Fee-Based Research: The Good, The Bad And The Ugly

By Rick Wayman AAA

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.

SEE: What Is The Impact Of Research On Stock Prices?

Defined
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.

The Good
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
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 Ugly
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.

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