Monday, October 31, 2011

What's Driving the High Correlation?

Here's a good Michael Santoli article in the most recent Barron's that covers the extreme correlation we've seen in recent times.

It turns out that since 1972, the median correlation of an S&P 500 stock to the index itself (over the prior three months) has been .46 (46% of individual stocks move the same way as the index).

According to the article, we're at .86 as of a week ago.

According to the article, the number of days at least 90% of all stocks in the S&P 1500 moved in one direction has progressed as follows:

2006: 14 times
2007: 23
2008: 39
2009: 44
2010: 47
2011: 58 (and 33 of the past 62 days)

Santoli also mentions that explanations range from high speed trading to ETFs.

So the number of days that 90% of all stocks in the S&P 1500 were up or down on a given day has progressed from 14 to 23 to 39 to 44 to 47 to this year's 58 and counting (this seems just a variation of the Bespoke Investment Group's 'All or Nothing' Markets that instead uses 80% of the S&P 500 instead of 90% of the S&P 1500).

More recently, it has been 33 out of the past 62. So every other day?
(By the way...it's too early to tell but I think we are having another 90% day on the downside as I write this)

Some assume this is driven by unprecedented systemic risks.

Maybe.

It's also a good bet that the many changes to equity market structure are a contributor:

"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders, in particular high-frequency traders ('HFT')." - Mason Hawkins of Southeastern Asset Management

Changes that may be progressively making it behave in a more correlated and erratic manner.

In other words, the all or nothing market behavior is only partly explained by nervousness over perceived real world macro systemic risks. Yet, to what extent it is market structure changes versus macro systemic risks is tough to call.

The global economy clearly does have serious problems with excessive sovereign debt, a need for deleveraging, and undercapitalized banks among others things. Much of it, of course, is centered in Europe.

The question I have is this: Is the increased correlation and volatility mostly just a reflection of these serious macro problems or is it, at least to a material degree, the continuation of a trend caused by changes in market structure?

Some seem to assume it is mostly just a reflection of the former and do not consider the possible role of the latter. That seems a mistake. If it is, to a meaningful extent the latter, then the changes to market structure over the past decade or so are making already difficult problems even harder to solve.

Why? They become more difficult to solve, in part, because perceived market instability feeds into less confidence by business and consumers that potentially leads to reduced investment and consumption.  In the long run it's healthy economies that give us the best shot to dig out of the excess global leverage.

From removal of the uptick rule, to Regulation NMS (implemented in 2007), to decimalization (2001), and other changes, there has been many reforms to the equity markets in the past 15 years. High frequency trading is but one by-product of these many changes.

Here's a good overview of the changes: Concept Release on Equity Market Structure

"High frequency trading is a product of Reg NMS, decimalization and technology improvements," says John Knuff, general manager of global financial markets for Equinix... - From Inside the Machine

It seems reasonable to expect high frequency trading oriented participants will continue to get a little smarter and, under the current rules of the game, their influence on the markets will continue to grow.

So, if they are at or near the root of these changes to market behavior, their influence on the markets isn't going to be reduced anytime soon without material changes. Does that mean we'll see even more highly correlated markets with excessive volatility in the coming years? Is this just an expensive nuisance (as measured by additional frictional costs and engineering/math/scientific talent used to design and build algorithms instead of more useful more things) or destined to eventually evolve into a system that becomes even less stable over time until its flaws become so obvious we are forced to change it?

It seems more than just possible that these market structure changes are driving up the frequency of 90% days and we've convinced ourselves that it's the real and perceived macroeconomic risks - not changes to the market structure itself - that is a material contributor.

Here's another way to look at it. Those year over year increases to the number of 90% days that have occurred since 2006 may just continue to grow until we really understand what is going on.

So is it high frequency trading that's behind this?

Removal of the uptick rule?

The increasingly widespread use of traditional and, more recently, leveraged ETFs?

Is the additional not-so-transparent financial leverage, that comes from things like options and derivatives of various kinds, if not a root cause at least a contributing factor to volatility*?

Munger on Derivatives

"We're not controlling ļ¬nancial leverage if we have option exchanges. So these changes repealed longtime control of margin credit by the Federal Reserve System." - Charlie Munger

"Unlimited leverage comes automatically with an option exchange. Then, next, derivative trading made the option exchange look like a benign event." - Charlie Munger

All the above? Something else altogether?

Or is it just the cumulative effect of all these many changes to capital market structure in combination with some of the very real macroeconomic and systemic risks?

I certainly don't know the answer but this needs some quality exploration and, ultimately, some solutions with teeth.

Who knows if this current way of doing business in markets is stable under times of real stress. It's all too new to know. To me, with something this crucial and increasingly complex, far to many fundamental changes have happened in too short a period of time for anyone to fully appreciate the ramifications.

Many have opinions as to why the market has been behaving this way and some are probably even partly right. I know one thing. It's important to not be too certain about the root cause until those who are unbiased with the right expertise have given it a rigorous look.

I just figure that, at least from the outside looking in, there's no way to know what's definitively at the root of something like this. It's too complex.

All I know is that looking at what has changed is usually a good place to start. The markets exist to serve us, not the other way around, and they're role is too vital to not fix if they get broken from time to time.

In the current form, whatever the root cause, capital markets seems designed in a way that creates an amplified response to news and events of various kinds. That, it seems, would serve no one other than possibly some of the participants.

As Mason Hawkins said, in this letter to the SEC, the intent of capital markets are "to facilitate the allocation of capital from investors to businesses." In the same letter, Hawkins also said "markets do not exist as an end in and of themselves."

If you believe that, the current way it is working for us seems rather foolish.

It all seems like one heck of an unnecessary self-inflicted wound.

