Retail Voters and Insider Traders
I confess that people who invest by buying shares of individual stocks, in 2017, are a little mysterious to me. I don't mean hedge-fund managers who pick stocks for their funds, I mean dentists who come home after a long day of dentistry, log into their Fidelity accounts, and look up the price-earnings ratios of a bunch of tech stocks so they can pick one to buy for their personal account. That activity seems to be in long-term decline, as more people put their money in index funds or exchange-traded funds or robo-advisers. This is sometimes described as a rise of passive investing, but it is also just the basic modern economic movement to increased specialization. In the olden days you grew your own wheat and churned your own butter and sewed your own clothes and bought your own stocks, but now you have people or robots to do all of that for you, and you can concentrate on your dentistry.
But this is an idiosyncratic bafflement of mine, and millions of retail investors still do trade individual stocks, and hey that's great, more power to them. There's a charmingly American optimism to it, the belief that by doing a little online research you can become smarter than the people who work full-time in the investment industry, and use your advantage to become rich.
On the other hand, it is doubly baffling to buy individual stocks and then take the time to vote your proxies. Buying the right stocks really can make you rich. Voting the right way on shareholder proposals for more board diversity can't. I mean, maybe a little: Many shareholder proposals are intended to improve the operations of the company and increase its share price, and there's some chance you'll be the deciding vote. But the effect is likely to be marginal, your vote probably won't be decisive, and at some point you have to choose rational ignorance. There are only so many hours in the day, and you have stocks to pick and teeth to pull; you can't spend all your time reading the academic literature on the effects of board diversity on corporate performance.
That opinion, at least, seems to be shared by most retail investors. Here is Gretchen Morgenson:
Voting is just too hard for retail investors, said Jill E. Fisch, a professor at the University of Pennsylvania Law School, and co-director of its Institute for Law and Economics. “It’s not surprising that they often give up,” she added. “As a result, there’s a group of investors that corporate managers aren’t hearing from consistently.”
The Broadridge-PricewaterhouseCoopers study bears this out. It found that 91 percent of the shares owned by institutional investors — but only 29 percent of those held by individuals — were voted during the most recent proxy season on director elections and shareholder proposals covering the full array of governance issues.
There is perhaps an inefficiency here that can be addressed by regulation or technology. ("Ms. Fisch and others are convinced that individual investors are interested in the makeup of corporate boards, executive pay and other governance matters.") But the evidence for that strikes me as pretty thin. The group of investors that corporate managers aren't hearing is precisely the group of investors for whom it would be irrational to develop deep knowledge about corporate governance, or to pester management with their findings. People with intense, concentrated, professional interest in corporate decisions vote; people with vague diffuse amateur interest don't.
More broadly, there is already a solution to the problem that retail investors are not fully engaged in corporate governance, and that solution is institutional investors. In the olden days, when companies' shares were mostly held by individuals, those individuals didn't have all that much more time to devote to their stock portfolios than they do now, and internet research was difficult in the 1930s. The result was that boards and managements were unaccountable to shareholders. The rise of institutional investors -- whose job it is to pay attention to companies, hold them accountable and improve them -- coincided with a rise in management accountability and shareholder-value theories. The solution to the problem of unengaged diffuse amateur investors is engaged concentrated professional investors, not modifying the proxy rules.
But there are some charming throwbacks:
Individual investors, who own an outsize proportion of Procter & Gamble Co.’s 2.55 billion shares, are expected to play a pivotal role in a vote Tuesday on Nelson Peltz’s campaign to win a board seat at the consumer giant.
Roughly 40% of P&G’s shares are held by individuals, while institutions like mutual funds and index funds own the rest.
That retail ownership has made the proxy fight "the most expensive in history with an estimated cost of $60 million as the company and Mr. Peltz’s Trian Fund Management LP splash out on phone banks, advertisements and old-fashioned mailings," a few dollars at a time:
In any proxy fight, a mailing costs $1.25 for each shareholder, plus postage, according to prices set by stock-exchange rules. Broadridge will take more for flashier packaging, opening on weekends and for rushing mailings.
Proxy solicitors on both sides have set up phone banks that can charge $4 to $6 per call.
Phone banks! Postage! Sixty million dollars! I am not convinced that involving retail investors more in corporate voting is a path to increasing efficiency.
Informed insider trading.
