securities analysis in the 21st century: fifty years of changes

Fifty years ago, the financial services industry in the US was a backwater, somewhere people went to work if they couldn’t find a job elsewhere.  But powerful changes were on the cards.  Americans were becoming wealthy, at least in part because the country’s industrial base was the only one in advanced economies left standing after World War II.  And they were developing an appetite for stocks.

reasons for rapid growth of financial services during 1970-90

–the maturing of the Baby Boom

–1974 ERISA legislation, which more or less compelled companies to hire competent third parties to manage their employees’ pension assets

–ERISA also established IRAs

–1978 tax legislation established 401ks

–the rise of discount brokers and no-load funds (even in the 1980s, load funds charged purchase fees of up to 8%) that made investing cheaper and easy

–the crash of 1987, which, I think, caused a fundamental shift by individual investors away from traditional brokers and individual stocks, to mutual funds

–a shift in the 1990s, motivated by wanting to reduce their legal liability, by traditional brokerage houses to convert brokers from “stock jockeys” into salesmen of packaged products like mutual funds

The result of all this was the spectacular rise of the money management industry during the second half of the last century.

seeds of decline

–downward pressure on commission rates

ERISA requires that when money managers transact, they obtain the best execution (buying/selling price) as well as the lowest transaction cost.  As technology developed, this meant that trading rooms had a legal obligation to use electronic crossing networks (“dark pools”) instead of routing orders through traditional brokers. Fidelity was a leader in this.

The move also had the positive side effect of denying brokers to opportunity to use client trading information for their own benefit–either by trading on it themselves or by blabbing about it to other money managers.

–questioning of “soft dollars”

money managers routinely buy information from research organizations, including brokers, by allowing them to charge commissions that are 50%-100% higher than normal (called “research commissions”).  Fidelity, the industry standard of best practice, has been working for years to restrict the amount of shareholder money that is being spent this way.  Yes, this is good for Fidelity–by being bad for smaller rivals.  And its efforts have been very effective in cutting the diameter of the firehose spraying commission dollars at research sources.

in recent years, there’s been a small but growing trend for big clients of money managers to demand that a portion of their soft dollar allotment be earmarked for buying services for the client, not the money manager

–the move to index funds, and ultimately to ETFs, which don’t require active management

–massive redemption of equity mutual funds during the Great Recession, reducing further the assets in the hands of active managers.  Since managers are paid a percentage of the assets they oversee as their fee, fewer assets means less money to pay employees like securities analysts and portfolio managers

–large-scale firings of experienced securities analysts by brokerage firms during the Great Recession.  Over the course of my career on Wall Street, brokerage companies have been gradually changing themselves into trading firms–because, rightly or wrongly, they regard trading as much more profitable.  They’ve been laying off experienced analysts for over a decade,  disgorging even the most deeply entrenched during 2008-9.

The net result:  the big brokerage research departments of the 1980s-90s are gone.  There may be bodies occupying seats today, but they generally lack training, supervision and experience.

Active managers, who had cut back their (mostly ineffective) research staffs in the 1980s,  in favor of buying information from brokers with soft dollars instead, have few internal assets to rely on.  They also have lower fee income.  Are they going to rebuild their own research?  If so, whose current pay gets cut?  Will new research be any better than the sub-par operations they ran last time around?

for individual investors, like you and me…


Yes, less well-informed institutions means that day-to-day volatility may be higher.  But it also means that we have a much better chance than we did a decade ago to discover valuable information that Wall Street doesn’t know yet.

Tomorrow, what companies are doing–with an aside on AAPL.

security analysis in the 21st century: the former paradigm

One of my California brothers-in-law, a savvy investor and an Apple devotee, sent me an email the other day lamenting the parlous state of brokerage house analysis of AAPL.  He supplied this link from Apple Insider as evidence.

The article talks about Peter Misek, an analyst from Jefferies, who:

1.  had a price target of $900 for AAPL last year while the stock was going up and one of around $400 now that the stock has weakened

2.  made a series of (mostly negative) predictions about new products and current sales for AAPL, none of which have come true, and

3.  is blaming his misses on AAPL management failures and has used these occasions to downgrade the stock further.


