Lessons: Narrow Doors Make for Tricky Thoroughfare

As a fund manager of a small cap fund, I am keenly aware of liquidity in the stock market. It is not just a constraint but a risk that needs to be managed on both a granular and an aggregate basis. And, sometimes, it can also offer some opportunities…

What is “liquidity”?

It is a simple question, but nuanced in terms of how you view, measure, report and track it.

I view liquidity as the ease, speed and frictional cost with which an investment can be bought or sold. “Ease” refers to the type of investment. For example, listed stocks are easier to sell than unlisted stocks and, hence, are considered more liquid. “Speed” refers to how many willing buyers or willing sellers may exist to be counterparties to any selling or buying of the said investments. You cannot sell something no one wants and you cannot buy what no one wants to sell. And, finally, “frictional costs” refer to how any activity to buy or sell the investment may directly impact on its price, i.e. Price slippage across a wide bidding spread, thin market depth or other such “costs” in buying or selling an investment.

With that definition of liquidity behind us, one of the nuances of the metric is that it is not a constant.

A stock can be liquid one moment and illiquid the very next, or visa versa. An illiquid unlisted stock can be listed and become liquid. An illiquid listed stock can be the target of a takeover bid to take it private (and make it more illiquid) and become, briefly, highly liquid as buyers bid it crazily up. A liquid stock can report some disaster and see buyers disappear as it’s stock’s liquidity evaporates. Indeed, entire markets can get pumped full of liquidity while others can be drained thereof (like what has just happened in the US’s repo market).

I repeat: liquidity is a dynamic metric and not a static one.

If two identical assets exist with differing degrees of liquidity, then the market will typically discount the illiquid asset. Further, because liquidity itself is dynamic, this discount itself is dynamic. Hence, patient investors with patient capital can sometimes acquire great investments at material discounts based almost solely on illiquidity.

(The inverse is also sometimes true: impatient investors with impatient capital can acquire mediocre investments at material premiums based almost solely on liquidity. That is worth thinking about, but it is not the point of this lesson.)

While we probably all know all of the above, it is always good to revisit and remind ourselves about liquidity and its nuances. Specifically, in the case of a small cap stock, what happens when it goes wrong?

In a classic, multi-bagger small cap investment, an investor will invest in a small, fast-growing company whose share price is undervalued due to a combination of investor ignorance and a large liquidity discount. As the small cap grows, year after year, reporting higher and higher profits, the market slowly sits up and takes notice. While the growing profits naturally lift the share price, the market is also willing to pay more and more for these profits and the resulting re-rating of the small cap’s valuation is an important component of return. The combination of higher profits on a higher multiple makes the company’s market cap larger and its share relatively more liquid. In this way, the re-rating of its valuation is not just attributed to growing investor awareness but also slimming (and ultimate removal) of the liquidity discount attaching to the stock.

But–and herein lies the caveat–it all depends on being in the right small cap stock. No growth, no rising market awareness, no re-rating and/or any combination of these things lacking and the ultimate return may be significantly lower.

Even worse, if profits start to slide backwards, the growth story becomes a bankruptcy story and a small stock starts to become even smaller…and even less liquid.

The wide dispersion and fat-tail returns across the small cap market’s stocks make stock selection is so important. When an investor gets a small cap stock pick wrong, it can be incredibly hard to get out. This is even truer at a large, institutional investor level and, hence, why so many large small cap fund portfolios are made up hundreds of small caps (i.e. glorified small cap ETFs), limiting this risk (but also limiting the upside potential).

Partly due to these severely asymmetrical outcomes, I stand by my emphasis on quality in stock selection in this space. Bad companies rarely grow into large companies and, even if not all good companies do, the odds of hitting the above-noted virtuous cycle of growth, re-rating and increasing liquidity are certainly higher in a good-quality sample of small cap stocks.

In closing, liquidity is an important, dynamic variable to track for all investors in all markets and all asset classes. This is particularly true in the small cap space where it can have material effects, either on the upside or downside. I, personally, believe that a focus on quality shifts a (patient) small cap investor’s odds in their favour, almost irrespective of the stock’s liquidity.

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