The U.S. market has been soaring hot for nearly seven years.
On the other hand, the Canadian market has been ice cold.
In the last five years, the TSX has climbed 25% while the S&P 500 has climbed over 70%.
Yet, the TSX Venture has done nothing but drop since its peak in 2011, losing over 70% of its value.
For many of you involved in the Canadian capital small cap markets, I don’t need to tell you just how bad things have been. Some of you may have already left for greener pastures.
But for you retail investors who may not completely comprehend what’s been happening, this Letter is a snapshot of the reality our small cap market is facing.
Nearly two years ago, I wrote a series of Letters about the potential demise of the Canadian public small cap capital markets.
“Most of you probably invested in a company listed on the commodities-focused TSX Venture within the last year, which means most of you probably lost some money.
On a year-over-year basis, the TSX Venture is down 30%, trading volume down around 25%, and transactions are down more than 45%.
While the commodities and precious metals market have slumped due to falling prices and rising costs, many of the companies that have fallen have not dropped because of core fundamentals.
The TSX Venture as a whole has succumbed to more than just a down-dip in metal prices or the rises in costs of production and exploration. This letter is intended to address some of the issues that have led to the crash of the TSX Venture.
These issues include how the big banks are forcing juniors out of the market, just like they have in the US, and also how one regulation has turned into a death spiral event leading to other regulations that collectively are crushing our Canadian market.
…This downturn has forced both investors and smaller institutions out of the market, leaving room only for the big boys to play.
The Canadian investment market is being changed to reflect large institutional firms that are only looking for yield products. Independent brokerage firms are drying up because funding for junior projects are drying up as investors have lost too much money to want to play again.
Much of the money remaining is now being filtered to bigger banks and bigger companies.
Juniors on the TSX Venture don’t stand a chance.
For the average junior, it costs on average around $200,000 just to maintain their listing and legal fees to keep up with regulators. That means a small junior, who just raised a million dollars, will need to take 20 cents out of every dollar to comply with security regulations.
It’s no wonder why analysts are predicting that at least 500 companies on the Venture will run out of money before the year is over. Many of these companies have less than $250,000 in the bank. Considering that it takes around $200,000 a year just to comply with regulations, there is a great chance that the analysts are right.
All of this is leading to the demise of the TSX Venture if things don’t change. All over the country, there are town hall meetings to address the issues. But who’s listening?”
It’s been two years since I wrote that piece, and sadly things have unfolded as predicted: the Canadian speculative small cap market is practically non-existent – except for a few exceptions. I’ll talk about these exceptions in an upcoming Letter.
How Bad is Bad? The TSX Venture Problems
One look at the TSX Venture, Canada’s small cap speculative market once thriving with capital, and you can see just how bad things have become: less liquidity, less volume, bigger spreads, and hundreds of stocks trading at less than five cents.
What’s worse is that many of the companies listed may not have the capital to pay even their auditors, which means hundreds of companies listed on the TSX Venture may not survive beyond this year. Many of them might have already crumbled if it weren’t for some leniencies granted by the exchange on which they trade on.
This is especially true for the mining and resource community, which just so happens to make up the majority of Canada’s small cap market.
In January, the TMX Group published its monthly financing statistics and noted that the TSX Venture Exchange listed 56 issuers in 2014 compared to 76 in 2013. What it didn’t talk about is the amount of companies being delisted.
But that’s not hard to find out.
Here are the total listings for the TSX Venture by year:
Based on those numbers:
- 60 companies disappeared from the TSX Venture between March 2013 and March 2014.
- 119 companies disappeared between March 2014 and March 2015.
Since the beginning of this year, 57 companies have already delisted from the TSX Venture, 50 have been suspended, and only 12 new listings have been added.
We’re not even halfway through the year, and we’ve already witnessed almost the same amount of delistings for the TSX Venture than we did between all of 2013 and 2014.
What do you think of all of the companies being delisted on the TSX Venture? How many will be left standing?
We’re Not Alone
According to IssuWorks, the U.S. fell from 1st place to 12th in small IPO output behind many smaller economies, and fell to 24th out of 26th in small IPO output on a GDP-weighted basis, ahead of only Mexico and Brazil dating back to the 1990s.
They further noted that the United States has seen a decline from nearly 9,000 listed companies in 1997 to approximately only 5,000 today.
“…If the SEC and Congress had not changed market structure beginning with the Order Handling Rules in 1997 and Regulation ATS (Alternative Trading System) in 1998, culminating in Decimalization in 2001, Sarbanes Oxley in 2002 and Regulation NMS (National Market System) in 2006, the American people would enjoy more than 13,000 listed companies versus the current 5,000 we currently have – and more than 10 million incremental jobs.”
David and Goliath
In my letter, “Proof the Largest Canadian Banks are Taking Over,” I noted that the big banks were slowly forcing the smaller institutions out of the market:
“The rules and regulations that took place last October added a lot more fuel to a fire that was already burning in the commodities sector, and thus the TSX Venture.
