Last Updated on Aug 2, 2023 by Anjali Chourasiya
A few days back, one of my friends made 40% on a stock, and he allocated 60% of his portfolio there and still couldn’t get his profit. No, it wasn’t the fault of the broker or any other market intermediary. He was at fault for investing a huge chunk of his portfolio in an illiquid stock. Seems unrealistic, right? But that’s the sad part ☹.
So firstly, let’s understand one of the most unacknowledged factors while investing, liquidity.
In simple language, if you can buy or sell a stock or any security without affecting the price of that particular stock or security, then it’s said to be liquid. For example, if you start buying a stock at Rs. 20 and because of your buying, the stock runs up to Rs. 32 due to the less float (quantity of shares available for trading) of a stock. Now, in this case, the stock is said to be liquid.
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Misconceptions around liquidity
There are some misconceptions about liquidity and liquid stocks. Let’s have a look at them.
If I buy an Illiquid stock, my returns would be much more than the market.
Lots of my friends and people I know commit this error of buying stocks that are cheap and are hitting upper circuits (This means the supply for the shares is less than the demand). Little do they know what’s happening, and most of the time burn their hands here. A stock can hit the upper circuit because of the low supply of the stock. In such illiquid scripts, it’s very easy for a group of operators to rig up stock prices. When this happens, most of the retail investors flock up on that share, and the price hits upper circuits. Remember a person who rigged up the price so much when they sell the price would drop that quickly.
An Illiquid stock is a bad investment.
Some great businesses have their share listed, and they are illiquid. So it doesn’t mean if the stock is illiquid, then you won’t study the business. In some cases, big chunks, even about 75% (According to the MPS norms, promoters can’t have more than 75% of their company), but even if 25% is available for the public, which includes institutions as well so those shares also don’t come out frequently for trading so that also impacts liquidity.
Liquidity can be ignored when it’s a good business.
I agree you can be in situations where you have found the best of the best businesses, but the float is really low. Now, in this case, you can buy the stock, but the weightage on the overall portfolio should be in the lower single digits because liquidity is a factor that cannot be ignored.
If I am thinking long-term, I should not worry about liquidity.
It’s not true. Liquidity is a factor that needs to be given importance even if you invest for the long term. At the time when you would require the money the most (For a better opportunity or any emergency), you would have the shares in your demat account, but you won’t be able to sell the shares at desired prices.
As a retail investor, how do I care about liquidity? It’s the big guy’s worry.
This is not a good way to think. First of all, if any big investor has an interest in an illiquid stock, then he or she might take a lower weight in that stock but suppose the fund size of that investor is Rs. 2000 cr., and he takes a base weight of 3% (In absolute, it’s Rs. 60 cr.) Suppose the company has a market cap of Rs. 1000 cr.; then also, the fund will end up buying 6% of the company, and there will be strong buying pressure. Now, just imagine if that fund wants to get out of this investment for any reason, then it can’t exit without affecting the price. So the price would get affected by these funds, so you would have to worry equally.
Ratios to understand liquidity
All said and done; one can see some ratios which will give a better understanding of liquidity.
Free Float/No of shares outstanding
You should deduct the shares that promoters or any strategic investors own to get the free float and then divide this by the total number of shares outstanding.
| Particulars (In numbers) | Shares outstanding |
| Promoters | 6,500 |
| PE Fund | 1,000 |
| Public | 2,500 |
| Total number of share outstanding | 10,000 |
As you can see in the above table, about 75% of the total shares outstanding will not come out for being traded in the market. So technically, the remaining 25%, which is owned by the public investor, is being traded.
| Particulars (In numbers) | Shares outstanding |
| Total number of shares outstanding | 10,000 |
| Shares held by Promoters and strategic investors | 7,500 |
| Free Float | 2,500 |
So the total volume available for being traded is 2500 shares. So you divide 2500/10000, which is 25%. So just 25% is available for being traded in open markets. The higher the % of free float to the number of shares outstanding, the higher the liquidity.
High traded volumes
The volumes of the stock also give an understanding of the liquidity. It shows that there is demand and supply for a particular stock. If a stock is seeing circuits constantly, be it an upper or a lower circuit, you would understand that there is low demand or supply for a stock.
Conclusion
So liquidity is one of the factors which should always be given importance, be it in any situation. An investor can follow the company and start building a weightage in it if he thinks the business is good, but liquidity is low. In such scenarios, one should track the split of company shares, a bonus of a company shares, or any type of incident where the company is diluting more stake so one can be aware of higher upcoming liquidity.
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