On HFT, Liquidity, and the Flash Crash

“I think the notion that liquidity of tradable common stock is a great contributor to capitalism is mostly twaddle.  The liquidity gives us these crazy booms, so it has as many problems as virtues.” –Charlie Munger

Today it seems like CNBC has designated high frequency trading and liquidity collectively as the topic du jour.  I find this slightly amusing, because the talking heads on TV and in my Twitter feed who I'd label as perma-bears are the ones complaining most loudly and frequently about market structure, liquidity and HFT.  Market structure is unquestionably something I view to be a problem, although the more long-term investors in the marketplace, the less short-term liquidity is actually all that important anyway.  Short-term liquidity creates profitable trading opportunities, but it in no way impacts the quality (or lack thereof) of an individual long-term investment.  

Liquidity in this context takes on a different meaning than what I think it really should mean.  We have used the term to drive spreads to within a penny on the bid and ask, but has moving from quarter to nickel to penny spreads changed the capacaty for individuals or institutions to make long-term investments?  Liquidity does seriously matter in terms of creating systemic opportunities for investment, but only to a point.  An entire marketplace without good liquidity increases the cost of investment substantially and that's not a good thing, yet, at the end of the day, none of these complaints about HFT are dealing with the fundamental question anyway.  We have plenty of systemic liquidity upon which any long-term investor could accumulate or distribute a substantial ownership interest, but we have a marketplace that is harder to make short-term money off of price spreads.  Those are two different questions.

On the day of the Flash Crash, before it was even dubbed the Flash Crash, I wrote a pretty emotional and frustrated rant, lashing out on HFT and supplemental liquidity providers.  I still think my statements from that day sum up the spectrum of my feelings about HFT.  Without getting into it any further, here's my post from May 6th, 2010, the day of the Flash Crash in its entirety:

So there's a report going around that a Citigroup trader hit the "b"illion button instead of the "m"illion and I just want to right off that bat make clear that not only do I not buy that story, but I am absolutely certain that it is not THE cause behind today's collapse.  I believe today's collapse is a confluence of factors that generated the perfect storm of volatility, chaos and panic.  Here are a few of those factors:

1. Global fear levels are elevated amidst talks of a Greece default and trouble in Spain.
2. Markets traded aggressively higher off of the February lows without a substantial pullback.  This led to large pent up selling demand.  People were waiting for the first downtick to sell, and when the selling begat selling.
3. With high frequency trading accounting for an ever-increasing percentage of total market volume, when the volatility storm, hit the computers shut off.  I was staring right at it in the Level IIs...the bids in just about every stock disappeared.  There was no liquidity.
4. Proctor and Gamble (PG) alone dropped almost $25 points from its intraday highs.  With the Dow being a price-weighted index--with each components $1 move correlating to 7.2 Dow points--PG alone accounted for 180 of the Dows nearly 1,000 point crash.  That's insane for a stable company.   I'm not a huge Cramer fan, but I LOVE what he had to say live on TV: "if that stock is there just go buy it...that's not real...just go buy it!"  Major props to Cramer for speaking some truth and bringing sanity to the panic.

Now just for some personal thoughts during all this and a rant: I got terribly scared today.  The speed with which the market dropped 700 Dow points, I could not help but think the worst.  My head was running wild.  Was there a terrorist attack?  A coup in Greece?  Hedge fund blowup?  Bank failure?  Sure enough there was not a single new story.  Nothing in the world changed!  Well not entirely true.  Trillions of dollars moved around, but absolutely NOTHING really changed.  The state of the economy and I'm sure investor and consumer confidence all took major hits today, but really, NOTHING CHANGED!  Sure it was perfectly explicable that there were sellers and the market went down today, but what happened?

I want to rant about #3 from my list of causes.  A considerable portion of high frequency trading is run by "supplemental liquidity providers."  These SLP's are supposed to be the good HFT programs which step in when bidders leave the market.  They are supposed to provide liquidity when there is none.  SLP programs run each and everyday and are incredibly profitable for their firms.  Sure enough, the largest such service provider and NYSE's primary partner in the SLP initiate is none other than Goldman Sachs.  Where was the liquidity?  What happened!?!?  These SLPs run each and everyday, yet today when liquidity evaporates they're not there?  I saw it.  There were NO BIDS!  Where were you Goldie when we need you?   Not necessarily saying it happened on purpose, but maybe just maybe we'd be better off bringing back a human specialist as opposed to a money-making machine.  HFT is not good liquidity and doesn't seem to play itself out in a market-neutral manner.  It steamrolls on itself.

