A preference for small caps is one thing, but there are limits.
A couple of weeks ago I wrote about my preference for small cap shares -- they're typically focused on a fewer areas, and as such their business models and accounts are easier to get to grips with.
But as in so many areas, moderation is the key. How small is too small, and what are the dangers of so-called 'penny shares'?
For a start, there really is no agreed definition of penny shares. In general, though, the term refers to very small companies whose shares trade for a few pence rather than a few pounds.
And there are lots of them out there; a quick search on ADVFN found 110 companies with market caps less than £10m and share prices under 1p. You could loosen those parameters considerably and still be within many people's definition of a penny share.
Liquidity
The first problem with these shares is the difficulty in buying and selling them in any meaningful volume. On a typical day, a FTSE 100 company like HSBC (LSE: HSBA) might see ten million shares changing hands, while many micro-caps may see no trading at all for days or even weeks.
Picking one share at random from that list of 110, The Weather Lottery (LSE: TWL) shares only traded on ten days in the past three months.
I know exactly nothing about this company, and it may be a fine business with excellent prospects, but I'd like to know that if I could sell the shares easily if I wanted to.
Bid-offer spread
A consequence of this illiquidity is a wide gap between the brokers' selling and buying prices, the 'bid-offer spread'. When the several market makers have buyers and sellers queuing up to do business in volume, competition forces them to settle for a small cut of that business, but they can still make a decent profit from being the middle-man.
In the case of HSBC, Yahoo! is showing a price of 539.5p if you want to buy, and 539.0p if you want to sell. So the spread is about 0.1%.
Contrast that with the Weather Lottery, where Yahoo! has 0.30p if you want to buy, and 0.15p if you want to sell. So if you buy the shares you are instantly down by 50%, without any change in the base price. Ouch!
Information
As I mentioned, one of the advantages of small companies is that they are usually easier to understand and follow. Newsflow for FTSE 100 companies can be overwhelming, and sorting the wheat from the chaff can be a real challenge.
While investing in a company that costs less of your time has its advantages, hearing nothing is not a good situation either. Google News has only one item for The Weather Lottery this year, and six last year. Which is fair enough, if there wasn't much to report, but I like a happy medium between being inundated with information and wondering what's going on.
Where to draw the line?
It's hard to say where one should draw the line in terms of company size, and it depends largely on how comfortable you are regarding these risks. Rather than using size a proxy, it's often better to look at the liquidity, spreads, and information flow relating to the particular company and deciding if they'll allow you to sleep soundly at night.
Some people really have done very well from penny shares, but it is so much easier to lose everything.
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