By David Randall
NEW YORK (Reuters) - With a nearly 30-percent gain in 2017, shares of industrial products maker Handy & Harman Ltd are outpacing hot stocks like Google-parent Alphabet Inc and Visa Inc. Yet few on Wall Street have ever heard of the $412-million market-cap company, in large part because no sell-side research analysts publish any estimates of its earnings.
That lack of information is a boon to Paul Sonkin, a portfolio manager at Gabelli Funds, whose firm owns shares of Handy & Harman. 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.
Top-performing fund managers at Fidelity, Janus Henderson, Hodges Capital and Baron say that the decline in research coverage means that they are seeing more small-cap companies that are mispriced and potentially undervalued, giving firms that have the capacity to conduct their own research an advantage over the long term.
Overall, the number of companies in the small-cap benchmark Russell 2000 that receive no formal attention from Wall Street research firms has jumped 30 percent over the last 3 years, according to a Reuters analysis.
That cutback has left a broader number of small-cap companies – including household names Tootsie Roll Industries Inc, Revlon Inc, and Ruby Tuesday Inc - essentially a black box for investors without the time or resources to analyze a company. Investors in index funds that track the Russell 2000, meanwhile, are putting money into firms that few on Wall Street know anything about.
Numerous academic studies have shown that an analyst initiating coverage of a stock pushes share prices higher, in part by improving investor recognition of the company and increasing its liquidity. A study published in Financial Management in 2008 found that stocks that traded for at least one year without research coverage jumped by an average of 4.8 percent once an analyst began tracking the company.
Investors have little way of knowing in advance when a sell-side brokerage firm will initiate coverage of a company, however, adding the risk that it may be a long time before other portfolio managers recognize a company and boost its shares.
SIDE EFFECT OF INDEX INVESTING BOOM
In some ways, the focus on companies with no analyst coverage is an unintended consequence of the index investing boom. Approximately 42 percent of all assets in stock funds are now in passive funds that track indexes, up from 24 percent in 2010, according to the Investment Company Institute.
With fewer investors buying and selling individual stocks, brokerage firms have been forced to cut research staffs, which had long supplied information about small companies in hopes of generating trading commissions.
Over the last 12 months, brokers such as BB&T, Nomura, and Avondale have shut down whole research divisions, leaving a hole in information that is unlikely to be filled quickly. BCA Research, an independent Montreal-based firm, estimates the total number of analyst reports being produced will fall by at least 20 percent as investment banks reshape operations to adapt to the popularity of indexing.
“Portfolio managers are increasingly relying on algorithms to track any changes in a stock, not a human doing a report," said Evan Pondel, president of Los Angeles-based investor relations firm PondelWilkinson Inc.
Portfolio managers who conduct their own research into uncovered small-cap stocks say that it provides a greater justification for annual fees that are often far higher than passive funds.
Laird Bieger, a portfolio manager at New York-based Baron Funds, said he began meeting with executives at Impinj Inc, a maker of radio frequency identification devices with $1-billion market cap, when there were no sell-side analysts covering the firm. Five analysts now cover the company, whose shares are up nearly 40 percent year-to-date.
"This is something that is way below other people's radars and at a point in their growth cycle when they are the most open to meeting with us," he said. Once companies reach market values of $3 billion and above, they typically have much more formalized investor-relations teams that block access to executives.
Eric Marshall, a fund manager at Dallas-based Hodges Capital, said he is looking at uncovered companies in out-of-favor industries such as industrials and financials to find mispriced stocks. He owns shares of Hallmark Financial Services Inc, an insurance company with a market value of $203 million, in part because it is "virtually unheard of," he said. Shares of the company are down 4.2 percent this year.
(Reporting by David Randall; Editing by Jennifer Ablan and Nick Zieminski)