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Illiquid Stocks: The Good, The Bad and The Ugly

Illiquid stocks are the last frontier for investors seeking an informational edge. It’s the wild west of financial markets. A stock picker’s dream. But it’s not all glam and gold on the lower end of the liquidity spectrum. Illiquid stocks are as great as they are dangerous. Like anything, it’s what you don’t know that hurts you.

We’ll discuss the good, the bad and the ugly of illiquid stocks. While a Wild West of financial markets, I can’t think of any better place to look for deep discounts and great businesses.

The Good

1. Little-to-Zero Analyst Coverage

Most liquid stocks have armies of analysts covering their every move. Like a celebrity, these stocks can’t go unnoticed. Think of your favorite large-cap, blue-chip stock. How many analysts cover that one stock? Hundreds … Thousands if you include retail analysts.

We know the markets are discounting machines. In other words, they discern real-time information and decide how that information affects the future cash flows of the business.

In the case of liquid stocks, the time between information hitting the news and the stock price reflecting that news is almost instantaneous. But, when we venture into illiquid territory, that time delta changes. It elongates significantly…

Why does it change? Analyst coverage. Like we mentioned earlier, illiquid stocks have low (to no) analyst coverage. This means new information doesn’t spread along the investment bank analyst wire. But along those holding the stock — i.e., retail investors. Information that travels along these pathways takes longer to reflect in the company’s stock price.

Another interesting aspect of illiquid stocks are the earnings calls. You might be the only investor on an earnings call with management. Where else do you get that type of connection and access?

Why is this a good thing? One obvious reason is that you (a disciplined investor) can take advantage of this information reflection delta. I’m not just referring to upside situations, either. A company could report a terrible quarter or an awful press release. If you’re in the know, you can (hopefully) get out before the stock price reflects said information. This is called the informational edge.

2. Informational Edge / Asymmetry

A lack of analyst coverage brings us to our second benefit: informational edge.

Informational edge occurs when one person knows more about a situation (or security) than someone else. It helps to think about this through insurance companies and their customers.

Customers of insurance companies know more about their health than their insurers. In that case, the customers have an informational edge. How does this look in the stock market?

Let’s take our example from earlier — a positive earnings release from a small, illiquid stock. If you’re a close follower of the company, you’ll be able to determine (roughly) how that news reflects the company’s future cash flows. This company could have released news of a major contract that doubles annual revenue.

But if a mere $2,000 worth of shares trade hands on average, it’ll take a while for that news to reflect in the stock price.

This is the information edge.

Let’s go through a real-world example from my own book with Tel Instrument (TIKK).

TIKK released an 8-K revealing a brand new contract with a United Kingdom customer. The contract marked the first time TIKK was able to penetrate the UK market. A pretty good business update if you ask me.

What happened with the share price that morning? Down 5%, of course. A press release that confirms my bullish thesis and (if anything) improves the long-term potential cash flows of the business … and down 5%? I bought, confident I was buying from uninformed sellers.

The hindsight bias rings loud but the principle remains. If you know a lot about an illiquid business, you create your own informational edge.

3. Adding Value To Investment World

The last benefit is a bit esoteric, so bear with me. When you research, discover and write about illiquid stocks, you’re adding value to the investment community. This isn’t to say that those analyzing MCD don’t add value. The point is you’re taking something that was unknown and making it known.

I don’t know if it’s the investigative journalist or construction worker in me saying this. But there’s a palpable feeling of discovering something new, something unique, something off-the-beaten-path… it’s addicting. It’s why I love this space. It’s why I wake up excited each day.

After those lovely words, let’s get to why illiquid stocks sometimes suck.

The Bad

1. Imperfect (or Wrong) Information

What makes illiquid stocks great also makes them troublesome. Accurate financial information is one such characteristic. Many illiquid stocks aren’t registered with the SEC. These so-called “dark” stocks trade on the OTC markets. While not legally required to provide financial information, you can find some information on the company’s website.

Investors used to up-to-the-minute financial data will have a tough time shifting gears to the slower-pace reporting of illiquid companies. Sometimes all you’re given is last year’s annual report. Your next piece of information for analysis? The next annual report.

When researching illiquid stocks, it’s best to go directly to the source. You can’t trust the financial information you see from your normal trusted data sites.

2. Can’t Make a Quick Exit

One of the benefits public markets offer is the ability to quickly exit an investment. Highly liquid stocks allow you to buy and sell within nanoseconds. There’s tight bid/ask spreads, it’s a nice world.

Illiquid stocks don’t offer that luxury. While we know the benefit of illiquidity (see Roger Ibottsson’s work) it also has drawdowns.

The bad part about illiquidity is that you can’t exit when you want when you need to. Well, that’s not entirely true. You could force-sell your entire position. But you’d move the market and destroy your cost basis.

Hence why illiquid stocks are a stock picker’s dream territory. If you’re wrong, you better have a margin of safety because you might not be able to sell!

3. Lack of Investor Relations

Many illiquid, micro-cap companies have a small (if they have one) investor relations department. Events we take for granted like press releases, report filings or general earnings announcements can be a rarity at the bottom of the liquidity spectrum.

Once again, this is as much a good thing as it is a bad thing. It all depends on your interpretation. You’re going to have to do some legwork to get what you want.

The Ugly

1. Difficult To Contact Management

Contacting management isn’t easy with illiquid stocks. Sometimes it’s almost impossible. In some cases, management makes shareholders jump through hoops to reach executives. Here’s a personal example.

I’ve been a shareholder in Butler National (BUKS) since July. On one earnings call, another shareholder asked if they could call management after the earnings release to chat about the business. Nothing out of the ordinary. But here was management’s response:

“If you want to get a hold of us you must mail us a letter, hard copy to our business address.”

No email, no phone call. I thought I was back in the 1940s.

2. Hard To Obtain Financial Information

Illiquid stocks have the added hurdle of spotty financial data. Like we mentioned earlier, you can’t trust financial data services. They won’t pick up accurate data on these companies (for the most part). And if they do report figures and metrics, they may be inaccurate. As always, it pays to double-check with the company’s actual filings.

But some companies make it almost impossible to obtain financial data. Check out this snippet from a company’s website:

How crazy is that? Want a copy of the latest annual report? Sure thing! Just make sure you:

    1. Are a current shareholder
    2. Write a request
    3. Sign a simple NDA

Oh and after you receive the report, you can’t trade the stock because now you have non-public information.

This isn’t the average case (thank God), but it’s an ugly part of the illiquid stock-picking business.

3. Lots of Time Saying No to Frauds

There’s a lot of good quality illiquid companies out there. Unfortunately, you need to turn over one fraudulent rock after another to find them.

I put this in the Ugly category because I’m not going to lie, some days it’s brutal. Why is it brutal? You can’t screen for illiquid stocks the same way you do other qualities. It goes back to the data issue. So, the best way to find great ideas is one-by-one. Starting at the A’s.

It’s an arduous, time-consuming process with little visible incremental progress. There are months I don’t find a single interesting idea. Then there are times when I can’t find the capital to deploy into every idea I find.

That’s the game. It’s brutal, it’s ugly. But it’s worth it.

Not A Game For Everyone

Investing in illiquid stocks isn’t for everyone. It takes a certain type of investor. One willing to endure volatility, uncertainty, lack of information and endless research. All for the hopes of finding a stock you want to back the truck on, knowing full well you may not get out of this position for years.

Illiquid stocks are the last remaining frontier in the financial markets. A true Wild West. A hybrid between public and private equity. A space I wouldn’t ever consider leaving.

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