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Back To Basics – Identifying The Real Problem In The Equity Market

02

December, 2011

While it may not technically qualify as academic research, the folks at Grant Thornton have just published a report which highlights the ultimate problem that our corrupted market structure has created. Their report titled “Back to Basics for Equity Markets” focuses on why there is a growing crisis in the small company sector. They conclude that the equity markets have been distorted by “high frequency trading and the unrestricted growth of synthetic equity products.” This study was done in the UK and analyzed UK companies but the problems and conclusions are exactly the same here in the US.

We would like to call your attention to page 15 of the report:

“In past years it was the revenue that could be earned from trading in small stocks that allowed brokers to fund research, which in turn fuelled greater levels of interest, thereby underpinning liquidity. This system may have looked costly and inefficient at the time, but it provided a much-needed route into the capital markets that helped many small companies grow into today’s corporate giants. The implications of the decline of this system are that small companies can no longer develop into the economic powerhouses of tomorrow.”

Many brokers that used to support IPO’s with research and introductions to institutional investors have exited the small cap space since the economics of the equity market have changed.

In the interests of cutting transaction costs and speeding up trading, spreads and commissions have been progressively reduced, to the point where there is little option for traders but to focus on the high volume end of the market in order to make money.”

Think of this as if you owned a very nice, small house that you remodeled but the house was located on a block where only large houses existed. Imagine that there were no real estate brokers for small houses (no Zillow or online brokers either). The real estate brokers only focused on the large houses because that is where they made the most money. How difficult would it be for you to find a buyer of your small house? Do you think a fair price could be set for your house? The longer that you couldn’t sell your house, the more real estate taxes and maintenance fees would be eating into your monthly budget. But then a developer comes along and offers to buy your house at a discount. Frustrated, you probably would just hit the bid.

This is exactly what Grant Thornton says has happened to the small cap market. Small stocks are not being valued appropriately. As public companies though, they still are incurring the costs of maintaining a public listing. Many are just giving up and either going private or are getting merged into bigger companies. This problem is not an easy one to fix. Grant Thornton says:

This is not a problem that can be solved by solely turning to the Government for further assistance. It is more an issue of market structure, one of changing economic priorities and the effects they have on market behaviour. As such, it is within the power of market participants to change the way that small cap companies are supported, in the long term interests both of the economy, and of the markets themselves.”

There are many that think that our post Reg-NMS hyper speed market has “added liquidity and reduced spreads” and therefore the market must be more efficient. They think this must be good for all investors and all public companies. We say, think again. Think about the effect that this trading-focused mentality, rather than an investment-focused mentality, has had on small companies. Think about how many companies have either not grown or have just been swallowed up by larger companies since their route to access the capital markets was cut off by the HFT roadblock.

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