Saving the Small-Cap Market

Joel Anderson |


There’s no two ways about it: The state of small-cap equities markets in America is not good. Where once a thriving economy of start-ups and growing firms existed that was the envy of the world, now resides a withering, overlooked segment of the stock market that’s dwarfed by the major players.

Unfortunately, a lot of America neither knows nor cares about this unfortunate reality. In fact, most people probably checked out before they finished reading the phrase “small-cap equities market.” If you’re among those people whose only connection to the stock market is the daily news’ check-in on the Dow Jones Industrial Average, you’re probably only vaguely familiar with the stock market’s biggest players, let alone its smallest. That doesn’t mean you aren’t affected, though.

Sure, the Apple Inc.'s (AAPL) , Exxon Mobile Corporation's (XOM) , and Google Inc.'s (GOOG) of the world may get the lion’s share of the headlines, but it’s the small-cap stocks that are creating the lion’s share of the new jobs. Without a healthy capital market, the next generation of Steve Jobs’ and Larry Pages’ won’t have the cash they need to take the proverbial big ideas in small garages and turn them into thriving companies.

The Small-Cap Salad Days

Not long ago, the American small-cap market was in an enviable place. Small-cap IPOs were plentiful, young companies with new ideas could get an influx of cash to really build something, and foreign markets looked on with envy at America’s ability to keep money flowing to the companies where it would do the most good.

So what happened? The choking off of the small-cap market was largely unintentional. No one set out to make it happen (sorry, conspiracy theorists). Instead, a combination of technological progress and well-meaning regulations combined to create an imperfect storm that strangled these once-vibrant markets.

Every Reg Has its Thorn

Since the dot-com bubble burst in 1999, the markets have undergone a lot of changes. Most of them generally good, helping shift the stock markets into a free-flowing, digital era where information about companies is plentiful, access to markets is easy, and trading is simple, direct, and fluid in a way that investors couldn’t even have dreamed of 30 years ago. Unfortunately, many of the regulations geared towards making this transition did so in a way that focused on the markets’ larger players to the detriment of its smaller ones.

Two prime examples of this are the so-called “Spitzer Decree” and section 404 of the Sarbanes-Oxley Act. In both cases, they were necessary and positives reforms, but they lacked the sort of language that would adjust their effects to fit the size of the companies involved.

The Spitzer Decree is named for Eliot Spitzer from his time as the Attorney General of New York. It grew out of the Late Trading & Market Timing Investigations of 2003, when Spitzer was digging into a scandal revolving around the illegal “late trading” of mutual funds by certain hedge funds and mutual fund companies. The “Spitzer Decree” was part of the 2003 legal settlement with investment banks that followed this investigation. The Spitzer Decree banned banks from using investment banking fees to directly pay for research products, a troubling conflict-of-interest his investigation revealed to be a major issue.

The Sarbanes-Oxley Act, meanwhile, was passed in 2002. In the aftermath of the collapse of Enron and several other major corporate scandals (including but not limited to WorldCom and Tyco International), it had become clear that tighter accounting regulations were necessary to restore investor confidence. Sarbanes-Oxley required public companies to improve on their accounting practices. Section 404 included restrictions that public companies have strict internal controls in place to ensure that their reporting would be accurate.

In both cases, the reforms were a net positive (depending on who you ask). They helped create public markets that were safer and more transparent, allowing individual and retail investors to invest in public companies and mutual funds with confidence. However, they also demonstrated that not all stocks are created the same.

The sort of research banned by the Spitzer Decree was essential to small-cap stocks. No one needs a research report to know what Apple does, but that’s not so true for those companies that have yet to make a name for themselves.

“Spitzer basically killed the small-cap research industry,” said Dara Albright, Co-Founder of the LendIt Conference, to

Sarbanes-Oxley, meanwhile, created a range of new expenses for all public companies. For larger firms, the new expenses were (arguably) more than manageable. But for a struggling small-cap company? Now, the basic costs of going public represented a heavy burden at a time in a company’s life cycle when every penny matters.

However, reforms like the Spitzer Decree and Sarbanes-Oxley are just pieces of a larger puzzle. In fact, the change that may have had the biggest negative effect on the health of small-cap markets was the seemingly innocuous change in tick sizes.

Tick Size Matters

The details of the exact mechanics of how stocks are traded aren’t necessarily essential to understanding the markets. Plenty of people whose association with the markets consisted of their 401k or investing in a handful of companies they read about online can get along pretty well without knowing precisely what happens at the point of sale. As such, not knowing what “tick sizes” are is something a lot of investors could be forgiven for.

