Lower Liquidity Can Boost Returns
Thursday, December 20, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Do you consider average volume when buying stocks?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 46.4%, up 3.2 points
  Neutral: 28.8%, up 2.1 points
  Bearish: 24.8%, down 5.3 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

Our offices will be closed next week in observance of the holidays. We will reopen on Wednesday, January 2. We will also postpone sending out our weekly emails next week. On behalf of everyone at AAII, I wish you a merry Christmas and a happy, healthy and prosperous new year.

There is arguably a fifth investment style in addition to the commonly followed growth, value, momentum and size styles: liquidity. The liquidity style focuses on buying stocks that trade with less volume. Rather than buying the glamour stocks, whose names are familiar to most, liquidity-style investors look for stocks few people are talking about or trading.

There is evidence to suggest that there are monetary benefits to not following the herd. A working paper by Yale Professors Roger Ibbotson and Zhiwu Chen and Research Analysts Daniel Kim and Wendy Hu finds that among the 3,500 companies with the largest market capitalizations, those stocks with the lowest level of liquidity have delivered annualized returns of 14.5% over the last 31 years (1971-2011). This is double the 7.24% annualized return realized by stocks with the highest level of liquidity. Lower liquidity stocks also outperformed stocks with the strongest momentum (12.8%) and stocks with the smallest market capitalization (13.0%). Only seeking out stocks with the lowest valuation would have given you better performance (16.1%).

The researchers use turnover to measure a stock’s liquidity. Specifically, they define a stock’s annual turnover as trading volume divided by shares outstanding. Ibbotson and his co-authors do not claim that this is the best way to measure liquidity, but they do defend it as “a simple measure which works well.” In my opinion, it also helps to level the playing field among companies of different sizes. Turnover looks at how many times shares exchange hands relative to all outstanding shares. It can tell you if many of the shareholders are active traders or long-term investors.

An alternative method is to consider dollar volume. This measures how much money is being exchanged in buy and sell transactions. Higher numbers here suggest greater interest among larger investors. If your goal is to put your money where other investors don’t go, especially the big institutional investors, high frequency-traders and the like, dollar volume is something worth considering.

Viewing liquidity from a dollar standpoint can also help you avoid those stocks that are too illiquid for your portfolio. Say you have $140,000 to invest. You could buy one share of Berkshire-Hathaway Class A shares (BRK.A), which closed at $135,700 per share on Tuesday or approximately 4,200 shares of MetLife (MET), which closed at $33.14 per share on Tuesday. It’s the same size of investment in either stock. More importantly, both stocks have enough daily volume to easily facilitate quick buying and selling for the dollar amount being discussed. Conversely, trying to invest $140,000 in a stock with very low liquidity, such as BTU International (BTUI), would be very difficult. On Tuesday, the total dollar value of the day’s trading activity was approximately $27,000. That fact alone does not make BTUI a lousy investment (I know nothing about the stock), but it makes it a relatively illiquid one—one that would be difficult to buy and sell quickly.

Our Foolish Small Cap 8 Revised screen uses dollar volume to identify stocks. It gets around the problem of liquidity being too low by setting a minimum average dollar volume. Specifically, passing companies must have average daily dollar trading volume of at least $1 million.

A third option is to consider market capitalization. Smaller companies typically have less liquidity because many large investors simply do not invest in them. Credit the laws of math as the underlying reason why. An institutional investor, be it a mutual fund or a pension fund, often cannot make a large enough investment in a small company to both offset transaction costs and make a difference on the portfolio’s performance. Though Ibbotson’s data shows an advantage to looking at turnover over capitalization size, there is a great deal of overlap between the two. Our Model Shadow Stock Portfolio and our O’Shaughnessy: Tiny Titans stock screen, both of which have long-term annualized returns in excess of 16%, set maximum limits on market capitalization.

