Why do institutional investors stay away from small cap companies?

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Every investor’s bite size is different. Imagine you’re sitting at the dinner table with your grandmother and your 6’4 hockey-playing teenage son. Both have steaks in front of them. Which is more likely to eat more meat?

If an investor is managing $100 million, he or she needs positions of at least $2 million to be material. Investors do not like being stuck in an illiquid position or a position that comprises a significant percentage of a company (too big a bite). The above factors contribute to institutional investors preferring market caps in excess of $50 million and average daily volume of share trading of at least $1 million.

Even with good projects, most small cap companies cannot deliver what investors need. If a company’s market cap is $5 million, it is impossible for an institutional investor to properly position himself in the market. No matter how good the project is, he is going to have a hard time explaining the bet to the compliance officer.

Good company management understands this issue and works to deliver liquidity and market cap to shareholders. By doing so, institutional investors can show up and leave without destroying the company in the longer term.

If you’re a small cap investor, look for material projects where once a company completes the next development stage, it will be rational for institutional investors to buy. A significant uptick occurs when a project makes the jump from small cap to mid cap and from retail to institutional.

If you’re a company, don’t get angry the next time the fund manager says the company is too early stage. Understand what he or she needs to see changed in order to get involved. Deliver those milestones, position yourself beforehand, and wait for the institutional investors to come calling.

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