The Illiquid Edge

My philosophy

After reflecting hard on 2025, I have decided to refocus my portfolio and this substack. I will now be focused entirely on illiquid investments, and I will be renaming the substack to “The Illiquid Edge.”

What is the Iliquid Edge?

In finance there is a term called the “liquidity premium.” It refers to the higher required rate of return that institutions demand for a security that is not easily traded. Something that can be liquidated quickly might have a yield of 4%, while something that can only be liquidated say once a year, would have a return of 8%. For an institution this might make sense, you have an institutional imperative to generate returns (and trades) every quarter so you have short time horizons and need liquidity. Also if depositors in your fund request a withdrawl, you would need to own liquid securities to honor that request. But for an individual investor with a long term time horizon, this is a strange idea. Why would how often I could trade a security change its underlying value? It doesn’t. To the contrary investing in less tradabale (illiquid) securities gives you an edge.

A number of things have convinced me that illiquid stocks are the right area to focus on.

Warren Buffet is the top performing investor of the last century. When asked how he would generate his 50% annual returns, if he were to start again, he answered “know everything about everything small.” So this is a clear idea to him as well.

I read through a lot of research backtesting various value investing strategies, and even backtested one myself, and the interesting conclusion of most papers is that the success of value investing is driven mostly by the investments in illiquid securities, if you exclude these, returns fall dramatically in backtests.

I have also been interested in the research of Gabaix and Koijen and their inelastic markets hypothesis. They point out that most investing institutions like index funds or hedge funds by their nature have a mandate to be fully invested at any given time. In a market downturn, these funds are locked up, and even face selling pressure as investors withdraw from the funds. What’s left is a small tradable pool of stock ( “float”), where any fund flows to or from the float cause a disproportionate impact. As a result, stock market fluctuations primarily reflect flows of funds interacting with these institutional mandates, not just changes in fundamentals. They found that each 1 dollar flowing into a tradable float increases the price of the security by 5. This further suggests that as a liquidity event occurs the re-pricing can be huge.

This year, I had an interview with a hedge fund manager, and I gave him a stock pitch. The first question he asked was “is it tradable?” Essentially “is it liquid enough for me to invest in?”

This fund manager manages $300M in capital. An average position is 10% of the portfolio or $30M. Now say there is a company that trades $100,000 worth of shares per day. In order to build a position without moving the market, you would need to buy less than 20% of the shares a day, and it would take you 1500 trading days or 6 calendar years to enter the position. As you can imagine, no fund would do this—and none do.

To illustrate this idea, I’ll borrow a concept from poker. In poker, the single most important thing you can do to increase your win rate, isn’t understanding probabilities or game theory (though those things help), it is table selection. That is, you don’t want to be at a table where everyone is better than you, or as the old poker maxim goes, “If you don’t know who the sucker is at the table, it is probably you.” Investing is much the same. Always think about what table you are playing at. Are you buying uranium stocks and playing across from hedge funds with the brightest nuclear engineers, ex-regulators, and detailed models of every daily uranium transaction in the world? Will you win at that table? I don’t think so. I think you have better odds of playing at a table where the stakes are so low, that these funds can’t be bothered to participate.

A few considerations on liquidity and how to avoid “value traps”

From time to time you will find a company that sells for half of what it “should” trade at by any reasonable measure, but never re-rates to the correct price. Investors get upset and call this a “value trap.” Unfortunately, here you are implicitly betting that the market will eventually set a higher price, and it never may. I firmly believe that a successful investment strategy should not be based on other investors bidding up the price. It should be based only on the fundamentals of the underlying company and cash flows. In other words, I wouldn’t bet that the market reprices a security correctly at some point in the future, but I would bet on situations where the market is forced to reprice the security.

That’s why when it comes to successfully investing in illiquid stocks I am looking for situations where a liquidity event is likely. This could mean:

A. The company will be bought. Private equity in many ways are forced buyers, they have to consistently deploy their book of capital, regardless of price paid. Competitors may also buy the company for synergies or “strategic reasons.” In either situation the buyer has a team that know what the company is objectively worth and will pay at least that and often much more. Buyers like these are ideal.

B. The company will be soon included in an index or listed on a major exchange. Indexes are also forced buyers, if a security is included, they will buy it.

C. The company is liquidating, selling assets or ongoing a strategic review that will likely lead to liquidation. If a company is selling for half of what it is worth and will liquidate within a year, that is a 100% return. Likewise if it is selling for half of what its worth, and sells half of its assets, returning capital to shareholders, the rest of the business is “free”.

D. The company is trading at a discount and buying back stock. This is enormously accretive. For example, say the company’s stock is trading at a 20% earnings yield on equity. If a company buys stock at that price, they are locking in 20% returns indefinitely.

E. If the company is growing, this provides major tailwinds. If it is selling for half of what it is worth, and never re-rates or experiences one of the catalysts above, but grows at 20% a year, that 20% growth provides tailwinds and a significant margin of safety.

Each of my current investments has one or more of these features.

To conclude, my investing rules are:

1. Invest in companies with less than $100k in daily average transaction volume - “Fish where the fish are.”

2. Businesses that I understand well enough to reliably predict their future cash flows, discounted back to the present, and arrive at a valuation.

3. Invest in businesses that once valued I can buy for at least 50% off their intrinsic value.

4. Businesses that do not have a significant likelihood of permanent capital loss. Generally this means companies with low debt, strong balance sheets and low business model risk (i.e. most mining, drilling companies who have significant commodity risk implicit in the business model).

5. I only invest in equities that are based in a country with the rule of law, where foreigners are allowed to buy securities outright (so not China), and where they are allowed to withdraw their money at any time (no currency controls).

6. Management should be at least an excellent management team in an average industry or an average management team in an excellent industry but never an incompetent or malicious management team.

7. In terms of position sizing, I think in terms of opportunity cost. For each investment opportunity. That also means that generally, if my top opportunity has a yield that far exceeds the rest, I will be concentrated there. If not, and my top opportunities have an equal yield, I am equally diversified.

8. Invest in companies that either are growing and present tailwinds to their valuation or that have a strong probability of a future liquidity event (buyout, take private, buybacks, liquidation).