*** In Tuesday’s issue, we told you that the smart money was flowing back into small-cap stocks. Small-cap exchange-traded funds received a $593 million infusionfrom institutional investors and hedge fund managers during the last three days of January – a reversal of fortune from earlier in the month.

Well, it looks like we’re on a roll. That’s because the leading small-cap indexes rose to 2.5% in the wake of the Fed’s quarter-percentage-point rate increase on Wednesday. The Russell 2000 closed up that day 3.84, or 0.61%, to 631.98 – while the S&P 600 finished the day at 326.02, an increase of 2.20, or 0.68%.

The news is actually better than it appears…

Since small-cap companies are generally considered a higher risk by lending institutions, they are forced to pay higher interest rates than large-cap borrowers. Naturally, higher interest payments mean lower profits. Still, Wall Street continued pumping money into the small-cap markets both before and after the widely anticipated
rate hike. Apparently, a sunny outlook on top-line revenue growth, hot IPOs and mergers-and-acquisitions consolidation is overshadowing the tedium of an incremental expense.

That makes me think that Punxsutawney Phil is wrong about six weeks more of winter …at least for small-cap investors.

*** Speaking of critters, the dragon may strike Nasdaq with a blockbuster Chinese IPO in the second half of the year. The company is Baidu.com, and it has everything going for it.

In terms of potential, it could be a mirror image of Google…simply because Baidu.com is the biggest search engine in China and the second biggest Web audience in the world – after the U.S. In fact, Google holds a minority stake in Baidu.com. Details of the impending IPO remain sketchy. But here’s what we have so far…

Baidu.com plans on selling about 25% of its capital, putting its valuation at some $800 million. The company has been profitable since 2004, with revenue growing about 150% annually. Revenues in 2003 were estimated at $12 million, but could dramatically accelerate with the estimated $200 million war chest it would get from the proposed IPO. That kind of money could buy a very serious marketing campaign to pull in advertising in an already superheated online market…as illustrated by Google’s recent fourth-quarter earnings.

Google reported that its ad sales hit $530 million, up 118% from the same quarter in 2003. The company’s profit was 71 cents a share. But since Wall Street excludes charges for stock option grants and other noncash items, Google actually raked in 92 cents a share. In any language, that’s huge.

The Baidu.com IPO will be a tough one to call. When Google went public at $85, skeptics cried that the company was overpriced. Now Google is north of $210, and the Street is euphoric over its dazzling fourth-quarter results. We’ll keep you posted on Baidu.com, but for those of you who missed my original story, “Chinese IPOs March on the Nasdaq,” click here: http://www.pennysleuth.com/alertholder/01.21.05

*** In the meantime, your ship may have just come in. At about noon yesterday, DRYSHIPS, Inc. started trading on Nasdaq. It was offered at $18, but opened at $19.28 and closed at $20.15 – an increase of 4.5% over the opening price in just a matter of hours. By day’s end, 10.2 million shares changed hands. Underwriters Cantor Fitzgerald originally intended to offer 7.1 million shares, but bumped it up to 13 million to satisfy demand. The $234 million from the IPO will go towards adding 11 new vessels to its fleet of six that carry coal, iron ore and grains.

As it turns out, I’d been talking with Kevin Kerr, editor of Resource Trader Alert, about the shipping industry. In his own words, “The shipping industry is red hot.I tend to focus on energy transport, but the same rules apply to all shipping. In my arena, companies like Teekay Shipping and OMI Corp. are perfect examples of stocks that are benefiting mightily from the growing demand for time charters and reliable, well-managed fleets that can live up to their commitments.”

Kevin explained that both Teekay and OMI were in his portfolio. Here, Kevin reports the latest on OMI…

“OMI rose 3.6% after the company said fourth-quarter earnings would come in above analysts’ estimates. The oil tanker operator expects earnings of $1.10 a share. Analysts were expecting earnings of 97 cents a share. OMI said that rates for its Suezmax vessels, which averaged about $84,500 a day for 80% of the days booked in
the quarter, are expected to fetch about $97,000 a day for the remaining unbooked portion of the quarter. Tanker companies are in a pretty good market right now. Oil demand is at its highest level since 1979.”

That’s one reason why Kevin is bullish on shipping in general.

“There is no doubt that all types of shipping are in the spotlight for investors these days,” he said. “No matter if it’s oil or petroleum products, foodstuffs, manufactured goods, etc. Cargo carriers, tankers…demand for all kinds of ships is surging. The shipping sector is ramping up for more and more profits from all directions. The astute investor will be sure to have some shipping stocks in his portfolio, as demand is far from shrinking.”

*** For many Sleuth readers, after-hours trading is like the Bermuda Triangle of Wall Street. Angela Roberts unravels this moneymaking mystery for you.

Shedding Light on After-Hours Trading

Sometimes, strange things happen. For instance, have you ever watched a stock close a mere 2 cents above your buy price with a strict plan to wait till the stock makes a little dip the next day to buy under your preferred buy price…But instead, you wake up to find that the stock is suddenly significantly higher in price at market
open than it was the day before at close?

