the research puzzle

pictures with warren

tom brakke — Wed, 03 Mar 2010 15:08:16 +0000

Modest Mussorgsky wrote Pictures at an Exhibition as a tribute; it was structured as a series of piano pieces imagining a stroll though an exhibition of his late friend's paintings.[1] It's time for us to take a similar journey.

The title of this posting refers, of course, to Warren Buffett. I have written extensively about investment gurus in previous postings;[2] Buffett is in a class by himself.

In our gallery, we have many pictures of Warren. Graham and Dodd disciple extraordinaire. Investor without peer. Cheapskate, as much as a multibillionaire can be. Folksy, happy -- the word "avuncular" seems to have been made just for him. A lovable capitalist.

In fact, that list shows that our little exhibition doesn't really have enough angst to it -- and amounts to variations on a smiley-faced theme -- that is, until you walk around the back of a two-sided canvas and see a profile of a predator. You quickly search the catalog; how could this work be here?

Every now and again, a renegade does offer a more penetrating view of Buffett than the standard fare, going beyond the flat abstractions toward a portrait that features depth and nuance.[3] Such renderings are important for us to see, because the complexity of Buffett and his creation, Berkshire Hathaway, are often overlooked amid the simplistic sketches.

Most ventures into gurudom include trying to copy an Old Master by using a paint-by-the-numbers technique. Mimicry can be dangerous, as many holders of Coca-Cola can attest. Thinking that Buffett's stamp of ownership meant a stock could be bought and held, "Coke was it" for many in the Nineties. But it became wildly overvalued, and value destruction was never quite so classic in its unfolding. In 1997, Buffett called the company one of "the Inevitables," destined to dominate its business for decades. He was right on that front: The Coke machine marches forward, but these many years later it still isn't close to the price it sold for back then. Perhaps Buffett used derivative strategies against the firm's position to cushion the blows and, in any case, the damage was sheltered by his winners; those that adopted the idea as their own likely suffered a worse fate.

One of the difficulties in assessing Buffett's work is that many of the pictures of Warren are pictures by Warren. He has always been a master of the catchy phrase and the well-choreographed show. As a legend, he gets to paint his own portrait most of the time, and the media can be as fawning as art critics are with the star of the day, distorting our perceptions of the man. Is he the one who warns of the "financial weapons of mass destruction" or the derivatives savant? Is he the "snatch 'em up when they are cheap" guy or the one who has bent value into many different shapes? Is he the "buy America" cheerleader or someone who can talk his book in a way that belies how much his firm has on the line?

A significant element of Buffett's greatness has been his malleability and willingness to address a complex world in new ways, which is quite apart from the iconic persona normally presented. Do we see who he really is?

It is time to go to the last area of our exhibit. Don't walk down the hallway to the left. That leads to the natural history wing and a diorama depicting the return of the sandhill cranes to the Platte River basin every spring. Turn instead to the right, for photographic evidence of the other great migration to Nebraska -- to see and touch the Oracle. The throngs show up in May, but throughout the year there are smaller pilgrimages as well, usually of business students that Buffett has made time to see.

As you enter the cavernous final room, you witness from floor to ceiling thousands and thousands of those travelers, in individual pictures with Warren. The snapshots are remarkable in their similarity, and a significant number depict the stranger in the photograph holding Buffett's wallet. The effect is dizzying, a montage of sameness that is an echo chamber for the eyes.

It is very hard to look past allegiance and admiration when doing investment analysis. I don't know whether Berkshire Hathaway is a buy today or a sell, but I know that if I keep staring at the pictures at the exhibition -- or imagining myself in one -- I'll never figure it out.

[1] Never published in Mussorgsky's lifetime, the composition didn't hit the charts until it was orchestrated by Maurice Ravel. Listeners looking for a somewhat edgier treatment can try the Emerson, Lake, and Palmer version.
[2] the research puzzle : Here are some examples for would-be members of a guru's gang.: http://researchpuzzle.com/files/view/guru-postings.pdf
[3] The Pragmatic Capitalist : See, for example, this posting titled "The Many Myths of Warren Buffett.": http://pragcap.com/the-many-myths-of-warren-buffett

structured myopia

tom brakke — Thu, 25 Feb 2010 16:17:53 +0000

When I was teaching MBA finance students, I included a class on the sociology of investing. Seeing it on the syllabus did not cause a stir of excitement throughout the lecture room, since the goals of many there were to a) learn how to find ten-baggers and b) get a job. Nevertheless, it should be part of "the core" for would-be investors.

An innate sense of where the crowd is going is critical to success, so that's "the sociology of investing" that gets most of the attention. Relatively little scrutiny is given to how investment firms work and how investment decisions are made within them. A great posting yesterday on the blog socializing finance[1] speaks to one of the themes I have been preaching for years: Firms are often structured in ways that make no sense given how markets work. The posting highlights some nascent efforts to integrate trading desks across asset classes at large brokerage firms, but the principles that underlie the need to do so should be applied even more broadly.

Specialization dominates the investment decision making process. There are remarkably few generalists in the business and, within firms, little sharing of information across asset classes -- or even within them if there's no incentive to do so. I once asked a famous strategist how much his equity people talk to those in fixed income. He said, "I can't even get the growth guys to talk to the value people."

Awhile back, I wrote about "where we draw the lines."[2] The "lines" of our organizations, like our analytical boundaries, are convenient, but they inhibit our ability to sense market opportunities and to seize them. The most rigid appear between asset classes -- and they are reinforced by consultants, advisors, media, etc., looking for simple descriptive boxes -- but there are many others that lurk as well. And they are cemented in place by the misguided belief that incentives should flow to individuals or teams or groups or divisions based overwhelmingly or exclusively upon their unique contributions.

Where those lines are depends on the past and the personality of the firm in question. One of the most common hierarchical equations amounts to "equity > fixed income," although it depends on a firm's history, assets, and who is in charge as to whether that's specifically in play. No matter, it serves as a wonderful example of the principles that I am trying to illustrate.

It is normally the case that fixed income and equity operations are quite separate at most firms. Those in research, trading, and portfolio management jobs are charged with doing their business and are compensated accordingly. That might make sense if the market was kind enough to act like one didn't matter to the other, but that's never been the case and the financial innovations of the last couple of decades have only intensified the interdependence. The flow of information between the two groups of specialists should be continual and substantive, but that rarely happens.

The ironic thing in the equation that I gave above is that, when push comes to shove, you are often better off paying attention to the developments in the bond market. I remember clearly an interview ten years ago, during which a star equity analyst explained to CNBC that her positive view on Amazon.com made sense, despite her firm's debt analyst having issued warnings on the company. She said that equity analysts look forward and fixed income analysts look backward. You may recall that Amazon got crushed.

Recently I saw an online commentary that boiled down to, "Who cares about Greece?" I tweeted a response that said that "the credit market is always the canary."[3] A litany of all of the examples over the last few decades where the first signs of trouble showed up in areas of the market that would be classified as "fixed income" would be very long indeed. As if more proof was needed, the financial crisis was Exhibit A. Equity investors ignored the rumblings for months and paid for it dearly.

Myopia is the enemy of the investor. Structured myopia makes no sense whatsoever, for the individual investor or for the biggest firms in the world, but you find it everywhere.

[1] socializing finance : The blog has several authors; this posting was written by Daniel Beunza.: http://socfinance.wordpress.com/2010/02/24/proving-sociologists-right-pencil-pushers-and-neardenthals-stave-off-the-next-crisis-by-uniting-on-the-trading-floor/
[2] the research puzzle : This posting used the Morningstar style grid as a jumping-off point to examine the analytical structures we create.: http://researchpuzzle.com/blog/2008/10/13/where-we-draw-the-lines/
[3] Twitter : I have a few updates a day, mostly links to interesting articles I find.: http://twitter.com/researchpuzzler

best in show

tom brakke — Fri, 19 Feb 2010 13:55:32 +0000

The dog world was abuzz this week when Sadie the Scottish terrier took top honors at the venerable Westminster Kennel Club Dog Show.[1] She became the first pooch to win the "triple crown," after her earlier victories at the National Dog Show and the American Kennel Club Show.

I love dogs as much as the next guy, including the wonderful mix of breeds that we have in our neighborhood. (They all have one thing in common: Labradors and rottweilers and terriers have all turned tail and run when they have heard the manic attack cries that Kitty emits if they approach our door.) Watching the televised coverage of the archetypes of the canine world parade around Madison Square Garden, you get caught up in the emotional aspects of the competition. Your biases show up in a hurry, from "I want one of those" to "I wouldn't be caught dead with one of those."

In a way, it is much like our instinctive reaction to various investments. We take a natural shining to some things and don't understand at all what others might see in that which disinterests us. At the dog show, in dulcet tones the announcer describes the breed being judged, including some hints about the personalities of the dogs that might not be noticeable at first glance. We would all be better off if someone was there to give us such advice before making our investment decisions; a little voice that said, "This one is guaranteed to break your heart," would be nice to have.

For someone who observes how decisions are made, watching Westminster leads to many questions about process. Certainly the winnowing behind the scenes (much like the screening that portfolio managers go through to get a chance to win an institutional account) would be fascinating to see, but the television coverage picks up with the semifinals, the judging of the various groups. A set routine is followed, with the judge for the group first probing the dog's physical characteristics, then observing its gait and presentation as it shows its stuff for the crowd. (Again the echoes of manager selection are inescapable for someone who has been through that drill.)

To the uninitiated, the next part seems like hocus-pocus, but I'm sure to devotees it's not. The judge, after having spent a short time with each of the dogs, and maybe seeing them take one last comparative walk, selects the best of the group. Like the figure skating judges on the other channel, they are highly-qualified arbiters of what's best, with technical checklists to run down in their minds, but it's done on the fly and in the moment. The investment business is full of decisions like that. It is fair to describe them as "hit and miss," with all sorts of behavioral risks about.

Which is all just a prelude to the final stage. The winners of the seven groups are to meet in the ring to determine which is the champion dog of the year. The judge is shown arriving in style, having been "sequestered for two days." He spends a short time with the dogs and pronounces the winner. It all seems a bit perfunctory to the uneducated.

Having seen the swings of emotional momentum in the markets and how they build over time, I could only wonder about whether the same things happen in the show world too. I had a hint when one of the announcers responding to the choice said something like, "Many people were enamored already before the announcement." Yes, this dog was the it girl and Westminster was the culmination of her coming out.

Certainly the judge was fully aware of the dog before his sequestration. Did he react to her introduction at the Garden with a thought of "there she is"? We'll never know, although he was quoted later as saying that a dog like Sadie comes around once every ten years. That's quite a statement to make after a few minutes together in the show ring.

Which is not to say that there was collusion or that the selection was preordained, only that our decisions come wrapped in packaging that we may not see if we don't look for it. The selection of an outside manager by an investment committee may come down to a little thing noticed at the last minute, or it may have been in the cards for months and the process was just a show. The stock-by-stock decisions of an individual investor are different from that drawn-out selection process in time and scope, but remarkably similar in the need to carefully and objectively sort out the "whys" of the choices that we make.

Sadie got to ring the bell of the New York Stock Exchange and, unless she spends her last days in dissolute living, she'll go down as one of the greats. For us, those markets open day after day, and our decisions today reverberate for some time to come. So, before you pronounce something best in show, take an extra minute. It may keep you from ending up with just another mutt.

[1] OK, I don't really know what the dogs thought of it, but the dog people were pretty excited.

unpegged

tom brakke — Wed, 10 Feb 2010 13:14:19 +0000

Investors are prone to using rules of thumb (high-falutin' folks now use the term "heuristics") to help in navigating the markets. One of the most common looks like this:

Yes, it's the famous PEG ratio, which is widely given as a reason to embrace or avoid a stock depending on which side of that line its numbers line up on. Many individual investors cling to it as a guide, and it's amazing how often professional investors cite this relationship in marketing materials, articles, and television appearances. Go to Investopedia and one of its featured articles explains why: "Stock theory suggests that the stock market should assign a PEG ratio of one to every stock."[1] Well, no.

