October 19, 2011

Fragmented Markets Increase Equity Cost of Capital

Did you see the Nicole Kidman film ten years ago called The Others?

A woman becomes convinced her house is haunted. In case you’ve not seen it, I’ll save the twist, but it’s the twist that matters. Things are not as they seem.

Crack WSJ markets writer Tom Lauricella asked in a page one article Oct 18 if markets are cracked. Traders he surveyed said building positions in stocks is getting harder. Liquidity is thin. Spreads are rising. Getting trades done – completing an order to buy or sell shares within projected price ranges – is challenging now in the most liquid names.

In the movie The Others, the problem is perspective. The answer to what’s going on depends on how you look at it. Since we’re limited by the camera and the perspective of the central characters, the reality of the problem doesn’t manifest itself till near the end.

In markets, it seems like liquidity is the problem. But what if it’s a matter of perspective? Classically, liquidity is capital. Today it’s somebody on the other side of the trade. Are they the same? No. What’s on the other side of most trades? A machine. Why is it there? Incentives. It’s not there because it’s committing capital. It’s there because it’s paid to be there.

Don’t believe me? Look up exchange fee schedules and see the difference between rebates for adding liquidity and fees for consuming it. You can Google it.

About ten years ago when The Others came out, regulators decided brokers had too much power. Markets were decimalized and automated to marginalize brokers. The idea was good: Middle men were driving up the cost of investing so get rid of the middle men.

But referees shouldn’t determine outcomes. It’s like the problem in all time-travel movies: The moment you interact with someone, you alter every future outcome. Brokers own most of the dark pools and exchanges. There are TEN TIMES as many middle men now in the form of speculative traders changing prices daily. But exchanges don’t commit capital. Speculators don’t commit capital.

Do you wonder why there’s no liquidity? There is no liquidity because rules and regulations discourage committing capital to match up buyers and sellers, because there’s no profit except in 100-share increments. Add the value uncertainty that flourishes when 100-share trades resulting from incentives set prices for the whole market, and you soon won’t see block trades in AAPL.

Which brings us to the cost on the corporate balance sheet. Calculate your average intraday volatility. You can do it by going to any repository of your historical quotes. Subtract the daily low price from the daily high price. Divide that result by the closing price. The result is your intraday volatility percentage. Do that over 20 days. Average it.

Across our client base, average intraday volatility is over 4%. If you substitute intraday volatility into a common calculation of the equity cost of capital in place of beta, you will arrive at something very near the REAL cost of your equity, based on implied volatility.

You will be stunned.

A top-twenty US public company’s treasury department and we both found real cost of capital between 13-14%. That’s cheap compared to many, where the cost of equity capital is between 20-30%.

What it means in effect is that your stock price is materially lower than it should be because markets today consist not of liquidity – capital – but trading fragments for immediate profit.

In The Hours, the question is who is haunting and who is haunted. The same one exists in equity markets. By driving brokers from markets in the name of lower spreads – thinking that somehow low spreads equal liquidity – we have exploded the cost of equity capital. We have haunted our own markets.

The parties robbed by these rules are investors and public companies. The two most silent participants in capital markets.

How to solve this problem? If your stock doesn’t reflect multiples of cash flows and can’t seem to break out of repeating ranges and loops, it’s not you. It’s the structure. Maybe it’s time to speak up.

The hours tick.

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