the impact of liquidity and free float on stock returns
TRANSCRIPT
THE IMPACT OF LIQUIDITY AND FREE FLOAT ON STOCK RETURNS: EVIDENCE FROM BURSA MALAYSIA
Anthony Lau Tiong Tiing
HG 174 L366 Corporate Master in 2013 Business Administration
2013
Pusat Khidmat Maklumat Akademik UNIVERSITI MALAYSIA SARAWAK
F'.KHIDMAT MAKLUMAT AKADEMIK
1llIlllIllli'iiilll"11111 1000245919
THE IMPACT OF LIQUIDITY AND FREE FLOAT ON STOCK RETURNS: EVIDENCE FROM BURSA MALAYSIA
ANTHONY LAD TIONG TIING
A thesis submitted
In fulfilment of the requirements for the degree of Corporate Master of Business
Administration
Faculty of Economics and Business
UNIVERSITI MALAYSIA SARAWAK
2013
Statement of Originality
The work describe in this project, entitled
THE IMPACT OF LIQUIDITY AND FREE FLOAT ON STOCK RETURNS: EVIDENCE FROM BURSA MALAYSIA
is to the best of the author' s knowledge that of the author except
where due reference is made.
June 21,2013 Anthony Lau Tiong Tiing
Acknowledgement
First of all, the author would like to extend his most sincere appreciation and gratitude to his
supervisors, Assoc. Prof. Dr. Mohamad Jais for his invaluable guidance and constructive
criticism throughout the progress of this study.
Besides that, he would like to express his sincere thank to his course mates for providing
valuab1e idea and suggestion. Last but not least, he also feels grateful to his family members
and friends for supporting him to complete this study.
ii
Abstract
The aim of this paper is to review the impact of liquidity and free float on stock returns of
Malaysian listed companies in Bursa Malaysia. In this study, liquidity is proxied by stock
turnover rate, which is the ratio of turnover by volume of specific stock over total turnover by
volume of the samples and free float is calculated as the ratio of free float market value over
market values of specific stock. Our study makes use of cross-sectional regression framework
using annual1y sample data over the period April 2003 to April 2013. We encounter that
liquidity is positive related to stock return, which is opposed the prior finding in the
researches that are executed by Datar, Naik and Radcliffe (1998), Chan and Faff (2005) and
Chang, Faff and Hwang (2010), but in line with Ramlee and Ali (2012) finding that liquidity
is significant positive related to stock return in Malaysia. The free float is found negative
related to stQck return.
,,
iii
Abstrak
Kajian ini bertujucin untuk mengkaji kesan kecairan dan pengapungan bebas kepada
pulangan saham bagi syarikat-syarikat Malaysia yang tersenerai dalam Bursa Malaysia.
Dalam kajian ini, kecairan diwaki/i a/eh kadar peralehan saham, iaitu nisbah peralehan bagi
saham tertentu dengan pera/ehan bagi jumlah sampel kajian dan pengapungan bebas dikira
dengan nisbah nitai pasaran apungan bebas dengan jllmlah nilai pasaran bagi saham
tertentu. Kajian kita ini menggwwkan rangka kerja regresi keratan rentas bagi sampel data
tahllan dari April 2003 ke April 2013. Kita mendapati kecairan adalah berkaitan pasitif
dengan pulangan saham, di mana ini adalall berlawanan dengan keplltusan yang didapati
dari kajian lepas a/ell Datar, Naik and Radcliffe (1998), Chan and Faff (2005) and Chang,
Faff and Hwang (2010), tetapi selaras dengan keplltusan yang didapati aleh Ramlee and Ali
(2012) menujllkkan kecairan adalah berkaitan pasitiJ dengan pulangan saham di Malaysia.
