The Global Importance Of The Neglected Firm Effect
Seeking Alpha Analyst Since 2021
Co-creator of the Markowitz-Van Dijk heuristic; a portfolio rebalancing mechanism that I worked on in close collaboration with Nobel Prize laureate dr Harry Markowitz (see also our joint paper in the Financial Analysts Journal; March/April 2003).
Global Citizen. Loves AI, FinTech, Emerging Markets, Travel & Chess
Focus on niche investment opportunities - both listed and non-listed - with a bottom-up preference for small and micro caps and/or venture capital. But the bottom-up portfolio will always be embedded in the top-down asset allocation methodology that Harry M and I worked on.
Part-time academic who started his career ages ago as scholar. Now with more of a focus on Emerging and Frontier Markets and AI.
Entrepreneurial; not afraid to go the extra mile to make investments work.
Summary
- In the 1980s and early 1990s the Neglected Firm Effect got a lot of attention in the academic finance literature.
- There is a link with the Small Firm Effect, but it is not exactly the same thing.
- This Anomaly is not a statistical peculiarity, but something directly related to Behavioral Finance teachings.
- When you do your own research and 'invest' time, money and other resources in digging up the 'truth', the potential pay-offs are largest for those securities that are not widely analyzed.
- Unfortunately, too often investors seem to come and go in herds: all buying and selling the same stocks. This often translates into 'Buying High; Panicking and Selling too Low'.
Introduction
In the 1980s and early 1990s scholars like Arbel and Strebel did a lot of work on the so-called 'Neglected Firm Effect'. Stocks that were not well-covered by financial analysts and/or the financial press showed better performance after risk adjustment than other stocks. Click here for background information about the anomaly from Investopedia.
The problem with studies about the effect - and it still being there or not - is first of all of course that there is a correlation between 'size' and 'neglect'. The larger the market capitalization of a stock, the more likely that analysts and financial press will give it a lot of attention.
The thin line between rational valuation and overreaction; and their link to 'Neglect'
And of course: when one or the other company will get a lot of attention, then all of a sudden prices can go up. There are two factors that can help explain that phenomenon. The first one is totally rational and related to the mechanics of stock market valuation.
Stock prices are the discounted present value of expected future cash flows (via dividend and a later selling of the stock; or - in case you want to hold on to a stock until infinity - via the dividend stream alone).
The discount rate used in such calculations is equal to the risk-free rate plus a risk premium, related to the uncertainties surrounding an investment in such stock. When a stock is 'discovered' by analysts and/or the financial press, the latter two groups of professionals will produce information. Often simply combining pieces of scattered data and news that were already out there. But because of the stock being neglected and small, the big masses of investors in the market, were simply not looking at it.
So in a way it is then rational when professional information producers of good standing are combining the pieces and translate it into documentation, analyses etc. that this info production is now giving interested investors a better chance to value the formerly neglected stock.
The risk level goes down, now that they know more. This translates into a lower discount rate and voila: even if everything else stays the same, the price of such stocks can go up.
But investors are also known for their sensitivity to 'herding'. The behavioral phenomenon that 'something just has to be good when all are talking about it and/or the attention by analysts and journalists has increased and/or chart patterns start to indicate that stock prices are going up' with this momentum then treated as something of value, etc.
This will translate into extra demand for the stock, and with new supply lagging, this will then translate into even larger price increaser for the formerly neglected stock....
Up to a level where another anomaly may actually start to play a role: 'Overreaction' and 'Mean-Reversion'. Too often, the Winners of Yesterday transform into the Losers of Tomorrow. It was actually also back in the 1980s that scholars like Werner de Bondt and Richard Thaler were the first to report on this effect. A portfolio of outperformers (based on their risk-adjusted returns over the last 3-5 years) would often become a portfolio of underperformers over the 3-5 following years. And vice versa.
The market is full with examples of the validity of this latter effect. Up to a level where one could think 'Will They Ever Learn?'.
Dare to Neglect and Invest Your Research Time Wisely
But funny enough, we saw the successes in new industries like 'Tech' and the successes of Unicorns translate into more and more investors chasing 'simple stories'. Investing in large caps and accepting gigantic PE levels when buying. Those stocks will only be delivering a great pay-off when A) their revenue and profit growth track records continue to surprise positively; or B) when you are able to sell in time to another 'believer'. With interest rates in the market falling as well to historical levels, and with therefore thousands of new investors entering without too much experience, we ended up with increased volatility and herds of traders all chasing the next unicorn at a time that ... companies are actually already very large!
Of course there will be new unicorns. But guess what: they will (still) either be part of the under-analyzed 'Neglect' group of listed, undervalued 'gemstones of tomorrow', or they are not listed at all yet. And in the latter case they will be often part of the portfolios of private equity providers, venture capitalists and/or angel investors. With sadly in those cases the trend followers allowing the pros to cash out via the listing of such stocks on an exchange.
