Financial health

May 17, 2020

Long-term investors depend on their stocks to remain viable during economic recessions.  In today’s Coronavirus Pandemic, businesses of all sizes are losing income from the forced reduction of consumer spending, which may destabilize companies to the brink of bankruptcy.  Investors can assess stability by reviewing the financial health of their companies.

Financial health is the ability to pay all obligations in a timely matter.  Credit ratings and analyst reports use propriety methods to measure financial health.  You can independently rate the financial health of a public company using a single numerical score from 0 to 10 based on liquidity and solvency; the higher the score, the healthier the company (eq. 1).

equation 1:    Health = Liquidity + Solvency

Liquidity

Liquidity refers to the ease of converting current assets into cash for payments of current liabilities.  Current assets are considered convertible to cash within one year.  Some assets are more liquid than others. Savings accounts, checking balances, money market funds, and receivables [i.e., customers’ IOUs] represent liquid assets. Inventory [i.e., unused supplies and unsold products] is considered an illiquid asset.  Current liabilities are the costs of paying business expenses such as wages, payables, and interest on short-term credit.  The following ratios provide useful measurements of liquidity:

  • Current ratio = Current assets / Current liabilities.
  • Quick ratio = (Current assets – Inventory) / Current liabilities
  • Interest coverage = EBIT / Interest  [EBIT is the company’s earnings before accounting for the charges of interest and tax; EBIT is a measure of recurring income]

 

liquidity

chart 1

Solvency

Solvency refers to the liquidation value of a company in case the company must pay all of its short-term and long-term liabilities. I use the shareholders’ equity [aka net worth or book value] as a common denominator for the measurement of solvency.  Solvency ratios and free cash flow provide useful measurements:

  • Debt-to-Equity = Long-term debt / Shareholders’ equity.
  • Financial Leverage = Total assets / Shareholders’ equity.
  • Free Cash Flow = Operating cash flow – Capital expenses

 

solvency

chart 2

Examples

Chart 3 displays health scores for a list of companies identifiable by stock tickers; they are the current holdings of my investment club.  The data were calculated with the formula in eq. 1 using open source data for liquidity and solvency.  Three stocks received low health scores of 2.

health

chart 3

From chart 3, I selected five strong competitors of VZ and CMCSA to determine if the low health score represents a larger group of 7 competitors listed in the trading sector of Communication Services.  The additional competitors are listed below in chart 4. Three of the additional competitors matched the scores of CMCSA and VZ, inferring that most companies in that select group operate with low liquidity and solvency.

competitors

chart 4

Another comparison was made using a sample of stocks with an open-source, proprietary grade of low financial health (chart 5).  One stock, JCP, recently filed for chapter 11 bankruptcy.

others

 chart 5

Risk management

The health scores in chart 3 are based on historical data at least 3 months old.  Stocks with the lowest scores are considered more unstable.  If, in your informed opinion, there’s a credible risk of bankruptcy and delisting, you can protect your investment by either selling the stock or placing a stop-loss order on it.

Conclusion

Open-source financial data can be used to assess the risk of potential bankruptcy and delisting among publicly traded stocks, especially during an economic recession.  Combined assessments of liquidity (chart 1) and solvency (chart 2) additively form a health score of 0 to 10, with lower scores implying poor financial health.  The scoring system is easy to implement, but unreliably predicts financial failure of public companies with low scores.  Additional fundamental analysis of the company is strongly recommended and meanwhile, if you wish to protect your investment from a substantial loss, place a temporary stop-loss order on the holding.

Copyright © 2020 Douglas R. Knight 

 

 

 

 

 

 


Stock Market Prices

April 1, 2020

SUMMARY:

The Stock Market is a place where professional traders arrange cash-for-stock transactions between buyers and sellers.  Other securities are sold in the Market, but stocks occupy the vast majority of listed securities—(securities are investment contracts worth money, of which stocks represent shares of ownership in companies).

Every transaction is called a Trade.  Regular trades involve the buyer’s payment of cash for securities offered by the seller.  Buyers and sellers propose trades to their brokers who then send the proposals (orders) to professional traders.  Market rules require traders to fill orders at the next available price, either the highest Bid of a buyer or lowest Ask of a seller, depending on the type of trade.  The general trend of prices among many trades is calculated as the Market Index.  Investors should prepare trading orders carefully with awareness of the potential consequences.

