Are You Liquid?

US stocks were narrowly lower yesterday as markets effectively stood still in front of the employment report coming out this morning.  Bond prices have gained ground as the 10-year Treasury note yield fell to 2.98 percent.

Earnings season officially started yesterday with Alcoa, the aluminum maker, whose earnings were poor on two impairment charges for acquisitions made a decade ago.  At the same time, Alcoa reported a settlement with the US government for $384 million over bribery charges with Bahrain’s state run aluminum smelter.

With JP Morgan announcing billion dollar settlements every few weeks, its easy to forget that a $384 million settlement is still a big deal.

Last month, I wrote about how some academics wonder whether the size premium, the idea that small cap stocks tend to outperform large stocks, was still valid.

Of the strategies that we employ, the statistics are the weakest, but the concept is intuitive and last year happened to be great for small cap stocks.

While the S&P 500 had a really terrific return, up 32.4 percent, small caps were better by a fair margin.

The Russell 2000 is the most common benchmark for small cap stocks and it was up 38.8 percent.  An index that our clients might also be familiar with, the S&P 600 small cap index, was up 41.3 percent.

If we slide down the size scale even further to micro-cap stocks, the results were even better.  The Russell Microcap index was up 45.6 percent, a truly remarkable return.

As I reviewed my article last night, I mostly talked about the statistic for small cap, why they are not as robust (to use a word from academia) as other strategies and why we continue to pursue the size premium (not because it did well last year, although that’s nice).

Today, I want to touch on why small cap stocks should outperform large cap stocks – the theory that goes with the data.

Small cap stocks tend to outperform large cap stocks because they are fundamentally riskier.

That’s good news since small cap stocks will always be riskier, and if you are willing to accept the idea that risk and return go hand in hand, there should be a higher return to compensate for the additional risk.

Some reasons that make small companies fundamentally riskier than large companies are that they have less diversified business operations, less efficient access to the capital markets (borrowing money or raising equity) and can have greater sensitivity to the business cycle.

Another reason why small cap stocks should outperform is market based – small cap stocks are less liquid than large cap stocks.

If I want to buy shares of Microsoft, a company worth $296 billion, and then have a bit of buyer’s remorse and want to sell the shares instantaneously, the difference between the price that I buy and the price that I sell is likely to be one penny per share, almost nothing.

However, if I want to do the same thing with Core-Mark Holding Company, a microcap company valued at $900 billion, I won’t be able to turn around and sell it for anywhere near the same price.

Many microcap stocks ‘trade by appointment’ which means that they don’t trade every second, minute, hour or even every day.

This inability to trade, or illiquidity, is costly, so an investor who chooses to hold an illiquid portfolio should be compensated for this risk as they are for a riskier set of companies (small cap or value companies).

It turns out that it’s nearly impossible to say which part of the excess return for small or microcap stocks is due to the illiquidity factor or the business risk.  Researchers haven’t been able to find a way to ‘disentangle’ (to use their word) these two risks.

They have also found, however, that it’s not possible to build portfolios around liquidity and expect a statistically significant excess return.

Some researchers including Roger Ibbotson, argue that you can, but the fund that he launched hasn’t demonstrated anything interesting yet, although these things take time and the fund was only launched in 2010.  It’s the American Beacon Zebra Small Cap fund, ticker AZSIX, if you’re interested.

I should note that almost everything in our clients is completely liquid with one exception and one caveat.  The exception is are the very small mortgage bonds that were once large positions.  They aren’t small because of losses – they’ve done quite well – but because a mortgage bond pays interest and principal back each month, the principal shrinks.

Our clients have hundreds of these remnant bonds collectively that are $500 or $1,000 positions and they really can’t be sold at reasonable prices (although taking a five percent haircut on a $500 position isn’t so bad).

The caveat is that all bets are off in a financial crisis like 2008.  We didn’t really run into problems even then, but I can’t make any promises about what may happen in the next crisis.