Small, Illiquid, and Cheap: A Winning Combo

In a column for Canada’s Globe and Mail, Norman Rothery says that, while many investors focus on popular, frequently traded stocks, the real profits lie in smaller, illiquid shares. 

“While the return potential of small value stocks is well known, the benefits of low liquidity may be less obvious,” Rothery writes. He examines a study recently published in the Financial Analysts Journal, which was performed by Roger Ibbotson and others. It looked at U.S. equity mutual fund holding from February 1995 to December 2009, classifying funds into groups based on the size of their holdings, growth/value characteristics, and liquidity.

The study found that value funds outperformed growth funds by an average of 80 basis points annually, Rothery notes, while funds with small stocks beat large-stock funds by 189 basis points annually. And small-cap value funds outperformed large-cap growth funds by an average of 323 basis points annually. In addition, “funds holding less liquid stocks fared better across the board,” he says. “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.”

When value, size, and liquidity were combined, the gap was very large — funds with small, illiquid value stocks beat funds with large, liquid growth plays by 499 basis points on average per year.

Rothery says there is an inherent problem with small, illiquid value funds, however: As they grow and have more money to put to work, they are forced into larger stocks. “As a result, it remains an area where smart small investors have an advantage,” he says, though he warns that investing in such stocks requires dedication and experience.

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