Education: Aggressive Growth Investing

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Stocks "Neglected" By Analysts

The word “neglect” has negative connotations in most cases, and with good reason. It is almost never good to neglect something, but as with many other things, the stock market is different. You can profit handsomely from neglected stocks. A neglected stock is a stock that institutions and even analysts haven’t heard of.

According to Multex, there were 8,911 companies traded on U.S. markets last year. Roughly 3,100 of those companies, or about 35%, are followed by at least one analyst. In other words, 65% of publicly traded companies in the U.S. are not followed by a single analyst. With that many uncovered stocks, you can bet there are many neglected ones out there. So how does one measure the “neglect-factor” of a stock?

Follow the Analysts

One of the best indicators that a stock is neglected is the number of analysts following the stock. Generally, the more analysts following a company, the better known the stock will be to institutions and money managers. Greater analyst coverage will lead to more pitching stocks to money managers, which will lead to better liquidity.

This brings us to the question of why greater analyst coverage is good for a neglected stock. The reason is simply that not enough managers are aware the stock even exists to cause the stock’s price to accurately reflect the true earnings potential of the company. Increasing analyst coverage is great because analysts almost always initiate coverage with a positive recommendation. This makes sense because there isn’t much point in writing a research report on an obscure company if it is a dog.

Analysts Gravitate to Potential Banking Fees

Analysts neglect stocks for a variety of reasons, but the main one is that there are no banking fees at stake. A little, unknown stock is much less likely to price a secondary offering or announce a merger than some blue chip such as General Electric.

As we all know, financial companies are in it to make money as well, and there is not too much money to be made by covering obscure stocks that won’t generate much revenue for the analyst’s firm.

Focus on Increasing Analyst Coverage

So how can you profit from analyst neglect? Focus on companies that have experienced increasing analyst coverage over the past month. The general rule is the fewer the analysts to begin with the better. When it comes to companies with little to no analyst coverage, that one new recommendation can sometimes give portfolio managers the validation they need to build a position. (And the more money they can invest, the more they can potentially influence prices.)

Simply look at the number of analyst recommendations now in comparison to the number of analyst recommendations four weeks ago. An increase in coverage is bullish whereas a decrease in coverage is bearish.

It’s typically more bullish if the increase went from none to one or if the coverage was minimal to begin with. (Going from 25 to 26 isn’t going to have the same impact because that 26th analyst isn’t discovering something ‘new’.) But increased coverage is better than decreased coverage –- assuming the coverage is positive of course.

Beware Excessive Growth Forecasts

By definition, aggressive growth stocks have high expected rates of earnings growth. However, it is quite risky to buy stocks that have recently been adopted by analysts with “hot” growth rates. The reason is that you are buying companies based on analysts’ long-term views regarding the company’s future earnings prospects. Not even the most knowledgeable analyst knows what will happen three or more years into the future. The problem is that these high growth rates often fail to materialize and the market prices in these huge rates of growth.

One important point is that high growth rates are not the same thing as rising earnings estimate revisions. In buying companies that are receiving upward earnings estimate revisions, you are buying companies that analysts expect will be earning more in the coming year than what the analysts expected just a few months ago. Basically you are buying companies whose immediate outlook is improving. This is a huge difference.