High Frequency Traders are Stealing from You

Readers,

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 19^th, 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.

Investopedia.com 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 6^th, 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: http://www.zerohedge.com/article/more-are-waking-hft-terrorism-iridian-asset-managements-latest-investor-letter-blasts-high-f. We would also like to thank the authors, Jeff Silver and Ben Hunt, as their explanations helped frame our analysis.

Sources:

1. http://www.nytimes.com/2010/05/07/business/economy/07trade.html
2. http://www.investopedia.com/terms/h/high-frequency-trading.asp
3. http://www.house.gov/apps/list/hearing/financialsvcs_dem/leibowitz_5.11.10.pdf
4. http://www.google.com/finance?q=NYSE:ACN
5. http://www.zerohedge.com/article/more-are-waking-hft-terrorism-iridian-asset-managements-latest-investor-letter-blasts-high-f
6. http://www.nasdaqtrader.com/trader.aspx?ID=topliquidity

Give Us Back Our Cash

The following is my latest piece (in Scribd to preserve formatting) about the large amount of cash on the balance sheets of US corporations. Based on the number of proposed M&A deals announced recently, it appears that companies are starting to put their cash hoards to work. But, is this good news for shareholders? Given the dismal performance of many big mergers you will forgive me if I do not trust the majority of US CEOs to allocate capital in a way that is optimal for shareholders. For this reason and a number of others, it is our position at West Coast Asset Management that companies with huge net cash positions should begin returning cash to shareholders as opposed to letting it languish on their balance sheets.

A version of this article was posted on WCAM's website at: http://wcam.com/newsroom. If you are looking for a value-biased, long only manager for your assets, feel free to contact former TV star Andrew Firestone at afirestone@wcam.com to inquire about WCAM's investment philosophy.

Give Us Back Our Cash!

Summer Update and Double Dip Analysis

Readers,
It has been a little while since I last had the opportunity to post and I thought I would provide a brief update on how my summer is progressing. But first, I want to thank everyone for the overwhelming outpouring of support after I created the post that asked for help in finding a summer internship. I literally received emails from people all over the world offering their assistance and guidance. I really appreciate all of the support and I hope that I can continue to create content and research that is both valuable and informative.

Thanks to my good friend Marcelo Lima, I was able to secure an internship position at West Coast Asset Management (WCAM) in Santa Barbara, CA. WCAM is a long only manager of separate accounts focused on high net worth individuals, institutions and charitable foundations. The firm was founded by Lance Helfert and Kinko’s founder Paul Orfalea. Anyone who attended the 2008 Value Investing Congress sessions in New York or California will probably remember the presentations made by Lance and CIO Atticus Lowe. Furthermore, Atticus was profiled in the April 2007 and May 2008 editions of Value Investor Insight and Lance makes regular appearances on Fox Business News and CNBC. Finally, Lance, Atticus and Paul are co-authors of the book, The Entrepreneurial Investor: The Art, Science and Business of Value Investing which has sold thousands of copies and has recently been translated in Korean.

If you would like to learn more about WCAM, I encourage you to check out the website at www.wcam.com. Additionally, if you are looking for a manager who is capable of handling both equity and fixed income separately managed accounts feel free to contact me or Andrew Firestone (of The Bachelor fame) at afirestone@wcam.com.

My role at WCAM is to find new investments for the equity separately managed accounts. So far this summer I have extensively researched a number of companies, including two exchanges, a power transmission company and a couple of data processing and outsourced services firms. We are specifically looking for companies with a market capitalization greater than $1 billion which possess robust moats, resilient business models, strong and recurring cash flow generation and preferably a consistent dividend. If this sounds like a relatively defensive stance, that is precisely because it is. As a team we continue to believe that the US is at risk of falling back into a recession and prefer to be invested in companies that will prosper even in stressed economic circumstances.

It was in this context that I was asked to contribute to the quarterly letter that recently went out to clients. Given our outlook, my goals were to shed some light on the risks that we see brewing in the US economy and explain to clients why we are positioned cautiously. There are clearly a number of people talking about the risks of a double dip recession. However, I decided to highlight those that I thought were most relevant to equity investors and our clients. I hope you enjoy my updated analysis (in Scribd format to maintain the formatting) and will stay tuned for additional posts in the near future.

5 Reasons to Fear a US Double Dip

The Investment Case for PMACA

Finally, I get to post some research. The following piece is an updated and expanded version of the research that I have been pitching to anyone and everyone who will listen. The last time I liked a P&C insurance company this much the company was IPC Holdings and Buffett/Berkshire made a bid for it before it got taken out by another company. Very simply, this microcap stock is under-followed and unloved and the market has yet to fully notice that the company has removed the overhang that has clouded the stock since about 2005.

I know this stock is not for everyone, but I think the valuation is compelling and the risk-reward is very attractive at the current price. As usual, I have kept the document in Scribd format in order to preserve the formatting of the charts. If anyone would like a PDF of the research, please feel free to email me. Also, I welcome any comments or questions.

