Sunday, 24 February 2013

Investing in Illiquidity - Where the small guy has an advantage

It's not very often the average investor has an advantage over the professionals with their training, their unceasing close monitoring of stock markets and their sophisticated computer tools. However, one such area is illiquidity. Liquidity or its opposite illiquidity, refers to how actively traded a stock is, either in total dollar value or number of trades per day. The Investopedia definition focuses on the fact that liquidity means the ability to quickly convert the shares into cash without affecting the price (i.e. you don't have to take a big discount to sell it) but the other side of the coin is obviously trading volume and that is easier to gauge. In short, illiquid stocks don't trade much.

Investors, especially big investors managing mutual funds and pension funds with massive amounts to invest, want and need high liquidity. The most popular mainstream market cap indexes like the S&P 500 and the TSX 60, eliminate stocks with insufficient liquidity. The illiquid stocks are left mainly to smaller individual investors.

Illiquidity pays off - the research
Yale University finance professor Roger Ibbotson has been the main researcher and proponent of what he calls the liquidity style or premium in stock investing. His technical paper, written with Zhiwu Chen, Daniel Y.-J. Kim and Wendy Y. Hu, is on his website here, while a summarized version presented in easily followed slides is on the Canadian Investment Review website here. What he found is that, in the USA at least: a) the least liquid stocks outperformed market averages and by a lot; b) liquidity is not simply a reflection of small cap stocks or value stocks, it is a separate factor that he isolated using standard financial statistical techniques and c) many stocks change in liquidity over time and as they become more liquid their prices rose more strongly, benefiting stock owners. One of Ibbotson's slide images copied below gives an idea of how impressive the results are.

A practical caveat - what works as an average won't work for every stock
There seems to be money to be made but no individual investor can afford to buy a portfolio of the 850+ stocks that Ibbotson combined in the lowest liquidity group. The average paid off but surely not every stock did.

The options for the investor are limited - funds or selected individual stocks. In terms of funds, it seems that the only offerings on the market are a couple of US-traded mutual funds (from American Beacon allied with Zebra Capital, a company co-founded by Ibbotson), which Canadians are not allowed to buy. There seem to be no specialized illiquidity-oriented ETFs and in Canada, no such mutual funds at all.

The Canadian investor is left to individual stock picking and in that case, the investor will be obliged by limited funds to invest to choose a manageable number. To put the odds on your side, we'd suggest applying normal value tests to pick stocks that look better. We're guessing this is the "dedication and experience" investor requirement that value investor Norm Rothery meant when he recently wrote Small, illiquid stocks offer best value in the Globe and Mail.

Finding illiquid Canadian stocks
We turned to the TMX Money stock screener since it provides as a selection criteria under Trading and Volume a wide choice of average daily trading volume levels ranging from the past 10 days to 90 days. We chose the 50 day average of 100,000 or less, the third lowest band. We are interested in common stocks of solid growing companies of mid to large cap size. We don't necessarily need to use the lowest volume band (which would give a lot of tiny companies and many listings of preferred shares). Liquidity is a relative term. The benefits Ibbotson identified work continually through the range of volume and market cap - the smaller the company and the less the volume, the greater the benefit but it still works comparatively through segments of the market (see the slide presentation linked above for details).

Our screening criteria:
  • daily average share volume over the past 50 days - 100,000 or less
  • share price - $1 or more to avoid penny stocks
  • market capitalisation - at least $500 million to avoid the smallest companies
  • price to earnings (P/E) - under 20 to avoid the too-richly valued and limit the riskiness of the companies selected
  • 5-year annual revenue growth - greater than zero to find growing companies
  • 5-year annual income growth - greater than zero
  • return on equity (ROE) - 5% or more to find companies with reasonable profitability

The criteria still gave us a list almost all made up of small to mid-size companies. The screenshot below of the TMX results shows 13 stocks and 12 companies (Atco's two entries are for the two classes of stock - voting and non-voting). The right-most column, whose title partly runs off the screen, is Return On Equity. The ROE is solid for all companies. All but one pays a dividend and most have P/E below the current 14.2 TSX Composite market average. In addition, the 60-month trailing beta, a measure of fluctuation versus the overall market, indicates that about half the stocks have quite stable prices as their beta is much less than the market average of 1.0.
(click chart to enlarge)

The largest by market cap in our list is Boliden (BLS), which is the 90th largest stock on the TSX. Interestingly, Boliden is not a member of the TSX Composite Index, probably because its headquarters are in Sweden along with the stock's low liquidity.

Less liquid larger cap stocks could be isolated by boosting the minimum required market cap in the filter and/or the maximum average volume.

Further analysis can and should be done comparing for example, price to book value, price to cash flow, debt to equity ratios, consistency of cash flows and profits, interest coverage etc in the classic value investing assessment mode. Other useful tests of stock attractiveness could include: dispersion of analyst EPS estimates (see our posts here and here); social responsibility (post here); the presence of women on the board (posts here and here); characteristics such as being dividend growers (posts here and here) or Purple Chips (post here) or low volatility / low beta (post here) or well governed (post here). Putting all these factors together should paint a picture for the investor about the stock. A further step is, of course, to go on the company website to read annual reports and management commentary on financial results, plans and strategies.

Bottom line: Seeking less liquid stocks is a worthwhile investment strategy that will work on average but it requires doing some sorting and digging through data to buy individual stocks since mutual funds and ETFs are not available.

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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