Getting defensive

This post is inspired by a question from a friend of how I like to play defense with my investments. 2018 has so far felt like treading water investing wise. Working pretty hard, not too much to show for it. That is the feeling. Numbers wise my account is up ~12% will SIXRX is down 2-3%, so I shouldn’t complain. My stockpicking has been a bit more spotty in the past with some decent successes in e.g. Xintela, Irisity, Smart Eye, KV77, Rottneros to name a few. However my largest weighted picks, Storytel and Xbrane have had a tough year. A lot of learning from those that I’ll try to write about in a future post. Here we’ll dwell on the macro outlook and how I’ve tried to adapt the portfolio the match the environment as it develops.

So the big picture is that central banks are, starting in the US, becoming less accomodative. This is expected to continue in Europe. Historically this has been tied, with some lag, to less favorable equity markets. The rising interest rate has, through the discounting mechanism, a stronger effect on the cash flow streams with a rising future payment. Such as growth stocks. Liquid assets are hurt less. Perpetuities such as preferred shares are hurt less since current payments are high. They will, all else equal decline, in both real and nominal terms with a rising interest rate. Inflation hedged cash flow streams, such as e.g. a tobacco company with pricing power (Swedish Match) will be able to increase their prices and have a stable demand outlook even in tough times. For this reason their cash flow stream can be expected to stay constant in real terms (rather than the nominal constancy of preferred shares). The cash flows will however be discounted more than at a lower interest rate. If they are also loaded with debt, such as SM, those payments will increase as well. So they are defensive, but only in relative terms.

Less coupled to interest rates are cash and commodities that always have utility value in the present moment (not counting commodity stocks here). In relative terms this will also apply to stocks holding such assets.

Currency-wise, the USD has been linked to relative outperformance in risk-off environments. There are arguments for a weaker dollar over the long term. I feel this will be overshadowed by the value of the reserve currency status, which is still mostly in place, during the coming 2-3 years. If this turns out to be the case exporters with costs in weaker currencies and incomes in dollars will have a slight cushion against the discounting of future cash flows in the form of increased growth at least over the medium term.

The opposite of being liquid is to need an influx of capital. Capital will become more costly to tie up than what the last decade has taught us, and cash drainers will likely see dilution at a level higher than they planned for before reaching profitability.

So to summarise, stock-picking should place an increased emphasis on:

1) Low capital needs

2) Exporters, primarily pricing in USD

3) Net cash rather than debt

4) Current profitability and profit levels

5) Demand resistant to recessions

If I match this to some stocks I like I see that MIPS checks 1,2,3, half of 4 and 5. It has also become expensive, so I have still sold most of my position.

Storytel has 1) thanks to funding themselves in the middle of the summer. They also have 5). Weaker on 2,3,4. Still, valuation has already come down and I see no reason to sell heavily now. Execution from the company and traction in the market seem stable to good.

Mekonomen has, after their purchase, 1,4 and 5.

SAAB are currently taking on more capital. Apart from that, they have 2, half of 4 and all of 5.

Forestry, e.g. Latvian forest, have 1-4) down pat. 5 is debatable, but current profits will not drive valuations as much as NAV. I have increased my holdings in Latvian during the autumn.

Gambling stocks, especially a service provider such as Evolution Gaming, has many of the qualities seen in 1-5. I have a minute position, but will evaluate it further inspired by writing this. I have an emotional problem with many gambling stocks, but Evolution are at least providing work for many young people and providing some form of real social interaction.

Banks have stable demand and high current profitability. Some prospects of raising interest margin with higher rates. Insurance companies have the same picture on the demand and profitability side. Interest income can increase with higher rates. Effect on profitability of claims inflation can usually be handled by price indexing. Here my main pick is Storebrand which in addition has a fairly sizable life portfolio where the liabilities will decrease in relative terms with an increasing interest rate. Sampo is also interesting and I have a small position. They are a counter-cyclical player that is currently well capitalised, e.g. high points on 3) above, as well as 1,4 and 5). The only fear is how declining new car sales and possibly an aging car fleet in case of a recession will hold back premium growth. On relative terms to other P&C insurers in the nordics recent results have been outstanding.

What to sell?

