Oaktree's Howard Marks’ Master Class on Liquidity

'Liquidity is expensive but illiquidity is much more so, 

because it destroys the very existence of a firm"

-William Manchester, The Arms of Krupp*

From Barron's Wall Street's Best Minds column:

As some fear a liquidity crisis in global bonds, a respected investor explores a topic central to markets.

My wife Nancy’s accusations of repetitiveness notwithstanding, once in a while I think of something about which I haven’t written much. Liquidity is one of those things. I’m not sure it’s a profound topic, and perhaps my observations won’t be either. But I think it’s worth a memo.

Liquidity Defined Sometimes people think of liquidity as the quality of something being readily salable or marketable. For this, the key question is whether it’s registered, publicly listed and legal for sale to the public. “Marketable securities” are liquid in this sense; you can buy or sell them in the public markets. “Non-marketable” securities include things like private placements and interests in private partnerships, whose salability is restricted and can require the qualification of buyers, documentation, and perhaps a time delay.

But the more important definition of liquidity is this one from Investopedia: “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.” (Emphasis added.) Thus the key criterion isn’t “can you sell it?” It’s “can you sell it at a price equal or close to the last price?” Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition. For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.

Liquidity Characterized I often say many of the important things in investing are counter-intuitive. Liquidity is one of them. In particular, it’s probably more wrong than right to say without qualification that something is or isn’t “liquid.”

If when people ask whether a given asset is liquid they mean “marketable” (in the sense of “listed” or “registered”), then that’s an entirely appropriate question, and answering it is straightforward. Either something can be sold freely to the public or it can’t.

But if what they want to know is how hard it will be to get rid of it if they change their mind or want to take a profit or avoid a possible loss – how long it will take to sell it, or how much of a markdown they’ll have to take from the last price – that’s probably not an entirely legitimate question.

It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell.

In other words, the liquidity of an asset often depends on which way you want to go . . . and which way everyone else wants to go. If you want to sell when everyone else wants to buy, you’re likely to find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case – and I’m sure it is – then the asset can’t be described as being either liquid or illiquid. It’s entirely situational.

There’s usually plenty of liquidity for those who want to sell things that are rising in price or buy things that are falling. That’s great news, since much of the time those are the right actions to take. But why is the liquidity plentiful? For the simple reason that most investors want to do just the opposite. The crowd takes great pleasure from buying things whose prices are rising, and they often become highly motivated to sell things that are falling . . . notwithstanding that those may be exactly the wrong things to do.

Further, the liquidity of an asset is very much a function of the quantity involved. At a given time, a stock may be liquid if you want to sell a thousand shares but highly illiquid if you want to sell a million. If so, it can’t be said categorically that the stock is either liquid or illiquid. But people do it all the time....MUCH MORE 

Howard Marks' Master Class on Liquidity

Here's Oaktree's "LATEST MEMO FROM OUR CHAIRMAN, HOWARD MARKS"

*Regarding the Manchester, here's November 2014's "The Coming Liquidity Implosion":

A couple times per year I dust off a quote I first used on these pages during August 2007's quant quake:

Liquidity in Business and Markets

'Liquidity is expensive but illiquidity is much more so, because it destroys the very existence of a firm"

I don't remember if it was Johannes or Ernst, it was a long time ago that I read Manchester, quoting one of the Schroeder boys on the insolvency of Krupp. That line has stuck with me. Here's the book.