06 Oct

The Ills of Liquidity

What a difference a couple of weeks make, although nothing has significantly changed.

Market volatility has returned and we would like to provide perspective on a characteristic common to all investments, liquidity, or the ability to readily convert an asset to cash or vice versa.

Public markets consist of stock listed on exchanges and registered bonds. Although the ease of executing has advanced dramatically with technology, the basic nature of the market has not. For every transaction, there is a buyer and a seller and the price at which they come together makes the "market". It does not matter if it is a house, a diamond, a car, or an investment instrument such as a share of stock.

As investors focused on fundamentals, we are concerned with factors such as the global and local economies and the operations and earnings of the companies in which we invest. We also pay attention to the credit worthiness of the institutions to which we loan money. Over longer periods of time, the value and return of an investment is highly influenced by these factors. However, in the short-term, anything goes.
With the advent of electronic trading platforms, exchange traded funds, leverage with options and futures, and the overload of data and opinions, it is no wonder the velocity of trading continues to accelerate. As investors ("traders" maybe a more apt description) become more short-term focused, price moves become more pronounced as more dollars attempt to execute the same transaction.

There are a couple of obvious reasons for this:

When there is no one (figuratively speaking) on the other side of a trade, the market must adjust to find willing participants to take the other side. In the good old days (which had its issues too), big banks and their proprietary trading desks would risk their own capital by taking the other side of trades that institutions want to execute, helping to stabilize markets. Right or wrong, regulators around the world have collectively decided that this is not a good idea. Now, when selling takes hold, the institutions that naturally buffered price moves have all but gone away.

In addition, the ease of entering an order to buy/sell whole baskets of stocks or bonds has never been easier or quicker. In the old days, portfolios were constructed one security at a time and someone had to enter tickets to execute each trade. Today, much of today's trading value can be attributed to ETFs, where whole portfolios are bought or sold seemingly instantaneously. What is not readily apparent is the fact that when market participants are all attempting to do the same thing, prices move very quickly. Throw in human emotion, the situation is magnified.

Case study: Enterprise Product Partners is one of the largest companies operating pipelines in North America with a $50+ billion market cap. It is no secret that the energy sector has had recent issues, but pipeline companies are stable businesses with utility-like characteristics. Selling accelerated in the last days of September and volume spiked on no new fundamental news. Volume swelled to more than three times the average and the price sank representing approximately $600 million in total value exchanging hands, or a little more than just 1% of the whole company.  There must be something wrong!

On the last day of the 3rd quarter, with no 'fire' in sight, the units rose nearly 13% from its 52-week low. To put that into perspective, the price move on that one day represents nearly two years' worth in cash distributions from the partnership! As of this communiqué, the price has recovered more than 25%. For the investor who allows their emotions to get the best of them, capitulating at the bottom would be a very costly move.

At EPIQ, we hold an investment thesis for all our positions backed by research and diligent analysis. We understand that short-term fluctuations do happen. If our opinion remains valid and no permanent impermanent is present, we evaluate opportunities to enter/add to or reduce/exit positions.

In summary, be patient. Emotional reactions may prove to be costly.


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