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1 MAGAZINE May/June 2007

2 I rely on Standard & Poor s Backtester TM and the historical data that it s built on to perform my rigorous backtests. Standard & Poor s Backtester as robust as your investment strategies DATA SERVICES RATINGS RISK SOLUTIONS EQUITY RESEARCH INDICES Standard & Poor s Backtester, powered by the Research Insight analytical engine, using the Standard & Poor s Compustat database as its core data foundation, is the tool you need for serious quantitative analysis. Efficient create your investment models and control the portfolio construction with one application Flexible see results quickly and make changes on the fly Intuitive simulate a complex trading environment by incorporating all the elements of typical backtesting workflow and decision-making environment Transparent provides detailed simulation outputs Americas Asia-Pacific Europe Analytic services and products provided by Standard & Poor s are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poor s has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

3 WHAT IS your MEASURE OF VALUE? EVALUATING investment performance is a complex business. A lot depends on the precision of the tools being used and the knowledge of the practitioner. But how do you measure who brings the most value to the task? CFA Institute offers a specialty certification program to help you develop the kind of expertise needed for consistent, precise execution every time: the Certificate in Investment Performance Measurement (CIPM). The CIPM program builds on the more than 40 years of experience that CFA Institute has in educating and testing investment professionals. With such seasoned perspective, a practice-based curriculum, and an emphasis on ethical standards, the CIPM program provides the skills you need to prove your worth at any firm. Covering professional ethics, performance measurement, and the GIPS standards, the CIPM program will help you demonstrate expert status to yourself, to your firm, and to your clients. See how the CIPM program measures up. Visit CFA Institute is the global, not-for-profit professional association that administers the CFA curriculum and examination program worldwide and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute created the Global Investment Performance Standards (GIPS) in conjunction with volunteers from more than 30 countries.

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5 MAGAZINE INSTITUTE May/June COVER STORY Are company site visits a delusion? Market INTEGRITY 24 Reflecting on a Two-Year Milestone: An Interview with Kurt Schacht, CFA BY CHRISTOPHER WRIGHT 43 Into the Breach Bridging the gap between earnings and financial reality BY SUSAN TRAMMELL, CFA Professional PRACTICE 54 Portfolio Performance Shareholder activism and returns BY LORI PIZZANI 48 Blowing Bubbles in the Punch Bowl Learning lessons from overvalued stocks BY JOHN RUBINO SPECIAL ANNIVERSARY COVERAGE 5 CFA Day: Celebrating Professionalism 12 Timeline: Member Profile: Andrew Brady, CFA 64 Point/Counterpoint: Should financial analysis be professionalized? 60 Private Client Corner Hiring for smaller firms BY ED MCCARTHY 25 Quality Information = More Efficient Markets BY CRYSTAL DETAMORE-RODMAN 28 Fair Value Financial Reporting, Part 2 BY REBECCA MCENALLY, CFA 31 An Apples-to-Apples Comparison BY MATTHEW ORSAGH, CFA, CIPM 32 China and Corporate Governance BY LEE KHA LOON, CFA 33 Financial Market Integrity Index BY MATTHEW ORSAGH, CFA, CIPM COLUMNS 5 In Focus Celebrating professionalism, meeting new challenges BY JEFF DIERMEIER, CFA 6 Viewpoint A curious dilemma: How can managers and traders reconcile conviction and uncertainty? BY WAYNE H. WAGNER 64 Point-Counterpoint Should financial analysis be professionalized? DEPARTMENTS 2 In Summary Just like television 56 Analyst Agenda Cash flow vs. earnings BY CHRISTOPHER WRIGHT 58 Trading Tactics The SEC looks at front running BY NANCY OPIELA 62 Standards in Practice New requirements for pension plans BY CYNTHIA HARRINGTON, CFA 8 Education Calendar Upcoming CFA Institute and society events 14 Briefs CFA Institute, member, and society news

6 IN SUMMARY MAGAZINE INSTITUTE The CFA Institute Member Magazine for Investment Professionals May/June 2007 Just Like Television This is just like television, only you can see much further. The movie Being There, released in 1979, is about a naïve gardener whose entire life has been spent cloistered on the estate of a wealthy man and whose only notions of the outside world come from watching television. Then fate intervenes, and Chance the Gardener (as he comes to be known) enters the wider world. Taking his first ride in a car, he says, This is just like television, only you can see much further. Sometimes life is like that. In fact, according to some observers, sometimes company site visits are like that a kind of optical illusion. But as our cover story ( Being There, p. 38) explains, veteran analysts often have a different perspective on the value of site visits. And how much further could analysts see if earnings management didn t come between them and financial reality? As Into the Breach (p. 43) reports, a recent survey of corporate managers produced some revealing responses, and analysts should act accordingly. These days, with 24/7 financial media coverage, telling the difference between appearance and reality can be a greater challenge than ever, but investors can still learn valuable lessons from studying the history of overvalued companies ( Blowing Bubbles in the Punch Bowl, p. 48). One man who knows the difference between television and financial reality is Gerry White, CFA, chair of the Corporate Disclosure Policy Council. Our story Quality Information = More Efficient Markets (p. 25) tells the story of White and the CDPC. And while we re on the subject of watching television, I should point out that our Point-Counterpoint section (p. 64) is a rerun of a Financial Analysts Journal episode that originally aired in Several of our Professional Practice articles also look at issues in which things are not always what they seem, such as cash flow (p. 56), unethical trading practices (p. 58), and accounting for defined-benefit plans (p. 62). We hope you ll find something in this issue that will help you see things a little more clearly. As Chance the Gardener reminds us, It is the responsibility of the gardener to adjust to the bad seasons as well as enjoy the good ones sage advice that goes far beyond gardening. DERIK RICE Editor CFA INSTITUTE PRESIDENT & CEO Jeff Diermeier, CFA ASSOCIATE EDITOR Roger Mitchell ONLINE PRODUCTION COORDINATOR Kara Morris ADVERTISING MANAGER Jenine Kaznowski EDITORIAL ADVISORY TEAM Shanta Acharya Bashir Ahmed, CFA Jim Allen, CFA Jonathan Boersma, CFA John Bowman, CFA Jarrod Castle, CFA Michael Chan, CFA Michael Cheung, CFA Josephine Chu, CFA Franki Chung, CFA Darrin DeCosta, CFA Nick Dinkha, CFA Jerry Donohue, CFA Alison Durkin, CFA Kenneth Eisen, CFA William Espey, CFA Julie Hammond, CFA Burnett Hansen, CFA M. Mahboob Hossain, CFA Vahan Janjigian, CFA Andreas Kohler, CFA CFA Magazine (ISSN , CPM ) is published bimonthly in January, March, May, July, September, and November by CFA Institute. Periodicals postage paid at Charlottesville, VA, and additional mailing offices. POSTMASTER: Send address changes to CFA Magazine, PO Box 3668, Charlottesville, VA Statements of fact and opinion are the responsibility of the authors alone and do not imply an endorsement by CFA Institute. Copyright 2007 by CFA Institute. All rights reserved. Materials may not be reproduced or translated without written permission. CFA, Chartered Financial Analyst, and the CFA Institute logo are just a few of the trademarks owned by CFA Institute. See for a complete list. Annual subscription rate for CFA Institute members is US$10, which is included in the membership dues. Annual nonmember subscription rate is US$75. THE AMERICAS 560 Ray C. Hunt Drive Charlottesville, VA USA Phone: or Fax: EUROPE 10th Floor, One Canada Square Canary Wharf London E14 5AB United Kingdom Phone: +44-(0) Fax: +44-(0) EDITOR Derik Rice EDITORIAL ASSOCIATE Rose Fry EDITORIAL ASSOCIATE Sara Plumhoff GRAPHIC DESIGN Communication Design, Inc. Aaron Lai, CFA Kate Lander Alecia Licata Casey Lim, CFA Michael Liu, CFA Bob Luck, CFA Farhan Mahmood, CFA Mark Mak, CFA Trevor Mak, CFA Dennis McLeavey, CFA Sudip Mukherjee Jerry Pinto, CFA Linda Rittenhouse Christina Haemmerli Schlegel, CFA David Shen, CFA Larry Swartz, CFA Jacky Tsang, CFA Gary Turkel, CFA Raymond Wai Pong Yuen, CFA James Wesley Ware, CFA Jean Wills ASIA-PACIFIC Suite 3407 Two Exchange Square 8 Connaught Place, Central Hong Kong, SAR Phone: or Fax: COVER IMAGE Photos: Double Image Studio 2007 and Corbis 2007 Photo Retouching: David Ridderhof VOL. 18, NO. 3 2 CFA MAGAZINE / MAY-JUNE 2007

7 Care for your brainchildren. And your brainchildren s children. Inspiration for fi nancial professionals available at ishares.com/ideas Carefully consider the funds investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the funds prospectuses, which may be obtained by calling iShares ( ) or by visiting Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. The ishares Funds are distributed by SEI Investments Distribution Co. (SEI) and advised by Barclays Global Fund Advisors (BGFA). BGFA is a subsidiary of Barclays Global Investors, N.A., which is a majority-owned subsidiary of Barclays Bank PLC, none of which is affi liated with SEI Barclays Global Investors. All rights reserved. ishares is a registered trademark of Barclays Global Investors, N.A iS-0906

8 Investmen t Managemen t Wo r kshop 8 12 July 2007 Harvard Business School Boston, Massachusetts, USA In partnership with Harvard Business School 39th ANNUAL The 39th Annual Investment Management Workshop provides a comprehensive, current perspective on the global investment management industry. Guided by course director André F Perold and other faculty from Harvard Business School, senior-level executives are able to explore the topics from sophisticated investment strategies and firm culture to market analysis and strategic decision making that define the context and realities of the world in which they operate. In order to increase their professional knowledge and enhance their capacity to lead, workshop participants will: Discuss challenges that investment management professionals face today View competitive strategy in both a local and a global context Explore innovative investment management techniques and reflect on their long-term implications Analyze successful and unsuccessful investment strategies Investigate new concepts and investment theory and consider their impact on the evolution of the industry Exchange ideas and experiences with peers from around the world For more information and to apply, please visit (800) (USA and Canada) or +1 (434)

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10 In Focus Celebrating Professionalism while Meeting New Challenges BY JEFF DIERMEIER, CFA O n 11 June 1947, representatives of four financial analyst societies Boston, Chicago, New York, and Philadelphia met in Schwartz s restaurant in New York City and agreed to establish what became known as the National Federation of Financial Analyst Societies (NFFAS), one of the predecessor organizations of CFA Institute. This year, in honor of that historic event, investment professionals in more than 100 societies around the world will be marking our first annual CFA Day during the week of 11 June. Together, we will be celebrating our common commitment to a higher standard of excellence in the investment profession. This year marks a doubly special celebration, as we observe the 60th anniversary of the founding of our profession. With CFA Day, we are joining not only with our colleagues around the globe but also with all those who came before us and whose professional legacy we are striving to expand. Our tradition explains why the CFA designation is now widely regarded as the gold standard for investment professionals. Increasingly, people inside and outside the investment industry, as well as regulators and standard setters, know what we stand for: mastery of a challenging body of knowledge and support for lifelong learning, an unwavering commitment to the highest ethical standards, putting investors first, and promoting the integrity of financial markets. And while we take pride in our past achievements and our current success, we should keep our focus on the future. One example is the area of continuing education, where we know our members face ever greater challenges. Our goal is to build upon our existing foundation to establish CFA Institute as the go-to resource for investment knowledge and educational material among investment professionals. To that end, we recently restructured our Educational Division, which included, among other things creating a dedicated educational content group under the direction of Tom Robinson, CFA. One of our aims is provide greater support for the important and growing segment of our membership involved with private wealth management. Heading up this effort will be Stephen Horan, CFA, an experienced and published researcher on topics in private wealth management. There are likely to be other developments in post-cfa Program educational offerings. Further initiatives will be forthcoming on educational content. Safeguarding Our Reputation As we celebrate our 60th anniversary, we also should not forget the continual challenge of maintaining that reputation. In March, the U.S. government charged 13 people, including employees at major Wall Street banks, with conspiracy, securities fraud, and commercial bribery charges. In a related civil suit, the U.S. Securities and Exchange Commission charged 11 people and three companies. Upon hearing the news of this scandal, which is considered to be one of the most pervasive insider trading schemes since the Boesky and Levine trading scandals of the 1980s, I felt compelled to voice my concern to the financial media in a press release. (The full text is available in the pressroom section on In my opinion, our profession is not held in as high esteem as it should be. I d like to change that perception, and I hope that you will join me in my crusade. To that end, I While we take pride in our past achievements and our current success, we should keep our focus on the future. believe that deterring malfeasance in our profession requires three things: (1) an ethical culture, (2) large penalties for misbehavior, and (3) a belief that no one will get away with it. One of the disturbing elements of the latest scandal is that one of the accused was allegedly making money illegally trading on prior day leaks about sell-side grade changes. Then, when some colleagues found out about it, they did not report the violation to the compliance department. Rather, they decided they wanted in on the action. Such a scenario would have been my worst nightmare during my former days. In light of recent events, I have called upon our Standards of Practice staff to review whether our code is strong enough on whistleblowing. Additionally, I plan to ask our Board of Governors to support initiatives that encourage and make it easier for us to self-police so the regulators don t have to. While some may believe that I am being overly optimistic, I encourage you not to turn a blind eye when you see misconduct. Make no mistake about it stepping forward takes courage. But if we are unable to encourage some form of selfpolicing, we shouldn t complain when bad behavior leads to more rules. With your help, we can work toward deterring dishonest individuals from discrediting our profession. Jeff Diermeier, CFA, is president and CEO of CFA Institute. CFA MAGAZINE / MAY-JUNE

11 Viewpoint A Curious Dilemma How can managers and traders reconcile conviction and uncertainty? How do managers and traders cope with the extraordinary complexities of market information yet reduce them to simple buy and sell instructions? I BY WAYNE H. WAGNER wonder where he comes up with these things? said the trader, looking at another offbeat order from a maverick portfolio manager. Where indeed! How do managers and traders cope with the extraordinary complexities of market information yet reduce them to simple buy and sell instructions? Many apply Mark Twain s observation that It was a difference of opinion that led to horse racing to financial markets. Twain is correct but doesn t really get to the source of the phenomenon. It s not the difference of opinion that counts; it s the different mental processes each of us employs. The market encompasses so many dimensions of human experience and emotion that each of us sees it not as it is but only through the filters and biases of our perception. Information Overload Simply stated, the market is too complicated for anyone to fully comprehend. There are just too many moving parts, more than can be simultaneously comprehended by the human mind. Our minds are trained over many generations to identify the stepping stones in front of us rather than take in the whole view as a camera does. We re not built with enough mental hardware. The environment contains a variety of goods and toxins, harbingers and distractors, stepping-stones and pitfalls, wrote philosopher of science Daniel Dennett in his book Kinds of Minds. These resources often amount to an embarrassment of riches in competition for the agent s attention. True in the hunter-gatherer s environment and certainly true in the market. Economist Herbert Simon, in Models of Man, identified this phenomenon as bounded rationality. Bounded rationality, stated simply, means that there is too much information for any one human being to process. We need to simplify in order to clarify the decision and find some handles by which we can secure a mental grasp. I look out my office window and see buildings, cars, clouds, and blue sky. See is not the right word; notice or perceive are more accurate. I didn t really see everything that was out the window: I just saw the things that caught my eye. Everything gets processed through filters of what is personally important or interesting, such as How long is it going to take me to get home in the traffic? Applied to the market, this principle suggests that each manager and trader focuses on a few things that he or she personally considers important; the rest gets ignored: These decision drivers might be fundamentals, technical signals, supply/demand shifts, and numerous financial variables, ratios, and shortcuts. Whatever they are, they are a relative handful in number. That s all the human mind can deal with at one time. Which of these elements are most important? Since our impressions derive from our personal life experiences, the answers differ from person to person. Thus, we walk backwards into the future, with our minds anchored by the imprinted lessons of the past. This filtering applies to both managers and traders, although their choices of decision drivers will differ significantly. The portfolio manager wants to take a long drive; the trader needs to know how to get the car started (or stopped.) Curiously, this few-variables effect is true of statistical models as well as active decision making. Those who build stock-selection or price-movement models know that after five factors or so, adding additional explanatory variables decreases rather increases the pre- 6 CFA MAGAZINE / MAY-JUNE 2007