What an absolutely insane day.  I really cannot explain the emotions that run through while staring at capitalism spontaneously combust and rebound in a matter of minutes.  Yeah we had our 2008 when everything melted down, but that was a process.  There was news.  Things happened.  This was 2008 and 2009 combined into one 5 minutes bar on a candlestick chart.  What a joke.  If this was a computer glitch then bring back the specialists.  It makes everything seem so fake and unreal.  Since when was an economy measured by green and red digitized numbers flashing on a computer screen?  What ever happened to REAL things?  Innovation, production, etc.  Today was/is ridiculous and is a sign of the lack of progress we have made since this "financial crisis" began.

End Rant.

Is Stock Picking Dead?

In these times of macro-volatility, it’s a line heard more each day: “stock picking is dead.”  The reasons listed are plentiful, but all focus on the increased correlations across the stock market and various asset classes today.  There is certainly an element of truth to the notion that in these volatility storms, everything moves closer together, but the claim that stock picking is dead is not a necessary outcome of the idea that correlations are higher.  There are factors that go beyond just what is happening in today’s market that have led to this misguided conclusion that stock picking is dead, so let’s take a deeper look at what’s behind this financially harmful directive.

Just the other day, Jason Zweig, in his Wall Street Journal column, took a look at whether “index funds are complicating the market,” and if so, what the consequences are.   This is an important conversation, and relates directly to whether stock picking is in fact dead, or not.

Who makes the claim:

There are several different groups behind this claim, and they are important.  In terms of economics, one of the core arguments for the efficient market hypothesis (EMH) is the notion that there is no alpha (outperformance), as prices reflect all known information, and therefore it is nearly impossible to beat the broader indices.  In a rational and efficient world, where information is ubiquitous, why would anyone sell to another with exactly the same information?  Or so the EMHers ask.  

In the stock market, indexers are a direct outgrowth of the EMH. Burton Malkiel’s Random Walk is probably the most visible bridge between the intellectual economics community and actual asset allocators.  Indexers carry out the theoretical consequences of the efficient market theory in buying broad baskets of stocks designed to mirror the performance of the economy at large. 

Next up are the class of speculators that call themselves technical analysts.  There are many kinds of technical analysts, and I use technicals as an important tool myself for timing and scaling into positions, as well as a basic risk management tool.   I do not mean those types of technical analysts.  More particularly, I am speaking of the technicians who use technicals as their one and only metric through which to buy a stock.  Stock picking doesn’t matter to these people, because they believe that charts rule the market and therefore only charts matter.  They buy the best looking lines on charts, and sell the worst, without “picking” a company based on its own intrinsic metrics.  Their intellectual ancestors are Charles Dow and Roger Babson.

Last are the perma-bears.  They believe that correlations are high, because volatility is here to stay as a direct result of some sort of serious global economic malady that will lead to the “end of the economic world” as we know it.  You’ll know these people based on their zealotry for gold as an asset class, complete conviction that they know exactly why everything is going to shit when markets are crashing, and ongoing claims that the market is “inflated, manipulated and rigged” whenever prices are moving higher. To them, everything is on its way to zero, so why bother?

Taking the other side:

The EMHers like to ask what information one person could possibly possess that the other does not, leading to the belief that buying Company A’s stock is worthwhile for oneself, while selling Company A’s stock is worthwhile for the counterparty?  The problem with this question is that there are far more reasons why one type of market participant would sell a stock than just a question about the known information pertaining to the value of a particular business. 

This is a crucial point in why the efficient market theory breaks down.  It only works in an environment when people are buying and selling based on the same information, focusing on the same companies, and thinking about only factors related to the underlying businesses.  There are plenty of people who don’t base their decisions on “information” at all, and are acting based on emotion like sellers in a panic or buyers in a bubble.  There are other examples outside the emotional realm: Indexers, macro-traders, technicians, and short-term speculators.  Importantly, in practice, indexing itself is a major source of company-specific inefficiencies, rather than a factual outgrowth of the EMH.  Legendary value investor, Seth Klarman, has specifically referenced his affinity for investment opportunities that directly arise out of inefficiencies during index rebalancing (Hat tip to Distressed Debt Investing), and this is but one example.

