As I discussed in my previous posts, "I Was Wrong" and "The SEC Should Ban High Frequency Trading", my stance on HFT has shifted over the past few months. Initially I, like many other fundamental investors, was worried about the dominance of HFT. A simple glance at the massive increases in volume and volatility, the explosion in the number of hedge funds employing quantitative strategies, their AUM increases, and the waterfall of profits they were generating, was an indication to me of the increasing success of their strategies. However, like many things in this world, it could not last forever. Markets are like a natural system, and HFT is part of that system. No matter how successful an element of a system is, it will always mean revert because nothing can escape the laws of physics and economics indefinitely.
As I mentioned in the last post, a lack of competitive barriers would eventually sap the abnormal profitability of HFT strategies as a whole. This seems to have occurred in the near term, as a recent WSJ article indicates that the average profit of HFT strategies has been cut in half from all time highs during the 2008-2010 credit crisis. This may be temporary, however, I believe it is a structural change in the industry that will continue, as evidenced by quants moving from equities to other asset classes. There are only so many active, liquid, and volatile asset classes (the ingredients for a successful HFT strategy). Thus, you can employ game theory to see the end result before it arrives. Too much capital chasing too few profitable trades results in less profit per trade and a normalized distribution of returns, with most players achieving a return within hailing distance of average. The quants will have their days in the sun, but they are no longer infallible.
I think there are very few real barriers to entry in most businesses, and HFT is no exception. All it takes is capital, infrastructure, and a handful of PHD's to put together these strategies. It turns out there is plenty of cheap supply for each part of that equation, and returns for HFT strategies will normalize in the future because of that fact.
Friday, May 6, 2011
Saturday, January 15, 2011
I Was Wrong.
You do not hear many investors saying this statement. In fact, you almost never hear investors saying this statement because it is simply a matter of psychology. Any active investor, myself included, is by definition stating that they are smarter than the person on the other side of the trade. This is clearly not always the case, which is why it is imperative that you learn early on in your investing career when to be persistent in remaining in / increasing a trade and when to pull out. Humility. Understanding and embracing that one word will go a long way in ensuring that you make the right trades for your portfolio. The truth is that the market will humble you at some point in time. The question is whether or not you listen to what it is saying, and more importantly, if you learn from that particular mistake. The greatest investors will admit they were wrong, and then will proceed to pull apart their own mistakes and the mistakes of others in trying to improve their investment process. This is what differentiates the good investor from the average. The good investor focuses on their process of investing, whereas the average investor focuses on the outcomes.
While I have made numerous mistakes in my investment portfolio, one of the ones that I have made on this blog is an entry I wrote in August 2009 entitled "The SEC Should Ban High Frequency Trading". In a very uncharacteristic moment of irrationality, I wrote the blog arguing that the SEC should be more responsible and should disallow HFT. I was wrong. Upon further thought and discussion, it is my contention that the SEC is not well equipped to deal with traders who are have more resources than and are faster and smarter than the market regulator itself. Banning HFT outright is a poor policy response to a natural evolution in the free markets. To disallow progress is to disrupt the very foundation upon which our capitalist system is built. Case in point, the Globe & Mail ran an article today about a new trading system named "Thor" that RBC Capital Markets has been developing for its buy-side clients. This product is designed to deliver much-needed relief to fundamental long-term investors who are getting out-gunned in the markets on a daily basis due to the natural advantages that high frequency trading systems have accorded to the quants and hedgies. This system is basically an evolutionary response by the markets to negate the abilities of HFT, and it appears to work successfully (for now). We do not need more regulation. Like animals in the wild, the markets have evolved and adapted to the hunting strategies of high frequency traders. Economics tells us that abnormal profits will eventually be eroded away through competition. The development of RBC's system is just the first step in the evolution of competition when it comes to HFT. My initial position was wrong. I believe in free markets.
While I have made numerous mistakes in my investment portfolio, one of the ones that I have made on this blog is an entry I wrote in August 2009 entitled "The SEC Should Ban High Frequency Trading". In a very uncharacteristic moment of irrationality, I wrote the blog arguing that the SEC should be more responsible and should disallow HFT. I was wrong. Upon further thought and discussion, it is my contention that the SEC is not well equipped to deal with traders who are have more resources than and are faster and smarter than the market regulator itself. Banning HFT outright is a poor policy response to a natural evolution in the free markets. To disallow progress is to disrupt the very foundation upon which our capitalist system is built. Case in point, the Globe & Mail ran an article today about a new trading system named "Thor" that RBC Capital Markets has been developing for its buy-side clients. This product is designed to deliver much-needed relief to fundamental long-term investors who are getting out-gunned in the markets on a daily basis due to the natural advantages that high frequency trading systems have accorded to the quants and hedgies. This system is basically an evolutionary response by the markets to negate the abilities of HFT, and it appears to work successfully (for now). We do not need more regulation. Like animals in the wild, the markets have evolved and adapted to the hunting strategies of high frequency traders. Economics tells us that abnormal profits will eventually be eroded away through competition. The development of RBC's system is just the first step in the evolution of competition when it comes to HFT. My initial position was wrong. I believe in free markets.
