Strategic market cap size or strategic market capsize

Listing badly using the same old broken water pumps to salvage a lost cause

A funny thing happened the other day on Facebook. A buy-sider was lamenting that the sell-side brokers don’t invite her out anymore. I joked to her that a sell-sider’s real worth now is measured by the lonely underperforming buy-sider inviting him/her to lunch and paying for it PA. While there is some tongue in cheek with the above there is no doubt that the financial services industry has almost always been ‘fair-weathered’ and self-serving. As the old adage goes, “when you have everything your friends know who you are. When you have nothing you know who your friends are.”

We have no intention to sugar coat realities to placate the hundreds of egos that may crumble under the weight of the bleeding obvious herein

The chart below shows the bias of the percentage of buy ratings on the sell-side versus the direction of Topix. What we see is some eerie similarity with the action pre GFC. The bias of positive ratings stood at around 48.5% in early 2008 however the market reaction was generally negative. Rolling 8 years forward we see a very similar trend emerging. As of April 2nd, 2016 we see that the percentage of buy ratings is at 47.6% with Topix behaving much like 2008.  

Fig. 6 : Topix Price versus % of Buy Recommendations on the sell side

Source: Custom Products Research

If one buys into the idea that the sharp selloff post Lehman Shock could occur again do we see Topix back with a 700 handle with a three-year sideways move? After we survived the GFC the sell-side was overwhelmingly positive on the basis of stocks bottoming. However the impact on share prices was negligible. Only when buy ratings had bottomed out, one presumes on capitulation, did the market rally again. So perhaps sell-side analyst capitulation will be the signal to buy the market but watch for the 48.5% bias level.

So has large cap coverage bias helped with performance?

The short answer is no. Looking at 1 year and 5 year total returns clustered by analyst coverage we see that the under-covered (zero to four analysts) trumped the 5-9, 10-14, 15-19 and 20+ analyst segments in a study of 1,000 stocks, Fig. 3.

Performance of 1,000 stocks grouped by the amount of analyst coverage

Source: Custom Products Research

Put another way, the 57 stocks with an average of ¥2.56 trillion market cap in the 15-20 analyst band had the worst performance and the 604 stocks with an average market cap of ¥136bn (coverage 0-4 analysts) performed best and was the only cohort that saw positive territory in both periods.

Download the report here

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