Investment Strategies that Emerge After Decoding Wall ...csinvesting.org/.../02/Decoding-Wall-Street-Propaganda-A-MUST-READ.pdf · Decoding Wall Street Propaganda. ... from Devil

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Investment Strategies that Emerge AfterDecoding Wall Street Propaganda

Page 2 Confidential and Proprietary New Constructs, LLC

Agenda

I. Define Propaganda and Why It MattersII. Outline Steps for DecodingIII. Present Emerging Investment Strategy


Part IWhat Is the Propaganda and

Why Does It Matter?“…transfer property from the hands of many to the

pockets of few.”from Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor


What Is The Propaganda

Reported Earnings Are Reliable• Quarterly Earnings Conference Calls Provide Adequate Information• Earnings are a reliable measure of profitability

Earnings Growth Drives Valuation• Price-to-earnings and other simple valuation techniques are accurate• Market cares about this quarter’s earnings more than anything else.

Wall Street Wants To Help Investors Make $• Research aims to help investors make more informed decisions• Brokerage services help create wealth for clients• Spitzer Settlement has been effective• Wall Street research coverage is not-conflicted

Simple But Very Misleading Messages


Define the Audience for the Propaganda

Speculator

InvestorVs.

“If you are a speculator, your decision to buy or sell is based on what youbelieve about the near-term direction of price.” - Ben Graham

“…speculation is the activity of forecasting the psychology of the market.” -John Maynard Keynes

“If you are an investor, your decision to buy and sell is based on the underlyingeconomics of the stock you own.” - Ben Graham

“Investing is an activity of forecasting the yield on assets over the life of theasset…” - John Maynard Keynes


Jump On the BandwagonProof That There Is Lots of Speculation

Shorter Holding Periods for Stocks• Until mid-1960’s average holding period was 7 years.• Today, average holding period is less than 1 year and annual portfolio turnover is

more than 100%1.

Major Reactions to Quarterly Earnings• Stock prices make large moves in response to earnings surprises.• Suggests that long-term cash flows are less important.

Amateur Individual Investors - growth market• Schwab, TD Waterhouse, Scottrade• Day trading

Media - growth market• TV: Mad Money, CNBC Squawk Box and Squawk on the Street.• Print: Wall Street Journal, Investors Business Daily, local newspapers.• Web: Motley Fool, The Street.Com, CBS MarketWatch

1Rappaport, Alfred. “The Economics of Short-Term Performance Obsession.”Financial Analysts Journal, vol. 61, no. 3 (May/June): 65-79.


Spec

ulat

ion

Investment KnowledgeHigh Low

Low Low

HighTurnover

High

Institutional Investor Categories Definitions1. Quasi-indexers - low turnover and small

stakes2. Transients - high turnover and small stakes3. Dedicated - low turnover and large stakes

Percentage Breakdown of Institutional Investor Categories

Quasi-Indexers 61%Transients 31%Dedicated 8%Total 100%

Source: Brian Bushee, "Identifying and Attracting the 'Right' Investors: Evidence on the Behavior of Institutional Investors,"Journal of Applied Corporate Finance, Vol. 16, 4, Fall 2004, 28-35

Noise Trumps Knowledge & Skews ValuationsPeople Who Know Less Tend to Trade More


Unrealistic Expectations Become A Self-Fulfilling Prophecy

Equi

tyVa

luat

ions

Fair

Investment KnowledgeHigh Low

Low

High

Speculators Skew Equity ValuationsNoise, Turnover and Volatility Create Aberrations


The Result: Bigger $ for Wall Street

The Bottom Line: Investment Banking Is What Matters• Research is loss leader for banking, trading profits are going away• Spitzer Settlement has not been very effective.• Wall Street is sales and marketing for Corporate America’s best-grossing product• Quarterly Conference calls are like commercials for selling stock

Investors $

Wall StreetToll$$$

Private Capital $ Public Capital $

Ignorance Is Bliss?


Part IIHow to Decode the Propaganda

From Enronʼs in-house risk management manual:“Reported earnings follow the rules and principles of accounting. The results do not always

create measures consistent with the underlying economics. However, corporate managementʼsperformance is generally measured by accounting income, not underlying economics. Therefore,

risk management strategies are directed at accounting, rather then economic, performance.”- The Smartest Guys In The Room by Bethany McLean and Peter Elkind page 132


Earnings Are Not ReliableOnly Economics Show True Profitability

• Translate accounting data into economic information.

