Financial Liquidity: Providing Context for Investors

Liquidity – the ability to convert assets into cash – generally worries investors.[1] In talking with clients and in my forestry investment research, I find that the issue of liquidity varies significantly by investor and over time, and that we are quick to generalize about the advantages and disadvantages of liquidity. How can we frame liquidity in a way that provides context for planning and decision-making?

Issues Related to Liquidity

In finance, liquidity is a construct that affects certain folks in certain situations; it does not affect everyone always. Liquidity, a problem when you need it and don’t have it, covers issues that may relate or overlap. For example, consider the use of debt (leverage) and the valuation of assets.

Debt differentiates during market crashes. While leverage has its role in finance, investors without debt will be less compelled to liquidate during tough markets. For highly leveraged organizations, debt compresses time and reduces options.

If we view liquidity as a balance of buyers and sellers at any time, then in the absence of buyers or sellers, how do we value an asset? When traders scramble to pay debts and meet margin calls, they don’t sell what they should, they sell what they can. Investors in comparable situations act surprised when markets tank and buyers are nowhere to be found. 

Plan Ahead to Manage Liquidity

At times, investors need cash. In forestry, for example, due to irregular harvest revenues on smaller timberland ownerships, an investor may need supplementary funds through a partial sale, an advance, or a loan. While situations require balancing time with flexibility, it helps to plan how one might unload a timberland tract in a crisis. Investors get part-way there by breaking down the forest into its salable components, including timber, hunting rights, and choice parcels. 

At the Federal Reserve Bank’s 2005 Jackson Hole Economic Policy Symposium in Wyoming, economist Raghuram G. Rajan, then working with the IMF, noted how actual and perceived time pressure from excessive debt, unusual financial structures, or other obligations can essentially manifest losses through illiquidity. He observed[2]:

Liquidity allows holders of financial claims to be patient… and allows the value of the net financial claim to more fully reflect fundamental real value. Not only does illiquidity perpetuate the overhang of financial claims as well as uncertainty about their final resolution, a perception of too little aggregate liquidity in the system can trigger off additional demands for liquidity.

Raghuram G. Rajan

Putting Liquidity in Context

Liquidity is largely a function of time horizon. Timber is a long-term play for long-term buyers and liquidity matters more for short-term sellers or investors reliant on significant leverage. 

In addition, investors may hold positions that are ‘effectively’ illiquid if they are too large or too small or too marginal in quality or location. When prices crash, it’s easy to blame an absence of buyers on liquidity. From this view, liquidity is a problem for poor planners.

Conclusion

The relevance of liquidity to risk, returns, or cash flow varies across investors and over time. Liquidity thrives during periods of stability and of growth. Crashes, panics, recessions, and blackouts dry up liquidity. Sizable investment assets, whether timberland or car dealerships, often comprise a diversified portfolio of smaller assets, inventories, and cash flows. The issue of liquidity is rarely all or nothing.


[1] This post includes content from the Q2 2024 Forisk Research Quarterly (FRQ) feature article, “Topics on Forest Finance: Investment Criteria and Timberland Liquidity” and from the forthcoming 7th edition of Forest Finance Simplified

[2] “Has Financial Development Made the World Riskier?” 2005 NBER Working Paper available at: https://www.nber.org/system/files/working_papers/w11728/w11728.pdf

Context Appropriate Communication: Comparing Investment Performance to Forest Sustainability

The growth of ESG investing – which screens investments and firms based on environmental, social, and governance criteria – and markets for forest carbon and other environmental “services” highlight the importance of clear communication skills and the value of those who possess them.

Consider the situation for professionals in the timberland investment sector, a part of our research portfolio at Forisk. Timberland professionals grapple with the most effective and “context appropriate” ways to report investment performance and forest sustainability. How do we answer questions ranging from cash flows to wood flows to rates of return? Finance, investing, and forestry, come down to math.

Example: The Math of Finance and Forestry

Consider measures of forest sustainability versus investment performance. Investment returns often focus on percentages, which simplify comparisons across investments. However, percentages communicate differently than dollar amounts. Saying “you earned 5% last year” differs than saying “you earned $5,000 on your $100,000 investment.” They mean the same thing, but hearing dollar amounts clarifies the implications of how much wealth you gained.

The math of investments can, when reported as percentages, camouflage the dollar impact of fees, as well. Consider two descriptions of investment management fees:

“You will pay a 1% annual fee on this $1 million investment.”

“You will pay a $10,000 annual fee on this $1 million.”

The phrases describe identical fee structures differently. Do they sound or feel identical? The Securities and Exchange Commission (SEC) has, since 2004, accounted for this issue in shareholder reports and quarterly portfolio disclosures by requiring the reporting of fees in both percentage terms and in dollars per $1,000 invested. 

The math of relative (percentage) measures versus absolute numbers applies to tree health and forest sustainability, which affects the reporting and communication of forest carbon investments and wood bioenergy projects. Saying that a timber market “has a growth-to-drain ratio of 1.1”, meaning growth exceeded removals by 10%, differs from saying “this market grows 1 million more tons than are harvested each year.” 

