The focus and nature of investment analysis has gradually shifted over decades, as the amount and complexity of information available to the analyst has evolved.

There have long been two schools of investment analysis.

One school, concentrating on price information, is called “technical analysis”.

The other school, focusing on facts about the issuers of securities and the terms and conditions of the issue, is called “fundamental analysis”.

Easy facts: the advantage of technical analysis

Price information has always be easier to come by than facts about issuers and the securities themselves.

Technical analysis: massaging price and volume data

Technical analysis, in all its varied forms, dominates much of what passes for investment analysis today.

From Japanese candlestick charts, dating to the 18th century, to Modern Portfolio Theory, with its emphasis on alphas and betas, to the Black-Scholes   equations that brought down Long Term Capital Management and the pride of the Nobel Gods — when we strip away the fancy graphs and esoteric equations, we find that the only facts involved seem to be price, volume, and simple data on corporate actions (like dividends, stock splits, or rights issues).

Some have compared technical analysis to astrology — more of a magical belief system than rational science. I would agree with them if technical analysis is the only basis for selecting investment.

However, when combined with fundamental analysis, examining price and volume trends can provide useful insights.

Hard facts: the bane of fundamental analysis

The availability of facts about issuers and the terms and conditions of the securities issued has improved gradually over the years.

Prior the regulatory reforms of the Great Depression, facts about securities (other than price and volume), were hard to come by.

When Benjamin Graham and David Dodd published “Security Analysis” in the 1930s, the availability of corporate information had improved considerably. They wrote in their book (which came to be the Bible of fundamental analysis):

… descriptive analysis consists of marshaling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. This function is adequately performed for the entire range of marketable corporate securities by the various manuals, the Standard Statistics and Fitch services and others. …

In an earlier article, I describe the quality of information available at the time “Security Analysis” was written.

The Standard Corporation Service volume of 1915   may be examined on Google books.

More information than an analyst alone can handle

Whereas the complexity of price-volume facts that support technical analysis has not changed much over the years, this is not true for the facts needed to support fundamental analysis.

  1. Complexity: Corporations, corporate operations, and terms and conditions of securities have become exponentially more complicated and difficult to understand over the years since Graham & Dodd set forth the principles of fundamental analysis.
  2. Information Overload: Due to the Internet, the volume of fundamental facts now freely available to the analyst often surpasses the capacity of any individual to gather and organize.
See: The heroic, solitary security analyst is long gone.

Whereas, in the days of Benjamin Graham, the analyst could count on Standard Statistics to provide most essential facts, three-quarters of a century later, this is no longer true for its successor, Standard & Poor’s.

Most of the book “Security Analysis” deals with the interpretation of the relatively simple data available in the market at the time. Little space is devoted to the task of obtaining this data.

The ratio between the work involved in fact-gathering to fact-interpretation was perhaps 1 to 20 in the 1930s.

Today, it would be more like 100 to 1!

Moving beyond Graham & Dodd

What this means for fundamental analysis is that in the 21st century much more attention must be given to the process of gathering, collating, and organizing basic facts about issuers, issues, and their operations.

Graham & Dodd gives no clue on how to do this for the simple reason that they knew nothing about the Internet, computer search techniques, capital market taxonomy, esoteric derivatives, or the myriad complexities that helped to crash the market in 2008.

Even the book, A Modern Approach to Graham and Dodd Investing   does not deal with the formidable task of mining the sea of information on the Internet, focusing instead on modern financial statement analysis. The problem is, as was seen in the billion dollar collapse of the market for Auction Rate Securities, the devil was in the terms and conditions of the issue rather than in the financial statements of the issuer — facts which the statistical publishers failed to make clear to subscribers.

Where we are today

The Crash of 2008 did a pretty good job of trashing the Efficient Market Hypothesis, which had become a pillar supporting the notion that technical analysis in all its manifestations could reasonably serve as a stand-alone approach to investing.

The movers and shakers of Wall Street were revealed as ignorant of the basic facts needed to value securities.

For too long, price and volume, and all their derivative statistics and indices, had dominated investment behavior — leaving fundamental facts about issuers, issues, and the arcane details of operations in the closet.

The rating agencies are now in the dog house.

It is time to move on.

