When I say style factor research I am thinking about things like value, size and momentum which over the years have been identified as explaining or predicting some of the excess returns delivered by certain stocks or groups of stocks. I reported recently on some research which reviewed the case for momentum, which if you missed it can be accessed by clicking on the highlighted momentum link above.
While today I thought I would share with you some more research which I read recently which was new to me and suggestive of a new unrecognised factor which is distinct from value, size and momentum. This is not new research as it was produced a few years back, but I only came across it recently, so apologies if you are already familiar with it.
So what it this unrecognised factor? Well it is liquidity and it has be researched thoroughly by Roger G. Ibbotson et al in two papers. The first one explores Liquidity as an Investment Style in which the authors:
"present comprehensive evidence in support of giving liquidity equal standing to size, value/growth, and momentum as investment styles, as defined by Sharpe (1992). First,we show that financial market liquidity, as identified by stock turnover, is an economically significant indicator of long-term returns. Then, we show that liquidity,as a characteristic, is not merely a substitute for size, value, and/or momentum. Finally,we show that liquidity has historically been a relatively stable characteristic of stocks, and that changes in liquidity are associated with changes in valuations."
The second paper By Roger G. Ibbotson & Wendy Hu - explores Liquidity Styles and Strategies in
U.S., International, and Global Markets in which the authors say:
"Liquidity is a strong predictor of future returns in U.S., International, and global markets, yet distinct from size, value, and momentum. We develop a strategy for implementing the liquidity style, creating portfolios that have positive and significant alphas, low betas, and good down-side protection geographically across all markets."
In this report they measure liquidity as measured by the annual share turnover (the sum of the twelve monthly volumes divided by each month’s shares outstanding). There was also a good interview with Ibbotson where he explains the background to the research and why it works. In essence you would be buying neglected out of favour stocks, presumably on the cheap which then get re-rated as they become more popular and heavily traded. It seems to have worked pretty well as you can see from the chart below which came from the interview. One Q & A of the interview I would highlight is this:
CR: If an individual investor wanted to build a strategy incorporating liquidity, what should he pair it with? Should he be looking at valuation and momentum? Are there certain criteria that pair well with liquidity?
RI: We pair it with value-type measures. You have to pair it with something because you really need to be buying fundamentally strong companies. You want to buy fundamentally strong companies that basically haven’t been recognized as such. So when you’re getting the less liquid stocks, they also are the less popular stocks. If they have strong fundamentals, but are less popular, these stocks tend to be selling at discounts. When the market recognizes more what’s going on, these stocks tend to migrate to becoming more popular. Then, if their fundamentals improve from there, they’ve got a double-whammy: improving fundamentals and the increase in popularity—this often creates very good returns.
This factor seems to be an ideal one for individual investors to try and exploit given their likely deal sizes and the ability to take a genuine long term view. This quite neatly sums up what I was saying in my post about PZC yesterday. However, the problem I have with this is that I have not been able to find a good source of data for 12 month trading volume to use for screening as most of the services seem to only offer 3 month data, which as Ibbotson point out in his interview is not as useful. I have asked the boys as Stockopedia if they could add it, but although they seemed positive about the idea, they suggested they were busy launching their other products this year, so I'm not holding my breathe on that. I have added a new feature request on Stockopedia under the title heading of Liquidity (here) asking for 12 month trading volume to be added for screening. So if you are a user of the service and like the idea then perhaps you could vote for it as an idea.
Meanwhile if anyone out there knows of a good source to download this type of data for free or from a subscription service then perhaps you could let us know in the comments section.