12 dictive power. A few variables are the main drivers; everything else is either too small or too fleeting to play a useful role in decision making. The Market of the Mind The net result is that we don t play the real market; rather, we hum along with the song the market sings in our individual heads. At times, our mental model fits well enough; at other times, we re out of tune. And we can t predict whether the next shift will be favorable to our thinking or not. However, because each participant reflects a different set of life s experiences, the market effectively processes all the information and choices those that are in sync as well as those that are not. Thus the market delivers its own truth. In The Wisdom of Crowds, James Surowiecki puts it this way: a crowd s collective intelligence will produce better outcomes than a small group of experts, even if members of the crowd don t know all the facts or choose, individually, to act irrationally people s errors balance each other out; and including all opinions guarantees that the results are smarter than if a single expert had been in charge. In other words, the market is smarter than any participant in it. Without such collective intelligence, an index fund could not work. Not only does the market allow us to act on our own decision drivers, but it also allows the world to correct us. The market s objective, jokes Ken Fisher, is to humiliate as many people as possible for as much money as possible for as long as possible. Ultimately, a standard outside ourselves becomes the judge of the correctness of our model. Without it, we live on our own little imaginary planets, spinning out of control. Then we go broke. The Market of the Gut The markets are good at sorting out rational thoughts and equally good at responding to emotional factors. In particular, markets need to punish overexuberance. Markets find the price that balances supplying sellers with demanding buyers. If either group is wildly overrepresented, markets cannot find clearing prices and transacting halts. The most dramatic example is the panic of October 1987, when the market had far too many sellers and nowhere near enough buyers. What went wrong? Portfolio insurance mechanically created a floor value so the portfolio could not lose more than some prespecified dollar amount. Sponsors quickly saw that as the possibility of loss was taken out of equity investing, the need for bond portfolios as stabilizers was strongly diminished. Why not sell the bonds and invest the proceeds in equities with a higher expected return? Then someone figured out that once you had made some money, you could raise the guaranteed floor and lock in your gains. Higher returns, lower risk, locked-in gains who could resist a proposition like that? Portfolio insurance had created riskless investments, contorting the greed fear balance for pension sponsors. Many plan sponsors couldn t resist, and by 1987, an estimated 10 percent of pension assets were insured. This crowd was destined to stampede in the same direction at the same time. When an external trigger caused markets to fall, portfolio insurance managers had to sell equities to fulfill the insurance contract. When they sold, the market dropped; when the market dropped, they had to sell more. A very vicious cycle indeed! Thus, fear is a necessary factor in the operation of any market. Remove fear, as portfolio insurance did, and the markets can not restrain rampant greed and exuberance. The only way to correct the imbalance was for portfolio insurance to default on its guarantee, thus creating an unforgettable psychological experience for many supposedly sophisticated investors. As Fred Schwed said in Where Are the Customers Yachts?, There are certain things that cannot be adequately explained to a virgin, either by words or pictures. Like all of life s rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature. Every Day Is a New Day As both Schwed and Fisher suggest, the stock market is among the most uncertain and anxiety-producing areas of human endeavor. Nothing is assured; nothing works at all times not even the best intellect, research, and ardor. Our most motivated and intensive efforts cannot guarantee the desired results. We need to apply the best of our science and art, but a few strokes of serendipitous timing always come in handy. We might be tempted to think that mega-super computers, threading through chaos theory or neural networks, might find signals that are too nuanced to be picked up by mere human intelligence. Unfortunately, capital markets are too complex even for such sophisticated, nonlinear techniques. What leads to outcome A on Monday may lead to Not-A on Tuesday. Think of the market as a flu virus once we think we have it pegged, it mutates into something new. Thus, traders, especially, need to attune to the ever-changing balance of buyers and sellers. While portfolio managers search for the long trends and hidden values, a trader experiences a brand new market every day. A curious dilemma affects managers and traders: Both need the courage of their convictions yet simultaneously must listen for the market s messages. Perhaps the song our memory is singing in our head is out of tune with what the market reveals. Experience means knowing when to act on the conviction and when to lay low. That s why savvy managers and traders get paid the big bucks. Wayne H. Wagner is senior advisor for ITG Inc. and founder of OM/NI Consulting Partnership. CFA MAGAZINE / MAY-JUNE

13 EDUCATION CALENDAR ASIA-PACIFIC 7 May Frank Reilly, CFA PHILIPPINES SOCIETY 3 PD CREDITS 9 May Frank Reilly, CFA THAILAND SOCIETY 1.5 PD CREDITS 12 May Frank Reilly, CFA HONG KONG SOCIETY 2.5 PD CREDITS 14 May Frank Reilly, CFA BEIJING 1.5 PD CREDITS 16 May Frank Reilly, CFA SHANGHAI 1.5 PD CREDITS EUROPE, MIDDLE EAST & AFRICA 7 May Bud Haslett, CFA LUXEMBOURG SOCIETY 7 12 May International Wealth and Tax Planning Seminar INTERLAKEN, SWITZERLAND 36 PD CREDITS High-net-worth individuals today are inevitably confronted with international tax and estate issues, whether through their investments, geographical mobility, or international family members. The seminar conveys a structured understanding of the international tax and estate planning issues affecting individuals and families today. Participants will explore international wealth planning opportunities and their pitfalls. This seminar is presented in partnership with the Swiss Finance Institute. 8 May James Ware, CFA GERMAN SOCIETY 8 May Bud Haslett, CFA SWISS SOCIETY ZURICH 9 May Bud Haslett, CFA SWISS SOCIETY GENEVA 10 May Bud Haslett, CFA IRISH SOCIETY 16 May Stewart Hamilton UK SOCIETY EDINBURGH 17 May Stewart Hamilton UK SOCIETY LONDON 18 May Lawrence Speidell, CFA UAE SOCIETY May Hedge Funds Programme DUBAI, UNITED ARAB EMIRATES 24 PD CREDITS Designed for finance professionals who are already familiar with hedge funds, the program seeks to explain why hedge funds have been so attractive in recent years and contemplates whether this performance is sustainable. Beginning with an overview of the hedge fund industry and its recent developments, the program then introduces various hedge fund investment models. This program is presented in partnership with the London Business School. 28 May Sixth Annual Global 1 June Investors Workshop FONTAINEBLEAU, FRANCE 36.5 PD CREDITS The Global Investors Workshop is a practice-based and case-based week of learning and networking, specially tailored for senior-level investment professionals. The workshop encourages participants to examine their knowledge of the key factors in portfolio management theory and security selection while also informing them of new insights into running a successful asset management firm, its drivers of success, its business model, and its marketing channels. This workshop is presented in partnership with INSEAD. CANADA 1 May Credit Derivatives Pricing and Evaluation Geoff Wakeling TORONTO SOCIETY 2 May Quant Presentation Guardian Capital VANCOUVER SOCIETY 3 May Credit Risk? What Credit Risk? TORONTO SOCIETY 9 May PFB Corporation Inc. TORONTO SOCIETY 15 May Real Estate Ray Townsend EDMONTON SOCIETY 15 May Writing Research Reports Your Clients Will Read James Spellman TORONTO SOCIETY 3 PD CREDITS 16 May Harry Marmer, CFA TORONTO SOCIETY 16 May Jean Brunel, CFA VANCOUVER SOCIETY 17 May Multiple Voting Shares Michael King, CFA MONTREAL SOCIETY 17 May Yellow Pages Group Marc Tellier TORONTO SOCIETY 8 CFA MAGAZINE / MAY-JUNE 2007

14 EDUCATION CALENDAR 22 May Mayo Schmidt SASKATCHEWAN SOCIETY 22 May Building a Financial Model Ian Schnoor, CFA TORONTO SOCIETY 7 PD CREDITS 23 May Donald Cassidy VICTORIA SOCIETY 24 May Using Behavioral Finance Insights to Improve Results Donald Cassidy VANCOUVER SOCIETY 12 June International Swaps and Derivatives Association TORONTO SOCIETY 21 June Dispersion Trading Basket Trading Strategies TORONTO SOCIETY June Private Wealth Management Conference CALGARY SOCIETY NEW YORK US 11 May The Essentials of Estate Planning: Trusts and Other Tools for Wealth Managers NEW YORK SOCIETY 3 PD CREDITS 15 May Forensic Accounting: Related-Party Disclosures and Nondisclosures Norman Bartczak NEW YORK SOCIETY 3 PD CREDITS 16 May Forecasting: Using Time Series to Predict Future Results Jack Yurkiewicz NEW YORK SOCIETY 3 PD CREDITS 17 May Annual Manager Search and Selection NEW YORK SOCIETY 7 PD CREDITS 22 May Minimizing Longevity Risk NEW YORK SOCIETY 3 PD CREDITS 23 May Hedge Funds Daniel Strachman NEW YORK SOCIETY 7 PD CREDITS 30 May Career Chat: Successful Negotiation Strategies Win Sheffield NEW YORK SOCIETY 31 May The Convergence of Hedge Funds, Private Equity, and Traditional Long-Only Management NEW YORK SOCIETY 6 June Metals and Mining Conference NEW YORK SOCIETY 12 June Medical Equipment and Supplies Conference NEW YORK SOCIETY 13 June High-Yield Bond Conference NEW YORK SOCIETY 6 PD CREDITS 19 June Middle East Investment Conference NEW YORK SOCIETY EASTERN US 2 May Current State of SEC Regulation with Regard to Hedge Funds BOSTON SOCIETY 3 May Trust Essentials for Portfolio Managers BOSTON SOCIETY 5 May The Value of Commodities and Other Inflation Hedges BOSTON SOCIETY 7 May A Logical Approach to Investing in China through Taiwan-Listed Companies BOSTON SOCIETY 10 May Regulatory Issues Facing the Structured Products Market BOSTON SOCIETY 14 May CDs 101 BOSTON SOCIETY 17 May Investing in Your Career BOSTON SOCIETY 17 May Tim Gaumer, CFA PHILADELPHIA SOCIETY 21 May André Perold BOSTON SOCIETY Continued on page 10 CFA MAGAZINE / MAY-JUNE

15 EDUCATION CALENDAR Continued from page 9 22 May Distinguished Speaker Series: Does Theory Lead Us Astray? The Performance Drag of Cap Weighting Rob Arnott BOSTON SOCIETY 24 May Surviving Today s Investment Environment BOSTON SOCIETY 4 June Even More Reason to Diversify Your Portfolio BOSTON SOCIETY 5 6 June The Efficient Market and Behavioral Finance BOSTON, MA 12.5 PD CREDITS Behavioral influences on the capital markets have been studied for decades, but they are now a subject of even greater interest in the wake of the equity bubble of the late 1990s and a growing industry emphasis on managing private client assets. Moderated by Arnold S. Wood, this conference will explore the latest thinking in behavioral finance and economics, including how behavioral economics can be reconciled with widely accepted thinking on market efficiency and different views on whether behavioral finance can be used to generate alpha. Hosted by the Boston Security Analysts Society, Inc. 6 June Distinguished Speaker Series: Looking for One-Foot Hurdles to Step Over and Staying out of Trouble in the Meantime Wally Weitz, CFA BOSTON SOCIETY 25 June Ronald Logue BOSTON SOCIETY 8 12 July 39th Annual Investment Management Workshop BOSTON, MA 33 PD CREDITS The 39th Annual Investment Management Workshop provides a comprehensive, current perspective on the global investment management industry. Guided by faculty from Harvard Business School, senior-level executives are able to explore the topics from sophisticated investment strategies and firm culture to market analysis and strategic decision making that define the context and realities of the world in which they operate. This workshop is presented in partnership with Harvard Business School. SOUTH CENTRAL US 2 May David Ranson AUSTIN SOCIETY 3 May Forecast Dinner HOUSTON SOCIETY 8 May Using ETFs to Implement Strategic and Tactical Portfolio Strategies Mary Kathryn Campion, CFA NEW MEXICO SOCIETY 9 May William Reichenstein, CFA OKLAHOMA SOCIETY TULSA 10 May William Reichenstein, CFA OKLAHOMA SOCIETY OKLAHOMA CITY 23 May David Hennessy AUSTIN SOCIETY 5 June State of CFA Institute Dan Meader, CFA NEW MEXICO SOCIETY 7 June Outlook for the U.S. Economy Kevin Kliesen MISSISSIPPI SOCIETY 21 June Donald Straszheim ARKANSAS SOCIETY SOUTHEASTERN US 8 May Asset Allocation for the Private Investor Frank Dohn, CFA TAMPA BAY SOCIETY 9 May Emerging Markets Hari Hariharan MIAMI SOCIETY 9 10 May Joel Shapiro NORTH CAROLINA SOCIETY 16 May Employment Trends in the Financial Services Industry Michael Imperiale JACKSONVILLE SOCIETY 16 May Creating Order out of Chaos in the Analysis of Investment Manager Performance Dave Umstead, CFA ORLANDO SOCIETY 24 May Donald Straszheim NAPLES SOCIETY MIDWESTERN US 2 May Lincoln Electric Company CLEVELAND SOCIETY 10 CFA MAGAZINE / MAY-JUNE 2007

16 EDUCATION CALENDAR 9 May SAP CLEVELAND SOCIETY 9 May Anthony Chan DAYTON SOCIETY 9 May Venture Capital Jeff Tollefson IOWA SOCIETY 9 May Lawrence Speidell, CFA TOLEDO SOCIETY 15 May Real Return Strategies: The Value of Commodities and Other Inflation Hedges CHICAGO, IL 8 PD CREDITS Investors, both institutional and private, look for strategies that will perform well in up and down financial markets, provide diversification, and, in order to meet future liabilities, supply a hedge against inflation. This program gathers practitioners and researchers to provide clarity on the global drivers and characteristics of real return strategies and discuss their role in investment portfolios. Just added Commodity Indices Workshop on 14 May, 2:15 6:30 p.m. Complimentary for registered Real Return Strategies conference participants. Space is limited. Hosted by the CFA Society of Chicago. 16 May Cleveland Cliffs CLEVELAND SOCIETY 22 May Does Theory Lead Us Astray? The Performance Drag of Cap Weighting Robert Arnott CHICAGO SOCIETY 23 May Ferro Company CLEVELAND SOCIETY 23 May Richard Bernstein DETROIT SOCIETY 1 June Unconventional Research Approaches, Unconventional Portfolio Management, and Unconventional Results Thomas Brown CHICAGO SOCIETY 5 June Looking for One-Foot Hurdles to Step Over and Staying out of Trouble in the Meantime Wally Weitz, CFA CHICAGO SOCIETY July Financial Analysts Seminar CHICAGO, IL 31.5 PD CREDITS This annual seminar focuses on tools and techniques to improve the investment decision-making process. Leading practitioners and researchers cover topics ranging from valuation analysis to asset allocation in an interactive classroom setting, and keynote dinner speakers offer insights into the changing investment landscape. Last year s program sold out register early. Hosted by the CFA Society of Chicago. WESTERN US 1 May An Iconoclastic Look at the Roots of Behavioral Analysis John Bollinger, CFA LOS ANGELES SOCIETY 1 May Sun MicroSystems SAN FRANCISCO SOCIETY 3 May Zaio Corporation Thomas Inserra PHOENIX SOCIETY 14 May A Behavioral Finance Approach to Asset Allocation Jean Brunel, CFA SPOKANE SOCIETY 15 May Jean Brunel, CFA SEATTLE SOCIETY 17 May Jean Brunel, CFA PORTLAND SOCIETY 19 June A Discussion on the CFA Test Program Bob Johnson, CFA SEATTLE SOCIETY 20 June A Discussion on the CFA Test Program Bob Johnson, CFA SPOKANE SOCIETY 24 May A Former Policy Maker s Perspective Robert Parry LOS ANGELES SOCIETY 31 May Does Cap Weighting Weigh Us Down? Robert Arnott LOS ANGELES SOCIETY If your region or society is not listed here, please ask your program chair to submit your society s educational programs to for inclusion in the next issue. CFA INSTITUTE EVENT: For details, visit conferences. Or to register by phone, call or SOCIETY EVENT: For details, visit socservices/socindex.asp or PD CREDITS: Event qualifies for the designated number of credit hours in the CFA Institute Professional Development Program. CFA MAGAZINE / MAY-JUNE

