Posts filed under ‘Profiles’

Stock Talk: The Value of Media in Finance

Man Speaking Into Microphones

I recently caught up with 50-year investment veteran Bill Kort to answer his questions regarding the media’s impact on the financial industry. After working for Kidder Peabody, A.G. Edwards, Wachovia, and Wells Fargo, Bill called it quits and decided to retire. Besides enjoying retirement with his wife, children, and grandchildren, Bill now also devotes considerable time to his blog Kort Sessions (www.KortSessions.com).

In a recent interview published on his Kort Sessions blog (KS), here’s what we discussed:

KS: Today, when you recommend a client take on, or increase equity exposure, what are the most common push-backs that you get? Have these changed in the past few years? If so, could you explain.

Wade Slome: “Given the events that have transpired over the last 15 years, I expect to receive a healthy dosage of pushback. Many investors have naturally been scarred from the 2008-2009 Financial Crisis, so convincing certain people that the 100-year flood will not occur every 100 days can be challenging. Regardless of the skepticism I receive, I feel it’s my duty to provide the best possible advice I can to existing clients and prospective clients. I can lead a horse to water, but I believe it’s not my job to force clients into a single investment option. At Sidoxia, we customize investment plans that meet clients’ risk tolerances, time horizons, and overall objectives.

With regard to sentiment changes in recent years, it is true that the tripling in equity market values since early 2009 has changed investor moods. Risk appetites have definitely increased. Nevertheless, cynicism is still rampant. Surveys done by Gallup show that stock ownership is near 15-year lows and despite stocks at or near record highs, ICI fund flow data shows money fleeing U.S. stock funds in 2014. With generational low interest rates, I see many long-term investors being too imprudently conservative. However, on the other hand, my responsibility is to also prevent other clients from taking on too much risk, especially if they have shorter investment time horizons or have limited funds in retirement.”

KS: When you speak with clients today, what are prominent worries do they have about their investments: The general level of the market, valuation, the economic backdrop, U.S. political issues or geopolitical concerns (all of the above)? Could you rank or tell me which concerns seem to be paramount.

Wade Slome: “In this 24-hour news cycle society we live in, an avalanche of real-time data gets crammed down our throats daily through our smartphones and Twitter-Facebook pages. As a result, the overwhelming barrage of news gets disseminated instantaneously, which in turn spreads fear like wildfire by word of mouth. In this type of environment it comes as no surprise to me that the general public is on edge. Every molehill is made into a mountain by media outlets for a simple reason…fear sells! Before the internet 20 years ago, virtually no one could find the location of Cyprus, Syria, Ukraine, or Gaza on a map – now we have Google and Wikipedia to show us or the Twitter feed scrolling at the bottom of our television sets reminds us. As far as concerns go, it’s tough to rank which ones are paramount. One day it’s the elections or Iran, and then the other day it’s the stock market crashing or the Ebola virus. Eventually the emotional pendulum will swing from fear and pessimism to optimism and euphoria, it always does. Like a lot of different professions, one of best strengths to have as an investment manager is the experience in knowing what noise to filter out and the ability to identify the relevant factors that drive outperformance.”

KS: Could you share the short-form responses that you might give to your clients when addressing the aforementioned issues.

Wade Slome: “The best advice I can give investors is to ignore the headlines. This principle is just as true today as it was a century or two ago. Mark Twain famously said, “If you don’t read the newspaper, you are uninformed.  If you do read the newspaper, you are misinformed.” This is obviously presented a little tongue-in-cheek, but the main point being is headlines should not drive your investment decisions. It’s perfectly fine to be informed about the economy and politics, but people must realize the stock market often moves independently and in contrarian directions to prevailing media stories. Rather than emotionally react to news flow, it is much more important to create an objective, long-term investment plan that takes advantage of market noise, hype, and volatility.”

KS: Finally, this is a little bit of a leading question that I hope you might run with. Do you find any useful purpose being served by the financial, general or political media that might aid an individual’s investment process?

Wade Slome: “In my view of the financial markets, there are a few underlying principles that drive stock prices over the long-term, and they include such basic factors as earnings, valuations, interest rates, and market psychology. What I would objectively try to argue is that the financial, general, or political media have little to no impact on the first three factors and only modest influence on the last one (market psychology). Part of the reason I have been so constructive on the markets on my Investing Caffeine blog over the last five years is because all these factors have generally pointed in the right direction. I will become nervous when earnings decline, valuations get stretched, interest rates spike, and/or psychology turns euphoric. Right now, I don’t think we are seeing any of that occurring.

