Writing Securities Research - CFA Institute

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Bolland

About the Author Writing Securities Research is a comprehensive guide for securities research analysts around the world. Analysts who want to write research that is clear, concise and actionable should carefully read and digest the contents of this book. I would say that it should also be compulsory reading for research managers, compliance officers, editors, securities lawyers, securities regulators and students of investment and finance. Jeremy Bolland’s book helps to equip analysts with many useful tools to help them achieve securities research success. aêK=j~êâ=jçÄáìë Executive Chairman of Templeton Asset Management Ltd.

Since writing the first edition of Writing Securities Research: A Best Practice Guide, Jeremy Bolland has been invited regularly to address CFA societies on the risks that their members face as chartered financial analysts. He has also addressed audiences of regulators, lawyers, and law students on the subject. Jeremy has over 25 years of experience in the world of investments, and has worked in London, Tokyo, and Hong Kong. For the past 16 years he has worked in securities research at global investment banks, including a five-year stint at Morgan Stanley, five years as a director at ING/ING Barings, and most recently five years at HSBC where his final role was Head of Training for Global Research. Jeremy has been a qualified supervisory analyst (SA) since 1997, and as such is authorized to approve securities research for U.S. distribution. Before entering the securities industry, Jeremy was marketing director and company secretary for a property development company that undertook industrial and commercial projects throughout the U.K. as tax-shelter investments for corporates and high net worth individuals. Jeremy is also the author of A Guide to Investment in Enterprise Zones (Longman, 1988, 2nd ed. 1990). Jeremy Bolland grew up in Malaysia, holds an honors degree in Classics from King’s College, London University, and studied Chinese at SOAS and Beijing Normal University.

Jeremy has made a major contribution by incorporating and explaining ethical principles in the writing and dissemination of investment research. He uses real-life examples as illustration which enhances the reader’s understanding. This is a practical book for analysts, academics, regulators and students of finance. iÉÉ=hÜ~=iççå Asia Pacific Head of Standards and Financial Market Integrity, CFA Institute

For every research analyst, research manager, research counsel and supervisory analyst, a large proportion of his or her role involves the circumnavigation of a dense body of global, often conflicting, regulation. In training sessions, many analysts ask: “But how does this apply to me? Why do the US rules apply if I’m based in Hong Kong? How do I recognize price-sensitive information?” Jeremy has done what no one thought of doing before: he has pulled together the rules and the examples where firms and individuals fell foul of those rules, distilled into a best-practice guide that can be used by the green and the seasoned in any jurisdiction.

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WRITING SECURITIES RESEARCH A Best Practice Guide

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At a time when the regulatory landscape in the financial world is becoming increasingly complex, it is refreshing to read Jeremy's book which identifies clearly and concisely the difficult regulatory, legal and ethical issues that research analysts must navigate around the world when producing research for their clients. It is the comprehensive nature of Jeremy's book and the fact that he provides practical solutions to problems that make it such a useful tool for analysts, institutions, regulators and professional advisers alike. ^ä~å=iáååáåÖ Partner, Sidley Austin, and Former Head of Enforcement, Hong Kong Securities and Futures Commission

Recent market events have heralded a new era of scrutiny, with consequences for the world within which securities analysts operate. At the same time, the regulatory environment has become increasingly sophisticated with complex, often competing, global requirements. Jeremy provides comprehensive guidance through all aspects of preparing securities research. The practical, focused case studies will also give real value to anyone who wants to fully appreciate the potential pitfalls that can and do arise. Whether you’re a lawyer or a regulator just starting out in this field, or you have been in it for many years, Jeremy’s research and guidance will offer you real insight.