17 THE FOUNDING OF A PROFESSION: This year marks the 60th anniversary of the formalization of what is now known as the investment management profession. In recognition, over the course of the year each issue of CFA Magazine will highlight milestones and seminal historic events by decade. This issue features the time period The Era of Innovation The technological innovations thus far in this century are unparalleled in the history of mankind. We differ from past decision makers in that we now incorporate technological change into our thinking, our plans, and our decisions. Henry Kaufman From address before the 40th Anniversary Forum of the Security Analysts of San Francisco, 28 October FAF relocates headquarters from Boston to New York ICFA and FAF sponsor joint committee to comprehensively revise the Code and Standards First Awards for Excellence in Corporate Reporting were given Securities Investor Protection Act establishes insurance for deposits with brokerage firms Financial Accounting Policy Committee meets with the Accounting Principles Board LARGE-BLOCK TRADES REACH 15 PERCENT OF NYSE VOLUME Research Foundation holds its first seminar, Personal Trust Investments FAJ published The Professionalization of the Financial Analyst, by C. Stewart Sheppard, then the ICFA executive director and FAF executive secretary Nicholas Molodovsky Award is established to recognize outstanding contributions to profession First Investment Management Workshop is held at Harvard Business School in Boston Jack Treynor becomes editor of Financial Analysts Journal First edition of The CFA Digest is published with Ed Mennis, CFA, as editor CFA Program Body of Knowledge expands with addition of qualitative techniques NASDAQ IS ESTABLISHED First FAF Distinguished Service Award is awarded to A. Moyer Kulp, CFA MAN LANDS ON THE MOON FAF President George Bissell, CFA, speaks out on corporate disclosure and inside information JAPAN BECOMES WORLD S SECOND STRONGEST ECONOMIC POWER FIRST CASH DISPENSING MACHINE IS INSTALLED BY FIRST PHILADELPHIA BANK 12 CFA MAGAZINE / MAY-JUNE 2007

18 CFA INSTITUTE FAF delegates present the 1970 Excellence in Corporate Reporting Award to the Schering Corporation FAF representatives testify on SEC hot issues hearings on disclosure requirements for first offerings of new or emerging companies FAF comments before the SEC s Advisory Committee on Enforcement Policies and Practices FAF supports proposed amendment to SEC Form 10-K Research Foundation name changed to Financial Analysts Research Foundation (FARF) Mary Petrie, CFA, becomes the first woman chair of the ICFA ICFA relocates to new location in Charlottesville; idea of merger of FAF/ICFA is first proposed FAF delegates adopt private self-regulation plans a precursor to the Professional Conduct Program Investment Analysis Standards Board is established International Coordinating Committee (ICC) consisting of five world analyst organizations is formed FAF delegates take field trip to South Africa The Losers Game, a seminal FAJ article by Charles Ellis, CFA, is published JOHN NEFF S WINDSOR FUND RETURNS 54.5% NIXON RESIGNS THE U.S. PRESIDENCY C. Stewart Sheppard Award is established to recognize individual contributions to the profession FAF and ICFA members testify before U.S. Senate Committee on Banking, Housing, and Urban Affairs DREXEL BURNHAM LAMBERT MERGER INITIATES JUNK BOND MARKET Canadian Council of Financial Analysts is formed OPEC OIL EMBARGO BLACK-SHOLES-MERTON OPTION PRICING MODEL IS INTRODUCED Marshall Ketchum receives the FAF Special Service Award DREYFUS OFFERS FIRST MONEY- MARKET FUND TO SMALL INDIVIDUAL INVESTORS INFLATION LEADS THE DOW JONES TO A LOW OF JOHN C. BOGLE STARTS THE VANGUARD GROUP CFA MAGAZINE / MAY-JUNE

19 CFA Institute BRIEFS Regional Meetings Deliver Sense of Community and Mission Regional society leader meetings brought together dedicated volunteers from nearly all 134 societies across the globe to share ideas and experiences. Leaders met in Bangkok, Istanbul, Winnipeg, Tampa, Dallas, and San Diego in the first quarter of With such a variety of regions and societies gathered, the meetings were awash with diverse viewpoints. The Europe, Middle East, and Africa (EMEA) region boasted the greatest number of societies represented at its meeting, with 32 member societies, ranging from Finland in the North, Bahrain in the East, South Africa in the South, and Bermuda in the West. The Asia- Pacific attendees received yellow polo T-shirts from the Thailand Society as a souvenir. Additional events associated with the regional meeting included speakers Charles Ellis, CFA, and Jeff Diermeier, CFA, presenting on Investing Excellence: Defining the Qualities of Great Organizations in Tampa. Marc Faber spoke before the EMEA society leaders in Istanbul. And John Barrass from the CFA Institute Centre for Financial Market Integrity presented on corporate governance to event sponsor Garanti Masters Bank employees and guests at their company headquarters in Istanbul. The main topic of discussion for the regional meetings across the board was strategic planning for societies. Pictured (from left) are Alp Keler, CFA Istanbul Society president; Attila Köksal, CFA, PCR, EMEA East Region; Demet Apak Sermet, Garanti Bank; Jeff Diermeier, CFA, president and CEO, CFA Institute; Dr. Helmut Henschel, PCR, EMEA West Region; and Nitin Mehta, managing director, EMEA Region. New Policy Provides Curriculum to All Candidates In an effort to improve overall candidate preparation, the CFA Program curriculum will be included in the exam registration fee and delivered to all candidates. The new policy ensures that all candidates will have equal access to the foundational material when enrollment and registration for the June 2008 CFA examinations open in mid-july The decision came as a result of extensive study, modeling, and the unanimous recommendation from the CFA Preparation Task Force, a working group that convened in 2004 to address questions of candidate preparation and examination performance. For further information, please go to the Course of Study section on the CFA Program area at 14 CFA MAGAZINE / MAY-JUNE 2007

20 CFA Institute BRIEFS Western Region Loses Two-State Society President Michael Barcelo, 56, treasurer and chief investment officer for Idaho Trust National Bank, president of the CFA Society of Idaho, and past president of the CFA Society of Spokane, died after a brief illness on 20 February in Monterey, California. A native of southern California, Barcelo was a Phi Kappa Phi graduate of the University of Hawaii, where he earned a Bachelor of Science degree in economics. He began his career at Washington Mutual Savings Bank and earned a charter in 1992 before joining Idaho Trust National Bank in A long-time volunteer at CFA Institute, Barcelo served as a CFA exam grader and as a member of the organization s Disclosures for Asset- Backed Securities Task Force. Known for his enthusiasm, he was awarded the CFA Society of Idaho s Distinguished Service Award for his work as vice president and program chairman. He is survived by his wife Pamela and two children, Justin and Julia. CFA Institute Reminds Industry of Need for Vigilance The latest case of insider trading prompted a swift reaction from CFA Institute, calling for more careful attention by all investment professionals. Our organization is deeply troubled about the impact these ethics-related allegations have on investor trust, said Jeff Diermeier, CFA, president and CEO of CFA Institute. The U.S. SEC alleged that eight Wall Street professionals, including a UBS research executive, a Morgan Stanley attorney, two broker/dealers, a day-trading firm, and three hedge funds, took part in the alleged crime. In addition, 13 people were charged by the U.S. Attorney for the Southern District of New York in the scheme. Diermeier added that he was outraged and dismayed to learn that one of the individuals allegedly involved was once a member of CFA Institute. We approach this with the knowledge that proper training and attention to ethics at an individual level, with continuous reinforcement, is part of the answer, he said. Some may never learn, but we hope the industry will join us in reaching out with a strong reminder. The Pfandbrief dependability in changing markets. Reliability pays off. Through rough or calm waters, professional investors stay on course. Guided by quality, liquidity and yield. Its top credit quality makes the Pfandbrief an especially safe asset class. A fact that investors outside Germany are increasingly recognizing, too. At the heart of the Pfandbrief s success lies a weather-tight safety concept. Founded on the German Pfandbrief Act and supported by a powerful trade organization, the Pfandbrief will continue to show the way in the Covered Bond market. For more information please refer to golinharris.de Aareal Bank AHBR Bayerische Landesbank Berlin Hyp Deutsche Hypo Deutsche Schiffsbank Dexia Aareal Kommunalbank Bank AHBR Bayerische DG HYP Düsseldorfer Landesbank Hypothekenbank Berlin Deutsche Essen Hypo Eurohypo Deutsche Schiffsbank Hamburger Sparkasse Dexia Kommunalbank HSH Nordbank DG HYP Hypo Düsseldorfer Real Estate Hypothekenbank Bank Real Essen Estate Hyp Bank Eurohypo International Hamburger Hypo Real Sparkasse Estate Holding HSH Nordbank HypoVereinsbank Real IKB Deutsche Estate Bank Industriebank Hypo Real Kreissparkasse Estate Bank Köln International Landesbank Baden- Hypo Württemberg Real Estate Holding Landesbank HypoVereinsbank Hessen-Thüringen IKB Münchener Deutsche Hyp Industriebank Norddeutsche Kreissparkasse Landesbank SEB Köln Sparkasse Landesbank KölnBonn Baden- VALOVIS Württemberg BANK Landesbank AG WarburgHyp Hessen-Thüringen Westdeutsche Münchener ImmobilienBank Hyp Norddeutsche WestLB Landesbank WL-BANK SEB Sparkasse Wüstenrot KölnBonn Bank VALOVIS BANK AG WarburgHyp Westdeutsche ImmobilienBank WestLB WL-BANK Wüstenrot Bank CFA MAGAZINE / MAY-JUNE

21 CFA Institute BRIEFS First CIPM Certificate Awarded The first CIPM certificate was awarded in late March to Douglas Lempereur, CFA, in Fort Lauderdale, FL. He was one of the 97 successful candidates in 18 countries who passed the three-hour, computer-based Expert exam, which was administered for the first time during September October 2006, and satisfied the experience requirements to be entitled to use the new CIPM designation. The credentialing program, launched last year, certifies a practitioner s proficiency in applying analytical techniques and preparing GIPScompliant presentations, which guide investment firms in fairly representing and fully disclosing performance results. Philip Lawton, CFA, head of the CIPM Program (left), awards Douglas Lempereur, CFA, CIPM, senior vice president, Franklin Templeton Investments, with CIPM certificate number 1. New Financial Market Integrity Index The CFA Institute Centre for Financial Market Integrity released a new index that measures member views on ethical behavior of market participants, segments, and foundations, such as regulatory protections. The inaugural index focused only on the U.S. market, where survey respondents from a cross-section of the membership revealed a need for improvement. Those outside the U.S. market consistently rated the ethical conduct of financial professionals and market foundations higher than did those who live and work within the United States. For example, U.S. respondents rated the ethical behavior of corporate executives in the United States at 2.66, whereas those outside the market gave the ethical behavior of U.S. corporate executives a rating of The Centre plans on expanding the index to cover several other markets in coming months, including the Canadian and U.K. markets. The full index is posted at cfapubs.org. Traveling Conference Series a European Success The latest CFA Institute traveling conference series in Europe provided more than 300 attendees in Luxembourg, Geneva, Zurich, and Milan with the latest thinking on investment strategies for serving private clients. For societies working to provide compelling events for their investment communities, the traveling conference series brings the highest-caliber speakers directly to their doorsteps. Launched in late 2004, the series offers societies the opportunity to collaborate with CFA Institute in developing an educational event that is tailored to their local markets at a significant cost savings to host societies. Geneva conference speakers from second left, Kristoffer Jonsson, Zvi Bodie, and Eric Bissonnier, CFA are flanked by Swiss CFA Society members Francois E. Aubert (far left) and Julien Froidevaux, CFA (far right). Zurich conference attendees included Swiss CFA Society members Marco Bagutti, CFA, and Anthony Cagiati, CFA (second and third from left), who enjoyed presentations by Francois E. Aubert (far left), Eric Bissonnier, CFA, (second from right), and Kristoffer Jonsson (far right). 16 CFA MAGAZINE / MAY-JUNE 2007

22 CFA Institute Centre for Financial Market Integrity Staff Lead Recent Industry Discussions John Barrass, head of CFA Institute Centre EMEA, chaired a buy-side panel at the Fourth AQ Research Conference in London in mid-march. The conference examined changes to the research marketplace in the United Kingdom. Also in mid-march, Lee Kha Loon, CFA, head of CFA Institute Centre Asia Pacific, chaired a session at a regional alternative investments conference in Hong Kong organized by Information Management Network (IMN). The session explored pension fund reforms, liability management techniques, and asset allocation toward hedge funds by plan sponsors from the Pan-Asia institutional portfolio research and consultancy perspective. Kurt Schacht, CFA, managing director of the CFA Institute Centre for Financial Market Integrity, chaired a session on corporate governance at the 6th Annual Conference on Emerging Markets and participated in the Corporate Governance in the United Arab Emirates Program sponsored by the National Bank of Abu Dhabi (NBAD) and CFA United Arab Emirates Society. Schacht also chaired a session on Corporate Governance at the NYSE on 19 March. Pictured from left to right are Paul Bennett, NYSE chief economist, and Marc Lipson, associate professor of finance at the Darden School, University of Virginia, and Kurt Schacht, CFA, managing director, CFA Centre for Financial Market Integrity, at the NYSE on 19 March. Pictured from left to right are Hani Kablawi, Bank of NY Abu Dhabi; Abhijit Choudhury, chief risk officer, NBAD; Kurt Schacht, CFA, managing director, CFA Centre for Financial Market Integrity; Stuart Hendrickson, head, corporate finance department, NBAD; and Zouhir Tamin, CFA, CFA United Arab Emirates Society board member Awards for FAJ Articles Announced Graham and Dodd Award Claude B. Erb, CFA, and Campbell R. Harvey received the prestigious Graham and Dodd Award for their article The Strategic and Tactical Value of Commodity Futures in the March/April 2006 issue of the Financial Analysts Journal (FAJ). Awarded by the FAJ s advisory council and editorial board, the Graham and Dodd Award for excellence in research and financial writing is the publication s highest honor. The Misuse of Expected Returns was also recognized as the Readers Choice Award. The FAJ advisory council and editorial board also awarded three Graham and Dodd Scroll Awards to recognize additional outstanding articles published in 2006: Scroll Awards Human Capital, Asset Allocation, and Life Insurance (January/February 2006) by Peng Chen, CFA, Roger G. Ibbotson, Moshe A. Milevsky, and Kevin X. Zhu Value Destruction and Financial Reporting Decisions (November/December 2006) by John R. Graham, Campbell R. Harvey, and Shiva Rajgopal The Misuse of Expected Returns (November/December 2006) by Eric Hughson, Michael Stutzer, and Chris Yung Best Perspectives Award The Myth of the Absolute-Return Investor (March/April 2006) by M. Barton Waring and Laurence B. Siegel CFA MAGAZINE / MAY-JUNE

23 CFA Institute BRIEFS Membership Renewal Reminder In late May, all members will receive an to renew their membership online for the membership year. The renewal notice will include a link to pay annual membership fees and submit Professional Conduct Statements in one easy step. Be on the lookout for this convenient way to ensure that your membership benefits do not lapse. GIPS Executive Committee Approves Translation The newly formed Global Investment Performance Standards (GIPS) Executive Committee recently approved the Chinese translation of the GIPS standards at a meeting in South Africa in March. In addition, The Ukrainian Association of Investment Business was approved as the country sponsor in the Ukraine. Charterholder Named New Director of FinCEN (U.S. Treasury Dept.) James H. Freis, Jr., CFA, was named the new director of the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Treasury Department, by U.S. Treasury Secretary Henry M. Paulson, Jr., in March. Freis was promoted from his previous post as deputy assistant general counsel for enforcement and intelligence. FinCEN is a bureau within the Treasury Department that works to prevent money laundering and other illicit financial activity in the financial system through the administration of the U.S. Bank Secrecy Act. FinCEN supports law enforcement and intelligence communities as well as regulatory agencies through sharing and analysis of financial intelligence. Member Reactions to Global Perspectives Book Vary Member responses to the recent gift of the book Global Perspectives on Investment Management ranged from surprise and delight to displeasure. Member Comments Excellent selection of articles/excellent member benefit. ANDREW ARBENZ I don t know if you have published this book in the past or how I even received it in the mail, but I think that this is the best thing that I have ever received from CFA Institute. Don t get me wrong. You guys publish some great stuff, but most of the time, I have to spend valuable time digging through the scores of research to find what would interest or apply to me. This text has some pieces that are both informative and practical. MARK DODSON, CFA A very interesting book indeed. These are the kind of things I like a lot about CFA Institute: up-to-date information/knowledge brought to your doorstep. PHILIPPE VANDEURZEN, CFA Thank you for giving us the generous gift of Global Perspectives on Investment Management. I feel very privileged that I can have so much opportunity to learn by being a member of CFA Institute. This is quite an excellent book. MINEO BITO, CFA It was a pleasant surprise receiving the hard copy yesterday, and I have enjoyed reading about China and challenges for the next generation of investors. I will find time to read the rest of the book, which has a lot of relevant and timely articles. TAY MUI HUANG, CFA Excellent work on the commemorative book fabulous idea and great execution! Thank you so much for your leadership, and I am proud to be a member of CFA Institute. Keep up the great work; I look forward to the next book. DANIEL L. CHAN, CFA As a Hong Kong Society member, I was thrilled to receive my copy of Global Perspectives on Investment Management. Since I m from Shanghai, one article titled China s Economy: Structural Strength, Cyclical Weakness by Jim Walker quickly attracted my attention. After reading through the article, however, I was disappointed at its inclusion in Global Perspectives. Not only did the author make bold predictive statements (e.g., China s GDP growth in 2007 will slow to 3-5%, which, in my view, is highly unlikely and could not be logically deduced from information in the article itself) that time will judge, he also made one comment in particular that I find insulting. The bulk of the Chinese labor force is unskilled and relatively ignorant and illiterate. (p. 91). Merits of this statement may still be subject to debate, since there are many ways to define bulk, labor force, and relatively though over 4 million students graduated from universities in 2006 alone and there are now 230,000 returnees in China who received higher education overseas. However, I cannot help but find it shocking that the author would make such a culturally insensitive statement and that CFA Institute would choose to retain this statement in an important publication with a huge distribution, a significant portion of which are Chinese members. JEFFREY JIN 18 CFA MAGAZINE / MAY-JUNE 2007