Monday, January 10, 2011
The Risks Inherent With Investing In Warrants - Part 2
So, apparently the security holders of GLW were sufficiently irate enough to launch a formal complaint against the previously announced FNV / GLW deal. As I profiled in my initial blog post, "The Risks Inherent With Investing In Warrants", my analysis indicated that both shareholders and warrant-holders should be unhappy with the deal.:
• Shareholders would be unhappy because they basically received no return on their investment since the IPO (albeit a good premium to recent trading prices). Regardless of my valuation concerns, with the proposed consideration, it would be an incredibly mediocre deal because the split between cash and shares would be exactly 60% / 40% (0.0934 FNV shares and C$2.08 in cash), which means that shareholders that wanted either consideration would only get that specific mix. In short, shareholders that wanted all FNV shares would receive only 60% of their consideration in that form and shareholders that wanted all cash would receive only 40% of their consideration in that form. Most investors would have a preference one way or another, which virtually ensures that all parties would be unhappy with the structure, let alone the valuation.
• Warrant-holders would be unhappy because they were being robbed of their optionality. Given that the consideration to be paid was 40% in cash, the warrants would lose a significant portion of their optionality as they could no longer be exercised into a full FNV share, but rather into the consideration only (cash has no optionality, which is really the only reason one would hold a warrant). Note that this is precisely why GLW warrants dropped so rapidly on December 13th, the day of the acquisition announcement.
On January 6th, 2011, a new deal with revised terms was announced:
• GLW shareholders can elect to receive a) C$5.20 per share in cash or b) 0.1556 FNV common shares, subject to the limitations of a cap on both forms of consideration as well as pro-ration. Total cash available is C$215mm and total shares available are 9.66mm.
• GLW warrants can be exercised for 0.1556 FNV shares or C$5.20 in cash. In essence, the warrant-holders are now not forced to swallow a 60% / 40% split, but are allowed to choose what form of consideration they want. As cash has zero optionality, in this situation, all warrant-holders would choose FNV shares.
What the revised offer does is it gives security-holders the option to select a form of consideration that is consistent with their individual needs and desires. In a situation like this, typically all shareholders would opt for the all-cash portion, thereby attaining a fixed price and real and immediate liquidity. Whether or not shareholders choose cash or FNV shares is dependent on their perception of the valuation of FNV (whether it is cheap or dear) and the opportunity costs to each individual investor. Moreover, the new option allows those that wanted to hold onto their GLW shares roll-over their ownership into FNV, whereas those that want to cash out can do so without having to rely on market prices and without causing market impact (which can be an issue for large shareholders trying to move blocks in an illiquid name). With all shareholders electing the all-cash option, this would cause the cash portion of the collar to be breached and all security-holders would receive a pro-rata share of both considerations, equivalent to the original 60% / 40% split. The same result would occur if all shareholders chose the FNV share option. It remains to be seen what GLW shareholders ultimately elect, and I will report on this once the election results are announced. It will be interesting to see what the results are, but like with most deals, I imagine that shareholders will gravitate towards the cash option. In my view, this is especially so because GLW is being valued at around 90% of NAV, whereas FNV is being valued in the market at around 150% of NAV. Moreover, FNV is not a pure-play on gold, but rather a conglomeration of royalty interests in gold, platinum, copper, nickel, oil, and gas. Unless I'm missing something, no rationale investor would agree to trade a position in a discounted pure-play into a position in a relatively over-priced conglomerate. My guess is that shareholders will get a pro-rata share of both considerations as a result of everybody clamoring for the cash option.
To me, what is very interesting is that most deals have to be renegotiated because the valuation is too low. Either shareholders negotiate a bump, force a bump through appraisal rights, or a new bid from another party comes forth. In this case, GLW shareholders were apparently happy with the valuation of the firm. However, warrant-holders (and probably shareholders) were unhappy in terms of the type consideration that would be paid. That is not the fault of the security-holders, but rather it is the fault of management. In essence, the forced re-jigging of this deal was really because of poor security-holder communication on behalf of management. It appears that GLW completed the deal in a hasty fashion, and did not fully consider its security-holders wants or needs, nor fully understand the market micro-structure of its securities. Luckily for warrant-holders, GLW management was smart enough to renegotiate the deal, and hopefully all parties can walk away from this averted debacle satisfied.
• Shareholders would be unhappy because they basically received no return on their investment since the IPO (albeit a good premium to recent trading prices). Regardless of my valuation concerns, with the proposed consideration, it would be an incredibly mediocre deal because the split between cash and shares would be exactly 60% / 40% (0.0934 FNV shares and C$2.08 in cash), which means that shareholders that wanted either consideration would only get that specific mix. In short, shareholders that wanted all FNV shares would receive only 60% of their consideration in that form and shareholders that wanted all cash would receive only 40% of their consideration in that form. Most investors would have a preference one way or another, which virtually ensures that all parties would be unhappy with the structure, let alone the valuation.
