Tuesday, March 31, 2015

Liquidity - Paying a Price for Immediacy

I've been following the latest letters from Howard Marks of Oaktree for some time now. It has been truly amazing given the amount of wisdom inputs I have received from this guy just by reading some of his letters. For those who has never read any of his letters previously, I would strongly recommend you to give it a try because I assure you will get something out of it. Nothing out of extraordinary if you don't read it but I think it'll help anyway, at least for me.

Anyway, Howard has published his latest recent letters on the topics of Liquidity. I'll be sort of summarizing them below and providing some thoughts on it myself which hopefully will help you get interested in his past and future works.

Debates on the Definition of Liquidity

For a start, we begin by defining our understanding on Liquidity. If you ask your friends around you on the definition of liquidity, they probably reply that of something (an asset) that is readily saleable or marketable. However, Howard thinks that it is more than that. He thinks that liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price (emphasis added). The key here is not simply the question of whether the timing or the availability of selling the asset itself but rather whether one can sell the asset at a price equal or close to the last price stated.

If you pause and think about it for a moment, it makes rather sense. An asset isn't usually liquid or illiquid by its nature. Liquidity is ephemeral, it can come and go according to a number of factors.

Take the case for our local property residential development for instance which everyone can relate to. Since the government introduces a couple of cooling measures for purchasing properties, liquidity has somewhat dries up in recent years. The reason for this is simple. The measures are put in place to slow down the rising trend of property price in recent years. Since there is essentially a ceiling to which the asset can grow further, there will be more sellers than buyers at this point in time. If you find yourself cash-strapped as a seller in the midst of this crunch hustle, then the asset is deemed to be illiquid to you.

The opposite is also somewhat true. During the property boom cycle, the nature of the asset itself is liquid from a seller's point of view. When you have demand flocking from all angles queueing up to purchase the asset, it is said to be a liquid transaction. I understand that at this point some may think that the property is ultimately still an illiquid asset no matter what the case is, but that's because you are comparing them against other assets relatively in a different situations.

For instance, the stock market is deemed to be a relatively liquid system where one can purchase or sell a stock as quickly as at a press of a button. If you think about the logic behind it, the liquidity for the stock market is very much a function of the quantity involved. If you are trading a blue chip counter like Capitaland or Keppel Corp, then I assure that liquidity is not a problem itself and one can buy or sell the stock based on the latest bidding price determined by the market. However, if you are trying to trade a counter with an extremely low free floating shares around, then buying and selling could become a problem. Heck, I even took a few weeks to get my bid price settled for Noel, a counter I am vested recently which I have blogged here.


Everyone knows the idea behind Contrarianism.

You buy low and sell high. You don't buy high and sell higher. That's not contrarianism. What is low and high is subjective of course, which is why an efficacy system of market exists in the first place. However, there's one indisputable explanation for why the market went up on any given day and that's because there's more buyers than sellers. When buyers feel the urgency more than sellers to transact on that particular day, the action drives the stock price upwards. Under those circumstances, sellers enjoy great liquidity and buyers have to pay a premium for the price in most cases.

This is the very same reason why some of the great investors around are advocating Value Investing. You buy when there are bloods on the street (everyone is fearing) and sell when there is party poops lying on the mainstreet. Okay fine, I made the last part out myself. What Howard is trying to say is basically in order to achieve immediacy, the sellers tend to sacrifice something else that is equally as important: Price (having to replace the "liquidity" factor for price). And as a buyer, the price discount that they accept makes an important contribution to the bargain hunter's excess return.

The Promise for Liquidity

According to Howard, one of his standing rules is that no investment vehicle should promise greater liquidity than what is afforded by its underlying assets.

If you ever encounter a salesperson that tries to talk to you and give promises in that manner, an investor should reflect and ask oneself what would be the source of that liquidity. Because if there are no such sources, the incremental liquidity is usually illusory, fleeting and unreliable. This is known as a Ponzi scheme as some of you may have heard of and the system gets exposed when markets freezed up or when the promise for liquidity is tested through in tough times.

Liquidity is a good thing (everything else being equal) and Illiquidity is not necessarily a bad thing. What we need to remember is that liquidity isn't free. It usually comes at a cost and in the form of return foregone if the situational itself is not going in your favor.

Sizing one's portfolio based on the nature of the asset itself is a good start before going situational, which is a form of unsystematic risk that we cannot control. When situational consequences come in the form of a recession, things do change pretty rapidly and even the stock market, which an investor deemed to be liquid in nature, may seem to be "illiquid" at such times when they had to replace the liquidity factor with a price foregone.

Final Thoughts

Looking back at where we are now, it is pretty obvious that we are in a situation where many of the major central banks are pumping in liquidity in the form of easy monetary policies. When you have liquid assets circulating around the global market like what we have now, what we are going to get is an increased value of assets or a bubble until it pops out and it goes back to the norm.

The bottom line is pretty clear. Liquidity can be transient and paradoxical. It is plentiful when you don't require any attention from it but scarce when you need it most. Given the way it comes and goes quickly based on situational, it is dangerous to assume that the liquidity that is available in good times will still be there when the tide goes out.

According to Howard, the worst thing that an investor can do against illiquidity is to:

  • Employ trading strategies under which an investor buys things by thinking how it would perform in the short run, not what they'll be worth in the long run.
  • Being focused on what the market says your assets are worth, not what your analysis shows them to be worth.
  • Buying with leverage that exposes you to the risk of a margin call in a declining market.

With that, I'll leave you to ponder around on the topics on liquidity and hope it'll give you better insights on how you should be approaching your investment towards the efficacy topics on liquidity.


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  2. Great article Brian! Now I start to see liquidity in a different light. Howard Marks and Oaktree memos seems very popular in the value investing community. I think I should start following it too.

    1. Hi BfGf

      Thanks for your kind comment.

      Yes, you should definitely start reading his memos. He has a book called The Most Important Thing written by him and it's basically a summary of his past memos lumped together under one. Definitely great piece of wisdom.

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