Want to beat the market? Buy stocks that you can’t trade easily

There are no sure things when it comes to investing.

But three specific investing styles (in the jargon, they’re called ‘factors’) have been shown by research to deliver market-beating returns over the long run.

Buy cheap stocks. Buy small caps. And buy winners – stocks that are in a rising trend beat those on a losing trend.

These are regarded as ‘anomalies’. They shouldn’t work in an efficient market. But they do.

And now there’s a fourth one to add to the list, it seems.

Buy stocks that are difficult to trade…

What is liquidity anyway?

There’s a very interesting piece by John Authers in the FT today. He looks at the work of well-known finance researcher Roger Ibbotson of Yale University.

For quite a while, Ibbotson has been doing research into liquidity. He reckons that he’s proved that illiquid stocks beat liquid ones over the long run, and that this is another measure to add to the three existing ‘factors’. (For more on the other three, my colleague Cris Sholto Heaton did a good piece explaining them in MoneyWeek magazine a couple of issues back.)

As Authers notes, this is something investors should pay attention to. “Huge sums of money are managed based on the three factors already acknowledged. For good or ill, Mr Ibbotson’s article is likely to spur a boom in investing in illiquid stocks.”

First off, what’s liquidity? It sounds like quite a technical term. But it’s just a measure of how easy it is to buy or sell an asset.

Houses are very illiquid, for example. It takes ages to buy or sell a house – they don’t change hands very often, even in a wild bull market.

And you can only ever have a rough idea of a property’s value. For example, right now you probably have a vague idea of what your house is worth, but you can’t be sure of that until you put it on the market and someone actually buys it.

And another aspect that makes housing illiquid is the high transaction costs. It’s expensive to buy or sell a house.

Compare that to a FTSE 100 stock, which is very liquid indeed – millions of shares change hands every day.

If you want to know how much it’s worth, you just look at the current price shares are changing hands at. You can be very confident that your own holding would fetch that price too.

Finally, transaction costs are fairly low on a very liquid stock – specifically, the gap between the price you pay, and the price you can sell at (known as the ‘bid-offer spread’) will be pretty narrow.

Of course, not all stocks are highly liquid. FTSE 100 stocks change hands every day. But some companies at the bottom end of the market can go days without a single share changing hands.

What you can learn from the outperformance of illiquid stocks

So Ibbotson looked at the US stock market. He took 3,500 stocks and ranked them by turnover – the value of stock traded each day.

The least traded stocks (the least liquid) returned an average of more than 16% a year, between 1972 and 2011. The most liquid returned 11%. (Just to be clear, that’s a massive gap. An extra 5% a year in returns is a life-changing amount over the long run).

Why does this work? I’d argue that it boils down to the difficulty of getting at your money. In normal circumstances, a five-year savings account pays more interest than a one-year one, to compensate for the fact that you can’t just get your money out when you want. Presumably, the same goes for investing in illiquid stocks.

As for the extra costs involved in buying illiquid stocks, as Authers points out, you can offset these quite easily – just don’t trade very often.

How would you play this? I’m sure we’ll see liquidity-based exchange-traded funds launching all over the place before too long. And I’ll be doing some more research into companies that fit the bill.

For example, family-owned companies often provide good examples of the sorts of thinly-traded and tightly-owned stocks that would classify as illiquid. Microcap funds may be worth a look too.

But for me the key point to take from this right now is what it tells you about good investment habits.

You see, if you’re going to invest in an illiquid asset – you tend to do your homework first.

Let’s go back to the property example. Most of us don’t buy a house on a whim. This thing represents a commitment. You need to take time to look around it, find out about the area, look for potential nasty surprises. In short, you do some due diligence.

That doesn’t stop people from making mistakes. But it’s not a financial decision that many of us take lightly, and that’s because it’s a very hard decision to reverse once it’s been taken.

But what about the stock market? I think anyone with any investment experience who was being honest about it would admit that they’ve occasionally bought a share on little more than impulse. You see a hot sector, you want exposure – why not? It’s just a matter of hitting a button on your keyboard.

I’d like to think that most of us learn quite quickly that this isn’t a sensible way to invest. But research tends to suggest the opposite. Study after study shows that investors – small investors in particular – find it almost impossible to just sit on their hands. They overtrade to the extent where they utterly destroy any possibility of beating the market.

Illiquid stocks on the other hand, tend not to be ‘hot’ stocks. They’re thinly traded partly because no one is paying them attention. So you have to dig to find them – you don’t buy them on impulse.

And when you do buy them, you’re very likely to immediately be significantly in the red, because the bid-offer spread will be pretty wide.

So you need to do your research before you buy. And if you decide to buy, you have to have conviction. And after you do buy, you need to be patient, and hold on.

In other words: if you want to make money by stock picking, do your homework, and don’t trade very often. And if you can’t spare the time to do that – just stick with tracker funds.

Our own David Thornton, for example, is one of the most diligent researchers I’ve seen  – you can learn more about his investment strategy, and the investment trend he’s currently most excited by, here.

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  • jimtaylor

    An interesting hypothesis and a 5%p.a. difference looks compelling.

    It could be that simply buying at the right time (which requires good analysis) and holding for the long term (which reduces churn costs and mimics a low liquidity stock) is more similar without requiring a higher Total Return to compensate for the increased risk of not getting full value when trying to dump illiquid shares?

    I look forward to seeing the results of your further research to find individual companies that prove the illiquidity theory.

  • OldHarryRocks

    “So Ibbotson looked at the US stock market. He took 3,500 stocks and ranked them by turnover – the value of stock traded each day.”

    Most stock quote sheets seem to track volumes, which I believe to be the number of shares traded.

    Is turnover a better indicator?