We talk a lot around here about my Laws of Insider Trading, things like "don't buy short-dated out-of-the-money call options on an undisclosed merger target" (number 2) or "don't insider trade in your mother's account" (number 4). The joke here is basically that people who get caught insider trading all tend to do it in a few stereotyped naive ways: They don't understand how people get caught insider trading -- at most they Google "how to insider trade without getting caught" (number 7) -- and so they are doomed to repeat it.
But of course this joke only works for the people who get caught. Perhaps there is a deep unseen pool of insider traders who do pay attention to the latest developments in insider trading enforcement, who are careful to avoid the obvious traps, and who don't get caught.
Here's a fascinating paper from Menesh Patel at Columbia called "Does Insider Trading Law Change Behavior? An Empirical Analysis." Patel notes that the Second Circuit's 2014 decision in U.S. v. Newman "substantially weakened insider trading law concerning so called 'tippee' liability." (We've talked about Newman a few times.) And then he measures how much insider trading there was before and after Newman. This isn't easy to do, but there is a rough proxy for it:
As its measure of insider trading, this Article uses the run-up in the stock price of merger targets in advance of merger announcements. The run-up is formally calculated using event study methodology (it is a cumulative abnormal return) but the basic idea is intuitive: if there is insider trading in the stock of a merger target in advance of the merger’s public announcement, that trading will be reflected in upward pressure in the target’s stock price and cause the stock price to exceed its expected price, i.e., insider trading will generate abnormal returns to the target’s stock price.
He finds that the average run-up before Newman was about 2.04 percent; after Newman it was about 6.35 percent, with the difference especially notable in the few months immediately after Newman, and dissipating after that. (His sample only runs through October 2015, and I'd be interested to see the effect of the Second Circuit's August 2017 Martoma decision, which more or less completely reversed Newman and made everything insider trading again.)
Is this solid proof that hedge-fund managers read the Newman decision, realized "hey if we structure our insider trading right we can do it without getting in trouble," and then went and did that in droves? Not really; the merger run-up is a pretty crude way to measure insider trading, and it's not immediately obvious how you would use Newman to set up a large-scale legally watertight insider trading operation. But it is at least a little suggestive that there might be a sophisticated economy of insider trading, that some people might be insider trading based on a nuanced and evolving understanding of the current legal and enforcement environment, rather than on blind dumb confidence and Googling.
Is it easy to raise money now, or hard? It seems pretty easy to me. In private markets, the SoftBank Vision Fund is throwing $100 billion at tech startups in an environment that many people thought was already a bubble, and Juicero raised $120 million to squeeze bags of vegetables. In public markets, Snap Inc. sold billions of dollars of stock in an initial public offering, despite offering shareholders no voting rights and never having made any money. In bond markets, Ireland can raise money at a negative yield, Argentina can raise money for 100 years, and average U.S. corporate junk-bond yields are around 5.5 percent. In cryptocurrency markets, you know, come on. It just doesn't seem like companies are desperate for cash and unable to raise it, that good ideas are languishing because it is impossible to find funding for them.
On the other hand, "over the last 20 years, the number of public companies in the United States has dropped by nearly 50%," and people seem worried about that. So here is a Treasury Department report on "A Financial System That Creates Economic Opportunities: Capital Markets," with 220 pages of recommendations on how to fix the capital markets to "promote economic growth and vibrant financial markets, providing opportunities for investors and issuers alike." It is a bit of a grab bag, recommending "increasing the amount that can be raised in a crowdfunding offering, to $5 million from $1 million," rolling back rules on conflict-mineral disclosure, reducing margin requirements for uncleared swaps, and doing a lot of other miscellaneous deregulation.
One thing that it doesn't do is try to encourage more companies to go public by making it more onerous to stay private:
Treasury believes that regulators can increase the attractiveness and efficiency of public markets while preserving the current vibrancy of private markets. Although some have suggested that restricting access to capital in private markets might force more companies to seek financing in public capital markets, Treasury does not believe that removal of choices from the marketplace is an appropriate path forward.
My view is that companies are staying private longer because it is easier than it used to be to raise lots of money, be a global household name, get liquidity for early investors, and otherwise run a big company without going public -- but it's just as annoying as it's always been to go public. (Maybe very slightly more annoying, with the conflict-mineral disclosure.) So tinkering with public-market rules is unlikely to massively change the proportion of companies that go public, unless private markets become less appealing for some reason.
