Morningstar Advisor - June/July 2009 - 24

Gray Matters reason that stocks are traded. A secondary reason is that they are bought or sold to meet liquidity needs. The other component of a present value calculation is the discount rate. Similar to the expected cash flows, these discount rates are unobservable. We can usually observe the riskless discount rates from a term structure of riskless bonds, which we unravel from U.S. government discount bonds. But there are usually other premiums that we would add to the riskless term structure. The most common one is an equity risk premium, which is often modified by a beta in the CAPM framework. We might also add a premium for size and another one for value (or distress). We argue here that another premium should be added for lack of liquidity. The difference of opinion that investors have about expected cash flows leads to the additional risk of a security. The risk of the security reflects not only the changing economy and company cash-flow expectations, but also the divergence of opinion that changes from moment to moment. This risk reduces the value of a security. Ironically, this divergence of opinion also leads to most of the trading of a security, thereby making the security more liquid for traders, whether they be active or liquidity traders. The higher liquidity increases the security’s value. We do not mean to imply that most investors actually make these present value calculations. Instead, investors rely on simple metrics, such as the price/earnings ratio. They try to buy stocks with relatively high but unspecified cash-flow projections at relatively low P/E ratios. Or they may simply think that a stock’s price is too low or high relative to its estimated value, leading them to buy or sell a security. The Illiquidity Premium somewhat illiquid, an illiquidity discount is often made to the present value, at the end of the calculation. Thus, a liquid stock is priced at the present value of the expected cash flows, discounted by the riskless rate and various other risk premiums, such as a beta-adjusted equity risk premium, a size premium, and a value premium. The final present value is then reduced by some percentage because of its lack of liquidity. The other way to calculate a present value is to add an illiquidity premium into the discount rate. Less-liquid securities would then have their cash flows discounted at higher rates. The benefit of this approach is that this illiquidity premium can be thought of as causing a higher discount rate. These discount rates are equivalent, under certain conditions, to the expected return that an investor receives for investing in less-liquid securities. The illiquidity premium is the extra return an investor would demand in order to hold a security that cannot costlessly be traded. This premium is not exactly a risk premium, because it more reflects a transaction cost. We can think of the premium as related to risk, however, because it is the risk of having to buy or sell a security quickly. The less liquid and more hurried the transaction, the more the cost. The illiquidity premium is potentially interesting to investors who can afford to hold a security over time, instead of continuously trading it. For investors with long-term time horizons, the trading costs become trivial because they happen so infrequently. The positive illiquidity premium is a benefit to the long-term investor. It means that the less-liquid securities will have higher returns and these higher returns are not likely to be affected by trading costs. It is sometimes argued that part of the expected return that is demanded from real estate, private equity, or venture capital comes from their relative illiquidity.1 In addition to any of their return for other risk characteristics, investors want an extra return for holding an illiquid asset. Thus, investors would only want to invest in alternative illiquid assets if they thought that they would receive extra compensation for their lack of liquidity. The illiquidity premium also is positive and substantial within publicly traded securities. There is a difference in the return of the more highly traded securities versus the lesstraded securities, even though most public securities can be readily traded. We can examine the relative impact of liquidity across publicly traded stocks on the New York Stock Exchange, American Stock Exchange, and Nasdaq. Liquidity and Stock Returns In the U.S. stock market, liquidity has substantial impact on stock returns. We examined the monthly data for the largest 3,500 U.S. stocks by capitalization over the period 1972 through 2008. These stocks were traded either on the NYSE, AMEX, or Nasdaq. All were publicly traded and relatively liquid, but, of course, some were more liquid than others. We divided the stocks into four quartiles separated from the prior year by the turnover rate. The turnover rate is the number of shares traded during the year divided by the number of shares outstanding for the stock. The stocks with the highest turnover rates were the most liquid, and the stocks with the lowest turnover rates the least liquid. The return, share volume, and capitalization data are from the Center for Research in Security Prices, at the University of Chicago Booth School of Business. Exhibit 1 illustrates the historical magnitude of the liquidity premium over the 38-year period from 1972 to 2008. Note that there is a substantial difference in the returns of the least-liquid quartile versus the most-liquid quartile, as well as a continual progression of higher returns as we move to less- Most conventional present value calculations ignore the illiquidity premium. These calculations usually implicitly assume that securities are perfectly liquid. If they are 24 Morningstar Advisor June/July 2009
Morningstar Advisor - June/July 2009

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