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Estimating future cash flows: Whether s/he is internal or external, the analyst is involved in projecting future (accounting) profits and often, more importantly, projected net cash flows. In order to gather these data, the internal analyst must involve different departments, thereby playing corporate “politics in order to complete the job.
For each of the following, indicate from which department the projections may come (e.g., economics, marketing, purchasing, etc.).
Unit Sales
First, the internal analyst may receive unit sales projections from the marketing department.
The analyst must also be aware of the issue of Cannibalization the detrimental effect on other sales of the introduction of the new project. For example, if Microsoft projects sales of two million units of Windows Vista, of which one million would have otherwise gone to Windows XP sales, the analyst would recognize on his spreadsheet only the one-million-unit increment. This is because the decision to introduce a new product came, in a sense, at the expense of the old product’s sales. Analysts are interested only in what the new product contributes incrementally – above and beyond present matters.
Sales Prices
In order to project future revenues, the analyst will thus possibly need to obtain both unit sales data (i.e., expected quantities sold) and “pricing” information (i.e., expected price per unit).
Operating Costs
This information may be derived from many different parties, e.g., purchasing, operations, etc. Operating costs may include:
• Cost of Goods Sold: This refers to inventory costs as explained earlier.
• Selling, general, and administrative costs: These costs refer to non-production expenditures, including salaries and wages, rent, advertising, and travel.
• Taxes: Although taxes are not an operating cost per se, we all know what Ben Franklin said about “death and taxes.” Since taxes cannot be avoided, they should be deducted in the analysis.
Non-operating and Capital Costs
In “spreading the numbers,” the internal analyst will pay attention only to projected operating data, and not to any capital or other non-operating data / costs. S/he is interested usually only in what the potential project will produce as a business enterprise alone. Capital costs include the cost of paying interest on debt, and the dividend and “growth” costs of equity.
Key Terms:
Cost of Capital
As a heads-up, the cost of capital is an issue with which we shall deal later in great depth. Once the analyst has arrived at the yearly operating numbers, usually projected cash flow (rather than accounting profits), the cost of capital will then be brought in as the “discount rate,” rather than as a dollar figure. This is the rate at which the future cash flows will be “discounted,” or translated, to present values, thereby enabling a level playing field, in terms of time. In other words, by discounting, we are able to equate the value of a dollar paid tomorrow with a dollar today. This way, an investment decision may be made based on profitability and possibly other measures.
Note:
As we continue through these readings, pay careful attention to the words “expense” and expenditure.” They are not the same. “Expense” is an accounting phrase reflected on the Income Statement; expense is a reduction to Net Income – it may or may not involve cash. “Expenditure” refers to the deployment of funds – it will involve cash but may or may not be expensed. Expenditures may be capitalized or expensed.
8.04: Incrementalism
Key Terms:
Incremental
Incrementalism
The analyst’s “end-game” is to produce a spreadsheet reflecting future years’ respective, incremental, or additional, cash flows and/or profits, and possibly other things as well. In general, the principle of incrementalism pertains. It is only incremental cash flows, i.e., those which are added due to the project’s implementation, which are relevant to decision-making. If the company brought in \$100 and now – with the new project – it brings in \$125, the increment is \$25. Incremental revenues – and costs – did not exist before the project was effected. Therefore, sunk costs and the cannibalized portions of projections’ data are excluded as will be discussed immediately below. It is the incremental data which drive the decision to invest or not. We will learn this better by example.
By contrast, the accountant reports all historical economic events. Later, we will conduct a basic exercise in producing a pro-forma statement, i.e., a projected, income statement. Below are the two types of incrementalism:
Sunk Costs
Sunk Coststhese are expenditures which have already been outlaid and should not be therefore “double-counted.” For example, suppose a factory has unused, or under-used, equipment, which may be exploited, for a proposed project. The cost of the equipment having already been spent or “sunk,” should not be considered again; the cost is not relevant to deciding, for example, whether or not an existing asset should be exploited in a new way. The project merely proposes to exploit unused, or under-utilized, assets or sunk costs in order to increase sales and profits.
Cannibalization
Cannibalization – When a new product is introduced, some of the revenue may have been cannibalized from the potential sales of the old product. For example, if the new product is expected to sell 1.5 million units, and the old product had sold 1.0 million, we are interested only in the 0.5 mm increment. That is what the investment decision depends upon. Hence the phrase “cannibalization.” A change in pricing would complicate this analysis, i.e., how much of the revenue increase is due to volume and how much is due to a price increase? | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/08%3A_Cash_Flow_Depreciation_and_Financial_Projections/8.03%3A_Pro-Forma(Projected)Cash_Flow_Analysis.txt |
A financial analyst will collect reliable financial data from internal numerous sources, if possible, which s/he will cite in his/her forecast, list the assumptions as part of the report, and “spread the numbers” accordingly. Interpretation and strategy then will follow.
The following is an exercise in creating a pro forma (accounting-based) income statement. Later, we will see some analytic techniques, which may be implemented to convert “profits” to “cash flow,” if the latter is deemed more desirable. A “strategic plan” involves forecasting financial data for multiple future years.
Pro forma Financial Statements
Complete the pro forma I/S based on the following assumptions:
1. Marketing projects sales growth at 10% p.a.
2. Purchasing projects inventory costs to rise at a rate of 12% p.a. – due to scarcities.
3. S, G, & A will grow at a rate of 8% p.a.
4. For depreciation, see information below.
5. Interest costs will rise due to acquisition of new property, \$10,000 of which will be financed entirely via a 20-year, “non-amortizing” mortgage (i.e., interest-only) bond at a rate of 7.5%. The other \$1,000 will be financed via retained earnings. The present property is fully paid for.
6. Taxes are charged at a flat 40% rate.
7. Calculate NI.
8. Calculate EPS – There are 1,000s outstanding – no new shares will be issued.
Depreciation
• Next year’s (“Year 1″) depreciation expense will be \$50. Thereafter the (old) building will be scrapped.
• At the end of Year 1, a new building will be in use (the cost of scrapping the old building will be included in the cost basis of the new building). At that time, a mortgage will be in place. The new building will cost \$11,000 and will have a twenty-year life. It will be depreciated on a straight-line basis; a salvage value of \$1,000 is assumed.
8.06: Forecasting Solution
Provide some interpretive statements or comments about this company’s (or investment project’s) prospects. Specifically, calculate the growth rates for each year versus its prior year – for GP, EBIT, and NI.
The Growth Rate is calculated as: (Next Year’s Number ÷ Last Year’s number) – 1.
For example, how much higher, in percentage terms, is the GP for “Year 1” in comparison to “Last Year”? Do this for each year until you get to Five versus (or “over”) Four. Use four decimal places throughout. What do you find and why?
8.07: The Tax Effect of Depreciation
Depreciation is a non-cash expense (and NOT an “expenditure”), which serves to recognize the consumption of fixed assets over time, e.g., plant and equipment, but NOT property.
The consumption,” or use, of long-term, fixed assets is reflected as a separate operating, depreciation expense. Although depreciation is a non-cash expense, it provides the corporation with cash because it reduces taxable income and hence the tax liability.
When depreciation can be imputed to the manufacturing process, its charges are included in the Cost of Goods Sold (COGS). For example, if the manufacturer of a \$1 million piece of equipment warrants that the machine will be used up after manufacturing 1 million units, the accountant may impute (i.e., include) \$1 per unit of production to COGS. This could confuse the statements reader. Below, we will not assume such “imputation.”
Illustration of Depreciation Tax Shield (Ignoring Interest Expense):
Due to depreciation, a non-cash expense, net income will be lower by only \$12 rather than the full \$20 of depreciation expensed; the \$8 difference represents the tax savings, and hence the “tax shield,” due to the deduction of the depreciation expense.
Tax Shield = (D) (T) = (\$20) (0.40) = \$8
The “tax shield” of depreciation, i.e., D (T), is a very real phenomenon in that it actually reduces the tax burden, which is viewed as a provision of cash, albeit depreciation alone provides no cash. The acquisition of a depreciable asset, e.g., a building or equipment, creates a tax shield or benefit that provides more cash flow than before the acquisition.
You may think of “EBITDA” (i.e., earnings before interest, tax, depreciation, and amortization) as EBIT plus depreciation (and amortization).
On Humility, Honor, and Accomplishment
A life spent making mistakes is not only more honorable, but more useful than a life spent doing nothing.
-George Bernard Shaw
That’s why pencils have erasers.
-Norman Isaac Bigel
(1917 – 2017) | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/08%3A_Cash_Flow_Depreciation_and_Financial_Projections/8.05%3A_Corporate_Forecasting_and_Strategic_Planning.txt |
Learning Outcomes
9.02: Free Cash Flow
Why Cash Flow? A corporation’s value is dependent, in large part, on the income and cash flow it produces. Cash flow is different from income in that “income” is based on “accrual accounting,” which will reflect certain non-cash events such as depreciation, and many other “distortions,” some of which were discussed earlier. One key distortion had to do with “timing” – the accountant may book a sale, for example when “constructively received,” i.e., when legally and economically receivable, but not yet received in actual cash.
Under accrual accounting, the accountant records economic transactions rather than the movement of actual cash received and paid out. (In theory, in the long run such accounting vs. cash differences even out.) Because of these differences, financial analysts, who are more cash-oriented, must make certain adjustments to the accounting data in their own calculations and projections.
In a certain sense, cash flow is more important to corporate valuation than income because dividends are paid out to investors in cash. Further, when engaging in corporate planning, a possible capital investment will be judged attractive dependent upon the cash flow it produces in the future because it is cash that, arguably, fuels growth.
What is Free Cash Flow? Capital investments, i.e., “growth” investments, include expenditures for hard assets, as well as for product development, and much more. “Free cash flow” is funds that an investment project or the corporation as a whole generates beyond its own internal and ongoing needs. We may think of free cash flow as the cash, which is left over from an investment project, after all net operating funds generated by the project are utilized for necessary, non-discretionary purposes, including hard assets’ maintenance and replacement, and increases in working capital; this “left-over” amount may be used for other financial purposes – growth or expansion, at the discretion of management.
Working capital must often be increased. The project, or corporation, first generates operating cash flows, some of which are needed to replace or maintain assets, to invest in inventory and receivables, and to maintain the firm’s competitive position.
So, think of “free” cash flow (FCF) as discretionary, think of it as “Discretionary Cash Flow.” Necessary capital and other non-discretionary expenditures are required in order to maintain the business as is. A leaky roof must be repaired; there is no choice. A worn-out gasket must be replaced.
Analogously, you may recall the parallel notion of “disposable income” in Macroeconomics. (After deducting taxes, and necessities, such as food and rent, from gross income, the consumer has some funds left over for discretionary purposes, which might include investment, or buying that deluxe Apple Watch s/he has coveted for so long.) Similarly, “free cash flow” is the net, operating after-tax cash that the firm may generate from investment in a new building or equipment (i.e., the investment “project”) after considering necessary operating and capital expenditures, including maintenance and replacement, but excluding expansionary, or growth-oriented, capital expenditures as this would be discretionary.
The more FCF the firm generates, the greater the firm’s ability to invest in new assets, to use the funds to pay down debt or to pay dividends, and still other discretionary possibilities.
The Mathematics
One formula for use in this process is presented below. We start with operating earnings, which, in this case, is defined as “EBIT” or, alternatively “EBITDA[1],”i.e., earnings before interest, taxes, and amortization[2]. To the financial analyst, the projected income or cash flow statement may look something like the following:
Thus the analyst would calculate Free Cash Flow (FCF) to equal:
[(EBITDA) (1 – T)] + [(Depreciation) (T)] [Necessary Capital Expenditures] [Increase in Net Working Capital]
The elements of the formula
The formula consists of four different parts. Let’s look at each of them.
1. EBITDA (1 – T)
2. Add: Depreciation (Tax Rate) = (D) × (T)
3. Less: Necessary Capital Expenditures[3]
4. Less: Increases in Net Working Capital
5. Equals: Free Cash Flow (FCF)
Note that “T” (in “1-T” and in “D x T”) stands for the firm’s tax bracket, or percent, whereas EBITDA is in dollars, including the “T” there. While at this stage of the corporate planning and investment analysis process, the firm has not yet decided whether it will choose the investment or not and, if so, how it will be financed, and therefore does not know its projected interest payments, it does know its tax bracket, which is based on the firm’s meeting a specified lower threshold (“bracket”) of earnings.
1. EBITDA:
Take note of the use of EBITDA rather than EBT in the formula. There are several details here, which bear explanation; we will take them one at a time. First, accounting EBT would include interest expense – as a deduction from EBIT. Interest expense” is the result of a prior capital financing decision and, as such, should be independent of this analysis, which focuses on the cash-based, operating earnings a firm or a project produces (EBITDA), and not on financial decisions. In our analysis and projections, we should thus exclude interest, which is a discretionary capital structure, solvency-oriented matter for decision.
Accordingly, the “EBITDA (1 – T)” adjustment eliminates the interaction of interest and its effect on tax. To see how this adjustment works, let us compare the results of the formula with the following alternate spreadsheet presentation. Let’s say that the firm produces \$100,000 of EBITDA, has interest expense of \$20,000, and pays taxes at a 30% rate. By formula we would project EBITDA (1 – T) = \$100,000 (1 – .30) = \$70,000. (For this example, we shall assume, for the moment, that depreciation and amortization are zero.) This is the figure we want, which represents earnings after taxes, in the absence of interest. The “1 – T” multiplier shows what is left after paying taxes. This project produces, or is expected to produce, \$70,000 in operating cash flow (next year).
In the following spreadsheet, we would show the same \$70,000 result, only by different presentation (in order to prove out the formula) – under the alternate FCF analysis. We also show, side by side, the accounting income reported, which does not suit the purpose of the analysis because it includes interest expense, which is a financial – not an operating – event or cash (out-) flow.
2. The Depreciation Tax Shield:
Depreciation is a non-cash expense (as is amortization, which we have been assuming herein to be zero), which is deducted from operating earnings before income taxes. Therefore, we add back just the tax savings that depreciation provides but ignore depreciation itself. It is assumed that the (internal) analyst knows the firm’s tax bracket. Depreciation is tax deductible and, as such provides cash, but otherwise itself directly provides no cash. You found above an in-depth illustration of the “tax effect of depreciation,” absent other media. You may wish to view that page again now.
Note:
EBITDA (1-T) + D (T) = EBIT (1-T) + D. (To prove this out, substitute in the equation the following values: EBIT = \$100; D = \$20; A = \$0; and T = .30) The two phrases are mathematically equivalent but appear to have somewhat different connotations. In the latter case, EBIT appears to refer to accounting income, hence our preference for EBITDA, a more cash-oriented notion. In the latter formulation, adding back depreciation, which is a non-cash expense, intuitively appears to contradict the aforesaid idea that depreciation does not provide cash flow, even though it does work out mathematically and conceptually.
3. Capital Expenditures:
There are the three categories of capital expenditures (“Cap Ex”), which we shall need to incorporate in the free cash flow projection. They are:
1. Maintenance 2. Replacement 3. Expansion
Occasionally, the walls must be painted and the premises properly maintained. Roofs may blow off, and machinery gaskets may “blow,” requiring replacement. Expansionary investments may involve acquiring additional factory space or equipment, in order to increase production, and hence sales and profits.
Maintenance and replacement expenditures are clearly necessary; expansionary expenditures are discretionary and are (generally) undertaken in order to provide growth, i.e., increased sales and profits. We would deduct necessary capital expenditures in order to arrive at free cash flow.
Accounting rules do not require separating out necessary from discretionary capital expenditures; any breakdown, if provided, may be found in the footnotes. This information will assist the analyst in gauging the firm’s growth prospects. Absent this breakdown, the most common practice among analysts is to use all capital expenditures in the formula, although this is a matter of analyst judgment.
4. Net Working Capital:
“Net working capital” may be defined as current assets less current liabilities (NWC = CA – CL). Any increase in current assets, or in net current assets (i.e., NWC), usesfinancial resources and thus reducescash or cash flow. For example, an increase in inventory uses funds.
Similarly, an increase in current liabilities providesfunds, and may be thought of as a “source” of funds. A decrease in current liabilities uses funds. For example, when a company pays its accounts payable, it uses funds.
If a firm is to grow it will have to increase its Net Working Capital.
The table below summarizes the possibilities and instructs you how to insert the changes into the FCF formula. Some add to FCF; others are subtracted from FCF.
Note that, in calculating Free Cash Flow and the relevant prospective changes in Current Assets, we ignore expected changes in the cash account, focusing instead on changes in the cash flow affecting the cash account. To include changes in the cash account itself in calculating FCF, would be “double-counting.”
What can the corporation do with its FCF?
• Purchase more P, P, & E.
• Expand inventory.
• Invest in Mergers and Acquisitions (using shares when high-priced).
• Increase R & D.
• Pay off Debt.
• Pay discretionary (common stock) dividends.
• Buy back common shares (when cheap).
A potential corporate investment project that throws off a lot of FCF is desirable. A firm, as a whole, that throws off lots of FCF may be thought of in a most positive light – as one, among other possibilities, that has a lot of growth potential and makes for a good investment.
1. In some instances, an analyst may choose to use “EBITDA,” i.e., EBIT with depreciation and amortization added back. The use of this figure will depend on the data presentation and analyst choice.
2. As we will learn later in this text, amortization has to do with the reduction in the value of an intangible asset over time; in this sense it is like depreciation.
3. Note that “Capital Expenditures” here refers only to required expenditures, i.e., maintenance and replacement expenditures, and not discretionary expenditures, which may be used for expansion and growth. By subtracting out necessary (i.e., non-discretionary) CE, we are left with Free CF. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.01%3A_Chapter_Nine-_Learning_Outcomes.txt |
Free Cash Flow: Exercise #1
That covers the formula. Let us work up a quick, all inclusive, example. You are given the following: solve for free cash flow.” Assume that there is no amortization.
[(EBITDA) (1 – T)] + [(Depreciation) (T)] – [Necessary Capital Expenditures] – [Increase in Net Working Capital]
FCF (Formulation) = \$100 (1 – .30) + \$1 (.30) – \$7 – \$2
(Calculation) = \$70 + \$0.30 – \$7 – \$2 = \$61.3 million
Working Capital next year versus this year increased by \$2 million: (6-2) – (5-3). Alternatively, one might say that current assets increased by \$1 million, a useof funds; current liabilities decreased by \$1 million, also a use of funds. The net use of funds was therefore \$2 million, which accordingly reduces free cash flow.
To summarize, free cash flow may be thought of as the firm’s after-tax cash flows less any spending on either the maintenance or replacement of fixed assets, and in acquiring working capital. The free cash flow left over may be used either to pay down debt, pay dividends, buy back stock, for discretionary growth investments and more. The firm will (should) choose investments that further maximize FCF.
This discussion has, so far, assumed that we, financial analysts, are perfectly capable of making accurate, numerical projections about matters that have not yet occurred. In reality, projections are virtually always going to be somewhat incorrect – when all is said and done. Projections “under uncertainty” are beyond this manual’s scope.
This example is generic in the sense that it may represent either the view of an external analyst looking at a corporation’s most recent financial report, and, based on the report, making an assessment of the corporation’s growth prospects and equity investment merits based on its FCF; or it could be a projection that an internal analyst makes for a potential corporate investment project.
Projecting Free Cash Flow: Exercise #2
We have already projected net income and earnings per share (see above under the heading Corporate Forecasting and Strategic Planning”). We also understand the implications of depreciation, a non-cash expense, on income and cash.
Now, we will conduct an exercise, based on the earlier net income and EPS projections, in which we shall create a pro-forma statement – of a sort – of free cash flows for multiple future years rather than just one year’s net income. This spreadsheet will be useful when, later, we assess such cash flows in present value terms in order to make capital investment decisions. In this connection, take note that interest, for example, is excluded from FCF because it is a capital cost, as discussed earlier.
In order to do this, we need to recall the FCF formula. Here, once again, it is:
[(EBITDA) (1 – T)] + [(Depreciation) (T)] [Necessary Capital Expenditures] [Increase in Net Working Capital]
In our pro-forma, Five-year income statement, we have many of the elements: EBIT, depreciation, and tax rate (i.e., 40%). Let us assume the following for the missing parts:
1. There is no amortization.
2. Replacement and maintenance capital expenditures shall be \$1,000 in “Year 1” and grow thereafter at a 5% rate.
3. Current Assets will increase in Year 1 by \$500 the first year, and each year thereafter at a growth rate of 10%.
4. Current Liabilities will increase in Year 1 by \$750 and each year thereafter at a growth rate of 5%.
• (Hint: an increase in current liabilities is a source of funds.)
• Take note that the differences are incremental.
To make matters simple, a spreadsheet is provided below, which is consistent with the FCF formula. Notice the (horizontal) line breaks, which assist you in separating out the pieces of the formula from their respective sub-parts. Note also that cash outflows should be bracketed, since they are negative. Some of the information in the spreadsheet will be imported from the earlier net income exercise, while some will be derived from the set of four assumptions noted on the prior page.
Until the day when G-d shall deign to reveal the future to man, all human wisdom is summed up in these two words, ‘Wait and hope.’
-Alexandre Dumas
The Count of Monte Cristo
(Exercise #2)
Here is the solution:
A mensch tracht un Gott lacht.
Man plans and G-d laughs.
-Yiddish expression | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.03%3A_Free_Cash_Flow_Exercises.txt |
A company needs additional “capital” (i.e., financial resources) in order to grow and to maintain its existing plant and equipment, and to acquire additional inventory. It cannot achieve a sales increase (“growth”) without adding on productive “capital assets (not to mention maintaining existing assets) in order to produce more goods for sale.
Key Terms:
Internal Funds
Some further internal funds will be generated by accounts payable, also in the normal course of business conduct. Payables are, essentially, free, short-term loans provided by the firm’s suppliers for, usually, 30 days. Payables are, financially speaking, (interest-) free sources of funds. We call these funds, including payables and retained earnings, by numerous names: “spontaneous, automatic,” or “internal.” Some of the company’s capital needs will be met “spontaneously,” in the normal course of doing business by retaining some, or all, of its earnings. Such funds may be thought of as having been generated “internally.”
External Funds
For the balance of its capital requirements, the corporation will need to go outsidethe firm’s normal venues – to bank lenders, and/or to bond and stock investors for its EFN or external requirements. The extent to which the company will use either debt or equity, and in what proportions, is the subject of the “Capital Structure topic; this topic will be discussed later. The EFN projection is an essential component to of the corporation’s capital planning.
The EFN Formula: The formula, which we shall develop, consists of three parts. The first part tells us how much additional assets the firm will require in order to support a stated sales growth objective. This part is based on the firm’s required ratio of assets to sales. It will need more assets in order to produce more sales. We shall refer to this amount as the “gross requirement,” for lack of a better phrase.
The next two parts indicate the extent to which first, accounts payable, and second, retained earnings may reduce the gross requirement. After having reduced the gross requirement by the two internally generated or spontaneous sources of funds, we are left with a figure, which tells us how much additional, external financing the firm will have to arrange for itself in order to achieve its pre-set sales growth objective. External financing will take the form of new debt and/or equity.
EFN Model’s Restrictive Assumption:
We shall assume that Financial Ratios remain the same over time, i.e., we will conduct “static analysis.” In practice, projections may not conform to past relationships precisely, for reasons known to, or assumed by, the analyst. Here, for simplicity, we shall dispense with this complication.
Static Ratios
In order to focus on the nature of the EFN formula – and not on dynamic financial ratio matters – we will assume, in the exercise to come, static ratios. Static means unchanging in time.
The EFN Formula – The Math
Terminology:
Fundsthis refers to any and all financial resources that the firm may call upon, including cash, various forms of debt or borrowings, and equity, the latter two of which, like cash, also enable the firm to invest in any proposed corporate investment project.
Internal Funds– these may also be referred to as either “spontaneous” or “automatic.” These funds are automatically or spontaneously generated in the normal course of doing business. An example of this is accounts payable. When a producer orders raw materials, a free loan for usually thirty days is created by the supplier. Over the course of the year, and as the thirty days continually “roll over” over the course of the entire year, the producing firm is supplied with a free source of “internal” funds. The company will also internally generate funds as it earns and retains a portion of its earnings – “retained earnings.
External Funds This refers to any “additional” funds the firm may need to raise beyond any funds that are generated in the normal course of doing business in order to finance a proposed corporate investment project. For external funds the firm will have to go, so to speak, outside the confines of its ordinary business by calling upon bank lenders, debt and equity investors, and possibly others. External funds are required to the extent that internal funds are insufficient.
The EFN Formula:
EFN= [(A0/S0) ΔS] – [(AP0/S0) ΔS] – [(M0) (S1) (RR0)]
OR
[(A0) (S1/S01)] – [(AP0) (S1/S0 – 1)] – [(M0)(S1) (RR0)]
EFN = Required increase in assets [(A0/S0) ΔS]
Less:“spontaneous” increase in Liabilities [(AP0/S0) ΔS]
Less:“spontaneous” increase in Retained Earnings [(M0)(S1) (RR0)]
Key: | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.04%3A_External_Funds_Needed_Formula%28EFN%29.txt |
A company needs additional “capital” (i.e., financial resources) in order to grow and to maintain its existing plant and equipment, and to acquire additional inventory. It cannot achieve a sales increase (“growth”) without adding on productive “capital assets (not to mention maintaining existing assets) in order to produce more goods for sale.
Key Terms:
Internal Funds
Some further internal funds will be generated by accounts payable, also in the normal course of business conduct. Payables are, essentially, free, short-term loans provided by the firm’s suppliers for, usually, 30 days. Payables are, financially speaking, (interest-) free sources of funds. We call these funds, including payables and retained earnings, by numerous names: “spontaneous, automatic,” or “internal.” Some of the company’s capital needs will be met “spontaneously,” in the normal course of doing business by retaining some, or all, of its earnings. Such funds may be thought of as having been generated “internally.”
External Funds
For the balance of its capital requirements, the corporation will need to go outsidethe firm’s normal venues – to bank lenders, and/or to bond and stock investors for its EFN or external requirements. The extent to which the company will use either debt or equity, and in what proportions, is the subject of the “Capital Structure topic; this topic will be discussed later. The EFN projection is an essential component to of the corporation’s capital planning.
The EFN Formula: The formula, which we shall develop, consists of three parts. The first part tells us how much additional assets the firm will require in order to support a stated sales growth objective. This part is based on the firm’s required ratio of assets to sales. It will need more assets in order to produce more sales. We shall refer to this amount as the “gross requirement,” for lack of a better phrase.
The next two parts indicate the extent to which first, accounts payable, and second, retained earnings may reduce the gross requirement. After having reduced the gross requirement by the two internally generated or spontaneous sources of funds, we are left with a figure, which tells us how much additional, external financing the firm will have to arrange for itself in order to achieve its pre-set sales growth objective. External financing will take the form of new debt and/or equity.
EFN Model’s Restrictive Assumption:
We shall assume that Financial Ratios remain the same over time, i.e., we will conduct “static analysis.” In practice, projections may not conform to past relationships precisely, for reasons known to, or assumed by, the analyst. Here, for simplicity, we shall dispense with this complication.
Static Ratios
In order to focus on the nature of the EFN formula – and not on dynamic financial ratio matters – we will assume, in the exercise to come, static ratios. Static means unchanging in time.
The EFN Formula – The Math
Terminology:
Fundsthis refers to any and all financial resources that the firm may call upon, including cash, various forms of debt or borrowings, and equity, the latter two of which, like cash, also enable the firm to invest in any proposed corporate investment project.
Internal Funds– these may also be referred to as either “spontaneous” or “automatic.” These funds are automatically or spontaneously generated in the normal course of doing business. An example of this is accounts payable. When a producer orders raw materials, a free loan for usually thirty days is created by the supplier. Over the course of the year, and as the thirty days continually “roll over” over the course of the entire year, the producing firm is supplied with a free source of “internal” funds. The company will also internally generate funds as it earns and retains a portion of its earnings – “retained earnings.
External Funds This refers to any “additional” funds the firm may need to raise beyond any funds that are generated in the normal course of doing business in order to finance a proposed corporate investment project. For external funds the firm will have to go, so to speak, outside the confines of its ordinary business by calling upon bank lenders, debt and equity investors, and possibly others. External funds are required to the extent that internal funds are insufficient.
The EFN Formula:
EFN= [(A0/S0) ΔS] – [(AP0/S0) ΔS] – [(M0) (S1) (RR0)]
OR
[(A0) (S1/S01)] – [(AP0) (S1/S0 – 1)] – [(M0)(S1) (RR0)]
EFN = Required increase in assets [(A0/S0) ΔS]
Less:“spontaneous” increase in Liabilities [(AP0/S0) ΔS]
Less:“spontaneous” increase in Retained Earnings [(M0)(S1) (RR0)]
Key: | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.04%3A_External_Funds_Needed_Formula(EFN).txt |
We said above that the firm may reduce its total requirement for acquiring funds through the “spontaneous” or “automatic” generation of internal funds.
Internal Funds:
• Accounts Payable
• If the firm bought supplies and raw or finished inventory etc. under “cash on delivery, or “COD,” terms of sale, it would have to pay for it – with cash! If it has enough cash, it will incur an opportunity costs, because the cash would not be invested. If it had to borrow the money, it would incur an explicit borrowing cost at a rate of interest. However, most firms are provided with 30-day terms of sale from its suppliers, which amounts to a 30-day free loan, during which time it incurs neither an opportunity nor an explicitcost. In this sense, credit terms – Accounts Payable – provide cash flow to the buying firm.
• Although the Accounts Payable will be paid in 30-days, the firm will have on average over the course of the year, 30-days of access to a free source of funds. The firm, more or less simultaneously, pays down the Payables and then re-orders more goods.
• Additions to Retained Earnings
• This, clearly, provides a stream of internal funds to the corporation as profits are made and retained.
We also said that, to the extent that internal funding is insufficient to satisfy all the investment needs, it may seek additional funding externally.
External Funds:
• Short-term bank lines of credit
• Short-term bank loans – “notes”
• Long-term (bank) loans – “debt”
• Issuance (sale) of corporate notes or bonds
• Issuance (sale) of equity
9.05: Internal and External Funds (Summary)
We said above that the firm may reduce its total requirement for acquiring funds through the “spontaneous” or “automatic” generation of internal funds.
Internal Funds:
• Accounts Payable
• If the firm bought supplies and raw or finished inventory etc. under “cash on delivery, or “COD,” terms of sale, it would have to pay for it – with cash! If it has enough cash, it will incur an opportunity costs, because the cash would not be invested. If it had to borrow the money, it would incur an explicit borrowing cost at a rate of interest. However, most firms are provided with 30-day terms of sale from its suppliers, which amounts to a 30-day free loan, during which time it incurs neither an opportunity nor an explicitcost. In this sense, credit terms – Accounts Payable – provide cash flow to the buying firm.
• Although the Accounts Payable will be paid in 30-days, the firm will have on average over the course of the year, 30-days of access to a free source of funds. The firm, more or less simultaneously, pays down the Payables and then re-orders more goods.
• Additions to Retained Earnings
• This, clearly, provides a stream of internal funds to the corporation as profits are made and retained.
We also said that, to the extent that internal funding is insufficient to satisfy all the investment needs, it may seek additional funding externally.
External Funds:
• Short-term bank lines of credit
• Short-term bank loans – “notes”
• Long-term (bank) loans – “debt”
• Issuance (sale) of corporate notes or bonds
• Issuance (sale) of equity
9.06: The EFN Formula Explained
The EFN Formula Explained
You will observe that the EFN formula has three parts (separated by two minus signs).
EFN= [(A0/S0) ΔS)] – [(AP0/S0) ΔS] – [(M0) (S1) (RR0)]
The first part represents the required increase in total assets [(A0/S0) ΔS)] needed to sustain the projected sales increase. Last year, assets equal to A0 were required by the firm to sustain a sales level equal to S0.Hence, we formulate the ratio A0/S0. Assuming this ratio remains static, next year, the firm will require so much more in assets; this is arrived at by multiplying the ratio by ΔS, the projected sales increase; ΔS = S1 – S0.
However, some of this “gross requirement will be spontaneously” or “automatically” met by the normal business generation of internal funds in the manner of spontaneous liabilities, by which we primarily refer to accounts payable (not notes payable or the current portion of long-term debt payable). Last year, such internal funds represented a certain percentage of sales: (A0/S0). If we multiply this dollar figure by the projected sales increase (ΔS), we may see to what extent spontaneous liabilities reduce the original “gross requirement.
Finally, the firm will also – hopefully – generate and retain some of its earnings, thereby further reducing its “gross requirement. If we take the firms net profit margin (NI/S = M0) and multiply it by next year’s sales (S1), we get next year’s projected net profits: (M0) (S1) = NI1. If we the net profit margin (i.e., M0= NI/S) times next year’s sales, we get next year’s net profits. If we further multiply this by the firm’s retention rate (RR0), we get the firm’s projected retained earnings.
After all is said and done, we have a figure – the dollar amount of EFN – that enables the firm to plan for next year’s acquisition of external financing, and hence increased asset levels in support of the planned sales increase. Interestingly, this formula does not instruct us relative to the extent to which the external requirement should be met by either debt or equity, and in what Debt-to-Equity proportion.
Note:
For simplicity of presentation only, below we will ignore the “rule” of using an average balance sheet datum when concocting mixed ratios (i.e., those that include both balance sheet and income statement data). This simplification is in addition to the static analysis already assumed.
Some useful formulae:
• ΔS = S1 – S0
• M0 = NI / S
• RR = (NI – D) / NI = A.R.E. / NI = 1 – PR
9.07: EFN Application
EFN Application
You are given the following income statement and balance sheet. Solve the question listed at the bottom of this page.If Sales are projected to grow to \$2,500, what is the additional amount of funds needed (“EFN”) to finance the growth in sales?
Balance Sheet for “TC Corp”
As of Fiscal Year Ending 12.31.20XX
(\$ Millions)
Income Statement for “TC Corp”
For Year Ending 12.31.20XX
(\$Millions) | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.05%3A_Internal_and_External_Funds_%28Summary%29.txt |
EFN = [(A0/S0) ΔS] [(AP0/S0) ΔS] [(M0) (S1) (RR0)]
= [(1,000/2,000) (500)]– [(100/2,000) (500)] – [(50.40/2,000) (2,500) (0.70)]
= \$250 – 25 – 44.10
= \$180.90
Question #1: What does this number mean?
Answer: It means that, if my company wishes to grow its sales next year by \$500, it will need to add on \$250 worth of assets, of which \$180.90 will be funded externally.
Remember: If it wishes to increase assets by \$250 in order to achieve its sales objective, it will have to increase the other side of the balance sheet by the same amount. In this case, \$25 will be provided internally by accounts payable, \$44.10 will be provided internally through retained earnings, and \$180.90 will be provided externally by some mix of debt and equity.
Note 1:
1. Use spontaneous changes only, that is, AP for liabilities, exclude Notes Payable (NP) and Long-term debt (LTD).
2. This was based on a static ratio analysis – our restrictive assumption.
3. This has been an incremental analysis; we were only interested in the additional amount of funds needed, and that’s what we got!
Question #2: How much of the \$180.90 will be externally funded by debt and how much by equity?
Question #2, Answer 1:
The present debt/equity ratio is 3:7, i.e., 30% debt and 70% equity. Total capital is \$1,000, with \$300 of debt and \$700 of equity (D ÷ TA = 30%). Assuming static analysis, 30% of the \$180.90 will be financed by debt and 70% by equity. This will maintain the capital ratios in the same proportions as prior to the new external funding.
Question #2, Answer 2:
Another, perhaps better, way of calculating the debt ratio, for this purpose, would be by excluding internal capital from the figures. In this way, we would be establishing only how much external debt and external equity should be raised, an approach, which would be more consistent with the purpose of the EFN formula. We agreed that the firm needs \$180.90 of external funds.
Thus presently, external debt ÷ external equity = 200 ÷ 500; that is 28.5% (2/7) in debt as compared to the total of external capital. We had raised \$2 of external debt for every \$5 of external equity. Total external capital was \$700 (5/7) (not the \$1,000 in total capital used in the prior calculation). In this alternate calculation, we have ignored internal accounts payable (\$100) and retained earnings (\$200). Incremental internal funds will be provided over the coming year as in the past.
Below we illustrate both answers.
Note 2:
In the first two expressions in the EFN model, i.e., [(A0/S0) ΔS] and [(AP0/S0) ΔS], we utilize the incremental, projected sales increase (i.e., ΔS) whereas the third portion [(M0) (S1) (1 – PR0)], we utilize the entire projected sales amount (S1).
Why, in fact, may Financial Ratios change?
In the foregoing analysis, we assumed that financial ratios do not change over time. In fact, ratios are dynamic. Here are some reasons why, in fact, ratios will change.
1. Economies of scale – as companies grow larger and produce more, they benefit, according to Microeconomic theory, from lower production costs per unit produced, even though total (production) costs are rising. The phenomenon will continue until the firm reaches full capacity and needs to add on assets in order to continue growing. The Asset/Sales and Profit ratios will be affected. Assets will remain flat as sales grow – until full capacity is reached. With unit costs down, gross profits will increase.
2. “Lumpy Assets” i.e., firms may reach a level where they have to acquire more (expensive) assets (assets don’t grow smoothly or in the same proportion as the sales increase, which is likely smoother). For example, the factory may be at only 60% of capacity, which affords substantial growth in production and sales without adding on capacity or expanding to an additional facility. Should sales continue to grow beyond present capacity, it would be incumbent upon the firm to add to its fixed assets at some point. Such assets would suddenly jump in size. Sales, by contrast, may grow relatively smoothly over time. The Sales/Total Asset ratio will provide some insight.
3. Capital Costs (i.e., the economic costs to the corporation of borrowing money and issuing stock) will likely change over time – interest rates will go up and down, causing changes in the cost of debt, borrowed money. If the cost of debt decreases, after-tax income may increase. It will then be cheaper to finance new fixed assets, so the firm may then decide to add on more P, P, & E. The T.I.E. Ratio (EBIT / Interest Expense) may provide some added insight here. Also, stock investors will demand that the company produce dividends and increased profits – to be retained if not distributed as dividends. Additions to Retained Earnings will increase the company’s value and hence its share price. (Capital Costs should not be confused with Capital Assets Costs.) In short, what investors require or demand, the corporation must provide; return to the investor is an economic cost to the corporation. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.08%3A_EFN_Solution.txt |
This might be a good place to review what we have learned thus far. First, we highlighted some difficulties in reading financial statements for financial analysts. We did this by focusing on examples of current (inventory) and long-term asset accounting (depreciation) respectively. These highlights assisted us in listing and understanding the four primary issues related to accounting data interpretation namely, historical bias, the arbitrary use of cost method, and problems having to do with estimates and reserves. For us, the statements may not be what they seem, with consequent reduced usefulness. If we are going to use accounting data as inputs for ratio analysis, we must first and foremost be cognizant of this, and (later) learn how to adjust the numbers, a skill, which you would acquire in a Financial Statements Analysis course.
Between highlighting accounting problems and presenting ratio analysis, we discussed the creation of pro forma financial statements and created a projected income statement. We also looked at a model for projecting free cash flow, a very important predictor of a company’s ongoing performance, and a metric by which possible investment projects are evaluated. Finally, we discussed the External Funds Needed model, an important tool in capital planning in order to accommodate growth.
9.10: Chapters Eight and Nine-Review Questions
Chapters 8 – 9: Review Questions
1. Define each of the following terms: Incrementalism, Sunk Costs, and Cannibalization.
2. In words, explain what is meant by Free Cash Flow.
3. Why is FCF important? Give two reasons.
• How do we use this model – for individual projects, for the entire corporation, or both? Explain.
• What options does the company have regarding how it may choose to utilize its Free Cash Flow?
4. Create a Free Cash Flowtemplate and spread the forecasted numbers based on the following assumptions:
• Last year’s sales were \$15.5 million and are expected to grow for the next two years at 15% per year, followed by three years of 8% growth.
• Cost of Goods Sold last year were \$12.6 million and are expected to grow at a 7% rate per year indefinitely.
• Depreciation is \$550,000 per year at a straight-line rate; in the fifth year, the building will have been fully depreciated. This company has no depreciable equipment.
• There is no amortization.
• Selling and General Administrative expenses last year were \$200,000 and will grow modestly at an annual 2% rate.
• This company is in the 30% tax bracket, including Federal and State. There are no local taxes.
• The company expects to spend \$2 million each year on CapEx, all of which will be necessary.
• Last year’s Current Assets, excluding Cash, were \$2.5 million, and is expected to grow at a 5% rate per year indefinitely.
• Last year’s Current Liabilities were \$2 million and are expected to grow at a 3% rate for at least five years.
5. How does the analyst handle depreciation in the FCF Model? Why does s/he handle it that way? Note that depreciation occurs twice in the formula.
6. Can you list all four capital items, which are included in the Balance Sheet?
7. Why don’t we include capital costs in the FCF Model?
8. An increase in Current Assets provides for/uses funds. Which is it? Why?
9. On what basis do we distinguish between “internal” and “external” funds?
10. List some internal and external funds.
11. Calculate the External Funds Needed formula for the LCM Company (below), based on the following assumptions.
• Last year’s sales were \$5,000 million.
• Next year’s objective is to increase sales by 30%.
• Variable costs will be 70% of sales. (Variable costs change with sales volume.)
• Fixed Costs are expected to run 30% of P, P, & E (Fixed costs do not change and are unrelated to sales volume.)
• Interest Expense is 5% of Notes Payable and 7% of Long-term debt.
• Taxes are 40%.
• The company expects to maintain its Payout Ratio at 20% of income.
What is the company’s EFN if it is to meet its growth objective?
1. What do this year’s three Solvency ratios look like?
2. Why will the company’s financial ratios change next year?
Selected Answers To Chapters 8 and 9
FCF Table
• You are ill-advised to do this by XL. Do it by hand. Place it in a Word table.
• One needs to figure EBIT by adding in the Income Statement data to the template in the chapter.
• “Last Year’s” numbers are not illustrated in this Spread Sheet.
• “Year 1’s” numbers follow “Last Year’s.” For example, Last Year’s Sales were \$15.5 Million. “This Year’s” sales increased by 15%. Therefore: (15.5) (1.15) = \$17.825.
• Be careful about the Current Assets and Current Liabilities numbers. We first calculate increases or decreases, not the gross numbers. Which data add to FCF?
(\$ Millions)
EFN Formula
(\$ Millions)
I have assumed, in the question itself, that the B/S and I/S data are stated in Thousands, rather than Millions. This is more palpable. Note that here, the numbers are simplified to Millions; it’s shorter. Assume that PR = 20%. Beware the differences!
• D/E = (900 + 475) / 1,415 = 0.97
• D / TA = (900 + 475) / (900 + 475 + 1,415) = 0.4828
• TIE = EBIT / I = 1.050 / 0.068 = 15.44x
• EFN = [(A0/S0) ΔS] [(AP0/S0) ΔS] [(M0) (S1) (RR0)]
• We will assume “Static Analysis.”
(\$ Millions)
• Sales and VC will change next year, but FC will remain the same. Therefore, we should see a change in the net profit margin, and changes in the dividend paid and retention rates – assuming no change in payout (percent of earnings) policy. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/02%3A_Part_II-_Ratio_Analysis_and_Forecasting_Modeling/09%3A_Corporate_Forecasting_Models/9.09%3A_Summary-_The_Fundamentals_of_Accounting_and_Financial_Analysis.txt |
Learning Outcomes
In this chapter, you will:
• Calculate Simple Future- and Present-Values both mathematically and with a simple calculator, and by using an Interests Rates Tables.
• Apply the Three Commandments of the Time Value of Money (TVM).
• Differentiate between simple interest and interest-on-interest.
• Consider the curvilinear nature of compound interest and TVM.
• Compare the relative volatilities of short-term versus long-term cash flows.
Note: Review questions for Chapters Ten and Eleven will appear at the end of Chapter Eleven.
10.02: The Time Value of Money and Interest
Key Terms:
Future Value
For each of the following questions, assume you have \$1 and that interest on it will be paid in full, at the END of the stated period. What are the future values (FVs) given each of the following questions? In other words, how much money will you have at the relevant future points in time? (If you had more than \$1, the answers would be the appropriate multiple thereof.)
Present Value
As we go through the questions and calculations, observe how the outcomes, or solutions, change. Try to explain the reasons for the differences in the outcomes. Also, observe that the seemingly small differences in outcomes are really not as trivial as may seem at first glance. We are illustrating Future Values, in each question, of just one dollar of money that we have now – of Present Value. Suppose we were instead dealing with millions of dollars?
As we go through each question, we will, methodically and painstakingly, create a general symbolic formula, which may be employed for any similar problem. Insert the appropriate values into the formulae to solve the problems numerically. (Solutions follow.)
1. You will earn 5% interest, paid once a year, at the END of the year, for one year.
You have \$1 now of Present Value (PV). In one year, you will receive your “principal” of \$1 back plus interest at an annual rate of return (R) of 5%. A general Future Value (FV) formula will therefore be:
FV = PV (1 + R)
Insert the relevant data into the formula in order to solve for the Future Value.
As we go through this analysis, you will need to learn and remember the symbols or abbreviations.
2. Same as question #1, but R = 10%.
Here we will use the same formula as above, but you will insert a different rate for R. What is the Future Value? Why is the outcome different?
3. Same as question #2, i.e., R = 10%, but for two years (n years), rather than just one.
We will now have two years of compound interest; n = 2. Therefore, we apply the FV formula, slightly modified, a second time:
FV = PV (1 + R) (1 + R)
FV = PV (1 + R)n
Here, the exponent, “n,” stands for the number of years in which the money compounds.Once again, in this case, n = 2. What is the Future Value? Why is the outcome different than in the prior question?
4. 10% interest, twice a year, for one year.
Interest is always quoted as an annual rate, unless explicitly noted otherwise.
Our annual rate is still 10%, but we will receive half of it, i.e., R ÷ p = 0.10 ÷ 2 = 0.05, at the end of each half-year. The letter, “p” stands for the number of compounding periods per year; here p = 2.
FV = PV (1 + R/p)(1 + R/p)
Notice that, while n = 2, there are now two compounding periods per year, so the exponent must reflect that. Our exponent is therefore now: “n × p.
Whenever p ≠ 1, we must make two adjustments to the formula: “R/p” in the rate part of the formula and “n × p” in the exponent. While in theory P can take on any integer value, it will actually be equal to 1, 2, 4, 12, or 365 for annually, semi-annually, quarterly, monthly, or daily respectively. (In this example, n = 1; when p = 1, we tend to leave it out as the power of one is implicit.) Our general formula now becomes:
FV = PV (1 + R/p)n × p
Our Future Value formula is now complete. What Future Value do you get? Why is the outcome different than in question #2?
Factor
Multiplier
Exponential
Compounding
Note that, when solving for Future Value, we multiply the Present Value by a “factor” of (1 + R/p) n × p. A factor is simply a multiplier. This multiplicative and exponential process is referred to as compounding.
5. Same as question #4, but for two years.
We can employ the formula in the prior question. Remember, “p” occurs twice in our formula. Here, n = 2, and p = 2. What is your Future Value? Why is the outcome different than in question #3?
6. What happens to future values as interest rates (“R”), the number of years (“n”), and compounding frequency (“p”) increase? In answer to this question, we present, in summary, the “Three Commandments” of the Time Value of Money.
The Three Commandments of TVM
Of course, the opposite will occur if R, N, and/or P decline. Below, we explain Present Values.
7. For each of the above questions, what would be the present value of \$1 to be received at the end of the stated periods? Here, we will re-employ our Future Value formula, but transpose the FV and PV numbers so that we can solve for PV, rather than for FV.
PV = FV ÷ (1 + R/p)n × p
Discounting
Reciprocal
Thus, when solving for Present Value we divide the Future Value by the (1 + R/p) n × p factor. This division process is referred to as discounting.
Rather than dividing, we can also multiply the Future Value by the reciprocal of the divisor.
PV = FV × [1 ÷ (1 + R/p)n × p]
Definition: A reciprocal is the inverse of a number, which is arrived at by turning the number upside down! So, 1/2 or 0.5 is the reciprocal of 2. The reciprocal of 5 is 1/5 – or 20%. So, (1 + R/p) n × p and [1 ÷ (1 + R/p) n × p] are reciprocals of one another.
In using Interest Rate Tables (soon), which display ready-made, already-calculated factors, you will note that all the factors’ values are stated as multipliers, including the Present Value Factors (PVFs). We will use tables in order to cut down on the number of calculations that we must make and to thereby reduce errors.
8. Is it a realistic question to ask what the PV is? How might this actually occur?
Of course it is! We will often know the future payments and wish to figure out the PVs! For example, you may wish to put aside some money for the down payment on a house in “n” years. Assuming you know the “discount rate, how much must you set aside today in order to fund that amount? How much will you need to set aside today to fund your newborn child’s college tuition? A bond pays interest every six months in a known amount. How much should you pay today in order to receive those future amounts?
Solutions and Explanations:
The \$1 in the question is referred to as Present Value (PV). The amount of money we will have in the future is referred to as Future Value (FV). Remember, we are, so far, assuming that the interest payments are made at the end of each relevant payment period.
An investment in knowledge pays the best interest.
-Benjamin Franklin | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/10%3A_The_Time_Value_of_Money-_Simple_Present-_and_Future-Values/10.01%3A_Chapter_Ten-_Learning_Outcomes.txt |
After one year (as noted in the example above), the investor will have earned \$0.10 for every dollar invested at 10%. This was represented by the formula: \$1 (1.10) = \$1.10.
We noted that if the investor had invested for two years (again at 10% per year) he would have \$1.21. This was represented by: \$1 (1.10) P2P= \$1.21. In other words, in the first year, s/he earned \$0.10 in interest, while in the second year, he earned \$0.11. Why does he earn more interest in the second year if the interest rate – 10% – remains the same?
In the second year, he once again receives \$0.10 interest on his principal investment of \$1. However, since he has already earned \$0.10 of interest from the prior year, he will also earn 10% on that dime! That is equal to another penny of interest earned: (\$0.10) (10%) = \$0.01. Thus, in the second year he will have earned another \$0.10 plus \$0.11 or a total of \$0.21. The following summarizes this notion:
This is the nature of interest-on-the-interest: Compound Interest! Each year, the interest-on-the-interest will continue to compound.
10.04: Some More Simple TVM Problems
What is my Future Value under the following scenarios? (After each solution, write out the equivalent mathematical, symbolic notation.)
Scenario 1: Assume I have \$1 and I invest for one year, receiving an interest payment of .12 at the year’s end.
\$1 (1.12) = ___________
Scenario 2: What if I invest for two years, receiving an interest payment of .12 at the end of each year?
\$1 (1.12) (1.12) = \$1 (1.12)2 __________
Scenario 3: What if Scenario 1 is changed to account for semi-annual compounding?
\$1 (1 + .12/2) 1 x 2 = __________
Scenario 4: What if Scenario 2 is changed to account for semi-annual compounding?
\$1 (1 + .12/2) 2 x 2 = __________
• If I know the Future Value of \$1, how do I calculate the PV? Solve for each.
Note:
Asking what is the present value of some money to be received in the future, is equivalent to asking how much money is needed today in order to have a certain amount later, assuming a given investment rate. In other words, for a person to have one dollar five years from now, i.e., FV, how much will s/he have to invest today at x%?
Some More Simple TVM Problems (Solutions)
1. \$1 (1.12) = \$1.12
2. \$1 (1.12) (1.12) = \$1 (1.12) 2 = \$1.2544
3. \$1 (1 + .12/2) 2 x 1 = \$1 (1.06) 2 = \$1.1236
4. \$1 (1 + .12/2) 2 x 2 = \$1 (1.06) 4 = \$1.2625
Notice how the above solutions display the fundamental principles of the Time Value of Money about which we already spoke. Namely, as interest rates, the number of compounding periods per year, and time increase, the Future Value increases and the Present Value decreases.
It is very easy to make mistakes in doing these calculations. For example, remember that the compounding frequency adjustment, “p,” occurs twice in the basic TVM formula; don’t forget to make the relevant adjustments here. Be methodical and go slowly.
In the end, “eyeball” your solution. If it does not look right in terms of the TVM rules that we already know, it probably is not! It will look correct if it seems to be consistent with the above-cited characteristics of TVM.
So far, in all the foregoing examples, we have used \$1 as present value. This makes it easy to learn and allows one to focus on the manner in which present and future values multiply out. In reality of course, present values would be other, greater numbers, such as \$1,237,874.32. All one need do is substitute in the relevant number where heretofore we had the lonely \$1 value.
Time is money.
-Benjamin Franklin
10.05: Simple Future and Present Values (Formulas)
Having done the foregoing work, it is plain to see that we can symbolically represent the mathematics using the following “language.”
Key:
The expression, or “factor,” (1 + R/p) n x p, may be used as a “multiplier” when compounding from present to future values and, in its reciprocal form, as a multiplier again when discounting from future to present values. You will find the factors, calculated out, in interest rate tables, truncated versions of which you will find on the pages following.
“R/p” means that if the annual interest rate (R) is 12% and the number of compounding periods (p) is 12 (i.e., monthly compounding) the periodic compound rate is .12 ÷ 12 = .01. After one year, the FV would be \$1 (1.01)12 = \$1.1268. (Notice that this compares with onceayear compounding at 12%: \$1 (1.12) = \$1.12. The difference in Future Values is nottrivial.
10.05: Simple Future and Present Values (Formulas)
Having done the foregoing work, it is plain to see that we can symbolically represent the mathematics using the following “language.”
Key:
The expression, or “factor,” (1 + R/p) n x p, may be used as a “multiplier” when compounding from present to future values and, in its reciprocal form, as a multiplier again when discounting from future to present values. You will find the factors, calculated out, in interest rate tables, truncated versions of which you will find on the pages following.
“R/p” means that if the annual interest rate (R) is 12% and the number of compounding periods (p) is 12 (i.e., monthly compounding) the periodic compound rate is .12 ÷ 12 = .01. After one year, the FV would be \$1 (1.01)12 = \$1.1268. (Notice that this compares with onceayear compounding at 12%: \$1 (1.12) = \$1.12. The difference in Future Values is nottrivial.
10.06: Compounding Frequency Assumption
Let’s examine the effect of changing the compounding (or discounting) frequency on both the Present- and Future-Values. Assume that we earn 10% for five years (R = 0.10; n= 5). Assume that we are given \$1 of Present- and Future-Values respectively.
Notice how, as “P” increases, FVs increase, and PVs decrease – both at decreasing rates!
The mathematics for continuous compounding and discounting follow on the next page. You will note that the difference between daily and continuous compounding and discounting is very small. Today, we don’t often – if ever – see instruments that exhibit continuous compounding. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/10%3A_The_Time_Value_of_Money-_Simple_Present-_and_Future-Values/10.03%3A_Interest-on-the-Interest-_The_Nature_of_Compound_Interest.txt |
In order to solve for continuous compounding, we must engage the “rule of limits” or otherwise utilize the “natural log.” The natural logarithm is the logarithm to the base e, where eis equivalent to the irrational number 2.71828. The following presents an exemplary solution for continuous compounding.
FV = PV (e Rn)
and
PV = FV (e -Rn)
Where, e = 2.71828
R = interest rate
Note:
P is omitted since the compounding is continuous rather than periodic.
Example: PV = \$1
R = .09
N = 10 years
FV = ?
Solution: FV = (\$1) (2.71828 (.09) (10) )
= \$2.4596
10.07: Simple Future and Present Values- Continuous Compounding (
In order to solve for continuous compounding, we must engage the “rule of limits” or otherwise utilize the “natural log.” The natural logarithm is the logarithm to the base e, where eis equivalent to the irrational number 2.71828. The following presents an exemplary solution for continuous compounding.
FV = PV (e Rn)
and
PV = FV (e -Rn)
Where, e = 2.71828
R = interest rate
Note:
P is omitted since the compounding is continuous rather than periodic.
Example: PV = \$1
R = .09
N = 10 years
FV = ?
Solution: FV = (\$1) (2.71828 (.09) (10) )
= \$2.4596
10.08: Characteristics of the Time Value of Money- FV and PV
The following summarizes and reviews some key characteristics of the Time Value of Money about which we already learned.
• As the interest rate increases, Future Value also increases.
• As the number of total periods (n × p) increases, the Future Value increases
• As the compounding frequency per year increases, the Future Value increases
• Restate each of the above statements for Present Values.
• FV and PV factors – or multipliers – are reciprocals of one another.
You will find below a partial interest rate table. If you use such tables properly, you will be able to locate the correct multipliers – or “factors” – for a given situation. You will note that the PV factors are expressed as the reciprocals of their corresponding FVs. In order to arrive at the FV or PV of a specified dollar amount, one need only choose the correct cell and multiply the specific dollar amount by the factor.
For example, the FV of \$1 at 5% for ten years is \$1 × 1.6289. The PV for 10% compounded semi-annually for five years is \$1 × .6139.
In cases where we have more than one compounding or discounting period per year, we would need to make the same adjustments that were made mathematically earlier. For example, the multiplier for 10% and 5 years semi-annually would be found under the 5% column and 10-period row. “Period” in the tables would be equivalent to “n × p” in our, more mathematical, nomenclature.
10.09: Future and Present Value Factors (Multipliers)
Here is another look at a somewhat less abbreviated interest rate table. Assume that we are given \$1 of Present- and Future-Values respectively. (Fill in the empty column by hand and compare your answers to the factors in the published tables; see the link to Interest Rate Tables below.) Note that, in using tables, “Periods” = n × p.
Future Value Factors Formula: FV = PV (1 + R/p) P n x p
Present Value Factors Formula: PV = FV ÷ (1 + R/p) P n x p
Here are some interest rate tables for you to use:
http://www.retailinvestor.org/pdf/futurevaluetables.pdf
10.09: Future and Present Value Factors (Multipliers)
Here is another look at a somewhat less abbreviated interest rate table. Assume that we are given \$1 of Present- and Future-Values respectively. (Fill in the empty column by hand and compare your answers to the factors in the published tables; see the link to Interest Rate Tables below.) Note that, in using tables, “Periods” = n × p.
Future Value Factors Formula: FV = PV (1 + R/p) P n x p
Present Value Factors Formula: PV = FV ÷ (1 + R/p) P n x p
Here are some interest rate tables for you to use:
http://www.retailinvestor.org/pdf/futurevaluetables.pdf
10.10: A Word on Compounding Frequency and Annual Equivalent Rate
Questions:
1. What is the difference between 10% annual rate, compounded annually versus a 10% annual rate, compounded quarter- in terms of FV of \$1?
2. How may the two rates be equated? In other words, how may I define the annual frequency at a rate equivalent to the quarterly frequency?
3. What happens as the compounding frequency increases?
Solution to Question #2:
In general, (1 + R/p) np = FV
Annually, (1.10) 1 = 1.10
versus
Quarterly, (1 + .10/4) 1 x 4 = (1.025) 4 = 1.1038
That is, 10% quarterly is equivalent to 10.38% annually!
In other words, the Annual Percentage Rate (APR) for 10% compounded quarterly, is 10.38%! | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/10%3A_The_Time_Value_of_Money-_Simple_Present-_and_Future-Values/10.07%3A_Simple_Future_and_Present_Values-_Continuous_Compounding_%.txt |
What if we have a fractional compound or discount rate – such as 9.5% – which is not to be found in published tables? Can we still use the tables? Or do we need to solve the problem mathematically (or by financial calculator)?
One way to get around this is by estimating the multiplier by means of averaging the two whole multipliers that bracket the fractional one in question. We call this process “interpolation” because we insert the average number in between the relevant values or factors, which are stated in the table. Let’s use the future value table below to illustrate this.
Future Value Factors
What is the appropriate, estimated future value multiplier for 10 years at 9.5%? This can be approximated by taking the simple average of the multipliers for 9% and 10%:
(2.3674 + 2.5937) ÷ 2 = 2.4806
This is only an estimate. Remember that time value factors increase (in this case – or decrease in the case of present values) at an exponential rate. The true mathematical future value for 9.5% for 10 years is:
1.09510= 2.4782
This differs from the simple average estimate, of 2.4806 – 2.4782 = 0.002. We first note that the simple average produces a higher number than the true, exponential figure; this is notable. This is as expected because, in dealing with future value factors, the numbers grow exponentially or more quickly, and thus we would start off with a lower number. Put differently, we do not grow from 9% to 10% at a linear rate, but at an increasing, curvilinear rate.
10.12: Interpolation Illustrated
Interpolation may be useful in order to estimate future (and present-) values when one does not wish, or have the ability, to calculate more precise measures. The reason for the error has to do with the curvilinear relationship between (discount- and) compound interest rates and their related multipliers. This is best seen by illustration.
One may readily see that, by connecting the asterisks, the interpolated value of 2.4806 resides on a straight line between the correctly calculated future value multipliers for 9% and 10% respectively.
However, the time value of money is not linear. Any time an exponent is involved, you will not get a linear relationship, but a curvilinear outcome of some sort. Hence, the correct multiplier for 9.5% is 2.4782, which is lower than the interpolated arithmetic average of 2.4806. If one joins the asterisks for 9% and 10% to the mathematically calculated middle value of 2.4782 (represented by “#”), one readily observes the curvilinear relationship between compound interest rates and their respective multipliers. In short, as rates increase, future values increase in non-linear fashion. Correspondingly, present values would decrease non-linearly. The non-linear nature of these curves will soon be discussed in greater depth when we get to “Volatility.” Basic mathematical examples will be presented.
10.13: Some TVM Practice Questions
You will need to solve all these problems by hand. You will not be able to use the tables.
1. You are given the following. Investment = \$2,800, Rate = 0.54%, P = quarterly, N = 8 years. What is the Future Value?
2. You are given two choices: 1. invest at an annual rate of 10% compounded monthly, or 2. at 10.1% compounded semi-annually. Which will you prefer?
3. Bonus question: You will receive \$24,000, \$29,500, \$58,000 and \$87,000 each year consecutively for the next four years. What are both the Present- and Future-Values of this unevenincome stream? Assume an annual rate of 4.6%. (We will learn how to do Uneven Cash Flowsafter we do Annuities– below.)
Solutions
1. (\$2,800) (1 + 0.0054/4) 8 x 4= \$2,923.5256
2. First Choice: (1 + .10/12) 1 x 12 = 1.1047 This is the one.
Second Choice: (1 + .101/2) 1 x 2 = 1.1036
3. Present Value =
(\$24,000 ÷ 1.046 1) + (\$29,500 ÷ 1.0462) + (\$58,000 ÷ 1.0463) + (\$87,000 ÷ 1.0464) =
\$22,944.55 + \$26,962.41 + \$50,679.57 + \$72,676.25 = \$173,262.78
Future Value =
(\$24,000 × 1.0463) + (\$29,500 × 1.0462) + (\$58,000 × 1.0461) + (\$87,000 × 1.0460) =
\$27,466.69 + \$32,276.42 + \$60,668 + \$87,000 = \$207,411.11
Notice the nature of the exponents in the Future Value calculation; the exponents decrease as we near the horizon. Interestingly, it is also true that \$173,262.78 ×1.0464 = \$207,411.11. If you had already calculated the Present Value of this uneven series of cash flows, you would not have had to go through the long calculation of the Future Value.
(If you have trouble with this, it’s OK. We will get to Uneven Cash Flow series soon. You can come back to it later.) | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/10%3A_The_Time_Value_of_Money-_Simple_Present-_and_Future-Values/10.11%3A_Interpolation.txt |
Discrepancies in TVM factors will widen as time increases, as one observes the relative factors between interest rate columns.
For example, a five-year IOU with a future value of \$1,000, using the tables, would have a present value of \$1,000 (0.7835) = \$783.50 – at a discount rate of 5%. The IOU could be purchased or sold for that amount, or price. Think of present value as an item’s dollar price. If the discount rate instead were 10%, the present value would be only: \$1,000 (0.6209) = \$620.90. In percentage terms, the present value of \$1,000 to be received five years from now, discounted at a rate of 5% is greater than at 10% by a difference of (783.5 ÷ 620.9) – 1 = 26.2%.
If however the IOU had a 30-year term, the difference in present value would itself compound. At 5%, the present value would equal \$1,000 (0.2314) = \$231.40. At 10%, the PV would equal \$1,000 (0.0573) = \$57.30. In percentage terms, the present value of \$1,000 to be received thirty years from now, discounted at a rate of 5% is greater than at 10% by a difference of (231.4 ÷ 57.30) – 1 = 303.8%.
Key Terms:
Geometry
This demonstrates the volatility and geometry of TVM! By geometry here we refer to its non-linear and exponential nature. Whenever there is an exponent in a formula, we get some kind of curve. As time increases, differences in present- and future-values for a given number of years themselves increase non-linearly.
If you had purchased a thirty-year IOU as an investment, any changes in interest rates (i.e., due to market conditions) would have a far greater impact on the value of your IOU investment than if you had, instead, purchased a five-year obligation. For a given change in discount rates of interest, the impact on the multipliers is greater the greater the time is. The impact on price, which is present value, is greater, the greater the timeperiod. “Price volatility,” so to speak, increases as the future payment grows more distant.
Again, this is because, the time value of money is non-linear; it is exponential. We are dealing, quite literally, with compound interest, i.e., interest on the interest. Holders of long-term fixed obligations, such as bonds, may experience greater price, or market value fluctuations, when discount rates for their bonds suddenly change.
Bonus Question: In the example above, we examined the increase in the Present Value Factor when interest rates drop from 10% to 5%. What would be the percentage change in the Factors if rates increased from 5% to 10%? Would it be same percentage change?
The virtually instantaneous changes in present values, when going from a discount rate of 10% to 5%, increases(“first derivative”) at a decreasing rate(“second derivative”). The table displays the extent to which 5% discounted present values exceed 10% discounted values.
When going from 10% to 5%, a five-year payment will increase in value about 26%, while a thirty-year payment by over 300%! Imagine if you could buy an IOU at 10% and immediately (“instantaneously”) turn around and sell it at 5%! Your profit would be much greater had you invested in the thirty-year obligation. While this case is exaggerated, the bond market works in similar fashion. Bond prices can, at times, be quite volatile due to changes in market rates although large changes do not occur instantaneously) except in the case of a disaster). Remember: prices are the present values of a bond’s future payments!
These relationships can also be illustrated using Differential Calculus, which would give you a more “continuous,” rather than a “discrete,” view of the progress of the numbers.
The Take-away: If interest rates change, (bond) prices could change dramatically!! | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/10%3A_The_Time_Value_of_Money-_Simple_Present-_and_Future-Values/10.14%3A_The_Volatility_of_the_Time_Value_of_Money.txt |
• We have just demonstrated that changes in longer-term discount rates affect present value (i.e., prices) more than in the case of short-term rates and cash flows. In our example, the rate of changes in present value factors increased in time, e.g., from 26%, to 101%, to 303%.
• However, the rate of increase is decreasing (i.e., “deceleration” or second derivative), e.g., from 126%, to 71%, to 38%.
• In Calculus, we would say here that the first derivative is positive while the second derivative is negative. If we think of the price of the cash flows as distance covered as a function of time (“speed”), then we can think of the “First Derivative.” We can think of the “Second Derivative” here as the change in the rate of speed (“deceleration”) Were the second derivative positive, we would be speaking of “acceleration.” We observe these characteristics in this diagram:
Imagine a payment due in the future; its present value would be determined by its rate – a short-term rate (and PVF!) for a short-term payment and so on. The rate of change in present value was noted in the first derivative column, while the rate of change in the rate of change in the present value was noted in the second derivative column.
In other words, as time increases, the differences in present values – for 5% versus 10% – increase, but the rate of increase decreases! Remember: the price of a financial asset today is its present value!
The Take-away (again): If rates change, prices (i.e., present values) could change dramatically!!
Interest (lit. “bite”). Exodus, 22:24: “Bite” means “interest,” since it is like the bite of a snake, which bites a small wound on one’s foot, which he does not feel, but suddenly it swells and blows up as far as his head. So, with “interest,” one does not feel (it) and it is not noticeable until the interest increases and causes him to lose much money.
-Rashi’s commentary on the Bible.
(Translated by Ben Isaiah and Sharfman, Brooklyn, NY: S. S. & R. Publishing Company, 1949)
On Work
Success in business requires training and discipline and hard work. But if you’re not frightened by these things, the opportunities are just as great today as they ever were.
-David Rockefeller
Economist and Banker
If you train hard, you’ll not only be hard, you’ll be hard to beat.
-Herschel Walker
American professional football player
and Politician
What doesn’t kill me makes me stronger.
-Friedrich Nietzsche
German Philosopher
Whenever heaven is about to confer a great responsibility on any man, it will exercise his mind with suffering, subject his sinews and bones to hard work, expose his body to hunger, put him in poverty, place obstacles in the path of his deeds, so as to stimulate his mind, harden his nature, and improve wherever he is incompetent.
-Meng Tzu, Third Century B.C.E.
Quoted in The Coddled Mind, Chapter One, by Jonathan Haidt
Ben Heh-Heh used to say: “According to the effort is the reward.”
-Mishnah, Avoth, 5:26
No pain, no gain.
-Somebody
When the goin’ gets tough, the tough get goin’.
-Somebody Else | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/10%3A_The_Time_Value_of_Money-_Simple_Present-_and_Future-Values/10.15%3A_The_First_and_Second_Derivatives_Illustrated.txt |
Learning Outcomes
In this chapter, you will:
• Derive the additive nature of Annuities.
• Calculate both Future- and Present-Value Annuity dollar values, using a simple calculator and Annuity Tables.
• Adjust Ordinary Annuity factors to Annuities Due.
• Relate the Law of Limits to Perpetuities.
• Provide the numerical analysis of No-Growth and Constant Growth Perpetuities, and Mortgages.
• Determine the total amount of interest paid on a mortgage over time in comparison to the principal originally borrowed.
11.02: Annuities
An annuity is a series of cash flows that must satisfy both of the following conditions, in order to qualify as an annuity, namely it:
• Consists of equal dollar amounts.
• Arrives (or leaves) in regular intervals.
If a series of cash flows may be defined as an annuity, we will employ an Annuity Table to figure the series’ FV/PV.
In investments, most (if not all) annuities may be qualified as “Ordinary Annuities,” since their cash flows occur at the end of the relevant periods.
Other annuities are called “Annuities Due,” meaning that the CFs occur at the start of the relevant periods.
If, as in most cases, the cash flows do not qualify as an annuity, then their FV/PVs may be derived only by calculating the FV/PV of each discrete CF and then aggregating.
This is the same process by which we shall derivethe “short-cut” Annuity TVM factors.
11.03: The Derivation of (Ordinary) Annuity Factors
You are given the following information. Column by column, complete the table by filling in the appropriate future value factors (FVF), the future values of each respective cash flow (FVCF), as well as the same for the present value factors and cash flows (PVF and PVCF). Once completed, add up the columns at the bottom.
Note that here we are dealing with “ordinary” annuities, which means that all the cash flows in the series are received at the end of the relevant period. Soon, we will examine another convention. Use the timeline below to properly place each of the three cash flows temporarily (see the timeline below). Placement will determine the proper exponents and hence periods.
Given:
3-year annuity
\$100 received per year.
Annual Discounting/Compounding Factor = R = .10
Code:
FVF = Future Value Factor
FVCF = Future Value of the Cash Flow
PVF = Present Value Factor
PVCF = Present Value of the Cash Flow
CF1 = First Cash Flow
CF2 = Second
CF3 = Third
11.03: The Derivation of (Ordinary) Annuity Factors
You are given the following information. Column by column, complete the table by filling in the appropriate future value factors (FVF), the future values of each respective cash flow (FVCF), as well as the same for the present value factors and cash flows (PVF and PVCF). Once completed, add up the columns at the bottom.
Note that here we are dealing with “ordinary” annuities, which means that all the cash flows in the series are received at the end of the relevant period. Soon, we will examine another convention. Use the timeline below to properly place each of the three cash flows temporarily (see the timeline below). Placement will determine the proper exponents and hence periods.
Given:
3-year annuity
\$100 received per year.
Annual Discounting/Compounding Factor = R = .10
Code:
FVF = Future Value Factor
FVCF = Future Value of the Cash Flow
PVF = Present Value Factor
PVCF = Present Value of the Cash Flow
CF1 = First Cash Flow
CF2 = Second
CF3 = Third
11.04: The Derivation of Annuity Factors (Solution)
Below you will find the solution to the problem on the prior page. Note that if you had an interest rate table for annuities, you would be able to multiply the annuity cash flow (in this case, \$100) by the appropriate factor. You would then arrive at the future- or present-values of the cash flows, in one step. Such annuity interest tables exist; a link is provided at the bottom of this page.
What may we observe from this table? Future value annuity factors are always greater than the number of periods. Here the FVF was 3.31, or greater than n · p = 3 periods. This is because the annuity multiplier is the sum of each respective yearly factor, each of which is greater than 1.0 (except the last one, which = 1.0) since they are all multiples of (1 + R) n. (This assumes that R > 0.)
Contrarily, each PVF is less than the number of periods because the respective factors are all less than 1.0, as each factor is the reciprocal of (1 + R) n. (Again, this assumes that R > 0.)
When utilizing a table, it is always a good idea to “eyeball” the factors you are using to make sure you didn’t lift the figure from the wrong table or make some other error. Use your head at all times. Do not be a robot!
The present value of the annuity is \$248.68. If you, alternatively, had had a single sum in the amount of \$248.68, and had invested it for three years at 10%, you would have \$331 at the horizon:
(\$248.68) (1.10)3 = \$331
and
\$331 ÷ (1.10)3 = \$248.68
Here are some more simple- and annuity- interest rate tables for you to use: | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.01%3A_Chapter_Eleven-_Learning_Outcomes.txt |
Below you will find the solution to the problem on the prior page. Note that if you had an interest rate table for annuities, you would be able to multiply the annuity cash flow (in this case, \$100) by the appropriate factor. You would then arrive at the future- or present-values of the cash flows, in one step. Such annuity interest tables exist; a link is provided at the bottom of this page.
What may we observe from this table? Future value annuity factors are always greater than the number of periods. Here the FVF was 3.31, or greater than n · p = 3 periods. This is because the annuity multiplier is the sum of each respective yearly factor, each of which is greater than 1.0 (except the last one, which = 1.0) since they are all multiples of (1 + R) n. (This assumes that R > 0.)
Contrarily, each PVF is less than the number of periods because the respective factors are all less than 1.0, as each factor is the reciprocal of (1 + R) n. (Again, this assumes that R > 0.)
When utilizing a table, it is always a good idea to “eyeball” the factors you are using to make sure you didn’t lift the figure from the wrong table or make some other error. Use your head at all times. Do not be a robot!
The present value of the annuity is \$248.68. If you, alternatively, had had a single sum in the amount of \$248.68, and had invested it for three years at 10%, you would have \$331 at the horizon:
(\$248.68) (1.10)3 = \$331
and
\$331 ÷ (1.10)3 = \$248.68
Here are some more simple- and annuity- interest rate tables for you to use:
11.05: Future and Present Annuity Values- The Nature of Their
Compounding:
There are, altogether, four compounding “periods”; the last cash flow to be received is not compounded because it is received at the “horizon” of the deal. Indeed, the last CF does have a zero-exponent attached to it: [1 + R] 0 = 1. The exponents are zero through four.
Discounting:
In contrast, there are five discounting periods. The exponents are one through five. Note that the arrows go in the opposite direction from before as we are now discounting to present values rather than compounding to future values.
While Simple Future and Present Values factors (as observed by the relevant tables earlier) are reciprocals, or mirror images of one another, annuities are not.
11.06: Future and Present Annuity Factors- Mathematical Formul
Let’s “put on the table” the formal mathematical formulas for ordinary annuities’ factors. Remember: a “factor” is a multiplier (for the given cash flows). These formulae will be useful when your tables do not have a particular interest rate that you need, and especially when you need to calculate a fractional rate, e.g., 10.23%.
Key: PVAF – Present Value Annuity Factor. FVAF – Future Value Annuity Factor.
Example 1: R = 0.10; N = 5; P = 2
Solution 1: [(1) ÷ (0.10/2)] – [(1) ÷ (0.10/2) (1 + 0.10/2) 5 × 2] = 7.72173493
*This multiplier should be the same as in your Present Value Annuity Table.
Example 2: R = 0.095; N = 5; P = 2
Solution 2: [(1) ÷(0.095/2)] – [(1) ÷(0.095/2) (1 + 0.095/2) 5 × 2] = Fill in your answer
*This multiplier is not in your Present Value Annuity Table. Compare the two solutions.
Example 3: R = 0.10; N = 5; P = 2
Solution 3: [(1 + 0.10/2)5 x 2– 1] ÷0.10/2 = 12.57789253554883
*This multiplier should be the same as in your Future Value Annuity Table.
Example 4: R = 0.1012; N = 5; P = 2
Solution 4: [(1 + 0.1012/2) 5 x 2– 1] ÷0.1012/2 = Fill in your answer
*This multiplier is not in your Future Value Annuity Table. Compare the two solutions. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.04%3A_The_Derivation_of_Annuity_Factors_(Solution).txt |
Let’s review the basics of annuities:
• The number of periods counted in discounting versus compounding are different.
• The Future Value Annuity Factor (FVAF) must always be __________ than the number of compounding periods.
• The Present Value Annuity Factor (PVAF) must always be __________ than the number of discounting periods.
• FVAFs and PVAFs, unlike simple TVM factors, are not reciprocals of one another for the following reasons:
1. The counting of the time periods is different for each, i.e., the timelines and “arrows’ directions” are different, therefore so are the simple factors’ respective exponents!
2. The annuity factors are themselves the result of an additive (aggregating) process for which reciprocals do notapply, e.g., 1 ÷ (1 + 2 + 3) 1/1 + ½ + 1/3. The reciprocal of a sum is not equal to the sum of reciprocals.
The answers to the fill-ins above are:
• The FVAF must always be – greater – than the number of compounding periods.
• The PVAF must always be – less – than the number of discounting periods.
Notes:
1. Over 30 years, an investor who has invested \$100 per year at 10% will have put down \$100 ×30 = \$3,000 in nominal terms. The FV of the \$100 annuity at 10% in comparison will be \$100 ×164.49 = \$16,449
2. Notice how quickly both the present and future value annuity factors increase. That is because we are constantly adding additional cash flows each year. That is also why the PVAFs increase, in contrast to the simple PV factors, which, of course, may only decrease – as per our three commandments – as time increases.
Key:
PVAF = Present Value Annuity Factor
FVAF = Future Value Annuity Factor
11.08: Annuities- Practice Problems
For each of the following problems, solve for both the present- and future values of the given annuity – at the given rate and for the stated number of years. Try not to look at the solutions in the table below.
1. \$2000 each year for 5 years @ 5% = _________
2. \$1,000 each year for 10 years @ 5% = __________
3. \$1,000 each year for 10 years @ 10% = __________
4. \$500 every six months (semiannually) for 10 years @ 10% = __________
11.09: Annuities Due
Annuities Due
An “annuity due” is a type of annuity whose cash flows occur at the start of each period. To illustrate, we will use the example – and chart – from above. Since the timing of the cash flows is different than in an ordinary annuity, the factors (and exponents) are also different. As you fill in the factors and the dollar amounts, draw the appropriate timeline.
Question: What would be the PV and FV for the \$100 three-year annuity at 10%?
Timeline
Questions:
1. Notice that both PV and FV annuity due factors (and dollars therefore) are larger than the respective ordinary annuity factors.
2. The PV of an annuity due is equal to the PV of an ordinary annuity multiplied by one plus the discount rate (1 + R/P)1 for one period.
3. The FV of an annuity due is equal to the FV of an ordinary annuity multiplied by the compound rate for one period. Show this mathematically.
11.10: Annuities Due (Solutions)
Question: What would be the PV and FV for a \$100 three-year annuity due at 10%?
Note:
The PV and FV for an ordinary annuity with the same term (time), rate of interest, and dollar amounts, were calculated at \$248.68 and \$331 respectively. Since an annuity dueprovides each of its cash flows one period earlier than the ordinary annuity, the PV and FV of the annuity are both equal to the ordinary annuity multiplied by (1 +R/p)1. In this case, that would be:
\$248.68 (1.10)1 = \$273.55
\$331.00 (1.10)1 = \$364.10
Due to the fact that the cash flows come in sooner there are both more compounding periods and fewer discounting periods. The fewer number of periods leads to more compounding and less discounting, hence greater future- and present-values.
This is handy to know because most interest rate tables provide ordinary annuities factors, but not annuities due.
11.10: Annuities Due (Solutions)
Question: What would be the PV and FV for a \$100 three-year annuity due at 10%?
Note:
The PV and FV for an ordinary annuity with the same term (time), rate of interest, and dollar amounts, were calculated at \$248.68 and \$331 respectively. Since an annuity dueprovides each of its cash flows one period earlier than the ordinary annuity, the PV and FV of the annuity are both equal to the ordinary annuity multiplied by (1 +R/p)1. In this case, that would be:
\$248.68 (1.10)1 = \$273.55
\$331.00 (1.10)1 = \$364.10
Due to the fact that the cash flows come in sooner there are both more compounding periods and fewer discounting periods. The fewer number of periods leads to more compounding and less discounting, hence greater future- and present-values.
This is handy to know because most interest rate tables provide ordinary annuities factors, but not annuities due. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.07%3A_Characteristics_of_Annuity_Factors-_A_Review.txt |
The PV and FV for an ordinary annuity with the same term, rate of interest, and dollar amounts, were calculated earlier at \$248.68 and \$331 respectively. (See the table at the bottom of this page for a key summary of the differences in exponents.) Since an annuity due provides each of its cash flows one period earlier than the ordinary annuity, the PV and FV of the annuity is equal to the respective ordinary annuity factors multiplied by (1 +R/p)1. (Note that in all instances the exponent is one because the cash flows are pulled ahead just one period.) In this case that would be:
\$248.68 (1.10)1 = \$273.55
\$331.00 (1.10)1 = \$364.10
The fact that the cash flows are received (or paid) sooner in the example of an annuity due has an interesting implication (as noted in the adjustment formula above). In the case of the PV, there will be fewer discounting periods than with an ordinary annuity, so the PV will be higher. In the case of the FV, there will be more compounding periods, hence the FV is also higher. Again, in both instances, the ordinary annuity factor is adjusted by a multiple of (1 +R/p)1. Note that even when p ≠ 1, the exponent will always be one, representing just the one period (even if part of a year) in which the series is “pulled ahead.”
Question: How would the adjustment in our example be made if the compounding frequency instead were semi-annual?
Answer: In this case, one would multiply by (1 +R/p)1= (1 + 0.10 / 2)1= (1.05)1.
11.12: Uneven Cash Flows
Not all cash flows series are as neat as annuities. Using the TVM Tables, calculate both the PV and FV for the series of Uneven Cash Flows presented below. Assume a periodic discount/compound rate of 6%.
The method by which this exercise will be done is the same as that which was done for deriving ordinary annuity factors earlier – except that the cash flows here are uneven (or unequal) rather than all the same. While we have already done a similar exercise earlier, well, you know, practice makes perfect!
11.13: Uneven Cash Flows (Solutions)
Solution Guidelines: First, fill-in the first or uppermost cell in the PVF column by dividing 1 by 1.06; then fill in each subsequent lower cell by once again dividing by 1.06 iteratively – or by copying the rates from the tables. Next, multiply each cash flow horizontally by the appropriate PVF. Aggregate.
In order to complete the FVF column, start at the bottom-most cell and fill in 1.00; in the next cell up, fill in 1.06. As you go up, continue multiplying by 1.06. Remember, the arrows in the FV timeline are pointed in the other direction.
Take note of the fact that the PV of the series is less than its nominal value and that the FV is greater. You will also note that, if you know the PV of the uneven series, you can simply multiply it by (1 + Rn) in order to arrive at the FV of the series. Wow!
(If you were unable to solve question #3 on Some TVM Practice Questions, you can go back to it now.)
11.13: Uneven Cash Flows (Solutions)
Solution Guidelines: First, fill-in the first or uppermost cell in the PVF column by dividing 1 by 1.06; then fill in each subsequent lower cell by once again dividing by 1.06 iteratively – or by copying the rates from the tables. Next, multiply each cash flow horizontally by the appropriate PVF. Aggregate.
In order to complete the FVF column, start at the bottom-most cell and fill in 1.00; in the next cell up, fill in 1.06. As you go up, continue multiplying by 1.06. Remember, the arrows in the FV timeline are pointed in the other direction.
Take note of the fact that the PV of the series is less than its nominal value and that the FV is greater. You will also note that, if you know the PV of the uneven series, you can simply multiply it by (1 + Rn) in order to arrive at the FV of the series. Wow!
(If you were unable to solve question #3 on Some TVM Practice Questions, you can go back to it now.)
11.14: Uneven Cash Flows (Practice Problem)
For the following series, assume a discount/compound factor of 7%. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.11%3A_Adjustment_from_Ordinary_Annuity_to_Annuity_Due.txt |
For the following series, assume a discount/compound factor of 7%.
11.16: Uneven Cash Flows- Another Self-Test Practice Problem
• Fill in the empty cells. Use 8% as your compound and discount rate.
• What if the order of the cash flows were exactly reversed? Answer each of the following three questions below.
1. Would the nominal value of the cash flow (i.e., the bottom cell at left) be changed? Answer “Yes” or “No.”
2. Would the total PVCF increase/decrease/not change?
3. Would the total FVCF increase/decrease/not change?
11.17: Solution to Another Uneven Cash Flow Practice Problem
Answers to questions:
1. No change. When dealing with nominal figures, the order of the cash flows is irrelevant.
2. Higher – when larger cash flows come in sooner there is less discounting of the greater numbers – PVs increase!
3. Higher – when larger cash flows come in sooner there is more compounding of the greater numbers – FVs increase!
11.18: Perpetuities- No-Growth Perpetuities
Key Terms:
Perpetuity
Infinite
Nominal
A perpetuity is a series of equal cash flows that arrive in equal intervals and are never-ending, a kind of forever annuity. We cannot evaluate its FV since it would be infinite, as would be its nominal value. However, we can figure the PV.
The PV of a perpetuity is simply the (fixed) payment divided by the interest rate. For example, if the cash flows are \$100 and the discount rate is 10%, the PV would be:
PV = \$100 ÷ .10 = \$1,000
The general formula would thus be:
PV = CF ÷ i
This works because of the mathematical “law of limits.” Simply put, as the cash flows grow more distant, the respective PVs of these cash flows approach zero. Adding increasingly distant cash flows will have an infinitesimalimpact on the outcome, the present value. Thus, the sum can be calculated as mentioned. Let us examine this further.
For example, a \$100 annuity for five years at 10% has a PV of \$379.08. A ten-year annuity has a PV of \$614.46. An annuity of 25 years has a PV of \$907.70 and a 50-year annuity would be \$991.48. As time goes on, the PV of each additional year’s cash flow becomes very, very small (i.e., time increases, PV decreases) so that adding such infinitesimal amounts provides no material addition to the aggregate. In the end, you will note that the above present values, when aggregated, will eventually approach, and theoretically equal \$1,000.
It is interesting to note that where perpetuities are concerned the present value does not depend on compounding frequency (“p”). This appears to violate one of our inviolable rules of TVM! For example, the present value of a \$1,200 perpetuity paid monthly at 12% p.a. will be the same as a \$1,200 annual perpetuity:
PV = (\$1,200) ÷ (0.12) = (\$1,200/4) ÷ (0.12/4) = \$10,000
The frequency of perpetuity payments does not influence its future value, which will still be infinity! It is also interesting to note that, because a perpetuity is forever, both the nominal and future values of the perpetuity are the same – infinity!
This formula is applicable to preferred stock whose dividends are fixed.
11.19: The Law of Limits and Perpetuities
We have already seen that present value of a perpetuity can be described by the formula: P0 = CF ÷ i. We have also provided both the algebraic derivation of this formula and a discussion as to how the present value of a perpetuity approaches (but never quite reaches) the price described by the formula.
Still, many students find the idea of limits – and of the infinitesimal – difficult to grasp. Our intent here is to further elucidate the notion that present values decrease over time with the result that distant cash flows become so small, so infinitesimal – they have so many decimal places – that they add virtually nothing to the aggregate present value. In making this observation, you will also note that, as a result, the cumulative value of the perpetuity’s present value approaches the theoretical price described by the formula, as posited by mathematicians. This is as it should be.
Let us say that a perpetuity’s cash flows are \$1 and the interest rate at which we shall discount the series is 10%. The present value therefore would be: P0 = \$1 ÷ .10 = \$10. This is confirmed in the table below.
After 25 years, we reach 90% of the aforecited aggregate present value, and by the 50thyear, we exceed 99% of the \$10 value. With the passage of more time, we shall get closer and closer to \$10, but only reach \$10 in infinite space.
Perpetuities: Pondering the Infinite
He counts the number of the stars; to all of them, He assigns names.
-Psalms 147:4
Lift high your eyes and see: Who created these? He who sends out their host by count, who calls them each by name: Because of His great might and vast power, not one fails to appear.
-Isaiah 40:26
If you always put limits on everything you do, physical or anything else, it will spread into your work and into your life. There are no limits. There are only plateaus, and you must not stay there, you must go beyond them.
-Bruce Lee | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.14%3A_Uneven_Cash_Flows_(Practice_Problem).txt |
A “growth” perpetuity is a perpetual cash flow stream (CF) that grows at a constant rate of growth, which we shall call “g.” It is a special case of perpetuity. If, in the last period, we received a cash flow of \$100 and its growth rate is 5%, the next cash flow would follow this formula: (Last Cash flow: CF0) (1 + g) = Cash flow in next period (CF1). “G” represents a constant rate of growth in the cash flow over time.
CF1 = CF0 (1 + g)
\$105 = \$100 (1.05)
The formula for a growth-perpetuity is: (Cash flow next period) ÷ (Discount rate – Growth rate). Symbolically, this may be expressed as:
PV = CF1÷ (r – g)
In the above example (where r = 0.10), if the growth rate had been 5%, the present value would be (assuming here that the next CF is \$105, that is, [\$100] [1.05] = \$105):
\$105 ÷ (.10.05) = \$2,100
Notice that for this formula to work, “g” cannot equal or exceed “r.” Mathematically, if g exceeds r we would get a negative denominator, resulting in a negative present value, which makes no sense. A mathematical rationale, while necessary, is however not sufficient to justify this relationship. There must be a financial explanation.
One, theoretically, earns some positive return – “rfor investing in a no-risk asset[1]; otherwise, no one would invest at all. Even with no risk (and no growth!), there is a positive return. Therefore r > g. As growth rates increase (in linear manner), so too does risk; higher growth rates are more difficult to achieve and hence are riskier. R (“r”) should exceed g, as a practical, non-mathematical matter. This is depicted in the diagram below.
Key Terms:
Negative Growth
This formula may also come in handy for cases of negative growth. Since “g” would be negative, in this case, the formula would require that one add the growth rate to the interest rate in order to determine the present value.
Suppose the last cash flow (CF0) was \$100, there is a nominal cash flow growth rate of negative 5%, and a discount rate of 10%. What would the present value be?
[(\$100) (1 – (0.05)] ÷ [.10 – (-.05)] =
\$95 ÷ .15 = \$633.34
Of course, the PV in the case of positive growth far exceeds the outcome we observed with negative growth. Is that not as it should be?
This formula is applicable to common stock, whose dividends may grow – positively or negatively.
Note:
Looking at this graph alone one may conclude that, at some point, r < g. This is because the line is steeper than at a horizontal plane, thus, there would be less “rise” than “run,” leading eventually to growth exceeding the discount rate, and producing a negative present value. While this may be true if one limits the analysis to the graph alone, it cannot be correct, in fact, that dividend growth is not reflected in return – which is also the discount rate, and part of the denominator. As dividends rise, so too must return. (Remember: discounting and compounding are the same; just the arrows go in different directions.) This anomalous and paradoxical case will be discussed in depth when we discuss the “Dividend Discount Model.”
1. As this is being written (2021), we observe an unusual environment wherein interest rates in many parts of the world are negative. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.20%3A_Growth_Perpetuities.txt |
So far, we have dealt only with whole periods and, therefore, whole exponents. True, you may argue that we have also broken whole periods into halves (or other pieces), such as (whole period) half years, so that, for example, an annual rate of 10% compounded / discounted semi-annually became 5% per period; exponents were still whole numbers. But let’s not stop here!
Occasionally, cash flows may occur before the end of a period. Suppose you earn 10% per year, compounded daily. What would be the FV after ¾ of a year?
If we assume a 360-day year13, ¾ ×360 = 270 days. (In short-term financial analysis, we often deal with, or otherwise assume, twelve 30-day months to a year.) Further, 10% ÷360 = .0002777. Therefore, after 270 days, you will have earned:
\$1 (1 + .10/360) 270 =
\$1 (1.0002777) 270 = 1.077850
By comparison, if the compounding period is three months or a quarter of a year, then:
1 (1 + .10/4) 3= 1.0769
If, in fact,the compounding period is a whole year, then we may employ a fractional exponent:
1 (1.10) 3/4= 1.0741
All of the foregoing choices are arithmetically correct. The compounding convention you use matters. In practice, you will have to know the proper convention commonly used in each situation.
Here are some more examples. Notice that if we calculate the FV of \$1 at 10% annually, after half a year we would have arrived at an FV of \$1.05 (\$1 (1 + .10/2)1) – as we may have assumed until now. However, if we use fractional exponents, we get a slightly different result:
\$1 (1.10)1/2 = \$1.048809
\$1 (1 + .10/2)1 P ≠ \$1 (1.10)1/2
It is therefore very important to understand the context of the problem and the use of the appropriate compounding/discounting convention.
The Take-away: Compounding assumptions matter. Be sure you use the correct assumptions.
11.22: Loans- The Conventional Mortgage
Mortgages are different from ordinary loans. With most loans, interest is paid over the term, or life, of the loan, and the entire principal is paid in one fell swoop at the loan’s term, or maturity. In contrast, mortgages are self-amortizing, which means that all payments include portions of both interest and principal, resulting in decreasing principal balances over time until, at maturity, the entire loan will have been paid off. Let us see, by way of (an unrealistic) example how this may work.
Given: Principal: \$100,000 Rate: 9 %
Term: 10 Years Period: Yearly
Mathematical Rationale:
The loan proceeds, i.e., \$100,000 in this case, represent the present value. The “periodic payment” represents the annuity payments to be made over future years and will include both Interest and Amortization. Amortization goes toward the reduction of the loan or principal balance. The present value of the annuity payments should equal the loan principal:
Principal = Periodic Payment x Present Value Annuity Factor
Calculation:
Payment = Principal ÷ PV Annuity Factor = \$ 100,000 ÷ 6.42 = \$ 15,576.32
Interest = Opening Balance × Rate
Amortization = Annuity Payment less Interest
Balance = Opening Balance less Amortization
Payment and Amortization Schedule:
In the first year, the interest portion of the payment is 9% of \$100,000 or \$9,000. This leaves \$15,576 less \$9,000 = \$6,576 going toward amortization. The new, amortized balanceis hence \$100,000 less \$6,576 = \$93,424. Each year the annuity installment is first used to pay the interest on the loan and the balance is used to reduce the capital outstanding. This continues for each period until maturity. In the maturity year the last annuity installment is sufficient to cover the interest still owed and the remaining balance. (You will note a rounded number in the last year.)
Note:
Mortgage payments are usually made in MONTHLY installments, and often with greater maturities. Mortgages in the USA today are at least 15 years in term and usually up to 30 years. Rates as of this writing are also substantially lower than illustrated. This has been simplified for illustration purposes, so that the reader may easily refer to standard interest rate tables.
11.23: A Few Thoughts about Mortgages
There are a few key points regarding mortgages, which require summary and notice.
1. Interest payments are tax deductible. Tax deductibility is important simply because it reduces the after-tax cost of the mortgage. Funds that would otherwise have gone to pay tax instead go to debt service. This benefit is reduced as the interest portion of the mortgage payment is reduced with time.
2. Partway through the loan, half the loan will have been paid off. A mortgage has a kind of “half-life.” In the foregoing example, half the loan will have been paid off after six years. This half-life will be greater than half the length of the mortgage because initially the annuity payments are used mainly to pay interest on the loan!
3. Total interest paid may be much greater than and in longer-term cases, a multiple of the principal – this can be calculated by evaluating the total payments minus the principal.
In the foregoing example, over the ten years the borrower will have paid a total of 10 annual payments of \$15,576.32 for a total of \$155,763.20. If you subtract from this figure the loan principal of \$100,000, you are left with a figure of \$55,763.20, which represents the total amount of interest paid over the life of the mortgage (unadjusted for time value). In other words, interest paid represents an additional 55% approximately of the principal borrowed. (We take note again that most mortgages require monthly payments and that, in today’s marketplace, most mortgages are 15 to 30 years.)
Let us compare 15- and 30-year mortgages in terms of the ratio of interest payments made relative to the principal. We remind ourselves that in the above instance (10 years and 9%) we had 55% interest payments relative to the loan principal. Let us use \$100,000 of principal again, and, this time, 6% in interest. We shall again employ the formula:
Principal ÷ PV Annuity Factor = Periodic Payment
15 years: (\$100,000) ÷ (9.7122) = \$10,296.33
Over 15 years total payments will equal (15) (\$10,296.33) = \$154,444.95. In this case, interest payments will equal 54.44% of the principal.
30 years: (\$100,000) ÷ (13.7648) = \$7,264.91
Over 30 years, total payments will equal (30) (\$7,264.91) = \$217,947.30. In this case, interest payments will equal 117.95% of the principal.
Even though the annual payments are less in the 30-year case, we see that interest payments multiply enormously over time. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.21%3A_Fractional_Time_Periods.txt |
The following table presents a comparison of the \$100,000 annual pay mortgage (above) at 6% interest for 15- and 30-years.
Notes and Questions:
• The shorter-term mortgage presents a higher periodic payment requirement but entails less overall interest payments over time.
• The longer-term mortgage presents a much higher total interest payment requirement but requires a lower periodic outlay.
• Question: Under what conditions does it pay to take out the shorter-term mortgage?
• Answer: It pays if the mortgagee has sufficient cash flow, and wishes to minimize total payments, especially interest, over time.
• Question: Under what conditions does it pay to take out the longer-term mortgage?
• Answer: It pays if one does not have sufficient cash flow, is unwilling to settle for a less-costly home, and is relatively unconcerned about the long-term, larger amount to be paid; perhaps he does not intend to stay for the full thirty years.
• In most circumstances, a 15-year mortgage will bear a lower rate than a 30-year mortgage – unlike this illustration. Here we focused on a single variable – time – which greatly impacts the scenario depicted relative to the minimal impact that a small premium interest rate would have for the increased term to maturity.
• Taxation will also have an effect. Recall that interest payments on mortgages are, under current law, tax-deductible.
The mortgage formula is important to master as it will be used again in three additional contexts: 1. Leasing; 2. Bond Accounting; and 3. Capital Budgeting: The Annual Annuity Approach.
Mortgages in the New Millennium
Innovation has brought about a multitude of new products, such as sub-prime loans and niche credit programs for immigrants… Unquestionably, innovation and deregulation have vastly expanded credit availability to virtually all income classes. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services. Home ownership is at a record high, and the number of home mortgage loans to low- and moderate-income and minority families has risen rapidly over the past five years.
-Dr. Alan Greenspan (2005)
Chairman of the Federal Reserve Bank
http://www.federalreserve.gov/BOARDDOCS/Speeches/2005/20050408/default.htm
Following an extended boom in construction driven in large part by overly loose mortgage lending standards and unrealistic expectations for future home price increases, the housing market collapsed – sales and prices plunged and mortgage credit was sharply curtailed. Tight mortgage credit conditions are continuing to make it difficult for many families to buy homes, despite record-low mortgage interest rates that have helped make housing very affordable… the contribution of housing investment to overall economic activity remains considerably below the average seen in past recoveries.
-Dr. Janet Yellin (2013)
Chairman of the Federal Reserve
http://www.federalreserve.gov/newsevents/speech/yellen20130211a.htm
11.25: Personal Financial Planning Problem
You are given the following:
1. This year, Abraham will start graduate school. The annual cost is \$30,000 per year for each of two years, payable at the start of the year.
