Will You Adopt Quality Financial Reporting?

Ø Introduction
Company is presently “playing around with the scorecard”
1. Embracing the Quality Financial Reporting (QFR)
2. Start representing as much useful public information as possible
o Those ways → promises low capital cost → higher security prices → because its more than likely that the capital markets respond to inadequate reporting by bidding stock prices down
Ø The traditional reporting model
Traditional reporting strategies → Capital markets depend totally on managers to provide public information for their use
No standardize Generally Accepted Accounting Principles (GAAP) → compromised
Report → too long → managers resisted to initiate new requirements
Political pressure → severely compromised standards
TQM → the goal is to build good customer relationship and keep working as good as possible
Adopt QFR → Build better relationship with capital markets by providing the best financial statement
Ø Solving the problem
Capital markets have needs and desires for financial information that are not addressed by traditional public reports
Balance sheet → perceived as irrelevant
Footnotes seem to frustrate analysts the most → capital markets cannot understand them → they do not contain adequate information
Three negative outcomes of complying with GAAP:
Lack of useful information in financial statements → cause market to pursue other investment opportunities → securities’ lower prices and higher capital cost
ii. Markets decide that the company’s investment potential is great → people may invest after:
1. Taking into consideration the resulting high degree of uncertainty
2. Insisting on higher expected rate of return→ doesn’t advance the stockholders’ interests
iii. Sophisticated investors and credits will turn elsewhere → market want to discover information that no one else know
Managers provide additional public information:
i. Less uncertainty would exist
ii. The analyst’ extra effort and the redundant cost of finding that information would be avoided
iii. Information would be more reliable
§ Uncertainty means more risk to investors → demand higher return
Ø Quality financial reporting–A superior strategy
Adopting QFR has positive effects for essentially everyoneManagersi. Having access to cheaper capital
ii. Earn more income and enjoy payoffs from appreciated stock options and other incentives
Stockholdersi. Greater demand for their sharesii. A rate of return that’s appropriate for their real risk
Investors and creditorsi. They can evaluate investment opportunities with more emphasis on their financial meritsii. Less concern for risk created by incomplete informationThe economy operates more productivelyi. The capital markets can establish security prices more efficiently
Two groups will lose when QFR is practiced:§ People who has somehow fooled the market§ People who successfully cheat the markets with illegal insider information
Ø The high road
Get started with QFL§ Doing what FASB recommended instead doing what it has permittedi. Managers usually do not use preferred method → they think that footnote will not improve their securities’ pricesii. QFR suggest → Markets usually penalized stockholders with lower security prices even management reports larger earnings on the income statement§ Engage tough auditors and do what they say instead of picking cheap and easy auditors who do what managers say§ Branch out into new areas based on your own market research and common sense as to what helps statement readers make better decisions
Ø Objection
o QFR → higher preparation costs created by additional reporting and auditing efforts Respond
o The cost of them is still less than the benefit to financial statement users of
§ Minimizing the cost of providing the data by having the firms doing it at once
§ Having the firms as the source of information
§ Making available an additional source of information that confirms or denies other sources
Ø Are you ready?
o Resisting QFR because of preparation costs seems to be very shortsighted
o It must flow from the efforts

“Back In the Bull Ring” (Job)

Interview with Don Hays

Ø Introduction
o Don’t expect conventional wisdom from longtime market → but Count on his contrarians bent and uncommon skill in determining the direction of the stock market to make you money
o Hays helping investors get the best read on important trends and subtle shifts in the economy and the market → through a variety of technical gauges he monitors

Ø Prediction
o Twice a week → provides colorful commentary and his own special take on the state of the markets
o Developed a matrix → based on investor psychology, monetary conditions and stock valuations → determining allocations
o For long-term growth → 100% equities, zero cash and zero bonds

Ø Green Light
o Investor psychology had turned too negative → the market got very oversold

Ø Psychology Measurement
o See the nervousness and fear Friday
o Smart Money Index → examines the last hour of cumulative trading in the Dow Jones Industrial Average
o "Smart" money → there is no real news reported and it gives a clearer view of how investors are thinking
o Smart Money Index a good indicator → but NOT primary indicator
o The American Association of Individual Investors' Bullish and Bearish Survey is much better

