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Liquidity, Crack And The Quest For Better Returns

 May 15, 2012 07:13 PM

(By Chris Mayer) "Liquidity is like crack: The more you rely on it, the greater is the craving."
— Louis Lowenstein, Sense & Nonsense in Corporate Finance

Liquidity is one of the most overhyped of modern financial ideas. In the context of the stock market, all liquidity means is that you can buy and sell easily. Lots of liquidity means lots of trading volume. It means the bid-ask spread is narrower in a liquid stock than it is in one that is illiquid.

As it turns out, the best opportunities are often the most illiquid. In what follows, we'll take a look at illiquidity as an investment strategy.

Markets are more liquid than ever these days, but that is not all a good thing…

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Back in 1960, investors held their stocks for an average of seven years. No one complained about a lack of liquidity. Today, people hold stocks for on average for four-eight months.

The ability to get in and out of a stock quickly means you have lots of sloppy owners. As Lowenstein points out: "Those who expect to sell out quickly and cheaply are more likely to buy for speculative or foolish reasons and to act as uninformed owners in between times."

An illiquid stock is, by its nature, more likely to attract a smarter shareholder base. This is simply because the people going in know they can't get out of it as easily, so they are more careful about how and why they get in.

This may have something to do with the outperformance of illiquid shares.

Roger G. Ibbotson and Wendy Hu of Zebra Capital Management studied the performance of liquid stocks against illiquid ones. They found that illiquid stocks tended to trade at a discount to more-liquid stocks. "Investing in less-liquid stocks thus pays," they write.

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Moreover, they found that less-liquid assets tend to become more liquid over time, thus helping to erase that gap.

Ibbotson and Hu also note that investing in less-liquid securities as a strategy has an advantage in that it "avoids, or invests less in, popular, heavily traded glamour stocks and favors out-of-favor stocks, both of which tend to revert to more-normal trading volume over time."

That's all fine and makes sense. But you can really see it in practice by looking at portfolios investors construct.

Nick Padgett and Stephen Mack are the managing directors of Frontaura Capital. The fund invests in frontier markets such as Cambodia or Mongolia. I've never met them personally, but hope to someday. I was introduced via email by my friend Doug Clayton at Leopard Capital. They share their shareholder letters with me, and the latest one had an interesting observation on this liquidity idea.

Frontier markets can be very illiquid. It can take weeks, maybe months, to buy even small positions in Mongolian stocks on the Mongolian exchange, for example. This means frontier markets are cheaper, but not always. Frontier markets have some liquid stocks.

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