Felix Salmon

Many thanks to commenter buysidemetrics for finding this very smart quote from Bill Gates, which actually comes from a discussion he had with Warren Buffett in 1998:

BUFFETT: The technological revolution will change the world in dramatic ways, and quickly. Ironically, however, our approach to dealing with that is just the opposite of Bill’s. I look for businesses in which I think I can predict what they’re going to look like in ten or 15 or 20 years. That means businesses that will look more or less as they do today, except that they’ll be larger and doing more business internationally.

So I focus on an absence of change. When I look at the Internet, for example, I try and figure out how an industry or a company can be hurt or changed by it, and then I avoid it. That doesn’t mean I don’t think there’s a lot of money to be made from that change, I just don’t think I’m the one to make a lot of money out of it.

Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people are going to chew gum. Bill probably does. I don’t think it’s going to change the fact that Coke will be the drink of preference and will gain in per capita consumption around the world; I don’t think it will change whether people shave or how they shave. So we are looking for the very predictable, and you won’t find the very predictable in what Bill does. As a member of society, I applaud what he is doing, but as an investor, I keep a wary eye on it.

GATES: This is an area where I agree strongly with Warren. I think the multiples of technology stocks should be quite a bit lower than the multiples of stocks like Coke and Gillette, because we are subject to complete changes in the rules.

This I think is the heart of the reason why technology stocks are trading at lower multiples than industrials. There’s no doubt that in an era of massive change, there will be a handful of tech companies which are huge winners. On the other hand, there will be some giant tech companies which are big losers, too. (Just see the fate of Apple since 1998, and compare it to the fate of Microsoft.) In general, if the number of losers exceeds the number of winners, or if the winners start out small and the losers start out big, then that’s a sector you’d be smart to buy only at relatively low multiples.

Meanwhile, in an area where change is unlikely to massively disrupt your business, income streams are more predictable and therefore more valuable.

Another way to look at this is to take the simple but powerful heuristic that the expected lifespan of any company is twice its current age. Wrigley’s and Coke and Gillette have been around a lot longer than Microsoft or Apple or Facebook, and there’s a very good chance that they’ll still be here when the current tech stars are distant memories. If I had to buy one asset for the ultra-long term — something on the order of a few hundred years — then I’d probably end up buying a timber forest: those things last forever, with growth that is so steady and predictable that it’s literally a science, and yields which can easily be stored up during periods of market weakness (just by cutting down fewer trees).

So then the next question arises: why are tech companies trading lower than industrials now, when they’ve never done so in the past? Has the market suddenly become uncharacteristically rational?

That’s a harder question to answer, but I think that it’s fundamentally based on the fact that the giants of the dot-com era are still big and entering a long-term decline — think Microsoft, or Intel, or HP, or Yahoo. Meanwhile, the exciting smaller companies, insofar as they exist, simply aren’t public.

And it turns out that even Warren Buffett’s boring and predictable companies like Coca-Cola can benefit from huge and unpredictable trends. Mark Bittman has a good piece in this weekend’s NYT which included this chart:

I don’t think that anybody — not even Warren Buffett — could have predicted 30 years ago that soda price inflation would so massively lag both consumer prices generally and food prices in particular. Healthy food is now twice as expensive, relative to soda, as it was in the early 80s. Which obviously does wonders for Coca-Cola’s brand franchise, even if it causes billions of dollars a year in damage elsewhere in the economy. If I’m a long-term buy-and-hold investor, that’s the kind of trend I want to jump on. Rather than, say, Farmville. To make money in Zynga stock you need to know when to sell. To make money in Coca-Cola stock, you don’t.

Thanks to Larry Summers for suggesting that I take a look at this chart. It wasn’t particularly easy to find, but it’s quite striking all the same. (And thanks very much to Roy Strom and Van Tsui, here at Thomson Reuters for putting it together.)

What we’re looking at here is a ratio of ratios: it’s the price/earnings ratio of the companies in the MSCI USA IT index, which covers technology companies, divided by the price/earnings ratio of the companies in the MSCI USA Industrials index. (For earnings, we’re using 12-month forward earnings — but we’re not really looking at the p/e ratios themselves here, just the ratio between the two ratios.)

Summers is absolutely right: this ratio is currently at an all-time low. The TR data goes back to 1994, so this chart encompasses 17 years, but I suspect you’d need to go back a lot further to find the last time this ratio was trading this low.

Importantly, the ratio is trading at less than 1: the market is saying that earnings at technology companies, which historically exhibit high growth, are worth less than earnings at established industrial companies.

Now this might be an artifact of the specific indices I’m using here: according to another chart sent to me by John Coogan, the ratio is still at an all-time low, but is above 1. Still, the fact is that the market clearly isn’t giving technology earnings the premium they’ve historically commanded.

Why might that be? Frankly I don’t really know. Maybe it’s a function of industrial earnings rebounding less quickly than earnings in the tech sector more generally. Maybe it’s largely an Apple thing. But there’s definitely an indication here that either industrial earnings are too expensive, or technology earnings are too cheap right now. Or both.

If you want a great example of the kind of mean things that people are saying about Groupon in the run-up to its IPO, you could do a lot worse than Rocky Agrawal’s TechCrunch essay entitled “Why Groupon Is Poised For Collapse”. It’s a great example of overstretch and dubious logic, with a couple of moments of brilliance and genuine insight thrown in at the same time. Groupon, of course, being in its quiet period, can’t react. Except, it just can’t help itself, and has put up a whiny post, supposedly authored by the company cat, about how unfair the whole situation is.

The fact is that when Groupon made the decision to go public, it invited exactly this kind of attention — both before the IPO and forever more. When Groupon was private, no one really knew anything about its financials, and CEO Andrew Mason could happily declare that he’d much rather talk about building miniature dollhouses. Once it’s public, however, he’ll have a fiduciary responsibility to his shareholders, and will have to answer such questions at length. Will that make him happier than answering such questions with a death-ray stare? I doubt it, to be honest. Revenues and business models and profits and forecasts are serious things, and you can’t kid around with shareholders in the same way you can with journalists.

In other words, Mason will have to go from saying nothing, which can be fun, to saying something, which almost certainly won’t be. Rather than moan about his inability to say anything in the quiet period, he should enjoy it while it lasts. From now on in, the boring financial questions are going to be unavoidable — from analysts, from journalists, from shareholders, even probably from merchants and customers who wonder whether Groupon’s profitability is a sign that they’re being ripped off.

Which brings me to one of Agrawal’s smartest points:

Underlying Groupon’s success is an auction. It’s not explicit, like Google’s AdWords bidding platform, but the economic effects are similar. The fact that Groupon runs daily deals creates artificial scarcity and drives up pricing to absurd levels. Even with four deals a day in a given market, you’re talking about fewer than 1,500 deals a year.

The reason that Groupon can get away with retaining 50% of the proceeds of its offers is precisely because the supply of those offers is so constrained that demand will always exceed it. Groupon can then pick and choose among the various different merchants clamoring to do business with it, aiming to maximize its own revenues by selecting the offers which are most lucrative for Groupon.

In this, Groupon’s interests are not aligned with either merchants or consumers. With merchants, indeed, the interests are almost diametrically opposed: the greater the proportion of total revenues that Groupon takes, the less well the merchant does. And consumers will always prefer an offer with a low up-front cost, while Groupon wants to maximize the up-front spend, since that’s all that Groupon ever sees.

