What's So Good About an Illiquid Stock?

There’s been a fair amount of research into the subject of liquidity--how many shares a stock trades per day--and its effect on stock-market performance. The studies point to one conclusion: illiquid stocks produce higher returns, on average, than liquid stocks. One of my favorite books, The New Finance: Overreaction, Complexity and Uniqueness by Robert Haugen, discusses this subject at length.

There are a couple of reasons why illiquid stocks tend to do better. First, stocks with low trading volumes tend to be small caps. Many of these aren’t included in any major indexes or covered by Wall Street analysts. They are relatively underfollowed by institutional investors and, all else equal (my favorite caveat), sell at lower PEG ratios than larger stocks. You may have heard the saying "No one ever got fired for buying  IBM (IBM)." Well, these stocks ain’t IBM; many institutions simply will not buy small caps. In fact, larger funds couldn’t buy them even if they wanted to because of their size relative to the fund’s asset base.

Second, because small caps are, typically, younger companies, they have more room to grow without bumping up against the law of large numbers. Theoretically at least, it’s a lot easier for a $100 million company to grow 15% than for a $100 billion company to do so. Think about the difference in incremental revenue needed for growth--it’s huge. The data shows that over long periods of time, small caps grow their earnings faster. All else equal (there it is again), this should result in better stock-price appreciation.

But of course, in the real world, all else isn’t usually equal. Faster earnings growth doesn’t necessarily produce better returns--otherwise, all you’d have to do to beat the market is invest in the hottest new growth mutual fund. No, it’s not earnings growth alone that matters, it’s an expanding P/E ratio combined with earnings growth. Consistently buying companies with P/E ratios that will expand over time is, essentially, the key element of good stock-picking.

The P/E ratios of small caps often expand over time. As a small-cap stock grows, Wall Street analysts may pick up coverage of it. It may be added to an index such as the Russell 2000. And it starts showing up on institutional investors’ radar screens. When these things happen, the stock’s volume increases. And when volume increases, all else equal, the P/E will expand because it’s easier to "get out" if you need to sell at some point in the future. Many investors insist on liquidity for this reason and won’t buy a stock unless they feel they can easily exit their position.

Besides brute size, another thing that brings liquidity is a large share float. And because liquidity often brings a one-time increase in the P/E ratio, companies like to split their stock. In fact, over time, almost all companies split their stock. Even if the company founders are opposed to this policy, you can bet that sooner or later, someone with a short-term focus will be made CEO of the company, and that person will insist on a stock split to help get the price up quickly.

Unfortunately, the more liquid a stock is, the more likely it will attract short-term speculators. This often results in more volatility. Speculators like to trade a lot, flipping stocks like tiddlywinks, hoping to make a few percentage points before moving on to the next flavor of the week (or day).

Some companies would rather not have a large percentage of their shareholder base change from day to day and month to month, so to prevent this, they purposely keep their stock illiquid. These companies buck the trend; they trade like small caps even though they aren’t. The incredible thing is how rare they are.

I did a search in Morningstar.com’s Premium Stock Screener to find out how many companies fit into this category. To do so, I screened for companies with a share price above $200--a good indication that a company has made a conscious decision not to split. The result was astounding--only nine stocks, out of more than 6,600 in our database, sell for more than $200 a share. Almost all of these have performed splendidly over the long term.

That’s no surprise. By keeping their stock relatively illiquid, these companies are sending a signal that they take a long-term view toward increasing business value, rather than pandering to speculators who bludgeon the CFO into doing a stock split whenever the price gets above $50.

In addition to the nine stocks that trade above $200, another 22 stocks trade between $100 and $200. Remarkably, all of the other 6,570 or so trade below $100 a share. Whenever their stock gets close to $100, they split it. In fact, more than 95% of publicly traded companies have a stock price below $50, and more than 70% are below $25.

All nine of these $200-plus stocks are listed below. Morningstar covers six of them. The three we don’t cover are Alleghany , Seaboard (SEB), and Grey Global Group . An overview of these three companies follows. For the other seven, I’ve included links to the Analyst Report on Morningstar.com.

