Paul Krugman on The Size of Finance

I don’t always agree with Paul Krugman, but in this op-ed from a couple of days ago he makes some good points about the size of the financial services industry. He’s prompted to do so by Michael Lewis’s new book Flash Boys (although Paul Krugman probably needs little encouragement to whack Wall Street). But the dead straight tunnel from Chicago to New York, built that way to save milliseconds off the time it takes to transmit a market order between the two cities, may be the catalyst that draws a needed review of all this computerized trading activity. The fact that the tunnel was apparently a good investment highlights that the market is not as focused on serving end-users as it should be.

As Krugman points out, drawing on work by Thomas Philippon (whose research I found helpful in writing Bonds Are Not Forever) the financial services industry has grown much faster than GDP since 1980 and the abovementioned tunnel inspires one to question whether more is always better for this sector. Channeling savings to productive forms of capital formation is society’s legitimate objective; the less this is done, the greater should be the subsequent public policy examination of financial services.

The Regime Shifts From Momentum to Quality

Making short term market predictions is a fool’s errand, and consequently we don’t do it. Investing for the long run is hard enough without being confused by all the pundits on cable TV. But underneath the visible noise of market direction an interesting shift is taking place.

We tend to own stocks that are less exciting than most on a day to day basis. Typically these are companies that have at least a decent prospect of generating long term capital gains rather than the more highly taxed short term gains that result from rapid moves. This approach worked reasonably well last year but when the S&P500 is up 32% it’s unlikely that the slow and steady approach will do as well, and it modestly lagged. The bias of investors towards growth over quality dates back to about July the way we measure it.

Over the past month we noticed that the prevailing relationship was shifting, and that low beta, or low volatility stocks were beginning to outperform (noted in our April newsletter). It seemed to coincide with the satiation of so many investors keen to get into the market before the opportunity was missed (although this last piece of evidence is highly qualitative). Some of the worst performers (Facebook, Netflix, Tesla) are of course some of the previously most loved names.

Mike Cembalest at JPMorgan Asset Management  writes intelligently about many aspects of investing. Most recently he put numbers on this phenomenon by noting that on a market cap weighted basis valuations were at a fairly modest 55th percentile P/E of trailing earnings (using data going back to 1983), whereas the median stock’s equivalent P/E was at the 80th percentile. Since larger cap stocks tend to be more stable than mid-caps, it’s a neat way of capturing their relative valuation difference.

Recent market moves have been in the direction of narrowing this gap. We’ve seen this in the our own investment strategies. Generally such regime changes last at least several months, so while we don’t know where the market’s going over the next few weeks, it does appear to be a decent bet that the recent bias away from high growth will continue a good while longer.

The Developing Student Debt Crisis

Last weekend’s Economist examined the pay-off for students of the investment they make in various degrees. It’s the kind of unsentimental return analysis that needs to take place far more often. Not surprisingly, Engineering graduates enjoy anywhere from $500,000 of additional lifetime earnings to over $1 million (depending on the school from which they graduate). At the other end of the scale an arts graduate from a state school in Kentucky is, after paying for college, worse off than a high school graduate.

No doubt some will quarrel with the numbers, but the toxic combination of plentiful financing for students and tuition inflation that bears no relationship to the economy at large has resulted in debt burdens for thousands of young people that are disproportionate to their ability to pay them off. Making it almost impossible to default on college debt served the admirable public policy purpose of making loans more available, but it’s also resulted in young people taking on mortgage-sized obligations before they were old enough to buy a beer (though who could blame many for making up for lost time as they contemplate their finances?).

It’s a sobering thought when one discusses such issues with the children of friends – I had one such conversation very recently, and the best advice I could offer was to seek a renegotiation of existing debt. In fact, the true villains in this sorry spectacle must be the colleges themselves who have allowed their expenses to rise uncontrollably while their young and generally poorly informed customers sought higher education on virtually any terms available without regard to the return on investment. Institutions of higher education seek to educate, except on the basic economics of whether their young charges are investing their time and money wisely. Surely every applicant for a college loan should receive a disclosure of salary ranges for graduates in their chosen major and years required for repayment?

In my book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors I highlighted the sharp growth in tuition debt and noted how unsustainable it was. It shouldn’t be surprising if over time it becomes a political issue that eventually leads to the inevitable discussion of a Federally-funded bailout of some type. When I researched the issue in 2012-13, tuition debt outstanding was $1 trillion. It’s still growing. It’s another section of the population that is poorly equipped to handle higher interest rates, and shows why “low for a long time” is a pretty good description of the Fed’s intentions for policy rates.

