As is now beyond reasonable doubt, the efficient market hypothesis is, at best, often inaccurate. Warren Buffett and Sam Bankman-Fried may be billionaires separated by generations, but their net worths are testament to the possibility of finding hidden value in financial markets. Yet for every investor who finds hidden value in a stock, there are other assets that remain undervalued.
At Edison we have, for the past year or so, been using the term Dark Capital as shorthand for vast pools of potential liquidity which exist – but which many companies are not aware of and cannot access. Our analysis concludes that Dark Capital has occurred because of a rising tide of global equity market dysfunctions.
The results of the phenomenon can be serious. When capital and issuers are hidden from each other’s view, the signal of a stock’s value gets lost. Liquidity dries up, institutions divest and a downward price and liquidity spiral begins. Investors who should have made money lose out.
Edison’s mission is to illuminate Dark Capital and ensure our clients have the liquidity and stock price that they deserve. To be successful, we have made it our business to fully understand the phenomenon. Below is a short summary of our investigations into its causes.
- Failures in regulation
Companies generally engage with investors through the equity research and sales departments of an investment bank or broker. Yet reforms that started with Spitzer in the early 2000s and continued with MiFID 2 in 2018 have put this information flow under pressure.
In the name of competition, EU fund managers cannot now receive research that is free at the point of provision. The partial reversal of this reform – for companies with a market cap of less than €1 bn – is telling. Yet even in 2022 Edison’s clients have continued to highlight how they often struggle to reach investors that do not pay for their broker’s research; that educating, informing and accessing investors outside of domestic markets has become a bigger challenge; while the need to communicate with the growing pool of smaller funds and private wealth money is also increasingly difficult.
It appears the regulatory reforms need further reform themselves.
- Individual investors
Continuing the theme of informational asymmetry, private investors are now playing a deeper and more structural role in many equity markets. For instance, retail volumes peaked at 40% of total US market volumes in Q120 and the number of brokerage accounts at the top seven retail brokers increased by 36m from 59m accounts in 2019 to 95m in 2021.
While the fervour of the post-pandemic recovery has been dampened by 2022’s bear market, few commentators doubt the structural shift towards retail investing. Accessibility has increased with the growth of trading apps, social media, editorial websites, financial literacy and connection speeds. All of which created a culture of equity ownership for a younger generation of investors, accelerated by FOMO (fear of missing out).
Yet retail investors cannot access analyst research from highly regulated brokers. Much of their insight comes from influencers: a vast ocean of less regulated journalists, as well as entirely unregulated bloggers and vloggers. All of whom may not perfectly understand what they are doing and whose business models largely rely on the volume of clicks and views, not the accuracy of the information they provide.
If influencer musings were of equal value to the analysis of brokers, professional fund managers would no longer pay for analyst research. Which, of course, is not the case. And this means, by and large, retail investors are part of the increasing glut of Dark Capital. Reliable insight often fails to reach them.
- Passive investment
The Federal Reserve’s May 2020 paper The Shift from Active to Passive Investing: Risks to Financial Stability? states that ‘the shift to passive investing is a global phenomenon. In the U.S…. passive funds made up 48 percent of the AUM in equity funds and 30 percent for bond funds as of March 2020, whereas both shares were less than five percent in 1995.’
Despite the hypothesis that passive is a more efficient form of investment than active, the concern is that it also makes capital entirely inaccessible to a vast number of issuers. And this, alongside shorting and algorithmic trading, creates a more fragile market with increasing levels of Dark Capital.
This also highlights a key difference between active and passive investing. An active manager assesses the fundamentals of a stock and takes a view on valuation, becoming a buyer or seller of a security at a particular price. The difference in active managers’ views is what provides liquidity to the market. They are price makers.
A passive fund, by contrast, is a price taker. The manager has no opinion on valuations. As money comes into the fund, it has to buy the index or basket of stocks the fund is tracking, taking the market price. Then, as money is redeemed from the fund, it has to sell stock. Again, taking the market price. The flows of funds into and out of passive funds might influence share prices, but they don’t dictate them.
When the passive price takers drown out the active price makers, the pricing signal in the market can become weaker. For instance, in the build-up to the COVID-19 pandemic in March 2020, active managers were aware of the coming crisis. China was shutting down, Italy had serious problems and the United States was starting to see cases in New York. Yet markets continued to levitate. Active managers looking for signals found this confusing. In March, as the active manager community broke and tried to de-risk, they found no buyers for the stock they were selling. Passive funds do not step into a market when it goes on sale.
This muting of the price signal creates inelastic demand: demand that fails to respond to price movements. Despite falling prices, no one buys, leading to further price falls. Overly discounted stocks can then easily fall into the liquidity trap, especially when exacerbated by shorting. With prices crashing, even active institutional investors are forced to sell as the stock slips below the waterline of their remits, placing yet more downward pressure on price and liquidity.
What is the solution?
When darkness is the issue, illumination is always going to be the solution. It is vital, therefore, for an equity to be known widely. And to be known widely for having an attractive investment case. Only then can sufficient numbers of active investors start to consider buying the stock, generating the liquidity needed for the equity to move away from becoming a casualty of Dark Capital.
At Edison we have created an entire methodology, Investor Relations 3.0, to illuminate Dark Capital and connect our clients to it. We put award-winning equity research into the hands of all investors, from the largest institutions to the smallest retail players. It ensures relevance and reach via digital marketing and more than 60 financial platforms including Bloomberg, Refinitiv and S&P Capital IQ. Our direct investor outreach then becomes an efficient activity of starting real life conversations with those investors most likely to purchase stock. Which is why we are having so much success, regardless of the weather in the market.
If some of what we have discussed in this article has touched a nerve – whether you are an issuer or investor – we would like to talk.
