Understanding the Neglected Firm Effect

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Academics and practitioners have long been stumped by the Neglected Firm Effect. The crux of the anomaly relates to superior returns, adjusted for risk, over an extended period of time with hardly any exceptions! Bizarre as it may sound, there is considerable evidence to show that a diversified portfolio of neglected stocks selected at random significantly outperforms the market. Imagine the possibility of improving the “quality” of the portfolio using a number of simple filters. But before we come to the “bells and whistles”, a number of practical issues come to mind:

• What amounts to a usable definition of neglect?
• How does one identify such stocks in practice?
• Is it not obvious that such stocks must be more risky?
• Is the effect replicable over time or is it characteristic of certain phases of the market? Should it not vanish, once investors get acquainted with it?
• Why does neglect work?
• Is it a subset of either the small firm effect or statistical cheapness?
• And most importantly, if the method works, which investors are best suited to adopting the approach?

Without providing detailed answers to these questions, any investment strategy based on this approach would be esoteric, quirky but fundamentally useless. The quintessential concept of neglect is rooted in the information available about a stock. Ideally, the degree of neglect should be measured by (a) the quantity, (b) the quality, and (c) the convenience and rapidity of obtaining information on the stock at any given point in time.

While no measure exists to quantify or rank neglect, two basic indicators are useful in identifying neglected stocks. The first deals with a lack of analyst coverage. The second indicator is captured by the extent of ‘institutional’ ownership. Not surprisingly, there is a high degree of overlap between the two measures since brokerage analysts are unlikely to waste their time on companies in which their clients are not interested! It must be pointed out that the dynamics of the process should not be ignored. A change in the extent of analyst coverage or the level of institutional holding might prove to be just as important as the absolute measure. Other yardsticks such as average daily trading volume, cheap valuations, penny stocks and low market cap are useful adjuncts but far less reliable in identifying neglect since they are considerably less explicit measures in terms of information content. Gary Putka, a highly respected journalist wrote in his “Heard on the Street” column in the Wall Street Journal: “A study by two finance professors may shake up some investment theoreticians, as it tends to cast doubt on the popular efficient market theory. The findings also suggest something that may be heresy to many on Wall Street: That the biggest gains on a stock may already be behind it before brokerage house analysts begin following it.”

Academic research in the US (‘Pay attention to Neglected Firms!’, Journal of Portfolio Management, Winter 1983) has revealed insignificant differences in the observed market risk between stocks with varying degrees of neglect. Even better, the study finds that unsystematic or specific risk does not greatly change with degree of neglect. A number of academic studies seem to be equivocal about the uniqueness of the Neglected Firm Effect vis-à-vis the Small Firm Effect. The evidence does not support this notion. The data clearly suggest that the excess returns provided by small cap stocks do not prevail once returns are adjusted for total risk. Further, when controlled for degree of neglect, the Small Firm Effect largely disappears. In other words, the performance of small popular firms is no better than that of large popular firms. Also, large neglected companies perform better than small popular companies! Finally, the findings hint at a possible reverse Small Firm Effect, i.e, among institutionally popular securities, the larger firms perform better than the smaller firms.

Intuitively, most investors seem to believe that the four most important anomalies—the Small Firm Effect, the Neglected Firm Effect, the low PE Paradox and the January Effect—are somehow related. Yet, Wall Street is not known to offer a free lunch. Therefore, the excess returns represent reward for an unspecified factor. Proponents of the Neglected Firm Effect are convinced that each of these is related to a common informational variable that affects the risk perception of investors. These anomalies in a sense represent proxies of what is labelled generic premium in academic jargon—a premium that is well deserved and can be entirely captured. Could it be possible that part of the return available from neglected stocks is a premium for loneliness, for having the guts to wander far from the herd?

The conventional wisdom on generic products is that they do not have the stamp of approval provided by a brand name or trademark. Parents often elect to send their children to elite academic institutions (the Ivy League, Oxford/Cambridge) because of their reputation for high standard of education and partly for the prestige. Do you necessarily get a lower quality if you buy a generic product? The immediate answer is ‘no’ but a more balanced view might be ‘it depends’. By implication, you are buying confidence by purchasing a brand. On the flip side, in choosing to buy a generic product, you are prepared to live with greater uncertainty as a trade-off for paying a lower price. And you retain the ability to reduce the uncertainty by carrying out a detailed check on the product prior to purchase. The same idea applies to stocks, since you happen to buy a company as well as its image among a broad spectrum of investors. In effect, what you get is the right to participate in a number of fuzzy, conditional outcomes—dividends, capital gains, liquidity and so on.

Perceptions among investors vary given the uncertainty and lack of perfect information available. When you gamble in a casino it is possible to work out the odds pretty accurately; not so in the stock-market! Virtually all models of investment decision-making ignore the perception component or ex ante measures of risk. In fact, the more mathematically elegant theories assume homogeneous expectations, or a complete consensus among investors regarding the future potential and risk of all companies! But what happens if investors do not subscribe to such a neat assumption about risk and return? This is where the quantity and quality of informational content makes all the difference. A company covered by hordes of analysts and significantly owned by the big boys is close to informational heaven. But you need to pay an extra fee for the better quality information, higher confidence and constant surveillance—which in turn lead to lower returns. What about the company with no analyst forecasts, tight-lipped management and a complete absence of institutional ownership—extreme information deficiency. By checking out such a company diligently, you stand to earn a massive reward in case you get it right. Generic stocks do not possess a reputation, but a lack of reputation should not be confused with low standards. Think of the Kendriya Vidyalayas, Sahakari Bhandar and low-cost airlines in daily life!

As James Montier puts it: “The amount of information that assaults us on a daily basis is truly staggering. Unfortunately, we tend to equate information with knowledge. Sadly the two are often very different beasts. Experimental evidence suggests that often where information is concerned, less is more!”

A subsequent article will tackle the ‘how to do it’ question, or in simple terms, the path to riches by using this phenomenon to advantage.

Sanjoy Bhattacharyya is a partner at Fortuna Capital

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author frequently invests in the shares discussed by him.