IndustryInsights

By James MacGregor, Vice Chairman
The Abernathy MacGregor Group Inc.

Algorithms have taken over the stock markets. The New York Stock Exchange and NASDAQ agree: More than three fourths of all trading volume is automated, driven by program traders, electronic market makers and computerized speculators. The results: Lots of liquidity, lots of volatility, obstacles for desirable “real” investors and such perverse side effects as share price declines following the announcement of unexpectedly good results.

That’s the (mostly) bad news. The good news is that new analytic tools make it possible for companies to understand what automated trading is doing to its share price and ownership, and sometimes to take actions that will improve the situation. Paradoxically, as the algorithms take over, traditional investor values—disclosure, targeting, outreach, responsiveness, and a good story—matter more than ever.

A modest example: The pricing of options causes a couple of days of automated trading “noise” in a stock’s trading activity. So: When possible, don’t announce information important to investors on noise-filled days. If there’s no choice on timing, wait for the noise to settle down before judging the market’s real reaction to the news—and before reporting the reaction to management.

A slightly more ambitious example: Suppose value investors want to leave a company’s shares; growth investors want to come in. High levels of automated trading are making these movements more expensive, perhaps deterring some investors. So: IROs can target sharp-elbowed institutions that specialize in these kinds of transitional situations and that will take shares away from the algorithms.

What’s important to IROs? Another thing on which NASDAQ and the New York Stock Exchange agree: The market-moving influence of any given rational-investor purchase or sale is ten times what it was ten years ago. These are the investors who buy and sell based on their assessment of a company’s past performance, current condition and future prospects—the investors who IROs have always known how to deal with. So investor relations, now dealing with a smaller proportion of daily trading volume than ever before, has never been more important.

To get deeper into what’s going on here we first need to introduce the cast of characters: the six basic categories of investing that today comprise the trading in an exchangelisted stock. Starting with the smaller ones: Inventory trading is wholesale and interdealer volume. It reflects share supply in the market, and fills roughly the same role it has for years. Hedge trading comprises equity trades that are made to offset portfolio risk. This is “hedge” in its oldfashioned sense of risk management, not in its modern “hedge fund” manifestation.

Rational trading is the buying and selling actions that result from traditional active corporate-performance-based investing strategies. Rational investors are the ultimate target of investor relations—but today they account for 10 percent, 5 percent, on some days even as little as 2 or 3 percent of a stock’s trading volume. Today, conventional investment managers deploy far more resources in quantitative strategies, “beta” portfolios and mixes of derivativestyle securities like ETFs, options and futures.

Now the three larger categories: Speculative trading includes arbitrage, day-trading and other strategies that exploit market dynamics. Some of it reflects individual human decisions; more of it is automated. Program trading is algorithmically-driven, involves multiple securities, and implements the strategies of models, funds, ETFs and baskets. Electronic market making (EMM) is automated trading that profits from being an intermediary between buyer and seller, both of which may also be automated. These three larger categories are all high-velocity forms of trading, often buying and selling in literal nanoseconds. The forces behind them include hedge funds, large banks making markets, proprietary traders and institutional investors using third-party technology platforms to constantly adapt to the market.

All these algorithms have this in common: They’re very good at reacting to changes in share prices and trading patterns (they constantly monitor the millions of electronic “indications of interest” that initiate so many instantaneous transactions). But they’re not so good at determining what those shares are really worth. That job they leave to the rational investors who actually look at financial statements and consider business strategies. So when a new rational investor takes a position in a stock (or an old one leaves), many algorithms interpret that as a new statement of intrinsic value, and reset their parameters to revolve around the new valuation. This greatly magnifies the significance of any one rational investor’s buy/sell decision. Hence our theme: Today the most important result of IR is often one new rational institutional investor.

These algorithms don’t just watch each other closely. They react quickly and dramatically to perceived changes in pattern—as witness the May 6th “flash crash.” Not long before, a company hired an investment bank for a confidential corporate finance project. To avoid conflicts of interest, the bank removed its new client from its algorithmic trading programs. The other “algos” interpreted the diminished market noise as “Something’s wrong, so let’s back off.” The stock dropped sharply, and took some time to recover.

NASDAQ and NYSE can, on request, provide their listed companies with vast amounts of daily trading information. These data can be sorted and analyzed not just to document automated trading activity, but also to reveal broad trends (e.g., value money is coming in from Europe, maybe because of last week’s non-deal roadshow). The data can also reveal issues that require consideration (e.g., hedgemakers are underweighting the shares, maybe because of underlying company-specific uncertainties that aren’t reflected elsewhere). Note: This kind of analysis identifies conditions that need attention. It doesn’t identify causes or cures. That’s the task of the IRO.

Some of the rules of the road change in a world dominated by automated trading. Try not to announce valuationchanging news during the last couple of trading days of the month—the algorithms won’t care, but rational investors, whom IR cares most about, cannot respond in time to affect the end-of-the-month results for which they are rewarded or penalized. If the news is unexpected, don’t view the first couple of days’ trading as necessarily indicative of rational investor sentiment—that may be initially drowned out by hedge-position adjustment (good news means higher share price, which means fewer shares needed in hedge, which means selling pressure).

This new world of trading also underlines once more the importance of a diversified shareholder population. Most managements want stable, long-term institutional investors; most companies have at least a few. But the bulk of rational investors tend to move on when their targets are achieved or when better opportunities show themselves. The automated trading disciplines can make the transition to the next group of investors more difficult or costly, especially if the next group isn’t quite ready to make its move. Here’s where a company needs to know transitional investors who can bridge the gap—specifically including hedge funds, whose numbers include quite a few very savvy rational equity investors.

The bottom line? Automated trading has transformed the stock exchanges. This means new inputs and new practices for investor relations. But the traditional values— outreach, responsiveness, and a good story well told—still matter as much as always.

AUTHOR’S NOTE: For many of the thoughts expressed here, I am indebted to Tim Quast of Modern IR, who understands today’s market structure far better than I.

If you would like to discuss this article, please contact James MacGregor at 212-371-5999 / jtm@abmac.com.