Truth, fact, and opinion

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

Truth, Fact, and Opinion

Fundamental concepts in open source research include “truth”, “fact”, and “opinion”. These ideas have occupied philosophers since the beginning of history.

Truth ... beyond our reach.

Since Post Modern Security Analysis is meant to be a practical field, it is convenient to choose a rather arbitrary, but useful, definition for these terms:

1. Truth: Objective reality in a theoretical universe that lies beyond human capacity of verification. Philosophers have many definitions of truth, but for practical purposes, we shall think of truth as an ideal — a goal that never can be obtained with certainty.
2. Facts: Statements that would generally be accepted, universally, as representing truth, based on available knowledge at a particular time. At one time, that the earth was the center of the universe was considered to be true. Later, people thought it true that the sun was the center of the universe. Still later, the idea that the universe had a center at all was in doubt. Today, scientists ponder “parallel universes” and “membranes”.
   “A fact is a pragmatic truth, a statement that can, at least in theory [to a certain degree], be checked and confirmed. … A scientific fact is an objective and verifiable observation, in contrast to a hypothesis or theory.^[1]”
   In this article:

   • Truth, Fact, and Opinion
   • Relevant facts
   • Opinions provide leads to relevant facts
   • Forewarnings of a Ponzi scheme
   • Turning opinions into actionable intelligence
   • Why open source information is valuable
   • Separating fact from opinion
   • Are financial statements fact or opinion?
   • Complexity and opinion
   • Shortcomings in accounting
   • Related Posts
   • Comments (1)

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3. Opinion: Any statement that would generally be regarded as a belief or non-factual interpretation or position of a particular individual or group. An opinion may be based on fact, on conjecture, or on faith — but is still only an opinion. Theories and hypothesis are opinions, not facts. All belief systems have at the core a set of axioms or fundamental propositions that cannot be proven and must be taken on faith. That millions of people, or even a majority, may hold a certain opinion, does not make that opinion a fact, unless the opinions would almost universally be regarded as true.

Most open source information about capital markets is opinion. Prices in securities markets are expressions of opinion (among other things such as the forces of supply and demand). What passes for a “research report” in most investment markets is almost always a statement of opinion, which may or may not be based on fact.

Relevant facts

An early Ford: interesting but irrelevant.

The central idea of Post Modern Security Analysis is to rigorously separate the gathering of relevant facts from the development of useful opinions based on the analysis and interpretation of these facts.

“Relevant facts” are those that help answer questions that the analyst poses at the start of the research process. Every research assignment should start out with express or “implied” questions that guide the researcher in sorting useful from irrelevant information.

See: Implied questions on Capital Market Wiki
and Recommended formats for research projects.

Most information available on the Internet regarding capital market topics — both, opinion and fact — is irrelevant to the purpose of most research projects. For example, a research project on the Ford Motor Company will turn up thousands (or millions) of pages about the various automotive models produced by the company, information on car repair, tips on bargaining with car dealers, and so forth.

The fact that the New York Stock Exchange sponsored the racing car driver Marco Andretti is interesting, but irrelevant, to most capital market research projects about that exchange.

See: Open source analysis trade-craft.

Opinions provide leads to relevant facts

Although the first goal in Post Modern Security Analysis is to produce factual, encyclopedia-style articles that answer predefined “relevant questions”, this does not mean that information that is based on opinion should be disregarded.

Valuable clues hidden in useless opinions ...

Most information related to capital markets published on the Internet is opinion. Much is anonymous, unconfirmed, lacking footnotes to sources, and poorly drafted — even incomprehensible. Some information is purposely false and fabricated. Some is concocted out of thin air. Much is obnoxious ranting, casual or silly conversation, or outright propaganda.

Some opinion is formal and carefully prepared, such as “forward looking statements” that management may insert in annual reports to stockholders. Most opinion, however, is carelessly put forward, without reference as to a basis that might justify such statements.

However, by following up such whiffs of information, by applying skeptical standards and commonsense, and by seeking confirmation and detailed information from more reliable sources, much can be revealed.

