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.

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.

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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This is the third article in a series of tutorials about post-modern security analysis.

The economics of security analysis

Security analysis provides a service for investors (often self-service) that has a cost in terms of the analyst’s time. To make economic sense, this cost must bear a reasonable relationship to the benefits of analysis.

The purpose of this analysis is to provide a factual basis for investment, in order to diminish risk and increase profit opportunities.

Security markets are said to be “efficient” when factual information is freely available and amply researched and analyzed by skilled investment experts, and when investors act on this information in a “rational” manner.

The Crash of 2008 provides evidence that markets were not efficient in the first decade of he 21st century, partly because the volume of free information had become greater than analysts could digest, and partly because many investors had foregone the task of security analysis, trusting that others would do this work. Billions were invested in unmanaged “index funds”. Major financial institutions failed because of their inability to accurately evaluate their own financial assets.

Efforts of paid financial analysts

According to the US Bureau of Labor Statistics, there were 221,000 people working as financial analysts in the United States in 2006, with total annual earnings (salaries and bonuses) of USD $14.7 billion.

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This is the second article in a series of tutorials about post-modern security analysis.

Classic “Intrinsic Value”

The central concept of classical security analysis is “intrinsic value”.

This term is defined as follows in the first chapter of “Security Analysis (1940 Edition)” by Benjamin Graham and David Dodd:

… intrinsic value is an elusive concept. In general terms, it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a mistake to imagine that intrinsic value is a definite and as determinable as is the market price.

Our notion of intrinsic value may be more or less distinct, depending on the particular case. The degree of indistinctness may be expressed by a very hypothetical “range of approximate value”, which would grow wider as the uncertainty of the picture increased … It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside the maximum or minimum appraisal.

The “facts” on which “intrinsic value” was to be based were considered to be relatively simple and easily acquired at the time Graham & Dodd published the first edition of “Security Analysis”, which stated:

Descriptive analysis consists of marshalling the important facts related 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.

Because of this assumption (reasonable at the time), almost the entire volume of “Security Analysis” (often considered to be the Bible of “fundamental analysis”) was devoted to the analysis of data from these standard, easily obtained secondary sources. Little attention was devoted to the job of collating and researching data from original sources (OSINT). More »