Is Illiquidity Bad?

Foreword from ShareInvestor

This article “Is Illiquidity Bad??” by Cai HaoXiang was first published in The Business Times on 09 Mar 2015 and is reproduced in this blog in its entirety.

In a costly blue chip market, investors willing to do research should check out listed SMEs

An illiquid stock, to paraphrase a conversation I once had with a value fund manager, could be a nice girl next door. She may not be interested in dating now, but does that mean she is not marriage material?

While other markets now seem more exciting, there are a number of relatively illiquid, small-sized stocks in the Singapore market that might still be intriguing buys.

These companies trade at relatively cheap valuation metrics when compared to their larger peers. For example, they are valued at five times earnings. Or they might be valued at a discount to their book value.

These stocks tend to be manufacturers, traders and distributors. Some have been boosting their dividend payouts recently on improving results.

These counters are more like small to medium-sized enterprises (SMEs) than full-fledged corporates. Investors who enter these companies will face a different set of risks.

Over the past year, I have been dipping my toes into this market, nudged along by what I see as expensive valuations among defensive blue chip stocks that might not be justified if and when the global economy picks up. Dividend yields of 5 to 8 per cent among these SMEs also don’t hurt.

You can hunt up some of these businesses yourself by going to the Singapore Exchange (SGX) website and using the StockFacts screener to screen for high-dividend or low earnings-multiple stocks around the S$100-500 million market cap range.

These can be risky investments, so some diversification is advisable. I prefer companies with long operating histories and a track record of profits and growing shareholder value, without having to raise capital from shareholders too often.

Sometimes, we put off buying these stocks because of sheer inertia. We think they are too risky and don’t put in the effort to do our own research. And even when we do, we tell ourselves these stocks must be cheap for a reason.

Some of these reasons are justified. Indeed, some are value traps. The stereotypically super-cheap company is a China company with a large amount of cash and a growing amount of receivables. Some of these trade at just a fifth of their net asset value. These are big red flags.

Sometimes, the reasons we give ourselves might just be excuses. We examine some below.

Liquidity

Due to a lack of interest, a small amount held by outsiders, or existing investors not willing to trade, the stock might be illiquid. This means it is not traded often, and not much gets traded even if it gets traded.

In some of these stocks, shares worth just thousands or tens of thousands of dollars trade every day. You might be the only person buying the stock that day should you make a purchase.

It might be easy to build up a position, but good luck to you should you decide to sell. If you are desperate enough to sell, you will have to lower your selling price to entice other investors to buy your shares.

Because it might not be as easy for investors to unload their positions, valuations stay depressed. Yet, the liquidity reason is not sufficient enough a reason for a long-term retail investor to stay away from a stock.

If your holding period is 10 years or longer, you don’t need to worry about having to unload your stake quickly. You can be happily compensated for the “liquidity premium” attached to these stocks.

If your investment amount is just a few thousand dollars, you are more likely to be able to sell the stock in a day should you decide to do so.

But if your position is a few hundred thousand or more, it will be far more difficult to unload your stake.

Size

These stocks tend to be smaller enterprises, in terms of the profits they earn.

Small companies tend to be riskier especially if they have a short operating history. Without the time needed to build up relationships with customers and suppliers, they are vulnerable to business climate shifts.

If they depend on bank financing, they might be left adrift during a downturn.

Yet small companies also have the potential to grow significantly in value. This can come from breaking successfully into a new market, being lifted up by a rising tide if their industry is booming, or being acquired by a competitor.

If you cannot sleep at night because you are worried that the stock might go bankrupt, then the stock is not for you.

But if you see that the company has survived past recessions, and is generating a reasonable amount of cash every year over their investing requirements, then you might be more comfortable holding it.

Key Man Risk

For SMEs, much of their fate depends on the founder, who is usually the CEO as well as the chairman of the board.

If the founder is not around any more for whatever reason, the business might lose its direction.

If the founder is corrupt or dishonest, investors might lose all their money. Yet we should not scare ourselves silly. Many businesses are designed to carry on even though the CEO is no longer around to drive it. Any CEO worth his salt will have put in a succession plan.

Some SMEs, both listed and unlisted have been professionalising their operations. Others get help from the government through various grants.

When a founder is gone, the business might also be targeted by private equity funds which previously could not gain any headway in acquiring the firm because the founder was insistent on holding on to his stake.

Going For Sustainable Dividends Is Easier Said Than Done

For these stocks, the market may ignore them for a long time until something happens, like a merger and acquisition deal, a privatisation, or the compounding of good results until the stock becomes simply too cheap to ignore. Only then will you have a liquidity explosion, along with a stock price surge. Yet it can be many years before the investor sees some value getting realized.

For me, it is not worth getting into these stocks unless they offer a sufficiently sustainable dividend yield to compensate me for the time I’m holding it.

Yet dividends are not everything. There’s a balance to be struck between paying dividends and reinvesting business earnings.

After investing in equipment, warehouses or machinery necessary for their business, the ideal company espoused by value investors has cash to spare every year.

Unfortunately, it is difficult to find these companies on SGX.

A number of small-cap stocks on SGX are local electrical component traders and distributors with heavy financing requirements and volatile earnings. Or they could be small construction firms with lumpy cashflows and long periods of investing and taking on debt before their projects are sold.

You can recognise trading companies easily. Their net profit margins tend to be very small. They also tend to have large movements in their working capital – receivables, payables and inventories – as well as cash flows from financing such as short-term debt due to banks.

On their balance sheet, they tend to hold a large amount of short-term debt relative to their equity.

All these are indicators a value investor might baulk at. Yet, at current valuations and yields, some of these businesses are arguably worth a look.

But you need a strong stomach.

You might think a 15 per cent discount to book is cheap. What if that widens to 25 per cent, 30 per cent, 50 per cent? You might be sitting on huge unrealised losses.

What if it takes 20 years before the market recognises the value of these stocks?

What if yields are not sustainable? Check out the dividend payment histories of some of these companies and you’ll find that payouts fluctuate with the business cycle.

On the flip side, if yields are sustainable, you might make back your original investment from the dividends alone. These companies will be recognised by the market. The longer that takes, the more power for you, because you can keep reinvesting.

In the small-cap world, markets are not efficient. And therein lies opportunity.

Finding the right stock is like finding the right partner. You have to get out there, get your feet wet, and learn some lessons along the way.

However, there is a major difference: falling in love with a single stock is dangerous. Date a few at the same time.