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.