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One of the items most investors look at when investing is liquidity. However, while it is a key concern, for most retail investors, given the size of their investment, it tends to be an overrated risk measure.

Liquidity really comes into play when you are managing large positions and not when you are managing smaller positions as most stocks will trade in amounts easily held by retail holders.

And from a fund manager point of view, you have to think of liquidity as a double edged sword - i.e. it's great when you have a large position and others want in - because they will drive up the price. But it is dangerous if you make the wrong call and want out - because you will likely drive the price down trying to exit.

So the reward has to be pretty good to induce a fund manager to buy a large position in a company with limited liquidity.

So what makes a fund manager take that risk?

I recently wrote an article on Boyd Income Group (OTC:BFGIF) introducing this company to Seeking Alpha investors. Now while the stock has appreciated approximately 10% since I wrote the article, one of the key features of this company is the limited amount of shares outstanding.

I also highlighted two other companies in it that were similar in nature to it - being Stella Jones (OTC:STLJF) and Black Diamond Inc. (OTC:BDIMF). One of the things all three companies share in common is that they pay a dividend and have low share counts.

So is that the key to finding good companies to invest in?

Well if you look at the charts for the year of 2013, they look like this:

(click to enlarge)Dourble Edge Sword - 1

When compared to the TSX which returned 9% in 2013, anyone willing to take the liquidity risk was well rewarded as the chart shows.

I expanded my search further and looked for some other companies with a low float that paid a dividend and found several others, including Chesswood Group Limited (OTC:CHWWF), AutoCanada Inc. (OTC:AOCIF), and Canadian Energy Services & Technologies Corp. (OTCQX:CESDF). Now when added to the above chart you get the following:

(click to enlarge)Double Edge Sword - 2

As the chart shows, these stocks all had pretty good performance in 2013.

However, when you look at the float, you see a trend emerging. The lower the float the better the performance (with the exception of CESDF).

(click to enlarge)Double Edge Sword - 3

Source (Koenig)

Of note - Stella Jones up until Q3 had a float of 17.2 million shares and then did a 4:1 stock split. Coincidentally, their return performance was approaching 100% for the year and declined only after they did the stock split, suggesting once a company gets over a certain share count, the performance diminishes.

With respect to the other anomaly of the group - Canadian Energy Services & Technologies Corp. - this company has done several acquisitions where they issued shares to the existing owners of the companies they acquired. Now what I speculate is that in most instances for these companies they took over, management stayed and has held on to their shares thereby reducing the public float. When they did a financing in 2013, it was for only a small amount, 2.11 million shares.

So why the great performance if this is the case?

My thesis is quite simple. There are a lot of companies out there with small floats. However, if they are capable of paying a dividend on a consistent basis, and more importantly if they are able to grow the dividend on a consistent basis, then this gives fund managers an indication that these are stable companies and worth the risk of limited liquidity.

Small companies don't usually pay a dividend unless they foresee a consistent cash stream - something appealing to investors.

So when small cap fund managers find these type of situations, they usually buy the stock because it fits the model they are looking for. And as long as the dividend growth occurs, they will likely hold on to their shares further reducing liquidity.

So the key as a retail investor is to find these companies at an early stage before they get on the fund managers' radar screen.

Disclosure: I am long BFGIF, CESDF, CHWWF, BDIMF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Liquidity - The Double Edged Sword