Investing in Neglected Stocks

The term neglected stock can give rise to several different attributes and connotations, but perhaps the most common feature of a neglected stock and the one investors associate most with the term is a relative absence of heavy analyst coverage on the stock. Most often, within the relative comparisons of what constitutes neglect in this sense, there is some agreement that stocks possessing three or fewer analysts covering them are thought to be neglected by the market. The relatively lower number of analysts covering a stock is the primary driving force behind the neglected stock phenomenon. The idea here is that, with fewer analysts covering a stock, the availability of discriminating information on the stock is lower (for example, outside of 10-Ks, and so on), and therefore its scope for a mispricing in the market is greater.

Conversely, those stocks with several or more than one dozen analysts covering them tend to build a cumulative body of knowledge in the market that is both broad and continuously updated. This body of knowledge comes to represent a premium that appears in the stock price versus the neglected firm because investors place a higher value on the supposed visibility and predictability of a firm’s earnings and cash flows. Incidentally, this value premium that appears in the stocks of well-covered or heavily promoted issues ultimately conspires against investors as they are effectively paying up for the prevalent analyst services versus the true underlying fundamentals of the firm, whatever they may be.

In addition to assessing the lack of analyst attention paid to a particular stock, the amount of institutional ownership may also be a worthy indicator of neglect. As a general guideline, institutional ownership of less than approximately 30% would qualify as reasonably neglected. The idea regarding institutional ownership coincides with the degree of information available on the company at hand. One way to think of this has to do with the clients who are paying the bulk of the commissions to the analysts and their brokerage houses. Without these commissions, many of the larger brokerage firms (who are not seeking an independent or niche strategy in equity research) will have heavy disincentive to add coverage if there is no scope for interest from their large clients.

On the other side of the coin, many large institutional money managers are reluctant to go trailblazing into uncharted territories of the market. This reluctance can be due to many reasons, but one important measure is the amount of trading liquidity in a given security. Generally, low trading volume creates the biggest single source of inertia for institutions who are investing in individual securities. From this vantage point, the phenomenon of neglect among securities from analyst coverage and institutional ownership takes on a chicken-versus-the egg dynamic; that is, does growing institutional ownership spur research coverage, or does increasing research coverage spur further institutional ownership? If we had to choose, it is more likely owed to the latter of the two, but that is of no consequence. What really matters here in this relationship is that one presence is unlikely to persist without the other, and in the absence of both, neglect and the pricing inefficiencies it fosters are likely to prevail in these securities.

For those investors who equate pricing inefficiency with an opportunity to generate better performance than the market (for example, the modus operandi of a value investor), these relationships are a welcome phenomenon to be taken advantage of whenever the circumstances permit. To bring the breadth of these neglected stocks prevailing in the market into focus, data provided by the NASDAQ stock exchange several years ago cited that 35% of the stock market had no analyst coverage whatsoever.

–Scott Phillips, Lauren Templeton Capital Management.

Excerpted from Investing in Neglected Stocks by Scott Phillips (Insights for the Agile Investor Series; FT Press).

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