2. The tuition will increase by 3% in the second year, due to inflation.
3. Abraham currently owes \$25,000 from his undergraduate student loans.
4. When he finishes his M.B.A. in two years, his parents will give him a \$50,000 gift.
5. Upon graduation, Abraham plans to pay off his loans fully in ten years. How much will he have to pay annually in order to achieve his goal?
6. Assume throughout an 8% cost of funds rate, compounded quarterly, except for the annuity payoff payments, which will be at an 8% annual rate.
Solution Plan:
• First lay down the given data, in nominal terms, in their proper places in a timeline; then, import the numbers into a spreadsheet.
• Calculate the future value of the costs at the end of year 2, using the cost of funds rate given. Note the gift as money in.
• Use the mortgage formula to calculate the annuity payment required to pay off the accumulated debts in the last 10 years.
Solution:
Calculations:
Step 1: (\$30,000) (1 + .08/4) 2 × 4= \$35,149.78
Step 2: \$30,000 × 1.03 = \$30,900
(\$30,900) (1 + .08/4) 1 × 4 = \$33,447.15
Step 3: \$25,000 × (1 + .08/4) 2 × 4 = \$29,291.48
Step 4: \$50,000 gift
Step 5: Sum of Steps 1-4
Step 6: Calculate the annual annuity payments.
(47,888.41) = (x) (PVAF 0.08; 10)
(47,888.41) (6.7101)
x = 7,136.77
11.26: Summary- The Time Value of Money
Virtually everything one does in the finance discipline involves, at some level, the time value of money. It is central to all of financial analysis and must be mastered. It is a basic tool.
In the prior two chapters, we developed a rationale for assessing “simple” future- and present-values. We defined the two qualifications for a cash flow series’ being categorized as an annuity, and then defined an ordinary annuity as the sum of the series’ present- and future-values. We further defined “annuities due” and outlined a means for converting an ordinary annuity into an annuity due. Additionally, we determined how interest rate tables may be used as a shortcut tool for calculating the time value of money.
Then we assessed uneven cash flow series that do not qualify as annuities. We examined two cases of perpetuities (no-growth and growth) as a special case of annuity. We examined fractional time periods and discovered the arbitrary nature of certain time value calculations, which have to do with the varying conventions regarding the definition of “period” and the use of interest rates in this regard. Finally, an illustration of a mortgage was presented and evaluated.
“Before one continues further in this text, it is imperative that the student master fully the critical concept of time value of money in all its variety.” | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.24%3A_Summary_Comparison_of_15-_and_30-Year_Mortgages.txt |
1. You are given \$2.30 in the present. It will compound quarterly at annual rate of 12% for ten years. What is its Future Value?
2. What if you willhave \$2.30 in ten years – in the prior question. What is its Present Value?
3. Define “Annuity.”
4. Why are simple Present- and Future-Value factors reciprocals of one another while annuity factors are not?
5. How are Ordinary Annuities and Annuities Due different?
6. How does one adjust an Ordinary Annuity in order to make it an Annuity Due?
7. Give real world examples of Annuities.
8. How are annuities and perpetuities different from one another?
9. An annuity due pays \$138.55 every quarter for seven years at a rate of 4.375%. Calculate both its present- and future-values. (Hint: use the mathematical formula for calculating annuity factors and also use the annuity adjustment multiplier.)
10. What is a “Growth Perpetuity”?
11. Explain the “Law of Limits.” How does it apply to Perpetuities? (Search Law of Limits online if it helps.)
12. Simple Future Factors grow at a(n) increasing/decreasingrate. Which is it? Why?
13. The rate of change in Future Value factors is increasing/decreasing. Which is it? Why?
14. A mortgage is self-amortizing. Explain.
15. Over time, interest expense on a mortgage is increasing/decreasing. Which is it? Why?
16. Over time, a mortgage’s amortization increases ordecreases. Which is it? Why?
17. You are given an 8% annual rate on a bank Certificate of Deposit, which pays quarterly. What is its Annual Percentage Equivalent Yield?
18. A mortgage charges 5% interest payable annually for thirty years. How much interest and amortization will there be in the second year? Assume a loan of \$1 million.
19. Over the life of this mortgage, how much interest will there have been – above and beyond the principal payments?
20. An investor will receive a \$400, 4% annual annuity for the next ten years, payable semi-annually; that is \$200 every six months. What are the present- and future values of the annuity?
21. What if this were an Annuity Due?
22. In the case of a Perpetuity, why is Present Value unaffected by discounting frequencies?
23. A semi-annual, “constant-growth” cash flow series last paid, \$5.80. Payments will be made every six months and will grow at an annual rate of10% per year. Assume a four-year horizon. What is the Present Value of the cash flow series?Utilize a 12% discount rate.
24. In the prior question, what if “G” were negative 5% (annually)?
25. A Perpetuity last paid \$1.50. It will be discounted at an annual rate of 16% and its cash flow will grow at an annual rate of 8% to be paid in quarterly installments. What is its Present Value? Be sure to adjust for frequencies.
26. What would the future values be in each of the prior two questions?
27. Besides for the mathematical necessity, why must “R” exceed “G,” in the Perpetuity model? We are assuming here, “normal” economic circumstances.
28. The Present Value Annuity Factor must have a value greateror lessthan “n × p.” Which is it and why? What about the Future Value Annuity Factor? | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/03%3A_Part_III-_The_Time_Value_of_Money/11%3A_The_Time_Value_of_Money-_Annuities_Perpetuities_and_Mortgages/11.27%3A_Chapters_10_-_11-_Review_Questions.txt |
Learning Outcomes
In this chapter you will:
• Define three forms of Income.
• Introduce the Valuation Premise.
• Calculate both the Holding Period Returnand the Dollar Price of a Bond.
• Distinguish the characteristics of Discount, Par, and Premium bonds.
• Explore how Creditability and Maturity affect Market Yields, i.e., the Yields-to-Maturity.
Note: Review questions for Chapters Twelve through Fourteen will appear at the end of Chapter Fourteen.
12.02: Security Return- The Holding Pattern Return (Raw Calculation)
In order to figure the return on an asset (a percent), it is useful to first outline the various components of the return on the asset – and then to calculate the return. The two principal components of return are income and profit, i.e., sales or “exit” price less investment cost. Income is common to many assets including bonds (interest), stocks (dividends), and real estate (rent). The exit price may be equal to, greater or less than the asset’s original investment cost, hence “profit” is included in return.
Example:
• Stock/bond/real estate cost or investment (C) = \$1,000. This is an “outflow.”
• Income (I) received over the course of the holding period = \$100.
• Sales (exit) price (P) = \$1,050.
• The income and sales price are “inflows.”
Holding Period Return (HPR):
HPR = inflows ÷ outflows -1 = [(I + P) ¸ C] – 1
HPR = [(100 + 1,050) ¸ 1,000] – 1 = + 15%
Alternatively, we could have calculated the HPR by focusing only on the profit (Π), in which case, we would have left out the “-1” expression at the end. The result is the same.
HPR = [(I + Π) ¸ C]
HPR = [(100 + 50) ¸ 1,000] = + 15%
Note:
In either application, this is a “raw” calculation in that it does not account for the time value of money. This approach ignores the length of the holding period and the timing of the cash flows. Clearly one would rather earn the raw 15% return over a shorter period than longer. Would you rather 15% over one year or ten? A dollar earned today is worth more than a dollar earned tomorrow.
While the HPR has severe conceptual limits, it provides key information upon which a better model may be constructed. In this section, we will present the calculation for dollar price and return of a bond.
When you make a sale to your fellow…do not victimize one another.
-Leviticus 25:1
And when you transact a purchase to your friend, or acquire from the hand of your friend, you shall not defraud one another.
-Leviticus 25:14
12.02: Security Return- The Holding Pattern Return (Raw Calculation)
In order to figure the return on an asset (a percent), it is useful to first outline the various components of the return on the asset – and then to calculate the return. The two principal components of return are income and profit, i.e., sales or “exit” price less investment cost. Income is common to many assets including bonds (interest), stocks (dividends), and real estate (rent). The exit price may be equal to, greater or less than the asset’s original investment cost, hence “profit” is included in return.
Example:
• Stock/bond/real estate cost or investment (C) = \$1,000. This is an “outflow.”
• Income (I) received over the course of the holding period = \$100.
• Sales (exit) price (P) = \$1,050.
• The income and sales price are “inflows.”
Holding Period Return (HPR):
HPR = inflows ÷ outflows -1 = [(I + P) ¸ C] – 1
HPR = [(100 + 1,050) ¸ 1,000] – 1 = + 15%
Alternatively, we could have calculated the HPR by focusing only on the profit (Π), in which case, we would have left out the “-1” expression at the end. The result is the same.
HPR = [(I + Π) ¸ C]
HPR = [(100 + 50) ¸ 1,000] = + 15%
Note:
In either application, this is a “raw” calculation in that it does not account for the time value of money. This approach ignores the length of the holding period and the timing of the cash flows. Clearly one would rather earn the raw 15% return over a shorter period than longer. Would you rather 15% over one year or ten? A dollar earned today is worth more than a dollar earned tomorrow.
While the HPR has severe conceptual limits, it provides key information upon which a better model may be constructed. In this section, we will present the calculation for dollar price and return of a bond.
When you make a sale to your fellow…do not victimize one another.
-Leviticus 25:1
And when you transact a purchase to your friend, or acquire from the hand of your friend, you shall not defraud one another.
-Leviticus 25:14
12.03: Valuation Premise
So, the HPR is not acceptable because it does not include the critical notion of time value of money. In general, we will find that the (dollar-) valuation of any asset will adhere to the following rule:
The value of an (financial) asset is equal to
the future cash flows the asset is expected to produce,
each of which cash flow is discounted to its present value
and then all such present values are aggregated to
a single value.
This says that in valuing an asset, we must first identify its future cash flows, and then discount each of those cash flows at an appropriate discount rate, and aggregate the figures into a sum, which shall be the asset’s valuation or price.
We will also find that, in a certain sense, the dollar value and the discount rate are interchangeable; in fact, we will note that the discount rate, in a large sense, is the “true” price of the asset.
These premises are basic to finance. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/12%3A_Fixed_Income_Valuation/12.01%3A_Chapter_Twelve-_Learning_Outcomes.txt |
Since the coupon cash flow of a bond constitutes an annuity, the calculation of a bond’s dollar price involves a simple solution:
The above formula says that every (annuity) coupon payment plus the one-time face value payment are discounted and aggregated to present value, which is the bond’s price. This is based on our “valuation premise.” Here are some important terms to know:
Face Value = Maturity Value = Par Value = Principal: These phrases are synonymous and interchangeable. Maturity value is the amount of money the investor, or bondholder/lender, gets back when the bond matures. This represents, in most instances (and herewith) a one-time cash inflow to the investor.
Coupon Rate (C) = Interest Rate (I): This is the amount of interest that the bond pays. (An exception would be a variable rate, but we do not deal with that here.) The dollar amount paid is this rate times the face value. Thus, if the rate is 10% and the Face Value is \$1,000, it will pay \$100 per year. If this bond pays semi-annually, the investor will receive two \$50 payments per year, one every six months. This represents an annuity series of cash flows for the life of the bond; this is the bond’s second set of cash flows.
Yield-to-Maturity (YTM) = Market Rate = Discount Rate:This is the market-determined rate at which the bond’s cash flows – both the Face Value and the coupon payments – are “priced, or discounted, to present value. Do not confuse coupon and market rates; they are separate and mathematically distinct. The market yield will constantly change. Coupons are (generally) fixed.
We may think of Face Valueand the bond’s Dollar Pricein terms of \$100s or \$1,000s or any multiple thereof. Since the bond’s price is expressed in terms of 100% of the bond’s “Par” value, it doesn’t matter for calculation purposes, how many zeros we add on in an illustration or exercise. This will be demonstrated immediately below.
The bond trader will quote the bond in terms of a percent of par and will then ask the buyer or seller what the size of the trade is? In other words, how much they are dealing with. Of course, in reality, buying or selling a thousand, or a million, dollars worth of bonds matters a great deal. An example follows.
Creditors have better memories than debtors.
-Benjamin Franklin
12.05: Fixed Income Securities- Dollar Price and Yield-to-Maturity
Fixed Income Securities: Dollar Price and Yield-to-Maturity Calculation
Since the coupon cash flow is an annuity, a simple valuation solution would utilize the following formula. Take note, that it does not matter how many zeros you use, although, we shall always figure a face value in this text of \$1,000 for consistency and convenience, unless otherwise noted:
Example:
Coupon .10 (Semi-annual)
Term-to-Maturity 5 years
Market/Discount Rates (Y-T-M) .08, .10, and .12
You’ll need calculators and interest rate tables for this!
Discount Rates
Here you shall need to insert the appropriate present value annuity factor (PVAF) for the coupon and the present value factor (PVF) for the Maturity Value. Do not forget to make the proper adjustments for semi-annual discounting.
Dollar Values
Here you shall need to multiply the above factors by the dollar amounts of the coupon/annuity and face value respectively.
The “true” price of the bond may, in fact, be considered the YTM. It is conceivable that there exist two bonds with the same maturity (or even issued by the same company) but due to having been issued at different times, the two bonds carry different coupons. Thus, the YTM will be the same for each, but the dollar prices will be different. Therefore, YTM is the true market price, at which bonds’ values are assessed.
Question: What would the prices be if the above bond’s coupon were 0%?
Answer: The PV of just the Face Value at the appropriate YTM / Discount Rate.
Fixed Income Securities: Dollar Price and Yield-to-Maturity (Solution)
It is important not only to solve problems, but to interpret them as well.
• Note that this illustration has used ordinary annuity factors, rather than only simple present value factors.
• The “Quoted Price” is stated as a Percent of Par.
• Premium/(Discount):
• You get more (less), you pay more (less)!
• You get more (less) coupon than the current market yields, you pay more (less)!
It is interesting to note, for instance, using the discount bond above, that the future value of the bond’s price equals the future value of its cash flows. 926.41 (1.7908) = \$50 (13.181) + 1,000. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/12%3A_Fixed_Income_Valuation/12.04%3A_Fixed_Income_Securities-_Bond_Components_and_Valuation_Formula.txt |
In the case of investment grade bonds (but not in the case of “junk bonds”), corporate issuers usually endeavor to set the coupon so that the initial offering price for the new bond at the time of issuance is Par (100% of the bond’s face value). The coupon and other important terms of the underwriting are written into a legal document called the indenture.
Once the indenture is completed, prospective bonds investors are provided with a prospectus, which lays out the terms of the bond, the financial condition of the company, and other important facts. Investors have some time until the bond is issued in which to decide whether they wish to purchase the bond or not. In this short time, market yields are subject to fluctuation. As a result, at the ultimate time of issue, the coupon rate and the contemporary market yield (Yield-To-Maturity or “YTM”) will likely have diverged.
Therefore, it is not terribly common to see new bonds being issued at a price of precisely Par; this of course results in new issue prices being at either discounts or premia to Par. There are these two possibilities. Moreover, over the life of the bond, market yields may diverge still further from the coupons.
For example, when an investor purchases an “old” bond, which may have been issued when market yields – and hence coupons – were lower, it may be looked at as inferior to newer bonds in that its coupon pays less than bonds issued today with the same maturity and credit rating. This is why mathematically such lower paying bonds trade at a discount to par. You get less (i.e., a lower coupon rate of interest than the current YTM), so you pay less.Of course, this is also true in reverse.
Similarly, for premium bonds, you pay more, because you get more (coupon than the current YTM). The time value of money discount rate (i.e., YTM) is the great equalizer. You may take two bonds that are similar in all respects except the coupon; they will trade at the same market yield, as they should, by definition, but their dollar prices will differ. Therefore, the “true” price of a bond is the YTM!
While many people believe that bond prices are stable, any volatility can increase investment risk relative to bond portfolios. Volatility may stem from default risks and macroeconomic causes and will be reflected as changes in YTM.
You get more (Coupon than Market Yield) you pay more!
12.07: The True Price of a Bond
Once again, it may be said that the “true price” of a bond is its yield-to-maturity. YTM is the means by which the bond’s cash flows are discounted or “priced.”
Two bonds may have the same credit rating and maturity but may have been issued at different times and thus will have different coupon rates, and therefore will be valued at different dollar prices even though, the market yields today are the same for both.
To illustrate this, solve the following problem for two bonds. You will note that the YTMs and TTMs for each of the two bonds in the example are the same, but the coupons differ, causing the dollar prices to differ. We assume equal creditability for each.
YTM = 4%
N = 10
P = 2
Cpn. Bond #1 = 4%
Cpn. Bond #2 = 0%
Solve this without glancing at the solutions.
Price Bond #1 = (\$20) (16.3514) + (\$1,000) (0.6730) = 100%
You should have known that the price would be Par- without having to calculate.
Price Bond #2= (\$00) (16.3514) + (\$1,000) (0.6730) = 67.30%
We now also see, that as the coupon rises, so too does the dollar price.
Note:
Review questions for Chapters Twelve through Fourteen will appear at the end of Chapter Fourteen. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/12%3A_Fixed_Income_Valuation/12.06%3A_Bond_Dollar_Prices-_Discount_Par_and_Premium.txt |
Learning Outcomes
In this chapter you will:
• Distinguish between the return on an investment and the firm’s Cost of Capital.
• Define various qualitative bond risks.
• Contrast Price or Interest Rate Risk versus Reinvestment Rate Risk.
• Compare Investment Grade to High-Yield Bonds, and their different Credit Ratings.
• Discuss Liquidity Preference Theory and its impact on the slope of the Yield Curve.
• Define each of four Yield Curve Theories.
• Calculate the Spot Curve.
• Explore Credit Spreads
• Consider the Macroeconomic circumstance under which Credit Spreads will narrow and widen.
• Utilize Credit Spreads in a predictive manner.
13.02: Interest Rates- Returns to Investors Cost to the Corporation
Interest rates, and, hence securities’ returns, are a function of economic circumstances that are manifest in the financial markets. Return to investors represents cost to the corporations that issue the securities; they are the two sides to the same coin. As in the case of “return on investment,” the phrases “return” and “cost of capital” to a corporation are described in percentage terms, i.e., as a rate, and not as a dollar amount. Cost of capital refers to the weighted-average cost of the corporation’s debt and equity.
Both debt and equity provide the corporation with funds with which to acquire assets, so that the corporation may grow. Investors who provide these funds to the corporation expect a return on their investment; this return represents an “economic cost” to the corporation. The money is not free. “Economic Cost” is a financial term, not an accounting term such as “expense,” and should be understood differently.
• The cost of debt capital to the corporation is the aftertax cost of interest paid on the debt.
Key Terms:
Cost of Debt Capital
Cost of Equity Capital
• The cost of equity capital includes the dividends paid to investors plus their expectations of capital gains resulting from the growth in earnings. Remember, shareholders may expect to receive dividends and to see additions to retained earnings. Should the investors’ expectations, which we may also view as their minimum required return, not be met, they may sell the security.
Investors expect that retained earnings and other capital sources be productively employed in the growth of the company so that their shares’ value increases – due to increased earnings and growth expectations. Corporations therefore must provide the assurance of price appreciation, or shareholders will sell, and/or hire new managers and directors. This prospective price appreciation is also part of the firm’s capital costs, as viewed from the economist’s eye.
Required Return
Risk-free Rate of Return
In general, the required return (R) whether for stocks or bonds, consists of two parts: one, a return associated with the “risk-free” instrument and the risk-free rate of return (RF); the other, a premium, or extra, return for incremental risk above zero-risk. That is, the required return equals the risk-free rate of return plus a “market risk premium” (MRP).
R = RF + MRP
MRP = RM – RF
On the next page, you will find a graph that depicts these concepts.
• The phrase “risk premium” (referring to RM – RF) is a bit of a misnomer, as the term “risk” draws your attention toward the horizontal axis rather than the vertical axis where the premium (return for incremental risk) is observed.
• The “Market Risk Premium” (MRP) = Market Return (RM) less Risk-free Rate-of-Return (RF).
• In the graph above, we have risk (a quantifiable measure) and return, which is measured in percentage terms. We also have the overall or average “market risk” and its corresponding market return.
There is also a theoretical zero-risk investment and its corresponding risk-free rate of return. Even though the zero-risk investment has no risk (excuse the redundancy), it still provides a positive rate of return. If it provided no return, no one would invest in it. There is no agreement about the real-world proxy for the risk-free instrument; it is usually taken as either the three-month Treasury Bill, or the ten-year Treasury Note.
Market Risk Premium (MRP)
Again, the Market Risk Premium (MRP) will be the difference between the risk-free and market rates of return. In other words, the market return provides a premium or additional return to the investor for taking on a level of risk greater than zero. Any particular investment, or portfolio of investments, may provide more, or less, risk and return than the overall market.
In such cases, the investor’s portfolio may contain a level of risk greater than or less than the market’s risk level, i.e., to the right or left of the Market Risk on the horizontal axis. Accordingly, the investor may expect to earn more than the market return, or less. The investor’s expected return will then be either above or below the Market Return on the vertical axis. Can you draw this? What would be the investor’s Portfolio Risk Premium?
Rational Expectations
Portfolio Risk Premium
Take note, once again, of the odd use of the term “risk premium” relative to additional return. The more risk one takes on, the proportionally greater should the return be. This is due to the notion of Rational Expectations. One might say that to accept more risk for no added return is irrational, and no one would do that. That is why the slope of the diagonal is positive. The diagonal market line in the diagram reflects this positive risk/reward relationship. The more the risk, the more the (expected) return.
• Many researchers will use the 3-month Treasury Bill as the proxy for the theoretical risk-free instrument. This choice has to do with three explanations.
• First, the United States Treasury is considered the least risky of all debtors (although that may no longer be true).
• Second, because the 3-month term is so short, market price fluctuation is not at issue; in a very short while, the bills will mature and pay their full, face value.
• Third, Liquidity is also enhanced by the sheer size of the Treasury market itself; size comes with greater trading volume and hence more liquidity.
• Not all agree about the risk-free proxy. Some argue for the use of the 10-Year Treasury Note as the realworld equivalent of the risk-free instrument. This is because Equities tend to be longer-term investments and, more importantly, because Credit Spreads (to be discussed in a later chapter) are usually figured in a ten-year timeframe.
The sages of Yavne used to say: I am a creature of G-d and my neighbor is also;
my work is in the city and his is in the field; I rise early to work and he rises early to his. As he cannot excel in my work, I cannot excel in his. But you may be tempted to say,
‘I do great things and he small things!’
We have learned that it matters not whether one does much or little, if only he directs his heart to heaven.
-Babylonian Talmud
Tractate Berachoth, 17a | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/13%3A_Interest_Rates/13.01%3A_Chapter_Thirteen-_Learning_Outcomes.txt |
It is important to know both what you are getting into when dealing with a financial adviser and who may be some of your co-workers if you choose to work on “the street.” What insights do you derive from the table below?[1]
1. From: Inside the Banker’s Brain: Mental Models in the Financial Services Industry and Implications for Consumers, Practitioners, and Regulators, by Susan M. Ochs (November 2015). Initiative on Financial Security, The Aspen Institute, Washington, D.C. [email protected].
13.04: Fixed Income Risks
Risk in theoretical finance is defined mathematically usually as the chance or extent to which the actual return may differ from the required or expected return.
“Differ” allows for the actual or “realized” return to be either less or greater than the expected return.
From the investor’s perspective, bond risks may be divided into the following qualitative components:
Liquidity Risk – the risk that the security cannot be converted to cash at its reasonable intrinsic or “fair market value” due, possibly, to a lack of buyers.
Credit- or Default Risk – the possibility that a corporation may, in the worst case, go bankrupt, or, in a lesser case, not honor its interest and other related payments timely and in full.
• If the firm is in violation of any of the technical terms (“covenants”) of its loan agreement (“indenture”), it may also be considered in “technical-” default even if it is timely in making all its payments.
• Note that interest must be paid before any dividend payments on preferred and common stocks may be made.
• If a borrowing company defaults on its debt, it may thus become insolvent which would lead to bankruptcy.
Inflation Risk– the risk that the return, i.e., the interest payments, will be eroded over time by inflation, i.e., a reduction in the purchasing power of the interest payments.
• Note that, in most cases, interest payments are fixed.
• Many governments sell inflation-linked, or inflation-indexed bonds that have payouts linked to the inflation rate. The United States Treasury sells Treasury Inflation-Protected Securities (TIPS).
Interest Rate (or “Price”) Risk– the negative effect on market values, or prices, due to rising levels of general interest rates.
• Interest rates and prices are inversely related. If rates go up, ceteris paribus, bond market prices go down.
• Think of it this way: If you already own a bond and interest rates, in general, go up since the time of purchase, then new bonds will be issued at higher rates than your bond. All else equal, that will make your bond relatively less attractive and thus its market value will go down.
• Possibly more than any other risk, this is tied into macroeconomic factors, including Federal Reserve policies.
Reinvestment Rate Risk– the risk that cash interest payments received during the life of a bond will be reinvested at less than the rate originally expected, thereby reducing the overall holding period return.
• When the investor purchases a bond, s/he has some expectation to either spend the money or to reinvest the interest payments at some anticipated future rate. Should rates go down, the reinvestment rate will be less than expected (or less than it was at the time of purchase) and the investor’s savings at the bond’s maturity (i.e., the bond’s “future value”) will have accumulated to less than that which was originally anticipated.
• Note that interest rate and reinvestment risks are inversely related to (i.e., the opposite of) one another.
Countryor Sovereign Risk– for example, war, changes in administration, etc.
• When there is war, people nervously sell stock, as occurred in December 1990 when the Gulf War broke out. When Donald Trump was elected U.S. President in November 2016, the stock market rose sharply.
Foreign Currency Risk– possible negative effect of repatriation of funds
• In general, most U.S. companies have substantial assets domiciled or revenues generated overseas. These funds may be repatriated or brought home at an unfavorable exchange rate. Thus, even American companies bear some foreign currency risks even though their stocks are dollar denominated.
Notes:
• “Nominal” rates (or prices) are not adjusted (lower) for inflation.
• “Real” means “corrected” for inflation, i.e., adjusted. The real rate will be lower than the nominal rate, given some inflation.
• The following phrases all usually mean percent: return, rate, yield, margin, bracket.
13.05: Interest Rate and Reinvestment Rate Risks
An additional, clarifying word about interest rate and reinvestment rate risks is warranted at this time.
If in general, interest rates go up, market prices for existing, “older” bonds will go down – and vice versa. General interest rates and bond prices are inversely related. In an environment where market rates have gone up, bond investors holding “old” bonds will receive less interest income than if they had purchased “new” bonds that were issued more recently – at higher (coupon) rates. This will cause market values for existing bonds to go down; they are simply worth less competitively. Rising rates are “bad” news for (existing) bondholders in terms of interest rate risk.
However, bondholders will be able to reinvest their interest proceeds at higher rates than before if rates rise. Investors receive regular, periodic interest payments over the life of the bond, which upon receipt, is assumed to be reinvested into other alternatives that pay higher rates than before. Thus, rising rates are “good” news for bondholders – in terms of reinvestment risk.
In short, interest rate and reinvestment risks are inversely related to one another. The table below summarizes the relationships vis á vis the bond investor. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/13%3A_Interest_Rates/13.03%3A_Inside_the_Bankers_Brain.txt |
Corporations are rated by credit-rating agencies that assess a corporation’s ability to service its debt (i.e., to pay interest and principal in full and on time) and, thus, to keep bankruptcy at bay. This is a risk, which may also be referred to as “default risk.”
We have already examined three solvency ratios which attempt to provide some insight into this risk. Clearly, there are many more tools and considerations that enter into the process of credit analysis and rating. Companies must pay for this service, but not all do so, as some bond issues are too small to justify the expense, while others may be sold directly to institutional investors and thus do not require a rating.
Today, there are two major rating agencies: Standard & Poor’s (S&P) and Moody’s. Fitch is still a third agency, but it does not enjoy the market presence of the others. In addition, there are numerous nationally recognized statistical rating organizations or “NRSRO’s” that perform similar functions (see: https://www.sec.gov/ocr/ocr-current-nrsros.html). The agencies rate bonds on the scale illustrated below. As you will note, there are some differences in the rating scales, and, although not visible in the ratings themselves, the manners in which the agencies conduct their respective analyses and what they consider important also differ from one agency to the other. As a result, the agencies may not rate the same bond issuer the same.
Within each rating category, the agencies may append additional notation, such as “A-” in the case of S&P. This provides some further refinement to the ratings.
Note:
The “S&P 500” is a stock index and does not apply to bonds.
Ratings will clearly affect the bond’s yield – in inverse relation to the rating with lower ratings generally bringing higher yields. The better the bond’s initial rating, the lower the bond’s coupon rate of interest, and, of course, the lower the issuer’s cost of debt capital; this is also true for the bond’s subsequent secondary market yield, (a.k.a. yield-to-maturity). Do not confuse coupon and market yields; they are separate.
Agencies do not necessarily agree with one another; in some cases, the agencies may rate the same company somewhat differently. Interestingly, the bond market itself seems to understand what the true yield for a bond should be; indeed, yields often adjust long before a rating change (i.e., either an upgrade or a downgrade) announcement. Further, a bond’s rating is not necessarily “correct.”
In the case of municipal bonds, the agencies conduct similar analyses and provide similar ratings. The interpretation of municipal ratings, however, is somewhat different in practice, with municipal bonds less likely to default than their ratings might imply. In some instances, municipal bonds may be insured by private insurance companies, in most of which cases the bonds will therefore bear a “AAA” rating regardless of its intrinsic creditability. Most insurers are considered to be in the best financial health.
United States Treasury and Agency bonds are highly rated but are no longer perceived as being completely risk free. “Agencies” are considered slightly lower in quality than “Treasuries” and will therefore trade at very slightly higher yields. The markets “know” how to price their securities.
While the rating agencies do not provide the details of the manner in which they conduct their ratings, it is accepted that their formulae consist of a combination of the examination of the issuer’s financial health (based on its financial statements), its economic environment, and an examination of the bond’s covenants.
Key Terms
Covenants
Indenture
Covenants are agreed-upon terms to which the issuer assures it will adhere; in a way it is a restriction imposed by the lender in order to secure or strengthen his position. For instance, the issuer may assure the investors that its financial ratios will remain within certain parameters, or that it will not issue any further debt, which shall be senior to the issue at hand. In general, such negative covenantswill also prohibit the firm from paying too much in dividends, selling or pledging assets to other lenders, maintaining collateral in good condition, or adding on more debt. Timely interest and principal payments would certainly be included in this category. These assurances are spelled out in the bond indenture, a legal document in which all the terms of the bond issue are spelled out, including the bond’s maturity and coupon interest rate.
In Default
Technical Default
Although a bond issuer, or borrower, may pay its bond interest in full and on time, which is to say it is not indefault, any violation of any of the bond indenture’s covenants may be interpreted as a technical default and result in a downgrading of the bond’s credit rating. The bond covenants are aimed at providing investors with reasonable assurances of the issuer’s fealty to its obligations under the bond, but not so much as to disenable it from running its business effectively. Failure to abide by the covenants is, thus, a negative circumstance.
The restrictiveness of the bond’s covenants will vary. Secured, or asset-backed, securities will have less restrictive covenants than unsecured issues. Furthermore, lower rated, non-investment grade, bonds are likely to be more restrictive and more complex, and hence will require a more careful reading prior to purchase and investment. Evaluation of these riskier securities’ covenants is relatively more important than in the case of investment grade bonds. Moody’s places some emphasis in the determination of its ratings for high-yield bonds on the issue’s covenants. High yield bonds tend to attract more sophisticated investors who are capable of studying the technical terms of the covenants; moreover, many such issues are placed privately among institutional investors.
Lien
Investment grade bonds will typically contain three standard covenants. First, there may be a covenant regarding “liens,” which assure the investor that no other party may obtain a “senior” (prior) claim to the asset (or collateral) subsequent to the bond’s issuance. Under the law, a lien is a claim by a person upon another person’s property for purposes of securing payment of a debt or the fulfillment of an obligation. If there is a prior lien on a property, no other person can subsequentlymake a claim on the same property. By manner of another example, when you buy a house, your attorney will conduct a “lien search,” to be sure that no one else owns the house except the seller with whom you are dealing.
Next, a covenant will protect against any reduction in seniority of the bond in case of a merger of the issuer with another corporation. This covenant will ensure that the bond is paid off first in any case.
Finally, another covenant may address the sale of an underlying asset – in the case of a secured bond. Obviously, should an asset underlying a collateralized bond be sold, the bond’s financial status will change markedly. Such assets ought not to be sold unless the bond is also redeemed.
There is no doubt that credit ratings are critical to pricing primary and secondary market issues. Ratings influence both the coupon rates of interest in the primary market, and market yields, or yields-to-maturity in the secondary markets.
13.07: The Yield Curve
Key Terms:
Yield Curve
Yield-to-Maturity
Term-to-Maturity
The Yield Curve depicts the relationship between Yield-to-Maturity (YTM) and Term (or Time)-to-Maturity (TTM) for a given class of bond, such as Treasury Notes and Bonds, Municipal Bonds, or Corporate Bonds. When one speaks of the Yield Curve without specifying the instrument, it is assumed to refer to the market for Treasury securities. The yield usually is stated in nominal terms, i.e., not in real terms, which would adjust for inflation. The horizontal axis is the term, or Time-to-Maturity (TTM), and the vertical is Yield-to-Maturity (YTM) or market yield. The slope of the yield curve can be flat, positive (upward sloping) or negative. It may, at times, be kinked. As will be shown later, YTM will determine the dollar-price for a given bond.
Liquidity Preference
Under “normal” circumstances, the yield curve will reflect an upward, but not necessarily linear, slope; that is, as maturities get longer, yields will also rise. The theory of Liquidity Preference attempts to explain this. Investors prefer being liquid rather than illiquid. When liquid, investors have the entire range of options available to them; they may either spend or invest their money. When illiquid, choices and alternatives are reduced or eliminated. The longer one ties up his money, the greater his illiquidity. As one’s illiquidity increases, s/he will accordingly demand more and more return as compensation for the illiquidity, hence a positively sloped yield curve.
Inverted Yield Curve
The Yield Curve need not always be positively sloped, however. For instance, in times of tight Federal Reserve monetary activities, short-term rates will be driven up. As markets have learned to interpret tight money policy as effective inflation-reducing medicine, which takes effect over future periods, the longer end of the yield curve tends to decline, leading to a negatively sloped, or “inverted,” yield curve. As Fed tightening usually does not last long (the 2004-2007 period being an obvious exception to this), inversions are similarly short-lived.
The Yield Curve normallyis positively sloped due to Liquidity Preference although it does not have to be a straight line.
On the next page, we observe average yields for three-month to ten-year government (Treasury) bonds for the decades noted. Yields are first stated in nominal (unadjusted) terms, followed by real (adjusted for inflation) terms. In general, the yield curve is stated in nominal terms, because that is how bond yields are quoted in the market.
Note:
The yield curve, typically, is presented in nominal terms.
The following link provides some insight into the “historical yield curve,” which is to say, how the yield curve has changed over the last few decades. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/13%3A_Interest_Rates/13.06%3A_Credit_Ratings.txt |
Here we shall present four theories that attempt to explain why the Yield Curve may take on one or another slope – upward (positive), flat, or downward (negative). We cannot say that any one theory is more correct than the other, nor can we necessarily reconcile one theory in terms of another. Still, the following theories are eminently informative.
1. Pure Expectations – The Market Yield reflects the average of future short-term rates.
First, we assume that investors think about the future and, specifically about the future direction of short-term interest rates. In this notion, we say that the observed Yield Curve is, in a sense, secondary to what market players believe – in their minds – future short-term yields will be. If, as in the mathematical example below, market participants believe that future short-term yields will go higher and higher, then the observed yield curve will reflect this collective belief and be positive in slope – and vice versa. In other words, the Yield Curve reflects market participants’ a priori beliefs.
What makes this interesting is that while we can directly observe the Yield Curve – after all, it is quoted in the media, and by traders and brokers – it is first the unexpressed thoughts and beliefs about the direction of future short-term rates that determine the Yield Curve’s openly expressed slope. We know what is in the public’s minds regarding the future by observing the effect of their collective thought on the slope and shape of the “Yield Curve.” The Yield Curve expresses what people think about the future!
Similarly, the observed Yield Curve – mathematically – will express the average of market participants’ expectations about the course of future short-term rates. For example, standing here today, in the here and now, and assuming first that the investor’s horizon is two years, the investor is faced with two choices: (1) Buy a two-year bond, or (2) Buy a one-year bond and “roll it over” for another year when it comes due at the end of the first year.
Given this line of thinking, if his horizon is three years, an investor can buy a three-year bond, or choose to consecutively roll it over twice. If we assume initially that the two choices in each case should be and are equivalent, we can extrapolate the investor’s beliefs about the “Spot Curve,” i.e., the market’s collective belief about future short-term rates, from the Yield Curve, working backwards. Let’s clarify by mathematical illustration.
Here is an example of how we may calculate “Spot Rates,” or the “Spot Curve” given the Yield Curve (“Market Y-T-M”).
Question:
“x” and “y” represent the future short-term rates that market players anticipate. Specifically, “x” represents the rate for the second period. Likewise, “y” represents the rate for the third period. Working backwards from the observed Yield Curve, what are the values for the two unknowns? Again, we must assume that the two alternatives are equivalent. This mathematical process, by the way, is referred to as “Boot Strapping.”
Solution:
(1.08)2 = (1 + .07) (1 + x)
x = .09009 where, x = 2r1 (i.e., the one-year rate in the second year)
The two alternatives – that of buying (or lending) a two-year instrument or buying (or lending) a one-year instrument and rolling it over at the end of the first year – must be viewed as equivalent alternatives if this idea were to work. And it does because should one alternative be superior, rational, smart market players would go for that one, and the market’s efficient self-correcting mechanism would drive the alternatives together.
This is known as the Law of One Price. This “law” says that if two equal alternatives are present, they must offer the same price or, in this case, yield. If one of the choices were more attractive, investors would choose that one, driving up the price and lowering the yield. They would sell the other, which would have, in the end, an equal and opposite effect. While we have used here the term “investors,” this argument refers to the activities of both borrowers and lenders, in fact.
You should be able to draw these two curves (i.e., both the YTM Yield Curve and Spot Curve, given the calculated values of “x” and “y”) on a chart, with the yield on the vertical and the years-to-maturity on the horizontal. Note that after the first year, the two curves diverge, with the Spot Curve, in this example, rising above the Yield Curve, pulling it upward. Investors expect future, short-term rates to increase! Of course, if the Yield Curve is inverted (negatively sloped), the spot curve would be lower that it and we would conclude that future, short-term rate expectations are decreasing.
As for the nomenclature noted above, and more formally speaking, “2r1” means the “spot rate” starting at the beginning of the second period for the length of one period, while “3r1“starts at the beginning of the third period for one period’s length.
Again, and in summary, why does this math work? This is based on two notions: first, that market players are “rational,” and make optimal decisions that maximize their wealth; second, that markets react “efficiently” to a perceived mispricing should the two opportunities not be equivalent. Together, these two concepts (i.e., Rational Expectations and Efficient Markets) act in unison and cause the alternatives to be equivalent at present. What will actually happen tomorrow is another story.
Under this Pure Expectations Theory, we say that the Yield Curve has no a priori upward (positive) or downward (negative; inverted) bias. The slope of the Yield Curve simply reflects whether people think rates will be going up or down and will acquire its slope accordingly. The observed Yield Curve’s slope thus is a consequence of Pure Expectations.
2. Liquidity Preference – Investors prefer Liquidity to illiquidity.
Investors prefer to be liquid at all times in order to have the freedom to choose whether to spend or invest their funds. Don’t we all want to be free? Should investors choose to tie up their money in an investment, they would demand to be compensated for the illiquidity that comes with investment. Should they tie up their money longer and longer, they would demand that they be increasingly compensated, in terms of higher yield, for their increasing illiquidity. Under this theory, therefore, we conclude that the Yield Curve would have a notable upward bias.
The theories of Pure Expectations and Liquidity Preference are said to work hand-in-hand. When we get both theories working in the same direction, that is, when the Spot Curve is positive, we get a positively sloped Yield Curve. However, if Pure Expectations are such that market participants believe that future short-term rates will decline, the slope will be determined by which force is greater than the other – whether Pure Expectation outweighs Liquidity Preference or not. The following formula expresses this theoretical notion:
(1.07) (1 + x + L) = (1.08)2
While we can measure “x,” i.e., the spot rates, and have just done so, the Liquidity Preferences (L) of the market are not measurable.
There are two more theories to go.
3. Market Segmentation – different segments of the yield curve attract different issuers and investors and are thus subject to varying supply/demand conditions respectively. These conditions will determine the independent slopes of each segment.
In Market Segmentation Theory, we say that participants generally invest or borrow in limited portions or “segments” of the market. Commercial Banks invest very little in the long-term whereas Pension Funds are heavily invested there. Different players tend to “reside” in different “segments.”
Given this segmentation, rates within it would be a function of the supply and demand characteristics of each individual segment, separately and alone. Any changes in a particular maturity’s yield would not affect any other segment, or rate, for any other maturity. There would, thus, be no ex-ante bias whatsoever for the slope of the Yield Curve. In fact, the Yield Curve could conceivably have multiple kinks.
4. Preferred Habitats – Market Segmentation may be altered by yield incentives whereby investors and borrowers may be lured away from their Preferred Habitats.
Preferred Habitats Theory comes to the rescue! Maybe. This theory says that yes, players indeed have their preferred segments, or habitats, but they (i.e., both lenders and borrowers) can be lured away from their preferred habitats if interest rates are attractive enough – low enough for borrowers and high enough for investors.
YOU decide! | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/13%3A_Interest_Rates/13.08%3A_The_Term_Structure_of_Interest_Rates-_Four_Yield_Curve_Theories.txt |
Credit Spreads represent the incremental yield provided to compensate for additional default risk above a no-risk alternative (Treasury Notes), and for a given maturity – usually 10-years. We have drawn in the yield curves for Treasuries and “B”-rated Corporates. The Credit Spread below is represented by the difference in yields between points “B” and “T.”
Questions:
Which companies issue credit ratings?
What are the important credit ratings?
What do “Investment Grade” and “Junk” or “High-Yield” Bonds mean?
Reality Check: Credit spreads are not constant. During weak economic periods, credit spreads widen, in response to fear of the perceived risks associated with lower-rated bonds. In fact, default rates themselves may not worsen, but still, people get nervous. In such times, people demand more premium return versus Treasuries than before.
How exactly does this happen? Many will sell their lower-rated bonds and buy Treasuries with the sale proceeds. Lower-rated bonds’ prices therefore fall and their yields rise; Treasury prices rise, and yields go down. Credit spreads widen. Remember that price and yield (i.e., discount rates) are inversely related. This does not say that actual credits, i.e., default risks, have worsened; that may or may not eventually happen. A bond may be considered a “credit.” This phenomenon – whereby credit spreads widen – is referred to as a flight to quality.
Below we illustrate the flight to quality.
The Flight to Quality
Yields
Above, in anticipation of weak times ahead, Credit Spreads widen from B0 less T0 to B1 less T1. That does not imply that default rates have worsened in reality, although, in time, as conditions worsen, that could happen as well.
When rates increased between 1978 and 1982, the spread between (Ten-Year) Treasuries and Baa Corporate Bonds widened. Baa and BBB bondholders lost money in part due to increased rates and, in addition, due to a widening of the spread (such bondholders would have lost less in Treasuries).
Credit spreads were wide when the technology “bubble” burst in 2000-2001. Greater credit spreads reduce corporations’ ability to borrow and thus serve to dampen economic growth.
Just prior to the Banking Crisis of 2007-2008, Credit Spreads were very narrow by historical standards. To some prognosticators, the optimism implicit in such narrow spreads boded ill for near-term economic conditions. They were right.
Many things can happen that may interact with credit spreads, including moves up or down in the entire yield curve. What is important to recognize, at the base level, is that lower grade bonds – and their yields – are (usually) priced relative to Treasuries, i.e., at some premium to Treasury yields. The lower the credit rating, the greater the impact of “nervousness” on yield.
For a graph of historical credit spreads, click on: Bond Yield Credit Spreads – 150 Year Chart | Longtermtrends
13.10: High Yield Securities- Junk Bonds and Other Speculative Securities
The phrase “junk bonds” is a bit unfair because no rational person would throw out something of value, as s/he might do with something that is truly “junk.” Even bonds in default may have some monetary value greater than zero. High yield securities merely have lower credit ratings and therefore higher yields.
In 1978, there was less than \$10 billion worth of junk bonds outstanding – in terms of aggregate face value. In 2006, this figure exceeded \$1 trillion! Whereas in the past, most issues consisted of “fallen angels,” or securities issued by corporations that once enjoyed investment grade credit ratings, but fell on hard times, today most junk bonds are originally issued as high yield securities. Further, emerging markets the world over add to new issuance; the prospective high returns attract many investors.
This low-grade security growth has precipitated two other interesting phenomena: the markets for “syndicated loans” and “leveraged loans.” Syndicated loans are package deals provided often by investment banks rather than commercial banks, which traditionally have made such large loans. These loans are aggregated and packaged, and then “securitized,” that is, sold as securities. Many of these bonds went bad in the 2007-2008 Banking Crisis. A leveraged loan is one which is made to companies that already may have low-grade bonds outstanding; such loans are then often syndicated.
Distressed debt consists of junk bonds whose companies are in such dire straits that their yields are substantially higher than the risk-free rate. “Defaulted debt” represents corporations who have defaulted on their bond issues. A “default” may consist merely of the violation of its bank lending agreement or its bond’s indenture, i.e., the legal document, which sets forth all the terms of the loan, and which may require that the issuer maintain its financial ratios within certain parameters. It may also result, more seriously, from a late or missed interest payment.
Key Terms:
Distressed Debt
Vulture Funds
Vulture funds are often operated by hedge funds and attempt to profit off the remains of bankrupt corporations by purchasing the defaulted bonds and repossessing the company’s assets. The vultures then sell off the assets at a profit.
Typically, default rates increase as the economy enters a recession. Default rates are sometimes defined as the dollar amount of defaults relative to the aggregate amounts outstanding. The credit rating agencies define default rates in connection with the number of high-yield issuers who default.
13.11: Summary- Interest Rates the Corporation and Financial Markets
Corporations are intimately connected with the financial markets because the value of the corporation depends on ever-changing prices reflected in the markets, and because corporations periodically require access to the financial markets in order to acquire capital for growth. In this chapter, we outlined four financial markets: money, capital, derivatives, and foreign exchange markets. The focus was, of course, on securities markets, that is, the markets for stocks and bonds. Securities markets, in turn, are connected to the macroeconomic world, and monetary and fiscal policies are a key component of security markets analysis.
The means by which corporations gain access to the financial markets and its capital raising function is the subject of investment banking. In particular, we are interested in new securities’ issuance, or initial public offerings (IPOs), but I-banking serves various other essential roles in our financial sector.
Interest rates affect securities’ valuations, most visibly affecting bonds’ prices, but the impact on equities is notable also. This is but one example of the connections between macroeconomics and securities markets. In this section, we also glanced at the interconnections between interest rates of various sorts.
There is much to know.
Note:
Review questions for Chapters Twelve through Fourteen will appear at the end of Chapter Fourteen. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/13%3A_Interest_Rates/13.09%3A_Credit_Spreads.txt |
Learning Objectives
In this chapter, you will:
• Calculate the prices of both Preferred and Common Stocks, and Capital Gains using the Dividend Discount Models.
• Explore the various approaches to stock valuation.
• Uncover the various sub-elements within the Dividend Discount Model.
• Provide both Annual Portfolio Returns and Multi-year Geometric Returns.
14.02: The Philosophy of Equity Valuation
Earlier, we read that “the value of an asset is equal to the future cash flows the asset is expected to produce, discounted and aggregated to its present value.” We refer to this value or price as “intrinsic value.” This Valuation Premise shall serve as the starting point for the valuation (i.e., pricing) of equity.
In this section, we will commence with a simple example of stock valuation, one which perfectly corresponds with this statement. We shall then observe that the formulation does not conform to, or is not applicable to, many, or most, equity situations. For example, our starting point will be the application of this TVM premise to Preferred Stocks that have fixed dividends. However, what about other stocks, whose dividends are not constant? For this there will be another model, a variation on the original model.
What about investors who buy stocks for capital growth rather than income? In other words, what about investors who do not care about dividends, but instead purchase stocks for profit? Most American stocks pay no dividends at all! What are such stocks worth? For that too, we shall offer a further refinement of the original model.
To summarize, we shall systematically address shortcomings in the initial model and progressively build more comprehensive and complex models, which encompass all, or many “complaints” about the simplicity of the earlier models. Keep this in mind as we proceed down the equity valuation path.
For most things are differently valued by those who have them and by those who wish to get them:
what belongs to us, and what we give away, seems very precious to us.
– Aristotle
Nicomachean Ethics, Book IX
(F. H. Peters translation)
14.03: Equity Valuation
We look at Equity Valuation from different perspectives.
• Going-Concern value sees the firm from a perpetual operating perspective. It is an ongoing concern that will produce EBIT (or EBITDA) forever.
• Liquidation Value is diametrically opposed to the going concern value. Here we imagine what the firm’s assets would fetch were the firm to go out of business and its assets liquidated, i.e., sold off to the highest bidders or available buyers.
• Book Value (BV) represents the accountant’s stated net (common) equity divided by the number of shares outstanding (NOSO).
• Relative Value compares a security to another based on some shared or relative metric, such as default risk.
• Market Value (P for Price per Share) is defined as the market value of the firm’s equity. Markets can misprice assets on occasion.
• Intrinsic Value (V) represents the “intrinsic” or “internal” worth of the company based on financial analytic formulae and models. You may think of this as what the shares are “really” worth. Such formulae often rely on a discounted cash flow paradigm, e.g., the DDM. The intrinsic value may differ from the market price, thereby offering investors the opportunity to purchase shares cheaply or sell the shares short, if over-valued. Does V = P? If not, what advantage does the investor have?
All the foregoing valuations may differ from one another. In a perfectly efficient market, observed market prices should equal intrinsic values.
Equity Valuation and the Macroeconomy
How we value the stock market now and in the future influences major economic and social policy decisions that affect not only investors, but society at large, even the world. If we exaggerate the present and future value of the stock market, then as a society we may invest too much in business start-ups and expansions, and too little in infrastructure, education, and other forms of human capital. If we think the market is worth more than it really is, we may become complacent in funding our pension plans, in maintaining our savings rate, in legislating an improved Social Security system, and in providing other forms of social insurance. We might also lose the opportunity to use our expanding financial technology to devise new solutions to the genuine risks – to our homes, cities, and livelihoods – that we face.
-Irrational Exuberance by Robert J. Shiller
Preface, p. xii
(Princeton University Press, 2000) | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.01%3A_Chapter_Fourteen-_Learning_Outcomes.txt |
We shall assume that the security’s Intrinsic Value (V) will be equal to the market price (P), i.e., that P = V. Intrinsic value refers to what the security is truly worth. To the extent that P ≠ V, one would be presented with the opportunity to earn an extraordinary profit (by either buying cheaply or selling “richly”). Hereforward, we shall use P rather than V, although you may see V used elsewhere.
A stock is a kind of perpetuity; the corporation, as a going concern, is eternal. Dividends will be paid in perpetuity. Unlike bonds, there is no face value to be paid at a specified time in the future. The only cash flows are the dividends.
This formula says that the price of a stock is equal to its aggregated discounted future cash flows, i.e., the dividends discounted to present value. Since, for the moment we assume that dividends are fixed (as in a preferred stock), the foregoing, never-ending equation may be simplified algebraically to the following (as was demonstrated for a perpetuity, only the terms have been modified to accommodate stock):
This simplification works because of the “Law of Limits,” discussed earlier in our TVM section. Interestingly, by transposing, the above formula may be re-formulated as:
Note: D ÷P is the Dividend Yield!
While corporations pay dividends quarterly, the formula looks at annual dividends. Recall that, in the case of a perpetuity, discounting frequency has no effect on Present Value.
14.04: The Dividend Discount Model (DDM)- Fixed Dividend or No- Growth Ver
We shall assume that the security’s Intrinsic Value (V) will be equal to the market price (P), i.e., that P = V. Intrinsic value refers to what the security is truly worth. To the extent that P ≠ V, one would be presented with the opportunity to earn an extraordinary profit (by either buying cheaply or selling “richly”). Hereforward, we shall use P rather than V, although you may see V used elsewhere.
A stock is a kind of perpetuity; the corporation, as a going concern, is eternal. Dividends will be paid in perpetuity. Unlike bonds, there is no face value to be paid at a specified time in the future. The only cash flows are the dividends.
This formula says that the price of a stock is equal to its aggregated discounted future cash flows, i.e., the dividends discounted to present value. Since, for the moment we assume that dividends are fixed (as in a preferred stock), the foregoing, never-ending equation may be simplified algebraically to the following (as was demonstrated for a perpetuity, only the terms have been modified to accommodate stock):
This simplification works because of the “Law of Limits,” discussed earlier in our TVM section. Interestingly, by transposing, the above formula may be re-formulated as:
Note: D ÷P is the Dividend Yield!
While corporations pay dividends quarterly, the formula looks at annual dividends. Recall that, in the case of a perpetuity, discounting frequency has no effect on Present Value.
14.05: The Dividend Discount Model (DDM)- Constant Growth Version
a.k.a. “The Gordon Model”
Of course, not all stocks pay fixed dividends. Let us take a small step forward and assume that the dividend grows at a constant rate of growth. In this version of the Dividend Discount Model (DDM), the constant dividend growth rate is designated as “G”:
This formula is identical to a constant growth perpetuity. The nomenclature was altered here in order to suit common stocks. With some simple algebraic transposition, we can re-formulate the DDM so as to isolate the discount rate to one side:
Code: D0 = the last reported Annual Dividend (i.e., the sum of the last four, quarterly dividends)
D1= D0(1 + G)
G = the imputed growth rate for dividends.
Note, interestingly, that this means that the discount rate is equal to the sum of the dividend yield plus the growth rate in dividends. This formulation presents a percentages view on the model; all terms are percentages.
Note also that when G = 0, we have the “no-growth” version of the DDM. If G > 0, we have the “Constant-Growth” DDM. As discussed in the TVM section, R must exceed G for both practical / financial and mathematical reasons. Remember that when we speak of “growth,” we refer to growth in dividends, which, in turn, comes from growth in sales and profits.
Questions:
Given: R = .15 D = \$1.50 G = 0
1. What is the price?
2. What happens to P if R goes down?
3. What happens to P if G goes down?
Solutions:
1. P = (\$1.50) / .15 = \$10
2. Just as in the TVM, as the discount rate decreases, present values (P) increase. So too here!
3. “R – G” increases, and D1 decreases, both of which result in, or cause, a lower price
Note:
This version of the DDM is a.k.a. The Gordon Model, named after Myron Gordon. This idea is not without its controversy or weaknesses, the discussion of which is beyond our current scope. | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.04%3A_The_Dividend_Discount_Model_%28DDM%29-_Fixed_Dividend_or_No-_Growth.txt |
a.k.a. “The Gordon Model”
Of course, not all stocks pay fixed dividends. Let us take a small step forward and assume that the dividend grows at a constant rate of growth. In this version of the Dividend Discount Model (DDM), the constant dividend growth rate is designated as “G”:
This formula is identical to a constant growth perpetuity. The nomenclature was altered here in order to suit common stocks. With some simple algebraic transposition, we can re-formulate the DDM so as to isolate the discount rate to one side:
Code: D0 = the last reported Annual Dividend (i.e., the sum of the last four, quarterly dividends)
D1= D0(1 + G)
G = the imputed growth rate for dividends.
Note, interestingly, that this means that the discount rate is equal to the sum of the dividend yield plus the growth rate in dividends. This formulation presents a percentages view on the model; all terms are percentages.
Note also that when G = 0, we have the “no-growth” version of the DDM. If G > 0, we have the “Constant-Growth” DDM. As discussed in the TVM section, R must exceed G for both practical / financial and mathematical reasons. Remember that when we speak of “growth,” we refer to growth in dividends, which, in turn, comes from growth in sales and profits.
Questions:
Given: R = .15 D = \$1.50 G = 0
1. What is the price?
2. What happens to P if R goes down?
3. What happens to P if G goes down?
Solutions:
1. P = (\$1.50) / .15 = \$10
2. Just as in the TVM, as the discount rate decreases, present values (P) increase. So too here!
3. “R – G” increases, and D1 decreases, both of which result in, or cause, a lower price
Note:
This version of the DDM is a.k.a. The Gordon Model, named after Myron Gordon. This idea is not without its controversy or weaknesses, the discussion of which is beyond our current scope.
14.06: Dividend Discount Model (DDM) (Problems)
Buy when there’s blood in the streets.
– Nathan Mayer Rothschild (1777-1836)
14.06: Dividend Discount Model (DDM) (Problems)
Buy when there’s blood in the streets.
– Nathan Mayer Rothschild (1777-1836)
14.07: Dividend Discount Model (Solutions)
The following table presents the solutions to the problems on the prior page.
• As G increases, R – G decreases, and P increases. G, as the growth rate in dividend, also affects D1 (because D1 = D0 [1 + G]). As G increases, so too does D1.
• So far, we have assumed that P = V, i.e., Market Price = Intrinsic Value. If however, V > P, we then have an unusual opportunity to achieve an excess (“unearned”) return; if the opposite pertains, we should sell the stock – if we already own it, or sell it short – if we are aggressive
Stock prices climb a wall of worry.
-Anonymous
14.07: Dividend Discount Model (Solutions)
The following table presents the solutions to the problems on the prior page.
• As G increases, R – G decreases, and P increases. G, as the growth rate in dividend, also affects D1 (because D1 = D0 [1 + G]). As G increases, so too does D1.
• So far, we have assumed that P = V, i.e., Market Price = Intrinsic Value. If however, V > P, we then have an unusual opportunity to achieve an excess (“unearned”) return; if the opposite pertains, we should sell the stock – if we already own it, or sell it short – if we are aggressive
Stock prices climb a wall of worry.
-Anonymous | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.05%3A_The_Dividend_Discount_Model_(DDM)-_Constant_Growth_Version.txt |
No doubt you have noticed that the Dividend Discount Model, as so far presented, assumed that dividends are paid annually. We all know that companies pay dividends in quarterly payments. Does this difference in payment frequency matter? Should we not employ the DDM using quarterly payments? If dividends are paid quarterly, most of the funds will arrive sooner. Is it not a basic principle of the Time Value of Money that if the funds come in sooner the present value is greater, and isn’t a stock’s price present value? Ought that not affect the way we write the formula?
To adjust for this, we modify the formula and arrive at the following, using the simpler no-growth version:
Price = (D / 4) ÷ [(1 + R)1/4 – 1]
To illustrate this, we shall assume that:
D = \$1
R = 0.10
When we calculate based on annual dividends, we get:
P + D / R
P = 1 ÷ 0.10 = \$10
When we calculate based on quarterly dividends, we get:
P = (D / 4) ÷ [(1 + R)1/4 –1]
P = (1 / 4) ÷ [(1.10)1/4 –1] = \$10.37
This value is substantially higher!
On Speech and Deed
On Accurate Speech
Speak clearly, if you speak at all: carve every word before you let it fall.
-Oliver Wendell Holmes, Sr.
Justice of the Supreme Court
Speak softly and carry a big stick.
-Theodore Roosevelt
President of the United States
… a sage weighs his words carefully…. Every argument and opinion expressed by the Sages is subject to close scrutiny. The same is true for their actions.
-Rabbi Adin Even-Israel Steinsaltz
Reference Guide to the Talmud, p. 124 (2014)
The noble man is modest in his speech, but exceeds in his actions.
-Confucius
I sez what I means and I means what I sez.
-Popeye
Famous Sailor And Philosopher
On Accuracy in Deed
Simon Says.
-Source and date unknown
14.09: Components of the Dividend Discount Model
The DDM formula contains several variables whose values must be ascertained in order to solve for Price (P). Here is the formula (again).
P = [D0 (1 + G)] ÷ (R – G)
= D1 ÷ (R – G)
The variables are:
Price = Intrinsic Value
We must solve for “P.” The market price (P) will equal the security’s intrinsic value (V) if the security is efficiently – or correctly – priced in the market. That is what we are trying to uncover with the formula. We will assume here that P = V.
The Last Annual Dividend
D0 is the prior year’s dividend, and is thus a known, historical fact. D1 is the next dividend.
Next Year’s Dividend
Next year’s dividend depends on our expected dividend growth rate, “G.”
D1= D0 ×(1 + G)
Growth Rate in the Dividend
The dividend’s growth rate is defined as:
G = (D1÷ D0) 1
However, we do not know D1, the next year’s dividend. Therefore, we need a formula for “G.” Here, is the non-intuitive formula for G.
G = ROE × RR
ROE = Return-on-Equity = (NI ÷ Eq.)
RR = Retention Rate = (NI – D ÷ NI) = (A.R.E. ÷ NI)
A.R.E. = Addition to Retained Earnings = NI – D
Therefore:
G = (NI ÷ Eq.) (A.R.E. ÷ NI)
G = (A.R.E.) ÷ Eq.
We will examine “G” more closely below and introduce “R.”
14.10: A Closer Look at Dividend Growth
In order to fully understand the “g” term in the dividend discount model, a term which is not intuitive, let us have a closer look. (As you go through this example, keep in mind that, as the company retains earnings the balance sheet gets bigger.”) We are given the following information about a company:
If:
Then:
Given this information, G = (ROE) × (RR) = (.10) × (.90) = .09. By definition, G, the growth rate in the dividend, must also be defined, far more simply, as: G = [(D1) ÷ (D0)] – 1. This simple formula is readily understood. Note also that G = ARE / NI, or the rate at which the Equity grows. Take note that, here, we have assumed that G, ROE, and RR are constants.
Let’s see if the two formulae work out to be the same; if so, we will therefore also know that the “G = (ROE) (RR)” formula makes sense, given the same data. Let’s see first how the simple formula, G = [(D1) ÷ (D0)] – 1, works out using an accountingtype (i.e., chronological) approach.
This gets us the same result – as it should! (In fact, we could not have known the value of D1 had we not had the first formulation!) This notion assumes that the retention rate (and payout ratio), dividend growth rate, and ROE are constants. You’ll note that the equity is growing at the same rate of 9%. This latter table says that if we earn and retain earnings, we will be able to pay out more money in dollars as dividends later.
14.11: Summary of DDM Variables' Sources
Buy low, sell high.
-Bernard Baruch (1870 – 1965)
To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward
-Sir John Templeton | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.08%3A_What_About_Quarterly_Dividends.txt |
Buy low, sell high.
-Bernard Baruch (1870 – 1965)
To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward
-Sir John Templeton
14.12: Value Prediction Problem
You are given the following information:
• Next year’s projected EPS for the S&P 500 = \$132 per share
• The dividend growth rate has been = 0.04
• The risk-free rate = 0.025 (either the T-Bill or the 10-Year Note, your choice)
• The MRP (Market Risk Premium) = 0.06
• The Return-on-Equity has been = 0.11.
Using the data given, what is the value for the S&P (per share) for next year?
Solution Plan:
Let’s use the DDM!
First, write out the DDM formula first to see what variables you already have and which are missing.
P0= [D1÷ (R – G)]
Then, in no necessary order:
1.G = (ROE) (RR)
2. 0.04 = (0.11) (RR)
3. RR = 0.36
4. PR = 1 – RR
5. PR = 1 – 0.36 = 0.64
6. D = (EPS) (PR)
7. D1 = [(\$132) (0.64] = \$84.48
8. R = RF+ MRP = 0.025 + 0.06 = 0.085
9. P0= D1÷ (R G)
10. P0 = \$84.48 ÷ (0.085 – 0.04) = \$1,877
14.13: A Qualitative Look at The Discount Rate
The discount rate, or “R,” for the market (RM) or for a company’s stock (RS) is a variable, which itself is determined by general market levels of interest rates, the default risk of the company’s bonds, and credit spreads.
R = f (general levels of interest rates, default risk, credit spreads)
General levels of interest rates: All interest rates are interrelated. In general, if rates go up for a base rate, such as Treasuries, other rates will follow.
Default risk: If a company’s bond default risk increases, the dividend on preferred stock will also be less secure. Discount rates on “Preferreds” will go up and prices will go down. So too will the discount rate and price of common equity follow. The company’s ability to pay common stock dividends and to retain additional earnings will be reduced. Remember: Default risk, essentially, has to do with the chance that a corporate borrower, or issuer of bonds, will not pay the interest on its borrowings in full and on time.
Credit Spreads: We know that credit spreads reflect rate differentials between, typically, 10-year Treasury Notes and 10-Year B-rated Corporates. However, we can create spreads between Notes and anything, such as discount rates on “Preferreds.” Thus, spreads may be observed between T-Notes, Preferred-, and Common-Stock Returns. And we already know that spreads narrow or widen according to economic circumstances and outlooks. If spreads widen, required stock returns will go up and prices will go down.
These three variables, when aggregated, will constitute the stock’s risk (β). “R” can be stated (again) formulaically:
RM = RF + MRP
MRP = Market Risk Premium = RM – RF
RM = RF + (RM – RF) βM
The Market Return (RM) equals the Risk-free Rate (RF) plus a Market Risk Premium.
A specific portfolio’s or security’s return (RPor RS) will equal the Risk-free Rate (RF) plusa Market Risk Premium (RM– RF), adjusted for the relative risk (βS) of the portfolio. βP (portfolio risk) or βS (individual security risk) can be equal to, greater than, or less than the Market’s Risk level (βM). Thus, we can also speak of a “Portfolio Risk Premium” (RP– RF). We can substitute “RS” for “RP” at the individual stock level and use “RS” as the discount rate in the DDM.
14.14: Business Ethics - The Small Investor's Experience of Insider Trad
We have just completed a discussion of the elements in securities’ valuation. Some individuals try to get an upper hand in their stock selections by engaging in illegal activities. The following is a salient example.
“Insider Trading” has to do with the personal use of material nonpublic information about the future prospects of a company – whether good or bad, in order to garner an unearned profit by trading its securities ahead of any public announcements regarding the pertinent information. An “insider” is an employee, a relative, or friend of an employee. Insider trading, in the United States, is illegal. Don’t even think of it.
Is such trading, from a moral point of view, fair or not? Is it fair that an insider may have an exploitable advantage to enrich himself/herself? Is the law “correct” in making it illegal? Imagine the scenario below and respond to the questions that follow:
Suppose we focus on three parties to a series of transactions on a security at a point in time. Mr. X is interested in selling 1,000 shares of ABC corporation; Mr. Y is interested in purchasing 1,000 shares; Mr. Z, an informed corporate insider, is interested in purchasing a large block of the stock. Messrs. X and Y are small investors each of whom has personal reasons for engaging in the transaction.
In a normal market, X would sell to Y at the current price. Both parties would be satisfied at having engaged in the transaction. However, Mr. Z holds some critical information concerning the very favorable portents of the shares and wants to buy before the word gets out. His bid causes the share price to rise and thus Mr. X gets a higher price than he may have otherwise received, all else equal. No harm done.
Due to the rise in share price, Mr. Y pays more than he may have otherwise. Such possible harm may be overcome by the pending rise of the shares once the information is announced. The slight short-term harm is overcome by the longer-term profits Mr. Y shall earn. Mr. Y may nonetheless feel harmed.
However, had Mr. X known about the pending release of favorable information, he may have either waited before selling or changed his mind completely about his decision to sell. Mr. X may feel harmed.
Questions:
1. Justify Mr. Z’s insider trading on a moral basis.
2. Denounce Mr. Z’s trading – morally speaking.
3. What is your own view of Mr. Z’s trading? Find a moral justification for your position – apart from what you stated already.
Bottom Line: It is illegal. Don’t even think about it! | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.11%3A_Summary_of_DDM_Variables'_Sources.txt |
We have just completed a discussion of the elements in securities’ valuation. Some individuals try to get an upper hand in their stock selections by engaging in illegal activities. The following is a salient example.
“Insider Trading” has to do with the personal use of material nonpublic information about the future prospects of a company – whether good or bad, in order to garner an unearned profit by trading its securities ahead of any public announcements regarding the pertinent information. An “insider” is an employee, a relative, or friend of an employee. Insider trading, in the United States, is illegal. Don’t even think of it.
Is such trading, from a moral point of view, fair or not? Is it fair that an insider may have an exploitable advantage to enrich himself/herself? Is the law “correct” in making it illegal? Imagine the scenario below and respond to the questions that follow:
Suppose we focus on three parties to a series of transactions on a security at a point in time. Mr. X is interested in selling 1,000 shares of ABC corporation; Mr. Y is interested in purchasing 1,000 shares; Mr. Z, an informed corporate insider, is interested in purchasing a large block of the stock. Messrs. X and Y are small investors each of whom has personal reasons for engaging in the transaction.
In a normal market, X would sell to Y at the current price. Both parties would be satisfied at having engaged in the transaction. However, Mr. Z holds some critical information concerning the very favorable portents of the shares and wants to buy before the word gets out. His bid causes the share price to rise and thus Mr. X gets a higher price than he may have otherwise received, all else equal. No harm done.
Due to the rise in share price, Mr. Y pays more than he may have otherwise. Such possible harm may be overcome by the pending rise of the shares once the information is announced. The slight short-term harm is overcome by the longer-term profits Mr. Y shall earn. Mr. Y may nonetheless feel harmed.
However, had Mr. X known about the pending release of favorable information, he may have either waited before selling or changed his mind completely about his decision to sell. Mr. X may feel harmed.
Questions:
1. Justify Mr. Z’s insider trading on a moral basis.
2. Denounce Mr. Z’s trading – morally speaking.
3. What is your own view of Mr. Z’s trading? Find a moral justification for your position – apart from what you stated already.
Bottom Line: It is illegal. Don’t even think about it!
14.15: Capital Gains
It is interesting to note that, if G > 0, the model will automatically generate capital gains. Here again is our formula. Below is a problem whose resolution illustrates the model’s automatic generation of capital gains.
Question:
Formula:
P0 = [D0 (1 + G)] / (R – G)
P0 = D1 / (R – G)
Given:
D0 = \$1 The Last Dividend
R = 10% The Discount Rate
G = 5% The Dividend’s Constant Growth Rate
What is the price today?
What would the price be in one year?
Solution:
Price Today:
P0= \$1 (1 + .05) / (.10 – .05)
= 1.05 / .05
= \$21
Price in One-Year:
P1 = D2 / (R – G)
P1 = \$1.05 (1 + .05) / (.10 – .05)
= 1.1025 / .05
= \$22.05
We observe that \$22.05 / \$21 = 1.05. That is to say that next year’s price will be greater than last year’s by 5%, or the same as the stock’s growth rate (again, assuming a constant pay-out ratio).
We often say that a stock is “ahead of itself,” if the rate of growth in price exceeds the dividend – or earnings – growth rate (assuming a constant pay-out ratio).
Capital Gains, Dividend Growth: Some Practice Problems
The following should help summarize some relevant concepts.
1. Complete the empty cells, given the data noted below for a stock. The basic formula for the Dividend Discount Model is:
P0= [(D0) (1 + G)] ÷ [R – G]
2. Once again, complete the spreadsheet, given the data noted for a particular stock.
Given:
Solve:
• Explain, in words, what is meant by the term, “G,” in question #2.
• Assuming G is a constant (question #1), P0 (1 + G) = P1.
Problem 1:
Problem 2:
14.16: Portfolio Return (Weighted Averages)
Now that we know all about individual bond and stock returns, what about portfolios of securities? A portfolio is a collection of individual securities.
If the market values of the portfolio’s constituent securities were the same, the portfolio weights would be equal, and the simple arithmetic- and weighted-averages would be the same. In calculating the simple arithmetic return, one would take the observed returns and divide by the number of observations. Here, the weights are unequal, so we must employ a weighted average calculation as below.
Example: Calculate the (historical or expected) weighted average return for the following portfolio, which consists of three securities (A, B, and C) and has the market values and individual returns as noted.
Note: Portfolio risk is not simply a weighted-average of the portfolio constituents’ respective risks – due to “covariance” among securities.
Portfolio Return (Solution to Problem)
Solution (table form):
Solution (by formula):
RP= 1/6 (.10) + 1/3 (.12) + 1/2 (.16) = 0.1367
Short-cut solution:
RP= [(100) (.10) + (200) (.12) + (300) (.16)] ÷ 600 = 0.1367
In the short-cut solution, we do not take the weights first. Instead, we multiply the dollar values by each expected return and, at the end, divide by the entire portfolio value.
The 0.1367 return means that the investment would increase by 13.67% in one year. If you had invested \$1,000, after one year’s time, you would have one thousand dollars plus \$136.70 for a total of \$1,136.7. Some of the return, presumably, would come from income (rent, interest, or dividends) and some from capital growth (price appreciation). The constituent security returns, as given here, were themselves represented without any further detail as to the breakdown of income and growth portions.
If the weights had all been equal (i.e., .3333, in this case), we could have calculated a simple average by adding the sum of the returns and dividing by (n =) 3. In other words, a simple average implies equal weights.
If one of the constituent security’s returns were negative, we would of course get a different result. Let us say that the return on Security “A” were -.10, rather than positive. In this case, the portfolio return would be:
RP = 1/6 (-.10) + 1/3 (.12) + 1/2 (.16) = .1033
Another way in which we could have calculated this would have been as follows:
0.1367 – (2) (.0167) = .1033 | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.14%3A_Business_Ethics_-_The_Small_Investor's_Experience_of_Insider_Tradin.txt |
Now that we know all about individual bond and stock returns, what about portfolios of securities? A portfolio is a collection of individual securities.
If the market values of the portfolio’s constituent securities were the same, the portfolio weights would be equal, and the simple arithmetic- and weighted-averages would be the same. In calculating the simple arithmetic return, one would take the observed returns and divide by the number of observations. Here, the weights are unequal, so we must employ a weighted average calculation as below.
Example: Calculate the (historical or expected) weighted average return for the following portfolio, which consists of three securities (A, B, and C) and has the market values and individual returns as noted.
Note: Portfolio risk is not simply a weighted-average of the portfolio constituents’ respective risks – due to “covariance” among securities.
Portfolio Return (Solution to Problem)
Solution (table form):
Solution (by formula):
RP= 1/6 (.10) + 1/3 (.12) + 1/2 (.16) = 0.1367
Short-cut solution:
RP= [(100) (.10) + (200) (.12) + (300) (.16)] ÷ 600 = 0.1367
In the short-cut solution, we do not take the weights first. Instead, we multiply the dollar values by each expected return and, at the end, divide by the entire portfolio value.
The 0.1367 return means that the investment would increase by 13.67% in one year. If you had invested \$1,000, after one year’s time, you would have one thousand dollars plus \$136.70 for a total of \$1,136.7. Some of the return, presumably, would come from income (rent, interest, or dividends) and some from capital growth (price appreciation). The constituent security returns, as given here, were themselves represented without any further detail as to the breakdown of income and growth portions.
If the weights had all been equal (i.e., .3333, in this case), we could have calculated a simple average by adding the sum of the returns and dividing by (n =) 3. In other words, a simple average implies equal weights.
If one of the constituent security’s returns were negative, we would of course get a different result. Let us say that the return on Security “A” were -.10, rather than positive. In this case, the portfolio return would be:
RP = 1/6 (-.10) + 1/3 (.12) + 1/2 (.16) = .1033
Another way in which we could have calculated this would have been as follows:
0.1367 – (2) (.0167) = .1033
14.17: The Geometric Average Return- Multi-year Returns
Generally, we quote return in annual terms. In order to calculate the return for multiple years, we must arrive at a reasonable, average annual return figure.
Suppose you observe the following three (historical or projected) annual returns:
.10 .25 .35
The simple, arithmetic average return would be:
[.10 + .25 + .35] ÷ 3 = .2333
For the average to be valid in terms of the time value of money, its future value should equal the product of the three observations. However,
(1.2333) 3≠ (1.10) (1.25) (1.35)
Again, the conceptually correct average must be consistent with the time value of money and its “(1 + R) n” format. By modifying the line above and asking what the correct average rate, “R,” should be, we arrive at:
(1 + R) 3= (1.10) (1.25) (1.35)
(1 + R) = [(1.10) (1.25) (1.35)] 1/3
R = [(1.10) (1.25) (1.35)] 1/3 – 1
R = .228981
Thus, the average multi-period return is 0.2290. This calculation is referred to as the “geometric average” and is consistent with the manner in which we do the time value of money. The general notation for this formula requires the use of product summationnotation – “Π (as opposed to using the usual sigma summation notation, Σ). The notation reads as follows:
Geometric Average = [Π (1 + Ri) 1/n] – 1
Question: What would this average be if the 10% observation were negative?
Answer: 0.1495. How did you get this?
Note: Should there be a negative return in the mix as above, the same method should be used as always. The following should make common sense. For example, should one experience a 50% loss and a 100% gain in consecutive years, the geometric average return would be: [(1 + {-0.50}) × (1 + 1)] ½ – 1 = 0.0.
Had you instead calculated the simple average, you would have gotten: [(-0.50) + (1.0)] ÷ 2 = 25%. That cannot be correct! | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.16%3A_Portfolio_Return_(Weighted_Averages).txt |
Chapters 12 – 14: Review Questions
1. How are the Return to the Investor and Cost to the Issuer related?
2. What is the cost of debt? Are taxes included? What is the relevant formula?
3. What is meant by “Technical Default”?
4. What are the two elements in the Cost of (Common) Equity Capital?
5. The investors’ “Required Return on Equity” (RM) consists of what elements?
6. What is meant by “Market Risk Premium”?
7. What is meant by “Portfolio Risk Premium”?
8. What is meant by “Rational Expectations”?
9. Define each of the following Risks:
• Liquidity
• Credit
• Inflation
• Sovereign / Country / Political
• Foreign Currency
With respect to Inflation Risk, utilize the phrases “Nominal” and Real” properly.
10. How are Price and Reinvestment Risks related? Explain.
11. Who are the two major credit rating agencies?
12. Do the agencies agree with one another on all ratings? Explain.
13. What is the difference between “Investment Grade” and “High-yield”?
14. How do credit ratings relate to default risk?
15. To what do “Indenture” and “Covenants” refer?
16. What is a “lien”? What relevance does it have to bonds?
17. What two variables are depicted on the “Yield Curve,” and on what axes are they depicted?
18. If the bond category is not stated on the Yield Curve, what is the default option?
19. Define “Liquidity Preference.” What impact does this concept have on the “normal” slope of the Yield Curve?
20. What is meant by an “Inverted” Yield Curve? Why does it come about? How long does it usually last?
21. Discuss each of the four Yield Curve theories.
22. Observed rates are stated below. Fill in the Spot Rates. Graph it.
23. Draw in a fictitious Yield Curve for Treasuries of your liking. Then, draw in a B-rated Corporate Bond Yield Curve. Posit a Credit Spread for the Ten-year bonds.
24. Using the graph you drew in the prior question, show how Credit Spreads may expand or contract.
25. Why do Credit Spreads expand and contract?
26. What is meant by a “Flight to Quality”?
27. Define the three forms of income. To which financial instruments does each refer?
28. Explain the “Valuation Premise.”
29. Calculate the “Holding Period Return” (HPR), given the following:
• Initial cost: \$12 million
• Income over holding period: \$1.3 million
• Sale Price: \$11 million
30. What is the key deficiency of the HPR?
31. Define each of the following. Can you find another name for each?
• Face Value
• Coupon
• Market Yield
32. What is meant by “Par, Discount. and Premium”? Why are bonds priced one or the other of these ways?
33. Given the following, calculate the price of this bond? Your answer should be stated in percentage terms.
• Coupon: 4%
• Term-to-maturity: 10 Years
• Discounting Frequency: Semi-annual
• Yield-to-maturity: 8%
34. What would be the price for the bond in the prior question if its coupon were 0%? Explain in words why the price is higher or lower.
35. Why does compounding frequency matter in pricing bonds?
36. What two variables determine a bond’s market yield? Explain your terms.
37. Why may it be said that the “true” price of a bond is its Market Yield and not its dollar price?
38. Is it reasonable to ascribe the Valuation Premise to equities, or just to bonds? Why?
39. Define each of the following terms relative to equity valuation:
• Going-concern Value
• Liquidation Value
• Book Value
• Market Value
• Intrinsic Value
• Relative Value
40. Why are equities so important to our Macroeconomy?
41. Given the following, calculate the stock’s Intrinsic Value, and its current and prospective Dividend Yield.
• Last Dividend = \$3.20
• Discount Rate = 8%
• Growth Rate = 3.5%
42. In addition to a mathematical explanation, why must a stock’s discount rate exceed its dividend growth rate?
43. What categories of equity are best suited to the no-growth and constant growth Dividend Discount Models (DDM)?
44. Does it matter that the DDM is based on yearly dividends when stocks pay dividends quarterly? Explain.
45. You are given the following. Calculate the stock’s dividend growth rate.
• Common Equity = \$100 million
• Return on Equity = 10%
• Number of Common Shares Outstanding = 5 million
• Payout Ratio = 20%
46. If the Equity Discount Rate in the prior question is 10%, what is the Intrinsic Value of the stock?
47. What will be next year’s price for this stock?
48. Explain each of the three variables that determine the Equity Discount Rate.
49. What is the relationship between the growth rates of the dividends and the price of the stock? Explain.
50. Given the following data, what is the expected portfolio return? (Note the signs.)
51. Following are the annual returns for Joseph’s portfolio for the last five years.
a. What are his arithmetic and annualized geometric returns?
b. Does it matter that the data are not ordered chronologically?
c. Why are the two measures related as such, i.e., where one is higher than the other? Which calculation is more conceptually accurate?
Solution to Question #22:
A = 1r1 = 2.0%
B = 2r1 = (1.02) (1 + B) = 1.0252
C = 3r1 = (1.02) (1.030024) (1 + C) = 1.03253
D = 4r1 = (1.02) (1.030024) (1.047687) (1 + D) = 1.044
E = 5r1 = (1.02) (1.030024) (1.047687) (1.062827) (1 + E) = 1.03755 | textbooks/biz/Finance/Introduction_to_Financial_Analysis_(Bigel)/04%3A_Part_IV_Interest_Rates_Valuation_and_Return/14%3A_Equity_Valuation_and_Return_Measurement/14.18%3A_Chapters_12-14-_Review_Questions.txt |
“In investing money, the amount of interest you want should depend upon on whether you want to eat well or sleep well.”
-- J. Kenfield Morley
Investing is not as difficult as you think; we will show you how. (Speculating and trading are very, very difficult; we can't help you with those. Sorry.) After you have taken this course, you will have a strong foundation of the most important financial investments. We cover stocks, bonds, mutual funds, short-term investments, commonly referred to as "cash," hybrid instruments, and a few others. We want to emphasize that this is an introduction class. You do not need any prior investment experience. We start from the very beginning with the question: "What Is an Investment?"
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Don’t worry if any or all of this sounds scary now. We will learn all these terms and concepts in good time. They really are not as hard as they sound. Again, not for the last time, we want you to remember that this is an Introduction to Investments class. You need no prior investment experience nor training.
Every chapter has a corresponding presentation file and study guide. In BUS-123, Introduction to Investments, we use Google Docs. Please remember that all class material is located on the class website, https://www.wonderprofessor.com/123/. In this first chapter, we have a video presentation that discusses the study guides and also demonstrates how to download documents or make a copies of documents using Google Docs.
• 1.1: What Is an Investment?
Welcome to Introduction to Investments. Do you want to be a successful investor? You can. You do not need any prior investment experience to take this class. You don’t have to be a genius or a technology whiz. There is no advanced math, only simple arithmetic that any 99¢ calculator can perform. So let's get started with a very simple question: What Is an Investment?
• 1.2: Investment Characteristics and Attributes
What follows is a list of general characteristics and attributes about the major investment options. Study these terms, write them down, print the chapter 1 Study Guide, and watch or listen to the first lecture for chapter 1 on the website or Canvas. This is all you need to learn and know for now.
• 1.3: An Overview of the Investment Universe
Let’s become casually acquainted with the major investment asset classes. We will dispense with all the tedious details. As before, concern yourselves with just what we cover here. Don’t fret. There will be plenty of time later on to learn the many intricacies of these investments. As we introduce each investment asset class, we will touch on the risk and return that we can expect from each.
• 1.4: Risk versus Return ‒ The Eternal Struggle of Investing
Here it is, Dear Readers! This is the entire class in one section! Do you want to eat well or do you want to sleep well?
• 1.5: Short-Term Investments Revisited ‒ A Place to Park Your Money
Short-term investments are vehicles that we use when we need the money to be safe. They are place to park our money. In return for this safety, we receive a much lower rate of return. Short-term investments allow us to sleep very well.
• 1.S: Summary
Congratulations ‒ You Have Finished Chapter 1 ‒ Introduction, Overview, and Risk versus Return
01: Introduction Overview and Risk versus Return
“In investing money, the amount of interest you want should depend upon on whether you want to eat well or sleep well.”
-- J. Kenfield Morley
Welcome to Introduction to Investments. Do you want to be a successful investor? You can. You do not need any prior investment experience to take this class. You don’t have to be a genius or a technology whiz. There is no advanced math, only simple arithmetic that any 99¢ calculator can perform, addition, subtraction, division, and multiplication. The concepts, techniques, and skills, while extensive at times, are not difficult. The research is relatively painless. As the famed investor, Mr. Warren Buffett, has been quoted as saying, “Investing is simple … but it ain’t easy.” What? Why? How? Mr. Buffett is referring to the fact that there are two parts to the world of investments. The simple part is the intellectual part, the cognitive part. Read, listen, watch, study the material, spend some time doing the research and the assignments, and you should find that the concepts, techniques, and skills are actually very straightforward. The “ain’t easy” part is the emotional part of investing. We will spend a great deal of time doing our best to help you learn techniques, tricks, and tips that should help you succeed with the emotional part, but again, as Mr. Buffett says, “it ain’t easy!”
Mr. J. Kenfield Morley encapsulates our predicament perfectly. “In investing money, the amount of interest you want should depend upon on whether you want to eat well or sleep well.” If we may be so bold as to suggest a better rendition of this timeless advice, we would ask Mr. Morley to substitute the word reward for his choice of the word interest. Interest is just one type of investment reward; there are others. Nevertheless, the meaning shines through brilliantly. As we are introduced to the many investment choices, we are going to see that some of the choices will help us eat well. Some others will allow us to sleep well. However, there aren’t any choices that can do both. Take heart! We will learn some techniques that should allow us to eat reasonably well and sleep reasonably well but as we will say over and over and over again, “There ain’t no guarantees!”
Investing versus Speculating/Trading
We are going to introduce a distinction here that will run through our journey together. Do you want to be an investor or do you want to be a speculator, also known as a trader? Becoming an investor is something that we can definitely help you with. You will learn the most important and most popular investment alternatives. You will learn the types of rewards we can expect from each and the levels of risks that we will have to accept to receive these rewards. We will also cover some important techniques and skills to help us deal with these risks. We will learn that building wealth through investments is a long-term process; it does not happen overnight. We can help you become a prudent, long-term investor. However, if you want to become a speculator or a trader and earn tremendous amounts of money quickly, then we are sorry to say that you will be very disappointed in this class. We are not able to help you to become a speculator or trader. Our sincerest apologies.
So let’s get started. We start from the very beginning with a simple question: What is an investment? There are many definitions available. Here is the definition we will use in our class:
An investment is any vehicle into which resources can be placed with the expectation that it will generate positive income, or that its value will be preserved or increased, or both.
For the vast majority of us, the resources placed will be dollars, typically from our work-related income. There are many investment vehicles and, as mentioned, we will cover the most popular alternatives. We see that there are a few goals that we might seek with regard to our investments. One goal is to generate positive income, also known as cash flow. Another goal is to increase the value of our investment, also known as capital appreciation. At the very least, we want to preserve the value of our investments over the long term. Lastly, we could also seek both goals of cash flow and capital appreciation. As we introduce each investment alternative, we will discuss the goals associated with each investment alternative and the risks that each carries.
Here is another important definition that revisits our distinction of being an investor or a speculator/trader:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” – Benjamin Graham
This definition, Dear Readers, is very near and dear to Your Humble Author’s heart. This quote is from The Intelligent Investor, written by Mr. Benjamin Graham. Mr. Graham was Mr. Warren Buffett’s teacher and mentor. Eventually you will want to read The Intelligent Investor. (Don’t read it as your first book! There are better books to read as your first book on investing. Please see the Bibliography for which books you should read first.) We will return again and again to this definition. If nothing else, we want you to understand the difference between prudent investing for the long term and speculating/trading in the short term.
Mr. Buffett is famous for boiling down Mr. Graham’s concepts into very simple sayings. To illustrate this concept, Mr. Buffett famously said, “Rule #1: Don’t lose money. Rule #2: Never forget Rule #1.” Although we will see that investment values bounce up and down all the time, if you do your research and choose prudent, long-term investments that have done well over time and should continue to do well into the future ‒ and you don’t panic when the markets fall ‒ you won’t lose money in the long term*. You won’t be a speculator/trader. You will be an investor.
We will now discuss various characteristics and attributes of the major investment alternatives.
*Disclaimer: Please note that investment success is not guaranteed. If technologically based civilization cracks, falls, and dissolves into a pool of tears, then all bets are off. Of course, if that happens, you won't be worrying about your investments. You'll be joining the teeming masses digging for beetle grubs and boiling bark for dinner. Personally, I don't believe this is going to happen any time soon. I am very optimistic. Failure is not an option. But the truth is that nobody knows what the future will bring. Oh, well.
We will now discuss various characteristics and attributes of the major investment alternatives. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/01%3A_Introduction_Overview_and_Risk_versus_Return/1.01%3A_What_Is_an_Investment.txt |
Video - Audio - YouTube - Presentation File (Material for this section begins on slide 5.)
As you work through the material in this introductory chapter, remember that this is an Introduction to Investments class. Don’t worry about all the jargon and buzzwords and proclamations and sexy graphics and silly antics that you may have heard or seen from the talking heads on the financial media outlets. Please forget anything and everything your brother-in-law, the self-appointed Expert-On-All-Things-Including-How-To-Invest, told you at the Thanksgiving dinner table. What follows is a list of general characteristics and attributes about investments. Study these terms, write them down, print the chapter 1 Study Guide, and watch and listen to the first lecture presentation for chapter 1 on the class website. This is all you need to learn and know for now.
Securities, Property, and Personal Investments
There are three broad categories of investments: securities, property, and personal. According to Wikipedia, a “security is a tradable financial asset.” Investopedia goes into more detail and defines a “security as a fungible, negotiable financial instrument that holds some type of monetary value.” The fancy words fungible and negotiable mean that the security can be traded and its value can be negotiated. Another popular definition of security is “an investment that represents debt or ownership or the legal right to acquire or sell an ownership interest.” This last definition introduces the three main categories of securities that we will detail later. The word security is an unfortunate term. Many people don’t have a clear picture of what is meant by the word security. Our class used to be titled, “Investments and Securities.” Students would say, “I’m not an Administration of Justice major. I don’t need to take this class.” No, not that type of security! For now, please understand that a security is a financial asset that can be traded and whose value changes over time.
Property investments are sometimes referred to as hard assets or tangible assets. They include gold and other precious metals, art and other collectibles such as cars, commodities such as basic foodstuffs and materials, and real estate. We will discuss property investments toward the end of our journey together. They are important options but for the vast majority of us, securities are the best choice for prudent, long-term investments. This class concentrates on securities.
Finally, personal investments are endeavors we undertake to better ourselves. Examples include education, training, and travel. Many say that their personal investments such as college or traveling the world were often the best investments they ever made. I agree. We will do our best to make our time together one of the best, if not the best, personal investments you will ever make. None other than Benjamin Franklin said, "An investment in education pays the best interest."
Primary Assets versus Derivative Assets
Investments fall into either primary or derivative assets. For the vast majority of our time together, we will be covering primary assets. Primary assets fall into two categories: debt and equity. Debt investments are investments where investors lend their money to someone else. Examples of these include bonds and savings accounts. Equity investments are investments where the investor has full or partial ownership of the entity. Examples include stocks, real estate, and partnerships. Debt investors are loaners. Equity investors are owners.
On the other hand, derivatives are securities that derive their value from other assets. Examples of derivatives are options and futures. With derivatives, you can make a whole lot of money quickly and then lose a whole lot of money quickly. In fact, you can lose the whole value of your derivative investment overnight. Many in the industry do not categorize derivatives as investing. According to Mr. Graham’s definition above, derivatives would certainly be regarded as speculative. As we will see, in the investment world, “speculative” is a euphemism for the word “gambling.” We will discuss options and futures in detail at the very end of our journey together. Before we impress upon you just how dangerous these speculations are, if anyone tries to entice you with riches beyond your wildest dreams trading in options or futures, please tell them you are waiting until the end of the Introduction to Investments class before you make a decision one way or the other. (Spoiler alert: Unless you enjoy losing money quickly, stay away from derivatives of all forms! They are hazardous to your financial well-being.)
Direct Investments versus Indirect Investments
Direct investments are investments for which you have control of the underlying investment assets. Your name is on the title or the account. You are in control of the asset. Examples of these types of investments include stocks, bonds, real estate, and hard assets. With an indirect investment, someone else is making the decision about what underlying investment will be chosen. You may have some input into the decision but more often than not, you have no control of what assets will be chosen. Examples of these investments are mutual funds, limited partnerships, and Real Estate Investment Trusts (REITs). With indirect investments, you choose the mutual fund or limited partnership or REIT, and the manager or general partner chooses the underlying investments in stocks or bonds or real estate.
Investment Domesticity
Domesticity describes the location of an investment. There are three categories: domestic, global, and international. The first category is easy; a domestic investment is domiciled inside the United States. There is a subtle but important distinction with regard to the second two categories. A global investment means that it could be based anywhere in the world, including the United States. An international investment is based outside the United States. Please pay attention to this important difference. International investments are also often called foreign investment or overseas investments.
Until the 1970’s, the differences between these categories were important. However, as globalization has evolved since the 1980’s, the differences have become much less pronounced. Greg Ireland, a successful mutual fund manager with over 35 years of experience once said, “The world is a very small place economically.” The influential magazine Forbes reported that, “Sixty-five percent (by value) of the parts in the Ford Mustang come from the U.S. and Canada. Ninety percent of the parts in the Toyota Sienna – which is built in Indiana – come from the U.S. and Canada.” Which is the more American car, a Ford Mustang or a Toyota Sienna?
In the presentation, we list seventeen well-known companies and ask, “Which are domestic and which are foreign?” (Spoiler alert: They are all foreign.) In the United States, the issue of globalization has spilled into the political arena and elicited much controversy. At times, this controversy has taken the form of anger, fear, and loathing. This is unfortunate from our viewpoint as investors. Nothing is perfect and that includes our efforts to globalize the economy. However, on balance, globalization has been a tremendous positive for investors around the world and has helped bring hundreds of millions of people out of poverty and into the global middle class. The tricky part is ensuring that all enjoy the benefits of the expansion of the global economy.
Next in the presentation, we list the top 18 countries according to per capita gross domestic product. We then ask a simple question: Which country had the best average annual return between 1970 and 2021? (No spoiler here! Please watch or listen to the presentations on the class website.) The world is indeed a very small place economically these days.
Time Horizon
One of the most important, if not the most important, characteristic that we must decide upon before we make an investment decision is our time horizon, also known as our time frame. When will we need to use the funds from our investment? Here are some popular guidelines:
Time Horizons
Time Frame Financial Industry Life Insurance Industry
Short-Term Up to a year or so 1 to 3 years
Intermediate-Term 2 to 5 years 3 to 5, 6, or even 7 years
Long-Term More than 5 years More than 7 years
Before you make an investment, we must know our time frame. As we will learn, our time frame will dictate what types of investment we can and cannot use.
Liquidity
No, not how much beer we need for the weekend! Liquidity refers to how easily your investment can be turned into cash. Liquid investments are easily and quickly converted into cash. There is a ready market to purchase the investment and change of ownership happens quickly. Examples include stocks and mutual funds. Go online or call your broker and you will have your money very quickly, usually within a day or two. Illiquid investments are the exact opposite. The market for the investment is small or the change of ownership happens slowly, or both. It usually takes some time ‒ sometimes much time ‒ to convert your investment into cash. The poster child for illiquid investments is real estate. Real estate usually takes at least two or three or more months to sell. Other examples of illiquid investments include limited partnerships, fine art, and collectibles.
Risk versus Return
Do you want to eat well or do you want to sleep well? In the investment world, risk is the chance that your actual investment returns will differ from your expected return. Wait a minute! That is not the typical definition of risk. When most people think of risk, they think of the possibility of suffering harm or loss. They think of danger. When they think of risk with regard to investing, they think of losing their investment. They think of losing all their money. Instead, in the investment world, when we endeavor to measure risk, we calculate the probability that what we receive from our investment will not match what we expect from our investment. It is an imperfect measurement but it can help us to keep a long-term perspective and can even help us to take advantage of the risks inherent in an investment.
In general, the higher the expectation of investment returns, the higher the risk level we will have to accept. There is no way to negate this relationship. If we want high returns, we are going to have to accept high risk. Here is the risk versus return spectrum that we will use:
Risk versus Return Attributes of Investments
Risk Level Return Expected
Low Risk 2% to 4%
Moderate Risk 4% to 8%
High Risk 8% to 12%
Speculative Risk Greater than 12%
Unless they are being dishonest, others will use different but ultimately similar spectrums. Please remember that speculation is not considered investing by many in the industry, Your Humble Author included. As mentioned, we are going to do our best to help you learn how to handle the ups and downs of moderate to high-risk investments and at the same time, generate reasonably moderate to high returns over the long term. We want you to eat reasonably well and sleep reasonably well!
It’s time for some checking for comprehension. At the end of the presentation, we list six examples of investments. We want you to ascribe the various characteristics and attributes we covered to the six investments. Again, only concern yourself with what we have covered so far. Relax and have fun. Give my regards to Uncle Harry! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/01%3A_Introduction_Overview_and_Risk_versus_Return/1.02%3A_Investment_Characteristics_and_Attributes.txt |
Let’s become casually acquainted with the major investment asset classes. We will dispense with all the tedious details. Concern yourself with just what we cover here. Don’t fret. There will be plenty of time later on to learn the many intricacies of these investments. As we introduce each investment asset class, we will also touch on the risk and return that we can expect from each.
Equity Securities, Also Known as Common Stocks or Stocks
In the investment world, equity refers to ownership. Equity securities, also known as common stocks, represent partial ownership in corporations. Most people just use the term stocks. The term stocks is a bit unfortunate. Your Humble Author prefers to refer to them as companies or better yet, businesses. You are investing in a business. Why invest in a business? When all goes well, businesses grow and earn money. This creates two great opportunities for investors. When the business grows, your partial ownership of the business should also grow. That’s capital appreciation, also known as capital gains. Also, the business can optionally distribute earnings to you in the form of dividends. (You can think of dividends like interest payments even though they are legally two different forms of payments.) We invest in businesses for potential capital appreciation and potential dividends. We invest for growth and income.
Note that we said, “When all goes well.” Obviously, all doesn’t always go well in this wicked world of ours, does it? Both capital appreciation and dividends are optional and are not guaranteed. Therefore, we find that stocks are high-risk investments. We say that stocks are volatile. Stocks exhibit high volatility. Volatility is a euphemism for, “I lost a whole lotta’ money!” You might ask someone how that stock he or she bought is doing and they may sheepishly say, “Oh, it’s been volatile.” That means they bought it for \$11.88 and sold it for 30¢. Do you know anyone who bought a stock for \$11.88 and sold it for 30¢? I do. I have known him all my life. He’s kind of a goofy guy who teaches Introduction to Investments at Southwestern Community College in Chula Vista … Look, it was a really good company and they were going to strike it rich by making artificial blood and there would be no more need for blood banks or calls to the public to donate blood and well, um, it just didn’t turn out the way it was supposed to. Ahem. Stocks are volatile. Stocks are risky. In fact, to paraphrase Professor Burton Malkiel from his famous book, A Random Walk Down Wall Street discussed in our Bibliography, the 2008 definition of stocks is, “Stocks are equity investment instruments designed to lose value.”
