The fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. John Maynard Keynes
One line of questioning we are hearing more and more from clients, here on The Value Perspective – and presumably it is no different for other professional investors – relates to the liquidity of our portfolios. A typical inquiry, for example, might run: “Based on their average daily trading volumes, how many of the stocks you own would take more than five days to liquidate?”
And each time we are asked such a question – the subtext of which, of course, is “How quickly can you get out of a stock if it goes wrong or you change your mind?” – we think of the above quote. Granted, Keynes was talking in a different context about market liquidity but his underlying point – that liquidity can be no comfort for the market as a whole – is often overlooked by investors.
We found the line while reading Concentrated Investing: Strategies of the World's Greatest Concentrated Value Investors – along with another Keynes quote that, at least to our way of thinking, goes a long way towards answering that subtextual client question on how quickly we could completely bail out of a stock should we so wish.
Asked to account for the significant losses one of his portfolios experienced in 1937 – and particularly his policy of remaining invested as markets had continued to fall – he wrote: “I do not believe that selling at very low prices is a remedy for having failed to sell at high ones … As soon as prices had fallen below a reasonable estimate of intrinsic value and long-term probabilities, there was nothing more to be done.”
The answer clients would really like us to give to their liquidity questions is that, if we change our view of a business, we can sell out of it almost immediately – but, in that case, average daily trading volumes are pretty much an irrelevance. Instead, they should be asking how much of a stock we might reasonably expect to be able to trade in the first two minutes of the typical day on which it posts its results.
After that, unless your view on the business is very different to that of the great majority of investors, then all bets are off. As Keynes implied in our first quote, the market cannot collectively sell out of a share – all it can do is push the price down. What is more, when a CEO unexpectedly resigns, say, or evidence of an accounting scandal or other negative news emerges, the price can fall very rapidly.
At that point, if you have a meaningful position in the stock, then whether you could theoretically have liquidated it in three average days or five is just that – theory. In practice, once the relevant information has been incorporated into the shares’ valuation, there is – as Keynes said – “nothing more to be done”.
In truth, once you run more than £100m, say, you just cannot trade in the way many clients believe you can.
Another thing to bear in mind with liquidity is it is directional – that is, it is not a one-way street. The way many people think about liquidity – or, more accurately, illiquidity – is as if everybody is trying to leave a building at the same time via one emergency exit and not everyone succeeds. Sometimes, to add extra drama to the image, the emergency exit is shrinking from the size of a barn door, say, to a cat-flap.
But this analogy does not take into account the possibility that some people might actually be trying to get into the building – looking to buy, that is, rather than to sell. It would therefore be more accurate to picture everybody trying to leave a building at the same time and – ignoring all received wisdom – using its elevators to descend to the ground floor.
In this situation, should you happen to be downstairs already but have good reason to believe there is in fact no emergency, you will find plenty of empty elevators waiting to take you up – lots of, as it were, attractive opportunities to get in. So, yes, liquidity matters but only insofar as your liquidity differs from that of the average investor in the market – and that tends to be linked to your view of a stock or a sector.
In Private view, we recently suggested that what researchers had interpreted as excellent timing by a certain group of investors was, more accurately, a greater flexibility on their part to choose at which point they made their investment. If you have that flexibility – in the context of the elevator analogy, a well-founded contrarian view and the ability to bear the associated liquidity risk – you can be richly rewarded.
When a piece of negative news emerges about a stock we happen to hold, here on The Value Perspective, we typically find the market reacts very quickly – to the extent that the share price is down perhaps 10% in the first minute or so of trading. In that respect, the market can actually be quite efficient in the short term – the share price falls but then, over the next week or two, it does not really move.
The market is, in other words, pretty good at making a seat-of-its-pants assessment – for example, that this accounting scandal or that product recall will cost the business £5bn so we will knock £5bn off its market capitalisation. Where it is much less efficient is in pricing in the longer term implications of the news – which is where value investors, who typically operate a much longer time horizon, can profit.