How to buy low-liq­uid­ity stocks

In most cases, Si­mon Brown just stays away from very small stocks. But for those brave enough to take the plunge, he pro­vides some help­ful tips on build­ing a po­si­tion in low-liq­uid­ity stocks.

Finweek English Edition - - MARKETPLACE INVEST DIY - Ed­i­to­rial@fin­

iwrote 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 lowliq­uid­ity 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 pri­va­tee­quity-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.

With small, low-liq­uid­ity JSE stocks we need to be pre­pared to pay up when buy­ing and be pre­pared to hold for many years.

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