The case for buying small cap stocks

Most investors fawn over the big banks, Westfield and Woolies – great companies, dominant positions and highly liquid stocks that you can buy or sell in a heartbeat. The trouble is that everyone else likes these qualities too and so popular stocks often come with hefty price tags, leading to mediocre returns.

But if you're willing to buy the forgotten minnows of the stock market, the opposite principle may apply.

A 2012 study assessed US mutual fund returns from 1995 to 2009. Funds were classified according to their value or growth orientation, as well as the liquidity of their stock holdings.

Funds that held the least liquid 20% of stocks returned an extra 2.65% a year compared to funds holding the most liquid quintile.

And when you add market cap and value-growth orientation to the equation, the results are even more impressive: funds that held the least liquid small-cap value stocks outperformed those with the most liquid large-cap growth stocks by 4.99% a year. 

What's more, “the outperformance of the mutual funds that hold less liquid stocks was primarily due to superior performance in down markets. One possibility is that during periods of turmoil, high-liquidity managers may be more likely to trade; thus, the most liquid stocks may, in fact, suffer the steepest declines because there is a greater propensity for their owners to trade them,” said the study.

Basically, in times of crisis, people sell whatever they can, so liquid stocks get sold first. Liquidity may be an illusion.

Before you invest, a few points to consider

1. The first thing to note is that the spread between the bid and offer prices for illiquid stocks is generally large. The last matched price might be, say, $2.00 but the best offer price $2.50. To ensure you aren't caught overpaying, it's important your purchase orders have a limit price and are not made ‘At Market'.

2. The idea of an ‘average daily volume' is pretty meaningless for illiquid stocks. Some days a large slab of stock may be traded, or a week could go by without a single share changing hands. Volume moves in floods and droughts so be sure to have your bucket ready when it rains. Leave an order in the market using the ‘good until cancelled' option or a distant expiry date.

3. You'll need to exercise an ungodly level of patience and be prepared for it to take several weeks to accumulate a large position. Don't bid up the stock. If you've decided $2.00 is what you're willing to pay, don't jump on a new offer made at $2.10. Sellers are often more desperate than buyers and will come to you if you stand your ground.

4. Don't be afraid to bid for a large block of stock. You may only see a few lots of, say, 1,000 shares trading or no offers to sell, but there's nothing wrong with putting in one large buy order for 10,000 shares. Firstly, it reduces the brokerage commission. Secondly, you'd be surprised how volume suddenly materialises. Many times I've put in a large order without another in sight, only to be matched later that day. There may be eager sellers waiting in the shadows. Another strategy is to stagger your orders at different prices – perhaps bidding for 2,000 shares at $2.00 to 'test the market' and 8,000 at $1.80 to tempt sellers towards a lower price.

5. Assuming you're happy to tie up your cash for a very long time, there's no individual stock too illiquid to be a viable investment. Warren Buffett deals with illiquid investments all the time due to the size of the positions he needs to take to move Berkshire's needle. However, there is a limit to how illiquid you should make your entire portfolio. It's fine to buy thinly traded assets, but your personal balance sheet needs some liquidity for emergencies and to take advantage of better opportunities. In any case, if you'll need the cash in the next 3–5 years, you shouldn't put it in stocks at all. Find a high-interest savings account instead.

Forget for a moment that you can buy or sell with a few mouse clicks, and imagine that your local bakery owner has offered to sell you a share in their business. If this were the case, you wouldn't be worried about whether there's someone to buy your share the next day, you'd be focused on things like the business's earnings potential, local competition, debt and what price you have to pay. This is the mindset you should take when investing in stocks, too, whether they be the largest blue chips or the smallest tiddlers.

Note: You can find out about investing directly in the InvestSMART Australian Small Companies Fund along with other Intelligent Investor and InvestSMART portfolios by clicking here.