The Liquidity Curse
Is the liquidity premium turning into a discount? Traditionally, investors have been willing to pay a premium for stock liquidity. This premium appears to be turning into a discount. Could this phenomenon last? Historically, market participants have been willing to pay a premium for liquidity. In the equity market, in the hypothetical situation of two otherwise identical stocks, the one with the better trading liquidity would be expected to command a premium over the less liquid stock. In other words, everything else being equal, a stock that is easier to trade (one with better liquidity, i. e., more trading volume) would be expected to be awarded a higher valuation multiple than the less liquid alternative. Frequent readers are well aware that I am a strong fan of Warren Buffett. He has repeatedly noted how perverse it is that investors treat stocks so differently from real estate, simply because stocks are a much more liquid investment. Paraphrasing Mr. Buffett, he recently remarked how absurd it would be if a homeowner liquidated his or her home just because a neighboring home was sold at a discount versus its fair value. Homeowners do not track the theoretical value of their homes on a daily basis, and their investment psychology is not affected by the price fluctuations in their homes anywhere near to the extent that they are when they see the price swings in their stock holdings. Thus, Mr. Buffett often reminds us that, in the short term, the equity market functions as a voting machine, whereas in the long run, it is more like a weighing machine. That is one of the key reasons behind the success of long-term equity investing. In the long run, the stock market weighs the cash flow generating ability of the underlying equities, whereas in the short term, fads and popularity tend to determine the price at which a particular stock trades at specific point in time. The implied discrepancy is what often creates wonderful buying opportunities in very desirable equities for the long term. How could trading liquidity ever be a bad thing? In the short run , better stock liquidity can certainly work against a stock price. Particularly in severe market-wide corrections (or if a specific stock is heavily owned by leveraged traders), a liquid stock may suffer disproportionately in the short term as traders take advantage of the relatively high liquidity to raise cash. This is when particularly attractive entry points are often created for long-term investors, but also why I advocate that such investors never use margin debt to increase their exposure to stocks. Owning stocks on a leveraged basis does potentially expose market participants to a sort of ‘liquidity curse’. One may receive a margin call and be forced to liquidate a particular stock in a sudden market correction. But other than that, trading liquidity should always be considered a positive characteristic in a stock, in my view. Still, and perhaps because investors seem to be increasingly shunning volatility, it appears almost as if the historical liquidity premium may be turning into a discount, and that the liquidity curse may be becoming more widespread and more of a permanent feature across equities! Much has been written lately about the millennials. The so-called millennial generation does seem generally less open to equity investing than previous generations were at the time they were in the age range of millennials today. Having seen their parents go through the burst of the TMT bubble and the global financial crisis may have traumatized millennials enough to generally shun investing in publicly traded equities, at least for the time being. That said, investing in private equity seems much more currently popular. This is reflected both in the staggering valuations now prevalent in a number of late-stage venture investments, as well as in the growing popularity of ‘crowdfunding’. More investors than in the past, perhaps bolstered by young people including millennials, seem to be increasingly comfortable tying up their funds in illiquid investments. Equity is equity, and that which is not traded in the public markets is almost by definition riskier than publicly traded stocks, even everything else being equal. Thus, it would seem as if more people are choosing venture capital and private equity at the expense of the public markets, at least implicitly preferring trading illiquidity. One hypothesis I have for this phenomenon is that it is less traumatic for those investors not to know exactly how much a particular equity investment they own is worth at a particular point in time, just as is the case in real estate.