PMA Capital Corporation (PMACA) Research

Summer Internship

Dear Readers,

I hate to do this, but given the wonderful state of affairs in the market for jobs in investment management, I am running out of options. For those of you who do not know me, I am currently a first year MBA at the Anderson School of Management at UCLA. I went to the Wharton School of Business at the University of Pennsylvania for undergrad. After that I spent about four years working for my family in commercial real estate before my inoculation into the value investing world. From there I was fortunate enough to work at two small, long/short hedge funds in the New York City area, focusing mainly on financials. I think I understand the banking and P&C insurance sectors the best, but I have had plenty of exposure to other sectors. Specifically, the time I spent focusing on financials was mostly based on the market environment that included very attractive short opportunities (October 2007 to early 2009) and then compelling long opportunities (March-April 2009).

Right now I happen to be looking for hidden value among financial companies that have been left behind by this improbable and seemingly bulletproof market rally. I have been pitching both Synovus (SNV) and PMA Capital Corp. (PMACA) to just about anyone who will listen. They have both had very nice runs since I started recommending them but I still believe that they both offer long term, patient investors significant upside potential. If anyone would like to see my research on either company feel free to check out this post on SNV but stay tuned for my updated research on both companies.

I am looking for an internship position this summer that will help me become a better analyst and a better investor. To be honest, I am not focused on working for a "big name" fund. What I care about is working for a smart manager who can help me improve my research skills and for whom I can add a lot of value. I now am going to say something that people are never supposed to say: I don't care about being paid this summer. I am much more interested in finding an opportunity to learn and to potentially secure a full time position for when I graduate in June 2011. Clearly, I would rather not work for free because I know my research has the potential to help boost returns, both on the long and short sides. But, in the grand scheme of things, 10 weeks of salary will be just about meaningless if I can get one step closer to living my dream of being a portfolio manager.

So, I am looking for help from readers and from those in the value investing space. Anyone who has seen my recent notes from the Berkshire meeting, the Wesco meeting or the Value Investing Congress can see that I have a passion for investing. I am dedicated to making securities analysis a part of my life for the long run. Accordingly, if you know of anyone who could use a diligent and disciplined value-biased analyst for the summer, I would appreciate your willingness to keep me in mind. I am happy to email out copies of my resume and even sample research to anyone who might be interested.

Thank you for your time and for anything you can do to help.

Sincerely,

Ben Claremon
The Inoculated Investor

Classic Value Investors

Readers,

I thought that I would introduce you to another talented member of the value investing clan who I believe has a lot to offer both new and experienced investors. His name is Mariusz Skonieczny and he runs the site called Classic Value Investors. He has also written a very comprehensive book entitled Why Are We So Clueless about the Stock Market?. I have read the book and have told Mariusz that it should be required reading for all incoming MBA students. As many of you know, I am getting my MBA currently at the UCLA Anderson School of Management in sunny, southern California. It probably won't surprise you to hear that my knowledge and passion for financial markets and investing make me a little bit unique. In fact, many of my classmates do not have a formal business background and initially have trouble with relatively simple concepts and vocabulary as a result of not being exposed to finance previously. This is where I think Mariusz's short, but comprehensive book could really add value. If students were required to read it before they started taking classes, they would be much more familiar with the concepts and would not struggle to learn the terminology and the technical concepts at the same time.

Accordingly, for anyone who is new to investing or who is thinking about making a career switch, I highly recommend going to Amazon.com and picking up a copy of Mariusz's book. I know that learning about the financial markets, especially given their global nature and the seemingly never-ending complexity, can appear to be a daunting task. However, everyone must start somewhere and in my mind there is no better place to start than with this book. I also urge you to go through his website (linked above). There is a lot of information on it about his investing strategy and how to invest with him if you are looking for a value-biased asset manager. I met Mariusz in Omaha a few weeks ago and was very impressed with the way he approaches investing. Since then multiple people have mentioned to me that they thought he was very intelligent and seemed to have the proper temperament required to be a great investor.

Please help me welcome Mariusz to the club by checking out his website. If you would like to learn more about him, I'm sure he would not mind if you emailed him at

♫

mskonieczny@classicvalueinvestors.com.

I hope that everyone enjoyed all of the notes from the various events from the past few weeks. Thanks to all of you who sent me emails. I promise I will email each and every one of you back. It just might take a little time.

Stay tuned for my updated research on PMA Capital Corp. (PMACA). The stock is up but I think it is still severely undervalued.

Thanks for following me and I look forward to trying to create valuable content that resonates with everyone.

Sincerely,

The Inoculated Investor

2010 Value Investing Congress Notes

Readers,

The following are my detailed notes from the 2010 Value Investing Congress in Pasadena, CA on May 4th and 5th.. The great list of speakers included Bruce Berkowitz, Mohnish Pabrai, Eric Sprott, Tom Russo and Whitney Tilson, just to name a few. Topics ranged from the merits of owning gold to the attractiveness of small caps to investing in India and China.

After over 33 pages and about 18,000 words I hope have I captured all of the stocks discussed as well as the unique investment philosophies and themes highlighted by the speakers. I also included all of the responses from the Q&A sessions after each one of the presentations.

Again, these were hand-typed in real time so I apologize for any errors or omissions. I want to thank John Schwartz and Whitney Tilson for allowing me to attend this year's Congress and to post my notes. I hope you all enjoy them.

Sincerely,

A very tired of typing Inoculated Investor

2010 Value Investing Congress Notes