A Walk Down Liquidity Street

After our most recent annual meeting, a few people asked me to explain what I mean by “liquidity.” This is a finance term that carries different meanings depending on when it is used. In this post, I’ll do my best to explain how and when I use it. I will also share a few tips that might help you manage liquidity in your small business. These tips are vague so contact me if you want to talk about your own situation and goals.

First, let’s divide the term “liquidity” into two broad uses. The first is used by our friends in high finance. They would use the term “liquidity” to describe the ease and speed of converting a stock or bond into cash. A stock that can be bought or sold quickly is said to have high liquidity. Most traders scurry to a trading terminal and chew on the number of historical shares that trade every day and make a judgement about liquidity as a relative term to other stocks of similar total dollar size. If I buy $100,000 of this company’s stock, how long will it take me? If I were to sell, how long would that take me?

People commonly assume the purchase or sale will occur without much of an effect on price. The market is more organic than that. As an example, if you own a few thousand dollars of a very large company, and the company trades millions of dollars of shares per day you would likely consider this highly liquid. If you owned millions of dollars of a stock that trades thousands of dollars per day you may say this has low liquidity.

A more astute student might divide average daily trading volume by total outstanding shares of a particular company. This is closer but not a precise measure of overall liquidity. You would not judge my bank account as less liquid if fewer dollars departed as a percentage of the whole. You could say I had low turnover or few transactions of material substance. I point out this example because the common definitions do not fully capture the speed and likelihood of your successful conversion to cash. So, in some ways, external liquidity is more of a concept to be aware of. If/when I use it, I may at times slip into this definition. As a concept, it is worth study.

Side note: If you desire high liquidity and are inclined to convert your shares to cash you should hope there are eager buyers on the other end. If not, you may find the price collapsing as you run out the door, unloading your shares. Buyers tend to assume there is a fire and flee as well. This often makes it challenging for anyone desiring liquidity to take substantial ownership of a business without taking control. In fact, this is true of investors with billions under management as well. Do I smell an edge for small business owners?

John Maynard Keyes warned us in 1936, “there is no such thing as liquidity of investment for the community as a whole.” Or, said another way, you must have buyers on the other end if you want to liquidate quickly… this cannot occur for the market as a whole, as buyers would be outside the market, and no longer be a buyer! So, a flight from the entire market (whether you are selling or not,) will reduce liquidity for those stuck inside the burning house.

Seth Klarman points out that sellers often wind up realizing they are trapped in the marketplace as a whole and flock to value, increasing liquidity (shares per day) of the best businesses. This is like people flocking to the safe room in an emergency.

At LEV, we are investors of the value-sort. As a result, we find ourselves occasionally filling this liquidity need for passionate sellers. It is one of our primary endeavors. We take a premium from the impatient that sometimes recurs for a long time as a result of the internal properties of the business.

The second way I use the term liquidity is when speaking about internal liquidity within a business. Internal liquidity can be evaluated by studying both the balance sheet and the income statement. The more popular approach is to study the ratio between the balance sheet’s current assets versus long term assets. The line between these is 12 months. However, you can and should estimate the liquidation value of various assets at various speeds. Cash is not normally discounted. It has full liquidation value. Accounts receivable, finished inventory and other current assets can be converted to cash more easily and more quickly than most “long term” assets. This may or may not always be true. As you move deeper into the assets, some things like buildings and equipment are expected to move more slowly without prices being adversely effected. The more slowly your assets turn into cash the less liquid they are said to be. Goodwill and other intangibles are the slowest of all. However, they can be the most valuable because things like brand and intellectual property are often the secret sauce to generating higher than average returns on all other assets. A pipe wrench is a wrench, except in the hands of an expert plumber with a reputation.

Let’s move the discussion to the income statement. Some, if not all, assets are used to produce a profit at some point in the future. The speed at which you can extract a profit in the form of cash (or other highly liquid assets) is a form of liquidity worth considering. With this method, you are essentially measuring the rate at which you can recover the purchase price. A lower price or higher rate of earnings will speed things up. An extreme example is an asset that recovers its value in profit in less than a year but maintains its full earning power at the end of that year. Does that alone make this asset “current?” (it is less than 12 months!) Some of the more illiquid assets on the balance sheet produce high recovery rates. Unfortunately, many do not.

Finally, some businesses are a joy to own and easily and quickly sold at fair prices. This makes determination of internal liquidity of long term assets more akin to the expense relative to account balance example earlier. So, beware of over-emphasizing internal liquidity for short sighted reasons.


Tips for small business owners:

As an owner, you have the responsibility and freedom to determine your personal liquidity level. This varies between life stage, risk tolerance and whims of other people in the marketplace. If there is a linear continuum then let’s imagine it as a street. On one end of the street, down by the river of most liquid, would be resided by people who hold 99% of their net worth in cash, on their person. Maybe the other 1% of their net worth would be in the form of a gun as their other current asset. On the other end of the street, up the rocky hill, there is a group huddled around their speculative intellectual power. All their net worth is wrapped around some yet to be patented idea that will pay off in buckets if only the world knew about it and was willing to pay what it was worth. The key these folks hold is a firm grasp on the idea, keeping anyone from extracting value from it. Tip #1: Move off either one of these two extremes. (I’m sure you already have… but humor me.)

