Wednesday, May 20, 1998

Cash-King Portfolio Report
by Rob Landley

Austin, TX (May 20, 1998) -- On Wednesdays we publicly respond to feedback from Fools around the country, things they've either emailed us or posted to the Cash-King message boards. And today, we have a common theme: knowing the bias of your news sources.

Let me start with a quote: "To believe or not to believe.. that, my Fools, is the question... "

Ok, enough!

Today, we're going to address bias. No editorial or news organization will ever (should ever) (could ever) claim to be completely unbiased in its reporting. It just isn't possible. Media companies in the U.S. are just as competitive as software companies, soda companies, you name it. Most of our media companies are public entities, competing to create shareholder value for themselves and the world. As such, they often don't tell positive news stories about their competitors, nor the partners of their competitors, without visibly, audibly or discernibly cringing.

With that as our preface, look in at today's questions. We're going to start with one looking at bias in financial dealings... but then we'll move to media.

Kevin Delin emailed me the following after reading my column yesterday on Merrill Lynch analyst Tom Kurlak's coverage of Intel:

Rob, even if you don't try to time the market with your investments, you should include in your thinking how timing is still an important aspect of the way Wall Street thinks. Notice that Kurlak chose to make his remarks on options expiration day. If you think this is a coincidence, look at the last time he made similar remarks (when he said INTC was going to the $60s). Yep, it was options expiration time back then, too. Interesting.

Thanks for the note, Kevin. We'll sit up and take notice of this game come the next witching hour. That said, I'm sure we all agree that this little business of analysts timing their remarks is just another reason for Fools to ride out the storm on Wall Street.

Now on to media. Vodkajim wrote the following message on the Cash-King Web board (Is Datek Dirty?). Here's a clip from it:

Guys and gals, the lead story in the Sunday, May 10, New York Times "Money & Business" section was an article about online broker Datek. The Times states:

"Behind Datek's burgeoning on-line empire in Iselin, N.J., is a securities firm with a murky and blemished past -- a record of aggressive, and sometimes illegal, trading activity; of fines, censures and suspensions, and of shadowy deals involving offshore accounts. And not all of Datek's problems are history."

I won't go into all the details of this three-page article, but I strongly urge anyone with a Datek account, and anyone looking to open a Datek account, to go to your local library and read the NY Times article. Or save yourself the work and switch to a different online broker....(end)

Well, that's an interesting post. I mean, my mind is open, and we have to be curious skeptics as we venture out into managing our own money. But we also have to be vigilant media skeptics. Because basing a major judgement on information from a single source, even The New York Times or The Fool itself, just is not Foolish.

I enter this lifelong game of investing recognizing that everybody has an ulterior motive. If people didn't, they wouldn't bother to get out of bed in the morning. So like it or not, we all have to make our own decisions, even if it's the decision to blindly follow the leader. That's part of the reason that the Motley Fool runs an April Fool's joke every year: To remind you not to take our words -- nor anyone's words -- as gospel. In a world bustling with information and free access to that information online, double-checking becomes extremely important.

So, if you're worried about some piece of information about your discount broker, or about your insurance provider, or about your favorite stock, check it out for yourself. Never "save yourself the trouble" when it comes to investment-related research -- particularly when it can take 20 minutes to check up on things! It can mean hundreds or thousands of dollars (or more) in savings.

Now, for an additonal viewpoint on the topic of Datek, I'd like to point readers to another article that may in part explain what upset David Barboza (The NY Times reporter) so much that he'd write an attack.

The article I refer to is the cover story in the April 6th issue of Forbes Magazine (cf. Free Enterprise Comes to Wall Street). It's an interesting read, but I'll sum it up for the slackers out there. The author writes that Datek (and other online brokers) are seriously threatening the established market institutions by simply undercutting them.

The story centers around the way day-traders are using electronic trading systems (like Datek's "Island" system) to trade inside the spread on stocks, a form of arbitrage that allows them to cash in on profits that used to go to the market makers. Before I go any farther I should probably explain what "arbitrage," "market maker," and "spread" mean.

Arbitrage means buying and selling the same commodity at almost the same time, for different prices -- and thus making a profit. Hey, it's fun work if you can get it. For example, if you can buy a stock on the New York Stock Exchange for $84 and sell it on the Nasdaq system for $85, it makes sense to keep doing that until the prices equalize. It's an instantaneous return. And there are big computers in trading houses that do exactly that, day and night and night and day, all over the world. They serve to keep all of the exchanges more or less in sync.

That's arbitrage. Now, on to market makers.

A market maker's job is to guarantee that whenever an investor attempts to buy or sell a publicly traded stock, there will always be someone out there to buy that stock from or sell that stock to. Every public company has at least one market maker, the first of which is usually the brokerage that orchestrated (or underwrote) the Initial Public Offering (IPO).

Now, as a reward for guaranteeing liquidity, market makers get to pocket what is called the "spread." The spread? The market maker always sets the price at which they're willing to sell a stock slightly higher than the price at which they are willing to buy it. That creates the spread between the bid and the ask price.

That's why you can buy Intel at $78 5/8 but can only sell it for $78 1/2. The "spread" between those prices is pocketed by the market maker, as compensation for its troubles. You'll note that market makers don't really care if the stock goes up or down, they're just rooting for it to be heavily traded.

Back to Datek's role in all of this. When a day-trader performs arbitrage by trading inside the spread, here's what's going on. Suppose the spread on a stock is 1/4 of a dollar -- $100 by $100 1/4. In essence, the market maker will buy it for $100 but sell it for $100 1/4.

