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.
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