The managers of the TAMIM Australian Equity Small Cap Individually Managed Account (IMA), take a look at how they manage the liquidity risk you inevitably face when investing in the small-cap space, particularly relevant considering the recent move away from that area of the market.
Managing Smaller Company Liquidity Risk - April 2017 -
In recent months we have seen significant volatility in the micro and small cap space, in part because of a rotation of capital out of smaller stocks. The volatility has been heightened because of a lack of liquidity in these smaller companies. Managing liquidity risk effectively is arguably one of the biggest challenges all smaller companies’ investors face. In this article we discussed our strategies to manage this risk.
Upside versus downside risk - value investing at work
In our opinion the starting point in the liquidity risk management discussion is to build a clear view of both the potential upside risk and downside risk for any smaller company you are considering investing in. This is par for the course as a value investor in any stock. Once you have an opinion of both the upside and downside risk, you can then weigh up that equation versus the stock’s current liquidity.
For example, if a stock’s upside versus downside risk ratio is 10 to 1, you are likely to be more comfortable taking on a higher level of liquidity risk. However, if that ratio is only 2 to 1, you are likely to be uncomfortable taking on significant liquidity risk. This sounds simplistic but we have found this an effective first level risk control when managing liquidity risk.
STOCK EXAMPLE: Reverse Corp (ASX:REF) is one of the less liquid stocks in the portfolio. However, we believe its illiquidity is justified by the stock’s upside versus downside risk at present. We view the stock’s downside risk as only around 15% as at this level the stock would be trading in line with its net cash surplus. However, the upside risk is at least 7 times higher in our opinion if the company successfully executes on its online contact lens expansion strategy. As a result, the stock’s liquidity risk is justified in our opinion albeit at a relatively low portfolio weighting.
Trust your analysis and conviction levels
Investing in under-valued smaller companies can take courage. You are often investing in stocks which the market is totally unaware of, or doesn’t understand, and thus you are going against the herd. We often find that our best performing stocks were in hindsight the stocks which required the most courage to invest in at the time. And with this benefit of hindsight we are very aware that we need to trust our analysis and conviction levels when the market may have a more negative view than us, or no view at all.
STOCK EXAMPLE: Fiducian (ASX:FID) is one of our high conviction positions within the TAMIM small-cap portfolio. Around a year ago, a major shareholder sold down their position which lead to a very weak period for Fiducian’s share price when it was trading at $1.90-2.00. At the time the market was clearly worried that there was more behind this major shareholder’s selling than met the eye. We saw this as an opportunity and bought more stock into the weakness. The stock is currently trading at $4.25.
Remember liquidity changes over time
Stock liquidity is highly change-able in our experience. It tends to improve when a stock is becoming more widely followed, which often correlates with periods of out-performance, and tends to deteriorate when a stock is becoming less followed, which often correlates with periods of stock under-performance. This is arguably the biggest challenge when investing in smaller companies.
There a number of implications in our opinion:
You need to ensure your portfolio management positions your portfolio in as high a percentage as possible of stocks which are on the improving liquidity / out-performance side of this equation. Ideally, this will see you purchasing stocks when there is little interest in them, then taking advantage of improving stock fundamentals and interest by selling into improving liquidity.
And when you get it wrong, you need to ensure you minimise the losses as much as possible (more on this later).
STOCK EXAMPLE: Pioneer Credit (ASX:PNC) is a good example of a stock within the portfolio which has seen a dramatic increase in liquidity throughout our holding period largely reflecting the stock’s price appreciation. We purchased our initial position when the company’s market cap was around $70m some 2 years ago. If you include the recent $15m equity raising and current $5m rights issue, the company’s current market value is just under $130m, almost double since our initial purchase. In that period, the market’s understanding of the stock has improved significantly.
Keep some bullets in the gun
Even the most illiquid stocks will at some point present liquidity opportunities. These may arise from such events as:
Increased (short-term) market awareness arising from a news or reporting event;
A major shareholder sell-down (on or off market); or
A capital raising or stock placement.
We believe it is prudent to carry some cash which can used to take advantage of market opportunities as they arise, which is why the portfolio’s cash weighting is generally at least 20%. This means we are rarely at a maximum weighting in any of our portfolio positions, and rather than panicking in the event of short term market weakness, we often see these periods as offering us genuine opportunities. Remaining on the front foot like this allows us to see through short term noise which may cause liquidity challenges for shorter term focused investors.
Remember the overall portfolio’s liquidity position
As bottom up focused investors we let the stocks do the talking in our portfolio construction process. However, we are always very aware of the level of liquidity risk we are taking at a portfolio level and will factor that into our stock weightings. Out of a 15 stock portfolio we aim to limit the fund’s exposure to truly illiquid micro caps to only 2 or 3 small weightings at any given time, and only if the upside potential justifies this liquidity risk in each case.
Have a plan in place for if things go wrong
This is arguably the strategy most smaller company investors struggle with the most as many will panic after bad news is announced and will take any price being offered at the time. This is often the opportunity we are waiting for with our large cash weighting.
The key question we ask when bad news has been announced is: does this affect the long term business fundamentals? If the answer is no, then we’ll often aim to buy more stock into weakness. However, if the answer is yes, which happens in surprisingly few cases, then we will move to the next stage of our liquidity risk management plan, the divestment strategy.
At this point, rather than panicking we will take our time to fine-tune our divestment strategy and will ask a number of questions:
Has the market over-reacted on the downside? If yes, we may await a better opportunity to exit.
Is further bad news imminent? If yes, we may move faster to exit.
If we were to sell now would we have a significant impact on the share price? If the answer is yes, we may sell a portion of our holding now and await a better opportunity to exit the balance.
Are there any foreseeable liquidity opportunities? The answer to this is often no once bad news is out but sometimes larger shareholders will want to increase their position (as we often do).
We aim to be faced with this situation in as few cases as possible as it is a difficult but not insurmountable challenge to exit a stock at this point. However, being ready for this situation makes it a lot easier to address when it does happen.
Think long term
We have mentioned the need to think long term throughout the article since this really is core to successful smaller company investing and dealing with liquidity risk. Most of the challenges of smaller company investing, including managing liquidity risk, are most effectively dealt with by taking a long term view on each smaller company investment and trusting your analysis. We would go so far as to say that if you don’t intend to own any smaller company investment you are considering purchasing for the next 5 years, you would be well advised to reconsider.
We view managing liquidity risk as bread and butter business for smaller company investors. Having a clear strategy and being ready for both positive and negative surprises is key in the wonderful world of smaller company investing.
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