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

Researching comparables

Capital markets are made up of many securities. Most investment decisions, at some point, involve comparing the characteristics of one security with those of other securities.

One purpose of security analysis is to determine intrinsic value, but this generally involves making comparisons with a number of securities.

Intuitively, we feel more confident in a decision if we can say that security “A” has a greater or lesser intrinsic value than security “B”, than if we were to try to fix the intrinsic value of security “A” without knowing anything about other securities in the market.

For example, if we were to invest in Company ABC, a stock in the Russian Federation, we would usually like to know the dividend payout ratio of other stocks in that market.

However, in order to make value comparisons, we need to have research available about many comparable securities — often more than we can possibly research alone. Therefore, we come to depend upon not only our own research, but on research done by many others.

The need to reduce the cost of researching comparables is the reason for collaborative research.

Parallel sources

When researching comparables, useful facts are often uncovered relative to the primary target of a research project.

For example, if we are studying the common stock of “ABC”, a health-care REIT, a parellel study of other health-care REITs will probably reveal useful information about the health-care REIT business, not found in a direct study of sources about “ABC”.

If we follow the research techniques suggest in Part Five of this series — posting our findings to separate “folders”, by topic — from parallel research, we will develop a fact-rich folder on the topic of the health-care REIT line of business that will greatly facilitate our analysis of target “ABC”.

The type of useful information revealed by such “parallel research” might include:

• Operational procedures
• Relevant laws and regulations
• Business risks
• Competitive advantages
• Economic constraints
• Market size and growth

However, to get at this valuable “parallel information” requires much more time and effort than an individual analyst would normally be able to expend.

The help of other researchers is necessary.

More »

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, 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

An important lesson of the current economic crisis should be that it is not always wise to depend on rating agencies and commercial providers of financial data to do investment research for you.

Standard & Poor’s, Moodys, Bloomberg, Fitch, Thompson, and Morningstar: That’s pretty much the list of companies that deliver financial information to most investors, including market professionals.

Some of these companies are big, with revenues in the billions. Their offices occupy skyscapers. Taken together, they employ tens of thousands of analysts. Surely, they must be able to deliver the necessary facts that investors need to invest prudently.

Unfortunately, this is not the case.

Commercial publishers of financial statistics do fairly well at delivering numerical information of interest to traders, like price-earnings ratios, betas, earnings per share, Sharpe ratios, and condensed financial statements.

They are not so good, however, in providing analysis and understanding of legal, tax, and accounting information that is often essential to prudent investment.

Hidden terms and conditions you should know

Not all preferred shares or bonds are the same.

Terms and conditions for equities, structured products, and debt securities are not standardized. To understand an investment, detailed information is essential. In the United States, terms and conditions are often available somewhere on the Internet.

But not in the terse investment reports that commercial publishers provide the average investor.

This critical information can be hard to find.

Note: Derivative securities, based on negotiations between institutional investors on the over-the-counter market, often are poorly documented, and have no forms filed with the SEC. This is one kind of toxic asset. However, there are also examples of “toxicity” in public securities, registered with the SEC.

Digging for critical information

The SEC doesn’t require issuers to republish terms and conditions of securities with every financial report. Auditors’ notes generally omit these details. Stock exchanges usually do not publish terms and conditions of most securities traded on their markets.

The SEC may require issuers to publish terms and conditions of securities only in initial registration statement, omitting such information in subsequent disclosures. To get terms and conditions from SEC arquives, you must know when the security was issued.

SEC files are by issuer, not security, which makes it harder to find the initial registration statement when a company has different kinds of securities.

From time to time, an issuer may alter the terms and conditions of securities outstanding. This alteration will be published somewhere, generally in documents related to a meeting of security holders that approve the change.

However, to find this information, you need to know that there was a modification, when it occurred, and the type of SEC document where this information might be found.

Finally, when you locate the information, you may find dense, legal text, separated into “Articles Supplementary”, that require hours and with a legal dictionary to figure out what it means.

Also, something may be missing — some crucial element or protection — that is not disclosed by a negative statement or warning notice.

What is not said can be more important than what is. Only a patient analyst, willing to spend time going back and forth over documents to make sure something is indeed not there, will pick up a “toxic omission” in the terms and conditions.

The case of Auction Market Preferred Shares (AMPS)

The billion dollar markets for AMPS experienced sudden and global lack of liquidity when the auctions in these securities “failed” in 2008.

There is no law that says that all AMPS must have the same terms and conditions. In fact, this type of security may have different terms and condtions from issuer to issuer. Each must be analyzed independently.

Generally, these securities have three big problems:

1. Under certain conditions, these apparent perpetural preferreds can be transformed over-night into quasi-debt with short-term mandatory redemptions, forcing the issuer to raise cash and often to sell assets at a loss into a falling market.
2. There is usually a “toxic omission” in the terms and conditions: No institution is actually responsible to “make the market” at these periodic auctions or to otherwise assure continued liquidity.
3. If the auction markets “fails” to find buyers, there are often provisions that make it difficult for holders to sell to anyone else.

This deadly information is not published in red letters on the front of the initial prospectus. It is generally not published at all in annual reports of issuers. The SEC, as usual, is asleep at the switch.

