Sunday, February 16, 2014
The cost of manufacturing liquidity premia
In addition to paying dividends and providing price appreciation, stocks provide an amenity flow in the form of expected exchangeability, or liquidity. Like any other consumption good & service, the provision of such an amenity requires an outlay by the supplier. In the same way that a widget producer won't sell widgets below marginal cost, the marginal seller of stock, the issuing firm, won't manufacture new liquidity if the cost of production exceeds the benefits.
Say that a firm can hire an entire investor relations department for next to no cost. The IR team, full of eager promoters, will double the price that the marginal investor is willing to pay for the liquidity services thrown off by the firm's stock. They go about improving the stock's liquidity services by evangelizing the firm's "story", thereby widening the base of investors who deal in the shares. They make it easier for investors to hop in and out of the market.
The firm can now issue new stock at a much higher price thanks to its swollen liquidity premium. It invests the proceeds of new issuance at the risk-free rate of return. The firm has succeeded in getting something for nothing—at no cost to itself it has increased earnings-per-share. By issuing more shares the firm can continue to earn these extra-normal returns, at least until new issuance has satiated investor demand for liquidity and driven the firm's liquidity premium back to its previous level, at which point the strategy will have exhausted itself. New stock issuance will no longer increase per-share earnings.
Of course, investor relations teams can't be hired for nothing. If firms could perpetually increase earnings per share by costlessly boosting their liquidity premium and issuing new shares, then everyone would be doing it. In general, the price of hiring an IR team should be set such that it just offsets the benefits of the increase in a firm's liquidity premium. If the cost is lower, then firms will all try to purchase IR services in order to enjoy extra-normal profits, driving IR costs higher until the window for extra-normal profits has been closed. If the cost is higher, then firms will fire their IR department, the benefits of the liquidity premium manufactured by the IR department not justifying the expense of paying their salaries. In this case, IR costs will retreat until firms once again see some advantage in trying to hire an IR department to generate liquidity premia.
In short, the price that investors pay to enjoy a liquidity premium will be competed down to the IR costs of producing that premium.
Incurring IR costs are not the only way to do encourage liquidity. Relationships with market makers, dealers, and investment banking research departments will also help boost liquidity premia. Illegal practices like wash-trading can do the trick too.
Keep in mind that there are also large network effects at play. Incumbent stocks that have enjoyed high liquidity premia for decades will remain locked into that position, even if the incumbent's CEO were to fire the entire IR department. Liquidity is sticky. It would take incredibly large marketing outlays for a small rookie stock to displace an incumbent like IBM from its superior liquidity position.
If you get the chance, try visiting ten or twenty websites of publicly-traded companies and note how fancy each IR section is. Some will have only bare-bones text (like Berkshire Hathaway), others will have incredibly fancy flash animation and gorgeous pictures (like any junior gold miner).
These websites will give you some sense for each firm's pool of potential projects and respective strategy. Firms with a plenty of high-yielding investment opportunities will see no benefit in allocating funds to boost their liquidity premium. These sorts of firms will generally have ugly IR sections. Firms with fancy IR websites, on the other hand, have presumably measured all potential investment opportunities and decided that the highest yielding one is to hire aggressive IR so as to boost their liquidity premium, subsequently floating new shares. Investors who value liquidity on the margin would do well to gravitate to firms that see value in manufacturing liquidity premia. If you want liquidity, then buy from the people who make the stuff. Those investors who prefer pecuniary returns rather than liquidity returns should always avoid firms with fancy IR pages. After all, why buy liquidity if you don't value it?
The boundary case of firms pursuing higher liquidity premia are penny stock promotes. These firms have no real underlying business. Their only purpose is to create a temporary liquidity premia, the insiders exiting before those premia collapse to zero.
The general principles behind the manufacturing of liquidity premia described above apply not just to stocks, but to bonds, bitcoin, gold, cars, land, banking deposits, and all sorts of other assets. As long as people face uncertainty, they will always want to own liquidity. Those skilled in the manufacturing of this liquidity—marketers, salespeople, investor relations execs, promoters, bankers, and evangelizers—will always find their talents in high demand.