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:

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

The analysis of corporate governance

The term “corporate governance” came into vogue in the 1990s and now dominates discussion of ethics and morality in investment markets.

For five essays on “corporate governance” on this site, go here.

	Stakeholders have different interests

Often, the pretense of “good corporate governance” has served to shield ethically-challenged management from critical scrutiny by ordinary investors — an exercise in hypocrisy.

However, the corporate governance movement has come up with one important concept: stakeholders. The view that a corporation has many different “stakeholders”, with different interests, is essential to Post-Modern Security Analysis.

Management still talk about “looking out for shareholder interests”, but the influence of other stakeholders can hardly be ignored, especially the stakes of various governments, labor unions, franchise owners, administrators of off-balance sheet assets, license holders, creditors, employees, trading counter-parties, out-sourced suppliers, down-stream customers, banks, and, last but not least, management itself.

The analysis of corporate governance and of the relative importance of various stakeholders should be the first step in Post Modern Security Analysis.

Determining the relative importance of various stakeholders

Investment securities are a combination of contractual agreements and legal requirements merged with expectations of customary behavior. Normal and reasonable expectations of the benefits and risks of a specific investment opportunity vary among the stakeholders in each case.

	Corporate governance is a "can of worms"

For example, fifty years ago, common stockholders expected that most profits would be distributed to them in the form of dividends and that hired management would be content to provide faithful service for a fixed salary and occasional modest bonus.

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