Liquidity of a Stock: Why it is so Important?
What is liquidity of a stock?
Liquidity of a stock refers to how easily and quickly it can be bought and sold. It is closely related to the volume of the stock traded.
In an ideal scenario where a stock is liquid, the price a buyer offers per share (the bid price) and the price the seller is willing to accept (the ask price) should be close to each other. In other words, the buyer wouldn’t have to pay more to buy the stock and would be able to liquidate it easily. When the spread between the bid and ask prices widens, the market becomes more illiquid, and a transaction can lead to a drastic change in the stock’s price. (Investopedia) A perfect example will be Tat Seng Packaging today as seen below:
You can see that the share price of Tat Seng Packaging went up by 10.15% on a volume of 100 shares traded. (1 = 100 shares traded) This is because of the wide spread between the bid and ask prices (0.70 SGD to 0.76 SGD) which goes to show how illiquid the stock is. (Also see my analysis on Tat Seng Packaging)
So why is liquidity so important?
Lets say you found a company that is currently under-valued. If the stock is highly illiquid however, it presents a higher risk for you. And higher risk = higher required rate of return! This is because it will be hard for you to exit your position in the event of the company under-performing or an economic recession. (Even if you do manage to exit, you will most likely suffer a considerable loss due to the bid and ask spread). Therefore you will have to take into account its illiquidity when calculating the intrinsic value of the stock, or rather you will have to set a lower entry price.
For example, if a company’s intrinsic value is $5 while its current share price is $4.5, it might be better to wait and enter at a price lower than $4.5 (such as $4) to make up for the liquidity risk. If the price does not go down to your target entry price, it will be better to give it a miss. After all, investing is all about the risk to reward analysis.