The Hindu Business Line : Importance of liquidity

Often the day-to-day swings in the Sensex are attributed to buying or selling by foreign institutional investors. If stock prices are linked to the profits companies earn, why are the markets so worried about who is buying or selling?

If a company's fundamentals (growth in sales and profits) decide the fair value at which its stock should be trading in the market, the ability of the stock to attract an adequate number of buyers (liquidity) decides the price at which it actually trades. A company with a solid balance-sheet and attractive business prospects can fail to deliver decent returns to its shareholder if it lacks liquidity — a steady stream of interested buyers in its stock. On the flip side, a loss-making company, with nothing in its kitty except a bright idea, can turn out a winner if that idea finds enough takers and attracts a steady activity in the stock. Liquidity is an important influence not only at the individual stock level, but also for the market as a whole.

Global fund flows

In recent years, several countries have freed up cross-border money flows, which means that large investors and institutions can now pick and choose their investments across the globe. This means a veritable flood of liquidity sloshing around the world, looking for the best investment opportunities! How these global investors allocate their money among countries — be they emerging markets such as India, Brazil and Thailand or developed ones such as Japan and the US — plays a key role in deciding how stock markets fare.

The Indian stock market, in particular, relies quite heavily on investments from foreign institutions for liquidity as domestic investors invest only to a limited extent in stocks. As the FIIs are the most active participants in Indian stocks and own a significant proportion of the outstanding shares, their actions have a make-or-break impact on domestic stocks. You can track FII activity on a day-to-day basis on SEBI's Web site. The Securities and Exchange Board of India compiles and puts out details of gross purchases and sales made by the FIIs in Indian stocks on any given day, the very next day. Domestic mutual funds, which pool investment flows from domestic investors, are the other main protagonists in the domestic stock market with enough clout to influence stock prices. Trends in mutual fund activity are also presented on the SEBI Web site on a daily basis.

Liquidity as a screener

If tracking FII and mutual fund flows helps you gauge the overall direction of the market, liquidity is also an important screener that you should put a stock through, before you buy it. Looking at the historical trading volumes in a stock usually gives you a feel for the liquidity in it — the ease with which you can buy or sell large lots. The liquidity in mid- and small-cap stocks often ebbs and flows with the overall market conditions; hence, looking at trading volumes for a stock through an entire market cycle is important to gauge if it enjoys reasonable liquidity. In addition, the liquidity in a stock is also influenced by factors such as how many equity shares make up a company's capital outstanding, what proportion of this is held by the promoters and by public shareholders and how widely tracked and visible a company's business is.