How to hunt for small-cap shares that analysts have overlooked

Analyst research plays an important role in helping investors decide which stocks to own - but it has flaws. One problem is that popular companies often get a lot more research coverage than lesser-known firms. This distortion can put too much focus on well-known names - but it may also create opportunities to profit from stocks that analysts have missed.

In his book One Up on Wall Street, the well known American investor Peter Lynch, wrote: “If you find a stock with little or no institutional ownership, you’ve found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you’ve got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm.”

Lynch’s point was that out-of-favour stocks that are overlooked by the City can be a source of great returns for investors prepared to do their homework.

Small-caps struggle for research

In the UK, company size is very influential in determining how much research a firm gets. For analysts (and their employers) large-cap company research offers a much greater prospect of lucrative brokerage and corporate deal-making fees, so it makes sense for them to cover those companies.

As a result, smaller companies generally have far fewer analysts covering them. Some don’t have any at all, while others only have their house broker to rely on. With scant research and few, if any, earnings forecasts, investors face a much more difficult task understanding them.

Yet this lack of research is actually a key reason why investors - including institutional fund managers - make the case for investing in this part of the market. They claim the price inefficiencies caused by fewer investors knowing the value of smaller companies is a major reason for buying them.

In my recent interview with Dan Nickols, who runs the Old Mutual UK Smaller Companies Fund, he confirmed this view. In fact, he said the introduction of the new MiFID II regulations, which will tighten the rules surrounding fees paid for research, will actually exacerbate the dearth of research among smaller companies.

Profiting from the ‘neglected firms’ effect

Academic research into the ‘neglected firm effect’ has found evidence that this kind of inaccurate pricing can be profitable for investors prepared to do the research themselves. Some argue that the anomaly is really about these companies being ‘small’ rather than being particularly neglected. But either way, the evidence points to pricing errors turning up in smaller and less well researched stocks.

At Stockopedia, we track a Neglected Firms screen, which has produced a decent 15.9% return over the past year. In essence it’s a quality-plus-value strategy that lasers in on companies with two brokers or fewer. It looks for below average valuations using price-to-earnings and price-to-book. And it also looks for above average earnings growth, net margins and return on equity. The idea is to target small, higher quality firms that the market has mispriced.

I’ve duplicated that screen and given it a Stockopedia twist by adding our ‘Style’ and ‘RiskRating’ classifications to the table and sorted the list for StockRanks. I’ve also insisted on a focus on FTSE SmallCap and AIM companies. This offers a new perspective on stocks and how they rank for their exposure to quality, value and momentum factors.

To be fair, this is really a strategy for stock pickers rather ‘factor farmers’. These are very small companies that may be showing promising signs, but further research is especially important in this part of the market. This is exactly the type of territory that analysts are likely to overlook. Yet some of these shares, like Synectics, Volvere, Anpario and Dewhurst, have promising profiles when assessed against the StockRanks and the Style classifications.

An advantage over the analysts

Small cap fund managers like Dan Nickols, Giles Hargreave and Mark Slater are well known for their views on the information vacuum around smaller companies, and how it can be an advantage for brave investors. Investing in firms this small is risky, and this type of screening tactic is just a starting point. Without analyst research, it needs strong confidence that the companies really are misunderstood by the rest of the market. Yet the evidence suggests that patchy research can cause pricing errors that can be very profitable for those investors prepared to take a closer look.

You can find the Neglected Small-Caps screen here.