That doesn’t mean it’s not exceedingly important, though.

Tick sizes are simply the lowest price increment one uses in buying and selling stocks. Since April of 2001, tick sizes have been normalized at a penny, something that was called “decimalization.” Prior to 2001, stock prices were frequently quoted in fractions of a dollar, anywhere from 1/4 to 1/16. That doesn’t SEEM like something that would matter that much. After all, the increments you trade in can only matter so much, right? Wrong, those fractions can actually make a big difference, and dropping the tick size by some 96% caused some serious ripples. Particularly with market makers.

Market Makers the Key to Liquidity in Small-Cap Markets

Every stock needs a market maker, a firm that buys shares from sellers and sells them back to buyers. Market makers create liquidity and ease trading by creating a pool of shares, not unlike the way leaving a little slack in a rope can allow it to feed through a machine more smoothly. Without a market maker, a big buyer might get to market and not be able to find enough sellers to fill her order or vice versa.

Market makers take profits by selling a share of stock for one tick more than they buy it for – what’s known as the “bid-ask spread.” So, larger tick sizes meant larger bid-ask spreads, and bigger profits in market making. That hidden fee was fine with everyone when buying and selling stocks still involved having someone wade onto a trading floor to complete transactions. However, with exchanges moving online and digital, market makers started to become increasingly obsolete middle men. They were still necessary, but their presence was becoming less and less valuable for the biggest stocks.

“[A stock like] Apple is innately liquid. Tens of thousands of investors are watching Apple every minute of every day,” David Weild, the founder of Weild & Co. and the former Vice Chairman of Nasdaq, told “Apple is followed by many, many stock analysts on both the buy- (institutional investor) and sell-side (Wall Street firms like Morgan Stanley (MS) and Goldman Sachs Group Inc. (GS) ). Apple trades ‘symmetrically,’ which is to say that there are likely hundreds, if not thousands of buyers and sellers offsetting each other at any given point in time.”

In the case of these big stocks, decimalization made a ton of sense. Smaller bid-ask spreads meant more of the money flowing through the markets was ending up in the hands of investors and companies rather than market makers. That meant more capital where it would do the most good. Besides, mega-cap companies frequently trade millions of shares a day, so market makers were still doing pretty well for themselves, even if they only made a penny a share.

Small-Cap Markets Driven by Bid-Ask Spreads

However, the markets aren’t just made up of mega-cap companies like Apple. There’s also a lot of small-cap companies out there struggling to carve out a place for themselves. For them, liquidity is a lot harder to come by.

“Small-cap equities often take considerable time to break through the noise and find an investor audience,” said Neal Wolkoff, the former CEO of the American Stock Exchange and founder of Wolkoff Consulting Services, to “Until that time comes, they need to be viewed differently from Fortune 500 companies, whose stocks have greatly benefitted from the reduction in transaction costs brought about by decimalization. With smaller cap companies, trades tend to happen less frequently, and price movements can be more volatile than they are with large caps. The risk to the market maker/intermediary to take one side of a trade is greater when he may need to hold that position because of limited liquidity, and face the risk of an adverse price move.”

So, small-cap stocks appeal to market makers much less than a company like Apple. Unfortunately, small-cap companies also need those market makers way more than Apple.

“[Most] markets require an intermediary to provide a quote that allows a trade to happen at a fair price, and at a time when the investor wants his execution to occur,” Wolkoff added. “Remove the market-maker, the broker, and the dealer from the market, and that process discourages investor participation and harms an issuer who is trying to build a following.”

Weild agrees.

“Small companies are innately illiquid. Very few if any investors are watching a given small company stock at any point in time,” he said. “The small company may have no equity research coverage from either the buy- or sell-side as Wall Street loses money covering small company stocks. Small company stocks trade ‘asymmetrically,’ which is to say that when there is a big buyer it is unlikely that there will be a matching seller, and when there is a big seller it is unlikely that there will be a matching buyer.”

Smaller tick sizes meant better efficiency for the major companies, though it also erased the incentive market makers needed to offer support to smaller players.

“Market makers ... would buy at the $10.00 bid and sell at the $10.25 ask price, booking a handsome 25 cent profit,” said Weild. “As a result of these rich incentives, market makers deployed quite a bit of capital to support the ‘asymmetrical’ trading nature of small company stocks and make them trade ‘symmetrically’ …. These small-cap markets were liquid and profitable, and so Wall Street invested in them with research, broker sales attention, and capital commitment. This attracted investment dollars from sophisticated institutions, which caused stock prices to rise and more companies to go public.”

