May 10, 2007 6:01 pm

The Short View: Analyst coverage

To be is to be perceived. This philosophy, made famous by the 18th century philosopher George Berkeley and still in the curriculum today, runs into the problem that things must cease to exist as soon as nobody is looking at them. Berkeley invoked God; He is always looking at everything.

New research by a group of US academics shows that this philosophy applies to equity markets. (Khorana, Ajay, Mola, Simona and Rau, P. Raghavendra, ”Is There Life After Loss of Analyst Coverage?” (March 15, 2007). Available at Social Science Research Network. The authors are from Georgia Institute of Technology, Arizona State University, and Purdue University respectively).

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If sell-side analysts stop watching a company and publishing research, chances are that it will soon cease to exist.

Companies that lose coverage do, of course, tend to be small and to be performing poorly.

You would expect them to be more likely to delist. But comparing 2,753 companies that lost analyst coverage between 1983 and 2004, with similarly small and poor-performing companies that kept coverage, the research found that losing coverage increased the chances of delisting soon after by 34 per cent. This is far more than can be explained by chance.

Unsurprisingly, companies that generate less work for a broker’s investment banking division are more likely to lose coverage. This does not necessarily reflect on their value as an investment. But once out of sight, as far as investors are concerned, a company ceases to exist. If brokers are not doing it for them, individuals will not do their own research.

How to profit from these insights? First, setting up a sell-side research firm might be lucrative. The researchers cite companies that pay brokerages to initiate coverage of them, even if it is a “sell”. They are rational to do so.

Also value investors, who look for undervalued stocks, should be careful. Under-researched companies are a good place to look. But unless there is some catalyst to release its value, it may be unwise to invest in an uncovered company.

Once out of sight, even if they are at a bargain prices, companies cease to exist – even if God is still looking at them.

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