“Price is a function of liquidity, having nothing to do with value.”
Charles Biderman recounts how he went bankrupt in 1987 even though he had a positive net value in his real estate investments. Why, because his banks went bankrupt and his loans were called. If he had had time to sell his properties, he says, he wouldn’t have had to declare bankruptcy. This taught him the following:
Price is a function of liquidity, having nothing to do with value.
What does this mean for the investor? Ultimately, in the real world, fundamentals should eventually win, but the market depends not on that value but on the ability of investors to maintain their liquidity. Thus, the most liquid players during severe downturns will be able to add value to their portfolios. The real trick of investing is twofold: (1) Determining what stocks have a real value; (2) being liquid when the vast majority of other market participants are illiquid–only then can the investor be assured of getting the bargain basement price for an asset. This means keeping a tight lid on one’s use of leverage. My policy is to keep leverage below 1:1 debt to equity; and to use only a fraction of the bank loan permitted to me.
Another lesson is perhaps less obvious: Never invest in the company in which you carry your loans. If that financial institution goes bankrupt, so will your investment. So you will be hit with a double whammy. Say you invest in ABC bank where you have your line of credit which is your funding of last resort for your margin account. When ABC bank goes bankrupt, then your loan gets called. At the same time, your portfolio takes a hit because your ABC bank investment has also gone down to zero. This could result in the margin call to which one is unable to respond, except by liquidating the remaining portfolio at severe losses.