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Your highest conviction idea for 2014 + why

steph

By steph
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NomadicRiley Newbie

NomadicRiley

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Thanks for the feedback.  So you don't think that the technological infrastructure, know-how, and regulatory system will keep others from taking market share from Knight?  It seems like others would see the trading glitch as a good reason to stay away as it is an easy business to shoot yourself in the foot in.  Since there are some people in the industry here, are GETCO and Knight going to offer a better product than the other market makers?  Why are competitors trading at over 3x TBV while KCG is just a little over 1x TBV?

 

The lack of moat for market makers is partially because it is a secondary business for most of their competitors which provides benefits for their primary business and is not forced to stand alone. 

 

In the case of the large investment banks (Citi, Morgan Stanley, Goldman, BAC, etc.), there are multiple benefits:

 

1.  For firms that they have a prime broker relationship with (hedge funds, buy side, prop, etc) they will often stipulate that as part of their prime brokerage agreement the firm is obligated to send their firm through the investment banks infrastructure / market maker and if they chose to route to a different firm they will have to pay additional fees. 

 

2.  All of these firms have a substantial amount of "captive" order flow that originates from their retail broker and wealth management arms.  Their market maker division gets exclusive rights to this.

 

3.  They view it as a service they are expected to offer as part of an overall relationship with large customers.  Not having this capability could be viewed as a negative when pitching large potential clients.

 

The second set of firms that often end up with market making firms are HFT/Prop firms (Wolverine, Two Sigma, Getco before Knight merger).  In this case, these firms are already active on the major exchanges running their own HFT algos and trading their own accounts.  At some point, they realize that by virtue of being a successful HFT they have created the vast majority of the infrastructure required to be a market maker for client flow and since the majority of the infrastructure can be shared any additional revenue they generate from attracting client order flow will offset the increasingly large costs of maintaining an up to date infrastructure.  Furthermore, the idea of having some diversification from prop trading which is heavily dependent on volatility and volumes is extremely attractive.  The interesting thing is that most firms don't move in this direction until their HFT profits have peaked because retail market making is far, far less profitable than successful prop trading.

 

The final problem these firms face is that all of their clients have relationships and connections with multiple of their competitors so in the case where a firm does get into trouble, their clients completely abandon them w/in hours.  This is what happened with Knight during their blowup.  In the couple days between the event and the announcement of the new investor buy-in, the majority of their clients had ceased to send _any_ orders to them.  Why would they take even a modicum of risk when they can receive the exact same product at multiple other firms who did not have that same level of risk?

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BG2008 Mentor

BG2008

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I would be less worried about another trading glitch and more worried about the erosion of the market making business model over the last decade. A lot of it is driven by HFT hedge funds (a superior business model). Some is also driven by more efficient brokers. How low will their ROE go? If they can only earn 5% ROE going forward, it's not worth book value.

 

I also work in the industry and agree with constructive.  The market maker space is incredibly competitive and provides no sustainable moats.  There are often price wars when new entrants enter the market which drives down returns for all participants.

 

A fund manager that I know who is currently managing double digit million AUM had mentioned that interactive brokers is far better than all the other market makers out there.  I trade through IB as well.  It does appear that the infrastructure does allow you to do all sorts of trades even with a smallish amount of capital.  He firmly believes that IB has a long runway.  Thoughts?

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no_thanks Newbie

no_thanks

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Thanks for the feedback.  So you don't think that the technological infrastructure, know-how, and regulatory system will keep others from taking market share from Knight?  It seems like others would see the trading glitch as a good reason to stay away as it is an easy business to shoot yourself in the foot in.  Since there are some people in the industry here, are GETCO and Knight going to offer a better product than the other market makers?  Why are competitors trading at over 3x TBV while KCG is just a little over 1x TBV?

 

The lack of moat for market makers is partially because it is a secondary business for most of their competitors which provides benefits for their primary business and is not forced to stand alone. 

