The Psychology of Investing In Illiquid Stocks
What I’ve learned From 25 Years of Investing in Micro and Small Caps
For over 25 years I have invested in micro and small cap companies, sometimes in stocks that would not even transact a single share in a day. I’ve had some stocks become massive winners and some end up big losers. Thankfully, most of my investments have been successful and I try to not repeat my mistakes.
I bring this up now because to invest in publicly traded cannabis stocks that “touch the plant” in the U.S. means you are investing in illiquid stocks. One of my favorite cannabis stocks that I have written about before is AYR Wellness (CSE: AYR.a, OTC: AYRWF). On Thursday it traded approximately 186,000 shares (It’s 30 day average volume is approximately 131,000 shares). Over two days AYR traded less than $8 million worth of stock, and over those two days the stock went down over 10%, lopping off over $150 million of market cap. If $8 million of stock trading can wipe out that much market cap and send your stock price diving, you are an illiquid stock!
Over the same time period, Canadian cannabis company Tilray (NASDAQ: TLRY) traded 30 million shares or almost $300 million worth of stock and the stock price was flat. Remember Tilray can trade on the NASDAQ because it is federally legal in Canada to sell cannabis, but not federally legal in the U.S. Despite not being profitable and operating in a country that is smaller than California, Tilray is able to access the liquid markets and has tons of liquidity.
Institutional capital, indexes and the broader financial system are not able to invest in AYR. And while this is a big part of the opportunity, it also means if someone or some large holder wants to sell some AYR or other illiquid US Cannabis stocks, those stocks could go down and they could go down precipitously.
You have to know and understand that illiquid stocks can and often do move completely independently of fundamentals. Are you prepared for a 30-50% downdraft in your investment and how would you realistically react? If you would panic or could not handle such a selloff, you should not be buying these stocks to begin with.
I’ve come to believe that investing in US cannabis stocks is almost like investing in private companies with these weird trading stubs that are wildly illiquid. A comparable might be post-bankruptcy claims.
Maybe an even more apt description would be that buying publicly traded cannabis stocks is like buying options, but with no expiration. Options can swing wildly in price and are often illiquid, similar to cannabis stocks. The option is that they will trade in the US one day and cannabis will be legal.
So how do you deal with these downdrafts and this illiquidity? First, you need to size positions appropriately according to your own risk tolerance and in way that makes sense to the size and makeup of your overall portfolio.
Second, you need to stop looking at stock prices as a source of intel like you would in the broader markets where stock price movements can actually tell you something. When stocks make big moves up or down, many think that there is news around the corner or that some insider knows some secret. At times you even read about grand conspiracies. About 99% of the time, short term movements in stocks are based on capital flows and this is especially true in illiquid stocks.
Third, understand the game you are playing. Personally, I am making long term investments in companies, management teams and theses that should pay off massively in the long run. All I care about is how the company is executing on its strategic plan, is management ethical and are they making capital allocation decisions that make sense for shareholders. Short term price movements should not change my opinion of my investment. Now that doesn’t mean that others can’t trade in and out of stocks and play a shorter term game, but that’s not my plan.
And that is why when I talk to investors interested in the new fund I’m launching to invest in these illiquid cannabis stocks, I make it very clear that these stocks may keep going down, they may go nowhere for years, but that one day, they will trade on different exchanges. And when they do, you may get five years worth of performance in an extremely short period.
If the rental car company, Avis Budget Group (NYSE: CAR), can go up 200% in one day, what would AYR do if it could trade on the NASDAQ? What would happen if every institutional investor, Robinhood customer and index suddenly wanted to buy a leading cannabis stock that is used to trading $4 million worth of stock a day. I think I know the answer and this is why I’m invested in these cannabis stocks.