Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / The Liquidity Trap in Your Stock Picks
Transcript
- Lucas: Look, most people think stock picking is just about finding a good company. But today, with the ten-year Treasury yield sitting at its highest level in nearly two decades, that assumption is dangerous. Cash has become expensive again, which means the cost of being wrong in an individual stock just went up significantly. Luna: Right, because when risk-free money costs four percent or more, you need a much bigger margin of safety to justify tying up capital in one name instead of an index fund. Lucas: Exactly. And I want to drill into something specific: the liquidity premium. When you hold Berkshire Hathaway, you own a basket of businesses and liquid securities. When you buy a smaller-cap tech firm like Akamai Technologies, you are providing your own liquidity to the market every time you trade it. That friction is a real, measurable tax on your returns. Luna: So you’re saying the bid-ask spread and the impact cost of entering and exiting positions matter more now than they did when borrowing was basically free? Lucas: Precisely. Let’s look at Akamai. It’s a solid infrastructure play, but it trades in a market where volume dries up quickly during volatile periods. If you bought it five years ago thinking you’d just hold forever, you might have forgotten that selling isn’t always instant at fair value. In a high-rate environment, that delay costs you compound annual growth rate. Luna: It’s the illusion of permanence. You assume you can sell whenever, but in reality, slippage eats into that thesis. Lucas: And here is the kicker: most retail investors don’t track their transaction costs as part of their total return calculation. They see the price move from point A to point B, but they ignore the hundred basis points lost to spreads and market impact. Over a concentrated portfolio, those losses add up faster than you think. Luna: Yeah, especially if you’re rebalancing frequently. High turnover in a illiquid name is a double whammy. Lucas: Let’s talk about that turnover. Warren Buffett built Berkshire Hathaway partly by avoiding the need to trade constantly. He holds huge stakes in Apple and Bank of America, but he does so knowing he can exit without moving the needle against himself. That’s structural advantage. When you pick a mid-cap stock, you are the liquidity provider, not the beneficiary. Luna: So the best way to avoid that trap is to either stick to large caps or accept that your required return needs to be higher to compensate for that illiquidity. Lucas: Correct. If you are going to concentrate your portfolio, you must demand a discount that covers both business risk and liquidity risk. Otherwise, you are better off buying the S&P 500 and accepting lower returns with zero transaction friction. Luna: That’s a tough pill for active managers to swallow, but mathematically it makes sense. Lucas: Before we go deeper into how to calculate that discount, I want to mention something about how this show operates. If our money conversations have helped you think about a decision differently, consider supporting us directly. Listener support keeps this network ad-free and allows us to do this deep research. You can find us at buy me a coffee dot com slash fexingo. Any amount helps keep the lights on and the research sharp. Luna: Thanks for listening and for keeping this independent voice alive. Now, back to the numbers. Lucas: Let’s get concrete. How do you actually price that liquidity risk? I suggest looking at the average daily dollar volume relative to your position size. If your position is larger than ten percent of the average daily dollar volume, you are already exposing yourself to significant slippage. Luna: Ten percent is a hard limit? That seems conservative for a long-term hold. Lucas: It is conservative, but it protects you. If Akamai suddenly drops on bad news, the bid-ask spread widens instantly. If you are over-concentrated, you cannot exit without accepting a massive haircut. Diversification isn’t just about risk; it’s about optionality. Illiquidity removes your optionality. Luna: So even if you believe in the company for ten years, you need an exit strategy that accounts for market stress. Lucas: Always. And this ties back to the current macro environment. With rates high, valuations are compressed. Companies that used to trade at a premium for growth are now being judged on cash flow. Akamai generates strong cash flow, but its valuation doesn’t account for the liquidity penalty you pay when you trade it. Luna: It’s interesting that you bring up cash flow. Does that mean you’d rather hold a boring utility stock with no liquidity issues than a tech stock with great cash flow but poor depth? Lucas: I’m not saying choose one over the other blindly. I’m saying if you choose the tech stock, you must adjust your expected return. You need a twenty percent internal rate of return on an illiquid small cap to match the eight percent you might get from a diversified index. The hurdle is much higher. Luna: That explains why so many stock pickers underperform. They forget to factor in the cost of doing business. Lucas: Exactly. They focus on the alpha of the business, not the beta of the market structure. And in a rising rate environment, the beta component becomes more expensive. Every day you are in the market, you are paying the opportunity cost of cash. Luna: So the 'missing piece' for AI exposure mentioned in the headlines might not be the chip maker, but the infrastructure layer that trades efficiently. Lucas: That’s a sharp observation. Infrastructure plays often have better liquidity profiles than pure-play software names. If you want AI exposure, look for companies where you can enter and exit without moving the stock price against yourself. That is a tangible competitive advantage. Luna: It changes the entire due diligence checklist. You aren't just analyzing the product anymore. Lucas: You are analyzing the market for the product too. Who is selling? Who is buying? What happens if everyone wants out at once? Those questions matter more than ever right now. Luna: It feels like we’re shifting from fundamental analysis to behavioral finance, but it’s really just practical survival. Lucas: It is survival. Because if you can’t exit, you don’t own the asset. You own the liability. And in a concentrated portfolio, liabilities kill compounding. Luna: So the lesson is: check the volume before you check the valuation. Lucas: Check the volume first. Valuation tells you what to buy. Liquidity tells you if you can sell. Both are necessary. Luna: Does this apply to ETFs as well, or is it mostly individual stocks? Lucas: Even ETFs have liquidity traps if you are trading the underlying holdings. But generally, broad market ETFs are safe. The danger is in single-name concentration. That is where the risk lives. Luna: Makes sense. So stay diversified, or demand a huge discount for concentration. Lucas: Stay diversified unless you have a specific reason to concentrate, and then make sure you are getting paid for the inconvenience. That is the new standard. Luna: A paid inconvenience. I like that framing. Lucas: It’s the only rational way to view it in this market. Everything else is hope. Luna: Hope doesn’t cover the bid-ask spread. Lucas: No, it doesn’t. And that is why we need to be precise. Luna: What should listeners ask themselves before making their next big bet? Lucas: Ask yourself: if this stock halves tomorrow, can I sleep knowing I can sell it without losing half my principal to slippage? If the answer is no, you need a bigger position size or a different stock. Luna: Or maybe you just need to step back and take the index fund route. Lucas: Maybe. Or maybe you wait for a better entry point where the liquidity is clearer. Patience is also a form of liquidity management. Luna: Patience as a tool. I hadn’t thought of it that way. Lucas: It’s the ultimate edge. Waiting for the market to give you price AND liquidity. Luna: That sounds like a rare combo these days. Lucas: It is. Which is why most people fail. They chase price and ignore liquidity. Luna: So we watch the tape, not just the ticker. Lucas: We watch the tape. Always. Luna: And if the tape is thin, we walk away. Lucas: We walk away. There are plenty of other games being played. Luna: Thanks for the perspective, Lucas. Lucas: Anytime. Keep your liquidity tight and your expectations realistic.