For more on the crisis of information, see:

See: Crowdsourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowdsourcing investment research: Capital Market Taxonomy and Innovation in investment research; dealing with free information and Modern technology for institutional investment research

Fundamental securities analysis will be advantageous for investors in the wake of the Crash of 2008. (See: Finding investment opportunity in the post stock-buyback era.)

By “fundamental securities analysis”, I don’t mean just financial statement analysis as in Graham and Dodd, but rather a combination of such techniques with data mining for relevant facts, using open source financial intelligence techniques (OSINT).

Open source financial intelligence

The main profit opportunity in fundamental securities analysis lies in the fact that only a tiny portion of available financial information is actually published by the leading commercial sources such as Standard & Poor’s, Moody’s, and Thomson’s. (See: Commercial sources of information.)

Much of the information omitted by the commercial services is available free on the Internet, but the time and effort required to find the facts, discard the irrelevant, and analyze meaning is a greater burden than most of us, even sophisticated investors, are willing or able to expend.

Many investors  share the tunnel vision of commercial information sources
Many investors share the tunnel vision of commercial information sources

Open source intelligence (OSINT) is a technique used by intelligence agencies throughout the world to gather and analyze free, non-secret, raw public information such as in public government files (like the SEC), newspapers, websites, and miscellaneous printed ephemera. (See: Open source financial intelligence.)

Open source intelligence is used by UK MI5

The US Central Intelligence Agency and the UK MI-5 are typical users of open source intelligence techniques.

Techniques and the trade craft of open source intelligence are taught in universities such as John Hopkins, Maryland, Trinity Washington, American Military University, and Mercyhurst College, but not in most business schools. (See: Open source tradecraft.)

The fact that most MBAs are not trained in open source intelligence, but rather the opposite — the Harvard Business School case method — gives a competitive advantage to those analysts who know how to mine the vast bog of free information for those facts that are important in security selection.

Teaching open source financial intelligence techniques

Security analysis is much more than financial statement analysis. The analyst must also know the terms and conditions of each class of security and the laws that constrain the operations of a particular venture.

A company may be limited by off-balance sheet liabilities on pension plans, contracts with suppliers, restricted licensing agreements, and much more. Only when you have this essential information, can you decide what financial ratios are appropriate.

In fact, the skillful analyst will devise ratios and ways to measure an enterprise that are tailor-made for specific circumstances.

To get information that you need, you must know how to wade through the vast marshes of open source information, hunting for clues as to what is relevant and what is not.

Somewhere in this marsh of information, there is vital data ...

Most open source information is useless. Garbage to be discarded. Puffery, opinion, irrelevancies, and non-facts make up much of what you must wade thorough.

SEC documents are laced with disclaimers, legal boilerplate, and required irrelevant “facts” that waste your time, but must be sorted through. Much is repetitious.

But now and then, you come across that pearl of wisdom … an “ah ha” moment … that makes it all worthwhile.

Of course, competing analysts who are too busy for such drudgery, will never have your insights and will march off in lockstep to the tune of the very limited informational ditty served up by the same easy, convenient, commercial sources.

Fundamental analysis has never been easy — which is the reason that Warren Buffet and Benjamin Graham were able to make money.

Fundamental analysis that is relevant to the 21st century and the over-abundance of free information, must go beyond the 1930 techniques of Graham, Dodd, and Buffet.

Capital Market Wiki provides templates for teaching open source financial research in universities. This wiki also has formats, guidelines, and help files that allow you to learn on your own, by doing.

Non-standardized information

The challenge of open source financial intelligence is that the information marsh through which you must wade is unorganized and uncharted.

Like Forrest Gump’s mother’s “box of chocolates”, you never know what you’ll get.

OSINT is like a box of chocolates ... you never know what you'll get.

Things are even more complicated by the fact that capital markets are now international. Information available in Indonesia is not the same as in the United Kingdom. Not only are there language barriers, but there are differences in culture, laws, and commercial customs.

Extremely important information can easily be over-looked. For example, the fact that Bernard Madoff was, according to SEC documents freely available on the Internet, holding in custody billions of dollars of client assets, with full managerial discretion, and audited only by a tiny one-man firm in a strip mall in a New York suburb, should have been sufficient to set alarms bells ringing. But this information was available only to open-source analysts who were looking very closely, with a skeptical eye.

Technology and economics for open source financial research

Internet technology and search engines such as Google have brought open source intelligence techniques within the reach of anyone.

