April 2, 2014

Dear Investor:

The new book Flash Boys by Michael Lewis has garnered buzz saw-like attention for its contention that securities markets are rigged by high frequency traders (HFTs).

I wrote a Forbes piece on the topic, News Flash: Flash Boys Not News, in which I agree. What’s more they always have been rigged—at least in the sense that individual day-traders never stood a chance against nimble and sophisticated hedge funds. I argue that while people wait for regulators and other would-be protectors to catch up to the “new” regime of HFT and other market abuses, they should protect themselves by being long-term investors, not short-term traders.

Being a long-term investor is not a zero-sum game. Trading is. For each trade, there must be one loser and one winner: the stock either goes up or down after the crossing buy and sell orders transfer ownership. To participate in this vicious zero-sum game is not just a bad idea for individuals but also for savvy traders. Even most trading hedge funds lose out over time to arbitrageurs and HFTs, not to mention the commissions, bid-ask spreads, taxes and other frictional costs that render rapid trading a fool’s errand.

Investing, on the other hand, can be an ever-expanding pie if a quality asset is purchased at a discount to its underlying, intrinsic value. Two investors can buy Apple at the same moment, at a discount to its intrinsic value, hold it for a few years, and both make money on the sale.

To repeat the example I use in my piece:

Take a front-running high frequency trader who trades ahead of your 100 share bid for Apple at $540 per share. Assume the trader anticipates your bid, buys Apple at $540, and then effectively sells it back to you for $540.05, robbing you of the nickel you would’ve held onto were the trader not ahead of you. You’ve been legally fleeced of five bucks.

Is it right? Of course not. Should the regulators ban it? Of course.

Will it make a difference in your returns? That part is up to you, not the high frequency trader.

If you bought Apple because you thought you could turn around and sell it a few seconds, hours, or days later at a dime profit, well then you’ve just played in the casino and lost. The high frequency trader will steal another nickel when you sell. After the commission, you’ve come out a small-time loser. Add up thousands of those doomed trades over a year, you come out a big-time loser. Try to retire on that strategy: you’ll be a pauper soon enough.

But if you bought Apple because you thought the stock was worth at least $650 based on business fundamentals–and the stock rises to reflect those fundamentals over the next three years–then you’ll make 20% plus dividends on the investment (alert: it’s an investment, not a trade), even after paying out a nickel on each side to the high frequency hucksters. That’s successful long-term investing in a nutshell.

That’s why we always buy an ETF or stock with an expected holding period of not less than three years, and with no expectation of a short-term gain. If my view about underlying value is correct (as determined by valuing the expected free cash flows and discounting them back to the present) the asset will rise in price eventually, and any “tax” exacted by the HFT’s will turn out to be less than a rounding error. In this way we don’t trade against the HFTs. Instead, we rely on the HFTs, arbitrageurs and other traders to eventually bring prices in line with value. The key word is eventually.

To that end, I am currently adding to positions of emerging market and steel stocks (via the exchange traded funds SCHE and SLX respectively) in client portfolios. These sectors are as cheap as Europe was three years ago, with free cash flow yields that exceed 7% on average. If we buy these diversified baskets of quality companies and hold them for more than a day or a month, we should get a reasonable return—a return that renders the HFTs and other market bandits meaningless.