In one sense, this is “normal” Wall Street behavior.   As an analyst trying to make a name for himself, Misek has been making out-of-consensus predictions.   He wants distinguish himself from the crowd and catch the attention of institutional clients who might direct trades (and therefore commissions) to his firm in exchange for access to his research.  In this, he’s following the time-honored dictum that customers will remember the home runs and quickly forget about the strike outs.

From what I’ve read on the internet–I haven’t seen Mr. Misek’s actual research, and have no desire to–what really sticks out in this case is the lack of skill he’s shown in the predictions he’s made.

Even that is not so surprising.

An illustration:

Early in my career (I’d been a buy-side oil industry analyst for maybe three years), I got a call to interview for a job as assistant to Charles Maxwell, then the dean of Wall Street sell-side oil analysts.  I went.

The interview was with the research director for Maxwell’s firm.  It was very short.

The hours were long.  The pay was poor.  I would be away from home visiting companies and clients about 60% of the time.  The payoff would come–if one did–three or four years hence.  Having made a reputation with clients, and with Charlie’s blessing, I’d be hired by a major brokerage firm as its oil analyst.  I’d do basically the same work as before but be paid the equivalent of several million dollars a year in today’s money.

The look of horror on my face at the prospect of a ton of boring travel–hadn’t they ever heard of the telephone?–was enough to tell both of us that I wasn’t the man for this job.

Two points:

–back in the day, securities analysts spent long apprenticeships learning their trade before they were allowed to take the reins as sell-side analysts covering major companies. and

–compensation was relatively high.

Both factors have changed a lot during the past decade.  Nevertheless,  I don’t think either the investing public or the companies being researched understand what’s happened.  Neither group appears to me to have adjusted to the new world we’re in.

More tomorrow.





calculating operating leverage

I’ve written a number of posts on operating leverage.  You can use the search function on the blog to get them.

The basic idea is that a company has both fixed costs, which it must pay whether it sells anything or not, and variable costs, which are a function of the number of things a company sells.  Once a company covers its fixed costs through sales, the operating profit on additional sales can be very high.  This is a key source of positive–and negative–earnings surprise.

As a practical matter, though, how can we calculate how operating leverage works in a given company?

For some firms, it’s impossible.   Take 3M (MMM).  It makes a gazillion different items, many of them sold in massive quantities. For an investor, there’s no way to see very deeply inside the company.

We also have to realize that the data we get from any company’s financials is going to be imperfect, at the very least during our initial look.  If we take the time and energy to compare our projections to the actuals the company publishes, listen very carefully during management conference calls for clues, and call the company every once in a while, we may be able to refine the numbers we come up with in a surprisingly significant way.

Nevertheless, for smaller companies that sell only one or two main products, there’s a very simple way to get an idea of whether a firm has significant operating leverage or not:

–take two most recent consecutive quarters

–subtract the revenue reported for Q1 from the revenue reported from Q2

–subtract the operating income of Q1 from that of Q2

–calculate an incremental operating margin by dividing the operating income change by the sales change

–compare that with the operating margin achieved during either quarter.

An example:

Harley-Davidson (HOG–I own shares, despite the fact the ticker symbol spells a word) sells motorcycles, spare parts and branded merchandise.

During 2Q13, the company posted motorcycle-related revenues of $1.631 billion and operating profit of $362.9 million.  The operating margin was 22.2%.

During 1Q13, HOG had motorcycle revenues of $1.414 billion and operating profit of $279.0 million.  The operating margin was 19.8%.

The quarter-on-quarter revenue difference was $217.9 million, and the q-on-q operating profit difference was $83.1 million.  The operating margin on the extra production was 38.1%.

In HOG’s case, we can go on to make a number of refinements.  We can try to separate out the profits from sales of merchandise and spare parts, which are relatively small in revenue in comparison with motorcycles but which carry higher margins.  And we can examine whether the much higher margin on incremental sales comes from manufacturing efficiency or from leveraging SG&A (it’s the latter).

But the main point is clear.  HOG makes almost twice as much on incremental sales as it does on average sales.  And we found this out just by making some simple subtractions.


the Larry Summers market rally

Summers withdraws

Yesterday evening, Lawrence Summers, President Obama’s choice to replace Ben Bernanke as Chairman of the Federal Reserve, announced he was withdrawing his name from consideration.

Global stocks and US bonds jumped on the news.  The dollar declined slightly, as well.

why the celebration?