Ø Sentiment Indicators
o Raised Cash → the bullish sentiment had gotten very high
o Bullish sentiment had come down and bearish sentiment had moved up → entered a zone that historically has been a good time to do some buying
o Insider-trading data collected by Scott Gambill of Emergent Financial → tracks the five-day moving average of insider buys and sales on the Russell 3000 index
o Average has moved above 25% it has suggested some great buying opportunities
o SEC started requiring timely disclosure of insider buys and sales
o OEX → options on the S&P 100 → open-interest put/call ratio
o OEX options are highly liquid → tracking the level of fear in the market

Ø Monetary Conditions
o The most important indicator is the yield curve
o The yield curve → 10-year yield divided by the Treasury-bill yield
o The perfect yield curve is 1.25 to 1.5
o Today we have the T-bill yielding 3% and the 10-year note at 4%, → a healthy yield curve
o But remember → monetary conditions have about a one-year lead time on the economy → so what happened a year ago is affecting the economy now
o It will start coming out of the funk → not because of the Fed → but because of the huge amount of money that is coming into money–market funds.
o The money will eventually but won't initially end up in stocks → but right now, it is going into Treasuries → everyone is afraid and playing it ultra safe

Ø The Strong Dollar vs. Fed
o Fed is still tied → an inflation mentality → in fact US in the new era → that inflation will not be a problem for 15 more years
o Even though the commodity prices → gold, oil, and silver → are shooting through the roof
o Because US interest rates are too low → The dollar is not weak
o Dollar is weak → because people think the United States is fighting their economy with one leg tied to a branch
o Why would you want to invest in the U.S. under restrictive policies and a dumb Federal Reserve, when you have China and other places flooding the system with money
o The two-year Treasury has a very good record of predicting inflation → fed-funds rate should be about a half percent under that
o Oil is the decoy → distorting the picture for the Fed right now
o productivity → keeps inflation down
o Correlation between the 10-year Treasury yield and the S&P 500 12-month forward earnings yield → shows that money goes where it is treated best
o Compared with the yield of the 10-year Treasury note, stocks are about 42% to 43% undervalued
o When you get too much pessimism → expected earnings will come down → people will not pay much for earnings → they'll buy the bonds
o When you get too much optimism like in 1987 and 2000 → expected earnings grow to the sky → buy more for stocks

Ø Stock Pick
o growth investors → pick stocks quantitatively based on our own system of earnings momentum, relative valuation, and relative strength
o The only reason the stock came down → CEO mentioned the company would feel some effects from the sub-prime mess through its financial customers

Back In The Bull Ring - Article

Sandra Ward. Barron's. New York, N.Y.: Dec 3, 2007. Vol. 87, Iss. 49; pg. 37, 2 pgs

