Baruch has noted a curious thing about this results season, dear readers. Sell side analysts seem to have stopped doing as much research as they used to. I think it’s because, in the light of the SEC’s insider-trading investigation and a lack of certainty between what constitutes legitimate insight and illegal information, they are keeping a low profile. If it continues it could give great power to some of the market’s worst actors, and create a lot more single-stock volatility. Already this earnings season there seemed to be a lot more violent moves in stocks than usual. Hopefully Baruch is imagining it, and if he isn’t, let’s hope it is temporary.
It was most obvious when F5 blew up in late January. The print was merely in line, and the guidance, sin of sins, was weak. FFIV opened down 20% and stayed down. This sort of move off a quarter can happen in tech, and is not at all uncommon. What was vaguely unusual, however, was the extent of the surprise: there was no warning. The company had made no hints it had seen any weakness, and none of the analysts covering it had done the usual checks with their sources. Worse, no-one really knew what everyone else was expecting. There were no “whisper” numbers out there. Frightened of being accused of insider trading , no one had done the work.
Up until recently, there was a fairly clear procedure ahead of the quarterly report of a company like F5. At or near quarter end, sell side guys would call a bunch of resellers and ask how business was shaping up. C-suite guys, or guys in the finance dept. who actually knew the full numbers and could go to prison, would typically not be involved. So the data would be partial, and sometimes downright misleading, but would often have some truth to it. Based on that, the analysts would publish a preview, say something like “F5’s Q4 is shaping up well”, or “F5 may just come in line”, maybe fine tune their estimates, and call round their clients. The stock would move.
The good thing was, the quarter had now become slightly less of a random event. Clients would also give the sell side dude feedback on what they were looking for, and eventually those who were interested would have a whisper number, the real yardstick by which the quarter would be judged by, a number more realistic than the typically low-balled formal estimates. If the company was having a crap quarter, this whole process could cushion the bad news when it hit on the day. Of course, things would still go wrong and the stock would still cary what we call “gap risk” on the print, but in general, things were smoother. This went on for years, and the SEC (one assumes) knew all about it.
This time around, none of the above happened because it was no longer clear whether this was OK or not. Moreover, due to Reg FD, put in place about 12 years ago, management is unable to say anything substantive about current trading outside the quarterly report, unless in the form of a public profit warning or pre-announcement. Without being able to learn anything concrete from meeting managenent, investors just had what analysts call their “body language” to go on.
Now I don’t know how many of you ever hang out with the CEOs of listed companies, but unless their world is falling apart and they are at that very moment being eaten by a bunch of hungry pigs, the body language of CEOs is always extremely “upbeat”. The white-toothed, well tanned, can-do optimism you see on CNBC is what you get in person. In CEO-world everything is for the best, in this, the best of all possible worlds. Major problems are invariably mere bagatelles, teething issues. Product flaws are features we didn’t know we wanted. Revenues aren’t going down; all that’s happening is that “sales cycles are lengthening”. F5’s C-suite had gone around the houses visiting investors (Baruch saw them as well) and had said that overall the prospects of the business were as good as ever, hiring was strong, and lots of super new products were coming.
All systems go, then. Upbeat management, gleeful analysts congratulating themselves on FFIV’s meteoric rise, armchair retail technologists discovering cloud computing for the first time, and a track record of spectacular “beat and raises” in the last few quarters, were the only ingredients going into the mix. Nay-sayers were cowed, shorts were absent. Altogether, you’ll agree, classic ingredients for a spectacular, portfolio-shattering blow up if the numbers were light. And they were.
Now Baruch, and every finance professional with a brain, fears the SEC like a primitive tribesman fears an angry god. Be in no doubt: this is a Good Thing. Baruch applauds the feds’ activities against the blatant (alleged) cheating of the Galleon guys and those company officers (allegedly) selling information on their own stocks to hedge funds by acting as “consultants”. Lock them up, fine by me. Baruch himself is one of their victims; it appears many of his competitors had a massively unfair advantage over him in the past few years. Wankers.