Now, if a day-trader steps up and offers to buy that stock on the open markets for $100 1/16, they'll get it before the market maker does. And if they immediately turn around and offer to sell the stock to the next person who comes along for $100 3/16 (1/16th below the market maker's price), they'll probably be able to unload it to the very next person who wants it. Since the original price difference via the market maker was 1/4, we subtract out the 2/16 (which is 1/8) and you're left with 1/8 (12.5 cents) profit per share. The electronic trading systems are now undercutting market makers.

Now we don't advise that any individual waste her time doing this at home -- clipping spreads by the minute. Daytrading, ugh -- few other professions consider antacids a food group. But in this case, rah rah for the daytraders, because their active trading is serving to make the markets a bit more liquid and efficient for the rest of us.

In April 1996, the Securities & Exchange Comission (SEC) ruled that the market makers were "colluding and gouging the public." In 1997, the market makers settled a class action suit for $1 billion dollars, and the rules changed. Now, all valid orders must be entered into the system immediately, available for execution by anybody who wants to snatch up or supply the appropriate shares. And the spreads are narrowing.

And with the invention of electronic trading systems like Datek's Island, all of a sudden finding and claiming the best offer currently available is a piece of totally automated cake. And it's only going to get better and more visible because of the Internet. With computers matching up orders between individual traders, the market makers are being bypassed en masse, and spreads are shrinking big time. Even without day traders performing that arbitrage, the electronic trading systems will automatically compare your offer with that of everyone else willing to buy or sell the stock, and it will automatically find the best price it can get you.

As good as this news is for investors, obviously the market makers are NOT happy about it. In fact many of the old stock market institutions operate on business models that are threatened by modern technology -- by the commodified modem! Do you remember yesterday's tirade about the advantage of Intel's lower costs -- about how high-volume manufacturing at lower and lower prices can create huge business winners?

Well, look at Wall Street -- much of their present model is at risk to variations on the Intel strategy. After all, having chubby men in suits throw little slips of paper at each other in big marble buildings is actually hideously expensive. Conversely, having computers matching up offers ends up costing a lot less -- creating savings that in an open, public, capital market gets passd on to us. Datek's Island system (and other computerized "limit-book" systems, which are getting more and more interconnected all the time) is bypassing the old market institutions and fundamentally changing the way stocks are traded.

And the result of this is that the old market institutions are hurting. The Nasdaq and AMEX stock exchanges recently announced a merger designed around reducing costs to compete. And really, that's just the tip of the iceberg. Ultimately, electronic Internet brokerages don't need "trading floors." They can match requests in-house or they can electronically communicate directly with other brokerages to get the best price for their clients. They're literally making their own, highly liquid markets.

So to wrap up, I return to the original point. Do I know why The New York Times wrote that negative article on Datek, just as Forbes Magazine was praising them for freeing up the marketplace? Nope, I don't. But I don't take either of them at face value. Because it may just be that the Times and its reporter have relationships with the big financial instutitions that are threatened by the Internet. The Times itself may be disenchanted by the Internet, price wars, and immediate access to information.

Or the Times might have pointed to some real concern about Datek's services. But I don't just take their word for it -- or the word of a single poster online -- or the word from my Grandma Sue (and she's an outstanding investor). Nope, I double- and triple-check, and remain vigilant. After all, most media organizations told us to stop buying America Online in 1993 (truly, they were roundly criticizing the company -- which was also providing timely news and analysis... sounds like competition, no?). The stock is up 17x in value since then.

But don't take my word for it. Do your own research! There's a very active discount broker folder in Fooldom -- check it out Discount Broker Discussion. It's a great place to learn more about them.

Fool on,

Rob Landley


Stock  Change    Bid 
 CHV   -  11/16 81.50 
 KO    +1 3/4   79.81 
 GPS   -  3/8   52.50 
 EK    +  7/16  70.69 
 XON   -1 1/16  71.25 
 GM    +  11/16 73.38 
 INTC  -2 9/16  77.00 
 MSFT  -  11/16 85.75 
 PFE     ---    112.81 
 TROW  +  5/16  36.13 
                  Day   Month    Year  History 
         C-K      -0.15%  -0.55%   7.87%   7.87% 
         S&P:     +0.86%   0.66%  11.76%  11.76% 
         NASDAQ:  -0.76%  -1.96%  10.82%  10.82% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   22 Pfizer        82.30    112.81    37.08% 
    2/27/98   27 Coca-Cola     69.11     79.81    15.49% 
     2/3/98   24 Microsoft     78.27     85.75     9.56% 
     2/6/98   56 T. Rowe Pr    33.67     36.13     7.28% 
     5/1/98   37 Gap Inc.      51.09     52.50     2.76% 
    2/13/98   22 Intel         84.67     77.00    -9.06% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     70.69    11.94% 
    3/12/98   20 Exxon         64.34     71.25    10.75% 
    3/12/98   17 General Mo    72.41     73.38     1.34% 
    3/12/98   15 Chevron       83.34     81.50    -2.21% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   22 Pfizer      1810.58   2481.88   $671.30 
    2/27/98   27 Coca-Cola   1865.89   2154.94   $289.05 
     2/3/98   24 Microsoft   1878.45   2058.00   $179.55 
     2/6/98   56 T. Rowe Pr  1885.70   2023.00   $137.30 
     5/1/98   37 Gap Inc.    1890.33   1942.50    $52.17 
    2/13/98   22 Intel       1862.83   1694.00  -$168.83 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1413.75   $150.80 
    3/12/98   20 Exxon       1286.70   1425.00   $138.30 
    3/12/98   17 General Mo  1230.89   1247.38    $16.48 
    3/12/98   15 Chevron     1250.14   1222.50   -$27.64 
                               CASH   $3910.83 
                              TOTAL  $21573.77 
 *The year for the S&P and Nasdaq will be as of 02/03/98