Profiting from Disruption Trades

(Bloomberg Opinion) -- Amazon, etc.

From time to time Amazon.com Inc. will announce that it is going to start doing a thing, and the stocks of other companies that do the thing will drop on the assumption that Amazon will eat their lunch. Amazon, the reasoning goes, is big and smart and good and efficient at doing things, so it will probably be able to out-compete the incumbents. Also Amazon is strikingly good at training investors to allow it to do things without making money on them, so it can undercut the incumbents’ margins by just doing the thing for free. You don’t want Amazon as a competitor, any bookstore owner will tell you.

Yesterday Amazon announced that it will start filling prescriptions online, buying a startup called PillPack Inc. for about $1 billion; it had the usual effect:

The deal for PillPack fires a warning shot to drug chains and retailers including CVS Health Corp. and Walmart, which have big pieces of the prescription market. The acquisition means Amazon doesn’t have to build capabilities in-house that current players have spent years assembling.

Shares of CVS, Walgreens Boots Alliance Inc. and Rite Aid Corp. tumbled Thursday, and the three companies lost more than $11 billion in market value.

A couple of readers asked me the question that I guess I am doomed to answer perpetually, which is, “what if they had insider traded on this?” If Amazon had shorted some Walgreens stock on Wednesday, it would have made a very predictable profit on its announcement. If it had shorted $10 billion of Walgreens stock, it would have made enough to pay for PillPack. Would that be legal?

Sure, I will say, sure. (This is never legal advice, I will always add.) It is obviously, necessarily legal to trade on your own intentions, even if your intentions can move the market; it is okay for Berkshire Hathaway Inc. to buy stock in a company, even though stocks tend to go up when Berkshire announces a position. Amazon, in this hypothetical, is not using anyone else’s nonpublic information, and has no “inside” information about Walgreens; it is just planning to do something itself and setting itself up to profit. 

This idea has an enduring appeal to a certain type of finance person. It’s a neat trick! We have talked before about Joe Weisenthal's old proposal that disruptors should fund themselves by shorting their disruptees, paying for their disruption by profiting from the destruction of the incumbents. Matt Yglesias famously called Amazon “a charitable organization being run by elements of the investment community for the benefit of consumers,” and in some ways it’d be funnier if it was instead a Robin Hood scheme, taking from other companies’ investors to give to its own customers.

Still, a couple of objections. One is boring and obvious: If Amazon had shorted $10 billion worth of Walgreens stock, the stock would have fallen before Amazon’s announcement, and Amazon probably wouldn’t have made any money. Short-selling makes prices more informative, and if Amazon regularly shorted the stocks of companies that it was going to disrupt, then the disruption would be incorporated into the prices before it was announced. This trick might work for some teeny startup disruptor—if it succeeds!—but it’s hard to see how it could move the needle for Amazon. And while Amazon’s intentions are material to Walgreens, they’re not the only thing that’s material; for all you know Walgreens might announce great earnings—or be acquired—between Amazon’s short and its announcement.

A second objection is legalistic. This trade is not, I think, “insider trading.” But people who are in the habit of (1) shorting companies’ stocks, and (2) doing things to cause those stocks to drop, always find themselves getting accused of bad stuff by those companies. Traditionally the bad stuff goes by the name “manipulation,” a far vaguer category than “insider trading.” If you announce “we are getting into the pharmacy business and we think it’ll be great,” and your competitors’ stocks go down, and you were shorting those stocks and profited from your announcement, then your competitors are going to flock to the Securities and Exchange Commission to accuse you of manipulating their stocks and lying about your pharmacy prospects and so forth. And the trade looks weird, is the thing, so the SEC is going to look into it. It just feels a bit more legally perilous than the more normal ways of financing yourself.

A related question is: Forget about Amazon trading; what if an Amazon employee knew about the PillPack deal in advance and shorted some Walgreens stock? Is that insider trading? There—and again, it's never legal advice—I think the better answer is that it is illegal insider trading. You have nonpublic information (about Amazon), you have a duty to your employer (Amazon) to keep it confidential, the information is material (to Walgreens), and you traded Walgreens stock based on it. You might argue that you don't have any inside information about the stock you traded, but that’s a tough argument. If Amazon were planning to acquire a public company, and an Amazon employee bought stock in that target before the deal was announced, that would clearly be insider trading, and I don’t think the Walgreens case is too different.

But I’m not sure, because I never see cases like this, and it's easy to see why: How would they catch you? When Company A buys Company B, financial regulators look into well-timed option trades on Company B stock. They compile lists of people who traded Company A and Company B stock, and send questionnaires to the people involved in the deal asking “hey do you know any of these people?” They don’t compile lists of people who traded every other stock that moved on the news. The focus in insider trading enforcement seems to be on insider trading in the companies you have inside information about, not, like, other correlated stocks.

