Is the liquidity premium turning into a discount?

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.

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Author: Claudio Brocado writes for Seeking Alpha

Image: The Pierre building is seen through a stairway. REUTERS/Adrees Latif