The Real Stock Market Villain

Falsely Accused Michael Lewis' 2014 treatise on high-frequency trading, Flash Boys, generated enormous attention. The most comments this column has ever attracted was when it reviewed the book.

Unfortunately, the story lacked a true villain. Yes, Lewis had some success at painting high-frequency traders (HFTs) as all things anti-American. However, the charge has not stuck. HFTs figured out how to get an edge on their trading competitors by purchasing data from stock exchanges, establishing rapid communications lines, and collecting many, many pennies. You might not like them, just as you might not like McDonald's displacing mom-and-pop diners, but it's hard to argue that HFTs are anything but a conventional business success.

Now, as my colleague Eric Jacobson points out, this version of democracy isn't exactly democracy for all. It's democracy for those who are wealthy enough to play the game. If you don't have a few dozen million dollars with which to pay the stock exchanges and purchase the necessary technology, you can't play the game. Once again I say: Welcome to America!

Another problem with casting HFTs as the baddies is that they don't hurt Main Street, at least not in any meaningful way. At circa $2 billion, annual HFT revenues amount to about 0.01% of stock market trading volume. Using a very rough back-of-the-envelope calculation, this means that a retail stock investor who owns $250,000 worth of stock and who turns over 20% of her portfolio each year, would spend $5 a year on HFTs. It might not even be that much. Many credible sources, including Vanguard CEO Bill McNabb, have argued that HFTs improve retail investors' returns by increasing stock-market liquidity, which lowers trading spreads.

Guilty Parties Here is a better idea, for Mr. Lewis' next expose: Companies that spend their time attempting to boost their stock prices. Consider the opening paragraph of "Analysts Say 'Buy' to Win Special Access," published in Friday's The Wall Street Journal:

Analysts who want top executives at Coach to attend private events with their investor clients have to show they are "brand ambassadors," as the luxury handbag retailer dubs it. You can't be a brand ambassador if you have a sell rating on Coach's stock.

Well now, isn't that lovely. Corporate executives dangle the carrot of swanky parties in front of stock analysts, while simultaneously brandishing the stick of banishment, should the analysts resist. If analysts accept the offer that they dare not refuse and recommend the company's stock, they then can use the party invitation to flatter their clients by escorting them to exclusive events. The clients, who are mostly professional investors who bear a fiduciary duty to people who are not invited to such parties, and who never will be invited to such parties, accept the invitation on behalf of those people who were not and will not be invited.

If you like how that sounds, you'll love the International Olympic Committee.

More from the article:

1) One third of all money spent on "stock research" in 2016 went toward buying access to corporate managements.

2) Stock-research firms routinely track how much time their analysts spend with corporate executives and how often they bring those executives to meet with the research company's clients. Often, that information is used for calculating bonuses.

3) Of the 11,000 analyst recommendations on S&P 500 stocks, as tracked by FactSet, only 6% are sell ratings.

States a former stock analyst, "When your compensation is in part based on how many meetings you set up in a given year [and companies won't meet with you if you have placed a sell recommendation on their stock], it's really tough to stick to your guns."

Another example from the article: "Media analyst Richard Greenfield of BTIG LLC says his emails, phone calls, and a request for an investor meeting with Walt Disney Co. have gone unanswered since he issued a sell rating on the company in December 2015. Before then, when Mr. Greenfield had a buy rating on the stock, he was regularly invited to Disney events and once hosted a meeting between a group of investors and a Disney executive, the analyst says."

Doing It Wrong As with high-frequency trading, corporate gamesmanship carries few direct costs. Brokerage charges are somewhat higher than they otherwise would be, and party bills need to be paid. Those items aren't worth bothering about. Nor will I shed tears about investor results, because ultimately, this is a zero-sum game. One investor profits from a stock being oversold; another loses when reality intrudes and the stock retreats. Such is the nature of the financial markets. Nobody said they were perfectly efficient.

My quarrel is moral, not financial. It is with the system's coercion and corruption. It is with corporate executives who huckster their stocks rather than run their businesses; with stock analysts who get lured (or bullied) into participation; and with professional investors who accept the invitations without thinking through why such exclusivity exists, and what deals have been struck. My quarrel is that, unlike with HFTs, the corporate executive/stock analyst relationship is thoroughly un-American. It depends not on the transparent exchange of money, but instead on back-door relationships and the mutual swap of conflicts of interest.

This topic, Mr. Lewis, would be ideal for your next book. The Journal fired an excellent opening salvo. But this subject could benefit from a larger, more protracted assault.

Final Note Morningstar faces the executive/analyst issue from both directions. The company's stock trades on Nasdaq, and its equity analysts conduct research on other companies. Although as this column's disclaimer states, I do not necessarily speak for company policy, in this instance our thoughts align. Morningstar executives do not address private questions from shareholders; all such queries are handled through a public question-and-answer forum. For their part, the company's stock analysts are not evaluated--or tracked--on the basis of their number of company meetings.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.