Stocks

Three Kinds Of Analysts And What You Need To Know About Them


There are several types of "analysts" on Wall Street, and they produce different kinds of reports because they have different kinds of clients. This article will define the three main categories of analysts and briefly touch on analyst independence.
Sell-Side Analysts
These are the analysts that are dominating today's headlines. They are employed by brokerage houses to analyze companies and write in-depth research reports, conducting what is sometimes called primary research. These reports are used to "sell" an idea to individuals and institutional clients. Individual investors gain access to these reports mainly by having accounts with the brokerage firm. For example, to get free research from Merrill Lynch, you need to have an account with a Merrill Lynch broker. Sometimes the reports can be purchased through a third party such as Multex.com. Institutional clients (i.e. mutual fund managers) get research from the brokerage's institutional brokers.

A good sell-side research report contains a detailed analysis of a company's competitive advantages and provides information on management's expertise and how the company's operating and stock valuation compares to a peer group and its industry. The typical report also contains an earnings model and clearly states the assumptions that are used to create the forecast.

Writing this type of report is a time consuming process. Information is obtained by reading the company's filings for the Securities & Exchange Commission, meeting with its management and, if possible, talking with its suppliers and customers. It also entails analyzing (using the same process) the company's publicly-traded peers for the purpose of better understanding differences in operating results and stock valuations. This approach is called fundamental analysis because it focuses on the company's fundamentals. This is a rigorous and time-consuming process that limits a typical sell-side analyst specializing in two or three industries and covering about 10-15 companies, depending on the number of sectors he or she follows.

The challenge facing the brokerages is that it's extremely expensive to create all this research. Brokerages must recover the costs of paying sell-side analysts from somewhere, but deregulation has significantly reduced the ability to make a profit at anything except investment banking deals. The main result of these "forces" is that research departments cannot research any companies that do not have a potential investment bank deal of about $50 million or more. This leaves thousands of great companies without research. Couple this with the fact that research departments drop coverage rather than issue "sell" reports, and you'll get the perception that analysts only issue "buy" recommendations.

Buy-Side Analysts
Buy-side analysts are employed by fund managers like Fidelity and Janus, as well as pension funds. Like the sell-side analysis, the buy-side analyst specializes in a few sectors and analyzes stocks to make buy/sell recommendations; however, the buy-side differs from the sell-side in three main ways: they follow more stocks (30-40), they write very brief reports (generally one or two pages), and their research is only distributed to the fund's managers.

Buy-side analysts can cover more stocks than sell-side analysts because they have access to all the sell-side research. They also have the opportunity to attend industry conferences, hosted by sell-side firms. During these conferences, the managements of several companies in a sector present why they are a better investment. After gathering this information, buy-side analysts summarize their case in a brief report that also contains an earnings forecast. These reports are only distributed to the fund's managers.

The sell-side provides research and conferences to the buy-side in the hopes that the buy-side will let them execute the large trades that the funds make when they act on the recommendation provided by the sell-side. Having access to the sell-side's primary research and the ability to attend industry conferences allows the buy-side analyst to follow many more stocks than a sell-side analyst. To compensate the firm for this information, the funds will buy and sell stocks with the brokerage firms that provide the best information.

Independent Analysts
Independent analysts are practitioners who are not employed by either brokerage firms or mutual/pension funds. "Indies", as they are sometimes called, are firms established to provide research that is "untainted" by investment banking deals.

Some Indies focus on serving institutional clients and are paid a fee to follow certain stocks and/or to find new ideas that the sell-side is missing. In some cases, these institutional Indies have a relationship with a brokerage firm and are compensated by trades given to them by the funds. Sometimes it is a fee-only arrangement.

Other Indies provide their research to both the institutional and individual investors. These firms may provide their research on a subscription basis or for free. In either case, it is important to understand the nature of the relationship between the research firm and the company that is being analyzed (generally called the "Subject Company"), even if the report is not free.

Every research report is required to have a section called the disclaimer that discloses, among other things, the nature of the relationship between the research firm and the Subject Company. Every major brokerage firm and every Indie must provide this information. This disclaimer generally appears at the end of the report and is in small type. In it, the research firm must disclose if and how it is compensated for providing research. For example, major Wall Street firms will disclose that they provided investment-banking services to the Subject Company. Some Indies will accept stock or other forms of equity as payment for their services. Other Indies will only accept a cash only fixed-fee.

Analyst Objectivity
The objectivity of research reports is a major question, one that is now asked of both the large Wall Street firms as well as the Indies. Is Wall Street research objective? Can an Indie provide an objective research report if it is paid by the Subject Company? These are difficult questions to answer without reading the disclosure and the report and knowing something about the firm and the analyst. Just like on Wall Street, some Indies strive to meet a higher standard of ethical conduct while others just try to manipulate stocks. But it is your responsibility to understand and evaluate this information.