With that said, I do believe there are exceptions to the rule that the “media is evil.” If you have the time, interest, and patience to stagger through the endless desert of financial media, you can find a few rare flowers. Although I do consume mass amounts of media, 99% of it ends up in the trash or ignored. I do my best to reserve my media consumption to those successful investors who have lived through multiple market cycles and have a winning track record to back it up. It is possible to find sage investment bloggers; Warren Buffett interviews on CNBC; or newspaper interviews of thriving venture capitalists, if you properly dine on a healthy media diet. Unfortunately there is a lot of junk food financial content out in media land. What should generally be avoided at all costs are rants from economists, journalists, analysts, commentators, and talking heads. No matter how eloquent or articulate they may sound, the vast majority of the people you see on television have not invested a professional dime in their careers, so all you are getting from them are worthless, vacillating opinions. I choose to stick to commentary from the tried and true investment veterans.”

Bill, thanks again for the thoughtful interview questions, and continued success with your Kort Sessions blog!

www.Sidoxia.com

Investment Questions Border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own GOOG/GOOGL, and a range of positions in certain exchange traded fund positions, but at the time of publishing SCM had no direct position in TWTR, FB, WFC, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

August 23, 2014 at 6:57 pm Leave a comment

NVEC: A Cash Plump Activist Target…For Icahn?

Cash-Icahn

Some might call Carl Icahn a greedy capitalist, but at the core, the 78 year old activist has built his billions in fortunes by unlocking shareholder value in undervalued companies. His targets have come in many shapes and sizes, but one type of target is cash bloated companies without defined capital allocation strategies. A recent high profile example of a cash ballooned target of Icahn was none other than the $591+ billion behemoth Apple Inc. (AAPL).  

His initial tweet on August 13, 2013 announced his “large position” in the “extremely undervalued shares” of Apple ($67 split adjusted). We have been long-term shareholders of Apple ourselves and actually beat Carl to the punch three years earlier when the shares were trading at $35 – see Jobs: The Gluttonous Cash Hog. Icahn doesn’t just nonchalantly make outrageous claims…he puts his money where his mouth is. After Icahn’s initial proclamation, he went onto build a substantial $3.6 billion Apple position by January 2014.

Icahn Tweet

Icahn initially demanded Apple’s CEO Tim Cook to execute a $150 billion share repurchase program before downgrading his proposal to a $50 billion buyback. After receiving continued resistance, Icahn eventually relented in February 2014. But Icahn’s blood, sweat, and tears did not go to waste. His total return in Apple from his initial announcement approximates +50%, in less than one year. And although Icahn wanted more action taken by the company’s management team, Apple has repurchased about $50 billion in stock and paid out $14 billion in dividends to investors over the last five quarters. Despite the significant amount of capital returned to shareholders over the last year, Apple still holds a gargantuan net cash position of $133.5 billion, up approximately $3 billion from the 2013 fiscal third quarter.

Icahn’s Next Cash Plump Target?

Mr. Icahn is continually on the prowl for new targets, and if he played in the small cap stock arena, NVE Corp. (NVEC) certainly holds the characteristics of a cash bloated company without a defined capital allocation strategy. Although I rarely write about my hedge fund stock holdings, followers of my Investing Caffeine blog may recognize the name NVE Corp. More specifically, in 2010 I picked NVEC as my top stock pick of the year (see NVEC: Profiting from Electronic Eyes, Nerves & Brains). The good news is that NVEC outperformed the market by approximately +25% that year (+36% vs 11% for the S&P 500). Over the ensuing years, the performance has been more modest – the +42% return from early 2010 has underperformed the overall stock market.

Rather than rehash my whole prior investment thesis, I would point you to the original article for a summary of NVE’s fundamentals. Suffice it to say, however, that NVE’s prospects are just as positive (if not more so) today as they were five years ago.

Here are some NVE data points that Mr. Icahn may find interesting:

  • 60% operating margins (achieved by < 1% of all non-financial companies FINVIZ)
  • 0% debt
  • 15% EPS growth over the last seven years ($1.00 to $2.29)
  • Cutting edge, patent protected, market leading spintronic technology
  • +7% Free Cash Flow yield ($13m FCF / $194 adjusted market value) $294m market cap minus $100m cash.
  • $100 million in cash on the balance sheet, equal to 34% of the company’s market value ($294m). For comparison purposes to NVE, Apple’s $133 billion in cash currently equates to about 23% of its market cap.

Miserly Management

As I noted in my previous NVE article, my beef with the management team has not been their execution. Despite volatile product sales in recent years, it’s difficult to argue with NVE CEO Dan Baker’s steering of outstanding bottom-line success while at the helm. Over Baker’s tenure, NVE has spearheaded meteoric earnings growth from EPS of $.05 in 2009 to $2.29 in fiscal 2013. Nevertheless, management not only has a fiduciary duty to prudently manage the company’s operations, but it also has a duty to prudently manage the company’s capital allocation strategy, and that is where NVE is falling short. By holding $100 million in cash, NVE is being recklessly conservative.

