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Will The Internet Bring Retail Investors Back To The Stockmarket? March 16, 2010

Posted by Bernard Lunn in Uncategorized.

Does Jane Q Public still invest her savings in individual stocks? The short answer is: not often. In this post we ask a) why? b) does this matter? and c) what might change this?

According to Investopedia,  “retail investor” means:

“Individual investors who buy and sell securities for their personal account, and not for another company or organization. Also known as an “individual investor” or “small investor”.

According to a book called “A Requiem For The Retail Investor” by Alicia Davis Evans:

“In 1950, retail investors owned over 90% of the stock of U.S. corporations. Today, retail investors own less than 30%. “

What happened to the retail investor?

1. “Retail” describes how they are treated by the financial services industry. The ideal retail “customer” is a passive consumer who will happily pay mark-up and is susceptible to marketing.

2. Some smart investor realized that John Bogle is right and that most investors cannot beat the average and so, “costs matter”. So they have gone “passive but cheap” via index tracking funds. But they look at the numbers and those market averages don’t deliver what they need. They can see a big gap, but they don’t trust themselves or any intermediary to fill that gap.

3. Many have lost confidence in a market that they view as a casino run by an operator with their finger on the roulette wheel. They have simply opted out.

4. A tiny minority think they can outwit the professionals by being faster and smarter. These “day traders”  move in and out of tech stocks, Florida condos, currencies or China “plays” before most of us have had breakfast.

Why Retail Investors Have Left The Market

They have 4 logical reasons:

1. They have been “bamboozled by footnote obfuscation“. Warren Buffett, a billionaire and one of the most sophisticated investors in the world, has said,

“For more than forty years, I’ve studied the documents that public companies file. Too often, I’ve been unable to decipher just what is being said”.

If this obfuscation was purely incidental complexity that would not matter. Unfortunately, footnotes is where the really ugly stuff gets hidden and so we get the next problem.

2. Too many frauds and wild blow-ups. Unless you know how to use short trading techniques, the tales of Enron, Lehman and other companies that crash overnight, are a big “stay away” sign on the market.

3. Institutions don’t like small cap so why should I? The old story was that careful research and then patient investing in undervalued companies  would always win out in the long run. Fortunes have been made this way in the past. But when pricing is driven by large institutions that do not trade small cap stocks, you could be waiting forever. This becomes a self-fulfilling prophecy.

4. Technology is changing markets so fast that the buy and hold idea is under threat even when management is honest. The idea that newspapers could disappear was inconceivable. Investors as smart as Warren Buffett were taken totally by surprise. Investors in music retailers that were decimated by MP3 were not deceived by management. They were sideswiped by disruptive change.

Why Retail Investors Are Important To The Market

The decline of the retail investor has now reached a tipping point where some policy makers at the SEC question whether we should move to an institutional only market. The argument goes something like this:

1. The regulations to make the market fair and transparent for retail investors are so onerous and costly that they prevent companies from going public or make it too expensive for small companies to be publicly traded.

2. Therefore we should have a lightly regulated market that is only open to institutional traders.

Fortunately even those who suggest this, accept that it would be politically unrealistic. This is another way of saying that politicians might stop this “highway robbery”. For that is is what it would become. A market that prevented retail investors from operating on a level playing field would erect a massive moat for the financial services industry which could charge retail investors whatever they wanted.

“A Requiem For The Retail Investor” by Alicia Davis Evans argues the case more carefully:

“Retail investor market participation, though declining relative to that of institutions, is growing on an absolute basis. Thus, individuals represent an important source of capital for U.S. corporations. In 2006, approximately $5.5 trillion of U.S. equity investment dollars came from individual investors, up from $616 billion in 1965.