Indies play an important role in today's market by providing research on small/micro cap stocks that are ignored by traditional brokerage research departments. Wall Street has become myopic, focused on big cap stocks and pleasing big institutional investors. This has resulted in the majority of stocks becoming "orphans" despite their investment potential. Indies attempt to bridge this information gap by providing research on stocks Wall Street has orphaned. While the Internet revolution has increased the ability of individual investors to do their own trades and research, it takes time and experience to do a thorough job. Legitimate Indies take the time to provide useful information. It is up to you to judge its worth.

What Does "CFA" Mean?
The Chartered Financial Analyst® (CFA®) designation is regarded by most to be the key certification for investment professionals, especially in the areas of research and portfolio management. It is, however, one of many designations used today, which may cause some confusion. This article will define what the CFA designation signifies and what this means to investors.
CFA Defined
The CFA designation is given to investment professionals who have successfully completed the requirements set by the globally recognized CFA Institute (formerly the Association for Investment Management and Research®, or AIMR). To be eligible for the CFA designation, candidates must attain the following:

1. Have at least three years of professional investment experience.
2. Pass three rigorous six-hour exams over at least three years.
3. Commit to abiding by CFA Institute's Code of Ethics and Standards of Professional Conduct.

The exams test the candidates' knowledge of investment theory, ethics, financial accounting and portfolio management. This course of study was formed in 1962 and is constantly updated to ensure that the curriculum meets the demands of the global investment decision-making practice. This graduate-level curriculum generally entails six months of study prior to each exam date. Pass rates vary from year to year, but since the first exam was given in 1963, the overall rate is 59%; fewer than 20% of the candidates pass all three tests within three years.

Believe me, this is not an easy test. I studied on average 19-20 hours each week from the end of December to the end of May. The concentrated study, however, was a better education than graduate school because of its total focus on investment management and practice.

CFA Institute is a global non-profit professional organization of more than 58,000 financial analysts, portfolio managers and other financial professionals in 112 countries. In addition to administering the CFA Program, the institute is also recognized around the world for its investment performance standards, code of ethics and standards of professional conduct.

More information on the CFA Institute and the CFA program is available at www.aimr.org.

What the CFA Designation Means to Investors
To investors, the CFA designation means the following:
• A CFA charter-holder has demonstrated a commitment to become better at his or her craft, whether it is security analysis, portfolio management, business reporter or broker.
• CFA charter-holders and candidates alike strive to maintain a higher level of integrity by committing to following CFA Institute's Code of Ethics and Standards of Professional Conduct.
In other words, CFA charter-holders are investment professionals who have striven to better their skills and knowledge on behalf of their clients and who committee to adhere to a high standard of ethical conduct.

Having the CFA charter does not automatically make one a better stock picker, but it does distinguish the charter holder from other practitioners. There are some very well-known investment professionals who hold the CFA charter: Abby Joseph Cohen, Gary Brinson and Sir John Marks Templeton. The reasons why these famous names pursued the CFA designation may vary, but I believe it is safe to say they all have one thing in common: the desire to be the best.

Inventory Valuation For Investors: FIFO And LIFO
June 5, 2002 | By Investopedia Staff, (Investopedia.com)
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Are you one of those investors who doesn't look at how a company accounts for its inventory? For many companies, inventory represents a large (if not the largest) portion of assets and, as such, makes up an important part of the balance sheet. It is, therefore, crucial for investors who are analyzing stocks to understand how inventory is valued.

What Is Inventory?
Inventory is defined as assets that are intended for sale, are in process of being produced for sale or are to be used in producing goods.

The following equation expresses how a company's inventory is determined:

Beginning Inventory + Net Purchases - Cost of Goods Sold (COGS) = Ending Inventory

In other words, you take what the company has in the beginning, add what they have purchased, subtract what they've sold and the result is what they have remaining.

How Do We Value Inventory?
The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement and statement of cash flow. There are three inventory-costing methods that are widely used by both public and private companies:
First-In, First-Out (FIFO) - This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf (recorded on the income statement) because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (appears on the balance sheet).
Last-In, First-Out (LIFO) - This method assumes that the last unit making its way into inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period.
Average Cost - This method is quite straightforward; it takes the weighted average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. In our bakery example, the average cost for inventory would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
An important point in the examples above is that COGS appears on the income statement, while ending inventory appears on the balance sheet under current assets. (For more insight, see Reading The Balance Sheet.)

Why Is Inventory Important?
If inflation were nonexistent, then all three of the inventory valuation methods would produce the exact same results. When prices are stable our bakery would be able to produce all of its loafs of bread at $1, and FIFO, LIFO and average cost would give us a cost of $1 per loaf.

Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which means the choice of accounting method can dramatically affect valuation ratios.

If prices are rising, each of the accounting methods produce the following results:

FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay.

LIFO isn't a good indicator of ending inventory value because the left over inventory might be extremely old and, perhaps, obsolete. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.

Average cost produces results that fall somewhere between FIFO and LIFO.
(Note: if prices are decreasing then the complete opposite of the above is true.)

One thing to keep in mind is that companies are prevented from getting the best of both worlds. If a company uses LIFO valuation when it files taxes, which results in lower taxes when prices are increasing, it then must also use LIFO when it reports financial results to shareholders. This lowers net income and, ultimately, earnings per share.

What we are doing here is figuring out the ending inventory, the results of which depend on the accounting method, in order to find out what COGS is. All we've done is rearrange the above equation into the following:

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods Sold
LIFO Ending
Inventory Cost = 1,000 units X $8 each = $8,000
Remember that the last units in are sold first; therefore, we leave the oldest units for ending inventory.

FIFO Ending
Inventory Cost = 1,000 units X $15 each = $15,000
Remember that the first units in (the oldest ones) are sold first; therefore, we leave the newest units for ending inventory.

Average Cost Ending Inventory = [(1,000 x 8) + (1,000 x 10) + (1,000 x 12) + (1,000 x 15)]/4000 units = $11.25 per unit

1,000 units X $11.25 each = $11,250
Remember that we take a weighted average of all the units in inventory.

Using the information above, we can calculate various performance and leverage ratios. Let's assume the following:

Assets (not including inventory) $150,000
Current assets (not including inventory) $100,000
Current liabilities $40,000
Total liabilities $50,000

Each inventory valuation method causes the various ratios to produce significantly different results (excluding the effects of income taxes):

As you can see from the ratio results, inventory analysis can have a big effect on the bottom line. Unfortunately, a company probably won't publish its entire inventory situation in its financial statements. Companies are required, however, to state in the notes to financial statements what inventory system they use. By learning how these differences work, you will be better able to compare companies within the same industry.

Conclusion
As a final note, many companies will also state that they use the "lower of cost or market". This means that if inventory values were to plummet, their valuations would represent the market value (or replacement cost) instead of FIFO, LIFO or average cost.

Understanding inventory calculation might seem overwhelming, but it's something you need to be aware of. Next time you're valuing a company, check out its inventory; it might reveal more than you thought.

The Five Biggest Stock Market Myths


When fiascos like the Enron bankruptcy, auditing scandals and analysts' conflict of interest occur, investor confidence can be at an all-time low. Many investors are wonder whether or not investing in stocks is worth all the hassle. At the same time, however, it's important to keep a realistic view of the stock market. Regardless of the real problems, common myths about the stock market often arise. Here we go over these myths in order to bust them.
1) Investing in stocks is just like gambling.
This reasoning causes many people to shy away from the stock market. To understand why investing in stocks is inherently different from gambling, we need to review what it means to buy stocks. A share of common stock is ownership in a company. It entitles the holder to a claim on assets as well as a fraction of the profits that the company generates. Too often, investors think of shares as simply a trading vehicle, and they forget that stock represents the ownership of a company.

In the stock market, investors are constantly trying to assess the profit that will be left over for shareholders. This is why stock prices fluctuate. The outlook for business conditions is always changing, and so are the future earnings of a company.

Assessing the value of a company isn't an easy practice. There are so many variables involved that the short-term price movements appear to be random (academics call this the Random Walk Theory); however, over the long term, a company is only worth the present value of the profits it will make. In the short term a company can survive without profits because of the expectations of future earnings, but no company can fool investors forever - eventually a company's stock price can be expected to show the true value of the firm.

Gambling, on the contrary, is a zero-sum game. It merely takes money from a loser and gives it to a winner. No value is ever created. By investing, we increase the overall wealth of an economy. As companies compete, they increase productivity and develop products that can make our lives better. Don't confuse investing and creating wealth with gambling's zero-sum game.

2) The stock market is an exclusive club in which only brokers and rich people make money.
Many market advisors claim to be able to call the markets' every turn. The fact is that almost every study done on this topic has proven that these claims are false. Most market prognosticators are notoriously inaccurate; furthermore, the advent of the internet has made the market much more open to the public than ever before. All the data and research tools previously available only to brokerages are now there for individuals to use.

Actually, individuals have an advantage over institutional investors because individuals can afford to be long-term oriented. The big money managers are under extreme pressure to get high returns every quarter. Their performance is often so scrutinized that they can't invest in opportunities that take some time to develop. Individuals have the ability to look beyond temporary downturns in favor of a long-term outlook.

