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Wednesday 15 September 2010

The Small Cap Trap

Rampaging Elephants

The theory is that small capitalization stocks offer great rewards. After all, as Jim Slater pointed out in The Zulu Principle: “elephants don’t gallop”. Well, apart from when they’re being chased by a psychopath, armed with an elephant gun, in a bulldozer. As the last few years have shown, even behemoth sized corporations can grow startlingly quickly if they’re priced to go bust and then get bailed out by obliging governments.

Still, the idea that smaller cap companies offer outsized rewards is hard to shake. To the extent that share price grows with earnings then it ought to be easier to double the price of a small company than a large one. Which is, more or less, true. The only trouble is that it’s probably more likely you’ll see it sink to zero.


Back in 2007 a small spat erupted between the US Securities and Exchange Commission and the London Stock Exchange over the perceived ineptness of the latter's regulation of the UK’s junior market – the Alternative Investment Market (AIM). Roel Campos, an SEC commissioner, was quoted as saying:
“I’m concerned that 30 per cent of issuers that list on AIM are gone in a year. That feels like a casino to me … It is a losing proposition to tout lower standards as a way to promote your markets.”
The background to this was an increased prevalence for companies to list on AIM rather than in the US. There were a variety of reasons for this, including the increasing onerousness of a US stock listing in the wake of the Sarbane-Oxley, but the contention of Mr Campos was that AIM was simply too lax in its supervisory standards. And, frankly, a 30% failure rate of new stock issuance would seem to back up his point pretty conclusively.

AIM a Casino?

However, the world being what it is a trio of intrepid researchers wondered if this statistic was actually grounded in real data or was … ahem ... possibly just made up. So Susanne Espenlaub, Arif Khurshed and Abdulkadir Mohamed decided to do some analysis which got reported in Is AIM a Casino? They proved that Mr Campos was misinformed, but their results don’t offer much comfort for those investors who like to indulge themselves with a few small cap growth stocks.

Before digging into this UK centric research it’s perhaps worth looking a bit further afield. Well, back to the SEC’s own playground, in fact, where research into Penny IPO’s offers some insight into small cap problems. In Penny Stock IPO’s the researchers looked at the performance of a bunch of stocks issued off the NYSE, AMEX and Nasdaq – on markets such as the Nasday SmallCap Market – where the issues weren’t backed by an investment advisor and where the initial offer price was less than $5.

Digging around with the data what the researchers uncovered was a particularly unappetizing set of results. The stocks tended to be underpriced at IPO, outperformed immediately afterwards but were then doleful in the subsequent years – a behaviour that seems to be linked to a particularly unscrupulous set of underwriters. Basically the thrust of the results is that these stocks, listed on junior US markets, are subject to price manipulation and it’s investors who pay the penalty of a lack of proper supervision. And, incidentally, they find that Venture Capitalist backing lessens the overall risk: presumably because VC’s tend to do stuff like proper due diligence and financial management.

Risky IPO's

Meanwhile Kooli and Meknassi had a look at The Survival Profile of U.S. IPO Issuers 1985-2005 and discovered data that links nicely to the previous study. Larger IPO’s were less likely to fail and underpriced IPO’s more so. Smaller IPO’s tended to be offered cheaply, presumably to get the less attractive issues away. To dovetail further with the Penny Stock IPO study, the more prestigious the underwriter and greater the VC involvement then the more likely the stock was to survive.

Overall, the results aren’t pretty but they tell a fairly straightforward story. Small cap IPO’s, especially when backed by less well known advisors, are much more risky for investors. Overall, it would seem that the SEC’s own backyard hasn’t been a particularly pretty place for new small cap stock listings. It’s as yet unclear as to whether Sarbane-Oxley has made a significant difference to this – although the early evidence suggests not – but it might be understandable if its greater regulatory envelope persuaded dodgy issuers to look elsewhere.