Abstract (Summary)
In an interview, Don Hays chairman and CIO, Hays Advisory Group, talked about his decision to turn 100% bullish. According to Hays, they developed a matrix in 1987 based on investor psychology, monetary conditions and stock valuations that they use exclusively in determining allocations. Right now, for long-term growth it points to 1000% equities, zero cash and zero bonds. On what gave him the green light, Hays said investor psychology had turned too negative and the market got very oversold. On the action last Monday when stocks plunged in the last hour, Hays said not to down play the move, but focusing on the new low in the S&P 500 from its October peak does not tell the whole story. He added that they consider the Smart Money Index a good indicator, but it is not a primary indicator. On monetary conditions, Hays said the most important indicator is the yield curve.
» Jump to indexing (document details)
Full Text (2055 words)
Copyright Dow Jones & Company Inc Dec 3, 2007
Interview with Don Hays
Chairman and chief investment officer, Hays Advisory Group
DONT EXPECT CONVENTIONAL WISDOM from longtime market seer Don Hays. But count on his contrarian bent and uncommon skill in determining the direction of the stock market to make you money. For close to 40 years, Hays has been helping investors get the best read on important trends and subtle shifts in the economy and the market, through a variety of technical gauges he monitors at his Nashville, Tenn.-based Hays Advisory Group. Twice a week he provides colorful commentary and his own special take on the state of the markets. The firm also recommends sectors and individual stocks and manages $2 billion on behalf of clients. After a brief spell of caution in mid-October, Hays turned 100% bullish a few weeks ago and hasn't looked back.
Barron's: You, a longtime bull, turned cautious in mid-October. What's your stance now?
Hays: We developed a matrix in 1987 based on investor psychology, monetary conditions and stock valuations that we use exclusively in determining allocations. This is what determines how much cash we have. We don't argue with it. Right now, for long-term growth it points to 100% equities, zero cash and zero bonds. That compares with Oct. 15, when investor psychology signaled we should raise cash in our portfolio to 8%. But we put it all back in a few weeks ago.
What gave you the green light?
Investor psychology had turned too negative and the market got very oversold.
How do you measure psychology?
You could see the nervousness and fear Friday, Nov. 9, in the CBOE's VIX, a measure of volatility. We also looked at what we call the Smart Money Index, which examines the last hour of cumulative trading in the Dow Jones Industrial Average, considered to be the "smart" money because there is no real news reported and it gives a clearer view of how investors are thinking, compared with the more emotional moves made in the first 30 minutes of trading in the day by "dumb money." On Nov. 9, the smart money was buying and the dumb money was not.
What about the action last Monday, when stocks plunged in the last hour?
Not to downplay the move, but focusing on the new low in the S&P 500 from its October peak doesn't tell the whole story. The internal numbers, as reflected by the number of stocks making 52-week lows, show a substantial number of stocks did not share the experience on the downside. For instance, on Aug. 16 on the NYSE, we had 1,125 stocks making new 52-week lows. Yet Monday, 717 of those 1,125 did not violate the prior low-water mark from August's panic decline. On the Nasdaq, there were 231 stocks making new 52-week lows, compared with 338 on Nov. 8 of this year.
We consider the Smart Money Index a good indicator, but it is not a primary indicator. The American Association of Individual Investors' Bullish and Bearish Survey is much better. The bullish sentiment had gotten very, very high on Oct. 15, when we raised cash, but as of Nov. 9, bullish sentiment had come down and bearish sentiment had moved up and the threeweek average of bulls to bears showed more bears. Sentiment also entered a zone that historically has been a good time to do some buying.
What other sentiment indicators give you confidence at this point?
Insider-trading data collected by Scott Gambill of Emergent Financial. He tracks the five-day moving average of insider buys and sales on the Russell 3000 index. Any time this average has moved above 25% it has suggested some great buying opportunities. It happened in the selloff in February and March and it just happened again. It is up to 70%, and that is a very positive sign. Corporate insiders are buying at the highest rate of any time in the past four years, when the SEC started requiring timely disclosure of insider buys and sales. The missing link has been the OEX [options on the S&P 100] open-interest put/call ratio. OEX options are highly liquid, so people that want to do big trades use them and, again, it's a way of tracking the level of fear in the market. It hasn't yet provided confirmation, but it has started coming down.
Let's turn to monetary conditions.
The most important indicator is the yield curve. The yield curve, as I measure it, is the 10-year yield divided by the Treasury-bill yield. The perfect yield curve is 1.25 to 1.5, in my opinion. If you go through history, you will see that any time you keep it in that span we have had a very good period of time. We are pretty close to being in the right zone. Today we have the T-bill yielding 3% and the 10-year note at 4%, a healthy yield curve. But remember, monetary conditions have about a one-year lead time on the economy, so what happened a year ago is affecting the economy now and the economy is going to be weak next quarter and maybe one more quarter after that. Then it will start coming out of the funk not because of the Fed but because of the huge amount of money that is coming into money-market funds.
That money will end up in stocks?
It will eventually. It won't initially. Right now, it is going into Treasuries because everyone is afraid and playing it ultra safe.
You have been critical of Fed Chairman Bernanke for not cutting rates more.
