Sometimes, I hear that high-frequency trading causes problems on Wall Street, and that is why some people are afraid to invest in stocks. High-frequency trading accounts for about 70 percent of the daily volume on the exchanges and roughly 18 percent of the profits.
But don’t let this scare you away from buying small pieces of large companies that are traded on the exchanges. To understand why, one must understand what algorithmic trading is. An algorithm is an effective method expressed as a finite list of well-defined instructions for calculating a function. The instructions describe a computation that, when executed, will proceed through a finite number of well-defined successive states, eventually producing an output and terminating at a final ending state.
Algorithmic trading, which is sometimes referred to as automated trading, black box trading or even algo trading, employs the use of electronic platforms for entering trading orders with an algorithm that decides on aspects of the order, such as the timing, price or quantity of the order, in many cases entering the order without human intervention.
The last part is what scares some people, but it shouldn’t. The reason is that if an investor is using limit orders to buy and sell, why should one care what a stock trades at until it hits your desired sell or buy price? If you’re a trader, then yes, you may be at a disadvantage, but as I’ve said many times, investors do better than traders do as a whole over the longer term anyway. So let the traders have their fun and get their high from trading, while the investor plugs along and sees their money double, triple and quadruple over time, and pays a lot less in taxes with a far lower stress level.
High-frequency trading does produce profits for Wall Street as I said earlier; back in 2010, a 400,000-square-foot facility was opened on the NYSE-Euronext at a cost of $600 million. Because of the high frequency trading, you now only pay $7-9 per trade.
Last week we saw some companies report earnings and either miss the estimate or see their earnings per share fall from last year. Let me share with you some of the important information I’m reading in the company reports and conference calls of the companies we own. Sorry, I won’t give you the names of the companies in my portfolio, but you should be able to learn from what I’m reading and check to see if the companies in your portfolio are having the same issues. These are issues that all the high-frequency traders will miss and have sold many of their positions at losses.
Company A beat the estimate by 16 percent, saw their equity increase by 11 percent year over year on a diluted basis, and currently pays a 4.2 percent dividend. Yet the stock has dropped seven percent over the last couple weeks. Company A could have made a lot more money on earnings if it wanted to, but the company invested 22 percent more in R&D (research and development) at a cost of nearly a half billion dollars. For the investor, this is a great thing to see the company you own spending money for the future. As I’ve said many times, companies don’t run their business for quarterly results, so why invest for quarterly returns?
Company B saw its book value per diluted shares increase 7.3 percent year over year. It beat the estimate by 6.3 percent and the stock fell 8 percent. This company has had an inventory problem for about nine months now and reported that it has almost worked off the inventory, and the demand for its product is increasing. This company is doing everything right, yet the traders hit the stock.
Company C had the nice problem of not being able to build enough of its product to meet demand, so it missed the estimate and lowered earnings expectations going forward. This company has a forward PE of 11.5, no debt and generates large amounts of cash each month. If you had a business with this type of scenario you would be extremely happy, and I will point out that if you hold a company stock like this, you, too, should be extremely happy no matter what the traders do.
Please don’t worry about the talk of high-frequency trading; it will not affect you if you are an investor.
Have a question or a company you'd like me to take a look at? Email me at firstname.lastname@example.org.
Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.