Oh The Humanity!

For a chronological index of my path to the CFA, click here.

This is not what was supposed to happen.

I started the CFA program in order to replace my ad hoc investing education (gleamed mostly from bestselling finance books) with something more in-depth and comprehensive.

One reason for doing this is to gain credentials for a possible future career change. My primary reason though was to fill knowledge gaps in order to simply become a better investor.

So in my pre-enrollment crystal ball, I saw myself gradually transforming my current (no doubt elementary) stock-trading algorithms into something more sophisticated and professional as I acquired a proper investing education while working my way through the CFA study guides.

Until recently, my vision matched the reality. The quantitative and statistical material from Volume I was very helpful since my present investing style relies heavily on number-crunching.

Economics in Volume II didn’t seem as useful, but it was nice to understand the terminology and unspoken reasons behind some of Bernanke’s statements while testifying to congress a few weeks back.

Incidentally, ’twas also neat to see which of the questioning senators appeared to have a decent economics background (Paul Ryan).

But something has since gone horribly wrong. I’m now in the middle of a the more I learn, the less I realize I know paradox. And it all started with Financial Statement Analysis, which is Volume III of the CFA study guides.

floor.jpgFinancial Statement Analysis (FSA) was initially a pleasant experience.

The first 300 pages or so found me becoming increasingly able to decipher income / cash flow statements and balance sheets – documents that previously may as well have been written in Pashto.

And as I got deeper into Volume III, I had a chuckle at how naive my current method of screening stocks was starting to appear, which is based mostly on crunching historical ratios such as EPS, P/E, ROIC, and BV/S while totally the ignoring financial statements they come from.

But as I progressed beyond page 300, I became increasingly less amused. Volume III shifts here from teaching you how to simply read these statements into the myriad ways that what appears in them may be misleading and therefore needs to be adjusted in order to get the true picture.

And this continues, subsection after subsection, for about the next 250 freaking pages

In some cases, adjustments are required just to get two companies’ statements drawn up by the same set of rules. Elsewhere, something seemingly minor, mentioned in a footnote, results in your doing some recalculations and seeing a company’s solvency in a totally different light.

So this should have been a happy time for me, right? Wasn’t that my goal, to become a more intelligent investor?

In truth, by the time I came through the other side of all these manipulations and re-adjustments around page 550, I was thoroughly demoralized.

With each passing chapter, I realized that my halcyon days of being able to decide in mere minutes whether or not to invest in a stock flagged by my screener were over.

    I no longer trust my stock screeners to filter out bad stocks.
    I no longer trust my stock screeners to NOT filter out good ones.
    I no longer trust my computer scripts to crunch ratios to perform proper valuation to identify bargain buys.

And thanks very much Volume III for planting an additional seed of doubt. I’ve always liked businesses with consistent earnings, sales, and equity increases from year to year, because that told me that the biz had an economic moat and therefore a predictable future series of cash flows.

But you had to go and say that while that may be true, it can also be a sign that management is playing accounting tricks in order to smooth the annual numbers.

Yes, my whole investing modus operandi is in ruin. Sure I can still use my favorite parameters to make investing decisions, but I need to compute my own ratios which will come from my own adjusted financial statements for every bleeping company I look at.

The good news is that the CFA program has provided me with the tools to do this. The bad news is that you really have to dig to find the gotchas and then hope the ginkgo biloba helps you figure out what to do with them. I see little hope in automating this process.

So what do I do in the mean time?

Twice last week, I ended up selling stocks that were fully valued (though how can I be sure any longer?). But whereas I usually immediately replace one stock position with another, this time…

    I ran my stock screener.
    I examined the cheapest of what came out.
    I crunched numbers.
    I glanced at the companies’ financial statements.
    I remembered the American Airlines example on page 527 of Volume III, where $10 billion of off-balance sheet debt changes the purported 0.9 debt-to-equity ratio to a hefty 2.3 instead.
    I threw up my hands and bought a broad index ETF instead.

Bernstein would probably say I did the right thing. But me! Index funds! Oh the humanity…

I kept hearing a phrase from Joel Greenblatt‘s Magic Formula book going through my head:

Most people have no business picking individual stocks.

It’s not that I’m too lazy to do the financial statement digging and recalculations. But this is going to take some time to learn to do properly and efficiently. Till then I’m paralyzed!

For those following, I’m currently on pg. 637 of the massive 700 (content) pages of Volume III. I’m loving the readings on how to combine all the profitability, liquidity, and solvency ratios for thorough analysis. Even if my confidence in getting accurate ratios from the likes of any investing websites has been utterly destroyed.

One last admission. Those ETFs I bought? They were bond ETFs.

Utterly destroyed, I tell you! 🙁