2014 Speaker Series: Michael Lewis
July 31, 2014
Portfolio Manager Rob Britton kicked off MPMG’s Speaker Series event on July 31, 2014 by pointing out that Minneapolis Portfolio Management Group reached three important milestones this year. The most significant, and that which MPMG is most proud, is that accounts that invested in MPMG’s All Cap Value (ACV) Composite at its inception would have seen the size of their account grow by over 10x, or nearly twice what an investor would have earned in an index fund or exchange traded fund (ETF) that tracks the S&P 500 Index. In addition to this significant achievement, this year marks the 20th anniversary of MPMG, and MPMG’s firm assets now exceed $1 billion.
MPMG showed a short video on the history of the firm, the principles upon which it was founded, and some of the investment themes that give us great hope for the future for investors. This video is posted to our website under the About Us tab.
MPMG continues to focus on company-specific value opportunities. These are stocks that are often misunderstood and inefficiently priced by Wall Street, but offer tremendous upside potential, while being less risky than more popular stocks.
At last year’s Speaker Series event Harrison Grodnick outlined MPMG’s investment thesis for Xylem, a company that we were patiently waiting on to perform. Xylem is the largest pure play investment opportunity in water infrastructure technology, addressing the full cycle of water from supply to end use to return into the environment. At the time our investment in Xylem had yet to appreciate significantly, as the business had recently been spun off from ITT Corporation and Wall Street was still learning about the new stand alone company. Over the past year that patience was rewarded, as the price of the stock rose by approximately 45%2. The future continues to look bright for Xylem in a world where water demand is growing, but supplies are challenged.
A newer holding in the portfolio that MPMG has high hopes for is Laboratory Corporation of America (LabCorp), the dominant player in the highly fragmented laboratory testing market. LabCorp boasts structural advantages that few competitors can replicate, enabling them to perform the highest quality laboratory diagnostic testing at one of the lowest prices on the market. While the company’s modest stock valuation may be due to the uncertain consequences of the Affordable Care Act, we see LabCorp as a beneficiary of this new legislation. This potential seems to be overlooked by Wall Street, offering a real value opportunity that creates strong upside potential for investors. The MPMG ACV Composite is filled with stocks that offer a similar value profile, stocks that appear to be undervalued in the current environment and create intriguing opportunity for patient investors.
Michael Lewis – from Liars Poker to Flash Boys
Journalist and author Michael Lewis has written about everything from sports to politics, but is most recognized as one of the nation’s premier chroniclers of Wall Street and the major changes that it has experienced in recent decades. Lewis began his writing career with Liar’s Poker, a New
York Times best selling novel that provided his first-hand account of a transformation of how Wall Street conducted business, moving from Shoot-from-the-Hip and instinct driven traders to mathematically driven financial engineers. More recently, Lewis focused on the financial crisis with his books The Big Short and Boomerang. This year, he made waves from Main Street to Wall Street with the story behind the phenomenon of high frequency trading and the efforts to overcome the riggings of the market by some players in his best seller, Flash Boys.
Lewis shared his insights from nearly 30 years of following the inner workings of Wall Street and the global financial markets as the featured guest of MPMG’s Speaker Series event. He spoke with MPMG Senior Portfolio Manager Harrison Grodnick about his career and what he’s seen in the markets. Here are highlights of Michael’s comments:
How High Frequency Trading (HFT) has changed the market:
Firms that specialize in high frequency trading seek to capture profits based on price movements caused primarily by large institutional traders that buy and sell big blocks of stocks. This strategy is most profitable when the traders can get a jump on trade orders that have been placed by institutions in a practice akin to front running. For example, if a Wall Street firm places an order to buy 5,000 shares of a stock, HFT firms may see that order and actually be able to execute the same trade first, buying the stock at the listed price, then selling it back to the Wall Street firm at a marginally higher price in order to generate a modest profit. While front running is an illegal activity in securities markets, the way it is practiced by high frequency traders is not specifically outlawed. HFTs trade more than a billion shares of stock a day. No single trade will yield more than a minimal profit, but because of the sheer volume of trades, HFTs can generate sizable profits over time. HFTs are not to be confused with investors. For HFTs, the difference between success and failure is less about sound judgment in differentiating securities, and more about making the trade faster than your competitors.
Our image of traders on the floor of an exchange screaming out buy and sell orders is becoming a thing
of the past. The bulk of market trading today takes place between computerized systems that bypass the need for floor traders.
High frequency trading now makes up approximately half of the trading volume in the U.S. market today.
To demonstrate the extremes that trading firms will go to in order to secure a speed advantage, private investors put $300 million into building a more direct fiberoptic connection between exchanges in Chicago and New Jersey. This could help shave tiny fractions of a second in the time it takes to transact each trade. The difference for major trading firms could be measured in the billions of dollars in profits.
However, this kind of speed advantage also creates an unfair marketplace that left other investors in a less favorable position. The market was not acting as a level playing field for all participants.
One trading firm publicly touted its record of 1,000 trading days without losing money in any single day. This would not be possible without the playing field being tilted in favor of those with access to the fastest trading capabilities.
Mr. Lewis made considerable headlines at the release of Flash Boys by describing the stock market as being “rigged.” However, he acknowledged that equities are the greatest wealth creation vehicle in recorded history and that the inefficiencies caused by these HFTs are primarily a risk to the short-term speculator and not to the long-term investor.
Mr. Lewis’s concern is that it is morally outrageous that such a system is allowed to exist.
