Tuesday, March 30, 2010

Wall Street doesn’t run the world.

Time, liquidity and control

Consumers and investors, as in the general public, have an immense advantage over many institutional investors, especially in terms of reducing systemic stability. Usually discussions of individuals verses institutional traders and investors focus on information (e.g., access to research and market information favors the pro), size of trades (e.g., the limited liquidity available to support large block trades by institutions favors the individual), resources (e.g., classic economies of scale favoring the pro), etc.

There is an often overlooked factor that can be decisive. Western economic thinking focuses almost exclusively on the competition between market participants on the same side of the market: sellers compete with sellers, and buyers with other buyers. It is true that some of the discussions of the economics of information advantages (asymmetric information in the technical jargon) address buyer verses seller competition. But, the technical literature makes simplifying assumptions that exclude an important factor from consideration.

With respect to investing, the simplifying assumption often made is that there is parity in objectives, or put differently, everyone’s after the same thing. Granted the assumption that every investor wants to make money is reasonable as far as it goes. But, it doesn’t go far enough. Make money with what risk exposure, with what liquidity requirements, under what accounting constraint, with what potential tax implications, relative to what alternative, and over what time frame? These factors alone can create sufficiently difference incentives to make a market even if all parties share a uniform perception about the future.

To illustrate from a recent example, let’s consider Kimberly-Clark. (A disclosure is in order. I own it and acquired more despite the event noted below. But, the disclosure is really unimportant. Nothing I do, or will do, is going to have any impact on the market). Here’s the quote which I found on MARKETWATCH (www.marketwatch.com). It was in the comments. I pulled the full comment from the blogger’s page at ( http://community.marketwatch.com/Balthaszar ). The quote is from March 22nd and goes:

“Story: Kimberly-Clark sticks to 2010 earnings view
I find it amusing that Goldman Sachs issued a SELL recommendation on KMB recently. They were afraid that the company was going to disclose some bad news today, in spite of the upbeat scenario management pitched earlier this year. Glad I picked this up when it slipped under $60 earlier this year. The stock slumped even as dividend increase was announced. But, babies and incontinent adults need their diapers. Women need their monthly "paper fix.” Kimberly Clark continually sells it to them, regardless of the state of the economy.
I feel sorry for anyone who would act on a sell rating from an investment bank, just as I feel sorry for anybody who thinks GS is the devil. GS is overrated anyway you look at them.”

One can look at the SELL recommendation quite differently. To some extent, the quote emphasizes out-analyzing Goldman (better information). That is one way to go. However, it is equally constructive to take a totally different approach. One should never assume greater smarts than another seller or buyer. It’s risky; it isn’t important, and it shows a tendency toward over confidence. None of those behaviors serve an investor well.

The safer assumption is that Goldman’s recommendation was right for someone. Then an individual investor can look at KMB and decides whether the recommendation fits that individual’s unique objectives. If not, the recommendation can create an opportunity: someone’s circumstances are sufficiently different to create a reason for them to do the opposite of the buyer’s incentives. Further, whether the substance of the recommendation is correct doesn’t matter. In fact, the best circumstance is when it is clearly right, but irrelevant within the context of the individual’s objectives. If it is right, it may create additional opportunities.

What’s the individual’s advantage and how does it relate to information asymmetry? Using the Goldman example, the individual knows a lot more about Goldman’s target market than Goldman knows about the individual. It isn’t the individual institution that matters; rather it is the collected institutional investors. One can discern these constraints for institutional investors collectively and for their target markets. I’d argue that there are so many similarities between institutional investors that over time individual investors can use the information to their advantage. Thus, from a buyer to seller perspective, the information asymmetry favors the individual.

Now, let’s get back to the title “time, liquidity, and control.” Individual investors should consider time their ally. Not just because of the power of compounding, but because control of timing is a powerful ally. To illustrate, nothing can wreck a good day like a forced sale. It is well known that prices in forced sales differ from market prices.

“How does this help the individual?” you ask. Well, the individual knows more about their timing requirements and has more control over them than do most institutional investors. Yes, the individual can give up that advantage by taking on leverage or by trading in time constrained products. But, that’s different from never having had the advantage. The individual investor can decide how to use that control of timing. They can use it to buy and hold, to try to time the market, to rebalance on their own schedule, to shift to alternative investments, or to do whatever is necessary.

Let’s talk liquidity next. Time and liquidity are obviously related. One might argue that differences in how investors are affected by the need for liquidity are all timing related. But, there is another side to it. That has to do with the interaction between balance sheets and cash flows.

Just as the individual knows more about their time constraints, individuals have more control over their liquidity requirements. To illustrate, the savings rate recently became positive and the media is full of stories about consumer saving more to rebuild their balance sheets. It is probably true, but the saving rate is a flow statistic and doesn’t say anything about balance sheets directly. Further, from the perspective of liquidity requirements, the more important point is that the positive saving rate is demonstrating that consumers control their cash flow requirements.

In the vernacular of start-ups, they are demonstrating an ability to control their burn rates. Said another way, they are demonstrating that they can control the rate at which they generate free cash flow. Controlling free cash flow is controlling one dimension of cash requirements. Ultimately, cash requirements determine liquidity requirements. When individuals are saving, it demonstrates that they are probably meeting their liquidity requirements from current income without any forced adjustments to their collective balance sheets. The control derived from saving results from the act of saving. What is done with the savings probably reinforces the control, but if consumers burned their savings, the act of saving would still indicate that they are meeting their current cash requirements from current income.

Individuals’ cash flow requirements are less a product of their balance sheet size than is true of institutional investors. For individuals, cash flow requirements are more a function of age and lifestyle choices. But even if liquidity requirements aren’t a separate factor from timing, they at least magnify the individual’s advantage. Individuals who know they won’t need liquidity have a broader set of options that they can easily access. Hedge funds try to get lock up periods during which funds can’t be pulled because they recognize this advantage. Instant liquidity has a price. The price of liquidity is usually lower average long run returns.

This is one aspect of control. Another related advantage that individuals have is that they don’t need to mark to market or continuously maintain any specific financial posture. They can if it serves their financial objectives, but that’s different.

How does this work to the individual’s advantage? An asset with a falling price will produce (note: that is produce, not attract) sellers from among institutional investors. It is well known that the prices in forced sales differ from market prices. It is hard for individual investors to time the importance of their advantage because in the cut throat jargon of Wall Street: “blood in the water attracts sharks.” So, once Wall Street senses falling prices are producing forced sales, the sharks show up. But, the individual can take a position based on their individual circumstances and avoid the risk that mark to market will push them into a sale. Again, they can leverage the purchase in ways that eliminate that advantage, but that’s different from not having it.

There’s a sayings about runs forcing assets into “strong hands.” In a down market individuals grossly underestimate their ability to be the strong hands. Most individuals should have a much longer time horizon than institutional investors for at least some, perhaps most, of their investments.

Seeking alpha (i.e., beating some benchmark) is always stylish. But, individuals can pick their own alpha. The Street has to accept the alpha imposed on it.

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