What to do when holding an illiquid asset?

In the third chapter of this module, we delved extensively into the concept of liquidity and saw how important it is for an asset. In this one, however, we’re going to be dealing with illiquidity and what you can do when holding an illiquid asset. 

What is an illiquid asset?

As you’ve already read before, an illiquid asset is something that cannot be bought or sold in the market quickly. Finding buyers for an illiquid asset is almost always hard and may take days, weeks, or even months. That’s not all. When it comes to selling an illiquid asset, you might sometimes even have to compromise on the price to make it more attractive for buyers. 

For instance, immovable assets like land, buildings, and heavy machinery, among others are traditionally illiquid in nature. In terms of stocks, penny stocks, micro-cap, nano-cap, and small-cap stocks are a few examples of commonly illiquid assets.    

Why are some stocks illiquid?

By now, you know that certain stocks of companies can be illiquid. However, do you know why they are illiquid? Let’s take a look at a couple of reasons why they are so. 

1. The company may have been delisted from the exchange

Delisting from the stock exchanges is one of the primary reasons why the stock of a company becomes illiquid. A stock exchange’s primary aim is to provide an open marketplace for the investors, where they can buy and sell shares of the company freely. 

And so, as long as the stock of a company is listed on a stock exchange, it enjoys access to this open marketplace and can be bought and sold at will. But as soon as the stock gets delisted from the stock exchange, the access to its stocks is cut off, leaving investors with no place to buy or sell the stock. This ultimately makes the stock illiquid.      

In the history of the Indian stock market, there have been several instances where stocks have become completely illiquid because they were delisted from the exchanges. Here’s an illustrative list of a few well-known companies that have had their shares delisted from the stock exchanges:

• • Reliance Media Works Limited
  • Sreeleathers Limited
  • Panasonic Home Appliances India Company
  • Essar Oil  

2. The demand may be far lower than the supply

Another major reason for the illiquidity of a stock lies in its demand and supply metrics. For instance, if the supply for a stock is far higher than its demand, such a stock tends to be illiquid in nature because there are few or no buyers. There are plenty of reasons why a stock may have more sellers, with little to no buyers. Let’s quickly take a look at three of the main ones. 

• Poor fundamentals

A stock with languishing fundamentals and bad management is obviously going to have investors trying to offload their investments, which would result in a huge spike in the supply. However, there wouldn’t be any takers, since no investor would want to get involved in a company with poor fundamentals. Such a situation is bound to lead to illiquidity. 

• Listing on regional exchanges

Certain stocks, instead of being listed on the country’s premier exchanges such as the NSE and the BSE, might be listed on regional exchanges. However, the level of investor participation in regional exchanges generally tends to be far lower than that in the NSE and the BSE. With low investor participation, buying and selling the stocks gets extremely tough, thereby leading it towards illiquidity.   

• Bad press or market sentiment

Some stocks may get bad press due to severe mismanagement or lapses in corporate governance, turning the market sentiment towards them into the overly negative zone. In such a situation, the supply for the stock would see a sudden spike and the demand would fall flat. This is likely to make the said stock illiquid in nature.   

Illiquid stocks in the Indian equity market

Here’s a snapshot from the Bombay Stock Exchange’s website indicating the list of illiquid stocks listed in the exchange. 

As you can see from this image, these are some of the stocks that carry very low amounts of liquidity. Throughout an entire trading session, only as many as 1 to 31 shares have been traded in these companies. In such a case, it is virtually impossible to sell the shares of the company through the exchange. 

On the contrary, take a look at the following snapshot, which was again taken from the BSE’s own website. 

All of these stocks are some of the most liquid counters in the exchange. Look at the volume that’s been traded in a session - ranging from around 2.65 lakhs and going all the way up to 15 lakhs. Buying or selling the shares of these companies would be extremely easy and almost instantaneous.     

What are some key identifying markers common to most illiquid stocks?

Now that you know all about illiquid stocks, let’s take a look at some of the key metrics that you can use to identify them. 

