Monthly Archives: April 2014

Valeant (VRX) – Announces $50 Billion Hostile Deal for Allergan, Inc. (AGN)

Picture this.

At high noon, a majestic and lone antelope on the wide-open plains of the Serengeti is peacefully grazing on the wispy wind blown grass.

Then BANG!

A bullet pierces the heart of the young antelope not knowing a big game hunter looking for his next trophy has shot it. The poor dying animal not only struggles physically but also is mentally confused thinking its well being was protected by its multi-billion dollar market capitalization and substantial premium market valuation.

The panicked antelope gets a glimpse of two men approaching from behind scrub bushes. The hunter, the one with the rifle, being one J. Michael Pearson of Valeant Pharmaceuticals and his partner, one Mr. Bill Ackman, to me better known as Bill “The Butcher” Cutting from the movie “The Gangs of New York”.

Mr. Bill

Mr. Bill “The Butcher” Cutting

The young antelope is, you guessed it, Allergan Inc.

Financial Engineering versus R&D and Innovation

Financial engineering – making barrels full of money – can and will trump everything, even reason. When one has the financial math, or the golden keys if you will, why not use them?

J. Michael Pearson seemingly knows the financial math and is building an empire. Mr. Pearson has acquired through Valeant over 100 acquisitions since becoming CEO back in 2008. I have borrowed Mr. Ackman’s ‘PowerPoint’ slide depicting the concurrent history of Valeant’s CEO, Mr. Pearson and the company’s stock price with a few noted acquisitions annotated for your convenience.

I copied this chart from Mr. Bill Ackman's 'PowerPoint' presentation to investors.

I copied this chart from Mr. Bill Ackman’s ‘PowerPoint’ presentation to investors.

Valeant, the company, and its activities are known as a ‘Rollup’. What is a ‘Rollup’ you ask? A ’Rollup’ is where multiple small companies in the same market are acquired and merged together by a consolidator. In this case the consolidator is Valeant and its mastermind is one Mr. Pearson. See my original blog about Valeant and its activities here and a reblog (with new financial data) here.

Financial history is filled with ‘Rollups’. Usually the consolidating company and its mastermind – the protagonist behind the company – is very successful in the beginning and during the numerous acquisitions the consolidator completes. Valeant, the company, and Mr. Pearson maybe new to business history stage but their corporate acquisition activities are NOT new to the annals of business history.

The difficulty behind ‘Rollups’ and ultimately its undoing – failure – is the complex financial math behind the consolidator’s acquisition activities. In my original blog I identified the protagonist, J. Michael Pearson, as an individual who potentially may have figured out the financial math behind doing hundreds of acquisitions with a steadily climbing stock price rewarding him and common shareholders. Readers have to admit I wasn’t wrong in my assessment. See once a protagonist – Pearson – and the consolidator – Valeant – gets on a roll (no pun intended), why stop? The financial math works proportionately irrespective of the magnitude. Hundreds of thousands of dollars can turn into multi-billions and the math still works except for the inconvenience of dealing with the zeros and commas.

With this in mind, Mr. Pearson is reaching all the way for the $50 billion acquisition instead of playing around with an acquisition in the small mid double digit billion. And why not? Mr. Pearson has a solid track record from previous acquisitions and has earned market credibility proving he knows the financial math to make his ‘rollup’ vehicle, Valeant, successful by making shareholders money.

Allergan, Inc. is a company that has a corporate culture prized and steeped in science. A full 17% of Allergan’s revenue is spent on research and development, higher than many of its rivals. Valeant claims to have spent 3% of its revenue on R&D last year but with revenues growing as quickly as the acquisitions were completed and costs slashed as fast as possible one has to give a ‘Spockian’ eyebrow to this percentage. Pearson reassured investors that $2.7 billion in cost savings could be realized from the acquisition of Allergan, Inc.

So much for Allergan’s R&D!

As Bud Fox asked Gordon Gekko in the movie Wall Street, “Why do you need to wreck this company?”

“Because it’s WRECKABLE, all right?” yells Gekko!

