VideoWhen a former employee of Cohort — a small-cap technical and advisory services provider for defence and security firms — cashed in nearly 20,000 share options on his departure, the firm's stock price dropped 7%. "It's just ridiculous," says Simon Walther, finance director of the £34m (€43m) UK company. "There is a big disproportion between the volumes being traded and the price at which the share is being traded because no one is there to buy 20,000 shares. Liquidity is a big issue for us." That's leading him to wonder what happens when Cohort's share option plans mature and employees go to the market looking for cash to make a big purchase such as a car. "How do I get rid of 7,000 shares?"
Liquidity is an issue that most CFOs of small- and mid-cap companies in Europe must grapple with, not least because competition for investors' attention is growing as more and more of these firms list on exchanges such as the London Stock Exchange's AIM, Deutsche Börse's Entry Standard and Euronext's Alternext.
One way to attract attention is through independent analyst coverage but small- and mid-caps often only have their house brokers to help them get their story out to the market. "There is a weakness in the quality and volume of research generated by stockbrokers for small issuers," says Philip Secrett, head of capital markets at Grant Thornton, an accountancy firm and a nominated adviser for AIM. The London Stock Exchange, for its part, says it is developing a set of recommendations to boost analyst coverage of small issuers, which should be ready by the end of the year. But a spokesperson stresses, "It will be much more about brokering a solution than providing it."
How can under-covered firms persuade independent analysts to publish research on them? CFOs and investor relations experts agree that coverage is driven not only by a good story and growth potential, but also by regular communication and intelligent targetting of the analyst community. The last two factors can eat into a CFO's time though — Walther spends nearly a third of his time out of Cohort's office, knocking on the doors of potential analysts and investors in London.
Is it worth the effort? Absolutely, says Secrett. Coverage drives investor interest and liquidity, which in turn leads to a more accurate share price and a truer company valuation.
And there are other unfavourable consequences of dropped coverage. In a 2007 study — Is there life after loss of analyst coverage? — three US finance academics compared a sample of 2,753 firms that had lost their coverage with a similarly sized control group that had not. Researchers found that one year after losing coverage, the sample companies' performance in areas such as market value, liquidity and institutional shareholder interest had fallen compared with the control group. What's more, the sample companies had a higher probability of delisting. In the first two years after losing coverage, 29% of them delisted, compared with 8% of the control firms. Between two to five years after losing coverage, the percentages increased to 34% and 18% respectively.
Simona Mola, assistant professor of finance at Arizona State University and co-author of the study, says the team came up with two hypotheses. The first — limited attention — argued that investors who can invest in only a limited number of stocks use analysts' reports as a source of information. When an analyst drops a stock, it falls off investors' radar screens. Here, lost coverage is a cause of delisting.
To test the hypothesis, researchers identified a sub-sample of the 163 top performers from the 2,753 firms. They matched the sub-sample against a control group and found that in the year following loss of coverage, there was no difference in performance between the sub-sample and the control group, although the sub-sample still had a higher probability of getting delisted.
That left the academics with another hypothesis — superior information. This suggests that analysts have data that allows them to predict more accurately than investors which companies have a higher probability of getting delisted, and drop coverage in anticipation.
There are two other reasons for analysts to stop following a company. The first is poor performance. Giampaolo Trasi, vice chairman of the European Federation of Financial Analysts' Societies, says, "Systematic disappointment in meeting earnings targets often implies that the company is not paying enough attention to investors' needs." Three consecutive quarters of disappointing earnings can be enough to get dropped. The second reason is monetary, and more relevant to most small- and mid-cap CFOs. If the liquidity of a stock is so low that there is little chance of earning brokerage or underwriting fees from it, analysts are less likely to cover it. This is compounded by the separation of analysts and brokers in investment banks. As a separate function, analysts are a more expensive overhead, which makes them less likely to cover low-return stocks.
Two things may help companies get information about themselves out into the market despite low liquidity. The first is an increase in company-commissioned research. "Because smaller companies become frustrated at the lack of research, they have had to go out and buy [it] from independent research agencies," says John Pierce, CEO of Quoted Companies Alliance, which represents small- and mid-cap listed firms in the UK.
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