Liquidity has value. We know this. It is why people hold cash instead of investing it, even though cash does not yield any returns. It is also why we are willing to keep money in current-savings accounts even though the interest income is very low compared with fixed deposits — we know can withdraw cash more easily in emergency situations. In other words, the value of cash is its immediate monetisation.
Different investment assets have varying degrees of liquidity — in terms of the ease of buying and selling without causing material changes to prices. So, publicly traded stocks where there are many standing buyers-sellers are generally more liquid than shares in private assets, and bonds will be more easily converted into cash than real estate (property).
There is a price to liquidity, or rather, illiquidity. For example, money market investments with very short maturities are highly liquid assets, so much so that they are commonly equated to cash investments. But that also means their yields are generally lower than long-dated bonds, which lock up your money for longer periods of time. You will, though, earn higher yields (income) on the latter — called the liquidity premium — to compensate for the higher risks of default, inflation, interest rate changes and so on during the duration to maturity. Hence, a yield curve under normal circumstances has a positive slope.
The fair value of a company is equal to the sum of its discounted future cash flows (DCFs), or as we have written before, some short-form version of this methodology, such as price-earnings or price-sales ratios. However, in reality, share prices are also influenced by the stock’s liquidity.
Stocks that are very liquid usually command higher valuations while illiquid stocks tend to trade at a discount to their fair DCF valuations, all else being equal. This is because you can easily and quickly dispose of a stock that has high trading volumes without impacting prices. Conversely, sparsely traded stocks tend to have wider bid-ask spreads (prices) — and trying to dispose of a big position in these stocks means risking having to accept lower-than-prevailing market prices. In other words, illiquid stocks carry higher risks.
The accompanying charts underscore this phenomenon. For example, the Standard & Poor’s index has the highest daily turnover — and valuations — among the major indices in the world. Of course, valuations are also determined by many other factors such as country risks, the composition of stocks in the index — and thus, overall growth prospects — ease of accessibility, degree of market liberalisation, support from domestic funds and so on and so forth.
Similarly, individual stocks would differ in fair DCF valuations based on their respective growth prospects and risks as well as qualitative factors such as management integrity. But as our sample groups show, liquidity does play an important role in enhancing stock attractiveness and drives share prices. In particular, stocks with very high liquidity (the outliers) tend to trade at significant premium valuations.
All of the above explains why stocks generally rally when included into major indices, even though nothing has changed fundamentally. The pool of index funds is huge — and growing by the day. Index-linked stocks therefore enjoy high liquidity, which translates into higher valuations. Higher valuations, in turn, mean bigger weightage in the index and even higher liquidity and prices. In other words, the positive feedback loop ultimately leads to larger and larger companies, which are also the most liquid and trade at high valuations. You can see how this could lead to bigger problems. For starters, it justifies lazy investing through ETFs (exchange-traded funds) and MSCI weightage.
The positive correlation between liquidity and valuations also encourages companies to focus on strategies that boost share liquidity instead of underlying profitability. For instance, by undertaking stock splits and bonus issues to raise the total number of shares in the market — which do not enhance underlying values but would improve liquidity and, therefore, likely boost share prices.
Companies may spend too much time on investor relations, actively engaging journalists and analysts, to promote market awareness and appeal — though better transparency is always good. As we have seen recently, some — the likes of Elon Musk (Tesla) and Adam Aron (AMC Entertainment) — are also promoting their stocks through less conventional means, playing to retail audience by leveraging social media.
Beyond the above, there are broader implications of valuations driven by liquidity, which we will explore in future articles.
The Global Portfolio gained 0.4% for the week ended June 9. The notable gainers were General Motors (+5.2%), Adobe (+3.8%) and Microsoft (+2.5%). Meanwhile, Alibaba Group Holding (-3.0%), Awanbiru Technology (-2.0%) and Home Depot (-1.9%) were among the big losers last week. We made no change to the portfolio, which remains fully invested. Total portfolio returns stand at 55.8% since inception. We are still outperforming the MSCI World Net Return index, which is up 51.6% over the same period.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
Photo Credit: Bloomberg