Enter Bill “The Butcher” Cutting – Bill Ackman

Looking at his acquisition strategy chessboard Mr. Pearson probably thought about my metaphor of the antelope (just kidding) in that Allergan in the flickering of life between the bullet in the heart and death itself still maybe saved. First, the numbers are getting too big to hide and an acquisition as big as this will attract a lot of financial press. And secondly, Allergan could play the sympathetic ‘Little Red Ridinghood’ card and wrap them selves in scientific innovation helping humankind type of company that will be destroyed by the big bad wolf (Valeant’s greedy ‘Rollup’ financial machine).

Mr. Pearson is smart enough to know this acquisition fight will be fought at the “Five Points” district in lower Manhattan. (OK, yes this fight will occur in the canyons of Wall Street…but Five Points is relatively close and it follows the story line of my analogy so I’m going with it!) And with any fight, especially a knife fight, you need an antagonist. An antagonist that is totally crazy with greasy hair and blood on his apron. An antagonist who will sharpen his knives, axes and isn’t afraid to die especially in front of the countless lawyers and investment bankers Pearson and company will have to deal with to get this deal done.

“The Butcher” and his gang doing what they do best. Anybody want to fight?

Pearson (Valeant) and Ackman (Pershing Square) form a Partnership (PS Fund 1)

So Mr. Pearson tells Mr. Ackman of his plans to tender a hostile bid for Allergan after the two were introduced. Together through their respective companies they setup a partnership called PS Fund 1. Valeant chips in $76 million in cash into the Partnership – PS Fund 1. Pershing Square, through the partnership, quickly amassed a 9.7% stake in Allergan, much through the purchase of stock options – very little capital required. On April 22nd Valeant launched their hostile takeover bid for Allergan, Inc. pushing shares of AGN up to $168 – as of Friday’s close April 25th. The true cost of the 9.7% – 10% being the legal limit – stake in Allergan by the partnership has not been disclosed but for the sake of round numbers let’s say the partnership of PS Fund 1 profit is $35 per share. With some 29 million shares controlled by the partnership that’s a cool profit of $1 billion dollars. If a ‘white knight’ appears on the scene and bids a higher price than Valeant and wins Allergan, Valeant gets its money back, $76 million, and 15% of any profit the transaction yields. Of course ‘The Butcher’ and his clients get the rest.

Isn’t this insider trading? How could this be legal you ask? Well, Bill “The Butcher” Cutting’s lawyer – Robert Khuzami – former director of enforcement at the SEC – vetted the Valeant partnership (PS Fund 1) and deemed it legal.

“Folks, it’s smart people like me who make America great.”

Allergan probably could have defended itself against Valeant however with the two of them the heartbeat of my young antelope is growing fainter, indeed.


How do you feel about ‘Financial Engineering’ now! Is this capitalism at its’ finest or something else? I will leave the moral and ethical judgments to you. In no particular order here are my conclusions.

  1. Call and book the taxidermist. In my opinion Allergan has limited options available to keep themselves independent. The CEO of Allergan could recapitalize the company – pay a huge dividend to shareholders with debt – and perform the necessary self-mutilation in terms of employee layoffs and reduced R&D spending planned by Mr. Pearson and Valeant to remain independent. The other option is, of course, a ‘white knight’, a company of Allergan’s choosing to purchase Allergan at a premium to Valeant’s bid. This ‘white knight’ will have to be careful though. If the CEO’s ‘white knight’ purchase is a vanity purchase and the company’s share price gets crushed because the market doesn’t like the acquisition – the acquisition numbers don’t work – then the ‘white knight’ company maybe the next target for Pearson, Ackman and Company. After one antelope has been shot and two humans are walking around the Serengeti the other animals – pharmaceutical companies – will be visibly nervous.
  1. I spent all Tuesday afternoon, the day of the formal bid, April 22nd, using Model Price Theory (MPT) and pushing around some of the numbers on Valeant’s pro forma balance sheet if this Allergan deal gets done with the announced numbers. Shockingly the numbers work! Investors and equity market observers might have deduced this because Valeant’s share price appreciated on the announcement of the deal. It amazes me how the market, within seconds of an announced deal can make a snap judgment – and a correct judgment – whether the announced deal is beneficial to the acquiring company’s market value or model price. Mr. Pearson is a financial engineering genius my friends and I have the math to prove it!
  1. If Valeant’s acquires Allergan, Inc. Bill Ackman and his investors will invest $4 billion in Valeant’s shares with board representation. This is no surprise to me. Bill wants to get closer to the action. Maybe pick up some financial engineering math from his new friend Mr. Pearson. To repeat what I said earlier if the financial math works the magnitude of the numbers are of no consequence. Will the boys, Pearson and Ackman, be happy after this $50 billion dollar Allergan deal gets completed? Of course not! There are still bigger deals to do. How about a $100 billion dollar deal?
  1. What’s the end game for Valeant, you may ask? Rollups finally get crushed under their own weight. The numbers just get too large. Or maybe in this situation there are no more publicly available pharmaceutical companies to acquire. There is only a hand full of elephants out there after all. Merck has a market capitalization of $167 billion, and Pfizer $196 billion. And both companies are trading below our calculated model price or fair market value. If this Allergan deal gets done, Mr. Pearson and his new best friend, I’m sure, will be getting restless and will be looking for bigger game grazing on the Serengeti. After all a new business history can be written here and isn’t making future history more important then money?

