Liquidity and the stock market

By Colin Nicholson

Liquidity is a concept with several meanings. One important meaning is in the financial sense of the word. If we say that a company is liquid, we mean that it has a sufficient cash flow to meet its financial obligations as they fall due. While this is a very important aspect for investors to look for before investing in a company, in this article I want to deal with another meaning.

This meaning has relevance to the secondary market in a company's shares. Once a company has been sold or floated to institutions and private investors, the promoters will have arranged for the company to be listed for trading on a stock exchange. The initial sale of shares in the floatation is referred to as the primary market. Subsequent trading of the company's shares on a stock market refers to the secondary market. In this environment, liquidity refers to the ease with which it is possible to buy and sell shares.

Assume that there is plenty of buying and selling volume at a range of reasonable prices. It will be easy to buy and sell shares and we would say that the market is liquid in the absolute sense. Likewise, if there is very little buying and selling volume at reasonable prices it will be difficult to get orders filled and we would say that the market is relatively illiquid in absolute terms.

As a rough guide, big companies with hundreds of thousands of shareholders will be regarded as liquid and small companies with maybe only a few hundreds or thousands of shareholders will be less liquid. There are exceptions when, even in a largish company, there is one, or only a few very large shareholders, who never trade their shares.

For every investor, liquidity also has a relative as apart from absolute meaning. Here we look at the available buying and selling orders in relation to the order that an investor wishes to place. If we only wanted to buy or sell 100 shares, almost any company will have a relatively liquid market for us. However, if we were an institution wishing to buy or sell ten million shares, hardly any company will be really liquid relative to their order size. There is a wide range of investors with varying order sizes between these extremes, where the market in a given share will be relatively liquid or illiquid.

Relative liquidity also depends to some extent on price. There may be no liquidity at one price, but plenty if the investor is prepared to buy at much higher prices. Likewise, relative liquidity depends on the time the order is placed and also on market conditions.

Colin Nicholson's books: Building Wealth in the Stock Market and The Psychology of Investing may be purchased from Colin's website www.bwts.com.au and good bookstores). Contact Colin at colin@bwts.com.au or through his web site where you can also subscribe to his newsletter.