The Cube

Investor-relations is an itinerant profession. We’re on the road a lot.

If you’ve had one of those three-hour flights, say from Denver to Atlanta, in a cramped regional jet (we’ve vowed to avoid them but United interdicts our solemn ecclesiastical commitments), you may utter profanities.

You might also ponder the supply chain. It takes work to match plane to demand so well that a body is wedged into every seat, leaving no logistical slack. Give airlines credit (or the finger) for it.

Like seats on planes, there’s a finite supply of your shares. If long-term holders never sell, who supplies them to new buyers, and how can your owners drive trading volume? The Investment Company Institute (ICI) in 2013 measured median portfolio turnover at 29%, meaning most big investors sold just a third of holdings over the year. Supposing a seller must exist for every buyer, you should see roughly a 7% change in ownership on a net basis in a typical quarter.

Go to Whalewisdom.com and look up your own ticker (or pick one of your choosing).  At the top of ownership data you’ll see net increase or decrease between the two most recent periods (December 2014 to Mar 2015).

There’s a company in Basic Materials, market-cap over $30 billion. The IRO and I have talked about Market Structure Analytics (our proprietary software and algorithms for measuring the composition and price-setting activity behind daily volume).  I checked: Net institutional change period-over-period was 40,000 shares.

Even I, an inveterate student of market mechanics, raised an eyebrow. I went to Google and pulled data for Oct 1, 2014-Mar 31, 2015. The stock traded over a million shares daily and in the period had composite volume topping 163 million shares.

Holy cow. Hidden inside 163 million shares of volume was real ownership-change of a few thousand shares over 130 trading days. They’ve only got 214 million shares out.

“Wait a minute, Quast,” you say.  “You’re looking at this wrong. There’s a lot of musical chairs, people jumping up and sitting down again across those quarters.”

No, that would contradict the ICI data indicating many investors sit on positions. Picture a Rubik’s Cube. (Am I dating myself again?) The multi-colored tiles comprising the puzzle never change.  They just trade places, like your institutional owners. What determines the outcome isn’t fluctuation in tile-count but how tiles are manipulated.

Without Market Structure Analytics, you’re measuring tiles, not what moves them.  Suppose your CEO said, “You’re telling me we traded 163 million shares over two quarters, and the net result of all that movement was 40,000 shares?”

Telling your executives the truth carries a measure of risk, sure. They may challenge you. They’ll ask you questions. The facts about market-function demand a corresponding change in perception and measurement, and you, IR, keep that gate. The alternative is perpetuating a myth. Choose wisely.

Back before we were vacuum-packed like camping rations into aircraft – “we hope you have a pleasant flight” – a lot of airlines went broke.  You leave too much space free and it takes a toll on finance when you’re in the business of moving people around.

Today in the brokerage business, about 30 firms control 90% of volume and half of those are the biggest banks the world has ever seen. The truth is your share-price is set by them.  The supply chain. In the past week 45% of all market volume came from borrowed shares. Indexes trade back and forth with the ETFs tracking them. How that movement nets out at quarter-end is often a random act with no connection to fundamentals.

You’d think the suppliers and the consumers would get together and change the distribution model.  But that’ll never happen so long as the C-suite believes owners set prices. There’s only one constituency capable of changing that: You. The IR profession. It begins with redefining what you tell Management and Boards, so they know the difference between 40,000 and 163 million.

The math doesn’t lie.  But it raises questions deserving answers (which we have—and for which you can get credit!). Ask yourself:  Is an executive team that never asks IR questions better or worse for you – and your value – than one with lots of questions?  Ponder it.

Smart Beta

“Management wants answers when we don’t trade with our peers.” This is a lyric from a song by the rock band Smart Beta.

Just kidding. But Smart Beta is as good a rock-band name as One Direction and each begets the other in the stock market. Because capital-markets globally have become variations on a barcode theme – call it one direction – investors are experimenting with ways to break away.