Securities research in developing markets, especially those in Asia, requires a practical hands-on approach. In markets where transparency is not a given, Jeremy gives analysts the intellectual framework necessary for making sound, honest judgments about any company. These aren’t the lessons they teach you in MBA programs. They’re the real deal! píÉîÉ=sáÅâÉêë President and CEO of FTI-International Risk

John Wiley & Sons

WRITING SECURITIES RESEARCH Financial markets have experienced turmoil in recent years. Whilst new regulations may be introduced around the world, Jeremy Bolland argues in this second edition of his unique guide to writing securities research that securities analysts don’t need more regulation—just a clearer understanding of the issues and challenges they face. Books that help analysts understand securities analysis and valuation abound. Writing Securities Research fills a serious gap by helping analysts appreciate the risks that they run when doing their job, wherever they operate. These include insider trading, frontrunning, conflicts of interest and defamation. Jeremy also comprehensively covers corporate governance risks that analysts need to draw to investors’ attention, concerning social responsibility, equal treatment of shareholders, executive compensation, independent non-executive directors and risk management. These topics are explained through actual case studies taken from around the world, accompanied by Alex cartoons to add a light-hearted perspective. The advice contained in Writing Securities Research does not just help analysts stay out of jail and avoid penalties, it also helps them write better research reports and be more competitive. As Dr. Mark Mobius, Executive Chairman of Templeton Asset Management, says in his foreword, “The book will equip analysts with many useful tools to help them achieve success.”

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Jeremy can be contacted at: [email protected]

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Jeremy Bolland

The book is a must-have reference tool for all securities research professionals, including equity and credit research analysts on both the buy and sell sides. Moreover, as Alan Linning, Partner at international law firm Sidley Austin and former Head of Enforcement at Hong Kong’s Securities and Futures Commission, attests to, the book should also prove invaluable to other professionals such as lawyers and regulators. Students of investment and finance can’t fail to gain a clearer understanding of their subject after reading this well-researched manual.

Book reviews/press comments for the first edition (2007) “. . . is very timely . . . a good analysis . . . a highly readable and incisive book . . . provides a clear guide to industry insiders . . . and a detailed understanding for those who read research”. Geoff de Freitas, Shanghai Business Review, May 2008

“. . . sharp, readable and timely book . . .” The Correspondent, the magazine of the Foreign Correspondents’ Club of Hong Kong, Sept/Oct 2007 issue

“. . . definitive best-practice guide . . . a very readable and engaging book filled with sound advice and workable recommendations”. Keith Hall, China Daily, April 13, 2007

“. . . excellent book”. R. Sivanithy, Singapore Business Times, April 2, 2007

“. . . an essential textbook for securities professionals around the world”. Johannes Ridu, Malaysian Business/New Straits Times, April 1, 2007

“It ought to be mandatory reading for courses focused on securities research”. MoneyLife, India, July 5, 2007

“Extensive case studies are also well-used and interesting. This is a sound and generally useful piece of work for all investment market professionals and, indeed, investors everywhere”. James Rose, Corporate Governance Asia

“. . . plenty of practical examples”. CPA Australia, June 2007

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Endorsements of the first edition (2007) There is a strong need for this book . . . This book is relevant in any setting. It will equip analysts with many useful tools to help them achieve success. Mark Mobius, President of Templeton Emerging Markets Fund

This guide to doing it properly is an obvious selection for the bookshelf of anyone who aspires to offer investment advice and a fine reference for anyone who receives such advice. Jake van der Kamp, Financial Columnist of South China Morning Post

At last, here’s a comprehensive yet easy-to-read guide explaining all the best practice principles involved in writing securities research. It is full of useful information . . . I highly recommend it. Anthony Espina, Chairman of Hong Kong Stockbrokers Association

. . . essential reading for all people involved in writing securities research. Andrew Leeming, author of The Super Analysts

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Writing Securities Research A Best Practice Guide Second Edition

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Writing Securities Research A Best Practice Guide Second Edition

Jeremy Bolland

John Wiley & Sons (Asia) Pte. Ltd.

