(Photo: REUTERS / Nicky Loh)
A man looks at a display board showing stock market prices inside a brokerage in Taipei May 25, 2010.
The stock market is not exactly a model of orderly progress, is it? The New York Stock Exchange (NYSE) became the latest bourse to experience a 'glitch' yesterday. Volume was light on the NYSE because trading in 216 of its 3825 stocks was suspended. The exchange's matching engine wasn't functioning properly.
A matching engine sounds like a complicated thing. You can imagine one breaking down. But the line between technical complexity and incompetence is a fine one. High-volume, high-frequency trades are putting more pressure than ever on the hardware that runs the world's stock exchanges. It's an arms race. And the exchanges can't keep up.
Then there's the issue of attacks on the stock market from places like 'Hackistan' and 'Cyberia'. Those aren't real places of course. But it's the idea we're after here. Anyone with a keyboard, a modem and some computing power can target the stock market or an individual stock for their own nefarious purposes.
In fact a man was just jailed in Hong Kong for conducting a distributed denial of service (DDOS) attack on the Hong Kong Exchange's news website. A DDOS attack is when the server that runs a website is flooded with so many requests at one time that it shuts down.
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It wasn't just any website, though. It was the website where price sensitive announcements are published. Tse Man-lai's publicity stunt forced the exchange to halt trading in eight stocks, including HSBC. You can't have an orderly market where some investors have access to price sensitive information and others do not, can you? (Putting aside the fact that this happens every day anyway.)
The whole attack was a stunt because Tse runs a cyber-security firm that produces anti-DDOS software. He took screen captures of the website after his attack, hoping to use them in a future marketing campaign. His aim was to show what damage a DDOS attack can do to your business and the value of having the right software protection.
This is a little like the fire department burning down your house to show you the importance of smoke alarms.
But you should expect to see more of this thing. Field Marshal Bernanke has effectively taken over the stock market and become the world's fund manager. His flattening of yields across the risk spectrum has forced investors to become speculators in order to find higher yields. It won't be long until there is a guerrilla war in the electronic world to combat Bernanke's top-down stock price manipulation.
Finding out the fair price or intrinsic value of a security seems like a waste of time if the market doesn't even function properly - or is heavily manipulated. But when in doubt, start with first principles. When you build a house you have to start with a solid foundation. The same is true of any argument. First principles are the foundations of good arguments - even if the first principle is an assumption or, in mathematical terms, a postulate (assuming a truth so you can make an argument from it).
Are there any first principles in investing? Hah! If there were, everyone would use them and there would be no difference of opinion about the value of securities, and hence no market. Fortunately, people are imperfect and often stupid, so there IS a market reflecting their different ideas of value.
The best first principle to start with is that you're buying a business, not a stock. Go back and read Greg Canavan's essay about value investing on this distinction from earlier this year. It's a classic. Once you've established that you're buying a business, the job of the analyst is to figure out what price to pay today for future cash flows.
But then, that's probably a prior first principle! Businesses exist to provide cash to their owners. This is little gem came out of the mouth of Nick Hubble earlier this year when he spoke at the After America conference in Sydney. It's so obviously true that people immediately forget it. But it's a pretty useful place to start if you're, say, looking for businesses that can generate enough cash flow that you can safely rely on it when you're making your retirement plans.
How do you find businesses that consistently generate high cash flows, high returns on equity, and high returns on capital? Being able to analyse a balance sheet and income statement helps you. But part of it comes down to finding out what businesses match your own income needs (or the required rate of return, in valuation terms).
Or you could just find someone whose set himself the task of matching your retirement needs with the right business or income producing idea. This is the task we set Nick Hubble three years ago. Yesterday we announced that his project has finally reached lift-off. It's called The Money for Life Letter.
Three years is a long time to get something off the ground in the modern world. But we believe in doing things right. Besides, it takes about a year to unlearn everything they taught you in university. It takes another year to start figuring out what your first principles are. And it takes another year to see whether the solutions you've come up with actually match the problems real people have. Nick's project is right on time.
for The Daily Reckoning Australia
The article was first published by The Daily Reckoning Australia