Small Cap

Looking at the US Turnover Snake

A lot of people talk about small cap being illiquid and harder to trade. But is that really true?

A lot of people talk about small cap being illiquid and harder to trade. But is that really true?

Small cap is small

One fact that is impossible to avoid is that small cap is small. It’s impossible to buy $100 million worth of a company that has a market cap of $80 million. But that same trade is a fraction of a day’s liquidity in a company worth $800 billion.

It’s a mathematical fact that small cap companies have less market cap, and usually fewer shares too. That typically limits the size of position that an institution is able to buy. In turn, for very large institutions, there may not be a cost benefit to even look at certain small companies.

A better measure of liquidity for issuers

Obviously it’s not really fair to expect a small cap stock to trade more than a larger stock. But we should expect to see “relatively” constant liquidity across the cap spectrum if the market structure works evenly for all companies.

The best way to do that is to look at turnover as a manufacturer would. How many times does the available inventory trade in a year? We do that in Chart 1 below, calculating the total value traded/total market cap for each ticker. We also color the Russell 3000 stocks, to highlight those stocks that are most widely held by institution investors.

Chart 1: Turnover is not constant across the cap spectrum

Turnover of Public U.S. Companies

Source: Nasdaq Economic Research, FactSet, SIP, Data for 2018

The data is pretty interesting. Far from a flat line, turnover snakes across the market cap spectrum (x-axis):

  • Index inclusion matters: Turnover is typically higher for index stocks than those non-index stocks. Although the Russell 3000 excludes less liquid So for large cap stocks the lower liquidity might cause the exclusion from the index, not the other way around. But once market cap falls below the range for index inclusion, turnover falls—and troughs at around $100m market cap in fact—the log-scale in this chart distorts how dramatically the turnover falls. Median turnover for small cap stocks (between $1 billion and $2 billion in market cap) is 220%, while stocks between $50 million and $300 million turnover a much lower 88% on average.
  • Mega cap stocks are actually less liquid than other institutionally held stocks.
  • The highest turnover is in the nano-cap stocks with often extremely low market cap.

How much liquidity is in these thinly-traded stocks?

As the data shows, turnover starts to fall at around $1 billion market cap.

Amazingly, if we add up all the value that trades in stocks with market cap below $1 billion, it comes to less than $10 billion each day, despite representing 2,703 stocks (Chart 2). In contrast the 500 largest companies trade a total $171 billion each day, despite representing just 10% of all corporates.

Chart 2: Cumulative daily value traded as market cap increases.

Cumulative ADVT of Public U.S. Companies

Source: Nasdaq Economic Research, Data for 2018

Small cap is also more expensive to trade

As we saw in our analysis of spreads, small cap stocks also usually have wider spreads. That makes each share more expensive to trade in-and-out of each investment. Investors demand a higher return from their investments, to offset those entry and exit costs. That in turn increases the Weighted Average Cost of Capital (WACC) for smaller firms.

It’s no surprise that traders complain about tradability in the microcap, thinly traded, subset of the market. And that’s before they look at how fragmented liquidity could be in a stock that on average trades $3m/day.  

If we could design a market structure to improve tradability and liquidity for smaller companies it should reduce the liquidity premium and WACC of those small companies, and in turn their share prices should rise.

That’s one reason why we have proposed revoking UTP for thinly traded stocks in our recent TotalMarkets blueprint.

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Phil Mackintosh

Nasdaq

Phil Mackintosh, Nasdaq Chief Economist, has 28 years of experience in the Finance industry, including roles on the sell-side, buy-side and at accounting firms, which included managing trading, research and risk teams. He is an expert in index construction and ETF trading and has published extensive research on trading, ETFs and market structure.

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