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Understanding the Neglected Firm Effect
A cademics 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?

e. Intuitively. the low PE Paradox and the January Effect—are somehow related. Even better. which investors are best suited to adopting the approach? Without providing detailed answers to these questions. two basic indicators are useful in identifying neglected stocks. In other words. Further. the excess returns represent reward for an unspecified factor. Journal of Portfolio Management. Other yardsticks such as average daily trading volume. the performance of small popular firms is no better than that of large popular firms. Ideally. The first deals with a lack of analyst coverage. quirky but fundamentally useless. 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. the findings hint at a possible reverse Small Firm Effect. (b) the quality. Therefore. the Neglected Firm Effect.   Why does neglect work? Is it a subset of either the small firm effect or statistical cheapness? And most importantly. the degree of neglect should be measured by (a) the quantity. 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. Gary Putka. Could it be possible that part of the return available from neglected stocks is a . Winter 1983) has revealed insignificant differences in the observed market risk between stocks with varying degrees of neglect. The evidence does not support this notion. 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. the study finds that unsystematic or specific risk does not greatly change with degree of neglect. Not surprisingly. Yet. Wall Street is not known to offer a free lunch. i. most investors seem to believe that the four most important anomalies—the Small Firm Effect. the larger firms perform better than the smaller firms. 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. large neglected companies perform better than small popular companies! Finally.” Academic research in the US („Pay attention to Neglected Firms!‟. if the method works. as it tends to cast doubt on the popular efficient market theory. the Small Firm Effect largely disappears. cheap valuations. when controlled for degree of neglect. 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. any investment strategy based on this approach would be esoteric. Also. While no measure exists to quantify or rank neglect. 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. 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. The quintessential concept of neglect is rooted in the information available about a stock. The data clearly suggest that the excess returns provided by small cap stocks do not prevail once returns are adjusted for total risk. The second indicator is captured by the extent of „institutional‟ ownership. and (c) the convenience and rapidity of obtaining information on the stock at any given point in time. among institutionally popular securities. A number of academic studies seem to be equivocal about the uniqueness of the Neglected Firm Effect visà-vis the Small Firm Effect.

less is more!” Read more: http://forbesindia. Perceptions among investors vary given the uncertainty and lack of perfect information available. 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. In effect. Parents often elect to send their children to elite academic institutions (the Ivy League. its link with information deficiency and the prospect of a „free lunch‟ over an extended period in the stock market were briefly explored. Unfortunately.com/article/column/understanding-the-neglected-firmeffect/36161/1?utm=slidebox#ixzz2iHaz46Ja How To Identify Neglected Stocks I n an earlier article we discussed the Neglected Firm effect and its ability to consistently deliver superior risk-adjusted returns. In fact. A company covered by hordes of analysts and significantly owned by the big boys is close to informational heaven. capital gains. tight-lipped management and a complete absence of institutional ownership— extreme information deficiency. higher confidence and constant surveillance—which in turn lead to lower returns. 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. conditional outcomes—dividends. you are prepared to live with greater uncertainty as a trade-off for paying a lower price. the more mathematically elegant theories assume homogeneous expectations. And you retain the ability to reduce the uncertainty by carrying out a detailed check on the product prior to purchase. By checking out such a company diligently. not so in the stock-market! Virtually all models of investment decision-making ignore the perception component or ex ante measures of risk. you stand to earn a massive reward in case you get it right. liquidity and so on.premium for loneliness. In order to offer practical suggestions on how to implement the . When you gamble in a casino it is possible to work out the odds pretty accurately. The idea of a generic stock. Generic stocks do not possess a reputation. in choosing to buy a generic product. Think of the Kendriya Vidyalayas. Experimental evidence suggests that often where information is concerned. On the flip side. 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‟. Oxford/Cambridge) because of their reputation for high standard of education and partly for the prestige. since you happen to buy a company as well as its image among a broad spectrum of investors. 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. The same idea applies to stocks. Sadly the two are often very different beasts. what you get is the right to participate in a number of fuzzy. you are buying confidence by purchasing a brand. but a lack of reputation should not be confused with low standards. But you need to pay an extra fee for the better quality information. What about the company with no analyst forecasts. we tend to equate information with knowledge. By implication.

