In the financial world, the mosaic theory is a research approach where analysts use the available information on a security or a company to arrive at a meaningful conclusion. Under this approach, analysts collect public, non-public, and non-material information on a company or a stock. This information is then used to arrive at the value of the stock and thus, helps the analyst recommend the stock to the clients.
One can say that the use of this theory makes the valuation of financial securities more accurate and comprehensive. This is so because more information goes in to arrive at the valuation. At the same time, the use of this theory makes the valuation process complicated as well. Analysts have to integrate much more information into the valuation model to arrive at the security’s price.
Sources of Information
Analyst has several legal sources available at their disposal to collect information in the current world. Some of these sources are:
- Financial reports from the company, such as 10-K and 10-Q.
- Using reports of other analysts or industry experts.
- Information available on social platforms, such as LinkedIn, Glassdoor, etc.
- Insight from the company’s employees and management.
- Google Trends.
- The Pew Research Center.
Mosaic Theory and Insider Trading
There is a very thin line that differentiates Mosaic Theory and Insider Trading. The CFA Institute (formerly the Association for Investment Management and Research (AIMR)) sees Mosaic Theory as a legal analysis method. However, insider trading is a punishable offense.
Analysts that use this theory to collect information must reveal the data and methodology they use for their analysis. Analysts using such an approach must be very careful when dealing with non-public information. Use of the material non-public information is a punishable offense under the law.
A very famous case that triggered the debate over the misuse of insider information under Mosaic Theory’s approach was of Raj Rajaratnam. Raj used the mosaic theory as his defense during his insider trading trial. However, the court found him guilty.
Material and Non-material Information
Understanding the difference between the two is very important for the effective use of mosaic theory.
Such information has the potential to affect the price of the stock or security. If such information becomes available publicly, it can cause severe price changes in security. Thus, analysts are recommended to use public material information in their analysis.
Such information does not affect the price of the security. Though they do not directly impact the share price, such information does help the analyst to predict the future performance of the security. Some common examples of non-material information are Internet searchers, assessing employee satisfaction, and more.
For example, assume Mr. A is an analyst who is carrying out research on company XYZ. Mr. A uses a company’s 10-K and 10-Q media reports and published reports of other analysts for his report. On the basis of these sources, Mr. A came to the conclusion that XYZ would acquire company ABC.
Neither company XYZ nor company ABC has revealed this information. Other analysts and industry experts are also not aware of this. Mr. A is the first to know this, thanks to the pieces of information that he was able to join in arriving at this conclusion.
Since the acquisition information is not disclosed publicly, it is material, nonpublic information. But, one can argue that Mr. A hasn’t got this information from an insider, so he is not doing anything illegal.
Despite the explanation above, it is very hard to determine what constitutes insider information. Raj Rajaratnam’s case highlighted the same issue as well. There is no clear, legally available definition as well. In the eyes of law material, non-public information constitutes inside information. But, deciding if the information is material or not is left to the law and for juries to decide.