Friday, September 28, 2007

Which should I use, a full-service or discount broker?

Reader's Question: I trade commodities through a full-service broker, paying commissions of $73 for each option trade I make. I am considering switching to a discount broker for lower commissions but have read that discount stock brokers can end up costing an investor more through "hidden costs" coming from time delays in trade execution, worse pricing when filling orders, etc. Which is the better alternative: full-service or discount?

Trading Cost Comparison

First, from a trading efficiency point of view, we need to examine whether the higher commissions full-service brokers charge are worth any improved trade execution they offer. For the sake of this discussion, I assume that considerations relating to the choice between full-service or discount brokers generally apply to both commodities and stock trading. The information I share comes from the stock arena.

In the way of background, you may wish to browse an SEC article summarizing the methods available to a broker for execution of a customer's trade: a) direct to stock exchange; b) through a market maker, with the broker earning payment for order flow; c) to an electronic communications network (ECN) for automatic processing, particularly for limit orders; and d) internalization of the trade on the brokerage firm's own account. Discount brokers often route trades through third-party market makers and get paid a "rebate" for order flow, which allows them to offer lower commissions. Full-service brokers usually route trades more directly to the stock exchange, which can result in better execution. Let's see how the two compare.

An academic paper published in 2005 reports on an empirical study conducted in 1999 involving 64 actual (32 buy and 32 sell) trade executions of 100 shares each of NYSE- and Nasdaq-listed stocks through six different brokerages, two from each of three categories: full-service voice-order brokers charging commissions averaging $47, brand-name online brokers with $23 average commissions, and deep-discount online brokers with $7.50 commissions. The authors found that "for NYSE listed stocks online brokers disproportionately route orders to regional and third-party exchanges offering fewer price improvements, compared to traditional brokers." However, for trading involving a 50/50 mix of NYSE- and Nasdaq-listed stocks, "we find no statistically significant difference among the three types of brokers on price improvements." Consequently, "Our empirical study found that online brokers offer lower quality trade execution [by about $0.01-$0.02 per share on NYSE trades], but that the higher commission costs of full-service brokers are not [emphasis mine] offset by these quality differences."

The bottom line is that you can generally execute "retail" size, small trades more efficiently using online discount brokers, since what you save through lower commissions will typically more than offset what you lose through the marginally worse trade execution the discount brokers tend to provide. However, if a full-service broker has a more direct connection to the commodities or stock exchange and can achieve better fills by, say, a penny or two on an underlying price of $50 to $100--that's one part in 5,000--then when notional trade size exceeds about $250,000, we reach a breakeven between paying commissions of $20 to a discount broker or $70 to a full-service broker.

Suggestion: You can do your own "experiment" by opening up accounts at both a full-service and a discount broker, splitting your trades in half, and proceeding to give equally sized, simultaneous and identical orders to both brokers. This will allow you to check which alternative really offers you more efficient overall trade execution, taking both commissions and fill pricing into account. If you do proceed with the experiment, I and many other readers I'm sure would be curious to find out what you discover; so, please post your findings as a blog comment below.

What's a Broker Relationship Worth to You?

Beyond strict, easily measurable economic cost, another consideration is that, if you have developed a good relationship with a full-service broker and believe you are significantly benefiting from the trading and investment advice and market information the broker provides, then you might not want to switch.

Here's some anecdotal evidence that may help: A few years ago a friend of mine told me that, despite drastically reduced commissions available through Internet-based discount brokers, he sticks with his traditional full-service broker since he "enjoys" being awaken at five in the morning by phone calls from his broker with breaking news about the stocks he owns. He insists that on at least a few occasions timely information from his broker directly impacted his buy-sell decisions and actually allowed him to make "many thousands of dollars" in profit, far outweighing the "mere hundreds of dollars" he paid in full-service commissions each time he traded.

Personally, I'm at the other end of the spectrum. I like to rely on my own ability to follow and interpret the news and do my own analysis. As such, I favor using reputable online discount brokers (at commissions of about $10 per trade) and can live very happily without any word-of-mouth investment tips, information and advice from brokers. At the same time, however, I do realize that there are some successful and sophisticated investors who prefer the full-service alternative, if for no other reason than they choose not to spend their time watching the markets so closely. Perhaps it's more of a lifestyle choice than anything else.

Saturday, September 22, 2007

Will Keystone Automotive shareholders approve the $48 buyout by LKQ?

