My Complete Interview with Howard Schilit

The great people over at IR Magazine were kind enough to print an interview that I conducted with Forensic Accounting icon Howard Schilit in their April edition.

For publishing purposes IR Magazine ran only a portion of the interview. The entire interview is here for those who are interested.

Dan: I’m here with an old friend of mine, Howard Schilit. Howard holds a CPA designation and has earned a Ph.D. in accounting. Howard is a former professor at American University and was the founder of the Center for Financial Research and Analysis, commonly known as CFRA. Howard is also the author of “Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.”

Your book, Financial Shenanigans, was required reading for me at one of the hedge funds that I worked at early in my career and I made it required reading for all of the analysts that worked for me at my fund, Clipper Capital Management. This book is thought by many to be the book of record for short sellers. In it you identify seven categories that companies typically use to overstate financial performance. You have also broken those categories down into 30 specific techniques. Please explain how you identified all of these techniques.

Howard: The original version of the book was published in 1993 and it did indeed have the seven categories of what I call “financial shenanigans”, and a second edition was published in 2002. As we’re speaking, a 3rd edition is being finished which will be out in April of this year and will have a broader structure.

So what I called “financial shenanigans”…think of them as earnings manipulation tricks so all of those seven categories are things that would misstate company’s earnings. As I did research for the 3rd edition of the book the structure of the practices was much broader than I originally thought. That is, in addition to the seven earnings manipulation categories there are two new categories.

There’s cash flow manipulation and I’ve identified four different categories of that and the other new grouping is what I call key metrics shenanigans there are two new groupings of those which include things that are found more in the narrative that are considered non GAAP. For example a company might disclose same store sales or they may disclose EBITDA or cash earnings, things that are not specifically included in the GAAP rules and I’ve noticed quite a bit of manipulation in those, and believe me, investors pay a lot of attention to non GAAP metrics. So the new book has a lot of additional trickery that certainly the 1st and 2nd edition did not include.

Dan: Great, that leads to my next question. We’ve known each other a long time. I think that it was nearly 15 years ago when I flew down to Rockville, MD to sit with you and your analysts and learn exactly how you screen for aggressive tactics and connect the dots to uncover financial deception. A lot has changed in the capital markets since then. Have the accounting tricks evolved as well? If so, how? And it sounds like you’ve identified some new cash flow manipulation and I wasn’t sure if there were derivative instruments involved in these manipulations as well, so I guess my question is: What’s new under the sun?

Howard: That’s an interesting question…what’s new under the sun. The opening line in the new book begins with a quote from the book of Ecclesiastes which says essentially there is nothing new under the sun. And I try to explain that if there is nothing new under the sun, why do I need to write a 3rd edition? Well, I clarify and expanded upon that, and I examine that fact that what’s not new under the sun is the yearning for management to always put a positive spin on the results. That whether we’re talking about 2010, 1950 or 2070, there will almost certainly be the human quality of trying to accentuate the positive. Now, that being said, there are always new techniques that deviant management will come up with.

For example, in the last decade we had big frauds at Freddie Mac and Fannie Mae. The fascinating thing about Freddie Mac was that they had a reputation and even a nick name related to that; it was called steady Freddie, meaning they wanted to have as smooth and steady an earnings release as possible and that’s what the market paid a lot of attention to and gave them a very high valuation based on.

There was a little monkey wrench thrown into their plan when the FASB came out with a new rule on accounting for derivatives and their business, however. It related so much to interest rate movements and derivative instruments were very important. Well, they had done some calculation to figure out what impact converting to the new accounting rule would have to their earnings. To their surprise, it would have created an enormous initial increase in their earnings from the gain on derivative contracts.

Well, for most companies having a big increase in profits is a happy event, but Freddie started really freaking out, saying “we can’t show that!” As a result they held back enormous amounts of that gain that should have been realized in that first year and they set up these reserves on their balance sheet and over the next few years they would try to release portions of that each and every quarter to give them very smooth earnings.

The reason why this is such an interesting story is they got caught before they used most of their reserves. Most companies such as WorldCom, Enron – you know, the typical big frauds – are in a situation where company has inflated its profits to investors. Freddie got nailed during this period where they had actually under reported their profits by something in excess of $5 billion.