Adam

Related post: 
'All or Nothing' Markets

* During the financial crisis a substantial amount of trading was financed by the "repo" market and the amount in use on any given day is far from transparent (best case, all we have is end of quarter snapshots). The repurchase or "repo" desks were responsible for borrowing money every night to finance a securities portfolio. Here's a quick look at the repo system's role in the crisisHow much of this form of leverage is a factor today? "Our regulators allowed the proprietary trading departments at investment banks to become hedge funds in disguise, using the 'repo' system—one of the most extreme credit-granting systems ever devised. The amount of leverage was utterly awesome." - Charlie Munger in the Stanford Lawyer
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 28, 2011

Buffett: "Disinvestors Lose As Market Falls -- But Investors Gain"

Warren Buffett wrote the following in the 1997 Berkshire Hathaway (BRKa) shareholder letter:

If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. 

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices. 

Now, consider this headline from yesterday:

US Stocks Soar In Global Market Rally As Investors Cheer European Pact

Well, a trader who is long may want to cheer but certainly not an investor.

Anyone investing for the long haul should logically cheer just the opposite. More from the letter:

For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire "saves" for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners' indirect savings program will be.

Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today's repurchases, made at loftier prices.

At the end of every year, about 97% of Berkshire's shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.

So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls -- but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.")

We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence.

The S&P 500 index has rallied from a low of 1,074.77 to a close of 1,284.59 yesterday, a 19.5% move off the intraday bottom on October 4th.

Many individual stocks are up much more from their recent lows.

At what level is it easier to find undervalued equities and make a long-term investment in shares of a good business?

The answer is obvious yet, for whatever reason, when it comes to stocks it is rising prices that get "cheered".

With everything else, from buying burgers to cars, it is falling prices that get the favorable reaction.

Adam

Long BRKb

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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, October 27, 2011

Munger on European Leaders: 'Shooting an Elephant with a Pea Shooter'

Earlier this morning, it was announced that what looks like a substantial European debt-crisis deal was forged.

Maybe they were listening to what Charlie Munger said earlier this week. In this interview, Charlie said the following about how the region's leaders are handling the debt crisis:

Munger Says Europe Leaders 'Behind the Curve' on Debt Crisis

"They have to stop shooting at this elephant with a pea shooter."

The article points out that, on prior occasions, Munger has praised policy makers in the U.S. for how they handled the 2008 bank bailouts.

Markets may be rallying in reaction to this deal...

Wall Street Journal: U.S. Futures Rally After EU Deal

...but it's early. This is all still very short on the kind of details needed to understand what the full long-term impact of the deal is likely to be.

This Barron's article goes on to point out the deal may prevent a worsening of the crisis but "it is far from sufficient to address the region's economic woes".

This article also added some historical perspective. It points out countries usually escape a debt trap via devaluation.

The burden of debt is reduced by paying with depreciated money and competitiveness is improved with cheaper exports.

Greek Mythology: Deal Will Solve Debt Crisis

The article adds that most modern economists (from Keynes to Friedman) like letting the currency bear the burden of the adjustment.

That option doesn't exist for European countries. At least it looks like European leaders might be, in Munger's words, getting a little less "behind the curve" and may no longer just be using a "pea shooter" to deal with the mess.

Adam

Wednesday, October 26, 2011

Munger on B of A's Moynihan: 'Back to Basics'

From this short Bloomberg interview Monday with Charlie Munger:

Bloomberg article:

"He has the right attitude, back to basics," Munger said of Moynihan.

For Bank of America (BAC) investors, it's a matter of how much time it will take and what it will cost to fix what's broken.

What happens to shareholder value if the bank's problems persist right into another financial crisis or another recession?

Will liabilities (legal, mortgage, other credit losses etc.) in the short to medium run become so large that it inhibits the kind of focus and energy needed to clean things up?

Could this force expensive share dilution and the sale of vital assets?

The bank is built to absorb a lot but it's important that the costs are spread out over time and the economic environment remains somewhat stable.

It would seem very likely that time measured in years will be needed to fix something this large and complex.

Ultimately, there's a pretty good franchise inside what is a very messy situation. Between here to where they need to be lies many hard to estimate risks.

In an interview back in August, Buffett said that Wells Fargo (WFC) and Bank of America had the best deposit franchises in the country. He also said that his investment in Bank of America wasn't unlike past investments in American Express (AXP) and GEICO.

In other words, messy situations that once cleaned up have a pretty good core franchise inside. Those have worked out very well for Berkshire Hathaway (BRKa) in the long run.

Still, Buffett's unwillingness to buy the common stock of Bank of America says a lot. Instead of buying the common shares, he purchased $ 5 billion in preferred stock with a 6% yield sweetened by warrants to buy $ 5 billion of the common stock at $ 7.14/share (700 million shares). These purchases can happen anytime over the next ten years.

Not a bad deal. More than enough time to see how it plays out and a price locked in for the common stock that will look very cheap once you know things worked out okay. That price (and the current market price) will look quite cheap if material dilution doesn't occur, and they aren't forced to sell too many key assets in the process of fixing the bank. Things that obviously cannot be known today.

By structuring the deal this way Buffett doesn't have to know.

So if only modest dilution occurs (the warrants, if exercised, actually would cause some dilution) and the core franchise remains in tact the price to normalized earnings will look more than very reasonable.

I'm just not convinced enough that, at the current share price, getting from current B of A to future B of A is worth the risk of the common stock (and I can't, of course, buy the preferred shares).

Now, if the price of the common shares continued to fall...