Just yesterday you could see a currency patina painting worldwide equities, with some Asian markets up equal to declines in European stocks. Then when US shares began trading, ours were both up and down, a sort of global convergence.  As currencies fluctuate, divergences spill into assets denominated by them, feeding short-term arbitrage. It’s still a pattern.

Back to the opening salvo, it’s a routine refrain: “My CEO wants to know why we’re down and our peers are up.”  Patterns vex not only IR folks trying to answer management but the scads of money entrusted to fund managers promising as they all do to “outperform the market.”

Enter Smart Beta.  Some call it “factor-driven investment,” others “strategic beta.” Beta in investment-speak defines comparative performance so smart beta implies better comparative performance. Beta 1.0 defines behavior for the whole market. Figures above or below 1.0 signal a security’s historical tendency to be more or less volatile than broad measures.

We get all that, right? It’s outdated. Beta no longer captures volatility well since any widely traded stock will have thousands of daily prices, the final one the closing price. We prefer to measure intraday volatility.

And our hunt for better metrics is like quantitative effort to break from the Blackrock/Vanguard pack. That’s smart beta. Vanguard itself is toying with the concept through funds like the Vanguard Dividend Appreciation ETF.  Founder Jack Bogle nonetheless scoffs, telling CNBC’s Tom Anderson in a March 2015 story, “Active managers are just trying to come back and say there is a better way to index, when they know damn well there isn’t a better way.” (more…)

25 Basis Points

Whether public companies are winning in the stock market comes down to basis points.

The Buttonwood Agreement formulating the US public equity market in 1792 affirmed in two terse sentences that its parties would charge a quarter-point commission.

Last weekend Jason Zweig wrote about “May Day” for the Wall Street Journal. On May 1, 1975, under pressure from the SEC and Justice Department antitrust lawyers, and seeing a path to reducing market-fragmentation and competition from low-cost platforms like Instinet, the NYSE ended fixed commissions. Many brokers saw doomsday looming and called it “Mayday.”

As Mr. Zweig says, assertions of industry demise proved both exaggerated and misplaced. Volumes boomed, advertising about stock-trading exploded, Charles Schwab created the greatest Everyman brokerage in the history of the profession and here in 2015 the notion that set costs for trading was ever a good one are scorned.

It was called “deregulation” since the rule inked by quill pen May 17, 1792 stating “We the Subscribers, Brokers for the Purchase and Sale of the Public Stock, do hereby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever, any kind of Public Stock, at a less rate than one quarter percent Commission on the Specie value of and that we will give preference to each other in our Negotiations” was rescinded.

Under deregulation has come tens of thousands of pages of rules ranging from exchange order-types that hide shares even though exchanges are markets where shares are displayed, to the structural opus magnum Regulation National Market System decreeing trading at the best national price and dividing consequent data revenue.

When you dine out, what’s a fair tip?  If somebody handles bags for you at the hotel, what do you give them?  In 1792, brokers thought 25 basis points an acceptable fee for finding a buyer for a seller, and vice versa. (more…)

New Answers

What’s the purpose of life?

We want simple answers to complex questions.  Such as when management asks why the stock price is up or down. Since elementary explanations are often incorrect, there’s been a loss of confidence.  “We broke through our moving averages” wears thin with the CEO.

I’ll give you a couple examples. Yesterday an energy master limited partnership trading on the NYSE announced an unchanged cash distribution for the first time in years. This company is known for steadily ratcheting up quarterly outlays to holders.

The stock tanked. Right?  Nope, it doubled the modest sector gains in energy yesterday. Maybe investors thought the company would trim the distribution?  Now we’re speculating because the opposite of what was expected occurred.

We’re also assuming price depends on rational thought, which if the feds now contending a trader spoofing the futures market with placed and canceled trades caused the Flash Crash, is the exact opposite of reality.  Do you know the SEC’s own trading data show at least 25 cancels for every completed trade in stocks of all market-caps (250 per trade in high dollar-volume issues), and over 1,000 cancels-per-trade in big ETFs?