Pengapungan bebas didapati berkaitan negat~fdengan pulangan saham.
iv
Pusat Khidhlll MaklulOa. Antlemik UNIVERSITI MALAYSIA SARA,WAK
Table of Contents
Statement of Originality ......................... .. .... .. .. .... .................. ....... .. ........ .. ....... .... ........ .. .. ... ........ i
Acknowledgment ... .... ...... .. ............ ... ..... ...... .... ....... ... .. .. ... .. ..... ......... ..... .... ... ........... .... ... ... ... .... ii
Abstract ......... ... ... .. .. .... ...... ... .......... .... .... ... ....... '" ...................... ...... .. .... ..... ........................ .... .. iii
Abstrak .. .. ..... ....... .... .. ... .. .... .. .......... .. ..... ... ... .... .... .... ... ..................... ....... ........................... ....... iv
Table of Contents ... .... .. ... .. ....................... ... .. ... ...... ................................................................... v
List of Tables ........... ... ............................... ... .... .. ... .............................. .. ............... .... ... ... ......... vii
List of Abbreviations .. ... .. .................................. .... ........ .. ..... ......... .... .......... .. ..... ..... .... ..... .... ... viii
Chapter 1: Introduction .. ............................... ............ ........................... .. ..... ............................... 1
1.1 General Overview .. ... ....................... ....... ... .. ... ............................ .. .............................. ... 1
1.2 Background of Study ....................... ..... .. ............ .. ........................... ............. ... ... ... ........ 2
1.2.1 Liquidity .. .. ..... .. .. .......... .. .. ... .... .... ................ ..... .... ...... ........ ........................ .. ..... 2
1.2.2 The Sources of Illiquidity .......... .. ...... .. ........ .. .... ...... .. .. .. .................................... 3
1.2.3 The Measures of Liquidity and llliquidity .......................... .. ............................. 5
1.2.4 Free Float of Share ................ .. ...... ........ .............................. .. .......................... .. . 7
1.3 Problem Statement ... .. ................................................................. .. ................... ... .. .. ... ... 9
1.4 Objective of Study..................................... ... ....... .. ..... ... .. .... ........ ................ ...... .. .... ..... 10
1.4.1 General Objective .. ........ ............ .. .... ...... .... .... .... ....... .. ........ .. ..... ... .... .... .. ......... 10
1.4.2 Specific Objective ................... .. .. ... .... ........ .. ..................... ... .. .... ...................... 10
1.5 Significance of Study ... .. ........................... ....... ............................... .. .. ..... ................... 10
1.6 Scope of Study ............. .... .............................. .... ............................. .. ............... .. ....... .. 11
1.7 Organization of Study .. .... .. ........................... ....... ...... .. ............... ................. .. .... ......... 12
Chapter 2: Literature Review ... ... ... .... ........ .. ... ............ .. ...... .. .. ........ .... ... .... .... .. ... ....... ............. 13
2.1 Introduction .... .. .. ............ ....... .... .... ..... .. .. .. .. ........ .. .... .......................... .. ....... ................ 13
2.2 Related Literature Review in Developed Countries .............................. .. .................... 13
2.3 Related Literature Review in Developing Countries ...................... .. ...... .... ...... .. ......... 17
2.4 Summary ...................... ... .... ......................... ..... .... .... ... .... .. ........ .... ..... ........ .. ... .... .. ..... . 20
Chapter 3: Data Description and Methodology .. .. .......... ...... .. .......... ...... .. .. .. .... .......... ........ .... .. 21
3.1 Introduction ................. ........ .. .... .... ...... ... .. ... .. .. ... ......... ..... .................. .. ... .... ... ............. 21
v
--------------=- ~------ -- -
3.2 Data Description .......................................................................................................... 21
3.3 Theoretical Framework ................................................................................................ 23
3.4 Empirical Methodology ............................................................................................... 24
3.4.1 Fama-MacBeth (1973) Model ......................................................................... 24
3.4.2 Practice the Fama-MacBeth Model to Identify the Impact of Liquidity and
Free Float of Shares on Stock Returns ............................................................. 28
3.5 Hypotheses .................................................................................................................. 30
3.6 Summary ...................................................................................................................... 31
Chapter 4: Data Analysis ......................................................................................................... 32
4.1 Introduction ................................................................................................................. 32
4.2 Data Analysis .............................................................................................................. 32
4.2.1 Descriptive Analysis ....................................................................................... 32
4.2.2 Combined Liquidity and Free Float Related To Stock Returns ...................... 34
4.2.3 Individual Liquidity and Free Float Related To Stock Returns ....................... 37
4.2.4 Global Financia1 Crisis Effect ......................................................................... 38
4.3 Summary ..................................................................................................................... 40
Chapter 5: Conclusion and Recommendation ......................................................................... 41
5.1 Conclusion ................................................................................................................... 41
5.2 Limitation of Study ..................................................................................................... 42
5.3 Recommendation ......................................................................................................... 42
Reference ................................................................................................................................. 44
Appendix 1: t -Table ................................................................................................................ 47
,.
