This week I am departing from my usual format to bring you excerpts from a talk given by Samuel Eisenstadt, the former Research Chairman of Value Line Inc. in front of a packed house of analysts and portfolio managers at a QWAFAFEW meeting in New York during April of last year. QWAFAFEW (The Quantitative Work Alliance For Applied Finance Economics And Wisdom)  is a Quantitative Investment Society with chapters in New York, Princeton, Hartford, Boston, Washington DC, Chicago, Denver and San Francisco. The talk was given in a question and answer format. At the end of the presentation, I have added three questions that I asked Sam this week along with his answers.

Sam started his financial career at Value Line in 1946 as a proof reader, but was quickly recognized for his acumen with statistics. "In 1965 Eisenstadt persuaded Bernhard to switch from time series regression analysis to "cross-sectional", a procedure that studies relationships at a point in time rather than across time. This was a major shift that greatly improved the performance of the ranking system in subsequent years. The new system ranked about 1700 stocks relative to one another, based largely on measures of momentum for both earnings and price. In effect the system is designed to ride winners and avoid losers. Sam became the Research Chairman for Value Line in 1987 and held that position through the remainder of his career at Value Line, which came to an end in 2009. Sam remains active in investment research and is often quoted by Mark Hulbert in his Market Watch articles.

Special Meet of QWAFAFEW, New York
April 16, 2012

Question: Please describe the circumstances that lead to the development of the Value Line Timeliness Ranking System. What needs were perceived to need addressing? When it started, did you have any idea how long it would take to complete?

Answer: No, it was an open-ended research project for us. The purpose was to produce an improved system. We noticed that interrelationships between highly related variables frequently caused factors to drop out of regressions. An example of this was IBM, a consistently up-trending stock, where the lagged price became the most important factor.

Question: The academic literature references relative earnings and price ranks, EPS growth, price momentum, and earnings surprise as being factors in the model. It has also been noted that Value Line was the first known system to use earnings surprise as a factor. How did this factor become a part of the system?

Answer:  A physics professor from Brooklyn Polytech, Professor Fabricant had detected that whenever an analyst's earnings projection (next 12 months) was raised, the relative price action of the stock subsequently improved. The question became: "How could we take advantage of this action in the Ranking System?" We believed that by examining the reason for the revision, we might improve the System. We found that, more often than not, the revision took place after an earnings release.  Thus, by evaluating the earnings release, we could get a jump on the analyst revision itself. Hence the birth of the earnings surprise factor. It was tested, found significant, and introduced into the system prior to anyone else's use of this factor (to the best of our knowledge).

Question: The first famous article about the Value Line ranking system as an "anomaly" to the Efficient Market Theory being trumpeted by academics was called "Yes, Virginia, There Is Hope; Tests Of The Timeliness Ranking System" by Dr Fischer Black. Could you tell us how the article came about; what assistance you provided in helping him perform his tests, and any other things you think we might find interesting?

Answer: Dr. Black was invited by Arnold Bernhard to test our ranking system using any procedures and tests that he could think of. The result was "Yes Virginia, There Is Hope;". Value Line provided the computer power and Fischer was paid for his efforts. Several professors at the University of Chicago claimed that Dr. Black was "paid and quartered by Value Line", thus suggesting that his results were biased towards a favorable outcome for Value Line. Subsequent results of the ranking system for many years would appear to have validated Fischer Black's conclusions. Indeed, Value Line's ranking system results might have resulted in some modifications in the Capital Asset Pricing and Efficient Market discussion!

Question: Why do you enjoy tinkering with data so much?

Answer: I was always looking for numerical solutions to stock price forecasting. Discovery of statistical solutions and significance, particularly in stock price forecasting provided a thrill - even if only a momentary one, at times. It shed a bit of light on the darkness that enveloped the subject. I think the thrill would have been there, even if the subject under investigation were other than stock prices.

Question: What other ranking systems and models have you been involved in testing and attempting to develop over the years?

Answer: I've developed a technical ranking system. Most technicians do not use statistical methods to construct and test their systems. This is one field that requires such testing since much of their beliefs are not justified by mathematical verification. The technical system provides a small amount of explanatory power with mixed results, particularly in recent years. Relative strength is the primary tool, but applied using multiple regression techniques. Also, in the early years, a model was constructed in order to assign quality grades to companies based upon growth and price stability.

Question: Getting back to some of the efficient market debates, one of the reasons for the persistence of that theory is the simple empirical fact that the majority of mutual fund managers under-perform their benchmark indexes even before fees. What are the biggest factors contributing to this prolonged phenomena? 

Answer: In a nutshell, success carries with it the risk of ultimate failure. This is also true to some extent of the Value Line timeliness rankings and other statistical approaches. Recent studies have indicated a shrinkage in the spread between good and bad companies making discrimination much more difficult. This may be due to the proliferation of ETFs which select companies on the basis of sector rather than individual company characteristics. These days, they buy the whole steel industry rather than only the "good" steel companies.

