Think Low Liquid Stocks - Think High Returns!

All traders and investors enter the market to make profits, an obvious fact. However, each of them differs in terms of capital investment, return expectations, investment strategies, and risk appetite. Some talk about being a momentum investor, some about being a value investor, some focus on small cap stocks, whereas,some target opportunities in buying beaten-down stocks. We also find contrarian investors doing well in the markets. 

While exponents of all these proven strategies exist, a few investors have dabbled with low liquid stocks or so-called low float stocks and have been able to create a mullah for them. Vinay Bogawat is one such investor. Vinay has been studying the low liquidity stocks with a microscopic lens and has been deriving good returns from his investments in low liquidity stocks. Says Vinay, “The huge jump or slump in low liquid stocks caught my attention in the initial years of my investing. I then started observing the performance of these so-called low volume, low free float stocks over 6 months, 9 months, and 18 months period. I somehow concluded that the longer one holds on these low volume stocks the chances of making above average profits improve dramatically. I was fortunate enough to buy stocks like Confidence Petroleum, Shivalik Rasayan, and Kingfa Science, when these stocks were trading with low liquidity. I bought Confidence Petroleum in September 2016, when it was trading close to `8 per share. Hardly, 30,000 to 50,000 shares of the company used to trade at that time. Similarly, when I bought Kingfa Science in November 2014, the number of shares traded was in the range of 1,000 to 4,000 shares. Shivalik Rasayan used to be thinly traded with only 11 to 20 shares being DSIJ. traded on a given day at times. Within three to five years of my holding period, these shares became multi-baggers and my portfolio swelled much better than what I expected. While focusing on low liquidity or low free float stocks may sound lucrative, the risks need to be understood in advance before venturing. “While multi-baggers made me rich, not all of my low liquid stocks have done well. As of now, I am holding a few low liquidity stocks, such as CCL International and Classic Global Finance, which turned out to be wealth destroyers,” adds Vinay. 

What are these low free float stocks? How do we identify them and how have they fared in recent history? 

Low Free Float Stocks 

The free float shares are the total number of shares that are available for trade for investors. Low float simply means that the company has very less number of shares accessible for trade. This would imply that these companies have a large promoter shareholding and fewer numbers of shares for traders. On an average, the traded quantity of these stocks is fairly low. Stocks that meet the definition of the low float are not easily available for either a buy or a sell. These low float stocks offer high volatility, which means, they have the potential to pocket you gains like none other as they can spike in big ways. Keep in mind that such stocks, which are this volatile, do come with some risks attached. 

There is no specific number, which denotes a low float, investors and traders may have their definition of what constitutes a low float. However, the following criteria can be adopted to determine low free float stocks:

1. The companies classified under the group “XC”, “XD”, “X” and “T” on the BSE.

2. Low average traded quantity with a high volatility. A company, whose shares are not easily available due to its low float.

3. The two-week average volume is between ~4 thousand and 60 thousand. 

In short, low free float stocks, thus, share the properties of having a high promoter holding, being highly volatile, characterized with less liquidity, and fall mostly under the small caps or micro caps. 

REWARDS

As mentioned above, low volume stocks are attached with high risk but all investors and traders already know that high risk could result in high rewards. There are multiple ways of making a profit while dealing with low-volume or low free float stocks. These low float stocks usually do not fall under the radar of mainstream investors or traders. They do not seem interesting enough to investors because of the liquidity. But, if you have a high-risk appetite then you must hunt these low float stocks and reap the advantage of high volatility.

Multi-bagger Opportunity :

Companies, such as Jiya Eco-Products, were once lesser-known stocks, trading at a very less volume. Investors, who picked them young, even in a short period, were able to multiply their investments.Simply put, those investors bagged some multi-baggers. If an investor understands the market trend and does his fair share of market research, then windfall gains in low volume stocks are no surprise!

Benefits through Corporate Actions :

Stocks like Page Industries or MRF are expensive and thus have low volumes too. For such stocks, a corporate action, such as a stock split, usually results in a lower price and a higher trading volume. Consequently, the result in increased liquidity, coupled with higher market participation, presents the opportunity for substantial returns. However, the challenge is to catch the right time to dive, that is, when corporate actions occur. 

Benefiting from overall market rise : 

During a bull market, everyone is celebrating their gains but those, who possess the low-volume stocks are the ones that relatively benefit the most, since these stocks can spike up abnormally in a single day while other stocks that are characterised with many publicly available shares cannot zoom that much as there are sellers at every level on the way up, who are willing to take profits. The overall market rise could be a result of positive news, stable government, fluctuations in oil prices, appreciation of currency, or any other global developments. So, accumulating some low float stocks into your portfolio can raise the portfolio value quite well. 

High Volatility to your advantage : 

The very fact that the low float stocks usually trade in a very small number, makes them susceptible to higher volatility. Any positive corporate announcement could act as a catalyst for their movement on the exchanges and could result in the stock gaining momentum in a short span and leading to big gains for investors even in a single day. However, there is also the possibility of the stock falling drastically, reacting to negative news. 

High return once the stock gains popularity : 

If any of the low float companies are seen in the headlines or if an advisory firm or a brokerage firm issues initiating coverage report, the stock gains some recognition, which leads to people being aware of the profitable position of the stock. Subsequently, the volume increases and the investor, who held on to the stock till the volume sprung, will be the winner. This, on the other hand, serves as a good opportunity for bagging potentially higher returns. 

