Beware the micro-managers

25th August 2011 by The Value Perspective

By Nick Kirrage.

High-frequency trading involves the use of sophisticated technology and computer algorithms to analyse market data and then buy and sell stocks and options according to set market strategies – all in the blink of an eye. Essentially, it is about trying to gain an edge by being faster than everybody else.

In the olden days, which in IT terms means a year or two ago, trading speed was measured in seconds but now it is measured in microseconds – that is, millionths of a second. As an indication of how fast that is, experts have calculated the high-frequency trading equivalent of a supermarket checkout could process every single product the average household would ever buy in less than a second.

All very impressive but a crucial question has to be, what is actually happening in these microseconds? These are computers doing the trades – computers that will never speak to a company’s management team, never read its report and accounts, never do any in-depth research and thus do not know the businesses they are buying and selling. All they are doing is trying to take advantage of any lag between other people’s data feeds and their own.

Furthermore, nothing happens in the real business world in microseconds or even seconds. Does the fair value of Tesco change on a second-by-second basis? Of course it does not. According to Tesco’s most recent results, its annual sales were £44.57bn, which equates to about £1,413 every second. That is certainly not going to change the overall value of Tesco – and yet some investors are trading on precisely that basis.

That is of some concern – or at least it should be – but it has two consequences from a value perspective. First, it means correlations across the market inevitably increase because these computers, which are hugely sophisticated but hardly grounded in fundamental analysis, are trading stocks as if they are the same across the board. They will not distinguish between, for example, Tui Travel and Thomas Cook, which are two very different businesses with two very different balance sheets.

High-frequency trading computers only view them as one price according to one data feed and one price according to another and will try to arbitrage the two. That inevitably increases correlation in the short term – particularly in times of stress – and so, as we have seen in recent weeks, the participation or otherwise in the market of the high-frequency traders move shares up and down irrespective of their starting valuation or their prospects.

In the short term, this can be bad news for our portfolio holdings as it means the financial strength or prospects we have paid for in each business are being ignored by the computers and the share price can decline irrespective of whether a fall is justified. However, on the upside – and this is the second consequence – it does give us opportunity. If computers do not pay attention to a business’s fundamentals as we do, and since we have a timeframe of more than a few seconds (we prefer three to five years) then in the longer term we have an advantage.

Thus, to take an extreme example, should there be another ‘Flash Crash’, such as happened in 2010 when shares of leading US companies such as Accenture traded down from $40 to one cent in a matter of hours because the computers were following preset trading strategies and did not recognise what was really going on. That would provide us with an opportunity.

To the value investor, high-frequency trading appears a strange way of doing business but it now makes up more than three-fifths of market trading volume. Thus when the computers stop trading for whatever reason, it can lead to a dearth of liquidity and share prices move very erratically. When the intraday spreads of huge companies can be plus or minus 20%, regardless of whether they have published results, that is obviously a sign things are not quite working properly because no business’s value changes that much in the course of a day. This goes beyond speculation and is in danger of missing the point of investment, which is about buying low and selling high, not buying fast and selling faster.

Still, as we have noted: the short termism and indiscriminate nature of others, provides plenty of opportunities for the more considered investor.

by Kevin Murphy
Schroder Specialist Value UK Equity team and co-manager of the Schroder Recovery Fund since 2006.

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