Felix Salmon

Eric Hunsader, at Nanex, has managed to put together some fantastic charts of what exactly happened in Elan, the stock at the center of the latest big insider-trading case.

First, here’s the big picture:

The red arrow shows the period “throughout 2007 and up to July 2008″ during which SAC “established a substantial long position” in Elan. The blue arrow points to the frantic week during which SAC sold off more than its entire holding, ending up with a significant short position, just before the stock plunged.

When Elan opened for trade on Monday July 21, 2008, it was at a multi-year high of more than $35 per share, and SAC’s long position was massively in the money — after all, they had been buying since it was less than $15. And then SAC started selling, aggressively.

Over a four-day period, SAC sold its entire position of 10.5 million shares between Monday and Thursday, at a super-high average price of $34.21 per share. The head trader, who said that he sold the stock “quietly and efficiently through algos and darkpools”, continued to sell. By the end of the trading session on the 29th, he had sold more than 15 million shares for more than $500 million. The complaint notes that the SAC trading “constituted over 20% of the reported trading volume in the seven days prior to the July 29 Announcement.”

What does that kind of massively one-sided selling do to a stock price? This:

Basically, Elan moved sideways for most of the time that the stock was being sold. Day 1 was great, Day 2 was decent until the end of the day, Day 3 started off well but then deteriorated, Day 4 was horrible, Day 5 was much better, Day 6 had a good morning and a gruesome afternoon, and Day 7 was pretty good.

And by the end, in the wake of $500 million of concerted selling in a pretty illiquid stock, the share price was about $33.50 — pretty much exactly where it was on the Friday before the selling started.

Eric’s detailed day-by-day charts are well worth looking at, but for me there are two big-picture lessons here. The first is that SAC is an amazingly good trading shop; we probably already knew that. And the second is that any time you see a market reporter blaming “selling” for the fact that a stock went down, you can take that with a pinch of salt. Because the lesson here is that an absolutely enormous amount of very real selling can have a surprisingly small effect on a stock’s price.

Last year, when Groupon went public, I entered into a “small wager” with Rocky Agrawal. We would check back on Groupon’s market valuation in one year’s time, and compare it to the valuation of Priceline. At the IPO, Groupon’s market capitalization was 72% that of Priceline; if that number fell below 30%, I would lose. Otherwise, I would win.

Well, here’s what happened to that ratio:

This actually understates how badly I lost the bet. Shortly after the bet expired, two things happened: Priceline announced that it was buying Kayak, and Groupon plunged on disappointing third-quarter earnings. Today, Groupon closed at $2.76 per share, giving it a market capitalization of $1.8 billion. Priceline, by contrast, closed at $625.87; if you add its capitalization to that of Kayak, you get a total of $32.74 billion. Which means that the Groupon:Priceline ratio is basically down to about 5.5%.

Obviously, something went horribly wrong at Groupon after the IPO. So, what was it? Did Groupon suffer a massive loss in revenues? Did it start racking up enormous losses? Well, here’s the chart.

The blue bars, here, are Groupon’s quarterly revenues, from the second quarter of 2010 onwards. The red bars are its net income. And the jagged line, of course, its its plunging share price.

The main thing to note is that Groupon’s results don’t seem particularly gruesome; they’re certainly better now than they were when the company went public. The share price didn’t fall because revenues were falling: it fell because revenues — and profits — weren’t rising fast enough.

This is why I’m generally so mistrustful of stocks: they just don’t behave in a remotely predictable manner. It’s impossible to know what kind of future growth rate is priced in to a stock, and it’s even more impossible to have a good grasp of what a company’s future growth will be. If you’re valuing fast-growing companies on some kind of discounted cash-flow model, then tiny tweaks to your growth assumptions or your discount rates can have an enormous effect on the share price which pops out the other end.

I knew this, of course, when I entered into my bet with Rocky. So what was I thinking? Three things.

Firstly, volatility cuts both ways. Groupon could fall precipitously — but it could rise very fast as well, in which case I’d be well in the money.

Secondly, I was already well in the money: Groupon stock could fall in half and I’d still win the bet. I don’t believe in the efficient market hypothesis, but I do believe that the markets are more efficient than any individual. Given the cushion that Rocky was offering me, I’ll take the side of the market against anybody.

Finally, the kind of things which hurt one bubbly tech stock tend to hurt them all. When we entered into the bet, Priceline had risen from just over $50 per share in the fall of 2008 to more than $500 per share in the fall of 2011. Rocky’s bet wasn’t just that the Groupon bubble would bust: it was that the Groupon bubble would burst and the Priceline bubble wouldn’t. Which, of course, turns out to have been exactly what happened: it wasn’t long before Priceline was trading at more than $750.

So, next time we’re in the same city, I’m buying Rocky dinner. At least I’m still winning the other bet, for the same stakes.

If you haven’t read it yet, you really must read Jessica Pressler’s fantastic Robert Benmosche profile — the man really shines through, in all his blustery glory.

So how well has Benmosche actually done, as CEO of AIG? He certainly put an end to a misguided fire sale after he arrived in the fall of 2009, and he deserves a lot of credit for that. And over the course of his tenure, the government has managed to unload nearly all of its stake in the company — at a profit, no less. That’s a notable achievement, too: I, for one, didn’t think it could be done and said as much in January 2010, five months after Benmosche took over.

It’s impossible to know how much of that is thanks to Benmosche, and how much is thanks to the Federal Reserve, which sparked a massive credit-market rally and which also held onto various bits of AIG nuclear waster until it could get a good price for them.

Either way, the results can be seen in the chart above, which was much harder to put together than it looks, and I’m very indebted to both Ben Walsh and Jonathan Weil for help with it. It shows AIG’s share price, in black, and also the value of the shares available to the public, in red. The green area is the value of the government’s stake in AIG, calculated as the value of the shares that the government ultimately ended up converting its stake into. Go back to the excellent column that Jonathan Weil wrote shortly after Benmosche took the reins, saying that the value of AIG was “either $5.1 billion or $26.5 billion” depending on what you were counting: the first figure is the red area, and the second figure is the combination of the red and green areas.

