Investing Strategy: Less Liquid Stocks Give Better Returns

It seems counter-intuitive and goes against the flow to pick stocks that are less liquid i.e. whose trading volume is less in absolute terms or relative to shares outstanding. More actively traded stocks by definition have more investors and analysts paying attention so one would expect fairer prices and a more accurate reflection of what they are really worth.Highly liquid stocks have lower bid-ask spreads and it is easy and quick to buy or sell.

The fact is that liquidity is valued but it comes at a price, a higher price. The backwaters where illiquid stocks reside are where the best fishing is to be had so to speak. Low liquidity entails a discount, a lower price. Highly active trading on a stock reflects more over-enthusiasm, over-popularity and too-high prices than efficient pricing.

One of the most visible investigators of the liquidity effect and a proponent of exploiting this as an investment strategy is Yale University finance professor Roger Ibbotson, who is renowned for creating the baseline data source for asset class investment returns and as an author. His firm Zebra Capital aims to profit from liquidity.

The Low Liquidity Advantages:
1) Higher long term returns
Ibbotson's research (see Liquidity as an Investment Style) conclusion is categorical: "Less liquid publicly traded stocks have higher returns than more liquid publicly traded stocks."  The difference in returns was enormous for US stocks during the period 1971 - 2009: 7.4% per year compounded between the most liquid and least liquid.

Furthermore, " ... there is an incremental return from investing in less liquid stocks even after adjusting for the market, size, value/growth, and momentum factors." In other words, this outperformance is not just a reflection in another guise of the well-known fact that over the long term value stocks (low Price to Book Value - see our previous post on the subject) and small cap stocks (see our previous post here)or momentum stocks (ones that have established a trend), outperform the market average. Here is a chart that shows the outperformance of low liquidity in the US stock market.

2) Low liquidity wins internationally as well
Another Ibbotson paper (Liquidity Styles and Strategies in U.S. International and Global Markets finds that liquidity matters too in other markets "Similar to the U.S. markets, liquidity has the characteristics of an investment style in international and global markets. It is different from size, value/growth or momentum, but just as powerful in effect." That strongly suggests the same will be true for Canada though it was not studied separately.

3) A bit less upside, a lot less downside
The same paper shows that low liquidity stocks perform best in a defensive role when markets are declining - sacrificing a bit on the upside but losing a lot less on the downside, as this chart shows, and similar charts in the paper show for other markets. That behaviour looks quite attractive in current markets.

Is the low liquidity effect just a fluke that will go away?
Investors are always wise to question whether any outperformance is the effect is durable or just a reflection of the time period and data chosen. Apart from the finding of the effect across global markets, it is not just Ibbotson and his co-researchers saying this. His papers cite numerous other studies that found the the same thing in various forms. Books like the Handbook of the Economics of Finance (see Google search result for this book) cite these and other studies.

If low liquidity stocks are cheap, won't they stay cheap?
Another way to look at the question of durability is Ibbotson's finding that stocks move up or down in liquidity as they move into or out of popularity. A less liquid stock tends to get more liquid over time and a more liquid stock gets less liquid. Since less liquid stocks are valued at a liquidity discount the low liquidity investor takes advantage of the movement: "The migration of liquidity is the primary driver of returns."

Practical investing challenges
As with many such effects, the benefits come out on average over a large number of companies and over longer periods. Buying less liquid stocks that then make high returns will not work for every stock for every year. It would be helpful if there existed mutual funds or ETFs that implement the strategy but in fact, at the moment in Canada and the USA there seem to be no such mutual funds or ETFs at all (except one US mutual fund which Canadians are not allowed to buy due to regulation).

The Canadian investor is left to do it him/herself. Since simple, blind buying of only a handful of low liquidity stocks probably won't work, the liquidity factor is best used in conjunction with fundamental analysis, as Ibbotson himself recommends. To get a list of low liquidity candidates, the TMX Stock Screener includes as a selection criteria within the Trading and Volume heading the 10-day average volume, which can be set to its lowest value of 10k. Adding other criteria such as low P/E and low P/Book can narrow the list further to a manageable number. Another screener is on the ADVFN website. It is a bit more cumbersome to use but offers as a liquidity filtering criteria the Weekly volume as a percent of shares outstanding under the Identification and Quote Information drop down box. ADVFN has plenty of other filtering criteria and company fundamental information to add analysis of potential candidates for a stock buy.

