Of late I have been delving into the details that an investor should look into when selecting securities to put his money in. I did a post about the financial documents that an investor has to read to make an informed decision, I did a post on the types how an investor analyses a stock, and yet another on how an investor analyses a bond. There was also another important concept to consider called margin of safety.
In line with the most recent of investing posts, I am going to do one on other things that a value investor has to consider when making investment decisions.
General stability of the company– in value investment circles, this is measured by the maximum decline in per share earnings (how much each share earns) in any of the past say 7 years, or any figure that you please as against the average of the three preceding years i.e. you have the per share earnings of a company going back 7 years from now. Take the average of the earnings of the preceding 3years and use it to measure how far the earnings have decreased or increased in each of the last 7 years. Increase or no or little decline is favorable.
General growth of the enterprise. This should not be explosive over a really short time because a company whose growth and earnings increase in biblical proportions, like growth stock have the tendency of falling away in the same fashion(am thinking the tech bubble in the nineties). It is better to invest in companies that have satisfactory growth record over a given time say 7 years and have shown fairly good performance in bad times(this are mostly blue chip stocks)
Profitability– a lot of profit is always an attraction to investors since they are mostly followed with high annual growth rates in earnings per share. This is more often than not a show of the general strength or weakness of the company. The company has strong fundamentals if the profitability goes on for a fairly long time.
Good financial standing– This will be brought out in the analysis of the company’s financials. A good consistent financial standing is always a requirement in an investment stock. An investor’s criteria for this financial standing can be a ratio of 3 to 1 for current assets to current liabilities, meaning that the liabilities of the company are covered three times by the current assets
The stock price variation over the given period– an investor is inclined to stocks that have had a favorable increase in price over a given period over those whose prices have remained stagnant or have fallen for no good reason
Dividends– If the company gives them, an indicator of the favorableness of the company is whether these have been awarded to the investors consistently in the past without fail. The company should be particularly favorable if this dividends were also continued in a very bad economy like in the past recession. Companies that continued their dividend payments while others were failing should be given some consideration.
The industry that the company is in– there are some industries that are more are more poised for more profit than others and while this is something that the investor has to consider, he must mot spend too much of his time looking for the next big thing since there is no way of really predicting what will happen in the future and so he should concentrate on things that are quantifiable.
So those are the major factors that you should consider before you invest in any stock.
In all aspects of life there is a modus operandi to be followed and this goes without saying in investing. While there is always the option of throwing away your hard earned money in any media hyped stock or bond, the results may not be as good as when you sit down and do your homework on a security before investing in it.
I have covered an overview on how stocks are analysed and this page will look at how bonds are analysed by value investors.
1.First of there is to be the realization that bonds are not for safety [as I have suggested in earlier posts-hey i am also learning ] but investments with limited returns. The investor in essence gives up yield for more safety of hard earned principal. This is because there are also a lot of risk associated with this investment as seen in part of this article.
2.An investor should focus the bond part of his portfolio on bonds with returns higher than high grade bonds(their yields are always very low because the are more or less very safe from default) with a lower risk of loss of principal that is not as high as those of high grade junk bonds. This makes sense to me because it mean that one should also be just as concerned with the returns as with the safety of principal.
3.Avoid companies with a high credit risk. This risk comes from them being inherently unstable (financial, management etc) and having too much debt relative to their income. A combination of these two can erode the margin of safety i.e. the number of times that the interest payments are covered by earnings. This is independent of the size of the company because even a large company with too much debt relative to their cashflow means that they are very much prone to hard financial times during upheavals.
4.when analysing individual bonds there are a lot of things to include in the analysis like the industry that the issuing company is in, the quality of management, the number of times that the interest payments to bond holders are covered with the earnings, financial structure, sources of cash, value of the business and such things should weigh heavily when considering to invest in a bond.
5.The very popular buy and hold method of investing should have no real basis in a value investor and he/she should give the securities a very long hard look from time to time and assess whether they are still fit to hold after reanalyzing all the aspects of bond investing as mentioned above. She must not sell or buy because of market fluctuations or anything that fickle.