AIG’s market cap today is around $60 billion, more than double what the market thought the company was worth back in 2009. So that’s another Benmosche achievement. Then again, both the share price and the market capitalization are lower than they were in early October 2009, and much lower than they were in February 2011. The chart shows the government doing a great job in selling down its stake in the company; but there’s nothing particularly up-and-to-the-right going on here. After all, over the same period, the S&P 500 has risen more than 50%.

But here’s the thing: AIG might be worth roughly as much now as it was in January 2010. But back then, AIG’s valuation was a weird, fantastical thing, based on extrapolating a share price which represented only the tiny sliver of shares actually traded on the markets. I thought that the valuation was bonkers, most other observers did as well, and there were precious few people standing up to defend it.

Today, by contrast, AIG is a real company, with a justifiably positive valuation, based on a huge number of shares being traded every day. The company which had arguably the biggest balance-sheet black hole the world has ever seen has managed to come back from that brink, with the help of unprecedented government assistance, and is now a viable stand-alone business. That’s a huge victory for the people who made the decision to rescue AIG, not that they had much choice in the matter. And it’s surely a victory for Benmosche as well.

Back when this blog was on hiatus, I put a chart of Microsoft and Apple valuations up over at felixsalmon.com. People liked it, and so I decided to take the obvious next step, and animate it. The result is the video above, and this gif.

The data are a little bit out of date at this point, and so you can’t see Apple soaring to its latest $650 billion valuation* — but it’s easy to see where it’s going. And the big picture is still very clear: Apple basically curves up with market cap being an inverse function of p/e, as you’d expect; when Microsoft, by contrast, reached its highest valuation, it had a whopping great p/e ratio.

Today, for the record, Apple has a market cap of $650 billion and a p/e ratio of 16.4; Microsoft has a market cap of $260 billion and a p/e ratio of 15.6. As far as their earnings ratios are concerned, both are very much in line with the S&P 500, which is currently trading at a p/e of 16.5. Wherever excess earnings growth is going to come from, the market isn’t expecting it from either of these tech giants.

*Yes, I said $700 billion in the video. I meant $700 per share. Oops.

Fifteen years ago today, on September 4, 1997, Dell stock closed at $86.69 per share; on a split-adjusted basis, that works out to $10.84 per share today. The stock peaked at almost 5 times that level, in March 2000, but it’s not looking quite so hot any more: it’s now back down to $10.52 per share.

Over the course of the intervening 15 years, Dell has been solidly profitable, and in fact reached record earnings per share of $1.87 in 2011. It has never had an unprofitable year, and the company’s total earnings since 1997 (if you exclude 1997′s earnings but include the $1.68 in 2012) total $15.40 per share.

How is it possible that Dell has earned more than $15 per share since 1997, has never lost any money, has never paid a dividend, and is now worth less than $11? The answer, of course, is buybacks:

Based on their annual 10K filings, from Fiscal Year 2005 to 2012, Dell has purchased approximately 989 million of its own shares at a cost of over $24bn… Going back further to 1997 (through February 3, 2012), Dell has reportedly spent approximately $39 billion in share repurchases under a $45 billion repurchase program.

$39 billion is more than double Dell’s current market capitalization of $18 billion, and it’s over a thousand times more than the $30 million that Dell actually raised from the market in its 1988 IPO.

Dell, then, is an extreme example of a phenomenon that is actually typical of the market as a whole, which has seen net equity issuance of negative $287 billion in just the past ten years — and that’s not even counting dividends. Shareholders like to think of the stock market as a place where they fund companies with equity, take risks, and then reap returns. But in reality shareholders take out much more than they put in.

Every company says it wants buy-and-hold shareholders, who will stick with the firm for the long term. But a buy-and-hold shareholder in Dell is looking particularly idiotic right now. If you bought 15 years ago at $10.84, you should expect to have at least $15.40 in value at this point: after all: that’s how much the company has made since then. Instead, you have less than you started with. And all the extra money went to fickle shareholders who sold their stock back to the company.

In principle, I quite like buybacks over dividends: they’re a way of returning cash to shareholders, without sticking those shareholders with possibly-unwanted income. In theory, shareholders who want income will sell some percentage of their shares back to the company and get income that way, while shareholders who don’t want income will see the value of their shares rise, thanks to the fact that there’s extra demand in the market and the fact that the free float is shrinking.

In practice, however, as we can see with Dell, it doesn’t always work that way. The company ends up overpaying for its shares when the stock is high, thereby essentially taking money which belongs to all shareholders, and distributing it only to those who are exiting. As a result, the most loyal and faithful shareholders can end up with less than they started with, even when the company has been solidly profitable all along.

If things were sensible, a company could simply declare a dividend, and then the investors who didn’t want the income could just reinvest that dividend back into the stock. In the UK, we have things called scrip dividends which serve that purpose*: you basically get your dividend paid in stock rather than cash. If you want to sell that stock and take the dividend you can, but if you don’t, you don’t have to.

If Dell had gone for a scrip dividend rather than buybacks, then at least our hypothetical 1997 buy-and-hold investor would have more stock now than she had originally, and the past 15 years’ profits wouldn’t have disappeared into the pockets of the lucky few who sold high on the secondary market. Those people would still have made money on the movement of the stock; they just wouldn’t have taken profits from other shareholders.

As for Dell’s statement, justifying its lack of a dividend, saying that “our earnings are best utilized by investing in internal growth opportunities, such as new products, new customer segments and new geographic markets” — well, it doesn’t pass the laugh test. Dell has spent all of the money from its earnings — and then some — on stock buybacks, rather than on new products or new markets. And stock buybacks are never an “internal growth opportunity”.

(h/t Elfenbein)

*Update: Many commenters, along with jdpink, have pointed out that scrip dividends are basically just fractional stock splits, and don’t return any cash to shareholders. From a behavioral-econ perspective, shareholders might be more willing to sell their scrip to get a dividend check than they are to sell some percentage of the shares that they hold in a non-dividend paying stock. But unless the scrip dividend is optional, it doesn’t get cash off a company’s balance sheet. And if it is optional, then the new shares count as income for tax purposes.

