The Selling Process Part 2 1 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
What does one do with a stock in his porfolio that has stayed stagnant for a long duration without any price movement either upwards or downwards? It is one of those questions similar to the question of whether stocks will rise or fall if the Fed hikes interest rates --- it depends on the context.

Conventional wisdom, according to the pure fundamentalists, is that so long as the original reason(s) for buying the stock still remain valid, one should hold tightly and avoid selling out of impatience. It is very logical advice, but yet sometimes I think the danger is that this view places too much emphasis on the validity of the individual's original judgment; the world is dynamic and one should perhaps have more of the spirit of the fox (see "Is too much knowledge a good thing? Part 2")in monitoring the fundamental situation of his stock: the ability to hold multiple viewpoints and not just a singular rose-tinted one.

Sometimes the inertia of the stock prevents any significant upward movement. Admirers of Newton's laws will recognise this term: it is the resistance of an object to any attempt to change its current state (stationary or otherwise), also otherwise known as the mass of the object. Well, the inertia of a stock would probably be the quantity of outstanding shares. Overly low shares outstanding tends to lead to low trading liquidity while overly high number of shares provides tremendous drag on price movement---an overhang, even, if there is a consistent seller. I often also look towards the shareholding structure of the stock: for tightly-held shares (by majority shareholder) trading liquidity tends to be very low.

While strictly this surely has nothing to do with the pure fundamentals of the company, it has everything to do with the technical position of the stock, and perhaps one might incorporate these into his thinking when considering whether to continue holding. Low liquidity due to stock inertia or shareholding structure is also a form of risk: liquidity risk, and is intricately tied to valuation. In the bond market, "on-the-run" (ie. most recent) issues are priced at lower yields (ie. higher prices) compared to "off-the-run" (ie. less recent) issues primarily because of liquidity risk; things are no different in the sister market of equities.

Consider the following situation: a stock with high liquidity trades down to low volatility with no change in price, over time. Although there are no negative news associated with the stock and business prospects appear similar to before, it may be a signal to sell; liquidity risk has increased. Bid-ask spreads might easily widen. I sometimes think of it as a normally lively child becoming less and less vivacious over time: a bad sign. Of course, you can't cut off your child, but you can cut off the stock.

Perhaps the buzzword is "catalyst". I have written on this in an earlier article ("Why undervalued stocks remain undervalued") and basically it is the idea that a positive newsflow, significant and preferably persistent, brings the "undervalued" stock to the market's attention, much like a peacock flaunts its feathers to attract the peahens. Put in technical terms, it attenuates the liquidity risk.

Having said all this, the final selling decision is up to the individual's assessment of the context. There is a price for everything, and there are large enough valuation gaps (disparity between high value and low price) that would convince the long-suffering investor to keep holding. But let me quote the perfect example of the sideways-moving stock with good fundamentals: Sincere Watch. Over 2004-06, the stock has been moving around a band of 75-85 cents, and daily liquidity is usually <100 lots. The luxury watch industry is a play on a believable trend: Asian reflation, and Sincere has churned out consistent profits. There is no main catalyst, and the shares are tightly-held. The low liquidity suggests a lack of strong buyers, following a bout of accummulation by Chartered Asset Management in early 2004. Assuming the economy continues doing well, the company might continue its performance and one day the market might wake up and revalue it. When? That's the million-dollar question that I'm not prepared to pay to await the catalyst (it definitely needs one). On the other hand, if there is a downturn taking the luxury watch sector along with it, the holdings of Chartered Asset Management will constitute an overhang and depress prices severely. That is the danger of low liquidity stocks.