Howard Marks, the chairman and cofounder of Oaktree Capital Management, is renowned for his insightful assessments of market opportunity, cycles and risk. His memos, which encapsulate his thoughts, are eagerly read across the globe. Here is an extract from the latest which appeared on Morningstar’s U.S. website.
Liquidity Defined
Sometimes people think of liquidity as the quality of something being readily saleable or marketable. For this, the key question is whether it’s registered, publicly listed and legal for sale to the public.
“Marketable securities” are liquid in this sense; you can buy or sell them in the public markets. “Non-marketable” securities include things like private placements and interests in private partnerships, whose salability is restricted and can require the qualification of buyers, documentation, and perhaps a time delay.
But the more important definition of liquidity is this one from Investopedia: “The degree to which an asset or security can be bought or sold in the market without affecting the asset's price.” (Emphasis added) Thus the key criterion isn’t “can you sell it?” It’s “can you sell it at a price equal or close to the last price?”
Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition. For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.
Liquidity Characterised
I often say many of the important things in investing are counter-intuitive. Liquidity is one of them. In particular, it’s probably more wrong than right to say without qualification that something is or isn’t “liquid.”
If when people ask whether a given asset is liquid they mean “marketable” (in the sense of “listed” or “registered”), then that’s an entirely appropriate question, and answering it is straightforward. Either something can be sold freely to the public or it can’t.
But if what they want to know is how hard it will be to get rid of it if they change their mind or want to take a profit or avoid a possible loss – how long it will take to sell it, or how much of a markdown they’ll have to take from the last price – that’s probably not an entirely legitimate question.
It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell.
In other words, the liquidity of an asset often depends on which way you want to go . . . and which way everyone else wants to go. If you want to sell when everyone else wants to buy, you’re likely to find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case – and I’m sure it is – then the asset can’t be described as being either liquid or illiquid. It’s entirely situational.
There’s usually plenty of liquidity for those who want to sell things that are rising in price or buy things that are falling. That’s great news, since much of the time those are the right actions to take.
But why is the liquidity plentiful?
For the simple reason that most investors want to do just the opposite. The crowd takes great pleasure from buying things whose prices are rising, and they often become highly motivated to sell things that are falling . . . notwithstanding that those may be exactly the wrong things to do.
Further, the liquidity of an asset is very much a function of the quantity involved.At a given time, a stock may be liquid if you want to sell a thousand shares but highly illiquid if you want to sell a million. If so, it can’t be said categorically that the stock is either liquid or illiquid. But people do it all the time.
Investment managers are often asked how long it would take to liquidate a given portfolio. The answer usually takes the form of a schedule that says: “We could sell off x% of the portfolio in a day, y% in a week, and z% in a month, etc.”
But that’s a terribly simplistic answer. It doesn’t say anything about how the price received would compare with the last trade or the price at which the assets were carried on the previous valuation date. Or about how changing market conditions might make the answer different a month from now.
Bottom line: to the statement “we could sell off z% in a month” one should add “but who knows what the price will be, or what effect changing market conditions might have on that percentage?”
Anything else requires an assumption that the assets’ liquidity is constant. That’s often far from the case.
Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there. (In the 2014 Berkshire Hathaway Annual Letter, released early this month, Warren Buffett expresses his dislike for “substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed.”) The truth is, things often seem more liquid when you buy than when you go to sell.
The bottom line is that it can be wrong to assume it’ll be easy and painless to get out of your holdings, and especially to exit a position after its price has begun to drop.