Beyond styles, there are many reasons that people may sell (or buy) stocks that have nothing to do with company-specific beliefs.  This list includes, but is not limited to, young workers’ deposits into 401(k)s, retirees selling savings to live off of, and mutual funds that are forced to sell shares in a spin-off which is worth a price below the fund’s mandated minimum capitalization.  All of the above transactions have nothing to do with what the person inspiring the purchase (or sale) of an equity thinks about that one particular company.  Again, this is important.

Why we have markets in the first place:

While financial headlines swing from "the end of the financial world" to dramatic rescues, it's necessary to take a step back and think about what investing in markets is all about.  Stock picking is precisely it. 

When we look to the essence of the stock market, we realize that it is an arena for companies to sell fractional ownership interests in exchange for the capital necessary to build, grow and/or maintain a business (forget for a second that most IPOs today are to cash out early investors).  This is not a transaction based on the belief that one person is wrong and the other right, nor is it a situation where one person must lose at the other’s expense.  It’s really supposed to be a win/win for the buyer and seller—the buyer gets an ownership stake in a company, and the seller gets the capital they need to deploy in order to increase the value of the buyer’s ownership interest.  At the end of the day, unless people are in markets to invest in companies themselves, then everything else is illusory, and that’s not really the case.

Somehow, the meaning of markets has been so greatly abstracted by the proliferation of types of participants that this existential fact ends up forgotten.   In many ways, it’s thanks to actual inefficiencies in markets that people learned ways beyond just investing in businesses in order to make substantial sums of money in capital markets.  This is why they say that “stock picking” aka investing in companies is dead.

Pulling it All Together:

These other strategies have made money for periods of time, but the most consistent through all time periods is investing in strong businesses for the long-term.  This is not to discount the efficacy and importance of other types of analysis.  In some ways, it is the generalist who is most adequately equipped for long-term investment, for knowledge of macroeconomics, technicals, etc. are invaluable tools for an actual company-specific investor.  It’s important for any kind of investor to understand who the market participants are, and why happenings play out as they do.  Use these other strategies as tools to maximize the returns from investing in really solid long-term businesses, not as ends in and of themselves. 

In 2010, I conducted an interview of Justin Fox (now the editorial director of the Harvard Business Review Group) shortly after he wrote The Myth of the Rational Market, a comprehensive review of the history of the competing types of investment theories and how they came together to form competing bases of economic theory.  Fox concludes that Benjamin Graham-style value investing is the only conssitent strategy through all time, but asserts that t is psychologically draining to consistently instill a sense of discipline on oneself, and therefore people tend to float dangerously towards alternatives. The book is an excellent read that traces the history of investing and economics from Irving Fisher to Benjamin Graham to Eugene Fama all the way through the physics-drive Santa Institute.  In my interview with Fox, we had the following exchange that I think very aptly sums up the problem with the question "is stock picking dead" and why the answer is conclusively no:

Elliot: Now, correct me if I’m wrong but one of the concepts that I took to be a semi-conclusion in “The Myth of the Rational Market” was the idea that the Benjamin Graham model of value investing has withstood the test of time, that people who are able to take the information and come up with what they think is a fair value and have the ability to ignore what “Mr. Market” is telling them on a daily basis have an edge over time.  Do you think that’s a valid interpretation?

Justin: Absolutely – I completely think that’s true.  And I think one of the interesting things that is sort of common sense, but that finance scholars have finally started studying and recognizing, is that one of the big reasons for why it’s really hard for a professional investor to stick it out as a value investor is that it requires being unfashionable and going against the crowd.  And unless you’ve either built up this incredible reputation—although even that doesn’t really help you that much in investing as people forget your reputation and a year or two if you fail to beat the market—or you get a situation like Berkshire Hathaway where it’s actually not the investors’ discretionary money that you’re investing, but the cash flow from Berkshire.  There’s really no way anybody can discipline Buffett except over maybe a really long period that gives you the freedom to do it.

