Thursday, October 28, 2010

America's New Risk: Regulatory Risk

With the elections only a few days away, it seems to me that the US political system has reached an important crossroads. The question that many people are currently asking themselves is: what will happen if the Republicans take a number of seats in the House and Senate? Will the logjam in Washington D.C. just get worse?

The following piece examines the uncertainty surrounding future regulations that would only be exacerbated if we end up with with a Congress that refuses to be on the same page as the President. As always, my point of view is that of an investor. As such, my concern is that many companies currently have no way to plan for potential new regulations and as a consequence, investors have little ability to price in the changes that may be coming. My thesis is that this nebulous future many companies are facing is only holding back the economic recovery because investment and hiring decisions are being postponed. In highlighting three industries that I feel are uniquely susceptible to being hit by further regulations, I hope to illustrate that point. Let me know what you think.

(Disclaimer: The opinions expressed in this article are my own and do not necessarily reflect those of West Coast Asset Management or any employees of the firm.)

America’s New Risk: Regulatory Risk

When assessing the stocks of companies domiciled in emerging markets, the risk that the home government will take monetary, fiscal, legal or even military actions that undermine the value of the equity market is usually called country or regime risk. This concept comes with the implication that investors should demand a higher rate of return to compensate them for the risk that the government will do something capricious, misguided, or even unethical. For example, if you run an oil company with assets in Venezuela you are concerned about regime risk because the government might nationalize your assets. Or, if you are investing in the nascent equity market in a war-torn African country, you should price in the risk that war breaks out once again or that there is some sort of coup. The point is that investors and companies who are familiar with regime risk can act appropriately by making sure the potential returns are worth all of the uncertainty.

Fortunately, over the last number of decades, investors who focus on the US have not needed to price in any regime risk. The US hasn’t experienced a Civil War since the 1860s. Aside from the impact of going off the gold standard during the Nixon administration and intentionally devaluing the dollar versus gold in the 1930s, the US has never defaulted on its debt obligations. Furthermore, what has made the US the safest country to invest in over the last 60 years is the strict adherence to the rule of law. When all of this is combined with the economic stability that the US has enjoyed, many investors have rightfully not felt the need to demand a premium return for country risk. In most people’s minds, such considerations only applied to “frontier” or “emerging” markets.

Unfortunately, a new risk is emerging in the US that investors should take note of. It is my position that it is not as severe as country risk or regime risk. However, I do believe that there is more potential for what is known as regulatory risk to affect equity markets than in recent history. For a simple definition of regulatory risk, we turn to Investopedia.com1:

“The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape.”

Could it be that this risk has become a real threat to companies and investors in the US? Sadly, I believe it has. Let’s look at three very distinct industries to illustrate the uncertainty caused by increased regulatory risk: (Examples of potentially affected companies are included in the adjacent parenthesis)

  1. Retail Pharmacies (CVS, WAG, RAD): Just about no one questions the need to reduce health care costs and expenditures in the US. With an aging population, health care spending will represent a larger and larger percentage of US GDP and this increase threatens to put states and the US government in very difficult fiscal positions due to their responsibilities to Medicaid and Medicare patients. Unfortunately for retail pharmacies, they have been caught in the crossfire even though they do not appear to be part of the cost inflation problem. Specifically, pharmacies are reimbursed based on their cost of acquiring drugs. They are paid a slight premium to their cost along with a flat fee for dispensing the drugs. However, reimbursement rates are under pressure as many states are now unable to cope with prescription drugs needs of Medicaid patients.

As such, there is a battle looming over reimbursement rates that unfortunately could lead the pharmacies to stop filling prescriptions for Medicaid patients. This is exactly what happened in Washington state in January of this year when rates were reduced to a level that no longer covered Walgreen’s cost. Not only is the uncertainty regarding reimbursement bad for patients, but it is also a problem for pharmacies in that the ambiguity makes hiring and expansion decisions very difficult. This is on top of the fact that a change in reimbursement rates could decimate the already low operating margins for these companies and likely cause a further drop in their stock prices.

