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Low Liquid Stocks- High risks, High returns!

| 02/01/2018 Thursday

Low float, low liquidity stocks are often ignored by retail investors for long term investing. Yogesh Supekar and Tanay Loya explore the pros and cons of investing in low float stocks

Sensex has crossed the 36,000-mark and, on a YTD basis, it is already up by 6 per cent. With the major benchmark indices, viz., Sensex & Nifty enthusing investors like never before, nothing could be more rewarding for the investors. How does one beat the market that is touching record highs and still looks formidable? 

If you follow what Gunvanth Vaid, an HNI investor based in Chennai, has been doing to beat the markets, do not be surprised if you end up beating the benchmark Sensex by a huge margin as well, even while the Sensex is on a tear. Gunvanth Vaid has been a master at investing in those stocks that have low float and are illiquid, but at the same time, the fundamentals of these companies are strong. Gunvanth explains that Caplin Point Lab was trading at just Rs.60 during July 2014 and the market cap of the company was a meagre Rs.100 crore. It was difficult to accumulate the stocks at that time as the liquidity was low. Caplin Point Lab today is trading at Rs.622 and the market cap of the pharma company is roughly Rs.4,656 crore.

He believes that if one is confident about the business model of the company and if one believes that the fundamentals of the company are good, investing in shares with low liquidity and low float will definitely prove to be a winning strategy. 

But then, what is this “low float investing strategy” and how does it work? Is it really rewarding and can a small investor also adopt such a strategy? 

What is a low float stock? 

To understand which stock can be called a low float stock, we will first understand what is ‘share float’. The share float is nothing but the number of shares of a company that are available for trading. Floating stock for any company is calculated by subtracting closely-held shares and restricted shares from the company’s total outstanding shares. The shares that are held by insiders, major shareholders and employees are termed as closely held shares. The insider shares are not allowed to be traded because of a temporary restriction such as the lock-in period after initial public offering and are known as restricted shares. 

While such low percentage of free float shares may prove to be difficult for active traders who would look to exit from profitable positions, by no means is a low float stock a disadvantage for long term investors. In fact, the company’s floating stock typically goes up over time. Often, the company sells its shares in a secondary offering to expand its business. Funds could be raised from the secondary market for the purpose of acquisition as well. The float also increases when an employee exercises his or her stock options. Thus, the stock float of a company can increase over time. 

However, one has to study the corporate events unfolding in respect of the company as it has direct impact on the price of floating shares. A share split can increase floating shares, while a reverse split decreases the float. A simple share buyback by a listed company will ensure that the total number of outstanding shares decreases, thus lowering the percentage of free float shares as a percentage of total number of outstanding shares . 

Why Invest in Low Float Shares? 

Many investors might think it is a bad idea to invest in low liquidity and low float stocks. Satyajit Hange, who has been investing in stock market for more than a decade, confirms he has never invested in scrips with low liquidity. Says Satyajit, “I stick with A group stocks only as I find them safer”. The common misconception is that the low float and low liquidity scrips are not fundamentally strong stocks and hence it may be a bad idea to buy and hold these stocks. While there is no evidence to suggest that all low float stocks are fundamentally good to invest in, similarly it cannot be concluded that all low float stocks are fundamentally poor stocks. 

Investing in fundamentally strong scrips with a low float is something that should catch long term investors attention. Because the availability of shares is low in case of low float stocks, the stock prices can show a quick upmove the moment there is a positive news in the stock. It is also seen that the rallies in the low float stocks can be more news-driven. 

It is all about demand and supply of stocks. The case in favour of low float stocks is that when the fundamentals of such a company is seen improving, the visibility of the company increases and, as the visibility of the company increases, more investors will attempt to buy the shares of such low float companies. Such development triggers a sharp rise in stock prices for low float companies, much sharper than those seen in large-cap stocks or even mid-cap stocks for that matter. 

Ideally, the stock should be identified in its early growth stage and its takes accurate understanding of the underlying business to estimate the business potential or market opportunity for a small to micro-cap company with a low float. 

Basically, if the fundamentals are good for any company and the growth potential is visible along with the expanding market size, low float should not be a hindrance but a boon for the early investor.

Nilesh Shetty 

Associate Fund Manager-Equity Funds, Quantum AMC 

Companies with large promoter shareholding with very little shares available for public ownership are known as low float companies. Given that there is limited number of stocks available for trading, sometimes it may hinder price discovery. But whether a stock outperforms or underperforms is linked to its business and not the float available. 

It is possible that a company may have large number of shares outstanding and yet a fairly limited float. It is common to see several companies with less than 20 per cent of outstanding shares as free float shares 

Anita Gandhi 

Whole Time Director, Arihant Capital Markets Ltd 

It is certainly a good strategy to buy and hold fundamentally good low float stocks. However, it is essential to continuously monitor quarterly results of these companies and the trend of the sector (demand–supply situation, its peer group positioning in the sector) to which it belongs. However, there could be risk associated with selling of the stock at one go if something goes wrong with the company 

An early investor who has entered a low float stock can reap moolah from such investments, assuming the stock is has low liquidity and happens to be the stock of a micro-cap sized company that is fundamentally sound with multi-year visibility in growth. 

Simply put, the risk-reward ratio is extremely favourable for such fundamentally qualified low float stocks. It may take some time for the larger audience to notice the positive developments in the stock; however, once noticed by the investing community, the kind of traction that can be seen in such low float stocks can surprise the best of seasoned investors. The returns could be manifold and the time frame need not necessarily run into decades. 

Such deserving low float stock can quickly reflect the true value (intrinsic value) and also discount the positive future developments in its price. One can also expect institutional investors to chip in once the liquidity improves and the stock gets noticed by both the retail and HNI investors. 