Andrew Ross Sorkin has a rather odd column about Facebook CFO David Ebersman today, blaming him for the miserable trajectory of Facebook’s stock since its gruesome IPO. It’s hard for me to disagree, since I said exactly the same thing back on May 23 putting Ebersman at the very top of the list of Facebook incompetents.

But my post in May was narrowly focused on the Facebook IPO; Sorkin aspires to something bigger. “When Facebook’s I.P.O. first started to appear troubled back in May, I purposely avoided weighing in,” he writes. “Frankly, I thought it was too soon to judge. But we have passed the pivotal three-month mark.”

It’s not actually true that Sorkin avoided weighing in; in fact, at the time, he was calling the Facebook IPO the “ultimate” case of the 1% versus the 99%. Kyle Drennen helpfully transcribed Sorkin’s appearance on the NBC Nightly News:

This idea that the playing field is not level — that certain people, certain investors, are getting access to information, and the other guys, Main Street, isn’t getting the same information. And who’s holding the bag? It’s the greater fool theory. In an IPO, somebody’s buying and somebody’s selling. But in this case, the public is the one that’s the buyer. And in that case, maybe they were the fool in this case.

If the public was the buyer in the Facebook IPO, then the seller — the rich guy with all the information — was David Ebersman, the villain of Sorkin’s current column. So Sorkin hasn’t exactly been scrupulously agnostic on this issue for the past three months.

And here’s the reason why Sorkin thinks that the point three months after the IPO is so important:

Statistically, the three-month mark is a much better predictor of a company’s future share price than any of the closing prices in the first week or two. According to Richard Peterson of Capital IQ, 67 percent of technology companies whose shares lagged their I.P.O. price after 90 days were still laggards after a year. Until Facebook’s stock rebounds, Mr. Ebersman will be feeling the pressure.

In other words, short-term movements in the share price don’t matter. What matters is medium-term movements in the share price!

But while Ebersman can be blamed for messing up the mechanics of the IPO, I do not think it’s fair to blame him for where Facebook’s stock might be trading 3 months or 1 year after the IPO. The stock price is not under his control; Ebersman should be judged on things which are under his control, which generally surround issues like how much money Facebook has, and what it’s doing with that hoard.

As for the idea that Ebersman “will be feeling the pressure” until Facebook’s stock gets back near its IPO price, well, I think that’s probably wishful thinking on the part of IPO investors more than anything else. Certainly Ebersman doesn’t seem to be taking a particularly groveling stance towards his public investors: Sorkin notes that when he met with some of them in New York recently, he sent out the invites so late — for a summer Friday, no less — that many of the more senior invitees couldn’t make it. I’m sure Ebersman wasn’t too bothered.

After all, there’s only one shareholder who matters, when it comes to Facebook, and that’s Mark Zuckerberg. The rest of them can huff and puff to the financial press, but they have no real influence on Facebook or its management — and no real ability to put pressure on Ebersman, either.

The other shareholders who matter are Facebook’s employees, without whom the whole company is nothing. They want to see the share price rise, of course, but Sorkin oversimplifies what’s good for them, and for the company:

Facebook’s falling stock price is not just a problem for investors; it is quickly creating real questions inside the company about its ability to retain and attract talented engineers, the lifeblood of any technology company.

Employees who joined the company starting in 2010, for example, are now holding onto restricted shares that were granted at a higher price — $24.10 — than the current trading price. (It should be noted that these are restricted stock units, not underwater stock options, so they do still have real value, but not nearly what the employees had expected.)

Let’s say you’re an employee who gets $50,000 of RSUs every year. Then in 2010 you got just over 2,000 RSUs, which are now worth about $37,500. Sorkin’s point is that you had hoped that they would be worth more than that by now — maybe you thought that Facebook would be a $100 billion company, and your RSUs would be worth $75,000.

But here’s the thing: if Facebook were worth $100 billion right now, then you would get only 1,300 RSUs this year. Whereas if Facebook is worth only $40 billion, then you’ll get 2,750 RSUs — more than twice as many. You’re increasing your stake in Facebook much faster than you would if it was worth more.

Zoom back and look at what’s happening across Facebook’s workforce as a whole: Ebersman is doling out a lot more shares to employees than he might have expected. That dilutes external shareholders and makes them even less relevant, but it’s not necessarily bad for employees.

Having a low share price can actually help in terms of attracting and retaining talent: it gives existing employees a reason to stay on rather than cash out, and it gives new employees much more upside. After all, anybody coming on board today and getting RSUs at $18 each knows that only a few months ago, there were market participants willing to pay more than $40 per share. And that nothing much has really changed since then as far as Facebook’s fundamentals are concerned.

Sorkin doesn’t get caught up in the detailed mechanics of the IPO: after all, he claims to be interested in the medium term, not the short term. But he never explains what he means when he says that “this wasn’t a traditional IPO and should never have been priced that way” — is he saying that the Facebook IPO was priced in some kind of traditional manner? Because, if he is, he’s wrong.

And more generally, it’s worth noting that Sorkin uses the word “investors”, in this column, no fewer than 13 times: it’s clear where his sympathies lie. But Ebersman’s job is to run Facebook’s finances much more than it is to worry about the mark-to-market P&L of the fickle buy side. He didn’t much care about investors before the IPO, and he doesn’t seem to care much about them after it, either. If they react by selling Facebook’s stock, that’s their right. But Zuckerberg — the guy who really matters — has made it very clear he’s concentrating on the long term. And so long as Zuckerberg has confidence that Ebersman is a good steward for Facebook’s finances, Ebersman is going to be safe in his job. No matter what investors think.

