A commenter on my recent blog Sietel deserves a citation lamented, 'There are no sellers'. And in fact the stock hasn’t traded for over a month. But as a software developer might say: ‘That’s not a bug; that’s a feature!'
Most investors steer clear of stocks with low liquidity, believing they need ample liquidity to be able to sell their holdings immediately should they so desire.
Of course, many investors only invest in liquid stocks for other reasons: perhaps they have short-term timeframes. Or maybe they're fund managers whose mandates forbid them from investing in such stocks or, for practical reasons, they don't invest in illiquid stocks because they have to worry about meeting redemption requests from their investors.
Happily, though, most individual investors such as those reading this blog don't have these concerns.
For conservative value investors focused on the long term, the fewer analysts and investors there are researching a stock, the greater the chance that it is mispriced and that you can find a bargain. As Howard Marks, co-founder of Oaktree Capital Management, has said, ‘You can’t take the same actions as everyone else and expect to outperform’.
Not convinced yet? Table 1 summarises the data compiled by Roger Ibbotson and Daniel Kim (courtesy of Ian Cassel at the MicroCapClub) on a top 3,500 market capitalisation universe of US-listed stocks from 1971-2016. Each year the top 3,500 stocks were ranked by market capitalisation and allocated to the respective liquidity buckets (as measured by their turnover the previous year). These portfolios were held for one year before the process was repeated.
|Quartile||Low Liquidity||Mid-Low||Mid-High||High Liquidity|
|Note: All returns are compound annual returns|
|Source: Ibbotson, Roger and Daniel Kim, 2017, "Liquidity as an Investment Style: 2017 update"|
Perhaps there is some survivorship bias at work here but I'd guess that a stock that subsequently goes bust is unlikely to have had low turnover in the previous year.
Based on the data in Table 1, generally speaking the smaller and less liquid the stock, the higher the compound return one should expect. In other words, the less popular the stock, the greater the chance it will outperform, proving Marks's comment above.
As Ibbotson and Kim note, less liquid stocks take longer to trade and also tend to have higher transaction costs. The authors believe these costs need to be compensated for somewhere, explaining the outperformance of less liquid stocks versus their more liquid counterparts regardless of their respective sizes (as measured by market capitalisation).
Of relevance to those interested in Sietel (ASX:SSL), the study also shows that a portfolio of illiquid 'value' stocks – using the academic definition of value as low PER, low price-to-book-value, high dividend yield, etc – beats a portfolio of highly liquid, 'growth' stocks – high PER, high price-to-book-value, etc in the academic definition – by more than 16% per year.
While this study concerns American stocks, it's reasonable to assume Australian stocks would yield similar results. Nonetheless, investors should still research the stocks they are interested in rather than just relying on this study.
The authors go on to note that investing in less liquid stocks suits investors who have longer horizons and trade less frequently – precisely the investors we target here at Intelligent Investor. (To see our Buy list, please consider taking a 15-day free trial).
A word from the Oracle
And if you’re still not convinced that illiquidity is pretty much irrelevant for long-term value investors, I’ll leave the final word to Warren Buffett: ‘I buy on the assumption that they could close the market the next day and not reopen it for five years’.