Another company last week dropped sharply amid block volumes, prompting conventional stock soothsayers to conclude big holders were selling. Seems logical, right? If your stock trades 8,342 times daily on average your closing price is the 8,342nd trade.  It’s where the day’s music stopped and useless as a central tendency – and yet closing price is the de facto measure of action (we prefer midpoint price, by the way).

In the 1961 science fiction novel Solaris by Polish writer Stanislaw Lem – made into a 2002 movie starring George Clooney – Kelvin the protagonist questions his sanity. Seeing things that appear real but seem impossibly so, he begins to believe his entire journey may be occurring in his own mind.  To establish a reality baseline he performs some calculations. He reverts to the math.

Back to the stock above, the math showed the opposite of what reality appeared to say. Active value investors had been buyers. When buying stopped, traders abruptly quit lifting prices, prompting a brief plunge. Short volumes, which had jumped 40% in two days, sharply retreated at once, implying block prints reflected short-covering – by the very brokers who’d just filled buys for Value money.  The stock is now trading higher, which would be unlikely if big holders were sellers.

Ah for simple answers – but we don’t live in that world. Which brings us to today. Two vital macro events collide like matter in a particle accelerator: In the morning, we’ll get a first read on US GDP this quarter.  Then later the Federal Reserve via the non-apparitional personage of Janet Yellen will pronounce something about monetary policy.

Beneath the surface the market is on pins and needles. The Fed represents the supply of money, economic growth its cost.  The US dollar has been coming off decade-highs for days now, indicating some see growth drearier than hoped.  In the ModernIR 10-point Behavioral Index, sentiment is still weakly over neutral, meaning investors think whatever happens will be accommodative and therefore helpful to stocks.

But hedging is breathtaking – radically greater in the past five days than any other behavior. Investors are in fact in sharp retreat as price-setters. Effectively, everyone but the Fed has transferred the risk of being wrong to somebody else. Where that hot potato lands will determine the fate of equities. Moves either direction could be large.

Data suggest the economy will offer a limp pulse, perhaps wheezing in below 1% despite expectations from the Fed itself last December of 3%. If the Fed is off by 70% nobody there will get fired, which is good news for the jobless rate.

What’s it all mean? We pine for Easy, Simple. We’re sure as IR officers our shares stand out, and I hear all the time, “My stock is different.”  Like doctors studying angiograms we see the data and say, “You look like the typical patient to us. The good news is that means we’ve got answers.”

The great modern opportunity for the IR profession is the same presented to any generation, scientist, philosopher or explorer challenging convention.  We first face complex reality and then translate it into refreshing value for those we serve.

It’s not simple – but it’s exhilarating. So today, whatever your stock does in response to Janet Yellen’s invigorating oratory and the probable whiff from the economy, ask the question – why? – and if you’re still laboring along the flat earth of old-fashioned perspectives, stop.  Seek new answers. They exist!

Then the CEO will again ask you for them – a measure of value from those you serve.

Chasing Spoofers

Apparently the market is very unstable.

This is the message regulators are unwittingly sending with news yesterday that UK futures trader Navinder Singh Sarao working from home in West London has been arrested for precipitating an epochal US stock-market crash.

On May 6, 2010, the global economy wore a lugubrious face. The Greeks had just turned their pockets out and said, “We’re bollocks, mate.”  (Thankfully, that problem has gone away.  Oh. Wait.) The Euro was on a steep approach with the earth. Securities markets were like a kindergarten class after two hours without some electronic amusement device.

By afternoon that day, major measures were off 2% and traders were in a growing state of unease. The Wall Street Journal’s Scott Patterson writing reflectively in June 2012, interviewed Dave Cummings, founder of seminal high-frequency firm TradeBot. Heavy volume was scrambling trading systems, Patterson wrote, leading to disparities in prices quoted on various exchanges. The decline became so sharp, Cummings told Patterson, that he worried it wasn’t going to right itself. If the data was bad, TradeBot would be spreading contagion like a virus.

