Saturday, March 11, 2017

Equity management #5 : The Small Firm Effect

Some investors like investing in small firms because it is an area where the natural strengths of a retail investor can really shine.

Institutional investors can't invest in some counters like Karin Tech and Global Testing because there is so little liquidity in these counters that it would be a struggle to even pick up more than 2000 shares in a single transaction.

The small firm effect is a well known in academic literature. You can earn higher returns if you focus on smaller stocks.

But there are some caveats :

a) Small firms might also be neglected firms

A large component of small firm returns is also attributed to its neglect. You may also have oversized returns if you invest in stocks which are not covered by analysts. I can't seem to get a lot of information on a counter like Figtree, for example.

b) Small firms are illiquid.

There is a high bid-ask rate and low number of bids so it will take a lot more transactions for a position to hit 1% of your portfolio. My dad took weeks to pick up 1,700 shares of Global Testing. I think that is quite enough because of the amount of cash which needs reinvestment every month.

c) Small firms effect can disappear when macroeconomic conditions change.

Small firms are fragile.

When there is increase in BAA corporate bond interest rates or T-bill rates, returns may disappear. Similarly returns may go up when there is an unexpected increase in industrial rates. When there is expected inflation, small firms are also impacted negatively.

Academic research on small firms is not particularly practical for retail investors but one is clear : It might be useful and fun to research and accumulate a small portfolio of 20 local small stocks when you are younger and have smaller portfolio size below $50k.

When you start managing a larger portfolio, you would have to look for other opportunities.

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