Friday, April 4, 2014

Is the Market Rigged?, $75 Oil, and Bank Lending-

The Sixty Minutes program on Sunday night about High Frequency Trading, based on the book "Flash Boys: A Wall Street Revolt" by Michael Lewis, has become the central focus of the investment community.  Today, Attorney General Eric Holder announced an investigation into the improprieties involved with HFT market makers.  Accompanied with the Justice Department query is an additional look by the Securities and Exchange Commission.  Several CEO's of large companies like Charles Schwab and Toronto Dominion Bank have jumped into the fray by stating they believe high frequency trading should be banned.

There are many issues involved with high frequency trading, but much of it centers around broker dealers using technological advantages of high speed fiber lines, superior software design and coding, and the implementation of routing techniques to either front run trades, create dummy transactions and use the information to arbitrage price differences between dark pools and the the open market, or a combination of the two schemes.   Mr. Lewis's book and the 60 minutes piece, while attracting a lot of attention and selling quite a few books, ignore the past five to ten years as this has been taking place for quite some time.  Wall Street brokers have always benefited by scalping more than their fair share from investors, the difference here is the spreads are narrow because of decimalization and computer trading.  History has shown for a hundred years the investment banks, exchanges, and broker dealers control the the mechanics of buying and selling securities.  If you have read Warren Buffett's and Charlie Munger's opinion's on trading and why investors should minimize it, as well as the fact they have long thought high frequency trading was front running, none of these issues are surprising.  What is surprising, though not shocking, is how long the regulators have not been paying attention.

Even further, using the term that "the market is rigged" is also in many ways quite irresponsible.  At no point during the television segment was any kind of attempt made to break down what the capital raising process is, what ownership of a stock is, how many people own stocks, and then tie trading costs into any of these basic principles.  Also, at no point was anything mentioned about what the alternative to the "rigged market" might be.  If you are advocating the market is rigged, the logical conclusion for a viewer would be to stay away from that entity.  If you stay away, where else might you go?  How might staying away from the nefarious activity affect life goals in the future?  At a time where the general public has very little faith in stocks, irrespective of the massive gains for shareholders over the last five years, the media's sensationalism make any kind of a rational and fact based discussion difficult.  During the week, Mr. Lewis and the protagonist of his book, who set up a competing exchange free of conflict and one which neutralizes HFT advantages, and the CEO of a competing trading company lined up on CNBC to have a discussion about the matter.  Naturally, the result was a vigorous argument about the merits of HFT trading by those involved. The bottom line is high frequency trading is indeed not good for market participants as it raises the costs of buying and selling assets, and allows some to benefit at the expense of others in what can be viewed at as a zero sum game.  However, I might also point out the guys who are the sharpest and wealthiest investors, Buffett and Munger, made their money investing capital in equities.  Speaks for itself, I'd say.

The jobs report today was not the greatest, and the market continues to sell off hard, especially in momentum, technology, and biotechnology related names.  The lack of any kind of accelerated strength for job creation continues to lend fuel to the fire that the current policies being employed are at best inefficient and not well thought out.  The only real job creation which took place was from the private sector, what a shock, huh?  The misguided notion of an enlarged role for government is the underpinning of the Affordable Care Act, which has recently made headlines about meeting the seven million enrollment number.  One notices nobody mentioning the number of those who have made their premium payments.  I suspect the chicken has yet to come home to roost on the public's verdict of the Affordable Care Act.

In the oil market, the continued movement to rationalize portfolios and asset ownership by the large integrated oil companies is occurring all over the globe.  Whether it is in North America, Europe, Africa, Australia, or Asia, the largest oil enterprises are starting to make the hard decisions about what assets they want to own and where they want to own them.  Whether it is Shell selling in Nigeria, BP closing down a refinery in Australia, or Exxon scaling back projects in North America, big oil knows their capital investment programs and returns on capital are going to evaluated very closely every earnings report and year, and it will probably not change for quite some time.  As a shareholder, these are good things as capital allocation decisions are always crucial for the future, no matter how large the entity is.

