This is the ninth article in the series about Post Modern Security Analysis.

Operational versus financial information

In the classic 1934 text, “Security Analysis” by Benjamin Graham and David Dodd, the emphasis was on financial analysis (balance sheets and income statements) and the analysis of the terms and conditions of securities.

Operations: the How and Why of markets ...

Over the next seventy years, capital markets became vastly more complicated, with greater cross-border investment flows.

At the end of the century, the Internet brought an explosion of information and new investment tools.

Today, financial analysis is still the focus of security analysis, but complexity and internationalization has created a need for this focus to expand, bringing in new areas such as economic conditions and legal protections in foreign markets and operations of capital market supporting institutions (such as central banks, development banks, securities and derivative exchanges, clearinghouses, and central security depositories).

There is also greater need to include research in the area that Capital Market Wiki calls “Operations” which is defined as including the following:

  1. Behavioral standards: Any type of rule or mandate that governs behavior of market participants. Behavioral standards include treaty and constitutional law, jurisprudence and legislative law, decrees and administrative regulations, customs and traditions, and religious law. Behavioral standards may be promulgated by government or private bodies, or may be the result of long-observed customs, traditions, or religious practices.
  2. Economic theory: Every type of belief system that underlies or justifies behavioral standards and market operations. These are articles that explain the theoretical justification for financial operations and institutional methods, and behavioral standards.
  3. Financial operations: Methods used by investment banks, commercial banks, issuers, fund raisers, stock exchanges, OTC markets, clearinghouses, CSDs, investors, and portfolio managers in raising capital and funds, providing liquidity, selecting and pricing securities, managing financial and other risks, and enhancing income.
  4. Institutional methods: Supporting systems, procedures, strategies, and other factors and means used by capital market institutions to provide basic capabilities needed to conduct financial operations.

Operations: The “How” and “Why” of markets

What passes for “full disclosure” in registration statements and company reports under regulatory regimes around the world is determined by the laws of each jurisdiction.

Mandatory disclosure generally does not include an explanation of the laws, rules, and other legal constraints that govern an issue. The public is usually presumed to know such things — although this may be unreasonable.

Nor do disclosure documents contain thorough descriptions of complex operations and institutional methods that may effect risks and rewards.

For example:

Backoffice procedures may be important ...
  • Disclosure documents on a closed-end REIT fund in the United States will not ordinarily explain the laws that govern closed-end funds, nor the tax regulations that constrain REIT operations.
  • Feeder funds that support Bernard Madoff’s Ponzi scheme were not required to disclose and explain in detail the “split-strike conversion strategy” that supposedly explained the extraordinary stable, high-returns of these funds.
  • Auditors’ notes on major banks that were speculating in over-the-counter options were not required to contain an explanation or evaluation of the counter-party risks inherent in such trades.
  • Prospectuses for the hundreds of municipal bond funds that were leveraged by auction market preferred shares (AMPS) did not contain careful explanations as to how the liquidity of such instruments was to be preserved.
Financial statements can't explain everything ...

Information of this type, however, is often available on the Internet or in university libraries.

However, such information is not necessarily found in a compact, convenient format in a single location.

Sometimes knowing the “how” and “why” of investment operations can be more important than audited financial information about the issuer.

For example:

Prior to the collapse of the AMPS market in 2007, Moody’s generally gave AAA ratings to auction market preferred shares and thousands of investors were misled into believing that AMPS were safe, short-term investments.
What was missing was operational information about exactly how and by whom liquidity in these shares was guaranteed or assured. After the fact, we can see that there was no assurance of liquidity and that the AMPS auctions were fundamentally flawed. Furthermore, operational information that warned of this unsatisfactory situation was available, all the while, on the Internet. However, by focusing primarily on financial statement analysis, these dangers would be overlooked.

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This is the eighth article in a series about Post Modern Security Analysis.

Truth, Fact, and Opinion

Fundamental concepts in open source research include “truth”, “fact”, and “opinion”. These ideas have occupied philosophers since the beginning of history.

