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Why share liquidity is so important

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A useful guide to what it is and how it is measured.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

In July 1914 the world was bracing for war. Investors were selling their foreign assets and bringing capital back behind domestic borders. In response to an impending international sharemarket collapse, global exchanges were pulling down their shutters and suspending trade.

The New York Stock Exchange (NYSE) was the last major exchange to act. Aware of how grave the situation had become its governors called an emergency meeting on the morning of 31 July and decided, effective immediately, to close the trading floor for an indefinite period. (It remained closed for the next four months.)

What happened then was something the exchange's governors had not counted on. Behind the NYSE building is a narrow thoroughfare called New Street, where a fringe group of outside brokers had long gathered to buy and sell small parcels of shares. Suddenly, free from the ruling that had closed the principal exchange, business for the New Street brokers started to boom.

It was clear many investors feared the prospect of holding their shares for an indefinite period. To regurgitate the well-worn Warren Buffett quote: "I buy on the assumption that they could close the market the next day and not open it for five years." The reality is the closure of the exchange would see the palms of many become very sweaty.

That the sharemarket provides a deep and reliable secondary market for the purchase and sale of shares is one of its great attractions. The term describing this feature is market liquidity. This article explores what market liquidity is, how it is measured and how important it is to the average investor.

What is market liquidity?

Sharemarket liquidity refers to the 'ease' by which shares can be traded, and there are two essential features in defining the word ease.

First, speed. A liquid stock is one that can be sold quickly. For this to happen there must always be willing buyers when sellers choose to sell.

Second, price. Liquidity also implies that a stock can be sold without materially affecting the market price. In other words, there must be sufficient demand to support the price during the course of the transaction.

Clearly, most things can be sold quickly if sellers are willing to accept a low price. But if a significant price adjustment is required to facilitate the sale, the market is not liquid.

We can bring these two factors together and define liquidity as: "The ability to trade a substantial amount of a financial asset at close to current market prices."

That sounds fine, but how do we measure it?

Measuring market liquidity

The most useful measure of liquidity for any stock is its average daily trading volume. This varies from day to day so it is best to use an average. Yahoo Finance provides up-to-date averages on its web page. Look under "key statistics" for the company. Daily averages are shown for the previous 10 days and three months. If the two figures vary significantly, investigate the reason. One might be atypical.

Once the average is found, it is useful to compare this to the size of your own shareholding, be it actual or intended. If the trading volume is consistently much higher than your required trade volume, it should provide a degree of comfort.

Another liquidity measure commonly used is the share turnover ratio. Its two inputs are:

  1. Average daily trading volume, as discussed above.
  2. The float. The second input to the share turnover ratio represents the company's total number of outstanding shares minus those owned by insiders (such as the founding owner(s), the CEO, directors, etc.) and what the company is holding back (treasury stock). In other words, the float represents the shares available for public trade. Yahoo Finance provides this information also.

Let us calculate the share turnover ratio for two listed stocks, BHP Billiton and building materials company Embleton Limited. For this example the daily trading figure used is the average for the previous 30 days. Embleton had not traded over the previous 10 days!

Share turnover ratio (BHP) = 7.166 million/5.310 billion

= 0.135%

For Embleton:

Share turnover ratio (EMB) = 68/276.34 k

= .0246%

The share turnover ratio for BHP is higher than for Embleton, which is not a surprise. But given that BHP is the largest mining company in the world and Embleton is a $14 million minnow, an assessment of relative liquidity cannot be made by reference to the ratio alone.

That is because company size is such an important factor in defining liquidity, and the share turnover ratio masks this metric. Large companies typically deliver high liquidity even when their turnover ratios are low.

Liquidity also carries a personal face. For example, the liquidity of listed company Hansen Technologies (with a recent average daily trading volume of 78,000 shares) might be fine for "Mum and Dad" investors but I am sure a very large investor would consider it illiquid.

Illustrating these points, and again comparing Embleton and BHP, the average daily trade value for Embleton (based on the previous 30 days) was an incredibly low $440. The value of BHP's average daily trade was $275 million. That is a massive 625,000 times the value in daily trade for BHP despite its share turnover ratio being just five times that of Embleton.

What the share turnover ratio is actually telling us

Having established that the share turnover ratio is of limited value to investors, it should be said that it is more useful to traders. Traders view it as a relative measure of the supply and demand relationship for a stock. The higher the turnover ratio, the more potential there is for price volatility (both up and down).

Does market liquidity really matter?

The answer is, it really depends on who you are and whether your game is investing or trading.

A commonly stated benefit of liquidity is that it allows the rapid exit from a stock when the share price falls. For traders who use a stop-loss (a pre-determined point at which you sell, to minimise losses), this advantage is clearly very relevant. But for investors it is less so. If the investment story remains appealing, true investors should be prepared to hold a stock even after the price drops. Even if the investment story has changed for the worse, my experience has been that the market price adjusts rapidly to reflect the news.

That means a so-called "quick" exit by most small investors is usually well behind the play. Which means the rapid exit benefit that liquidity is said to provide is not that useful and grossly overstated.

Liquidity discount

Given that most traders and investors place a value on liquidity, the question needs to be asked, do illiquid stocks typically trade at lower prices? Because they could present bargains for long-term investors if they do. While it appears that such discounts do exist, quantifying them is difficult.

It is a very interesting concept to explore, and perhaps it is why Warren Buffett turned his main focus away from the sharemarket years ago and became more interested in purchasing relatively illiquid non-listed companies instead.

The final word

If you are a trader, liquidity is important, both in formulating strategy and executing stop-loss orders.

If you are a Warren Buffett type who looks to buy for keeps, liquidity would appear to be less important. After all, investors are supposed to take the view that they are buying a part share in a business. And the reality is most businesses are not even listed on stock exchanges.

But few "investors" fit this mould. Most perceive liquidity to be important and for them I would recommend limiting their shareholding to a comfortable fraction of the daily trading volume. That is easy to do for stocks such as BHP and Woolworths. But keep an eye out when investing in the less-liquid smaller-cap stocks.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

From ASX

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