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Copyright © 2010, 2007 Jeremy Bolland Published in 2010 by John Wiley & Sons (Asia) Pte. Ltd. 2 Clementi Loop, #02–01, Singapore 129809 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte. Ltd., 2 Clementi Loop, #02–01, Singapore 129809, tel: 65–6463–2400, fax: 65–6463–4605, e-mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Neither the authors nor the publisher are liable for any actions prompted or caused by the information presented in this book. Any views expressed herein are those of the authors and do not represent the views of the organizations they work for. Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany

Library of Congress Cataloging-in-Publication Data ISBN 978-0-470-82602-7

Typeset in 10/12pt Cheltenham by MPS Limited, A Macmillan Company, Chennai, India Printed in Singapore by Toppan Security Printing Pte. Ltd. 10 9 8 7 6 5 4 3 2 1

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Writing Securities Research

Michael Gordon, the global head of institutional investment at Fidelity International, contributed an article to the November 6, 2008, issue of the FT entitled, “Analysts must pay more heed to company cash flows”. His message was that analysts had been focusing on companies’ P&L accounts and whether or not earnings beat estimates, but with the economic slump looming they would need to pay as much attention to cash flow, the balance sheet and the effect that different forms of financing have on a company’s common stock. In an earlier market cycle, as reported in the February 3, 2002, issue of the Independent on Sunday, Richard Dale, joint head of equity research for Citigroup, gave a presentation on a similar theme to the firm’s analysts: “There is a generation of analysts who have grown up in the bull market . . . and never had to look at a balance sheet. That is where the real story is, and they have to learn what alarm bells sound like.” The presentation was entitled “Time for forensic analysis”. A degree of forensic analysis never goes amiss at any time. Indeed, RiskMetrics, an independent research firm based in New York, specifically focuses on companies that its analysts think are heading for a fall. As reported by Steve Johnson in the FT on November 19, 2008, the firm claims to have identified, for example, the challenges facing Northern Rock a few months ahead of the crisis. The FT cites Niels Aalen, managing director of international operations at RiskMetrics: “We look for any deterioration of the business model via forensic analysis . . . We are exclusively focused on getting down to the weeds of the accounts.” Of course this approach of spotting firms with accounting issues is not without its own hazards, as Gradient Analytics experienced. See the case study in Chapter 3 on potential or apparent conflicts of interest for independent research firms, in which Gradient was accused of colluding with hedge funds to drive stock prices down. In addition to scrutinizing the numbers, analysts need to take a close look at the notes and disclosures to the accounts. They need to compare them from period to period to see what words have been added or deleted, or how definitions may have changed over time. Analysts might also need to compare translations of disclosures—is the company giving one version to local investors and another version to international investors?

EXAMPLE Disclosures and notes Summary: New Century Financial was the first major financial company to fail during the subprime-driven credit crisis in 2007. According to an independent report commissioned by the U.S. Justice Department, the company engaged in “significant improper and imprudent practices”.

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Disclosures and notes—cont’d Details: According to an article by Vikas Bajaj in the International Herald Tribune on March 28, 2008, the investigators did not find sufficient evidence to conclude that New Century engaged in earnings management or manipulation, although its accounting irregularities almost always resulted in increased earnings. The commissioned report contended that profits were the basis for significant executive bonuses and helped persuade Wall Street that the company was in fine health when in fact its business was coming apart. The investigators also criticized KPMG for not being skeptical enough in auditing the accounts of New Century Financial. Marc Siegel, head of accounting and governance research at RiskMetrics, cites a specific example of a note to New Century’s accounts to the effect that the allowance for losses on loans held for investment at June 2006 was US$209.9 million. Then on September 2006, the statement was changed slightly to show the allowance for losses on mortgage loans held for investment and real estate owned was US$239.4 million. On the face of it the number had increased. However, disaggregating the reserves revealed that it was an increase in the real estate owned valuation allowance that was masking a decrease in the loan loss allowance under the original definition—these had fallen by 9 percent to US$191.6 million. Conclusions: As mentioned earlier, analysts are not auditors and do not have access to internal records and information, but neither should they necessarily rely totally on auditors to uncover or reveal fraudulent or irregular accounting. Investors rely on an analyst’s analysis and recommendation. Analysts should therefore be extra diligent in uncovering the true state of a company’s finances. They should also be watchful that whatever accounting treatment firms use, they are consistent from period to period and not just as it suits them. Later on in this chapter, where we discuss the need for analysts to highlight risks to their views, we discuss various aspects of corporate governance at companies. The old “falsus in uno, falsus in omnibus” adage would apply. If the analyst catches management doing or saying anything suspicious or inconsistent, then they should suspect everything that management says or does, and consequently dig that much more deeply into the company’s accounts and statements. Aside: Here’s an embarrassing story from New Zealand. NZX, the national stock exchange, asked NZ Farming Systems Uruguay in August 2009 to explain a note to the annual financial statements relating to depreciation that read, “Fudge this to equal depn in