Up until now, there’s been one overriding narrative when it comes to Groupon: its astonishing, breakneck rate of growth. The secondary story was the quirkiness of the place, and its sense of humor. And I’m sure that from the company’s point of view there’s something frustrating about running into its first real barrage of negative press just when it can’t respond at all. But my guess is that it won’t take long before executives look back wistfully on these quiet days. Because the aggressive questions aren’t going away — and the questioners are never going to be satisfied with Groupon’s answers, either.

Dan Primack has some huge news today: new legislation being put forward is likely to radically change the calculus which currently forces companies to go public after they have more than 500 shareholders. If the bill being proposed by David Schweikert and Jim Himes becomes law, most VC-backed companies would never run into a shareholder limit: not only would the number be raised from 500 to 1,000, but employees and venture capitalists and other accredited investors wouldn’t count towards that total.

Schweikert tells Primack that the bill could get enacted by year-end, and that it’s likely to “move substantially on its own” rather than being subject to horse-trading. Certainly it doesn’t seem to be particularly right-wing or left-wing, and Schweikert says he’s got support even from the exchanges. There’s no natural constituency to oppose the bill, or lobby against it, which certainly helps its chances.

The bill would certainly be very popular in Silicon Valley, which is an important source of campaign donations in a presidential election year. And conceptually it makes sense. There’s no reason to force companies to go public just because of anachronistic rules, not when going public is such a drastic and irreversible move.

On the other hand, I do worry that if this bill goes through, the number of companies going public will fall even more, and the investing public will have access to even less of the investable universe than it does at present. Is it a good idea that only VCs and plutocrats have access to asset classes like fast-growing VC-backed companies? Probably not. But I’m also not sure that’s in and of itself reason to oppose this bill. The key constituency here is the SEC: if they’re OK with this, it’ll go through. And maybe Facebook won’t go public after all.

Mark and Joseph over at Observational Epidemiology have come to the end (I think) of a fantastic series of posts about Groupon which get to the heart of the question I was trying to ask here: does Groupon actually work, in practice, in the way it’s meant to work, in theory?

A lot of the recent analysis of Groupon has concentrated on the financials, which have a habit of proving whatever you want them to prove. Yes, Groupon is losing ever-increasing amounts of money — but it’s doing so because it can, and because it’s convinced that all the money it’s spending on customer acquisition today is going to be repaid in spades tomorrow. If Groupon stopped spending money today on customer acquisition and marketing, it would be extremely profitable already, at its present size. It just wants to get even bigger and more profitable still, as fast as possible: a perfectly respectable capitalist goal.

Which brings us to the question of whether size matters, when it comes to Groupon. Insofar as Groupon has a moat — something which protects it from competition — it’s scale. But is scale particularly useful for Groupon? Where are the economies, there?

The simple and obvious answer is that the more customers Groupon has, the better it can get at targeting deals. Groupon is all about local — but if you live in a big city, some restaurant over on the other side of town ain’t local. If, thanks to its scale, Groupon can show you places much closer to home, or otherwise targeted to what you’re interested in buying, it will have a huge advantage over most of its competitors.

And then there’s the “Group” part of “Groupon” — the social aspect of the site, with people turning deals into opportunities to get together with their friends in the real world. Again, as with any network, size is crucial.

Mark started off the thread by pushing back against my assertion — sourced to Groupon itself — that diners spending their Groupon at a restaurant averaged a check 80% greater than the face value of the Groupon. Looking at the offers in his area, he reckoned that diners both could and would spend almost exactly the amount of the Groupon.

Joseph then followed up with more anecdote, buttressed by provocative thinking:

A good mate who owns a restaurant and did one of these deals after said it was outright amazing – many people would come in and spend EXACTLY the amount of the coupon. They didn’t want to go 50c under and heaven forbid they went 50c over and have to pay more at full price

Even worse, you seem to have to more effects. One is a priming effect. New customers assume your $30 entree is worth $15. That is poison.

I’m generally unpersuaded by argument from anecdote, and I don’t think the priming effect is all that strong. But the post was a great one if only because it set off a whole stream of posts from Mark, starting with the smart thesis that people buying Groupon shares are basically buying a lottery ticket. It’s true that if Groupon cracks the targeting nut, then it will be worth many billions of dollars. But there’s no evidence that it knows how to do that, or that it has yet done so, or that it’s going to be able to do so in future.

While it’s true that almost all marketing is targeted to some extent and a few companies have been able to take that targeting to a relatively high level, identifying customers who have a high likelihood (rather than a slightly higher likelihood) of buying something remains an extraordinarily challenging business problem…

Groupon has to worry about non-responders (who are still associated with some costs), and about bargain hunters who use the offer then never come back (who cost Groupon’s partners a substantial amount), and about regulars who use an offer for a visit they would have made anyway (who represent a double loss).

Separating all this chaff from the customers you want would be daunting even with the best of data and you will not have good data. How do I know? Because I’ve been there. I’ve dealt with third party data and I’ve written the hundreds of lines of SAS code needed to produce clean, usable data-sets. And I was only dealing with data from four or five sources, not trying to tease out a badly defined target variable from data collected from thousands of merchants.  (remember, we’re trying to identify customers who made their first visit using a Groupon offer and have since returned on their own dime.)

In a follow-up post, Mark tried to work out how Groupon was targeting its offers, based on the offers he was receiving. Except it was pretty clear, from an offer he got for a 24-Karat-Gold Specialty Facial and Chocolate Foot Scrub (only $125!) that there was really no targeting going on at all. Which impression was buttressed by the fact that Groupon was advertising as “New” its attempts to get its readers to hand over basic information about themselves, such as their sex and zip code.

And Mark’s smart when it comes to noticing the strategy behind Groupon’s messaging, too: the company is signing up subscribers by promising to save them money, rather than help them discover new merchants. Maybe that’s the best way to get new subscribers in the door — but it does hint at a quantity-over-quality mindset which isn’t entirely alien to Groupon’s founders:

The people behind Groupon have proven extraordinarily adept at running up big numbers and generating hype, but they have shown remarkably little interest in setting up a sustainable, profitable company. Their targeting strategies would have been considered somewhat primitive a decade ago. Their attitude toward customer data is nonchalant. They’ve used a carpet bombing approach to advertising (including the inevitable Super Bowl ad) which generates large email lists but seldom produces high quality ones.

All of this makes me wonder if these people are more focused on the stock price in 2012 than in the solvency of the company in 2020.

If there’s a weakness here it’s that Mark is being way too scientific about the fuzzy art of marketing when it comes to small local merchants. Groupon can carve out an impressive business just by being better than a billboard, if enough merchants come back for more. And so far, Groupon’s merchants have shown themselves to be quite willing to be repeat customers. But will that last? I suspect Mark might be right about this:

Merchants keep coming to Groupon despite its mediocre list and the fat slice it takes out of every deal (from Wikipedia):

As of 2010, it is difficult for local merchants to get Groupon interested in agreeing to a particular deal. According to the Wall Street Journal, seven of every eight possible deals suggested by merchants were dismissed by Groupon.

Just to be clear, merchants spend time and effort putting together offers that will probably be rejected and, if they’re not, will probably bring in a lot of customers they don’t want. They do this because Groupon has successfully branded itself as the next big thing.

This is not something the company stumbled into. Groupon has aggressively pursued fast growth, generated ubiquitous buzz and has done its damnedest to portray itself as part of the social media movement. The ‘social’ aspect of Groupon’s business has always been trivial to the point of cosmetic but it plays a large, even dominant role in the public image of the company.

I do worry that Groupon is as famous for being valuable and fast-growing as it is for providing the first-ever scalable solution to the problem of how small local businesses can leverage the marketing power of the internet. It feels like a momentum play, in contrast to say Google, which is a stock I’d happily own on a multi-decade time horizon.