So what I learned over the years is that each company has a specific game plan. Just like we’re sitting and talking the day before the Super Bowl, you know, you do a lot of planning for your opponent. Each company knows who their constituents are and what they are looking at, almost like a student trying to size up a teacher. And if they had a copy of the test in advance, they would always get the A.

So I mentioned one of the new sections in the 3rd edition deals with cash flow manipulation. Going back to the earlier writing of the book, in 2002, I said a good way for investors to see if there was manipulation in the earnings is to compare the earnings with the cash flow from operations. Well, not only did good guys, like you, read “Financial Shenanigans”, but probably a lot of bad guys read it as well. And they probably said “hmmm, Schilit is teaching the world that a good way to assess whether the company’s earnings are clean or not is to compare the earnings to cash flow from operations…why don’t we make the cash flow from operations as high as possible?”.

Once the bad guys figured out that the intelligent analysts had figured out all of these earnings manipulation tricks and the investors are now paying more of a premium for cash flow from operations they started migrating to the statement of cash flow to manipulate that.

It’s always like a cat and mouse game where the good guys figure out the tricks of the bad guys, so the bad guys have to come out with new tricks and they do. Fortunately I am spending a lot of time going back and studying the last 30 years of the most important accounting scandals. I have over 100 companies I have done research on and at each one I have been able to identify what screens could have found these tricks. You have to keep on top of it. You have to keep looking because the bad guys keep getting more and more clever about how to showcase themselves in the most favorable light.

Dan: I was definitely one of your apostles. I would always go and compare cash flow to net income as you taught, but cash flow seems like a more difficult thing to manipulate. What are some of the things that the bad guys are doing today to manipulate that number?

Howard: Great question. Think of the cash flow statement as being divided into three groups. The first one is cash flow from operations, which is the one that people pay the most attention to. Then you have cash flow from investment activities. This is capital equipment or things related to selling businesses; things related to long term assets. The third category is…

Dan: …cash flow from financing activity.

Howard: Exactly. So, directionally, you want to move all of the good stuff – anything that is going to be a plus to cash flow – into the first group, and anything that is going to result in a minus to cash flow you want to move into the second or third groups. It is simply a matter of shifting the good stuff into the operating section and the things that would be a drag on cash flow out of that.

Take WorldCom, for example. They were spending billions of dollars on normal operating costs related to leasing lines to transmit long distance calls. Those were normal operating expenses. They decided to shift those off of the statement of income, which obviously goes to the operating section, and turn them into a long term asset, almost like property plant and equipment. And they were writing that off over say…30 years.

So not only were the earnings manipulated because they threw the expenses on the balance sheet, but on the cash flow statement they moved it from the first section to the second section. Now how would you have known they were manipulating their books? Instead of looking at the cash flow to net income, what you have to do is also then subtract out capital expenditures and you would have seen it immediately. They started doing this in 2000. So if you look at each of the four quarters in 1999 and each of the four in 2000 – so the year before and the first year they started to capitalize those billions of dollars – and you computed the free cash flow, which is the cash flow from operations minus the capital expenditures, you’d see that they had a positive free cash flow before and every quarter after they had huge deficits in free cash flow.

Another example is companies that sell off their receivables. Now, not all of these things are necessarily illegal, since some of it is how you are categorizing things on the different statements.

Dan: How did you decide to start CFRA?

Howard: Interesting question. I was not an entrepreneur by birth or by disposition. I was an accounting professor; a full time tenured professor at American University. For about 16 years my research interest was on accounting loop holes and I started doing research and eventually wrote Financial Shenanigans in 1993. I was still a full time professor and it was just a matter of luck that many of the people that began reading my book turned out to be investing managers.

So in 1993, after the book came out, I was hired to do some seminars with some big mutual funds like with Fidelity and Putnam and others. And then investment managers began to pay me to do some research on specific companies, and I did about eight of those customized reports, which took me to the end of 1993. And I said: “you know this is not that great of a business model…waiting for somebody to call me up to write a report.” So at the beginning of the following year, 1994, I officially launched the business. Before I knew it I had a following of a dozen or so investment managers and I thought that it would be a better approach to identify companies where I thought there were issues and sell that research on a subscription basis.