3) Fallen angels will all go back up, eventually.
Whatever the reason for this myth's appeal, nothing is more destructive to amateur investors than thinking that a stock trading near a 52-week low is a good buy. Think of this in terms of the old Wall Street adage, "Those who try to catch a falling knife only get hurt."

Suppose you are looking at two stocks:
• XYZ made an all time high last year around $50 but has since fallen to $10 per share.
• ABC is a smaller company but has recently gone from $5 to $10 per share.
Which stock would you buy? Believe it or not, all things being equal, a majority of investors choose the stock that has fallen from $50 because they believe that it will eventually make it back up to those levels again. Thinking this way is a cardinal sin in investing! Price is only one part of the investing equation (which is different from trading, whch uses technical analysis). The goal is to buy good companies at a reasonable price. Buying companies solely because their market price has fallen will get you nowhere. Make sure you don't confuse this practice with value investing, which is buying high-quality companies that are undervalued by the market.

Below is a chart of Nortel's decline. Imagine how much money you would have lost had you bought Nortel just because it kept on hitting new lows!
This chart was supplied by Barchart.com
4) Stocks that go up must come down.
The laws of physics do not apply in the stock market. There is no gravitational force that pulls stocks back to even. Over ten years ago, Berkshire Hathaway's stock price went from $6,000 to $10,000 per share in a little more than a year. Had you thought that this stock was going to return to its lower initial position, you would have missed out on the subsequent rise to $70,000 per share over the following six years.


Below is a chart of Wal-Mart from 1997 to 2000. We've circled every time the stock chart hit resistance to reaching a new high. Those investors who were waiting for the stock to come back to earth would missed out on a return of 500% or more. What's behind the stock? It's the company! Wal-Mart is another example of an excellent company that has dominated its industry by being innovative and creating value for both shareholders and customers.
This chart was supplied by Barchart.com
We're not trying to tell you that stocks never undergo a correction. The point is that the stock price is a reflection of the company. If you find a great firm run by excellent managers, there is no reason the stock won't keep on going up.

5) Having just a little knowledge, because it is better than none, is enough to invest in the stock market.
Knowing something is generally better than nothing, but it is crucial in the stock market that individual investors have a clear understanding of what they are doing with their money. It's those investors who really do their homework that succeed.

Don't fret, if you don't have the time to fully understand what to do with your money, then having an advisor is not a bad thing. The cost of investing in something that you do not fully understand far outweighs the cost of using an investment advisor.

Conclusion
Forgive us for ending with more investing clichés, but there is another old adage that is very much worth repeating: "What's obvious is obviously wrong." This means that knowing a little bit will only have you following the crowd like a lemming. Like anything worth anything, successful investing takes hard work and effort. A partially informed investor is about as effective as a partially informed surgeon; he or she will only hurt themselves and those around them.

Indexes: The Good, The Bad And The Ugly

In the beginning, Dow created the index, and Wall Street saw that it was good. Then the Dow begat the S&P 500, which begat the Nasdaq Composite, which begat the Russell 1000, 2000, and on and on and on…

Despite the proliferation of indexes, the "big three" - Dow Jones Industrial Average, Nasdaq Composite and the S&P 500 - rule the headlines, influence the investment decisions of fund managers and command the emotions of the individual investor. And this is not so good. In fact, many times it is bad, and it makes for an ugly market.
The Good
Indexes are useful tools for tracking market trends. Despite the shortcomings discussed below, indexes are the only tool we have that provides a historical perspective to a market with a chronically short memory. By understanding how and why the indexes react in the economic trends over time, investors might gain insight that will help them make better investment decisions.

For example, there have been a growing number of charts that compare recent index trends to the patterns from the 1929 Crash and the Japanese bubble. While there are many differences between the economies of then and now, studying the similarities and differences will help us prevent repeating the sins of our fathers (although this did not happen during the dotcom bubble).

The Bad
There are two main criticisms of indexes:

1. Calculation Bias (the way the indexes are calculated) - Most indexes are market-cap weighted, meaning that the stocks with the largest market capitalization have the larger weighting in and larger influence on the index. This overweighing means that if the "big dog" is sick, the whole "market" gets the flu, regardless of the strength in the smaller stocks that are in the index. For a current example, look at the Nasdaq Composite. Because all the tech giants (MSFT, ORCL, SUNW, etc.) are falling, the whole index is pulled down, despite the fact that there are numerous other smaller stocks that are rising.

It could be argued that market weighting is a legitimate way to capture an image of the "market" because it represents the impact of the bigger stocks on the market being measured. This methodology, however, will result in increased volatility because of the overweighed influence the big dogs have as they go up and down. A more-equally weighted index is more democratic and captures the impact of smaller stocks that may be rising.