Mark concludes:

In one sense, Groupon’s strategy has worked very well. After all, the people who started the company will almost certainly walk away with a great deal of money. Eventually, though, the company will have to make the transition to former next big thing and since being the current next big thing is an essential part of the company’s model, that transition is not going to be pretty.

I can definitely see Groupon recapitulating the arc of AOL. It will build a solidly profitable core business, which will go into decline, and then will have to work out whether and how to pivot to something else.

At the same time, I can also see Groupon — and especially its nascent Groupon Now business, if it ever takes off — becoming part of life as it’s lived on a daily business, a bit like local cable TV. As Mark says, it’s a lottery ticket. And if you buy it on the first day of trading, after it’s already had its first-day pop, then you’d better be feeling lucky.

As I secretly hoped that he might, Guan came to the rescue and provided me with exactly what I was looking for — and with Thomson Reuters data, no less! (It comes from SDC Platinum, I should probably befriend someone there.) I wanted a chart of the ratio of foreign IPOs to domestic ones, for U.S. companies, on a rolling five-year basis, to see whether the current level around 10% constitutes a big spike upwards. And the answer is that yes, it does:

Guan cautions that the data from before 1980 or so might not be particularly reliable, since it’s hard to know when a U.S. company lists abroad unless you’re a truly global company. But that doesn’t really matter: the proportion of IPOs of U.S. companies which took place abroad only cracked 2% for the first time in 1999. It stayed between 1% and 2.5% all the way from 1998 through 2004, and then it suddenly started spiking: 7.1% in 2005, 8.4% in 2006, 9.3% in 2007, and a whopping 15.7% in 2008, when 6 companies had IPOs abroad and only 38 managed the feat domestically.

On an absolute rather than percentage level, the record year was 2007, when there were 24 foreign IPOs; there’s a three-way tie for second place, with 17 foreign IPOs in each of 1999, 2005, and 2006.

In any case, the thick blue line is what I was looking for, and it’s going up and to the right about as fast as any five-year moving average is ever likely to.

My next project, which maybe I can find someone at SDC Platinum to help me with, is to have a look at all those U.S. companies which had an IPO abroad — there are 157 of them, altogether — and work out how many of them ended up getting a fully-fledged US listing. Could a listing on, say, London’s AIM end up being a reasonably common bunny slope for U.S. companies which want a cheaper and gentler introduction to the world of being public than a major listing on the New York Stock Exchange?

Aaron Lucchetti takes a detailed look at the US decline in global stock-market listings today, and finds a bunch of US companies deciding to list overseas:

In all, 74 U.S. companies have done IPOs in foreign countries since 2005, raising about $13.1 billion, according to Dealogic. That is a small fraction of the more than 650 U.S. companies that have gone public on U.S. exchanges since 2005. Still, such capital raising abroad was much less common before.

The numbers here seem high to me: if you’re a US company which has gone public since 2005, there’s a greater than 1-in-10 chance that you’re listed overseas. 74 companies is a lot of companies: we’re clearly not talking about one or two exceptions here. And if you look at the example given in Lucchetti’s piece, the Seattle-based but London-listed water-purification company HaloSource, there’s no obvious reason to discount it as some unique outlier.

I would love to see a quantitative comparison here, however, rather than the qualitative “much less common.” Did some small but significant proportion of US companies always list abroad? I guess what I’d really like to see here is a chart of the ratio of foreign IPOs to domestic ones, for US companies, on say a rolling five-year basis, going back as far as there’s data. Does the current level around 10% constitute a big spike upwards?

What seems certain is that the US stock markets just aren’t particularly interesting when it comes to new listings any more. LinkedIn made a big splash, yes, but mostly just because of its huge opening-day pop. And it wasn’t even the biggest IPO last week — Glencore raised much more money, has a much higher valuation, and chose to list in London and Hong Kong. And as Bob Greifeld noted when he announced Nasdaq’s bid for the NYSE, In 2010 the US generated only 16% of the capital raised worldwide and attracted only one of the 10 largest global IPOs.

Meanwhile, this week’s big share offering — of AIG — is looking decidedly sluggish, as though the US stock market really isn’t capable of digesting such things. (To be fair, the syndrome is global: the same thing seems to be happening to Glencore as well.)

Lucchetti waves his hand vaguely at the economic implications of all this, quoting a venture capitalist as saying that “we’re losing the ecosystem that has helped buoy the US economy over decades.” But a venture capitalist would say that — she just wants as many ways to exit as possible.

The more immediate implication, I think, is for individual investors. Even today, most US investors think of stocks in terms of US listings and tickers; if you watch CNBC all day, you could be forgiven for thinking that nothing matters unless it has a US ticker. But realistically, anybody investing in equities over a long-term time horizon is going to have to have a comprehensively global outlook. And while millions of investors still get their hands dirty with individual US stocks, buying this one rather than that one, trying to do anything remotely similar with global stocks is a non-starter. Just buying them is hard enough; doing real homework on them and picking between them is almost impossible, given the huge size of the global stock-market universe.

As a result, investing is going to have to become much more index-driven than it is right now, dominated by top-down global asset-allocation decisions rather than bottom-up stock-picking. And that in turn is going to drive correlations higher and increase the amount of systemic risk in global markets. I also suspect that the decline in US listings presages a relative decline in US markets. As US investors begin their exodus out of domestic stocks and into global stocks, the US stock market is likely to underperform its foreign counterparts. As they say, follow the money. It’s not here, any more. It’s there.

In the blue corner, we have Joe Nocera and Henry Blodget (twice). In the red corner, there’s The Epicurean Dealmaker (twice), with The Analyst as cornerman. The debate centers on the fact that the shares LinkedIn sold Thursday are worth hundreds of millions of dollars more than LinkedIn received from its bankers. To Nocera and Blodget, the conclusion is clear: LinkedIn’s bankers screwed the company out of that money, giving it instead to their favored buy-side clients.

There’s no doubt that investment bankers deliberately underprice IPOs. Blodget explains why:

If underwriters aimed to price each IPO exactly at fair-market value, there would be no incentive for institutions to take the risk of buying the stock before the shares started trading. Instead, they’d just wait to see where the stock traded and then make their buying decision then.

In the case of an oversubscribed IPO like LinkedIn, this isn’t completely convincing — getting a large allocation of shares at once is preferable to having to taking your chances with respect to being able to cobble together a significant position in the secondary market. After all, as TED says, the banks “want to weight the initial buyers in the deal toward investors who intend to not only hold the stock after it frees to trade but also add to their positions in the aftermarket”.

But the bankers don’t only want to place stock with high-quality long-term investors; they also want to achieve one of the main purposes of going public in the first place, which is price discovery. For that, you need a substantial volume of buyers — and sellers — all day every day for years and decades to come.

In other words, it’s the market which sets the price of the stock; it’s the job of the bankers to bring the company to market. And the bankers only have room for error in one direction. They can underprice the IPO; in fact, they have to underprice the IPO by some amount. But they can’t set the price too high.

Now the view of Nocera and Blodget is that the bankers can or should have a very good idea where the shares are going to end up trading, and that therefore if they end up underpricing the IPO by as much as we saw on Thursday, that’s unprofessional at best and downright theft at worst. Nocera says that the LinkedIn bankers “absolutely must have known” that the IPO was going to double in price; Blodget says that “Wall Street underwriters are paid massive amounts of money to estimate fair-market value, so they deserve to be held accountable when they blow it.”

I agree with Blodget’s premise here, but I come to a different conclusion. The whopping 7% fee that banks charge for an IPO is indeed a very large sum of money; if markets were remotely efficient, that fee would be much smaller, closer to the kind of fees normally seen on bond issuances, which can be less than 0.2%. Or, you can consider the 7% fee to be the cost of a guarantee that the company will get analyst coverage from the lead managers for the foreseeable future, rather than the price of market expertise which costs much less in other contexts.