The history of this myth is of interest. When Peter Lynch shepherded Fidelity Magellan to extraordinary gains, he became the first investment star to "go platinum." He was copied widely by other managers and, with the increased democratization of the market, by individuals too. The main tenets of his philosophy could be described as "buy what you know" and "look for cheap growth." Each has come to be applied beyond reason, the latter resulting in senseless application of the PEG ratio.

In looking at that calculation, only one of the three variables has any precision: We can observe the market price (P) at virtually any time and be assured that we have an accurate number. The E is a different matter entirely. Which earnings? Forward, trailing, smoothed, operating, adjusted, owner? Why? How deep into accounting and the theory of finance do you want to go?

For most investors, not very far. We like our heuristics clean and easy, not hairy. So, in combining the first two variables we get the P/E ratio, the "multiple" upon which most valuation work rests, despite the questionable assumptions that may be baked in at any time. The addition of the third element, growth (G), gives us not the epiphany we seek, but even more confusion.

While we can debate which earnings number is best to use, each approach is the result of a fair bit of scrutiny -- reported earnings hew to accounting standards and estimated earnings and the various "adjusted" constructs are the product of intense analyst effort. Conversely, the long-term growth rates commonly used in PEG ratios get little attention and are, in general, lousy. Analysts spend almost none of their time thinking in depth about those numbers, and the buy side doesn't press them on the validity of their projections. Consequently, many of the growth rates tend to be extrapolations of the past and/or the echo of management fantasies, and are a lagging indicator at best. Studies of realized growth rates have shown that the projections don't pass muster; they are way too high for most firms, especially the ones that are expected to grow the fastest, while actually being too low for those firms that analysts are most downbeat about. Figuratively speaking, one might say that the denominator of the equation is, in fact, the lowest common denominator.

To add to all of those shortcomings, a finance whiz can quickly dispel any notion that there should be a linear relationship between the P/E ratio of a stock and its growth rate, or that the PEG ratio can be effectively used to compare the valuation of one firm to another, given differences that would exist in their financial structures. As for specific calculations, valuation expert Aswath Damodaran says that the use of the forward P/E ratio as the numerator is erroneous, since that year of earnings growth is also in the estimated growth rate, resulting in double counting. Yet, that may be the most widely-used version of the PEG. It is the one found on the basic Bloomberg stock description page.

Lynch's concept makes sense: Incremental growth is worth something. Figuring out what that might be, though, is tricky and difficult business. In common practice, the PEG ratio takes that good idea and simplifies it into meaninglessness. Unfortunately, most of those that use it don't realize how unpegged from reality it really is.

[1] Investopedia : The title of the piece is "PEG Ratio Nails Down Value Stocks.": http://www.investopedia.com/articles/analyst/043002.asp

thinking about doing

tom brakke — Thu, 04 Feb 2010 13:35:29 +0000

Dominating the front page of the science section of the New York Times the other day was a large graphic that depicted the stages of a jump that is a specialty of Ryan St. Onge, who will be competing in freestyle aerials at the Winter Olympics. Specifically, it showed each element of "a triple-flip jump with a full twist in each of the second and third flips." I got dizzy just looking at it.[1]

The article -- as you might expect in something called the "Science Times" -- quickly started breaking down the physics of it all, and then examined how jumpers who do those types of maneuvers make the tiny adjustments while en route that will allow them to master those natural forces (and maybe even take home a gold).

What caught my eye was this paragraph:

But while not in the air, Mr. St. Onge devotes a lot of time to analyzing what he does. "I probably spend 80 percent of my time thinking about it, and 20 percent doing it," he said.

Over the years, I've met investors of all stripes, from individuals to fiduciaries to big-name players, and they use strategies that range across every approach you could imagine. As far as I could see, almost none of them came anywhere close to St. Onge's allocation of time. Part of it is the allure of the information flow: Flip on the screen and it starts washing over you and you start making decisions. Part of it is that the business has gotten to be one where transaction costs are nothing and positions are fleeting (and "ownership" does not extend to governance). Much of it is that following is an art form in the markets, and whether it's the legendary gurus or the latest smart-sounding Tweetster that we use as a role model, we tend to copy first and think later. Plus, human nature is such that just doing it feels instinctively correct, and, in the hurly-burly of the modern world, we expect activity above all else.

For every investor and for every strategy, there is a sensible mix of doing versus thinking about doing, and the almost universal tendency is to shortchange the latter. Investment firms that battle each other for excess returns (and the client dollars that go with them) often are remarkably similar to each other in how they approach the investment equation. With little innovation in methods (exacerbated by the tendency to hug benchmarks), the quest for sustainable advantage becomes hiring the smartest people, since everyone is doing the same thing. It can sometimes work, but in the investment business, smart people are a dime a dozen.

Those that are unusual are the ones that can see a new way or a new angle, and those that, like St. Onge, spend tremendous amounts of time questioning, practicing, anticipating, adjusting, and exploring how they do what they do, before they do it. We are all forced to react when it's time to perform. The nature and amount of our preparation will determine how well we do.

[1] The New York Times : The online link does not have the graphic, but it does have a video. Even better.: http://www.nytimes.com/2010/02/02/science/02ski.html

stuck in one dimension

tom brakke — Wed, 27 Jan 2010 21:07:32 +0000

While there tends to be a right size of things beyond which problems seem to occur,[1] there is also a right scope of things. As with individuals, organizations struggle with the question of how specialized versus how generalized they should be in their efforts. Personally, we often know if the fit is bad ("a square peg in a round hole"), but in aggregating our efforts it is more difficult to optimize our approach.

There are certainly errors that are made by being spread too thin. In my own case, I think that my roles as a consultant, advisor, and writer work off of each other in a way that yields benefits for my clients, but there are days when I wonder if I'm getting the equation wrong. As for firms, we need look no further than the "financial supermarkets" of yore (for a time, I was a cog in one of the many wheels of a prime example) to see that trying to be all things to all people can damage the firm as well as the people that work for it and invest with it.

The topic today is the opposite case, and as an example we'll look at the world of golf. In August, I wrote a piece about the Accenture advertisements that featured Tiger Woods and my take on the "competitive keys" that they illustrated.[2] As was clear years ago to anyone familiar with the structure of the PGA Tour, there was only one golfer that really mattered. Everything revolved around Woods and everything was based upon Woods. An entire economic edifice, inside and outside of the tour, was built upon his ever-broadening shoulders.

It worked until it didn't. While few could have written the script as to how it would unwind, since the specific risk that caused the blowup wasn't widely known (they rarely are), the conditions were ripe for a reversal of fortune. In this case, the golf world had a taste of life without its Tiger the year before, when he was injured. (Bottom line: Golf was injured too.) While it would be foolish to count such a great player out going forward, there's no doubt that everything has changed, and that the one person who was holding at bay all of the weaknesses in the structure of the sport can't do it anymore.

Such is the nature of a star system. The similarity to the world of investment management is easy to see. Firms have a hard time resisting the concentration that comes from riding a successful strategy or a successful manager. One thinks of Janus during the go-go years, ever more invested in a philosophy, with the huge cash flows plowed into that way of thinking (and the archetypal stocks of the time). More recently, the soap opera involving TCW and Jeffrey Gundlach is but the latest example of the lurking hazards if an investment firm is dominated by one personality. The list of similar situations is very long indeed, if lacking in some of the juicier bits of the back-and-forth lawsuits that have been filed in that particular case.

Day to day, it's easy to get similarly trapped when facing investment decisions. If you have your rally cap on, it's hard to see the negatives cropping up, just as positive possibilities are obscured if there is a bearish haze that clouds your view. You could have a paired trade on and think of yourself as market neutral, but if both the long and the short represent your world view, all you are is leveraged to your belief system.

It's a fine line to walk, since having the strength of your convictions is important, as is making the most of the things you do best. But when you fall in love with a narrow approach, especially if it's what's working now, you can lose sight of many of the clues that matter. Consciously looking for the other side of things should be an integral part of your decision processes.

Even the unthinkable happens now and again. Inching away from a perceived winner rather than being increasingly attracted to the light of success is prudent risk management. But it's very hard to do.

[1] The Reformed Broker : Which was the "In 2009, I learned that . . ." lesson that I shared in this compilation by Joshua Brown.: http://stocktwits.net/thereformedbroker/2009/12/30/in-2009-i-learned-that/
[2] the research puzzle : The posting, linked here, was written in advance of the PGA at Hazeltine, which turned out to be the first time Woods lost a major championship when holding the lead entering the final round. The link from my posting to the Accenture ads no longer works, for obvious reasons.: http://www.researchpuzzle.com/blog/2009/08/10/competitive-keys

unbiased industriousness

tom brakke — Thu, 21 Jan 2010 13:13:07 +0000

Every now and again, a phrase sticks in your head. I'm not above grabbing them for blog titles,[1] and this one comes from an email sent to me more than a year ago by a former colleague.

He and I have had long-running discussions about what should be expected of investment analysts, from the tools of the trade that they need to learn to the type of individuals that seem to find success. It was within that context that he wished for "unbiased industriousness" from himself and others that are charged with analyzing investments. A better short description of excellence could not be found anywhere.

The investment business touches all of our lives. The proverbial man on the street is faced with decisions about how to deal with the complexity of the markets and uncertainty regarding intermediaries that proclaim expertise and offer recommendations. Those a bit better off financially might have a wider circle of advisors, but face many of the same issues. So too the fiduciaries at foundations and the like, who may or may not have higher levels of experience, but probably have more information with which to make their decisions. Those in the investment business, charged with making those choices themselves, often must rely on others, from co-workers to brokers of securities, for input.

It is a chain of dependence for all of us, and we could ask nothing more from the links to which we are connected than unbiased industriousness.

Knowing the conflicts and misaligned incentives that affect the people with whom we deal is a starting point. Of late, Goldman Sachs has taken it on the chin for previously structuring mortgage-related products for clients and promptly shorting them after the transactions.[2] In published accounts, the default adjective for the buyers of the paper is "sophisticated," even though their purchases collapsed in price. Who knows whether they relied on Goldman for an opinion or if it was simply a transactional intermediary. It is an important distinction.

The giving of advice, whether by a financial planner in a coffee shop or a Master of the Universe in a Wall Street private dining room, should be with all the cards on the table. If there are conflicts, they should be laid out; if there are caveats, they should be provided. The range of possibilities should be explored and the advice delivered in the full light of day. Unfortunately, too much advice is tainted and biased, with the elements of analysis that it is based upon overwhelmed and overshadowed by other factors.

Within organizations, some of the same issues present themselves. It is difficult to buck the orthodoxy of the group or the inclinations of the person who signs off on your bonus. At the margin, it is easy to sell what sells, and to rationalize a tweaked and tailored version of what you really believe. The real stars are those who can avoid the behavioral pulls and deliver an unbiased evaluation.

As for industriousness, one dictionary defines it as "attentive and persistent effort." While there are building blocks that an investment professional must use, there should be nothing rote about the process of evaluating ideas. Those who do it best are alert to every possibility and willing to doggedly pursue every avenue of inquiry. Persistence pays; you never know when you will discover that bit of information or have that flash of inspiration that makes all the difference.

Those with unbiased industriousness have the chance to be effective and trustworthy investment professionals. (A combination of book smarts and street smarts -- plus the ability to communicate ideas well -- round out the preferred package.) Those without one quality or the other are sure to let you down.

[1] the research puzzle : As was the case with "situational awareness" after a pair of Northwest pilots claimed to have lost it a few months ago.: http://researchpuzzle.com/blog/2009/10/26/situational-awareness/
[2] the research puzzle : Last year, in response to Goldman's "huddles," I had called it "long-term stupid" for some of its choices in how to deal with clients, which could easily apply to other firms as well.: http://researchpuzzle.com/blog/2009/09/02/back-at-it/

the error price

tom brakke — Wed, 06 Jan 2010 20:55:50 +0000

One staple of the investment research game is the target price, that device for indicating where a stock will trade at some future time. Usually a data item on a research report, it can be visualized as well:

But wait, another line has been added. What shall we call it? I always refer to it as "the error price," although analysts never have any idea what I'm talking about when I do. Research is mostly a game of "how high," with little time spent on understanding risks, and no term has come into common usage to describe the concept I feature here.

