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How does liquidity of stock effect your target price and weighting


Packer16
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I am looking at some cheap but illiquid stocks and was wondering how folks adjust there security target price and weighting by liquidity.  Also in theory, a high dividend should reduce the discount for lack of marketability. 

 

I am currently using a 35% DLOM from NAV for no dividend paying stocks, a 25% DLOM for an up to 5% yield and a 20% DLOM for a yield greater than 5%.

 

Packer

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It depends on your AUM of course: is it personal or others?  For me it's some of both, so I limit illiquid holdings to an amount that is equal to the amount of semi-permanent AUM (I count close to a decade as semi-permanent AUM) plus my amount. 

 

 

As long as you have quite a bit of liquid holdings and/or cash in a personal or checking account, you know you could sell if you ever had to.  Plus illiquid holdings can still be sold, just over a period of a month or two (hopefully at worst).

 

 

But my guess is that I'm much more likely to hold illiquid stocks.

 

 

One paradox that I've realized: in a meltdown some of the more illiquid stocks we own will meltdown less, because by their very nature they're closely held by longer-term holders who've done the research and are intimately familiar with them.

 

 

But in a meltdown the prices will usually drop for ALL stocks, maybe for a few illiquid ones just a bit less, but could liquidity go up, just like it did in 08'-09'?  So are illiquid stocks really that risky?

 

 

But IMO, if you really love a stock and you truly could go lie on an island for a few years with it, illiquidity matters, but only a bit.

 

 

The below post by Barel Karsan really drives the fear of illiquid stocks home and shows that those who are willing to own illiquid stocks might have a very-easy-to-come-by-advantage:

 

 

"It had zero volume today!"

 

http://www.barelkarsan.com/2014/07/it-was-comments-that-lict.html

 

 

One can ask themselves, why do I really feel the need to have liquidity?  Is it because I'm potentially wrong about this stock?  Should those overly concerned about liquidity (this isn't directed at anyone in particular) have more cash lying around and not be investing quite so much in stocks in the first place?

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I do think a smaller discount for dividend paying stocks is appropriate for obvious reasons, but there are imo a couple of other factors that are pretty important:

 

1. How much liquidity do you personally need? If you have a long-term horizon and you don't need to generate a lot of income from your holdings an appropriate DLOM should be a lot smaller. If the market is willing to sell you stuff with a big discount because of the lack of liquidity: buy it IF you don't need liquidity.

 

2. What is the probability that you want to sell your position in a given year? If you have a high quality company with a strong management team you can accept lower liquidity than when you buy some cigar butt that's just too cheap to ignore.

 

PS. I personally think that a 20% DLOM for a 5%+ yield is excessively high. An presumably under-priced security at a 5% yield would probably be a great investment since the under-priced part of the story implies an growing yield. You will probably generate a nice return even if you never sell.

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Most of the $ will be made by trading against order flow, as a 2nd market marker. To do any volume you have to buy in disruption & sell into a maturity/takeout. You will seldom get full price, & unless its a bond/deb the holding period could be almost forever.

 

Take the same approach on a brand-name, & marginable, cyclical stock - & there is some merit. Rinse & repeat on the same cyclical & you will be one of the few who actually knows something about the stock & its business prospects. Do it on a junior, & you deserve everything coming to you.

 

Where liquidity is an issue, expect to pay a discount on both entry (30-40%) & exit (10-20%), & make your $ from dividends - not trading. Usually not the game most people thought they were getting into.

 

SD

 

 

 

 

 

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packer they constantly seem to issue shares and convertibles. And large exposure to mainland china real estate (with everyone talking about a bubble). They do seem to pay out though and not hoard cash (compared to debt at least).

 

keck seng seems like a more low risk pick.

 

edit: prices of the commercial real estate doesn't seem that out of whack judging by lease yields. But are they going to monetize and pay dividends soon? Seems like hong kong investors only look at dividend yields for some reason, sometimes to a extreme. If they are going to hoard cash and only slowly pay out, price could barely be up 4 years from now.

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Like JAllen said, it really depends on the projected portfolio need for liquidity. In my retirement accounts, I'm fine holding extremely illiquid positions, but with taxable assets prefer a bit more liquid positions.

 

My love of illiquid securities is twofold. One, you don't have the bullshit games you see in the larger space, particularly those names that end up being toys of hedge funds (HLF, NFLX, Z, etc), where folks are buying and selling for reasons totally irrespective of underlying business value. Second, it really is more of an exchange of one partner selling their interest and another partner buying their interest, almost trading by appointment. Since as we all know, equities represent fractional ownership in a business, I find the infrequent trading refreshing.

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Second, it really is more of an exchange of one partner selling their interest and another partner buying their interest, almost trading by appointment. Since as we all know, equities represent fractional ownership in a business, I find the infrequent trading refreshing.

 

Just keep in mind that you are a very minority partner, hoping that majority partners will transact fairly at IV less an appropriate liquidity discount. Majority partner abuse is quite common (take-under), & forced minority sales (majority partner > 90%) at manipulated prices is not unheard of.

 

Also keep in mind that liquidity & time horizon are assets, they have value, & they were sold when the illiquid stock was purchased. You should be paid for it with either a deep discount up front, inflated cash yield, or both. How much, depends on the pessimistic probability weighted prospective risk of XYZ.

 

SD

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  • 1 month later...

Packer, Aswath Damodaran discusses his thoughts on industry standards for illiquidity discounts and his thoughts on how to come up with them in the first half of lecture #20 here:

 

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqspr14.htm

 

He also talks about the same thing on pages 683-688 of the third edition of his Investment Valuation book.  I think the lecture does a better job of explaining the top level concepts, but the book is better explaining the actual math.  I hope this helps.  (I'm not sure if this quite addresses the exact question you're asking...)

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