Liquidity and Ponzi Scheme

Every time, when I saw some news talking about how investors lost hundreds of billions of dollars because index dropped 3% in a day, I can’t stop thinking that this kind of news is designed to get attention of the unwary public.

Theoretically, the value of stocks is the share price times the number of shares. But that calculation totally ignores the liquidity factor. Just because some crazy guy is willing to pay 10 times of what the share is worth, it doesn’t make every shareholder 10 times richer. This is because the shares being traded is only a tiny percentage of all the outstanding shares.

However, this is exactly how the manipulators design the game. If the shares are being traded in a price range, it gives a misleading impression that the shares are worth that much. After all, the market is efficient, right? In reality, it is far from the truth. Otherwise, try to explain those bubbles in the history.

In some sense, Ponzi Scheme is using this liquidity factor to fool people. At any given moment, as long as the people who demand redemption is only a small percentage, or the people who seek redemption (sellers) are less than the people who get sucked into this game (buyers), the manipulators (or call them the game designers) will have no problem to keep this game going. However, when all the existing stockholders want to seek redemption, you can be pretty sure that there is no way it can still be able to maintain the same or similar price.

Perhaps this is not news to many experienced investors/traders, but what is more interesting is that many investors/traders are participants of this Ponzi Scheme when they have already knownthis is a Ponzi Scheme!

This actually happens quite often in the stock market for those momentum players. Some of them are the unwary public, but many of them do know that the stocks are not worth much. But as long as it can keep on going up, why don’t enjoy the ride? Last year, the Chinese stock market had a crazy run from March to June when many stock traders, including many who just joined the market for the first time don’t really believe there is much value in those stocks. Yet, most of them think they can get out before others do, and there is plenty of money to be made during this crazy bull run.

What happened to them eventually? Well, I don’t know individually, but collectively, you know for sure that they are determined to lose in a big way.

This brings another paradox of the market efficiency theory. Something clearly not “efficient” to those fundamental investors can become efficient for some other market participants. Even though you know this is a ponzi scheme, it doesn’t mean there is no money to be made here. In fact, the FANG stocks are still the best stocks in this weak market, right? (Other than Google, I believe the other 3 are all much overvalued.)

But when you factor in the liquidity factor, it is not that hard to see where the bubble stocks are. Why did you see a big value gap last year between the valuation of BABA (BABA) and Soft Bank (SFTBY)? Can Netflix (NFLX) raise new equity capital easily at today’s valuation, or maybe that is why it has to get more debt instead? What about LNKD (LNKD) dropping 45% in a day?

That is also the reason why companies with bubble stocks like to use the stock as a currency for acquisitions or stock based compensation. These transactions are both non-cash, and also hide the fact that there isn’t much real liquidity for investment purposes at that high valuation.

What is more interesting here is that it is actually a “win-win” situation for almost all stakeholders. For the acquirer’s management, they just expanded their empire, gaining more power and better pay. For the acquirer’s short term investors, the acquisition will show higher growth rates without affecting earnings or FCF, and therefore may bring more premium on valuation. For the acquirer’s long term investors, using expensive stocks as a currency is creating value for them.

What about the company being acquired? They get some premium (usually 30% or more) during the transaction, but what if the shares are 3 times overvalued? Don’t they lose eventually? Well, that really depends on their size and time horizon. Also, if this game can continue for long enough, the acquirer may gain enough “value” to make the overvalued stocks to be really worth that much, which is exactly what happened in 1960’s conglomerate scandal. (Even though the conglomerate was overvalued at the moment, if it can continue to use overvalued stock to exchange for many fairly valued smaller businesses, the value created from this process could later make it worth the price at that particular moment!)

How can “value” be created in this zero-sum game and make every player happier than before? That is the “magic” of Ponzi Scheme. Before the music stops, you really don’t know who the loser is, and all the “current” participants could all be winners if there are enough losers joining this game later, but you also know that collectively, there will be a lot losers for sure.

Ideally though, these companies also like to raise equity capital when the stocks are overvalued, but that is much harder to do because it is too much risk for the investors to take so much stock at such a high valuation (again, the liquidity factor is in play). So the best they can do is often just some convertible bonds or warrants. (After all, day dreams are only worth that much.)

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One Response to Liquidity and Ponzi Scheme

  1. dajian888 says:

    BTW, I just learned that Munger also mentioned the bubble-like market is a “ponzi-like” scheme, which confirmed my own thinking 🙂

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