Small Cap Research Can Have A Big Impact

By Lisa Smith AAA

Some investors have expressed surprise that so many small-cap companies continue to focus their investor relations efforts on getting the attention of institutions, rather than pitching their wares directly to the public. While it is certainly true that many of these companies will fail to generate the kind of attention among Wall Street analysts that companies listed on the Dow Jones Industrial Average (DJIA) enjoy, it is also true that generating coverage by a single big-name analyst is likely going to be more worthwhile than capturing the attention of 1,000 individual investors.

Institutional Attitudes
From the other end of the spectrum, Wall Street's limited attention to small caps is not surprising. The large institutional investors run Wall Street research, which caters to the needs of institutional shareholders.

The link is an obvious one in that the large banks, mutual funds, pension funds and endowments that make up the bulk of institutional investors account for the bulk of the stock market's daily trading volume and the bulk of the fees paid to Wall Street. There's no mystery here: talent and resources follow the money. This often means that small cap stocks escape the radar when it comes to Wall Street research

Another important point to consider is liquidity. Many publicly-traded stocks are caught in liquidity limbo: they have good fundamentals but not enough trading volume for large institutions to take notice. Large mutual funds trade billions of dollars. In order to buy a large enough position in a stock for the holding to have any impact at all on the overall portfolio, the big funds need to make big purchases of securities.

A single fund might need to purchase nearly every outstanding share of a small company's stock just to get enough shares to represent 5% of the fund. If the fund ever needed to sell, it would be at the mercy of buyers because the marketplace for those shares would be illiquid. Trading shares of a company listed on a major market index such as the Dow or S&P 500 is a much safer bet.

The Impact of Individuals

Individual investors have a larger impact today than ever before. First, the Internet provides the individual with the power to do his or her own research and make trades. Secondly, individuals advance their education every day thanks to the information provided in the financial press and investment-related websites.

When the SEC adopted Regulation FD (for "fair disclosure") in 2000, individual investors got more of a level playing field with their institutional counterparts. The law prohibits all publicly-traded companies, except for investment companies (other than closed-end investment companies), from disclosing information to securities market professionals, such as securities analysts or institutional investors, before disclosing the information to the public. Professional research can also be purchased.

While professional investment firms still have vast resources not commonly available to individual investors, if you have the time and energy to do your own research, you can get equal access to the data. Overall, the Internet, investor education efforts and legislative changes have combined forces to reduce the individual investor's dependency on large Wall Street brokerage firms.

DIY Research
When looking at small-cap companies, even though you won't likely be able to access or find research reports, it is important to still do your own due diligence. Thankfully, through greater access to information from increased laws and the use of the Internet, this has become easier than ever. It is important to gain a full understanding of the small cap's business, how the company makes money and its plans to grow. Also, ask yourself whether the company's revenue is sustainable and determine whether it is making money. If not, how long will it be until the company becomes profitable? Does the company have the funds to sustain these losses?

If you want to try your hand at besting the big boys and doing your own research, the tools are available to help you give it try. On the other hand, just because you can do something doesn't mean that you should. If you choose to try, be smart and use only a small portion of your assets to invest in the little gems that you uncover, and leave the rose-colored glasses at home.

The Bottom Line
Studies have shown that Burton Malkiel's "blindfolded monkey throwing darts at a newspaper's financial pages" may indeed be able to select a portfolio that would beat the experts, as demonstrated by picks from celebrity centerfolds and Wall Street Journal staff members, but just as the experts can and have been beaten, you can be beaten too. So, test your skills and enjoy the experience, but don't bet the ranch on your picks.

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