Thursday, May 06, 2010

Why Traders are Important for Value Investing

OK, before someone lambasts me for switching to trading, please read and re-read the title carefully. I mentioned that “traders” are important for investing, and not “trading”. The use of the two somewhat similar-sounding words makes a whale of a difference though, and this post shall proceed to explain why, and how I can justify the above statement.

In any stock market, there always exists an abundance of traders/speculators while there are usually only a handful of investors. The investors sit on their butts and wait patiently for their shares to reach their perceived fair value, all the while exercising patience and engaging in detailed due diligence to ensure all is moving right. By contrast, the active traders are the one who zip around like dragonflies on a hot noon day, flitting from counter to counter in the hopes of entering and exiting with maximum profit (and minimum loss). There exists a certain relationship between the two camps – one whereby each takes advantage of the other’s actions to generate opportunities to make money. Let’s take it from the point of view of the investors, first.

Investors have the unenviable job of researching, reading and analysing company fundamentals, and waiting for margin of safety to appear when Mr. Market presents it. Traders help to accelerate this process by 1) creating liquidity and also 2) creating instances where mis-pricing is so evident that investors will be “forced” to react. These two factors alone are pertinent reasons for the importance of traders to the investing process. Liquidity can be seen as the oil which greases the wheels of the stock market, and it is important when an investor wishes to take a position in a company which he feels offers long-term investment potential AND a margin of safety. However, it is well-known that illiquidity in some counters creates wide bid-ask spreads, and this can severely hamper an investor’s ability to purchase a significant stake in a company at a low enough price due to the illiquidity premium, and also the prohibitive bid-ask spread which results in higher fees. Traders are responsible for providing much-needed liquidity, so that an investor can find the volume to purchase a sizeable stake, and also to avoid the associated higher costs which come from a wide bid-ask spread.

During instances of market frenzy or market panic, traders are responsible for the gamut of emotions which flood the stock market, creating over and under-valuations of sound securities. The emotional tenor of the market is determined by these traders, and share prices can be severely marked up or down depending on the prevalent news, rumours and/or reports. Investors make use of such opportunities to find bargains to purchase, when share prices are uncharacteristically depressed due to one-off events or due to fear and panic in the markets. Conversely, traders who are excessively exuberant will also bid up prices of securities far above their fair value, and this presents opportunities for investors to offload their shares for a comfortable profit, as the share price may have run far ahead of fundamentals and prospects.

The above two situations illustrate how traders help investors by reducing the opportunity cost of holding cash, and also creating situations which benefit the conservative investor. Investors, on the other hand, also help traders by providing liquidity with their persistent buying or selling, especially when they target to invest in or divest a certain company. Generally though, I believe the presence of traders helps to enhance the opportunities present for an investor, but the investor must do his own due diligence and be vigilant for such opportunities presented by Mr. Market.

However, it should be noted that traders usually stick to companies with heavy volume (institutional favourites), and hence the “churn” which is produced will usually be limited to the same few blue chips and/or speculative counters which see cyclical volume spikes. Certainly, if there are bargains to be found, they may mostly reside in the quiet, untraded counters which dot the landscape; and these may still present the same problems to investors who wish to accumulate a sizeable stake. Liquidity is contingent upon certain events in which the market either recognizes the true intrinsic value of a forgotten gem, or a corporate event which throws the company into the spotlight. Both instances do not create conducive buying opportunities, however, because people will then bid up the price of the under-valued security. Hence, it may still be a challenge for investors to accumulate good companies in suitable quantities to make a positive difference to their portfolio.

Ultimately, investors should still watch for events to unfold which may offer them some glimmer of hope to accumulate at a price far lower than intrinsic value, in order to maximize margin of safety. A lot of patience and fortitude is required for such an operation to take place successfully. In the meantime, it would be a worthwhile exercise to let cash pile up until it can be deployed at a suitable time and in suitable securities which can yield a decent (better than inflation) long-term return.

24 comments:

Createwealth8888 said...

Value investors are important to traders too as they help to limit the supply of shares in the market by holding them and that will help to induce price volatility .

cif5000 said...

Oh ya, traders are stupid and investors are smart. Traders do not understand mispricing and only investors do. And if one really thinks that, I must criticize that he is either too shallow, too naive, or too arrogant. Personally, I know of a full-time trader who is a better investor than I am. Very deep, very detail, very focus, and has a good track investment record. And he trades for a living. And btw, which statistics allow you qualify "abundance of traders/speculators while there are usually only a handful of investors."?

Delete this comment if you think it is too abusive.

Musicwhiz said...

Hi 8888,

Thanks, I didn't think of that. Good that you contributed a valid point!

Regards,
Musicwhiz

Musicwhiz said...