Question: You once had a debate with Dr. Rex Sinquefeld who went on to become the founder of Dimensional Fund Advisors. What was the nature of this debate? Are there any specific exchanges that you can recall?

Answer: The title of the debate was "The Efficiency of Capital Markets". The debate was held at the University of Chicago before a large group of MBA students. I was chosen, largely as a defender of the Value Line ranking system who argued that if our results at Value Line were accurate, then equity markets were not as efficient as claimed. This was largely a continuation of the old debate which Fischer Black had addressed in "Yes Virginia, There Is Hope". Either the Value Line results were misleading or the efficiency argument was faulty.

After a lengthy discussion of Value Line results, Rex argued that if Value Line numbers were correct, in time the results would deteriorate as more and more followers followed the system. There was a large element of truth in this as later results would show. My response at the time, which drew considerable laughter from the MBA students, was that as long as the University of Chicago continued to teach their market efficiency argument, there was hope for us! Later papers on the market efficiency argument tended to soften the position of the university's academics. 

Question: Are there any areas of quantitative analysis that you would like to explore that just were not viable in the past due to lack of computing power or lack of data? 

Answer: I feel computer power and lack of data do not represent a problem today.  Indeed, there may be too much data available - so much so that I sometimes think it serves to confuse the issue.

Question: As more and more funds have turned towards quantitative analysis and rules-based investing have you seen any changes in the performance of your own models? Have factors that have suggested the potential for out performance in the past now stopped working? Also, have you seen the duration of the holding periods for the stocks that your model picks change? 

Answer: Factors that have worked in the past have not worked well in recent years.  Earnings growth and price momentum which worked extremely well prior to 2000 were largely displaced by value factors since 2000. 

One does not hear of outstanding results from relative price strength in recent years.  It appears that overall, the markets have become more efficient in recent years.  The overall spread between outperforming stocks and underperformers has shrunk in the past 10-15 years. If good and bad stocks are performing more and more like the general market, it becomes more difficult to differentiate.  Perhaps the influx of Phd's in mathematics and physicists from academia have accentuated this process. In addition, the phenomenal growth of ETF's, which tend to group stocks by industry and sector rather than by value or growth have contributed to the diminution of spread between attractive  and unattractive.  This may be carried too far and will probably reverse some day.

Question: If you could impart one pearl of wisdom to someone just starting out in the investment field, what would it be? 

Answer:  With respect to newcomers in the field, I would recommend - stick to it.  I am optimistic.  While answers may never be found, it's fun looking for them and potentially profitable even if one gets close.

Thank you Sam.

The above excerpts make up about half of the original Q&A session plus my three questions. The article is getting a bit long in the tooth now, though, so I will save the second half for some time in the future.

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Today I am interviewing Pierr Johnson, a veteran of Wall Street with twenty-two years as an analyst in both investments and banking. Pierr is the founder, Principal and Analyst at Neoga Advisors, a firm that offers research, analytic and advisory services to Tech and Life Sciences companies and investors. Prior to Neoga, he was a Vice President and Equity Research Analyst at John Hancock Funds where he specialized in technology companies. Pierr also was a Senior Vice President and Analyst in Bank of America’s Tech Banking Group, where he supported a wide range of M&A and related financing transactions. He got his start in the business as an Equity Analyst at The Value Line Investment Survey in the early 1990's.

So, what's in your library Pierr?

Graham & Dodd's Security Analysis 3rd Edition by Benjamin Graham & David Dodd  I first read this great work when I got hired as an Analyst at Value Line. I devoured a library copy eager to learn about a discipline that was new to me. I soon bought the 5th edition, along with various finance books, as my mentors there guided me through their analytic program. As it has been for so many analysts, Graham & Dodd was my doorway into a profession I’ve truly loved to pursue. It’s a great book for learning how to do investment analysis.

Margin of Safety by Seth Klarman - This is a very hard-to-find book on value investing by a hedge fund legend in Boston, where I live. Yet through networking with colleagues I learned that a pdf is available via the Internet and it is well worth the read, even in a notebook display. (A hard copy will set you back a couple thousand.)  As a Tech investor, I realize scarcity always enhances value. With so many growth companies and stocks to follow, a focus on valuation to me is very important. 

The Dark Side of Valuation: Valuing Young, Distressed, & Complex Businesses by Aswath Damodaran - Damodaran is well known for his classic Investment Valuation, which explains the discounted cash flow valuation process. Here he offers ways to apply these processes to valuing bubble-like stocks, which for me was very useful when he published it at the time. The book also gives strategies that are useful for investors looking to value trending stocks. Understanding discount rates with high-multiple stocks (e.g., when P/S looks like P/E) is very helpful to me, especially once I’ve aggregated the fundamental factors that support the high valuation. 

