One More Time: Temporary Setback = Opportunity.

August 8, 2012

It’s a knight! In shining armor! Get it? Do we have to explain everything to you?

Last week we wrote about the meteor that landed on Knight Capital. If you can’t be bothered to read that post, the New York Stock Exchange’s biggest market maker endured a computer glitch that resulted in the company losing $440 million. Knight fell victim to a singular event (at least one wag actually used the term “black swan”), shrank to a third of its size overnight, and looked like it might not survive the week.

Here we have a company that

  • Provides a valuable service.
  • Is the market leader, more or less.
  • Has a solid reputation.
  • Suffered a temporary, non-lethal, inadvertent misfortune, as opposed to doing something villainous.

Knight’s stock (KCG) opened trading at $10.33 last Wednesday. The software flaw showed up immediately and was contained within 45 minutes. KCG closed the day at $6.93, opened the next morning at $3.48, reached a nadir of $2.43 late in the afternoon, and closed at $2.59.

This is what’s called a buying opportunity. KCG opened the following Friday at $3.11, closed at $4.05, and on Sunday received the $400 million cash infusion it needed to stay alive.

Who loaned them the money?

  • TD Ameritrade, one of Knight’s biggest clients.
  • Stifel Nicolas, a brokerage that sounds faintly Swiss but is actually based out of St. Louis.
  • Blackstone Group, a private equity firm.
  • General Atlantic, another private equity firm and owner of Getco (Global Electronic Trading Company), another market maker, one of 6 firms designated as such by the NYSE.
  • 2 unnamed investors, probably selfish capitalists like that job-killing tax cheat Mitt Romney.

The money comes with strings attached, of course. The lenders received something called “convertible securities”, which are bonds that will turn into stock at a certain undisclosed price. The 4 disclosed lifeguards and Mystery Firms E and F don’t make it a habit of lending money without it offering the likelihood of decent return, especially when forced to make a decision with only 2 days’ notice.

While we don’t know many more details of the deal, including the strike price of those convertible securities, the consensus belief is that it’s less than the $4.05 Knight stock ended the week at.

Here’s the type of reasoned response that makes the consistently under-water easy to distinguish from the enterprising few. From the LA Times story on Knight:

Not that internet comments are ever going to be a source of any usable knowledge, but it’s probably fair to say that COOLTUB and Highpressure’s opinions are not out of the mainstream.

The easy, effortless, simplistic, reactionary and false way to look at the Knight capital infusion is as fat cats covering for each other. The first commenter seems to think either that federal taxpayers are cutting a check to Knight, or that there isn’t a difference between that and private capital.

We don’t want to assume anything, but we’re guessing that when Magic Johnson and a handful of rich white financiers recently did the exact same thing for the Los Angeles Dodgers, COOLTUB and Highpressure were ecstatic about it.

Don’t be an idiot. How can you compare the two? The Dodgers as a team are a community icon, not just a bunch of rich guys shuffling paper.

No, they’re a bunch of rich guys swinging bats and fielding balls. The Dodgers pay an average of $3,171,452 to their top 25 employees. We don’t have a similar figure for Knight, but it’s almost certainly less.

We’re getting off track here, and we swear we didn’t start this post intending for it to turn into a sports analogy. But it’s important to remember that when a legitimate business that provides a benefit to society (in the form of liquidity) gets smacked in the mouth, it’s a chance for a sharp investor to make some money. If Knight had been charged with fraud, that’d be something vastly different, and inapplicable here.

Maybe you’re tentative, and still don’t think KCG is a good buy. Or you’re not familiar enough with the company’s stock in trade to take a position. Fine. Look around you and you’ll see opportunities daily. Seriously, daily. The local business that needs cash to expand and is looking for a silent partner. The overextended homeowner, or car owner, desperate to sell. The stock of the company that recently underwent an even less traumatic event than Knight did. (Read WSJ.com and Yahoo! Finance, just for a few minutes a day at the start. Think of it as unmarked course work for your future career in self-determination.)

You can get past the initial reluctance, the thought of “The markets? Not for me. Nothing more demanding than a conservative mutual fund in my company-directed 401(k), thanks very much.” Really, you can.

Or you can just assume that your job and its annual cost-of-living raises will help you build wealth as convincingly as seizing opportunities will. Whatever.

Filed Under: Capitalism, Estate Planning, Finance, Investments Tagged With: ,

Knight Pun Goes Here. “Dark Knight of the Soul”, For Instance.

August 3, 2012

 

This isn’t a stock photo. It really isn’t. We’ve run similar ones before. On any given day, you can find a trader assuming this position. (Assuming a position! Another double entendre! God, we’re clever)

Knight Capital is hanging by a thread this morning. A formerly robust business, and one of the biggest players on the New York Stock Exchange.

