Analyst neglect of UK small-cap and mid-cap stocks subtracts £8 billion ($14.7 billion) from the capitalization of the UK equity market, according to UK research boutique Equity Development. Comparing the valuations of stocks for which there are nil, one, two, or more than three analysts publishing research, Equity Development found discounts for neglect in 75% of the sectors for which there is useable data.
The average discount for stocks with no coverage is as high as 32%, while the average discount for stocks suffering from relative neglect is 26%.
A lack of research coverage also has a significant impact on liquidity, Equity Development found. Taking the bid-offer spread as a proxy for liquidity, it found that stocks with no analyst coverage have spreads that are on average 35% higher than stocks of the same size with one analyst. Stocks with just one analyst covering them have spreads on average 26% higher than stock of the same size with two analysts.
Surprisingly dramatic
The relationship between research, valuation and liquidity works in both directions. A lack of analyst coverage leads to lower valuations and reduced liquidity. At the same time, demand for research falls as a company?s market capitalization or trading volumes fall.
?What these results show is that regardless of a company?s individual operating merits, a lack of research coverage is bad for your share price rating,? says Andrew Edmond, head of origination at Equity Development. ?What surprised us was just how dramatic the effect can be.?
These results are significant because they quantify the impact of research coverage on market capitalization and liquidity for the first time and because research coverage, especially of small- and mid-cap stocks is falling, not just in the UK but in the US and elsewhere too.
In the US, fewer than half of stocks are covered by analysts. In the UK the proportion of stocks with no analyst coverage rose from 25% to 30% between 1999 and 2003. In 2002, as few as 5% of companies with a market cap below $25 million were covered by analysts in the US while in the UK that figure was 42% in 2003.
Although fewer than 8% of UK listed companies have market capitalizations of more than £1 billion, they are the subjects of more than 40% of analysts? forecasts.
By contrast, the half of all listed companies that are capitalized at less than £100 million account for fewer than 20% of forecasts.
Although the concentration of research coverage on the largest stocks makes sense for many index-benchmarked fund managers, more active investors would benefit from proper coverage. After all, mid-cap stocks have outperformed large caps in the UK in recent years. The FTSE 100 has fallen nearly 20% over the past five years, whereas the FTSE 250 is up by just over 1% over the same period.