But before we look at that bottom line, let's look at the top one. If you find yourself in front of a Bloomberg machine or the like, you can see how the average target price for a given stock has varied over time. Certainly some quantitative genius has found a way to integrate that series with other information into a profit-making stew, but it's hard to find a mushier data series than that one. That said, as with earnings estimates, seeing analysts leapfrog one another (up or down) with their target prices can provide some important clues as to the flow of attention and money (especially if you recognize a trend early), since those behavioral square dances tend to last for awhile.

In fact, target prices are best understood as marketing tools rather than analytical ones. Despite decades of related folly, it's amazing how the notion that target prices matter lingers on. The charade is a bit muted right now, although the bounce off of the bottom has brought it back somewhat. When the animal spirits return in force, you can bet we'll see fantasy numbers thrown around again (with the media circus featuring them in the center ring).

While some research firms are good about enforcing a measure of discipline in the target prices that appear under their banners, others are not. Practice is all over the map, which makes the notion of an average of target prices pretty ridiculous. Where, exactly, is the target time to go with the target price? Why, precisely, should the stock reach it, in terms of fundamentals and valuation? What, specifically, are the two or three things that have to happen for that to all come together? How much, do you suppose, will the market be up in the meantime?

To the last point: The dirty little secret of this whole game is that by looking at the target price you can't separate stock-specific expectations from the inexorable grinding of the wheels of Finance 101. You're buying a stock and expect it to give you some kind of return commensurate with the risk you are taking. An unsuspecting user of a research report can see a target price up twelve percent and think it looks pretty good, while it might represent too low an expected return for the risks undertaken. The pieces of the puzzle are hidden unnecessarily.

A single-point error price would have many of the same problems as the single-point target price does, but including it in an analysis is the first step toward a much better framework for decision making, by simply acknowledging the existence of the other side of the distribution of outcomes. Of course, the range of possibilities is even wider than the brackets provided by the target and error prices, but two markers are better than one in plotting a course of action.

Those looking to sell you something might not like to admit it, but they are occasionally wrong. As I wrote elsewhere recently, "The economic world is one of uncertainty rather than certainty, and no amount of bluster can change that."[1] It would be nice if the tools of our trade acknowledged that fact.

[1] tjb advisors : The quote referred to those that play the new-year forecasting game; it comes from the current newsletter for my investment advisory business. (It is published every couple of weeks via email if you have an interest in signing up.): http://www.tjbadvisors.com/newsletters/edition004-12-29-09.html

loose ends

tom brakke — Mon, 14 Dec 2009 20:56:15 +0000

And so we come to the end of my series on the Global Research Analyst Settlement.[1] Fittingly (since we all like round numbers so much), this is also posting number one hundred of these little essays since I started blogging. I guess it's time to pull together some of the loose ends.

As I have indicated in previous postings, October 31 marked the end of my involvement in the settlement. That meant wading through the paper files that piled up from research firms, the performance evaluation service that I used, and that I produced myself -- and sending them off for archival storage, probably never to be read again. In addition, there were more than fifty gigabytes of electronic information (including over seventeen thousand emails and Excel spreadsheets of all manner and complexity) copied onto a drive for posterity.

While my documents have been put to rest, there are some loose ends for the settlement. Two investment banks settled later than the original ten, so the independent research will flow there for a little while longer. And I believe that all of the banks are awaiting further rulings from the court on a number of operational issues, including leveling the playing field versus other firms in cases where the settlement posed additional burdens. (Post-settlement, if the rules make sense they should apply to all; if they don't, they should apply to none.)

Many of the issues that drove the settlement have not gone away, not the least of which is the advantage that accrues to brokerage firms from bundling their research with other services in ways that other research providers cannot.[2] I've always thought it'd be great if the whole world of research worked off of hard dollars. I think it makes better sense if the consumers of the research pay for it cleanly and directly, leaving out the distortions from bundling, soft dollars, etc., but a debate on the conceptual alternatives and nitty-gritty realities is best left for another day.

As it is, the market for research is alive with change. New firms pop up as others are shuttered. Electronic communities swap ideas of all kinds (that run the gamut from outstanding to awful), and a byproduct is some "Napsterization" of investment research published by leading firms. That should be expected, since it seems to happen to any product delivered electronically these days, but it presents an important issue going forward. In general, while the research business is still too tied to traditional processes and formats for my taste, there are lots of interesting developments around the edges.

The performance pattern of the equity market during the settlement provided an unusual backdrop for the evaluation of research, in that it so clearly was marked by two distinct periods. The first three years it was smooth sailing, with low volatility, and then all hell broke loose. The resulting strains tested the underpinnings of the business itself -- where the shock waves will be felt for years -- but it was a wonderful laboratory in which to examine the interplay of the market, research firms, and end users.

A former colleague told me when I signed on as a consultant for the settlement, "Take notes. It will make for a fascinating book." For now, you'll have to settle (so to speak) for the nine postings I have written. Maybe someday I'll delve into the details a bit more, but doing the topic justice in longer form would require a thorough investigation that included the perspectives of other consultants, the settling firms, research providers, and regulators, rather than just my own observations and opinions.

For me, a chapter of life has passed. For the business of investments, another episode of cat and mouse with the regulators is just about completed, although the list of them is never ending. There are always loose ends for someone to play with, and stories like this one to be written yet again.

[1] the research puzzle : Here's the entire series of postings.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/settlement-series.pdf
[2] Financial Times : This is a recent FT article on the aftermath of the settlement which addresses that point.: http://www.ft.com/cms/s/0/642fae88-e128-11de-af7a-00144feab49a.html

of the regulatory pattern

tom brakke — Thu, 10 Dec 2009 21:28:45 +0000

Over the last decade or so, there haven't been many dull moments for those watching the merry-go-round of financial market crises/scandals and subsequent legislative and regulatory actions. One of those turns of the carousel (now largely complete), the Global Research Analyst Settlement, is the subject of this continuing series of postings.[1] Five regulatory bodies settled with twelve investment banks for an advertised price tag of $1.5 billion, although implementation costs at the banks were not included in that figure, so the real cost was greater.

Rather than focus on too many details of the settlement or enumerate the other events of note during this period (which featured low returns in addition to all of the messes), a look at the regulatory process itself is in order.

Of course, there are those who always argue for less regulation, and those views increasingly held sway during the final twenty years of the last century. Like a lot of things, in the short term it seemed wonderful and in the long term more the case of, "What were we thinking?" Even a hard-core believer like Alan Greenspan was forced to ask himself the question. I can dream of a world where little or no regulation makes sense, it's just not this one.

And some believe that self-regulation works. I'll go with the words of Satyajit Das, who wrote, "The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance."[2]

To discuss what should be regulated and by whom is beyond the scope of this review -- there are sites that deal with those questions on a regular basis, and which do so more effectively than I can. I do, however, think that a different approach to regulation is needed. What we have now is behavioral regulation, akin to behavioral finance, where actions are anchored by the events of the immediate past.

The settlement looked backward rather than forward, and its provisions addressed the specific issues that triggered it. That is the very nature of the regulatory model; it fights the last war. (Those battling are not just regulators, per se. Looking backward and reacting to well-known problems is natural for the political classes in the legislative and executive branches as well.) For example, in the independent research portion of the settlement, the parties agreed to an approach that ignored emerging trends in the research business, perpetuated a narrow view of what research is, and did not anticipate some key implementation issues.

Many of the overlooked considerations came to light during meetings of the consultants charged with implementing the independent research portion of the settlement and the representatives of the regulatory bodies. The group of consultants included individuals with significant experience in various parts of the investment industry. It was clear in a short while that the group was good at seeing the problems from new angles and coming up with solutions. Unfortunately, outside of certain implementation issues, the die was cast before we got involved.

There were better times to have included a group of experts of that type in the regulatory process. For one, had such a group been involved in structuring that portion of the settlement, it would have looked different, to the benefit of the clients of the settling firms. The firms and the regulators did not consider a sufficiently broad range of issues -- or the needs of different types of investors -- when arriving at terms.

Even more important would be to have that type of multidisciplinary expertise integrated into the day-to-day process of regulation itself. Some argue that the investment industry always will win the arms race because of the money it generates and the talent it can afford, and there is truth in that. But a change in approach by regulatory bodies would make a significant difference. Certainly they exist to enforce the regulations on the books, but they must know the industry inside and out, be aware of the state of the investment art, and anticipate where the industry is going, not just where it has been.

In the great rethinking after the biggest of the crises, there have been signs of progress on this front, but amid the confusion over the grand regulatory scheme of things, they are small steps. Giant steps are needed.

As for me, I'll complete this series by tying up some loose ends in the next posting.

[1] the research puzzle : This is the eighth in a series on “the settlement.” This link will take you to an index of the postings on the topic that will include all of the postings as they are written.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/settlement-series.pdf
[2] naked capitalism : The line comes from a guest post by Das on the linked blog.: http://www.nakedcapitalism.com/2009/09/guest-post-satyajit-das-on-dr-jekyll-and-mr-hyde-finance.html

behind the scenes

tom brakke — Thu, 03 Dec 2009 21:02:47 +0000

Any investment endeavor -- from that of the biggest, most sophisticated asset manager to the day trader in his bathrobe in his basement -- relies on accurate and timely information. In a firm, doing the plumbing on those information pipes is part of "operations" or the "back office." Often, those areas are taken for granted. (That is, until something goes wrong.)

The firms that settled under the Global Research Analyst Settlement[1] needed to work with outside vendors and consultants like me to ensure that the independent research they were obligated to deliver made its way to the intended recipients as it should have. Along the way, the appropriate statistics had to be gathered for reporting to the regulatory authorities.

The specifics of the implementation differed by firm, and I won't deal here with the intricacies of the application. Instead, I'll focus on four examples of situations with broad implications in the investment world.

Dan Brown has made a fortune off of tales of intrigue centered around the fictional Harvard "symbologist" Robert Langdon. I dream of making a fortune as a symbologist on Wall Street. I write a fair bit about the belief structures that drive investors and the symbols and shortcuts that they use, but here I'm talking about something different. Stock tickers (or symbols), those short and unique representations of a security, pose all sorts of operational problems. U.S. equities are as straightforward as you can get, but even they cause issues throughout the system of data terminals and repositories. Static and functional most of the time, changes in them can have important repercussions on decision tools.

Most of those types of changes were more of a nuisance than anything else under the settlement, which dealt primarily with domestic equities. Broader applications involving foreign stocks and other asset classes are more challenging, and algorithmic trading applications offer another level of complexity.

I have a hard time believing that this crazy quilt of security identifiers will be with us in twenty years. New options symbols are on the horizon, Bloomberg is starting to establish unique identifiers for all securities, and there are other developments of note. Time to work on my symbology chops.

Another operations issue is really a research reporting issue that ties back to my last post on performance. Remarkably, we still have research reports that are created after market-moving news about a company has been released, but which bear the closing price of the security prior to the release of the news. I grant you that it's sometimes tough to find a better price if there's no or limited off-hours trading, but stamping a price on a report that misrepresents the state of the world is unacceptable. Our customs (write a report, use last price) get in the way of the accurate capturing of when and how a point of view has changed.

An educated reader of a report should be able to tell that the price is not representative, but a less sophisticated one will not. In any case, in these unfortunate situations the metadata on the report can show a new rating based upon the new information, but an old price. Some performance measurement services work directly from that metadata and therefore institutionalize the distortion. Garbage in, garbage out: Another reason to take performance rankings with a Minnesota road truck's load of salt.

The consultants involved in the settlement were required to fill out annual reports about our work, and to include relevant statistics that had been compiled. One set of particular interest was the usage numbers. The debate about whether the settlement spawned enough usage of independent research can wait for another day; right now, I'm interested in the calculation and interpretation of such aggregations. Too often, I see people assume a level of precision that's not there. There are a variety of issues with web analytics, and you ought to understand that before reporting or using information based upon clicks.[2] The metrics are broadly indicative and helpful, but any internal or external use of the information ought to be within the context of its shortcomings.

In every investment application, data quality is critical, yet many organizations don't put forth enough resources (or structure them in an optimal fashion) to lower the rate or lessen the impact of data errors. A year ago, I wrote about "the art of triangulation," including the way in which analyzing data from different directions helps to improve its quality.[3] I saw much benefit during the settlement from using the separate databases of the investment bank and the technology aggregator in conjunction with my own; the comparisons helped to ensure that the data flow to the end user was as good as it could be.