But other stocks often move on deal news in fairly predictable ways. If Company A announces it’s buying Company B, Company C’s stock might go up because it’s a sign the industry is rushing to consolidate, or it might go down because it was hoping to be acquired by Company A and won’t be, or whatever. If you are a Company B insider who knows the industry well, you might be able to predict that dynamic pretty reliably and profit by buying or selling Company C stock before the announcement. And you might get away with it. 

You never hear about this happening, but that could be because it doesn’t happen, or because it happens constantly and no one gets caught. If I wanted to insider trade without getting caught, I think that's what I’d try, though, to be clear, (1) I don’t and (2) oh man is that ever not legal advice. 

More Equifax insider guessing.

Last year Equifax Inc. discovered that it had suffered a massive data breach, and then waited a month before publicly disclosing that breach. In between the discovery and the disclosure, three senior executives—senior enough that they have to report their stock trading in the Securities and Exchange Commission filings—sold stock, avoiding losses when the stock fell after the disclosure. This obviously looked suspicious—did they sell because they knew about the hack but the market didn’t?—but, on the other hand, it looked so obviously suspicious that I couldn’t really believe they had insider traded. It would just be too dumb. The executives “had no knowledge that an intrusion had occurred at the time,” said Equifax, and I believed it and still do. 

But it’s certainly ugly enough that the SEC had to investigate. It did, and none of those executives has been accused of any wrongdoing. But other people at Equifax—people who weren’t senior officers, and who didn’t have to report their stock sales publicly—seem to have been insider trading all over the place. We talked in March about an Equifax technology executive who worked on its breach response without actually being told that Equifax had been breached (he was just told that it was an exercise for an unnamed client, codenamed Project Sparta), but who allegedly figured it out and traded anyway. Is that illegal insider trading? Meh, sure, probably, though there is some precedent that just making a really good guess based on what you see at your company might not be illegal.

And then yesterday the SEC, and federal prosecutors in Georgia, brought a case against another Project Sparta employee. He too was apparently never explicitly told that Equifax had been breached, but was able to figure it out from context clues:

He was entrusted with information that allegedly resulted in him concluding that Equifax was the victim of a data breach.  On August 25, 2017, Bonthu and other Equifax employees were asked to assist in responding to the breach, although he was not directly informed that Equifax had been breached.  On August 25, 2017, Bonthu was informed that the target date for announcing the breach publicly was September 6, 2017.  Around August 30, 2017, Bonthu learned that approximately 100 million individuals’ information was exposed as part of the breach and that the data included names and Social Security numbers. 

Oh right fine one more clue:

The next day, Bonthu received an email related to his work on the breach with a file attached named “EFXDatabreach.postman_collection.”  “EFX” is the stock ticker symbol for Equifax.

One lesson here is, if you are going to give a project a codename to keep it secret from your own employees, use the codename consistently! I don’t know whether Bonthu would have figured it out—or whether he’d have been charged if he had—if he’d gotten a file called “SpartaDatabreach.postman_collection,” but putting the ticker in there really gives the game away.

Also if you were one of the multiple Equifax employees who was allegedly very cleverly insider trading on this breach, how mad would you be at those executives who were blindly dumping their stock and drawing the SEC’s attention?

Stress.

So Goldman Sachs Group Inc. and Morgan Stanley … failed-ish … the Federal Reserve’s stress tests? We talked the other day about the semi-arbitrary guesswork of the stress tests, where a bank has to guess how much capital the Fed will let it return, and if it goes over by a penny it “fails” and can’t return anything. Goldman and Morgan Stanley guessed wrong. But, the Fed concluded, they were understandable mistakes—due to the recent changes to U.S. tax law, which “resulted in one-time downward adjustments in the capital ratios of these firms, which do not reflect the firms’ performances under stress”—and so it didn’t fail them exactly. Instead:

The Board of Governors did not object to Goldman Sachs’ capital plan. The firm fell below the minimum required tier 1 leverage and supplementary leverage ratios on a post-stress basis. Goldman Sachs has agreed to limit the amount of its planned capital distributions to no more than a benchmark based on prior actual capital distributions. The benchmark is set at the greater of the actual distributions the firm made over the previous four calendar quarters and the annualized average of actual distributions over the previous eight calendar quarters.

What a weird paragraph. The Fed “did not object” to Goldman’s capital plan; it just said that that capital plan would leave Goldman undercapitalized, and Goldman “agreed to limit” its return of capital. As the Wall Street Journal puts it:

The Fed’s treatment of Goldman and Morgan Stanley—a compromise without the black eye of failure—was unprecedented and, to some bankers, a sign of an administration that is friendlier to Wall Street’s interest.