2. Representative Bias (what the indexes do not measure) - By definition, an index is comprised of a small number of stocks, picked to represent some universe of stocks. Committees pick which stocks are included in the index, and they change these stocks over time in order to reflect the economy as it is for that year. (Indexes are generally redefined each year.) Consequently, you cannot look at a historical chart of any index and assume that it represents the trading pattern of the same stocks over a long period of time. This also means that committees, being human, can make mistakes and pick the wrong stocks to be in the index. (I wonder if the Nasdaq committee would like to go back and revise the decisions they made in 1999!)

While these are structural issues that can be debated ad nauseam, it does lead us to…

The Ugly
Because we are a lazy society with apparently no long-term memory (or else more people would have recognized the last bubble sooner), we have come to rely on indexes and 30-second trend analysis as reality, paying attention to soundbites instead of sound reasoning. We can't wait to get our fix of CNBC before we hit the office and during work when we surf the Net. Consequently, if the index is down, the bears are in town and we are down. We become more intent on watching the tickers on our computer screens and forget why we are at work. Maybe that is why the economy remains in a recession: everybody is watching CNBC instead of being productive.

The market, however, is more dynamic than the indexes. There are many publicly-traded companies that have strong fundamentals and growing earnings, but they remain undervalued because nobody knows about them. Maybe that is why some say the economy is ahead of Wall Street.


The Bottom Line
Indexes are useful tools if you know what they represent and what they don't represent. They provide a good historical perspective, but they should not be viewed as the market. Yes, Virginia, there is a bull market out there, but it isn't where Wall Street is looking.

A Brief Summary of Some of the Major Indices
The Dow Jones Indexes
The Dow Jones Industrial Index is the oldest index. Because it is the oldest, it provides a long-term perspective of the industrial (i.e. smokestack) segment of our economy. This is also why it is the headline index. It is viewed also as the blue chip index because it is comprised of the biggest stocks traded on the New York Stock Exchange. Charles Dow created his original index in 1884. He later created other indexes to monitor the high-tech sectors of his day - electric utilities and railroads. In 1928, the number of stocks in the Dow increased to 30, where it stands today. For more information, go to http://www.djindexes.com/jsp/industrialAverages, or see this article on Calculating the Dow.

Nasdaq Composite Index - see the list of companies in this index
The Nasdaq Composite Index measures all Nasdaq domestic and non-U.S.-based common stocks listed on the Nasdaq stock market. This index is market-value weighted. This means that each company's security affects the index in proportion to it's market value. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day and is stated in relation to the total value of the index.

Today the Nasdaq includes over 5,000 companies, more than most other stock market indexes. Because it is so broadly based, the Composite is one of the most widely followed and quoted major market index.

Nasdaq 100 Index - see the list of companies in this index
Launched in January 1985, the Nasdaq 100 Index includes 100 of the largest non-financial domestic companies listed on the Nasdaq National Market tier of the Nasdaq stock market. Each security in the index is represented according to the proportion of its market capitalization in relation to the total market value of the index.

This index reflects Nasdaq's largest growth companies across major industry groups. All index components have a minimum market capitalization of $500 million, and an average daily trading volume of at least 100,000 shares.

NYSE Composite Index - NYSE
The NYSE Composite Index is a market-value weighted index that relates all NYSE stocks to an aggregate market value as of Dec. 31, 1965, adjusted for capitalization changes. The base value of the index is $50, and point changes are expressed in dollars and cents.

The S&P 500
The S&P 500 is one of the best benchmarks for large-cap stocks and accounts for about 70% of the U.S. market. The performance of the S&P 500 is considered one of the best overall indicators of market performance and a mutual fund manager's goal is to beat it. Unfortunately, the top 45 companies comprise more than 50% of the index's value.
Cooking The Books 101

Every company games the numbers to a certain extent to achieve budget and get bonuses. This is nothing new. But two things make the here and now different for us. First, our money is the issue (history is always about other people's money). Second, these are BIG numbers.

Enron, Aldelphia and WorldCom are extreme examples. They are the few bad apples that get all the headlines. I believe that people with better ethics run the majority of companies. They may bend the rules, but few take the process to the extremes of Enron or WorldCom. If this weren't true, we'd all be investing in government bonds.
What can you do to protect yourself from Enron-style disasters? You need to learn some of the basic signs that will alert you about possible earnings manipulation. While the details are even hidden from the accountants, learning these signs will help make you a better investor.

Outlined below are some of the fundamental ways companies can create earnings:

Accelerating Revenues
1. One way to accelerate revenue is booking lump-sum payment as current sales when services will be provided over a number of years. For example, a software service provider receives upfront payment for a four-year service contract but records the full payment as sales of only the period that the payment is received. The correct, more accurate, way is to amortize the revenue over the life of the service contract.