The best of Canada Day to readers!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

What Long Term Return Can We Expect from the TSX?

In our last post we noted that the level of stock prices, or stock valuation, versus dividends, earnings and Q (replacement value of corporate assets) give an indication of how risky it is to invest in stocks as well as how much future returns are likely to be. As of Thursday June 21st market close, the TSX Composite Index per the TMX Money website is paying a dividend yield (dividends/price) of 3.22% with a price/earnings ratio of 14.3 at an index price level of 11,408. Let's work through an estimation of future returns using dividends, which though simple is well-grounded in research and finance theory.

The Magic Dividend Formula

It may surprise some people, but it is a fact that historical returns from equities come mainly from dividends, reinvested and compounded. Though stock market performance is not identical, Canada has been quite similar to the USA over the long term, so we use (it's hard to find nicely graphed Canadian data) the chart of the US market below taken from What Risk Premium is Normal? by Robert Arnott and Peter Bernstein to show the dominance of dividends over capital gains in cumulative total returns.

The same paper lays out a simple formula (called the Gordon model) for estimating future stock returns:

Return = Dividend Yield + Growth Rate in Dividends

The numbers to plug in:

• Dividend Yield is the current TSX value of 3.2%. The higher this value is the better since a high dividend yield is the higher the future total stock return will be according to John Cochrane's Presidential Address: Discount Rates.
• Growth Rate in Dividends depends on growth of the economy, or more precisely, as established by research, on real GDP per capita, which is less than total GDP growth (for several fascinating reasons per Arnott and Bernstein, such as, 1) the fact that a good part of economic growth comes from new businesses that we investors cannot buy in the index of existing companies and 2) stock dilution/issuance to managers). Based on the past 50 to 60 years, real GDP per capita has risen about 1.8% to 2% on average (see Jay Ritter's Economic Growth and Equity Returns William Bersntein's The Two-Percent Dilution and the Google chart of nominal non-inflation adjusted GDP below), of which around 60% actually flows through to the equity investor i.e. about 1%.

 

The result is, as of today,  we expect a long-run real net-of-inflation return of 3.2 + 1 = 4.2%.

How Much Chance of More Downside Before the Upside Comes?
To cross-check the chance that the market equity price might decline further, we can compare the current dividend yield and the P/E, or its inverse E/P aka earnings yield, against historical values to see if they are high or low. This chart from Are Equities Cheap? by Derek Holt of Scotia Capital going back to 1956 puts the current 3.2% dividend yield just above its long term average and the earnings yield of 7.0% about 1% above its long term average. Those numbers are reassuring, indicating reasonable valuation. However, we also see that the red and blue lines have ranged considerably above the average in past decades, which indicates times of low prices. Reasonable current valuation does not guarantee the TSX cannot drop further, possibly a lot, before it rises.

Another measure of over- or under-valuation of the market that is often-cited for the USA but hard to find for Canada is the Cyclically-Adjusted P/E (CAPE), which averages inflation-adjusted earnings over the past ten years to smooth out the effects of recessions. The same Scotia Capital presentation shows the CAPE value for the TSX as of January 2012 when the TSX traded around 12,200 to be just over the 20.2 average for the time since the mid 1960s i.e. slightly over-valued at that level.

Actual Return Might be Well Above or Below Our Expected Value
Our calculation of the expected return is subject to fairly wide uncertainty about the actual future return. What we are promised is not necessarily what we will get.  The chart below from an early 2001 study of deriving expected returns from valuation by John Campbell and Robert Shiller indicates how widely spread around the expected value of the line the subsequent 10-year returns (the vertical axis) ended up depending on an initial dividend yield (the D/P horizontal axis). What we obtain as a prediction from higher dividend yield is better odds, not an assurance, of a more favourable return.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Are Stocks Risky in the Long Run?

Stocks go up and down but inevitably they eventually gain, right? Not everyone agrees and the dispute has been simmering for years even amongst distinguished research academics. The "No, stocks are not risky" side leader is Jeremy J. Siegel, Professor of Finance at the Wharton School of business at the University of Pennsylvania and author of the best-selling book Stocks for the Long Run, which makes the case. The "Yes, stocks are risky, even in the long run" side is represented by Zvi Bodie, Professor of Management at Boston University and author of many books including the classic textbook Investments. Interestingly, both men did their PhDs under the guidance of Nobel laureate economist Paul Samuelson.