The consensus view on Wall Street is that Mr. Summers would have begun to raise interest rates in the US much more aggressively than had been the Bernanke policy.  It isn’t clear that Mr. Summers’ view is wrong.  After all, the Fed is justifying its current super-accommodative stance by pointing to its mandate to fight unemployment , not the more typical central bank responsibilities to keep the economy on an even keel.

But Mr. Summers is also somewhat of a loose cannon.

For example, he was removed as president of Harvard after alienating the tenured faculty by his brusque management style.  He’s also suggested that the paucity of women scientists in the US may be due to genetic deficiencies in the female brain.  As well, in an article titles “How Harvard Lost Russia,” the Institutional Investor questions Mr. Summers’ defense of a protege, Andrei Schleifer, who was convicted of conspiracy to defraud the US for violating conflict of interest rules while working as a government adviser in Russia.

why the withdrawal?

Mr. Summers’ withdrawal comes after a series of prominent Senate Democrats publicly announced they would not vote in his favor.  The one who caught my eye is Elizabeth Warren of Massachusetts, who was a professor at Harvard while Summers was president.

who will the new nominee be?  

It’s hard to say.  The gracelessness with which Mr. Obama terminated Ben Bernanke a few months ago suggests there’s a big personal eqo issue involved.  Janet Yellen, the number two person at the Fed, and the “easy” choice, was never Mr. Obama’s favorite–maybe because she was an adviser to the Clintons.  I guess it’s possible that choosing Summers was less about him than about Ms. Yellen.

Since Mr. Summers’ abrasive personality and peculiar social views are as much a pert of his rejection as his economics, it could be that a new nominee will also hold Summers’ more aggressive interest rate views.

In any event, I think the present market advance is a one-day affair, that may well be reversed when a new Fed nominee more acceptable to the Senate surfaces.



Verizon Wireless: who’s getting the better of the deal, Verizon (VZ) or Vodafone (VOD)?

I think it’s VZ.  The company says that even at a cost of $130 billion the buy-in of VOD’s 45% minority interest will add 10% to VZ’s earnings.  But VZ is also adding a significant amount of risk in leveraging itself financially.

a simplified history

In 1982 the federal government forced the breakup of the monopoly telephone service provider, ATT.  It separated the parts into a national long-distance provider, which retained the ATT name, and a bunch of regional local service providers, nicknamed the “Baby Bells.”  Each Baby Bell contained its area’s nascent mobile services.

Soon enough, the Baby Bells began to merge with one another, ultimately forming into a Western US group (which subsequently acquired “new” ATT and took on the ATT name) and an Eastern group, which subsequently renamed itself Verizon.  Proto-VZ wanted to keep its mobile assets.  Proto-ATT didn’t.  To keep the mobile assets out of the clutches of prot0-VZ, Airtouch, the proto-ATT mobile operation, sold itself to VOD in 2000.

VOD promptly struck a deal with VZ in which it merged Airtouch with the VZ mobile operations to form Verizon Wireless.  VZ had operating control and a 55% interest.  VOD had veto power over some decisions and held the other 45% of Verizon Wireless.

Got all that?

culture clash

VOD is a British company.  It apparently believed in the old-style colonial European way of doing business, according to which a firm with global pretensions could get more bang for a buck (or quid, in this case) of capital by taking large minority interests in important foreign  firms.  Through superior intellect/management technique, or force of will, or sheer European-ness, it would dominate the board of directors.  It would thereby get the benefits of 100% ownership without the capital outlay.   The resulting network of companies would move in lockstep with its European leader, buying the capital equipment suggested (getting discounts for all) and perhaps paying management fees to the European company for its advice.

VZ, an American firm, would have thought that no one in his right mind would accept a minority stake.  If would have figured that VOD would soon see the light and be persuaded to sell.

