Wednesday, September 21, 2005

Trading is an Addiction & Your Broker is the Pusher

What Is Active Management ?
A recent article in the Wall Street Journal caused me to consider what it means to actively manage an equity portfolio strategy in an environment in which brokerage analysts constantly vie to create “new information.”

Our strategy, Pathfinder, trades less often than many equity portfolios and funds. If new money is invested, it will be used to buy the most recent equity selections for that month. Otherwise, the strategy holds investments for approximately six months.

The more active part of our management is our constant monitoring of equity market performance in order to position ourselves long or short to the desired degree.

This approach results from rigorous analysis and a desire to employ an approach which combines both fundamental and technical information about the universe of S&P 500 stocks. To trade more frequently than quarterly would be to overweight technical information, as financial reports are released on a quarterly basis.

Another Source of “Information”
There is another source of fundamental “information.” It is the sell side analyst community. By the way, that reference, “sell side analyst,” tells you pretty much all you need to know regarding motivation. The article referred to earlier in this piece appeared in the August 29th issue of that newspaper, in section C- the financial news section. The essence of the article is that some homebuilder sector analysts have been releasing more than one report per day. In one case, an analyst actually published five reports in one day.

Isn’t that thoughtful of them? Otherwise, the major fundamental news would be a company’s quarterly report, or perhaps a sector-wide report issued periodically by some rather more objective institute. Or the monthly new and existing home sales figures. With this onslaught of reports, however, these institutional sell-side analysts are implicitly arguing that what they write is “new information,” necessitating reactions, in the form of trades, from their clients and prospects, the institutional fund managers. Isn’t it convenient that these analysts work for brokerage firms which just happen to have trading desks?

And let us not forget the ever-changing “ratings” activities. Accompanying the many written reports are the solemnly announced ratings of companies by sell-side brokerage analysts. These can vary from the simple “buy/sell/hold” variety to any of countless other categorization schemes. In a manner similar to report publishing, these ratings changes are intended to trigger a stampede of orders from institutional managers in response to the presumably objective changes. In reality, though, any change is beneficial to the analyst’s brokerage firm. It might be said, to use a familiar quote, “the more things change, the more they remain the same.” What “remains the same,” in this case, is the brokers’ revenue streams, in the face of institutional trading triggered by the ratings “changes.”

Mind you, we aren’t even talking about the M&A-related suspect research of the late ‘90s that triggered the Spitzer probes. In fact, in this case, the last thing these analysts want to do is make one large, unidirectional call. It’s far more profitable for a brokerage operation if the analysts activities cause frequent changes in direction, causing more trading as the “new information” flows from them.

The brokerages never directly charge the customers for this research. Instead, it is built into the cost of the trading desks which deliver the resulting trades. Since trading is capital intensive, volume increases due to analysts-driven trading yield the payoff to funding the analysts groups. The institutional customers pay indirectly, even at fractions of cents on the dollar per share traded, or in the bid/ask spread.

An Overlooked Effect
There is another, often overlooked second-order effect from this over-reporting of sector “information.” It is the conditioning of institutional managers, and fund-of-fund managers, to take it as an article of faith that actively managed funds or strategies need to be reacting to all this “information” flowing from the analysts. It is a timeless effect. Somewhere, analysts are pumping out “new information” for the sector du jour of interest. Yesterday it may have been home building. Today it might be energy. Tomorrow- who knows? But rest assured, some sector is always ripe for over-reporting and a steady flow of information on which trades are therefore expected to be made in reaction. If you aren’t trading on constantly-flowing analysts’ reports, you’re just not an “active” portfolio manager.

Where’s the Beef?
What is missing, though, is an objective analysis of whether all this type of “new information” actually constitutes value which can be used to change portfolio positions profitably. There are no studies of which we are aware showing that frequent trading, trimming positions with every jot and tittle of some analyst’s pen, will actually improve fund returns. In fact, the blizzard of analyst reports looks very self-serving for the brokerage firms which employ them. By addicting institutional investors to the steady flow of “research” and “ratings changes,” the analysts help assure a steady flow in the other direction of trades by institutional customers in reaction to the apparent “new information.”

