An ISS voting recommendation adds 9%+ to the value of BKS: does this make sense?

My guess is that it doesn’t.  But this will be an interesting case to watch.

Barnes and Noble

The management of BKS, the Riggio family, is locked in a struggle with dissident shareholders, Ron Burkle and Peter Eichler, over the strategic direction the bookseller should take.  Each side controls about a third of the stock.  The Burkle group has nominated three candidates to oppose management’s selections in the upcoming shareholder vote for members of the company’s board of directors at the firm’s annual meeting.

Both sides are actively campaigning for their candidates.  That’s where Institutional Shareholder Services (ISS), a part of the MSCI asset management consulting conglomerate MSCI, comes in.

what does ISS do?

Each year, a publicly traded company will prepare a list of proposals that it needs a favorable vote of shareholders to implement.  The list varies from company to company, and country to country, but almost always includes names of candidates for election to the firm’s board of directors.  The document that contains this list is called a proxy statement. In the US, companies file the proxy statement with the SEC and send copies, along with what amounts to an absentee voting ballot, to its shareholders.

Over the past twenty years or so, government regulation has more closely defined the obligations of registered third-party investment advisers, like mutual fund or pension fund money managers, toward voting the shares of stock they hold for their clients.  Current SEC rules require that investment advisers:

–vote the shares they control,

–vote in the best interests of their clients, and

–let clients know what they’re doing, and why.

This is a large legal and administrative burden for an asset management company, which may hold thousands of different stocks in its portfolios.  And if a money management firm performs this task completely by itself, it risks being second-guessed or possibly sued for actions it takes.  So virtually everyone hires a proxy consulting firm, both to ease the administrative burden and as insurances agains possible lawsuit.

ISS is the largest and most influential proxy advisory firm.  It has been in business since 1985, about the time voting clients’ shares started to become a hot-button issue.  ISS analyzes and makes voting recommendations to its clients–primarily asset management companies–on matter contained in publicly traded companies’ proxy statements.  Yes, someone–more likely, a committee of investment professionals–in the asset management firm will review the proxy and cast the firm’s vote.  But in addition to the proxy, he will have a detailed ISS report in his hand.  As a practical matter, he/they will either follow the ISS recommendations, or extensively document the instances where the vote is in the other direction.

The bottom line:  ISS has immense influence in directing the votes of institutional shareholders of stock.  And for most publicly traded companies, institutions hold a majority of the shares.

the BKS case…

In the case of BKS, ISS has recommended voting for the dissident board nominees, not management’s.  Hence the spike upward in BKS stock yesterday.

…is not a typical one

BKS has a market capitalization of about $1 billion.  That’s tiny, but it still overstates the liquidity of the stock.  In addition, the Riggio family + the dissidents own about two-thirds of the shares.  That means that the “float,” that is, the shares available for ordinary trading, amounts to only about $350 million.

Average trading volume is about one million shares a day–or about $15 million worth.  So an institution would figure to be able to trade at most $2-$3 million a day without making a lot of noise in the market.  Even that might require very skillful trading.

In other words, BKS is too small and too illiquid for most institutions.


My guess is that the ISS recommendation is going to have little effect on BKS voting.  Institutions probably don’t own the stock, and non-institutions don’t know–or care–who ISS is.

I think retail investors hold most of the float.  That’s important.  Typically, retail investors are intensely loyal to the incumbent management, even in cases where this attitude seems to fly in the face of common sense and the retail investor’s own economic interest.

There is, of course, the wider issue of whether having  Mr. Riggio or Mr. Burkle calling the shots will make any difference for a firm whose market is undergoing rapid structural change.

As I said at the outset, this vote should be interesting to watch.

Dividend-paying stocks: some choices are better than others


One basic criterion for buying a security is how that issue fits into an investor’s overall investment plan–that is, how it helps meet his goals and objectives, whether it falls within his risk tolerances, and whether he is willing to expend the time and effort needed to research and monitor the position.  (This third aspect is, in my opinion, the one that investors most commonly overlook.)

Looking at dividend-paying stocks, I think the main conceptual issue is the possible tradeoff between getting the highest current income and getting the best total return.  You may not be able to do both.  If your primary need is to generate, say, a 4% current yield from the US stocks you hold,  you can probably do that, but chances are that you’ll underperform the S&P 500.

