As Small-Cap Institute has discussed, there is widespread confusion among small-cap leaders on the subject of trading volume; i.e., where it actually comes from, where it doesn’t come from, and how to get more of it. One of the most insidious byproducts of this knowledge gap is the astronomical waste of time and money expended by small-cap companies targeting investors who are foreclosed from buying stock due to… illiquidity. The goal of this piece is to provide some buy-side “math” that will obviate such waste in the future.

The Recurring Fact Pattern

Company ABCD has a market capitalization of $125 million, and its stock trades approximately $90,000 per day (number of shares multiplied by its volume weighted average price). ABCD and its investor relations firm agree that they should undertake a non-deal roadshow (NDR) to visit with investors in New York. ABCD meets with a dozen hedge funds during its trip, and management feels like the meetings went well. During the weeks subsequent to the NDR, there is no change in ABCD’s stock price or trading volume, despite having announced record operating results in the interim. ABCD’s officers and directors are disappointed in the results, and left to wonder whether it was a good use of time or money.

This fact pattern happens dozens of times a week, 52 weeks per year, in the small-cap ecosystem. Here’s why.

The Math

Institutional investors have minimum position sizes that are driven by the quantity of assets they manage. A hedge fund with $1 billion under management is not going to invest $250,000 in a company, because even if that investment increases in value by several times, the result won’t be statistically impactful on $1 billion.

Let’s assume a hedge fund has a minimum position size of $1 million. Most funds lack the patience to acquire positions in the open market that take more than about 20 trading days to buy. Accordingly, to build such a position, our hypothetical hedge fund would need to buy an average of $50,000 of your stock per trading day. That said, investors can rarely be more than approximately 15 – 20 percent of the daily dollar trading volume, because if they buy more than that on any given day, they risk pushing up the price of the stock to a level where they are no longer interested in buying. Accordingly, if a stock doesn’t trade $300,000-plus per day, this fund would be functionally excluded from buying the stock in the open market. When you consider that many small-cap hedge funds have minimum position sizes of $2 million-plus, a stock needs to trade more than $500,000 per day for many funds to comfortably purchase shares in the open market.

Though it perhaps goes with saying, if ABCD met with hedge funds that had either $1 or $2 million position size limitations, its stock is not remotely liquid enough for any of those funds to buy its stock in the open market.

“So, If That’s True, Then…”

Whenever I explain this math to CEOs and boards my firm advises, it invariably leads to two great questions.

Shouldn’t my IR firm know this math? The short answer to this question is, of course, yes. The longer answer is a bit more complicated.

In the spirit of being brutally frank, there are definitely investor relations firms that don’t understand this math – full stop. There is no nice way to put it; they simply aren’t good at what they do, and lack basic capital markets proficiency.

There are other IR firms that do understand this math, but – and let’s be frank here again – take advantage of the fact that the majority of their clients… don’t know the math. It would be nice if it weren’t true, but it is. Is this disingenuous? Well, yes, it is.

It’s also important to point out there are still other IR firms that understand this math, and actively dissuade their clients from undertaking roadshows with institutional investors to no avail. Put differently, small-cap CEOs and boards are partially at fault here as well. Without knowledge of this math, they erroneously believe that “public companies meet with institutional investors.” Plenty of high integrity, expert IR professionals will happily regale you with stories about how clients with illiquid stock absolutely demanded NDRs with institutional investors in New York, Chicago, San Francisco, etc. under threat of immediately terminating their relationship.

What it really comes down is that there a finite number of small-cap hedge funds. Everyone knows who they are, and knows their email/physical addresses. Accordingly, it’s comparatively easy to contact them, and meet with them. You know what’s not easy at all if you’re an IR firm? Telling your illiquid client’s story to… retail investors. Why? Because there are millions of them scattered in every town in the United States, they have varying amounts of money to invest, they have disparate education and investing skill, and there isn’t really a contact list for them.

Why would investors take these seemingly wasteful meetings? I won’t speak for other institutional investors, but I will tell you why our fund met with companies that were too illiquid for us to buy in the open market: (1) we were doing a favor to the IR firm (who needed to “fill up their schedule” to make the client happy); (2) we were using that meeting to get smarter about one of our existing portfolio positions; or (3) we knew that the company was likely going to require growth capital before long, and a NDR was a good opportunity to get smarter about them in advance of a fundraise.

Takeaways

• The lion’s share of small-cap companies need to routinely access the equity capital markets for infusions of growth capital. Accordingly, none of the foregoing is intended to assert that NDRs with institutional investors are a waste of time for companies that lack the liquidity necessary for institutional open market buying. Said differently, educating institutional investors is important for small-cap companies, because they will need those institutions to provide growth capital. But what’s critically important is for small-cap leaders to realistically frame the purpose of an NDR; if the purpose is principally to increase share price and trading volume… do the “math” first and be guided by the outcome.

• Prior to agreeing to meet with any institutional investors on an NDR, ask your IR professional/firm to ascertain the minimum investment size of every fund they recommend meeting with. If the “math” doesn’t add up, make sure there is a valid, alternative reason to meet with them. The best question for meeting proponents is: “Can you confirm whether they recently acquired positions in the open market in companies with our liquidity and market cap profiles?”

• If your IR professional/firm tells you that “they don’t provide that information” or they tell you to “trust them,” hire new investor relations counsel.

• When targeting potential investors, you want to be telling your story to investors who routinely buy stock in companies that look/feel just like yours. Just like you never want to have the most expensive or the cheapest house on your block, you are not going to effectively sell stock to investors if your company is smaller/less liquid than the companies they typically invest in.

• If your investor relations professional/firm professes to have expertise in targeting retail investors, reach out to former clients who shared your current market cap/trading volume and see whether they would agree.