Adam

Long position in all stocks mentioned
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, October 25, 2011

Tom Russo: Paying 50 Cents to Buy Dollar Bills That Grow

From this talk given this past May by Tom Russo, at the 8th Annual Value Investor Conference in Omaha, just before the annual shareholder meeting of Berkshire Hathaway:

I'm going to talk about value investing and my goal is what is simply described as buying fifty-cent dollar bills. But I recognize a couple of things that Warren Buffett spoke to our business school class at Stanford Business School in 1982 that affect how I apply that that notion of the 50-cent dollar bill. And the first important point was that the government only gives you one break as an investor and that's the non-taxation of unrealized gains and so you should probably build your investment practice in a way that you capture the benefit of that, which means you want to buy and hold for a very long time. And so if you just buy a fifty cent dollar bill and it doesn't grow in value, your return is entirely dependent on when that discount closes and so if it closes quickly in the first year, you might make a 100 percent on your money, but if it takes 10 years for that discount to close it will be a 7 percent return and if it takes 20 years it will be a three and a half percent return.

Now the offset of that is if you find businesses that are undervalued but have the capacity for that dollar to grow, you're much better off.

Dollar bills that grow with a high rate of return come in the form of a durable business franchise able to put capital to work at a nice rate of return over a long time frame:

...the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. - Warren Buffett

Of course, for many durable high return business franchises the need for capital is rather modest. In those cases, having management in place that knows to (and is disciplined about) returning the excess capital to shareholders is key*.

Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases. - Warren Buffett

If not returned in some form (dividends or stock repurchases), the capital often ends up getting chewed up in the form of wasteful low return projects and acquisitions that may grow the footprint of the "empire" but do little to fatten shareholder returns.

Check out the full transcript of Tom Russo's talk at GuruFocus.

Adam

* This doesn't necessarily apply to high-return businesses in fast changing industries, under constant competitive threat. What seems like high-returns now can disappear fast. Nor does it necessarily apply to, as we've seen in many cases, highly leveraged financial institutions. Otherwise, excess capital that cannot be put to high-return use invites all kinds of of potential for operational sloppiness (ie. sub-par quality, service, or something more subtle like carrying excess inventory due to poor working capital management practices). In other words, operations that end up undisciplined but little penalty is felt (at least in the near term) because of the inherent strengths or advantages of a franchise. That situation encourages the waste of shareholder wealth and most likely reduces competitiveness. Much better that it be returned to owners.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, October 24, 2011

Bogle: Back to the Basics - Speculation Dwarfing Investment

Speculation has been in the driver's seat to an increasing extent over the past couple decades.

Well, okay so that's not exactly breaking news but an important subject with substantial long run consequences. It also happens to be the topic of a new book that John Bogle is currently working on.

From this recent Morningstar interview with John Bogle:

Speculation Dwarfing Investment

High Turnover
"...the most actively traded stock today, everyday, is the SPDR, the Standard & Poor's 500 exchange-traded fund. And it turns over at about 10,000% a year. 10,000% a year! And I think 25% is a high turnover."

The Financial System
"Well, the idea of our financial system, our capitalistic system, was a system that directs capital to its highest and best uses, the best companies, the best growth prospects, making the best products at the best prices."

That's the idea of the financial system but...

"Well, in a typical recent year, ...our financial system has directed around $200 billion a year into initial public offerings and additional new public offerings and then additional offerings of company stock--$200 billion. We trade $40 trillion worth of stocks a year. So, that's 200 times as much speculation as there is investment." 

Bogle adds that, by definition, this doesn't enrich anyone but the croupier in the middle. He also points to the turnover in the SPDR ETF and the ratio of trading to initial public offerings to show how extreme this has all become. Other measures reveal the same.

In some other posts, I've pointed to the average holding period of stocks as another indication (a measure that has gone from several years to more like a few months).

When it comes to a vital system more of some activity is not necessarily better. Proportion matters. I think it's more than fair to say the tiny proportion of investment compared to an ever larger amount of speculation is now more than just a little out of balance.

Adam

Related posts:
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 21, 2011

Buffett on The Theory of Investment Value: Berkshire Shareholder Letter Highlights

From Warren Buffett's 1992 Berkshire Hathaway (BRKashareholder letter:

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons."

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.

Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons." At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success. 

So...
  • Value comes from cash flows discounted at an appropriate rate.
  • The lowest price that can be paid relative to the discounted value of cash flows is what matters...not growth.
  • Superior businesses can employ large amounts of incremental capital at a high return but are rare.
  • The math is not difficult but get outside your circle of competence misjudgments of future coupons will happen. Stick to businesses you can understand.
  • Always make sure a substantial margin of safety exists.
Try to figure out where gold fits into all of this.

The above nicely combines what matters in an investment whether stock, bond, or real estate. Basically, any asset that can produce a stream of cash flows (something gold is not going to do). None of it sounds (or is) difficult to understand but staying disciplined about this stuff certainly is not necessarily easy. Consider this:

"More insurers don't copy BRK's model (underwriting for profit and stepping out of the market for extended periods of time when pricing is bad) because our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

Sidekick has sage advice of his own

I think when some come to learn how Buffett and Munger approach investing, they make the same mistake that other insurers make. They think there's got to be more to it. It also sounds too straightforward so they underestimate how difficult it is to do things like what Buffett describes above consistently well.

I.Q. may matter to an extent but is trumped by discipline and temperament.

Adam

Long BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, October 20, 2011

'All or Nothing' Markets

The increased influence of things like high frequency trading in recent years seems to be at least part of the reason for additional market volatility (or instability, depending how you look at it, that has the potential to have a negative impact on the real economy) and higher correlation.

These wild swings are actually good for the disciplined value-oriented investor (as it likely contributes to the increased mispricing of individual securities) even if the capital markets are likely serving their intended purpose less well than they otherwise could.

This CNBC article says we are on pace for 61 so-called 'all or nothing' days which is defined as when 400 or more stocks in the S&P 500 are moving in the same direction as the index. That's more than what we saw during the financial crisis and the most on record.

'All or Nothing' Markets

Consider that the bursting of the dot com bubble through the worst days after the attacks in 2001 produced a total of seven 'all or nothing' days.

