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As a long-time small cap investor, I assumed that any incremental increase to my rate of return would come from the portfolio’s tilt towards smallness. My belief revolved around Roger Ibbotson and Rex Sinquefield’s book Stocks, Bonds, Bills, and Inflation, which was published in 1982. The study broke out the return from the smallest quintile of stocks listed on the NYSE as well as the return from the S&P 500 Index and its predecessors. For the period 1926 to 1981, small caps delivered an annualized return of 12.1 per cent versus 9.1 per cent for the bigger cap benchmark.
Small cap stocks were riskier as measured by volatility, but they were seen as an attractive diversification for a small part of many institutional portfolios and specialty mutual funds were soon established to tap into the retail market.
Not everyone bought into the small cap thesis. In 1985, Professor Avner Arbel of Cornell University wrote the book How to Beat the Market with High-Performance Generic Stocks. In essence, he argued that the driving force of superior return came not from smallness, but from neglect by the professional investment community. This he measured either in terms of the number of sell-side analysts following a stock, or the number of institutional investors in the company.
He conceded that there was a high degree of correlation between size and neglect because institutions typically do not buy small cap stocks and sell-side analysts don’t follow stocks which are not on their clients’ radar screen, but he claimed that it was better to own a neglected big cap stock than an actively followed small cap. His research showed a 16.4 per cent annual return for neglected stocks versus 9.4 per cent for highly followed stocks for the period from 1970 to 1979.
The efficient market hypothesis tells us there is no free lunch in the stock market, so how did Prof. Arbel account for the outperformance of neglected stocks? He claimed the generic stock premium return came from information deficiency. This meant that investors had to do a lot of their own homework at a cost of time and effort, plus they built in a higher margin of error for risk to account for the poverty of information. As a result, neglected stocks are more likely to be inefficiently underpriced than overpriced.
One problem with assessing the superior performance of portfolios tilted towards any value-seeking factor is that databases are very susceptible to data mining, as well as start and end date sensitivity. So we should always view them with a grain of salt. Plus, in this case, the study is 40 years old and the database covers the era of the Seventies when the world was a very different place. Still, there is a certain intuitive appeal to the logic underlying Prof. Arbel’s thesis, especially for the individual investor.
Institutional investors of all types today have access to infinitely more resources and are beginning to deploy AI into the portfolio construction process. As a result, the individual investor is essentially bringing a knife to a gun fight if they plan to compete in the big cap sector, where dozens of professional analysts spend all day researching a handful of companies. It makes more sense for the individual investor to buy an index fund or an exchange-traded fund for the bulk of their equity exposure and focus on the neglected small cap sector for the value-added portion of a portfolio.
This task is made easier by the monthly publication of an article by Jennifer Dowty which lists the components of the major indexes and includes the analysts’ recommendations and target prices. There is also a downloadable Excel spreadsheet. She correctly points out that the target prices should be viewed with suspicion because they are not always updated promptly, but we are not interested in those statistics – just how many analysts follow each stock.
My primary interest here is the S&P/TSX Small Cap Index, but I also took a peek at the numbers for the S&P500 and the TSX Composite.
Small caps to watch: K-Bro Linen, Premium Brands Holdings, Calfrac Well and more
For the S&P500, the typical company is followed by 30 analysts with Alphabet Inc., Meta Platforms, Inc. and Nvidia Corp. up in the 75 to 85 range. The list brings up only three stocks with fewer than five analysts covering them – Loews Corp., Erie Indemnity Company and Texas Pacific Land Corp. The S&P500 appears to be a well researched universe: it is difficult to imagine an individual investor bringing new perspectives to the party.
The situation is more encouraging for the S&P/TSX Composite. Here the typical company is followed by 16 analysts with Shopify Inc. the winner with 54 followers. There are seven with fewer than five analysts coverage: North West Company Inc., Onex Corp., Richelieu Hardware Ltd., Seabridge Gold Inc., Allied Gold Corp., Fortuna Mining Corp. and Winpak Ltd. I already have Richelieu Hardware and Winpak on my followed list and their appearance here suggests that they have potential for wider recognition.
The S&P/TSX Small Cap Index spreadsheet provides more fertile ground for neglected stocks. The typical stock in this index is followed by only seven analysts with Lightspeed Commerce Inc. the winner with 20 analysts. In this situation, a cut-off of five analysts as a measure of neglect would leave us with almost half the list. We can be more rigorous and focus on orphan stocks with zero coverage: The following five are not low expectation stocks – they are zero expectation stocks!
Corby Spirit and Wine Ltd., Frontera Energy Corp., RFA Financial Inc., ADF Group Inc., Amerigo Resources Ltd. I don’t currently own any of these stocks, but ADF Group, Corby and RFA Financial are now on my research to-do list.
Why is now a good time to focus on neglected stocks, regardless of your investment style? In the current market environment many stocks are trading on the basis of elevated investor expectations. They must deliver on these ambitious goals just to sustain the current stock price. Neglected stocks will suffer in a bear market also, but it is more difficult for a zero expectation stock to disappoint shareholders and suffer a total collapse.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.