Aswath Damodaran has a post titled "Asset Selection and Valuation in Illiquid Markets." It’s a fine theoretical discussion of the subject. But I’d like to talk about practical illiquidity. What does illiquidity have to do with stock picking?
Let’s start with the big question: Should you apply an illiquidity discount to specific stocks?
The answer is no.
My view of illiquidity discounts is basically Warren Buffett’s view of using risk based discount rates. Risk isn’t something you account for in the last step of the process. Risk is something you think about every step along the way. The same is true with illiquidity.
You start by asking, is it safe to hold this stock forever? Can I afford to get locked into this stock?
That means you check the stock’s vital signs. What’s the Z-Score and the F-Score? How is the balance sheet? Does it have 10 straight years of positive free cash flow? Does it have minimal cap-ex requirements? Has it earned an above average return on tangible capital over the last 10 or 15 years?
Then you can afford to hold the stock forever. The downside risk of getting locked in the stock is not catastrophic. The stock is safe in the sense that the business itself isn’t going to implode and the intrinsic value isn’t likely to decline over time. At worst, it’s a big time suck. But, if you buy at the right price, you’re risking your opportunity cost instead of your principal.
Next, you calculate if it’s possible to get in and out of the stock. If you’re a patient, individual investor the answer is almost always yes. Even if we take a very illiquid stock like one that on average trades shares worth $5,000 each day, that’s usually enough for an individual investor to make a long-term investment in the stock.
Here’s why: A stock that trades $5,000 a day trades $100,000 a month (if a month is 20 trading days).
Charlie Munger mentioned that Berkshire Hathaway (BRK.B) bought 30-40% of the daily trading volume in Coca-Cola (KO) when it amassed its stake. Buying micro-caps, I’ve often bought even more than 40% of a stock’s volume. In several cases, I never paid a cent more for any of my shares than the last price the stock traded at before I started buying. Weird, huh? But totally true. It doesn’t always work that way. Obviously if I’d tried to force it and buy the amount I wanted without regard to price, that’s not what would’ve happened. Instead, I just sat at the same bid for weeks and took whatever shares came down to that price.
I should point out that sometimes it works differently. Sometimes you get your shares the way Berkshire Hathaway got its investment in the Washington Post (WPO). Berkshire got virtually all its stock in the Washington Post from just 4 or 5 large investors. It happened very fast. I’ve had that happen too. I go in expecting to be buying for a month, and then in just a couple trades over 1 or 2 days my entire order is suddenly filled with 20 or 30 times the stock’s normal volume.
The truth is that with micro-caps there is no such thing as normal volume. There’s just an arithmetic average. But no one said the mean is the mode. If you look at the day-to-day numbers, you see the volume comes in droughts and floods. Just make sure you have your bucket out when it rains. So, you have to head into an illiquid stock with the idea that you aren’t going to trade it. You’re just going to collect it. It isn’t a commodity. It’s a piece of art. That’s the attitude going in.
If we take a very conservative estimate on that hypothetical stock that trades $5,000 a day and say you can only buy 20% of the volume, that would mean sinking $20,000 a month or $60,000 a quarter into the stock. For most individual investors, $20,000 is more money than they’re adding to their investable savings each month. So, for individual investors who are willing to spend weeks and months buying a stock, there’s really no limit to how illiquid you can go.
But how illiquid should you go?
My advice here is that for a true Buffett and Graham type stock picker, there’s absolutely no limit to how illiquid you can go in terms of individual stocks. There is, however, always a limit to how illiquid you should make your entire balance sheet.
These are really two completely different questions. An illiquid balance sheet is dangerous. An illiquid security on a liquid balance sheet is often just a good investment. And that’s my biggest problem with using illiquidity discounts. From an investor’s perspective, illiquidity is not a security specific threat, it’s a system wide threat.
Your entire financial life should be organized in a way that lets you buy illiquid stocks. That means you never, never, never put money into a brokerage account you may need anytime soon. And anytime soon means the next 3-5 years. I’m not kidding about this.
A “safe” security you can’t hold beyond 5 years isn’t an investment anymore, because you’ve gutted the margin of safety. In stocks, the margin of safety is the combination of intrinsic value and time. How long you actually hold a stock isn’t important. What’s important is how long you can hold a stock if you keep getting ridiculously low offers for it.
Remember, Berkshire Hathaway was ready to take on Long-Term Capital's portfolio. Buffett felt the investments were sound if they were on someone else's balance sheet. But they needed to be held by someone who had the ability to hold them into somebody offered a fair price for them. Long-Term didn't have that luxury.