How market forces are overcoming a “rigged” market:
Working for a Canadian-based financial firm, Brad Katsuyama started to notice that prices for securities that appeared on his screen weren’t the prices at which he was ultimately able to buy or sell those securities. Rather, he regularly paid a little more for positions he wanted to buy, and earned slightly less for those he intended to sell. He spent years trying to determine why the prices that appeared on his screen weren’t the ones he actually was able to obtain at the time trades were executed.
Early on, as he sought answers his complaints were dismissed, often blamed on technical glitches with his computers. But ultimately, Brad was able to prove that high frequency traders were “trading ahead of” his own buy and sell orders.
Katsuyama showed others on Wall Street that this was happening to them as well, and most were surprised to learn of it. Katsuyama appealed to regulators to look into the matter, but no significant actions were taken.
He felt a moral imperative to do something to make the market more fair, and recruited like-minded Wall Street veterans to help create a new exchange. In essence, he was determined to pursue “moral capitalism” as a way to correct a “rigged market.”
This exchange was designed to better regulate trading activity as a way to eliminate the unfair speed advantage some firms gained due to their proximity to computerized exchanges.This startup exchange has grown quickly, with many prominent Wall Street firms participating in it.
While capitalism untethered created the problem with HFTs and regulators were not able to resolve the problem, the solution came from capitalism with a moral compass. Brad’s new exchange is helping restore trust to the market.
Working in the world of “Liar’s Poker”:
Mr. Lewis landing a job right out of college at Salomon Brothers in 1985 provided a front-row seat to a major transformation that was underway on Wall Street. Firms like Salomon made big bets in various parts of the bond market, and generated huge profits as a result, but were doing it more and more through mathematical models, and less through traditional “shoot-from-the-hip” trading methods.
The atmosphere was chaotic, and old-time traders were starting to lose their standing to the “financial
engineers” who helped generate huge profits through sophisticated modeling.
One of these “dinosaur” traders once stopped a young salesman who was off to catch a flight. The senior trader tossed the young man $10 and asked him to take out crash insurance with the senior trader listed
as the beneficiary. “Why?” asked the salesman. “I feel lucky,” responded the senior trader. This was an
example of the cavalier atmosphere and high tension that existed in the midst of the Salomon trading floor.
Another trademark of this environment was the perception that the company often worked against the interests of its clients. While traders in the firm took one side of a “bet,” they attempted to sell clients on the idea of taking the other side, with the knowledge that the transaction being offered was not best interests of their customers.
The trades that created the opportunity for firms to earn the highest margins were generally the trades that were the least beneficial for customers.
This trend has continued in other forms over the decades, and contributed to a growing mistrust of WallStreet that came to a head with the financial crisis in 2008.
How events of 2007 to 2009 affected the market:
As reports emerged in 2007 that some of Wall Street’s biggest players were losing billions of dollars in subprime mortgage securities, the question was how that could have happened.
These were institutions that hired the best and brightest, yet the firms were so dysfunctional that they essentially committed financial suicide. Key players interviewed about how major firms incurred such huge losses almost universally said “it wasn’t my fault, nobody saw this coming.”
As documented in The Big Short, 15-20 money managers made a successful bet against the entire financial system and beat the institutions that were on the other side of the trade.
In the meantime, other countries like Iceland, Ireland, and Greece were also getting caught up in bad debt that took a significant toll on their economies, all related to the same market activity that took down big Wall Street firms.
Throughout the financial crisis, the entire Wall Street establishment essentially avoided prosecution save for a Russian corporate programmer from Goldman Sachs. He was accused of stealing computer code from Goldman Sachs, even though it is not clear that he could have done anything nefarious with that code. News of the arrest of this programmer brought the world of HFT to Lewis’s attention and ultimately led him to discover the story that resulted in the publication of Flash Boys.
At the heart of much of the crisis were the independent ratings agencies (i.e. Moody’s, Standard & Poor’s, etc.) that have a functional problem – they are paid by the very entities they are called on to research and rate. While it is unclear whether their misguided ratings on what turned out to be risky debt securities was sinister in nature, it is clear that the impact of their actions was incredibly costly.
Despite all of the challenging developments in recent years (led by HFT), investing in assets that are undervalued is still a sound approach, whether in the securities markets or in baseball. Oakland A’s General Manager Billy Beane did it with baseball players (as chronicled in the book Moneyball) and a small group of traders did it by shorting highly overvalued mortgage securities (as told in The Big Short). Value offers opportunity regardless of what activity may be occurring behind the scenes in the market.
While we at MPMG applaud Mr. Lewis for bringing the critical issue of HFTs to the forefront, we maintain that all of the attention that HFTs are receiving is more of an expensive distraction than a risk to creating long-term and meaningful wealth in the stock market. The market is simply a place to transact the business of investing, and the inefficiencies created by these HFTs do not materially impact the process of successful investing. Speed and technology have always been an advantage for professional traders – consider the advantages brought about by the telegraph and later the telephone and the ticker tape.
However, these advantages have never prevented the “little guy” from profiting considerably in the stock market. The stock market has been the greatest wealth creating vehicle in history and we believe that long term investors that show proper discipline and patience by buying good businesses at the right price will continue to be rewarded…despite this unsavory practice.
Thank you to our friends and clients for your continued trust and making this event possible. We look forward to many future events.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG‘s future investments. As with any investment, there can be no assurance that MPMG‘s investment objective will be achieved or that an investor will not lose a portion or all of its investment.