A few months ago, I bought a low-volume stock, Oregon-based Willamette Valley Vineyards (WVVI). I had seen the company’s name on a screen of liquor stocks I occasionally run and was prompted to take a closer look when the company sent us a prospectus for a preferred stock offering. (I think my wife put us on their mailing list at a tasting.) After doing my own analysis, I passed on the preferred stock, but bought shares of the common stock.
When I talk about the common shares having low volume, I’m not exaggerating. Daily trading has averaged just under $36,000 per day over the past three months. This is the cumulative dollar amount for all of the shares traded on an average day. Some days, it’s less; on others, it’s more.
I’ll share some observations I’ve had while owning Willamette Valley Vineyards, along with some suggestions about how to go about investing in a low-volume (aka less-liquid) stock in general. But before I do, I want to explain why it even makes sense to consider a stock with low levels of trading volume.
One of the advantages we have as individual investors is the ability to invest without many constraints. Most institutional investors (mutual funds, pension plans, etc.) operate with market capitalization and volume constraints. Many are not allowed to invest in companies below a certain size (e.g., a stock that is not part of the S&P 500 index or the Russell 1000 index). Many also face issues relating to the sheer amount of dollars they have to invest: This can create liquidity issues if the amount needed to make the investment worth their while exceeds the normal trading activity for a given stock or bond. Lower levels of liquidity make it difficult to transact without causing the stock price to move and can also make it difficult to get money out at prevailing quoted prices.
The constraints faced by institutional investors and the desire of traders to play in the same sandbox as the mutual funds, pensions, endowments and other big investors create a lopsided environment in terms of attention. The largest and most frequently traded stocks receive the most analysis. As market capitalization and trading volume decrease in size, less and less attention is paid. It’s not a linear change, either; it’s a lopsided change. Most of the attention is given to a comparatively small group of stocks. A far larger number of stocks are practically ignored or at least exist outside of the “popular crowd.” The lack of attention can result in these stocks being mispriced.
As individual investors, we can take advantage of this situation. We can buy any publicly traded stock as long as there is enough volume for us to complete a trade.
We do, however, want enough volume (a concept referred to as “liquidity”) to ensure we can buy and sell fairly easily without our orders impacting the security’s price. Though this is a constraint, it is a much smaller constraint for us than it is for a manager who has hundreds of millions, or billions, of dollars to invest. We can easily buy and sell a far greater range of stocks without leaving any trading footprint than our bigger counterparts can.
As for where you should draw the line when deciding how much you can invest in a low-volume stock, consider the guidance we give for following our Model Shadow Stock Portfolio: seek average daily dollar volume of at least 10 times the amount needed for your position. In other words, if you desire to invest $4,000 in a stock, check to see whether its average daily volume is at least $40,000. (An off-the-cuff calculation is simply to multiply the stock’s current price by its average daily volume. Yahoo Finance states the average number of shares traded over the past three months on each stock’s quote page.) This should ensure there is enough volume for you to buy into the stock without driving the price upward and fairly easily sell out of the stock without driving the price downward on a day with average volume.
Realize that the daily average can be very different from the number of shares traded on any given day. With a less-liquid stock, you may see days where the actual volume is far below average. For example, about three weeks ago there was a day when just 500 shares of WVVI traded. This equated to approximately $3,500 worth of shares exchanging hands for the entire day.
Also realize the need for patience. It took over an hour (possibly longer) for my order to buy shares of WVVI to be fully executed. My use of a limit order likely slowed the process. The limit order specified the maximum price I was willing to pay to own the stock.
Limit orders are a good idea for any stock, regardless of volume, and they are particularly important for low-volume stocks. Such stocks are likely to have wider bid-ask spreads, which is the difference between what buyers are willing to pay and what sellers are asking. By setting a limit order between the bid and ask prices, you reduce your transaction costs.
Beyond volume is the need to do additional research. Because low-volume stocks receive less attention, there is less research and news about them. (I didn't see any research reports on WVVI, for instance.)This, in turn, increases the onus on you to fully analyze the stock. You will need to go through the 10-K (an annual filing required by the Securities and Exchange Commission), review the financials and read the earnings releases. While these are things you should do with any stock, realize that with a less-liquid stock you won’t have anything to compare your analysis to. You will have to be confident in your ability to determine whether a stock is attractive or not.
One last point, and this one is a big one: Stick to exchange-listed stocks that are up-to-date with their SEC filings. Never buy a stock that is traded on the pink sheets or recommended through an unsolicited tip or pitch. A good rule of thumb is that the stock should cost more than a cheap cup of black coffee. When in doubt, pressured to buy, or unable to find information about the company from a reliable third-party source (e.g., the Securities and Exchange Commission’s EDGAR database), hold onto your wallet as tightly as you can and walk away.
- The Liquidity Style: Finding Bargains by Seeking Less Popular Stocks – Yale professor Roger Ibbotson says stocks with lower relative trading volume offer the potential for higher returns.
- How Liquidity Impacts the Attractiveness of an Asset – I discussed the upsides of low liquidity and why some investors choose to avoid less frequently traded assets in this 2013 AAII Journal article.
- Have You Ever Bought a Low-Volume Stock? – If so, share your observations on the AAII Discussion Boards.