Seven.

All or Nothing Days Becoming More Common Than Uncommon

We had only seven 'all or nothing' days during a very difficult time.

Seven over a two year period.

This year we are having one of those days every four trading days or so.

That's a good way to illustrate the extreme correlation but what about volatility? The CNBC article also points out there have been 12 moves of 7 percent or more in less than than three months.

In this earlier post, Doug Kass had this to say about the increasing influence of computer programs that, as he says, lack "any redeeming social and/or economic value. Indeed, one can argue that their influence on the market's volatility is contributing to the negative feedback loop that is threatening our domestic economy's growth trajectory."

A market dominated by short-term oriented participants focused on macro issues seems destined to frequently misprice individual securities and be less stable.

Beyond that, this inevitably leads to misallocated capital and a bunch of unnecessary frictional costs in the system (including the not easy to measure cost of lost of human capital...all that engineering, physics, and math talent who could be building something more useful that are instead using their brainpower building things like algorithms).

 More from Doug Kass...

"...a risk-on/risk-off atmosphere (which changes daily) owing to the increased presence and disproportionate role of high-frequency, momentum-based trading strategies. Some have estimated that high-frequency trading now accounts for about three-quarters of all trading!*

This unfortunate set of affairs has, in essence, transformed a relatively stable marketplace into a casino-like environment (up 400 points one day, down 400 points the next day), as investors have been replaced by machines that trade securities not based on intrinsic value decisions but on small trading edges and price-momentum-based algorithms."

If you add up all the 'all or nothing' days that occurred in the entire 1990s decade the total comes to 27.

So what was happening twice or three times a year that decade now happens every couple weeks. It's a somewhat arbitrary measure for correlation, but a nice way to illustrate how much day-to-day market price action has changed.

The past century threw a few curveballs at us and the next century will likely be no different. The point is none of this relatively new and, for the most part, economically useless activity that may be contributing to high correlation and volatility has been around long enough to know how stable it really is.

Something has fundamentally changed and not for the better. As outside observers, we can't know for sure what really is at the root of it. Yet, it seems obvious that much probably gets back to the epidemic of short-termism and the many new tools available to rapidly trade (and maybe aided by some forms of hidden leverage).

High frequency trading and the extremely high-turnover in ETFs (some leveraged) seem likely to be near the heart of the problem. Maybe not precisely the heart of it but near it.

If not the right house then at least the right neighborhood.

The tail does seem to be wagging the dog.

"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders, in particular high-frequency traders ('HFT')." - Mason Hawkins of Southeastern Asset Management

So there have been meaningful structural changes to the market and it seems some changes are needed sooner than later before it really costs us something.

Adam

* So, apparently, the various types of high speed trading does now account for something like three quarters of all trading. If so, that goes a long way toward explaining the startling reduction in the average holding period for stocks to 2.8 months from what for decades was a more healthy 2 to 4 year average holding period. 
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, October 19, 2011

Apple Reports 4th Quarter Earnings

From Apple's (AAPL) latest quarterly earnings press release:
  • Revenue: $ 28.27 billion vs $ 20.34 billion in the year-ago quarter
  • Net Profit: $ 6.62 billion ($ 7.05/share) vs $ 4.31 billion ($ 4.64/share) in the year-ago quarter
  • Cash and Investments: $ 81.6 billion ($ 86.8/share) vs $ 51.01 billion a year ago
  • No Debt
For the full year, Apple earned $ 25.92 billion ($ 27.68/share) compared to $ 14.01 billion ($ 15.15/share) the prior year. The stock is down to ~$ 400/share this morning as I write this.

Subtract net cash and investments per share of ~$ 87/share from that share price and you have an enterprise value per share of $ 313.

So enterprise value/earnings is $ 313/$ 27.68 or a 11.3x multiple.

Not exactly pricey. When a high flying stock selling at a high multiple of earnings misses expectations it makes some sense for it to drop substantially. That's because so much of that price was based on hope and speculation. Hopes dashed...so look out below.

Apple has no such speculative cliff to fall off.

Back to fundamentals. According to Apple's CFO Peter Oppenheimer, they expect substantially higher earnings next quarter.

Oppenheimer said the following in the press release: "Looking ahead to the first fiscal quarter of 2012, which will span 14 weeks rather than 13, we expect revenue of about $37 billion and we expect diluted earnings per share of about $9.30."

$ 9.30 per share is equal to $ 8.7 billion of earnings.

In one quarter.

It's hard to believe a company that size is capable of still profitably growing that fast with modest need for capital. Growth for its own sake is overrated but this is of the high return variety.

Somehow this all qualifies as a disappointment.

As a result the stock is down.

Good.

Reuters: Apples Shares Fall After Rare Earnings Miss

I've seen quite a few headlines like the above.

Back to expectations. Naturally, a business that does not meet expectations will often move a stock in the short run. The voting machine at work.

Yet, this expectations game obviously has no effect on value or long run returns for investors.

In the end returns come mostly down to how the business performs over time and whether shares be acquired at a reasonable discount to value.

A durable stream of earnings bought at a discount that provides sufficient margin of safety against the unknown and unknowable.

Greater uncertainty = more margin of safety required.

Apple's return on capital and profitable growth is exceptional. At least for now. Unfortunately, it's always tough to judge the durability of any technology business.

Are their economics sustainable? They look sound for now but we shall see.

This judgment is always much easier with something like Coca-Cola (KO) or Procter & Gamble (PG) yet I don't see either of them putting up numbers like Apple anytime soon.

Apple's stock may or may not go down substantially. That's of no concern to me. The price is fair enough. They're on a roll without a doubt. What does concern me is the changes to Apple's highly competitive landscape and how the dynamics of the industry could eventually hurt its core economics.