Is there a reason management is being so stingy with their cash hoard? Even with cash tripling over the last five years ($32m to $100m) and operating margins surpassing an incomprehensibly high threshold (60%), NVE still has managed to open their wallets to pursue these costly actions:

  • Double Capacity: NVE doubled their manufacturing capacity in fiscal 2013 with minimal investment ($2.8 million);
  • Defend Patents: NVE fought and settled an expensive patent dispute against Motorola spinoff (Everspin) as it related to the company’s promising MRAM technology;
  • R&D Expansion: The company shored up its research and development efforts, as evidenced by the +39% increase in fiscal 2014 R&D expenditures, to $3.6 million. 

The massive surge in cash after these significant expenditures highlights the indefensible logic behind holding such a large cash mound. How can we put NVE’s pile of cash into perspective? Well for starters, $100 million is enough cash to pay for 110 years of CAPEX (capital expenditures), if you simply took the company’s five year spending average. Currently, the company is adding to the money mountain at a clip of $13,000,000 annually, so the amount of cash will only become more ridiculous over time, if the management team continues to sit on their hands.

To their credit, NVE dipped half of a pinky toe in the capital allocation pool in 2009 with a share repurchase program announcement. Since the share repurchase was approved, the cash on the balance sheet has more than tripled from the then $32 million level. To make matters worse, the authorization was for a meaningless amount of $2.5 million. Over a five year period since the initial announcement, the company has bought an irrelevant 0.5% of shares outstanding (or a mere 25,393 shares).

A Prudent Proposal

The math does not require a Ph.D. in rocket science. With interest rates near a generational low, management is destroying value as inflation eats away at the growing $100 million cash hoard. I believe any CFO, including NVE’s Curt Reynders, can be convinced that earning +7% on NVE shares (or +15% if earnings compound at historical rates for the next five years) is better than earning +2% in the bank. Or in other words, buying back stock by NVE would be massively accretive to EPS growth. Conceptually, if NVE used all $100 million of its cash to buy back stock at current prices, NVE’s current EPS of $2.59 would skyrocket to $3.63 (+40%). 

A more reasonable proposal would be for NVE management to buy back 10% of NVE’s stock and simultaneously implement a 2% dividend. At current prices, these actions would still leave a healthy balance of about $75 million in cash on the balance sheet by the end of the fiscal year, which would arguably still leave cash at levels larger than necessary. 

Despite the capital allocation miscues, NVE has incredibly bright prospects ahead, and the recently reported quarterly results showing +37% revenue growth and +57% EPS growth is proof positive. As a fellow long-term shareholder, I share management’s vision of a bright future, in which NVE continues to proliferate its unique and patented spintronic technology. With market leadership in nanotechnology sensors, couplers, and MRAM memory, NVE is uniquely positioned to take advantage of game changing growth in markets such as nanotechnology biosensors, electric drive vehicles (EDVs), consumer electronic compassing, and next generation MRAM technology. If NVE can continue to efficiently execute its business plan and couple this with a consistent capital allocation discipline, there’s no reason NVE shares can’t reach $100 per share over the next three to five years.

While NVE continues to execute on their growth vision, they can do themselves and their shareholders a huge favor by implementing a shareholder enhancing capital return plan. Carl Icahn is all smiles now after his successful investments in Apple and Herbalife (HLF), but impatient investors and other like-minded activists may be lurking and frowning, if NVE continues to irresponsibly ignore its swelling $100 million cash hoard.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in Apple Inc. (AAPL), NVE Corp. (NVEC), and certain exchange traded funds, but at the time of publishing SCM had no direct position in TWTR, MOT, Everspin, HLF, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

July 27, 2014 at 6:23 pm Leave a comment

Shiller CAPE Peaches Smell Like BS

Peach-Poop

If something sounds like BS, looks like BS, and smells like BS, there’s a good chance you’re probably eyeball-deep in BS. In the investment world, I encounter a lot of very intelligent analysis, but at the same time I also continually step into piles of investment BS. One of those piles of BS I repeatedly step into is the CAPE ratio (Cyclically Adjusted Price-to-Earnings) created by Robert Shiller. For those who are not familiar with Shiller, he is a Nobel Prize winner in economics who won the award in 2013 for his work on the “empirical analysis of asset prices.” Shiller vaulted into fame in large part due to the timing of his book, Irrational Exuberance, which was published during the 2000 technology market peak. He gained additional street-credibility in the mid-2000s when he spoke about the bubble developing in the real estate markets.

What is the CAPE?

Besides being a scapegoat for every bear that has missed the tripling of stock prices in the last five years, the CAPE effectively is a simple 10-year average of the P/E ratio for the S&P 500 index. The logic is simple, like many theories in finance and economics, there often are inherent mean-reverting principles that are accepted as rules-of-thumb. It follows that if the current 10-year CAPE is above the 134-year CAPE average, then stocks are expensive and you should avoid them. On the other hand, if the current CAPE were below the long-term CAPE average, then stocks are cheap and you should buy. Here is a chart of the Shiller CAPE:

Shiller-CAPE

As you can see from the chart above, the current CAPE ratio of 26x is well above the 134-year average of 16x, which according to CAPE disciples makes the stock market very expensive. Or as a recent Business Insider article stated, the Shiller CAPE is “higher than at any point in the 20th century with the exception of the peaks of 1929 and 2000 – you know what happened after those.”