Growth plays of all kinds, especially those where unsure of eventual success or possible capital needs. List to come, but some obvious candidates are:

ClimeOn,Veoneer,Immunovia (I like the co..),Hövding (I like this co though..), BIMObject (demand in construction a headwind?),Optifreeze, Alzecure after IPO, Risk Intelligence. Feel a resistant to do this, but I think I will force myself to do it, and do it on a market up day since we seem to have a daily sigsaw going lately.

Apart from stocks and cash I have about 1% invested in put options for end of 2019, 15% below current level of OMX index. Also 5% in USD cash, 3% in gold and a few % in commodities. Now what remains is to be patient till it gets really cheap sometimes in the next few years, and not get left behind waiting for a bottom that never comes. I expect some leveraged players to have a thin sliver of equity when it turns, and have a quick ride up. Hope to take advantage of that when the time comes.

Results and thoughts of 2017

Time for the yearly summary. There might not be much content here, but in investments consistency is key. Therefore this habit will be kept alive.

Results this year was +38% in SEK. Add 2-3% for cryptocurrency gains on the side. The SIXPRX which is the main benchmark was up 9%.


Process Successes

– trying to participate in inefficient markets: This has been a hallmark since starting to invest in illiquid micro caps. Continued this year with Cryptocurrencies. There is clearly more irrationality and tradeable patterns in this type of space.

– Hedging. I lowered the risk a lot and made some money by hedging. I.e. selling short Electrolux, Tesla, Snap. Also Vestas but there I didn’t have conviction to hold and exited +- 0 after which the downward trend began promptly. Also adding to a select few yield type instruments I believe decreased risk, although at a pretty big opportunity cost. Still I think it’s worth it for peace of mind.

– allocating on a % range to asset classes. I knew this from reading, but knowing the emotional side happened this year with Bitcoin. Before deciding on this strategy I sold of a quite large position after a +50% gain and only kept 10% of said position. If I had used the %range strategy to this of 2-4% allocation to cryptocurrencies that I later adopted it would have added something like 10% to the return figure.


Process Mistakes

– too slow/weak rebalancing of positions. I want to train myself to sell aggressively when conditions warrant it, although if it means not being able to execute at quite the current price. I.e. after house-rally in Stillfront, XBrane get overstretched. It is of course never totally apparent that it’s overstretched but you can get an indication thinking about: What more does the company have capacity to deliver after this? Is the pace of positive news likely to increase or decrease? How big part is positive now? The other side of the coin is to allocate at scale to obviously cheap positions. I think I’m slightly better at this, but also feel like it could be improved and has become a bit too cautious because of the increased size of the portfolio.

– too much focus on IPOs. They have definitely added to returns, but probably not commensurate to the amount spent. The strategy of selling after 3 days on a positive opening seems to work decently well. Unless it is up +80% when profit is taken immidiately. Sell out slightly negative openings right away.

– hedging with weak conviction. I feel like options work better than the. miniskirt/minilongs which I don’t truly understand how they work. Options are expensive to trade but my results have been much better. Will see if someone offers more options than Avanza / Nordnet for shorting i.e. Tesla.


– Had time for two physical presentations this year – XBrane and DDM. Will try for a few next year as well. It can add or detract from conviction in a good way. I think in XBranes case it on the balance added to conviction while DDM was neutral/slightly negative (update Nov 2018: being to this presentation made it easier to sell this after mgmt changes, which turned out being a good move).

Portfolio update

  • Largest positions: DDM, Ferronordic Machines. XBrane, Storebrand, Catena Media, Stillfront, Storytel.



Vem är näst största ägaren?

Marknadsposition: Cykel – verkar vara på väg att börja dominera. Sålde 1,6 miljoner enheter 2016. Gissar att det dubblas till i år? Världsmarknaden verkar vara i storleksordningen 30 miljoner enheter.

Marknadsposition skidor: Verkar vara hyfsat känt bland inbitna skidåkare. Mer tester bör kunna driva lite ökad adoption.

Marknadsposition ridning: Verkar vara på väg.

Marknadsposition MC: Verkar på g.

Marknad polis etc – känns inte som rotation är huvudproblemet? Skeptisk.

