Finding Undiscovered Stocks

Wall Street tends to be focused on a minority of large-cap stocks - after all, that's where the investment banking (and big profits) are. As a result, small/micro/nano-cap stocks (however you want to classify them) with solid fundamentals and great investment potential are sometimes left to languish without a way to get their story to individual investors. The challenge for investors is to find reliable sources of information on these "undiscovered" stocks.

Why Is Wall Street Focused on a Small Number of Big-Cap Stocks?
Wall Street focuses on a very small number of big-cap stocks because that's where the money is, and because mergers eliminated independent regional brokerage firms that used to support small-cap stocks. Investment banking now drives profitability, and the bigger deals have the biggest margins. Brokerages typically only make a market in the most liquid stocks (which are also big-cap names) in order to generate enough volume to justify their existence. With every investment banker vying for the same deal, research coverage has become a lemmings' market with everybody following the same stocks.

Merger activity cut down small regional brokerage firms that provided financial support to small-cap stocks. These regional brokerage houses provided investment banking, market-making, and research coverage to companies in their market area. This provided small-cap firms with access to capital and a growing shareholder base. As larger brokerage houses and banks acquired these smaller firms, however, their activities were redirected to the large-cap sector. Companies that do not meet a specific market cap or do not have the potential to yield a sizable investment banking deal are sometimes dropped from coverage lists as a result.

Why Look at Small/Micro-Cap Stocks?
If the pros are focusing on the big caps, why should you look elsewhere? The reason is value. Granted, some of the companies at this end of the food chain may not warrant any attention. But there are many companies with solid fundamentals that are undervalued simply because investors are not aware of them. "Undiscovered" stocks will tend to get discovered when they are acquired by larger companies, which tends to send the stock shooting up. These are stocks that were found to be extremely undervalued by the acquiring company, but not by Wall Street because of the lack of coverage.

To summarize, Wall Street is focused on a small number of stocks for the following reasons:

  1. Low volumes on small caps tend to force firms to trade only the more liquid (big-cap) stocks.
  2. Investment banking drives profitability and the biggest profits lie with the biggest deals.
  3. Mergers and acquisitions have eliminated small regional firms that used to support stocks as they grew from micro-cap to mid-cap.

This scenario has created an information gap between investors and the large number of good companies without research coverage.

What Investors Need to Know
Investors must differentiate between substance and hype. Here, listed in order of importance, are some questions to ask to ensure you are reading professional research:

What Is the Nature of the Relationship Between the Company and the Analyst?
The nature of the relationship should be clearly disclosed in the analyst's report about a particular stock. A disclosure statement is required by Securities and Exchange Commission regulations and is usually found at the end of the report (and in small type). Information as to what, if anything, has been paid for the report is usually placed in the middle or end of the small type. If you cannot find a disclosure statement, beware. If the nature of the payment is not disclosed, and the report has not come from a known brokerage or investment banking firm, you may not be looking at an objective analysis.

Compensation Structure
A fixed-fee relationship is preferable to one in which the analyst is paid in some form of equity (stock, warrants or stock options) and/or receives a bonus if the stock appreciates. The absence of an "equity kicker" significantly decreases the risk that the writer is hyping the stock to maximize his or her income. A fixed-fee relationship also indicates that the information source should be a more reliable source of information for the investor, at least during the term of the engagement. Generally, a fixed-fee relationship will require the research firm to cover at least a one-year period and call for the issuance of quarterly reports on a timely basis. In contrast, "pump and dump" shops will write on a company only as long as it will take to achieve their schemes.

Does Compensation Adversely Impact the Analyst's Objectivity?
Generally speaking, professional analysts are only as good as their last ideas. To be successful, analysts must build their credibility one good stock at a time. This "invisible hand" forces professional analysts to focus their efforts on finding and promoting the best investment ideas and developing a reputation as being a source of good information.

Wall Street research used to be viewed as objective because there were no fees paid by the company being researched; however, now there is increasing debate as to how objective a Wall Street analyst can be. The reason for this is that analyst compensation packages generally consist of a base salary, a percentage of the investment banking deals in which they are involved and a percentage of the trading volume generated by their research coverage. With this arrangement, it is no wonder that investors are beginning to question Wall Street's objectivity.

So now this question emerges: how objective can fee-based research be when analysts are being paid directly by the company being analyzed? Many users (buy-side, sell-side and individual investors) feel that fee-based research is more objective because the compensation is fixed and not dependent upon investment banking deals or stock trades. Overall, the best determination of objectivity is the quality of the research.

What Is the Quality of the Research?
Readers need to judge the tone and content of a research report. A "report" that is full of promotional language and is sparse on details is a hype piece and should not be used in making investment decisions. This is a type of fiction that talks about how the stock will "rocket" to new highs and how the author "guarantees" a huge return on your investment.

Beware if the word "guarantee" is used anywhere in a report - nothing is ever guaranteed.

What an Objective Research Report Should Contain
A professional research report provides a balanced view by discussing a firm's competitive advantages, providing an overview of the prospects/challenges facing the company and the industry, analyzing operating results against a relevant peer group and providing earnings estimates based upon clearly-stated assumptions. The "G" word (guarantee) is never used. The report does deal with assumptions and expectations with which the reader may disagree, but they are presented for consideration.

Continuous Coverage
Due to the significant amount of time and effort required to initiate research coverage on a stock, the analyst is making a long-term commitment to following the company and the industry. Consequently, professional objective coverage usually means that the writer has a long-term commitment and will therefore be a reliable source of information for a long time. This is in contrast to others who will issue "reports" only until they have achieved their pump and dump goals.

What Are the Author's Credentials?
The report should indicate the author's experience and background. A professional research report clearly identifies the writer and his or her contact information so that you can investigate the author and his or her firm.

Credentials may not always determine who is a better analyst, but they do indicate a person's desire to reach a certain level of competency. An analyst who has 20 years of experience but does not have an MBA could be a better stock picker than a newly minted MBA. But having an MBA or CFA generally indicates that the analyst has attained a certain level of knowledge.

The Chartered Financial Analyst (CFA) designation is a key credential. The charter is issued by the CFA Institute, which is an international society of financial professionals. To achieve the designation, one must pass a series of three six-hour exams (held once a year) on ethics, government regulations, economics, accounting, stock and bond analysis, and portfolio management. Not having a CFA does not necessarily mean that an analyst is not competent, but it does signify that the person has passed a series of difficult and demanding tests and has a proven a mastery over a body of financial knowledge. More importantly, however, the CFA charter indicates its holder has a commitment to a high standard of ethical and professional standards.

The Bottom Line
Fee-based research is a useful way to bridge the gap between companies and investors looking for new ideas and undervalued stocks; however, both parties must be aware of the differences between an objective research report and a hype piece designed to manipulate a stock's price. Likewise, under-followed companies need to find reputable independent research firms to reach the growing number of individual investors who are making their own investment decisions.