• Reconciling accounting rules with economic principles.• Accounting rules were created by accountants for creditors,

not equity investors.• Analyzing the economics of businesses – quickly and easily.


The Core ProblemGAAP Offers Insufficient Information• Actual profitability of businesses is obscured• Valuation metrics based on GAAP metrics are misleading• When EPS and Cash Flow diverge, the market follows cash

= Economic Profit

=Profit- capital charge

= Reported Profit

=pretax earnings- taxes

= pretax earnings- taxes

Revenues- operating expenses- Cost of ESOs

Revenues- operating expenses

Economic P&LTraditional P&L


Misleading EarningsMore Companies Overstate Than Understate Profits


Return on Invested Capital

Earn

ings

Gro

wth

Assume all equity financed; 10% WACC; 20-year forecast period

8% 10% 15% 20%

5% 8.5x 10.0x 12.0x 12.9x

10% 5.7 10.0 15.8 18.6

15% 0.1 10.0 23.4 29.9

20% NM 10.0 38.2 52.2

Earnings Growth Does Not Drive ValuationROIC Drives P/E Multiples


Quantify Expectations Embedded In PriceLet Market Be the Fortune Teller

• Value of business boils down to three key drivers:1. How fast will the business grow2. How profitable will it be3. How long can it sustain profitable growth

Revenue Growth

ROIC - WACC

Growth Appreciation Period

8.5% CAGR (organic)

1% (versus -2% last year)

21 years (maturing market)

AssetValue

$57StockPrice

Davita (DVA)Stock

Every stock price reflects expectations for future cash flows.


Modeling SpeculationExpectations Reach Extremes


Part IIIInvestment Strategies that Emerge

Back To the Future: Understanding Risk/Reward


Finding the Dark CornersExploit Short-Termism and Misplaced Incentives

Qualifiers Qualifiers


Risk Versus Reward Rating SystemResults Provided By Every Model


Disconnects Between Price and ValueBetter Mousetrap For Finding the Fat Tails


No Substitute For Rigorous AnalysisOnly 3 Ways to Beat the Market

Better Data - difficult and expensive to obtain• Gathering and analyzing data from the Notes to the Financial Statements provides

a competitive advantage.

Better Analysis - not just your neighbor, one must out-think the entire market• Better data means better models.• Better models provide better analysis.

Better Discipline - stick to your guns, don’t follow the herd.• Long and short strategy is built on specific, quantifiable thresholds derived from a

model we can trust.• Our models do all the number crunching to supply our human capital with superior

information and decision-making capabilities.


Most Attractive/Dangerous - documented picksHypothetical Long/Short Portfolio: Jan 05 - June 10

This graph represents the historical performance of a hypothetical portfolio of securities consisting of the stocks listed in New Constructs’ “40 MostAttractive Stocks” and “40 Most Dangerous Stocks” lists. This chart does not account for transaction costs, dividends, rebates or fees taken by theGeneral Partner. The chart assumes equal-weighted holdings in all 80 stocks and assumes that the holdings will be updated upon the publication ofnew reports. Accordingly, the chart shown herein does not necessarily indicate overall portfolio performance that has been or may be expected to beachieved. Past performance is not an indication of future results.


Most Attractive/Dangerous - Jan 05 to June 10Hypothetical Long and Short Portfolios Outperform

Part 4 - Our Process

This graph represents the historical performance of a hypothetical portfolio of securities consisting of the stocks listed in New Constructs’ “40 MostAttractive Stocks” and “40 Most Dangerous Stocks” lists. This chart does not account for transaction costs, dividends, rebates or fees taken by theGeneral Partner. The chart assumes equal-weighted holdings in all 80 stocks and assumes that the holdings will be updated upon the publication ofnew reports. Accordingly, the chart shown herein does not necessarily indicate overall portfolio performance that has been or may be expected to beachieved. Past performance is not an indication of future results.