Problems Behind the Broken CAPE Tool

There are many problems with Shiller’s CAPE analysis, but let’s start with the basics by first asking, how useful has this tool actually been over the last, 10, 20, or 30 years? The short answer…not very. For example, if investors followed the implicit recommendation of the CAPE for the periods when Shiller’s model showed stocks as expensive (see above chart 1990 – 2014), they would have missed a more than quintupling (+469% ex-dividends) in the S&P 500 index. Over a shorter timeframe (2009 – 2014) the S&P 500 is up +114% ex-dividends (+190% since March 2009).

Even if you purchased at the worst time at the peak of the stock market in 2000 when the CAPE was 44 (S&P 500 – 1553), an investor would still have earned a total return of about +45% from 2000 – 2014, despite the CAPE still being 63% higher (more expensive) than the 134-year CAPE average of 16.

Peaches for $.25 Post-Bubble?

To illustrate a point, let’s assume you are a peach lover and due to a bubble in peach demand, prices spiked to an elevated level of $2.60 per pound for 9 years, but in year 10 the price plummeted to $.25 per pound today (see chart below). Assuming the 134-year average for peach prices was $1.60 per pound, would you still want to purchase your beloved peaches for the fire sale price of $.25 per pound? Common sense tells you $.25/lb. is a bargain, but if you asked the same question to Robert Shiller, he would say absolutely “NO”! The 10-year Peach CAPE ratio would be $2.37 ([9 yrs X $2.60] + [1 yr X $.25]) #1, but since the 10-year CAPE is greater than the LT-Average peach price of $1.60 per pound #2, Shiller would say peaches are too expensive, even though you could go to Kroger (KR) and buy a pound of peaches today for $0.25 #3.

Peach Chart

This complete neglect of current market prices in the calculation of CAPE makes absolutely no sense, but this same dynamic of ignoring current pricing reality is happening today in the stock market. Effectively what’s occurring is the higher P/E ratios experienced over the last 10 years are distorting the Shiller CAPE ratio, thereby masking the true current value of stocks. In other words the current CAPE of 26x vastly exaggerates the pricey-ness of the actual S&P 500 P/E ratio of 16x for 2014 and 14x for 2015.

There are plenty of other holes to poke into CAPE, but the last major component of Shiller’s ratio I want to address is interest rates. Even if you disregard my previous negative arguments against Shiller’s CAPE, should anyone be surprised that the ratio troughed in the early 1980s of 7x when long-term interest rates peaked. If I could earn 18% on a CD with little risk in 1981, not many people should be dumbfounded that demand for risky stocks was paltry. Today, the reverse environment is in place – interest rates are near record lows. It should therefore come as no surprise, that all else equal, a higher P/E (and CAPE) is deserved when interest rates are this low. Nevertheless, this discussion of P/E and CAPE rarely integrates the critical factor of interest rates.

While I have spent a decent amount of time trashing the CAPE-BS ratio, I want to give my pal Bob Shiller a fair shake. I can do this by looking into a mirror and admitting there are periods when the CAPE ratio can actually work. Although the CAPE is effectively useless during long, multi-year upward and downward trending markets (think bubbles & depressions), the CAPE makes perfect sense in sideway, trendless markets (see chart below).

Cycle Chart

The investing public is always looking for a Holy Grail financial indicator that will magically guide them to riches in both up and down markets. Despite the popularity of Shiller’s CAPE ratio, regrettably no one perfect indicator exists. So before you jump on the bandwagon and chase the hot indicator du jour, make sure to look down and make sure you haven’t stepped in any Shiller CAPE-BS.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds, but at the time of publishing SCM had no direct position in KR, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 14, 2014 at 2:08 pm 22 comments

Lewis Sells Flash Boys Snake Oil

Snake Oil

I know what you’re saying, “Please, not another article on Michael Lewis’s Flash Boys book and high frequency trading (HFT),” but I can’t resist putting in my two cents after the well-known author emphatically proclaimed the stock market as “rigged.” Lewis is not alone with his outrageous claims… Clark Stanley (“The Rattlesnake King”) made equally outlandish claims in the early 1900s when he sold lucrative Snake Oil Liniment to heal the ailments of the masses. Ultimately Stanley’s assets were seized by the government and the healing assertions of his snake oil were proven fraudulent. Like Stanley, Lewis’s over-the-top comments about HFT traders are now being scrutinized under a microscope by more thoughtful critics than Steve Kroft from 60 Minutes (see television profile). For a more detailed counterpoint, see the Reuters interview with Manoj Narang (Tradeworx) and Haim Bodek (Decimus Capital Markets).

While Lewis may not be selling snake oil, the cash register is still ringing with book sales until the real truth is disseminated. In the meantime, Lewis continues to laugh to the bank as he makes misleading and deceptive claims, just like his snake oil selling predecessors.

