Morningstar Advisor - June/July 2009 - 23

Gray Matters The Liquidity Premium By Zhiwu Chen and Roger G. Ibbotson Less-liquid stocks have higher expected returns than moreliquid stocks. Liquidity has many different, but similar meanings. In every case, it is related to the ease of movement. In the banking system, liquidity measures the degree to which loans are made. In the securities markets, liquidity is the ease with which transactions can be made. In valuation, liquidity has an impact on value: The more liquidity an asset has, the more value it has, all other things being equal. The absence of liquidity lowers the value of the asset by the amount of an illiquidity discount. In the financial crisis, it is quite natural that the financial media are focusing on liquidity in bonds and loans. The president and Congress are providing bailout money so that financial institutions can prop up balance sheets to make it easier for them to start lending again. Corporations, such as automobile manufacturers, are not able to meet their cash flows with their illiquid assets and cannot get sufficient financing. Potentially healthy corporations or individuals are not able to get refinancing as their loans become due. In this article, we instead focus on liquidity as the ease of executing securities in general, especially equities. We focus on liquidity’s impact on valuation and in particular its impact on security returns. We will demonstrate that less-liquid securities have higher expected returns. Valuation as Present Value of Cash Flows In equilibrium, an asset has a value that equals its present value, or the discounted sum of its expected cash flows. These future cash flows are unobservable, except for risk-free assets. For stocks, there is great disagreement as to what these expected cash flows might be. This disagreement is the primary MorningstarAdvisor.com 23
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Morningstar Advisor - June/July 2009

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2009

Morningstar Advisr - June/July 2009
Contents
New on MorningstarAdvisor.com
Letter from the Editor
Contributors
Is SRI a Relevant Investment Strategy?
A Head for Numbers
Building a Business on SRI
Investment Briefs
The Liquidity Premium
Navigating the SRI Patchwork
Profit and Progress
How the Fed Contributes to Crises
Holding Steady
Appleseed Adds Value to SRI Formula
Four Picks for the Present
Long-Term Investors Can Find Value among Industrials
Higher Yields, Hold the Risk
Bargains in U.S. Industrials
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
Talkin’ ‘bout a Revolution
Morningstar Advisor - June/July 2009 - 47
Morningstar Advisor - June/July 2009 - Morningstar Advisr - June/July 2009
Morningstar Advisor - June/July 2009 - Cover2
Morningstar Advisor - June/July 2009 - Contents
Morningstar Advisor - June/July 2009 - 2
Morningstar Advisor - June/July 2009 - 3
Morningstar Advisor - June/July 2009 - New on MorningstarAdvisor.com
Morningstar Advisor - June/July 2009 - 5
Morningstar Advisor - June/July 2009 - 6
Morningstar Advisor - June/July 2009 - Letter from the Editor
Morningstar Advisor - June/July 2009 - Contributors
Morningstar Advisor - June/July 2009 - 9
Morningstar Advisor - June/July 2009 - Is SRI a Relevant Investment Strategy?
Morningstar Advisor - June/July 2009 - 11
Morningstar Advisor - June/July 2009 - A Head for Numbers
Morningstar Advisor - June/July 2009 - 13
Morningstar Advisor - June/July 2009 - 14
Morningstar Advisor - June/July 2009 - Building a Business on SRI
Morningstar Advisor - June/July 2009 - 16
Morningstar Advisor - June/July 2009 - 17
Morningstar Advisor - June/July 2009 - Investment Briefs
Morningstar Advisor - June/July 2009 - 19
Morningstar Advisor - June/July 2009 - 20
Morningstar Advisor - June/July 2009 - 21
Morningstar Advisor - June/July 2009 - 22
Morningstar Advisor - June/July 2009 - The Liquidity Premium
Morningstar Advisor - June/July 2009 - 24
Morningstar Advisor - June/July 2009 - 25
Morningstar Advisor - June/July 2009 - 26
Morningstar Advisor - June/July 2009 - 27
Morningstar Advisor - June/July 2009 - 28
Morningstar Advisor - June/July 2009 - 29
Morningstar Advisor - June/July 2009 - Navigating the SRI Patchwork
Morningstar Advisor - June/July 2009 - 31
Morningstar Advisor - June/July 2009 - 32
Morningstar Advisor - June/July 2009 - 33
Morningstar Advisor - June/July 2009 - 34
Morningstar Advisor - June/July 2009 - Profit and Progress
Morningstar Advisor - June/July 2009 - 36
Morningstar Advisor - June/July 2009 - 37
Morningstar Advisor - June/July 2009 - 38
Morningstar Advisor - June/July 2009 - 39
Morningstar Advisor - June/July 2009 - How the Fed Contributes to Crises
Morningstar Advisor - June/July 2009 - 41
Morningstar Advisor - June/July 2009 - 42
Morningstar Advisor - June/July 2009 - 43
Morningstar Advisor - June/July 2009 - 44
Morningstar Advisor - June/July 2009 - 45
Morningstar Advisor - June/July 2009 - 46
Morningstar Advisor - June/July 2009 - 47
Morningstar Advisor - June/July 2009 - Holding Steady
Morningstar Advisor - June/July 2009 - 49
Morningstar Advisor - June/July 2009 - 50
Morningstar Advisor - June/July 2009 - 51
Morningstar Advisor - June/July 2009 - Appleseed Adds Value to SRI Formula
Morningstar Advisor - June/July 2009 - 53
Morningstar Advisor - June/July 2009 - 54
Morningstar Advisor - June/July 2009 - 55
Morningstar Advisor - June/July 2009 - Four Picks for the Present
Morningstar Advisor - June/July 2009 - 57
Morningstar Advisor - June/July 2009 - Long-Term Investors Can Find Value among Industrials
Morningstar Advisor - June/July 2009 - 59
Morningstar Advisor - June/July 2009 - 60
Morningstar Advisor - June/July 2009 - 61
Morningstar Advisor - June/July 2009 - Higher Yields, Hold the Risk
Morningstar Advisor - June/July 2009 - 63
Morningstar Advisor - June/July 2009 - Bargains in U.S. Industrials
Morningstar Advisor - June/July 2009 - 65
Morningstar Advisor - June/July 2009 - Mutual Fund Analyst Picks
Morningstar Advisor - June/July 2009 - 67
Morningstar Advisor - June/July 2009 - 68
Morningstar Advisor - June/July 2009 - 69
Morningstar Advisor - June/July 2009 - 50 Most Popular Equity ETFs
Morningstar Advisor - June/July 2009 - 71
Morningstar Advisor - June/July 2009 - Undervalued Stocks
Morningstar Advisor - June/July 2009 - 73
Morningstar Advisor - June/July 2009 - 74
Morningstar Advisor - June/July 2009 - 75
Morningstar Advisor - June/July 2009 - Most Popular Variable Annuities
Morningstar Advisor - June/July 2009 - 77
Morningstar Advisor - June/July 2009 - 78
Morningstar Advisor - June/July 2009 - New at Morningstar
Morningstar Advisor - June/July 2009 - Talkin’ ‘bout a Revolution
Morningstar Advisor - June/July 2009 - Cover3
Morningstar Advisor - June/July 2009 - Cover4
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