Markets and liquidity

By Richard Sipley
In mid-2008, in the aftermath of the Bear Stearns shotgun marriage with JP Morgan and thoughts of the financial crisis being contained, there was a picture of Fed chairman Ben Bernanke with the caption “In ur markts addin likwidity,” which made the rounds. The hip-hop spelling drove home the point that the erstwhile staid keeper of monetary policy was acting fairly radically.

In a topsy-turvy world, it’s good to know some things are constant. Liquidity. The market floats on the ebb and flow of credit, backstopped by the value of productive private enterprise. It’s for this reason the market doesn’t necessarily mimic the goings-on in the economy. As Benjamin Graham said decades ago, “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Graham was pointing to the short run being dominated by how risk-seeking or risk-adverse investors were at the time — Keynes called it “animal spirits” — and the availability of credit and its relative abundance or scarcity.

My own indoctrination into the markets drove home the primary importance of liquidity. Rather than starting at a value shop concentrating on book values or a growth mutual fund investigating revenue projections and margin expansion, my first job was at a small broker-dealer proprietary desk doing market-neutral investing. My first project (this was way back in 1995) was to find every publicly traded company with multiple classes of stock — the most common type being a voting class (like Brown Forman Class A, BF/A) and non-voting class (e.g., Brown Forman Class B, BF/B).

Normally, the economic difference was small or non-existent. Each share, outside of its voting rights, represented a similar ownership stake in the company. But, the voting stock was majority held by the founding family and traded far fewer shares than the broadly held (and more liquid) non-voting shares. The difference, or “spread,” between these shares tended to be fairly constant. The key to doing well with these spreads wasn’t superior forecasting ability or unusual brainpower, but patience.

We would monitor these stocks and wait for a large seller of the voting shares to appear, demanding liquidity in a thinly traded issue. My job was to buy the voting stock at a significant discount to where they normally traded in relation to the non-voting shares and then lock in the spread by shorting the non-voting shares. We would then wait as the difference returned to normal and we liquidated our position. This trade might only appear a few times per year for a given issue, but with more than 100 of these situations, it was enough to keep me busy.

The advance of algorithmic trading has fairly squeezed the old levels of opportunity out of this strategy. But the initial lessons remained. Be a provider of liquidity first, and a forecaster of earnings trends or liquidation value second. As the investment world’s attention span narrows and the pressure to show consistent profits ratchets higher, the concept of liquidity provider increasingly becomes an advantage. Think about it — the person who rented can now buy property in foreclosure. Or the firm that resisted levering up to do a buyback in 2006 can now hire top-notch talent or purchase machinery in a liquidation.


Coal in context
I met with a coal analyst a few weeks ago. Different job. Different professional background. But he had a similar story to tell. He was fairly neutral on the industry but told of a trip to Europe in the summer of 2008 to meet with clients who were portfolio managers. His schedule was packed; lunches were standing-room only as interest in coal companies was at a high given a seemingly nonstop rise in coal prices (he was cautious on owning the stocks at the time). Six months later his schedule was exceedingly quiet; few were interested as the price of coal had been cut in half and inventories were at record highs (to anyone who would listen he’d lay out the bull case). “DCF has saved me again and again over the years,” he told me.

“DCF” (short for discounted cash flow), is derided in some corners as a futile effort to divine the unknowable future with an overstated sense of precision. It can be easy to get lost in a spreadsheet and forget about the actual business. But, in this context, it gave the analyst a rough idea of the longer-term intrinsic value and forced him to consider the cyclical nature of his industry. In a sense, it was a barometer of liquidity for his group as invested money flowed in and out.




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