Someone who reads my articles sent me this email:
Hi Geoff,
Thinking about one of your posts, "Illiquidity and You"… I have a question that is somewhat imprecise.
I have doubts about the size of the position you should have in illiquid stocks (like SODI and others) regarding the overall size of your portfolio. You can assume here that we are not talking about control investing in any form and you do not need the money… considering that usually you do not take too concentrated position in this kind of stock (as opposed to a Buffett-Munger kind) what size should be wise?
Up to what amount can you consider that your portfolio is too big for these kinds of opportunities?
It would be very helpful for me if you can give me a numerical example and some advice to analyze this type of situation.
Regards,
Fernando
For things like Japanese net-nets, I don’t put more than 10% of my portfolio in any one stock. And I don’t put more than 50% of my portfolio in the whole group. But this is my personal preference. Let’s talk a little about how illiquidity applies to everyone — not just me.
First of all, I’m going to take your question about at what size your portfolio is too big for a Ben Graham-type net-net like Solitron Devices (SODI, Financial). It depends on the amount of stock you can buy and the position size you like. For me, I try not to start buying a stock that I think will never make up 10% of my portfolio. If you don’t mind having 5% positions in your portfolio, your portfolio can obviously be twice as big as mine and you can still consider buying the same small stocks I do. In terms of specific stocks, it depends on the amount of float and the volume the stock trades in an average month. We are really getting into specifics here. And I may be boring people. But if you’d like to hear more about the minutiae of how you actually buy and sell tiny stocks like these, let me know, and I’ll do an article on the subject.
By the way, there is a hard and fast rule of thumb that it usually makes no sense to invest in a company with a market cap that is smaller than your portfolio. This is true for both fund and individual investors. Funds break it all the time. But, frankly, it is probably a waste of an analyst/fund manager’s time to even analyze such tiny positions relative to the size of the whole portfolio. Since even when we are discussing very small stocks we are still talking about millions and millions of dollars in market cap, this is hardly a concern for most individuals.
So, for individual investors, actual inability to acquire enough shares of a company to meaningful influence their portfolio is rarely the problem. If you bid for a stock month after month — you’ll get your shares.
The concern for individual investors is not whether buying enough shares is possible. The concern is how quickly and easily you can buy and sell. This is what we call “liquidity.”
Instead of thinking about stocks as liquid or illiquid, you should think in terms of your portfolio and your liquidity needs. It doesn't make much sense to use what I'll call an "objective" (as in stock-oriented) approach to liquidity rather than a "subjective" (as in investor-oriented) approach to liquidity.
For example, let's say you have a $1 million portfolio. And let's say that given your current situation in life, your job, how much you are saving, etc., it makes little sense for you to ever need more than $100,000 to spend in a year. This would even be true if say you have needs in terms of making a down payment on a house, paying for a child's education, etc. In this example, you would have a large portfolio for an individual investor. However, whether you have a $1 million portfolio or a $100,000 portfolio is not the determining factor in your attitude toward liquidity.
So what is?
The fact that you are an individual investor means your liquidity needs are lower than any institution. This is critical. And many people overlook it. What works for a mutual fund manager — or what doesn’t work for a mutual fund manager — may have little to do with what works for you as an individual investor. I point this out because I would never manage an institutional fund — especially something like an open ended mutual fund — the same way I would manage my own money or a small, investment partnership where investors are “locked up.”
Bruce Berkowitz (at Fairholme) and Marty Whitman (at Third Avenue) need to be careful about liquidity. You don’t. At least not in the same way they do. And not for the same reasons. They need to make sure individual position sizes are not huge. Why? Because they could own too much Bank of America (BAC) shares at the same moment that too many of their investors want to bail out. If you look at the history of many value mutual funds, you’ll see that their investors abandoned them in the midst of the dot-com craze. That was probably the worst time to sell old economy value stocks. But if you managed an open-ended mutual fund, that’s exactly what you had to do. You had to sell whether you wanted to or not.
You don’t have that problem. Only you can force yourself to redeem stocks for cash. The one exception to this — and it’s a big exception — is a personal emergency. A funding need. Like, for instance, losing your job. That is something you can’t control. And you need to be prepared for things you can’t control. So does a mutual fund manager. But for the mutual fund manager the risks of illiquidity are higher. Because his own fund’s investors can force him to sell stock at exactly the wrong moment. They’ll probably panic when everyone else panics. When the market panics.
Will you?