The flip side of that is that as an investor you have a situation where there’s such little control over the investment decisions.  That’s the difficult situation that our investors fear. There’s a reason why people invest in mutual funds.  They like the flexibility of being able to take their money out.  But the very fact that they do that, and that if you’re some value fund and it’s 1999, everybody wants to take their money out of your fund regardless of your own performance; that’s exactly why it’s hard to be a value investor, and a good economic reason for why value investing works.  Beyond that is the individual as a value investor.  Obviously, you don’t have to worry about customers but you just need a pretty strong constitution and maybe a different psychological wiring than most people to be able to stick that out.

Links for Thought -- February 17th

The IPO of the Decade? My Valuation of Facebook (Musings on Markets) -- Aswath Damodaran, professor at finance at NYU, takes his stab at constructing a valuation analysis on Facebook.  This is an outstanding post for anyone who has an interest in the Facebook IPO, and even better for those who want to learn the "how to" of valuation analysis from an outstanding teacher.

Memo to Lyle LaMothe: The Die is Cast (The Reformed Broker) -- Josh Brown offers some strong points on why the Registered Investment Advisor (RIA) platform is gaining momentum at the expense of the traditional wirehouse brokers.  Great read on the state of the investment industry today.

Kodak: A Parable of American Competitiveness (Harvard Business School) -- Very interesting analysis of Kodak's decline as a company and what lessons can be drawn for America at large.  A key point is the idea that outsourcing manufacturing resulted in the outsourcing of the means through which people derive innovation.

Allan Mecham: The 400% Man (Frankly Speaking) -- Frank Voisin takes a look at the recent SmartMoney profile on an under-the-radar investor from Utah who has earned a 400% return for his investors over the past 12 years.  Embedded in this post is an interview with Mecham conducted by the Manual of Ideas in 2010 which is a must read on how to become a successful investor (clue: one must think differently than the herd).

Lasry Sees Europe Bankruptcy Bonanza as Bad Debts Obscure Good Assets (Bloomberg) -- This article is as much an expression of Marc Lasry's belief that there are good values to be bought in Europe, as it is a mini-biography on one of my favorites in the investment business.  Lasry is a Moroccan immigrant, who studied hard to become a lawyer and then a successful investor.  A lot can be learned from this man, both as a person and a fund manager.

What Does Declining Gasoline Consumption Mean (Ritholtz) -- With oil prices on the rise yet again, James Bianco bring to light an important fact.  Gasoline consumption in America has been falling since 2007, and recently accelerated the pace of the decline.  What does this mean?  Go ahead and read the link to find out what Bianco thinks.

A Kevin Douglas Update

A few commenters have pointed out the extent of the American Superconductor losses, and they are vast: Mr. Douglas has lost somewhere in the neighborhood of $220 million over the past two years in this position.  The loss is real, and absolutely impacts his performance over the past ten years.  That being said, it’s most likely not nearly as bad as the sticker shock number suggests, considering he first purchased the stock in the single digits in 2006, and did sell 20% of his holdings during 2008 and 2009, at prices double what he first paid, before piling back in during 2011.  Have no doubt, I clearly recognize that the man lost a bunch of money on this investment, particularly of late.  Yet still, what is most impressive is that DESPITE the loss in AMSC, his outstanding gains on Monster/Hansen, IMAX and Westport combined are well in excess of his losses in AMSC, and those are just three of his investments. 

Let me further add that I under-calculated his stake in Monster/Hansen in the original post, as the numbers quoted were based on his personal stake, held in his own name, not additional shares purchased for the Douglas Family trusts, and other family members for whom he invests.  The losses in AMSC are reflective of these other beneficial holders as well, and as such, this greater gain helps provide more context to the AMSC loss.  With this new number on MNST, Mr. Douglas’ initial investment in Hansen was closer to $950,000 and total gains were at minimum $120 million, and realistically more like $150 million considering he locked in some profits during the company’s initial surge in 2006.