As I said the other day, this approach does seem more efficient, though the old draconian don’t-go-over-by-a-penny approach also has its benefits. And the Fed seems to be moving to the more flexible approach, formally, by regulation, in future years. It just sort of casually did it this year. Oh also Deutsche Bank AG’s U.S. unit actually failed.

Bridgewater will be a partnership.

Bridgewater Associates, the world’s largest hedge fund firm, presumably spends a lot of time analyzing financial markets and choosing the best investments, but these days its public persona focuses almost exclusively on its exhausting self-analysis. “Never mind stocks and bonds,” Bridgewater always seems to be saying, “have you heard about the benefits of listing all of your personal qualities on a baseball card and constantly updating your stats based on feedback from your colleagues?” And you see the wild look in its eyes and slowly back away. “We’re about to take the algorithms we have, and we’re going to give them to others,” founder Ray Dalio said on Bloomberg Television last year, but he didn’t mean the investment algorithms that power Bridgewater’s returns; he meant the constant-quantification-of-employee-behavior algorithms that power its endless introspection.

Anyway Bridgewater is organized as a limited partnership—you can tell because it is “Bridgewater Associates, L.P.”—but soon it will be organized as a different sort of partnership, and there is of course a lot of exhausting self-analysis that goes along with that:

Initially, Bridgewater will have two classes of partnerships. A handful of senior employees have been chosen as so-called seed partners, including Mr. McCormick and Ms. Murray, who have begun laying out the contours of what the partnership will ultimately look like. That will include the financial arrangements, which haven’t yet been set.

Then there is a bigger group of 50 provisional partners, whose job will be to represent the broader group of phantom equity holders and work with the seed partners on finalizing the terms of the partnership.

Honestly it’s a little disappointing that it will be a partnership and not, like, a Decentralized Autonomous Organization. Why doesn’t the computer that does Bridgewater’s investing get any votes in the partnership? I can at least hope that the voting procedures will be incredibly convoluted, and that partnership votes will be re-allocated in real time based on each partner’s credibility score in Bridgewater’s algorithms. It would be weird if the votes were just allocated based on, like, seniority. 

Elsewhere, Dealbreaker’s Thornton McEnery mashed up David Solomon’s “Don’t Stop” remix with Ray Dalio’s “Principles” animated videos, and I must say, it really works. 

Family activism.

Here is a letter from James Hughes to Christopher Hughes, the Chairman and Chief Executive Officer of TSR, Inc.:

Dear Chris,

Joseph F. Hughes  & Winifred M. Hughes (JFH & WMH)  have asked me ( James Hughes ) to dispose of their 819,000 shares of TSR, Inc.  (“TSRI”) common stock which represents approximately 41.8% of the outstanding shares of TSR, Inc.

At Friday’s closing price of $4.60 per share, TSRI’s stock is trading at a price that does not accurately reflect it’s true value.  The reported sales and earnings for the first nine months of the fiscal year ending May 31, 2018 are a disappointment.

I ask that you immediately pursue  a sale of TSRI. I believe that while the Board needs to conduct an appropriate process  in evaluating my request to sell the company, time is of the essence and your prompt consideration of this proposal is requested.

Godspeed,

James Hughes

Awkies! Christopher Hughes is Joseph Hughes’s son, and succeeded him as chairman and CEO last summer; James is Chris’s brother. The stock was down about 10 percent since Chris Hughes took over, though it jumped 31 percent on Monday when this letter became public. I respect a father who expresses his disappointment in his son in the form of a letter to his board of directors attached to a Schedule 13D filing. That is the old-school approach to paternal disapproval.

Blockchain blockchain blockchain.

“If the Mets had used blockchain in 2015, they would have won the World Series,” I wrote yesterday, but as a joke. I was kidding. The blockchain doesn’t work that way, was the point I was trying to make, through sarcasm. Meanwhile the Sacramento Kings are mining Ether. “We know blockchain is going to revolutionize the world,” says Chief Technical Officer Ryan Montoya. And here is an ominous "for now”:

For now, the mining project has no application on the basketball court, and no players are involved. But Montoya says, “I think when players come to Sacramento, they know we’re a tech-savvy group and if there’s anything we can do to introduce them to tech companies, we can do that. These players are younger guys, I’m confident they will have an interest in how this works.”

They’re going to win the NBA Championship next year, you heard it here first, doesn’t matter who gets LeBron, the Kings have the blockchain.

Things happen.

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To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

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