Liquidity and Volume

The relevance of liquidity and turnover levels is easy to overlook when assessing a stock, or an entire market. Liquidity refers to the availability of shares in a company. Volume describes turnover, or trading levels, in a stock.

BHP and NAB are the two most liquid stocks on the Australian market. Thousands of investors have shares in them; the stocks are actively traded in every market session.

In contrast, the shares of many smaller companies, particularly those with major or controlling shareholders, normally trade both irregularly and in small volumes, with the price tending to fluctuate from one transaction to the next. The lack of liquidity is a feature of the market in such stocks.

Clearly, the level of turnover in a stock or a market will be strongly influenced by its liquidity.

The daily newspapers’ sharemarket trading summary pages detail the number and value of shares traded each day for the overall market, major sectors and, in the share lists, of all listed companies.

Investors who have dabbled in thinly traded smaller companies will know that a stock’s liquidity can decisively influence the direction of its price in the short term. Just one or two active buyers or sellers can represent the total market in a stock for a period and be decisive in determining where the price goes.

Because the shares of smaller companies are infrequently traded (sometimes going for days, even weeks on end, without a serious buyer or seller in sight), investors intending to deal in such stocks, either as buyers or sellers, need to take special care about how their orders are placed on the market.

When dealing in these stocks, it helps if the investor has an established relationship with a broker. If readers who are new to the market intend to be active in the smaller companies area, they should invest some time in choosing and establishing a relationship with a broking adviser.

Specific price limits should normally be given with buying or selling instructions to the broker, so the price you pay, or get, does not end up out of the range you intended to trade at. When orders are active, the market should be watched for potential buying or selling interest, or to amend your price range. Your broker may need to refer back to you for further instructions as buyers or sellers become apparent, or to amend limits if nothing appears to be happening.

It pays to be both patient and opportunistic when dealing in thinly traded stocks: patient because it may take days or weeks to attract a serious buyer or seller to meet your bid or offer, and opportunistic because if a buyer or seller does appear, you may need to act quickly, adjusting your price according to circumstances, if you want to do a deal.

The shares of most larger companies are comparatively liquid. Substantial volumes of shares are traded every day in big companies. The market for the shares of these companies is characterised by the continuing involvement of brokers representing numbers of buyers and sellers, large and small, continually trading (both buying and selling) the companies’ shares.

By international standards the Australian stock market is not particularly liquid. More than anything, this reflects the fact that it is comparatively small, representing about 1.5 per cent of global stock market capitalization. Only the larger Australian companies provide the degree of liquidity required by international fund managers to allow transactions of the size they normally undertake.

This means that offshore investors focus mainly on the industrial and mining leaders when they invest in the Australian share market. The concentration of overseas interest in a comparative handful of large companies and the mining sector means a tendency towards a two-tiered local market, at least in valuation terms, with prices of the leaders being more immediately subject to international influences than the prices of smaller companies.

The comparative smallness of the Australian market is a contributing factor, together with its substantial resources exposure, to its historical performance being more volatile than that of larger world markets. This is paralleled within the Australian market by the generally more volatile performance of the smaller companies sector compared to larger stocks.

Part of the reason why less liquid markets are more volatile is that by nature they fluctuate more dramatically on changes in market sentiment than larger markets. The limited availability of shares means that, for example, a surge of buying interest is likely to flush out all immediate sellers while not satisfying all the buyers: to obtain stock, buyers must bid up the price to induce new sellers into the market.

Similarly, a large number of selling orders will tend to swamp less liquid markets, placing strong downward pressure on the price until buyers reappear.