Use Case 5: Ongoing Due Diligence

Our recent series of articles has covered Use Cases for Deception And Truth Analysis in the investment process. As a review, there are five major due-diligence steps in almost every investment process. They are:

1. Establishing your investible universe.
2. Relying on high-level criteria to identify state changes.
3. Deeper dive analyses that establish an investment thesis.
4. The buy-sell decision.
5. Ongoing due-diligence of your investments.

We believe that Deception And Truth Analysis (D.A.T.A.) provides a powerful assist in each of the above steps. In this week’s article we review how we may serve as a force multiplier allowing your investment teams to rapidly surface actionable investment insights.

At most firms, ongoing due-diligence typically centers around two sources of information:

• Movements in securities prices; and
• Information released by companies.

Movements in Securities Prices

One of the ways that investors, even those who are pure quants, track progress with the holdings in their portfolio is to track securities price movements. This is true whether you track stock prices as an equity investor, bond prices as a fixed income investors, and so on. If the price of a security in your portfolio moves a lot it is hard to resist the tempting thought that “the market knows something that I do not.”

Due to the behavioral bias of loss-aversion there is an outsized importance placed on price declines of securities. Ironically, most investors believe that they have an edge over “the Market,” but if a securities price movement is large enough it is typically taken as evidence that your understanding of a security is wrong. This then triggers a deeper investigation on the part of most investors. On the flip side, when securities prices accelerate there is less of a concern about whether your investment thesis is incorrect.

But here’s the thing: securities price movements are lagging indicators, not leading indicators. This is because out-sized securities price movements are the effect of a change in the understanding of the company. The information that drives price movements is, in turn, driven by management’s choices; and finally, management’s choices are driven by their behaviors. If you have insight about management’s behaviors therefore, you have a leading indicator.

This is exactly what we find in some of the validation work we have done to demonstrate the power of the D.A.T.A. algorithm. For example, our average lead time of predicting fraud at the ten worst frauds of all time is 6.2 years. Furthermore, using nothing but DATA Scores (our primary output) we can demonstrate that truthful DATA Scores (i.e. those that are positive) are predictive of future stock price outperformance. Also, deceptive DATA Scores are predictive of future stock price underperformance.

Unlike the frauds, where management is incentivized to conceal and where it can take years to become public. If a company is performing well, they shout it from the tallest mountain with the loudest megaphone. In our work examining stock price movements we have looked at latencies as short as one day and then extending all the way out to almost a year of lag from DATA Score assessment to trade implementation. 

Thus, a part of the ongoing due-diligence of D.A.T.A.’s Clients is to build a portfolio of their holdings and to closely pay attention to new DATA Scores as they are assessed on a company’s latest filings and/or transcripts. This allows our Clients to have insights that are leading indicators of securities price movements. Said succinctly, no longer do you have to wait for a blow up in your portfolio to direct your attention to critical information.

Information Released by Companies

As a byproduct of their operations, businesses create voluminous amounts of information. From regulatory filings, to transcripts, to one-on-one meetings, to marketing campaigns and advertising literature, to testimony provided in civil courtrooms, and on and on. All of this material can be assessed by Deception And Truth Analysis’ myDATA product. Here we can assess almost any document of your choosing so long as it is: in English and contains about two pages of narrative.

That said, most investors digest a limited amount of the informational output of the companies in which they invest. Most typical are earnings call transcripts and regulatory filings. Both of these documents are available, pre-scored for their level of deceptiveness and truthfulness in D.A.T.A.’s DATAbase product.

For our Clients that are subscribers to DATAbase ongoing due-diligence looks like: creating a portfolio; logging into our platform; and examining our assessments for companies. We are 350x faster than people at assessing documents for their level of deceptiveness and truthfulness, and our scientifically-tested double-blind accuracy at this task is 88.4%. This means that rather than waiting for the market, a regulator, or an auditor to tell you that you are wrong you now have the capability of seeing at-a-glance which companies’ documents are becoming more deceptive, and those that are becoming more truthful at-a-glance.

Additionally, subscribers to our REDline premium product can rapidly go through each portfolio companies’ filings and transcripts to zero in on the key issues happening at a company. That means that earning season is now much less painful and you need not feel guilty about not reading each of the quarterly or annual reports as they stack up in your e-mail queue or on your desk. Instead, you are now equipped with key issues, both deceptive and truthful, identified for you.

Deception And Truth Analysis is a force multiplier that allows investment teams to rapidly surface actionable investment insights. Ongoing due-diligence of an investment portfolio is made easy because of D.A.T.A.’s speed and its accuracy. Investors can more easily monitor all of the issues happening at portfolio companies and have significant changes automatically identified for them. By using D.A.T.A. for ongoing due-diligence there is a high probability that you will have key issues identified for you prior to the market pricing them.