For example, during the week of October 7, 2004, an analyst at one fairly well-known brokerage trashed the entire homebuilding sector. Pulte’s return for the period, from July, plunged from 18% to –3% in a week. It further deepened to –6% the following week. After quarterly results were released later that month, Pulte rocketed back 16% return points in two days. First on news of Toll Brothers blowout quarterly results, and then the next day on Pulte’s own quarterly report. By December 17th, it was back up to a 22% return for the holding period, where it finished the year. Golden West also recovered to a period-near-high of 17%.

So the analyst caused a temporary plunge with ‘new’ information which turned out to be wrong. The market corrected back to its original valuation. How much trading occurred in the interim to drive the prices down, then up? Who gained from that? Well, regardless of the timing of the institutional buys and sells, we know the brokerage firms profited from this little episode. No doubt it is repeated many times each quarter throughout many sectors.

When you think about it, being right isn’t actually all that good for an analyst’s employer. Better, from a trading volume perspective, to cause a change in price in both directions of a stock, rather than correctly signal only one move.

Effective “Active” Management
What puzzles me is why, in the absence of published evidence that frequent, sell-side-analyst-caused trading increases net returns to portfolio managers, more institutional fund allocators and managers don’t frown upon such “active” management.

Why is holding positions for more than a month seen as being a “passive” manager? In the case of Pathfinder, it is a conscious, empirically-research based choice to pursue the accumulation of returns and lower trading expenses. Trading more frequently than quarterly drives a strategy to become technically-based, i.e., defined purely by market price moves. This is where the analysts’ reports come in. By creating a constant flow of “information” with which to affect stock prices, the analysts create trading revenues for their institutional equity desks, while also creating a climate in which managers and investors expect frequent rebalancing and trading as the norm, rather than the exception.

At Performance Research Associates we eschew this frequent-trading approach. Instead, we base our selections and holding periods on longer-time-framed signals and measures. Actively managing Pathfinder means we continually monitor the market for long/short allocation signals to drive that decision, because it is a particularly important and value-laden one. We also monitor positions on a daily basis in order to better understand how economic and company-specific news affects our portfolio selections. However, within existing long/short allocations, we remain confident in our selections, daily ‘new’ analyst-provided information notwithstanding.

We believe the results of equity portfolio management are what count, not the frequency of the trading or investing which produces those results.

Who Should Decide How To Rebuild New Orleans ?

First, let me state that it’s terrible that hurricane Katrina killed people in the Gulf states and caused so much property damage. The loss of life is a tragedy.

Now, the greater than $100B question- who should have the most, or deciding, say in how New Orleans is rebuilt?

If you are reading this, there is a 98% chance that you live in one of the states that is expected to be paying to rebuild New Orleans, but not in Louisiana. And there is a 99.8%, literally, that you don’t, or didn’t, even live in New Orleans. So that means chances are very good that your tax dollars are expected to rebuild a city you don’t directly support in your own state. Illinois has its Chicago, and New York state, its namesake city. Massachusetts supports Boston. I’m sure there are similar examples in other states as well.

But a whole country to support one city?

Does it makes sense that the city of New Orleans, and its state, which together couldn’t manage to keep it safe from reasonably expected hurricane exposure in the first place, are the groups who should have the final say in rebuilding it with other people’s money?

Nevermind that by requesting, or expecting, the rebuilding of the entire city, more or less, on a federal tab, they are already living beyond their means. I guess that’s federalism at work, like it or not.

Personally, I’d have a lot more respect for the government of the city of New Orleans, and the state of Louisiana, if they asked for federal loan guarantees, rather than direct grants and aid. For crying out loud, can't the local and state governments show some pride and initiative in this?

If they want the final say in rebuilding their city, then let them earn it. Ask for help borrowing capital that they will repay with a revitalized port, energy-related commercial zone and tourism areas that are safe and survivable. Rather than issuing demands that the rest of us, through the conduit of the federal government, simply hand over more than $100B to those government entities to spend as they wish. It takes a lot of gall to request/demand $100B to rebuild a city that wasn't safe in the first place, while seeming to stiff-arming the very people from whom they want the money when questioned as to how and why the reconstruction is to take place.

