Managing Liquidity In Small Cap Portfolios

Liquidity risk arises when the demand/supply of securities in the market becomes limited due to either market or stock specific reasons. Small Capitalisation stocks are perceived to carry a premium in terms of liquidity risk relative to their mid and large cap peers.

 It has been stated that, due to increased volatility and lack of liquidity in the small cap space, there is no room or concentrated 10-20 stock portfolios. We disagree with this assertion.

According to the CFA Institute’s “Investment Analysis and Portfolio Management”, around 90% of the maximum benefit of diversification was derived from portfolios consisting of between 12 to 18 equally weighted stocks. Further, we believe that by optimising the capacity of the portfolio (i.e. being cognisant of the effect of size on nimbleness when it comes to trading securities) a manager can effectively manage and mitigate some of the liquidity risk inherent in a concentrated small cap portfolio. Further, we believe the benefits of managing a concentrated small cap portfolio can outweigh the impact of well managed liquidity risk in a concentrated portfolio of stocks.

The requirements for the successful management of small cap portfolios have been widely discussed. Arguably the most important requirement for investment in a small cap company is a detailed knowledge of the business financials and the management team leading the operating effort, this certainly appears to be a recurring theme in the discussions around successful small cap investing. Most active managers in the small cap space visit upwards of 300 companies in a year and many have portfolios comprised of 60+ stocks at any given point in time. If intimacy with company management is key and liquidity risk can actively be managed to support a portfolio of 10-20 stocks, why then would a small cap manager seek to hold more than this in their portfolio? Surely such levels of diversification would act as distraction from following/supporting the managers highest conviction ‘best ideas’?! The response to this question may lie in the impact of size/scale. It is not uncommon for well-known small cap funds to have $500 million, $1 billion or even higher asset bases within their small cap offerings. The only way to run such a fund is to increase the amount of holdings a fund manager has in their portfolio which in effect dilutes the performance of their best ideas. This was recently confirmed by Ron Bird, Director of the Pail Wolley Centre at the University of Technology Sydney, when he said "larger managers can end up diluting their best ideas by spreading capital across a greater number of stocks".

So, the argument for diversification as a means to mitigate liquidity risk in portfolios is, we believe, unfounded. We would also go so far as to assert that diversification actually works against small cap managers, as it directly works against developing intimacy with investment targets and those held in the portfolio, being more a supporter of distraction to core holdings and best ideas.

The NAOS Emerging Opportunities Company (ASX:NCC) is a Listed Investment Company focused on investing in portfolio of Australian emerging companies through a concentrated (circa 10-20 holdings), long/short structure. The asset base for the NCC investment portfolio as at 31 December 2014 was circa $44m with no further anticipated capital raisings to come.  Since its inception in February 2013, the NCC investment portfolio has returned 49.85% in nominal terms relative to the S&P/ASX Small Ordinaries Accumulation Index (as at 31 December 2014).