the impact of liquidity and free float on stock returns

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


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


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


Stock Returns on Free Float from April 2003 to April 2013 ................... 38


Stock Returns on Turnover Rate and Free Float of Share from April 2007

to April 2009 .. .................. .. ...... .. ....... .... . . . ......... . .. .... .. . ....... ... .. 39


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

----~========---=--~-= -~-- -

the impact of liquidity and free float on stock returns

Documents