Tuesday, November 21, 2006

The ups and downs of the stock market

There is an almost religious faith by many in the invisible hand of the market to guide us in the direction that is of benefit to the greater society. As this reasoning goes human involvement, whether through democratic institutions or totalitarian governments, always turns out for the worse. Collective decision-making is bad and laissez faire is good.

Is this true? Not really.

Michael Kinsley has some interesting observations on the pricing of stock in the Stock Market:
…. There are things capitalism does not do well, and other things that masquerade as capitalism at work, and claim its virtues, without being entitled to do so.
Capitalism is brilliant at setting the price of potatoes. But how good is it at setting the price of a large company? To all appearances, the stock market is capitalism operating under near-laboratory conditions. Financial markets deal almost entirely in electronic blips. Supply and demand can chase each other around the world with no actual goods to get in the way, and prices can adjust constantly and instantaneously. Yet the prices set in financial markets are patently wrong.
In America, most people now have money invested in the stock market, either directly or through their company or union or government-employee pension funds. President Bush famously wanted to put money from Social Security, America's public retirement system, into the stock market as well.
The website of the Securities and Exchange Commission, which regulates stocks, offers the conventional explanation of why publicly traded stocks are a good thing. They are good for individuals because they allow people to share in the growth of the economy. They are good for society because, by creating a market and setting a value for corporate shares, they make it possible for corporations to raise money by issuing shares in the first place.
All of this depends, though, on the assumption that the stock market sets the right price for shares of big companies. But a whole separate part of corporate finance is based on the assumption that those prices are wrong. These special deals used to be called leveraged buy-outs. Now they're called "private equity". The details are different, but the principle is the same. Private investors buy a company from its public stockholders. They have a letter from an investment bank saying the price is a fair one. They usually have the support of management, or they actually are the management. The public stockholders have little choice. But time and again - surprise, surprise - the investment bank turns out to be wrong. The company is actually far more valuable! (And any bank that can't be counted on to get this wrong will not be in this profitable line of work for long.) Soon the company is sold at a large profit, either to another company or back to the public.
So free-market capitalism has decreed three different values for this company. One is set by the stock market: the value of all the company's outstanding shares or "market capitalization." One is what the private investors are offering - usually a bit more than the market cap. And one is what the private investors sell the company for a blink of an eye later - which is usually a lot more than the other two. Which of these numbers is the true capitalist price? Which one represents the most sublime interaction of supply and demand? Anyone? Anyone?
… the big question is this. Either the stock market is a fraud on the public or these deals that dominate the business pages are a fraud on the public. Which is it?


Joel Monka said...

Neither one- price and value are not the simple matter the question implies. Sometimes those investment banks guess right, and sometimes they guess wrong- the way the question is stated, that would mean that if the investment bank guessed wrong and lost money, then the company defrauded the bank!

Pricing inventory- something that must be done for taxes or net worth statements- is an example of how difficult the matter of setting a price for anything can be. Suppose you are a printer and have 1,000 sheets of paper on the shelf- what is it worth? The $12.00 it would cost to buy from the mill? Or the 10 cents you might get at auction if you went under? Or the $1,000.00 you might get from a customer if it were printed, folded, etc.? If I as the company accountant said $12.00, and then it was in fact sold to a customer, have I defrauded the government of taxes on $978.00? If the company goes bankrupt, have I defrauded the lienholders of $11.90? Which of these was the "true" price?

Kinsley must have forgotten his high school economics- "price" and "value" are not set numbers, not even for the potatos he mentioned.

Early Riser said...

I wouldn't expect Kinsley to understand corporate finance, but this is just plain silly...

- When a company goes private it is, essentially a different company. No more Sarbanes-Oxley, different tax structure, different management overhead.

- Just because someone is willing to pay more than the market price is not a signal that the market pricing is wrong. It just means that a group of investors is more optimistic than the rest of the market.

- Kinsley's claim that LBO's are always successful is not supported by any analysis and I doubt it is true. Just think about it... if LBO's ALWAYS worked, wouldn't the majority of companies be bid-up by knowledgeable investors?

Just remember, money always chases the best return. Kinsley has not figured-out some secret path to easy profits... he's just an arm-chair commentator who would prefer socialism.