Why you can’t always get what you want when it comes to small cap stocks

Credit: financialpost.com

Over the years, equity investors have always found outsized returns available in “small cap” stocks — that is, small companies that are publicly listed that hopefully become big companies over time. In Canada, investors who purchase the shares of companies listed on the TSX Venture Exchange have the opportunity to invest in these types of small, publicly-traded firms.

In the immortal words of the Rolling Stones, You can’t always get what you want

By trading stocks of these public companies, investors, in theory, are taking advantage of the two main characteristics that make public companies more attractive than private companies: price discovery and liquidity.

In reality, in the immortal words of the Rolling Stones, “You can’t always get what you want.”

Price discovery refers to the ability to be able to “mark”, or value, any security at any time based on its trading price. Liquidity refers to the ability to buy and sell that security at the whim of the investor.

The two are closely linked. For the quoted price (typically the last price at which the security traded, taken with the current bid/ask spread to determine at what price it might next trade) to have any meaning, there must be adequate trading volume to give quoted pricing any probative value.

Similarly, the concept of liquidity is tied both to trading volume and the market capitalization (size) of a company. Any company that is listed and trades on a recognized exchange is, technically, “liquid.” Not all listings, however, are created equal.

In the case of companies with market caps below, say, $500 million (and even companies considerably larger), the company is often either ignored by the public (including analysts), or very tightly-held by a concentrated group of shareholders, or both.

In these cases, the stock sometimes trades in extremely small volumes and, even then, only intermittently (referred to in the business as “trading by appointment”). A little-know and uncovered stock that trades for, say, 80 cents one day and 60 cents the next day may or may not have changed in value overnight; the differential in trading price provides zero insight into whether or not is has.

Similarly, if a thinly-traded company with a market cap of $250 million trades 5,000 shares at $1.00 on Monday afternoon and another 5,000 shares at $1.20 on Tuesday morning, the chance that an investor holding 100,000 shares could decide to sell those shares on Tuesday afternoon at anywhere near $1.20 cents is virtually zero.

In fact, by looking deeper into the depth of the bid versus the offer at various prices (i.e. how many shares are offered for sale or sought for purchase at various prices above and below the last price), one might conclude that to sell 100,000 shares in the example above could lead to a 50 or even 75 per cent discount to the last trading price. This is why buyers and sellers in this side of the market must never enter a “market” bid or offer, since there will always be an enterprising buyer or seller who will post stink bids or offers in case some unsuspecting participant comes along who is unaware of what is going on behind the black curtain of the “public” markets.

In these examples, we see that both of the so-called benefits of being listed — price discovery and liquidity — are all but non-existent for virtually all investors with any substantial investment in smaller sized companies that are thinly traded.

In recent years, the problem of lack of price discovery and low liquidity in smaller companies has been exacerbated by another related but different issue: stocks — especially sub $1 billion companies — trading at significant discounts to their net asset value (NAV) for prolonged periods of time.

John Maynard Keynes’ famous statement that “markets can stay irrational longer than you can stay solvent” is equally as salient today as it was a century ago. There are numerous stocks (many of which are real-estate-related) that seem to defy the “markets are rational in the long term” thesis by perpetually trading at 20 to 40 per cent discounts to their audited NAVs.

In fact, some smaller Canadian listed companies suffer from the trifecta of the problems discussed in this piece. They trade in small volumes at wide spreads, making their market values hard to discern. They are largely ignored by analysts and institutional investors, meaning that anyone wanting to open or close a position might have no way of doing so without moving the market. And they seem to be perpetually price-punished for no good reason, irrespective of how much solid and optimistic financial information is provided through disclosure of audited financial results.

As a result, trading in smaller listed companies in Canada can be like being a guest at the Hotel California. You can check out any time you like, but you can never leave.  

David Kaufman is president of Westcourt Capital Corp., a portfolio manager specializing in traditional and alternative asset classes and investment strategies. He can be contacted at drk@westcourtcapital.com.

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