That shouldn’t be a big deal, since your aim is to produce steady income, not generate capital gains.  It only becomes one if you forget–or don’t understand in the first place–what your primary goal is.

Why should an income-oriented strategy underperform?

In theory at least, prevailing prices express the aggregate market preferences for dividend yield and potential capital appreciation.  In the US at present, this preferences are for a 2% dividend yield and a forward PE of about 12 .  To tilt my personal portfolio away from the market by a little bit, by trading some capital appreciation potential for extra current income, I should not have to give away much more than I receive.  But as I try to trade more and more appreciation for income, other participants in the market become increasingly reluctant to accommodate me, since doing so would move them farther away from their desired portfolio mix.  So I have to “sweeten” any deal by offering increasing amounts of capital appreciation to get an extra unit of dividend income.  Therefore, I start to underperform.

That’s the argument, anyway.

By the way,  I think in today’s market it may be possible for an income-oriented strategy may do better than one might think.  Several reasons:

–I imagine the movement of investors reaching for yield by moving from one part of the fixed income market to another as being kind of like the tide coming in.  First it was government bonds, then corporate debt , then junk, now gimmicky things like century bonds.  The wave hasn’t hit the equity market yet.  But maybe it will.

–dividend haven’t been important in the US stock market for twenty-five years.  Arguably, if/when the wave hits equityland, it’s not going to be as efficient as it might be.

–as far as I can see, there isn’t very much good research information about dividend-paying stocks around.

If so, great.  It would be icing on the cakebut not by itself a compelling reason to concentrate on dividend-paying stocks.

how I’m choosing

In today’s US markets:

the two-year Treasury yields 0.46%

the ten-year Treasury yields 2.7%

the thirty-year Treasury yields 3.9%

the S&P 500 yields 2%

the forward market PE is about 12, meaning an earnings yield of 8%.

a first step

Over the past thirty years, the dividend yield on the entire stock market has only been higher than the coupon on the long bond during periods of extreme market stress–and even then only for brief periods of time.  March 2003 and March 2009 were the only two instances over the past decade.

We’re obviously not in that position today.  But still, in a less than 4% long bond world, there’s got to be some point beyond which a high dividend yield is an indicator of potential trouble–of potential investor worry that the dividend can’t/won’t be maintained at the current level.

Let’s say that point is a 6% dividend yield–above which one must tread very carefully.  As a matter of stock triage, unless you are willing to spend the time doing careful research you may want to discard these high yielders as too good to be true (although as you’ll see below, they may merely be stocks with little hope of capital appreciation).

three cases

Let’s work out three simple examples to try to distinguish among the various types of dividend-paying stocks that are available in today’s market.  They are:

1.  an 8% dividend yield, no earnings per share growth

2.  4% yield, 5% average annual eps growth

3.  2.5% yield, 15% annual eps growth.

We’ll take a five-year investment horizon and assume that all of the stocks pay a constant percentage of profits in dividends and that none enjoy PE expansion or suffer PE contraction.  To make the arithmetic easier, let’s also say that the initial price of each issue is $100.

Stock #1:  at the end of five years, the stock price remains $100.  The owner has received $40 in dividends.  The stock yields 8% on the $100 purchase price.

Stock #2.  The fifth-year stock price is $$127.70.  The owner has received $21.83 in dividends.  The stock yields 5.1% on the $100 purchase price.

Stock #3.  The terminal stock price is $200.  The owner has collected $16.88 in dividends.  The stock yields 5% on the $100 purchase price.

the differences–objectives matter

Stock #1 generates by far the most income.  Even the fast-growing #3 will not be matching #1 on a current payout basis for close to another five years.  #2 won’t be doing so for at least a decade.

On a total return basis, #1 and #2 are within striking distance of one another.

Stock #3 is the total return winner.  It does so on the basis of its capital gain, which, in turn, rests on its ability to generate above-average growth for an extended period of time.  It produces only a third of the income of #1.  A #3 also takes a lot more careful monitoring.

My investment personality orients me toward #3, but then I’m content to wait five years for serious income to start to kick in.  But I also own one or two #3 types, understanding that they may underperform, because of the income they produce.


There are specific risks associated with every stock.