The idea that the SEC wants to stop people from doing proper equity research is also absurd. They know the markets would cease to function. However, it may be that they don’t mind being a little vague about what is or what isn’t allowed. The real world definition of what constitutes insider trading is very gray: look at Kid Dynamite’s agonising /HT Felix) over an insight gleaned in a job interview. The test du jour for insider-dom– does your information comes from a source who has a likely fiduciary relationship with the stock you are trading — arguably could mean it is insider trading when you find out anything from a company supplier or partner that the company’s management doesn’t want you to know.
Taken to extremes, insider trading laws maximally interpreted imply that very little real-time information-based analysis can be done at all. Ultimately, all equity research is aimed at finding insights which are both material (otherwise it would be meaningless) and at least relatively non-public (otherwise it would already be in the price). As a result, almost every research-based institution fears they are already, arguably, guilty, and if the SEC really wants to Get You, it doesn’t need much effort on their part. Hell, just the announcement that you are helping the feds with their enquiries is enough to seriously mess up your business; look at the guys at Level Global who had to close this week merely for being raided. They had $4bn! If they are innocent, it’s a terrible thing.
If the only way we are going to be able to analyse a stock is by parsing the press release from the company, we’re pretty screwed. We will not be in good hands. Since The Crisis, we have been trained to vilify banks and traders, and by extension the hedge fund managers who pull down the big bonuses. What we have forgotten is just how dangerous villains the CEOs and CFOs of big companies can be, and just how much the game is stacked in their favour. We remember Enron, Worldcom and Parmalat, but there are so many more cases just like them on a smaller scale. Hedge fund managers get big bonuses, sure, but they “earn” them by being lucky or taking risks. If it goes wrong they walk away with nothing, their franchises ruined. But the managers have somehow structured it so that they walk away with millions even if they’re completely useless. AMD’s CEO got fired by his board the other day, for a lack of strategic vision. AMD’s market share is at a historic low, and is generally falling behind its key peers, so it didn’t seem unfair. He got $100 million as a “thank you” parting gift! The merely mediocre make out like the bandits they generally are.*
If you think over-powerful investors trading with inside information is bad for the little guy, wait until you see what happens if company managements get a total monopoly over market-moving information. We’ll have an Enron every week.** The nature of the beast is that company managements will never, ever fess up to bad stuff until they really really have to. When they do, it is generally too late, and tends to come at the end of a massive run in the stock, after they have cashed in all their options.
It is a recipe for micro-bubbles, big rallies and spectacular blowups in single stocks, in other words, a world of gap risk. And if investors and analysts are too scared to call them out when it is really going wrong, it is going to be a very pretty kettle of fish indeed. It will hurt precisely the people the insider trading laws were set up to protect. Significantly more volatility will likely discourage small investors much more than the suspicion that someone knows more than they do (smart investors know someone always knows more than you do).
Anyway, Baruch is hopeful. I don’t think we’ll get to the very bad place; the good investors and analysts ultimately will start to analyse again like they used to, if only because they can’t resist. And things will be better, the SEC and FBI will have done their job and the blatant insider trading rings will either be gone or discouraged for a while. But things would more assuredly return to normal, and much faster, if the SEC defined for once exactly what sort of information is legal and which is not. Anyway, just a thought.
* Oh don’t get me started on this. Bad actor CEO/CFOs have so much more of a pernicous impact on the market than dodgy hedge funds. Half the time they can basically print what they want on a quarter. Except just ahead of when the next round of management stock options get struck, then things turn weirdly negative, only to snap back to normal when the damn things are priced. They smooth earnings all the time, pay themselves fantastic amounts in stock options, then spend shareholders’ money buying the options back at market price to avoid the dilution their massive payoffs to themselves have wrought. However, maybe because most of their tricks are aimed at making shares go UP, not down, they are rarely prosecuted.
**James Suroweicki, please note this is a wilful exaggeration. We won’t literally have an Enron every week.