Collaborative research

Reading time: 12 – 19 minutes

This is the sixth article in a series about Post Modern Security Analysis.

Researching comparables

Capital markets are made up of many securities. Most investment decisions, at some point, involve comparing the characteristics of one security with those of other securities.

We evaluate a pearl by comparing it to others ...

One purpose of security analysis is to determine intrinsic value, but this generally involves making comparisons with a number of securities.

Intuitively, we feel more confident in a decision if we can say that security “A” has a greater or lesser intrinsic value than security “B”, than if we were to try to fix the intrinsic value of security “A” without knowing anything about other securities in the market.

For example, if we were to invest in Company ABC, a stock in the Russian Federation, we would usually like to know the dividend payout ratio of other stocks in that market.

However, in order to make value comparisons, we need to have research available about many comparable securities — often more than we can possibly research alone. Therefore, we come to depend upon not only our own research, but on research done by many others.

The need to reduce the cost of researching comparables is the reason for collaborative research.

Parallel sources

When researching comparables, useful facts are often uncovered relative to the primary target of a research project.

For example, if we are studying the common stock of “ABC”, a health-care REIT, a parallel study of other health-care REITs will probably reveal useful information about the health-care REIT business, not found in a direct study of sources about “ABC”.

Useful facts in parallel research ...

If we follow the research techniques suggest in Part Five of this series — posting our findings to separate “folders”, by topic — from parallel research, we will develop a fact-rich folder on the topic of the health-care REIT line of business that will greatly facilitate our analysis of target “ABC”.

The type of useful information revealed by such “parallel research” might include:

• Operational procedures
• Relevant laws and regulations
• Business risks
• Competitive advantages
• Economic constraints
• Market size and growth

However, to get at this valuable “parallel information” requires much more time and effort than an individual analyst would normally be able to expend.

The help of other researchers is necessary.

Traditional collaborative methods

The traditional way to acquire expanded research has been to buy it from financial statistics publishers, such as Standard & Poor’s and Moody’s. This has been the earliest and simplest form of “collaborative research”.

By dividing the cost of a researcher among thousands of subscribers, expanded research became more affordable.

S&P provides research for a fee ...

However, publishers of financial statistics face a serious and intractable marketing problem — demand for published research services declines in falling markets, sometimes for long periods.

Faced with periodically falling revenues, publishers were led to reduce costs by restricting coverage.

Since researchers are high-cost employees, often credentialed and in limited supply, to hire and fire researchers with the ups and downs of the market would damage staff morale, perhaps resulting to lower quality of research personnel. To keep the best people, a statistical publisher must reduce the output of services to a level sustainable in market downturns.

Solutions to this business problem have been:

1. The substitution of opinion for factual research. Opinion, in the form of ratings, is far less expensive to produce than factual research. Publishers also stabilized income by making the issuers (the subject of these opinions) pay for ratings in up and down markets. This, of course, created a conflict of interests that degraded the quality of the product.
2. The reduction or elimination of coverage of securities that are not actively traded or of issuers that don’t pay for ratings of their securities.
3. The reporting of only basic financial data, price information, and the opinions of others about the reduced segment of the market that is covered.

Government intervention

In the United States, the economic position of a few publishers of financial information has been significantly improved, from the publisher’s point of view, by government intervention:

• Insurance company and pension fund regulators have restricted inclusion of issues in portfolio to “rated securities”.
• The US Securities and Exchange Commission has restricted the issuance of ratings for regulatory purposes to a few Nationally Recognized Statistical Rating Organizations (NRSROs).

The result has been the establishment of an oligarchy and the rise of the marketing of ratings as opposed to the much more costly publication of factual information.

According to testimony in the US Congress in 2008, reduced competition and conflicts of interest have led to a decline in the quality of the research product.

The failure of the NRSRO system

The NRSRO system began in 1975, just as complexity in security markets began to take off (financial derivatives, asset backed securities, global trading, emerging markets, and so forth).

A heavy burden ... information overload.

By the 21st century, the NRSROs were far behind in filling the market need for collaborative research of factual information, while confidence in the value of published ratings — essentially opinions — was falling.

Furthermore, the NRSROs operated on a model of copyrighted publications, restricting access to their factual research to subscribers.

For most small investors, NRSRO full-service subscription fees were high when compared to the amount of assets they have to invest.

This increased in inefficiency of the market.

The Crash of 2008 highlighted the failure of the NRSROs to fulfill the collaborative research function. However, neither the regulators nor the traditional market institutions had developed an alternate model of filling the research gap.

The US SEC publishes raw source material on the Internet, but millions of documents are involved and essential information is buried behind abstruse SEC filing codes, legal declaimers, and repetitious boilerplate.

Changing times called for new solutions.

Innovative approaches

When Standard Statistics (the ancestor of Standard & Poor’s) began publishing financial data in 1906, it would have been difficult for an analyst in Boise, Idaho, another in Hong Kong, and still another in Rio de Janeiro to easily collaborate in an investment research project, based on sharing the work to be done.

International cable ... fast, but very expensive.

International communication was extremely expensive (each word in a cablegram was counted and charged) and regular international mail could take weeks. The cost of quickly sharing research files across oceans was prohibitive.

A hundred years later, all this has changed. An analyst can share a thousand word document with another at the far side of the earth, instantly and for virtually no cost.

Today, there are readily available, proven computer systems for collaborative research (wikis) that can bring together analysts from across the globe, with extreme efficiency and insignificant cost.

This opens the door to collaborative shared research through networks, in place of the traditional subscription service model.

The paradigm of shared research

One paradigm of modern collaborative research is Wikipedia — a general purpose, multi-lingual free encyclopedia with articles contributed by unpaid volunteers for the common good.

