Conventional wisdom dictates that stocks with little or no coverage from brokers and analysts can be some of the riskiest prospects for investors. Scant knowledge and debate about these misfits means that often they fail to appear on the investment radar at all, let alone represent attractive opportunities. But in the search for stocks with the potential to outperform, could a focus on neglected firms actually deliver superior returns? Some investors think it can...
A market inefficiency?
Like other market anomalies (such as calendar effects) the Neglected Firm Effect is a concept that beckons investors to take advantage of apparent market inefficiencies. So the theory goes, stocks that fail to attract much in the way of analyst coverage actually outperform their well-researched peers. Some commentators have claimed that the uncertainty and comparatively illiquid nature of these stocks causes investors to demand a premium on their expected returns. Inevitably, this means digging around in a basket of unloved and misunderstood companies for signs of value, such as higher growth rates and low P/Es. Investors that use a value strategy like this arguably get an advantage before the rest of the market catches on. It takes investors into territory known as ‘post earning announcement drift’ – where the market fails to fully respond to positive earnings news from stocks.
Scrutiny of the neglected firm effect kicked off in the early 1980s with a paper by US academics Avner Arbel and Paul Strebel. They studied S&P stocks between 1972 and 1976 and found that comparatively neglected stocks easily outperformed those that were well researched. Their study examined the role of analyst research as a predictor of future company earnings and its ability to influence stock prices. They posited that higher levels of analyst research on a stock reduced risk and also narrowed the distribution of expected returns. In other words, the existence of analyst research provides much more certainty about how a company will go on to perform – hence less need for a risk premium.
A separate study in 2008 by Australian academics William Bertin, David Michayluk and Laurie Prather took a closer look at the specific liquidity issues surrounding neglected firms. They concluded that these companies are much less liquid than their counterparts, which means the associated trading costs (bid-ask spreads) are generally higher. As a consequence, they claimed, investors do demand a…
