Illiquidity is the friend of the small-cap investor

Many investors focus on the risks of illiquidity and overlook its rewards, creating opportunity for the rest of us.

When talking about small caps, the conversation always seems to find its way to the subject of illiquidity. Something along the lines of “small caps are risky because they are so illiquid” is what often comes up.
 
It’s true that the number of freely traded shares is typically lower with small caps, making them harder to buy and sell. And like a lobster in a lobster pot, being stuck in a bad investment only pushes you closer to hot water.
 
But this fails to acknowledge an important point: the only bad risk is an uncompensated risk. Just like operational, financial or market risk, illiquidity is one of a long line of potential risks faced by investors. It is impossible to eliminate all risk from an equity investment, so our job is to ensure we receive enough return for the risks we’ve taken. It seems that most investors myopically focus on the risk of illiquidity, while overlooking its endearing qualities and leaving a lot of money on the table in the process.
 
The best thing about illiquidity is its ability to create “inefficiency”, which is to a value investor what catnip is to a cat. Illiquidity keeps most investors away from the smaller end of the market, and this is something that smaller investors should celebrate.
 
Stockbrokers can’t justify researching small stocks because the potential commission pool is too small, so many decent businesses go un-researched. And the big fund managers won’t get far allocating their billions of dollars with stocks with market capitalisations in the tens of millions. When lots of people overlook an entire sector, it increases the chances of success for the rest of us.
 
And while illiquidity can make a bad investment worse, it can also make a good investment great, as the scarcity of tradeable shares adds to the tailwinds from good business results.
 
Many people believe that small-cap stocks outperform large ones over time, and there’s ample statistical evidence to support this claim. What is less well understood is how illiquidity contributes to this outperformance. Interestingly, a study of US stock returns from 1972-2009 found that illiquidity was a better predictor of returns than size. 
 
Thankfully, most of us are not institutional investors burdened with billions of dollars to invest. When working with smaller sums, being nimble is a big advantage. So don’t fixate on the risks of illiquidity, also consider its rewards, or you’ll be joining the army of other investors who reinforce the inefficiency.
 
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