Biotechnology Micro-Caps And Their Lack Of Liquidity: How To Make A Virtue Out Of Necessity

|
 |  Includes: IBB
by: Alberto Abaterusso

Summary

Low liquidity makes biotech micro-caps unattractive to investors.

Too many biotech micro-caps are chasing a few investment dollars.

Liquidity as an Investment Style to reconsider the investment in biotech micro-caps.

Biotech micro-caps, that is companies that operate in the biotechnology industry and have a market capitalization less than $300 million, are usually characterized by shortage of liquidity in stock markets.

This peculiarity makes biotech micro-caps unattractive to investors, especially institutional ones, because if levels of trading activity are very low (shortage of liquidity), it is very difficult for the investor to enter and exit the position whenever he wants. Furthermore bad news such as a setback in the approval process of the product by the Food and Drug Administration or a delay in the launch of the product on the market (the investment risk is too high when compared to its reward), may cause a longer delay than expected -- and resulting negative effects on share price are amplified by the lack of liquidity.

In this article we'll look at the lack of liquidity affecting the biotech micro-caps, not as a discouraging factor for investing but rather as a screening criterion that if properly combined with others allows investors to select potential investment opportunities among the biotech micro-caps.

Some data about the biotechnology stocks

We have run the stock screener and we found 242 biotechnology stocks that are listed on U.S. Stock exchanges as of March 24, 2014. See results below:

As you can see the most copious groups are those of small-caps (103) and micro-cap companies (95). The first two groups together (nano and micro-caps), with a market capitalization under $300 millions of U.S. Dollars account for 45.87% and three groups together (nano, micro and small-caps) account for 88.43% of the total number of companies that operate in the biotechnology industry and that are listed on U.S. Stock exchanges. Only 11.6% of the industry is composed by mid- and large-caps which have a market capitalization over $2 billion.

The table below shows data in terms of market capitalization shares:

Click to enlarge

As you can see 85.74% of biotechnology industry's market capitalization is held by mid and large cap companies and just 2.5% by stocks with market capitalization below $300 million.

If we match the results of table 1 and 2 with each other, we can see that the first three groups together (nano, micro and small-caps) account for 88.43% of the total number of companies that operate in the biotechnology industry and held only 14.26% of the entire industry market capitalization while just 11 large-caps (4.55% of the total number of biotechnology companies) held about 3/4 of the entire industry's market capitalization.

We have run the same stock screener to determine % of biotechnology companies' shares outstanding held by institutions. See table below:

Click to enlarge

The portion of total nano and micro-caps market capitalization that is held by institutions is 0.9% while the portion of total large and mega-caps market capitalization that is held by institutions is 60%. This doesn't mean that institutional investors are not at all interested in investing in the smallest biotechnology companies, but they prefer to invest heavily in large caps and allocate only a small part of their resources in micro-caps.

The reason why the large investment funds continue, albeit a very tiny part of their resources, to invest in biotech micro-caps might be that probably biotech micro-companies also show to have the strongest liquidity effect that declines from micro to small to mid to large-cap stocks (see this study, table 2 page 27). The liquidity effect is the difference between the annualized mean (compounded) returns between the lowest liquidity portafolio and the highest liquidity portfolio across micro, small, mid and large-cap group.

So there are too many companies that chase a few investment dollars. The major contributors to this lack of interest to biotechnology micro-caps are:

  • high risk/reward ratio
  • product failures
  • liquidity
  • consolidations among investment houses have dramatically reduced the number of analysts devoted to cover biotechnology micro-caps.

Biotechnology micro-caps cannot attract such investment to get stock prices moving because of their low trading volumes (liquidity). Because they suffer extremely if there is any contingent stop in the process of development and approval of products, it would be very difficult for the investor to easily exit from the position if share prices collapse (see this article).

Does this mean that investors should abandon the idea of ​​investing in micro-cap biotech? The answer is no. This article concludes that there are two possibilities to satisfy the investors' appetite to biotech micro-caps:

  1. ''strategically combining several well-matched micro-cap companies''
  2. ''or having these companies acquired by larger, more successful biotechnology firms''.

The investor has no active role in the second solution to the problem, instead he can take some actions with respect to the first solution and implement an investment style that might allow him to get some interesting results through investments in micro-cap companies too.

The investment style should be such that the investor will achieve important goals by selecting the stocks that make up the portfolio according to certain criteria.

The liquidity as an investment style.

Change the style with which to invest rather than abandon altogether the idea of ​​investing in biotechnology micro-caps. The idea comes from this study and its findings:

Ways to outperform with the smallest biotechnology stocks :

  • hold a passive investment style (buy and hold for long horizons ). Few trades in the long run allow the investor to mitigate the costs due to higher commissions on low liquidity stocks. These costs are generally higher when low liquidity stocks are traded than those characterized by higher trading activity.
    The results of this study (Trading volume liquidity and investment styles, pp. 12-13) suggest that low liquidity stocks have higher returns in equilibrium than high liquidity stocks, not because the first are riskier than the second one but rather because the first have higher transaction costs than the second one.
  • Micro-caps + low liquidity. As written before probably biotech micro-companies also show to have the strongest liquidity effect that declines from micro to small to mid to large-cap stocks (see this study, table 2 page 27).
  • combining high-value with low-liquidity stocks (see table 3 p. 28 of this study). '' The best return comes from combining high-value with low-liquidity stocks''.
  • high momentum - low liquidity stocks (see this article's findings). Those stocks that were winners in the past they might be so in the future; but those stocks that were losers in the past, they will almost certainly be so in the future, according to a way of saying.

Furthermore another study (Transactions costs and investment style: an inter-exchange analysis of institutional equity trades) that empirically analyzes the relation between transactions costs and investment styles for a sample of institutional equity trades finds that ''in general, value traders have lower costs than index traders, who in turn have lower costs than technical traders.''

Since micro-caps typically don't pay dividends and dividend yield is a measure to evaluate whether a stock is a value stock, the liquidity investment style might be the trait-d-union between low-liquidity and value stocks among biotech micro-caps for the higher returns.

Conclusions:

Biotechnology micro-caps are characterized by a shortage of liquidity. This makes them unattractive to investors. But it does not mean that investors should completely abandon the idea of ​​investing in these companies.

General findings from some studies we have mentioned here show that by strategically combining several well-matched micro-cap companies investors might achieve interesting results. That's why the investor should look at the lack of liquidity, not as an impediment but even as a factor from which to take advantage.

Be aware that liquidity is not a proxy for size, but it is true that the odds to find low-liquidity stocks is higher among micro-caps than among mid or large-caps.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.