Neglected Firm Effect

What Is the Neglected Firm Effect?

The neglected firm effect is a financial theory that explains the tendency for certain lesser-known companies to outperform better-known companies. The neglected firm effect suggests that stocks of lesser-known companies are able to generate higher returns because they are less likely to be analyzed and scrutinized by market analysts, leading savvy investors to scoop up values under the radar.

Neglected firms might also exhibit better performance because of the higher risk/higher reward potential of small, lesser-known stocks, with a higher relative growth percentage.

Understanding the Neglected Firm Effect

Smaller firms are not subject to the same scrutiny and analysis as the larger companies, such as blue-chip firms, typically large, well-established, and financially sound companies that have operated for many years. Analysts have a vast amount of information at their disposal, on which to form opinions and make recommendations. The information regarding the smaller firms may at times be limited to those filings that are required by law. As such, these firms are "neglected" by analysts, because there is little information to scrutinize or evaluate.

In a 1983 study that examined the performance of 510 publicly traded firms over the course of a decade (i.e. 1971-80), three Cornell University professors found that the shares of companies that are neglected by institutions outperformed the shares of firms that were widely held by institutions. This superior performance persisted over and above any other "small firm effect", and indeed both small- and medium-sized neglected firms outperformed the broader market.

The study found that investing in neglected firms may lead to potentially rewarding investing strategies for individuals and institutions. In another study, firms in the Standard & Poor's 500 Index that were neglected by security analysts outperformed highly followed stocks from 1970-1979. Over that nine-year span, the most neglected securities in the S&P 500 returned 16.4% each year on average (inclusive of dividends), compared with a 9.4% average annual return for the highly followed group.

Counter-Evidence for The Neglected Firm Effect

While the neglected effect was found to exist in the 1970s and '80s, it may have since gone away. In a 1997 study of the performance of 7,117 publicly traded companies from January 1982 through December 1995, financial economists Craig G. Beard and Richard W. Sias found no support for the neglected firm effect after controlling for the correlation between neglect and market capitalization.

These authors suggested that the neglected firm effect may have disappeared over time because investors have learned to exploit it, as institutional investors have increased their investment in smaller capitalization (and typically more neglected) stocks over the years.

Meanwhile, the studies that found a neglected stock effect in the 1970s may have been sample-specific. Furthermore, sell-side analysts and buy-side firms alike have poured more resources into equity analysis, providing more coverage and fundamental analysis of even the smallest, least-known firms in the market. The result is more market efficiency and less information asymmetry.