Did you hear something? I'm no entomologist, but I swear that was the sound of crickets coming from lower Manhattan.
According to a recent FactSet Research Systems study featured in The Wall Street Journal, from September to mid-May there were about 2,200 cases of Wall Street analysts formally dropping company coverage. That represents about a 25% drop in overall research for the period, just another example of continued fallout from the economic crisis.
You might think that's great. It means fewer inane seven-part questions on conference calls, more reasonable growth estimates, and a longer-term mind-set for the markets.
That may all be true, but as individual investors, our relationship with these analysts is actually a lot more important than we may care to admit.
See, analysts provide classes of investors with critical company information, stoke interest in a wide range of stocks, and consequently make the markets more liquid.
That liquidity means increased trading, which tightens securities' bid-ask spreads, which in turn makes it easier to buy and sell stocks without drastically affecting the price. That's crucial -- especially when it comes to small caps.
Smaller companies generally have less analyst coverage to begin with, but they're losing even more this year. According to the FactSet study, in the first five months of 2009, a whopping 25.7% of small-cap companies announced an instance of dropped analyst coverage. In 2007, that figure stood at just 6.4%.
By contrast, larger companies have reported a 15.5% dropped coverage rate so far this year, but many still enjoy sufficient coverage from Wall Street. Telecom titan Verizon (NYSE: VZ ) , for instance, recently lost five analysts, but still has more than 20 sell-side analysts covering its every move.
What's more, the lack of information in the market makes it more costly for small caps to raise public money. This was the topic of a 2007 study demonstrating that companies without analyst coverage have substantially higher cost of equity (that's the minimum return that equity holders demand from their investment).
The more capital costs a company, the greater the risks it will need to take to satisfy its investors -- which can lead to more volatile results.
What this means for you
Still, there have always been some advantages to a lack of Wall Street coverage. Individual investors can beat the big boys to the punch on underfollowed stocks, especially in the small-cap arena.
You as an individual investor have a much better chance, for instance, of identifying an information advantage on an undercovered small retailer like Fossil (Nasdaq: FOSL ) than well-known names like Gap (NYSE: GPS ) and Nordstrom (NYSE: JWN ) .
This advantage still holds true, of course, but the further decline in analyst coverage means it could take even longer for the big money to recognize a small company's success story.
Just a little patience
When it comes to small-cap holdings, then, we as individual investors would be wise to remain patient, because the market can't ignore these stocks forever, especially those that are:
- Financially strong.
- Well managed.
- Dominant in their market niche.
If those five criteria seem like a killer combination, they are. They are also the same qualities that Starbucks (Nasdaq: SBUX ) , Wal-Mart (NYSE: WMT ) , and Home Depot (NYSE: HD ) possessed early on. And those are some of the best stocks of our generation.
That's why co-advisors Seth Jayson and Andy Cross use these very criteria to pick out stocks for Motley Fool Hidden Gems subscribers. After all, it stands to reason that the best stocks of the next 10 years will also possess these traits.
One stock the team feels fits the profile is Brink's Home Security, provider of home security systems to over 1.3 million customers. The recent spin-off from The Brink's Company only has five analysts following it, but has a strong balance sheet, is free cash flow positive, and has a high level of recurring revenue.
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Fool analyst Todd Wenning hopes you're enjoying your summer. He owns shares of Home Depot, a Motley Fool Inside Value pick. Starbucks is a Stock Advisor selection. Starbucks and Wal-Mart are Inside Value picks. Fossil is a Hidden Gems recommendation. The Fool owns shares of Starbucks, and has one wicked disclosure policy.