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How to buy low-liquidity stocks

Jul 11 2017 10:26
Simon Brown

I wrote last week about Ansys and the problems with stocks that have very low liquidity and that, as a rule, I avoid them. But we do have other options that I want to delve into.  

Two major issues with low-liquidity stocks

First, I want to highlight the problems associated with low liquidity. The first issue is that such a stock often has a wide bid/offer spread. In other words, the price difference between the buyers and sellers can be huge. Consider a stock with buyers at 88c and sellers at 105c. That’s 17c, or more importantly, it’s a difference of almost 20%.  

So, if you want to buy, you have a few options and none of them are great. You could just cough up the 105c, but now if you wanted to exit, you’d immediately lose some 20%.

Put another way – you need the buyers at 88c to increase their price by 20% for you to be able to sell at break-even. You can try putting some buy price in between the current buy/sell levels in the hope you’ll get traded. But a low-liquidity stock means this may take an age, or worse, happen in small volume over several days, costing a fortune in transaction fees.   

The other concern is the quantity of stocks available to buy or sell. You may want to buy X quantity, but to do so you’ll be pushing the price higher, or worse, there simply isn’t enough for you to buy. The same could happen when you’re exiting, driving the price lower and potentially bring in other sellers. 

How do we get around this?

The trick is therefore to think of this investment differently. With all my JSE-listed stocks, one of the attractions of owning them is that I could sell my entire portfolio in minutes. When I decide to exit a stock, or add to a position or add a new position, there are no concerns about my ability to carry out the transaction at the current price.
 
With small low-liquidity stocks we need to think more like a private equity investor. Private equity is unlisted, so buying and selling is hard and there is no true price discovery.  

Further, private equity is long-term and it either goes well or it goes terribly. There is very little middle ground.  

So, with small, low-liquidity JSE stocks we need to be prepared to pay up when buying and be prepared to hold for many years with the real risk of losing money and selling at a discounted price.  
It also means we need to be very selective regarding what we buy, and keep this part of the overall portfolio very small. Say 5% of an entire portfolio in one or two quality, low-liquidity private-equity-style stocks.

This is not something we can do on a whim because when things go wrong, the losses can be massive due to not only a falling share price but also the reduced ability to exit the position.  

The other point about it being private equity is to be an active investor. Attend the annual general meeting and vote. Engage with management in-between results, either via phone or email (calling the CEO or chief financial officer of a small company usually works and gets answers). Being an involved shareholder will help with your understanding of how the company is doing.

Lastly, be prepared for some of these investments to go spectacularly wrong in that a 100% loss is very possible. In order to help us reduce the risk of this happening, the very last point is that quality matters perhaps more than usual here. Find those hidden gems, ask experts about them, build a case, engage management and start slowly building a position.

This article originally appeared in the 6 July edition of finweek. Buy and download the magazine here.

investment  |  portfolio  |  jse  |  small caps

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