Third Avenue Fund’s Marty Whitman on Ben Graham and high frequency trading (HFT).
Letter from the Chairman
Dear Fellow Shareholders:
High Frequency Trading (“HFT”) has been on the front pages of the financial press ever since the publication earlier this year of Michael lewis’ book, Flash Boys. The book demonstrates once again how difficult it is to prosper as an investor in markets where longer-term fundamental analysis of companies and securities are ignored. The ways most market participants who lack specific knowledge about individual companies and the securities they issue can prosper seems to encompass at least one of the three factors:
1.) Front running, which is the principal topic of Flash Boys. Have information about buy or sell order flows before such orders are executed, and place your order before the other orders are executed.
2.) Obtaining and using inside information either about prospective market events or corporate events or announcements.
3.) Getting large compensation off the top in the form of commissions, management fees incentive fees, interest income on credit balances, fees for order flows, and /or trading spreads.
Understandably 100% of high frequency traders, as well as the vast majority of other market participants (with the exception of those engaged in risk arbitrage), have little or no interest in becoming knowledgeable about individual companies and individual securities. after all, fundamental, underlying, factors seem to have no impact on immediate security prices.
Most market participants just are not in a position to make determinations about intermediate to long-term fundamental values, which requires a detailed study of companies and the securities they issue. rather, most market participants have to be short-run oriented. Virtually all of academic finance involves only the study of markets and market prices; for academics the study of companies and the securities they issue tends to be somebody else’s business. For those involved with “sudden death” securities short-run considerations tend to be the only factor that makes sense. This lack of interest, especially by traders and finance academics, is understandable. “Sudden death” exists where an investment situation will come to a definitive end in a relatively short period of time, say, call options are to expire or a merger transaction is to conclude. “Sudden death” securities and situations include options and warrants, risk arbitrage, short maturity credits, many credits likely to suffer a money default, heavily margined portfolios, and situations where the investor and his advisers know little, or nothing, about the companies in which they invest. in contrast, emphasis on determining intermediate to long-term values and dynamics is a necessary approach in value investing, control investing, most distress investing, credit analysis, and first and second stage venture capital investing.
It is extremely hard to use most conventional security analysis – see Graham & Dodd – and be focused on determining underlying fundamental values for common stocks. This is because in most conventional analysis, four factors tend to be so overemphasized for non-control investors that they lose sight of underlying, long-term values and the underlying dynamics of businesses. These four areas of overemphasis in conventional investment approaches seem to be as follows:
1.) a belief in the primacy of periodic earnings in determining value or prices whether those periodic earnings are cash flows from operations or accounting earnings from operations. There probably is no one factor in the accounting cycle that deserves primacy in the analysis of an individual company, but if there were, the one i’d pick would be credit worthiness, rather than earnings, certainly subsequent to the 2008 financial meltdown.
2.) a belief in short termism. if one is acutely conscious of securities price fluctuations – whether hourly, daily, weekly, monthly or annually one, per se, has to be focused on the short-term. if the market participant believes that the market knows more about a particular security than he or she does, that participant ought to place great weight on security prices and the short term. The guts of value investing and control investing, however, revolve around the conviction that the market participant knows more about the security than the market does. The opposite is true for traders as well as most other market participants.
3.) a belief that top-down considerations, such as predicting the business cycle, the Dow-Jones industrial average, inflation, and interest rates, are far more important investment considerations than are bottom-up factors, such as the strength of corporate financial positions, access to capital markets, earnings, or the price discount for a common stock from net asset value (“NaV”). The actual times when top down factors seem to have been actually more important than bottom-up considerations for long-term investors seem to have been few and far between – say, 1929, 1933, 1937, 1969, 1974, 1987, 2000 and 2008.
4.) There is a belief that securities markets reflect a price equilibrium. at any time, the prices for securities are right (i.e., efficient) and will change only as the market digests new information. What nonsense! For the value investor, as well as the control investor, most prices are wrong most of the time and most short-run price changes are merely random walks. How can one gauge whether a price is right from an intermediate to long-term point of view unless the particular security and issuing company are examined in depth? admittedly, the market for equities where “sudden death” conditions dominate tends to be highly efficient but the problem faced by academics, traders and conventional analysts is that they apply valid reasoning for “sudden death” situations to all investments. Traders are not equipped to conduct such examinations in the secondary market; value investors and active investors are. if you are a high frequency trader who makes, say, ten trades a day, how can you possibly have fundamental knowledge about the securities you are trading? Someone like Warren Buffett probably undertakes no more than ten new investments a year – forget about 10 a day.
According to Flash Boys, investors are being ripped off by High Frequency Traders who, on any trade, front run for a profit of, say 1¢ to 5¢ a share. While this view has validity in regard to average traders, it is an utterly immaterial consideration for buy-and-holdinvestors, such as those managing Third avenue portfolios.