2. A second tactic is called "channel stuffing". Here, a manufacturer makes a large shipment to a distributor at the end of a quarter and records the shipment as sales; however, the distributor has the right to return any unsold merchandise. Because the goods can be returned and are not guaranteed as a sale, the manufacturer should keep the products classified as a type of inventory until the distributor has sold the product.

Delaying Expenses
AOL got in trouble for this in the early 1990s when it capitalized the costs of making and distributing its CDs. AOL viewed this marketing campaign as a long-term investment and capitalized the expense. This transferred the costs from the income statement to the balance sheet where it was going to be expensed over a period of years. The more conservative (and appropriate) treatment is to expense the cost in the period the CDs were shipped.

Accelerating Expenses Preceding an Acquisition
This may sound a little counterintuitive, but bear with me. Before a merger is completed, the company that is being acquired will pay, possibly prepay, as many expenses as possible. Then, after the merger, the EPS growth rate of the combined entity will be easily boosted when compared to past quarters; furthermore, the company will have already booked the expense in the previous period.

"Non-Recurring" Expenses
(An oxymoron if ever there was one.) By accounting for extraordinary events, these one-time charges were meant to help us to better analyze ongoing operating results. It seems, however, that companies take one of these each year. Then a few quarters later, they "discover" they reserved too much and are able to put something back into income (see next item).

Other Income or Expense
This category can house a multitude of sins. Here companies book any "excess" reserves from prior charges (non-recurring or otherwise). This is also the place where companies can hide other expenses by netting them against other newfound income. Sources of other income include selling equipment or investments (a la Amazon.com).

Pension Plans
If a company has a defined benefit plan, it can use some special techniques to smooth earnings. During a bull market, the company can improve earnings by reducing its pension expense - or even record revenues - if the investments in the plan grow faster than the company's assumptions. During the late 1990s, this was done by a number of large firms, some of them blue chips.

Off-Balance-Sheet Items
A company can create separate legal entities that can "house" liabilities or incur expenses that the parent company does not want to have on its financial statements. Because the subsidiaries are separate legal entities, which are not wholly owned by the parent, they do not have to be recorded on the parent's financial statements and are thus hidden from investors.

Synthetic Leases
A synthetic lease can be used to keep the cost of new building from appearing on a company's balance sheet. The lease is a long-term (five- to 10-year) agreement under which a company will pay a fixed lease expense to be in a new headquarters. At the end of the lease, the company is obligated to buy the building, but because of the nature of the lease, this liability is not included on the balance sheet! (Who said accountants were boring and uncreative?) At the time the lease was made, the company may have been in fine financial shape and the economy may have been booming; however, the ability of the company to meet this huge obligation is hard to determine until shortly before maturity (one to two years).

Disclosures: The Good, The Bad, And The Ugly


Disclosures are at the center of the public's crisis of confidence when it comes to the corporate world. They should be viewed as a very important and informative part of a research report, but until recently, they have gone relatively unnoticed. This article will define what a disclosure is and why it is important to investors.

Defined
According to Webster's Dictionary the definition of "disclose" is "to uncover or reveal". In research reports, a disclosure is a statement that reveals the nature of the relationship between the analysts, their employer and the company that is the subject of the research report (also known as the "subject company"). It also provides other statements (warnings) that investors should read.

The disclosure is as important to a research report as footnotes are to a corporate financial report. The Securities & Exchange Commission requires that all research reports contain a disclosure statement. In my article "Six Signs Of An Objective Research Report", I stated that if you are reading a research report that does not have a disclosure statement, you should throw it away. You should not trust a so-called research report that does not have a disclosure statement.

The Good
The importance of disclosures is evidenced by the fact that they appear at the end of the report and usually in very small print, like footnotes to a 10k. A disclosure contains information on the relationship between the analyst, the brokerage firm that employs him or her, and the subject company. It may take a magnifying glass and a strong cup of coffee, but if you read it you should be able to determine who "paid" for the research report and the degree of objectivity that may, or may not, be present.

The Bad
The bad thing about disclosure statements is that they are written by lawyers who are more concerned about protecting the brokerage firm than providing easy-to-read information. Lawyers use legal boilerplate that makes disclosures verbose and hard to read (hence the need for the strong coffee). Disclosures have typically been printed in small type because they are long and because brokerage houses want to save paper (thus the need for a magnifying glass).