In the run-up to Facebook’s IPO in May, Henry Blodget explained just what it was that made Mark Zuckerberg a great CEO: his ultra-long-term time horizon. “It often takes decades to build the sort of companies that the best executives and entrepreneurs hope to create,” wrote Blodget, explaining that Facebook’s dual-class share structure, and Zuckerberg’s control of the company, would allow the young CEO to build a company for the ages, rather than one which hurt itself by chasing short-term profits.

When talking about Zuckerberg’s most valuable personality trait, a colleague jokingly invokes the famous Stanford marshmallow tests, in which researchers found a correlation between a young child’s ability to delay gratification—devour one treat right away, or wait and be rewarded with two—with high achievement later in life. If Zuckerberg had been one of the Stanford scientists’ subjects, the colleague jokes, Facebook would never have been created: He’d still be sitting in a room somewhere, not eating marshmallows…

Companies are a lot more than ticker symbols. They create jobs that employ people. They create products that help people. They devote resources to ensure that they’ll keep creating this value for decades, despite the fact that these investments reduce their near-term profits. In other words, these companies create societal value. As Warren Buffett and a handful of other investors have often observed, this balanced approach allows such companies to create huge value for some shareholders: the ones who stay put for the long term.

But where are we now, just three months after Facebook went public? Dalton Caldwell’s blog post about Facebook has gone viral this week because it seems to depict a company which, having gone public, is doing the exact opposite of the kind of things that Blodget so admires. Caldwell built a Facebook app, but was then told by Facebook that because it had embarked upon a similar project internally, he basically had two choices: be taken over and shut down by Facebook, or just be shut down by Facebook. Dalton wrote, in an open letter to Zuckerberg:

Mark, I don’t believe that the humans working at Facebook or Twitter want to do the wrong thing. The problem is, employees at Facebook and Twitter are watching your stock price fall, and that is causing them to freak out. Your company, and Twitter, have demonstrably proven that they are willing to screw with users and 3rd-party developer ecosystems, all in the name of ad-revenue. Once you start down the slippery-slope of messing with developers and users, I don’t have any confidence you will stop.

The point here is that although Facebook might be controlled by Zuckerberg individually, it’s still nothing without its thousands of employees. And those thousands of employees have entered into a bargain with Zuckerberg: they’ll accept relatively modest salaries, and work hard, because Zuckerberg is giving them substantial amounts of equity in the company. Once Facebook went public, every single Facebook employee became acutely aware of the company’s share price, what direction it was going in, what that move was doing to their net worth, and what public investors wanted to see from the company (revenues, and profits, rising sharply).

As such, despite his voting control at board level, it’s actually really hard for Zuckerberg to keep his employees focused on long-term platform-building, rather than short-term obsession over the share price. For one thing, they don’t own the company; many of them are going to leave, at some point, and so their time horizon is necessarily going to be shorter than Zuckerberg’s. And at any company with broad share ownership and a public share price, employees are always going to pay a huge amount of attention to whether it’s going up or going down.

On top of that is the classic Silicon Valley problem — which is that employees are always searching for the new new thing, the company where they can get early-stage equity and make themselves a fortune. Or, at the very least, join a mature company like Apple where the stock can still rise enormously. If Facebook’s stock is going down rather than up, its employees will start looking for other opportunities, and the company will find it much harder to attract talent.

Facebook has a lot of money and a lot of great employees, and so should by rights have the luxury of spending both money and its employees’ time in the service of building a platform for the ages. In practice, however, now that Facebook has gone public, it doesn’t work like that. The markets want to see quarterly results — and the employees’ incentives are aligned more with the markets than they are with Zuckerberg. He might have been a very good CEO of a private company. But trying to run a public company, as he’s discovering, is very different.

Last week, Arik Hesseldahl — a tech writer who’s the first to admit he’s no expert on finance — discovered the wonderful world of credit default swaps in general, and single-name CDS on Hewlett-Packard, in particular. The cost of single-name protection on HP has been going up, and that can only mean one thing: it’s “mainly a barometer of the state of anxiety over its finances and its balance sheet”, he wrote.

Hesseldahl’s corporate cousins Rolfe Winkler and Matt Wirz followed up a couple of days ago:

A $10 million five-year insurance policy on H-P debt costs $260,000 according to data provider Markit. That price has doubled since April and quadrupled since a year ago. While there is no prospect of H-P going under any time soon, bond investors are clearly unhappy about the company’s deteriorating prospects and balance sheet.

But I don’t buy it. For one thing, as David Merkel points out in a comment on on Hesseldahl’s latest post, the HP bond market is not panicking at all: its bond prices remain perfectly healthy. He continues:

The markets for single name CDS are thin because there are no natural counterparties that want to nakedly go long credit risk. Those wanting to nakedly short credit risk therefore have to pay a premium to do so, usually higher than the credit spread inherent on a corporate bond of the same maturity.

And if one or two hedge funds want to do it “in size,” guess what? The CDS market will back off considerably, and make them pay through the nose.

It’s hard to spook the bond market for a liquid bond issuer; it is easy to spook the CDS market.

Why might one or two hedge funds suddenly want to buy protection on HP (and Dell, and Lexmark)? There’s an easy and obvious explanation: their share prices. HP, Dell, and Lexmark are all trading at less than 7 times earnings, at the lowest prices they’ve seen in a decade. They’re all in the fast-changing and volatile technology business. The only certainty here is uncertainty: it’s reasonable to assume that in five years’ time, each of these companies is going to be in a very different place to where it is now.

Which sets up an easy and obvious capital-structure arbitrage. You go long the stock, and then you hedge with single-name credit protection — the only way you can effectively go short the debt. The stock market is deep and liquid enough that you can buy your shares without moving the market; the single-name CDS market isn’t, but no mind. Even if you overpay a bit for the CDS, the trade still looks attractive, on a five-year time horizon.

In five years’ time, it’s entirely possible that at least one of these companies will be toast — in which case anybody who bought the CDS today will have scored a home run. On the other hand, if they’re not toast, the stocks are likely to be significantly higher than they are right now. Basically, the stock price is incorporating a significant probability of collapse, and if you take that probability away, then it should be much higher. And buying protection in the CDS market is one way of effectively taking that probability away.

