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Mutual Funds To Buy Amid Global Jitters

Global growth fears have been prominent in recent times. Dismal economic data out of China had sparked jitters in the global markets. Also, disappointing factory data in the Eurozone recently, dampened investor sentiment. The record exports data from Germany was a bright spot, but that is not enough to dispel the global growth fears. In fact China, the second largest economy, poses a big threat as acknowledged by the IMF. They believe China’s slowdown may have graver repercussions on other countries than what was forecasted. The U.S. markets were not immune to the global market rout, but economic data looks convincing enough to suggest that the U.S. is relatively better positioned. Latest data showed that the U.S. economy has recovered significantly from the sluggish growth conditions in the first quarter. In this situation, mutual funds that mostly hold companies with a domestic focus are likely to gain from improving fundamentals. China, Europe Jitters China The China Federation of Logistics and Purchasing reported that the official manufacturing PMI index declined to a three-year low in August to 49.7 from July’s reading of 50. Meanwhile, the final Caixin Manufacturing Purchasing Managers’ index fell from 47.8 in July to 47.3 in August, reaching its lowest level in the last 77 months. The reading below 50 signaled that manufacturing activity contracted in August. Moreover, a plunge of 8.3% in exports and a decline of 8.1% in imports in July indicated the world’s second biggest economy is suffering from both weak global and domestic demand. It was also reported that producer prices declined to the lowest level in six years in July. Yesterday, data from China proved to be dismal once more. Fears of China-led global slowdown intensified after the National Bureau of Statistics in China showed China’s fixed-asset investment growth slowed to 10.9% in the first eight months of 2015. This is the weakest in about 15 years. Alongside, factory output increased 6.1% in August from prior year period. This missed the market expectations of a 6.4% gain. China stocks dropped the most it had in three weeks and also dampened sentiment in the U.S. markets. These disappointing data raised concerns that China may fail to achieve the target of 7% GDP growth rate this year Europe Investors are also worried about the economic condition of Europe. The final reading of Markit’s manufacturing PMI came in at 52.3 in August, below July’s reading of 52.4. Though the reading of the index reached a 16-month high in Germany, the reading out of France and Italy declined to the lowest level in the last four months. Meanwhile, the Markit/Cips U.K. manufacturing PMI declined from 51.9 in July to 51.5 in August, indicating a slowdown in manufacturing activity in the U.K. Meanwhile, it was also reported that the Euro zone’s inflation rate was at only 0.2% in August, significantly below the targeted rate of 2%. Last month, Eurosat reported that the common currency bloc expanded at a rate of only 0.3% in the second quarter, down from the first quarter’s growth rate of 0.4%. Last week, the Bank of England (BOE) decided to keep the key interest rate unchanged. The committee members voted 8-1 in favor of keeping the interest rate flat at 0.5%. It acknowledged that the China developments has increased downside risk to the global economy, but didn’t see any effect on the U.K. economy yet. The U.K. Office for National Statistics recently reported that manufacturing production declined at an adjusted rate of 0.8% in July, compared to a rise of 0.2% in the previous month. Most of the manufacturing sub-sectors witnessed a decline in production during July. The bright spot from Europe has been the Germany exports data. According to Germany’s Federal Statistics Office, exports gained a seasonally adjusted 2.4% from the prior month to 103.4 billion euros ($115.35 billion) in July. Imports were up 2.2% to 80.6 billion euros. These are the highest values since records started in 1991. Both exports and imports comprehensively beat expectations of gains of 0.7% and 0.5% respectively. On a seasonally adjusted basis, foreign trade balance showed a surplus of 22.8 billion euros. U.S. Shows Strength Amid the global concerns, the U.S. has done relatively well. Right now, uncertainty prevails over the rate hike decision. It is not clear if the FED will raise rates during the two-day policy meeting that begins tomorrow. However, the economic indicators are fairly encouraging. Despite global growth coming to a grinding halt, the “second estimate” released by the U.S. Department of Commerce last month showed that the GDP in the second quarter advanced at a pace of 3.7%, significantly higher than the first quarter’s rise of only 0.6%. The report also showed that gross domestic purchases surged at a rate of 3.4% during the quarter compared to a gain of 2.5% in the first indicating an increase in domestic demand. Also, the personal consumption expenditure (PCE) price index gained 1.5% during the quarter, a turnaround from the first quarter’s 1.9% decline. Though August jobs data came lower than expected, June and July’s job additions were revised higher. Analysts note that August’s job numbers have been revised higher later due to seasonal factors. Separately, the unemployment rate fell to 5.1% in August, its lowest level since Apr 2008. The unemployment rate was also lower than the consensus estimate of 5.2%. The unemployment rate was within the Fed’s goal of full employment. 3 Domestic Funds to Buy Funds that have limited international exposure should be more shielded from global growth concerns. Meanwhile, these domestically focused funds are poised to benefit from the favorable economic environment in the U.S. Thus, we present 3 funds that hardly have foreign stock holdings. The following funds also carry a Zacks Mutual Fund Rank #1 (Strong Buy). We expect the funds to outperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. The funds have encouraging year-to-date, 1-year and 3 and 5-year annualized returns. The minimum initial investment is within $5000. The Oppenheimer Discovery Fund A (MUTF: OPOCX ) primarily focuses on acquiring common stocks of domestic companies having impressive growth potential. OPOCX invests in securities of small cap companies having market capitalizations below $3 billion. As of the last filing, OPOCX, a Small Growth fund, allocates their fund in two major groups; Small Growth and Large Growth. OPOCX currently carries a Zacks Mutual Fund Rank #1. The fund has gained 6.7% and 9.6% in the year-to-date and 1-year periods. The 3 and 5 year annualized returns are 14% and 17.7%. Expense ratio of 1.12% is lower than the category average of 1.33%. The Neuberger Berman Mid Cap Growth Fund A (MUTF: NMGAX ) invests a large chunk of its assets in companies having market cap size identical to those included in the Russell Midcap Index. NMGAX maintains a diversified portfolio by investing in common stocks of companies across a wide range of sectors and industries. NMGAX may focus on specific sectors that are expected to gain from market or economic trends. NMGAX, as of the last filing, allocates their fund in three major groups; Small Growth, Large Growth and Large Value. NMGAX currently carries a Zacks Mutual Fund Rank #1. The fund has gained 7.1% and 11.1% in the year-to-date and 1-year periods. The 3 and 5 year annualized returns are 14.8% and 15.5%. Expense ratio of 1.11% is lower than the category average of 1.29%. The Diamond Hill Select Fund A (MUTF: DHTAX ) seeks to provide capital growth over the long term. DHTAX invests in 30-40 U.S. equities which the Adviser believes are undervalued. These equity securities may be of any size. The adviser estimates a company’s value devoid of its market price and also takes into effect the industry competition, regulatory factors and various industry factors among others. As of the last filing, DHTAX, a Large Value fund, allocates their fund in three major groups; Large Value, Large Growth and High Yield Bond. DHTAX currently carries a Zacks Mutual Fund Rank #1. The fund has gained 2.9% and 7.5% in the year-to-date and 1-year periods. The 3 and 5 year annualized returns are 18.8% and 15.2%. Expense ratio of 1.20% is however higher than the category average of 1.11%. Link to the original post on Zacks.com