Standard & Poor's Fundamentals in Corporate Credit Analysis by Blaise Ganguin - When I first became the Senior Analyst to the BofA Tech Banking Group, my Research Director had me read a number of works to get me up to speed on Corporate Finance and Investment Banking. The obvious one to single out is S&P’s guide to Credit Analysis.  I had read Fabozzi’s giant tome twice, but as a bank, they had an army of people pricing debt. When you participate in a company’s manifold capital transactions, credit analysis and corporate finance have a different importance. This book and the Van Horne/Wachowicz Fundamentals of Financial Management were both required and valuable reading.

Valuation: Measuring & Managing The Valuation of Companies by Tim Koller, Marc Goedhart, & David Wessels - With the Banking Group, I got involved in all the significant strategic and financing events of our closest clients, especially those related to M&A. Investors purchase  marketable securities, hoping to sell them for a gain. With our clients’ capital transactions, however, Valuation and Financial Management required a broader perspective and I found this book (published by Wiley for McKinsey and Company) a great resource to me.

Acquisition & Corporate Development: Contemporary Perspectives For The Manager by James Bradley & Donald Korn - My firm grew from networking with local Investors and Corporate Development professionals as they sought to leverage my deep skills and experience. Two of a number of books I read were especially interesting as I rounded out my service offering. Bradley and Korn’s work I found on Google Books, which at the time allowed full access to the text. Placing M&A at the heart of strategy in the corporate development process was key. There is also Christopher Clarke’s Shareholder Value: Key to Corporate Development, which is still in print, if a bit pricey.

Biotech Valuation: An Introductory Guide by Karl Keegan – Some years back I was asked to extend coverage to Life Sciences and Biotech, having at the time covered Tech for way over a decade. Two books were very helpful to me is getting my coverage launched.  Karl Keegan’s book is targeted more to Equity Analysts and provides both a great introduction to this unique industry and a useful framework for valuation.  Keegan for many years was Canaccord Adams’ Biotech Analyst.  Boris Bogdan’s Valuation in Life Science also has a great introduction to the industry but is more targeted to valuing transactions and alliances in the industry. 

Valuation in Life Sciences: A Practical Guide by Boris Bogdan & Ralph Villiger - (mentioned above)

Thanks Pierr.

As always you can buy any of the books Pierr mentioned at the The Sniper Book Bin. If you'd like to see another great read, sign up for The Sure Shot Lettermy monthly newsletter that is packed full with great investment ideas.
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This week I am speaking with Larry Rothman, an Associate Editor at Dealreporter, a subsidiary of the Financial Times. Larry started his career as an analyst at Value Line, working in both equity and convertibles. He then jumped to Miller Tabak, where he was a high yield and convertible analyst, before moving to William Blair, where he specialized in convertibles. Larry has also worked at a couple of independent research companies over the years covering the entire capital spectrum, from equities, to convertibles, and high yield. 

Larry is always happy to hear from analysts, portfolio managers, and investment bankers that would like to comment for future articles. It can be for attribution or kept as background. 

So, what's in your library Larry?

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One Up On Wall Street by Peter Lynch - This was one of the first books I had read on investing. It was insightful and paved the way for me to analyze equities. In fact, I still use some of what I learned from it today, particularly when I read various arguments that have nothing to do with the underlying fundamentals of an investment. 

Graham & Dodd's Security Analysis by Benjamin Graham & David Dodd - A book that is as timely today as it was when it was first written! Core principles that are necessary for analyzing all stocks can be found in this book. All said, I believe this book should be mandatory reading for all finance majors.

Buffett - The Making of an American Capitalist by Roger Lowenstein - An interesting history about "The Oracle of Omaha". The book goes beyond his personal biography, though, and there are nuggets of investment wisdom to be gained. The main tenet: "We should all think like owners in the businesses in which we invest".

When Genius Failed: The Rise & Fall Of Long Term Capital Management by Roger Lowenstein - Besides being a fascinating read, the book shows the pitfalls of hubris and greed. Add leverage to the mix and the potential for disaster rose exponentially. All said, "pride goeth before a fall...and the fall here was epic! A great, overall read.

A Random Walk Down Wall Street by Burton Malkiel - A timeless lesson on how difficult it is to beat the market. It shows the powerful effect of bubbles, why they are formed, and the inevitable pain when they pop. Another "must read" for market participants! 

As always you can buy any of the books Larry mentioned at the The Sniper Book Bin. If you'd like to see another great read, sign up for The Sure Shot Lettermy monthly newsletter that is packed full with great investment ideas.
Today I am going back to the well and giving you a second list of books that have helped to shape me as an analyst. I told you in the inaugural article that I might give you a second list from me, and with two potential interviewees having to put me off this week due to a looming deadline and a vacationing compliance officer I thought this week would be a good time to give you that second list.

