Take Advantage of Time Arbitrage

Many worry that insider trading, or stock price manipulation, undermines the fairness of the stock market. They worry that even if you pick the right stock, price manipulation will rob you of your chance for profit. It’s axiomatic that there’s always someone on the other side of your trade, and they may know more than you. While reading about Joseph Kennedy recently, I found a story that illustrated stock manipulative behavior beautifully.

Kennedy’s wealth grew from his shrewdness and a serious lack of morals. For instance, Kennedy decided to profit from the repeal of prohibition in an indirect way. The repeal was going to benefit companies that made supplies needed to distribute alcohol. One was the bottling company Owens-Illinois. But, rather than investing directly in Owens-Illinois for a small profit, Kennedy purchased shares of a company called Libbey-Owens-Ford, which manufactured plate glass for automobiles, not bottles. Its name and ticker symbol, however, were close enough to the bottle glass company to fool some investors. Once repeal was announced, Kennedy and his partners traded shares of Libbey-Owens-Ford back and forth between each other, pumping up trading volume to draw attention. That drew in other investors who bought shares on the mistaken belief that they were buying shares of Owens-Illinois, the bottle manufacturer. The price surged, Kennedy dumped Libbey-Owens-Ford with a $1 million inflation-adjusted profit. Shortly thereafter, the price of Libbey-Owens-Ford collapsed.

Kennedy’s exploits show that stock manipulation can significantly alter the price of a stock in the short-term. But they also remind us that it is important to understand exactly what you own and what its fundamentals are. Stock prices eventually return to fair value, whether that’s above today’s price or below it.

Companies I invest in are at times the targets of price manipulation. That, however, does not concern me, because such price fluctuations are just one of many short-term irrational price movements in the market. Those price movements do nothing to change the underlying fundamentals of the company behind that stock price. Patience is the key here. As I mentioned in another article, if you bought an index fund 20 years ago and checked your account statement for the first time this morning, you could legitimately call yourself one of the top investors on Wall Street: you would have outperformed three-quarters of mutual fund managers. You could say this only because you were willing to ride out the bumps and swings, while most investors were trading, fidgeting, rotating, and following aphorisms like “sell in May and go away.”

Most outperformance in the stock market doesn’t come from Kennedy-like manipulative schemes, but instead from something called time arbitrage: exploiting the gap between your time horizon and that of most other investors. This is just another way of looking at value investing. If a short-term investor is worried about where his portfolio will be in six months, the investor that has a ten year time horizon has an advantage over him. The short-term investor may sell shares today because he doesn’t want to have another down month, and the long-term investor might be happy to buy those shares to help with an up decade. Time arbitrage takes advantage of irrational price fluctuations that scare most of Wall Street and it waits for the price to move to fair value. Patience doesn’t require inside information, differential equations, or high-frequency trading algorithms. All you need to take advantage of time arbitrage, to be a true value investor, is a diversified portfolio of stocks that you know to be fundamentally stronger than their current price indicates.

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