Does High Frequency Trading Harm Small Cap Stock Valuations?

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The technological revolution on Wall Street has enabled superfast computers and networks to execute high frequency trading (HFT) strategies. Estimates are that 65 to 70 percent of market volume is now attributable to high frequency traders, with the average holding period 22 seconds.

Some experts in recent congressional testimony claim that HFT has damaged small company stock valuations and reduced liquidity. They claim small firms are ignored as traders and market makers at the for-profit exchanges focus on the higher volume (and more profitable) larger companies. According to the testimony high frequency trading requires the liquidity and volume of the larger firms. Company fundamentals, sector forecasts, and valuations are ignored.

They also point out that most of the exchanges are now for-profit entities that tend to allocate capital and focus on those areas that will generate the highest returns – which is not the small cap sector.

Industry Comments

Eric Noll, executive vice president of Nasdaq OMX, at a Georgetown University conference noted the smallest 1,000 names on the Nasdaq exchange constitute less than 1% of trading volume. As such traders and exchanges focus on the larger, more liquid, firms. In light of the lack of volume “it might be time to consider different market-structure models for different kinds of companies” he concluded.

Michael Lynch, a managing director at Duff & Phelps, also argues that high frequency trading results in investors ignoring small cap stocks. “A stock that’s traded infrequently doesn’t accurately reflect a company’s market value, usually doesn’t get covered by research analysts, and its price movements have little or no correlation with market news”.

Larry Tabb, CEO of the TABB Group, noted that the current market structure means highly liquid names are traded with tight spreads and low costs. “However,” says Tabb, “the less-liquid names become very hard to trade. The least bit of activity causes significant price volatility, and makes it harder for investors to either get into or out of these stocks.” So large institutions “shy away from buying them altogether.”

Brokerage firms often can't afford to spend money developing reports on thinly traded companies because firms are less likely to make back that money through commissions linked to trades in such securities. With less research available on small-cap companies, mutual funds and other institutions are generally not inclined to invest in such stocks.

Investment Implications

Academic studies have historically found that the small cap sector of the market is inefficient. Individual and institutional investor attention is generally focused on the larger, more liquid firms. It appears from the congressional testimony that HFT strategies, and the for-profit nature of the exchanges, is serving to make the sector more inefficient and more illiquid. Small cap share prices will be even less indicative of the true underlying value of the business enterprise.

From an investor standpoint we would expect share mispricing to result in an increased amount of merger and acquisition activity, especially once the political, tax, and regulatory climate becomes more settled after the election. We would also expect the mis-pricings in the small cap sector to provide investors with opportunities to earn excess returns in a stable investment environment

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About Joseph Dancy

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