Acquisitions: vilken typ av företag kan det vara? Kandidater: Hövding? Hjälmföretag?

Aktieinnehav: Verkar finnas bra incitament i ledning, lite mindre i styrelse.

Hur tolka att största kunderna också är ägare – vad säger det om prisbilden? Tänker här att det förmodligen inte finns så stor potential att få upp priset. Det kan nog vara färdigförhandlat för överskådlig tid med åtminstone de största märkena. Bell och Giro, Fox Racing mfl. Istället är det växa antalet enheter som gäller.



Have got a feeling of slight confusion, indecisiveness in my investing this year. This has led to an unfocused portfolio. The risks have spread into more categories. Can be logical. It is unlikely to perform great, but will also not be a catastrophe.

Right now my allocation is about 90% in long, 5% in high yield and 4-5% short. This is still agressive and my plan is to decrease this to 60-70% long during the year.

On the stock selection side I have increased holdings in insurer, Storebrand, Sampo and a small position in Fairfax. The prime reason is to decrease the interest rate sensitivity in the portfolio. Currently these two are about 12% of the portfolio together.

DDM holding is currently the largest position, about 10%. I’m comfortable with the valuation here. Management continue to build a track record of executing on plan. Borrowing costs are trending down, portfolio size is growing and fixed costs are close to flat. A large purchase in greece has been announced. It seems likely to be at a cheap price in this seemingly unmature market. Europe will stop Greece from bleeding too badly. With Brexit and similar feelings in the east (Hungary/Poland) Greece is likely to be pushed along a string, in my opinion.

Another large position is Bahnhof, also ~10%. In hindsight I should’ve sold this more agressively when the Elementica sales process failed. At current prices I think it’s decently valued and has a low downside risk. I’m prepared to sell if I find another bargain and am short on cash.

The high yield is mostly Volvo reseller in Russia, Ferronordic Machines. Yielding ~11%. The interest rate sensitivity is limited due to planned floating of common stock and redemption of these preference shares as well as increasing dividend. I’m currently feeling increasingly uncomfortable with the political risk in Russia. Fueled by studying history, seeing all the lies and corruption and seeing the same attitudes in place today in the leadership. What will happen when Putin dies? Knowing historical figures of the sensitivity of trade to political events would be useful here. For the moment I will see it is a likely 0 given a default due to increased sactions or a civil unrest/war in Russia.

I have experimented with cryptocurrencies during the year. Currently have a small win in total. For now I’m happy to hold a miniscule stash on coinbase where there are no fees and I don’t have to see the price which fluctuates wildly.

I have a few new bets in the Life science sector. MIPS, Immunovia and Raysearch. More thoughts in another post.

So far the portfolio is up 19% on the year, a few % more than the index.







I wrote a short text in Swedish on my only biotech investment, Xintela. Currently about 1.5% is invested in this.

Xintela – en sympatisk trisslott

Xintela är ett 8 år gammalt bolag inom bioteknik grundat av forskaren Evy Lundgren-Åkerlund. Det är ett av många bolag sprunget ur Lunds life science-fabrik som till synes pumpar ut bolag på löpande band. Dessa bolag tenderar att vara svårvärderade och då det nästan alltid handlar om produktidéer i mycket tidiga stadier och i princip samtliga kan betraktas som lottsedlar. Så även Xintela, men kvalitén på lotten framstår som ovanligt hög.

Denna bedömning grundar sig i tre saker. Ett. Bolagets två huvudsakliga produkter adresserar en stor och en jättestor marknad där betalningsviljan kommer att vara mycket hög om effektiva produkter kan tas fram.

Två. Teamet som skall göra detta ser ut att vara både meriterade, ha vettiga ekonomiska incitament och vara engagerade. Även partners som hjälper till med genomförande av kliniska studier verkar se produkterna som lovande och viktiga.

Tre. Kapitalbehov är en faktor som ofta gör det mer effektivt att investera i senare skeden inom bioteknik, när de flertal bolag som misslyckas med sin produkt fallit ifrån och det är dags för skördetid för det fåtal lyckliga vinnarna. I Xintelas fall finns det en chans att antalet emissioner på vägen blir ovanligt litet.