In some ways, you can be less concerned about selling during a panic. I don’t know. This depends on your own disposition. Maybe you are just as likely to panic as any other investor. If that’s true — you have a big problem. And you need to address it. Either by curing yourself of panicking when everyone else is panicking too or by staying out of stocks. But if you are going to be a successful individual stock investor you’ll need to hold stocks when everyone else is selling them. Mutual fund managers don’t have this luxury. They have to sell when their investors sell. You don’t.
So that’s a personal issue. One only you can answer. Let’s talk about something that applies to everyone.
The way to think about liquidity is to imagine a bath tub. This analogy works as well for your liquidity position as it does for a company’s liquidity position. Ask the same questions about your liquidity that you would ask about a company’s liquidity.
Is cash flowing into or out of your portfolio on a, let’s say, monthly basis? If you have a few thousand dollars on hand in a bank account, and you're 35 or 45 and/or you're putting some money into savings every month, liquidity is a very minor concern for you. It may not feel that way. But if you are adding to your investable funds every month or every year or whatever, you are actually in a pretty strong position in terms of liquidity. If you need to, you can stop adding to investments and increase the amount of cash you have on hand that way.
Liquidity is not just about being rich or poor. It’s not just about having few liquid assets or having a lot. The flow is often more important than the stock. Even a rich retiree is often in a weak liquidity position. If you're retired with $1 million, that may mean you can't invest much in illiquid funds.
If you're usually drawing on your investment funds over a full year instead of adding to them, illiquid stocks aren’t for you. This is an ironclad rule. Illiquid stocks are for savers. Not for spenders.
Okay. What if your liquidity position is okay — you’re working age, have a salary and save a little bit at least every month — what should you do?
My advice is to divide your portfolio into three parts:
You should always treat your investment in a stock like Solitron Devices as if it would take a full year to extract that money and put it in your pocket.
Always touchable money is cash. For individuals, there's little reason for it not to be a simple bank account, money market fund, etc. For most investors, you can just let this stock sit in your brokerage account. Many brokers will sweep unused cash into a money market account — or other form of savings — where it can earn a tiny amount of interest for you while staying totally liquid. One advantage of keeping cash in this form is that you can look at your cash and stock positions on the same (web)page any time you want. So, for example, if you know you want to keep 10% of your portfolio in cash — you can see that you have $12,000 in cash as part of your $120,000 brokerage account and that means you are right on target with your liquidity goal.
In my personal opinion — and I must warn you this is not a popular or consensus opinion at all — a good individual stock picker who likes to do research himself, is better off increasing the cash portion of his portfolio and reducing the highly liquid stock portion than sticking picking only liquid stocks. So, instead of being 100% in IBM, Microsoft, Apple, Wal-Mart, 3M, etc. to get his needed liquidity, he should put 20% of his portfolio in cash, 30% in liquid stocks (like IBM), and 50% in illiquid stocks (like Solitron). In this way, he can instantly and always touch 20% of his portfolio. And he can get 50% of the money in a real time of personal need. The other 50% is totally untouchable at all times. That 50% should be thought of as retirement money or something similar. It should never be thought of as anything approaching cash.
So, in our example of a stock picker with a $120,000 portfolio, he could divide up his funds as follows:
1. $24,000 in cash
2. $36,000 in blue chip stocks
3. $60,000 in illiquid stocks
Look at that portfolio and ask yourself whether you could live with that arrangement. I know it seems inefficient to keep some money permanently in cash. But if that small cash pile allows you to — comfortably — keep more money in illiquid stocks, that could very well be the best way to go.
All of this depends on your stock picking abilities. It depends on what areas of investing you excel at. If you’re great at picking Ben Graham bargains, don’t put all your money in the IBMs of the world. Put some in cash. And some in stocks like Solitron.
Of course, you need to weigh how much cash to hold against how heavy that cash anchor is — and how far it drags down your performance. If we compare net-nets to blue chip stocks, you'd actually find that a portfolio that is 50% net-nets and 50% cash will tend to perform about as well as a portfolio that is 100% blue chip stocks.
By the way, that’s only true if you keep your net-net trading costs to a minimum. This is something I’ll talk about in other articles. But basically it means you can’t trade net-nets frequently. You have to bid for them conservatively, be patient enough to wait for someone to come down to your price, and then hold net-nets for years instead of months.
If you can do all that, you can afford to hold a lot of cash and a lot of net-nets rather than a lot of blue chip stocks and zero cash.