Internet forums, blogs, blog comments, chat rooms, social networks, and groups offer a deep, rich lode of clues to important facts, if used properly. Even visual information such as provided on flickr or YouTube can be useful.

Open sources provided warnings ...

Forewarnings of a Ponzi scheme

Open sources and opinion on the Internet provided indications that something might be seriously wrong with the Bernard Madoff hedge funds, years before this massive Ponzi scheme was revealed in December 2008:

On December 16, 1992, the Wall Street Journal published an article, “Wall Street Mystery Features a Big Board Rival”, that questioned the extraordinary profits that Bernard Madoff was returning to investors, describing the supposed investment strategy. There was no follow up.

On May 7, 2001, Barron’s published an article, “Don’t Ask, Don’t Tell,”raising substantial doubts about Bernard Madoff’s operations. There was no follow-up.

In May 2001, the MAR/Hedge newsletter (available in many university libraries) published an article “Madoff tops charts; skeptics ask how” by Michael Ocrant questioning the results of Madoff funds.

On May 22, 2003, a trader on the Optionetics forum questioned how the split-strike conversion strategy used by Fairfield Sentry fund (a Madoff feeder) could return such high results as claimed. The forum participants (who seemed to be quite conversant with arcane option strategies) could not provide a satisfactory answer.

On January 9, 2006, someone logged in the forum “Elite Trader” asking about a rumor that the SEC was going to shut down Bernard Madoff and all his hedge funds. On December 15, 2008, (after the Madoff Ponzi scheme made the news), the poster revealed that he had been an investor who met with Madoff and became suspicious and took his money out two years before the collapse of the firm. (The original post was dissed by other participants on this forum.)

On March 8, 2008, a poster on the Wilmott forum questioned Bernard Madoff’s ability to achieve above average returns using the “split-strike conversion” strategy.

SEC FOCUS report on Madoff's firm ...

From these sources, plus public information in SEC files, a researcher could find the following about Bernard Madoff’s operations prior to his exposure as a fraud:

1. Bernard Madoff was reported to be extremely secretive.
2. Unlike other money managers, he charged no management fee as was the custom, claiming to be satisfied with commissions only.
3. The returns paid to his investors were reportedly above average and remarkably stable.
4. His investment tactics were said to depend upon a “split-strike conversion strategy”, but reported returns were higher than anticipated with such a strategy.
5. He did not maintain client funds with an independent depository, although the amounts involved were in the billions of dollars.
6. His operations were audited by a tiny, two-man firm (one partner retired and living in Florida) operating out of a store front in a New York suburb.

In order to dig out usual leads on the Internet and in university libraries, it often is necessary to be willing to go back years and examine every bit of information.

Turning opinions into actionable intelligence

Now this information about Bernard Madoff could have been found on the Internet with a simple Google search and in most university libraries.

University library + Internet = open source info

If a researcher were to have continued to follow up on these clues, using the rules of Capital Market Taxonomy to split up the topic into separate articles on the “split-strike conversion strategy“, the various Madoff feeder funds, as well as the Madoff investment firm, even more information could have been developed.

From this information, what could have been included as “fact” in an encyclopedia article about the Madoff organization (before the Ponzi scheme was revealed) would have been that multi-billion dollars in customer accounts were kept not in an independent custodian (as might be expected with a reputable firm), but in the Madoff office, and that large scale trading operations were audited by a tiny auditing firm operating out of a store front in suburban New York, and that the “split-strike conversion strategy” was said to be used to manage this money, and that Madoff did not charge a customary management fee for managing clients’ assets.

In another article about the “split-strike conversion strategy”, it would have been appropriate for a researcher to include the fact that the Madoff funds were said to use this technique and that questions had been raised regarding Madoff reported profits in the financial press.

Using the “revelation template” available in Capital Market Wiki, these key facts could be highlighted, without expressing the opinion that the Madoff operation might be fraudulent. It would then be up to the analyst to reach an appropriate conclusion based on these facts.

