Liquidity is not Constant

When LTCM got into trouble, the only way out was to offload some of its positions and hope that they can reduce their leverage. Thanks to the fact that for many of the bonds, they had become the market and with negative news all around, volumes dried up. This meant that when they tried to sell a small quantity, they moved the market enough to lose even larger on what they continued to hold. We saw the same episode repeat in Amaranth in Natural Gas. 

Liquidity begets Liquidity until it doesn’t. Bombay Stock Exchange is Asia’s oldest stock exchange but today, NSE is the leader when it comes to volumes. 

In 2017, your portfolio would have been a happy portfolio if invested in small cap stocks. Cut forward to today, if you have a large small cap portfolio, you would have not only suffered enormous draw-down but as one PMS has seen, its unable to exit its stocks since the volumes are so low that any large quantity sell will impact prices making losses even larger for the rest of the clients.

SEBI’s new rules have meant that there is a clear classification of what constitutes Large Cap, Mid Cap and Small Cap. On AMFI, the first file with the new classification was uploaded on 2nd January 2018.

Using that data, I wanted to compute the average volume and value of stocks that qualified for those categories and then compare with what is seen in the same set of stocks today. The results aren’t surprising, but average 10 day volume for small caps (using market cap based Ranks from Rank 251 to 500) has plummeted 65% while average value is down 70%.

One reason Institution coverage is basically negligible when it comes to small cap stocks is that there is barely any volumes is most counters making entry and exit humongously difficult. In fact, the above mentioned PMS is rumoured to have asked clients to take delivery of the stock in lieu of funds when they wished to close out the account.

Yet, such lack of liquidity and coverage is also the reason there is long term evidence of small cap premium {there is a dispute on whether this still exists when we adjust for volatility, but that is for another day}.

Small caps become Mid Caps and some later become Large Caps. Very few are able to make that journey, but those who do provide returns of a nature that is beyond what any active or passive fund can generate. The million dollar question of course is how to identify such stocks 🙂