Originally Published MX September/October
2002
FINANCE
Covering the Bases
For publicly held small-cap healthcare companies, the first
step toward maximizing market value is to get known among investors.
Chris Sassouni
Structural changes in the U.S. stock market have made access to capital increasingly difficult for emerging growth companies, particularly those with large capital needs such as high technology, telecommunications, and biotechnology companies. These structural changes have been brought about largely by massive inflows of cash into the U.S. stock market during the latter half of the 1990s. In turn, these inflows have been driven by investors seeking superior returns in an era of low inflation and low interest rates on fixed-income and money market instruments.
As described below, the massive inflows of cash into the U.S. equity markets have forced institutional investors to change the way they manage their portfolios—and especially to focus on and invest in larger and larger companies. Whereas 10 years ago, there was significant institutional interest in companies with public market valuations between $100 million and $500 million, this is no longer true. The assets managed by institutions have grown so dramatically—and institutional money managers now have so much capital to invest—that institutional investors are now interested primarily in companies with market capitalizations of at least $1 billion that trade at least 300,000 shares per day.
Such fundamental market shifts have had a tremendous impact on the availability of capital for healthcare companies, including those in the medical device, biotechnology, pharmaceutical, and healthcare services sectors.
In this article, we propose that the keys to accessing capital in public markets are a demonstrated track record of superior operational performance coupled with a market capitalization that is sufficiently high to attract the interest of institutional investors. Companies that do not have a large enough market cap to attract institutional investors must therefore find ways to bridge this gap. One possibility is to arrange for research coverage by one or more of the independent research boutiques that provide unbiased investment research ideas and tools to both individual and institutional investors.
New Structures
Although leaders of medtech companies have been affected by the dramatic changes sweeping the U.S. equity markets, they may not have a sense of just how significant those changes have been. Following is a summary of some of the key trends that have altered the structure of the U.S. market for publicly held companies, with emphasis on areas of greatest importance for medtech companies.
Realignment. To begin with, over the past decade, institutional investors have dramatically realigned the thresholds for defining market capitalization. In the early 1990s, the range of market values that defined small-cap stocks was roughly $50 million to $200 million. Today, this range has increased sixfold, to roughly $300 million to $1.5 billion. However, the revenue-generating potential of such small companies did not increase commensurately over that same period. Consequently, emerging growth companies that once would have attracted the attention of small-cap institutional investors have now been abandoned in favor of more-established companies with larger market capitalizations.
According to Morningstar, the average market capitalization of companies held in the portfolios of the nearly 800 small-cap funds in the United States is around $800 million.1 Since the average market cap–to–sales ratio for high-growth companies is about 4:1, it can be inferred that small-cap mutual funds are primarily interested in companies with sales of $200 million or more. Despite the fact that such small-cap mutual funds are supposed to be focused on small companies—which formerly included those without any revenues as well as those with revenues as high as $200 million—it can readily be concluded that today's fund managers have very little interest in such small companies.
Reduced Choice. The realignment of market-capitalization
thresholds has had a direct impact on the choices available to institutional
investors. By definition, when the thresholds of revenue, market capitalization,
and liquidity (measured by trading volume) are higher, fewer companies will
be able to meet those requirements in order to attract the attention of institutional
investors.
There are far fewer companies with revenues in excess of $200
million than there are companies with revenues below $200 million. As a result,
the realignment of thresholds over the past 10 years has dramatically reduced
the universe of companies that institutions are interested in owning in their
portfolios.
Since the universe of companies that institutions can buy has
contracted, the differences among the holdings of various mutual funds have
also been reduced. As a result, the differences in performance experienced by
various equity mutual funds have less to do with the variety of their stock
holdings than they used to. Instead, such differences result more from the relative
weighting of fund holdings in a relatively limited universe of stocks or from
strategic differences about when a fund should purchase or sell stocks.
Broker Consolidation. The repeal of the Glass-Steagall Act in 1999 has led to tremendous consolidation in the brokerage industry. Once commercial banks were allowed to offer investment banking services, most of the large global banks (Citibank, Chase Manhattan, Deutsche Bank, Credit Suisse First Boston) decided to buy their way into this market. As a result, many regional brokerage firms and other specialized investment banking boutiques have become part of large global banks.