Or maybe that’s just how the two parties rationalized the unhappy partnership that they entered into.

what each party gets from the deal


–when the deal closes early next year, VZ will have access to the cash flow from Verizon Wireless for the first time.  US tax law   requires that a parent have an 80% interest in a subsidiary before cash can flow tax-free from it to the parent

–VOD will no longer have an operational say in Verizon Wireless

–the very mature fixed-line telephone business will be a significantly smaller proportion of the whole

–the deal is accretive to earnings by 10%


–VOD extracts itself from its awkward minority position

–ir gets a big payday, even after distributing the bulk of the proceeds to shareholders, which it will presumably use for EU acquisitions

–VOD believes it can use a provision in UK tax law regarding transactions between conglomerates to pay only about $8 billion it taxes on this deal

Tobin’s q and LinkedIn (LNKD)

James Tobin was a Nobel Prize-winning economics professor at Yale.  One of the things he’s famous for is his formulation of the “q” ratio, which is:   total market value of a publicly traded company’s outstanding stock ÷ the replacement value of the company’s net assets.

Sometimes q is taken to mean:  per share stock price ÷ book value per share.  But that’s not right.  A company may have a brand name or powerful distribution network that don’t show up in book value (Warren Buffett’s key investment insight).  Or it may have potentially lucrative mineral leases that appear on the books only as raw land, because they haven’t been fully explored.  Or, in today’s world, a firm may have created big software research/development assets whose only effect on accounting values comes from the subtraction of associated salaries from earnings.

Tobin understood that sometimes a company has assets that are hidden from public view.  As a result, a company’s true q is likely best known–or solely known–to its top management.

Tobin’s advice to managers is this:  if your company q > 1, meaning the stock is worth more than the value of the company’s assets, sell stock.  If your q < 1, buy stock back in.  Never do the reverse.

There’s a certain paradox to q.  If, out of the blue, a company launches a stock offering whose proceeds will find no obvious near-term use, then top management, which knows the firm the best, must think the present q is a lot bigger than 1.  If so, no rational person should want to buy the shares being offered.

…which brings us to LNKD, which has recently announced a $1 billion stock offering.  Year-to-date, the stock is up 123% vs, an 18% gain for the S&P.  The trailing PE, which is probably not relevant, is 730x.

My guess is that the offering will be heavily oversubscribed, despite the implicit warning that the offering itself entails.

It will be interesting to see how LNKD shares fare over the coming months.

housecleaning at the Dow Industrials

Standard and Poors, the part of the McGraw Hill empire that controls the Dow Jones averages, announced today that the Dow Industrials would be bouncing out three of its thirty components, effective September 20th.

The companies to be shown the door are :  Alcoa (AA), Bank of America (BAC) and Hewlett-Packard (HPQ).  Their offense?   …stock prices that are too low, and not enough diversification appeal.

They’re being replaced by:  Goldman Sachs (GS), Visa (V) and Nike (NKE), all of which have higher stock prices and supposedly give the Dow more diversification.

We all know the Dow is a weird index.  That’s because it’s calculated using each stock’s per share price (not the total value of the company’s equity) as the weighting factor.  So a stock that sells for $50 a share has twice the potential impact on the index of a stock that sells for $25–even though the latter may be a much bigger company, with a much larger total market value.

No wonder Alcoa, an $8 stock, and Bank of America ($14.60) are gone.  They’re insignificant!

No surprise, either that Apple ($494) and Google ($888) aren’t in.     …too large.

Why calculate an index this way?  The only answer I can come up with is that in the (computer- and calculator-less) late nineteenth century, when the Dow was invented, the math was simple enough for reporters to get done quickly at the end of the day.

Why does it still exist?   …and why do individual investors still pay attention?  At first blush, the answer is that the Dow is almost all the news media talk about.  But the media would ditch it in a second if the Dow weren’t a surprisingly good mimic of the more sensibly constructed S&P 500, which is what investment professionals use as their benchmark.

Think about it for a minute (something I haven’t done until recently).  What are the chances that a small, wacky index can track the S&P 500 so closely?

As I recall, it wasn’t always this way.  Back in the day, investors tracked the Dow vs. the S&P.  If the Dow was doing better, it meant the ghost of Christmas past was in the room.  If the S&P was outperforming, then smaller stocks in less mature industries were on the relative rise.

Not so much anymore.

It seems to me a tremendous amount of brainpower and computer time has recently gone into–and continues to go into–tuning the Dow Industrials so that they’ll keep on tracking the S&P pretty faithfully.  That’s the really interesting thing about the Dow, to my mind.  And it’s the reason AA, BAC and HPQ had to go–not for diversification, but because they weren’t helping the Dow track the S&P.