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Further reading: Turn down the volume

UK investors might still have nightmares about exposure to low liquidity companies due to Neil Woodford, but a duo from Zebra Capital say it could be its own investment style
Further reading: Turn down the volume

We rely on upstarts to keep us entertained, to keep markets turning over and to keep top dogs on their game for fear of replacement.

Companies  such as Tesla (US:TSLA) have used 'challenger status' to reach valuations out of reach for any established competitor or any standard valuation metric. But challenger status as an investment style is a different ballgame. The authors of the 2018 paper ‘Liquidity as an Investment Style’, Roger Ibbotson and Daniel Kim of Zebra Capital Management, want liquidity to sit alongside size, value, growth and momentum as its own strategy. 

For London investors, low liquidity might more be a signifier of a company’s junior status or the local stock exchange’s failings than any indicator of quality. But Ibbotson and Kim see high liquidity as such a valuable trait that investors are often willing to overpay for it, thus diminishing its potential return. It should be noted here that it is easier to overpay (or pay at all) for higher-liquidity shares – but let’s keep it academic for the moment.

Solid or liquid? 

There are a few options for working out a company’s liquidity. Ibbotson and Kim go for a company’s previous year stock turnover, which they define as the sum of the 12 monthly volumes divided by each month’s shares outstanding. 

For a glimpse at London’s high- and low-liquidity companies we’ve looked at trading volumes over the three-month period to 12 June. The liquidity leader on that day was Lloyds Banking (LLOY), with around 500m shares changing hands. Over the past 90 days, around £121m-worth of stock has traded each day, equivalent to around 334m shares, according to FactSet. At the other end of the spectrum you will find some companies with market capitalisations above £50m with no on-market share sales on some days. 

Among those stocks is hire company Andrew Sykes (ASY), which has just 9.7 per cent of its shares in public hands, giving it a relatively small free float. Over the past three-months, around 2,800 of its 42.2 million shares have changed hands each day, which doesn't provide much opportunity to buy in or sell out. We have in the past looked at the relative outperformance of family-run companies such as FW Thorpe (TFW), which is illiquid and has a float, and there is significant crossover here, although the liquidity-as-investment-style authors do not go down that road in the paper. 

To put the trait alongside size, value/growth and momentum, Ibbotson and Kim have sought to meet investment style rules set out by William Sharpe (famous for his Sharpe ratio). To study the trait as an investment style, the authors looked at 3,700 US stocks between 1971 and 2017. They demonstrated that liquidity ticks Sharpe's ‘before the fact’ criterion for an investment style as it is defined by previous performance. Sharpe's other rules are ‘not easily beaten’, ‘a viable alternative’ and ‘low in cost’. In real terms these rules mean stocks bought using the style should perform consistently above market average, work as an 'additive' to other styles, and not require too much portfolio maintenance by conforming to a style over a long period, cutting buying and selling costs. 

Looking more closely at those three requirements, the showiest measure is ‘not easily beaten’. Finding a factor that lends itself to outperformance for 46 years is a real feat. Ibbotson and Kim’s research puts the geometric mean return (which we’ll just call return from here) at 15.2 per cent for the lowest-liquidity companies between 1972 and 2017. For the highest-liquidity companies, the return was 7.7 per cent. This return was measured by looking at each company’s market capitalisation at the end of each calendar year. The 15.5 per cent return for the lowest-liquidity shares beat out the size and momentum-style picks, but not value, which had an average return of 16.3 per cent. 

The high/low-liquidity difference gets starker in the micro-cap space, which the authors gave a valuation floor of $5m (£4m). The micro-cap, low-liquidity portfolio had an average return of 16.1 per cent a year, with the small high-liquidity companies returning 0.11 per cent. This narrowed for the larger companies, with returns of 11.4 per cent and 9.1 per cent respectively. 

High road or low road? 

The US numbers presented by the Zebra Capital pair are compelling. According to the research, low-liquidity US stocks outperformed markets in general and portfolios built around momentum, value and size. For individual investors this might not be that helpful, however, and anyone familiar with Neil Woodford’s downfall will be aware of the risks involved. 

As we’ve said in the past, a portfolio built around family-run companies could be a winner. But with the added difficulty of firstly buying in and more importantly selling out, private UK investors are likely to be better served finding a closed-ended investment product or that has a few low-liquidity companies in it – probably far fewer than Mr Woodford favoured.

'Liquidity as an Investment Style' can be read in full here