The Wiki concept

Starting from scratch in 2001, by 2009 Wikipedia had 13 million articles and 75,000 active contributors.

The quality of the articles varies considerably, but there are thousands of articles that have been compared favorably with traditional publications such as Encyclopedia Britannica.

With adaption and special extensions, the same software that drives Wikipedia may be used for collaborative investment research.

The idea of collaborative research has now been tested in a variety of contexts with notable successes, from Linux software to the Human Genome Project.

In each case, the motivation of the participants is different as is the design of the collaborative effort and the tools employed.

One model for collaborative research is open source software, where participants voluntarily contribute to the development and maintenance of a product that is then made available without cost to anyone. In some cases, the value of voluntary contributions is in the hundreds of millions of dollars.

To those thinking in terms of 20th century capitalism, such sharing of valuable services seems contrary to entrepreneurial self-interest. However, this is not the case.

Facts vs. informed opinion

Security analysts may collaborate in creating open source investment research, publishing their product on the Internet, providing free access to investors worldwide — and still realize substantial economic benefits.

By publishing factual research without charge, researchers draw attention to their command of a subject, as well as attract other researchers to participate in the collaborative project, expanding the base for expertise and critical review.

Writing requires higher skills than reading ...

Facts that might cost $100 to gather may be worth only $10 on the open market to readers, while opinions based on these facts may only cost an additional $10 to produce, while finding a ready market at $200.

Most investors lack the skills, experience, or confidence necessary to commit their life savings to their own analysis of investment information. The market value of reliable factual information to the ordinary investor is far less than the advice and opinion of a reputable analyst, based on this same information.

The researcher that produces the facts will understand how to interpret them, judge their validity, and reach a conclusion as to intrinsic value far better than a lay reader who only has access to the published factual information, without the benefit of having invested time in researching original sources and in working with other collaborative researchers to answer questions that require special expertise.

A comparison might be made to the field of medicine, where medical know-how is freely available on the Internet and in libraries, but where, nevertheless, most people would prefer the opinion and skills of a physician over trying to make a medical judgment on their own limited study of a topic.

Here's the facts ... Are you ready to operate?

Researching open source information and then writing your findings as factual articles requires a thought process of a much higher order than merely reading an article someone else has produced. The writer might have spent 75 hours on producing a page of material than the reader consumes in 3 minutes — but the reader is less likely to have as full an understanding of the material as the writer.

Each sentence the writer produces may represent the analysis of many pages of raw source material that had to be evaluated, and understood.

The research writer will be able to ascertain the reliability and relevance of the facts presented from subtle clues in the raw source material, by comments of other collaborative researchers, and by the effort of transforming notes into sentences, citing sources and paying attention to logical consistency.

Access to special expertise

There is no “capital market expert” who fully understands all the financial, operational, legal, and accounting factors that effect the intrinsic value of securities in the global market.

The market has become too vast and complex. Everyone needs assistance from others with specific knowledge of fields that are beyond their own expertise.

The advantage of collaborative research is not only the sharing of time cost, but — perhaps more importantly — the sharing of expertise.

A lawyer in Hong Kong perhaps will usually not be familiar with regulations on municipal securities in the United States, while an expert in settlement systems in Europe might know nothing about security laws in India.

To get specialized knowledge on securities across international borders requires people with local expertise, as well as specific language skills.

Collaboration calls upon many different skills ...

Post Modern Security Analysis adopts a more holistic approach to the subject than the security analysis advocated by Graham & Dodd. Many experts who might not consider themselves “security analysts” can make valuable and essential contributions, including lawyers, accountants, operations specialists, macro economists, translators, and experts in comparative law, political systems, exchange trading systems, clearing, custody, and settlement, security administration, insurance, central bank operations, international organizations, religious law as applied to finance, and many, many other topics related in some way to capital markets.

All of this wide range of expertise must be multiplied several hundred times to address the complexities introduced by the internationalization of capital markets.

Many topics of interest to Post Modern Security Analysis are not even suggested in the curriculum for a Certified Financial Analyst designation.

Open source investment intelligence

Collaborative investment research not only calls upon many fields of expertise, but also, and perhaps more to the point, knowledge of how to exploit raw information sources.

When a factory burns down, an investor needs to know this as soon as possible. There is no time to wait for an academic study with high-level peer review. Any information is useful, whether it be a newspaper article, a blog, a message on twitter, or even someone running down the street yelling “fire”.

However, it takes a special turn of mind to deal effectively in raw information.

The researcher needs to combine healthy, high-level skepticism with an open mind and a willingness and knowledge of how to validate potential information.

In a way, an open source researcher is like a scavenger, digging through trash, looking for a valuable coin that might have been thrown away.

OSINT sources call for special tools ...

Open source research calls for special tools, techniques, and skills to extract valuable facts from raw information.

OSINT methods and techniques are well-developed in the military and espionage communities, but are less known among economists and investors.

OSINT methods, in fact, are the opposite of the Harvard Business School Case Method, in which a professor provides students with a prepared set of “facts” and calls for a conclusion.

In teaching OSINT methods, the professor presents a topic and asks students to go on the Internet (or elsewhere) and find out all that is relevant to answer a certain question.

The Harvard Business School professor calls for a quick answer, based on impartial, perhaps false information. The OSINT professor asks for an answer that represents the truth.

Organizing collaborative research

In the first decade of the 21st century, the need, the tools, and the potential for greater use of collaborative investment research are all in place.

However, the development of powerful, collaborative investment research communities is only beginning.

Next Lesson: Post Modern Security Analysis: Part Seven (Creating a Research Community)