To hell with liquidity


Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. [1]

These words of John Maynard Keynes ring in my ears every time I hear the term 'liquidity'. Yes, fetish is the right word. To someone uninitiated to finance, the persistent talk of terms like volumes, flows, depth and liquidity will make him feel as if he is sitting in a fluid dynamics class.


Had I been an MBA, I would have been fluent with these fluid terms, but the engineer in me revolts against pseudo scientific talk which uses terms that can't be defined or measured. Liquidity is one such term. Keynes made an important assertion that "there is no such thing as liquidity of investment for the community as a whole". He meant that the capital already deployed in production of goods and services can't be pulled back at will. A new steel plant cannot be liquidated just because the steel prices have gone down. The investor of that steel company may liquidate his investment and turn it into cash but for that, there must be other investor who is willing to part with his cash and invest it into the steel company.


Keynes correctly questions the rationale behind organizing the markets to promote liquidity.
When I say that the investors should think like the owner of a business, what should be their view to liquidity? Before I build my argument further, let's see when do you need liquidity. You need liquidity at the time of sale and only to the extent of the stocks owned by you. If I to sell hundred stocks, does it matter if there are thousand stocks traded a day of a million? If I'm not planning to sell, does it matter if the stock is traded at all?


Liquidity drives down the spread between bid and ask price of a stock which reduces the transaction cost. That's a definite virtue. And then there are other questionable virtues. A liquid stock attracts more participation from institutional investors. It is also said that the liquid stocks are less volatile. The participation from institutional investors is a virtue if they act like long term investors. It's a virtue if they stand up against any actions of management which are detrimental to the interests of minority shareholders. Both these aspects are questionable. The volatility of the highly liquid stocks raises doubts on the credibility of the notion that liquidity reduces volatility.

The long term investors do not share the high opinion about liquidity with the rest of the investing community. Charlie Munger said, "I think the notion that liquidity of a tradable common stock is a great contributor to capitalism is mostly twaddle". Warren Buffett's Berkshire Hathaway is one of the most illiquid stocks in the US. At a price of $90,000 per share, it's out of the reach of most investors. Once when he was asked about splitting the stock to increase liquidity, Buffett quipped, "Over my dead body". In the letter to shareholders in 1983[2], he has described the reasons behind the no- split policy.

Now let me speak from my personal experience. I've never rated liquidity as a virtue in my investment decisions. In fact, about 20% of my equity portfolio consists of stocks which have been delisted and a further 20% is bordering on illiquid. This is not by design but it so happens that the investor apathy which is the reason behind low volumes, sometimes brings the prices down to the bargain basement levels which they find me waiting. It is also true that value I can see so clearly in those stocks, won't go unnoticed by the promoters. The net result is that promoters have either raised the stake so high that the stock has become illiquid or they have delisted the companies. Pretty scary state to be in! Right??


Well not quite. Here are the records from 3 such illiquid companies where I chose to invest a significant portion of my portfolio.

CompanyMALCOEicher LtdNovaritis Ltd
Avg. Purchase price21.3279.85289.45
Purchase DatesJuly-04 to Sep-04Aug-05 to June-06Mar-08
Exit Offer 1 Price48265351
Exit Offer 1 DateMar-05Dec-06Mar-09
Exit Offer 2 Price115354.37450
Exit Offer 2 DateMar-09Jul-09May-09
Current StatusHolding onExitedHolding on
Returns(No. of times)5.394.441.55
CAGR45.43%53.08%42.33%



As you can see, I have been rewarded handsomely for foregoing the liquidity. In case of Eicher Ltd, I opted to remain a private shareholder when they delisted the company. Later, I exercised the option to convert into preferred stock, which I redeemed at a price 33% above the delisting price. In case of MALCO, I not only refused to exit at a price of 115 but invested more money before delisting. In case of Novartis, I did not participate in their two open offers and bought more.

These seemingly counter- intuitive actions can be explained by a simple principle that when I own a stock, I own a part of a business. Whether someone else is willing to buy out doesn't matter to me as long as my business grows. If you own something valuable, rest assured, you will find buyers. You can't say so about a piece of junk that's a regular entrant in the list of highly traded stock.

None of this will impress those who offer daily prayers to the Goddess of liquidity. Nor will they pay heed to Charlie Munger's advice to study carefully the example of the English economy which continued to do well despite the ban on trading of stocks after the South Sea Bubble in 1720.

For those who invest on leverage, liquidity assumes paramount importance. The same can be said about the institutions that attract hot capital by promises of high short term returns. They have a sword hanging over their neck. Liquidity is important to them but all the long term investors can safely say, "To hell with liquidity".

References

  1. The General Theory of Employment, Interest, and Money
    John Maynard Keynes
    Chaptor 12 'THE STATE OF LONG-TERM EXPECTATION'
    http://ebooks.adelaide.edu.au/k/keynes/john_maynard/k44g/chapter12.html
  2. Stock Splits and Stock Activity
    Warren Buffett, Letter to Shareholders
    http://www.berkshirehathaway.com/letters/1983.html


3 comments:

S.Sujai Gangatharan said...

Dear Kamlesh,
Good article which cleared a lots of doubt regarding value investing with some illiquid stocks.
Thanks a lot.
Regards

Shanx said...

Please let me know the date when the open offer expires. My father owns MALCO for the past 46 years. I don't want to cashout cheap at the same time I do not want to hold to an illiquid stock. Thanks in advance!
Ravi

Kamlesh Pandey said...

Hi Ravi, It's December 21, 2009.
You can refer to this Public Announcement

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