However, if we can learn to stomach the volatility that comes along with stock investing, history tells us that we can reasonably expect to receive some of the best long-term returns available from the investment world. We like to say that stocks have an average annual return of 8%, 9%, or even 10% over the long term. The problem is that they almost never return 8% or 9% or 10% in any given year. The returns vary substantially, up and down. For this reason, when we want to invest in stocks, we must think long term. We must give our stock investment enough time to reward us with 8% or 9% or 10% annually. As Warren Buffett is quoted as saying, “If you aren’t thinking about owning a stock for ten years, don’t even think about owning it for ten minutes.” Stocks are long-term investments.
Disclaimers: The real estate fans are most likely jumping up and down and screaming that real estate has given investors better returns than stocks. Calm down and please accept my apologies. In one sense, they are correct. In another, they are not. The problem is how we measure investment returns and how different investments are typically purchased. We will deal with this thorny issue later on. Some stock fans might also be screaming saying that 8%, 9%, 10% is too low. Stocks have done better. This is actually true. Stocks as a whole have done better than 10% over the last 100 years and some stocks have done a whole lot better. However, some have done a whole lot worse. We prefer to keep new investors’ expectations muted, especially since there are long periods of time where stocks have done a whole lot worse than 8%, 9%, or 10%. Finally, a scant few stocks can be considered moderate risk and moderate return vehicles. In the presentation for the previous section ‒ You have watched it already, right? ‒ we discussed Nestlé, the world’s largest food company. Companies such as Nestlé can be categorized as moderate risk and moderate return investments.
Fixed-Income Securities, Also Known as Bonds
Fixed-income securities are typically referred to as bonds. Bonds are long-term loans to corporations, state and local municipalities, and the Federal government. When you invest in a bond, you get to play the part of a bank. You lend your money to one of these entities. In return, they promise to repay the principal ‒ the money you lent them ‒ and along the way, they will pay you interest. Most people pay their debts to the banks. Likewise, most corporations and state and local governments also pay their debts. The United States Treasury has always paid its debts. Hence, we find that bonds are far less risky than stocks. And subsequently, we find the long term return from bonds is far less than stocks. (Are you starting to see a pattern here, Dear Students?) What can we expect from bonds? Investors used to be accustomed to receiving 3% to 8% in interest from their bond investments. During the years after the Global Financial crisis, many bonds paid 1% to 3%. Greater than 4% is unusual. In 2022, interest rates rose and investors could again find attractive interest rates from many bonds.
Remember that bonds are securities and bond prices change in the marketplace every day just like stocks. At first, it may seem a bit odd that the value of a loan could vary. Yet there are times when the prices of bonds can fall, too. However, as mentioned though, the volatility with regard to bonds is much less than what stocks exhibit. To repeat, the fall will typically be far less than stocks but it can still sting. For example, when some stocks lost well over 50% during the Global Financial Crisis of the late 2000’s, many bonds lost between 10% and 20%. A similar decline in bonds was experienced in 2022. We again paraphrase Professor Malkiel by saying the 2008 definition of bonds is, “Bonds are fixed-rate investment instruments designed to lose value.”
Short-term Investments, Also Known as “Cash” ‒ A Place to Park Your Money
Short-term investments are often referred to as “cash.” We usually see cash put in quotes because these investments are not dollar bills that we stuff under our mattresses. Many of these short-term instruments are tradable securities so again, their prices do change. However, they are vehicles that are typically guaranteed by some governmental organization. And if they are not guaranteed, they are pretty darned close. If you have been paying attention, you should be able to guess correctly that since these choices have very low risk, these investments will not give us much reward. Therefore, we say that short-term investments are a place to park your money. You aren’t going to lose your money, but you also aren’t going to make much money. That is why we call them short-term investments. If we need the money in the short-term, we don’t want to place our funds into the stock market. Even the bond market might be too risky for us. We need to park our money into a short-term investment so that in three, six, or nine months, we know it will not have lost 10%, 20%, or more of its value. At the end of this introductory chapter, we will cover short-term investments in detail. Our 2008 Definition? “Short-term investments are instruments designed to accept what remains of investors’ money after they have given up on stocks and bonds.”
Mutual Funds, Also Known as Investment Companies ‒ Investments for the Masses
Unless you live on a deserted island or somehow effectively have shut out all forms of mass media, you no doubt have been subjected to advertisements for mutual funds. There is a valid reason for this. Mutual funds are investments for the masses. Just as most of us workaday individuals don’t build our own cars, make our own shoes, or grow our own food, most people will not dedicate the time to learn how to invest. (This is most unfortunate. Everyone should take Introduction to Investments, not that I’m biased, of course.) And education is just the beginning! They then need to spend many hours doing the necessary research to identify, choose, and monitor their individual stock and bond investments. You, Dear Readers, are going to make this a fun and profitable labor of love. Many other people are either not interested, too nervous or frightened, or just simply too busy living their lives. This is where mutual funds come into the picture.
The legal term for a mutual fund is an investment company. Now doesn’t that name make more sense? The term investment company tells you what the mutual fund does for you. Do you need a car? You go to a car company. You need shoes? You go to a shoe company. You need investments? You go to an investment company! Mutual funds / investment companies are companies that pool investors’ money and invest in a diversified portfolio of securities, typically stocks, bonds, or a combination of stocks and bonds. Investors receive two valuable benefits, diversification and professional money management. Because of the size of the typical mutual fund, they are not limited to 10 or 20 stocks or bonds as is common with an individual investor. More than 20 stocks and an individual investor often becomes overwhelmed with the necessary research to simply keep track of their holdings. A typical mutual fund will hold 100 or 200 securities. Some hold many more.
So how does the mutual fund keep from becoming overwhelmed? The mutual fund is managed by professional money managers, the second major benefit of investing in mutual funds. The mutual fund portfolio managers are highly skilled and very well-paid professionals whose day-to-day job is to identify, choose, and then monitor the diversified portfolio of investments in the mutual fund. As we shall see, it is not an easy job and there is some controversy over whether these individuals are actually worth the high salaries they demand. We will explore this debate in our chapter dedicated to mutual funds.
Because of these two valuable benefits ‒ diversification and professional money management ‒ mutual funds have become extremely popular. Adding to their popularity are the countless employer-sponsored retirement programs such as 401(k) and 403(b) plans. Mutual funds are the dominant investment choice for employer-sponsored retirement programs. Almost half of all American households own mutual funds. In our next chapter, because of their importance as investments for the masses, we will spend a great deal of time on mutual funds.
Mutual Funds: Investments for the Masses, Graphics courtesy of Ferran Capo: StudioCapo
What kinds of risks and returns can we expect from mutual funds? Mutual funds will exhibit risks and returns similar to their underlying investments. There are many mutual funds that fall into the short-term investment category. These are called money market funds. Low risk, low return. However, most mutual funds are dedicated to stocks or bonds or both and they will exhibit the same risk versus return characteristics of stocks and bonds. Hence, what is their 2008 definition? “Yeah, them too.” 2008 was a very difficult year for everyone.
Hybrid Securities – Preferred Stocks and Convertible Securities
Hybrid securities are designed to offer the stability of fixed-income investments (bonds) with the opportunity for capital growth of equity investments (stocks). With these investments, we are trying to get the best of both worlds. The pesky fly in the ointment with this approach is that along with the advantages of both stocks and bonds, you also get the disadvantages of both stocks and bonds. So, we get the best of both worlds … and we get the worst of both worlds.
Other annoying flies buzzing around the hybrid security worlds are the names of the major types of hybrid securities. The two major examples of hybrid investments are preferred stock and convertible securities. Don’t they sound enticing? Wouldn’t you really rather have “preferred stock” instead of just “common stock?” Well, actually, no, you and I and most individual investors don’t really want preferred stock. They are typically owned by corporations. Plus anything that has to do with convertibles must be cool, right? You know, driving down the highway in your convertible car with the wind blowing through your hair? Well, convertible securities are nowhere near as sexy as that, as we shall see. For now, all you need to know is that hybrid securities are an attempt to combine the advantages of stocks and bonds together but they also combine the disadvantages of stocks and bonds. We will postpone discussing these oddities until much later in our class. Finally, they constitute a very small part of the investment universe.
Other Investment Alternatives – Real Estate, Physical Assets
Not everyone wants to invest in just stocks or bonds or mutual funds. For them, they may want to dabble in the world of real estate or try their hand at precious metals, art, collectibles, cars, or even enter the high-stakes world of commodities. Suffice to say, these investments are not for everyone. For many people, just scraping together the resources to purchase a home is enough real estate for a lifetime. Also, as we will see, some alternatives such as gold that get a great deal of attention have not necessarily been very good investments over the long term. At the very end of our journey together, we will touch on these alternatives. By the way, none of these choices were spared during the Global Financial Crisis in 2008.
Derivatives – Options Contracts, Futures Contracts
Derivative assets are speculative securities that derive their value from an underlying security or asset such as a stock or bond. “What? You are not buying the stock or bond?” No, you are buying a security that depends upon the price movements of a stock or bond. That sounds very confusing. Well, yes, it is. Derivatives are very confusing. More importantly, they are immensely risky. You can make 100% in one day … and then lose it all the next day. For this reason, we do not categorize them as investments. They are speculations. (Throughout the class, when you see the words speculative or speculation, simply substitute the word gambling, okay?)
Two major examples of derivatives are options and futures. Actually, to show you how confusing these things really are, their actual names are options contracts and futures contracts. Try saying those names three times fast. For now, this is all you need to know about derivatives: Derivatives derive their value from another asset, two major examples of derivatives are options and futures, and derivatives are extremely dangerous. In 2008, the derivative speculators did not feel so all alone. Usually, they are the only ones who are proud to have only lost 30%.
We have completed our Overview of the Investment Universe. Once again, we remind you that, for now, the material in this chapter is all you need to study and learn with regard to the investment alternatives discussed above. As you may have gathered by now, in this class, we will emphasize stocks, bonds, short-term investments, and mutual funds. For the vast majority of us retail investors, these are the most popular and most important financial investment options. It is now time for us to delve deeply into the Eternal Struggle of Investing, Risk versus Return. But before we do that, we want you to review the investment alternatives we have just covered. Please make sure you watch the presentation on the class website. There is a comprehension checking exercise at the very end of the presentation. Also, work through the Security Types Handout. Memorize this document for the first exam. (Hint, hint. Wink, wink. Nudge, nudge.) | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/01%3A_Introduction_Overview_and_Risk_versus_Return/1.03%3A_An_Overview_of_the_Investment_Universe.txt |
Here it is, Dear Readers! This is the entire course in one section! Do you want to eat well or do you want to sleep well? By now, you should be seeing that there is a pattern in the world of investments. The more return you want from your investments, the more risk you will have to accept. In the previous section, we saw that stocks have given us the best returns over time but have also subjected us to the most risk. Bonds are less risky but give us less return. Short-term investments are risk free or pretty darned close but they pay very little. Mutual funds will more or less reflect the underlying assets that they invest in. In the corresponding presentation on risk versus return, you will see how these various investment asset classes have done over very long periods of time. We see that stocks are the stars! Bonds are a distant second. And short-term investments have barely kept up with inflation and currently are losing to inflation. Take a quick look at this graph that compares stocks (businesses), bonds (loans), Treasury bills (short-term guaranteed investments), and inflation as measured by the Consumer Price Index.
We see that the rewards from investing in businesses via stocks have completely overwhelmed the two other choices and have handily beaten inflation. However, what is different about this graph than most graphs we are used to viewing? What is this graph hiding? In this graph and many graphs in the world of investing, we use a logarithmic scale. In the opinion of Your Humble Author, all graphs using a logarithmic scale should have warning labels attached to them since most individuals don’t completely understand how they work. Each unit on the left is 10 times bigger than the previous unit. Logarithmic graphs are used when the numbers grow exponentially. The graph is hiding the enormous difference between stocks on the one hand and bonds, Treasury bills, and inflation on the other. It is also minimizing the large downturns that stocks experience from time to time. Here is an arithmetic version of the same graph:
Do you see why we initially used a logarithmic scale? Because of the enormous differences in results, the bonds, Treasury bill, and inflation don’t even begin to show any rise in value in the arithmetic graph. Around 1988, the arithmetic graph also begins to show us the exponential curve that stocks exhibit. It also highlights that what we thought were little rises and falls in the price of stocks are actually very dramatic. Stocks are volatile!
What happens if we go back to the dawn of the Industrial Revolution?
The numbers become staggering and we are left with a few takeaways. Bonds and "cash" investments have done admirably; they have beaten inflation. Gold? Not so much. However, stocks are the hands-down best choice, right? Well, yes, but again, let's not be too hasty. We need to look at the other side of investing, risk, as well as the return. We will examine in detail the risks involved with stock investing soon.
It is no accident that stocks and bonds have produced better returns than short-term investments. If that were not the case, why would investors assume the higher risks of stocks and bonds? The answer is they would not. If guaranteed (or pretty darned close to being guaranteed) short-term investments returned the same as stocks or bonds, investors would prefer those guaranteed short-term investments. They would choose an investment for which there is no chance of losing money and they would be happy to accept the risk-free rate of return on their money. In theory, there is no investment with absolute zero risk. However, short-term United States Treasury bills come as close to absolute zero risk as you can get in this world. Therefore, when investors want to know what the current risk-free rate of return is, they often look at the interest rate that three-month United States Treasury Bills are currently paying. (We will cover Treasury Bills in more detail in our next section dedicated to short-term investments.)
To make prudent investment decisions, we investors need to know what the risk premium is for our potential investors. The risk premium is the reward for bearing risk. It is the extra return on a risky asset over the return that we receive from a risk-free rate of return. As we would expect, the risk premium for stocks is the highest at over 8%. The risk premium for large company bonds is a bit less than 4% and less than 2% for government bonds. Here are the risk premiums for large company stocks, large company bonds, government bonds, and Treasury bills (guaranteed short-term "cash" investments).
Investment Risk Premiums from 1928 to 2022
Investment Average Return Risk Premium
Large Company Stocks 11.51% 8.17%
Large Company Bonds 6.99% 3.62%
Government Bonds 4.87% 1.53%
Treasury Bills ("Cash") 3.34% 0.00%
These risk premiums may not seem like much but over time, the effects of the higher returns are enormous as we saw in the graphics above and in the presentation. Investment returns are very easy to measure. How much did you start with? How much did you end with? How long did it take you to earn this amount? From this information, we can calculate your return. But what about the risks involved. How do we measure risk?
Variance and Standard Deviation ‒ Two Imperfect Measures of Risk
Investment risk, on the other hand, is much more difficult to measure. The reality is that risk is impossible to measure and predict. There is no measurement that accurately reflects the amount of risk that investors must accept when choosing an investment. That does not stop us from trying, though. Each year, the investment community measures the average annual return and the amount of variance from the average return. Using statistics, the resulting measures of risk are called variance and standard deviation. By far, the most popular measure of risk is standard deviation. Standard deviation is the measure we will use for our class.
I already know what you are thinking. “Aye, this is math! I need to drop this class!” Relax. Please don’t drop the class. We don’t do any variance or standard deviation calculations. We leave those calculations for your statistics class. We just do a quick library or Internet search and the investment community readily and happily gives us the results. Please. Don’t drop the class. Keep reading.
It is important to understand what the variance and its more popular and important companion, standard deviation, can tell us about a potential investment. In general, the higher the variance and standard deviation, the riskier the investment. The higher the variance and standard deviation, the more the investment return will deviate from the average annual return of that investment. In other words, we said that stocks can give us an average annual return of 8%, 9% or even 10% over the long term but we also know that in any one year, the probability is very high that we won’t get 8% or 9% or 10%. We might get +17% in one year, -9% the next year, +22% after that, and then -4%. With stocks, the variances and deviations from the annual returns are extreme. A high standard deviation means the volatility is high. The investment is risky.
Please take a close look at the following frequency distribution graph:
Source: NYU Stern School of Business
How do we interpret this graph? This graph shows us the annual returns from the stock market for every year from 1926 until 2022. Each year is placed in the column that corresponds to the return for that year. For example, in 2020, the return from the stock market was between 10% and 20%. In 2015, the return was between 0% and 10%. In 2018, the return was between -10% and 0%.
From the graph, we see that stocks are similar to Henry Longfellow’s little girl with the little curl right in the middle of her forehead. When she was good, she was very, very good, but when she was bad, she was horrid. “Minus 20% in 2001 and 2022, minus 30% in 2002, minus 40% in 2008!? No way! Not for me! I ain’t gettin’ involved in investing in stocks,” is how some people react. Relax. Calm down. We are going to learn how to use this volatility to our advantage. We can make volatility our friend, not our enemy.
Also, does the distribution graph above resemble anything that you are familiar with? Why yes, you may remember it as the normal curve, also known as the normal distribution or the bell curve. Here it is in all its mathematical glory:
Source: NYU Stern School of Business ; Graphics courtesy of Ferran Capo: StudioCapo
If you are allergic to all things mathematical, please feel free to ignore the above graphic and just read on. What this graph is trying to show us is that the returns from the stock market tend to clump around the average return for the past century. What the graph is also telling us is that the probability that we will actually get that market average is quite low. We can’t know what the return will be next year but history tells us there is about a two-thirds chance that the return will be between ‑8.0% and 31.0%. There is a 95% probability that the return will be between ‑27.5% and 50.5%. And there is a better than 99% chance that the return will be between ‑47.0% and 70.0%.
Here is another view of risk versus return:
If we start with Treasury Bills, the least risky investment, and work our way up to stocks, we see the average annual return rise but we also see the standard deviation rise. It is a bit interesting that the corporate bonds gave us more return while actually having a bit less volatility.
“So, does you’se got’s it yet? You’se wants high returns? You’se gonna’ gets high risk! You’se gonna’ lose some money, maybe a lot o’ money! And if’n anybodies tells you’se differently, de’re lying!”
The lessons from history are that if we want high average annual returns, we are going to have to accept high risk and high volatility. There are going to be times when we lose money, sometimes a lot of money. There will be market downturns, corrections, crashes, etc. It is inevitable. As famed investor Peter Lynch says in his landmark book, One Up on Wall Street, “A stock market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.” The good news is that history also tells us that the global economy and the stock markets around the world have always come back from those snowstorms.
Please note that there are charlatans and grifters and con artists aplenty in the shadows of the investment industry. They will brazenly ‒ and illegally, by the way ‒ tell you that they can guarantee, for example, a 12% risk-free average annual rate of return. They are lying, pure and simple. There is no such thing as a 12%, risk-free rate of return. It’s a blue unicorn, a flying panda; it simply does not exist. Some crooks might even make claims of 300% or 3,000%. Check the class website for some examples. Or better yet, just type “100% return in 3 days using options” into any Internet search engine and see how many sharks want to separate you from your money.
Investing versus Speculating/Trading ‒ Revisited
But isn’t someone doing it? Aren’t there people who make tremendous rates of returns?” you may rightly ask. The answer is yes. There are individuals who make tremendous rates of return. But those people are not prudent, long-term investors like us. They are speculators, also known as traders. Being a speculator/trader can be very profitable but it is also very stressful and perilous. Furthermore, you are up against the best in the world. Here is a quote from one of the famed speculators of the early 20th century, Jesse Livermore.
“The speculator is not an investor. His object is not to secure a steady return on his money at a good rate of interest, but to profit by either a rise or a fall in the price of whatever he may be speculating in.” – Jesse Livermore
So do you want to be an investor or a speculator/trader? As we mentioned at the beginning, we can help you learn how to become a patient, prudent, successful long-term investor. We cannot help you learn how to become a successful short-term speculator. Sorry. We can’t do it ourselves; how could we possibly teach anyone else to do it? If we have not yet convinced you to renounce any dreams you may have had of making riches quickly by day trading, surrounded by two computers and four monitors while simultaneously on the phone with two different companies, please take some time to listen to the story of John Gutfreund and John Meriweather from the book Liar’s Poker by the accomplished investment author Michael Lewis. You never, ever want to play Liar’s Poker with John Meriweather, let alone try to out trade him.
It’s really very simple. When the task is immensely difficult and the competition is ferocious, as it is in speculating/trading or in sports or the arts, for that matter, it is only natural that a select few will rise to the top. Can you throw or hit a fastball at 98 miles per hour? If you successfully can hit a fastball at 98 miles per hour three times out of ten tries, you can snag yourself a contract for tens of millions of dollars each year. Can you dunk a basketball? Can you sing the lead part in a five-act opera? Can you write or direct or act in a movie with a \$100+ million dollar budget? Can you hit a tiny white ball 350 yards down the fairway in just three shots? The average person can’t accomplish any of these. But that does not mean there aren’t people who can. There are. Are you going to compete with them in their venue? I think not.
One of the best observations ever about investing versus speculating/trading was made by John Bogle, the founder of the Vanguard Group mutual fund company. He was interviewed by Steve Forbes, the Editor-in-Chief of Forbes magazine, back in 2009. The interview used to be available on the magazine’s website but was taken down long ago. I contacted them and begged them to make it available again. I never got a response. So we put the passage here for you. Read carefully, Dear Students.
“Well, the first thing you have to think about is, and this is an issue that I’ve almost never heard discussed, Steve, and that’s the first question you have to ask yourself is: Am I an investor, or am I a speculator? An investor is a person who owns business and holds it forever and enjoys the returns that U.S. businesses, and to some extent global businesses, have earned since the beginning of time. They have capital, they earn a return on their capital and that capital grows over time. It’s not complicated. That’s the business of investing.
Speculation is betting on price. I think I can buy this for \$10 and sell it for \$12 or \$14 or \$20 or \$100. Speculation has no place in the portfolio or the kit of the typical investor. Speculation leads you the wrong way. It allows you to put your emotion first, whereas investment gets emotions out of the picture. You own these businesses, they’re still sound, if the market doesn’t think they’re worth as much as they were, well, pity, the market doesn’t know everything.” ‒ John “Jack” Bogle, Founder and former CEO of the Vanguard Group
When the video was still available, we would show this segment in the face-to-face class and I would call out, “We do, Mr. Bogle! We do! We emphasize the distinction between investors and speculators/traders in our Introduction to Investments class!” The entire interview is over 30 minutes and highly informative and enterprising. Let’s hope Forbes resurrects it.
Oh, by the way, Jesse Livermore, the famed speculator/trader, wound up heavily in debt and committed suicide. Please do not endeavor to become a speculator/trader. But if you do, we wish you the best of luck. You’ll need it.
Observations about the End of the World
Some readers will ask, “Well, what if stock prices all go to zero? What if the economy and the stock market don’t come back?” This is a very probing question. It speaks to our justifiable fears about investing, especially in stocks. Let’s rephrase the question: What if the world ends? The truth is someday the world is going to end. There are numerous scenarios. For example, we know that in about 1 or 2 billion years, the sun will expand and swallow Mercury and Venus and maybe even the Earth. However, it won’t need to swallow the Earth for our world to end. By the time it gets to Venus, temperatures on the Earth will be hot enough to melt tin and lead and copper. Thankfully, we have a long time to prepare for this scenario. But what about all the other disasters looming on our horizon? Global warming, climate change, income inequality, nuclear war, rising sea levels, pandemics, tsunamis, earthquakes, fires, floods, disco returning!
As we said at the beginning, there will always be proclamations of doom and gloom, especially from charlatans ready to sell you their sure-fire method for surviving the end times. Don’t listen to them! If the world does end, if our technologically based civilization cracks and falls and dissolves into a pool of tears, if there is no food at the grocery store, no gas at the gas station, no clothes at the mall, the cell phones aren’t working, the utility companies are not pumping out electricity or natural gas, the trash isn’t being picked up, the sewers are clogged, the hospitals, schools, fire departments, police stations, banks are all boarded up, etc., your stock portfolio will be the last thought on your mind. You will be digging for beetle grubs and boiling bark for dinner. Let’s meet at the beach. You bring the marshmallows. I’ll bring the vodka. We can get drunk and watch the world burn.
Take heart, Dear Students! This scenario is not going to happen! Failure is not an option! As I have already told you, Your Humble Author is firmly convinced that the next 20, 30, 50 years are going to be the most prosperous years in the history of our civilization. There is no doubt that we have tremendous hurdles to overcome, some might say they are insurmountable. But never underestimate the innovative power of our species. Just look at what we did with Covid in 2020. A vaccine usually takes at least 4 years and often up to 10 years to develop. Multiple groups around the world created safe and effective vaccines in a matter of months! We will overcome climate change. We will phase out fossil fuels. We will have driverless cars and some will be able to fly. We will cure cancer. We will colonize Mars. We will have universal language translators. We will have domestic robots. We will see the day when close to 100% of the citizens of our world are connected to the Internet. We will ensure that never again does disco become the dominant cultural icon of our nation! Economically, I am very confident of this and more. (Politically, I am very scared. Democracy is being attacked in many countries around the world, including the United States. But that discussion is for another class in another department. Thank goodness this isn’t Kindergarten where all the disciplines are taught in the same classroom. Go take up our political woes with your Political Science professor.)
So What Is a Realistic Rate of Return for Me?
After you have taken this course, you will have a strong foundation of the most popular types of securities investments: stocks, bonds, “cash,” and mutual funds. You will also know what levels of returns and what levels of risks you should reasonably expect to receive. And if you are a patient, long-term investor, I believe it is realistic to expect 8% to 10%. I am certainly working on it myself. So far, so good. Of course, as we will reiterate time and time again, there are no guarantees.
You are now most likely thinking, “But is 8% or 9% or 10% good enough for me?” It turns out the answer to this question is a resounding, “Yes!” There are some caveats we need to add, though. If you start early, if you invest patiently and consistently, if you do not get cocky or greedy, if you do not chase after every “Next Big Thing” that comes along, and most importantly, you do not panic when the market swoons, as it inevitably will do from time to time, then ‒ unless the world ends ‒ we believe it is entirely reasonable and realistic to expect 8% or 9% or 10% over the long term. As mentioned, some investors have done better. The trick is to take advantage of the time value of money, also known as the compound annual return or the compound annual growth rate.
The time value of money is the amount to which a sum you invest now will increase based on a specified rate of return and time period. Calculating amounts into the future is called compounding. The result is the future value of money. Future value can be computed for a single amount, also known as a lump sum, a principal, or a single payment. Future value can also be determined for a series of deposits, also known as a stream of investments or an annuity. (In our class, we usually don’t use the term annuity because an annuity is also an insurance product. We discuss annuity insurance products at the end of the class. We do not have kind words for them.)
There is a future value handout available on the class website. We leave the calculations to you as an optional exercise. Quite possibly you have already taken our Financial Planning and Money Management, now called Principles of Money Management, class at Southwestern. We spend a good deal of time learning future value calculations in Principles of Money Management. At the very least, please review the answer key and listen to the commentary to see the kinds of wealth that one can reasonably build over the working careers. We will also see some great examples in our next chapter on mutual funds. The news is good!
The future value calculations allow us to move from the present into the future. Later on, when we learn how to assign valuations to stocks and bonds, we will use the inverse of future value, present value, to move from the future back to the present. (“Huh? What?” Relax. Study what is in this chapter. We have a long road ahead of us.)
So are you ready to start your journey to become a prudent, long-term investor? Are you excited? I know I am! Well, before we get to the good stuff, we are going to take a small detour. We will now revisit short-term investments, vehicles that we use if we need the money in three, six, or nine months or even a year or two, depending upon the importance of the uses for the short-term funds. Short-term investments aren’t very exciting. They aren’t supposed to be. We don’t want excitement with money that we need in the short term. We want certainty.
“Oh, yeah?! This guy says I can earn 25% per month! Whaddya’ say about that, huh?”
Before we move on to short-term investments, we want to warn you again that there are plenty of con artists out there ready to take your money. Dear Students, if you are involved in the investment world for any period of time, eventually you are going to come across an advertisement, flyer, electronic mail or United States mail solicitation that promises eye-popping returns of 25%, 100%, 3,000% per year or even 300% or more per day. Investment scams have been with us forever. They will always be with us. Sadly, many uninformed individuals fall for their snake oil. Here is an example of one such outrageous claim:
This advertisement was found on the Yahoo! Finance web site which is generally considered a reliable and reputable media outlook. Prepare to see far more outlandish and preposterous claims on less reputable locations. This guy is claiming that he was able to generate returns of 25% per month. That is over 1,300% per year. This is total rubbish!
Oh, by the way, these advertisements are against the law. “What?! Huh?! Don’t we have freedom of speech in the United States?” you ask. Well, yes, you are correct. We are free to express our viewpoints, opinion, and our understanding of the facts in the marketplace of ideas. But when it comes to investment advice and products, that freedom of speech is severely limited. So how do people get away with this? The Securities and Exchange Commission has a skeletal crew of regulators that can not begin to tackle this problem. They only go after the worst scoundrels. The same kind of illegal behaviors also go on in the world of weight loss supplements. Some even sneak controlled, prescription-only drugs such as Prozac and Viagra into their products and some even put dangerous, banned chemical substances. Be careful out there, Dear Students! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/01%3A_Introduction_Overview_and_Risk_versus_Return/1.04%3A_Risk_versus_Return__The_Eternal_Struggle_of_Investing.txt |
Short-term investments are vehicles that we use when we need the money to be safe because we are going to be using it soon. For example, we are setting aside our financial aid for living expenses for the coming semester. We are building a down payment fund for a car or house. Hence, we often say that a short-term investment is a place to park your money. We don’t want the value to decrease. We don’t want to lose the money. We want the money to be there when we need it. For this reason, short-term investments are typically guaranteed or pretty darned close. Short-term investments are also very liquid; we can get our money very quickly, usually within a day. Some even allow us to write a check. These are the advantages and benefits of short-term investments.
What are the disadvantages of short-term investments? As we have seen, the returns from short-term investments are very low. Low risk? Low return! In fact, for many years since the 2008 Global Financial Crisis, many short-term investments were paying almost nothing. Short-term interest rates started to climb very slowly starting in 2015 and were actually approaching respectable amounts in 2019 as the economy was finally shaking off the lingering effects of the economic devastation a decade earlier. And then Covid hit and short-term rates again fell close to zero. (Darned, stupid microbe!) In 2022, the Federal Reserve Bank started raising short-term rates and as of this writing, they are once again paying typical returns of between 1% to 4%.
Stated Rate of Interest versus Discount Basis
As we explore the various short-term investment alternatives, we will see that some offer the stated rate of interest method of paying interest and some offer the discount basis method. The stated rate of interest is the method that we are already familiar with if we have ever opened a savings account. The bank will tell us that they will pay us 1% on our money. If we deposit \$100, after one year, we will earn 1% of \$100 or \$1. This is very straightforward.
The discount basis is a bit trickier. This method of earning interest entails purchasing the security at a price below its redemption value, also known as the par value, maturity value, or face value. The difference between the purchase price and redemption value is the interest earned. Since the securities are negotiable, the value of the investment grows as it approaches its maturity date. We say the interest “accrues” on the short-term investment. On the date of maturity, the current owner of the security receives the maturity value. An example: You purchase a security now for \$4,800 that will be redeemed for \$5,000 in ten months. Your interest would be \$200. If you were to sell the security in five months, ‒ one half the time until maturity ‒ the value would likely have accrued to \$4,900. One half of the \$200 would be \$100 of interest and that would be added to the price of the security.
Risks of Short-Term Investments
Risks of short-term investments!? Wait a minute! You told me that these investments were risk-free!” Yes, short-term investments are risk-free regarding the loss of principal, also known as the risk of default. We are not going to lose our money. However, there are other risks when investing. There is the risk that we may lose purchasing power. Over time, short-term investments have barely kept up with inflation. Currently, they are losing to inflation. There is also the risk of lost opportunity cost. Opportunity cost is an annoyingly nebulous concept that you would discuss in detail in your ECON 101 class. It is real, though. Whenever we make a choice, we must think about the opportunities that we forego by making that choice. What else could we have done with our money? If we choose short-term investments for money that we won’t need for the long term, we will almost certainly have done much worse than by carefully researching and choosing prudent, long-term investments. You first saw this in the graphics discussing the returns of stocks versus bonds versus short-term investments in the previous presentation and we will see examples of this throughout the semester.
Sadly, you will sometimes come across individuals who have placed all their investable savings into short-term “cash” investments. This is usually money that they are saving for long-term goals such as retirement. These people need to take Introduction to Investments! In time, Dear Readers, you will be the Investment Gurus for your friends, family, and colleagues. You will gently but firmly educate and guide them in choosing prudent, long-term oriented investments that will clobber the meager returns they were getting from their short-term investments. You will speak with authority. They will thank you profusely. We will be proud of you. You may even decide that you want to pursue a career in the investment services industry.
That’s just the first of many pep talks. Stay tuned for more because the industry needs you. For now, it is time to run through the various types of short-term investments. Don’t do this before bedtime … unless you are prone to insomnia. Again, these choices are not very exciting but then again, they are not meant to be exciting. They are meant to ensure safety of principal. With short-term money, boring is good.
Demand Deposit Accounts
Demand deposit accounts are offered by commercial banks and credit unions. The name comes from the fact that depositors can withdraw the funds at any time; the funds are available upon demand. However, there are sometimes certain restrictions upon this ability such as when you want to withdraw a large amount of money in cash. Demand deposit accounts at banks and credit unions have a very important benefit: They are typically guaranteed by an agency of the Federal government. You may have heard of the Federal Deposit Insurance Corporation (FDIC) or the National Credit Union Administration (NCUA). Your money is safe. Practically all banks and credit unions belong to these entities. If you are unsure if your bank or credit union belongs, just ask. For each account at each bank or credit union, you are currently insured up to \$250,000. If you have more than \$250,000, you can simply distribute that amount into separate banks or credit unions. (If you have more than \$250,000 and this is not short-term money, you need to take Introduction to Investments and learn where to allocate your investable assets more effectively and prudently for long-term growth of capital and income. My apologies if you have heard this before but it bears repeating. The opportunity cost of keeping long-term money in short-term investments is very high.)
Common examples of demand deposit accounts are checking accounts and savings accounts at banks and share-draft accounts and share accounts at credit unions. Those of you who use credit unions have probably never heard of share-draft or share accounts. That is because no one at the credit union uses those terms; they just use the same terms that the banks use, checking and savings. Even though there are legal differences, as far as we retail customers are concerned, there are no differences. They both work the same way. For many years, the regulators would not allow checking accounts to pay interest. For this reason, banks and credit unions offered Negotiable Order of Withdrawal (NOW) accounts. Again, no one called them that; they just called them checking accounts that paid interest. That restriction was removed in 2010 so now, NOW accounts are not as popular as they once were. (And no, that is not a double word typo.) Lastly, banks and credit unions can offer money market accounts, also known as money market demand accounts. Money market accounts typically pay more than checking and savings accounts. These accounts are very similar to the money market mutual funds. In fact, the banks and credit unions simply copied the concept from the mutual fund industry. The main difference between money market accounts and money market mutual funds is that the money market accounts at banks and credit unions have the same \$250,000 guarantee as other demand deposit accounts; money market mutual funds at mutual fund companies do not have this guarantee. We will discuss money market mutual funds a bit later on.
We mentioned that there may be some restrictions on your ability to withdraw your funds upon demand. An example of this would be if you were to walk into your neighborhood bank and ask to withdraw the entire \$187,000 in your savings account ‒ in cash! The bank would most likely ask you to wait until tomorrow because they simply don’t keep that much cash on hand. (There’s over \$250,000 in the ATM next door, though. Shows you how safe and secure the banks believe their ATMs are.) The bank would also contact the FBI and report a “suspicious transaction.” This is courtesy of the Patriot Act, hurried through Congress within a month after the attacks on the World Trade Towers on September 11th, 2001. Some people will tell you that a deposit or withdrawal of \$5,000 or \$10,000 constitutes a “suspicious transaction.” This is not true. There is no specific dollar amount. The bank or credit union must determine what is a “suspicious transaction,” depending upon the circumstances. Kinda’ creepy, huh? The FBI will check up on you for carrying around your own money.
Certificates of Deposits (CDs)
Certificates of Deposits (CDs) are also offered by banks and credit unions and have the same guarantees as demand deposit accounts, namely the \$250,000 deposit insurance guarantee. Unlike demand deposit accounts, though, CDs are time deposit accounts, also known as term deposits. They have a maturity date. You agree to keep your money on deposit for a certain time, anywhere from seven days to several years. Typically, the longer the time period, the higher the rate of interest a CD investor will receive. The rate of return is usually better than demand deposit accounts such as savings accounts or money market accounts. What are the disadvantages? If you need to withdraw the money before the maturity date, there will be a penalty. Also, your rate of return is fixed and typically does not change. If interest rates rise, your CD will not rise with them. For this reason, many banks and credit unions offer Bump-Up CDs. If interest rates have risen, the Bump-Up CD allows an investor to “bump up” their initial interest to the current interest rate. CD investors need to be aware of the rollover or renewal provision of some CDs. Some banks or credit unions will automatically renew your CD at the end of the time period. The bank or credit union is required to notify you of the upcoming renewal. You typically have the option of requesting that the funds be automatically deposited into your savings or checking account. It definitely pays to shop around for the best CD interest rates. CD rates vary widely and as long as your bank or credit union belongs to the FDIC or NCUA, you can do business with institutions in the United States and its territories and have the same guarantee of principal.
Some brokerage firms and some banks offer Brokered CDs. The brokerage firm has invested a great deal of money with a bank and that generates more income than a typical retail investor will receive. The brokerage firm then can offer these higher rates to their customers. Also, unlike typical CDs, they can be bought and sold on the open market as are other securities. An investor does not have to wait until the maturity to receive their principal. The downside is that Brokered CDs are not FDIC-insured. For this reason, it is important that Brokered CD investors deal with a reputable brokerage firm.
Money Market Mutual Funds
Money market mutual funds are short-term investments offered by mutual fund companies. Recall that a mutual fund is a company that pools the capital of a large number of investors. A money market mutual fund uses their investors’ capital to invest exclusively in short-term securities. They are also known as mutual money funds, or more simply and more typically, money markets. Because they are offered by mutual fund companies and not banks or credit unions, they do not have the same protections that money market accounts at banks and credit unions have, namely the \$250,000 principal protection guarantee. However, in practice, they are considered essentially as safe as their counterparts at banks and credit unions. Why? There is a long history of the government and the industry doing their parts to ensure that money market clients do not lose a penny! In practice, that is exactly what can happen. Your money market fund can “break the buck.” When that happens, the whole world sits up and takes notice. Just type “breaking the buck” into any Internet search engine and see how many millions of results you get. There are tremendous forces allied against any money market ever breaking the buck.
Money markets are very versatile and popular. Virtually every mutual fund company offers one or sometimes several different types of money market funds. Many money markets allow you to write checks, although in practice, most investors simply link their money market funds to their checking and savings accounts at their banks and credit unions and electronically withdraw funds as needed. Money markets allow you to easily exchange funds to and from your stock and bond mutual funds at your mutual fund company. Money market funds typically pay interest rates higher than checking and savings accounts and only a bit less than CDs. However, unlike CDs, the interest rates on money market funds change daily. Therefore, if interest rates rise, your money market interest rate will rise with them. There is much to like about money market mutual funds.
Series EE, HH, and I Savings Bonds
Savings bonds are short-term investments that are offered by the United States Treasury. The Treasury currently offers both Series EE and Series I savings bonds. The Series HH bonds were discontinued in 2004 and will all mature and disappear by 2024. The Series EE savings bonds use the discount basis of accruing interest. In other words, for example, you might buy a Series EE savings bond for \$50 and it will pay its maturity value of \$100 in 20 years. Currently, though, Series EE bonds purchased online electronically are purchased at face value and earn interest in the stated rate of interest manner. Savings bonds are exempt from state income taxes. (We will discuss more about the tax relationship of the Federal government and the state and local governments later in the class.) If you use the proceeds from your savings bond for qualified higher education expenses, then the interest is also exempt from Federal income taxes.
The “I” in Series I savings bonds stands for Inflation. Series I bonds were introduced in 1998 to cater to those investors worried about inflation. Like Series EE savings bonds, Series I bonds do come with a fixed rate of return but that rate of return is far less than other types of short-term investments, including Series EE bonds. Instead, Series I bonds add an inflation-adjusted interest amount every six months that varies with the rate of inflation. Hence, Series I bonds are guaranteed to keep pace with inflation. Series I bonds became immensely popular with the investing public in 2022 when inflation spiked.
The yearly purchase limits are currently \$10,000 for Series EE bonds Series I bonds. For decades, United States savings bonds were popular gifts to newborns. Grandparents and aunts and uncles would buy them at their local bank for the new arrival to the family. The bonds would be tucked away in a drawer somewhere and promptly forgotten about until the parents passed away and the adult kids and adult grandkids were tasked with clearing everything out of the house. The Treasury has done away with paper savings bonds for Series EE bonds and are phasing out paper savings bonds for Series I bonds. All bonds are now available for purchase and safekeeping at www.TreasuryDirect.gov. TreasuryDirect.gov is the subject of one of your chapter 1 assignments.
Treasury Bills
Treasury Bills are short-term investments that are also offered by the United States Treasury. They are often informally referred to as T-Bills. T-Bills all have maturities that are less than one year. The most typical periods are one month (4-week), three months (13-week), and six months (26-week), although two months (8-week) and twelve months (52-week) are also available. Treasury Bills are often considered the safest of all investments. As mentioned, when the investment community wants to report the current risk-free rate of return, they often use the rate for three-month Treasury Bills.
T-Bills are usually sold in \$1,000 increments and use the discount basis method for paying interest. For example, you may purchase a six-month \$1,000 Treasury Bill for \$990 that will mature at \$1,000. The \$10 difference would be your interest received. Along the way to the six-month maturity date, because these are securities, you could sell your Treasury Bill, again, at a discount to the \$1,000 maturity value. As the date of maturity becomes nearer, your Treasury Bill will increase in value. The price would depend upon the prevailing market rates but any volatility would be close to zero. Remember, Treasury Bills are very safe. At the date of maturity, the T-Bill would be redeemed for the full \$1,000 face value.
Like the Series EE and I savings bonds, interest from Treasury Bonds is tax-exempt at the state and local level. Unlike Series EE and I savings, though, the interest is not tax-exempt if used for the qualified higher education expenses.
Also like the Series EE and I savings bonds, Treasury Bills are available for purchase at www.TreasuryDirect.gov. TreasuryDirect.gov offers you and me, the common retail investors, the same prices as the big boys and girls on Wall Street. It is a very well done website and, as mentioned, the subject of one of your chapter 1 assignments. The Mexican government has a website very similar to TreasuryDirect.gov. It is called Cetes Directo. Your Humble Author had the good fortune to meet the project manager during a visit to Mexico City. He acknowledged that they essentially copied TreasuryDirect.gov verbatim. We love to complain when our government screws up. Hence, we should rightly praise them when they do something well. Thanks, United States Treasury!
Commercial Paper and Banker’s Acceptance Notes
Commercial paper investments are short-term, unsecured promissory notes (IOUs) issued by corporations with very high credit standings. Corporations typically use these vehicles when they need a very short-term loan for payroll or maybe for the large purchase of goods in anticipation of a coming increase in business activity such as major retailers preparing for the Christmas surge. Instead of going to a bank, the corporation can go to the investment community and get a much better rate than the bank would charge. Like Treasury Bills, commercial paper investments use the discount basis and are sold at a discount to their maturity face value and have short-term maturity periods of one, three, six, and nine months. Unlike Treasury Bills, commercial paper investments are typically denominated in \$100,000 increments and commercial paper dealers normally want you to buy many of them at one time. Hence, they are usually purchased by financial institutions such as life insurance companies and pension funds. Money market mutual funds are also eager buyers of commercial paper. You and I are not going to buy commercial paper except indirectly through our investments in money markets. (If you are indeed in the market for commercial paper and can afford multiples of \$100,000 denominations, then congratulations but I have a sneaking suspicion that you have your own private broker.)
Banker’s acceptance notes are cousins to commercial paper investments. They, too, are sold at a discount, are tradable securities, are typically denominated in \$100,000 increments, and mature quickly. Banker’s acceptance notes usually mature in 90 days but the maturity date can be up to 180 days. They are often used to facilitate domestic and international trade for companies that do not have the prestige and financial wherewithal to issue their own commercial paper in the marketplace. The company petitions the bank for help and the bank issues the acceptance notes which the company can sell on the open market. The company then uses the proceeds to facilitate the trade. The company must pay the bank the face value at the maturity date so that ultimate holders of the notes can be paid. If the company defaults, the bank must make good on the notes.
By keeping the maturity periods to less than one year, the issuers of corporate paper and banker’s acceptance notes are not required to register their securities with the Securities and Exchange Commission. This helps keep the fees associated with these short-term investments low.
Which Short-Term Investment Is Right for Me?
We have explored the various short-term investment alternatives. It is time for you to answer the question, “Which short-term investment is right for me?” Everyone is different and so that question can only be answered by you. Here are our observations: Because of their costs, commercial paper and banker’s acceptance notes are usually only suitable for institutional investors. Savings bonds used to make cute gifts for newborns in paper form but now that they are all electronic, will the proud new parents still coo and awe when the card is opened only to say that their newborn’s savings bond is safely tucked away at TreasuryDirect.gov? Many savvy investors purchase Treasury Bills directly from the Treasury at www.TreasuryDirect.gov. Certificates of Deposit are okay for those that are sure that they will not need the money until maturity. In our opinion, their flexibility and ease of use make money market mutual funds and money market deposit accounts the preferred choice of most investors, especially since every bank, credit union, brokerage firm, and mutual fund company offers them. Sadly, many uninformed savers still use a passbook savings account from a bank or credit union. (They have not taken this course yet. Such a shame!)
Emergency Fund Debate
If you watch the financial media outlets and listen to any of the talking heads with their perfect hair and immaculate dental implants, they will vehemently insist that you have an emergency fund. An emergency fund is essentially a liquid, short-term investment in which you place three, six, nine, or even twelve or more months of income. This is a self-insurance program in case of losing your source of income or another costly emergency arises. Some experts, most notably David Chilton, author of The Wealthy Barber, do not agree with this strategy. Of course, no one is advocating that you have \$17.87 in your rainy day savings account; some substantial amount socked away for that rainy day is obviously a great benefit to your financial well-being. However, for those still working, assuming you have a marketable skill that would allow you to find gainful employment in a reasonable amount of time, there can be better uses for that money. You can use those funds to pay down expensive debt or increase your monthly retirement or investment contributions. There are exceptions, though. Anyone who works in sales or has their own business or works in a seasonal industry definitely needs a substantial emergency fund. We would be remiss if we forgot to ask one last thing: You do have proper and adequate insurance, yes? For more discussion about emergency funds and insurance and all topics related to personal finance, please consider taking BUS-121, Principles of Money Management, at Southwestern Community College.
The Federal Reserve Bank and Short-Term Interest Rates
We mentioned that short-term interest rates change over time. You may be wondering, “Well, who sets these short-term interest rates?” For a more thorough investigation, you will want to take an Introduction to Economics class. The short answer, though, is that the Federal Reserve Bank is responsible for setting short-term interest rates in the United States. It is often referred to as the Fed. They are the nation’s central bank and are often called the bankers’ bank since the banks of our nation use the Fed as their bank. The Fed has major two objectives. They are charged with keeping the nation’s economy at full employment while at the same time, keeping inflation under control. These two objectives are often at odds with one another. The Fed has tremendous power and the Chairperson of the Federal Reserve Bank is often called, “the second most powerful person in the nation.” (The most powerful person, of course, is the President, who is the Commander in Chief of the military.) The Federal Reserve Bank was designed to be independent and not subject to political pressures. That does not stop politicians and other high-profile individuals from criticizing their actions. In fact, many vocal critics even claim that the Federal Reserve Bank is unconstitutional. Suffice to say that no system we humans have ever created is perfect, and that includes the Fed. However, for over 100 years, the Fed has bumbled along and sometimes has executed brilliantly and sometimes has failed miserably. We don’t call Economics the “Dismal Science” for nothing, Dear Students.
1.S: Summary
Congratulations ‒ You Have Finished Chapter 1 ‒ Introduction, Overview, and Risk versus Return
You have reached the end of chapter 1, Introduction, Overview, and Risk versus Return. In this chapter, you have:
You should now be able to:
We told you not to worry, right? It was not that hard, was it? If you are still a bit fuzzy on some topics, that is okay. Go back and read the text and listen and watch the presentations again. Much of the task of learning about investments is just getting past the odd and strange names that we hear all the time on the television but don’t really know what they are talking about. Well, now you know more about what they are talking about, don’t you?
Your Feedback, Please
Are you getting an education about investments? We hope so! Our goal is for this class to be one of the few classes that you remember 10 or 20 or more years from now. We hope that you can say to yourself, “Ya’ know, that Introduction to Investments class really helped me.” There is also a free chat group consisting of individuals who are using the concepts, techniques, and skills we learn in our class. Come join us! Perhaps you might want to start your own journal to help you organize your learning process using your computer or mobile device. We welcome any and all questions, comments, criticisms, suggestions, complaints, etc. We want you to be the best investors the world has ever seen!
In our next chapter, we will investigate Mutual Funds: Investments for the Masses. The chances are very high that you will have a job with a company that offers you some kind of employer-sponsored retirement plan. That plan will almost certainly have mutual funds as the investment alternatives. As we will see, there are more mutual funds in the investment universe than visible stars in the night sky. (There are about 9,000 visible stars in the sky. There are approximately 12,000 mutual funds.) Choosing a mutual fund is extremely difficult, especially for those who have had no training or experience whatsoever. You, Dear Students, are going to be the Investment Gurus for your family, friends, and fellow co-workers. You Can’t Let Them Down! Thank you so very much for being in our class and we will see you in our next chapter. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/01%3A_Introduction_Overview_and_Risk_versus_Return/1.05%3A_Short_Term_Investments_Revisited__A_Place_to_Park_Your_Money.txt |
“Mutual funds will bore you to wealth.”
-- Industry saying
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Mutual funds are truly Investments for the Masses. The probability is very high that at some time in your future, your employer will offer you an employer-sponsored retirement plan. That plan will almost assuredly have mutual funds as their primary investment vehicles. Your friends and family and co-workers will also likely be investing in mutual funds and they will need your help. As the Investment Guru for your family, friends, and colleagues, you need to know and understand mutual funds thoroughly. That includes knowing the major categories of mutual funds and the ways that investors are charged for mutual fund services. As you will see, both are complicated. You will help your family, friends, and colleagues. You will speak with authority. Dear Students, study hard and bring honor and glory to Southwestern Community College when you tell them where you learned everything you know!
• 2.1: Introduction to Mutual Funds
What is a mutual fund? It's an investment company! It is an indirect investment where the mutual fund portfolio managers choose the stocks or bonds or other investment choices for us. Mutual funds are truly investments for the masses. With mutual funds, investors get two important benefits, professional money management and diversification.
• 2.2: Growth of the Mutual Fund Industry
The mutual fund industry is immense. Mutual funds now hold more of investors' money than either commercial banks or life insurance companies. They are the nation's largest financial intermediary. There are powerful reasons for this that we will explore.
• 2.3: Advantages and Disadvantages of Mutual Funds
No investment is perfect. Every investment has advantages and disadvantages. Mutual funds are no different. Let's explore the advantages and disadvantages of mutual funds.
• 2.4: Open-end, Closed-end, and Exchange-Traded Funds (ETFs)
There are three major types of mutual funds, open-end mutual funds, closed-end mutual funds, and Exchange-Traded Funds, commonly referred to as ETFs. What are the differences between the three and which is best for me?
• 2.5: Regulation and Organization of Mutual Funds
How are mutual funds regulated and organized? What protections are in place to safeguard investors' money?
• 2.6: Fees, Expenses, and Share Classes, Oh, My!
One of the most misunderstood aspects of mutual funds are the fees. Investors mutual fund investors know that they are paying for the services of the mutual fund. They just don't understand how. We will dig deep into the fees, expenses, and share classes, oh, my!
• 2.7: Categories and Types of Mutual Funds
We are going to try to do the undoable. We want to get our arms around the 800-pound gorilla that is the mutual fund industry. To do this, we are going to work through the broadest categories of mutual funds and their investment strategies. Wish us luck! We will need it.
• 2.8: The Great Debate ‒ Active Management versus Passive Management
The past several years has seen great controversy over the value of active management in the mutual fund industry. Are the mutual fund investment managers who research, identify, choose, and monitor the investments in their mutual funds actually worth the high salaries they are paid? Let's explore the debate.
• 2.9: Mutual Fund Families and Fund Services
"Choose a Family, not a Fund." This sound advice was given by Forbes in the mid-1990's. It still rings true today. Let's peruse a few of the mutual fund families as well as the important mutual fund services they provide.
• 2.10: A Sample Mutual Fund
“Okay, So How Do I Pick a Mutual Fund?!” By now, you are most likely feeling quite overwhelmed, yes? You are not alone. Let's focus on a single mutual fund and identify the characteristics that distinguish a good potential choice.
• 2.S: Summary
Congratulations ‒ You Have Finished Chapter 2 ‒ Mutual Funds: Investments for the Masses
Thumbnail: The Wedding Dance, By Pieter Brueghel the Elder, Detroit Institute of Arts
02: Mutual Funds- Investments for the Masses
When teaching Introduction to Investments, one is confronted with the thorny problem of where to put mutual funds in the class. There are advantages to having mutual funds taught after stocks and bonds. Since almost all mutual funds rely on stocks and bonds as their underlying investments, it helps to have become acquainted with the ins and outs of stock and bond investments before tackling mutual funds. However, the advantages of teaching mutual funds before stocks and bonds are tempting. First, since investing in mutual funds is almost certainly to be in almost everyone’s future via individual and employer-sponsored retirement plans, it pays to be introduced to them as soon as possible, especially since for whatever reasons, many students will drop the class within the first few weeks. Also, as we slog through the copious amount of concepts, definitions, attributes, calculations, etc. of stocks and bonds, inevitably several students will decide, “Ya’ know, this stuff just ain’t for me.” That is fine! That is something we hope you will be able to decide for yourself as we progress through the semester. Not everyone will have the time, inclination, aptitude, and most importantly, receive enjoyment from doing the detailed research necessary to identify, choose, and continuously monitor individual stock and bond purchases. If you are one of those who decides that investing in individual stocks and bonds is not for you, no problem! That’s why mutual funds exist! But whether you are an Investment Guru that relies upon mutual funds or one who chooses your own individual stocks and bonds, or both, it is important that you know and understand mutual funds thoroughly. Mutual funds are in your future. And remember that your friends, family members, and colleagues are counting on you. So let’s get started!
What is a Mutual Fund? An Investment Company!
A mutual fund is an investment company that invests its shareholders’ money in a diversified portfolio of securities. Investment company is the legal term; mutual fund is the popular term. Mutual funds are one type of investment company; there are others. By far, though, the most popular investment companies are mutual funds. Although the term mutual fund does connote that investors are getting together to invest with one another, the term investment company more accurately describes the work of the mutual fund. The mutual fund will invest on your behalf.
The mutual fund industry is immense. There are approximately 12,000 mutual funds available in the United States. How could this be? Are there 12,000 different types of breakfast cereals in the grocery stores? Are there 12,000 different types of cars or mobile phones available for purchase? Why and how has the number of mutual funds grown to such an unwieldy number? The mutual fund industry is also very lucrative. The competition is ferocious. As we shall see, the number of categories and numbers of mutual funds has exploded as companies have been competing for business for the past several decades. Also, as mentioned, mutual funds are very popular with employer-sponsored and individual retirement plans. We find that this is the most difficult issue with mutual funds: How do you choose the best mutual fund for you?! The answer: It ain’t easy! However, once you have chosen a mutual fund or maybe two or three mutual funds, your work is done. The rest is up to the mutual fund.
The graphic below is a very rudimentary representation of how mutual funds work. The people on the lower left are we, the Little Folk. We contribute \$25 or \$50 or \$100 or whatever we can comfortably afford per month to the people in the top hats. These individuals are the mutual fund managers, also known as portfolio managers, portfolio counselors, and money managers. The mutual fund managers are highly skilled and well-paid professionals whose job it is to identify, choose, and monitor the underlying investments in the mutual fund. If the mutual fund managers purchase stocks for the mutual fund, it is called a stock mutual fund. If they purchase bonds, it is called a bond mutual fund. If the mutual fund concentrates on the short-term “cash” vehicles that we discussed in chapter 1, the mutual fund is called a money market mutual fund but is usually just referred to as a money market or money market fund. We also can see that a mutual fund that invests in both stocks and bonds is called a balanced mutual fund. This is just the beginning of the many categories and types of mutual funds. There are literally dozens of other categories. We will learn about a dozen as the rest are variations on the categories that we will cover.
Every month, there are millions of us Little Folk giving billions of dollars to the folks in the top hats. They create huge pools of money, hence the term “mutual funds.” Because this is their career and their full-time job, the mutual fund managers can afford to identify many choices of their underlying investments. The mutual fund managers don’t just purchase 10 or 20 stocks or bonds, which is typical for an individual investor. They purchase 100 or 200 or many hundreds of stocks or bonds. Therefore, we find that the two major advantages of mutual funds over individual stock and bond investments are professional money management and diversification.
Professional money management is sometimes the subject of some controversy. There are some in the industry and the public who question whether or not the mutual fund managers are really worth the high salaries they earn. For now, suffice to say that some are and some aren’t. We will discuss this controversy throughout our coverage of mutual funds. However, most investors do not question the advantage of managing the risks inherent in investing through diversification. Having a wide range of stocks or bonds across the various categories of each will help us eliminate much but not all of the risks of choosing individual stocks and bonds. You have heard the saying, “Don’t put all your eggs in one basket.” With a mutual fund, you are putting your eggs into hundreds of baskets. There are some who shun and even mock diversification but they are not investors. They are the short-term speculators and traders. They most likely put down this book before reaching the end of chapter 1 since we are catering to prudent, patient, long-term investors. Dear Students, for us investors, diversification is a good thing. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.01%3A_Introduction_to_Mutual_Funds.txt |
Video - Audio - YouTube (Material for this page starts on slide #4.)
The mutual fund industry in the United States started in the mid-1920’s and by 1940 there were 70 mutual funds. By 1970, the number had grown to 350 and by 1980, it was 600. The exponential growth started in the 1980’s and 1990’s and by the year 2000, there were over 9,000 mutual funds. This unbridled growth coincided with the great bull market that started in 1982 and ended in March of 2000. Since then, the growth has moderated but still, as of December 2021, we have approximately 12,000 mutual funds, each with its own investment objective.
Growth of Mutual Fund Industry
Year Number of Mutual Funds
1940 70
1970 350
1980 600
1990 2,000
2000 8,000
2021 12,038
Source: Investment Company Institute, ici.org
How and why did this aggressive growth occur? As mentioned, the mutual fund industry is very profitable and has engendered tremendous competition. So when one company creates a new category or type of mutual fund, many other companies follow suit. We will do our best to internalize the broadest categories.
Likewise, the growth in the assets of mutual funds and number of investors have been equally stupendous. According to the Investment Company Institute, the trade group for the investment company industry, in 1980, five million Americans owned funds, holding 3% of their household financial assets. As of December 2020, 106.3 million Americans in 60.9 million households owned mutual funds. That is 47.4% of all U. S. households. In the table below, we see that as of December 2002, mutual fund assets totaled \$29.6 trillion dollars. That is approximately 23% of the financial assets of United States households. Mutual funds are now the nation’s largest financial intermediary followed by commercial banks and life insurance companies.
Growth of Assets in the Mutual Fund Industry
Year Assets
2007 \$13.0 trillion
2008 10.4
2009 12.2
2010 13.1
2011 13.0
2012 14.7
2013 17.1
2014 18.2
2015 18.1
2016 19.2
2017 22.4
2018 21.4
2019 26.0
2020 29.6
2021 \$34.5 trillion
Source: Investment Company Institute, ici.org
Notice the pronounced dip in 2008. "Wait a minute," you ask, "Didn’t the stock market and many stock mutual funds lose over 50% during the Global Financial Crisis?" The answer is yes and some lost even more. However, the bond market and bond funds only lost 10% to 15% and the money market mutual funds didn’t lose a penny. Hence, the mutual fund industry only saw about a 20% decline in their assets. Also, many stock and bond investors simply moved their assets from stock and bond funds into money market funds when the turmoil hit. Therefore, much of the assets were just shifted around within the industry. (Actually, two money market mutual funds did lose a penny or three in 2008 but again, for those of you interested, type “breaking the buck” into any Internet search engine or contact your local librarian. It’s a nail-baiting story for you Rising Investment Gurus.)
After growing fairly slowly throughout the 2010’s, take note of the slight dip in 2018. At the end of 2018, the stock market lost almost 20%. Christmas Eve was a seriously down day that year. No doubt, many hapless individuals gave up and pulled their money out of their stock mutual funds ‒ only to see tremendous gains in 2019, 2020, and 2021. From \$21.4 trillion, the industry saw their assets balloon to \$26 trillion in 2019, \$29.6 trillion in 2020, and then \$34.5 trillion in 2021. That’s trillion with a T. This is typical of market movements. Of course, 2022 saw losses in both stocks and bonds. We hope that those ill-fated investors didn’t finally decide to move their money back into mutual funds in early 2022 ‒ just in time for the next major downturn. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.02%3A_Growth_of_the_Mutual_Fund_Industry.txt |
Video - Audio - YouTube (Material for this page starts on slide #7.)
We have already reviewed the two major advantages of mutual funds, professional money management and diversification. As a Rising Investment Guru, you must internalize these two important characteristics of mutual funds. If someone were to call you at 2:00 am in the morning and ask, “What are the two principal advantages of mutual funds for investors?” you should be able to be woken out of deep sleep and answer without hesitation, “professional money management and diversification.” With a mutual fund, your investments are diversified instantly. Your \$50 monthly contribution buys 20¢ of Nike, 15¢ of Visa, and 25¢ of Home Depot. This diversification provides some reduction of risk that is difficult for an individual investor to obtain on their own. In addition, the professional money managers are working diligently to identify, choose, and monitor the stocks and bonds that populate your mutual fund. They better be working diligently as you are paying them very well to do so.
Another benefit of mutual funds is the initial low outlay of capital. This is a fancy way of saying that you don’t need \$500 or \$5,000 or \$50,000 to invest in a mutual fund. You can start with \$25 or \$50 per month. Until recently, it was not advantageous to buy individual stocks with less than \$500 or more. (Technology is changing this but at a hidden cost. More about this movement later on when we get to stocks.) There are some mutual funds that have minimum investment amounts of \$1,000 or \$5,000 or \$25,000. In general, these are more exotic, sometimes called “boutique” funds, catering to very wealthy investors willing and able to sustain large losses. These are normally funds that we retail investors avoid.
The last major benefit of mutual funds is the PITA factor. PITA stands for “pain in the a**.” With mutual funds, once you have chosen your one or two or three mutual funds, the PITA factor is extremely low. (This gem comes to us courtesy of David Chilton, the author of The Wealthy Barber. I sure wish I had thought of it. Read The Wealthy Barber!) Once you have chosen your mutual fund, there is almost nothing for us investors to do except check them over every six or twelve months. Yes, Dear Students, mutual funds are boring. And not for the last time will we emphasize that in the investment world, boring is good.
What are the disadvantages of mutual funds? As mentioned, one problem is that there literally are too many of them. It is very difficult to choose from the dizzying array of options. However, there is a more significant disadvantage of mutual funds. You may not be surprised to learn that they are not charities, doling out their services for free. Mutual funds are private enterprises that must charge fees and have earnings to survive, just as any other company must do. A more subtle problem associated with the fees that mutual funds charge is the manner in which they are charged. Few investors understand thoroughly how they are being charged. This is very important. We will cover fees in detail in our next section.
The last potential disadvantage relates to the controversy over whether or not the mutual fund money managers are worth the money that we investors pay them. Some critics are damning of the whole industry and state that no mutual fund managers are worth what we pay for them. Others counter that the criticism has been too broadly applied and there are indeed mutual fund managers who earn their salaries. This topic is covered in detail in a later section. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.03%3A_Advantages_and_Disadvantages_of_Mutual_Funds.txt |
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There are three major types of mutual funds, open-end mutual funds, closed-end mutual funds, and Exchange-Traded Funds, commonly referred to as ETFs. Please don’t ask me why the name is capitalized but it is while the first two are not. Also, sometimes you will see Exchange-Traded Fund with a hyphen and sometimes you will see it without a hyphen. The investment world is full of these types of ambiguities. It is one of the reasons why the general public often throws up its hands and gives up trying to understand investments. That is why you need to study hard, Dear Rising Investment Gurus, to help your family, friends, and colleagues.
By far, the largest number of mutual funds are open-end mutual funds. When people refer to mutual funds without any qualifier, they are invariably referring to open-end mutual funds. An open-end mutual fund is a type of investment company in which investors buy shares from, and sell them back to, the mutual fund itself. There is no limit on the number of shares the fund can issue. Shares are issued and redeemed by the investment company at the request of investors. Investors can buy shares from (purchase) and sell shares to (redeem) the investment company at any time. As of December 2020, there were 9,027 open-end mutual funds totaling \$23.896 trillion dollars in assets. They make up approximately 76% of all mutual funds.
The second major fund category consists of closed-end mutual funds. A closed-end mutual fund is a type of investment company that operates with a fixed number of shares outstanding. Shares are issued by an investment company only when the fund is organized. After all original shares are sold you can only purchase shares from another investor. In this way, closed-end mutual funds are bought and sold like stocks and bonds on the open market. The investor will incur brokerage commissions. Closed-end mutual funds are a much smaller part of the mutual fund universe. As of December 2020, there were only 494 closed-end mutual funds holding only \$279 billion dollars in assets. That number represents only 4% of the available mutual funds. In recent years, both numbers have been steadily shrinking.
The current underlying worth of any mutual fund is represented by the Net Asset Value (NAV). At the end of every day that the stock market in the United States is open, all mutual funds are required to compute the Net Asset Value of a single share. The mutual fund staff sum the value of the securities in the mutual fund and subtracts any liabilities. The securities are quoted as of 4 pm New York time. The liabilities consist of pending redemptions to be sent to investors, pending purchases of new securities, and any other day-to-day costs of running the mutual fund. The liabilities are typically very low compared to the value of the securities. The result of the value of the securities minus the liabilities is then divided by the number of mutual fund shares. This is the Net Asset Value. This is the number you will see when you investigate your mutual fund. Although it is good to understand what the Net Asset Value represents, there is really no need to perform the calculation for yourself; each day, it is computed for you automatically and all you need to do is run to your nearest Internet-enabled device and ask for it.
Open-end mutual funds are bought or sold at Net Asset Value. Some open-end mutual funds may add a sales commission, also known as sales charge or sales load. If a sales commission is added, the resulting price is called the Maximum Offering Price (MOP) or just the Offering Price. The NAV or MOP is the price that the investor will pay when the fund is purchased. The NAV is the price the investor will receive when the fund is redeemed. Since closed-end mutual funds are bought and sold on the open market, their price usually either reflects a premium or discount to the Net Asset Value. They are very rarely priced at their Net Asset Value. Closed-end funds more often than not will sell at a discount to the Net Asset Value. The investor will pay the current market price when purchasing closed-end mutual funds and receive the current market price when redeeming closed-end mutual funds.
What are the advantages and disadvantages of open-end versus closed-end mutual funds? Open-end mutual funds are much more popular than closed-end mutual funds and therefore offer the investor a much wider range of options. With open-end mutual funds, there are no market forces so the investor does not pay any brokerage commissions and does not have to worry about any supply and demand market forces.
One downside of open-end mutual funds is something that the investor has no control over. Invariably, if an open-end mutual fund becomes very successful, it will become very popular. Floods of new contributions will inundate the fund. At first, this may sound like a great boon to the company. However, too much money flowing into a mutual fund can create serious challenges for the mutual fund managers. They must put this money to use and that can be problematic. Will they choose to purchase more of the same securities that they already have in the portfolio? Will they decide to invest in new securities? Both have their pitfalls. Purchasing more of an existing security that is already in the mutual fund may bump the mutual fund up against the 5% rule discussed in the next section. It also could be difficult for the fund to purchase more shares without adversely affecting the price of the security, especially if the security is a smaller issue such as small company stock. Also, identifying, choosing, and monitoring new securities places more burden upon the mutual fund company. Too much diversification can be too much of a good thing. How many resources will the mutual fund company devote to the 250th stock in their portfolio? For this reason, many open-end mutual funds will decide to close the fund. Other mutual funds handle this problem by adding more mutual fund managers, essentially creating multiple portfolios within the overall portfolio. Again, this is an issue that the mutual fund company must handle but it is important for us investors to be aware of.
In addition to the problem of a flood of contributions into the open-end mutual fund, if an open-end mutual fund experiences a flood of withdrawals from the fund, the exact same problem happens in reverse. Now, the mutual fund managers might be forced to sell securities to pay for redemptions. This may occur at precisely the worst time, namely when the market is experiencing a major downturn and ill-informed investors are running for the exits. Or it may occur when a very successful and popular money manager leaves a fund after many years. Too many contributions and too many withdrawals are both uncommon events but they are something that investors need to be aware of.
Closed-end mutual funds have the issue that the investor must pay a broker’s commission just as they would when they bought or sold a stock or a bond. (You may be saying to yourself, “My brokerage firm doesn’t charge commissions. I am not paying anything for my trades!” Ah, Dear Student, please know that you are being charged, one way or another. We will tackle the industry’s current sleight of hand in our next chapter.) Closed-end funds must be bought and sold in the marketplace so the forces of supply and demand are at work. Hence, there is sometimes a premium or, more often than not, a discount to the Net Asset Value. However, one advantage of closed-end funds is that it is much easier for the mutual fund investment advisors to manage the underlying assets. Recall that the number of shares is set when the closed-end mutual fund is established. The closed-end mutual fund managers do not have to worry about a flood of purchases or redemptions as do the open-end mutual fund managers.
A third type of mutual fund has emerged in the past few decades. Exchange-Traded Funds (ETFs) are hybrids of open-end and closed-end mutual funds. Exchange-Traded Funds are open-end mutual funds that have no limit to the number of shares. The mutual fund company issues new shares as needed. However, they trade on the stock exchanges like closed-end mutual funds. Therefore, the investor must purchase the fund using a brokerage account, incurring brokerage transaction fees as would a closed-end mutual fund. Competition and innovation have led some mutual fund companies to find a way to eliminate the brokerage transaction fees. Some mutual fund companies have opened their own brokerage firms and if you purchase their Exchange-Traded Funds through their brokerage firm, they waive the commission.
Exchange-Traded Funds were introduced in the early 1990’s. Starting in the 2000’s, their popularity began a meteoric rise, as shown in the table below. This has led many in the industry, especially the financial media talking heads doing their best to attract your attention by making profound revelations, to confidently predict that ETFs will supplant all other mutual funds. To steal from Mark Twain, the reports of the death of open-end and closed-end mutual funds are greatly exaggerated. Even given their spectacular growth, ETFs still only account for about 19% of the total number of mutual funds.
Growth of Exchange-Traded Funds
Year Number of Funds Assets (\$US)
2006 359 \$423 billion
2007 629 \$608
2008 743 \$531
2009 820 \$777
2010 950 \$992
2011 1,168 \$1,048 (\$1.048 trillion)
2012 1,239 \$1,337
2013 1,332 \$1,675
2014 1,451 \$1,974
2015 1,644 \$2,100
2016 1,744 \$2,500
2017 1,900 \$3,401
2018 2,057 \$3,371
2019 2,175 \$4,396
2020 2,296 \$5,449
2021 2,690 \$7,191 billion (\$7.191 trillion)
Source: Investment Company Institute, ici.org
There is some confusion surrounding the underlying investments in Exchange-Traded Funds that we will discuss when we discuss the various types of mutual fund strategies and objectives. Furthermore, because of the ability to buy and sell Exchange-Traded Funds throughout the trading day, many speculators and traders have begun to use ETFs as trading vehicles. Many in the industry including John “Jack” Bogle, founder of The Vanguard Group, have lamented the use of ETFs as trading vehicles as mutual funds were originally designed to be long-term investments. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.04%3A_Open-end_Closed-end_and_Exchange-Traded_Funds_%28ETFs%29.txt |
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The mutual fund industry in the United States started in the mid-1920’s. The concept was borrowed from the famous Scottish Investment Trust that has been in operation since the 1880’s. The idea was to be able to bring professional money management and diversification to the masses. At first, some regulators were very skeptical about these new investment alternatives and some states had conflicting rules and regulations. Especially troublesome from the governments’ viewpoints was how these entities should be taxed. That all changed with the Investment Company Act of 1940. This legislation is the foundation of the modern mutual fund industry. The Investment Company Act defined a “regulated investment company,” also known as a “pass-through” investment vehicle. The mutual fund does not pay taxes on the interest, dividends, and capital gains from the underlying investments. Instead, the mutual fund “passes through” the rewards to the investors and the investors are responsible for any subsequent taxes. (The mutual fund earns its money from the fees charged to the investors and must pay any taxes on those earnings.)
There are several rules, regulations, and guidelines that must be adhered to for a company to qualify as an investment company. The entity must hold almost all its assets as investments in stocks, bonds, and other traditional securities. It has a very limited ability to use derivatives and other risky strategies. Also, the mutual fund may use no more than 5% of its assets when acquiring a particular security. This rule is crucial. By limiting the amount of assets to 5% to any one particular stock or bond, the mutual fund is guaranteed to have at least 20 securities. Obviously, most mutual funds have far more investments in their portfolio but there are some mutual funds that do limit their portfolios to the bare minimum. One such fund was the infamous Janus 20 mutual fund. Where did the name come from? Again, a mutual fund must have at least 20 different stocks, bonds, or other securities. The strategy of the Janus 20 fund was to have a portfolio of only 20 stocks. This anti-diversification strategy works great ‒ if you choose 20 great stocks. Of course, if even one or two of your choices don’t work out as expected, it can quickly sour the long-term results of a mutual fund. If you investigate the history of the Janus 20 fund, you will find that this is exactly what happened. Janus 20 was a high-flying and very popular mutual fund ‒ until 2008. Janus finally merged the fund into another mutual fund ‒ Janus 40! This is an example of what is called in the industry “burying the evidence.” It happens far more often than it should.
Another important provision of the Investment Company Act of 1940 is that mutual funds must create an organization with “checks and balances.” This is the exact same concept that is embedded into the Constitution of the United States and is taught in high school Civics and United States History classes. In the case of mutual funds, the idea was to help ensure that the investors’ assets would be protected by separating the various tasks among several different entities. In truth, a mutual fund is not just one company; it consists of a group of companies.
The mutual fund is a corporation run by a Board of Directors for the benefit of the investors who are shareholders in the corporation. The Board of Directors is voted in by shareholders and are charged with overseeing the fund operations on behalf of the shareholding investors. In the past, some Boards of Directors were criticized for not exercising the highest standards in fiduciary oversight. This is a fancy way of saying that they were asleep at the wheel. Some Board Members are paid handsomely for their services. Critics contend that this creates a conflict of interest and question whether Board Members would be fearful of jeopardizing their positions by being too critical of the mutual fund management.
By far, the most important component of the mutual fund structure is the Investment Manager, also known as the Management Company or simply the Fund Manager. This is the company that is charged with researching, identifying, choosing, and then monitoring the securities that will populate the mutual fund. Many mutual fund companies use what is sometimes referred to as the “star manager” approach where one individual is responsible for all the final decisions of what investments will be included in the fund. This person is assisted by many research analysts who cover specific sectors and industries such as energy, technology, and health care. Other companies use a committee that must come to a consensus about which securities to buy. An approach that is a hybrid of these two strategies is to have several money managers responsible for the investment decisions. The group does their research as a team but the individual money managers make their own decisions. This approach is gaining popularity as it has some advantages over the “star manager” approach. It allows the portfolio managers to focus on fewer investment choices, ones in which they have the most conviction. It also allows for a smoother transition when a money manager leaves the firm. This is in stark contrast to the problem a “star manager” mutual fund has when their individual retires or joins another firm.
The custodian is the company that actually holds the securities. This company is often a bank or trust company. The investment manager makes the decisions, the custodian company holds the investments. This is done to reduce the risk of any financial misconduct and is part of the “checks and balances” that is built into the mutual fund. As their name suggests, the distributors distribute the shares to the public or to other financial professionals dealers who then deal with their own clients. The transfer agent keeps track of purchase and redemption requests from shareholders, not the most glamorous of tasks in the investment industry but very important, nonetheless. Lastly, the independent public accounting firm certifies the fund’s financial operations and reports. They are the watchdog that ensures that the investments are safe and sound and that there is no financial fraud. Normally the independent public accounting firm is one of the Big Four public accounting firms. (Note: In the case of the fraud perpetrated by Bernie Madoff, the accounting firm that he was using was some guy out in Connecticut working who worked out of his garage.)
Why the large diversification of tasks and companies? Mutual funds are highly regulated in order to protect shareholders’ investment from fraud and collapse. How often have you heard of a scandal at a mutual fund company? Until 2003, never.
“Wait a minute, Paiano! Did you just say, ‘Mutual Fund Scandals?!’ You want me to invest in an industry that is plagued with scandal?!” Well, as a matter of fact, yes, I do. I want you to invest in mutual funds. But on the contrary, the industry is not nor has it ever been plagued with scandal. Since 1940, the mutual fund industry has been regulated and for decades escaped any but the slightest hints of impropriety. In 2003, some practices that were not quite illegal but obviously unethical were uncovered. Only a handful of mutual fund companies and people in the firms were affected such as Strong, Janus, Bank of America, Putnam, and Alliance. The vast majority of companies never engaged in any of the shenanigans. Two individuals at Alliance were guilty of these improper actions and the entire company was unfairly tarred and feathered. The worst example was the sad story of Strong Funds where the CEO, Richard Strong, who built the company from scratch, supposedly earned \$600,000 in ill-gotten gains. This was a man who was worth a reported \$800 million dollars at the time of the ruse. What causes a titan in the industry to risk their most important asset, their good name and reputation, for what to him was essentially pocket change? Mr. Strong was barred from life from the securities industries, paid a \$60 million fine, and publicly apologized for his actions. Strong Funds paid \$115 million in penalties and \$80 million to investors. And unlike most such settlements, the firm admitted wrongdoing and apologized to its investors. The assets of Strong Funds were eventually sold to Wells Fargo and, once again, the evidence was buried.
What were these terrible things that these few rascals were guilty of? We won’t get into the gory details of mutual fund late trading and market timing. Although these actions were certainly dishonest and corrupt, the effect upon the average mutual fund investor was essentially unnoticeable. Those who invested heavily in Enron, WorldCom, or Bernie Madoff lost \$99,999 on a \$100,000 investment. In contrast, the investors of the affected mutual funds typically lost less than a penny on a \$100,000 account. The offenders were stealing hundredths of pennies from their fellow mutual fund investors. There just happened to be millions of said fellow mutual fund investors to steal a few hundredths of a penny from every few days or so. Even though the harm was negligible to the typical mutual fund investor, these actions were counter to the honest and principled operation of a mutual fund. Again, only a handful of culprits were guilty. As usual, it is the very few who give all the hard-working, honest professionals a bad name. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.05%3A_Regulation_and_Organization_of_Mutual_Funds.txt |
Most mutual fund investors know that they are paying for the services of the mutual fund. However, typically their understanding of how they are being charged is vague at best. My apologies on behalf of our industry because as you will see, we have done our best to make sure that the vast majority of mutual fund investors do not fully understand the costs associated with mutual fund investing. And for the most part, the industry has succeeded. As Rising Investment Gurus, it is your duty to understand thoroughly the fees and expenses of mutual funds. Study this section over and over. Your friends and family and colleagues are depending upon you.
Annual Operating Expenses
Every mutual fund has annual operating expenses. These expenses are reported as a percentage of the assets under management. Understanding the percentage of assets under management is only the first hurdle for most potential mutual fund investors with regard to expenses. There is much more to understand and internalize about mutual fund fees. Sadly, understanding the costs resulting from the percentage expense of assets under management is also often the last hurdle for puzzled would-be investors. Subsequent explanations of fees and expenses often elicit only glassy-eyed stares. Our intrepid future mutual fund investor then decides quickly to banish from their mind any further thought of the costs of mutual fund investing and to concentrate on the other juicier aspects of mutual funds such as the investment returns touted in the slick marketing material their representative sent them.
This dynamic is unfortunate because understanding the costs as a percentage of assets under management is not difficult once it is explained adequately. For example, if the annual operating expenses are 1% of assets under management, then for every \$100 in the account, the mutual fund will charge 1% of \$100 or \$1 each year to operate the mutual fund. If the assets under management were \$1,000, 1% would be \$10 yearly. \$100,000 would mean an expense of \$1,000, and so on. It is typical to see annual operating expenses range from 0.05% or less to up to 2% and sometimes even more. Although the difference between, for example, 0.5% and 2% might seem small at first, the difference in absolute expenses can be substantial, especially when the investment amount becomes considerable.
Mutual funds have up to four annual operating expenses. Normally, the most costly annual operating expense is the management fee. This fee goes to the professional money managers who are identifying, choosing, and monitoring the securities that populate the mutual fund. Management fees range from 0.2% up to 2% yearly. Proper securities research is not inexpensive. If the money managers are doing the serious work necessary to actively manage the underlying choices in the mutual fund, the costs will be significant. As we have discussed, the world is a very small place economically and money managers must have a global outlook. Doing research across the globe is costly and the management fee reflects this cost. However, we shall see an important exception to this rule as we progress through our discussion of fees.
A second annual operating expense is the 12b-1 fee. Where did this comically baffling name come from? The 12b-1 fee’s name comes from Rule 12b-1 of the Investment Company Act of 1940. This annual fee is used to defray advertising, servicing, and distribution costs of the fund. Mutual fund companies are required to report what they pay for these costs. Are banks or life insurers, or beverage companies or car companies, for that matter, required to tell the general public what they pay for advertising? No, but according to the Investment Company Act of 1940, mutual funds companies must. Over the past two decades, 12-b fees have gotten a bad reputation because of some abuses which will be discussed soon. The 12-b fees are usually 0.25% but can be as high as 1.0%.
The third category of annual operating expenses consists of the accounting and other expenses. This is a broad category that consists of all the other expenses of operating a mutual fund such as the rent, utilities, communications, and, very importantly, the accounting. This expense ratio is usually less than 0.2%.
A last category of mutual fund annual operating expenses usually only applies to accounts that the IRS has deemed tax-advantaged accounts, also known as tax-qualified accounts. Examples of these are retirement accounts such as Traditional and Roth IRAs, health savings accounts, and educational accounts. With these accounts, the IRS requires the funds to be held by a separate trustee. Unlike the first three expenses, instead of a percentage of assets under management, the trustee typically charges a set fee of between \$10 and \$35 per year per account. Also, unlike the previous three fees which are paid automatically from the proceeds of the account, this fee can be paid separately outside the account by the investor. In practice, very few investors bother to write a check each year for \$10 and send it to the mutual fund trustee.
Disclaimer: Because of the intense competition in the mutual fund industry, there are now a few funds that do not charge any annual operating expenses. Fidelity Investments was the first to offer a few of their funds with no annual operating expense. In marketing, this is often referred to as a loss leader. Fidelity is courting new customers with a few free mutual funds and anticipating that once they are loyal clients, Fidelity will be able to sell them other for-pay services. Obviously, no company can exist indefinitely without revenue so we will see if this marketing gambit is successful over the long term for Fidelity. If it is, we can expect other companies to follow Fidelity’s lead.
According to the Investment Company Act of 1940, all the previous fees and expenses, along with much other information about the mutual fund, must be reported in the funds’ prospectus. No doubt you have heard or seen in advertisements about mutual funds and other types of investments, “Be sure to read this and other important information about the investment in the prospectus.” Ha, ha, ha, ha, ha! This is one of our industry’s little jokes. No one reads the prospectus. Before the revolution in digital communication, every investor was required to have been given or sent to them the prospectus in writing. Now, as with other online services, you simply, “Click or tap here to acknowledge that you have read the prospectus.”
As Rising Investment Gurus, it is important for you to at least slog through one or two prospectuses. (No, the plural of prospectus is sadly not prospecti.) There are various links on the class website for you to follow. The truth is the prospectus can be very useful. If you ever suffer from insomnia, simply start reading a mutual fund prospectus. Your insomnia will be a distant memory. When Your Humble Author was first introduced to mutual funds, the representative gave me the required prospectus in writing along with the marketing material. Although I skimmed quickly through some of the material, I read every page. When I saw her again to discuss the potential investments, I asked for the prospectus of the second mutual fund that she was also thinking of recommending. She looked at me oddly and said, “You read the prospectus?” I replied that I had and was eager to read the other one. She was dumbfounded. This was a woman who had over 20 years of experience in the industry at the time and she replied, “I don’t know anyone who has read a prospectus. I’ve never read a prospectus!” At the time, I thought that this was odd since if you are going to trust your money with this company, shouldn’t you know everything you can about them? Since then, I believe that only one of my clients has ever actually read the prospectus. Also in recent years, the Securities and Exchange Commission has allowed the mutual fund companies to issue a summary prospectus which is about ¼ of the size of the full prospectuses. It is still written in such a way to put the average person asleep within one or two pages.
Before the advent of pervasive digital communications, there was a saying in the industry. “The more important the information, the cheaper the paper. The less important the information, the more expensive the paper.” This was a comment on the fact that the prospectuses were printed on drab, inexpensive paper. On the other hand, the slick marketing materials were always printed on luxurious paper in full color.
One operating expense that is often overlooked is the cost related to trading. The trading costs are not required to be reported in the prospectus. So how does one know how much the mutual fund is paying in trading costs. A quick guide is to look at the mutual fund’s turnover ratio. This is a measure of how much of the portfolio “turns over” in one year. If the turnover ratio is 100%, the mutual fund will have bought and sold the entire portfolio in one year. If it is 50%, it will take two years to turn over the portfolio. The higher the turnover ratio, the more trading costs the mutual fund will incur.
What is an optimal turnover ratio for a mutual fund? The answer depends as some mutual funds will have a high turnover ratio simply by the nature of the underlying investments. Examples of this type of mutual fund are money market mutual funds that hold short-term securities that mature in three, six, or nine months. Therefore, it is typical to see 300% or more turnover in money market mutual funds. However, with stock mutual funds, a high turnover ratio implies that the mutual fund managers are acting more along the lines of speculators and traders instead of investors. We will see when we discuss stock valuations that a turnover ratio of 20% to 30% for stock mutual funds is a respectable turnover ratio. The mutual fund managers are holding onto their stocks for an average of 3 to 5 years. A turnover ratio of 200% or more for a stock mutual fund means the managers are only holding onto their stocks for an average of six months or less. A stock turnover over 200% is not long-term investing; it is short-term speculating/trading, better known as gambling.
Load Funds versus No-load Funds
Along with the annual operating expenses, some mutual funds have a commission. The commission goes by various names including the sales commission, the sales charge and, historically, the sales load. Hence, mutual funds that come with a commission are called load funds. Mutual funds that do not have sales commissions are called no-load funds. During the first few decades of the mutual fund industry, mutual funds were sold by financial representatives such as stockbrokers and came with a sales load. The commission was used to compensate the financial representative along with the fund distributor. Eventually, enterprising new mutual fund companies began to offer no-load mutual funds without commissions that bypassed the financial representatives. The investor would deal directly with the mutual fund company via 800 toll-free phone numbers and then eventually, the Internet and other digital communications. The incessant drumbeat from the financial media will tell you that you should never buy a load fund and should only purchase no-load funds. There are two problems with this. First, along with the sales load, you need to compare the annual operating expenses. Over the long term, a no-load fund with higher annual operating expenses may wind up costing you far more than a load fund with lower annual operating expenses. Secondly, if an investor believes that they need the services of a financial representative, they should be expected to pay for these services. We will see that traditional load fund sales commission can wind up costing orders of magnitude less than the current system that has evolved to replace the traditional sales load.
In addition, as you nose about the financial media, you will invariably see something along these lines, “If you invest \$100,000 into a mutual fund with a 5% sales load, at the time you invest, \$5,000 will be taken out of your account and used to pay the broker and other distributors that helped get you to choose that investment. If your mutual fund grew by 8% compounded for 50 years, a \$5,000 sales load charge would result in you having \$234,508 less in wealth.” The problem with this assertion is that the writers are assuming that the load fund and the no-load fund will have the exact same investment returns. This would almost always never be the case. No two funds are exactly the same. The other problem with this example is that a mutual fund with a 5% sales load typically has reduced commissions for amounts over \$25,000 or \$50,000. We will look at so-called sales charge breakpoints below.
How did the investment services industry respond to the challenge of charging clients for their services in the face of no-load funds? The industry introduced various mutual fund share classes. As we work through the next discussions of the various types of share classes, their non-descriptive names, their sales loads and other fees and expenses, we will see yet another reason why mutual fund investors would rather not concentrate on how they are being charged. Again, it is up to you, Dear Rising Investment Gurus, to study these share classes thoroughly and internalize them so that you will be able to help your friends, family, and colleagues make sense of the fees they are paying for their funds.
Share Classes ‒ Alphabet Soup, Anyone?
The first mutual funds had a front-end sales load. The sales commission was subtracted from the purchases of the mutual fund shares. These mutual funds shares are typically now referred to as Class A shares. They would traditionally have the lowest annual operating expenses of load funds. Also, as mentioned, the sales load is typically reduced as the contributions or the amount of the investment reaches certain sales charge breakpoints. For example, the maximum sales load on a mutual fund’s A shares may be 5%. However, once the contribution or the amount in the account reaches \$25,000, the sales load would be reduced to 4.5%. At \$50,000, it might be reduced to 4%, and so on. Typically, once the contributions or the amount in the account reaches \$1,000,000, the sales load is waived entirely. (Does this give you an idea of how much the industry simply adores high net worth individuals, often called sophisticated investors or accredited investors?) As no-load funds became more popular, many in the general public soured on the idea of sales commissions. If nothing else, the investment services industry is very good at marketing. For those individuals who did not want to pay a front-end Class A sales load, the industry created Class B shares. Class B shares have a back-end sales load. The investor paid a commission when they sold the shares. Savvy investors would respond, “Ms. Financial Representative, what difference does it make if I pay a front-end load or a back-end load? I don’t want to pay any sales commission!” The industry was already one step ahead of them.
“No problem, Mr. and Mrs. John Q. Investor! Our Class B shares have a Contingent Deferred Sales Change (CDSC). You only pay the back-end sales charge if you don’t hold on to the shares for 4 years. After that, there is no sales charge.” The representative is correct but she and her cohorts were often withholding an important piece of information. The Contingent Deferred Sales Charge does indeed reduce over 4 or 5 or 6 years. The first year, it may be 4%, the second year, 3%, and so on until the back-end sales charge disappears. However, what the sales representative did not divulge ‒ “But Ms. Jane Q. Investor, it was all contained in the prospectus that you read!” ‒ is that the Class B shares typically charge higher annual operating expenses over 6 or 8 years. Much of those higher annual operating expenses are going to compensate the advisor and their firm.
Where did the higher annual operating expenses come from? They came from the 12b-1 fees, of course! Doesn't everyone know that? Class B shares typically had 12b-1 fees that were four times higher than Class A 12b-1 fees. Over time, the Class B shares can wind up costing an investor more than the Class A shares. Plus, there is a point at which the sales charge breakpoint makes the Class A shares a much better deal for the investor than the Class B shares. This and a few other abuses of the Class B shares perpetrated by a number of financial representatives gave the Class B shares a less-than-stellar reputation. Many mutual fund companies have already done away with their Class B shares.
“Mr. Ron Q. Investor, you say you don’t want a front-end load nor a back-end load? No problem! We have the shares for you! They are called Broker No-load Funds.” The next attempt by the industry to counter the challenges of the no-load funds was the invention of the Class C shares. At the time, many representatives referred to them as Broker No-load Funds. That name is no longer allowed by the regulators. Class C shares have no front-end load and no back-end load except for a typical 1% back-end load that is charged if the investor withdraws the funds within one year. “But you are not going to withdraw your money within a year, Señorita Juana Q. Inversionista, right? Mutual funds are long-term investments.” However, like the Class B shares, the Class C shares have much higher 12b-1 fees for typically 8 or 10 years and therefore, they, too, can wind up costing far more than the front-load Class A shares. As with the Class B shares, most of those higher 12b-1 fees are used to compensate the client’s advisor.
As mentioned, the term Broker No-load Funds is no longer permitted to be used by investment representatives. Why is this? The Securities and Exchange Commission has ruled that Class C shares are a type of load fund. The only difference is that instead of front-end or back-end load, the mutual fund is charging the sales load yearly over time on an amortized basis.
So you go to your broker and you say, “I don’t want to pay a front-end load nor a back-end load and I want lower annual expenses.” What do you think your broker is going to say? Are you starting to see a pattern here? Can you guess what the first words out of the advisor’s mouth will be?
“No problem! For you, we have the new and improved Class F shares! And by the way, we are not your brokers anymore. Oh, no, no, no! We are your wealth managers, your investment advisors, your trusted personal financial consultants. We don’t charge commissions anymore!” The Class F shares go by various designations, Class FI, Class I, Advisor Class, and now, clean shares. These shares have no front-end load, no back-end load, typically no 12b-1 fees, and overall, have much lower annual operating expenses than the Class A, B, and C shares. If you are wondering where the funds to compensate the advisor are coming from, then you have been paying attention and are a good candidate for entering our industry as a professional. What has the sales representative left out of the conversation?
With the Class F shares, the advisors and their firms are tacking on an additional annual operating expense separate from the mutual fund expenses. Currently, it is typical for a brokerage firm to add an additional 1% or even 2% on top of the mutual fund annual operating expenses. With this additional charge, over time, the potential fees that a mutual fund investor pays dwarf the fees of the corresponding front-end load Class A shares, especially for those who can take advantage of the sales charge breakpoints available to Class A share investors. However, this is not the investment world of the 1960’s. If you seek the services of a personal investment advisor, chances are that they will want to pony up the additional 1% or 2% “wealth management fee.”
In addition, the wealth managers normally don’t want us, the Little Folk, who are putting \$50 or \$100 per month away into our Roth IRA. For example, one such firm, Fisher Investments wants you to have at least \$500,000. With your \$500,000 or more, you get charged 1.25% for the privilege of having them manage your money. According to a report from Investopedia, the average fee as of 2019 was 1.02%. As of this writing, larger firms are experimenting with more automated, less personalized, services and are offering lower annual operating expenses. One example of this is a company called Betterment that offers wealth management services for a fee that is between 0.25% and 0.40% of assets depending upon the size of the account.
The A, B, C, and F/I/FI/Advisor/Clean shares classes are only the beginning. Depending upon the mutual fund company, there may be many more share classes. Take heart. All of them are variations on one of the four share classes described above.
The very last share class consists of no-load funds. The financial media often refers to them as “true” no-load funds. This unofficial designation was meant to distinguish these funds from the so-called “broker no-load” Class C mutual fund shares. (Recall that the SEC now prohibits Class C shares from being called no-load funds.) The debate between load funds in all their many permutations and no-load funds will continue unabated for years to come. Remember that no two mutual funds are the same and some load funds have done better than some no-load funds over significant periods of time. Also recall that if you want the benefits of a financial professional, you should be expected to pay for it. One way is to pay of paying your financial professional is through sales loads, whether through Class A front-end shares, Class B back-end shares with a contingent deferred sales charge (CDSC), Class C shares with the load spread out of several years, or Class F/I/FI/Advisor/Clean shares with the additional wealth management, also known as the assets under management (AUM) fee.
A last word on paying for professional financial services is needed here. Some financial professionals are “fee-only.” This has added yet another option into the debate. Some in the industry argue that fee-only professionals do not have the same potential for a conflict of interest since the professionals are not being paid on commissions. However, there are various types of fee-only professionals and some do indeed earn a commission or an assets under management fee or both. Added to this confusion is that often the fees for fee-only advisors can be more expensive than paying the commissions on Class A front-end mutual fund shares.
Breakpoint Sales Charge Reductions and Contingent Deferred Sales Charges
The sales charge breakpoints for Class A shares are often overlooked as a potential powerful method to lower an investor’s costs over time. Below is a typical sales breakpoint schedule for Class A shares.
Table 2.6.1: Sales Charge Breakpoints Example
Investment
(either purchased or accumulated)
Sales Charge
Less than \$25,000 5.75%
\$25,000 but less than \$50,000 5.00%
\$50,000 but less than \$100,000 4.50%
\$100,000 but less than \$250,000 3.50%
\$250,000 but less than \$500,000 2.50%
\$500,000 but less than \$750,000 2.00%
\$750,000 but less than \$1,000,000 1.50%
\$1,000,000 or more None
As we can see from the table above, as we contribute more or as our account reaches higher levels, the sales charge on future purchases is reduced. Investors can even sign a Statement of Intention with their mutual fund company, agreeing to invest a sufficient amount to qualify for a certain breakpoint. The investor has 13 months to satisfy the statement. This allows the investor to pay fewer dollars of sales commission on their initial investments. For example, an investor might know that they will be able to invest at least \$100,000 over the next 13 months. After signing the Statement of Intention, the investor could initially invest \$10,000 now and only pay a 3.50% commission instead of the 5.75% maximum commission. If they fail to satisfy the statement of intention and the 13-month period expires, the mutual fund company will charge the commission that was waived.
In the past, some unscrupulous brokers would fail to mention the sales charge breakpoints provision to their clients. As the client reached a breakpoint, the broker would recommend that the client contribute to a different fund. Today, any broker that attempted this breach of fiduciary trust with their clients would have their license revoked as well as be liable for fines and restitution to be paid to the clients. Once again, we apologize on behalf of our industry and once again, it is the few bad apples that give all investment professionals a very bad name. By the way, “breach of fiduciary trust” is the investment industry’s gently ambiguous euphemism for, “fraud and theft.”
As mentioned, the Class B shares typically have a Contingent Deferred Sales Charge that is reduced over time until it disappears entirely. Below is a typical Contingent Deferred Sales Charge schedule. This type of schedule is also common with annuity investments in the insurance industry. However, the annuity schedules often last upwards of 20 years and can start at up to a 20% or 25% back-end fee.
Table 2.6.2: Contingent Deferred Sales Change Example
Year of Redemption Contingent Deferred Sales Charge
1 4.0%
2 3.0%
3 2.0%
4 1.0%
Fees and Expenses of Several Example Mutual Funds
It is now time to take an in-depth look at the fees and expenses of several sample mutual funds. If you have not done so, please listen or watch the second presentation of chapter 2 on the class website or on YouTube. Stick around for the denouement where we compare not only the fees but the investment results for four different mutual funds and compare them to an industry standard.
Pay special attention to the “checking for comprehension” slides at the end of the presentation. You need to be able to explain the subtle and obtuse differences between the various mutual fund share classes. Last, note that the share classes that we have described above and describe in the presentation are just the major share classes. There are many, many more! Luckily, all the other mutual fund share classes are simply variations on the themes that we cover here. Study and learn these thoroughly. Memorize them.
In the presentation, we see that there is a strong difference in the fees charged by actively managed mutual funds and passively managed index mutual funds. The simple reason a passively managed index mutual fund costs much less than an actively managed mutual fund is that the passively managed index mutual fund is doing absolutely no research and is not identifying, choosing, and monitoring the securities that populate the mutual fund. The index fund is simply reading from a list of stocks or bonds and buying them; if the stocks or bonds are not on the list; they don’t buy them. It’s that simple. On the other hand, the actively managed mutual funds have entire staffs of multilingual, multicultural portfolio managers and research analysts that need to span the globe to identify, choose, and monitor their investments. If done well, this is an expensive undertaking.
There is one exception to the rule about low-cost passively managed index funds. As your family’s, friends’, and most importantly, your colleagues’ Future Financial Wizard, you must be aware of this exception. Some employer-sponsored plans will try to sneak index funds into the plan with high fees. This is typical when the plan administrator is an insurance company. You may ask, “Who would do that to their employees?” One example is Southwestern Community College, the folks sponsoring this class. When the representatives from the new insurance company ‒ We won’t name any names ... Nationwide! ‒ came to tell us how wonderful our new employer-sponsored plan was, they didn’t plan on Your Humble Author being at the meeting. In the fund, they had snuck index funds with fees almost 10 times as much as index funds from other companies. I asked them why the index funds had such high fees and they were gob smacked and started stumbling and mumbling something about how they were working to find lower fee funds. They didn’t lie. They did replace the obscenely high-priced index funds with funds that were only very high priced, their own Nationwide brand funds. For several years, I complained and complained to my colleagues in our Human Resources and Benefits Department. It wasn’t that they didn’t care. They simply did not understand what the problem was. Finally, one of the women in the department took this class and exclaimed to me, “You are right! They are screwing us!” Soon after that, we moved to another insurance company that is screwing us much less. Dear Readers, never trust an insurance company with your investments. When we get to annuities, we will see how insurance companies are not always on your side." (Disclaimer: I am also a licensed insurance agent in the State of California.)Dear Readers, never trust an insurance company with your investments. When we get to annuities at the end of our journey together, we will see that when it comes to investments, insurance companies are usually not “on your side.” (Disclaimer: As well as a registered representative, aka stockbroker, I am also a licensed insurance agent in the State of California.)
