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Bella Brown is an experienced generalist securities analyst employed by Lang & Co., a major U.S. brokerage firm whose clients have a high regard for her research and stock selection abilities. She was visited recently by a Lang managing director who said, "Please take a look at SpecChem Inc., the specialty chemical producer. They are going to need an investment banker soon and, because we make a market in their stock, we will be one of the firms considered for this business. I had lunch with SpecChem's Treasurer today, who told me that their European problems are being resolved and that earnings results are definitely looking good. He likes us and is expecting you to call him for details." The managing director then left Brown's office, saying, "It would be great if you could rate the stock a 'Buy'."
In a subsequent hour-long telephone discussion with the Treasurer, Brown obtained some useful information concerning recent company trends and developments as well as SpecChem's overall view of the outlook for sales and earnings during the next several quarters. Brown began thinking quite positively about the company and its prospects. She then reviewed some general source material on the chemical industry and read the Standard & Poor's Stock Guide on SpecChem Inc. That afternoon, she wrote a report recommending purchase of the stock, shown below as Exhibit B. In accordance with Lang's routine procedures for pre-dissemination review of Research Department recommendations, the report has been sent to the firm's Director of Research, who is aware of the circumstances under which it was prepared.
Exhibit B
LANG & COMPANY Company Report
Industrial: Specialty Chemicals Equity Research
Rating: Buy
SpecChem Inc. (NYSE: SCM)
We are initiating coverage of SpecChem Inc. with this report.
Earnings, up to 51% in the first quarter, are expected to be up again in the quarter ending June 30. Higher sales, better margins, an improved geographic sales mix, and savings from reduced pension expense are all contributing to this year's gains.
Although European production is up only modestly year-over-year, successful cost reduction efforts are limiting the adverse effects of weak volume and pricing. A possible plant closure in September could improve plant utilization by 10%, accompanied by potentially dramatic margin improvement. However, a $30 million after-tax special charge could be taken at the time of the closure.
We expect a moderate increase in second half 1994 sales. Although management looks for European demand to remain slow, it feels that U.S. sales could be above expectations if auto-related demand strengthens. Management is also optimistic about receiving a sizable U.S. government contract in the next few months.
Based on the factors noted above, our confidence level concerning earnings levels over the balance of the year is high.
We think SpecChem stock is undervalued and believe it can easily reach the low 100s on the strength of continuing earnings momentum. The downside is estimated to be in the mid-80s. There is plenty of room for upside earnings surprises if volume and prices improve, which would take the stock up strongly. Purchase is recommended.
Analyst: Bella Brown
Research Department
This report is based upon information which we consider reliable, but we do not represent that it is accurate, and it should not be relied upon as such. We, or persons involved in the preparation or issuance of this material, may, from time to time, have long or short positions in the securities of the company mentioned herein.Under the CFA Institute Code and Standards, it is the responsibility of the Director of Research, a CFA Institute member to: A)
| not knowingly participate or assist in any violation of laws, rules, or regulations. |
| B)
| exercise reasonable supervision over those subject to their supervision or authority to prevent any violation of applicable statues, regulations or provisions of the Code and Standards. |
| |
The Director of Research, as a CFA Institute member, is bound by the Standards of Professional Conduct. Accordingly, "members shall not knowingly participate or assist in any violation of such laws, rules or regulations" (Standard I(A): Knowledge of the Law). This responsibility is applicable under the circumstances. As a supervisor, the director of research has a responsibility to exercise reasonable supervision over subordinates to prevent violations of laws, regulations, and the provisions of CFA Institute Standards of Professional Conduct (Standard IV(C): Responsibilities of Supervisors).
Under the current circumstances, the Director of Research should: A)
| require the report to be redone with a neutral or hold rating pending the outcome of the awarding of the investment banking business. |
| B)
| require the report to be redone to ensure compliance with CFA Institute Standards. |
| C)
| allow the report to be distributed, as is. |
|
Based on the current circumstances, the supervisor (Director of Research) must not allow the report to be distributed. In this situation the overriding responsibility is to ensure that diligence, thoroughness, and independence be exercised in forming the investment judgment and in preparing the research report.
The research report, as shown, has several aspects which violate CFA Institute Standards of Professional Conduct. Which of the following is NOT an apparent violation of CFA Institute Standards? A)
| The report does not adequately discuss the factors important to analysis, recommendations, or action. |
| B)
| The report violates guidelines on investment performance presentation. |
| C)
| The report does not distinguish between fact and opinion. |
|
There is no attempt in the report to present data on the firm's performance as an investment manager. Violations relating to the report itself include the following:- Though SpecChem's current and prospective earnings are mentioned, no real basis of SpecChem's earnings power is discussed, nor are such factors as cash flow, operating strength or financial condition. Brown has violated Standard V(B): Communication with Clients and Prospective Clients.
- The report fails to disclose Lang's market-making activities with SpecChem. This omission violates Standard VI(A): Disclosure of Conflicts.
- Brown is not separating fact from opinion in her comment, "There is plenty of room for upside earnings surprises if volume and prices improve further, which would take the stock up strongly." This is a violation of Standard V(B): Communication with Clients and Prospective Clients. The above-noted comment could also be considered a violation of Standard I(C): Misrepresentation.
As to the process by which Brown's report in Exhibit B came into being, which of the following is NOT a procedural error in violation of CFA Institute Standards of Professional Conduct? A)
| Brown has violated the Standard relating to independence and objectivity. |
| B)
| Brown has violated the Standard relating to the prohibition against plagiarism. |
| C)
| Brown has violated the Standard relating to disclosure of basic characteristics. |
|
There is nothing to indicate that a violation of the Standard on Prohibition against plagiarism has occurred. The word "process" violations include: - Brown's report and investment conclusions were influenced by a senior member of her firm. In addition, near total reliance was put on the information supplied by SpecChem's management. She has violated Standard I(B): Independence and Objectivity.
- Brown showed a lack of diligence and thoroughness in forming her investment decision and preparing the report. Her analysis was cursory at best; the report was not objective nor was it based on adequate understanding of company fundamentals. Standard V(A): Diligence and Reasonable Basis was violated by Brown.
- A violation of Standard V(B): Communication with Clients and Prospective Clients has also occurred. Brown failed to investigate SpecChem's basic investment characteristics properly and did not communicate the company's investment characteristics through the research report.
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