How Challenges in Equity Research Are Affecting SMEs

How Challenges in Equity Research Are Affecting SMEs

Regulatory, technological, and other factors have come together to jeopardize the value of equity research and even its quality. Read this blog post to learn how this is impacting small and medium-sized companies in particular by affecting their liquidity and room for growth.

Equity research is a necessary activity in developed markets as it increases the visibility and liquidity of listed securities and aids informed investment decisions. However, recent regulatory and technological developments have hindered its application, especially for small and medium-sized enterprises (SMEs). In addition, there are non-financial factors and trends that need to be incorporated into the analysis today for equity research to be truly valuable.

What Is Equity Research?

Equity research is used to provide an overview of a company’s key financial figures and to highlight possible risks for investors. The results of equity research are available in the form of reports that assess a company’s strengths and weaknesses. All market participants that invest in shares for themselves or others rely on these reports to make well-founded decisions.

According to “The Future of Stock Market Analysis,” a paper presented in March 2022 by IEAF, the Spanish Institute of Financial Analysts, equity research in the European Union faces at least three major challenges:

1. The Lower Number of Companies Covered by Equity Research Following MiFID II

The EU’s MiFID II directive incorporates the obligation to separate research and recommendation services on listed securities or companies from the investment in – or divestment of – the same securities. This unbundling has led to a lack of research coverage especially for listed securities of SMEs.

A study by the Financial Conduct Authority highlights that the reduction has been remarkable in recent years. In the United Kingdom 70% of SMEs with a capitalization up to 50 million euros have no coverage today and 20% have only one analyst. The coverage for companies with a market value between 50 million and 100 million euros is somewhat higher, but 40% of the total fall off the experts’ radar.

EU regulators have taken note of these consequences, have gauged the negative effects that MiFID II may have had, and have made some modifications. They have done that while maintaining the key objective of the directive, which is the protection of investors. With the modification in the future it will not be necessary to comply with unbundling when the analysis refers to issuers whose market capitalization does not exceed 1,000 million euros.

The partial rectification of the unbundling will have a positive effect on the number of companies covered by equity research and will alleviate the situation.

2. The Rise of Passive Funds and the Robotization of Company Selection

Since 2008, the volume of passive funds has increased almost tenfold to around 10 trillion dollars worldwide. In the United States, they already account for 53% of all mutual funds and ETFs. Low cost has acted as a major attraction for passive funds, especially in a bullish stock market environment.

Passive investment basically includes index funds that follow a benchmark, highly systematized. But it also includes quantitative strategies that follow factors or factor systems, algorithms or technical indicators, also with a high degree of systematization. Both cases can lead to financial products that can be “robotized” to a large extent.

This trend is undoubtedly a challenge for equity research and analysts who, in this dynamic, lose opportunities to carry out their work and add value to the investment process. At the same time, in this way, small investors have less qualitative information on companies and are therefore less protected.

3. ESG Factors That Need to Be Incorporated into the Equity Research

Environmental and social impact and corporate governance, in short ESG factors, now affect the volatility and therefore the cost of capital and other parameters that ultimately modify the valuation of companies. Until now, the fundamental value of a company hinged exclusively on cash flow, growth, and the cost of financing.

ESG factors are non-financial concepts that have always existed but which, unlike just ten years ago, today do have an impact on the market valuation of listed companies. Moreover, the need to measure them is also due to a strict demand from investors for companies with a good ESG rating, i.e., companies that operate sustainably according to defined standards.

This question presents an intellectual challenge. ESG certifications can be of vital importance in answering it. It is necessary to define their metrics, ensure the quality and independence of their measurement, and decide which actors are qualified to issue them.