“In 1998, the US converted to electronic markets with smaller and smaller price increments. This was through something called ‘Regulations ATS’ (Alternative Trading System). Immediately, the $0.25 price increment collapsed to 1/32 or $0.03125 per share. That caused an 87.5% loss in maximum profit incentive for Wall Street to make markets in small company stocks – overnight. … At one cent tick sizes, Wall Street loses money supporting small companies, so they really have cut their support of small companies to the bone.”

A Safer, Healthier Market…Unless You’re the Little Guy

On the whole, the collective result of these reforms has been to create a stronger, more trustworthy market – it has meant less fraud, corruption, and conflict of interest, making for a friendlier market for investors in many ways. However, it has also led to a complete lack of after-market support for those companies that need it the most, meaning that fewer and fewer companies have even bothered taking the plunge into public markets at all.

“The United States now has the lowest tick sizes in the world, and that this has caused an abandonment of support for small company stocks, causing the US small IPO market to drop from 1st place to 12th place,” said Weild. “However, weighted for the much larger size of our economy, the United States is now in 24th place out of the 26 markets tested, ahead of only Mexico and Brazil.  We think this has had a disastrous impact on the US economy.”

From 1980-2000, there was an average of 311 new IPOs a year. From 2001-2009, that number plummeted to 102. In and of itself, that two-thirds decline in IPO volume is disconcerting. However, it’s even more pronounced for small companies – a more-than 80% decline from 165 a year to 30 a year. With little to no support for small caps, and increased costs of being a public company even as the benefits have steeply declined, fewer and fewer firms see any good reason to take the plunge.

By now, some readers are undoubtedly wondering “Why should we care?” Is it just because we love the plucky underdog? Are we suggesting this is a serious issue solely because we admire the fighting spirit of these small caps?

No. The reason why it should matter to everyone is because those start-ups are the primary, if not the only, source of job growth in our economy. A system that enriches larger companies at the expense of small caps’ ability to raise capital chokes off economic growth for everyone. It’s bad news for Main Street and Wall Street alike.

Start-Ups are the Engine of Economic Growth

Big, established companies may employ the majority of American workers, but they’re also stagnant in terms of growth. When taken as a whole, the jobs they add are more than counter-balanced by the ones they eliminate. Not so for a start-up. These are aspirational companies, bringing new ideas to the market that can create new economic activity.

A Kauffman Foundation paper by Tim Kane reveals that from 1992 to 2006, firms in their first year of existence created an average of three million jobs a year. Those numbers rapidly decline by the second year, particularly when you factor in just how many jobs are destroyed in those later years.

In fact, since 1977, start-ups created about three million jobs a year, plus or minus a couple hundred thousand. For existing firms, that figure was only positive one out of four years. More often than not, existing companies show a net loss in jobs.

“The lack of economic incentive has caused the number of IPOs to drop from a projected 900 IPOs a year to an average of 140 IPOs a year, and the number of NASDAQ- and NYSE-listed companies to drop from a projected 13,000 publicly listed companies to 5,000,” said Weild.

The moral of the story? Mega-cap companies are great in their own ways, but they’ve already arrived. For the most part, the actual creation of new economic activity has already taken place. The number of people employed by existing mega-cap companies is going to hold steady, at best. It’s not being a mega-cap that creates new jobs, it’s growing to that size, making it the small-caps and start-ups that really matter.

Liquidity Keeps Small-Caps Solid

Long term, the best thing for the American economy is to have money flowing easily to small companies in the early stages of their existence. That’s hard to argue. A stock that trades with liquidity is typically an essential piece of the process for raising money – money that’s essential to turning these start-ups into a revenue machine like Apple or Wal-Mart Stores, Inc. (WMT) .

“A liquid stock serves as a form of currency for acquisitions, competitive compensation and hiring of new talent,” said Wolkoff. “A liquid equity market is also essential for the company to be able to further fuel its growth through the capital markets by returning for subsequent issues when growth demands new capital.”

This is something that was echoed by R. Cromwell Coulson, President and CEO of OTC Markets (OTCM) when spoke with him.

“There’s lots of academic research that says more liquidity lowers your cost of capital,” said Coulson.

But liquidity for smaller companies doesn’t come easily.

Firstly, small-cap stocks are a lot riskier. They’re more volatile with much more pronounced price swings than your standard blue-chip stock would ever see. That can mean either much bigger gains or much bigger losses. There’s more opportunity there for those with an appetite for risk, but it can scare away a lot of investors, as well. Investing in IBM (IBM) may not make you rich, but the odds of you losing it all are pretty slim.