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Disclosures and notes—cont’d FA note 11”. The comment had been left in the accounts inadvertently when they were formally filed at the exchange. I can’t wait for the film to come out—Fudge This, the alternative sequel to Analyze This, starring Robert De Niro and Billy Crystal.

In addition to publications by RiskMetrics, there are some good books on the subject of identifying fraud and other accounting irregularities. Three bestsellers are Accounting for Growth by Terry Smith, Financial Shenanigans by Howard Schilit and The Financial Numbers Game: Detecting Creative Accounting Practices by Charles Mulford and Eugene Comiskey. Pro-forma accounting and use of selective data Analysts should make sure they present to readers a complete picture of a company’s financial position, and not ignore data that do not fit with the analysts’ theses. Neither should analysts blindly accept a company’s reason for focusing on other measures of earnings (pro-forma, core, operating, recurring, underlying, parent or whatever), unless they are comfortable that it really does represent a more appropriate methodology. They should draw readers’ attention to any earnings numbers or P/E valuations that they quote or focus on which are not based on standard net earnings per share. Analysts should always make clear what adjustments have been made to any “adjusted” earnings, and include the standard net numbers anyway for readers to consider.

Reasonableness of valuations If/when giving fair or target valuations, analysts should say how and why they think their underlying estimates differ from those of consensus, and why they think their own valuations are realistic and achievable. For example,

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a stock analyst might refer to a DCF (discounted cash flow), DDM (dividend discount model), EVA (economic value added), NAV (net asset value) or SOP (sum of parts) calculation. Comparisons can be made against the stock’s historic valuation multiples or peer valuations (for example, using one-/ three-/five-year peak/low/average P/E, EV/EBITDA or P/B for the stock, market or sector). Consideration can be given as to whether the P/B is justified by the expected growth in ROE, whether the P/E is justified by the expected growth in net earnings or how competitive the expected dividend yield is compared with yields from alternative investments given the risks attached. When analysts give valuations they must make clear what their underlying assumptions are; for example, the discount rate used for calculating the net present value of future returns (whether the returns are represented by earnings, cash flows or dividends). Analysts should also be able to justify the choice of peers used for any comparable market-based valuations given, and why any obvious examples, such as industry leaders, may have been omitted. Analysts must make clear what valuation years are being used and, if they are prospective, whose estimates they are based on. Highlight valuation changes Analysts should always make clear if their fair value or target price for a stock is being maintained or changed. If the latter, they should say what element of the valuation has changed (for example, forecasts, discount rate or—in the case of price-based valuations for comparison purposes— the multiple, the forecast year and so on). Readers need to see to what extent a change in recommendation is being made as a result of a change in the analyst’s target valuation or multiple, as opposed to a change in the market price. Giving the history of recommendations and target prices is a requirement in some markets. The appropriate valuation methodology Most fundamental equity valuation techniques attempt to ascertain a net present value of future streams of income from the company (whether in terms of cash flow, net earnings or dividends). Supply and demand factors are also relevant. However, the “horses for courses” maxim applies, since different earnings and valuation drivers apply for different industries. Some companies, such as utilities, tend to produce pretty regular and dependable income streams, whereas in other industries a lot of money needs to be invested in research and development, and capital expenditure needs to be invested in assets and equipment, with varying degrees of likelihood of returns. Examples include metals-mining or oil-drilling, where future business growth is determined by the likelihood of new supplies of the raw commodity being found (categorized, for example, in terms of

