Investment Matters

"Liquidity". What is it and what does it mean for investors?

What is liquidity?

In the context of publicly listed companies, liquidity can be broadly defined as how quickly and easily a company’s shares can be bought or sold.

This is determined by whether there is an active market for a company’s shares, i.e. the number of its shares that are available for sale, relative to the demand for these shares.

What determines the liquidity of a company’s shares?

In general, liquidity depends on a company’s ownership structure.

Broadly, it reflects the holding period of a company’s shareholders and the concentration of ownership of the company.

Typically, companies that are owned by a small number of long-term shareholders tend to be less liquid.

Conversely, companies that are owned by a large number of short-term shareholders tend to be more liquid.

This 'liquidity' can fluctuate, as the ownership structure of the company can change – impacting the number of shares available for sale or purchase on a day to day basis.

What does liquidity mean for investors?

The significance of liquidity differs depending on the investor, their time horizon and the number of shares they are looking to buy or sell.

Liquidity determines how easily an investor can purchase or sell shares on the market, and the premium or discount they bear to do so.

This premium or discount depends on the number of shares an investor is trying to buy or sell relative to the number of shares on offer at a specific price.

Take Company X for example.  Company X is an illiquid company, with only 0.01% of its shares outstanding typically trading on any given day.

For a buyer looking to purchase a small number of shares (say 0.001% of the company), this may not be a problem.  They will be able to purchase the number of shares they require at no to little premium to the company’s current traded price.

On the other hand, for a seller looking to sell 0.5% of Company X, the company’s low liquidity will be a significant factor, as they will look to sell a greater number of shares than are in demand.  The imbalance between supply and demand will result in the investor having to sell these shares over a number of days, which will push the company’s share price below its current traded price.

The duality of low liquidity

As can be seen in the example of Company X, when there is a large seller, relative to the demand for shares in the market, prices can be pushed down.

As detailed in our article “Parts of the share-market feeling pain of massive funds’ shift”, we assess that this phenomenon has occurred with several companies over FY-19, as specialist fund managers who have lost their mandates have become forced sellers.

Conversely, when there is high demand for shares in a company with low liquidity, its share price can appreciate suddenly and dramatically.

This can often be seen when small companies garner the attention of investors and experience a sudden and rapid appreciation in their share price as a result.

Furthermore, when there is little news, there tends to be more sellers than buyers and the share prices of companies with low-liquidity will tend to drift downwards.

Thus, share prices of companies with low liquidity tend to be more volatile, as their share prices are buffeted by the balance between supply and demand on any particular day.

This volatility means that the share price of these companies can be untethered from their intrinsic value – with their share price reflects the actions of a small volume of buying and selling, rather than their fundamental value.

Liquidity and your portfolio

Several companies within the Australian Shares portfolio have low liquidity (Threat Protect, Cardno, Coronado and TZ Limited).  As a result, their prices have been volatile over the last year.

We can broadly measure a company’s liquidity based on the volume of its shares that are traded on average per year, relative to the number of shares outstanding in the company (its annual share turnover).

  Company Name Annual share turnover Annual Volatility of returns
less liquid companies Threat Protect Australia Ltd 6% 75%
  Cardno Ltd 13% 40%
  Coronado Global Resources Inc 21% 33%
  TZ Limited 5% 98%
more liquid companies BHP 39% 22%
  QBE Insurance Group 83% 21%
  Challenger 105% 37%

The table above shows that the volatility of these companies is highly correlated with their liquidity. This is in comparison to more liquid companies in the portfolio (QBE, BHP and Challenger). As a result, the volatility of their returns is more reflective of their liquidity than their riskiness as an investment.  Thus, price changes may not be reflective of a change in the intrinsic value of these companies, rather, they reflect the supply-demand dynamics for a small number of their shares.

But what will ultimately determine the long-term performance of these companies is their intrinsic value, not the short-term supply and demand for their shares.

This intrinsic value will be realised either on-market, as they appear on the radar of other investors (in which case their share prices can rapidly appreciate – as we have seen with Coronado) or off-market, in which case an acquirer who recognises their value will purchase them at a premium to their current price (as we have seen in the past with Patties Foods, Aevum, Energy Developments and Pacific Brands).

Thus, as long term investors, we focus on the long-term prospects of these companies rather than the short-term noise from their prices.