Så vad gör bolaget konkret? Kärnkompetensen är att selektera stamceller av specifika typer via målsökande markörproteiner. Denna förmåga används i två tillämpningar: att selektera stamceller som bildar brosk för att förebygga och laga skador i syfte att förhindra ledförslitning och artros samt inom cancerformen glioblastom, en typ av hjärntumör. Den tredje lotten i denna trisslott är licensiera ut markörteknologin till externa partners.

Vad gäller broskprodukten är marknaden stor för en framgångsrik produkt. Artros är en folksjukdom. Ca 50 miljoner personer har en artrosdiagnos från en doktor. I många fall står dessa helt enkelt ut med sin smärta. Andra behandlingar är smärtstillande tabletter, operation med konstgjord led eller steloperering samt injektion med stamceller. Det senaste är inte så vanligt i Sverige men desto vanligare i USA där det bland annat erbjuds av företaget Regenexx. I USA är det också vanligt som en del i operationer att man injicerar benmärg fylld med stamceller. Xintelas stamceller har flera fördelar jämfört med dagens stamceller som gör att de både kan förbättra de befintliga procedurer där stamceller används, men framförallt addressera en större marknad. Den stora poängen med Xintelas produkt är att endast stamceller som är specialiserade på att bilda glatt brosk (finbrosk) selekteras. Dagens varianter innehåller stamceller av olika sort vilket gör att den läkning man får är av en vävnadstyp som på engelska kallas fibrocartilage (fulbrosk). Det är en typ av ärrvävnad som inte är lika hård eller har lika låg friktion som det ursprungliga brosket. Förutom att välja specifikt rätt celler finns två andra fördelar: cellerna kan massodlas och frysas ner. Man behöver alltså ej egna celler vilket är den gängse metoden idag. Regleringen av stamceller är snårig. I USA får man tex inte odla en persons egna celler för att sedan återinjicera. Detta har lett till medicinsk turism till bland annat Bermuda där detta är tillåtet. Med Xintelas produkt slipper man denna problematik där de framodlade cellerna inte är personliga utan istället betraktas som ett gängse läkemedel som genomgår kliniska prövningar. Även tillverkningskostnaden kan på detta sätt bli betydligt lägre.  I en först studie på hästar som ett partneruniversitet till Xintela i USA nyligen genomfört kunde man se att en injektion av Xintelas specialiserade celler i en skadad led hade en skyddande effekt både på brosk och underliggande ben samt kunde fylla igen sprickor i broskvävnaden. Inga negativa effekter noterades. Detta får ses som ett mycket lovande resultat och planen är nu att gå vidare med en andra studie på fler hästar under andra halvåret 2017, varefter produkten kommersialiseras för hästar och studier på människa inleds under 2018.

Produkten inom glioblastom adresserar en mycket mindre patientgrupp. Men för dessa är behovet mycket stort av en effektiv behandling då överlevanden i dagsläget är 15 månader i snitt med dagens behandlingar. Tanken med Xintelas produkt är att binda ett cellgift till markörproteinet och på så vis kunna specifikt behandla tumörceller och därmed minska biverkningarna. En utmaning här är hur man kan få in proteinet i hjärnvätskan som är skiljd från blodbanan. Och för en lekman inom fältet framstår risken som högre i detta projekt. En fördel kan tänkas vara att man troligen kan få särläkemedelsstatus och en snabbare väg till marknad.

Incitamenten ser okej ut där VD Evy äger cirka 15% av bolaget och ett antal andra engagerade personer har ägarandel i ensiffrigt antal %. Om bolaget är ungt så är snittåldern i styrelse och ledningen högre. Det är många personer med lång erfarenhet från jättar som Astra, GSK och Novo Nordiskt samt ett par personer med erfarenhet från inkubator och startups. Då det kommer vara avgörande för bolaget vilka partnerskap och strategiska val man gör snarare än en hög aktivitetsnivå är förmodligen den stora erfarenheten ingen nackdel. Möjligtvis finns ett litet frågetecken för om ekonomi och finanssidan av företaget är lika stark som produktsidan.

