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Wall Street Has a Big Company Bias

Another bias on Wall Street is an ongoing emphasis on big companies. Analysts have a tendency to focus their coverage on stocks that have the highest market capitalizations. These names are more actively traded and widely held, with the most institutional investor interest. This is where most investment banking business is derived and investment firms generate most of their equity business profits. The bulk of phone calls and press attention pertains to such companies. They are over-covered, over-analyzed, and the price valuations of their stocks tend to be more efficient, fully reflecting all known factors. Technology, telecommunications, and healthcare are the most over-researched, covered by the most analysts. Wall Street tends to add analysts in sectors where it does the most banking and trading business, not necessarily in areas representing the best investments. According to a study by Doukas, Kim and Pantzalis referenced in CFA Digest in mid-2006, there is a clear relationship between excess analyst coverage and stock premiums. The same study showed a direct correlation between low analyst coverage levels and stock price discounts.

Individuals can benefit by making an astute, early investment in smaller companies not already picked over by Wall Street. Mutual funds and other institutions need to take sizeable positions in stocks. Though they may invest in some smaller cap stocks, even a spectacular winner there has minimal influence on a fund’s total performance. Therefore, when analysts pound the table on a thinly traded company that proves to be a fine idea, the overall impact is muted. There are meager economics for a brokerage firm in recommending small stocks, whether for trading, banking, or commissions. Brokerage revenues are decidedly boosted by outstanding calls (a rare event) on broadly held stocks, not small caps.

Executives and board members have a similar preference for bigness—they hesitate to do spin-offs, love acquisitions, and are obsessed with company size, enjoying the status of being a part of the S&P 500. But mass usually indicates mediocrity. And mega-mergers never work. Smaller market caps are not emphasized by analysts. Even if a small cap stock is a table pounding Buy recommendation that soars in price, the analyst gets little recognition for being an advocate. Small companies have few shares outstanding and thus only a scant number of investors own the stock and benefit from its appreciation. Most analysts at major firms get attention and make their reputations by emphasizing big cap recommendations. Small stocks present the individual investor with a better prospect of undiscovered value and the potential to achieve greater prominence in the future as their market caps expand.

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