Those rules are forcing the little guys, both public companies on the TSX Venture and smaller financial institutions, out of the market. It’s important to note that while the little guys are shrinking, the big banks are getting bigger.
… While the smaller institutions are drying up along with the TSX Venture, it seems the big Canadian banks are doing just fine; replacing a loss in trading revenue with wealth-management profits and investment banking.”
Today, nearly two years later, the strategies of the big boys seem to be paying off.
While you may hear that liquidity has dried up in Canada, that’s not exactly true; it’s simply shifted from the small to the large cap market.
Last year on December 19, 2014, the TSX set a new trading record with a new daily volume record of 1,535,887,985 shares traded. This blew the previous record of 895,769,152 out of the water, which was set on December 19, 2008.
The TSX also reached a new record for value traded on the same day with $20,213,746,759. The previous record of $19,278,924,809 was set during a massive sell-off on September 18, 2008.
In the U.S., the big banks have also taken over and sucked the life out of many of the junior institutions which once heavily supported the small cap market.
As Issuworks also noted via their report:
“162 banks acted as a book runner on a small IPO (< $50 million) in 1994. Only 34 of these are in existence today.
Last year, only 31 banks acted as a book runner on a small IPO (< $50 million), and the number of book runners declined 81% from 1994 to 2014.”
Some critics will argue that we’ve cleaned out a lot of bloodsucking companies that should not have been there in the first place. And to some degree, they are right.
But conversely, new rules, new regulations, and new predatory technologies have made it very difficult for great small cap companies to exist.
The small cap market provides many new jobs and brings about innovation. The large caps, on the other hand, have been slashing jobs, and using the cost cutting measures to buy back shares of their company.
One look at the job cuts from some of the big companies and you can see my point: Scotiabank plans to cut 1500 jobs, CIBC has recently cut over 500 jobs, and Canaccord Genuity is cutting its workforce by another 4%.
The problem that we will always face is that if you loosen regulation to try and provide a strong speculative small cap market, standards of the companies looking to list will drop.
But I’ve seen both sides of the spectrum: from hard working people striving to build a real company, to those in the industry who recycle assets so they can sell stock for their benefit.
By enforcing rules and regulations to prevent the bloodsuckers from operating, we are also preventing the creation of great companies.
How do you think we should police the small cap market, without stifling the progress of great companies?
Is there a Solution?
Obviously there is a problem. So what’s the solution?
First, we have to create a fair and transparent marketplace – not just for institutions, but for everyone. This begins with direct solutions to problems currently facing our market.
There’s a lot we can talk about here, but let’s focus on some key factors that seem to keep popping up in industry discussions.
The Accredited Investor
A primary focus has been the suggested removal of the accredited investor rule.
Industry Professionals argue that it would be easier for small cap companies to raise money if the accredited investor rule were removed.
For those unaware of this rule, it essentially means you have to be wealthy enough in order to partake in private placement financings – the primary source of capital for small cap listed companies.
Private placement stock is often sold at a slight discount to market and often incentivized with additional warrants, which allow an investor to buy stock at a locked in price no matter where the stock is trading. If the stock goes up, private placement financings can be very lucrative.
Conversely, they can also be very dangerous if the stock moves down.
Private placement stock has a four-month hold, which means you can’t sell the stock for four months – no matter the direction of the stock. When the stock becomes free trade, and the stock is at a profit, everyone begins to sell. If liquidity is absent, then the share price can fall very fast; thus, making private placements even riskier.
The rationale behind the accredited investor rule is that if you’re wealthy, you understand risk in the financial markets and can sustain a loss more than someone who has less money.
Sophisticated investors, who don’t qualify as “accredited investors”, argue that they should have equal rights to participate in private placements, and not be segregated based on wealth.
The regulators argue that the accredited investor rule protects investors – sophisticated or not – from making financial mistakes.
I’ve heard much debate on this subject.
But the solution to the accredited investor rule is very simple: change the definition of accredited investor.
The rule should be based on education, not wealth status.
In other words, any one should be able to invest in private placements, based on knowledge – not wealth.
For example, if you want to be accredited, a small online course could be provided that outlines how private placements work, and the risks involved.
This is a much better way to protect the investor. It will not only prevent a wealthy old lady (who, by definition, could meet the accredited investor criteria) from being suckered into an investment, but it will also allow someone who understands the risk, but doesn’t meet the current accredited investor definition, to participate.
“Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime.” – Moses Maimonides
What do you think? Should investors who understand the risk of private placements be allowed to participate in them, even if they’re not accredited?
A few years ago, the uptick rule was removed. I talked about this in my Letter, “Why the TSX Venture is Failing“:
“Historically, you could only sell a stock short if the price is higher than the last different price; simply put, you can only short a stock as it was moving up.”
Removing the rule means anyone can short a stock no matter which way the stock is headed. For small cap companies with little liquidity, this can be a very big problem – especially when trying to raise money.
What’s the solution?
Remove shorting completely from the small cap market.
The small cap market is meant to provide a platform for companies to raise money and grow; they can’t do that if someone is continually shorting their stock.