Not an easy thing to judge.

I'll use my energy trying to understand that but most assuredly will not worry about quarterly results measured to the penny or even pennies per share.

Adam

Established position in Apple at a substantially lower price
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, October 18, 2011

Current Earnings vs Pre-Crisis Peak Earnings: Coca-Cola, Pepsi, Google, Wal-Mart, and Microsoft

With all the market noise and a focus on near term results it's worth taking a step back. Here's a look at each company's peak earnings pre-crisis (before 2008) compared to earnings this year*.

Coca-Cola (KO)
Expected current year earnings/share: $ 3.84/share
Pre-crisis peak earnings/share: $ 2.57/share

Pepsi (PEP)
Expected current earnings/share: $ 4.41/share
Pre-crisis peak earnings/share: $ 3.41/share

Google (GOOG)**
Expected current earnings/share: $ 32+/share
Pre-crisis peak earnings/share: $ 13.29/share

Wal-Mart (WMT)
Expected current earnings/share: $ 4.49/share
Pre-crisis peak earnings/share: $ 3.13/share

Microsoft (MSFT)
Expected current earnings/share: $ 2.85/share
Pre-crisis peak earnings/share: $ 1.87/share

The focus on short-term movements in the stock price seems to sometimes mask this progress.  Each of the above has materially improved a main driver of their intrinsic value....the capacity to earn. It's not as if we're in an economic boom. They're all making a nice living despite plenty of headwinds.

The increased earnings power is certainly not driven by cyclical factors.

Changes in stock price in the short to even intermediate run reflects market sentiment, macro issues, and various other perceptions (true or not) of a business. Stock prices can change fast but the intrinsic value of most businesses rarely do.

Sometimes a stock price is substantially higher than intrinsic value entering a particular period of time. Google's as good an example as any. The hype around Google's stock had it selling at over $ 700/share the year it earned its pre-crisis peak earnings of $ 13.29/share. More than 50x earnings.

Similarly, the stock of Microsoft and Wal-Mart have have gone nowhere this past decade precisely for this reason. They entered the decade with a stock price well in excess of even an optimistic view of intrinsic value.

So earnings had to "catch up". The returns may still turn out okay in the long run if the business continues to create value. Yet, paying a price above intrinsic value creates increased risk of permanent capital loss or below par returns relative to risk if the business stumbles.

What business doesn't stumble from time to time?

In contrast, let's say an undervalued stock continues to get cheaper while the business does fine (or, at least, long run prospects remain sound despite headwinds).

In this case, the long-term owner shouldn't mind. In fact, long-term owners should hope that it gets even cheaper in the near term.

The lower price just provides more opportunities for both the shareowner to buy more shares below intrinsic value and management, via buybacks, to do the same. As long as something is selling below intrinsic value and especially if, like the businesses above, intrinsic value continues to grow.
(None of this refers to any trading scenarios, of course...an entirely different game.)

A rising or falling stock price often creates its own dynamic that spills over into the perception of business performance. What psychologists have called the "halo effect" and first documented in the U.S. Army decades ago. From this Wall Street Journal article:

In this quirk of the human mind, one powerful impression spills over onto our other judgments of a situation.

Wall Street Journal: The Halo Effect

The result: Investors think...they are evaluating the stock and the managers independently, but one opinion inevitably colors the other, often leading investors to be too bullish on the upside and too bearish on the downside. The managers haven't changed; our perceptions of them have.

It's easy to allow a positive or negative "halo" distort the perception of business value. Use of more objective factors is the best way to prevent misjudgments.

The discrepancy between price and value works itself out, eventually, but wide disconnects when in comes to price versus value can go on for a very long time (easily long enough for an investor to lose patience).

The above businesses appear to have made substantial progress on the value creation front in the past several years. Is that capacity to earn persistent? Will capital be put to good use that creates high return incremental growth? That will be the real determinant of long run value.

Some of these stocks have seemed to go nowhere in recent years (though opportunities have been there to buy them at a nice discount to value). Microsoft and Wal-Mart receive their fair share of coverage in this regard.

Dead money, right?

Yes, but it had little to do with what the businesses accomplished.

The above businesses have been creating value. The problem was the cheap became cheaper or the shares were overvalued in the first place and earnings had to catch up.

Adam

* Coca-Cola, Pepsi and Google end the fiscal year in December of 2011. The Wal-Mart fiscal year ends in January 2012 while the Microsoft fiscal year ends in June 2012. 
** I'm using Google's more conservative GAAP earnings. Many analysts use the non-GAAP number. Either way Google's capacity to earn has been improved substantially.

Established long positions in KO, PEP, and GOOG when selling at much lower price levels. Also long WMT and MSFT slighly below recent prices.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational and educational use and the opinions found here should not be treated as specific individualized investment advice. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions.

Monday, October 17, 2011

Buffett on Buying "Small Pieces of the Best Businesses": Berkshire Shareholder Letter Highlights

From Warren Buffett's 1995 Berkshire Hathaway (BRKa) shareholder letter:

The Story of the Man with an Ailing Horse
Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as Secretariat.

Acquisitions vs Passive Investments
...we face the inherent problem that the seller of a business practically always knows far more about it than the buyer and also picks the time of sale - a time when the business is likely to be walking "just fine." 

Even so, we do have a few advantages, perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market. Our practice of making this comparison - acquisitions against passive investments - is a discipline that managers focused simply on expansion seldom use.

Talking to Time Magazine a few years back, Peter Drucker got to the heart of things: "I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work . . . dealmaking is romantic, sexy. That's why you have deals that make no sense."

The seller of an entire individual business usually knows far more about the company than the buyer and will put it up for sale when it's most advantageous for the seller.

The "For Sale" sign usually goes up at a time when business conditions are most favorable...to the seller.