One of the best parts of a low float stock is that such stock shows relatively less correlation with the overall market and, hence, it can add tremendous diversification benefits to the portfolio. 


How have low float stocks performed in general in 2017?
 

Having understood the concept of low float investing and grasped the advantages of entering early into quality low float stocks, it will be enlightening to know how the low float stocks in general performed in 2017. 

If we define low float stocks for all the BSE listed stocks as those stocks with promoter and institutional holdings exceeding 60 per cent of total equity shares and the average number of shares traded (volume) in the last one month not being more than 1,00,000 shares, we get a list of 286 companies with market cap of more than Rs.100 crore. 

We find that for all the companies with market cap greater than Rs.100 crore and the promoter holding plus the institutional holding exceeding 60%, the performance in terms of average returns is impressive. For those companies where the liquidity is too low or is less than 25,000 shares traded on an average in a month, the average one year return is 31.19 per cent

For those companies having an average monthly trading volume of less than 50000 but higher than 25000 the average return for the past one year has been an impressive 61.69 per cent. The number of such companies stood at 85. Similarly, for those companies where the average monthly trading volume has been less than 100,000 shares but more than 50,000 shares, the average return in the past one year has been 46.64 per cent. These returns are average returns which have not been filtered for stocks with proven fundamentals and track record of superior growth. The list of stocks considered for the calculation of returns have been based only on their low floats. 

Risks involved in buying low float stocks:- 

While the rewards can look extremely lucrative for investing in low float stocks, the risks involved in investing in such stocks cannot be ignored. The obvious risk while investing in such shares is the liquidity risk. Imagine a situation where an investor has over time assiduously accumulated 1,000 shares of an illiquid stock. The share has inched up by 50 per cent from the average buying price and the investor now wants to dump all the 1,000 shares, thus expecting a 50 per cent return on investment. However, when the shares are being offered for sale, the probability of the stock price coming down is quite high, which will definitely impact the ROI. The situation can be ugly for an investor when he or she wants to exit from the low float stock which is being impacted by negative news about the company. In such a case, the selling pressure will not only impact the share price negatively, but it will also hamper the ability to sell such shares quickly. 

Beyond low liquidity and high impact cost for such low float shares, the other risk that traders and investors transacting in these shares are exposed to is that the prices of these shares are prone to be manipulated by one big investor or a group of investors to their own advantage. The probability for manipulation is high as there are few shares available and a large shareholder can be highly influential and that may not augur well for small retail investors.

The average share float for all the stocks listed on the BSE is 46 per cent, while for the BSE 500 companies, it is 20.93 per cent.*

Low float stocks can prove to be an impediment for active traders as the lack of trading activity makes it difficult for the traders to exit their positions. 

A low float company will normally be more volatile than a stock with a large float. Low liquidity and high bid-ask spread is another characteristic of a low float stock. Due to these reasons, institutional investors usually do not prefer to invest in low float stocks 

Impact Cost 

Impact cost is the cost of executing a transaction on the stock exchanges for a given stock for a specific order of a predefined size at any point in time. The impact is the difference in the general average or ideal price of the stock against the price at which it is actually bought. It is the percentage mark-up identified while buying or selling any specific quantity of shares in reference to the ideal price of the stock. The impact cost varies for different transaction sizes and also considers the outstanding orders. The impact cost is a real measure of the liquidity of the stock and is viewed to be closer to the true cost of transaction as compared to the bid-ask spread concept, which is the difference between best buy and the best sell orders. In case of insufficient liquidity for a stock, a penal impact cost is applied. The greater liquidity a stock has, the lower will be its impact cost. The impact cost rises if the stock lacks liquidity. Liquidity of a stock is referred to the availability or the willingness of the buyers and sellers to transact in the stock. 

Jaikishan Parmar, 

Research Analyst, Angel Broking 

These stocks could work as a double-edged sword, i.e., if the company reports hefty growth in one quarter, then the stock would generate good returns in a short duration. On the contrary, if subdued to average financials are reported, then the stock could correct aggressively. Hence, the only risk to low float stocks is a quick correction on the announcement of the subdued results or some external negative news related to the company's sector. 

However, an investor should not keep low float or higher weight as a criteria while searching for a company. If any company is steadily reporting growth in revenue, EBITDA and net profit coupled with improving return ratios and strengthening balance sheet, then an investor should consider investing in the stock despite it being a low float stock. Lastly, one should also look for corporate governance of the company with low float and also the pledge by the promoters.

Low float companies are prime candidates for delisting 

 

Conclusion :- 

Most of the time you will find that a big chunk of the quality stocks is held either by the government or the promoters. In India, one may observe that, traditionally, promoters have been wary of sharing their coveted and prized assets with the public. It should be noted here that India remains of the countries that has lowest free-float capitalisation when compared with not only the developed markets but also the emerging markets. 

A careful selection of stocks by the retail investors is all that is warranted in the low float space in order to generate market beating returns. The opportunity is real and a genuine one for those willing to adopt the strategy of investing in low float stocks and for those with an appetite for long term investments. The risk-reward will be in favour of those investors who have the ability to identify fundamentally good stocks within the available list of low float stocks. 

It is quite possible that the valuations could be rich for low float stocks, and the trick for the investors is to buy the low float stocks at the right premium as no one wants to overpay for a stock simply because it has a low float. Valuation matters and is relevant in case of low float stocks as well and it should not be ignored. 

Without getting overboard for the low float stocks, despite the upside potential that these stocks can provide, assuming one scans them for fundamentals, a maximum of 15 per cent allocation of the total portfolio can be made for these stocks.

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