Advantage: Little Guy

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"Liquidity is overpriced," says money manager Jeremy
Grantham, of Grantham, Mayo, Van Otterloo & Co. "A long-
term investor should always try to exploit the other guy's
short-term horizon and be paid for taking illiquidity."

Grantham's idea is really pretty straightforward: Since
most big investors can only buy big "liquid" stocks, the
best values available in the stock market usually reside
among the small, "illiquid" stocks. Don't worry if that
doesn't make a lick of sense at this point - it will, if
you stick with me here.

Jeremy Grantham knows a thing or two about the importance
of liquidity; his money management firm oversees no less
than $70 billion worth of global equities. He is a well-
respected value investor, the type of guy who adores cheap
foreign equities, as opposed to glitzy tech stocks. But
like many value-focused money managers, Grantham believes
today's equity markets offer very few compelling
values…especially within the universe of large, liquid
stocks where most managers of his size explore for
opportunity. (Anyone who wants a taste of Grantham's
analysis can head over to www.gmo.com and click on
"Research & Commentary." Occasionally, Grantham will post
his observations and insights about the financial markets.
The headline of one of his most recent pieces, "Apocalypse
Not Now: Inevitable Pain Postponed," gives you a flavor of
what's in his report).

Grantham's plight is hardly unique. Many of today's very
best value managers gripe about the dearth of value in the
U.S. stock market, while complaining about the difficulty
of putting money to work in worthwhile opportunities. Even
Warren Buffett, in his most recent annual letter to
Berkshire Hathaway shareholders, confesses his inability to
find many investment opportunities in 2004. Hence,
Berkshire Hathaway is now sitting on $43 billion in cash!
$43 billion is a nice problem to have, but it is problem
nonetheless, to the sorts of investors like Grantham who
must attempt to make money by investing in big, liquid
companies.

So what is "liquidity?" It is simply the ability to buy and
sell something quickly without moving the market price
significantly. It's the grease that keeps markets moving.
For example, a large-cap stock like Intel is very liquid.
On average, about 70 million shares trade hands every day,
or about $1.8 billion worth of stock. So it's possible to
buy a large amount Intel stock without affecting the share
price. By contrast, a stock like Grupo Aeroportuario del
Sureste (NYSE: ASR), dubbed ASUR for short, is illiquid.
The stock of this operator of nine airports in southeastern
Mexico trades only about 100,000 shares per day, or about
$3 million worth.

This is a company I recommended in November to the
subscribers of my Fleet Street Letter. Even though the
stock has advanced very nicely since then, its market cap
remains just under $1 billion, which is still too small for
most professional money managers.

In other words, ASUR is one of the many, many stocks that
are functionally "off limits" to big investors…and that's
a good thing for the rest of us little guys. As individual
investors, we can easily buy and sell shares in ASUR,
almost as easily as we could buy and sell Intel. Roughly
6,000 stocks with market values below $500 million trade on
U.S. exchanges. Very few of these securities provide
sufficient liquidity for big money managers.

Professional managers value liquidity, not only because
they must move around large amounts of money, but also
because their careers rely on short-term performance
measurements. They can't AFFORD to focus on the long-term.
So they avoid the sort of illiquidity that impedes their
short-term trading activities. They want the ability to buy
and sell meaningful chunks of stocks quickly, without
upsetting the market. And, increasingly, big investors are
buying and selling as frenetically as rug-dealers.

As the nearby chart illustrates, the average holding period
for a stock on the NYSE has tumbled from 8 years in 1960 to
less than one year today. In other words, long-term
investing is a lost art among most professional investors.
Therein lies the opportunity for the intrepid individual
investor in small-cap stocks.

Even though the big, professional money managers can't
afford to "waste" their time examining micro-caps stocks,
we can. And even though the professionals have to worry
about illiquidity, we don't. The only "liquidity risk" most
of need to worry about is that posed by a broken water pump
in the basement.

"[The] ability to handle illiquidity is a major advantage
for long-term investors," says Grantham.

Individual investors are much better equipped to "handle
illiquidity" than their professional counterparts. For one
thing, individual investors move around smaller amounts of
money. For another, they needn't worry about short-term
performance measurements. They may sit on stocks, like old
Horton trying to hatch an egg in the Dr. Seuss classic,
"Horton Hatches the Egg."

As a result of these two differences, small-cap investors
hold a distinct advantage - for once - over the likes of
the world's greatest money managers - yes, even over Warren
Buffett.

Since liquidity is so valued by the "big money," it is
often "overpriced" in the marketplace. Conversely, the
illiquid or smaller companies are more likely to fall
through the cracks and be discounted or ignored, because
they are too small to attract the big money. For example,
in the case where two fundamentally similar companies - one
big and one small - trade on a U.S. stock exchange, the big
one might sell for a higher valuation than the small one.
The big one might sell for 20 times earnings, whereas the
small one might sell for 12 to 15 times earnings.

Almost no professional investor would dispute the fact
that, over the long term, small, "illiquid" stocks tend to
produce higher returns than big, liquid stocks. Investors
should focus their attention on small stocks.

The individual investor, with a long-term focus and without
the constraints of a big professional money manager, should
always be willing to dig around and explore the small-cap
arena to take advantage of possible discounts. It is one
area where the little guy has a decided edge.

What's more, small, illiquid stocks sometimes become big,
liquid stocks. In such happy circumstances, the plucky
small-cap investor will already have been in the stock for
some time - well before the Big Money discovers the name.
At that point, you just sit back and feed your stock to the
big boys for a big profit.

[Ed. Note: Do you want specific small-cap stock
recommendations? James Boric has known this little secret
for years and, by simply picking strong undervalued small-
caps, has been beating the market the whole time. Subscribe
to PSF for a list of current recommendations…

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No sector demonstrates the advantages - and disadvantages -
- of illiquidity better than the gold share market. In a
rising gold market, small- and mid-cap gold stocks tend to
produce a much bigger bang than simply buying gold itself.

But as the chart below illustrates, mid-sized gold stocks
(as represented by the TSX Gold Stock Index) have been
lagging well behind the gold price for more than a year.
Since November of 2003, the gold price has jumped more than
10% to $441.00 an ounce. But the TSX Gold Index has FALLEN
10% over the same time frame.

Where's the leverage that gold stocks have traditionally
provided? It will return, predicts John Hathaway, manager
of the Tocqueville Gold Fund. As the gold bull market
advances into its next phase, he says, gold shares should
begin to deliver more "high octane" than the metal itself.

"The octane to which [Hathaway] refers," writes James
Grant, editor of Grant's Interest Rate observer, "is the
embedded optionality of a gold stock (a rising bullion
price lifts the value of proven and probable, or even
illusory, reserves)."

Therefore, if/as/when gold breaks through $450 an ounce en
route to new multi-year highs, small cap gold stocks (as a
group) are likely to perform much better than either big
cap stocks or the metal itself.

Of course, resource stock investors should bear in mind
that the universe of small-cap gold stocks is a virtual
mine field of speculative ventures and shady operators.
Even the most honest of honest speculations is prone to
"zeroing out."

[Ed. Note: When it comes to making absolutely staggering
gains in gold and silver small-cap stocks, Doug Casey -
whose classic, Crisis Investing, was #1 on the New York
Times best-seller list for 29 consecutive weeks - has a 20+
year track record unduplicated by any other investment
advisor.