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West Coast Asset Management - High Frequency Trading May Be the Friend of the Value Investor

October 27, 2010
CanadianValue

CanadianValue

211 followers
I used to notice West Coast Asset Management speaking at the various Value Investing Conferences in 2007 and 2008. It has been a while since I have seen anything public from them. I think they likely had a pretty rough 2008 given some of their concentrated energy bets and I hope that isn’t the reason why. They had some interesting ideas and had performed very well heading into 2008.


I first was introduced to ATP Oil and Gas (ATPG) while reading a book written by the WCAM guys. They had made ATP a position after coming across the company’s employee challenges that rewarded everyone in the company with a new car if certain performance objectives were met. They were impressed with the program to match employee motivation with company objectives and liked the discount to Net Asset Value that the company was selling for.


I still regularly read WCAM’s monthly newsletter as it often contains some interesting thoughts. This month they discussed High Frequency Trading. Some of their more interesting observations were as follows:


History and Backdrop


Most people are well acquainted with the stock market crash that occurred on October 19th, 1987 in which the Dow Jones dropped by 508 points or 22.61%. After the fact, the


largest one day percentage decline in the market’s history was mainly blamed on portfolio insurance. This was a risk management tool that employed stop losses through automatic, computer-based selling. Unfortunately, the prevalent use of strategy caused a cascade of selling once the market started to drop. Hindsight being 20/20, commentators who opined on the events of the day claimed that the outcome was obvious and predictable. Clearly it should not have been a surprise that indiscriminate selling by computers could cause the market to plunge. How could anyone have believed that thoughtless machines controlling the most important stock market in the world was a good idea?


Now, here we are almost 23 years later and apparently we have learned nothing from our past mistakes. In fact, computer trading programs, or algorithms, now dominate the day-to-day trading on the major exchanges. While it is difficult to quantify precisely, most estimates suggest that what is known as high frequency trading (HFT) makes up between 50% to 75% of all trades1. Let us say that again: Robots trading shares in between one another now accounts for anywhere between half and three-quarters of market activity on a daily basis. So much for fundamental, bottoms up investing.

What is High Frequency Trading ?


Investopedia.com defines HFT in the following manner2:


“A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds.”

Basically, companies engaged in high frequency trading use trading speed and sophisticated computer programs to create an advantage over other traders. The specific strategy of many of these programs is to use superior technology to make pennies or fractions of pennies on every trade. This process, which is kind of like collecting pennies in front of a steamroller, may not seem particularly lucrative until you realize that there are billions of trades executed on US stock markets each day. A billion pennies sure adds up over time.

Why is High Frequency Trading Tolerated ?

If it sounds like these firms profit from an unfair and uneven market structure, it is because that is precisely the case. But why is this inequity tolerated and often cited as a positive thing?

The common defense of firms who utilize HFT is that these algorithms are providing liquidity, a measure of the degree to which a stock can be bought and sold without affecting the price. Generally, the more liquid a stock, the easier it can be traded without causing huge swings in the price.



As long as the liquidity is real and those who provide it are committed to it, greater liquidity can be very beneficial to investors. Specifically, it can lead to lower bid-ask spreads (which can lead to lower costs of trading) and a greater ability to move into and out of cash when investors so desire.

Who are the Major HFT Players ?

Want to know who the major players are? Well, according to NASDAQ’s website, the top five liquidity providers for the NYSE as of July 2010 were Wedbush Morgan Securities, GETCO, Citadel Securities, Merrill Lynch and UBS Securities.

And Why it Might Help You the Value Investor

West Coast Asset Management engages in bottom’s up value investing. Our belief is that if you buy shares of a company at a price less than their intrinsic value, the market will eventually appreciate the fundamentals of the company and bid the price up near the stock’s true value. But what does it mean if 50% to 75% of trading comes from predatory robots trading shares back and forth? It means that shares are not necessarily trading based on economic or company-specific factors in the short term. The irony is that this dynamic may actually create opportunities for value investors. We invest based on the notion that markets are often inefficient in the short run but that the market’s pricing mechanism functions properly in the long run; allowing us to profit from the contrarian strategy.

Accordingly, if the presence of the HFTs causes temporary dislocations in price of individual securities, we may be able to take advantage and generate excess returns for our clients. Additionally, if the HFT algorithms begin to focus on a stock that previously had not been particularly liquid, investors who own that stock could benefit from the increased tradability of the security.


The entire article and prior WCAM newsletters can be found here:


http://wcam.com/files/wcam_excloutlk_nwsltr_october2010-final%20post.pdf




About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 3.3/5 (6 votes)

Comments

DocMoney
DocMoney - 4 years ago
High frequency trading is nothing but front-running and should be made illegal immediately. The liquidity argument is BS - it's like saying that urinating in the pool adds liquidity to it. Also, when the market conditions are not optimal for them to skim money off the top, this so-called liquidity dries up in a hurry.

http://moneymorning.com/2010/10/26/wall-st-bonuses/
mla
Mla - 4 years ago
It does seem like HFT has the potential for more harm than good.

Couldn't the exchanges incorporate a short random delay in their queuing process? In other words, a trade could be delayed anywhere from 0 to 200ms or somesuch. That would effectively put everyone on an equal playing field, no?

edp2005
Edp2005 - 4 years ago


















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