Finally, an important question for these companies has to do with which party has the power to influence and pass legislation in Congress. If the Republicans gain enough seats in the House and Senate to repeal the Obamacare initiative, then 32 million people who were going to have access to prescription drug coverage will no longer have that luxury. No matter what your beliefs are about the merits of the health care reform bill, the potential for it to be reversed makes pharmacies unable to forecast demand or execute their expansion policies. Cleary, this is not a recipe for job creation in the industry.

  1. Oil and gas-related companies (XOM, APC, DO): The damage done by the BP oil spill has clearly affected the environment and the local economy of the Gulf of Mexico region. What is also noteworthy is the impact it has had on the offshore drilling (especially deepwater) and oil and gas exploration industry. As a result of the government’s response to the spill, the companies that operate in this space have no idea how to budget for the coming year. Probably the most important question is: are there going to be moratoriums on offshore drilling? To that question I recently came across a comparison to the airline industry that I thought was interesting. The idea is that enacting a moratorium on offshore drilling is like grounding all the airline flights in the US because one plane crashed. Said another way, while the images of the oil spill were horrifying, a moratorium looks like an attempt to indiscriminately punish an entire industry for one company’s apparent negligence.

Additionally, what happens if the Republicans win the House or the Senate in the November elections? Could they find a way to eliminate the potential for a prolonged moratorium? Would a windfall tax on oil profits be off the table? As you can see, the uncertainty makes it impossible for companies to know how much to invest, what to do with idle equipment, or how to make hiring decisions. Unfortunately, in an environment in which the US economy desperately needs businesses to start investing and hiring once again, this regulatory risk could serve to postpone a legitimate recovery.

  1. Financial institutions (GS, JPM, BAC): The financial regulation bill that just passed was widely seen as a victory for the major commercial and investment banks as the most draconian proposed measures were not included into the final bill. However, what must not be forgotten is the fact that much of the rules of the industry are going to be set by (unelected) regulators in the coming years. Specifically, the bill left an incredible amount of discretion in the hands of the FDIC, the consumer protection agency and the Federal Reserve. In fact, law firm Davis Polk counted 243 rulemaking decision and 67 studies that the bill authorizes regulators to be involved in2. I will spare you most of the details of what actually is left to be decided, but how to approach the threat created by derivatives, appropriate capital levels, and exactly how to handle the risks of too big to fail institutions will be figured out over the next few years. In other words what we got was a framework for a financial regulation bill (with many exclusions and exemptions embedded in it) without a whole lot of additional certainty as to the eventual details.

Financial institutions can adjust to bad news. They can shut down operations, sell assets, and fire people if necessary. What they cannot plan for in prolonged uncertainty. So, if you are wondering why banks are not lending to consumers and businesses, you can be sure that their inability to predict what the eventual legislation will entail has caused them to be very cautious. Unfortunately, there will be no sustainable recovery until the banks re-start the credit intermediation process. Making the situation even worse, in addition to the impediments listed above, there is also the risk that whoever controls Congress or White House will try to influence the regulators to make decisions that are favorable to their constituents. The fact that the rules could change dramatically depending on who voters favor at any given moment means that financial institutions will have to continuously adjust their operations in order to comply with the shifting regulations. Given the lack of stability in the financial sector over the last few years, increasing regulatory risk just makes it harder for companies to figure out what their “new normal” reality will be.

These are just a few examples among many. Credit rating agencies, for profit education firms and utilities trying to figure out if Cap and Trade is a reality, all are facing similarly uncertain circumstances. It should be noted that I am not arguing the regulation is not necessary. In fact, I believe that many industries were long overdue for legislation aimed at protecting customers, investors and taxpayers. My point is that the gridlock in Congress and the number of companies that could see their industries undergo dramatic changes have created ambiguity that no company can properly plan for. While this is not the first time in US history companies have had to be prepared for major shifts in regulation, I feel as though the number of sectors and companies that could be impacted is larger than it has been anytime in the recent past.

