Alex Hughes

Written by Alex Hughes
International Analyst, StocksInValue

First published in StocksInValue on 25 September 2015

The core principle of value investing is that price and value are not the same thing, and if a discrepancy between the two variables exists, it can be exploited for investment profits. However, in the day and age of electronic distribution of information and the rise of active investment management, share prices are quick to incorporate new information, suggesting markets are more efficiently priced than they once were, and profits from active investment is harder to come by. While this may be partially true, it does not automatically mean that inefficiencies no longer exist and the death of active management is imminent, it simply means that the importance of seeking out inefficiencies has intensified for investors. So what are some reliable sources of inefficiency? Inefficiencies can emerge in a number of areas.
Out of favour stocks are an obvious example for those with the temperament to separate the facts from the noise. However, out of favour stocks come and go and it takes a nimble eye to spot them and pick the winners from the losers.
Cyclical stocks offer opportunities for investors  who can anticipate the cycle and purchase stocks at low prices during cyclical troughs, leading to returns during cyclical highs. This also requires superior insight and the ability to think independently.
Perhaps the most reliable area is small caps, a segment of the market that is structurally inefficient, and potentially an enduring source of inefficiency for those who are willing to do the necessary work. To illustrate why this structural inefficiency exists, let’s look at the research coverage of ASX companies.
In the table below, we can see that the 3 companies with a market cap over $100B have 57 analysts covering their stock, translating to 19 analysts per company, who spend their waking hours anticipating the companies every move. However, as we look to smaller and smaller companies, it is clear that fewer and fewer analysts cover each company. For companies with a market cap of between $100 and 500 million, there is only one analyst covering the company on average. It is interesting to consider that there are more analysts in Australia covering the largest 7 companies than the smallest 1141 companies combined. In a game that is based on developing unique insights and using those insights to get an edge over other market participants, it seems obvious that the easiest place to do this is where the competition is the least.
When we look to the US market, the theme is also the same. While the amount of companies is greater, the largest companies also have the most coverage, and the smallest companies have the least, despite the fact there is considerably more small companies than large ones.
We conclude that the most covered companies are likely to be the most efficiently priced. These companies have the greatest number of professional analysts studying their business and disseminating this information to the most people, hence the possibility of the market overlooking or misunderstanding important factors is lower. Conversely, the companies that have the least analyst coverage, which is typically smaller companies, are likely to be the most inefficiently priced, which suggests the best bargain hunting is likely to be most commonly found in smaller companies.
We suspect the underlying cause of this is structural and is unlikely to change. For sell side brokers, profit maximising incentives drive there research universe, as covering large companies offers the greatest commission potential from large institutional clients, not to forget lucrative capital raisings and other corporate work for their investment banking divisions. And as the majority of the funds management industry is mandated to invest in the largest companies, a structural demand for research on large companies also exists. This suggests that the largest companies will always have the most research, and hence small companies will continue to be relatively more inefficient.

Market Cap (m) Companies No of Analysts Average Analysts
Per Company
>$100,000 3 57 19
$50,000 – $99,999 4 70 18
$25,000 – $49,999 5 68 14
$5,000 – $24,999 56 697 12
$500 – $4,999 177 435 2
$100 – $499 247 238 1
< $99 1141 116 0

Table 1. ASX

Market Cap (m) Companies No of Analysts Average Analysts
Per Company
>$100,000 60 1116 19
$50,000 – $99,999 98 1328 14
$25,000 – $49,999 182 2759 15
$5,000 – $24,999 756 10651 14
$500 – $4,999 1903 16135 8
$100 – $499 1054 4627 4
< $99 583 1297 2

Table 2. USA