24 CFA Institute Enhances Commitment to India with Consultancy Appointment CFA Institute took steps to bolster support and service in India by appointing S.V. Balachander, CFA, CPA, MBA, as a consultant. Balachander and his staff will provide support and service to prospective and enrolled CFA candidates, CFA charterholders, and other CFA Institute members, both directly and in cooperation with the Indian Association of Investment Professionals, the local member society of CFA Institute in India. He will also be representing CFA Institute in outreach activities for employers, regulators, universities, and the media in India. We are very pleased to have a professional of Mr. Balachander s caliber coming on board. His appointment exemplifies our increasing commitment to India, a market of growing importance to CFA Institute as evidenced by the rapidly growing numbers of CFA candidates and CFA charterholders in the country, said Jan R. Squires, CFA, managing director, Asia Pacific Operations, CFA Institute. In association with Balachander s appointment, several new CFA Institute India contacts, along with live help support, have been established to respond to inquiries about the CFA Program and CFA Institute. During business hours of 11:00 to 20:00 India Standard Time (M F), callers from MTNL and BSNL phones in India may call tollfree, and callers from other phones in India may call In either case, messages may be left for next business day support. Inquiries may also be made via . Interested parties are encouraged to visit the CFA Institute India web pages. Hedge Funds Event with CFA Program Partner a Great Success The latest research surrounding hedge funds was shared recently with a group of industry insiders in an intensive three-day program run by the London Business School in partnership with CFA Institute. Fifty-five participants from 15 countries attended the advanced program at the school s Regent s Park campus. The program used recent research to help practitioners understand the latest developments in the hedge fund industry, Attendees discuss developments in hedge funds. assess the investment strategies of individual hedge funds, and consider alternative models for the contractual relationship between hedge fund manager and investor. Practitioners also had the opportunity to apply their newly acquired knowledge via a hedge fund simulation exercise. The event, which was sold out, also focused on recent developments about hedge fund clones, which attempt to replicate the systematic or alternative betabased component of hedge fund returns, how they will affect performance evaluation, contract renegotiation, and in general, transform the nature of the industry. From left to right: José Luis Velasco, CFA, member of CFA Institute Board of Governors, Professor Narayan Naik, and, Jeff Diermeier, CFA, president and CEO. CFA MAGAZINE / MAY-JUNE

25 CFA Institute BRIEFS MEMBERS On the Move Eric Becker, CFA, was recently named a 2007 Environmental Leadership Program (ELP) Fellow. Each year, the ELP selects emerging environmental leaders who represent the cutting edge of environmental thought, policy, and action to participate in a two-year fellowship. Becker, a member of the Boston Security Analysts Society, is a vice president and senior portfolio manager at Trillium Asset Management Corporation in Boston where he co-manages the Green Century Balanced Fund, an environmental mutual fund. Ed Crotty, CFA, recently joined Davidson Investment Advisors, a money management firm based in Great Falls, MT, as senior vice president, chief investment officer, and portfolio manager for the company s equity income Crotty investment strategy. In his new role, Crotty oversees Davidson Investment Advisors investment process. Previously, Crotty, who is a member of the New York Society of Security Analysts, most recently served as a managing director for Spectrum Advisory Services, Inc., in Atlanta. Tony Demarin, CFA, was named president and chief investment officer at BCV Asset Management, Inc., a research-driven, valueoriented investment firm in Winnipeg, Canada, Demarin where, in addition to business strategy, he leads the firm s investment management committee and heads up all investment research initiatives. Prior to his appointment, Demarin was senior vice president, portfolio manager, and principal at an investment firm in Canada. He is a member of CFA Winnipeg. Yves Gagné, CFA, was recently promoted to vice president, major investments and buyouts, at Desjardins Venture Capital Group, a subsidiary of Desjardins Group, where he is responsible for the venture capital and buyout Gagné activities of the group. Previously, Gagné was business development manager for mid-market financing at Desjardins Group. Gagné is a member of the CFA Montreal Society. Kevin Gibbons, CFA, recently co-founded and is managing director of Six Degrees Capital Management (SDCM), an asset management firm based in Chicago that specializes in innovative structured Gibbons finance. Prior to joining SDCM, Gibbons served as managing director for BMO Capital Markets, where he helped to build the company s securitization franchise and served as co-head of the group s origination activities. Gibbons is a member of the CFA Society of Chicago. Jeffrey Hinkle, CFA, recently joined Barrier Investments, LLC, a hedge fund in McLean, VA, focused primarily on the financial services sector. As an investment analyst, Hinkle is primarily responsible for helping develop investment strategies by conducting both company-specific and macroeconomic-level analysis. Most recently, Hinkle was with Navigant Consulting, where he was responsible for conducting valuations of emerging market investments involved in international investment treaty disputes. He is a member of the CFA Society of Washington, DC. Todd Johnson, CFA, joined BCV Asset Management in Winnipeg, Canada, as associate portfolio manager, where he is responsible for investment research, building customized portfolios for high-net-worth individuals and businesses, and identifying business development initiatives. Johnson Prior to joining BCV Asset Management, Johnson was an assistant vice president and portfolio manager for a high-net-worth investment firm in Canada, where he shared responsibility for the direct management of US$850 million. Johnson is a member of CFA Winnipeg. Dirk Lienemann, CFA, was recently promoted to vice president at SCM Strategic Capital Management in Switzerland, an independent advisor focused on international private equity and real estate/infrastructure portfolios, representing client assets of about US$5 billion. Prior to working at SCM, he was an M&A advisor with Lienemann Sal. Oppenheim Corporate Finance. Lienemann is a member of the Swiss CFA Society. Winston Wenyan Ma, CFA, recently joined Barclays Capital (New York) as an associate director, where he heads up equity-linked financing and equity derivatives for corporate finance, risk management, and mergers and acquisitions. Ma 20 CFA MAGAZINE / MAY-JUNE 2007

26 CFA Institute BRIEFS MEMBERS On the Move Most recently, Ma was a vice president and marketing specialist at JPMorgan Equity Capital Markets, also in New York City. Ma is a member of the New York Society of Security Analysts. Howard McEwen, CFA, won a 2006 Kentucky Press Association second-place award in the best enterprise or analytical story category for his article for the Sunday Challenger headlined While Queen City McEwen Dawdled, NKY Took Action. The article is a history of the Cincinnati Northern Kentucky Airport. McEwen, a member of the CFA Society of Cincinnati, is an investment adviser and freelance writer living and working in the Cincinnati/Northern Kentucky area. Lorenzo Newsome, Jr., CFA, and Pamela Turner, CFA, recently cofounded Xavier Capital Management, LLC, an independent registered investment adviser specializing in fixed-income portfolios in Largo, MD. Newsome As chief investment officer, Newsome heads all investmentrelated matters. Previously, Newsome was director of risk management, alternative assets, at Friedman Billings Ramsey Investment Management. As senior analyst, Turner heads up research initiatives and revises internal models. Turner is currently a finance professor at Howard University. Both are members of the CFA Society of Washington, DC. Cristian Patilea, CFA, joined the portfolio risk management team of Ambac Assurance U.K. in London, the U.K. subsidiary of Ambac Financial Group, Inc., as assistant vice president responsible for portfolio risk management. Previously, Patilea was an associate banker with London-based multilateral European Bank for Reconstruction and Development. Patilea is a member of the CFA Romania Society. Scott Reinhardt, Patilea CFA, recently co-founded Passive Capital Management, LLC (PCM), a fee-only investment advisory firm with offices in Syracuse and Baltimore. PCM is dedicated to structuring portfolios for individuals and institutions using low-cost, passively managed asset-class funds. As principal and founding member, Reinhardt has portfolio management, client relations, and compliance responsibilities. Prior to found- Reinhardt ing PCM, Reinhardt served as an investment adviser at RJR Associates in Syracuse. Joseph Virostek, Jr., CFA, recently joined BPU Investment Management, Inc., in Pittsburgh, as vice president of investment operations, where he is responsible for manager due diligence and monitoring as well as portfolio trading, performance reporting, and portfolio accounting. Prior to joining BPU Investment Management, Virostek worked at First Commonwealth as an investment adviser. He is a member of the CFA Society of Pittsburgh. Tony Warzel, CFA, recently joined Rival Capital Management, Inc., in Winnipeg, Canada, as lead fund manager responsible for all investment management activ- Warzel ities of the Rival North American Growth Fund. Previously, Warzel was vice president, Canadian equities, at GWL Investment Management, Inc., where he managed assets in excess of C$1.3 billion. Warzel is a member of CFA Winnipeg. Daniel Yeung, CFA, recently joined Accessor Capital Management in Seattle, as senior investment officer responsible for overseeing and monitoring Accessor s funds subadvisers, managing the company s funds of Yeung funds, and overseeing the investments department. Previously, Yeung was an investment consultant with Morningstar Associates, LLC, in Chicago, where he provided asset allocation services to such institutions as major insurance companies and defined-contribution plan providers and sponsors. Yeung is a member of the CFA Society of Seattle. Adrián Zicari, CFA, recently authored a book entitled Responsabilidad Social Empresaria, un Enfoque Financiero [Corporate Social Responsibility, A Financial Approach] (Fondo Editorial Consejo Profesional de Ciencias Económicas Ciudad de Buenos Aires, 2007). Zicari is a graduate-level finance professor at Universidad del CEMA, Buenos Aires, and Universidad del Centro Educativo Latinoamericano, Rosario. Please information regarding a recent promotion, job change, or professional award to CFA MAGAZINE / MAY-JUNE

27 Society BRIEFS Members from the Toronto CFA Society gathered at the Air Canada Centre to cheer on the Toronto Maple Leafs on 17 February. Penson Financial Services Canada, Inc., sponsored the networking event. Pictured from left to right are John Skain, CFA, Penson Financial Services Canada, Inc.; Peadar Duignan; and Howard Atkinson, CFA, president, Toronto CFA Society. On 7 February, the CFA Society of Orlando hosted its 2007 investment forecast dinner at Dubsdread in Winter Park, FL. A panel of investment, economic, and political experts gathered to address several pertinent investment questions. Panelists included Lee Schultheis, Alternative Investment Partners, LLC; Timothy Hayes, NDR; Kathleen Camilli, Camilli Economics; Vahan Janjigian, CFA, Forbes Investors Advisory Institute; and Vincent Catalano, CFA, ViewResearch, LLC. The Italian CFA Society forecast dinner was held in Milan on 7 March at Banca Esperia. More than 100 participants gathered to hear panelists Vittorio Gaudio, Duemme SGR; Stefano Zoffoli, Julius Baer Zurich; and Jonathan Stubbs, Citigroup Global Markets London. Pictured from left to right are Gabriele Montalbetti, CFA, society president; Stefano Zoffoli; Vittorio Gaudio; Jonathan Stubbs; and Andrea Bergamaschi, CFA, society vice president. CFA Jordan hosted its annual forecasting dinner on 12 March at the Four Seasons Hotel Amman. Jalil Tarif, Stock Exchange (ASE), Shadi Al-Majali (pictured), Saraya Aqaba, and Talal Samhouri, MENA Asset Management at Global Investment House, were keynote speakers. More than 150 people attended the event, which was sponsored by a group of prominent local and international financial institutions, including Global Investment House of Kuwait. On 7 February, the Montreal CFA Society held a commodities presentation and luncheon at the Queen Elizabeth Hotel featuring keynote speakers Martin Murenbeeld, Dundee Group of Companies, and Mark Thomson, Galena Asset Management Limited. Pictured (from left) are Stéphane Gagnon, CFA, program chair, Montreal CFA Society; Martin Murenbeeld; Mark Thomson; and Michèle Moisan-Girard, president, Montreal CFA Society. The CFA Association of Pakistan held an interactive session on Global Investment Performance Standards (GIPS ) on 13 March at the Sheraton Hotel Karachi. Louis Boulanger, CFA, a member of the GIPS Executive Committee (EC) of the CFA Institute Centre for Financial Market Integrity, was the guest speaker. Pictured (from left) are Amina Sultan, society executive director; Ashraf Bava, CFA, society programming chair; Louis Boulanger, CFA; Qasim Lakhani, CFA, society vice president; Mohammad Saqib, CFA, society secretary; Mohmmad Jafar, CFA, society treasurer; Zaheer-ud-Din Khalid, CFA, society public awareness chair; and Amna Waheed Khalid, CFA, society advocacy chair. The CFA Society of Spokane held its 13th annual economic forecasting dinner on 6 March at the Spokane Club. Major sponsors included Major ICM Asset Management and Ken Roberts Investment Management. Featured speakers were George Nethercutt, a former U.S. Congressman, and Martin Barnes, managing editor of the Bank Credit Analyst. Pictured (from left) are Bill Kalivas; Weiling Zhu, CFA; Dean Kiefer, CFA; Karen Oeser, CFA; Martin Barnes; George Nethercutt; Brian Brill, CFA; Dominic Cozzetto, CFA; and Paul Steenblik, CFA. 22 CFA MAGAZINE / MAY-JUNE 2007

28 Society BRIEFS The New York Board of Trade (NYBOT) welcomed more than 70 members of the New York Society of Security Analysts (NYSSA) to its trading floor for a tour and mock trading session on 30 January. Organized by NYSSA s alternative investments, derivatives, and institutional asset management committees, the afternoon event gave members the chance to experience the open outcry market at New York s original futures, options, and soft commodity exchange. On 14 December, the Stamford Society held its charter award ceremony at the Riverside Yacht Club in Greenwich, CT. New charterholders received their charters from society board members along with congratulations from more than 80 members and guests who attended the evening event. The CFA Society of Chicago hosted a private wealth seminar on 1 March at the Standard Club. The Illinois Financial Planners Association and the CFA Society of St. Louis cosponsored the event, which attracted 100 attendees. Hersh Shefrin, professor of finance at the Leavey School of Business, was the keynote speaker. Other presenters included Robert Gordon; David Handler; Michael Pompian, CFA (pictured); Peng Chen, CFA (pictured); and Gordon Fowler, Jr. (pictured). More than 270 attendees came to the Hartford Society of Financial Analysts forecast dinner on 8 February at the Connecticut Convention Center in Hartford. Jim Angle, chief Washington correspondent for Fox News, and Richard Berner of Morgan Stanley were keynote speakers. Pictured in the front row (from left) are Amanda Abdella, CFA; Jim Angle; Thomas Keene, CFA, society president; Dorothy Meggie, CFA; and James Rice, CFA. Pictured in the top row (from left) are Edward Novak, CFA; Edward Steiger, CFA; Edward Ohannessian, CFA; Timothy Burns, CFA; Jack Cockerill, CFA; and James Hammel, CFA. A sell-out crowd of 500 turned out for the fifth annual forecast dinner of the CFA Society of Los Angeles, held on 1 February. Guest panelists (pictured second from left) included Abby Joseph Cohen, CFA, Goldman Sachs; Paul McCulley, PIMCO; and John Taylor, University of Stanford economist. Society president Donald Straszheim (pictured left) served as moderator for the event, which raised money through sponsorships for its economic and investing literacy program that benefits high school students. As part of its efforts to promote the highest standards of professionalism in the Bahrain financial community, CFA Bahrain/Bahrain Investment Professionals Society sponsored a speech by Daren Miller, CFA, titled The CFA Institute Code of Ethics and Standards of Professional Conduct. More than 25 members and candidates attended the evening presentation, which was held on 24 March at the Bahrain Institute of Banking and Finance in Juffair. The CFA Society of Melbourne, Australia, held a sold-out professional development event on 6 March at the Mercer offices. Robert Arnott, chairman of Research Affiliates, gave a presentation on fundamental indexing. Arnott (left) is pictured with André Roberts, CFA, president of the CFA Society of Melbourne. CFA MAGAZINE / MAY-JUNE