The Inside Perspective

Regardless of what side of the fence you fall on, the debate created by Lewis’s book has created deafening controversy. Joining the jihad against HFT is industry veteran Charles Schwab, who distributed a press release calling HFT a “growing cancer” and stating the following:

“High-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges.”

 

What Charles Schwab doesn’t admit is that their firm is receiving about $100 million in annual revenues to direct Schwab client orders to the same HFT traders at exchanges in so called “payment-for-order-flow” contracts. Another term to describe this practice would be “kick-backs”.

While Michael Lewis screams bloody murder over investors getting fraudulently skimmed, some other industry legends, including the godfather of index funds, Vanguard founder Jack Bogle, argue that Lewis’s views are too extreme. Bogle reasons, “Main Street is the great beneficiary…We are better off with high-frequency trading than we are without it.”

Like Jack Bogle, other investors who should be pointing the finger at HFT traders are instead patting them on the back. Cliff Asness, managing and founding principal of AQR Capital Management, an institutional investment firm managing about $100 billion in assets, had this to say about HFT in his Wall Street Journal Op-Ed:

“How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars… on the whole high-frequency traders have lowered costs.”

 

Is HFT Good for Main Street?

Many investors today have already forgotten, or were too young to remember, that stocks used to be priced in fractions before technology narrowed spreads to decimal points in the 1990s. Who has benefited from all this technology? You guessed it…everyone.

Lewis makes the case that the case that all investors are negatively impacted by HFT, including Main Street (individual) investors. Asness maintains costs have been significantly lowered for individual investors:

“For the first time in history, Main Street might have it rigged against Wall Street.”

 

In Flash Boys, Lewis claims HFT traders unscrupulously scalp pennies per share from retail investor pockets by using privileged information to jump in front of ordinary investors (“front-run”). The reality, even if you believe Lewis’s contentions are true, is that technology has turned any perceived detrimental penny-sized skimming scheme into beneficial bucks for ordinary investors. For example, trades that used to cost $40, $50, $100, or more per transaction at the large wirehouse brokerage firms can today be purchased at discount brokerage firms for $7 or less. What’s more, the spread (i.e., the profits available for middlemen) used to be measured in increments of  1/8, 1/4, and 1/2 , when today the spreads are measured in pennies or fractions of pennies. Without any rational explanation, Lewis also dismisses the fact that HFT traders add valuable liquidity to the market. His argument of adding “volume and not liquidity” would make sense if HFT traders only transacted solely with other HFT traders, but that is obviously not the case.

Regardless, as you can see from the chart below, the trend in spreads over the last decade or so has been on a steady, downward, investor-friendly slope.

How Did We Get Here? And What’s Wrong with HFT?

Similarly to our country’s 73,954 page I.R.S. tax code,  the complexity of our financial market trading structure rivals that of our government’s money collection system. The painting of all HFT traders as villains by Lewis is no truer than painting all taxpayers as crooks. Just as there are plenty of crooked and deceitful individuals that push the boundaries of our income tax system, so too are there traders that try to take advantage of an inefficient, Byzantine exchange system. The mere presence of some tax dodgers doesn’t mean that all taxpayers should go to jail, nor should all HFT traders be crucified by the SEC (Securities and Exchange Commission) police.

The heightened convoluted nature to our country’s exchange-based financial system can be traced back to the establishment of Regulation NMS, which was passed by the SEC in 2005 and implemented in 2007. The aim of this regulatory structure was designed to level the playing field through fairer trade execution and the creation of equal access to transparent price quotations.  However, rather than leveling the playing field, the government destroyed the playing field and fragmented it into many convoluted pieces (i.e., exchanges) – see Wall Street Journal article  and chart below.

The new Reg NMS competition came in the form of exchanges like BATS and Direct Edge (now merging), but the new multi-faceted structures introduced fresh loopholes for HFT traders to exploit – for both themselves and investors. More specifically, HFT traders used expensive, lightning-fast fiber optic cables; privileged access to data centers physically located adjacent to trading exchanges; and then they integrated algorithmic software code to efficiently route orders for best execution.

Are many of these HFT traders and software programs attempting to anticipate market direction? Certainly. As the WSJ excerpt below explains, these traders are shrewdly putting their capitalist genes to the profit-making test:

Computerized firms called high-frequency traders try to pick up clues about what the big players are doing through techniques such as repeatedly placing and instantly canceling thousands of stock orders to detect demand. If such a firm’s algorithm detects that a mutual fund is loading up on a certain stock, the firm’s computers may decide the stock is worth more and can rush to buy it first. That process can make the purchase costlier for the mutual fund.