This is where you come into the picture. When that slick financial representative in the three-piece silk suit with a \$5,000 watch on his wrist tries to sell you on how wonderful your 401(k) plan is, you are going to ask him, “Why do we have a Nationwide index fund that costs 10 times more than a Vanguard or Fidelity index fund?” He will start to stammer and hem and haw and your colleagues will look at you with awe and admiration. And hopefully, your company will realize what absolute scoundrels these people are. When your colleagues are amazed and ask you how you became an Investment Guru, don’t forget to tell them about Introduction to Investments at Southwestern Community College. You’re welcome, by the way.
Comparison of Commissions versus Assets Under Management (AUM) Fees
In the presentation, we saw how a front-end load fund using Class A shares can cost an investor less in fees and expenses than the other share classes including the financial advisor “wealth management” shares. This difference can become enormous if the potential investor is eligible for the sales charge breakpoints. Later on in the chapter, we will discuss mutual fund illustrations, also called hypothetical illustrations or just hypotheticals. These are examples of the investment returns that mutual funds have produced in the past. We will run long-term hypotheticals for the same mutual fund at the \$500,000 level, one using the traditional Class A shares and paying the front-end load, the other using the Class F shares without sales commissions but paying a typical 1.25% annual wealth management fee for assets under management. The differences in the final resulting amounts over 20 and 25 years are eye-opening.
Some investment professionals may cry foul here. We must acknowledge that we are making a major assumption here. We are assuming that the investor has a very long-term time horizon and does not plan to move their investments around often. If that is not true, then switching your Class A share investments every one, two, or three years would quickly generate large front-end load fees. We again reiterate that mutual funds should be considered long-term investments.
The same investment professionals might be quick to say, “Well, we don’t use the mutual fund in the example your class used. We use different investments.” If that is the case, then we would need to run hypothetical illustrations of their chosen investments, one with the front-end commissions and one with the annual wealth management fee. Again, if the investor has a long-term perspective and intends to buy and hold their investments, the commission fee structure will normally be less costly than the annual wealth management fee.
The Bottom Line on Fees
Fees and expenses are very important, but they certainly do not tell you the whole story about a mutual fund. When comparing mutual funds, you must look at many attributes, not the least of which are the rates of return, preferably over long, statistically significant time periods. Many financial advisors will say that a 10-year period is far more than enough to evaluate mutual funds. However, even 10 years might not be a long enough time period to evaluate your potential mutual funds. There are 10-year periods where some types of mutual funds do very well while others languish. Those times are often followed by a subsequent 10-year where the reverse is true. Look for companies with track records of 20, 30, or even 50 or more years of successful investing. We will do this as an assignment in a later chapter. In our next section, we will try our best to do the impossible. We are going to try to get our arms around the mutual fund industry and identify the major categories of mutual funds. Wish us luck. It’s not easy! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.06%3A_Fees_Expenses_and_Share_Classes_Oh_My.txt |
Many decades ago, there were three types of mutual funds. Some mutual funds invested in stocks, some invested in bonds, and some invested in a balance of stocks and bonds. The mutual funds that invested in stocks were called stock mutual funds. The mutual funds that invested in bonds were called bond mutual funds. And the mutual funds that invested in a blend of stocks and bonds were called balanced mutual funds. Life was simple.
Life ain’t so simple anymore.
What follows is a catalog of the broadest categories of mutual funds. There are many, many more. Study and learn and memorize these major categories and know that all the others are variations on these major themes. You will want to have the attached Mutual Fund Types Scramble Sheet available to help. We recommend that you print a copy for your reference while reading and watching the presentation.
Stock Mutual Funds
In our discussion of stock mutual funds, we are going to use an analogy that may or may not help you. If it helps, great. If it doesn’t help please accept our apologies and just ignore it. We will liken the choices of stock mutual funds to a buffet table and we will start with the riskiest stock mutual funds ‒ the spiciest offerings ‒ and move to the least risky stock mutual funds ‒ the most boring, often ignored, items on the buffet table.
The riskiest stock mutual funds are called aggressive growth funds. These funds seek outsized capital gains by investing primarily in companies that are experiencing the strongest growth in the markets. They also often engage in extensive trading to attempt to offer eye-popping short-term results. Although the funds often report excellent returns in some years, as one would expect, they also are the funds that will fall the fastest and furthest when the markets stumble. These funds are the spicy jalapeño and habanero peppers of the mutual fund world. When we visit the buffet table, do we fill our plates with just the spiciest foods? No, most of us put a little bit of spice on our dishes, maybe 10% or even 20%. So it should be with aggressive growth mutual funds.
However, some adventurous folks may decide to fill their plates with the spiciest mutual fund alternatives. Hence, they must also be prepared for the inevitable downturns. Herein lies the danger with aggressive growth funds. Someone just starting out in the world of investing might take a look at the long-term results of the funds in their employer-sponsored 401k plan at work and say, “Look at this! The Getritch, Quik, and Retyre Aggressive Fund has the highest returns of all the choices. That’s what I want!” Does this person understand the risks they are taking? Are they emotionally prepared for the rollercoaster-like plunges that are in their future? Will they pull their money from the fund at the worst possible time, after a 30% or 40% or 50% or more decline?
To make matters worse, there are one or two categories of mutual funds that are riskier than aggressive growth funds. They often have “Ultra” or “Pro” in their names. They use exotic strategies to enhance the positive returns of the fund. As you would expect, those exotic strategies also can enhance the negative returns. Do you remember the Janus 20 fund that only had 20 stocks to decrease the diversification to the least amount allowable by law? Do you also remember that the Janus 20 mutual fund was merged into another mutual fund to bury the evidence of unsatisfactory returns for the investors? Aggressive mutual funds will exhibit severe volatility. And if you remember, volatility is our industry euphemism for, “Aye, I lost a whole lotta’ money!”
Our second category consists of growth mutual funds. Like their aggressive growth siblings, growth mutual funds will primarily invest in companies with growth prospects higher than the economy and most all stocks. Unlike their aggressive growth siblings, they typically do not take the same level of risk as their aggressive growth siblings. However, they will still demonstrate strong volatility. They are still spicy! Prudent, long-term investors would do well to temper their enthusiasm and limit their allocations of growth mutual funds to 20% to 40% of their overall portfolio.
Here is where it starts to get tricky and you will see how complicated categorizing mutual funds can be. A third category of mutual funds consists of capital appreciation funds. Capital appreciation is just a generic term that describes a rise in the value of an investment. Therefore, capital appreciation funds seek long-term growth of capital. They seek to increase the value of your investment. So how does that differ from a growth or aggressive growth fund? The differences are very subtle. Most growth funds and aggressive growth funds will have a provision in their prospectus that states they will invest primarily in growth stocks, usually staying between 80% and 100% invested in these types of companies. Capital appreciation funds can invest in anything they like and anywhere they like. They can invest in slow growing companies or out-of-favor companies if the investment managers deem that there is the opportunity for the value of the company to rise for whatever reason. Another analogy that we may use is that capital appreciation funds paint with a broad brush and can invest in any type of company whereas growth and aggressive growth funds paint with a narrow brush and primarily choose growing companies.
If you refer to the mutual fund scramble sheet, you will see that we show capital appreciation funds wrapping around the aggressive growth and growth funds. They are normally associated with aggressive growth and growth funds but they are technically not the same. In general, they tend to be as risky as growth and aggressive growth funds although not always. The well-known Fidelity Magellan Fund is a capital appreciation fund. It was managed by famed investor Peter Lynch from 1977 to 1990 and returned an astonishing 29% annual yearly return. Mr. Lynch was very good at choosing all types of companies, growth and non-growth, that had capital appreciation potential.
Yet another example of the confusion inherent in the mutual fund industry is the fact that one of the nation’s oldest and largest capital appreciation funds is called The Growth Fund of America. If you accosted the fund managers of The Growth Fund of America and asked them how they account for the apparent inconsistency with regard to the name of their fund, they would counter, “Excuse us. The Growth Fund of America was named long before the category of capital appreciation fund emerged in the industry.” This is common when researching and investing in mutual funds. The industry can’t even decide upon how best to categorize the thousands of funds available.
The next category of stock mutual funds is called growth and income. These funds primarily invest in stocks for growth of capital and income from dividends. Most funds emphasize capital gains while some may emphasize growth of income from dividends. The fund manager may also sometimes own bonds to augment the income when they believe the opportunity for income is lacking from stocks. They are also sometimes referred to as blend funds. We shall see that some in the industry use the term blend fund to designate another category that we will cover later on. To further complicate the categorization of mutual funds, some will refer to growth and income funds as value funds. Referring to the mutual fund scramble sheet, we see that we have wrapped the terms blend and value around the term growth and income. We will discuss the subtle difference and uses of the terms blend and value in the investment world later on.
Where will we find the growth and income funds on our buffet table? These funds are the main entrees. They are the pasta dishes, the meat and potatoes, the lasagna. Most people will have from 50% up to 75% or even 100% of their plate filled with the main entree and so it is with growth and income funds, especially younger adults up into their late 30’s. These funds will exhibit less volatility than their riskier brethren described above. However, they often have returns very close or on par with growth and aggressive growth funds. A well-run growth and income stock mutual fund is an excellent choice for what is sometimes called a core mutual fund for your portfolio. None other than Sir John Templeton, founder of The Templeton Funds (now merged with FranklinTempleton), believed that if you were to own just one fund during your working years, it should be a global growth and income stock mutual fund.
The last category of stock mutual funds is equity income. Recall that equity is another term for stocks and that income from stocks is in the form of dividends. These are mutual funds that primarily are seeking income from stocks. The investment manager can also use bonds to augment the income. Equity income funds are the least riskiest of stock mutual funds. They primarily invest in slow-growing companies that are paying generous dividends. These funds will not participate in the festivities when the markets are rocketing upward. On the other hand, they will typically hold up very well when there is a market downturn or a crash. They are still stock mutual funds; they will go down in a panic but they will not fall anywhere near as far as the stock funds described above.
Would it not be more descriptive to use the term stock dividends funds? Once again, we apologize on behalf of our industry. We often use very confusing, vague, and obtuse terms to describe an investment in place of more common-sense descriptions. This is why we need you, Dear Students, to become the Investment Gurus for your friends, family, and colleagues. They need your help and guidance! Stick with us, Rising Investment Gurus!
In our buffet analogy, equity income funds are the oatmeal, the broccoli, the lima beans, the stuff your mother always told you to eat when you were a child. Equity income funds are not exciting but they are very good for us, especially as we enter our late 40’s, our 50’s, and beyond. A 30% decline in an equity income fund is much easier to stomach for middle-aged investors than a 70% decline in an aggressive growth mutual fund. This is exactly what happened during the late 1990’s Internet mania when equity income funds lagged the market badly and were derided as stodgy, boring, out-of-touch investments that invested in “Old Economy” companies. In the subsequent Internet meltdown bear market of 2000 to 2002, equity income funds did very well, some even went up as many aggressive growth funds lost 70%, 80%, and even 90% of their value. And in 2022, many equity income funds lost less than many bond funds, no small feat!
We have gone from the most riskiest to the least riskiest stock mutual funds. It is now time to add two other types of categories, market capitalization and domesticity. Market capitalization refers to the size of the companies. We will discuss this concept in detail in our next chapter. There are three broad categories of market capitalization, usually referred to as large-cap, mid-cap, and small-cap. They refer to large companies, mid-sized companies, and small companies. In general, large company stock mutual funds exhibit the least risk while small company stock mutual funds exhibit the most risk. Of course, mid-sized company mutual funds find themselves somewhere in between but are normally closer to their small company cousins with regard to risk.
The domesticity of a mutual fund refers to where the stock investments are based. The three broad categories are domestic, global, and international, also called overseas or foreign. Recall that the term domestic refers to investments that are based in the United States, global refers to investments based anywhere around the world, and international describes investments based outside the United States. Decades ago, the conventional wisdom was that domestic funds were the least riskiest, international funds were the most riskiest, and global funds were somewhere in between. Also recall from our discussion in the first chapter that these distinctions are not as important and pronounced as they once were. The world is indeed a very small place economically these days.
What the industry did is overlay these two types of categories on top of the first type of category. Refer to the mutual fund scramble sheet. In their efforts to be more competitive, a mutual fund company would offer a global, large-cap growth fund or a domestic, small-cap aggressive growth fund. Pick one from column A, one from column B, and one from column C. And of course, if one mutual fund company does it, many others believe they need to follow suit. Do you see how the industry wound up with approximately 12,000 different mutual funds? Ask your statistics professor to help you compute how many permutations there are for all the possible combinations.
Wait! There is more! There are regional stock mutual funds that invest in a certain region of the world such as Latin America, the Nordic countries, Canada, Japan, and the Far East. There are emerging market stock mutual funds that invest in developing countries such as India, Brazil, the Philippines, Russia, and China. There used to be a mutual fund that invested only in companies based in California but that fund seems to have vanished. Upon analysis, this actually was not such an eccentric idea. California by itself ranks as the fifth largest world economy, ahead of India and behind Germany. (If anyone can uncover what happened to this fund, please contact us.)
There are also stock mutual funds that invest in companies based in just a certain sector of the economy such as energy or real estate or wireless communications. These are called sector funds. Both regional mutual funds and sector funds are an attempt to enhance returns by concentrating the portfolio of the investor. Some investors may have some intimate knowledge of the region or the sector of the economy. If that is so, then, just like the aggressive growth funds, placing 10% or maybe even up to 20% of your portfolio may be a decent choice providing you are aware of the risks. However, we investors use mutual funds to diversify, not concentrate, our portfolios. Regional and sector funds should generally be avoided by prudent, long-term oriented investors.
One last category of stock mutual funds consists of mutual funds that use market timing as their primary strategy. We will discuss market timing as a strategy in our next chapter on stocks. Suffice to say that only speculators and traders should ever consider market timing. Prudent, long-term oriented investors should never mention market timing in polite company.
We have spanned the world of stock mutual funds. Study these categories thoroughly. It is time to turn our attention to bond mutual funds.
Bond Mutual Funds
Bond mutual funds primarily invest in fixed-income bond securities. Recall that bonds are essentially loans to corporations, state and local municipalities, and the Federal government. Bond investors lend their money to the bond issuer, the corporation, the state or local municipality, or the Federal government. In return, the bond issuer agrees to pay interest to the bond investor and eventually repay the principal. Bonds, and therefore bond mutual funds, are far less risky than stock funds. We will see later on that bonds often move in the opposite direction of stocks. When stocks are experiencing a market downturn, bonds often move up, or at least keep their value. Hence, many investors use bond mutual funds for stability and preservation of capital. In the following discussion, as we did with the stock mutual funds, we will start with the riskiest bond mutual funds and then move to the least riskiest.
The riskiest bond mutual funds are high-yield bond funds. This is the polite name. Usually these funds are referred to as “junk” bond funds. High-yield bonds are also known as junk bonds, speculative bonds, distressed bonds, and non-investment grade bonds. They pay much higher rates of interest. By now, you obviously understand why. These bonds are issued by entities that have low credit standing and, in many cases, are in danger of default. Default is another polite term we use in the industry for an individual or entity who cannot make good on the financial promises they made. High-yield bond funds typically invest in the bonds of corporations that are in distress but there are also high-yield municipal bond funds that invest in state and local governments and entities that are also in distress.
High-yield “junk” bond mutual funds also have a characteristic unlike other bond funds; they tend to follow the stock market up and down. This is counter to most other bond funds. However, when investigated further, it makes sense. Often, the stock market falls in response to falling economic conditions. When economic conditions are falling, companies that are in distress are in far more danger of defaulting. Therefore, the high-yield “junk” bonds that populate the high-yield “junk” bond mutual funds become more likely to default and the high-yield “junk” bond mutual funds suffer along with the stock market and stock mutual funds. When economic conditions improve, the stocks and the stock market typically rebound and so do the high-yield “junk” bonds. We say that high-yield “junk” bond mutual funds are positively correlated with the stock market and the stock mutual funds. We will discuss correlation in more detail later on in our journey together.
The next bond fund category consists of corporate bond mutual funds. Corporations borrow money for many of the same reasons that you and I borrow money; the difference is just that the numbers are orders of magnitude greater. Most individuals repay their debts and that is true of most corporations. With the exception of the high-yield “junk” bond funds described above, most corporate bond mutual funds have a long track record of earning interest income and returning principal repayments to bond fund investors.
There is a caveat that needs to be addressed here. Since the Global Financial Crisis of 2008, interest rates for many bonds have fallen to levels not seen since the Great Depression. Bond mutual fund investors were accustomed to 5% or 6% or higher annual returns over decades. They became unhappy with the 2% or 3% or lower returns that their corporate bond funds were now returning. In response, many corporate bond mutual fund money managers began to incorporate corporate bonds of lower credit quality, including some that would be categorized as high-yield, distressed “junk” bonds. In the industry, this is referred to as stretching for yield. This led Morningstar, the mutual fund research and reporting company, to create separate bond funds into two new categories, core and core-plus. The term core-plus is misleading as it might tempt potential bond mutual fund investors to believe that core-plus funds are somehow higher quality or better quality than core funds. In reality, the exact opposite is the case. The core-plus funds are the funds incorporating higher yield but lower quality bonds into their portfolios.
Sliding down the risk versus reward spectrum to our next category, we find municipal bond mutual funds. These funds invest in the bonds issued by state and local municipalities, such as states, cities, counties, school districts, bridge and water authorities, and other local governmental entities. In general, these governments and institutions will suffer default far fewer times than corporations. Some municipal bond mutual funds will even invest in municipal bonds that are insured to further reduce the risk of default.
One of the major benefits of investing in municipal bond mutual funds is that interest from municipal bonds is tax-exempt at the Federal level. This makes municipal bonds and municipal bond mutual funds very popular with high net worth investors in higher tax brackets. In addition, if an investor chooses a municipal bond fund that invests in municipal bonds domiciled in their state of residence, the interest from the municipal bond will also be tax-exempt at the state and local level. Hence, state-specific municipal bond funds are often called double tax-exempt. Because of this tax advantage, it is difficult to compare the returns from municipal bond funds to other bond funds. Later on, we will learn how to compute the taxable-equivalent yield of municipal bonds and municipal bond funds. The taxable-equivalent yield will allow us to compare municipal bond funds with other bond funds.
The next two categories consist of bonds that are either issued by the United States Treasury or an organization that is somehow backed by or associated with the United States government. Over the decades, the United States government chartered various private institutions such as Fannie Mae and Freddie Mac and other such entities. Their purposes were to issue bonds to raise funds for such worthy goals as increased home ownership and offering student loans. The representatives in the United States Legislative branch of government, the Congress, and the Executive branch of government, the White House, always maintained that these institutions were separate from the United States government. No way would the United States taxpayer ever be asked to bail them out of default. Over the years, the investment community never believed these assertions. The bonds issued by the organizations were normally considered to be as safe as those from the United States Treasury.
In the Global Financial Crisis of 2008, the investment community’s belief was borne out. When Fannie Mae and Freddie Mac and others were in danger of default, none other than the United States Treasury came to the rescue. As of this writing, these companies are still under the protection of the United States Treasury. Thankfully, they have come back from the brink of disaster and now add billions of dollars of earnings to the Treasury each year. Although there is often much talk about how important it is for the government to extricate itself from these institutions, there is very little agreement about how it should be done. Consult your Political Science professor for more discussion of this vexing situation.
The last category consists of United States Treasury bond mutual funds. They are also often referred to as government bond funds. These carry the least amount of risk of default. The United States Treasury has never defaulted and it is safe to say that it will never default in our lifetimes. Over the past few decades, the issue of raising the debt ceiling has come into the news. There have been times when rabble-rousing politicians have threatened default by not allowing the debt ceiling to be raised. This is pure political theater. The United States government will pay its debts. In fact, there are constitutional experts who argue that the debt ceiling is a ruse and can be ignored by the Treasury. The 14th Amendment of the Constitution states, “the validity of the public debt of the United States, authorized by law...shall not be questioned.” This is yet another delicate matter for your long-suffering Political Science professor.
One often overlooked aspect of Treasury bond mutual funds is that the interest from Treasury bonds is exempt from state and local taxes. Hence, the interest from Treasury bond funds is also exempt from state and local taxes. This is an important benefit for those investors in higher tax states such as California and New York.
As we did with stock mutual funds, we will overlay two additional types of categories, the domesticity and the maturity of the bond funds. The categories of domesticity are identical to the stock mutual fund categories, namely domestic, global, and international, as is the risk versus reward profile. The second type of category refers to the bond maturity within the bond mutual fund. When will the bonds repay their principal? There are three broad categories, long-term, intermediate-term, and short-term. Long-term bond funds typically have bonds that will mature in 7, 10, 20, and up to 30 years. Intermediate-term bond funds favor bonds that mature in approximately 3 to 5 years. And short-term bond funds will populate their funds with bonds maturity in 1 to 2 to 3 years.
With regard to the risk versus reward profiles, one might be tempted to liken these categories to the large-cap, mid-cap, and small-cap categories of stock mutual funds. Large and long both start with the letter L, small and short both start with the letter S, and the terms mid and intermediate are very similar, right? The reality is that they are exactly the opposite of one another. Long-term bond funds are the riskiest and offer the greatest returns, short-term bond funds are the least riskiest and offer the least returns, and intermediate-term bond funds fall somewhere in between the two. Upon further investigation, this scenario fits with the facts. With regard to lending your money to others, the longer the time frame, the more opportunities there are for adverse events. Hence, investors would require a higher rate of return. The opposite is true for shorter time frames. In fact, short-term bond funds start to resemble short-term securities such as money market mutual funds as the maturities get closer and closer to short-term time horizons such as three, six, or nine months.
As they did in the stock mutual fund world, the mutual fund industry is guilty of the same fragmentation in the bond mutual fund world. According to the industry, more options is obviously better and so we experienced the same explosion of permutations and combinations of bond mutual funds as we saw with stock mutual funds. Referring again to the mutual fund scramble sheet, we randomly chose one category from column A, one from column B, and one from column C and, lo and behold, we brought forth a mythical domestic, long-term, high-yield bond fund, just one of dozens and dozens of variations. The mutual fund industry did likewise, but their creations are factual funds that contribute to the further bewilderment that is choosing a mutual fund.
Balanced Funds
The next category of mutual funds is balanced funds. Balanced funds traditionally offer a balance of stocks and bonds and are one of the original categories of mutual funds. Indeed, the nation’s oldest balanced fund has been around since 1929 so the idea of blending stocks and bonds together is not new. Since we said that we would be moving from the most riskiest to the least riskiest, one might be tempted to exclaim, “Wait a minute! If you blend stocks and bonds together, wouldn’t the resulting investment be less risky than stocks but more risky than bonds?” The answer is no. Balanced funds often exhibit less risk than either stock mutual funds or bond mutual funds. The reason has to do with the history of stock and bond price movements. Although every market downturn is different, in the past, often when the stock market fell, the bond market rose or at least stayed relatively stable. We will discuss this phenomenon in more detail much later on. It has to do with the aforementioned negative correlation of stock and bond prices. Note: In 2022, both stocks and bonds fell significantly in tandem. The last year this happened was 1969. It is a rare occurrence.
Typically, balanced funds will have an approximate allocation of 60% stocks and 40% bonds. The investment advisor can adjust the allocation as conditions in the economy and the stock and bond markets warrant, but in general, responsible money managers strive to stay balanced. One of the nation’s oldest and largest balanced funds states in its prospectus that the fund is “managed as the complete U. S. investment program of a prudent investor.” They can never be more than 75% stocks, 25% bonds or less than 50% stocks, 50% bonds.
Balanced funds are not immune to the confusion and puzzlement endemic in the mutual fund industry. A category of mutual fund that is closely associated with balanced funds is asset allocation funds. Asset allocation funds spread their investors’ money across stocks, bonds, and money market securities. They are similar to balanced funds, however, the investment advisor often more diligently tries to “fine-tune” the allocation as market conditions change. Whereas a balanced fund usually stays around 60% stocks and 40% bonds, an asset allocation fund might try to move money into cash when they thought the stock and bond markets might fall. Or they might move all the assets into stocks if they believed the stock market was ready to surge ahead. Critics at times accuse some asset allocation fund managers of being stealth market timers. For all their hype, the returns of many asset allocation funds are very close to balanced funds. Some asset allocation funds trail balanced funds considerably because they “timed the market” badly.
Adding to the befuddlement with regard to balanced funds comes from the tendency of some in the industry to also describe balanced funds as blend funds. Recall that the term blend funds was also used to describe growth and income stock mutual funds. However, even with all the accompanying unsettling distractions, well-managed balanced funds are a prudent choice for investors, especially for those who are nervous about investing in the stock market alone. They also become excellent options for those in retirement who are in good health with statistically many years of life ahead of them. Balanced funds allow us to eat reasonably well and sleep reasonably well.
Money Market Mutual Funds
The mutual fund category with the least amount of risk is money market mutual funds. We covered money market mutual funds, usually just referred to as money markets, in detail in chapter 1 in the section on short-term securities. To review, although money market mutual funds are not guaranteed by an entity of the Federal government, they are very secure. And we now understand that low-risk investments are accompanied by low returns. Currently, at the time of this writing, money market mutual funds are paying close to zero percent interest. Money market mutual funds are a place to park your money in the short term.
We have run through the major categories of mutual funds, from the riskiest to the least risky. It is now time to turn our attention to a few other categories of interest.
Mutual Funds of Mutual Funds
It was inevitable. You know it had to happen. There are now mutual funds that invest in other mutual funds. Some might throw up their hands in frustration and exclaim that the industry has simply gone mad. However, upon further investigation, we find that there are legitimate reasons for these so-called funds of funds. Many employers offer employer-sponsored retirement plans such as 401k or 403b plans to their employees. In an effort to promote their employees to save for their retirement, employers would often automatically place 3% or 4% or 5% of the employees’ salaries into the plan. The employee always has the option to “opt-out” of the plan but empirical evidence has shown that employees tend to allow inertia to take its course and the retirement savings continue with interruption. There was, however, a serious problem with this system that concerned the choice of investments.
Whenever an investment choice is recommended, whether explicitly or implicitly, if the investor is not happy with the choice, there is always the possibility that the investor may sue the individual or organization that made the recommendation. The investor may claim that the investment was not suitable to their circumstances, especially if the investor experienced unsatisfactory results. To guard themselves from these legal actions, employers would typically automatically place the savings into short-term investments such as money market mutual funds. These are very safe but also very low yielding. For someone just starting out in their careers, short-term investments are certainly not the most desirable long-term choices. Something needed to be done.
The Pension Protection Act of 2006 gave employers legal protection from lawsuits if the employer used an appropriate fund of funds for their employees. These funds are often called target-date mutual funds. They also go by the names target-retirement or lifecycle. The mutual fund manager then appends a year to the name. This year corresponds roughly to the approximate year that an employee plans to retire. For example, the Federal employees’ Thrift Savings Plan offers their so-called Lifecycle funds from Lifecycle 2025, Lifecycle 2030, on up to Lifecycle 2065. The Thrift Savings Plan uses the employee’s year of birth and chooses the appropriate Lifecycle fund. For the underlying investments in the funds, the manager chooses a mixture of other mutual funds that are appropriate for the year that the employee plans to retire. When the year of retirement is in the distant future, the investments are more growth oriented. As the year of retirement approaches, the underlying investments become more and more risk averse. Of course, the employee has full control over their contributions and the investments in their account but as mentioned, often employees simply allow the system to make the choices for them. The Thrift Saving Plan is the subject of one of your chapter 2 assignments. Enjoy!
Funds of funds are also popular for investors saving for a child’s education with names like College 2030 and College 2035. They are often paired with tax-qualified educational savings accounts such as 529 plans. The tax advantages of these plans are often skewed toward high net worth and high income families. For many others, a Roth IRA or other account might be a better alternative.
Specialty “Boutique” Funds
The mutual funds categories above constitute the majority of mutual funds available and hold the vast majority of investors’ assets. However, there are numerous specialty funds available. They are sometimes referred to as “boutique” mutual funds. The competition in the mutual fund industry is ferocious and new companies must do their best to differentiate themselves from other funds to attract investors. It is not hard to argue that many of these attempts have resulted in outlandish and laughable results. There was the StockCar Stocks fund that invested in companies that sponsored NASCAR races. There was the Pauze Tombstone mutual fund that invested in cemeteries, mortuaries, and casket makers. The investment manager of The Timothy Funds, “avoids investing in companies that are involved in practices contrary to Judeo-Christian principles,” and that it tries to, “recapture traditional American values.” Not to be outdone, The Amana Funds invest with Islamic principles foremost in mind which include avoiding interest, gambling, pornography, liquor, and pork. But the silliest of all attempts must certainly be The Chicken Little Growth Fund for investors who were afraid that the sky is falling. Fact is always stranger than fiction, Dear Readers.
Obviously, such gimmicks and grandstanding should be met with more than a skeptical eye by prudent, long-term oriented investors. However, there have been some specialty funds that may deserve attention. Some investors want to invest in more than just stocks and bonds and there are mutual funds that will allow them to do so. Some sector mutual funds invest in real estate, typically through Real Estate Investment Trusts (REITs). Also worthy of attention for a select group of aggressive investors are commodities funds that invest in hard assets such as foodstuffs and basic materials. Again, the prudent, long-term oriented investor would only choose this type of fund as a small percentage of their overall investment portfolio.
ESG - Environmental, Social, and Governance Funds
Every decade or so, a new theme emerges in investing. The typical response in the mutual fund industry is to create brand new funds that have the theme somewhere in the name of the mutual fund. So it is with the new theme of ESG ‒ Environmental, Social, and Governance. The belief is that companies that adhere to these three attributes will outpace all other companies going into the future. Since 2019, the inflows into these funds have been substantial. It is in the order of tens of billions of dollars. And in the mutual fund world, nothing succeeds like success. Depending upon the source, there are anywhere from approximately 400 to over 700 mutual funds touting themselves as ESG funds as of mid-2021. They have names such as Social Index Fund, USA ESG Select ETF, Green Alpha Fund, and Sustainable Future Fund 2025.
ESG is not a fad. These qualities are important and investors ignore them at their peril. The problem is that ESG is complex and multi-dimensional. Trying to marry climate change with human rights with executive compensation and a whole other host of issues and characteristics can make for some strange outcomes. There are two third-party analysis groups that monitor the ESG world and give grades to companies based on their research, Morgan Stanley Capital International (MSCI) and Sustainalytics. Sustainalytics is owned by Morningstar, the popular mutual fund research company that we will use in our chapter assignments. For an example of the contradictory outcomes, consider that MSCI gives Dollar General a high-risk rating while Sustainalytics gives Dollar General a low-risk rating. MSCI then gives 3M a low-risk rating while Sustainalytics gives 3M a high-risk rating. Who is right? Who do you trust?
ESG qualities need to be examined in the context of all the other components, aspects, and properties of a potential investment. The well-run mutual funds with decades of successful results already have incorporated ESG into their day-to-day research operations. These companies do not need to create new mutual funds simply to sop up inflows from uninformed investors who just saw on the Internet that ESG is the Next Big Thing and they had better get in now while the gettin’ is good. If history is any gauge, many of these new funds will have mediocre ‒ or worse ‒ returns and then will have their names changed or be merged into other funds. Burying the evidence in the mutual fund industry is a fad that never goes out of style.
Going back further into the history of mutual funds, we find that ESG was predated by the emergence of Socially Responsible Funds. Some Socially Responsible Funds go back many decades. These first took the form of mutual funds that would not invest in companies that produced alcohol or tobacco. Then starting in the 1970’s and beyond, Socially Responsible Funds began to avoid companies that polluted, built weapons systems or nuclear power plants, destroyed the rainforests, exploited their employees, etc. It was surprising that there were any companies left to invest in! Silliness aside, many Socially Responsible Funds did quite well for their investors and led to the current ESG movement. Possibly as a backlash to socially responsible funds and their perceived political overtones, there is a mutual fund called The Vice Fund. Yep! You guessed it! They invest in tobacco and alcohol and all the other corporate nasties you can think of such as gambling and military defense firms. Who said the investment world was dry and uninteresting?
We have covered the broadest mutual fund categories. There are many, many more. Luckily, most of the other categories are sub-categories or sub-sub categories of the broad categories discussed above. Memorize the categories above that we have covered, using the Mutual Fund Types Scramble Sheet as your study guide. In the meantime, peruse the following list of the mutual fund categories as defined by Morningstar as of mid-2021. No, Dear Students, no one will ever ask you to remember them all. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.07%3A_Categories_and_Types_of_Mutual_Funds.txt |
The past several years has seen great controversy over the value of active management in the mutual fund industry. Are the mutual fund investment managers who research, identify, choose, and monitor the investments in their mutual funds actually worth the high salaries they are paid? Should investors instead solely concentrate on low-cost, passively managed index mutual funds? We now explore the debate.
The History of Passive Management
The history of passive investment management, also known as index investing, goes back to the late 1960’s. Before that time, all mutual funds were actively managed. The mutual fund managers researched, identified, chose, and monitored the investments in the mutual fund portfolio. Some individuals in the industry and some in the world of academia began to question the value of the average mutual fund manager. They conducted studies that compared the average mutual fund manager with a randomly selected portfolio. They “had a monkey throw darts at a dartboard” and chose those stocks. They then compared this random portfolio to the portfolios of mutual funds. The monkeys won! The average mutual fund portfolio manager did not beat the random portfolio.
Index Funds
In the early 1970’s, some companies decided to put this research into practice. They experimented with setting aside a percentage of their portfolio for non-active management. They created funds that were purely passively managed which were not available to the general public. Instead of a random group of stocks, though, they choose a popular stock index. A stock index is simply a list of stocks. We will cover stock indexes in detail in our next chapter. One of the most popular indexes is the Standard & Poor's 500, also known as the S&P 500. In 1975, John Bogle of The Vanguard Group started the first retail index mutual fund available to the public, the Vanguard Index 500. The success of this mutual fund and their other index funds has made The Vanguard Group the largest mutual fund company in the world. Many mutual fund companies now offer index funds.
As discussed in the section on fees, index funds generally have very low operating expenses. There is a simple reason for this: They do no research. You or I could manage an index fund. All you need to do is look at the list of stocks or bonds in the index. You then purchase the items on that list and you avoid any choices that are not on the list. When an item is added to the list, you buy it. When an item is removed from the list, you sell it.
As we warned back in the section on fees, the would-be index fund investor must be vigilant. There are many index funds that have high fees. Many are furtively slipped into employer-sponsored retirement plans such as 401k’s, especially by insurance companies. Be on your guard! You are the last line of defense for your fellow colleagues.
Exchange-Traded Funds (ETFs)
The success of index funds led to the emergence of Exchange-Traded Funds (ETFs). The first ETFs were passively managed and like their index fund cousins, had very low operating expenses. To review, ETFs are bought and sold on the open market so you need a brokerage account to invest in them and you incur brokerage commissions. However, some enterprising mutual fund companies started their own brokerage firms and allow investors to buy and sell ETFs without commissions. Also, several brokerage firms now offer no-commission trades to their clients. (We will discuss how the clients are being charged in our next chapter. No-commission transactions does not mean free transactions.)
The subsequent success of ETFs has led the industry to create ETFs that are actively managed. Since these newer ETFs are actively managed, they will have higher annual operating expenses since doing the research necessary to actively manage a portfolio is costly. The industry is nothing if not complex. You are going to have to explain to your family, friends, and colleagues that not all ETFs are index funds.
The Financial Media Orthodoxy versus Not So Common-Sense Heresy
The financial media has made up its collective mind. The incessant drumbeat is that actively managed funds can’t beat passively managed funds. The drumbeat goes something like this: “You are better off investing in a passively managed portfolio of index funds or ETFs. And, oh, by the way, buy my book or, better yet, sign up for my monthly newsletter that keeps you abreast of the best index funds and ETFs. It’s only \$50 per month. A bargain!” Do the talking heads in the financial media have a point, though? Are passively managed index funds and ETFs better than actively managed funds?
It is true. The average actively managed mutual fund does not beat its respective index. There are a variety of reasons why this may be so. One of the most important reasons is that the average mutual fund has an expense ratio of 1% whereas an index has no expense ratio; it is just a list of stocks or bonds. Therefore, the mutual fund must beat the index by 1% just to match the return of the index! Another important factor has been the culture and competitiveness of the investment industry. New mutual funds starting out in their careers knew very well that they must produce quickly or they wouldn’t be around for long, typically 1½ to 2½ years. This led many to take on more risk than would normally be appropriate. The managers knew that if their choices did well, they would get to keep their jobs and be showered with love and attention and a whole lot of money. Of course, if their choices didn’t produce good results, oh, well, they weren’t going to be around for very long, anyway. Luckily, much of the mutual fund industry has seen the error of their ways and adjusted accordingly. New mutual fund managers now normally get more time to prove their worth. Dear Students, no investment strategy is perfect.
The same can be said to be true for passive management, though. No investment strategy is perfect. What are the disadvantages of passive management? Many decades ago, Benjamin Graham, the author of The Intelligent Investor, warned against any investment strategy that removed human judgment from the investment process. Passive management does just that. Passive management removes the ability of a mutual fund manager to make a judgment regarding the value of an investment. Passive fund proponents might argue that this is precisely the point. That is the beauty of an index fund. If there is no judgment, there can be no emotion attached to the choices made.
However, active fund proponents would counter by pointing out that there are instances when a company’s stock, for example, has risen to the point where it is absurdly valued. In this situation, the passive fund manager is not able to sell. Instead, the rise in the price of the stock raises the value of the stock in the index. Hence, the passive fund manager must buy more of the stock. This raises the price even further in what essentially becomes a feedback mechanism. The higher the price of the stock, the more the index fund managers must buy the stock. The more stock the index fund managers buy, the more the price of the stock rises. The opposite is true when the price of a stock has been beaten down. The index fund manager must sell the company as it is now worth less within the index. Whereas the active manager has the ability to take advantage of an attractive price for a stock that they might want to have in their portfolio. In the presentation, we discuss this phenomenon and two popular indexes and what happened when the indexes were skewed by market euphoria. We will return to them later on in the semester after we have discussed the particular indexes and the statistics that accompany them.
Ultimately, though, the fundamental flaw in the argument of the passive management proponents is their use of the word average. As Don Phillips, the founder of Morningstar, said, “The real-world average of almost anything is an ugly thing.” Yes, the average fund does not beat their respective index but there are many mutual funds that are above average. There are many mutual funds that have beaten their respective indexes and have done so over many decades. Here is a quote from a retired mutual fund manager with over 35 years of experience at the time:
“As with any human endeavor, whether it is athletic competition, the performing arts or technological innovation, some people clearly perform at a higher-than-average level.” – Mark Denning, mutual fund manager with over 35 years of investment experience
Many actively managed funds do beat their respective indexes over time. Prudent, long-term oriented investors seek mutual funds that have consistently beaten their respective indexes over decades, in good times and bad. We will return to this discussion later on in our journey together. For now, we will end this discussion of the controversy over active versus passive management with another quote from Don Phillips:
“The active-versus-passive debate has been greatly overplayed to the detriment of many fine, actively managed fund shops and to intelligent investment discourse.” ‒ Don Phillips, Founder and Managing Director of Morningstar
Let us relate one last note about the active versus passive debate. Many passive fund advocates can become quite agitated and angry if you attempt to discuss both sides of the debate. Mr. Phillips hints at this in his mention of “intelligent investment discourse.” When you mention some of the mutual fund families that have done well over decades, you may even be accused of being an industry shill and peddling for the companies. Once again, we ask, “Who said investing was dry and uninteresting?” | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.08%3A_The_Great_Debate__Active_Management_versus_Passive_Management.txt |
In the first few decades of the mutual fund industry, most companies would have one or two mutual funds that they managed. Competition pushed companies in the industry to offer more and more mutual fund choices and to support more and better customer services. This led to the growth of what are now referred to as mutual fund families.
Mutual Fund Families
A family of funds exists when one investment company manages a group of mutual funds. The funds in the family vary in their objectives. You can move your money from one fund to another within a fund family, almost always with no charge. This is especially important if you purchased a load fund. If you decided to move your money to another fund, you would not be charged the sales load again. However, there may be an exception to this rule. Some mutual fund companies will charge an “excessive transfer” fee to discourage trading of mutual funds. This fee only applies to open-end mutual funds. It does not apply to closed-end mutual funds or ETFs since they are bought and sold on the exchanges through a brokerage account. Mutual funds are meant to be long-term investments. Short-term trading of mutual funds is highly discouraged.
Although the fund family will not charge you to move your money into another fund, be aware that the IRS regulations say that you have generated a taxable transaction. You will need to declare either a loss or a gain on the sale of your previous mutual fund. Therefore, taxes should be considered when deciding to alter your investments. We will discuss taxes on mutual funds shortly. This consideration does not apply to mutual funds that are tax-qualified accounts such as retirement accounts, educational savings accounts, or health savings accounts. We will discuss a few of the more popular types of qualified and non-qualified accounts at the end of our journey together.
Many years ago, Forbes, the popular financial magazine, gave the following advice: Choose a Family, not a Fund. The authors were lamenting the tendency of investors to have many mutual funds from several different mutual fund companies. They believed that investors were better served concentrating on a single mutual fund family where most all funds have consistently done well over significant periods of time and experienced both favorable and unfavorable markets. Below is a list of the top ten mutual fund families.
Table 2.9.1: Top Ten Mutual Fund Companies by Assets Under Management
Fund Family
1 Vanguard Group
2 Blackrock / iShares
3 Fidelity Investments
4 American Funds (The Capital Group)
5 State Street Global Advisors / SPDR
6 T. Rowe Price
7 Invesco
8 Dimensional Fund Advisors
9 PIMCO
10 Franklin Templeton Investments
It is surprisingly difficult to find precise data about the top ten mutual funds families. The source of the data above comes from ThinkAdvisor in September 2019. They reference Morningstar. However, this data is not available on Morningstar’s website. Note that other sources have the top 10 listed differently. Some mistakenly add non-mutual fund assets to the totals. For this reason, for example, you may see Blackrock as the #1 company. Although Blackrock holds more assets under management than any other company, not all of the assets are mutual funds. Vanguard has more mutual fund assets.
Mutual Fund Services, Transactions, and Sources of Information
The growth and competition in the mutual fund industry has led the industry to offer many convenient and powerful mutual fund services for investors. Three of these services are automatic contribution plans, automatic reinvestment plans, and automatic withdrawal plans. The most important of these is the automatic contribution plan, also known as an automatic investment plan or a systematic investment plan. These plans allow an investor to establish an automatic contribution from their checking or savings account at a bank or credit union. The investor can specify a day of the month that \$50 or \$100 or whatever is appropriate is taken from their checking account and sent to their mutual fund. Systematic investments plans are also available with employer-sponsored retirement plans. The employer automatically takes a sum from the employee’s paycheck and invests it into the employee’s account. Examples include 401k or 403b or Simple IRA accounts.
Automatic contribution plans make investing very simple. The investor no longer needs to concern themselves when it is the best time to invest. The investments happen automatically. Every month is a great time to invest. Indeed, these plans are practically the only way that many individuals will ever start or continue to invest. Well-intentioned people might say to themselves, “I will wait until I save up \$5,000 and then start investing.” When and how is that going to happen in one’s life when there are always so many other costly responsibilities to attend to? This manner of investing is often called “paying yourself first” and is widely recommended by financial planning and investment experts.
According to the Investment Company Act of 1940, mutual funds must distribute their earnings to their investors at least once a year. Some distribute their earnings semi-annually, quarterly, or monthly. With an automatic reinvestment plan, the earnings an investor receives are automatically reinvested back into the mutual fund. The investor is credited with more shares of the investment. Today, this is the default. The mutual fund company will enroll the investor in their automatic reinvestment plan unless they specify otherwise. This allows the investor to earn fully compounded rates of return. Unless an investor needs the income, it is always a good idea to reinvest dividends and capital gains.
Now here is the best part! An automatic withdrawal plan, also known as a systematic withdrawal plan, is the exact opposite of the automatic contribution plan. This service enables shareholders to automatically receive a predetermined amount of money periodically. Typically, this would be monthly but others may decide upon quarter, semi-annual, or annual withdrawals. Ideally, the investor will establish a periodic electronic withdrawal transferred directly to their checking account. So, here you go, young adults! Start putting away \$50, \$100, or whatever you afford while you are young. Choose prudent, long-term oriented mutual funds with an eye toward growth and income. Don’t get caught up in the Next Big Thing and don’t panic when the markets tumble. Do this throughout your working career, ideally bumping up your contribution \$5 or \$10 per year, especially when you get a raise or some other debt is paid off. In your retirement, you will be happy to discover that ‒ providing the world did not end ‒ you will be able to withdraw \$2,000 or \$3,000 or \$4,000 per month for the rest of your life! (Did we mention that there are no guarantees? Good! Just checking.)
These and other mutual fund services help to give mutual funds their very low PITA factor. (Recall that PITA stands for Pain-in-the-***.) One factor that is out of the control of the mutual fund companies, though, is taxes. We will reiterate throughout the course that we should not allow taxes to dissuade us from an investment. Taxes should not be the “tail that wags the dog.” However, we should be mindful of their presence. For regular, non-qualified accounts, there are two types of taxes, income dividends and capital gains. Each is taxed differently depending upon the investor’s income level and whether the distribution was a short-term distribution or a long-term distribution. In this context, a short-term distribution means a year or less and a long-term distribution means anything more than a year and day. We will leave the details for your accounting classes.
One item to keep in mind, reinvested dividends and capital gains are still taxable transactions. This can create an awkward situation for some investors. In a year when markets fall, the mutual fund is still required to distribute the earnings. The investor receives a Form 1099 that requires the investor to pay taxes on the earnings. The investor exclaims, “But I lost money this year! Why do I have to pay taxes?!” Our representatives in Congress get this complaint often from constituents. Every so often, there is discussion about allowing these unrealized gains to be taxed when the investor actually sells the mutual fund. Again, we will leave the details and a discussion of the pros and cons of such a change to the tax code to your accounting professor. Suffice to say that it is highly unlikely that this will ever happen. It would be an accounting nightmare! In any event, be sure to save your year-end statements.
What about tax-qualified accounts such as retirement accounts? These accounts are typically tax-deferred. You do not pay taxes until the money is withdrawn, typically in retirement when the investor is often in a lower tax bracket. All the proceeds are normally taxed as income. The exception to this rule applies to Roth IRA and similar accounts. Roth IRA accounts are normally tax-exempt in retirement. We will cover types of accounts in detail much later on.
Where does one go for information about mutual funds? What tools are available for research? The quick answer is, “There is too much information and too many resources!” However, there are two documents that are indispensable when investigating a potential mutual fund for your portfolio, the prospectus and the annual report. We discussed the prospectus when we covered the fees that mutual funds charge. The prospectus contains a tremendous amount of other information such as a statement describing the risk factors, descriptions of the fund’s past performance, the type of investments in the fund’s portfolio, information about dividends, distributions and taxes, and information about the fund’s management. It is quite unfortunate that practically no investor had bothered to read one. In fact, the Securities and Exchange Commission has authorized the use of much shorter versions of the prospectus, called the Summary Prospectus, in an effort to save paper since most prospectuses wind up in the landfill.
The other important document is the annual report. The mutual fund is a corporation and corporations must provide an annual report to their investors that describes their operations and financial conditions. The annual report is often divided into two distinct parts. The front part of the report is printed on glossy, high-quality paper and contains tasty graphs and failsafe superlative prose that describes how wonderful the mutual fund is performing. The back part of the report is typically printed on low-quality paper and contains the hard and fast numbers that often call into question the ornamental and flowery words found in the first part. There is an old saying in the investment industry that the most important information about an investment is printed on the least quality paper. This is also true of stocks and their annual reports.
Of course, in this day and age of digital publications, inventors typically don’t even receive a prospectus or annual report in the mail anymore. “Click here to confirm that you have read the prospectus and agree to the terms of this investment.” As part of one of your assignments for chapter 2, we are going to ask you to dig into the prospectus and annual report as well as other resources for researching mutual funds.
What are some of the other resources for researching mutual funds? There are two major mutual fund rating companies, Morningstar and Lipper, now owned by Thomson Reuters. Their information is available online and at most libraries. Be careful as Morningstar will do their best to get you to subscribe to the service for a monthly fee. Remember that most of the information from these two agencies is available at your local library for free.
Other resources include the vast number of financial publications such as Bloomberg BusinessWeek, Forbes, Kiplinger's Personal Finance, and Barron’s, and financial websites such as Yahoo Finance and MarketWatch. Most offer mutual fund surveys usually include the fund’s overall rating compared to other funds in the same category, fund size, sales charges and expense ratios, risk factors, and the rewards history for the past three, five, and ten years. The mutual fund companies themselves have invested heavily in their own websites and along with all the normal marketing materials now include excellent educational articles and commentaries on investing and the markets. The chapter 2 sections of the class website have numerous links to websites of some of the largest and most successful mutual fund companies. There are many, many others. Last, the mother lode of information can be found at ici.org, the website of the Investment Company Institute, the non-profit trade organization sponsored by the mutual fund companies. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.09%3A_Mutual_Fund_Families_and_Fund_Services.txt |
Video - Audio - YouTube (Material for this page starts on slide #72).
By now, you are most likely feeling quite overwhelmed. What a wealth of material about mutual funds and the mutual fund industry you have covered! You should be proud of yourself. But do you now feel ready to invest? Has any of this actually helped you at all with the most important question, namely ...
“Okay, So How Do I Pick a Mutual Fund?!”
With approximately 12,000 mutual funds to choose from, the typical investor is completely bewildered and often has no idea where to even begin the process of choosing a mutual fund. You have read and studied about mutual funds and it is likely that you are no better off, possibly even worse off than when you started. There is no way to sugar coat the issue. Choosing a mutual fund is incredibly difficult. Many individuals will seek a trusted investment professional for help. Others will succumb to the ubiquitous advertising campaigns of one or another mutual fund company. Serious-minded investors might take it upon themselves to research, investigate, choose, and then monitor their mutual fund choices. But even then, no one should fool themselves into thinking they are going to be able to do these rigorous processes for all the mutual funds available. By the time you researched all the mutual funds available, it would be time for your retirement! So how does one pick a mutual fund?
Our advice is to pick a mutual fund that invests in high-quality stocks or bonds, is well diversified across several industries and sectors of the economy, has a long-term perspective and a manager or, better yet, a global management team with many decades of experience, and most importantly, has been around for decades and performed consistently well in both good and bad markets. Be sure to place more emphasis on how well the mutual funds did during market upheavals. Anyone can do well when the markets are charging ahead. Although their investments will suffer along with all the others, the best managers will hold up well during the inevitable downturns. Also, you want to avoid companies that “shuffle” their managers every few years. Luckily, the industry is moving away from this tactic and giving their managers more time to prove themselves. Lastly, be mindful of fees and bend toward lower-cost funds but concentrate on the quality of the investment manager and their long-term results.
ICA: Investment Company of America, A Sample Mutual Fund
For a sample mutual to showcase, we chose the Investment Company of America, typically referred to as ICA. It is one of the nation’s oldest and most successful mutual funds. We want to emphasize that we are not recommending this fund to you as an investment. Rather, the idea is to demonstrate the characteristics of a high-quality, long-lived, successful mutual fund. ICA’s inception date was January 1, 1934. (It actually dates back to the mid-1920’s but the current investment manager took over the operation on December 31, 1933, in the depths of the Great Depression.) This means that ICA will soon be celebrating its 90th birthday. Hence, there is a long history available to study.
On the class website, there are several commentaries that discuss the fund. One particular commentary walks through their entire history and the investment returns of the fund. ICA is a domestic, large-cap, growth and income stock mutual fund. This means that ICA invests primarily in large company stocks based in the United States that are growing and paying dividends. We have already discussed how volatile stock investing is, yes? In the commentary, you will see that the path to wealth was anything but smooth. However, even with the many bumps and stomach-churning plunges in value, investors who stayed the course were well rewarded. Often, the sharp fall in value of one or two years was followed by a significant rise in the one or two subsequent years. So how does one handle the inevitable downturns? The key is to keep a long-term perspective and take advantage of dollar-cost averaging.
Dollar-Cost Averaging
Dollar-cost averaging is a horrible name for a simple, but highly effective investment strategy. Dollar-cost averaging is a system of buying an investment at regular intervals with a fixed dollar amount. We discussed the automatic contribution plan, also known as a systematic investment plan. When an investor utilizes this method to invest, the investor is automatically taking advantage of dollar-cost averaging. Dollar-cost averaging takes the emotion out of investing. Every month is a good time to invest. In fact, with dollar-cost averaging, each day when you awake, there is always good news waiting for you. If the market is up ‒ good news! ‒ your account is worth more. If the market is down ‒ good news! ‒ next month, you will get more shares at a lower price when the \$50 or \$100 comes out of your paycheck or checking account. We will revisit this important technique later on. And remember, an automatic investment plan is practically the only way that most of us working class individuals will ever begin and continue the process of investing.
Hypothetical Illustrations
At the beginning of this chapter, we noted that those who needed motivation to read the chapter should jump to this section and review the accompanying commentaries. There was a very good reason for this. The news is good! Prudent, long-term investing has been very rewarding. To share this good news, most mutual fund companies have a system for running what are normally called hypotheticals or illustrations or hypothetical illustrations. The life insurance industry also extensively uses these tools. Hypotheticals are examples of returns of investments for lump sum principals or streams of investments or combinations of both. A stream of investments is another term for automatic contribution plan or dollar-cost averaging. Hypotheticals must be approved by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) and contain numerous disclaimers about past versus future performance.
Please review the hypothetical illustrations for 30 years at \$100 per month and 40 years at \$100 per month. These are impressive results. However, the real eye-opener is the scenario where the investor started contributing \$100 per month 40 years ago. Then every year, the investor increased their monthly contribution by \$10, two fewer trips to FiveBucks, ah, Sixbucks, no, Starbucks! Hopefully, you will never look at another cup of expensive coffee the same way. The last illustration shows what is typical when an investor waits until their 40’s before they start investing. They must put away far more each month and even then, the investor does not have the blessings of time. Mirroring the manifold disclaimers in the hypotheticals, this is backward-looking data. As you will see and hear over and over again, past results are not guarantees of future returns. No one can predict the future. However, this is a pretty darned good endorsement of prudent, long-term investing.
We also want to emphasize that ICA is just one mutual fund. There are many others with similar results and many with even better returns. But with 12,000 mutual funds to choose from, we have to start somewhere. One other issue about the use of ICA is important to note. We used ICA because of its long lifespan as well as its success. However, if we were going to recommend a single mutual fund to the typical younger investor, we would suggest a global fund over a domestic fund. Recall that ICA is a domestic, large-cap, growth and income fund. The issue here is that there are no global, large-cap, growth and income funds that have a 40-year lifespan. The first global, large-cap, growth and income funds started appearing in the late 1980’s.
Just in case you still might be tempted to believe that you must run out right away and invest in ICA, please note that there are many other mutual funds that have been around for decades and done well in both good and bad markets. Below is a list of mutual funds that have greater than 50 years of experience as of December 31, 2022. Most of them have returned 10% or better or pretty darned close to 10%. The news is good. Choose a well-run mutual fund (or maybe two or three), contribute consistently through good times and bad, don’t panic when the markets tumble, and ‒ assuming the world does not end ‒ your mutual fund or funds will bore you to wealth.
Notice that all of these funds are either growth, growth and income, or equity income stock funds. All except two are domestic. These are the oldest types of mutual funds. As explained, many other types of mutual funds with similar or better returns simply don’t have as long a lifespan and don’t make the list. We emphasize that there is no one-size-fits-all in the mutual fund industry. Many investors will want much more aggressive choices or much more risk-averse choices than what are available on this list. You decide. Do you want to eat well or do you want to sleep well? Hopefully, you are starting to see that dollar-cost averaging will help you gain control of your emotions and when the inevitable downturn occurs, you will see it as an opportunity to let your automatic contribution take full advantage of the reduced prices. You might even decide to make an extra contribution or two because stocks are on sale. Welcome to prudent, long-term investing. You should do well over the long term, Dear Students. And, oh, by the way, you’re welcome.
Mutual funds with 50 or more years of excellent returns as of December 31, 2022
Investments With Over 50 Years
Of Excellent Returns
Annual
Return
Inception
Date
AMCAP Fund 10.93% 5/1/1967
American Mutual Fund 10.20% 2/21/1950
Dodge and Cox Stock Fund 9.84% 1/4/1965
Fidelity Contrafund 12.19% 5/17/1967
Fidelity Equity-Income Fund 11.13% 5/16/1966
Fidelity Fund 10.07% 4/30/1930
Fidelity Magellan Fund 15.35% 5/2/1964
Fidelity Trend Fund 11.66% 6/16/1958
Franklin Dynatech Fund 9.92% 1/1/1968
Franklin Growth Fund 10.16% 3/31/1948
Franklin Income Fund 9.74% 8/31/1948
Franklin Mutual Shares Fund 11.18% 7/1/1949
Invesco Global 10.57% 8/3/1960
The Investment Company of America 11.82% 1/1/1934
MFS Investors Growth Stock Fund 10.56% 1/1/1935
New Perspective Fund 11.69% 3/13/1973
T. Rowe Price Growth Stock 10.57% 4/11/1950
T. Rowe Price New Horizons Fund 11.44% 6/3/1960
T. Rowe Price Small-cap Stock Fund 12.62% 6/1/1956
The Dreyfus Fund (now BNY Mellon Large Cap Securities) 10.31% 5/24/1951
Templeton Growth Fund (Franklin) 11.00% 11/29/1954
Vanguard Windsor 11.24% 10/23/1958
Washington Mutual Investors Fund 11.64% 7/31/1952
Characteristics of Successful Long-Term Mutual Funds
One study by the Capital Group some years ago attempted to survey the vast array of mutual funds and find the most common characteristics of long-term, successful mutual funds. They found that almost all had three characteristics in common. The first attribute was that the funds had lower than average annual operating expenses. Please make sure you review the presentation that compares the commission-based hypothetical illustrations with the assets under management-based hypothetical illustrations on the class website. You will see just how much an extra 1% or so in fees can eat into your long-term results. The second most common property was that the mutual fund managers had substantial amounts of their own money invested in the funds. In the industry, this is referred to as “eating one's own cooking.” The third most common trait was that the funds demonstrated substantial downside resilience. They held up comparatively well when the markets fell. One of the statistics we want you to research in your Mutual Fund Annual Report Assignment is the upside/downside ratio. It is one of the most important measures in Your Humble Author's opinion. Downside resilience helps us sleep reasonably well when the inevitable market downturn occurs.
Mutual Fund Returns versus Investors’ Returns
We have seen how well some mutual funds have done over decades. The question to ask is how well the typical mutual fund investor has done. One would expect there to be an easy answer to this question. Mutual fund investors have done the same as their mutual funds, of course. How could it be any different? We are sad to report that mutual fund investors have done much worse over time than the mutual funds they invest in.
“Wait a minute!” you say, “That does not make any sense whatsoever. How could a mutual fund investor do worse than the mutual fund that they invest in.” Actually, it does make sense. It makes perfect sense and is entirely predictable given human emotions and what we have learned. Do you remember Mr. Warren Buffett’s observation? “Investing is simply … but it ain’t easy!” Many investors allow their emotions to control their actions. “The market’s up! Ooh, ooh, ooh! Is it too late to get in!?” When you hear this question asked often by your friends, family members, neighbors, and colleagues, the answer is invariably, “Yes, it’s too late to get in.” Many uninformed investors pile into mutual funds during the market’s upward swings and typically start pouring mountains of money into mutual funds just before or at the peak in the market. For whatever reasons, the market will then head lower and you will then hear, “The market’s down! Ooh, ooh, ooh! Is it too late to get out?!” When you hear this from those around you, the answer is again invariably, “Yes, it’s too late to get out.” This is where you come into the picture. You are going to have the “talk them off the ledge” chat with them. You are going to explain to them that these times of panic are historically the best times to invest for the long term. You are going to be their Investment Guru and explain the wonders of long-term investing via dollar-cost averaging. It is a weighty responsibility. We are counting on you. You can do it!
The green bars in the above graphic shows the mutual fund inflows and outflows. The yellow line is the global stock market’s performance. Notice how in 2000, mutual fund inflows were immense. This coincides with the beginning of the bursting of the Internet bubble and the end of a decade with close to 20% annual returns. The United States market then went on to lose close to 50% from March of 2000 to October of 2002. Notice that ill-informed investors finally started pulling their money out of mutual funds precisely at the end of the 2½-year downturn … just in time for the market to come roaring back. The inflows followed suit, that is, until the greatest downturn in stock prices since the Great Depression occurred in 2008. What did many mutual fund investors do? Of course, they pulled out their money during the downturn. This time, it wasn’t until 2013 when they started to pile back into stock mutual funds.
There is an old saying in the mutual fund industry: “Most mutual fund investors do worse than the mutual funds they invest in.” The data shows this to be true. Many uninformed mutual fund investors buy high and then sell low. You are not going to be one of them.
The Bottom Line on Mutual Funds
The bottom line of mutual funds is to choose a fund family and stick with them. Reevaluate your fund or funds periodically. Every six months or every year is more than enough. Make changes judiciously and sparingly, giving your funds enough time to prove themselves through good times and bad. As you approach retirement, migrate from stock funds to bond funds but do not give up on stocks entirely. (We will discuss portfolio diversification and asset allocation in detail later on.) Use automatic investment plans to take advantage of dollar-cost averaging. Contribute \$50 or \$100 or whatever you can afford every month. But for the most part, forget about them!
Do not be one of the mutual fund investors that does worse than your mutual funds. Allow your mutual fund or funds to bore you to wealth. In the world of investments, boring is good! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.10%3A_A_Sample_Mutual_Fund.txt |
Congratulations ‒ You Have Finished Chapter 2 ‒ Mutual Funds: Investments for the Masses
You have reached the end of chapter 2, Mutual Funds: Investments for the Masses. In this chapter, you have:
You should now be able to:
So are you ready to be bored to wealth with mutual funds? Well, if mutual funds are not exciting enough for you, you are in luck. In our next chapter we begin the process of studying stocks. Before that, though, study this material thoroughly. Remember that you are going to be the Investment Guru for your friends, family members, and colleagues. You can’t let them down!
There is a Future for You in the Investment Services Industry
Have you enjoyed listening to and watching the presentations and reading the text? Instead of being dry and dull, did the material seem exciting and promising to you? Can you envision yourself relating this material to potential clients who are terrified of investing but know they need to do something soon because they are not getting any younger? Would you like to help them understand that investing is not as difficult as it seems and that you can show them investments that are prudent, long-term oriented, and have performed well over decades?
If so, please consider pursuing a career in the industry. The financial and investment industry is enormous. The industry is always looking for new, energetic individuals. There are numerous career path opportunities. From banking to real estate finance to insurance to brokerage firms, there is a place for you. In fact, the industry is actively seeking bilingual speakers and women. Going forward, they understand that diversity is essential to the success of their businesses. They simply love ex-military folks. (The financial industry is highly regulated and who better than those who have already lived and worked in a structured, regulated environment?)
Here at Southwestern, we offer an Associate in Business Administration with an Emphasis in Finance. We also offer a Certificate of Achievement in Financial and Investment Services. Either of these will help you land a position at a bank or credit union, an insurance company, a real estate finance firm, a brokerage or other investment management company, or any of the many other finance-related and investment-related companies.
You don’t believe me? You think you need a four-year degree from a prestigious university? Aha! You are wrong! The dirty little secret in our industry is that a degree from a prestigious university is not a guarantee that someone will perform well as a financial adviser with the general public. The recruiters will tell you that they have no reliable method for predicting how someone will do in the industry. Someone with a certificate from a community college might surpass a whole room full of graduates from the Ivy League universities.
I have my own predictors. Are you a positive, optimistic person with a sunny disposition? Do you like to socialize? Do you enjoy meeting new people? Do you want to help them succeed? Are you not afraid to ask someone if they need your help? If they say, “No,” are you still willing to go to the next person and ask the same question ... and then go on to ask twenty-seven more people? In short, are you a go-getter who refuses to give up? Will you never give up?
If you can answer, “Yes,” to all or most of these questions (especially the part about never giving up), I guarantee you will do well in the industry. You might bounce around from one position to another for a bit but you will find your place. Talk to a counselor about our programs. Or better yet, please contact me. I gotta’ warn ya’! I can talk about finance and investments far longer than most any reasonable person would ever want to listen.
I wish you all tremendous success in the future and I look forward to talking to you about a potential career in the finance and investment industry.
Your Feedback, Please
Remember that we want this class to be the best class you have ever taken! We want this class to be one of the few classes that you can look back on 5, 10, 20, or more years and say, “Ya’ know. That Introduction to Investments class really helped me in this crazy, beautiful, scary, joyful, absurd, sad adventure that we call life.” As always, contact me directly if you have any questions, comments, criticisms, suggestions, complaints, etc.
We are now ready for stocks. Exciting stocks! Sexy stocks! Risky stocks! Dear Rising Investment Gurus, read and study consistently and earnestly. See you in our next chapter. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/01%3A_Chapter_1/02%3A_Mutual_Funds-_Investments_for_the_Masses/2.S%3A_Summary.txt |
“Don’t gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.” -- Will Rogers
Question: How do you make a small fortune in the stock market?
Answer: Start with a large fortune!
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Stocks are exciting! Stocks are sexy! Stocks are risky!
Yes, Dear Students, stocks are where the action is in the investment world, especially for those with a long-term time horizon. We are going to spend the six weeks immersing ourselves in the world of stocks.
Remember that you are Rising Investment Gurus for your family, friends, and co-workers. They are counting on you to cut through all the hype and hoopla and show them the good news of prudent, long-term investments. So let's get started on our journey. All of us at Southwestern are very proud of you!
• 3.1: What Are Stocks?
Stocks are exciting! Stocks are sexy! Stocks are risky! Let's get started on the long march. What are stocks? What are the rewards of investing in stocks? What kind of investment returns can we expect from stocks over the long term? And just what do professionals mean when they say, "Stocks are volatile"?
• 3.2: The Stock Market
What exactly are we referring to when we say, "the stock market?" What is it? Where is it? Actually, the stock market is not just one entity. It is composed of many competing elements. Let's explore.
• 3.3: Stock Transactions, Transaction Costs, and Stock Quotes
What are the basic types of stock transactions? How much does it cost to buy and sell stocks? (No, Dear Students, it is not free to buy and sell stocks, no matter what Robinhood tells you.) Where can we find stock quotes? We will answer these burning questions in this section.
• 3.4: Stock Market Averages and Indexes; Volatility Reexamined
How can we say that, "the stock market has returned 10% over the last 80 years?" The industry uses various benchmarks measures called averages and indexes. It is time to take a close look at these tools.
• 3.5: Stock Characteristics and Measurements
It is time to start peeling away the first layers of research and exploration of our potential stock investments and their corresponding businesses. "Show me the numbers!" exclaimed Benjamin Graham, author of The Intelligent Investor and Warren Buffett's mentor.
• 3.6: Types of Stocks, Growth versus Value, and Market Capitalization
Although people tend to lump all stocks together, the truth is no two stocks are exactly alike because no two businesses are exactly alike. However, there are certain broad categories that are discernable. Let's take a look at them.
• 3.7: Stock Investment Strategies
There are various stock investment strategies. A few are worthwhile. Some others, not so much. You decide!
• 3.S: Summary
Congratulations ‒ You Have Finished Chapter 3 ‒ Introduction to Stocks
Thumbnail: Pennsylvania Power and Light Stock Certificate, public domain, Wikimedia Commons
03: Introduction to Stocks
Stocks represent ownership in a corporation. The legal term is actually common stocks. Where did the term common stocks come from? The investors are “shareholders in common.” Investing in corporations goes back to the 1600’s. Entrepreneurs were eager to take advantage of the new trade routes and opportunities for development as pioneers explored the world. The entrepreneurs needed resources and sought out investors to fund their new ventures. Before the advent of stock investing, entrepreneurs would borrow money from wealthy investors with a promise to repay the money. These new corporations, on the other hand, sold common stock to raise the funds and the investors were now part owners of the venture. Hence, another term for stock investing is equity financing. Equity is another word for ownership.
The term stock is somewhat unfortunate. A much better term would be business. As a stock investor, you are investing directly in a business. You are a partial owner of the business. You are able to participate in the profits and growth generated by the business enterprise. Contrary to what many believe and how many behave, stocks are not simply millions upon millions of worthless pieces of paper ‒ now electronic bits! ‒ that people trade with one another each day for no apparent reason. Stocks represent ownership in real businesses.
However, unlike other forms of businesses such as a sole proprietor, investors of common stock are limited liability owners. A stock investor is only liable for their investment, even if the corporation incurs debts above and beyond the value of the stock. A sole proprietor, on the other hand, can be held liable for debts beyond the business value and creditors can attempt to seize the personal assets of the business owner, up to and including their personal residence. There are corporations that are established for the mere purpose of shielding assets from creditors. If the courts deem that the corporation’s sole purpose was simply to hide assets from creditors, the courts might allow creditors to “pierce the corporate veil.” For those interested in business structures and how businesses interact with the law, we recommend to you our BUS-120, Introduction to Business, and BUS-140, Business Law, at Southwestern Community College.
Why invest in stocks? Stock investors receive two optional benefits, dividends and capital appreciation. Dividends are optional payments of earnings from the business. Capital gains, also known as capital appreciation, occur when the value of the corporation rises as the business grows. Please note that both of these benefits are optional. They are not guaranteed. The corporation is not under any obligation to pay dividends although some companies have paid dividends for decades. Also note that there is no guarantee that the business will succeed. Hence, the expected capital gain may result in a capital loss. Stocks are risky! Stocks are volatile! (Recall that “volatility” is our industry’s euphemism for, “Aye! I lost a whole lot o’ money!”)
Prudent, long-term stock investors must learn how to handle the volatility of stocks. We discussed this in our previous chapter on mutual funds. If we can keep our heads while others are losing theirs and resist the temptation to panic when the markets fall, then we can learn to use the volatility to our advantage. And if we can keep that long-term perspective and not panic, historically, the rewards for stock investing have been significant. (Ah, did we mention that there are no guarantees? Yes? Good. Just wanted to be sure.)
Historical Performance
Over the long-term history of modern finance, stocks have given investors the best rewards of the major financial investment alternatives. The return from the stock market has averaged approximately 10% to 11% annually for the last ninety years. We get this statistic from a list of stocks called the Standard and Poor’s 500 Index which we will discuss in detail soon. Ten to eleven percent annual return on your investment is pretty good, yes? Wouldn’t it be just grand if we received that 10% or 11% each year? Sadly, investing in stocks does not work that way. In any given year, it is highly unlikely that the return will be 10% or 11%. The return has varied from a high of 53.8% in 1954 to a low of -43.4% in 1931. The return in 2008 was -38.5%, one of the worst! In any given year, there has been a one-in-three or one-in-four chance of a down market. And no, the stock market does not predictably go up for three or four years and then go down for one year. For example, from 1982 to 2000, with only two years of slight downturns, the market went in two directions, up and way up. It then proceeded to fall for three years in a row. Let’s revisit and reexamine some graphs from chapter 1.
The above graphic shows how investing in stocks compared with other popular alternatives. We see that over the long term, the rewards for stock investing have outpaced loans (represented by bonds), savings accounts and other short-term investments (represented by Treasury bills), and inflation (represented by the Consumer Price Index). However, to show this disparity, we used a logarithmic scale. Notice that the numbers of the left do not increase arithmetically, they increase exponentially. From \$1, we jump to \$10, then to \$100, on to \$10,000. This is because if we used an arithmetic scale, the lower three alternatives would all appear as essentially flat lines. The danger of using a logarithmic scale is that it makes large movements look small and may mask the magnitude of the historical downturns. It appears that the return on stocks is moving in a relatively straight line upward. This is not the case! Those little squiggles that represent downturns from 1973 to 1973, 2000 to 2002, and in 2008 were large drops downward, approximately 50% down in all three cases.
Here is the graph if we did not use a logarithmic scale:
This second graph uses an arithmetic scale. You know, the ones that we mere mortals are used to using. However, because of the exponential growth, we don’t begin to see any change in any of the investments until the 1970’s. Then we begin to see business investments, as represented by stocks, begin to climb far above their alternatives. We can begin to see the exponential swoosh upward of growth in the stock investments. And we can also see that the downturns in 2000-2002, 2008-2009, and 2022 were far more pronounced than they were in the first graph.
Why are we emphasizing the downturns? As you may already have guessed, we want you to be emotionally prepared for them. History tells us they will occur, most likely at least once or twice or more times in your investing career. Intellectually, we can see and learn and know that stocks reward us with the best financial investment returns. But when the economy falters, when the outlook is bleak, when the organic matter hits the ventilating device, when the end of the world is nigh, etc., and the markets subsequently plummet, we have to be prepared emotionally. We must not panic.
Let’s now take a look at a much longer time frame. Let’s go back to the dawn of the Industrial Revolution. We see that the rewards from investing in stocks are staggering. Again, if we used an arithmetic scale, none of the other alternatives would be noticeable. Notice how poorly gold has done relative to the other alternatives. We will discuss investing in precious metals near the end of our journey together.
Okay, all right, none of us have a 200-year time frame. (It is entirely possible that some of the younger adults reading this may have a 100-year time frame, though. Supposedly, the first person to live to 150 has already been born.) Let’s break down our investment time horizons into rolling 10-year periods. Once again, we are reminded of the volatility that accompanies stock investing.
Source: Dow Jones Industrial Average, based on average annual compound returns over 10-year periods
Starting just before the Great Depression, we see three 10-year rolling periods where stocks have lost money. You invested \$1,000 and in ten years, you had less than \$1,000, for example. What did we hear people say? “Ooo, ooo, ooo! Is it too late to get out?!” Yes, as the United States and the world emerged from the Great Depression and World War II, we saw the greatest expansion of the economies of the United States and many parts of the globe that the world had ever seen. Dishwashers, televisions, air conditioning, refrigerators, washers and dryers, an automobile in every driveway! By the late 1950’s, the United States stock market had returned upwards of 20% over the 10-year rolling periods. What did your great-grandparents hear from their family members, friends, neighbors, and colleagues? “Ooo, ooo, ooo! Is it too late to get in?!” Once again, the answer was yes. We will let the famed investor, Peter Lynch, in his excellent, must-read book, One Up On Wall Street, describe the resulting 1973/1974 market crash:
“For two decades after the Crash of ’29, stocks were regarded as gambling by a majority of the population. This impression wasn’t fully revised until the late 1960’s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments and dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not.” – Peter Lynch
The 10-year return in the mid-1970’s was close to zero. It was a golden opportunity to invest in stocks. Yet, most potential investors ran the other way. Why? By now, we hope that you can answer that question on your own. Our emotions get the better of us. “Investing is simple … but it ain’t easy!”
Like clockwork, the cycle began all over again. Coming out of the 1970’s, the world began to hear the terms, “globalization,” “personal computers,” “mobile phones,” “telecommunications,” “Internet,” etc. The stock market in the 1980’s and 1990’s then proceeded to go in two directions, up and way up. By the end of the 1990’s, the 10-year rolling returns were again approaching 20%. “Ooo, ooo, ooo! Is it too late to get in?!” You know the answer! We were greeted with two vicious downturns, from 2000 to 2002 and then again in 2008. We saw for the first time since the Great Depression rolling 10-year periods with negative returns. “Ooo, ooo, ooo! Is it too late to get out?!”
Why? Why do we humans act this way, over and over again? We will discuss some of the psychological issues of investing later. For an in-depth study, we recommend Thinking Fast and Slow by Daniel Kanneman, the Nobel laureate who proved, once and for all, humans are not rational. Be prepared for some illuminating yet disconcerting news about human nature.
For ten years after the Global Financial Crisis and the Great Recession in 2008, the stock market again moved in two directions, up and way up. The Covid-induced recession of 2020 and then the rise of inflation and interest rates of 2022 led to two jarring downturns. But as of early 2023, the markets are again rising. Are we destined to repeat the cycle? We will know in 10 or 20 years. In the meantime, your guess is about as good as anyone else’s. The one truth we do know is that if you had kept investing, prudently and consistently, and did not panic when the markets fell, you would have profited greatly by investing in stocks.
The Power of Dividends
Traditionally, close to half of the return from stocks was from reinvested dividends. Stockholders used to expect 4% to 6% in dividends each year. That was as much or more than bonds returned in interest since stocks were considered much riskier than bonds. From 1936 to 2008, the average dividend return was 3.8%. Starting in the 1980’s, the return from dividends fell dramatically. From 1997 to 2007, the average dividend return was 1.5%. At the peak of the market in March of 2000, the dividend yield had fallen to 1.0%. Capital gains & growth were what investors wanted in the 1990’s. Many reasons were forwarded. They included the fact that dividends were taxed at a higher rate than capital gains, people wanted the business to reinvest the earnings for growth instead of distributing it to the investors, stocks were no longer considered riskier than bonds, and savings accounts were now paying less than 2%. But probably the most compelling reason was that people lost track of their senses and bid up the prices. It was the New Millennium! (Feels kinda' like the old millennium, don't you think?)
The market downturns of 2000-2002 and 2008 changed investors’ perception about dividends. We now see investors and companies focusing more and more attention on dividends. Many companies that never paid dividends in the past are doing so now. Good examples of this are the tech companies. Many tech companies are no longer growing at phenomenal rates and the industry as a whole is maturing. Mature companies can afford to distribute more of their earnings to shareholders. Also, the tax law has changed dividends so that they are taxed roughly the same as capital gains.
“Dividends Don’t Lie.” − Geraldine Weiss
“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” − attributed to John D. Rockefeller
The dividend yield from stocks compared to the interest rate from bonds.
The graphic above shows the relationship between the dividend yield from stocks in red and the interest rate from bonds in blue. In 1960, they were fairly close to one another. As inflation rose in the late 1970’s, we saw the interest yield on bonds climbing as investors demanded a higher rate of interest to lend money. The dividend yield on stocks climbed also, but that was mostly because the prices of stocks fell sharply in the mid-1970’s. Starting in 1979 and then into the early 1980’s, the Federal Reserve Bank raised short-term interest rates to break the back of inflation. It worked! We saw both the interest rates on bonds and the dividend yields on stocks falling in what has been called the Great Moderation. It was a time of great wealth accumulation … until the market crashes of 2000 to 2002 and 2008. Since the Global Financial Crisis and Great Recession, the two had been fairly close to one another and the markets have gone in two directions, up and way up. That changed in 2022 when the Federal Reserve Bank raised interest rates dramatically to combat the Covid-induced inflation. What will the future bring? Your Humble Author’s crystal ball is about as useful as anyone else’s. However, we do know that the only constant is change and that we are guaranteed at least one or maybe two dramatic downturns in the next 10 to 20 years. As Mr. Peter Lynch says, down markets are as inevitable as snowstorms in January. Prudent, long-term investors weather the storms and wait for the good times to come again. In the meantime, dividends always give us investors a positive return on our investment. “Dividends don’t lie!”
Bull Markets versus Bear Markets
By now, no doubt you have heard the two popular phrases for the upward and downward swings in the stock market. Bull markets are favorable markets normally associated with rising prices, investor optimism, economic recovery, and government stimulus. Bear markets are unfavorable markets normally associated with falling prices, investor pessimism, economic slowdown, and government restraint. Where did the terms bull market and bear market come from? Typically, we point to the manner in which bulls and bears fight and attack their opponents. Bulls charge ahead and throw their opponents up into the air. Bears use their paws and claws to slash downward. Of course, the actual origins of the phrases are more complicated than these simplistic descriptions and a great source of sport and entertainment for all budding etymologists, seeking to enlarge their knowledge base of word origins.
Advantages and Disadvantages of Stock Investing
Along with the best historical returns over time for financial assets via dividends and capital gains, there are other advantages of stock investing. To review, stock investing allows the general public to share in the rewards of global business enterprises. Stock investors enjoy limited liability and can only be held responsible for their monetary investment. Additionally, in general, stocks are very liquid investments; they are easy to buy and sell. (There are exceptions to this advantage. Stocks of many sham or very distressed companies may be very illiquid. Most are “penny stocks” that are utilized in scams and swindles perpetrated by con artists. We will learn how to identify and stay far away from these tricksters.)
Finally, an advantage that is often overlooked is that the capitalist system has resulted in an increased standard of living for all. Nothing we humans do or have done is perfect and that includes our economic system. In fact, capitalism might just be the worst possible system for distributing goods and services to a population … except for all the others! We have a long way to go until the time when every person has access to clean water and healthy food, adequate clothing, and safe shelter … and Internet access, of course. If some other system comes along that proves its worth above and beyond capitalism, we will be sure to give it a chance. In the meantime, we global investors are helping raise the standard of living all around the world and at the same time, earning a good return on our investments. (My apologies. It sounds like a public service advertisement, eh?)
Now, what are the disadvantages of stock investing? Hopefully, as you have already observed and internalized, stock investing is risky. Stocks are “volatile.” (Recall that “volatility” is our industry’s popular euphemism for, “Hey! I lost a whole lot o’ money!”) The volatility of the stocks of legitimate companies is bad enough when markets fall or a company falls on bad times. Added to this is the fact that there are many scam “penny stock” corporations that are used in various swindles. Even some well-known, bona fide companies have engaged in deception and misconduct. But even with all the volatility and financial “hanky-panky,” remember that stocks have been the best financial assets over the long term. (Note that we are qualifying our statement about investment returns with the use of the word financial. This is to placate the real estate investors who might now be jumping up and down screaming that real estate investing has done better than stock investing. Recall that the two are very different. The difference mainly rests with how stocks are purchased and how real estate is purchased. We will discuss real estate investing and highlight the differences near the end of our journey together.)
Volatility Examined
The graphic below demonstrates the volatility inherent in stock investing. Suppose you had stock investments of \$10,000 on January 1, 2020. To be sure, the year 2020 is one that most of us would rather forget thanks to the Covid-19 pandemic. But for some unfortunate investors, there is another reason they will want to forget 2020. Note the dramatic downturn as the world became aware of just how dangerous Covid-19 was. 2020 recorded the fastest bear market on record. Those uninformed investors who sold in late March or early April locked in 30% declines. They were then left with the difficult decision of when to jump back in. Many never did. (Psst. When would you have heard your friends, family members, and colleagues saying, “Ooo, ooo, ooo! Is it too late to get out?” Hint: It was about the same time that we were all hoarding toilet paper.)
On the other hand, if you had simply turned off the tele, stopped swiping your mobile device, and stopped checking your brokerage account online and instead went to the park to play volleyball with your kids, you would have enjoyed the fastest recovery from a bear market on record. In fact, you did pretty darn well for yourself in spite of the Covid-19 pandemic and a very contentious United States presidential election.
Let’s now take a look at 2022, another challenging year.
What a roller coaster! You put \$10,000 into the market at the beginning of the year. It promptly dropped more than 10% to less than \$9,000. Of course, being a concerned investor, you quickly pull out your money … only to see the market rise 10%. You put your money back in and watch it now fall 20%! Okay, that’s enough, you pull out your money and the market then rises 16%. All right, one more time. You put your money back in and it falls again, this time 16%. “¡Aye, no más! ¡Nunca jamas!” Never again you will invest. Oh, by the way, if you had just left your \$10,000 in the market the whole year, you lost about 18% and your \$10,000 became \$8,200. By trying to time the market and moving in and out, your \$10,000 became \$5,880.
The volatility is real, Dear Students. It’s the price we pay for investing in stocks. Oh, well. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.01%3A_What_Are_Stocks.txt |
We are going to turn our attention to the stock market. Although we normally use the singular when referring to this system, the stock market is actually a collection of markets and exchanges that compete with one another. These systems allow for the efficient trading of stocks and other securities. The stock markets are a part of a larger system that is called the capital markets. Entities such as businesses and governments come to the capital markets when they need to raise money. This money is referred to as capital, hence the term capital markets. These entities may seek to borrow money, typically through bond offerings which we will cover in detail later on. Businesses may also attempt to raise money through stock offerings where partial ownership of the corporation is sold to the public. We will see that these systems are undergoing tremendous change. And the changes are showing no sign of slowing down anytime soon.
The Primary Markets and Initial Public Offerings
The capital markets are broken into two parts, the primary market and the secondary market. The primary market is the market in which new issues of securities are sold to the public for the first time. This is called an Initial Public Offering, commonly referred to as an IPO. It is also referred to as “going public” or “taking the company public.” Most retail investors do not participate in the primary market. There is a very good reason for most prudent, long-term investors to avoid the primary market. Obviously, some IPOs eventually become large, successful companies and their stock values rise considerably. However, one year after the Initial Public Offering, the typical new stock has lost 50% of its value. Benjamin Graham, author of The Intelligent Investor, was not fond of IPOs, to put it mildly. He believed that IPO really stood for, “It’s Probably Overpriced,” “Imaginary Profits Only,” and, “Insiders Profit Opportunity.” If you desire to become a Registered Representative, the legal term for a Stockbroker, you will be required to internalize the entire IPO process before taking the Series 7 licensing exam. Hopefully, as a securities professional, you will heed Mr. Graham’s advice and not subject your clients to the vast majority of Initial Public Offerings.
Why would a corporation issue an Initial Public Offering? Why go public?” As mentioned, the corporation is attempting to raise money to start or expand their business. They may already have issued stock but need to go back to the capital markets to raise more money to help pay for ongoing business expenses. This is very typical here in San Diego, California, where there are many biotechnology startup companies that need tremendous sums of money to fund their drug development.
Another very common reason to issue stock to the public is that it is a way to gain prestige and respect within the investment and industrial communities. Once a business is large enough, it is simply expected that they will become a public corporation and sell stock. In the early 2000’s, the owners of Google were reluctant to take the company public. The boys and girls on Wall Street came a’ callin’ and showed them another more personal and profitable reason for going public. In an IPO, those who started the business usually become instant millionaires and sometimes billionaires. One example is Faceplant, ah, Fleecebook, no, Facebook. After the Facebook IPO, the California taxes for the CEO of Facebook were \$1 billion. That’s \$1 billion with a “b” for the California taxes alone.
This is why we call starting a business the Ultimate Investment. At the very end of our journey, we will briefly discuss becoming an entrepreneur. It’s definitely not for everyone but the rewards can be enormous. But please do remember for every Facebook, there was MySpace, Ello, Bebo, Friendster, and QuePasa. For every Google, there was Yahoo, AskJeeves, Lycos, Excite, AltaVista, and Dogpile. Capitalism breeds intense competition.
A final important reason for issuing stock and becoming a public corporation is that once a business becomes sufficiently large, it becomes very difficult for the owners to “divvy up the spoils” without going public. If you were one of the people who started GE or Coca-Cola or Walmart, how would you sell your share of the business? In fact, by keeping a business private, the owners run the risk of family dynamics negatively affecting the future success of the enterprise. One such example was In ‘n’ Out Burger. Family dysfunction and tragedy put the entire empire into question. Luckily for In ‘n’ Out Burger fans, the story has a happy ending but other companies are not always so lucky.
Corporations that issue stock to the public are under no obligation to repurchase the shares of the stock. The corporation does not have to repay the money they raised. The shareholders may or may not be able to find someone who will purchase their shares from them, especially if the enterprise fails. However, the corporation is now a public entity. As such, it now has many rights and responsibilities that private companies do not need to worry about. The corporation must file annual reports and quarterly reports with the Securities and Exchange Commission (SEC). The annual reports are called the corporation’s 10K report and the quarterly reports are referred to as the 10Q report. Part of our assignment will be to research a recent annual or quarterly report.
Another obligation of public corporations is that they must have at least one public meeting annually where shareholders can air their grievances. Unfortunately, the annual meeting does not necessarily have to be in a location that is easily accessible to shareholders. One such example was the 2005 annual meeting of Sempra Energy, the parent company of San Diego Gas and Electric. Instead of Southern California where it typically held its annual meetings, Sempra decided to hold its 2005 annual meeting in London. Although Sempra publicly stated that their goal was to, “raise Sempra’s profile with European investors and to expose directors to its European operations,” it was widely believed that they were simply running away from some local disgruntled shareholders.
The Secondary Markets: Exchanges versus Over The Counter Markets
The secondary stock market is the collection of markets and exchanges where securities are sold after they have been issued. The secondary market is much larger than the primary market. When people refer to the “stock market,” they are almost always referring to the secondary market. Secondary markets provide liquidity, an easy method for transferring ownership of securities. They also provide an efficient mechanism for pricing and valuation of securities. For example, if a lender wants to know the value of those 100 shares of Chevron you want to use as collateral for a loan, you can quickly point to the current price that Chevron shares are selling for.
The secondary market is divided into two major systems, the organized securities exchanges and the over-the-counter (OTC) markets. The securities exchanges are centralized institutions in which transactions are made in outstanding securities. The over-the-counter markets are widely scattered telecommunications networks through which transactions are made in outstanding securities and smaller IPOs. The exchanges featured face-to-face “double auction” trading while the over-the-counter markets used a quote-based system, originally communicating via telephone and then moving online. However, this is a woefully outdated comparison. Due to technology advancements, mergers, and acquisitions, the traditional differences between the two have been erased. And the changes are just gettin’ started!
Historically, all trading on the securities exchanges was done on the trading floor. Trading was conducted using a “double auction” system. Instead of the “one seller, multiple buyers” that you would see at an estate or farm auction, for example, there were “multiple sellers and multiple buyers,” all calling out prices and quantities of stocks they were buying or selling on behalf of their clients. But due to both technology & the sheer massive volume of shares traded, things have changed. Almost all of the trading is now conducted electronically. Some large trades still involve human interaction but they now consist of far less than 1% of the total number of trades. Many in the industry have declared the trading floor dead. For those interested in the history of the exchanges and the double auction process, there are numerous videos available online of brokers calling out prices and quantities, simply type “stock exchange videos historical” into YouTube or any search engine.
The New York Stock Exchange, aka NYSE, the Big Board
The largest exchange in the United States is the New York Stock Exchange, commonly referred to as the NYSE and the “Big Board.” For over 200 years, the NYSE has been the dominant exchange in the United States. Traditionally, it was responsible for over 90% of the volume of transactions on all the exchanges. There are approximately 2,400 companies traded on the Big Board worth about \$23 trillion as of December 2022. About 1 billion shares trade daily.
Companies traded on the NYSE must meet stringent listing requirements. Traditionally, these companies were the largest and most prestigious. If a company fails to continue to meet the NYSE requirements, the company can be delisted. This happens when a company falls on hard times and the stock price plummets.
Many people believe that the NYSE was the first stock exchange in the United States. Actually, that distinction belongs to the Philadelphia Exchange. However, the NYSE quickly grew to be far larger than its older sibling. It was established as a members-only entity in 1792 named after their favorite meeting place, a buttonwood tree on Wall Street when Wall Street really was next to a wall in lower Manhattan.
Traditionally, change happened slowly at the NYSE. It wasn’t until 1967 that the first woman, Muriel Siebert, was admitted as a member. The first minority member, Joseph L. Searles III, was admitted in 1970. In 1991, the first minority-owned company, BET Holdings, was listed on the exchange. The next year in 1992, the exchange celebrated its 200th birthday. That year, if you had told the folks at the NYSE that the next 20 years would see far more changes than in their first 200 years, they would have thought that you were quite insane. However, you were about to prove them wrong.
By 1992, the face-to-face double auction system had already shown itself to be woefully inadequate to keep pace with sheer volume of trading. If there were any doubts, Black Monday and the Crash of 1987 put them all to rest. The NYSE began moving as quickly as possible to electronic trading. They also began a push to expand through acquisitions. In 2005, the Big Board purchased the Archipelago electronic exchange and the Pacific regional exchange. (We will discuss more about these two systems soon.) In March of 2006, they changed their business structure from a members-only partnership to a publicly traded corporation. You could now buy shares in the New York Stock Exchange! That year, they merged with the Euronext electronic exchange and aggressively started to phase out the face-to-face double auction trading in favor of exclusively trading electronically.
Here is where events start to appear similar to something out of a science fiction or fantasy movie. In 2011, Germany’s stock exchange, the Deutsche Börse AG based in Frankfurt, tried to purchase the New York Stock Exchange. The European regulators blocked the deal. Two years later, on November 13, 2013, the NYSE was acquired for \$11 billion by a 13-year-old derivatives trading firm from Atlanta, the Intercontinental Exchange. This was a company that did not exist until the 21st Century!
In the historical videos, from afar, the interactions on the floor of the exchange appear to be pure chaos. People, mostly men, are scurrying about with different colored jackets. Some are standing in one place and wildly gesturing and shouting. If one were to approach a particular group, it would become clear what is happening. The people are making deals with one another. Most of the individual buying and selling are floor brokers. The floor brokers executed orders on behalf of their firm’s customers or occasionally on behalf of their firm’s own account. Some are independent brokers who provide as-needed execution services to other brokers, independent of a particular firm. The floor brokers were very worried that the NYSE’s aggressive moves to all-electronic trading meant the end of their way of life. It was not really the end; it was just a big change – from face-to-face interaction to sitting in front of a computer screen all day. Sound familiar? What other major institution is experiencing the same transition? (Hint: You are enrolled at one such institution. Education!)
Some of the professionals on the floor of the exchange had a special role. The specialists were stock exchange members who specialized in making transactions in one or more stocks. The job of the specialist was to manage the auction process. The specialist bought or sold the stock from their own inventory to provide a continuous, fair, and orderly market. If there were not enough buy orders to maintain an orderly market, the specialist was required to step up and buy. Likewise, if there were not enough sell orders, the specialist was expected to offer his or her shares for sale. The role of the specialists has essentially been squeezed out by technology and the tremendous volume of trading. They are involved in only a tiny amount of trading each day.
The specialists were replaced by “designated market makers” and “supplementary liquidity providers” in 2009. From time to time, the specialists were either praised or maligned. Suffice to say that the specialists were trying to make a profit just like everyone else. While their goal may have seemed altruistic, they made sure that when the market received benefits from their efforts, so did they.
The American Exchange, aka, the Curb, now the NYSE American Exchange
For decades, the American Stock Exchange was the distant challenger to the NYSE. The AMEX, as it was commonly called, never achieved more than 3% of the total volume of shares traded on all exchanges. Another popular name for the American Exchange was the “Curb.” Where did that name come from? The AMEX literally started on the curb outside the NYSE! Their brokers would follow the action of the NYSE by looking inside the window and then trade outside. Happily for them, they were able to move into a permanent location down the street from the NYSE. (It gets cold in New York in the winter!)
By the early 1990’s, the AMEX started concentrating on securities other than stocks over 20 years ago. The Exchange Traded Funds (ETFs) that we discussed in our chapter on mutual funds were first introduced on the AMEX. The changes in the industry did not escape the AMEX. In 1998, the NASDAQ purchased the American Exchange. (We will discuss the NASDAQ very soon.) The AMEX then was kicked to the curb (pun intended) in 2004 by the NASDAQ. Finally, in 2008, the NYSE purchased the American Exchange and moved them down the street into the NYSE's building on Wall Street. The NYSE first changed the name of the AMEX to the NYSE MKT and then mercifully changed the name to NYSE American.
The Regional Exchanges
The regional stock exchanges were modeled after the NYSE and AMEX. They only ever accounted for 4% of all exchange volume. These include the Chicago, Philadelphia, Pacific, Boston, Denver, and Cincinnati exchanges. Each is a single location where the trading took place with the exception of the Pacific Exchange which was located in both San Francisco and Los Angeles. Many of the securities listed on the regional exchanges are also available on the NYSE or NASDAQ. Traditionally, the regional exchanges were often places where undesirable or unethical issues were sold. The regional exchanges have tried to diversify and differentiate themselves from the NYSE and NASDAQ in order to survive. Plus the regional exchanges have not been immune to the rush to consolidate. The NYSE bought the Pacific Exchange and the NASDAQ bought the Philadelphia and Boston Exchanges.
Options and Futures Exchanges
We briefly discussed the two major types of derivatives in our first chapter, options contracts and futures contracts, typically referred to as options and futures. Briefly, options allow traders to sell or to buy an underlying security at a specified price for a given time and futures are contracts that guarantee the delivery of a specified commodity at a specific future date at an agreed-on price. We will discuss these in detail toward the end of the class. The Chicago Board Options Exchange (CBOE) was organized to facilitate options contracts trading and likewise, the Chicago Board of Trade (CBT) was created for futures contracts trading. Options and futures are also traded on most all the major and regional exchanges now as well as the CBOE and CBT.
Over-the-Counter Markets and the Role of Dealers / Market Makers
Over-the-counter markets (OTC) started out as widely scattered telecommunications networks through which transactions of securities were made. In an over-the-counter market, there is no single location as with an exchange. It is a quote-based system as opposed to the face-to-face double auction of the exchanges. Decades ago, the widely scattered telecommunications network took the form of people scattered around the country calling one another on the phone and making deals and transactions.
Two of the groups that make up the OTC are the OTC Bulletin Board and the OTC Pink Sheets. And yes, you guessed correctly, the Pink Sheets got their name from their newspaper that listed the thousands of companies and their most recent prices. The newspaper was printed on pink paper. The Pink Sheets are now called the OTC Markets Group. There are approximately 5,000 companies listed on the Bulletin Board and 10,000 companies listed on the Pink Sheets. Virtually all of these companies are sham corporations that should not be discussed in polite company. Their stocks are typically used in swindles. There are some legitimate issues but they are the exception, not the norm. Our advice is to stay far away from the OTC Bulletin Board and OTC Pink Sheets. In recent years, these two groups have stated publicly that they are trying to clean up their acts. However, the sham corporations remain.
The OTC markets use dealers instead of brokers. Dealers, also called market makers, are traders who “make markets” by offering to buy or sell certain securities at stated prices. Similar to the specialists of the exchanges, the dealers / market makers offer buy and sell quotes from their own inventory of stocks. This is different from brokers who simply serve as go-betweens between buyers and sellers and typically keep no inventory. The dealers / market makers post an ask price and a bid price. The ask price is the retail price; it is the price that we retail investors will pay for the shares we want to buy. The bid price is the wholesale price; it is the price we will receive when we sell the shares back to the dealer / market maker. The dealers / market makers earn money from the bid-ask spread, the difference between the ask price and the bid price.
For those who live close to a border such as the United States / Mexico border or the United States / Canada border, this system should be familiar. Situated along the borders are money exchange houses that keep an inventory of United States dollars and Mexican pesos or United States dollars and Canadian dollars. Here is a presentation that highlights the “casas de cambio” that you find along the United States / Mexico border. There is not just one price advertised. There are two prices. When you want to exchange your dollars to pesos, for example, you will receive one price ‒ the ask price ‒ for your dollars. When you want to change the pesos back into dollars, you will receive a lower price ‒ the bid price ‒ for your pesos. This is exactly how it works on the OTC markets. The dealer’s markups or markdowns are not reported to the customers whereas the broker’s commissions are reported. (Psst. How do you think the Internet brokers make money on only \$5 or \$7 or now \$0 per trade? Stay tuned.)
So how did these OTC markets work before modern telecommunications? An OTC dealer in Minneapolis held shares of a tiny company based in someone’s garage in Iowa or Idaho or one of those places that starts with the letter I. Another OTC dealer in Mobile, Alabama, found a sucker, oops!, we mean, a client who wanted to buy the shares of the garbage, sorry, garage company. After the dealers hung up on each other a few times, the deal was finally made. The client in Mobile was now the proud owner of 10,000 shares of Flim Flam, Inc. worth a total of \$70 at \$0.007 per share. Of course, if our hero immediately wanted to sell his 10,000 shares back, the dealer in Minneapolis would only give him \$0.005 per share for a total of \$50. The bid-ask spread in this case is \$0.002, a small sum indeed but equivalent to 28% of the ask price. Our hero just lost 28% from buying the shares. Of course, virtually all the transactions are now executed online with no human interaction but the result is the same. Most of the shares are garbage.