Stocks above $200
Alleghany Corporation 
Stock price: $268
Average daily volume: 7,000 shares

Alleghany is a holding company with interests in several lines of business. Over the past 20 years, its stock price has risen by an average of more than 14% per year. In 2003 about 56% of its earnings came from insurance, mostly property/casualty reinsurance. The firm also owns interests in some mining companies, owns a manufacturer of steel fasteners called "Heads and Threads," and holds various real estate properties in the Sacramento, Calif., area that it sells off periodically.

Alleghany has been around since 1929, and the company’s conservative, nonpromotional nature oozes from every pore of its 10-K. It’s an insurer, so that’s not too surprising, I guess. Its chairman, F.M. Kirby, is 84 years old. Its CEO and CFO are 72 and 71, respectively. These guys have been around the block. And get this: Alleghany splits its stock 102-for-100 every year at the end of March. In other words, for each 100 shares of the stock investors hold, they get two more shares each year. I’m guessing, but I assume this policy was put in place because the management team decided it didn’t want speculators owning the shares, but still wanted to make it a bit easier to trade the stock. According to First Call, no Wall Street analysts cover the company even though it has a market cap of $2 billion.

Seaboard (SEB)
Stock price: $397
Average daily volume: 820 shares

Seaboard, formed in 1928, is a year older than Alleghany. Seaboard raises hogs, markets wheat, corn, soybean meal and other commodities, processes grain, provides containerized cargo-shipping service to over 20 countries, is involved in the production and refining of sugar cane and citrus, and generates electricity for sale by operating two floating barges with a series of diesel engines that generate power off the coast of the Dominican Republic. It also processes jalapeno peppers in Honduras for sale to a single U.S. customer, owns a truck transportation business, and has an equity investment in a winery. Whew!

The Bresky family owns more than 70% of the shares, and mutual-fund company DFA owns another 6.5%. So if you’re a minority shareholder, you have to trust that management will take care of your interests because you have no say in how things are run. The company is also complex and difficult to understand. Additionally, growth has been sporadic and slow. These factors explain why the stock sells at a discount to its book value. Add to this the lack of liquidity and the fact that no Wall Street analysts cover the company, and you have a stock that may have some real hidden value. Unfortunately, we don’t cover it (yet) and I don’t know enough about the company to give an opinion about its suitability for individual investors.

Grey Global Group 
Stock price: $766
Average daily volume: 2,619 shares

Grey, formed in 1917, is older than either Alleghany or Seaboard. This is the only one of the nine $200-plus companies that trades on the Nasdaq, making it the most-expensive Nasdaq stock.

(Sidebar: Can you name the second-most expensive Nasdaq stock? If you know it, e-mail me at mark.sellers@morningstar.com)

Grey is one of the largest advertising agencies in the world, though it’s much smaller than the Big 3 ( Interpublic Group of Companies (IPG),  Omnicom Group  (OMC), and  WPP Group PLC ADR (WPPGY)).  Procter & Gamble (PG) has been a client for more than 40 years and represents 10.6% of Grey’s revenue. While this customer concentration is a risk, it signals that Grey can hold on to clients for a long time. The longer an advertising client sticks around, the more profitable the relationship becomes for the ad firm. Advertising is a great business if you can keep your churn rate low.

As with Alleghany and Seaboard, no Wall Street analysts cover Grey Global.

Here are the $200-plus stocks we do cover.

 Berkshire Hathaway B (BRK.B)
Stock price: A shares: $89,950. Average daily volume: 272 shares
B shares: $2,988. Average daily volume: 12,598 shares

Insurance is the key to the success of this legendary company.

 Markel (MKL)
Stock price: $296
Average daily volume: 18,966 shares

Markel is starting to look like a mini-Berkshire Hathaway.

 White Mountains Insurance (WTM)
Stock price: $517
Average daily volume: 12,146 shares

Management's knack for acquisitions makes us big fans of the company.

 NVR (NVR)
Stock price: $455
Average daily volume: 63,905 shares

NVR's aggressive share-buyback program has led to stock-price appreciation of more than 4,000% over the past decade.

 Washington Post (WPO)
Stock price: $967
Average daily volume: 13,265 shares

Washington Post's education business is booming.

 Wesco Financial 
Stock price: $389
Average daily volume: 2,163 shares

We recommend that investors who want to benefit from Munger's and Buffett's expertise buy Berkshire shares instead.