Hedge Fund Urges Small-Caps to Pay for Research After MiFID

(Bloomberg) -- Add another group to those disgruntled by MiFID II: small-cap fund managers.

London-based Toscafund Asset Management wrote a letter this month to about 30 small and mid-sized companies urging them to pay for research on their own stocks, or else face being abandoned by the investment community once Europe’s revised Markets in Financial Instruments Directive kicks in from January. The $3.5 billion asset manager said it’s been a significant investor in U.K. small-caps since its founding in 2000.

“The impact of MiFID II on listed small- and medium-sized companies has the potential to be devastating if independent research coverage ceases or is significantly diminished,” according to the letter, which was seen by Bloomberg News and confirmed by Toscafund. Losing analyst coverage will result in “a lack of liquidity in a company’s stock and discourage investors from investing,” it said.

Discontent with MiFID II ranges from stock-exchange operators irritated with compliance burdens to overworked lawyers, but most of the attention has focused on brokerages that won’t be able to give clients research for free. Most observers predict that means a lot less coverage for small-caps, as it won’t be cost-effective for banks to provide.

Value Traps

But while a research shortage has been widely anticipated, the knock-on effects are less clear. Quantitative funds may not bother generating the liquidity in certain stocks that they do today without analysts’ estimates as a catalyst in their trading models, according to Steven DeSanctis, an equity strategist at Jefferies LLC.

And while stock pickers could benefit from the diminished competition to uncover investing ideas, they risk getting burdened with something they can’t sell if a small-cap languishes in obscurity.

“You can be exposed to a company that’s doing fantastically and growing its earnings -- but until there is a reason to draw the market’s attention to it, then that company can quite happily de-rate," getting cheaper relative to its earnings, said Andrew Neville, who leads Allianz Global Investors’ global small-cap focused funds from London. “You could end up in a value trap for longer.”

Value traps refer to stocks that are cheap when compared to the profits they generate and their competitors -- and, for whatever reason, stay that way, disappointing bargain-hunting investors. That would be a reversal of fortune given how small-caps have outperformed.

The MSCI Europe Small Cap Index is up about 24 percent this year through Nov. 13, outpacing the 18 percent gain by the MSCI Europe Index. T. Rowe Price’s European Smaller Companies Equity Fund returned 34.6 percent during the period, while Henderson’s European Smaller Companies Fund gained 32.5 percent, according to data compiled by Bloomberg.

Hedge Fund Urges Small-Caps to Pay for Research After MiFID

A positive analyst note can generate a flurry of trading in an illiquid small-cap, but after MiFID II, McKinsey & Co. forecasts banks will reduce spending on research by 30 percent as hundreds of analyst jobs disappear. Bank of America Corp. has warned that coverage of firms valued at less than 2 billion euros ($2.4 billion) is particularly vulnerable.

“It’s great that you have inefficiencies between stocks,” said Jefferies’ DeSanctis. “The question is, can you actually take advantage of the inefficiencies, based on the fact that liquidity may be so poor that you really can’t build up a significant position?”

The importance of analyst coverage may be seen in market barometers like Britain’s FTSE SmallCap Index -- where about a quarter of the 286 stocks get none at all. Stocks in the benchmark covered by 10 analysts or more post a 30-day average trading volume that’s almost 12 times that of companies with no coverage, according to data compiled by Bloomberg. In the U.S., a Jefferies study of small-caps this year found those with no analyst coverage tend to underperform the overall stock universe by 4.2 percent annually.

Hedge Fund Urges Small-Caps to Pay for Research After MiFID

“At least five independent research firms are needed to ensure fair valuations and an orderly liquid market,” Toscafund wrote to the 30 small companies, which were picked by its fund managers due to their perceived vulnerability after MiFID II. While paying for research “will lead to a moderate expense for you, we are firmly of the opinion that the increased visibility will deliver a stronger and better informed shareholder base.”

Toscafund isn’t the only voice calling for small companies to act. Peter Sidoti, founder and chief executive officer of U.S. small-cap focused firm Sidoti & Co., warned clients in July that the amount and quality of research on small and micro-cap companies is likely to “decline dramatically” due to MiFID II. His firm is pitching small and micro-cap companies to pay Sidoti’s analysts to cover them.

“The onus is likely to fall more on the C-suite of the businesses themselves to raise their profiles, undertake their own roadshows and proactively engage with their shareholders or potential shareholders to keep their share prices healthy and improve news flow," said Richard Philbin, chief investment officer of Wellian Investment Solutions, which helps clients invest about 1 billion pounds ($1.3 billion).

To be sure, investors like Eoin Murray, investment chief at Hermes Investment Management, which manages 41 billion pounds, are confident that they’ll still be investing in small-caps come January.

“There will still be inefficiencies and value available in smaller companies,” he said. “We will find a way of doing our research.”

But Murray agrees that a research shortage will be an unintended consequence of reform -- and says investors will just have to wait longer for their returns.

©2017 Bloomberg L.P.