• Warrant-holders would be unhappy because they were being robbed of their optionality. Given that the consideration to be paid was 40% in cash, the warrants would lose a significant portion of their optionality as they could no longer be exercised into a full FNV share, but rather into the consideration only (cash has no optionality, which is really the only reason one would hold a warrant). Note that this is precisely why GLW warrants dropped so rapidly on December 13th, the day of the acquisition announcement.
On January 6th, 2011, a new deal with revised terms was announced:
• GLW shareholders can elect to receive a) C$5.20 per share in cash or b) 0.1556 FNV common shares, subject to the limitations of a cap on both forms of consideration as well as pro-ration. Total cash available is C$215mm and total shares available are 9.66mm.
• GLW warrants can be exercised for 0.1556 FNV shares or C$5.20 in cash. In essence, the warrant-holders are now not forced to swallow a 60% / 40% split, but are allowed to choose what form of consideration they want. As cash has zero optionality, in this situation, all warrant-holders would choose FNV shares.
What the revised offer does is it gives security-holders the option to select a form of consideration that is consistent with their individual needs and desires. In a situation like this, typically all shareholders would opt for the all-cash portion, thereby attaining a fixed price and real and immediate liquidity. Whether or not shareholders choose cash or FNV shares is dependent on their perception of the valuation of FNV (whether it is cheap or dear) and the opportunity costs to each individual investor. Moreover, the new option allows those that wanted to hold onto their GLW shares roll-over their ownership into FNV, whereas those that want to cash out can do so without having to rely on market prices and without causing market impact (which can be an issue for large shareholders trying to move blocks in an illiquid name). With all shareholders electing the all-cash option, this would cause the cash portion of the collar to be breached and all security-holders would receive a pro-rata share of both considerations, equivalent to the original 60% / 40% split. The same result would occur if all shareholders chose the FNV share option. It remains to be seen what GLW shareholders ultimately elect, and I will report on this once the election results are announced. It will be interesting to see what the results are, but like with most deals, I imagine that shareholders will gravitate towards the cash option. In my view, this is especially so because GLW is being valued at around 90% of NAV, whereas FNV is being valued in the market at around 150% of NAV. Moreover, FNV is not a pure-play on gold, but rather a conglomeration of royalty interests in gold, platinum, copper, nickel, oil, and gas. Unless I'm missing something, no rationale investor would agree to trade a position in a discounted pure-play into a position in a relatively over-priced conglomerate. My guess is that shareholders will get a pro-rata share of both considerations as a result of everybody clamoring for the cash option.
To me, what is very interesting is that most deals have to be renegotiated because the valuation is too low. Either shareholders negotiate a bump, force a bump through appraisal rights, or a new bid from another party comes forth. In this case, GLW shareholders were apparently happy with the valuation of the firm. However, warrant-holders (and probably shareholders) were unhappy in terms of the type consideration that would be paid. That is not the fault of the security-holders, but rather it is the fault of management. In essence, the forced re-jigging of this deal was really because of poor security-holder communication on behalf of management. It appears that GLW completed the deal in a hasty fashion, and did not fully consider its security-holders wants or needs, nor fully understand the market micro-structure of its securities. Luckily for warrant-holders, GLW management was smart enough to renegotiate the deal, and hopefully all parties can walk away from this averted debacle satisfied.
Wednesday, January 5, 2011
M&A In 2010
As a quick follow up to my post of February 8th, 2010 entitled "2009 vs 2010: Developments In The M&A Market", I wanted to touch on how M&A actually played out in 2010. As you can see from the recently released Dealogic League Table below, both Goldman and Morgan Stanley came in 1st and 2nd (or vice versa, depending on how it is counted), as I initially predicted. In addition, the dealers that received very large amounts of TARP (Citi and BoA / Merrill in particular) slid in the rankings. Their loss came at the gain of large international dealers such as UBS and Credit Suisse. Moreover, other international dealers such as Deutsche Bank, BNP Paribas, Nomura, and HSBC all moved up in the rankings at the expense of smaller US-focused boutique firms. Part of this has to do with a trend that I did not foresee, which was the massive expansion in M&A activities in emerging markets - specifically Asia. Earlier in the year, there were numerous reports of various firms racing to open up shop in Shanghai and other financial hubs in the East.
From a global perspective, it looks like there was $2.25 trillion worth of deals done in 2010, up for the first time since 2007. With liquidity taps opening and credit markets easing, corporate acquirers were clearly on the hunt in 2010, which is basically in line with what I expected. It is a trend that I expect will continue in 2011. On sector basis, O&G and telecom did quite well, as expected.
I'll be back shortly to expand further on my expectations of M&A in 2011.
From a global perspective, it looks like there was $2.25 trillion worth of deals done in 2010, up for the first time since 2007. With liquidity taps opening and credit markets easing, corporate acquirers were clearly on the hunt in 2010, which is basically in line with what I expected. It is a trend that I expect will continue in 2011. On sector basis, O&G and telecom did quite well, as expected.
I'll be back shortly to expand further on my expectations of M&A in 2011.
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