Risk of Loss Caused by Infrequent Trading

Investment assets that are seldom traded may be difficult to sell unless you are willing to offer a price concession to attract a buyer.  It is especially difficult to obtain a fair price when you are in a hurry to sell an asset that has little trading activity.

Many stocks are actively traded and offer excellent liquidity to a seller; even when it it necessary to sell the stocks immediately.  At the opposite end of the liquidity scale, some stocks in which limited trading occurs may be difficult to sell on short notice unless you are willing to accept a price that is substantially lower than would be received in an active market.

The ownership of inactive stocks is not a great concern if you are investing for the long term.  The common stocks of relatively small, little-known companies frequently offer an opportunity to earn large capital gains.  Unfortunately infrequent trading caused by a current lack of investor interest means that you may have difficulty disposing of the stock at a reasonable price on very short notice.

• If you are investing to achieve short- or intermediate-term goals and expect that you will have to sell your stocks in the not-too-distant future, owning stocks that don't have an active secondary market is a risky investment choice.  
• You can avoid this risk by limiting your selections to stocks that are actively traded on one of the organized exchanges or in the over-the-counter market.

Understand why Cash is King

'Turnover is vanity, profit is sanity, but cash is reality."

The most common reason that businesses fail is not through lack of profit but through lack of cash.  Many failed businesses are highly profitable but run out of cash.


Profitability versus liquidity.

Whereas profitability is the return generated by a business, liquidity is the ability to pay expenses and debts as and when they fall due.  Liquidity is essential for the financial stability of a business.  A failure to manage liquidity may lead to a business being unable to pay its suppliers and debt holders, which may ultimately lead to bankruptcy.

Cash is like oxygen.

A useful analogy is that profit is like food, whereas cash is like oxygen.  The survival 'rule of threes' states that people can survive three weeks without food, three days without water, but only three minutes without oxygen.  Similarly, a business can survive without profit in the short term but cannot survive without cash.  If employees and suppliers aren't paid the business will not survive for long.

When the cash runs dry.

Although this sounds simple, many businesses don't place enough attention on their liquidity.

• Firstly, businesses aren't realistic when predicting their cash income and cash expenses.  Generally, they overestimate income and underestimate expenses. 
• Secondly, not enough businesses regularly forecast cash flow and foresee problems before they arise.  When they run out of cash, it's often too late.

Ideal goals.

Naturally, both a healthy cash flow and high profits is an ideal goal, but in practice it is not that easy.  

• The short-term goal of a business should be to manage cash flow, and 
• the medium- to long-term goal to manage profitability.

Deciding a suitable cash balance.

Businesses should discover their optimum balance of cash flow.  There is a balance between holding enough cash to meet all short-term demands and utilising cash in more profitable investments.  There is thus a trade-off between holding sufficient liquid assets and investing in more profitable assets.

Successful businesses manage cash flow in the short term and profit in the medium to long term.

Measure short-term solvency and liquidity

Short-term solvency is the ability to meet short term debts from liquid assets.  Liquid assets include money on short-term deposit and trade receivables, but not inventories, which cannot be quickly turned into cash.


LIQUIDITY versus PROFITABILITY

In the short term liquidity is more essential to financial stability than profitability.  Cash generated from operating activities is a major source of liquid funds, as measured by the statement of cash flows.  There may be other priorities for funds from operating activities, therefore it is important to have sufficient liquid assets to meet short-term debts.



CASH FLOW

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is a useful measure of the time taken to generate cash.  Cash flow forecasts enable businesses to predict and deal with liquidity problems before they arise.  It is one of the most important measures of future solvency.


THE CURRENT RATIO

Current ratio =  Current assets / Current liabilities

This is a standard test of short-term solvency and simply measure if a business can meet its current liabilities from its current assets.  Depending upon the nature of the business, the current ratio should usually be greater than 1, depending upon the speed of inventory turnover.



THE QUICK RATIO (or ACID TEST RATIO)

Quick ratio = (Current assets less inventory) / Current liabilities

This is a more reliable short-term solvency measure because inventory is not easily convertible into cash for many businesses.  This ratio should be close to 1, depending upon the business.


INTERPRETING LOW AND HIGH RATIOS

Don't interpret current and quick ratios too literally.  Different businesses operate in different ways.  Low ratios are not always indicative of insolvency risk and high ratios are not always healthy.

LOW RATIOS.


For example, a high volume retailer, such as a supermarket could have healthy liquidity but very low current and quick ratios.  Supermarkets have relatively low inventories as their goods are mainly perishable and turnover quickly.  They have minimal receivables as customers pay in cash.  In addition, their purchasing power results in long trade payable payment periods.  Therefore overall - relatively low current assets and relatively high current liabilities.

HIGH RATIOS.


A poorly managed business with slow-selling inventories and many outstanding receivables may have high current and quick ratios.

Short-term solvency is the ability to pay short-term debts from liquid assets.


Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

One possible cause of bubbles is excessive monetary liquidity in the financial system

Liquidity

One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which asset markets are then caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation. For example, Axel A. Weber, the president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles."  According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate.

Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. Once the bubble bursts the central bank will be forced to reverse its monetary accommodation policy and soak up the liquidity in the financial system or risk a collapse of its currency. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Advocates of this perspective refer to (such) bubbles as "credit bubbles," and look at such measures of financial leverage as debt to GDP ratios to identify bubbles.

http://en.wikipedia.org/wiki/Economic_bubble

Implication of less liquid stocks or funds

Liquidity (relative lack of interest and trading activity) can be a double-edged sword:


•If you're selling, you may not get as good a price, but

•if you're buying, you'll likely get a discount.