This kind of trade only works for companies in unpredictable sectors that have low stock prices and relatively low borrowing costs; such opportunities don’t come along very often. But when they do come along, it’s entirely predictable that a hedge fund or two will put on this kind of trade. In no way are such trades a sign that bond investors are worried about the company’s future: in fact, bond investors are not the kind of investors who put on this trade at all.

And so, as Merkel says, reporters should be very wary indeed of drawing too many conclusions from movements in the illiquid CDS market. Sometimes, they really don’t mean anything at all.

Is a bubble bursting in Web 2.0 stocks? The NYT says there is, and says indeed that this implosion is even more dramatic than the one we saw in 2000. In reality, of course, it isn’t.* In 2000, trillions of dollars of wealth evaporated as the share prices of thousands of companies plunged to earth; in 2012, by contrast, we’re talking about a mere handful of companies, including Facebook, which, with its $65 billion market cap, still looks pretty well valued to me.

That said, most of the public self-described “social” companies — with the prominent exception of LinkedIn — have indeed seen their share prices hit hard of late, to the point at which many recent private rounds look decidedly rich. The result is that there’s a pretty strong case to be made that we have what you might call a steep inversion in the valuation curve.

In general and in aggregate, corporate valuations are meant to rise over time. There’s a lot of volatility in the process, of course, and individual companies go bust all the time. But in the Silicon Valley model, companies begin as startups at relatively low valuations, and then as they raise more money in successive rounds, their valuation steadily rises. Eventually, if and when they go public, they’re worth so much that anybody who bought in during one of the private rounds will be sitting on a nice profit.

That’s not just a matter of growth over time, either: it’s also a matter of a much larger investor base. There are only a relative handful of individuals and institutions who buy into private rounds; in contrast, there are millions of investors around the world who can buy stocks listed on public markets. If the number of people bidding against each other to buy equity in any given company suddenly rises by many orders of magnitude, it stands to reason that the price is going to rise as well.

With the latest crop of tech stocks which have gone public, however, that hasn’t been the case — despite what seemed to be enormous appetite, for Facebook stock in particular, from investors all over the world. Instead, even if valuations are still getting steadily richer from round to successive round in the private markets, there’s no a significant drop at the end of the curve — the point where private markets go public.

So what’s going on? The answer, I think, can be found in the psychology of the dot-com bubble. Back then, there were a lot of people making enormous amounts of money by investing in technology stocks. You’d put together a portfolio of tech stocks, the portfolio would rise in value, and you would conclude that you were doing very well, and therefore buy ever more tech stocks. After all, your brokerage statements were proof positive that you knew exactly what you were doing, and were very successful at it. A bull market, especially a soaring bull market, creates confidence and momentum and inflows.

Turn that story on its head, and you wind up where we are today. There are still dedicated technology investors and funds in the public markets, but all the top technology investors have moved, at this point, to the private markets. If you’re in the public markets, your performance has been mediocre for over a decade, and you’re liable to take any brief buzz-induced inflow of funds into the sector as an opportunity to cash out and make a rare and precious profit.

In theory, the fact that the public markets are so much bigger than the private markets should be great for any tech company going public which cares mostly about its valuation. There’s a finite number of shares out there, and the demand for those shares is now vastly bigger than it was. Therefore, price must go up.

In practice, however, it doesn’t work like that. Instead, we have a very small pond of private investors, where valuation momentum can pick up incredibly quickly. But the minute the gates come down and the company’s valuation wave spills into the ocean of the public markets, it just gets absorbed into the broader tech-valuation sluggishness, and disappears.

Yes, Facebook had a very large IPO, but it was always a bit ridiculous to hope that a single offering could change the psychology and momentum of the entire technology sector — even if it had gone well, which of course it didn’t. Stock markets are moody animals, and they don’t like being told how to behave by Sand Hill Road types with an eye to a big payday. The tech sector might turn around and begin a rally at some point. But chances are, that point won’t come until after Silicon Valley’s VCs have been properly chastened.

*Update: I apologize for mischaracterizing the NYT article; it did not say that the current pop was as loud as the one we all heard so loudly in 2000. I misread the article, or read it too quickly. Sorry.

Marc Andreessen agrees with me that it sucks to be a public company. But he disagrees on the reasons why:

Basically, it was very easy to be a public company in the ’90s. Then the dot-com crash hits, then Enron and WorldCom hit. Then there’s this huge amount of retaliation against public companies in the form of Sarbanes-Oxley and RegFD and ISS and all these sort of bizarre governance things that have all added up to make it just be incredibly difficult to be public today.

Andreessen, of course, as the lead independent director at Hewlett-Packard, knows all about “bizarre governance things”. But Sarbanes-Oxley and RegFD and ISS don’t even make it into the top ten. And as for the idea that they’re “retaliation against public companies”, that’s just bonkers; in fact, it’s really rather worrying that we have directors of big public companies talking that way.

The three things mentioned by Andreessen come from three different places: Sarbanes-Oxley came from Congress; RegFD came from the SEC; and ISS is a wholly private-sector company which allows shareholders to outsource the job of ensuring that governance at the companies they own is up to par. If there wasn’t significant buy-side demand for such services, ISS wouldn’t exist.

It’s directors’ job to care deeply about governance, rather than to dismiss serious concerns from legislators, regulators, and shareholders as “bizarre governance things”. And for all that companies love to bellyache about the costs of Sarbox compliance, the fact is that if you’re looking to governance issues as a reason why it sucks to be public, you’re looking in entirely the wrong place.

The real reasons it sucks to be public are right there in the name. Being public means being open to permanent scrutiny: you need to be very open about exactly how you’re doing at all times, and the market is giving you a second-by-second verdict on what it thinks of your performance. What’s more, while the glare of shareholder attention on the company can be discomfiting, it tends to pale in comparison to the glare of public attention on the company’s share price. I was on a panel last week talking about IPOs in general and Facebook in particular, and I was struck by the degree to which Mark Zuckerberg’s enormous achievements in building Facebook have already been eclipsed by a laser focus on his company’s share price.

