Musings with Analyst, January 2024
Recent Improvement in Liquidity Criteria, Windmill Capital
Liquidity is one of the most important metrics when it comes to stock investing. Irrespective of how good the fundamentals are of a company, if there are liquidity issues with the company, it becomes difficult for you to enter and exit the stock properly. In this edition of Musings with Analyst, we will explain to you the way Windmill Capital ensures that there is no inclusion of any stock in our smallcases that have liquidity issues.
To set some context, we recently improved our liquidity criteria to screen stocks. I will take you through both the old and the new methodologies and in turn highlight the enhancements we have made.
Old Methodology
Under the old methodology, we used to measure the liquidity of stocks using the concept of Average Daily Trading Value (ADTV). Since it’s average, the trading value is calculated over a time period (let’s say 3 months) and then ADTV is calculated. First, let’s look at the Daily Trading Value.
Daily Trading Value = (Total Shares Traded * Volume Weighted Average Price)
This averaged over approximately the past 65 trading days (3 months as per our assumption earlier) and becomes your ADTV. Now this was the approach we were following to gauge liquidity. However, we discovered a loophole in this. The loophole is that the ADTV takes into consideration the entire day as a whole unit without going into the specifics of the day. Meaning, that out of the ~6 hours or 375 minutes that a stock is live on the market, even if the stock gets traded for only 5 minutes out of the entire day, the daily trading value will jump up to pass our threshold. Now let’s move to the new methodology which helps you understand the problem and the solution better.
New Methodology
With the new methodology, rather than taking an entire day’s approach, we went into minute-wise trading data. The objective was to check that out of the total of 375 minutes in a day, how many minutes is the stock getting traded? This will help us capture intra-day liquidity.
So what’s the rationale behind it and why did we do this?
- You see when our investors place their rebalance orders, the time varies significantly. One user could place the order at 9:15 AM, one could place it at 1 PM, and then another at 3:30 PM. Therefore, it becomes crucial for us to have only those stocks in our smallcases which have sufficient liquidity throughout the day. We do not want our investors to be stuck with the order execution throughout the day because of liquidity concerns.
- Secondly, from the perspective of market slippage. Market slippage means the difference between the expected trade price and the actual executed price. This slippage usually occurs because of a wide bid-ask spread. A wide bid-ask spread is a consequence of lower liquidity or asymmetrical liquidity throughout the day. For instance, if you placed a market order to buy a stock that is trading at ₹100 and it got executed at ₹102, then ₹2 is the market slippage. While it might not sound too big a deal in this example, in practicality it is.
Let’s take a look at a few practical examples for better understanding. Check out the table below.
While we ran the old vs new methodology on all stocks & ETFs, I have highlighted two distinct examples to drive home the point.
First, Heidelbergcement India. We dropped this company from our Infra Tracker smallcase a few quarters ago due to concerns about business growth and valuations. Now, when we conducted the old vs new methodology exercise, we discovered that there was also the issue of liquidity. As per the old methodology, the liquidity parameter showed 100% whereas the new one suggests only 34%.
Second, Akzo Nobel India. This company has never been a part of any smallcase but used to come into our universe for consideration. However, post the implementation of the new logic, it might not even come into our universe for further consideration.
In conclusion, the new liquidity check helps weed out illiquid stocks from our stock universe. This test ensures that only the most liquid stocks are considered for inclusion into Windmill Capital smallcases. We may miss out on trending stocks like Ethos Ltd. or companies like Akzo Nobel Ltd. They might have good fundamentals and prices in their favor, but if they fail our liquidity screening process, we won’t consider them, as liquidity is a core to our screening process. As iterated before, we look to innovate both in our smallcases and our processes to deliver the best results to our investors.
Until our financial paths cross again! ✌️
Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
The content in these posts/articles is for informational and educational purposes only and should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy/sell any security or financial products.Users must make their own investment decisions based on their specific investment objective and financial position and using such independent advisors as they believe necessary.
Windmill Capital TeamWindmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. CIN of the company is U74999KA2020PTC132398. For more information and disclosures, visit our disclosures page here.
