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How to ensure you never get stuck in investment quicksand again

by , 12 February 2016

Suresh recently asked me: "How do I determine the liquidity of a company? If I buy shares and then decide to sell them, how can I determine if there would be buyers for my shares? Will I always be able to sell my shares?"

Being in a position where a share that have no liquidity is like being in quicksand. You can struggle to sell the shares, but you'll get absolutely nowhere!

Fortunately, you'll be able to sell all the shares I tip because I make sure I only tip shares with a minimum liquidity of R50,000 to R100,000 a day. So if a share doesn't have liquidity and doesn't trade in decent volumes every day, I won't tip it.

Now, for the answer to the rest of Suresh's question.

The easiest way to find out about the liquidity of a share is to ask your broker! Pick up the phone and ask him what the average daily traded value for a share is. He'll be able to give you an answer.

But if you're like me and you want to make sure about these things for yourself, then there's the long way…

How do you determine liquidity?
 
All you need to determine how liquid a share is, is to know how many shares are traded each day. You can get these figures from your online broker. But some companies also post this on their websites. I’ve even seen companies give an average value traded for their shares in their Annual Reports.
 
For the shares in our PowA! portfolio I prefer to have the average value traded per day above R100,000. That ensures that there’s enough liquidity in a share.
 
Remember though, if you want to buy R20,000 worth of a share the liquidity has to be higher. I prefer to keep the liquidity ten times more than the value of shares I hold. So if you buy R10,000 worth of shares the average value traded must be R100,000. For R15,000 worth of shares the average value traded must be R150,000.
 
There are many reasons for low liquidity. Often it’s because a company has very little shares in free float. This means most of the shares are tightly held by long term investors and directors. This would mean there aren’t a lot of sellers of the share, and that can be a good sign!
 
But on the other hand there are cases where there are no buyers for a share…
 
No buyers of a share is a very bad thing for you
 
This is what you have to watch out for…
 
I’ve seen some bad penny shares in the past! Shares that have loads of sellers, but absolutely no buyers!
 
That means if you held those shares there’d be absolutely no way to get rid of the shares you had. You’d be stuck with a bad share!
 
This is usually the case when things go sour at a company… There’s just no interest in the share and buyers dry up. 
 
And that’s why my PowA! strategy is so selective when I pick a share. 
 
I have to make sure that there’s a safety net that’ll protect you no matter what. 
 
I don’t just predict bad things that might come; I avoid them at all costs!
 
What do you do if you want to know whether you can sell your shares?
 
This can be solved easily by picking up your phone and calling your broker. The preferred brokers we have on our FSP Invest Broker Letter will all be happy to help you.
 
Alternatively you can check the buyers and sellers of your share online. You’ll see a table that looks like this:
 

 
This table shows you all of the bids to buy share XYZ and all of the offers to sell share XYZ.
 
Here’s the terminology:
  • Ord – this tells you how many different orders are on the JSE at the same price. In this example, there are four orders to buy a total of 1,834,000 shares at 2c each.
     
  • Volume – the amount of shares that are on order to be bought or sold.
     
  • Price – this is the price that an order is in the market for. The highest buying price will be on top of the Bids to buy column, the lowest selling price will be on top of the Offers to sell column. When the lowest selling price and the highest buying prices are matched the order will execute.
It’s important to remember that you can’t sell more shares than the number on order to be bought. So in the example above, you’ll see there are 13 sellers that want to sell 2,329,840 shares at 2c, but there are only 1,834,000 shares on order to be bought. This means that all four of the investors that want to buy shares will be able to do so. But not all 13 of the sellers will be able to sell all of their shares.
 
How does this help you if you want to sell your shares immediately?
 
If you want to sell your shares immediately you have to make sure you get your order in at the top of the list and that it matches with a buyer. It’s that easy. But remember, that might not be the price at which you want to sell your shares.
 
That’s why if I want to sell shares at a specific price I set my order to stay in the market for a month and to only execute at the price I’ve stated. That way I make sure I get my target price when the share goes up.
 
You can do the same thing if you’re buying a share. Sometimes it happens that all the sellers for a share at the price you want to buy it at have been taken out – meaning all their orders have been matched. Instead of buying the share at a price that’s higher than the safe buy range I’ve given you, it’s better to place your buy order in the market for a month and wait for it to trigger when the share price pulls back!
 
 
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How to ensure you never get stuck in investment quicksand again
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