For these general sketches, it seems to me that the risk in #1 is that the company cuts the dividend, either because it can no longer afford to pay at that high level or because management decides to use the money that would otherwise be returned to shareholders in an effort (usually futile) to expand.

For #3, the risk is that the company can’t sustain a 15% growth rate for longer than a few years.  As its business matures, it may turn into a #2.  As it does so, its PE would likely contract.  This means capital appreciation will be lower than the simple projection above anticipates.

who are they?

Do instances of these three general forms exist?  Yes.

#1s are probably European banks or telecoms.

#2s are gas or electric utilities.

#3s are harder to find.  They’re maybe TIF, or WMT, or maybe even INTC.

Exotic turns in the quest for yield

bond yields are paltry

The yield on the ten-year US Treasury bond is 2.74%.  The yield on the thirty-year Treasury is 3.9%.  The two-year note yields 0.46%.  In shorter-term instruments, your capital is safeguarded but you receive basically no income.

We know that income-oriented investors, both individuals and institutions, have been forced to search for yield elsewhere.  Year to date, the dollar value of new junk bond issues in the US has already surpassed the total for all of 2009–which itself was a record year for issuance.  High yield bond prices have already returned to the levels of mid-2007, before the financial crisis began to take its toll on valuations.  True, yield spread over Treasuries is more than 300 basis points wider today than then, but the two-year note was yielding about 4.9% during the summer three years ago (how quickly we forget!).

New issuance appears to be accelerating.

exotic alternatives

Two new, more exotic types of issue have begun to make the news recently.  I don’t pretend to be an expert on bonds, but in the stock market these would be signs that the market is topping.  They are:

the hundred-year bond Norfolk Southern recently issued, at a price of about 101, $250 million in 6% unsecured notes due in 2015.  Yes, they’re redeemable, but at the company’s option, not the holders.  No, they’re not secured by the company’s physical assets.  Yes, they’re very sensitive to changes in interest rates.  No, trading them won’t be easy.

the mandatory convertible General Motors is planning to issue one along with common stock in its IPO.  Details of the GM mandatory haven’t been announced, but the idea is that it will initially be a preferred stock yielding, say, 5%.  After some specified period of time (two years?) the security will automatically convert into being common equity according to a formula that will give holders some protection against a decline in the new GM shares, and the company some relief it its stock is very strong.

One notable feature of this mandatory is the pik (pay-in-kind) option.  That is, GM can choose to pay the dividend in shares of GM stock rather than in cash.

Put another way, GM will be giving you a 10% discount for agreeing now to buy common stock around the then prevailing market price two years from now.  GM wins if the stock is 10% higher then than now.  And you win vs. buying the common now, if …?

bullish for stocks

To me, this all means that silly season for bond investors is in full swing.  This development is ultimately bullish for stocks, I think.  If investors are willing to buy these exotic instruments, can the purchase of stocks–even regarded as a funny type of bond–be far behind?

FedEx’s first fiscal 2011 quarter (ended August 31st): stronger global growth

the FDX report

Last Thursday FDX reported strong first quarter fiscal 2011 results.  Earnings per share were $1.02 for the three months, up 108% from the $.58 tallied in the comparable three months of fiscal 2010.

FedEx also announced plans to address the loss-making freight segment by merging FedEx Freight with FedEx National LTL (less than truckload) commercial shipping operations into one unit next January.  Despite terminal closings and layoffs, FDX expects to gain market share–and profits–with the move.

FDX upped full-year earnings per share guidance from the previous range of $4.60 – $5.20 to $4.65 – $5.25, ex merger related expenses of $150-$200 million.

By line of business, operating earnings for the quarter were as follows:

FedEx Express     $357 million vs. $104 million in the year-ago quarter

FedEx Ground     $287 million vs. $209 million

FedEx Freight     -$16 million vs. $2 million.

FedEx as bellwether

Transport has a high-beta relationship with overall economic growth.  FDX’s strong earnings performance is a good indicator that economies, around the world but especially in Asia, are continuing to expand.

Express, primarily an international business, saw international package volume rise by 19% and weight by 41%, producing revenue growth of 20%, year over year.  Small, high value packages from Asia (like cellphones or iPads) are a particular strength.  So much so that FedEx has added two scheduled daily flights from Asia over the past few months, bringing the FDX total to 12.  The company will soon boost capacity again as it replaces older airplanes with new purchases.  FDX’s planes are booked through the year-end holiday season.  Load factors are the highest they’ve been in ten years.  Customers are upgrading to premium service.

