Small Cap Risks: Large Shareholder Risks


From an investor's point of view, small cap companies are often exposed to a number of risks that are far more commonly experienced compared to larger companies. These risks are reasons why small cap companies do not always reach high valuations or even industry average valuation multiples. Indeed, a large number of companies trading on low multiples during the height of bull markets are often exposed to one of the main risks, which include customer dependency, exchange rate impacts and liquidity problems, amongst others. Investors should therefore be able to assess for some of the most common risks to avoid getting caught in a 'value trap' - a situation when a company looks 'cheap', but with good reason. This three part series will look at a few of the main small cap risks. Company reviews will promptly resume thereafter. This is part two of the series.

What are Large Shareholder Risks?

A large shareholder is a shareholder who holds a highly material percentage of a company's shares - these risks disproportionately impact upon smaller companies because the £ values of the stakes of the large shareholders are much smaller, hence large shareholders are much more common. In terms of quantifying large, it's usually looked at in percentage terms - a significant shareholder by transparency rules is a shareholder who owns 3% of a business. However, that is altogether not very material at the boundary, so when we talk about large shareholders, we refer to those who have a 5%+, 10%+ and even up to 50%+ of the total shares in issue.

Large shareholder risks can broadly be split into two categories:
1. Liquidity Risk = Liquidity risk is to do with a lack availability of the shares for private investors
2. Voting Power Risk = The risk of one or a couple of large shareholders being able to solely or collectively decide upon very important company matters

Liquidity Risk

As mentioned above, liquidity is all about how easy it is to trade shares in the company. If a large percentage of shares are held by one or two parties, then it is likely to be more difficult to trade shares compared to if there were many parties. To put it numerically, if two large shareholders collectively hold 80% of a small company's shares and do not actively trade them, then it will be particularly difficult to get hold of the remaining 20% without a wide spread (you will likely have to pay a material premium to the mid price). We call the percentage of shares that are actively traded, the Free Float. In this instance, the free float is 20%.

However, if the free float is 60%, then it is far more likely that you will not have to pay as large a premium to the mid price and that the spread will be narrower.

Why is this a risk?

1. Some institutions and funds are barred from investing in companies with a low free float. Therefore, the potential demand for shares in these companies is more restricted to private investors

2. At times, the spread (the difference between the price you can buy at and sell at) can widen significantly. That means that you may find it very difficult to sell at a price and volume that you deem to be acceptable. In rare cases, you may not be able to sell at all if there are no active buyers of the stock. A quick example of the negative impact of a wide spread is shown below.


If the spread for a stock is over 10%, then the investment must be questioned seriously and the fundamental case should be very strong. You should be prepared to hold for the medium-long term. If the spread is over 15%, then you should think twice about the attraction of the stock. Ideally the spread should be within 5% and preferably within 3%.

3. When liquidity is low, significant shareholders (3%+) can find it difficult to dispose of their stake in a company. That is because institutional ownership of many small caps is low, and private investors rarely generate enough buying pressure to allow a significant shareholder to sell down their holding with ease. Therefore, these significant shareholders often opt to drip-feed the shares into the market. This can cause an overhang - where a significant shareholder creates major selling pressure through feeding the shares into the market.

The trick in these cases is to observe two things. Firstly observe if there are signs of significant shareholders selling down their stake - evidence would be in the form of a 'Holdings RNS' which details any change in stake of a significant shareholder. Secondly, observe the bid-ask spread in relation to the mid price. If the difference between the tradable mid price and the ask price is far smaller than the difference between the mid price and the bid price, then an overhang may be present. You can look at a list of recent trades to identify if that is the case. As an overhang is unwound, you should see the difference between the mid price and the ask price widen.

Liquidity is clearly an issue with small caps, especially when it is so serious that the spread is excessively wide (over 10%) or when you cannot actually exit a position. An overhang can create high selling pressure that can lead to a large fall in a company's share price.

