The world of finance has been evolving rapidly in the past few decades, and it has become increasingly complex and interconnected. One of the most important of these developments has been the rise of behavioral finance, a field that seeks to understand how human behavior and decision-making affect the functioning of financial markets. In this article, we take a look at how behavioral finance has impacted the way investors evaluate potential investments, and how this has led to the persistence of the “neglected firm effect.” Already back in the 1980s academic scholars wrote about this effect, which showed that small- and micro-cap companies with less following by financial analysts and the media, did outperform other stock-market-listed firms in terms of net investment returns even after risk adjustment. It was assumed that arbitrage would wash the effect away. But that did not happen. On the contrary, we saw that we can extrapolate 'neglect'-related issues all the way down into similar themes that non-listed companies are confronted with. 

We will discuss how this phenomenon has impacted the ability of small and medium-sized enterprises (SMEs) to attract investor attention, as well as strategies entrepreneurs can use to increase their chances of obtaining funding.

Introduction to Behavioral Finance

Behavioral finance is a relatively new field of study that looks at how human emotions, biases, and heuristics influence the decisions of investors. It has been gaining traction in recent years and is now widely accepted as a valid approach to understanding financial markets.

At its core, behavioral finance is based on the premise that investors are not always rational and can be heavily influenced by their emotions and biases. For example, when making investment decisions, investors may be influenced by cognitive biases such as the “gambler’s fallacy” or the “availability heuristic.”

Similarly, investors may be influenced by herd behavior, which is the tendency to follow the decisions of others without necessarily thinking about it.

These human factors can lead to certain investment patterns that may not always be rational. For instance, it can lead to the “big is beautiful” phenomenon, where investors tend to favor larger companies over smaller ones, even if the smaller companies may be more profitable in the long run.

But these biases are not something that only investors suffer from. After all, investors are humans like other people. Or someone may be an investor on some occasions (for instance when taking decisions for their 401k or pension plan), and an entrepreneur or professional executive at other times. And sometimes the complexity is related to the fact that 'the investor' is not always a single person who unilaterally takes decisions. Institutional Investors for instance are big organizations in which professional executives - who often are not owners, but salaried workers - take decisions allegedly on behalf of the ultimate beneficial owners (UBOs); with academic research indicating that in many cases such decisions were also one or the other way affected by the personal goal agendas of these 'agents' and not just the goals of their 'principals'.

Cognitive Bias and Herd Behavior in the Market

The effects of cognitive bias and herd behavior can be seen in the market in many different ways. For example, investors may be more likely to invest in companies that have a large market capitalization, even if the fundamentals of the company are not necessarily sound. Similarly, investors may be more likely to invest in companies that have a large following, even if the company’s prospects may not be as promising.

These biases can lead to a “bandwagon” effect, where investors are more likely to invest in companies that have already attracted a lot of attention. This can lead to a situation where smaller, less-known companies are ignored or “neglected” by the market, even if they may be more profitable in the long run.

But entrepreneurs may themselves also struggle with these factors. We all know for instance from economic theory about the so-called 'pork cycle' in which one after the other entrepreneur would start with the same products or services as previously successful peers, thereby totally forgetting the iron rules of supply and demand!

The Big is Beautiful Phenomenon

The “big is beautiful” phenomenon is a term used to describe the tendency of investors to favor larger companies over smaller ones. This is due to the perception that large companies are more stable and less risky, and thus, more likely to provide a consistent return on investment.

However, this perception may not always be accurate. In fact, smaller companies may be more profitable in the long run, as they are often more nimble and able to respond quickly to changes in the market. Unfortunately, these smaller companies are often overlooked by investors, as they may not have the same brand recognition or market presence as larger companies.

But again: entrepreneurs and others should be able to understand these phenomena because they are sensitive to them too. Very often decisions to buy a certain raw material or service from one of two candidate suppliers is to a large extent not based on quality and/or relative price alone, but also to a large (and often even dominating extent) on the perception gained via the front office look and feel that we get about the company.

This is for instance very often a big problem when companies from developed countries buy goods or services in emerging countries. They often end up doing business with a big layer of phony or semi-phony suppliers that did not focus on providing the best service for the most reasonable price but instead more on massaging the eye of the beholder. Result: the buyer is often paying too much for too little, simply falling for the trap that the phony supplier understood that the buyer decides to a large extent based on his perception of what a successful company should look like, thereby totally forgetting the difference in wealth, culture and other factors when comparing richer developed with poorer emerging countries.

The Unicorn Obsession: Size Matters

But the success stories of the companies that are now part of (especially) Big Tech have also translated into a new obsession that both investors and entrepreneurs are guilty of.

The “unicorn obsession” is a term used to describe the tendency of investors to focus on companies that have a high valuation, even if they may not necessarily be profitable. This phenomenon is often seen in the tech sector, where investors are willing to invest large sums of money in startups that have the potential to become “unicorns,” or companies with a valuation of over $1 billion. Even when they are still far from profitable.

Unfortunately, this obsession with size and valuation often leads to the neglect of smaller, less-known and more realistic companies that may be able to provide higher returns in the long run. These smaller, more realistic companies may not have the same brand recognition or market presence as larger or more super-growth-focused companies, and as a result, they may be overlooked by investors.

