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?


  1. This sounds like a very cool idea so I want to make sure I pin it down. I'm not sure I get what the severing of the investment from the investments liquidity would look like, or more exactly, what would the liquidity portion look like?

    By moneyness and liquidity premia, do we essentially mean the right to sell? This sounds a lot like a put option, except one where the seller of the put option wouldn't have to tender his stock or an equivalent monetary value given a certain future state, he just has to hold it no matter what.

    The owner of the put holds it because he wants to either hedge a bet or thinks it will expire in the money and thus receive a capital appreciation. What is the owner of the title to a stocks "moneyness" buying, or what is he hedging against/betting on?

    Is he somehow able to transform an illiquid part of his portfolio into something more liquid? I don't understand how the mechanics of this would work... I think this might be more likely -

    Is he able to short the stock without paying the borrowing fees, and thus more able to make a long term short bet? Or from a social perspective, not artificially increase the supply of a stock by his shorting?

    (An aside: It is now suddenly starting to sound like a fractional vs. full reserve banking type of argument)

    If THIS is the case though (now here some really not well thought out speculation begins), then the "liquidity premia" could possibly be parsed out of the data by looking at borrowing costs on shorts as they should be comparable.

    I don't know if this is at all what you had in mind, but regardless, this could be a way to make shorting a much less controversial financial activity

    1. John, good comments.

      "By moneyness and liquidity premia, do we essentially mean the right to sell?"

      Yes, that's how I see moneyness. It's a bit like owning a put option, except put options usually have strike prices. Moneyness is the right to make your best effort to sell something in the future, though the price that you receive isn't guaranteed. It is related to the ease and speed at which you can resell something.

      I was going to get into the structure of it it next post, but the way I see the mechanics working is that a stock owner deposits a stock for some fixed term at a clearinghouse. The owner still gets all dividends, votes, and capital gains/losses, but they're locked in for x years. The clearinghouse is free to use the borrowed stock for whatever purposes they wish and will pay the stock owner a fee for this benefit.

      This is a similar concept to what happens in a traditional short, so you're right when you say that we can get a rough idea of liquidity premia by parsing borrowing costs on shorts. The difference is that a traditional stock loan tends to be immediately callable and is collateralized by cash/t-bills. To properly measure the term structure of moneyness you need a range of terms (1, 2, 5, ... 20 year) + no collateral.

      Anyways, this is all in brainstorming stage, so nothing I say should be used or held against me ;)

    2. I'm trying to think of the social functions this might perform.

      With some rudimentary supply-demand analysis, it seems that buy-and-holders actually make the stock market more volatile. By taking shares and never drawing them out of inventory, the supply and demand curves have less quantity to work with and thus become more vertical and inelastic. Would this make the supply curve more elastic, and dampen volatility in shares?

    3. Yes, thinking about it in terms of a demand and supply curve is one way to go about it. Stock is a 2-in-1 good. There are separate demands for the real component and the liquid component of a stock but they get expressed in the same demand curve.

      If the demand for the liquid component rises, then the stock's price will jump. If buy and hold investors are able to price and sell just the liquidity component of the stock (while keeping the real component) then they would be able to "fortify" the supply curve for the liquid component of a stock.

      So yes, I agree that this could dampen volatility. Specifically, it would help in liquidity crisis. Value investors would be able to act like lenders of last resort to the market, much like a central bank.

  2. My impression was that this is all about the fact that a halving in price needs to be followed by a subsequent doubling in order to get back to where you started BUT half of $100 is a $50 loss whilst doubling $100 is a $100 gain. So if you rebalance across a collection of securities with prices that are randomly bobbing up and down you capture that volatility and convert it into gains. Securities need to be liquid if you are doing this on a frequent basis without trading costs being onerous.
    Basically a asset with a price that randomly bobs up and down is inter-convertable with one that pays a cash flow.