Tuesday, June 20, 2006

Contrarian-speak: Small is Big!

I would like to make just one more point regarding the contrarian viewpoint and small capitalization companies.

The contrarian is interested in stocks that the consensus does not wish to own. When everyone else is running for the sidelines, contrarians are buying and when the rest of Wall Street is bidding up everything with a ticker symbol, contrarians are yelling Sell, Sell, Sell!

Widely accepted thinking in the capital markets is the Efficient Market Hypothesis, which holds that the market prices of public companies are reflective of all information and are therefore efficient representations of value. Security prices revert back to the mean as soon as public information becomes available.

Are contrarian’s thumbing their noses at such hallowed wisdom?

Recent studies have shown that share prices will reflect new information more rapidly as the number of informed investors increases. These studies show there is a delayed reaction to both common and firm-specific information among small firms, whereas large firms evidence more timely reaction. Analyst coverage in particular appears important in adjusting stock prices to new information.

Since complete information diffusion is reached at a much slower pace for the smaller company, we believe the contrarian investor has time in the small-cap sector to ply his “stubborn, illogical” style. Indeed, empirical evidence has shown that contrarian portfolio returns are stronger for firms which have a lower rate of information diffusion. One recent study using NYSE and AMEX listed securities found that the average return difference between contrarian portfolios in the smallest and the largest capitalization quintile stocks was 0.46% per month.

The contrarian investment style is heavily dependent upon intensive research that goes beyond the summary data provided by financial services or developed internally by summarizing company reported financial information. Investigating a possible investment involves communicating directly with company management, suppliers and customers to determine the company’s competitive position. Relative to other investment strategies, it may be time consuming to initiate a position. Yet where pricing inefficiencies correct more slowly, contrarian investors have the time to complete the investigation that others are unwilling to undertake. I believe this makes the contrarian’s “stubborn and illogical” approach particularly effective in the small-cap sector.

A discussion of contrarian strategies that are effective in the small cap can be found in my market paper “Contrarian Strategies: selecting small capitalization stocks.”

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