I have a basic premise: the larger the pond in which I fish, the more fish available, so the more discerning I can be. This is why I wish to access the broadest range of investment opportunities practicable – so I can build a high quality portfolio as cheaply as possible.
I see that my major point of difference amongst my fund manager peers is also my competitive advantage – I am free from institutional imperatives. I am not concerned about losing my job (career risk). I have no conflicting interests. I don’t need to pay for a team of analysts, marketing departments, or provide returns to external shareholders (business risk). So, I can invest how I want. I can be agnostic to index returns, short term performance, tracking error, alpha, beta, etc. I have a low level of funds under management and I am comfortable with this. I intend to keep it this way. The reason is simple: I do not want to encounter the investment constraints that are inherent in managing large levels of funds. Because I am so heavily invested in the Strategy, my goal is investment performance, not managing large sums of external capital.
A significant constraint facing institutional investment managers is the “liquidity constraint”1 . This refers to large investors not being able to access smaller stocks at desired prices in sufficient scale to build meaningful positions. It is simply impossible for many of my competitors to take the positions I adopt. For example, our Fund may hold a 5% position in an attractive, well priced business that has a market capitalisation of USD500 million. However if a USD10 billion fund manager also saw the merits of this business, then in order to build a 5% position they would have to acquire the whole company (which would no doubt breach their investment mandate), and they would have to pay a lot more for it. In all likelihood, the USD10 billion investment manager would have to limit their investment to a position significantly less than 1% (because at that level the manager would control 20% of the company’s stock). The outcome of this dilemma is that these smaller businesses are often under-researched and less efficiently priced, and this creates investment opportunities. I want to have the maximum possible access to these opportunities.
Don’t get me wrong though. Conversely, I do recognise the benefits associated with investing in larger, more liquid assets. The benefit I appreciate most is that although larger stocks are generally more efficiently priced, the higher prevalence of institutions on the share registers often entails a shorter term investment horizon which can create periods of inefficient pricing. It has always been my intent to capitalise on such opportunities when they are present.
Net-net though, whilst my investment process does not intentionally target any specific market capitalisation or liquidity ranges, due to the prominence of the liquidity premium, the Strategy can be expected to exhibit a bias toward less liquid investments.
1 Liquidity premiums and constraints are well researched. For example in “Liquidity as an Investment Style: 2014 Update” Ibbotson and Kim conclude: “Extensive academic literature has confirmed that less liquid stocks outperform more liquid stocks using various measures of liquidity”.