- When it comes to small-cap financings, trading volume is everything
Nearly 80 percent of U.S. public companies have market capitalizations below $500 million, and the vast majority of them periodically require infusions of outside capital to fuel growth, to the tune of $25 billion to $50 billion per year. Without predictable cash flows and material fixed assets to lend upon, equity capital markets are the most prevalent source.
Since the financial crisis, in particular, there is an inextricable link between trading volume and cost/availability of capital. The financial crisis was, above all else, a liquidity crisis, where investors were stymied by a global run on the bank. In the years following the crisis, institutional limited partners (i.e., those that invest capital in the hedge funds that finance small-cap companies – also known as “LPs”) have remained focused on, among other things, avoiding another liquidity crisis. That is, large LPs have made it abundantly clear that they want general partners (i.e., hedge funds or “GPs”) to invest the bulk of their capital in highly liquid stocks in order to thwart a repeat of 2008. GPs have, in turn, obliged; hence the reason why less liquid small-cap companies that previously had fairly robust access to the equity capital markets, no longer do.
There are two key takeaways:
- The most capital, and the best financing terms, are reserved for companies with the most liquid stocks.
- Companies can avoid wasting precious time and money planning for a financing that’s not going to happen as envisioned by studying financings transacted by more liquid peer companies. That means, all things being equal, your company is likely going to raise less capital (as a percentage of your market cap), and on less attractive terms, than whatever a more liquid peer company was recently able to undertake.
The harsh reality of small-cap capital raising is that… it’s far better to be liquid than good.
- Executives who think trading volume is only important for financings… should think again
Institutional investors routinely interact with small-cap officers and directors who respond, when asked about their illiquid stocks, with “we’re profitable and don’t need any financing, so trading volume is not a big concern of ours.” There are several reasons why this mentality should be reconsidered.
Gateway to institutional ownership. Irrespective of whether they like your company and believe it’s a good value, most institutional investors are mathematically foreclosed from buying stocks in the open market that don’t trade a few hundred thousand dollars of stock per day. For example, if an investor has minimum position sizes of $1 million, and will characteristically not take more than 20 trading days to build such a position, then they need to buy an average of $50,000 of your stock per day. But investors can rarely be more than 15 – 20 percent of the daily dollar volume without pushing up the price of the stock. Accordingly, if a stock doesn’t trade $250,000+ per day, the fund would be functionally excluded from buying the stock.
Foundation of equity research. Equity research analysts are compensated, in large part, by the amount of stock that their research clients – institutional investors – buy and sell through their trading desks. When a stock is too illiquid for an analyst’s key clients to trade, then they can’t make any money from recommending it. In other words, no trading volume, no high-quality equity research.
M&A. The more trading volume a small-cap stock has, the more likely it can use that stock as a currency to buy other companies. The opposite is also true. For example, why would another company accept an all-stock acquisition offer if the stock doesn’t trade in sufficient volume for the acquisition consideration to ever be monetized? The answer is: high quality acquisition targets won’t.
Employee retention. The more trading volume a stock has, the more value employee retention tools (e.g., stock options) have. For example, employees are not going to stay at the company because of in-the-money stock options, if the company’s stock doesn’t trade in sufficient volume to enable employees to exercise the options and sell the stock.
Trading volume in small-cap stocks is tantamount to alternatives, while a lack of trading volume leaves a small-cap company with a dangerously low margin for error.
- Many small-cap executives unwittingly shun the primary source of trading volume
Until such time as small-cap stocks are sufficiently liquid for institutional investors to buy and sell them in the open market, the primary source of trading volume is retail (i.e., nonprofessional) investors. You read that correctly: trading volume comes from retail investors. Despite this reality, leaders of illiquid small-cap companies routinely instruct investor relations firms to set up non-deal roadshows exclusively with institutional investors. The result? CEOs and CFOs wonder why all the time and money spent on non-deal roadshows aren’t impactful on share price or trading volume. Illiquid small-cap companies that don’t expertly engage with retail investors are simply delaying, if not impeding, institutional ownership.
- It often comes down to… storytelling
One of the anomalies of the small-cap ecosystem is that you can have two similar companies with similar products and financial metrics, yet one of them trades $75,000 of stock per day and the other trades $1 million of stock per day. More times than not, the more liquid company is simply better at storytelling. That is: (1) they explain their company in simple terms, using plain English; (2) their website is modern, accessible, and inviting to all interested constituencies; (3) they use video to effectively educate current and prospective investors; and (4) their CEO is a charismatic extemporaneous speaker. There is an old adage that “Investors don’t buy small-cap stocks… you have to sell it to them.” Selling small-cap stock, particularly to retail investors, is about accurate, efficacious storytelling.
- How sustainable trading volume is not generated
As important as it is for small-cap officers and directors to take appropriate steps to generate ample, sustainable trading volume, it’s equally important for them to avoid common mistakes which don’t achieve the objective.
‘Head in the Sand’ approach. Perhaps the most common, and worst, strategy for inactively traded small-cap companies is the, “We’re just going to keep our heads down, deliver results, and the investors will find us” strategy. Even if the company operates in a sector that is hot and the company’s revenues are growing quickly, this is a strategy that will not result in sustainable, ample trading volume. Sectors come in and out of favor, and while revenue growth will always attract attention, the vast majority of small-cap companies can’t grow at breakneck speed forever. Therefore, sooner or later, company management is going to have to formulate a strategy to actively, constructively communicate with its target audience on the Street. Moreover, like a lot of things having to do with corporate finance and capital markets, it’s a numbers game. There are literally thousands of small-cap companies, so the “head in the sand” strategy is doomed on that basis alone.
Too much of a good thing Part I. There are small-caps that take the opposite approach from the “head in the sand” strategy and often can end up with similar results. There are management teams that are incessantly on the road speaking to investors. But the law of diminishing returns applies to this situation for two reasons: (1) companies that continuously speak to investors can’t possibly always have something new and material to report, so each meeting can be greeted with correspondingly less interest from investors; and (2) investors will begin to question who is running this small company while the CEO and CFO are crisscrossing the country every week speaking to investors.
Too much of a good thing Part II. Some small-caps elect to serially issue press releases in lieu of meeting incessantly with investors. This strategy will not generate sustainable trading volume either, because smart retail and institutional investors know the difference between hype and material news. The former is always bad, whether cleverly disguised or not.
There are no short cuts. Small-cap officers and directors should approach any third parties that promise to quickly increase the company’s trading volume with circumspection. First, the goal for small-cap companies should be sustainable trading volume, not incidental or periodic spikes in trading volume. Second, since there are no functional short cuts to creating sustained trading volume, vendors that promise to magically increase trading volume are likely peddling half-truths or they are engaging in unethical/unlawful activity. Both are bad.