I cringed at the headline: "Why decimalization is a bad idea." It's the second article I had seen in as many days apparently supporting a proposed new Congressional bill that I find incredibly stupid.
Of course, I'd also misread the headline. What it actually said was "Why dedecimalization is a bad idea" [emphasis mine]. And it wasn't just the headline that Felix Salmon nailed, as he concluded in the post that "there's no way that small investors can possibly benefit from this."
But let's backtrack for a moment. The "problem" this bill attempts to rectify is that there are many small public companies out there that don't have much Wall Street research coverage. The reason is that trading is so sparse and spreads -- that is, the difference between the bid and ask prices -- are so thin that there's little money for Wall Street firms to make trading the stocks and, thus, little reason to follow them closely. This situation was a result of "decimalization" -- the changeover from quoting stocks in fractions to decimals, which allowed bid/ask spreads to fall in many cases to just a penny.
This leads to what Fortune columnist Dan Primack deemed "a cycle of arrested development." And, as he expanded, that cycle is far less amusing than the TV show of the same name:
They are small, so they are ignored by analysts and market-makers. And because they are ignored by analysts and market-makers, they remain small.
To Primack and supporters of the bill, this sad situation would be mitigated by walking back decimalization and making spreads wider -- between five and 10 cents.
Boiling down Salmon's rebut to Primack: hogwash! Wall Street analyst coverage is not the public-market version of Miracle-Gro. Small companies grow because they have -- among other things -- a good business model and products and services that customers value. Wall Street can choose to not cheerlead a good, small public company to its own detriment. There's only so long that the market can ignore growing profits from a good company, and by the time those big-money Wall Streeters decide to tune in and recommend the shares, their clients may have missed out on a good deal of the growth.
But even if Wall Street glad-handing isn't necessary for a company to grow, perhaps it's nonetheless helpful. And there's a case to be made for that. A public company can access growth capital by selling new shares into the market. The higher the company's stock price, the more money a company can raise at a lower implied cost (for the finance nerds, it creates a lower cost of capital). If these small companies have Wall Street analysts -- known for their bullish bias -- cheering them on, we could expect that financing costs would be lower, more growth capital would be tapped, more jobs would be created, and everybody would be a big, big winner. Yay! Right?
Not so fast. All things held equal, lower financing costs can be cheered as a positive. But in this case, the cost of creating this dynamic is pushed through to investors -- both institutional and retail -- as the total cost of purchasing or selling a stock equals the fees you pay plus the trading spreads. Since this bill would widen those spreads, costs to the investor go up.
And what do investors get in exchange for those higher trading costs? Wall Street rah-rahs small, potentially ill-capitalized companies that are hoping to dilute shareholders through new share sales. And as for the "research" coverage, how many full Wall Street research reports are average retail investors getting access to? Yet they'll be helping to subsidize that research through these wider spreads.
In other words, this isn't a boon for investors small or large, nor is it necessarily helpful to profitable, growing companies or those with attractive business models.
It is, on the other hand, an attractive proposition for Wall Street. Brokers benefit because they profit from the trading spread. It's been a hellish decade-plus for the industry because decimalization has whacked the amount of money they typically make on a trade. This bill would take a step in the opposite direction -- more money in the brokers' pockets via less kept in those of investors.
Wall Street investment bankers should love this as well. Though the big investment banks prefer to do deals for giant companies such as Facebook (cringe), in a tougher deal environment they're likely to take what they can get. This month, Citigroup (NYSE:C) has taken Emerge Energy public, Goldman Sachs (NYSE:GS) has brought Cyan to the public markets, and Wells Fargo (NYSE:WFC) has led Insys Therapeutics' IPO. All of these companies are at or near the market cap threshold for what this bill would cover.
To the extent that Wall Street firms can suddenly make more money dealing in the stocks of smaller companies, it would make doing more deals like these that much more attractive. It's also an additional selling point when the bankers are trying to rustle up business.
In other words, we have a potential bill that would put more money in the pockets of Wall Street at the expense of investors, while amping up the cheer section for small, questionable companies that want to sell more stock to public-market investors.
Come on. Is this for real?
Matt Koppenheffer owns shares of Goldman Sachs. The Motley Fool recommends Facebook, Goldman Sachs, and Wells Fargo and owns shares of Citigroup, Facebook, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.