P.S.      Friends I would be remiss if I didn’t point out the obvious here. In February 2008 one J. Michael Pearson started out as a lowly CEO of a generic pharmaceutical company with $5 million in Valeant company stock. Today, after short 6 years, Mr. Pearson is now a billionaire financier – yes, he is worth over a billion dollars – and CEO of a public company that will have a market capitalization of $75 billion US dollars if Valeant gets the acquisition of Allergan done. Truly amazing, especially considering that global growth hasn’t been stellar since the Financial Crash of 2008.  What have you been doing over the last six years?

A Closer Look at the S&P/TSX Energy Sub-Index

Yes, we have model price charts of each of the sub-groups making up both the S&P 500 and the S&P/TSX Composite Indices.


So let’s have a look at our super-long term model price chart of the S&P/TSX Energy Sub-Group.


S&P/TSX Energy Index with monthly price bars and EBV Lines (colored lines).

S&P/TSX Energy Index with monthly price bars and EBV Lines (colored lines).




  1. Looking at 19 years of history gives observers a sense of the valuation distribution of the Canadian energy sector. Back in 2005 to 2007 ‘oil patch’ equity valuations, as an index, reached a high of EBV+5. On the low side, except for a brief period in 2008 and 2009, EBV+2 seems to be the valuation lows achieved in 1999, 2011 and recently at the end of 2013.


  1. In general this Energy Sub-Group, as an index, seems to follow EBV+3 most of the time. Yes, when crude pricing and probably M&A activity are favorable valuations stretch over EBV+3. However when a secular bear market hits the sector this sub-group spends considerable amounts of time under our ‘Red Line’ or EBV+3.


  1. After the market decline and worldwide slowdown in 2000, and starting in late 2002 this Energy Index started in the valuation zone of EBV+2 and EBV+3 (the same valuation level as today – see ‘up’ arrow on chart) and rallied all the way up to EBV+5.


A Closer Look


Here are our short-term or weekly price bars of the S&P/TSX Energy Index model price chart.


S&P/TSX Energy Index with weekly price bars and EBV Lines (colored lines).

S&P/TSX Energy Index with weekly price bars and EBV Lines (colored lines).


  1. As you can observe this energy sub-index used our calculated EBV+2 as support for the month of December 2013 and into 2014. Again as you can observe since mid-February this index ‘ lifted off ‘ from EBV+2 for a nice gain.


  1. From April 21st, 2014 this energy sub-index has 22% upside potential to EBV+3 or Red Line.


  1. For fun, today’s current value of EBV+5 is 6043. Yes, that’s a full 82% above current levels.



The energy sector in Canada has been on a tear since mid-February. Large capitalized oil stocks like Suncor, CDN Natural Recourses, and EnCana have been moving upwards after many years in the doldrums. Just like 2002, the worldwide economy was recovering from an economic setback delivered by the equity – technology – crash in 2000. The circumstances in terms of worldwide growth for 2002 and today are quite similar and one could reasonably argue that the economic contraction of 2008 was certainly deeper than any economic recession experienced since the Great Depression. As global growth accelerates so does the worldwide demand for hydrocarbons.


Yes, Canadian energy stocks are starting to move upwards since mid-February. But if worldwide global growth starts to accelerate, this sector and sub-index do have a long way to run if this current period is any way analogous to 2002 to 2007.

