Moving beyond Standard & Poor’s

Reading time: 14 – 24 minutes

In this article, I continue discussing new directions in investment research.

See: Crowdsourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowdsourcing investment research: Capital Market Taxonomy in Capital Market Wiki.

Two basic tasks in security analysis

New Technology

The first is gathering facts about the security.

With the facts in hand, the next job is to analyze the data critically and answer the question being asked.

Current information technology and the costs of data determine how the research should proceed.

Facts: Complete and accurate

The most common way to judge the effectiveness of an analyst depends upon ex-post results relative to the analyst’s recommendation, compared to results of competing analysts.

Reasoning skills being equal, the analyst with the most complete and accurate information should have the best relative performance.

Analysts can not compensate for incomplete or inaccurate information — and it costs time and/or money to obtain quality input. As Bernard Baruch, the famous Wall Street speculator of the early 20th century put it:

“Every man has a right to his opinion, but no man has a right to be wrong in his facts.”

“If you get all the facts, your judgment can be right; if you don’t get all the facts, it can’t be right.”

The larger and more varied the investment market, relative to the analyst population, and to the level of technology applied to securities research, the higher the cost of gathering facts and the greater the chances that superior opportunities may be overlooked.

In other words, complex markets that have more information than can effectively be handled by the average analyst are inefficient. Inefficient markets have more opportunities waiting to be discovered than efficient markets.

Research in Ben Graham’s time

In 1934, when Benjamin Graham, the legendary security analyst and teacher of Warren Buffet, published the investment classic, Security Analysis, the US SEC had recently been created and the first rules on disclosure were being issued.

Most information about securities was not free and, compared to today, was difficult to obtain.

Paper spreadsheet

Registration statements and offering documents submitted to the SEC were available to the public only in SEC reading rooms in selected cities.

To get this information, the analyst had to go to the SEC, find the document, request a photocopy, and pay copying costs per page.

Once you had the document in hand, financial analysis consisted of copying numbers to a paper spreadsheet, summing columns by hand or with a non-electric adding machine, and calculating ratios, also by hand, or perhaps by using a mechanical calculator driven by a little crank.

Adding machine

Stock prices were delivered on a telegraphic printer, called a ticker, on a long band of paper.

To create a graph of stock prices it was necessary to plot prices and volumes, one by one, on graph paper.

Calculations of present value, bond interest rates, or annuities were done by using little volumes of financial tables.

Everything was paper-based. Newspapers clippings were annotated, pasted on backing paper, and filed. Some subscribed to clipping services.

Analyst with paper spreadsheets, files, and a stock ticker

Not only was financial information hard to get at and work with, there was far, far less of it than today. Corporations were much simpler.

There were no organized exchanges for financial derivatives.

Products like asset-backed securities, index funds, and swaps were not available. Most markets were local, only 5% of the population invested in equities, and far fewer companies were listed than today.

Early publishers of financial statistics

In 1860, Henry Varnum Poor published a book on the “History of Railroads and Canals in the United States”. In 1906, Standard Statistics Bureau was formed to publish previously unavailable data on U.S. corporations.

1910 ad for 'Standard' stock index cards

In 1910, the Standard Statistic Bureau service consisted of a 600-page bound 2-volume quarterly covering U.S. and Canadian stocks and bonds.

The service was also provided in the form of index cards, with updates delivered periodically.

Standard Statistic Bureau advertised the dual convenience of having hard to get information gathered into one place, but also having this information indexed and filed — what served the purpose of a database in those days.

This early service proudly proclaimed that only facts, not opinions, would be delivered:

No advice on the market, no “tips” but every bit of authentic information that can be obtained from any source about any one or any number of securities in which you may be interested.

The data was not only hard to get (requiring trips to libraries, archives, and corporate headquarters and tedious hand-copying of data and payment of copying fees), but, in terms of the market at that time, quite complete.

Western Union report 1910 (Standard Statistics)

Of course, there just wasn’t that much information available.

A typical Standard Statistics report (on Western Union, a leading stock at the time), shown on the right, had:

• Unaudited four year income statements with five items: Gross revenues; Operating expenses; Other income; Interest on bonds; and Dividends.
• Unaudited two year balance sheets with 22 items, divided between assets and liabilities.
• High and low stock prices of the last nine years.
• Dividends paid with dates.
• Directors’ names, addresses of the company, transfer agent, etc.

