Monthly Archives: February 2013

The Definition Of A Must Read

If you care about investing at all, I implore you to read the 2013 Credit Suisse Global Investment Returns Yearbook.

The section on “low-return world” deserve special attention and should be required reading for anyone who ever mentions “asset allocation”, “expected rate of return” or “retirement planning”.  I fear there are far too many firms/advisors/products still basing future estimates off US bond/equity returns from the past 70 years, an environment that is not only very different from where we are today, but was also one of best investing environments ever recorded.

Also make sure to read the section on “Mean reversion” and the results of their walk-forward testing on mean reversion of valuation ratios.  Their conclusions may change the way you react the next time you are presented with an extremely well written and researched piece discussing a market’s extreme over/under valuation.

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Tick Sizes Are Not The Problem

On the day that Dell announced it is becoming a private company, the SEC is holding a roundtable to discuss tick sizes in the securities markets. This discussion is mandated by the JOBS act passed last year and is based on the theory that the substantial reduction in the number of public companies and IPOs is due to SEC changes to the securities markets microstructure.

In 2011 the Treasury Department created an IPO “Task Force” to generate recommendations on how to generate more IPOs. There primary results were summarized as (quoting from the report):

According to the IPO Task Force Report, the impact of decimalization has been twofold.  First, market structure changes associated with decimalization favor short-term trading strategies over long-term fundamental strategies.  For smaller public company stocks with lower liquidity, the lack of fundamental strategies results in trading volume that is too low “to make money for the investment bank’s trading desk.”  The IPO Task Force Report argues that this lack of profitability undermines the incentive for underwriters to take smaller companies public.”

Translation – Investment banks are not making as much money trading small cap stocks due to lower spreads so they do not want to facilitate an IPO and collect 6% of the dollar amount raised.

If this were the case, why wouldn’t investment banks just raise their IPO fee to a level that made it worthwhile to facilitate an IPO?

“Second, the IPO Task Force Report states that “decimalization . . . put the economic sustainability of sell-side research departments under stress by reducing the spreads and trading commissions that formerly helped to fund research analyst coverage.”  The IPO Task Force Report also argues that analyst coverage has significantly shifted away from smaller capitalization stocks towards highly liquid, larger capitalization stocks, reflecting the change in financial institution focus.  In particular, the IPO Task Force Report suggests that analyst coverage of smaller public companies has become unprofitable both because of the Global Analyst Research Settlement in 2003, which prohibited the direct compensation of research analysts through investment banking revenue, and the advent of decimalization, which reduced spreads that formerly helped fund analyst coverage.
Thus, the IPO Task Force Report concludes, less analyst coverage of smaller capitalization companies means that less information on these stocks is generated, which, in turn, reduces market interest in these stocks.”

Translation – Investment banks are not making enough money trading small cap stocks to pay analyst to publish research on these companies.  No one outside of Wall Street analysts has any economic incentive to do any independent analysis on these now inefficently priced assets, so no one wants to trade the stocks.

It is difficult to imagine that the thousands of hedge funds, mutual funds and other buy-side institutions that collectively employe tens of thousands and analysts and quantitative researches striving to maximize performance are ignoring a large percentage of potential investments due to a lack of Wall Street provided research.

“Prior to the IPO Task Force Report, in a paper released in June 2010, Grant Thornton also concluded that decimalization has had a negative effect on the equity markets, and characterized decimalization as a “death star.”  The paper argues that decimalization almost eliminated the economic incentive to trade in small capitalization stocks, taking “96 percent of the economics from the trading spread of most small cap stocks – from $0.25 per share to $0.01 per share.” The paper also asserts that decimalization, combined with other innovations such as an increase in online brokerage, was significantly more damaging to the IPO market than oft-criticized provisions from the SarbanesOxley Act of 2002. As with the IPO Task Force Report, the Grant Thornton paper argues that increasing the tick size for smaller capitalization stocks will encourage financial institutions to spend more resources to analyze these stocks.”

Translation – the 96% reduction in the cost of trading small cap stocks has made them less attractive to investors.  Everyone would be better off if it cost 20x as much to purchase a small cap stock and that extra money was used to subsidize Wall Street “research” – without which no one will trade these stocks anyway.

I wonder if any of the subsidized “research” that there is no longer money for ever tried to make the argument that a company’s product would be less attractive to potential customers if it’s cost was reduced 96%?

The underlying theme of all these arguments is they are solely looking at the world from Wall Street’s perspective.  Every major argument centers around the lack of trading profits for Investment Banks and Market Makers on the secondary market and the lack of extra profits to subsidize research.  The report goes on to do an exhaustive analysis of other secondary market statistics such as effective spread, market vs limit orders, volatility and market maker participation / profitability.  Again, all things Wall Street cares about.

Nowhere in this report or in any of the agendas for the roundtable discussion does anyone look at this issue from the perspective of either a public company or a private company considering an IPO.  Everything is around increasing trading profits and subsidized research, to the benefit of Wall Street.  This model may have worked well when companies did not have other options, but since the late 90’s the rise of private equity, private secondary markets and other forms of private capital have given companies many alternatives to Wall Street.

For Wall Street to attract companies back to the public markets it needs to stop focusing on the minutiae of secondary market tick sizes and start asking the hard questions about what benefits the public markets provide a company versus the private finance alternatives.

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