We're almost done looking at the settlement. On now to thoughts about regulation in general and this specific case.

[1] the research puzzle : This is the seventh in a series of postings about "the GRAS." This link will take you to an index of the postings on the topic that will include future postings as they are written.: http://researchpuzzle.com/files/view/settlement-series.pdf
[2] Wikipedia : Speaking of sources of information on which there is some debate regarding accuracy, Wikipedia is useful for summaries of issues like this one.: http://en.wikipedia.org/wiki/Web_analytics
[3] the research puzzle : I also focused on triangulation in products, investment decisions, regulation, and due diligence.: http://researchpuzzle.com/blog/2008/12/22/the-art-of-triangulation/

the performance parade

tom brakke — Mon, 30 Nov 2009 22:21:33 +0000

As any blogging manual will tell you, humans crave lists. And what is more appealing than a ranked list? How about a ranked list that has some scoring system or ranking methodology that justifies the ranking? Such a list magically becomes a simple statement of truth about what or who is best or worst.

In this continuing series of postings on the Global Research Analyst Settlement,[1] we have finally gotten to the obligatory posting on research performance. Long-time readers will be familiar with my thoughts on the matter, since I have covered it many times in postings like "the research performance derby"[2] and "to the precipice."[3]

In standard practice, a performance evaluation firm takes the ratings put on stocks by research firms and judges which firms have had the best performance. What could go wrong? To start, I'll quote myself (from a piece I wrote for the users of independent research under the settlement):

Ratings, which are used in the performance calculations, do not encompass the breadth of research information contained in a report.

There are different criteria used by firms to arrive at a rating on a stock (for example, some ratings imply a prediction of a certain level of absolute performance, while some are relative to the performance of the general market). Such differences are not reflected in the rankings.

Firms have different ratings schemes; to try to compare them, evaluation services must make the simplifying assumption of “mapping” each firm's ratings to a common standard. Such simplifications yield distortions.

Performance for an individual client should always be viewed in the context of the client’s objectives and tolerance for risk. A “good” idea for one client may not be good for another. No ratings system adequately deals with that reality.

So, a research analyst (or computer in the case of a quant firm) boils down all sorts of valuable information into one variable, which is adjusted further in the mapping process, and evaluated without regard to time horizon or risk. That's what we use to determine who is best? If so, we get what we deserve.

In studying this area throughout the settlement, I saw nothing to make me believe that chasing research performance in that simple fashion is a better idea than chasing any other kind of performance. It is one of the most common and most dangerous investment mistakes.

To be clear, there are things to be learned by analyzing performance, even in a basic way. More worthwhile still is a complex evaluation of ratings behavior (and other variables, if available), using a variety of tools that can help to ascertain the strengths and weaknesses of a research analyst or firm. Statistical analysis of what has happened can be helpful to determine what might happen, but not in isolation. It should provide hints and clues to pursue and questions to ask. The goal should be to understand how that performance might have come to be (remembering that much of it at any time is luck or statistical noise) and whether it's reasonable to assume that it might be repeated given what you know about how the analyst or firm goes about their business.

It is the classic process-versus-outcome situation, where unsupportable observations about worth get made because of where a performance outcome shows up in a ranked list. It is the same trap that plan sponsors often fall into: While they say that past performance only counts for some small part of their evaluation process in selecting asset managers, anyone who has been "in the room" knows that in practice it usually overwhelms most everything else during the decision making.

My recommendation is to ignore most published lists of performance. They don't tell you what you need to know. But to the extent to which you have a chance to delve into a richer trove of statistical information, it can help you to figure out which research firms are right for you. But, you should use that information to answer some basic questions:

What kinds of things is the research process you are evaluating good at? What is it not good at? There are always trade-offs.

How would you expect a particular firm to perform in a certain market environment? When will it produce its best performance (and why) and when its worst? Many mistakes arise from not understanding that relative performance naturally fluctuates.

If you think that you can switch from one provider to another in anticipation of future performance, have you properly judged the switching costs and the odds that you are making changes based on false leads from information on past performance? Those rankings will often lead you in the wrong direction.

Performance evaluations are predicated on having accurate data. That brings us to our next topic in this survey: Operations and the nuts and bolts behind the scenes.

[1] the research puzzle : This is the sixth in a series of postings on “the settlement.” This link will take you to an index of the postings on the topic that will include future postings as they are written.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/settlement-series.pdf
[2] the research puzzle : This posting was triggered by a Bloomberg listing of "best" analysts.: http://researchpuzzle.com/blog/2008/07/22/the-research-performance-derby/
[3] the research performance : This one looks at a simple stock chart to think about the meaning of performance.: http://researchpuzzle.com/blog/2009/04/30/to-the-precipice/

all about the frame

tom brakke — Mon, 16 Nov 2009 21:20:42 +0000

In building the understanding of an investment organization that I wrote about in the last posting, it is essential to assess the framing of issues, events, processes, and goals, and to gauge whether the resulting framework is appropriate.

The firms competing for business under the Global Research Analyst Settlement[1] framed the marketing of their research as you would expect given the times (circa 2003). They positioned it in accordance with their interpretation of the regulators' goals for the settlement and used stocks that had recently made headlines to illustrate their research acumen. This time around, that meant a clustering of sample reports that had foreseen problems with Enron and the dot-coms that had exploded.[2] So, the first order of business is to throw away the historical frame and to try to find a forward-looking one. That is always a challenge.

If you think of the market ecosystem as a gigantic mural of activity, an investment firm (or a team within a big firm) is holding up a frame on one part of that mural and saying, "This is what we do. This is the picture I want you to view." Some of the most interesting firms that I saw during my due diligence were those who held up very small frames, somewhat irregular ones, or those centered on parts of the mural otherwise ignored. But most providers were trying to capture a much bigger swath of the canvas.

My challenge was to reconcile that frame with the one I was developing for my settlement solution, and to constantly judge what adjustments to either would make sense. Of the famous "four Ps" of due diligence, an analysis like this concerns a firm's philosophy and how that translates into process (the other two Ps are people and performance). The framing starts with simple breakdowns of research into type: fundamental, quantitative, and technical. Broadly speaking, the last two gave the best reads on those Enron reports, but consultants were instructed by the regulators to give "fealty" to fundamental research over quantitative research, and to exclude technical research altogether. (Another frame.)

Within each of those categories, one of the most interesting distinctions is between firms which tend to be adaptive in their approach versus those that are absolutist. As always, there are advantages and disadvantages to both (and firms are not exclusively one or the other), but to judge a research provider, you need to understand where in its decision processes it has made those choices. It is very difficult to anticipate the nature of successes and errors that a firm is likely to make without knowing it to that depth.

Of course, "framing" is now well-known as one of the investor mistakes featured in the study of behavioral finance, and so all of this talk of frames is an attempt to consciously review how decisions are made. After a due diligence meeting, I would often find I had scribbled "behavioral" next to my notes on some aspects of a firm's operations. It indicated that I thought there was a blind spot in its approach, that it didn't see certain ramifications. Some thoughts:

A defensiveness as to methods is usually a good tip off that there may be issues lurking. The best firms are open to new lines of thought and different views of their processes and output. Not that as an outsider I have the answers, but I'm good at moving the frame around and throwing light on new considerations. Those at firms that are thoughtful about their approaches effectively deal with questions by providing context I hadn't considered or by gladly entering into a discussion about the relative merits of their construct versus others. Those that bristle at such lines of inquiry tend to see things in black and white, not a good way to look at the multicolored market picture.

There is no substitute for having a grounding in the investment practice of the day, but a knowledge of academic research and market history helps to put things in context. The world definitely changes, but a research process that relies on analyses whose worth looks questionable within a broader perspective is flirting with trouble. It is surprisingly common for firms (especially fundamental ones) to veer into what works short-term without seeing the developing risks.

Organizations are by definition behavioral. Choices have to be made, and how they are made may be preconceived or the result of actions that aren't anticipated. I am reminded of a well-known firm whose pattern of analyst rating behavior evinced a striking resemblance to behavioral work on the subject as opposed to what the firm said its analysts did. In that case, I had enough statistical information to be able to pinpoint the reality and we could untangle the policies that contributed to it. Other questionable assumptions are better hidden, but trying to find them is of critical importance.

The frame that is hardest to break apart is that of past performance, with its magnetic attraction that has the power to avert the eyes from everything else. We shall try to view it clearly in the next chapter of this series.

[1] the research puzzle : This is the fifth in a series of postings on "the settlement." This link will take you to an index of the postings on the topic that will include future postings as they are written.: http://researchpuzzle.com/files/view/settlement-series.pdf
[2] A similar clustering of examples always seems to occur. For years, if you requested a sample report, you got one for IBM; then it was Wal-Mart, then Cisco, etc.

in search of understanding

tom brakke — Wed, 11 Nov 2009 21:16:54 +0000

To assess the quality of an investment organization and its output, a certain sleuthing is required. It doesn't really matter whether you are looking at an asset manager or a research provider or a pension fund or whatever. While the elements of the evaluation will differ somewhat -- as will the relative importance of each in the final analysis -- some basic principles apply. First and foremost for me is the need to understand the organization and what it is trying to do.

In cases where you are asked to improve the structure and processes of a firm, there is a temptation to start giving recommendations before that understanding is achieved. Even in situations where your evaluations are simply descriptive, the same pitfalls exist; you can start grading before the full picture is revealed.

To analyze the independent research firms contending for business under the Global Research Analyst Settlement,[1] I asked them to complete an exhaustive request for proposal. That allowed me to get as much information as I could to narrow the field a bit, since it was impractical to visit all of the research firms that sought to participate. A similar approach is used in other parts of the business, especially in the selection of asset managers, and the process brings with it some common mistakes, mainly in relation to judgments about "performance." (More on that in a future posting.)

Onsite interviews are the real meat of the due diligence process, and there is no getting around spending the time and money it takes to do it well.[2] Once at those meetings, it is nothing fancy; just a pad of paper and some good questions. Think of it as akin to the many "procedurals" on television, only more boring. Piece by piece, information is revealed and put in context, as the mosaic is built, with that elusive understanding of what makes a firm work (or not work) the ultimate goal.

There are "aha" moments along the way (sort of like those that bring on the far-off stare of Gregory House), and they are very often triggered by little things.[3] In the same way, you can sometimes learn more about how a firm works from a junior analyst than from the chief investment officer (to say nothing about those that are purely interested in the message control of marketing). I have no interest in the "party line" other than to judge how far off of it the firm tends to drift. That makes PowerPoint presentations and lots of people around a table unlikely venues for discovery. One-on-one interactions with people in various parts of the process are always the most illuminating part of due diligence.

Let me be clear that it isn't because people say things that they shouldn't say, thereby revealing deep, dark secrets. That's not the case. Rather, the interviews flow in different ways, people have a variety of perspectives, and important things can take on divergent looks "at altitude" versus on the ground. After a cluster of such interviews, the result is a richer mix of inputs that tends to spawn a subsequent round of better questions. The process is repeated until you attain the understanding you seek or realize that you are never going to get there.

The circumstances of the settlement were such that the providers of research wanted the business badly enough to be very forthcoming with detailed information and arranged interviews with anyone that I wanted to see. (That isn't always the case for other due diligence assignments, which makes it hard to endorse the firms being scrutinized without lots of caveats and reservations.) In the next chapter of this series, I'll detail some of my observations from those due diligence meetings.

[1] the research puzzle : This is the fourth in a series on the settlement. This link will take you to an index of the postings on the topic that will include future postings as they are written.: http://researchpuzzle.com/files/view/settlement-series.pdf
[2] Advisor Perspectives : This is a piece I wrote about the difficulties of doing due diligence "from a distance.": http://www.advisorperspectives.com/newsletters09/pdfs/Due_Diligence_from_a_Distance.pdf
[3] the research puzzle : My very first posting on this blog was called "look at the little things.": http://researchpuzzle.com/blog/2008/05/27/look-at-the-little-things/

know your audience

tom brakke — Mon, 09 Nov 2009 15:47:00 +0000

The independent research portion of the Global Research Analyst Settlement[1] was structured in a way that delivered research reports from independent providers to the clients of the twelve firms that were subject to the settlement (but only for stocks covered by the settling firm, or that it had recently dropped). Since there were no other opportunities for the clients to grill the independent researchers, the report and its accompanying rating comprised the whole of the research product delivered. A future posting will address the ratings on those reports; this one is focused on the reports themselves.

