Overlooked Liquidity Ratio, Large Funds And Hedge Funds Can’t Use, Gives You Higher Returnsby Tim du Toit, Quant Investing

Do you think the value of a company’s shares traded on the stock market can have an impact on your investment returns?

Unusual research paper

I didn’t, but that changed when some time ago I read an interesting research paper called Liquidity Styles and Strategies in U.S., International and Global Markets written by Professor Roger Ibbotson and Wendy Hu.

What it found

The paper found that liquidity (defined as the number of yearly shares traded divided by the company’s total outstanding shares) is a strong predictor of future returns in the USA and international markets.

Low liquidity outperforms the market

The paper tested an investment strategy  only using liquidity and found that it outperformed the market with lower risk as well as good down-side protection across all markets world-wide.

Tested if it works

Even though we are sure the researchers did good work when they tested the strategy we wanted to make sure that we could repeat the results before incorporating liquidity as another ratio for you to use in the screener.

Results confirmed – outperformance

We found the same as the Prof Ibbotson’s research.

If you use a simple strategy of buying only the most illiquid companies (not undervalued or any other criteria) you would have done very well, substantially outperforming the market.

How the strategy performed

The following table shows the results of the back test of the European, Scandinavian, UK and North American markets over a period of 13 years from July 2001 to July 2014:

Liquidity Ratio, Hedge Funds, Higher Returns

CAGR = Compound annual growth rate

Defined it slightly different

In the back test we defined liquidity as adjusted profits to yearly trading value and not as the number of yearly shares traded divided by the company’s total shares outstanding.

We tested both ratios and adjusted profits to yearly trading value gave much better returns (this is also a ratio Professor Ibbotson hinted at in other papers and interviews)

Q1 = illiquid and Q5 = liquid

In the above table Q1 (Quintile 1) represented the 20% most illiquid companies as measured by profits to total yearly traded value.

177% better than the market

Over the same 13 year period we tested the market returned 8.1% per year or 176.6%.
So, as you can see, the companies with the lowest liquidity (Q1) beat the market by 4.4% per year or 186.6% over the 13 year period, substantial out-performance I am sure you will agree.

Liquidity worth looking at

The back test thus clearly confirmed the conclusion that liquidity is a ratio definitely worth considering when you are looking for investment ideas.

Added to the screener

This is also the reason why (shortly after finishing our own back test) we added liquidity as one of the ratios in the screener.

Liquidity definition

In the screener we called it Liquidity (Q.i) and it is calculated as follows:

Liquidity (Q.i) = Adjusted Profits / Yearly trading value

The ratio gives you an indication of how high a company’s yearly traded value per share is compared to its adjusted profits.

A high value thus means low turnover and thus a larger chance of the company’s shares being mis-priced.

How to find low liquidity companies

To find these companies set the slider to 0% to 20%.

Liquidity Ratio, Hedge Funds, Higher Returns

How to find high liquidity companies

A low value means high traded value which means more analysts may follow the company giving you a lower chance that the company is mis-priced.

To find these companies set the slider 80% to 100%.

Liquidity Ratio, Hedge Funds, Higher Returns

Large shareholders low analyst interest

Selecting low liquidity companies can help you to identify companies with large controlling shareholders or a stable base of shareholders where traded value is low and thus less analyst interest because they cannot make money by recommending and trading of the company’s shares.

Shareholders with a long term focus

These long term stable shareholders will also most likely allow management to focus on the long-term health and profitability of the company and not just meeting the next quarterly profit forecast.

Your liquidity analyst

Tim du Toit