Size does matter

A popular mantra amongst many investment advisors is that large blue-chip stocks are safe investments and smaller companies are risky and speculative. That may well be the opposite for individual investors.

Risk comes from not knowing what you’re doing. Many small companies are easy to understand. Compare that to large blue-chip corporations with hundreds of business units and complex derivative structures.  Some are impossible to analyse.

The individual investor’s advantage

Most large fund managers underperform the market averages after taking into account management fees.  These funds in aggregate are basically the entire market, and the market can’t outperform itself. With billions of dollars under management, they have no choice but to invest in the biggest companies. Many end up buying the same BHP, Rio Tinto and Telstra shares.

The individual investor has a distinct advantage in its small size. Many smaller companies are ignored by brokers and professional analysts. With $1 million or less, you have a choice of investing in 1,600 companies on the ASX. With $1 billion under management you probably have to stick with the largest 100.

Liquidity

A stock’s liquidity generally decreases proportionally to the company size.  There are other factors such as the amount of shares tightly held by insiders etc. Many fund managers and insurance companies are restricted by law or policy to hold a portfolio of investments with a certain level of liquidity. Margin lenders refrain from taking micro-cap companies as collateral even though some of them are well established with strong balance sheets.

It is reasonable to expect that illiquid shares will be priced lower in the market and hence provide higher expected returns in order to make up for the extra time of getting rid of it. The question is how much lower are these illiquid shares priced?  If high liquidity is not a significant portfolio objective i.e. if an investor can obtain short term cash withdrawals by other means then it may be worthwhile buying illiquid shares if the liquidity premium is significant.

Quantifying the liquidity premium

We looked at 1,900 companies on the Australian Securities Exchange and sorted the companies by market capitalisation into groups of 100 each. The smallest 600 companies are all under $8 million which is extremely small in share market terms – we will ignore those.  We divided the largest 1,300 companies into 13 groups of 100 each, with group 1 as the largest companies and group 13 the smallest by market capitalisation. A detailed analysis of the data can be found here.

Both Price/Sales and Price/Earnings valuation metrics suggested that bigger companies are higher priced. While these statistics are only approximate we can conclude from the data that large blue-chip companies are on average priced approximately 60% higher than companies in the sub $50m market cap space.

If we assume that corporate profits as a whole will grow each year in line with inflation (approximately 3%) then investing at P/E of 16, and re-investing all returns will turn $100,000 into $468,251 over 25 years. But if you constantly invest at a P/E of 9 and re-invest all returns then an initial $100,000 investment will grow to $1,461,378. So investing in the small cap arena over 25 years can make a million dollars difference with only $100,000 initially invested.  That is not the price we want to pay for the privilege of more liquidity. The spreadsheet with calculation details is here.

Also, what a large institution define as illiquid is not necessarily illiquid for an individual investor. Investing $100,000 in a company with a market cap of $50 million is rather easy for an individual investor.  The bid/ask spread is usually under 5% and if you are patient with limit orders then the bid/ask spread shouldn’t be a cost either. (There is also an opportunity for ’scalping’ with bid/ask spreads which we will cover in a seperate article).

It is impossible for large institutions who have billions of dollars to invest to make meaningful investments in small caps.  Individual investors have a distinct advantage when it comes to investing in small companies. Yet so few exploit this advantage and still tend to follow the investment habits of the large investors.

We have to keep in mind though that larger competitors may have better economies of scale and better market power to push small companies out of existence. We are searching for small industry leaders with unique competitive advantages. Big companies also tend buy these small market leaders out at a premium.