You want to be rich like Warren Buffett? Read This! – Reblog

Energy companies are ‘jiggy’ my friends on both sides of the border. The number of energy companies making new 52 – week highs is astonishing. Please take your time and ‘Speed Chart’ your way through the ‘SP500 Energy’ sub index of the S&P 500 and the ‘S&P/TSX 60 Index’ for valuable possible investable ideas. Large capitalized energy companies, after years of sub par returns, are having positive transits and should not be ignored.

I blogged about Exxon Mobil Corporation back in November, when Mr. Buffett made a very shrewd and well timed investment – would expect anything different! At the time of the Buffett investment and my blog, it was later disclosed that infamous short seller Jim Chanos had a short position on the same Exxon Mobil!


(P.S. Hope you enjoying your Easter Sunday!)

Last Thursday Warren Buffett, chairman and CEO of Berkshire Hathaway, reported his third quarter portfolio update.  He, or one of his hired fund managers Todd Combs or Ted Weschler, reported holding a new stock position in the third quarter: Exxon Mobil Corporation.  The size of the position suggests that it is a Buffett position.

Berkshire reported owning Exxon Mobil in the third quarter in an amended filing, but actually first bought the stock in the second quarter without filing, and hid the fact until now.  In the second quarter he bought 31,244,110 shares.  In the third, it added 8,845,261.  The average share prices for the two quarters were both $90.

As always when I hear such an announcement I rush to my model price charts to see what is happening and for a quick analysis.  I didn’t have to for Exxon Mobil, this model price chart is well known to me and Buffet’s purchase makes all the sense in the world.

If you want to be a successful investor in real estate the cliché is “Location, Location, Location”.  To emulate Warren Buffett in the equity markets you have to know Valuation, Valuation, Valuation (and tax-free compounding).  The business press will always tell you who, what, when and the where.  I will disclose the why and the how!  Let’s have a look at Warren’s playbook.

First, let me show you our super long-term model price chart from our database for Exxon Mobil.

Exxon Mobil with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Exxon Mobil with monthly price bars, EBV Lines (colored lines) and model price (dashed line)


As you can see our model price chart goes back to 1995, some 18 years.  I have annotated by ‘up’ arrows only two other times – 1995 and 2010 – that Exxon Mobil traded at the same EBV level that Mr. Buffett made his most recent purchase of XOM (EBV+3).

One of America’s largest and best-managed public companies is trading at a valuation only seen twice before over the last 18 years.  Mr. Buffett used this valuation level to purchase a sizable stake in the company.  This is why Mr. Buffett is one of the wealthiest men in the world.  The market is, for whatever reason, placing a valuation on Exxon Mobil that rarely occurs.  First, Mr. Buffett recognizes this fact and has the investment capital to take advantage of the situation.

Another secret of Warren’s that rarely ever gets any coverage is the man rarely, if ever, sells his main positions.  Warren has two things working for him when making an investment, the first is the valuation level of his purchase and the second is tax free compounding as the book value of the company goes up over time – as you can see in our model price chart in that our EBV (parallel multi-colored lines) slope upward on a logarithmic scale.  Another bonus is Exxon Mobil pays a dividend of 2.64% in line with 10 year US treasuries.

To summarize, Warren’s has some cash lying around.  One of the best-managed companies in the world, a company that can trace its roots to John D. Rockefeller, is trading at a valuation that’s only occurred twice before in the last 18 years.  Plus as an added bonus Exxon pays out a yield of 2.64% –  same yield one receives on US Treasury bonds.  (In ten years the US Treasury gives you your money back, one can only speculate what the value of Warren’s shareholding of XOM would be and the future yield the company would be paying.)

This is how the rich get richer my friends!

NASDAQ Finds Support at EBV+5

Sometimes pictures can say a thousand words.


NASDAQ 100 Stock Index with weekly price bars and EBV Lines (colored lines).

NASDAQ 100 Stock Index with weekly price bars and EBV Lines (colored lines).


Enough said.

P.S. I hoped everyone noticed the ‘Chicken Littles’ in the news media have gone from hysterics to calmness once the NASDAQ market found support.

P.S.S. Twitter and the ‘Echo Chamber’ of the usual suspects last week when the NASDAQ stocks were declining.