Conclusion

A percentage, while informative, provides incomplete information. We can always estimate performance in percentage terms, while absolute values, whether in dollars or tons or board feet, communicate the cash, wood, or forests available today.

Dollar-Cost Averaging: An Effective Investment Hack

Classic lessons and finance fundamentals inform my approach to investing. Start saving and investing early to crank the flywheel of compounding interest. Minimize costs to keep more of what you earn. Diversify to mitigate risk. Commit to regular and systematic investing, instead of trying to time the market. My Dad introduced this last one to me, years ago, through dollar-cost averaging

Words inform, and the name of this strategy previews its priorities. “Dollar” means money, as opposed to volume (e.g. numbers of shares). “Cost” is about what we spend (now) as opposed to what we might get later. “Averaging” speaks to doing this over time. In short, dollar-cost averaging is a process that focuses on what we can control.

With dollar-cost averaging, we regularly and systematically invest a fixed dollar amount, regardless the share or fund price or situation in the overall market. When prices are up, we will buy fewer shares, and when the market is down, our allocation pays for more shares. This strategy tends to result in a lower average cost per share over time when compared to lump-sum purchases.

If you participate in a workplace retirement plan with monthly contributions, such as a 401(k), you effectively employ dollar-cost averaging. In addition, users of 401(k) accounts and the like typically trade less frequently in those accounts, further reducing costs and preserving capital. The framework reduces emotion and anxiety while supporting a proactive approach to building wealth.

Dollar-Cost Averaging in Action

In the timber industry, my research focus at Forisk, the easiest vehicles for applying a dollar-cost averaging strategy are the publicly traded timberland-owning REITs (PotlatchDeltic (PCH); Rayonier (RYN); and Weyerhaeuser (WY)). The Forisk Timber REIT (FTR) Index, commonly called the “footer index,” is a market capitalization weighted index of the public timber REITs.[1] The figure below summarizes a dollar-cost averaging approach to investing in the timber REIT sector based on buying $10,000 worth of FTR Index shares at the end of each year for ten years from 2014 through 2023.

With this strategy, the weighted average cost per “share” is $277.44, while the straight average of the ten year-end prices was $285.21. With dollar-cost averaging, your portfolio has more of the lower-priced shares and fewer of the most expensive shares, which brings down the weighted average. The strategy is not always advantageous. If you had simply purchased $100,000 worth of shares at $270.52 in 2014, you would have been better off. For that reason, it helps to think of dollar-cost averaging as a robust and systematic approach to cost-effectively stay invested over time.

Discussion and Considerations

With the regular, systematic investing of dollar-cost averaging, you acquire more shares when the market is lower, thereby reducing the average per-share price in your portfolio. When the market rises, you acquire fewer share, but you still gain from rising prices because your portfolio already contains shares bought previously at lower prices. In this way, periodically buying fixed dollar amounts outperforms the regular buying of fixed numbers of shares.

Fundamentally, dollar-cost averaging is a risk-averse, conservative approach. While it helps manage risk, it also reduces the likelihood of outsized returns. Dollar-cost averaging functions best in a world where the market always mean reverts. However, the stock market rises, tends to rise, has risen over time, even as it does so on a random path. If the market or asset of choice were guaranteed to increase and appreciate, we’d be better off investing all money now, regardless the prices. But that’s not how life or access to capital work. Most of us save and invest over time as we earn income and generate cash, and dollar-cost averaging serves as an investment hack, a short-cut for the person who wants a reasonable, low cost, relatively effective way to invest systematically without the stress of timing the market.

As a strategy, dollar-cost averaging is also agnostic and indifferent. It will acquire more shares of underperforming firms or funds as easily as attractive and performing investments, so there are still decisions to make. This is one reason why dollar-cost averaging fits well for investing in diversified index funds that tend to follow the overall market. 

Conclusion

With dollar-cost averaging, you buy shares of a stock or fund regularly over time at the prevailing prices. With this approach, your average cost is neither the highest nor lowest market price. It is a weighted average that systematically acquires more shares when they are cheaper and fewer when they are dear. This strategy keeps you invested in the market without any need to deliberate over “timing” the market.


[1] Initiated in 2008, the FTR Index provides a benchmark for comparing timber REITs to other timberland investment vehicles and the overall market. To subscribe to the free weekly FTR Index Summary and to obtain historical FTR Index data in an Excel format, please contact Pamela Smith, psmith@forisk.com.

Options and the Risk of Missing Out

In graduate school, I conducted research on managing risk in the forest industry. My working assumption was and remains that vigorous management of organizations requires the deliberate identification, assessment, and management of risks. In forestry, these include, for example, those in operations (e.g., equipment breakdowns), distributions (e.g., transportation delays), and human resources (e.g., hiring and retaining personnel). 

My research, however, focused on financial risks, which comprise those risks that a firm is not typically in the business of bearing. For a forestry firm or timberland investor, these may include the impacts of exchange rates, energy prices, and interest rates. Within this area, I studied the potential for timberland investors and forest owners to use financial contracts, operational hedges, and “options.” 

