Why Traders are Important for Value Investing

OK, before someone lambasts me for switching to trading, please read and re-read the title carefully. I mentioned that “traders” are important for investing, and not “trading”. The use of the two somewhat similar-sounding words makes a whale of a difference though, and this post shall proceed to explain why, and how I can justify the above statement.

In any stock market, there always exists an abundance of traders/speculators while there are usually only a handful of investors. The investors sit on their butts and wait patiently for their shares to reach their perceived fair value, all the while exercising patience and engaging in detailed due diligence to ensure all is moving right. By contrast, the active traders are the one who zip around like dragonflies on a hot noon day, flitting from counter to counter in the hopes of entering and exiting with maximum profit (and minimum loss). There exists a certain relationship between the two camps – one whereby each takes advantage of the other’s actions to generate opportunities to make money. Let’s take it from the point of view of the investors, first.

Investors have the unenviable job of researching, reading and analysing company fundamentals, and waiting for margin of safety to appear when Mr. Market presents it. Traders help to accelerate this process by 1) creating liquidity and also 2) creating instances where mis-pricing is so evident that investors will be “forced” to react. These two factors alone are pertinent reasons for the importance of traders to the investing process. Liquidity can be seen as the oil which greases the wheels of the stock market, and it is important when an investor wishes to take a position in a company which he feels offers long-term investment potential AND a margin of safety. However, it is well-known that illiquidity in some counters creates wide bid-ask spreads, and this can severely hamper an investor’s ability to purchase a significant stake in a company at a low enough price due to the illiquidity premium, and also the prohibitive bid-ask spread which results in higher fees. Traders are responsible for providing much-needed liquidity, so that an investor can find the volume to purchase a sizeable stake, and also to avoid the associated higher costs which come from a wide bid-ask spread.

During instances of market frenzy or market panic, traders are responsible for the gamut of emotions which flood the stock market, creating over and under-valuations of sound securities. The emotional tenor of the market is determined by these traders, and share prices can be severely marked up or down depending on the prevalent news, rumours and/or reports. Investors make use of such opportunities to find bargains to purchase, when share prices are uncharacteristically depressed due to one-off events or due to fear and panic in the markets. Conversely, traders who are excessively exuberant will also bid up prices of securities far above their fair value, and this presents opportunities for investors to offload their shares for a comfortable profit, as the share price may have run far ahead of fundamentals and prospects.

The above two situations illustrate how traders help investors by reducing the opportunity cost of holding cash, and also creating situations which benefit the conservative investor. Investors, on the other hand, also help traders by providing liquidity with their persistent buying or selling, especially when they target to invest in or divest a certain company. Generally though, I believe the presence of traders helps to enhance the opportunities present for an investor, but the investor must do his own due diligence and be vigilant for such opportunities presented by Mr. Market.

However, it should be noted that traders usually stick to companies with heavy volume (institutional favourites), and hence the “churn” which is produced will usually be limited to the same few blue chips and/or speculative counters which see cyclical volume spikes. Certainly, if there are bargains to be found, they may mostly reside in the quiet, untraded counters which dot the landscape; and these may still present the same problems to investors who wish to accumulate a sizeable stake. Liquidity is contingent upon certain events in which the market either recognizes the true intrinsic value of a forgotten gem, or a corporate event which throws the company into the spotlight. Both instances do not create conducive buying opportunities, however, because people will then bid up the price of the under-valued security. Hence, it may still be a challenge for investors to accumulate good companies in suitable quantities to make a positive difference to their portfolio.

Ultimately, investors should still watch for events to unfold which may offer them some glimmer of hope to accumulate at a price far lower than intrinsic value, in order to maximize margin of safety. A lot of patience and fortitude is required for such an operation to take place successfully. In the meantime, it would be a worthwhile exercise to let cash pile up until it can be deployed at a suitable time and in suitable securities which can yield a decent (better than inflation) long-term return.