Because of the premiums paid to acquire such firms, however,
the new owners exerted considerable pressure on their newly acquired units to
generate significant profits. As a result, the newly acquired investment banks
were asked to focus on larger and larger investment banking transactions that,
by definition, involved companies with larger market capitalizations. In addition,
they were asked to pursue greater commission flows. In many cases, this meant
focusing the research coverage provided to institutional investors exclusively
on large-cap companies. The result is that the number of brokerage and investment
banking firms focused on small companies has been reduced dramatically.
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Figure 1. Number of analysts
providing research coverage versus average market cap for publicly held
healthcare companies with market caps below $2 billion.
(click to enlarge) |
Limited Market Research Coverage. In order to focus on meeting the needs of their institutional clients, almost all of the major investment banks today limit the research coverage they provide to those companies with market caps of at least $1 billion. This limitation has left literally thousands of public companies—including hundreds of healthcare companies—with no research coverage. One recent study has estimated that 46% of all publicly held U.S. companies have no research coverage.2 That estimate is supported by studies using the database of all publicly held U.S. healthcare companies maintained by our firm, Healthcare Capital Advisors (Clearwater, FL), where 354 companies out of 868 (41%) were found to have no research coverage.
Absence of research coverage creates its own set of difficulties. Most of the small-cap companies that have lost research coverage were previously covered by their investment banks. But once the investment banks dropped coverage of these companies, their trading departments stopped making a market in their stock and liquidity dried up. Without interest from investment banks—and a virtually nonexistent market for initial public offerings—it has become difficult, if not impossible, for small healthcare companies to gain access to capital.
Our studies have shown that there is a very strong correlation between research coverage, increased market valuation, and greater institutional ownership of a company's stock. In short, research coverage is an essential tool in creating shareholder value for publicly held healthcare companies. The challenge for emerging growth companies—those with revenues of less than $50 million, whether public or private—is to attain research coverage even though they are below the interest thresholds of most institutional investors and the research departments of brokerage firms.
The Importance of Research
The goal of every CEO is to create shareholder value. The primary driver of a company's value is its future free cash flows, which are, in turn, determined by the following factors.
- The concentration of competitors in a market.
- The competitive strategies of a company.
- The value provided to customers by the product or service.
- The operating profit margins of a company.
- The degree to which a company is leveraged.
- The asset intensity of the business, and the need for ongoing capital expenditures to replace the assets.
When the free cash flows generated by a company exceed its cost
of capital, the company is said to be creating economic value. A firm's
value can therefore be estimated by discounting its projected free cash flows
by its weighted average cost of capital. In a perfectly efficient market, the
market value of a company would instantaneously reflect changes in its free
cash flows or cost of capital, both of which can be affected by external and
operational factors.
Today's capital markets, however, are a far cry from such
perfect efficiency. To improve the efficiency with which stock markets reflect
changes in the market value of a company
—based on changes in its future free cash flows—company leaders must
exert a controlling influence to achieve the following goals.
- Demonstrated operational and competitive superiority.
- Research coverage to interpret and disseminate company information
among institutional and retail investors on an uninterrupted basis.
- Significant institutional ownership of a company's outstanding shares.
Companies typically have a great deal of control over the first of these factors, which is a staple of any competitive marketplace. For companies with small market caps, however, the latter two factors are much more difficult to control. This is partly due to the fact that the achievements of research coverage, institutional ownership, and increased shareholder value are intertwined with one another in a way that makes it difficult to achieve one without the others (see Figures 1 and 2).
Of the three achievements that can most influence a company's
stock performance, attaining research coverage is arguably the most important.
Analytical research is a critical ingredient in maximizing shareholder value
for several reasons.
- Visibility. For publicly held
companies, research means visibility. Most firms that provide research have
the ability to distribute their reports to a wide network of individual and
institutional investors. Without research coverage, company news and achievements
are like trees falling in a forest—heard by no one.
- Prerequisite for Investment. Our
studies suggest that many pension funds and mutual funds consider research
coverage essential before they will consider a stock as a potential investment.
- Company Barometer. Research provides a consensus against which the market can gauge a company's performance. Without such ongoing reporting and analysis of key events and changing fundamentals, institutional investors can find it difficult to justify purchasing a company's stock because they will have to rely on their internal resources to monitor their investment.
