Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
The CFA Society Toronto recently hosted an investment forum for institutional investors. Given the audience, it is ironic that the opening speaker, Roger Ibbotson, made what I believe is a compelling argument for a strategy where the individual investor actually has an advantage over a large institution.
Investors who have been around a while will recognize Mr. Ibbotson as the co-author with Rex Sinquefield of the definitive study of rates of return on stocks, bonds, bills and inflation from 1926 to 1976, published in 1977. Back then, he was assistant professor of finance at the University of Chicago. Now he is chairman and chief investment officer of Zebra Capital Management, a U.S.-based money management firm with a focus on illiquid stocks.
The 1977 study did not examine the small-cap phenomenon, but later editions did break down returns from the stock universe by size ranking. They identified strong outperformance by the smaller group, accompanied by significantly higher risk. It is no coincidence that a flurry of small-cap mutual funds were created in the 1980s after the publication of this study, including Dimensional Funds Advisors in the United States, Hoare Govett in Britain and Saxon Small Cap, which I set up in Canada in 1985.
Mr. Ibbotson now believes that a focus on illiquid, or thinly traded, stocks will provide even more value than small-cap or value stocks alone. His studies suggest that investors place such a high priority on liquidity (the ability to exit a position quickly and with low transaction costs), that they underprice illiquid securities, leading to higher rates of return going forward. If you are truly a long-term investor, his point is "don't pay for liquidity you don't need."
The reward for owning illiquid stocks is not confined to the small-cap sector, although that is where the greatest return advantage is seen – approaching 7 per cent. Even if you are confined to the large-cap sector of the market, there is still a return advantage of 2 to 3 per cent a year over the most liquid stocks which dominate the benchmark indexes. His research is based on a 3,500 U.S. stock database, but a similar reward for owning illiquid stocks is apparent in other global markets, including Canada.
The really good news is that if you overlay this illiquidity strategy on a portfolio also tilted toward value and small-cap stocks, then your incremental return increases even further. One interesting side note to his research is that while small-cap stocks as a group outperform the benchmark index, actively traded microcaps do not. In other words, it is better to own a neglected big-cap stock than a popular microcap.
The Toronto audience had no issue with the analysis presented by Mr. Ibbotson, but as institutional investors managing large sums of money, they were understandably skeptical of their ability to execute on this strategy, especially as the studies did not include transaction costs. The individual investor has no such constraints and is ideally suited to capture the premium associated with illiquidity. When liquidity improves, you can sell the winners to the institutions!
Putting all this together, where should a long-term individual investor direct their research focus? In the Canadian context, the TSX Venture Exchange is heavily populated with small and microcap illiquid stocks. Your immediate reaction may be that there are few value stocks in this universe, but a screen of the GlobeInvestorGold database turned up the following sample of half a dozen stocks. They are definitely illiquid, microcap and appear to be value picks (based on a price-to-book ratio of less than one).
- Delmac Energy Inc. (DAL-X)
- New West Energy Services Inc. (NWE-X)
- Reko International Group (REK-X)
- Rocky Mountain Liquor Inc. (RUM-X)
- Sangoma Technologies Corp. (STC-X)
- Westbond Enterprises Corp. (WBE-X)
Needless to say, this strategy requires additional research on your part and should apply to only a small percentage of your total portfolio.
Robert Tattersall