It’s like any other brokerage firm, but it’s analysts cover stocks as ideas primarily for institutions, mutual funds and hedge funds — the buy side.

The buy side guys are the managers who are pulling triggers on large share positions each and every day. Traditionally, the buy side has its own analysts, but the workload is usually too great for them to cover all of the stocks they need to, so fund managers utilize sell-side analysts to come up with additional, fresh investment ideas. If a manager likes what a particular sell-side analyst provides him, he repays him by directing a certain amount of trades through that analyst’s trading desk. Frequently, trading desks make only pennies per share on institutional trades, but in sizable volume it can be a lucrative business.

That’s where the aversion to small-caps comes in.

If sell-side firms make a sizable portion of their money based on how many shares they trade, a small-cap stock trading 30,000 shares a day won’t be too attractive to them. They won’t want their analysts to waste time covering it…unless there is a lucrative banking deal attached to it…at which point you might question that analyst’s objectivity.

Let’s look at a sample of small-cap stocks and large caps:

The list of small-caps at the top has companies with market caps of around $250 million. Only one trades more than a million shares a day, but most of them trade less than 100,000 shares daily. The list of large-caps includes the largest companies traded on U.S. exchanges. The market caps of theses companies are in the hundreds of billions of dollars, and average trading volumes are many millions of shares a day.

As you can see, more sell-side analysts are covering the bigger names. The large-caps have more transactional value and greater banking needs. In short, there’s more money to make off of them than the minnows.

But how much value can one analyst in a sea of 34 others add about Microsoft? How much additional insight can be gleaned about Wal-Mart with 22 analysts already scrapping over every bit of information? How much time can any of the large-cap CFOs devote to speaking to any of these analysts? The answer to all of these questions is: Not much.

That’s one of the main reasons why I love small-caps.

There are a lot of truly undiscovered, or under-discovered gems, in this space. There are lots of opportunities for us to add value through our research. There is also the tendency for small-caps to outperform large-caps over long periods of time.

But forget about history for a moment.

Let’s just look back year-to-date at the top performing stocks so far in 2006:

Of the top ten performing stocks so far this year, nine of them are small-caps. On top of that, half of them have no sell-side analyst coverage!

So, when you see little or no analyst coverage on a small-cap you really like, don’t be scared away necessarily. It just could be the best opportunity around.

Until next time,
Craig Walters
November 2, 2006

Unnoticed Small-Cap Stocks was originally featured in the Penny Sleuth.