For a chronological index of my path to the CFA, click here.
A fairly amazing thing has happened since my last post about preparing for the Level II CFA exam. After all my belly-aching about how my studying is only teaching me how little I actually do know about investing, some puzzle pieces are finally coming together.
When I was 14 years old, my father bought me a guitar from a pawn shop. I remember sitting in front of guitar chord books for weeks trying to get the fingerings right and it was just so difficult. Trying to play a song was even worse because the chord changes which were supposed to take place within a split second took me ages. I was the musical equivalent of a bad stutterer.
Then a friend taught me about simple barre chords and within days everything seemed to fall into place. These two-finger chords were training wheels that had me graduating to more complex fingerings in no time. Previously, my practicing wasn’t even resulting in the expected linear improvement proportional to time I was putting in. Now the improvements came in non-linear overnight leaps and seemed to grow exponentially.
The point of my telling you this is that I think I found my training wheels for being able to read and understand financial statements. I wasn’t even aware I needed them!
I was in the Border’s book store, in the investing section as always, when I saw Warren Buffett and the Interpretation of Financial Statements, a book co-written by a former daughter-in-law of Warren Buffett. I picked it up with a snicker…
“You’ve got to be kidding me!”
“So THAT qualifies her as a stock market genius?!”
“Give me a break!”
I flipped through the book to confirm it’s worthlessness… I sat down in a chair to probe further… I ended up buying it!
This book gets very mixed reviews so buyer beware with my little amazon.com link above. I don’t know whether I was just ripe for one of those non-linear quantum leaps and it was the catalyst or whether it’s truly as good as I think it is, but this seems one of my best purchases in a long time.
The marketed selling point of this book is that it’ll teach you how to pick winning stocks like Buffett by being able to read financial statements and identify which companies have a “durable competitive advantage”. That’s all well and good, but for me its value is its broad breaking down of what each line item represents, what sort of percentages and patterns you’d ideally like to see from a common-size point of view, and why.
No I haven’t forgotten that to draw proper conclusions you might need to first make adjustments to the 10-Q’s and 10-K’s as filed by the companies (and the book does even offer some hints here), but I’m just elated to now be able to examine the financial paperwork and draw any conclusions at all. I think the deeper material of the CFA program has had me unable to see the forest for the trees, especially not coming from a business background where all this stuff has been first presented at the broad 50,000 ft. level. Now it all seems to be gelling and while the study guides do teach what seems like 1000 corrections you must make to a set of financial statements before beginning to interpret them, I’m guessing that Pareto’s Principle applies here as it does almost everywhere else.
So – long story short – I no longer think it will be decades until I’m ready to venture back into individual stock picking again. I’m now reading and pretty much understanding the financial statements of companies I currently have a position in, at both the gross (Buffett) and subtle (CFA) level. This is giving me a buzz! 🙂
What else is on the agenda for today… Well I just finished my first pass through Volume 3: Corporate Finance. This study guide didn’t have any appeal for me initially as I didn’t find the Level I readings on corporate finance particularly relevant.
For the uninitiated, corporate finance mainly consists of the calculations a company goes through in order to decide which projects they’re going to fund, and whether it’s cheaper to raise the capital to do so through issuing more shares (equity) and/or or issuing bonds (debt). It’s also about the decision making process that goes into using surplus cash to fund more projects, buy back stock, or issue dividends.
It wasn’t a subject I found particularly hard during Level I, it’s all time value of money stuff, picking the option that maximizes net present value, etc. I guess I just wasn’t too into corporate finance because it seemed to be a more helpful subject for a CFO responsible for managing the capital budget of a particular company. And while there do seem to be quite a few CFO’s out there who have CFA’s, my interest in this program from the get-go has been all about enhancing my skills in buying and selling stocks.