The Small Cap Trap

Which brings us neatly back to the UK where our intrepid researchers dug into spectacular detail in their efforts to uncover the truth. And, broadly speaking, after much effort and statistical analysis, they showed that the results from the US are broadly replicated in the UK. Similar factors are at work: the reputation of advisors and the size of the initial issuance are both determining factors in the likely survivability of the stocks, although the presence or otherwise of VC’s doesn’t seem to make a difference. They also find that the age of firms when floated is also significant – young companies disproportionately go bust.

However, the UK research goes beyond that carried out elsewhere and, on the assumption that it’s also broadly applicable to the rest of the world – or at least the US – it carries a number of very interesting implications. What was found is that the median survival time of a company after IPO is just over six years and companies issued during hot markets – 1999 and 2004 – have a much lower survivability likelihood. However, what they also showed was that nearly a third of all of the AIM stocks delisted for reasons other than M&A within 5 years. We can guess that some of the M&A would have been in distressed situations so the actual numbers will probably look worse than that.

It’s a pretty grim statistic that a third of all of these lightly regulated small cap stocks fail within 5 years of listing, although at least we have some clues on what to look for if we absolutely have to look at these stocks for bargains. On the other hand maybe the SEC’s research department needs to look at how it calculates its stats – the one year failure rate on AIM is more like 4% than 30%. Still, it was good that back in 2007 they were keeping their eye on the ball worrying about the dangerous and loosely regulated UK junior market rather than concerning themselves with the closer to home, rather more heavily regulated, US financial sector.

Regulatory Arbitrage

In fact regulatory arbitrage – where companies try to identify the supervisory regime that most facilitates their type of business, by imposing the least cost and restrictions – may have been a significant factor behind the market collapses from 2007. As August de la Torre and Alain Ize put it:
"A key lesson from financial history is that a regulatory unevenness that may seem inconsequential in the short run can trigger dynamics of regulatory arbitrage that turn out to be acutely destabilizing. Financial flows will sooner or later find the line of least resistance, giving the lesser regulated intermediaries a competitive advantage and making them grow to the point they become systemic behemoths”.
Basically the SEC was worrying about the right problem, but from the wrong angle. Small cap stocks engaging in regulatory arbitrage aren’t going to do much damage to anyone other than psychologically and numerically challenged small investors and the listing revenues of the relevant exchanges. On the other hand, as we now know too well, large cap stocks, especially financials, are entirely another matter.

It’s hard to know whether to be encouraged or discouraged that regulators are as subject to behavioural biases as the rest of us. Whatever, the main lesson is that small cap stocks on lightly regulated exchanges require even more analysis than normal. So probably best to look elsewhere unless you have time – and money – to burn.

Related articles: Basel, Faulty?, Are IPOs Bitter Lemons?, It's Not Different This Time

1 comment:

  1. Timmar, you have written a very good article about AIM listings and their concommitant risk levels.

    However, you imply in your opening remarks, inadvertently I think, that small caps by the very fact of their being small cap are AIM listed. That is most certainly not the case. Many have full listings. It is the fully listed ones I believe Slater generally alludes to in my own copy of "The Zulu Principle". I doubt your copy differs.

    It is fully listed small caps that I trade mostly. I confess that, once my research is done, I feel I am running very low levels of risk and inviting higher levels of reward than those offered by large caps.

    If the FT Weekend "Winners & Losers" column (inside back page) is to be believed, these better chosen small caps do consistently outperform large caps even in sluggish times when the aggregate of large caps outperforms the aggregate of small caps.

    I do not specialise in AIM traded stocks but having run the red pencil and slide rule across the odd one or two that have caught my eye over time, AIM too holds some quality stocks.

    You will often find large caps putting on a short burst of (SP) speed. Very few ever show sufficient stamina to maintain strong growth - not just growth but strong growth - over an extended time period. The niftier of the fully listed small caps and some of the better managed AIM listings display both speed and stamina.

    By the way, your captcha is so damned difficult to read I shan't be posting here again. It probably explains why you have no responses in three years.