The neglected firms effect is a result of tests of the small firm effect. Small firm tests also found that firms that have only a small number of analysts following them have abnormally high returns. These excess returns appear to be caused by the lack of institutional interest in the firms. The neglected firm effect applies to all sizes of firms. Why would there be excess returns if there is low analyst coverage? Shouldn’t it be the other way around? Or is it that when there is a general sector “run” these neglected stocks “piggy back” off the run?
You should think about it this way. The lower the number of people following or interested in a stock, the lower the chances of it being “efficiently priced” and the higher the potential return from trading on the mispricing. Company A could be as good an investment and Company B, but if it receives no media /analyst coverage, not too many investors (both institutional and individual) would purchase is for their portfolios. Consequently, its price would not be driven up as close to its ‘fair value’ as Company B’s and therefore, it would offer higher abnormal risk-adjusted returns to potential investors.
understood. thanks.
the fact that a firm is not widely covered might also mean investors require an additional premium for investing in those types of stocks and that the excess return is just that. this is in favor of efficient markets. it means that our models for calculating expected return(CAPM, fama and french multi-factor CAPM) are not doing a good job at explaining risk/return