What Gives the Small-Cap Investor an Edge

Well, according to most Lombardi Financial editors, that distinctive edge that small-cap investors have would be liquidity, or rather, the lack thereof. Please don’t think that we have lost our collective marbles. There is logic to our madness.

On any given day, the so-called “smart money” or big institutions move millions of dollars from one investment to another. When institutions trade, they must obey certain market rules. One such rule prevents them from buying or selling big blocks of shares in companies with small market capitalization because they may unduly move the market.

To comply with the rules, professional traders search for “liquid” stocks, which are, in 99% of the cases, large caps. They have an obligation to fill large orders without adversely impacting the price of a company. Unfortunately for big investors, equity markets are not what they used to be. Among large caps there are very few that still offer competitive values at relatively reasonable prices.

What exactly is “liquidity?” Imagine a large institutional investor trying to invest $10 million worth of shares in the technology sector. Now, I don’t have to tell you that $10 million is a lot of money, even for big-time portfolio managers. So, what would they be looking for? Well, they would really like to buy cheap stocks, but one can only dream. Often, they have to look for big companies with plenty of outstanding shares. Why? Well, they have to be able to buy and sell a stock quickly without moving its price significantly — and that “luxury” comes with a price.

An example of a liquid stock is Cisco Systems (CSCO/NASDAQ), with a three-month daily trading average of about 53.3 million and a market cap of about $165.0 billion. Obviously, buying big blocks of Cisco shares will not negatively impact the market.

However, if you were to invest those $10 million in Westcast Industries Inc. (WCSTF/Pink Sheets), that story would be quite different. In the last three months, the average daily trading volume of this company was measly 292 shares. At a price of $11.75 per share, we are talking about only $3,431.00 worth of shares trading each day. Rather pathetic in comparison, don’t you think? Clearly, Westcast Industries is an example of an illiquid stock.

Fortunately, ordinary investors are not limited to buying large caps like portfolio managers are. But, what do they get in return for speculating on small and often illiquid companies? Well, for starters, such stocks are, more often than not, cheap. The “smart money” cannot buy them (i.e. push the price up) because portfolio managers must move large sums of money quickly in the hope of turning a profit based on short-term performance measurements. Big boys literally cannot afford to invest long term.

Ordinary investors, on the other hand, choose their own investment horizon. They are not responsible for anyone’s money except their own. Because portfolio managers avoid illiquid stocks as they hinder their short-term trading activities, a huge playing field is left for ordinary investors. There are about 6,000 companies with market caps of less than $500 million that trade on the U.S. exchanges. The number of those who satisfy the liquidity test for big money managers can be counted with one’s fingers.

Professional traders don’t have the necessary flexibility to trade illiquid stocks. But, individual investors do! Firstly, individual investors move only small amounts of money (in comparison to their institutional counterparts, of course). Their investment horizon differs, but it is not impeded by short-term performance obligations.

In addition, since “smart money” is usually not involved in making the market for small caps, these stocks are cheap. Some portfolio managers even go as far as to equate liquidity with “overpriced” stocks. As a result, small caps are often ignored, discounted and simply flying under everyone’s radar.

Finally, there is always a possibility for a small stock to make it to the Big Leagues. This offers an ordinary investor with a distinct edge. By the time institutional investors discover the stock, all that the little guy has to do is give them the stock and haul in the profits.

Inya Ivkovic’s Take on Yesterday’s Meltdown — Is the sky falling?

If I bored you in my previous two or three Profit Confidential editorials with macroeconomics, I’m sure yesterday’s market performance certainly didn’t. It was a clear example of what happens when the economy experiences supply and demand shocks.

Simply, the world suddenly realized, and by “the world” I mean western economies, that China is not going to be the everlasting engine driving the aggregate demand for nearly everything infinitely up and up. What the macroeconomic theory long expected, and what we saw the results of yesterday, is that China’s return to optimum output (or, in other words, optimum GDP), seems to have put everyone’s noses out of their respective joints. Perhaps China achieving its long-term supply and demand equilibrium would not have come as such a surprise if it had been moderate in manner. But, what did everyone expect, considering that China has no economic breaks, or doesn’t know how to use them, either going up or down?

So, now the reality kicks in. Meaning, now that the safety net of China’s everlasting demand has been pulled from under us, we look to everything that is wrong in our own backyards. And, boy, is there plenty wrong!

The stock market is inflated. The demand for durable goods is dwindling, while manufacturing barely has a pulse. The U.S. GDP is decelerating more than anyone would like to admit. The U.S. housing market may not have bottomed out after all. All we see is debt and deficits, while the national savings rate in the U.S. is a negative number. Heck, even Alan Greenspan, now that he no longer chairs the Fed, admits the U.S. may be heading for a recession. And, my fellow Canadians, just because our own situation looks better on paper, don’t forget that more than 80% of our foreign trade is owed to our U.S. trade partners. So, we’re bound to take a hit as well.

So, what’s next? Is the sky falling? Is the abyss opening? Well, no. Now we get to the rough part of the ride when things simply have to play themselves out. The silver lining is in the macroeconomic postulate that, regardless of the size of the swings, the pendulum will eventually come to a stop. However, the million-dollar question remains how much of a price will global economies have to pay for the global supply and demand equilibrium this time around? Well, that will depend on how badly things are screwed up domestically. The expectations on the size of the hit will go along the line, “the more screwed up the domestic economy, the higher the price for reaching the equilibrium.” Which is why I have a feeling many economists and governments will be burning the midnight oil in the days ahead.