A common theme of investing in small cap stocks is limited liquidity, or in other words, difficulty acquiring or selling stock. This can naturally present a challenge for those on the outside looking in (and even those on the inside looking out). Investors can be left scratching their heads as to how an equity fund manager has built a significant stake in a particular stock given its limited trading volume.
This article outlines the corporate opportunities presented to fund managers and some key points for retail investors to position their portfolios towards higher quality small-cap stocks and management teams.
Rights issues allow companies to raise funds without penalising existing shareholders. Raisings are typically done at a decent discount where existing shareholders are invited to purchase additional shares in the company. For small caps, rights issues are usually non-renounceable, that is not tradeable, which means liquidity might not improve as the rights are tied only to existing shareholders. However, any underwriting of a rights issue shortfall provides a way for new shareholders to access shares which is effectively a placement of rights which are not taken up by existing shareholders.
Key point: watch for management and substantial shareholder involvement. If they are not prepared to take up their rights in full, then consider, why should you? Is the offer accelerated or not? If not it can have a drag on the share price.
Placements are the bread and butter of growth capital in small caps, often providing the most effective entry point for a fund manager to gain meaningful positions. Placements may be done in conjunction with a share purchase plan (SPP) which provide all existing shareholders the ability to subscribe for up to $15,000 worth of stock under the same terms as those participating in the placement. We like it when companies offer an SPP as it shows they are treating all shareholders equally.
Key point: for a retail shareholder when deciding whether to participate in an SPP, consider these two red flags; firstly, is the placement only for working capital purposes? Secondly, is the placement occurring at a price lower than a previous placement?
A private placement is when a company conducts a share transfer to one particular shareholder. Typically, this will occur either to a strategic investor or to a fund manager who is unable to buy the desired share parcel on the market. Private placements are encouraging for investors and they show that someone is willing to be the only party providing growth capital and are therefore likely to be a long-term investor.
Key point: is the placement a transfer of existing shares from a large shareholder or new equity raised? We prefer seeing new equity private placements as it shows key shareholders are not cashing out and it provides the company with growth capital.
As a rule of thumb, if directors or management are selling, external investors should not want to buy. There are however exceptions where it can prove to be a highly effective way of improving liquidity, attracting institutional investors and improving the business profile within the market.
A sell-down should be judged on a case by case basis, and questions to ask include:
- Who is selling down, why and how much?
- What is the cash balance of the company?
- Is this the best way to improve liquidity?
- Are they likely to require a capital raising short term?
We like to see a strong management track record or share price returns and organic growth before we consider participating in a sell down.
Key point: be sceptical where you see a manager sell-down to exit their full position, as skin in the game is paramount for quality small caps.
Investors can be right to ignore a small cap IPO, as the business can be ‘dressed up’ for sale and a prospectus can only tell you so much. You are unlikely to get a good read on how successful management has been on actuals vs forecasts in the past, and this can create a high level of downside risk.
Unlike a private placement or sell-down, IPOs tend to be more widely spread to participating investors. This means fewer ‘long-term hands’ and more ‘short-term hands’ will receive stock. Furthermore, a lot of the time you are either paying down debt or funding an individual cashing out. In any good quality small cap, you don’t particularly want to be funding either of those.
Key point: take a long-term view. Would you be happy to own shares in this business for three years or are you just banking on a short-term trade? If the latter then you’re probably not the only one and the optimism might not translate to reality.
Advice for retail investors
You can learn a lot from the actions of a company’s board, management, and key shareholders. How they conduct their corporate activity can give you confidence or otherwise in their long-term thinking. A healthy amount of scepticism can prove a valuable commodity when picking stocks.
This article is general information, it is not intended as financial advice and does not consider the circumstances or investment needs of any individual.