Navinder Singh Sarao, a U.K. high-frequency trader, was arrested recently for using market manipulation to destabilize the market causing the May 6, 2010 Flash Crash where, among other markets, the Dow Jones Industrial Average lost 9% within minutes only to recover shortly thereafter. On that afternoon, Mr. Sarao placed thousands of trades that he had no intention of executing. By placing the trades and later cancelling them, he was attempting to manipulate the market through spoofing tactics designed to give him an indication of the very short-term direction of the market so he could profit from this knowledge.
Call me old-fashioned, but aren’t stock markets supposed to be critical economic tools that provide a means for companies to raise funds towards the growth of their businesses and for investors to discover value? A place where analysts work diligently to determine the intrinsic value of a business and take action to profit from their successful study? Today, it seems, there are large elements at work (like Mr. Sarao) that couldn’t care less about the fundamentals of businesses.
How it should work…
Let’s say you have a company that is very successful in selling a unique widget in your home city. The product is so successful that you believe it will sell well in other cities across the country. Unfortunately, your bank is unwilling to provide you with the funds required to expand your widget operation, so you decide to sell half of your $100 million business to the public. After the transaction, you now own 50% of the business and have $50 million from investors to fund the expansion. Your investors own the other half of the business and have the expectation that you will allocate the $50 million in capital wisely to increase the value of the company (and their shares).
The beauty of public stock markets, unlike private share ownership, is that after a company has issued public shares, the investors can change their minds at any time, for any reason. They may not always get the price they desire (or even the price they paid) but they are typically able to exit. The value of their share ownership, over time, will be directly related to how successful you are at investing the $50 million to grow the company.
With this basic premise, all investors in your company should be concerned about:
- Your product. Is there competition from other companies? Is it easy to copy? How much do customers need it? Is it the industry leader?
- Your talent. Is the management team capable and honest? Does it have significant ownership in the business? Has it shown an ability to allocate capital effectively?
- Your books. Does the business generate/require a lot of cash? Does the company have too much debt? Does it have good profitability metrics?
Intuitively, this makes sense, right? Unfortunately, investors like Mr. Sarao do not care about your product, your talent nor your books. All that interests them is what others, at this instant, think about your company. If they can jump ahead of them in the cue, they can profit from the well-intentioned investor who, via hard work, has decided to buy or sell based on the fundamentals of your company. Call me old-fashioned but this is not fair, nor is it right. Rather than shake my proverbial fist, however, I find comfort in long-term historical trends which demonstrate that smoke and mirrors may cause a stir in the short term, but over the long term company fundamentals prevail.