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.

My investment reading 2015

Some of the worlds top investors apparently read 500 pages a day.  I wasn’t close to that number in 2015, but I had a lot of joy reading good books. With exception for the Swedsec books the books were read for pleasure. Below the books I’ll share some thoughts on what and how I plan to read in 2016.

Investing: The Last Liberal Art, by Robert G Hagstrom

This book opened my eyes to the concept of complex adaptive systems, which I’m going to learn more about this year. The book is based on Mungers idea of having a broad set of mental models. The author shares some of the biggest ideas across the disciplines of physics, mathematics, ecology, psychology, sociology, philosophy and decision making with plenty of references to further reading.

Swedsec books

I studied for the swedsec exam reading parts of the books Placeringsrådgivning by Oxenstierna, Vår Ekonomi by Klas Eklund and Finansiell Ekonomi i praktiken by Gavelin and Sjöberg. Vår Ekonomi is really well written and broad introduction to economy. Placeringsrådgivning also had interesting parts and would also be worth a read for anyone who leaves their money in the hands of advisors.

Det är jag som äger Carnegie by Karolina Palutko Macéus

A book about the swedish investment bank Carnegie and it’s takeover by the government. Similar to the Erik Penser book in that a lesson learned is that treating you fairly will not always take center stage when you are supervised by the financial authorities and step too close to a thin line. Pretty well-written book with some insight into an interesting opportunistic company culture and the strengths and weaknesses of it.

Spekulanten by Bengt Ericson

Story of swedish financial hero Erik Penser. How he went into trading, came to own his own bank and later had to sell for 1 SEK to the government. In a similar vein to the book above one learning is that you don’t always get fairly treated when you owe money. And that if somebody tries to bully you to sign a document quickly, you should probably delay.

The Match King

The story of Ivar Kreuger. Interesting and well told. Kreuger was one of the first to use shady business practices still being used today. He doesn’t come across as a pure fraud like Maddoff at least became later in life but more like an extremely intelligent person who pushed a working strategy too far and wasn’t humble enough to scale back. Reading this you will also learn about negotiating a monopoly by giving government loans and how Kreuger used perpetual preferred shares.

The INTP: Personality, Careers, Relationships, & the Quest for Truth and Meaning

Not exactly an investment book. But given it will probably save you from badly investing time by avoiding stupid mistakes come close. For me the main takeaway from the book was that the need I feel for independence, feeling out of place in groups, is something I share with more people than I imagined. And some strategies to deal with it, such as living cheap.

King Icahn: The Biography of a Renegade Capitalist

Listened to this one on my way to work. Some fun stories about Icahn’s intimidation based negotiation tactics. Can’t recommend since I found it a bit longwinded.

The Education of a Value Investor

Guy Spiers shares his story from highly educated to employed in shady wall street bank to running his family’s money. He comes across as a genuinely nice guy. Good example of how far, and in what unexpected ways, conscious mimicking of other people can take you.

Charlie Munger: The Complete Investor

More of Mungers mental models. There is a list of the 24 tendencies from the talk on human misjudgement. Also a section of 7 principles that describes the Berkshire Hathaway investing style. Recommended!

Some quotes:

“The iron law of nature is that you get what you reward for. If you want ants to come, put sugar on the floor.” [Reward and punishment superresponse tendency]

“An example of a really responsible system is how the romans built an arch. The guy who created the arch stood under it as they removed the scaffolding. It’s the same as packing your own parachute.” [Reward and punishment superresponse tendency]

“It’s counterproductive for a prey animal that is threatened by a predator to take a long time in deciding what to do” [Doubt-Avoidance Tendency]

“Three things ruin people. Drugs, liqour and leverage” [Drug-misinfluence tendency]

“The brain of man conserves programming spaces by being reluctant to change” [Inconsistency avoidance tendency]

The Rational Optimist: How Prosperity Evolves

In a similar vein as Guns, Germs and Steel and Sapiens. A historical escapade exploring the power of trade and free markets for innovation and improved living standards.