Hur ser siffrorna ut? Marknadsvärdet är idag 120 MSEK. I dagarna (t.o.m 10 februari) löper teckningsperioden för bolaget optioner som kan inbringa totalt 17,5 MSEK. Efter Q3 2016 var kassan 23 MSEK med en avbränningstakt på runt 22 MSEK per år. Kursen pendlar just nu runt teckningskursen om 5 kronor, så det är osäkert hur stor del som tecknas. Förmodligen åtminstone ett tillskott som gör att kassan räcker en liten bit in på 2018. Bolaget har som mål att göra en första kommersiell deal under 2017 och löpande kassaflöde från hästprodukten har stor chans att börja under 2018. Gissningsvis behövs dock minst en emission till efter nuvarande teckningsperiod innan bolaget kan stå på egna ben.

Hur bra kan det gå i bästa fall? En positiv aspekt är att betalningsviljan är hög inom båda bolagets utvalda produkter. Med en billig tillverkningskostnad kan marginalen bli hög. Undertecknad har själv en gammal idrottsskada och har i samband med det undersökt marknaden i USA för dagens behandlingar. Det handlar om priser för en operation på drygt en halv miljon kronor för en operation av en led inklusive injicering av kroppsegna stamceller från benmärg. Man kan också välja att enbart injicera kroppsegna stamceller i en led, vilket med dagens teknik ger bra smärtstillande effekt under ett par år, men liten egentlig läkning. En sådan behandling ligger på ca 60 000 kronor, där många väljer att upprepa behandlingen flera gånger för att i längsta loppet undvika att sätta in konstgjorda leder eller steloperera sig. Man kan också välja att åka till Bermuda för att få en större mängd celler till tredubbla priset.

Gissningsvis kan Xintela ha en nettointäkt på åtminstone någon tusenlapp per injektion. En injektion med broskceller kan bli något man gör inte bara i behandling av personer med utvecklad artros utan även i förebyggande syfte efter till exempel kraftiga stukningar där brosket ofta är påverkat. Antalet injektioner som kan bli aktuellt är svårbedömt. Men som ett exempel genomförs årligen ca 700 000 knäoperationer per år i USA där ledytan ersätts med konstgjort material. Flertalet av dessa patienter bör rimligen prova injektioner med stamceller innan operation blir aktuell. Om vi gissar att ett par injektioner per patient med en intäkt för Xintela om 2000 kronor per injektion kan bli aktuellt skulle denna del av marknaden kunna vara värd 2,5 miljarder SEK om året. Sedan tillkommer potential i fot och knäled, andra patientgrupper mm.

Potentialen inom glioblastom är också betydande. I USA dör ca 12 000 per år av denna typ av tumör. Dödligheten idag är i princip 100%. Om Xintelas metod visar sig så effektiv att den med cellgift kan hålla en tumör stången under längre tid känns inte intäkter på en kvarts miljon per patient orealistiska. Det skulle då vara värt 3 miljarder SEK.

Att Xintela verkligen går hela vägen och når upp till dessa nivåer är sett till statistik mycket osannolikt. Om det ändå sker kommer man nog ha samarbetat med och gett bort en stor del av kakan till partners. Detta är ingen aktie en person med vanlig riskaptit skall köpa i någon större mängd. Men inom kategorin lottsedel framstår den som ganska attraktivt prissatt.

My investment year 2016

Time for the yearly look-back ritual.

Results were great. +47% during 2016. Now CAGR of 45% year since 2012-01.

+ Focus and positive mindset throughout the year. I like doing this, it hardly feels like work. At least when things go well. Now is the time to prepare mentally for worse times and staying process oriented.

+ Continued learning. I took a Swedsec license. Good volume of reading. And some experimentation with new instruments and markets in a small way.

+ I did some proper valuations and write-ups and posted them online, which I set as a goal previous new years.

+ I went to a board meeting for the first time. Small company, I happened to be the biggest shareholder in attendance outside of management. Good learning experience. I’d like to try and make more time for this type of thing even in my current full-time job + small kids situation.

