What is this thing called liquidity?

Among issuers and in financial circles generally, few concepts are more cherished, more misunderstood or carry more urgency than liquidity. Should you seek it? Where is it? Does it exist? We went looking for answers—and found plenty
By Peter Shawn Taylor

Love might make the world go ’round, if you happen to be a songwriter or a poet. But when it comes to the market, it’s all about liquidity. Just ask Max Lof, chief financial officer of Surge Energy Inc., a Calgary-based intermediate producer pumping out 9,000 barrels of oil and oil equivalent a day.

Late last year, Surge (TSX:SGY) graduated from the TSX-Venture Exchange to the TSX, a move signifying the firm’s growth beyond its junior roots. Part of planning the shift to the big board, recalls Lof, was the expectation it would make Surge a more liquid stock.

True that. After the switch to the senior exchange, Surge saw daily trading volume increase a stunning 56%. “I would call that dramatic,” says Lof, with obvious satisfaction.

“We see improved liquidity as leading to greater investor interest, improved access to capital and enhanced valuation. So liquidity is really important to us,” he points out. Lof says his investor relations team at Surge puts a huge emphasis on continual improvements in liquidity.

That liquidity is a good thing is an opinion backed by plenty of street wisdom. This includes executives who spend their days fretting over trading volumes, hedge fund traders and other large institutional investors who won’t touch a stock that isn’t bursting with liquidity as well as academics who pronounce on a clear and reliable link between market liquidity and firm performance.

But then again, maybe liquidity, like love, is just a fantasy. At least that’s the considered opinion of long-time Bay Street investor Sandy McIntyre.

“Liquidity is an illusion in every market,” warns the CEO of Sentry Investments Inc. “When you need it, it’s not there.” McIntyre has carved out a long and illustrious career in the mutual fund business by deliberately eschewing conventional fascination with liquidity. “I don’t understand why any business would ever want to attract investors who are motivated by liquidity. That’s not investing, that’s speculating on volatility. And speculating is a crappy game. I just scratch my head at that.”

And there you have it. Liquidity is either the single most important issue facing the market. Or a complete MacGuffin. So what is this thing called liquidity?

No market concept has been as complicated by multiple definitions, perceptions and fixations as liquidity. (See sidebar, at bottom: “A definition…or 68”) Simply put, however, market liquidity refers to the ability to convert one type of asset into another without suffering any loss of value: turning a $100 share into $100 in cash whenever you want, and vice versa. And for the largest segment of the market—institutional investors—liquidity is often top-of-mind when looking for places to park money.

“For someone who is buying stock with a short-term view, liquidity is paramount,” says Greg Steers, vice-president and investment adviser at National Bank Financial in Toronto. “Large investors, and hedge funds in particular, are typically looking for positions they can clear out in three days without suffering on price.” Selling (or buying) a large position in three days without significantly pushing the price down (or up) requires plenty of motivated buyers (or sellers). In other words, a deep market with lots of liquidity.

Surge’s Lof knows firsthand the market’s incessant demand for liquidity: “I’ve had investors tell me to my face that they won’t touch our stock until it’s trading at least $3 million to $4 million dollars a day. They need that kind of liquidity to get in and out quickly.” Hence the need to move exchanges.

Graduating to the TSX has allowed Surge to market its stock to a whole new class of investors—mutual funds managers, for example, who were unable or unwilling to buy stocks listed on junior exchanges. Moving away from the Venture also opens up the possibility for Surge to be included in various indices or sub-indices, again improving liquidity by attracting ETFs and other indexers. Liquidity opens many doors.

With the institutional market putting such a big emphasis on liquidity, it’s not surprising that corporate executives such as Lof put an equally big emphasis on improving it.

Liquidity garners considerable attention from the academic world as well. Dennis Chung is a business professor at the Beedie School of Business at Simon Fraser University in Burnaby, B.C., and has written frequently on the importance of liquidity. He explains business school interest in the subject as arising from “the connection between liquidity and the cost of capital. If a company is not very liquid, then its cost of capital should be higher.”

If increased liquidity is a signal of greater investor attention, then improvements in liquidity should improve a firm’s ability to raise funds through stock offerings, Chung argues. Lof concurs: “The energy business consumes capital and generally speaking, liquidity leads to improved access to capital at a lower cost.” In addition, all other things being equal, liquid stocks should be considered less risky, since they can theoretically be unloaded quickly and without penalty if circumstances change.

Given all these benefits, what can firms do to improve their liquidity?

The example of Surge suggests the benefits of moving to a bigger exchange. While Surge’s experience was dramatic, it’s not unexpected. Among the almost two dozen junior energy firms that graduated from the Venture to the TSX over the past four years, the average gain in liquidity (measured as trading volume in the 120 days prior to and following graduation) is an impressive 35%. Some firms doubled trading volume, while others, to their chagrin, saw liquidity decrease after the move.

