Liquidity sounds like something an investor might need after a bad day in the market. But when it comes to stocks, a highly liquid approach is not the way to go. Instead, teetotallers are more likely to outperform.
At least that’s the conclusion of professor Roger G. Ibbotson, et al. in a study that was recently published in the Financial Analysts Journal. It turns out that actively traded stocks underperform dramatically over the long term whereas thinly traded issues handily beat the market on average.
But Mr. Ibbotson doesn’t measure a stock’s liquidity simply by counting the number of shares that trade each day. He uses a stock’s monthly turnover, summed over the last year, as his gauge. A stock’s turnover compares its trading volume to its shares outstanding.
Think of turnover as a relative, rather than an absolute, measure of liquidity. It focuses on how easy it would be to buy, say, 10 per cent of a company’s stock rather than $10,000 of its shares. As a result, most investors should be able to easily buy, and sell, large stocks with low turnovers.
It also means his findings are of interest to a broad spectrum of investors. They don’t just address the concerns of micro-cap aficionados. Liquidity is also important in the realm of large stocks.
In his study, Mr. Ibbotson looked at 3,500 of the largest U.S. stocks with market capitalizations of more than $5-million and share prices of $2 or more. On the whole, the stocks gained an average of 12.2 per cent annually over the study period from January 1972 to December 2011.
To measure the impact of liquidity, the all of the stocks were sorted by turnover each year. The list was then divided into four equal groups and the performance of each group was tracked for a year after which the process was repeated.
The portfolio with the lowest liquidity gained an average of 14.5 per cent a year. But when liquidity was increased the returns got worse. The most liquid portfolio advanced only 7.2 per cent a year and trailed the market by 5 percentage points annually.
Mr. Ibbotson also compared the liquidity-based portfolios to three other popular styles using size, value, and momentum. Size was measured by a stock’s market capitalization, value was based on its trailing price-to-earnings ratio, and momentum determined by its returns over the prior year. Just as with the liquidity-based groups, each of these factors were studied by splitting stocks into four different portfolios.
The low-liquidity portfolio beat the portfolio with the smallest stocks, which climbed only 13 per cent a year. It also fared better than the high momentum group that grew 12.9 per cent a year. However, the low-P/E value portfolio won the race with average annual returns of 16.1 per cent.
Mr. Ibbotson then went on to consider how performance varied by liquidity within each of the different portfolios based on the size, value and momentum. Such two-factor studies can be quite revealing and this one was no exception. In all cases, investors were better off with low-liquidity stocks.
If you just focus on the quarter of stocks with the smallest market capitalizations, the least liquid option would have bested the most liquid by an average of 14 percentage points annually. On the other hand, the least-liquid large stocks outperformed the most-liquid large stocks by 3.2 percentage points annually.
Value investors should note that low-P/E low-liquidity stocks gained a whopping 18.4 per cent a year on average. Whereas the most liquid low-P/E stocks only gained 10 per cent a year and actually underperformed the market by 2.2 per cent a year.
Similarly, high-momentum low-liquidity stocks gained 16 per cent a year whereas the high-momentum high-liquidity group disappointed with returns of only 8.5 per cent annually.
Mr. Ibbotson’s study shows that investors pay far too much for the ability to buy and sell at a moment’s notice. The less liquid portfolios favoured by sober investors might be less fun, but even a lush should appreciate their returns.
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