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Robinhood, Sports Bettors and the Recent Myth About Volatility

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During the recent months of the outbreak of Covid-19, we’ve seen some significant volatility in equity prices. There was a gut-wrenching selloff in March, followed by a strong recovery rally that brought the major indices close to their pre-crisis levels. Even during the rally of the past three months, there have been several days of triple-digit moves in the Dow Jones Industrial Average and even bigger percentage moves in many individual stocks.


Much of that volatility has been attributed to the actions of Millennial investors using platforms like Robinhood to execute trades as well as former sports bettors who have turned their attention to the equity markets to satisfy their desire for action while most professional and college sports are not being played.


It’s certainly an interesting story, but when you take a hard look, it doesn’t really make much sense.


Let’s start with Robinhood, a privately held brokerage firm founded in 2013 with the stated purpose of democratizing equity investments. The company pioneered the move toward zero-priced equity commissions. Other larger firms like Charles Schwab (SCHW - Free Report) and E-Trade (ETFC - Free Report) were essentially forced to follow suit.


Low account minimums and a high-tech interface that allows users to trade from mobile devices like their smartphones – and even the Apple watch – made Robinhood popular with investors in their 20s, many of them investing in the capital markets for the first time. The company had 3 million users on the platform by 2018 and is reported to have as many as 10 million current users. That’s more than E-Trade and its new parent Morgan Stanley (MS - Free Report) combined, but the total amount of assets at Robinhood is much lower.


Official figures are not public knowledge, but it’s believed that the average account at E-Trade holds about $70,000. That number creeps toward a million dollars per account at Morgan Stanley. The average Robinhood customer has less than $5,000 in their account.


Robinhood remains a privately held company, but several rounds of venture funding have pushed its value up significantly. The most recent investment by venture giant Sequoia Capital in May of 2020 implies a total value of over $8 billion.


The zero-commission model was made possible by the low touch, high-tech execution platform, as well as the interest rate spread earned on account balances and the practice of “payment-for-order-flow” in which market makers pay a small amount on each trade that Robinhood routes to them for execution.


Robinhood has changed the face of investing – especially for young people – and in addition to democratizing the markets, they also offer responsible options like automatic recurring investments and dividend reinvestment which should theoretically allow those younger investors to invest responsibly and grow their assets into a sizeable nest egg throughout their peak earning years.


Unfortunately, many Robinhood customers don’t see it that way. Instead of using the platform as a way to grow their assets over decades, they’re trading actively, especially in low-priced stocks. The motive is understandable. Even with a small account, you can buy hundreds or thousands of shares of a small company for the same price as a single share of high-priced names like Amazon (AMZN - Free Report) or Tesla (TSLA - Free Report) .


It’s also been posited that many Millennial investors spent their recent government stimulus checks on penny-stock shares – issues priced under $1/share.


The starkest example is recent action in the shares of car rental firm Hertz (HTZ - Free Report) - which filed for bankruptcy protection in May. Hertz bottomed out at $0.56/share and traded as low as $0.40/share intraday, but then made a spectacular comeback, closing at $5.53/share on June 8th – a gain of 1,000% in just two weeks. Recently, it has settled back to near $2/share.


That move is a stark example of the “greater fool” theory in action. Even if you feel that a given stock is basically worthless, all you need is someone else to pay $0.50/share more than you did and you have yourself a 100% return in a short period.


Smart investors know that in a bankruptcy situation, bondholders and other creditors are paid first before equity investors get a penny. Most maturities of outstanding Hertz debt are currently trading at 30-40 cents on the dollar. Bond investors anticipate that they’ll receive less than 50% of the face value of the bonds in a liquidation. Obviously, that would leave equity investors with nothing.


We still don’t know how the situation will ultimately play out and it’s not a foregone conclusion that equity shares will be worth nothing, but there’s no math that produces a fair value of more than $5/share.


To a certain extent, the bizarre moves in Hertz can be explained by Robinhood traders – and similar traders at other discount firms. With a total market capitalization of just $278 million as well as significant short interest, a flurry of small orders in the same direction can push the stock around.


That’s not investing however, it’s gambling.


Which brings us to the next volatility scapegoat – sports gamblers.


It’s a compelling story – people who are used to betting on sports have suddenly found themselves bored during an extended period during which there simply aren’t any sports events being played for them to wager on.


It’s also pretty silly.

Since the US Supreme Court made it broadly legal for states to allow sports gambling in 2018, the total amount wagered legally in the US – known in the industry as the “handle” -  has grown to over $20 billion/year. Obviously that’s the pre-pandemic level. Since March 2020, it’s been near zero.


Industry analysts expect that eventually the legal sports-betting industry will put the black market bookie out of business and the total legal handle will grow to $100-150 billion/year. That sounds like a lot of money, but for perspective, the NASDAQ market has been trading around $200 billion in notional value of equities every day. That doesn’t include NYSE listed stocks or equity derivative securities like futures and options.


It’s somewhat absurd to think that the bored gamblers are significantly moving asset prices on the major stock exchanges. Just as we’re seeing with stocks like Hertz, it might be possible for small traders to move the shares of small companies for short periods of time, but there’s a high likelihood that they’ll eventually lose money and leave the stock market for some other venue that strikes their fancy.


In the meantime, savvy investors would be wise to ignore the noise of volatility in micro-cap names and remain focused on solid companies that grow earnings and return profits to shareholders.


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