Small Cap Companies and Efficient Markets

One of my favorite quotes about the capital markets comes from Fischer Black, the financial mastermind who helped invent the Black-Scholes option-pricing model. Black, who had been a Professor at MIT, situated on the Charles River in Cambridge, left the world of academia to work for Goldman Sachs, which sits near the Hudson River in Manhattan. After experiencing finance from both the academic and practitioner viewpoints, Black commented, “Markets look a lot less efficient from the banks of the Hudson than from the banks of the Charles.”

I bring this up because last week I was involved in the East Coast IDEAS Conference in Boston at which most of the presenting companies were small capitalization firms. My background is primarily in large capitalization firms, so the conference was an opportunity to see the other end of the spectrum and learn a few things. The most surprising thing I learned as a result of speaking to company managements was how difficult it is for good small cap companies to get noticed by investors. It seems that finding a good match between underfollowed companies and investors can be a daunting challenge.

Part of this can be ascribed to much less sell side coverage available to small cap stocks. The name of the game with sell side coverage is commission flow, and small cap stocks have a lot less of it than larger cap stocks do. Without the distribution of information available from the sell side sales force, small cap companies are forced to try and bring themselves to the attention of investors through their own efforts. Similarly, investors have a hard time finding the good companies through all of the “ground clutter” on their radar screens. Add to this the fact that many smaller companies do not have full time investor relations officers, relying instead upon their CFOs to speak to investors and you have a combination of factors that can lead to companies just not finding the right investors. The result is that the markets seem a lot less efficient in the small cap space.

In theory, (from the banks of the Charles) the efficient market theory would say that as long as your company information is public, investors will find you and properly value your firm. So filing required reports with the SEC and having a web site should be sufficient. In reality (from the banks of the Hudson) this rarely seems to be the case for small cap stocks. What is required of smaller companies is what I refer to as “retail institutional marketing”. They have got to go out and actively bring themselves to the attention of potential investors because they are competing with so many other small cap companies for attention and investment dollars. And it seems as though those investors are not easy to find.

There is a solution for this, and that is for investor relations firms with knowledge of the capital markets for small cap companies to bring companies and investors together. One way to think of this is that IR consulting firms step into the role of the sell side sales force in terms of their knowledge of what investors may be interested in, introducing their client companies to interested investors. The difference is in the method of payment. The sell side is paid for via commissions from the buy side, whereas IR firms are paid by the company. When done correctly, a good IR firm can add to the efficiency of the markets by helping to match the right investors to the right companies, helping them achieve better liquidity and proper valuations

(Full and fair disclosure: The author consults for Three Part Advisors, an investor relations consulting firm and a sponsor of the East Coast IDEAS Conference.)