+/- Quite a bit of money was made trading news with a small part of the monies. A thousand here and there adds up if it can be repeated a hundred times a year. It’s not hard to see how some day-traders produce their stellar graphs. If I ever tried to be a day trader my first strategy would be to sit watching the news ticker with a filter for swedish stocks with market caps under a few hundred million USD or so. Even if the returns were okay doing this, I’m not sure it’s a total positive on my situation given that it’s quite distracting for the brain even if doing this just one hour in the morning and takes away both from analysis of long-term holdings.

– Feel like the portfolio is deteriorating. The gap between my belief of instrinsic value and portfolio value of holdings is less. If this feeling continues to rise it might be time to get less than 100% invested. Currently own 93% stocks and 7% debt.

– I was guilty of diworsification, holding too much of low-conviction holdings. This was mostly due to the feeling above which made me reluctant to add to existing positions, and instead added some in big companies where I was less likely to make a big mistake. But also much less likely to earn +50%/year. Examples of this was holding Sampo, Starbucks, Apple.

– Got an account-addiction habit, mindlessly checking the balance without purpose. Will try to counter this again by writing down more of my thoughts in journal + occasional blog/twitter posts.


Going forward

Go to two board meeting this year. Results target is to beat index with 15%/year over time. When this feels hard it seems I can spend my time better elsewhere (unless my account has become so large that 15% is much more meaningful).

Investment method:

– Try to incorporate a framework of self-reinforcing / self-defeating processes into my thinking (ala The Alchemy of Finance) and actively look for such situations. See fundamentals as less static and more like a dynamic process. I.e. be willing to deviate in assumptions (discount rates, growth prospects) in valuations if there is a prevailing bias, or likelihood of one developing.

– Do one writeup and/or valuation per month with a bit more depth

Sizing pscyhology

As my portfolio has grown over the last few years I feel myself struggling to size investments appropriately. Especially short term ones.

A bet that used to be 10% of the portfolio is now about 5 times larger than 2012. On a few occasions this year I’ve identified high probability bets that I’ve profited way too little from. Stanley Druckenmiller was famously most harshly critiqued by George Soros not when he lost money, but when he bet too small on winners.

One such trade occured today when Ahlsell was listed. It is the largest listing in 15 years or so in Stockholm. The price interval in the original offer was wide, 45-58 crowns. This caused several high profile media outlets to recommend not signing for the IPO. As a result the interval was set to 46-50 at the last minute. I made a minor bet here as I felt that the stock is probably worth at least 54-55 given the original interval and the figures in the prospectus. I got stocks for 0,2% of the portfolio at 46 SEK.

When the exchange opened I added about 3% of the portfolio in the stock at 47,5. Then sold at 50,5. Stock now closing at 54.

Nice to make money, but I don’t have such a strong feeling of opportunity on short term trades often and it’s important to make enough money on them. Appropriate sizing would’ve been more like 15% of the portfolio. Next time the goal is to feel uncomfortable:)



(draft from April 17 2016 that I decide to publish now in October)

Summary Investment Thesis

  • Fast growing (85% subscriber growth last year).
  • Steady revenue stream
  • Platform type business model can create virtuous circle. I.e. comparable to Netflix, HBO.
  • Low visibility due to: Non-regulated list, Reverse Merger listing, Prime target group (middle age women) doesn’t correlate strongly with small cap stock picker demographics.
  • CEO and his wife are big shareholders (total 20+%) and likely most of their wealth in the company.
  • Apart from Amazon/Audible (english) the competition seems limited in local european languages.
  • Unlimited listening for $20/month is a better value for the customer than Audibles which charges per book.
  • Long run-way left with growth just from current markets.


  • Move from print books to audio is slower than expected.
  • Usurped by a better offering. E.g. Amazon expanding or other major book retailers getting better at audiobook distribution. Examples in Sweden are BookBeat (Bonnier).

Links of the month

Google-owned Boston Dynamics’s new robot Atlas(video).

CFA lectures from Mark Meldrum (video).

Psychologist William James on Attention, Multitasking, and the Habit of Mind that Sets Geniuses Apart – from BrainPickings.Org.

Freakonomics author Stephen Dubner on the Tim Ferris show Related quote: “”Have fun, think small, don’t fear the obvious — these are all childlike behaviors that, according to us at least, an adult would do well to hang on to.”



