Editor’s Note: Yesterday, I shared part one of Senior Analyst Brian Hunt’s two-part Easter Egg hunt series. If you missed it, you can check out the first part here.
Now, in part two today, Hunt compares a quiet, small egg hunt to one with hundreds of people. If you had your pick, I’d be willing to bet you would go for the smaller egg hunt, where you are more likely to be successful.
As Brian explains, this same dynamic is at work in the stock market every day… I’ll let Brian take it from here…
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Picture this…
It’s Easter and you’re ready for the neighborhood Easter egg hunt.
Over 100 eggs have been hidden in a small local park. Each egg has a treat inside it. You’re told that one special egg even has a cash prize in it.
If you’re in this hunt, which of the two following scenarios would you rather be in?
- In addition to you hunting for eggs in the park, there are 1,000 other people hunting for eggs. It’s a madhouse.
- In addition to you hunting for eggs in the park, there are just 10 other people hunting for eggs.
If you’re like most reasonable people, you picked B.
You’d rather have this:
Than this:
You’d rather have just 10 people in competition with you… instead of 1,000 other people picking over the park like a swarm of locusts.
What does this have to do with investing?
Well, this same dynamic is at work in the stock market every day.
The financial markets are where millions of people go to pick through opportunities in stocks, commodities, currencies, options, bonds, and real estate.
In this big market, everyone is looking to buy assets for less than what they are worth and looking to sell assets for more than what they are worth.
Essentially, everyone is trying to outsmart everyone else.
Everyone is looking for eggs.
The financial markets price most assets correctly most of the time.
However, it’s not a perfect system. Windows of opportunity – where you can buy assets for less than what they are worth or sell assets for more than what they are worth – appear from time to time.
In the investing world, these windows are called “market inefficiencies.”
These are the opportunities that can make us big money.
However, the more people that are studying, monitoring, and picking over a market and its opportunities, the more competition you have in that market… and the less likely you’ll be able to find market inefficiencies.
The more people picking over a market, the smaller its pricing inefficiencies will be and the shorter its windows of opportunities will be open.
In the financial markets, the biggest competitors are “institutional investors.”
Institutional investors are the elephants of the financial markets. This group includes mutual funds, pension funds, large hedge funds, and insurance funds. It also includes sovereign wealth funds, which manage the savings of entire nations.
A single large institutional investor can manage over $10 billion in assets.
So, even a wealthy individual with $5 million in assets is a mouse compared to this elephant (in this case, the elephant is 2,000 times larger).
Some institutional investors manage much more than $10 billion.
The sovereign wealth fund of Norway – which has been fattened by oil revenue for years – was worth more than $1 trillion in 2017.
This is 100 times bigger than the large institution with $10 billion to invest.
The large institutional investors of the world have ridiculously giant amounts of money to invest in stocks, bonds, and other assets.
These large institutional investors typically employ armies of analysts who spend hundreds of thousands of hours every year scouring the world for opportunities.
These analysts perform a lot of old fashioned “financial detective” work by visiting public companies and interviewing industry experts.
They also use the world’s most advanced computer algorithms and “Big Data” analytical programs to comb through market data.
The programs run 24 hours a day, seven days a week… sifting all of the world’s financial data a thousand different ways at warp speed… hunting for pricing inefficiencies, small and large.
Picture those Easter egg hunts again… and realize that the stock market is a brutally competitive Easter egg hunt.
That’s the bad news.
The good news is the financial market is a big, diverse place.
And there are Easter egg hunts the big guys can’t participate in.
The Problem of Size
In the investment world, professional investors obsess over “liquidity.”
When it comes to buying and selling investments, liquidity is a measure of how easy or difficult it is to transact in a security.
For example, take Amazon stock. Because Amazon is one of the world’s largest companies (worth over $983 billion in 2022), and since many people like to buy and sell its stock, we can say Amazon stock is “very liquid” or “has huge liquidity.”
There is a large market for Amazon stock where buyers and sellers execute many sales each day. In 2022, it was common to see over 70 million shares of Amazon change hands in a day.
On the other side of the spectrum, take an unknown small-cap firm with a market cap of just $50 million (less than one-tenth of one percent of Amazon).
Because this company is tiny by stock market standards, and since most people have never heard of it, the company’s stock will not have much liquidity.
Remember, market cap is simply the number of outstanding shares times the share price. That means with small-cap stocks, there simply aren’t all that many shares out in the market (compared to, say, Amazon, which we just talked about). This makes it harder for someone to buy up a huge amount of those shares – there may not be all that many sellers.
Now here’s where it gets interesting…
Let’s say you manage a $10 billion stock portfolio.
For a stock position to make a meaningful positive impact on your fund’s results, you need it to represent at least 3% of your fund’s assets.
Most good managers would rather put 4% to 8% of their fund into a stock idea they believe is truly great.
If you’re looking to put 3% of $10 billion to work in a great idea, that means you are looking to place $300 million.
That is six times more money than a $50 million small-cap.
Even if you wanted to put just 1% of your fund into a stock, that is $100 million.
You get the idea.
Big money managers can’t join in the small-cap stock Easter egg hunt.
They also can’t “play” in other small markets with limited liquidity, like many options markets, smaller investment funds (like closed end funds and ETFs), individual bonds, small-cap foreign stocks, and penny stocks.
When you “play” in small markets with modest liquidity, you don’t take on the world’s richest, most powerful institutions armed with armies of topflight analysts and the world’s best computers.
Instead of competing against thousands of other Easter egg hunters, you compete against modest amounts of them.
Think of it like you would buying a house. You want to be a buyer in an area with just a few other buyers… instead of being a buyer in a town where lines form down the block after homes go on sale. When you’re a buyer, you don’t want loads of competition.
I can’t resist rolling out one more analogy to get you on board:
Think of it like fishing. You don’t want to fish in the same spot as 1,000 other anglers. You’d rather have a quiet stream and its fish all to yourself.
Successful investing and trading is all about tilting the odds in your favor.
The more you can get this advantage, the more successful you will be.
Hunting in smaller, less liquid markets – like the small-cap market – is one of the best ways to do that.
Regards,
Brian Hunt
InvestorPlace Senior Market Analyst
P.S. It’s Louis again.
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