Dan: At the height of CFRA, how many clients did you have?

Howard: We had over 500 clients. It grew into a pretty big operation.

Dan: Every person that I knew in the business had a very healthy respect for your work. That’s one of the things that I want to point out in this blog: if investor relations officers think that investors aren’t looking at these things, they need to think again and they really need to educate themselves on these practices because they have to answer to these analysts and portfolio managers.

Howard: Actually, even though the majority of our clients were investment management firms, less than half were hedge funds. In addition to investment management professionals we had the big accounting firms as clients. We had regulators like the SEC. We had credit rating agencies, law firms and insurance companies, so the reason our client roster grew so large was because it was an eclectic group.

The clients were anyone who may have had exposure from an investment standpoint, a credit standpoint or an underwriting standpoint. We also had some customized projects for firms. For example, if there was a hostile takeover of a software company and there were some messy accounting issues that were involved, we would be hired to get involved in some of those transactional deals.

We were mostly a subscription model but we also had quite a number of training activities that we did as well.

Dan: I think that it is important to know, in fairness, that CFRA became branded somewhat as the short seller service firm but really the bulk of your revenue also came from long-only investors who were just looking to avoid bad situations.

Howard: I’m glad that you noted that. Even though you come out of the hedge fund space – the short seller space – and we had a lot of folks using the product like you were, those types of firms were never the majority of our clients. We basically were giving people a heads up when we found a problem.

I remember having conversations with some of our larger hedge fund clients and I would ask them, as I got to know them, how they used our product. I was at first surprised when people would say: “Well, we don’t use this for short ideas because so many hedge funds are shorting the names and the shorts get crowded so we look at this almost like your long clients would – to help us identify problems in companies that we have a position or we get out of it.”

Dan: That’s a great point because crowded shorts are a very dangerous area to play. They usually wind up revealing themselves by ultimately imploding. But to a short seller there is a lot of pain that can go along the way in a crowded short, as squeezes can persist…but that’s very interesting.

Howard: I very much want to help companies avoid doing things where they end up shooting themselves in the foot. So to the extent I can help the company or the auditor identify practices that are perceived as very negative by the investment community, I want to be in the middle of that. I want to work with the auditing firm or speak directly to the CFO or the IR person and let them know what practices are frowned upon. I want to explain to them that if they do certain things, they will be seen as not playing fair. At the same time, I am always interested in speaking to the investors and pointing out the companies whose top priority is making their numbers by any means necessary.

I just recently gave a speech where I began with a quote that I got from the litigation involving a company that was accused of cooking their books a few years ago. Basically, their CEO said that there was nothing more important than making their number. He essentially said that he didn’t care how they did it.

Dan: We’re going to hit that number one way or the other.

Howard: That’s right! So in terms of how an investor should be evaluating a company, in many ways you’re just trying to size up the management of the company. And there are some slimy people out there.

If I were advising IROs I would say if you guys are honest people, if you are competent and you really want to grow the long term value of the company, then you just don’t want to do things that are stupid.

Dan: I agree with that. In the last two versions of your book you acknowledge that there are varying degrees of aggressiveness and that not every accounting gimmick is the handy work of a fraudster but when you start it’s a slippery slope.

Howard: Exactly.

Dan: And that it’s a lot safer to be perceived by Wall Street as being on the conservative side of accounting rather than walking that grey line.

Howard: That’s it. Once you lose the trust of Wall Street and they see you as a Walter Forbes type or as somebody who is not playing fair, well the stock is going to be traded at a discount for a very long time.

Dan: You CFRA sold to a private equity firm in 2003, and it was then later sold to Risk Metrics in 2007. You seem to have been enjoying the retired life for the last few years but you are now coming back to teach people how to catch these bad guys. So you’re releasing the new version of Financial Shenanigans and have also started a new firm, which is called?

Howard: Financial Shenanigans Detection Group, LLC. I’ve also agreed to teach a seven week course in the fall at the University of Maryland, where I have my doctorate. I should be up and running with the new business by the later part of October.

Dan: Are you going to start the new business back in Maryland or are you going to do it in Florida?