So an excited and, at least at times, emotion-driven acquirer meets informed and disciplined seller of an entire business. Once a deal gets in motion the process takes on a life of its own whether it makes sense or not.

The result frequently being "silly purchase prices".

In contrast, the price available for "small pieces of the best businesses" tend to swing wildly above and below intrinsic value in an often emotional and increasingly algorithm driven short-term oriented stock market. The situation, reversed. In this case, an informed and disciplined buyer has little difficulty finding sellers that are less so.

Which scenario is more likely to create better opportunities for a buyer?

Adam

Long BRKb
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, October 14, 2011

Google's 3rd Quarter 2011 Earnings

From the Google (GOOG) 3rd quarter earnings press release:

GAAP net income in the third quarter of 2011 was $2.73 billion, compared to $2.17 billion in the third quarter of 2010. Non-GAAP net income in the third quarter of 2011 was $3.18 billion, compared to $2.46 billion in the third quarter of 2010.

GAAP EPS in the third quarter of 2011 was $8.33 on 327 million diluted shares outstanding, compared to $6.72 in the third quarter of 2010 on 322 million diluted shares outstanding. Non-GAAP EPS in the third quarter of 2011 was $9.72, compared to $7.64 in the third quarter of 2010.

 The stock is selling at $ 594/share (up 6.4% from yesterday's close) as I write this. With $ 37.4 billion ($ 114/share) of net cash on the balance sheet the enterprise value per share of Google is...

Enterprise Value: $ 594/share - $114/share = $ 480/share

Google should earn close to $ 32/share this year (using GAAP earnings) and likely quite a bit more than that in 2012.  So a 15x or so multiple. Even if not cheap, not exactly outrageously expensive either (though I wouldn't buy it near the current price) given what appear above average prospects.

Now, I am skeptical of the non-GAAP earnings estimates used by Google and widely accepted by analysts.

As good as Google's business is, I think it is fair to say that the non-GAAP numbers are optimistic.

Now, it's not that the GAAP earnings numbers are a perfect measure. They certainly are not.

I just think it just makes more sense to go with the more conservative number that GAAP provides in this case.

Here's why.

First of all keep in mind that, primarily due to stock option grants, shares outstanding will tend to grow over time (like many technology companies).

I realize the extra 5 million shares outstanding year over year (327 million minus 322 million from above) isn't the end of the world. On a percentage basis it's a small number.

Still, even though 5 million additional shares is not a huge number on a percentage basis, a company that continues to add that many shares each year for let's say a decade or so will guarantee the long-term owners  find their share of an expected to grow in value pie to be meaningfully less.

The pie will grow nicely but there'll be meaningfully more slices.

Now, there is no precise or useful way to measure the cost of stock options (stock-based compensation* expense is an attempt) but there's no need to measure it with precision. That the ultimate cost of options is difficult to estimate doesn't make the cost to owners less real.

The extensive use of options makes it almost certain that a material amount of extra shares will likely exist down the road. An investor can attempt to make a rough estimate of how much dilution will likely occur based upon current compensation practices.

That's, at least, a good place to start.

With Google, you have a business that will slowly grow its share count. In contrast to this, many very good businesses these days are lowering their share count each year via share repurchases.

In fact, some are currently at a buyback run rate that could cut their share count in half in 5 years or less (whether that actually happens, of course, depends on the stock price among other things).

Google has a fine business yet the extensive use of stock options needs to be weighed appropriately to judge longer term return potential. Any estimate of Google's future business value should be given a haircut on a per share basis to account for the additional shares outstanding. The investment may still provide a satisfactory return but the effects of dilution need to be estimated.

Stock-based compensation expense* is an attempt an GAAP to estimate the cost of stocks options. It's far from perfect but shouldn't be ignored. The non-GAAP earnings number reported by Google and used by many analysts back out this non-cash expense. Some argue that since stock-based compensation is not a cash expense that the non-GAAP earnings number better reflect reality. There are cases when it makes sense to back out non-cash expenses. I'd argue in this case it makes less sense.

Why?

Stock-based compensation serves as a useful if imperfect way to make sure there is some sunlight on the not so easy to estimate but real potential cost of stock options to owners over time.

The long run share dilution becomes a real cost to shareholders even if, as a non-cash expense, it doesn't impact free cash flow. It's still a real cost because those cash flows, the main driver of future value, will be divided among more shares outstanding.

So stock-based compensation expense is very much an imperfect way to estimate the cost of stock options to investors but I applaud the attempt to make those costs more visible.

Adam

Long position in Google at a substantially lower price

* Calculating stock-based compensation expense requires the input of highly subjective assumptions (things like stock price volatility and forfeiture rate). Best case it represents a good faith estimate of something that's nearly impossible to know.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, October 13, 2011

JPMorgan Repurchases $ 4.4 Billion in Stock

In JPMorgan's (JPM) latest quarterly earnings released this morning, the bank announced that it had bought back $ 4.4 billion of stock during the quarter.

At that rate of repurchase, the bank could cut its shares outstanding just about in half in a little over 3 years near the current share price.

In his recently released 3Q 2011 letter to shareholders, Mason Hawkins had this to say about share repurchases:

Mason Hawkins On Share Repurchases
While the market is ignoring positive fundamentals, many of our investees are using the negative sentiment to meaningfully grow value through share repurchases. When stocks completely decoupled from corporate values in late 2008-early 2009, we called on our CEO partners to repurchase as many shares as possible. A few responded, but most were too fearful of how bad the economic damage might become to aggressively use any cash cushion. Today, most of our corporate partners see minimal growth but believe that their strong business prospects over the intermediate term make repurchasing today's discounted shares the optimal capital allocation choice. Our portfolio companies collectively are shrinking shares at an average 4% annualized rate, with CEOs at DIRECTV, Travelers, Philips, FICO, and Wendy's repurchasing at a rate in the teens. Warren Buffett has initiated Berkshire Hathaway's first buyback. Not only have strengthened balance sheets and strong cash flow given companies the arsenal to steal shares, beneficial capital allocation work over the last two years has put our partners in a much improved position.