Which portfolio is more liquid?
It depends on your point of view. To me, the 50% net-net and 50% cash portfolio provides more safety because it is still very liquid even in a market panic. The 100% blue chip stock portfolio can still drop 30% or more in a 2008 style panic. If that happens to coincide with you losing your job or something — boy, that 100% liquid stock portfolio is suddenly forcing you to sell at a bad time. Liquidity doesn’t feel like much of a blessing in the midst of a market panic.
Individual position size is far less important than the overall liquidity of your portfolio. For individual investors position size shouldn’t be a significant concern.
It's really the three categories: cash, liquid stocks and illiquid stocks that matter.
You can have 10 illiquid stocks of 5% each or five illiquid stocks of 10% each or two illiquid stocks of 25% each. Day-to-day the fluctuations will feel very different. But in terms of liquidity they are all similar. It can easily take one month to sell half your portfolio — if it is in stocks like SODI — in an orderly way. I wouldn't think the amount in each stock matters as much. What matters is how much of your portfolio you have in: (1) cash, (2) liquid stocks and (3) illiquid stocks.
Always look at your own personal situation. Especially pay attention to whether you are adding or subtracting from investable funds each month and each year.
Personally, I'd suggest holding more cash and more illiquid stocks at all times rather than holding only liquid stocks.
You can always hold more illiquid stocks if you increase the amount of your portfolio you keep in cash. That’s one way to get comfortable holding less liquid stocks.
But each investor has to do what makes him comfortable.
So, if illiquid stocks make you uncomfortable I'd amend that advice. The best decision for any investor is usually the program — system, approach, whatever you want to call it — that allows you to make investing decisions without feeling uncomfortable and prone to panic.
Never pick a portfolio allocation that looks good on paper — and is empirically proven — if it makes you uncomfortable. The element of human error you introduce will destroy any advantage the portfolio had.
Instead, pick a portfolio you can live with. Something that has empirical support. And that is psychologically suitable for you personally. Both of these elements must be present. Having only one or the other is not enough.
You need to use a proven strategy, like net-net investing. And you need to invest in a way that keeps you comfortable.
Talk to Geoff About Illiquid Stocks [email protected]
Hi Geoff,
Thinking about one of your posts, "Illiquidity and You"… I have a question that is somewhat imprecise.
I have doubts about the size of the position you should have in illiquid stocks (like SODI and others) regarding the overall size of your portfolio. You can assume here that we are not talking about control investing in any form and you do not need the money… considering that usually you do not take too concentrated position in this kind of stock (as opposed to a Buffett-Munger kind) what size should be wise?
Up to what amount can you consider that your portfolio is too big for these kinds of opportunities?
It would be very helpful for me if you can give me a numerical example and some advice to analyze this type of situation.
Regards,
Fernando
For things like Japanese net-nets, I don’t put more than 10% of my portfolio in any one stock. And I don’t put more than 50% of my portfolio in the whole group. But this is my personal preference. Let’s talk a little about how illiquidity applies to everyone — not just me.
First of all, I’m going to take your question about at what size your portfolio is too big for a Ben Graham-type net-net like Solitron Devices (SODI, Financial). It depends on the amount of stock you can buy and the position size you like. For me, I try not to start buying a stock that I think will never make up 10% of my portfolio. If you don’t mind having 5% positions in your portfolio, your portfolio can obviously be twice as big as mine and you can still consider buying the same small stocks I do. In terms of specific stocks, it depends on the amount of float and the volume the stock trades in an average month. We are really getting into specifics here. And I may be boring people. But if you’d like to hear more about the minutiae of how you actually buy and sell tiny stocks like these, let me know, and I’ll do an article on the subject.
By the way, there is a hard and fast rule of thumb that it usually makes no sense to invest in a company with a market cap that is smaller than your portfolio. This is true for both fund and individual investors. Funds break it all the time. But, frankly, it is probably a waste of an analyst/fund manager’s time to even analyze such tiny positions relative to the size of the whole portfolio. Since even when we are discussing very small stocks we are still talking about millions and millions of dollars in market cap, this is hardly a concern for most individuals.
So, for individual investors, actual inability to acquire enough shares of a company to meaningful influence their portfolio is rarely the problem. If you bid for a stock month after month — you’ll get your shares.
The concern for individual investors is not whether buying enough shares is possible. The concern is how quickly and easily you can buy and sell. This is what we call “liquidity.”