29 MARKET INTEGRITY Centre Managing Director Reflects on Two-Year Milestone The CFA Institute Centre for Financial Market Integrity was launched in November 2004 with the mission of making CFA Institute more relevant and engaged in the ongoing ethical and professional debates facing the financial services industry. At two years old, the Centre has made significant progress toward achieving that mission. The Centre s Managing Director, Kurt Schacht, CFA, reviews the Centre s accomplishments to date and the future for this new advocacy division of CFA Institute. Why was the Centre created and how has it developed? The Centre s primary focus is to develop a consistent and directed effort at commenting on issues of professional integrity impacting the financial services industry. CFA Institute created the Centre to be a prominent voice and thought leader with regulators, members, and the financial media for improving ethics and integrity, at a time when investor confidence in market protections and financial reporting was suffering. The Centre developed its capabilities over the past two years and now serves as a stronger voice for investors. We have made great strides in reaching out to regulators and industry associations to communicate investor concerns. We are also developing our connection with the financial media and providing them with regular commentary on important issues. We ve been interviewed in the U.S. broadcast media on both television and radio, a number of times, including CNBC and National Public Radio. We have had strong coverage in the Wall Street Journal, the Financial Times and have had dozens of mentions in a variety of regional and national publications. How would you describe the Centre s project work, and what do you view as its major accomplishments to date? The Centre continues to actively promote the CFA Institute Code of Ethics and Standards of Professional Conduct as well as the Global Investment Performance Standards. We have also introduced several new initiatives into the public debate. In particular, the Centre created and launched an Asset Manager Code of Professional Conduct (AMC), which is currently being promoted among investor and asset manager groups on a global basis. The AMC itself has become an integral part of the current debate over hedge fund regulation. In the area of corporate governance, the Centre has released The Corporate Governance of Listed Companies: A Manual for Investors, which references the primary governance issues to consider as part of investment analysis. This manual has been adopted into the CFA Program curriculum and is widely used by practitioners as a reference guide regarding the issues of corporate governance. In financial reporting standards, the Centre continues to build on historic success at CFA Institute, serving as a leading voice for investors with global standard setters concerning accounting and auditing rules. This is an area where our viewpoint is highly valued and we can have an impact. The Centre continually tracks industry developments and has published position papers and served as a media commentator on subjects including options backdating and expensing, Sarbanes Oxley reforms, hedge fund regulation, and short-term behavior in the financial markets. We are pleased by the interest our material has generated and the attention given our projects by various market participants and regulators thus far. Kurt Schacht, CFA Managing Director As the Centre continues to expand and develop its work plan, what are some new issues and projects that will be of primary focus? There is no shortage of issues and ideas to consider as part of the Centre work plan. We have a strong Advisory Council chaired by John Neff, CFA, the long-time mutual fund guru, who helps us identify and develop project ideas. The Centre has an extensive network of consulting committees and advocacy leaders that help identify and refine issues facing the financial services industry. One new focus will be to establish stronger advocacy capabilities in both Hong Kong and London, with a focus on issues of more regional concern. Our list of new projects includes an analysis of the selfregulatory system around the world, an executive compensation manual for investors, a code of conduct for pension trustees, and the delivery of an ethics training program for financial firms. The Centre has also recently released a new financial market integrity index based on a proprietary survey of CFA members. This index measures member opinion about the honesty and integrity of various participants and infrastructure. For more information on the Centre, visit The Centre developed its capabilities over the past two years and now serves as a stronger voice for investors. 24 CFA MAGAZINE MAY-JUNE 2007

30 Market INTEGRITY Quality Information = More Efficient Markets Corporate Disclosure Policy Council strives to improve financial reporting BY CRYSTAL DETAMORE-RODMAN G erald Gerry White, CFA, has long been a part of CFA Institute efforts to promote improved quality in financial reporting, most recently as chair of the Corporate Disclosure Policy Council (CDPC), which addresses issues affecting the quality of financial reporting and disclosure worldwide. In this interview, White, president of Grace & White, Inc., in New York and a member of the New York Society of Security Analysts, discusses how the CDPC advocates on behalf of CFA Institute members, the movement toward global standards, and the diverse challenges the CDPC faces in trying to improve financial reporting practices. This is the first in a series of interviews featuring the chairs of various CFA Centre Policy Councils. These volunteer committees serve as an invaluable resource for the organization in the areas of advocacy, professional conduct and public awareness, to name only a few. For more on the volunteer policy councils, visit centre/about/policy_councils.html. CFA MAGAZINE MAY-JUNE

31 MARKET INTEGRITY You have been involved in efforts to improve financial reporting for almost four decades. Why have you been such a strong advocate? One, as an investment adviser, I rely on financial statements to make investment decisions on behalf of my clients. So, it s very important for me to have good-quality financial statements, and this is a way I can try and get financial statements to be better. I run a company, I m busy as most people are, but I feel that with the time I put into this, I really have an impact on financial reporting, and that s really a good reason for me to do it. Another reason is that it keeps me up to date on what s happening in financial reporting. I sometimes find out about issues before most people are aware of them. I can sort of see the impact they re going to have on financial statements, so that s another benefit. In addition, because of the CDPC activities, I interact with a lot of people standard setters, auditors, corporate people who I would not necessarily get to meet and sometimes it s interesting when you talk to people on a different basis than you normally do. You learn something about their organizations, you learn something about them, and that s sometimes interesting information. I guess perhaps the last thing is that the profession has been good to me, and I feel this is my chance to give something back, something for the good of all of our members. I feel that with the time I put into this, I really have an impact on financial reporting. What is the current charge of the CDPC? Essentially, the CDPC s existence is based on the idea that financial markets run on good information. The better the quality of information, the more efficiently those markets will run. The goal of the CPDC its mandate is to try and work for better-quality financial statements, the statements themselves and the accompanying disclosures, and increasingly, on a worldwide basis. That s what we do. We do this by involving CFA Institute members all over the world. I m not an accountant. While some of the CDPC members are CPAs, many, perhaps most, are not, and that s not a requirement for membership. The idea is to present the perspective of people who use financial statements to the groups the Financial Accounting Standards Board, the International Accounting Standards Board, and the Securities and Exchange Commission that mandate the accounting and disclosure requirements. How does the CDPC carry out this mandate? I think our primary role is to write letters, responding to initiatives by the FASB, the IASB, the SEC, and other bodies that propose changes that affect financial reporting. I think our letters are taken very seriously and very often do have an impact on what final standards look like. We also participate, in most cases individually, on advisory groups, in discussion roundtables we respond to surveys we speak informally with staff members from the various standard setters and have formal meetings with those who set standards. We have an annual meeting with the FASB and just a few weeks ago we met with the IASB in London this was the first time we met with them to present our views on what the International Accounting Standards Board is doing. And we do meet from time to time with SEC staff and with other groups that are involved in the financial reporting process. We also conduct surveys of CFA Institute members to find out what their views are and, in a sense, to make sure that the views we express are not out of sync with those of our membership. What are some of the challenges facing the CDPC s efforts to improve financial reporting? I think the biggest problem is the resistance to change. Companies and auditors have been doing things a certain way, and they don t particularly want to change. There are costs involved in changing. I think there s a fundamental conflict, if you will, with what analysts want to know. They want to know not just reported income and the numbers on the 26 CFA MAGAZINE MAY-JUNE 2007

32 Market INTEGRITY balance sheet and cash flow statement; they want to know what s behind them. They want transparency, and companies are very resistant to that. They would prefer not to give out those details because I think it could take away some flexibility, and they like to be able to present their results in the way that flatters them the way that makes them look good rather than in a way that allows analysts to ask questions that a company might prefer not to answer. I think another factor is that, too often, the preparation of financial statements is viewed as a compliance exercise rather than a communication exercise. This is a point I ve made many times over the years, that financial statements should be a way companies communicate with their shareholders. I think that that s often not the case, but that is certainly something we try to push for. I guess the final point I would make about this is that financial statement preparers and auditors are very happy to tell standard setters what information analysts need. I think one of the most important functions of the CDPC is to tell them ourselves, to speak for ourselves, rather than allowing others speak for us. That does require some effort, and one of the challenges is that all of us are busy with our day jobs, and we just don t have the time to respond to everything and put as much time in responses as we might like. But we do the best we can, and at times, we do draw on nonmembers of the CDPC other members of CFA Institute who have expertise in areas where we may feel that we need some help (for example, very technical areas like derivatives or other financial instruments). We do occasionally look for help so our responses can be as good as possible. What are the key areas in financial reporting that will directly affect CFA Institute members? I think the major change over the last five years has been the emergence of the International Accounting Standards Board as a meaningful standard setter. What are now known as international financial reporting standards, IFRS, have emerged as a credible alternative to the U.S. standards set by the FASB. And for a host of reasons, some of them political, companies outside of the United States would prefer to use standards that are set in the international arena rather than simply adopting U.S. GAAP. And the IASB has come a long way in meeting the demand for good standards. There has been a convergence project whereby the two boards are trying to adopt the same, or virtually the same, standards. So I think the point is that IFRS now needs to be on the radar screen of all analysts and especially those who are looking at companies outside of the U.S., as most of us do. It has, in a sense, increased our workload, but it s necessary because of the change in the standard-setting arena. Turning to accounting issues, I think the major area of focus is the increasing use of fair value some people call it market value in the financial statements. That is a trend that we have encouraged. We believe that fair value information should be more widely used, that it is more relevant than historical cost information, but that is the highly controversial area, and that is probably the most significant area right now. How can CFA Institute members become more involved in the CDPC s advocacy efforts? We are always looking for new members. This is an ongoing process; we are not a private club. Anyone who is interested in financial reporting is encouraged to let us know, and we are particularly interested in members who are outside of North America, particularly because of the increasing focus on international standards. We have immediate vacancies in the Asia-Pacific and European regions. We are also always looking for members with expertise in technical areas who, even if they feel they don t have time to join the CDPC, would be willing to lend us their expertise in specialized areas be it derivatives, leases, insurance some of these specialized areas where standards are being set and we would love to have the benefit of your expertise. We do send out surveys. This is an opportunity for you to let your views be known. We do try to make them as a user-friendly as possible. If you get one of the surveys, I urge you to respond to it and make your view count. Crystal Detamore-Rodman is a freelance journalist with a background in small business. CFA MAGAZINE MAY-JUNE

33 MARKET INTEGRITY Fair Value Financial Reporting An investor perspective, part 2 BY REBECCA MCENALLY, CFA This article is the second in a two-part series. Today, the majority of standards comprising the bulk of current GAAP are not based on fair value principles but on historical cost measurement, the amount initially recorded for a transaction or event. Such measures may be based on a market price, a vendor s invoice amount, managers estimates of the cost, a discounted cash flow measure, or some other amount. In contrast, a fair value measure is defined by Financial Accounting Statement No. 157 to be (1) a market price for an identical asset, (2) a market price for a similar asset that can be suitably adjusted using market inputs such as a market rate of interest, or (3) managers estimates, preferably prepared using methods and inputs that the markets would use to value such an asset. The mixture of the two measurement bases, fair value and historical cost, in financial statements results in the so-called mixed (measurement) attribute system. Much work remains to be done to bring these older standards into compliance with FASB s fair value standard. In the interim, the CFA Institute Centre for Financial Market Integrity has proposed modifications to the current financial reporting model that will better serve the investment analysis needs of investors and accommodate the mixed attribute system during what is expected to be a lengthy transition period to a full fair value financial reporting model. The Comprehensive Business Reporting Model (CBRM) 1 is designed to separate financial statement disclosures by the type of measurement used for an item in the statements. These measurements include historical cost, managers estimates, fair value measures, and cash flows. From the standpoint of investors, the key question is: How can investors more efficiently and effectively use the mixed attribute information currently available to them? In regard to fair value, the CBRM addresses this question in two ways: (1) the statement of changes in net assets available to common shareowners and (2) the reconciliation of balance sheet, cash flows, estimates, and valuation adjustments. The Statement of Changes in Net Assets Available to Common Shareowners The CFA Institute Centre model includes a new display format for the income statement, the Statement of Changes in Net Assets Available to Common Shareowners. This statement would expand and transform the current income statement commonly provided in most financial reporting systems. While retaining all of the information currently available in the statement, the changes would more clearly and completely distinguish among items with different measurement attributes, including items measured at historical cost and fair value, reflect the different types of business activities (operating, investing, and financing), display items in the statements by the economic nature of the item rather than the function for which it is used, and reflect and incorporate (1) the company s obligations to the various claimants on the net assets of the company and (2) the transfer of assets to settle those claims. As currently measured, net income is the result of the recognition of some revenues and gains on accounting transactions less some expenses and losses. In contrast, the Statement of Changes in Net Assets Available to Common Shareowners is designed to include timely recognition of all changes in the fair values of assets and liabilities that are currently required or permitted to be recorded at fair value, while continuing to accommodate the separate display of historical cost information, including managers estimates. That is, the model will separate the various measures so that investors can make better use of the information. Furthermore, the statement will not require information that current standards do not require to be reported. If investors are to be able to evaluate how the value of their investment in a company is increasing or decreasing, then they must be able to fully understand how the company s operations and activities are increasing or decreasing the values of the assets they hold and the obligations they have incurred. The clearest measures of a company s wealthgenerating or -consuming patterns are changes in the fair values of these assets and obligations. This statement highlights the information investors need to make these assessments. A schematic diagram of the Statement of Changes in Net Assets Available to Common Shareholders is provided in Figure 1. The first column of the statement indicates the general layout of the items. Separate categories are established for operating, investing, and financing items. A line is provided for the net change in net assets before transactions with owners. One particular innovation is the inclusion of information in this expanded-format statement that is currently available only in the statement of shareowners equity: payments of assets and distributions of equity interests to the various categories of owners of the company, including minority interest and common shareowners. The final line is the net change in net assets available to common shareowners. 28 CFA MAGAZINE MAY-JUNE 2007

34 Market INTEGRITY FIGURE 1 Statement of Changes in Net Assets Available to Common Shareowners Operating Investing Financing Net Change in Net Assets before Transactions with Owners Net Change in Net Assets The second column, current-period transactions, provides for separate display of the effects of all transactions and events occurring during the period that affect the company s activities. The third column includes managers estimates for items such as depreciation, amortization of assets, provisions for bad debts, and the like. Managers estimates are somewhat different in nature from transactions and events, requiring a greater degree of judgement in their development. The valuation implications of such estimates may differ from those of transactions and events, so they have been separated for greater clarity and to enhance the usefulness of the information. The fourth column displays changes in the fair values of assets and liabilities that are currently required to be reported, or those that managers have chosen to report when standards provide such elections. 2 Hence, changes in the fair values of derivative instruments, share-based compensation, portfolios of trading securities and the like would be given separate recognition. Investors will be able to make use of the information much more readily than they can in the current reporting Current Period Valuation Net Change Transactions Estimates Adjustments In Net Assets framework where all of the information about changes in a single line item, effects of transactions, changes in estimates, and fair values, are aggregated together in a single number. This separate display for the fair value components of line items may also assuage the concerns of those who are less than comfortable with the concept of introducing periodic fair value remeasurement into the accounts. The fifth column accumulates and summarizes the net changes in net assets. Note that this column is somewhat similar to the limited and highly aggregated display that is normally provided in the income statement today. However, the items displayed in the column have been expanded to include all changes in net assets, including items currently reported in the statement of changes in shareholders equity. Observe that one of the major features of the statement is that it unbundles the various items by measurement type, permitting users of the statements to directly evaluate the items. Because the current financial reporting model provides for such items to be aggregated together by line item and also by function, investors must expend con- siderable effort to attempt to develop the information they need to value their investments. Given that such information is readily available currently in most companies general ledgers, the provision of the information to investors in the new model should result in little or no additional cost to companies. The company itself will benefit from the improved disclosure, and the greater clarity and reduced uncertainty that investors will have about the company s operations should result in lower risk premiums the company must pay to obtain needed capital and greater pools of available capital. This latter outcome has been well established in academic research over the years. That is, clearer and more complete disclosures reduce the company s cost of capital. Reconciliation of Balance Sheet, Cash Flows, Estimates, and Valuation Adjustments Entirely new is the Reconciliation of Balance Sheet, Cash Flows, Estimates, and Valuation Adjustments, which is provided in Figure 2. Indeed, this is likely to be the most useful statement of all for investors because it is based directly on the analyses that investors must undertake to value their investments and the types of information they try to generate from the limited disclosure currently available. (Notably, such reconciliations are also a common feature of the analytical work undertaken by managerial accountants as well as independent auditors when conducting their analyses of the company s accounts to ensure that the accounts are complete and accurately stated.) In brief, the reconciliation traces individual line items from one balance sheet to the next, separating the information by measurement type, cash flows, managers noncash estimates, Continued on page 30 CFA MAGAZINE MAY-JUNE

