Abnormal Returns from Small Stocks with Good Prospects

In their December 2005 paper entitled “Information and Prospects: Investment Opportunities and Market Efficiency in the Small-Cap Segment”, German Espinosa and Robert Veszteg examine the value of analysts as guides for selecting stocks that amplify the small firm effect. Is it better to search independently for “hidden gems” or to focus instead on small stocks followed by analysts? Are those analysts one step ahead in the relatively slow diffusion process for new information about small firms? The authors test the hypothesis that small firms with unusually large analyst followings tend to be those with the best prospects. Using monthly data on financial analyst coverage and returns for the stocks of U.S. and Canadian markets between June 1996 and June 2004, they find that:

• Both raw and risk-adjusted returns confirm the existence of a small firm effect, indicating a lower level of market efficiency for small stocks.
• Focusing on stocks with the largest analyst followings amplifies the small firm effect. Analysts do help investors exploit the relatively low level of market efficiency for small stocks.
• Game theory explains why small firms with unusually large analyst followings tend to be those with the best prospects. In general, firms that are undervalued (have good news) seek analyst attention. Firms that are overvalued (have bad news) avoid analyst attention. Because analyst attention is a scarce resource, self-promotion by undervalued small firms skews analyst coverage toward the best small investment opportunities. This dynamic does not apply for large firms, because analysts follow large firms regardless of their self-promotion efforts.

In summary, hidden gems (unlike hidden lumps of coal) generally do not want to be hidden. The best small firms solicit analyst coverage to get investor attention.

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