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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.

A flood of complex information ...

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 the 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.

Of this total, only 48,000 worked in the finance and insurance sector in areas related to securities, commodities contracts, and other financial instruments, with total annual earnings of about USD $3.1 billion. Another 3,000 worked in financial publishers (like Standard & Poor’s), with total annual earnings of about USD $200 million.

In 2006, according to Federal Reserve flow of funds tables, the total market value of US corporate equities was USD $24 trillion. The market value of US and foreign corporate bonds (in the US market) was USD $9.9 trillion. The equivalent figure for municipal bonds was USD $2.4 trillion.

Too few analysts ... a thorny problem.

In 2006, total salaries and bonuses of analysts working in finance, insurance, and financial publishing was USD $3.3 billion, which was only 1/100 of one percent of the value of outstanding corporate equities, domestic and foreign corporate bonds, and municipal bonds.

CUSIP Global Services website indicated that there were at least 8 million security issues identified by CUSIP numbers in 2009. This would be about 2,600 issues per financial analyst working for publishers like Standard & Poor’s or Moody’s.

Assuming a normal work week (with no time spent on administrative or marketing tasks), this would limit the total time spent by analysts of these publishers to about 45 minutes a year per issue.

Too few analysts

All analysts working in finance, insurance, or publishing, would be able to focus their combined attention of only about five hours on each issue per year. This allows for only the most cursory examination, without time for independent checking or review.

The number of companies listed on the New York Stock Exchange in 2007 was 3.5 times the number listed in 1934, when Graham & Dodd published “Security Analysis”. Furthermore, in 1934, because of limited communications, markets tended to be strictly local, whereas today, markets are international.

In 2007, companies listed on the NYSE accounted for only 5% of companies listed on stock exchanges worldwide (according to statistics from the World Federation of Exchanges).

Just in terms of the number of listed securities, the global market available to investment analysts today is at least 100 times more complex than the New York markets of the 1930s.

However, when complexities due to different legal jurisdictions, tax laws, trading rules, clearing and settlement systems, and new instruments (like exchange-traded funds, asset-backed securities, exotic derivatives, and structured products) are taken into consideration, complexities of todays market relative to 1934 are more likely on the order of one to ten thousand.

Work and motivation of financial analysts

The majority of security analysts are employed by banks and broker-dealers located in or near major financial centers. These institutions make the most money from “deal making” (underwriting new issues, mergers, acquisitions, and so forth) or in trading proprietary portfolios of securities, or in fund management of various types.

Institutional profits constrict information ...

The work of most analysts is focused on the highly lucrative area of deal-related studies or on research supporting speculative trading.

When basic, original-source-based security analysis is performed, it is most likely with reference to highly liquid, popular securities for which there is much public interest, and for which much analysis is redundant.

With focus on deal making and short-term portfolio performance, the upwardly mobile analyst will seek to attract management attention by research that will win lucrative deals from important clients and a promotion to management status.

Research follows institutional profits

Up and coming analysts are expected to help in the marketing efforts of their institutions, giving talks to clients and assisting in selling the firm’s products.

They may even be called on by traders to help unload bad trades on unsuspecting clients.

The overall result of this diversion of effort is that even less time is spent on the average, run-of-the-mill stock or bond.

Millions of issuers are not analyzed in depth by professional analysts and the investor must seek regulatory filings or annual reports to reach a judgment.

The average investor, relying on fund managers or investment advisors to protect their accumulated savings, does not realize how little of management fees actually go towards investment research, or how much fund managers rely on second-hand, nominal research efforts of the statistical publishing houses.

Long-term investors forgotten

Long-term, buy-and-hold investors seeking to preserve the real value of their assets over twenty to forty years are not the prime target of most investment institutions. Rather, the emphasis is on year-to-year (or shorter term) capital gains rather than dividends or protection against inflation.

The computer software provided by brokerage houses to clients is focused on short-term trading indicators, rather than long-term fundamentals.

Despite this emphasis on short-term trading, it was precisely the failure of market liquidity (supposedly bolstered by speculators) that was the dominant feature of the Crash of 2008.

The focus on short-term trading had created a shortage of fundamental research at a critical juncture, making it difficult, or in some cases impossible, to determine the intrinsic value of securities.

The inefficient market

The essence of classical security analysis was to focus on factual evidence that helped in estimating intrinsic value of a security and then compare this value with the current market price in order to select investment opportunities.

The presumption was that the market is inefficient — a situation denied by the Efficient Market Hypothesis that predominated during the long decades of Modern Security Analysis.

See: The Non-Efficient Market and Post-Modern Security Analysis: Part Two (Intrinsic Value).