Hi cif5000,

I think the point I am trying to make is that most of the liquidity is generated by traders and many retail investors tend to be traders/speculators who get excited both ways, thus creating mis-pricing situations. The fellow which you mention would qualify as a very sophisticated trader who "knows his stuff". I never implied that people like him who trade full-time do not understand what they are doing; in fact the post was referring to the multitude of people who generally are clueless and trade in and out just to fatten the pockets of their brokers.

Statistics do show that there are many more traders out there as compared to investors - just ask around a group of people and you will find 1 out of 10 being an investor, and the other 9 are traders/speculators.

Thus, I stand by my point.

And don't worry, I don't delete comments which are constructive, as yours is! Abusive doesn't even come close to what I used to see in 2008.

Cheers,
Musicwhiz

cif5000 said...

Traders do provide liquidity. This I totally agree. However, it is not traders (alone) who create mispricing. How about institutions that buy high sell low? Some are supposedly professional "value funds" and they transact in millions.

When I asked around, 9 out of 10 "retail investors" think that they are investors. And many have read about Buffet, Graham and Fisher and value investing. They try not to speculate but will sometimes (hopefully not too often) ended as the speculator group that you had described, that creates the mispricing. Myself included. Doesn't mean I am anywhere near good, but I do consider myself as an investor. Much like you when you bought FSL at a dollar plus. Were you not creating mispricing?

The major premise of your post can be summarized as Investors taking advantage of Traders because of their behaviors that result in mispricing. The minor being the liquidity. My strong reaction is against the major.

CreateWealth8888 said...

Many people come to market to trade for some coffee money but most of them end up as investors so we are likely see many more investors than traders

JW said...

Many people come to market to trade for some coffee money but most of them end up as investors so we are likely see many more investors than traders ==> How true!

I copy a post of mine from CNA forums... Someone asked me 2 questions and I answered:

You are not going to let go even if ...
1) Your invested counters go below 200MA ?
2) Your invested counter left with 10% of your original invested worth ?

My answer:
1) no, because my time to truly go with the flow is very limited. I working hard to start a small business by end 2011. That's where my main goal in life is.


2) If it happens, it means my understanding of businesses and fundamentals is flawed. Therefore I should not start my small business.

But I protect myself by making sure the dividend yields are quite ok, and look at the stock at a 5 to 10 year horizon. Like SPH, Starhub, I can't see how it will fail in 5 years time. By then, I would have gotten at least 40% to 50% of my invested cash back in the form of dividends.

If I were to have a business, I would have to learn how to read balance sheets and income statements for my own business in the future anyway. I might as well learn now.

Musicwhiz said...

Hi cif5000,

I don't agree with you on the mis-pricing situation when we, as investors (or "investors"), purchase a share of a company. I believe mis-pricing can arise due to two factors - sentiment and ignorance. In the case of FSL Trust, I admit I was ignorant of the true situation of the shipping cycle and the risks of investing in a shipping trust, hence I paid too much for FSL Trust back then. The mis-pricing arose because there was a perception gap, and not because it was perpetuated by investors purchasing the shares. The other factor, sentiment, is easily understood and I won't go into it.

I still stand by my point that the actions of traders (mostly retail, unsophisticated ones) create mis-pricing situations which can be exploited by investors.

By the way, I think this discussion is purely academic, but is nevertheless interesting. :P

Cheers,
Musicwhiz

Musicwhiz said...

Hi 8888,

I think those people you refer to are "stuckists".

Regards,
Musicwhiz

Musicwhiz said...

Hi JW,

Yes, I guess holding power and time will render an investment "safer" over the long-term as it would have returned a portion of your investment back in the form of dividends. That's why people choose blue chips with steady yield.

Regards,
Musicwhiz

cif5000 said...

"Traders help to accelerate this process by...2) creating instances where mis-pricing is so evident that investors will be “forced” to react."

"I believe mis-pricing can arise due to two factors - sentiment and ignorance."

First you said traders create mispricing, and then you said mispricing arises due to 2 factors.

My point is, it is the collective effort of **all market participants** that creates the market prices (or mis-prices). Don't accuse the traders (or whatever names you may like to call people).

Another point is that a stock can stay mispriced for a long time without the traders' participation. Investors get it wrong.

All these are academic but I dislike the generalization of people (investors vs. traders), especially when investors are being portrayed as a camp of rational beings.

Investors or traders, they create mispricing together. That's just human.

Createwealth8888 said...

If there is no mispricing in the market, nobody will want to buy and no one is going to sell. The whole market is going to be frozen.

Mispricing will always happen and that is the nature of the market because the bearish investors will think that others are too bullish and the bullish investors will believe others are too bearish.

donmihaihai said...

White and Nigger.
local Singaporean and foreign talent.
Investor and trader(speculator).