Voila_Capture 2014-04-16_12-47-51_PM


Voila_Capture 2014-04-16_12-49-06_PM


Corrections don’t matter anymore…I guess they can’t get peoples attention unless they say the word ‘crash’!

Do you like Optical Illusions?

Here are a few popular optical illusions that you might have seen before.


The Infamous Elephant Drawing

The Infamous Elephant Drawing


and this,


See a young woman with her head turned or an old hag?

See a young woman with her head turned or an old hag?



Want to see another one?


S&P 500 Index from 1997 to Present

S&P 500 Index from 1997 to Present



Sometimes I do pop my head ‘up and about’ and try to see what others in the world of finance are seeing.


This chart has been making the rounds, seemingly produced by J.P. Morgan Asset Management (Can you believe anything on the internet these days?) and I have seen it numerous times on predominantly bearish websites and used by individuals who say there is a crash coming in US equities.


I have to admit I did stare at this chart for quite some time. Then I cracked a smile, shake my head and say “gotcha”.


This S&P 500 Index chart is an optical illusion like the other two! So please don’t be fooled. This stuff embarrassingly is passed off as serious research however it is anything but.


For comparison purposes have a look at our long-term model price chart of the S&P 500 Index over a slightly longer but an inconsequential two years. (Our S&P chart starts in 1995 instead of 1997.)


S&P 500 Index with monthly price bars and EBV Lines (colored lines).

S&P 500 Index with monthly price bars and EBV Lines (colored lines).



As a reminder we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.


Our model price chart does look different in some very important ways.


Logarithmic versus Linear Charts? The best is …


We do all our chart work on a logarithmic or a semi-log scale instead of linear charts. This is a very important distinction. Why? When viewing a price graph or chart on a linear basis, you are observing a chart numerically based on a standard measure of the y-axis – the numerical value of the S&P 500. I would recommend that you view a price chart on a semi-log basis so you can easily observe the percentage change of the stock or index in question. Compare where the S&P 500 bottomed in 2009 on both charts. The market bottom on the linear chart looks relatively calm compared to our semi-log model price chart where the downward price spike looks longer and more hazardous to your financial health, which it was. In general, distortions can appear in the market or equity bottoms or tops, for that matter, on linear price charts that can fool the observer in the actual price volatility that actually did occur.



How to disclose meaningful financial data in chart form?


In the history of finance we have yet to formally discover or thought about how best to display fundamental information on a price chart. You can observe the preparer of this S&P 500 Index chart – assuming it was J.P. Morgan Asset Management – tried their best to insert on what they thought were key pieces of information for your consideration. Was this financial information disclosure meaningful? Should investors make important investment decisions on relative measures like dividend yields, bond yields and the simplistic price/earnings ratios? How about something more concrete? Wouldn’t it be better to try and find another financial fundamental independent variable to chart so users make more informed investment decisions?


Re-Thinking the Use of Corporate Balance Sheets


Nobody it seems think about public companies balance sheets in terms of financial price analysis. Firstly, all corporate balance sheets by definition have to balance numerically, which is a good thing. And secondly, management and auditors spend an inordinate amount of time to ensure valuations on key asset and liabilities are properly recorded and reflect economic reality. Whether you have thought about a company’s balance sheet in terms of company analysis you may have to agree with me though, as an independent price variable to be charted over time this variable would be very strong.



Accounting Book Value per share + our ‘Secret Sauce’


The accountants call it ‘book value’ – simply divide the net book value or net worth of the company with its shares outstanding. To this number we add our ‘Theoretical Earnings’ value on a per share basis. (Remember our calculation of Theoretical Earnings is the net income a company needs in order for its balance sheet to stay of constant value or state over a period of time. See Theoretical Earnings under ‘Key Concepts’ tab above.) This result gives us our ‘Economic Book Value’ – to distinguish and differentiate from accounting book value – that graphically we chart on a semi-log scale as the green line, which we call EBV. The constants above this green line we number EBV+1, EBV+2 and so on to EBV+10. There are only three EBV lines below our calculated EBV or our charted Green Line that we number EBV-1, EBV-2 and EBV-3. See below



By calculating and charting these EBV levels or zones over time observers can observe how the balance sheet of any company or companies grouped together in an index have grown or compounded their net worth over time – especially on a semi-log price chart.