Cash should be invested in assets that very quickly increase in value, ideally as they revert to the mean value, or because you have added some value to them that costs less than your sales price. If you sell these newly acquired assets at a higher price you immediately convert them back into more cash than you had before. If you own that process, you are a business owner, by my definition.

Most people are taught to travel to work (buy gas & vehicle) and sell their time and talents for a paycheck. This is a foundational building block… or fractal, as I like to think of it. It is a very simple rule that compounds, organically into a fantastically complex ecosystem. The intellects on the other end of the street participate in the same way, often spending hours of their mental muscle to extract a paycheck. They are no different than a hired gun, checking off his hit list (well, maybe a little, but not economically.) Tip #2: Use your time and talents wisely. We are each uniquely gifted.

A more complex, but often more valuable maneuver to convert low liquidity brain power into tangible assets is to acquire assets that can be resold directly. This is normally the basis for delineating a solo business owner versus an employee. The banana king Sam Zemurray in “The Fish That Ate the Whale” acquired soon-to-be discarded “ripes” for pennies on the dollar and resold them nearby for a terrifically fast and large mark up. Some scrappy entrepreneurs will buy houses and resell them quickly. The most basic intellectual business is arbitrage between a seller and a buyer that are unaware of each other… but you are. As soon as you see this and act on it, you are likely to experience an awaking of sorts. If you inherited a business or stumbled into it because it seemed like the next step in your zoned-out life, I invite you to return to this paragraph and really ask yourself what it is that you do that derives a profit on an intellectual level. As simple as this seems, it is core to making your business more valuable per hour of your time. Tip #3: Think deeply about new combinations between disparate parties.

If your time or insights are accumulating cash you must then face an investment decision. Of course, plowing back into ripes that you can immediately resell is ideal, but these edge cases often evaporate as you and others close the value gap and run out of supply. You are then likely to consider interest paying bank accounts, bonds, real estate or other slow moving, long term, tiny coupon generating investments as your easy, next move. There are more of these assets in the world than anything else and there are regular, developed markets for trading them. Although they have high external liquidity, I would argue that they are often of a poor quality when measuring internal liquidity (safe and rapid recovery of purchase price.) Only when the market really, really envies cash and has simultaneously overpriced it equities should you buy lots of these assets… and only until better alternatives reveal themselves. I have had wise people tell me that they are like a ballast in your portfolio, stabilizing you for the storm ahead. That may be true, but didn’t the Titantic sink when too many ballasts were flooded? A flooded boat goes nowhere. Tip #4:Take a calculated risk.

As this is a post about liquidity I’ll stave off the vagabonds of creative thinking and hunker down around our subject at hand. Liquidity management, both internal and external are one in the same. It is a fractal of the macro economy that you will want to wield with skill. Buy cheap, sell higher, and do it faster than others.

In a future post, I’ll try to write about how to sustain speed as volume increases. (I’ll try to use the word “fractal” in that post, too!)

As your business gathers assets and becomes more complex, debt becomes an option. I bring this up because lending and borrowing is one of the oldest enterprises (I won’t describe the oldest.) Individuals, businesses and banks step into the marketplace, offering liquidity (cash) for collateral. Those who can be patient earn the interest. Only a fool buries his denari and does not at least earn interest.

Your interest earned and your interest paid are somewhat related. The obvious case is to pay off high interest credit cards before adding to your low interest savings account. This expense trimming mechanism is plain to see. However, what if your interest expense accrued and interest earned were the exact same? What then? Again, liquidity goals can be used as a guideline.

Let’s first assume no credit risk in either of these scenarios (I know, we are living in dreamland for a moment.) First, if I were to offer you $10,000 of credit bearing an interest charge of 8% APR on the amount drawn, and I were to simultaneously offer you a savings account paying 8% APR on a $10,000 deposit, which would you choose? Why?

Some people would choose the credit card and go shopping. Some would choose the savings account, and check its balance daily. These are emotional reasons. Others might borrow from the credit and earn more than 8% using their brain or brawn. I like that answer best. Which would I choose if I lacked the brains or brawn? Why? How does it relate to liquidity? By selecting the savings deposit, you still have the option to borrow. As you borrow you reduce your options. I would opt for the savings account and work on the brains and brawn. It has higher liquidity because the two together are greater than the borrowing alone. It is also a confession you don’t have brains or time to do anything better than earn the going rate… but at least now you know why. Tip #5: Earn more than your interest AND liquidity cost of capital.

There are a few fantastic businesses that maintain high internal liquidity. Their balance sheet has current assets that turn over frequently and generate solid margins. If they sustain high margins in the face of competition their goodwill valuations often sky-rocket relative to peer companies with lower liquidity at poorer margins (coupon clipping long term assets.)

I want to propose that volume of stock trading is a poor proxy of liquidity as it is limited to only very fractional owners of the business, and is dependent on whims of marketplace. The better approach is to consider the internal liquidity of the business to a private owner. How quickly can the assets be turned into cash? Can you still possess them after turning them into cash?

By taking a bottom up approach to liquidity as a small business owner you have an advantage others do not. You can exploit these incongruences as you convert long term assets to cash while retaining or even accelerating their effectiveness.