and is typically of poorer quality. Measures of neglect are relative yardsticks vis-a-vis other stocks as well as over time. The screening is useful in identifying stocks with high financial risk. The major issues here are:     All measures of neglect are fundamentally proxies rather than exact indicators. Stocks that are vulnerable to the risk of bankruptcy need to be rejected since their neglect is well . The next step is putting together a plan to reliably identify neglected stocks. lower is better. these objectives need to take account of the investor‟s time horizon. As a rule of thumb. By far. Finally. low daily traded volume relative to its peers and its own trading history is a fairly efficient neglect confirmation technique. The safety net of a comforting dividend yield is usually absent. it is essential to present a roadmap that outlines where we are headed. mutual funds and FIIs) and the extent of research coverage by analysts. it is essential to supplement the data with experience and judgement. It also highlights the amount of effort the investor should be willing to put in to achieve the „minimum information threshold‟. There is a need for constant review and monitoring to validate the degree of neglect. the next step is to put them through a sieve. the two most reliable indicators of neglect are the number of institutional investors that own the stock (banks. Finally. experience suggests that it is best to use different measures to maximise „neglect confirmation‟. A relevant concern therefore is to identify the minimum level of information (quantity and quality) that allows you to sleep well at night. it is essential to identify the primary investment objectives in an explicit manner. The importance of using overlapping measures and doublechecking with additional sources such as brokers. Investing in generic stocks is likely to result in a situation where:     Information is far less continuously available on a convenient basis. A critical element in implementing this strategy is doing a really thorough job of verifying neglect.„generic investment idea‟ strategy. There is hardly any consensus among analysts or other investors on the outlook for such stocks. if less than five analysts cover the stock and provide earnings forecasts. the consequences of going down this route and the sequence in which we move forward. which can prove very dispiriting. In each case. bankers and journalists is crucial in confirming neglect. Before adopting any investment strategy. What matters is the proportion of the free float that is owned and the number of such owners. insurance companies. desire for liquidity and level of acceptable risk. Typically. you are justified in assuming neglect. if institutions own less than 10 percent of the free float and there are three or fewer owners. the need for diversification as a means of risk-reduction becomes absolutely vital. Consequently. The point to note is that limited institutional ownership is not necessarily a negative. Apart from these bellwether metrics. The universe typically includes a higher proportion of smaller companies which tend to be less liquid. it is a reasonable proxy for neglect. Typically. Limited press coverage and the absence of analyst meets are also signs one should look for. Once you have put together an extensive list of generic stocks.

the amount of time and resources available and most importantly.deserved! Secondly. you want to avoid „perma-sleepers‟. The first set of filters. Effective portfolio construction therefore requires a trade-off between the two alternatives. The attempt to eliminate bankruptcy risk leans heavily on multivariate prediction models. Now compute the average of this annual PE for the past 5 years and you have a crude normalised PE. In practice. the conclusion may be either not to invest or relax the screening criteria to take on a higher level of risk. and the order in which you implement them. Having reached this far. given the time value of money. The need for intelligent screening to achieve superior returns has no substitute. personal temperament and super-ordinate objectives. The recommended filters. the investor‟s expertise. The next challenge in putting together the generic stock portfolio is to stay away from over-valued stocks and reject companies that are fairly priced but unlikely to appreciate given the mediocrity of their underlying business. A what-if analysis of checking the sensitivity of end results to marginal changes in the filters is always helpful. among which Altman‟s Z-Score is probably the best known. and (b) diversification. The stepwise screening process is the closest one can get to finding diamonds in the rough! Stocks that fail to meet even a single screen are eliminated immediately. One such ratio that is dependable. This one needs a bit of explanation and a fair amount of effort! Calculate the „normalised PE‟ for the last 5 years by using the average of the high and low price for the year and dividing that value by the annual EPS. which are also easy to implement. But to succeed in the market it is not enough to simply avoid disaster. The ideal mix depends on information availability. While such models are robust. In fact. a portfolio of 12-15 stocks gets rid of more than 90 percent of „diversifiable‟ risk. emphasise the opportunity for growth and its valuation relative to the peer group. are listed below:   Compounded annual EPS growth in excess of 15 percent (a proxy for nominal GDP growth) over the past decade. The real issue is identifying high-quality filters that do not consume excessive time and resources. you have hopefully knocked off the lemons. Current PE ratio not in excess of normalised PE trading band. they are difficult to construct and extremely data-intensive. the ideal generic investment is a neglected stock of a solid company that springs to life shortly after purchase because of the existence of a set of factors that appeal to a broader base of less picky investors. These ends can be accomplished by applying a combination of two methods: (a) rigorous filters. If the current PE is clearly higher than the normalised PE. So. it is not possible to eliminate risk solely through diversification. easy to understand and has predictive value is the ratio of operating cash flow to total debt. you wish to anticipate a change in popularity. Since we are dealing with a group of stocks that share neglect driven by information deficiency. Subsequent filters seek to identify financial solidity and the long-term attractiveness of the business. either the stock is over-priced or the popularity flow is already a work in progress! . Experience suggests that less complicated financial ratios that are easily obtained from financial statements work almost as well. If the final list is not extensive enough to permit judicious diversification (less than 12 stocks). not only do you wish to avoid the lemons. The rationale for its efficacy is that it captures the ability of the company to repay its outstanding liabilities without having to resort to external financing.

