Those who follow our Malaysian Portfolio column will recall that we acquired five small-cap stocks in April that we think offer value — because there is no story to drive interest and stock prices. We have since disposed of four of the five stocks, making gains on three of them. The reality is that, as a portfolio fund, we do not have the luxury of holding stocks for an extended period of time. And by that, we mean years, not months.
Markets attach a value to liquidity, for the possibility of immediate monetisation. We discussed this last week. To briefly recap, there is a positive feedback loop between stock liquidity and valuations — a highly liquid stock is more appealing as investors can buy and/or sell quickly without causing significant price changes. Strong investor interest translates into higher share prices and valuations, which will attract even more investors — and portfolio fund inflows — as the company grows in size (market cap) and commands ever larger weightage in bellwether indices.
Conversely, this means less-liquid stocks will suffer the opposite effect. Portfolio funds largely avoid illiquid, small-cap stocks that are perceived as higher risks — because it is harder to exit without being forced to accept lower-than-prevailing market prices. As a result, many such stocks often trade below their fair discounted cash flow (DCF) valuations, all else being equal, which further discourages investments, even by retail investors. We have shown the anecdotal evidence for this phenomenon in our previous article. The question is, how do we capitalise on it?