The AAII Model Shadow Stock Portfolio, which is a real-money collection of micro-cap stocks, posted a strong month in March, adding 6.2%. Twenty-two of the 30 stocks that were in the Model Shadow Stock Portfolio at the end of February were up in March, including 10 that were up more than 10% for the month and three with more than a 25% gain in March. These high-performing stocks helped offset the two shadow stocks that fell more than 20% for the month. Overall, the portfolio slightly lagged the performance of the Vanguard S&P 500 Index fund (VFINX), which was up 6.8% in March.
Year to date, the AAII Model Shadow Stock Portfolio is in the black with a 1.8% gain, compared to the S&P 500, as represented by the Vanguard S&P 500 index fund, which is up 1.3%. Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.4% versus the Vanguard S&P 500 Index fund, which has gained 8.9% a year, on average, over the same period.
There are no changes to the Model Shadow Stock Portfolio this month. The portfolio underwent its quarterly review at the end of February.
Thirty-one stocks passed the Shadow Stock screen at the end of March, down from 38 at the end of February. Six of stocks in the actual portfolio qualified for purchase at the end of December, down from seven at the end of February: CSS Industries (CSS), Key Tronic Corp. (KTCC), L S Starrett (SCX), Rocky Brands (RCKY), Salem Media Group (SALM) and Willis Lease Finance Corp. (WLFC). Qualified stocks are companies held within the AAII Model Shadow Stock Portfolio that currently meet the initial purchase rules.
The AAII Model Fund Portfolio surged 8.2% in March and is now up 1.5% year to date. All nine of the funds in the portfolio posted gains in March, with three rising more than 10%. The portfolio, which was started in June 2003, has a compound annual average return of 8.1% since inception, which matches that of the VFINX over the same time period.
Following the April quarterly review, no changes were made to the AAII Model Fund Portfolio. You will be able to read AAII chairman James Cloonan’s latest quarterly model portfolio commentary in the May issue of the AAII Journal.
First-quarter earnings season will remain busy, with 124 members of the S&P 500 scheduled to report. Included in this group are Dow Jones industrial average components Pfizer (PFE) on Tuesday and Merck & Co. (MRK) on Thursday.
The week’s first economic reports will be the April PMI manufacturing Index, the April ISM manufacturing survey and March construction spending. All three will be released on Monday. Wednesday will feature the April ADP Employment Report, March international trade and the first estimate of first-quarter productivity. April jobs data, including the change in nonfarm payrolls and the unemployment rate, will be released on Friday.
Six Federal Reserve officials will make public appearances: Atlanta president Dennis Lockhart and San Francisco president John Williams on Monday; Lockhart and Cleveland president Loretta Mester on Tuesday; Minneapolis president Neel Kashkari on Wednesday; and Lockhart, St. Louis president James Bullard, Dallas president Robert Kaplan and San Francisco’s Williams on Friday.
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Pessimism among individual investors about the short-term direction of stock prices is at its highest level in nearly two months, according to the latest AAII Sentiment Survey. Neutral sentiment is also higher, while optimism is lower.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 6.0 percentage points to 27.4%. The drop more than reverses last week’s rise and puts optimism at a four-week low. The drop also keeps optimism below its historical average of 39.0% for the 25th consecutive week and the 58th out of the past 60 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.4 percentage points to 44.0%. The rise keeps neutral sentiment above 40% for a seventh consecutive week. This week’s increase also keeps neutral sentiment above its historical average of 31.0% for the 13th consecutive week and the 65th out of the past 69 weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 4.7 percentage points to 28.6%. Pessimism was last higher on March 2, 2016 (29.2%). This week’s increase was not large enough to prevent pessimism from staying below its historical average of 30.0% for a ninth consecutive week.
The survey period is Thursday through Wednesday. As such, most of the responses to this week’s survey were logged before yesterday’s Federal Open Market Committee statement was released.
Even though the S&P 500 index is trading near its record high and the smaller-cap Russell 2000 index has rebounded as well, many individual investors remain cautious. Fewer than one out of three survey respondents have described their short-term outlook for stocks as bullish during 21 out of the past 24 weeks. As stated last week, when the S&P 500 set its last record closing high on May 21, 2015, just 25.2% of surveyed individual investors described their outlook as bullish.
Giving individual investors cause for concern is the slow pace of U.S. economic growth and uncertain global economic growth, terrorism and global unrest, lackluster corporate earnings and the prevailing level of valuations. Some AAII members, however, are encouraged by sustained domestic economic growth, expected corporate earnings growth and still-low energy prices.
This week’s special question asked AAII members whether it makes sense for the S&P 500 to be trading near its record high. Respondents were divided: 38% said it makes sense and 36% said it doesn’t. The low levels of interest rates and bond yields were primarily cited as the reasons why it makes sense for the S&P 500 to be trading at current levels. The lack of adequate earnings growth and stock valuations were the primary reasons given for why the large-cap index shouldn’t be trading at current levels.
Here is a sampling of the responses:
- “It makes sense at the current level of interest rates.”
- “It does. Interest rates are at historically low levels and the economy is doing reasonably well.”
- “No, because earnings continue to decline, as do revenues.”
- “It seems too high compared to estimated corporate earnings.”
- “Only in this alternate universe with ridiculously low interest rates could the S&P be where it is.”
Bullish: 27.4%, down 6.0 points
Neutral: 44%, up 1.4 points
Bearish: 28.6%, up 4.7 points
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