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May 2, 2016

Think Before Investing in a Low-Volume Stock

A few months ago, I bought a low-volume stock, Oregon-based Willamette Valley Vineyards (WVVI). I had seen the company’s name on a screen of liquor stocks I occasionally run and was prompted to take a closer look when the company sent us a prospectus for a preferred stock offering. (I think my wife put us on their mailing list at a tasting.) After doing my own analysis, I passed on the preferred stock, but bought shares of the common stock.
When I talk about the common shares having low volume, I’m not exaggerating. Daily trading has averaged just under $36,000 per day over the past three months. This is the cumulative dollar amount for all of the shares traded on an average day. Some days, it’s less; on others, it’s more.
I’ll share some observations I’ve had while owning Willamette Valley Vineyards, along with some suggestions about how to go about investing in a low-volume (aka less-liquid) stock in general. But before I do, I want to explain why it even makes sense to consider a stock with low levels of trading volume.
One of the advantages we have as individual investors is the ability to invest without many constraints. Most institutional investors (mutual funds, pension plans, etc.) operate with market capitalization and volume constraints. Many are not allowed to invest in companies below a certain size (e.g., a stock that is not part of the S&P 500 index or the Russell 1000 index). Many also face issues relating to the sheer amount of dollars they have to invest: This can create liquidity issues if the amount needed to make the investment worth their while exceeds the normal trading activity for a given stock or bond. Lower levels of liquidity make it difficult to transact without causing the stock price to move and can also make it difficult to get money out at prevailing quoted prices.
The constraints faced by institutional investors and the desire of traders to play in the same sandbox as the mutual funds, pensions, endowments and other big investors create a lopsided environment in terms of attention. The largest and most frequently traded stocks receive the most analysis. As market capitalization and trading volume decrease in size, less and less attention is paid. It’s not a linear change, either; it’s a lopsided change. Most of the attention is given to a comparatively small group of stocks. A far larger number of stocks are practically ignored or at least exist outside of the “popular crowd.” The lack of attention can result in these stocks being mispriced.
As individual investors, we can take advantage of this situation. We can buy any publicly traded stock as long as there is enough volume for us to complete a trade.
We do, however, want enough volume (a concept referred to as “liquidity”) to ensure we can buy and sell fairly easily without our orders impacting the security’s price. Though this is a constraint, it is a much smaller constraint for us than it is for a manager who has hundreds of millions, or billions, of dollars to invest. We can easily buy and sell a far greater range of stocks without leaving any trading footprint than our bigger counterparts can.
As for where you should draw the line when deciding how much you can invest in a low-volume stock, consider the guidance we give for following our Model Shadow Stock Portfolio: seek average daily dollar volume of at least 10 times the amount needed for your position. In other words, if you desire to invest $4,000 in a stock, check to see whether its average daily volume is at least $40,000. (An off-the-cuff calculation is simply to multiply the stock’s current price by its average daily volume. Yahoo Finance states the average number of shares traded over the past three months on each stock’s quote page.) This should ensure there is enough volume for you to buy into the stock without driving the price upward and fairly easily sell out of the stock without driving the price downward on a day with average volume.
Realize that the daily average can be very different from the number of shares traded on any given day. With a less-liquid stock, you may see days where the actual volume is far below average. For example, about three weeks ago there was a day when just 500 shares of WVVI traded. This equated to approximately $3,500 worth of shares exchanging hands for the entire day.
Also realize the need for patience. It took over an hour (possibly longer) for my order to buy shares of WVVI to be fully executed. My use of a limit order likely slowed the process. The limit order specified the maximum price I was willing to pay to own the stock.
Limit orders are a good idea for any stock, regardless of volume, and they are particularly important for low-volume stocks. Such stocks are likely to have wider bid-ask spreads, which is the difference between what buyers are willing to pay and what sellers are asking. By setting a limit order between the bid and ask prices, you reduce your transaction costs.
Beyond volume is the need to do additional research. Because low-volume stocks receive less attention, there is less research and news about them. (I didn't see any research reports on WVVI, for instance.)This, in turn, increases the onus on you to fully analyze the stock. You will need to go through the 10-K (an annual filing required by the Securities and Exchange Commission), review the financials and read the earnings releases. While these are things you should do with any stock, realize that with a less-liquid stock you won’t have anything to compare your analysis to. You will have to be confident in your ability to determine whether a stock is attractive or not.
One last point, and this one is a big one: Stick to exchange-listed stocks that are up-to-date with their SEC filings. Never buy a stock that is traded on the pink sheets or recommended through an unsolicited tip or pitch. A good rule of thumb is that the stock should cost more than a cheap cup of black coffee. When in doubt, pressured to buy, or unable to find information about the company from a reliable third-party source (e.g., the Securities and Exchange Commission’s EDGAR database), hold onto your wallet as tightly as you can and walk away.
The Week ahead
First-quarter earnings season will remain busy, with 124 members of the S&P 500 scheduled to report. Included in this group are Dow Jones industrial average components Pfizer (PFE) on Tuesday and Merck & Co. (MRK) on Thursday.
The week’s first economic reports will be the April PMI manufacturing Index, the April ISM manufacturing survey and March construction spending. All three will be released on Monday. Wednesday will feature the April ADP Employment Report, March international trade and the first estimate of first-quarter productivity. April jobs data, including the change in nonfarm payrolls and the unemployment rate, will be released on Friday.
Six Federal Reserve officials will make public appearances: Atlanta president Dennis Lockhart and San Francisco president John Williams on Monday; Lockhart and Cleveland president Loretta Mester on Tuesday; Minneapolis president Neel Kashkari on Wednesday; and Lockhart, St. Louis president James Bullard, Dallas president Robert Kaplan and San Francisco’s Williams on Friday.
About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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