A recent report from Goldman Sachs Portfolio Strategy Research highlights that low turnover stocks tend to outperform historically during time periods when the Federal Reserve is raising interest rates (tightening cycles).

Low Turnover Stocks

GS analysts Elad Pashtan and colleagues offer a convincing argument supporting their thesis that now is the ideal time to buy low turnover stocks. “Over the past 20 years, stocks with low turnover (a measure for liquidity) outperformed high turnover stocks in all cases where financial conditions tightened for at least three months. We expect financial conditions to tighten throughout 2015. Since 1985, low turnover stocks outperformed high turnover stocks during 69% of semi-annual holding periods by an annualized average of 8%. We recommend investors with a medium-term horizon buy our low turnover basket and sell our high turnover basket.”

Share turnover as a method to measure liquidity

Pashtan et al. suggest that share turnover, measured as the trailing 12-month average of daily shares traded divided by float, is a straightforward and reasonable accurate metric for liquidity. They prefer share turnover for “its simplicity and effectiveness towards constructing our trading strategy.” Th

The GS analysts note that share turnover also broadly tracks NYSE equity market trading volumes. Of note, turnover on the NYSE as measured in shares has dropped notably since the financial crisis in 2008, although  the decline is not as significant on a notional dollar basis.

Two reasons to own low turnover stocks

Low Turnover Stocks

The Goldman Sachs report argues there are two reasons to own low turnover stocks today. First, low turnover stocks tend to outperform because of an illiquidity discount. Both investors and market makers alike would rather hold liquid assets so they can manage their balance sheet and portfolio risks. This means that less liquid assets often trade at a discount, reflecting their liquidity risk.

However, fund managers with long-term investment horizons and a tolerance for liquidity risk can capture this risk premium.

Low Turnover Stocks

Low turnover stocks also outperform historically when financial conditions tighten. Pashtan and team studied 18 episodes where financial conditions tightened for a quarter or longer. In 16 out of 18 cases low turnover stocks outperformed high turnover stocks. Moreover, the median outperformance was a startling 14%.

Low Turnover Stocks