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! 🙁

11 thoughts on “Oh The Humanity!”

  1. Hi,

    I’ve enjoyed your blog and I actually started reading it before I received my CFA curriculum October 2007. You might like checking out http://www.analystforum.com . It’s where you will see other demoralized people and hear stories of excruciating failure (for each of Level I, II, and III).

    It’s interesting how grueling the studying for these exams is, some very academically-capable people find it difficult (for example, +99% on SATs, 750+ on GMAT, PhDs in science/engineering/math, etc.). I myself have comparable numbers, and I must truthfully say that I consider my academic abilities inadequate! It seems like the challenge now is mostly from the sheer volume of material and the little technical details, though I think that the material will get much harder in later levels, while maintaining the ridiculous amount of volume.

    I and many others have found the financial statement analysis a huge shock. Wait till you do the questions on practice exams…your head will spin! Those questions take every little technical detail, for example, from LIFO vs. FIFO, capital vs. operating leases (and their implications in the cash flow, income, and balance sheets), etc.

    Perhaps the opinion I have (not “advice” proper since I’m not qualified to give it) is that you will want to phase out everything until the June 2008 if you want a decent shot at passing it. I wish you continued motivation.

    – CFA Level I candidate

  2. Hey,

    Congratulations!!! You have been transformed from a trader into a true investor…If working for a firm, a trader can make big bucks using the firms capital. Trading alone using one’s capital is a long shot to riches. A true investor is the opposite of this thought…

    You have not posted in awhile and I thought you had given up entirely on the CFA…

    I wish you well, and hope you continue your search for wisdom and wealth…

    On the ETF – Why Bonds? American economy is surely in deep trouble if we are to continue on this low interest rate era. And if the Fed decides to turn the rate around your investment will be at risk…Do you think interest rates will be this low in the next 3-5 years? If yes, you are correct on your forecast on Bonds. If not, it’s time to reallocate your funds…just a thought…again good luck to you and I hope you continue posting…

  3. Fellow CFA sufferer – thanks for the comments and indeed Volume III was a big shock. It was the first volume where even after (supposedly) studying the readings closely, I missed almost every sample problem at the end of each chapter. Your advice on phasing out is a good one. I’ve still got my engineering contract work which I can’t give up so I’m just gonna keep at it with the mind that I can always take it again in December. In fact, I expect to have to.

    Mike – nice to hear from you. Yes I guess I’m growing up after all! Volume III so completely undermined any ability I thought I had to pick stocks that I’m moving any money I get from selling long positions into stock and bond index ETFs until I have a new methodology that I have confidence in (maybe Volume IV will give me that?). In The Intelligent Investor Graham recommends that a minimum of 25% of your portfolio be in bonds so I decided to dilute my 100% stock portfolio and put some money into a Total Bond Market ETF and a TIPS ETF.

    Indexing should only be temporary if I get what I’m expecting from the CFA program! In the mean time, anything but money market…


  4. Luminog,

    I hope you DO find/receive what you expect from the CFA program. In the meantime, you’re right on staying conservative with your investing methodology until your confidence and your chances of success in investing has you in the higher probability mark again…

    My question is: Why change your tactic if they have been working for you in the past? I know your new found knowledge has you hesitating a bit on pressing the BUY button, but shouldn’t you ride the wave until there’s good evidence that your tactic is no longer valid?

    Remember investing is a zero sum game. Somebody has to lose and somebody has to win, regardless if all known humans in the world are CFAs. My point is… CFA might NOT be the answer to better investing as you are expecting, but it CAN be the answer to a better career.

    Investing and career in investments could be mutually exclusive per individual and that your thought of CFA to fill both gaps could be misleading…

    until then….

  5. Thanks for writing Mike.

    The main reason behind changing my tactic is that though it has worked well, we were mostly in a bull market the whole time I was using it. And bull markets tend to make almost everyone’s “system” work well. 🙂

    The recent downturn has knocked around my portfolio a bit – though I do seem to be tracking the indices fairly closely. However I have a few stocks that I bought at what my old system said was a 50% margin of safety. Now they’re at an 85% margin of safety! 🙁

    Good words on the CFA maybe not being the answer to better investing but perhaps an answer to a better career, and I know we can’t all be above average (except in Lake Wobegon). But I must say that I’ll be a bit disappointed if the day I get my charter in hand, my thinking at the end of it all is that the best investment strategy is simple asset allocation across a handful of relatively uncorrelated index funds with periodic rebalancing.

    Pleeeease noooooo…

    – Lumilog

  6. Lumilog,

    “But I must say that I’ll be a bit disappointed if the day I get my charter in hand, my thinking at the end of it all is that the best investment strategy is simple asset allocation across a handful of relatively uncorrelated index funds with periodic rebalancing.” BINGO !!!

    How sad would this scenario be!!! But I think this is where investing boils down to. How can it not???

    Let me ask you this: If the CFOs or CEOs of a given firm knows the inside and out of their firm (strengths and weaknesses), wouldn’t they know what particular growth rate, discount rate, and earnings to use in “their formula”? So why not just research their buying price and add a Margin of Safety on it? If they buy at $10 we buy at $8, providing a 20% discount. Our exit is 20% above their price of $10, so at $12. They make 20% we make 40%, They lose 40%, we lose 20%. This is like the mother of all margin of safeties. Without the work of recasting earnings!!! as suggested by the great CFA>.