One way to think about the reports is by using this graphic:

Obviously, we would want our assessment of a given piece of research (or a firm's reports in general) to be as far into the upper right as possible, firmly in quadrant A, with high-quality informational content being presented in an easy-to-understand fashion. Each dimension is critical, but often firms struggle to effectively represent their ideas and how those ideas are specifically the product of their unique research process. There are many firms in quadrant B -- those that have work of value but that haven't figured out how to effectively communicate it. Quadrant C is to be avoided at all costs. Those providers deep into quadrant D can be particularly dangerous, in that they are good at presenting ideas, but there is little of substance behind them.

Each of these attributes is a mere representation of many considerations. Quality of "content" can be debated at length, and there's a real "know it when you see it" element in play, since there are so many avenues of research that are fruitful. (The next posting will delve further into that due diligence.) Communication is lower on the priority list for most firms, which results in many of them defaulting to industry norms for research reports. That's too bad, since the average report isn't very good.

To further mess up the works, let's add a third dimension to the chart: institutional users of the research versus retail users. Suddenly, things change dramatically, and a firm's quality of presentation might be evaluated differently for one class of users than the other (or for financial advisors, who are generally "in between"). Even a judgment on the quality of the analysis might change, since more experienced users of the research would understand the nature of that research, how it should be used, where it might go wrong, and where else to look to supplement the information. Others don't have that perspective. A given piece of research, looked at in isolation, might be judged as being of lower quality on its own than if viewed within a mosaic of other sources.

Which brings us to a key issue when judging the benefits of the settlement. Generally speaking, it was crafted to redress industry practices that were most damaging to those least aware of how business was done and most likely to take things at face value, i.e., individual investors. Yet the settling firms had different mixes of retail and institutional clients. It didn't matter; the same rules applied to all of the firms, and at a given firm, the same independent research was supplied to all of the clients, retail and institutional. This had a significant impact in many ways, including the extent to which the research was used throughout the settlement.

The research reports produced by the independent firms usually were honed to some degree in advance of the settlement, part of the process of winning the business. A few providers did surveys and focus groups about what users were looking for from their research, and made adjustments in response. (To my knowledge, all of those targeted retail investors.) Other changes came in reaction to ideas, recommendations, or demands from independent consultants who saw shortcomings in the reports. In some cases, consolidators or research consortia also had requirements to be met.

What was lacking is what often is -- the ability to target a specific audience. Shooting at the middle of the distribution of users can make a report too basic for the experts and too advanced for the novices. In content and in form (we need to get away from reports that are "frozen in time"[2]), research reports need to be reworked. Readers of them are looking to solve particular analytical problems, and the next generation of report capabilities must provide a platform for the entire range of users to do just that.

[1] the research puzzle : This is the third in a series on the settlement. This link will take you to an index of the postings on the topic as they are written.: http://researchpuzzle.com/files/view/settlement-series.pdf
[2] the research puzzle : That was the title of a piece I did regarding the switch from paper to PDFs in producing reports.: http://researchpuzzle.com/blog/2009/01/14/frozen-in-time/

the gold rush

tom brakke — Wed, 04 Nov 2009 19:37:24 +0000

The independent research portion of the Global Research Analyst Settlement put a few hundred million dollars on the table to be doled out to research firms by consultants like me. Unsurprisingly, that made us very popular, as we chose those that could stake a claim and those that couldn't.[1]

It was about fifteen months from the announcement of the settlement to the provision of independent research, and the period was a blur of activity, as research firms tried to get in on the action. The contenders were little firms and big ones, new and well-established, niche players and those with large universes of covered companies. Some tried to roll a variety of capabilities together to serve as one-stop shops for technology, information, and research. In other cases, there were new affiliations of providers, and consolidators who aggregated the work of a wide range of firms.

The overall feeling was that independent research was the next big thing in the business. Thomson Financial published its first (and only) Directory of Independent Investment Research, almost five hundred pages in a bound volume of the type that used to line the shelves of every office, but that are increasingly rare in these days of digitization.

The settlement order laid down a couple of prohibitions and a set of criteria to guide the independent consultants in their choices of providers. The regulators added some interpretive guidance along the way. Within those parameters, each of the consultants needed to figure out how to spend the money set aside for independent research in the settlement order. We didn't lack for suggestions.

Some firms -- mostly larger, established ones but a few upstarts too -- could overwhelm you with information. In the selling process, there's a fine line between providing too much information and providing enough. As someone on the receiving end, I generally prefer more than less, because on balance it makes the due diligence process easier for me. Not because I accept what I see at face value, but because it gets a lot of information out right away, so that I can hone in on the anomalous items in a firm's story more quickly. That is much preferable to a series of general conversations or (God forbid) dog-and-pony shows that take far longer than they should for the amount of information imparted. I'm going to get to the targeted questions eventually before making a decision anyway, so it's best to see as much of the picture as I can before beginning the more intensive aspects of the review.

That said, a blizzard of paper and/or digital pages does not necessarily enlighten, especially if the substance is buried under mounds of marketing. Across the range of firms I analyzed, there were distinct differences in how promotional the firms were in talking about their work. (That variable served as information in and of itself about how the firm approached its business.) Stripping away the fluff is relatively easy in most cases. It is only when that cover cannot be removed for proper inspection of the substance that it becomes a problem.

To stand out in the crowd of providers, many firms made claims of greatness: the best process, the best research, the best performance. "Don't you want the best?" was a question that I heard rather frequently.

Why, of course. It's just that there are many types of research, many good firms, and many ways to pull research together to solve an investment problem. There is no one way and no best way. Each of the consultants had to come up with a framework that fit the characteristics of the settling firm on whose behalf they were working, the nature of its research universe, its client base, and the amount of money it was required to set aside for independent research (which varied by firm). My solution looked different than others, for what I think are justifiable reasons, and I'm sure the other consultants feel the same way about the choices they made.

Making the decisions to not use some firms that I admired and that I would have used under different circumstances was particularly difficult. By not selecting them, I was not stamping them as substandard, but simply determining that they were not a part of my solution to a particular puzzle. That was not an easy message to deliver and a harder one for quality providers to hear, since so much was on the line. Had I been free to structure a solution outside of the boundaries within which I was operating, it would have looked much different.

As it was, I was faced with a situation where there were quite a number of worthy providers and many ways of putting them together. I had to choose one and did. Of most interest (hopefully, since I want you to keep reading) are some of the considerations I needed to ponder to do so, and which I will explore in future postings.

[1] the research puzzle : This is the second in a series on the settlement. This link will take you to an index of the postings on the topic as they are written.: http://researchpuzzle.com/files/view/settlement-series.pdf

goodbye to all that

tom brakke — Sun, 01 Nov 2009 15:32:42 +0000

Yesterday marked the end for me of more than six years of direct involvement in one of the biggest regulatory actions in financial market history, the Global Research Analyst Settlement.[1] For a man of a certain age (today), looking back wistfully on the experiences of life can become something of a habit. In this series of postings on the settlement, I will try not to veer into that sort of reflection, but to focus on the unique views of the business that my window provided.

Born of conflicts of interest in investment research that came to light after the bursting of the dot-com bubble, the settlement started with a bang of publicity and piece by piece is ending with a whimper, overshadowed by an even bigger crisis that posed an alarming risk to the financial system and further eroded confidence in Wall Street. The settlement had several components, including mandated operational changes at the firms and penalties levied to fund investor education, restitution, and the provision of independent research to clients of the firms. It was an independent research program that I ran on an arms-length basis for one of the settling firms.

I am not well versed in the investor education or restitution programs, but published commentaries have disparaged their lack of effectiveness.[2] Of more impact were those operational changes. It is hard to sort out the effect of the settlement from everything else going on at the time, since other regulations that came into being shortly before it, such as Reg FD (fair disclosure) and Reg AC (analyst certification), also targeted the abuses that had been uncovered. Interestingly, some of the operational strictures that applied to the firms that settled were never required more broadly throughout the investment banking industry, so that practices outlawed at some firms were not outlawed at others. Nevertheless, the spotlight caused changes in the relationship between investment research and investment banking at sell-side firms, whether they were subject to the settlement order or behaviorally affected by the attention that it generated.

One of the most noticeable effects of all of this activity was the change in the distribution of ratings on stocks by brokerage analysts, there being far fewer buy-rated stocks and more "holds" and "sells" than had been the case. (This has subsequently reversed to a great degree.) One other phenomenon that occurred was a migration of investment research talent from the Street, with experienced and well-known (read "expensive") analysts going off to hedge funds, traditional buy-side shops, or, in some cases, starting their own firms. It is hard to ascertain the degree to which the settlement contributed to those movements, but there is no doubt that it played a key part in them. Other effects could be seen in the IPO process, sales trading, and elsewhere throughout the business.

As for the independent research component of the settlement, some wags have said that its primary benefits flowed to the independent research firms that won the business and the independent consultants (like me) that ran the programs for the twelve investment banks. For obvious reasons, I'll leave that assessment to others. Quite apart from the money, it was an enriching experience for me.

When I received the phone call out of the blue during which I was asked if I was interested in serving as an independent consultant,[3] I responded that the assignment sounded like it was "right up my alley," but I had no idea how well in practice it would fit my interests and expertise. Almost perfectly, I am pleased to report, since it was a blend of the theoretical and the practical, required good due diligence skills, concerned a range of investors and investment firms, dealt with the nature of the investment process employed by the creators and users of research, and involved the operational issues in delivering investment information in an accurate, timely, and revelatory way -- all things I have worked on during my career. Add the fact that I had complete authority and responsibility to create and operate the research program within the regulatory framework that existed, and you have what could be called a dream job description.

There were important developments, intriguing considerations, and interesting people galore along the way, which I'll touch upon in posts to follow in the coming days.

[1] SEC : This is a link to the SEC's series of documents on the settlement. For the record, throughout the settlement the Wikipedia entry has been inaccurate as to the monetary penalties paid by the settling firms. I'm waiting to see how many years it takes for it to show up correctly.: http://www.sec.gov/spotlight/globalsettlement.htm
[2] Securities Law Prof Blog : Judge Pauley, who presided over the settlement, also expressed his displeasure with the execution of those elements of the order.: http://lawprofessors.typepad.com/securities/2009/06/sec-v-bear-stearns-co.html
[3] the research puzzle : You're right, the word "independent" comes up a lot when talking about the settlement: "independent research," "independent consultant," "independent monitor," etc. I touched on this a bit in a Fourth of July piece called "celebrating independence.": http://researchpuzzle.com/blog/2009/07/03/celebrating-independence/

situational awareness

tom brakke — Mon, 26 Oct 2009 19:50:12 +0000

Last week, a pair of pilots sailed past my local airport, somehow not receiving the frantic messages from a series of air traffic controllers that had expected them to descend and land there. Eventually they made their way back from neverland and once on the ground said that they had been distracted by an intense debate they were having about "airline policy" that caused them to lose "situational awareness." It goes without saying that among the most important of airline policies are those designed to minimize the chances of misplacing such a valuable commodity.

While investment professionals may not be entrusted with the lives of their clients in the way that airlines are, we are charged with their financial well being, and a loss of situational awareness by us can be devastating for them. That is why recent events continue to ripple through the industry and will do so for many years. Faith was lost in many of the human pilots and there was no autopilot to avert calamity. The owners of target-date funds (with cool "glide paths" among other marketing hooks) were obvious casualties of that lost stewardship,[1] but the damage was much more widespread than that.

Two staples of the investment game, relative performance and relative valuation, play a large part in the periodic bouts of disorientation that imperil the industry and the profession. When everything is relative, it is easy to lose situational awareness. Shrinking time horizons and misplaced incentives[2] have given career risk priority over prudence. Voices of reason and increasing alarm from the control tower are not heeded or not even heard.

