade. Once perceived as a poor cousin to traditional sell-side research, CSR today plays a valuable role in the capital infrastructure for the small and microcap markets, by producing equity research with comparable standards to Wall Street firms.
While conflicts still exist today for both sell side research and CSR, closer scrutiny and voluntary changes in the process at least promote the appearance of independence. Yet even as company-sponsored research fills the vacuum created by declining trends in analyst coverage for EGCs, a fundamental issue remains for research at this level, one that extends beyond relationships and potential conflicts of interest.
Rethinking the Model for EGC Research
Sell side research has fundamentally changed little since the 1980s when the first big wave of emerging growth companies entered the public markets, propelled by advances in computing and biotechnology and the emergence of the likes of Apple and Genentech.
Today, many finance experts rightly question whether some of the most widely-used metrics in financial statement analysis are sufficient for companies whose valuations are driven by intangibles to a high degree.
Arguments in favor of the traditional approach are easier to justify for larger firms with a track record of earnings. However, they break down for EGCs, most glaringly for those in technologically-driven industries.
Formative-stage companies have stories that investors struggle to evaluate and project over the long term. Relying too heavily on backward-looking financial statements produces barely a glimpse into the most relevant aspects of EGCs: intangibles and strategic assets such as R&D, all forms of intellectual property including employee know-how and ideas, in-house technology and software systems, data, non-transaction events or contracts, and more.
These items represent a potential storehouse of intrinsic value tough to capture in SEC filings or through other readily-available corporate documents. Of course, while generally accepted accounting principles (GAAP) disclosures fail to provide much of the information required for an analysis of the intangibles and strategic assets of an EGC, non-GAAP data and information, along with disclosures made during management’s conference calls, point analysts and investors in the right direction.
Contextual analysis of exogenous factors that are beyond the immediate control of management also yields valuable insights. Such factors include the activities of customers, competitors and suppliers; the labor market; legal, regulatory, competitive and economic conditions; and the supply of technological and other types of knowledge of value to innovation. These factors create formidable challenges and opportunities for EGC management, as well as the analysts covering them.
In the next phase of the digital economy all EGCs will be enhanced by, if not born out of emerging digital technologies. These include advanced analytics, artificial intelligence/machine learning, cloud & managed services, collaboration tools & software, cybersecurity, digital health (e.g., bioinformatics, drug R&D, digital therapeutics) and the Internet of Things.
Any analysis focusing on the impact of digital transformation will gain an advantage by recognizing the value to companies that apply these tools most effectively in their business strategy and operations.
Analyses of intangible and strategic assets have few boundaries. Companies are comprised of a diverse group of people with a range of expertise, who interact with partners, alliances and customers. Research on emerging growth companies can do more to investigate such relationships to expand understanding of strategic strengths and weaknesses, map central narratives, and better articulate the stories and prospects.