A central theme is that the true message, that our lives are improving quicker than ever, doesn’t cell newspaper copies as well as more heavy subjects.

Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future

Bold visionaries are often interesting to read about. What seems rare about Elon is his level of technical genius. And his personal awkwardness.

The Little Book of Market Wizards

Nice summary of different aspects that are important when trading. And an illustration that there are many, many different ways to trade. And that success comes from trading in a way that lets you utilize your personal strengths.

The Dao of Capital: Austrian Investing in a Distorted World

A contrarian manifesto. Roundaboutness. Hardness of money. It is a high level book built on metaphors. My favourite one is about the strategy of the conifers whose cones will only open through intense heat during forest fires. The bottom line is that patience is underpriced. Patience is seldom rewarded but when it happens the magnitude can be big.

There’s also a section in forest economics that I found interesting.

‘When the physical growth of the forest and expected future price of timber are such that they yield a return greater than the interest rate the forester should stay his axe.

Clearly then, an increase in interest rate, with all else equal, will decrease the optimal rotation period. T’

The Most Important Thing

Howard Marks main message is that investing is a complex processes and that you need to consider many things in parallel to make good decisions.

Flash Boys by Michael Lewis

An interesting read on HFT firms and the competition for speedy access to markets. Michael Lewis is one to count on to enjoyably convey financial stories and doesn’t fail in this one. I can understand why people get upset when people can create money out of ‘nothing’ as the HFT firms do. As active private investors however it’s a phenomenon so inconsequential it’s not even worth thinking about in my opinion. The hero of the book is Brad Katzuyama who is head of X, prompting a new type of exchange. Will be interesting to see how much traction that can gain, being backed by Y.

Teach Us to Sit Still: A Skeptic’s Search for Health and Healing by Tim Parks

The authors shares his story of trying to heal from prostatitis. He goes through horrors in the conventional medical system and eventually finds a breathing exercise that helps. He then proceeds to take up meditation and join a silent retreat.

Since I’ve shared the authors condition this was of personal interest. I had a few experiences similar to the author, but not as bad. The author found the same book as me that actually understands this condition as being caused by excessive habitual tension in the pelvic floor: A headache in the pelvis.

How to Get Rich by Felix Dennis

Felix Dennis, creator of Maxim magazine shares his story and strategies for getting rich. Not a way that I personally plan to copy, but enriching to read about. The book is full of poetry, and I love it. You can listen to some of his poems here. Read this without knowing Felix had already passed from cancer the year before.

Books I want to revisit in 2016

The Nature of Value: How to Invest in the Adaptive Economy (Columbia Business School Publishing)

Complex adaptive systems. Ecology thinking. Niche identification. Generalist vs specialist business models (or what is the rat equivalent of the investment world?).

The Intelligent Option Investor: Applying Value Investing to the World of Options

Learning by doing is my main motto. Except for subscription rights I have close to zero experience in options. It is a zero-sum game with transaction costs. I know from my poker days the downside of such a setup and don’t believe options are necessary to have a good investment career. They do have their uses however. It could be worth a lot to be prepared with the option knowledge and options for leverage it offers for when an opportunity presents itself in the market. I want to pave the way for this by trying my hand at some low volatility options strategies, such as covered calls and entering a stock selling put options.

This book was at the right level for me but I feel I need a refresh.

The Checklist Manifesto: How to Get Things Right

Since I’ve shared the authors condition this was of personal interest. I had a few experiences similar to the author, but not as bad. The author found the same book as me that actually understands this condition as being caused by excessive habitual tension in the pelvic floor: A headache in the pelvis.

Since checklists mainly take care of our lapses and weaknesses I want to read this book with the following questions in mind:

What items can I check to prevent impatience?

What items can I check to prevent sloppiness?

What items can I ask to ensure I have done enough own thinking?

How can I intertwine checklists with what I feel is a natural strength – combining short term trading with investing?

I’ll think about this and perhaps follow-up with another post.

If you have any suggestions for good books – please leave a comment.