Secondly, there’s a certain inertia to liquidity. In a huge stroke of irony, liquidity is easy to come by when you already have it, and pretty hard to create if it’s not already there. When a stock has low liquidity, it’s harder to buy and sell, driving away potential investors. If you decide to sell an illiquid stock, there may not be enough buyers to take it off your hands. The stock may then drop in price between your decision to sell and the moment you can actually execute the sale, adding an extra layer of risk to your already volatile position.

That, unfortunately, has a snowball effect.

The increased risks scare away a lot of investors, which reduces liquidity even further, thereby increasing risk even more, which scares away more investors, which reduces liquidity…see where I’m going with this? It’s a vicious cycle.

Are Private Markets the Solution?

Some would argue that what we’re seeing is actually companies relying on private markets for capital, avoiding going public in favor of venture capital, then selling to larger firms before going public. However, even if that’s the case, it still presents a troubling new vision of our capital markets.

“With such inhospitable stock markets, mergers and acquisitions have become virtually their only outlet to realize value for their hard work,” wrote Weild in a 2011 op-ed for The Wall Street Journal. “And as we've so often seen during this tough economy, M&A generates job cuts, not new jobs.”

Publicly-traded companies also have the benefit of offering everyone a chance to buy their stock. Public markets offer an opportunity for anyone to participate in corporate profits. Even if it’s extremely indirect, like a mutual fund held in a 401k, it’s still giving Main Street a chance to get in on the game.

This is not the case for most private financing. While the JOBS Act has opened up bold new avenues for raising private capital, like equity crowdfunding, the options for investors who aren’t accredited are still fairly limited (though, the SEC very recently appeared to have taken an important step towards potentially remedying this). Accredited investors, defined by the SEC as individuals with a net worth of $1 million or an income of $200,000 in each of the last two years, have a range of options that don’t exist for the rest of the investing public.

So, a lack of small-cap IPOs means that the non-accredited investors of the world are getting cut out of the potentially substantial returns created by start-ups. In fact, despite stock trading being only a click away for most people, today’s non-accredited retail investor has fewer opportunities than ever. Rather than a system where companies are encouraged to go to the general public to raise capital, and subsequently broadly share the rewards of success, we appear to be headed to an economy that saves the shot at the biggest returns for a small slice of the wealthiest investors.

And this point shouldn’t be overlooked. One of the truly wonderful things about public markets is that they create an avenue through which any American can share in the massive corporate profits racked up by the market’s biggest players. For all the focus on how the stock markets can be elitist and exclusionary, they can just as easily be a force for democracy in our economy. Plus, the private equity markets are positively aristocratic when compared to our public markets.

Giving every American a chance to share in the prosperity our nation is creating has to be an important part of capital markets. Even if it’s indirect, taking the form of mutual funds or ETFs getting bought up by 401ks or pension funds, it’s something that should be encouraged. Incentivizing start-ups to go public rather than relying on private money isn’t just about investment bankers and market makers, it’s about a vision of the American economy that works for everyone.

The Definition of “Small” Gets Bigger

So what’s to be done about this? We’re all better off when start-ups and small-cap companies have an easier time raising money, but how do we convince more people to take the plunge? How do we grease the wheels of the capital market to make them work for everyone, not just the wealthiest investors and the biggest companies? Is it even possible to make the necessary changes?

Short answer: Yes. This is hardly a situation that can’t be remedied. Investing in small-cap stocks is actually one of the best investments you can make. Sure, there’s volatility and risks that don’t exist in fixed income or large-cap stocks, but the potential for higher returns more than make up for that.

“The definition of what’s small has grown if you’re talking about the investment perspective, because research has really been cut back in the small-cap arena. It really provides for a lot of opportunity,” Robert Maltbie, managing director and founder of Singular Research, told “If you do your homework, you can actually find companies that run undercover, forgotten, misunderstood, or not understood at all. They’re mispriced, consequently that’s where the real opportunity is.”

What’s more, there’s arguably more opportunity to build a healthy market for small-cap stocks than ever. While the internet gave rise to many of the regulatory changes that are currently handcuffing small caps, the information age has also created an environment that could be ideal for the small-cap investor. We are living in an unprecedented era for the availability of company information, arming investors with an array of resources that even top-level investment bankers would have envied 30 years ago.