Bernanke doesn't have a choice. He is still tied to the Greenspan puppets on the Federal Reserve Board. They have had an inflation mentality and, in my opinion, we've passed through that era. We are in a whole new era where inflation will not be a problem for 15 more years and maybe not 50, depending on what happens in the world. But for the next decade or so, inflation will not be a problem until you get this huge glut of labor absorbed and until technology runs its course.
Even though commodity prices are shooting through the roof?
Correct. The commodity prices that are shooting through the roof are gold, oil and silver. There was a one-time adjustment on industrial commodity prices-copper and aluminum, for example-because of the new global demand. Price hikes were needed because these producers could not make money; their return on capital was terrible. Now, the return on capital is high enough where they can find new minerals and increase their productivity. I don't expect the prices of those commodities to drop a lot, but they have been stable for over a year.
How do you explain the action in gold, oil and silver? Speculation?
I think that is what is driving it. And China. Look at the Baltic Freight Index as an indicator of China's economy and look at the price of gold. The Chinese, who are known to be pretty good speculators, are looking for a place to put the huge amount of cash they have, and it is going into anything they can find. oil I can't explain. I don't know of anyone, except those that could be a beneficiary of oil prices going higher, that says oil is not overpriced. Inventories have gone down because at these prices nobody is being paid to keep inventory. Inventories will go up as soon as the price normalizes.
What about the dollar?
The dollar is not weak because our interest rates are too low. The dollar is weak because people think the United States is fighting their economy with one leg tied to a branch. Why would you want to invest in the U.S. under restrictive policies and a dumb Federal Reserve, when you have China and other places flooding the system with money.
Where do you think rates should be?
They should cut the Fed funds rate to 3'/i% to 3%%. They know that inflation is coming down and it has been pretty evident that is happening. The two-year Treasury has a very good record of predicting inflation, and the fed-funds rate should be about a half percent under that. Oil is the decoy that is distorting the picture for the Fed right now. But productivity is what keeps inflation down, and the productivity numbers have been good and unit labor costs are coming down.
What else gives you confidence?
People love to hate this indicator, but there is no other one that works like this one does: the correlation between the 10-year Treasury yield and the S&P 500 12-month forward earnings yield. It shows that money goes where it is treated best. The S&P 500 earnings yield, based on the next 12 months' earnings estimate, is about $103.19. Compared with the yield of the 10-year Treasury note, stocks are about 42% to 43% undervalued. The market has only been this cheap five other days in 28 years.
Which days were those?
The days that marked the closing lows of the bear market in 2002 and the days of the successful retest and bear market end in March 2003. The market was up more than 30% 12 months after the 2002 lows and more than 40% from the March 2003 lows in the next 12 months. When you get too much pessimism people expect earnings will come down, and when that happens, people will not pay much for earnings, and so they'll buy the bonds instead. When you get too much optimism, as happened in 1987 and 2000, people expect earnings to grow to the sky and they will pay more for them.
Aren't profit margins coming down?
Profit margins are not going to come down. Profit margins are in a new era. We are a services-based economy and our companies’ farm out the low-margin business overseas and keep the high-margin business. Now, I'm not saying profit margins will stay exactly where they are-there will be some troughs-but they will be much higher than in the past. Analysts have underestimated earnings 17 out of the last 20 quarters and one of the reasons is because they expect profit margins to narrow. The median estimate for growth in S&P 500 earnings is in double-digits, around 11%, and that's including the financial write-offs that have occurred. Three months ago they were expecting 6% or 7% growth.
How about a stock pick?
We love industrials. We love information technology. And we love health care. We are growth investors, and we pick stocks quantitatively based on our own system of earnings momentum, relative valuation and relative strength. Based on that, I don't think there is a stock I like better than Cisco Systems [ticker: CSCO]. They'll be a major beneficiary of the technology revolution, and their earnings have been fantastic. The only reason the stock came down a bit is the CEO mentioned the company would feel some effects from the sub-prime mess through its financial customers.
What else?
Coca-Cola [KO], which is not typical for us. I have never owned Coca-Cola, and I didn't think I would ever own it. But they are getting their house in order, and there is no better-known name in the world than Coca-Cola. So that is a global play.
What about on the industrial side?
Bucyrus International [BUCY1. It makes coal shovels. With the margins the energy companies are making, they can afford to dig, and that is what they are doing. It is a very attractive stock.
And information technology?
We just bought Nvidia [NVDA], which makes semiconductor graphics packages for cell phones and video games. It has been a hot stock, but it is still very, very attractive. Their revenues in the July quarter rose 36%, and they are expecting another 25% in the next year or so. We also like General Cable [BGC]. They make cable for all sorts of industries, from electric utilities and mining to telecom. They are also benefiting from the global boom. They bought manufacturers and suppliers in Germany and China and have a partnership in India. That's the growth part of the business. We recently bought EMC [EMC], as well. It's a play on global computer storage, and we like that their earnings have been rising.
Thanks, Don.

