How do you pick stocks for investment? Well, you probably run a valuation screener and select stocks that appear under-valued. But, have you ever run a volume check on stocks? Consider this. Last month 2,700 companies of the listed universe in BSE saw an average volume of less than 2,500 shares a day. This means that a shareholder wanting to sell 3,000 shares or more in any of these 2,700 companies on a specific day wouldn't have found buyers.

Studying volume history of a stock is as important as studying the company's fundamentals or the stock's valuation ratios, especially when it is a small-cap stock. Low volumes also mean high impact cost on trades, even if it were for few hundred shares. So, it is better to be guarded about low liquid counters.

Why should one look at volumes?

Volumes in a counter reflect market demand for the stock. It therefore also reflects the ease with which traders can enter and exit a particular stock. Liquid counters let buyers and sellers trade at the ideal price and at impact costs less than a per cent. Now, what is impact cost? Impact cost is the difference between the traded price of a stock and the stock's ideal buy/sell price. Ideal price is the average of the best bid and offer price of a stock at a given time.

Suppose the order book snapshot of stock XYZ shows the best price for a buyer as Rs 100 and the best price for the seller as Rs 98, the ideal price is Rs 99. While liquid counters will see buy and sell transactions of a large size getting executed at close to ideal price, illiquid counters will see a big difference between the traded price and ideal price. Following the earlier example, if one is able to buy XYZ stock at Rs 101, they are suffering an impact cost of 2 per cent.

Blue-chip counters such as Reliance Industries, ICICI Bank, Infosys and Tata Steel typically enjoy low impact costs. These stocks, for instance, have all shown an impact cost of less than 0.05 per cent for July (on volume data of last six months on transactions of value Rs 1 lakh). That said, there were stocks that did not enjoy such high trading interest and had impact costs over 10 per cent in this period. Birla Capital and Financial Services, Wall Street Finance, Oriental Trimex, Gini Silk Mills, Bell Ceramics, Prime Property Development Corporation and Gravity India are few examples.

Scarcely traded counters are generally the ones abandoned by institutional investors. When institutions keep away from a stock the reasons could be many including poor company fundamentals and questionable governance standards. So, beware! A high promoter holding that leaves a low free float of the stock and a general apathy on stocks from less fancied sectors can also turn away institutions from investing in a stock.

When should one get suspicious?

There are a few indicators that signal poor liquidity in a stock. For instance, if you find ‘$' tag in a BSE (Bombay Stock Exchange) stock, be careful. These are stocks from the Indonext segment - which denotes that it falls under the small and medium enterprises group. Stocks from this segment do not see good market demand and generally suffer high impact cost. Be on vigil for stocks from the ‘Z' category and ‘T' categories too.

Based on certain qualitative and quantitative parameters, BSE has categorised stocks into different groups. ‘A' group stocks, the most liquid in the lot, are the ones that have reported trading in 98 per cent of trading days in the preceding three months and have been checked by the exchange for adherence to compliance norms. ‘T' group stocks come in trade-to-trade category where only delivery trades are allowed due to surveillance reasons. ‘Z' category companies are ones that have not complied with listing requirements of the exchange and have pending investor complaints.

Apart from these, one should exercise caution for stocks of multi-national companies too, where the free float stock is low. These counters therefore tend to be very unpredictable with large volumes in a day and nil trades in subsequent days.

Where to find information

Under SEBI's direction, BSE publishes a list of illiquid securities (follow the link: http://www.bseindia.com/about/illiquidscrips.asp) every month. Investors can use this list or even check volumes of the particular stock in the exchanges' website. As a thumb rule check the average daily volumes for preceding three to six months of a stock before you buy it.

Volume data on stocks can be taken from the websites of both the BSE and NSE (National Stock Exchange). In BSE you can look for volume history by navigating through the price quote window and clicking on the link ‘archives' in the box- ‘stock history' or by directly clicking on the ‘archives' link in the bottom of the website's home page and extract information by citing the specific stock's name. In the NSE website too the procedure is simple. By mentioning the stock's name in the price quote box, you will be taken to a screen where you will find historical data on both the stock's price and traded volumes.

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