The key points covered/stated in most disclaimers are as follows (with my added comments/explanations):
• "This report contains forward-looking statements ...actual results may differ from our forecasts." (In plain English, "This is our best guess, but we may be wrong.")
• "This report is based on information from resources that we believe to be correct, but we haven't checked it." (In other words, "As recently proved, we all assumed that corporate financial statements contained true information about a company's operations. But no analyst can audit a company's books to verify the truth of that assumption. That is the job of the accountants.")
• The nature of the relationship between the subject company and the brokerage firm. Does the firm make a market in the stock, and/or have they done investment banking for the subject company? (Brokerage firms do not produce research reports for free. Historically, income generated from trading or investment banking has funded research departments.)
• Whether or not the analysts and other members of the firm may trade/own shares in the subject company. (Is it bad that an analyst puts his money where his mouth is?)
• "This report is being provided for informational purposes only and on the condition that it will not form a primary basis for any investment decision." (Then why are you giving me the report?)
• "Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals and in consultation with their financial advisor." (Probably the best bit of advice in the disclaimer.)

The Ugly
More disclosure is always a good thing, but if history is a guide, the "new" disclosure rules will be no better than what we already have. Some of the current proposals call for the disclosure to be on the front page and to contain "more information". But this requirement may result in more words and less information.
The Solution
Disclaimers best serve investors when they are written in the KISS (keep it simple, stupid) style. For example, I propose the following format for disclaimers:
• This report is based on public information that we assume to be true and correct.
• My assumptions and forecast may be wrong.
• I own xx shares and have owned these shares for xx years.
• Our brokerage firm makes money by making a market and performing investment-banking services for the companies in this report.
• This investment may not be suitable for all investors. You must consider your specific investment goals and styles before investing in any stock. Consult with your financial advisor before making any investments.
Disclosures of this clear and succinct style will help investors regain some confidence in Wall Street. And they just may add some lawyers to the unemployment line.

Capitulation Defined
There tends to be a lot of talk about "investor capitulation" when stocks continue to tank. But what is meant by capitulation in Wall Street terms and what does it mean for future stock trends? This article will discuss both.
Capitulation is defined in the American Heritage Dictionary as the following:

ca•pit•u•la•tion (n)

1. The act of surrendering or giving up. Surrender.
2. A document containing the terms of surrender.

In Wall Street the term refers to the time when investors (all of them) sell all their stocks because they want out. The sole motivation for trading is to get out of the market and seek shelter in "safe" investments such as bonds or your mattress. The selling frenzy is painful, but relatively quick. Consequently, a sign of capitulation is mass selling that occurs over a brief time span.

Historical Examples
Good historical examples are the Black Mondays of 1929 and Oct 1987. In both cases, investors ran for the exits, producing the big market drops. In 1929, the drop was prolonged as bad economic policies aggravated the situation and created a depression that lasted until World War II. In 1987, the drop was painful, but stocks started to climb within the next few days and continued until Mar 2000.

Surprisingly, the sudden drop in the stock market in Oct 1987 was called neither a capitulation nor a crash. Other euphemisms such as "correction" were used. While some of us realized what had occurred in real time, it took the media a long time (years) to label the event correctly.

In mid July of 2002 there was some speculation of another capitulation possibly occurring as stocks fell below their Sept 2001 lows. The S&P 500 hit a low of 797.7 on Jul 23, 2002 (a 47.8% decline from the high set in Mar 2000). This free fall was accompanied by data that indicated that individual investors were taking money out of mutual funds and into bonds and money market funds bonds. In order to meet these withdrawals, mutual fund managers had to sell their stocks, which accelerated the drop.

A sign of capitulation? Possibly. The mass transfer of funds from stocks to safer investments and increased news stories on investors preferring their mattresses over the market replaced the go-go stories of the late 1990s, when investors poured money into dotcom stocks that had no fundamental strengths. This type of reverse is a good sign of a capitulation.

But there are two things that indicate to me that mid-July this will not be the same situation we saw in 1987. First, the very act of calling it a capitulation is a defiance of the definition. The media full of capitulation talk is a bullish indicator. This bullish sentiment invalidates the primary criteria for a capitulation, which is the total lack of any bullish sentiment for stocks. Second, in real-time the media is wrong in its calls on market turns. The media is a good "misleading" indicator, one that you should almost always bet against. It was late in calling the 1987 crash, the dotcom bubble, and this recession.

The media, however, is a reflection of the market's beliefs. We wanted a quick end to this two-year bear market, just as the market wanted dotcom dreams of fast riches in late 1990. The common denominator is short time frames. Investors wanted quick riches in 2000. Today they want a sharp and quick sell-off to end the pain.

But what we face cannot be undone overnight. It took five years for the market to fund the building of overcapacity in telecom, tech, and Internet grocery stores. And it will take more than two years for the economy to absorb that capacity. It will also take a long time for investors to forget about the illusory 20% returns that the market posted in the late 1990s and get used to the idea that a good year for stocks is a return in the high single digits.

