When many investors hear the term ‘liquidity risk’ they think of it as something technical that they needn’t be too concerned about. However it is something that is likely to effect everybody at some point.
Liquidity refers to how quickly something can be sold. Shares in Naspers are highly liquid because hundreds of thousands of them are bought and sold in thousands of deals every day on the JSE.
A game farm in Vaalwater, on the other hand, is a lot less liquid as there aren’t thousands of people lining up on a daily basis to get their hands on one. It will therefore take a lot longer to find a buyer.
Why this is significant is that if something cannot be disposed of quickly, it is very difficult to prevent or minimise a loss. If shares in Naspers fall and you want to exit, you should have little trouble in selling your holding to someone else and therefore managing your realised loss. If however the bottom falls out of the game farm market in Vaalwater, disposing of that property could be almost impossible.
Small caps and large properties
This is why liquidity risk is often spoken about in terms of small-cap stocks on the JSE. A stock like Erin Energy Corporation, for instance, hasn’t traded in months.
Shares in the company last changed hands in mid-December 2017 at R30 per share. However, the only bid currently in the market for that same counter is R2.18.
On Wednesday, Erin announced that it was filing for bankruptcy protection in the United States. If anyone holding the stock on the JSE wanted to offload it on the back of this news, they would not have been able to do so.
The reality is that any asset is only worth what you can sell it for. And if you have to sell something in a hurry, if it is not liquid, you may find yourself getting a lot less for it than you expected.
Another obvious example of this is the housing market. A home may be valued at R1 million, but in a downturn it is unlikely to realise that much.
If market conditions are poor and there is little demand, buyers may only be offering R800 000 or less. An owner who is in need of cash or has some other financial demands at that point may have no option but to sell at that price.
No value at all
Liquidity risk can also be taken one step further. If an asset is only worth what you can sell it for, then it also follows that if you can’t sell it at all, it is worth nothing.
This is a risk that many people putting their money into ‘alternative’, unregulated investment schemes fail to appreciate.
A unit trust, locally-regulated hedge fund or exchange-traded fund offers guaranteed liquidity. If you ever want to buy into or sell out of one of these funds you will always be able to do so because they are constructed to ensure that this is always possible.
However, this isn’t the case with a number of other so-called investment opportunities.
A particularly infamous example is Mandela Coins bought from dealers who do not guarantee that they will buy them back when you want to sell them. If you can’t find a buyer for the coin that you paid thousands of rand for, then what is its actual value?
A more extreme example was Electio Alternative Investments, which purported to be selling clients baskets of rare earth metals. They priced these baskets at regular intervals (although how they did so was highly questionable), but there was never actually any market into which to sell them.
Investors have therefore been left holding assets which are, effectively, worthless. No one will buy them, and so they have no value.
This is something that investors should be extremely alert to when considering ‘investment opportunities’ that are out of the ordinary. If they involve buying an asset in the belief that its value will increase over time, always remember that there has to be another party on the other end of that equation.
How is that value actually to be realised? In other words, who is going to buy it from you.