    Here’s a few quotes:

    By periodically investing in INDEX funds, the know-nothing investor can actually out-perform MOST investment professionals. Warren Buffett.
    note by me: Know-nothing to me means non-insider or someone who is not in the board meetings discussing strategy…

    Super stock trader Jim Cramer pays Bogle’s investment style the ultimate compliment by going on record as saying that “After a lifetime of picking stocks, I have to admit that Bogle’s arguments in favor of the index fund have me thinking of joining him rather than trying to beat him.”

    “The only value of stock forecasters is to make fortune-tellers look good.” – 1992 Annual Report of Berkshire Hathaway

    and one more for the road…….

    “There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”

    – William Bernstein, The Intelligent Asset Allocator

  7. Talk about kicking a man when he’s down!! Oh the humanity!

    Truth be told the little hintergedanke(s) that make it hard to keep studying when passing through the less interesting (or completely overwhelming) CFA study guide chapters are the ones you outlined above – especially Bernstein.

    Except I had never heard the one on MOS based on insider buying so thanks for giving my unconscious some additional ammunition! 🙁 Maybe I’ll just tell myself that sometimes CFOs have to sell shares in order to write a check for Buffy’s college tuition, or for the divorce settlement with Muffy.

    I’d be curious as to your opinion about this famous speech, concluding that if beating the market consistently is all about being a lucky coin flipper, the value investors seem to be better coin flippers than most.

    My hope is that what I learn about markets, economics, and business fundamentals in the CFA program will help reduce my average error when estimating intrinsic value. But that may indeed be wishful thinking. 😐


  8. Lumilog,

    On CFO…It doesn’t matter when they sell really, so long as the entry point has MOS. They would buy if they knew the stocks are undervalued right? If they sell out of necessity, even better…more undervalued shares are avail (cateris paribus)…

    “I’d be curious as to your opinion about this famous speech, concluding that if beating the market consistently is all about being a lucky coin flipper, the value investors seem to be better coin flippers than most.”

    Indeed, value investing is the way to invest…problem is…..drum please….I can count with my fingers and toes who the “true” value investors are! Labeling one’s self a value investor and practicing it does not “automatically” transform into a magnificent return on capital…Oh Humanity! It misleads us to truth….

    Here’s what I mean….
    There are 20 coin flippers…10 are value investor type chaps and the other 10 not…

    Collectively the 10 value chaps’ avg. ROIC is 18%, thus beating the market avg of 12%. — definitely join this group…

    The 10 non-value chaps’ ROIC is 6% — stay out of this group, no doubt…

    Look a little closer to our value chaps and lo and behold…
    1 out of 10 crushed the mkt – ie, Warren Buffett
    3 out of 10 performed about mkt level return
    6/10 did well relative to non-value chaps but did not beat mkt…(9to10% ROIC)….

    Now the Big picture and the Bottom Line!!!
    only 1 out of 20; crushed the mkt….
    3 out of 20; performed at mkt level..
    16 out of 20; well…..

    translation: the best investment strategy is simple asset allocation across a handful of relatively uncorrelated index funds with periodic rebalancing.

    Thank you CFA books for confusing us and thus guiding us to the light !

  9. I must say CFA taught me the process of valuing MBS. While i was studying this material for level II the mortgage bubble was begining to burst. I remembered reading about model risk. hmmm mass forclosures and long depreciating housing market..was this forcasted properly in the prepayment schedules?. i doubted it. I thought to myself these securities are in trouble. I never fully understood CDO’s but I knew they were even more complicated. I know this, if i had never studied CFA material, my funds would have sat in my 80-20 portfolio. instead i pulled out before the credit crunch. not only that i used a portion of my funds to buy SKF and SRS (ultra short ETF’s of finacial and housing sectors) and i am up 42% with those funds. Thank you CFA!!!

    As for the volume of material it seems overwhelming but my guess is you are retaining more than you think. for me, on level I and II i thought i had no chance until i took the third practice exam and finally got over a 70%. keep in mind this after 5 months of studying and not until 3 days before the exam. I finally thought wow i have a chance.

    Hang in there folks.

  10. Also, when you get to level III you start to realize that you are studying to be a professional asset manager. Sure Allocating to index funds is prudent, but someone has to construct and manage the index funds!! That is the profession of a CFA charter holder.

  11. Wow – congrats Mick and thanks for the comments re: the exams. I’ve periodically considered buying the ultrashorts but always end up talking myself out of it just based on the assumption that the long term trend is up and my probability of calling the dips is low.

    Call me naive but I thought that while the individual stocks of the indices are chosen by humans, most index funds tracking them were essentially managed by computer mostly based on market cap and that’s why expense ratios are so low. But all index funds tracking the same indices don’t get exactly the same returns so there’s something I’m missing here.

    My mood has lightened since finishing Volume III. But I’ll save that for a new blog post!

    – Lumilog

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