Though there is certainly a case to be made for looking at liquidity, no single indicator can assure you that a specific stock is a great investment. Rather, investing is much like cooking—mixing the right ingredients together will give you better results. Combining liquidity with a low valuation and earnings growth is a good basic mix. Adding momentum can help as well. Be sure to set some minimum restrictions on liquidity and market capitalization to avoid going too small. You especially want to avoid bulletin board and pink sheet stocks, which are very risky. You may also want to follow our Model Shadow Stock Portfolio’s requirement for companies to have filed 10-Q reports within the past six months.

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Model Portfolios Updated on AAII.com

The Model Shadow Stock Portfolio gained 2.3% in November, continuing its strong year. The Model Shadow Stock Portfolio outperformed both the Vanguard Small Cap Index fund (NAESX), which gained 1.2%, and the DFA US Micro Cap Index fund (DFSCX), which gained 0.9%. For the year, the Model Shadow Stock Portfolio is now up 28.5%, outpacing the 14.5% gain achieved by the Vanguard Small Cap Index fund and a 13.9% gain for the DFA US Micro Cap Index fund. No transactions were made last month.

The Model Fund Portfolio was up 2.1% for November. This compares to a 0.7% gain for the Vanguard Total Stock Market Index fund (VTSMX). For the year, the Model Fund Portfolio is up 12.3%, while the Vanguard Total Stock Market Index fund is up 14.9%. No transactions were made last month.

The Week Ahead

The U.S. financial markets will be closed on Tuesday, December 25, in observance of Christmas, and on Tuesday, January 1, in observance of New Year’s Day. The U.S. stock exchanges will close early, at 1 p.m. ET, on Christmas Eve.

No U.S. exchange-listed companies are currently confirmed to report earnings next week. S&P 500 members Family Dollar Stores (FDO) and Mosaic (MOS) will report on January 3 and January 4, respectively.

The first economic report for the week of December 24 will be the October S&P Case-Shiller housing price index, published on Wednesday. Thursday will feature November new home sales and the Conference Board’s December consumer confidence survey. November pending home sales and the December Chicago PMI will be published on Friday.

Scheduled for release on January 2 are the December ISM manufacturing index, the December purchasing manager’s index, November construction spending and the minutes from the December Federal Open Market Committee meeting. January 3 will feature the December ADP employment report. The December jobs data (including the change in nonfarm payrolls and the unemployment rate), the ISM’s December non-manufacturing index and November factory orders will be published on January 4.

AAII Sentiment Survey

Bullish sentiment rose to its second-highest level of the year, as bearish sentiment fell for the fourth time in the past five weeks in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 3.2 percentage points to 46.4%. This is the highest level of optimism registered by our survey since February 9, 2012. It is also the fourth consecutive week that bullish sentiment has been above its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rose 2.1 percentage points to 28.8%. Even with the increase, neutral sentiment remains below its historical average of 30.5% for the 10th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.3 percentage points to 24.8%. This is the lowest level of pessimism registered by our survey since February 9, 2012. It is also the first time bearish sentiment has been below its historical average of 30.5% on consecutive weeks since August 23, 2012.

Though bullish sentiment is near its high and bearish sentiment is near its low for the year, both remain well within their typical long-term ranges. Optimism seems high right now because pessimism has been above average for most of this year.

Individual investors’ short-term outlook for stock prices has improved over the past few weeks, however. A rebound in stock prices, monetary stimulus, continued economic growth and seasonality are all playing a role. Likely also helping is the crowding out of other potentially negative news headlines by the ongoing fiscal cliff negotiations.

This week’s special question asked AAII members how the Federal Reserve’s announcement of more bond purchases and introduction of an unemployment rate target impacted their sentiment toward stock. About 40% of respondents said it helps the stocks. Roughly 20% thought it would not have much of an impact. Some respondents said they thought the market has become dependent on monetary stimulus, inflation is a worry or that the recent announcement is bad for bond prices. A few respondents said the fiscal cliff negotiations are having a bigger impact on their short-term outlook.

» Take the sentiment survey