The Crash of 2008 demonstrated that the market is indeed inefficient. Therefore, it makes sense to return to the search for intrinsic value.

However, unlike the time of the Great Depression, when Benjamin Graham outlined the basis for Classical Security Analysis, the market is now far, far more complex and there is no longer an easy source of factual information to be consulted. Now the emphasis must be on data mining and digging into raw data — a daunting task for the solitary analyst.

This suggests that the basis for Post Modern Security Analysis must be the introduction of new ways to gather and digest the factual information that is essential to the discovery of intrinsic value.

See: The heroic, solitary security analyst is long gone.

Taming the information beast

In examining the problem of researching raw investment information, the first realization that we come to is that some issuers and issues have simply become too complex to permit analysis on an economical basis.

The time and effort it takes to gather and research data about a situation makes informed investment impractical.

A typical example of indeterminate intrinsic value in today’s market would be the stock of a major multinational financial institution such as Citicorp.

With thousands of branches, products, jurisdictions, affiliates, subsidiaries, off-balance sheet deals, and speculative trading portfolios in every kind of over-the-counter derivative, an analyst quickly becomes lost in an endless jungle of data — even should this information be easily available, which it isn’t.

See: Is big bank complexity irreversible? The McKinsey Heresy.

Avoiding complexity

So 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.

To further reduce the universe of possible research, the analyst should eliminate issuers or instruments that fall into any of the following categories:

1. Companies with clear indications of unethical, dishonest, or morally conflicted management. (Never do business with crooks.)
2. Companies or situations that use extreme leverage in which the risks of collapse due to changes in economic conditions outweigh any possible benefit.
3. Companies overly dependent upon highly speculative trading skills of only a few individuals. These skills cannot be analyzed and therefore the investment situation cannot be based on fact, only opinion or guesses. (Giving money for someone to bet at the racetrack isn’t investment.)

Analysts may develop other screens to select investments that merit in-depth research and those than do not.

Help in resolving time constraints

Even the most skilled analyst cannot eliminate risk in selecting investments. It is impossible to see the future clearly and chance events always play a role.

The traditional technique to reduce the risk of selection error is diversification. Instead of investing in only one security, the investor may select twenty or thirty.

However, the greater the diversification of risk, the more time required in selecting and monitoring a portfolio of securities.

Commercial sources drop the ball

In the days of classical security analysis, corporations were simpler, while information published by commercial statistical sources represented a greater percentage of open source information.

Today, very little of this information is published by the standard statistical compilers, while the amount of available information has exploded exponentially.

As indicated above, the amount currently being spent on investment analysis (at least in the US) is only a tiny fraction of what might be justifiable in terms of the potential for risk reduction and improvement in investment results offered by in-depth security analysis.

However, the commercial models of providing this information appear to have failed. It seems unlikely that companies like Standard & Poor’s or Moody’s could increase their subscription fees one hundred times (an estimate of the order of magnitude necessary to provide at least adequate coverage) and still find a market.

See: Innovation in investment research: Dealing with free information

Regulators could try to be useful

Theoretically, security regulators could require issuers to supply information in such convenient digital packages, without legal boilerplate, disclaimers, and fluff, so that computers could make this information easily available at little or not cost to analysts on the Internet.

However, this would require a degree of government competency no where found today.

It also would require government regulators that were free from influence and the persuasive powers of issuers and market intermediaries — another highly unlikely scenario.

It would also be possible for modern, demutualized exchanges to evolve a business model based on pre-cleared trades and income from the float on investors’ deposits, with higher profits and far lower transaction costs.

Listing rules could require issuers to provide far more complete and relevant information in an appropriate digital form that could be made available without cost to investors as a way to encourage trading volume. However, so far no exchange has moved significantly in this direction.

See: Demutualized exchanges change stockbrokers’ role

Diversification vs. depth of analysis

This expansion of free information poses a significant problem for the analyst.

There is now a conflict between the time it takes to study an investment in adequate depth and the time each analyst would need to select and monitor a diversified portfolio of securities.

A new technique is needed to gather this information economically.

The Internet and collaborative research offer a way for analysts to collaborate for mutual benefit, expanding research coverage, while keeping costs under control.

This technique is called crowd sourcing of investment research. It is one of the tools available to Post-Modern security analysts.

For more on crowd sourcing of investment research, see:

See: Crowd sourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowd sourcing investment research: Capital Market Taxonomy and Innovation in investment research; dealing with free information and Modern technology for institutional investment research and New technology in open source investment intelligence

Also, see the Help pages on Capital Market Wiki.

Next Lesson: Post Modern Security Analysis: Part Four (The analysis of corporate governance).