The Truth Behind Discount Brokerage

Since I read Flash Boys, those ads for discount brokerage now appear differently to me. I used to think that when, say, TD Ameritrade offers commissions of $9.99 a trade it’s because their platform is so efficient, so geared to enjoy economies of scale, that this low rate was sufficient to generate revenue in excess of its costs. But after reading Michael Lewis’s latest book it’s now dawned on me that an important element in the business model of these firms is to sell their order flow on High Frequency Trading (FHT) outfits or “dark pools”. The payment for order flow concept is a market-based recognition that many investors represent a reliable source of profit for the counterparties to their trades over and above the commissions they pay. So the $9.99 commission doesn’t represent the full return to (in this case) TD Ameritrade from their participation in your business.

It’s all naturally legal and therefore held to be beyond reproach. And perhaps the clients on such terms are naive for assuming that their visible cost of execution (i.e. the commission) was the only cost. But wouldn’t most people like to know if their orders were in effect the subject of a bidding war among the HFT crowd? Wouldn’t you think that the broker is getting you best execution not in the literal sense as defined in the regulations, but actually setting about to do that? If a discount broker can sell your orders on to a profit-seeking algorithm, they may still be providing you with a service but are not obviously working in your best interests.

It just seems as if there’s been a colossal error of judgment. The client might well be staggered to comprehend the economics of the online broker. The HFT apologists are no doubt equally shocked that anybody else is shocked. Hasn’t all this been disclosed? Well, technically I guess it has, but you can’t blame the average retail investor for wondering who they can trust. The brokerage model is full of the potential for principal-agent conflict. Dark pools and HFT algorithms are the latest manifestation. At a minimum, this is a PR disaster. The burden of proof is on those who equate volume with liquidity, who find nothing offensive in computer software being implemented to front-run orders. When it’s worth $300 million to build a perfectly straight fiber-optic line from Chicago to NY so as to transmit orders in a fraction of the time it takes us to blink, the casual observer may be forgiven for assessing that something is very wrong.

High Tech Front Running

In his new book Flash Boys, Michael Lewis describes how Brad Katsuyama at Royal Bank of Canada deduced what the high frequency traders were doing. Brad had been frustrated that whenever he went to trade stocks on a posted price, he’d routinely get a much smaller amount of shares than advertised. 10,000 shares of stock may be offered on several different exchanges and yet he would wind up with a fraction of that.

It turned out that his order was reaching different exchanges at different points in time. Mere milliseconds separated the time at which his orders arrived at each exchange, and yet this was sufficient to allow the HFT traders to see his order when it arrived at the first exchange (BATS), and then swiftly move to buy in front of him at the other exchanges where his order arrived less than a blink of an eye later.

Brad figured this out by inserting software that slowed down his order from reaching the closest exchange, thus ensuring they all arrived simultaneously. When transmitted in this way he was generally successful in trading the amount of shares advertised.

So nice move by the HFT crowd. Very clever, you’ve made your money. It ought to be illegal but of course technology has outpaced the regulatory framework that forbids front running. It’s obviously wrong. This is why the claim by HFT proponents that they merely provide liquidity is so disingenuous.



Flash Boys

I eagerly read anything that Michael Lewis writes. He must be one of the most erudite and entertaining writers of our time. From Liar’s Poker on he’s produced books and essays that are highly entertaining as well as informative. I even enjoyed Moneyball, even though as a Brit I know very little about baseball. It was that good.

So now that he’s turned his focus on High Frequency Trading (HFT), let’s hope it causes a reaction. I’ve always felt that there was little social utility and possibly worse in trading systems that need physical proximity to the exchanges in order to reduce the latency in their order transmission. It’s always looked like high tech front-running, although the data to show this conclusively has been frustratingly absent.

On 60 Minutes last night Michael Lewis discussed his new book – out today so I have not had an opportunity to read it yet. But his description of HFT firms viewing orders and then buying/selling in front of them was compelling. I hope it draws greater regulatory scrutiny. For our part, we almost always enter limit orders rather than market orders. Although this doesn’t make us immune to the transaction tax that HFT likely represents, it’s harder to exploit a participant who has a price at which they’ll trade and doesn’t improve it in response to changing market prices. We’re willing to buy at $50.25, and if we get hit fine but we’re not going to chase it to $50.30. A market order to buy that begins at $50.25 can provoke HFT firms to bid $50.26 or $50.27 in less than the blink of an eye, causing the market order to pay a few pennies more than otherwise needed, perhaps buying from the HFT firm at $50.30. A limit order is less vulnerable but by no means totally immune.

