Royalty Investing: Is Liquidity Overrated?

Sep 30, 2014

An Investment in Name Only

In the 1960s, the average holding period for a stock was eight years. Today, stocks are held for an average of five days, according to research from LPL Financial published in Business Insider.

average holiding period for Stocks by Decade

As investing has become less of a marathon and more of a sprint, investors have increasingly gravitated towards the most liquid stocks or ETFs.

Liquidity refers to the ability to quickly turn an investment into cash. Liquid assets are easy to trade and can be immediately bought or sold in large volumes without impacting the price. Short term trading demands highly liquid assets for which there is always a ready market.

And although liquidity can offer a semblance of safety, it's often the illiquid investments, those that aren't priced every day or flipped every month, which offer the alpha investors seek.

Slow Ride: Take It Easy

Just as there is value in diversifying your portfolio by asset type, so can there be value in adding assets of differentiating levels of liquidity.

The point is that, with illiquid or fixed assets such as infrastructure, royalties or real estate, the length of holding period can be the largest determinant of success.

That's especially true with royalty assets, which are immediately income-producing, have negligible holding costs and whose return can never go below zero. They're income streams, not penny stocks.

The most familiar example of an asset that benefits from a long holding period is also most people's biggest investment: their home. One doesn't trade residential real estate like shares of GoPro (GPRO) or Groupon (GRPN). Your home isn't priced every second of every day like the Dow Jones Industrial Average.

Yet despite (or perhaps because of) its illiquidity, residential real estate has demonstrated attractive long-term returns, even taking into account the biggest collapse in housing prices in modern history. If you held, you made money.

Returns on Residential Real Estate
Home price index
S&P/Case-Shiller 10-City Composite Home Price Index, January 1987 €“ March 2014

Here are some stats to consider from the chart above:

Over a 20-year holding period, the average return has been 115.41%.   The worst return you could have achieved over 20 years was 83.92%

Over a 3-year period, however, residential real estate is significantly more uncertain bet. The average return was 17.64%, but the worst was €“a negative -34.91%.

This absence of liquidity is a common concern with music royalties. You can't unload songs from 3 Doors Down and Public Enemy in seconds like shares of Netflix (NFLX) or Alibaba (BABA). Music royalties are long term, income-oriented assets more akin to an annuity or illiquid bond than an actively traded S&P 500 stock.

Keith Shocklee and 3 Doors Down, royalties sold at recent auction
Source: Royalty Exchange, Inc.

Royalties at Auction

However, assuming a music royalty allocation is made with risk capital, the supposed need for liquidity in such assets isn't just mitigated, it's moot.

Next week in Royalty Review: Position sizing.