vi
List of Tables
Table 4.1: Summary of Descriptive Analysis for Stock Returns from April 2003 to
April 2013 . . .. .. . .. .... .... .. .. .. . . ...... .. . . . ..... . ..... . . ......... . . . . . . ... ....... .... 32
Table 4.2: Summary of Descriptive Analysis for Liquidity from April 2003 to April
2013 ..... . .............. . .. . .. . . ..... .. .......... . .............. . .. . ....... . . ... .... ... . 33
Table 4.3: Summary of Descriptive Analysis for Free Float from April 2003 to April
2013 .... ... . . . . .. . . .. .. .. .. ... . . . ........ .. . . . ...... ... ... ..... . .. .. .. . ......... . ..... .. 33
Table 4.4: Slope Coefficients of Annually Cross-Sectional Regressions of Stock
Returns on Turnover Rate and Free Float of Share from April 2003 to April
2013.. . . ... ........ .. ..... . . . . ... .. .......... . . ... .......... .. ....... .. .. ... .......... ... 35
Table 4.5: Average of Annual Mean Values for Measures of Liquidity and Free Float
from April 2003 to April 2013 .. ...... .................. .. .... .. .......... .. ........ 36
Table 4.6: Average Slope Coefficients of Annually Cross-Sectional Regressions of
Stock Returns on Turnover Rate from April 2003 to April 2013 .... ........... 38
Table 4.7: Average Slope Coefficients of Annually Cross-Sectional Regressions of
Stock Returns on Free Float from April 2003 to April 2013 ................... 38
Table 4.8: Average Slope Coefficients of Annually Cross-Sectional Regressions of
Stock Returns on Turnover Rate and Free Float of Share from April 2007
to April 2009 .. .................. .. ...... .. ....... .... . . . ......... . .. .... .. . ....... ... .. 39
Table 4.9: Average Slope Coefficients of Annually Cross-Sectional Regressions of
Stock Returns on Turnover Rate and Free Float of Share From April 2003
to April 2013 with Excluding of Years 2007 to 2009............................ 40
vii
List of Abbreviations
AMEX American Stock Exchange
CAPM Capital Asset Pricing Model
HIS Hang Seng Index
IPO Initial Public Offering
KLCI Kuala Lumpur Composite Index
NYSE New York Stock Exchange
OTC Over The Counter
SHSE Shanghai Stock Exchange
SZSE Shenzhen Stock Exchange
viii
L
r- I)
Chapter 1: Introduction
1.1 General Overview
The stock market is one of the main resources for a firm to obtain funds for their further
developments and expansions. We observe the world main exchange markets such as Wall
Street; one of the features that magnetize investors and generate confidence in them is the
liquidity that an exchange can provided, whether there is likelihood for investors that in
admissible time can spend a short period and lowest possible cost to trade their securities with
reasonable price.
Basically, free float is the available quota of the outstanding shares of a listed company,
which is for day-to-day trading by investors. The sum of shares offered for trading, directly
limit the number of buyer and seller that are able to participate in the market. It is important
for investor to understand about the free float of a listed company because it offers an
indicator of the company's stock volatility. Small free float has a tendency to be less liquidity,
which create more complication to match buyers and seller at their desired price and time.
In view of the two issues in consideration of investors (liquidity and free float) and study of
the relation between them can assist investors to better approach the market. Therefore, the
, current research pursued 'to study this relationship by using data on listed companies in Bursa
Malaysia and the systematic way.
1
- - -- - - -- -....."..= ,..".'="""=...................~----~----
1.2 Background of Study
1.2.1 Liquidity
Liquidity has long been a concern for securities investments. Some degree of liquidity is
essential for securities to be traded in the amounts ordered in a timely fashion. The liquidity
that an exchange provided usually refers to the easiness of converting an asset to cash, which
can be sold immediately after purchase without suffering any losses due to price discount and
transaction cost.
Whenever an investor considers a potential asset investment, he will consider very carefully
the ability to resell, cost to trade and selling price in the future. These determinations
implicate the liquidity of assets and affect the future cash flows, so it ought to be a significant
factor in asset pricing.
