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Small, illiquid stocks offer best value

Far too many investors look for big, popular, and liquid stocks. They fawn over large firms with excellent prospects that are easy to trade. Problem is, loved stocks often come with big price tags and that can to lead to disappointing returns.

On the other hand investors who take the opposite tack and favour small value stocks that don't trade frequently tend to do quite well. But they swap comfort for profits as they scour the back alleys of the market where many fear to tread.

While the return potential of small value stocks is well known, the benefits of low liquidity may be less obvious. That's why I was pleased to read a study on the topic by Roger Ibbotson, and others, in the latest Financial Analysts Journal, which dissects mutual funds.

They examined the holdings of U.S. equity mutual funds, offered for sale to U.S. residents, from February, 1995, to December, 2009. Each fund was classified into different groups based on the size of the stocks held (as measured by market capitalization), where they stood on the value-growth spectrum (based on a 10-factor model from Morningstar), and their liquidity. Liquidity was calculated by taking a stock's average volume over the last year divided by its shares outstanding.

True to form, value funds fared better than growth funds over the period. They outperformed by an average of 80 basis points annually. Similarly, funds with small stocks beat those holding large stocks to the tune of 189 basis points annually. Combine both factors and you'll find small-cap value funds beating large-cap growth funds by an average of 323 basis points a year.

Given the record, it may be surprising to learn that there were 238 small-cap value funds on offer in the United States when the study ended and 1,048 large-cap growth funds. Hope springs eternal for growth investors.

When you add liquidity into the mix the differences become even more dramatic. But funds holding less liquid stocks fared better across the board. It didn't matter whether they were value funds or growth funds. The same goes for funds with large or small stocks. Mind you, the effect was most pronounced in the small-cap arena.

For instance, value funds that held the least liquid 20 per cent of stocks outperformed value funds with the most liquid stocks by 228 basis points. Similarly, growth funds with the least liquid stocks outperformed those with the most liquid stocks by 225 basis points.

The results grow when you combine all three factors. Funds following the least-liquid small value stocks beat those with the most-liquid large growth stocks by a whopping 499 basis points on average each year.

But just how illiquid are the low liquidity stocks? After all, some stocks trade only a few times a day but many funds would be hard pressed to buy a significant amount of them. In the study the least liquid 20 per cent of stocks held by the funds had average annual turnovers of 110 per cent. Theoretically all of their shares traded hands a little more than once a year. On the other hand, the high liquidity 20 per cent group had annual turnovers of 573 per cent.

That comes as good news to small investors because it should be easy to put modest amounts of money to work in such stocks. It isn't necessary to stick to companies that basically trade by appointment to take advantage of the low-liquidity effect.

However, there remains an inherent problem with small value funds. They can still only put a limited amount of money to work without growing out of their niche. Once they get too big, perhaps powered by good performance, they're forced to move into larger names. As a result, it remains an area where smart small investors have an advantage.

As much as I'd like to recommend small illiquid value stocks to a wide audience, they require some dedication and experience. But it's a very worthwhile area for those with the interest.

First published in the Globe and Mail, December 16 2012.

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