Ah, but wait. Regulators now say mass global algorithmic pandemonium May 6, 2010 was just reaction to layered stock-futures spoofing out of Hounslow, a London borough featuring Osterly Park, Kew Bridge and a big Sikh community. If you think the Commodity Futures Trading Commission’s revelry over finding the cause of the Flash Crash just north of the Thames and west of Wimbledon stretches the bounds of credulity, you should.

Mr. Sarao is accused of plying “dynamic layering” in e-mini S&P 500 futures, a derivatives contract traded electronically representing a percentage of a standard futures contract. It’s called an ideal beginner’s derivative because it’s highly liquid, trades around the clock at the Chicago Mercantile Exchange, and offers attractive economics. (more…)

Patterns

Happy Tax Day!  Don’t you wish you could be somewhere else?

Sit at Saba Rock looking north where beyond the earth’s curvature lies Anegada and you know why Richard Branson embraced the British Virgin Islands.

We did too, abandoning electronics including in my case a shaver. From the Soggy Dollar on Jost Van Dyke (named for a Dutch privateer) to Sandy Spit and Sandy Cay and into the azure chop around The Indians off Norman, we let time run a delightful course.

Norman Island is among the reputed inspirations for Robert Louis Stevenson’s “Treasure Island” (which gripped my young imagination), ostensibly eponymous for the pirate Captain Norman, a Briton caught and hung by Puerto Ricans.

Today Norman Island is owned by billionaire Henry Jarecki who in his youth fled anti-Semitic Nazi Germany and later pioneered commodity-futures investing in the USA. His son Andrew recently made film headlines with HBO’s The Jinx on accused killer Robert Durst, the black sheep of the New York real-estate family managing Freedom Tower.

Dr. Jarecki, for years a practicing psychiatrist (still a Yale medical school faculty member) before switching to quantitative futures-trading at his firm Gresham Investment Management LLC, told Wall Street Journal reporter Cynthia Cui in a 2010 interview that both trading and psychiatry are about recognizing patterns. So armed, Jarecki said, you can “transform a modest effort into a grand result.”

How you announce your earnings-date is a recognizable pattern for traders.  One of our clients wrote while I was out, “I know you’re still floating among the virgins but when you reconnect thought you might like to see this exchange I had recently with the quant shop (name removed for privacy but we know and track them)…”

Our client had gotten inquiry from these traders asking when the company would report results. Our client said you’re quants so why do you ask? An analyst there with a Ph.D. thoughtfully responded:

“We are indeed a quantitative firm, focusing in options market making…. Options are typically priced based on the current stock price, a volatility component which characterizes the typical stock price movements possible, and a time component which characterizes how much time the volatility component has to act on the stock. The wrinkle in the problem of option pricing is that volatility doesn’t act uniformly in time; after earnings the stock prices tends to move more than on a typical day. Therefore it is important that we have the correct earnings date in our trading system as soon as it’s publicly available…”

This trading group is profiting in options-volatility, which depends on eliminating price uncertainties including questions about the timing of your earnings. What your company does, your financial results, are irrelevant to the grand opportunity. What matters is the volatility pattern.

This is why we track patterns everywhere in your trading.  We know a great deal about the patterns and we’ve been telling you for ten years now that if you move differently from your peers it’s not about your results but standard deviation, arbitrage, spreads. (more…)

EDITORIAL NOTE: Richard Branson says hello!  Well, I imagine he would if we bumped into him here off Necker Island on the gloriously azure plane of the Caribbean Sea snuggling against the British Virgin Islands. Today would’ve been my father’s 80th birthday had he lived to see it and he said cowboys and sailors were kin, both loving freedom and wide-open spaces. With that spirit, we invite you to ponder the philosophical question below for the IR profession, which first ran Feb 4 this year. I think it’s important.  We’ll be back riding office chairs next week!  Enjoy, and may your soggy dollar always buy a tall Painkiller…

Let me go. I don’t want to be your hero.