With building a sufficient capital cushion a top priority during the financial crisis, banks could not (weren't allowed by regulators) allocate capital to the repurchase of undervalued shares. As a result, long-term holders of the stock could not benefit from the buying back of shares when they were selling at enormous discounts to intrinsic value.

That's no longer the case for the stronger banks. No doubt it can be annoying to stare at an undervalued stock price quote on your computer screen. If value has been judged well, of course. If not, it's more than annoying. Yet, as long as the business is financially sound, an undervalued stock that remains that way for an extended period that is bought back persistently* creates huge benefits for the remaining long-term owners.

When some of the other partners in ownership are willing to sell their share of the business at something like half what it's intrinsically worth I see no reason to complain.

Of course, whether or not what is causing the stock to decline could permanently impair or damage the business franchise needs to be understood.

Otherwise, if the business remains sound...no worries.

Adam

* Unfortunately, sometimes shares are bought back when the stock is not cheap or as a way to prop up a share price.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, October 12, 2011

Buffett on Post-Bubble Equity Prices: Berkshire Shareholder Letter Highlights

From Warren Buffett's 2002 Berkshire Hathaway (BRKa) shareholder letter:

We continue to do little in equities. Charlie and I are increasingly comfortable with our holdings in Berkshire's major investees because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don't yet believe their shares are undervalued. 

In our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge. 

The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.

When Buffett wrote that letter (February 21, 2003), the S&P 500 had already fallen from a high of 1,552 to the bottom at 768 then closed out the year at 879.

The day the letter was written the S&P 500 was at 848...just 10% higher than that low of 768.

Generally, you'd expect, after a roughly 50% drop in the market, to get some pretty good values.

Not that time.

Check out the price to earnings ratio of his top 2 holdings as of the date the letter was written:

Coca-Cola (KO) had dropped from the high of nearly $ 89/share to just under $ 39/share (the post-bubble low up to that point). After all that lost market value Coca-Cola's price to earnings ratio was still a pricey 33x (mid-20s on a forward basis).

So a price to earnings ratio of 33x near the bottom of a major bear market.

While certainly not cheap now, consider that Coca-Cola currently has a price to earnings ratio of ~17x after having already rallied 78% off the lows in 2009.

Night and day. Obviously, not all bear markets are created equal when it comes to creating investing opportunities (trading is another story, of course).

Buffett's 2nd largest holding at the time was American Express (AXP). It had a more reasonable, at least in comparison to Coca-Cola at the time, mid-teens price to earnings ratio. Not outrageously expensive but, again, not really cheap for being near the bottom of a major bear market (though the price did go lower the prior year on temporarily depressed earnings ie. not normalized earnings).

Now, compare that multiple to what happened to the stock of American Express in 2009.  Its price fell to just under $ 10/share in March of that year* (it currently sells for over $ 47/share as I write this or nearly 12x current earnings).

American Express should earn $ 4/share this year and, prior to the financial crisis, the company had already comfortably demonstrated it could earn $ 3/share. So, at the time it was selling for something like a 2.5x to 3.3x multiple on an earnings stream that has a high probability of growing nicely forward (AXP generates extremely high return on equity relative to other financials so it doesn't take much incremental capital to create earnings growth).

On a normalized basis $ 3/share was a conservative estimate of Amex's future earning power yet when it was heading toward that $ 10-ish/share price analysts were downgrading the stock.

American Express & the Analyst Upgrade/Downgrade Cycle

An example:

March 12th, 2009: Citi maintains a 'Sell' rating on American Express Co., but lowered their price target lowered from $14 to $9. The firm said sell any strength on deteriorating fundamentals. Link

After Buffett wrote the 2002 letter, stocks would go on to get even more expensive again as stocks rallied over the next 4-5 years leading up to the beginning of the financial crisis. Jeremy Grantham has called that 2003-2007 period "the biggest sucker rally in history". The 2003-2007 so-called "sucker rally" made an already difficult decade even worse if you were an investor looking to buy shares of good businesses selling at a comfortable discount to value.

It's quite a bit different now. Things can no doubt get even cheaper from here but the investing landscape today provides a substantially better possibility of finding a good entry point to own shares of a good business for the long-term.

Adam

Long BRKb, KO, and AXP

*A month or so after it fell below $ 10/share I mentioned AXP as a stock that I like in the Six Stock Portfolio. At that point, it was up from its lowest price (selling at $ 16-18/share) but still very cheap relative to intrinsic value. Since then, AXP is up substantially, of course, as is the porfolio (up ~ 74% compared to 44% for the S&P 500 including dividends...with those gains most of the stocks are tough for me to buy more of at this point). The portfolio, while certainly not stock recommendations (something I never do), it was meant as an example of how returns can be achieved with minimal trading if you buy 5 or 10 good durable businesses you understand at the right price and hold them long-term. I know it flies in the face of some of the more popular approaches to investing these days but that's pretty much the point. All this trading activity is entirely unnecessary and is more likely to make your broker rich. Inevitably one of the stocks will have a bad year or two but the long run results should be fine as long as the economics of each core business franchise remain unimpaired. If something that materially impairs one of these businesses in a permanent way then a change will be in order. Otherwise, my bias is to make no changes and just let the value created by each business compound.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, October 11, 2011

The Disproportionate Role of ETFs and Algorithmic Trading

From this recent article by Doug Kass:

"The proximate cause of our so-sick and volatile market is not the eurozone crisis nor the ambiguity of our domestic growth trajectory; moves such as yesterday are made and exaggerated by intraday reweighting of leveraged ETFs and by the disproportionate impact price-momentum-based, high-frequency trading strategies."