In any event, I disagree with Blodget and Nocera that the banks knew what was going to happen when LinkedIn went public, and generously gifted hundreds of millions of dollars to their clients rather than giving 93% of that sum to LinkedIn and keeping the rest for themselves.

For one thing, if the large 7% fee does anything, it aligns the banks’ interests with the issuer’s. If the banks felt they could make millions more dollars for themselves just by raising the offering price, it’s reasonable to assume that they would have done so. I’m sure that the institutions which were granted IPO access are grateful to the banks for the money they made, but that gratitude isn’t worth a ten-figure sum to the ECM divisions of the banks in question.

But there’s an even easier way to prove that the banks didn’t know what was going to happen on IPO day. Which bank, after all, is the greediest and most knowledgeable of them all? Goldman Sachs. And Goldman was one of the few investors which sold its entire position at the IPO price of $45 per share. If Wall Street knew that LinkedIn was going to soar into triple digits on day one, you can be quite sure that Goldman would have held on to most if not all of those shares.

This, then, looks much more like a cock-up than a conspiracy. If the banks knew that they could get the IPO away at $80 per share and still see a 15% pop, they would surely have done so. But they didn’t know that, because LinkedIn was the first social-networking company to go public, and therefore no one — on either the buy side or the sell side — really had a clue where the public markets would end up valuing it.

And indeed it’s not entirely clear that the banks could have gotten the IPO away at $80 per share. The way that the LinkedIn IPO worked, the shares were issued at $45 to investors who were happy to hold them at that level; those investors then started selling when the first-day pop reached insane proportions. At $80 per share, however, very few of those investors would have been happy to hold on to the stock for the long term — which means they wouldn’t have put in bids in the first place. The banks might well have had serious difficulty even allocating the shares in the first place, and would have been risking a busted IPO.

What’s more — and this is a point which, weirdly, neither TED nor The Analyst have made — bankers and investors actually had a very good idea what the market price for LinkedIn shares was. It was $35 per share. LinkedIn was the fourth-most-traded stock on SecondMarket, with an auction every month from April 2010 through March 2011. In January there was a significant pop to $34 per share, and then it stayed there: in February the auction cleared at $35, and in March it was the same amount.

Yes, the LinkedIn prices were arrived at with only a small number of buyers and sellers, but they were real market prices in an anonymized market; pricing well above the SecondMarket level was always going to be dangerous. The bookbuilding process is vague and error-prone compared to the hard numbers being generated on a monthly basis on private markets, and so bankers were naturally going to trust SecondMarket as a very important datapoint in their pricing decisions. If LinkedIn had priced well below the SecondMarket price and then popped up to exactly that level, then it would have been easy to criticize the bankers. But instead it priced at a 30% premium to the highest-ever SecondMarket price — which was pretty aggressive, I think.

The SecondMarket story also shows that auctions often don’t work very well. There’s a 50-page paper here explaining all the reasons why that might be, especially when it comes to initial public offerings. But this is an important point: the Noceras and Blodgets of this world are very quiet on the question of whether there’s a better way of doing things than the one we’ve got right now.

Auctions have been tried, in many markets and jurisdictions around the world, and they’ve always failed; attempts to improve them have been unsuccessful, largely because it’s pretty much impossible for underwriters to distinguish between investors who have done their homework and know exactly how much they want to pay, on the one hand, and free-riders who add a lot of noise to proceedings, on the other, who trust in the former group to get the pricing right. On top of that, the mathematics of the winner’s curse means that bidders have to be extremely sensitive to the number of other bidders in the auction — and that is a number they’re unlikely to know.

And yet I’m not completely on board with the people who think that everything’s fine. Consider the point is made by The Analyst, that the only people complaining, here, seem to be kibitzers in the press. The bankers, the sellers, and the buyers are all happy — so what’s not to love? Here I think Nocera and Blodget are on stronger ground, because of the slightly invidious way in which IPOs are set up.

Essentially, there are two types of stock sale, generally known as primary and secondary, although “secondary”, in particular, can have different meanings. What I’m talking about here is the distinction between primary offerings, where a company sells shares in itself; and secondary offerings, where shareholders sell stock to each other. Rights issues are primary offerings, even if they’re not IPOs, while a founder selling stock in the market would be considered a secondary offering, even though such activities are generally done very quietly.

The LinkedIn IPO was, like most IPOs, mainly a primary offering — LinkedIn itself sold most of the shares, and received most of the proceeds. Insofar as those shares were underpriced, LinkedIn was the victim. Now LinkedIn is owned by many shareholders, who can be considered victims proportionally to the number of shares that they own. If I own 1% of LinkedIn, and the company left $200 million on the table, then $2 million of that money can be considered mine.

But the fact is that if I own 1% of LinkedIn, and I just saw the company getting valued on the stock market at a valuation of $9 billion or so, then I’m just ecstatic that my stake is worth $90 million, and that I haven’t sold any shares below that level. The main interest that I have in an IPO like this is as a price-discovery mechanism, rather than as a cash-raising mechanism. As TED says, LinkedIn has no particular need for any cash at all, let alone $300 million; if it had an extra $200 million in the bank, earning some fraction of 1% per annum, that wouldn’t increase the value of my stake by any measurable amount, because it wouldn’t affect the share price at all.

In that sense, the extra $200 million, while having a huge amount of value to the lucky investors who got to buy in at the IPO price, is actually worth very little to LinkedIn’s shareholders. If markets were wondrously efficient, that $200 million in cash would be reflected in a share price being $2 higher. In reality, the people buying the shares at this level really don’t care how much money LinkedIn has in the bank — especially now that it has a much stronger acquisition currency, should it want to start buying other companies, in its own stock.

As a result, almost none of the “losers”, here, bar LinkedIn’s corporate treasurer, really cares about that money. LinkedIn’s shareholders care about the share price, and the amount of money that LinkedIn has is irrelevant to the share price. LinkedIn’s managers and executives care about the fundamental business, not about trying to manage a cash pile which was already very large and is now significantly larger. The only real losers are the investors in Goldman Sachs’s fund — I suspect they’re rightly very angry about the company’s decision to divest itself of its entire stake at $45 per share.

Meanwhile, the big winners — the funds given access to the IPO — are ecstatic. But those funds did nothing, really, to deserve their windfall. Early-stage investors in the company were taking big risks and locking up their money for years; the people who got IPO allocations were taking no risk at all and locking up their money for, oh, a few minutes.

It would be wonderful if there were a better, fairer way of running IPOs, which didn’t give Wall Street banks the power to make millions of dollars overnight for their well-connected friends. But many attempts have been made to find such a way, and none of them have really caught on.

And here’s where SecondMarket could come in handy. Companies wanting to go public could simply lift most of the restrictions on who can buy and sell company stock on SecondMarket, SharesPost, and other private exchanges — including any restrictions limiting the number of shareholders to less than 500. At that point, under SEC rules, the company would be making a clear statement that it intended to have a fully-fledged listing the following year. It could file an S1, and maybe release some shares of its own onto the private markets just to improve liquidity and price discovery.

Then, a few months later, the company would officially sign up with Nasdaq or the NYSE, and let its shares be listed, possibly in conjunction with another tranche of newly-issued shares coming to market at the same time. Because a large number of shares had already been trading in a quasi-public market for months, there probably wouldn’t be nearly as much room for pricing error as there is now. There needn’t even be a big official IPO; that would be up to the company and its bankers.