Traditionally, the NASDAQ was lumped together with the other two OTC markets. Today, NASDAQ does not want to be associated in any way with the OTC anymore, and deservedly so. It warrants its own section.
The NASDAQ
The NASDAQ was created by the NASD, the National Association of Securities Dealers. NASDAQ initially stood for the National Association of Securities Dealers Automated Quotation system. The National Association of Securities Dealers was the non-governmental organization that used to be responsible for self-regulation of registered representatives. The NASD was sponsored by the Securities and Exchange Commission (SEC). In 1971, the NASD created the NASDAQ, the first electronic communications network for trading securities. The NASDAQ used to be the arena for small companies to get started. Once the companies became large enough to qualify for listing on the New York Stock Exchange, they would typically move to the NYSE. However, since the 1980’s, many prestigious companies decided to stay on the NASDAQ rather than move to the NYSE. You may have heard of a few of them? Ever hear of Apple or Microsoft or Google or Amazon? One can guess with absolute surety that when this started to happen, there were two words that came out of the mouths of the executives sitting atop the 23rd floor of the NYSE building. The first word was, “Oh,” just in case you were wondering.
Although still smaller than the NYSE, the NASDAQ has made the securities trading industry a two-horse race. The National Association of Dealers gave up their position as the non-governmental organization responsible for self-regulation of registered representatives. (That task is now served by FINRA, the Financial Industry Regulatory Authority.) They also changed their name to NASDAQ. No more NASD, no more National Association of Securities Dealers Automated Quotation system, and certainly no more association with the OTC markets. The NASDAQ is simply the NASDAQ and it provides up-to-date bid and ask prices on approximately 3,300 stocks.
The NASDAQ is now a three-tier system. There is the NASDAQ Global Select Market. These are 1,200 companies that would easily qualify for the NYSE, the “crème de la crème.” There is the NASDAQ Global Market, née NASDAQ National Market, that consists of 1,450 larger companies. The third tier is the NASDAQ Capital Market, née NASDAQ SmallCap Market, that lists 650 smaller companies. In an obvious jab at the NYSE, in their advertising, the NASDAQ began positioning itself as the “Securities Market of the Future” as it became apparent that the traditional face-to-face, double auction model was not adequate to keep up with the massive increase of trading. The value of the companies on the NASDAQ is roughly \$17 trillion as of December 2022.
Alternative Trading Platforms: The Third and Fourth Markets
With the advent of telecommunications and computing advances in the 1980’s, two alternative trading platforms began to emerge. The third market was a system that sponsored over-the-counter transactions made in securities listed on the NYSE or one of the other organized exchanges. The third market was reserved for institutional investors such as mutual funds, insurance companies, pension plans, etc. The institutional investors trade in large blocks of securities and hence could realize reduced transaction costs. However, the transactions were still facilitated by a dealer / market maker. One example was the Intermarket, which was subsequently purchased by the NASDAQ and became the NASDAQ Intermarket.
The fourth market was similar to the third market. The difference was that the fourth market eliminated the dealers / market makers and let their customers make transactions directly with one another. At first, the fourth market catered to the same large institutional buyers and sellers of securities as the third market. With the advent of the Internet, they successfully started to court retail customers, creating privately owned electronic communication networks, ECNs, that automatically match buy and sell orders that customers place electronically. This got the attention of the big players. The fourth market securities trading system Archipelago was purchased by the NYSE and became the NYSE Arca. Another fourth market player, BATS, the Better Alternative Trading System, was purchased by the Chicago Board Options Exchange.
As with many of today’s technological innovations, the overarching theme we see in the securities marketplaces is disruption. The relatively inexpensive and immensely powerful technologies available are allowing new companies to enter the industry and challenge the staid, storied titans of the past. No longer does a company need to be centered in New York or one of the other historical centers of finance. For example, BATS was started in a strip mall in Kansas City! As such, the newer companies are able to offer their services for less than the older companies. This has created the “urge to merge” in the industry as we saw with the NYSE and NASDAQ buying up their smaller rivals. And by no means is this just limited to the United States as we saw with NYSE merging with Euronext and Germany’s stock market trying to buy the NYSE.
Finally, just in case you might be under the mistaken impression that these securities trading marketplaces are offering their services free of charge as a philanthropic gift to humanity, know that these systems are all for-profit operations. As well as other fees that are charged the companies that list on the securities trading system, there is a fee for every share that changes hands. It makes you wonder yet again how brokerage firms are offering their customers commission-free trades. (Stay tuned!)
“One Big Malignant Casino?”
You may share the same thought that many people believe and ask, “C’mon, Paiano! Isn’t the stock market all just one big malignant casino?” It is a legitimate question. Simply put, the answer is, “Yes,” and “No.” At first, this response seems confusing and at odds with itself. How could it be both, “yes,” and, “no?” It depends upon how you approach stock investing. The answer is, “Yes,” for many individuals who see the markets as one big crapshoot. For them, the way to riches is to buy and sell, buy and sell, buy and sell. We call them speculators or traders. Speculating is very difficult and you are up against the best in the business. Neophytes become very upset when the market turns against them. There is a reason why we often call speculating or trading, “The Loser’s Game.” (This term was coined by Charles Ellis. Please see the Bibliography for more about “Charley.”)
The answer is also, “No.” Many others look at the stock market and the other capital markets as a way to participate in the growth and prosperity of the global economy. We call them investors. With a prudent, long-term orientation, investors are usually very well rewarded. How will you answer the question? Obviously, we hope that you will choose the latter and choose to be an investor. This gives us yet another opportunity to quote from Mr. Benjamin Graham.
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” − The Intelligent Investor, Benjamin Graham
One might be tempted to counter, “Oh, yeah, but what about Enron? Aren’t corporations all crooks?” Fraud and accounting trickery and gimmicks have always been with us. They are always going to be with us. The bank robber, Willie Sutton, when asked why he robbed banks, reportedly was quoted as answering, “Because that’s where the money is!” (He didn’t actually say it, though. A random reporter just made it up. Mr. Sutton was very grateful, though, as it helped him “build his brand,” as we would say now.) Normally, but not always, those firms are relegated to the nether reaches of the OTC markets. But for every one Enron, there are hundreds – no, thousands! – of companies that continue to do business with integrity and honesty (uh, usually). In 1973, it was Equity Funding. In 1986, it was Ivan Boesky and Michael Milken and Vagabond Inns. In 2002, it was Enron, Global Crossing, Tyco, and WorldCom. In 2008, it was Fannie, Freddie, Lehman, Citi, WaMu, Wachovia, and AIG. And don’t forget Bernie Madoff who made off with \$13 billion dollars from his luckless investors. Ten or twenty years from now, during the next big bull market craze, someone else will take their place.
To recap, the securities markets exist to allow investors a safe, cost-effective method to participate in the success of the global economy. And even with all the underhanded shenanigans, they have performed very well. They are changing at breakneck speed and the change is accelerating. Whether or not we ever have one or more oft-mentioned global, 24-hour trading markets remains to be seen. But it is exciting and for some, scary, to watch, especially for those of us in the industry who have a stake in the outcome. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.02%3A_The_Stock_Markets_a.k.a._The_Capital_Markets.txt |
We now know where the stock transactions take place. Let’s discuss what types of transactions we can use to buy and sell our stocks, how much it costs to conduct those transactions, and how and where we can get stock quotes.
Types of Stock Transactions
There are several types of stock transactions. We will cover the four major types. If and when you ever take the Series 7 Registered Representative (aka Stockbroker) exam, you will need to learn many more. However, in Your Humble Author’s opinion, there is really only one type of transaction a prudent, long-term investor will ever need, the market order. A market order is an order to buy or sell at the current price. You want to buy some shares, you buy them and pay the current market price. If you want to sell some shares, you sell them and you receive whatever price the transaction offered. With today’s technology, the order will execute in milliseconds or sooner.
An investor may be thinking, “I want to buy this stock but the price is too high at \$25. If it ever drops down to \$20, I will buy 100 shares.” This investor would use a limit order. The investor would enter a limit order to buy the stock at the price they specify. The same situation would apply if an investor held shares and thought, “If the price ever reaches \$30, I want to sell.” The investor would specify a limit order to sell the stock at \$30. With a limit order, the investor knows what price they pay or receive. However, the downside is that the transaction might never take place. The price may never fall to the buy limit price or rise to the sell limit price.
A third type of transaction is called a stop-loss order, also known as a stop order. Stop-loss orders are similar to market orders. However, with a market order, the investors cannot specify what price the transaction will settle. With a stop-loss order, the investor is saying, “If the price ever reaches a price that I specify, execute the order as if it were a market order.” Stop-loss orders are typically used to protect an investor from incurring a loss. “If the price ever falls below this amount I specify, I want the stock to be sold.” This is why they are called stop-loss orders.
A stop-limit order is very similar to the stop-loss order. The key difference is that a stop-limit order becomes a limit order, not a market order, when the trigger point is reached. To illustrate this subtle difference, say an investor utilizes a stop-loss order to protect from a loss. “If the price ever falls to \$20, sell at the market.” For whatever reason, what if the price fell quickly from \$25 to \$16. This is very unusual but it happens. The stop-loss order would be triggered and the investor would receive the \$16 price for their shares. A stop-limit order might specify, “If the price ever falls to \$20, sell my shares but only sell if the price stays at \$20 or higher.”
Your Humble Author normally uses and recommends market orders. Short-term traders often state that they prefer limit orders, stop-loss orders, or stop-limit orders on all their trades. Although you can use limit orders to buy or sell at the price you want and stop-loss and stop-limit orders to “lock-in” profits or protect against losses, remember that they trigger automatically. If for some reason you change your mind, it is often too late to cancel the order. The order will be executed in thousandths of a second or quicker.
Types of Stock Transactions
Order Type Buy Sell
Market order Buy at the best price available. Order will execute almost instantaneously. Sell at the best price available. Order will execute almost instantaneously.
Limit order The order will be executed at the buy limit price or lower. The order may never be executed if the price does not fall low enough. The order will be executed at the sell limit price or higher. The order may never be executed if the price does not rise high enough.
Stop order The order will be converted to a market order to buy when the stock price crosses the stop price from below. Since the order becomes a market order, the price may be much higher than the stop trigger price. The order will be converted to a market order when to sell when the stock price crosses the stop price from above. Since the order becomes a market order, the price may be much lower than the stop trigger price. Also called a stop-loss order.
Stop-limit order Same as a stop order except the order is converted to a limit order when the price crosses the stop-limit price from below. Same as a stop order except the order is converted to a limit order when the price crosses the stop-limit price from above.
Transaction Costs
Traditionally, transaction costs were in the 1% to 5% range, sometimes higher. The largest portion was the brokerage commission. Deep-discount Internet brokers drove the commissions down to as low as \$5 per trade. Two companies experimented with \$0 trades but were unsuccessful. A few years ago, the brokerage firm Robinhood started offering free trades, targeted to young adults and has managed to stay afloat and disrupt the industry. Their success has prompted other brokerage firms to follow them with \$0 trades. But have transaction costs really gone down? The quick answer is, “Yes, transaction costs have gone down.” However, more and more of the cost is now hidden from the investor.
Let’s look at an example. A deep-discount Internet broker offers trades for \$5 or \$7 or now \$0. In the fine print of the client-broker agreement is included a provision for allowing the broker to solely utilize exclusive stock dealers / market makers. The quoted price the investor sees before making the trade is simply the best price available but at any one time, there are dozens of prices quoted as dealers and market-makers compete for buy and sell orders. The chosen dealer doesn’t necessarily have the best price. Instead of paying \$20 per share, the investor might pay \$20.05. So on a 100 share transaction, the investor sees the \$5 or \$7 or \$0 commission on their confirmation. The investor does not see the extra \$5 they paid on a 100 share purchase because of the dealer’s \$0.05 markup.
The following disclaimer was included in each trade confirmation email from Scottrade (purchased by TD Ameritrade which was then purchased by Charles Schwab):
“SCOTTRADE INC. RECEIVES REMUNERATION FOR DIRECTING ORDERS TO PARTICULAR BROKER/DEALERS OR MARKET CENTERS FOR EXECUTION. SUCH REMUNERATION IS CONSIDERED COMPENSATION TO THE FIRM AND THE SOURCE AND AMOUNT OF ANY COMPENSATION RECEIVED BY THE FIRM IN CONNECTION WITH YOUR TRANSACTION WILL BE DISCLOSED UPON REQUEST
Our first observation is that the notice is in all upper case. Companies use all uppercase when they want something to appear important but they also don’t want their customers to read it. Uppercase sentences are actually harder to read than normal upper- and lower-case sentences. The second observation is that even if we did read it, it doesn’t make any sense. What are they saying? Scottrade is telling us that they are getting a kickback from the exclusive “particular broker / dealers or market centers” that they are using to execute their trades. This is how brokerage firms that charge no commissions are \$0 are actually making money now. In Scottrade’s defense, at least they prominently disclose this relationship. Robinhood, on the other hand, brashly declares that they are not making money using this technique when they most obviously are, at least according to both Investopedia and CNBC.
So now you know how brokerage firms can offer commission-free trades. When a friend or family member or colleague brags that they trade for free, it is your responsibility as a Rising Investment Guru to explain that, no, the trades are not free. They are paying by not getting the best price available when they buy shares and when they sell shares. Oh, by the way, this system is innocently called, “payment for order flow,” or simply, “order flow.” Doesn’t that sound better than, “kickback?” Order flow has been in the news as the Securities and Exchange Commission has floated the idea of banning order flow. Stay tuned!
Wait a minute! Doesn’t the SEC say that “your broker has a duty to seek the best execution that is reasonably available for its customers’ orders?” Yes, but it is not a guarantee. According to Investopedia, “… the SEC requires broker/dealers to notify their customers if their orders are not routed for best execution. Typically, this disclosure is on the trade confirmation slip you receive … after placing your order.” And determining whether or not a customer got “best execution” can be very difficult. Here is an example of the SEC trying to enforce the rules and not doing a particularly good job.
The SEC was looking into making the costs more transparent. They possibly would require the brokerage firms to show their customers the difference between the dealer’s price and the best price available at the time of the transaction. They might even – gasp! – show the total cost of the transaction from the markup/markdown. Needless to say, the deep-discount brokers cried that it would drive up the cost of commissions and ultimately hurt the consumer and the proposal died. So it is up to you to check if you are getting the “best execution.” But how can you, a lone investor, determine if you are getting the best price if even the SEC has trouble watching over the brokerage companies? Wait. It gets worse.
High Frequency Trading
Who are these particular broker/dealers that the commission-free brokerage firms are routing their customers’ transactions to? They are typically High Frequency Trading (HFT) firms. HFT uses computers to transact large numbers of orders at very fast speeds. For example, Robinhood routes the majority of their transactions to a firm called Citadel. High Frequency Trading and firms such as Citadel were detailed in an excellent book, Flash Boys, written by famed investment author Michael Lewis. There is little doubt that High Frequency Trading has reduced transaction costs dramatically. However, at the same time, HFT firms have been accused of using their ability to transact at the microsecond level to “front-run” investors. They are essentially stealing tiny amounts of money from the average retail investor and even large players like mutual funds and pension funds.
In his book, Mr. Lewis is the first person to tell you that no one actually knows how much the HFT firms are stealing from investors from front-running. The HFT firms keep their technology under lock and key. From experts in the field at the time of the writing of the book, the best guesses ranged from five to fifteen billion dollars per year. To the average person, that is a staggering sum of money. However, if we split the difference and say \$10 billion. That is approximately how much money is bet each year on the NCAA March Madness Basketball Tournament. In a system where trillions of dollars are changing hands every few days, \$10 billion dollars per year is actually a very small sum of money.
The hero of Flash Boys, a victim himself of the HFT firms’ front running, started his own securities trading marketplace to combat the HFT firms, IEX, and garnered support from some major players in the world of investments including FranklinTempleton and the Capital Group. IEX created what they call a “speed bump” so the HFT firms cannot “jump” in front of you and “front-run” your transaction. In June 2016, the SEC approved IEX’s bid to become an exchange. In 2017, the New York Stock Exchange followed suit and added their own speed bump, but only for small- and mid-sized companies.
At the time of the writing of the book Flash Boys in the early 2010’s, there was much publicity and controversy regarding High Frequency Trading. FINRA, the Financial Industry Regulatory Authority, and the SEC, the Security and Exchange Commission, both were publishing statements saying how they were investigating HFT to determine whether or not HFT firms were taking unfair advantage of investors. And then in 2015 or so, the statements stopped. The best that one can guess from their silence is that, yes, the authorities are aware that the HFT firms have an unfair advantage and are exploiting that advantage. But at the same time, HFT has reduced transaction costs dramatically. To coin an old adage, do the authorities want to throw out the baby with the bath water?
The lesson we retail investors can learn from HFT is that we are once again reminded how difficult short-term trading is. Not only do we have to tame our human emotions, we are also up against firms with billions of dollars invested in systems that can trade millions of shares in milliseconds. We are totally outgunned. We come to the fight with our pistol; they come with automatic assault rifles, tanks, and jet fighters.
Round Lots, Odd Lots, Mixed Lots
Traditionally, brokerage firms would encourage their customers to buy shares in round lots. This was encouraged because it helped speed up the transaction process on the floor of the exchanges. A broker would call out, “25!” while pulling his arms toward himself. This meant that the broker wanted to buy 100 shares, one round lot, at 25 per share. If the broker had pushed her arms away from herself, it signified that she had 100 shares to sell at 25. “2 at 25!” meant that he had 200 shares, two round lots, to buy or sell.
An odd lot is a quantity to sell less than 100 shares. If a customer wanted to buy or sell 17 shares, the broker would need to yell, “17 shares at 25!” and either signal a purchase or a sale using their arms gestures. This slowed the trading process. Hence, brokers would charge their clients an odd-lot differential. Traditionally, this was typically 12½ cents to 25 cents extra per share. or increments of 100 shares. Mixed lots of more than 100 shares but not divisible by 100 were also subject to the odd-lot differential. The face-to-face double auction trading process is now part of ancient history and so the need to buy and sell in round lots is a thing of the past. The odd-lot differential now is typically waived or far less than 5 cents per share, often much less. Nevertheless, old habits die hard and some of your older friends or family members will admonish you to always buy in 100 share round lots. Don’t listen to them. Since this is such a small matter, there is no need to waste your time trying to convince them that it is no longer necessary to buy in round lots. Wait until they are ready to sell everything after the market has fallen 50%. That is when they really need your expertise.
The competition for your investment dollars has become so intense, in fact, that brokerage firms are now allowing investors to buy fractional shares of stocks. Was one share of Amazon too much for you at over \$3,000 per share in February of 2022? If you had \$100 to spare, you could have purchased 0.03000 shares with that \$100. Ah, don’t expect to get a very decent price using a service such as this. The markup will be substantial. (In our BUS-121, Principles of Money Management, class, we warn students that the price of convenience is typically very high. Note: Amazon split their stock so as of February 2023, it was selling for around \$100.) Your Humble Author does not use any of these services. If any students do, it would be greatly appreciated if you could relate your experiences. Did the brokerage show you the difference between the best price available and what price they sold you the fractional shares? One brokerage firm that offers this service is Schwab. In the fall of 2022, I contacted one of their representatives and asked how much they charged for this service. He had no idea and said he would do some research and get back to me. He never did.
Stock Quotes
Before the Internet (BI?), most people would wait until the next morning to read the price quotes of their favorite stocks. They were published in every major newspaper. If the need for a stock quote was urgent, you would call your broker who had a Quotron machine in his or her office. The Quotron machine was receiving data directly from the stock exchanges and OTC markets. How 20th Century!
Now we simply swipe our mobile device and a fire hose of information about our stocks drenches us. One peculiarity to know about stock quotes from the Internet is that they are typically not up to date. You may have an account with a broker that offers you real-time quotes. But unless you have been assured ahead of time from your source that you are receiving real-time quotes, the quotes are normally delayed 15 to 20 minutes. (Real-time quotes are yet another fee that stock markets charge for.) Also, always remember that the quoted prices are not the only prices available. At any one time, there are many prices available from many different dealers/market-makers. The quoted prices are simply the best prices available.
Different sources will contain different amounts of information. A few of the more popular free websites available are bloomberg.com, marketwatch.com (free version of Wall Street Journal), morningstar.com, finance.google.com, and finance.yahoo.com. Bloomberg, Marketwatch, Morningstar, and now Yahoo Finance will pepper you with solicitations to enroll in their monthly subscription services. There are others. If you have any experience with any other free websites that you believe would be worthwhile to your fellow students, please contact us. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.03%3A_New_Page.txt |
Finally! We are finally at the point in our journey together where we will discuss market measures that we have been using since our first discussions about investments. It’s about time! How can we say that “stocks have returned approximately 10% over the past 90 years?” The industry uses market averages and indexes. These are standards, also called benchmarks, that are used to measure the general behavior of securities prices at a given point in time or over specific time periods. In other words, they are just lists of stocks. You cannot help but hear about these every day in the news. “The Dow went down! The NASDAQ went up!” What are they trying to tell us and how much significance should we attach to them? Let’s explore.
Market Averages versus Market Indexes
A few of these standards are market averages and reflect the average price behavior of the list of stocks. Most others are market indexes and reflect the relational price behavior. The differences between a market average and market index are subtle. Most people do not even know there are differences. Market averages use share price calculation only. They look solely at the price of the stock without regard to the market value of the stock. The most important example of a market average is the Dow Jones Industrial Average. Market indexes use a market-weighted calculation. They take into account the overall market value of the company as well as the stock price. The larger the size of the company, the more weight and influence the security will have in the index. The most popular example of a market index is the Standard and Poor’s 500 Stock Index. Market-weighted calculations are generally regarded as better measures than market averages but for our purposes, the differences are mostly unimportant. As with anything we humans have done, neither is perfect.
The Dow Jones Industrial Average and other Dow Averages and Indexes
In 1896, Charles Dow and his partner, Edward Jones, created the Dow Jones Industrial Average, a list of 12 stocks. It is also represented as the DJIA, the Dow Average, or simply the Dow. The Dow is the second oldest market benchmark and is the most famous of all stock market measures. The list of companies in the average is composed of 30 high-quality stocks selected for total market value and broad public ownership and believed to reflect overall market activity. Since it is an average, it uses share price calculation only, not taking into account the size of the company. As the economy and technology change and evolve and companies rise and fall, from time to time, the list of stocks is adjusted. Some companies are removed and others take their place. As such, it now has more non-industrial stocks than industrial stocks. Although the Dow is by far the most popular index and is reported more than any other, with only 30 companies, it really isn’t the best measure of the stock market’s performance.
For decades the Dow was managed by Dow Jones, the company that publishes the Wall Street Journal. Dow Jones was controlled by a close-knit family for generations, the famed Bancrofts. The stock of the company was selling for approximately \$36 when in 2007, Rupert Murdoch of Fox News, offered to buy all shares for \$60 per share and fold the business into his publishing empire. Some in the family did not want to sell. However, the allure of the elevated premium was too powerful to resist. Since then, it appears that Fox News has either sold or simply delegated the management of the Dow to Standards and Poor’s, the research company that manages the Standard and Poor’s 500 Index and the subject of our next section. However, it is difficult to know for sure the exact nature of the relationship between Dow Jones and Standard and Poor’s. If anyone wants to take on this research as an extra credit assignment, please contact me.
Table 3.4.1: The Thirty Stocks of the Dow Jones Industrial Average
American Express Goldman Sachs Nike
Amgen Home Depot Procter & Gamble
Apple Honeywell Salesforce
Boeing IBM 3M
Caterpillar Intel Travelers
Chevron Johnson & Johnson United Healthcare
Cisco Systems J. P. Morgan Chase Verizon
Coca Cola McDonald’s Visa
Disney Merck Walgreens Boots
Dow Microsoft Walmart
The table above lists the 30 stocks that are contained in the Dow Jones Industrial Average as of February 2023. Only a handful are associated with the industrial industry. That is why it is more often referred to as the Dow. Also, the past 25 years have seen numerous changes in the makeup of the index. Many of the recent changes have seemed erratically, questionable, and even slow-witted. For example, AIG and Citigroup were removed from the Dow as they teetered on the edge of bankruptcy. GM was in bankruptcy when it was removed. This is yet another reason why the Dow is not a good measure of stock market performance. With only 30 stocks, just one or two spectacular failures muddle the long-term results.
There is a more insidious problem with the Dow. For example, you may hear after a severe market downturn, “The Dow is where it was 15 years ago!” The problem with this statement is that the Dow 15 years ago was a very different index. Many of the companies that are now in the Dow weren’t in the index 15 years ago and others that were in the list have been removed. This is a problem with all averages and indexes but it is especially a problem with a list such as the Dow which only has 30 stocks. In Your Humble Author’s opinion, the Dow should be retired. However, that is not going to happen anytime soon.
Dow Jones has many other benchmarks. One average that is followed by many is the Dow Jones Transportation Average. This average is actually the first average that Mr. Dow and Mr. Jones created. It was created in 1884, twelve years before the Industrial Average. It is a list of 20 stocks in the transportation industry. The Transportation Average is followed by many because of the belief that the transport industry is a leading indicator of economic activity. Before the products can be produced and then sold, the raw materials must get to where they need to go to be developed into finished products and then the finished products need to be delivered to where they will be sold. Another long-lived Dow Jones average is the Dow Jones Utility Average. It was created in 1929 and contains 15 prominent utility companies. Put them all together and you have the Dow Jones Composite Average. The Transport average is sometimes reported in the media. The Utility Average and the Composite Average are rarely ever reported.
A Dow Jones benchmark which is worthy of following is the Dow Jones U.S. Total Stock Market Index. This is a broad-based index that includes large companies, mid-sized companies, and small companies, representing approximately 95% of the total market value of stocks domiciled in the United States stocks. The original index was created by Wilshire Associates in 1974 and was called the Wilshire 5000. In 2004, Dow Jones somehow cajoled Wilshire to rename the index the Dow Jones Wilshire 5000 Index and then in 2009, they kicked Wilshire to the side of the road and renamed the index to Dow Jones U.S. Total Stock Market Index. We don’t know about you, but Wilshire 5000 is a whole lot easier to say than Dow Jones U.S. Total Stock Market Index, don’t you agree? Unfortunately for us tongue-twisted investors, this index is important for us to be aware of. It is used in many passively-managed index funds and Exchange Traded Funds.
Another important Dow Jones index is the Dow Jones U.S. Completion Total Stock Market Index. What a mouthful! Like the Wilshire 5000, Dow Jones somehow spirited away the idea behind this index from Wilshire Associates. The original index was called the Wilshire 4500. Wilshire Associates wanted to measure the results of medium-sized and small companies. They took the 5,000 stocks in the Wilshire 5000 and then removed the 500 largest companies. This index may be familiar to those who have finished the Thrift Savings Plan assignment. One of the funds uses this index as its benchmark. Do you remember which one?
Dow Jones published many other benchmarks. One of their more forgettable indexes was the Dow Jones Internet Index. The index was created in February of 1999 as the “dot com” Internet mania was in full swing. Companies with no prospects of earnings for several years attached “.com” to their names and saw their stock prices rise tenfold! The “dot com” mania was then followed by the “dot bomb” crash. The Dow Jones Internet Index proceeded to fall 96% from its peak. Yet another example of why it is dangerous to follow the crowd to the “Next Big Thing!”
The Standard & Poor’s 500 Index and other S&P Indexes
Standard and Poor’s is an investment research firm with many decades of experience. They now refer to themselves as S&P Global but everyone still refers to them as Standard and Poor’s, or just S&P. Their most famous index is the Standard and Poor’s 500 Index, commonly referred to as the S&P 500. We have been using it in our studies since the first chapter. While the Dow Jones Industrial Average may be more popular in the eyes of the general public, the S&P 500 is by far the more influential benchmark. The index consists of approximately 500 stocks chosen for market size, liquidity, and industry group representation. Traditionally, the index contained the largest 500 companies based in the United States. The S&P 500 is a very popular index and is used by many index mutual funds and Exchange Traded Funds.
Because the S&P 500 is market-weighted, it was affected by the Internet bubble of the late 1990’s in a bizarre manner. The market values of a small percentage of technology companies were inflated to extremes. This skewed the index even more toward those companies. Consequently, in 1998, 10% of the gain in the S&P 500 was due to one stock. This same phenomenon is currently in play with the top ten companies having an outsized influence on the index.
If Wikipedia is to be believed, Standard and Poor’s has over 100,000 benchmarks consisting of their own and the Dow Jones averages and indexes that they also manage. There are small company indexes, mid-sized company indexes, global and international indexes, sector indexes, you name it! None are as important as the S&P 500. Feel free to peruse them at your leisure at their website. Enjoy!
The NYSE, AMEX, and NASDAQ Indexes
The NYSE, the AMEX, and the NASDAQ all have their own composite indexes consisting of chosen stocks on their respective stock marketplaces. The NYSE Composite and the AMEX Composite Index are not generally reported by the media nor followed by the investing public. However, the NASDAQ Composite is. Since the NASDAQ is dominated by technology companies, the NASDAQ Composite is often called the “tech index.” The NASDAQ Composite went from 800 in March of 1995 to 5,000 in March of 2000. As the Internet bubble burst, the NASDAQ then dropped to 1,200 in September of 2002 before starting to recover. When this happened, you often heard the talking heads in the investment media asking rhetorical questions such as, “When will the NASDAQ reach 5,000 again?” or, “Can you believe that the NASDAQ is back to where it was in 1996?” Both of these questions show a profound misunderstanding of how indexes work. In 2000, the index was nothing like it was in 1996. Dozens and dozens of companies were not in the index in 1996 and had sprouted up during the Internet euphoria. Many of these companies were not likely to ever be profitable yet but had profound valuations. Likewise, when the NASDAQ finally did reach 5,000 again in 2015, most of those new companies that were in the NASDAQ in 2000 were gone, bankrupt, finished, kaput! The name of the index was the same. However, the companies on the list were very different.
For this reason, prudent, long-term investors may follow the popular indexes in the news as they would follow the weather. They are both interesting and a frequent topic of polite conversation. However, making any kind of investment decisions based upon the short-term or long-term performance ‒ or lack thereof ‒ of any particular index or group of indexes is contradictory to one’s long-term success.
The Russell 2000
In 1984, the investment research firm Russell Investments, née Frank Russell and Associates, created the Russell 2000 Index. They took the 3,000 largest companies and then chopped off the largest 1,000 companies. What is left are 2,000 small and mid-sized companies. Many investors look to the Russell 2000 as a leading indicator for the United States economy as small businesses tend to suffer sooner when an economic downturn occurs. However, smaller companies tend to recover more quickly when the economy turns around as they are more nimble and can more rapidly take advantage of new opportunities.
Global and International Indexes
After World War II, some domestic investment firms started searching for investment opportunities outside the United States. However, there was no index designed to measure the performance of global and international markets. In 1969, Capital International, then a division of the Capital Group, launched a series of indexes to measure the performance of global and international markets. In 1986, Morgan Stanley licensed the rights to the indexes and rebranded them with the title MSCI, Morgan Stanley Capital International. The most popular and useful indexes were the MSCI World Index and the MSCI EAFE Index. The MSCI World Index was meant to measure the global stock market, including the United States while the MSCI EAFE Index was meant to measure the international stock market, everyone except for the United States. EAFE stands for Europe, Australia, and the Far East. When these indexes were created, they focused primarily on developed countries. No provision was ever made for the fast-growing emerging and developing economies. As they grew, their companies were left out of the indexes. Instead of including companies from these countries, MSCI decided to launch two new indexes, the MSCI All Country World Index and the MSCI All Country World Index ex-USA. (And you thought that the Dow Jones U.S. Completion Total Stock Market Index name was bad!)
Which indexes are important for investors to follow? Each investor will decide upon which indexes are important to them or indeed, if any are important. However, for our class, we need to internalize the following eight indexes as described in Stock Worksheet #1. (As with all worksheets on the class website, there is an answer key, and most have audio commentaries.)
Table 3.4.2: The Most Important Stock Market Averages and Indexes
Market Average or Index Description
Dow Jones Industrial Average, also known as the DJIA or just the Dow Stock market average made up of 30 high-quality stocks selected for total market value and broad public ownership and believed to reflect overall United States market activity
Standard and Poor’s 500 Index, also known as the S&P 500 or just the S&P Traditionally, the 500 largest stocks based in the United States chosen for their market size, liquidity, and industry group representation
NASDAQ Composite Market index mostly composed mainly of high-tech companies based in the United States
Dow Jones U.S. Total Stock Market Index, née Wilshire 5000 Market index designed to gauge the total United States stock market
Dow Jones U.S. Completion Total Stock Market Index, née Wilshire 4500 Market index designed to measure the total United States stock market excluding the largest 500 companies, very popular with many index funds
Russell 2000 Market index most often used as a measure of the strength or weakness of medium-sized and small-sized companies based in the United States
MSCI All Country World Index (née MSCI World Index) Market index designed to measure the global stock markets of the world including the United States
MSCI All Country World Index ex-USA (née MSCI EAFE Index) Market index designed to measure the international stock markets of the world excluding the United States
Stock Market Index Mania!
The job of the mass media is to keep you on the edge of your seats. "Stay tuned for the latest disasters!" The investment media is not immune from sensationalism. Each day, you will be bombarded with graphics similar to this one, entitled Today’s Unstable Stock Market:
There is a joyful little book entitled How to Lie with Statistics by Darrel Huff. It was written in 1954 so the numbers are very different from what we would see today. Nevertheless, the concepts are timeless. In the book, Mr. Huff shows us one of the most common ways to lie with statistics is to simply not show the whole story. In this case, by just showing you the Dow from 34,075 to 34,099, we perceive that the market is widely convulsing up and down. However, if we were to include from 0 to 35,000, the graphic would show a much different story. Please consider today’s stable stock market:
This graphic would not elicit much emotion, would it? Good! That’s what we want! When the news or radio or website is screaming about how volatile the stock market is, please pull out this graph and remind yourself what their scary slick graphic would look if they showed us the whole picture.
Volatility Reexamined
We can now revisit volatility. Here is the same graph of the S&P 500 Index for the year 2022 that we first saw at the beginning of this chapter. The only difference is that this graph shows us the whole picture, starting at \$0. For Your Humble Author, when we get to this slide in a face-to-face class, this is typically one of the most satisfying moments in the whole semester. Invariably, you can literally see the faces of at least a few students relax as they realize, “Hey! A 30% downturn ain’t so bad. I can handle it.”
P.S. You won’t see this graph on the nightly financial news! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.4%3A_Stock_Market_Averages_and_Indexes_Volatility_Reexamined.txt |
We will turn our attention to various stock characteristics and measurements.
Stock Spinoffs
A stock spin-off is the conversion of one of a firm’s subsidiaries to a stand-alone company by distribution of stock in that new company to existing shareholders. After the spin-off, the investor will still have shares in the previous firm but will now also have shares in the company that was spun off. Sometimes, the new company is still majority-owned by the company that spun it off. Examples include Kraft Foods which was spun off from Altria, the makers of Philip Morris and Virginia Slims cigarettes. Altria then divested itself of its international tobacco business, now called Philip Morris International. After both spin-offs were spun off, investors held shares in Altria, Kraft, and Philip Morris International.
Some investors show keen interest in spin-offs. They believe that the-spin off is being undertaken because the management believes the spun off company will be successful on its own. You will hear some in the industry say, “This spin-off will unlock value.” However, the history of spin-offs has been checkered. Some spin-offs have done better than the companies that spun them off. Examples of this are the Baby Bells after being spun off from the old AT&T 1984. Two of the companies grew to be Verizon Communications and SBC Communications. Verizon used to be Bell Atlantic. SBC Communications bought the old AT&T in 2005 and changed its name to AT&T. Some spin-offs have not fared so well. Examples of this are Coca-Cola Enterprises, spun off from Coca-Cola, and Lucent Technologies, spun off from the old AT&T. Both were disappointments to their investors.
Stock Splits
A stock split is an accounting maneuver in which a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share. The most popular split is 2 for 1 split. For example, in a 2 for 1 split, if you had 100 shares, after the split, you would now have 200 shares. Of course, the price will also experience a 2 for 1 split. The price will fall in half. There is no increased value from stock splits. If you had 100 shares at \$20, now you have 200 shares at \$10; the value is still \$2,000. It is a psychological increase at best. Warren Buffett of Berkshire Hathaway has refused to split his stock since its inception. As of April 2022, a single share was selling for over \$500,000!
Historically, the investment community encouraged companies to split their stock prices because of the historical face-to-face double auction system. Recall that to facilitate trading, investors were encouraged to buy round lots in multiples of 100. When a stock price starts to get into the 100’s of dollars, 100 shares can become very pricey and out of the reach of many investors. With the new technology, there is no longer any advantage to buying and selling round lots. The computer system does not care if there are 100 or 17 or 5 or even one share. Therefore, stock splits are not as common as they once were.
Two for 1 splits are not the only types of splits. There are 5 for 1 splits, 3 for 2 splits, etc. There are even reverse splits. For example: a 1 for 10 split means that the company will replace 10 of your shares with only 1 share. What is the rationale for this? When a stock price falls below approximately \$5, the company’s standing in the investment community suffers. Not only that, but the listing requirements of the NYSE and NASDAQ come into play and the company may become in danger of being delisted. To compensate, the company will issue a reverse split. For example, if an investor owned 100 shares of a stock that were selling for \$2 and the stock split 1 for 10, the investor would now only own 10 shares. However, the price would jump to \$20. Recall that the value does not change, only the accounting. A reverse split is usually a sign of a company in distress.
Treasury Stock and Share Buybacks
Treasury stock are shares of stock that have been issued to the public and then subsequently repurchased by the issuing firm. The process of repurchasing stock by a company is called a share buyback, also known as a share repurchase or simply a buyback. The shares are taken out of circulation. Hence, share buybacks reduce the number of outstanding shares. The logic being that after the buyback, there is less supply of outstanding stock. And any first semester student of economics will tell you if the supply of a product or service is reduced, assuming the demand does not change, the price should rise. Existing shareholders now have a larger percentage ownership of the corporation.
During the run-up of the 1990’s, share buybacks were often seen as a better alternative to dividend increases. The belief was that investors were more interested in capital gains than dividends and that buybacks increased the potential for capital gains by reducing the supply of stock. Recently, with interest rates at generational lows, companies borrowed money to repurchase shares of their stock, as well as pay additional dividends. The dramatic lowering of corporate tax cuts in 2017 also prompted many corporations to accelerate their share buybacks, instead of the promised productivity and wage gains.
Common Stock Classes
From time to time, some corporations will issue different classes of common stock. Typically, there might be two classes but sometimes more. At one time, General Motors is reported to have had seven classes of stock. One typical reason for two different classes of stock is to allow the original owners or family to have specific privileges that retail investors do not receive. For example, the A shares of a company stock would be for the general public and the B shares would be owned only by the family and they would receive a much higher dividend. Sometimes, the B shares have far more voting rights per share allowing the original owner or the family to keep ultimate control over the company. This is how Facebook structured their two share classes. The A shares are owned by the general public while the B shares are owned by the CEO and executive team. The B shares have 10 votes for every 1 share and give the CEO 58% of the voting rights, essentially ensuring that no other shareholders will ever have a voice in the operations of the company. This structure is increasingly being used in many technology companies such as Lyft and Google. Recently, The Council of Institutional Investors (CII) and other shareholder groups have begun to petition the NYSE and NASDAQ to limit the use of these techniques, arguing that these structures are ultimately not in the best long-term interests of retail shareholders.
There is an interesting story about multiple shares classes and Berkshire Hathaway, the holding company run by the famed investor Warren Buffett. You may recall that Mr. Buffett refused to split the shares of Berkshire Hathaway. Hence, the price of one share had ballooned to \$30,000 by the mid-1990’s. The financial world pressed Mr. Buffett to make it easier for retail investors to invest in the company, not so subtly threatening to take action if Berkshire Hathaway did not comply. Berkshire Hathaway responded by issuing class B shares at 1/30th of the price of the original shares, now renamed class A. In typical fashion, the class B shares had much lower voting rights than the class A shares. In the prospectus for the Initial Public Offering of the class B shares, Mr. Buffett said that he would not buy the class B shares and recommended that others not buy them, either. However, later on, in 2010, Mr. Buffett and Berkshire Hathaway found a new usage for the class B shares. They split the B shares 50 for 1 in 2010 and started using the B shares like cash to purchase new investments. The price of a single B share was close to \$310 as of February of 2023.
Par Value, Book Value, and Market Value
The par value of stock is the nominal value, also called face value, of the stock. It may be as low as a penny or even much less. For example, the par value of Apple shares is \$0.00001. This number is sometimes required for legal purposes and is fairly meaningless to investors. A more important measure is book value. Book value is the amount of shareholders’ equity in a firm. It is computed by taking the firm’s assets and subtracting the firm’s liabilities and preferred stock. Students of accounting will instantly recognize this calculation. In our BUS-121, Principles of Money Management, class we call it our net worth. However, the book value is usually ignored by investors who instead concentrate on the market value. The market value is the prevailing market value of a security. It’s the current price of the stock set by the forces of supply and demand. In other words, what is the company worth? What is its valuation? What should I pay for a share of a company’s stock? This is an enormously difficult question to answer. We will introduce valuation techniques in our next chapter.
Stock Dividends, Earnings per Share, and Dividend Yield
Dividends are optional distributions of earnings given to stockholders. Companies in the United States and countries that were associated at one time or another with the United Kingdom normally pay dividends quarterly. Companies from other countries typically pay dividends either semi-annually or annually. The corporation’s Board of Directors decides how much, if any, dividends should be paid and when to pay them. Dividends are usually a percentage of the earnings per share, a very important statistic. Earnings per share, often expressed as EPS, are the amount of annual earnings available to common stockholders, as stated on a per share basis.
For example, the annual earnings of a company may be \$1,000,000 and there are 500,000 shares outstanding. Therefore, earnings per share = \$1,000,000 earnings / 500,000 shares = \$2.00 earnings per share. The Board of Directors might decide to pay out 50% of the earnings per share in the form of dividends. Hence, each shareholder would receive a \$1.00 dividend for each share of stock they owned. In this case, the company is paying out 50% of their earnings to shareholders in the form of dividends. The percentage of dividends paid out from earnings per share is called the dividend payout ratio. Larger, more mature companies tend to pay out larger percentages of their earnings in the form of dividends. Smaller, growing companies typically pay out a much smaller percentage of the earnings or, more likely, they will not pay out any dividends at all. This is because the company needs the earnings to invest back in the business to help with the growth. Accounting students will remember that the portion of earnings that are not paid out in the form of dividends is called retained earnings. (We take this opportunity to remind you yet again that we will not be doing any accounting in this class. We will simply utilize the financial statements and other statistics that the accountants create for us.)
Earnings and dividends are two very important measures of the value of a company. We will be discussing these for the remainder of our time together. Dividends are the only statistic that we know absolutely for sure is correct. All the other statistics could be pure fantasy, and sadly, sometimes they are. However, we know the reported dividend is true because the company sent us a check. Well, actually, they don’t send us checks anymore; dividends are now paid electronically and deposited automatically into our brokerage account. Nevertheless, we can emphatically say once again, “Dividends don’t lie!”
The dividend yield is another very important statistic. It is a measure that relates the dividends paid by a stock to the share price of the stock. This puts stock dividends on a relative percentage basis rather than an absolute dollar basis. Continuing the example from above, if our stock that was paying us \$1 dividend were currently selling for \$20, the dividend yield would be 5%. Dividend yield = \$1 dividend per share / \$20 market price of one share = 0.05 or 5%. The dividend yield allows us to compare stocks with other income-oriented vehicles such as bonds or savings accounts. You may recall that traditionally, 3% to 6% was a typical dividend yield. In the 1990’s dividends went to 2% and eventually 1% at the peak of the Internet bubble in March of 2000. Dividends then went above 3% in the 2008/2009 turmoil as stock prices plummeted. They are now back down below 2% as of February 2023.
Important Stock Dividend Dates
There are four dates to remember with regard to dividends. The first is the declaration date. This is the date that the Board of Directors declares the dividend. For example, on May 15th, the Board might say, “On June 17th, shareholders of record will be eligible for our quarterly dividend of \$1.” In this example, June 17th is the date of record, the date on which an investor must be a registered shareholder of a firm to be entitled to receive the dividend. It is also called the record date. The date of record is typically a few weeks after the declaration date.
Now here is where it gets a bit tricky. You may believe that you could purchase the shares of the stock before June 17th and hence be eligible for the dividend. This is not the case. You must purchase the shares before the ex-dividend date. The ex-dividend date is actually two business days before the date of record. Only those shareholders who have purchased the shares before the ex-dividend will be eligible to receive the dividend. Why is the ex-dividend two days before the date of record? This is because stock transactions clear in 2 business days. When you buy a stock, you don’t actually become the official shareholder for 2 business days. Likewise, when you sell shares of stock, because stock transactions clear in 2 business days, the proceeds from the sale aren’t actually deposited into your account for 2 business days.
Once you have a good working relation with your brokerage, because of this characteristic of stock transactions, your broker may allow you to initiate a stock purchase without the sufficient cash in your account. You then have 2 business days to get the money into the account. Some brokerage firms will not allow a purchase to occur if sufficient cash is not in the account. When you sell shares, again, with a good relationship with your brokerage firm, the brokerage firm may deposit the cash proceeds the day of the sale in anticipation of receiving the funds 2 business days later, sometimes as a loan with minimal interest charged.
If you research the ex-dividend date, you may find some sources still claiming that stock transactions clear in 3 business days. The reason for this is that the move to 2-day settlement is fairly recent, starting in 2017, so some sources may still report a 3-day settlement. In 1993, the Securities and Exchange Commission changed the settlement to 3 business days from 5 business days. You had to wait an entire week to get your shares or receive your cash! Technology has enabled much faster transaction settlements.
In our example from above, if the date of record were June 17th, assuming that June 17th were not on a Monday or Tuesday, then the ex-dividend date would be June 15th. Of course, if the date of record is a Monday or Tuesday or if there is a holiday just before the date of record, the ex-dividend date is modified accordingly.
The last date to be aware of is the payment date. This is the date on which the company pays the dividend and the cash arrives in your account. This is normally a few weeks after the date of record.
Theoretically, the opening share price on the ex-dividend date should reflect a drop in price commensurate with the amount of the dividend. In our example above, the \$1 per share dividend should result in the opening stock price being reduced by \$1. Of course, it never really works that way in the marketplace since prices are changing all the time.
Don’t Buy the Dividend!” is a common saying in the industry. Those who advance this technique believe investors are often better off waiting until the ex-dividend date before buying a stock. The logic behind this admonition is thus: Dividends are taxable transactions. If you “buy the dividend” – buy the stock just before the ex-dividend date – you will be responsible for paying the tax, and presumably, the stock price will fall commensurate with the amount of the dividend, so you are better off waiting until after the ex-dividend date so that you will get the stock at a better price and not generate a taxable transaction. This might be a useful strategy for those dealing in large-scale investments involving significant sums of money. Of course, for the vast majority of us retail investors, the initial purchases will be modest and the price and tax savings will be negligible. (When and if the purchases become gargantuan, congratulations! You are very welcome, by the way.)
Cash Dividends versus Stock Dividends
There are two types of dividends, cash dividends and stock dividends. If the following definitions and comparison escape you, remember this: You Want Cash Dividends! With cash dividends, payments are in the form of cash. Before modern telecommunications and information processing, the company would send you a check. Now, the cash is automatically deposited into your brokerage account. If you were using the dividends for income expenses, most brokerage firms will allow you to set up your account so that the dividends are sent electronically to your bank or credit union. Cash dividends are taxable transactions. Every January, you will receive a Form 1099 that lists your cash dividends and you would be required to declare them on your tax return. If your investments are in tax-qualified accounts such as IRAs or 401(k) plans, the transactions would not be reported and you would not pay any taxes until you withdrew the money. (If you have a Roth IRA and you wait until retirement age, all distributions are tax-exempt! More later.)
In contrast, stock dividends are dividend payments in the form of additional shares of stock. All other things being equal (and they never are, by the way), stock dividends have no value because they constitute a dilution of ownership and there is no change in value. They are similar to stock splits. For example: The Board of Directors declares a 10% stock dividend. For every 10 shares, an investor will receive 1 extra share. However, similar to a stock split, the price of the shares will drop 10%. Thankfully, unlike a cash dividend, a stock dividend is not taxed. “Gee, thanks, IRS, for not taxing me on something that isn’t worth anything!” Prudent, long-term investors are normally never interested in stock dividends.
Bottom line: You Want Cash Dividends!
Dividend Reinvestment Plans (DRIPs)
Dividend reinvestment plans, often referred to as DRIPs, are plans in which shareholders have cash dividends automatically reinvested into additional shares of the firm’s common stock. These are not to be confused with stock dividends. DRIPs are cash dividends. However, instead of receiving the cash in your account, the plan purchases shares of the stock on the open market with the cash dividends. No new shares are issued and hence, no dilution of ownership occurs. Since these are cash dividends, these are taxable transactions. DRIPs are an excellent way to own stock for those interested in long-term growth and not interested in current income. It allows an investor to take advantage of compounding automatically with normally no, or very small, transaction costs. There is an example along with a commentary about a DRIP on the class website. Many corporations sponsor DRIPs for their stocks and you deal directly with the corporation at a very low cost. Also, most brokerage firms now offer DRIPs to their clients. Plus, won’t your friends and family members think it’s cool when you tell them that you have a DRIP?
Here is an example of a dividend reinvestment plan (DRIP) from Sempra Energy, the parent company of San Diego Gas and Electric. Notice that Sempra Energy does not administer the DRIP. They hired a company called Equiserve (which is now part of Computershare) to do the accounting for them. Most DRIPs are very low cost. Every so often, in the [Fees] box, we would be charged \$0.03 or \$0.06 or \$0.09. Pretty good deal! However, how would you like to keep track of 18 different DRIPs? For this reason, most brokerage firms now offer DRIPs for their clients and you can have your DRIPs all together in one place. (I just love writing and saying DRIP!)
Price-to-Earnings Ratio, aka P/E, PE
By far, the most watched stock valuation statistic is the price-to-earnings ratio. It is also written as price to earnings ratio and often abbreviated as P/E or just PE. It is a simple calculation. The price-to-earnings ratio is calculated by taking the market price of one share of stock divided by the earnings per share. However, there is never any end to the mountain of analysis, research, conjecture, opinion, predictions, weeping, gnashing of teeth, and beating of breasts that accompany price-to-earnings ratios. In our previous example with a \$20 market price and \$2 earnings per share, the price-to-earnings ratio would be \$20 price / \$2 earnings = 10 P/E. The price-to-earnings ratio is unit-less. We don’t place a \$ or % next to our result.
Traditionally, stocks typically sold for P/E ratios of between 5 to 15. A P/E ratio of 20 or above was only reserved for the fastest growing stocks. During times of market manias and bubbles, a P/E of 20 was not unusual. During market downturns, P/E ratios come down greatly. We will spend a great deal of time learning P/E and other valuation techniques in the next two chapters.
Before moving to the next section, it is time to work through Stock Worksheet #2. As with most all worksheets in our class, there is also a commentary and answer key on the class website. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.5%3A_Stock_Characteristics_and_Measurements.txt |
Many people mistakenly believe that all stocks are the same. This is similar to believing that all companies are the same. This is obviously untrue. Is McDonald’s similar to The New York Times? Is Kellogg’s the same as Google? Who or what is Fifth Third and what do they do? Every company is different. However, there are broad categories that we can identify. Some companies fit neatly into one category, some fit into more than one category, and some don’t fit well into any category. In this next section, we will identify and discuss the major categories of companies. Much of this material was paraphrased from Peter Lynch’s excellent and very easy-to-read book One Up On Wall Street. It is one of the two books that should be your first investment book to read. The other is A Random Walk Down Wall Street by Professor Burton Malkeil. Both are readily available at your local library. Some libraries even allow you to download them to your mobile device. (Psst. If you want to have an unfair advantage over your fellow students and your future colleagues at work, read. But since you are reading this, you already knew that, didn’t you? Lucky you!)
Blue-Chip Stocks
Blue-chip stocks are financially strong, high-quality stocks with long and stable records of earnings and dividends. They have their roots deep in the economy. Most are multinational and many earn more money outside the United States than inside the United States. They are sometimes referred to as value stocks. They are suited to conservative investors who are attracted to stocks for their growth and income opportunities but who also want stocks with downside resilience. (In this context, conservative applies only to investments, not politics.) Examples included ExxonMobil and Johnson & Johnson, companies that have been in business for over a century. Most blue-chip companies have survived many market downturns. Peter Lynch calls blue-chip stocks the stalwarts. Blue-chip stocks normally never explode on the upside but they almost never implode and dissolve into a pool of tears.
Interestingly, the term blue-chip comes from the world of gambling. Over 100 years ago, only gentlemen owned stocks. Gentlemen also went to the gambling tables. It was what a gentleman did. At the time, the blue chips were the most expensive tokens.
Income Stocks
Income stocks are the stocks of companies with long and sustained records of paying higher-than-average dividends. Income stocks are also often referred to as value stocks. These are normally slow growth companies in mature industries. Examples included utilities and banks. Investors typically choose income stocks for their dividend opportunities. Similar to blue-chip stocks, income stocks are also very popular with conservative investors looking for downside protection. Remember that the return from dividends is also positive. Unlike capital losses, there are no dividend losses. However, growth opportunities from income stocks are normally very limited. Sometimes the industry that the income stocks are situated within is actually shrinking. This has been likened to a melting ice cube. Eventually the stream of income runs dry.
Growth Stocks and the Growth versus Value Debate
Growth stocks are stocks of companies that are experiencing high rates of growth in operations and earnings. Their growth rate is typically 15% to 20% per year or higher. They are normally associated with high price-to-earnings (P/E) ratios. Usually, they pay no dividends at all or possibly a very small token amount. This is because the earnings are needed to reinvest back into the company as it grows. Their stock prices should go up but they will exhibit strong volatility.
Examples of growth companies are typically found in the current news. They are celebrities. Their photos are on the covers of all the magazines from Forbes to Vogue and GQ. They have the perfect haircuts and the bright white teeth and the well-defined abs. Money flows into these stocks and the prices often rise to unsustainable levels. When the slightest hint of their growth slowing appears, the stock prices are often punished. For the math fans reading this, growth investors often look at the second derivative (the acceleration of growth), not just the first derivative (the velocity of growth). For everyone else, please ignore the previous sentence.
The investment world loves to throw around the terms “growth” and “value.” Unfortunately, the meanings of these terms are not exact. Typically, investors often use the term “growth” to designate a high P/E stock while they use the term “value” to denote a low P/E stock. For others, “value” means there is something attractive or compelling about a stock, either from an opportunity for growth and capital appreciation or from a current or growing income perspective or maybe both growth and income. Hence, a stock with a high P/E ratio might be a great value while a stock with a low P/E ratio might not be a good value. An excellent example of this was the story of Google and GM in 2005. In January of 2005, Google was selling for around \$200 with a sky-high P/E ratio while the old GM was selling for \$34 with a very low P/E ratio and a huge dividend. As of Feburary 2023, Google sells for approximately \$4,500, split adjusted, with a much lower P/E ratio, and the old GM stock, first renamed Liquidation Motors and then ultimately Motors Liquidation, went into bankruptcy and last sold for \$0.04 in March of 2011 and is now completely worthless. Which one was the better value?
Therefore, to avoid confusion when reading, researching, or simply talking with other investors about potential stocks to invest in, always be sure which definition of value is being used.
Speculative Stocks
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” − The Intelligent Investor, Benjamin Graham
So does anyone wanna’ go buy some stock of that sure-fire high-tech startup your friend told you about? Well, before you do, take a look at the history of GoBroke, oops!, sorry, I meant GoPro (GPRO). Recently, as of February 2023, we have seen the prices of many of the high-flying growth stocks fall 50% or more. Research Meta (META, née Facebook), Netflix (NFLX), Roblox (RBLX), and Shopify (SHOP).
Cyclical Stocks
Cyclical stocks are stocks whose earnings and overall market performance are closely linked to the general state of the economy. These businesses follow the business cycle of advances and declines. The poster child for cyclical stocks are car companies. When the economy is strong, car sales soar. Everybody wants a new car! What happens when there is economic turmoil? Car sales hit the brakes and screech to a halt. Other examples include manufacturers of basic materials such as timber, steel, and chemicals. In fact, any company that makes products that are used in the manufacturing process is typically cyclical. A generation ago, the chip manufacturers were growth stocks. Now that almost every product contains at least one computer chip, the chip manufacturers have more and more become cyclical.
Defensive Stocks
The opposite of cyclical stocks are defensive stocks. Defensive stocks tend to hold their own, and even do well, when the economy starts to falter. These companies typically exhibit strong downside resilience during declines in the market. Sometimes, the prices of their stocks go up as the market goes down. The conventional reasoning for this dynamic is that momentum speculators and traders “rotate” out of their short-term, growth-oriented speculations and move to the relative safety of the defensive stocks. As with much of the conventional wisdom regarding investments, whether or not this is correct is subject to debate because no one has ever stopped to ask the millions of traders if that was their motivation. Defensive stocks are often associated with income and value stocks. Examples include food companies such as Kellogg’s and consumer staples companies such as Procter & Gamble.
Turnaround Stocks
Turnaround stocks are companies that have fallen on hard times. As a potential investor, you must judge whether or not there is the potential for a rebound. Your Humble Author normally refers to turnaround stocks as “goners.” In practice, the percentage of companies facing bankruptcy that can successfully turn themselves around is small compared to the companies that do eventually disappear. For those who love a great business story, research Lee Iacocca and Chrysler in the late 1970’s and early 1980’s. Mr. Iacocca is generally regarded as bringing Chrysler back from the brink of extinction. For you budding entrepreneurs who believe engineering a turnaround of a company is in your future, please consider reading Mr. Iacocca’s autobiography. Another successful example of a turnaround is GM, which went through bankruptcy after the Global Financial Crisis and has emerged as a much stronger company. Examples of turnaround companies to study now are AMC, GameStop, and Bed Bath and Beyond. Any predictions?
Asset Play Stocks
A company that is sitting on an asset that could be sold or spun off is called an asset play stock. Investors often must dig a bit deeper than usual to find the hidden assets in a company. A good example was JCPenney’s. Their retail business has been struggling for many years now and there were reports that they were going to head into bankruptcy. However, most people did not know that JCPenney’s had a very profitable insurance division. They were able to sell the insurance business in 2015 to help keep the company afloat. Another example is the company that owns Frito-Lay. Care to guess who they are? (Great research assignment!) Whenever we research a company, it pays for us to look under the rug and see if there are any golden nuggets hiding underneath the company’s visible face to the world.
Penny Stocks
Penny stocks are normally not to be discussed in polite company. The vast majority of them are sham corporations that are used by con artists. They live on the wrong side of the tracks in the rough part of town, namely the OTC Markets, the Bulletin Board and the Pink Sheets. Yes, every so often you will find a company that has hit on hard times and is trying to make the big time again, but that is the rare exception, not the norm. There are literally thousands of these penny stocks with names like butterfly.com and Flim-Flam, Inc. One real example was Definitive Rest which started out making mattresses but then suddenly switched to making specialty metals for the aerospace industry before disappearing from the face of the planet. Another is Deep Earth Resources which has somehow managed to stay in the same business but as of April 2022 was selling for \$0.0002 per share while earnings were a stunning negative \$0.0010. At least in Deep Earth’s defense, they published their earnings. Many other penny stocks don’t bother to fulfill their SEC requirements and simply wait until they are kicked off the OTC Markets before reemerging in some other incarnation. Oh, by the way, Deep Earth Resources stock is no longer being traded.
You may be thinking, “So what is the purpose of penny stocks? The purpose is to separate you from your money, pure and simple. A mass email or text or social media page will tout the wonders of this particular unknown company which has a technology that will revolutionize the world and it is only selling for 7¢ per share! They scream in ALL UPPER CAPS that it will rise to 25¢ by the end of this week so you must act NOW! So you think, “Okay, what have I got to lose?” You buy \$70 or \$700 worth of Bogus Enterprises. Sure enough, the next day, it rises to 10¢. Oh, my Goodness! (Or as the younger folk text one another, OMG!) You buy some more shares. Two days later, it’s now 17¢! You can’t believe your luck. You break the bank and sell all your other stocks and spend every last dime and buy as many shares as you can afford at 17¢ a share because, well, gee, I can get out tomorrow or the next day just before it hits 25¢, right? The next day, you check the price of Bogus and it is now 0.001¢. What? What happened? You have been had. You have been scammed by an age-old trick in the financial world, pump ‘n’ dump.
A bit of investment industry trivia: When you open a brokerage account, in the application process, you will be asked if you have any other brokerage accounts open. The reason for this is that often, the scammer is just one person. He or she needs to be able to make trades with themselves to make it appear that there is market activity in the penny stock they are using for the scam. The SEC is monitoring individuals with multiple accounts and watching for just such activity. For this reason, most pump ‘n’ dump schemes need to have multiple scam artists. Hence, when a pump ‘n’ dump scheme is uncovered, the individuals are also charged with conspiracy. By the way, many brokerage firms will simply not accept trades of sham penny stocks.
Deciding what exactly constitutes a penny stock is not always easy. Traditionally, when the price of a stock fell below \$5, it was in danger of being labeled a penny stock. However, as we saw, a reverse split can remedy this situation with one stroke of the accountant’s pen. Identifying a penny stock can be compared to determining whether something is a work of art or not, “You know it when you see it.” Upon examination of the company’s business, their reported products, customers, and financial statements ‒ or lack thereof of these essentials ‒ it often quickly becomes evident that the company is a sham and their stock is worthless except for the perpetration of fraud.
Some people think they can outsmart the scam artists. Don’t even try. There is an old saying, “If you don’t know who the patsy is at the poker table, the patsy is you.” The scam artists are watching every trade that happens because there aren’t that many of them. Normally, the only trades were your trades and the trades that the scam artists were selling to one another to make it look as though there was normal trading going on. Dear Readers, stay away from penny stocks. Again, penny stocks should never be discussed in polite company.
Foreign Stocks
Foreign stocks, also called international stocks, are stocks that are domiciled outside the United States. For several decades, it was difficult and sometimes impossible to purchase foreign stocks directly. A potential investor needed to open a brokerage account in the country the company was domiciled and then exchange their dollars for the currency of the company. Most investors seeking to invest globally would utilize global or international mutual funds. The mutual funds have the sufficient resources and skills to trade globally.
However, many investors still wanted to invest directly in foreign companies. Many prudent, long-term investors used American Depository Receipts (ADRs) to purchase the stocks of high-quality foreign companies. A large bank or trust company would go abroad and purchase a substantial block of shares of a large multinational company based in London or Frankfurt or Tokyo. The bank or trust company would then issue dollar-denominated American Depository Receipts in New York on the New York Stock Exchange. Global Depository Receipts (GDRs) followed in the footsteps of ADRs and are traded around the world.
Due to technological advancements and competition, many brokerage firms now offer international brokerage accounts that allow investors to easily convert their dollars to foreign currencies and then trade on foreign exchanges. When converting dollars to another currency and investing abroad, one must be mindful of currency risk. Every business day, the dollar rises and falls relative to foreign currencies. In general, all other things being equal (and they never are), when the dollar strengthens, the values of your investments abroad fall. When the dollar falls, the values of your investments abroad rise. Since the Global Financial Crisis of 2008, the dollar has risen substantially. Coupled with the outsized performance of the United States stock market, this had made foreign stock investments look comparatively poor relative to the United States.
Some market professionals argue against investing abroad. One of the most famous was Jack Bogle, Founder and past CEO of Vanguard Funds. The last decade has made their argument appear strong. However, going back decades before the turmoil of 2008, the performance of the United States relative to foreign markets had been fairly even, albeit volatile. For this reason, before the last decade, many prudent, long-term investors believed it was a good strategy to be invested in both the United States and abroad. In general, diversification is a good thing and there are many great opportunities around the world. It is simply not true that all the best companies are based in the United States.
In addition, there are many who argue that at this point in time (May 2022), it is imperative that investors seek opportunities abroad. Many international stocks are inexpensive relative to their United States counterparts. At the same time, the dollar is very strong. This is a great one-two combination. Investors can use strong dollars to buy relatively cheap stocks of great companies. Time will tell if this strategy is successful compared to staying invested solely in the United States. In the interests of full disclosure, Your Humble Author is a strong advocate of global diversification. (Psst. Who is the world’s largest tire manufacturer? The world’s largest food company? The world’s largest cement company?)
Market Capitalization
When discussing stocks, many casual observers will invariably concentrate on the market price. This is unfortunate and ultimately unproductive. Prudent, long-term investors are far more interested in researching the market capitalization of a company, rather than just the price of a single share. Market capitalization represents the total value of the company. It is a simple calculation. The current price of a single share of the stock is multiplied by the number of shares outstanding. The resulting number is how much the company is worth. There are three major categories, two sub-categories, and an additional category that should never be discussed in polite company.
Table 3.6.1: Market Capitalization Categories
Category Market Values Sub-category (if applicable)
Large-cap
Greater than \$10 billion
(Some now say >\$15 billion)
Mega-cap ‒ Greater than \$100 billion
Mid-cap
Between \$2 billion and \$10 billion
(Some now say between \$5 or \$6 billion up to \$15 billion)
Small-cap
Between \$100 million and \$1 or \$2 billion
(Some now say up to \$5 or \$6 billion)
Micro-cap ‒ Less than \$100 million
Do you remember our discussion of the various types of stock mutual funds and the three major market capitalization categories, large-cap, mid-cap, and small-cap? A playful way to remember the three major categories is to think of the large-cap companies as the Papa Bears, the mid-cap companies as the Mama Bears, and the small-cap companies as the Baby Bears. (Goldilocks is nowhere to be found in this analogy.) Large-cap companies typically have their roots deep in the economy and can withstand the inevitable economic downturns better than their mid-cap and small-cap counterparts and hence exhibit less risk than the others. Small companies are nimbler and can better take advantage of changes in the economy but are more likely to be hurt substantially when the ill economic winds blow their way. Mid-cap companies fall in between their large-cap and small-cap siblings.
The two sub-categories that are popularly discussed and researched are mega-cap and micro-cap. As the names suggest, mega-cap companies exist in that rarified air of market capitalizations in the 100’s of billions of dollars. In the past few years, a few companies have cracked the trillion-dollar mark. Micro-cap companies are very small companies that have the potential to generate outsized capital gains but are just as likely to disappear from the markets all together, often for reasons out of their control. The last category that was omitted from our table above is penny stocks. Hopefully, we have already skewered these foul reprobates of the investment community enough for you to steer far away from them.
To illustrate an example of computing market capitalization, suppose a company’s stock is selling for \$20 per share. We don’t know the value of the company nor which category the company fits into without knowing how many shares are outstanding. If the number of shares outstanding were 5,000,000 (5 million), then the calculation would be \$20 per share multiplied by 5,000,000 shares or \$100,000,000 of market capitalization. This is a small-cap company. Stocks Worksheet #3 on the class website has some example companies and calculations for you to do. However, in practice, we investors don’t need to bother with the calculation. A simple Internet search renders the number immediately. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.6%3A_Types_of_Stocks_Growth_versus_Value_and_Market_Capitalization.txt |
In our last section, we will discuss various stock strategies. Some go so far as to call these strategies investment philosophies, sets of beliefs and principles that guide investors’ decision making processes. That may sound a bit far-fetched to many. Should investing be likened to a philosophy or religion? Maybe not, but it is true that without sufficient education and a well thought out strategy beforehand, investing in stocks can be difficult and very challenging. There is an old saying in the industry attributed to George Goodman, who wrote under the pen name Adam Smith: “If you don’t know who you are, [the stock market] is an expensive place to find out.” Let’s see which of the following stock investing strategies will help you find out who you are without having to pay a princely sum.
Buy and Hold Strategy
The most common strategy for prudent, long-term oriented investors is called the buy and hold strategy. Buy and hold investors use research and analysis to identify high-quality companies with good growth prospects and potential for dividends at reasonable prices and hold them for the long term. It is also referred to at times as value investing or growth at a reasonable price (GARP) investing. How long should one hold onto their stock investments? The renowned investor Warren Buffett was once asked what Berkshire Hathaway’s favorite holding period was. He famously quipped, “Our favorite holding period is forever.
Let’s revisit the wisdom of Jack Bogle, Founder and former CEO of the Vanguard Funds:
“An investor is a person who owns business and holds it forever and enjoys the returns that U.S. businesses, and to some extent global businesses, have earned since the beginning of time. They have capital, they earn a return on their capital and that capital grows over time. It’s not complicated. That’s the business of investing.” ‒ John “Jack” Bogle, Founder and former CEO of the Vanguard Group
Obviously, Mr. Buffett and Mr. Bogle are engaging in a bit of mischief because no one lives forever. However, their advice makes sense. If you owned a shoe shop or a pizza restaurant, you would not sell it just because the price went up or down 10%. You would hold onto your business. When the time comes, you may decide to sell it and retire. You may also decide to hand it over to your heirs or ultimately bequeath it to them. But as long as the business is sound, you would want to hold on to it. The same can be true for your stock investments. They are businesses, after all. Don’t lose perspective.
Income Strategy, aka Equity Income
A strategy that fits well with the buy and hold strategy is the income strategy, also known as the equity income strategy. Do you recall the equity income category of stock mutual funds from our previous chapter? Income oriented stock investors emphasize dividends over capital appreciation. Ideally, investors are seeking companies with rising earnings that will support rising dividends. Companies that pay consistently growing dividends tend to do well when the market as a whole does poorly and have been some of the best long-term investments. In general, this strategy is appropriate for conservative stock investors and works very well with Dividend Reinvestment Plans (DRIPs). Investors using the income strategy resemble the tortoise in the fabled race between the tortoise and the hare.
Growth Strategy
The growth strategy involves investing in stocks with above-average forecasts of earnings growth. Dividends are a secondary concern since growing companies usually need to use their earnings to reinvest and grow the business. As discussed, the stocks of these companies usually have high price to earnings ratios in expectation of higher earnings in the future. A growth-oriented investor should be prepared for a great deal of volatility. However, if the investor researches, chooses, and subsequently monitors their investments carefully ‒ and does not panic when the markets fall! ‒ a growth strategy can be very profitable in the long term.
A well-respected group that advocates the growth investing strategy is the National Association of Investors Corporation (NAIC), now known as BetterInvesting.org. They have been in existence since 1951. BetterInvesting.org sponsors investment clubs which are groups of investors who are dedicating to educating themselves about investments while pooling their resources and collectively investing a portfolio of stocks. The investment clubs use a time-tested tool called the Stock Selection Guide (SSG). BetterInvesting.org says that their goal is to achieve a 15% annual rate of return. Joining an investment club is an excellent way to learn while you earn. We discuss BetterInvesting.org and the Stock Selection Guide in Addendum A.
Aggressive Growth Strategy
The aggressive growth strategy entails much speculation and short-term trading. An aggressive growth investor aggressively trades in and out of stocks in order to achieve eye-catching returns. They don’t really ever want to own a stock; they are simply renting the stock. Instead of waiting 3 to 5 years for a stock to move, an aggressive stock trader would go after the same investment return in 6 months to a year or less. Some traders have time horizons in the weeks or days or hours or minutes. Recall that there are High Frequency Trading (HFT) companies who are using computers to make millions of trades per day. Aggressive growth investors somehow believe that they can outsmart and outgun these HFT firms.
The aggressive growth strategy is the strategy that many people think they are supposed to use when they start investing in stocks. They see images of traders behind four screens talking on two telephones at the same time and gesturing wildly with their colleagues. They believe they need to do the same. We refer you again to the phrase, “The Loser’s Game,” coined by the excellent investment author Charles “Charley” Ellis. Aggressive growth investing is fraught with perils and drawbacks, not the least of which are the serious transaction costs that can be generated as a result of frequent trading. Stockbrokers simply adore suckers, ooops!, uh, we mean speculators and traders who use this strategy.
Just in case you have not noticed, Your Humble Author sincerely hopes that you don’t attempt this strategy. Remember, if you don’t know who you are, the stock market is a very expensive place to learn. And if we haven’t convinced you yet about the dangers of short-term trading, please take a look at the following graph.
These are the month-to-month percentage returns of the MSCI World index from 1991 to 2000. In the short term, stock movements appear random. Trying to predict what the next month will bring is futile. Let’s now look at the same time period, except in this graph, we see the year-to-year results of a hypothetical \$10,000 investment.
Source: The Capital Group
Contrarian Strategy
The contrarian strategy is a strategy that merits our attention, even though few of us will have the will to follow it unerringly. Contrarian investors invest in stocks that are out of favor with the market for some reason, as reflected by low price to earnings ratios and low prices compared to their fundamentals. It involves actively seeking stocks from companies with sound financial statements that the market has undervalued. A famed contrarian investor quipped, “I always try to be accommodating. I buy when others want to sell; I sell when others want to buy.” Of course, this is easier said than done. Historically, the market goes up three or four years for every one year that it goes down. If you are always selling when others are buying, fairly soon, you won’t have any stocks to sell. Likewise, one must wait until there is panic in the markets before stepping up to the plate and buying with abandon. When asked what it was like to be a contrarian investor, Howard Marks, CEO of Oaktree Capital, said, “[It’s] not a steady business.”
An example of a master contrarian investor in action was Warren Buffett in the mid-2000’s. As the prices of stocks and, more ominously, real estate rose to nosebleed valuation, Mr. Buffett patiently sat on his hands and waited. In the Fall of 2008 as the wheels fell off the economy because of the real estate bubble bursting, Mr. Buffett penned an opinion piece in the New York Times. In his opinion piece, he encouraged his fellow countrymen and countrywomen to, “Buy American. I Am.” Did Mr. Buffett follow through on his own advice? Yes, he did. He swooped in and bought \$5 billion worth of General Electric and Goldman Sachs. He then subsequently invested \$10 billion in Bank of America. All three purchases proved immensely profitable.
Long-term buy and hold investors can take a tip from contrarian investors. Typically buy and hold investors invest systematically, in good times and bad. However, when the organic matter hits the ventilating device and there is panic in the streets, prudent, long-term oriented investors can accelerate their investment program and purchase more than they normally would, assuming additional funds are available. They can then proudly state that they have something in common with the likes of Warren Buffett, even if that something in common is not the size of their investment portfolios.
Sector Rotation, Momentum Trading, and Market Timing Strategies
The last three strategies we will title, Tweedledumb, Tweedledumber, and Tweedledumbest, although their order is entirely up to you. Sector rotation involves buying stocks in the current "hot" sectors of the economy and selling those stocks in the stale ones. An investor attempting to utilize this strategy must determine which methods they will use to decide which sectors are hot and which are not and if and when those sectors will reverse themselves. Typically, the neophyte will choose a hot sector just as it is beginning to cool and turn downwards. Of course, they will stubbornly hold onto it just long enough for it to hit bottom. That is when they finally give up on the sector and move to another hot sector just in time for the first sector to start gaining and the second sector to start losing. If it were not for the fact that the unfortunate individual is losing real money, it would be comical.
Momentum trading is very similar to the aggressive growth strategy. The momentum trader buys stocks as they go up and sells stocks as they go down, often utilizing trading techniques that profit when stock prices go down. This is sometimes called the “Greater Fool” Theory. Momentum traders say to themselves, "Hey, it’s okay if I buy high because somewhere out there is a greater fool than I am so I will be able to sell higher." This theory was utilized by far too many uninformed speculators in the dot-com bubble of the late 1990’s and in the housing market mania of the mid-2000’s with the subsequent Global Financial Crisis being the end result. Many market historians are saying that cryptocurrencies and NFTs (Non-Fungible Tokens) are exhibiting similar trends to what happened in the late 1990's and the mid-2000's but the similarities and analogies from one mania to the next are never perfect. In any event, whenever markets are moving higher or moving lower, the momentum traders will be there, attempting to realize short-term gains on the movement of the markets. We wish them well. They will need it.
The market timing strategy involves attempting to predict the future directions of the market. The hardest part of market timing is that you must be correct twice. You must time the fall and then time the subsequent rise of the market. Just picking one would be a Herculean feat! The famed mid-20th Century investor Bernard Baruch said, “Don’t try to buy at the bottom and sell at the top. This can’t be done … except by liars.”
Obviously, which choice you make is up to you as it is your money that will be invested. However, Your Humble Author hopes that you will see that for the vast majority of us the aggressive growth, sector rotation, momentum, and market timing strategies should be avoided at all costs. Being a growth or contrarian investor is not easy but should be rewarding if executed well. The buy and hold and income strategies are the easiest to implement, not the least of which is because they help us to tame our emotions when we are confronted with adverse markets.
3.S: Summary
Congratulations ‒ You Have Finished Chapter 3 ‒ Introduction to Stocks
You have reached the end of chapter 3, Introduction to Stocks. In this chapter, you have:
You should now be able to:
There is much material in this chapter. Please read it again and study the concepts and terms every day. Remember that your family members, friends, and colleagues are counting on you!
Your Feedback, Please
Did you enjoy our introduction to stocks? As you rummaged about the Internet or library researching the companies in the two assignments, did you find yourself excited about stumbling upon detours into unanticipated intellectual alleyways and dark corners? Did you unexpectedly come across prized nuggets of information about a company that interested you? Or was the research process similar to watching paint dry or worse, visiting the dentist? How was listening to the earnings calls and working through the worksheets? Again, as you did with the mutual fund research, analyze how you felt and what you thought during your studying of the material about stocks and working on the stock assignments. For those enrolled in the class at Southwestern, please post your questions and thoughts and feelings about stocks and your relationship to them on The Stock Steakhouse discussion forum. All others, please contact us directly or join our GroupMe discussion group. Most of all, we hope you are proud of yourselves. As mentioned, there is a ton of material in this Introduction to Stocks chapter but it is of utmost importance for you to know it all thoroughly. Remember: You are one chapter away from being an official Investment Guru for your friends, family, and co-workers. It is a weighty responsibility. You can’t let them down!
Lastly, it is my sincere desire that you are excited and ready for more analysis about stock investing. Why? Because, oh, boy, do we have a treat in store for you! We are going to learn techniques that should tilt the odds of being a successful prudent, long-term oriented stock investor in your favor. But as we will say over and over again, there are no guarantees! We will see you in our next chapter, Chapter 4: Fundamental Analysis: Valuation Models. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/03%3A_Introduction_to_Stocks/3.7%3A_Stock_Investment_Strategies.txt |
“Value matters. You ignore value at your peril.” ‒ Greg Ireland, mutual fund manager with over 35 years of experience
“It is a capital mistake to theorize before one has data.” ‒ Famed Detective Sherlock Holmes (Sir Arthur Conan Doyle)
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
This is it, Dear Students! This is the heart of our course!
In this chapter, we will learn techniques that should tilt the odds in our favor and help us become successful, prudent long-term investors. We will learn how to predict the future price of a stock. Are our predictions guaranteed? Yes, indeed! They are guaranteed to be wrong! They will almost always be very far away from the actual price one, two, three, or four years from now. However, our predictions should help us identify companies that will allow us to build wealth slowly over time. Most of the companies that we identify with these techniques won't make us rich overnight. But on the other hand, they will help us to avoid large losses when the markets hit a downturn, a correction, a bear market, a crash, etc. We want you to eat reasonably well and sleep reasonably well.
• 4.1: Common Stock Valuation
Do any of know what is going to happen in the future? No! So will predicted a stock price in the future be easy? No! Oh, well. We will do our best nevertheless. Stick with us!
• 4.2: Dividend Discount Models (DDMs)
Let's get started on our first set of stock valuation models, the Dividend Discount Models. "Dividends Don't Lie!"
• 4.3: The Discounted Cash Flow Model
This is it! The Discounted Cash Flow Model! This is the model that will transform you into a full-fledged Investment Guru!
• 4.4: The Value Line: All the Financial News That’s Fit to Print
And just where will we get all the data we need for our valuation models? From The Value Line, of course! All the Financial News that is Fit to Print!
• 4.5: The Bottom Line
Finally, what should we do with all our predictions? Ignore them. No, toss them, shred them, burn them! We ask ourselves a simple question: Would I want to own this company?
• 4.S: Summary
Congratulations ‒ You Have Finished Chapter 4 ‒ Fundamental Analysis: Valuation Models
"Measure" by jayninelessons is licensed under CC BY 2.0
04: Fundamental Analysis- Valuation Models
Stock valuation is the process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance. At any given time, the price of a share of common stock depends on investors’ expectations about the future behavior of the security. A fundamental assertion of finance holds that the value of a stock is based on the present value of its future cash flows. The future cash flows of a company are determined by the expected earnings or the expected dividends or both the expected earnings and dividends. Simply put, the worth of a company is primarily based on the earnings the company will produce in the future. But if we knew what was going to happen in the future, it would not be called the future, would it? Professor Burton Malkiel sums up the dilemma perfectly in his acclaimed book A Random Walk Down Wall Street:
“The most fundamental influence on stock prices is the level and duration of the future growth of earnings and dividends. [However,] future earnings growth is not easily estimated, even by market professionals.” ‒ Burton Malkiel
So, if someone were to ask you, “What is the most important factor in determining the future value of a company?” In a few words, you could respond, “Future earnings!” or, “Future dividends!” But do any of us know what is going to happen in the future? No! So is valuing stock going to be easy? No! In fact, it is downright impossible to know what a company will be worth three, four, or five years from now. The best we can do is calculate imprecise estimates.
If it is so difficult, even for professionals, to predict the values of stocks, we might be tempted to just give up, pack it in, and go home. Why bother? Luckily for us, there are techniques that we will learn that will help tilt the odds in our favor. We know beforehand that our predictions have a very low probability of being correct. However, our predictions will help us identify prudent investments that will help us build wealth slowly but surely over the long term. Stick with us, Rising Investment Gurus!
Security Analysis
We are going to embark on the process of security analysis. Security analysis is the process of gathering and organizing information and then using it to determine the value of a share of common stock. We are searching for the intrinsic value of a stock, the underlying or inherent value of a stock, as determined through our security analysis. What is the company worth? The question is, “What security analysis methods or measures does one use to determine the intrinsic value of a company?” Future earnings? Future dividends? Potential capital appreciation? Price/earnings ratio? Financial ratios? Past price performance? Amount of risk? Value is in the eye of the beholder.
Fundamental Analysis
There are two major forms of security analysis, fundamental analysis and technical analysis. We will first tackle fundamental analysis. Fundamental analysis is the examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock. Examples of some of the fundamentals are the competitive position of the company, who are their competitors, suppliers, and customers, the growth prospects for company and its market, their profit margins and company earnings, what assets are available, the company’s capital structure, how much debt do they have, how much equity, etc. There are many other measures that are available to examine. Simply put, the value of a stock is influenced by the performance of the company that issued the stock. The fundamental analyst says, “You are buying companies, not stocks.”
Technical Analysis
Technical analysis is the study of the various forces at work in the marketplace and their effect on stock prices. Those who adhere to technical analysis believe that they can predict the future price of a stock by analyzing the behavior of the stock price’s history or the overall stock market or both. Simply put, the future price of a stock is influenced by factors other than the company’s fundamental future outlook. The technical analyst says, “You are buying stocks, not companies.” We will explore technical analysis much later on.
There are many fundamental analysis valuation models. We will cover a few of the more popular and powerful models. In your investing career, you will possibly want to branch out and experiment with others. Alternatively, you may find that the models we discuss here suit your needs. Either way, in the opinion of Your Humble Author, the use of these models will go a long way toward helping you choose prudent, long-term oriented investments that should withstand the test of time. Please keep in mind throughout our discussion that these models are simply crude guides and their results are not guaranteed. The one aspect that we can be fairly certain of is that our predictions will not be correct. Let’s now get started with our first stock valuation models, the Dividend Discount Models. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/04%3A_Fundamental_Analysis-_Valuation_Models/4.01%3A_New_Page.txt |
One popular group of models of fundamental analysis are the dividend discount models, often abbreviated as DDM or DVM for dividend valuation model. According to the dividend discount models, shares of stock are valued on the basis of the present value of the future dividend streams the stock is projected to produce. Recall that we stated that the value of a stock is based on the present value of its future cash flows. The future cash flows from stocks come from their dividends. Therefore, dividend discount models should be extremely popular, right? During the late 1990’s, investors who adhered to these types of models were considered old fashioned and outdated. But those investors weathered the 2000-2002 downturn very well. Dividends became important again to many investors. “Dividends don’t lie,” is a famous saying. This saying comes from the fact that all the numbers that a company reports on their financial statements could be total fabrications except for one, the dividends. You know the dividends are not a lie because they sent you a check. (Well, actually, they don’t send you a check anymore. The dividends are electronically deposited into your brokerage account but you get the idea.)
The dividend discount models require a discount rate. The discount rate is the required rate of return that we choose to calculate the value of shares of a stock using the dividend discount models. The predicted valuations are very sensitive to our chosen discount rate. Our results will vary widely depending upon our choice. The fact that everyone has a different required rate of return means that different investors will expect and demand different stock prices. Someone might be happy with 6%. Another might expect 10%. A third wants 15%. Mark Twain is reported to have said, “It is the difference of opinion that makes horse races.” This describes the stock market, too.
The term discount rate does cause some uncomfortable looks of confusion from new investors. It does sound a bit strange to many. “Does the discount rate have anything to do with shopping and buying items at a discount?” Uh, no. We will use the terms required rate of return or desired rate of return or expected rate of return. They all mean the same thing as far as the models are concerned.
The Zero Growth Dividend Discount Model
The Zero Growth Dividend Discount Model assumes dividends will continue at a fixed rate indefinitely into the future. It is useful for very mature companies in slow growth or no growth environments. The poster child for the Zero Growth Model is a utility company. Do utility companies grow quickly? In the initial stages of the rapid growth of a city, yes, the local utility will also grow quickly. Think of San Diego County in the 1950’s and 1960’s and San Diego Gas and Electric. However, once the area’s infrastructure is put in place, the utility will grow very slowly, if it grows at all.
The formula for the Zero Growth Model is actually very simple:
``` Annual Dividends Value of Stock = ——————————————————————— Required Rate of Return ```
For an example, let’s assume that a slow-growth company has been paying \$3 of dividends per share for many years and we believe it will continue to do so in the future. If our required rate of return were 6% (0.06), the formula would be:
``` Annual Dividends \$3.00 Value of Stock = ——————————————————————— = ————————— = \$50 per share Required Rate of Return 0.06```
Does the Zero Growth Model look familiar? It is simply another way to view the Dividend Yield which we calculated in the previous chapter. Recall that the Dividend Yield was calculated as:
``` Annual Dividends Dividend Yield = ——————————————————————— Market Price of Stock ```
For those of you who enjoy math, note that we simply swapped the Value of Stock with the Market Price of Stock and we swapped the Required Rate of Return with the Dividend Yield. (For those of you who don’t enjoy math, just ignore the previous sentence and hide the Dividend Yield formula.) The take-away is that investors who emphasize the Zero Growth Model are valuing the stock almost exclusively for its dividend yield. What is the current income the stock is generating from its dividends?
For a real-life example, let’s explore Consolidated Edison, symbol ED, the energy utility for New York City and environs. It started its life as the New York Gas Light Company in 1823 and started delivering electricity in 1882. As of February 17, 2023, ED was paying \$3.24 in annual dividends and we believe it will continue to pay this dividend into the future. Let’s assume our required rate of return is 8% (0.08). The formula becomes:
``` Annual Dividends \$3.26 Value of Stock = ——————————————————————— = ——————— = \$40.50 per share Required Rate of Return 0.08```
The current market price as of February 23, 2023, was \$93.25 per share. However, the model is stating that we believe the stock is worth only \$38.75. Therefore, the model says that the stock is overpriced for our required rate of return. Let’s try a different required rate of return. How about 5%?
``` Annual Dividends \$3.24 Value of Stock = ——————————————————————— = ——————— = \$64.80 per share Required Rate of Return 0.05```
The model again is stating that we believe the stock is too expensive for us. With a market price of \$92.25, the stock is yielding 3.47%. Investors who are happy with a 3.47% required rate of return would believe that ED was correctly priced. Again, the Zero Growth Model works well for stable, income-producing stocks.
Disclaimer: Although they do so very slowly, unlike some other utility companies, Consolidated Edison actually does grow their dividend payments. Therefore, we should really use the next model. However, we simply could not resist showcasing a company that has been in business for 200 years.
The Gordon Growth Dividend Discount Model
The Gordon Growth Dividend Discount Model was named after Myron J. Gordon of the University of Toronto. It is also referred to as the Constant Perpetual Growth Model. This model takes the Zero Growth Model one step further and assumes dividends will continue to grow at a specified rate perpetually into the future. The formula is:
``` ( Annual Dividends * (1 + Dividend Growth Rate) ) Value of Stock = ———————————————————————————————————————————————————— ( Required Rate of Return - Dividend Growth Rate )```
Compare the formula above with the Zero Growth Model. See how “(1 + Dividend Growth Rate)” has been added to the numerator and “- Dividend Growth Rate” has been added in the denominator. (If you substitute zero for the Dividend Growth Rate, you get the Zero Growth Model. That’s yet another insight for you math-friendly folks.)
For an example, let’s investigate a company that is paying \$1 dividend per share. They have been growing their dividend at a constant rate of 5% per year for several years and we believe they will continue to do so going into the future. Our desired rate of return is 10%. Therefore, the formula becomes:
``` ( \$1 * (1 + 0.05) ) ( \$1 * 1.05 ) \$1.05 Value = ————————————————————— = ——————————————— = ——————— = \$21 per share ( 0.10 - 0.05 ) 0.05 0.05 ```
The model is telling us that we believe the stock should be valued at \$21 per share. This model is good for companies with consistent dividend growth. Companies with consistent dividend growth tend to be large, well-established companies with their roots deep in the economy. Historically, they have been some of the stock market’s best performers over the long term. Remember: Dividends don’t lie!
A note about the arithmetic: We must calculate the numerator and denominator before doing the division. That is why we use the parentheses in the formula. Remember to calculate what is inside the parentheses first.
Let’s look at some real-life examples. Our first is the well-known discount retail chain Target, symbol TGT. As of February 19, 2023, their stock price was \$173.22. They are paying \$4.32 per year in dividends. Let’s assume that they have been growing their dividend at 8% per year and that our required rate of return is 13%. The formula becomes:
``` ( \$4.32 * (1 + 0.08) ) ( \$4.32 * 1.08 ) \$4.6656 Value = —————————————————————— = ———————————————— = ——————— = \$99.31 ( 0.13 - 0.08 ) 0.05 0.05 ```
Hmmm. The stock price is \$173.22 and our model tells us that we believe it is worth only \$99.31 if we desire a 13% rate of return. The model is telling us the stock is overpriced if we require a rate of return of 13%. What if we reduce our expected rate of return to 10%? The only change is to the required rate of return and the formula becomes:
``` ( \$4.32 * (1 + 0.08) ) ( \$4.32 * 1.08 ) \$4.6656 Value = —————————————————————— = ———————————————— = ——————— = \$233.28 ( 0.10 - 0.08 ) 0.02 0.02 ```
What a big difference! Do you see how sensitive the model is to our required rate of return? By simply changing our required rate of return from 13% to 10%, Target now looks like a bargain. Do you think that Target is a good value? Would you want to own Target? Remember that whenever we research a company, we also need to investigate their competitors, their customers, their suppliers, the industry they are operating in, etc. We do not simply rely on the results from our models. That would be folly.
Our next example is AbbVie, symbol ABBV, a pharmaceutical company that was spun off from Abbott Laboratories a few years ago. As of February 19, 2023, the market price was \$151.31 and they are currently paying \$5.92 in annual dividends. Again, let’s assume the dividends are growing at approximately 8% per year. Let’s again use an expected rate of return of 13%:
``` ( \$5.92 * (1 + 0.08) ) ( \$5.92 * 1.08 ) \$6.3936 Value = —————————————————————— = ———————————————— = ——————— = \$127.87 ( 0.13 - 0.08 ) 0.05 0.05```
At this market price, AbbVie does not look attractive. Let’s again reduce the desired rate of return down to 10%. Remember that the only change is to the required rate of return:
``` ( \$5.92 * (1 + 0.08) ) ( \$5.92 * 1.08 ) \$6.3936 Value = —————————————————————— = ———————————————— = ——————— = \$319.68 ( 0.10 - 0.08 ) 0.02 0.02 ```
Wow! AbbVie looks like a screaming good deal! However, remember the model is pointing us to companies like AbbVie. As mentioned, this will tilt the odds in our favor. But we now have to spend a whole lotta’ time researching their products, their competitors, customers, suppliers, etc. We can’t rely on the model alone. No, no, no, no, no!
Our third example is Illinois Tool Works. Who or what is Illinois Tool Works? They are one of those companies that have been around for over 100 years and you never hear about them but you are surrounded by their products every day and don’t even know it. Their market price as of February 19, 2023 was \$240.34 and they were paying \$5.24 in annual dividends. If we assume the same 8% per year dividend growth rate and the same required rate of return of 13%, the formula becomes:
``` ( \$5.24 * (1 + 0.08) ) ( \$5.24 * 1.08 ) \$5.6592 Value = —————————————————————— = ———————————————— = ——————— = \$113.18 ( 0.13 - 0.08 ) 0.05 0.05```
Again, at 13%, the model is saying the stock is overpriced. What happens if we again reduce the desired rate of return down to 10%:
``` ( \$5.24 * (1 + 0.08) ) ( \$5.24 * 1.08 ) \$5.6592 Value = —————————————————————— = ———————————————— = ——————— = \$282.96 ( 0.10 - 0.08 ) 0.02 0.02 ```
Maybe we ought to spend more time researching ITW and their competitors. Think of how impressed your friends and family members and colleagues will be when you wax eloquently about large companies important to our economy that they have never heard of.
Now it is your turn to do the calculations. Caterpillar, symbol CAT, is a Dow Jones Industrial company that makes heavy construction equipment. As of February 19, 2023, the market price was \$247.79. They were paying \$4.80 annual dividends and we will assume that they are growing their dividends at 8% per year. Use the model to compute the predicted value at both a 13% and 10% required rate of return. (You should receive \$103.68 for 13% and \$259.20 for 10%.) Did you know that Caterpillar owns Solar Turbines, a local San Diego company that has been operating next to our downturn airport since 1927?
Our last example is Altria, symbol MO, the maker of Marlboro and Virginia Slims cigarettes in the United States. Over a decade ago, Altria spun off Philip Morris International, symbol PM, based in the United States, which is now the company that sells the same cigarettes outside the United States. (Kinda’ bizarre, huh? Philip Morris International is based in the U.S. but does not sell any products in the United States.) As of February 19, 2023, Altria’s market price was \$48.07 and they were paying \$3.76 in annual dividends. If we assume a dividend growth rate of 8% and desire a 13% required rate of return, the formula is:
``` ( \$3.76 * (1 + 0.08) ) ( \$3.76 * 1.08 ) \$4.0608 Value = —————————————————————— = ———————————————— = ——————— = \$81.22 ( 0.13 - 0.08 ) 0.05 0.05```
Whoa! Our model says that Altria is worth \$81.22 if we expect 13% and the current price is only \$48.07. What a buy! Ah, that is, if you conveniently ignore the fact that tobacco kills 400,000 Americans each year. Would you buy Altria or Philip Morris International or their other major competitor, British American Tobacco, makers of Lucky Strike and Camel cigarettes? All three companies are saying that they are looking past the day when cigarettes are no longer sold. (Your Humble Author has a very good idea of what they mean. Who do you think will win big when marijuana becomes legal at the Federal level, eh? Well, at least it's safer than beer.)
Now, after one hypothetical example and five real-life examples, you may be wondering if the Gordon Growth Model is very near and dear to your Humble Author’s heart. You would be right. For all its many limitations, this model is an excellent place to start your research. Please, please, please do not ignore these calculations. They are very easy to do. They will be on exam #2, exam #3, exam #4, and the final exam. You can’t leave BUS-123, Introduction to Investments, without being able to do these simple calculations. It is bad for my self-esteem!
Oh, by the way, you may also be wondering why we simply assumed that the dividend growth rate was 8% for all these companies. Shouldn’t we find the actual dividend growth rates? The answer is, “Yes, of course, we should!” Not only is the model sensitive to our required rate of return, the model is also very sensitive to the dividend growth rate. The recent dividend growth rates of Target, AbbVie, Illinois Tool Works, Caterpillar, and Altria are all 8% or higher. Altria is 8.3%, Caterpillar is 9.3%, Target is 10.6%, Illinois Tool Works is 13.9%, and AbbVie is 15.5%. All these companies are growing their dividends faster than 8% per year. However, the model does not work if the required rate of return is equal to or less than the dividend growth rate. You get bizarre and anomalous results such as division by zero or negative expected prices. Therefore, we should actually raise our expected rates of returns for all of these companies! According to the model, all these companies are actually better buys than what our initial results were telling us for our required rates of return. Note that these are blue chip companies with long histories of rising dividends. But they are not alone. However, before 2022, it had been harder and harder to find good prospects using this model. Translation: Many stocks were very expensive before the 2022 downturn. That has changed. As of February of 2023, there are more companies that are priced attractively using this model.
The Constant Growth Dividend Discount Model
The Constant Growth Dividend Discount Model assumes dividends will continue to grow at a specified rate for a specified number of years. This model takes the Gordon Growth Model one step further, adding a term to account for constant growth for a set number of years. This is similar to how the Gordon Growth Model evolved from the Zero Growth Model, adding an additional term to account for the consistent growth of dividends. We are going to use a fancy equation editor to display the model. Relax. Before you drop the class, know that we are not going to use this model. We are only showing it to you so you can see how much energy has been put into building these models. The Constant Growth Dividend Discount Model formula is:
Aye! Scary math stuff! Just gotta’ love those math folks, eh? They use single characters to denote quantities when we normal folks would use an entire descriptive word. The equation is using D as the annual dividend, g as the dividend growth rate, r as the required rate of return, and T as the number of years of growth. The formula computes what we believe the Value of the stock is worth. The ? means that we are afraid that this equation is going to scare students away. Remember we are not going to use this model. Please keep reading. Please don’t drop the class.
Do you see what they have done? The left side of the formula is the Gordon Growth Model that we just studied. To the Gordon Growth Model, they have added another term that takes into account the growth for a set number of years. When using this model, you are asked to estimate just how long the company will be growing their dividends. That is a dubious speculation at best.
Wait. It gets worse.
The Two-Stage Dividend Growth Discount Model
The Two-Stage Dividend Growth Discount Model, also known as the Variable Growth Model, assumes dividends will continue to grow at a specified rate into the future (presumably the fast-growth stage) and then grow at a second (presumably slower growth rate once the company matures). Here it is, Friends:
Are you impressed? Well, this model may look very impressive, especially to those who love math, but it has some serious problems. It is very difficult to accurately predict future dividend growth during the initial fast growth stage of a stock. Usually, companies do not pay significant dividends while they are growing quickly because they need the earnings to reinvest in the growth of the company. Again, we show you this model not because we believe it is actually a worthwhile model. We don’t use it and we certainly don’t want you to use it! We show it to you to demonstrate the lengths to which investors have gone to determine the value of companies. Many decades ago in The Intelligent Investor, author Benjamin Graham warned against using overly sophisticated mathematical models to value stocks.
Observations of the Dividend Discount Models
Let’s take a few moments to reflect upon the various Dividend Discount Models that we have covered. One serious issue with the models is that dividend growth rates are very difficult to estimate. With large, well-established companies that have consistently been growing their dividends for a significant period of time, historical growth rates may be useful. But with fast growing companies in new industries, it is almost impossible. However, a more important question arises: How do you use these versions of the models for companies that aren’t paying any dividends? The simple answer is, “You can’t!” If a company is not paying dividends, then the present value of the future stream of no dividends is zero! These models say that a company that does not pay any dividends is worthless. This is obviously not true. The problems of the previous Dividend Discount Models notwithstanding, repeat after me: “The value of a stock is based on the present value of its future cash flows.”
