Are You Missing Out On Returns By Ignoring Liquidity Premium?

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Includes: DNB, F, FLIR, GOOGL, JNJ, KO, MO, OI, PBI, PEP, PG, PKI, PM, SPY, T, UNH, UPS, VZ, XOM
by: Kurtis Hemmerling

Summary

Common investing styles are growth, value, size, quality and momentum. Liquidity is often not included.

Investors pay extra for stock liquidity. Stocks of lower liquidity are discounted.

Three approaches are discussed to take advantage of the liquidity premium.

Most people are familiar with investing styles such as growth, value, size and momentum. But what about liquidity? We often think about liquidity in terms of how easy it is to buy and sell a stock without unduly moving prices up or down - but could you create a broad investing style based on how much volume a stock trades? Academics say yes.

Advantage of Lower Liquidity

Stocks with lower liquidity produce higher returns on average. This likely occurs because investors discount stocks based on how difficult it is to get your money in and out of a product. Research has shown that restricted shares may trade at a 30 - 86% discount (see white paper below) depending on the country. Nobody likes the idea of having their money tied up. If you want quick and easy access to your capital, you will have to pay a little extra for that privilege. We are familiar with this practice in bank accounts - a CD (certificate of deposit) with withdrawal restrictions will generate more interest than a simple savings account.

If you want a more through discussion of liquidity premiums and the various ways to take advantage of it, please read the white paper,Liquidity as an Investment Style, 2010.

Size of Liquidity Premium

How much extra return on average might you get from the liquidity premium? The following chart shows average annual historical returns for the Russell 3000 index if you divide stocks into 20 groups based on liquidity. Liquidity for my testing purposes will be the average turnover (volume x price) over the past 200 days. The test runs from 1999 until today. The left-hand side of the chart is the portfolio with the highest liquidity and the right-hand side is the lowest liquidity.

Russell 3000 index dividend into 20 portfolios based on liquidity

The annual returns are three times higher on average for stocks of lower liquidity.

Low Turnover Stocks in an Index

How can you take advantage of the liquidity premium? One way is to focus attention on the lowest turnover stocks in an index that you feel comfortable trading.

How do you know what you are comfortable trading? My rule of thumb is to not buy more than 5% of the daily trading volume, 10% if you have a measure of skill executing trades so as to minimize slippage. If you are investing $10,000 per stock you would want stocks with a minimum of $200,000 of daily turnover.

For the purpose of this article we will stick to the S&P 500 index (NYSEARCA:SPY). All testing will be carried out using the Portfolio123 stock screening and backtesting platform.

If you perpetually held the 25 stocks of lowest liquidity in the S&P 500 index, this would be your return profile.

Least liquid names in the S&P 500 index Click to enlarge

The top 5 names on this list are:

(NYSE:DNB)

Dun & Bradstreet Corp (The)

(NASDAQ:FLIR)

FLIR Systems Inc

(NYSE:PBI)

Pitney Bowes Inc.

(NYSE:OI)

Owens-Illinois Inc.

(NYSE:PKI)

PerkinElmer Inc.

Click to enlarge

The one problem with this approach is that stock size and turnover often go hand in hand. So by following this approach you are also exposing yourself to the size effect. But perhaps you do not want to favor smaller stocks - what then? The approach below will account for stock size while trading the liquidity premium.

Low Turnover Stocks Relative to Float Size

This approach compares turnover, not with that of all the other stocks, but with the float value. The float is the amount of outstanding shares that are available for trading. If they are tied up in institutions or held by insiders, these would not be considered part of the float.

In this approach, assume we have two stocks where the first has a float value (available shares x price) of $1 billion and the other of $10 billion. The first company has a daily turnover of $10 million and the second has an average turnover of $20 million. In our first approach, the first company would have lower liquidity but in this approach the second company would have lower liquidity once you factor in what's available to trade.

If you hold the least liquid tickers in the S&P 500 index based on the 'turnover to float value' ratio, the historical annual returns are 1.5% higher than the market. But the big advantage is seen in market downturns. The 2007 - 2009 crash was a lot less severe. Market averages fell 57% while the 25 stock portfolio stocks with low liquidity fell only of 41%. Because volatility is less, the 1.5% excess annual return is more attractive.

Some notable names are at the top of this list currently are:

(NYSE:PM)

Philip Morris International Inc

(NYSE:JNJ)

Johnson & Johnson

(NYSE:MO)

Altria Group Inc

(NYSE:PEP)

PepsiCo Inc

(NYSE:PG)

Procter & Gamble Co (The)

(NYSE:VZ)

Verizon Communications Inc

(NYSE:KO)

Coca-Cola Co (The)

(NYSE:XOM)

Exxon Mobil Corp

(NASDAQ:GOOGL)

Alphabet Inc

Click to enlarge

Earnings and Volume

The third approach which seemed to be the author's preference of the above referenced white-paper is the volume-to-earnings ratio. This ratio compares the value of the volume being traded to trailing earnings. The idea is that stocks which trade relatively low compared to their earnings have a better liquidity premium.

The problem I have with this approach is that it may inadvertently force you into value stocks. Take an example of two stocks, one value and one growth. The value stock has earned $1 EPS over the past 12 months and trades at $10. The growth stock has earned $0.10 EPS over the past 12 months and trades at $10. These two stocks will be at a liquidity equilibrium only if the growth stock trades one-tenth as much. That is not likely to happen. If both stocks trade equal amounts, the growth stock will look 10 times worse with this system. Thus, value stocks will naturally be favored.

If I was to use this approach, I would have a tendency to use it on just value stocks or just growth stocks - but I would be very hesitant to trade it on a universe of growth and value.

I tested the approach recommended by the white paper and it resulted in 5% out-performance in the S&P 500 index since 1999. But the portfolio mimicked value stocks with losses over 70% in market down-turns.

My next step was to isolate half of the index based on value (based on the pre-defined value ranking system by P123) and re-test. The draw-down was still high at 68% but the return rose to 7% in excess of the market (or 10% annually).

Last, I isolated the growth half of the S&P 500 index (based on the pre-defined growth ranking system by P123).

Least liquid growth stocks using volume to earnings ratio Click to enlarge

The annual returns are similar to the value universe but with a better draw-down number during the bear markets.

Some notable non-financial names on the list:

Verizon Communications Inc

(NYSE:T)

AT&T Inc

(NYSE:UPS)

United Parcel Service Inc

(NYSE:F)

Ford Motor Co

Altria Group Inc

(NYSE:UNH)

Unitedhealth Group Inc

Click to enlarge

Summary

Liquidity is an often over-looked investment style. There are many ways to invest in the liquidity premium and just a few were covered in this article. The question you have to answer is this: this stock is traded less compared to what?

  • Other stocks in the index?
  • Size?
  • Earnings?

The more difficulty you have in trading a security, the more barriers there are, and the less competition you will likely find. Thus, you will probably have a deeper discount and a higher return if you can live with slightly less accessibility to your capital.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.