November 2, 2010

The Trouble with Liquidity

We can’t compete with beat-by-beat election updates, so we’ll keep it short and sweet.

Speaking of sweet, we came back last night from six days in the desert trinity—Moab, Sedona, Santa Fe. Hard to beat this time of year!

You heard the one about two guys getting robbed? They’re walking down the street, a mugger stops them and demands their wallets. As they’re complying, one reaches in his wallet before handing it over and says to the other, “Here’s that $20 I owe you.”

It may be like that with the obsession over liquidity in the trading markets. By “liquidity” we mean ready shares to consume or sell. The structure of trading markets is built around this concept – enhancing the ready supply of shares. It’s in a sense the idea underneath mandated price spreads in decimals, mandated trades at the best bid or offer, high-speed mathematical trading, and fees for “making” and “taking” liquidity (which simply means consuming it or providing it). The market today is all about liquidity.

We’ve noticed something curious in the data. Low-liquidity stocks can show more frequent rational prices. We define “rational price” as trades that show thoughtful investment dollars competing with other forces to set the stock price.

Side Note: We think the delta between rational price and market price is an excellent measure of effective IR messaging. Wide spread between the two, and you’ve got confusion about investment thesis and risks. Small spread, small knowledge gap, and that’s good.

Back to liquidity, what we’re seeing is that companies with solid messages but trading less volume show stronger rational price-setting. You might say, “Well sure. Less volume, less high-frequency trading, more fundamental investment.”

If that were true, why get big? Once you reach $2 billion in market cap, spin something off public and create another fundamental investment vehicle. Maybe there’s merit to that idea. But the fact is, small caps have 60-70% high-frequency trading oftentimes, just like their large counterparts. And small caps can have the same or even greater levels of program trading. Asset-allocation or model-driven money today picks baskets of shares for total liquidity. It’s easier to move small pieces of many things than big pieces of just a few.

That’s revealing too. Institutions basket-invest in small caps about like they do large caps, data suggest. But they trade around positions more in large caps. Why? It’s what structure offers. Liquidity. The apparent conclusion is that liquidity doesn’t enhance investment, but speculation (now, risk is another matter).

The vast majority of public companies are small-caps. But the majority of IPOS today are large, not small. In essence, the structure from capital-raising through to trading is geared toward transient trading. While we’re incubating fewer small companies today, it’s also a bit of disservice to large companies paying big fees to exchanges. What’s a large cap to do that trades 50 million shares daily but sees little 13F turnover? For one, measure your IR success differently. To our earlier joke, traders are mugging investors whenever they try to collect the $20 that growth should owe them. So to speak.

How to fix it? We might put heads together and propose forming a voluntary equity market where speed and liquidity aren’t the core trading drivers. Who’s in?

Now if you’ll excuse me, there’s an election update coming on.

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