“A Wall Street firm got screwed? Good! Serves those greedy bastards right!”, capitalist oppression, the 1%, etc., etc.

Yeah, except it’s way more complicated than that, and besides, no poor people were hurt in the making of this fiasco. You want the real story, or do you want to sit there and pretend you know what’s going on?

Knight Capital is a market maker. That means if you’ve got a certain security to buy or sell, they’ll sell it to/buy it from you, instantly. Instead of waiting on the rest of the world so you can get the price you want, you can do business with Knight and get your stock or cash at the speed of light.

A market maker does this by keeping separate bid and ask prices. They’ll buy your Baltimore Opera Hat Company stock for, say, $10 a share. At that same moment, if there’s some other investor who wants a piece of Baltimore Opera Hat, he can buy it from a market maker for…$10.05 or so.

It shouldn’t matter to a market maker whether the stock is rising or falling. If Baltimore Opera Hat shoots up in value for some reason – a hostile takeover bid, LeBron James sporting one of the company’s hats ironically at a postgame press conference – a market maker adjusts its bid and ask prices correspondingly. The more powerful a market maker’s algorithms, and the more business it does, the smaller a spread it can offer between bid and ask prices. Taken to the extreme, a cosmically large market maker could buy a security at $10, sell it at $10.0000000000001, and make a profit by sheer volume. Thus market makers do serve a legitimate purpose, letting people trade all the faster. This is a good thing.

When you do business with a market maker, you’re paying for liquidity. Are you really that set on selling your stock at $10.50, knowing it might never get that high? A market maker might drive a hard bargain, but you get your money (or stock, depending on what side of the transaction you’re on) that much more quickly.

Market makers exist with the sanction of the exchange they do business on: Knight is officially designated as a market maker by the New York Stock Exchange. Also, a particular market maker only makes markets for particular securities. You can immediately buy or sell Garmin stock via a certain market maker, say, but not Walgreens stock.

Knight’s largest customers are retail brokerages, not individual investors like you. When you execute an order through your TD Ameritrade account, TD Ameritrade will sometimes (certainly not always) go through Knight.

There are hundreds of firms that operate as market makers, and Knight is one of the biggest, handling 15% of the NYSE’s volume. Was one of the biggest, until a couple of days ago.

Wednesday morning, Knight endured a computer glitch. A bug in the software. Knight started trading stocks at 10, 20 times their normal volume, leading to a concomitant and profound change in prices. Knight’s computers were executing trades that didn’t have a real buyer or seller on the other side. Which isn’t a big deal in and of itself; Knight wasn’t taking possession of people’s actual stock and/or money at false prices, and no individual investor got screwed.

But the trades still counted, and the prices were valid throughout the market. So other firms, ones with error-free information systems, saw the price changes and handled their own trades accordingly. Here, look at the chart and see if you can tell whether Knight was a market maker for Anheuser-Busch:

Knight was forced to trade out of its erroneous positions. It lost $440 million in one day.

 

no individual investor got screwed.

 

Wait, that’s not quite true. Knight itself is a publicly traded stock. That $440 million corresponded to a similar hit in Knight’s market capitalization. The company’s value shrank by 2/3 in one day. Here’s what happened to Knight stock overnight:

Understandably, Knight’s clients stopped doing business with it. They had no choice. These are big firms, too – Vanguard, Citigroup and other investment managers.

Just because Knight’s principals and employees wear tailored suits and wing-tips, that doesn’t mean they’re crooks. Far from it. Knight handled the 45-minute glitch the best way possible, immediately halting trades and disclosing everything to their customers, the market and the exchange.

The result is that Knight needs to borrow money, and fast. The company might go bankrupt. Investors hold $375 million in convertible notes issued by Knight, and could demand their money now, given how Knight’s business has changed so abruptly so quickly. (Knight’s biggest bondholders are the actual crooks at Goldman Sachs, but that’s a different lament.) The consensus opinion is that Knight should find a buyer before things get any worse. Yes, a company whose primary service was liquidity could go under for want of its own liquidity.

Speaking of a buyer, Knight’s stock is trading at barely twice earnings. If you’re interested, you probably won’t have to wait long to have your order executed. You might not even need a market maker.

This wasn’t a fault of regulation, or lack thereof. Putting an additional 100 SEC agents on the case wouldn’t have changed a thing. It was an error without malice or criminal intent. Now, go read the comment boards on Yahoo! Finance and see the easily confused blame Knight’s downfall on everything from Mitt Romney to the U.S. military to the Illuminati.