Barron's had a cover article last week on the increased possibility of $75 oil because of technological improvements in a variety of different ways to potentially increase the supply of oil in the future.  Some of us who majored in or studied economics also know there is another part of the equation, which is demand.  I would argue the Barron's piece missed the demand side of the equation and where the growth of demand will go, especially in Asia. The largest oil companies all predict the majority, if not all of the expansion of demand will take place in Asia.  If you look at the projections of both supply and demand, it is hard to see how oil goes to $75, unless supply absolutely explodes.  In addition, there is the additional variable which has to be considered, and that is how oil gets moved.  Given the fact that we in the United States currently have been waiting six years to find out whether the Keystone pipeline will be approved, a point recently made by Boone Pickens, lets just say our ability to streamline the process for different ways to move oil and gas ain't exactly perfect.  Some in Europe want the U.S. to just start shipping liquid natural gas to help relieve Europe's dependence on Russia's Gazprom.  Seems like a good idea, right?  You would think Mr. Obama would endorse it and go with it.  Even if he did, it takes five years to start making the terminals and planning the logistics to build the facilities.  The private sector is itching to get it done and has been for years.  The problem is the leadership and it's loyalty to a constituency which does not understand the strategic importance of energy.  Yes, the environment matters, and the future of the planet is important.  No one denies it, and the oil companies work in nearly every kind of environment there is.  In fact, the engineers and scientists from the largest energy companies probably care as much or more about the planet then those who continually criticize and complain about them, including the pandering politicians.   The political positions in the United States and Europe regarding energy continue to leave our citizens in a far weaker situation than we ought to be.

Elsewhere in the market, it seems some believe bank lending might be turning a corner.  Mortgage lending is still a problem and is showing contraction, but business lending is expanding.  Any expansion of interest rates would improve banks net interest margins, and the large money center banks would benefit immensely if it were to materialize.  Last week the regulators gave the red flag to Citi's capital plan and turned down a potential dividend increase. The fact Citi let $400 million dollars of loans go misplaced in Mexico I am sure did not help their cause.  Prudent lending is not an easy job, and don't the boys at Citi know it.  Having gone through four CEO's in six years do not inspire confidence, let alone having an equity lose ninety percent of it's market value.  Still, Bob Rubin and Sandy Weill get no heat, so I guess, as they say, timing is everything.

Thank you for reading the blog this week, and I am sorry it took so long to post.  Any comments, thoughts, or questions on the material are most welcome and please share them!

Y H &C Investments, Yale Bock, and the family of Yale Bock own positions in securities mentioned in the blog post. Investing in stocks can lead to the complete loss of your capital. As always, on any company mentioned here, past performance is not a guarantee of future returns. Investing involves risk of losses on invested capital. One should research any investment and make sure it is suitable with your objectives, risk tolerance, risk profile liquidity considerations, tax situation, and anything else pertinent to your financial situation. Also, the CFA credential in no way implies investment returns will be superior for any charter holder.

Saturday, March 22, 2014

Dead Money Disses, IPO Heaven, and Buffett's Billion Dollar NCAA Tournament Bracket-

"Dead Money" is the term derisively given to an investment which does nothing (like the current President and Congress of the United States, but that is an all together different matter).  The worst thing for anyone investing capital is to plunk your hard earned money down, and then watch the asset lose 20-50% of its value very quickly.  If you do your homework, having a bad experience like this should be the exception but not the rule.  Once in a while it happens to even the best investors.  Look at what happened to Warren Buffett with his investment in TXU bonds, it went south real fast.  Ackman's short of Herbalife cost him at least 25% last year, and that is starting to change, but still, the position went against him very quickly. Still, these kinds of experiences are not something anyone wants to get accustomed to.  However, probably much more common is the idea of "Dead Money."

Of all the situations investors have to handle the most, a non performing asset has to rank up there as the most common and the most frustrating.  When you own something for one, two, three, five, or even more years, and it gives you no benefits, well, an intelligent person has to question why they own it.  My own opinion is dealing with the non activity portion of investing is incredibly important if you do want to have better than average returns.  In all too many situations, while an asset may not increase in market price for a long time, the fundamental value of the company may be growing quite substantially.  The disconnect between market value and business value gets overlooked by those who have to see market price gains to think they made a good investment decision.  Then, with no announcement, and no fanfare, the pet rock which you thought you owned suddenly starts to become your favorite item in the whole world.  The next time you hear anyone, especially traders, start pontificating on the "deadness" of a specific company, you might take a very good hard look at that particular area. 