Combining together both EBV levels and the S&P 500 Index Value


Thinking of these two variables separately – EBV levels and Index pricing – they are both independent of each other and readily verifiable. So combining them together on one chart provides what I believe is a fundamental financial analysis first. Two independent variables on one financial analysis chart interacting together and giving an observer valuable fundamental information not only on valuation levels but also positive and negative transits alerting investors of a possible change in fundamentals.



Analyzing Both Charts – J.P. Morgan Asset Management and our Model Price chart – at the Same Time


Look at the first market high in 2000, on the JP Morgan produced chart. Now look at our long-term model Price chart. The S&P market high, in 2000, almost put the Index value up to EBV+6 – amazing in hindsight. Now trace the second high, in 2007, on the JP Morgan produced chart – with an Index high of 1565 versus 1527 in 2000. Again, referencing our Model Price chart this market high was at EBV+4. Same index price level, however a big difference in terms of valuation in the market.


Now look at the third and last high on this chart produced by JP Morgan, an index level of 1872, after a heroic and seemingly Everest climb from the market bottom of March 2009. Again consulting our model price chart, this same index level, 1872, places the S&P 500 in a valuation zone just above EBV+3.




Is the valuation on the S&P 500, something to worry about when the past previous tops in the market were at (almost) EBV+6 and EBV+4? Phrased another way, the market – as defined by the S&P 500 – traded over EBV+3 from 1993 (not on chart) to 2007, (14 years) probably without fear of excessive valuation. But now in 2014 investors should now be worried of excessive valuation?




Grazers of financial information on the internet must be on guard. Information can be displayed in such a way that can lead users to the wrong conclusions or worse support the originators narrative or agenda. I have essentially proven that two price charts, each displaying essentially the same piece of information – the price series of the S&P 500 Index over a certain period of time – of having two different meanings. Depending how the price series and the information around the price series are displayed.

Optical illusions can be fun for you and the whole family.  Unfortunately and often optical illusions do appear in the financial news media and get spread around the Internet like a wild fire.  Take great care when viewing and assessing this information.  As the colloquialism goes, this free piece of information and 50 cents won’t buy you anything at Starbucks or worse may put a dent into your financial future.


Flash – Rundown or Strategic Review of our Model Price Equity Indices Charts

After another down day in the markets, let’s have a look at our model price charts of the three major North American equity indices that maybe of interest.


In no particular order,


S&P/TSX Composite Index


S&P/TSX Composite Index with weekly price bars and EBV Lines (colored lines).

S&P/TSX Composite Index with weekly price bars and EBV Lines (colored lines).


No correction here.  At least not yet!

If things do get hairy south of the border, then look for downside support at EBV+2 or 13,906.  That’s only 2.6% below tonight’s close.  No big deal, right?


S&P 500 Index


S&P 500 Index with weekly price bars and EBV Lines (colored lines).

S&P 500 Index with weekly price bars and EBV Lines (colored lines).


I can hardly see any correction on this price chart, can you?  Support for this Index is back to EBV+3 or 1716.  That’s only 7% from tonight’s market close, which doesn’t sound like much but I’m sure this will shake investors’ confidence if this Index did reach support in the immediate future – leaving buyers with a great buying opportunity.  Keep in mind the closer this Index gets to EBV+3 the less risk investors will be taking in the US market in general.


NASDAQ 100 Stock Index (NDX)


NASDAQ 100 Stock Index (NDX) with weekly price bars and EBV Lines (colored lines).

NASDAQ 100 Stock Index (NDX) with weekly price bars and EBV Lines (colored lines).


I guess I don’t need to tell anyone that the NASDAQ stocks have been the ones that have corrected the most.  The good news, as of tonight this Index has a downside risk of only less than a percentage point before touching support at EBV+5.  Look for the NASDAQ Index to start looking for support, or better still individual NASDAQ stocks to start holding their ground in the next few days at their own support levels or the bottom of their current EBV zones.


Big rallies have and do occur when Index EBV support levels are reached when individual stock declines become tapered.  Buyers do become emboldened when they think the sellers have abated for whatever reason.


Hopefully this will give you some guidance on where we are at with this market and plan your investment or trading plans accordingly.

My “Aha” Moment with US Equity Electronic Trading

You have heard the expression “Conflict of Interest”.