We think that provides us some protection, but we’d all like to know that it really is a level playing field. It also highlights the morally bankrupt activities in some areas of Finance. If what Lewis describes is really accurate, what is the point of such activity? I’m sure we’re all better off for his shining a light in this area.

Tax Expert Sees Little Risk to MLPs

Interesting perspective on where the IRS is likely to focus from Robert Willens in Barrons today. He notes, “While the IRS is getting more restrictive on REITs and inversions, they are getting more expansive on MLPs, for some unknown reason. They are allowing a broader class of entity to convert to MLP status.”

Coke’s Management Pushes Their Way to the Trough

The proxy statements filed by public companies prior to their annual meetings are not always interesting to read. But Coca-Cola’s (KO) has caught my attention, thanks to some diligent work by David Winters of Wintergreen Advisers, LLC. Like many companies, KO is putting its compensation plan up for a non-binding shareholder vote. However, it turns out that when you wade through the various elements of Annual Incentive Compensation, stock options, Performance Share Units and Restricted Stock, the company has estimated that as much as 500 million shares of KO could transfer from the owners to management depending on meeting various performance metrics. The potential dilution could be as much as 14.2% according to KO’s own documents, some $24BN of value based on its current market capitalization. In 2013, 6,400 employees received some type of long term equity compensation, so this amounts to just under $3.8 million per eligible employee.

What makes this even more staggering is that Berkshire Hathaway (BRK) is the largest shareholder in KO and one would imagine that Warren Buffett’s support of owner-oriented corporate governance would have been more fully reflected in this plan. Perhaps he was unaware of the details, but it looks like a shocking attempt to unreasonably enrich KO’s management.

The details listed above are not prominently featured; KO’s proxy statement that was mailed to shareholders omits the pertinent facts listed above. For those you have to go to the electronic filing and read the supplemental information, something I was only prompted to do by Mr. Winters raising the issue.

An interesting sidebar from my perspective is that the Compensation Committee is chaired by Maria Elena Lagomasino, fondly known as “Mel” (her initials) when she ran the Private Bank catering to Chase Manhattan’s wealthy clients (prior to its merger with JPMorgan). I didn’t work closely with Mel, but she was generally well liked and respected by those that knew her. Sadly, Mel’s judgment in overseeing the development of this plan has come up short. Perhaps she’s trying to create a whole new class of high net worth clients among the ranks of KO’s senior management. 

We are shareholders in KO and BRK (as is Wintergreen Advisers). My faith in the judgment of KO’s management is somewhat shaken by this plan. They note that only 77% of shareholders voted in favor of the 2013 compensation plan last year, and incredibly this 2014 plan was drawn up as a shareholder-oriented response to last year’s low approval rating. We find the 2014 plan an egregious and unnecessary transfer of shareholder wealth to management, and shall be voting against its adoption. We’re interested to hear what Warren Buffett thinks.



Bonds Are Not Forever Book Review

Laurence B. Siegel, Research Director at the CFA’s Research Foundation, has written a generous, largely positive review. He has evidently read the book quite carefully and has written one of the more extensive reviews I’ve seen. I am flattered by his kind attention.

Why Brokers Like to Sell Municipal Bonds

Today’s Wall Street Journal has an article that analyzes the transactions costs, or commissions, faced by retail investors in municipal bonds. They find that the cost of buying a typical muni is about twice that of a high grade corporate bond. I wrote about this in my book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. The SEC published a 2012 Report on the Municipal Bond Market in which they also identified relatively high transactions costs.

The problem isn’t necessarily the high costs faced by investors; it’s the effort the industry makes to avoid full disclosure. Finance routinely benefits from opaque pricing of its products, from brokers knowing more about pricing than clients. There’s a basic conflict of interest between a municipal bond broker, who wants to sell bonds at a high price, and a retail client who wants to buy them at a low price. The type of price transparency that exists for equities would clearly benefit the clients, but not the brokers since it would impede their ability to charge such a high commission. The industry is generally against improved price disclosure, for obvious reasons.

If brokers had to invest in what they push on their clients, such as overpriced municipal bonds, the problem would probably solve itself quite quickly. But that’s unlikely to happen anytime soon, so in the meantime retail investors in municipal bonds should approach the market with a healthy level of skepticism and recognize that their is no alignment of interests between the retail bond buyer and their broker.