10 exciting small-cap shares the analysts have missed

In the mechanics of the stockmarket, analyst research plays a vital role in helping investors decide which stocks to own. One problem though, is that popular companies often get a lot more research coverage than lesser-known firms. This distortion can mean investors herd towards well-known names - but it also creates opportunities to profit from the stocks that analysts may have missed.

In his book One Up on Wall Street, the onetime star fund manager Peter Lynch, wrote:

"If you find a stock with little or no institutional ownership, you've found a potential winner. Find a company that no analyst has ever visited, or that no analyst would admit to knowing about, and you've got a double winner. When I talk to a company that tells me the last analyst showed up three years ago, I can hardly contain my enthusiasm."

Lynch's point was that out-of-favour stocks abandoned by professionals can be potentially bought at the bottom, just before they rebound.

In the UK, one of the biggest determinants of how much research a company gets is its size. For analysts (and their employers) large-cap company research offers a much greater prospect of lucrative brokerage and corporate deal-making fees, so it makes sense for them to cover these companies.

As a result, smaller companies generally have far fewer analysts covering them, and some don't have any at all. With scant research and few, if any, earnings forecasts, investors face a much more difficult task understanding them.

Yet this lack of research is actually a key reason why investors - including institutional fund managers - make the case for investing in this part of the market. They claim the price inefficiencies caused by fewer investors knowing the value of smaller companies is a major reason for buying them.

Academic research into the 'neglected firm effect' has found evidence that this kind of inaccurate pricing can be profitable for investors prepared to do their homework. Some argue that the anomaly is really about these companies being 'small' rather than being particularly neglected. But either way, the evidence points to pricing errors turning up in smaller and less well researched stocks.

With this in mind, we used Stockopedia tools to screen the Alternative Investment Market (home to some of the smallest UK stocks) for those with low broker coverage. We looked for those with evidence of above-average earnings growth and below-average industry valuations on a price-to-earnings basis. We included Stockopedia's 'Style' and 'RiskRating' classifications to get a view about the investment profile of each stock.

Encouragingly, these simple rules pick up a range of shares with strong exposure to high financial quality, attractive valuation and positive momentum - with five 'Super Stocks' having strong exposure to all three of those factors.

At the top end of the market-cap range are Highland Gold Mining and the airline and logistics group, Dart. Among the micro-caps that are potentially overlooked by analysts are the recruitment group Servoca, security specialist Synectics, advertising business Mission Marketing and the IT services firm SciSys.

An advantage over the analysts

Small-cap fund managers such as Giles Hargreave, Gervais Williams and Mark Slater have long noted that the information vacuum around smaller companies can be an advantage for brave investors. But it's important to note that investing in smaller companies is risky.

Without analyst research, it needs strong confidence that the companies really are misunderstood by the rest of the market. Yet the evidence suggests that patchy research can cause pricing errors that can be very profitable for those investors prepared to take a closer look.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.