The Liquidity Discount
Big institutional investors need to move millions of dollars quickly in and out of a stock, and they tend to avoid companies that don’t have a high number of shares outstanding, big average daily volume, or a large float of tradable shares. This lowers the valuation of “less liquid” stocks and leaves a nice opening for Mr. or Ms. Small Investor. You’re in the proverbial catbird’s seat. The individual investor doesn’t need to be scared away by a stock’s limited liquidity. You’re probably not going to be buying or selling enough shares to really affect the market.
I once sent my students’ research to a money manager at a big Chicago-based investment firm. He thanked me for the reports and complimented my students’ work. But, when I asked him if he had purchased stock in any of these ideas, he said, “I have for my own account, but not in the fund. These stocks don’t have the liquidity I need. It’s tough to sell a lot of shares in these kinds of companies without knocking down the price. For institutional investors, these are called ‘Hotel California’ stocks. You can check in anytime you want—but you can never leave.”
Because the big institutional investors shy away from these stocks, they tend to sell at more attractive valuations. We call this “the liquidity discount.”