The smaller company investor faces a new problem following the fall out over Woodford’s funds; this is the focus on liquidity. How long would it take to liquidate a position at the quoted price?
This is the question portfolio managers are being asked by their risk departments and business managers. The usual answer is to say if you do 20% of the average daily volume of a stock and divide that into the number of shares held we get an idea of how many days it should take to sell.
The problem with this answer is it does not necessarily reflect how the market for smaller companies works. The daily volume number is taken direct from figures published by the London Stock Exchange (LSE).
A trend in recent years has been for there to be more trades happening ‘off market’, in the so-called dark pools. It is estimated across the market as much as 40% of trades by value happen this way. Therefore, using just LSE volumes over-exaggerates the liquidity problem. Currently, small cap trading volumes have been low as investors sit and watch macro-economic developments. Activity will pick up as confidence returns and the current problems with small cap investment will partially recede.
Advantage investment trusts
Mid-cap companies are not suffering the same problem, so takeover activity by larger established companies is likely to be a feature of 2020. However, the current concerns over liquidity are an opportunity for funds with a mandate to invest in genuine small companies.
It is closed-ended funds that are best suited to these mandates because they do not have to meet redemptions in the same way that open-ended funds do, meaning a trust will not become a forced seller in times of stress. This is why the Henderson Opportunities Trust portfolio has more than 60% invested in AIM (alternative investment market) stocks.
The premium investors are paying for liquidity has expanded significantly. However, the earnings and dividend growth of large companies in comparison to the small companies is unlikely to justify this premium valuation.
Smaller companies are often tied more closely to the fortunes of the UK economy. The UK has been subdued as a result of the consumer drawing back and corporates putting spending plans on hold. These plans cannot be deferred indefinitely and a replacement cycle will start up with capital investment injecting momentum into economic growth.
Many UK small domestic companies have been focusing on cost-savings, so when sales growth increases on this disciplined low cost-base; operating profit margins will expand. The drop through of increased sales to profits usually surprises as an economy grows. The analyst upgrades will follow and this is the catalyst that will prompt investors to move money into UK shares in an unloved sector.
Liquidity: The ability to buy or sell a particular security or asset in the market. Assets that can be easily traded in the market (without causing a major price move) are referred to as ‘liquid’.
Mid-cap: A term used to describe medium-sized companies based on their market capitalisation.
Small-cap: A term used to describe companies with small market capitalisations.