PEER PRESSURE

Industry group impact on stock valuation precision and contrarian strategy performance

o Introduction

§ Stock Valuation and portfolio construction are two core activities for active equity investment managers

§ Portfolio construction is studied from the point of view of efficient diversification of risk, individual stock of return, return standard deviations and return correlations

§ Stock valuation → analyzed in absolute terms → various multiple → company’s standing among comparable firms

§ Portfolio construction → rank on Market Cap. → Large, mid, small → as value, blended, or growth

§ Investment strategies that favor portfolio over-weighted in → value stocks as opposed to Growth stocks.

§ Practitioner used the ratio for individual company valuation

§ Academics used portfolio constructions concerns the universe of stocks considered

§ Testing for the effectiveness of contrarian portfolio strategies:

Þ Academics sort over universe of all listed stocks → defined by market capitalization

Þ Practitioners generally focused on narrow group of firms drawn from the same industry

§ On one level → test whether the peer group perspective actually improves upon assessments of relative values

§ First examine the usefulness of → book-to-market, cash flow-to-market, earnings-to-market ratios → in explaining the cross-section of observed individual stock values

§ Second, In particular → estimate how quickly individual firm value ratios correct themselves back toward the peer group median

§ Finally → specifically highlight industry effects on portfolio design and returns to contrarian strategies.

o Literature Review

§ Lie & Lie → apply the multiples-based firm valuation model in a peer group setting → determined by SIC groupings → examine the explanatory power of both assets-based multiples → in company valuations → enterprise value and equity value

§ Dremen and Lufkin → analyze returns to contrarian strategies → using relative-value rankings and compare them to returns from corresponding rankings based on aggregated marketwide sorting

o Data and Peer Group Construction

§ Kim and Ritter → bankers use valuation via median peer group characteristic multiples for prospective IPO

§ Typical investment banker’s peer group definitions for multiple-based valuation analysis seems quite useful

§ Median multiple level → differ significantly across industry peer groups at any given time

o Using Characteristic Multiples to Value Stocks

§ Lie and Lie (2002) → presuming → forming industry peer groups improves valuation precision

§ Industry-based median ration approach → significantly reduces stock pricing error → compared → aggregated single median ratio approach

§ Current median multiple for industry peer group → used as a forecast of the fair multiple → for soon-to-be-listed firms

§ Relative stock valuations within a peer group appear sticky at the one-year horizon → currently observed differences in individual firm book-to-market ratios appear → to reflect firm-specific factors → that tend to persist

§ Both equations tell a consistent story → current observed stock price cheapness or richness based on peer group ratio analysis tends to persist over a one-year horizon

o Ranking Produce Excess Returns in Hedge Portfolios

§ Test for the contribution of industry-based peer group valuation analysis in terms of the risk-adjusted returns to contrarian strategies

§ Generic contrarian strategies → constructed without regard to industry exposures based on relative value ranking across the full universe of firms

§ Create a second net return series → (Rich stock return – Cheap stock return)

§ This net return series → return on quasi-arbitrage strategy → purchases the portfolio of the cheapest stocks & sell the richest stocks

§ Excess returns to contrarian strategies persist

§ Estimates imply → annual returns to contrarian strategies are even higher in year 2 and 3

§ Average return on the industry-neutral version → could be higher / lower → depend on valuation ratio used and the particular forward period considered

§ Identification appropriate peer group → crucial first step in the company valuation process

o Result from Deciles Portfolios

§ Our two key equal-weighted portfolios have been created by drawing the cheapest and richest stocks in each industry

§ This hedge portfolio has no net exposure to industry effects

§ Average net of return between these richest and the cheapest portfolio equals zero

o Conclusion

§ Peer pressure is a term describing the pressure exerted by a peer group in encouraging a person to change their attitude, behavior and/or morals, to conform to

§ Company affected by peer pressure may → or may not want to → belong to these groups

§ They may also recognize dissocialize groups with which they would not wish to associate → thus they behave adversely concerning that group's behaviors

§ Two types of peer pressure → positive and negative.

§ Positive peer pressure → tries to help a company change → better

§ Negative peer pressure → tries change a company → worse

§ Contrarian Strategy → approach based on the idea that the market will eventually rediscover out-of-favor stocks and bring the high-flyers back down → it looks for medium to large cap stocks with low price / earnings ratios and a potentially strong financial condition