Howard: No, it will probably be in Maryland and maybe New York also; you know wherever the talent is. In terms of doing the research I’m here in Key Biscayne during the winter months and up north the rest of the year.

Dan: And the new company will target whom?

Howard: We’ll be targeting a pretty wide group including investors, creditors, regulators IROs, auditors and audit committee members.

Dan: So it’s important for people to know that this isn’t a short selling service. This is really an educational service.

Howard: It is meant to help those who can get hurt by those who disseminate misleading information. We will also target the insurance underwriters who have to pay these big tickets when there is a fraud, as well as the users of that information, so investors, creditors and regulators.

Dan: The entire ecosystem.

Howard: Exactly, and doing it from an educational perspective. We show them what the tricks are, and how to spot them.

Dan: What advice can you give IROs to help identify aggressive accounting within their own firms, because in many cases the accounting decisions are made by the firm’s CFO and the internal audit committees? The Investor Relations Officer is charged with conveying information to Wall Street and often times, I suspect the IROs find themselves in situations where some aggressive accounting practices are being used without them really knowing and they wind up finding out after the fact when they start fielding calls from analysts and PMs .

Howard: When we would do a research expose on a company, we would always call the company before the report went out. And nine times out of ten, the person who would be on phone with us would be the IR person.

Dan: Right, and in some cases when it comes to fraud and aggressive accounting they are almost the last to know.

Howard: Exactly.

Dan: Because these aggressive accounting practices are intended to deceive and people who are looking to deceive others often don’t surround themselves with large groups of people and tell everyone what they are up to.

Howard: And that underscores why I like to have a relationship with the IRO, because they are typically the ones who are being duped as well. They are made to look really, really bad and deceitful if I ask them a number of questions and they have to go back and speak to the CFO to get answers to some of these technical things and they become the conduit for lying to us and lying to the investors.

I think to the extent that they really don’t have as much technical background in this as the CFO and the people who are involved in making these accounting policy decisions, the IRO’s reputation is certainly on the line if they are answering questions and that information goes into my report and it’s false.

I then communicate that information to the investors. If I made my living as an investor relations person I would want to know as much as I can about whether the information in the financial statements that the company is portraying in a press release or in an SEC filing is a fair representation of what really happened.

Dan: And as aggressive accounting continues to evolve and become more complex, the investor relations officer’s job becomes more difficult as well. So I’m glad that I have the opportunity to talk to you and for you to share your thoughts. I think that Financial Shenanigans should be required reading for every IRO out there.

Switching gears a bit, I remember early on when you were issuing reports, you would do so on a monthly basis. Investors would eagerly await the report and it would often have a very dramatic and immediate impact on stock prices. You later you switched up your model a little bit and began producing smaller reports that were more like maintenance reports. What was behind the decision to do that?

Howard: The reports from 1994 until November of 1999 all were, as you described, reports that we sent out the middle of each month in a FedEx package. They typically came out on the 16th of the month and it was almost like D-Day.

We would put these reports out in a specific ranking – a number one alert, a number two alert, etc. – and we’d do maybe a dozen companies in each packet. We started to get a big following and we were getting more and more influential, and it built up into a crescendo in 1999.

Stocks were getting hit immediately and I was starting to get very concerned that we were starting to do a lot of damage. We became this bludgeon to hurt the stock price, which was not our intention at all because, as I said, most of our clients were not hedge funds.

Our clients who were on the long side were getting angry because we wrote a report and their stock was down 15 percent. But I saw my role as being somebody who should give a heads up by saying “hey I think there is a problem here; take a look at this and if you agree with us do something about it.” So I looked at this and determined I was doing something very harmful. I thought: “I’m not helping my clients who I’m trying to give a heads up to because the damage is already done.” And my clients who were looking for short ideas were frustrated because the stock moved before they could even open the report. So it was sort of like this rush to judgment, and people were getting very angry at me.

In the chat rooms people were writing all kinds of bad stuff and I came close, honestly, to closing the business down because I was scared because I had created this monster, which was never my intent. But I realized that many of my clients we starting to adopt the Internet; remember, we are talking about 1999 – 11 years ago – so not everybody was into using the Internet to conduct research.