 

Like any highly profitable business, success eventually attracts competition, and that is exactly what has happened with high frequency trading. To appreciate this fact, all one need to do is look at Goldman Sachs’s actions, which is to leave the NYSE (New York Stock Exchange), shutter its HFT dark pool trading platform (Sigma X), and join IEX, the dark pool created by Brad Katsuyama, the hero placed on a pedestal by Lewis in Flash Boys. Goldman is putting on their “we’re doing what’s best for investors” face on, but more experienced veterans understand that Goldman and all the other HFT traders are mostly just greedy S.O.B.s looking out for their best interests. The calculus is straightforward: As costs of implementing HFT have plummeted, the profit potential has dried up, and the remaining competitors have been left to fend for their Darwinian survival. The TABB Group, a  financial markets’ research and consulting firm, estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014.  As costs for co-locating HFT hardware next to an exchange have plummeted from millions of dollars to as low as $1,000 per month, the HFT market has opened their doors to anyone with a checkbook, programmer, and a pulse. That wasn’t the case a handful of years ago.

The Fixes

Admittedly, not everything is hearts and flowers in HFT land. The Flash Crash of 2010 highlighted how fragmented, convoluted, and opaque our market system has become since Reg NMS was implemented. And although “circuit breaker” remedies have helped prevent a replicated occurrence, there is still room for improvement.

What are some of the solutions? Here are a few ideas:

  • Reform complicated Reg NMS rules – competition is good, complexity is not.
  • Overhaul disclosure around “payment-for-order-flow” contracts (rebates), so potential conflicts of interest can be exposed.
  • Stop inefficient wasteful “quote stuffing” practices by HFT traders.
  • Speed up and improve the quality of the SIP (Security Information Processor), so the gaps between SIP and the direct feed data from exchanges are minimized.
  • Improve tracking and transparency, which can weed out shady players and lower probabilities of another Flash Crash-like event.

These shortcomings of HFT trading do not mean the market is “rigged”, but like our overwhelmingly complex tax system, there is plenty of room for improvement. Another pet peeve of mine is Lewis’s infatuation with stocks. If he really thinks the stock market is rigged, then he should write his next book on the less efficient markets of bonds, futures, and other over-the-counter derivatives. This is much more fertile ground for corruption.

As a former manager of a $20 billion fund, I understand the complications firsthand faced by large institutional investors. In an ever-changing game of cat and mouse, investors of all sizes will continue looking to  execute trades at the best prices (lowest possible purchase and highest possible sales price), while middlemen traders will persist with their ambition to exploit the spread (generate profits between the bid and ask prices). Improvements in technology will always afford a temporary advantage for a few, but in the long-run the benefits for all investors have been undeniable. The same undeniable benefits can’t be said for reading Michael Lewis’s Flash Boys. Like Clark Stanley and other snake oil salesmen before him, it will only take time for the real truth to come out about Lewis’s “rigged” stock market claims.

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in GS, SCHW, ICE, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

April 11, 2014 at 1:04 pm 3 comments

Women & Bosoms on Wall Street According to Jones

Holiday Retail

Billionaire hedge fund manager of Tudor Investment Corporation, Paul Tudor Jones, recently suffered from a case of foot-in-mouth disease when he addressed a sensitive subject – the lack of female traders and investors on Wall Street. Rather than provide a diplomatic response to the mixed audience at a recent University of Virginia symposium, Tudor Jones went on an unambiguous rant. Here’s an excerpt:

“You will never see as many great women investors or traders as men. Period, end of story….As soon as that baby’s lips touch that girl’s bosom, forget it. Every single investment idea, every desire to understand what’s going to make this go up or gonna go down is going to be overwhelmed by the most beautiful experience, which a man will never share of that emotive connection between that mother and baby.”

 

A more complete review of his unfiltered response can be found in this video:

Clearly there is a massive minority of females on Wall Street, but why such an under-representation in this field relative to other female-heavy professional industries such as advertising, nursing, and teaching? I addressed this controversial subject in an earlier article (see Females in Finance)

If there are 155.8 million females in the United States and 151.8 million males (Census Bureau: October 2009), then how come only 6% of hedge fund managers (BusinessWeek), 8% of venture capitalists, and 15% of investment bankers are female (Harvard Magazine)? Is the finance field just an ol’ boys network of chauvinist pig-headed males who only hire their own? Maybe cultural factors such as upbringing and education are other factors that make math-related jobs more appealing to men? Or do the severe time-demands of the field force females to opt-out of the industry due to family priorities?

Although I’m sure family choices and quality of life are factors that play into the decision of entering the demanding finance industry, from my experience I would argue women are notoriously underrepresented even at younger ages. For example, anecdotal evidence coming from my investment management firm (Sidoxia Capital Management www.Sidoxia.com) clearly shows a preponderance of internship applications coming from males, even though it is premature for these students to fully contemplate family considerations at this young age.

If under-representation in the finance field is not caused by female choice, then perhaps the male dominated industry is merely a function of more men opting into the field (i.e., men are better suited for the industry)? More specifically, perhaps male brains are just wired differently? Some make the argument that all the testosterone permeating through male bodies leads them to positions involving more risk.  If you look at other risk related fields like gambling, women too are dramatic minorities, making up about 1/3 of total compulsive gamblers.