Among the new technologies that are useful for open source financial research are collaborative research thorough wiki systems, semantic databases, capital market taxonomy, and open source economics.

I’ll get into these issues in a future article.

Or you can find more information on the Capital Market Wiki introduction page.

Photo credit: “Tunnel vision”: nikpawlak (flickr)


Where will investment opportunities be found in the post stock-buyback era?

Let’s first consider the implications of the demise of stock buybacks:

On a tightrope, without a net ...
  1. The end of upward bias on equity prices:: As estimated in the article on assessing the buyback era — since 1983, buybacks totaled $5.7 trillion (in 2008 dollars), which pushed stock prices upwards for over a generation, weakening corporate financial structures, and eventually leading to the Crash of 2008.

    Stock buybacks were essentially stock manipulation on a grand scale, sanctioned by SEC Rule 10b-18, largely unperceived by the public.

    This meant that you didn’t have to be smart to earn a decent return in the stock market, despite the hiccups of 1987 and 2000.   Just “buy and hold” a diversified portfolio in an unmanaged index fund in which no analysis was involved in selecting investments — just “buy and hold” and be happy. (Of course, as demonstrated by the Crash of 2008, there was an inevitable bill that eventually came due.)

    Without buybacks to push stock upwards, investment risks will now have shifted. There will be a premium on stock selection based on facts. Stock investors will be on a tightrope, without the buyback safety net. It’s back to Graham & Dodd — but in a modern context.
  2. A down draft from a surge of IPOs: The need for capital to repair the damage of the buyback era, as well as practical repercussions from policies of the Obama administration (corporate taxation, regulation, unions, emissions , inflation, the dollar, and trade), are likely to favor corporations that are well-capitalized and more resistant to government interference.

    Inflation alone, if as high as expected, should restrict access to bonds as a source of capital, leaving only equities. The era of buybacks could be followed by decades with positive flows into IPOs, which would exert downward pressure on stock prices.

    Investors need to be smarter to pick winners in a market without an upwards bias.

What the crash of 2008 revealed

The dominant feature of the Crash of 2008 was that nobody seemed to know what was going on. No one knew how much stocks or other securities were really worth. The Efficient Market Hypothesis was in tatters.

No one could trust Standard & Poors, Moody’s, Fitch’s, Morningstar, Bloomberg, Thomson’s, the Securities and Exchange Commission, Lehman Brothers, Citicorp, the Federal Reserve, or the US Department of the Treasury.

It wasn’t that there was no information. This was not 1929. On the contrary, there was a tsunami of financial information available on the Internet, largely hidden in millions of SEC files, government documents, and institutional websites — unanalyzed and uninterpreted.

Most of this information was free, but few had the time, resources, or inclination to dig it out. Besides, if stocks were going to rise anyway, in the long run, why bother?

Too much information, like too much water, can be counter-productive
What passed for information was mainly derived from security prices, freely available on and elsewhere, parsed and regurgitated as simple and exponential moving averages, Bollinger bands, money flow indices, moving average convergence-divergence, parabolic stop-and-reverse indices, rate of change and relative strength indices, fast and slow stochastics, simple and exponential moving average volumes, the Williams %R indicator, betas, and a host of other greek letter indicators.

The commercial information services left huge portions of the financial markets unreported and unanalyzed.

Information even on major traded securities was limited to price graphs, simple financial data derived from financial statements, and a brief summary of the line of business. Essential information on the terms and conditions of particular issues was generally omitted, as was explanation of the laws, regulations, and major contracts that constrained operations.

A typical stock report

A typical Standard & Poor’s stock report was only seven pages long, one of which would be disclaimers. The report would contain many opinions, including opinions of other analysts, but little explanation of the terms and conditions of the securities, stock buyback practices, executive remuneration, ties with affiliates, pension fund burdens, or off-balance sheet contingencies.

Morningstar and Thomson reports on closed-end funds generally failed to provide the terms and conditions of auction market preferred shares, without which it would be impossible to gauge the risk of holding these securities, even to common shareholders.

Superficiality marked most investment thought in Q4 2008, as could be seen in a host of message boards, investment blogs, tweets, and sundry grunts and groans that were meant to pass for rational discourse on the Internet.