For those of you that didn't read the first article, I am Wayne Nef, President of Sniper Research and author of The Sure Shot LetterI have worked on the Street for over twenty years with stints at Value Line, Merrill Lynch and Circle T Partners. For the past ten years I have worked as a consultant to hedge funds through my company Nef Value Research.

So what's in my library?
A Zebra In Lion Country by Ralph Wanger - This book gives you another look into the mind of a great investor. As the man says right in the beginning of the book "If you've done it, it ain't braggin!" And this man has done it! Wanger had an average annual return of 17.2% for the Acorn Fund from 1970 through 1998. He got there by investing in small cap stocks. This book does a good job of explaining his investment  philosophy and gives some good accounts on how he found some of his greatest picks.

Reminiscences of a Stock Operator by Edwin Lefevre - An oldie but a goodie. This book was first published in 1923, yet I don't know many in the business that haven't at least heard of it, if not read it! If you don't read it for the great story, then read it for the great thoughts on crowd psychology or market timing. While some of the stocks mentioned are no longer with us, the set ups that created the opportunities are timeless and you'll think of many instances where the same story has been played out by other stocks in other times. A great book, even today, 90 years after it was first published.

Contrarian Investment Strategies: The Next Generation by David Dreman - Here's another investment master giving away secrets. Dreman is a big believer in psychology and probability. The book focuses in on certain investor behaviors and how to potentially exploit it. A Well-researched read that is also entertaining.

John Neff On Investing by John Neff - Neff is an advocate of low P/E investing. This man is an excellent writer. Not only does he convey his strategy and why it works, but at some points he can make you feel the fear that was driving the market at a given point in time (1973, for example) and how it helped to set up some of his most profitable investment opportunities. 

The Devil's Dictionary by Ambrose Bierce - If you are looking for investment advice, you're not going to find it here. Instead this book is a "how to" book on developing cynical wit, which can be useful in our line of business! The Devil's Dictionary gives example after example of Bierce tearing down ideas, notions and people who were considered untouchable in his time. All said, if you want an education on how to be cynical, Ambrose Bierce stands up there along side H.L. Mencken!

As always you can buy any of the books I mentioned at the The Sniper Book Bin. If you'd like to see another great read, sign up for The Sure Shot Lettermy monthly newsletter that is packed full with great investment ideas.
Today I am interviewing Peter Gaynor a long-time Wall Street veteran. Peter has been a Senior Portfolio Manager at Wilmington Trust and has worked as an Investment Officer at Evergreen Investments. Prior to that he has had stints at Merrill Lynch Investment Managers and PNC Bank, both as money managers. He started his career as an analyst at the Value Line Investment Survey in the early '90s.

So, what's in your library Peter?

Investing: The Last Liberal Art by Robert Hagstrom The book ties together the scientific models of different disciplines as they might relate to an investment framework. Hagstrom looks at the governing models of other disciplines such as physics, biology, philosophy and literature and spotlights their potential use in investing. The book highlights the importance of cyclicality and life cycle and how investors can improve their returns by moving away from financial concepts only and including strategies and methods from other fields of study.

Advances In Behavioral Finance by Richard Thaler Thaler explores the emotional biases of investors and how those biases affect decision making. A classic example of this is people's reluctance to sell stocks that have lost money due to a fear of admitting mistakes or recognizing a loss. This bias also runs in the opposite direction as many people will also sell winners too early in order to realize the pleasure of winning. Finally, the efficient market theory can never explain thoroughly high over or under valuation for any individual stocks.

What Works On Wall Street by Jim O'Shaughnessy A good review of the long-term historical predictive value of financial ratios. Over very long time horizons he shows which ratios hold the greatest chance for making money. This is a good source for background information for building quantitative models. He goes over price to book, price too earnings, price to sales, price to cash flow etc., providing a valuable historical perspective for decision making.

Financial Shenanigans by Howard Schilit This book helps investors identify balance sheet tricks that companies can use to inflate earnings. It's useful for identifying high-flying companies that have unsustainable trends. This book really puts the spotlight on accounting gimmicks and is filled with case studies. I love case studies!

Extraordinary Popular Delusions & The Madness of Crowds by Charles MacKay The book reaches back into history to vividly describe cultural manias and preoccupations, including tales of 18th century investment fads in Tulip bulbs, South Seas trading and Louisiana land development. MacKay examines the basis for the hyperbolic expectations and colorfully shares the ultimate folly of even the most respected intellectuals of the day. This is definitely a buyer beware type of book! Its enduring message: weigh carefully the wisdom of popular belief. 

Thanks Peter.

As always you can buy any of the books Peter mentioned at the The Sniper Book Bin. If you'd like to see another great read, sign up for The Sure Shot Lettermy monthly newsletter that is packed full with great investment ideas.
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