The Debate
Naturally, a disagreement between two high profile respected researchers makes for good press and lively debate that can also be highly instructive. One such debate took place in Toronto in 2004 at the conference of the National Association of Personal Financial Advisors, the transcript for which Prof Bodie posted on his website. Bodie also makes his case in the 1994 paper On the Risk of Stocks in the Long Run, available from SSRN and in his mass-audience 2007 book Worry-Free Investing.

The debate is about holding stocks in general, a whole diversified basket of stocks, such as the S&P 500 in the USA, or the TSX Composite in Canada (such as many ETFs and mutual funds allow investors to do), not about holding individual stocks, which are obviously forever exposed to financial catastrophe and bankruptcy. There may be a few casualties amongst companies within a broad index but as a whole there is little question of its survival, at least in countries like Canada and the USA.

Stocks are risky arguments

• The "conventional wisdom that if you hold stocks long enough they are bound to outperform all other asset classes" is wrong! Bodie proves this theoretically in the SSRN paper with an option-pricing example. In the same paper he also cites research by his mentor Samuelson and others like Robert Merton, another Nobel winner, that rely on expected utility maximization to analytically prove why such statements are wrong.
• The idea is false that eventually, after many years holding stocks, there will be a positive and high return, more or less in line with long term averages (e.g. those in the Credit Suisse Global Investment Returns Yearbook 2012 which showed annual real returns in Canada over the years 1900 to 2011 of 5.7% for equities vs 2.2% for government bonds and 1.7% for T-bills). With the aid of Monte Carlo simulation, Bodie calculates (Chapter 6, Worry-Free Investing) that due to the volatility of stocks, though the probability is low of such a bad outcome, after even 30 years of holdings stocks, their value could be half in real terms what it was at the start. In fact, he says, though the probability keeps going down, the really bad outcomes just get worse and worse. Meanwhile a risk-free security like a T-Bill wouldn't make much money compared to big majority good equity outcomes, but it would not lose money.
• Even in the historical record, highly successful countries like the USA and Canada have been the outliers as the Credit Suisse Yearbook shows. There is always the chance that the floundering of the Japanese stock market for the last two decades may be the direction we are headed too - reversion to a lower mean.

Stocks are not so risky arguments
The essence of these counter-arguments relies on the historical record.

• "It is very significant that stocks, in contrast to bonds or bills, have never delivered to investors a negative real return over periods of 17 years or more" (using data from 1802 to 2006). Meanwhile both bonds and T-Bills have had real negative returns, even over periods as long as 30 years. Inflation takes its toll on low returns. Siegel did not even apply any estimate of taxes that would push bond and T-Bills further into negative territory.
• Siegel does concede in the debate transcript that such past performance does not mean he believes long-held stocks are absolutely safe or offer a guaranteed good return or the best return. In other words the future may not be like the past. That statement (in 2004) seems to have been a wise position since the Credit Suisse charts for Canada show that in the 27 years from 1984 to 2011, bonds outperformed equities by 1.5% per year.

Stocks vary in riskiness arguments

• Valuation at the time of purchase of stocks has been shown to make an enormous difference in subsequent returns. It is obvious in retrospect that buying at a market low such as in 1932 or 1981 produced tremendous gains - see details in Evanson Asset Management's Stocks for the Long Run?. The question is whether any indicators can successfully predict when is a good time to buy, when the market is cheaply valued. The answer seems to be yes, valuation indicators such as dividend yield, trailing P/E ratio, Q-ratio do give worthwhile over- or under-valuation signals. Read Evanson for some examples. A blog called Laguna Beach Bikini (quite a name for a site with some substantial investing content but hey, that's California!) in Recent Ideas in Modern Finance and How Expected Return Varies delves into a paper on the topic which emphasizes the importance of dividend yields - a low current dividend yield presages low returns, high dividend yield foretells of higher future returns. When valuations are low, there are much better chances of making higher returns with equities.

Investor Takeaways

• Simply putting all your money into equities on the expectation of higher returns isn't a wise plan - the long run for outperformance may be very long and who knows, you may need to cash out before you plan to, or the severe market gyrations may cause a panic reaction. Diversification between bonds and equities makes sense.
• The percentage allocation between equities and bonds (or other asset classes which we have not discussed today) should depend more on your goals and risk capacity not on the length of your time horizon - see our previous posts on Setting Investment Objectives, Risk: What Can You Afford and What Can You Put Up With? and Asset Allocation: the Most Important Investing Decision You Will Make. Bodie and Siegel seem to agree on this aspect of the issue at least!