Many companies, of course, love seeing their name splashed across the Corinthian columns of the NYSE, and having their executives ring some bell or other to celebrate their listing. All that pomp and ceremony is worth something — as is the press coverage which comes with it. A fairer way of going public would necessarily mean that IPOs would become much less momentous events. Which is why I suspect that we’ll stick with the old-fashioned way for the time being. Even if it means dumping hundreds of millions of dollars into the laps of investors who really don’t deserve it.

Why is LinkedIn doing so well on the stock exchange today? At $100 per share, by one measure it’s the most expensive stock in America. Evan Newmark has one theory: it’s because the IPO price was raised, by Morgan Stanley, by $10 per share shortly before the offering was launched. By doing that, he says, they increased the size of the pop:

Strangely, jacking the price by 30% made the offering even more enticing for lots of prospective IPO buyers.

The laws of supply and demand may say the higher the price, the less the demand. But again, that’s common sense and this is Wall Street, where a higher price equals more demand, where if the other guy wants something, then you want it even more.

Does this explain why the shares rose as high as $122 apiece this morning? No: that’s mainly just a function of the fact that it’s all in the hands of the day traders and the speculators right now. And the fact that if you buy the right hot internet stock even at the very top tick of the day, you can still make a fortune over the long term.

Take Baidu, for instance, the post-bubble record holder when it comes to first-day pops. It went public in 2005 at $27 per share, and closed that day at $122.54 — a gain of more than 350%. Today, it’s trading at $134 per share. Which might not seem like much of a gain, until you realize that there was a ten-for-one stock split last year: it’s up more than ten times from that IPO-day high point.

My feeling is that LinkedIn is going to remain hot until Facebook goes public and it’s no longer the only way for most investors to buy shares in a social network. I’ve had two conversations with LinkedIn fans over the past couple of days, and I still don’t really understand what they see in the company, or the website, beyond the fact that it’s a good way of finding and vetting possible employees or business partners. Which, admittedly, is a great niche to be in, if you can monetize it somehow.

And even at a capitalization of $10 billion, LinkedIn could still be acquired quite easily by Facebook, especially after Facebook goes public. And that is going to be a hot IPO. Maybe if they price it at a $70 billion valuation, it’ll be worth $150 billion by the time the day is out.

Herb Greenberg kicked off an interesting discussion today when he said that it took “a lot of guts” for Wedbush Morgan analyst Michael Pachter to go on CNBC today with his bearish view on Netflix, ahead of its earnings announcement this afternoon. David Wilkerson has the details of Pachter’s analysis, complete with the context:

With the stock hovering in the $80 range in April 2010, Pachter downgraded the shares to underperform from perform, with a target price of $73. Even after seeing the stock zoom into the $240s, Pachter is sticking to his rating, and a target price of $80.

That’s a very aggressive price target: Pachter’s saying that Netflix is set to lose more than two-thirds of its value, despite having a subscriber base of some 23 million Americans. But is it really a bold move for Pachter? Does it take a lot of guts for him to say this, and if so, why?

Part of the answer to that question is buried in a market symmetry: the long bias of investors is matched by a bullish bias on the analyst side. Most investors are long-only, and even the ones who go short tend to follow a 120/20 or 130/30 strategy: they nearly always have many more long positions than they have short positions. As a result, the market as a whole is already biased against anybody with a “sell” recommendation.

And when it comes to screamingly-hot stocks like Netflix, that’s even more true. Such stocks tend not to be held as part of a long-term portfolio of diversified names; they’re held by momentum traders who want to buy high and sell higher. These people tend to be pretty emotionally invested in their trade and in the sentiment which is driving it, and they can be quite aggressive towards anybody who might damage that sentiment.

On top of that, Wall Street does have a habit of boiling everything down to a right/wrong duality: if you say that a stock will go down, you’re right if it does, and wrong if it doesn’t. The intelligence of your analysis, or the idea that all these things are probabilistic rather than certain, rarely even gets lip service. This is why you see so much technical analysis on Wall Street: it makes no intellectual sense at all, but it works just as well as — or even better than — fundamentals-based analysis. (Which, admittedly, isn’t saying very much.) And that’s all that matters.

There’s also an inability for anybody to appreciate the difference between “buy/sell” on the one hand, and “long/short” on the other. A “sell” rating is not the same as a recommendation to go short. Selling your NFLX at $250 is a risk-averse move: you’re taking a volatile and overvalued stock, taking what are probably enormous profits, and saying that you’d rather sell too early than too late. Shorting NFLX at $250, by contrast, is a highly risky move which can hurt you very badly indeed. Yet when an analyst says “sell”, everybody starts talking about his “short position”, and saying things like “how’s your Netflix short coming along, Mikey?”.

One thing that’s certain about a “sell” rating, of course, is that it’s going to annoy the management of the company in question. And this is where the distinction comes in between issuing a “sell” rating on a privately-circulated report, on the one hand, and loudly proclaiming your analysis on CNBC, on the other. The television audience isn’t just sophisticated investors: it’s a much broader public than that, and corporate management hates even thinking about the idea that their company is being trashed in front of a huge audience. So if you’re going to present a bearish case on TV, be prepared to lose much if not all of your access to management.

If you make a very public bearish case, on TV, for a very visible consumer stock with lots of name recognition, that’s about as far as you can stick your neck out if you’re an analyst. That’s what Greenberg was referring to: yes, on one level it’s Pachter’s job to have an opinion on Netflix and be willing to be called on it if CNBC calls him up. But it’s easy to see why most analysts try hard never to put themselves in that kind of situation. “Clients will always be pissed if you’re wrong,” Greenberg told me in a short conversation this afternoon. “A long guy against the crowd is a value investor. A short is taking his life in his hands.”

Finally, if Netflix does fall dramatically from here — if Pachter’s call turns out to have marked the very top of the Netflix market — he’s still not going to be a hero. He’s been wrong for long enough, now, that people can just say that he was sure to be right eventually. And they’ll probably credit their own perspicaciousness if they followed Pachter’s advice, rather than giving him the credit he deserves.

So well done to Pachter for sticking to his convictions. I hope he doesn’t expect to gain much from them.

Update: I just got a great email from someone who wishes to remain anonymous:

a. In Pachter’s specific case, he’s been down on Netflix for quite a while, so it’s not exactly a significant amount of courage to go out and keep reiterating it. Whatever bridges there are to burn with a company are already burned by now, and, he’s just at the point of re-re-re-reiterating or capitulating.
b. The incentives for a guy at a (relatively) smaller shop can be a bit different – you make a name for yourself by standing out more. Whereas the bigger-shop guys have more of an incentive to limit how crazy their calls get.
c. From my perspective, there is minimal need for a research analyst to actually get his calls right. The majority of his compensation is driven by how useful he is to institutional clients. Fidelity is not going to outsource their investment decisions to a bank (for the most part), so they don’t really care what your rating or target is. They just want you to know everything there is to know about a company when they call. Some analysts are good stock pickers and they end up at hedge funds eventually. Many successful analysts are not.
d. As an outgrowth of c, I think it can be a disservice to retail investors to put some analysts on tv. They’re better at setting the scene than telling someone who owns a couple hundred shares of a stock what to do with it (setting aside whether that person should be holding/trading individual stocks to begin with).
e. Also, an analyst has to have a rating on every stock he covers. But he might only have a strong opinion on one, or a small handful. Good luck getting that context if you aren’t a paying client.

I spent most of this morning at SecondMarket, having a long conversation with Adam Oliveri, the person in charge of their private company market. That’s the part of the company which gets the most attention: it’s where stock in companies like Twitter and Facebook change hands, for instance. I learned a huge amount while I was there, and have now changed my mind on whether Facebook is going to go public: I finally understand exactly why companies need to do an IPO once they have more than 500 shareholders.

