Sunday, March 13, 2005

Three rings of market information

People make money in the market by trading on secrets (sometimes dubbed information asymmetries). The law has placed boundaries around the kinds of secrets that are tradeable. It is illegal for a corporate insider to trade on the insider's knowledge of a corporate event.

But it's legal to profit from the sheer market moving power of a large trade. When, say, a big buyer wants to purchase a large volume of shares, traders disguise the buyer's intent by breaking up the transaction into little pieces to hide the buyer's identity and intent. An executive at a mutual fund company described to me how when the company's largest fund wants to execute a large transaction, the fund doles it out to "hundreds" of brokers. This little game allows the buyer to pick up the shares at a lower price while masking the buyer's intent.

Recent events have reminded me of how some traders can profit from these information asymmetries by exploiting the three rings of market information, which I first wrote about in e-Stocks. The inner ring profits from its superior control of trading to the detriment of the outer rings. The theory of the three rings has important implications for individuals and their ability to rely on stocks as an investment. Here are the three rings:
  • Inner ring (e.g., traders at major investment banks, hedge funds, and mutual fund complexes);
  • Middle ring (e.g., intermediaries between the inner ring and individual investors such as stock analysts, brokers and NYSE specialists); and
  • Outer ring (e.g., individual investors).

Different media seem to cover different rings. The inner ring is somewhat swathed in mystery; however, I think that certain publications, such as's premium content and certain investment newsletters, provide insights into the thinking of those in the inner ring.

The middle ring is fairly well covered by the mainstream financial press. But sometimes this coverage leaves out important information that compromises its objectivity. An investment banker told me that he spins reporters on his client's M&A transactions. Readers may not realize how much reporters depend on investment bankers for such "news." The economic interests of reporters and their sources could compromise the objectivity of what passes for analysis in the articles. Thus investors should understand how these economic interests might skew the analysis of of the deals.

And the outer ring is covered in ways that create sell signals by publications such as Time, Newsweek and USA Today. For example, when's Jeff Bezos was named Time's Person of the Year on December 27, 1999 savvy insiders took it as a cue to sell.

Martha Stewart Omnimedia's (MSO) stock performance since December 2003 illustrates the theory of the three rings of information. MSO rose from $9 in December 2003 to $36 on the day of her release, March 4, 2005. Since then the stock has lost 22% of its value.

The inner ring in MSO's case is represented by Jeffrey Ubben of hedge fund ValueAct Capital Partners who joined MSO as Chairman in July 2003 after Martha Stewart left that job. Ubben bought 22% of MSO for $68 million in January 2002 not long after MSO plunged in the wake of allegations that Stewart dumped her Imclone stake based on insider information. While MSO dropped 37% between January 2002 and Ubben's appointment to MSO's board, the stock seems to have recovered nicely despite a 35% plunge in MSO's revenues and a huge net loss.

And Ubben got out in time. In a financial disclosure filed on March 8, 2005, Ubben revealed that in the days just before Stewart's release, ValueAct dumped 1.24 million shares of company stock for $42.7 million. That was most of Ubben's investment in the company. The general public has no way of assessing Ubben's impact on MSO's price during the tenure of his investment. Perhaps he bought MSO thinking that Stewart's legal problems had driven the stock too low. But surely as Chairman he was aware of MSO's deteriorating financial performance. The timing of his exit from the stock suggests that he realized that MSO was enjoying an artificial levitation due to the public's loyalty to Stewart combined with short covering.

The middle ring, the analysts who covered MSO, were mostly bearish about the company's prospects. They noted that MSO was losing revenues and increasing its losses. These analysts expressed concern about those who were buying the stock because they believed that at some point the weak performance of the company would hurt the stock.

The outer ring, individuals who bought MSO as Martha Stewart went to trial, seemed to be ignoring the weakening financial prospects of the company. Instead, recognizing the Stewart was MSO's largest shareholder, these individuals wanted to demonstrate their loyalty to Stewart by purchasing shares of her company.

While some of the outer ring may have profited if they sold their shares prior to Stewart's release, there may be many who bought the shares in the excitement of the days prior to her release when the mainstream media was flooded with reports about Stewart's TV programs -- whose benefit to the company were hard to quantify. Those in the outer ring must now be licking their wounds in the wake of the stock's 22% decline since her release.

Much of this analysis is speculation because the market operates without providing investors with insight into what is going on in the three rings of market information. If the outer ring had real-time answers to the following questions, then perhaps stocks would be better investments:

  • Who is in the inner ring on each transaction?
  • On each transaction what factors motivate the inner ring to buy or sell?
  • How do inner ring participants coordinate their transactions on individual stocks?
  • What are the links between the inner ring and the middle ring on individual transactions?
  • What are the links between the media and the three rings?
  • How would the real-time release of the above answers influence stock prices?


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