Damodaran (2005) related the pnce of illiquidity to the pnce of buyer's compunction;
sometimes, when investor buys an asset or a business, he faces remorse that he wants to
reverse his decision and sell what he just brought.
. Obviously, it matters what asset we buy. If we buy a treasury bills or government bond, we
would be able to sell it immediately with almost no costs. On the other hand, resell a small
2
..
private unlisted company's share will need a longer time to search for potential buyer and can
be costly.
There are different degrees of liquidity with stocks. The most liquid are those heavily traded
stocks in widely held companies in developed markets. Conversely, the stocks in companies
with a small float and lightly traded are considered as less liquid stocks.
1.2.2 The Sources of Illiquidity
According to Amihud, Mendelson and Pederson (2005), the sources of illiquidity consist of
exogenous transaction costs, demand pressure, inventory risk, asymmetric information and
search frictions.
a. Exogenous Transaction Costs
The trading expenditure such as brokerage charges, order-processing charges and transaction
taxes will have direct effect on the profit of trader; both the seller and buyer may possibly
affected by exogenous trading charges. This can be characterized as a source of illiquidity as
these costs promote frictions in the capital markets, they will affect the investor's dealing
price. If the transaction is not carry out completely with themselves over open market orders,
these various transaction charges will also be revealed in the bid-ask price that quoted by
market markers or dealers. The dealer will account for the costs when quoting the prices.
3
b. Demand Pressure
The demand pressure or price impact demonstrates the possibility of investor to sell big
quantities of an asset instantly and without cutting the price. However, when stocks are not
perfectly liquid, a large trade can cause a shock to the equilibrium between supply and
demand. There is a probability that the investor would not be able Ito perform the trade at the
current market price, because there will not always be a present buyer and the investor might
need to ask for a lower price if he needs to liquidate the assets. Thus, large order can result in
price change. The price change will be negative when investor places a selling order and
positive for a buying order. The smaller the price impact the more liquid the market for the
stock.
c. Inventory Risk
The inventory risk is closely related to demand pressure. Sometimes, an investor could catch
in a situation where he could not found a buyer for an asset that need to be liquidated
immediately. Instead of waiting for a buyer, he is selling to a dealer. This dealer, who holds
the inventory, is bearing the risk that the security price will drop. To compensate this risk, the
dealer will quotes bid and ask prices in which the present value of the expected future losses
is covered.
d. Search Frictions
The search frictions are another source of illiquidity. In the "over the counter" (OTC) market,
where there is no centralized market and investors trade bilaterally; when a trader needs to sell
4
Pusat Khidmat MaklulIlat Akad~lllik UNIVERSlTI MALAYSIA SAIlAWAK
his stocks, he must initially search for counterparty that willing to buy. After the potential
counterparty is located, the trader will need to negotiate the price. If the negotiation failed,
they have to find for other counterparties. Further to that, the intermediaries could have the
market power, allowing them to earn fees, which translate into trading costs for investors.
Under certain conditions, search frictions increase the liquidity premium (i.e., lower prices)
and increase bid-ask spreads.
e. Asymmetric Information
The asymmetric information as a source of illiquidity relates to the fact that dealing with
acquainted counterparts can be costly. The transaction with the counterpart that has private
information will create a loss. There is a situation where an agent has private information
about future large order that is expected to affect the price of the stock. Trading on such
private information is profitable. Trader will care about this risk, which the trading
counterpart possibly wills has superior information. This is what actually creates the adverse
selection and the illiquidity contribution from asymmetric information.
1.2.3 The Measures of Liquidity and Illiquidity
In the following, some of the widely used alternates for liquidity, illiquidity and the cost of
illiquidity will be presented. Briefly, liquidity can be measured using the elements of the
s urces of illiquidity r~viewed above.
5
- . -- --- - - ----~------ --.... -
a. The Bid-Ask Spread
Most of the sources of illiquidity mentioned above are the drivers of the bid-ask spread. The
more illiquid the stock the larger the bid-ask spread. The bid-ask spread is the spread between
the price that a stock is sold (bid price) and the price that it is purchased (ask price) by the
market marker. This spread is a result of the fact that dealer wants to compensate the
transaction costs, the inventory risk and the risk of dealing with informed counterparts.
b. Amihud's ILLIQ-measure
In previous discussion, liquidity demonstrates the possibility of selling large amounts of an
asset immediately after purchase without cutting the initial price. Hence, an appealing
measure of illiquidity is a measure of the sensitivity of prices to the traded volume. Amihud
(2002) introduced such measure, which refers as the Amihud ILLIQ-measure.
c. The Turnover Rate
A widely used alternate for liquidity is the turnover rate of stock. It is simply the amount of
securities exchanged over a period divided by the amount of securities outstanding during that
period. This is a fundamental measure, as it basically states how many times the outstanding
equity switched hands during a period.