Revenues for Ground, a US-centric business, were up 13% on a 7% increase in package volume.   The volume boost comes almost completely from market share gains.  In FDX’s view, the US economy is showing “slow but sustained” growth.  The shape of the recovery is “normal.”

The US LTL industry suffers from chronic overcapacity.  Too many trucks chasing too few goods–plus contracts signed when things looked bleakest last year–are the two reasons for FDX’s poor showing in its domestic Freight business.  The company thinks it sees a remedy by using advanced software to more or less replicate the structure of its international air business on the ground at home.   Hence the merger of Freight and National LTL.

The ongoing recovery of world economies is being led by the industrial sector, and by China, India, Mexico and Brazil.  From the remarks FDX management made in its conference call, it seems to me that FDX thinks the securities analysts who follow it–and by extension, American investors generally–just don’t “get” how big these countries are.  Presumably, the international business will be a major topic of the firm’s annual analyst day in Memphis in a couple of weeks.  The main idea will likely be that the developing world is growing like a weed.  In 1980, the developed world made up two-thirds of the global economy and was twice the size of the developing nations.  Within two or three years, however, the developing world will make up over 50% of global output, more than the developed countries’ GDP.

FDX as a stock

I know what the issues are but I don’t know FDX well enough to have an opinion.

1.  At present, manufacturers are controlling the distribution of products by keeping inventories centralized and shipping them at the last minute by air.  The other alternative would be to put the output on boats and truck them to their final destination from the destination port.  The former means higher transport costs but creates extra flexibility for firms to avoid sending products to places where inventories are already high and sales are unexpectedly slow.

The current situation plays to FDX’s strengths and is a financial bonanza for it.  The company strongly believes customers are not reacting to worries about an uncertain world, but are rather taking advantage of supply chain management software advances that save them money through more precise inventory control.

Sounds reasonable to be, but I don’t know.  Not good for FDX if manufacturers go back to using boats.

2.  The domestic freight business has low barriers to entry.  FDX is trying to create one by introducing advanced software to control its commercial truck freight shipments in the same way it does internationally with air.  Its marketing research says customers want the pricing flexibility the new system will provide–and that therefore FDX will be able to make more (or at least some) money with less invested capital.

I’m big on “work smarter, not harder,” so again this sounds good.  But we still have to see.

3.  Fiscal 2011 is a transition year, filled with all sorts of one-time costs.  There are:

–maintenance for previously mothballed planes now being put back in service

–capital expenditure for new planes to service booming international package demand

–higher personnel costs from health care plus restoration of salary and benefits cut during the recession

–writeoff of merger costs, estimated at $150-$200 million.

This kind of stuff happens every once in a while.  It seems to be bothering analysts, but I don’t think it’s such a big deal–especially if #1 and #2 end up doing what FDX thinks.

If both #1 and #2 pan out, FDX looks to me like a very cheap stock.

No reversion to the mean?: El-Erian (II)

In yesterday’s post, I outlined the Pimco investment case, contained in a Financial Times article, which boils down to:  we’re in a time of great uncertainty, so buy government bonds.

my thoughts

For what it’s worth, I think the world is a lot less uncertain place than it was two years ago.  In a way, uncertainty is old news.  That isn’t to say our situation is good, but we now know:

1.  world governments will act to avoid the worst economic outcomes (this is the #1 worry in any macroeconomic crisis)

2.  financial regulators in the US and the EU have been doing a terrible job

3.  banks are weaker companies than we thought, and generally poorly managed, to boot.

In my opinion, a lot of this news is already reflected in security and currency prices.

What uncertainties still exist?

1.  Economically speaking, the developed world is still a fragile place.  The effects of the large excess supply of housing and business space created in the US and UK over the past few years, and of those countries stopping adding to it, are still with us.

2.  The steps that policymakers may take, and the economic effects of those actions, are hard to foresee.  The world has used up much (all?) of its safety margin for dealing with mistakes.

