By Rainford M. Knight, PhD
Dr. Knight’s doctoral thesis analyzed initial public offerings (IPOs). He teaches finance in the Florida Atlantic University Executive MBA program, is the founder and Director of the FAU Financial Analyst Program, and is a member of the CFA Institute and the CFA Society of South Florida. He also actively participates with his students in the CFA Global Investment Research Challenge.
The political posturing of “Make America Great Again” never seems to get old. In 1980, Ronald Reagan’s “Let’s Make America Great Again” supported his bid for the White House at a time when the US was suffering from a deteriorating economy. In his 1992 presidential campaign, Bill Clinton also used the phrase in many of his speeches and used it again in radio commercials aired in support of his wife’s 2008 presidential drive. And before its latest application, President Trump used it as a subtitle for a book he published in 2011. Surprisingly, even as this enduring slogan has been used successfully by three American presidents, none have been particularly detailed in their descriptions of what made America great in the first place.
What Made America Great?
Entering the modern era, commerce and innovation replaced plunder and conquest as the engines of wealth and prosperity. Greatness became the prize of an accepting nation that incorporated in its society the world’s best laborers and thinkers (including Albert Einstein, who immigrated to the US in the 1930s after being targeted by the Nazis). Motivated by this relative acceptance, immigrant talent fueled the US growth and influence, from the westward expansion in the 19th century and industrial dominance in the 20th century, to our technological preeminence in today’s digital age. But signs are present indicating stress and tarnish on the “Great” moniker that the US has held for decades.
To return America to its greatest position in history, we should be focusing on what got us there: small, emerging growth companies. These companies were, and will continue to be, at the forefront of innovation in exploration, science, medicine, and technology. While the financial channels provide repetitive updates and investment rationale for our country’s largest and most established companies, where can you learn about and follow the companies that will be instrumental in shaping the new world? How will these companies attract the human and financial capital needed to complete their missions if no one is hearing their stories? This problem is not new for burgeoning businesses, but the situation has worsened dramatically over the last two decades.
Barriers for Emerging Growth Companies
Catastrophic events like the meltdowns of Enron, Tyco, and WorldCom, and the financial crisis of 2007, had lawmakers scrambling to find ways to curb the bad behavior through regulatory control. The result was the passing of the 2002 Public Company Accounting Reform and Investor Protection Act (referred to as Sarbanes Oxley or SOX) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The latter brought the most significant changes to financial regulation since the Great Depression.
While arguments can be made for and against regulatory constraints, most agree that these legislative missiles were aimed at the largest companies in America and the giants of Wall Street. But the emerging growth companies and the small, independent broker-dealers facilitating their growth capital were hit the hardest, even though it was not their malfeasance that brought on the legislation.
Emerging growth companies, by description, have not yet transformed into household names. Many never will, as the large multi-nationals are eager to gobble them up once their product, service, or technology is proven, or even promising. But the regulatory labyrinth has severely hampered their ability to tell their stories and attract investment capital needed to get to that emergent place. The giants of industry and Wall Street can overcome almost anything by shoveling money at the problem. These little companies do not have that luxury, often struggling to stay ahead of their burn rates.
What the Experts Say
At a recent emerging growth conference that brought together representatives of Wall Street and the executive teams from more than 120 small public companies, three experts took the stage to address the headwinds these companies face, and to offer possible solutions. They tackled the problem from three critical perspectives: company, investor and lawmaker.
The Experts’ Profiles
David Weild IV is a stock market expert best known for his position as Vice Chairman of NASDAQ. Weild is also known as the “father” of the JOBS Act (Jumpstart Our Business Startups Act, 2012), which relies heavily on studies conducted by Weild and coauthor Edward Kim. Part of what Weild expressed in 2012 was the potential for a new stock market that could handle the financing needs of small-cap companies and promote small businesses in the US. Josh Scheinfeld is a Harvard Law graduate, and founder and managing member of the investment firm Lincoln Park Capital. He has over 20 years’ experience in starting, running, and raising capital for public companies. Colin Goddard, PhD, is Chairman and CEO of BlinkBio, a biotechnology company (private) developing cancer therapeutics. Goddard was formerly CEO of OSI Pharmaceuticals, which, over the course of 12 years, raised over $1.5 billion for the commercialization of a lung cancer drug. The company was acquired by Astellas Pharma for $4 billion.
The Experts’ Conversation
The debate began with a consensus: while a higher level of risk exists when investing in small-cap companies, the returns can justify the risk. They were also in agreement that regulation has had an unintended negative impact on small public companies, and that a void of information—equity research—makes distinguishing winners from the losers increasingly difficult. “We now have a one-size-fits-all market which is optimized for large-cap stocks and is a disaster for smaller companies which is, of course, where all of the jobs are created,” said Weild. “Another thing that really disturbs me is that entrepreneurships in the United States—start-ups—are at the lowest level in 40 years. With the economy raging, they should be way up. Ironically, we are teaching entrepreneurship in colleges more than we ever did before.”