Why open source information is valuable

In the case of Bernard Madoff, we see how “opinion” expressed in newspaper articles, a newsletter, and by anonymous sources on Internet forums could have indicated to a researcher that routine matters, such as how client assets are held in custody, the qualifications of a firm’s auditors, and unusual fee practices provided clues that something was wrong that deserved to be further investigated — in this example, by extracting information from official forms submitted by Bernard Madoff to the US SEC.

MI6 Secret Intelligence Building - London

The example shows how information reported sporadically over a quarter of a century, when brought together in a concise, factual article, could provide warnings that might otherwise be missed by investors.

The basic OSINT technique, adapted from open source trade-craft used by government secret services, is practical and economical for investment markets today, thanks to the Internet, wiki technology, and easy availability of raw information.

However, by simply presenting the facts about Bernard Madoff, even with warning signals highlighted, most lay investors would not have been protected against the Ponzi scheme, because most can’t understand or would not have recognized the implications of arcane technicalities such as “split-strike conversion strategy” or the practical consequences of a weak auditor or in-house custody of multi-billion dollar client assets.

This is the reason that the second phase of the process is necessary — analysis of the gathered facts by professionals to produce informed opinions that might have value to investors.

Separating fact from opinion

In an open encyclopedia, dedicated to collaborative research, it would not be wise to publish the opinion the Bernard Madoff was a fraud, since this could invite lawsuits, and might even not be true. However, separate from the collaborative research vehicle, individual researchers could publish their own conclusions, even charging a fee for this service.

It is now known, after the fact, that one professional researcher, Harry Markopolos, had been gathering data on the Madoff fraud for years, and had tried repeatedly to get the US SEC to shut down the operations, to no avail. He had also presented his report and evidence to the Wall Street Journal in 2006, which decided to ignore the matter.

With an open collaborative research vehicle available, such as Capital Market Wiki, Harry Markopolos could have posted additional facts about Madoff and his operations (even using that wikis anonymity feature), increasing the chances that at least some investors might have been saved.

Are financial statements fact or opinion?

Much of the information that is freely available about capital market securities is derived from audited financial statements.

Most security analysts, since the days of Graham & Dodd, recognize that financial statements, in large part, are based on opinions of management and executive decisions as to which accounting rules to apply to certain situations, plus the impact of accounting restrictions that are not a matter of management choice.

We must conclude that financial statements are opinions, not fact. Even the auditor’s letter that certifies the statement is an opinion, not an attestation of fact.

Historical cost is not current value ...

Financial statements never represent current conditions of a firm, but only a rule-based accounting representation of past behavior.

Clearly, some long-accepted accounting rules present numbers that do not provide useful factual information as to the value of a firm, such as the rule that fixed assets are to be posted at historical cost, even after years of inflation, or the arbitrary nature of depreciation. The list of such accounting anomalies is long.

Accounting rules differ from country to country and are applied differently from firm to firm.

Complexity and opinion

For large international firms, covering hundreds of subsidiaries and affiliates, multiple managements, consolidated statements, based on multiple currencies and different rules for consolidation, hundreds of profit lines, off-balance sheet liabilities and assets, contingencies, and varying closing dates — the interpretation of such numbers is indeed problematical and it may be hard to say which number is factual and which number is either a matter of opinion or plainly false.

In Post Modern Security Analysis, financial statements have the status of opinion and serve as a rich source of clues as to what might be factual, but should not be taken at face value.

Shortcomings in accounting

Most of the data put forth by the commercial publishers of financial statistics, including popular ratios such as earnings per share and measures of leverage, is opinion and should not to be accepted as factual.

False or misleading financial statements do not necessarily (or even usually) represent deliberate fabrications, but rather inherent shortcomings in the accounting process, magnified by the increased complexity of modern corporations.

Researchers, in attempting to present factual information, should be acutely aware of the shortcomings of the accounting process and the likelihood that investors will be misled by financial statements, unless an attempt is made to separate and extract those numbers that are more likely to be factual and to present, even these, with appropriate qualifying explanations and in the context of specific questions to be answered.

It is useful to present and separate accounting data that is relevant to specific questions and that have a greater factual component, rather than to show overall, generalized results that are clearly non-factual.

Next Lesson: Post Modern Security Analysis: Part Nine (Operational versus financial information)