Something I hear a lot from other investors when they are looking at small-cap stocks is a complaint about the bid-ask spread. This is just part of the game with small-cap stocks. It is not uncommon for stocks to have a spread of 10% or more, particularly in illiquid names, which can put some investors off.
It is always worth considering if the wide spread is worth paying for the opportunity on offer, however.
For example, stocks tend to have a large gap between the bid-ask when they are illiquid, which leads me to think that they also fly under the radar of most other investors. If they fly under the radar of the rest of the market, then these names are more likely to be undervalued and, as a result, offer hidden value that you can't find elsewhere, particularly in large caps with tight bid-ask spreads.
Another factor to consider is the cost of the bid-ask spread in comparison to the opportunity. If you think you have found a hidden value stock with a potential upside of 100%, is it worth paying 10% to acquire the opportunity? I think so.
Further, if you find an attractive investment opportunity and you plan to hold it for five or 10 years, then a fee of 10% doesn't look that bad in the grand scheme of things. If you wait for the spread to tighten, you could miss the opportunity. It would then be a wasted opportunity if you let it go by just because you wanted a few extra percentage points of profit.
Another thing to consider is that there is a great deal of research that shows that illiquid stocks tend to outperform over the long term because they are challenging to buy and sell.
The illiquidity premium
One of the most comprehensive studies on this was conducted by Yale's Roger Ibbotson, who published his findings in a copy of the Financial Analysts Journal in 2013.
Ibbotson and his team set out to measure the performance of stocks compared to liquidity. The team chose turnover, or the proportion of the stock's market capitalization that changed hands on a given day, as their preferred measure of liquidity.
They ranked 3,500 U.S. stocks by their turnover from 1972 to 2011. During this period, the universe of stocks under control returned an average of 14.46% per annum. In comparison, the least liquid quartile returned 16.38%, and the most liquid stocks returned 11.04% per annum.
Further research conducted by Ibbotson and his team revealed that this illiquidity premium was a factor in performance in itself. In other words, these stocks didn't outperform just because they were undervalued to start with. The data show that illiquidity was, for the majority of the time, the main reason for failed performance.
Costs stop selling
All of these findings seem to show that high trading costs are, in fact, a good thing for long-term performance.
One of the theories that have been suggested as an explanation to this anomaly is that trading costs prevent investors from buying and selling quickly, as they would do with the heavily traded names in periods of market stress. This means investors are effectively protected against themselves. They are blocked from buying and selling their own securities quickly, which goes some way to stopping them from selling at a bargain basement price.
So, you could argue that there is more to this argument than just market dynamics. Investor psychology also has a significant part to play in the performance of illiquid names, and that's probably the primary take away from the evidence above. Overtrading can be damaging to your long-term investment returns; if investing in illiquid securities helps stop that, then it could be an excellent strategy to pursue for your portfolio.
Disclosure: The author owns no share mentioned.
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