“Great quarter, guys!”–the smarmy analyst refrain

Bob

A few days ago, my friend Bob emailed me a link to a recent Wall Street Journal article commenting on the omega-dog behavior of brokerage house securities analysts on company conference calls.  The ultimate acknowledgment of this inferior status is the obsequious “Great quarter” comment.

A distant cousin is “Thank you for taking my question,”  which typically means “I know you control who gets to be heard on the call and I appreciate the status you’re granting me.”  It can also convey an undertone of irritation that the analyst has been denied this opportunity on previous calls, despite his obvious stature in the industry.  If so, the analyst is also implying (sometimes, to his regret) that management isn’t clever enough to pick this up.

my take on the sell side, and on earnings calls

Anyway, Bob’s email prompted me to write down these thoughts.

1.  The earnings release and conference call are, in the first instance, the straightforward way that publicly traded companies feel they meet disclosure requirements mandated by regulators.

At the same time, companies understand these are marketing opportunities as well.

Of course, management controls who gets to speak on the call–and it’s virtually always favorably inclined analysts who get the air time.  If you don’t believe this, read anything Mike Mayo has written about the securities industry.  For the better part of two decades he was blackballed by the major banks, not because he was an incompetent (he’s quite the opposite) but because he pointed out banks’ weaknesses and recommended selling their stocks.  Not only was he denied access to managements, but he was repeatedly fired from brokerage houses when firms he covered directed investment banking business elsewhere and when institutional investors who had large bank stock positions shifted their trading away.

No, being seen as the CEO’s boot-licking lapdog isn’t pretty.  Looking on the bright side, though, a lapdog has unparalleled access to his master–and that access is something institutional investors are willing to pay for.

2.  Securities analysts are deeply dependent on the managements of the companies they cover.  Investment banking business is only part of the story.  Will the CEO help an analyst burnish his reputation by attending a conference the analyst organizes or will he dispatch an IR person who will give a canned presentation that’s months old.  When the CEO or CFO travels to meet large institutional investors, will they let the analyst arrange the agenda and travel with them?  If the analyst has a question, will the CEO return his call?  How fast?  These are all factors an institutional investor considers in deciding how much he’s willing to pay an analyst for services.

Companies are also the primary source of industry information for almost every analyst.  Cutting off access to management is like taking away your internet connection.  That’s doubly true today when brokerage house research budgets have been pared to to bone and many laid-off analysts have been forced to open up shop on their own.

3.  The traditional communication system, of which many earnings conference calls are still a part, is broken.  When I was a rookie analyst, publicly listed firms would feed financial information to shareholders and interested investors through “tame” brokerage house securities analysts.  Many companies regarded analysts as quasi-employees whose job was to relay the info–untouched–to shareholders.  After all, everyone had to have a brokerage account.

Lots has changed since then:

–investors under the age of, say, 60 have spurned traditional brokers in favor of a do-it-yourself approach through discounters like Fidelity.  Two reasons:  much lower costs, and a fundamental distrust of the motives of traditional brokers.  Sell side analysts still have contact with institutions, but will almost no individual investors

–Regulation FH (Fair Disclosure, August 2000) has clearly specified that the practice of selective disclosure is illegal

–many of the analysts companies communicate with no longer work for brokers.  They’re in independent research boutiques that repackage the information they receive and sell it.  They talk to some institutions, but not all.  And they have no content whatsoever with individual investors.

The upshot of the traditional practice is that individual shareholders are cut out of the information loop altogether.  Ironically, CEOs can end up giving corporate information (which is the property of shareholders) for free to professional analysts, who are typically not shareholders, while denying it to owners.  To add insult to injury, these middlemen then sell the information to shareholders, who are forced to pay thousands of dollars a pop.

Yes, the “tame” analysts kowtow–but they’re laughing all the way to the bank.

The current system is so broken, I think it’s only a matter of time before there’s wholesale change.  That day can’t come too soon for me.

information for investors: avoiding information overload

In the US of eighty or a hundred years ago, one of the biggest problems facing individual investors was that information flowed slowly and was expensive and time-consuming to acquire.  Also, the government regulations that now require uniform financial reporting standards and regular disclosure by companies of specified operational data didn’t yet exist.  All this tilted the playing field sharply in the favor of the largest and wealthiest investors.  For lack of anything better, everyone else was reduced to studying price and volume patterns in daily trading, trying to figure out what the rich and powerful were doing.