Individual investor participation is particularly important for small capitalization companies. Almost all large institutional investors are confined to making investments in large cap corporations. Either their own charters or government regulations limit their ability to buy stock in small companies because of minimum size and maximum ownership requirements. Moreover, most small cap stocks have thin floats, so any attempt to buy a significant number of shares in a small cap company could move the price of that stock higher instantly, making such investment no longer attractive. Because institutions own only a small percentage of the stock of small cap corporations, retail investors are important for the survival of many of these firms.”

A Counterweight To Frenetic Trading

Alicia Davis Evans goes on to point out that retail investors also:

“provides a stable ownership base for public corporations, as evidence shows that most individual stockholders trade relatively infrequently. For example, according to a study performed by the Investment Company Institute and the Securities Industry Association, 60% of surveyed individual investors made no trades at all during 2004.Of the remaining 40% that did trade, 57% made five or fewer trades during the year and 79% made twelve or fewer trades. These figures stand in sharp contrast to the much higher trading rates of institutional investors, with annual turnover rates approaching or exceeding 100%.”

What Would Bring The Retail Investor Back?

In a word, confidence.

The SEC has done a lot to create a level playing field and that is a critical piece of confidence-building. Reg FD means that institutions do not have an informational advantage. Insider trading is prosecuted. Jane Q Public gets the same information at the same time. That confidence is critical, but it is not enough.

Retail investors also need to be able to:

1. Compare a stock to other comparable stocks. This is the bread and butter of stock analysis.

2. Understand the murky stuff in the footnotes to spot problems before they blow-up.

3. Understand the market in which the company operates so that they can spot the wave of disruptive change before it decimates the company.

How The SEC XBRL Mandate Can Help With Comparables

This is where it gets a bit geeky! XBRL stands for eXtensible Business Reporting Language. It is a standard way to “tag” data in a financial report in a consistent way so that a computer can do automatic analysis. For example, so that the line “cash in bank” is tagged the same way for all stocks.

How does this help? Consider what you need to do in order to:

Compare a stock to other comparable stocks

A long time ago this work was done by stock analysts on Wall Street. Now it is outsourced to folks in India. This work is easy to outsource as it is routine. It is routine enough that with a bit of standardization that is coming, it will soon be automated.

There is one part of creating comparables that requires a bit of real insight/analysis which is defining which companies are “comparable”. You have to know a market to make that decision. But that is not hard if you know the market.

Then you have to do the boring hard work. Let us say you want to compare the cash in bank for 10 comparable companies. You may want to see the growth/decline in cash in bank quarter to quarter. Here are the 3 steps you have to do:

1. Go to the 10Q statements at SEC.gov for each of those 10 companies.

2. Scroll down until you find the line that says “cash in bank”.

3. Copy and paste that number into a spreadsheet.

That is not hard, but it does take time. And 2 of the 10 companies may not call it “cash in bank”. They call it something else. So that takes a bit of extra work. But it is still routine.

Here are the options today to get this analysis:

1. Do it yourself. It is not rocket science. But “time is money”.

2. Pay somebody to do it for you. That is what the investment banks are doing by setting up shop in India.

3. Create a clever bit of software that automatically goes through those 3 manual steps. That is beyond the reach of retail investors. Institutions that do millions of these jobs can do a simple ROI on that compared to the people cost. The reality is that these automated systems are still error prone and require a lot of manual checking.

This is where XBRL can help. Your spreadsheet can automatically collect “cash in bank” for all 10 companies each quarter. It can also do that for 10 other parameters you want to track on those 10 companies.

Your spreadsheet now does what was done by expensive MBAs on Wall Street and then later by rather less expensive MBAs in Bangalore.

That One Footnote Can Kill You

So you have done the comparables analysis. One company jumps out as being a screaming bargain, the type of  company that made Warren Buffett a rich man.

But maybe that one company has a footnote which you ignore and the footnote says something like “the cash in bank has been pledged to xyz company”. Except it won’t say it as clearly as that!