6
d. Option Pricing
Longstaff (1995) modeled the value of liquidity as the price of an option on the underlying
stock. The general idea is that it is important to know how to sell a stock. The value of an
option escalates with the time to maturity. This is explained in the Longstaff model, the cost
of illiquidity rise with the duration of time that the stock cannot be sold.
e. Block Trades
Block trade is an order in which a significantly large number of shares in the company are
traded. Prior studies have been carried out to investigate the price reaction to this block trade.
This price reaction provides a reference on the level of liquidity for that stock.
f. Restricted Stock Offerings
Several studies have resolved the illiquidity discount by investigating the restricted stock
issues. Restricted stocks are the stocks, which are restricted for trade within a period of time
and often one year after the issues. These restricted stocks are sold at a discount price that is
lower than the regular traded stock. The variance between the restricted stock price and
rdinary stock price can be measured as an illiquidity discount.
1.2.4 Free Float of Share
Free Float is sometimes referred as float or public float. It is usually described _ as all the
shares that are available for trading in public equity markets by investors, other than restricted
7
--------- --- -- -----==---:---~-=-------------
shares owned by strategic shareholders such as the company directors, officers and other
various insiders. Because of those restricted shares are expected to be held on a very long
term basis, so it is excluded. For an example, a company has total outstanding shares of 9
million; 3.5 million are restricted shares, so the free noat would be the remaining 5.S million
shares that available for trading. It is a measure of how many shares are reasonably liquid.
Free Float is helpful to prospective investors because it offers perception of the company's
stock volatility. Stocks with small free float tend to be low liquidity and more volatile because
only a restricted number of shares that can be bought or sold in the event of major trading
news. As such, investors may face a difficulty to trade their shares on the stock exchange and
may not be able to obtain a good deal as the spread, which is the variance between the buying
and selling price for shares with small free float is likely to be significant. For the same reason,
companies with targer free floats are generally less volatile.
Furthermore, any counters with small free float that has a major shareholder in it, leads the
threat of being transferred private by the shareholder when the stock market depressed. This is
due to the share price is likely to be low when market depressed and any privatization attempt
will be much cheaper. As such, the shareholder is not possible to offer great price to purchase
the hares that retain by the public. The investor that purchase the stock with high price may
forced to receive a shortfall during such a privatization attempts since the offer price may
below the initial purchase price.
8
_ --- ---- -
Therefore, investors prefer to invest in stocks with large free float as they can purchase or sell
a significant number of shares without heavily impacting the share price.
1.3 Problem Statement
Liquidity and free float of share are especially important for investors because it will
determine the easiness of converting their purchased shares into cash without suffering any
losses due to price discount and transaction cost, and also the trading of the significant
number of shares will not create heavily impact to the share price.
The question on what is the correlation between liquidity; free float of share and the expected
stock returns is difficult to answer without doing a study to investigate the problem. The
relationships between liquidity and stock returns have received a number of interests. Studies
in developed countries by Datar, Naik and Radcliffe (1998), Chan and Faff (2005) and Chang,
Faff and Hwang (2010) among others have find the evidence of negative correlations between
liquidity and stock returns. However, the studies in developing counties show a mix result.
Besides that, there is not much study on the relationship between free float of share and stock
returns.
,.
---------=,....-:---,--,-------= ....=
9
1.4 Objective of Study
1.4.1 General Objective
The motive behind the study is to investigate the impact of liquidity and free float to stock
returns in Malaysia stock market.
1.4.2 Specific Objective
The specific objectives of this study are as follows
• To identify the liquidity and free float with reference to stocks
• To measure liquidity and free float in scientific method.
• To investigate the correlation between liquidity, free float and stock returns based on
sample of Malaysia publicly traded stock.
