Back in the 1970’s an American economist by the name of Professor Eugene Fama put forward a theory called the efficient market hypothesis (EMH).
This theory maintained that all stocks are perfectly priced given that all market participants possess equal knowledge of the companies.
Like the broader investment community, we have not found this to be strictly true given that there are investment approaches that have been shown to consistently outperform the stock market. However the message that markets are generally efficient does ring true.
For example, when a fund manager comes to us with a 200 stock portfolio of, say, FTSE 350 stocks we are sceptical of his claim that over half of a truly internationally-traded stock market like the UK is really undervalued. With literally hundreds of thousands of investors glued to their Bloomberg screens every minute with billions to invest at any moment for new investment opportunities, the suggested mass misvaluation seems unlikely.
However, Professor Fama’s point has particular resonance for small company shares. In particular, when the EMH refers to the relationship between full and equal information and the efficient pricing of stocks, we start to see this break down the further you go down in size of company.
If a UK company needs to provide information to the stock market, by law it has to be announced via the Regulatory News Service, whether you are BG Group or GB Group (small company valued at £200m that specialises in identity data). So, no difference there.
However, the real point of difference is in the research coverage of the companies – the detailed analysis and valuation done by investment banks. Using our two examples above, BG Group has 26 analysts who cover it closely based in London alone and countless others, no doubt, overseas. Our small company GB Group, however, has one. Here is where the information gap begins to open up significantly.
This is not an isolated example. Small-capitalisation stock fund management group Montanaro has compiled some data on the research coverage of stocks, as below;
|Market Capitalisation Range||Average Number of Bank Research Analysts|
|£8.5bn - £40bn +||30|
|£2.5bn - £8.5bn||20|
£80 m – £2.5bn
Here, you can see why imperfect information, and thus inefficient pricing, is more likely in the smaller companies.
But if there are these opportunities in the smaller companies, surely it will not be long until some investment bank wades in and closes this information gap?
In actual fact, over the last two decades the reverse has been true.
As investment banks have become larger and more global, they are only interested in researching companies that they can 1) trade in very large size, and 2) encourage to indulge in very lucrative (for the investment bank) merger and acquisition activity.
Nevertheless, this has opened up the opportunity for fund management companies instead to take up the reins of research coverage and use the valuations to determine the positions in their portfolios.
Attractive growth dynamics, combined with these pricing inefficiencies, are some of the key reasons that the EQ model portfolios are weighted in favour of small and mid-capitalisation stocks. Fund managers of our portfolio funds, such as Miton and Marlborough, have built up significant expertise in this part of the market which has outperformed the broader stockmarket over many years.
However, this phenomena is not confined to our shores. This has become a broader issue as recent data from JPMorgan Asset Management in Japan has shown. Of the 1,689 companies in the broad TOPIX Index, around 20% have no research coverage and nearly 30% only have one – that’s over 800 stocks with low or no coverage!
Again, this is another region where these inefficiencies have been used to garner performance from smaller companies in the Equilibrium portfolios with funds such as the Baillie Gifford Japanese Companies unit trust.
Thus, whilst Professor Fama’s theory has largely been debunked by the investment world, it provides a good starting point to examine where the opposite is true – where information inefficiencies mean that stocks are not perfectly priced and provide outperformance opportunities.
As it is clear, smaller companies are being left high and dry by investment banks that give the rest of us a chance to profit from the resultant information gap.
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The commentary provided in this article is for information purposes only and does not constitute financial advice. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.