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probable and provable reserves). Airlines and telecom companies, with expensive assets bought or leased at different times, are often valued on a like-for-like cash-earnings-generating basis, stripping out interest, tax, depreciation and amortization. Ultimately, the challenge for any analyst is to determine how long new investments might take to bear fruit, how big the fruit will be and what the risks will be along the way. Incidentally, Andrew Milligan, head of global strategy at Standard Life, wrote an interesting article in the FT on October 16, 2007, arguing why valuation tools are powerful but dangerous. He and his colleague, Richard Batty, found from their research that in the long term, say 12 to 24 years, valuation mainly matters as a driver of equity, whereas in the short term, say one year, technical issues such as investor sentiment and positioning are more significant. They determined that across the big markets dividend yield, P/B and P/E were the most significant drivers. They also determined that, rather than returning to long-term averages, valuations merely return to recent trends. Fashion and simplicity matter in terms of which valuation technique is regarded as superior at any one time. Given that many valuation approaches come down to forecasting changes in the equity risk premium, which is one of the more sophisticated aspects of financial theory, they were not surprised that some investors look for simpler solutions. They concluded that valuations matter as one part of a wider toolkit including other measures such as behavioral finance, analysis of margins and understanding the long-term drivers of the inflation cycle. Analysts need to appreciate how relevant or important their valuations are to investors, especially given their investment timeframes. One thing I’ve learned from my own trading experience is that for every dollar that’s pushing a currency, commodity or security one way fundamentally, there’s more or less another dollar speculating or hedging against that direction—thereby providing liquidity (and volatility) for the market. Ultimately, individual buyers and sellers have different investment or trading purposes, different investment time frames and different risktolerance levels. When buyers and sellers collectively meet in the market place it’s like a tug-of-war match, with the market price being subject at times to a relatively even match between buyers and sellers, and at other times to periods of dominance of one side and weakness or even collapse of the other. Yes, it’s difficult for the price to avoid the pull of fundamentals indefinitely, but technical, behavioral and momentum factors, whether driven by hedgers or speculators, can be serious forces in the meantime. As John Maynard Keynes famously remarked, “The market can stay irrational longer than you can stay solvent.” Tell me about it. Unrealistic expectations or questionable bases for valuation During the credit crisis there was much controversy over fair-value or mark-to-market accounting, and how this practice of valuing marketable securities may have contributed to the crisis. Newt Gingrich, the

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former speaker of the U.S. House of Representatives, said in a Bloomberg interview in October 2008: “Historians will look back some day and say that the government drove companies into bankruptcy by creating artificial losses.” What became clear in the crisis is that the market had little idea, if any, as to how structured products such as collateralized debt/mortgage obligations (CDOs and CMOs) were constituted, what their real underlying valuations were and who bore the ultimate liabilities. Market clearing prices became the ultimate basis for valuation. However, marking-to-market proved to be an academic exercise at times when there was no market demand for these securities. If there’s no market for a security, instrument or product at any particular time, given the absence not just of fundamental investors but also of speculators, arbitrageurs and even market-makers, does that really mean that its fundamental fair value is zero, or is it just a temporary anomaly? Of course historic cost accounting also has its critics. What seems fair to say is that neither method is particularly meaningful when asset prices are spiking irrationally, whether at the top or at the bottom. The Internet bubble that burst in 2000 provided another classic example, albeit in hindsight not quite such a dramatic one as the financial crisis of 2007–2009, of how the markets can fall prey to unrealistic expectations and unreasonable valuations. The market’s behavior was characterized as “irrational exuberance” by the then chairman of the U.S. Federal Reserve, Alan Greenspan. There was talk of a “paradigm shift” in the productivity of the world’s economies, brought on by globalization and technological advances, which to some justified the ever-increasing valuations for stocks. For example, staid old utility companies suddenly found themselves with the infrastructure needed for exciting new technologies. How were they to be valued—as defensive utilities or fast-growing technology companies? Other technology startups promised nothing except a good idea. Analysts came up with ever-imaginative valuation methodologies to justify current valuations and target prices for specific stocks, such as the number of eyeball hits on Internet web pages.