It is not hard to see that these less liquid stocks or funds should be considered long-term investments.

Banks - It's All about Risk

Whether a financial institution specializes in making commercial loans or consumer loans, banking is centered on: risk management.

Bank accepts 3 types of risks:

• credit,
• liquidity, and,
• interest rate,

and they get paid to take on this risk.

Borrowers and lenders pay banks through interest or fees because they are unwilling to manage the risk on their own, or because banks can do it more cheaply.

But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan loss grow faster than expected.

Technical Forces That Move Stock Prices

Technical Factors

Things would be easier if only fundamental factors set stock prices! Technical factors are the mix of external conditions that alter the supply of and demand for a company's stock. Some of these indirectly affect fundamentals. (For example, economic growth indirectly contributes to earnings growth.)

Technical factors include the following:

Inflation - We mentioned inflation as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies. (To learn more, read All About Inflation.)

Economic Strength of Market and Peers - Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements - as opposed to a company's individual performance - determines a majority of a stock's movement. (There has been research cited that suggests the economic/market factors account for 90%!) For example, a suddenly negative outlook for one retail stock often hurts other retail stocks as "guilt by association" drags down demand for the whole sector.

Substitutes - Companies compete for investment dollars with other asset classes on a global stage. These include corporate bonds, government bonds, commodities, real estate and foreign equities. The relation between demand for U.S. equities and their substitutes is hard to figure, but it plays an important role.

Incidental Transactions - Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often prescheduled or driven by portfolio objectives. Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official "votes cast" for or against the stock, they do impact supply and demand and therefore can move the price.

Demographics - Some important research has been done about the demographics of investors. Much of it concerns these two dynamics: 1) middle-aged investors, who are peak earners that tend to invest in the stock market, and 2) older investors who tend to pull out of the market in order to meet the demands of retirement. The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples. (For more on this, see Demographic Trends And The Implications For Investment.)

Trends - Often a stock simply moves according to a short-term trend. On the one hand, a stock that is moving up can gather momentum, as "success breeds success" and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean. Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are "trendy" does not help us predict the future. (Note: trends could also be classified under market sentiment.) (For more insight, check out Short-, Intermediate- and Long-Term Trends.)

Liquidity - Liquidity is an important and sometimes under-appreciated factor. It refers to how much investor interest and attention a specific stock has. Wal-Mart's stock is highly liquid and therefore highly responsive to material news; the average small-cap company is less so. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community). Large-cap stocks have high liquidity: they are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent "liquidity discount" because they simply are not on investors' radar screens. (To learn more, read Diving In To Financial Liquidity.)


http://www.investopedia.com/articles/basics/04/100804.asp?viewall=1

How to analyze the market? Bank

Because the service that banks provide is so vital to long-term economic growth, the banking indutry is almost certain to grow in line with the world's total output, no matter which sector generates the greatest need for capital. Whether the demand for money comes from an industry such as technology or pharmaceuticals or consumers' incessant demand for housing, banks will benefit.

The banking business model is simple. Banks receive money from depositors and the capital markets and lend to borrowers,profiting from the difference, or spread. If a bank borrows money from a depositor at 4 percent and lends it out at 6 percent, the bank has earned a 2 percent spread, which is called net interest income. Most banks also make money from basic fees and other services, which is usually referred to as noninterest income. Combine net interest income and noninterest income to get net revenues, a view of the bank's top line. That's the banking model.

Interest income
- Interest expense
__________________
= Net interest income
- Provisions for loan losses
+ Noninterest income
__________________
= Net revenue


The low cost of borrowing - combined with the advantae banks have on the lending side - allows banks to earn attractive returns on their spread.

That said, because many banks enjoy these advantages, we think there are few that truly have wide economic moats. Money is a commodity, after all, and financial products are generic. So what makes one bank beter than another? Here are a few examples of wide-moat banks with different strategies:

• Citigroup uses its worldwide geographic reach and deep product bench to increase revenues and diversify its risk exposure, which allows it to perform well in even difficult environments.
• Wells Fargo is an expert at attracting deposits which area key source of lower cost funds, and it has a deeply ingrained sales culture that drives revenues.
• Fifth Third has an aggressive sales culture, a low-risk loan philosophy, and a sharp focus on costs.

It's all about Risk.

Whether a financial institution specializes in making commercial loans or consumer loans, the heart and soul of bnking is centered on one thing: risk management. Banks accept three types of risk:

1. credit,
2. liquidity, and
3. interest rate,

and they get paid to take on this risk. Borrowers and lenders pay banks through interest or fees bcause they are unwilling to manage the risk on ther own, or because banks can do it more cheaply.

But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan losses grow faster than expected.

Assessing Investment Risks using B-FLExCo

This is how I assess investment risks of the companies that I wish to invest in. I have shortened this to B-FLExCo.

This abbreviation stands for:

B = Business risk
F = Financial risk
L = Liquidity risk
Ex = Exchange risk
Co = Country risk (Also, known as political risk)

At the moment, there is significant political risk for those investing in the KLSE. Accordingly, many KLSE counters are trading at a discount reflecting this risk and other prevailing risks.