The entire 1911 Western Union “Standard Statistics” report could fit into a single item on a footnote to an auditor’s report on public companies in today’s market.

The economics of financial publishing

Comparing the photo (above) showing the messy office of a stock analyst in the early 20th century, with the “modern” convenience of Standard Statistics “index card” system of hard-to-get data covering most of the US and Canadian securities markets, it would seem that statistical publishing was a pretty good business opportunity.

However, costs of these publishing services were quite high and did not rise and fall with the stock market, whereas subscription income did.

Statistical publishers could not expand and contract coverage with the ups and downs in stock prices.

Production involved not only gathering facts, but the costs of layout, typesetting, proof-reading, printing, binding, delivery and much more.

Wordprocessing in olden times ... Click ... hiss ... Bang! Bang!

Not only were production costs inflexible, but there was a limit as to how much a subscriber could pay, based on portfolio size and average expected return on investment.

Periodic panics standardized statistics

Financial institutions were more likely subscribers than individuals, but there are a limited number of such institutions and their willingness to pay for statistical services tended to decline in the periodic panics that assailed the securities markets throughout most of the 19th and 20th centuries.

Publishers found that the easiest way to control production costs was to reduce coverage and content and to standardize output, attending to the needs of institutional clients.

Although in 1911 Standard Statistics Bureau  promised to deliver only facts, not opinions or “tips”, by 1916 the service began to include bond ratings.

The shift towards issuing opinions, away from simple gathering and presenting facts, became the dominant trend over the next century.

It is far less expensive to produce opinions than factual information, and the profit margin can be easily concealed, because the “work” that goes into producing an opinion need not be revealed, while erroneous opinions are forgotten and hidden by the passage of time, revised and “updated” opinions, and prior disclaimers — whereas the “product” of fact-gathering is obvious and errors can immediately be seen by all.

The number of companies in the business was reduced in each successive financial crisis, until today, after many mergers, consolidations, and takeovers, the financial publishing business is an oligarchy of surviving firms.

Free data, globalization, new technology

The Great Depression brought the US Securities and Exchange Commission and laws requiring full disclosure of material financial data by issuers.

Information available in libraries

The impact of the SEC on the information publishing business was only gradual, over decades, because although more information was available, it still was necessary to travel to an SEC reading room to get it.

The process of taking this information away (photocopying, or transcribing by hand to spreadsheets and notebooks), was tedious and expensive.

The SEC’s own efforts to make this information more widely available involved the selection of private sector firms that were allowed to charge investors for access to the data.

Only at the end of the 20th century, with the advent of the Internet and legislative changes requiring the SEC to make more information available without cost to investors, did the world of free information really come into being.

Yahoo Finance offers instant free information on securities

With globalization and the Internet, not only did information become free, but the amount of information exploded geometrically.

Furthermore, the nature of the information also changed, shifting from primarily official sources (such as statements from issuers, trustees, or government documents) in the early 20th century, to a far more diverse mixture of open source information, of uncertain reliability, requiring different techniques and skills to mine.

The Information Crisis of 2008

The rapid devaluation of financial assets in the fourth quarter of 2008 was characterized by a general recognition that nobody had ready information that could provide support as to the intrinsic value of a huge portion of financial assets held by investors and financial institutions.

The publishers of financial statistics, which by now were known primarily for their rating services rather than for their capacity to deliver factual information about securities, were excoriated before Congressional committees.

Treasury Secretary Hank Paulson

Secretary of the Treasury, Henry Paulson, ex-chairman of the premier investment house, Goldman Sachs, with 30,000 employees and thousands of certified financial analysts, plus contacts in every corner of the financial world, came before Congress, wide-eyed and scared, confessing that he didn’t have the slightest idea of what financial assets were worth or how to value them.

The purported bastions of financial data — Standard & Poor’s, Moody’s, and Fitch — were not even considered by Congress or the government as possibly having the answer to the conundrum of asset valuation.

Just as the Great Depression caused people to focus their minds on the problem at hand, bringing about significant, worthwhile reforms to the financial system, the Crash of 2008 is a similar event.

We will have to wait and see whether it is the government or the private sector that comes up with the best solutions to the informational crisis, and in which countries these solutions will be best implemented.

Chances for reform

The financial reforms of the Great Depression were instrumental in assuring that the United States retained the premier position in world finance throughout the 20th century.