Read more: http://forbesindia. Given the methods recommended earlier. Consequently. Just a few more points to keep in mind in case you opt to generic: What is the most sensible way to review and monitor the portfolio and how do you judge the right time to exit individual holdings? The final article will come to terms with these nuances and offer a shortlist of generic stocks that make the cut in the current environment. you now stand on the brink of success. the only question that remains is how many stocks to own. Without further ado. Five-year average return on equity in excess of 18 percent (an estimated cost of capital for smaller companies). The efficacy and robustness of the filtering procedure should also have a significant impact in reducing risk. If you completed this process. it is worth remembering that the universe of “neglected stocks” is not representative of the broader market since it is a very unique subset of companies. it is only fair to expect that diversification is likely to be less effective in these circumstances. let me share the results of my most recent efforts at putting together a bunch of high-performance generic stocks that allow me to sleep well at night! .com/article/column/how-to-identify-neglectedstocks/36251/1?utm=slidebox#ixzz2iHbA1idY Neglected Firms Stocks: Knowing When to Sell N ow that you have identified the universe of neglected stocks and are ready to screen the stocks for fundamental strength. While no perfect answer exists in specifying the ideal level of diversification. Consistent growth in revenues during the last 5 years. a portfolio of 15 carefully chosen stocks should prove adequate in trimming market risk without diluting the essence of the approach. Much will depend on the magnitude of the offsetting effect (or what Harry Markowitz refers to as the co-variance matrix) given the mix represented in the aggregate portfolio.   Current financial leverage of less than 50 percent (total debt as a proportion of net worth).

As long as the relative strength persists. evaluate the opportunity cost of switching and avoiding the rank duds! The crux of the generic investment strategy is to diagnose each stock‟s position relative to the popularity flow.” The best time to sell. you enjoy the ride. “I always sell too soon. he summed it up by saying. as a practitioner of generic stock investing. While these two sets of signals tend to move in lockstep. . Calculating a measure of price momentum such as relative strength (vis-à-vis your chosen benchmark index) is probably the most dependable measure of “popularity flow”. The price indicator has the advantage of being timely as well as more sensitive in its feedback. When Baron Rothschild was asked about the essence of his investment success. is when both of the following conditions are satisfied:  The price momentum is clearly exhausted and begins to reverse. Changes in the primary measures of neglect serve as reliable leading indicators but are difficult to track on a regular basis given the absence of weekly/monthly data. The time period chosen to determine price momentum can vary from a month to the last six months. One obvious method is to monitor changes in the primary measures of neglect—analyst attention and institutional ownership. you now need to grapple with the issue of when to sell. The other alternative is to track changes in price. quite often the response time differs.Having passed the moment of truth by committing your money to these stocks. The critical question is knowing when to sell.

com/article/column/neglected-firms-stocks-knowing-when-tosell/36339/1#ixzz2iHbJ2G6G . The suggestions on the screening process. extent of diversification and exit strategy are clearly idiosyncratic. have realistic objectives and remain patient. There is absolutely no doubt that the generic investing strategy is a DIY approach that depends considerably on personal judgment and preferences. Analyst coverage and institutional ownership begin to trend upwards. Read more: http://forbesindia. As the Reverend Samuel Johnson put it: It is by studying little things that we attain the great art of having as little misery and as much happiness as possible. The method is bound to improve over time like good wine as you continually incorporate the feedback from your own learning process. sell when either the fundamentals begin to decline or the price momentum is worse than the index for three consecutive months. these methods are nothing more than techniques to support better decision making. Remember to stay flexible and open-minded. The truly successful investor is dispassionate in implementing a clearly defined exit strategy without allowing either emotion or ego to get in the way of disciplined selling. In case the popularity flow fails to materialise. the greater the rewards. Embrace risk in a positive manner. While they have a veneer of formulaic precision and are supported by empirical research. The better your judgment and the more creative your decision making.

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