 

In the case of the large investment banks (Citi, Morgan Stanley, Goldman, BAC, etc.), there are multiple benefits:

 

1.  For firms that they have a prime broker relationship with (hedge funds, buy side, prop, etc) they will often stipulate that as part of their prime brokerage agreement the firm is obligated to send their firm through the investment banks infrastructure / market maker and if they chose to route to a different firm they will have to pay additional fees. 

 

2.  All of these firms have a substantial amount of "captive" order flow that originates from their retail broker and wealth management arms.  Their market maker division gets exclusive rights to this.

 

3.  They view it as a service they are expected to offer as part of an overall relationship with large customers.  Not having this capability could be viewed as a negative when pitching large potential clients.

 

The second set of firms that often end up with market making firms are HFT/Prop firms (Wolverine, Two Sigma, Getco before Knight merger).  In this case, these firms are already active on the major exchanges running their own HFT algos and trading their own accounts.  At some point, they realize that by virtue of being a successful HFT they have created the vast majority of the infrastructure required to be a market maker for client flow and since the majority of the infrastructure can be shared any additional revenue they generate from attracting client order flow will offset the increasingly large costs of maintaining an up to date infrastructure.  Furthermore, the idea of having some diversification from prop trading which is heavily dependent on volatility and volumes is extremely attractive.  The interesting thing is that most firms don't move in this direction until their HFT profits have peaked because retail market making is far, far less profitable than successful prop trading.

 

The final problem these firms face is that all of their clients have relationships and connections with multiple of their competitors so in the case where a firm does get into trouble, their clients completely abandon them w/in hours.  This is what happened with Knight during their blowup.  In the couple days between the event and the announcement of the new investor buy-in, the majority of their clients had ceased to send _any_ orders to them.  Why would they take even a modicum of risk when they can receive the exact same product at multiple other firms who did not have that same level of risk?

 

 

Thanks a lot for the explanation.  Really great insight.  I will keep it in mind.  Sorry I am a little uninformed, but isn't the Volcker rule going to force the big banks out of this business? 

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NomadicRiley Newbie

NomadicRiley

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A fund manager that I know who is currently managing double digit million AUM had mentioned that interactive brokers is far better than all the other market makers out there.  I trade through IB as well.  It does appear that the infrastructure does allow you to do all sorts of trades even with a smallish amount of capital.  He firmly believes that IB has a long runway.  Thoughts?

 

Yes, IBKR is miles beyond any of their brokerage competitors.  They also have more than enough internal flow to support their Timber Hill market maker.  They are players in the external flow market making area, but not nearly as dependent on it as the Knights and ATDs of the world.

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NomadicRiley Newbie

NomadicRiley

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Thanks a lot for the explanation.  Really great insight.  I will keep it in mind.  Sorry I am a little uninformed, but isn't the Volcker rule going to force the big banks out of this business?

 

My understanding under the current interpretation of the Volcker rule is that pure market making is still allowed.  I have not heard anyone in the industry mention or imply that the banks will be under any pressure to spin off their market making arms like they were forced to do with their prop and hedge fund arms.

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no_thanks Newbie

no_thanks

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Thanks a lot for the explanation.  Really great insight.  I will keep it in mind.  Sorry I am a little uninformed, but isn't the Volcker rule going to force the big banks out of this business?

 

My understanding under the current interpretation of the Volcker rule is that pure market making is still allowed.  I have not heard anyone in the industry mention or imply that the banks will be under any pressure to spin off their market making arms like they were forced to do with their prop and hedge fund arms.

 

Thanks, really appreciate it.  How did you get into the industry?  Math or CS background?

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BG2008 Mentor

BG2008

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J.W. Mays (Nasdaq:MAYS) - Former bankrupted department store owns 7 seven buildings including 2 prime assets (> half a million sqft) in Downtown Brooklyn.  Standalone RE company not married to some struggling dept store/restaurant etc and free to raise rent.  Debt/EV is only 8%.  Net Operating Income is obscured by public company cost, inefficient corporate structure (not a REIT), and lack of scale in operation.  Private owner NOI is 8-9% based on a $38/share price.  Current rent is substantially below market.  Most importantly, neighborhood is gentrifying and being re-developed.  Company owns some prime retail frontage in Fulton Street Mall where rent is rumored to be $300 for prime space.  http://www.nytimes.com/2012/08/29/realestate/commercial/national-retailers-discover-fulton-street-mall-in-brooklyn.html?_r=0

They are charging $27/sqft, some discounts needed for larger size and location within the Fulton Street Mall.  But still very much below market nonetheless.  Hard to screen as the P/S, P/EBITDA does not appear cheap.  Also requires some serious digging to figure out all the assets owned by the company. 

