We all are aware of what happened on October 19, 1987, commonly known as “Black Monday”. The day is marked for a sudden and largely unexpected stock market crash that hit markets globally. Apparently, it is remembered as a dark day in the history of the stock market crash in the world economy. While Black Monday is an example to show what can happen if stock markets are not accurately monitored, it is also often used by critics to discover a famous financial theory that is still being discussed today: The efficient market hypothesis (EMH). Researchers have discovered several market deviations that are seen reoccurring at certain points in time. This is due to the fact that stock markets are sometimes flourishing, sometimes crashing, and may not always be as efficient as predicted. These patterns in stock returns are referred to as market anomalies. A number of market anomalies exist that every investor should know to have a better understanding of the market. This article explains one of the anomaly- the ‘Neglected firm effect’.

There are no easy ways to beat the market as hundreds of investors are constantly trying for even a fraction of an extra percent of performance. Nevertheless, many investors are fascinated by certain tradable anomalies that seem to persist in the stock market. In financial markets, anomalies refer to a price action that contradicts the predicted behavior of the stock market. It is a situation when security or groups of securities do not perform according to the notion of efficient markets, where security prices are said to reflect all available information at any point of time.

You must have noticed on most of the financial news channels or the infinite number of apps related to stock markets we have these days, they focus only on a certain set of stocks and their performances. It is hardly seen where analysts talk about companies whose balance sheet valuation is below a certain threshold. These are the stocks with low liquidity that are classified as neglected stocks. These stocks have minimal analyst support and are usually left undiscovered by ordinary investors.

Conventional wisdom dictates that stocks with little or no coverage from brokers and analysts can prove to be some of the riskiest prospects for investors. Neglected stocks fail to appear on the investment radar at all due to scant knowledge and debate about them. These misfits let alone represent attractive opportunities. But in the search for stocks with the potential to perform better than the rest, could a focus on neglected stocks actually provide superior returns? Some investors think it can!

Like other market anomalies (such as small firm effect and January effect) the Neglected Firm Effect is a concept which beckons investors to take advantage of apparent market inefficiencies. So the theory explains that the stocks that fail to attract in the way of analyst coverage actually outperform their well-scrutinized peers or competitors. Studies have even 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 price-earnings ratio. If an Investor uses a value strategy like this arguably get an advantage before the rest of the market catches on.

Research and careful investigation for the neglected firm effect kicked off in the early 1980s by US academics Avner Arbel and Paul Strebel. After studying S&P stocks in the year 1972 till 1976 they inferred that neglected stocks easily outperformed those that were well researched. Their study showed that analyst research helped in predicting the future of company earnings and has the ability to influence stock prices. A higher level of analysis on a stock is also useful to reduce risk and narrow 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 and hence less need for a risk premium. 

A close cousin of the “small firm effect”, neglected firm effect is also thought to outperform the broad market averages. But the two are often confused together. The neglected firm effect persists over and above the small firm effect, namely, the excess returns are not fully attributable to size.

Wall Street analysts don’t usually research or give opinions on small companies with market caps under $1 billion. This is because analysts may not have a vast amount of information on which they could form an opinion and not as many investors will be willing to take a chance on a company they know little about. The result is that when these companies do well, they tend to outperform other stocks by a wide range. But the downside is that there is also the risk that these companies will crash completely and you will lose all your money.

The problem with the neglected firms’ anomaly is that it requires so much more research in order to invest successfully. In the words of Benjamin Franklin “An investment in knowledge pays the best interest”. When it comes to investing, nothing will pay off unless we have complete knowledge about it. Since there is no library for analysts’ estimates and research, you need to directly refer to the companies’ financial documents to make your own analysis. But this seems difficult if you don’t know what you are looking for or how to put together a valuation.

In another study, firms that were neglected by security analysts outperformed highly followed stocks in the Standard & Poor’s 500 Index from 1970-1979. Over that nine-year span, the most neglected securities in the S&P 500 gave a return of 16.4% each year on average (including dividends) as compared with a 9.4% average annual return for the highly followed group.

The neglected stocks are taken in notice when some institutional level investor discovers the value proposition in it. The discovery leads to information dissemination, which in turn pushes more pressure to buy these stocks, which eventually leads to the outstanding performance of the neglected stocks. Research also says that this anomaly actually is not true as once the effects of the difference in market capitalization are removed, there is no real outperformance. Consequently, companies that are neglected and small tend to outperform because they are small, but larger neglected stocks do not perform any better than expected. With that said, though the performance appears to be correlated with size, neglected stocks do appear to have lower volatility.

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