3.  The econometric models that economists use in predicting how our economic future will play out–essentially, elaborate trend-following devices–don’t work well in times of economic transition.  They also didn’t predict the financial meltdown.   So a major tool (bond) portfolio managers have wielded in plying their trade is out of action.  Managers are now working in a room whose lights have been turned out.  (If you believe Nobel laureate Joseph Stiglitz, however, these models were radically flawed from the outset–and were a contributing cause to our economic woes.)

3.  The behavior of economic agents, especially portfolio investors, is harder to predict.  In particular, the chances of extreme, far-from-consensus, and really bad, outcomes has increased.

What does the article conclude from this litany of sorrows?  –we are in a “world where the realized return rarely (emphasis added) equals the expected valuation.”

a curious argument

Okay.  Now comes the weird part.

We’re in a world where no one can tell how the world economy will play out and where investment managers’ portfolios are going to blow up in their faces.  But luckily for us, Mssrs. Clarida and El-Erian are affected by none of this.  They know (no explanation given) how the US economy will develop–very low growth and structural unemployment for as far as the eye can see.  They also know that while virtually every other investment strategy founders on the rocks of uncertainty, one–buy government bonds–will not.  Again, no explanation given.  Just by coincidence, both authors happen to work for a bond fund manager and have this product available for sale to us.

Another point:  The thrust of the Clarida- El-Erian argument is that economic circumstances demand that investors carefully rethink their investment strategies, because macroeconomic conditions today are radically different from what they’ve been before.  Their actual conclusion, however, is far different.  It is that investors will almost never (rarely) be able to figure things out.  In the paragraph above, I’ve pointed out that they think this situation applies to everyone except them.

My  point here is that they provide no support for the actual conclusion they draw.  What they write looks like an argument in support of a conclusion, followed by the conclusion as a logical consequence of what they said before.  But that’s just a kind of sleight of hand.  The idea that no one (except themselves) will be able to figure out what’s going on is a bald assertion, no more.

extreme outcomes don’t all favor bonds

I think it is right to give extra thought to the possibility of extreme outcomes.  In can imagine three, although I’m sure there are more:

1.  The US and EU play out like Japan since 1990.  This would mean bonds would be fine   Stocks would have a period of stability followed by maybe another 30% decline.

2.  The US and EU recover faster than we now think.  Stocks might go up by 25%.  Government bonds would fall, maybe by 15%.

3.  The rest of the world loses faith in the US and EU.  Their currencies fall by 15% vs. the rest of the world and their bond yields rise.  In this case, safety would lie in stocks, not bonds.  Stocks +35%, bonds -15%.

To me, it seems that the possibility of extreme outcomes is an argument for diversification, not  concentration in one asset class.

the authors seem to know nothing about stocks

If we exclude financial Armageddon, equity investors can operate successfully under a wide variety of economic conditions.   In particular:

Value investors do use reversion to the mean, but in a narrower sense than is used in the Pimco article.  The value investor looks for assets that are worth $100 that he can buy for $30 and hopes to sell for $60-$70.  Given that stocks are the cheapest they’ve been vs. bonds (a proxy for the cost of financing purchase of such assets) in about sixty years, this should be a fertile ground to work in.

Growth investors do have deep economic concerns, but they’re  generally microeconomic, not macro.  Will, for example, well off thirty- and forty-somethings continue to buy iPhones and iPads?  Will TIF continue to sell jewelry to Europeans trading down or to newly affluent Asians trading up?  Will the casinos in Macau keep on booming?

Yes, if world economies implode again, equities will be in trouble, at least for a while.  But equity investors don’t need to understand the entire globe to be successful.  All they need is a stable playing field and one or two places where they’re ahead of the consensus.

No more reversion to the mean?–Mohamed El-Erian (I)

“uncertainty changing investment landscape”

The other day I was paging through some old newspapers that I never got to during August (yes, I read the business news on paper).  Sometimes it gives you a sense of perspective to read, a couple of weeks after the event, what trivial things people were thrilled or fearful about at a certain moment.  But mostly I got lazy when the weather got hot and read novels instead of news.  So I was catching up.

I ran across an article from August 2nd with the above title in the Financial Times. It was written by Mohamed El-Erian and Richard Clarida, a professor of economics at Columbia.  Mr. El-Erian is the chief executive of the mammoth bond manager Pimco and an occasional columnist for the FT; Mr. Clarida consults for Pimco.

