DEFINITION of Neglected Firm Effect

The neglected firm effect is a theory that explains the tendency for certain lesser-known companies to outperform better-known companies. The neglected firm effect suggests that the stocks of lesser-known companies are able to generate higher returns, because they are less likely to be analyzed and scrutinized by market analysts. The smaller firms might also exhibit better performance, because of the higher risk/higher reward potential of small, lesser-known stocks, with a higher relative growth percentage.

BREAKING DOWN Neglected Firm Effect

Smaller firms are not subject to the same scrutiny and analysis as the larger companies, such as blue-chip firms, typically large, well-established and financially sound companies that have operated for many years. Analysts have a vast amount of information at their disposal, on which to form opinions and make recommendations. The information regarding the smaller firms may at times be limited to those filings that are required by law. As such, these firms are "neglected" by analysts, because there is little information to scrutinize or evaluate.

The Neglected Firm Effect Debate

In a 1983 study of the performance of 510 firms over a decade (1971-80), three Cornell University professors found that the shares of companies that are neglected by institutions outperformed the shares of firms that were widely held by institutions. The superior outperformance persisted over and above any "small firm effect"; i.e., both small- and medium-sized neglected firms outperformed. The study found that investing in those firms may lead to potentially rewarding investing strategies for individuals and institutions. In another study, firms in the Standard & Poor's 500 Index that were neglected by security analysts outperformed highly followed stocks from 1970-1979. Over that nine-year span, the most neglected securities in the S&P 500 returned16.4% each year on average (including dividends), compared with a 9.4% average annual return for the highly followed group.

However, in a 1997 study of the performance of 7,117 publicly traded companies from January 1982 through December 1995, Craig G. Beard and Richard W. Sias found no support for the neglected firm effect after controlling for the correlation between neglect and capitalization. The authors suggested that the neglected firm effect may have disappeared over time because investors exploited it, institutional investors may have increased their investment in smaller capitalization (and typically more neglected) stocks over the years, and the studies that found a neglected stock effect in the 1970s may have been sample specific.