As an investors, I just want to know what the rules are going to be so I can figure how to play the game. I am not used to and do not liking discounting the value of the companies I research just because of some lingering regulatory risk. I know that this situation will eventually be resolved and that American will hopefully get back to its prosperous ways. However, I believe that it is imperative that regulators decisively set policies and the let the private sector get back to focusing on reinvigorating the economy through prudent investment and hiring. Excessive government intervention is inefficient and costly, especially when the US is facing strained economic circumstances. I look forward to a time when regulatory risk and regime risk is more prevalent within the usual emerging market suspects, not at home in the US.



Wednesday, October 20, 2010

High Frequency Traders are Stealing from You


I would like to provide a brief update on my life and post an article I wrote for clients of West Coast Asset Management. I am back in school but have luckily been able to continue my relationship with WCAM. I am working a few days a week from LA doing research and creating content for quarterly letters and blogs.

However, what takes up most of my time is this field study I am performing with a number of my colleagues on the Student Investment Fund at Anderson. We are attempting to come up with a proposal to improve the investment management (IM) program at Anderson. We are contemplating a number of suggestions, including a yearly speaker series, an IM conference (like the one Columbia hosts each year), a stock pitching challenge, a curriculum refresh that includes more practical investing classes and maybe even a separate track for IM like those offered by Columbia and Kellogg. Additionally, we are looking for support from UCLA alumni and any asset managers in the LA area. So, if you or anyone you know would like to be involved, please email me.

Without further ado, the following is an article I wrote about high frequency trading (HFT). The subject was getting a lot of press until ForeclosureGate started dominating the newswires. But, despite the lack of headlines, mini flash crashes continue to happen in certain securities on a weekly basis. This is a warning sign that the system itself is very unstable and that we may be at risk of another crash like the one we saw in May of this year. For those who are still unclear on what HFT is and what risks it may pose, I tried to put together a simple primer on the subject. I am not an expert on this subject but I hope this adds to people's understanding of what I believe is an undesirable trend towards more computer control of the stock market.

High Frequency Traders are Stealing from You

The history and backdrop

Most people are well acquainted with the stock market crash that occurred on October 19th, 1987 in which the Dow Jones dropped by 508 points or 22.61%. After the fact, the largest one day percentage decline in the market’s history was mainly blamed on portfolio insurance. This was a risk management tool that employed stop losses through automatic, computer-based selling. Unfortunately, the prevalent use of this strategy caused a cascade of selling once the market started to drop. Hindsight being 20/20, commentators who opined on the events of the day of course claimed that the outcome was obvious and predictable. Clearly it should not have been a surprise that indiscriminate selling by computers could cause the market to plunge. How could anyone have believed that thoughtless machines controlling the most important stock market in the world was a good idea?

Now, here we are almost 23 years later and apparently we have learned nothing from our past mistakes. In fact, computer trading programs, or algorithms if you will, now dominate the day-to-day trading on the major exchanges. While it is difficult to quantify precisely, most estimates suggest that what is known as high frequency trading (HFT) makes up between 50% and 75% of all trades1. Let us say that again: Robots trading shares in between one another now accounts for anywhere between half and three-quarters of market activity on a daily basis. So much for fundamental, bottom’s up investing.

What is HFT? (Moved to the top from the bottom)

We understand that we are attempting to tackle a difficult topic. In fact, we are in the process of trying to understand it better ourselves and are certainly not experts. However, if we did not think that the emergence of HFT was an incredibly important development or that we could not present our analysis in approachable manner, we would not be stressing the issue. The truth is that HFT potentially affects all investors, not just those who are involved in the daily trading of the markets. defines HFT in the following manner2:

A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds.”

So far, not so complicated. Basically, companies engaged in high frequency trading use trading speed and sophisticated computer programs to create an advantage over other traders. The specific strategy of many of these programs it to use their superior technology to make pennies or fractions of pennies on every trade. This process, which is kind of like collecting pennies in front of a steamroller, may not seem particularly lucrative until you realize that there are billions of trades executed on US stock markets each day. A billion pennies sure adds up over time.

