Liquidity and Position Sizing

Monday 11/02/15

    Over the last few weeks the share price of Valeant pharmaceuticals has fallen dramatically amid concerns surrounding its business practices. Short sellers have uncovered several instances of what appears to be fraud and it seems like new scandals are popping up on a daily basis for this company. Amid intense selling pressure, billionaire hedge fund manager Bill Ackman stepped up and bought shares of Valeant which ended some of the selling pressure. Ackman's fund, Pershing Square, is the second largest holder of Valeant and it makes up about 30% of the portfolio. This week I want to use the example of Pershing Square and Valeant to discuss two important concepts: liquidity and position sizing.

Liquidity

    Liquidity is the ease with which one can buy or sell a security. Most smaller investors who are buying large companies don't worry too much about liquidity. If you want to buy 100 shares of McDonald's you can find someone willing to sell it to you right away, if you want to sell it right away you can easily find someone willing to take it off your hands. However, if you want to buy 30,000 shares of a small company that only trades about 20,000 shares per day, you may have difficulty buying it, or more likely you will probably pay more than you want to. Too better understand how this works, let's take a look at the order book shown in figure 1.

    There are three columns: bid size, ask size and price. The bid size column shows the number of bids (the price someone else is willing to pay to buy this stock) for a stock and the different prices of each of those bids (each number represents 100 shares). The ask size shows the prices and quantities that other investors are willing to sell the stock for. The highlighted row in the center column shows the last transaction, so in this case 200 shares changed hands at 120.69. The tops of the columns show the total number of shares (the reason the ask size appears higher is because it is rounded up), you can easily sell 3200 shares and easily buy 2600 shares. Let's say you want to sell 3200 shares at the market, you will first get filled for 2300 shares at 120.69, then 200 shares at 120.68, 100 at 120.67 and the rest at 120.65 (In reality it's a little more complex, but for illustration purposes we'll leave it at that). So let's say you want to sell 50,000 shares. Your sale would easily take out all the bids in the order book and as a result the stock price would fall until it reached a price where more buyers were willing to step in. Every stock can become illiquid depending on the size of the order.

    A stock can also become illiquid because of a news event. Let's say a reporter leaks a story that ABC corporation is in talks to buy XYZ corp. People will rush to buy XYZ corp and liquidity will go away for buyers until the stock reaches a price appropriate to justify an expected takeover. The same can happen on the downside if the deal falls through.

    Stocks of small companies are generally less liquid than those of larger companies. You might only be able to buy the much, smaller ZXY stock for 10.50 and sell it for 10.15, if you were to buy and sell it in quick succession you would quickly rack up trading losses. Also, more popular companies like Twitter or Facebook will have more liquidity than unpopular companies of similar sizes. As a general rule, the more trading volume a company has, the more liquid it will be.

    Now let's jump back to Valeant. Valeant is a large company, it is currently very popular with traders because of the volatity created from all the headlines. So for most people it is pretty liquid, albeit volatile. However, if you are Bill Ackman and you own almost 20 million shares of Valeant your position is significantly less liquid. 20 million shares represents over 5% of the company and Ackman is the most public promoter of this stock. In order to exit this position, he would need to sell slowly over time without news leaking about the sale. Last Friday, Ackman defended Valeant against some of the charges, but he also revealed that when he bought more shares of Valeant he used all the remaining cash that was available to him to buy more. At first you might think that it's smart to buy more of a stock after it falls 50% if you believe the drop was unfounded, but what happens if one of Bill Ackman's investors decides to redeem their money from Pershing Square? Since he doesn't have any excess cash, Ackman will need to sell shares either from Valeant or one of his other positions in order to redeem that money. Pershing Square, once one of the best performing hedge funds is now down 15.9% year-to-date, while the S&P 500 is slightly up. It wouldn't be unreasonable to assume that several investors may want to pull their money from the fund at the same time. This would create a problem for Ackman who would be forced to sell Valeant at lower and lower prices to meet redemptions, which could lead to worse performance which would lead to more redemptions—a vicious cycle.

Position Sizing

    Pershing Square is a large fund known for taking large positions. Most people are familiar with the idea of diversification: Invest in a variety of different assets in order to reduce the risk that any one particular asset may have on your portfolio. Also known as: “Don't put all your eggs in one basket.” Pershing Square is pursuing the opposite strategy. This can lead to really great returns or it can lead to disaster. A different billionaire investor, Paul Tudor Jones, was photographed in front of a piece of paper taped to his wall that said, “Losers Average Losers.” This is a well understood concept amongst professional traders and investors, it means: don't keep adding to a losing trade. If your goal is to reduce risk one should generally add to winning strategies and reduce positions in losing strategies. Valeant consistently beat the market for years and slowly trended higher, during that time it made sense to slowly and methodically add to the position or simply do nothing and watch the position increase organically. Once Valeant started trending lower, a good strategy would be to slowly reduce your position until the uptrend resumed or avoid adding until the bleeding has stopped. A common risk management strategy that does this is the Kelley Criterion explained here.

    In a Reuters article from 2010 another portfolio manager who knew Ackman well, describes the failure of Ackman's first fund. Ackman had created a concentrated portfolio of illiquid investments, and eventually closed after "a confluence of difficult things that all happened at once...Tilson recalled the failure was instructive in many ways...Ackman learned lessons from this.” He said that Ackman's Pershing Square now steers away from illiquid and speculative investments. Clearly that isn't true. There is a lesson to be learned regarding position sizing. Diversification is important not just because it spreads around risk, but it is also important because it can keep you from making investment decisions based on emotion. Bill Ackman may eventually be vindicated on this purchase, but if he continues to pursue this strategy I would not be surprised if he blows up another fund.