A common feature of some, but not all, micro-cap stocks is low liquidity. This is extremely common for stocks not trading on a major exchange, such as the OTC or OTCQB. But what does low liquidity mean exactly? And how do investors deal with the liquidity premium in valuing a particular company?
Liquidity – The Basics
Liquidity is the ability for an investor to sell their position to a willing buyer. Liquidity takes two general forms: the investor’s legal ability to sell a security, the investor’s ability to find a seller or buyer, and transaction costs. Generally, the liquidity of a security is caused by one, or both, of those factors. Each of these factors determine, generally, how wide a bid-ask spread is. Recall the bid price is the best price someone is willing to purchase at, whereas the ask is the best price someone will sell at. The more liquidity, the tighter the spread, and vice versa.
Let’s break those down.
Legal Restrictions
First, the investor’s legal ability to sell a security depends greatly on what security the investor owns. Many securities or investments one can purchase are not actually legally able to be sold for certain periods of time. A primary example are pooled investments such as private equity, hedge funds, or syndicate real estate. Many of these funds require investors to hold their money in the fund for a minimum period of time before being able to sell. In the micro-caps, this typically isn’t an issue unless you are an accredited investor purchasing restricted shares directly from a company.
Transaction Partners
Second, the investor’s ability to find a seller or buyer can make investing in a particular security very difficult. For micro-caps, this can be very important. We’ve all been there; we find a company that looks great, and we want to invest. We open up our stock quote and bang, the bid price is $2.35 and the ask price is $4.10 and your heart sinks.
This form of liquidity is completely driven by how active of a market there is for the stock you want to buy or sell. As the buyer, you are hampered by nobody wanting to sell it to you at a price anywhere near the current bid price, and vice versa for the seller. Generally, liquidity in this form is determined by a couple of things, such as:
- Publicly available information on the stock – if nobody can figure out what they’re all about, nobody will touch it.
- Market capitalization – generally the smaller the company is, the fewer the number of trades occur.
- Stock exchange – like I mentioned above, not being listed on the NYSE, NASDAQ, etc. tends to hamper transaction partners.
- Float – this is the number of shares available for trading to the public. This figure excludes shares held by directors, etc. which cannot be sold.
Transaction Costs
This, put simply, is the time, effort, and monetary cost to actually enter or exit a position. Time and effort relate to how difficult it is to navigate the bid-ask of a stock. For example, do you have to set 50 alerts and press F5 every two minutes on the bid-ask spread just waiting for a fair order to come through? Or can you sell your stock at $0.01 less than the current ask price at any time?
Monetary costs relate to any expenses you must incur to close or enter a position. Purchasing a common share in today’s age is almost always free in the US, along with ETFs, bonds, CDs, and preferred shares. Conversely, a great example of high transaction costs is selling a home. You have to pay realtor fees, legal fees, taxes, duties, the list goes on and on! There’s a reason why people don’t sell property every two weeks. Believe it or not, the high transaction costs of selling your home actually drives the price down.
Liquidity Premium
Without getting into the theoretical principles…generally the more illiquid an investment is, the greater return an investor will require. Think of it this way, I have two identical securities: one is highly liquid, and I can sell it in two seconds, the other is highly illiquid, I have to hold it for five years, and there is hardly a market to sell it. Which would you invest in? Clearly the liquid security.
However, what if I told you the liquid security was trading at a fair market price of $5.0, but the illiquid security was trading at $3.0. That illiquid security looks more appealing now, doesn’t it? That’s because the market has applied a higher discount rate, via adding a liquidity premium, thus lowering the current price. You can earn more money theoretically in the long term, but you are taking on more risk via liquidity. If things go great with the stock, maybe you can sell it easily, maybe you can’t, hence the risk.
Another factor in the risk, which is inherent in the above logic, is that if there is a large bid-ask spread, it is very difficult to tell what the fair market price is. The fair market price is likely somewhere in between, but because nobody is actively trading, people are taking wide bid-ask positions hoping someone is desperate to buy or sell. This makes it very difficult to mark your positions correctly and you need to pay close attention to glean a market price.
Liquidity – How does it Affect my Micro-Cap Strategy
Modeling
As I alluded to above, you must add some sort of liquidity premium to your discount rate in your modeling if liquidity risk exists. Estimating this is very difficult, so take a more conservative added percentage. For example, if your discount rate without a liquidity premium is 20%, add 5% to it. Basically, think to yourself, how much extra do I want to be compensated for the additional risk I am taking.
Trading
The first thing you need to do after identifying a particular investment target is open up the ticker (during trading hours) and analyze the following:
- The bid-ask spread – note how much the two differ, and even monitor it for several days before purchasing. Does it fluctuate much, or does it stay consistent?
- Average volume over the last 10 days and average volume over the last 90 days – see how often people trade the stock and if the 10-day and 90-day averages are near each other. If they are near each other, the stock likely has a consistent volume. If not, then it is more sporadic, and you will be more hampered in your ability to transact.
- Volume spikes – is the average volume over the 10-day and 90-day happening consistently? Or is it driven by 1-2 days of trading activity around regulatory filings or news?
You might be asking then, how can I buy and sell a more illiquid stock? This is going to sound oversimplified, but you need to exert quite a bit of effort.
How can we achieve this? A few tips:
- You must pay very close attention to how the bid-ask moves throughout the trading day by setting alerts or manually checking.
- From there, you need to know for certain, always, what your entrance and exit price is, based off your modeling.
- You must be ready to act instantly, too. If you wait sometimes even 30 seconds, someone else may swoop in and fill the bid or ask order.
But how do I strategize by bid-asks?
Set Deep Bid-Asks
This is very risky, but one strategy is setting a permanent ask well above the current ask. Note – this is incredibly risky. For example, say the current ask has sat at $3 for weeks. You set your ask to $7 thinking nobody will ever pay it, but if they do, you’ll make a killing. Sounds like a no-brainer, right? Wrong. What happens if you don’t pay attention for the day and the stock cures cancer and bids shoot up to $20. Your ask will get eaten up in a second and you just missed out on a ton of money.
The opposite is true of bids. You can set a ridiculously low bid hoping someone gets desperate. Again, the same risk applies. What happens if your CEO announces he sold off the factory and he is fleeing the country? That bid you set will be completely asinine.
Set the Market and be Patient – My Preferred Approach.
Say the bid-ask is $2 and $4, and your intrinsic price to enter the market is $3. Follow the price like a hawk and set a bid price of $2.01 with enough shares that it registers on major trading platforms. Enter your bid order for a smaller percent of the total position you want to purchase. For example, I want to invest in 100 shares total, so I will only do 10 shares at a time.
Set the bid to expire at end of close that day. If it doesn’t fill, re-assess tomorrow. If someone out-bids you, raise your price, but not higher than your intrinsic value. This way you set the market, you are still paying attention to price movements, and you might be able to catch someone getting desperate. The risk of a price shock like my above example, which is still possible, is somewhat mitigated as you don’t enter your whole position at once.
Remember, all of the investors in this stock are trying to win out on the liquidity risk. They are trying to get you to lose patience and slip up on the mechanical trading. Don’t dump your position at a bad price just because you want it gone or enter a position because you’re too excited about it. Be calculated and tactical about your buys and sells like I mentioned above. Someone will gladly rip you off at a bad bid/ask if you get impatient.
Bottom Line
Liquidity risk is everywhere in the pennies, and you need to factor in the lack of an active market to your models and trading strategy. For modeling, ensure your discount rate is adjusted upwards to reflect any liquidity risk that may exist. For trading, be patient, follow the market, and stick to your intrinsic value price per share. Don’t get ripped off by people who were more patient and smarter than you, take your time, enter the market for a security slowly, and let the market come to you.
If you’d like to read my previous post in this series, I’ve provided the link here:
Micro-Cap Valuation Basics – Using Comparable Multiples in Low-Growth, Profitable Companies
DISCLAIMER – THIS IS NOT FINANCIAL ADVICE AND IT IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. THIS ARTICLE SHOULD NOT BE CONSTRUED AS A RECOMMENDATION OF ANY STOCK OR A RECOMMENDATION OF ANY SECURITY OR FINANCIAL INSTRUMENT.