6.Market timing must have no place in the investors analysis unless it is favored by all these other factors. What I mean is that if after a fundamental analysis of all the things that are analyzable(what is mentioned above) then he can use market timing to buy the very attractive bonds at a price lower than what he was originally prepared to pay. Market timing should not follow interest rates of other temporary unpredictable things
7. Finally to avoid the inevitability of defaults (when a company cannot pay the interest payments or the principal back to the investors because of financial difficulty meaning that the investors lose everything), he must diversify his bond investing and avoid junk bonds unless his diversification is good enough to handle the danger of default of these very risky issues
Basically this is the M.O. that the value investors follow. In the near future I will revisit this post with figures and everything.
As you can see there is a lot that goes into bond investing just like i showed you with the stock analysis post. And I haven’t even said anything about the analysis of the financial structure of the companies….
When one wants to seriously invest in stocks, one just doesn’t google “best media hyped stocks for 2009” and the first option that comes up is what he/she will put his money in. No. That is when the work begins because the has to find the stocks that have the best chance of giving him returns that will satisfy him in that they will compensate the work he did in finding them.
So this begs the question; how does one find a good stock. There is but one answer. Due diligence. An investor has to look through numerous financial records of public companies looking for those that suite the requirements that he has set. This post will not deal with these requirements per se but on the documents
These financial records that the investor looks at are;
The financial statement. This consists of
1.The balance sheet– which show the financial position of the company as at the closing date(a single day). That is why the heading is always “as at dd/mm/yr” it is a detailed record of what the company owns (its assets) both tangible like machines and furniture and intangible like goodwill and its liabilities(what it owes) that include bank loans, debts incurred in running of the business etc.
2.The income statement/profit and loss statement/statement of revenue and expense– as the name implies, it show the earnings for the period covered (financial year). You may have noticed that they are always entitled “for the year ended dd/mm/yr”. It is not always year because some companies issue these results quarterly so basically, it is for the financial period ended. They contain sales, non operating income, gains and losses from all the various business transactions, depreciation and depletion of assets, income taxes, dividends paid, etc. it basically shows how cash flows through the business.
The prospectus– This document is used by companies offering securities for sale. It basically describes the business and how the proceeds from the sale of the securities(IPO) will be used, the company’s market cap, everything that you would want to know about the directors like their contacts, resumes, amount of shares each hold etc
The interim statements– these include the company’s earnings only for less than that company’s financial year.
Conference calls from C.E.O.s. some companies have regularly scheduled conference calls where the CEOs talk about the companies present standing to the shareholders.
These are the four major documents that an investor needs to know how to analyse but this is not the end of it there are so many other sources of information that an investor can go to find more information.
Periodic reports to public agencies– they are just like financial statements but more detailed
Statistical and financial reports
Requesting specific information from the company. If the shareholder still cannot find information he is looking for from the above sources, then he should contact the company and ask for it since technically being a stockholder means that he owns part of the business and thus entitled to most of the information pertaining to the business.
Pro-forma statements-but alert investors normally ignore them because they are kinda useless. What I mean is that companies misuse them and mislead their shareholders. Initially they were meant to provide investors with a better picture of long term growth by removing short term non recurring expenses but now they also include normal expenses like shareholder’s dividends, costs of mergers and acquitions. So to avoid being thrown off, the investor should not take it seriously.
I wanted to keep this post really short (something that I have failed to do) because in the near future, I will redo it in vivid minute (and disturbing detail).
Are there any other documents that any investor out there uses in stock analysis for his stock portfolio?
The easiest day to put a noose around your neck in the stock markets and it is called short term investing, popularly known as day trading.
Basically this is where an day trader(this is what they are called) hopes to make money in the selling of various securities, be it stocks, warrants, stock options after having bought them at a lower price. The biggest difference between this guy and other investors is that he only holds the securities for hours at a time and not days or months or years like other real investors
While a large number of people do engage in this dangerous game, there are a few things that they do not consider;
Sometimes a trader may buy a value stock in the morning in the hope that the price will increase by a few points in the course of the day but the opposite happens and the stock’s price decreases. Because the trader wants to reduce the paper losses has already incurred, the will desperately try to sell the secutities at any price, even if it it lower than the price he bought them at.