Those words strung together move me now viscerally after seeing the movie Boyhood, in the running at the Academy Awards, as I write, for best of the year. I’m biased by the video for “Hero” from the band Family of the Year because it highlights rodeo, something bled into the DNA of my youth.  See both. The movie is a cinematic achievement that left us blurry. The song is one I wish I’d had the talent in youth to write.

As ever for the ear that hears and the eye that sees, there’s a lesson for investor-relations. We might have heard MSCI last week refraining those lyrics – let me go, I don’t want to be your hero – to the ValueAct team, activist investors.

Over the past few years as activism has flourished, many companies have longed to be let go but have benefited from the activist grip. Herbalife and Bill Ackman.  Hewlett-Packard and Relational Investors. Dow Chemical and Dan Loeb’s Third Point.  Tessera and Wausau Paper and a raft of others just off Starboard.  On it goes, all around.

A curious condition has laid hold of stocks in the last number of years. It used to be that results differentiated.  Deliver consistent topline and bottom-line performance, do what you say you’ll do, explain it in predictable cadence each quarter – these were a reliable recipe for capital-markets rewards. Form followed function.

Activism by its nature supposes something amiss – that a feature of the form of a company is incorrect or undervalued, or simply operated poorly. By calling attention like the old flashing blue light at Kmart (have I just dated myself?), activists have often outperformed the market. (more…)

Relevance

I saw this definition for the word “study”:  The act of texting, eating and watching TV with a textbook nearby.

Modern trading markets can cause investor-relations to seem like a nearby textbook, as the following guest commentary illustrates (and that’s no April Fools’ joke).

Special thanks to good friend Ian Richman and colleagues at IR Magazine both for permission to reprint and for the perspicacity to run it in the first place. Ian, President at IR Magazine, doesn’t shy from facts and our profession is the better for it.

I’ll plant this introductory thought (don’t miss the epilogue): If machines are writing the news, reading it and trading your shares, do we keep on doing what we’ve always done and ignore it?

Is IR Obsolete?

Ian Williams, Imation Inc.

Originally at IR Magazine, Mar 23, 2015

Anyone who is not at least mildly worried that computers can trade stocks faster than people can follow the trades is surely on the way to not knowing where their DNA ends and the silicon starts. Neurologists have calculated that the human ‘now’ is about 2.5 seconds long, and events we observe that happen faster than that generate a fuzzy chronology in our minds, so that it is difficult to remember the actual sequence of data inputs – or memories, as they used be known.

When the original joint-stock companies began their sales process, it was mediated at the speed of a fast horse or speedy ship, and a quill pen scratching out the details in copperplate established ownership. But when securities are whizzing round at close to light speed in virtual reality, who owns them at any given moment? Could a security be in a state of superposition like a quantum particle, bought and sold simultaneously?

Did I buy it back from myself before I had sold it to someone else? Is it insider trading if a security has the same owner several times in a nano-second, less time than ‘now’ for a human brain? If the intellectual foundation for the whole premise of the market is that fully informed buyers and sellers are trading to approximate the true value of a security, then what purpose is served by these lightning-fast quantum churnings? (emphasis ModernIR)

The mind-bogglingly tenuous connection between humans and finance is stretched even thinner with the news that the Associated Press now generates its reportage of most quarterly earnings filings without any human intervention. One of the pioneers estimates that the system, Automated Insights, can generate 2,000 articles per second, which is far faster than any human can actually read them. (more…)

Compensation Model

What do you get paid to do?

That’s the question the SEC may soon pose to high-frequency traders, according to a story from Bloomberg yesterday.

“The maker-taker compensation model is very much in the core of what our market structure review folks are looking at,” said SEC Chair Mary Jo White.

