"Neglect Effect" Study Proves Ray is Right

[adios]

Ray has pointed out many times that there are stocks that "fly under the radar screen" i.e. don't get a lot of analyst coverage and that they often present excellent opportunities. In In his excellent book, Investment Valuation, Dr. Aswath Damodaran discusses a study where stock performance was measured by the number of analysts covering the stock. As you might guess the data shows that the best performing stocks, by quite a bit I might add, were those that received NO analyst coverage i.e. nada, squat, ZERO analyst coverage. The worst performing stocks, by quite a bit, were those that had greater than or equal to 11 analysts covering the stock. From 1-10 were roughly the same but the less analyst coverage the better the stock performed. This phenomona is referred to in the book as the "neglect effect." The study is a little dated as I wonder what the results be today with much more info available to the average investor.

[MtSmalls]

This is one of a host of studies looking at informational 'control' in the equities markets. One of the earliest theories that one learns in business school is the "Efficient Markets hypothesis" which exists in several forms. Suffice it to say that the popularly accepted form (Semi-strong) is that all public information (i.e. everything except 'insider' information) is reflected in the stock price almost immediately, therefore, in the abscence of insider information, all rational investors (another oxymoron) will behave the same way and have returns in direct relation to the risk they take in their portfolios.

'Under the radar stocks' are almost without exception, small cap stocks (companies with few shares out, usually at smaller prices). These start-up companies often don't have a great product or service, but are trying to develop one. Or they may have a decent product/service, just sell it into a small market. This puts additional risk on the company and the returns for these stocks is increasingly higher.

[adios]

"This is one of a host of studies looking at informational 'control' in the equities markets. One of the earliest theories that one learns in business school is the "Efficient Markets hypothesis" which exists in several forms. Suffice it to say that the popularly accepted form (Semi-strong) is that all public information (i.e. everything except 'insider' information) is reflected in the stock price almost immediately, therefore, in the abscence of insider information, all rational investors (another oxymoron) will behave the same way and have returns in direct relation to the risk they take in their portfolios."

When you have the mean equity risk premium being between 2% and 14% with a 95% confidence interval how effecient is that? I submit that there is insufficient data to show the following:

"Suffice it to say that the popularly accepted form (Semi-strong) is that all public information (i.e. everything except 'insider' information) is reflected in the stock price almost immediately,"

In fact if anything the events of recent years show that there is a lot of irrationality. IMO the this notion that stocks immediately reflect all information is baloney as ineffeciencies show up all the time. They just tend to be "arbitraged" or "corrected" very quickly.

"'Under the radar stocks' are almost without exception, small cap stocks (companies with few shares out, usually at smaller prices). "

You'd probably be surprised at the size of some of the companies that receive little to no analyst coverage. They definitely don't have to be microcaps. Check out mortgage REITS sometime if you don't believe me. We're talking companies with north of $100,000,000 market caps. I suppose one could consider a $100,000,000 market cap company to be a small market cap but your next statement seems to imply differently.

"These start-up companies often don't have a great product or service, but are trying to develop one."

We're going from small market cap to start up? That's a bit of a stretch don't you think? Anyway IMO you're wrong if you believe that well establish companies rarely "fly under the radar screen."

"Or they may have a decent product/service, just sell it into a small market."

Would you consider a company that has over $300,000,000 in revenue that receives no coverage selling into a small market? Ok I realize that more statistics are required as to the companies that receive little or no coverage but IMO you are way underestimating the frequency that this occurs in say mid cap companies.

[Ray Zee]

the efficient market theory and random walk(book random walk down wall street by burton malkiel it think) is the same ball of crap. it works kind of for big stocks. but it says that all info comes to the surface immediately and is immediately acted upon to make the price fair. anyone can see that just isnt so. over time it is. but people are people and they are inherently lazy so they act irrationally on info. look at the market over the past ten years. do you think it was based on info or hype.

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/forums/images/icons/cool.gif it's amazing how often a stock will go up 50-70%..then go on big analyst's buy recommendations....then tank back down...you watch...when mot makes its move...at about 20-26/sh it will be a "find"by the big boys....almost resembles a pump and dump game..lol..gl /forums/images/icons/smirk.gif /forums/images/icons/smile.gif

[MtSmalls]

FYI, the currently accepted capitalization definitions are: up to $2 Billion = Small cap
2-10 Billion = Mid Cap
>10 Billion = Large cap.

So Yes, I would say $100 million is very small cap, in fact most would classify it as micro cap.

Your original post cited a book or study (I'm not sure which) that 'proved' stocks with increasing analyst coverage 'performed' poorly compared to stocks that had little or no coverage. I assume that the performance measure was the overall price change (may or may not have included dividends paid). Again, with more analysts coverage, there are fewer 'surprises' in earnings or valuation, and thus the price of the stock changes more slowly (performs worse) in a generally rising market. (you didn't mention the time span for the study, so I'll assume its a couple of years old as most of these studies tend to be). It would be more interesting if you could post not only the overall returns for the categories, but the variance in returns within each category.

Of course there are inefficiencies in every market, and by the same reasoning there are irrationalities all the time (there are many good books looking at historical manias starting with the tulip mania in the 1600's), that is how good investors make money over time. (See: Graham, Buffett, Lynch, Price).

I never have (and never would) claim that ANY economic theory is perfect or in many cases even useful, other than as a starting point. They all start with the phrase: Assume that.... I only meant to point out that this recent book/study is not breaking any new ground or telling us something we didn't know.

[David Steele]

I dunno about that for "the efficient market theory"

There have been some Nobel prizes awarded for some fairly
mathmatical analysis of this, although I am not personally
knowledable of those details.

When you look at how fund managers perform, it seems it is
extremely hard to pick stocks. Also when you look at
the super-pickers, the overall theme seems to be the enormous
expense, staff and hard work they use to get a very small
results edge over the rest.

D.

[Ray Zee]

sure but remember that fund managers are forced to have to move large amounts of money, and doing that makes it hard to find good value. they tend to be relegated to larger stocks.
also fund managers are corrupt by their job. they must entice new investors so they have to have the hot stocks in their portfolio and must dump out of favor ones. as the general public follows the hype. so they are never investing in the best interests of their current clientele only shooting for more new investors. even though they have to show a good return to lure them in.

[adios]

To try and illustrate your point. The following portfolio in terms of percentages based on Fridays closing prices may not be practical for an amount of $1 million, probably not $10 million and more than $10 million is out of the question I would guess due to liquidity concerns. For $250,000 not a problem. The combined avg price to book ratio is 1.08 (almost at BV) and the combined avg yield is 14.86%. Whether or not this portfolio would beat the market is debatable but we're not talking about a lot of iffy dividends here either, at least dividends that won't go through any big cuts this year IMO:

Percentage allocation

AMC 4.11
HCM 4.13
NFI 12.15
AXM 5.08
AHR 6.07
MCGC 5.59
FB 8.55
BLU 5.21
MFA 4.86
RVT 5.00
ANH 4.74
NLY 3.89
IMH 3.99
NCN 4.11
PVX 4.26
RAS 4.22
TMA 4.04
Cash 10.00

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