Overvaluing Liquidity: Invest For The Future, Not For Today

If you talk to individual investors about which stocks they own, you will undoubtedly hear a recitation of the same stocks that dominate the financial media on a daily basis. Everyone owns and trades stocks like Apple AAPL and Google GOOG that the big funds tend to own. Investors who label themselves as more conservative in nature all tend to own stocks like McDonald's MCD and Merck MRK. Investors will often cite the comfort of owning familiar names as a reason for owning these stocks, as well as their urgent need for liquidity. These arguments make no sense if you are approaching the markets from a business-like perspective. Are you investing for comfort or long-term profits? If you are investing in equities, you should not have money involved that you need anytime soon Related: How To Buy Cheap And Reap The Rewards In fact, Warren Buffett famously suggested that if you foresee a need for the money in the next five years, it should not be in stocks. He also suggested that you should not buy a stock where it would upset you if the exchanges closed for several years and you were unable to sell your stake, except by privately negotiated transactions. This is in line with Ben Graham's suggestion that investing works best when conducted on a business-like basis. Investors should treat stocks like an equity interest in the underlying business and not just a betting slip in the world's longest ongoing popularity contest. If you approach the markets with a business-like point of view, the need for immediate liquidity is lessened substantially. Broaden Your Horizons The need for liquidity and the comfort of familiar names keeps investors from taking advantage of some of the most lucrative opportunities available in the markets. Consider the current situation in small, regional and community banks that has developed over the past few years: the banks saw their portfolio of loans take a turn for the worse during the credit crisis -- profits and stock price suffered. Many of these stocks trade well below their tangible asset value as a result. As the industry is in the midst of healing, these little banks have seen their asset quality improve dramatically, but their stock price has not done the same. Investors overvalue liquidity and avoid the sector, as it can take days and even weeks to get trades completed in some of the stocks with market capitalizations of $25 million or less. As the old Wall Street saying goes, they trade by appointment. If you approach the sector correctly, you are buying these stocks to hold for many years, so the time to accumulate a position today should not be a factor in your decision. The Process There are two ways that these little stocks can pay off big over the next several years. We are starting to see a merger and acquisition wave in the sector that will last for several years. The cost of compliance is simply too much for smaller banks, and the larger banks are finding that the total lack of organic growth opportunities means that to grow, they have to buy smaller institutions. It creates a perfect storm of consolidation and many of these little banks trading below book value will be sold well above that value. The small banks that survive will be those that are able to dominate their local markets and take market share away from the large bank, perhaps using a merger of equals to increase their local footprint by combining with other little banks in the area. The profit growth of these strong, competitive little banks should lead to a much higher stock price over the next decade. Related: A Better Way To Get Into The Private Equity Mindset These little banks are safe and cheap investments in the current economic and market environment. They have improved the quality of their loan portfolio and disposed of troubled assets over the past few years. Many of these stocks trade for a fraction of their book value and at very low multiples of earnings. Many of them had reduced or even eliminated their dividend to preserve capital during the crisis and that trend is starting to reverse. This should be one of the best sectors over the next decade for dividend growth in addition to the upside potential of the stock price itself. Small banks are safe and cheap right now, but they are not liquid -- that shouldn't bother you. There is no need for instant liquidity in a business that can provide you returns of several times your original investment over the next 5-10 years.