Women Better than Men?

The funny part about the under-representation of females in finance is that one study actually shows female hedge fund managers outperforming their male counterparts. Here’s what a BusinessWeek article had to say about female hedge fund managers:

A new study by Hedge Fund Research found that, from January 2000 through May 31, 2009, hedge funds run by women delivered nearly double the investment performance of those managed by men. Female managers produced average annual returns of 9%, versus 5.82% for men and, in 2008, when financial markets were cratering, funds run by women were down 9.6%, compared with a 19% decline for men.

 

The article goes onto to theorize that women may not be afraid of risk, but actually are better able to manage risk. A UC Davis study found that male managers traded 45% more than female managers, thereby reducing returns by -2.65% (about 1% more than females).

Regardless of the theories or studies used to explain gender risk appetite, the relative under-representation of females in finance is a fact. Many theories exist but further thought and research need to be conducted on the subject.

However, before Paul Tudor Jones is completely demonized or sent to the guillotine, let’s not forget Tudor Jones is obviously not your ordinary, heartless, cold-blooded Wall Street type, as evidenced by his recent philanthropic profile on 60 Minutes. Thanks to his generous efforts, Tudor Jones and his Robin Hood Foundation charity have raised more than $400 million for worthy causes since 1988.

While Paul Tudor Jones may not have harbored any malicious intent with regards to his comments, it may make sense for Tudor Jones to take a course on gender sensitivity. Bosoms and women may be an interesting subject for many, however he might consider filtering his commentary the next time he speaks to a large symposium recorded on the internet.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

See also:

Harvard Magazine article

BusinessWeek article on female fund managers

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

 

 

May 25, 2013 at 1:25 pm Leave a comment

The Central Bank Dog Ate My Homework

Jack Russell Terrier Snarling

It’s been a painful four years for the bears, including Peter Schiff, Nouriel Roubini, John Mauldin, Jimmy Rogers, and let’s not forget David Rosenberg, among others. Rosenberg was recently on CNBC attempting to clarify his evolving bearish view by explaining how central banks around the globe have eaten his forecasting homework. In other words, Ben Bernanke is getting blamed for launching the stock market into the stratosphere thanks to his quantitative easing magic. According to Rosenberg, and the other world-enders, death and destruction would have prevailed without all the money printing.

In reality, the S&P 500 has climbed over +140% and is setting all-time record highs since the market bottomed in early 2009. Despite the large volume of erroneous predictions by Rosenberg and his bear buddies, that development has not slowed the pace of false forecasts. When you’re wrong, one could simply admit defeat, or one could get creative like Rosenberg and bend the truth. As you can tell from my David Rosenberg article from 2010 (Rams Butting Heads), he has been bearish for years calling for outcomes like a double-dip recession; a return to 11% unemployment; and a collapse in the market. So far, none of those predictions have come to fruition (in fact the S&P is up about +40% from that period, if you include dividends). After being incorrect for so long, Rosenberg has switched his mantra to be bullish on pullbacks on selective dividend-paying stocks. When pushed whether he has turned bullish, here’s what Rosenberg had to say,

“So it’s not about is somebody bearish or is somebody bullish or whether you’re agnostic, it’s really about understanding what the principle driver of this market is…it’s the mother of all liquidity-driven rallies that I’ve seen in my lifetime, and it’s continuing.”

 

Rosenberg isn’t the only bear blaming central banks for the unexpected rise in equity markets. As mentioned previously, fear and panic have virtually disappeared, but these emotions have matured into skepticism. Record profits, cash balances, and attractive valuations are dismissed as artificial byproducts of a Fed’s monetary Ponzi Scheme. The fact that Japan and other central banks are following Ben Bernanke’s money printing lead only serves to add more fuel to the bears’ proverbial fire.

Speculative bubbles are not easy to identify before-the-fact, however they typically involve a combination of excessive valuations and/or massive amounts of leverage. In hindsight we experienced these dynamics in the technology collapse of the late-1990s (tech companies traded at over 100x’s earnings) and the leverage-induced housing crisis of the mid-2000s ($100s of billions used to speculate on subprime mortgages and real estate).

I’m OK with the argument that there are trillions of dollars being used for speculative buying, but if I understand correctly, the trillions of dollars in global liquidity being injected by central banks across the world is not being used to buy securities in the stock market? Rather, all the artificial, pending-bubble discussions should migrate to the bond market…not the stock market. All credit markets, to some degree, are tied to the trillions of Treasuries and mortgage-backed securities purchased by central banks, yet many pundits (i.e., see El-Erian & Bill Gross) choose to focus on claims of speculative buying in stocks, and not bonds.

While bears point to the Shiller 10 Price-Earnings ratio as evidence of a richly priced stock market, more objective measurements through FactSet (below 10-year average) and Wall Street Journal indicate a forward P/E of around 14. A reasonable figure if you consider the multiples were twice as high in 2000, and interest rates are at a generational low (see also Shiller P/E critique).