Similarly, the smooth-flying business models and fat profit margins of financial companies weren't questioned much either. This was especially true for the asset management firms, since they have proven to be wonderful money machines over time. But with fees largely based upon assets, the publicly-held managers have had very volatile stocks over the last two years, given the bumpy ride through the turbulence. Lately, we are starting to see more mergers and acquisitions in the business, which brings up an important question: Are you a buyer or a seller?

In the short term, of course, it depends on the performance of the various asset markets and the respective asset mixes of the firms. Beyond that, it seems that two issues are primary in considering whether the golden eggs will continue to be laid: Can firms that specialize in active management make the case for their services in the face of the ETF onslaught (and in light of their own weak records)? Were investors so badly harmed that they will change their behavior for good, rendering the old days, old ways, and old values irrelevant?

So far, cost cuts and better revenues from higher market prices have helped conceal the real issues. And new marketing campaigns ("let's rebuild that nest egg together") are being rolled out. It's less clear how many firms realize how far off course they are and that the old maps and navigators may not get them to their destination.

[1] the research puzzle : Here's a piece I wrote at the beginning of the year about target-date funds.: http://researchpuzzle.com/files/view/way-off-target.pdf
[2] the research puzzle : I did eight postings on this topic awhile back.: http://researchpuzzle.com/blog http://researchpuzzle.com/files/view/incentives-series.pdf

layer upon layer

tom brakke — Fri, 09 Oct 2009 14:52:53 +0000

There are a few square yards of exposed rock in the Arrowhead region of Minnesota that look like this:

It is a geological puzzle: Layers of different kinds of rock, laid down more than a billion years ago, the whole formation then flipped on its side for us to examine. Great formative processes, apparently frozen in time. Students troop to the outcropping each summer to study and to wonder.

As observers of the market, we have quite a different task, to discern movements that are of the social sciences. Economics, sociology, and psychology dictate the patterns that we study and bet on -- anthropology too. And maybe a bit of geology, when we stop to think about it.

Yes, the structures upon which we do our work are man-made, while the rocks came from somewhere else again. (Let's not get into that discussion right now.) Is it bedrock upon which we can build or soft stone that will easily crumble away or even sand that will soon fall through that infamous hourglass? The questions linger and in some ways seem less likely to be addressed now than when we were in the throes of the Great Unwinding.

At the macro level, the debate goes on as to what the role of government ought to be in regulating market behavior. Read Steve Forbes, in the introduction to his magazine's annual money porn issue celebrating the Four Hundred, and you will find that everything that went wrong could be traced to the government and its mistakes. There is no doubt that many of the layers of governmental action (and inaction) were ill advised, but that's like looking at the photo above and only seeing the layers of one color. Champions of free markets failed just as miserably, because they talked a good game but did not play a good one.[1] There were many layers (and many players), and it's so big picture that it's almost impossible to get things done.

We should start a bit smaller, say with the rating agencies. I have written about them before.[2] This is a great example of the sedimentation of actions: Unwise government rules about relying on ratings, reinforcement from plan sponsors and other overseers, dereliction of duty by the raters themselves, rapacious action by the financial engineers, and apparent obliviousness from financial professionals who bought the dreck. Layer after layer after layer. Bold action is needed now to start over, but it is not happening.

One need not look outward to apply the analogy, however. We so often don't recognize the way our philosophies and opinions have been built over time. Why is your firm structured as it is? Why is your investing methodology the one that you have chosen? Why do you expect the market to do the things you expect it to do?

Layer upon layer. Sometimes you just need a geologist to come along and figure out what must have happened to create the pattern. Redoing a firm or a strategy or a market position is not easy. But it is about time.

[1] the research puzzle : Here's an eight-part series on misplaced incentives I did earlier in the year; "one hand clapping" takes it to the buyers of crappy paper who didn't do their work.: http://researchpuzzle.com/files/view/incentives-series.pdf
[2] the research puzzle : Principally in "agents of record.": http://researchpuzzle.com/blog/2008/10/20/agents-of-record/

thus spake the king

tom brakke — Thu, 24 Sep 2009 17:19:30 +0000

A wonderful recent piece by Michael Mauboussin[1] explores the behavior of investment committees, and provides a broad survey of issues that confront groups of decision makers of all kinds. It reminded me to return to the table I first included in "rational choices,"[2] albeit with a new character in position (yes, that's a crown, not a pumpkin for the season):

I once was a member of a committee (this was not in the investment world) that had received a lengthy analysis from a consultant charged with making detailed recommendations for us to consider. Having pored over the report, I was looking forward to a robust discussion about its contents. When it came time on the agenda to review it, the person wearing the figurative crown began by saying, "OK, here's what I want to do." It was not a statement of the process he thought we should follow, but of the decisions that should be made. Instantly, the debate was framed and the die was cast.

There also are subtle ways that decision making processes get distorted. (For example, one time I participated in an important set of decisions that were done via conference call. The votes were taken one after another using the same order of roll call each time. By virtue of their verbal framing of their choices, there was no question that the votes of those at the end were influenced by those at the beginning.) However, as Mauboussin's piece suggests, it is incumbent on those "in power" to strive to get the process right. If they don't, they can consciously sway the group for good or evil, or just bungle it without intent.

Consider a slightly revised image, one perhaps more appropriate to decisions within an investment firm:

Performance success, especially when accompanied by media praise, confers a certain status on those that have generated it (usually defined as relative performance not adjusted for risk). In many organizations, that can lead to leadership roles being added to portfolio management responsibilities, a particularly perverse strain of the Peter Principle. Even if that is not the case, there is a natural tendency to defer to such individuals, especially if not making waves helps at bonus time.

It never makes sense. The leaders of groups, and the star performers of the investment world, need perspective and honesty from those with whom they work. If they lack the humility and insight to understand that, it likely will end in tears for all.

Building high-functioning teams in the investment world is difficult -- these are, after all, typically highly compensated, very smart people, with larger-than-average egos to boot. And I'm not saying that a feel-good, consensus-only kind of environment makes sense. I actually prefer it when there is a benevolent dictator that understands what makes sense for everyone concerned (and not just for today but for the long term), and is willing to see things in new ways.

It's just that they're so hard to find.

[1] Legg Mason : Mauboussin is a great thinker and writes interesting pieces about the "how" of investing. The fact that Legg Mason has struggled for much of the time since he has been there does not diminish his work. Process versus outcome and all of that, or maybe a touch of the very thing I write about in this piece?: http://www.leggmason.com/individualinvestors/documents/insights/D8293-MauboussinOnStrategyInvestmentCommittees.pdf
[2] the research puzzle : This piece looked at how decisions get made at investment institutions.: http://researchpuzzle.com/blog/2009/03/16/rational-choices/

another monday

tom brakke — Mon, 14 Sep 2009 13:31:34 +0000

It is a quieter, less fearful Monday morning than a year ago. Lehman's demise, so shocking at the time, proved to be a turning point that changed the perceptions of investors and politicians. There are endless debates about whether the venerable firm should have been allowed to fail or not, but its bankruptcy and the other events that week seemed to indicate at the time that the business of money had changed for good. That Monday, I wrote about things that were "symptomatic of the age" that seemed officially kaput.[1]

Now we are back to wondering how much really has changed. There are signs of progress and "selling optimism" is back in vogue (now that having optimism has worked for a few months running). "Luxury goods are selling again," said a headline yesterday, and some very-high-paying trading jobs are now "easy to get," according to a story today. The stock market has trampolined and credit restrictions continue to ease bit by bit. Despite some very real economic strains, a semblance of normalcy has returned.

That's a problem in one respect, according to the financial historian, Niall Ferguson:

We could have another Lehman Monday. The system is essentially unchanged, except that post-Lehman, the survivors have "too big to fail" tattooed on their chests.[2]

Over the tattoos, some are even back to wearing their Superman costumes.

After going through the wringer, one would think that we had made more progress in the quest "to reduce the socially harmful effects of finance while keeping its benefits."[3] For all of the tumult, that has not happened yet.

Which leaves us essentially where we were and where we will always be. As I wrote earlier this year,[4] the theoretical and actual responsibility for markets working as they should lies with the investment professionals that are the outlet for the fare of the day. Whatever they "demand" gets provided in the end, and the makers of the products will see that they are given more than enough of it.

Investors are, as always, in a process of price discovery, and the judicious taking of risk in search of return is what the business is all about. As a byproduct of the choices that we make, the systemic risk of the market is formed brick by brick, although it can, has, and will be altered by government actions as well. One year after that incredible September Monday, "too big to fail" is still with us. We have seen that both profits and losses can result from that foundation, and now must get back to the work of deciding how our conceptual models (and the spreadsheets that attempt to mimic them) should value the market structure for today and tomorrow.

[1] the research puzzle : The car crash line must have been good, since the New York Times picked it up.: http://researchpuzzle.com/blog/2008/09/15/symptomatic-of-the-age/
[2] Bloomberg : Ferguson is the author of the 2008 book The Ascent of Money.: http://www.bloomberg.com/apps/news?pid=20601087&refer=top_news&sid=aUTh4YMmI6QE
[3] Financial Times : The quote comes from this article on the Tobin tax.: http://www.ft.com/cms/s/0/6210e49c-9307-11de-b146-00144feabdc0.html
[4] the research puzzle : I wrote an eight-part series on misplaced incentives in the market ecosystem, an index of which is found here. The chapter called "one hand clapping" placed the great share of the blame for our troubles on the "buy side.": http://researchpuzzle.com/files/view/incentives-series.pdf

back at it

tom brakke — Wed, 02 Sep 2009 13:55:29 +0000

The last week of summer (as practiced) is upon us and soon most of the players will be back in force, acting their parts in the market drama. That doesn't mean that the weeks preceding Labor Day have been devoid of action -- certainly the returns have been interesting, especially in equities, and there have been some notable stories as well.

One of interest is the discussion of the "huddles" at Goldman Sachs.[1] On the heels of a Rolling Stone article that blamed the firm for pretty much everything (a former intern's mother, upon reading it, wondered if the job he accepted at Goldman meant he was going to work for the devil), the Wall Street Journal examined the practice of using research analysts to generate trading calls for top clients.[2]

It's hard to know where to start with this story, since there are so many angles to it. Almost all of the articles I have seen about the huddles have mentioned the Global Research Analyst Settlement and one of its core goals, to ensure that research analysts aren't publishing one opinion and saying something else again to favored clients.[3] As I have written before, research reports are "frozen in time" in more ways than one,[4] with the stated view of the firm from a research standpoint often being different from how the firm is trading and even from what an analyst is thinking day to day. That is why institutional investors like to talk to analysts on the phone or in meetings and why they like to get the signals from these huddles: they are accessing what is changing at the margin and trying to get an inkling as to the probability that an analyst's opinion is going to change "officially."

We can debate the worth of such activities and whether any lasting value is created from them, but they are common features of the business, yet at odds with the regulatory framework for published research opinions. (I'll leave enforcement considerations to the regulators and engage in other sorts of idle speculation.) In years past, when the operating decisions of the big brokers were questioned, someone would always say that they were the smartest people around and knew what they were doing (with the implication that the questioner did not). Surely the events of the last two years put the lie to that, so it's a bit more comfortable to doubt their wisdom.

The Rolling Stone article talked of Goldman's stated interest in being "long-term greedy," and I'm sure that it believes it is doing so by adopting policies that favor its most important clients, thinking that some version of the 80/20 rule applies and that it makes sense to cater to the few with the greatest economic heft. My advice: If you want to restrict services, fine, but be upfront about your actions, distinguish the differences among the services, and tell clients why they are or are not eligible. Otherwise, if you have clients entitled to research, a push of the button makes it available to all instantaneously. Pretty simple stuff.

The practice of skirting the edges of regulations, client relations, and possible conflicts of interest, so much a part of the Wall Street model of yore, needs rethinking, even at the cost of near-term profits. It simply hasn't worked, other than to allow for outsized payoffs for the edge-pushers (until the inevitable retrenchment due to enforcement action or market failure). It's not long-term greedy, it's long-term stupid.

It also puts a strain on spokespeople for the firm, who have to do semantic gymnastics when the stuff inevitably hits the fan. In defense of its selective disclosure of the signals called in its huddles, a Goldman representative said it doesn't want to "overload" its clients -- do they really believe that? Let the clients decide what's important and how to filter it. And, while you're at it, please don't use price targets in an ill-conceived way to talk about why the short-term ideas from the huddles aren't in conflict with the long-term published outlook. Those targets are usually meaningless (a topic for a future posting) and no one believes that they provide an explanatory blanket for anything.