Further there remain several significant gains that I glanced over for the purposes of this writing.  One substantial gain was his ~14.5% stake in Rural Cellular Corporation, which he accumulated primarily in the single digits, with buys up to $20.  In 2007 the company sold itself to Verizon for $2.67 billion, or $45/share (the deal closed in 2008).  At the very least, he cashed out $387 million on an investment that was no more than $150 million.  I am fairly certain that I am overstating his initial investment in the company, however I cannot track down an old price chart on Rural Cellular in order to more accurately calculate a cost basis.  I only know dates and filings. 

But I digress.  It is unquestionable that Mr. Douglas has made massive amounts of money on his investments, it’s simply impossible to calculate a) how much capital he was working with; b) what his cost basis was in most investments; c) if he made any investments that did not require SEC filings.  For these reasons, building a composite performance number is in my view, unnecessary to understand the magnitude of Mr. Douglas’ gains and his investment track-record.  Further, let me make explicitly clear that my intentions in writing about Mr. Douglas were two-fold: first, to deliver some accolades to a man who unquestionably has built an outstanding track-record; second, and most importantly to me, to share some of the insights I have gained from my attempt to back into his investment thesis for 10 of his investments, 8 of which were successful, one of which is a failure as of today, and another which in my opinion remains to be seen.  There is much to learn from the process Mr. Douglas undertakes, even when presented with a losing outcome on an individual investment.  

Kevin Douglas – The Greatest Super Investor No One Knows

With everyone reading the 13fs filed last night, we see the quarterly drool-fest over what the super investors are doing.  While it’s interesting to see what others are buying, I find it most interesting to learn why it is they are doing that buying.  Sadly, one of my favorite super investors is a man named Kevin Douglas, and he, as usual, will not be filing any planned 13fs this quarter.  Who is Kevin Douglas?  Odds are you probably don’t know, yet over the past decade he has built one of the most impressive investment track records.  Recently he has received some headlines for his thus far poor investment in American Superconconductor Corp., but even those articles reference the fact that he is little known above any other point (see the Wall Street Journal on the topic).  If you do a Google Search for Kevin Douglas, it’s almost astonishing how little meaty information comes up for a guy who invests tens of millions at a time right now, in the age where Big Brother (aka the Internet) is always watching.

From what I can gather, Mr. Douglas made his initial money as the founder and Chairman of Douglas Telecommunications, a VoiP company.  Beyond that, little is even know about Douglas Telecom (as it is/was known) for even the company’s website no longer exists.   I found one old press release from the company that included a root directory phone number, but that line now leads to a perpetual busy signal.  This only adds to the mystery and intrigue.

Swinging for the Fences, and Connecting

One may ask why I care, and that’s a fair question.  I first encountered Mr. Douglas when he made a substantial investment in IMAX as the company seemed to be in a great deal of distress amidst the financial crisis, crumbling under its debt load accrued a decade earlier during the Dot.com.  IMAX caught my eye at that time, as Dark Knight emerged as a hit on the platform and the catalyst to look deeper was Mr. Douglas, already the majority holder, ponying up for more shares in an equity raise that helped pay down a substantial chunk of the company’s debt load.  Following that move, Mr. Douglas owned nearly 20% of the company and as a result, I dug further into Mr. Douglas’ portfolio holdings and investment track-record to determine whether that was a good or bad thing. 

I was pretty amazed with what I found on two fronts: first, he had an outstanding success rate, as he made money on nearly all of his investments; and second, that nearly all of his successes were home runs.  In baseball terms, this was not your all-or-nothing home run machine like a Jim Thome, nor was it your dinky little singles hitter like Ichiro.  This was something like Barry Bonds in 2001 where each at bat was either a walk (a pass in investment terms) or a home run (greater than 25% CAGR over a substantial stretch of time).

For the most part, the only known investments by Mr. Douglas are in situations where he has taken in excess of the 5% ownership interest reporting threshold by the SEC, and as such, any picture is inevitably incomplete.  That being said, by all appearances, when Mr. Douglas invests, he buys big and keeps on buying, plus he operates a fairly concentrated portfolio in companies with market capitalizations under $1 billion.  He owns enough of companies to safely say that he doesn’t trade at all around the holdings, and sits tight as his money works for him.  It’s this last element that is particularly impressive.  He sits tight amidst volatility, he sits tight holding losses, and he sits tight holding massive gains.  Patience is the man’s best friend. 