If it sounds like these firms profit from an unfair and uneven market structure, it is because that is precisely the case. But why is this inequity tolerated and often cited as a positive thing? Well, the common defense of HFT is that these firms who run these algorithms are providing liquidity, a measure of the degree to which a stock can be bought and sold without affecting the price. Generally, the more liquid a stock is the easier it can be traded without causing huge swings in the price. As long as the liquidity is real and those who provide it are committed to it, greater liquidity can be very beneficial to investors. Specifically, it can lead to lower bid-ask spreads (which can lead to lower costs of trading) and a greater ability to move into and out of cash when investors so desire.

However, we believe that the problems created by HFT are twofold:

  1. Increased volatility and the risk of extreme moves in the markets
  2. Increased trading costs through predatory activities

The market roller coaster

First off, all of the evidence we find suggests that HFT creates unusual volatility in the markets. Let’s go back to the so called “Flash Crash” on May 6th, 2010. The Dow Jones dropped 600 points in a matter of minutes, shares of Accenture (ACN) dropped from over $40 to a penny, and shares of Apple (APPL) rose to over $100,000 each. Even though the exchanges eventually cancelled these outlier trades, how is it possible that share prices can fluctuate so dramatically? The initial reaction to this dramatic move in the price of market indexes was the “fat finger” theory. This is the idea that some incompetent trader who meant to sell one thousand shares inadvertently added three extra zeroes and sold one million shares. However, we believe that such explanations are created in an attempt to obscure the fact that the markets are broken. Actually, these are not our words but basically what Larry Leibowitz, the COO of NYSE Euronext (owner of the New York Stock Exchange), said during his testimony in front of a House Financial Services Subcommittee five days after the Flash Crash 3. Specifically, this is what he said about the impact of technology on the functioning of our stock markets:

“The May 6 market drop certainly should inform the SEC’s [Security and Exchange Commission’s] current examination of the changes in the markets, and in particular how certain recent advances in technology may have fostered trading practices that negatively impact the entire market…As regulators seek to determine whether regulatory action is necessary to address the shifts in market structure resulting from technological change, the events of May 6 make it clear that the regulators also need to consider steps to avoid the types of extreme volatility our markets experienced that day.”

This indictment of the recent technological revolution in trading came from a man whose company thrives on market volatility since fees go up as volume increases. Additionally, NYSE Euronext jus opened a huge new $500 million data center in order to take advantage of co-location (where exchanges like NYSE allow traders to plug directly into their servers and increase their trading speed dramatically) revenue that is derived solely from firms who want quicker speeds for their electronic trading. So, despite his vested interest in the increased proliferation of HFT, Mr. Leibowitz is clearly concerned that the practice is a threat to the integrity of the U.S. stock markets.

Liquidity dries up

The problem arises when other market participants depend on liquidity that will only be present when the market is going up or trading sideways. Unfortunately, as we believe the Flash Crash proved, when the market declines rapidly the liquidity dries up as the algorithms shut down to avoid catching a falling knife. Essentially, our concern is that when the market plunges the HFT algorithms are programmed to stop trading so that the firms are not caught holding assets that are falling in value. But, this just exacerbates the drop in the market as there are subsequently fewer buyers remaining. A true liquidity provider would remain in the market in order to bid on assets even if they are declining in price and make an active market (one with both buyers and sellers) in stocks. But, if the HFTs flee the market at the first hint of weakness, the market can stop functioning. When this happens, stocks such as Accenture, which usually trade close to 4 million shares a day but saw volume spike to 10.3 million shares on the Flash Crash day4, can fall from over $40 to $.01. Unfortunately, this type of volatility can make stocks stray far away from their intrinsic values and cause retail investors to leave the market because they are unable to stomach the price swings.

