Operating vs Financial Cash Flows

Photo Credit: Daniel Broche || To the victor goes the spoils, or, does a victory get spoiled?

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I was at a CFA Baltimore board meeting, and we were talking before the meeting.  Most of us work for value investors, or, growth-at-a-reasonable-price investors.  One fellow who has a business model somewhat like mine, commented that all the money was flowing into ETFs which were buying things like Facebook, Amazon and Google, which was distorting the market.  I made a comment that something like that was true during the dot-com bubble, though it was direct then, not due to ETFs, and went to a different group of stocks.

Let’s unpack this, starting with ETFs.  ETFs are becoming a greater proportion of the holders of stocks, and other assets also.  When do new shares of ETFs get created?  When it is profitable to do so.  The shares of the ETF must be worth more than the assets going into the ETF, or new shares will not get created.

It is the opposite for ETFs if their shares get liquidated. That only happens when it is profitable to do so.  The shares of the ETF must be worth less than the assets going out of the ETF, or shares will not get liquidated.

Is it likely that the growth in ETFs is driving up the price of shares? Not much; all that implies is that people are willing to pay somewhat more for a convenient package of stocks than what they are worth separately.  Fewer people want to own individual assets, and more like to hold bunches of assets that represent broad ideas.  Invest in the stock market of a country, a sector, an industry, a factor or a group of them.

The creators and liquidators of ETF shares typically work on a hedged basis.  They are long whatever is cheaper, and short whatever is more expensive — but on net flat.  When they have enough size to create or liquidate, they go to the ETF and do that.  Thus, the actions of the creators/liquidators should not affect prices much.  Their trading operations have to be top-notch to do this.

(An aside — long-term holders of ETFs get nipped by the creation and liquidation processes, because both diminish the value of the ETF to long-term holders.  Tax advantages make up some or more than all of the difference, though.)

Does the growth in ETFs change the nature of the stickiness of the holding of the underlying stocks?  Does it make the stickiness more like a life insurer holding onto a rare “museum piece” bond that they could never replace, or like a day trader trying to clip nickels?  I think it leans toward less stickiness; my own view of ETF holders is that they fall mostly into two buckets — traders and investors.  The investors hold a long time; the traders are very short term.

As such, more ETFs owning stocks probably makes the ownership base more short-term.  ETFs are simple looking investments that mask the underlying complexity of the individual assets.  There is no necessary connection between a bull market and and growth in ETFs, or vice-versa.  In any given market cycle there might be a connection, but it doesn’t have to be that way.

ETFs don’t create or retire shares of underlying stocks or bonds.  And, the ETFs don’t necessarily create more net demand for the underlying assets.  Open end mutual fund holders and direct holders shrink and ETFs grow, at least for now.  That may make a holder base a little more short-term, but it shouldn’t have a big impact on the prices of the underlying assets.

My friend made a common error, confusing primary and secondary markets.  No money is flowing into the corporations that he mentioned.  Relative prices are affected by greater willingness to pay a still greater amount for the stock of growthy, highly popular, large companies relative to that of average companies or worse yet, value stocks.

Now the CEOs of companies with overvalued shares may indeed find ways to take advantage of the situation, and issue stock slowly and quietly.  The same might apply to value stocks, but they would buy back their stock, building value for shareholders that don’t sell out.  In this example, the secondary markets give pricing signals to companies, and they use it to build value where appropriate — secondary markets leads primary markets here.  The home run would be that the companies with overvalued shares would buy the companies with undervalued shares, if the companies were related, and it seemed that management could integrate the firms.

What we are seeing today is a shift in relative prices.  Growth is in, and value is out.  What we aren’t seeing is the massive capital destruction that took place when seemingly high growth companies were going public during the dot-com bubble, where cash flowed into companies only to get eaten by operational losses.  There will come a time when the relative price of growth vs value will shift back, and performance will reflect that then.  It just won’t be as big of a shift as happened in the early 2000s.