Options Have Value

Options? Yes, some view forest management as a series of real options. For capital budgeting and strategic planning, real option theory addresses limitations with net present value (NPV), which does not account for flexibility, volatility, and contingency with potential investments, whether in forestry or any other industry.

Flexibility. Volatility. Contingency. In the context of forestry, flexibility refers to the manager’s ability to defer, abandon, expand or reduce a silviculture investment or harvest schedule due to new information or investment opportunities. Volatility references changing market conditions – particularly changing timber prices – or new technologies that affect our view of potential investments. Contingency refers to situations where future investments depend on investments made today. Presumably, these options provide value and should be accounted for, or at least considered. 

Options, Flexibility, and the Risk of Missing Out

In practice, not all investors have the same levels of flexibility, exposure to volatility, or concerns about contingency. In many cases, traditional analytic approaches like NPV, which views decisions as fixed, is sufficient for making decisions. This makes real options analysis a whiteboard discussion for comparing and discussing a dynamic view of future choices for strategic planning, and less about risk mitigation.

For a firm focused on downside risk, risk management and hedging programs transform undesirable risks into acceptable and manageable forms by increasing certainty and decreasing volatility. The management of risk helps firms achieve their optimal risk profile by balancing the costs of hedging with the protection offered. 

While some view risk management defensively, others may incorporate risk management into a process of appraising investment opportunities, as risk features both potential upsides and downsides. The view of managing risk to protect the firm from catastrophes or losses ignores the risk of missing out on profitable or strategic opportunities with upside potential.  

In short, the risk of missing or underinvesting in promising projects represents a risk unto itself. Risk management can play a role in protecting and increasing the bundle of cash flows that make up the corporation, and the associated opportunities for future investments that require these cash flows. Rather than husbanding resources exclusively for precautionary safety nets or insurance-like reserves, risk management can include the allocation of capital among competing investment alternatives.

Conclusion

At a certain level, executives and investors manage risk instinctively. In forestry, this occurs through the normal calculus of assessing the risks and rewards associated with silvicultural treatments and timber sales. Executive professionals identify, assess, and manage the risk and uncertainty encountered by their operational activities in business environments subject to financial risks emanating from outside of their sectors, and in doing so preserve the ability, the option, to make opportunistic investments.

Framing Disruptions

Simple approaches can focus the mind. When thinking through the means and mechanisms by which disruptions could affect my business, my community, or the economy, I often ask two simple questions rooted in economic fundamentals[1]:

  • Big or small? In other words, how impactful, whether positive or negative, would we expect this disruption or change to be on local infrastructure, needed supplies, or aggregate demand? 
  • Long or short? What is the likely duration, whether positive or negative, of this disruption or change on supplies or demand in the community, market, or industry?

As an example from my work in the forest industry, consider the impacts of natural disasters on timber markets. In August 2005, Hurricane Katrina, a Category 5 event, struck the Gulf States, brutally affecting homes, forests, and infrastructure. As a disruption, how would we provide context to its impact on timberland owners? Consider these two questions to organize our thinking:

  • Big or small? Big event locally; devastating to some forests and damaging to many. 
  • Long or short? Short-term increase in supplies; negative impact on timberland value.

Using Frameworks to Make Decisions

Simple frameworks add value to the extent that they prove useful. This analytic exercise supports decision analysis. Using experience, knowledge, and available data, it screens and ranks the relative importance of potential disruptions on lives, businesses, and markets. We can then probe assumptions and, while there may be no “right” answer, develop operable approaches to establish priorities.

With family or colleagues or neighbors, the resulting discussions can clarify how much control we have. Some disruptions, like a zombie apocalypse, get thrust upon us from the outside, while others, like new internet providers or car technologies, offer choices. And a big impact or opportunity for an individual, family, or single forest owner can be small for the overall market and community. 

With respect to applying this approach with executives and other decision-makers, I think in terms of “tactics” (operations) versus “strategies” (capital allocation). Disruptions that get handled on the ground via operations tend to qualify as shorter or smaller in this framework, while anything that requires a board meeting or act of Congress reflects longer-term disruptions affecting investments and strategic advantage. Given this approach, how do we develop strategies and assess exposures across multiple disruptions for these situations locally?

Time as a strategic idea remains malleable. Discussions about potential disruptions reinforce the arbitrary nature of the “short” and “long” term. The space and time required for impacts to realize themselves can extend beyond today, tomorrow, or next year. 

Conclusion

Regardless, we succeed by prioritizing in the name of preparation. My working assumption is that a person or firm that is ready for everything is ready for nothing. We avoid personal and organizational paralysis through taking positions on what matters, on where we have control, on eliminating the gnats and knots to go after the disruptions that threaten survival or offer outsized opportunities. 

In March 2020, I posted “Thinking Through Risk and Uncertainty: Contemplating the Coronavirus” and am returning to these themes as ideas and questions related to risk, disruption, and stability have become more frequent in my conversations. For those interested in a further discussion of strategic thinking (and how the coronavirus affects the forest industry), click here to read a five-page white paper.


[1] These questions are a variation on the frequency-severity framework used for insurance and risk management applications. In forestry, I have found it useful to think through duration – how long something lasts – rather than, or in addition to, the gap in time between occurrences.