This neglected ratio gives you higher returns. And Hedge Funds can't use it.

Retail investors often have an edge that they're not aware of.

Hi Everyone,

too many investors believe that a successful investment strategy involves finding the right stocks. But that’s only part of the job. Before you even see the right stocks you have to increase your chances by knowing where to look in the first place. I prefer to divide stocks into groups with "characteristics". If you learn to look at stocks as groups you will automatically have a higher selection and you don't have to focus so much on one stock, instead, you can put several with the same "characteristics" into your portfolio.

That's why I try to look at the big picture and find out what characteristics stocks have that have outperformed. Both from a qualitative point of view and from a valuation point of view. Based on this, I put together a portfolio in which stocks that have historically outperformed predominate. A successful portfolio strategy is to get the probability of outperformance on your side. In this article, I present to you a ratio that has historically outperformed, is suitable for retail investors and has been neglected in the financial community (for some mysterious reason): Liquidity.

What is Liquidity?

Liquidity can be measured in many ways. For today’s topic, we are going to define it as “stock turnover”. It’s the proportion of a stock’s market capitalization that changed hands on any given day. Liquid securities are easier to trade with lower market impact costs, are higher priced, and are desired by rapid turnover investors. Whereas illiquid securities are more difficult to trade, lower priced, and great for long-term investors because of higher expected returns. To view it from a different angle: Liquidity often overlaps with “newsworthiness”. Stocks that are the darlings of financial media and get more media attention are often liquid and easier to trade. Stocks that are neglected and ignored will be relatively illiquid.

If we take the previous sentence into consideration, then liquidity has the most obvious connection to valuation. Illiquid stocks often trade at a discount, have a higher bid/ask spread and trading costs. In other words, if all else is equal, investors will pay more for more liquid stocks and pay less for less illiquid stocks. Buying Less Liquid stocks means that the same cash flows can be bought cheaper. This is where the savvy investor can find a great risk/reward opportunity.

Isn’t investing in illiquid stocks the same as investing in small-caps?

To answer that question, let’s take a look at a research paper called Liquidity as an Investment Style. The researchers examined 3.500 U.S. stocks from 1972-2013. First of all, here are the general results:

Low liquidity stocks significantly outperformed the compared strategies and landed right after High Value. But what did it look like across company sizes? My first thought was that this selection criterion should only apply to small-cap stocks, but the results showed that I was half correct:

In all four sizes (large-cap/mid-cap/small-cap/micro-cap) the low liquidity stocks outperformed significantly. But, as you will notice, the difference in returns diminished with increasing size. Yes, you will find more illiquid stocks among microcaps simply because of the characteristics of the sector, but nevertheless, even among large-cap stocks, you can put the odds on your side.

But High Value performs better, so why not just focus on that?

Here comes the interesting part: As a standalone style, high value outperforms low liquidity, but how are the results if we select among high-value stocks the ones with the lowest liquidity? Would that make any difference? Yes, it would:

As you see, liquidity is a legit investment strategy that works well among different sizes and factors. In theory and practice, less liquid stocks outperform. Over the four decades of the research, liquidity was inversely related to risk – the lower the liquidity, the higher the return and the lower the risk.

Conclusion

At the beginning of my investing journey, I stayed away from illiquid stocks simply because the bid/ask spread was too big and I was afraid that during market crashes those are the stocks that suffer the most. In reality, illiquid stocks suffer the least during a selloff and offer great downside protection because investors sell what they can during a panic (which are liquid stocks).

The liquidity style rewards the investor who has longer horizons and is willing to trade less frequently. Liquidity is not only a good stock selection criterion but also a great overall portfolio strategy. A low-turnover rate as a strategy ensures that you don’t react emotionally to news trying to trade in and out and stay focused on what has worked historically: Going against the crowd.

I hope you learned something today, until the next issue. 👋