All of this is not to say that I think that today's system of regulation regarding research and its relationship with trading and investment banking is the best one possible or reflects the changes over the last couple of decades in communications technology and the investment business. It isn't and it doesn't. But I do believe the game of cat-and-mouse that brokers play with regulators and clients is the wrong way to improve things. Yet that is the game that they are taught to play and, in this case, Goldman and those that copy it are back at it again.

[1] This terminology is quite timely as well, with the impending start of the football season, which this year features dazed and confused Minnesota Vikings fans cheering for the guy with the funny name that they used to shout epithets at.
[2] Wall Street Journal : This is a subscription article, but there are a variety of summaries available on market blogs.: http://online.wsj.com/article/SB125107135585052521.html
[3] Disclosure: I have been an independent consultant under the settlement, the final reports of which are now being written. I guess that means I have some available time should this trigger another regulatory action.
[4] the research puzzle : This posting focused on how little progress there had been in creating better reports during the electronic age.: http://researchpuzzle.com/blog/2009/01/14/frozen-in-time/

in a number

tom brakke — Thu, 20 Aug 2009 17:28:28 +0000

Returning from a hiatus, it is always hard to grasp the markets. The nuances are certainly not apparent at first look, and even the big picture can appear quite a bit different than it had only a short time before. The "tells" are harder to tell and the story line not as easy to discern.

To return to the golf analogy at least one more time,[1] it is not dissimilar from trying to understand what was going on at the PGA Championship last week while doing my duties for the championship and the club. I was up close with the players at times, but elsewhere on the grounds at other times. I could see things that most people couldn't, but I actually had less of an idea of some developments than those watching at home.

Even for those glued to their televisions, I doubt that many thought that Padraig Harrington would be lost at sea for the second week in a row, since he looked so solid. (Like market players, he should have brushed up on his history, since getting too aggressive on Hazeltine's eighth hole has cost others championships over the years.) The dynamics of the battle between Tiger Woods and Y.E. Yang was another matter entirely. Most thought that one would pull off incredible shots and the other would fold, it's just that we had the roles reversed because we were conditioned to believe that was the order of things. Some inklings of the surprises to come, those "tells," were available to the viewing audience getting close-ups of the players' behaviors and reactions, but most didn't believe them.

That all changed when Yang hit his magnificent shot into the eighteenth green. When it landed, the realization was instantaneous: Our assumptions were all wrong.

One of the challenges of the investment business is playing the odds yet preparing for different outcomes. Too often we fail to see the whole picture, and it's easy to become a "special kind of dimwit" by ignoring all of the possibilities.[2] We've seen a lot of that in the two years since the first cracks in the market appeared.

As behavioral finance has taught us, we often grasp at rules of thumb and anchor to that which we think we know, even if it is no longer representative of the world. Time will tell if this year's PGA will mark a turning point in the career of Tiger Woods or the future of men's professional golf. The possibility exists. His 14-for-14 record of winning when leading major championships going into the final day seemed to indicate something on which we could rely. But it did not.

And so, back to work we go. One of the first things I saw this morning was this sentence from a market commentator: "Asian stocks renewed gains after a sticky week so far, with the Shanghai composite rebounding, moving out of the bear market territory it hit yesterday with yesterday’s losses." It's amazing to me that such drivel is published on websites and in the leading newspapers of the day and said on financial television by otherwise cogent commentators. Unlike the Woods record, which actually meant something, a market being down twenty percent means nothing in and of itself, and those who persist in ascribing some mystical properties to that demarcation are useless as guides.

What's in a number? Most of the time, less than you think. The world changes and you best be prepared for it.

[1] the research puzzle : My last effort, "competitive keys" focused on attributes featured in the Tiger Woods Accenture print advertisements.: http://www.researchpuzzle.com/blog/2009/08/10/competitive-keys
[2] ABC News : The Irish betting parlor Paddy Power paid out early on Woods as the winner and used that phrase in announcing its unforced error.: http://www.abcnews.go.com/Travel/story?id=8355486

competitive keys

tom brakke — Mon, 10 Aug 2009 15:37:34 +0000

At the beginning of the year, it was possible to hope that Tiger Woods would be arriving at Hazeltine National Golf Club this week with the opportunity to capture the elusive calendar Grand Slam and also tie Jack Nicklaus for the most professional major championships ever won. Alas, it was not to be.[1]

Golf is under a lot of pressure these days, with rounds played down and equipment sales down and corporations somewhat afraid to attach their names to tournaments -- even though such support is usually effective brand advertising and local charities benefit greatly as a result of a successful event. This posting, however, is not a "state of golf" one, but a reflection on the dynamics of the game, which has never suffered for a shortage of analogies to life itself. Others have commented that the quality of the literature about a sport varies inversely with the size of the ball used, and there is much for writers of all kinds to plumb in golf.[2]

Similarly, Accenture has used Woods in a string of clever advertisements that explore the human elements of the game in ways that define the nature of play on the course and in business.[3] They are presented as simple percentages of two important competitive attributes making up a whole, so one could spend a lot of time quibbling about the numbers. For example, is golfing really 75% thinking about reward and 25% thinking about risk? I know that at Hazeltine you generally need a healthier respect for what can go wrong than that, and that's probably true in the markets as well, as we have discovered.

Many of the word pairings in the campaign are reflective of themes that I have written about since starting this blog, like agility versus stability, information and interpretation, right brain and left brain, and "what you did" as quite unimportant compared to "what you do next." A couple of the Accenture ads seem appropriate to golf and fit with the campaign, but are not as transferable to business. Lining up a putt is more than just heart and nerve (there's slope and grain and even wind to consider -- and the feel of the green through your feet), and while there are certain business tasks that come down to those two factors, most don't.[4]

Of all of the messages, this is the one that seems most important to me (at least now):

Finding that balance is so important. Many business opportunities and investment ideas are studied to the nth degree, with each piece of additional minutiae examined with a microscope -- even though there may be a very simple factor that is all that really matters in the end. Conversely, an observer of the markets is confronted by lots of electronic chatter these days that indicates that many make trades based upon only the scantest of information, with "a whim and a prayer" the apparent analytical approach.

Is 50/50 about right? As always, it depends on the situation, but that seems a good starting point. Having a healthy balance between macro and micro perspectives -- and a willingness to see the wisdom of either approach -- is as important in business as it is in golf. Sometimes you get to hit a booming drive to a wide fairway and at other times you must tap the ball five feet with a perfect combination of pace and target or you will miss a shot that looked easy but wasn't.

Those with a complete game tend to win.

[1] Much to my chagrin, since I am the chair of Hazeltine's Heritage Committee.
[2] the research puzzle : I took a crack at it once before, counseling investors and firms to consider what to do when they are "out of position.": http://researchpuzzle.com/blog/2008/07/16/out-of-position/
[3] Accenture : The campaign has evolved somewhat recently, with the inclusion of "economic adversity advertising." This link is a gateway to all of the ads referenced.: http://www.accenture.com/Global/About_Accenture/Company_Overview/Advertising/default.htm
[4] Still, I like that ad, and think that the pounding of the heart and the calming of the nerves provide nice imagery and do fit in some circumstances. Imagine the moment of stepping up to a podium to give a speech.

the sand-castle issues

tom brakke — Thu, 06 Aug 2009 18:23:54 +0000

The markets prove endlessly fascinating, often because the life cycle of an idea can be so unpredictable, especially as to duration. Some gradually take hold and hang around for years, like the low-volatility, "great moderation" meme that was so widely believed earlier this decade -- or the buy-and-hold religion that reigned supreme for a good long time. Other notions arrive quickly and capture attention like a giant magnet, only to lose their power to attract in no time.

Figuring out the nature of the market sociology is a fun exercise in and of itself, but the real payoff obviously comes from betting wisely on your observations.[1] Anticipating the arrival of ideas in the mind of the market is particularly tricky. Take, for example, the abrupt awareness of the issues surrounding high-frequency trading. The debate changed overnight, and now everyone is talking about it and, if the papers are to be believed, something will be done about it soon. (Hopefully, even more details will follow on exactly what "it" is, what should be done, and why.)

On the flip side, knowing when to exit an investment means judging how long its supporting theses might be believed -- are they resistant to change and only subject to erosion after long years of wear, or will they be washed away shortly by the tides, like today's sand castle?[2]

A scant five months ago, it looked like the beach was littered with ships. Not ones built from sand -- or even wood that would rot away over time -- but hulking destroyers made of steel that had run aground and looked to stay on shore forever as stark reminders of risky behavior. It was a grim landscape and there was no hope of the mess being cleaned up any time soon. Yet today it is as if a great flood came and washed the debris away.

Investors and investment organizations can easily get caught up in the norms of the day, especially when chasing relative performance. One result is an inability to make an independent judgment on what is transitory and what is longer-lasting, resulting in reactive decision making rather than a judicious weighing of the odds.

At any given time, there will be issues and ideas that are central to the belief structure of the market that will be washed away, literally overnight. Which ones that shape your view (and portfolio) today are most at risk from a rising tide?

[1] Don't worry. As is always the case, this is not a blog of investment advice, but of advice on the process of investing, so there will be no hot tips for you.
[2] I must come clean and admit that the title of this posting stems from that great source of inspiration, misheard rock lyrics. Specifically, I was wrong for many years in thinking that the headline phrase was included in Jethro Tull's Thick as a Brick. Alas, it was actually "and the sand-castle virtues are all swept away / in the tidal destruction, the moral melee," which made more sense given the concept behind the concept album.

in lombard street

tom brakke — Mon, 03 Aug 2009 12:42:27 +0000

It seems like I read all of the time and yet the books and other materials keep piling up, partially because the electronic flow has me engaged, sometimes productively, many times not.[1] So, I thought I'd attack the problem by integrating bits of a book into my cyberstream via DailyLit, a service that will send books to you one installment at a time.[2]

The book I chose to have arrive each day (precisely as the noon whistle blew) was Lombard Street: A Description of the Money Market, by Walter Bagehot, a seminal work from 1873. While the mechanics of banking take up much of the work and are still valid in many respects, the inescapable conclusion is that the thing that has changed least since its writing is human nature. The failure of Overend, Gurney and Co. was much like those of our time, with protagonists that owned "great estates" and earned "immense income." They lost it all, "And these losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better."

The pattern seems eternal:

The first taste is for high interest, but that taste soon becomes secondary. There is a second appetite for large gains to be made by selling the principal which is to yield the interest.
So long as such sales can be effected the mania continues; when it ceases to be possible to effect them, ruin begins.

But before that ruin, there is the excitement:

Such a period naturally excites the sanguine and the ardent; they fancy that the prosperity they see will last always, that it is only the beginning of a greater prosperity. They altogether over-estimate the demand for the article they deal in, or the work they do. They all in their degree -- and the ablest and the cleverest the most -- work much more than they should, and trade far above their means.

It is when the bankers finance the party to an unwise extent -- and party hardy themselves -- that things get really ugly. Bagehot stressed the need for real managers who understand risk.

As private banking became bigger and more complex in Bagehot's day, the London banker, in archetype "a certain union of pecuniary sagacity and educated refinement," had moved away from taking on personal liability to a more corporate approach. His clients became more removed and their trust in him came more from reputation than knowledge, with the reputation being for that of the firm rather than the individual. It all became too distant: "Probably not one-thousandth part of the creditors on security of Overend, Gurney and Co., had ever expected to have to rely on that security, or had ever given much real attention to it."

On the macro level, Bagehot wrote of what the Bank of England should do, as the "lender of last resort" (the need for which we apparently will never get away from), and speculated on how the oversight of the banking system could be better, while realizing:

A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it, or because books are written against it.

Time and again, we stress the system near the point of failure, then tweak it in response. There must be a better way, although I'll leave that to others to profess. It seems impossible to do the big things and the politicians and regulators and monetary authorities don't have the nerve to take the punchbowl away when the party really gets going.

Maybe they should hand out a few old books instead.