However, the cast of characters in the Obama administration, with such people as Nancy Pelosi, Harry Reid, Barney Frank, Chris Dodd, Henry Waxman, and others, seem to lack the seriousness of purpose or intellectual capacity to enact reforms of similar stature at this critical juncture.

This obvious weakness provides an opportunity for some other country (or countries) to seize the moment and replace the United States as the world financial leader.

New technology for security analysis

A dominant aspect of security analysis today is that there is more free information available on the Internet than any analyst can effectively process.

In effect, the market has become inefficient because there is too much information to be handled by 19th century technology.

Traditional statistical financial publishers only collate and summarize a tiny drop from this ocean of data.

Most of this free information is not standardized, which means that it is not possible to send out a clerk to a reading room somewhere to copy down data from an expected source.

Special tools are needed to handle excessive information.

Instead, the task now requires a highly-paid securities analyst to dig through an endless, disorganized pile of information — a process called “open source intelligence analysis” — to find those gems of information that will provide competitive advantage in terms of insight and understanding, over less-energetic competitors.

Because the market is inefficient (as proven by the Crash of 2008), the analysts with the best tools have an advantage.

For anyone with a computer and access to the Internet — from anywhere on earth — the web-based tools to do this job are now available for free.

However, you have to know what tools are available and how to use them.

Tools for the 21st century

The essential research tool ...

The US Securities and Exchange Commission is, perhaps, the most open, free source of official information on issuers and securities in the world, although many other countries, like Singapore and Hong Kong, have institutions that compete rigorously on open source disclosure practices.

Internet access to free information varies from country to country.

In many countries, information access resembles the situation in the United States one hundred years ago — or worse. In each country, sources and means of access to information are different.

However, there is a worldwide trend towards improved disclosure via the Internet.

In some places, this movement is led by securities exchanges — in others by government regulators.

The basic tool for accessing this data is the laptop computer with wi-fi capabilities.

Subject to local laws and customs, a laptop computer can often be used to gather information, even in old-fashioned, non-digitized libraries and official archives.

However, its greatest utility comes from the ability to mine free information from any place on earth, via the Internet.

Open source software for OSINT

The first tool an investment analyst should have is a free Firefox browser with the Zotero add-on.

The Zotero add-on is a Firefox extension, developed by George Mason University and the Center for History and the New Media, sponsored by the Andrew W. Mellon Foundation and the Institute of Museum and Library Services. It serves to integrate the collection, management, and citation of research sources found on the Internet or elsewhere.

The second tool in Capital Market Wiki — a collection of web-based research tools that can be accessed from any computer, anywhere, via the Internet. Analysts may use this tool alone (in a private sandbox), or with others in the crowdsourcing of investment research.

Capital Market Wiki provides integration with the Zotero citation system, plus many other special research systems:

1. Semantic MediaWiki: A semantic database system, funded by Institut AIFB of Universität Karlsruhe, Germany and integrated with Capital Market Taxonomy by the Center for Capital Flow Analysis. This is the 21st century version of the old “Standard Statistics” index cards (see above).


Information can be presented in an infinite number of semantic tables ...



Freely create and publish spreadsheets

2. Wikicalc® Spreadsheet: A a full-featured, web-based spreadsheet, created by Dan Bricklin, a pioneer in spreadsheet technology, integrated with Capital Market Taxonomy. Researchers can analyze financial data, publish it in spreadsheet form, and access it from any computer, anywhere.
3. SIMILE Timelines: Graphical timelines used to illustrate the historical development of financial institutions and systems by simple input of data. Developed at the Massachusetts Institute of Technology and financed by the Andrew W. Mellon Foundation.


Dynamic timelines are easily created to explain events ...



Analysts can post information from anywhere

4. MediaWiki collaborative editing system: MediaWiki is the same software that drives Wikipedia, augmented for Capital Market Wiki with dozens of extensions that provide special resources for investment analysts, including charting and drawing, calendars, templates, and data tables.

Tools for collaborative research

Because there is so much free information to be harvested and organized, the best results can be expected through collaborative research that combines the knowledge and skills of people in different locations and professional backgrounds.

This opens possibilities that would have been impossible even twenty years ago.

One obvious advantage is that people who otherwise would not be considered for positions as Wall Street research analysts, now become available — for example, a stay-at-home mom in Boise, Montana or an accounting student in Kerala, India.

I’ll discuss how investment banks and other institutions may take advantage of open source investment research opportunities in a future article.

Photo credit: Information hydrant. Will Lion, Flickr.