Articles
The Last Major Arbitrage
Imagine a small town divided by a river but connected by a bridge. Let’s say that you can buy oranges on one side of town, walk across the bridge, and sell the same oranges for a bit more. That’s a money-making arbitrage. You might be a faster runner, or you make better use of the available information. Still, one way or the other, the same oranges trade at different prices, and you can take advantage of market inefficiency. In investing, there used to be more arbitrage opportunities. As stock trading got faster, the markets more efficient, and the information spreads in a blink of an eye, the most apparent inefficiencies have become more scarce. There is one advantage, though, that is left, an advantage that may not only stay with us forever, but it’s bound to get bigger – I call it the last arbitrage, the time arbitrage. Let me explain.
Arbitrage is defined as the practice of taking advantage of a price difference between two or more markets. There was a time when the same security, a stock, or a bond would trade at different prices at various exchanges. Savvy traders could take advantage of it. If you read stock market history books, you’ll hear about arbitrage departments at investment firms. Their role was to look for those opportunities across the country and the world. In the early years of my investment education, I spent days and nights devouring investment books and memoirs. In the process, I came across books about George Soros, a legendary speculator. I vividly remember stories of his experience working in an arbitrage department of a 1950s Manhattan investment firm. He specialized in European stocks at the time.
We have come a long way from those days. Michael Lewis’s book, Flash Boys, introduces us to the world of high-frequency trading. The author has a gift for turning market tales into fast-paced reads that are hard to put down. In this publication, he explains how trades are happening faster and faster. To make a point, he tells a story of constructing an 827-mile fiber cable to connect exchanges in Chicago and New Jersey. The goal was to shave milliseconds of the data transmission. When I was hiking in the woods of Pennsylvania this year, I was wondering where this cable might be running as the cabin that we rented happened to be precisely between Chicago and New Jersey. Michael Lewis’s book was made into a movie called the Humming Bird Project. The data transfer speed was likened to the speed of a humming bird’s wings, which beat up to 80 times per second. If you wonder how fast it may be, imagine that a human being blinks only up to 15 times per minute. With this speed race in the background of financial markets, the price arbitrage has shrunk and almost vanished.
There is more than a price arbitrage. I’d call it an information arbitrage. The information might have been available, but the arbitrage existed since few were looking. Investors eventually come across books about Warren Buffett’s mentor, the father of investing value, Benjamin Graham. Through his stories, we can learn about the stock research process of the 1920s to 1950s. If someone took the time to read the companies’ financials, one could find opportunities others would have missed. Benjamin Graham turned the process into a mathematical formula. He would buy companies for less than 2/3 of the net current asset value (cash and receivables less current liabilities and any debt). These were companies priced for liquidation. That practice slowly faded away as computers allowed analysts to sift through numbers and quickly and efficiently find those opportunities. It’s important to remember the historical backdrop. At the time, many companies were worth more dead than alive in the aftermath of the 1929 market crash and the 1930s Great Depression. That arbitrage opportunity eventually disappeared.
The last major arbitrage left for us disciplined investors is what I like to call – the time arbitrage. You can buy an undervalued stock with a healthy underlying business and wait long enough for it to recover and rise. It may sound simple, but it’s far from easy. We don’t claim to be faster than price arbitrageurs, we don’t claim to analyze more data than anyone else, but we are more patient than most.
When we buy undervalued stocks, we can potentially make money in three stages: 1) the sentiment recovers and a company turns from undervalued to fully valued 2) the business continues to prosper and grow and becomes even more valuable than we thought 3) the market enthusiasm takes over, and the price rises well into the overvalued territory. The momentum and growth investors usually join in the last stage. It is typically the stage when we start to trim slowly and exit the position. Being early gives us a margin of safety (room for error). Since we bought the stock so cheaply, the odds of avoiding losses are better than if we had chased a fast-rising stock in the last leg of its rally. For momentum and growth, investors being late to the party come at a price. Eventually, the market turns cold again, and investors lose the gains earned during the enthusiastic third stage and the earlier two stages. From our experience, we know that if any doubts about growth appear, the market can push the stock back down in a blink of an eye.
Ideally, we’d like to buy a down, cheap, out of favor stock with lots of promise and never sell it. It’s been a successful practice in bull markets. In sideways or falling markets, though, it’s wise to sell at times. Our practice shows that many of our investments do little in the near-term, only to prosper in the long run. They go through an interesting cycle from being unloved to loved and, unfortunately, often enough back to unloved. If we can buy them when they are unloved and wait until the market warms up to them again, that’s a great time arbitrage. It’s not guaranteed, and it may take years, and that time frame happens to be outside of the investment or trading horizon of a growing majority of investors out there.
Depending on the method, we could conclude that today’s holding time for stocks can be measured in seconds if we include the vast majority of the trading volume done by earlier mentioned high-frequency traders. Other calculations imply four months, which is still a fraction of an 8-year holding period half a century ago. Whichever way we decide to look at it, we can tell that we have grown increasingly impatient as a society. Studies show that technology is making us even less patient. If a website doesn’t load in a blink of an eye, a Netflix show doesn’t start playing instantly, or a package isn’t delivered the same day, we are ready to revolt. Apparently, on average, it takes us 22 seconds to express frustration when something is not happening right now.
While high-frequency traders might be chasing a fraction of a penny in a race for milliseconds, there might be hundreds of dollars left behind for those who can wait. I often think of a Charlie Munger’s (Warren Buffett’s longtime business partner) quote that I shared with my audience at my California TEDx talk – “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait.” Technology made it very hard to chase price or information arbitrage, but it continues to make our time arbitrage shine brighter and brighter. The less patient the world becomes, the more patient we seem in comparison. In our opinion, we can’t think of a better and faster-growing advantage an investor can have! It might be the last major arbitrage left, but also the more lucrative.
Happy Investing!
Bogumil Baranowski
Published: 12/3/2020
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