I decided to do analysis on companies that were widely held, in addition to the companies where my screens were telling me there were problems. The idea was that I was covering companies that a lot of people hold and if they are clean then that is valuable information, because I’m always looking for problems.

So I started writing reports every day – sometime one a day and sometime two – that were educational in nature. I changed the whole focus so that I wasn’t simply writing the “Wow!” kind of story but it was sort of blended in. I stopped ranking them and I didn’t put them in any kind of order, which helped the rush to judgment. I was very successful in doing that, but it caused certain clients to say, “I don’t have time to read all of these reports.”, which changed the whole nature of the relationship, particularly with the shorts.

Dan: You became a victim of your own success. You became so influential in the market that the fact that you were negative on a company meant that they were guilty until proven innocent.

Howard: Absolutely. In fact, there was an article written about me that called me the most hated man on Wall Street. I was really so vilified. I was saying, “What did I do?”

I was just a teacher, but I guess I was really good at convincing people. I might have had 500 clients but there were 5,000 people in the information loop because everybody speaks to everybody and even though I didn’t sell it to the sell side, believe me, they were getting copies and they were writing rebuttals. It was crazy.

The stocks would trade down and then up because there were situations where there would be a rumor of a report that we were about to publish. The stock starts trading down. A few of the sell side analysts start writing rebuttals.

Dan: For a report that you had never written.

Howard: Exactly, for a report never came out. Because what happens is, before we put the report out, we call the CFO and have a long conversation. The CFO probably knows who I am and he calls his buddies at the sell side and says, “Do something about this”. Based upon the questions that I asked the CFO, the sell side guy would try to respond to each of those. It was the funniest thing because there were rebuttals to these phantom reports.

Dan: In most instances the companies that you published research on refused to talk to you or your analysts. How did you deal with that when issuing research?

Howard: No, that’s not so. I would say we spoke to at least 75% of them, and we would make at least three separate overtures to them because we would always want to document and be on the record. We made every reasonable attempt to talk to them because the liability to me if I got something wrong was enormous. I always wanted to be sure that I had all of my facts right but also there was a lot of additional information that I could glean by speaking to the company. Now, we wouldn’t always speak to the CFO, but in many instances the investor relations people would call us back and in most cases they were very nice.

Dan: Thank you for your time Howard and good luck with your new ventures.

NIRI Annual Conference

I am happy to announce that I have been asked by the National Investor Relations Institute’s Investment Process Subcommittee to speak on a panel at the upcoming NIRI Annual Conference.

The name of the session is “The Changing Sell Side, and Buy Side Expectations of the IRO.”

The learning objectives for this panel include:

• Better understand why research quality and depth has declined over past several years;
• Understand impact on company as fundamental value drivers may not be well understood;
• Learn typical information gaps and blind spots resulting from diluted sell side coverage;
• Methods IROs can use to increase interaction and impact with the buy side.

During my years on the buy side I lived through many of the events that have changed the way that the buy and sell side operate with each other. I have also written a white paper on this topic, and am very excited to share my knowledge with others.

If anyone has any thoughts or comments related to this topic that you would like me to consider or share, please leave me a comment.

Back Blogging

Over the past several weeks, I have not blogged much as a result of my discussions with Instinet Inc. (The corporate parent of Instinet brokerage companies). Now that Instinet has issued a press release announcing their entrance into the management access market with the roll out of Meet the Street LLC I want to tell the world what a great deal this is.

As many of you know, I have been developing a unique web-based management access platform designed to place the planning and meeting allocation power directly in the hands of the IRO. I have shared demonstrations of the application with many IROs and I have received great feedback and generated a fair amount of excitement within the market.

The development of the platform has been both challenging and fun. However the platform's success depends heavily on the depth of the investor pool that signs on to use it. A deeper pool of investors will help attract more issuers to the platform by strengthening Meet the Street's ability to book full roadshows.

Instinet represented the perfect partner for Meet the Street. Its brokerage subsidiaries trade with approximately 1,400 institutional investment firms in the United States and have a strong global reach with eight international offices. Instinet has a 40 year+ track record of utilizing technology to help bring efficiencies to the institutional investment process, while promoting neutrality and anonymity which matches up nicely with Meet the Street's business plan.