Janet Yellen's commentary this week sent the market into a bit of a tizzy on the idea interest rates might actually get increased sometime before the next century.  Still, I find it questionable, at best, that the difference between 2.6875% and 2.87986% on the 10 year bond is going to be your determination on whether you want to own a risky asset like a stock.  If it were judging between 2.6875% and 12%, I could see the concern.  Since we are nowhere near that variance in interest rates, well, some people might want to just calm down a bit.


The IPO activity and pipeline keeps getting more active as it certainly is time to cash in for a few lucky groups.  The investment banks and Silicon Valley venture capital firms have to be loving 2014 as the dollar bills keep raining down from the skies.  Can you just imagine what will happen when Pinterest and Dropbox get ready to go public?  Dropbox has raised capital at a late stage value of $10 billion.  By the time these companies get ready to have an IPO, you could be looking at $30-$50 billion dollar valuations.  If WhatsApp is worth the $19 billion Zuckerberg paid for it, and they don't have much revenue, well, consider Pinterest's sales pitch to the investment bankers.  We have X in revenue and Y in cash flow and Z in users, so we are worth G(azillion).   The bankers just nod their heads and go, kaching, kaching, kaching, in the hope they are selected as the lead underwriter in the syndicate.  Now, if you are buying these IPO's in the hope of an appreciating asset, make sure you do your homework very carefully bv reading the prospectuses, if you can get your hands on one.


Elsewhere in the market, the Biotechnology sector had a very rough go of it during the past week.  If ever there was a sector which most closely resembled a dice game, small cap biotechnology would have to be it.  I am not saying it is impossible to do well in this area.  In fact, over the last year, it would be very interesting to see how it performed versus a regular small cap index or the S&P 500.  However, the analyst part of me has to bring up the fact that many of these companies have no revenues, no cash flow, and may have drug pipelines which are limited to a few compounds, and in many cases, only one drug.  Even worse, they are merely at stage one or stage two of the FDA licensing and approval process, and there are usually all kinds of twists and turns in navigating that obstacle course. Consequently, I don't even bother to touch biotech as it is hard enough to invest in companies with revenues and cash flow, let alone those which have none.


Apparently some banks and those in charge are starting to rethink their opinion on Apple as the prospects for the I-phone 6 and a larger screen may be better than originally thought.  I also would note it will be interesting to observe how the retail part of Apple is coming along under ex-Burberry chief Angela Ahrendts.  If you combine these things with a new China Mobile partnership, and any innovation in products like the I-Watch, I-TV, I-Car, I-Plane, or I-Underwear (oops, you get the point), well, let's just say don't count out the big shiny red object crew just yet (yes, my company owns Apple for clients).


Finally, the NCAA Tournament began this week and like always, it proved to generate massive interest.  Warren Buffett's Billion Dollar Bracket challenge also created plenty of enthusiasm as the potential billion dollar prize has more than a few people curious, to say the least.  As of this writing, it seems Mr. Buffett's ability to calculate the risk reward ratio of a premium payment weighed against the odds of a winning contestant is quite good.  There are no possible winners thanks to the fine efforts of Harvard, Mercer, and the hard working lads at North Dakota State, among others.  Maybe next year.

I hope everyone has a great spring and thank you for reading the blog this week, I very much appreciate it.

Y H &C Investments, Yale Bock, and the family of Yale Bock own positions in securities mentioned in the blog post. Investing in stocks can lead to the complete loss of your capital. As always, on any company mentioned here, past performance is not a guarantee of future returns. Investing involves risk of losses on invested capital. One should research any investment and make sure it is suitable with your objectives, risk tolerance, risk profile liquidity considerations, tax situation, and anything else pertinent to your financial situation. Also, the CFA credential in no way implies investment returns will be superior for any charter holder.