Of course, trading low volume stocks seem risky and it is also evident that the benefits of profits are subject to many factors, not in control of the investor. However, the best bet for an investor is to take a long term perspective and go ahead. 

RISKS INVOLVED IN LOW FLOAT STOCKS 

High risk, high reward! A common mantra the investor community chants. We have already covered the rewards/ benefits which these low volume stocks offer. However, we need to weigh in the downside of investing in them too. Below, we have noted some of the problems that you might face while investing in the low free float stocks.

Difficulty in selling: When we talk about low float stocks, it is an established fact that there are only a few market participants. This indicates a lack of trading volume and the investors do find themselves in trouble while they try selling the stocks. For example, if you have bought 1,000 shares of a low float company at `10 and, let us assume that in 1-year period, it rises to `13, you are currently sitting on 30 per cent unrealized gains. You decide to sell the stocks and settle for 30 per cent at the current market price of `13; however, if the average trading volume is only 100 shares per day then attempting to sell all your shares could take a longer time and also there is no guarantee of getting the opportunity to sell at the same price. 

Lack of accurate company information :

Low float stocks are available across stocks belonging to all market capitalizations but usually, they are common in low priced stocks and micro caps. These companies trade on several bourses and are not as established as mid caps or large cap companies. Transparency becomes an issue for these low float stocks. Investors find it difficult to track the records of the company’s finances. It could be too late for an investor to get out of the bad investment in such cases and, thus, fall prey to such fraudulent companies.

Non-favourable to investors :

Low trading volumes may be a clear indication of a deteriorating company. If an investor, without appropriate studies, buys into a company that slowly shows sign of a deteriorating reputation results in a disastrous situation. The reason for low volume could simply mean that the company is not worthy of investing in and many have studied the company fundamentals to have come to such a conclusion. If you hold shares of such a company and if the market is made aware of its deteriorating performance, this will further affect the stock return potential. With the low float stocks, you may not find any buyers, if any such situation arises. However, it may also be an indication of a relatively new company that has yet to prove its worth and maybe waiting out is the best answer to your grim situation.

Volatility as a disadvantage :

Since only a few shares are available for trade when it comes to low float, the supply-demand can be impacted quickly and largely based on news. If the news spreading is negative which may be either true or may need clarification from the company but the investor who holds the stock may want to sell it but due to low volume may not find buyers at the appropriate price level and may have to book losses in a panic sell-off situation. This leads to a substantial fall in stock prices.

Promoters pulling the strings behind the curtains :

The promoters of the company are the true knowledge holders of the realistic view of a stock. Promoters can offload their large shareholdings to the investors which will spike the share prices and lead to an artificially inflated price. This could result in the investors buying at a high price and leave them with a long term loss potential.

How to avoid the risks involved with the low free-float stocks

The most important aspect investors need to understand is that over exposure to low-float stocks can be very risky. Risk profiling is very important before an investor purchases low float stocks. Even if an investor is classified as a high-risk taker (aggressive investor), only a small percentage of the overall equity portfolio has to be invested in low float stock. For example, 5 per cent or 10 per cent of the total portfolio can be invested in low float stocks.

The basics rules of portfolio management, such as the below ones, must be followed stringently:

• Maintaining strict predefined stock weight

• Highly diversified portfolio of low float stocks

• Stocks screening based on profitability, valuations, leverage, etc.

• Decide on top-down or bottom-up research methods to choose stocks

• Quarterly reviews (earnings) a must for such stocks

• Stocks with high corporate governance should be preferred

• Strict stop losses to be in placed

• Earnings momentum should be visible

Let numbers do the talking :

Historical data suggests the prospects are good for investors when low liquidity stocks are focused. We have taken all the stocks listed across BSE and calculated the returns and picked out the multi-baggers belonging to each bracket differentiated via market capitalization. Our focus here is to see if the low liquidity stocks, usually falling in the low market capitalization category are worth betting on.

If we look at the data, we find that the maximum number of opportunity where the stocks deliver more than 100 per cent returns within a year fall under micro cap to small cap stocks category. These are relatively low liquid scrips we are talking about.

Low float stocks offer high volatility, which means, they have the potential to pocket you gains like none other as they can spike in big ways. Keep in mind that such stocks, which are this volatile, do come with some risks attached. 

For sure investors can scan more rigorously in micro-cap categories if one is seeking aggressive returns. Now let us look closer on how low liquid scrips have performed over the past six years when compared to Sensex returns.

If we refer to the data in the table below, we find that in five out of six previous years the low liquid scrips have outperformed Sensex if we consider the average returns of all the low liquid scrips. This evidence is enough to have investors excited about the opportunity of beating Sensex returns by focusing on low liquid scrips. 

Conclusion

Every strategy has its pros and cons. The strategy of investing in low liquid scrips also has some benefits and drawbacks. Those, who understand the pros and cons of investing in low liquid scrips and then participate in the equity markets with the right temperament, have a better chance to gain benchmark returns. Since, low liquidity scrips are highly uncertain,diversifying by investing in higher number of scrips becomes imperative. 

The market timing will be very crucial while building a portfolio of low liquid scrips, as the volatility is very high in these stocks. The rewards are substantially bigger in case of low liquid stocks, when the timing is right. Hence, technical analysis skills will prove to be an advantage while building a portfolio of low liquid scrips.