Investment thinking is counter intuitive. As Howard Marks (Trades, Portfolio) said, “It requires second level thinking.” Natural instincts of fear and greed are the first causes of investment mistakes.
Investment styles
William Sharpe, the winner of a Nobel prize in economics for his contributions to the establishment if the Capital Asset Pricing Model, didn’t focus his work only on the efficient market theory. He, and others like Fama and French, also studied the complete opposite camp: investment styles or factors. They asked, “What factors can explain supra-normal returns in stocks?”
In a 1992 study, Sharpe defined four criteria that should characterize a benchmark style: “identifiable before the fact,”“not easily beaten,” “a viable alternative” “low in cost.” Over the years, several investment styles were tested and generally accepted, namely: size (Banz 1981), value/growth (Basu 1977; Fama and French 1992, 1993) and momentum (Jegadeesh and Titman 1993, 2001).
But one factor has been systematically forgotten and ignored: liquidity.
In a 2013 paper named “Liquidity as an Investment Style,” professors Roger Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim and Wendy Y. Hu, examined stock-level liquidity in a top 3,500 market-capitalization universe of U.S. equities over 1971 to 2011 and subjected it to the four style tests of Sharpe.
Four criteria
First, the “identifiable before the fact” measure of the factor (liquidity) was the stock turnover.
Second, when returns from the four quartiles are compared, quartile one (the most illiquid stocks) always outperformed the equally weighted market portfolio. Also, when the returns of the low-liquidity quartile were compared to those of the other styles, they beat the size and momentum factors but trailed value. Therefore, Ibbotson considered all four styles tested to be “not easily beaten.”
Third, Ibbotson’s team examined double-sorted portfolios, comparing liquidity with size, value and momentum. The impact of liquidity on returns was somewhat stronger than that of size and momentum and roughly comparable to that of value.
They also concluded that the liquidity factor was additive to each style. This means that, for example, microcap investing provides better returns than large cap investing over the long term, but microcap illiquid investing provides even better returns.
Thus, Ibbotson et al concluded that liquidity is “a viable alternative” to size, value and momentum.
Finally, they also demonstrated that less liquid portfolios could be formed “at low cost.” Their portfolios were formed only once a year, 62.93% of the stocks stayed in the same quartile and the high performing low-liquidity quartile had 77.28% of the stocks stay in that quartile. “Thus, liquidity portfolios themselves exhibit low turnover, which can keep their costs low,” the author said.
Conclusion
Warren Buffett (Trades, Portfolio), who started his career investing in microcap low-liquidity companies, has said that he “wouldn't mind if the stock market closed down for a few years.” The implications of this quote are significant. It means that you have to have complete confidence that the business you are investing in will be worth significantly more some years from now, and therefore you don’t consider the markets liquidity at all.
Generally, short-term investors need liquidity to trade. Long-term investors need the liquidity of large caps because they feel safer investing in them but also because they always want to leave an open door or a plan B in case they want out. There is nothing wrong with that, but the point is that in an investment market where supra-normal returns are harder to get, this reasoning excludes one of the best investment styles that is available.
Professor Roger Ibbotson concluded:
“Liquidity has perhaps the most straightforward explanation as to why it deserves to be a style. Investors clearly want more liquidity and are willing to pay for it in all asset classes, including stocks. Less liquidity comes with costs: It takes longer to trade less liquid stocks, and the transaction costs tend to be higher. In equilibrium, these costs must be compensated by less liquid stocks earning higher gross returns. The liquidity style rewards the investor who has longer horizons and is willing to trade less frequently.”
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