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Is Drop in Liquidity and Analyst Coverage of UK Mid-Caps An Investment Opportunity?

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Independent FCA-registered capital markets researcher Hardman has released data that shows the liquidity of London-listed companies valued at between £600 million and £5 billion fell by nearly 10% over the first six months of this year. Small caps such as the companies listed on the LSE’s AIM market have been hit even harder with liquidity down by as much as 25%. Volatility in the share price of mid and small-cap companies is also increasing in correlation to falling trading volumes. However, while a general concern, the situation could also present an opportunity to savvy and experienced stock pickers investing online.

The drop in liquidity that mid-cap and small-cap companies are experiencing is being put down to the introduction of the new EU Mifid II legislation. Mifid II means brokers and banks are obliged to charge separately for any company research their analysts publish. Before the new legislation was introduced, brokers tended to ‘bundle’ research with trade execution fees.

This practise was considered to be a potential conflict of interests. Paying for research separately is supposed to remove doubt as to whether investors have been ‘induced to trade’ as well as ensuring the research is independent and has not been commissioned by the companies covered. Pre-Mifid II, smaller listed companies often commissioned ‘independent’ research to ensure that there was research that investors asset managers could refer to when assessing them as an investment option. Brokers and investment banks, many of whom have recently been slashing analysis costs, can only provide research on so many companies. This meant that smaller companies were and increasingly not covered unless they took proactive steps themselves to make sure research on them was available.

The number of analysts covering mid-cap companies has, Hardman’s research suggests, dropped by 3% since the introduction of Mifid II. Research coverage of large caps has actually dropped more, by 6%, but has had little impact due to the much larger volumes of research available on those companies. Small-cap companies have traditionally struggled for research coverage but the current situation is relatively new for mid-caps. Hardman chief executive Keith Hiscock commented for the Financial Times:

“At the small end of the market, companies have always struggled. It’s at the middle of the market that this is going to be a bit of a revelation”.

City stockbrokers believe that the regulatory change will be felt increasingly as the year goes on with less coverage deepening illiquidity for some stocks. However, less professional research and increased volatility could also provide opportunities. Experienced stock pickers willing to put in their own time to research neglected companies could well find it easier to uncover undervalued gems among the mid-caps of the FTSE 250 and below. Increased volatility could also mean more ‘buy the dip’ opportunities presenting themselves.

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Paul

The author Paul