The Flight of the Sell-Side Analyst

Sell-side analysts are fleeing smaller issuers, leaving executives at those abandoned companies to fend for themselves in dealing with large investors. Indeed, analysts who work for the sell-side research units of large brokers and investment banks are heading en masse for the economic shelter of large-cap companies.

The reason for the exodus? Large-caps boast heavily-traded stocks — and their whopping fees — as well as the potential for profitable investment-banking business.

The movement to big-company stocks has, however, been spawning a large share of losers. According to Reuters Research, there's been a 13 percent increase in the number of companies that lost sell-side coverage completely since 2002. The researchers calculate that 666 companies of the 4,075 in its database had been "orphaned" by sell-side analysts as of January 2004. Two years ago, only 85 companies were left without analyst coverage.

Most of the new orphans are small: 97 percent of the companies left without analyst coverage this year have a market cap under $1 billion. The bulk of the remainder consists of big-caps that lack heavy trading volume. All but eight of the 19 large-cap companies that lack coverage came in under 1 million shares of total volume over the last 10-day period ending July 1. By way of contrast, heavily covered giants like Microsoft Corp., General Electric Co., and Ford Motor Co. traded between 90 million and 500 million shares during that same period.

The effects of the analyst migration extend beyond the orphans to those companies that are hanging on by a thread. Reuters reports that 380 are down to a pair of analysts tracking their stock, while 473 companies have just one. At such companies, executives will surely be under increasing pressure to keep from losing their existing coverage or to replace lost analysts in some way.

That's because decreasing coverage means a dwindling exposure to investors — a situation that makes raising capital difficult. "If you don't have analyst coverage, investors don't really know about you," warns Ashwani Kaul, a senior market analyst at Reuters Research. At the same time, Kaul reckons, the analyst rush to big-caps creates "a void for investors who are interested in small- and mid-cap companies."

Sell-Side Economics
Even if analysts had the will to fill the void, however, the bodies just aren't there. Layoffs and voluntary exits from the sell-side-research business have gone hand-in-hand with a sputtering stock market, explains John McInerney, a senior director at Citigate Financial Intelligence, a communications firm. As a result, the number of sell-side analysts has decreased over the last few years by 15 percent to 20 percent, estimates McInerney, whose firm recently conducted 90 interviews with corporate issuers as well as sell-side and buy-side analysts.

For many sell-side analysts, choosing which companies to cover seems thus to have become a matter of triage. With the analyst force shrinking, individual researchers have been scrambling to cover their existing lists plus those of the departing analysts, according to issuers surveyed by Citigate. They've also had to hustle to cope with accelerated regulatory filing requirements that force the researchers to squeeze more financial-statement reviews into the same work week.

The situation of fewer analyst bodies doing more work can also lead to "analyst churn." The increased switching of analysts from company to company is the most significant change in investor relations over the past few years, notes Bruce Nolop, CFO of Pitney Bowes Inc. The turnover, he explains, forces the Pitney Bowes investor-relations team to constantly reeducate analysts about the not-so-easily-defined company. A venerable postage-meter manufacturer with a $10 billion market cap, the company has made a recent foray into mailroom services and outsourcing.

In December 2002, 10 sell-side analysts covered Pitney Bowes, Nolop recounts. But by April 2004, that number had dropped to five — three of whom are still new to the company story, having come on board since 2002. That's left Pitney Bowes with only two veterans, Carol Sabbagah of Lehman Brothers and Shannon Cross, formerly of Merrill Lynch, now with the eponymous Cross Research.

Besides the diminished analyst workforce, Wall Street economics are also spurring shifts in coverage. In effect, the research subsidiaries that employ sell-side analysts aren't self-sufficient. Investment banks and brokerage houses derive operating profits from investment-banking fees and share-trading commissions, not analyst reports. In the end, sell-side research tends to be a loss leader, bundled for clients along with lucrative services.

Thus, it's the fees and commissions that "drive analyst coverage," maintains Reuters' Kaul, "because that is where the money is." He contends that many small-cap and mid-cap companies that have great investment potential don't garner coverage because they don't represent a substantial source of profit for the firms.

Others agree with Kaul's assessment. San Francisco-based investor-relations consultant Peter Ausnit, a former sell-side analyst, predicts that over the next decade, sell-side research sponsored by big financial-services firms will increasingly focus on large companies that support Wall Street's revenue model. Further, analysts tied to big Wall Street firms will soon focus on "only a handful of big-cap stocks that provide sufficient profit margins," predicts Richard Wayman, president of researchstock.com.

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