Category Archives: Getting financial advice

securities analysis in the 21st century: where the companies stand

September 20, 2013 By in Constructing a Portfolio, Current Market Thoughts, Getting financial advice, Portfolio management, Securities regulation Tags: , , , , , , Leave a comment

two communication theories

1.  When I entered the business in the late 1970s, the attitude of publicly traded companies toward their actual and potential investors was personified by a Mobil Oil public relations executive named Herb Schmertz.

Herb’s view was that brokerage house securities analysts were a specialized kind of newspaper reporter.  If his company wanted to tell the financial community some tidbit without the information hitting the press, Schmertz would call in/call up favored analysts and let them know.  Their obligation, in his view, was to faithfully relay the company’s information–spun the way the company wanted–to their clients.  No actual analysis, no contrary conclusions, needed.

That’s not quite today’s view, though.

2.  I remember vividly a time in the mid-1990s when I held a large position in Sony (embarrassing but true–although I’m one of the few portfolio managers who can truthfully say he made money holding Sony).  I went to E3 in Los Angeles that year, where Sony Computer Entertainment was having a briefing for securities analysts.  I arrived at the meeting room and sat down.  A SCE official came up to me and told me to leave.  Why?  that Sony (Kaz Hirai) was going to be discussing sensitive information about strategy and upcoming products.  Only sell-side analysts were allowed to participate.  Everyone else, including shareholders (i.e., company owners!!!) , were barred.  I refused to leave and the guy left me alone.

Blend #1 with #2 and you get the way most companies act today.

what’s wrong with this picture?

Post Regulation FD (Fair Disclosure), the company behavior I just described is, to me, clearly illegal.

It seems a little crazy to me, as a shareholder, that a company may refuse to communicate with me directly, but will give information to a brokerage house analyst from whom I have to buy it.

Most important in a practical sense, the old system is broken–and most companies don’t realize it.  It’s broken in two ways:

–most brokerage houses have gutted their research departments because they believe research loses them money.

–I think the equity market swoon that accompanies the Great Recession has marked a key turning point in the way individual investors behave.  I think that as a group they’ve soured on mutual funds and have begun again to invest in a blend of index products plus individual stocks that they research themselves.  They instinctively know that active managers generally have no edge any more, and that brokerage research is threadbare.

clueless in Delaware

(that’s where most publicly traded companies are incorporated)

My experience over the past few years in dealing with investor relations departments is that they exhibit what one might call an “emperor’s new clothes” attitude.  They don’t want to acknowledge that the world has changed, and that the communications protocol they’ve used for decades no longer works.

what to do?

For companies, it seems to me a basic rethink of communication strategy is in order:

–previously analyst-only meetings should have a provision for individual shareholder participation.  This might be at the same physical location.  The very least should be a webcast with interactive chat and ability to participate in Q&A sessions.

–same thing for appearances at broker-sponsored conferences, including breakout sessions.

–investor relations departments should become more responsive to queries from individual shareholders, or potential shareholders.  This isn’t as glamorous as coast-to-coast travel to talk with big institutions and brokers, but both of those constituencies are withering on the vine.

For our part, if/when a phone call (or several) to a company isn’t returned, a letter to the chairman is in order–explaining why we think the policy of not responding to shareholder inquiries is misguided.  I think the key points are that it isn’t fair to give information to non-owners but not to owners, and that it’s doubly unfair to give it to brokerage intermediaries who then force us to pay for information about our own companies.  (A word about how the world has changed may be in order;  pointing out that current practices violate Reg FD will probably get you, at best, a form letter from the legal department (i.e., nowhere).)

 

 

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

September 19, 2013 By in Current Market Thoughts, Getting financial advice, index funds, Industry Analysis, Investment firms, Portfolio management, using research Tags: , , , , , , Leave a comment

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…

THIS IS GREAT!!!

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

September 18, 2013 By in Current Market Thoughts, How your broker gets paid, sell-side analysts Tags: , , , , , Leave a comment

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.

 

 

 

 

the SEC says issuers of private securities, like hedge funds, can now advertise their wares

July 11, 2013 By in Current Market Thoughts, Getting financial advice, hedge funds, Private equity, securities markets, Securities regulation Tags: , , , , , , Leave a comment

SEC disclosure 

The SEC has very specific rules that limit what a company can say, either about itself or about the securities it’s selling, when it’s in the process of issuing stocks or bonds.

The securities of some companies aren’t subject to general SEC oversight,  either because the firms are tiny or the securities are being sold only to a small group of supposedly savvy buyers.  In such cases, the SEC rules have been, basically, that the firm can say nothing publicly.  In particular, the issuing company can’t solicit interest from the general public or advertise its offerings in ways the general public might see–like in newspapers or on the internet.

a rule change

That changed last year when Congress passed the JOBS (Jumpstart Our Business Startups) Act.  This legislation requires the SEC to take back the regulations that bar solicitation and advertising by issuers of non-regulated securities.  Mary Shapiro, former head of the SEC, decided this was a bad idea and didn’t comply.  The current chairman, Mary Jo White, has followed the Congressional directive and removed them.

Yes, Ms. White had no legal choice…

…but is this a good idea?

At first blush, it would seem that it isn’t.  After all, the consensus is that the JOBS Act, by eliminating the requirement for many issuers to offer audited financial statements to potential buyers, is an open invitation to fraud.