With the deal comes some changes. I have been given the title of Co-President and I will be sharing leadership responsibilities with my Co-President Mike Dolan. Mike and I have know each other for about three or four years now and he is a great guy and very capable executive.

Over the past few weeks Instinet has begun cross introducing the Meet the Street platform to its client base and the concept has met with strong enthusiasm among professional investors. We are going to continue to promote the adoption of the platform over the next several weeks and once a critical investor adoption threshold has been realized, we will open the network to issuers so that they can begin booking their own non-deal roadshows over the platform.

I am very excited about Meet the Street's next stage of growth and I look forward to sharing my thoughts with you along the way.

Twitter Blog Funnel

I recently started a free Twitter IR blog aggregation service on Twitter that goes by the Twitter handle @IRThoughts. While the idea of aggregating blog feeds and posting them to Twitter is not new or unique, I decided to start my own for the simple reason that I can pick and choose the blogs that I like.

I have selected a diverse group of blogs focusing on matters that appeal to investor relations professionals. I am happy to take requests from people if there are any blogs that you would like me to add. I have chosen to follow blogs that present opinions and ideas in a professional manner and who are respectful of dissenting opinions. I will not be following any blogs whose authors fail to treat others with respect.

I launched @IRThoughts on Saturday and it already has 25 followers. The interesting thing is that 40% of these followers are not following me at my @meetthestreet handle (I would encourage you to do so).

I am excited to offer this service to my IR friends as a way to help keep them informed on the issues of the day. I am also excited to use this platform as a way to reach out to other IR professionals who I am not currently engaged with. For all of @IRThoughts' new followers, I would like to invite you to join #irchat which I host every Thursday at 1:00 PM EST. #irchat is a great engagement platform where IR related issues are discussed and debated.

Please let me know what yo think of @IRThoughts and please let me know if there are blogs that you would like me to add to the list.

Ethical Issues Related to IR Practices

Two issues have recently gained some momentum among IR professionals. Those issues include the pre recording of executive’s prepared comments for quarterly conference calls and the practice of the sell side paying for logistics associated with non deal road shows.

To my knowledge, this first issue began to take shape during a NIRI webinar entitled 2010: The Year of the Tiger for IR which was hosted by Maureen Wolff-Reid of Sharon Merrill Associates and originally aired on December 15^th, 2009. During the webinar, several senior level IROs discussed the idea of taping the prepared remarks, which was the first time I had heard about this practice.

Weeks later, in a LinkedIn discussion group, a member asked “Would you consider simply posting the prepared remarks for a quarterly report and allocate conference call time to just Q&A?” This discussion, which also had its roots in the above mentioned NIRI webinar, solicited many responses in the LinkedIn discussion group and was even mentioned by NIRI’s CEO Jeff Morgan in his blog.

This past Wednesday Rob Berick of Dix Eaton hosted a session at NIRI’s Introduction to Investor Relations Seminar in Santa Monica, where I questioned the idea of recording prepared remarks ahead of a conference call and playing them in lieu of live comments. A vibrant discussion followed and I was surprised to hear how common this practice is. It was determined at the conference that such a practice need not be disclosed since the information being shared publicly was being shared for the first time.

Given all of this interest in the subject, I decided to ask the same question during this week’s #irchat on Twitter. The debate began when Tim Wood of AlphaFound suggested that the practice was material and should be disclosed.

This issue was later picked up by Dominc Jones and the debate reignited. I understand the argument of disclosing the practice because it is a simple thing to do. Despite that, I still don’t think that it is necessary. The content of the message doesn’t change in a material way and therefore I am comfortable with the practice. I respect the opinions of those who feel passionately about the idea of disclosure but I stop well short of subscribing to the theory that the practice is unethical. I also think that it is a stretch to question the integrity of the executives who employ this practice while speculating about the integrity of the reported numbers as was suggested during the debate.

Another practice that seems to have generated some buzz is the sell side paying for management’s logistics for non deal road shows. The Investment Company Act of 1940 prohibits institutional investors from accepting outside gifts or compensation when operating on behalf of a mutual fund. The CFA code of ethics mandates that their members must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity. These practices are strictly enforced on the buy side and travel related transgressions resulted in a high profile case where industry titan Fidelity Investments and iconic fund manager Peter Lynch paid civil penalties in 2008 to settle a case brought against them by the SEC.