1.5 Significance of Study
Numerous researches have focus on the relation between liquidity and stock returns. However,
there are small number of researches were conducted by the Asian data. Current empirical
findings suggest that some emerging Asians are different to those developed markets.
Furthermore, there is also not many study is investigating the impact of free float of share to
stock returns. Thus, in order to spot the root of these benefits, the study that is designed to ,
investigate the role of liquidity and free float in pricing stocks in Bursa Malaysia in details is
substantially needed as a point of Asian study.
10
In addition, it is hopefully that this study will provide some useful information to investment
practitioners, academicians and other researches where:
1. It provides knowledge on the relationship of liquidity and free float of share with expected
stock returns in Malaysia stock market. Understanding the correlation between these
variables is important for investors and fund managers in their investment decision and
risk management.
2. It provides reference to the further study on the topic of liquidity, free float of share and
stock returns in Asian market and developing countries.
1.6 Scope of Study
The focus of this study is on the role of liquidity and free float of share in stock returns. The
data sampling for this study comprises 408 companies shares published in Bursa Malaysia
from April 2003 to April 2013.
For the purpose of this study, yearly data on turnover by volume, free float market value,
market value, share price and dividend per share of each company are used to determine the
impact of liquidity and 'free float of share to expected stock returns.
11
1.7 Organization of Study
This study is structured into five chapters. Chapter 1 presents the general overvlew,
background of study, problem statement, objective of study, significant of study and scope of
study.
Chapter 2 contains the literature reviews on developed countries and also on developing
countries. This chapter summarizes the relevance past literature on the subject matters.
Chapter 3 explains the data and methodology used in this study. It includes a description
about the data, data sources and the instrumentation used. Brief explanation on econometrics
methodology adopted is also discussed in this chapter.
Chapter 4 discusses the findings of the analysis for this research. The data will be interpreted
and elaborated in order to achieve the objective of the study.
Lastly, Chapter 5 highlights the key findings and conclusion developed from the research
findings. Besides that, some recommendations will also be stated as the guideline and
suggestions to be considered for future study on related topic.
12
Chapter 2: Literature Review
2.1 Introduction
In this chapter, the related literature review of this study in developed countries such as
America, Australia, Japan and Hong Kong, and also in developing countries like China,
Vietnam, Iran and Malaysia will be presented.
2.2 Related Literature Review in Developed Countries
Amihud and Mendelson (1986) were the first to conduct a study on the role of liquidity in
asset pricing. They evaluated the hypothesis following the methodology of Fama and
MacBeth (1973) for cross-sectional regressions . They applied this methodology to observe the
correlation of rate of return, market risk and spread for stock portfolio. These portfolios were
created on the basic of individual stock betas (market risk exposure) and the relative bid-ask
spread of the stocks. The data sampling for their study comprises the shares published in
NYSE1 from year 1960 to 1980.
Through the tests, they notice that the slope coefficients of the spreads are positive and
generally decreasing for higher spread. This result denotes the concave relationship of return
spread and reflects the lower sensitivity of long-term portfolio to the spread.
I New York Stock Exchange
13
Datar, Naik and Radcliffe (1998) tested the impact of liquidity to stock price usmg the
turnover rate, which is given by the number of shares trades as a fraction of the number of
shares outstanding. Basically, they used the same methodology as Amihud and Mendelson
(1986), but add in the book-to-market ratio of the stocks. In this study, the analysis is based
on the individual stocks rather than portfolios of stocks, monthly data for all stocks of non-
financial companies on NYSE from July 1962 to December 1991 are collected.
They encountered that there is a significantly negative relationship between liquidity
(turnover rate) and stock returns. This is in compliance with the theory that less liquid stocks
should yield higher returns to offset the higher degree of illiquidity. Hence, a stock with low
turnover rate should yield a return premium.
Chan and Faff (2005) investigated the role of liquidity as proxy by the share turnover rate in
stock pricing in the framework of Fama and French (1993) model. Just as Amihud and
Mendelson (1986) approach, the dependent variables of their analysis are the return of
portfolios of stocks rather than individual stocks. The independent variables are mimicking
portfolio derived from the size, book-to-market and liquidity factor. This approach is
established from the leading study of Fama and French (1992) . The Monthly Australian data
for the period from 1989 to 1998 were used in this study. \
14
----~========---=--~-= -~-- -