The news hasn’t been great, volatility measurements (i.e., VIX) have been signaling complacency, and every man, woman, and child has been waiting for a “pullback” – myself included. The pace of the upward advance we have experienced over the last six months is not sustainable, but when we finally get a price retreat, do not listen to the bears like Rosenberg. Their credibility has been shot, ever since the central bank dog ate their homework.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

April 14, 2013 at 11:11 pm 5 comments

Organizing Your Investment Basket

basket

With the Easter bunny relaxing after a busy holiday, kids from all over are given the task of organizing the candy and money collected during their hunts. Investors are also constantly reminded that their portfolio eggs should not be solely placed in one basket either. Instead, investors are told to diversify their investments across a whole host of asset classes, geographies, styles, and sizes. In other words, this means investors should be spreading their money across commodity, real estate, international, emerging market, value, growth, small-cap, and large-cap investments. As Jason Zweig, journalist from a the Wall Street Journal points out, much of the diversification benefits can be achieved with relatively small change in the position count of a portfolio:

“As many studies have shown, at least 40% of the variability in returns can be reduced by moving from a single company to 20. Once a portfolio contains 20 or 30 stocks, adding more does little to damp the fluctuations in wealth over time.”

 

But wait. Going from one banking stock to 20 banking stocks is not going to provide you with the proper diversification you want or need. Rather, what is as important as investing across asset class, geography, style, and size, is to follow the individual stock strategies of guru Peter Lynch. In order to put his performance into perspective, Lynch’s Fidelity Magellan fund averaged +29% per year from 1977 – 1990 – almost doubling the return of the S&P 500 index for that period.

More specifically, to achieve these heroic returns, Lynch divided the stocks in his fund into the following categories:

Slow Growers: This group of stocks wasn’t Lynch’s favorite because these companies typically operate in mature industries with limited expansion opportunities. For these single-digit EPS growers, Lynch focused more on identifying high dividend-paying stocks that were trading at attractive valuations. In particular, he paid attention to a dividend-adjusted PEG ratio (Price-to-Earnings Growth). A utility company would be an example of a “Slow Grower.”

Stalwarts: These are large established companies that still have the ability to achieve +10% to +12% annual earnings growth regardless of the economic cycle. Lynch liked these stocks especially during recessions and downturns. Valuations are still very important for Stalwarts, and many of them pay dividends. An investor may not realize a “home run” with respect to returns, but a +30% to 50% return over a few years is not out of the question, if selected correctly. Former examples of “Stalwarts” include Coca Cola (KO) and Procter & Gamble (PG).

Fast Growers: This categorization applies to small aggressive firms averaging about +20% to +25% annual earnings growth. While “Fast Growers” offer the most price appreciation potential, these stocks also offer the most risk, especially once growth/momentum slows. If timed correctly, as Lynch adeptly achieved, these stocks can increase multi-fold in value. The great thing about these “Fast Growers” is they don’t have to reside in fast growth industries. Lynch actually preferred market share gainers in legacy industries.

Cyclicals: These companies tend to see their sales and profits rise and fall with the overall economic cycle. The hyper-sensitivity to economic fluctuations makes the timing on these stocks extremely tricky, leading to losses and tears – especially if you get in too late or get out too late. To emphasize his point, Lynch states, “Cyclicals are like blackjack: stay in the game too long and it’s bound to take all your profit.” The other mistake inexperienced investors make is mistaking a “Cyclical” company as a “Stalwart” at the peak of a cycle. Examples of cyclical industries include airline, auto, steel, travel, and chemical industries.

Turnarounds: Lynch calls these stocks, “No Growers,” and they primarily of consist of situations like bail-outs, spin-offs, and restructurings. Unlike cyclical stocks, “Turnarounds” are usually least sensitive to the overall market. Even though these stocks are beaten down or depressed, they are enormously risky. Chyrysler, during the 1980s, was an example of a favorable Lynch turnaround.

Asset Plays: Overlooked or underappreciated assets such as real estate, oil reserves, patented drugs, and/or cash on the balance sheet are all examples of “Asset Plays” that Lynch would consider. Patience is paramount with these types of investments because it may take considerable time for the market to recognize such concealed assets.

Worth noting is that not all stocks remain in the same Lynch category. Apple Inc. (AAPL) is an example of a “Fast Grower” that has migrated to “Stalwart” or “Slow Grower” status, therefore items such as valuation and capital deployment (dividends and share buyback) become more important.

Peter Lynch’s heroic track record speaks for itself. Traditional diversification methods of spreading your eggs across various asset class baskets is useful, but this approach can be enhanced by identifying worthy candidates across Lynch’s six specific stock categories. Hunting for these winners is something Lynch and the Easter bunny could both agree upon.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) and AAPL, but at the time of publishing SCM had no direct position in KO, PG, Chrysler, Fidelity Magellan, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

April 7, 2013 at 12:24 am Leave a comment

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