 

At $38 probably selling at land value of the 2 Downtown assets alone.  The As Is Price today is closer to $90/share and as the lease roll off and are replaced with better tenants, value could approach $170/share.  Key risk is that management team owns 47% but has not given themselves any equity compensation.  There is a 23% owner who will act as an advocate for minority shareholder. Obviously, we're not investing alongside Sam Zell, but management team doesn't seem like they will purposely destroy value. 

 

NYC based investors should take the subway to the Fulton Street Mall and see the assets in person 9 Bond Street and 25 Elm Place.  Best comparable transaction is the 490 Fulton Street building. 

 

   

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BG2008 Mentor

BG2008

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Yes, I've done a lot of work in the name.  It's my highest conviction idea because I've personally seen all the assets except for their Ohio assets.  I've been to the shareholder meeting and been inside their buildings.  This is an example why the public market is not efficient.  In a private market, it is hard to imagine that an owner with broker representation will sell these assets at the current price.   

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BG2008 Mentor

BG2008

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I've met with management team during the shareholder meeting.  To be totally honest, they are not Sam Zell.  They are not the best allocator of capital or at leasing new space.  But they have not paid themselves in equity when they easily could have.  They also have not made any acquisitions which from my experience tends to dilute away any MOS over time.  Mark Greenblatt is accessible.  I've spoken with him a few times and he's happy to answer questions.  The adage of "watch what they do, not what they say" applies here.  G&A is high.  They have staff that they definitely do not need which is why the true value is obscured here.  They also had a lot of space for admin purposes, but have since cut that in half to lease to their customers.  During the shareholder meeting, there were admin type personnel that are excess for a company this size.  This is why my estimate of private company NOI is in the 7-8mm range when the AS IS operating cashflow is about $4mm.  A Vornado can operating these assets at much lower cost. 

 

The CEO owns 47% and is roughly 70 now, so I'm sure there is some estate planning in the works.  Long story short, the discount to intrinsic value, the gentrification tail wind makes up for a so-so management team.  Although, I don't think they will outright steal from the minority.  If they do, the 23% owner will likely act as an advocate for minority.   

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BG2008 Mentor

BG2008

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I went by Downtown Brooklyn yesterday again to look at the changes in the Fulton Street Mall.  It is amazing to see the neighborhood transform before your eyes.  We are at a point where newer shops owned by national retailers are starting to equal the number of legacy shops.  The contrast is so dramatic.  As you walk along the street, you can notice the quality difference between the old and the new.  The legacy shops like Conway, Pretty Girls, etc are just big racks of clothing with very little Cap Ex.  The walls are whitewashed, fluorescent lighting, bad carpeting, no store furniture to speak of, and no ambiance to speak, and single digit price points.  The new stores like Banana Republic, American Eagles, and Swarovsky put substantial amount of cap ex into their stores.  Nice furniture, nice finishes, great layouts, and each stores has its unique feel.  My wife mentioned that she recall the Soho (South of Houston) neighborhood going through the same transformation in the late 90s.  If you go visit today, take some pictures and then compare it to Google Maps images of the same location.  You can readily see the before vs after.  Seems like there are 500 share offer this morning at around $46.           

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beerbaron Contributor

beerbaron

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Not sure what my highest conviction pick is, I like RCL.TO.

 

But I also like a little investment company listed on the London Stock Exchange, CLP, has an asset on the balance sheet that has had two cash offers which value it alone at about 3x the market cap.

 

It was covered here http://investingsidekick.com/aim-project-clp/

 

You are in good company with Ridley, I think FFH owned a big share of the company.

 

BeerBaron

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