Mar 11, 2009

A Week on Wall Street: Day 3

New York Stock Exchange

It was a rare treat to go down to the trading floor of the NYSE for the opening bell. Although the vast majority of trading has gone electronic, they still have specialists for many stocks that manually open and close the trading day. The specialist we talked to seemed to base trading decisions on split second gut reactions and news events - there was no time for any kind of fundamental analysis or even technical analysis (one screen had a chart on it, but he didn't seem to rely on it much). Interestingly, these market makers get paid by the exchange for providing liquidity. There were also mad swarms of people running around writing down the expected opening price from the specialists, which was then sent upstairs. There is an electronic feed that provides similar information, but apparently this manual one is more accurate (one of the advantages of having a seat on the exchange is that you can get better pre-market information). Sadly, I learned that the funny looking colored jackets used to be used to identify different positions on the floor, but have since been made unnecessary (though many still wear theirs).
The NYSE gave us a sales pitch on how companies list on their exchange because they want to co-brand themselves. I'm skeptical that this is a prominent consideration when a company lists itself today - the increases competition with Nasdaq over fees has certainly had an impact on the NYSE. In the next 10 years, it would not surprise me if the trading floor was gone all together. Or, the room will be filled with actors hired by CNBC so they can still claim to be reporting from the middle of the action - a live shot of a room full of servers is less glamorous, but more likely where the real trading action is taking place.

WL Ross

It's not everyday that you get to meet a legend in the industry, so we were understandably impressed by Wilbur Ross and one of his managers. These guys were sharp. It is not an exaggeration to claim that before they make an investment, they know more about the company than its own CFO. They have the patience to wait and not bid up deals when dumb money is rushing in. They are also prudent about leverage - if a deal needs a ton of leverage to work, then you're probably paying too much for it. If they think it's an attractive opportunity, they'll consider restructuring an entire industry (such as the entire US steel market). If I could invest with anyone we met this week, it would be this firm.

Oppenheimer Funds

A quantitative fund manager and his team spoke to us about their fund. They have a multi-factor model with almost 100 inputs. They do a lot of back testing. They revise their model periodically. Overall, they seemed like intelligent guys. You'd think that all this fancy math would remove human emotion and mistakes from the investment process - but all of this quantitative analysis eventually came down to which factors they thought would best predict future performance. Given that their fund has been lagging its benchmark, I find it hard to believe that these guys have any edge in factor selection (despite their overall level of intelligence and sophistication). They were unwilling to engage in a discussion of active versus passive management, although they did mention that one of their small cap funds had about 1200 holdings in it (that sounds a lot like a closet index fund, with a higher expense ratio). A cynical observer might note that active management fees do provide for well appointed office space.

The old debate about active versus passive management really fascinates me. Generally, I believe that the market for public equities in the US is pretty efficient. It is exceedingly difficult to earn abnormal risk-adjusted returns of any substantial magnitude over the long run. The statistics regarding active mutual funds that fail to outperform the S&P 500 confirms this. Hence, most mutual fund companies are wasting their time (and their investors' money). However, when you get into active management the way WL Ross does it, the game changes. They have access to opportunities not available to a mutual fund because of their investment process, their investment opportunity set, their time horizon, and their access to deal flow. The stark contrast between Oppenheimer Funds and WL Ross made it very clear to me that one firm is positioned to take advantage of market inefficiencies, and the other, not so much.

Overall sentiment: trending towards bearish.

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