Once the 500-shareholder limit is breached, companies have to start reporting detailed financial information to the SEC. Which isn’t in and of itself a compelling reason to go public — lots of private companies with public debt file that information, after all. But there’s something else which gets triggered when you have more than 500 shareholders: you have to register your equity securities with the SEC. And at that point, your shares can be traded by anybody at all in the public over-the-counter markets, even if you haven’t had an IPO.

It’s conceivable that companies could continue to encrust their shares with various contractual restrictions which prevented shareholders from trading their shares in the OTC markets, even after those shares were formally registered with the SEC. But in practice, it’s almost impossible for companies to prevent OTC trading in their publicly-registered securities. And when a stock trades in the OTC markets, that trade is registered and printed in public. At that point, with a company’s stock being traded by anyone at all, at any time, at a public price, on the basis of public information filed with the SEC, the company is to all intents and purposes public already. So it might as well just make it official by having an IPO.

Now that Facebook has said that it passed the 500-shareholder limit this year, then, it’s pretty certain to go public in 2012. (Kara Swisher thinks it might be even earlier than that: I have a bet with her that it won’t happen before September 21 of this year. If it does, I need to go to San Francsico and buy her dinner, but if it’s still private at this point she needs to come to New York and take me out.)

SecondMarket actually has two platforms for trading private-company stock. The main one is Adam’s private company market, which is about two years old at this point, and has seen equity in 50 different growth stocks change hands. It’s pretty much restricted to growth stocks: none of those 50 companies has ever paid a dividend, and they’re overwhelmingly in the technology space.

For other companies, SecondMarket has set up a much more nascent market, which kicked off in January with those trades in Pimco stock. It’s also designed to help trade stock in partnerships (like McKinsey, say), or maybe even large, established private companies like Mars or Cargill. But mostly it seems that SecondMarket has its eyes on companies like Pimco which are subsidiaries of larger companies but which still use their own equity as a recruitment and compensation tool. Reddit is one company which might try to price stock on SecondMarket, as a way of helping it attract talent and grow while still remaining a part of Conde Nast.

Adam also helped answer my question of why SecondMarket is taking off now. Look at the three companies which really got this market started: Facebook, LinkedIn, and eHarmony. They’re all highly visible companies, with metrics that can be measured externally with quite a lot of specificity by companies like ITG Investment Research. It’s also much easier these days to find such companies’ articles of incorporation and the like online — and of course huge amounts of information about these firms is published by the fast-growing blogosphere. So while the amount of information that would-be investors have is surely lower than if there was a formal SEC-registered prospectus, the rise of the internet has made it much easier to do reasonably good diligence on how much a company might be worth. And that’s especially true when the company is young enough that its revenues don’t matter very much.

On top of that, webby companies like these are generally pretty capital-efficient: there’s very little risk that existing shareholders will be unpleasantly diluted by some big upcoming capital-raising round. It’s no coincidence that SecondMarket hasn’t seen trading in green-tech or biotech startups, which are much more capital-intensive.

And then there’s the big picture, which is simply that we’re seeing fewer IPOs of small companies, and that most companies when they do IPO are more like 8-10 years old rather than 3-4 years old. At that point, you’re likely to have had a reasonable amount of turnover in terms of employees, and early employees who have long since left the company are reasonably going to want a way to cash in their equity stakes. That demand for liquidity — along with long-term employees who have a lot of paper wealth but still live relatively frugally and who would like to monetize some of their stake — is what helped get SecondMarket’s equity business started.

Letting employees sell some of their vested stock doesn’t disalign incentives — quite the opposite, in many cases. After all, venture-capital owners of fast-growing tech startups are looking for high-risk home-runs and have diversified portfolios. Employees, by contrast, are always going to be more risk-averse, and letting them cash out in the growth phase can give them enough money to be willing to take the kind of risks their VC paymasters want to see.

It’s also worth clearing up some of the misconceptions in Dennis Berman’s column today on SecondMarket and SharesPost. For instance:

Many in Silicon Valley and Washington regard SharesPost and rival SecondMarket as small saviors of American capitalism. These markets give young companies and their employees new ways to raise capital or sell private stock without the arduous financial and legal disclosure of fully public companies.

This is partly true, but I’m pretty sure that neither SharesPost nor SecondMarket has ever let a company raise capital using their platform. I asked SecondMarket about this today, and in principle they’re open to exploring the idea in future, but for the time being they’re concentrating on simple transfers of shares, rather than the capital-raising issuance of new equity.

Berman continues:

SEC boss Mary Schapiro seems conflicted about these new markets’ purpose. The agency is investigating potential abuses in these secondary markets, including conflicts of interest and insider trading.

There’s no hyperlink here, so I have no idea what Berman thinks he’s talking about. It’s conceivable, I suppose, that he has an SEC source feeding him secret information about an internal SEC investigation that nobody else knows about. But if he did, one imagines he’d write a news story about that, rather than mentioning it in passing in a column which leads with the death of his grandmother 20 years ago. Certainly I’ve seen nothing to indicate that the SEC is investigating SharesPost or SecondMarket for potential abuses including insider trading; this seems to me to be both inflammatory and false.

After quoting Ben Horowitz as someone who is skeptical about such markets (but not mentioning that Horowitz spent $80 million buying shares of Twitter on SecondMarket in the secondary market), Berman comes out with this:

For a market to work best, investors need to be comfortable that they can trade at will.

This manages to completely miss the point of SecondMarket and SharesPost. They’re emphatically not trading vehicles: they’re designed to facilitate one-off transactions. In the two-year history of SecondMarket’s private-companies market, the company has seen maybe half a dozen instances of what you might call tertiary trades: someone who bought at one point and then sold later, once the price had gone up. SecondMarket gives an opportunity to invest in private equity, and private equity by its nature is illiquid. In fact, that’s why many investors like it: they want to capture the illiquidity premium, happy holding on to their stake for many years and knowing that they have an asset which isn’t highly correlated with public markets.

Going forwards, of course, SecondMarket would love it if the 500-shareholder restriction was relaxed. When the rule was introduced in 1964 it was pretty arbitrary, but it was set at a level which wasn’t particularly onerous: the 500-shareholder limit was very rarely triggered before a company went public. After all, in those days you could go public when you were still small; today, that’s much harder. Today, the 500-shareholder limit is a real constraint on how companies do business, how they compensate their employees, and how they structure themselves internally. Is there any good fundamental reason to change the way you incentivize and compensate employees just because you’re hiring lots of people? Of course not — but that’s the effect the rule has.

So while I worry about the public-policy effects of having fewer public companies, I also see no reason for the SEC to keep this rule at its anachronistic 1964 level. On the other hand, I think it might make sense for the SEC to regulate SharesPost and SecondMarket more explicitly than it does at present, rather than having them operate in the shadow of exemptions which were written long before they were founded. If the SEC set clear rules for how private exchanges like this could operate, then that might open the way to bring the rules for companies listing on public exchanges into the 21st Century.

Update: SecondMarket’s Mark Murphy emails to say that Horowitz’s secondary-market acquisition of Twitter shares did not take place through SecondMarket.

Clare Baldwin and Sarah Lynch are unambiguous: “As US regulators review rules on shares issued by private companies,” they write, “they must not make it too easy for hot Internet companies such as Facebook or Twitter to avoid the scrutiny that goes along with an initial public offering.”