Today, investors in most world equity markets face the opposite problem.  The industrial structure of any developed economy is now much more complex than in those days, and the reach of many economic agents is global, not just national.  In addition to newspapers and trade journals, radio, TV, cable and above all, the internet, bombard us with much more information than any individual can hope to absorb and make sense of.

How do you cope?

Many professional investors, particularly among brokerage houses and hedge funds, have turned to computer analysis of fundamental or technical data to speed their decision-making.  In both cases, they’ve approached the challenge of the plethora of information now available by finding ways to continue to collect all of it.  In the second, they’ve returned to technology-enhanced versions of the primitive tools of several generations ago.

Others, mainly on the buy side, have built elaborate (and expensive) research organizations with analysts stationed in the major investing centers of the world.   Again, this is to be able to collect all the data the world generates about investing. Brokers have tried this approach as well, but have laid off many of their most highly skilled (and most highly paid) analysts during the recession.  The decentralized approach, although it sounds good on paper, risks creating an in-house bureaucracy and a resulting “designed by committee” portfolio that doesn’t stand for much of anything.

As individuals, however, this approach simply isn’t open to us.  We’ll drown in a sea of data, taking our portfolios down to Davy Jones’ locker with us, if we try to follow everything.  What do we do?

1.  Figure out how much time you’re going to devote to your investments.  If you’re going to spend, say, an hour a week and no more, stick with a passive approach.

When I was working, I thought I could spend 50 productive hours a week on my portfolio.  More time than that and I would be too tired and would just be spinning my wheels.

Let’s say I spent half that time on general research, administrative stuff and interacting with clients.  That leaves 25 hours.

My portfolio might have 60 positions in it (typical of growth investors; value investors usually have double that or more).  The largest five would make or break my performance.  The next 10 were stocks I thought would do well but didn’t have (yet) the same degree of confidence I did in the first five.  I’d allocate my time at maybe three hours a week thinking/studying about the biggest positions and one hour each for the other ten.  This is probably a good approximation for how informed the guy on the other side of the trade from you is.

My rule of thumb for individuals like us would be that we should expect to spend at least an hour a week on average on investments for every significant–meaning more than 2% of total assets–equity position we hold.

2.  Focus.  One of the occupational diseases of professional investors is thinking that you need to, or actually can, have an informed opinion about everything.  That’s a terrible mistake.  It spreads you much too thin.  What you do need to have is a few areas (or even one) that you know a lot about.  Myself, I like retail, hotels/casinos, and technology.  Actually, it’s a little more specific than that.  I like luxury goods, business/convention hotels, cellphones and semiconductors.

I find consumer-related industries particularly appealing because you can use the products, visit the stores, talk with salespeople.  You can also get feedback from your friends and acquaintances.  I like tech gadgets.  As an investor, though, the IT industry reminds me of the oils, where I got my first investing experience.  In both cases, I think, analysts make the mistake of spending all their time on the technical aspects of making the products rather than on who will buy them and how much will the customer pay.  It makes some sense that they act this way, because, they’re mostly electrical or petroleum engineers.  But this gives the generalist like me an advantage I arguably shouldn’t have.

You may have background, experience or interests that give you a special insight into an industry.  This would be a natural area to focus on.  In general, it’s much better to have one stock you know really well than a dozen that you’ve bought only because you got a “hot tip.”

3.  Find (a few) reliable sources of information. 

I like the Financial Times, the Economist and the business section of the New York Times.  Sometimes the Los Angeles Times has interesting articles, especially either about the west coast or about Asia, but I usually only read it when a search engine brings me to the paper.

Once you’ve focused on an industry, government and trade group websites can be extremely useful.  If you have access to a college research library, you can often find information there–with the help of a research librarian–that’s not widely known on Wall Street.  Company websites, their annual reports and 10ks, are extremely important, too.  And don’t forget to look at a company’s competitors’ filings/websites.

If you have access to research reports from traditional brokers, make sure you get the longer versions aimed at institutional investors, not the abbreviated versions brokers some time prepare for retail clients.  As brokers have pared back on research as a cost-cutting measure, however, I find it’s harder and harder to locate good research reports.