There is a reason why private equity works much better in this regard.
Let’s leave the shorting to the large cap market where liquidity and institutional support balances a company’s market value.
What do you think? Should shorting be allowed on the small cap market?
Of course, there are many more problems with the Canadian small cap market than just the accredited investor and downtick rules; I touched on some of these in my letter, “Why the TSX Venture is Failing.”
And while little has been done, it does seem that there are those finally willing to accept some change.
In a recent report, the TMX Group noted the following three major issues affecting our market:
- Canadian order flow is migrating to the United States (U.S.)
- Technology-driven markets are not optimized to serve all
- Market complexity is on the rise
It then gave solutions on how they will help solve these issues:
“We have examined each of these issues at great length and through extensive consultation with our clients and a broad group of other market participants. After careful analysis, we are now proposing bold steps to tackle each one.”
While all three are major issues, let’s focus on the second point, as it is one that will directly affect the retail investor.
As the TMX put it:
“Technological innovation has brought extraordinary changes to trading in capital markets around the world.
…As we embrace this change in technology-driven capital markets, it has become clear that in an environment where some participants increasingly compete on speed, others are challenged and concerned about compromised quality of execution and market integrity. Specifically, apprehensions around excessive short-term intermediation, the technology race to zero latency and the disenfranchising of the human trader have eroded some participants’ confidence in a market that is meant to balance the needs of all stakeholders.”
In other words, the TMX notes exactly what I have been saying for years: robot traders have taken over.
Via my letter, the Shocking Truths Behind High Frequency Trading:
“…Technology and the advent of high-frequency computer trading/algorithmic software have changed the way the stock market is now being manipulated.
On average, high frequency traders (HFT) hold stocks for no more than 16 seconds:
“Investors have turned into day traders. Day traders have turned into algo-traders, who not only make trades in 10 milliseconds or less, but also typically hold stocks for no more than 16 seconds. The days of watching the ticker tape to get a sense of where a stock is headed is over.” -The Equedia Letter: A Nuclear Threat, Jan. 2013.
Not only are stocks being held for no more than 16 seconds, the software’s decision to buy or sell a stock is made in less than 10 milliseconds. Some say it’s as fast as half a millionth of a second – that’s more than a million times faster than the human brain can process a decision.
…So how can the average trader or technical chart expert make smart bets when they’re competing with a program that can make decisions faster than any human ever could?
These programs are also used to trade stocks up, or down, by giving the optical illusion that a stock is being bought with momentum, or sold with force. It’s essentially rigged market making.
That is why it is so hard for technical traders, and those who follow the ticker tape, to get a grasp of where price action will lead a stock.
…One of the things that you rarely hear about is the competition between many of these software-trading platforms.
Not only are these supercomputers programmed to analyze market feeds and trading patterns, they are also programmed to sabotage each other by creating false price action and fake market orders; in other words, pure manipulation.
These computers not only make trades in milliseconds, but they also fake them in milliseconds.
Trade orders are often sent and cancelled just to throw a kink into competing programs. Many of the trades are made just to flood the market and trick other computers (or investors) into thinking that a trend may be occurring in a particular stock, when no trend really exists.”
So how is the TSX going to deal with this? What is their solution?
Via the TMX:
“In Q4 2015, TSX and TSXV plan to implement changes which will enhance the quality of execution for natural investors and their dealers – both retail and institutional – by rewarding those willing to commit liquidity to the book for a period of time by using the new Long Life order type.
Long Life orders will be committed to a minimum resting time in the book – measured in seconds – and cannot be cancelled during that time. In return for providing committed liquidity, these orders will receive priority over orders at the same price that are not subject to the minimum resting time. Trade allocation therefore becomes Price/Broker/Long Life/Time rather than the current Price/Broker/Time matching sequence.
By choosing to use the Long Life order type, natural investors, their dealers and other non-latency sensitive participants will be able to more effectively and confidently participate in the markets without having to compete on speed.”
What does that mean?
By the end of this year, the TSX is attempting to give priority to investors who leave their orders open for longer. That should mean their trading platform will be able to distinguish between a real investment (natural investor) and one made by a computer program.
While I applaud the TMX for trying, the effectiveness of their solution remains to be seen. My concern with this is that the robot traders will somehow take advantage of natural orders being open for longer periods by giving the algorithms even more time to work, since the program will be able to see all of the Long Life orders.
But hey, at least they’re trying.
The TSX plans on initiating this order flow in Q4 this year. It will be interesting to see how this affects the small cap market – if at all.
What do you think? Will the TMX solution to robot traders solve the issue?
Many of you have been wondering why there have been a few missed Equedia letters over the past month or so.
I have been extremely busy working on something very special that I believe will lead to a better financial market. I’ll provide more details in upcoming letters.
It’s clear there are many problems facing our small cap market.
Next week, I’ll discuss what I believe is the biggest problem facing our markets. It’s a problem that no one in the industry wants to talk about, but someone needs to tell it.