In this article, Martin Alvarez, chief commercial officer and global head of listings at the Long-Term Stock Exchange (LTSE), provides a guide for investors and companies to increase their understanding of how to navigate and utilise market volatility and liquidity.
As a company that is public or preparing to go public, you’re keenly aware that the market is geared for short-termism. You’ve likely observed first-hand how the market is fuelled by volatility and liquidity.
These terms, volatility and liquidity, are used liberally but have been normalised into a definition and market practice best suited for hedge funds, investment banks, and traditional stock exchanges.
The level of volatility and type of liquidity dominating the markets create headwinds for you. But what exactly is the impact on your company? And what if you could turn the tides in your favour?
A company’s guide to volatility
Volatility is just a statistical measure that reflects stock price returns for a given stock or index over time. Short-term investors love volatility, and there is plenty of evidence showing how demand for volatility is being satisfied.
A market driven by volatility
We see evidence of a market driven by demand for volatility based on the record amount of capital raised via SPACs, which carry a significant amount of warrants. [At time of writing in October 2020], over $57bn in SPACs had been raised. This is greater than the amount raised via SPACs over the last 12 years combined. [By the end of 2020, this figure had risen to $64bn.]
We see additional evidence based on the 12-year record amount of capital raised by public companies in the convertible debt market. Convertible debt is simply debt plus a call option. The call option is very attractive to, and in high demand by, hedge funds. Over $114bn in convertible debt has been raised by public companies as of August this year.
Profiting from volatility
Long-term investors want to be long stock. Hedge funds, generally, want to be long volatility. One way they do this: create trading positions by purchasing warrants or convertible debt, establishing an initial short-position, and rebalancing their short-position throughout the life of a warrant or convertible security.
Hedge rebalancing captures returns that allow hedge funds to profit from volatility. This activity is heavily guided by myriad trading models and algorithms. Volatility, as a pricing variable, drives valuation in nearly all types of option pricing models. Higher volatility translates into higher option value.
Assumes five years of time value, 1.3% reference rate, 0% dividend yield, $25 current stock price and a $50 strike price.
A stock option with a higher volatility assumption indicates a stock has more opportunities to trade above and below the option strike price throughout its life. So, more opportunities to profit from volatility. This is why higher volatility translates into higher option value.
A company’s perspective on volatility
While higher volatility always translates into higher option value, it does not mean that higher volatility increases the likelihood that your stock price will equal or exceed a target stock price in the future.
Most stock price probability models show that higher volatility has the opposite effect regarding the likelihood your stock will equal or exceed a specified price at a specified date in the future.
Compare two companies that want to understand the mathematical likelihood that their stock prices could double at the end of five years.
Company A has an investor base that generates trading volatility of 25% and Company B at 70%. Both companies carry an identical expected return of 20%. Company A has a 54% chance of doubling, or more, at the end of five years whereas Company B has a 26% chance.
Assumes five-year time horizon, 20% expected return, and 0% dividend yield.
We all know reality imposes its own will on the market, but these simple mathematical models clearly highlight how one variable — the quality and stability of your investor base — can drastically affect outcomes.
What this means is that companies should seek to build a more stable investor base. This will translate into lower stock-price volatility over the long term.
A company’s guide to liquidity
The US capital markets processed over $33trn of stock trades in 2018 and much of that was executed in 100-, 200- or 300-share lots. Much like volatility, however, liquidity means very different things depending on who you are in the capital markets ecosystem.
Liquidity for traders
Traders primarily define liquidity as average daily trading volume. That is, how much a stock trades each day. A well-rounded definition of liquidity for a trader also includes the ability to easily borrow stock for purposes of short trading. The more liquid a stock trades, the easier it is to rebalance short positions in small increments to profit from volatility.
Liquidity for companies
Liquidity for companies is much simpler: the ability to access and raise adequate low-cost growth capital. A well-rounded definition of liquidity also includes raising capital from long-term investors that are aligned with your long-term strategy.
Your average daily trading volume influences your access to capital. However, the quality and composition of your shareholder base is a more important driver of capital access.
It’s all about that base
Public companies spend an enormous amount of time, energy, money, and resources attempting to build the best possible investor base. Through no fault of their own, public companies are dominated by an ecosystem that severely limits the transparency, tools, and access to make that a reality.
The construction of a quality shareholder base primes the capital access pump — for when a company needs to raise high-quality growth capital.
Designing a shareholder base
You are best served when supported by long-term investors. A well-constructed shareholder base can help decrease volatility and increase access to patient capital.
Companies are often exposed to just three basic investor varieties: fundamental, hedge fund, and retail investors. The reality is that the investor landscape is much vaster and more complex.
Fundamental investors are generally considered to be the long-term gold standard. Fidelity [FNC], Franklin Templeton [BEN], T.Rowe Price [TROW], or Wellington are the types of institutional investors that fit into this category.
