Market making needs long term thinking

Last week's letter referred to the need for ongoing step change innovation to maintain the health of an economy and the fact that this activity frequently is best undertaken within small companies aspiring to become much larger companies. Software Radio Technology (LON:SRT) last week exemplified both the underlying wealth creating potential of such companies from the standpoints of shareholders and the overall UK economy, and also the fragility of the UK's capital market processes for supporting such companies. Incidentally, I have previously congratulated SRT on seeking to create a level playing field in terms of communicating with both private and institutional investors. Visit www.softwarerad.com and click on its webcast for a good illustration of how AIM companies can approach investor relations.

On 21st June, final results to March 2011 were announced showing sales of £9.2 million (2010: £3.6 million) and pre-tax profit of £1.9 million (2010: £386,000 loss).

On the morning of 24th June, the share price dropped 26% from 39p to 29p on the back of a sell recommendation from Tom Bulford, editor of Red Hot Penny Shares. He had built up a strong following during the past 18 months, based on an initial recommendation of SRT at 6p and accordingly a desire to take some profit at 38p was not surprising.

The reason that shareholders want their investments to be listed is so that they can easily trade shares at a reasonably predictable price range at a time of their choosing. At the heart of the UK's capital market process lies marketmaking. It is conducted in a way which is counterproductive to long term investing because of the inherent volatility of an activity undertaken with too little capital, too few people and inadequate knowledge about the underlying business of the stocks being traded. This is illustrated by the following:

• I know of one marketmaker where one employee is allocated £1 million of capital to service 100 smallcaps.
• the CEO of one very nice AIM listed engineering company, with sales at the time of our conversation of c.£40 million and operating profit of £3 million, saw the share price drop 20% on the back of a sale of 2,000 shares. The CEO offered to meet the various marketmakers to explain the business and was turned down by all of them!

The purpose of investment is to make a return on one's capital. Ultimately this can only be driven by companies which themselves create wealth for the economy as a whole, for example net exporters. Building such companies requires a long term mindset during the period from start-up through to becoming properly established businesses and yet right at the heart of the UK's capital market process lies marketmaking, which is generally run with a short term mindset. However, the good news is that nature abhors a vacuum and I think that there are at least two solutions beginning to emerge, namely:

AIM listed XCAP Securities (LON:XCAP) - an interview with one of the founders can be seen on Stockopedia by clicking here. XCAP's strategy appeals to me as a long term investor because properly capitalised marketmaking is its core activity, on to which it has bolted the co mplementary activities of i) investment services with a focus on private investors and ii) corporate finance.

AIM listed Share (LON:SHRE) , which has developed its own trading platform, Sharemark. This platform seems to me to have the potential for offering the following benefits to capital market participants, including private investors:

• Shares get traded on it at a single price, ie, investors can choose to trade with no spread.
• Companies can select the periodicity of auctions (eg weekly, monthly, quarterly) appropriate to the needs of their investors and thus provide time for supply and demand to build.
• It will provide greater visibility of supply and demand to marketmakers,
• It enables private investors to participate directly in the share price formation process and hence focus a lot more capital and eyes on a single smallcap, with the great advantage that the private investors are acting as principals and not as agents - this potential introduction of long term capital to marketmaking is, I believe, a vital part of the solution to the problem described above - re the problem, Oscar Wilde's definition of a cynic as 'a man who knows the price of everything and the value of nothing' springs to mind!
• Companies' shares can be dual traded eg AIM listed Brainjuicer (LON:BJU) and Share are tradable on both Sharemark and AIM.

Imagine a world where Tom Bulford could recommend to his followers that they patiently consider taking a profit on a particular stock using the Sharemark facility rather than all needing to head for an exit before the next man via the existing marketmaking process!