Monday, April 4, 2011

The Relationship Between Sell Side Coverage and Commissions

Go to almost any gathering of investor relations officers and you are likely to hear them bemoaning the decline in the number of sell side analysts that follow their companies and publish earnings estimates. And if you are talking to small and even mid cap company IROs, you may hear them complaining that they are having trouble attracting sell side coverage at all. So I thought I would spend some time this week explaining why this might be so.

The answer is simple, really, and like many things in life, it boils down to “that’s the way the math works”. My children would always roll their eyes whenever I said that, so before I get to the quantitative part, a bit of historical perspective is in order. In the old days, before Elliott Spitzer, research departments received much of their budget funding from their bank’s investment banking departments and there was more coverage of companies because investment bankers wanted potential clients to get coverage from the firm. Of course, there were also quite a few conflicts of interest, as investment bankers only wanted the research department to have buys on potential clients. In addition, there was a lot of pressure from investment bankers for stock analysts to give generous recommendations to companies they were taking public. All of this culminated in the 1999 – 2000 dot com bubble when many highly touted internet company IPOs foundered on the shoals of reality.

Enter Elliott Spitzer, who, before he became Client 9, was Attorney General for the state of New York. Sensing that political hay was there to be made, Mr. Spitzer demanded that the conflicts of interest arising from the intersection of investment banking and research be eliminated. Using the bully pulpit of the Attorney General’s office, Mr. Spitzer was able to extract settlements from the investment banks that basically separated investment banking and research. No longer could investment banking departments contribute to the research budgets of their firms. In fact, investment bankers couldn’t even talk to research analysts unless an attorney was in the room to insure that no insidious conflicts reared their ugly heads.

This meant that research departments now needed to justify their existence based upon their only revenue source, which was commissions. And commission rates, due to a number of factors, were declining and continue to decline to this day.

This is where the math comes in, because for research departments, it all comes down to how many commission dollars covering your company can generate for their firm, and that in turn is heavily dependant on the average daily trading volume of the company in question. If you look at a mega-cap company such as Wal-Mart, they trade in excess of 14 million shares per day. Assuming an average institutional commission rate of $.04 per share, this means that on an average day, trading in Wal-Mart shares generates $560,000 in commissions. Even if you are a mid-tier analyst covering Wal-Mart, and you figure you can get credit for 5% of the commission flow, this means that potentially you have available to your firm $28,000 per day.

On the other hand, a small cap stock with average daily trading volume of 100,000 shares, generates commissions of $4,000 per day. Even if you figure the very top, go-to analyst on the stock can get credit for 25% of the commissions, the potential dollars available total $1,000 per day.

Wall Street firms are economically rational, and they will naturally gravitate to where the most money is to be made. And the long and the short of it is that it is a lot better to be a middle of the pack analyst following a mega cap stock than it is to be the number one analyst following a small cap stock.

So the next time you hear someone bemoan lack of sell side coverage, ask them what their daily trading volume is.

Because that’s the way the math works.

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