Reader's Question: In July, LKQ Corp. (Nasdaq: LKQX) offered $48.00 per share for Keystone Automotive (Nasdaq: KEYS) in an all-cash deal. Keystone is currently trading around $47.65. The merger is contingent upon approval by Keystone shareholders on October 10. Do you feel that the deal will go through? I am a Keystone shareholder and have voted "no."

Deal Background

For the benefit of any who have not been following the details of this deal, here's a chronology according to the September 5th proxy statement for the merger: Our story begins in December 2006 when Joseph Holsten, CEO of LKQ Corp. (Nasdaq: LKQX), phones Richard Keister, CEO of Keystone Automotive (Nasdaq: KEYS), to arrange a meeting. At dinner on January 18, Mr. Holsten broaches his interest in pursuing an acquisition, which leads to a meeting involving these two CEOs and the chairmen of their respective boards on March 2, when Keystone's shares are at $32.00. Since both companies are active in the replacement auto parts market--Keystone as a leading distributor of aftermarket collision auto parts and LKQ as a provider of replacement parts including recycled parts from salvaged cars--the merger is expected to produce abundant synergies, creating new efficiencies and marketing opportunities for the combined enterprise.

LKQ's initial price indication is $37 to $39 per share, half in cash and half in LKQ shares, which Keystone directors, now having engaged JPMorgan as advisor, formally reject on May 3, when Keystone's shares close at $37.57. Supported by JPMorgan's opinion that Keystone would be undervalued in the low-$40s, the Keystone team states (posturing?) that Keystone is "not for sale" and, even if it were, LKQ's indication of value is "significantly less than the intrinsic value of Keystone."

On May 7, LKQ raises its offer to $45 all-cash. The following day, the Keystone team discusses the situation and concludes that, besides LKQ, "no other automotive aftermarket supplier or other strategic industry participant would likely have an interest in acquiring Keystone due to, among other things, the differences in their business models with that of Keystone." Thereafter, JPMorgan turns to private-equity buyers, and a short list of six interested parties is whittled down to one potential buyer who offers $46 to $48 per share on June 15, contingent on arranging financing for the purchase.

On June 19, LKQ again raises its offer, now to $47, based on 60% cash and 40% stock, which Keystone counters with $49 all-cash. Over the ensuing month, Keystone decides to reject the private-equity buyer's offer, reasoning that LKQ is further ahead in the due diligence process and would be more likely to close given the financing commitment LKQ has already obtained from its bankers. Further negotiation between Keystone and LKQ leads to agreement, and Keystone's board approves the $48 all-cash deal on July 16, when Keystone's share price closes pre-announcement at $43.61.

The day of the merger announcement, July 17, Keystone's shares close at $46.80, up just 7%, while LKQ's shares jump 15% from $25.38 to $29.09. During the next two months through the close of trading this past week, LKQ's shares rise another 21% to $34.44, while Keystone's share price crawls up barely 2% to $47.67, just shy of the $48 all-cash buyout price. In short, while acquiror LKQ's shareholders have enjoyed an impressive 36% gain since the deal was publicly announced in mid-July, acquiree Keystone's shareholders have seen a much smaller 9% gain (see graph). With acquiror's shares having risen more than acquiree's, which is just the reverse of typical acquiror-acquiree share price action following merger announcements, something seems amiss. This unusual price behavior leads me to suspect that further surprises could follow.

How Should Keystone Shareholders Vote?

Apparently, the market is assigning kudos to acquiror LKQ in this deal, who manages, if the deal goes through at $48 as planned, to buy Keystone "on the cheap" and benefit from the resulting synergies between the two companies' businesses. Keystone shareholders, with their upside capped at $48 per share, certainly appear to be getting the short end of the stick. Indeed, there are some (viz., 4% shareholder Rockhampton Management and an analyst) who have already spoken out, insisting that the Keystone board failed to represent the best interests of the shareholders in negotiating and accepting the deal. However, rather than go down the path of discussing who's right or wrong, let's focus on the question at hand: Will the shareholders approve the $48 buyout deal on October 10?

