HIGH RISK HIGH REWARD GAMES
People often ask me about what is wrong in investing in small company stocks? By small, I mean ‘small’ in terms of market capitalisation. Market capitalisation is the price of each share multiplied by the number of shares issued. For example, as of close of 22nd July 2014, the Bombay Stock Exchange had 3,232 scrips that were ‘traded’ (or where a price was available). The total market capitalisation of these companies was Rs.91,02,473 crores if we used the closing prices of that date. Interestingly, the 100 largest companies accounted for Rs.67,81,963 crores. In other words, three percent of the number of companies accounted for nearly three fourths of the size of the market!
Why does liquidity in a stock matter? Liquidity has a direct impact on the tradable prices of a share. You may assume that once you see a price on the exchange, you can buy or sell reasonable quantity of the stock at that price. Nothing could be farther from the truth, if the stock is not liquid. Less than a hundred stocks will meet that qualification.
What would be a reasonable quantity? For a FII it could be a million dollars ( or Rs.6 crores), for a domestic mutual fund it could be around Rs.50 lakh and for an individual it could be, say, a lakh of rupees. So, can one buy or sell ‘reasonable’ quantity of a stock at the indicated price? If the answer is positive, then you could say that the stock is ‘liquid’. Most often, if you exclude the top fifty stocks, the price you pay/receive will not be what is quoted on the screen. You will end up paying a higher price if you are a buyer and get a lower price if you are a seller. That is the ‘impact’ cost of your trade. The poorer the liquidity, the higher the impact cost of your trade.
So, if you are trading for a few rupees, this hurts you badly. So you will see that the day traders generally flock to the large liquid scrips. Poor liquidity is also the reason why it is easier to manipulate prices in smaller company stocks. A large buying by a group of seemingly unconnected people is sufficient to drive prices higher and higher, when the stock is illiquid. Often, the smart operator first accumulates a stock, then issues a recommendation to buy and provides supplies at gradually increasing prices. Once someone creates a buzz in a stock, the price of such a stock moves with huge jumps making each buy more and more expensive.
The negative side is that when the sentiment turns against the stock, the bottom seems to fall out of the stock. The stock keeps hitting the lower circuits with not much volume and we could get stuck with a stock where stop losses and sells do not work. All theories go out of the window, when such a fall happens.
Thus, if you decide to buy or sell a stock that is not liquid, you have to plan for properly. You cannot invest or trade in this for a small return like ten percent. The impact cost of buying and selling could easily take away ten percent! Probably you will have to buy early and sell early also. You cannot wait to sell at the highest possible price because if the selling starts, you will be unable to execute a trade except at a huge disadvantage.
The tough part is that if you are seeking big winners, they are hidden within this group. The large well known names may offer you average to above average returns, but if you want a kicker, it would be from this universe of illiquid stocks. Thus, I would not ignore this space. However, I will also not put all my money in this space. And keep looking for longer term buy and hold stocks.
In a bear market, this illiquid segment becomes very illiquid and as sentiments keep improving, volumes in this segment keep getting better. As a contrarian, it makes sense to buy illiquid stocks when the bottom is falling off the market and sell when everyone wants to buy. As far as I am concerned, it is a good time to get rid of some of these stocks.
(This article appears in today's Asian Age/Deccan Chronicle)