Paradigm Shift Trade-off Between Depth and Breadth Is Overcome


The Source of Better InformationIntegrated Financial Data Value Chain

Gathering and analyzing data from the Notes to the Financial Statements is key.


DISCLOSURES

New Constructs™, LLC (together with any subsidiaries and/or affiliates, “New Constructs”) is an independent organization with no management ties to thecompanies it covers. None of the members of New Constructs’ management team or the management team of any New Constructs’ affiliate holds aseat on the Board of Directors of any of the companies New Constructs covers. New Constructs does not perform any investment or merchantbanking functions and does not operate a trading desk.

New Constructs’ Stock Ownership Policy prevents any of its employees or managers from engaging in Insider Trading and restricts any trading wherebyan employee may exploit inside information regarding our stock research. In addition, employees and managers of the company are bound by a codeof ethics that restricts them from purchasing or selling a security that they know or should have known was under consideration for inclusion in a NewConstructs report nor may they purchase or sell a security for the first 15 days after New Constructs issues a report on that security.

New Constructs is affiliated with Novo Capital Management, LLC, the general partner of a hedge fund. At any particular time, the hedge fund may ownsecurities that New Constructs recommends to other clients to sell, or may sell securities that New Constructs recommends to other clients topurchase.

All charts appearing in this presentation are based on New Constructﾕs internal models and are included in this presentation solely to reflect the opinionsof David Trainer and New Constructs.

DISCLAIMERS

The information and opinions presented in this report are provided to you for information purposes only and are not to be used or considered as an offer or solicitation of an offer to buy or sellsecurities or other financial instruments. New Constructs has not taken any steps to ensure that the securities referred to in this report are suitable for any particular investor and nothing in thisreport constitutes investment, legal, accounting or tax advice. This report includes general information that does not take into account your individual circumstance, financial situation or needs,nor does it represent a personal recommendation to you. The investments or services contained or referred to in this report may not be suitable for you and it is recommended that you consultan independent investment advisor if you are in doubt about any such investments or investment services.Information and opinions presented in this report have been obtained or derived from sources believed by New Constructs to be reliable, but New Constructs makes no representation as totheir accuracy, authority, usefulness, reliability, timeliness or completeness. New Constructs accepts no liability for loss arising from the use of the information presented in this report, and NewConstructs makes no warranty as to results that may be obtained from the information presented in this report. Past performance should not be taken as an indication or guarantee of futureperformance, and no representation or warranty, express or implied, is made regarding future performance. Information and opinions contained in this report reflect a judgment at its originaldate of publication by New Constructs and are subject to change without notice. New Constructs may have issued, and may in the future issue, other reports that are inconsistent with, andreach different conclusions from, the information presented in this report. Those reports reflect the different assumptions, views and analytical methods of the analysts who prepared them andNew Constructs is under no obligation to insure that such other reports are brought to the attention of any recipient of this report.New Constructs’ reports are intended for distribution to its professional and institutional investor customers. Recipients who are not professionals or institutional investor customers of NewConstructs should seek the advice of their independent financial advisor prior to making any investment decision or for any necessary explanation of its contents.This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or jurisdiction where suchdistribution, publication, availability or use would be contrary to law or regulation or which would be subject New Constructs to any registration or licensing requirement within such jurisdiction.This report may provide the addresses of websites. Except to the extent to which the report refers to New Constructs own website material, New Constructs has not reviewed the linked site andtakes no responsibility for the content therein. Such address or hyperlink (including addresses or hyperlinks to New Constructs own website material) is provided solely for your convenienceand the information and content of the linked site do not in any way form part of this report. Accessing such websites or following such hyperlink through this report shall be at your own risk.All material in this report is the property of, and under copyright, of New Constructs. None of the contents, nor any copy of it, may be altered in any way, copied, or distributed or transmitted toany other party without the prior express written consent of New Constructs. All trademarks, service marks and logos used in this report are trademarks or service marks or registeredtrademarks or service marks of New Constructs.Copyright New Constructs, LLC 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010. All rights reserved.

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Investment Strategies that Emerge After Decoding Wall ...csinvesting.org/.../02/Decoding-Wall-Street-Propaganda-A-MUST-READ.pdf · Decoding Wall Street Propaganda. ... from Devil