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Greed and fear had evidently taken hold of the collective psyche of the market—greed to make more money and fear of being left behind. The individual analysts who were criticized for ramping up share prices should not, however, be expected to shoulder the blame on their own—the insatiable demand by some retail investors and the sensationalizing of the stories by some less-reputable newspapers evidently contributed to the hype.

EXAMPLE Excessive valuations Details: Internet bookseller Amazon.com was one of the more highprofile companies to be brought to market during the Internet bubble. By July 8, 1998, the Wall Street Journal was questioning how much higher the stock’s valuation could go. Despite not having actually generated any profits at that stage, the company was already valued at about twice as much as the combined value of Barnes & Noble and Borders Group, the two largest booksellers with real bookshops. The article said that the methods being used to value Internet stocks ranged from estimating revenues and profits much further out in the future than was customary, to extrapolations based on current marketing expenditures, to the number of Web site users. The article cited Morgan Stanley’s Mary Meeker (dubbed “Queen of the Net” by Barron’s) as saying that the new valuation zone for technology companies warranted new valuation approaches. In a later issue, on July 17, 2000, the WSJ recounts that in December 1998, when Amazon.com was trading at US$240, Henry Blodget made a forecast that the share would hit US$400 within 12 months. It passed this target within four weeks on its way to a high of over US$600. By the time of the July 17 article, the stock was back to trading at a third of this. PCCW provides a good example of optimism-fuelled valuations for Internet companies in Asia. The WSJ of February 18, 2000, quotes the stock’s price as HK$25.80 at the time, up more than 15 times in less than a year. The company was in discussion to buy Cable & Wireless HKT Ltd. (which in the end it did). The WSJ article cites a target price for PCCW by Lehman Brothers of HK$35 per share within 12 months as equating to a market capitalization of almost US$46 billion, just shy of General Motors’ value at the time. According to the article, the head of Lehman’s Asian Internet coverage explained the difference between the HK$10 per share SOP valuation and the HK$35 target price by saying that such fundamental analysis is largely irrelevant when it comes to valuing Internet

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Excessive valuations—cont’d companies. He further argued to the effect that the premium valuation was accounted for by the deal-making abilities of the company’s chairman, Richard Li. David Webb, a local investor and financial commentator, remarked that he doubted the market would be willing to pay that much even for Bill Gates, the co-founder and chairman of Microsoft. PCCW shares subsequently fell by more than 90 percent from their February highs. A Reuters article of November 4, 1999, provides further quotes from Internet analysts at the time, again demonstrating how nebulous valuation methodologies had become for Internet stocks. According to the article, the head of Asia Pacific Internet research at Merrill Lynch told a news briefing: “I don’t think they [Internet valuations] can be quantified”; and an Internet analyst at Goldman Sachs said: “Qualitative measures are going to be more important than quantitative measures because of the nascent stage of this industry.” Postscript: At least Amazon.com and PCCW survived, while some other Internet companies didn’t. After the bubble burst in 2000, Mary Meeker maintained her confidence in leading technology companies (see the WSJ of October 23, 2000) and continued with her successful career at Morgan Stanley. Henry Blodget was eventually fined and barred from the industry (see the case studies on conflicts of interest in Chapter 3).

Highlighting risks and volatility The foregoing discussion on excessive valuations leads us nicely into a discussion on drawing readers’ attention to investment risks. Under securities regulations, analysts are invariably required to draw investment risks to investors’ attention. Note that in some markets a distinction may be drawn

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