35 MARKET INTEGRITY Continued from page 29 and fair value adjustments. Note that to prepare such a reconciliation, the cash flow information must be reported using the direct method. This method is the cash flow cognate to the income statement currently in use in most reporting jurisdictions. The indirect method, in contrast, begins with reported net income and patches the net income number for two major categories of items: (1) noncash items appearing in income in the current period (such as depreciation and amortization and noncash revenues recognized) and (2) items with cash consequences that have not yet appeared in income, such as additional purchases of inventory, or payments on prior period obligations (for example, compensation accrued at the end of the prior period and paid in the current one). The direct method provides much clearer information on cash receipts and payments, information critical for evaluating the ability of the company to convert resources into cash flows, and for determining the distribution of cash flows to the various claimants on the company s resources. Note that in the Reconciliation, any transactions and events that have been recognized in the second column, ( Current Period Transactions, of the Statement of Changes in Net Assets Available to Common Shareowners, ) but that have not either been converted into cash or consumed cash would be displayed in the Estimates column. That is, both noncash accruals, such as noncash revenues, and other estimates, such as depreciation, would appear in the Estimates column. This display highlights the fact that until items such as revenues are collected in cash, they are estimates of the cash flows that will occur in the future and only that. The format throws into sharp relief the nature of the company s various FIGURE 2 Reconciliation of balance sheet, cash flows, estimates and valuation adjustments Balance Sheet: Cash Flow Statement, Valuation Balance Sheet: December 31, 200X Direct Method Estimates Adjustments December 31, 200X + 1 value-generating activities and shows how new resources are generated and claims against those resources arise, how the company converts resources into cash and distributes the cash to claimants, and how the value of the residual claimants investments is changed as a result of these activities. Importantly, too, the statement provides clear insight into the underlying riskiness of a company s operations by displaying the information needed to evaluate both the company s short-term and long-term prospects. One might question why the issue of cash flow reporting is given such prominence in discussions focused on fair value reporting and measurement. The answer is direct and straightforward: cash flows are the ultimate fair value measures. That is, by definition they are current and up-to-date at every moment and therefore are continuously measured at fair value. One way of understanding this notion is to recognize that at the last split second before an item is received or paid in cash, it is measured or remeasured at fair value. Any difference between the accrual amount recorded in the books and the amount to be received or paid in cash must be recognized as a gain or loss at the time the cash flow is recorded. To do otherwise is to misstate the accounts. Conclusions This brief discussion has had as its objectives to explain the importance of fair value financial reporting for investors and its role in the investment decisions they must make. It also provides discussion of a simplified model for presenting fair value information, including cash flows and information based on other measurement attributes. The CBRM does not require information that is not currently mandated by standard-setters for financial reporting or that is not already available in the company accounts for purposes of managerial decision-making and control. Hence, it should be relatively straightforward for standard-setters to move toward such a display model. The benefits to financial statement users and, ultimately, to the companies that present such information will be immediate. Rebecca McEnally, CFA, is a senior policy analyst for the CFA Institute Centre for Financial Market Integrity. FOOTNOTES: 1. The CFA Institute Centre for Financial Market Integrity paper A Comprehensive Business Reporting Model: Financial Reporting for Investors provides expanded discussion of the development of the model as well as examples of how it would apply to a variety of transactions and events. The full report is available on the CFA Institute Centre section of the CFA Institute website. 2. For example, the FASB has recently issued FAS No. 159, The Fair Value Option, which permits managers to selectively choose to apply fair value measurement to financial instruments held by companies. 30 CFA MAGAZINE MAY-JUNE 2007

36 Market INTEGRITY An Apples-to-Apples Comparison Centre introduces template for reporting quarterly earnings BY MATTHEW ORSAGH, CFA, CIPM In April 2007, the CFA Institute Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics issued a report, Apples to Apples A Template for Reporting Quarterly Earnings, that aims to help reform earnings guidance practices and improve communications and transparency between public companies and their investors. The report expands on recommendations from an earlier joint paper Breaking the Short-Term Cycle (July 2006). Before discussing the details of a standard earnings template, let s take a brief step back to assess the current state of quarterly reporting transparency and what has been done in recent years to address any shortcomings in quarterly communications. In March of 2003, the U.S. SEC adopted Regulation G (Reg. G) to direct companies using non-gaap financial measures in their communications with shareowners (e.g., quarterly earnings announcements) to reconcile such information to the most directly comparable GAAP measure. Reg. G was issued in response to the growing concern that quarterly earnings releases were becoming increasingly opaque and potentially misleading in terms of actual GAAP earnings information. There is still concern, however, that simply asking for such reconciliation may not be enough to provide shareowners with the level of transparent and fair disclosures they desire. The concept behind the Apples-to-Apples report is to encourage companies to provide better transparency in their quarterly earnings reports. One of the beauties of the report is that it does not require companies to produce or disclose any additional information. It is the format that needs an update. The report simply offers a template that provides for greater transparency between headline numbers and the reconciliation to U.S. GAAP. For example, if a U.S. company reports a pro forma earnings number, the SEC already requires a reconciliation table. Unfortunately, that table is often buried deep in the report and is frequently confusing. Oftentimes, it is also difficult to tie non-gaap numbers back to GAAP, in some instances because of the absence of complimentary financial statements, such as a statement of cash flows that may not be released until weeks after the initial earnings release. In addition to reiterating the Breaking the Short-Term Cycle recommendation to end quarterly earnings guidance, the Apples-to-Apples report makes the following recommendations: Include a GAAP income statement that starts at the revenue line and proceeds to net income: The GAAP statement which could use either gross or net measures, depending on how the company normally reports ought to 1) provide sufficient line-item information for the investor to follow the calculation from revenue to net income and 2) display shares outstanding, making it easy for investors to calculate per-share figures and the per-share earnings for the quarter. Position GAAP reconciliation tables in immediate proximity to the non-gaap financial measures they are meant to illuminate: A concise GAAP reconciliation table should be positioned immediately after (or next to) non-gaap earnings or income highlighted in the release. Include a balance sheet and statement of cash flows: The balance sheet and cash flow information should be sufficiently representative so that it is possible to reconcile income statement items that have a direct cause or effect on the balance sheet or cash flow statement. Place information consistently: The report encourages the consistent placement of all tables and reconciling information within the release. Specifically, it recommends placement of such information at the front or the end of all future quarterly releases. In preparing the Apples-to-Apples report, the Business Roundtable Institute for Corporate Ethics conducted an analysis of recent quarterly earnings releases from the S&P 500 Index in order to determine how companies are currently complying with the recommendations made in the report. The findings demonstrate that: For companies presenting non-gaap information and thus required by Reg. G to reconcile to GAAP, two-thirds of large-cap companies presented the reconciliation in close proximity to the income statement; however, only one-third of mid-cap and small-cap company releases have their non- GAAP reconciliation tables nearby. Significantly, most companies analyzed present GAAP income statements and balance sheets; however, complete cash flow statements are provided by approximately 60 percent of large-cap companies and approximately one-third of mid-cap and small-cap companies. As this analysis suggests, some companies are already doing a good job of providing analysts, asset managers, and investors with concise and expedient access to the numbers that really matter. It appears that more needs to be done, however, especially among small- and mid-cap U.S. companies to provide the markets with the clear and transparent information necessary to make informed investment decisions. The standard template for reporting quarterly earnings may offer such a model, one that companies can quickly and easily adopt to better serve their shareowners. To read the full report, go to Matthew Orsagh, CFA, CIPM, is a senior policy analyst with the CFA Institute Centre for Financial Market Integrity. CFA MAGAZINE MAY-JUNE

37 MARKET INTEGRITY China and Corporate Governance CFA Institute Centre survey examines investor views on needed reforms BY LEE KHA LOON, CFA Although China s transition from a state-planned to a marketoriented economy started about two decades ago, corporate governance reforms have gained prominence only in recent years. The need to improve corporate governance practices in the financial and capital markets has become a top priority in both the public and private sectors. In August and September 2006, the CFA Institute Centre for Financial Market Integrity conducted a study of corporate governance practices in China and received 475 responses from CFA charterholders and members in Hong Kong and China who have investments or interests in Chinese companies. The main objective of the survey was to obtain opinions and views on the effectiveness of recent reforms made by China to improve corporate governance practices, issues relating to corporate governance and financial disclosures among Chinese companies, and ways to further improve corporate governance practices in China. The respondents were asked to give their views on the effectiveness of the following corporate governance reforms: split share structure reform of listed companies by China s Securities Regulatory Commission to convert nontradable shares into regular Class A common shares by the end of 2006, China s release of a new accounting standards system based closely on the International Financial Reporting Standards in February 2006, the March 2003 directive on quarterly reporting, and introduction of the Qualified Foreign Institutional Investors program in December 2002 to allow foreign investors to invest in Chinese securities. Overall, respondents viewed the implementation of corporate governance reforms to be somewhat effective. The conversion of nontradable shares to freely tradable shares received the highest rating among the four reforms, possibly because full conversion of nontradable shares increases both liquidity and transparency of ownership. The survey questionnaire also presented 16 corporate governance issues, grouped in three main categories: (1) board composition, structure, and mechanisms; (2) the relationship with stakeholders and shareholders; and (3) disclosure and transparency. The respondents were asked to rate (on a scale of 1 to 5) how important each issue was to the investment decision-making process and the extent to which that issue has improved in quality over the last three years. The following categories received the highest ratings (between somewhat important and extremely important ) for importance to the investment decision-making process: skills and experience of management (4.37), accuracy of financial and company information disclosed by companies (4.30), completeness of information disclosed (4.22), timeliness of financial and company information disclosed by companies (4.17), and protection of shareholder rights (4.17). Regarding change in quality over the last three years, only two issues received a rating above 3.6 (signifying a modest improvement): skills and experience of management (3.81), and executive compensation aligned with company performance (3.65). The survey results clearly show that while the Chinese government has made efforts to improve the corporate governance framework, substantial improvements are still not evident in financial disclosures and transparency, which are viewed as very important for decision making. The changes observed over the past three years vary from one company to another. Some have made strides and others have not; room for improvement definitely remains. As China s financial reporting system evolves, there will continue to be significant disparities in both the quality and quantity of information from one company to another, and investors should recognize these disparities in their decision-making approach. Another interesting observation from the survey results is that changes in aligning executive compensation with company performance could be linked to changes in skills and experience of management. A more attractive compensation package may have been able to attract superior managers. The issue skills and experience of management received the highest rating for importance to decision making and change in quality. China s progress on corporate governance has been widely acknowledged. But the acceptance of good governance practices by Chinese companies and their regulators will likely be a long and involved process. Some notable suggestions from the survey respondents are to increase institutional investor participation, both local and foreign, to inculcate good governance practices in the market place, encourage the development of professionals with a variety of industry and financial skills that can serve more effectively as independent directors, develop programs/activities for investor and director education, enhance the structure of board governance (e.g., more independent director participation and creation of board committees, such as the compensation committee), and improve practices associated with completeness, accuracy, and timeliness of information disclosed. Lee Kha Loon, CFA, is head of the Asia-Pacific office of the CFA Institute Centre for Financial Market Integrity. 32 CFA MAGAZINE MAY-JUNE 2007

38 Market INTEGRITY Financial Market Integrity Index Report on U.S. market released; other markets to follow BY MATTHEW ORSAGH, CFA, CIPM The inaugural Financial Market Integrity Index report for the U.S. market was released by the CFA Institute Centre for Financial Market Integrity in March. The index is derived from the opinions of CFA Institute members around the world about financial market integrity in certain markets. The goal of these annual index reports is to advance the discussion about the integrity of global financial markets. The survey coverage will be expanded over time and will provide the Centre with useful data as it continues to sharpen its focus on ethics. As a result, our members will have a direct voice in this discussion. Reports on the Canadian and U.K. markets are being completed and will follow in the coming months. The Centre expects to cover more markets in the future as the global membership base of CFA Institute continues to grow. These reports are not intended to compare one market with another but are primarily designed to track members perceptions of market integrity in a particular market over time. While there may be some overlap in survey populations from one country to the next, they will not be homogeneous. The index aggregates the opinions of our members concerning the integrity of such financial market professionals as money managers, corporate executives, and others as well as market foundations, such as legal protections and corporate governance. The full value of the index will be realized in coming years when time-series comparisons can be made to determine the degree to which member sentiment concerning the integrity of markets and their participants has changed. For example, if a regulatory regime or legal protections in a particular market were perceived to be weakening over time, investors might react by adjusting their assessment of that market to reflect increased risk. Conversely, if the rating of corporate governance standards were improving over a span of surveys, investors might interpret such a development as a signal of declining risk in that market. This first index report serves as a baseline with which future reports will be compared for member sentiment concerning the integrity of the U.S. market. The Centre developed the survey and index report in conjunction with Fleishman Hilliard Research. This initial survey involved more than 800 respondents around the world. Each survey participant was asked 10 integrityfocused questions on topics ranging from the ethical behavior of sell-side analysts to the level of financial reporting transparency in the United States. Each survey participant would then give an answer between 1 (poor) and 5 (excellent) for each question, with the option of don t know if the participant felt they did not have the expertise to judge that aspect of financial market integrity. Participants were also encouraged to add any relevant written comments to enable further insight and detail on their impressions of a particular sector. A selection of these comments were integrated into each report to provide further insight on participant views. The Centre is pleased to offer these new reports and believes they will provide a helpful context for discussion as well as assist our advocacy efforts. The survey will be conducted again in the fall of 2007 for compilation and reporting in For further details on how you can get involved, contact Matthew Orsagh A copy of the inaugural index report can be found in the Centre section at Matthew Orsagh, CFA, CIPM, is a senior policy analyst with the CFA Institute Centre for Financial Market Integrity. CFA Institute Centre for Financial Market Integrity Ethics Symposium 2007 Competition and Ethics in Finance: The Market Integrity Challenge Tuesday, 22 May 2007 Chartered Accountants Hall London Supported by the UK Society of Investment Professionals and Tomorrow s Company Speakers include John Plender of the Financial Times and Lindsay Tomlinson of Barclays Global Investors Europe For more information and to register, visit or call Join us for a look at the impact of financial scandals and regulatory reforms on the competitive positions of the markets in London, New York, and across Europe. CFA MAGAZINE MAY-JUNE

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40 An Independent BY JONATHAN BARNES Perspective Andrew Brady, CFA, brings outside thinking into debt investment In conjunction with our 60th anniversary, CFA Magazine has launched a new series that profiles some of today s up-and-coming investment professionals people who may have the potential to shape, or reshape, the profession over the coming decades. The town of Willow, Alaska, isn t big. With only a few hundred residents, Willow makes up for its small population with wide-open spaces. I usually tell people the area called Willow is about the size of Rhode Island, says Andrew Brady, CFA, about his hometown. The limits are simply the rivers and mountains as far east or west as you can drive. An objective view comes naturally in rural Alaska. It teaches you an independence of action and thought; if you go hiking in the mountains on your own, there s no one to help you if something goes wrong. Also, with few people around, there was little pressure for conformity, says Brady. So, conformity never had much appeal. Living 20 miles from school, Brady would walk about a mile to catch the bus and hope there wasn t a moose on the road. He took to studying astronomy, history, economics, and accounting independently. He also charted the stock market before knowing much about it. On Black Monday, he recalls, I ran out of space on the bottom of my page. I had to attach another page. When no one could explain what had happened, Brady started reading on his own: reference books, a collection of Dun & Bradstreet reports, and anything else he could find about the markets. After finishing a BS in economics at Wharton, Brady declined offers from large asset managers and investment banks to join a small group called Indosuez Capital, which gave him the opportunity to focus on fixed-income asset management, merchant banking, and private equity. In more than eight years with Indosuez (now named Lyon Capital), Brady covered companies in nearly every industry, advancing to senior credit analyst for par and distressed high-yield bonds, leveraged loans, and mezzanine debt. Now, Brady leads the U.S. par leveraged loan activities for Marathon Asset Management, LLC, a New York based global manager of fixed-income and private equity investments, including hedge funds and collateralized debt obligations (CDOs). CFA MAGAZINE / MAY-JUNE