There must be a better breed which distinguish itself to be better than the rest.

Blockhead!

The problem is not about trader and investor or white and nigger. The problem is try to think in this way and fit everything in...

I can reverse the whole article and it still work.

Hitori said...

Hi, I too believe that we need traders to make the market liquid. That's why we have "contra" in Singapore to move stocks given our very limited population. Sometimes there are really good companies in Singapore but their share prices are way undervalued and totally illiquid, it ended up making more sense to invest in blue chips or do fast trades. It's really difficult to be a pure investor.

Dapeng said...

I think traders are critical for the market because they provide liquidity. without traders/market makers, the market will be dead. There are not going to be a lot of buyers/sells, which will result all stocks are over-priced if the company is good.

as for mis-pricing, it is not because of traders or investors. mispricing is required for market makers/certain group of traders to make money in the market. they are the dominant power of the stock market, we can almost say that they determine the short term to medium term price of every single stock in the market. although saying that, it does not mean price can be away from fundamental too long. over-price will be corrected. as small traders and investors, they just follow the flow, they can't really control anything in the market. everything is almost pre-fixed. even news, certain events are all controlled to certain extent.

la papillion said...

Actually, I just think that there is both mis-pricing and liquidity in the market because the value of the the company is both changing constantly and is subjective to every market participant. What the hell is value anyway?

I've never known anyone, traders or investors, who willingly bought a share at a price thinking that it wouldn't go up in the long term/short term. Same thing for people who sell their shares.

Musicwhiz said...

Hi cif5000,

I don't have the habit of calling people names. It's either investor or trader - simple as that. I never said either party was rational. All the article talks about is how investors MAY take advantage of mis-pricing created by traders. I think perhaps you got my meaning mistaken.

I do agree sometimes prices do not reflect the intrinsic value of a company, but it's not the investor who created the mis-pricing; but as you say humans in general.

The article I wrote is simply to show how important traders are for investors; it's not meant to attack traders or imply investors are superior. In fact, many investors get it wrong as well and buy securities based on flimsy reasons or even errorneous reasons (like I had done myself), thinking they got a good bargain.

So don't worry, I've made my share of very silly and foolish mistakes even though I am an "investor".

Regards,
Musicwhiz

Musicwhiz said...

Hi 8888,

Yes, you are right about mis-pricing, or in this case it could also be percieved mis-pricing; as both groups try to take advantage of it to make money.

Cheers,
Musicwhiz

Musicwhiz said...

Hi Donmihaihai,

Sorry, once again I fail to understand what you are trying to say. Could you possibly type in simpler sentences so that I can understand? What is your point and what are you trying to say? Maybe you can turn the article around and write one yourself to explain why it also works the other way?

And also, why "blockhead"?

Thanks,
Musicwhiz

Musicwhiz said...

Hi Hitori,

Somehow, I think contra is a legacy from our old system which has yet to be totally abolished, and which makes more people lose money than gain it! But then again, it does create liquidity which is sort of an irony.

I once heard a remark which said that Singapore Bourse would shut down if they disallowed contra! Well, I never knew there were so many punters in the stock market.....

Regards,
Musicwhiz

Musicwhiz said...

Hi Dapeng,

Thanks, I like what you said. It sounds logical and explains what does on in the market in general. But I guess over or under pricing may take quite a while to "correct" itself.

Cheers,
Musicwhiz

Musicwhiz said...

Hi La Papillion,

Haha! That's true! Value is changing all the time and the company's fundamentals are also changing daily too, as a result of business activities. So it's impossible to pinpoint an exact "value" on a company, hence the frenetic activity involved in trading to determine the true value. Fair enough and I like the explanation!

Well yes, even investors buy because they believe the business will grow over time and translate to a higher share price, so everyone has their views on value and the future. Good point thanks!

Regards,
Musicwhiz

AK71 said...

Hi MW,

You have some heavy duty discussion going on here. ;)

Now, I wonder if I am an investor or trader? hahaha... I think I am both. I don't think the debate on FA and TA will ever go away.

Allow me to share my story here:

http://singaporeanstocksinvestor.blogspot.com/2010/02/excuse-me-are-you-investor.html

Remember what Deng Xiaoping said: "It doesn't matter if the cat is white or black. If it catches the rat, it is a good cat!" ;)

Musicwhiz said...

Hi AK71,

Yes, it's pretty heavy and I realized that on hindsight that I had broached a very touchy and sensitive topic which was sure to get people emotionally involved. For that, I apologize to those who may feel offended by this post. There was never any intention to insult or offend anyone, and I will be more careful in future about how I write and phrase things.

Anyhow, even for me as an aspiring "investor", I make so many mistakes that it keeps me awake at night; so no one is perfect and I am always learning everyday as well.

Thanks everyone,

Musicwhiz