Operational versus financial information

Reading time: 9 – 14 minutes

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: How markets work

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.

Back-office procedures may be important ...

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:

• 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.
  

  Financial statements can't explain everything ...

• 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.

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.

Taxonomy, redundancy, and operations

One of the main reasons to use Capital Market Taxonomy is to avoid redundancy in collaborative investment research.

The redundancy-avoidance factor is particularly notable in the Operations namespace.

For example, a collaborative research project on closed-end funds in the US market may include “articles” on several hundred funds, but only one article on the Investment Company Act of 1940.

Research is bound by named links ...

Capital Market Taxonomy contains a number of semantic named links between articles, one of which is “important legal provision” that, as the name implies, links articles with related articles in the Operations namespace about “important legal provisions”.

This semantic linkage makes it easy for researchers to find the important laws and regulations that govern a particular fund, or to find all researched funds to which a particular law or regulation is applicable.

Using taxonomy to organize collaborative research also makes it easier to focus special skills on specialized topics. For example, an article about the US Investment Company Act of 1940 would benefit from research contributions made by lawyers, who, on the other hand, might not have interest in doing research on individual investment funds.

The Operations namespace may contain many targeted articles calling for the skills of lawyers, accountants, or specialists in risk management, economic theory, clearing and settlement procedures, income enhancement techniques, custodial services, and many other operational areas.

Semantic linking of Operations

Within the structure of Capital Market Taxonomy, there are more than two dozen named semantic relationships that help researchers tie “articles” together, avoiding redundancy while improving coherency in the body of collaborative research.

These “named links” are set up automatically when creating articles in Capital Market Wiki.

Here are some of the special semantic relations relevant to Operations:

Categorizing financial operations

In order to organize articles regarding financial operations relevant to a research project, Capital Market Taxonomy has a number of pre-defined categories that can be set up automatically when a new article is created:

These categories are broken down into further sub-categories, not shown here.

By organizing research around an expanded semantic structure, Post Modern Security Analysis allows for far greater detail and depth of understanding of relevant factors than classical security analysis.

Categorizing institutional methods

The final operational classification, “Institutional methods”, is broken down into further categories as follows:

All of these categories have formal definitions under Capital Market Taxonomy.

By breaking out information into separate articles and organizing these articles in a strict logical structure, it becomes possible to quickly extract information based on mass collaboration by using semantic software.

For example, for a large research project on the airline industry, there could be separate articles for each carrier in the Institutions namespace, and articles on each carrier’s fleet or management contracts in the Operations namespace.

This would make it possible — with a few mouse clicks — to quickly extract all articles describing airline fleets or all articles about airline management contracts.

A broad view of security analysis

Post-Modern Security Analysis takes the view that to discover critical information relevant to the intrinsic value of a security, researchers should examine the widest range of information relevant to the question.

This is considerably different from classical security analysis which tends to focus on financial statements, information about line of business, and the terms and conditions of particular securities.

The classical targets of interest continue to be extremely important, but much more is required.

Here, the attempt is to broaden the field of investigation, bringing in a much wider range of specialists, and controlling the large body of collaborative research generated by applying a Capital Market Taxonomy

Next Lesson: Post Modern Security Analysis: Part Ten (Tools for fact gathering)