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 higher return premium from them.
So how would you go about finding these kinds of neglected stocks? While a simple screen to identify companies with just one or two analysts will tackle the most important angle, it is essential to also screen for signs of quality and value (i.e. the information that's slow to disperse). At Stockopedia we have developed an interpretation of a screen suggested by Ludwig Chincarini and Daehwan Kim in Quantitative Equity Portfolio Management: An Active Approach to Portfolio Construction and Management. The criteria include a focus on attractively priced stocks that are growing faster than their sector averages:
- # Brokers <= 2
- EPS Growth % (TTM) > Industry Group Median
- P/E < Industry Group Median
- Net Margin % > Industry Group Median
- Price-to-Book < 3
- Return on Equity % 5y Avg > Industry Group Median
- Market Cap £m > 25
- No Investment Trusts or Banking Services
How can I apply this screen?
Does it work?
While it's early days, the Stockopedia Neglected Firms Screen has seen an annualised return of 32.84%. In the last six months it has outperformed the FTSE 100, albeit in negative territory, with a return of -0.25% versus -2.36%.
Watch Out For
It is worth noting that not everyone goes along with the neglected firm effect per se. In their study, Arbel and Strebel had concluded that not only did the neglected firm effect exist but that it persisted quite separately from another phenomenon known as the small firm effect. This was a concept first mooted by Rolf Banz in 1981, which argued that smaller stocks outperform larger stocks over the long term. However, a 1997 study by Craig Beard and Richard Sias called into question the distinction between the two theories. Covering 7,117 stocks between 1982 and 1995, they tracked neglect and capitalisation and found that while neglected firms did outperform, they were almost all small stocks. Their view was that the premium had more to do with the stocks being small, than anything else.
- Investment Analysis and Portfolio Management, Frank Reilly and Keith Brown
- Quantitative Equity Portfolio Management: An Active Approach to Portfolio Construction and Management, Ludwig Chincarini and Daehwan Kim
Filed Under: Value Investing,