I gave a presentation the other night and talked about the concept of value investing in general, the trade of the decade in community banks and some other stock ideas that I thought offered a solid value proposition over the next few years. In the Q&A session, one of the first questions was about liquidity. Most of my stock picks are smaller companies and every time I talk about stocks I get this question. I talk to people all the time who seem to think they need instant liquidity for tens of thousands of shares at any given time. This may be the case if you are running a multi-billion pool of money and have the quarterly watchdogs looking over your shoulder, but for those of us with smaller asset pools illiquidity should not be an issue. In fact it can be the very best friend you have.
Warren Buffett once said that if you are not willing to own a stock if the exchange shuts down for five years after purchase, then you should not buy the stock. When I buy a stock I am looking our five years or longer. I have no need to be able to get out at any instant. I expect to sell it the same way I bought it, slowly and carefully. I find that buying less liquid stocks makes me more focused on the initial analysis as well. If I can't get out immediately, I want to make sure I am right about the value of what I own.
Owning less liquid stocks also helps avoid many of the market ills I hear more short-term focused investors and traders complain about. When I buy a $50 million market cap bank stock, I do not have to worry too much about high-frequency trading. Mutual fund managers will not distort pricing with quarter-end window-dressing and I have little concern about what ETF mangers might be forced to buy or sell based on fund flows. I can focus on the fundamentals of the company and how things develop for the bank over time.
The small stock anomaly has been pretty well documented over time and there is a recent study by Robert Novy-Marx of the University of Rochester. In his paper "Quality Investing," he looked at buying stocks with high gross profitability and low price-to-book ratio. He looked at a bunch of different value strategies including Graham-like stocks based on the Intelligent Investor, stocks with high Piotroksi F-scores, and compared performance from 1963 to 2013. When he looks at the large-cap universe, they all do pretty well. The benchmark Russell 1000 runs $1 into $111 over that timeframe, while Graham grows to $218, F-scores to $335, Magic Formula to $364 and the professor's high gross profitability strategy is the winner, growing to $595.
Look what happens when he applies it to small-cap stocks. The benchmark Russell 2000 grows to $269.The small-cap value strategies really catch fire in the smaller, less liquid stock universe. The Graham-based portfolio turns $1 into $1561, high F-scores value stocks grow to $1462, Magic Formula to $1022 and again the high gross profitability approach is the winner, turning that $1 into $1690.
In my own portfolio, the illiquid stocks I have owned over the years have far outperformed the more liquid stocks. The small bank portion of my portfolio has driven returns over the past several years, and many of them are so small they trade by appointment. Banc of California (BANC) at $324 million and HomeTrust Bancshares (HTBI) at $316 million are the larger market cap stock in that portfolio.
I own banks with as little as $6 million in market cap and the average is less than $50 million. In the past five years we have had more than two dozen takeovers, with seven occurring in just the past year. Liquidity was not a concern, even though there are more than a few of these stocks that I couldn't sell if I wanted to most of the time. As long as they are cheap enough and safe enough based on balance sheet strength and loan portfolio quality, I really do not feel the need to have a security blanket of a liquid market.
Illiquid safe and cheap stocks are the very best source of potential profits for individual investors. Thinking more like a private equity investor and focusing on the price and value relationship and less like a Jesse Livermore in the making with a need for massive liquidity should improve the returns for most investors.