Zuckerberg — or any other CEO — has very little control over his company’s share price, but once a company is public, that’s all the public really cares about. If Facebook’s share price falls, all that means is that external investors today feel less bullish about the company than they did yesterday; if it falls from a high level, that probably just says that there was a lot of hype surrounding the Facebook IPO, and that the hype allowed Facebook to go public at a very high price. Facebook could change the world — Facebook has already changed the world, and did so as a private company — but at this point people don’t care about that any more. All they care about is the first derivative of the share price. And maybe the second.

When companies go public, people stop thinking about them as companies, and start thinking about them as stocks: it’s the equivalent of judging people only by looking at their reflection in one specific mirror, while at the same time having no idea how distorting that mirror actually is. Many traders, especially in the high-frequency and algorithmic spaces, don’t even stop to think about what the company might actually do: they just buy and sell ticker symbols, and help to drive correlations up to unhelpful levels. As a result, CEOs get judged in large part by what the stock market in general is doing, rather than what they are doing.

And meanwhile, CEOs of public companies have to spend an enormous amount of time on outward-facing issues, dealing with investors and analysts and journalists and generally being accountable to their shareholders. That’s as it should be — but it isn’t pleasant. When Andreessen says that it was very easy to be a public company in the 90s, he’s right — but he’s wrong if he thinks the 90s were some kind of halcyon era to which we should return. They were good for Andreessen, of course, who took Netscape public in a blaze of publicity and more or less invented the dot-com stock in the process. But they were bad for shareholders, who saw their brokerage statements implode when the bubble burst. And, as Andreessen rightly says, they were bad for the broader institution of the public stock market, which has never really recovered from the dot-com bust.

As a venture capitalist, Andreessen has a fiduciary responsibility to his LPs, and he needs to give them returns on their investment, in cash, after five or ten years. It’s a lot easier to do that when you can exit via an IPO. But the way to make IPOs easier and more common is not to gut the governance that’s in place right now. Instead it’s to embrace it, and make public companies more like private companies: places where management and shareholders work constructively together and help each other out as and when they can. Mark Andreessen is a very active and helpful shareholder of the companies that Andreessen Horowitz invests in — and he has a level of access to management and corporate information that most public shareholders can only dream of. If he likes that system, maybe he should start thinking about how to port it over to public companies, as well.

Update: See also this great post from Alex Paidas, who’s found a quote from Andreessen saying that all of his companies should have a dual-class share structure. Despite the fact that I can’t ever imagine Andreessen himself being happy with non-voting shares.

“In a way,” says Jeffrey Goldfarb today, “the scandal may have been the best thing to happen to News Corp,” on the grounds that Hackgate is likely to end up forcing Rupert Murdoch to spin off his newspapers, along with HarperCollins, into a new, separate company.

I can see what Goldfarb means: it’s probably fair enough, if you’re writing for a service like BreakingViews, to assume that whatever is good for a company’s share price is good for that company. But from a journalistic perspective, the news at News is much less good.

I was at the Loeb Awards gala dinner tonight, where the WSJ’s Jerry Seib won the Lifetime Achievement Award. He’s been at the WSJ since 1978, and in his acceptance speech he talked about the culture shock which descended upon the newspaper after it was bought by Murdoch. At the same time, however, he welcomed it: “there’s a reason it’s called the News Corporation,” he said — and he’s right. Murdoch, at heart, is a news man, and although most of his wealth is attributable to sports and entertainment, it’s clear that his heart is very much in journalism. Moreso, it should probably be said, than most of the Bancrofts who sold him the Journal.

In the short term, this makes sense. It would give the entertainment company more latitude to operate without the reputational baggage associated with News International, and if anything it would allow Rupert Murdoch to further consolidate his control of his newspapers, since the valuation of the spun-off company would be low enough that he could quite easily take it entirely private, if he wanted. Rupert Murdoch won’t be any poorer after this deal is done — in fact, he’ll be richer, thanks to the eradication of the “Murdoch discount” — and so his newspapers’ charmed lives as playthings of a billionaire who doesn’t care much about ROE is likely to continue either way.

But so long as the print properties remain public, shareholders are going to be even noisier about making them pay than they are right now. At the moment, News Corp shareholders mostly just want the newspapers to go away. But after the spin-off, shareholders in the new company will be agitating noisily for profits. Murdoch will ignore them, of course — but that kind of thing is difficult to ignore entirely.

Up until now, Murdoch has never really needed to worry very much about his newspapers’ profitability, because the rest of his empire was throwing off such enormous profits. That’s going to change. Even if he does take the papers private, none of his heirs particularly wants to inherit them. There’s a big question mark over the papers’ future, now, which will only grow as Murdoch gets older.

There’s also the fascinating question of what’s going to happen with Fox News. When News Corp loses most of its news properties, only Fox News and Sky News are likely to remain — and when big broadcast companies own news operations, those news operations tend not to perform very well. The fact that news is part of News Corp’s DNA has surely been a crucial factor in Fox News’s success; now that’s coming to an end, Fox News’s new overseers might view the channel in a significantly different light.

Again, nothing is going to happen overnight: Murdoch will continue to have personal control of both companies, and both will be run exactly the way he wants them to be run. But in the world of journalistic business models, I’ve always been a fan of being owned by a benign gazillionaire, who cares about more than just profits. Both Bloomberg and Reuters fall into that category, as do outfits such as the Atlantic, Condé Nast, and The New Republic. But Murdoch has always been the first billionaire you think of when you think “press baron”. And it’s foolish to believe that a change as big as this at the corporate-structure level will have no effect on his individual properties.

Last week I explained why Wall Street prefers lower-priced stocks: they mean that bid-offer spreads are wider, in percentage terms, and when that happens, brokers make more money.

So it comes as little surprise to see that Wall Street is now agitating for some stocks to trade in increments of 5 cents or 10 cents, rather than the current 1 cent:

Brokerage firms often can’t afford to spend money developing reports on thinly traded companies because firms are less likely to make back that money through commissions linked to trades in such securities, said Healy. With less research available on small-cap companies, mutual funds and other institutions may not be inclined to invest in such stocks, he said.