Filed Under: Capitalism, Finance, Investments Tagged With: , ,

You, CFA

August 1, 2012

If you don’t handle your retirement, he might do it for you. IS THAT WHAT YOU WANT?

You can do this.

Fund managers have to be conservative, by definition. Even the smallest fund has tens of millions of OPM (Other people’s money. What are you, 80?) under its control. A fund manager has far less margin for error than does a private investor, at least professionally. If you maintain your own portfolio, and it loses 40% of its value in a given year, that’ll affect you and a handful of others. Do so as a fund manager, and your career will be dead on impact. (Actually, that’s not true. You’d be fired way before you lost 40%.) Imagine the looks of horror and sotto voce comments at the Wharton class of ’07 reunion. (And yes, plenty of fund managers are indeed that young.) You wouldn’t dare show your face. “Is that Spencer? Wasn’t he on the fast track at Vanguard? I heard he’s working in the suburbs now. Had to cut his cocaine use back to weekends only. Poor bastard.”

Fund management, for the most part, is regression to the mean. The same funds hold the same damn stocks, over and over again. Some funds are required to hold the stocks of companies that have reached a certain size. Make the Wilshire 5000, and that automatically qualifies you to be in somebody’s fund. Join the Dow (and someone soon will, to replace recently departed Kraft), and the same thing happens.

This is perverse. The tail is wagging the dog, for lack of a more original phrase. A fund doesn’t take on a new component because the fund manager sees something he likes and discreetly buys a position before someone else can. Funds take on new components because they have to. Or because everyone else is doing it.

Furthermore, fund managers aren’t just sheep. By and large, they’re hypocrites and liars. (Yes, we know. Welcome to the human species.)

Joe Light recently wrote in The Wall Street Journal that Facebook didn’t just seduce ordinary investors suffering from Streisand Syndrome. The professionals got sucked in, too. Big names. Fidelity. JPMorgan. The most successful website since Google (by number of users, anyway) went public, and did so in at least a couple of senses of the phrase. Everyone was talking about it and familiar with the story of its origin (thanks to a timely and critically acclaimed big-budget movie), and few institutional investors had the fortitude to say “no”. Or even say, “Can we take a look at the company’s financials?”

160 mutual funds bought Facebook. These included Fidelity’s Dividend Growth Fund.

Read that last sentence again. Facebook doesn’t pay a dividend.

The JPMorgan Intrepid Value Fund presumably invests in value stocks. An unproven IPO (that ended up losing 1/3 of its market cap out of the gate) doesn’t fit anyone’s definition of a “value” stock.

The managers of these funds didn’t answer the allegations of impropriety. Neither did any company spokespeople. And for the sake of consistency, we’ll end this paragraph in italics, too.

So why the hell were these funds, with their objectives included in their titles, buying a stock that had nothing to do with those objectives?

Again, defense. Say Facebook did what its devotees wanted, and exploded out of the gate. The punishment, professional and otherwise, for being the manager who could’ve bought Facebook but didn’t is overwhelming.

You can complain about how the financiers are screwing the little guy, Wall Street over Main Street, etc. if it makes you feel good. Or you can go David and aim for their heads.

Being small and nimble, i.e. an individual investor, gives you advantages that no fund manager can ever enjoy. Why?

  • You don’t have to answer to anyone.
  • You can take calculated, intelligent risks. Ones where you’ve weighed the potential downside and have decided you can live with it. Professional fund managers can do that too, to some extent, but when they do it it’s no bold move. It’s a piddling activity whose downside is mitigated by there being so many components to their funds. Hundreds of funds owned General Motors stock when it got delisted and the company eventually went bankrupt. No manager who bought GM lost his job, at least not for buying GM.
  • Your objectives are clearer. You’re there to make money. To maximize return by finding value and exploiting it.
    Is a fund manager there to make money? Yes, but not as unambiguously as you are. A fund manager makes a cut, yes, and also makes a salary. Thanks to that salary, the fund manager is operating under the same directive that most people do – I must preserve my job at all costs. The higher the salary, the more tightly someone will hold onto that job and the less they’ll to do risk getting fired. Playing not to lose isn’t just acceptable, from a fund manager’s perspective, it’s good business sense. At least as far as longevity is concerned.

Yes, selecting investments (it’s not “picking stocks”, thank you very much) is hard. It’s not an intellectual exercise along the lines of solving one of Hilbert’s Problems, but it’s hard in that it requires discipline. The same intestinal fortitude that gets your heart in shape or your lungs tobacco-free, can get you rich. Here’s how to start.

Filed Under: Estate Planning, Finance, Healthy Living, Investments, Making Smart Choices Tagged With: , , , ,
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