The question facing each investor is how quickly they will need to dump equities as financial conditions tighten.Getty Images/iStockphoto
'Liquidity" is darn near a sacred word on Wall Street, almost as important as "Hippocratic" is to doctors or "high school football" to Texans.
The ability to sell an asset quickly at a fair price is often considered an important attribute of an investment. You only have to go back a few years to the last financial crisis and ask owners of obscure debt derivatives how everything turned out for them.
Liquidity grows even more important during times when interest rates rise and credit spreads widen. And lo and behold, that may very well be in the horoscope as the Federal Reserve considers raising its benchmark interest rate from record lows. The Bloomberg U.S. Financial Conditions Index, which falls as markets become more stressed, closed last week at a two-month low of 0.305. That signals credit may already be growing more scarce as stocks fall and junk-bond yields jump further above Treasury rates.
This may lead one to believe that the most liquid stocks are the best ones to hold in preparation for even tighter credit markets. The strategists at Goldman Sachs Group, however, would tell you you're wrong, at least if you have a medium-term horizon.
Stocks that turn over less frequently did better than high-turnover equities in all cases over the past 20 years when financial conditions tightened for at least three months, Goldman Sachs strategists, including Elad Pashtan, wrote in a note dated Dec. 12.
The strategists have come up with separate baskets for low- and high-turnover stocks. The less-liquid basket outperformed the more-liquid stocks in 69 per cent of semi-annual holding periods since 1985. The average annualized outperformance was 8 per cent. In 18 instances where financial conditions tightened for at least three months, low-turnover shares outperformed in 16 of the periods and beat by a median 14-percentage points across all 18.
The reason for the outperformance is that fund managers tend to discount stocks that they can't liquidate quickly without having a major impact on prices, according to Goldman.
Peeking inside the Goldman baskets reveals some surprises when it comes to which stocks are considered less liquid, based on their average daily volume as a percentage of shares in the hands of public investors. In the low-turnover basket are such stock-market staples as AT&T Inc., General Electric Co., Exxon Mobil Corp., Berkshire Hathaway Inc. class B shares, Johnson & Johnson and Procter & Gamble Co. Each trade 0.5 per cent of their free float a day or less, according to the report.
In the high-turnover basket are companies that trade a median of 2.9 per cent of their float a day. They include: Tesla Motors Inc. (9.5 per cent of free float traded); SolarCity Corp. (12.4 per cent); Yelp Inc. (7.8 per cent); Intercept Pharmaceuticals Inc. (4.1 per cent) and First Solar Inc. (5 per cent).
The question facing each investor is how quickly they will need to dump equities as financial conditions tighten. If you're able to ride out the storm without having to sell in a hurry, you may actually want to consider keeping all your stocks in one basket.