Of course, there were lots of silly reasons put forward too: one executive even said that he was pushing the change for investors‘ sake, on the grounds that they “like round numbers”. But the real reason is the obvious one: the higher the bid-offer spread, the more money brokerages make. I, like Alex Tabarrok, am naturally suspicious when industry insiders say that higher tick sizes are in the public interest.

But there’s something else going on here, surrounding the semiotics of nominal share prices. The fact is that it’s pretty easy to choose a wide or a narrow bid-offer spread without changing tick sizes at all: if you want a wide spread have a low nominal share price, and if you want a narrow spread, have a high nominal share price. Anything over $50 or so will give you the narrowest possible spread, since bid-offer spreads almost never go lower than 2bp. On the other hand, if you want a spread of 30bp to allow Wall Street to make a killing, then just do a big share split which results in a share price of $3 or so.

Why don’t companies do this? Because nominal share prices matter, at least to retail investors. After I wrote my last post, a Wall Street veteran emailed me:

Trust me on this: Individual investors HATE HATE high-priced stocks. I know the logic makes no sense but you simply cannot sell a $70 stock to an individual unless it’s a very well-known blue chip. They hate it.

You would be surprised to hear how many people say that they’re looking for something “in the $23 range.”

This is weird, and irrational, but true. What’s more, individual investors are highly suspicious of very low-priced stocks, too. If Apple suddenly announced a 150-for-1 stock split, so that its shares started trading at $3.86 apiece, that would be bearish for the stock, the conventional wisdom that investors like stock splits notwithstanding. A company whose shares trade below $4 just feels as though it’s small, or struggling: certainly not a world-beating behemoth. (Incidentally, if Apple did do that 150-for-1 stock split, it would have 140 billion shares outstanding, and would trade on average 3.1 billion shares per day.)

The subtext of nominal share prices, beyond the obvious realm of penny stocks, is something I’ve never been good at understanding; if you know any good guides to it, I’d love it if you could point me in their direction. And even penny stocks don’t make a lot of sense to me: if you don’t want the stigma of being a penny stock, why don’t you just do a reverse stock split?

In any case, for reasons I don’t pretend to understand, it’s obviously a lot easier to try to change tick sizes than it is to change nominal pricing conventions. Some things are incredibly sticky, even if they don’t make any sense. I guess they’re a bit like that weird American love of pounds and miles and gallons.

Three weeks ago, Alex Tabarrok found an intriguing post by high-frequency trader Chris Stuccio. The idea is very elegant: if you want to stop high-frequency traders extracting rents from the market, there’s an easy way to do so — you just allow stocks to trade in increments of much less than a penny. Matt Levine puts it well: right now, he says, “because you can’t be outbid by another bidder within the same penny increment, you get free money by just getting there first”. If high-frequency traders could compete on price rather than just on speed, then a lot of the silly arms-race stuff would be replaced by better prices for investors.

It’s a serious proposal, so I was glad to see that Matthew Philips wrote it up for Businessweek. But after starting off well, Philips ends up joking about it, and refusing to adjudicate between Stucchio and his on-the-other-hand trader, Ben Van Vliet.

The fact is that on the face of things, Stuccio is undeniably correct. Here’s the chart, from Credit Suisse via Cardiff Garcia:

The y-axis shows the bid-offer spread on any given stock, in basis points; the x-axis shows the price of the stock, in dollars. Clearly, there’s an artificial clustering around that curve. For a lot of stocks trading at less than $50 a share, the market would happily provide bid-offer spreads of less than a penny if it could; but it can’t. And when stocks get really cheap, the bid-offer spread becomes enormous. For instance, an eye-popping 3.766 billion shares of Citigroup were traded on December 17, 2009, when the stock fell 7.25% to $3.20. At that level, a one-penny bid-offer spread is equivalent to a whopping 31 basis points; if Apple traded at a 31bp spread, then its bid-offer spread would be almost $2.

Clearly, the traders were the big winners when Citi was trading at a very low dollar price — if you make the assumption that traders capture half the bid-offer spread on each trade, then the traders made almost $20 million trading Citigroup alone, in one day.

On the other hand, it seems that the market almost never trades stocks at a bid-offer spread much below 2bp. Which in turn means that for stocks over $50 per share, we’re pretty much already living in Stuccio’s ideal world, where the spread is determined by traders, rather than by an artificial rule barring increments of less than a penny.

Which brings me to my theory: that companies deliberately price their shares at less than $50, as a way of greasing their relationship with Wall Street a little bit. Back at the end of 2010, I was very confused by the fact that Facebook had done a 5-for-1 stock split, reducing its share price from about $75 to about $15. But in hindsight, maybe it was all part of its IPO preparations: you almost never see stocks go public at more than $50 per share.

Here’s a question for the data geeks out there: did nominal share prices decline after the stock market moved to penny pricing in 2000? If so, that would support my argument: that Wall Street manages to engineer stock prices so that it makes good money trading shares. And companies are generally happy to go along with Wall Street on this: most stocks trade at $50 per share or less.

It’s true that a lot of the rents from the sub-penny rule and low nominal share prices are captured not by Wall Street proper but rather by HFT shops. But all Wall Street banks have some kind of HFT operation of their own, and in general it’s probably fair to say that the lower the nominal share price, the more money that Wall Street makes. And conversely, the higher a company’s nominal share price, the less beholden it feels towards Wall Street.

To put it another way: the sub-penny rule is a way of allowing companies to price their stock so that Wall Street can make good money trading it. And we don’t need Stuccio’s rule, since it can effectively be implemented just by pricing your stock above $50 per share. If the companies don’t want to subsidize Wall Street, all they need to do is price their stock higher. And if companies do want to provide this hidden subsidy to Wall Street, maybe they should be allowed to do so.

