Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
As a small cap value investor, I recognize that many of the stocks in my portfolio have little or no sell-side research coverage. In fact, I often argue that this neglect creates the value opportunity that will be corrected as analyst coverage emerges to fill the void. As further evidence, I would point out that back in 1985, Avner Arbel, a professor at Cornell University, wrote a book that asserted that both small cap and value stocks were highly correlated with analyst neglect. Neglect is in fact a bigger contributor to value added than either a small cap or value strategy alone.
Now, a recent article in the Britain’s Sunday Times by reporter Sabah Meddings suggests that there may be a different outcome from a dearth of analyst coverage – and it will not be positive.
At the beginning of 2018, British regulators introduced the Markets in Financial Instruments Directive II (MiFID II), which requires fund managers to pay separately for investment research produced by brokerage firms. Previously, this sell-side research was provided “free”: It was bundled into the commissions charged for trading shares on the assumption that institutions favour brokers that provide continuing research coverage of their holdings. Now that clients have to pay for research coverage with hard cash, there has been a dramatic reappraisal of its value and budgets have been cut by between 20 per cent and 30 per cent.
The intent of MiFID II was to increase transparency and reduce costs for investors and this goal has apparently been achieved: Last year, British investors saw a reduction in charges from this source of about £180-million ($296-million) according to the Financial Conduct Authority.
The collateral damage is that fewer analysts are now covering companies and more of those analysts are “cheaper” junior analysts. As a result, financial shenanigans are less likely to be spotted before they blow up and destroy investor value in the market. The article lists several recent British financial train wrecks including long-haul trucker Eddie Stobart Logistics PLC, pastry shop chain Patisserie Valerie and infrastructure builder Carillion PLC, which also had repercussions for its Canadian division. All of these had suspect accounting statements that could have been identified by sharp-eyed analysts – according to several forensic accounting firms that have set up to fill the vacuum created by this hollowing out of the analyst community. These firms are providing seminars and mini-courses on financial-statement analysis for large buy-side clients such as pension funds and hedge funds.
At this point, I part company with the thesis of the article for two reasons.
First, I cannot recall many examples in which sell-side analysts blew the whistle on accounting excesses in the Canadian market. Most of the time, they are cheerleaders for their corporate clients and are reluctant to rain on the parade. The recent uptick in British financial disasters may coincide with reduced analyst coverage, but as we all know, correlation does not prove causation.
Second, if companies are truly exploiting this lack of scrutiny of their financial statements, then the solution is not to reinstate conflicted brokerage research, but to pursue the business model that is apparently evolving: Buy-side investors either do their own research in-house or they pay for it from independent research houses. The cost to investors will go up, but transparency and value for money will have been achieved.
Canadian regulators have been monitoring developments surrounding the introduction of MiFID II and, at this stage, have seen no reason to change the current policy that permits the bundling of research and order execution into a single commission. As a result, there is no reason to fear a wholesale eradication of sell-side research in this country from a similar regulatory intervention. But the trend toward low-fee exchange-trade funds and index funds will reduce the supply of funding available for investment research on both sides of the Street, so the end result may very well be the same.
Although I may not agree with the logic sequence set out in the Sunday Times article – MiFID II equals fewer sell-side analysts equals more corporate fraud equals more investor losses – I will concede that not all neglected stocks are hidden bargains waiting to be discovered.
As I have learned from experience, some of them will decide that the cost of remaining a public company is simply not worth the benefit: They will go private at a modest price because there are no other bidders. Others may leverage up the balance sheet in an effort to grow to a size that merits wider investor attention and self-destruct a few years down the road. A final group of value traps will always be on the cusp of a breakthrough that will vault them into a new phase of growth and profitability, only to lapse into the comatose state that characterizes their industry environment.
Whether value trap or not, all of these companies look the same at the time of purchase. In the years ahead, an investor with a focus on neglected stocks, whether large or small cap, will need to rely heavily on internally generated research and run a widely diversified portfolio to be sure of success.
Robert Tattersall