Call it the sell-side's Project Fear. Early 2018 saw the introduction of the EU's Markets in Financial Instruments Directive II (Mifid II). Thousands of pages of new rules governing the financial sector included provisions on unbundling research from other broking services.
Many feared the rules would have a debilitating effect on the amount and quality of analysts' research on UK companies, with smaller companies especially likely to be neglected. But they were only half right. Or to use analyst speak, perhaps the long-term future of research is a hold, not a sell.
One study found that the amount of sell-side research has indeed fallen post-Mifid II, with 334 listed European firms having lost their coverage entirely. "Fundamentally the make-up of the market has changed and it is now uneconomic for small-cap analysts" to do much research, says Simon French of the financial consultancy Bixteth Partners.
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"We felt we needed to supplement... good stuff... from the brokers with our own efforts," he says. "So we took on an additional research analyst and it means we can do more of our own research [to find] some great investment opportunities."
The target remains a large one. There are 780 small companies on Aim alone and the pre-Mifid II analyst landscape at least acted like a filtering system. They were performing the kind of legwork that many small-cap fund managers have been conducting for a long time, digging in to results statements and talking to management. "In terms of discovery it won't make much of an impact," says Paul Mumford, co-manager for Cavendish's UK Opportunities and Aim funds. "We have traditionally trawled through all the results to get our ideas."
More to the point, he thinks that talking to the companies directly is much more important than getting anything from an analyst. "It's about the vibes you get from the directors, particularly on the long-term outlook," he says. Other small-cap funds may be pleased to find out that their fund managers are also taking the hint and putting in a spot more tyre-kicking.
For individual investors, of course, such opportunities very rarely exist, but in this post-Woodford environment liquidity for any listed company is an issue and it means some companies are having to go the extra mile to communicate their story to a retail investor base.
Moreover, it will be small investors, those who trade in relatively small sizes, who often determine the price of many smaller companies. Firms "have the big blocks on the shareholder register, but the share price is determined by small trades," says Keith Hiscock of independent research house Hardman & Co. "Average trade sizes are low." Some companies have a natural advantage. A consumer-friendly product such as tonic water (Fever-Tree) or chocolate retail (Hotel Chocolat), to cite two popular smaller stocks, can leverage consumers' awareness into the investment sphere. But if, say, you are a logistics company then it will come down to engaging with investment platforms and generating press coverage.
Go your own way
This desire for coverage on the part of both companies and investors has led recently to a plethora of independent research houses growing up in the shadow of Mifid II. The rise of companies such as Redburn, Autonomous Research and the aforementioned Hardman & Co can be viewed as being part of what Shah calls the "democratisation" of research.
Indeed, the flourishing of independent research might see more companies being covered, and in greater detail, than in the pre-Mifid II days, when large institutions did most of the research. Such a flourishing of research will more than see the analyst gap covered; it will also go towards quenching a thirst for more information among small investors. Hiscock cites evidence from the Office for National Statistics from 2016, which found that individuals have the highest propensity to hold non-FTSE 100 shares.
No wonder, says English. "It is among the small caps where you can find the real growth opportunities... this [sector] will include some companies that won't survive; that's the nature of the beast. But sift through the detritus and you can find tomorrow's winners. I think that is what retail investors are cottoning on to."
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