After all we have heard regarding the importance of the area to agricultural transport, energy production and distribution, and other general shipping needs, I don’t understand why the local and state governments can’t borrow against their infrastructure-based revenues to rebuild. I’d prefer to see the funds coming from increased prices paid for goods passing through that region to pay for the new and improved facilities, funded by bonds, than to simply hand over $100B to local and state governmental authorities.

Nobody questions the need and value or rebuilding damaged commercial infrastructure to standards which can better withstand a major hurricane, so long as that cost is economically rational. Either private or public revenue-backed bonds would seem to be feasible. If they can't attract capital, based upon the expected costs and revenues of improved and repaired facilities, then it begs the question of rebuilding commercial facilities there in the first place. What seems to be more in doubt is what kind of residential reconstruction is reasonable. Holman Jenkins wrote an excellent editorial about this in the Wall Street Journal two weeks ago.

I think Dennis Hastert had it right when he questioned whether the United States ought to be reconstructing a city which lies inside a below-water bathtub of levees. In the interest of full disclosure, by the way, I hail from Hastert’s state, Illinois. But that notwithstanding, I admire his comments. As the Speaker of the House of Representatives, the “people’s house” where spending bills originate, he is the ideal elected public official to voice such thoughts. He speaks for the 98% of us, from 49 other states, who wonder why, if we are going to substantially rebuild the city of New Orleans, those of us being asked to pay the tab don’t get to decide how it will be done.

Tuesday, September 20, 2005

Wal-Mart and the Wheel of Retailing

Did you read the piece about Wal-Mart in the Wall Street Journal’s first weekend issue on Saturday? Am I the only person who doesn’t understand why Wal-Mart thinks it can trade-up from being the nation’s largest purveyor of cheap, bulk provisions to the masses to being a destination for those seeking fashion, style and upscale wares?

Back when I was earning my degrees in Marketing, there was a theory which was taught that went by the name of “the wheel of retailing.” It essentially observed that every so often, a new, low-cost retailer will arise that rips through the existing sector structure like a hot knife through butter, growing at the expense of outmoded, expensive older giants.

In the 1920s in hard goods, it was Sears. In the 1930s, in groceries, it was The Atlantic & Pacific Tea Company, a/k/a A&P. In fact, so virulent was A&P’s impact on the world of small, neighborhood grocers that the Robinson-Patman Act of 1934 was informally known as “the anti-A&P Act.”

That said, the Wal-Mart saga since the 1980s is both remarkable, yet not surprising. What the company did is not all that new. It upended several existing chains of general merchandisers who had grown inefficient, insensitive to consumer needs and wants, and basically moribund. How it did it was with the latest version of what the lowest entrants on the wheel of retailing always use- low-cost supply of large volumes of goods. It looks glitzier now, with integrated IT functions shared among vendors. But if you go back to the architect of Sears’ great transformation, you will find that Robert Wood, the creator of that transformation, learned his supply skills as quartermaster on the Panama Canal, one of the more challenging logistical projects of that era.

What is puzzling me is why there is all this attention paid to the mid-late life growth pangs of a retail success. Retailers who began life at the bottom always try to extend growth, once they saturate the market with stores, by moving up-market. And they nearly always fail in doing so.

So will Wal-Mart. The company appeared briefly as a selection in the large-cap equity portfolio I manage. That was back in the 90s. But it hasn’t performed in a consistently superior fashion in over a decade.

If Wal-Mart really wants to move up-market, they should do what Les Wexner did with The Limited. He employed a strategy of buying different brands to move out of the original retail niche in which The Limited succeeded. Wal-Mart could probably employ its size and legendary logistics acumen to vault some existing fashion brands into the big leagues, and at the same time, bring better financial management to them. And attract the more upscale consumers it now seeks, albeit through doors with other brand names on them.

Whether they do or not, at least they would have a fighting chance with both customer segments- the current Wal-Mart shopper, and the fashion-conscious shoppers who now move up to Target and Kohls. It’s not like Wal-Mart is aiming at uncharted, nor vacant, product/market territory.