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.…

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