The hidden HFT tax5

The following is the most technical portion of this analysis. However, we think that if you are willing to stay with us, you will understand why HFT likely costs you money. The best way to explain the HFT tax is through an example. Let’s say you are a mutual fund that wants to buy one million shares of Microsoft (MSFT). This is such a large order that you are worried that you may move the market up with your trade. Therefore, in order to make sure you don’t pay more than you want per share you put in a limit order. Let’s say the stock is trading at $24.95 but you put in a limit order (i.e. the most you are willing to pay) of $25. Many mutual funds use what are known as VWAP (Volume Weighted Average Pricing) trading algorithms to execute these large trades. The problem with these algorithms is that even if they break up the buy orders in smaller batches (i.e. not all one million shares in a single trade) they create patterns that the HFT algorithms can sniff out.

Think of a VWAP kind of like an 18-wheeler trying to switch lanes on the highway. It takes a long time to move and therefore a quicker vehicle has the opportunity to outmaneuver it. This is what the HFTs do when they sense a VWAP-based order. By exploiting the predictable patterns created by the VWAP, the HFT algorithm is fast enough to sense the limit order of $25 on the MSFT shares, buy the shares at $24.95 and then sell them to the mutual fund at $25. No harm, right? The mutual fund got its trade executed at $25 and no one ever thinks twice. Wrong! The problem is that the HFT basically engaged in what is known as front running by jumping in front of the VWAP and causing the mutual fund to pay $.05 too much for each share. If this only happened every once in a while it might not be a big deal. But imagine the costs to mutual fund shareholders if this dynamic played out each and every day with thousands of stocks. We are talking about billions of dollars in potential profits for the HFTs. If you are wondering why the NYSE pre-sold ALL of its co-location spots for its new data center within a short period of time, you now have the answer.

Want to know who the major players are? Well, according to NASDAQ’s website, the top five liquidity providers for the NYSE as of July 2010 were Wedbush Morgan Securities, GETCO, Citadel Securities, Merrill Lynch and UBS Securities6.

How does HFT affect the price of stocks?

West Coast Asset Management engages in bottom’s up value investing. Our belief is that if you buy shares of a company at a price less than their intrinsic value, the market will eventually appreciate the fundamentals of the company and bid the price up near the stock’s true value. But what does it mean if 50% to 75% of trading comes from predatory robots trading shares back and forth? It means that shares are not necessarily trading based on economic or company-specific factors in the short term. The irony is that this dynamic may actually create opportunities for value investors. We invest based on the notion that markets are often inefficient in the short run but that the market’s pricing mechanism functions properly in the long run and allows us to profit from our contrarian strategy. Accordingly, if the presence of the HFTs causes temporary dislocations in price of individual securities, we may be able to take advantage and generate excess returns for our clients. Additionally, if the HFT algorithms begin to focus on a stock that previously had not been particularly liquid, investors who own that stock could benefit from the increased tradability of the security.

What should be done about HFT?

Unlike many of the problems we face as investors, this one seems easily solvable. Specifically, it is our position that HFT should be banned. By disallowing co-location the regulators could level the playing field in terms of speed and thus limit the ability of the HFTs to outrun other investors. The SEC is currently looking at the issue and we hope they come to the conclusion that the increased clout of the HFTs is not good for our markets. As we have illustrated in the preceding discussion, HFT does not appear to serve any purpose from an overall public welfare perspective. In fact, it seems as though these algorithms extract rents directly from smaller investors who do not have the same technological advantages. We also can’t forget the violent swings in market prices that the HFT facilitates and the associated potential for a severe market crash. When all of these issues are combined it becomes unambiguous that high frequency trading presents a real threat to the vitality of our stock markets and to investor confidence. Therefore, we hope that the U.S. regulators do something proactive to protect the investing public as opposed to catering to the powerful financial “services” industry. Let’s stop this practice before we all are forced to look back at a debilitating market crash and say, “we knew this was going to happen all along.”

For more information on the subject of HFT we highly recommend reading the second quarter shareholder letter from Iridian Asset Management ($7.1 billion assets under management) available here: We would also like to thank the authors, Jeff Silver and Ben Hunt, as their explanations helped frame our analysis.