Is illiquidity in stocks an opportunity or threat to the investors?

Yesterday the market cap of entire BSE-listed stocks crossed a total value of over Rs 127 lakh crore (nearly $2 trillion), a life-time record level. Despite such robust surge in the market cap of entire secondary markets, it is surprising to note that many mid-cap stocks still have poor liquidity in the markets.

In 2013, when the Sensex hit nearly 3-year low of 16,000, many mid-cap stocks lost their liquidity along with steep erosion in their market cap. For example, stocks like JK Tyre and Force Motors fell as low as Rs 90 (then the face value Rs 10) and Rs 300, respectively, and their daily average volume on the markets turned out to be very thin.

Many retail investors lost confidence in these illiquid stocks in the bearish phase and became scary to touch such stocks though some of them were available at PE multiple of less than 6 or at market cap, which was less than the net cash the companies were holding. However, the market cap of these stocks moved up to 8 to 10 folds within next three years.

Now the reverse is happening. Many mid-cap stocks have run up multi-folds from their three-year bottom or from their offer prices in case of IPOs. Despite such boom in the mid-cap stocks, and the whole market is now available at record level of market caps, the liquidity of many mid-cap stocks is very poor now.    

There are over 500 mid-and-small-cap stocks trade at more than 30 PE multiple on their trailing earnings – a majority of them trade at more than 50 PE. A large number of these stocks have multiplied their market cap by 100% to 200% from their bottoms in the last 52 weeks, but their trading volumes have shrunk to abnormally low levels.

For example, a newly listed stock trades over 50 PE on FY17 earnings despite significant de-growth in its net profits. Daily average trading volumes in this stock are less than 3,000 shares. A small-cap stock has moved up nearly four-fold within a year, but its daily trading volume sometimes stands at poor single digit and the stock trades at more than 100 PE on FY17 earnings.

Illiquidity in the stocks, which have good management and balance sheet, and also valuation comfort, throw great opportunity in the bear market for the wealth creation.

However, the mid cap stocks, which lack valuation comfort, their illiquidity on the secondary markets in the bull market is a threat to the retail investors – their market caps can fall like a pack of cards when fear on over-valuation unfolds.

The writer is founder and managing director, Equinomics Research and Advisory