As I see it, there are four possible outcomes:

1. New buyer enters bidding: By the terms of the merger deal, Keystone may terminate the agreement by paying LKQ $30 million plus expenses up to $1.4 million, which amounts to about $1.90 per share based on 16.6 million shares outstanding. This implies that any new buyer would need to offer at least $50 per share to enter the bidding at this stage. Similar to what occurred in the Blackstone Group's buyout of Equity Office Properties in February, it is possible that a qualified and serious second bidder surfaces over the next few weeks prior to October 10, forcing LKQ to raise its offer to above $50 per share to stay in the running. If a bidding war develops, the buyout price could run as high as $60 per share or more, in a combination of shares of the acquiror and cash. Possible bidders include auto parts distributors and retailers, recyclers and steel companies, and private-equity firms. The same private-equity buyer who bid earlier in the process could re-enter the bidding, and I have to believe that, however respectable JPMorgan's banking contacts are in the auto-related and private-equity sectors, there could very well be other potential buyers who, for whatever reason, are only now considering the situation seriously.

2. LKQ pre-emptively raises offer: If LKQ begins to sense that the Keystone shareholders could reject the deal in the October 10 vote, LKQ may wish pre-emptively to raise its offer to $50 per share or a bit higher to "sweeten" the deal to make sure that it gets approved. In my opinion, based on the attractive synergies the merger promises, LKQ will be better off in the long run following through with the deal, even if at a slightly higher price, than shortsightedly tolerating a rejection by Keystone shareholders and walking away with a $30 million consolation prize in hand.

3. No new offer and shareholders reject $48 buyout: If fewer than half of the Keystone shares are voted in favor of the deal, the $30 million termination payment will kick in, resulting in a one-time loss to Keystone of about $1.90 per share. That's, of course, an undesirable outcome; however, through deal disapproval, there's also a potential positive: Keystone's share price could actually rise a few dollars, based on the market's realization that the $48 buyout price was too cheap to begin with. Meanwhile, LKQ's share price would almost certainly fall, giving up part of the 36% gain from its pre-announcement price level, since the synergies of the merger would no longer be available. At this point, the stage would be set for a brand new round of buyout talks, this time with all parties having a better understanding of the value of Keystone, the synergies of an LKQ-Keystone combination, the market's consensus view of the situation, etc.--and I believe that all of this information, now public, should work to the advantage of Keystone shareholders.

4. No new offer and shareholders approve $48 buyout: In my opinion, a simple "yes" vote to approve the deal as it now stands would lead to the worst possible economic outcome for Keystone shareholders, since the share price is capped at the $48 buyout price. Each of the alternative scenarios above provides a means for Keystone shareholders to realize higher value for their shares.

Basically, the market has "spoken" through the unusual acquiror-acquiree price behavior of LKQ and Keystone shares following the July 17 deal announcement, revealing very clearly that Keystone is worth more than $48 per share, even though there remains some skepticism regarding a mechanism for Keystone shareholders to realize this value--hence, Keystone's share price still sits marginally below $48 per share. The market seems to be telling us that, despite factors in Keystone's business such as the Ford patent litigation risk and the question of whether State Farm will re-commence authorization of aftermarket parts, fundamentally the alternative auto parts market is a viable growth opportunity for LKQ, Keystone and other companies in their business niche.

I wonder whether the Keystone shareholders--the largest among them being Artisan Partners (7.6%), T. Rowe Price (6.9%), Wells Fargo (6.1%) and Wasatch Advisors (6.1%)--will collectively make the proper choice on October 10. Fortunately, control now rests in the hands of these shareholders, who, in my opinion, would only be shortchanging themselves by voting for the merger as it is currently priced. If, over the next few weeks, no new buyer surfaces and LKQ does not pre-emptively sweeten the deal to guarantee approval, then I believe Keystone shareholders will do themselves a favor by rejecting the $48 offer.

Potential Upside

While the actual outcome of the vote is difficult to predict, it is very possible that either another buyer surfaces and/or LKQ sweetens its offer on or about October 10, giving Keystone shareholders a more attractive deal to approve, significantly above the current $48 per share offer price. With Keystone's shares trading below $48, it appears that the market is suggesting that no higher bid will come. Though this might end up being the case, I note that market opinion can change very quickly, once the slightest hint of renewed buyout deal activity begins to flicker on traders' screens.

As an investor or speculator, what's the best strategy to follow? If the $48 deal as written closes by scheduled vote on October 10, anyone holding Keystone shares will realize a return of about 70 b.p. (= 48.00/47.67 - 1) over the three-week holding period from today through settlement shortly after October 10. Although 70 b.p. may seem small, it annualizes to a rate of about 12%, which is actually a very respectable worst case return. If any of a number of events lead to an elevated buyout price, a windfall gain of at least a few dollars per share could result, driving returns considerably higher. By the way I see it, there is essentially a "free" call option embedded in Keystone's current below-$48 share price, and the payout of this option could very well surprise on the upside.