Instead of thinking about stocks as liquid or illiquid, you should think in terms of your portfolio and your liquidity needs. It doesn't make much sense to use what I'll call an "objective" (as in stock-oriented) approach to liquidity rather than a "subjective" (as in investor-oriented) approach to liquidity.
For example, let's say you have a $1 million portfolio. And let's say that given your current situation in life, your job, how much you are saving, etc., it makes little sense for you to ever need more than $100,000 to spend in a year. This would even be true if say you have needs in terms of making a down payment on a house, paying for a child's education, etc. In this example, you would have a large portfolio for an individual investor. However, whether you have a $1 million portfolio or a $100,000 portfolio is not the determining factor in your attitude toward liquidity.
So what is?
The fact that you are an individual investor means your liquidity needs are lower than any institution. This is critical. And many people overlook it. What works for a mutual fund manager — or what doesn’t work for a mutual fund manager — may have little to do with what works for you as an individual investor. I point this out because I would never manage an institutional fund — especially something like an open ended mutual fund — the same way I would manage my own money or a small, investment partnership where investors are “locked up.”
Bruce Berkowitz (at Fairholme) and Marty Whitman (at Third Avenue) need to be careful about liquidity. You don’t. At least not in the same way they do. And not for the same reasons. They need to make sure individual position sizes are not huge. Why? Because they could own too much Bank of America (BAC) shares at the same moment that too many of their investors want to bail out. If you look at the history of many value mutual funds, you’ll see that their investors abandoned them in the midst of the dot-com craze. That was probably the worst time to sell old economy value stocks. But if you managed an open-ended mutual fund, that’s exactly what you had to do. You had to sell whether you wanted to or not.
You don’t have that problem. Only you can force yourself to redeem stocks for cash. The one exception to this — and it’s a big exception — is a personal emergency. A funding need. Like, for instance, losing your job. That is something you can’t control. And you need to be prepared for things you can’t control. So does a mutual fund manager. But for the mutual fund manager the risks of illiquidity are higher. Because his own fund’s investors can force him to sell stock at exactly the wrong moment. They’ll probably panic when everyone else panics. When the market panics.
Will you?
In some ways, you can be less concerned about selling during a panic. I don’t know. This depends on your own disposition. Maybe you are just as likely to panic as any other investor. If that’s true — you have a big problem. And you need to address it. Either by curing yourself of panicking when everyone else is panicking too or by staying out of stocks. But if you are going to be a successful individual stock investor you’ll need to hold stocks when everyone else is selling them. Mutual fund managers don’t have this luxury. They have to sell when their investors sell. You don’t.
So that’s a personal issue. One only you can answer. Let’s talk about something that applies to everyone.
The way to think about liquidity is to imagine a bath tub. This analogy works as well for your liquidity position as it does for a company’s liquidity position. Ask the same questions about your liquidity that you would ask about a company’s liquidity.
Is cash flowing into or out of your portfolio on a, let’s say, monthly basis? If you have a few thousand dollars on hand in a bank account, and you're 35 or 45 and/or you're putting some money into savings every month, liquidity is a very minor concern for you. It may not feel that way. But if you are adding to your investable funds every month or every year or whatever, you are actually in a pretty strong position in terms of liquidity. If you need to, you can stop adding to investments and increase the amount of cash you have on hand that way.
Liquidity is not just about being rich or poor. It’s not just about having few liquid assets or having a lot. The flow is often more important than the stock. Even a rich retiree is often in a weak liquidity position. If you're retired with $1 million, that may mean you can't invest much in illiquid funds.
If you're usually drawing on your investment funds over a full year instead of adding to them, illiquid stocks aren’t for you. This is an ironclad rule. Illiquid stocks are for savers. Not for spenders.
Okay. What if your liquidity position is okay — you’re working age, have a salary and save a little bit at least every month — what should you do?
My advice is to divide your portfolio into three parts:
- Money that is always touchable
- Money that is only touchable in a true emergency
- Money that is never touchable — not even in an emergency
You should always treat your investment in a stock like Solitron Devices as if it would take a full year to extract that money and put it in your pocket.
Always touchable money is cash. For individuals, there's little reason for it not to be a simple bank account, money market fund, etc. For most investors, you can just let this stock sit in your brokerage account. Many brokers will sweep unused cash into a money market account — or other form of savings — where it can earn a tiny amount of interest for you while staying totally liquid. One advantage of keeping cash in this form is that you can look at your cash and stock positions on the same (web)page any time you want. So, for example, if you know you want to keep 10% of your portfolio in cash — you can see that you have $12,000 in cash as part of your $120,000 brokerage account and that means you are right on target with your liquidity goal.
