Thursday 13 September 2012

Is Liquidity Important?

Very Good article…..
Is Liquidity Important?
Real-estate markets all over the world have one common characteristic; they are highly illiquid. It takes, on average, many weeks to buy or sell a piece of real estate and in many cases several months. Yet, the illiquidity of real-estate markets world-wide has not prevented long-term investors from becoming very wealthy. By and large, real estate investors all over the world have become rich simply by following this advice that Henry George gave more than hundred yeas ago:
"Go, get yourself a piece of ground, and hold possession... You need do nothing more. You may sit down and smoke your pipe; you may lie around like the lazzaroni of Naples or the leperos of Mexico; you may go up in a balloon, or down a hole in the ground and without doing one stroke of work, without adding one iota to the wealth of the community, in ten years you will be rich."

The Fetish of Liquidity
If illiquid, but sound, real-estate investments have made people rich, should the same rule not apply to the stock market? Why is it that when it comes to investing in the stockmarket, most investors give undue importance to liquidity? In 1936, John Maynard Keynes wrote the following words in his classic work, "The General Theory of Employment, Interest and Money": "Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investors to concentrate their resources upon the holding of "liquid" securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.... The actual, private object of the most skilled investment today is "to beat the gun", as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half crown to the other fellow."

As Keynes said, there is no such thing as liquidity for the community as a whole. When everyone lines up on the same side of a trade, the liquidity that many had relied upon in making their investments proves to be an illusion. Suppose, tomorrow if only 10% of Rs 40,000 crores in Indian stocks are suddenly offered for sale, who will buy them?

Liquidity is very important for the speculator who, when the market falls, wants, as Keynes put it, "to pass the bad, or depreciating, half crown to the other fellow." For, it is only the speculator who usually needs to liquidate his commitments in a hurry. The long-term investor, on the other hand, is not likely to be in a hurry to sell or to buy his stocks. For him, liquidity is not so important. To quote Warren Buffett: "After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% ownership of See's or H.H. Brown to validate our well being. Why, then, should we need a quote on our 7% ownership of Coke?"

Liquidity Vs Value
Other things being equal, it is obviously better to own a liquid security than one with a poor market. But a problem arises when value must be sacrificed in favour of liquidity. The specific question is whether the investor should avoid an otherwise attractive issue because it is relatively illiquid. The logical answer is no. Extraordinary bargains are more likely to arise in relatively illiquid stocks than in highly liquid stocks.

If, at any given point of time, millions of investors and speculators are focusing their attention on a handful of heavily traded securities, chances are low that an investor with a long-term focus will findvalue. On the other hand, if nobody is spending any time and effort researching companies simply because their stocks are illiquid, chances are high that bargains will emerge in such securities. Therefore, it is better to sacrifice liquidity in favour of attractive value rather then vice versa.
It is not necessary to invest in highly liquid securities in the stockmarket to achieve satisfactory long-term results. In fact, the reverse is more true; of the total number of companies that have created substantial wealth for their shareholders, a large proportion have relatively illiquid stocks.

Berkshire Hathaway, Warren Buffett's investment vehicle, is a Fortune 500 company. Even so, the company's shares are one of the most illiquid large company stocks traded on the New York Stock Exchange. However, the illiquidity of the stock has not prevented Berkshire's long-term shareholders from becoming enormously rich. Over the last 31 years, Berkshire's per-share book value has grown from $19 to $14,426. The market price has grown from somewhat less than $19 to more than $35,000 per share.

Madras Cements Limited is an example of an Indian company that has made its long-term shareholders very rich. An investor who invested one lac rupees in this company in 1990 has seen the value of his investment go up to 87 lac rupees currently. Madras Cement is one of the most illiquid large Indian company stocks.
Another noteworthy fact about liquidity is that the most liquid stocks seldom prove to be superior long-term investments. Take the example of two of India's most liquid stocks - Reliance Industries and Tisco. Both companies have earned mediocre stockmarket returns for their long-term investors compared to many other companies who have done far better, in spite of having relatively illiquid stocks. Again, this is not just an Indian phenomenon, but an international one. The stock of General Motors in the U.S is one of the most liquid securities traded on the New York Stock Exchange but long-term returns for GM shareholders have been dismal.

Note that I am not saying that all liquid stocks are bad investments. Rather, I am saying that a disproportionately large number of wealth destroying companies happen to have highly liquid stocks and a disproportionately large number of wealth creating companies have relatively illiquid stocks.

Why Broking community Love Liquidity

Stock market brokers love liquidity. Why? Benjamin Graham answered this question several decades ago. He wrote: "Much of the emphasis on liquidity emanates from the stock brokerage business. This is readily understandable. Brokers are in the business to earn commissions. It is easier to get orders and to execute them in active rather than inactive stocks. Market traders, who have always supplied the bulk of brokerage commissions, concentrate their interest on the active issues. This bread-and-butter situation has an important and not too favourable impact upon the profession of security analysis as it is practised by members of brokerage-house staffs. They are likely to overemphasise the popular and active issues in their work, and to slur over the values presented by less liquid issues."

It is vital for investors to understand that what's in the interest of brokers is not necessarily in the interest of the investors. Warren Buffett is another outstanding investor who has, over the years, ridiculed the entire concept of the emphasis placed on stockmarket liquidity. Here are two of his quotes on the subject: "One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as "marketability" and "liquidity," sing the praises of companies with high share turnover (those who cannot fill your pocket will confidently fill your ear). But investors should understand that what is good for the croupier is not good for the customer. A hyperactive market is the pickpocket of enterprise." "Brokers, understandably, love client hyperactivity: Wall Street's income depends upon how often prescriptions are changed, not upon the efficacy of the medicine."

The Cost of Liquidity

Liquidity does not come for free. It carries a very high cost that is borne by investors, in aggregate. Warren Buffett once explained in detail how much do investors end up paying to achieve a highly liquid stockmarket. Here is what he said in 1984:
"Consider a typical company earning, say, 12% on net worth. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be higher on low-priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business and means that 1/6 of them are lost to the owners through the "frictional" cost of transfer.

All that makes for a rather expensive game of musical chairs. Can you imagine the agonised cry that would arise if a governmental unit were to impose a new 16.67% tax on earnings of companies or investors? By market activity, investors can impose upon themselves the equivalent of such a tax. Days when the market trades 100 million shares are a curse for owners, not a blessing - for they mean that owners are paying twice as much to change chairs as they are on a 50-million-share day. If 100-millionshare days persist for a year and the average cost on each purchase or sale is 15 cent a share, the chair changing tax for investors in aggregate would total about $7.5 billion - an amount roughly equal to the combined 1982 profits of Exxon, General Motors, Mobil and Texaco, the four largest companies in the Fortune 500.

These companies had a combined net worth of $75 billion at yearend 1982 and accounted for over 12% of both net worth and net income of the entire Fortune 500 list. Under our assumption investors, in aggregate, every year forfeit all earning from this staggering sum of capital merely to satisfy their penchant for "financial flip-flopping". In addition, investment management fees of $2 billion annually - some spade for chair-changing advice - require the forfeiture by investors of all earnings of the five largest banking organisations. These expensive activities may decide who eats the pie but they don't enlarge it."

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