On the minus side, I find the talking heads on TV to be pretty useless.  I’ve come to like the Wall Street Journal‘s sports, and the paper has interesting gossip in it, but I no longer find it a useful investing tool.

information for investors: 10K, annual, proxy–what to read?

the 10k and annual

Let’s put the proxy to the side for now, and consider the annual report and the 10k.  They’re both once a year reports of a publicly traded company’s performance.

what they have in common

Sometimes, the annual and 10k are just about one and the same document.  Some companies complete the 10k, wrap another cover on it, include the chairman’s letter and a picture or two, and call that the annual.  It’s not the norm, but it happens.  It tells you something about the company that does this, as well:  no-nonsense, spartan, don’t think they have much need for marketing, the record speaks for itself.

In most cases, the 10k and annual are separate documents, however.  They do have two features in common.  Both contain:

–detailed audited financial statements, complete with many pages of footnotes, and

–the auditing firm’s “opinion,” or statement about the conformity of the financial statements to Generally Accepted Accounting Principles.

Understanding the financial statements requires knowledge of financial accounting, which every serious investor must sooner or later acquire.  Checking out the auditor’s opinion, however, is relatively straightforward.  Look for three items:

–by most far the most important factor is that the opinion  be “unqualified,” that is, that the auditor state the accounts are fully in accordance with GAAP.  A “qualified” opinion, on the other hand, one that says that in some respect the accounts are not in accordance with GAAP, is a gigantic red flag.

–who the auditor is.  Any large company should hire a major accounting firm to do its audit.  For a microcap stock, this may not be possible.  But one of the more obvious long-term signs of trouble with Bernie Madoff was the fact that his auditor was a small, obscure firm that was radically dependent on Madoff’s business.

–how long the current auditor has held the position.  A change of auditor is always worrying.  Frequent changes almost always signal trouble.

how they differ

10k

The 10k is the annual filing required by the SEC.  It contains a detailed description of the company’s operations, line of business by line of business.  It has an assessment of the competitive environment, the positioning of all the firm’s major products and the most important variables influencing earnings.  There’s also a comprehensive discussion of the profit performance of the company during the year.

The company analysis can easily run 50 pages or more.  A comforting fact for investors (at least, for me):  any material misstatement or omission can be a cause for government prosecution of the offending parties, which can result in possible jail time.  Therefore, I regard the 10k as completely reliable.

There may well be material information that a company would rather not make well-known.  In my experience, such data will never find its way into the annual report.  But because it’s material it must be in the 10k.  It may not necessarily be easy to find–but it’s got to be there.

The one drawback I find in the 10k is that it is fundamentally backward looking.  There won’t be a discussion of new products or changes in strategy or other plans that may affect the company’s profits in the coming year and beyond.

the annual report

The annual report is an information document.  But it’s a marketing document, as well.  It’s not only aimed at shareholders as its audience.  It also wants to build morale among present employees, to help to recruit new talent, and to keep suppliers and customers content to do business with the firm.

The annual is usually shorter in length than the 10k, and contains lots of pictures and upbeat prose.  While what the annual says must be true, it need not be as complete and as blunt about miscues as the 10k.

To my mind, the main plus of the annual is that, despite its positive bias, it’s the best place to find out what the company’s plans and ambitions for the next few years are.  There is, of course, no certainty that the company will be able to achieve its goals.  But this future orientation is, by design, almost completely lacking in the 10k.

the proxy

The proxy statement contains information on the structure of the company’s board of directors, and the background and compensation of its members.  It lists major owners of the company’s stock.  It also contains details of any proposals that will come up for a shareholder vote at the annual meeting, along with the company’s recommendation for or against.

For individual investors, the proxy statement might well be best regarded as a cure for insomnia.  But there’s a section that’s crucial to read, especially when dealing with smaller companies.  It’s called “Related Person Transactions” or something similar.  It deals with any business the company may do with other firms in which directors have a financial interest.

Why is this important?  It’s to make sure your economic interests and those of the directors/management of the company you’re interested are aligned.  For example, suppose Director A is the largest single shareholder of your company, with a 10% interest.  Director A owns 100% of another company that either supplies your company or buys its products.  You have to consider whether these dealings are arm’s-length transactions, or whether Director A’s 100%-owned firm is getting a better deal than it should.  The proxy is the only place this potential conflict of interest will be disclosed.

