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(B Szewczyk/Getty Images/iStockphoto)
(B Szewczyk/Getty Images/iStockphoto)

STRATEGY LAB

Want high returns? Don’t pay for liquidity you don’t need Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Warren Buffett has a problem that most investors could only dream of. He has too much money. His company sits on a huge pile of cash and he’s having a hard time investing it all.

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Decades ago Mr. Buffett would snap up small firms, such as See’s Candies, without much difficulty and they could meaningfully boost his returns. These days, he seeks companies in the $5-billion to $20-billion range because the smaller fry aren’t really worth his time.

Size is also a big issue for many professional money managers. Once their portfolios grow too big, it becomes necessary for them to stick to large liquid stocks that can be easily traded.

Problem is, these are just the sort of stocks that tend to perform poorly according to a study by Yale University professor Roger Ibbotson.

There are several ways to measure liquidity, and Prof. Ibbotson opted to add up a stock’s monthly turnover (trading volume divided by shares outstanding) over the past year. Turnover focuses on how easy it would be to buy, say, 10 per cent of a company’s stock rather than $1,000 of its shares. The measure scales well, which makes it applicable to a broad range of investors, from small-stocks aficionados to the blue-chip crowd.

Prof. Ibbotson looked at the 3,500 largest stocks in United States by market capitalization from January, 1972, to December, 2011, with some exceptions. As a group, these stocks gained an average of 12.2 per cent annually over the period and had an annual standard deviation (or volatility) of 22.4 per cent.

To investigate how liquidity affected returns, he sorted the stocks by turnover and divided the list into four equal groups. He then tracked each group’s performance for a year before repeating the process.

The least liquid stocks fared the best, with average gains of 14.5 per cent a year and a volatility of 20.4 per cent. Moving to the more liquid groups yielded decreasing returns and increasing volatility, which is a bad combination. The most liquid group advanced only 7.2 per cent a year and came with a staggeringly high volatility of 28.5 per cent.

Liquidity comes at a premium. Regular investors who don’t need much liquidity shouldn’t pay for it.

I’m not saying everyone should go out and buy roach-motel type stocks that are next to impossible to sell. But they’d probably do well to avoid very active stocks.

Consider Prof. Ibbotson’s results when he sorted the stocks according to liquidity and size. The largest and most liquid stocks gained an average of 8.4 per cent a year.

On the other hand, large stocks in the second most liquid group climbed 11.2 per cent per year. That represents a huge return difference for a liquidity reduction that wouldn’t be noticed by most investors.

To emphasize the point that popular stocks stink, money manager Patrick O’Shaughnessy looked at 25 U.S. stocks with the highest turnovers from the start of 1984 through to the end of 2013, using rolling annual rebalancing. Over the period the most popular stocks lost an average of 3.1 per cent per year whereas the market gained 11.4 per cent annually. The collapse of the Internet bubble is responsible for some, but by no means all, of the poor performance.

The lesson seems clear: Small investors can benefit by avoiding highly liquid stocks. It might not make them the next Warren Buffett, but it should help their returns over the long term.

 

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