But the Level II corporate finance volume did give me some new skills to try. One interesting insight was that instead of just modeling a stock’s returns as a normally distributed random variable you can actually get more insight into what causes year-to-year variability by computing a mean and standard deviation for growth rates of individual line items in the financial statements. At least by doing this you get, for example, some insight into the reasons behind a corporation’s fluctuating earnings by identifying line items with larger relative standard deviations.
The readings on leverage were also insightful. In my previous attempts at determining intrinsic value, which – using time value of money – was always a function of my required rate of return, I always used 10% as my discount rate because that is what the S&P has historically averaged. But the study guide helped me understand the emphasis on required rate of return. If a biz is highly leveraged, it’s more risky. Therefore I should use a higher discount rate when computing intrinsic value since I require a greater return from a riskier investment. It’s the same ol’ forest-for-the-trees stuff again. I have a feeling I should have recognized this at Level I.
What else? Well I found it interesting that, holding all other factors constant, a company’s optimal capital budgeting comes from all debt due to the tax write off. I’m continually revising upward my view of debt as I go through this program. I used to believe that debt was to be avoided at all cost. Then I graduated to realizing that debt is only bad if you’re using it to buy services or goods that are decreasing in value (or increasing more slowly than your interest rate).
And as the Level II program insightfully points out, the same rules apply to governments. Ask any person on the street their opinion about government borrowing and no one would tell you that it’s absolutely fine as long as the government is doing it to buy assets (or build infrastructure). I had the great idea of using my new-found financial statement prowess to examine the statements of my government. Does the government even produce such documents?!
The answer is yes! Alas it’s 186 pages for FY 2007 so I’ve only scanned it. My quick overview didn’t reveal whether we’re borrowing to buy assets or have a “durable competitive advantage”, but the brief glimpses I got of charts showing exponentially increasing interest payment curves with titles like Current Trends Are Not Sustainable did not inspire confidence! Unlike other PDFs produced by the US government, this one actually looks quite informative & accessible – filled with color photographs, charts, explanatory sections, and even a MD&A! Despite it’s readability and aesthetics, it is looooong so I’ve saved it to my desktop to return to in the future.
Another important tidbit from Volume 3’s section on dividends is a very brief mention of being able to take tax credits for tax withheld from foreign dividends. I’ve certainly filled out forms at international airports to get my VAT tax back – is it possible to get a portion of foreign dividend tax back too? I need to check with my CPA…
The corporate finance volume ends with a long reading on mergers and acquisitions. I especially found interesting the examples concerning a few different ways to value a company by examining its peers, either for intrinsic value or to include the large takeover premiums that acquirers pay. According to this value investing lecture from Columbia by a billionaire you’ve probably never heard of (Michael Price), this is the real way to value companies. He basically says to hang up all that present-value-of-future-cash-flows-time-value-of-money analysis and examine the proxy statements of M&A’s to learn what similar companies are really worth as the investment bankers who put together such deals perform a ton of due diligence.
And what a terrible transition point I now find myself in by saying how excited I am to finally get to the next study guide Volume 4: Equity, which will no doubt be a lot of present value of future cash flows! I’ve only read the first couple of pages, but this is the volume I’ve been waiting for since enrolling in the CFA program – a huge toolkit of chapters dedicated to teaching the candidate how to determine whether a stock is over- or under-valued, and by how much.
And what’s this I see in the introduction? That a core part of the CFA’s equity valuation techniques stems from Graham and Dodd’s Security Analysis?! Why does this seem so strange to me? I think it’s because I often see this book on the shelf at my local bookstore, right next to Mad Money and Rich Dad, Poor Dad! I’ve read both of those with amusement and picked up some useful tidbits. But looks like Security Analysis may have more than just tidbits…
In either case, this seems to be THE volume I’ve been waiting for. Now it begins!
Here’s a tally of my (pathetically little) logged study time so far.
Read/Work Problems of Volume 1: 26 hours
Read/Work Problems of Volume 2: 15 hours
Read/Work Problems of Volume 3: 13 hours
Total Preparation Time So Far: 54 hours