Takeaway: In times of market crisis, transparent firms remain easy to trade. This study looks at liquidity – the cost associated with acquiring or offloading shares of a company – and uncovers a variety of ways in which investors prefer transparent firms to opaque ones.
Suggested Audience: Investor relations and CFOs of public companies, corporate citizenship managers building the business case
Researchers looked at primary exchanges in 37 countries between 1996 and 2008. In total, they made 507,822 firm-month observations over that time period. Transparency was measured as follows:
- Earnings management: The variability of net income relative to cash flows and the correlation between accruals and cash flow (i.e. measures how grounded a company’s financial statement is in cash flow: the more grounded, the more transparent)
- Firm’s auditor: Whether a firm’s auditor was a global and well-known company (specifically, a Big Four accounting firm)
- Accounting standards: Whether the firm reports under either IFRS (International Financial Reporting Standards) or U.S. GAAP (Generally Accepted Accounting Principles)
- Analysts: The number of analysts forecasting the firm’s earnings
- Forecast accuracy: Captures the extent to which analysts are able to accurately forecast earnings
For liquidity, the researchers measured how reactive the price of a stock was to market activity. A very liquid stock could be sold in massive quantities and its price would not fall very steeply. In contrast, the price of a very illiquid stock would fall dramatically if even a small number of its shares were sold. Investors naturally prefer liquid stocks to illiquid stocks, since they represent a more stable trade.
- The liquidity of transparent firms is more predictable (and thus attractive to investors).
- Stocks with greater transparency experience fewer cases of extreme illiquidity – unpleasant situations where it becomes incredibly costly to trade – than more opaque stocks.
- More transparent firms are less likely to experience substantial reductions in liquidity at the same time that liquidity is low for other firms in the market.
- More transparent firms are less likely to experience illiquidity during market downturns, which is precisely when investors are more likely to want to sell shares.
- Each of these preceding observations became more pronounced during market crises: the larger the crisis, the more pronounced the effect.
- The liquidity indicators (liquidity reliability, low risk of extreme illiquidity events, limited relationship with market liquidity, limited relationship with market downturns) were all positively correlated with firm value and with firms that were more transparent.
Stocks of transparent firms are more reliably liquid to trade than stocks of opaque firms. All of these effects attract investors and increase the value of transparent firms.
If citing, please refer to original article: “Transparency and liquidity uncertainty in crisis periods”, Journal of Accounting and Economics, July 2011, Mark Lang and Mark Maffett