In short:  read the 10k for facts, the narrative part of the annual for aspirations, and the proxy for potential conflicts of interest.

information for investors: Edgar vs. the company website

EDGAR

The Electronic Data Gathering, Analysis and Retrieval (EDGAR) system of the SEC is maintained in an online database that contains all the filings the regulator requires from publicly traded companies–and some others.  The top 10,000 companies by market capitalization can be searched for by ticker symbol.  Documents, including 10Ks and 10Qs (annual and quarterly earnings statements, respectively), can also be searched for by industry or by time period.  Since most companies make all their filings electronically directly into the database, EDGAR is up-to-date, as of the prior day at 5:30 pm.  Most important, the database is available to anyone, and is free.

Bookmark this site. It probably the single most important source of information a US-based investor can have.

accessing EDGAR

1.  The link above will bring you to a page on the SEC website titled “Filings and Forms.”

2.  Click on the second choice in red, “Search for Company filings.”

This will take you to a page titled “Search the Next-Generation EDGAR system.”

3.  From the first list in red, click the first item:  “Company or fund name, ticker symbol….”

This brings you to the Company search page.

4.  Enter the company name or ticker symbol in the appropriate place in the blue search box to access all company filings in time order, with the most recent filings first.

You can also get a general introduction to the EDGAR system by clicking the red link under the topic “Other Resources” on the Search the Next-Generation EDGAR system page.

why is EDGAR so valuable?

It’s the wealth of detailed company information it contains (in tomorrow’s post I’ll go into more detail about the 10K and proxy, which I consider the most important).  In the early 1990s I was hired by a fund management company to reestablish a global equity investing effort that had suffered through a long period of underperformance.

In those (pre-internet) days, companies filed their SEC-mandated disclosures in Washington, DC, in person and on paper.  Brokerage houses stationed research or trading assistants armed with cellphones at the SEC to make copies of expected filings, read them quickly and phone information to their research departments or trading desks.  Sounds crazy today, but that’s what people did.

On the buy side, people like me thought this was an unnecessary expense.  Instead, we would receive the reports, about six weeks after filing, on microfiche from a third-party data service that had a contract with the SEC.  A library of past filings + updates cost $125,000 a year.  In today’s dollars, that would be about $250,000.  And, of course, you’d have to be at work to access the data.

The high cost of data access represented a huge competitive disadvantage for individuals, no matter how intelligent or highly motivated, versus professionals whose size allowed them to afford it.

That’s no longer the case.  Anyone with internet access can look at the data any time of night or day–for free.

vs. the company website

The investor relations section of most company websites provides a direct link to EDGAR. Some companies, however, provide only PDFs of selected documents.  This really doesn’t make much difference, since EDGAR is only a couple of clicks away.  It’s just something to be aware of.

The company website does have a number of items of interest that I think are useful and that would be hard to find elsewhere.  They include:

–a description, with pictures, of company products and services.  This can be helpful if they are highly specialized or technical in nature.  Remember, though, that the website is a marketing tool.  So you have to take what’s said their with a grain of salt.  There probably won’t be a comparison with competitors’ offerings.  Take a peak at the Nokia site, for example.  I haven’t looked hard, but I don’t see anything about GOOG or AAPL eating their lunch.

–a place to sign up for email receipt of documents and press releases, and notification of webcasts,

–a library of webcasts of past presentations at investor conferences and earnings conference calls, plus a place to listen to upcoming ones in real time.  There may be PDFs of handouts, as well.  Webcasts are particularly useful, although you can easily find transcripts at, say, Seeking Alpha.  Seeking Alpha has pretty weak analytic content, in my opinion, but you can’t complain about a free transcript of an hour-long call that you can read in 10-15 minutes.

–a library of past press releases, plus PDFs of past annual reports, all in one place (more about annuals in tomorrow’s post),

–the name, email address and phone number of an investor relations contact.   I’ve found that IR departments vary greatly in their attitude toward individual investors who call with questions.  If you can demonstrate that you have an intelligent question, that you’ve read the pertinent company documents and are sincerely interested in the answer, you’ll probably be treated well.  If you’re not, it may be an expression of the company attitude toward shareholders.  But it could equally well be that the IR people don’t know much.  In either case, you’ll have learned something.

As a simple contrast between the two, the EDGAR data are intended to inform and the website data are intended to persuade.  More about this difference in tomorrow’s post about the 10K vs. the annual report.