Monday, March 24, 2008

How To Make Money In Stocks Part 3: The Illiquidity Premium 2 comments



(P.S: Sorry for any disturbances the advertisements above may have caused you)
There is a premium for illiquidity that can be reaped and should be priced into a thinly-traded stock. This is acknowledged both qualitatively and quantitatively even by academic valuation theory, but common sense will suffice, actually.

For a stock that nobody is really interested in, for one reason or another --- even though it does have a certain intrinsic value --- the tendency is for the stock to sink under its own weight below intrinsic value. Firstly, there is unlikely to attract any speculative elements --- hence little overshooting above value; secondly, even institutions tend not to like these stocks because of the fact that they need good daily trading volume so that they can sell without too much market impact should a cash call arise; thirdly, many investors shun these stocks because of opportunity cost of holding; fourthly, many retail investors simply don't know much about these illiquid stocks because brokerages do not provide research on them. Clearly, there is an opportunity for the diligent individual here.

The opportunity arises because the individual's intended appetite is small, which facilitates entry and exit without too much market impact. He avoids initial overvaluation because of limited speculation in the stock. If he is willing to research into these companies, he can find hidden opportunities in a truly inefficient segment of the market. And because he has done research, he can hold with conviction and not be too bothered by persistent thoughts of opportunity costs. This is the essence of reaping the illiquidity premium.

The premium is the difference between the intrinsic value of the stock and its market price which is likely to be substantially lower. If things go well, and the market wakes up to the stock's possibilities due to say, a strong dividend or some new developments as a catalyst, the illiquidity premium is the first to be reaped. Then follows brokerage reports which excite the market and introduce institutional interest and then speculative elements, with PE revaluation on top of optimistic forward earnings projections. One may view the illiquidity premium as the margin of safety for the stock so that even if all the above does not materialise, there is still a buffer between buy-in price and intrinsic value that protects downside to an extent.

This is somewhat allied to the time horizon premium earlier mentioned, for one especially needs to have a long investment horizon to reap good rewards off illiquid stocks. It is important to do some in-depth research and to have a sense of value to unearth the correct illiquid stocks to invest in. Personally, I've had good experiences with illiquid stocks (before they became liquid): stocks like Boustead, Easycall (now China Education), Hiap Seng, Heeton, OKP, MTQ. Even when the illiquidity premium does not manifest, the losses are minimal: stocks like Tsit Wing, Bonvests, Pertama, for example. Some of these I will relate in my Investing Journey series another day.

Another situation where this illiquidity might reward boldness: when there is market-wide illiquidity, characterised by low trading volumes and often large bid-ask spreads for many stocks. That, of course, means there is marketwide uncertainty, and the market can be illiquid for an extended period of time as it resolves the uncertainty --- which means again, there is illiquidity premium to be reaped. Another way of seeing this is that the investor is rewarded for supplying much-needed liquidity to the market. Sir John Templeton has a nice saying that he would like to be a philanthropist in the market and always provide other people with what they need in earnest. That is, to be a buyer when others are desperately selling and a seller when others are greedy searching for stocks to buy. There is no better way to describe the illiquidity premium than that.

 

 

2 Comments:

Blogger Amit said...

Before you decide where to invest your money, it is important to keep in mind that you should never try to invest in 'markets'. Only huge financial institutions like index future traders or mutual funds worry about market indexes. Try to ignore most of what you hear about the so-called 'markets'. Do not try to understand where the market is going because market is a collection of major stock indexes. Therefore try to free yourself from the opinions of mediocre mutual funds and financial planners.

Instead, you must learn to find out the good but cheap companies to invest in and hold your stock till they grow to reward you with good profits. The key to success is to clearly understand the true worth of the company. Then you can use the age-old formula of buying low and selling high. You should identify a good company, wait till its stock price falls below its true worth by a tempting margin. Once you buy its stock, you need to keep track of the company's value. You should sell the stock when its price rises to an uncomfortably high premium to its true worth, so the basic lesson in stock trading education is that all your trading decisions should be guided by comparing the company's stock price to its true worth and not by rumors of what a hot stock at a given moment is.

3/26/2008 4:19 AM  
Anonymous Learn Stock Market said...

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4/16/2013 5:13 AM  

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