Thursday, October 30, 2008

There are benefits to allowing secrecy (at least from other investors) in stock trading, as well as costs.

Steve Waldman has another interesting article, "Share buybacks and uninformed investors". There are several points I'd like to comment on, but I don't have time (deadlines for the University of Arizona Free Personal Finance Site, with five hour personal finance course, set for release December 15th). I will, however, comment on one important one.

Steve summarizes the main focus of the post when he writes:

An easy way to think about all this is just in terms of information: Share buybacks of an overvalued firm create artificial, potentially price-insensitive demand that allows informed investors to exit without suffering adverse price movements from revealing their information. Dividend payouts serve as a shock to investor portfolios that forces informed investors to periodically reveal their information, diminishing their advantage over less informed investors. So uninformed, buy-and-hold investors are less likely to be taken advantage of if they invest in firms that issue frequent, substantial dividends and don't repurchase stock than if they invest in firms that don't pay substantial dividends but use stock buybacks to "return cash".

He makes a good point that a corporate share repurchase may provide some camouflage to informed investors, so that they can buy/sell more when the company's shares are underpriced/overpriced ,without tipping off others, who would jump in and bid up/down the price before they could milk it for very many shares (or as many).

There is, though, definitely a question of how big an effect this would be. The effect seems logical, and it may exist, but if it's tiny, then it's not a big deal. I don't know of any research on this, but it certainly may be out there. Also, the camouflaging from a share buyback is going to make no difference to the vast majority of uninformed /liquidity investors anyway. They have no idea what's going on either way, and won't spend the time to closely watch the market for a single stock. The money sits in the 401K, probably in a fund, or funds, of hundreds, or thousands, of stocks, and they periodically check the balance, that kind of thing. What the camouflage may help is to protect one expert and active investor's information from being used by other active expert investors, or specialists at the exchange.

But the issue that I'd like to bring up is whether we'd even want to eliminate all camouflaging – or hiding – of informed investor's trades, so that they benefit very little, if at all, from their information and understanding. I don't think that should be the goal, because then the informed and expert investors get little or no compensation for obtaining that expertise and then using it, spending the time and money to research the company and the real worth of its stock.

And this effort is very important. The more accurate the prices of firms are, the more accurately capital will be funneled to its highest and best use (for the most part – even with perfect accuracy of stock prices, there are still other market imperfections), so we want to make sure that this effort is adequately rewarded.

The situation is analogous to patents. Most patents lasts about 17 years. If we make patent lengths shorter it gives less reward, and thus incentive, for people to become expert, and then put in the work and/or money to innovate. But if we make patent lengths longer, then the ideas are less utilized. If the idea is free, then everyone who gets any marginal benefit from using it, will use it. But If you charge, say, $100,000 to use it, plus transaction, negotiation, and/or legal costs (and these can be really big), then anyone who has a marginal benefit of less than $100,000 will not utilize it, even if that marginal benefit was still big, like 80 to 90 thousand dollars.

Suppose there were 3,000 people or organizations like this, which had an average marginal benefit of $50,000 each. With the patent in force, they would not use the idea – a big waste, because the idea, the understanding, has zero marginal cost, but the marginal benefit is 3,000 x $50,000 = $150 million.

If the patent had instead expired, then the idea/understanding/invention could be placed on the internet and made easily available for free to anyone, anywhere in the world, so it would not be underutilized (or perhaps ridiculously underutilized). So, you can see a big problem that can often occur when relaying on the pure free market, instead of balancing the benefits of the market with the benefits of the government to find the most efficient mix or hybrid.

Could you imagine how much less medicine would advance if instead of the government sponsoring the mapping of the human genome, and then placing it for free on the internet to be used easily be any scientist orstudent in the world, it was owned be a company and kept secret, and could only be utilized by a small number of companies paying a high fee after long negotiations. It would be monopolized, and with the great difficulty of price discrimination, monopoly's maximize profits when they restrict supply, and usually when they restrict it greatly.

In fact, a private company, Celera, launched by mathematician Craig Venter, tried to do this, and it really showed the pros and cons of the market. Venter did come up with a faster and better method than the government project -- with the market you often have the benefit of many people and parties working on an idea in competition from many angles -- but then he tried to patent the genes, which would have caused them to be grossly underutilized by scientists. In 2000 however, President Clinton ruled that the genes could not be patented, and were to be made freely available to any scientist or student in the world over the internet. As a result, Celera's stock plummeted.

What's best here is for the government and the market to both be involved. The government pays private companies for their work (that is, it does some sub-contracting, like in a well run private business when -- and only when -- the control and coordination costs don't outweigh the benefits. This is an important lesson taught in MBA schools that the Republican party never learned.), for example paying Celera for it's improved gene finding process, but the government owns the gene information, and makes it available for free over the internet so that it is100% fully utilized, with virtually zero transactions costs.

In any case, you can see the trade-off in extending or shortening the length of patents, and there's a similar trade-off with the secrecy/camouflaging of trades by expert and informed investors; the more secrecy you allow, the less you let others use someone's ideas/understanding/information (about a stock) for free, and so the more reward and incentive there is to perform the important function of pricing stocks accurately. But, there is also more of a problem with things like market manipulation and corporate corruption, plus, like with patents, your ideas/understanding/information get less widely used.

Suppose you understand that IBM is worth $110, but it's only currently priced at $100, and suppose you have complete secrecy for your trades, but you only have enough wealth that you buy enough shares to push IBM to 105. The stock is still mispriced by $5. But if everyone could use your ideas/understanding/information, there would be far more people buying IBM, and it's price would be pushed all the way to its correct level of $110. In other words, your ideas/understanding/information would be fully utilized, rather than substantially underutilized.

There is a trade-off, so you want to allow the amount of secrecy/camouflaging that optimizes the trade-off, an amount where any more would provide more additional costs of lower utilization of ideas/understanding/information, and of market manipulation, corporate corruption, etc., than benefit from increased incentive to learn about the true values of stocks. And with any less, you'd lose more in incentive than you'd gain in increased utilization and decreased market manipulation, corporate corruption, etc. In the jargon of economists, you want to find the optimal point where the marginal benefits just equal the marginal costs.