Building A Hedged Portfolio Of Governance Metrics International’s Top-Ranked Stocks

Summary A way to potentially boost your returns when building a concentrated portfolio is to start with stocks that are rated highly by quantitative analysis. The Governance Metrics International, or GMI, rating system uses quantitative analysis to assess financial reporting and corporate governance, and determine which stocks are likely to substantially outperform the market. With any quantitative system, there’s a risk the analysis will be wrong, or the market will move against you. Using the hedged portfolio method can limit your downside risk. We show how to create a hedged portfolio starting with top-rated GMI stocks, and provide a sample hedged portfolio designed to limit downside risk to a 20% drawdown. In the Wake of Enron, A Focus On Financial Reporting One of the forensic accounting firms founded in the wake of Enron’s fraud was Audit Integrity, which later changed its name to Governance Metrics International (GMI), and was acquired by MSCI ‘s ESG Integration Unit last year. GMI uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies. The best-known indicator GMI uses is its Accounting and Governance Risk ( AGR ) ratings, which range from “Very Aggressive” to “Conservative.” According to GMI, companies rated “Very Aggressive” are 10 times more likely to face SEC enforcement actions than those rated “Conservative,” and 4 times more likely to file for bankruptcy. GMI uses its AGR ratings to derive its AGR Equity Risk Factor, which it considers to be a leading indication of share performance. AGR Equity Risk Factor ratings range from 1 (“Substantially Outperform Market”) to 5 (“Substantially Underperform Market”). We’re going to start with the universe of GMI’s 1-rated stocks to build a concentrated, hedged portfolio. Why a Concentrated Portfolio The point of a concentrated portfolio is to invest in a handful of securities with high potential returns, instead of a larger number of securities with lower potential returns. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998: If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Why a Hedged Portfolio Because we’re not Warren Buffett. We don’t have vast wealth to absorb large losses, and hedging limits our downside risk in the event that we pick the wrong stocks, or the market moves against us. There is, of course, a tradeoff between what we are willing to risk and our potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 25% decline will have a chance at higher returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $100,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising stocks In this case, we’re going to start with the universe of stocks rated by GMI as likely to “substantially outperform the market”. To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities First, you’ll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating Expected Returns While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with 1-rated GMI stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get the universe of 1-rated GMI stocks we used Fidelity ‘s screener to screen for optionable stocks rated 1, or “substantially outperform” according to the GMI AGR Equity Risk Rating. Since over 1,000 stocks met those two criteria, we added a third: 52-week price performance in the top 20% by industry. That winnowed the list to 247 names, and we picked the top 5 to input into our automated hedged portfolio construction tool: ABIOMED (NASDAQ: ABMD ) Bassett Furniture Industries (NASDAQ: BSET ) Sketchers USA (NYSE: SKX ) JetBlue Airways (NASDAQ: JBLU ) Universal Insurance Holdings (NYSE: UVE ) Using the Automated Tool In the first step, we enter the five ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (100000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor supply its own potential returns. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Monday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. In this case, that turned out to be three of the five stocks, ABMD, JBLU, and SKX. Since it aims to include four primary securities in a portfolio of this size, and only three of the ones we entered had positive net potential returns, Portfolio Armor added one of its own top-ranked stocks, Post Holdings (NYSE: POST ). In its fine-tuning step, it added Restoration Hardware (NYSE: RH ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before their hedges expired, the portfolio would decline 18.78%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.26%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 12.07% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.93% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created on Friday using the same and decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Restoration Hardware, the cash substitute, is hedged with an optimal collar with its cap set at 1%, and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return. Here is a closer look at the hedge for JetBlue: JetBlue is capped here at 14.25%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $1,050, or 5.7% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $735, or 3.99% of position value. So, the net cost of this optimal collar is $315, or 1.71% of position value.[i] Note that, although the cost of hedging this position is positive, the cost of hedging the portfolio as a whole is negative. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). [i]To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

