Filling a small caps hole

Broker research on smaller listed companies is scarce. An ASX trial is aiming to address that knowledge void.

PORTFOLIO POINT: Investors keen for more information on smaller capitalised companies now have access to broker research on a number of stocks, thanks to an ASX trial.

Knowledge is power when it comes to investing, and there’s a classic failure of the market at the moment leading to a knowledge black hole when it comes to smaller listed companies.

That’s because it’s often simply too expensive for brokers to produce research on small cap stocks, for too little interest or return.

But for retail investors hungry for more information on up-and-coming companies, and who want more market liquidity for these stocks, a new trial scheme from the Australian Securities Exchange could be about to change this.

Of the roughly 2,200 ASX listed companies, 92% have a market capitalisation below $1 billion, and more than half have a market cap below $50 million. The problem, as ASX capital markets general manager Richard Murphy puts very simply, is that “once you get past the top 200, the quality research falls off a cliff”.

Broker research improves the liquidity, and the ease of raising capital, of listed stocks by distributing information about the company to the relevant investors, be they retail or institutional, and thus increases awareness and the ability for them to make informed decisions. The problem is that this research is expensive.

Ord Minnett analyst Brad Dunn says the cost in time and resources to a broker beginning to produce research on a company is large, regardless of its size: “It can often run into the weeks and even months in terms of getting models, speaking to management, doing all the background work.”

The million-dollar equity research scheme from the ASX was launched last week to address this shortfall. Brokers applied for funding to be research providers under the scheme, and 10 retail providers and six institutional are now signed up. The brokers get to choose which companies they research, with the provisos that they fall in the $50-$200 million market cap range for retail brokers, and the $200 million to $1 billion range for institutions, and that there are no more than two current pieces of research being produced on that company. The 1,200 or so companies under the $50 million market cap will have a simple company snapshot provided by Morningstar.

“It’s about looking where the problem is and trying to cover that gap,” ASX’s Murphy says. “The cost of research is extremely high. Essentially what we’re doing is underwriting the development of research.

“There aren’t enough research analysts in Australia to cover the 2,200 companies that are listed, so what we need to do is develop that – within the investment banks, and within the next tier down smaller investment banks, the mid-tier brokers and corporate advisers who would like to cover more but don’t have the cost basis to allow them to do so.”

Ord Minnett is one of those mid-tier brokers, most of which already provided some detailed research on small and mid cap companies. Dunn says while Ord already provides research on 50 smaller cap companies from $75 million to $3.5 billion, the scheme is “thinking outside the box” to improve the amount of research available.

“I think it really does come to just having the resources and the capacity to do it,” he says. “Also, sometimes there’s a self-imposed cut-off amongst fund managers about the size of the market cap they can look at. A small cap fund can often go down to a $100 million market cap but below there they find it difficult to justify. That causes a limiting of coverage at the smaller end of the market as well.”

Most brokers readily agree there is a lack research at the smaller end of the scale, but not all are happy with the way the new scheme has been structured.

BBY executive chairman Glenn Rosewall says it’s “ridiculous” that the ASX has restricted the institutional component of the research scheme to big investment banks, imposing a 3% market share cut-off rule – just above where BBY sits with about 2.7%.

“We’re actually the broker that covers more stocks in that [$200m-$1bn] space. That’s our sweet spot.”

Rosewall says the ASX is being anti-competitive with the division. “The only non-foreign broker in the [institutional] pool was Macquarie. Personally, I felt that the Exchange should have thought to themselves: ‘How do we spend some of the revenue line that we receive back into the domestic market, which is more likely to look at the small Australian companies?’,” he says.

“I think it should have been an Australian broker-orientated scheme, but instead they’ve excluded the Aussie brokers from a big chunk of it.”

But Rosewall agrees it’s difficult for stocks lower down the food chain. “The problem is brokerage rates are so low and research costs are so high. I think there’s some merit in the scheme, but I just think they’ve executed it really poorly.”

Table 1: Companies to have retail reports published

Table 2: Companies to have institutional reports published

Full lists of the 10 retail and six institutional brokers involved are available from the ASX here and here.

Currently a $1 million trial scheme, it is slated to be expanded to $10 million next year if successful, paid for through small increases to listing fees, and it’s part of a broader push from the ASX to make the exchange attractive for companies to list on.

Other recent measures include the proposed increase of the capital threshold small companies can raise through placements – from the current 15% to 25% for companies outside the S&P/ASX300 with a market cap of less than $300 million.

Discussions have also begun on reducing the standard timetable for rights issues – which can currently take up to 26 days – and earlier this month ASX said some efficiencies identified could get the time down to a maximum of 16 days. This will make it easier for companies to raise money faster and therefore with less pricing risk in volatile markets.

That’s important for smaller investors, because it may also encourage companies to go with a standard rights issue – where retail and institutional investors participate at the same time – rather than accelerated issues which have become widely used, despite often disadvantaging retail investors.

“The general thinking we’re doing in this space is looking at all of the impediments to capital raising and the impediments to liquidity,” Murphy says.

This is, at least in part, a response to the increasing competition the Australian exchange faces both currently in resources up-and-comers looking to list in Hong Kong and Singapore, and also potentially in future. The domestic market has been opened up to competition and, while the currently sole competing Chi-X exchange remains a very minor player by comparison, exchange competition has developed rapidly in other markets.

“We want to grow the value proposition of being listed on the ASX, so that it compares well globally,” Murphy says.

“Research is just one piece of this – it’s a big piece – but just one piece of broader thinking which basically is saying we need to look after all areas of the market, not just the top 200.”

Dunn says research does make a difference for smaller companies.

“One of the stocks I cover, when we started [producing research], its liquidity was really quite low, it was trade by appointment, and now it’s had turnover increases many multiples of where it was.”

If impartial research can be improved for small cap stocks, paid for through listing fees, it would appear to be something of an ‘everybody wins’ scenario.

The companies achieve greater exposure and ease of raising capital, the ASX encourages listings and trading volume, the brokers have more and wider research paid for to provide their clients, and investors have more information available on listed companies.

If the trial works, it may just be that the ASX has identified a market failure between brokers, clients and companies, and has found a market mechanism to address it.

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