Friday, June 12, 2009

Researching Investments

We briefly touched on how to research investments in our previous discussion, but will do so more thoroughly here.


As we said before, the first consideration regarding research is independence. Why? Let's think for a moment about the way investment banks (now chartered as commerical banks, by enlarge, but still fulfilling the primary roll of raising capital for publicly owned businesses) are structured.

The part of brokerage firms with which women are most familiar is that of the investment advisers. This consists of brokers who invest money on behalf of clients, and either:
  • Earn commissions for buying and selling securities; or
  • Earn a commission based on a percentage of assets under management.

In a related part of the firm, the brokerage earns fees from companies for raising money for them by

  • Selling ownership in the company (stock) to their brokers' clients
  • Borrowing money for the company (bonds) from their brokers' clients
  • Providing strategic management advice to the company about their capitalization (stock and bonds outstanding)

In a separate part of the firm, the brokerage owns stocks and bonds in its own account, and buys and sells those securities to make a profit.

In an additionally separate part of the firm, the brokerage provides investment advice (buy and sell recommendations) to its brokers and to the general public.

While legally, there is a "Chinese wall" separating these various functions in a brokerage firm, it is apparent that there exists the possibility that, if a brokerage wanted to sell a stock from its own account, its analysts could be encouraged to provide a "buy" recommendation on that stock in order to provide both a market and favorable price to sell that stock to its brokers' clients and the general public who follows its research. I am not saying that this does happen; rather, I am saying that it could happen, and therefore there is the a possibilty of impropriety.

Remember, too, that Standard & Poor's and Moodys both provided their highest ratings to so-called Auction Rate Securities, securities that were backed by mortgages, some of which were sub-prime. When reviewing the procedures used to qualify for that rating, it became clear that the fact the issuers of those securities were paying fees to these rating agencies for the rating, resulted at least in part to receiving that highest available rating- the same as is provided to US Treasury debt. Here, the conflict of interest was obvious.

So, researcher independence is critical. Who, then, independent?

Some companies are paid for their research by their clients who are subscibers - not by the companies they analyze. The largest, and most experienced of these companies are

  • Value Line (specializing in stock research)
  • Morningstar (specializing in mutual fund research)

MORAL: Your research is best when in comes from a company that does not benefit from your decision of whether to buy or sell a security, and has a lengthy track record.

MORAL: Even if you use a full service broker, ask what research she uses. If it's not independent, neither is your broker.


Broadly, there are three types of investing: growth, value and passive.

  • Growth investors choose securities that are growing faster than the stock market as a whole, and try to take profits before any negative news causes the stock to drop
  • Value investors buy high quality but out-of-favor companies that are inexpensive because of a negative short-term situation
  • Passive investors buy an "index" that replicates the market averages, thinking that no one, after trading costs and taxes on sales, beats long term market performance

Growth investors will find Value Line stocks rated as 1 for timeliness as meeting their general criteria. It is noteworthy that, over the last 25 years, a portfolio of such stocks beat the S&P 500 average significantly.

Perhaps the most famous value investor in our time is Warren Buffett. Those securities in his Berkshire Hathaway portfolio are examples of long term value investing. For individual stock research, Mary Buffett's "Buffettology" series is a good way to learn to select and evaluate such stocks. I have worked and taught with Mary, and find her books the most accurate and easy to understand approach to learning value investing research and principles.

Passive investors, and those who prefer to buy mutual funds can use Morningstar reports to find funds that meet their investment goals.

Value Line, Morningstar and the Buffettology series should all be available to you through your public libraries.

There are many other sources of independent research. If you choose to use one, check the author's experience and portfolio performance carefully, and ensure that both have been evaluated independently over at least ten years.

MORAL: Pick an investment strategy and stick to it. Moving back and forth (e.g., growth and value) does not work. Once you know your preferred strategy, use the best source of information available for that method of investing.

1 comment:

  1. knowing your investment strategy obviously takes research and thought.

    thank you, kitty, for sharing what you know.