However, a mutual fund complex like Fidelity contains hundreds of sub-funds with many investment strategies. Companies are not exposed to that level of granularity.
A large fund complex is a brand that carries a reputation. Reputation plays a role, but investment behaviour is far more important. This behaviour happens at the sub-fund level. Ultimately, it is far better to evaluate funds based on their actual investing behaviour.
You need more transparency and access to data-driven insights in order to objectively evaluate investors and their behaviour. We’ve created the tools to help you do that.
Introducing the LT Score: How to identify healthy investor behaviour for your company
Until now, there has not been a simple, transparent way for companies to gauge and evaluate investor behaviour. But this has a profound impact on your company and the external pressures put on your priorities. So, if this is the key, how do you evaluate investors and their past behaviours?
LTSE has developed a proprietary algorithm to help companies demystify this: the LT Score. LT Score tracks investment behaviour at the sub-fund level and gives companies a scale (zero being the shortest term, 100 being the longest term) upon which to evaluate investors.
Different LT Scores, different outcomes
We analysed all the technology and healthcare companies included in the S&P MidCap 400 Index. One eligibility requirement for the S&P 400 is that public companies must have had a total market capitalization between $2.4bn to $8.2bn at the time of addition to the index.
Across these 90 technology and healthcare companies, we isolated the top 50 actively managed investors — excluding passive funds and insiders — to calculate the LT Scores of each of these investors. Then, we calculated a position-weighted LT Score to arrive at a single company-level LT Score that reflects the behaviour of each individual company’s top 50 investors.
We discovered that companies with an LT Score in the top decile — those companies with the most long-term investors — trade with average volatility levels that are 14.5-20.5 points lower than those companies in the bottom decile.
This shows that the companies with the highest LT Scores trade at volatility levels that are as much as 30% lower than those with the lowest LT Scores when looking at average 100-day and 250-day historical volatility levels. This is a striking difference.
Our LT Score is a tool that is designed to provide companies with transparency and access. Existing public companies can evaluate the LT Score of their own shareholder base and compare it with the LT Scores of other public comparables. They can also track LT Score trends across an investor’s overall portfolio.
For companies planning to go public, this allows you to use data to hone in on the best long-term investors for you.
Additional differentiators of the LT Score:
Funds not firms
It is vital that companies have the ability to monitor investors at the sub-fund level because this is where the investment decision-makers (portfolio managers and analysts) live. A company’s stock price volatility is a reflection of its shareholder base. LT Score helps companies filter out the noise so they can target and engage with the most relevant long-term investors.
Finance and investor relations teams are overdue for access to quality data to support decision making. The LT Score instantly analyses investor behaviour in companies across industry, sector or market cap.
This allows us to uncover unique insights such as our targeted evaluation of the 50 actively managed investors for technology and health care companies in the S&P MidCap 400 Index. We can not only identify the most long-term investors and how that impacts volatility, but the LT Score can also uncover unique insights such as where outliers exist.
For instance, our analysis shows some hedge funds carry higher LT Scores than well-reputed mutual funds. Take Fidelity’s sub-funds behaviour for this cohort: it carried a range of LT Scores between 18.6 and 58.4. This may indicate where an investor is bearish and where they are bullish.
As a public company, imagine having the ability to strategically prioritise and plan for investor meetings following an earnings release. LT Score can evaluate the investment behaviour for existing and prospective shareholders to help you plan accordingly.
Management teams can leverage LT Score to optimise non-deal roadshows. Most importantly, management can send a strong accountability signal to the street by leveraging LT Score to prioritise time spent with investors.
Consider having the ability to make transactional allocation decisions by balancing price with investor quality. This is a much better way to generate price discovery, and can be just as (or more) important than valuation alone. This sends the most significant accountability signal to investors. A company may ultimately choose to maximize price — but at least it will understand the investment behaviour associated with its allocation decision.
Pick up where direct listings leave off
Recent IPO innovations such as direct listings are purely transactional and eliminate a company’s ability to choose their investors. Direct listings are designed to maximise valuation.
Price maximisation does not equal optimising investor quality or rigorous price discovery. An investor with a five-day investment horizon probably doesn’t carry the same risk profile and valuation sensitivity as an investor with a five-year time horizon. LT Score helps companies (who cannot choose their investors at IPO) target and engage with high-quality investors once they are public.
Companies deserve the tools and systems that allow them to make decisions on how they access capital with greater transparency and control. LTSE is committed to developing innovative tools — like the LT Score and others — that help companies plan for the long term.
Once we help you cut through the noise and properly map the investor landscape, the real work begins. The Long-Term Stock Exchanges’ listings principles are a great place to start. We are levelling the playing field for you — join us.
This article was originally published on the LTSE’s blog by Martin Alvarez, the chief commercial officer at LTSE, where he partners with both private and public companies to help them plan for success into the next decade and beyond.