Elsewhere in the grab bag, here's a bit on equity market fragmentation and possible amendments to the order protection rule:
The SEC should consider amending the Order Protection Rule to give protected quote status only to registered national securities exchanges that offer meaningful liquidity and opportunities for price improvement. Furthermore, protected quote status should go to exchanges only if the cost of connecting to the market offsets the burden in market complexity and data costs that connecting would impose on broker-dealers and other market participants. Accordingly, the SEC should consider amending the Order Protection Rule to withdraw protected quote status for orders on any exchange that do not meet a minimum liquidity threshold, measured as a percentage of the average daily trading volume executed on the particular exchange versus the volume of all such securities transactions executed on all exchanges.
A lot of the fragmentation in U.S. equity markets is driven by regulation: If you set up a national exchange, people will have to route to your exchange if it displays the best price, and so you immediately have a captive market for data feeds and trading connections and so forth, and the market gets a bit more complex and fragmented. If the rules were amended so that people only have to route to exchanges that are good and useful, then some of that fragmentation might go away.
Here is a story about how John Cryan, the chief executive officer of Deutsche Bank AG, hasn't met with HNA Group Co., Deutsche Bank's largest shareholder, and "has told associates he wanted nothing to do with the Chinese conglomerate." It is not exactly clear to me why, but here's one part of the problem:
In early May, HNA disclosed details of its nearly 10% Deutsche Bank holding in a regulatory filing. It showed that HNA used more than $2.8 billion in financing, mainly from UBS Group AG, to help purchase shares worth about $3.8 billion at the time. It also did a derivative deal with UBS. One portion of that deal protected HNA if the shares fell below €15. They have been below €15 since early August and closed Friday at €14.72.
HNA is technically Deutsche Bank's largest shareholder, with 9.9 percent of the stock. But economically it isn't: It bought its position using a funded collar with UBS, meaning that in practice its exposure to Deutsche Bank is limited. Based on HNA's filings and a Black-Scholes calculator, I very roughly eyeball its current economic exposure at around 1/3 of its underlying shares. That still makes it a pretty big shareholder, but if I were the CEO I would also be a bit suspicious of a hedged shareholder whose voting position much exceeds its economic exposure. Cryan told people "that he didn’t like that the investor bought the bank’s shares and effectively bet against them," and he might quite reasonably want to work on behalf of the shareholders who are straightforwardly long the stock rather than the ones who are hedged.
This is nice: Wells Fargo & Co. built "AIERA, short for artificially intelligent equity research analyst, a bot that does massive automated grunt work to support human analysts as they track stocks and make trade recommendations," and now it has come out with sell recommendations on Alphabet Inc. and Facebook Inc. The human analysts who make use of AIERA's grunt work are not convinced:
“Of course, we would reiterate that AIERA remains in test and learn mode, and therefore has no current bearing on our long-term outlooks or ratings (including Facebook and Google, both of which we rate Outperform with $215/$1,250 price targets, respectively).”
Obviously if she's right and they're wrong, Wells should fire them and give her their jobs. (AIERA seems to be female.) Hahaha no, analysts are not primarily in the business of making buy/sell calls; their jobs are about discussions with investors and management access and industry knowledge and help with modeling and all of the nuances that aren't captured in a buy/sell rating. The basic function of an analyst is to help institutional clients make their own investment decisions; there are lots of ways to do that, but just making the buy/sell decision for them probably isn't one of them. The buy/sell rating is so trivial that a computer can do it, and pretending that it is the entirety of the analyst's job -- as regulators sometimes do -- is a fundamental misunderstanding of the business.
Nonetheless I am rooting for the computer to show up her bosses.
People are worried about bond market liquidity.
Needless to say, the Treasury report on capital markets deregulation included some worrying about bond market liquidity:
In corporate bonds, the different measures of liquidity tell a mixed story. Record trading volumes and low bid-ask spreads indicate good liquidity, while reduced frequency of block trades suggest more difficulty in moving large blocks of risk. However, these oft-cited measures do not capture the full story. For example, bid-ask spreads have decreased primarily for retail investors, rather than for institutional investors.
Moreover, measures of trading activity only capture activity that has occurred, not trades foregone by market participants because liquidity was not available or the cost was too high. Liquidity metrics also generally do not convey the reduction in immediately available trading opportunities. Such opportunities have declined as more dealers act as agents, and accordingly customers must wait until the opposite side of the trade has been found. Finally, market participants report that dealer willingness to make markets in size, take on risk, and provide firm quotes have all declined.
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