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above commentary is not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

How Many Stocks to Create a Diversified Portfolio, or Should You Even Try?

Investment theory, and intuition, tell us that risk is reduced by diversification - not putting everything in one basket by holding more than one stock. The question naturally arises: how many stocks should one hold? Is it even a worthwhile endeavour?

What diversification can and cannot do
Before answering the question of how many stocks it takes, we need to note that diversification can only reduce the volatility risk associated with an individual company. It cannot reduce the so-called market or systematic risk common to all stocks, visible as generalized movement up or down in the same direction at the same time. It makes sense that macro-economic factors like booms and recessions and financial crises often drive stocks in the same direction. That is market risk and is not diversifiable. The kind of risk that can be diversified is the non-systematic risk associated with individual companies due to management skill, product success and the like.

The theoretical answer - 15 to 50 stocks
Consult a finance textbook or paper such as How Efficient is Naive Portfolio Diversification? by Gordon Tang of Hong Kong Baptist University and you will find this kind of statement - "for an infinite population of stocks, a portfolio size of 20 is required to eliminate 95% of the diversifiable risk". 15 Stocks eliminates over 93%. The benefit of adding more stocks tails off very rapidly after even about ten stocks, which eliminates 90% of the diversifiable risk.

Tang's paper contains a table of researchers who have validated this result with empirical studies mainly of the US stock market. Most of the studies show the ideal number topping out at 30, though a couple go as high as 40. A similar Canadian study Diversification with Canadian Stocks: How much is Enough? by Sean Cleary and David Copp in the 1999 Canadian Investment Review concludes that 30 to 50 stocks would have captured most (85-90%) of the diversification benefits during 1985 to 1997. Ok, let's go invest, you might say.

Caveat #1 - Diversification works effectively with low market risk
When inter-stock correlation (aka market risk) rises, holding more stocks does little to reduce overall portfolio volatility. Even when stocks have a relatively low overall average correlation of 0.4 what starts off as 50% standard deviation (volatility) for one stock can only be reduced to around 32% with 100 stocks. That's not even half the overall volatility gone. The chart below shows what happens with stock correlation numbers. The lower the correlation, the more the portfolio's volatility can be reduced. When correlation is high at 0.9 diversification has little effect: one stock with a 50% volatility can only be reduced to about 47.5% volatility in a 100-stock portfolio. With a more normal 0.5 correlation, the 100-stock portfolio reduces volatility to about 35.5%.

Bottom line: holding many stocks won't help much in a crisis when panic causes all stocks to fall in tandem.

Caveat #2 - Cost and effort go up with larger portfolios
The time to do research into companies, to track and assess on-going results and the transaction costs to keep the portfolio in balance can be a considerable burden.

Caveat #3 - Averages of randomly selected stock portfolios will not represent your reality
The above cited research gave the average results of thousands of randomly selected portfolios. Like betting on a coin flip which will be half heads and half tails on average, on a single flip you do not get the average but one or the other only. Author William J. Bernstein in The 15-Stock Diversification Myth tested random equal-weighted portfolios of US S&P 500 stocks bought in 1989 and held for 10 years. He found a huge variation in returns of the portfolios. A few did very well but three quarters failed to attain the market return of an equal weighted S&P 500. He attributes this difference to the fact that a only a few stocks contributed to the overall average so if the portfolio was lucky enough to hold some of those stocks it did very well. Otherwise it did poorly. The investor is not just concerned about volatility but also about the return. Portfolio returns are merely the average of the return of the stocks in the portfolio in proportion to the amount held.

Investor Takeaways

• Option 1 -  Develop the skills, do the analysis and pick stocks. Recognize that you will only be somewhat diversified. Indeed a primary objective will be not to be diversified but to be concentrated in a restricted  number of stocks that you feel will do better. Legendary investor Warren Buffett puts it this way as quoted on StreetDirectory.com: "Diversification may preserve wealth, but concentration builds wealth." Nevertheless, that doesn't mean holding only one or two companies. Even Buffett's investment company Berkshire Hathaway owns dozens of companies and stocks.
• Option 2 - Own the market or a large chunk of it in a diversified low-cost index ETF or mutual fund. That is what Bernstein suggests and it is a wise course for many who do not have the financial knowledge, and/or who are not willing to devote the time and effort required to manage a portfolio of individual stocks. As SkilledInvestor blog discusses in How many common stocks are needed for a well-diversified portfolio? the index fund alternative should always be weighed by an investor.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Investing Implications of a Globalized World

Every day brings news of bank or government debt crisis development in Greece, Spain or some other far away country that seems to dictate how the TSX fares that day. Canadian investors can understandably feel that foreign events affect market results more than company and government performance in Canada.

