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Be wary of liquidity in small, mid caps

Andrew Doherty  |  30 Mar 2009Text size  Decrease  Increase  |  
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Investors should be aware of the liquidity of shares ahead of any investment. This is an issue of great importance during the current bear market. Liquidity has dropped away dramatically, particularly among smaller stocks, adding to risks and potentially reducing investment returns. Here we define what liquidity is, discuss methods to test for liquidity and look at the impact the bear market has had.

Liquidity is the ease with which an asset can be bought or sold without shifting its price. The higher the volume of trading activity, the greater the liquidity. Liquid assets can be easily bought or sold. Listed shares in general are more liquid than assets like houses, cars and antiques that are characteristically illiquid. However, there are degrees of liquidity in the share market that investors need to be wary of.

Less liquid stocks are more risky than others. The market price will tend to be more volatile because there are fewer market participants willing to purchase or sell the shares, and fewer trades. Buyers push the price up and sellers push the price down. There will be greater spread between the price at which buyers would like to buy and sellers would like to sell. This "buy/sell spread" is a cost to the investor, often a more significant cost than brokerage, and can significantly reduce the realisable return on a trade. The costs are even greater during times of market turmoil when there is an imbalance between the number of buyers and sellers. Sale of illiquid shares may not be possible at all, or only at the cost of a lot of money.

Liquidity is driven by the number and volume of buys and sells. Large cap stocks tend to be highly liquid. They have many buyers and sellers trading actively throughout each day. Activity in small- to mid-caps will be more limited. Liquidity can be a substantial problem at this end of the market.

Investors shouldn't have a high proportion of their portfolio in stocks with liquidity concerns. Depending on their risk tolerance, they may choose to avoid less liquid securities altogether. Those that choose to go ahead with an investment should be patient and choose the buy or sell price carefully. This price should be instructed to the stockbroker executing the transaction. It may also be wise to transact in smaller lots to limit the impact on the share price. Illiquid shares cannot be sold quickly.


Tips to judge liquidity

Liquidity information is available from your broker and is also published on a number of investment information websites. Investors should examine the following numbers carefully, particularly for small companies.

The buy/sell spread, also known as the bid/ask spread, is an important indicator of the liquidity of a stock. It can be calculated as the average percentage difference between the last bid and ask price each day over a certain period, say a year. Typically, large-cap stocks trade on low spreads, usually less than 1 per cent. Smaller companies can sometimes trade on much higher percentages.

Turnover is the average number of shares traded per year as a percentage of total shares outstanding. Turnover provides an indication of the liquidity of a stock and the general level of interest in a company's shares. Turnover is usually higher in large-cap stocks, with a significant degree of institutional shareholders trading in large volumes. Turnover tends to be around 100 per cent of issued shares each year for larger companies, but well below that for smaller stocks.

Look also at average trading volumes to be sure the size of trade you anticipate seeking will be well covered by regular activity.

Top 20 shareholder ownership represents the percentage of the company's stock held by the 20 largest shareholders. It can provide an indication of a company's liquidity. A high figure will often mean there is less stock available for trading. Top 20 shareholders tend to own 60-70 per cent of company shares on average, both in large and small caps.


Liquidity and the bear market

Smaller cap liquidity has dried up during the bear market to a far greater extent than in large caps. Average turnover among large caps in the S&P/ASX100 index increased from 98 per cent to 118 per cent between 2007 and 2008 as investors shifted portfolio positions. Turnover has declined modestly so far this year to 104 per cent as many investors stayed away from the market. Large cap average buy/sell spreads have marginally increased from 0.4 per cent to 0.5 per cent since 2007.

Investors have left the smaller-cap space in more dramatic fashion. Average turnover among stocks outside the S&P/ASX100 dropped from 48 per cent in 2007 to 23 per cent in 2008. Turnover of 10 per cent this year is tiny. Smaller cap average buy/sell spreads rose from 4.1 per cent in 2007 to 9.8 per cent in 2008, then to as wide as 13.7 per cent so far this year.

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