Capital Markets

Analyst (Un)coverage Hurting Small Firms

Wall Street analysts have been more likely to ignore smaller companies since Reg FD took effect in the fall of 2000.
Stephen TaubJuly 16, 2004

The decline in analyst coverage of small companies has cost those businesses roughly 138 basis points per year, reports a study from the National Bureau of Economic Research. And Regulation Fair Disclosure (Reg FD) deserves some of the blame, according to the authors, Wharton finance professors Armando Gomes, Gary Gorton, and Leonardo Madureira.

Wall Street analysts have been more likely to ignore smaller companies since the Securities and Exchange Commission’s new rule took effect in the fall of 2000, the study determined. “We find that the adoption of Reg FD caused a significant reallocation of information-producing resources, resulting in a welfare loss for small firms, which now face a higher cost of capital,” stated the study’s abstract.

“This effect was more pronounced for firms communicating complex information and, consistent with the investor recognition hypothesis, for those losing analyst coverage,” it added. “Our results suggest that Reg FD had unintended consequences and that information in financial markets may be more complicated than current finance theory admits.”

The study also pointed out that the loss of the “selective-disclosure channel” for information flows could not be compensated for by other means.

Small companies experienced a 17 percent decline in sell-side analyst coverage after Reg FD went into effect, reported Dow Jones, quoting the study, compared with a 5 percent decline for midsize firms. In contrast, large companies enjoyed an increase of about 7 percent, confirming widespread predictions that Wall Street firms would increasingly focus on large companies after Reg FD went into effect.

Of course, other factors probably came into play. Global stock markets began their multiyear decline around the time that Reg FD went into effect. As Wall Street firms laid off many employees, they moved coverage to more-actively-traded stocks that would presumably generate higher trading revenues from institutional investors.

In addition, New York State Attorney General Eliot Spitzer’s crackdown on Wall Street research departments, and the subsequent settlement, has resulted in an overall scaling back of sell-side analyst coverage.