Taming the Lion. Richard Farleigh
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opponent’s armoury. The problem is that our opponent is nearly perfect. It is very ‘efficient’ at setting prices that offer no opportunities. If we buy and sell on just whims, or on unfounded ideas, we cannot win the battle.
Efficiency in markets is a concept stemming from economics. Quite simply, an efficient market is unbeatable. It sets a price whereby you may as well toss a coin to decide whether to buy or sell. At any time, the price completely reflects all relevant information. There is no point taking the view that because of factor X, a market is undervalued; factor X is already known and factored into the current price.
No opportunities in an efficient market
One consequence of an efficient market is that prices move in a random manner. All current information is already reflected in the current price, which means that the price can only move in response to new (and thereby, as yet, unknowable) news. Therefore there is no trend, and no one can predict what the price is going to do next.
Microsoft shares could be a good example of market efficiency. As I write, their price in New York is $24.91. This is the price that reflects all the known information about Microsoft. As ongoing information emerges about the company, it is disseminated quickly, traders buy and sell on the basis of that information, and the price moves accordingly. Your guess is as good as anyone’s about where the price will go from here.
An efficient market offers us no opportunities. It is an opponent without weaknesses.
Fortunately, markets are not always efficient
Luckily for us, however, the markets are not always efficient. The most likely reasons that a market fails to operate efficiently are that:
All the relevant information is not equally available to all buyers and sellers. An example would be a bargain in the property market which exists because too few buyers are aware of the opportunity.
The buyers and sellers all have the relevant information but do not sufficiently understand the implications of that information. Here an example would be when people continue to pay high prices for property even when they know that the economy is going into recession.
Occasionally, it is suggested that some illiquid markets – where there are not many buyers and sellers – are inefficient because they can be unfairly dominated by a few players. However I will argue later that those players usually lose out.
It is possible that markets are inefficient when they are deliberately fed misleading information, as happened with Enron and Worldcom, but hopefully that type of malpractice is on the decline.
With these Strategies, I will try to identify, in a very structured and disciplined manner, where it is that I believe the market does not operate efficiently. This is where we will find opportunities to beat the market.
Unfortunately, most people do not approach trading and investing in that way. Rather, they start with an assumption that the markets are inefficient and that there are obvious buy or sell opportunities. They have vague, untested beliefs, and make comments like ‘the consensus is always wrong’, or ‘the market always overshoots’. Both of which we will see are completely untrue.
1.3 Market opportunities are disappearing
When I entered the world of finance in the mid 1980s I was fortunate enough to join the right investment bank: Bankers Trust Australia. With a reputation as the highest paying employer in Australia, it was the place to work. The people were very creative and motivated, and it operated as a genuine meritocracy with little bureaucracy or politics. At one stage, in terms of percentage return on capital, it was rated as one of the most profitable banks in the world.
I was put to work in the trading room, which I found amazing. I was a bee in a beehive – all around me there was activity. There were about a hundred of us in the room, with lots of screens and telephones and paper everywhere. There were all types of people, and most of them were very engaging and friendly. Everywhere, the mood was generally upbeat and there was a lot of joking around.
The room was divided into a number of different departments: foreign exchange, bonds, money market, options, and the area I joined, cross-markets. With a mix of clever people and abundant market opportunities, all of the departments were humming along making money.
It was a time when the winds of change were howling through the markets. By aiding their design, personal computers were allowing financial products to become far more sophisticated - the abacus and slide rule could be thrown in the bin! Improved communications such as mobile phones were making it easier to keep track of what was going on around the world.
On top of this, governments were encouraging greater competition in the financial sector. The lazy old-fashioned banker, who enjoyed boozy lunches and golf days, no longer found life so easy. Suddenly there was pressure to offer competitive prices and to be more innovative.
The search for market inconsistencies
In cross-markets, one of our roles was to look for market inconsistencies, and to take advantage of them using the bank’s own funds. We were also responsible for the pricing of swaps, (sophisticated products that can protect businesses from volatility in currencies, interest rates and other markets).
Both of these activities were slightly complicated, but they were relatively low risk because we would simultaneously buy in one type of market and sell in another, leaving us with only a small exposure to market moves. After getting a grip on the mathematics involved, we usually had some time to plan our strategies, and to allow our positions to bear fruit. This type of thing suited me. I would never have made the grade if my job was to juggle phones like the book makers, or shout at the top of my voice like the floor traders. I liked having the chance to think, and to be able to watch things unfold over time.
Due to the relatively low risk, we were able to really go for it – our trades involved very large sums of money. So, here I was in my early twenties, with a few grand in the bank, a cheap suit and no real experience, and I was on the phone doing deals worth tens and hundreds of millions. I was so happy to feel that important. I knew I’d been given a big chance, and I didn’t want to mess it up. I had to be careful and check the calculations carefully before I did anything. Even a slip of the tongue could be dangerous, because saying ‘buy’ instead of ‘sell’ could obviously cost a lot of money. Once I fretted for an entire weekend thinking I had made just that mistake. On the Monday, I found that I hadn’t. The relief was like waking from a bad dream.
I stayed in this role for three or four years, and during that time we enjoyed a lot of success despite the low risks. It was great, there were no major problems and I became accustomed to dealing in large amounts of other people’s money. It was lucrative too. I had nervously taken a pay cut when I joined Bankers Trust, but my salary took off like a rocket and continued to rise while I was at the Bank. Starting at twenty thousand dollars at the age of twenty four, it more or less doubled every year: to fifty, one hundred, two hundred and fifty, five hundred, and then to one million and beyond by the age of thirty. That was big money, especially fifteen years ago. My friends couldn’t believe it, and I couldn’t believe it would go on. So, like a squirrel, I saved just about all of it.
Not so easy now
As I look back on that era, it’s clear that a lot of the ways that our trading room made money have simply disappeared. The markets have become relentlessly more sophisticated as the changes that started in the early 80s have continued. Nowadays, everyone is extremely well qualified, there are computer programs everywhere and there are instant communications. The market has evolved, like bacteria against antibiotics, to beat out opportunities. This has happened as people have spotted opportunities and exploited them till they no longer exist.
So over the years, as my career progressed, I have looked for high quality opportunities which are somehow resilient. I will present these in later chapters and explain why I believe they have persisted