Daily Management Review

As Wall Street Cuts Analyst Jobs, Funds Target 'Unknown' Stocks


As Wall Street Cuts Analyst Jobs, Funds Target 'Unknown' Stocks
Hot stocks like Google-parent Alphabet Inc and Visa Inc. are being outpaced by shares of industrial products maker Handy & Harman Ltd with a nearly 30-percent gain in 2017. Yet, in large part because no sell-side research analysts publish any estimates of its earnings, few on Wall Street have ever heard of the $412-million market-cap company.
But for Paul Sonkin, a portfolio manager at Gabelli Funds, whose firm owns shares of Handy & Harman, that lack of information is a boon. Approximately 15 percent of the companies in his portfolio are more likely to be overlooked because they have no sell-side analyst coverage, Sonkin estimates.
"What we're looking for is some kind of edge, and if there are fewer analysts covering a stock there's a greater chance that it will be mispriced," he said.
With the hope that an industry-wide pullback in analyst research will allow them to buy into more ‘unknown’ companies before they get on other investors’ radar, like Sonkin, other fund managers are increasingly turning to small-cap companies with no sell-side coverage.
Small-cap companies that are mispriced and potentially undervalued, possess an advantage over the long term if they have the capacity to conduct their own research and such companies  are being seen more due to the decline in research coverage, says top-performing fund managers at Fidelity, Janus Henderson, Hodges Capital and Baron.
According to a Reuters analysis, there has been a jump of 30 percent over the last 3 years in the overall number of companies in the small-cap benchmark Russell 2000 that receive no formal attention from Wall Street research firms.
And left essentially as a black box for investors without the time or resources to analyze a company are a broader number of small-cap companies – including household names Tootsie Roll Industries Inc, Revlon Inc, and Ruby Tuesday Inc due to that cutback. Meanwhile, money into firms that few on Wall Street know anything about is being put by investors in index funds that track the Russell 2000.
In part by improving investor recognition of the company and increasing its liquidity, an analyst initiating coverage of a stock pushes share prices higher, numerous academic studies have shown. Once an analyst began tracking the company, there is an average jump of 4.8 percent for stocks that traded for at least one year without research coverage, found a study published in Financial Management in 2008.
An unintended consequence of the index investing boom is the focus on companies with no analyst coverage. According to the Investment Company Institute, up from 24 percent in 2010, approximately 42 percent of all assets in stock funds are now in passive funds that track indexes.
Research staffs, which had long supplied information about small companies in hopes of generating trading commissions, have been forced to be cut by brokerage firms because of fewer investors buying and selling individual stocks.
A hole in information that is unlikely to be filled quickly, has been left as brokers such as BB&T, Nomura, and Avondale have shut down whole research divisions over the last 12 months. And as investment banks reshape operations to adapt to the popularity of indexing, the total number of analyst reports being produced will fall by at least 20 percent, estimates BCA Research, an independent Montreal-based firm.
“Portfolio managers are increasingly relying on algorithms to track any changes in a stock, not a human doing a report," said Evan Pondel, president of Los Angeles-based investor relations firm PondelWilkinson Inc.