This difference in the price he bought the stock at and the price he sold at is called market impact. While in that trade, the loss may not be so significant that is causes his death, this small losses pile up over time and in the grand scheme, a large loss is incurred. Those pennies and dimes really add up.
In another scenario, a day trader can be desperate to buy shares of the next big startup and this end up offering a higher price for the stock that the current price so as to lure sellers to part with it. This market impact will is a small loss that will pile up over time and will happen each time you desperately buy or sell shares desperately trying to get into “the next microsoft”
This i got from Benjamin Graham’s the intelligent investor that when one gravitates towards day trading than to investing, the turns long term gains into ordinary income. This also contributes to your demise because ordinary income is taxed higher than the long term gains. I will not put figures here because the tax retes vary from country to country.
Something else that will cause your death in day trading is the costs. Each transaction has a fee and so each time you trade a fee is deducted whether you make cash or not. So it goes without saying that the more you trade the higher this transaction fees and the less returns you take home.
So this post generally shows why value investors like Warren Buffett are for value investing meaning analysing the stock, analysing the bonds and scrutinising all the companies financials before buying even a single security.
Do you agree with my point of view when it comes to day trading??
One of the major reasons why i started this site was to make financial news easily understandable. This was because there was a time when i used to go through the financial pages of the wall street jounal, CNN money or the new york times and wonder why people were making so much noise over things that very few people understood.
So in explaining financial concepts in a simple language(i really try hard to make this stuff easily understandable) i assume that readers start seeing sense in the financial pages.
So i was reading though the wall street journal and found this post on hedge funds increasing in popularity and i remembered that i did a post explained how this hedge funds work(here is the post). So i assume that someone who does not know what hedge funds are, after reading my post will easily understand what Brian low is talking about.
After reading through my post explaining what hedge funds are, do you find it easy to understand the wall street journal article in hedge funds??
Some time back I did a post on money market funds and how they are used as alternatives to cash by investors- aggressive and conservative alike. They also come highly recommended by Benjamin Graham in the sixth edition of security analysis. He says that if an aggressive investor can see no investment that fits the criteria set out as a value approach would, then be should put his cash in the money markets.
There are many reasons for this but the main reason is the short term maturity period and very high liquidity and the safety that these investments provide for the investor’s hard earned cash among other things.
So in this post I will mainly dwell in the type of money market instruments available for the value/ fundamental investor. The definition of a money market is the global market where short term financial instruments are bought and sold.
These money market instruments include:
CERTIFICATES OF DEPOSIT [CDs]
These are offered by depository institutions like banks and credit unions but they are sometimes bought through established brokerages. These money market instrument is also referred to as a time deposit because they have specific investment durations like 3 weeks to five years much like bonds. Other things that these CDs have in common with bonds are a predetermined interest rate and being available in more than one denomination. To give evidence that you have invested cash into the institution, the certificate is awarded to you and the information that appears is the amount invested, the maturity date and the interest rate how the interest is calculated.
These certificates of deposit while they have a higher interest rate than T bills and savings accounts in banks have the down side of being a little riskier [just like bonds in that the higher the interest rate offered to the investor, the higher the risk of default the investor has to bear] but overall the interest offered is much smaller than most other investments.
Another advantage is the safety from the whimsical stock market and the ability to calculate what your cash will amount to when it matures.
Another thing about certificates of deposit is that there are restrictions on withdrawing cash. This can be a good thing in that the investor will not be tempted to withdraw cash all the time (and thus forcing him to delay gratification) and a bad thing in that he cannot count on the investment in when disaster comes a knocking. But it is worth adding that the larger denomination CDs can be sold before maturity.
They are perfect for keeping cash safe for a specific amount of time and I think that this is why security analysis recommends them.
Finally they differ from money market accounts, something that about.com has brought out rather well.
TREASURY BILLS (T bills)
These are ways that a government uses to raise money from the public, much like government bonds
With T bills, the investor buys them at less than the par value or full value or at a discount and government will buy them back at the predetermined par value. The difference is what the investor keeps
The investment period of these T-bills is 3months(90 days), six months and one year and the various short maturities is one of the things that make them so popular. Other reasons for their immense popularity are;
-the fact that they are so simple to understand and invest unlike investments like stock options and bonds and warrants and stocks
-the fact that it is possible for the investor to get a T bill that matures at the time convenient for him and at an interest that he can specify at an auction
-A variety of denominations that cater for the investor with modest funds to the richest of the rich
– A very low risk of default since they are backed by the government and it is only in very extreme cases that a government can go bankrupt and fail to pay back cash to investors
While the returns are not the best, let us not forget that this is a security that an investor uses when he is between investments.