Given the buy side’s strict rules against accepting gifts and travel from the sell side, I find it interesting that similar rules do not exist for issuers. Some of the participants on #irchat acknowledged the issue as a problem while others were comfortable with the practice. The BNY Global Trends in IR Survey polled 270 companies from 42 countries and found that 69% of the IROs surveyed believed that there is a conflict of interest when the sell side arranges non deal road shows of which 21% believed that there was a significant conflict of interest. Despite these findings, the survey went on to say that 73% of investor introductions are facilitated through the sell side. According to the NIRI webinar Best Practices in Non Deal Roadshows, 94% of roadshows are arranged by the sell side. One has to question the ethics of ignoring self admitted conflicts of interest simply because the sell side has agreed to pay for, and coordinate, logistics.

I was surprised to hear seasoned IROs urge new practitioners to “leverage the sell-side for logistics” at the recent NIRI seminar in Santa Monica, CA. While there is certainly nothing illegal about leveraging the sell-side for logistics, the ethical implications certainly warrant further discussion in my opinion. Since this practice is commonplace and perfectly legal, I am sure that it never made it to NIRI’s radar screen. Now that the issue is front and center, it will be interesting to see if NIRI looks into the issue, and if so what guidance they may offer members.

High Frequency Trading

As I sit here looking out over the nearly 2 feet of snow (~61 cm) that recently blanketed coastal Massachusetts I was inspired to write my third installation in my series on advanced trading. The snow triggered a strange thought about trading and investment classifications. In this post I am going to cover high frequency trading.

Rarely have I seen a practice as universally misunderstood as high frequency trading. People seem to misuse the term high frequency trading in much the same way that the term hedge fund was misused in the past. Hedge funds were often referred to as an investment style rather than a legal structure for unregulated investment vehicles. While hedge funds can be broken up into various style buckets such as long/short equity and convertible arbitrage the style buckets often share little resemblance with one another and the funds within the style buckets can often vary widely in their investment approach. For example; one long/short equity fund may focus on small cap stocks while another focuses on technology stocks.

Hedge funds and high frequency trading firms remind me of snowflakes in that no two are perfectly identical. While snowflakes are each unique they all share a common core structure. For example; snowflakes are hexagonally arranged frozen water molecules with perfectly straight sides (facets) which are angled at 120° to one another. Each snowflake builds upon it’s common core structure and develops differently depending on its unique environment and interactions with its surroundings.

While no two are exactly alike, high frequency trading firms also all share common traits. To be considered a high frequency trading firm you must deploy fully automated trading strategies, across one or more asset classes, which identify and profit from short-term pricing inefficiencies. These inefficiencies may last from milliseconds to hours. Most high frequency trading firms close their positions at the end of every trading session and hold cash (or remain market neutral) until the resumption of trading. High frequency trading strategies try to make small amounts of money on each trade. The profits from these trades are amplified by high volume.

Estimates suggest that HFT accounted for about 15% of US equity share volume as recently as 2005. The Tabb Group estimates that high frequency trading is now responsible for 61% of US equity share volume. They also estimate that 83% of HFT firms trade equities, 67% trade futures, 58% trade options, 36% trade bonds and 26% trade FX.

It is largely believed that there are three broad investment strategies that comprise high frequency trading including automated market makers (the most common), predictive traders and arbitrage traders. These players are typically traditional broker dealers, hedge funds or proprietary trading firms using private capital. The Tabb Group estimates that there are between 10 and 20 broker dealer prop desks and fewer than 20 active hedge funds employing HFT techniques. The independent proprietary trading firms are believed to be between 100 and 300 in number.

Automated market makers provide liquidity to market participants and generate revenue from rebate trading. Rebates are earned when traders buy or short stock over and ECN and receive a rebate or payment from that ECN for “adding liquidity”. The ECN charges those who “take liquidity” and use a portion of that fee to compensate liquidity providers. This practice is typically employed in high volume stocks because the HFT firm has to be assured that they can trade the stock without moving the price (since price movements do not account for their strategy). This has lead to asymmetrical volume in the markets where active stocks benefit from even more liquidity while low volume stocks are ignored.

