Small-Cap Investing and Illiquidity

The stock market can be exciting, thrilling, scary, and disheartening by turns. Stocks come in all shapes and sizes and cover a wide variety of industries – investing in them will keep you on your toes. There are large market capitalization stocks in the healthcare industry, such as household names like Johnson & Johnson (JNJ). There are small market capitalization stocks in the metals industry, offered by relatively unknown companies like Horsehead Holdings Corp. (ZINC). And, of course, there are thousands of stocks in between. 

Many investors look to market capitalization as a proxy for how well stocks trade and how easy it is to buy or sell stocks at a given price over a given time period. Most believe that large market capitalization stocks are easier and faster to trade (more liquid) than smaller market capitalization stocks. Because of this, smaller capitalization stocks they tend to receive a “liquidity premium” – an extra return or additional compensation investors can get just for holding small capitalization stocks. But the liquidity premium is not always realized, and there are analysts who believe that liquidity has very little impact on returns. So is liquidity always sacrificed because stocks have low trading volume? If so, how does this impact returns?

In the American stock market, small market capitalization stocks are ones valued at less than $2 billion. In international markets (particularly emerging markets), the $2 billion mark often characterizes mid-to-large capitalization stocks, with small stocks valued at less than $1 billion. (For more insight, read more about small- and big-cap stocks.)

When using the strict definition of trading volume as a proxy for liquidity, it does appear that small capitalization stocks have a liquidity problem. It's because of this problem that investors tend to shy away from the market, leaving open opportunities for investors who are on the lookout for undervalued stocks. But before making the leap into smaller sized stocks, investors need to understand potential pitfalls. Firstly, the liquidity premium is not guaranteed, and investing blindly in small capitalization stocks without performing the necessary research and due diligence can result in tremendous losses.

Secondly, small stocks tend to outperform large stocks in the long term but can exhibit greater volatility during shorter periods. In fact, research shows that the estimated annualized risk premiums for illiquid stocks are 1.1% higher than for liquid stocks.

Because of the perceived liquidity risk, the stocks of many small firms are overlooked. The good news is that liquidity risks can be managed. We recommend the following methods: 

1. Research comparing the portfolios of small and large firms at similar liquidity levels shows that portfolios of smaller firms outperformed the portfolios of larger firms even at equal levels of liquidity. This means that highly liquid small stocks could outperform large stocks while rendering liquidity risk a non-issue. 
2. With small capitalization stocks, liquidity tends to disappear when there are no sellers, or when all sellers have already sold. Buyers may still be out there with nothing to buy, and in such cases, the stock price might move sideways (not going up or down) until some event triggers a newfound willingness to transact. However, buyers who've done their research may find that points at which interest is a stock is low are also the best times to buy. This strategy requires patience and a willingness to pounce as soon as the stock does turn liquid.
3. Two scenarios may occur when trying to sell small stocks. In the first, more desirable scenario, investors look to sell when the stock price has appreciated to its expected level and the valuation looks full. At this point, the stock may have caught the attention of other investors, sell-side analysts, and media outlets. This typically means that liquidity has opened up, with more buyers entering the market, and in this scenario, the market is eager to take the stock off your hands and selling is easy and quick. The second scenario can occur while liquidity is still low. At this point, investors have to execute sell order patiently and wait out the market, just as they did when purchasing the stock.

If you've done your homework, take the long view, and exercise patience, you're likely to find that investing in small market capitalization stocks is no riskier than investing in large stocks. Because of the lower interest in this category, it's often easier to find attractively valued stocks – and the resulting performance is often impressive.