TLO: Long Term Treasury Securities For Portfolio Stability

Summary TLO offers investors a low expense ratio and a negative beta. The average effective duration is around 17 years but the actual breakdown on securities is in the 10-15 range and heavily in the 20 to 30 year range. Negative correlation with major equity investments makes TLO an intelligent choice for diversifying the portfolio. For investors that are going heavy on bond funds, I would start with SCHZ and then add on TLO as a second option. For investors going heavy on equity and only using bonds for diversification, I would start with ZROZ and then use TLO as the secondary option. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is an option for investors seeking exposure to the longer portion of the treasury yield curve. This kind of allocation can be used for an investor seeking interest income (2.6% yield) and willing to take on duration risk. However, I think the best use of this fund by a significant margin is to use it in a portfolio that goes overweight on equity securities and uses regular rebalancing to take advantage of the highly negative correlation between TLO and the major market indexes. Expense Ratio The fund has an expense ratio of .10% which is very solid for bond ETFs. I’d still like to see it get into the single digits because I’m very frugal with expense ratios, but I wouldn’t complain about including an ETF with a .10% expense ratio in my portfolio. Quick Figures Over 99.8% of the holdings of the security are invested in domestic government debt. This is quite simply a quick way to get government debt into your portfolio without paying high trading costs. Rationale If the purpose of the position is to keep the portfolio properly balanced and reduce the volatility of the portfolio, then it makes sense to treat trading costs as a major issue due to rebalancing. TLO is one of the options on Schwab’s free ETF trading system which was a major reason for it going onto my short list of treasury ETFs. Fixed Income Statistics The statistics below provide a rough idea of the numbers on the portfolio. The bonds trade at a substantial premium due to having higher coupons. (click to enlarge) While those numbers are useful for an initial impression, I think it is important to also look at the breakdown along the yield curve because this is not a bullet fund where the bonds are all maturing in a very tight date range. Maturity The SPDR Barclays Long Term Treasury ETF is primarily using the 20 to 30 year debts but also contains a material allocation to the 10 to 15 year range. (click to enlarge) Having a small allocation to the 10 to 15 year range should make TLO less volatile than some other treasury security ETFs. On one hand that is a positive factor in isolation but for investors using their bond allocation strictly for negative correlations the longest exposures and higher volatility can produce the appropriate hedge against equity volatility with smaller allocations. Building the Portfolio I put together a hypothetical portfolio using only ETFs that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion TLO and ZROZ post fairly similar numbers on negative correlations and if I was simply using the ETF for producing some income it would be easy to select TLO over ZROZ. On the other hand, because the correlations are so negative, higher volatility in the ETF can become an attractive feature. The quickest way to demonstrate this factor is to look at the negative beta for each ETF. On TLO the beta is a negative .49 and on ZROZ the beta is a negative .90. TLO is a good option with rebalancing to make a steadier portfolio value. For the simple purpose of stabilizing portfolio values I think ZROZ a quicker way to accomplish my goal because I can use a smaller allocation to the bond ETF to maintain the negative beta exposure that reduces the overall volatility of my portfolio. If an investor wants more bond allocations, then I think they should start with diversified exposure like SCHZ and then look to add TLO before adding ZROZ. If the goal is simply creating negative beta for the portfolio, the order of the ETFs would be reversed with investors favoring ZROZ, then TLO, and finally SCHZ. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.