Known investment successes include Hansen Natural, now Monster Beverages, Westport Innovations, Jos. A. Bank, Stamps.com, IMAX, and SilverBirch Energy, with one seemingly large failure in American Superconductor and a remains to be seen, although losing position in Cree Inc. right now.

Monster Beverages and Westport happen to be two of the market’s top performers over the last two years, and they just so happen to be two of Mr. Douglas’ most noteworthy investments.  In Monster Beverages, formerly Hansen Natural Corporation, Mr. Douglas bought 329,719 shares at an average price of $0.58 between 2003 and 2004.  At today’s share price of $109.68 that represents a 92% CAGR, having turned around $190 thousand into a sum greater than $36 million (Hat Tip to Stockpup for the cost basis info).

With Westport Innovations, Mr. Douglas accumulated 18.5% of the company’s shares, at prices between $12.95 and $20/share.  Let’s assume an average price of roughly $18/share (which is high if anything considering he had plenty of purchases, most of which happened below that price), that represents a 144% return over the last year and a half.  Whereas Monster/Hansen generated a stellar return on a relatively small sum, Mr. Douglas put over $150 million to work in WPRT and thus far has seen an equally lucrative outcome in terms of percent return, and a far more impressive outcome in terms of gross return.  Don’t underestimate for a second how hard it is to double $150 million in contrast to any number in the thousands.

How Does he Do It?

Considering how little is known about Mr. Douglas, it’s hard to know exactly how or what he looks for in an investment.  However, I have spent a decent amount of time digging into each and all of his known investments during since 2003 and drawn several conclusions.  First, it’s most clear what Mr. Douglas doesn’t look for.  He doesn’t look much at all at economic forecasts, or anything of that kind, and further, Mr. Douglas is neither a traditional “value” nor “growth” investor.  In many respects, he operates far more like a venture capitalist operating in public markets, than a traditional equity strategist.  Incidentally, the only clear-cut theme one can glean from his present holdings is that Mr. Douglas has a “thing” for Canada, as many of his investments are companies domiciled in Canada.  Yet, that appears more of a coincidence than anything else, and is most likely reflective of the fact that many American investors turn to “sexier” countries like the BRICs when looking abroad, while ignoring our neighbor to the north. 

My intuition after reviewing as many investments as I can is that Mr. Douglas first assesses a company’s addressable market and then assigns probabilities based on the likelihood of the company capturing different portions of the addressable market.   For example, let’s say we’re talking about a company with a $20 billion addressable market.  He would then assign probabilities for the company to capture that market opportunity.  For example, let’s say there is a 20% chance that the company captures 50% of the market, a 50% chance of the company capturing 30% of the market, and a 30% chance that the company captures 10% of the market, he then calculates the weighted average of the future revenue base (.2*$10) + (.5*$6) + (.3*$2) = $5.6 billion.  So long as the company is worth less than the present market capitalization grown at his target rate of return (let’s say 25%), he will invest.  For a $5.6 billion market opportunity five years down the road, that means Mr. Douglas will be buying so long as the company is worth less than $1.8 billion today, Mr. Douglas will be buying. 

Each of these investments are positioned for some kind of secular super-trend, some of which people knowingly acknowledge and talk about, others of which Mr. Douglas is clearly early in recognizing the opportunity.  All in all, there are two key elements to his analysis: first is the subjective analysis of the companies’ business and market opportunity, and next is the objective mathematics, based on probabilistic outcomes and his CAGR objectives.   It is in these subjective metrics that his skill is clearly superior.  His ability to identify and quantify market opportunities for his portfolio companies is simply uncanny.   Whether it is energy drinks, fine men’s apparel, digital postage or a movie display platform, Mr. Douglas has tremendous skill at identifying the largest market opportunities, targeting the company best positioned to prosper, and quantifying the investment upside in order to make a concentrated wager.  Call me impressed.

Mr. Douglas, if you’re out there and reading this, I would love to get in touch with you in order to learn a little bit more about your investment background and process.

Update: I have added a follow-up post to give some more color and background on the AMSC loss and the HANS/MNST gain.  Plus I added a brief little bit about Mr. Douglas very successful investment in Rural Cellular Corp.  Be sure to check it out.

Author Disclosure: Long IMAX, CREE