Arbitrage traders typically look to benefit from short term divergences from price correlations between stocks. There are also volatility traders who look to profit from differences in implied volatility and future forecasts for realized volatility with stocks underlying options contracts. Pairs traders try to exploit relative price discrepancies between closely related companies (think Home Depot and Lowe’s). Stocks which benefit from the same macroeconomic factors are often highly correlated. When a price correlation breaks down the stocks are paired against each other in a bet that their price relationship will revert to the mean. Short term stat arb resembles pairs trading but may pair various securities or baskets against each other.

The most controversial strategy is liquidity detection. High frequency traders that employ liquidity detection strategies have developed programs which look to identify large institutional orders sitting in dark pools or other liquidity venues. They do this by sending small orders on recon missions. The small orders interact with large orders by being filled very quickly. When this happens repeatedly or when orders are executed in larger amounts than the displayed size of the market hidden liquidity is present. When large orders are identified the HFT firms trade ahead of that order in the belief that large orders will move the market which they will benefit from.

There are certainly pros and cons with high frequency trading. On the positive side, high frequency traders add liquidity, narrow spreads and provide greater book depth. They ensure greater price discovery and provide for more orderly markets. On the negative side, liquidity detection programs may cost investors money by making it more difficult to trade large quantities of stock at good prices. High frequency traders who act as virtual market makers also profit at the expense of designated market makers. Designated market makers are appointed by exchanges which require them to be on both sides of the market. They are required to make markets in both highly liquid and illiquid stocks. It is more difficult to make money in illiquid stocks (despite their wider spreads) but it is looked at as the cost of doing business. Virtual market makers are not bound by these same rules and can cherry pick the liquid stocks. This makes it more difficult for the designated market makers to earn a profit. If HFT traders are allowed to act as market makers without having to adhere to the requirements of market makers, it could undermine the trading of less liquid stocks and further divide the market along market capitalization lines.

High frequency trading is on the top of the SEC's regulatory agenda for 2010 as a result, in part, of the pressure being applied by Senator Edward Kaufman who was very recently quoted as saying that he was concerned that the amount of money being allocated to high frequency trading strategies could quintuple over the next year.

Turning back the technological clock is impossible but one can rest assured that high frequency trading as we know it today will most likely look different in 2010.

Liquidity

Yesterday I tweeted a link to an academic study:

Liquidity, not analyst coverage shown 2 improve stock performance http://bit.ly/pMIZ1 The question remains how do you promote liquidity?

My friend and long time IR professional Jim Flanagan responded by saying:

@meetthestreet too bad the Abstract did not share how they defined liquidity, they only defined impacts to m/b ratio.

Jim raised a great question. Shouldn't you define liquidity before trying to figure out how to promote it? Kudos to Jim for emailing co-author Sheri Tice of Tulane University for an explanation.

Jim asked:

"Your Abstract with your co-authors about Liquidity is a focus of a thread on TWITTER this morning among Investor Relations professionals...the one question we have that is noticeably absent from the Abstract summary is how do you define and measure liquidity?

Hope you can she a little light?"

Sheri got back to Jim with the following:

"We measure liquidity using several different measures in the paper (the relative effective spread, the Amihud mean-adjusted illiquidity measure, the LOT zero returns liquidity measure, and the relative quoted spread). The main results are robust to the various measures. The liquidity measure we report in all of the tables is the natural logarithm of relative effective spread, RESPRD. RESPRD is defined as the difference between the execution price and the midpoint of the prevailing bid-ask quote divided by the midpoint of the prevailing bid-ask quote."

The abstract says "We show that liquidity increases the information content of market prices and enhances the value of performance sensitive managerial compensation. Finally, momentum trading, analyst coverage, investor overreaction and liquidity’s valuation effects do not appear to drive our results."

If liquidity drives stock price performance and NOT ANALYST COVERAGE the question remains....why do IROs spend equal time between the buy-side and sell-side? Going direct to the buy-side will help drive liquidity. I think that it is time for IROs to rethink their time allocation.