Market disconnects

Why has Sun's share price fallen by one third in the same six month period that the company produced a billion dollars in net incremental shareholder wealth? Simple: traders, people who respond to each other, have taken over from investors: people who respond to what the company does.

Last November 12th, the day of the 1:4 reverse stock split, Sun's shares closed at $20.33 for a market cap of around $15.7 billion. Six months later, on May 12th, they closed at $13.42 for a market cap of about $10.3 billion - a 34% decrease over the period.

During that same six month period - and I'm using estimates because the period doesn't correspond to Sun's fiscal quarters - Sun took in about $7.2 billion in revenues, spent about $300 million buying back their own shares, and increased their cash or equivalents horde by a bit over $700 million.

Meanwhile problems at Dell surfaced, Microsoft thrashed, HP continued its decline to Compaq, IBM failed to settle its internal battles, and Apple's iPhone success signaled the beginning of the end for the traditional personal computer.

GAAP to the contrary, the simple version of this is that Sun's executives ran the business, paid for some new assets, improved the company's competitive position, and enriched shareholders by about a billion in cash over the same period that its shareholders sold the company down by about one third.

By way of comparison, google makes about 40% less in revenues, could be put out of business at the drop of a better search idea, and currently has a $188 billion market cap - more than eight times the "Total Stockholder Equity" listed on their 2007 summary financials.

So what's wrong with this picture? Fundamentally I think that whatever reality there may once have been to the idea that the stock market tracks the issuer's long term profitability has long since given way to a different reality: one in which the market for shares tracks the short term profit opportunities associated with the share rather than with the company.

There are many reasons this has come about - but because they mostly revolve around the combination of ignorance and opportunity they've affected the tech sector more than others.

Ignorance because gossip, the mostly wrong stuff everybody knows, is a better predictor of market valuation than independent assessment or real industry professionalism; and opportunity because day trader volatility has combined with the enormous dollar amounts that can be thrown around by major market institutions to create a situation in which the signals driving the market come more from people buying and selling the share than from anything the company does.

The key disconnect here is that theory says that the appearance of new information about the company behind a share should drive change in the value of that share, but what actually drives the value isn't the company's behavior but that of the people who trade its shares. Basically, traders have driven out investors - and the information that makes the market is information about the behavior of traders, not information about the companies whose shares they trade.

You and I could, for example, see a new product announcement by somebody like Ford as grounds for investing in the company's shares - but the guy managing a thirty billion dollar portfolio knows that he can make Ford's price fall significantly any time he wants to just by placing an order for a billion in GM -because where the game is follow the leader, what matters is where the leader goes; not why he goes there.

There's a continuing pretense to the contrary, of course, with "analysts" pontificating profoundly on the meaning of management changes or other announcements and offering the usual well thought out advice: buy what they're selling (usually M&A services), and cut all other costs regardless of consequences.

For tech stocks the generic problem is made worse by two factors: more and deeper ignorance, particularly among day traders whose transaction numbers combine with the big guy's dollar numbers to make averages triggering automated trades; and the tendency tech companies have to hold on to large amounts of cash.

Originally tech companies tried to hold large amounts of cash and near cash equivalents first to serve as a kind of ballast assuring creditors and others of the company's steady viability as a business partner, and then as a kind of MAD (mutually assured destruction) deterrent against market raiders - because distributing the cash to shareholders of record prior to the attack leaves the attacker paying a large premium for the dubious satisfactions of fighting the lawsuit and firing the executive.

For most of the companies involved - Apple, Microsoft, Sun - the value of the cash horde in enabling a closer matching of receivables to payables has long since become minimal - and the MAD effect has been both diluted by lawsuits and gamed by traders to the point that it now encourages more attacks on the share than it discourages.

The basic reason for this is simply that selling down one company to make a profit on your holdings in a competitor only works more than once if the victimized share can reliably bounce back. Large cash holdings act, in this context, a bit like weights on a pendulum: bringing the share back to a reduced normal after every hit - thus making it a viable target for the next one.

So what's the bottom line? Any public company, but particularly high technology companies with big cash hordes and products few on Wall Street understand, can become a vehicle by which large traders victimize individual shareholders - and while the only sure solution is to go private, there may be alternatives worth discussing: tomorrow.