Now, if only there were a model that could value a company that is not paying dividends. Ah, Dear Students, read on. You are all about to become full-fledged Investment Gurus! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/04%3A_Fundamental_Analysis-_Valuation_Models/4.02%3A_New_Page.txt |
A powerful version of the Dividend Discount Models is the Discounted Cash Flow Model. This model states that the value of a stock is equal to the present value of all its expected future cash flow, not just its dividends. The Discounted Cash Flow Model formula is:
The cash flow for each year, CashFlow1, CashFlow2, CashFlow3, etc., is divided by the quantity (1 + Rate)1, (1 + Rate)2, (1 + Rate)3, etc., for as many years as we can reasonably estimate the future cash flows. Relax. We promised you that you did not have to do any exponentiation and we are not going back on that promise. We will do the exponentiation for the following example and then show you how we avoid the exponentiation. Your 99¢ calculator will still suffice.
Let’s say a company is going to pay their shareholders three annual dividends of \$10 per share and from then on, there will be no more dividends. Let’s set our required rate of return to 7%. The calculations are:
``` \$10 \$10 \$10 \$10 \$10 \$10 Value = —————— + ——————— + ——————— = —————— + ———————— + ———————— ≅ \$26.24 1.07 1.072 1.073 1.07 1.1449 1.2250 ```
The model is saying the company’s stock is worth \$26.24. But how often do companies pay three annual dividends and then promptly go out of business?! Plus, we keep using this term “present value.” What does present value mean anyway?
What is Present Value?
Present value is the value today of a lump sum principal or series of payments to be received at some future date. It is the opposite of future value. Present value and future value are inverse operations. We say that present value and future value are “two sides of the same coin.” Future value tells you what a single investment or series of investments made today will be worth in the future. Present value tells you what a single quantity or series of quantities that you receive in the future is worth today in the present. The present value tells us what cash flows received in the future are worth today.
There were some optional future value calculations in chapter 1. One of the problems asked you to compute the future value of a \$10,000 lump sum investment in 10 years if we received an 10% average annual rate of return. We could use the exponential formula but instead, we use the future value multiplier from the future value table. We go across to 10% and move down to 10 years and find that the future value multiplier is 2.594.
We then multiply the \$10,000 investment by the future value multiplier of 2.594 and that gives us a result of \$25,940. The future value of \$10,000 at a 10% average annual rate return for 10 years is \$25,940. If we invest \$10,000 today and receive a 10% rate of return, in 10 years, we will have \$25,940.
What if we wanted to do the opposite? What if we wanted to determine how much a result that we receive in the future is worth to us today in the present? In other words, what is the present value of that payment that we will receive in the future? Again, there is an exponential formula but we promised you that you would not have to use exponents. We compute the present value using the same technique as the future value calculation except we will use the present value table. Let’s say we are going to receive \$25,940 in 10 years. If we desire a 10% annual rate of return, what is that \$25,940 worth to us today? In the present value table, go across to 10% and down to 10 years. The present value multiplier is 0.386.
We multiply the \$25,940 by the present value multiplier of 0.386 and the result is \$10,012.84. The result is not exactly \$10,000 because the table is only using three digits of accuracy. If we had used 7 or 8 digits after the decimal point, we would receive \$10,000 exactly as our result.
So, what would you rather have, \$10,000 today or \$25,940 in ten years? If our required rate of return is 10%, they are equivalent. The future value of \$10,000 in 10 years at 10% is \$25,940. The present value of \$25,940 in 10 years at 10% is \$10,000. They are two sides of the same coin! Calculating the future value of investments made today is called compounding. Calculating the present value of payments received in the future is called discounting. Oh, no! There’s yet another weird sounding phrase! I know. I know. “Discounting a stream of future cash flows” sounds kinda’ dumb but get used to it because those are indeed the words we use. Look, all it means is that we are going to look up numbers in the present value table and then multiply them. You Can Do It! Again, all you need is a 99¢ calculator and the present value table.
What is Discounting a Stream of Future Cash Flows?
We are going to take payments that we receive in the future and calculate what those future payments are worth today. We say that “we are discounting those future payments” back to the present. The process is actually very easy but the words get in the way. Let’s use the present value table and redo the example above of three annual dividends of \$10 at an annual rate of 7%. We go to the present value table and find the present value multipliers for years 1, 2, and 3 at 7%.
The present value multipliers are 0.935, 0.873, and 0.816. We then multiply the future cash flows of \$10 per year by each of the three present value multipliers:
Value = \$10*0.935 + \$10*0.873 + \$10*0.816 = \$9.35 + \$8.73 + \$8.16 = \$26.24
Now that wasn’t so bad, was it? For many students, doing the calculation is often much easier than understanding what the terms present value and discounting actually mean. So please do not worry if you are still a bit confused about what the words mean. Just do the calculations … over and over and over again. The meanings will shine through soon. Another way of displaying the problem involves using a table:
Year Future Cash Flows Present Value Multipliers7% Discounted Cash Flows
#1 Dividend of \$10 0.935 \$9.35
#2 Dividend of \$10 0.873 \$8.73
#3 Dividend of \$10 0.816 \$8.16
Total: \$26.24
Many find the table format is much easier to use. You multiply each year’s future cash flow by the year’s present value multiplier to get the discounted cash flow. You then compute the sum of the discounted cash flows. That gives you the present value of the future stream of cash flows.
Examples of the Discounted Cash Flow Model
We are ready to put the Discounted Cash Flow Model into practice. Our first example did not take into account that the stock will still have worth at the end of the three years. To make the model more useful, we simply add our predicted market price of the stock at the end of the three years to the present value calculations. We treat the price of the stock at the end of the three years as a future cash flow that needs to be discounted. What if the current stock price were \$125 and we predicted the stock price to be \$135 at the end of three years? We add the price of the stock in the last year to the table above:
Year Future Cash Flows Present Value Multipliers7% Discounted Cash Flows
#1 Dividend of \$10 0.935 \$9.35
#2 Dividend of \$10 0.873 \$8.73
#3 Dividend of \$10 0.816 \$8.16
#3 Expected stock price of \$135 at the end of year #3 0.816 \$110.16
Total: \$136.40
Notice that the present value multiplier for the expected stock price is the same as the dividend future cash flow in year #3. This is because the dividend in year #3 and the expected stock price at the end of the third year are both cash flows that we receive in the third year. We therefore use the same present value multiplier. When we sum the discounted cash flows in the last column, we compute a present value of \$136.40. The current stock price is \$125. The model is telling us that if we require a 7% annual rate of return, the stock is worth \$136.40 while the marketplace is offering us the stock at \$125. The model is saying that this stock is a potentially good investment for us if our desired rate of return is 7%.
DISCLAIMER: WARNING: REPUDIATION: DISAVOWAL: REFUTATION: ABNEGATION: RENUNCIATION: In no way should we make a final decision, either yea or nay, about whether or not we should buy or sell any stock simply based on the results of this or any other model. We are using these models to point us in the right direction. We are attempting to tilt the odds in our favor. We have a whole lot more research that we need to do before we actually decide to choose a stock as one of our investments. Got it? Good. Just wanted to make sure. Let’s continue.
Example #2: Pretzels Unlimited, symbol PU, is a stolid, imaginary company that has been making pretzels and other baked goods for almost 100 years. Their stock is currently selling for \$22 per share and will pay \$2.00 per share in dividends in 2023. PU expects to increase their dividends to \$2.20 in 2024, \$2.30 in 2025, and \$2.30 in 2026. We will be selling the stock at the end of 2026 and we expect the price to be \$27 per share at that time. Our required rate of return is 12%. We put the years in the first column and the future cash flows in the second column.
Year Future Cash Flows Present Value Multipliers12% Discounted Cash Flows
2024 \$2.00 0.893 \$1.786
2025 \$2.20 0.797 \$1.7534
2026 \$2.30 0.712 \$1.6376
2026 \$2.30 + \$27 = \$29.30 0.636 \$18.6348
Total: ≅ \$23.81
Find the present value multipliers for years 1 through 4 at 12% in the present value table. Did you find 0.893, 0.797, 0.712, and 0.636? The present value multipliers go in the third column. With your 99¢ calculator, multiply the future cash flows by the present value multipliers to compute the discounted cash flows in the last column. Last, sum up the discounted cash flows in the last column to compute the present value. The model is saying that PU is worth \$23.81 if we require a 12% rate of return. However, the price of the stock is only \$22. The model says that this stock is possibly an attractive investment for us. We need to do much more research but this is a good start. PU is a stock that might just make it into our portfolio.
Notice that we added the expected stock price in the last year to the dividend in the last year. This allowed us to skip a multiplication. But more importantly, it also allows us to utilize a very powerful spreadsheet function to calculate the Internal Rate of Return.
The Internal Rate of Return
The Internal Rate of Return is a measure of what rate of return we expect to get from a series of cash flows, including positive and negative flows. In other words, we required a 12% rate of return from Pretzels Unlimited, but what do our numbers tell us will be our expected rate of return? Someday, when you take an upper-level or graduate finance or investment class, you will learn how to manually compute Internal Rate of Return. Hopefully, you will not have a sadistic professor who will require you to calculate it manually more than once! We are simply going to enter the numbers into the spreadsheet formula and press the [Enter] key, okay?
For those not familiar with an electronic spreadsheet, know that they are just like our 99¢ calculator, just a whole lot more powerful. We use Google Docs which is free to anyone who has a Google account. You may use Microsloth Excuse or maybe even LibreOffice or OpenOffice. They all work the same, kinda’ like a giant Bingo game. The spreadsheet formula is:
=IRR(values,approximate-rate-of-return) where
values is the block of cells containing the cash flows, both positive and negative, and
approximate-rate-of-return is our guess as to what the Internal Rate of Return will be
In cell C10, the formula is =IRR(C4:C8,0.12) This tells the spreadsheet to use the cash flows in cells C4, C5, C6, C7, and C8. The 0.12 (12%) is our guess of what the result will be. We can just leave it as zero and ask the spreadsheet to do its best to find the result. Notice that we must include in the initial price of the stock as a cash outflow, a negative number, in cell C4. Internal Rate of Return calculations require all cash flows, both inflows and outflows. So, what is the result from the Internal Rate of Return calculation telling us? If we pay \$22 for the stock today and then we receive the expected dividends over the next four years and the stock is worth \$27 at the end of the four years, our Internal Rate of Return will be 14.51%, better than our 12% desired rate of return.
Here is the spreadsheet on the class website. You will notice that it has two pages. The first page allows us to simply put in the cash flows and the spreadsheet will automatically calculate the present value. There is no need for us to look up the present value multipliers, multiply, and then sum the results. The second page automatically calculates the Internal Rate of Return formula calculation. Pretty handy, these electronic spreadsheets! And they are free, too, if we use Google Docs or OpenOffice or LibreOffice. Who needs to pay some company that shall remain unnamed (Micro\$oft) that treats its customers like vermin, continually requiring them to endure painful and costly upgrades in the hopes that someday, somehow, their programs might actually work? (I know. I have a pathological disgust of that unnamed company. Nobody’s perfect, eh?)
But What If a Company is Not Paying Any Dividends?
When we reviewed the problems with the initial Dividend Discount Models, we found that they simply did not work if the company was not paying any dividends. The present value of nothing received in the future is zero. This is not the case with the Discounted Cash Flow Model. Unlike the other Dividend Discount Models, the Discounted Cash Flow Model can still be used if there are no dividends. We simply treat the expected future price of the stock as a single future cash flow. Very cool!
Example 3: Genes ’R’ Us, symbol GRUS, an exciting, dynamic, make believe San Diego-based biotechnology company, is currently selling for \$21 per share. It pays no dividends and is currently losing money. They are working on a drug that will cure baldness. We believe that GRUS will sell for around \$50 per share in five years. Our required rate of return is 13%. How can we determine if this is a potentially good investment?
Let’s construct the the cash flow table:
Year Future Cash Flows Present Value Multipliers12% Discounted Cash Flows
2023 \$0 0.885 \$0
2024 \$0 0.783 \$0
2025 \$0 0.693 \$0
2026 \$0 0.613 \$0
2027 \$0 + \$50 = \$50 0.543 \$27.15
Total: \$27.15
Actually, we did not need to construct the entire cash flow table. All we really needed was 2027, year #5, since the present value of zero dividends is zero. We could have simply multiplied \$50 by the present value multiplier for 13% for 5 years, 0.543. \$50 future value times 0.543 equals \$27.15. The model is telling us that we believe GRUS is worth \$27.15 while it is selling for only \$21 per share. Once again, the model is pointing us in the direction of the company as a potentially worthwhile investment.
Unlike the table above, when we use an electronic spreadsheet to calculate the Internal Rate of Return, we are forced to include all the years, even those with no cash flow:
Year Cash Flows Internal Rate of Return
(\$21.00) Initial cash outflow is negative \$21.00
2023 \$0 There are no dividends
2024 \$0
2025 \$0
2026 \$0
2027 \$50.00 Expected price of stock in 5 years
18.95% =IRR(B2:B7,0.13)
If Genes ‘R’ Us does reach \$50 in five years, then we will have achieved almost a 19% rate of return. Pretty awesome!
Wait a minute! Hopefully, by now, you can now look at both Pretzels Unlimited and Genes ‘R’ Us and make some simple observations. Which company is the safer alternative? Which company is offering their investors cash each year and growing that stream of income? If you answered, Pretzels Unlimited, you have been paying close attention. Which company is the more risky investment? Which company offers the potential for great reward but also could fall down, crack open, and dissolve into a pool of tears? If you answered, Genes ‘R’ Us, give yourself a gold star for today’s very important lesson.
Pretzels Unlimited could easily be one of the blue-chip or income-oriented companies, big, stodgy, growing at a very slow pace or simply not growing at all and throwing off gobs of cash to their investors because they just don’t need the money to reinvest in the company anymore. Genes ‘R’ Us, on the other hand, could easily turn our \$500 or \$1,000 investment into \$50,000 if they hit the big time because their drug works and is approved by the authorities as safe and effective and everyone who is bald is going to fork over gobs of money to buy it. However, Genes ‘R’ Us could also easily turn our \$500 or \$1,000 into 50¢ when it turns out the drug doesn’t work or turns people’s livers into pate. If the truth be told, a half million years ago, Your Humble Author was a sucker for these small, biotechnology startups based here in San Diego. I would go to the annual meetings and talk to the employees. The technology was so cool and was going to change the world and, uh, well, it didn’t always work out the way it was supposed to. Luckily for me and my wife, I only put a tiny percentage of our investments into these very speculative ventures. I called it our “Vegas Fund” … and it lived down to its name. Now I concentrate on companies like Pretzels Unlimited and call the account our “Benjamin Graham Fund.”
We are not saying that you should never choose a Genes ‘R’ Us as one of your investments. We are not saying that you should only choose companies like Pretzels Unlimited. However, for the vast majority of us individual investors without the benefit of global research teams based all around the world speaking dozens of languages, the Pretzels Unlimited’s of the world are more likely to help us successfully build prudent, long-term wealth. How ‘bout this strategy? For every one Genes ‘R’ Us you find, choose four or five Pretzels Unlimited’s. Would that work for you?
What is most important from this discussion is that you learn to identify the risks inherent in the companies you research. We want you to have your eyes wide open. If you do choose a speculative issue such as Genes ‘R’ Us, have the courage of your conviction and we wish you the best of luck and success. But realize that you are assuming a large risk. You are taking a big gamble. Be prepared for volatility. (Translation from personal experience: “I bought it at \$11.88 and I sold it at 30¢.” That was Alliance Pharmaceuticals. They were working on artificial blood! No more blood banks or pleas for people to donate blood! Uh, don’t bother looking for them. Alliance Pharmaceuticals is gone, not the blood banks. The SEC officially revoked their securities in 2013 but they were long gone way before then. That was one of my speculative issues. Remember that speculation is our industry euphemism for, “Aye! I lost a lotta’ money!”)
You know what is next, right? We once again revisit Mr. Benjamin Graham’s definition of an investment:
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” ‒ The Intelligent Investor, Benjamin Graham
We also revisit our original definition of an investment:
“An investment is any vehicle into which resources can be placed with the expectation that it will generate positive income, or that its value will be preserved or increased, or both."
So now when you approach a potential investment, you will look at it with fresh eyes. You will investigate what type of cash flows the investment will return to you in the form of income or capital gains or both. You also now have the tools to value those future cash flows, the Dividend Discount Models, including the very powerful Discounted Cash Flow Model, and the equally powerful Internal Rate of Return calculation, given to you courtesy of an electronic spreadsheet. You will also be able to estimate the relative risk of the investment. Congratulations, Dear Students, you are now official Investment Gurus!
You Must Learn How to Discount a Future Stream of Cash Flows!
We know that for some individuals, as soon as they see numbers and formulas and symbols and calculations, their mouths become dry, their eyes gloss over, and they vow to completely ignore whatever they see in front of them. Don’t do it! Don’t Give Up! Never Give Up! Go back and read the above sections again. Listen to or watch the accompanying presentation. Practice the calculations and the worksheets. There are answer keys and commentaries. Do them. If they don’t make sense and you are confused and you get the wrong results, go play volleyball or walk the dog or ride your bike. Then come back and do it all over again. You Can Do It! The calculations are very easy once you do them a few times. Remember that all you need is a 99¢ calculator and the present value table. Learn to use the free electronic spreadsheets and you don’t even need the calculator or present value table. You can’t leave BUS-123, Introduction to Investments, without knowing how to discount a future stream of cash flows. These calculations are going to be on exam #2, exam #3, exam #4 and the final exam so you may as well learn how to do them now. You must learn how to discount a future stream of cash flows! (Please. Remember it is really bad for my self-esteem if you don’t.)
Other Valuation Models
As mentioned, there are numerous valuation models. We have concentrated on the Dividend Discount Models. One of my favorite aspects of investing is that a person will never, ever learn all that there is to know about investments. You have the rest of your life to explore the various models. Please contact me when you find a model that is as good or better than the Discounted Cash Flow Model, okay?
You may be thinking, “Okay, Mr. Know-It-All, this is all great, but just where are we supposed to get all this historical information, anyway? And just who decides what next year’s earnings or dividends per share, the dividend growth rate, etc. are going to be, let alone the expected price of a stock in 3 to 5 years?!”
Before the Internet (BI?), this information was not readily available. Normally, you would ask your broker for it or you would use one of the securities industry’s trusted information sources. Traditionally, the most respected source was The Value Line, the subject of our next section. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/04%3A_Fundamental_Analysis-_Valuation_Models/4.03%3A_New_Page.txt |
The Value Line is an investment research company that collects data and analyzes the performance of thousands of companies. They have been around for decades and are still one of the most respected and trusted sources of data and analysis. Traditionally, it was often the only source many investors used for data and analysis of a stock, along with the company’s annual and quarterly reports, the 10K's and 10Q's. The Value Line is expensive but can be obtained for free at various libraries. Your Humble Author is a big fan of The Value Line, especially their Timeliness and Safety indicators. One study which ignored transaction costs and tax consequences only used their Timeliness indicator. It showed how you would have beaten the market handsomely over a twenty-year period by just buying and selling stocks as they received and lost their #1 Timeliness designation.
Recently, The Value Line has switched to the so-called “freemium” business model that is very popular with Internet websites. An individual has access to some of their data for free on their website but must subscribe to one of their packages to get all the data on companies.
A Sip from the Financial Fire Hose
Let’s take a sip from the financial fire hose. Scan through the The Value Line February 11th, 2022, report for Johnson ‘n’ Johnson, the medical company. Can you find the following?
Do you see the highlighted historical yearly dividends? From them, we can easily compute the dividend growth rate. Do you see the predicted price in three, four, or five years? Yes, they are giving us a range and we must use our own judgment but at least now we have a prediction from a company with a long track record of excellent results. By the way, do you remember when we were discussing mutual funds and we said approximately a 20%, 25%, or 30% annual turnaround was recommended? That means the mutual fund managers are holding on to their stocks for an average of 3, 4, or 5 years. That is about as far into the future that anyone would dare predict, including The Value Line.
Plus, did you look at the Annual Rates section? The Value Line has already computed the dividend growth rate for the past 5 and 10 years and is giving us their prediction for the dividend growth rate for the next three to five years. We could compute our own historical growth rate for whatever number of years we wanted or we could use their computed historical growth rates. And we could use our own judgment for the dividend growth rate going into the future or use theirs. Last, read the analyst’s report. It gives you a very good idea of where the company is and where they are heading. Your Humble Author does not make any decision about an individual stock without consulting The Value Line!
Example Stock Predictions using Our Models and Data from The Value Line
Now let’s use the data from The Value Line to compute the Gordon Growth Model, the Discounted Cash Flow Model, and the Internal Rate of Return for Johnson ‘n’ Johnson. We are breaking the spreadsheet into three parts below. However, when you use the spreadsheet, you will see all three parts on one page.
In the shaded areas, we enter the historical dividends per share, the current price, the predicted price in 3, 4, or 5 years, and The Value Line’s predicted dividend growth. The spreadsheet does the rest! This part calculates the Gordon Growth Model predictions. Note how our choice of required rate of return changes the prediction results drastically.
Here we calculated the predictions from the Discounted Cash Flow Model using both the average dividend growth rate of 6.00% over the past seven years and The Value Line’s predicted dividend growth rate of 6.5%. They yield very similar results.
The Internal Rate of Return calculations using both average dividend growth rate and The Value Line’s predicted dividend growth rate again give us similar results. Would you consider owning Johnson ‘n’ Johnson? Ah, have you ever used Q-tips or Band-Aids? How ‘bout Tylenol? Oh, by the way, you may have gotten their Covid-19 one-dose vaccine, too.
I can hear you saying, “Aye, Paiano! Do we have to use the spreadsheet? It’s so confusing!” We promised that you could perform all the calculations in this course with a 99¢ calculator and we have kept that promise. You can do all these calculations manually but wouldn’t you rather bang away at the spreadsheet until you figure out how to use it. It really ain’t that hard! Again, spreadsheets are kinda’ like a big Bingo calculator: B3 + N15 - G11 … and so forth. The real prize here is that all we need to do is consult The Value Line for the data to go into our spreadsheets or to use in our manual calculations. Are you excited? Are you ready? Good! Because, ...
Now it’s your turn! Find a library near you that has The Value Line. Before you go, think of a few companies that you would like to research, maybe downloading their annual reports from their websites beforehand. Ask the reference librarian for The Value Line packages. Find the Index of companies in alphabetical order. The Index will tell you which packet contains the company you are seeking. The Value Line groups competitors close to one another so you can easily look at the competition. Get lost! Ah, in a nice way, that is. Have fun! Before you leave the library, flip through The Value Line Index and gawk at the sheer number of publicly traded companies. Could any one person ever become qualified to give advice on more than a small percentage of the companies available? Is it any wonder that mutual fund companies have entire global research teams of highly qualified individuals? In my humble opinion, this is a great opportunity for us individual retail investors. There will never be an end to how much you can learn! You now have a lifelong, fun-filled, profitable hobby. You’re welcome, by the way.
Some speculators and traders love to trash The Value Line. “They are old-fashioned! They are stodgy and out-of-touch!” The Value Line makes mistakes, too, just like everybody else. But it would be very illuminating how their long-term results stack up against the long-term results of The Value Line! Who do you think would have the better results? | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/04%3A_Fundamental_Analysis-_Valuation_Models/4.4%3A_The_Value_Line%3A_All_the_Financial_News_Thats_Fit_to_Print.txt |
Video - Audio - YouTube (Material for this section begins on slide 47.)
Okay now, once we have finished all our valuation calculations, what should we do? Should we really place much value in our predictions? The answer is an emphatic, “NO!” Rather, we should…
• Hurl them into the vast ocean along with the ashes of our dead pets and relatives, or
• Shred them into millions of little pieces and use them as confetti at our next party, or
• Burn them in a huge bonfire as we dance naked under the full moon, or all three!
We know beforehand that as we make these calculations that there is a 99.99% chance that they will be inaccurate. So why do we perform them? We do these calculations to simply tilt the odds in our favor. These calculations help us identify companies that are prudent, long-term oriented investments. They won’t make us wealthy quickly, but they will make us wealthy. To quote a very wise, long-term investor, “I don’t have to win big. I just have to win.”
Instead of placing any significance in our predictions, after we have finished all our calculations and predictions and soothsaying and tea-leaf reading and magical prestidigitations, we should ignore out predictions and ask ourselves a very simple question: Do I want to own this company? Mr. Warren Buffett suggests asking yourself, “If I had the resources to buy the entire company, would I want to own it outright?” If the answer is yes, go ahead and buy 10 shares or whatever you believe is prudent or what you can afford. (Ah, he can buy the entire company and he often does!) In his excellent book, One Up On Wall Street (which you are going to read soon, right?), Mr. Peter Lynch detailed how after he had done all his research and calculations and placed them all in a three-ring binder, he would hold the three-ring binder up in front of himself and give himself the 60- to 90-second story about the company. Why did he want to buy or sell or hold the company? That usually sealed his decision, one way or the other.
Recall how Mr. Benjamin Graham wanted us to avoid any investment strategy that removed human judgment from the process? Your judgment is the ultimate valuation method. You will make some mistakes. You will make some very good choices. As time goes by, your experiences will hone your judgment skills and you will become excellent, prudent, long-term investors. Be kind to yourself and, as Mr. Benjamin Graham states, have the courage of your conviction.
We will let the famed investor, Mr. Seth A. Klaman, have the last word on valuation methods:
“The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones. Any attempt to value businesses with precision will yield values that are precisely inaccurate.” ‒ Margin of Safety, Seth A. Klaman
4.S: Summary
Congratulations ‒ You Have Finished Chapter 4 ‒ Fundamental Analysis: Valuation Models
You have reached the end of chapter 4, Fundamental Analysis: Valuation Models. In this chapter, you have:
You should now be able to:
You Have Risen, Dear Student. You are now an official Investment Guru!
You have been initiated into the Sacred Temple of the Dividend Discount Models. It is a great privilege and honor, Dear Student, but it also carries tremendous responsibility. Never again can you look at a potential stock investment the same. You now will look at any potential stock investment through the eyes of one who understands how to value a future cash flow, whether it be from the dividends that the company pays or the expected future stock price or both. Congratulations! Go forth into the world, rejoicing in the power that you have been given. Help yourself and others! Identify and choose prudent, long-term stock investments that have done well in the past and should continue to do well into the future. Oh, and by the way, you are welcome.
Work through the examples and worksheets in this chapter over and over again until you can do them in your sleep. Then get out there and find companies that interest you and use these same models on them. What do the models say the companies’ stocks are worth? How is the market pricing their stocks? Finally, throw away all your calculations and ask yourself, “Do I want to be a partner in this company? Do I want to own a piece of this business?” We wish you the best of luck and success. It is our sincere desire that you become the best investors the world has ever seen!
There is a Future for You in the Investment Services Industry
Yeah, yeah, we know. You have heard it before. We want you to consider a career in the industry. Ah, we did mention that salaries in the financial and investment industries are well above the national norms, right? Okay, we just wanted to be sure.
Your Feedback Please
Yeah, yeah, we know. We’ve already asked you to give your feedback. So why do it again? Because we value your feedback greatly. Are you getting an education? Is the material too difficult? Too easy? What could we do better? What did we do well? For this to be the best class you have ever taken, we need your input!
Now that you have been introduced to a few valuation models, it is time to spend a bit of effort learning how to read financial statements. Relax, you Accounting students! We don’t do any journal entries or trial balances or any other accounting procedures. We just use the financial statements that the company’s accountants have created. See you in our next chapter, Chapter 5: Fundamental Analysis: Financial Statements and Ratio Analysis. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/04%3A_Fundamental_Analysis-_Valuation_Models/4.5%3A_The_Bottom_Line.txt |
“If an accountant’s spouse cannot sleep at night, all he or she has to say is, “Dear, tell me about your day at work.”
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Ratio Analysis Rounds Out the Investigation of Our Potential Stock Investments
In the previous chapter, we learned some powerful techniques that give us a “yes/no, continue researching/don’t continue researching” kind of answer, even though we know that we should never place much credence in the result. In this chapter, we learn how to compute and analyze many financial ratios using the financial statements that a public company must publish quarterly. Financial ratios do not give us a “yes/no” answer about an individual stock. Rather, we treat financial ratios like a stew of information that gives us a more rounded analysis of our potential investment and allows us to compare our stock with its competitors and the market as a whole. The financial statements that we utilize to compute our financial ratios are also very handy whenever we are experiencing a bit of sleeplessness. Just ask any accountant's spouse!
• 5.1: Financial Statements
Every publicly-traded corporation must publish their financial statements every three months. The three financial statements are the Balance Sheet, the Income Statement, and the Cash Flow Statement. Luckily, the accountants are tasked with creating the financial statements. We investors just need to learn how to read them and pick out the important elements. We use the financial statements to create financial ratios that help us "round out" our research into our potential stock investments.
• 5.2: Common Stock Ratios
The Common Stock Ratios convert key information about a firm to a per share basis. Most are readily available from all stock information sources.
• 5.3: Profitability Ratios
The Profitability Ratios are popular ratios that measure a firm’s returns by relating profits to sales, assets, equity, and invested capital.
• 5.4: Liquidity Ratios
Liquidity Ratios measure a firm’s ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due. "Can we make payroll this week?"
• 5.5: Activity Ratios
Activity Ratios measure how well a firm is managing its accounts receivable, inventory, and total assets.
• 5.6: Leverage Ratios
Leverage Ratios are used to measure the amount of debt being used to support operations and the ability of the firm to service its debt.
• 5.S: Summary
Congratulations ‒ You Have Finished Chapter 5 ‒ Fundamental Analysis: Financial Statements and Ratio Analysis
05: Fundamental Analysis- Financial Statements and Ratio Analysis
Financial Statements come from the world of Accounting, which has established so-called Generally Accepted Accounting Principles (GAAP) to guide their actions. The financial statements are created using GAAP techniques to communicate to the world the financial situation and financial performance of a company. Fortunately, we investors don’t have to perform any of the accounting. We rely on the accountants to create the financial statements for us. However, the more we know and understand Accounting, the better we will be able to understand and analyze the companies we are researching using the financial statements and other reported financial data.
Recall from our Introduction to Stocks discussion that once a company “goes public,” it is now a public entity and as such, has certain responsibilities and obligations that private companies do not have to concern themselves with. One of the most important obligations is publishing the financial statements every quarter. Accounting firms pride themselves in following the rules and there is rarely ever any controversy with regard to the financial statements of most all bona fide companies and their Accounting firms.
However, this is not always the case. From time to time, you will hear in the news that a company must “restate their earnings” or “refile their financial statements.” Something somewhere went wrong. Given the complexity of large, multinational corporations, it is only a matter of time before some unintentional errors will snake their way into the numbers. However, there are times when the corporations and the accountants aren’t always on the up and up. In fact, some corporations, in collusion with their accounting firms, have used gimmickry and trickery and downright fraud to “cook the books.” One of the most egregious examples of this was the case of Enron, formerly Houston Natural Gas.
Enron Corporation was an American energy, commodities, and services company. At the time, the bankruptcy of Enron was the largest bankruptcy in recorded history. The company, with the help of their accounting firm, was engaging in accounting fraud. Their accounting firm, Arthur Anderson dissolved as a result of their association with the fraud and their confessed accounting sleight-of-hand and trickery. When the scandal hit, the corporate executives at Enron claimed ignorance. “We didn’t know that there was any accounting hanky-panky going on!” The executives were subsequently called to Congress to testify. One of those executives was Jeffrey Skilling, the former CEO of Enron, who had previously bragged about creating value out of thin air when Enron was flying high. He was now feigning ignorance about the whole misadventure, under oath and in front of Congress. There was one exchange with Senator Barbara Boxer from California about one of the more egregious accounting maneuvers Enron had used. Mr. Skilling firmly proclaimed that he was totally unaware that the maneuver was illegal. Senator Boxer asked, “Where did you go to school?” Mr. Skilling replied flatly, “Harvard Business School.” Those in attendance burst out laughing.
As a result of Enron and other scandals of the time, including WorldCom, Tyco, HealthSouth, and Global Crossing, the United States Congress passed the Sarbanes-Oxley Act of 2002. Under this law, corporate executives can be held responsible for the published financial statements of their accounting firms.
Now you understand why we love to say that, “Dividends don’t lie.” All the numbers on the following three financial statements could be, and on rare occasions are, completely made up, picked directly out of thin air, stupid wild fantasy guesses. All, except one. And that is the dividend. We know the dividend number is not a lie because the company wrote us a check. (Well, not exactly. The money is deposited electronically into our brokerage account. But you get the idea.) Even so, financial statement manipulation, accounting gimmickry and trickery, and outright fraud have always been with us. They will always be with us. That is also why we recommend large companies with their roots deep in the economy and long histories and earnings and dividends as the bulk of your investment portfolio.
Disclaimer: Speaking of accounting gimmickry and trickery, the following financial statements for Sprouts Family Market (symbol SFM) have been modified somewhat from various sources for educational purposes. It is typical for various sources to present financial statements in slightly different manners. The most reliable source is the company’s annual and quarterly submissions to the Security and Exchange Commission.
The Balance Sheet
The Balance Sheet is a snapshot in time of a company’s assets and debts. What assets does the corporation own? How much debt has the corporation incurred and will have to pay back with interest? The accountants enumerate the assets of the corporation and then compute the total value of the assets. They do the same for the debts, also known as liabilities. They then make a simple calculation to compute what is left over after the debts are subtracted from the assets. The result is called Stockholders’ Equity. This is how much of the corporation is owned by the shareholders.
Stockholders’ Equity = Total Assets - Totals Debts
The accountants will sometimes simplify and rearrange the formula thusly:
Asset - Liabilities = Equity
In our BUS-121, Financial Planning and Money Management, class, at Southwestern, we cover a very simplified version of the Balance Sheet. We call it our Net Worth Statement in personal financial planning. Similar to the accountants’ Stockholders’ Equity, we compute our Net Worth by subtracting our debts from our assets. The procedures involved in creating a Balance Sheet using Generally Accepted Accounting Principles are vastly more complicated than how we create a personal Net Worth Statement. Also, the numbers are a whole lot bigger. However, the idea is exactly the same. How much do we own? How much do we owe? What is left over? That is our equity, our ownership, our net worth.
There is one major difference between a Balance Sheet and Net Worth Statement that should be noted. When we assess the value of an asset in our personal Net Worth Statement, we use the Fair Market Value of the asset. Usually, the Fair Market Value is easy to find. How much is a 2015 Toyota Corolla worth? Consult any of a number of industry publications such as Kelly Blue Book or Edmunds or just take a look at Craigslist to see what people are asking for them. Assessing the Fair Market Value of other items is much more difficult for some assets such as furniture or baseball card collections. Often, individuals have an overly optimistic idea of the value. It is only when they endeavor to sell the items that the current Fair Market Value can be ascertained.
The values of assets on the Balance Sheet of corporations are assessed in a totally different manner. Accountants use a procedure called Depreciation. The value of the assets are reduced using any one of many depreciation methods until finally the value of the asset is reduced to zero or a predetermined Salvage Value. The current value of an asset as it is being depreciated is called the Book Value. This is the value of the asset “on the books,” the accountants’ records. The Book Value may or may not have any relation to the actual Fair Market Value of the asset. In other words, just because the Balance Sheet says that a particular asset is worth a certain amount does not mean that the asset would demand that price if it were sold. More likely, the value in the marketplace is very different from the Balance Sheet. This is yet another reason why we must be wary when we utilize and interpret the numbers we find on the Balance Sheet.
Another difference to take note of is the time frame of assets. In accounting, any asset that will be utilized within one year is called a Current Asset. All other assets are considered Long-Term Assets. This is very different to how we in finance and investments category assets with our short-term, intermediate-term, and long-term time frames.
Below is the Balance Sheet for Sprouts Family Market as of December 31, 2022.
Notice the phrase “All numbers in thousands.” This means we must add three zeros to every number. For example, Sprouts did not have only \$247,000 in Cash and Cash Equivalents on December 31, 2022. They had \$247,000,000, two hundred and forty-seven million dollars.
The Income Statement
The Income Statement lists the revenue and expenses of a corporation in order to report the earnings of the corporation. Whereas the Balanced Sheet is a snapshot in time, the Income Statement is more similar to a movie and reports the difference between a company’s revenues and expenses over a set time period, usually either a three-month quarter or an entire year. An older term for the Income Statement that is still used by many is the Profit and Loss Statement. The ultimate goal of the Income Statement is to compute the net income of the business. The formula boils down to:
Net Income = Revenue - Expenses
The Income Statement, however, breaks down this simplistic formula into many steps. Although there are many calculations and entries regarding revenues and expenses, two of the entries on the Income Statement are followed more closely than the others, the “top line” and the “bottom line.”
The “top line” of the Income Statement refers to the revenues, also known as sales, of the corporation. The “bottom line” of the Income Statement refers to the net income, also known as the earnings, net earnings, profit, or net profit. Although Income Statements may vary depending upon the source, the revenue/sales are always at the top of the Income Statement and the net income/earnings/profit are always at the bottom of the Income Statement. During earnings calls, research articles, or discussions in the media about companies, the executives, authors, and analysts will invariably discuss the relationship and differences between the top line growth and the bottom line growth as they discuss the past and future performance of the company.
The bottom line net income is used by the corporation to pay dividends to stockholders. However, as we have learned, corporations are under no obligations to pay dividends. If the earnings are not paid to shareholders, they are referred to as retained earnings and are kept within the company to finance future growth.
Here is the Income Statement for Sprouts Family Market as of December 31, 2022.
The bottom line net income is computed using the same GAAP procedures mentioned above. Hence, we find that there are some entries in the Income Statement that are not always received or paid in cash. One of the most important of these types of entries is our old friend, depreciation. As with the Balance Sheet, depreciation can obscure the numbers behind the Income Statement. Depreciation can complicate and obscure how much cash a company is actually being earned from their operations. Depreciation and other accounting entries can create a situation where the earnings that are reported by a company are widely different from the amount of cash that flows in or out of the company. That is why there is the Cash Flow Statement.
The Cash Flow Statement
The Cash Flow Statement, also known as the Statement of Cash Flows, follows the age-old advice, “Follow the money.” It peers into the corporation’s checkbook to see all the cash inflows and outflows. Depreciation is one of the biggest reasons for the potential differences between the earnings and the cash flow of a company. A company does not write a check for depreciation. No cash was paid. However, the depreciation amount reduced the company’s earnings. That amount is still contained within the company’s checking account. Other entries in the Cash Flow Statement refer to the cash and non-cash inflows and outflows from its ongoing operations and non-operating financial and investment transactions.
Here is the Cash Flow Statement for Sprouts Family Market as of December 31, 2022.
Note: This Cash Flow Statement is an amalgam of two different sources of the financial data for Sprouts Family Market. My apologies. I am not an accountant and I am pretty sure that these numbers need to be adjusted to better reflect their financial situation. (That is a fancy way of saying that I need help from someone more skilled in accounting.)
The Cash Flow Statement can be especially important when there are situations that are obviously conflicting and contradictory. For example, how could a company be reporting record earnings but at the same time, the cash balance of their checkbook was going down? This was the situation of many high-flying technology companies such as Lucent Technologies during the late 1990’s as the Internet dot-com bubble was raging.
Lucent Technologies was spun off from the old AT&T. It had originally been the manufacturing arm of AT&T and was known as Western Electric and Bell Labs, the folks that invented the transistor, the laser, photovoltaic cells, and Unix. They built the best telephone equipment in the world. During the Internet mania, many new companies sprung up to carve out a niche for themselves in the burgeoning world of telecommunications. Lucent was eager to sell wireless and Internet equipment to these new companies. However, the companies did not have the cash to pay for the equipment nor any earnings that would help them finance the purchase using a bank or other form of borrowing. In order to facilitate the transactions, Lucent agreed to sell these companies their equipment and accept payments over many years. In essence, Lucent became their banker. Hence, Lucent’s sales were enormous and they were reporting record earnings. However, since only a small part of the payment was being realized each year, the cash position was falling. When the dot-com bubble burst, events did not end well for Lucent. Many of these companies failed to ever achieve profitability and went bankrupt. In the bankruptcy, Lucent received the equipment back but now the equipment was obsolete and could not be sold again except at salvage prices. Its stock price fell from a high of \$84 down to \$2.13. Close examination of Lucent’s Cash Flow Statement during the heady years of the dot-com mania would have warned prudent, long-term investors of the dangers ahead for Lucent. “Hey, Lucent! How come you are recording record earnings but your checkbook balance is declining?”
SEC Edgar
As a central repository for the financial statements of corporations, the Securities and Exchange Commission (SEC) uses a system called EDGAR, the Electronic Data Gathering, Analysis, and Retrieval system. Annually and quarterly, publicly traded corporations are required to file their financial statements with this system. The annual reports are called 10-K’s and the quarterly reports are called 10-Q’s. Anyone with Internet access is free to download the statements. Before Internet technology made the dissemination of information to anyone around the world readily and easily available, it was typical for analysts and other Wall Street professionals to be apprised of the upcoming financial information coming from a company. With the advent of the new technologies, in the year 2000, the SEC instituted Regulation FD, Fair Disclosure. Companies were prohibited from sharing any information before the material was submitted to the EDGAR system. Subsequently, companies now schedule an Earnings Call for when the material is available on EDGAR and all parties are privy to the information at the same date and time.
EDGAR and the financial statements are just the beginning. We must also take advantage of the company’s annual report and other materials found on their website. And don’t forget The Value Line! However, there are countless reliable and scrupulous and not-so-reliable and not-so-scrupulous sources. These days, it is common to hear investors complain that there is just too much information. A quote from the author Nick Murray is useful here. When discussing the value of a financial advisor, Nick Murray once quipped, “Wisdom sold separately.” Yes, there is no end to the information available. Deciding what information is important and how to make sense of it is a very different matter.
Starting in the heady dot-com mania days and continuing to this day, much attention was and still is focused on the whisper number, the unofficial, unregulated, unsubstantiated, presumed company earnings. For some short-term traders and speculators, what passes for intelligent investing is gambling whether or not a company will beat the whisper number or not. If the company’s official earnings beat the whisper number, the stock price might zoom higher. If not, the stock might be punished. Should a prudent, long-term investor ever pay attention to the whisper number? If you have been paying attention, you already know the answer.
Financial Ratios and Ratio Analysis
We will use the financial statements to compute financial ratios. Financial ratios are simply the relation between two financial quantities expressed as the quotient of one divided by the other. We have already covered a few such as the Price-to-Earnings Ratio, Earnings Per Share, Dividends per Share, and Dividend Payout Ratio. We will then utilize the various financial ratios to perform ratio analysis, the study of the relationships between financial statement accounts. Does it sound as exciting as the Dividend Discount Models and the Discounted Cash Flow Model? Ah, yeah, right, it does not sound that exciting and to be honest, it really isn’t. However, ratio analysis is important and it helps us get a more complete picture of the companies that we are researching and investigating as potential investments.
The more important point to keep in mind is that there is no one ratio that can accurately sum up the overall general state of a company. Each ratio must be considered in the context of all the information gathered. Plus you must consider any ratio in the context of the industry the company exists within. We will see an example of this as we investigate the most popular financial ratio, the Price-to-Earnings Ratio, also known as P/E or just PE. (No, not Physical Education.) | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/05%3A_Fundamental_Analysis-_Financial_Statements_and_Ratio_Analysis/5.01%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide #8.)
The common stock ratios are popular financial ratios that convert key information about a firm to a per share basis. They are also known as market ratios. We introduced a few in our Introduction to Stock in chapter 3. Others are new. These ratios use data from the Balance Sheet or the Income Statement or both.
Earnings per Share (EPS)
Earnings per Share is the amount of annual earnings available to common stockholders, as stated on a per share basis. We can think about each share that we own as a business entity in and of itself, earning X amount of dollars. Earnings per Share was one of the key statistics that we asked you to research in our chapter 3 assignment. It is readily available and a subject of much discussion and speculation, especially with regard to companies that are growing their earnings.
``` Net Income Earnings Per Share = ———————————————————————————— Number of Shares Outstanding ```
The Earnings per Share is subsequently used in combination with current market price to compute the most important stock market statistic, the Price-to-Earnings Ratio (P/E).
Price-to-Earnings Ratio (P/E, PE)
The Price-to-Earnings Ratio is the most popular stock market statistic. It is often abbreviated as either P/E or just PE. A simple Internet search will yield tons of materials dedicated to the study, investigation, scrutiny, and dissection of the P/E ratio of a company or the stock market as a whole. The calculation is easy.
``` Market Price per Share Price-to-Earnings Ratio = ———————————————————————— Earnings per Share```
Historically, P/E ratios were in the 5 to 12 range for mature companies and 14 to 20 range for growing companies. Greater than 20 was unusual. Today, it is commonplace. Assuming no changes in earnings, the P/E ratio also tells you how long it will take in years for the company to earn back its price. A P/E of 3 will take three years; a P/E of 20 will take twenty years. In the heady dot-com mania days, eBay once had a P/E of 10,000 associated with the stock. Recently, Tesla’s P/E was over 1,000.
Let’s take a look at the P/E ratios for a random set of companies:
Price-to-Earnings Ratios for a random set of companies
ExxonMobil 8.35 Facebook 20.08
Amgen 19.50 Wells Fargo 14.94
General Mills 16.32 Bristol Myers Squibb 23.42
These companies are all in very different industries. It would not be proper to compare the P/E ratios ‒ or any of the financial ratios that we will cover ‒ of these companies to one another. What we need to do is compare these companies to their competitors:
Price-to-Earnings Ratios for a similar companies in various industries
ExxonMobil
Chevron
ConocoPhillips
Shell
BP
8.35
8.84
7.22
5.43
n/a
Facebook
Google
Apple
Netflix
Amazon
20.08
20.17
25.38
33.20
n/a
Amgen
Biogen
AbbVie
Illumina
19.50
12.85
23.33
n/a
Wells Fargo
U.S. Bank
J. P. Morgan
Bank of America
14.94
12.95
11.80
10.78
General Mills
Kraft Heinz
Kellogg’s
Hormel
16.32
20.03
23.20
24.12
Bristol Myers
Merck
Pfizer
Eli Lilly
23.42
18.90
7.35
44.43
All data as of March 6, 2023
We must always compare any financial ratios with companies within the same industry. Sometimes the ratios will vary wildly as in the drug companies above. Other times, they will be within a very narrow range such as the energy, food, and banking companies. When we encounter a situation such as the outsized P/E ratio of Eli Lilly or the much lower P/E ratio of Pfizer, it is a signal to us that we must do much more research. Why is this company so different from its peers? Why are P/E ratios of BP, Amazon, and Illumina reported as “n/a?” This signifies that these companies are losing money. Rather than display a negative P/E ratio, the industry typically uses “n/a” for not applicable or “nmf” for no meaningful figure.
How can we account for the wide P/E disparity between different industries and different companies within industries? It is the expectation of future earnings and dividend growth by investors. The following quote is attributed to Jack Dreyfus, the founder of The Dreyfus Funds, which are now owned by The Bank of New York Mellon. (The Bank of New York, incidentally, was the first stock that was traded on the New York Stock Exchange in 1792.)
Take a nice little company that has been making shoelaces for 40 years and sells at a respectable six times earnings ratio. Change the name from Shoelaces, Inc. to Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word “furth-burners” which no one understands. A word that no one understands entitles you to double your entire score. Therefore, we have six times earnings for the shoelace business and 15 earnings for electronics and silicon, or a total of 21 times earnings. Multiply this by two for furth-burners and we now have a score of 42 times earnings for the new company.” ‒ Jack Dreyfus, Founder, Dreyfus Funds, as quoted in A Random Walk Down Wall Street
Today, you replace furth-burners with cryptocurrency or 3-D printing and replace electronics and silicon with NFT and meme stocks. Technology changes rapidly; human nature, not so much.
Price-to-Earnings to Growth Ratio (PEG)
The Price-to-Earnings to Growth Ratio, also known as the PEG ratio, compares the P/E ratio with the company’s earnings growth rate. The formula is:
``` Stock's P/E Ratio PEG Ratio = —————————————————————————————————————————— 3-year or 5-year Growth Rate of Earnings```
A PEG Ratio of 1.0 means that P/E Ratio matches its growth rate. Historically, a PEG Ratio of 1.0 was desirable since it meant that the P/E Ratio equaled the growth rate. Anything above 1.0 was considered high and therefore, risky. However, greater than 1.0 is common as of this writing. This is another indication that stocks are generally on the expensive side of March 2023, even after many of the high flying “disruptive” companies have fallen from great heights such as Netflix and Shopify.
Dividends per Share
The Dividends per Share tells us how much dividends each share of stock will receive.
``` Annual Dividends Paid to Shareholders Dividends per Share = ——————————————————————————————————————— Number of Shares Outstanding```
As we discussed, dividends became taboo during the 1990’s. Since the 2000-2002 bear market, many investors have changed their minds about dividends. Dividends can be discussed in polite company again. Remember: Dividend Don’t Lie!
Dividend Yield
The Dividend Yield is the important measure of how much dividends are as a percentage of the stock price.
``` Dividends per Share Dividends Yield = ———————————————————————— Market Price per Share```
This important statistic allows an investor to compare a company to other forms of investments that pay income such as savings accounts or bonds. Traditionally, 4% to 6% was considered good. According to the Nasdaq, as of March 2023, the S&P 500 as a whole was yielding 1.68%. After many years of meager returns from savings accounts and bonds, yields have risen for both. As of March 2023, the 10-year Treasury bond was yielding approximately 4%. A year before, the 10-year Treasury bond was yielding approximately 2%. Many savings accounts that were yielding far less than 1% are now paying upwards of 4%. We will see if the yield of stocks rises along with the yields of bonds and savings accounts. Of course, for this to happen, either stocks must pay higher dividends (the numerator increases) or stock prices must fall (the denominator decreases). There are many experts who have exclaimed that stock prices have been too high for too long and that stock prices must come down to more reasonable levels so that the dividend yields will be more in line with historical returns. Since the Great Recession, they have been wrong. We shall see what the future brings. Stay tuned for further developments.
Dividend Payout Ratio
The Dividend Payout Ratio tells us how much of a company’s earnings are being paid out to shareholders in the form of dividends.
``` Dividends per Share Dividends Payout Ratio = ————————————————————— Earnings per Share```
More mature companies often pay out almost all their earnings in the form of dividends. Growing companies retain their earnings (called Retained Earnings) to support the growth of the company.
Book Value per Share
The Book Value per Share is a measure of the net worth of a company on a per share basis. The formula is:
``` Common Stockholders’ Equity Book Value per Share = —————————————————————————————— Number of Shares Outstanding```
Book Value per Share tells an investor how much assets are behind each share of stock. In other words, if all the assets of the company were liquidated, how much would each shareholder receive? It is common for the actual market price of a share to be more than the book value per share since a company is typically worth more intact than if it were dissolved. Today, it is common for the market price to be far above the book value. Remember that the actual Fair Market Value of a corporation’s assets may be very different from what the accountant’s declare the value of the asset to be worth “on the books” because of the various methods of depreciation.
There are rare occasions when the market price of a share of stock falls below the Book Value per Share. Usually, these are very mature companies in declining or disappearing industries. When this happens, there is a real danger of the company becoming a target for corporate raiders. The corporate raiders are also known as private equity groups, activist investors, and takeover artists. Depending upon the company, through various methods, the corporate raiders might attempt to liquidate the assets of the company, pay the remaining debts, and walk away with whatever is left over. They might attempt to sell off various valuable pieces of the company, profiting from the sale but leaving the remaining company unable to compete.
Understandably, the employees of the company and citizens of the community in which the company does business don’t normally take too kindly to this. They complain to their elected representatives and calls to rein in unbridled capitalism are heard. Imagine if you had worked at the same company for 22 years and were now out of job because someone flew in on their private jet, sold off all the assets of the business, and closed its doors forever. This is the reason, Dear Readers, that we have unemployment insurance. A society wants its capital ‒ physical and human ‒ to be employed as efficiently as possible. If a business is failing for whatever reason, that capital needs to be redeployed. However, when you are trying to feed your family and keep a roof over your heads, those high ideals are not your first priority. Hence, we created unemployment insurance to help individuals stay afloat as they find new work, or in other words, as their human capital is redeployed.
Price-to-Book Value per Share
The Price-to-Book Value per Share ratio compares the market price of the stock to the Book Value per Share. This calculation makes it easy for us to see if the market price is above, the same, or below the Book Value per Share.
``` Market Price per Share Price-to-Book Value per Share = ———————————————————————— Book Value per Share```
Given that the Book Value per Share is often less than the market price, the Price-to-Book Value per Share tells an investor how far above the book value the market value is. If the Price-to-Book Value per Share is equal to 1, they are the same. Today, Price-to-Book-Values per Share of 3 to 6 are not uncommon and some are much higher.
Price-to-Cash Flow per Share (P/CF)
The Price-to-Cash Flow per Share ratio is very similar to the Price-to-Earnings Ratio. The exception is that we use Cash Flow per Share instead of Earnings per Share.
``` Market Price per Share Price-to-Cash Flow per Share = ———————————————————————— Cash Flow per Share```
As we discussed above in the section on the Cash Flow Statement, the Earnings per Share can differ dramatically from the Cash Flow per Share for various reasons. During discussions by analysts and market pundits, you may hear talk of the quality of earnings of the company and whether the earnings are “good quality” earnings or “bad quality” earnings. What they are trying to identify is what is happening to the cash flow of the company. Is the company reporting record earnings and at the same time their cash flow is falling? As we saw with Lucent Technologies, this type of situation can end badly for investors.
Price-to-Sales per Share (P/S)
The Price-to-Sales per Share ratio is another attempt to compare the market price with a number associated with the running of the business. In this case, we use the company’s Sales per Share.
``` Market Price per Share Price-to-Sales per Share = ———————————————————————— Sales per Share```
During the Internet mania, many analysts used Price-to-Sales instead of Price-to-Earnings since most of the new high-flying technology companies never generated any earnings. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/05%3A_Fundamental_Analysis-_Financial_Statements_and_Ratio_Analysis/5.02%3A_New_Page.txt |
The Profitability Ratios are popular measures used to evaluate a firm’s returns by relating profits to sales, assets, or equity. Profitability Ratios allow an investor to measure the ability of a firm to earn an adequate return on sales, total assets, equity, and invested capital. As with all financial ratios, the profitability ratios must be compared to a company’s competitors as well as the market as a whole.
In the ratios that follow, we will be using the financial statements for Sprouts Family Market (SFM) that were introduced above. So get out your 99¢ calculator and have the financial statements available. It will also be helpful to have the chapter 5 formula street available. The formula sheet tells you which financial statement or statements we need to consult.
Net Profit Margin, also known as After-tax Profit Margin
The Net Profit Margin, also known as the After-tax Profit Margin, is the rate of profit being earned from earnings after expenses and taxes.
``` Net Income Net Profit Net Profit Margin = ——————————————— or ————————————— Total Revenue Total Sales ```
'The Net Profit Margin compares the two most popular entries from the Income Statement, the “top line” Total Sales, also referred to as Total Revenue, and the “bottom line” Net Income, also referred to as Net Profit. The higher the result, the better. But we repeat that we must always compare this result with similar companies because the Net Profit Margin varies greatly from one industry to the next.
Consulting the Income Statement, we see that the Net Income for Sprouts was 261,160 and the Total Revenue was 6,400,000. The Net Profit Margin, therefore, is 4.08%. Is that good? Ah, we don’t know. We need to compare this result with their competitors. What would you expect the Net Profit Margins would be for grocery stores? Would they command higher margins than the stock market as a whole? Or would the fact that there is such tremendous competition in the grocery retail industry result in net profit margins that are depressed when compared to the stock market as a whole? Much more research is needed!
Gross Margin
The Gross Margin reports the rate of profit being earned from Gross Profit. Gross Profit differs from Net Income (also called Net Profit). Looking carefully at the Income Statement, we can see that Gross Profit is simply the Total Revenue minus the Cost of Goods Sold.
``` Gross Profit Gross Income Gross Margin = ——————————————— or —————————————— Total Revenue Total Sales ```
This ratio is not as popular as the Net Profit Margin. However, it can help us compare a company against its competitors. The Gross Margin tells us how efficiently it was able to produce a profit from the goods or services provided by the company. A Gross Margin higher than their competitors demonstrates the company is better adept at being able to earn money from its business activities. As with the Net Profit Margin, it varies greatly from industry to industry.
For Sprouts, we see that their Gross Profit is 2,820,000. Dividing that by the Total Revenue gives us 37.22%. That is typical of most retail outlets. In general, unless it is a very high-end retail outlet with exclusive and expensive items, you can expect that the store will be paying anywhere between 30% and 40% less than the retail prices. On some high-volume items, it is far less. Sure, they only make a few percent on high-volume items such as milk, eggs, and bread. But they sell you milk, eggs, and bread every week, sometimes every few days.
Operating Margin
The Operating Margin takes the Gross Margin one step further. The Operating Margin uses the Operating Income, also called Operating Profit or Income from Operations.
``` Operating Income Operating Profit Operating Margin = —————————————————— or —————————————————— Total Revenue Total Sales ```
The Operating Income starts with the Gross Profit above and then subtracts the overhead expenses such as research and development, sales, administrative, and general expenses. As with the previous two ratios, the higher the better but remember to compare the result with companies in the same industry as the results will vary widely from industry to industry.
The Operating Income for Sprouts is 352,580. Dividing the Operating Income by the Total Revenue gives us an Operating Margin of 5.51%, a number that would need to be compared to their competitors.
Return on Assets (ROA)
Return on Assets is a measure of how profitable a company is relative to its total assets. It looks at the amount of resources a company needs to support operations and reveals how effective the company is in generating profits from the assets it has available. The previous three ratios only used the Income Statement. The Return on Assets uses both the Income Statement and Balance Sheet.
``` Net Income Return on Assets = —————————————— Total Assets```
Return on Assets and the next two ratios are very popular ratios. Obviously, the higher the better. For Sprouts, the Net Income of 261,160 divided by the Total Assets of 3,466,000 results in a Return on Assets of 7.53%.
Return on Equity (ROE)
Return on Equity relates the overall profitability of a company in relation to the shareholders’ equity.
``` Net Income Return on Equity = ———————————————————————————— Total Stockholders' Equity```
Because Return on Equity uses Stockholders’ Equity instead of Total Assets for the denominator, Return on Equity is sensitive to the amount of debt a company is carrying. Specifically, if a company carries a great amount of debt, Return on Equity will be much larger than Return on Assets. This is often referred to as leverage. You will hear investors say, “You are using other people’s money to make your money.” You are using borrowed money as a lever to enhance your profits. Some investors view this positively; others are worried about the possible negative consequences of too much debt. Looking at the data for Sprouts, the Net Income of 261,160 divided by the Total Stockholders’ Equity of 1,050,000 gives a Return on Equity of 24.87% that we would compare with their competitors.
Return on Invested Capital (ROIC)
Return on Invested Capital measures the overall profitability of a company in relation to both debt and equity.
``` Net Income Return on Invested Capital = ————————————————————————————————————————————— Long-term Debt + Total Stockholders’ Equity```
Return on Invested Capital is used by many long-term investors such as Warren Buffett. However, there are a few different ways of calculating ROIC. We are using the most simplistic version. By using both long-term debt and stockholders’ equity, ROIC measures how well a company is managing all the capital the company needs to earn its profits.
Adding the Long-term Debt of 1,400,000 and the Total Stockholders’ Equity of 1,050,000 gives us a denominator of 2,450,000. Then dividing Net Income of 261,160 by the 2,450,000 denominator gives us a Return on Invested Capital of 10.66% for Sprouts. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/05%3A_Fundamental_Analysis-_Financial_Statements_and_Ratio_Analysis/5.03%3A_New_Page.txt |
Video - Audio - YouTube (Liquidity Ratios start on slide 28.)
The Liquidity Ratios are financial ratios concerned with a firm’s ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due. These ratios ask critical questions: Can the company meet payroll? Can they pay the bills that are due? Are they in danger of being forced into bankruptcy? These ratios use entries from the Balance Sheet.
Current Ratio
The Current Ratio is a very popular ratio. It compares the Current Assets with the Current Liabilities. Recall that accountants use the term current to mean any assets or debts that are due within one year.
``` Current Assets Current Ratio = ————————————————————— Current Liabilities```
The Current Ratio is a good indicator of how stable a company is. Anything over 1.0 is normally considered acceptable. If your Current Assets equal or exceed your Current Liabilities, you should be able to satisfy your short-term obligations without any problems. Obviously, the greater the number is, the better. On the Balance Sheet of Sprouts, we see that the Current Assets are 673,800 and the Current Liabilities are 522,380. The resulting Current Ratio for Sprouts is 1.290. This is above 1.0 and indicates that Sprouts is able to pay its short-term debts. We don’t have to worry about them not being able make payroll or being hauled off to bankruptcy court.
Net Working Capital
Net Working Capital is the one oddball in our group. It is not a ratio. Instead of dividing, we subtract. It is the result of subtracting the Current Liabilities from the Current Assets. In essence, it is the Current Ratio in absolute dollar terms. Net Working Capital is often discussed when discussing the Current Ratio and our next liquidity ratio, the Acid-test Ratio, but it is not as popular as the two ratios.
Net Working Capital = Current Assets - Current Liabilities
If the Current Ratio is greater than 1.0, then Net Working Capital will be positive since Current Assets will be greater than Current Liabilities. Conversely, if the Current Ratio is less than 1.0, then Net Working Capital will be negative. The higher the Net Working Capital, the better. This statistic is less popular than the Current Ratio. Since the Current Ratio of Sprouts is 1.290, we should expect their Net Working Capital to be positive. Taking the Current Assets of 673,800 and subtracting the Current Liabilities of 522,380 gives us a positive 151,420 for the Net Working Capital. Remembering that all numbers are in thousands, this means their Current Assets exceed their Current Liabilities by more than \$151 million dollars. For their size, Sprouts has plenty of Net Working Capital and is in no danger defaulting on its short-term obligations.
Acid-test Ratio, also known as the Quick Ratio
What a great name, the Acid-test Ratio! The Acid-test Ratio is a stricter version of the Current Ratio. For the Acid-test Ratio, we remove the Inventory from the Current Assets.
```Acid- Cash + Accounts Receivables + Short-term Investments + Other Current Assets -test = ————————————————————————————————————————————————————————————————————————————— Ratio Current Liabilities```
Unlike the Current Ratio, the Acid Test Ratio excludes inventory. This ratio measures the ability of the company to meet its short-term obligations even if its current inventory becomes obsolete or undesirable and hence, difficult or impossible to be turned into cash. Anything greater than 1.0 is considered adequate. It is also called the Quick Ratio. (We don’t know where the name Quick Ratio came from but it certainly reminds us of one of the early founders and eventually the third CEO of the Intel Corporation, Andrew Grove, who loved to say that there were only two types of companies, the Quick and the Dead. He also used to quip that, “only the paranoid survive.” Mr. Grove was instrumental in building Intel into the world’s largest semiconductor company.)
An easier form of the Acid-test Ratio formula is:
```Acid- Current Assets - Inventory -test = ———————————————————————————— Ratio Current Liabilities```
We will take the easier route to calculate the Acid-test Ratio for Sprouts. The Current Assets of 673,800 minus the Inventory of 310,550 gives us a numerator of 363,250. Dividing the numerator of 363,250 by the Current Liabilities of 522,380 gives us an Acid-test Ratio of 0.695. This number is more concerning than the Current Ratio. We need to take a good, long look at the Inventory for Sprouts and ask if there is a danger of the Inventory becoming obsolete or otherwise undesirable. We would combine that analysis with another ratio that we will discuss below, the Inventory Turnover, to determine if this is something that should give us pause. At first blush, though, we might intuitively surmise that the majority of products that a grocery such as Sprouts carries are not going to become obsolete or otherwise undesirable barring any natural catastrophe. Everybody got’s t’ eat, right? | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/05%3A_Fundamental_Analysis-_Financial_Statements_and_Ratio_Analysis/5.4%3A_Liquidity_Ratios.txt |
Video - Audio - YouTube (Activity Ratios start on slide 32.)
Activity Ratios are used to relate how well a firm is managing its assets. Activity ratios measure a firm’s ability to convert different accounts within their balance sheets into cash or sales. Companies will try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues. These ratios utilize entries from both the Balance Sheet and Income Statement.
Accounts Receivable Turnover
Accounts Receivable Turnover is a measure of how well Accounts Receivable are managed. Businesses often will deliver goods or services but accept payment later. Accounts Receivable are the amounts that are owed to the business for those goods and services.
``` Total Revenue Accounts Receivable Turnover = ————————————————————— Accounts Receivable```
The higher the number, the better. It indicates the return a company is getting from its investment in accounts receivable. By maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients. A high ratio implies that the company operates either on a cash basis, or its extension of credit and collection of accounts receivable is efficient. A low ratio implies that the company should reassess its credit policies in order to ensure the timely collection of imparted credit not earning interest for the firm. Or that may just be how that industry operates. An example of this is the Defense industry. Uncle Sam will eventually get around to paying you for that aircraft carrier you built for him. But he does take his good old sweet time. The large Defense contractors are used to this but smaller contractors often have a difficult time waiting since they simply do not have the same amount of resources. Some years ago, the small contractors complained bitterly and it is our understanding that the government has stepped up the payment time frame.
Initially, we could guess that a retail grocer such as Sprouts would not have a significant sum in Accounts Receivable and we would be correct. Accounts Receivable for Sprouts is only 34,260. Dividing the Total Revenue of 6,400,000 by the Accounts Receivable of 34,260 gives us an Accounts Receivable Turnover of 186.807. This means that almost 187 times per year, Sprouts turns over their Accounts Receivable. That is every two days. There is no problem here!
Inventory Turnover
Inventory Turnover is very important to many industries. It is a measure of how a company manages its Inventory.
``` Total Revenue Inventory Receivable Turnover = ——————————————— Inventory```
The higher the number, the less time an item spends in inventory and the better the return the company is able to earn from funds tied up in inventory. As with all ratios, this ratio must be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective inventory buying or maintenance. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also potentially exposes the company to trouble in the case of falling prices or obsolete products.
With a Total Revenue of 6,400,000 divided by the Inventory of 310,550, we see that the Inventory Turnover for Sprouts is 20.609. Sprouts is turning over their Inventory approximately every two and a half weeks. If you shop at Sprouts and come back two or three weeks later, virtually all the products you see on the shelves have been replaced. Obviously, some high-volume products are being replaced daily while others are replaced much less frequently. However, you get the idea. The high Inventory Turnover relieves much of the concern we initially had with the low Acid-test Ratio above.
Total Assets Turnover
Total Asset Turnover measures how well the company manages its total assets.
``` Total Revenue Total Assets Turnover = ——————————————— Total Assets ```
The Total Assets Turnover Ratio measures the firm’s efficiency at using assets to support sales and revenue, the higher the number the better. Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover. With Sprouts, we take the Total Revenue of 6,400,000 and divide the Total Assets of 3,466,000 and get a Total Asset Turnover of approximately 1.85. Sprouts is turning over their total assets about twice a year. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/05%3A_Fundamental_Analysis-_Financial_Statements_and_Ratio_Analysis/5.5%3A_Activity_Ratios.txt |
Video - Audio - YouTube (Leverage Ratios start on slide 36.)
The last group of financial ratios we will cover are the Leverage Ratios. Leverage Ratios are used to measure the amount of debt being used to support operations and the ability of the firm to service its debt. They are also referred to as Solvency Ratios and are similar to the Liquidity Ratios except they focus on long-term debt instead of short-term debt. Debt is often referred to as leverage. The idea is that you are using other people’s money to make money. You are using the borrowed money as a “lever” to increase your earnings. When one firm buys another firm using borrowed money, it is often referred to as a “leveraged buyout.”
Debt-to-Equity Ratio
The Debt-to-Equity Ratio is a measure of a company’s financial leverage calculated by dividing long-term debt by shareholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets.
``` Long-term Debt Debt-to-Equity Ratio = ———————————————————————————— Total Stockholders’ Equity```
A higher Debt-Equity Ratio generally means that a company has been aggressive in financing its growth with debt. This can result in lower earnings as a result of the additional interest expense and hence, lower taxes. Sometimes investors use total liabilities instead of long-term debt. The lower the result, the better for the more risk averse investors. Of course, debt levels vary widely from industry to industry so, as with all ratios, we must always compare our results with competitors and what is customary for the particular industry.
One noticeable event that we can see on the Balance Sheet of Sprouts is the change in Long-term Debt from 2018 to 2019. Long-term Debt jumped from \$310 million to \$1.63 billion. Sprouts joined a long list of companies who loaded up on Long-term Debt. Why? Interest rates had not been this low in generations. Many companies took advantage of the ultra-low interest rates to borrow. Will this mountain of debt come back to haunt them? That is something investors need to be aware of and do their best to anticipate. Currently, with a Long-term Debt of 1,400,000 and Total Stockholders’ Equity of 1,050,000, the Debt-to-Equity Ratio of Sprouts is 133.33%. Typically, businesses and individuals want to keep this ratio to no higher than 1.0 or 100%. Many individuals, Your Humble Author included, want it to be less than 0.5 or 50%. Obviously, the management of Sprouts does not seem concerned about this. We would want to consult what their management had to say about their debt situation in the annual report and other filings with the SEC.
Times Interest Earned
Time Interest Earned was Benjamin Graham’s favorite financial ratio. It measures the ability of a company to meet its fixed interest payments. A company can choose to stop paying dividends but interest payments on debt must be paid or else the company will be hauled off to bankruptcy court.
``` Earnings before Interest and Taxes Times Interest Earned = ———————————————————————————————————— Interest Expense```
Times Interest Earned is used to determine how frequently interest payments are earned by the company during a year. The higher, the better. Normally, 3 or 4 is considered adequate. When you read The Intelligent Investor, you will see the master in action. Mr. Graham deftly shows how investors who pay special attention to this ratio can avoid some nasty surprises in the form of bankruptcies of the companies that they invest in.
With Earnings before Interest and Taxes of 360,380 and an Interest Expense of 11,070, we find that the Times Interest Earned ratio is 32.55. Now we see why the management of Sprouts is not overly concerned with their debt level. Approximately every one and a half weeks, Sprouts is earning enough to pay their annual Interest Expense. That would be similar to an individual earning enough in one and a half weeks to pay their mortgage payments for the entire year.
Total Debt-to-Total Assets Ratio
The Total Debt-to-Total Assets Ratio relates how much of the company’s total assets have been financed by debt.
``` Total Liabilities Total Debt-to-Equity Ratio = ——————————————————— Total Assets```
Total Debt-to-Total Assets includes both short-term and long-term debt and assets. If it varies substantially from the Debt-Equity Ratio, the company may be relying heavily on short-term debt. A heavy reliance on short-term debt can denote more risk. Relying on short-term debt to finance a long-term operation is akin to someone financing their start up business using credit cards. Although it might be the only way they can get financing, it is very pricey and dangerous.
Sprouts has Total Liabilities of 2,380,120 and Total Assets of 3,466,000. The resulting Total Debt-to-Total Assets ratio is 68.67%. For investors with an aversion to too much debt, this might be something of concern. Generally, investors concerned about excessive debt want to see this number less than 0.5 or 50%.
Total Debt-to-Capitalization Ratio
Finally, the Total Debt-to-Capitalization Ratio is used to measure the total amount of outstanding company debt as a percentage of the firm’s total capitalization.
``` Total Debt Short-term Debt + Long-term Debt -to- = ———————————————————————————————————————————————————————— Capitalization Short-term Debt + Long-term Debt + Shareholders Equity```
Similar to the Total Debt-to-Total Assets ratio. As with the other debt ratios, the higher the debt level, the more risk of insolvency. However, some industries with high rates of debt such as utilities also have more reliable earnings. As always, we must compare our results with the competitors and the industry as a whole.
For Sprouts, we add the Short-term Debt of 136,600 to the Long-term Debt of 1,400,000 to get a subtotal of 1,536,600 for the numerator. In the denominator, we add the Short-term Debt of 136,600 and Long-term Debt of 1,400,000 to the Total Shareholders’ Equity of 1,050,000 to get 2,586,600. Dividing the numerator by the denominator gives us a Total Debt-to-Capitalization Ratio of 59.41%, a bit less than the Total Debt-to-Total Assets Ratio above.
5.S: Summary
Congratulations ‒ You Have Finished Chapter 5 ‒ Fundamental Analysis: Financial Statements and Ratio Analysis
You have reached the end of chapter 5, Fundamental Analysis: Financial Statements and Ratio Analysis. In this chapter, you have:
You should now be able to:
We Have Finished Our Coverage of Fundamental Analysis of Stocks
Dear Investment Gurus, we have done the heavy lifting with regard to stocks. It is now time to step back and take a look at much of the research that has been done regarding whether or not any of what we have learned will actually do us any good. In our next chapter, we discuss Efficient Market Theory and ask a simple question, “Who Can Beat the Market?” We will also focus on the research that has been done regarding behavioral finance and what it can tell us about ourselves as investors and as human beings. Last, we review some of the All Stars of Investing. If you want to do something well, why not study and learn from those who have shown that they can do it well? See you in our next chapter, Chapter 6: Efficient Market Theory: "Who Can Beat the Market?" | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/05%3A_Fundamental_Analysis-_Financial_Statements_and_Ratio_Analysis/5.6%3A_Leverage_Ratios.txt |
“I can calculate the movement of the stars, but not the madness of men.” – Sir Isaac Newton
“The investor’s chief problem, and even his worst enemy, is likely to be himself.” ‒ Benjamin Graham
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Are Markets Efficient? Can Investors “Beat the Market?”
This chapter discusses the various theories about market efficiency. The proponents of the efficient market theories believe that no one can “beat the market.” The fly in their ointment is that there are many investors who have beaten the market over statistically significant periods of time. We will take a look at just a few of those successful investors who have proven that the efficient market theories are wrong. We will also review some of the research from behavioral finance and what it says about us as investors and as human beings as well as revisit the controversy surrounding active versus passive management. We end with a few famous market myths and stupid sayings. Enjoy!
• 6.1: Efficient Markets
Are markets efficient? Can investors “beat the market?” Or should they not even bother to try? Let's examines the various forms of the Efficient Market Theory and see if there is anything of value we can learn from them.
• 6.2: Manias and Crashes
Manias and Crashes. Bubbles and Panics. The history of capitalism is the history of booms and busts. Nothing's perfect, especially the stock market. The key is to keep a long-term perspective and remember the age old adage, "This too shall pass."
• 6.3: Investor Psychology and Common Investor Weaknesses
Investor Psychology? We prefer to call it "Sly-chology!"
• 6.4: Active versus Passive Management Revisited
Careful! Index fund investors can get very defensive and angry when you point out their life-sustaining illusions.
• 6.5: All Stars of Investing
There's an old saying: "If you are going to steal, steal from the best!" Let's see what wisdom we can steal from these All Stars of Investing.
• 6.6: Famous Myths and Stupid Sayings
Beware of these famous myths and stupid sayings.
• 6.S: Summary
Congratulations ‒ You Have Finished Chapter 6 ‒ Market Efficiency Theory: "Who Can Beat the Market?"
"Snail race" by nojhan is licensed under CC BY-SA 2.0
06: Market Efficiency Theory- Who Can Beat the Market
The Efficient Market Theory states that in an efficient market, the prices of securities reflect all possible information quickly and accurately. What is an efficient market? The New York Stock Exchange and the NASDAQ are examples of efficient markets. These are markets where there are large numbers of rational, knowledgeable investors who react quickly to new information. Hence, the theory claims that security prices will always adjust quickly and accurately. Rational investors will immediately buy any stocks that are undervalued and immediately sell any stocks that are overvalued.
Associated with the Efficient Market Theory is the Random Walk Theory. This theory states that stock price movements are random. There is plenty of evidence that in the short term, this hypothesis is correct. Stock prices movements are random in the short term. However, so far, long-term price movements are anything but random as the global economy has grown exponentially over the last 200 years. Some critics believe that capitalism has emphasized growth of the economy at all costs and that this growth cannot possibly continue. The reality is that we as a species have a long way to go until every human can live a dignified, healthy, and fruitful life with sufficient food, clothing, and shelter ‒ and Internet access! The trick will be to share more equitably in the wealth generated by our combined endeavors. The current distribution of wealth here in the United States is unconscionable and cannot continue.
For a thorough discussion of the Efficient Market Theory, please read A Random Walk Down Wall Street by Professor Burton Malkiel. It is one of two books that we recommend for your first book to read about stock investing. (The other is One Up On Wall Street by Peter Lynch. We will discuss Mr. Lynch later in this chapter.) We have already quoted and referenced Professor Malkiel’s classic text. It is a whole lot o’ fun. Professor Malkiel skewers Fundamental Analysis (which we covered in chapters 4 and 5), Technical Analysis (which we will cover in our next chapter), and the Efficient Market Theory, even though he was one of the early pioneers of the theory. Nobody gets away without being jabbed, needled, or harpooned. Read it!
The theory was initially put forth in 1970 and developed throughout the 1970’s. At the same time, the physics world was working on their own set of theories and were using terms like weak and strong. This spilled into the world of the Efficient Market Theory and we wound up with three forms, the weak, semi-strong, and strong hypotheses.
The Weak Efficiency Hypothesis
The Weak Efficiency Hypothesis states that past data on stock prices are of no use in predicting future prices. Although statistically, stock price movements in the short term are random, there are times when stock prices do tend to demonstrate momentum in one direction or the other. Stock prices tend to rise more often than they fall and they tend to move far higher than is usually justified resulting in a mania or bubble, or fall far lower than is usually warranted resulting in a crash or panic. An oft-told story is that a group of investors was convinced the stock market was overvalued and they eventually turned out to be correct; the market was overvalued. They asked the famed economist, Sir John Maynard Keynes, how the market could stay so overvalued for so long. He famously quipped, “The market can stay irrational longer than you can stay solvent.” (This story has been repeated thousands of times. However, there is doubt as to its accuracy and whether or not Sir John actually was the origin of the famous quote. No matter. It's a great story to remember when prices become wildly overvalued or undervalued.)
Contrary to the Weak Efficiency Hypothesis, many speculators and traders believe they can use recent stock price movements to predict the market. If this theory is true, then Technical Analysis is useless. We will cover Technical Analysis in our next chapter.
The Semi-Strong Efficiency Hypothesis
The Semi-Strong Efficiency Hypothesis states that abnormally large profits cannot be consistently earned using publicly available information. In an efficient marketplace, prices instantly adjust rapidly to any new information available. In other words, no amount of analysis that you do to determine the future price of a stock will help you achieve a return that is better than the market as a whole. Both Technical Analysis that we will cover in the next chapter and Fundamental Analysis that we covered in the previous two chapters will not help us. According to the Semi-Strong Efficiency Hypothesis, no one can beat the market!
There is only one problem with this theory. There are many seasoned investors who have beaten the market over statistically significant periods of time. How do the Efficient Market Theorists respond to this obvious failing of their theory? Their response is that those people are just lucky. If you have sufficiently large numbers of investors, then a few will be lucky enough to beat the market. This is reminiscent of the famous quote that is attributed to many different individuals. The usual story goes like this: Famous Golfer X does something fabulous and a reporter comments, “Gee, you were really lucky today.” The Famous Golfer X quips, “Ya’ know, you are absolutely right. And the funny thing is, the more I practice, the luckier I get.” We will investigate some of the “lucky” All Stars of Investing later in this chapter and see how much of it we can attribute to luck and how much to skill and practice.
The Strong Efficiency Hypothesis
The Strong Efficiency Hypothesis asserts that no information, public or private, will allow investors to earn abnormally large profits consistently. This is obviously false. If you had material nonpublic information about a company, you could make a fortune overnight! If you do not get caught and wind up in jail, that is, since what you were doing is quite illegal. Material nonpublic information is the legal term for what is normally referred to as insider information. An example of material nonpublic information would be if you were the CEO of a drug company that was applying to have their soon-to-be blockbuster for approval by the Food and Drug Administration and you learned that the drug was going to be denied. If you made any trades that would benefit you from this information, you would be guilty of insider trading. This is exactly what happened in the infamous case surrrounding the celebrity Martha Stewart. That case, and others like it, are rarely found and prosecuted. Because of this, some industry observers believe it would just be better to make insider trading legal again. However, a return to legal insider trading is unlikely to ever occur.
Efficient Market Rational
The Efficient Market and Random Walk theorists are often also major proponents of index funds. They point to the fact that many professional money managers simply do not “beat the market,” especially during bull markets. From 1963 to 1998, the S&P 500 index outperformed the average equity mutual funds 22 out of 36 times. They reason that you are better off accepting close to the market’s return with low-cost index funds since their theory tells them that no one can consistently “beat the market.”
Why can’t many pros beat the averages? To start with, many mutual funds have high annual operating expenses. The mutual fund must beat the index by the annual fees just to break even with the index. That is why lower fee mutual funds tend to do better over the long term than higher fee mutual funds. In addition, since many mutual fund managements have a very short time horizon, many mutual fund managers have a very short lifespan. Therefore, if you are a new mutual fund manager, you are often tempted to trade often and take undue risks. You then will have subsequently high turnover and associated costs. Why invest in this manner, especially if you know that it is not the best long-term strategy? You reason, “If I do well, great! I get to keep my job and I will be showered with love and attention and a whole lot of money. If I don’t perform, oh, well, they are going to fire me anyway so why not just shoot for the moon and see what happens.” So much for efficient and rational market behavior! Here we have money managers doing what they know is not in the best interests of their shareholders simply because the incentives are misplaced. Luckily, more and more mutual fund companies are evaluating their managers over longer time frames.
However, the final nail in the coffin of efficient and rational markets came from the world of psychology. Two psychologists, Daniel Kahneman and Amos Tversky, spent their careers studying how humans make decisions. Even though he was a psychologist, Mr. Kahneman won the Nobel Prize for Economics Science in 2002 because their work challenged the assumption of human rationality prevailing in economics. Sadly, Mr. Tversky had passed away in 1996 and the Nobel Prize is not awarded posthumously. In Daniel Kahneman’s ground-breaking book, Thinking Fast and Slow, he describes their research and how it came to be used by economists. Read it!
In the final analysis, the premises and casual observations of the Efficient Market theories show them to be patently absurd. Many money managers have “beaten the market,” over statistically significant long periods of time. “The more I practice, the luckier I get.” Plus if markets are efficient and rational, how do you explain manias and crashes? Read on, Dear Student! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/06%3A_Market_Efficiency_Theory-_Who_Can_Beat_the_Market/6.01%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide #8.)
Occasionally, investors get caught up in what are called manias, also known as bubbles. The Internet dot-com bubble of the late 1990’s was one of the most famous stock manias. The NASDAQ hit a high of over 5,000 in March of 2000 only to fall approximately 80% to around 1,100 by October 2002. Before that, there was the “Nifty-Fifty” of the early 1970’s. An investor needn’t worry about valuation. These companies will go up no matter what. Predictably, it ended badly for many of those stocks and their investors. The mania of the late 1920’s resulted in the Crash of 1929. At the peak in September 1929, Radio Corporation of America ‒ you know it as RCA ‒ sold for over \$500 per share. In three years, it would sell in the teens, a loss of approximately 98%. The Goldman Sachs Trading Corporation investment trust, a precursor to modern mutual funds, went from over \$200 to \$1.75. Before then, in the 1840’s, there were 400 railroad firms. Now there are only a handful. In bubbles, a few fortunes are made, many more fortunes are lost.
The greatest bubble of all time will always be remembered as the Dutch tulip bulb craze of the early 1600’s. Although there is controversy over the exact nature of the mania, speculators did drive the price of tulip bulbs to insane levels. One poor fellow who had just arrived in The Netherlands and had no idea of what was happening mistakenly ate one of the bulbs thinking it was an onion and wound up in jail. There are two wonderful books that chronicle the events, Extraordinary Popular Delusions and the Madness of Crowds and The Botany of Desire. The first book discusses the various instances of mob psychology gone mad. It was written in 1841 but is still shocking to today’s readers. The second book discusses our relationships with plants and turns the tables on the human race. Are we controlling the plants or are they controlling us? Great question! Read both books!
During each bubble, the phrases were, “It’s a New Era,” or, “It’s different this time,” or, “The old ways of valuing stock are gone.” And each time, they were wrong! Again, so much for Efficient and Rational Markets!
Why do manias occur over and over again? Why haven’t investors learned their lesson? Leonard Kaplan, president of commodities brokerage firm Prospector Asset Management in Evanston, Illinois, believes that, “[market manias] will happen over and over again because the public is infinitely stupid.”
In his 1972 edition of The Intelligent Investor, Benjamin Graham opined, “The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some ‘action’ in progress. It will fall for any company identified with ‘franchising,’ computers, electronics, science, technology, or what have you, when the particular fashion is raging. … the abuses are so largely the result of the public’s own heedlessness and greed.” Replace “franchising,” computers, etc. with Internet, biotechnology, etc. and Good Ol’ Ben could have been writing in 2000 instead of 1972. Today, the buzz words are cryptocurrencies, meme stocks, and NFTs.
Are we in a mania/bubble now? Many believe we are. Certainly, some stocks are trading at extreme valuations. However, some other stocks are still valued at reasonable levels. What makes the current investment environment seem like a bubble is the pandemonium over cryptocurrencies, meme stocks, and NFTs. “Quick! Hurray! They are giving away free money! Go get yours now! Bitcoin will be \$1,000,000 soon!” Our technology changes quickly but our psychology has barely budged since we invented civilization. We want to believe that we can get rich quickly. In any bubble, a few do become fabulously wealthy. Most lose. Some lose everything. When you hear, “Ooo, ooo, ooo! Is it too late to get in?” then the answer is invariably, “Yes, it’s too late to get in.” It shouldn’t be long before we hear, “Ooo, ooo, ooo. Is it too late to get out?” Because …
How do most manias end? Yes, you guessed it! They invariably end with a crash, also known as a panic. “The bigger the party, the bigger the hangover.” They are not fun but the odds are you will live through at least one or two during your investing career. What we hope we have convinced you by now is that you must take a long-term perspective and not panic. It won’t feel good. In fact, it will feel as if someone punched you in the gut. Provided you did not succumb to the siren’s call of quick fortune and chose prudent, long-term oriented companies with their roots deep in the economy ‒ and the world does not end ‒ your portfolio should recover as the global economy recovers.
The following quote is from Jon Lovelace, a mutual fund money manager and the individual who oversaw the exponential growth of The Capital Group, the parent company of The American Funds, in the 1950’s through to the 1990’s. Mr. Lovelace uttered these words in August 1999, a heady time in the stock market when articles and books were touting an imminent “melt up” for stock prices, some predicting a four-fold rise.
“With this many strong years, I have the concern that there are a vast majority of companies that are significantly overvalued on a long-term basis.” ‒ Jon Lovelace
Mr. Lovelace would retire in 2000 with 50 years of experience, just as the bubble was bursting. His words fell on deaf ears. Speculators and traders spent two and a half years from March of 2000 to October of 2002 learning the painful truth about manias and crashes, bubbles and panics.
Oh, by the way, the 2008/2009 market crash was not caused by a stock market bubble. It was a real estate bubble and the mortgage-backed bonds that were tied to the real estate mortgages. We will discuss this later when we get to bonds.
A History of Bear Markets
The table below contains a history of bear markets of the Standard and Poor's 500 since the Great Depression.
A History of Bear Markets of the Standard and Poor's 500
High Low S&P 500 at High S&P 500 at Low Percent Decline Months to Recover S&P 500 P/E at High S&P 500 P/E at Low P/E Percent Decline
Sep 1929 Jul 1932 32 4 -88% 267 27 4.3 -84%
Jul 1957 Oct 1957 49 39 -20% 11 15.4 10.6 -31%
Dec 1961 Jun 1962 73 52 -29% 14 16.1 12.3 -24%
Feb 1966 Oct 1966 94 73 -22% 6 19.1 15.7 -18%
Nov 1968 May 1970 108 69 -36% 21 20.2 13.1 -35%
Jan 1973 Oct 1974 120 62 -48% 69 18.6 9.2 -51%
Nov 1980 Aug 1982 141 102 -28% 2 10.3 7.2 -30%
Aug 1987 Dec 1987 337 224 -34% 19 17.3 12.5 -28%
Jul 1990 Oct 1990 369 295 -20% 3 15.3 12.9 -16%
Jul 1998 Oct 1998 1,184 959 -19% 1 34.5 30 -13%
Mar 2000 Oct 2002 1,527 777 -49% 55 37.4 18.8 -50%
Oct 2007 Mar 2009 1,565 667 -57% 66 23.6 9.7 -59%
Feb 2020 Mar 2020 3,386 2,237 -34% 6 25.4 22.2 -13%
Jan 2022 n/a 4,797 n/a n/a n/a 23.1 n/a n/a
Scanning the table, you will find that there is no typical bear market. The percentage declines, the time to recover, and the declines in the Price-to-Earnings ratios do not follow any particular pattern. Some experience deep declines; some do not. Some take years to recover; some recover quickly. Again, the key point to remember is that bear markets will come and ‒ assuming the world does not end ‒ bear markets will go. Prudent, long-term prepare themselves emotionally for these events and do not panic. In fact, history tells us these have been the best times to allocate more resources to your investments. But as we cautioned, it jest ain’t gonna’ be fun to live through them. Oh, well. We did warn you, didn’t we? Do you want to eat well or do you want to sleep well?
Note: As mentioned beforehand, a bear market is generally defined as a 20% decline in prices. Many histories of bear markets do not include the late 1998 market downturn since it did not actually decline 20%. Also, at the time of this writing, we are still wallowing in the bear market that began in 2022. When will the next bull market start? For prudent, long-term investors, a better question is, “Which companies will do well over the next 3 to 5 years and beyond and are any of them on sale during the current bear market?”
October is the Cruelest Month
With all due respect to T. S. Eliot, we beg to differ. April is not the cruelest month. October is. The following table shows a very interesting and puzzling characteristic of severe one-day declines in the stock market.
Date Net Change Close % Decline
19-Oct-1987 -508.00 1,738.74 -22.61%
16-Mar-2020 -2,997.10 20,188.52 -12.93%
28-Oct-1929 -38.33 260.64 -12.82%
29-Oct-1929 -30.57 230.07 -11.73%
12-Mar-2020 -2,352.60 21,200.62 -9.99%
6-Nov-1929 -25.55 232.13 -9.92%
18-Dec-1899 -5.57 58.27 -8.72%
12-Aug-1932 -5.79 63.11 -8.40%
14-Mar-1907 -6.89 76.23 -8.29%
26-Oct-1987 -156.83 1,793.93 -8.04%
21-Jul-1933 -7.55 88.71 -7.84%
15-Oct-2008 -724.00 8,577.91 -7.78%
18-Oct-1937 -10.57 125.73 -7.75%
Notice how out of the thirteen worst days in the market, six of them were in mid- to late-October and one was in early November. Two of the days were in March of 2020 and were caused by the Covid-19 panic. We should really discard those days from this list. Therefore, we are left with the fact that seven of the worst eleven days occurred at the same time of the year. This is the October effect, as it is sometimes called. Why? Why have so many more severe market declines happened in this period?
The reality is that there is no good explanation for this that can be tested and proven. Most likely the best explanation goes back hundreds of thousands of years. The season is not called the fall for nothing. We saw the leaves change and the plants die off. We saw the days growing shorter and the nights growing longer. The temperature dropped. We looked around and knew that some of us weren’t going to make it to the next spring. There is a very good reason that All Soul’s Day, the Day of the Dead, All Hallows' Eve, and Halloween are in this season. As much as we like to believe that we are masters over nature ‒ flip a switch, push a button, shelter in our climate-controlled cocoons ‒ the truth is we are still animals, slaves to the natural world around us. The belief is that these animal instincts spill into the stock market from time to time. This leads us to our next section on Investor Psychology and Common Investor Weaknesses.
FOOTNOTE: You may be wondering why these remembrances and festivals would not occur in December and the winter solstice, instead of the fall. The winter solstice begins the return of the sun’s journey back to us. This is the reason the end of December was chosen to celebrate the birth of the Christ child. Jesus Christ was called the Light of the World. The winter solstice marks the birth of the light. For more about the symbols that permeate our world and how they affect us, please consider reading The Hero with a Thousand Faces by Joseph Campbell. If there is one book you should read in your lifetime, it is this one. Mr. Campbell has created a “how-to” manual for humans. In The Hero with a Thousand Faces, we learn that we are all heroes on an adventure. That adventure is what we call life. We see how the world’s major religions are calling to us from thousands of years ago. They hope we learn how not to waste this precious gift that we have been given. And if that does not pique your interest, it is also the book that George Lucas used to create Star Wars. Mr. Campbell was on the sets of the first three Star Wars movies as a consultant. He was the man behind the Force. Oh, by the way, although they won’t acknowledge it publicly, Disney has stolen from Mr. Campbell many times, the most egregious being The Lion King. Dear Students, The Hero with a Thousand Faces is a life-changing book. Read it! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/06%3A_Market_Efficiency_Theory-_Who_Can_Beat_the_Market/6.02%3A_New_Page.txt |
Because of the tremendous amount of money involved in the markets, much research has gone into trying to understand investor psychology. Some of the research is very revealing about who and what we are, not only as investors but also as a species in general.
“There are three factors that influence the markets: Fear, Greed, and Greed.” – Old Wall Street Saying
In 1962, there was a brief recession and a sharp market downturn. The President’s chief economic adviser was giving a presentation to many of the political and economic leaders of the time, describing what they were doing to right the economy. One of the attendees asked, “So when is the stock market going to recover?” The adviser curtly responded, “I am an economist, Sir, not a psychiatrist.”
What follows is a list of the common investor weaknesses.
Reading Too Much into the Recent Past
Even though there are countless examples of investors “getting on the bandwagon” just as the wagon was about to veer into a ravine, we trick ourselves into believing that, “It’s different this time,” or, “It’s a New Era.” Remember that markets move in cycles. Andrew Tobias succinctly and playfully warned, “Beware the permanent trend.” (That’s an oxymoron. There is no such thing as a permanent trend.)
The problem here is that we are hard-wired to follow the herd. We are social animals. Twenty thousand years ago, when you saw a group of your fellow humans running in a certain direction, you ran that way. The ones who didn’t were eaten by the tiger and did not get to pass on their genes. Fast forward to the modern world and this behavior can kill you, financially, that is.
Examples of this are eToys, TheGlobe.com, or CMGI in 1999. Do any of you remember these stocks? How about condo conversions in 2006 or oil in mid-2008 or gold in 2012? Will we add cryptocurrencies, SPACs, and NFTs to this list 5 or 10 years from now? I think so.
Misperceiving Randomness
Even though stock price movements in the short term are random, our brains will trick us into seeing a pattern. We humans are “heuristic.” That means we look for patterns, even if we know that there aren’t any to be found. For example, in a series of a million random digits, the probability that one digit will be repeated 13 times in a row is essentially 100%. Of course, if you happened across that digit repeated 13 times, you would swear that the series was not random. However, if it did not occur, we would know that the series is not statistically random. Technical Analysts are guilty of this, in our humble opinion. Even when they are told that the data is completely random, they will attempt to interpret the resulting graphs using their Technical Indicators. Again, we will discuss Technical Analysis in our next chapter.
Being Overconfident
We tend to believe we know more than we actually know. Or we believe that we are better than most other investors. The truth is we only see the “tip of the iceberg” with regard to what is happening within a company, an industry, and the economy. And we are usually only average or mediocre investors at best, especially if we decide to become speculators/traders!
This is called the Lake Wobegon Effect, named after the fictional town created by the author and famed storyteller Garrison Keillor. It is our natural human tendency to overestimate our capabilities. If you ask 100 people if they are excellent, good, average, fair, or poor drivers, typically over 80% will say they are excellent or good. This can’t be the case because only 50% are better than average. The effect was named after Lake Wobegon because Garrison Keillor always ends his stories about the town with the phrase, “That’s the news from Lake Wobegon, where all the women are strong, the men are good looking, and all the children are above average.”
Just in case you forgot, remember that when you decide to become a speculator/trader, you are up against the best in the business. Go back to our first chapter and listen to the story of John Meriwether and John Gutfruend from the excellent book, Liar’s Poker, by Michael Lewis. Read it! (Actually, read anything and everything by Michael Lewis. Trust me. You’ll love ‘em all! John Williams of the New York Times Book Review wrote, “I would read an 800-page history of the stapler if he wrote it.”)
Selling Your Winners and Holding onto Your Losers, also known as Loss Aversion
Loss aversion refers to the tendency of people to feel much more pain from experiencing a loss as opposed to experiencing a gain. For this reason, we will often refuse to acknowledge the loss. This is very easy to do with regard to our stock investments. As humans, we hate to admit we made a mistake, so we stubbornly hold onto our losers, hoping that they will at least get back to where we bought them. Then we can sell and tell ourselves we did not lose. The reality is that our memories are hardwired to forget unpleasant experiences. If we sell our losers, we will quickly forget about them. If we hang onto them, each time we review our portfolio, we will always be reminded of our mistakes.
In contrast, we investors tend to sell our winners too quickly. We want to lock in that profit so we can say that we made a good trade and did not lose. However, in contrast, hanging on to the winners is what will make an investor rich. So hang onto your winners! (Psst. Keep doing the research and reevaluate your choices regularly. Has the story changed? Or maybe you have found a better investment alternative? If so, it might be time to sell that winner. You can always come back to it later, especially if it experiences a downturn.)
A wonderful example of why you should hold on to your winners comes from Peter Lynch. Mr. Lynch was once asked what his worst investment decision was. He responded, “Well, I bought Home Depot when it was just getting going. My position went up 100% and I sold.” The interviewers were dumbstruck. They asked how that could have been your worst investment decision. In his wry, self-deprecating style, Mr. Lynch deadpanned, “Home Depot’s stock then went up 20-fold.” Hold on to your winners, Dear Investment Gurus! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/06%3A_Market_Efficiency_Theory-_Who_Can_Beat_the_Market/6.03%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide #20.)
In our discussions of index funds and passive management in chapter 2, we discussed the controversy surrounding active versus passive management. Passive management advocates will often make the claim that nobody can beat the market, something we have already seen is simply not true. One aspect of passive management that is not usually discussed is the effect that manias and crashes have on passive management and index funds.
Passive Management, Index Funds, Manias, and Crashes
When a mania occurs, especially if it is concentrated in a particular country or sector of the economy, index funds may become skewed and their holdings lopsided toward that country or sector. This is a serious problem with smaller and more obscure indexes but sometimes it is even a problem with broadly based indexes.
In the graphic below, we see the composition of the MSCI EAFE index as of December 31, 1989, and the composition of the Standard and Poor’s 500 Index as of March 31, 2000. Recall that the MSCI EAFE was designed to track the international stock markets outside the United States. (It has been replaced by the wonderfully named MSCI All Country World Index ex-USA. Now there’s a name you won’t quickly forget, right?)
Source: Capital Group
In the late 1980’s, the Japanese stock market and real estate market skyrocketed. What happened is the EAFE became skewed toward Japan, so much so that fully 60% of the value of the index was composed of Japanese stocks. All the other countries and areas, Canada, Western Europe, Australia, Hong Kong, Singapore, etc. made up only 40% of the index. Note the Price-to-Earnings ratios of each. The Japanese stock market had a P/E ratio of 51.9 when all the other markets had a P/E ratio of 13.0. An investor believed they were getting a well-diversified, broadly based index when in reality, almost 60% of their investments were concentrated in Japan with a very high Price-to-Earnings ratio. By August of 1990, the Japanese stock market had fallen in half. From a peak of almost 39,000 in 1989, the market fell to approximately 7,500 at its lowest point in 2008/2009.
The same phenomenon happened to the S&P 500 during the late 1990’s. The Information Technology sector, the so-called “New Economy” stocks, soared. It became known as the Internet bubble, also called the Dot-Com Bubble. The NASDAQ Composite index, which is often used to track the technology sector of the economy, went from 800 in 1995 to 5,000 in March of 2000. Subsequently, fully one third of the S&P 500 was composed of the technology sector stocks. Two thirds were everything else in the United States economy, real estate, health care, energy, consumer products, etc. Note the relative P/E ratios. The technology sector had a nosebleed Price-to-Earnings ratio of almost 60. Everything else had a lofty but not outrageous P/E ratio of a bit over 19. What happened next? Although most stock prices suffered over the next two and half years, the prices of stocks in the technology sector collapsed. Many Dot-Com companies evaporated, never to be seen or heard from again. Recall that between March of 2000 and October of 2002, the NASDAQ Composite dropped to approximately 1,100 before starting to recover.