(Disclosure: The author presently has no position in any of the companies mentioned in this article.)

Thursday, September 20, 2007

I'm new to investing. Is there a simple place for me to start?

Reader's Question: I'm really new to investing. Do you have a simple place I can start or an article you've written that you can point me to?

Early this year, I assembled the main threads of my thinking on investing into a five-part blog series:
  1. Passive Wealth Generation: From Zero to a Million Dollars in Five Measured Steps

  2. What Investment Return Should We Target?

  3. Investing in Equities

  4. Why Controlling Fees and Expenses Matters

  5. Perseverance in Long-Run Investing

In this series, I outline the basic methodology behind my own approach to investing, explaining why saving, setting realistic targets, buying equities, watching expenses and staying in the game are so critical to long-term success. As an investor, my own objective is to implement a sustainable investment system that works for perpetuity and properly sets the stage for managing whatever wealth remains in my portfolio when my time on our planet expires.

Within the blog articles, I mention a few books that you might find useful, one of which is Jeremy Siegel's Stocks for the Long Run.

In investing, as with most endeavors in life, I believe that focus and determination can carry one a long way. Since global equity markets tend to exhibit strong secularity (i.e., long-run returns are very significantly positive), really, time is on your side if you have sufficient patience and level-headedness to stick with it.

Monday, September 17, 2007

Should I use an investment advisory service?

Reader's Question: Which is a better way to invest--subscribing to a portfolio advisory service or choosing mutual funds on my own?

I look at investing as consisting of three primary decisions:

  • Buy equities or fixed-income instruments?

  • Buy individual securities or a highly diversified portfolio?

  • Use advisors or do it yourself?

  • Favoring Equities

    As I have mentioned in earlier blog entries, I strongly favor holding essentially 100% equities in an investment portfolio. Historically, equities have outperformed bonds, bank deposits and other fixed-income instruments over multi-decade time horizons. Surely, there have been instances, like the post-tech-bubble fallout during 2000-2002, when equities have shown sharply negative returns. However, over the long run, given our wealth-centric, industrial economy driven by political, govenmental and social forces all promoting growth, it is, in my opinion, highly unlikely that equities will underperform bonds and cash for significant time periods. The current softness in the real estate sector may dampen consumer spending and lead to a recession, but I believe that our economy is quite resilient (though always "on the brink," as George Soros puts it) and will in due course provide better returns for businesses, owners of capital and risk-takers than for those who choose the "safer," fixed-income alternative.

    Concentrated Portfolio

    Owning one stock or mutual fund is not diversified enough and owning more than a few dozen stocks or mutual funds can be cumbersome to manage. I prefer to hold somewhere between 10 and 20 positions in my portfolio. In practice, I have found that if I hold more than this number of positions, I become unable to track closely enough the news and relevant events affecting my securities. Also, with fewer than about 10 positions, it becomes more difficult to tell if portfolio success (or failure) is just good (or bad) luck or actually statistically significant. For those who prefer mutual funds, it is possible to achieve adequate diversification with just a few fund selections, since the funds themselves are usually quite diversified. For reasons I provide below, however, I prefer managing my own concentrated portfolio of individual securities over investing in more highly diversified, fee-taking mutual funds.

    Investing On Your Own

    The price behavior of stocks is driven by a combination of random and non-random elements, with the predictable (i.e., non-random) factors typically being so weak that management fees, trading commissions, bid-offer spreads and other frictional costs tend to "wash away" the advantage that any sliver of predictability offers. Hence, we often hear how mutual fund and, more recently, hedge fund managers generally underperform market averages, despite their education, experience, talent and high incentive pay. Compared to practitioners of other professions (e.g., medicine, law and accounting), which offer services exhibiting more predictable outcomes and demonstrable benefits for clients, portfolio managers unfortunately find themselves battling market forces beyond their control. Given the intrinsic unpredictability of the financial markets (at least in the short run), it makes little sense to hire "expert" advisors who have no better than a random chance of outperforming the markets, especially after taking into account the management fees they charge.

