Small-Cap Activism vs. Large-Cap Activism – Part 1 by Troy Marchand, Foundry Capital
Over the next few weeks, I want to discuss my thoughts on why micro- and small-cap activism generate higher returns over time. I view micro and small cap stocks to be a more inefficient asset class. Fewer analysts/investors researching small stocks, fewer dollars able to be invested, less Wall Street research coverage, and illiquidity cause more micro- and small-cap stocks to be mispriced, in my opinion. versus larger cap stocks. In the future, I will look to provide some research from academia to back up my hunch. I then want to combine micro- and small-cap investing with activism and see how the results compare versus larger cap companies.
To start with, the sheer number of companies trading at under $500 million in market cap is many times the number of companies trading over $5 billion. To use a rough approximation, I calculated using Capital IQ, and there are 3,250 companies under $500 million in the market, while there are about 1,000 companies trading at over $5 billion in market cap. My sense is that as the biggest money managers continue to get larger and assets have been flowing to the largest hedge funds, it will force their hand into larger and larger companies. It often doesn’t make sense for such large hedge funds to buy micro-cap stocks, or they would end up owning too much to make a dent in their overall portfolio. It also makes their portfolio more illiquid, and we know everyone demands liquidity today… This brings me to a couple comments on liquidity.
Here are some quick stats on liquidity and returns from Tim Melvin at Real Money:
Einhorn’s FOF Re-positions Portfolio, Makes New Seed Investment In Year Marked By “Speculative Exuberance”
It has not just been rough year for David Einhorn's own fund. Einhorn's Greenlight Masters fund of hedge funds was down 3% net for the first half of 2020, matching the S&P 500's return for those six months. In his August letter to investors, which was reviewed by ValueWalk, the Greenlight Masters team noted that Read More
The 2013 study “Liquidity as an Investment Style” by Roger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim and Wendy Y. Hu is one of the best examples of how to handicap stocks in the pursuit of better results. Illiquid stocks perform better than liquid stocks. The study found that illiquid stocks outperform their more-liquid brethren across the board. The less-liquid growth stocks outperform liquid growth stocks. Illiquid value stocks outperform liquid value stocks. If you look at the extremes, the best-performing illiquid value stocks from 1971-2010 had a compound annual return of 18.4%, while highly liquid growth stocks returned just 2.4% annually. However, when you talk to most investors, which ones do they own? The highly liquid, well-known growth stocks, of course.
Last fall, Sterne Agee released a study of community banks that had an activist investor as a 5% or greater shareholder in the last decade. The study concluded that the average small bank with an activist investor outperformed the NASDAQ Bank Index by 28 percentage points, and 29% of them were taken over at a premium. There were 80 activist bank buys during the study period, and 59 of the stocks were winners. I will note that most of the 21 non-winners still have activists as shareholders, and many of them are in my community bank portfolios.
[Source: TheStreet ]
Overall, I think investors demand liquidity and the ability to get in and out of stocks in a short amount of time as a fallacy. First of all, if an illiquid company trades at a substantial discount, mainly due to it being difficult to buy and sell (all else being equal is obviously subjective), I will choose the illiquid competitor trading at a steep discount — such are the perks of managing a small fund. Second of all, in a market crisis, all stocks suddenly become illiquid, including the ETFs you own. (Read the terrific Murray Stahl’s latest commentary on ETF’s). I understand that volatility is higher for micro- and small-cap stocks, but if you can handle your own emotions, volatility alone is not a bad thing. Often it provides terrific entry and exit points due to wild trading on no news. Volatility is also not risked, just your ability to manage your emotions, which is easier said than done. Risk is the permanent impairment of capital.
Stay tuned for the next part in which we will start to dive deeper and bring in micro- and small-cap activism into the fold.