Voting Power Risk

Voting power problems are not particularly common, although when they do occur, they can completely change the outlook for an investment - for that reason, it is absolutely crucial that you examine for this risk before investing in a small cap company. In the worst scenarios, it can lead to a 100% loss of any capital you invested in the company. A lot more factors come into play with the Voting Power Risks.

Let's simplify the topic a little by assuming that for every one share you hold, you have one voting right. Therefore, if I hold 50 shares in Tesco, I have 50 voting rights. These voting rights are literally votes - if Tesco puts forward a proposal, a.k.a. a resolution, then I hold 50 votes, out of the total shares in issue. If 50 shares is equivalent to 2% of the total shares in issue, then I have voting rights of 2% because I would own 2% of the company.

You can now start to see where problems could arise. If I had 40% of Tesco and 2 million people had the other 60%, then I could significantly sway the results of any resolution using my voting rights. While you cannot do much with 2% of a company, when you become a large shareholder (over 5%), then you start to have some controls. After all, you own a large part of the company.
Aside from this, one of the biggest risks revolves around a share having its stock market listing deleted through a delisting. This is usually a process initiated by a company's directors that sees its shares removed from the stock market, thereby taking the company private. In such situations investors are left in a very difficult position. On one hand they can remain shareholders in the company, but without a public method of exchanging shares - that means that it becomes very difficult to trade shares at a reasonable price and is often problematic. For that reason, if a company announces its intentions to delist, the share price often falls dramatically.

It varies for each market but for an AIM stock to delist, 75% of the total votes are required. Therefore, be cautious of any company which has one or just a handful of shareholders who control over 50% of the voting rights. For the main market it is slightly more difficult after the FCA recently brought in measures to protect small shareholders. Now, the company must have 75% of the total voting rights plus a majority of votes from independent shareholders (i.e. shareholders not involved with the deal).

Voting Power Risk Example in a Chart for Toye & Co.

In this recent example, Toye & Co's own Chairman used a position of strength to purchase the company at a large discount to 'fair value', leaving private shareholders stranded and unable to exit due to a lack of liquidity, unless they accepted the offer. Private shareholders were squeezed into a corner by both of the risks associated with large shareholders and this is a great example of how private investors can lose a substantial percentage of their investment if an opportunistic bid is made. Many holders of the stock who bought in at 50p (for example), would have been pressured into selling the stock to the dominant shareholder for 35p, cementing a 30% loss in short order.

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Basic Checks to Avoid Falling Victim to these Risks

Liquidity

- Check for "Holdings" or "Notification of Major Interest in Shares" RNS' to identify if there are any institutions actively selling shares into the market
- Glance at a long-term chart for the company. How liquid has it been over the past 3 months and past 1 year? Even if the current spread is narrow, you do not want that spread to widen too much if volumes fall so check for historic spread levels
- If you suspect an overhang, check the bid/ask spread for a skew and if available, look at Level 2 data for large sell orders

Voting Power

- Run through the liquidity checklist. Companies that are illiquid are more prone to delist as a result of poor share price performance relative to the costs of being listed
- Check to see whether the Takeover Code is in place. This affords some protection to minority shareholders
- Check the shareholder list, make a note of any large shareholders and try to calculate the free float. Is there sufficient protection?
- Research who the large shareholders are. Are they aligned with you and are likely to make money when you do? (e.g. an institutional investor) Or will they benefit from making a low takeover offer? (e.g. a company that is in the same sector looking for a cheap acquisition)
- If directors are major shareholders, research their backgrounds to try and identify their level of integrity and track record
- Is there institutional leverage? In other words, are there large institutional investors like pension funds, who will react against any 'unfair' treatment

If you do have credible doubts over the shareholdings of certain parties in a company, then do research thoroughly and question management if necessary. At the same time remember that management can be involved with 'unfair' deals so if there is a very large proportion of the shares in the hands of directors or a third party, then do steer clear - the dangers of investing in companies where there are large shareholder risks are very real and any such company is immediately higher risk