Or the opposite happens. Overnight, the price of a stock you own drops. And for many small-cap investors, small price fluctuations can mean substantial percentage differences in gains. But don’t get confused, discouraged or angry if you see your profits evaporate overnight. Instead, what you can do is understand what’s going in the shadowy hours between 4:00 p.m. and 9:30 a.m. on Wall Street – and leverage the heck out of it.

The process itself is called after-hours trading. It isn’t a new phenomenon, but it’s constantly evolving and growing. After-hours trading is conducted by highly sophisticated electronic bulletin boards called electronic communications networks (ECNs). You may have heard of some of these ECNs: Archipelago, ATTAIN, INET, MarketXT and NexTrade.

These emerging networks are giving brokers and individuals more access to after-hours trading, boosting the frequency and volume of late-night trading. But as you know, this can end up becoming a nuisance.

Back in the days of Wall Street superstars like Benjamin Graham and Bill Tweedy, investors used the hours between 4 p.m. and 9:30 a.m. to contemplate companies, read the news, develop strategies and even sleep. In turn, companies used those hours to issue news alerts and update investors on corporate activities.

In those days, only stockbrokers could trade on the market, and the only trades going on in the after hours were big-block trades from professionals and institutions. In the 1990s, the stock market opened its doors to individual investors, and it wasn’t long until those investors wanted the same benefits as the large institutions and mutual funds, including equal access to after-hours trading. They got their wish in 2003.

Historically, all investors had a fair jump into the trading day when the bell rang at 9:30 a.m. With after-hours trading open to all investors, it is possible that a stock could experience a major price movement overnight. That means your stock might now open at a completely different price than the one you saw when you shut down your computer and headed home the day before.

But nighttime and daytime trading are as different as, well…night and day. Technically, after-hours trading isn’t so much trading as matchmaking. Shares swap on ECNs, but there is no human exchange of them. There is no verbal deal-making. So how are all those shares bought and sold in the middle of the night? Electronically. ECNs are like massive electronic bulletin boards that connect matching orders.

The major exchanges do have trades that go through for up to an hour after market close, and those trades are based on market close prices. And some NYSE-listed stocks are traded on foreign exchanges, in different time zones. But for the most part, post-4 p.m. and pre-9:30 a.m. orders go through an ECN. Even though they’ve been around for over 5 years, ECNs were off limits to individual investors until 2003. In simple terms, ECNs are subscription-based services that retail brokers can use to match buy and sell orders during the market day, and after hours.

One substantial risk in after-hours trading is limited volume. To avoid such a problem, the NYSE has specialists to control the trades between buyers and sellers. The Nasdaq is an electronic exchange, but it has market makers who are able to accept and give orders at slightly different prices between buyer and seller. That window of flexibility is called a spread, and the market maker will keep the profit or take the loss incurred by the spread. But ECNs have none of those built-in protections and can only match exact trades. Therefore, they can also only take limit orders.

Of course, the obvious problem with this system is that the ECN may not be able to match a buy or sell order. In that case, the order will remain unfilled until a matching trade materializes. If it doesn’t, the trade won’t happen. In regular market hours, this normally isn’t a problem, because there are specialists or market makers keeping track of everything. But when dealing with ECNs, your options for order execution are much more limited.

The obvious advantage to after-hours trading is that investors can respond immediately to news released after normal trading sessions end. But the resulting problem is that there are fewer buyers and sellers, and many trades are left uncompleted. And this limited liquidity is a greater issue for smaller-cap stocks, which don’t have as many shares in the open market to begin with.

Not to mention that after-hours trading is an unbalanced situation between the individual investor and largei nstitutions, with the individual investor in the weakest position. Individuals end up competing for limited liquidity with resource-laden institutions.

Compacting this weakness is the fact that individuals still depend on their broker’s relationship with the ECN. Some brokers don’t have the ability to trade on multiple ECNs and therefore can’t match orders across networks or even view quotes from other ECNs. As it stands now, there isn’t even a public ticker for after-hours trading.

Also, flexibility is sacrificed when it comes to the actual order itself. Most ECNs only accept limit orders, because the ECN is simply connecting matching buy and sell orders. If the stock you’re trading never reaches your limit buy or sell price, your transaction will not be executed. And because the order goes from brokerage to ECN and back, transaction times are much slower than what you find during normal market hours.

Already, we can see that as the world moves toward a truly global economy, after -hours trading is an integral element of the future. And there are initiatives to improve it, including talk of a public after-hours ticker.

For now, if you do trade on the ECNs, find a broker that has access to multiple ECNs. If you decide not to take your chances on the ECNs, you can still make after-hours trading beneficial for you. With the increasing participation of individual investors after hours, overnight price fluctuations will become more common. By simply monitoring the after-hours trading, you can pregauge the next regular trading session’s activity. Also, because there are stock markets all over the world, in dozens of time zones, after-hours trading can also serve as a way to monitor the effects of international markets.

By the way, INET has already applied to the SEC to be a new stock exchange. If that is approved, expect to see traditional exchanges like the NYSE suffer drops in activity. Along with the rest of the world, Wall Street is surging ahead toward a global, 24-hour market.

Best regards,

Angela Roberts

February 04, 2005

Shedding Light on After-Hours Trading was originally featured in the Penny Sleuth.