It is said that the world has become globalized. How true is it, are all markets simply moving in sync and does that mean international equity diversification has become ineffective?

The Meaning of Correlation
The statistical measure of "moving in sync" is correlation. The measure ranges from:

• +1, termed perfect positive correlation, when securities always move in the same direction at the same time, down through;
• 0 correlation, when securities move randomly relative to each other, to;
• -1, when they move always in opposite directions. Note that such negative correlation does not mean negative returns, it just means securities move in opposing directions at any particular time, relative to the security's own average past return. Wikipedia gives us the math here.

Correlation can range over any value from +1 to -1. For an investor, the lower the correlation the better: positive correlation between securities reduces the diversification benefit of reducing portfolio volatility. Negative correlation significantly reduces portfolio volatility risk.

Evidence that Equity Correlations are Rising
It appears that the last 15 years or so have indeed brought undesirable increases in the correlation of equity returns across countries and within markets.

• Quaker Funds tells us that Diversification is increasingly difficult to attain, with its figure 2 (screen image below) showing correlations rising towards +1 for all the various US equity market caps along with the international developed market MSCI EAFE equity.

• CIBC's Looking for a place to hide found (screen image below) a positive correlation of Canadian stocks with international equities throughout the years 1970-2010 but the correlation took a big jump upwards from an average 44% to 83% around 1998. Worse, the correlations were highest in periods of worst market returns and highest volatility, which is exactly the moments when an investor would want offsetting stability the most. Not surprisingly, CIBC found that the financial sector exhibited the highest correlation of about 70%. The least correlated sector was Telecommunications.

• The Wall Street Journal's Failure of a fail-safe strategy sends investors scrambling includes a neat inter-active chart (screen image below) that shows the rising correlation of MSCI Emerging Markets equities to the S&P 500 from 1994 to 2009, along with MSCI EAFE and the small cap US Russell 2000.

• JP Morgan's May 2011 report Rise of Cross-Asset Correlations shows the same pattern (screen image below) averaging across 45 developed and emerging countries by sector and by individual stocks.

• How Index Trading Increases Market Vulnerability by Rodney Sullivan and James Xiong finds that within the S&P 500 the correlation of returns has risen markedly since 1998.

Will Correlations Go Back Down?

Yes, they will

• Author and financial advisor Larry Swedroe tells us in Why concerns about diversification are overblown that we should take the long view, recognize that correlations have fluctuated hugely in the past and have risen temporarily  with crises, so we should not panic. His own test of the S&P 500 vs the MSCI EAFE showed no significant increase up to 2007, the beginning of the recent on-going crisis period. When the crisis subsides, correlation will go down.

No, they won't, this is a permanent change

• The proponents of this view cite multiple factors to support a belief that high international equity correlation will continue: globalization of industrial corporations whose results depend on many countries; globalization and size of pension funds, banks and hedge funds whose risk-on risk-off decisions and trading shift markets; expansion of trade and integration of economies; integration of capital markets.
• Sullivan and Xiong in the paper cited above assert that index trading through index mutual funds and ETFs have become such a large volume pushing in the same direction, up or down at any one time, that stock correlations will remain high. IndexUniverse in Special Risks in ETFs also states that there has been a rise in correlations due to index trading.

What Can the Investor Do to Diversify?
1) Find and hold as part of the portfolio asset classes that remain with low or ideally with negative correlations to equities. Bonds, especially government bonds with the most secure AAA rating like those of the Government of Canada, remain the bedrock of portfolio diversification. Note how, in the USA, the above Wall Street Journal chart shows US Treasury TIPS moving very much out of sync with equities.
2) Invest more in less correlated equity sectors. Some Canadian equity sectors like Telecommunications, Health, Consumer Staples and Utilities, according to the CIBC report, have exhibited low correlation with overall equity markets. A variation on this theme - most of the holdings are in the low correlation sectors - is to focus on what we have posted about several times in recent weeks - low volatility and low beta stocks and ETFs here and here.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.