In a recent story by Reuters: Funds target ‘unknown’ stocks as Wall Street cuts analyst jobs, Paul S. was asked about the effect of Wall Street cutbacks on research coverage:

Sonkin estimates approximately 15 percent of the companies in his portfolio have no sell-side analyst coverage, leaving them more likely to be overlooked.

“What we’re looking for is some kind of edge, and if there are fewer analysts covering a stock there’s a greater chance that it will be mispriced,” he said.

Like Sonkin, other fund managers are increasingly turning to small-cap companies with no sell-side coverage, hoping an industry-wide pullback in analyst research will allow them to buy into more ‘unknown’ companies before they get on other investors’ radar.

The presumption is that less research coverage will result in an inefficient stock price. As we discuss in Chapter 5 of our book, How to Think About Market Efficiency, a mispricing is either caused by information not being adequately disseminated, a systematic error in processing or a failure of incorporation as seen in the figure below:

Lack of sell side research can mainly impact dissemination and processing. If the analyst gathers non-material nonpublic information and by using his domain specific knowledge arrives at a conclusion which is material, this can correct an inefficiency.  Obviously if the company has no sell side coverage, this can’t take place.

But one can’t narrowly define “research coverage” solely as sell side coverage.  The buy side counts too.  If there are 50 buy side analysts following a stock with no sell side coverage there is a strong possibility that its not mispriced.

One could argue that sell side coverage could actually cause mispricings. If investors rely on the sell side analyst and don’t do their own research this lack of independence could cause a systematic error in processing.

So does less or no sell side coverage result in mispricings?  It depends.

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  1. John Emerson

    I discussed in 2013, the three U’s of value investing which account for the mispricing of stocks a few years back.

    Lack of sell side coverage falls under the undiscovered category.

    I originally discussed the three UUUs in the epilogue of my investing saga in 2011: “The aspiring investor must also understand how opportunity arises. It has been my experience that value opportunities invariably result from what I call the “UUU.” Either a potential value stock is: Unloved, Undiscovered or not Understood. Of course many value stocks may overlap the various categories. In other cases, it is the investor, not the market, who is mistaken about the intrinsic value of a stock.”

    It would appear that all great minds think alike.

  2. Paul Sonkin

    Good point John. We would say that of your three categories, “Undiscovered” is an inefficiency due to dissemination of information, while “unloved” and “not understood” are inefficiencies due to systematic errors in processing – either a lack of diversity or a breakdown of independence. We discuss this in our book in chapter 5 – How to Think About Market Efficiency, Chapter 6 – How to Think About the Wisdom of Crowds and Chapter 7 – How to Think About Behavioral Finance.

  3. John Emerson

    Thanks Paul, it would seem that I need to put your book on my reading list. Hope your sales are going well.