41 Can you describe the objective view that comes from growing up in Alaska? You have to make up your own mind through a pure lack of outside influences. Alaskans tend to question dictates from beyond the borders, what we call Outside. That means not just accepting expert opinion; for example, our local weatherman could be off by 40 degrees within hours. Similarly, I remember hearing a long time ago about the market going up one day because interest rates might go down. The next day, they said the market went down for the same reason. How did you come to Marathon? Before I arrived, we were involved in distressed, senior, and junior debt and also buying asset-backed securities, including other people s CDOs, but we did not manage CDOs. We had all the pieces to do so portfolio and risk management, credit analysis, trading, operations but we did not focus on the par loan market. So, in 2004, I came over to coordinate that effort and build that business. What have you been up to? We ve raised two cash flow CDOs totaling roughly US$740 million, which focus on the standard U.S. par leveraged loans, and we ve recently raised another US$1.1 billion CDO with more flexibility, a new type of structure with the flexibility to own U.S. and European debt with any mix of first liens, second liens, unsecured or mezzanine. We prefer to own the equity of our vehicles, focusing on return on investment rather than the simple asset grab common in the market, where managers are paid for maximizing assets. How do you look at capital structures? We like to think throughout a company s capital structure, taking off the blinders produced by a fund s narrow investment focus. We might have a CDO that does focus just on one asset class, but we think about each opportunity within the capital structure first-lien versus second-lien debt, versus subordinated notes, versus convertible bonds, versus synthetics, versus equity both within a company as well as among competing or comparable companies. What do you see in the credit markets? Increased mispricing of risk. Twelve months ago, if you asked people if they would be making senior secured loans to finance dividends or leveraged buyouts with no covenants and few creditor protections at record-low pricing and record-high leverage, people would have said, That s impossible. I would never stoop that low. In fact, that has become the market standard. Twelve months ago, if you asked people if they would be making senior secured loans to finance dividends or leveraged buyouts with no covenants and few creditor protections at record-low pricing and record-high leverage, people would have said, That s impossible. I would never stoop that low. What are the biggest challenges today to finding investments you like? To maintain discipline and have the willingness to wait not to just chase returns. If the risk reward is out of balance, if the debt is missing certain deserved and reasonable protections, we have no qualms about passing on the investment. There s a helpful old saying: When everybody s thinking the same thing, nobody s thinking very much. That uniformity of thinking is usually prevailing somewhere. Residential real estate was a clear example until recently. Also, over the past year, the Chinese stock market, as well as CDO issuance, is up more than 100 percent. When you see segments become extremely overheated, the most important question is: Why can t it drop significantly, especially if gains were just driven by higher valuations rather than fundamentals? Have subprime mortgage defaults affected your investments? They have not affected market pricing on U.S. secured loans at this juncture, but it s a prescient reminder of market risk. There has been a slight impact on pricing for new CDO liabilities through the ABS markets. But the subprime collapse is a 36 CFA MAGAZINE / MAY-JUNE 2007

42 very interesting example as to how inefficient the markets are, since the lax lending standards and upcoming interest rate resets were a known fact for years. It very much became a game of musical chairs, as in, We ll crank out this deal and sell it off. But originators caught long when the music stopped got hammered. There is a great deal of that catch as catch can approach in the markets these days. How does your interest in financial panics influence your work? Financial panics are integral to my thinking. They show how quickly sentiment can turn. The history of finance is often nothing more than a history of psychology the overconfident valuations, the bubbles, the panics. I found David Dreman s Psychology and the Stock Market early in college; it remains the most influential book I ve read about investing, right along with Charles MacKay s book Extraordinarily Popular Delusions and the Madness of Crowds. The latter goes through the tulip mania, the witch hunts, and the Crusades. All kinds of unsubstantiated beliefs and scares tend to take hold, not just investing manias. They all provide a reminder that one might be best served by admitting error and changing course. What s at the heart of financial panics? Buying into any mass psychology, I suspect, is tied to striving for conformity and fear of being left behind. The mentality within panics is identical to other manias or beliefs that turned out to be folly, such as hula hoops, the Atkins diet, the inferior abilities of women and other races, the short sailing route to Cathay, etc. The goal is to think rationally in real time, not just in retrospect. The concept of choosing what to overlook, including the opinions of the masses or the acclaimed experts, is a critical lesson of history. That message was a clear take-away from my reading of the Wall Street Journal from 1929 to 1933 on microfiche in the university archives. Is there a particular panic you find intriguing? More interesting than 1929 would be the Panic of 1907, which was largely psychological and momentum driven, with many runs on the banks. The panic became self-fulfilling, and in the days before the Federal Reserve, it only ended when J.P. Morgan himself locked the leading bankers in his house until they agreed to provide the necessary liquidity to end it. How do you evaluate risk? By focusing on how much we can lose rather than how much we can gain. Evaluating downside risk can t be as simple as just looking at historical statistics. For U.S. leveraged loans, historically, they have very low default rates with high recoveries, but assuming that will not change ignores the human element of risk as well as changes in structure. Recent loans are likely to be of weaker credit quality with fewer protections than in the past, which argues for more defaults and lower recoveries. If you could change one thing about the structure of the markets, what would it be? Certainly in the leveraged loan markets, it would be a rebalancing of risk and return. That includes reasonable protections for your investment, such as covenant triggers if a company is underperforming. Having a reduction in liquidity in the system so there s not an absolute flood of money chasing all opportunities would certainly help produce this rebalancing. The change in liquidity, however, may only occur when people start to take losses, rather than from an accurate forward assessment of risk. Then, liquidity could be shut off overnight, a phenomenon most recently exemplified in the sub-prime market. Jonathan Barnes is a journalist in the Pacific Northwest. CFA MAGAZINE / MAY-JUNE

43 BEING THERE Are Company Site Visits a Delusion? BY CHRISTOPHER WRIGHT 38

44 IT WAS A TALE OF TWO HEADQUARTERS: the best of times for management versus the best of management for shareholders. The time was the early 1990s. A site visit to the first company, a large conglomerate in Mexico, revealed a huge modern headquarters with priceless art on the walls. Dinner provided another revelation. I had dinner with management in a private dining room in the penthouse four-course meal, white-gloved waiters, recalls Cindy Sweeting, CFA, executive vice president and director of research of the global equity group at Templeton Investment Counsel in Ft. Lauderdale, FL. As she was leaving, Sweeting concluded that these managers were primarily interested in their own enrichment and this big building was nothing more than a monument to their colossal egos. Her next stop was another Mexican conglomerate this one housed in rented space in a modest bank building. At 7 o clock at night, she recalls, there were still people at their desks working. The board room had recently been expanded. Sweeting could still see a line running down the middle of the floor where the old carpet met the new. The managers owned a stake in the company and were very focused on shareholder value. The second company, clearly the better steward of shareholder funds, was the one Sweeting recommended for investment when she returned home. Skeptics contend that company site visits are useless or even counterproductive. Some analysts argue that the financials are enough to tell the company s story and nothing worthwhile can be learned where rules are in place against selective disclosure (See sidebar, page 42). Worse, they believe, is that a visit gives corporate managers the opportunity to pull the wool over the eyes of analysts, who are either naive or emotionally overcommitted to the company. But Sweeting and other analysts tell a different story. Sometimes, it s hard to tell who s being up-front and who s just trying to feed you a story, admits Michael Cumming, CFA, energy equity analyst at research provider Morningstar in Chicago. But he remains convinced that company site visits add value: It really helped me, especially early in my career, gain a better feel for how the industry worked and how all the assets fit together. Cumming visits oil and gas properties as well as company headquarters. He goes to get an idea of whether I think management is competent or not. More importantly, he visits to get a sense of whether the company has the best possible long-term strategy in light of industry trends. When the subject is what is happening in the industry, Cumming has found that managers will go well beyond what they have said in regulatory filings and earnings calls. With enough visits, he believes an analyst can spot management teams that are unaware of their own best opportunities or that play up areas that (according to the analyst s other research) augur poorly for the company s future success. NOT IN THE PRESS RELEASE A visit to a watch and jewelry company in Shanghai was an epiphany for Francisco Alzuru, CFA, managing director for emerging market research at Hansberger Global Investors in Ft. Lauderdale. He thought the company was just a manufacturer, but the visit revealed that the company s best growth opportunities were in its new distribution and retail initiatives. The company was blanketing retail outlets throughout China with fashionable middle-market goods and, in addition, selling high-end luxury items through its own outlets. Although the company had issued press releases announcing the opening of new stores, the genius of the strategy was not apparent until he was on site and could see how situating stores in low-cost, high-traffic locations in affluent areas in Shanghai and other major Chinese cities allowed the company to avoid the steep rents other luxury outlets were paying in high-end malls nearby. Alzuru went to one of the stores and witnessed for himself the ambience the company successfully created to pamper its well-to-do customers wine cellar, walk-in humidor with Cuban cigars, etc. It may sound a bit much, but these are customers who think nothing of spending US$100,000 on a wristwatch. You can t see that in a press release, says Alzuru. Another discovery came in Latin America. He went to see an upstart telecom operator that was competing against the incumbent carrier with a unique low-cost solution for the last mile (from network node to individual house). He saw the technology how fast it could be deployed to new customers and how little it cost to implement. Although not apparent from its website, the company was getting ready to roll out several new value-added services. In other words, it was offering new and improved services at a lower cost than the incumbent. Not until he saw the installation first-hand did the case for potential investment in the company click in his mind. Site visits also made something click for Templeton s steel analyst in the early 1990s, according to Sweeting. The analyst CFA MAGAZINE / MAY-JUNE

45 was able to contrast traditional behemoths to the mini-mills, which were new at the time. He visited US Steel, which, Sweeting says, had a steel mill the size of a city the beginnings of it were decades old, it was union-run, with old technology, really poor logistics. On the same trip, he saw the mini-mills of Nucor Corporation, where most of the employees seemed to be in a computer room; everything was mechanized. In short, Sweeting says, site visits can really bring home the cost advantages of new technology versus old technology. VALUES AND CULTURE For Chad Kilmer, CFA, it s not about visiting hard assets but trying to get a read on the company culture. Kilmer co-manages a small-cap value mutual fund at William Blair & Company in Chicago. Kilmer has had good luck making longterm investments in companies located in the U.S. heartland. He tunes in to the company s value-set and is more receptive when his gut tells him he has found honest, hard-working, frugal, unpretentious people. We re active managers, he says. The site visit allows us to have more conviction. That confidence lets us take bigger positions. In 2004, Kilmer visited a consumer health care products company in Minnesota with good numbers. The company was located in a nondescript warehouse-type building. Staffing was lean. He was struck by how polite and friendly the employees were and how genuine and intelligent the leaders seemed. Culture is very important when we re investing in companies long term, he explains. You want to make sure that you re investing in companies that have healthy cultures and foster employee development and that it s a place where people want to come to work. In this case, you could tell they were very excited by what they did every day. Earning a paycheck wasn t their primary motivator; they had fun doing what they did. He went away feeling extremely confident about the long-term outlook for the company. It was a US$10 stock at the time and was recently acquired for US$37.50 a share. In 2001, he visited a high-end commercial office furniture maker in Iowa with strong return on invested capital and a very conservative balance sheet. Despite the company s positioning at the high end of the market, it was very Spartan HOW TO MAKE THE MOST OF SITE VISITS Know Your Objectives Cindy Sweeting, CFA, isn t looking for short-term guidance. Her focus is on the strategic positioning of companies over a five-year time frame. Will the company stick to what it does best? Does it allocate capital judiciously? She uses the visit to assess these and other points that will make a difference in the long-term value of the company. Francisco Alzuru, CFA, also has a strategic focus. Tell me why your company is going to be better five years from now than it is today, he says. To sharpen his forecasting, he also wants to know how sustainable the company thinks its pricing is. The company managers are the ones who know how much competitors are investing in new productive capacity and what effect that will have on prices. Go Prepared Before visiting, Chad Kilmer, CFA, reads up on a company analyst reports, proxy material, earnings call transcripts, and so on. He also talks to sell-side analysts and the company s competitors. Show the management team that you re knowledgeable about their business, he says. They re going to respect you more and talk to you longer. Take a checklist of topics you want to cover, advises Michael Cumming, CFA. You ll be skipping around during the meeting. Checking items off a list helps you get to all the points you meant to cover. Sweeting starts with a generic list of key questions that typically apply. Cumming confirms arrangements over the phone shortly before the visit to ensure that his plant tours and appointments with field managers are all lined up. Kilmer recommends bringing good maps when you re new in town. Get Beyond Investor Relations It s definitely far more valuable to have a chance to talk to the CEO or the CFO, Cumming says, because they re the people who are making the decisions. Investor relations can tell you what they ve been told to tell you or what they understand to be the direction of the company, but to get it from the people at the top is really vital. He also likes to talk to hands-on people out in the field; they give better tours, he believes, than investor relations people. Talking to the people who manage the assets gives you a different perspective from the traditional company line, he says. Kilmer tries to talk to as many people as he can, including workers on the shop floor and the sales force. They can give you a read on whether the company is excited about what it s doing. He tries to see whether their body language matches what they re saying. Reading peoples body language is an art, he says. The people who are good at picking up nonverbal cues tend to have pretty good investment track records. Sweeting is also a strong proponent of talking with field personnel. She was covering a U.K. pharmaceutical company that derived half its revenue and most of its profits from the U.S. and that had been pummeled by sell-side analysts (because they thought that its top-selling pharmaceutical product would be negatively impacted by generic substitution upon patent expiration and because of the company s announcement of higher marketing costs to roll out its own replacement product). Instead of dealing with investor relations in London, she went to Cleveland, in March 2002 to meet with 40 CFA MAGAZINE / MAY-JUNE 2007

46 the furnishings hadn t changed in their humble downtown building in 40 years. The visit allowed him to invest with high conviction at a stock price of US$20 a share. Its share price exceeds US$50 today. BE A DETECTIVE Another reason to visit is to test the credibility of the company s assertions about itself. Templeton s Sweeting visited a generic drug manufacturer that was told by the U.S. Food and Drug Administration to stop selling a certain product until safety concerns were met. The managers were upbeat in their public pronouncements, saying the situation would soon be corrected. But when she toured the manufacturing facility, Sweeting saw a distinct lack of activity in the production area for the drug in question. It was quiet. She could see that quite a bit of staff had been laid off. It made me very skeptical about the contention that this issue was going to be resolved soon, she says. If management really believed its own words, manufacturing would have been ramping up and test batches would have been rolling off the assembly line. Instead, inventory canisters date-stamped two years earlier sat gathering dust in a corner. From all these signs, she concluded that management was not sanguine about getting a green light on this drug; they weren t making the necessary preparations to restart manufacturing. Sweeting s instincts turned out to be right, but it was the site visit that gave her the critical information. the U.S. heads of sales, marketing, and R&D, the people in charge of the company s key product. She found out that no U.K.-based analyst had ever visited these people before and concluded that the negative conclusions in the sell-side reports were unfounded. She recommended buying the company, and it turned out to be a strong investment, tripling in share price over the past four years. Stay Detached Some analysts believe the best practice is never to interact with corporate managers because analysts who establish relationships are too easily swayed by management. Kilmer disagrees: If these are going to be the people that you re putting your shareholders capital to work with, wouldn t you want to get to know them and see what makes them tick? As a long-term investor, he definitely is trying to establish a relationship. This way, he gets his phone calls returned and an early heads-up when their tone or demeanor changes. He acknowledges, however, that all management teams to some extent are trying to promote their company, so they re usually going to paint a rosy picture. The antidote? Walk in there, take off your rose-colored glasses, and be a healthy skeptic. Or as Sweeting puts it, Don t drink the Kool-Aid. Kilmer also maintains objectivity by setting price targets. When the company reaches its target price, he trims or sells his position. The practice of selling or trimming stocks that have reached estimated fair value is an everyday occurrence whether we love the management team or not, he says. Alzuru takes the same approach and has no problem telling managers that he will sell a position when a target or stop has been reached. Understand the Cultural Context When visiting companies in foreign countries, Cumming recommends that analysts who don t speak the local language have their own translator accompany them. He recalls a meeting in China conducted in Chinese. The company made a translator available, but for Cumming, having his own Asian colleagues with him helped ensure that my questions were asked the way that I wanted them and my analyst could help me get any language cues or other sort of hidden information beyond what was said. If you don t have the context, you can easily misinterpret the information you are receiving. Alzuru had a meeting at 1 p.m. at a petrochemical/plastics manufacturer in Taiwan. Arriving 15 minutes early, he went to the second floor where the meeting was to take place. As we walk in the door, the entire floor is dark and every single employee is with his or her feet on the desk, sleeping, he remembers. At 1, somebody turned the lights on and everybody went to work. This was not at all strange to the Venezuelan-born Alzuru, who watched his father take a 10-minute siesta every afternoon before going back to work. Nor were the bottles of wine he saw on every table in a steel mill cafeteria in Italy any cause for concern. In other cultures, he explains, you can have a beer or a shot of whiskey at lunch and nobody would even think of questioning it. CFA MAGAZINE / MAY-JUNE

