As the late Rodney Dangerfield might have said, some stocks get no respect.
But neglected stocks, or those that are generally ignored by the investment community, are precisely the ones investors should be looking at.
According to Francois Trahan, chief investment strategist at Bear Stearns, stocks with low but growing analyst coverage have posted strong excess returns over the past decade. In fact, "orphan" stocks have risen at a compounded annual rate of 27.6% since 1995, he said. In contrast, stocks that have seen an increase in coverage but are already widely followed by Wall Street analysts rose just 12.4%.
While Trahan admits that his study might suffer from substitution or survivorship bias, the favorable results "suggest to us that the orphan stock theme is a real phenomenon and one that investors can use to their advantage."
John Doukas, professor of finance at Old Dominion University in Norfolk, Va., agrees. He notes that excessive analyst coverage tends to feed investor optimism and overconfidence about stocks, which in turn leads to overvaluation and lower future returns.
Doukas, who co-authored a recent paper on the subject, said investors wrongly associate analyst attention with high growth prospects. "Companies with high analyst coverage tend to overinvest, have excessive external financing and produce lower returns" than stocks that are less widely followed, he said.
The list of neglected stocks is naturally very long, and not all of those companies make for good investments. But names like
These companies are tracked by just a handful of analysts and saw a 25% sequential increase in coverage in the third quarter, according to Trahan. They also have market capitalizations of at least $500 million.
In the case of Offshore Logistics, a low price/earnings ratio and strong outlook for growth add to the stock's appeal. The firm is expected to earn $2.33 a share in fiscal 2005 and $2.65 in 2006, up from $1.64 in fiscal 2004.
Offshore, which provides helicopter transportation and production-management services to the oil and gas industry, posted solid results in its fiscal first quarter and said growth opportunities exist as oil companies continue to explore to meet global demand and replace reserves.
As for American Greetings, the company saw a sharp improvement in both earnings and cash flow in its second quarter and reiterated its full-year profit forecast.
Back in June, the company retired debt worth about $186.2 million, helping to reduce future interest expense and freeing up cash for a new 6-cent quarterly dividend. Although the firm faces stiff competition from Hallmark, its improved financial position and reasonable price/earnings ratio suggest the stock could continue to climb after tacking on 19% so far this year.
Chemical maker Georgia Gulf has also posted strong gains in 2004 and recently hit a 10-year high. Yet the stock trades at less than 1 times sales and just 14 times this year's earnings. Both sales and profits are expected to come in above expectations in the third quarter, and the company is projected to earn $3.08 a share this year, $4.82 in 2005 and $5.28 in 2006.
Other stocks with low but increasing analyst coverage include
Dun & Bradstreet
( YELL) and
Doukas, the finance professor at Old Dominion University, said investors may be hesitant to invest in these stocks because there is a perception that low analyst coverage means less transparency.
Investors often assume that when a company is being tracked by just a small number of analysts, it is under less pressure to release information to the public. In addition, some say that under-followed stocks tend to be smaller and carry more risk than their higher-profile brethren.
Still, brokers have dropped coverage of many promising stocks in recent years because thousands of analysts have been laid off and research budgets have been cut amid difficult market conditions. Smaller companies are also less likely to produce investment banking business for securities firms, and that means brokers have little incentive to provide research on them.
Meanwhile, the notion that neglected stocks are somehow more opaque is inaccurate, according to Doukas. "Analysts tell stories, but they don't produce too much private information," he said, adding that all the important news is publicly available through press releases, conference calls and
Securities and Exchange Commission
Although "orphan" stocks have generated solid returns for investors over time, both Doukas and Trahan say investors should exercise caution and consider many different variables when employing this strategy. "While the orphan theme certainly shows attractive investment potential, we would suggest that investors use it as a tool within the context of more in-depth fundamental analysis," said Trahan.