[1] the research puzzle : Here are some postings I did on the use and misuse of tools.: http://researchpuzzle.com/files/view/tools-series.pdf
[2] DailyLit : In a nice bit of circularity, the service is really the same as the serialization in newspapers in days gone by.: http://www.dailylit.com/

first name basis

tom brakke — Thu, 16 Jul 2009 17:29:46 +0000

It happened again this week. The market moved because Meredith had spoken.

Correctly anticipating the strong earnings of Goldman (no last name needed there either), Meredith got the week's move going with her attention-grabbing upgrade. I have no idea whether it will in retrospect be seen as a good call or a bad one, but it does provide me with more fodder for another look at our fascination with market gurus.[1]

An important inflection in the guru curve seems to come when everyone calls them by their first name. Of course, some market participants really do know these icons by their first names. They talk to them on a regular basis as part of their jobs and it would be unnatural to use their last name when talking to colleagues. It's when the rest of us start doing it too that the inner "Danger! Danger!"[2] alert should go off.

Remember Elaine, who could move markets just as well? And Abby, who rode the big bull that lumbered off into the sunset? And Henry, too.

No, not the dot com Henry who, despite being banned from the securities industry has carved out a nice spot for himself commenting on it,[3] but the earlier Henry, the "Dr. Doom" of the 1980s. He made the bond market move with every statement, and the stock market followed in suit. That another Henry took over the spotlight a decade later with a radically different mindset and approach said much about the changing nature of the world and the markets. He could make things jump too.

We don't just love and follow our market gurus, but our business ones as well. Jack was the man for many years -- the earnings always came in, the stock always went up. You still see him on the tube every now and again, but Jack isn't as Jack was. He was the best known of a whole crop of chief executives of large and famous firms who retired just before the music stopped at the turn of the century. Timing is everything; most of us wish ours had been as good.

And then there was Bernie. No, not that Bernie. This one kept rolling up telecommunications companies as "his" stock kept skyrocketing. It was amazing that everyone in the investment business just called him Bernie, and were all wide-eyed when they did. I never understood it. Little did I know that at the same time, another Bernie was building a cult of personality, more whispered than shouted, that would come crashing down many years later. Both Bernies are now behind bars.

Careful analysis of investment and business opportunities requires a dispassionate look at situations and the weighing of opportunities and risks. While there are a few people who are adept at riding the personality waves that ripple through the markets, most get sucked in without thinking about the consequences.

It is best to save the first names for true friends on whom you will always be able to rely.

[1] the research puzzle : Among other postings, I covered this in "i hired a guru.": http://researchpuzzle.com/blog/2008/11/21/i-hired-a-guru/
[2] That was what my father would say when he was teaching me to drive and I would approach a situation when caution was in order. I still find myself hearing his voice.
[3] And, among others, to whom I am grateful for providing the impetus for a wonderful, long consulting assignment.

celebrating independence

tom brakke — Fri, 03 Jul 2009 18:10:28 +0000

In times of plenty, the fireworks that are endemic to the holiday we celebrate this weekend get more extravagant each year and serve as emotional bursts of wonder and pride. This year, some communities have cut back or eliminated them altogether, and where they are proceeding as before, some might think of the displays as "a waste of gunpowder and sky."[1]

As representations of the ideals and spirit that formed and have sustained this country, the fireworks are subject to our impressions and moods about how things are going politically, economically, and in every other way. I may not see them this year, but I can hear them in the distance from my home, and they will remind me of my aunt Edith, who embodied the values at the core of the American dream, and whom we buried yesterday at the township cemetery that she tended, in the soil that she knew all of her life, full of family and friends and roots.

This has never been a personal blog, except tangentially, and so you might expect that I will find a way to the business of investments from my reflections on country and kin. It is not too hard, given that the words independence and independent are so much in vogue these days.

It all seemed to start with the Global Research Analyst Settlement (which for the most part will wind down later this month), with independent research being selected by independent consultants (of which I am one), and independent "monitors" gauging whether the settling firms have complied with the operational aspects of the court order in addition to the research ones.

Of course, the failures of corporate governance earlier in the decade also brought lots of talk about the need for independent board members at corporations, and whether the roles of chairman and CEO should be separated to reduce conflicts of interest and the agency costs that have arisen because of misaligned incentives.[2]

One long-standing perversion of the term involves the boards of mutual funds, which are supposed to be independent, but are too often anything but. I was once asked whether I had an interest in being on a mutual fund board, and it is telling that I was contacted not by a representative of the board, but by a representative of the investment adviser that manages the fund. Even in the wake of the mutual fund timing scandals, this conflict seems to never end.[3]

Of late, so-called independent broker-dealers are the rage, as the big firms lose financial advisors and many (including me) have set up independent advisory firms over the last few years. The question with all of these is, what's in a name? Just because you call yourself independent, is that the case?

On the one hand, all of us have conflicts of interest of one kind or another. Disclosure and the application of fiduciary standards are necessary but not sufficient to deal with those realities; character and honor are what matter in the end and, unfortunately, tough regulations are needed to deal with the scofflaws.

But just as important is an independence of thought; the common lack of it is actually a bigger problem for the industry than illegal activity. Something described as an independent approach, but which really isn't, seems to lack danger, but is full of it.

One definition of independent is "free from the influence, guidance, or control of others; self-reliant." That doesn't mean that someone has to go it alone, but it does mean that if they are part of organizations, they must be forceful in their objections, always willing to stand up for what is right, and ever ready to remind others of the principles on which decisions should be made.

My aunt Edith was a joiner, and seemed to be an active member of every community organization that you could list. She didn't join to socialize or to capitalize, but rather to make sure that things were done that should be done. Her actions were always subservient to her own interests.

We can proclaim independence and celebrate it, but living it in our actions is much harder, yet that is what the investment industry needs today.

[1] The phrase is courtesy of Aimee Mann, from the song "4th of July" (Whatever, 1993).
[2] the research puzzle : For new readers, I did a series of postings on misaligned incentives throughout the investment business. This is a link to the index of them, which includes the summaries received by those who get notifications of postings via email.: http://researchpuzzle.com/files/view/incentives-series.pdf
[3] Investment News : This, for example, is one recent announcement.: http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20090630/REG/906309970

the card player

tom brakke — Tue, 23 Jun 2009 21:35:57 +0000

Sunday's New York Times featured a lengthy article about Bill Gross, he of the draped necktie, and Pimco, the powerhouse bond manager he made in his image.[1] While much of the ground has been covered elsewhere, it is a worthwhile read for its window on the state of our financial system and the world of money management.

On one level, there is the guru culture of which I have written extensively (for example, in "i hired a guru"[2] and "in him we trusted"[3]) and which Gross has played very well throughout his career. His youthful success in Vegas is the stuff of legend, and he plays his cards as well as anyone -- and has the extra advantage that he shares with Warren Buffett (his friend, according to the article) of being able to play them differently simply because of who he is.

His story is also the story of fixed income, a once-staid backwater of the markets that has grown increasingly complex and important since Gross started as a junior credit analyst. It often seems like 95% of the attention is on the equity market and 95% of the really important stuff is happening in fixed income, something that most financial journalists and bloggers realize only at times of absolute crisis.

The story says that Gross has "always been partial to mortgage bonds." I have traditionally been wary of mortgages, because you get more cash flow when you don't want it (when rates are dropping and prepayments on mortgages are plentiful) and little when you do (when rates are rising and you could reinvest at higher levels). Plus, with lots of dangerous structured product out there putatively in the "mortgage" arena, it was easy for the unaware to get clobbered. You can't just play along in the mortgage market, and Gross and Pimco have demonstrated a mastery of it.

The article is light on the secret of his success, but Alan Greenspan (yes, the subject of the very same "in him we trusted" cited above) is quoted on Gross' individualistic nature, and the opening paragraph shows Gross isolating his "lieutenants" in a daily meeting, away from computers and cell phones, to think and plan. Time and again over the years, Gross and Pimco have been ahead of the curve, unafraid to consider new possibilities and take bold bets. In my opinion, that is the single biggest factor in their success, and a great difference from most investment organizations, where ideological, product, and price trends are clung to for much too long.

The card player looks for shifting odds and the right times to make a move. He also is very good at talking his hand; "talking your portfolio" is always expertly done by Gross, be it in his written commentaries or via his distinctive voice on CNBC or elsewhere.

Of course, the main thrust of the article is that Pimco and Gross hold and wield tremendous power as the government tries to stabilize the financial system and cement the footings of a new prosperity. The bond market vigilantes of yore gained fame in their ability to affect monetary and fiscal policy. Now we have firms, with Pimco dominating, who are too big to ignore in crafting the solutions to our many financial problems. It's very hard to argue that they shouldn't be consulted or hired -- they have demonstrated an expertise that is sorely needed -- but you'd have to bet that Gross sees a payoff matrix that he likes for Pimco and for himself.

No one can fault him for that, but you come away wishing for something else. Had the dealer and the house not allowed the game to get out of control, we wouldn't be thinking that our only way out was to peek over the shoulder of the smartest guy in the room.

[1] The New York Times : It was titled, "Treasury's Got Him on Speed Dial.": http://www.nytimes.com/2009/06/21/business/21gross.html
[2] the research puzzle : As I say, "a guru is a consultant." It pays to keep that in mind and not fall in love with him.: http://researchpuzzle.com/blog/2008/11/21/i-hired-a-guru/
[3] the research puzzle : During a recent guest lecture to MBAs, I asked students to fill in the "in [blank] we trust" for today's market. One said, "Bill Gross.": http://researchpuzzle.com/blog/2008/10/26/in-him-we-trusted/

commencement exercises

tom brakke — Thu, 18 Jun 2009 13:58:56 +0000

For those anxiously awaiting my next posting on the use of academic research by investment professionals (and who have waited a prolonged period of time for it), the title of this entry may seem like the end of the series. To quote virtually every commencement speaker ever, this is not the end, but a beginning. We commence from here.

In fact, it does mark the start of my second year of blogging, and also a change in the series on academic research, new chapters of which I will intersperse with other material going forward, rather than in sequence.[1] It also marks the start of a new investment advisory business of mine. It will provide more fodder for writing, although this space will not provide investment advice and will continue to focus on the "how" rather than the "what."[2]

In the interregnum since my last posting, I attended commencement exercises at a famous institution of higher learning. Such events are always a time for reflection, but especially in places where the aged ivy on the walls was growing when legendary people who shaped the world received their degrees nearby. On the prairies of my youth, the quartzite that pokes out of the ground has lichen that grows an inch every hundred years. It inspires awe by its natural simplicity; the ivy is different, attesting instead to the evolution of the institutions of man.

Many of those institutions, especially those at the center of the investment business, have been rocked in the last two years. To wit, the undergraduate and doctoral students whom I watched receive their degrees in "operations research and financial engineering" probably wish that the last three words had never been added. Many in the audience were probably either quick to judge them for choosing such a now-vilified field or else felt sorry that they'd likely not get jobs on Wall Street until the next great rush to riches.

To hear the college president acknowledge that the still-formidable endowment could not lay as many golden eggs as it has in recent times was to be reminded that even venerable institutions fall victim to fad and fancy. The lessons of earlier years and centuries, borne of wars, panics, and depressions, must be learned once again -- and taught once again. They always seem to be forgotten when they are needed the most.

Thankfully, it's impossible to be around such an incredible crop of graduates and not feel hope about the future. They will come up with the good questions that start the discovery process, as they were urged to do in the valedictory address. For those that manage to get into an investment business still bloated with too much capacity, those questions will hopefully be a refreshing change from the standard fare of the recent past.

The process of investment is complex, nuanced, and ever changing. To sell securities, funds, or whatever, the industry became adept at wrapping them in simplicity and selling them like soap on a shelf. It has also been willing to peddle orthodoxy rather than innovation. It took the calamity of recent times for there to be much introspection at all, yet many firms continue to act like nothing happened.

As every graduate is told, the real world awaits. Let's see what you can do.

[1] the research puzzle : The postings to date in the series on academic research can be found via this index.: http://researchpuzzle.com/files/view/incentives-series.pdf
[2] tjb advisors : Early readers of this posting can click through to a simple page that summarizes the advisory offerings; a complete website will be up soon.: http://www.tjbadvisors.com/