Washington is the same crew that repealed the Glass-Steagall Act in the late 1990s, allowing commercial banks to reenter businesses they helped cause the Great Depression with–and which they promptly used to help cause the Great Recession that we’re still digging ourselves out of.

In this case, the glaring issue is that there’s lots of evidence that significant numbers of hedge funds misstate in their marketing materials their investment performance, their professional qualifications and the size of their assets under management.  It doesn’t take a genius to guess what side of the ledger the misstatements fall on.  (Search PSI for my posts on hedge funds.  If you read one, maybe it should be about an NYU study.)

Why would hedge funds change their stripes when selling to a much wider group of individual investors.

accredited investors

Yes, issuers are supposed to sell the bulk of their offerings to “accredited” investors.  But that only means that buyers are supposed to have either:

–net worth of at least $1 million, excluding the value of a primary residence, or

–income of $200,000 in each of the past two years, with prospects of the same in the current year ($300,000 for couples).

That doesn’t mean they know anything about finance.

maybe it is

But there may be a method to the apparent madness.

Ms. White seems to be drawing a sharp distinction between the character of the buyer of a private offering (supposedly sophisticated parties, who are outside SEC purview) and the disclosure materials relating to it.

Because the offering documents have so far been disseminated only to qualified buyers, the SEC had no say over their accuracy. That was up to the buyer to judge.  Now, thanks to the JOBS Act, these materials can be disseminated to everybody, whether “accredited” or not.  The issuer subsequently screens potential buyers to ensure they meet the accreditation criteria before he allows them to purchase.

The SEC is asserting that the wider dissemination gives the agency jurisdiction over the accuracy of the materials.  It is preparing rules it intends to have issuers of private securities follow.

It may turn out that the JOBS Act has accidentally given the SEC another weapon in addition to prosecution for illegal insider trading in its fight to clean up the hedge fund industry.

how are your mutual funds doing?

June 4, 2013 By in Constructing a Portfolio, Getting financial advice, hedge funds, index funds, Portfolio management, securities markets Tags: , , , , , , , Leave a comment

the SPIVA scorecard:  index funds rule!

Standard and Poors did a major overhaul of its website a while ago.  I’d been delaying getting familiar with the new layout while the old site still held the information I usually look for.  But S&P shut down the old page with monthly performance on it, and I was forced to move too.  I eventually found the performance data, but while I was poking around, I also stumbled across a SPIVA (S&P Indices Versus Active Funds) Scorecard report for yearend 2012.

The scorecard tally?  …about what you’d expect.

Over the three-year period 2010-2012 (all bull market) and the five-year period 2008-2012 (includes both bear and bull periods), the typical equity fund and thee typical bond fund underperformed its benchmark index.

Three exceptions:

–the median small-cap international fund outperformed its benchmark.  This is a small category, however, and all the outperformance seems to have come from having a rip-roaring 2013.

–the median large-cap value fund also outperformed.  Unfortunately, the S&P 500 Value index lagged the S&P by an average of 180 basis points a year over the past half-decade.  Actively-managed large cap value funds performed more or less in line with growth-oriented funds and “core” funds that compete against the plain-vanilla S&P 500 rather than a style-tilted version.

–investment-grade intermediate bond fund managers outperformed as well.  But, like the value equity managers, they had the weakest benchmark.

fewer funds

Over the past five years, almost 27% of the domestic equity funds either merged with other funds or simply liquidated.  23% of international equity funds did the same, as did 18% of fixed income funds.  These were presumably the ones with the worst performance records–the fund industry burying its dead, as it were.  That’s also a huge percentage.

why hire an active manager?  why not index?

For almost everyone, in my view, indexing is the way to go.  It’s the cheapest.  Because your focus on getting exposure to the asset class (stocks) at the lowest possible cost, fewer things can go wrong.  This means less time, effort and skill needed on your part to monitor this part of your overall portfolio.

Why don’t more people index?

–It’s kind of boring.  Just look for the biggest index fund (it’s Vanguard).  It’ll have the lowest costs and the most faithful mirroring of the index.  And you’re done.

–Some people have motives other than making money for being in the stock market.  Some actually like risk for its own sake, believe it or not.  Others want to feel special or be the center of attention at parties.  They likely also want the $200 oil change at the Mercedes dealer (where you get coffee and a bagel, too), not the $30 deal at Jiffy Lube.

–Many financial advisers dislike index funds.

There are typically no trailing commissions (recurring payments from the fund management company while a client continues to hold the fund).  No information seminars or reward meetings, either.

Suppose I’m your adviser and I say, “Let’s take the $1 million you’re allocating to stocks and put it in the Vanguard S&P 500 index fund.  We’ll leave it there forever.  By the way, I’m charging you $1,000 a month ($2,000?), again for ever, for this advice.”  At some point, you’re going to baulk.

More than that, because they charge high fees, actively-managed fund complexes have big marketing budgets.  And, unless they have a huge indexing operation, they don’t have cost-competitive index products.  So almost all the ads you see are for active management.  A lot of them air on financial news shows on cable.  Fat chance the talking heads will tout indexing.

one consolation for holders of actively managed funds

At least they’re not hedge funds, which continue their decade-long record of underperformance of traditional equity managers.