Friday, 29 June 2012

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.

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