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How to use stock turnover to improve your investing

Value investors like to use measures such as price-to-earnings, price-to-book-value, and discounted cashflow to buy stocks that are selling for below their intrinsic value. In this article, I will cover an often neglected measure – liquidity, as measured by share turnover.

The definition of share turnover is the percentage of shares on issue traded in a certain time period, be it a day, week, month or year.

Patrick O’Shaughnessy, an author and portfolio manager, has made the point that investing in the 25 stocks with the highest turnover would have returned -61% over the last 30 years. Yep, you read that correctly: $10,000 invested in 1984 would be reduced to a paltry $3,900, over 30 years, if you had always bought the most traded stocks, then sold them when their turnover dropped.

This academic article by Yale Professor Roger G. Ibbotson back tested liquidity-based investing strategies (based on share turnover) from 1971 – 2010. The paper measures liquidity based on annual turnover and finds that “low liquidity portfolios are not riskier than high liquidity portfolios,” except, of course, if you suddenly have to sell your shares. That’s one reason why Foolish investors only buy shares with money they won’t need for the next five years.

The point is this: “For high-value stocks, low-liquidity stocks have a 18.43% return, while high-turnover stocks have a return of 9.98%.” Similarly, “among the high-growth stocks, the low-liquidity stock portfolio has an annualised geometric mean (compound) annual return of 9.99% while the high-liquidity stock portfolio has a return of 2.24%.”

I decided to use daily turnover to assess the liquidity of a collection of ASX stocks in the four months since the beginning of 2014. Let’s meet the candidates:

Cryosite Limited (ASX: CTE) is a micro-cap cryogenic storage company that pays a dividend, has cash on the balance sheet and carries no debt. Its shares don’t trade very often, so I knew its turnover would be low. It averaged 0.03% turnover per day.

I chose XERO FPO NZ (ASX: XRO) because it has had such a volatile share price of late. I averaged just 0.05% per day, which I suppose goes some way to explaining the rapid share price rise. Fear of missing out had holders bidding up the price, with few apparent sellers. Now, reality has kicked in, and the shares have come back by about 30%.

iCar Asia Ltd (ASX: ICQ) owns car sales websites in a number of countries, and is a potential takeover target for Carsales.com Limited (ASX: CRZ). The share register dominated by a single holder, Catcha Group, owned by founder Patrick Grove. Since the start of CY 2014, an average of 0.29% of its shares have changed hands each day.

REA Group Limited (ASX: REA) is Australia’s tech stock darling, owning the popular realestate.com.au. I wasn’t surprised that its turnover was a bit higher, with an average of 0.24% of its shares changing hands each day. That’s quite a bit considering News Corp (ASX: NWS) owns about 60% of the company.

Cochlear Limited (ASX: COH) makes the eponymous hearing implants, and, in contrast to REA Group, is more of a former market darling, with concerns about competition somewhat depressing the shareprice. It’s heavily shorted, but turnover has averaged 0.37% per day. Cochlear remains almost 17% short sold, so based on the average number of shares traded each day, it would take short sellers 50 days to cover, if they bought 100% of the shares traded (and the average stayed the same).

Heavily indebted uranium miner Paladin Resources Ltd (ASX: PDN) had a much higher turnover at 1.07% of shares per day, but even that was dwarfed by Atlas Iron Limited (ASX: AGO) which has averaged share turnover of 1.62% per day since the beginning of this year. Few seem to want to hold the shares for long: they truly are like hot potatoes.

The graph below tracks the daily turnover of the seven companies named above, adjusted for dilution.

Data from Comsec, collated by Claude Walker

Foolish takeaway

No single indicator can tell you whether to buy or sell a stock. However, the high turnover of Atlas Iron and Paladin Resources – more than triple the bigger, more successful companies, should be food for thought. High turnover statistically indicates that a stock will achieve unsatisfactory returns. Logically, people simply don’t sell great businesses very readily – witness what happened when demand spiked for Xero.

If oversupply of uranium and iron ore is not enough reason to steer clear of Paladin Resources and Atlas Iron, then perhaps the high share turnover is. In any event, all investors should spare a thought for Professor Ibbotson’s research, because share turnover can be a useful addition to a valuation process.

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Motley Fool contributor Claude Walker (@claudedwalker) owns shares in Cryosite.