    Subscribing to a stock-picking or investment-timing advisory service will typically leave you no better off than handing over your investable assets to mutual fund managers. Instead, what I would suggest is one of two alternatives: either do your own research and pick your own equities, or invest in exchange-traded funds (ETFs) that replicate the performance of a market index or sector without making an attempt to time the market. The one area of investing that you do have control over is your out-of-pocket advisory fees and expenses, and keeping these at a minimum will likely improve your investment returns in the long run.

    Wednesday, September 05, 2007

    Are stocks with high price-to-book ratio worth buying?

    Reader's Question: Are stocks with high price-to-book ratio (P/B) such as Boeing (NYSE: BA) and Apple (Nasdaq: AAPL) worth buying? Is P/E always more important than P/B? Is there any benchmark for P/E and P/B ratios by sector and industry?

    High P/B ratio is often a sign that a business has rosier future prospects than past performance. Share price is high relative to book value because investors have bid up the share price based on expectations of better earnings and/or cash flow ahead.

    The quintessential example of a well-known company with high P/B ratio is Amazon (Nasdaq: AMZN), with book value of $550 million at the end of June 2007 and current market capitalization of $35 billion, giving a strikingly high P/B ratio of 64. By the nature of its capital-intensive (to build warehouses and technology) and loss-leader (to win market share) business model, Amazon recorded huge losses throughout most of its corporate history and only in recent years has begun to generate consistent profits. Even some value-oriented investors, such as Bill Miller who manages the Legg Mason Value Trust, have been holding large positions in Amazon's shares for years, looking beyond high P/B and focussing instead on the future earning potential of the company's Internet retailing business.

    Boeing (NYSE: BA) currently trades at a P/B ratio of 13, which is quite high. From 1997 through 2005, Boeing's P/B ratio was in the range from about 2.5 to 5.0, more in line with typical stocks in the S&P 500 index. During 2006, due to new FASB rules on pension accounting, the company showed a $6.4 billion reduction in book equity from $11.1 billion to $4.7 billion, which effectively raised its P/B ratio from 6 under the old rules to 15 as reported at year-end 2006. During the first half of 2007, earnings have boosted book value by over a billion dollars to $5.9 billion, giving the current P/B ratio of 13 at a market capitalization of $78 billion. As more retained earnings flow into book value over the years ahead when the much anticipated, super-fuel-efficient Dreamliner 787 goes into production, Boeing's P/B ratio should gradually revert towards the historical range reported prior to the pension-related accounting change.

    Apple (Nasdaq: AAPL) is now trading at a P/B of 9, which is the highest P/B ratio the shares have seen during the company's "second wind," post-Mac era. From its nadir of close to parity in 2001 and 2002, Apple's P/B ratio has "risen from the dead," tracking the launch of the company's spectacularly successful iPod in 2001, increased market share of personal computer sales, and summer 2007 launch of its innovative iPhone. Today, many of Apple's price ratios are similar to Microsoft's (Nasdaq: MSFT):

    Price-to-Book: 9.3 for Apple vs. 8.7 for Microsoft
    Price-to-Sales: 5.5 for Apple vs. 5.3 for Microsoft
    PEG Ratio: 1.6 for Apple vs. 1.4 for Microsoft

    However, Apple's P/E ratio of 40 is roughly twice Microsoft's 20, and analysts' 5-year earnings growth estimates for Apple are 24%, versus just 11.5% for Microsoft. The upshot is that investors expect Apple's earnings to grow rapidly over the next few years and are willing to pay up for the stock.

    In all of the examples cited above--Amazon, Boeing, Apple, Microsoft--the P/B ratios are considerably higher than the market's average P/B ratio of around 3. Importantly, each of these companies has highly successful products and services--Amazon's dominant presence in online retailing, Boeing's lead in airplane production, Apple's popular consumer electronics, and Microsoft's near-monopoly on PC operating system and productivity software. For these companies, sales and profit growth trends and investor expectations about future earnings have pushed valuations to high multiples of book value, so that forward P/E and PEG ratios are generally more useful indicators of value than P/B. (Note: In the extreme value investing world pioneered by the likes of Benjamin Graham, where the focus is on the liquidation value of assets instead of earnings potential, the situation is reversed, with P/B being a better indicator than P/E.)

    For a handy reference to compare P/E and P/B (and other ratios) by sector and industry, see the Yahoo's Industry Browser.

    (Disclosure: The author does not currently have a position in any of the stocks mentioned in this article.)