Bottom-line therefore: it pays to do your own research. Always. Not just as in being your own DIY financial analyst and use information from sides like Seeking Alpha, Yahoo Finance, Investing.com - Stock Market Quotes & Financial News and others wisely. But also by looking at existing research that was a bit less mainstream. E.g. because a country, sector or size class got less attention. Exceptional stocks can still be found. Always.
The logic of 'Neglect' is global. And of course the Investopedia entry that we used above to give you background information about the phenomenon seemed to suggest that it was not as clear and present in the 1990s and later as it used to be. Well, being both a hands-on (Angel) Investor and an Academic (click for instance here for MIT professor Mark Kritzman's test of my joint asset allocation work together with Dr Harry Markowitz), I have to warn you.
Academic studies about the small and neglected firm effects often look at relatively simple, quant-rule-based portfolios, which are then followed over time. With relatively simple trading rules etc. But wait a minute! If 'Neglect' is about using information that is not fully covered in prices .. and that thereby translates into 'hidden value' and 'potential overperformance' .. then the fact that we now know that the phenomenon exists, will translate into that simple rule being part of the battery of tools of - at least - quantitative investors.
So when the old 'Neglect' seems to be 'gone', it is not 'Neglect' that is gone. Grin .. you just have to dig deeper, because that what was unknown yesterday, is now part of the machinery of quant investors like Dimensional, LSV and others. And therefore: not really 'neglect' anymore in its old form.
These days it is getting harder and harder to find neglected gem stones in well-documented and -researched markets like the ones in the US or Western Europe. You may have to move from mid- or even small-cap to micro-cap to find nice undervalued stocks. Or you may contemplate to do more in emerging markets, where very often research levels are poorer and/or the attention paid to fundamental analysis of stocks is just not there. It is still possible to get a wealth of data which can then be translated into structured information and a strategy that incorporates this information. Databases like the one of Investing.com and Simply Wall Street provide enormous amounts of data and the possibility to create screeners to vacuum clean their universe. And Seeking Alpha's quant screeners give you that possibility as well.
Always good to see a 'confirming' Neglect Study: Professors Dalgar & Sak on The Neglected Firm Effect at the Istanbul Stock Exchange
So basically, it is both good-old, academic me and me the proprietary investor and trader now, who always loves to get 'neglect-related' ideas. Browsing through 'Google Scholar' will always translate into finding one or the other interesting academic paper and idea for exploitation when incorporating it in your investment strategy.
So when bumping into a paper by professors Dalgar and Sak about 'Neglect' at the Istanbul Stock Exchange it was good to find this and see that 'Neglect' was still there. Also on markets outside the 'normal' universe for most investors. Actually, their paper was in Turkish with an English-language summary.
Theory? Not really. If I then tell you that it was good to see this 'confirmation' regarding the how and why of our own global small- and micro-cap research leading us to investment into three relatively lesser-known Turkish stocks during the last 12 months - with as a result some amazing returns in a period in which lots of analysts were warning not to do too much in the country for various reasons -, then it explains. Eregli Demir ve Celik Fabrikalari (IBSE:EREGL) , Haci Omer Sabanci Holding (IBSE:SAHOL) and Turk Traktor ve Ziraat Makineleri (IBSE:TTRAK) delivered returns of more than 40-50 percent in relatively short periods. And I am not telling this with the idea that you should follow us there. Most of you probably cannot even invest directly in smaller Turkish stocks. And not just that: what I said above about Mean-Reversion and Overreaction is also a warning.
Don't follow what others are doing just because they did it with good results. Always do your own research.
But the bottom-line remains. Whatever gets less attention - be it stocks, sectors or countries - has a bigger chance of promising you some interesting deals. It is the pay-off to your 'invested time and research effort' that becomes larger.
'News' or 'Alleged Research' that anyone could have thought of (or that you think of because you read it somewhere) has a much larger chance of being embedded in today's prices already!
Analyst's Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The Turkish stocks mentioned as examples of 'underfollowed, neglected' stocks were in our trading portfolio in the past. They are used for illustrative purposes, because the general findings in the 'Neglect' paper by professors Dalgar and Sak were about the Istanbul Stock Exchange. Seeking Alpha does not provide direct links to the Turkish listings of these stocks. We therefore added as secondary ticker info their US listing. We ourselves had the opportunity to trade in the Turkish stock with our partners. The mentions are NOT AT ALL with the idea that you should follow us. Consult your advisor. Our aim with this blog entry is solely to give you 'food for thought' about Neglect and Underfollowed Stocks.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.