Just like corporate bonds, commercial paper is a way for the corporation to increase working capital by borrowing from everyone else other than the evil banks and just like T bills, they are offered at a discount from the face /par value.
These have fixed maturity periods between one to nine months and are issued by companies with a very high credit rating much like the first rate corporate bonds making then a very safe short term investment. This is where they differ from corporate bonds in that these have shorter maturity periods. The high credit rating requirement by issuing companies is because they are not backed by any form of collateral and so only companies that have a very strong financial base and thus cannot default are allowed to issue them unlike bonds which are issued by any type of company but are graded according to the risk that the investor is to incur when he decides to invest in them.
The down side of commercial paper to investors with modest funds is that they are only in very high but variable denominations and thus only cater for rich investors who have the luxury of choosing whether to buy then on discount or with an interest attached.
REPURCHASE AGREEMENTS (REPOS)
This security only works with government securities. With these, the government securities holder sells the security to the investors with the agreement to buy them back at a predetermined date and price which is normally worked out for the investors benefit. This is a real short term investment i.e. one(overnight) to over a month
There s a lot to know about repos like types and the structure, all of which are addressed in this answers.com linked article
Another name for the repurchase agreement apart from the repo is the buyback. A fitting name.
MONEY MARKET FUNDS.
I did a post about them some time back and instead or redoing it, you can just read through here
BANKER’S ACCEPTANCES (BAs)
For companies with a credit worthiness so low that they cannot issue commercial paper, this security somewhat more suitable. They are essentially created by a non financial firm and guaranteed by a bank.
The corporations issues this non interest security at a discount from the full value with a maturity period of less than one year and is backed by a bank with a very high credit worthiness. They are not very common in other areas apart from international trade
Apart from the fact that they don’t necessarily have to be held to maturity and offer the investor security for his money, this security also reduces the company’s cost of borrowing cash from a financial institution
They are very similar to treasury bills because of the discount issue.
Unlike the implication in the name, these securities have nothing to do with Europe. They are US dollar deposits in banks outside the USA. The maturity period is around six months and investments are in very large amounts and individual investors with modest funding are usually locked out unless through a money market mutual fund.
These are used by persons or organizations that need to keep large amounts free from government regulation, deposit insurance and thus allow for larger margins
There are Eurodollar time deposits and Eurodollar CDs and it is also worth mentioning that they are only found in the developed countries like USA and Europe.
FOREIGN EXCHANGE SWAPS
This nifty investment allows to parties to exchange different foreign currencies at a certain time in the future at a mutually agreed on exchange rate. The main advantage here is that this reduces the risk that the currencies will change in ways that will be inconvenient for either party and this saves them a lot of cash that can be lost in the easily fluctuating forex markets
Other names for these swaps are forex swaps, currency swaps, FX swaps and are mainly used by multinational companies or those that frequently deal with foreign currency
They are much more complicated than the one liner with which I have tried to explain them with, as Wikipedia shows
These securities are issued by municipalities to get cash in anticipation of tax revenues unlike munis bonds that are used to increase the cash that the municipality has to spend by borrowing from the public(a loan of sorts) as they wait for other forms of revenue. Their maturity periods range from a few months to a few years depending on many things.
Apart from the short maturity period and the relatively safe form of investments that they are, they do not have wide price and interest rate movements as compared to stocks and bonds
These are a few short term investments that are available to the value investor in between investments and those that are saving cash for a specified time like to buy a house or for school or something. I hope they are well explained
I realize that this post is longer than the ones that I usually write but I needed to give you all that I could find on highly liquid investments instead of hiding your money under the mattresses :~)
We have all heard of a company going insolvent but most of us never really know why investors make such a hullaballoo about them. Well I can assure you that they are not chicken littles yelling “the sky is falling” because a receivership is quite a serious issue for the owners and shareholders and this post will show you just that.