Small cap stocks generally have a liquidity problem.
This is one of the reasons why most investors stay away from small cap stocks. This is also one of the reasons why good undervalued stocks are easier to find in this asset class.
The market for highly liquid stocks is also normally highly efficient. The price you pay for the convenience of having your transaction execute in seconds (instead of hours or sometimes days) is returns that are at best average.
In my 18 years of investing in small cap value, I have found that lack of liquidity is hardly ever an issue. Part of it is just practicing good investing habits. The other part is understanding precisely what we are doing when investing in small cap value.
Value Investing Means Trading Assets Against the Market – You Can Bid Low and Ask High
This is a peculiar thing about the market – liquidity in shares is not constant over time, nor does the trading reflect the actual bid and ask balance on the stock.
Often there are more bids then asks and the liquidity can be low just because there is no supply and a lot of demand. If you take a position against the market, you will create supply and your trade will not have any issue executing.
It is a similar situation when the stock is under a selling pressure and you take a contrarian view. Your bid will create the liquidity that did not exist in the stock. The volume you see on the stock ticker is not reflective of what will happen when you enter your transaction.
If you are a novice investor, or follow the regular financial media, you have been told over and over again that liquidity is desirable. I suppose it is for ease of trading securities and taking comfort in the higher volume as it signifies that there are many other investors who think like you. When it comes to make profits though, liquidity should be of little concern.
How to Deal with Lack of Liquidity when Buying the Stock?
When you buy a small cap stock which is undervalued, you will find yourself in one of the following 2 situations.
- The price is low and the selling is not yet done (“Blood in the streets”) – One of the recurring themes for most value investors is that they are often early into the buy. A stock may be undervalued now because of many factors (missed expectations, a lawsuit, declining market, etc). If the price has fallen rapidly in the recent days, it means that there are more sellers than buyers at each price levels and the stock has not yet reached its equilibrium. If you determine that it is a good price to buy the stock at, you are buying a stock that the market can’t wait to get rid off. You will not have any trouble at all executing your buy.
- The price is low, the volume is miniscule (“Nobody cares”) – Liquidity often dries up when all the sellers have sold. At a certain point, there may be interested buyers but very few sellers. Investors who currently own the stock have either bought lower recently, or are not interested in selling because they share your investment thesis. Often, the stock just drifts along and there is not much interest in the market for this stock. If you are confident in your valuation thesis, this is the best time to buy the stock.
In either case, when you decide to buy, fix the price you want to pay and then set a limit order and keep it open until the order fills. In the first case, the limit order protects you from wild swings. In the second case, you set the limit order (GTC) as it might take a long time for the market maker to accumulate enough stock at your price to make a trade. Please note that other interested buyers are doing the same thing, but time is certainly on your side and patience is your greatest virtue.
How to Deal with Lack of Liquidity when Selling the Stock?
Once you have purchased the stock for value, there are only two possible reasons why you would sell.
- Price has risen to reflect the value and you are harvesting your gains – In majority of the cases when this happens, you will find that the liquidity of the stock has greatly improved. This being a small cap stock, it has now been discovered, articles are being written about the stock and the investors are rushing in. Perhaps an analyst or two have started coverage as well. Selling is not a problem at all since you are selling the stock that the market can’t wait to take off your hands.
- You have found better uses for your money – Perhaps a better stock, or you may have determined due to some reason that cash is a better investment than this stock. If the liquidity is still low, you will just have to execute your sell order patiently over time, similar to when you purchased the stock.
What is Good Liquidity for a Stock?
The answer to this question is highly personal to your situation. If you are a small retail investor, you want enough liquidity so you can complete your transactions within a few days without an undue impact on the stock price. You also want to drip your transactions out slowly so as to not signal to other market participants. Depending on how many shares you are transacting, your definition of good liquidity for that stock may vary.
I personally want the weekly volume in any stock to be higher than the number of shares I am looking to transact. I don’t expect to complete my transaction in less than a week for a low liquidity stock, but if it does finish quickly, it would not “make the market”, so to speak.
If you exercise requisite diligence in making an investment thesis, you will find that lack of liquidity, while real, is hardly ever a problem, since most of the time you are doing the opposite of what the market is doing. On the contrary, with patience, you can get a better bargain then you can for a highly liquid stock. Less liquid stocks tend to be the best stock picks, precisely because very few eyes are trained on them.
Reference: When Less Liquidity Means More