Blog : Pennies v Nickels; How to Detect a Lying Exec

by Ed Zwirn on January 9th, 2014

Plus: How to Spot Lying Conference Call Language (see farther down).

You have to be a little older than many investors to remember the days before decimalization. It's been over 10 years since stocks began trading in penny "ticks" instead of fractional increments like 1/8 or 1/4.

Now, in a move that could have a profound impact on penny stock trading, the Securities and Exchange Commission is considering a pilot project that would reverse this trend and allow some stocks to trade in nickel, rather than penny, increments. 

Critics of decimalization say that the smaller trading increments have mainly benefited rapid traders and hurts banks and big investors, who they say are discouraged from investing in small companies because the penny increments make it easier for high-speed traders to jump in front of big orders by just a cent. Some also say that the penny increments have discouraged initial public offerings, especially for smaller stocks, pointing to a recent SEC study that shows the percentage of IPOs for companies worth less than $50 million has declined markedly since the rules changed.

In November, a group that included representatives of investment banks, venture trading firms and the major exchanges, suggested a nickel-trading pilot for companies with market capitalizations under $750 million.

The SEC's Investor Advisory Committee, which was created under Dodd-Frank, is expected to produce a report this month which weighs in on the merits of the change. According to a recent Wall Street Journal article, the group is expected to find, not surprisingly, that a change from penny to nickel ticks would increase costs for investors.
 
But there are powerful advocates lining up in support of the move. This is because trading revenues should increase, with the wider trading increments meaning better bid-ask spreads. Big banks and investment houses could therefore reap huge profits if regulators turn back the clock.

They argue that these profits could help fund stock research, especially for smaller companies, and make it easier for long-term investors to buy big stakes.

The SEC pilot project, as well as the study, is one result of the so-called "Jumpstart Our Business Startups (JOBS) Act of 2012." As I pointed out in a November penny stock blog, the JOBS act also mandates the promotion of "crowdfunding," through which companies can raise up to $1 million annually selling stock without going through the formal IPO process.

Both of these initiatives claim to help create jobs by boosting funding for smaller companies. Whether this funding outweighs the costs and dangers to investors is a question that remains to be answered.
 
How to Detect Lying Executive Lingo

The earnings conference call can be a valuable tool for investors looking to gage the future prospects of a company. This can hold especially true for penny stocks and other small-cap companies, which often fly under the radar, leaving investors to ferret out information as best they can in the absence of expert guidance.

But are the CEOs and CFOs who conduct these dog-and-pony shows being truthful?

In an attempt to help investors answer that question, Stanford Graduate School's David F. Larcker and the University of Chicago's Anastasia A. Zakolyukina looked at 29,663 transcripts of quarterly earnings calls that U.S. public companies held between 2003 and 2007: an overall 17,150 instances of CEO-speak, and 16,032 CFO statements in management discussions and Q&A segments.

The result, as set forth in a Journal of Accounting Research paper, is a linguistic model that the researchers find to be as much as 16% more predictive of deception than would be found in a random approach.

"The language composition of truthful narratives differs from that of false narratives," the authors write. "Our models are developed with the word categories that have been shown by previous psychological and linguistic research to be related to deception."

Deceptive CEOs and CFOs, identified in the research as those needing to file subsequent restatements, were found to use "more references to general knowledge" including phrases like "you know" and "everybody knows," fewer "non-extreme positive emotion words (love, nice, accept) and fewer references to shareholder value" than their presumably more honest colleagues.

But they also found interesting differences between the language used by lying CEOs, as opposed to CFOs.

Deceptive "CEOs use more extreme positive emotion words (fantastic, great, definitely) and fewer anxiety words" than CFOs, who tend to go for "more negation words and for the most description deception criterion they use more extreme negative emotion words (absurd, adverse, awful) and swear words (swear, screw, hell)."

On the other hand, the statements of lying CFOs were also found to go on at greater length than those of their bosses. "There is strong evidence on the positive association for word count and the probability of deception for CFOs but not for CEOs," the study shows.
 
Being a former English major (true confession time), I actually enjoy reading through studies containing concordances, or lists of words and the frequency with which they occur. Even if you are not with me on this one, this paper makes a good read and may actually help you in sniffing out the smell of mendacity and in avoiding costly investment blunders.