How to Find an Edge

by Inya Ivkovic, MA

One of the functions of regulating the financial industry is to make it a level playing field for all participants. In an ideal world, that would be an achievable goal. But in spite of regulators’ best efforts, that field is never perfectly level. So the best that regulators can do is to strive for more transparency, while the best ordinary investors can do for themselves is to work even harder for more reliable information.

For example, short of counting how many trucks go in and out from a manufacturing plant, investors have very little recourse for finding out the real condition of its inventory. That’s hard work, but it doesn’t have to be necessarily that hard. There are two basic types of information in the financial industry, the first of which is of the “not-advisable-to-repeat nature.”

For example, a company’s management knows its company is in dire financial straits. The company’s employees know the same thing. That knowledge “tells” them it would be smart to dump the stock, but no one else on the Street knows it, so legally, their hands are tied. Another example could be that a company’s CEO has an expensive and no longer sustainable gambling habit, which puts him under undue pressure to fluff the company’s earnings in order to get that multi-million-dollar bonus. People gambling with that CEO might know the extent to which he might be prepared to go, but again, that would be hardly common knowledge on the Street.

And while these hypothetical scenarios sound like a good movie script, they are rarely any good for business. Of course, even less of this kind of information would ever find its way into analysts’ reports, because their hands are often tied with either being at arms’ length and not privy to such information or with protecting individuals’ privacy.

But where can investors get such information then? Usually, from middle management. They are typically people who are privy to a lot of information, who often gossip among themselves, but who are not permitted to speak either to the press or to analysts. If you have an opportunity to get them talking, and if you know how to keep a secret, this knowledge may not be completely useless (don’t forget, you cannot trade on material, non-public information — that’s illegal). Quite the contrary, it may give you an added edge to look for similar patterns, illogical occurrences, etc.

Another example would be the Fed’s insistence last year that Freddie Mac and Fannie Mae were in good shape. But mid-level congressional aides in Washington begged to differ. They couldn’t blow any whistles, of course, but enough slipped through in their “off-the-record” conversations to get some members of the press thinking and, more importantly, digging.

And then there is the much easier way of getting useful information deemed inside information, and quite legally at that. Simply filter through decisions made by a company’s board of directors, or dig for anything unusual in the background and qualifications of a company’s key personnel. For example, it might be time to start paying attention to the inner workings of a company’s board of directors. See what they are doing with dividends, as these decisions signal how much confidence, if any, the directors have in the company’s future cash flows that is not yet reflected in the stock price.

Similarly, if a board decides to put their faith into a CEO with an
unusual or strikingly different background, this may also serve as a signal of the direction in which a company might be going. For example, if a company suddenly fires its long-time CEO with years of experience and expertise in a particular industry and hires a lawyer whose expertise lies in corporate bankruptcy proceedings, this might signal that the company has serious financial problems and might be contemplating filing for bankruptcy protection.