Later in the article Kass added the following:

"I am convinced that, in the fullness of time, the SEC will recognize the damage that has taken place in our markets.

I am equally convinced that, by the time they do, it will be too late.

Kill the quants before they kill us."

Yesterday, Joe Saluzzi of Themis Trading had this to say about high speed trading on CNBC:

"What happened is we've gotten hijacked. Our equity markets are supposed to be a capital formation process to help small companies get bigger..."

Saluzzi asserts that high speed traders have taken over the markets and turned it into, more or less, a casino. If the bulk of the added volatility is in fact caused by some of these "innovations", then we are still making a big costly mistake not putting some safeguards in place.

We live in a world still influenced by flawed ideas like efficient market hypothesis (EMH). Even after decades of seemingly rather incontrovertible evidence refuting things like EMH, you'll hear statements spoken with confidence by market participants along the lines of:

"price is truth", and

"markets don't lie, people do."

I don't doubt that historically the market has been, at times, a better than average indicator of future economic outcomes. Yet, extending that to a belief that the market's price action provides a form of wisdom that always trumps all other judgments makes little sense.

Somehow, according to this thinking, a rather temperamental Mr. Market can reliably foresee the future.

Really?

With, at least by some estimates, 75% or more of trading volume now being driven by high frequency traders, how in the heck can market movements be providing reliably meaningful signals?

Now, even if you buy it has historically had some ability to anticipate, how does all this short-term oriented hyperactivity improve its ability to foresee? Any chance some of the recent changes make it less reliable and, more importantly, less stable? To me, it seems likely to provide lots more emotion driven false signals than it ever did historically.

Before the modern form of the capital markets came to be, Warren Buffett and Ben Graham have described the market and its participants with less than flattering words and phrases:

"The market is a psychotic, drunk, manic-depressive selling 4,000 companies every day. In one year, the high will double the low. These businesses are no more volatile than a farm or an apartment block [whose values do not swing so wildly]." - Warren Buffett at Wharton*

"...fractional-interest purchases can be made in an auction market where prices are set by participants with behavior patterns that sometimes resemble those of an army of manic-depressive lemmings." - Warren Buffett in the 1982 Berkshire Hathaway (BRKa) Shareholder Letter

"...Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental. When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that seems to you a little short of silly." - Benjamin Graham in The Intelligent Investor

The idea we want to take our cues from something that temperamental has always seemed hilarious to me. So, by its very nature, the market has never exactly been a stable beast. Yet, the amount of daily price movements we see in the modern iteration of capital markets makes the behavior Graham and Buffett were attempting to describe look rock solid by comparison.

These days, James Montier of GMO describes the situation as "the investment equivalent of attention deficit hyperactivity disorder".

We got by okay back then with a temperamental market so what's the big deal if it is a bit more volatile, and a bit more likely to misprice these days?

Well, we've obviously allowed some things to evolve, even if incidentally with the best intentions, that amplify the inherently temperamental nature of markets. The resulting feedback on the real economy is significant. It serves few, hurts many.

It's costly because businesspeople and consumers interpret the amplified market volatility in a way that can meaningfully affect investment and consumption behavior.

It's costly because hyperactivity inevitably drives unnecessary frictional costs within the system. These frictional costs from all the turnover certainly add up:

The "Invisible Foot"

It's also costly because the job of capital formation is likely to be done poorly. More mispriced assets, increased misallocation of resources.

Our markets operate below potential when it comes to their primary purpose: to facilitate the allocation of capital from investors to businesses.

Finally, why are we aspiring for our markets to function only as well as they have in the past? I know of nothing else like that. Shouldn't we be trying to improve them in terms of their primary purpose in life? I mean, Ford (F) isn't working hard to bring back the Model T nor is Apple (AAPL) going to bring back one of their "classic" computer designs anytime soon. As James Grant wrote in his book Money of the Mind:

"Progress is cumulative in science and engineering, but cyclical in finance."

Cyclical at best.

Some argue that our macro problems are now somehow worse than what we've seen historically and that explains the volatility. So I guess then one has to believe that the current macro problems are somehow materially greater than the things that happened in the past century?

Last I checked we had some pretty tough moments (a couple of world wars, the cuban missile crisis, and too many financial crises to list etc.) last century yet, during those times, volatility in the markets didn't even approach what we've seen this year.

Check out the so-called 'all or nothing days' in this post for some recent (the past 20 years) context.

High Frequency Trading: Tail That Wags the Dog

This situation certainly creates opportunities for the disciplined investor but that's not my focus here.

The economy already has some large challenges, to say the least, but these flaws in the capital markets are unnecessary, self-inflicted wounds that are likely making difficult problems even more so.

The capital markets serve us, not vice versa, and they can be redesigned to serve us better. There's no question, at least to me, that a 2.8 month average holding period is symptomatic of short-termism gone wild, computers or otherwise, with material consequences.**

There's little doubt that real damage is being done and many have an opinion of what's at the root of it. Yet, while it is likely that high speed trading and leveraged ETFs is part of the problem, until more unbiased analysis is complete, there is no way to know what's really the biggest contributor.

Time will hopefully tell, with some rigor and focus, what proportion of the damage being done is the direct result of high speed trading, leveraged ETFs, removal of the uptick rule, or some of the other recent financial "innovations" and market structure changes.***

Once we better understand the real root cause(s) it needs to be fixed yesterday as far as I'm concerned.

Adam

Long AAPL

* Based upon notes that were taken at a 2006 Wharton meeting.
** The average holding period has dropped to something like 2.8 months these days down from around 2 years in the 1980s and more like 4 to 8 years from the 1930s to the 1970s.
*** By experts with no material conflicts of interest, of course.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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