This same phenomenon is playing itself out somewhat in recent years. As of March 2022, the valuations of the top ten stocks in the S&P 500 reached unprecedented levels. Our Introduction to Investments class at Southwestern College has a bonus assignment on mutual funds. We ask the students to identify the percentage of the S&P 500 index that is made up of just the top ten stocks. Investors who are putting resources into S&P 500 index funds believe they are getting a broadly based, well-diversified index of stocks. In March of 2022, what they were really getting was approximately 30% of just 10 companies. Fifty out of 500 companies made up over 50% of the index. The Russell 1000 Growth Index was even worse. This index is used by many Exchange-Traded Funds. On March 24, 2022, the top ten companies constituted approximately 46% of the entire index of over 500 companies in the iShares Russell 1000 Growth ETF! The bear market of 2022 brought these levels down somewhat but they are still elevated. How will it end? We shall see. But we hope the parachutes are very large for investors of these very large growth companies.
The Argument for Active Management
Today in the financial media, passive management is touted as the better alternative to active management. As we saw, index funds do have the advantage of very low-cost investing. (That is, of course, unless your third-party administrator sneaks a high-cost index fund into your 401k. Be wary and review the fees in your 401k plan carefully. Your colleagues will thank you!) But decades ago, Benjamin Graham warned against any investment strategy that relied on deterministic or robotic decision making and removed the element of human judgment. And as we have discussed, there are individuals who have excelled in the investment world. There are investors who have “beaten the market.”
“As with any human endeavor, whether it is athletic competition, the performing arts or technological innovation, some people clearly perform at a higher-than-average level.” – Mark Denning, mutual fund manager with over 35 years of experience
The trick for us mutual fund investors is to find those individuals who have clearly performed at a higher-than-average level for decades. They are out there. A good start are the six mutual fund families that are listed in the chapter 2 section of the Introduction to Investments class website. But they are not the only ones. As we have mentioned before, you have an entire lifetime of research and discovery ahead of you when you begin the journey of investing.
Remembering that we are not rational beings, one must be careful when pointing out the disadvantages of passive investing. Many investors have convinced themselves that no active managers can beat the market even though there are many who have. If you point out this contradiction to them, be prepared for a vitriolic response. They will accuse you of being a shill for the money managers and companies that have beaten the market. At the very least, they will repeat the Efficient Market theorists’ thesis that those managers are just lucky. Right. “And the more I practice, the luckier I get.”
The Argument against Active Management
Apart from the cost, there is another very good reason that some investors might prefer passive management and index funds. One never knows when and whether your active money manager might succumb to some of the more foolhardy and ridiculous ...
Anomalies, Silly Theories, and Oddities
Given the financial incentive to discover a surefire way to make untold riches in the stock market, throughout the years, various theories, systems, and traditions have emerged. Most are superstition and downright silliness. There is the Lipstick Indicator that watches the sales of lipstick and other small indulgences to determine whether a recession is on the horizon. The Boston Snow Indicator, often referred to as the B.S. Indicator, posits that a snowy Christmas in Boston will signal a market upswing in the coming year. A particularly sexist and offensive oddity is the Hot Waitress Indicator. Don’t bother investigating this one. The Aspirin Count Theory believes that the higher the sales of aspirin, the worse the market is doing, and vice-versa. Hemlines of skirts were also supposed to predict the markets. In the 1920’s and 1960’s, skirt hemlines went up and so did the stock markets. In the 1930’s and 1970’s, hemlines went down, and so did the stock markets. You decide what to make of this theory.
However, the most popular and one of the silliest indicators is the Super Bowl Theory which states that the market will do well if a NFL National Conference team wins and will do poorly if an American Conference wins. That this so-called theory gets attention every year at Super Bowl time is a testament to the urgent need of media outlets to create some kind, any kind, of content to fill up the airwaves and Internet. When it was first introduced in 1978, the correlation had been 100%. The Super Bowl Theory had never been wrong. Have these people never heard of coincidences? For example, what would you think if we told you that the per capita consumption of mozzarella cheese correlates with 96% accuracy to the number of Ph.D. awards in Civil Engineering? Or that there is almost 100% correlation between United States spending on science, space, and technology and suicides by hanging, strangulation, and suffocation? Unless you are already a dyed-in-the-wool conspiracy follower, you would conclude that these are mere coincidences. The same is true of the Super Bowl Theory and all the other previous theories.
There are also Timing Theories that dictate when and how you should buy and sell. Supposedly, Monday is the best day to buy stocks. Or maybe it is the best day to sell stocks. We don’t recall. Some individuals look at January and if January does well, then the year will do well. As we have mentioned, the stock market generally goes up more often than it goes down. So, in truth, we could pick any month of the year and say, “If the stock market goes up in June, it will go up in the next twelve months,” and we would be correct more often than we would be wrong. Others expect there to be a Santa Claus rally at Christmas time. Of course, if the market falters in December, they will chalk it up to tax-related selling. There is one piece of advice that starts with empirically proven statistics and that is the adage, “Sell in May and go away.” Traditionally, the best months of the year are from November to April. September is the worst month of the year and October is close behind. However, trying to trade in and out of stocks using this information is a fool’s errand. The difference in returns over decades is very small. As Jack Bogle would admonish us, this particular contrivance has no business being in the investor’s toolkit. For us prudent, long-term oriented investors, a buy-and-hold strategy remains the best course of action. “Chill in May and go on vacation!”
Let’s end our discussion of silliness with a place that is synonymous with childishness and absurdity, and that is Washington, D.C. The conventional wisdom is that the markets will perform better with a Republican president in charge and worse with a Democrat in charge. In actuality, the reverse is true. Of course, over the long term, the difference is small. However, the reason for this is more a result of dumb luck than anything else, bad luck on the part of Republican presidents and fortunate luck on the part of Democratic presidents. Hoover, Nixon, and Bush, Junior, were in charge when the markets had some of their worst downturns in modern history. Kennedy/Johnson, Clinton, and Obama were in the White House when the markets produced some of their best returns. The reality is that both parties are pro-capitalism, no matter how the slogans and advertising might try to paint the other party. Again, for us prudent, long-term investors, it is not something we should concern ourselves with. Focus on buying and holding high-quality companies with solid businesses and leave the political arguments for when your crazy Uncle Lucas comes for Thanksgiving Dinner. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/06%3A_Market_Efficiency_Theory-_Who_Can_Beat_the_Market/6.4%3A_Active_versus_Passive_Management_Revisited.txt |
Video - Audio - YouTube (Material for this section starts on slide #23.)
“As with any human endeavor, whether it is athletic competition, the performing arts or technological innovation, some people clearly perform at a higher-than-average level.” – Mark Denning, mutual fund manager with over 35 years experience
As Mr. Denning makes clear, some people perform at a higher-than-average level, over statistically significant periods of time. As students of investing, it pays for us to study those individuals and learn from them. The good news is that we don’t have to win as big as they did. We just have to win.
Peter Lynch
Peter Lynch was the mutual fund manager of the Fidelity Magellan Fund from 1977 to 1990. In that time, he racked up a 29% per year average annual return. His book, One Up On Wall Street, is an excellent introduction to the concepts and practice of stock investing. It is one of the two books that we recommend as your first book to read. (The other is A Random Walk Down Street, discussed earlier.) He also wrote two other books that are likewise good reads, Beating the Street, and Learn to Earn: A Beginner’s Guide to the Basics of Investing and Business. However, One Up On Wall Street is his most popular and powerful offering. Read it!
Mr. Lynch champions the idea that you should invest in businesses that you know and understand. The idea is encapsulated in the phrase, “Buy what you know.” Critics accused Mr. Lynch of trivializing the practice of investing by saying people should buy the stocks of companies that they know and understand without doing more research. This is a wrong-headed criticism. Mr. Lynch never said anything of the sort. He used the idea as just a starting point. Of course, he wanted investors to then do the proper research and investigation. Obviously, those critics had never read his book.
Warren Buffett
In this day and age, Warren Buffett needs no introduction. He is idolized and quoted and looked up to by countless investors. The annual shareholders’ meeting of his company, Berkshire Hathaway, is often called the Woodstock for Capitalists. He is the consummate Fundamental Analysis investor, putting emphasis on the value of the entire company. His adage is, “Don’t buy a stock. Buy a company.” In other words, you are researching a company and you find that you like the business and its prospects. If you had the tens or hundreds of billions of dollars it would take to buy the company outright and you would do it, then go ahead and buy 10 shares. Mr. Buffett’s resources are such that he indeed is prone to buy the whole company!
Benjamin Graham
Benjamin Graham was Warren Buffett’s teacher and mentor. Mr. Graham is called the Father of Value Investing. He wrote what is typically referred to as the best book ever written about investing, The Intelligent Investor. Eventually, you must read The Intelligent Investor. However, we strongly recommend against reading it as your first book on investing. Mr. Graham’s prose is at times difficult to penetrate and at other times, it is overly flowery. For this reason, all new editions of The Intelligent Investor have a commentary after every chapter. The commentaries are written by Jason Zweig, an excellent investment writer in his own right. Mr. Zweig will bring the material back to Earth and let you know, “Okay, here is what Old Ben was trying to say.”
John Templeton
Sir John Templeton was also a student of Benjamin Graham. He was Knighted in 1987 for his philanthropic efforts. Becoming a Knight is no small feat for a kid from a small town in Tennessee! Sir John was one of the first investors to venture out of the comfortable confines of the United States and invest abroad. Indeed, the Templeton Growth Fund was one of only three global mutual funds on our chapter 2 list of mutual funds with over 50 years of experience that had a 10% or better average annual return. Sir John was also very much involved in philanthropic and spiritual matters and his spirit lives on in the Templeton Foundation.
Bill Miller
Bill Miller was the money manager for the Legg Mason Value Trust, now called the Clearbridge Value Trust. His is a cautionary tale of what the investment industry can do to a person. At the helm of the Legg Mason Value Trust, Mr. Miller was able to beat the S&P 500 index for an unprecedented 15 years in a row. Correspondingly, Mr. Miller became yet another investment celebrity, the media hanging on his every word. Mr. Miller was not particularly happy about his situation, publicly noting that the streak was an accident of the calendar. He noted that if the year had ended in any other month, there would not have been a streak. Mr. Miller is known for his saying, “any stock can be a value stock if it trades at a discount to its intrinsic value.”
So why is this a cautionary tale? After his 15-year streak that ended in 2006, the returns of the Legg Mason Value Trust began to badly underperform the market, especially in 2007 and 2008. Although he did well in 2009, he again badly lagged the market in 2010 and 2011. In 2012, he retired from Legg Mason. It’s a tough business. As Louis Rukeyser, the host of Wall Street Week with Louis Rukeyser for over 30 years, was fond of saying, “So what have you done for me lately?”
What do all these people have in common? They had the courage to not follow the crowd because the “conventional wisdom” is usually not very wise. However, most importantly, they had an eye for unrecognized value, similar to a “sixth sense.” This gave them the ability to sniff out value that others missed. In the world of chess at one time, Garry Kasparov and Anatoly Karpov were the two best players in the world. Mr. Kasparov was once asked why this was so. Why were he and Anatoly Karpov the two best chess players in the world? His answer was astonishingly simple and direct. “We attack better than anybody else and we defend better than anybody else.” These All Stars of Investing bought the best companies and they avoided the worst companies.
Charles Steadman (???)
Speaking of avoidance, as a mutual fund investor, Your Humble Author is not looking to find the next Peter Lynch or Bill Miller or Warren Buffet. Instead, I am looking to avoid the next Charles Steadman. Who was Charles Steadman, you ask? He was often referred to as the Rembrandt of Red Ink. Charles Steadman ran his own mutual fund, the Steadman American Industry Fund, from December 1959 until his death in late 1997. During one of the greatest expansions of the global economy in human history, he had a negative return over almost 40 years! His cumulative total return was -42.9%. He would have done much better simply placing his investors’ funds into a savings account at a bank. He would have done better putting it in a mattress! Why did the investors in his funds stay with such horrible investments? The simple answer is most of them were dead.
Let’s highlight some useful advice from our All Stars.
“Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffett
Mr. Buffett is paraphrasing his mentor, Mr. Benjamin Graham, who said, “Buy when most people including experts are overly pessimistic, and sell when they are actively optimistic.”
“Bear markets are born of pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy.” – Sir John Templeton
On a similar note, Sir John also famously said, “To buy when others are despondently selling and sell when others are avidly buying requires the greatest fortitude and pays the greatest reward.” Did Sir John take his own advice? Oh, yes, he did!
“When World War II began in Europe in 1939, he borrowed money to buy 100 shares each in 104 companies selling at one dollar per share or less, including 34 companies that were in bankruptcy. Only four turned out to be worthless. He turned large profits on the others.” ‒ Templeton Foundation
The time of maximum pessimism is indeed the best time to buy. Our last quote is attributed to Nathan Rothschild, a 19th-century British financier and member of the Rothschild banking family. “The time to buy is when there is blood in the streets.” Now that is contrarian investing!
If these stories about professionals in the industry pique your interest, consider reading Wall Street People by Charles “Charley” Ellis with James Vertin. Although this book is a bit outdated, it contains a treasure trove of stories about the men and women that populate the investment world. (It’s mostly men but we are changing the world. Isn’t that so, Ladies?) Some are heroes, some are villains, some are just regular folks trying to do the best they can in a high stress world, all are interesting. In addition, please note that anything that “Charley” writes is worth reading. Mr. Ellis is also noted for coining the term “The Loser’s Game” for short-term speculation and trading of securities. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/06%3A_Market_Efficiency_Theory-_Who_Can_Beat_the_Market/6.5%3A_All_Stars_of_Investing.txt |
Video - Audio - YouTube (Material for this section starts on slide #29.)
Let’s now turn our attention to common advice that is best to be avoided with our Famous Myth and Stupid Sayings. Most of these are paraphrased from One Up On Wall Street by Mr. Peter Lynch. “It can’t go any lower.” Oh, yes, it can! Until the stock price hits zero, it can and usually does go lower. Once the stock price hits zero, then it can’t go any lower. “It can’t go any higher.” Oh, yes, it can! There is no limit to how high a stock price can go. If the earnings are growing, if the story has not changed, if the business prospects look bright, the stock price can continue to rise. “It’s only \$2 per share. What can I lose?” Everything! The stock price can go to zero and you will have lost your entire investment. In these three sayings, the person giving the advice has focused on the price. The price is irrelevant. What is the value?
It has to come back.” Oh, no, it doesn’t! Companies can and do go bankrupt and become part of history. Have you ever heard of Penn Central, the nation’s largest railroad company that had been in business for over 100 years when it became the country’s largest bankruptcy up to that date? How about Trans World Airlines or Kodak? “It’s always darkest before the dawn.” Oh, yeah? Sometimes it’s always darkest before it’s pitch black.
When it rebounds to \$10, I will sell.” This is an example of the loss aversion tendency that we humans exhibit. The stock has no idea you bought it at \$10. If you would not buy it now at this price, accept that you made a mistake, sell it now, and take the loss. Remember, you will quickly forget about this unpleasant experience. If you hold onto the stock, every time you review your portfolio, you will be reminded of your blunder. Another example of loss aversion is the adage, “If it goes down 10%, sell.” Yes, the advice is trying to help you avoid large losses. However, the problem is that stock prices fluctuate greatly, even blue chips. If you sold each stock that lost 10%, you would almost always sell your winners along with your losers. Research and investigation are the keys to determine when to sell, not volatility.
It is taking too long.” Patience is the prudent, long-term investor’s most important trait. Besides, it gives you a chance to buy more! Remember that investing is a marathon, not a sprint.
Look at all the money I’ve lost! I didn’t buy it!” You did not lose a cent by not buying a stock that did well. Do not fret over it. Do your research and investigation and determine if it is still a good value now for the long term. “I missed that one, I will catch the next one.” The problem with this strategy is that “next one” rarely makes it. An exception to this rule happened in the big box do-it-yourself sector where Lowe’s was able to carve out a substantial niche for themselves after Home Depot had pioneered the business strategy.
The stock has gone up, I must be a genius.” There is an old saying in the investment community: “Never mistake a bull market for brains.” If you talk to seasoned investment professionals, they will tell you that the time they started their career affected their career greatly. The folks who started just before a major bull run will tell you that it was actually a curse, not a blessing. They began to feel invincible … until the next bear market. The individuals who started in a difficult market quickly learned humility and will tell you that it was a blessing for them.
The stock has gone down, I must be an idiot.” This is the previous saying in reverse. You are no more an idiot than the individual whose stock has gone up is a genius. You are going to make some mistakes. Redouble your research efforts and if you would not buy this stock at this price now, sell the loser.
It’s different this time.” As discussed above, this saying and the next two are three of the most dangerous phrases you will ever hear as investors. Yes, technically, it is different every time. But that does not mean you should pay an astronomical price for a company that probably will never make a dollar of profit such as the Internet stocks of the late 1990’s and the marijuana stocks or cryptocurrencies of today. “It’s a new era. The old ways of valuing stocks are gone.” Ditto. When you hear this, it is time to sell. “It’s a permanent trend.” What? There ain’t no such thing! “Permanent trend” is an example of an oxymoron, heavy on the moron.
And finally, you will hear friends and family members and colleagues say, “Stocks are too risky.” It is perfectly normal for individuals to fear stocks and stock investing. Here is where you come into the picture, Dear Investment Gurus. You will speak with authority and confidence. You will assure them that even with all the shenanigans, silliness, and stupidity, investments in businesses through stocks or stock mutual funds are still the best financial alternatives for patient, prudent long-term oriented investors. Of course, pointing them to BUS-123, Introduction to Investments, is yet another way to help them learn the good news. Thank you for your referrals. They are greatly appreciated!
6.S: Summary
Congratulations ‒ You Have Finished Chapter 6 ‒ Efficient Market Theory: “Who Can Beat the Market?"
You have reached the end of chapter 6, Efficient Market Theory: “Who Can Beat the Market?”. In this chapter, you have:
You should now be able to:
Get Ready for Some Real Silliness
In chapters 4 and 5, we examined Fundamental Analysis. Fundamental Analysis is not easy but it is the best method for identifying potential prudent, successful, long-term oriented stock investments, in our humble opinion. In this chapter, we examined the Efficient Market Theories and some remotely rational and some downright silly strategies. For our last chapter on stocks, we are going to examine the third major form of analysis, Technical Analysis. Get ready for some real silliness! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/06%3A_Market_Efficiency_Theory-_Who_Can_Beat_the_Market/6.6%3A_Famous_Myths_and_Stupid_Sayings.txt |
“The fundamental analyst says, “You are buying companies, not stocks.” The technical analyst says, “You are buying stocks, not companies.” ‒ The Theory of Investment Value, John Burr Williams
“The biggest mistake a fundamental analyst makes is thinking that a stock and a company are the same thing. The biggest mistake a technical analyst makes is thinking that a stock and a company are different.” ‒ Phil Roth, Technical Analyst
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
And Now for Something Completely Different!
Your Humble Instructor is a big fan of Monty Python’s Flying Circus and all things silly. In the previous chapter, we saw how the Efficient Market Theorists were engaging in some silliness when they wrongly claimed that no one can beat the market. In this chapter, we reach the pinnacle of silliness! In our humble opinion, choosing stock investments using Technical Analysis is right up there with scanning tea leaves, palm reading, interpreting chicken entrails, and practicing voodoo. However, an attractive aspect of Technical Analysis is that anyone can practice Technical Analysis without really knowing what they are doing because no one else really knows what they are doing either. That means that you, too, can become a Technical Analyst without knowing what you are doing! Our students can get 10 extra bonus points in the chapter 7 bonus assignment just by acting as if they know what they are doing even though they really don't. But don’t worry! I don’t know what I am doing either when it comes to Technical Analysis so as long as they act as if they know what they are doing, they will get full credit. It is a no-lose situation!
• 7.1: Technical Analysis
Get ready for some real silliness! We are going to do our best to keep a straight face and present the concepts, tools, and techniques of Technical Analysis. And now for something completely different!
• 7.2: A Career in Stocks
The Industry Needs You! There has never been a better time to launch a career in the investment industry. Thousands of professionals will be retiring in the next five to 10 years. The industry needs more diversity and is actively recruiting women, minorities, bilingual speakers, and ex-military. Think about it! (Psst. Did we mention that the salaries are higher than the national averages? Hmm?)
• 7.S: Summary
Congratulations ‒ You Have Finished Chapter 7 ‒ Technical Analysis: Reading Squiggles on a Computer Screen
"Technical analysis" by hardeep.singh is licensed under CC BY 2.0
07: Technical Analysis- Reading Squiggles on a Computer Screen
We spent a considerable amount of time on Fundamental Analysis and investigated the claims of those who espouse the Efficient Market Theory. We will now explore Technical Analysis, the last major investment analysis strategy. The reality is that Your Humble Author is the last person who should be introducing you to Technical Analysis. As this textbook grows and evolves, we hope to find someone who will take this topic more seriously. Your Humble Author has a very difficult time keeping a straight face while discussing the techniques and concepts of Technical Analysis. For a more detailed and thorough excoriation of Technical Analysis, we once again refer you to the excellent book by Professor Burton Malkiel, A Random Walk Down Wall Street. Read it!
In the meantime, please accept our humble introduction to the concept, techniques, and skills of Technical Analysis. We promise that we will do our best not to break into a Monty Python skit about dead parrots, cross-dressing lumberjacks, or Vikings extolling the joys of breakfast Spam.
Technical Analysis versus Fundamental Analysis
Recall that Fundamental Analysis concentrated on the company. Fundamental Analysts study the financial condition and operating results of the business. The goal is to determine the intrinsic value of the company. What is the company worth? Fundamental Analysts study everything about the overall economy and industry conditions and everything about the individual company including the management, their competitive position, its composition and growth in sales, earnings, and dividends, their profit margins and the dynamics of company earnings, their customers, their vendors, the composition and liquidity of corporate resources, what assets are available, the company’s capital structure, how much debt, how much equity, etc., etc., etc. Simply put, the value of a stock is influenced by the performance of the company that issued the stock. The valuation models from chapter 4 and the ratio analysis from chapter 5 are examples of just some of the many available tools and techniques of Fundamental Analysis. But there are many investors who don’t utilize Fundamental Analysis.
Technical Analysis is the study of the various forces at work in the marketplace and their effect on stock prices. Those who adhere to Technical Analysis believe that they can predict the future price of a stock or the stock market by analyzing the behavior of the stock price’s history or the overall stock market. Technical Analysts pour over charts and attempt to interpret any one or many of dozens of so-called “Technical Indicators.” Simply put, the future price of a stock is influenced by factors other than the company’s fundamental future outlook.
The Argument for Technical Analysis
Advocates of Technical Analysis note that stock prices do tend to move in tandem to the stock market as a whole. Hence, they believe that the overall behavior of stock prices will affect an individual stock’s price. When the market is rising, most stocks rise with it. There is an old Wall Street saying: “A rising tide lifts all boats.” Likewise, when the market is falling, most stocks are brought down with it. The rebuttal to this argument is that this is just the foundational economic concepts of supply and demand at work. When stocks are in favor, prices rise. When stocks become out of favor, prices fall. Returning to the research of the Efficient Market Theorists, we reiterate that there has never been a reliable methodology for predicting the short-term behavior of the stock market. Of course, there have been plenty of unreliable methods.
For an example of one of the most infamous examples of methodologies that was at first believed to predict prices in the short-term, only to ultimately fail miserably and almost bring down the entire financial system, we refer you to the story of Long-Term Capital Management. Roger Lowenstein chronicles the story in his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management. The PBS series, Nova, also related the story in their documentary, The Trillion Dollar Bet. The story of Long-Term Capital Management reads like a prequel to the Global Financial Crisis of 2008. The technology changes, human nature, not so much.
Market Price Indicators
Technical Analysts often rely on recent stock market movements and individual stock price changes for making decisions. One technique they utilize is momentum trading. “The trend is your friend,” is a favorite saying. This works great as long as the trend is trending your way. When the trend turns, you had better be quick enough to change directions with it. However, as we have discussed, we retail investors are hopelessly outmatched against the high-frequency-trading (HFT) firms. Momentum trading is one of those techniques that Charles Ellis labeled, “The Loser’s Game” way back in the 1970’s. Momentum trading for us retail investors has only become much more difficult since then. Since it has already been statistically demonstrated that stock prices in the short term are randomly distributed, we wish the Technical Analysts much luck in their usage of momentum trading. They will need it.
Two popular market price indicators are the support level and resistance level. The support level is a chosen price or level below which a stock or the market as a whole is unlikely to fall. Likewise, the resistance level is a chosen price or level above which a stock or the market as a whole is unlikely to rise. That is, of course, until the market price does rise above or fall below the chosen level. When that inevitably happens, it is called a breakout. Below are examples of the charting of support and resistance levels. A Technical Analyst must become proficient in choosing the correct support and resistance levels and then determining when the breakout will occur and whether the price will breakout to the downside below the support level or breakout to the upside above the resistance level. Since it has already been statistically demonstrated that stock prices in the short term are randomly distributed, we wish the Technical Analysts much luck in their usage of support, resistance, and breakout trading. They will need it.
Source: CC BY-SA 3.0, https://en.Wikipedia.org/w/index.php?curid=6127005
Technical Analysts also watch for psychological barriers for stock market levels and stock prices. Examples are the Dow Jones Industrial Average closing in on the 40,000 level or the Standard and Poor’s 500 close to the 5,000 level or a stock price that is close to \$100. Supposedly, these psychological barriers act as resistance levels until the inevitable breakout to the upside. Since it has already been statistically demonstrated that stock prices in the short term are randomly distributed, we wish the Technical Analysts much luck in their usage of psychological barrier trading. They will need it.
Our last price indicator is the very popular moving average. A simple moving average is the average of a stock price or stock market index level, calculated using a fixed number of previous days’ prices or levels. The 15-day, 50-day, and 200-day moving averages are typically employed, although many other moving averages are used. For example, to calculate the 15-day moving average, we calculate the average price for the last 15 days. The next day, we do the same calculation but now for the previous 15 days. We continue to do so going on into the future. Technical Analysts will then compare the 15-day moving average with the 50-day moving average or the 50-day with the 200-day. When the shorter moving average crosses the longer moving average, that is called a crossover. Crossovers are often considered trading signals, events that warrant the Technical Analyst that there is a strong reason to make a trade. In fact, two such crossovers have special names. When the shorter moving average crosses above the longer moving average, that is called a golden cross and is considered a bullish sign and a signal the price will rise. When the shorter moving average crosses below the longer moving average, that is called a death cross and is considered a bearish sign and a signal the price will fall. Please see the figure below for examples of the golden cross and death cross. The moving average is so popular that there are several variations of it used. Since it has already been statistically demonstrated that stock prices in the short term are randomly distributed, we wish the Technical Analysts much luck in their usage of moving averages. They will need it.
We have looked at just a few technical indicators. There are dozens and dozens of others. If you find any that actually do accurately and consistently predict the future price of stocks, please be sure to let us know. Good luck, by the way.
The Dow Theory
The Dow Theory has been around a very long time. It was originally proposed by none other than Charles Dow, one of the co-founders of the Dow Jones Industrial Average and the Wall Street Journal. Sadly, Mr. Dow passed away before he published the full theory. Since then, others have expounded upon the theory without the benefit of Mr. Dow’s insight. To the best of our understanding, the theory states that if the market does not go up or down, it will go sideways. Since it has already been statistically demonstrated that stock prices in the short term are randomly distributed, we wish the Technical Analysts much luck in their usage of The Dow Theory to assist in short-term trading. They will need it.
Relative Strength, Market Volume and Breadth, and the Tick
Relative strength, market volume, market breadth, and the tick are additional technical indicators used to assist Technical Analysts in their pursuit of riches beyond their wildest dreams. If you really want to know more about them, just follow the links. Since it has already been statistically demonstrated that stock prices in the short term are randomly distributed, … oh, wait. You have read this all before, yes? Our apologies. It is difficult for us to treat this hogwash seriously. Research high-quality companies, buy and hold them for the long term, and ignore anyone trying to get you to utilize Technical Analysis as a short-term trading technique.
Short Interest
Now here is an indicator that can actually be a useful tool to long-term investors. Short interest is the number of shares of stock that are sold short in the market at any given time. We will cover the details of short selling in more detail at the end of our journey together. In brief, short sellers want the price of a stock to go down. The more shares of a stock are sold short, the more investors believe the stock price will fall. For some reason, short investors are somehow considered more “sophisticated” and are therefore supposed to know when the market will fall. However, when large numbers of investors sell short, eventually they must buy the shares back. This creates a pent-up demand for stocks. A large amount of short interest is like a compressed spring. Eventually, there will be a “short squeeze” and the price will rise. For long-term investors, a large amount of short interest can then become a contrarian indicator. If long-term investors see that a large amount of short interest has driven down the price of a desirable company, they can use this situation to buy shares for the long term.
Your Humble Author was living through his first bear market as a market professional in 2000 through 2002. In August of 2002, the Standard and Poor’s 500 index was on its way to falling almost 50% since March of 2000. It was reported that the number of shares sold short on the New York Stock Exchange was the highest it had ever been in the history of the market. That gave Your Humble Author great comfort as I was absolutely sure we were coming to the end. The market bottomed in October of 2002. That is when you started to hear people ‒ including other market professionals ‒ say, “Ooo, ooo, ooo. Is it too late to get out?” History may not repeat itself perfectly, but it rhymes!
Contrarian Opinion
Another indicator that may be of use to prudent, long-term investors is Contrarian Opinion. Contrarian Opinion is the theory that if people are very optimistic, that is a predictor of falling prices for the market, and if people are very pessimistic, that is a predictor of rising prices. Therefore, we all should be as bearish as possible and that will make the market rise, right? We covered the Contrarian Strategy already in Investment Strategies. The idea is to buy when others are selling, sell when others are buying. The problem is the market historically has gone up three times more often than it goes down.
There is a journalist who has made it his life’s mission to track the consensus sentiment of the multitude of published stock market advisory newsletters. Mark Hulbert publishes the Hulbert Stock Newsletter Sentiment Index. When in the aggregate the newsletters are all extremely bullish, that has been a fairly accurate indicator that the stock market returns for the next several years will be poor. Likewise, when the newsletters are predicting gloom and doom, the actual returns over the next several years are often favorable. As with any indicator, it is not perfect. Mr. Hulbert himself also recommends that prudent investors take a long-term perspective and simply identify high quality companies and hold them for the long term.
Odd-lot Trading
A dubious technical indicator is the odd-lot trading indicator. The theory is based on the idea that small investors tend to buy and sell in odd lots. Recall that an odd lot is less than 100 shares. The saying is, “The best thing to do is the opposite of what small investors are doing.” If old-lot trading rises, it supposedly means that more and more small investors are entering the market. Small investors are supposedly notorious for getting into the market at the top of a bull market. Not only is the research and data behind this theory very suspect, technology has made odd-lot trading commonplace.
Charting Examples
Finally, the most celebrated weapon in the Technical Analyst’s arsenal is charting. Charting is the activity of using price behavior and other market information to create charts and then superimposing patterns the charts form to make investment decisions. The moving averages and the resistance and support levels that we discussed above are examples of popular charts. Also popular are open-hi-lo-close (OHLC) charts and candlestick charts. Both are types of bar charts that use each day’s price information. For a short-term trader, if the closing price is higher than the opening price, that is supposedly a bullish candlestick. Likewise, if the closing price is lower than the opening price, that is supposedly a bearish candlestick. Since it has already been statistically demonstrated that stock prices in the short term … oh, no! We won’t start that again! We will leave it up to you, Dear Reader, to determine the value of these and the chart patterns that follow.
The most famous chart pattern is the head and shoulders chart. When Your Humble Author took the Series 7 Stockbroker Exam in 1998 (discussed in our next section), the only question about Technical Analysis dealt with the head and shoulders chart. The question simply asked if one was aware of this famous pattern. The head and shoulders chart is supposedly a bad sign. Don’t bother asking anyone why this is so because it is just so obvious why it is a bad sign, right? (Sarcasm included at no cost.) Other popular chart patterns are triangles and wedges, flags and pennants, and cups and handles. The reader is left to decide whether to spend any valuable time researching and possibly using any of these tools for trading their way to untold riches and fame.
Source: Altafqadir: This work is licensed under the Creative Commons Attribution 3.0 License.
Sources: Commontrader - Own work, CC BY 3.0, https://commons.wikimedia.org/w/index.php?curid=5556078; https://commons.wikimedia.org/w/index.php?curid=5556071
For the final word on Technical Analysis, we will quote from a real live Technical Analyst who was asked what his short-term prediction for the stock market was.
“The market’s rise after a period of reaccumulation is a bullish sign. Nevertheless, fulcrum characteristics are not yet clearly present and a resistance area exists 40 points higher in the Dow, so it is clearly premature to say the next leg of the bull market is up. If, in the coming weeks, a test of the lows holds and the market breaks out of its flag, a further rise would be indicated. Should the lows be violated, a continuation of the intermediate term downward trend is called for. In view of the current situation, it is a distinct possibility that traders will sit in the wings awaiting a clearer delineation of the trend and the market will move in a narrow trading range.” ‒ A Random Walk Down Wall Street
Ah, I think it means, if the market does not go up or down, it will remain unchanged. So, really, Folks, if you want to make a ton of money on Wall Street as a Technical Analyst, all you have to do is learn how to convince people you know what you are doing even though you don’t. Could a \$500,000 per year ‒ plus bonuses! ‒ job be in your future? Think about it! (Oh, by the way, if you do become a Technical Analyst, we wish you much good luck! You will need it.) | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/07%3A_Technical_Analysis-_Reading_Squiggles_on_a_Computer_Screen/7.01%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide #23.)
As our last section on stocks and stock investing, we take this opportunity to once again implore you to consider a career in the investment industry. The industry needs you! There are thousands of professionals who are close to retirement. The industry knows this and they also know that they need diversity. We need more women, minorities, and bilingual speakers. Veterans are especially welcome since the investment industry is highly regulated and structured and who better to recruit than those who have lived and thrived in the highly regulated and structured world of the military. Over the decades of the 1980’s, 1990’s, and into the 2000’s, finding and nurturing new investment professionals became difficult. For that reason, the industry, led by the Financial Industry Regulatory Authority (FINRA), introduced a new entry-level exam to facilitate an easier way to break into the business, the Securities Industry Essential (SIE) Exam.
The Securities Industry Essentials (SIE) Exam versus the Series 7 General Securities Representative Exam
In 2018, FINRA rolled out the Securities Industry Essentials Exam, also known as the SIE Exam. The aim was to create a new entry-level exam that could be taken by anyone interested in a career in the investment industry. Before the SIE Exam, the previous entry-level exam was the Series 7 General Securities Representative Exam, also known as the Series 7 Registered Representative Exam, Series 7 Stockbroker Exam, or simply the Series 7 Exam. However, before someone could sit for the Series 7 Exam, they were required to be sponsored by a brokerage firm. Brokerage firms became very reluctant to sponsor individuals without knowing beforehand that they could pass the exam since the cost of preparing someone for the Series 7 as well as the cost of the Series 7 itself are not insignificant. The SIE Exam requires no brokerage sponsorship and the cost is substantially lower than taking the Series 7. As of March 2022, the cost to take the SIE Exam was \$60 as reported on FINRA’s website.
The material on both exams is very similar. By taking this course, you are learning the bulk of what is needed to be studied. There is more material that you are expected to know that we do not cover in this class, especially matters concerning compliance issues. There are numerous study guides and practice exams available from FINRA and from dozens of third-party. The free practice exam from FINRA is a great place to start to see how much you have already learned. Studying and taking as many practice exams as possible seems to be the best way to prepare for the exam.
Once you pass the SIE Exam, the industry will come a callin’. Recruiters will know that you are goal oriented and motivated to become an industry professional. They will also know that there is a very good probability that you will pass the Series 7 exam. For that reason, they will be willing to make the necessary and substantial investment in you as a new professional.
Okay, so what kind of time commitment are we talking about here, eh? We tell students that to pass the Series 7, you should expect to study one to two hours per day for at least 2 months. It pays to spend the same amount of time for the SIE Exam. Study hard, pass easily. At least one previous student told us that he spent two weeks studying three to four hours per day and passed the SIE Exam on his first try. Don’t be discouraged if you fail on the first attempt on either exam. Typically, what happens is an individual will believe that they sufficiently understand one or two of the more difficult sections of the exam when in reality, they did not thoroughly study enough. They then realize what topics they need to go back to and learn more completely. A few of the trickier concepts are options, buying on margin, and shorting. We will delve into these topics at the end of the course.
There is a second exam that one must take after taking the Series 7. It is the Series 63 or the Series 66, depending upon your potential position. Neither is as difficult as the Series 7. Both require about two weeks of studying one to two hours per day.
“But Do I Have What It Takes?”
Yes! There is a future for you in the investment industry. Not everyone in the industry has to be a stockbroker. There are numerous types of positions available within the investment industry. And don’t forget about other financial services industries such as insurance and banking. The real estate and mortgage industries need financial professionals, too. Many of the positions require direct contact with the public. However, many do not. There is room for everyone, extrovert and introvert.
As discussed previously, I have my own predictors. Are you a positive, optimistic person with a sunny disposition? Do you like to socialize? Do you enjoy meeting new people? Do you want to help them succeed? Are you not afraid to ask someone if they need your help? If they say, “No,” are you still willing to go to the next person and ask the same question ... and then go on to ask twenty-seven more people? In short, are you a go-getter who refuses to give up? Will you never give up? If you can answer, “Yes,” to all or most of these questions (especially the part about never giving up), I guarantee you will do well in the industry. You might bounce around from one position to another for a bit but you will find your place. We highly recommend you read this article from the prestigious industry magazine, the Financial Times: US Financial Advisors Struggle to Overcome Their Lack of Racial Diversity. The industry needs you!
7.S: Summary
Congratulations ‒ You Have Finished Chapter 7 ‒ Technical Analysis: Reading Squiggles on a Computer Screen
You have reached the end of chapter 7, Technical Analysis: Reading Squiggles on a Computer Screen. In this chapter, you have:
You should now be able to:
We Have Reached the End of Our Investigation into the World of Stocks
Congratulations! Think about how much you have learned about stocks. Go back over these chapters often, especially the first two, Introduction to Stocks (chapter 3) and Valuation Models (chapter 4), and study them often. Remember that you are an official Investment Guru and must be able to speak with authority when your family members, friends, and colleagues ask you questions about stocks and the stock market. Our next adventure takes us into the world of bonds. See you in our next chapter, Introduction to Bonds. Boring bonds, stodgy bonds, reliable bonds! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/02%3A_Chapter_2/07%3A_Technical_Analysis-_Reading_Squiggles_on_a_Computer_Screen/7.02%3A_New_Page.txt |
“Gentlemen prefer bonds.” -- Andrew Carnegie
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Bonds are stodgy. Bonds are boring. Bonds are reliable!
Yes, Dear Students, bonds are stodgy and boring. However, bonds are reliable. Bonds bring stability to a portfolio. Bonds let us sleep well at night. Let’s explore the world of bonds and see if they belong in your investor’s toolkit.
• 8.1: Bond Basics
What are bonds? How do they differ from stocks? What are the advantages and disadvantages of bonds? What are some of their characteristics? Let's begin our exploration of bonds by answering this questions.
• 8.2: Types of Bonds
Let’s review the major bond types. We will start from the least risky to the most risky types of bonds.
• 8.3: Bond Ratings, Trading, and Quotes
We will finish our Introduction to Bonds with a discussion of how bonds are rated, traded, and quoted.
• 8.S: Summary
Congratulations ‒ You Have Finished Chapter 8 ‒ Introduction to Bonds
08: Introduction to Bonds
Bonds are negotiable, publicly traded long-term debt securities. The issuer of the bonds agrees to pay a fixed amount of interest over a specified period of time and to repay a fixed amount of principal at maturity. Bonds are also known as Fixed-income Securities, Fixed Investments, or Debt Financing. A bond is basically an IOU issued by corporations, a state or local municipality such as a state, city, or school district, or the Federal government. The bond investors loan their money to the bond issuers. Bond investors are loaners as opposed to stock investors who are owners. The bond issuers agree to repay the money they borrowed with interest.
When a bond is issued, a document is created called the trust indenture. The trust indenture is the contract that sets forth the terms between the issuer and the bondholders. The indenture describes the bond investors’ rights and issuer’s obligations. A trustee is appointed to oversee that these obligations are carried out. The trustee is usually a commercial bank or a trust company. The trust indenture stipulates protective covenants, such as an obligation of the bond issuer to keep doing business, to keep equipment in good working order, to make payments on time, etc. For example, recently, the college where I teach, Southwestern Community College in Chula Vista, California, issued bonds to build a new stadium and the other new buildings. In the trust indenture is a protective covenant that states that the money received from the bond issue must be used for “capital improvements,” a fancy term for either new building or restoring old building. In other words, we could not use the money to give the staff and faculty raises.
Why Invest in Bonds?
Bond investors receive interest during the life of the bond. The interest is normally paid every six months. When the bond is redeemed at the end of the life of the bond, the principal is returned to the bond holder. Bonds mature anywhere from 1 to 30 years. However, bond terms are typically in the 20-to-30-year range. One might think of bonds like a mortgage, a long-term loan where the payments are stretched out over many years.
With bonds, there is also the potential for a capital gain or a capital loss. The potential capital gain or capital loss is normally much less than what is exhibited by stocks. “Wait a minute,” you ask, “how could there be a capital gain or capital loss on a loan? That doesn’t make sense. Wouldn’t the amount of the loan remain constant?” Yes, you are correct. The principal remains constant throughout the bond’s life but the price of the bond will fluctuate as interest rates fluctuate. We will discuss the relationship between interest rates and bond prices in detail soon. If interest rates fall, there is a potential for a capital gain but there is also a potential for a capital loss if interest rates rise. However, if you intend to hold the bond to maturity when your principal is returned, capital gains or losses will not affect you.
Some bonds offer tax advantages. We will see that municipal bonds are free from Federal income taxes and Treasury bonds are free from state and local taxes. Lastly, some bonds can be converted into stocks. These are called convertible bonds and they give us the opportunity for outsized capital gains if the underlying stock does well. That might sound exciting but these are bonds, remember? Bonds are boring. Convertible bonds rarely deliver in a big way for their investors. We will cover “convertibles” when we discuss hybrid securities in a later chapter.
Bond holders are first in line for repayment if there is default on the loans. Actually, any payroll or tax expenses must be paid first. Guess who is at the end of the line. That’s right, the stock investors. When a company goes through bankruptcy, the bond investors get to pick at the carcass first. By the time they are through, there is invariably nothing left for the stock investors. Just as most people pay their home mortgages and car loans, etc., most all bond issuers pay their interest payments and repay the principal. For this reason, bond prices are far less volatile than stocks. However, bond prices still fluctuate. Bond prices can go down and do go down when interest rates rise. Again, we will discuss this inverse relationship in detail later.
What kind of long-term results can we expect from bonds? For several decades, bond investors became accustomed to typically being paid between 4% and 8% on a diversified bond portfolio. Treasury and municipal bonds paid 4% to 5% while corporate bonds paid 6% to 8%. For several years, the return on bonds has been much, much less. Recently, they are beginning to rise again. As of May 2023, Treasury bonds were paying 4% to 4½%. Municipal bonds were paying between 3% and 4½%. High-quality corporate bonds were paying 4% to 6% while some lower quality, riskier corporate bonds were paying over 7%. Not surprisingly, this has renewed interest in bonds on the part of bond investors after many years of uninspiring returns.
Bonds versus Stocks
Over the long term, stocks have outperformed bonds. So why invest in bonds? Stocks are far more volatile and carry more risk than bonds. Bonds offer an element of stability to your portfolio. For some investors, stocks are simply too risky. They reason, “If I can obtain my long-term goals without taking on the risk of being invested in stocks, so be it.” Some call this the “I-Can-Sleep-Better-At-Night” factor. The investor’s time frame should also be considered. Bonds make good intermediate-term investments while stocks are better thought of as good long-term investments. And sometimes, bonds are just screaming good deals. Who wouldn’t want to earn 8% or 9% on a high-quality, fixed-income investment that had a very small probability of default? The last time that bonds offered these opportunities was in the 1980’s.
Even though stocks have performed better than bonds over time, there have been periods of time when bonds have outperformed stocks, sometimes for long periods of time. The last major example of this was the 2000’s, sometimes called the Lost Decade for stocks. The 10-year average annual return was approximately -1%. Before that you have to go back to the Great Depression to see a negative 10-year average annual return. However, I am going to tell you the truth, even though as a licensed investment professional, I could have my license revoked for saying it to a potential client. Stocks must outperform bonds over the long term. Why is this so? The reason for this comes from the fundamental structure of our capitalist society.
Corporations pay the interest and principal on the bonds that they issue mainly from their earnings. If the economy and the stock market have crashed … and subsequently don’t recover, then that means corporate and private individual earnings have evaporated and our society is in shambles. With no corporate earnings, it is only a short matter of time before the corporate bonds default and become worthless. Municipalities such as state and local governments and the United States Treasury rely on corporate and individual taxes to pay the interest and principal on the bonds that they issue. If corporations and private individuals are not producing earnings, then they are not paying taxes. Likewise, it is only a short matter of time before the municipal and Treasury bonds default and become worthless. Of course, we are discussing a situation where there is no food at the grocery stores, no gas at the service stations, no clothes at the mall, the cell phones and the gas and electric companies are no longer providing service, the schools, the banks, the hospitals, the fire departments, the police stations, etc., are all boarded up, and there are brown-shirted individuals driving around with guns attached to their vehicles, using up what little resources are left to scavenge. In this case, your stock and bond investments will be the last items on your list of things to concern yourself about.
Failure is not an option. We must never let this doomsday scenario become a reality. Hence, corporations and private individuals must thrive. Over the long term, for our capitalist society to survive, stocks must perform better than bonds. Sports analogies are always a slippery slope. However, I always like to think of stocks as baseball and bonds as football. In football and most other games that are played on a rectangular field, one must stay within the boundaries of the field. Their world is fixed, like bonds. In baseball, theoretically, the foul lines are open-ended and extend indefinitely, like stocks. The world of bonds is bound. The world of stocks is limitless. I think so.
The Risks Associated with Bond Investments
Although bonds are far less risky than stocks, there are still several risks that need to be taken into consideration when investing in bonds. The first is interest rate risk. Interest rate risk comes from the inverse relationship of interest rates and bond prices. As we will cover in detail, when interest rates rise, bond prices fall. If you intend to sell the bonds in the future before they mature, a rise in interest rates can translate into capital losses. If you plan to hold your bonds until maturity, interest rate risk is not an issue you would need to consider.
Purchasing power risk is the risk that your purchasing power will fall if inflation outstrips your return from bonds. Inflation is the bond investor’s worst nightmare. If inflation runs out of control, the dollars a bond investor receives in interest and principal repayments are worth far less and the investor’s purchasing power is gutted. Business risk and financial risk are risks that are shared by both stocks and bond investors. For bond investors, business failure or financial failure on the part of the bond issuer may result in default on interest payments or principal repayments. This is much less a problem with municipal bonds although some municipalities have gone bankrupt in the past. Except for the occasional political theatrics practiced in our nation’s capital, the United States Treasury has never defaulted since the founding of the Republic and will not default anytime within our lifetimes or our children’s children’s lifetimes, unless some politicians who are far less responsible than children have their way.
Some bonds exhibit liquidity risk, the risk that there may not be sufficient buyers when and if an investor wants to sell their bonds before maturity. This is less of a problem with municipal and Treasury bonds. It could be a serious problem with thinly traded bonds. However, with high-quality bonds, it is normally not something that an investor needs to concern themselves with. For investors who plan to hold their bonds to maturity, this risk is not an issue.
The last risk is call risk, also called prepayment risk. This is the risk that a bond will be “called away” from the investor before its scheduled maturity date. This is similar to what happens when a homeowner decides to prepay their mortgage and refinance with a new mortgage, normally in response to falling interest rates. The bond investor receives their principal. However, since interest rates have fallen, the bond investor must now invest in lower-yielding bonds. For this reason, some bond issuers offer non-callable or deferred-callable bonds. We will discuss the call feature of some bonds in detail soon.
Bond Interest, Principal, and Maturity
The feature of a bond that defines the amount of annual interest income is called the coupon rate. It also goes by the names nominal rate, coupon yield, and nominal yield. Interest on bonds is usually paid every six months, although some bonds pay from every month to quarterly to once a year. The term “coupon rate” came from the fact that bonds used to have coupons attached to them. When the interest was due, an investor was required to send the coupon into the bond issuer and the issuer would then send the bondholder the interest. To this day, earning interest from a bond is often called “clipping the coupon” even though now virtually all transactions are done electronically.
The amount of the loan and the amount of capital that must be paid at maturity is called the principal. (Careful. Principle is a different word with a different meaning.) The principal is also referred to as the par value or face value. The principal of most bonds is \$1,000. Another way of saying this is that bonds are denominated in \$1,000 increments. There are some bonds that are denominated in \$5,000 and \$10,000 increments. However, for our journey together, we will always use \$1,000 as our denomination, our par value, our face value, our principal.
Putting the coupon rate and principal together tells you how much interest you will receive each year. For example, a coupon rate of 7% and a principal of \$1,000 gives \$70 of interest each year. And since almost all bonds are denominated in \$1,000 increments, knowing the coupon rate gives you the amount of interest. Therefore, normally bond investors simply refer to their bonds by the coupon rate and maturity. “I bought a 7% 30-year bond.” So if we ask you what the annual interest on a 7% bond is, you will say, “\$70.” For a 5% bond, it will be \$50. For a 3% bond, \$30. Careful: A 10% bond would yield \$100 of annual interest whereas a 1% would yield \$10.
The maturity date is the date on which a bond matures and the principal must be repaid. Most bonds are term bonds. Term bonds mature all at once. For example, a company will issue 20-year bonds that all mature in 20 years on the same date. There are also serial bonds. Serial bonds have a series of maturity dates. For example, a company may issue “series” of 20-year serial bonds with 20 maturity dates, each series maturing each year for 20 years. Each year, a certain portion of the issue would come due and be paid off as that series matures.
Technically, there is a difference between a bond and a note. Notes mature in 2 to 10 years whereas bonds mature in 10 or more years, usually 20 to 30 years. Some bonds mature in 50 or 100 years. Recently the Government of México issued 100-year bonds. A very small number of bonds never mature. They are often referred to as perpetuities or consols. Examples of these are railroads and other industries that had their starts in the 19th century. Although there is technically a difference between a 10-year note and 30-year bond, most investors, including Your Humble Author, use the term bond to refer to both bonds and notes.
The Call Provision on Bonds
As briefly mentioned above regarding the risks of bonds, many bonds have a call provision. The call provision specifies whether and under what circumstances the bond issuer can retire the bond prior to the maturity date. If interest rates drop, just as a homeowner would want to refinance their mortgage, a bond issuer would want to refinance their bond loans. The issuer “calls in” the bonds. The bonds are “called away” from the bond investor. This is also called prepaying the bonds. All other factors being equal (and they never are), investors would prefer non-callable bonds to callable bonds.
There are three types of call provisions. Freely callable bonds can be retired at any time. With non-callable bonds, the issuer is prohibited from retiring the bond before the maturity date. The third type is a hybrid of the first two. A bond with a deferred call states that the issuer must wait for a certain length of time to pass before the bonds can be called. This length of time is referred to as the call protection period or call deferment period. Most corporate and municipal bonds are freely callable or have a deferred call. Treasuries have always been non-callable. Which of the above provisions is the least desirable? Which is the most desirable? Obviously, a non-callable bond is more desirable than a freely callable bond with bonds with a deferred call somewhere in between. Of course, all other factors being equal (and again, they never are), you can expect to receive less interest from a non-callable bond than a callable bond since non-callable bonds carry the call risk whereas non-callable bonds do not.
Some callable bonds will have a call premium, an amount that is added to a bond’s par value and paid to investors if and when a bond is retired prematurely. For example, a bond might have a call premium of \$85 that must be paid in addition to the principal if and when the bond is called away from the investor. This is similar to the “prepayment penalty” that some loans such as home mortgages have. The call price, also known as the redemption price, is the price the bond issuer must pay to the bond investors in order to retire the bond prematurely. It is equal to the par value plus the call premium. In our example, \$85 call premium is added to the par value of \$1,000 to give us a \$1,085 call price. If there is no call premium, the bond is said to be “callable at par.”
Bonds and Interest Rates
By far, the most misunderstood feature about bonds is their inverse relationship with interest rates. When interest rates fall, bond prices rise. When interest rates rise, bond prices fall. For many investors, the image of the playground seesaw is helpful.
Keep this image front and center in your mind when thinking about bonds. The inverse relationship of interest rates and bonds trips up everyone, even seasoned professionals.
Because of this ongoing relationship, the current market value of a bond could be greater than or lesser than the par value. A premium bond is a bond with a market value greater than the par value. This occurs when prevailing interest rates drop below the coupon rate of the bond. A discount bond is a bond with a market value lower than par value. Contrariwise, this occurs when prevailing interest rates are greater than the coupon rate. A bond selling at a discount to its par value can also occur when and if the investment community believes that the bond issuer is in danger of defaulting on interest payments or principal payments. If there is no premium or discount, the bond is said to be “selling at par.”
You may be wondering, “Wait a minute. Why would a bond sell at a premium or a discount to its par value? If the loan is for \$1,000, the bond would always sell for \$1,000, right?” No, this is not the case. Since the interest rate of your bond is fixed and cannot change, the price of the bond changes to reflect the change in the prevailing interest rates within the financial industry. Again, keep the image of the see-saw in your mind. Interest rates go down, bond prices go up. Interest rates go up, bond prices go down.
Let’s take a look at an example. You own a bond with a par value of \$1,000. (Remember, in our class, all bonds will have par values, also known as face values, of \$1,000.) It has a coupon rate of 10%. That means it is paying you \$100 every year. (It actually will pay you \$50 every six months. Picky, picky, picky.) Now what happens if two years after you purchase the bond, interest rates fall to 8%? New bonds with \$1,000 par values are only paying \$80 per year, \$40 every six months. The result is that your bond is now worth more than it was. You would not sell your bond for \$1,000 since now investors have to pay \$1,250 to get the same amount of interest. You could sell your bond for more than \$1,000. You would receive a capital gain on the sale of your bond.
What happens if interest rates rise? If we purchased the same 10% bond and then a few years later, interest rates rise to 12%, now investors only need to pay \$833.33 to get the same amount of interest as your bond is paying. New bonds are paying \$120 and investors only need to spend \$1,000 to get that \$120. The result is you could not get anyone to buy your bond for \$1,000. If you wanted to sell, you would need to lower the price of your bond to attract a buyer. If you sold now, you would realize a capital loss. Your bond would be sold at a discount. Of course, if you have no plans to sell your bond, you will still receive the \$100 each year until the bond matures and you receive your principal of \$1,000 back.
The amount of the premium or discount is not only related to the amount of the fall or rise of interest rates. In general, the greater the fall or rise in interest rates, the greater the premium or discount. The maturity date is also very important. In general, the longer the maturity, the greater the premium or discount. Just like a seesaw, the farther out you are, the greater the rise or fall. This is why long-term bonds are riskier than short-term bonds.
In the graphic above, we see that the farther you are out on the see-saw, the more dramatic the rise or fall. The same is true of the maturity of your bonds and the bond prices. The longer the time to maturity, the more dramatic the rise or fall of the bond price will be as interest rates fall and rise. The shorter the time to maturity, the less pronounced the rise or fall of the bond price.
In the graphic above, we see as bonds get closer and closer to their maturity date, the closer and closer the price of the bonds will get to their par values. In general, long-term bonds exhibit greater price volatility and a greater opportunity for capital gain or loss. Intermediate-term and short-term bonds exhibit less price volatility with a lesser opportunity for capital gain or loss. Bonds very close to maturity ‒ three, six, or nine months ‒ start to behave similarly to short-term investments such as commercial paper and Treasury bills. However, if you intend to keep the bonds until they mature, then you are not concerned about the price volatility. You will always receive the par value of the bond except in the rare case of a bond default.
We revisit this graphic from our Introduction to Stocks chapter. We see that in 1960, the yields on bonds and stocks were very close. As inflation took hold in the 1970’s, bond investors demanded higher and higher yields. After the Federal Reserve Bank broke the back of inflation in the late 1970’s and early 1980’s, the yield on bonds fell more or less consistently until 2022 when the Federal Reserve Bank again began raising interest rates to curtail inflation caused by the effects of the COVID pandemic on the global economy. Subsequently, bond prices fell as interest rates rose and bond investors experienced a rare occurrence, negative bond returns for the year. As mentioned, bond investors have begun sniffing out attractive yields on bonds for the long term. Are they right? Is now a good time for long-term investors to invest in bonds? We will know in a few years. Stay tuned! In the meanwhile, would you be happy with 5% to 6% on 20-year corporate bonds? Do you want to eat well or do you want to sleep well? | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/08%3A_Introduction_to_Bonds/8.01%3A_New_Page.txt |
Let’s review the major bond types. We will start from the least risky to the most risky types of bonds.
Treasury Bonds and Notes
Flight to quality!” When you hear these words, you know that someone is talking about Treasury bonds. Treasury bonds, or just “Treasuries,” are the safest bonds available. When some shock happens in the world, whether it be economic or political or a natural disaster, you can always count on Treasury bonds to shine. Some professionals tell their clients that they should think of Treasury bonds as air bags. In a crash, they inflate and will protect a portfolio from catastrophic disaster. You most likely have heard one or two wingnut radio or Internet commentators rail about the national debt being unconstitutional and that Treasury bonds will become worthless and that the United States government will default. Yes, we have a serious debt problem that will cause us pain in the future. However, the United States will pay its debts.
An example of the Flight to Quality was during the Global Financial Crisis of 2008 and 2009. All major investment classes fell sharply, stocks, mutual funds, oil and other commodities, real estate, and even most bonds, that is, except for Treasury bonds. Treasury bonds became scarce and their prices went up even as the supply increased. Another example of the topsy-turvy world of investment came in 2011 when political brinkmanship between the Obama Administration and the Republicans in Congress prompted Standard and Poor's to lower the credit rating of Treasury bonds. Typically, when an individual or corporation or any other entity has their credit rating lowered, the interest rates they must pay to borrow rise. This was not so with the United States Treasury! Treasury bond prices actually increased and interest rates fell as investors once again sought Treasury bonds as a safe haven from the turmoil.
Don’t forget that 2-year to 10-year Treasury notes are technically different from 20-year to 30-year Treasury bonds but also remember that there are many of us who just don’t care about the distinction. However, don’t confuse Treasury notes and bonds with Treasury bills which are short-term investments that use the discount method for paying interest. Treasury notes and bonds pay interest every six months and then repay the principal upon maturity.
So far, the Treasury has never issued anything other than non-callable notes and bonds. The interest on Treasury notes and bonds is exempt from state and local taxes but not Federal tax.
An increasingly popular Treasury offering are Treasury Inflation-Protected Securities, often referred to as “TIPS.” TIPS are guaranteed to keep pace with inflation and as such, remove one of the risks associated with bond investing, purchasing power risk, also known as inflation risk. TIPS pay much less interest than other Treasury bonds. However, every year, the par value principal is adjusted upwards according to the rate of inflation as measured by the Consumer Price Index (CPI). Hence, if inflation for the year were 5%, a \$1,000 TIPS bond would rise \$50 (\$1,000 * 5%) and the new par value would be \$1,050. Accordingly, next year’s interest would be based on the new par value so the bond investor’s interest would also rise. TIPS are very popular with investors who fear inflation. One disadvantage of TIPS is that the IRS requires a bond investor to pay income tax on the increase in par value, even though the investor did not receive the price rise in cash. This is known as phantom income.
Often associated with Treasury bonds and notes are agency bonds. Agency bonds are not direct obligations of the United States Treasury. They are offered by agencies that were initially sponsored by the Congress. Technically, they do not have the same weight as Treasuries, but they are considered very safe with almost no risk of default. Time and time again for decades, our government officials would swear that these entities were not backed by the full faith and credit of the United States Treasury and would not be bailed out in case of a default. This was the case until the Global Financial Crisis of 2008. Subsequently, Uncle Sam had to go back on his word and bail them out. These agency bonds are the topic of our next section.
Mortgage-Backed and Asset-backed Bonds
Mortgage-backed bonds are debt issues secured by a pool of home mortgages, issued primarily by the government-sponsored entities we just introduced. They are a type of agency bond that pools together home mortgages and repackages them into bond issues that are then sold to bond investors. The original goal was to increase the availability of home mortgages as a way to encourage and promote more home ownership. They have been very successful and now are responsible for 70% of home loan funding in the United States. The various flavors of mortgage-backed bonds go by various names including Pass-through Securities, Participation Certificates, Collateralized Mortgage Obligations (CMOs), Collateralized Debt Obligations (CDOs), and Mortgage-Backed Securities. Unlike most other bonds, the payments a bond investor receives consist of both interest and principal, similar to home mortgages.
The three main agencies are the Government National Mortgage Association (“Ginnie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and the Federal National Mortgage Association (“Fannie Mae”). For decades, these entities were very successful and earned a healthy profit while accomplishing the admirable goal of increasing home ownership. That is, until the real estate bubble of the 2000’s came along. These entities got caught up in the fervor and contributed much to the Global Financial Crisis. So much so, that, as mentioned, the United States Treasury had to step in and rescue Fannie and Freddie. So now, Dear Reader, as a citizen and taxpayer of the United States of America, you are proud co-owners of Fannie and Freddie. Maybe surprisingly or maybe not surprisingly, they have rewarded you well. Every quarter, Fannie and Freddie pay several billion dollars to the Treasury from their earnings. Not bad for a country that decries socialism and wants the government to have no part of any business! Everyone can agree that the current situation is not ideal. However, no one can seem to agree on how the government should extricate itself from the industry. Stay tuned for continuing developments!
Before the advent of government-sponsored entities such as Fannie and Freddie, a potential homeowner went to their bank, credit union, savings and loan, or other type of mortgage company and applied for the mortgage. The financial institution lent the home buyer the mortgage so they could buy the house and make it their home. Every month, the homeowner made their monthly payment consisting of interest and principal to the bank, credit union, or savings and loan and the interest was credited to the financial institution as part of their earnings. Life was simple.
Life ain't so simply anymore.
Now let’s see if we can follow the money once Fannie and Freddie come onto the scene. Life became far more complicated. As before, our potential home buyers still go to a financial institution for their mortgage. Except this time, the financial institution has no intention of keeping the loan in their portfolio. They immediately sell the loan to Fannie or Freddie. Why? They receive an infusion of cash that they can use to sell another mortgage to the next wave of home buyers, generating more new mortgage-related fees and more earnings. Plus they no longer have to worry about the homeowner going bankrupt. It’s not their loan anymore. They typically will continue to service the loan which means they are accepting the monthly mortgage payments and simply forwarding the money to Fannie or Freddie.
Now here is where it gets confusing. Fannie and Freddie bundle the mortgage into packages of thousands of home loans. They then create bond issues based on the mortgages. These bonds are then sold to investors, mostly institutional investors such as life insurance companies, pension funds, and mutual funds. The investors receive the “pass-through” payments from the homeowners. As mentioned, this system was very successful for decades until the real estate bubble of the 2000’s. That’s when it was learned that many of the mortgages were sold to home buyers who did not have the necessary resources to make the payments over the long term. Many of the mortgages were so-called “no doc loans,” also known as “liar loans.” Many started with very low payments that quickly increased to the point where they could no longer make the payments. The ensuing crisis almost brought us a second Great Depression. Although there is still much controversy over the handling of the crisis, the consensus is that those in charge at the Federal Reserve Bank and the United States Treasury somehow managed to avoid the worst of a depression and instead, we suffered through the Great Recession. History is still being written about this sad chapter in our financial history.
The process of transforming lending vehicles such as mortgages into marketable securities is called securitization. The issuer pools various income producing instruments together and packages them for investors. This process can be done with almost any debt or asset. The success of the securitization of mortgage-backed bonds spread into many other areas and led to the development of asset-backed securities. Asset-backed securities go by various names such as Collateralized Bond Obligations (CBOs) and Structured Investment Vehicles (SIVs).
Asset-backed bonds are securities that are similar to mortgage-backed bonds except they are backed by a pool of bank loans, leases, and other assets such as car loans, credit card loans, patents, stocks and bonds, and even pop artists. In the late 1990’s, the artist David Bowie shocked the financial world when he issued “Bowie Bonds.” These were bonds backed by Mr. Bowie’s artistic endeavors such as his upcoming concerts and previous album releases. Although many in the industry were skeptical, the Bowie Bonds survived a credit downgrade and all the interest and principal payments were made in full. Other artists soon followed suit. Who said bonds were boring?
Municipal Bonds
Municipal bonds, often called muni bonds or just “muni’s,” are debt securities issued by states, counties, cities, and other political and governmental entities such as school districts, water or bridge authorities, or hospitals. The most attractive feature of municipal bonds is the interest paid is free of Federal taxes. Note that the IRS wants us to call them tax-exempt; they don’t appreciate the term tax-free. Also note that any capital gains from the sale of a municipal bond are not tax-exempt. Municipal bonds are very popular with individual investors, especially high income and high net worth taxpayers in the upper tax brackets. These investors must take care when they purchase municipal bonds, though, as some municipal bonds do not keep their tax-exempt status if the investor is subject to the Alternative Minimum Tax (AMT). Some municipal bonds are insured which is a desirable feature.
There are three major types of Municipal Bonds. General Obligation Bonds, also known as GOs, are municipal bonds that are backed by the full faith, credit, and taxing power of the issuer. This means that in case the entity runs into financial trouble, the entity will be required to raise revenues in any manner they can to pay the interest and principal, including raising taxes. Some time ago, the City of San Diego, California, was finally coming to terms with a pension plan that was overly generous. This led none other than The New York Times to christen San Diego, “Enron by the Sea.” (Just for the record, the overly generous plan was offered to the city employees by Republicans in the City Council in exchange for their support of a pet project on behalf of the mayor. All those leaders were long gone by the time the organic matter hit the ventilating device.) The new leaders who were left holding the bag demanded concessions from the city employees and publicly threatened that San Diego would declare bankruptcy if the employees did not agree to the concessions. This was pure bluster. If San Diego had gone to the courts claiming bankruptcy, the courts would have noted that unlike many other cities, San Diego still had plenty of untapped tax revenue streams that they could employ. Suffice it to say, the city never came hat in hand to the courts asking to be placed in bankruptcy.
The second type of municipal bonds are Revenue Bonds. Revenue Bonds are municipal bonds that require payment of principal and interest only if sufficient revenue is generated by the issuer. They are generally considered less desirable than GO bonds since GOs must seek new sources of income to meet the interest and principal payments while Revenue Bonds do not. However, Revenue Bonds typically come with higher interest rates than GOs. When researching potential Revenue Bonds, an investor should investigate the projects behind the bonds in much the same manner as when an investor researches a stock. Is the project fiscally sound? Is it desirable? Will it be able to pay the future interest and principal payments?
The last major type of municipal bonds are Special Tax Bonds. Special Tax Bonds are payable from the proceeds of a special tax that is typically voted on by the citizens of the jurisdiction. As mentioned, the college where I teach, Southwestern College, issued bonds to upgrade the buildings and other facilities of our campuses. The college asked the voters to approve bond propositions via local elections. We are happy and grateful to report that the voters approved both our bond propositions. With the proceeds from the sale of the bonds, we have been replacing older builders with new ones. The money to pay the interest and principal on the bonds will come from a special tax that is levied on property owners in the district. Although many in our community have pointed with pride to our new stadium, Southwestern recently has earned Onion Awards for architectural cluelessness. Oh, well. Everything changes; some things mutate.
As mentioned, municipal bonds offer investors attractive tax advantages, especially higher income investors. They are typically free from Federal income taxes. If the bonds are purchased by investors in that municipality, they are also often free from state and local taxes. This is sometimes referred to as double-tax exempt or double-tax free interest. If an investor is based in California and purchases California municipal bonds, they will not pay any Federal income tax nor will they pay any California income tax on the interest from the California municipal bonds. Recall that the interest payments on some bonds are subject to taxes if the investor is subject to the Alternative Minimum Tax. Also recall that any capital gains taxes on the sale of municipal bonds are not tax-exempt.
Because of this tax-exempt feature, when we research municipal bonds, we must always look at the Taxable Equivalent Yield. This allows us to compare municipal bonds with corporate and Treasury bonds. There is a Taxable Equivalent Yield calculation for Federal tax-exempt municipal bonds and a Double-Tax Exempt Taxable Equivalent Yield for both Federal & state tax-exempt municipal bonds. We will learn how to calculate these in the next chapter. We will find that the higher the tax bracket of the investor, the higher the taxable equivalent yield. For this reason, we find that municipal bonds are favored by high-income investors and eschewed by lower-income investors for the mere fact that they are just more valuable for high-income investors who then bid the prices up relative to other bonds.
Corporate Bonds
There are two major types of corporate bonds, secured and unsecured. Secured corporate bonds are backed by a claim on specific property of the issuing corporation, such as real estate, airplanes, or railroad equipment. The secured bonds are then delineated as either senior bonds, also known as senior lien bonds, or junior bonds, also known as junior lien bonds. The senior bonds have priority over the junior bonds and would be satisfied first in case of any bankruptcy proceedings. This relationship is similar to the first mortgage and a subsequent home equity line of credit (HELOC) that are associated with a house. In the event of a foreclosure, the first mortgage must be paid first before the HELOC would receive any funds.
Unsecured corporate bonds are called debentures. They are backed by the “full faith and credit” of the corporation. These are similar to a credit card loan where there is no identified collateral for the credit card company to attach for payment. The credit card company must go after whatever income or assets that the credit card holder may have. Likewise, unsecured corporate bond investors must seek payment from whatever assets are available when a company goes through bankruptcy. Similar to the pecking order described above with secured corporate bonds, there are subordinated debentures which are only able to seek payment after the debentures are satisfied. Finally, corporations can issue income bonds which are unsecured bonds that require that interest be paid only after a certain amount of income is earned.
Junk Bonds
The riskiest bonds are typically referred to as junk bonds. This is not the most flattering of titles but it is the most commonly used when referring to bonds that are in distress. More gentle names include high-yield bonds, non-investment grade bonds, distressed bonds, and speculative bonds. Junk bonds are high-risk securities that have low ratings but can produce high yields. Traditionally, junk bonds were held in very low esteem and often compared to penny stocks. They were investments to be avoided. Junk bonds were not to be discussed in polite company.
This changed in the 1980’s. Junk bonds became an industry as companies not large enough to issue bonds began to issue bonds with very high interest rates. One individual, Michael Milken, of the firm Drexel Burnham Lambert, was generally regarded as creating this industry. Sadly, Mr. Milken became involved with a trader by the name of Ivan Boesky and the two set upon a scheme to use insider information to become filthy rich. (Recall: The legal term for insider information is non-public material information.) The two inspired the movie Wall Street. The famous speech from the movie where the character brazenly declares that, “Greed is good,” is based on a speech that Mr. Boesky gave at a graduation ceremony. Both gentlemen spent time in prison, paid large fines, and were barred from the securities industry for life.
Before Mr. Milken and Drexel Burnham Lambert, junk bonds were only associated with corporations that were in dire distress. Occasionally, the bonds of a municipality qualify as junk but this is the exception, not the norm. As we have learned, the eternal struggle between risk and return applies to all investments, including bonds. With junk bonds, there is tremendous risk but they also often offer the opportunity for large capital gains along with the high income.
Unlike other bonds, junk bonds tend to follow the stock market. We say they are highly correlated with stocks. (We will discuss correlation later on in our journey together.) Why is this? Recall that most junk bonds are corporate bonds. When the stock market is doing well, it is usually a sign that the economy is prospering. Hence, corporate earnings are strong and the companies associated with the junk bonds can more readily make their interest and principal payments. When the economy is in recession, corporate earnings are depressed. Hence, not only is the stock market typically suffering but so are junk bonds because the corporations associated with the junk bonds are having a difficult time making their necessary interest and principal payments because of the depressed earnings. In contrast, in a recession, interest rates typically go down and we learned in our previous section that when interest rates go down, bond prices go up.
Zero-Coupon Bonds
We now turn our attention to a type of bond that is a bit of an oddity in the bond world, zero-coupon bonds. Zero-coupon bonds, also known as “zeros,” do not offer semi-annual interest payments. Recall that many years ago, bonds had coupons attached to them and the investor would clip the coupon, send it to the bond issuer, and the bond issuer would send them a check for the interest. Hence, a bond that pays no interest has zero coupons to clip and send. Zero-coupon bonds are sold at a deep discount from par value, similar to the savings bonds we saw in our first chapter. Instead of receiving the interest in cash, the bonds simply accrue in value until maturity. (Accrue is the fancy accounting word for increase.) For example, a \$1,000 bond maturing in 20 years at 6.25% would cost \$300 when it is issued. After 10 years, it would be worth \$550. After 20 years, the investor would receive the full \$1,000 par value.
Zero-coupon bonds are popular with those who do not need the interest income and are more interested in growing their wealth. There are a couple of disadvantages, though. They are very sensitive to interest rate changes exhibiting wide price swings. However, if you don’t plan on selling your zero-coupon bonds before maturity, then this is not an issue that concerns you. The second disadvantage is that the IRS expects you to pay taxes on the accrued interest even though you didn’t receive it in cash. There’s that phantom income problem again! To circumvent this, investors will utilize municipal zero-coupon bonds since the interest is tax-exempt or the zero-coupon bonds will be purchased inside a tax-qualified account such as an IRA or other retirement plan.
Foreign Bonds
With all due respect to the beloved memory of Jack Bogle, founder of the Vanguard Group, who stubbornly advocated investing only in the United States, our country is not the only country in the world that offers bonds. However, for many years, Mr. Bogle’s advice was worth considering with regard to bonds. Traditionally, investing in foreign bonds was not easy for retail investors. Thankfully, the wide availability of international brokerage accounts has made investing in foreign bonds easier. Also, traditionally, most other countries had much less stringent regulations and standards than the United States but that has changed dramatically for many countries. Some countries now have stricter regulations and standards. However, there are still serious considerations a potential investor must take into account when considering purchasing foreign bonds.
Along with all the normal risks associated with bonds, foreign bonds carry currency risk. When a bond is purchased abroad, interest and principal payments are paid in foreign currencies. All other things being equal (and they never are), if the U.S. dollar rises relative to the foreign currency, the value of the bond will fall. Contrariwise, if the U.S. dollar falls relative to the foreign currency, the value of the bond will rise. It is an inverse relationship. Again, think of the see-saw analogy.
To counter the currency risk and attract investors from the United States, in the past, many foreign entities issued dollar-denominated bonds. The foreign bond issuer promised to pay the interest and principal payments in dollars, no matter what happened to the currency exchange rate. This removed the currency risk from the investor. However, some jurisdictions saw their currency fall precipitously against the dollar. This meant that the foreign bond issuers saw their payment double, triple, or more since they needed far more of their own currency to pay the dollar interest and principal obligations. Needless to say, some of the entities defaulted.
Ultimately, for the vast majority of retail investors, global and international bond mutual funds are the preferred choice for those interested in foreign bonds. Established and successful mutual fund companies have the resources to conduct the international transactions and more importantly, have the global research teams necessary to properly assess the risks and rewards of bonds based outside the United States. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/08%3A_Introduction_to_Bonds/8.02%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide #37)
We will finish our Introduction to Bonds with a discussion of how bonds are rated, traded, and quoted.
Bond Ratings
When you need a loan and apply at a bank or credit union, the loan officer will run a credit report from one of the several companies that keep credit histories on virtually all citizens. The credit agencies use numeric scales to assess an individual’s credit worthiness. The credit quality of bonds is assessed very differently. Bond ratings are letter grades that designate investment quality and are assigned to a bond issue by a few designated rating agencies, the two largest being Standard & Poor’s and Moody’s. The higher the letter rating, the better the quality of the bond and the lower the risk of default of interest and principal payments.
In the wake of the 2001/2002 corporate scandals, the rating agencies were caught completely off guard. They didn’t downgrade Enron and WorldCom until they were practically in default. They were again called to task because of the 2008 mortgage-backed bond crisis that spawned the Global Financial Crisis. Yep, you guessed it! They screwed up again, but this time, they almost brought down the entire economy! Personally, Your Humble Author has always thought of the credit ratings as similar to the “idiot lights” on your car’s dashboard. By the time the [Engine Oil] goes on, it’s too late. Your engine is toast! (Friends of mine who are more car savvy tell me that the warning lights or newer cars are far more useful these days.) By the time your bond has been downgraded to junk, it is too late. You are toast!
Bond Rating Designators
Moody S&P Definition
Aaa AAA Highest grade: The “gilt-edge”
Aa AA High grade
A A Medium grade
Baa BBB Medium grade: The last investment grade rating
Ba BB Starts non-investment grade: Speculative, Distressed, “Junk”
B B More speculative: Moderate protection
Caa CCC Poor quality: In danger of default
Ca CC Poorest quality: Close to or de-facto default
C
C
D
Moody C: In default
S&P C: Not paying interest; S&P D: In default
Anything BBB or Baa or above is considered investment grade. Below BBB or Baa is considered non-investment grade, the proper and more polite term for “junk” bond status. As mentioned, in the case of Enron, the rating agencies still had them pegged at BBB as the revelations of their widespread accounting fraud were being uncovered. During the housing bubble of the mid-2000’s, the rating agencies had absurdly given their highest rating, AAA, to the associated mortgage-backed bonds backed by the “no-doc liar” mortgage loans. Many critics of the rating agencies have time and time again emphasized that the system is broken. The bond issuers pay the rating agencies for their ratings. This is a glaring conflict of interest. The rating agencies are not stupid. They are not going to “bite the hand that feeds them.” Of course, they are going to want to give their customers a high rating or else fear that their clients will look for another rating agency. When representatives of the rating agencies were called to testify before Congress after the Global Financial Crisis, how do you think they responded to these accusations? “What? How dare you suggest that we would do such a thing?” Ah, yeah, right, sure.
One last wrinkle in the ratings needs to be addressed. To further fine tune their ratings, the agencies will add a plus sign or a minus sign to the rating in the case of Standard and Poor’s or a 1, 2, or 3 in the case of Moody’s. Therefore, for bonds rated by Standard and Poor’s, AA+ is higher than AA which is higher than AA-. What’s the difference between AA+, AA, and AA-? For that matter, what’s the difference between AA, A, and BBB? Uh, I don’t know. I guess you will have to ask Standard and Poor’s.
Bond Trading
For the vast majority of bonds, bond trading is very difficult for retail investors. Many bond investors hold onto their bonds until they mature. Hence, trading volume is often thin. Many bonds trade over the counter, which means you or your broker have to find someone who owns the bonds who is willing to sell. Traditionally, one of the more reliable sources for these transactions was and still is The Bond Buyer.
However, the impediment for most retail investors is that bond traders normally trade in the \$100,000 or more range. Many traders have minimum transactions of \$25,000. If you can find a bond trader that will handle transactions in the \$10,000 range, you can expect to be treated rudely and receive poor prices. Do you recall the famed bond trader John Meriweather and his encounter with John Gutfruend? For this reason, most of us working grunts use bond mutual funds to invest in bonds. The mutual funds have the purchasing power to buy bonds using transactions in the millions of dollars.
The exception to this grim situation for retail investors is the United States Treasury and www.TreasuryDirect.gov. As you researched way back in chapter 1, Treasury bonds, notes, and bills can be purchased directly from the Treasury and you, the lowly retail investor, will get the same prices as the big boys and girls on Wall Street. Very cool!
Bonds Quotes
Bond quotes are not quoted in dollars as stocks are. That would be too easy. The opulent and moneyed world of bonds has one last curve ball to toss at us. Bond quotes normally are quoted as a percentage of the par value, also known as the face value. For example: if you see 97.25, that means 97.25% of the par value of the bond. Recall that most bonds are denominated in \$1,000 increments. That means the price of the bond would be 97.25% * \$1,000 = \$972.50. An easy way to determine the price of the bond is to move the decimal point one to the right. 97.25 is a bond quote for a bond selling at a discount. A bond selling at a premium would be quoted over 100. A bond selling at par would be quoted at 100.
For our purposes, we will always use \$1,000 as the par value. However, do keep in mind that a few bonds are denominated in \$5,000 or \$10,000 increments. In the case of \$10,000 denominated bonds, you would simply move the decimal point two to the right. A bond quote of 97.25 would designate a bond selling for \$9,725. In the case of a bond denominated in \$5,000 increments, get out your 99¢ calculator.
Unlike stock quotes, free bond quotes are not easy to come by. The Financial Industry Regulatory Authority (FINRA) is one of the few Internet websites that offer free bond quotes. You can use www.finra.org for bond quotes. Actually, it appears that they are using Morningstar for their bond quotes. If you go to Morningstar’s website, there does not seem to be any way to procure free bond quotes. Go figure. Remembering that most investors who purchase individual bonds deal in very large numbers, we can safely assume that these folks have their own private brokers who specialize in bonds. For those of you who are considering a career in the investment services industry, you will find that most of us investment professionals immerse ourselves in stocks while only a few specialize in bonds. If you find that bonds interest you, by specializing in bonds, you will not only face less competition, you will also attract the most lucrative clients. Think about it. The industry needs you!
8.S: Summary
Congratulations ‒ You Have Finished Chapter 8 ‒ Introduction to Bonds
You have reached the end of chapter 8, Introduction to Bonds. In this chapter, you have:
You should now be able to:
We Are Halfway Through Our Investigation into the World of Bonds
In our next chapter, we will introduce the calculations necessary to compare and contrast bond yields. We will also learn a technique to assign a value to a bond that should look vaguely familiar, namely the Discounted Cash Flow Model. Hey, maybe bonds are really not as boring as they seem! (Ah, sorry. Yes, they are.) See you in our next chapter, Bond Yields and Valuations. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/08%3A_Introduction_to_Bonds/8.03%3A_New_Page.txt |
What is our bond paying us?
What is our bond worth?
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Let’s continue with stodgy, boring, reliable bonds
What is our bond paying us? What is the yield? What is our bond worth? What is its valuation? We will learn how to compute the various bond yields and how to use a bond valuation technique that will be very familiar. We will see that the fixed-income nature of bonds makes predicting bond prices much more reliable than predicting stock prices. We will also discuss the yield curve and some final aspects of bond investing.
• 9.1: Bond Yields
Over the long sweep of time, income is the principal reward an investor receives from investing in bonds. Therefore, it is important to know the yield of our potential bond investment. What is the bond paying us?
• 9.2: Yield Spreads and the Yield Curve
Yield spreads are the differences in interest rates that exist among various sectors of the bond market. The yield curve is a graph that represents the relationship between a bond’s maturity and its yield at a given point in time. The yield curve has also been a reliable indicator that the economy is heading for a recession.
• 9.3: Bond Valuations
A bond's value is dependent upon the present value of its future cash flows. Wait, that sounds familiar! Yes, it's the Discounted Cash Flow Model. And since most bonds pay their interest and principal payments reliably, our predictions for bond valuations are also fairly reliable.
• 9.4: Some Final Aspects of Bond Investing
We will finish our coverage of bonds with some final aspects of bond investing including reinvestment risk, bond investment strategies, and bond laddering.
• 9.S: Summary
Congratulations ‒ You Have Finished Chapter 9 ‒ Bond Yields and Valuations
09: Bond Yields and Valuations
Bond yield is one of the most important factors in bond valuation. What income is the bond paying? Over the long sweep of time, income is the principal reward an investor receives from investing in bonds. Although there are sometimes opportunities for capital gains, when the bond is redeemed, you are only going to get back the par value of the bond. Given that most all bond issuers repay their principal without incident, the valuations calculated using bond yields tend to be very predictable.
The unpredictable factor in bond valuation is the future direction of interest rates. However, for the many investors who hold onto their bonds until maturity when they get their principal back, the direction of interest rates is unimportant to them. They are mostly interested in the income and are not affected by the direction of interest rates since they have no intention of ever selling their bonds before they mature. You are only concerned about changing interest rates if you intend or are forced to sell your bonds before they mature.
There are several different types of bond yields. We will cover the most important.
Nominal Yield, also called the Coupon Yield
The Nominal Yield is the named interest rate of the bond. It also is called the Coupon Yield, the Nominal Rate, and the Coupon Rate. Recall that the term coupon came from the historical aspect of certain bonds that had coupons attached to the bond document. When the interest was due, the investor would clip the coupon and send the coupon to the bond issuer who would then send the bond investor a check. So to this day, “clipping the coupon” is the phrase that you will hear bond investors say even though no bonds have had coupons attached to them for decades.
The absolute dollar amount of annual interest is calculated by multiplying the nominal yield by the par value. For our purposes, we will always use \$1,000 as the par value of our bonds even though some bonds have par values of \$5,000 or \$10,000. For example, if a bond had a nominal yield of 8%, we would multiply \$1,000 by 8%. That would give us \$80 of annual interest. Recall that most bonds pay interest every six months so that would signify that we were going to receive \$40 every six months from our bonds.
The Nominal Yield, however, is not as important as the Current Yield, Yield to Maturity, and the Yield to Call. Let’s learn how to calculate each.
Current Yield
The Current Yield is the amount of current income a bond provides relative to its market price. It is also called the Current Rate. The method for calculating the Current Yield is:
``` Annual Interest Current Yield = ———————————————————————————————— Current Market Price of the Bond ```
For example, say we found a bond with a Nominal Yield of 8% that was selling for \$800. This is a bond that is selling at a discount, most likely because interest rates have risen or possibly because the bond issuer is in distress and investors are worried about the possibility of default on the interest and principal payments.
``` Annual Interest \$80 Current Yield = ———————————————————————————————— = ——————— = 0.10 or 10% Current Market Price of the Bond \$800```
The nominal yield is 8% but because the bond is selling at a discount, the current yield is actually 10%. We only have to pay \$800 to get \$80 of annual interest. What if the bond is selling at a premium because interest rates have fallen? Let’s say that the same 8% bond was selling for \$1,200.
``` Annual Interest \$80 Current Yield = ———————————————————————————————— = ———————— = 0.066667 or 6.67% Current Market Price of the Bond \$1,200```
The nominal yield is the same 8% and the annual interest is the same \$80, but because the bond is selling at a premium, the current yield is only 6.67%. We would have to pay a premium of \$1,200 to get the \$80 of annual interest.
Yield to Maturity
The Current Yield tells us what the bond is paying us at this moment. However, we must remember that when the bond matures, we will receive the par value, no matter what price we actually pay for the bond. Therefore, we need to look at the Yield to Maturity to know what the fully compounded rate of return that will be earned by an investor over the life of the bond. It is often abbreviated as YTM and is sometimes called the Promised Yield. The Yield to Maturity includes both the current income and the price appreciation or depreciation of the bond.
There are two primary methods of calculation. The more accurate method is the bond pricing formula that we will discuss later combined with an internal rate of return approximation. Although it is a more accurate method, it is difficult to do manually and is better left to a spreadsheet. The other more popular method is a formula that is much easier to use and gives a very good approximation to the more accurate method. The formula looks scary but is actually fairly easy to use. The Yield to Maturity approximation formula is:
` Par Value - Market Price `
``` Annual Interest + ————————————————————————————— Number of Years to Maturity YTM = —————————————————————————————————————————————————— Par Value + Market Price —————————————————————————————— 2```
Relax. Let’s break it down into pieces. The first observation that we can make is that it is somewhat similar to the Current Yield formula. Annual Interest is on the left in the numerator just like the Current Yield formula. In the denominator, instead of just the Market Price as we had in the Current Yield formula, we take the average of the Par Value and Market Price. Why do we use the average? Because we bought the bond at the Market Price but we will receive the Par Value when the bond matures. As mentioned, the Yield to Maturity formula takes into account not only the interest we receive but also the par value, the principal amount that we will receive when the bond matures.
Okay, how about that scary part on the right side of the numerator? What is that for? Remember that although we might have paid a premium or a discount for the bond, when the bond matures, we will only receive the par value. We do not receive the market price that we paid for the bond. The calculation takes that into account. The Par Value minus the Market Price computes the difference between what we paid for the bond (Market Price) and what we will receive when the bond matures (Par Value). We then divide by the Number of Years to Maturity to determine how much per year the price of the bond will appreciate (if it is a discount bond) or depreciate (if it is a premium bond). Let’s take a look at an annotated version of the formula:
Let’s return to our first example of an 8% bond selling at a discount for \$800 and now add that the bond will mature in 10 years. Remember that for our purposes, the Par Value will always be \$1,000. The formula becomes
` \$1,000 - \$800 \$200`
``` \$80 + ————————————————— \$80 + ———— 10 10 \$80 + \$20 \$100 YTM = ———————————————————————————— = ————————————— = ——————————— = ————— = 0.1111 or 11.11% \$1,000 + \$800 \$1,800 \$900 \$900 ——————————————— ———————— 2 2 ```
In the denominator, the average of the \$1,000 Par Value and the \$800 Market Value is \$900. In the numerator, we compute the difference between the \$1,000 Par Value and the \$800 Market Value and then divide by 10, the Number of Years to Maturity. The difference between \$1,000 and \$800 is \$200. The bond will increase in value \$200 from the Market Price of \$800 to the Par Value of \$1,000 when the bond matures. We then divide by the Number of Years to Maturity of 10 to get \$20. Every year, theoretically, the price of the bond will increase by \$20. (It doesn’t actually work that way in the marketplace since interest rates and bond prices are continuously changing due to market forces. However, this approximation serves our purpose.) Purchasing the bond at a discount means that we will receive more than the Current Yield of 10%. We will not only receive the interest payments but we will receive more than what we paid for the bond when it matures. If we hold the bond for 10 years, our Yield to Maturity will be approximately 11.1%.
The situation reverses if we buy a bond at a premium. The Yield to Maturity will be less than the Current Yield. Let’s return to the second example of an 8% bond selling at a premium of \$1,200 and matures in 10 years. The formula is:
` \$1,000 - \$1,200 -\$200`
``` \$80 + ————————————————— \$80 + ————— 10 10 \$80 + (-\$20) \$60 YTM = ———————————————————————————— = ————————————— = —————————————— = —————— = 0.054545 or 5.45% \$1,000 + \$1,200 \$2,200 \$1,100 \$1,100 ————————————————— ———————— 2 2 ```
The Current Yield was 6.67% but because we are paying \$1,200 for the bond and only receiving \$1,000 when the bond matures in 10 years, our Yield to Maturity is only 5.45%. Each year, we subtract \$20 from our Annual Interest as the price of the bond makes its way from the Market Price down to the Par Value.
Yield to Call
In the case of callable premium bonds, there is always the risk of the bond being called away from us. The Yield to Call calculates the yield on a bond assuming it will be called away from us on a specified date sometime in the future. This is only used on premium-priced bonds. A bond issuer would never call in discount bonds. That would mean they would be refinancing at a higher rate. As with the Yield to Maturity, there are two common methods of calculation. There is the bond pricing formula discussed later combined with an internal rate of return approximation that we would use with a computer spreadsheet. We can also use the same approximation formula as we used for the Yield to Maturity. The difference is we replace the Par Value with the Call Price and we replace the Number of Years to Maturity with the Number of Years to Call.
` Call Value - Market Price `
``` Annual Interest + ————————————————————————————— Number of Years to Call YTC = —————————————————————————————————————————————————— Call Value + Market Price —————————————————————————————— 2```
Returning to the second Yield to Maturity example above, let’s say that the premium 8%, 10-year bond selling for \$1,200 is eligible to be called in 5 years. The Call Protection Period ends in 5 years. For this example bond, if the bond issuer chooses to call the bond away from us, they must pay a Call Premium of \$85. Hence, the Call Value is \$1,085. Replacing the Par Value with the Call Value and the Number of Years to Maturity with the Number of Years to Call, we get the following formula:
` \$1,085 - \$1,200 -\$115`
``` \$80 + ————————————————— \$80 + ————— 5 5 \$80 + (-\$23) \$57 YTC = ———————————————————————————— = ————————————— = ————————————— = ————————— = 0.049891 or 4.99% \$1,085 + \$1,200 \$2,285 \$1,142.5 \$1,142.50 ————————————————— ———————— 2 2 ```
The Yield to Call was less than the Yield to Maturity. This is typical because if the bond is called away before maturity, we would have less time to take advantage of the outsized interest income payments of the premium bond. Note that if a bond is selling at Par Value, then the Nominal Yield / Coupon Yield, the Current Yield, the Yield to Maturity, and the Yield to Call will all be the same.
Taxable Equivalent Yield
Recall that municipal bonds are exempt from Federal income taxes. The Taxable Equivalent Yield formula takes this tax-exempt status into account. Before we compare the yield of a municipal bond with the yield of a corporate bond, we must calculate the Taxable Equivalent Yield. The formula is:
``` Taxable Municipal Bond Yield Equivalent = ———————————————————————— Yield 1 - Marginal Tax Rate ```
Let’s take a look at a municipal bond that is paying 6% and assume that the investor is in the 25% Federal marginal tax bracket. The marginal tax bracket, also called the marginal tax rate, depends upon your level of income. As your income rises, so does your marginal tax bracket.
``` Taxable 0.06 0.06 Equivalent = —————————— = —————— = 0.08 or 8.00% Yield 1 - 0.25 0.75```
e result is telling us that our municipal bond is paying us as much as a corporate bond that is paying 8%. How is that? Well, the interest on the municipal bond is tax-exempt. We get to keep all of the interest we receive. On a 6% bond, that would be \$60 annually. However, the interest on the corporate bond is fully taxable. That means we have to pay income taxes on the interest. We would receive \$80 interest on the corporate bond but we would have to pay the Federal government 25% of that. The \$80 of interest times 25% is \$20 taxes. We would only get to keep \$60. The two bonds would give us the same amount of money. They are equivalent.
Double Tax-free Equivalent Yield
If an investor purchases a municipal bond domiciled in their state of residence, most states will waive the state income tax on the interest, hence the bond is said to be double tax-free or double tax-exempt. In order to compare our double tax-exempt bond with a fully taxable corporate bond, we need to calculate the Double Tax-free Equivalent Yield. There are two versions of the formula, one for taxpayers who itemize their deductions and the other for taxpayers who do not itemize. Since most municipal bond investors are typically high net worth, high income taxpayers, this first formula is more useful.
``` Double Tax-free Double Tax-Free Municipal Bond Yield Equivalent = ——————————————————————————————————————————————————————————————— Yield 1 - (Federal Bracket + (State Bracket*(1- Federal Bracket)) ) ```
Again, it looks a bit scary but if we just plug in the numbers and then work our way from the innermost parentheses to the outermost, we can do it. Let’s revisit the previous example with a 6% municipal bond yield and a 25% Federal tax bracket. Let’s assume this is a California bond and the taxpayers are California residents in the 8% California tax bracket. The formula becomes:
``` Double Tax-free 0.06 0.06 Equivalent = ——————————————————————————— = —————————————————————— = Yield 1 - (0.25+(0.08*(1-0.25))) 1 - (0.25+(0.08*0.75)```
``` 0.06 0.06 0.06 = ———————————————— = ——————————— = —————— = 0.0890565 or 8.696% 1 - (0.25+0.06) 1 - 0.31 0.69```
Because the California resident does not pay Federal or state taxes on the interest from the California municipal bond, the Double Tax-free Equivalent Yield is higher than the Taxable Equivalent Yield. The second form of the formula is used when the taxpayer does not itemize deductions on their Federal income taxes. This is very unusual as most municipal bond investors are high net worth and high-income taxpayers. Here is the second version of the formula:
``` Double Tax-free Double Tax-Free Municipal Bond Yield Equivalent = ——————————————————————————————————————— Yield 1 - (Federal Bracket + State Bracket) ```
If the taxpayer in the previous example did not itemize deductions on their Federal tax return, then the Double Tax-free Equivalent Yield will be higher. The calculations would be:
``` Double Tax-free 0.06 0.06 0.06 Equivalent = ———————————————— = ————————— = —————— = 0.89552 or 8.955% Yield 1 - (0.25+0.08) 1 - 0.33 0.67```
It turns out, the higher the taxpayer’s marginal tax bracket, the higher the Taxable Equivalent Yield and the Double Tax-free Equivalent Yield will be. For this reason, as mentioned, municipal bonds are more desirable for those in the high income tax brackets. For those in the lower tax brackets, municipal bond yields often do not compete with fully taxable corporate bonds. We must always compute the Taxable Equivalent Yield or the Double Tax-free Equivalent Yield before we can make an informed decision about which bond is best for us. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/09%3A_Bond_Yields_and_Valuations/9.01%3A_New_Page.txt |
Yield Spreads
Yield spreads are the differences in interest rates that exist among various sectors of the bond market. The shorter the maturity, the lower the rate. The longer the maturity, the higher the rate. The higher the rating of the bond, the lower the interest rate and vice versa. Treasuries carry the lowest rates. Municipal bonds are next with general obligation bonds carrying rates lower than revenue bonds. Corporate bonds yield the highest rates, especially distressed “junk” bonds. In general, non-callable bonds carry lower rates than callable bonds.
Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding, April 7, 2023
Often, investors will speak about the bond spreads as being “tight” or “wide.” A “tight” spread signifies the interest rates among the bonds they are evaluating are very close to one another. An example of a “tight” spread would be if Treasury bonds were paying 4.8% and corporate bonds were paying 5.1%. A “wide” spread denotes there is a big difference between the bond interest rates. An example of a “wide” spread would be if Treasury bonds were paying 3.2% and corporate bonds were paying 8.2%. In yet another attempt to confuse the general population and show how smart they are, experts in the media use the term "basis point" to signify 0.01 of a percentage. 100 basis points equals 1%. The first “tight” spread example has a 30-basis points spread, 0.30%. The second “wide” example has a 500-basis point spread. For several years, bond yield spreads were very tight. During the turmoil of 2008/2009, the yield spreads widened to levels not seen in decades. They narrowed significantly during the 2010’s and now have widened somewhat since 2022 as interest rates rose.
The Yield Curve
The yield curve is a graph that represents the relationship between a bond’s maturity and its yield at a given point in time. The yield curve is also used to make comparisons among types of bonds. Normally, the yield curve is upward sloping. Longer term bonds have higher interest rates than shorter term bonds and bills. However, sometimes the yield curve is downward sloping. Shorter term bonds and bills have higher interest rates than longer term bonds. This is called an “inverted yield curve.” When bond yields follow an inverted yield curve, the investment world sits up and takes special notice as we shall see.
Normal Upward-sloping Yield Curve
The upward-sloping yield curve is considered normal. Indeed, for the vast majority of time, the yield curve is upward-sloping and is often called a normal upward-sloping yield curve.
Why do longer term debt securities normally have higher interest rates than shorter term debt securities? There are three hypotheses. The Expectations Hypothesis states that the shape of the yield curve reflects investors’ expectations of future interest rates. The Maturity Preference Hypothesis, also called the Liquidity Preference Hypothesis, states that investors tend to prefer the liquidity of short-term securities and, therefore, require a premium to invest in long-term securities. The Market Segmentation Hypothesis believes that the market for debt is segmented on the basis of maturity. Supply and demand within each segment determine the prevailing interest rate. Each of these three theories makes sense and each has some merit. But how do we account for the times when the yield curve is inverted? What factors could cause an inverted yield curve to occur? And what can an inverted yield curve tell us about the future of the economy?
Atypical Downward-sloping Yield Curve, the Dreaded Inverted Yield Curve
Since World War II, every time the yield curve has inverted when short-term rates were higher than long-term rates, the economy has fallen into a recession. The only exception was 1966. The yield curve inverted in 2019, ever so slightly, causing renewed fears of an imminent recession. But then the yield curve reversed strongly as the virus turmoil hit.
For about two years before the beginning of 2008, the yield curve was slightly inverted. The bond market was predicting a recession for over two years. The stock market, for the most part, didn’t believe them. It wasn’t until fall of 2008 that the officials charged with tracking the economy acknowledged that we were in a recession. It took over two years, but the bond “ghouls” were finally proven right.
That’s odd. Why are bond investors sometimes referred to as the “bond ghouls?” Think about the dynamics of the economy. When do interest rates rise? Interest rates usually rise when the economy is growing and getting stronger. Wages are rising, corporate earnings are healthy, life is good … but not for the bond investors! They see their bond prices falling. When do interest rates fall? Interest rates invariably fall when the economy falls into recession. Unemployment rises, corporate earnings are weak, life is not good … except for the bond investors! They see their bond prices rising. Of course, “bond ghouls” is a somewhat pejorative term. Luckily, it is usually used in jest because as we shall see, if bond investors keep a long-term perspective, rising interest rates means that newer bonds will be paying higher interest. Life is good for prudent long-term oriented investors.