Volatility doesn't matter. Having the ability to hold an investment is what matters. This is part of the reason I don’t think stock pickers should own bonds. I think defensive (non-enterprising) investors are fine mixing stocks and bonds the way Ben Graham suggested (25-75% in each) as valuations fluctuate. But I don’t think stock pickers should hold other assets just to reduce volatility. If you want less volatility, hold some cash.
You should buy bonds because you actually want to own some bonds. Not because you want the market value of your portfolio to bounce around a bit more or a bit less. By the way, mixing some illiquid stocks into an otherwise liquid stock portfolio will often make your portfolio less bouncy rather than more bouncy.
I don’t worry about beta here. And I don’t think you should either. You should buy an illiquid stock because you want to own the business. And you can’t find any businesses of comparable quality at anywhere near comparable prices among liquid stocks. That’s the only good reason to own an illiquid stock.
What about the risks of illiquidy?
You always look at liquidity from an entity wide perspective. In this case, you are the entity. And your obligations (like a mortgage) are part of the calculus, as is your employment situation, and your bank account, and your brokerage account.
Applying illiquidity discounts to individual stocks doesn’t make much sense. It’s extremely arbitrary. Especially since I’ve found you often get cashed out of these situations through buyouts. Each year, I find about 20% of my portfolio gets bought out. As a result, I’ve often ended up selling an illiquid position not to another outside investor in the stock – like me – but to someone who was paying for control of the whole company.
And dividends come in the form of cash regardless of whether you get them from a liquid or illiquid stock. I’ve talked about illiquid stocks on this blog that yield 3% to 5%. That’s at least half the expected return in the super liquid S&P 500. And that 3% to 5% comes in cash, which is the most liquid asset of all.
If you add returns from buyout premiums and dividends together it's a pretty big number. And none of it has anything to do with illiquidity. Dividends are paid in cash. And buyout premiums are paid by control investors, not people who buy and sell on a stock exchange. So, you always want to look at what liquidity means to you.
Do you need liquidity?
If so, you can’t buy that lovely micro-cap regardless of the price. But if you’ve structured your personal financial situation so you don’t need any liquidity from your stock portfolio – which is how every individual investor should structure things – you can buy as many illiquid stocks as you want. For each illiquid stock, all you need to do is a series of calculations on how fast the intrinsic value of the business is growing or decaying and how long you can afford to hold the stock.
In one extreme example, I calculated what would happen if I was stuck in a particular stock for 10 years and the business did worse than usual. The answer? I’d probably match the market. That was the downside risk of illiquidity. The upside, of course, is that something would happen in within 10 years to unlock the value.
In my experience, it almost always does. It’s hard to know what that something will be and when that something will come. But if you can afford to be stuck in a stock for 5 or 10 years, you’ll almost always find the price and intrinsic value meet somewhere along the way. And it's usually a lot faster than 5 or 10 years. If you want to emulate early Warren Buffett and Benjamin Graham, illiquid stocks are the place to be.
By the way, I think illiquid stocks are the best training ground for new value investors, because you see Ben Graham’s Mr. Market metaphor so clearly in these stocks. You realize that a price move up or down 6% isn’t a market signal, it’s just two guys trading some shares.
Finally, something I can’t stress enough is that you have to take illiquid stocks seriously. You have to evaluate them as pieces of a business. You have to do all the Warren Buffett and Ben Graham basics. You can’t think of them as play money. For some bizarre reason, I know a lot of folks who think they’ll put their "real" money into Microsoft (MSFT) and Kimberly Clark (KMB) and then their "play" money into Birner Dental (BDMS). It doesn’t work that way. Liquid and illiquid stocks aren’t two different arenas for you to play in. You evaluate each of them the same way. You judge each stock against all your alternatives.
You can’t speculate. Not even a little bit. Not even in illiquid stocks. And that’s what’s so weird about this perverse desire to speculate in illiquid stocks. I can show you long lists of illiquid stocks that have wonderful 10 and 15 year records. The notion that Microsoft is something you keep and Birner is something you flip gets no support from the past record.
Ben Graham and Warren Buffett didn’t discriminate against illiquid stocks. And Charlie Munger will tell you the best markets to operate in are the most inefficient markets. You can find some tremendous inefficiencies in illiquid stocks.
Some people can’t stand being out of stocks where you know you'll get to see a tick every day. And that’s fine. Illiquid stocks aren’t for folks like that. But for folks who consider themselves more business analysts than stock traders, illiquid stocks are the best place to be.