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Figure 2. Number of analysts
providing research coverage versus number of institutions owning publicly
held healthcare companies with market caps below $2 billion.
(click to enlarge) |
Research coverage is a very important catalyst in increasing institutional ownership of stocks (see Figure 2). Among publicly held healthcare companies, those with no research coverage are the least likely to have their stock purchased by institutional investors. By contrast, the greater the number of analysts following a company, the greater the likelihood that institutional investors will own stock in the company. Moreover, as the amount of research coverage increases, the likelihood of institutional ownership increases exponentially.
Solutions for Public Healthcare Companies
In the current state of the U.S. capital markets, publicly held healthcare companies with market caps of less than $300 million are at a disadvantage when it comes to maximizing shareholder value and accessing capital for growth. Although there are many possible means of addressing such a market disadvantage, the following two solutions seem especially suited to dealing with the problems currently facing publicly held healthcare companies.
Merge or Acquire. The market capitalization of a company is the product of the company's stock price and the number of its outstanding shares. When a company acquires a firm of similar size, it automatically increases its revenue base or the number of its outstanding shares—or both. The exact nature of the change depends on whether the acquisition is made in return for cash, stock, or a combination of the two.
If investors view such an acquisition as being synergistic,
they are likely to bid up the share price of the company to reflect its larger
base of revenues and projected revenue and earnings growth. In turn, such higher
share prices increase the company's market cap. Similarly, if the acquisition
is successful in creating economic value for the company, the market should
reflect this by increasing the company's market cap.
When evaluating prospective acquisitions, company leaders should
keep an eye on the potential effects that such a purchase will have on the company's
market cap. Their goal should be to increase the company's market cap into
the range between $300 million and $1 billion. Company leaders who are successful
in achieving this goal will dramatically increase the likelihood that their
company will receive research coverage by brokerage firms and interest from
institutional investors.
Seek Independent Research Coverage. In the United States, approximately 400 independent research firms provide fundamental and technical research to both institutional and individual investors. Those firms that publish research on specific companies are typically compensated in one of three ways.
- Commission. Some firms have
a trading desk. Institutional investors often compensate such firms in commission
dollars.
- Subscription. Some research
firms provide their services on a subscription basis. Individual or institutional
investors pay them in hard dollars.
- Contract. Some independent
research firms provide services to subject companies on a contract basis.
Such firms provide companies with research coverage for a negotiated period
of time, usually one full year. Compensation is typically in hard cash.
As noted above, achieving research coverage is an important factor in increasing a company's market capitalization. On average, companies with research coverage have much higher market caps than those that do not; and the more coverage a company has, the greater its market cap. In fact, our research indicates that the average market capitalization of healthcare companies with just one firm providing research coverage is nearly four times the average for healthcare companies with no research coverage (see Figure 1).
It is debatable whether increased research coverage drives increased market capitalization or vice versa. But the value of achieving research coverage by even a single analyst—instead of none—should not be underestimated. Such research is highly correlated with market value, making it an essential component in maximizing value for any company's shareholders.
Conclusion
Over the past decade, structural changes in the U.S. capital markets have made it increasingly difficult for publicly held healthcare companies to maximize market value and access capital for growth. Recognizing the fundamental and pervasive nature of these structural changes should be the company executive's first step toward dealing with the challenges they have brought about.
For many small-cap healthcare companies, the absence of analytical research coverage and institutional sponsorship is a key obstacle to maximizing their market value. Company leaders must overcome this obstacle if they are to continue growing their business. One way to do so is to increase the company's value through merger or acquisition, thereby bringing it within the range of interest for today's institutional investors. Alternatively, companies should seek out research coverage from an independent firm that can provide potential investors with an unbiased analysis of their market value and future potential.
References
1. Fund Analyst Reports [on-line]; available from Internet: http://www.morningstar.com.
2. S O'Brien and R Miller, "Wall Street's Other Analyst Flap," in Investment News [on-line] 23 July 2001 [cited 12 August 2002]; available from Internet: http://www.investmentnews.com.
Chris Sassouni, DMD, is founder, president, and CEO of HealthCare Capital Advisors Inc. (Clearwater, FL), an independent equity research firm focused on the healthcare industry.
Copyright ©2002 MX