They’re talking, of course, about the letter which SEC chairman Mary Schapiro sent to Darrell Issa on Wednesday. It’s a long and pretty boring document, and it’s certainly not as revolutionary as some of the press coverage would make you think. Jean Eaglesham, who broke the news without printing the letter, set the tone of the subsequent discussion by saying that the SEC review “could remake the way American start-ups raise capital,” “would upend the normal path for fledgling companies to raise funds,” and “could shut out many ordinary investors from one of the fastest-growing market sectors.”

But it’s hard to see anything in the letter which really supports Eaglesham’s reading. Mostly the letter is dry and legalistic, and in fact it takes pains to say that “the Commission seeks to minimize the costs of being a public company in the United States and provide a regulatory environment that encourages companies considering going public.” The part of the letter which talks about revisiting the 500-shareholder rule makes it clear that any change is overdue in any case, given how the rule isn’t having its intended effect:

All of this seems much more like a common-sense view of a rule which hasn’t really been updated since it was enacted in 1964, and much less like a revolutionary attempt to kill the IPO market by making it particularly attractive to stay private. Certainly there doesn’t seem to be any point in forcing companies to give out options, or phantom stock, or stock appreciation rights, or other such weird and wonderful inventions, just as a means of getting around a rule which has been around for half a century and is showing its age.

And it’s easy to overstate what exactly goes on in places like SecondMarket:

The SEC is wrestling with the needs of private companies to raise capital against the investing public’s need to make informed decisions.

The issue has jumped into the spotlight as Wall Street banks and electronic markets offer investors a chance to buy and actively trade stakes in hot Internet companies such as Facebook, Twitter, Groupon and Zynga before they go public.

Investors are indeed being offered the chance to buy stakes in companies like Facebook — although Facebook is sui generis and is much more of an outlier than it is typical. But as far as I know, no one is actively trading any of these properties. The auctions come up irregularly, they often require shareholders to hold on to their stock for a period of years, and the trading costs are very high — on the order of 5% per trade. Meanwhile, Goldman’s attempt to come up with a private exchange where shares could be actively traded has fizzled embarrassingly, and never attracted any hot internet companies.

As Jason Zweig says, there’s a good reason retail investors are barred from investing in private placements: they are very risky and dangerous things. But global high net worth individuals are increasingly interested in buying in to such placements, and the SEC has no real reason to stop them from doing so. I’m not a fan of this development. But that doesn’t mean I think the SEC should keep its rulebook in 1964, just because doing so might allow companies to prosper in private hands a bit longer.

Dave Nadig and Paul Amery of Index Universe have the best explanation (and excoriation) of the weird Nasdaq 100 Special Rebalance this week. In a nutshell, when the Nasdaq 100 wanted to become an exchange-traded fund and make lots of money in the process, Microsoft would have accounted for more than 25% of the index if it was simply cap-weighted. So the index gurus artificially depressed Microsoft’s weighting in the index, while boosting the weighting of smaller companies.

Fast-forward to today, and you end up with a rather silly situation where Microsoft and Apple, with similar market capitalizations, account for 4.3% and 20.3% of the index respectively. Enter the rebalancers:

Here’s the rule, which was just triggered: When any security gets over 24 percent; or when the aggregate of positions of more than 4.5 percent is greater than 48 percent; or whenever Nasdaq feels like it—seriously, that’s the trigger this time—a rebalance is triggered.

Apple isn’t over 24% of the index, and the aggregate of positions of more than 4.5% is just 25.25%, well below the 48% maximum. So there’s no reason at all to do this rebalancing now, beyond an unpredictable desire “to ensure the NASDAQ-100 Index remains a relevant benchmark for investors around the world who track the performance of the U.S. equity market.”

But the bigger picture is that all indexes are arbitrary by nature. For instance, the Nasdaq 100 itself is very weirdly comprised, as Nadig explains:

To get into the Nasdaq 100, here’s what you have to do:

1. Happen to have Nasdaq as your primary listing
2. Not be a financial company (for no particular reason)
3. Be “seasoned,” which means being on Nasdaq for two years, or being in the top 25 percent of the Nasdaq 100 in terms of market cap

And other indexes, while not being as bad, are also pretty arbitrary:

If you’re new to indexing, you may be surprised to find out that the membership criteria for companies entering the world-famous S&P 500 and Dow Jones Industrial Average indices are also highly subjective.

The Dow’s components are chosen by an “averages committee” comprised of the managing editor of The Wall Street Journal, the head of Dow Jones Indexes research and the head of CME Group research.

Selection for the S&P 500 is also at the discretion of an index committee, the goal of which is “to ensure that the S&P 500 remains a leading indicator of US equities, reflecting the risk and return characteristics of the broader large cap universe on an ongoing basis”.

According to one well-founded analysis of the S&P 500 index committee’s stock picking record, the committee members are subject to the same style biases and drift as the average active manager. They boosted the index’s weighting in tech stocks during the bubble of the late nineties, only to remove several of the same names shortly thereafter; and they relaxed a longstanding prohibition on including holding companies in 2001, allowing lots of real estate investment trusts to be added to the index during the greatest real estate bubble in US history.

Amery concludes that “when you’re selecting a tracker product it’s worth casting a very sceptical eye over the index being used.” But it’s also worth noting that stock-market indices tend to outperform the broad market, at least according to this paper. And that at the margin, the narrower the index, the more it’s likely to outperform — at least in bull markets. (In bear markets indices underperform, but stocks do tend to go up more than they go down.) That might explain how Dimensional Fund Advisers tends to outperform the S&P 500 by following an indexing strategy: it just invests in narrower indices which perform better.

I had a great conversation with Bob Pozen yesterday, who was in town to plug his new and exhaustive book on mutual funds. We talked a bit about active vs passive investment strategies; Pozen reckons that passive strategies won’t ever be much more than about 20% of the market. But the fact is that just about all funds use some big index — often but not always the S&P 500 — as their benchmark. And insofar as that index is a bit arbitrary, that skews the entire market in unhelpful ways. I doubt I’ll ever get the everything bagel I’m looking for in terms of a single global fund. But as far as US stocks are concerned, many people think the S&P 500 performs that role very well. And I’m not at all sure that it does.

Jean Eaglesham has a big piece of news today: yes, the SEC is looking into the private share dealings in Facebook. But not necessarily with any kind of enforcement in mind. Instead, it’s thinking about raising the 500-shareholder limit which marks the point at which companies need to start making public filings.

A move in this direction would be a huge ratification of private markets by the SEC, which was created to protect investors. I guess that one way of protecting investors is to ensure that they never get an opportunity to invest in the first place:

The move could potentially delay or derail IPOs by tech companies that want to grow but would rather avoid having to disclose vast amounts of information. It could also shut out many ordinary investors from one of the fastest-growing market sectors, since shares in private companies are generally available only to investors whose individual net worth is at least $1 million. And at a time when investors are seeking more market transparency, it would lessen the amount of publicly available data about those companies.

The point here is that there is literally an opportunity cost to such a move, which is almost impossible to calculate. How much diversification (in the technical sense) and diversity (in the more colloquial sense) are the public markets going to miss out on if important, fast-growing companies stay private rather than going public?

But I have to admit I don’t understand this:

The possible changes come amid concerns about a dearth of U.S. stock listings, which politicians on both sides of the aisle worry could hurt American competitiveness with the rest of the world.

I don’t know which politicians Eaglesham is talking about (Tim Geithner, perhaps?), but in what sense are stock listings a sign of international competitiveness? There might be a vague correlation there, but I can’t see much in the way of causation. Indeed, there’s a strong case to be made that US companies can be more competitive internationally if they’re free to concentrate on running themselves as best they can, and don’t need to use up precious management cycles dealing with analysts and journalists and people second-guessing all of their actions on the basis of how their share price is moving that day.

