The small cap squeeze: When more money chases fewer companies

Shares of small companies have always traded at a premium on Wall Street, where investors have historically been rewarded for taking chances on the sometimes high-flying stocks.But traders complain that the risks are getting higher and the rewards harder to reap as fewer small companies come to market and investors throw money at them almost indiscriminately via index-following exchange traded funds.The combination of those two factors has cut into what experts call liquidity – the ability of investors to trade at a desirable price at any given time. Traders at Hodges Fund, T. Rowe Price and other investment firms say the lack of liquidity in small company stocks has forced them to spread sales over weeks instead of minutes, eat higher trading costs, buy higher, sell lower and hire their own liquidity specialists to deal with the challenges. At times, they have been shut out of shares of companies they wanted to acquire, they say. Individual investors who buy small-cap mutual funds have been paying the price, too. Small-cap companies have underperformed large cap companies over the last six years, an unusual lag during a period of market expansion, according to data from Morningstar. Yet shares of small companies are far more expensive, relative to their earnings, than those of bigger companies. So far this year they are selling at an 86.2 percent premium over large companies; a 32.7 percent spread is more typical. “What you’re seeing now are big swings often on no news on small-cap equities on a daily basis and it’s not uncommon for something to move up 5 or 10 percent on seemingly meaningless news,” said Whitney George, chairman of Sprott USA, an asset management company. Liquidity in the small-cap end of the stock market has been deteriorating for years. But two factors have made that worse: With more startups staying private or selling themselves outright to larger companies, there are fewer new small company stocks on exchanges. The authoritative and imprecisely named Wilshire 5000 index, which claims to hold “all U.S. equities with readily available prices,” covers just over 3,700 companies, near its long-term low.

Meanwhile, investments in index-following mutual funds and exchange traded funds have exploded. U.S.-listed domestic equity ETFs now sit on $1.3 trillion in assets; they had $288 billion in 2006. Since 2007, assets have almost quadrupled in small-cap index ETFs, which often are required to buy or sell stocks in their target index regardless of price and may be squeezing out other traders. Small companies with high ETF ownership have lower liquidity than similar companies without big ETF play, according to a 2014 study by Sophia Hamm, an assistant professor at Ohio State University.Since 2008, small-cap stocks have traded at bid-ask spreads eight times as wide as the spreads of large company stocks, according to Ana Avramovic, analyst for Credit Suisse Trading Strategy in New York. Before 2008 they more typically traded at spreads five times as wide.Even small trades can create exaggerated price moves and force fund managers to decide between an undesirable price or a smaller-than-intended position. “We go in and we start buying it and within a day or two the stock moves and runs away from us,” said Eric Marshall, research director at Hodges Capital Management in Dallas. “We want to have a 1 percent or 2 percent position in that stock and we end up with a 25-basis-point position,” he said, meaning 0.25 percent.

Selling when everyone is dumping a stock can be even more fraught. Stephen Massocca, chief investment officer at Wedbush Equity Management LLC in San Francisco, says he sometimes does not buy as much as he would like of a specific company because he fears not being able to sell it when he wants to. He recently limited a biotech stock purchase to about half of what he might otherwise buy because “I wanted a manageable position when it came time to sell” so he would not get stuck with unsold shares. Fund companies have turned to more sophisticated strategies to place their trades – bunching them into earnings reporting season days when there is more trading than usual and turning to off-exchange private marketplaces known as “dark pools.” Stuart George, head of equity trading for Delaware Investment, which manages about $166 billion, said his firm uses “time-slicing” – spreading trades out throughout a day and sometimes, more than a day. Some high-volume trades of small cap stocks can take as long as several weeks, he said.

At T. Rowe Price, trader Chris Carlson said he clumps his small-cap trades at the end of the day, when liquidity improves as funds have to settle their accounts and price their portfolios. Nonetheless, he said he finds himself spending a few more cents per share for many of his small company trades.The lack of liquidity and outsized stock moves can be problematic for the issuing companies as well, according to Tim Quast, president of Modern Networks IR in Denver, which does data analytics and works on behalf of public companies.When low volume whip-saws a company’s share price, its treasurer cannot use the equity market as a barometer of value, or even attract investors who may stick to stocks with ample trades.For example, Kevin Mahn, a portfolio manager and chief investment officer at Hennion & Walsh Asset Management, said that because he invests only in companies with adequate liquidity, he tends to stay away from the smallest 700 or so companies in the Russell 2000 small cap stock index.”I don’t go into the microcap names,” he said. (Reporting by John McCrank and Chuck Mikolajczak; additional reporting by Trevor Hunnicutt; editing by Linda Stern and Dan Grebler)


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