Monday, April 8, 2013
If your favorite holding period is forever...
[This is a continuation of my post on liquidity adjusted equity valuation.]
If your favorite holding period is forever, then today's stock markets just aren't meant for you.
As I pointed out in my previous post on stocks and liquidity, stocks can do more money-ish and cashlike things than in times past. For most people, the ability of stock (or any other good or asset) to be easily-exchanged is desirable since it ensures that come some unforeseen event, that stock can quickly be swapped for more suitable items. We can think of easily-exchangeable stock as insurance against uncertainty. Investors estimate the stream of 'expected comfort' or 'uncertainty alleviation' that a stock's degree of exchangeability will provide, discount these streams into the present, and arrive at some value for the liquidity return provided by a stock. The more moneylike or liquid a stock, the higher its liquidity return.
A stock's liquidity return makes up but one bit of a stock's total expected return. The other bit is the risk-adjusted real return, or the stream of dividends and price appreciation that a stock provides. When an investor buys a stock, they're getting a 2-in-1 deal. They're buying a real return and a liquidity return. The all-in price paid for a stock is a sum of the prices investors put on the value of these two different return streams.
It's for this reason that modern stocks are not an ideal investment for value investors, the species of investor whose favorite holding period is forever. While most people appreciate the 2-in-1 deal provided by equities, the ability to easily resell a stock is pretty much worthless to a value investor. In order to enjoy a stock's real return stream (dividends plus price appreciation), a value investor must endure having that stock's liquidity return, which to them isn't worth a dime, forced down their throat.
Here's an analogy. Imagine that you're shopping around for a bare bones car. Unfortunately, the only models available have leather upholstery, oak trim, and a rear seat champagne cooler. Either you pay up for what you see as useless options or you walk away from the lot without a car. This is the same world that Warren Buffet type value investors face every day. Like it or not, they've got to buy stock with all the bells and whistles, even though they put zero value on these extras.
In the real world, a car dealer will let our car buyer strip out the oak trim, the champagne cooler, and the rest of the options they don't need until they arrive at a pared down car package that suits their needs and falls within their budget. Why not do the same in the stock market? Why not allow Buffet-style value investors to strip out the liquidity return of a stock so that they can own a pure real stream of returns?
The way to do this is to establish 'moneyness markets' for equities. In moneyness markets, the liquidity return of a stock is severed from the stock's real return and put up for auction. A value investor would be able to simultaneously buy a stock, sell off the stock's moneyness, or the right to enjoy that stock's liquidity, and be left holding a perpetually non-tradeable chunk of equity.
In doing so our investor has now effectively committed herself to an indefinite holding period. She will continue to earn dividends and enjoy price appreciation (or not), but she has limited her exits to either a cash takeover, the unwinding of the company, or a repurchase and cancellation of shares by company management. Gone is the traditional avenue for exit, the secondary markets.
In constricting her exits, our value investor is no worse off than before since her preferred holding time, moneyness market or not, was always forever. Indeed, moneyness markets have allowed her to improve her position. She has achieved the same final allocation that she would have without such markets, a perpetual long position in a stock, but she has succeeded in reducing the purchase price of her stock by auctioning off an option on which she placed no value whatsoever.
Let's say our value investor has a change of mind. Perhaps the circumstances surrounding a company in her portfolio have worsened and she no longer considers its shares worthy of an eternal holding period. Or maybe her personal situation is less stable and she wants to improve her ability to sell out should some unforeseen event occur. To return to a more liquid state our value investor would have to wade back into the moneyness market and repurchase the option to sell her stock. Put differently, she'd have to pay a fee to recapture her stock's old liquidity return.
How much would she pay to have these restrictions lifted? To restore her ability to freely trade in shares she'd have to pay others an amount sufficient to compensate them for being indefinitely deprived of that very same ability. This is the moneyness market.
This stock market story could be an allegory for all markets. Anyone with an indefinite holding period will usually overpay for things because most active markets are 2-in-1 markets. The asset being sold provides a real return and a liquidity return, whereas so-called "value" buyers typically only want the real return. Moneyness markets in everything would be a way to sell off the liquidity return so as to ensure people achieve the allocation they desire, at the right price.
Over the next few weeks I hope to sketch out a few related posts dealing with the following rough ideas:
1. When a stock trades at a high multiple to earnings, is this because the stock has an excellent liquidity return or because it is genuinely overvalued relative to its earnings power? Without equity moneyness markets, it's difficult to be sure. With these markets, value investors would be provided with the full range of liquidity price information necessary to decompose real returns from liquidity returns. Liquidity-adjusted earnings metrics would lead to greater accuracy in the pricing of equities, and along with more accurate prices would come a greater degree of precision in capital allocation.
Because they like to buy when everyone is selling, value investors are some of the market's best natural stabilizers. Without moneyness markets, the ability of value investors to efficiently price assets is limited as as their wherewithal to participate. Introduce these markets and value investor's capacity to contribute to market stability expands.
2. While fundamental investors would be sellers of moneyness, I've been a bit circumspect who the buyers would be. Intertwined with this is the question of how to construct an equity moneyness market. Over-the- counter or a central clearing house? Would the terms of a moneyness contract be perpetual or would we see 1, 2, 5, 10, and 30 year moneyness contracts? How well would such a structure port over to housing, fixed income, commodity, and goods markets?