Funds target 'unknown' stocks as Wall Street cuts analyst jobs

Hallmark Financial Services

07/08/2017 17:52

By David Randall 
    NEW YORK, Aug 7 (Reuters) - With a nearly 30-percent gain in 
2017, shares of industrial products maker Handy & Harman Ltd 
 HNH.O  are outpacing hot stocks like Google-parent Alphabet Inc 
 GOOGL.O  and Visa Inc  V.N . 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  .RUT  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  TR.N , Revlon Inc  REV.N , and Ruby Tuesday Inc  RT.N  - 
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.  
 
    OVERLOOKED BUYS 
    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 
 PI.O , 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  HALL.O , 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.  
 
 
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Uncovered gems     http://graphics.thomsonreuters.com/testfiles/fundsresearch/index.html 
Trading at Noon: Small-cap stocks     http://reut.rs/2hD2HcY 
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 (Reporting by David Randall; Editing by Jennifer Ablan and Nick 
Zieminski) 
 ((David.Randall@thomsonreuters.com; 646-223-6607; Reuters 
Messaging: david.randall.thomsonreuters.com@reuters.net)) 
 
Keywords: USA FUNDS/RESEARCH