If you’re the CFO or investor-relations officer for a public company, you should want an answer too. Because there’s belief silence from public companies about market structure indicates agreement.

Suppose I said, “In one minute, describe your business, its key drivers and how you differentiate yourself for investors.”  I bet most of you could.

What if I asked, “How do your shares trade and where, who trades them, and how are they priced?”

“I don’t even know what ‘maker-taker’ means,” you might mumble.

It’s convention in IR to ignore the stock but that ethos has led a generation of investor-relations professionals to think they don’t need to know how the stock market functions.

“I don’t want my executives watching the stock,” you say.  “If we run a good business, the rest will take care of itself.”

The largest institutional investors in the US equity market, Blackrock and Vanguard, are asset allocators. They’re not Benjamin Graham, the intelligent investor. They track benchmarks because that’s what they’re paid to do.

Active investors are paid to find good businesses, deals, and yet nearly 90% don’t outperform indexes. Stock-pickers are not less intelligent than mathematical models. But they seek outliers in a market that rewards conformity.

Follow me, here. The biggest investors use models, sending trades through the biggest brokers, which are required to meet “best-execution standards,” a wonky way to say “give investors good results,” which is determined by performance-averages across the market – which are being driven by the biggest investors and their brokers.

Thus Blackrock and Vanguard and their brokers perpetuate standards of conformity created by regulators.  Company story becomes secondary to indexes and Exchange-Traded Funds,  investment vehicles dependent on conformity. (more…)

Three Days

Some energy-sector clients lost 40% of market-capitalization in three days last October.

A year and a half cultivating share-appreciation and by Wednesday it’s gone.  How so?  To get there let’s take a trip.

I love driving the Llano Estacado, in Spanish “palisaded steppe” or the Staked Plains. From Boise City, OK and unfolding southward to Big Spring, TX lies an expanse fit for nomads, an unending escarpment of mottled browns and khakis flat as iron rail stretching symmetric from the horizon like a sea.

Spanish explorer Francisco Coronado wrote, “I reached some plains so vast that I did not find their limit anywhere I went.” Here Comanches were dominating horse warlords for hundreds of years. Later sprouted first the oil boom early last century around Amarillo and again in the 21st century a neoclassical renaissance punctuated by hydraulic fracturing in the Permian Basin.

The air sometimes is suffused with mercaptan, an additive redolent of rotten egg that signals the otherwise invisible presence of natural gas. But the pressure of a relentless regimen silts away on a foreshortened compass, time seeming to cease and with it the pounding of pulses and devices.  It’s refreshing somehow.

And on a map one can plot with precision a passage from Masterson to Lampasas off The Llano and know what conquering that route demands from clock and fuel gauge.

Energy stocks in August 2014 were humming along at highway speed and then shot off The Llano in October, disappearing into the haze.

(Side note: If you want to discuss this idea, we’re at the NIRI Tristate Chapter in Cincinnati Wed Mar 18 and I’m happy to entertain it!)

What happened?  There are fundamental influences on supply and demand, sure. But something else sets prices. I’ll illustrate with an example. Short interest is often measured in days-to-cover meaning shares borrowed and sold and not yet bought and returned are compared to average daily trading volume. So if you move a million shares daily and your short interest is eight million, days-to-cover is eight, which may be good or bad versus your average.

Twice in recent weeks we’ve seen big blocks in stocks, and short volumes then plunged by half in a day. Both stocks declined. Understand, short interest and short volume differ. The former is shares borrowed but not yet covered. It’s a limited measure of risk.  Carry a big portfolio at a brokerage with marginable accounts and you can appropriate half more against it under rules.

Using a proxy we developed, marketwide in the past five days short volume was about 44%, which at 6.7 billion total shares means borrowed shares were 2.95 billion. Statistically, nearly 30% of all stocks had short volume above 50%.  More shares were rented than owned in those on a given day. (more…)