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Does stock liquidity matter?

Photo of Michael Kemp, Barefoot Blueprint By Michael Kemp, Barefoot Blueprint

min read

Key trading stats to look at before buying and selling.

This month I want to talk about stock liquidity, but let’s start with a definition because the term liquidity has more than one meaning in the world of finance.

Put simply, stock liquidity describes the ease and speed with which a company’s shares can be bought or sold on the sharemarket without moving the share price. It’s an important topic, because when you’re buying or selling you want to do it quickly and at your chosen price.

So how do you get a handle on liquidity, measure it, and how much of it do you need to ensure you get set quickly at the price you want?

The answer is, it depends, because stock liquidity is very much an individual thing. Here’s an example:

Pete wants to buy some shares in an ASX-listed company, Collection House. It has a market capitalisation (share price times number of shares on issue) of $165 million and on a typical day around 300,000 shares are traded, worth about $350,000.

Pete logs onto his internet broking site and checks things out. He sees the best offer is for 16,000 shares at a price he’s prepared to pay. Even better, he only wants 10,000 so his buy order is transacted quickly and easily and the share price doesn’t budge.

For Pete, Collection House is a liquid stock.

Now consider Ingrid, an institutional investor who works for a fund manager with $10.5 billion under management.

Ingrid is looking at Collection House at the same time as Pete, but she is looking to buy a 5 per cent stake in the company – 6.7 million shares. Ingrid checks her trading screen and notes that, in total, there are 790,000 shares being offered at prices ranging from a low of $1.20 (the price at which Pete just got set) to a high of $1.35.

The problem for Ingrid is that if she places an order to buy all the shares at present on offer, not only will the company’s share price immediately jump by 12.5 per cent (to $1.35) but she will also have purchased only a fraction of the shares her fund wants to buy.

“Hang on a minute,” I hear you say. “I’m not J.D. Rockefeller, I’m more like Pete, so stock liquidity will never be a problem for me.” Don’t you believe it! Some of the smallest ASX companies, by market capitalisation, can have days when trade in their shares is very low.

Measuring share liquidity

There are metrics that are used to define share liquidity. For example, I could dive into an explanation of how to calculate a metric called the share turnover ratio. But I’m not going to bother because I’ve never felt the need to use that ratio, or any other liquidity metric for that matter.

In terms of liquidity there are only two things you need to know before conducting a trade:

1. First, check the live trading volumes and prices on your broker’s website. If you want to buy, look at the number being offered; if you want to sell, look at the number bid. If the volume close to and at the marginal price (the lowest offer or the highest bid) is larger than the number you want to trade, then it delivers a degree of confidence.

2. It is also wise to check the liquidity of the stock over a wider timeframe than just the day you want to trade. There will probably come a time when you want to trade again in that stock (for example, to sell what you are about to buy). Your best guide to assess this is to check the historical trading volumes for the stock.

There are several ways you can obtain historical trading volumes. Here are two:

  1. First, from your broker’s website. For example, CommSec users can click on Trade History once on the relevant company page and see the volume traded every day for the past 12 months.
  2. Yahoo Finance provides up-to-date trading averages on its web page. Look under Key Statistics for the company and 10-day and three-month rolling daily averages are shown. If the two averages differ significantly, investigate why. One might be atypical.

Studying historical trading patterns and volumes will help in judging the ease of trading again later.

Does liquidity matter for a long-term investor?

In theory, the answer is no. In practice, the answer is it depends.

The world’s most successful investor, Warren Buffett, has said that if you are not willing to own a stock were the exchange to shut down for five years, then you should not buy it in the first place. These are not idle words from Buffett. Berkshire Hathaway, the company he heads, has acquired around 90 unlisted companies in the time he has been at the helm, indicating that he’s not scared of buying relatively illiquid businesses.

But it is important to add that buying into investment situations that are difficult to exit requires supreme confidence in your ability to judge the future business prospects for the company. When things start to go pear-shaped, most investors (and pretty much all traders) prefer the comfort of being able to get out quickly.

Does illiquidity cause a stock to trade at a discount?

If you fancy yourself as a hot stock picker, illiquidity might be the best friend you have, because many investors and traders avoid less liquid stocks. So, there’s a tendency for these overlooked orphans to trade at a discount.

That doesn’t mean investing in a randomly selected group of illiquid stocks will guarantee market-beating returns. Skillful selection is still required so it’s a sport reserved for budding fund manager types.

The final word

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

If you are a skilled long-term investor who looks to buy for keeps, liquidity would appear to be less important. Investors 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 share investors behave this way. Most do perceive liquidity to be important, and I would recommend they limit their shareholding to a comfortable fraction of the daily trading volume of the company.

That’s easy to do for stocks such as BHP and Woolies. But keep an eye out when investing in the smaller-cap stocks.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint and author of the popular sharemarket book, Uncommon Sense: Investment Wisdom since the Stock Market’s Dawn, published by Wiley.

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