This tendency did already translate into it becoming an obsession for many founders too. They join the rat race of venture capitalists by allowing the latter in, in a quest for the highest possible valuation. This will then in turn attract other investors in later funding rounds who even pay more. With all these extra funds, the companies can try to deliver and become the super grower and later unicorns that investors want them to be. Many founders seem to forget that the bulk of companies does not succeed and go bust instead. And that this is a far bigger problem for company founders than venture capitalists because the latter follows a portfolio approach. Example: when I start a venture fund with the aim to deliver one unicorn or at least a reasonably-good overall portfolio return, then a situation in which 9 of my startups go bankrupt (= 9 times -100% return) with company number 10 generating a 10,000% return is good news. My overall performance is reasonable and investors will be happy (on average). However: 9 of the 10 founders that I started to work with are far less happy with the outcome. They lost their company.

Exploring the Neglected Firm Effect in Developing and Developed Markets

The neglected firm effect has been studied extensively in both developed and developing markets. In developed markets, the effect is often attributed to the “big is beautiful” phenomenon, where investors are more likely to invest in larger companies, even if they may not be more profitable in the long run.

But there is more to it. Some studies even seem to indicate that startups founded by teams in which a larger percentage of key staff has an academic background in a smaller group of top universities - where they often got far more easily exposed to big investors and/or their representatives - seem to do better when it comes to attracting funding. Something that is of course not necessarily true of the firm's performance after acquiring the funding. Just check out the background of the best and largest companies in developed markets. Of course, there are cases where founders were from good universities but there are way more success stories linked to entrepreneurs and their families who via learning by doing, having lots of failures and mistakes then, in the end, succeeded in growing their companies into huge success stories.

So, with there already being a difference in funding ability between founders within developed nations based on domicile and academic background, there is an even bigger gap when we compare founders in developed countries with the fate of their peers in emerging and frontier markets nations.

In developing markets, the neglected firm effect can be attributed to the lack of capital available to smaller, less-sexy companies. In many developing countries, access to capital is limited, and as a result, smaller companies may struggle to obtain the funding they need to grow and expand. This can lead to a situation where smaller companies are overlooked by investors, even if they may be more profitable in the long run. Especially when taking into account the increased growth levels in emerging countries that now start to benefit from better education and health care, the growth of their middle classes and the fact that China and other Asian nations are substantially increasing their demand for the countries' products and services.

But the latter will sooner or later resonate with smart investors, who understand that it will translate into gemstone growth opportunities that can be entered into at reasonable conditions. At One4All Platform we hope to present you with a large number of interesting companies from emerging and frontier market nations, both in listed and non-listed space. And the affected company founders from developing nations will then be able to find a place where they can find and pitch to real investors who are not automatically afraid when hearing that they have a background in Africa or Latin America or Central Asia as opposed to one in the USA, Canada, UK or Germany after first going through one or the other Ivy League educational program.

About 'Hot Sectors' like Tech and 'Not So Sexy Themes like Aging Populations

The “hot sectors” of the market are often the ones that receive the most attention from investors. These sectors include tech, sustainable energy, healthcare, and finance, which tend to have higher valuations and higher returns.

At the same time, there are also “not so sexy” themes that receive less attention from investors. These themes include aging populations, traditional manufacturing, fossil fuels, metals and mining and - surprisingly - diversity, which may not be seen as attractive investments by investors.

Unfortunately, this can lead to a situation where smaller, less-known companies in these “not so sexy” themes are overlooked by investors, even if they may be more profitable in the long run. These companies may not have the same brand recognition or market presence as larger companies, or size peers in sexier sectors and as a result, they may be neglected by the market.

Our One4All Platform is global and sector-agnostic in a manner, where the relative importance of countries and sectors is based on their fundamental value and not on their level of sexiness in the eyes of investors or other stakeholders. We aim to help fight 'neglect' and increase the level of market efficiency in the smaller segments of the listed and non-listed equity markets.

The Problems of Minority-Led and Female-Led Enterprises

In the previous paragraph, we already hinted at the fact that 'diversity' is not that popular a theme among investors. That may sound like a surprise, because the switch towards more ethical investment strategies and the United Nations SDG development goals may suggest otherwise.

The neglected firm effect is however especially pronounced when it comes to minority-led and female-led enterprises. These companies often struggle to obtain the funding they need to grow and expand, as they may not have the same brand recognition or market presence as larger companies. Or investors may incorrectly assume that the (majority of) entrepreneurs in this category are less good, or more focused on their social missions than on creating good, profitable companies.

This can easily lead to a situation where these companies are overlooked by investors, even if they may be more profitable in the long run. As a result, minority-led and female-led enterprises often struggle to obtain the funding they need to grow and expand.

Apart from the simple fact that we believe that there is no reason whatsoever to believe that someone with a minority or female background cannot be a great entrepreneur, we also want to point to the more general basic effect of 'neglect': when there is insufficient supply of capital for this category compared to the legitimate and fair demand, investors will be able to find great opportunities when they dare to give this group of 'neglected' entrepreneurs the chance they deserve!