The sourcing on the story is about as annoying as it possibly can be: Eaglesham says that the SEC review was “disclosed in a letter to a lawmaker,” without saying who did the disclosing, posting a copy of the letter, naming the lawmaker in question, or even explaining how the letter came to be written. This kind of coyness does nothing to advance the public interest; instead it looks like little more than a petty way of jealously guarding Eaglesham’s Capitol Hill source so that her competitors can’t find the same letter. Come on, WSJ, your job is to make news public, not keep it to yourself.

Eaglesham’s story comes in the wake of two very different takes on the prospects facing private markets. Evelyn Rusli has the bullish view from Silicon Valley, where entrepreneurs are turning down millions of dollars in funding and indeed are cashing out long before any IPO.

“By taking money off the table, you’re expunging a big source of risk, allowing you to focus on the interests of the company you’re building instead of your own,” said Andrew Mason, the 30-year-old founder and chief executive of Groupon. He said he was able to sell some of his shares in D.S.T. Global’s initial Groupon investment, a $135 million round last April.

Meanwhile, Gregory Zuckerman has the more bearish view from Wall Street, where Goldman Sachs’s attempts to put together a private stock exchange called GSTrUE have gone absolutely nowhere.

Goldman has largely stopped working on GSTRuE, merging it into the Portal Alliance, a fledgling network developed by Nasdaq, Goldman and Wall Street firms to act as a single market. That effort hasn’t attracted any new listings, either.

“When everyone ran for the door in the crisis it changed people’s desire to invest in things that aren’t listed” on an exchange, says Anton V. Schutz, manager of Burnham Financial Funds, who says he no longer buys issues that aren’t listed. “Even deeper markets than this haven’t come back after the crisis.”

Why was GSTRuE a failure while SecondMarket and SharesPost are much bigger successes? I suspect that the answer might have something to do with the fact that GSTRuE was set up to mimic a public exchange, with a common set of rules for every company looking to list and every investor looking to trade. The auction sites, by contrast, are happy approaching every deal on a case-by-case basis, structuring auctions to exactly the specifications of the company in question. And, of course, there’s also the fact that there’s a Web 2.0 bubble right now, while GSTRuE launched mainly with asset-management firms which are much less hot.

In any case, it looks very much now that all the current shareholders in SecondMarket were quite right to hold on to their shares rather than sell them on SecondMarket. (There have never been any SecondMarket trades in itself, because no one wanted to sell.) Today’s news has surely increased the value of the company substantially, and you can probably add SecondMarket founder Barry Silbert to the list of people who is politely telling would-be investors that sorry, he has no use for their money right now.

It’s not just me worrying about the implications of fewer companies going public. Tim Geithner thinks the same way:

At the earliest stages of funding, small companies have become more reliant on angel investors, universities, or sector-specific investment shops.

And as these small companies find their footing, they are waiting longer than ever to go public – financing themselves instead through multiple rounds of private equity or venture capital.

The number of IPOs in the U.S., for example, has decreased during the last two decades. And even though IPOs have picked back up in the wake of the financial crisis, an increasing number of U.S. companies are going public in other countries, or even deciding to stay private and access different sources of funding.

The reaction to my piece has been illuminating. Stephen Bainbridge, of course, blames Sarbox, citing survey data, among other things. I’m unconvinced, although I do agree that it’s a boon for accountants. Derrida, in the comments on my post, reckons that a stock-market transaction tax would help. I like that idea more: liquidity can be a bad thing, and throwing sand in the wheels of the stock market would almost certain bring correlations there down, thereby reducing the diversification benefit to investing in private equity. It would also, of course, make buying and selling stocks more expensive — and that’s arguably a good thing too, if we want shareholders who act like owners rather than short-term speculators.

The most interesting pushback came from Ryan Avent. It’s worth taking his points one at a time:

Mr Salmon hasn’t managed to convince me that this recent trend is actually a threat to American capitalism. For one thing, he’s argued persuasively that private ownership is likely to be advantageous for firms that don’t need to raise money in public markets. It spares them the need to deal with pushy, impatient, litigious shareholders, allowing the firm to focus on its private goals and long-term growth. From a public policy perspective, the incentives facing firms are of some consequence.

Well yes: which is why it’s a good idea to nudge incentives more towards public markets and less against them. In America for pretty much all of the 20th Century, and in the rest of the world even today, public markets have shown themselves to be a really good thing when it comes to value creation. Before we simply come to the conclusion that we were doing it wrong all along, and that the rest of the world is still doing it wrong, it might be worth asking whether public markets shouldn’t by rights be more attractive than they are. It’s also worth asking whether pushy, impatient, and litigious shareholders are creating or destroying value. I genuinely don’t know the answer to that one.

Ryan continues:

I’m also not convinced that this trend is likely to leave private investors shut out of capital ownership. If millions of Americans want to invest their savings in equity of some sort, and if firms are out there looking for funding (and if there aren’t firms out there looking for funding, the economy has a bigger problem than stock ownership), is it really plausible that the financial system won’t find ways to match the two? There are many things to be said by way of criticism of the financial system, but its inability to exploit a profit opportunity is not one of them. And letting trillions in small investor savings trickle into low-yielding bonds would represent a massive missed profit opportunity.

I’m not for a minute saying that individual investors are going to wind up in low-yielding bonds as a result of all this. I’m saying something worse: that individual investors are going to wind up in low-yielding stocks as a result of all this. The US stock market is still worth some $17 trillion — there’s no shortage of stocks to invest in. But I worry that individuals investing in the stock market are just going to be buying and selling stocks to each other, while being gamed all the while by high-frequency traders. The more important work of capital allocation, meanwhile, is being done by private equity and venture capital shops.

The point here is that while demand for stocks to invest in might well be a profit opportunity for Wall Street, firms are smart enough now to realize that things which make lots of fee income for Wall Street aren’t necessarily good long-term ideas. So given the choice between a Wall Street investment banker who says “I can make you rich in an IPO”, and a Silicon Valley VC who says “you’re already rich, I can give you all the money you want, I can personally help you become even richer, and you won’t need to worry about being public,” the latter looks a lot more attractive. Does that VC dream of an exit-via-IPO at some vague point in the future? Maybe, maybe not. But a delayed IPO is still better than one tomorrow. Meanwhile, individual investors will continue to invest in the stocks that already exist. They just won’t make that much money from them. Which brings me to Ryan’s final point:

A different question is whether small investors will earn a lower rate of return than the big, rich, connected guys. I’m going to go ahead and ruin the suspense: they will. Now, Mr Salmon wants to make the point that defined-benefit retirement plans can earn better returns than defined-contribution plans, because managers of the big plans can play on the same field as the rich, well-connected investors who get to put money in Facebook. Perhaps that would remain the case, or perhaps that premium would disappear if a larger share of workers invested in defined-benefit plans. I can’t say. But that’s a fundamentally different question from whether falling numbers of public stock offerings threaten to end ownership of capital by the masses.

Ryan forgets, here, that a larger share of workers did invest in defined-benefit plans, for most of the stock market’s heyday. And that during those years, defined-benefit plans did pretty well, considering.

I’m not worried that falling numbers of public stock offerings threaten to end ownership of capital by the masses. What I’m worried about is that the masses will end up owning the dregs of the capital world — the overpriced stocks which nobody else wants, and which they get automatically when they buy their index funds. Meanwhile, private companies will be owned by plutocrats, and will comprise an ever-increasing share of the US economy. Which might be good for both the companies and the plutocrats. But it’s clearly not so good for those of us with 401(k)s.