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Perception of a company can make the difference between $75 and $300 per share as Netflix (NASDAQ:NFLX) found out. The wild markets we see today are a product of a new stock market paradigm. Is long-term investing dead? Let's first consider how the game has changed and how it is the same.

Short-Term Mayhem

Benjamin Graham is noted for having said, "In the short run, the market is a voting machine but in the long run it is a weighing machine."

In essence, opinions and speculation drive short-term market prices as people bet on such matters as how the eurozone crisis will affect local markets. Over the long run, the true value of a company - or its weight - will eventually be realized. The face of the voters has changed but their short-term influence is the same. What is different about today's speculators driving short-term prices?

Average Joe Voter

Since the 1800s you had to have a NYSE membership or a seat to be in the big leagues of speculative trading. Then short-term trading began to work its way to the retail world. I can recall my grandfather phoning in not too many decades ago for hot tips before the market opened and then phoning his broker to make the trade. Next came online discount brokers that put much speculative trading power into the hands of the average person.

High frequency trading is the new breed of trading that uses complex computer algorithms to take even fractions of a penny per share with micro-second holding times. This is typically the playground for hedgefunds that can hire out quantitative analysts at hundreds of thousands or even millions per year with lightning quick computers and virtually no latency. Some game changers exist though as even this complex world is being served up to people in their homes with a good trading idea and a couple thousand dollars to test it out.

  • Programming guru, John Fawcett, is building a Python-based platform called Quantopian so the average Joe can develop and test a short-term trading idea with cutting edge software. He is currently accepting alpha users.
  • Nevis Trading is one proprietary trading firm where non-U.S. citizens with only a couple thousand dollars deposit can trade like the big boys using a 'Proprietary Algo Trading System.'

The point here is that high frequency or algorithmic trading is quickly introducing itself as a norm among individual traders around the world with a good idea. From buying a seat on an exchange floor to programming your computer to trade while you sleep is one of the major shifts in the market. Has the high-frequency trader killed the investor star?

Stick to Long-Term Goals in Specific Stocks

While a flash crash can rarely occur, one new study shows that intra-day volatility is actually lessened by HFT. As well, when a specific stock begins to trade with extreme volatility such as at earnings reporting - HFT activity is reduced. When the entire market, and not one stock, becomes increasingly volatile HFT activity increases. What might all this mean?

Again, with the exception of the occasional flash crash, computerized algo trading might not impact your investing as much as some conspiracy theorist suggest. These algo programs are more prone to sneak a quick profit as share prices revert to the short-term mean than to shorting a stock that is already down 20% due to bad earnings.

  • Taken as a whole, index investing in the S&P 500 (NYSEARCA:SPY) or the Russell 2000 (NYSEARCA:IWM) may not have as much edge as individual firms handpicked by yourself. If you are proficient at spotting aggressive stocks that make large jumps on decent earnings - the odds of a trading algo creaming some of the profit is reduced.
  • Keep an eye on volume too since the likes of Sirius (NASDAQ:SIRI) would be a more likely target with incredible volume with prices moving fractions of a cent this way and that during the day.
  • One other possibility: since many of these programs use a mix of options and shares to trade you may consider adding in some companies that do not offer options.

High Edge and Low HFT Interference

One strategy I like to run attempts to lower the odds of HFT and hedge funds playing short-term games with the stocks. My goal is to target firms without options, volume below 300K daily, and deep value that Benjamin Graham would approve of. I re-balance every three months and hold a maximum of 10 stocks.

  • 11-year gain of 1,201% vs. 16.5% of S&P 500
  • Beat the market in 2011 by 7.5%
  • Beat the market in 2010 by 59.8%

*Chart below compliments of Portfolio123 for historical 11-year performance.

(Click chart expand)

Here are the current quick picks using this strategy:

Ticker

Name

Last

MktCap

Yield

(NYSEMKT:SVT)

Servotronics, Inc.

9.81

21.95

3.06

(NASDAQ:EEI)

Ecology and Environment

16.7

70.82

2.87

(NASDAQ:FRED)

Fred's, Inc.

14.69

544.05

1.36

(NASDAQ:YDNT)

Young Innovations, Inc.

29.5

235.21

0.54

(NYSEMKT:SEB)

Seaboard Corporation

2001

2425.81

0.15

(NASDAQ:OBCI)

Ocean Bio-Chem, Inc.

2.21

17.92

NA

(NYSE:MOG.A)

Moog Inc

43.92

1985.16

NA

(NASDAQ:UFPT)

UFP Technologies, Inc.

15.36

100.26

NA

(NYSE:BIO.B)

Bio-Rad Laboratories, Inc.

104.01

2923.42

NA

Are all of these companies making the right moves on the price chart?

  • BIO has broken above $103 resistance and has been in a nice uptrend since last September. This is not a bad time to consider buying
  • EEI is stuck in a trading range between $15.50 and $17.50 and I would wait for the company to tip its hand either way before taking a position
  • FRED said that revenue at stores open at least a year fell by 0.8% in January vs. the anticipated 1.1% rise. The recent drop would need to consolidate and reverse direction before I'd jump in. Prices are up over 40% since October and I'm sitting this one out.
  • OBCI is trading at a 50% discount from last year. If you are a contrarian investor this could make a fair buy as it sits above $2 support.
  • SEB is trading in an increasingly tighter range. Two areas I am looking at for possible entries is if it bounces off 1900 trend or the 1800-1850 support.
  • SVT is a low volume stock that recently is picking up volume as it made a breakout. If you are a momentum style buyer this might be for you
  • UFPT is also range bound between $14 and $16 with no real impetus either up or down. I'd wait on this
  • YDNT is trending up but the recent pullback would need to start popping upwards soon for me to buy. If it falls below $29 I'd scratch the trade for a time
  • Moog makes nice bounces off the 50-day moving average. It is about to hit it once again at $43. Watch for reaction for a possible entry but be aware that $45 resistance above doesn't give you much upside at this point

Final Thoughts

My parting thoughts are this: high frequency trading has changed the game somewhat but long-term investing is still highly relevant. I've personally noticed that trading volume signals can be skewed if HFTs swoop into a stock inflating volume but there is little price advance. My recommendation (which many will not agree with) is to judiciously pick individual companies instead of buying into an index fund or broad ETF. There is lots of edge in the market - you just need to know which rock to turn over or at least narrow it down to a highly probable field of stones.

Source: Has High-Frequency Trading Killed Long-Term Investing?