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?

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.

Related Articles
  1. Mutual Funds & ETFs

    3 ETFs to Consider Before an Interest Rate Hike

    Learn about potential impacts of the Federal Reserve boosting interest rates and three ETFs that can help you capitalize on the perceived December increase.
  2. Retirement

    The Best Strategies to Maximize Your 401(k)

    Use these tips to watch your retirement nest egg grow from quarter to quarter.
  3. Mutual Funds & ETFs

    A Complete Guide to Tax Loss Harvesting With ETFs

    Using exchange-traded funds (ETFs) to harvest tax losses can be a smart way to maximize your portfolio's tax efficiency.
  4. Retirement

    What Your 401(k) Can Look Like in the Next 20 Years

    Discover how time and compounded growth of earnings can help even a modest 401(k) plan balance grow to a significant sum over a period of 20 years.
  5. Taxes

    5 Tax Moves To Make Before Year End

    Taxes aren't avoidable, but you shouldn't pay more than your fair share. Here are five moves you can make at year's end to lower your tax bill.
  6. Retirement

    Roth 401(k), 403(b): Which Is Right for You?

    Learn how to decide between a traditional or Roth version of the 401(k), 403(b) or 457(b) retirement plans to help you build your nest egg.
  7. Mutual Funds & ETFs

    Why ETFs Are a Smart Investment Choice for Millennials

    Exchange-traded funds offer an investment alternative to cost-conscious millennials who want to diversify their portfolios with less risk.
  8. Mutual Funds & ETFs

    Should Investors Take a BITE Out of This New ETF?

    ETF BITE offers a full menu of restaurants. Is now the right time to invest?
  9. Financial Advisors

    5 Things All Financial Advisors Should Know About ETFs

    Discover five things all financial advisors should know about ETFs, including when ETFs may be a better choice for your clients than mutual funds.
  10. Stock Analysis

    The Top 5 ETFs to Track the Nasdaq in 2016

    Check out five ETFs tracking the NASDAQ that investors should consider heading into 2016, including the famous PowerShares QQQ Trust.
  1. Can a 401(k) be taken in bankruptcy?

    The two most common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Whether you file a Chapter 7 ... Read Full Answer >>
  2. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  3. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  4. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  5. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  6. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
Trading Center