47 Be a detective is her advice. Before every visit, she asks herself, How can I uncover things that management really doesn t want me to know? Alzuru finds site visits helpful also in assessing whether management statements are credible. Before asking clients to invest in emerging market companies, he goes to kick the tires see if the headquarters are where they say they are, if the stores exist, if the plant exists, he says. Credibility problems are not confined to emerging markets. Alzuru began visiting a large retail bank in the United Kingdom in 1998 where the managers always had an excuse for low earnings and dwindling market share. The investor relations representative was very skillful at presenting the story in a way that made me give them the benefit of the doubt, Alzuru says. But after three years of hearing lame excuses, he figured there must be better investments elsewhere. He would not have picked up on the company s fancy dancing and dissembling had he not consistently visited the company once a year, he says. GREAT EXPECTATIONS The experiences of these and other analysts cannot be denied. There are times when company site visits provide valuable information. If done thoughtfully and well, when you ve already identified the key issues, says Sweeting, you can uncover some interesting conclusions and observations. But, she cautions, site visits are just one piece of the puzzle. They ll never solve the investment case for you. Christopher Wright is a freelance writer and the author of an investment newsletter in Arlington, Virginia. SITE VISITS AND STANDARDS OF PRACTICE Suppose you re an analyst in Country A and you are invited to visit a company listed in Country A but located in Country B. They ll fly you overseas at their expense, put you up at a hotel, and treat you to world-class golf while you re there. You know that refusing the invitation would be tantamount to accusing them of bribery in their culture, so you accept. At dinner overlooking the golf course, they tell you they want you to be the first to know that they have completely straightened out their plant operations and they expect efficiency gains to hit the bottom line in the future. When you get back, you discuss the operational gains in a note to clients and trade in the stock. Are you on ethical terra firma, or is the ground shifting beneath your feet? Even if the countries involved do not have insider-trading rules, CFA charterholders are still bound by Standard of Practice II(A) regarding material nonpublic information. If analysts come into possession of some inside information, they re basically locked down they can t act on that or cause others to act on it, says Jonathan Boersma, CFA, standards of practice director at the CFA Institute Centre for Financial Market Integrity Wined, Dined, and Brought Inside There are rules in some countries against the selective disclosure of material nonpublic information to analysts (e.g., SEC Regulation FD [Fair Disclosure] in the U.S.; FSA Conduct of Business Sourcebook at MAR 1.4 in the U.K.). Analysts must first decide whether information gained in a site visit is material. In other words, explains Boersma, Would it likely have an impact on the valuation or stock price or cause somebody to trade? If so, the question becomes whether the information is currently nonpublic. If the answer to both questions is yes, the CFA Institute Centre advises analysts to alert the company that a selective disclosure issue exists and encourage the company to disclose the information to the public in a simultaneous press release or some other way. Are operational improvements material? Beyond earnings guidance, profit margins, and acquisitions, the question of materiality gets murky. If you have any doubt in your mind whether it s material, says Chad Kilmer, CFA, talk to your compliance department and don t act on it until they say you can. Gifts and Other Perks Gifts, accommodations, meals, and entertainment are judgment calls, according to Boersma. Under CFA Institute Standards of Professional Conduct I(B), charterholders must use reasonable care and judgment in maintaining their independence and objectivity. Generally, accepting air fare from a company would be unethical. An exception would be a chartered flight that is the only way to get to, say, a remote mining operation. With regard to gifts, the CFA Institute rule limiting gifts to US$100 has been eliminated; charterholders must now consider whether a reasonable person would conclude that a proposed gift compromises the analyst s independence and objectivity. Boersma points out that a particular sum of money, such as the old standard of US$100, means more in some countries than in others. Analysts and their firms that want to avoid even the appearance of impropriety will reimburse the company for meals and pay for that round of golf. If refusing hospitality is not practical for cultural or other reasons, gifts, meals, and the like should be disclosed so that employers and investors can judge the analyst s objectivity for themselves. For further guidance, see Example 1 on page 20 in the current Standards of Practice Handbook (ninth edition, 2005). 42 CFA MAGAZINE / MAY-JUNE 2007

48 Into the Breach Can securities analysts bridge the gap between earnings management and financial reality? BY SUSAN TRAMMELL, CFA Illustrations: Robert Meganck CFA MAGAZINE / MAY-JUNE

49 With an ever-growing number of accounting standards, statements, and guidelines, one might think that public companies have little opportunity to manage earnings. But managements may rush in where accountants fear to tread. In one study of senior financial executives attitudes toward performance measurement and disclosure ( Value Destruction and Financial Reporting Decisions, Financial Analysts Journal, November/December 2006) researchers found that a surprising 78 percent of the 401 survey respondents were willing to give up long-term economic value to meet earnings expectations. The most popular strategy by far was to decrease discretionary spending if a company appeared likely to come in below an earnings target. A full 80 percent of respondents reported that they would be willing to reduce spending on research and development, maintenance, advertising, and other discretionary areas. Another 55 percent said they would delay starting a new project. Other decisions included booking revenues in the current rather than the next quarter, providing customer purchase incentives, drawing down reserves, and postponing the taking of accounting charges. Interviews with 20 chief financial officers (conducted subsequent to the survey) revealed that 15 of them were willing to take such actions as long as the actions fell within generally accepted accounting principles (GAAP) and the sacrifice was not too large. Although many of the tactics described had the potential to destroy company value, executives appeared to be willing to make these choices rather than resort to accounting maneuvers. As managers pointed out, businesses are much more volatile than earnings figures suggest but the market rewards predictability. Many security analysts may be startled to learn the extent to which companies feel it is their duty to manage earnings. Moreover, such valuedestroying actions can only complicate the analyses of analysts who already have their hands full keeping up with accounting-based earnings management. What Measure of Value? In the survey, earnings stood out as the most important measure reported to outsiders. In fact, earnings received three times as many top rankings as did revenues or cash flows from operations. Quality earnings are not necessarily conservative, points out Ed Crotty, CFA, senior vice president, chief investment officer, and portfolio manager for equity income investment strategy at Davidson Investment Advisors, who is based at the firm s Great Falls, Montana, office. When people speak of quality earnings, it really should be what reflects the intrinsic economics of a company, what represents the reality of a business. In other words, the analyst s job is to figure out whether the company is generating earnings from its core business and whether the reported earnings numbers fairly present the reality of the company s performance. Seasoned analysts understand the corporate agenda and adjust their investigations accordingly. Accounting assumptions are usually disclosed in the small print of the footnotes, which is where a company is likely to reveal whether it is engaging in accounting shenanigans. Analysts typically focus on those line items that give executives the most discretion. For example, management judgments regarding inventory valuation, reserves for doubtful accounts, pension fund accounting, deferred taxes, and loan losses are likely to draw scrutiny. Companies with high levels of accruals, such as those using percentage-of-completion accounting, also trigger warning bells. Cash may seem to be a more reliable measure of performance than earnings, but in the survey, cash flows from operations and free cash flows ranked below both earnings and pro forma earnings as the most important measure reported to outsider stakeholders. A lot of people look at the cash flow statement as beyond reproach, but that can be manipulated, too, says Crotty. He points out that managers can shift flows that fall into financing or investment activities into cash flows from operations and vice versa. In his article Accounting Shenanigans on the Cash Flow Statement (CPA Journal, March 2006), Marc Siegel, global director of research at the Center for Financial Research & Analysis (CFRA) headquartered outside Washington, DC, looked closely at the myth of cash flow s supremacy as a performance metric. Certain accounting shenanigans can either artificially boost reported operating cash flow or present unsustainable cash flows, he wrote. Chief among the various ways of hiding a company s true cash flows are the following four tactics: STRETCHING OUT PAYABLES The simplest thing is to stretch out payables by slowing the rate of payment to vendors. Eventually, vendors will balk and force the company back 44 CFA MAGAZINE / MAY-JUNE 2007

50 to more agreeable terms, but in the meantime, analysts can monitor the extension of payables by calculating days sales in payables. FINANCING PAYABLES Next on Siegel s list is the financing of payables, a variation of stretching out short-term liabilities. For example, the company engages a financial institution to pay vendors in the current quarter and then reimburses the lender in a subsequent period, enabling it to manage the timing of its reported operating cash flows. Analysts should ask themselves why financial intermediaries are inserted in transactions that would ordinarily not require a third party. SECURITIZING RECEIVABLES Nonfinancial companies may bundle their longer-term and highest-quality receivables and transfer them to a financial institution or a variable-interest entity to be securitized. The company s cash flow from operations is boosted as the proceeds from securitization increase. Also, management can choose where to report gains between the book value of the receivables at the time they are transferred and the amount received for the receivables. An aggressive treatment would be to record the gain in revenues. Other options are to offset operating expenses or report the gain below the line. STOCK BUYBACKS Companies may buy back stock to offset dilution that results from the exercise of stock options. The tax benefits generated by exercising such options may be reported in operating cash flow. But the cash outflow is considered a financing activity. As option exercises grow, so does the boost to operating cash flow, while the outflows are recorded in the financing section of the cash flow statement. Broad Concerns When the market heats up and stocks go on a run, it becomes more and more tempting to take advantage of new loopholes, says Christopher Laudani, founder of North Andover, MA-based Short Ideas, which seeks to identify stocks that have the potential to make large-percentage moves downward. Years ago, Howard Schilit identified a bunch of shenanigans, and they re all the same tricks today. Manipulation can always be found, especially in the hot sector du jour. Howard Schilit founded CFRA in 1994 for the purpose of performing forensic accounting research and due diligence. In Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (which was revised in 2002), Schilit identified seven broad areas where companies are likely to manipulate their numbers: recording revenue too soon or of questionable quality, recording bogus revenue, boosting income with one-time gains, shifting current expenses to a later or earlier period, failing to record or improperly reducing liabilities, shifting current revenue to a later period, and shifting future expenses to the current period as a special charge. As economies become increasingly service based, assets are becoming less tangible and impairment tests may become a bigger issue. When faced with difficult-to-value assets, the analyst should ask the company to explain, as explicitly as possible, how it conducts the valuation and then talk to competitors to see where the target company s approach differs from that of its peers. The analysts probably don t have the expertise and information to do their own analysis, advises Jeff Curtiss, CFA, who was the chief financial executive at several major exchange-listed companies. But if all the companies value similar assets the same way, there is a level of comfort. Even industry norms require a degree of skepticism. My view is that whatever is the metric that investors and analysts are valuing the most, that s where you should focus, advises Siegel. Take same-store sales. It s a made-up metric. What if you move a store, expand it, or close it? All these things can flatter same-store sales. In one analysis, CFRA looked at how the restaurant industry defined samestore sales and found that the definition differed from company to company. Seeing Red Regulatory actions may close some loopholes, but companies may simply become more creative elsewhere. Experienced analysts have become adept at spotting the red flags that may signal earnings management or deeper problems: CFA MAGAZINE / MAY-JUNE

51 TOO GOOD TO BE TRUE If a company is doing significantly better than its peers over a sustained period, one should question why. When you compare five or six companies going after the same customer, it makes you stop and think, Why is that one company s margins so much higher, why are their expenses so much lower, than their competitors? says Laudani, whose firm seeks to identify stocks that may be poised to take a dive. DEFERRED TAXES Because certain expenses are not deductible for tax purposes, a company may have paid more in taxes than is reflected in the income statement for the same period. The difference is accounted for as a tax deferral. Although the discrepancy is only a timing issue, I want to understand why there is a deviation between the IRS [tax] and the SEC filing, says Crotty. Paid taxes are a real economic event. It s cash going out to a government. DEBT MOVES OFF THE BALANCE SHEET Fixed-income analysts are particularly concerned with corporate maneuvers that attempt to veil the magnitude of a company s liabilities. A favorite ploy is the sale/leaseback arrangement, in which a company sells assets to another party and recognizes a gain on the sale. The company, however, still has need of those assets and leases them back. The arrangement will be disclosed in the footnotes. Conventional accounting presentation does a mediocre job of alerting analysts up front about sale/leasebacks. In the interest of transparency, some companies account for these arrangements by reporting EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent). CHANGES IN DISCLOSURE If a company shifts its focus from one long-held performance measure to another, the analyst may have reason to be suspicious. For example, management may have always talked in terms of EPS but now direct investors attention to cash flow. Another red flag is a change in disclosure language. Much of the footnote language in regulatory filings is immutable from period to period; only the numbers change. That s wellvetted language, Siegel points out. We focus on changes in verbiage because they can signal a change in accounting policies without outright disclosing the change. CREATIVE PRESS RELEASES A company s broadcast media pronouncements are not required to reflect the minutiae of its SEC filings. Siegel offers the example of an entity that broke out two reserves in its 10-Q form but then combined them in its press release. The action drew CFRA s scrutiny, which concluded that the company s reserves were not adequately funded. SERIAL ACQUISITIONS Despite the phase-out of pooling-ofinterest accounting, corporate managers retain considerable latitude in how to allocate the purchase price to a merged company s assets. Serial acquirers may be masking poor performance, particularly in share-based metrics such as EPS or return on assets. FREQUENT NONRECURRING EXPENSES Ignoring the oxymoron, companies will sometimes characterize write-offs that actually occur on a fairly regular basis as nonrecurring events. THE BIG BATH A company s results may be so dismal that the managers decide to leap into the red, load all of its expenses into one period, and thus impair quality of earnings. As soon as you start doing that, Crotty says of such corporate antics, that s a slippery slope. To get to the reality of the company s performance, the analyst must take some of those expenses and attribute them to future periods. Highly Motivated The widespread belief is that self-serving earnings manipulation is undertaken to preserve managers bonuses, but the results of the survey do not bear out this assumption. The most overwhelming incentive for meeting or beating earnings benchmarks appeared to be building credibility with the capital markets. Next came maintaining or increasing the company s stock price, preserving management s external reputation, and conveying future growth prospects to investors. Maintaining employee bonuses ranked far down on the list. Whether by making windowdressing business decisions or adopting certain accounting treatments, many chief financial officers (CFOs) believe that smoothing earnings is an important part of their job. But the CFOs interviewed in the study on value destruction and financial reporting decisions mentioned earlier realize that short-term earnings management has long-term consequences. There is a limit to a company s ability to bury its problems, and eventually, the truth 46 CFA MAGAZINE / MAY-JUNE 2007

52 will come to light. What the CFOs hope is that by the time adverse consequences set in, the positive results achieved through growth will reverse the problems. Won t Get Fooled Again? So, how can analysts avoid getting fooled by financial shenanigans? First, be prepared with knowledge of the company s industry. Each industry provides specific areas of concern, but an analyst who is familiar with a company s business can anticipate the vulnerabilities in its financial statements. Second, speak with the people who have the answers. Analysts should thoroughly review the company s financial statements its 10-K or 10-Q form. They should not be afraid to ask tough questions when presented with the opportunity to meet with managers at such events as the company s Investor Day or annual meeting. Curtiss advises that analysts even ask a company s investor relations department for access to the person within the accounting department who actually prepared the financial statements. Third, have a natural curiosity about how companies work. Siegel cites the case of the company that had three bullet points explaining why its inventories were growing. But when the reasons were quantified, they didn t fully explain the build-up, which implied imminent pressure on margins. Next, stay alert and be skeptical. Remember WorldCom? asks Laudani. It was doing so much better than its competitors, yet they were all in the same business. They all had the same customers. They all had the same business model. Why was WorldCom making so much more money than everybody else in the industry? When you asked management, they told you, We re better. Investors swallowed it for years. But that wasn t the case at all. The books were cooked. It was there for all to see. You just had to stop and think about it. Finally, work hard. As the clamor for increased transparency has grown, so has the size of regulatory filings. Many now have the bulk of a small phone book. The trend has the potential to create a risk of suffocation by disclosure. My belief is that many analysts do not read the SEC documents that companies file carefully enough nor do they undertake adequate critical thinking in their evaluation of companies or management, Curtiss says. Most companies portray themselves in as positive a light as their facts permit so as to keep the confidence of a number of their critical stakeholders. And, he adds, The investment community should expect this. Susan Trammell, CFA, provides business plan writing and market research services through her New York City consulting firm. PRESSURE POINTS Nearly everyone interviewed for this article volunteered that they have found most companies to be essentially honest. This finding in itself is heartening because senior financial executives must withstand the enormous, and often competing, pressures of their companies stakeholders. Today s chief financial officer faces a triangle of interests. The auditors want the company to be conservative in its accounting and play by the rules; the board of directors is strictly charged with corporate responsibility; and the investors (often including employees) just want the stock to go up. CFOs have always had pressures on them, and a good CFO feels those pressures, says retired chief financial executive Jeff Curtiss, CFA. You can t please all constituents all the time. The percentage of public companies that have gone astray is very small. Curtiss points out that since the 2002 enactment of the Sarbanes Oxley Act in the United States, a company s outside and internal auditors must report to an independent audit committee of the board. Whistle-blowers have access to the audit committee, and many companies have instituted disclosure committees. Moreover, both the CEO and CFO are expected to certify that such regulatory filings as the 10-K and 10-Q forms fairly present the financial condition of the registrant in all material respects. The mere compliance with GAAP does not let the CEO or CFO off the hook based upon their certification, Curtiss says. Aggressive GAAP-compliant accounting principles must be adequately disclosed. CFA MAGAZINE / MAY-JUNE

53 Illustration: Robert Meganck 48 CFA MAGAZINE / MAY-JUNE 2007

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