| Market Liquidity Matters |
We all are aware of the two main "r’s" in an investment criterion-the risk and the return, but now there is another factor which is proving to be equally important when analyzing the potential of an investment alternative-the liquidity-i.e., the ability to translate/trade the investment into realizing cash. This is proving to be a fairly important investment criterion. The more liquid the asset, the better it is for the investor, as he or she can then realize it with ease in case they need to do so.
Be it gold, real estate, equities, debt, or bank deposits, each has its own liquidity factor. At one end of the spectrum you have cash which is the most liquid, but then the returns of keeping cash in inflationary times, are negative. At the other end is real estate, the capital appreciation in this asset over a period of time is un paralled, but the asset is most illiquid, plus the transactional costs of translating the asset to liquid form are tremendous. Gold comes somewhere in between, it is liquid in the sense that one can always walk into a jewelers shop and sell it, but the transactional costs are high. Fixed deposits with banks and post offices, companies etc., all carry a penalty clause in case you encash them earlier than the tenure. Also these instruments have no secondary market-i.e., where they can be bought and sold regularly. That leaves us with equities, mutual funds and debentures. The debt market in India is still not very liquid and lacks depth, the transactional costs for such instruments are bound to be higher than those in instruments markets which have depth and are fairly actively traded.
So the darlings as far as the liquidity and return principle go are equities and mutual fund units. These have an active secondary market, which has depth, high turnover and thus the transactional costs are competitively low. Whenever you plan to invest in a scrip always look at the floating stock of the scrip. The floating stock represents the percentage of the equity capital which is with the public and the promoters and thus is available for being traded and re traded etc. However a finer definition of floating stock could mean, only the stock which is with the public as the promoters stock is normally held and very little percentage of that may be traded actively.
Other than trading, floating stock also affects the price of a scrip. The lesser the number of shares in the market for being traded, i.e.- in case of a closely held company, in the scenario when the demand of the scrip rises, then the supply does not match up and thus the rise in the price of the scrip is higher than what would it have been for a more openly held company. Take the example of Wipro, Visual Soft etc. So does that mean that closely held companies are better investments.
No not really. You see liquidity of a scrip, give you the exit route for your investment. The exit route is very important as you have a way out in case the circumstances of the scrip change or in case you want to encash your investment. Also with the advent of the big boys in the markets, like the domestic and foreign financial institutions, mutual fund majors etc., liquidity has acquired even more important proportions. These biggies have fixed policies on entering liquid scrips, this provides them with the trading opportunity as well the exit route which they need. Market indices are also based on market capitalization of scrips-that is –the price of the scrip into the floating stock. The weightages of various scrips in an index is determined by its market cap.
Take the case of the recent announcement by Morgan Stanley Capital International which has formally stated on the 10th of December that it intends to adjust its index weightings to reflect the free float in equities markets in addition to increasing its target coverage of each market from 60 to 85 per cent. This move further underlines the importance of the liquidity of a scrip. The term free float in effect refers to the amount of shares outstanding with the public, as opposed to being held by the company itself or by long term controlling shareholders. Fund managers make extensive use of MSCI’s equity indexes to benchmark their performance and any changes made in these can result in shifts of capital as fund managers rejig their portfolios.
Approximately $3 trillion in funds are benchmarked to MSCI indexes globally. MSCI has stated that it would publish index constituents and their inclusion factors, or the estimated free float in each market, on or before June 30, 2001, with the intention of helping out market participants to ready themselves to these changes. It has also made it clear that a free float of below 15 per cent is unlikely to be eligible for inclusion except in rare cases.
November 30, 2001 would be the day when implementation of half the free float adjustments in the first phase would take place while the balance would be implemented in the second phase, on May 31, 2002.
Emerging markets in Asia and Japan are likely to be adversely hit by this move, down grades are expected in Japan, Hong Kong, Thailand and Malaysia, while in the case of South Korea and Taiwan the reverse is expected.
This announcement in itself should inform the investors of the importance of liquidity. So remember, always look at the liquidity of a scrip, or any investment instrument before you invest. The higher the liquidity, the more the trading opportunity, the lower the transactional costs and the smoother the exit route.
Aru Srivastava
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