Because it refers to something that bridges the information gap created by Wall Street, fee-based research is a term that investors need to know about. This article will define the term and discuss how to decipher the good from the bad and the ugly.
Fee-based research is research compiled by an independent research firm that is compensated by the company that is the subject of the report (also referred to as the "subject company"). This research is different from subscription-based research, whereby the reader pays for research reports on a pay-per-view basis or with an annual subscription. And like investors using subscription-based research, investors using fee-based research need to know how to tell the difference between legitimate, objective research and reports written to manipulate stock prices.
Objective fee-based research plays an increasingly important role in today's market because it provides investors with information that would otherwise not be available. To fully appreciate how important this information service is, we need to review a bit of history.
In the beginning, the research departments of brokerage firms provided research on stocks of all market capitalizations. Wall Street firms tended to follow larger-cap stocks while regional firms followed smaller-cap stocks in their backyards. This allowed small brokerage companies to have access to capital, which allowed the small caps to grow to a point at which they were "discovered" by Wall Street. And investors saw that this was good.
But things changed when deregulation resulted in smaller commissions, shrunken trading spreads and industry consolidation. These events resulted in a smaller number of larger firms, which focused only on big-cap stocks because the big-cap stocks had enough profits to fund research departments. Consequently, thousands of small and micro-cap stocks were orphaned - dropped from research coverage - because they did not provide enough profit potential to the brokerage firm. If a stock did not generate a certain level of trading volume, or if the company did not have the potential for an investment banking deal of a specific amount, the stock was dropped from coverage. This left thousands of companies in the wilderness and unable to convey their story to investors. This was bad, but investors seemed unaware of the change because they were worshipping at the bull market of the late 1990s.
SEE: Free Markets: What's The Cost?
Onto the scene came fee-based research with a mission to bridge the information gap and guide orphaned stocks to the promised land of investor awareness. The independent analyst spends a lot of time and expense preparing fundamental research that is free to investors. In this way, the company's information is made available to the widest possible audience.
The increased need for fee-based research has been recognized by the investment community. In January 2002 the National Institute of Investor Relations (NIRI) issued guidelines for the use of fee-based research.
The bad thing is that for most of its history, fee-based research has been used to manipulate stock prices. Unscrupulous firms used this "research" and boiler-room operations to pump and dump stocks while supposedly legitimate research was done by Wall Street firms. This resulted in a stereotype that all fee-based research is illegitimate, but while there are still many cases of market manipulation, investors are taking a closer look at fee-based research.
Investors read fee-based research because things changed in 2002. Wall Street research is no longer viewed as legitimate since it has been tainted by investment banking considerations. Realizing that the Street follows a limited number of companies, investors today are more educated and are looking for other sources of information.
The really ugly part of all this is that there are many small-cap companies with good investment potential that remain orphaned because they do not believe that investors give any credibility to fee-based research. They continue to wander in the wilderness, expecting the Street to eventually recognize their worth and start covering their stock.
As these orphaned companies wait for the Street, their competitors are discovering that the orphaned shares are undervalued and acquire the orphan. Based upon our research, the average take-out premium for an orphaned company is about 20%. Had orphaned companies taken the initiative to reach investors by using fee-based research, they probably would not have left so much money on the table.
The Bottom Line
In this brave new world investors are more educated and are looking beyond Wall Street for their information. Legitimate fee-based research is becoming more recognized because it fills the market's need for objective information. The challenge for both investors and small-cap companies is to differentiate between the good and bad independent firms.
Fortunately, there are two good sources of information that will help investors and corporate management spot legitimate fee-based research. The first is an article entitled "Six Signs of an Objective Research Report", in which I detail how a reader can determine the objectivity of a research report.
The other source is the Research Objectivity Standards that have been proposed by the Association for Investment Management and Research (AIMR). These proposed standards detail the process required to issue an objective research report, and they provide the reader with a checklist to use in evaluating any research report. It also provides corporate management a list to use when evaluating the services of independent research firms.
ProfessionalsMutual funds are a good choice for emotional investors. Here are five popular funds to consider.
Investing NewsHere are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
Stock AnalysisUnderstand what value hedge funds can provide investors in the financial sector. Learn about seven hedge funds that pay consistent and high dividends.
Mutual Funds & ETFsExplore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
Chart AdvisorInvestors are keeping an eye on the transportation industry. We'll take a look at the trend direction and how to trade it.
InvestingBeing vigilant about the amount you pay and what you get for is important, but adding ETFs into the investment mix fits well with a value-seeking nature.
InvestingFinancial literacy is the confluence of financial, credit and debt knowledge that is necessary to make the financial decisions that are integral to our everyday lives.
Mutual Funds & ETFsLearn about the top three metals and mining exchange-traded funds (ETFs), and explore analyses of their characteristics and how investors can benefit from these ETFs.
Bonds & Fixed IncomeTaking on high-yield bond investments requires a thorough investigation. Here are looking the fundamentals.
RetirementRobo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
A hedge fund analyst primarily provides support to a portfolio manager on how to best structure the hedge fund's investment ... Read Full Answer >>
Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>