The WSJ has a good post-mortem on the Facebook fiasco today, pointing fingers very much at Nasdaq. And clearly Nasdaq was Ground Zero for the trading problems the day that Facebook went public. But this kind of thing smells fishy:

Some hedge-fund managers called Facebook’s chief operating officer, Sheryl Sandberg, because they hadn’t received any trade confirmations from Nasdaq, says a person familiar with the phone calls. Some hedge-fund managers apologized to Ms. Sandberg and said they needed to sell their entire positions because of the confusion, the person added.

This clearly comes from Sandberg’s office, if not Sandberg herself — and it sounds very much as though she’s blaming Nasdaq for a lot of investors dumping Facebook shares on the opening day. If I were in her position, I’d do the same thing: it’s a lot easier than finding fault with, say, Facebook’s CFO, or blaming herself.

I don’t doubt that Nasdaq glitches did take the wind out of the Facebook share price, if indeed it did open with a pop at $42. (The WSJ casts some doubt on that, quoting the head of electronic trading at Deutsche Bank as saying that it was “mathematically impossible” to come up with a $42 figure if the cross had been calculated with all of the orders put in.) But with hindsight, and given the degree to which Facebook shares have slumped in the last three weeks and not bounced back at all, any problems at Nasdaq simply hastened a fall in price that was surely inevitable.

None of which is to exonerate Nasdaq at all. The WSJ article ends with a perspicacious quote from Joseph Cohn, a retail investor in New York state:

“My experience on that day is that the markets aren’t built to handle failure,” he said. “With technology, you’re able to accomplish a lot more, but when it fails, it fails miserably.”

This I think is what the SEC’s Mary Schapiro is talking about when she says that the Facebook IPO was reminiscent of the May 2010 flash crash. The US stock market, when it works, works fine. But it’s not robust at all; it’s certainly not what Nassim Taleb would call “anti-fragile”. That’s why Nasdaq did so much testing of their systems before the IPO: they knew that if the systems failed, the outcome could be horrible. As, in fact, it was.

IPOs are a particularly hard task for stock exchanges, as we saw first with the BATS IPO and now with Facebook. Normally, any given trade happens at a price very close to the previous trade — but in an IPO, no one really has a clue what the price should be, and demand can appear and dissipate much more quickly than we see in the normal course of secondary-market trading. Momentum traders rule, and value investors know that the best thing they can do is wait patiently until things quiet down. As a result, once Facebook stock started falling and the supportive bid from the underwriters went away, there was basically no bid any more. Hence the fact that it’s now trading more than $10 below the IPO price.

On the other hand, the stock genuinely has stabilized in recent sessions, trading in a narrow band between $26 and $28 for more than a week now. That’s a pretty good sign that the market has worked out what Facebook is worth — and there’s no reason at all to believe that there were multiple equilibria here, and that if the IPO had gone better then we might have had a similar week-long stretch of trading between, say, $42 and $44 per share. Sandberg should probably call up her ex-boss Larry Summers if she really believes that. It might be a comforting unfalsifiable thought, but it’s still untrue.

There’s a fine art to pricing any scarce resource. Ex ante, it’s impossible to do a precise calibration of supply and demand, but being able to do so is crucial to getting things right. If you’re in a business where you can make more of whatever you’re selling when demand rises, that’s one thing. But when you’re selling tickets, or Facebook shares, that’s not the case.

In a world where you have to set the price in advance, and then it can’t be changed, the calculus is simple. Set the price too high, and you end up with insufficient demand and a general feeling of failure; you don’t attract the number of people you were hoping for, and even those people are likely to end up feeling ripped off. On the other hand, set the price too low, and you create disappointment among people who wanted to give you their money and can’t, quite aside from the fact that you’re clearly leaving money on the table.

In the past couple of days, we’ve seen good examples of both. At Yankee Stadium, the price of tickets is way too high, as is evidenced by the huge number of empty seats, and by the fact that on the secondary market, two thirds of tickets are sold for less than face value. Lots of seats are being sold by people asking less than $5 a pop, and at the top of the ticket-price range, the average discount to face value is more than $90.

At the same time, sold-out $125 tickets for the Big Apple Barbecue Block Party are being hawked on Craigslist for significant premiums to face value, prompting Ryan Sutton to declare that they should be more expensive next year.

The Yankees are taking a shoot-the-messenger approach to their attendance problems, blaming the secondary market in tickets, rather than the fact that the tickets cost a fortune. That’s just silly, and it’s a no-brainer that the price of Yankees tickets should come down. Just like an IPO, you want to price season tickets so there’s a small implied “pop” in there — people with season tickets should be able to sell them on the secondary market for a little bit more than they paid. That helps keep demand for season tickets healthy, year in and year out.

What’s more, the Yankees have the same stupid pricing as the Metropolitan Opera: every game or opera costs the same amount, no matter how in-demand or run-of-the-mill the matchup. Pretty much every other baseball team has pricing variable enough that at least the big games cost more; the Yankees should take a leaf out of Broadway’s book and do the same. Broadway pretty much always sells out every show, these days, at whatever the clearing price is, and scalping is way down. That would make Yankees games much less desolate.

Pricing the barbecue tickets is trickier, but Sutton is right: when you’re raising money for charity, it’s a little heartbreaking to see tickets being flipped for profit. And the cost of setting the price too high is small: if the tickets look as though they’re not going to sell out, you just run some kind of special offer where people can buy them at a discount for a limited period of time. No harm, no foul.

And what about IPOs? With them, there’s no do-over, and the process tends to be driven very much by big investment banks with more than half an eye on their reputation in the equity capital markets. They care about making money on every deal, but they care much more about getting a healthy stream of fee income from future deals. While the barbecue can overprice its tickets without too much damage, investment banks don’t have the same luxury.

And that’s probably the real reason why there’s an IPO pop. Underpricing the IPO might mean that the issuing company is leaving money on the table — but overpricing the IPO is much worse, as Facebook and its underwriters are still discovering. So banks always err on the side of underpricing. Except, as in this case, when the issuer has too much power, and gets too greedy.