Investments

Do Good Things Come In Small Packages For Investors?

Stocks and Bull Run

Liquidity is what makes markets go ‘round. It’s also what small-cap stocks generally lack and why investors have begun to build a “wall of worry” around them. Exhibit A: alt-lending stocks.

In the investment world, size matters. And small is beautiful and very popular on Wall Street.

It has been a truism on The Street that smaller companies and their smaller stocks (measured in terms of market capitalization) have commanded a premium against other, relatively larger brethren, with the caveat that, sometimes, the smallest stocks are the ones that climb to the most dizzying heights.

But, as Reuters noted recently, traders are getting antsy, as the field is getting crowded, driving up stocks and making returns all the scarcer. The dearth of IPOs, as exit strategies hinge on corporate sales rather than bringing firms to public markets, has also led investors to chase what is already available, with the proverbial “wall of worry” coming into play and with the crowd following itself into exchange-traded index funds. And the vicious cycle gets repeated.

The casualty of all this is liquidity, where price discovery proceeds unimpeded, with some smooth transition of assets (and money), across stocks. When liquidity gets jammed up, then the orderly conduct of markets becomes less orderly, and the fact remains that all but the most well-funded investors get priced out of where they want to be, for the prices they want to pay.

On Main Street, where Wall Street powers retirement funds and college funds — often via mutual fund holdings — the small-cap firms (and funds) have been lagging larger-cap peers. That’s a bit of an anomaly on The Street, where markets have been gaining steam, a trend that has stretched back several years. Valuation plays a factor here, as small-cap companies are proving to be quite a bit more expensive than bigger names, with a whopping 86 percent premium between small firms versus large and roughly twice that of the average.

In small-cap land, wild price swings can occur even in the absence of news that would normally be attributable to stock moving events. What gives? Rumors, perhaps, lurking in chat rooms or on virtual trading floors. Thus, the bid ask spreads for small caps come in at multiples above those of large caps, Reuters said, citing Credit Suisse research. Buying becomes difficult, and selling becomes even trickier when it comes time to exit, sources told Reuters. The end result is that firms cannot (and individuals cannot) accumulate, or dispose of, as much of a position as ordinarily they would like to.

One important side note: Corporate treasurers themselves must grapple with ebbing liquidity as they issue or buy back shares in their own firms or trade in stocks of other companies as part of their asset holdings. And this can, in some way, affect cash flow management.

Exploring the efficiencies, or lack thereof, in small caps has had more than its fair share of pain points in payments. Not only are their valuations in the hundreds of millions, rather than the tens of billions, but many of them have seen their valuations crash after their IPOs, which only further highlights their risk.

Square may face some of this pain when its lockup expires. Lending Club, which has dominated the FinTech press lately, was the darling of The Street, with an $8 billion market cap at the end of 2014. Now, it is hovering around $1 billion after a precipitous fall. Its peer, OnDeck, sports a $330 million market cap after a high of $1 billion-plus. The lack of liquidity, especially now, sets the category up for network effects in reverse, with fewer buyers and sellers putting up capital, which only signals others that things look too risky to jump in.

Whoever said that good things come in small packages clearly wasn’t gazing at the stock market.

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