Published June 23, 2007

It may not pay to follow the crowd

A small investor who does his own research can outdo the big boys

By TEH HOOI LING

SENIOR CORRESPONDENT

HERE's another reason why a retail investor who has done his own research can significantly outperform the big funds, and why following the crowd will not yield super-normal returns for you.

There are a lot more stocks in the market than there are analysts. It is impossible to cover all the stocks listed on the market. So broking firms and analysts have no other options but to pick and choose the stocks to cover.

And since analysts in the broking firms are paid for by the commissions generated by their firms, it makes sense that they will concentrate their efforts on companies with big market capitalisations which are highly liquid. These counters will generate the bulk of the trading commissions for the broking firm.

So, in other words, stocks which are hardly traded also tend to be the ones neglected by stock analysts.

A vast number of studies have looked at the relationship between estimate errors and firm neglect. In many of the studies, firm neglect is represented by the number of analysts covering a firm.

There is evidence that analyst coverage has an impact on the accuracy of estimation, and analyst coverage can be explained by factors such as company size and trading volume.

For instance, Dowen (1989) and Lim (2001) find a relationship between the forecast error and the number of analysts covering a firm. Bhardwaj and Brooks (1992) show that neglected firms, as measured by number of analysts following them, have excess stock returns. Intuitively, this can be explained by investors being compensated for a higher degree of unknown about these neglected stocks.

On the other hand, Branson, Guffey and Pagach (1998) investigate the market response to the announcement of analysts' initiation of coverage of a firm. They find that lightly followed firms, on average, experience larger price reaction to the announcements than either previously uncovered firms or more heavily followed firms.

Rajan and Servaes (1997) examine initial public offerings and analyst coverage, and find that higher underpricing leads to increased analyst coverage.

By looking at the market share of brokerages, Irvine (2001) determines that the brokerage's volume is significantly higher in stocks that they cover than in noncovered stocks. Along the same lines, Bhushan (1989) documents that the level of analyst coverage is positively related to the trad ing volume. Furthermore, O'Brien and Bhushan (1990) suggest that trading volume determines the level of analyst coverage of a certain firm.

Adding to the relation between firm size and neglect, Carvell and Strebel (1987) claim that the small firm effect is in fact a proxy for the neglected firm effect, measured as number of analysts following.

In summary, there is evidence that 1) analyst coverage has an impact on the accuracy of estimation, and 2) analyst coverage can be explained by factors such as company size and trading volume.

So if higher liquid stocks are covered widely, and that analysts' forecasts of widely covered stocks are more accurate, then it is also true that the stock price will already have reflected what the market expects of them.

In contrast, a thinly traded stock may remain undervalued for some time before the market wakes up to its potential. Once that happens, there will be increased trading in the counter, which will lead to analysts initiating coverage of it, which, in turn, may generate even more interest from investors.

Returns for illiquid stocks

I decided to do a little bit of back-testing to see if, indeed, buying illiquid stocks will yield superior returns over time.

Here's how I do it: I rank all the stocks listed on the Singapore Exchange based on the value of their shares traded in the past six months. The lowest 10 per cent, that is those which have the lowest trading value, will be in decile one. The next 10 per cent will be in decile two. The most liquid stocks will be decile ten.

I do the ranking every quarter beginning from Jan 1, 1990. Then I take the average returns of the stocks in each decile a year later. So altogether, there are 66 one-year periods.

I then assume that $100 is put at the beginning of 1990 into each of the 10 groups of stocks. The $100 is rolled over for the next 66 one-year periods. So, if the average return in decile one is 20 per cent in the first period, the initial $100 will become $120. That will be the amount available for investment in the second period, and so on. No transaction costs are taken into consideration.

The results may surprise some of you.

As you can see from the chart, low liquidity stocks - the first and second deciles - outperformed the market by a big margin if that performance is compounded over time.

Between Jan 1, 1990, and April 1, 2006, buying least liquid 10 per cent of the market every quarter and holding that portfolio for one year would return a whopping 27,349 per cent. A $100 invested then would balloon to $27,449. The next 10 per cent of stocks in terms of liquidity yielded even better results. The pot would have grown to $29,933.

After that, the more liquid the stocks get, the lower their return. The most actively traded 10 per cent of the market returned a measly 28 per cent. In other words, the original $100 only managed to grow to $128.

In comparison, the SES All Shares Index - using the same quarterly roll-over method - grew $100 into $1,257 during that period.

But perhaps the bulk of the gains were made in the 1990s when the market was arguably less efficient and investors less savvy.

So I checked the returns from 2000 onwards. The results are broadly similar. But in the new millennium, it was the second decile which had the outsized performance. A $100 put into the second decile portfolio would have grown to $1,520. The third decile, that is, stocks ranked 20 to 30 per cent lowest in terms of the value of shares traded in the six months prior, returned 353 per cent.

The first decile is third in performance, with a return of 288 per cent.

Again, it was the highly liquid stocks which failed to deliver in terms of share price performance. The 10th decile just broke even, with $100 at the beginning of the period almost unchanged at $101.3 by the end of the study period.

The seventh decile suffered a 29 per cent loss. During that time, comparable performance from the SES All Shares Index was 155 per cent.

One of the reasons for the super performance of the neglected stocks is that some of them became reverse takeover targets. And some turned around from losses, and hence saw a big jump in their share price.

Of course, in real life, investors may not be able to replicate similar performance. Illiquid stocks are by definition illiquid, which means that it takes time to accumulate them. Or should one want a sufficient number of shares, one will have to bid up the price. That will eat into the return.

Still, for those patient enough to wait, and have a good-enough nose to sniff out good bargains, it may be a good place to begin the search.

The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg