Portfolio Strategies: Liquidity

Liquidity for most investors can be measured in seconds, the amount of time it takes to open a portfolio and click 'sell'.  The speed at which investors can change their minds has created a distorted environment where frantic buying and selling is the norm, and patience is old fashioned.

I want to examine what liquidity is, why you need it, and also reframe the discussion.  I think sometimes discussions about liquidity are really discussions about symptoms, not the root cause.

What is liquidity?  Liquidity is a measure that represents the ease at which something can be bought or sold in a market.

Almost all purchase or sale decisions outside the stock market involve friction in both buying and selling.  Almost everything anyone buys is illiquid, yet this doesn't seem to bother consumers.  For example consider a house purchase.  A family decides they want a new house, they hire a realtor, tour houses and eventually find one they like.  Then they place an offer and haggle back and forth with the seller.  Once an agreement is reached financing needs to be arranged, documents need to be signed and a closing date is set.  Often the closing date is a month or more in the future.  If the buyers move in and decide they don't like the neighborhood they have to endure the same lengthly sales process they just went through before they can be rid of their purchase.

Consider another example of a smaller purchase, a dress shirt.  To purchase a dress shirt you need to drive to the store, pick it out, then stand in line to purchase it.  If you get home and decide you don't like it you need to make another trip to the store, stand in line again, and conduct the return.

Anything that's purchased out in the 'real world' involves friction in both buying and selling.  Once something is purchased there's a hassle factor to returning the item and receiving your money back.  I can't think of any purchases where one can buy something, immediately change their mind and within a few seconds have reversed the entire transaction.  It's fair to say that illiquidity is part of any transaction when something is purchased.

Even cash, the golden standard of liquidity, is sometimes illiquid.  When someone wants to move cash from a savings account to a checking account it takes three days for the money to post.  Say the person changes their mind on the transaction and wants the money back in their savings account, another three days to transfer back.  A full six days for cash to make a round trip between one account to another.

When consumers understand that a transaction has considerable friction or is hard to reverse they spend a lot of time up front to ensure they're making the right decision.  I've heard people joke that many investors will spend dozens of hours researching which washing machine to buy and then spend 15m researching a stock purchase.  On the face of it this is absurd, an investment is many times the value of the washing machine, so why the time differential?  It's because the cost of making the wrong decision on the washing machine is much greater than the cost of making a poor investment decision.  If one purchases the wrong washing machine it's not an easy task to return it.  Whereas if the investment purchase is wrong it's just a few mouse clicks from a sale.

When an investor is considering either an extremely large purchase of a business, or purchasing a private business they spend a lot of time researching their decision.  Large minority, or majority investors don't have the luxury of selling off their position anytime they want.  Their sale could be interpreted as a signal to the market with the share price negatively reflecting this information.  An investor buying a stake in a private business has to consider their decision carefully because they can't easily reverse it either.

Larger holders, and private company investors also have different investment objectives compared to the majority of private market buyers.  They aren't looking to flip their shares quickly for a small gain, rather they're in the investment for the long term.  They are looking for capital appreciation, or for the company to return a portion of their profits to them as dividends.

Dividends are under-rated, they provide liquidity in even the most illiquid situations.  If a company is profitable and investors are paid out a portion of earnings as a dividend not many investors can be found complaining about the inability to sell shares.  In fact the opposite is true.  I know of a number of very illiquid unlisted stocks paying very high dividends and it's impossible to buy shares because no current holders are willing to sell!

The drive to own a liquid stock stems from two underlying reasons, the near term need for the cash, and for the optionality to change ones mind quickly after a purchase has been made.

In order to purchase more illiquid assets a strategy needs to be put in place.  Here is how I structure my portfolio in a manner that allows me to own very illiquid assets.  Money I need for near term events, which I define as five years or less I hold in a savings account.  I never invest this money, and my liquidity on it is three days.  Beyond my initial cash I own a number of stocks that are either very liquid, or moderately liquid.  A moderately liquid stock is one where I could sell out of my position in a day or two, a very liquid one is where I could sell out of my position instantly.

The bulk of my portfolio consists of moderately liquid holdings.  Some of these holdings pay dividends, but not all do.  If the market provides an opportunity for an exit then I'm willing to forgo a dividend, although I prefer one if possible.

The last portion of my portfolio I invest in illiquid stocks.  I view these in the same way I'd view purchasing a stake in a local business.  I expect to be in these holdings for a very long time.  Because of the time commitment I will only invest when these stocks trade at a significant discount, and I always want them to pay me a dividend.  I have made one exception to the dividend rule, it was for a stock trading at 10-15% of BV and a few times earnings.

When I first realized the potential to dedicating a portion of my assets to illiquid securities I came across an article with a quote from Jack Norberg, the unlisted stock king.  He suggested to the journalist that no more than 15-20% of one's portfolio be dedicated to illiquid securities.  This seems like an accurate number to me as well, I personally have 18% of my portfolio in illiquid securities.

One question I haven't addressed that some readers might be asking is "what's the point of buying any illiquid stocks at all?"  Let me answer the question this way.  If a local businessperson approached you with the opportunity to buy shares in their successful business for 4x earnings and at 50% of book value that paid a 10% dividend would you consider that investment?  I think many investors would, and investors don't need to find local businesses to invest in.  There are many opportunities like that in the current market place found in stocks that don't attract a quote daily (or at times weekly).  Its in these stocks that some of the most incredible bargains can be found.