Although Scheinfeld is still an advocate for small companies, investing in them has become progressively more difficult. “Because of how the regulatory structure has evolved for institutional investors, you can no longer deposit shares or clear through brokers or transfer agents. It’s difficult to get the price in the system and when it’s an OTC [over-the-counter] stock or below a certain market cap [market capitalization – number of shares outstanding times the share price], few are willing to do the work. Even when you have something great, people are hesitant to invest.”
Now on his second start-up, Goddard finds building awareness and access capital for his new venture far more difficult this time around. “It’s become extraordinarily more complex in today’s market. You have to be incredibly clear and concise in your messaging in order to cut through the clutter and get your message out,” he said.
Institutional investors rely on third-party equity research to make more informed investment decisions. “There are five or six thousand micro-caps out there, so it helps distill all of the information down to bites we can actually chew, and narrow it down to the 50 or so worth investing in,” said Scheinfeld. Access to Wall Street firms that write independent research is problematic for emerging growth companies in the US and Canada, and close to impossible for small companies in Europe, where regulation has gone even further. According to Daniel Sclaepfer of FT Advisor, “The effect of the latest European regulation, implemented about a year ago, has been felt beyond European shores. Over half of the global asset managers have adopted policies for separating research and execution payments. The punitive effect for small-cap research providers may be felt on a worldwide scale.”
Those who are not directly involved in the financial industry may brush over articles with headlines like “Regs Are Killing Small Broker-Dealers,” which was recently in Barron’s. Considering the deafening effect of the 24-hour news cycle, these reactions are understandable. But executives of small public companies, investors at all levels of sophistication, and those who are simply interested in the survival of our economy’s lifeblood should take notice. The ripple effect is starting to look a lot like a title wave. According to Bloomberg’s Justina Lee, “For investors, the concern is that shrinking analyst coverage, especially in small- and mid-caps, will make the market less efficient, with lower liquidity. Already smaller companies are feeling the pressure to beef up investor relations resources, as they can no longer count on analysts alone to tell their story.”
While all of this paints a pretty bleak picture for emerging growth companies, recent developments provide some level of encouragement. Similar to the response in Europe, a hybrid form of equity research has surfaced on this side of the pond. Referred to as company-sponsored or paid research, the company the research is profiling pays for writing the research. In the traditional model of payment, the broker-dealer that issues research would be paid by institutional investment firms (usually through trading commissions) that use third-party research in their investment decision-making process. For all the reasons explored in this article, most institutions have stopped paying the issuers of small-cap research, so they either had to stop writing it or seek payment from the company itself.
On the surface, a clear conflict of interest could certainly exist. But distinguishing propaganda-pieces from trustworthy, non-biased equity research, even if it is company-sponsored, is possible. A regulated research analyst is the best source. Financial Industry Regulatory Authority (FINRA) sets strict rules for analysts and broker-dealers regarding the issuance of equity research. These analysts must take courses and tests, and be certified and licensed by FINRA. Both the broker-dealer and the analyst face stiff fines and even the loss of licenses for breaking the rules, which include:
- The decision to initiate coverage must originate from the research department (not from investment banking, for example)
- The analyst must certify if he or she is getting direct compensation for rendering his or her opinion
- Compensation from the subject company to the broker-dealer must be disclosed in the research report;
- The analyst may not share his or her price target, market rating, or fundamental analysis prior to publishing the report
A FINRA-licensed analyst has a lot to lose if he or she gets into cahoots with the researched company. And the relatively small financial compensation to the broker-dealer that sponsors the research ($6,000 per month or less) is not worth the compromise.
Getting the right research in the right hands is the next challenge. Broker-dealer-driven research is usually made available to the institutional investment community through research aggregators such as Bloomberg, FactSet and Capital IQ. All of these resources come at a hefty cost, which is not practical for the average Joe when trying to get more information on these obscure companies. Investor relations firms often sponsor retail investor (Joe) lunches and dinners with management teams. When these firms are featuring a company that has research coverage, you may get access through that route.
Another source that has recently surfaced is the website Channelchek (yes, I spelled it correctly). Channelchek lists over 6,000 public emerging growth companies and does not charge users to log in. The site provides:
- Full market data
- A bullish, bearish, and balanced take on the news
- Video webcasts from company executives
- A podcast series featuring from-the-ground-up guests like supermodel-turned super-mogul, Kathy Ireland, Christie Hefner (Hugh’s daughter who became Playboy’s CEO), and Patrick Drake (co-founder of Hello Fresh).
The site was launched last November with a growing number of companies covered with research. And yes, the research is written by FINRA-licensed analysts.
So do the research and invest the time necessary to make good decisions. These emerging growth companies have the capacity to impact human life in a profound way, and they deserve your support. Investing in these companies is a way to make America great again without carrying a sign.
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