A kind soul on twitter sent me a study the other day by Thomas M. Idzorek, CFA, James X. Xiong, CFA, and Roger G. Ibbotson that studied liquidity in the equity market. Want to guess what they found? The same thing they found every other time it has been studied. This studied mutual funds and they found that mutual funds investing in illiquid stocks beat those that favored more liquid issues. Further more those that had a value bias and bough illiquid stack best the ants off everything else out there. The study concludes “Overall, the liquidity investment style is clearly present in mutual funds and leads to dramatic differences in performance.” This is similar to the earlier Ibbotson study that found that illiquid value stocks crushed liquid growth stocks and the market indexes.

So we know it works. Stretch out time frame a bit, quit trading and own a portfolio of undervalued illiquid stocks and beat the market by a wide margin over time. A lot more naps and a lot less screaming at screens and throwing coffee cup across the office. It is good for everyone but the manufacturers of stress balls and coffee cups. It works. We know it does. It has been proven in theory and practice. Yet no one does it.

The want the liquidity to get in and out on a moment’s notice. Gotta be able to hit that bid baby. Ben Graham once said that investing works best when it is most business like. What in the world is business like about short term trading. What other capital asset would you demand provide you instant liquidity? Can’t do with a house. Can’t do with a private company, a tract of land, an office building and other investments but when it comes to fractional ownership of a corporation you need to be able to get out anytime everyday?

Folks tell me all the time I want to be able to get out if the market goes bad. I hate to tell you this Chicken Little but that is costing you a ton of money. The study also found “Surprisingly, the outperformance of the mutual funds that hold less liquid stocks was primarily due to superior performance in down markets. One possibility is that during periods of turmoil, high liquidity managers may be more likely to trade; thus, the most liquid stocks may, in fact, suffer the steepest declines because there is a greater propensity for their owners to trade them.” If it is difficult to see there is a tendency to hold the sock and just ride it out. Since most shareholders of an illiquid stock will have the same opinion there is a lot less selling pressure.

Think of it this way. You have two big jars of money. Every year the current balance of the jar will be increased by about 8% at the end of each year until you retire. One jar is easy access. Open the jar any day, take out the cash and be on your way. That’s liquid stocks. To open the other jar you are exposed to an electrical shock while in contact the lid. One the lid comes off you have to stick your hand thought a small hole with jagged edges wiggle your hand enough to unwrap the barbed wire that the cash will be wrapped in to take out what you wish to spend right now. That’s illiquid stocks. They are hard to sell and the costs of trading them can be quite high due to the wider bid ask spreads. When it comes time to retire which jar do you think will have the most money in it?

Mow figure that as Mr. Ibbotson found the easy open jar grows by the market average rate of return of roughly 10% but the ragged edge, electro-shock barbed wire jar grows by 18% a year? That’s illiquid value stocks versus the overall market. Quit avoiding illiquidity. It is your best friend as a long term investor.

Thus endeth todays lesson.

I am spending part of the evening at a middle school Holiday concert and event that has all the appeal of nice cool cup of ground glass but off I go anyway. It is what we do as parents and why we have wine. Mayve I will get lucky and the late edition of MLB Tonight will finally report that Bryce Harper and Mike Trout have been traded to the Orioles.

Enjoy the week.

Tim

If I have to listen to Bad Christmas songs tonight you should as well!

https://www.youtube.com/watch?v=OvF233fW4cI&list=PL251732E1A3AF3D07&index=41