Block ownership can pose another impediment to liquidity. David MacDonald, CEO of Softchoice Corp. (TSX:SC) of Toronto, knows all about that. For many years his business-to-business software firm had a dominant shareholder in the Ontario Teachers’ Pension Plan. While MacDonald credits Teachers with being a supportive owner, the fact the fund held a quarter of Softchoice’s outstanding stock meant daily trading volumes inevitably suffered. As a consequence, few analysts chose to cover the firm, further reducing investor interest.

“The fact we were only trading 5,000 to 10,000 shares a day was creating a blockage for the value of the company. We were growing as a firm, but our shareholders were not gaining,” notes MacDonald.

This past January, Teachers finally unloaded its position. The result “was a very good thing for shareholders of Softchoice,” says MacDonald. Trading volume has risen approximately 40% since the block was sold.

For MacDonald, better liquidity not only satisfies the constant demand for trading depth from the market, but also provides a more accurate reflection of how he’s doing at his job. “As a CEO, I want to see the stock price reflect the value of the performance of the business. If you don’t have the liquidity, then you aren’t going to get that same feedback effect. And as a result, it becomes more challenging to motivate your people.”

Share repurchases should also have an impact on liquidity, although the net effect is the subject of considerable debate among academics, executives and traders. Do buybacks improve liquidity over the short term by adding a new and motivated buyer to the market? Or do they consume liquidity by gobbling up what stock is available for sale? And what about the long-term effects of buying and cancelling shares?

Professors Brian Smith and Will McNally of Wilfrid Laurier University’s School of Business and Economics in Waterloo, Ont., have closely studied the impact of share repurchases on liquidity. Their findings suggest share buybacks improve liquidity the vast majority of the time. This is mainly due to ‘uptick restrictions’ in Canada and the U.S. that prevent firms from aggressively buying back stock at a price higher than the last independent trade of a board lot. Some Asian and European exchanges do not impose uptick restrictions, and thus buybacks in those jurisdictions can end up destroying liquidity.

As for the longer-term impact of buying and destroying shares by repurchasing, Smith suggests this does little permanent damage to liquidity, since firms generally end up issuing more shares in the future. And as Smith points out in an interview: “Many companies repeat buyback programs year after year, providing a sustained source of liquidity for sellers.”

Liquidity will also reflect the overall level of research activity and related interest from the media and public directed towards the firm. Analyst coverage, media attention and online chat activity can all contribute to the overall interest in a stock among institutional and retail investors. “We put a high level of focus on communicating with analysts, traders and investment bankers,” reports Lof. While buzz may be difficult to manufacture, it can have a substantial impact on liquidity. MacDonald, for example, suggests that the publicity surrounding the sale of the Teachers block of Softchoice shares “had a very positive effect in terms of awareness on the street. And awareness eventually creates liquidity.”

While liquidity might appear to be a preoccupation mainly among small- and mid-cap firms looking to get noticed, it is top of mind among the largest firms in the market as well. Consider Telus’ recent, unsuccessful effort to convert its dual-class share structure into a single voting stock, a move that would have nearly doubled the number of common shares available. In a letter to shareholders the firm promoted the idea as “enhancing the liquidity and marketability of Telus’ shares.” While the conversion was stymied by opposition from a U.S. hedge fund, CEO Darren Entwistle has vowed to revive it in the near future despite the obvious obstacles. Greater liquidity is clearly attractive, even to the biggest listed names.

In perhaps the most comprehensive academic study of liquidity, published in 2009, a trio of U.S. and UK academics threw every possible role and measure of liquidity into a statistical model and sifted through the impact on firm performance. Vivian Fang, Thomas Noe and Sherri Tice ultimately declared liquidity to be an unambiguous benefit to firm value. The main reasons for this are to be found in better feedback between the market and the firm and in attracting better-informed investors to the company. “Liquidity enhances firm performance through higher operating profitability. We also find evidence that liquidity enhances firm performance by increasing the incentive effects of managerial pay-for-performance contracts,” the trio concluded. From this perspective, liquidity is simply the market’s way of rewarding good firms. End of story? Not quite.

Iconoclast McIntyre argues frequently and convincingly that liquidity can often be a trap for investors and businesses alike. Slavish attention paid to liquidity can become a crutch for buyers who lack the confidence of their own convictions. Or worse, an illusion prone to disappearing at the very moment you need it most. And executives who obsess over market liquidity figures may end up courting the wrong owners.

“When an investor demands market liquidity as a condition of their investment, they’re in effect making a subconscious decision that they may have made an error—they’re looking for an exit strategy while they’re still entering,” the Sentry Select CEO opines. “I invest because I believe the assets I am buying have characteristics that will reward me over time. I would rather not put myself at the mercy of market vagaries.”

McIntyre disputes the argument that thinly traded stocks are more risky or that liquidity provides a bulwark against risk. “Market liquidity is frequently an illusion,” he warns. “It is never there when you really need it.” Case in point: the financial crisis of 2008. Prior to the subprime mortgage collapse, global markets were marked by a surfeit of liquidity, some of it due to trading innovations and some due to obvious over-confidence. And when market sentiment shifted, that much-relied-upon  liquidity dried up in an instant, leaving markets in free fall. “When liquidity disappears, the business itself becomes your backstop,” he says.

