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 »

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.

The global market crash of 2008 revealed basic, inherent conflicts in the regulatory and business models of commercial rating agencies on which financial and capital markets had come to depend.

Like a dog chasing her tail, conflicts between multiple, uncoordinated, poorly conceived regulatory requirements, commercial interests of rating agencies, loan covenants, capital and leverage limitations, and market forces, have created a powerful negative feedback loop that played a part in 2008 in quickly destroying global markets.

First Problem: “Selling” ratings is like the church selling “indulgences”

In some jurisdictions (the United States, for example), regulators require that the portfolios of certain types of financial institutions, such as insurance companies, contain only securities with “investment grade” ratings, while limiting the number of agencies entitled to issue such ratings.

Some issuers of mutual funds and other collective investments, contract to only hold securities with certain ratings in their portfolios.

Market participants, in general, pay less for securities with lower credit ratings. Therefore, a down-grading of the credit rating of an issuer results in a fall in the price of its securities.

Rating agencies are paid for their ratings by issuers and compete for such business. Consequently, rating agencies have an inherent conflict of interest, tending to rate securities higher than merited when first issued.

Second Problem: Ratings become a condition of default

Some lenders make the failure of a borrower or an issuer to maintain a certain credit rating a condition of default on loans or other contracts.

Many financial institutions have capital, margin, and leverage requirements dependent upon the market value of securities held as assets in portfolio. A down-grading of securities in their portfolio can result in an institution needing to sell assets or raise capital — both actions which tend to decrease market prices of securities. Furthermore, the down-grading of securities in an institution’s portfolio, resulting in capital deficiencies, can lead to the down-grading of an institution’s own securities.

In some cases, such as ratings of credit insurers or sovereign debt, a single down-grading can effect not only a single issuer, but automatically flows through to thousands of other issuers dependent upon that rating.

Third Problem: Defaults on low ratings make the agencies look good

Ratings are supposed to predict the default rate of debt issues. The higher correlation between negative ratings and defaults, the stronger the case that rating agencies can make with investors and regulators as to the value of their services. This gives rating agencies strong motivation to quickly down-grade an issue, if default appears at all possible.

However, because of the link between ratings, loan covenants, capital requirements, and portfolio acceptability, a downgrading of ratings can force many companies into default. In other words, the rating agencies are not independent observers of markets, but are factors directly influencing markets and consequently the ratings they are issuing.

The situation is further exacerbated in the U.S. and elsewhere by the extension and strict enforcement of mark-to-market accounting and the criminalization of what, in hindsight, might appear to be over-optimistic accounting estimates by company executives or their accountants, as a result of the Sarbannes-Oxley Act and similar measures.

More than simple reform is needed

Institutions and investors have become over-dependent upon the services of a few rating agencies, rather than upon their own analysis and research.

Rating agencies have too few analysts, spending too little time, working without adequate documentation and oversight, compared to the volume and complexity of issues in the market.

Large segments of the securities market are not rated at all, while financial institutions, to save money and boost short-term profits, have reduced the number of in-house securities analysts.

The massive breakdown in the informational system supporting financial markets on a worldwide basis, and the inadequate understanding of the potential for creating a negative feedback loop between regulatory requirements, ratings, and market prices, were factors in the Crash of 2008.

The rating agency regulatory and business model is obsolete

Congress will not be able to “fix” the rating agency problem by issuing a few rules and regulations. There are fundamental flaws in the rating agency business model, that is not the fault of the agencies, but rather of changing times and increasing market complexity:

1. The largest rating agencies have staffs that are too small to oversee the more than 3.5 million securities issued in hundreds of legal jurisdictions worldwide. When administrative and marketing staffs are subtracted, the remaining analytical personnel are far short of the number of people that would be needed to study and pass reasoned judgement on this vast number of increasingly complex issues.
2. With a view to international markets, none of the major rating agencies have sufficient personnel with skills needed to cover rapidly changing laws, accounting and tax regulations, and political and economic happenings in every jurisdiction.
3. The income that rating agencies can derive from issuers and market institutions in the form of rating fees and subscription for publications is highly volatile, dependent upon the ups and downs in the market, while the actual work needed to maintain a certain level of analysis does not fluctuate with security prices.
4. Security analysis, even assisted by computers in preparing and presenting data, still is almost entirely dependent upon the time consuming brain work of highly-trained humans.

To resolve this problem would require either moving backwards in time, radically simplifing markets, instruments, institutions, and operations — something that is extremely unlikely — or the invention of some entirely new approach that will enlist the services of many more people with more skills and far less cost.

Open-source techniques used in the development of software such as Apache and Firefox, and collaborative editing of research by volunteers, such as is possible with the wiki format, suggest the way forward.

In March 2009, a collaborative encyclopedia of world capital markets was launched to address this problem. Capital Market Wiki is just in the proof of concept phase, but has been designed specifically to address inadequacies in the current rating system.

See the article: 2008 Never Again! in Capital Market Wiki.