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Five Lessons with Liquidity

Besides all the usual skills and knowledge that goes with investing in stocks, operating in the small cap space forces you to master handling positions in low liquidity stocks.

Here are five rules to help you handle low liquidity stocks:

1. Stretch your time horizon

Low liquidity makes exiting a position in a stock challenging and, often, costly. But, what if you never exited an investment? Suddenly the investment’s lack of liquidity really would not matter to you (or, at least, matter less).

Forever is a long time, though, but this is also work if you take much longer-term perspectives with your investments. This not only allows your gains to far more exponential (i.e. 10-baggers) from which a small liquidity cost of exiting is minor, but it also can lead to situations where you bought into an illiquid stock that re-rates over years, becomes popular and when you sell your position the market’s liquidity is sufficient to barely notice.

For an example of this latter phenomenon, looks at how the Rand-value traded in EOH has steadily grown over the last decade during which the stock re-rated and the share price exponential rose.

2. Buy with a sufficient margin of safety

By their very definition, low liquidity stocks cannot absorb significant volumes of their script being sold in the market. Thus, low liquidity stocks could see their share prices crash for no apparent reason other than one or a couple of random sellers have decided to dump their positions.

You need to be comfortable enough that the investment you have made into the low liquidity stock is sufficiently discounted against its intrinsic value and future prospects that, if the share price halves on a couple of trades, you could not care less. If fact, perhaps you even consider buying more (see (4) below)?

The only way you satisfy this rule is to thoroughly research and understand the company and then diligently value the stock from all angles. If the stock still appears deeply discounted against your valuation(s) of it, you are likely buying it with sufficient margin of safety that the short-term volatility of its share price can be ignored in favour of your (1) long-term time horizon.

3. The bidding spread

The spread between the bid and offer of a stock is called the ‘bidding spread’. Bidding spreads are actually a cost. The wider the spread, the worse the spread is considered and the greater it may cost the investor.

Let me phrase it like this, if the bidding spread of a stock was 5% and you had bought the stock a second ago and were forced to sell it immediately, you would have to take the highest bid. As that bid is 5% below the Offer, thus it is likely 5% below where you bought the stock. In this case, the bidding spread would cost you 5% of your investment.

Now bidding spreads tend to be ludicrously wide in low liquidity stocks, but if (1) your time horizon is sufficiently long and (2) the stock is discounted enough against its valuation and upside potential, then why haggle about a couple of percent in the bidding spread?

Instead of trying to be clever and placing a low bid (where you could save a couple of percent, but also risk missing out on the stock’s upside by never owning it at all), rather simply cross the bidding spread and pick up whatever stock you want (assuming it is available). Why worry about losing 5% on a bidding spread? If you are never in the stock you risk missing out on 5,000% upside!

So, if (1) your time horizon is sufficiently long and (2) the stock is discounted enough against its valuation and upside potential, then you should be comfortable enough about the value of the long-term position in the stock to do this.

4. Averaging up and averaging down

Sometimes the stock is so illiquid that even if you (3) cross the bidding spread, you would not be able to pick up sufficient script (or sufficient script at the prices you are willing to pay for it). In cases like this, building a position can take time, so consider “averaging up” or “averaging down”, depending on which way the stock is moving at the time.

In other words, if the stock is rising, steadily pick up chunks of it raising your average entry price. If the stock is falling, steadily stagger bids lower and lower and pick up more at lower prices, lowering your average entry price.

This needs to judged on a case-by-case basis and is not always appropriate. But if you have done your homework and are comfortable that you are (2) buying the stock with a sufficient margin of safety and (1) have a long-term time horizon, then you are simply using the market mechanisms to your advantage.

5. Absolutely only ever invest cash you do not need

All the rules from (2) to (4) are meaningless if your (1) time horizon is (forced to suddenly become) too short.

While you can buy into a low liquidity stock with all the right intentions of holding it for many, many years, if somethings happens (probably in your personal life) and you become a forced seller of that stock, then all the above rules are meaningless and the low liquidity will likely cost you dearly.

So, only make investments into low liquidity stocks with funds that you are absolutely, positively sure you do not and will not suddenly need.

The article originally appeared on SmallCaps.co.za.