As for the ivory tower assertion that liquidity plays a major role in determining cost of capital, McIntyre again takes a contrarian stand. “People fixate too much on the liquidity of a stock, and not enough on the balance-sheet liquidity of the business itself,” he says. For firms with a high return-on-equity or a preference for debt financing, there’s little reason to suggest any reliable link between market liquidity and cost of capital. “I work in the real world,” says McIntyre, “and I can’t draw any dotted lines between liquidity and cost of capital.”

His skeptical view of liquidity reflects McIntyre’s well-honed personal perspective on investing. He likes dividends, prefers illiquid growth-oriented small- and mid-cap firms and generally plays the role of the active investor. “If I was the CEO of a publicly traded company, I would be trying to identify who I would like to own my stock and then create the characteristics within my business that will attract those investors to own my stock for a very long time.”Any firm hoping to attract McIntyre as an investor should thus pay more attention to free cash flow and forget about liquidity.

But what works for McIntyre won’t work for all. Liquidity remains a necessity for large institutional investors whose sheer size require them to take big positions, or hedge funds dependent on quick profits. Similarly, the academic evidence suggests liquidity is simply another means by which the market communicates with publicly traded firms and their executives. More shares in play means the stock price is based on a bigger and better set of data. Thus even the biggest firms are on a constant search for more liquidity.

Still, a liquidity trap remains a potential danger for issuers and investors alike. “Some folks just get fixated on liquidity,” observes National Bank Financial’s Steers. “But strict adherence to any sort of rule about liquidity not only prevents investors from considering good companies, but it means good businesses can stay undervalued because of a lack of liquidity. Of course,” he adds eagerly, “that also presents opportunities for smart investors.”

SIDEBAR

A DEFINITION…OR 68

Does everybody mean something different by “liquidity?” David Longworth, former deputy governor of the Bank of Canada, helps us get some definitions straight

The English language has plenty of options when it comes to liquidity in its natural state: lakes, rivers, oceans, creeks, seas, puddles, ponds and sloughs, to name just a few. Oddly enough, the same cannot be said for the financial world, where the single term liquidity has been forced to take on a huge variety of different meanings. One Australian researcher has actually identified 68 separate definitions of the word.

So what does the market mean when it talks about liquidity?

There are three main meanings for liquidity, says David Longworth, former deputy governor of the Bank of Canada and currently adjunct research professor at Carleton University’s Centre for Monetary and Financial Economics in Ottawa. They’re all somewhat related in concept and practice.

The most basic, accounting definition of the term is balance-sheet liquidity. For firms and households, this refers to the amount of cash-like assets that can be accessed quickly—bank balances, lines of credit and the like. “Liquidity here means how easy is it to raise funds quickly,” says Longworth. Banks also face something called funding liquidity, which is a measure of their ability to replace deposits or bonds that come due in order to generate new loans—in essence their ability to fund themselves.

A second, broader definition is the concept of market liquidity (the topic of the main story). “Market liquidity is a measure of the ability to buy or sell financial assets in the market without fundamentally changing their price,” explains Longworth. If selling a block of shares causes the price to drop 10%, then this suggests an obvious absence of liquidity.

Finally the most sweeping definition of all is the idea of macro-economic liquidity. Often referred to as “overall monetary conditions,” big-picture liquidity refers to the interaction between interest rates, credit conditions and money supply in a way that affects the ability of all firms and households to access funds.

“If there is a fundamental concept common to all the different definitions of liquidity,” says Longworth, “it is the ability to quickly and easily obtain cash, regardless of the asset you are holding.” This sense of access to ready money gives rise to the notion that liquidity is simply another way to express market confidence. “Liquidity is confidence. And confidence helps to produce liquidity,” says Longworth.

A lack of confidence in the subprime mortgage bond market back in 2008 led directly to a sudden crisis in funding liquidity at investment bankers, such as Bear Sterns, that could no longer readily convert assets such as collateralized debt obligations into cash. In time, this produced more generalized stock market fears, and dried up market liquidity. And that, in turn, hammered monetary conditions, forcing central banks around the globe to lower interest rates in order to maintain macro-economic liquidity. “The biggest surprise of 2008 was how quickly liquidity dried up in certain markets,” Longworth recalls.

Then again, you can have too much of a good thing. While more liquidity is generally a positive when it comes to balance sheets and markets, Longworth notes that too much macroeconomic liquidity—aka inflation—can cause plenty of havoc by distorting the relative values of different forms of assets and, in particular, cash. It is also possible for market liquidity to be in excess, Longworth suggests. “Sometimes people will take the fact that there is lots of liquidity as a sign there is little risk in the market,” he warns. “And this can lead to decisions that are overly risky.” The right amount of liquidity, figures Longworth, is somewhere between too much and too little. Spoken like a true central banker. —P.S.T.

 

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