Strategies for How to Get Funding for Your Company

Getting funding for your company can be a difficult task, especially if you are a smaller, less-known company in a situation of 'neglect'. However, there are several strategies you can use to increase your chances of obtaining the necessary funding.

First, you should focus on pitching your company to the right angel investors or private equity and venture capitalists. And depending on the case of 'neglect' that is the relevant one for you as a founder, who is 'right' may differ. And it is not just about non-listed startup firms finding it hard to secure the funding or relationship with investors that they are looking for. Investor Relations departments of small- and micro-cap companies will also recognize themselves in the issues that we aim to address on the One4All Platform.

Second, you should also focus on pitching to investors who are not just interested in “hot sectors” like tech when they come from entrepreneurs in hot places like Silicon Valley. There are also 'hot sector' specialists who focus on emerging countries. It may just be a bit harder to find them, but they exist. And of course: when you are 'neglected' but part of a “not so sexy” theme like aging populations, the environment, or diversity, you should also not assume that investors will never like you. The group that will consider your case is of course smaller, but that is not even necessarily bad news. Think about it this way: when your case is a great and sexy one in a hot sector, your odds are in and of itself better, but so is the number of opportunities at the disposal of investors. It is not upfront true that this will translate into a better hit ratio for your pitch.

But being an experienced investor with both an institutional and family office/angel background, One4All CIO Erik L. Van Dijk added: "There is however also something of a herd bias present in entrepreneurs, with tons of founders with one or the other 'neglect' element in their case all going after the well-known, bigger investors. Investors who normally can afford to lean back and pick only the best and easiest cases from the enormous group of options offered to them. It is especially a group of 'Growth Investors' that will like your company only when it looks like the inevitable next unicorn. And if you don't, well, then don't waste your time as a founder!"

So-called 'Value Investors' are less sexy in their investment style. They try to buy into good to reasonably-good companies at the right (read: not so expensive) moment. When you have reasonable fundamentals and do understand that you shouldn't ask for the impossible as a neglected founder, then your case may be great news for Value Investors. Van Dijk: ''Reasonably multiples and growth prospects that look fine? That is an interesting case for this type of investor!"

Van Dijk also added: "Finally, you should consider pitching to faith-based or other ethical investors. These investors may be more likely to invest in your neglected company if it aligns with their values and beliefs."

How to Pitch to Angel Investors or Private Equity and Venture Capitalists

When pitching to angel investors or private equity and venture capitalists, it is important to remember that these investors are looking for companies that have the potential for high returns. As such, you should focus on highlighting the potential of your company and how it can provide these returns.

You should also make sure to provide detailed information about your company, such as its financials, management team, and growth prospects. This will help investors understand your company and make an informed decision about investing in it.

Most certainly, you should also understand what kind of company you are. Are you a neglected firm with high-growth potential? Or are you a neglected firm with reasonable growth, but somehow a case of being undervalued vis-a-vis the valuation multiples that should be normal for your type of firm? Do not automatically assume that you are chanceless when of the second type. You are not! Unless you try to sell your case based on valuations that may be considered normal for the average growth firm. Growth Investors won't believe you, and you will miss out on the opportunity to find an interested Value Investor.

This means that you should focus on building relationships with the type of investors that are right for your company. This will help ensure that they are more likely to invest in your company, as they will be familiar with your company and its potential. And not just that: it will also improve the chances of finding the type of investor that wants to stay with your firm in great, good but also troubled times.

Conclusion

In conclusion, the neglected firm effect is a phenomenon that has been persistent over time. Investors - just like other human beings - are influenced by human emotions and biases. This effect has had a particularly strong impact on smaller and medium-sized enterprises (SMEs), as they often struggle to attract investor interest due to their lack of brand recognition or market presence.

However, there are strategies entrepreneurs can use to increase their chances of obtaining the funding they need to grow and expand. These strategies include focusing on pitching to the 'right' angel investors or private equity and venture capitalists for your kind of 'neglected company' case, as well as pitching to faith-based and other ethical investors who often may find one or the other 'neglect'-theme that resonate with their vision and/or mission very interesting. Additionally, entrepreneurs should focus on highlighting the potential of their company and how it can provide high returns to investors in a fair manner. Don't overestimate your growth rates and/or valuation. Investors are not stupid.

Ultimately, understanding the neglected firm effect is important for entrepreneurs and investors alike. For entrepreneurs, it can help them understand why their companies may be overlooked by investors, and it can help them devise strategies for obtaining the necessary funding. For investors, it can help them understand why they should consider investing in smaller, 'neglected' companies, as they may be more profitable in the long run.

One4All Platform and One4All Academy are here to help neglected companies and investors who understand that neglect is not just more risk, but also better return opportunities. One4All is also about the Changing World we live in; one where emerging countries deserve more attention because they grow faster and have younger populations whose average education level is also rapidly increasing.

With the right investments, these countries can not only benefit from economic growth but also reduce poverty and inequality. With the help of One4All Platform and One4All Academy, investors can make sure that their investments are aligned with their values, and that neglected companies, particularly in emerging markets, get the attention they need and deserve.