The Dangers of Paid Stock Research Reports
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Over the past decade and a half, we’ve been warning our readers to avoid penny stocks like the plague. We’ve backed up those warnings with dozens of examples where penny stocks became absolutely worthless over time. Were these outright scams, or just incompetent management teams who meant well? Who cares, investors still lost all their money.
Recently, we’ve been defining our approach to investing in disruptive tech stocks. It’s all detailed in a newly published page titled, “The Nanalyze Disruptive Tech Investing Methodology.” Going forward, we’ve set some new ground rules. We don’t cover penny stocks. It’s not because of all the cease-and-desist letters our articles generate, it’s because we have bigger and better things to do. We’d much rather spend our time generating insightful content for our Nanalyze Premium subscribers instead of getting in verbal altercations with stock promoters. So, we will no longer cover companies that:
- Trade on any over-the-counter (OTC) or penny stock exchange
- Have a market cap of less than $50 million USD
Today, we’re going to add one more screening rule. We will not cover any publicly-traded company that spends money on paid research reports.
Paid Research – Startups vs. Stocks
As a boutique research firm that produces insightful content, we’re accosted daily by public relations firms who want us to tell their clients’ stories. We have enough on our plates, so we developed a content marketing offering which means a firm can pay us to tell their amazing story. About half of these requests we’ll turn down because the story isn’t good enough for our lovely readers. In all cases, we turn down publicly traded companies, not because we wouldn’t consider investing in a single one, but because in most cases, companies that choose to pay for research are going nowhere fast.
Among the numerous reasons why we don’t accept compensation from publicly traded firms are the legal risks involved. Section 17(b) of the Securities Act of 1933 states that any present or future compensation should be disclosed along with the amount. (Read it for yourself.) We’ve seen what some of these “research firms” charge, anywhere from $10,000 to $30,000 a report. What we’ve found is that companies with compelling stories don’t need to pay thousands of dollars for faux research reports.
A Paid Research Example
In the past, we’ve looked at many firms that paid for market research reports, such as those people touting the supposed greatness of nanocrystal electricity. Just this past week, one of our European readers pointed us to an Australian firm that’s building a new form of RAM. (For anyone who remembers nanotube RAM, it’s the same sort of story.) Let’s call them COMPANY X.
We took a cursory look at COMPANY X and noticed a section on their website titled “Analyst Reports” which contained paid stock research reports from three providers, all of which admitted to receiving fees (actual verbiage below with names crossed out):
- EXAMPLE ONE: XXX receives fees from the company referred to in this document, for research services and other financial services or advice we may provide to that company.
- EXAMPLE TWO: The directors and associated persons of XXX may have an interest in the financial products discussed in this document and they may earn brokerage, commissions, fees, and advantages, pecuniary or otherwise, in connection with the making of a recommendation or dealing by a client in such financial products.
- EXAMPLE THREE: XXX receives fees from the company referred to in this document, for research services and other financial services or advice we may provide to that company.
At this point in time, we have absolutely no interest in going any further. If COMPANY X paid three research firms to write about them, and we write about them for free, you know what that makes us? Suckers. As we said earlier, we have absolutely no interest in being compensated to write about publicly traded stocks. Our readers expect better from us.
Another Paid Research Example
Just days ago, another one of our readers brought to our attention a Swedish firm – let’s call them COMPANY Y – that’s working in the exciting area of cancer blood tests. In order to prove the merits of the stock, we were directed to read a paid research report that concluded with:
- This report is marketing material and has been commissioned and paid for by COMPANY Y.
Our experience has been that you’ll learn very little by looking at glossy investor decks, much less marketing materials. We don’t need to see 15 slides that describe how big your total addressable market (TAM) is. Every company wears their giant TAM on their shirt sleeve. What we’re interested in are the red flags we’ll often glean by digging into the company’s regulatory filings. If we choose to cover a company, we won’t do it because we read about them in a research report.
The same reader argued that “most research reports are paid for one way or another.” For example, there are often indirect relationships that exist between analysts who write favorable things about COMPANY Y, who happen to work for financial institutions that are actively doing business with COMPANY Y. These conflicts of interest have been raised enough in the past that new regulations such as MiFID II have been put in place that require transparency of costs. As a result, the volume of research reports has plummeted, at least in the European Union.
To Pay or Not to Pay
There’s been an ongoing debate around the merits of paid research reports. Back in 2014, IR published a piece titled “Should You Pay for Equity Research?” which talked about how “Sell-side cutbacks have left more companies contemplating issuer-sponsored equity research. But not all providers are equal.” The below chart by Bloomberg shows how equity research headcount at major banks has been plunging over the years.
Now that less research is being produced, does that mean there’s a market for paid research? Perhaps, but the person who consumes the research should pay for it, that way the producer of the research can act in a purely objective manner. In some cases, we’ve seen research houses charge the companies they cover AND charge for the reports they produce. It’s hard to see how these arrangements benefit anyone except the firm that produces the reports.
The IR piece goes on to talk about how the notion of paying for research is much more accepted in Europe. It’s also a way for companies to get eyeballs on the bull thesis, while letting investors arrive at their own conclusions. We’re not buying it. Companies that have great growth potential but no revenues aren’t worried about telling others about the great opportunity they’re missing out on. They’re too busy executing. If the leadership team is remotely competent, they’ll be looking beyond paid research as a way to raise awareness for the firm.
Most the companies we come across that pay for research have small or non-existent revenues and some shelf dream they expound upon in glossy investor decks while issuing press releases about every “letter of intent” or “memorandum of understanding” that gets signed – as if the legal equivalent of a handshake is some great milestone. Sure, there may be some paid research pieces out there that are truly objective, but we’re not interested in spending the time to separate the wheat from the chaff.
The SEC Steps In
We’ve filed complaints before with the U.S. Securities and Exchange Commission (SEC) that fell on deaf ears, so we’re less than impressed with their ability to police all the bad men out there. Still, we listen when the SEC issues warning and/or takes action because it’s probably just the tip of the iceberg. In April of 2017, the SEC published an investor alert titled “Beware of Stock Recommendations on Investment Research Websites” which warns investors that “seemingly independent commentary on investment research websites may in fact be part of paid stock promotion campaigns.” From the alert:
Any time you get involved with a company where you’re compensated to write about them, you take the risk of being dragged into some future drama because another related party decided not to play by the rules.
If you ever come across a free research report issued by some no-name “research firm” that expounds on the merits of a stock, just scroll down to the disclaimer. Usually, you’ll find some mention of whether or not there is any relationship between the research firm and the company they’re writing about.
Even if the disclaimer does manage to convince you of impartiality, just remember what the SEC recently warned about. We believe we’re all better off just avoiding publicly traded companies that pay for research reports altogether.