There are undiscovered riches in microcap stocks

There’s tonnes of data on stock and bond prices going back over a hundred years, from all over the world.

When the legendary economist Eugene Fama was asked why he got into studying financial economics, his answer was very simple: it’s the only field where there’s any data!

There’s tonnes of data on stock and bond prices going back over a hundred years, from all over the world. That’s why financial economics is probably the most closely studied area in all of the social sciences.

Every question you can think of has been asked… hypothesised… and tested against the data.

As you may know I’ve been working on a microcap project recently, so they’ve been on my mind. I was wondering whether the fact that brokers and analysts don’t tend to cover microcaps makes any difference to their performance over time.

Wouldn’t you know it, a huge study from 1982 looked into just that question.

The neglected firm

The paper is called The Neglected Firm and Small Firm Effects, by Arbel and Strebel. You can read the full thing here.

So here’s the situation: some companies have hundreds of professional analysts and brokers studying them full-time. These tend to be the biggest companies, but it’s not all to do with size. When I open my market analysis software, and I click on Apple, and I click on the screen showing broker analysis, this is the first page of results that comes up:

As you can see, armies of brokers study Apple as a full time job.

Microcaps are the smallest stocks on the public markets. There are lots of them, and big investors don’t bother with them because they’re too small to invest large sums of money in. And not many professional analysts or brokers cover them.

To give you a rough sense of the difference between big companies and small companies – if Apple is the height of Mount Everest, a microcap would be the height of a barstool.

Anyway, here’s what the paper’s authors discovered:

This paper addresses the empirical question of whether the differential attention which companies receive affects the capital asset pricing process. The degree of attention was measured by research concentration rankings based on the number of analysts regularly following the firm’s securities. The results suggest: (i) that there is a “neglected firm effect” in terms of superior performance for less researched companies and (ii) that the neglected firm effect persists over and above the small firm effect; namely, the excess returns are not fully attributable to size.

They found that returns were higher in companies that are “neglected” by brokers and analysts. And they also found that the companies’ small size isn’t doesn’t account for these extra returns.

In other words, there are undiscovered riches at the smallest end of the stock market. That’s a good thought to leave you with this weekend.

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