I usually skip over what Mr. El-Erian writes.  It typically reflects the economic consensus.  Besides that, Mr. El-Erian has seldom been known to use one small word when six or eight big ones will do the same job.  He’s also the public marketing face of Pimco, so we know in advance what his investment conclusion will be namely:

–The global economic landscape will be bleak for many years to come.

–Therefore bonds, even at today’s super-expensive levels, are still a buy; stocks, which are the same price today as a decade ago and the cheapest they’ve been vs. bonds for sixty years, are still a sell.  Pimco’s only change to this mantra over the past year or so has been to kick dividend paying stocks off the approved list.

Nevertheless, I did read this piece.  Despite the fact Mr. El-Erian comes to his usual (horribly incorrect, in my opinion) conclusion about stocks and bonds, I’m glad I did.  For once, Mr. El-Erian wrote something really thought provoking.

I’m going to write about this in two posts.  Today I’ll outline what Mr. El-Erian says.  Tomorrow I’ll write about where I disagree.

the article

The article makes five points.  Four of them are different facets of the same idea–that the disinflationary era that began with the appointment of Paul Volcker as Fed chairman in the US almost thirty years ago is over.  As a result, we can no longer depend on continuingly rising bond prices and falling yields to bail us out of investment mistakes.  Investors have to rethink and retest their strategies.

That isn’t the interesting part.  Equity investors have been soulsearching about excessive leverage and unwarranted risk-taking since the collapse of the Internet bubble in 2000.  (If so, how did the financial meltdown happen?  Investors made three basic mistakes:  we assumed the banks’ accounting statements were reasonably accurate; we wildly overestimated the capabilities and appetite of the regulators to enforce banking and securities laws; and we attributed to bank managements a level of integrity and risk-management competence that most American industrialists possess but many in this industry didn’t.)

The intriguing point is Mr. El-Erian’s first, that “investing on ‘mean reversion’ will be less compelling” in the future.  He implicitly describes the (bond) investing process over the past twenty-five years as having two steps:

–determine the consensus economic forecast, and

–find securities whose valuations imply an outcome that deviates markedly from the consensus.  If the imbedded expectations are too pessimistic, buy the security; if they are too optimistic, sell it short.

Why won’t this work anymore?  In the past, a compilation of expectations from professional economists would form a bell curve, with the areas at and around the mean having very high probability.  The “tails” of the distribution, that is, the forecasts that deviate a lot from the consensus, were short and stubby, that is, highly unlikely and increasingly so the farther away from the consensus they were.

Today, the compilation of forecasts looks less like a bell with a sharp, fat peak in the middle, and more like a straight line with a small bump up in the center.  The economic situation around the world is so uncertain, and the policy actions governments may take to stabilize their countries so unpredictable, that there is, in effect, no solid macroeconomic consensus to bet against.  Not only that, but the more extreme “long tail” outcomes, both bad and good, have become much more likely.

What do you do in a world like this?  Mr El-Erian’s answer is (surprise, surprise)–buy bonds, sell stocks.  You do so because (government) bonds are liquid and default-free.  Therefore, they protect you against the world going to hell in a handbasket.  I guess this means individual investors haven’t been panicking over the past year or more but responding rationally to the current situation by dumping their stocks and embracing bonds.  I suppose that if you really wanted to secure yourself against the worst, you should also think about a cabin in the woods, stocked with freeze-dried food and near a good source of water, maybe with a bow and arrows in case you need to hunt.  Maybe people are.

I’m with Mr. El-Erian up until his conclusion, with which, to put it mildly, I disagree.  Not so surprising, since I’ve spent all my investing life on Wall Street.  The real question, the thought-provoking aspect of the article I’ve linked to above, is to be able to say why I disagree.  What’s wrong with what he’s saying?

More tomorrow.

high-frequency trading vs. computer-driven trading: the Trillium fine

In the aftermath of the “flash crash” of a few months ago, regulatory authorities have been, almost frantically, looking for a cause.  My guess is they won’t be successful.  If there is a single culprit, I think he’s highly unlikely to come forward himself.  (Would you, if you thought you would be made a scapegoat and driven from the business?  Neither would I.)  And the complexity of Wall Street–almost any business, for that matter–comes from taking relatively simple ideas and repeating them over and over again, sometimes with subtle variations.  The result is an end product that’s difficult to unravel by anyone not immersed every day in that line of work.