The SEC is trying to help with that as well. All the footnotes have to be tagged in XBRL as well. The idea is that something that has a material impact gets highlighted. This is not simple, it causes the people who prepare these statements a lot of work. And the really murky stuff will still need a sharp, well trained pair of eyes to spot. But this kind of “forensic accounting” will be easier when footnotes are tagged in XBRL.

Real Insight

XBRL will make the routine analysis a lot easier. But to make money as an investor, you need insight. This is what the Hedge Fund guys call “alpha”. You need to know WHY this company is doing well financially. If you know that you will have a chance of understanding whether those finances will be better or worse in future.

You can get that insight from the work you do or simply from what you buy. This is the classic model that Peter Lynch advocated.

Peter Lynch managed the Fidelity Magellan Fund from 1977 to 1990, during which time the fund’s assets grew from $20 million to $14 billion. More importantly, Lynch reportedly beat the S&P 500 Index benchmark in 11 of those 13 years, achieving an annual average return of 29%.

He is also famous for several books including, “One Up On Wall Street” (1989) and “Beating The Street” (1993), which are widely considered to be mandatory reading for any investor.

According to an article by Kaushal Majmudar, a CFA at The Ridgewood Group, Lynch shares his checklist with the audience at an investment conference in New York in 2005:

•    Know what you own.
•    It’s futile to predict the economy and interest rates.
•    You have plenty of time to identify and recognize exceptional companies.
•    Avoid long shots.
•    Good management is very important – buy good businesses.
•    Be flexible and humble, and learn from mistakes.
•    Before you make a purchase, you should be able to explain why you’re buying.
•    There’s always something to worry about.

Peter Lynch was also famous for his work ethic. If you cannot do that (you have a day job) or don’t want to do that (you have a life), you need some help.

With A Little Help From My Friends

No, that does not mean insider trading, you go to jail for that. But lets say you see a certain game flying off the shelves and you kid is bugging you to buy it. You find out who makes it and look at the company’s stock. You don’t know anything about the game business but know somebody who does. And you ask a group of other parents what their kids are saying about this game. You start to develop an investing idea.

That is one example. There are millions like that. You use your own trusted network to give you advice. Online social networking tools have made that a lot easier. This is very different from online stock forums. They became overrun by promoters and scammers hiding behind anonymity. Online social networking tools don’t give you a trusted network they simply make it easier to communicate with your trusted network. And you can sometimes find an expert via online networks and build a trust relationship once you have made contact.

Once you have an investment thesis, an idea, the hard work starts. That is where traditional investing clubs have been helpful. Lets say you think that company x that makes game y is a possible investment. You need to do some thorough work on comparables and valuation, digging through those 10Qs and footnotes and market research data.

If you are a member of an investing club, you can share the work. You have other sharp eyes to check it out. This is another area where online networking can help. Traditional investing clubs met face to face. It was a social occasion with a core purpose (which often made the gathering more interesting than just social chit chat). But there is no reason why an investing club today has to be constrained by distance.

At some stage in the investment due diligence you may even pay an outsider for some research. Maybe it is a pre-packaged piece of research. Or you may even commission a bit of custom research. Either way, it has to be at the right price. And more importantly, you are in charge, you make the decisions and you decide what price is right. This is very different from receiving lots of “free” advice where the cost is hidden in other fees that you have no control over.

That Is Logical, But What Will Trigger This Change?

We are not logical animals. If we were, we would eat our greens and abstain from booze and unhealthy food.

The network is there to enable a return of the retail investor. The SEC XBRL mandate will change the game but that will take a while. The conditions are ripe for a change, but it is likely that something external will trigger that change.

It is possible that some change in the market will trigger a change in behavior. It could be a change in either direction. The return of tech IPOs may be a trigger, only this time the investors will be much smarter, singing “won’t get fooled again”. But a big market crash could do the same thing, making stocks ridiculously cheap. This time the retail investor (who does not have to follow the herd) may lead the way back out of the next bear market.



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