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Benj Gallander, co-founder and president of the Contra the Heard investment service and newsletter, says he's happy to buy stocks regardless of whether they are followed by analysts. (J.P. MOCZULSKI For The Globe and Mail)
Benj Gallander, co-founder and president of the Contra the Heard investment service and newsletter, says he's happy to buy stocks regardless of whether they are followed by analysts. (J.P. MOCZULSKI For The Globe and Mail)

TRADERS

A stock not covered by analysts can bring big rewards, risks Add to ...

As 2014 began, Vecima Networks Inc. wasn’t getting much attention from investors. Its stock price was fluctuating around $5 a share, a level it had remained at since early 2010. Most days, fewer than 20,000 shares changed hands. One of the main factors holding it back was its lack of analyst coverage by stock brokerages.

But early in that year, the company caught the attention of Fabrice Taylor. Mr. Taylor is the publisher of The President’s Club investment newsletter, which has a joint distribution agreement with The Globe and Mail.

He noticed the Victoria-based maker of broadband networking equipment had plenty going for it. Vecima had $50-million in cash on its books, the chief executive officer and his family owned a lot of the company’s stock, it had no debt, and its stock price traded for just six times its earnings per share – a modest price for a growing company.

Mr. Taylor recommended Vecima to his newsletter subscribers just as its stock began to take off. The company has enjoyed a successful 18 months, and its shares now trade for about $10 apiece.

It’s a common story, Mr. Taylor says.

“As a general rule, a company covered by lots of analysts will tend to be very fairly valued, with little upside beyond the overall market’s move,” he says. “So if you’re going to be a do-it-yourself investor looking for big gains, you need to look for gems that are covered by few or no analysts.

“If a company has earnings, a good balance sheet and is trading at a reasonable price but has no analyst coverage, the odds are that it’s cheap,” he says.

Some other unconventional investors agree with Mr. Taylor. Benj Gallander is the co-founder and president of the Contra the Heard investment service and newsletter. He says he’s happy to buy stocks regardless of whether they are followed by analysts.

“Analysts can easily be wrong, and sometimes get too close to management and can be prone to ‘groupthink,’” he says. He also notes it can be more difficult for companies without analyst coverage to get their stories out when things are going well.

While the returns on investments in overlooked companies can be large, there are certainly significant risks. Stocks that don’t have analyst coverage can stay overlooked for quite some time – especially by institutional investors whose buying has the greatest impact on stock prices.

That means “dead money” for investors – or even worse, an investment that loses value. The effect can be especially pronounced with resource companies such as mining exploration firms, experts say. Those stocks are also vulnerable to the ups and downs of commodity prices, and investor interest in the sector.

Also, as Mr. Taylor puts it: “Some of these companies are too small or too early-stage or just too awful to deserve analyst coverage.”

Looking at stocks that aren’t covered by analysts gives rise to the question of how investment dealers decide which companies to follow.

Generally in Canada, the large bank-owned securities firms use the S&P/TSX composite index as a benchmark for their coverage, aiming to have analysts assigned to all of the companies on the index, if possible. If they see holes, they try to assign analysts to cover those firms.

As well, the brokerages examine trading volumes and listen to both institutional and individual investors to gauge the level of interest in companies they may not be covering.

Some observers feel the investment dealers have other motives for their coverage decisions. Since the most profitable part of their business is investment banking (helping companies go public, issue more stock and make acquisitions), there is a possible incentive to offer companies favourable analyst coverage in return for investment banking business.

“Analysts cover companies that need financing because ultimately a dealer earns money raising money for companies,” says Mr. Taylor. “But the best companies don’t need money. They generate enough cash to fund their stocks.”

Mr. Gallander has the same suspicion. “They often choose companies that generate fees for them,” he says. “That makes them less than impartial.”

None of the bigger securities firms would speak on the record about the matter, but they say there are strict rules and practices that ensure favourable analyst coverage is not given to companies that grant the firm their investment banking business. They say the interests of their institutional and retail investing clients is the primary driver for their analyst coverage.

Ultimately, whether a company is covered by analysts or not, the best rule for investors is to rely on their own research. “It really helps if people can understand financial statements and financial ratios,” says Mr. Gallander. “Do a ton of reading and analysis.

Going to annual company meetings and getting a better feel for the company’s management can also be extremely helpful. As well, sticking to sectors that are easy to understand or you have some expertise in can help you with your research.

As Mr. Taylor says: “A simple story is preferable to a complicated one if there are not analysts there to guide you.”

 

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