1. Institutional investor data

Institutional investors are large investor groups such as hedge funds, mutual fund houses, and other corporate entities with deep pockets. Since they almost always deal in bulk, they have the potential to sway the price of a stock. That’s not all. Their mere participation injects liquidity into the counter.

If the institutional investor participation for a stock is high, then the stock can be said to be liquid. However, if there’s little to no institutional investor participation, then the stock is likely to be illiquid. You can get this data for a stock from the exchange’s website free of charge. 

2. Daily trading volume

By analyzing the daily trading volume, you can easily determine the liquidity of a stock. High daily trading volumes mean more investor participation and therefore, high liquidity. On the other hand, low daily trading volumes mean very less investor participation and therefore. illiquidity. Again, the daily trading volume data for a stock can also be taken from the respective exchange’s website. You can refer to the two images in the previous segment of this chapter for more information. 

3. Lower circuit

Every stock has a price band within which it trades. The price band consists of a lower circuit and the upper circuit, as we saw in the previous chapter. If you find that a stock is consistently hitting lower circuits on each trading day, it could point to illiquidity of the said stock.  

4. Large bid-ask spreads

The difference between the bid price and the offer (ask) price for a stock is what is termed as the bid-ask spread. This spread typically tends to be small for stocks that are highly liquid. For stocks that are illiquid, however, the bid-ask spread can be quite large. This makes the bid-ask spread a huge indicator of illiquidity.  

What to do when you’re holding illiquid stocks?

We’ve finally come to the central part of this chapter. The previous segments were all essential to help you understand if you are holding illiquid stocks. If you find yourself owning illiquid stocks and not knowing what to do, then here’s some information that can help you out. 

1. Sell them in the third market

Well, you’ve read about the primary market and the secondary market, right? But did you know that there’s also a third market for stocks? This third market is essentially an over-the-counter (OTC) market. Here, individual investors and institutional investors participate and conduct trades outside the purview of the stock exchanges. 

When you hold an illiquid stock, especially one that’s delisted from the exchanges, you could try to sell it in the third market. There are plenty of companies that actively participate in the third market and are open to buying stocks that are delisted and illiquid. 3A Capital Services, Abhishek Securities, and Kajaria Securities are a few of the more well-known companies that deal with illiquid stocks.  

2. Hold those shares over the long term

Alternatively, you could also choose to hold onto it personally for the long-term. There have been plenty of instances where companies with illiquid stocks have bounced back up. And so, you could hold onto these illiquid stocks in the hopes that it would eventually become liquid again. But then again, the chances of a stock bouncing back depend on the reasons it was illiquid in the first place. Delisted stocks, obviously, cannot bounce back. 

But this strategy can be very lucrative in cases where you hold stocks of companies that are listed on regional stock exchanges. There’s always the chance of the company getting listed on the big bourses sometime later. And when it actually gets around to doing it, you can not only take advantage of the increase in liquidity, but you also get to enjoy significantly higher capital appreciation as well. 

A great example of this is the Orissa Minerals Development Company. The company listed itself first on the Calcutta Stock Exchange. However, it suffered from lack of liquidity. And in 2010, it was listed on the BSE, leading to a major spike in its liquidity and share price.  

Pilani Investment and Industries Corporation is another good example. It listed first on the Madhya Pradesh Stock Exchange and then moved onto the BSE and NSE in 2011, bringing high levels of liquidity and capital appreciation along with it. 

Wrapping up

And, that’s a wrap! With this, we’re done with the chapter. Now that you know how to deal with illiquid stocks, all that’s remaining for us is to get to know what you can do when a technical snag hits trading on exchanges, which we will be covering in the next chapter.

A quick recap

• An illiquid asset is something that cannot be bought or sold in the market quickly. Finding buyers for an illiquid asset is almost always hard and may take days, weeks, or even months. 
• Stocks may be illiquid because the company may have been delisted from the exchange, or because the demand may be far lower than the supply.
• When you’re holding illiquid stocks, you can either sell them in the third market or you could hold them over the long term.