Finally, what information was offered from commercial source, was far from free, as the Efficient Market theorists had postulated. A year’s subscription to Bloomberg could set you back $25,000, although not much more than was available elsewhere on the Internet was actually delivered.

A case of the one-eyed man

Erasmus said, In regione caecorum rex est luscus, which I first learned in Portuguese as, “Em terra dos cegos, quem tem um olho é rei.”

And so it may well be in the new markets, in which the “one-eyed man” will be the stock analyst who is able to escape the disdain for fundamentals that typified the buyback era, and pass into the light of informed equity selections based on hard, deeply-researched, factual data.

The reason that the end of the generalized use of buybacks should require a modification of investment practices is the effect of this change on market covariance — the tendency of stock prices to all move in the same direction, together.

Expectations of historical covariance have guided “Modern Portfolio Theory”, fund management, and investor behavior for a long time.

The end of the buyback movement is a cataclysmic event, that combined with inflation, modification in the trade deficit, and radical new measures being introduced by the Obama administration — can be expected to shake up the covariance model which investors have taken for granted for a generation.

In the land of the blind, the one-eyed man is king ...
In the land of the blind, the one-eyed man is king ...

The buyback movement, together with other factors, caused stock prices to move more closely in tandem for a variety of reasons:

  1. Manipulation: Stock buybacks were nothing more than price manipulation. And the manipulation was all in one direction — upwards.
  2. Index funds and the Common Stock Legend: Investors came to expect all stocks to rise together in the long-run and bought stocks indiscriminately through index funds. Non-selective investment leads to increased covariance.
  3. Popularity of technical analysis: Stock selection based on chart reading has come to dominated investment behavior. The “trading screens” that stock-brokers offer clients on the Internet are all skewed towards technical analysis. The motto of technical analysis is “the trend is your friend”. This means that more and more people were following the crowd, rather than the facts about individual securities. Stock price, itself, became the principal “fact”.
  4. The trade deficit and the secular decline in bond prices: Buybacks were possible because of a generation of easy money, funded in the ultimate analysis by the ever-increasing US trade deficit. The obverse of the long-term decline in bond interest rates was a long-term rise in stock prices. Increased covariance in bond prices was mirrored by increased covariance in stock prices.

Covariance is not a market constant. Covariance is unlikely to ever disappear — markets have always been dominated by the psychology of crowds — but how closely individual stocks track the market has varied over long periods. (See: “Testing for Covariance Stationarity in Stock Market Data”, Pagan and Schwert.)

Furthermore, the buyback movement and the associated covariance of stock prices is a long-term sociological phenomenon — investor behavior will not change overnight.

Chart-readers will continue to read their charts. Modest investors will continue to invest in index funds.

In this lies the opportunity for the “one-eyed man” who will turn to the hard road of investing on the basis of fundamentals.

Remember, the buyback movement is not ending because corporate executives have suddenly got religion and have decided to stop ripping off shareholders. Rather, behavioral change is being forced upon them by a shortage of easy credit, a government that takes a dim view of executive remuneration, hard times, bank de-leveraging, and their own over-reliance on asset-lite management techniques.

In other words, the opportunity for the “one-eyed man” lies in a change of corporate behavior that will be reflected in a change in investor behavior only later.

Not your grandfather’s Graham & Dodd

The book on fundamental analysis in this new market is yet to be written. Benjamin Graham and David Dodd published their classic work in the 1930s, in a market that was far less complicated than today.

Their basic advice — focus on the facts and commonsense to determine investment value — is valid more than ever. However, the techniques for getting at these facts have changed and fundamental analysis has become much more difficult. In this difficulty lies opportunity.

There were far less “facts” available in the 1930s than today, but on the other hand, the market was simpler.

Today, the problem of complexity goes beyond the obvious difficulty with derivatives. We also must consider:

  • Investment in foreign markets with different laws and customs and less information.
  • Exponentially more complex corporate structures based on supply-chain contracts, matrix management across different corporations, and multi-corporate groups without consolidated financial statements.
  • An over-abundance of information and the high cost of analysis in time and money
  • The multiplicity of product lines and the risk of massive product liability from some mistake in a far off corner of the world. (Like the “Nick Leeson” effect on Barings Bank.)

I’ll write more about this later and how to address the challenge of fundamental analysis in the new era.

In the meantime, you might take a look at these articles:

  1. 2008 Never Again!
  2. Commercial sources of financial information.

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