If you are still not convinced that the individual investor is at a huge disadvantage in the stock market today, then look no further than the current issue of the Financial Analysts Journal (Third Quarter 2018). No, I don’t mean the academic article full of statistics that explores how difficult it is to separate luck from skill in the stock market: I am referring to the ad on the back page of the Journal.
The ad, sponsored by S&P Global Market Intelligence, is headlined: “Corporate transcripts, meet metadata tagging. Uncover the subtext of corporate transcripts.” If you aren’t sure what this product offers, the next few lines of copy under the headline provide some clarification.
“Extract new alpha potential with alternative data. You don’t have time to read through every corporate transcript. That’s why we provide unstructured, textual data from earnings, M&A, guidance and special calls in machine-readable format for faster analysis. Then, we help you connect the dots with metadata tagging to quickly identify potential alpha opportunities.”
In other words, while you and I are at our day jobs, managers of megadollar portfolios who can afford this service don’t waste their time listening to management conference calls. They simply scan these reports to pick up key words or phrases that are important to their analysis. If they reflect an underlying message that is not currently incorporated in the stock price, there may be a trading opportunity for the portfolio.
We don’t know if this type of analysis adds value after the cost of the subscription and transaction fees, but one thing is certain: When the individual investor gets home from work and later tunes in to a recorded version of the conference call, all of the “alpha opportunities” have been gobbled up by the big guys, who already have access to huge financial databases and sell-side research reports. As we know, there is no guarantee that access to all this research generates positive alpha for actively managed funds, but the odds are remote that an individual investor will come out ahead of this pack on a consistent basis.
In effect, the individual investor is bringing a knife to a gunfight, at least in this sector of the market.
If the leading edge of investment research for stock selection now requires a subscription to metadata tagging, how should the small investor respond? My first suggestion is that you should pick your fights. No one says that you have to be an active manager of the big-cap stocks in your portfolio, so recognize that this is a fight you are unlikely to win. Instead, invest this portion of your assets in a low-fee index fund or exchange-traded fund.
As a long-time small-cap value investor, my next suggestion won’t come as surprise: Small-cap value is where you have a fighting chance of finding the alpha opportunities passed over by the big guys. With little sell-side coverage or institutional ownership of these stocks, your research could lead you to a proprietary insight and significant upside. If the illiquidity of the small-cap sector presents a problem, then confine your research to the universe of large-cap stocks with little or no analyst coverage as they won’t be on the S&P Global Market Intelligence database.
In fact, as far back as 1985, professor Avner Arbel of Cornell University found that S&P 500 companies with the least sell-side coverage delivered the best market performance. In his book How to Beat the Market With High-Performance Generic Stocks, he argues that neglect is a better predictor of future performance than smallness, although there is a high degree of correlation between the two factors. Subsequent research has confirmed that it is better to own a neglected big-cap stock than an actively followed small-cap stock.
There is another potential benefit from a focus on this sector of the market: Companies with little or no research coverage or investor following may decide that the cost/benefit payoff for being public is not working in their favour. So, they may decide to go private or accept a takeover offer from a larger competitor at an attractive premium.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Robert Tattersall