Estimating the cost of illiquidity

Since I invest mostly in small or very small listed companies with limited liquidity I have for some time been thinking about how to incorporate the cost of this into valuations.

In a private placement the cost can be even higher. This came to the fore a couple of months ago when I invested in Elementica. There I relied on the good old gut and increased my discount rate a couple of % to account for the illiquidity.

Being a believer in combining learning(reading) with doing I was happy to come across a chapter on this in Aswath Damodarans Strategic Risk Taking (by the way, this book seems very much like an earlier, simplified, version of his Investment Valuation, which I’d recommend instead as a purchase).

The professor brings up four ways of adjusting the valuation for liquidity.

A post-valuation fixed percentage discount

Valuations come up in tax litigation and there standard practice has been to discount private firms 25-35 percent compared to public firms due to reduced liquidity. This figure comes from old studies on the discount for restricted stock offerings, where the same instrument is priced is open to two differently sized sets of investors. The stock market as a whole, and the owners of the company.

This figure seems too large, and the tax authorities have in some recent cases succesfully argued for smaller discounts based on.

Firm specific discount

Estimate a firm-specific discount considering a number of things

Liquidity of assets. If the assets of the company are very liquid it should not matter as much that the company itself isn’t since assets can be sold. This mostly applies to transactions where control of the company is transferred.Liquidity of assets

Financial health and cash flows. Financially healthy companies with positive cash flows need to be discounted less.

Possibility of IPO. If there is a substantial possibility of an IPO there is less need for an illiquidity discount.

Size of the firm. Larger firms should be discounted less.

Control component. Investing in a private firm is more attractive if a controlling stake is aquired. Thus a 51% stake can be substantially more valueable than a 49% stake.

To this list I would like to add another that I think matters: The number of owners.

Bid-ask spread as a proxy

The bid-ask spread can be used as a proxy for cost of liquidity. It is a lower bound, since even when the bid-ask spread is crossed there might only be a small volume there. Thus leading to additional costs in the form of opportunity cost of waiting to trade or more bid-ask spreads being crossed.

Two options: If traded, use the average historical bid-ask spread of the company you are valuing.

Alternatively, use a formula that statistically predicts the spread:

Spread = 0.145 – 0.0022 ln (annual revenues in $) – 0.015 (ERNN) -0.016(cash/firm value) – 0.11 (monthly trading volume/firm value)

where ERNN = 1 if earnings are negative and 0 if earnings are positive. This regression was done in 2000 so should be taken with a grain of salt.

Option-Based Discount

I’m not going into this one since in much detail. The basic idea is to value an option and use it as a proxy to cost of illiquidity.If for instance you are entering a private placement that will IPO or go bust in two years the cost of illiquidity can be viewed as an at-the-money put option with a two-year life.

To me this approach seems like a bad idea since option pricing models are notoriously bad at non-normal distributions with fat tail and event risks. Which is exactly the type of thing which is common for illiquid companies.


These are some options that can be used to explicitly estimate the cost of illqiuidity. If this approach is choosen care needs to be taken not to let the illiquidity also creep into other parts of the valuation, e.g. discount rates.

Obviously the cost of liquidity will vary across different investors. Those investing large amounts of money and trading frequently will be much more sensitive to liquidity than smaller investors using strategies that trade infrequently. Thus the adjustment for liquidity will need to be tailored to your own circumstances.

The cost of illiquidity is for individual investors mostly relevant in private companies and small caps.

Investing in small firms it easier to find information that has not reached the market. But the transaction costs are also higher. Broker costs are usually a minor part if small companies. Cost of spread + opportunity co going forwardst of not trading are substantial. Often people on message boards and forums of small companies equate their valuation to companies hundreds of times larger and believe the PE should be the same. The cost of illquidity is but one of many reasons this is not true (less auditing is another). pain in downturns.

My own approach has so far been to implicitly penalize companies with bad liquidity through higher discount rates. This is a very subjective way, and the change in discount rate is close to a pure guess. The mental models in this post should be useful to guess a little better.

Food for thought: Can there be value to illiquidity? If the illiquidity is complete, i.e. private placement = no prices. I would argue YES. It both prevents a twitchy trading finger and decreases the pain of a dwindling account balance.