The current focus on capitulation (or a quick end to this bear market) indicates to me that the market will continue to be bearish. With economic fundamentals expected to remain weak for at least another year, stocks could trade within a range for several months. The range may be flat, or it could continue to decline if news about corporate misdeeds and terrorism persist. During this time, there could be moments of capitulation when stocks drop to the lower end of the trading range. For investor with a penchant to trade, these will be good short-term trading opportunities. For those of us who prefer to be long-term investors, it will just be frustrating.

Calculating The Dow Jones Industrial Average


The media always talk about the Dow being up or down a certain number of points, but what do these points represent? In this article we'll talk about how a change in the Dow corresponds to a tangible dollar value.
A Brief Summary
In the U.S. there are three major indicators, or indexes, of market movements. These three are the Nasdaq Composite, Dow Jones Industrial Average (DJIA or "the Dow") and the Standard & Poor's 500. As a collective, these market indexes are referred to as the Security Market Indicator Series (SMIS). They provide a basic signal of how specific markets perform during the day. Of these three, the DJIA is the most widely publicized and discussed. Fortunately for us, it is also the easiest to calculate and explain. (To learn more about indexes, check out the Index Investing Tutorial.)

History of the DJIA
Dow Jones & Co. was founded in 1882 by Charles Dow, Edward Jones and Charles Bergstresser. Despite popular belief, the first averages were not published in the Wall Street Journal but in its precursor called the Customer's Afternoon Letter. The first averages didn't even include any industrial stocks. The focus was on the growth stocks of the time, mainly transportation companies. This means that the first Dow Jones Index included nine railroad stocks, a steamship line and a communications company. This average eventually evolved into the Transportation Average. It wasn't until May 26, 1896, that Dow split transportation and industrials into two different averages, creating what we know now as the Dow Jones Industrial Average.

Charles Dow had the vision to create a benchmark that would project general market conditions and therefore help investors bewildered by fractional dollar changes. A revolutionary idea at the time, and its implementation was simple. The averages were, well, plain old averages. To calculate the first average, Dow added up the stock prices and divided by eleven, the number of stocks included in the index.

Today, the DJIA is a benchmark that tracks American stocks that are considered to be the leaders of the economy and are on the Nasdaq and NYSE. The DJIA covers 30 large-cap companies, which are subjectively picked by the editors of the Wall Street Journal. Over the years, companies in the index have been changed to ensure the index stays current in its measure of the U.S. economy. In fact, of the initial companies included, only General Electric remains as part of the modern-day average.

DJIA Complications
As you might have guessed, calculating the DJIA today isn't as simple as adding up the stocks and dividing by 30. Dow lived in times when stock splits (To learn more, see What is a stock split? Why do stocks split?) and stock dividends weren't commonplace, so he didn't foresee how these corporate actions would affect the average.

For example, if a company trading at $100 implemented a 2-for-1 split, the number of its shares doubles, and the price of each share becomes $50. This change in price brings down the average even though there is no fundamental change in the stock. To absorb the effects of price changes from splits, those calculating the DJIA developed the Dow divisor, a number adjusted to account for events like splits that is used as the divisor in the calculation of the average.

How Does the Dow Divisor Work?
To calculate the DJIA, the current prices of the 30 stocks that make up the index are added and then divided by the Dow divisor, which is constantly modified.

To demonstrate how this use of the divisor works, we will create a mock index, the Investopedia Mock Average (IMA). The IMA is composed of 10 stocks, which total $1,000 when their stock prices are added together. The IMA quoted in the media is therefore 100.00 ($1,000/10). Note that the divisor in our example is 10.

Now, let's say that one of the stock in the IMA average trades at $100 but undergoes a 2-for-1 split. Its price then reduces to $50. If our divisor remained unchanged, the calculation for the average would give us 95.00 ($950/10). This would not be accurate because the stock split merely change the price, not the value of the company. To compensate for the effects of the split we have to adjust the divisor downward to 9.5. This way, the index remains at 100.00 ($950/9.5) and more accurately reflects the value of the stock in the average.

If you are interested in finding the current Dow divisor, you can find it at the website of the Dow Jones Indexes and the Chicago Board of Trade.
And How Does the DJIA Number Translate into a Dollar Value?
To figure out how a change in any particular stock affects the amount the index changes, up or down, divide the stock's price change by the current divisor. For example, if General Electric was up $5, divide 5 by 0.14418073, which equals 34.68. Thus, if the DJIA was up 100 points on the day, GE was responsible for 34.68 points of the move.

Conclusion
The DJIA's methodology of calculating an index is known as the price-weighted method. On top of having to deal with stock splits, the downside to this method is that it does not reflect the fact that a one dollar change for a $10 stock is much more significant (percentage wise) than a one dollar change for a $100 stock. Because of price-weighting's associated problems, most all other major indexes such as the S&P 500 are market-capitalization weighted

That being said, despite all the shortcomings, the Dow is still one of the most watched indicators of stock market performance