Why Worry about Small, Thinly-Traded Stocks?

That question was posed by a someone commenting on the previous post ("How One Investor Found a Home Run Stock"). I initially responded in a comment, but it was a good enough question to warrant answering it more fully in a separate post.

As I noted in my comment, the reason such small stocks are worth paying attention to is that these stocks are more likely to be mis-priced, since they usually have no analyst coverage, little media attention, are ignored by most institutional investors, etc. This gives them the potential for higher returns than more widely-followed stocks. Recent academic literature supports this. See, for example, "Information Diffusion Based Explanations of Asset Pricing Anomalies", by Bolmatis and Sekeris. In this study the authors found that,

Stocks that have no-trade days outperform other stocks by a wide margin, even after correcting for their higher risk as captured by their larger betas. This result is expected when comparing stocks with large differences in information availability.

Mark Hulbert, of the Hulbert Financial Digest, wrote about this study last month in the New York Times (Strategies: "Roses among the Wall Flowers"), and fund manager Aaron Edelheit commented on this article in his blog ("This is What I Do for a Living!"). In that post, Edelheit wrote,

Academic studies finally back up what I have found in 10 years of investing:

No trade stocks outperform

In addition to Edelheit, another professional investor who has achieved excellent returns by investing in these sorts of stocks is Paul Sonkin, of the Hummingbird Value Funds.

It's true that investing in such small cap stocks is risky, but it's also true that there's plenty of risk in investing in many large cap stocks, as investors who bought shares in such stalwarts as Citigroup or Motorola over a year ago can attest to. Perhaps the conventional wisdom of risk-versus-reward (i.e., large cap is less risky than smaller cap; domestic is less risky than foreign) needs to be reconsidered. If an investor is going to take on significant risk investing in common stocks, he ought to have the potential of a significant upside to compensate him for taking on that risk.

Here is another way to think about size-versus-risk. Think of a small, local business where you live, one that is profitable and that has been so for decades. If there were a way for you to buy a small piece of that business (at a fair price, of course) would you buy it? Chances are, if that small, local business were publicly-traded it would be a micro-cap. Would that, in and of itself, make it a more risky¹ investment?

Another point the commenter made was that the recent paucity of comments on this blog was due to my posts about "super-obscure" stocks. He may well be right. I'd venture that for most people, reading about stocks you don't own and have no intention of buying is boring. I remember, years ago, as a trainee in a small brokerage/investment bank in Midtown Manhattan, how boring it was to read the WSJ's "Abreast of the Market" column everyday as I was instructed to do. I didn't own any of those stocks, and so I had no interest in them. Perhaps I'll add some more general interest posts in the future, but I'll continue to write about small stocks, because that is what interests me. If you are more interested in reading about more widely-followed companies, including Dow Components, Buffett picks, etc., you may want to peruse the Value Strategies & Ideas" forum on GuruFocus.

¹Risky in terms of the chance of you suffering a permanent loss of principal, not risky in terms of price volatility.