Such toxic terms and conditions pose problems for both holders of AMPS and for common shareholders. When auctions fail, common shareholders may suddenly find themselves holding equity in companies with debts that have come due. Worse yet, this fact is generally not highlighted in shareholder reports or mentioned by auditors.

A virtual lack of disclosure

The commercial publishers of financial statistics do not reveal terms and conditions information to investors. Nor does the SEC make it easy to get at this information.

The only way for an investor to find out the essential facts would be to dig through SEC arquives, find the original registration statements, and carefully analyze a complex legal document. The investor, of course, would have to have the time and skill to do this, especially that extra skill and wisdom needed to spot a “toxic omission”.

Moreover, the “failure” of the special AMPS auctions is generally not a condition of default. Rating agencies continued to publish the same ratings for these securities before and after they became illiquid.

However, for holders of AMPS, value suddenly became indeterminate. No one could say how much AMPS were worth. In common parlance, they became “toxic assets”.

Common shareholders, assuming that AMPS were just a form of perpetual preferred stock — and that the collapse of the auction market might be bad news for AMPS, but not for them — were harmed by a lack of adequate disclosure. Some issuers, papered over the problem, assuring common stockholders that the “failure” of the auction markets was not an event of default, which was true, but misleading.

The collapse of the AMPS auctions and the collateral damage to common shareholders of companies dependent on this form of leverage might offer rich pickings for tort lawyers — but investors would have fared better if the SEC and rating agencies had done their job in the first place and made the terms and conditions more readily available.

The “terms and conditions” of a security are essentially contractual details and an investor that buys a security without knowing these details is buying blind.

Why commercial sources fail to disclose critical information

Commercial publishers of financial information fail to disclose essential information about the terms and conditions, tax implications, and accounting consequences of securities simply because it would be too expensive for them to do otherwise.

It is easier to publish and “analyze” numerical data than the terms, conditions, and accounting and tax implications of particular issues. Numbers can be easily stored in databases, manipulated, and formatted into tables and graphs to feed various standardized publication templates. Once the data is entered, ratios and graphs can be churned out at little incremental cost.

However, analyzing and recasting legal jargon into simple, but accurate language is another matter. It takes skilled analysts, with knowledge of law, securities, taxes, and accounting. It takes a lot of time and is expensive. The output can’t be generated by computers, based on numerical data imput by clerks — skilled editors are required throughout the process.

Commercial publishing of financial information is an industrial operation, dependant upon the ability of managers to break a product into well-defined, standard packages with controllable costs. However, analysis of terms and conditions, legal constraints, tax provisions, and accounting rules relating to a specific issue is an undefined, open-ended task. Once the analyst starts down the road of trying to get information about a particular security, he or she must keep going, no matter how difficult. In some cases, the task is simple. In others, not so.

To get the job done properly, there can be no time-keeper to say, stop, move-on to the next task, you’re taking too long.

The analyst cannot assume that one preferred share is just like some other preferred share. A “toxic provision” may have been slipped into the registration documents. There is no law that securities must be standardized.

On the other hand, price/volume information can be processed and industrialized using computers, churning out standard graphs, ratios, charts, and indices at controllable, predictable cost.

Already, commercial sources of information, without essential information about terms and conditions, is too expensive for most investors. There is no way for commercial publishers to cover costs of full disclosure of terms and conditions that would match the economic capabilities of average investors.

Finally, we have a question of marketing.

Many clients of commercial publishers of information are short-term traders — people who place importance on reading patterns in graphs. This segment of the market often doesn’t care about legal details of the “things” they are trading. Commercial information publishers produce products that most clients are willing to pay for.

Differences due to corporate law

Corporations in the United States may be licensed in any of fifty jurisdictions, each with different corporate law.

Often the difference in corporate law between one jurisdiction and the other is not signficant. But it may be.

The notes to most audited financial statements usually indicate the jurisdiction under which the issuer is incorporated.

Rarely, however, would there be any explanation as to what this selection of jurisdiction might mean to a particular security holder. One might presume that the selection benefits the corporation, but in what way? Does this make any difference for holders of one kind of security or the other?

In dealing with cross-border issues, information regarding the implications of a particular jurisdiction for a certain type of security may be extremely important.

Generally, the SEC doesn’t require issuers to say much about such questions. The assumption is that investors can hire legal counsel to get help, which of course, few do.

Doing your own research: A Great Opportunity

The failure of commercial financial publishers to adequately cover the terms and conditions of traded securities is just another indication of the Non-Efficient Market., one of the basic tenets of Capital Flow Analysis.

The Crash of 2008 and the current demoralized market, plus the general recognition of market inefficiency, means that once again there are great opportunities for fundamental analysis — Graham & Dodd is Back!

However, doing your own research can be a tough, lonely road. Not everyone has the personality of a Warren Buffet and would be able to sit, shut up in a house in snow-bound Omaha, pouring over financial documents and SEC reports for months at a time.

To make do-it-yourself investment research easier, the Center for Capital Flow Analysis is sponsoring a collaborative encyclopedia of world capital markets that anyone can edit.. Check it out.