Well, a Bay Street veteran introduced me to its iteration early in my career “Where there is no conflict there is no interest.”

Now that Michael Lewis has blown the whistle on High Frequency Trading or HFT, in yesterday’s New York Times (here) and his just released book ‘Flash Boys: A Wall Street Revolt’, my question is ‘What took so long?”

I encountered an early version electronic trading back in 1999 – 2000. We at Acker Finley Inc. (AFI) had a sizable proprietary trading desk – prop desk – trading both US and Canadian equities. Traders using AFI’s capital to make short term trading gains in the equity markets.

For US equity trades our traders were using _______ ____’s on-line equity platform. Month after month things were going swimmingly, with AFI making a tidy profit after bonuses and expenses.

Then one day one of our traders was complaining about a US equity fill he received to a _______ representative over the telephone and the conversation wasn’t polite (if you catch my drift). I made a mental note but thought nothing of it, until a few months later there was a chorus of similar complaints from the guys on AFI’s trading floor.

Just like Michael Lewis’s article I stood behind one of my traders as he placed a buy market order on the offering side of the market and as he hit ‘enter’ on his computer the market offering immediately moved upward while we waited what seemed like hours – OK minutes – with no fill as the stock gapped higher.

I couldn’t believe my eyes.

So confusingly I picked up the telephone to enquire what the #%$# (expletive) was going on. The _______ rep said the explanation was simple. He explained _______ was internally ‘restricted’ on the stock and they had to ‘trade away’. Meaning, _______ was acting on behalf of or advising the company corporately and as a market maker they gave our buy order to another firm or worse, place our order in a very low priority so as _______ would not be in any ‘conflict of interest’ situation. If the market moved against us, so be it! ( _______’s commission rates still applied by the way!)


Thinking quickly I said “OK, so every morning could you please give me a list of your ‘restricted’ stocks so we can trade somewhere else or better still NOT trade the name at all?” This seemed reasonable in that if _______ couldn’t give us the best price and speed for our orders then why risk losing money on the trade to begin with.

“That information is confidential”, snapped the rep. I guess reasoning if the public knew the stock was on _______’s ‘restricted’ list some corporate activity was in the offing potentially impacting the stock price.

“This is ridiculous”, I shouted. “ If we get a lousy fill or no fill at all, then we are to assume you are ‘restricted’ on the stock”.

“Obviously!” the rep responded without a hint of incongruity.

And after this conversation we got lousy fill after lousy fill!

So as the saying goes, I was born at night, but not last night!   We began auditing the results of our traders over the last six months and the result was jaw dropping. Our traders were making money, but only in Canada. The US equity trading was slowly and steadily losing money, albeit in small amounts, consistently and repeatedly.

_______ was swallowing a bigger spread of our trading action. The more we would have traded the more we were to potentially lose.

We pulled the plug on _______’s platform and we modified our US trading habits to recognize the US equity market’s new reality – more on this in another blog. Canadian trading always was profitable and still is. I thought over time market participants would get smart to what was going on and fix what was a clearly a broken equity trading system.

Keep in mind this occurred in early 2000 where much of the work behind the trading interface was human. Over time these human acts were coded into high-speed servers and routers and placed not only in the big investment banks but also their ‘siren’ high-speed servers where in close proximity to if not in the stock exchange buildings themselves. Yes, these big investment banks, hedge funds and specialized ‘High Frequency Traders’ have had 14 years of open-field running and probably have accrued huge profits at the expense of investors.

Finally it has taken Michael Lewis and a Canadian boy from Royal Bank of Canada, Brad Katsuyama, to finally expose what is truly going on and did something about these unsavory business practices by starting his own independent equity exchange called IEX.

The final irony for me was _______ _____ announcing in the New York Times Op-Ed page their approval and use of this new equity exchange, IEX. My guess is the predator became the victim. Others ‘Conflict of Interest’ are finally boomeranging round and affecting them and their clients. This US financial heavyweight is now in the role of a client – AFI back in 2000 – and probably grew frustrated of what others were doing to them.

If you’re in this business long enough things do come full circle – eventually!


P.S. While in the midst of writing this blog – Monday night, the FBI announced an investigation of HFT. Another investigation of Wall Street, of how clients were disadvantaged for the sake of inflated salaries and excessive profits. Sound familiar?