Is it time to check out small cap and micro cap stocks and managers? Merrill Lynch recently announced that it would no longer make a market in anything but the 2,400 biggest, most actively traded Nasdaq issues. “It's the perfect contrarian indicator,” says Aaron Edelheit, of Sabre Value Management, a hedge fund manager in Boca Raton, Fla. “With fewer players, that means there will be more inefficiencies in that part of the market.”
Inefficiency spells opportunity. Below the 2,400 issues that Merrill is still trading exists a pool of 4,000 over-the-counter issues, including 1,300 Nasdaq National Market Listed securities. Merrill is limiting its Nasdaq trading mainly because of poor returns. There has been a dramatic drop in demand for over-the-counter issues, and Nasdaq is the worst performing U.S. index this year, down more than 40 percent; the Russell 2000 is down nearly 30 percent. Also, trading profits have shrunk because of decimalization and the rise of electronic communications networks, such as Archipelago, and other alternative trading platforms.
But there may be value among those issues that Merrill is leaving behind. If Edelheit is right about Merrill's exit being a contrary indicator, it may be time to start researching that sector or begin considering small and micro cap managers for your clients. “Remember that during the bubble all of these firms were all over small stocks, trading in and out of them and hyping them to death,” says Edelheit. “And that was the perfect time to sell.”
Brad Lawson, a senior research analyst at Frank Russell, an investment consultant, says, “It's not a rising tide lifting all boats, but you can certainly leverage your research since there is less competition for information.” Lawson says that, on average, micro cap and small cap managers tend to beat their benchmarks by a greater percentage than do large cap managers for this reason.