In my personal opinion — and I must warn you this is not a popular or consensus opinion at all — a good individual stock picker who likes to do research himself, is better off increasing the cash portion of his portfolio and reducing the highly liquid stock portion than sticking picking only liquid stocks. So, instead of being 100% in IBM, Microsoft, Apple, Wal-Mart, 3M, etc. to get his needed liquidity, he should put 20% of his portfolio in cash, 30% in liquid stocks (like IBM), and 50% in illiquid stocks (like Solitron). In this way, he can instantly and always touch 20% of his portfolio. And he can get 50% of the money in a real time of personal need. The other 50% is totally untouchable at all times. That 50% should be thought of as retirement money or something similar. It should never be thought of as anything approaching cash.
So, in our example of a stock picker with a $120,000 portfolio, he could divide up his funds as follows:
1. $24,000 in cash
2. $36,000 in blue chip stocks
3. $60,000 in illiquid stocks
Look at that portfolio and ask yourself whether you could live with that arrangement. I know it seems inefficient to keep some money permanently in cash. But if that small cash pile allows you to — comfortably — keep more money in illiquid stocks, that could very well be the best way to go.
All of this depends on your stock picking abilities. It depends on what areas of investing you excel at. If you’re great at picking Ben Graham bargains, don’t put all your money in the IBMs of the world. Put some in cash. And some in stocks like Solitron.
Of course, you need to weigh how much cash to hold against how heavy that cash anchor is — and how far it drags down your performance. If we compare net-nets to blue chip stocks, you'd actually find that a portfolio that is 50% net-nets and 50% cash will tend to perform about as well as a portfolio that is 100% blue chip stocks.
By the way, that’s only true if you keep your net-net trading costs to a minimum. This is something I’ll talk about in other articles. But basically it means you can’t trade net-nets frequently. You have to bid for them conservatively, be patient enough to wait for someone to come down to your price, and then hold net-nets for years instead of months.
If you can do all that, you can afford to hold a lot of cash and a lot of net-nets rather than a lot of blue chip stocks and zero cash.
Which portfolio is more liquid?
It depends on your point of view. To me, the 50% net-net and 50% cash portfolio provides more safety because it is still very liquid even in a market panic. The 100% blue chip stock portfolio can still drop 30% or more in a 2008 style panic. If that happens to coincide with you losing your job or something — boy, that 100% liquid stock portfolio is suddenly forcing you to sell at a bad time. Liquidity doesn’t feel like much of a blessing in the midst of a market panic.
Individual position size is far less important than the overall liquidity of your portfolio. For individual investors position size shouldn’t be a significant concern.
It's really the three categories: cash, liquid stocks and illiquid stocks that matter.
You can have 10 illiquid stocks of 5% each or five illiquid stocks of 10% each or two illiquid stocks of 25% each. Day-to-day the fluctuations will feel very different. But in terms of liquidity they are all similar. It can easily take one month to sell half your portfolio — if it is in stocks like SODI — in an orderly way. I wouldn't think the amount in each stock matters as much. What matters is how much of your portfolio you have in: (1) cash, (2) liquid stocks and (3) illiquid stocks.
Always look at your own personal situation. Especially pay attention to whether you are adding or subtracting from investable funds each month and each year.
Personally, I'd suggest holding more cash and more illiquid stocks at all times rather than holding only liquid stocks.
You can always hold more illiquid stocks if you increase the amount of your portfolio you keep in cash. That’s one way to get comfortable holding less liquid stocks.
But each investor has to do what makes him comfortable.
So, if illiquid stocks make you uncomfortable I'd amend that advice. The best decision for any investor is usually the program — system, approach, whatever you want to call it — that allows you to make investing decisions without feeling uncomfortable and prone to panic.
Never pick a portfolio allocation that looks good on paper — and is empirically proven — if it makes you uncomfortable. The element of human error you introduce will destroy any advantage the portfolio had.
Instead, pick a portfolio you can live with. Something that has empirical support. And that is psychologically suitable for you personally. Both of these elements must be present. Having only one or the other is not enough.
You need to use a proven strategy, like net-net investing. And you need to invest in a way that keeps you comfortable.
Talk to Geoff About Illiquid Stocks [email protected]