But the search for an answer has apparently turned up non-related market abuses.  One of the is is the case of Trillium, a small brokerage house and some of its proprietary traders just disciplined by FINRA (the Financial INdustry Regulatory Authority).

to step back a minute

High-frequency trading (admittedly not an area I’m very familiar with, so leave comments if you want) seems to me to come in two flavors:

arbitrage This is the computer-driven search for pricing discrepancies that provide risk-free or low-risk trading opportunities.  These can be as simple as quirks in the bid-asked spreads of different market makers in the same security.  Or they can be differences in the prices of derivatives linked to the same underlying security, or closely-related securities.  Or they can be differences in the prices of a given theoretical financial attribute as contained in different securities or derivatives.

This activity isn’t particularly new.  Harry Markowitz started the ball rolling in the early 1950s.

order execution A large money management institution deals in very large position sizes.  It has two basic choices in controlling its buying and selling.  It can deal in the traditional way, by developing a staff of highly-skilled (and highly compensated) professional human traders, or it can use computers.  I’ve only worked in firms that took the former strategy, so I can’t say from experience how the latter works.

There are two (maybe three) problems with using human traders:  the buying and selling process can be slow, and the firm’s intentions can easily leak into the market through the counterparty before the transaction is completed.

Firms using computers break large orders down into many small ones which they hope to execute quickly with a number of different counterparties and on various trading platforms.  So they hope to get the trading done before information about their intentions has spread, and therefore with limited market impact.  As I mentioned above, I have no idea whether this works well or not.

The third issue, which I haven’t seen discussed anywhere, is who pays for the trading.  A traditional buy-side trading staff can easily cost several million dollars a year, money that is paid by the management company out of its management fees.  My guess is that high speed automated trading systems get poorer executions but are much less expensive to run.  If so, the management company saves the traders’ salaries and the clients pay the economic cost of trading through higher buy prices and lower sell prices.   On the other hand, if the blitzkrieg approach gets better executions, everybody (except the displaced traders) wins.

returning to Trillium

According to the FINRA documents linked above, what Trillium did was this:

Let’s say the best (highest) bid for stock ABC was $50 and the best (lowest) offer for ABC was $50.25.

Trillium traders would decide they wanted to sell ABC.  They would place a limit order to sell just inside the best offer, say, at $50.24.  They would then rapidly place a bunch of orders to buy ABC at different prices just below the best bid.  These orders were “often in substantial size relative to a stock’s over all legitimate pending order volume.”

The Trillium traders never intended to buy ABC.  What they wanted to do was use the false impression of rapidly building buy volume to trick day traders into thinking a powerful upward movement was about to start.  They wanted short-term traders to rush in to buy the stock to ride the impending uptrend.  Of course, the first shares to be bought would be the ones Trillium had pre-placed in the market through their limit order.

As soon as the limit order was executed, the Trillium traders cancelled their phony buy orders.

This is a boiler room operator’s ploy that’s as old as the hills.  It’s the kind of market manipulation the syndicates of the 1920s-1930s did, though on a far larger scale than Trillium.  And it’s one of the abuses that Depression-era reform of the securities markets was intended to stamp out.

is this high-frequency trading?

What does this have to do with high-frequency trading, though?  Nothing that I can see.

Yes, the Trillium traders probably used computers to enter their orders, both real and fake.  And they worked this scam over 46,000 times during the three months FINRA cited in its disciplinary action.  That’s about once every 30 seconds while Wall Street was open for business.  Otherwise, what’s the connection?

More interesting, what would cause the Huffington Post, or the Financial Times, or Fortune to say there’s one?  I don’t know.  The Fortune Street Sweep blog does have a clue, though.   In its post on Trillium, it quotes FINRA’s Thomas Gira, who’s identified on the FINRA website as executive vp of the Market Regulation Department as saying (as I read it) that Trillium’s is a high-frequency trading abuse.

Maybe there is a dark side to high-frequency trading, but I don’t see Trillium as a case in point.  I don’t get why FINRA would say it is, other than the agency must be under pressure to do something.