DMX on Managing Smaller Company Liquidity Risk

DMX recently has seen significant volatility in the micro and small cap space, in part of because of a rotation of capital out of smaller stocks. The company believe this ‘volatility’ has become due to a lack of liquidity in these smaller companies. Managing liquidity risk is arguably one of the biggest challenges all smaller companies’ investors face.

KEY TAKEAWAYS:

• Upside versus downside risk-value investing at work
  • An opinion stated from DMX explains that within the liquidity risk management discussion it is clear to build views with the potential upside risk and downside risk for any smaller company you are considering investing in. Once you have an opinion of both the upside and downside risks, you can then weigh up that equation versus the stock’s current liquidity.
• Trust your analysis and conviction levels
  • Investing in under-valued smaller companies takes courage. DMX often believe that the best performing stocks were in hindsight the stocks which required “courage” to invest in at the time.
• Remember liquidity changes over time
  • Stock liquidity is highly change-able within the company’s experience. They believe that it tends to improve when a stock is becoming more widely followed, which often correlates with periods of out-performance, and tends to deteriorate when a stock is becoming less followed, which often leads to periods of stock under-performance. This is arguably the biggest challenge when investing in smaller companies.  
• Keep some bullets in the gun
  • Even the most illiquid stocks will at some point present liquidity opportunities. They may arise from such events as:
  • Increased (short-term) market awareness arising from a news or reporting event;
  • A major shareholder sell-down (on or off market); or
  • A capital raising or stock placement.
• Remember the overall portfolio’s liquidity position
  • DMX states “as bottom up focused investors we let the stocks do the talking in our portfolio construction process”. However, the company is very aware of the level of liquidity risk and take the portfolio level and factor that into their stock weightings.
• Have a plan in place if things go wrong
  • This is a strategy in which most smaller company investors struggle with the most as many panic after bad news is announce and will take any price being offered at the time. This is often the opportunity DMX are waiting for with the company’s large cash weighting.
  • The key question DMX ask as a company when bad news has been announced is: does it affect the long-term business fundamentals? If the answer is no, then the company often aim to buy more stock into weakness. However, if the answer is yes, which happens in surprisingly few cases, then DMX will move to the next stage of the company’s liquidity risk management plan, the divestment strategy.
• Think long term
  • The need to think long term throughout this article is essential to creating success within smaller company investing and dealing with liquidity risk. Most of the challenges of smaller company investing, including managing liquidity risk, are most effectively dealt with by taking a long-term view on each smaller company investment and trusting your own analysis. DMX assets management would go as far to say that if you don’t intent to own any smaller company investment you are considering purchasing for the next 5 years, you would be well advised to reconsider.

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