Here was the current yield curve as of later 2021:
Source: GuruFocus.com, October 25, 2021
Notice how the yield curve was slightly inverted in 2019. Although there was much talk of a coming recession during 2019, many experts were quick to point out that the yield curve could be inverted for quite some time before the economy actually fell into recession. Covid-19 came onto the scene and the short-term end of the yield curve collapsed as the Federal Reserve lowered short-term interest rates back to zero and bond investors braced for a pandemic-induced recession.
Here was the yield curve as of April 2023:
Source: GuruFocus.com, April 7, 2023
In late March 2022, the yield curve started to invert. As mentioned, the whole investment world sat up and started to take notice. The pundits began spinning their narratives about why the yield curve is inverting and what were the chances for a recession in the following months. The challenge this particular time was the unprecedented events that were taking place. Many believed we were finally emerging from the Covid pandemic while others suggested that the virus was not quite done with us, thank you very much. On top of that, there was the invasion into Ukraine by Russia that at first appeared to be Blitzkrieg 2.0 but bogged down into a messy and bloody stalemate. The West’s response was to place staggering sanctions on Russia which resulted in a significant loss of global trade. The Federal Reserve Bank and central banks around the world have risen short-term interest rates to curtail inflation. It has been a very murky and uncertain time. Since then, the yield curve has inverted even more dramatically. Is a recession just around the corner from this morass? Stay tuned! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/09%3A_Bond_Yields_and_Valuations/9.02%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide 29.)
Bonds are normally priced according to the present value of their future cash flows. Bond investors receive the semi-annual interest payments and the repayment of principal. Of course, other factors will always need to be considered such as the credit-worthiness of the issuer. If an issuer runs into trouble, the price of their outstanding bonds will fall because investors will be afraid of default.
The Discounted Cash Flow Model, Repurposed
Wait a minute! We just said that bonds are normally priced according to the present value of their future cash flows. Doesn’t that sound familiar? Yes, it’s the Discounted Cash Flow Model! The predicted bond price equals the present value of the yearly interest income and the present value of the principal repayment when the bond matures. Since bonds pay interest normally every six months, we really should use semi-annual compounding. However, annual compounding is easier to compute and will give you almost the exact same answer. Annual compounding computations are easily done using the present value tables. Of course, spreadsheets make annual compounding and semi-annual compounding calculations very easy. Here is the formula:
Predicted
Bond = PresentValue (InterestIncome) + PresentValue(Principal Repayment)
Price
First, we will learn how to do the calculation manually. We will then demonstrate the spreadsheet bond calculator which not only is much easier but also much more flexible. The manual calculation involves using our old friend, the present value table from chapter 4. That table gives us the present value multipliers for single payments. However, we will add another version of the present value tables to the mix. We could do the calculations using just the chapter 4 present value table. The only problem is that since bonds pay the same fixed amount each year, it would be very tedious to calculate the present value of each and every year. We would have to do 30 multiplications for a 30-year bond! This new present value table allows us to calculate the present value for a series of payments in just one multiplication calculation. That boils down the entire formula to just two multiplication calculations. The formula becomes:
Predicted Annual Present Value Principal Present Value
Bond = Interest * Multiplier for a + Repayment * Multiplier for a
Price Payment Stream of Payments Single Payment
The left side of the formula computes the present value of the fixed annual bond interest payments. The right side of the formula computes the present value of the principal payment we will receive when the bond matures. We are calculating what the future stream of cash flows from the bond are worth to us today, in the present.
You are thoroughly lost, yes? Again, as was the case when we first learned about present value and discounting and the Discounted Cash Flow Model, the words and concepts are very confusing but the calculations are very easy. After we do the calculations, go back over the paragraphs above and it should make more sense.
Let’s look at an example bond. Idaho Power Company is an electrical power utility company serving Idaho and Oregon. As of April 2023, they have a 5.50% bond coming due in 10 years on 1-Apr-2033, with a par value of \$1,000. The bond is rated A-. It was priced to yield 4.994%. This yield is close to 5% so we will use 5% for 10 years since the tables only display data for exact percentages and exact years. Here is a snippet of the present value tables:
The new table on the left allows us to calculate the present value of a series of payments, also known as a stream of payment or multiple payments. The table on the right is the same table we used in chapter 4. It allows us to calculate the present value of a single, lump sum payment. The annual payment for a \$1,000 par value bond paying 5.50% is \$55. The formula becomes:
Predicted Annual Present Value Principal Present Value
Bond = Interest * Multiplier for a + Repayment * Multiplier for a
Price Payment Stream of Payments Single Payment
Predicted
Bond Price = \$55.00 * 7.722 + \$1,000 * 0.614 = \$424.71 + \$614 ≅ \$1,038.71
For the left side of the formula, we use the left table. We go across to 5%, the “priced to yield” value, and then go down to the 10th year. The present value multiplier is 7.722. We multiply the annual interest payment of \$55 by the present value multiplier for a stream of payments at 5% for 10 years. That gives us \$424.17 on the left side. The ten interest payments we will receive in the future are worth approximately \$616.436 today in the present. On the right side, we use the right table. We go across to 5% and down to year 10. The present value multiplier is 0.614. We multiply the principal repayment of \$1,000 by the present value multiplier for a single payment at 5% for 10 years. This result is \$614; the \$1,000 bond principal repayment we will receive in ten years when the bond matures is worth \$614 today in the present. Adding together the two values gives us \$1,038.71. This is our prediction for the bond price.
How close were we to the actual price? The quoted price on FINRA on April 7th, 2023, was \$1,039.49. The bond spreadsheet calculator on the class website gave us \$1,039.02 for annual payments and \$1,043.02 for semi-annual payments. Pretty close, eh? Why is the prediction using semi-annual payments a bit higher than the annual payments prediction? We are getting paid every six months instead of waiting until the end of the year for the full payment. That makes the present value worth more, not much more, but more.
As mentioned, using the present value tables is impractical. The tables only display present value multipliers for exact years and exact percentages. There is an exponential formula but remember, we promised that you would only need a 99¢ calculator. However, Google Docs is free to use with a Google account. Please view the presentation about the bond spreadsheet calculator and explore the bond spreadsheet calculator itself. Plug in different values and watch how the bond price predictions change. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/09%3A_Bond_Yields_and_Valuations/9.03%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide 32.)
We will finish our coverage of bonds with some final aspects of bond investing.
Reinvestment Risk
Reinvestment risk is the uncertainty about the future value of an investor’s bond investments that result from the need to reinvest bond interest payments and redemptions at yields not known in advance. Changing interest rates don’t only affect the price of your bonds. They also affect your future income as you need to reinvest the interest income and bond repayments. If interest rates have fallen, although bond prices will have risen, your income level will fall as you reinvest your income and bond repayments. Likewise, if interest rates have risen, although bond prices will have fallen, your future income level will rise from reinvesting in higher paying bonds. This exact scenario is playing itself out of this writing in April 2022. Interest rates are rising, bond prices are falling. No doubt many bond investors are alarmed that the values of their bonds are falling. However, newly issued bonds will be paying higher interest rates. This is yet another example of why it is important for prudent, patient investors to keep a long-term perspective, no matter what the investment alternative.
Duration and Immunization
Duration is a measure of a bond price’s sensitivity to changes in interest rates and bond yields. Duration captures both price and reinvestment risk. It is used to indicate how a bond will react in different interest rate environments. The duration of a bond changes as it approaches its maturity date and current interest rates change. In general, the longer a bond’s maturity, the longer its duration and the higher a bond’s nominal rate and yield-to-maturity, the shorter its duration. Theoretically, the shorter the duration, the less potential price volatility the bond will exhibit from interest rate changes. The longer the duration, the most potential price volatility the bond will exhibit.
Investors who have a specified time horizon can use bond immunization to increase the probability of successfully achieving their desired goal. The goal is to keep the average duration of your bond investments equal to your time horizon. An investor would thus be more protected against interest-rate induced price swings. The problem with this strategy is that it requires constant rebalancing of your bond portfolio since durations of bonds change as interest rates change and bonds get closer to maturity. Only bond investors with very large bond portfolios would easily be able to implement this strategy. Hence, this strategy is mostly used by pension funds, bond mutual fund managers, life insurance companies, and other institutional investors with very large bond portfolios.
Bond Investment Strategies
There are three major types of bond investment strategies. The most common is the Income Strategy where investors purchase the bonds simply for the interest income they produce and typically hold the bonds until maturity. The Capital Gains Strategy entails speculating that interest rates will fall and capitalizing on the general increase in bond prices. Another form of the Capital Gains Strategy involves researching, identifying, and purchasing distressed, high-yield “junk” bonds in anticipation of the bonds increasing in credit quality and prices. The final strategy is the Total Return strategy. Investors purchase bonds for both the income and the possibility of capital gains. You will notice that there are many bond mutual funds that have the term “Total Return” in their name.
Which of these would be the easiest to implement? Which would be the hardest? The Income Strategy is the easiest method since the investor is unconcerned with the direction of interest rates and will typically keep mostly high-quality bonds in a portfolio. The Capital Gains Strategy is the most difficult as speculating on interest rates and the rehabilitation of junk bond issuers is not easily done. In fact, there are many professionals being paid tremendous sums of money to inaccurately predict the future of interest rates. (Can you imagine how much money they could make if they could accurately predict the future of interest rates?) Last, the Total Return strategy, being a mixture of the first two, sits somewhere in between.
Bond Laddering
A common method of diversifying a bond portfolio is bond laddering. This strategy involves purchasing bonds with staggering maturities. An investor, or more likely a pension fund manager or bond mutual fund manager, will purchase some bonds with short-term maturities, some with intermediate-term maturities and some with long-term maturities. Thus, the investor owns some higher-paying long-term bonds with the accompanying interest rate risk while also protecting the total portfolio with some lower-paying intermediate-term and short-term that carry much less interest-rate induced rate.
Here are interest rates as of October 25, 2021:
Interest
Rate
Maturity
Date
Maturity
(years)
3-month Treasury 0.04% Jan 2022 0.25
6-month Treasury 0.06% Apr 2022 0.5
2-year Treasury 0.47% Oct 2023 2
2-year A Corporate 1.01% Oct 2023 2
5-year Treasury 1.17% Oct 2026 5
5-year A Corporate 1.73% Oct 2026 5
10-year Treasury 1.63% Oct 2031 10
10-year A Corporate 2.74% Oct 2031 10
20-year A Corporate 3.52% Oct 2041 20
30-year Treasury 2.08% Oct 2051 30
30-year A Corporate 3.99% Oct 2051 30
Data as of October 25, 2021 Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding
What a difference less than six months can make. Here are interest rates as of April 1, 2022:
Interest
Rate
Maturity
Date
Maturity
(years)
3-month Treasury 0.75% Jul 2022 0.25
6-month Treasury 1.22% Oct 2022 0.5
2-year Treasury 2.49% Apr 2024 2
2-year A Corporate 2.97% Apr 2024 2
5-year Treasury 2.59% Apr 2027 5
5-year A Corporate 3.81% Apr 2027 5
10-year Treasury 2.39% Apr 2032 10
10-year A Corporate 3.95% Apr 2032 10
20-year A Corporate 4.51% Apr 2042 20
30-year Treasury 2.45% Apr 2052 30
30-year A Corporate 4.78% Apr 2052 30
Data as of April 1, 2022 Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding
Since then, through 2022 until to the time of this writing in May 2023, the Federal Reserve Bank has been ratcheting up short-term interest rates to curtail inflation. Below are the rates as of May 15, 2023. Notice the inversion of several rates. (Example: The three-month Treasury bill is paying 5.28% and the 10-year Treasury note is paying 3.51%. Recall the dreaded inverted bond yield curve!)
Interest
Rate
Maturity
Date
Maturity
(years)
3-month Treasury 5.28% Jul 2023 0.25
6-month Treasury 5.19% Oct 2023 0.5
2-year Treasury 4.07% Apr 2025 2
2-year A Corporate 4.44% Apr 2025 2
5-year Treasury 3.50% Apr 2028 5
5-year A Corporate 6.47% Apr 2028 5
10-year Treasury 3.51% Apr 2033 10
10-year A Corporate 7.25% Apr 2033 10
20-year A Corporate 5.80% Apr 2043 20
30-year Treasury 3.85% Apr 2053 30
30-year A Corporate 6.01% Apr 2053 30
Data as of May 15, 2023 Source: Fidelity https://fixedincome.fidelity.com/ftgw/fi/FILanding
We always knew that someday, interest rates would begin to rise back to historical norms. It is unlikely that anyone would have thought the rise would begin because of the shutting down of the global economy because of a global pandemic with the subsequent supply/demand imbalances causing global inflation and then compounding the misery by Russia invading Ukraine. (What’s next? China invading Taiwan?) Is a recession coming? Stay tuned!
9.S: Summary
Congratulations ‒ You Have Finished Chapter 9 ‒ Bond Yields and Valuations
You have reached the end of chapter 9, Bond Yields and Valuations. In this chapter, you have:
You should now be able to:
We Are Done with Bonds
And congratulations are also in order since we have finished our journey of studying all the major financial investment alternatives. In our next module, we will take a brief look at hybrid securities such as preferred stock and convertible bonds. They are a very small piece of the investment universe and not very popular with the general investing public, especially preferred stocks. After that, we will attempt to go back to the very beginning of the semester and tie together everything we have learned. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/09%3A_Bond_Yields_and_Valuations/9.4%3A_Some_Final_Aspects_of_Bond_Investing.txt |
The Best of Both Worlds, The Worst of Both Worlds
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
Hybrid Securities: The Best and Worst of Both Worlds
In a backwater of the investment universe rarely visited by retail investors lives a group of instruments known as hybrid securities. It is very unlikely that you as an individual retail investor will choose hybrid securities as part of your investment portfolio but you never know. You may be drawn to these instruments. At the very least, you need to be able to explain the inherent problems with these choices for retail investors to your brother-in-law who is all excited about buying preferred stock instead of just plain old common stock.
• 10.1: Preferred Stock
"Hey, don't I want Preferred Stock instead of just plain old Common Stock?" Ah, not really. Preferred stock does have some advantages but one major advantage for corporations who own preferred stock makes the usage of preferred stock for us retail investors not as attractive as they might seem. Let's explore.
• 10.2: Convertible Securities
Convertibles securities allow bonds and preferred stock to partake in the potential success of the company, similar to the common stock of a company. Let's see if you might want to choose these best of both worlds, worst of both worlds investments.
• 10.S: Summary
Congratulations ‒ You Have Finished Chapter 10 ‒ Hybrid Securities: Preferred Stock and Convertible Securities
"The Junction of Two Worlds" by Natalia Medd is licensed under CC BY-SA 2.0
10: Hybrid Securities - Preferred Stock and Convertibles Securities
Preferred stocks are stocks that have a prior claim ahead of common stocks on the income and assets of the issuing firm. They are one type of Hybrid Security. They are sometimes called Fixed-income Stocks because they usually pay a fixed dividend. The dividend is usually a percentage of a preset par value of the preferred stock in much the same way as a bond pays a fixed interest amount on the par value of the bond. However, preferred stocks represent equity and therefore, do not count as debt on the corporate balance sheet. And like common stocks, there is no maturity date as there is with a bond. There is also no guarantee of continued dividends; a corporation can suspend preferred stock dividends at any time. In case of corporate default, preferred stocks have priority over common stockholders but are subordinate to bonds. They are truly a hybrid mixture of both stocks and bonds.
When people hear the term preferred stock, they often believe that preferred stock is a better choice than common stock. It is true that preferred stock typically pay a reliable stream of dividend income and have priority over common stock investors in case of default. The critical issue, however, is that preferred stock typically does not participate in the success of the corporation, whereas common stock does participate in the success. For this reason, some professionals refer to preferred stock as bonds even though, legally, they are not bonds. The interest payments on bonds are mandatory; the dividend payments from preferred stock are not mandatory.
The Advantages and Disadvantages of Preferred Stocks
Preferred stocks typically offer a highly predictable stream of dividend income and, as a whole, have an excellent record of meeting those dividend payments. A major benefit of preferred stock is the tax benefits that are offered to corporations who own the preferred stock of another corporation. Corporations that receive dividends on preferred stock can deduct 50% to 65% of the dividend income from their corporate taxes. This strong incentive to corporations turns out to be a strong disincentive to individual retail investors like us. Because of this provision, corporations are willing to pay a higher price for preferred stocks than would be prudent for individual investors. This is the major reason that although the name preferred stocks is attractive to individual investors, the actual investment vehicle is not.
What are the disadvantages? Preferred stocks are susceptible to inflation risk, similar to bonds. Like common stocks, dividends can be suspended or postponed, unlike bonds, which must pay interest or risk default. Like bonds, because of the fixed nature of the dividends, there is a lack of potential of substantial capital gains, unlike common stock. Last, preferred stocks normally do not pay as well as bonds but the yield has been very close to bonds over time. And of course, the dividends of the common stocks of many corporations have grown substantially over the years whereas preferred stock dividends remain fixed.
We see that preferred stocks have some of the advantages of both stocks and bonds and some of the disadvantages of both stocks and bonds. They offer the best and the worst of both worlds. Also, the universe of preferred stocks is much smaller than either stocks or bonds. For these reasons, many in the industry recommend stocks for growth and income and they recommend bonds for income.
The Yield and Pricing of Preferred Stock
The dividend yield of preferred stock is annual dividend income divided by the preferred stock price, similar to the current yield of a bond or a common stock.
Annual Dividend Income
Dividend Yield = ────────────────────────
Current Market Price
For example, if the annual dividend income for a preferred stock were \$2 and the current market price were \$27.50, then the dividend yield would be:
\$2
Dividend Yield = ──────── = 0.0727272727 or 7.27%
\$27.50
This preferred stock is yielding 7.27% annually.
As with bonds, preferred stock prices fluctuate mostly inversely to interest rates. However, with preferred stock, there is a greater risk of non-payment of dividends. Recall that the dividends for both common stock and preferred stock are not mandatory. Bonds, on the other hand, would be declared to be in default if the interest is not paid. The bond issuer would be hauled off to bankruptcy court.
The pricing formula for preferred stock is:
Annual Dividend Income
Price = ───────────────────────────
Prevailing Interest Rates
Does this formula look familiar? It’s the Zero Growth Model. Well, of course, it is. Preferred stock dividends don’t grow! For example, if the annual dividend income were \$2.50 and currently, prevailing interest rates are paying 12%, then the formula would become:
\$2.50
Price = ──────── = 20.833333 or \$20.83
0.12
We would predict the market price of this preferred stock to be approximately \$20.83.
Some Characteristics of Preferred Stock
Some preferred stocks have a conversion feature. They are referred to as Convertible Preferred or just Convertibles. This allows the holder of a preferred stock to convert to a specified number of shares of the issuing company’s common stock. This helps alleviate one of the major disadvantages of preferred stock. With a conversion feature, if the corporation is very successful, the investor can then share in the growth of the common stock. We will discuss convertible securities in more detail in the next section.
A few preferred stocks are Adjustable-rate Preferred Stocks. They are often referred to as Floating-rate Preferred or just Floaters. Instead of being fixed, the dividends are adjusted periodically in line with prevailing interest rates. They are often tied to Treasury rates or other indexes. This helps alleviate the inflation / purchasing power risk.
Some companies issue different classes of preferred stock called Senior Preferred, Preference Stock, or Prior Preferred. Similar to the senior and junior bonds, the most senior preferred stocks are guaranteed to be paid before the less senior (aka junior preferred), etc. Also similar to bonds, preferred stocks can be issued as callable preferred or non-callable preferred. If interest rates fall, the issuer would want to refinance the preferred stock at a lower dividend rate similar to how a bond issuer would want to refinance their bonds at a lower interest rate. Finally, some preferred stock is issued as Participating Preferred Stock. This is a rare form of preferred stock that allows investors to participate in the earnings of a corporation beyond the stated dividend rate, similar to how many companies will increase the dividends of their common stock as their earnings grow.
Cumulative versus Non-cumulative Preferred Stock
One of the most sought after types of preferred stock is Cumulative Preferred Stock. Remember that with both preferred stock and common stock, the dividend payments are optional. Both can be suspended at any time. However, with cumulative preferred stock, if the company suspends the preferred stock dividends, those foregone dividends are said to be “in arrears.” The “in arrears” dividends must be paid before any future dividends can be paid, whether for preferred or common stock. Hence, cumulative preferred stock is preferable to non-cumulative preferred stock. And as expected, cumulative preferred stock will be able to offer a lower dividend to investors than non-cumulative preferred stock because of this provision.
What is the bottom line on preferred stock? Preferred stock is normally owned by corporations. Some individual investors may acquire a taste for them but it is our opinion you are better off with common stock for growth and income and bonds for income. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/10%3A_Hybrid_Securities_-_Preferred_Stock_and_Convertibles_Securities/10.01%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide 9.)
Convertible Securities are fixed-income obligations that can be converted into a specified number of shares of the issuing company’s common stock. There are both convertible bonds and convertible preferred stock. Convertible securities are often referred to as Deferred Equity because the convertible securities could become part of the company’s pool of common stock in the future. Because of this ability to share in the possible appreciation of common stock, convertible securities are also sometimes referred to as an “Equity Kicker.”
Example: A single \$1,000 bond can be converted into 20 shares of common stock
One of the major disadvantages of both bonds and preferred stock is that if the company is wildly successful, the bonds and preferred stock do not participate in the success. The ability to convert their convertible security into common stock allows the investor to partake in the potential success of the company. Oh, by the way, once you convert from the convertible bond or convertible preferred stock to the common stock, you can’t convert back.
Conversion Measures
There are several measures and conditions of the conversion feature of convertible securities, some are fixed and others depend upon the current price of the company’s common stock. The Conversion Period is the time period during which a convertible issue can be converted. The ability to convert a convertible bond or convertible preferred stock is normally deferred for a period of years. This is not usually a serious problem since when the convertible security is issued, a conversion is not normally advantageous to the investor. The common stock price normally will have to rise substantially before an investor would want to convert the security.
The Conversion Ratio is the number of shares of common stock into which a convertible security can be converted and is fixed. In the example above, an investor might receive 20 shares of common stock for each convertible bond. Hence, the Conversion Price is the price per share at which common stock will be delivered to the investor. The formula is:
Par Value \$1,000
Conversion Price = ────────────────── = ───────── = \$50 Conversion Price
Conversion Ratio 20
The Conversion Value is an indication of what a convertible issue would trade for if it were priced to sell on the basis of the price of the corresponding common stock.
Conversion Value = Conversion Ratio * Market Price of Common Stock
In the example above, if the market price of the common stock were \$60, the formula would be:
Conversion Value = 20 * \$60 = \$1,200 Conversion Value
Assuming the conversion period has begun, we would expect the \$1,000 convertible bond to be selling for at least \$1,200 since an investor can instantly convert the bond into 20 common stock shares worth \$1,200. However, the convertible bond would probably sell for more than \$1,200 because of its ability to convert to the common stock plus the fact that it is a bond and is generating interest every six months. This extra amount is called the Conversion Premium. It is the amount by which the market price of a convertible security exceeds its conversion value.
Conversion Premium = Market Price of Common Stock - Conversion Value
Let’s continue the above example. Assume we have a \$1,000 bond with conversion ratio of 20 and the common stock shares are trading at \$60.00. As computed above, the conversion value is \$1,200, 20 shares * \$60 market price of the common stock. Let’s also assume that the bond is currently selling for \$1,400. Therefore, the conversion premium formula would be:
Conversion Premium = \$1,400 - \$1,200 = \$200 Conversion Premium
The bond is selling for \$200 above the conversion value. The Conversion Parity is the price at which the common stock would have to sell in order to make the convertible security worth its present price. It is also called the Conversion Equivalent. The formula is:
Market Price of Bond \$1,400
Conversion Parity = ────────────────────── = ──────── = \$70 Conversion Parity
Conversion Ratio 20
We would expect the market price of common stock to be close to \$70. However, the price would most likely be less than \$70 because of the convertible security’s conversion premium.
Graphic courtesy of Ferran Capo: StudioCapo
The graphic above shows that the value of a convertible bond depends upon both the underlying common stock price and the value of the interest payments and principal repayment that the bond generates. If the underlying common stock price creates a conversion value above and beyond the value of the bond from interest payments and the principal repayment, the bond will sell for more than the value of the bond from just being a bond. However, if the underlying common stock price falls below the value of the bond from just being a bond, the price of the convertible bond will be propped up since the bond is still generating interest payments and the principal repayment.
What’s the bottom line on convertible securities? Convertible securities allow you to partake in the potential capital appreciation of the common stock with less risk because of the income from the convertible bond or convertible preferred stock. If the stock price is below the conversion price, then the convertible security’s price will be kept up because of its value from being an income producing investment. However, you pay for the reduced risk via the conversion premium. Again, our personal opinion is that we believe individual retail investors are best served by focusing their attention on common stocks for growth and income and bonds for income but there are always exceptions.
10.03: New Page
Congratulations ‒ You Have Finished Chapter 10 ‒ Hybrid Securities: Preferred Stock and Convertible Securities
You have reached the end of chapter 10, Hybrid Securities: Preferred Stock and Convertible Securities. In this chapter, you have:
You should now be able to:
It is Time to Reflect and Assimilate
We are at a significant milestone, Dear Students. We have covered the major investment alternatives for the vast majority of investors. In our next module, we will look back at what we have covered and attempt to tie it all together. See you in the next module, Portfolio Diversification and Asset Allocation. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/03%3A_Chapter_3/10%3A_Hybrid_Securities_-_Preferred_Stock_and_Convertibles_Securities/10.02%3A_New_Page.txt |
“Our portfolio is well-diversified. It’s 30% hopes,
30% wishes, and 40% prayers.
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
It is Time to Reflect and Assimilate
Congratulations! We have covered the most important investment alternatives for the vast majority of investors. It is time now to go back to the very beginning of the semester and tie everything together. We will reexamine the eternal struggle of risk versus return. We will see how a well-diversified portfolio can help us reduce risk while still offering us an attractive return. It turns out we can eat reasonably well and sleep reasonably well! We will also take a look at the techniques of asset allocation, portfolio rebalancing, and dollar-cost averaging and reexamine the role of mutual funds in diversification. We end with yet another example of what Mr. Benjamin Graham told us many years ago, “The investor’s chief problem, and even his worst enemy, is likely to be himself.”
• 11.1: Diversification and Portfolio Risk
"Don't put all your eggs in one basket." But some folks disagree. They say, "Put all your eggs in one basket -- and watch that basket!"
• 11.2: Asset Allocation
Asset allocation is the process of defining what percentages of the various investment alternatives an investor wants in their portfolio. How much should we have in stocks, bonds, "cash" short-term vehicles, and any other investments that might be attractive to the investor?
• 11.3: Dollar-Cost Averaging and Mutual Funds, Revisited
Two other tools of investing that help us reduce risk are our old friends, dollar-cost averaging and mutual funds. Let's revisit them.
• 11.S: Summary
Congratulations ‒ You Have Finished Chapter 11 ‒ Portfolio Diversification and Asset Allocation
11: Portfolio Diversification and Asset Allocation
Diversification is the strategy of spreading your investments across a number of asset classes to eliminate some, but not all, of the risks of investing. We have all heard the saying, “Don’t put all your eggs in one basket.” Most financial professionals recommend and most investors agree that diversification is a worthy technique for the vast majority of prudent, long-term oriented investors such as ourselves.
However, there are some in the investment community who disagree. They point to the counter advice from famed industrialist Andrew Carnegie, “Put all your eggs in one basket ‒ and watch that basket!” This quote is often attributed to Mark Twain. Mr. Twain made it popular but always attributed the quote to Mr. Carnegie. These two viewpoints once again point to the heart of our choices as investors. Do we want to eat well or do we want to sleep well? Those who follow Mr. Carnegie’s advice are more risk tolerant and we wish them well. However, we prudent, long-term oriented investors will hold fast to our diversification strategies, thank you very much.
Why is diversification a good thing? Diversification is one of the best strategies we have for reducing risk.
Source: The Capital Group
The table above highlights the market leaders from 1989 to 2013. Sure, you could have had all your investments in emerging market stocks but be sure to take a close look at the down years. You would have been watching that basket full of all your eggs crash to the floor oodles of times, probably many more than any one person could stomach. It pays to diversify. Also notice that not once was “cash,” the common euphemism for short-term investments, the market leader. It pays to invest! This conversation, however, begs the question, how do we measure risk?
Risk versus Return, Revisited
We have come full circle! Way back in chapter 1, we introduced the eternal tug-of-war between risk and return. We saw how the higher the average annual return, the higher the standard deviation and its companion measure variance from the average annual return. We have studied the major financial asset classes, mutual funds, stocks, bonds, “cash” short-term investments. We discussed the risks and returns of each. Return is easy to measure. How much money did you make? How long did it take? That’s your return! Risk is very difficult to measure. It is even harder to anticipate.
Most professionals point to variance and standard deviation as the best imperfect measures of risk. To review, variance and its more useful companion, standard deviation, tell us how much an asset class will vary from the expected return. These measures are readily available from the investment community. And da’ numbers ain’t pretty, For any randomly selected stock on the NYSE, the standard deviation is 49.24%! That means in any one year, many stocks on the NYSE – the most stable stocks! – will vary up or down close to 50% from their annual average return. The company with the largest market capitalization as of May 2023, Apple, for example, has a 5-year standard deviation of over 31.8% (Source: ABG Analytics). So how can we reduce the variance and standard deviation? In other words, how can we reduce the risk?
The answer, of course, is to diversify! If we go from 1 randomly selected stock to 2 randomly selected stocks, the standard deviation goes from 49.24% down to 37.36%. If we randomly select 10 stocks, the standard deviation goes down to 23.93%. Choose 20 stocks and the number to 21.68%, and so on. Diversifying our stock portfolio reduces our risk substantially as measured by reduced standard deviation and variance.
The Relationship of the Number of Stocks in a Portfolio and the Standard Deviation of the Portfolio
Number of Stocks Expected Standard Deviation Percent Compared to a Single Stock
1 49.236% 100%
2 37.358% 76%
4 29.687% 60%
6 26.643% 54%
8 24.983% 51%
10 23.932% 49%
20 21.677% 44%
25 21.196% 43%
30 20.870% 42%
50 20.203% 41%
75 19.860% 40%
100 19.686% 40%
200 19.423% 39%
300 19.336% 39%
500 19.265% 39%
1,000 19.211% 39%
19.158% 39%
Source: The Capital Group
However, there is a limit to how low the standard deviation will go as we add more and more stocks to the portfolio. There is a limit to which diversification can reduce your risk in any given asset class. In this case, we are discussing stocks but the same phenomenon occurs with other asset classes such as bonds or real estate. Notice in the table above, there comes a point where adding more stocks to the portfolio does not lower the standard deviation. Adding more stocks and diversifying more and more does not lower our risk any more. Why is this? What is causing this peculiar behavior? The answer is, “Correlation.”
Correlation and the Correlation Coefficient
Correlation is the tendency of the returns of two assets to move together. Of course, no two investment returns will be exactly the same. That is called imperfect correlation and it is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation. However asset classes such as stocks tend to move together. We say that assets that tend to move up and down together are positively correlated. On the other hand, assets that move in the opposite direction to one another are negatively correlated.
We measure correlation using the correlation coefficient. The correlation coefficient measures how closely returns on assets move together. The industry uses the letter “r” to denote the correlation coefficient. (Please don't ask me why. It’s yet another example of confusing the issue so that you will put your faith in us professionals. My apologies.) The correlation coefficient ranges from 1 or 100% down to 0 down to -1 or -100%. A correlation coefficient of 1 or 100% means that the two assets are perfectly positively correlated. They move in lock step with one another. When one goes up, the other goes up. If the correlation coefficient is -1 or -100%, that means that the two assets are perfectly negatively correlated. When one goes up, the other goes down and vice versa. A correlation coefficient of 0 means that the two are completely unrelated to one another.
So how does this answer our question about why diversification can only reduce by so much the risks of owning stocks? Although stocks are not perfectly correlated, they are positively correlated enough so that stocks in general tend to move in the same direction. This is why we often refer to stock investments as a whole as the stock market, even though at any given time, some companies are doing well, others are doing poorly, and many are simply chugging along as they always have done.
Correlation and Stocks versus Bonds
You may say to yourself, “Darned! That is still too much risk for me! I think I’m gonna’ stick to bonds!” You are a very conservative, risk-averse investor and you don’t like the volatility of stocks. Therefore, you decide to place all your investments into bonds. You will accept the lower return from the bonds in exchange for the lower risk of the bonds. Oops! Bad idea! Why? This is because, like stocks, bonds are positively correlated with themselves. Bonds also will tend to do well and do poorly as a whole and they are often negatively correlated with stocks! Stocks and bonds often but not always move in opposite directions. Stocks and bonds are typically negatively correlated.
Source: The Capital Group
The effect on return and risk as measured by standard deviation of various stock and bond allocations
Stocks Bonds Standard Deviation Expected Return
100% 0% 15.00% 12.00%
95% 5% 14.31% 11.70%
90% 10% 13.64% 11.40%
85% 15% 12.99% 11.10%
80% 20% 12.36% 10.80%
75% 25% 11.77% 10.50%
70% 30% 11.20% 10.20%
65% 35% 10.68% 9.90%
60% 40% 10.21% 9.60%
55% 45% 9.78% 9.30%
50% 50% 9.42% 9.00%
45% 55% 9.12% 8.70%
40% 60% 8.90% 8.40%
35% 65% 8.75% 8.10%
30% 70% 8.69% 7.80%
25% 75% 8.71% 7.50%
20% 80% 8.82% 7.20%
15% 85% 9.01% 6.90%
10% 90% 9.27% 6.60%
5% 95% 9.60% 6.30%
0% 100% 10.00% 6.00%
Source: The Capital Group
A combination of stocks and bonds actually created a portfolio with less risk while earning you more return than just bonds. If you are seeking less risk, it not only pays to diversify within an asset class, it pays to diversify among asset classes. The same kind of relationship occurs with domestic and foreign stocks and bonds although much less now than in the past. However, you already know what we are going to warn you about, right? Diversification is not a guarantee of positive results. For example, no diversification scheme worked well in 2008! We have a name for choosing the appropriate mix for an investor. It is called asset allocation and it is the subject of our next section.
Correlation and the Real World
Theories that work in the textbooks and laboratories sometimes fall flat on their faces in the real world. This is true for the expected negative correlation of stocks and bonds. Our theory tells us that a balanced portfolio blend of stocks and bonds should exhibit less risk than either a portfolio of only stocks or a portfolio of only bonds. Is this true in practice? The answer is, “Sometimes yes and sometimes no.” This textbook scenario played itself out to perfection in the 2000-2002 stocks bear market. Stocks fell almost 50% while bonds actually did well as interest rates fell from the effects of the post dot-com bubble recession. (Recall: When interest rates fall, bond prices rise.) This scenario did not work out so well in 2008 when both stocks and corporate and municipal bonds cratered. Indeed, everything except Treasury bonds tanked, including real estate and commodities. In 2022, the theory let us down again when stocks and all bond prices fell as interest rates rose and fears of a recession began to be voiced louder and louder. But this is the exception. You have to go back to 1969 to see a year when both stocks and all bonds fell together.
If we look at the risk measurements for sample stock funds, bond funds, and balanced funds for the last 10 years, we find that our theory has let us down yet again. Below is a table of stock funds, bond funds, and balanced funds. We expected the balanced funds to exhibit less risk than the stock funds and the bonds funds as measured by standard deviation. Ah, it didn’t work out that way.
Ten-Year Standard Deviation Measurements for Sample Mutual Funds
Data as of May 15, 2023 Stocks Bonds Balanced
Dodge and Cox Funds
Dodge and Cox Stock Fund
Dodge and Cox Income Fund
Dodge and Cox Balanced Fund
17.25
4.27
11.96
Vanguard Funds
Vanguard Windsor Fund (stocks)
Vanguard Wellesley Fund (bonds)
Vanguard Wellington Fund (balanced)
16.53
6.74
9.94
Fidelity Funds
Fidelity Contrafund Fund
Fidelity Total Bond Fund
Fidelity Balanced Fund
15.27
4.57
11.38
Capital Group (American Funds)
Growth Fund of America
Bond Fund of America
American Balanced Fund
16.07
4.38
9.40
Source: Morningstar.com
Although a balanced portfolio does not always protect us as much as we may expect, the results from balanced funds can be very satisfying for the prudent, long-term oriented investor. Please consult the chapter 11 section of the class website to compare and contrast the results from a stock-only portfolio, a bond-only portfolio, and a balanced portfolio. A balanced portfolio of stocks and bonds helped us to eat reasonably well and sleep reasonably well. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/04%3A_Chapter_4/11.01%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide 17.)
Asset Allocation is a fancy term for a simple series of questions that all investors should ask themselves or review with their financial advisor. “How much should I have in stocks? How much in bonds? How much of each stock & bond type?” Many advisors suggest a formula such as subtract your age from 100 (or maybe now 110 or 120). That is the percentage of stocks you should own and the rest should be in bonds. For example, a 40-year-old would have 100-40 or 60% invested in stocks and 40% in bonds. “Poppycock!” say others. Buy high-quality stocks and put up with the risk. Once you near retirement, start buying bonds. (Why does that number seem to be rising from 100 to 110 or 120? We are living longer! More about investing in retirement later.)
This example asset allocation is for someone who is comfortable with a significant percentage of stock investments. It does have some bonds, though, to add some stability. Notice that there is only a bit of “spice” in the form of aggressive growth and small company stocks. Do you like it? It is yours! But remember that everyone's situation and risk tolerance are different. This allocation might be too aggressive for some and too conservative for others.
Rebalancing
Another very popular diversification strategy is the technique of rebalancing. Let’s say you start off with the popular 60% stocks, 40% bonds portfolio. Every year, check to see if your percentages are still in balance. If stocks have had a banner year, you might now be at 70% stocks, 30% bonds instead of your original target of a 60%/40% allocation. You would sell enough stocks and buy enough bonds to bring the balance back to your target 60%/40% allocation. Likewise, if stocks have tanked, you would sell enough bonds and buy enough stocks to bring the percentage back up to 60%/40%. This strategy forces us to, “Do the right thing.” It forces us to, “Buy Low, Sell High.” Think about it. If stocks are rising, who wants to sell? Similarly, if stocks have tanked, who wants to buy? This strategy helps us to remove some of the influence our emotions have on our investing.
Recall the strategy of one of the balanced mutual funds that we discussed: The fund will never be more than 75% stocks, 25% bonds, and never less than 50% stocks, 50% bonds. This strategy forces the balanced mutual fund to stay balanced.
A Stock Portfolio Versus a Bond Portfolio Versus a Balanced Portfolio
The table below compares a 100% stock portfolio versus a 100% bond portfolio versus a balanced portfolio.
Source: The Capital Group
Having a balanced portfolio means that you almost never have the best returns in any one year. However, it also means you will very rarely ever have the worst returns in any one year, either. In addition, although it is very unlikely that you will not equal or surpass an all-stock portfolio, you should do much better than an all-bond portfolio. But you already know what we are going to add, right? There are no guarantees!
Stocks and Bonds in Retirement
Throughout our journey together, we have been discussing the accumulation phase of investing. In retirement, we move into the distribution phase. To that end, many advisors suggest that retirees shed the bulk of their stock investments in favor of bonds and cash investments in order to protect against market downturns. The only problem is people are living much, much longer today. A 65-year-old couple has a 45 percent chance that one of them will survive to age 90. As you near retirement, start migrating your investments from stocks to bonds but don’t abandon stocks entirely. Retirees still need some growth in their portfolio even as they are in the distribution phase of their investing career. In the chapter 11 section of the class website, there is a presentation that compares bonds in retirement, stocks in retirement, and then two versions of a balanced portfolio. Both versions of the balanced portfolio were able to generate much stronger returns than the bond portfolio while damping down the volatility that accompanied the stock portfolio. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/04%3A_Chapter_4/11.02%3A_New_Page.txt |
Video - Audio - YouTube (Material for this section starts on slide 22.)
Dollar-Cost Averaging, Revisited
Recall that dollar-cost averaging is a system of buying an investment at regular intervals with a fixed dollar amount. We essentially set our investment program on autopilot. We don’t worry about when it is a good time to invest or when it is not a good time to invest. This technique is another method to help remove emotion from our investing program. Recall the conversation we have with ourselves. With dollar-cost averaging, whenever we wake up in the morning, there is always good news. “The market is up! Good news! Our account is worth more!” or, “The market is down! Good news! Next month, we will get more shares at a lower price when the \$50 or \$100 comes out of our paycheck or checking account.”
Dollar-cost averaging also has another trick up its sleeve. Let’s take a look at a very volatile three-month period. The first month, you invest \$100 into an investment at a price of \$10. You receive 10 shares, \$100/\$10. The next month, the price falls to \$5. You invest another \$100. This time, you receive 20 shares, \$100/\$5. Fortunately, in the third month, the price recovers to \$7.50. This month, you purchase 13.333 shares, \$100/\$7.50. It appears that you have broken even, buying shares at \$10, \$5, and \$7.50. However, because you purchased fewer shares at the high price and more shares at the lower price, you have actually turned a profit. You invested \$300 over the three-month period. Yet you now have 43.333 shares at the current price of \$7.50 which is worth \$325.
Magic?! Hardly. Again, by investing the same amount each month, we are purchasing fewer shares when the prices are high and more shares when the prices are low. Our average cost per share should be lower than our average price per share. (Memorize that sentence. Think about it often.) In this case, the average cost per share was \$6.92, \$300/43.333 shares, while the average price per share was \$7.50. You know what comes next, right? Using dollar-cost averaging will not guarantee a successful investment outcome. Dollar-cost averaging is not going to turn a lousy investment into a profitable one. If the investment continues to lose money year after year, we are going to wind up with a whole lot of very worthless shares!
However, the absolute best benefit that comes from dollar-cost averaging is that it makes investing very simple and straightforward. We simply have \$50 or \$100 or whatever we can afford come out of our paychecks or checking accounts each month. Of course, this is much easier for mutual fund investors. It is a bit trickier for stock or bond investors but not impossible. We just need to allow the cash to accumulate until we can make our purchases. But then again, technology and innovation in the brokerage industry is advancing rapidly. Some brokerage firms such as Schwab are now allowing investors to purchase miniscule fractional shares with as low as \$5. (Please check what kind of markup and markdown the brokerage firm is offering. Our guess is that it is not the most advantageous to the investors. We contacted Schwab and asked what kind of spread we can expect from their fractional share purchases and sales. The representative said he would get back to us. He never did. Hmmm. We will try again soon but we have a sneaking suspicion that they really don’t want us to know.)
Mutual Funds and Diversification, Revisited
Speaking of mutual funds, wasn’t diversification one of the two main reasons why so many investors choose mutual funds? Yes! The other is professional money management. Mutual funds help us reduce our risk by spreading out our \$50 monthly investment over hundreds of stocks or bonds. But does that mean mutual funds necessarily have less risk than individual portfolios or the market as a whole? Well, it all depends on which mutual funds we are talking about. Some mutual funds do a very good job of reducing risk. In the assignment for this chapter, we ask our students to research the standard deviation and other popular measurements of risk for at least five mutual funds.
But what about the mutual fund investors? Did the inherent diversification in their mutual funds help them? Recall that most mutual fund investors do worse than the mutual funds they invest in. Revisit the graphic below and note how mutual fund inflows tended to follow strong market performance. When the markets fell, many mutual fund investors then ran for the exits and sold … at the worst possible times! Don’t be an average mutual fund investor. Keep a long-term perspective and dollar-cost average. Remember: Mutual funds will bore you to wealth.
11.S: Summary
Congratulations ‒ You Have Finished Chapter 11 ‒ Portfolio Diversification and Asset Allocation
You have reached the end of chapter 11, Portfolio Diversification and Asset Allocation. In this chapter, you have:
You should now be able to:
Congratulations, The Course Is Over!
Well, not quite. We have covered the most important investment alternatives for the vast majority of investors. However, we still have a few odds and ends to take care of. We will spend a little time studying options, futures, buying on margin, and shorting … if only to learn that we should stay far away from these exotic and dangerous speculative strategies. We will also spend some time with some miscellaneous topics in investing including a brief overview of real estate, precious metals and other hard assets, brokerage firms, and the various types of investment accounts. We will even take a quick look at kleptocurrencies, ooops!, my apologies, I meant cryptocurrencies and NFTs. We end by highlighting Starting a Business: The Ultimate Investment! | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/04%3A_Chapter_4/11.03%3A_New_Page.txt |
At a very exclusive party, a high-class, finely clad woman slinked up to the CEO of a Fortune 500 company and said, “I will do anything – anything you want.” The CEO flatly responded, “Reprice my options.” ‒ Attributed to Warren Buffett
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
We now embark upon a very unusual part of our journey. In the next several modules, we will explore various instruments that the vast majority of us should stay far, far away from. “That's a bit odd,” you say? "Why are we learning about products that we should stay far, far away from?" The reason we are learning about options is that we can protect ourselves, our family members, our friends, and our colleagues from them. Instruction about syphilis is not an instruction to get syphilis! And the same is true of options, futures, buying on margin, shorting, etc. However, since this is an Introduction to Investments class, we need to learn how these exotic and dangerous vehicles work, if only to protect ourselves and our loved ones from succumbing to their “get-rich-quick” siren calls. Before you start, please have the Options Notes Sheet handy. Get ready to be bedazzled, dazed, and confused by stock options!
• 12.1: What are Options Contracts?
What are options contracts? They are securities that we should stay far, far away from. However, since this is an Introduction to Investments class and textbook, we need to become familiar with these gambles, ooops!, sorry, I mean, speculations, if only to know how to protect ourselves and our family members, friends, and colleagues from succumbing to their siren song of "get rich quick."
• 12.2: Options Characteristics and the Breakeven Point
Options contracts have various characteristics that set them apart from other securities. Let's explore them and specifically, let's learn how difficult it is to actually make money gambling, uh, oh, there I go again!, sorry, speculating with options.
• 12.3: Options Strategies; Covered Calls and Naked Puts
Oh, boy! Just wait until we regale you with all the ways you can lose a lot of money and make your broker rich, ooops!, I am so sorry, I meant get fabulously wealthy in no time at all with these sure-fire, fail-safe, gotta'-us-'em, options strategies. (Ah, Folks. This is called irony. I am being sarcastic. Got it? Good!)
• 12.4: Employee Stock Options and Some Final Topics about Options
Finally, let's take a look a type of option that is popular with high-tech companies, Employee Stock Options, often abbreviated as ESOs. We will also discuss a few other types of options and make some final comments about why you should stay far away from them.
• 12.S: Summary
Congratulations ‒ You Have Finished Chapter 12 ‒ Options Contracts
"Spin" by conorwithonen is licensed under CC BY 2.0
12: Options Contracts
An options contract is a security that gives the holder the right to buy or sell a certain amount of an underlying financial asset at a specified price for a specified period of time. Options contracts are typically tied to stocks but any financial assets can be used as the underlying security. Options contracts are not investments. They are speculations which we already know to be a euphemism for gambling. Specifically, they are contracts between two market speculators. The buyer of the option contract gets the right to buy or sell the financial asset at a given price for a given period of time. If the buyer of the contract exercises the option, the seller of the option contract must buy or sell the asset according to the terms of the contract.
Options contracts are part of a class of securities called derivatives. Derivatives are securities that derive their value from the price behavior of an underlying real or financial asset. Options contracts have no voting rights, receive no dividends or interest, and eventually expire. Their value comes from the fact that they allow the holder of the option to participate in the price behavior of the underlying asset with a much lower capital outlay. By the way, options contracts are usually just referred to as options. Just try saying, “options contracts,” three times fast.
Options allow an investor to leverage their outlay of capital. As we’ve discussed, leverage is the ability to obtain a given equity position at a reduced capital investment, thereby magnifying returns. With options, you can make the same amount of money from a stock or other security as if you bought it for full price but only come up one-tenth or less of the money. Sounds too good to be true, huh? Well, you are right. It is too good to be true. Much of the time, you lose the entire outlay. Options have a time limit. Most options expire worthless.
What is the Rationale for Options Contracts?
You believe that a stock will do well and that the price will increase. Instead of buying the stock, you buy an option to buy the stock. Repeat: You don’t buy the stock; you buy an option to buy the stock. If the stock goes up, your option will go up almost always much, much faster and you can sell the option for a handsome profit. There is only one catch. The option expires in three, six or nine months. If the stock does not go up in that time period, the option will expire worthless. Surprise! Most options expire worthless. There are some scenarios where options can be worthwhile but they are few and far between.
To make the whole concept even more confusing, there are options to sell a stock if you believe that the price of the stock will go down soon. In essence, you are gambling, ooops!, sorry, speculating that the price of the stock will either increase or decrease in the short term. Options have limited appeal to prudent, long-term investors. Buying and selling options is speculating. And we all know that speculating is just a fancy word for gambling.
Let’s look at an example. There is a stock currently selling for \$20 that you believe will do well. Say you buy a share of the stock for \$20. If it goes up to \$30, you have earned \$10 on a \$20 investment. That’s a 50% return on your money. Pretty good! But that’s not good enough for you. Instead, you buy an option to purchase a share of the stock at \$20 currently selling at \$20. The option might only cost you \$1. If the stock goes up to \$30, your option price will probably go up to around \$11. You have earned \$10 on a \$1 investment! That’s a 1,000% return on your money. Whoa! That is “leverage” in action. Congratulations! Pat yourself on the back!
But what if the stock price stays at \$20 or goes down, even by a small amount. Your option will expire worthless at the end of three, six, or nine months.
And, of course, after your option expires, the stock price zooms to \$40. You were so sure that this stock was going to hit the big time and you were absolutely right. But because you bought an option that expired, you lost the ability to share in the success of the stock. My advice? Forget about the option and just buy the stock! But since this is an Introduction to Investments class and textbook, we need to become proficient in the concepts, terms, and techniques of options. So…
Calls Versus Puts
There are two types of options contracts, call options contracts and put options contracts. Call options contracts are usually just referred to as calls and put options contracts are usually just referred to as puts. A call option contract is a negotiable security that gives the buyer of the option the right to buy the underlying security at a stated price within a certain period of time. The example above was a call option contract. When people talk about options, they are usually talking about call options unless they specify a put option contract. A put option contract is a negotiable security that gives the buyer of the option the right to sell the underlying security at a stated price within a certain period of time. It is the exact opposite of a call option.
This is so confusing! Where did the terms ‘call’ and ‘put’ come from and how will I remember which is which?” The term “call” comes from the idea that when you buy a call option, you get the right to “call the stock away” from the seller of the option. The term “put” comes from the idea that when you buy a put option, you get the right to “put the stock to” the seller of the option. Get the idea? A “call” allows you to “call away the stock” from someone, buy it from them. A “put” allows you to “put the stock” to someone, sell it to them. Let us look at each in detail.
The Two Parties of a Call Option
There are two parties to a call option, the option buyer and the option seller. To make options more confusing to the uninitiated, we also refer to the option seller as the option writer or option maker. The call option buyer is the person who will do the “calling away” of the stock. They have the ability to buy the stock from the call option seller if they choose to exercise the option. According to the terms of the contract, when they bought the option, they bought the right to exercise the option and buy the stock at the agreed upon price. Note the call option buyer is under no obligation to exercise the option. They can allow the option to expire worthless. Did we mention that most options expire worthless?
The call option seller is the person who must sell the stock if the call option buyer exercises the option. The stock will be “called away from” from him or her. The call option seller is legally bound to sell the stock to the call buyer if the call buyer exercises the option. In return, they get the option premium, also called the option price, from the call option buyer. They get to keep the option premium no matter what happens.
“What is the call option buyer hoping for? Why did they buy a call option in the first place?” The call option buyer is hoping that the price of the stock will go up. A call option buyer is bullish. If an option buyer has a call option to buy at \$20 and the price goes to \$30, the buyer can buy a \$30 stock for only \$20. More likely, if our intrepid call option buyer sees the value of their call option rise dramatically, they can simply sell the call option ‒ we say, “close out the transaction” ‒ before the option expires. Why bother actually buying the stock? With their profits, they can go buy another call option. The gambling, ooops!, speculating never ends!
“What is the call option seller hoping for? Why did they sell the call option to the buyer?” The call option seller is hoping that the price of the stock will go down or stay the same. A call option seller is bearish or at least not very bullish. If the stock stays around \$20 or goes down, the call option buyer will not want to exercise the option and it will expire worthless. If the call option buyer exercises the option, the call option seller is contractually required to see the stock to the call option buyer at the agreed upon price. In any event, whether the option is exercised or not, the call option seller gets to keep the price of the option.
The Two Parties of a Put Option
A put option is the exact opposite of a call option. Everything is exactly the same except the put option allows the put option buyer to sell the stock instead of buy the stock. The put option buyer of the put options contract is the person who will do the “putting to” the put option seller. The put option buyer has the right to “put the stock to” (sell it to) the put option seller at the agreed upon price. Again, they do not have to exercise this right. That is why they are called options. Also, recall the majority of options contracts expire worthless.
In a further effort to confuse outsiders, the seller of the put options contract is also called the put option writer or the put option seller. The put option seller of the option contract is the person who must buy the stock from the put option buyer. The stock will be “put to” them. The put option seller is legally bound to buy the stock from the put option buyer if the put option buyer exercises the option to sell. No matter what, they get the option premium, also called the option price, from the put option buyer.
“What is the put option buyer hoping for?” The put option buyer is hoping that the price of the stock will go down. A put option buyer is bearish. If an option buyer has a put option to sell at \$20 and the price goes to \$10, the buyer can sell the \$10 stock. They can “put it to the option seller” for \$20. If the price of the stock goes down substantially, the put option buyer does not have to actually sell the stock. The put option buyer can sell the put option before the expiration date. This is called, “closing out the transaction.”
“What is the put option seller hoping for?” The put option seller is hoping that the price of the stock will go up or stay the same. A put option seller is bullish or at least not very bearish. If the stock stays around \$20 or goes up, the put option buyer will not want to exercise the option and it will expire worthless. In any case, the put option seller gets to keep the price of the option.
It’s Time for Questions about Options
“Options are confusing, aren’t they?” Yes! In fact, the section on options is one of the hardest parts of the Series 7 Stockbroker exam. “Options sound like gambling. Am I right?” Yes! Options are a form of gambling. It is a zero-sum game. Someone wins, someone loses. A family acquaintance once called me and exclaimed, “Hey, Frank. I hear you can make a lot of money investing in options!” I said, “Wait a minute. Yes, you can make a lot of money; you can also lose a lot of money. But you can’t invest in options. You can speculate with options. You cannot invest in something that has a 60% chance of being worthless in three months! That is not investing.”
“You keep saying that most options expire worthless. Well, just how many expire worthless?” That number is a subject of fierce debate. The percentage ranges from 10% to 90%, depending upon who is trying to present options in the best light or the worst light. The number that is most likely closest to the actual number is approximately 55% to 60%. If you want to explore the debate, just type “options contracts how many expire worthless” into your favorite Internet search engine. The management assumes no responsibility. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/12%3A_Options_Contracts/12.01%3A_New_Page.txt |
The Strike Price, also known as the Exercise Price
The strike price is the contractually agreed upon price of the stock between the buyer of an option and the seller of the option. It is also called the exercise price. It is the stated price at which the call option buyer can buy the stock with a call option or the stated price at which the put option buyer can sell the stock with a put option. Options listed on the major exchanges traditionally sold in \$2.50 increments for stocks selling for less than \$25, \$5.00 increments for stocks selling between \$25 & \$200, and \$10.00 increments for stocks selling for greater than \$200. However, pricing is more flexible now. There are many stock options that sell in \$1 increments
The Expiration Date
The expiration date is the date at which an option expires. Traditionally, listed options always expired at the close of the market on the third Friday of the month of the option’s expiration date. The hour before the close of the market on the third Friday is sometimes called the “witching hour” as markets can exhibit heightened volatility from the unwinding of all the options about to expire. As well as stock options, there are also stock index options and stock index futures which we will discuss later. When all three – stock options, stock index options, and stock futures – expire on the same day, then it is called the “triple-witching hour.” To add to your options gambling, oh, I’m sorry, speculating enjoyment, there are now weekly options that expire every Friday. Why wait until the third Friday of each month when you can lose money each week?!
The Exercise Style
The exercise style describes how and under what circumstances the option can be exercised. American options can be exercised at any time before the expiration. European options can only be exercised at expiration. Normally, if you wanted to take a profit from an option that had done well and there was still significant time until the expiration date, you would simply resell the option instead of actually exercising the option. However, with an American-style option, if you really wanted to buy or sell the stock, you could exercise the option and buy or sell the stock before the expiration date. By the way, there are several other types of options with various provisions. An options seller who thought that he had created a fail-safe, risk-free options position was rudely disabused of that fantasy when one of the options was exercised long before the exercise date.
The Options Chain: How Options are Quoted
Options quotes are available from many free Internet websites. At Marketwatch.com, Yahoo Finance, CBNC or any other site, first search for the stock. At the [Summary] page, choose the [Options] menu choice. The list of available options contracts and their prices for a particular security is called an options chain. Both Marketwatch.com and CNBC have an appealing method for displaying options. The call and put options are displayed next to one another. This is attractive on a larger screen but can be difficult to follow on a smaller screen device.
How Options Contracts Are Bought and Sold
We have discussed options contracts as if they were traded just as stocks are traded. In most ways, they are very similar but there is one major difference. Options are sold as contracts and each contract represents one hundred shares of the underlying stock. There are no odd-lots on the options exchanges. However, some market makers will facilitate old-lot contracts. So if the listed price of the option is \$5, then one contract will cost \$500, \$5 * 100 shares. Two contracts will cost \$1,000, etc.
The Option Premium, Also Called the Option Price
The option premium is the quoted price the option buyer pays to buy a listed put or call option. The option seller, also known as the option writer or option maker, receives the premium immediately and gets to keep it whether or not the option is ever exercised. (Did I mention that most options expire without being exercised? That most options expire worthless? Good! Just checking.) To make it even more confusing, the term premium is also used in a more precise manner when valuing options. For this reason, most people simply refer to the price of the option instead of the premium of the option.
Moneyness: “In-the-Money,” “At-the-Money,” “Out-of-the-Money”
A somewhat silly term used when discussed options is the “moneyness.” Is the option “in-the-money,” “at-the-money,” or “out-of-the-money.” This refers to whether or not it would be advantageous to exercise the option. An option buyer would want to exercise an “in-the-money” option. An option buyer would not want to exercise an “out-of-the-money” or “at-the-money” option. Let’s take a look at some examples.
A call option is “in-the-money” if the strike price, also known as the exercise price, is less than the market price of the underlying stock. In this situation, an option buyer would be able to purchase the stock for less than the current market price. For example, if the strike price were \$50 and the market price of the stock were \$54, then the call option buyer could exercise the option and buy a \$54 stock for only \$50. The call option would be said to be “\$4 in-the-money.”
An “out-of-the-money” call option would have no value because the strike price exceeds the market price of the stock. This time, if the strike price were again \$50 but the market price were only \$47, the call option buyer would have no incentive to exercise the option. They would be buying a \$47 stock for \$50. The call option would be said to be “\$3 out-of-the-money.”
As you might expect, the situation is reversed with put options. An “in-the-money” put option is a put option with a strike price greater than the market price of the underlying stock. If the strike price were \$50 and the market price of the stock were \$46, then the put option buyer can sell the stock at \$50 that is currently selling for \$46. The put option would be “\$4 in-the-money.”
An “out-of-the-money” put option is a put option where the market price exceeds the strike price of the stock. Let’s say the put option strike price was again \$50 but the current market price was \$52. There is no incentive for the put option buyer to exercise the option since that would mean selling a stock at \$50 that is currently selling for \$52. The put option would be “\$2 out-of-the-money.”
As the name implies, an “at-the-money” option has a strike price that is equal to the market price of the stock. With an “at-the-money” option, as with an “out-of-the-money” option, there is no incentive to exercise the option since the option buyer can buy or sell the stock at the same price as the strike price.
Moneyness and the Breakeven Point
The following graphic illustrates how the “moneyness” of a call option changes as the underlying stock price advances. With a strike price of \$50, when the stock price is below the \$50, the call option is “out-of-the-money” and the call option has no value. (There may still be some “time value” which we will discuss below.) Once the stock price advances past \$50, the value of the call option begins to increase. It is now “in-the-money.” Theoretically, for every dollar past the strike price, the call option buyer gains a dollar and the call option seller loses a dollar.
However, the graphic above ignores the fact that the call option buyer had to pay for the option. If the call option price were \$5, then the call option buyer would not actually see any payoff until the stock price rose to \$55, the strike price and the price of the option. This is called the breakeven point for a call option buyer. The graphic below illustrates this relationship.
The fact that a call option buyer does not even start to make any money until the stock price reaches the breakeven point is yet another reason that options contracts are not suitable for the prudent, long-term investor. And, by the way, have you noticed we have not even included the cost of the commissions or the kickback that the brokerage firm receives from the transaction?
As you might expect and rightfully fear, the situation is completely reversed with put options. The graphic below shows what happens when the stock price falls below the strike price. The put option buyer starts to make money and the put option seller begins to lose money. The farther the stock price falls below the strike price, the more money the put option buyer will make and the more money the put option seller will lose.
But again, we ignored the option price. Let’s again use a put option price of \$5. The put option buyer had to pay \$5 for the right to sell the stock at the strike price of \$50. The put option seller immediately receives the \$5 as their compensation for writing the put option. This means that the stock must fall to at least \$45, \$5 below the strike price of \$50, before the put option buyer starts to make money and the put option seller starts to lose money. Here, the breakeven point for the put option buyer is \$45. Once the stock falls below \$45, the put option buyer begins to make money on the transaction. The graphic below demonstrates this process.
The Time Value, Also Called the Time Premium
The time value, also known as the time premium, is the dollar amount by which the option price exceeds the option’s “in-the-money” value. In general, the longer the time to expiration, the greater the size of the time value. If an option is “out-of-the-money,” then the entire price of the option is due to the time value. In other words, an option that is “in-the-money” will sell for more than the amount it is “in-the-money” because of the time remaining until the expiration date. Often, an option that is “out-of-the-money” will still have time value. The option still has time to become worth more as the underlying stock price changes. In the theoretical call option “moneyness” graphic above, if the stock price were less than \$50 and the call option were “out-of-the-money,” the call option might still sell in the options marketplace for above \$0. The amount that it sold for would solely be attributed to the time value. Likewise, even in the theoretical put option “moneyness” graphic above, if the put option were “out-of-the-money,” it still might sell in the options marketplace for some amount. Again, that amount would be attributed to time value since no one would want to exercise an “out-of-the-money” option.
One last aspect of options deserves mention. Do not forget commissions! In the previous examples, we did not include the cost of the commissions. A commission is charged whenever an option is bought or sold. Both the buyer and the seller pay a commission when the contract is initiated. A commission is charged when and if the buyer exercises the option and buys or sells the stock and again, both the buyer and the seller pay a commission. A commission is also charged if the option buyer or option seller decides to “close out the transaction.” The option buyer can sell their option to another option trader. The option seller can buy the exact same call option, thereby canceling their position and handing over the seller’s responsibilities to another options trader. When you include the commissions, it makes it that much harder to make money in options. And if you are still somehow saying to yourself, “Well, I don’t pay any commissions with my broker so I don’t have to worry about that,” go back to chapter 3 and read about how your broker is receiving a kickback for every transaction you initiate. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/12%3A_Options_Contracts/12.02%3A_New_Page.txt |
Speculating Versus Hedging
We have discussed speculating at length. Buying and selling options is pure speculation. When traders/speculators defend their speculative practices, you will often hear, “If you feel the market price of a particular stock is going to move up … ” or, “If you anticipate a drop in price within the next six months …”, or “Options are a highly risky investment strategy, but they may be suited for the more speculatively inclined.” The flaw in these arguments is this: There has never been a successful method to predict stock prices in the short term. You may “feel” or “anticipate” that the price of a stock will go up or down, but that does not mean that it will. It is not investing, it is gambling. Plus, you may be correct but your option may expire before you are proven correct.
There is one options strategy that may be useful for a prudent, long-term investor, hedging. Hedging is a transaction or series of transactions made to reduce the risk of adverse price movements in an asset. Hedging can be thought of as insurance and although insurance can be useful in some circumstances, it is not free. You pay for the insurance via the price of the option or options and the accompanying commissions. Investors can use hedging strategies when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing except for the cost of the option and the commissions.
For example, you own 100 shares of FlimFlam.com and it is currently selling for \$50. You are afraid the price will plummet within the next 3 months to \$10. Therefore, you purchase a put at \$50. No matter what happens, you can sell the stock for \$50 … but only until the option expires! Then you must go out and buy more insurance. This is called a “protective put.” Remember, insurance is not free. Using options as insurance is one way to keep your broker very happy. If you are sure the stock will fall, why not just sell the darned thing?
How about this example? It’s late in the year and you want to sell your 100 shares of FlimFlam.com. You bought them at \$2 per share and will have a huge capital gains tax bill. You are afraid the price will fall back down to \$2 per share once the flimflam is uncovered at FlimFlam.com. In December, you buy the put option to protect yourself and then sell your shares in January and the tax bill is postponed until the next year. Ah, okay, maybe. Maybe there is a place in the prudent, long-term investor’s toolkit for the occasional option transaction. But they are few and far between. However, if you listen to your high-stakes broker, you may hear a different story. She tells you, "Let’s take a look at a couple of options strategies guaranteed to generate more commissions for your broker, ooops!, I meant, give you tax losses that you can forward to your CPA, no!, no!, no!, help you achieve your short-term goal of becoming fabulously wealthy and retiring in an exotic far-off tropical paradise. Yeah, that’s what I meant."
Straddles
An options straddle is the simultaneous purchase or sale of a put and a call on the same underlying stock. If the stock price is volatile in either direction, up or down, you will make money providing you pass the break-even point for both purchases plus the commissions. If the stock price is not volatile, you would sell, also known as write or make the straddle and hope that the stock price does not change greatly. (Two commissions at the same time! Yippee! Your broker is really gonna’ love you!)
You see that SwindlerNFTs is selling for \$50 and its price is extremely volatile. You purchase a call for \$50 and a put for \$50. The price of the call option is \$4 and the price of the put option is \$5. Now, no matter which way the price goes, one of your options will be “in-the-money.” But the call cost you \$4 and the put cost you \$5, so the price has to move at least \$9 either way before you break-even. And we did not include the cost of the commissions. You paid two commissions for the straddle and possibly one more for selling or exercising the option. Brilliant strategy, huh? Wait, it gets better.
Spreads
An options spread is the simultaneous purchase and/or sale of two or more options with different strike prices and/or expiration dates. Example: A stock is selling for \$50. You buy a call option at a strike price of \$50 for \$5. You sell a call option at a strike price of \$55 for \$2. You paid \$5 for the call at \$50, but you got paid \$2 for the call option at \$55. If the stock price rises past \$53, you will make money. The possibilities are endless … and so are the commissions and tax losses.
Selling Options, Also Known as Writing Options and Making Options
Usually, when speculators discuss their options trades, they are referring to buying call and put options. However, as we are reiterated often, there are two parties to an options contract, the buyer and the seller. Selling options, also known as writing options or making options, allows an individual to play the part of the casino. You become the Las Vegas casino and the option buyers are betting against you. “More often than not, the option writer is right.” Why? Did we mention that most options expire worthless? No matter what happens, the option seller gets to keep the buyer’s premium, the price the buyer had to pay for the option.
If and when Your Humble Risk-Averse Author ever begins trading options, it will be as an option seller. But that does not mean the option seller still cannot lose big. An option seller can be exposed to tremendous risk, especially if the price of the underlying stock makes a big move, up or down. The amount of risk the option seller accepts depends upon where their options are covered or uncovered. Uncovered options are also referred to as naked options. (Who says that the investment world is boring? Oh, by the way, it is unlikely that Your Humble Author will ever actually employ these options strategies. I just tell myself that I might do it someday. P.S. I have never bought a lottery ticket, either.)
Covered options allow an options seller to protect themselves against large losses. Uncovered options, also called naked options, imply the opposite; the options seller is subject to tremendous loss. The amount of return to the option writer is always limited to the amount of option premium received. However, the loss can be substantial, even unlimited in the case of an uncovered call, also known as a naked call. Using the concepts of covered options, there are two options selling strategies that can help a prudent, long-term oriented investor augment their returns, selling covered call options and selling naked put options.
Selling Options: Writing a Covered Call
You are a long-term oriented investor and you own 100 shares of a particular stock. You have been thinking of selling but you are not quite sure, though, and so you hesitate. The stock is trading for around \$50. Therefore, instead of selling the stock, you can “write a covered call,” also termed “sell a covered call,” or, “make a covered call.” Since you already own the 100 shares of stock, you are “covered.” The price of call options with a strike price of \$55 is currently \$5. You will receive \$5 times 100 shares or \$500 for selling the option. If the stock price jumps over \$55, it will be called away from you at \$55. It is as if you actually sold it for \$60, \$55 for the price of the stock and \$5 for the price of the option. If the stock price stays below \$55, you can write another covered call if you are still not sure whether or not you want to sell the stock. This strategy allows you to make extra money from a stock that you already own. Do you see any disadvantages? What if the stock price zoomed up to \$100? Oh, well, you were going to sell it anyway, right? What if the stock price plummeted? There would be very little probability that the option will ever be exercised so you don’t have to worry about that anymore. You can now use your valuation techniques to determine if you want to still keep the stock or sell it.
Do you now see why a naked call is so dangerous? If you sold a naked call ‒ wrote the call option without having the shares ‒ and the price shot up manyfold, you are now required to buy a stock for many times what you must sell the stock to the call option buyer. For example, you sold the naked put option on a stock with a strike price of \$50 … and the price jumped to \$200 per share, you now are legally required to buy 100 shares at \$200 per share ‒ \$20,000! ‒ and sell them to the call option buyer for only \$5,000. You may believe that this is highly unusual but it does happen from time to time.
Selling Options: Writing a Naked Put
Again, you are a long-term oriented investor. This time, you are interested in purchasing 100 shares of a particular stock. You are not quite sure, though, and so you hesitate. The stock is trading for around \$50. You have the \$5,000 to buy the 100 shares. Therefore, instead of buying the 100 shares of stock, you write a naked put. Since you have the \$5,000 to buy the shares of stock, you are “covered.” The price of put options with a strike price of \$50 is currently \$5. You will receive \$5 times 100 shares or \$500. If the price falls below \$50, the option will be exercised and you will be legally required to sell the shares to the put option buyer at \$50 per share. However, since you received \$5 per share from the sale of the put option, it is as if you actually purchased the shares at \$45, \$50 per share for the stock and \$5 from the price of the option. If the stock price stays the same or goes up, the option will expire worthless and you can then write another naked put. In any event, you get to keep the option price, also known as the premium option. Do you see any downsides to this strategy? What if the stock price plummeted to zero? What if the stock price rose? What would be the results of these situations?
Covered calls are the only options transaction that is permitted in an IRA. It is unfortunate that naked puts are not permitted assuming the IRA holder has the cash available in their account. The investment world does not recognize a put seller with sufficient cash to purchase the stock as covered. The way for a put option seller to cover a put option involves a technique we will discuss in detail soon, selling short.
One last word about options strategies is crucial to our understanding of why we want you to steer far away from options. Options are typically not tax efficient. Unlike stocks which, when held for more than one year, enjoy the tax benefits of being long-term capital gains when sold, options typically are considered short-term capital gains. However, options do often generate tax losses. Of course, tax losses could possibly be considered tax efficient since they allow us to reduce our taxable income. Nothing is all bad, yes? | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/12%3A_Options_Contracts/12.03%3A_New_Page.txt |
Employee Stock Options
Employee Stock Options, normally abbreviated as ESOs, are options granted to an employee by a company giving the employee the right to buy shares of stock in the company at a fixed price for a fixed time. They usually have some significant differences from normal call options. They cannot be sold, expire in many years, often up to 10 years, and have a vested period before the employee can take advantage of them, typically 3 to 7 years. If the employee leaves before the vesting period is over, the stock options are lost. During the technology boom of the late 1990’s, ESOs were used extensively to attract employees to start-up companies.
During the 2000-2002 bear market, ESOs were the subject of much controversy. There is still some fall-out and publicity as companies and the SEC continue to wrangle over how and even if they should be used. For many years, companies could give ESOs to their employees and not have to pay anything. They did not reduce the company’s earnings. However, ESOs must now be expensed according to the Financial Accounting Standards Board. Unfortunately, how do you come up with a price for something that is currently worthless?
To make matters worse, while some people became fabulously wealthy through ESOs during the Internet mania such as John Moores, a previous owner of the San Diego Padres and Peregrine Software, many other people were soaked with crippling tax burdens on worthless pieces of paper when their companies collapsed! How can that be, you ask? The Alternative Minimum Tax, AMT, does not care if you sell the stock of exercised options, only that you exercised them. You still owe the tax on the paper gain, even if you never were able to realize the gain because the stock price collapsed after the options were exercised. Bizarre!
“Wait a minute. Did you ask, ‘How do you come up with a price for something that is currently worthless?’” Yes, that is correct. Since many ESOs are “out-of-the-money”, often by a large amount, or cannot be exercised for a long time, or both, how does the company put a price on it? The financial world currently uses a system called the Black-Scholes Option Pricing Model. It may sound impressive, but it is really very silly, in the humble opinion of Your Humble Author.
Side note: Myron Scholes won the Nobel prize for Economics for this model and then proceeded to partner with John Meriweather, the famed bond trader that we discussed in chapter 1, to create Long-Term Capital Management. In 1998, they almost brought down the global financial system. The story is recounted in the book, When Genius Failed, by Roger Lowenstein, and the PBS NOVA documentary, The Trillion Dollar Bet. The story reads like a prequel to the Global Financial Crisis of 2008.
For example, for a stock currently selling for \$7.50 per share and ESOs with an exercise price of \$10 and options that cannot be exercised for 3 years, the Black-Scholes model might say that the employee stock option is worth \$2.50. What? You cannot sell the options. You cannot exercise the options for 3 years. The options are “out-of-the-money.” How are they worth \$2.50? The stock price might never go over \$10. What if the stock price does breach \$10 and you exercise the options and then you see the stock price plummet? If you are unfortunate enough to be affected by the AMT, you might have to pay taxes on the paper gain that you never were able to realize!
Stock Index Options
A stock index option is a put or call option written on a specific stock market index, such as the S&P 500. Stock index options allow an investor to purchase or sell options that respond to a stock market index. For example, an investor can hedge a portfolio by purchasing a put on a stock index option that represents the portfolio. If the market goes down and takes the value of the portfolio down with it, the stock index put option will act as insurance against the large loss because it will rise counter to the market. Of course, it will only do this until it expires. And then you have to buy another stock index put option. Let’s keep in mind that insurance is not free. There are dozens of indices represented including large-cap, mid-cap, and small-cap stocks, domestic, international, regional, country-specific markets. The possibilities are endless … and so are the fees. Whether speculating or hedging, it is still risky or expensive or both.
Other Types of Options
A few other types of options include interest rate options, currency options, and LEAPS. Interest rate options are put and call options written on fixed-income securities such as bonds. Interest rate options can be used as insurance to protect a bond portfolio from adverse interest rate movements, similar to the stock index options above for stocks. If interest rates rise, the value of the bond portfolio will fall. To protect against this, the investor can purchase insurance in the form of an interest rate option that would rise if interest rates rose. Again, the option eventually expires and the investor would be required to purchase another option to continue any protection.
Currency options are put and call options written on foreign currencies. These can be an important tool for foreign investors and multinational corporations who must periodically convert United States Dollars to and from other currencies. Unless we as retail investors regularly have significant amounts of our U.S. dollars converted to and from other currencies to buy and sell foreign securities or other assets, they would not be a useful tool for us.
Last, LEAPS is the acronym for Long-term Equity Anticipation Securities. LEAPS are long-lived options that expire in 9 months to 3 years. These instruments were introduced by the Chicago Board Options Exchange (CBOE) in 1990. Because of the increased time value, LEAPS command a higher option price, also known as the option premium, than shorter term options.
Warrants
A warrant is a long-lived option that gives the holder the right to buy stock in a company at a price specified on the warrant. Warrants are often issued as an incentive to investors. They may be issued by the same company that issued new shares of stock to the public. They sometimes accompany newly issued bonds or are given to employees as compensation, similar to ESOs. Unlike options, where each contract represents 100 shares of stock, one warrant represents the right to buy one share of stock. Warrants are usually always call options, however, there are some put warrants.
Final Comments on Options
STAY AWAY FROM THEM!
The possibilities are endless, and so are the losses and commissions. Options are a zero-sum gamble. Someone wins, someone loses. Of course, the brokerages and exchanges make money no matter what happens. But don’t take my word for it! There are dozens of folks who want to take your money, ah, I mean, teach to make riches beyond your wildest dreams. As of May 2023, here are just three:
Online Trading Academy, 7 Days, 42 Hours, Only \$7,995!
The Day Trading Academy - Used to be only \$2,997. Such a deal! But now the price is gone and you have to give them your contact data first.
TradeWins.com - These folks have got to be seen to be believed! ! Scroll down to see Chuck and Wendy and Bubba They want’s t’ learn ya’ good!
Here is one last attempt to steer you far away from options. Check out this unfortunate soul who committed suicide when he thought he had racked up \$700,000 in debt selling options. He was wrong. He did not actually incur the debt. He was just reading his account status incorrectly.
12.S: Summary
Congratulations ‒ You Have Finished Chapter 12 ‒ Options Contracts
You have reached the end of chapter 12, Options Contracts. In this chapter, you have:
You should now be able to:
And You Thought Options Were Risky?!
Well, just wait until we get to our next chapter on futures contracts. Unlike options contracts, futures contracts are financial instruments that actually have a valid reason for existence and are very important to our global economy. However, for the vast majority of us retail investors, they are extremely risky and dangerous and can turn a prudent, long-term investment portfolio into a pool of tears overnight. Remember, we are teaching you about these derivatives so that you will be protected against their siren calls of “get rich quick.” Once again, Dear Readers, instruction about syphilis is not an instruction to get syphilis. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/12%3A_Options_Contracts/12.4%3A_Employee_Stock_Options_and_Some_Final_Topics_about_Options.txt |
“There are two times in a man’s life when he should not speculate;
when he can’t afford it and when he can.” – Mark Twain
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
So what did you think about options, eh? Ready to start gambling, oops!, I mean, speculating with stock options contracts? Well, Dear Students, as the saying goes, "You ain't seen nothin' yet!" The amount of money that you can lose speculating with futures contracts is staggering. However, unlike options contracts, futures contracts actually do have a very important usage in the global financial system ... for large producers and consumers of commodities such as wheat, oil, and pork bellies. (The last one being used for comedic effect in the 1983 movie Trading Places. Pork bellies, Dear Students, are what they make bacon out of. You know, that tasty stuff that is responsible for colorectal cancer?) For the rest of us, we are best served by staying away from these "Weapons of Mass Financial Destruction." This is a phrase coined by famed investor Warren Buffett.
"Wheat" by kewing is licensed under CC BY-NC 2.0
"Oil well pump jacks" by Richard Masoner / Cyclelicious is licensed under CC BY-SA 2.0
"Coin Toss" by ICMA Photos is licensed under CC BY-SA 2.0
• 13.1: Futures Contracts
So what did you think about options, eh? Ready to start gambling, oops!, I mean, speculating with stock options contracts? Well, Dear Students, as the saying goes, “You ain't seen nothin’ yet!” The amount of money that you can lose speculating with futures contracts is staggering.
• 13.S: Summary
Congratulations ‒ You Have Finished Chapter 13 ‒ Futures Contracts
13: Futures Contracts
So what did you think about options, eh? Ready to start gambling, oops!, I mean, speculating with stock options contracts? Well, Dear Students, as the saying goes, “You ain't seen nothin’ yet!” The amount of money that you can lose speculating with futures contracts is staggering. However, unlike options, futures actually do have a very important usage in the global financial system ... for large producers and consumers of commodities such as wheat, oil, and pork bellies. (The last one being used for comedic effect in the 1983 movie Trading Places. Pork bellies, Dear Students, are what they make bacon out of.) For the rest of us, we are best served by staying away from these “Weapons of Mass Financial Destruction.” (This is a phrase coined by famed investor Warren Buffett.)
What Are Futures Contracts?
A futures contract is a commitment to deliver a certain amount of some specified item at some specified date in the future. A futures contract buyer and a futures contract seller specify a commodity or financial instrument to be delivered and paid when the contract matures. The futures price is guaranteed by the contract. Futures contracts started with commodities, also referred to as hard assets or real assets. Examples include wheat, soybeans, cattle, pork bellies, gold, silver, copper, oil, and gas. However, there are now futures contracts that cover financial assets such as stocks, bonds, and currencies.
Commodities Futures Contracts
Producers of commodities use futures contracts extensively. For example, a wheat farmer in Iowa plants 1,000 acres of wheat in April. He knows that if all goes well, Lord willin’ and the creek don’t rise, come September he will have 50,000 bushels of wheat. September wheat futures are currently selling ‒ in April! ‒ for \$6 per bushel. Our farmer can “sell” his wheat via a wheat futures contract while it is still germinating in the ground. He can guarantee a price that he is happy with and will result in a profit for him. The contract states he will deliver the wheat in September and receive \$6 per bushel no matter what happens to wheat prices.
Consumers of commodities also use future contracts. For example, cereal companies such as Kellogg’s, General Mills, and Post Cereal need tons and tons of wheat each year to make cereal and other foodstuffs. Via futures contracts, in April, they can purchase the wheat to be delivered in September and pay \$6 per bushel no matter what happens to wheat prices. In this way, we can think of futures contracts as insurance. The farmer and the food companies are using futures contracts like insurance to protect themselves.
Can you see the rationale behind these instruments? Futures contracts allow producers and consumers of commodities to hedge. Hedging is taking a futures position opposite to an existing position in the underlying commodity or financial instrument. “Hedge your bet!” Have you ever heard this saying? The farmer will have tons of wheat so he is taking a position opposite to his holdings; he is selling his wheat. The food companies will need tons of wheat so they are taking a position opposite to their need; they are buying wheat.
What are the disadvantages of using futures contracts when you are the producer and when you are the consumer? If wheat prices plummet, the farmer is protected, yes, but on the other hand, if wheat prices rise substantially, the farmer cannot take advantage of the higher prices since he is already contractually obligated to sell his wheat for \$6 per bushel. Likewise, although the food companies are protected against considerable price increases, if prices fell appreciably, they will not be able to take advantage of the lower prices since the food companies have already promised to pay the farmer \$6 per bushel, no matter what happens to wheat prices.
Here is a list of common commodities:
Food and Fiber Livestock and Meat Forest Products Precious Metals
Barley Feeder Cattle Hardwood Pulp Gold
Canola Lean Hogs Lumber Palladium
Cocoa Live Cattle Softwood Pulp Platinum
Coffee Pork Bellies Rhodium
Corn Silver
Cotton
Flaxseed Energy Metals Other
Milk Brent Crude Aluminum Amber
Oats Electricity Aluminum Alloy Palm Oil
Orange Juice Ethanol Cobalt Rubber
Rapeseed Gulf Coast Gasoline Lead Wool
Rice Heating Oil LME Copper
Soybean Meal Natural Gas LME Nickel
Soybean Oil Propane Molybdenum
Soybeans RBOB Gasoline Tin
Sugar WTI Crude Oil Zinc
Wheat
Financial Futures Contracts
The financial world adopted the technique of futures contracts to financial assets, treating financial assets like commodities. Financial futures contracts work similarly to commodities future contracts. Examples include currencies, interest rates, stock and bond indexes. “I will deliver \$25,000 worth of British Pounds to you next April.” “I will purchase \$10,000 worth of the S&P 500 stock index from you next August.”
For those working in the World of Finance and especially, the World of International Business, financial futures contracts can be very useful tools. For example, a car manufacturer based in the United States knows it will need to purchase 50,000 engines from Japan next October. The manufacturer can buy a currency futures contract for \$30,000,000 worth of Japanese Yen payable in October. This protects the manufacturer from adverse currency fluctuations. Again, we can use the analogy of insurance. The manufacturer bought insurance against the United States dollar falling relative to the Japanese yen. If the dollar does fall relative to the yen, the manufacturer is protected. If the dollar rises against the yen, the manufacturer bought insurance that they did not need.
Speculating with Futures Contracts
Can anyone buy futures contracts? Lucky You! You do not have to work in either the commodities world or the finance world to buy and sell futures contracts. You can be a speculator! You simply buy and sell the futures contracts. You never actually deliver or take delivery of the commodity nor the financial asset. You could buy the 50,000 bushels to be delivered in September even though you live in a condo in West Los Angeles and have never even seen a farm!
Speculating with futures contracts is accepting the futures price risk without having a position opposite to an existing position in the underlying commodity or financial instrument. It is the opposite of hedging. One boring Introduction to Investments textbook said, “… futures speculation is risky, but it is potentially rewarding if you can accurately forecast the direction of future commodity price movements.” Can anyone accurately forecast the future? If our LA speculator sitting in her condo had purchased the futures contract for 50,000 bushels of wheat to be delivered in September and wheat prices plummeted, she could potentially lose hundreds of thousands of dollars!
Note: When and if you ever start speculating with futures contracts, your broker will be watching your account like a hawk. They will do their best to make sure that you never get close to losing hundreds of thousands of dollars. Why? Because if you disappear and send them a postcard from East Jabip, the brokerage firm is required to make good on the transactions. If you start to lose too much money, they are permitted to close you out of the transaction, even if you will lose a substantial amount on the deal. We will discuss this in detail in our next chapter.
Final Characteristics and Comments on Futures Contracts
The largest, most active futures exchange is the Chicago Board of Trade although futures contracts are traded on many other exchanges. The “long position” is the buyer of the futures contract and is protected from futures price increases. In our example, these are the cereal companies, Kellogg’s, General Mills, and Post Cereal. The “short position” is the seller of the futures contract. The seller is protected from future price decreases. In our example, this was the farmer. We will discuss the term long and short in detail in our next chapter.
Futures contracts seem similar to options contracts. In fact, the two are very similar. Financial futures work very much like options. There is the potential for great rewards but there is also much more of the likelihood of sustaining great losses. In fact, the potential losses from futures contracts are staggering! And, just like options, they are a tremendous source of commissions for your broker. Oh, by the way, you can purchase options contracts on futures contracts. What do you think about that?
Our final comments on futures contracts?
STAY AWAY FROM THEM!
They are even more potentially dangerous than options. Here is an article about how hapless would-be speculators lost tremendous amounts of money in the world of futures contracts. If you search for other examples using an Internet search, unfortunately the numerous advertisements for how to teach you to get rich quickly “investing” in futures crowd out the articles trying to warn you about their dangers.
13.02: New Page
Congratulations ‒ You Have Finished Chapter 13 ‒ Futures Contracts
You have reached the end of chapter 13, Futures Contracts. In this chapter, you have:
You should now be able to:
So are ya’ gonna’ stay far, far away from options and futures? I hope so! But wait, we are not yet finished learning how to lose a lot of money. In our next module, we will learn two more techniques designed to make your brokerage firm rich, ah, I mean, designed to help separate you from your money, no!, no!, I mean, designed to help you take advantage of other speculative strategies. We are ready to tackle buying on margin and selling short. | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/13%3A_Futures_Contracts/13.01%3A_New_Page.txt |
“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” – Mark Twain
Learning Objectives
In this chapter, you will
By the end of this chapter, you should be able to
As if options contracts and future options were not bad enough, the investment world has two more strategies to help separate you from your money, aye!, I mean increase your wealth through speculative transactions. (Have I ever mentioned that I am not very popular with many brokers?) In this chapter, we discuss buying on margin and selling short. Both involve borrowing from your broker. Both have significant risks. And as we have said in the past, instruction about syphilis is not an instruction to get syphilis. Okay, okay, maybe someday down the line, you may find a suitable situation for buying on margin. But selling short is downright dangerous. It’s right up there with futures contracts. Let’s see if we can scare you away from selling short for good!
• 14.1: Buying on Margin
Let's see how we can magnify our gains -- and magnify our losses! -- with the technique known as buying on margin. Yet another way to separate you from your hard-earned money.
• 14.2: Selling Short
Okay, Fun Seekers! Just wait until you learn how to lose theoretically unlimited amounts of money by selling short!
• 14.S: Summary
Congratulations ‒ You Have Finished Chapter 14 ‒ Buying on Margin and Selling Short
"Horse Racing Betting Slip" by ATTRIBUTION: beatingbetting.co.uk is licensed under CC BY 2.0
14: Buying on Margin and Selling Short
Okay, Dear Students, we are ready to learn how to borrow money to buy stocks, commonly referred to as buying on margin. If you borrow money to buy stocks ‒ buy on margin ‒ not only will your brokerage firm be earning commissions from you but you will also be paying them interest! This will make your broker very happy. What’s that, you say? You say you are really not that interested in whether or not your broker is very happy and you are more concerned with your own financial success. My apologies. Well, did I mention that buying on margin can magnify your investment returns? Yes, indeed, it can! But I guess I also have to mention that buying on margin can also magnify your investment losses. Oh, well, nothing is perfect!
Cash Account
A cash account is a brokerage account in which all transactions are made on a strictly cash basis. Cash accounts are the simplest arrangements requiring no credit check of the customer by the brokerage firm. Once you have established a good relationship, most brokerage firms will allow you to purchase shares of stock even if you do not have enough cash in the account. This is because stock transactions settle in two business days. You have two business days to get the money into the account. Some of the deep-discount Internet brokers do not allow this. The cash must already be in your account. Conversely, when you sell a stock, it takes two business days to receive the money. Again, once you establish a good relationship with your brokerage firm, if you need the money sooner than two days, they will usually make arrangements so that you can immediately have access to the proceeds from the sale of the stock.
Margin Account
A margin account is a brokerage account in which, subject to specified limitations, securities can be bought and sold on credit. If you open a margin account, the brokerage firm will do a credit check to determine your creditworthiness, since you will be borrowing money from them. The interest rate you pay on the money borrowed from your broker is called the margin rate. It is actually a very good interest rate. It is often the prime rate plus 1 or 2 percentage points or 2 or 3 points above the current money market rates, depending on how much you borrow. The margin rate is almost always much better than credit card rates.
A margin account allows you to perform margin trading, commonly referred to as buying on margin. Buying on margin entails the use of borrowed funds from your broker to purchase securities, typically stocks. Hence, your account is often referred to as a leveraged account. You can use the borrowed funds as a lever to magnify your returns by reducing the amount of equity that you must deposit. Of course, leveraging as it is often called is a two-way street. The use of borrowed funds can magnify your returns but it can also magnify your losses. Ain’t nuthin’ free!
The margin is the portion of the value of your investment that is not borrowed. (This has always seemed odd to me. Shouldn’t it be the other way ‘round? Shouldn’t the part that you borrowed be called the margin? Oh, well. I don’t make the rules.) The margin is the amount of equity stated as a percentage in the investment. An example would be if you bought a stock for \$100 and you deposited \$75 and borrowed \$25. Your margin would be 75% while 25% of the investment is money you borrowed from your broker.
The Rationale for Buying on Margin
Why buy on margin? Buying on margin allows the investor to use financial leverage. (There’s that word again, leverage!) Leverage is the use of debt financing to magnify investment returns. We will see some examples shortly. Another use of buying on margin allows an investor to tap into the equity in their account without actually selling their investments and generating commissions and taxable transactions. Buying on margin is much like buying a house. When you purchase a house, you do not come up with the total amount. You deposit 10% or 20% down and finance the rest. However, when you buy stocks on margin, you are required to deposit at least 50%.
Generally, at first, a prudent, long-term investor would avoid buying on margin. We will see examples of why it is best to avoid buying on margin very soon. However, there may be situations where buying on margin is a suitable strategy. Let’s say an investor has built a solid, long-term oriented portfolio of high-quality stocks from many years of prudent and successful investing. The investor has an unforeseen incident which now requires a large purchase or outlay. The investor, though, does not want to sell their stocks. This would generate commissions and taxes and also, maybe they just believe that these are stocks that they want to continue to hold for the long term. The investor can use buying on margin to borrow on the value of their portfolio, similar to a Home Equity Line of Credit (HELOC) loan that homeowners can employ when in need of cash.
The important point to remember here is that in both cases, you are borrowing money, whether it is a HELOC loan from your bank or credit union or a margin loan from your broker. In our BUS-121, Principles of Money Management, class, we recommend that our students follow this tried and true saying, “Make Love, Not Loans.”
The Aspects and Mechanics of Buying on Margin
As mentioned, buying on margin requires an initial deposit called the initial margin. This initial margin requirement is the minimum amount of equity that must be a margin investor’s own funds. The initial margin requirement is set by the Federal Reserve Board and can change over time but has been set to 50% for many decades. You must deposit at least 50% of your own funds. This allows you to purchase the same amount of stock with half the money. The margin loan, also known as the debit balance, is the amount of your account borrowed.
Let’s take a look at an example. You deposit \$10 and borrow \$10 from your broker. You purchase one share of common stock for \$20. Your initial margin is \$10 or 50%. The margin loan is \$10 or 50%. Now let’s say the market price of the stock rises to \$30. Congratulations! You made \$10 on a \$10 investment! That is half of what you had to come up with when you simply purchased the stock outright with your own money. Instead of a 50% return on your investment, you received a 100% return on your investment.
Let’s revisit the example, you deposit \$10 and borrow \$10 from your broker. You purchase one share of common stock for \$20. Everything is the same as before, however, this time the market price of the stock drops to \$10. Oops! Only ½ of the money was yours! You borrowed the rest. You have lost your entire investment! Buying on margin magnifies your gains and magnifies your losses. Margin buying was one of the major contributing factors to the Crash of 1929. At the time, the margin requirement was only 10%. For this reason, the above scenario is prohibited today and our intrepid investor would have had a “margin call” long ago.
Because margin trading is inherently riskier, margin accounts are more highly scrutinized by brokerage firms. A restricted account is a margin account whose equity is less than the initial margin requirement. The investor may not make further margin purchases and must bring the margin back to the initial margin requirement when the securities are sold. Information technology has made the brokerage firm’s job of scrutinizing margin clients much easier. Now, the computer spits out a list of customers that are restricted.
The maintenance margin is the absolute minimum amount of margin that an investor must maintain in the margin account at all times. The Federal Reserve Board sets the minimum and it has been set at 25% for many decades. However, your brokerage firm may set the minimum higher for individual clients depending upon their creditworthiness. A client’s maintenance margin might be set at 35% or 40% if the brokerage firm believed that the client would have trouble absorbing the very large losses that may accompany a margined transaction.
If the amount of margin falls below the maintenance margin, the investor will receive the dreaded margin call, a notification of the need to bring the equity of an account whose margin is below the maintenance level up to the initial margin level or to have enough margined securities sold to reach this standard. If the investor does not meet the margin call in sufficient time, typically 48 hours, the brokerage firm is authorized to sell enough of the securities to meet the margin call. There is an old Wall Street saying: “Never meet a margin call!”
As the Internet bubble was deflating in the early 2000’s and many technology firms were seeing their prices plummet, some brokerage firms would send out the margin call notifications in the form of email messages overnight. However, the brokerage firms did not wait for the clients to respond. Immediately, when the market opened the next day, the brokerage firms sold the losing shares in an effort to stem the clients’ losses. How could they do this? When you open a margin account, you agree to many provisions that state that the brokerage firm is allowed to close out your transactions without your consent or approval. Why did they do this? They did this to protect themselves. If stock prices fall fast enough, an investor might lose enough money such that they now have what is called negative equity. This is a fancy term for having all the value of their portfolio wiped out and now they are losing borrowed money. If they disappear or declare bankruptcy, the brokerage firm is on the hook for the loss.
Of course, if your investments do very well, you will have excess margin in your margin, more equity than is required in a margin account. You can then use the excess margin you create in your margin account to purchase additional stock without having to come up with more money. This is called pyramiding, the technique of using excess margin from paper profits in margin accounts to partly or fully finance the acquisition of additional securities. What do you think of this strategy? Sorta’ flies in the face of, “Make Love, Not Loans,” eh?
And remember that you have borrowed money from your brokerage firm. You are paying interest on that borrowed money. Paying interest on the margin loan also adds yet another drag on your investment returns. Your margined investments must meet or exceed the margin interest rate in order for you to just break even! Commissions and interest, what a combination! Now you know why your broker is always so happy to take your calls.
You might be asking yourself the question, “So, why would I buy on margin?” The easy answer is, “You shouldn’t.” The risks are not worth the potential reward, in the opinion of Your Humble Author. Of course, you will find many other more adventurous individuals who disagree and believe buying on margin is worth the risks. Do you want to eat well or do you want to sleep well?
However, as discussed, there is a valid, logical reason for having a margin account. A margin account allows you to temporarily borrow against your investments without having to sell them. You do not incur commission costs and you do not trigger capital gains taxes, but you do pay interest. Do you think you would want to buy stock on margin?
The Account Balance Sheet
Traditionally, with margin accounts, the brokerage firms would create an account balance sheet to keep track of the account. It is all computerized now. Those of you with accounting experience will recognize this as a simple balance sheet using the formula:
Assets = Liabilities + Equity
The assets on the left of the account balance sheet must equal the liabilities and equity on the right of the account balance sheet. The account balance sheet also makes it easier to calculate the margin. To calculate the account margin, we use the formula:
Account Margin = Account Equity / Total Assets
Let’s take a look at an example and construct the account balance sheet. You purchased 100 shares of a stock at \$100 per share. That is \$10,000 in total. You deposit \$5,000 and you borrow the rest, another \$5,000. You owe your brokerage firm \$5,000. You are, of course, paying interest on the \$5,000.
Margined Account with Initial 50% Margin
Assets Liabilities and Equity
100 Shares @ \$100/shr \$10,000 Margin Loan \$5,000
Account Equity \$5,000
Total Assets: \$10,000 Total Liabilities and Equity: \$10,000
Using the formula for the account margin above, we get:
Account Margin = Account Equity / Total Assets = \$5,000 / \$10,000 = 50%
Now what if the stock price rises to \$120 per share?
Margined Account After Significant Price Gain of Securities
Assets Liabilities and Equity
100 Shares @ \$120/shr \$12,000 Margin Loan \$5,000
Account Equity \$7,000
Total Assets: \$12,000 Total Liabilities and Equity: \$12,000
Using the formula again for the account margin above, we get:
Account Margin = Account Equity / Total Assets = \$7,000 / \$12,000 = 58.33%
Congratulations, you have excess margin! You can use the excess margin to help purchase additional shares of stock. But what happens if the stock price drops to \$60? Your company was caught artificially inflating earnings!
Margined Account After Significant Price Reduction of Securities: Margin Call!
Assets Liabilities and Equity
100 Shares @ \$60/shr \$6,000 Margin Loan \$5,000
Account Equity \$1,000
Total Assets: \$6,000 Total Liabilities and Equity: \$6,000
We have a problem. The results from the formula for the account margin are now quite different:
Account Margin = Account Equity / Total Assets = \$1,000 / \$6,000 = 16.67%
Margin call! Unless your brokerage firm already sold the shares before giving you a chance to respond, you have a choice. You can either sell the shares and take a brutal loss. Or you can meet the margin call by depositing more cash into your account. What was the old Wall Street saying? “Never meet a margin call!” Take the loss and vow never to buy on margin again.
Final Thoughts Regarding Buying on Margin
Do you want to eat well or do you want to sleep well? Buying on margin allows an aggressive investor to magnify their returns but also magnify their losses. Of course, once a prudent, long-term oriented investor has built a solid portfolio of high-quality stocks and is in need of cash, the investor can borrow from their portfolio at attractive interest rates without the need to sell stocks generating commissions and taxable transactions. (And if you dared to say to yourself, “Oh, I don’t pay commissions,” then shame on you! Robinhood has brainwashed you!) | textbooks/biz/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/14%3A_Buying_on_Margin_and_Selling_Short/14.01%3A_New_Page.txt |
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