Small Caps and Liquidity in Basket Cs

NOTE: This entire blog series is my trading notebook. I am NOT an expert investor, so be very careful trying to learn from me, I am just taking steps to make my notes and research available to myself and close family. You are very welcome to read and comment and even tutor me should you feel gracious :)

Small caps in Basket Cs
VBR Vanguard small cap
2/4/13 close at 77.18
2/8/13 I hold VBR and it went down today. Last close 75.02. Buy, 15, limit@72.00.
3/8/13 80.90 Waiting for a correction HOLD

SCHA Schwab small cap
2/4/13 40.51
2/8/13 41.26 Smaller bet, buy 10, limit@ 37.5 ( Good luck with that, man has to have dreams)
3/8/13 42.48

3/8/13 Notes:
NOTE(1): As it says in the research section small cap ETFs tend to be highly correlated. Adding another ETF will probably not increase diversity, just be one more account to manage at tax time. Instead, concentrate on building the SCHA position on dips. ACTION: set an email alert.

NOTE(2): We barely have enough small caps to disturb the liquidity of the basket, much less the portfolio. Setting a very patent target allocation of 10% of the basket over time, by making small commission free trades in basket Cs. As of today, both ETFs together are 3.85% of Cs. A 10% small cap allocation will be part of the strategy that drives Cs.

Thesis:

Of course you can read anything on the Internet, but I just read an interesting article on the liquidity of small cap stocks and their performance. From the article: "On the other hand investors who take the opposite tack and favour small value stocks that don’t trade frequently tend to do quite well. But they swap comfort for profits as they scour the back alleys of the market where many fear to tread."

Liquidity and Small Caps

Liquidity is how easy it is to buy/sell an equity. Houses are not very liquid and Apple stock ( AAPL) is very liquid. I never really understood exactly what this meant in conjunction with small caps, until I read Peter Lynch's take on this: "Another way that a lot of fund managers hemmed themselves in was worrying about ‘liquidity’. They avoided all the wonderful small companies – a good collection of these could do wonders even for a big portfolio – because the stocks were ‘thinly traded’."

What does thinly traded mean to me? I do a lot of my trading from Hawaii and the market is usually closed by the time I get my SANS work done and start thinking about investing for retirement. I see some small cap stock that looks good, and it last closed at 35.11, so I make a market order and find that the next day I bought it at 40.2397, what the heck? If there are only a few shares outstanding then I might get this unpleasant surprise, I am bidding on the stock, so are others and it pops up/jumps up as buyers are matched to sellers and guess what, retail investors do not have the fastest trade network, the big boys do. They got it cheaper, I pay too much. I know many people have different opinions about the Motley Fool investment advice, but one of the most repeated statements they make is: "Use a limit order". I have the rest of my life to balance my portfolio, I need to quit using market orders, it hits, or it does not hit. So be it.

Small Caps and Volatility

One of the things that I am thinking about is trying to smooth out my portfolio. At a time (March 2013) when the general advice is avoid Municipal bonds, I am increasing the % allocation to bonds. They are short, no more than 3 years, A or better, 1.2% or better, it takes some digging to find them, but I am patient. I am also experimenting with Floating Rate Funds for the same reason.

Small caps, either growth or value tend to be very volatile, so am I contradicting myself? Nope, it is a portfolio. It is made up of a number of baskets and each basket has a strategy and rules or procedures to enforce the strategy. So I have make a small cap play somewhere in the portfolio. Now in general, if I do not know the company well, I might be better off with an ETF, but I should not ignore the small caps asset class because they are volatile, after all, volatile can mean great gains ( or losses ) in a short period of time.

Of course it can be hard to do your research on what the small value stocks are and whether they are a good investment because not many analysts are following them. If you know the company well, it could make a lot of sense.

SourceFire illustrates the volatility of a small cap investment

In February 2013, SourceFire, (FIRE) the IPS and other network security device company was down 6% over the past 30 days. They are a great company and have great products. However, they are competing against Cisco's marketing engine and according to this article, they are in a slowing market. Also, with a P/E of 210.5 one could strongly argue this is not a value play, though it has clearly been a growth play in the past five years. However, despite the brief down, if you had bought in at the IPO, you would be very happy with the overall performance. Here is a chart from March 8, 2013, up 4% in two days, sooner or later that could add up.

Small Cap ETF Research

I do not know that many small cap individual equities that well. Therefore, it might make sense to have a position in an ETF that focuses on small caps instead of individual equities. Let's screen the performance of five examples on 30, 90, 180, 365 days
March 8, 2013             30  90 180 365
January 7, 2013.
            30  90 180 365
VB                        1
VBR                      2   1          1    2
SLYV  2          2         2     2    2  
IJS      1    2     1         3     3    3    3
JKL          1                       1          1

The thing that just jumps out at you when you do your research is strongly they correlate. So, it might be the better long term play is to choose the one with a lower expense ration which is usually Vanguard. UPDATE: March 8, 2013 Warning, this chart could be misleading. It is amazing how tightly correlated these portfolios are. The difference between one and another is tiny, usually less than a percentage point. I think choosing a Vanguard product because of the expense ratio makes all the sense in the world.

Timing, of course I cannot time the market, but this is an aging bull. Small caps did very well in 2012, but people will start to turn to large caps and mega caps when they think the end is coming; a so called flight to safety, so choosing when to buy is also worth giving some thought. And buying on a dip may make all the sense in the world as well. Let's channel Peter Lynch again:"Bargains are the holy grail of the true stock picker. We see the latest correction not as a disaster, but as an opportunity to acquire more shares at low prices. This is how great fortunes are made over time. "