Truth ... beyond our reach

Since Post Modern Security Analysis is meant to be a practical field, it is convenient to choose a rather arbitrary, but useful, definition for these terms:

  1. Truth: Objective reality in a theoretical universe that lies beyond human capacity of verification. Philosophers have many definitions of truth, but for practical purposes, we shall think of truth as a ideal — a goal that never can be obtained with certainty.
  2. Facts: Statements that would generally be accepted, universally, as representing truth, based on available knowledge at a particular time. At one time, that the earth was the center of the universe was considered to be true. Later, people thought it true that the sun was the center of the universe. Still later, the idea that the universe had a center at all was in doubt. Today, scientists ponder “parallel universes” and “membranes“.   “A fact is a pragmatic truth, a statement that can, at least in theory [to a certain degree], be checked and confirmed. … A scientific fact is an objective and verifiable observation, in contrast to a hypothesis or theory.[1]
  3. Opinion: Any statement that would generally be regarded as a belief or non-factual interpretation or position of a particular individual or group. An opinion may be based on fact, on conjecture, or on faith — but is still only an opinion. Theories and hypothesis are opinions, not facts. All belief systems have at the core a set of axioms or fundamental propositions that cannot be proven and must be taken on faith. That millions of people, or even a majority, may hold a certain opinion, does not make that opinion a fact, unless the opinions would almost universally be regarded as true.

Most open source information about capital markets is opinion. Prices in securities markets are expressions of opinion (among other things such as the forces of supply and demand). What passes for a “research report” in most investment markets is almost always a statement of opinion, which may or may not be based on fact.

Relevant facts

The central idea of Post Modern Security Analysis is to rigorously separate the gathering of relevant facts from the development of useful opinions based on the analysis and interpretation of these facts.

An early Ford: interesting but irrelevant

“Relevant facts” are those that help answer questions that the analyst poses at the start of the research process. Every research assignment should start out with express or “implied” questions that guide the researcher in sorting useful from irrelevant information.

See: Implied questions on Capital Market Wiki and Recommended formats for research projects.

Most information available on the Internet regarding capital market topics — both, opinion and fact — is irrelevant to the purpose of most research projects. For example, a research project on the Ford Motor Company will turn up thousands (or millions) of pages about the various automotive models produced by the company, information on car repair, tips on bargaining with car dealers, and so forth.

The fact that the New York Stock Exchange sponsored the racing car driver Marco Andretti is interesting, but irrelevant, to most capital market research projects about that exchange.

See: Open source analysis tradecraft.

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This is the fifth article in a series about Post-Modern Security Analysis.

The challenge of complexity

In part three of this series, I wrote:

… the first step of Post-Modern Security Analysis is simply to identify issuers or instruments that are too complex to analyze and move on to more worthy objects of analysis.
At one time, securities were relatively simple ...

This raises the questions, “How do you know when a subject is too complex to analyze?” and “What is the nature of complexity in modern capital markets?”

These questions go to the heart of Post-Modern Security Analysis: that of recognizing the problem of complexity and seeing the analyst’s task as a process of first gathering, weeding out, and documenting relevant facts about an issue and only then, with the information carefully recorded, analyzing the points that have been selected and verified.

Under classic investment analysis, as described in Graham & Dodd’s 1934 edition of “Security Analysis”, scant attention was given to the first step: the gathering and documenting of relevant facts. Almost the entire book was focused on the analysis of facts, presumably easily extracted from published sources such as Standard Statistics.

In those years, the analyst’s complaint was more likely to be lack of information, rather than too much information.

In Post Modern Security Analysis we cannot assume simplicity or insufficient information. Instead, we must start with the expectation that the major challenge will be to wade through and manage a vast swamp of information, with the factual mixed in with the fanciful and irrelevant.

Note: In some developing markets with weak regulation and relatively simple, family- or group-owned companies, the assumptions of Graham & Dodd may still be useful.

Once we have dug out and recorded the relevant facts, there are an abundance of textbooks that can help in analyzing a specific type of security or aspect of the market.

For example: See: Investment analysis

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