“When you think about the quality of an experience the investor can get from their online broker in the past 15 years, how much that’s changed, it’s unbelievable,” said Coulson. “The amount of data that’s out there, the very places they can go for free data to premium data, the competing services on the Internet. The easy ability to look at not only trading data from the company, but company data, company IR websites…”

With just a few common sense changes and regulatory fixes to create an ecosystem for small-cap stocks that actually makes sense, it’s not hard to imagine that we could not just return our small-cap markets to the healthy state of yesteryear. Perhaps we could even forge a new age of prosperity for small-cap companies, unlike anything we’ve seen before.

Small Change is in the Air

One positive change could already be on the way. The SEC heard the cries about how penny tick sizes were killing the opportunity for market makers in small-cap markets, and put together the Tick Size Pilot Program to address the issue.

The pilot will take companies with a market cap of $5 billion or less and a per-share price of at least $2 and offer the chance for participants to trade with a tick size of $0.05 for one year. If this demonstrates increased liquidity and support from market makers, the odds are good that the drum beat for change could continue to crescendo.

Weild, though, thinks it doesn’t go far enough.

“The current proposed SEC Pilot Plan calls for only a one-year pilot and only five-cent tick sizes,” said Weild. “We believe this is inadequate because many market makers are not likely to recode systems to participate in a pilot that is one year in length.”

“Weild & Co.  believes that we should have a long-term pilot (five years) that tests five-cent and 10-cent price increments (in addition to the one cent price increment that is used on all listed stocks today),” he continued.

Take All Your Problems, Break ‘em Apart

Additionally, the “right-sizing” of some other regulations could further improve conditions. Certainly, overturning Sarbanes-Oxley or the Spitzer Decree in their entirety isn’t in the cards. However, creating exceptions in these rules for those companies that are struggling to get by could reap real benefits.

A lot of the impetus behind Sarbanes-Oxley was the fact that companies like Enron and WorldCom represented major players, so their collapse presented a real systemic risk to the stock markets as a whole. These were the sort of supposedly safe stocks that you could find in 401ks and low-risk mutual funds. With small-cap stocks, there’s no such systemic risk associated with a collapse or scandal. The idea that some small-cap stocks may ultimately fail and/or collapse is really sort of baked in, if you will. If a company is cooking its books, it’s going to burn some individual investors pretty badly, but it’s hardly going to run the risk of crashing the whole market.

And, to be sure, easing regulations like these does increase the risk of fraud. Small-cap markets have higher rates of dishonest players and pump-and-dump schemes, and easing regulations would likely only make it a little easier to cheat investors. However, there are other ways to minimize the effects of bad actors that won’t choke off opportunities for good ones. In the end, accepting the possibility of a few bad apples in the hopes of creating an enivronment that can produce multiple bushels of good apples that you would never get otherwise makes sense. And there are still plenty of ways to improve on how we identify and remove those bad apples.

Same for the Spitzer Decree. Conflict of interest for research reports is a serious issue, but if those are clearly disclosed, allowing investment banks to use fees to help introduce small-cap companies to their clients could go a long way towards getting investors to dip their toe into markets they otherwise might overlook completely. Again, what was a massive problem on a large scale could be much more manageable on a small one.

Both of these were among the recommendations made by President Obama’s Jobs Council in 2011, and the proposals there provide an excellent framework for potential reforms.

As Goes the Small-Cap Market…

Ultimately, the health of America’s small-cap markets is crucially important to the American economy, even if relatively few Americans really understand that. Capital markets that keep money flowing to the entrepreneurs and innovators bringing new ideas and products to the market are capital markets that create new jobs and build prosperity. Ultimately, everyone, whether they have a steady job at a massive corporation or just got hired at a budding start-up, is better off when the small-cap players of the market are getting a chance to test their ideas in the open market.

As such, ensuring that the incentives in our markets are guiding the most capital possible to the place where it does the most good would seem like a no-brainer. And yet, capital markets have taken a real hit over the last 15 years. Sure, the changes were a result of good intentions, but that doesn’t mean that, at this point, we can take stock of how these changes have functioned and seek out reforms that will make the most of our public markets. 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


Symbol Name Price Change % Volume
AAPL Apple Inc. 114.48 -1.11 -0.96 34,562,045
GOOG Alphabet Inc. 795.35 -3.72 -0.47 2,749,221
GS The Goldman Sachs Group Inc. 177.75 0.68 0.38 3,021,949
IBM International Business Machines Corp 153.35 1.54 1.01 4,229,336
MS Morgan Stanley 33.82 0.43 1.29 12,608,435
WMT Wal-Mart Stores Inc. 69.83 0.24 0.34 7,131,613
XOM Exxon Mobil Corporation 86.92 -0.17 -0.20 9,071,099


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