Competitive prices

The Stock Market is designed to set prices for securities at an agreeable price among competitive Bids and Asks –(the buyer’s price is called a Bid and the seller’s price is an Ask).  The agreed price varies according to the prevailing action of trading orders in which Buy orders are filled at the lowest available Ask and Sell orders are filled at the highest available Bid.  In a ‘seller’s market’, the buyers’ surplus demand for securities raises prices for the sellers.  Examples include the rising prices in rallies and bull markets.  In the ‘buyer’s market’, the sellers’ surplus supply of securities lowers prices for the buyers.  Examples include the falling prices in corrections and bear markets.  

Market Index

The Market Index is a singular value which represents the prices of many securities traded in stock exchanges [see index methodology in the appendix].  Graphs of the market index display daily fluctuations (volatility), trends, and market cycles.  The trend of a market index is useful in several ways:

  • Analysis of supply-and-demand: An increased demand for shares drives prices upward and conversely, an increased supply of shares drives prices downward.  The index follows the price trends.
  • Benchmark: Investors like to know if the prices of their holdings are performing better or worse than the market index.
  • Passive management: Index funds (e.g. ETFs)  are investment portfolios designed to match the performance of an index.
market indices, 5y

Chart 1.  The ‘Dow’ represents stock prices of 30 large companies traded in the New York Stock Exchange and Nasdaq market.  The ‘S&P 500’ represents market capitalizations of 500 large companies traded in U.S. exchanges (market capitalization is the sum of prices for all shares of a given stock).  The ‘Nasdaq’ is calculated from market capitalizations of all companies listed in the Nasdaq market.

Chart 1 displays the parallel behavior of 3 popular indices; they are broad market indices by virtue of describing the price volatility and trends of many stocks listed in the Market.  Small fluctuations represent daily values reported at the close of the trading day.  Large fluctuations display short and long cycles of market activity.  A long market cycle consists of one “bull” and “bear” market in succession.  Long bull markets create a general upward trend of market prices that endures several market cycles.

Trading Orders

In contrast to the market index, which represents many stocks, the quote represents one stock.  Quotes are widely published in the media and brokerage firms.  A typical broker’s quote shows the last traded price, traded volume, and opposing prices (bid & ask).  

Investors place a trading order by consulting their broker or employing the broker’s online trading platform.  In a trading platform, the investor completes an order form with the following information:

  1. Ticker.  The trading symbol of the desired security
  2. Action.  Buy or Sell
  3. Volume.  Quantity of units (shares) to be traded
  4. Type.  Method for filling the order (Market versus conditional)
  5. Price.  conditional or Market.

The basic types of orders are Market and conditional.  Market orders are filled immediately at the next available price, but the investor is unable to specify the price.  Conditional orders enable the investor to specify the price of a future trade within a period called the “time-in-force” (typically 60 days).  Conditional trades are activated at the specified price and filled at the next available price. 

Limit and Stop are two types of conditional orders available to most stock investors.  A Limit is the preferred price for a Buy or Sell order.  The Limit order is activated when a future market price matches the Limit price.  The activated trade is then filled at the same price or a more favorable price; but, if the next available price becomes unfavorable due to price fluctuation, the Limit order is cancelled unfilled.  A Stop is the specified price of a Sell order.  The Stop order is activated at the specified price and then filled by a Market order.  The seller has no control of the price after a Stop order is activated.

A Trading Story

Two fictional investors named ‘Green’ and ‘Red’ decided to place opposite trading orders for the same security on March 5th when the quoted price was $49.  ‘Green’ thought the price would eventually drop and wanted to buy 100 shares for a bargain at the Limit of $45.  The intended bargain was a $400 reduction of investment cost.  ‘Red’, who owned 100 shares, thought the future price would drop for a loss.  “Red’ wanted to prevent a deep loss by selling 100 share at the $45 Stop.  ‘Red’ would be happy if the Stop order were never activated, but just in case prices declined, the loss of $400 could be tolerated.  The outcomes are illustrated in Chart 2.

trading orders

Chart 2: The Fate of 2 Conditional Orders.  Red and Green symbols represent respective Stop and Limit orders made on March 5th.  The dashed line indicates that both orders remained-in-force until activated and filled on March 9th.  An overnight crash of prices halted trading at the start of the March 9th trading day.

On March 9th, a market crash activated both orders at the moment trading was halted by a circuit breaker.  When trading resumed, ‘Green’ bought 100 shares at the very favorable price of $41, even $4 cheaper than the intended $45 Limit.  ‘Green’s’ bargain was $800 instead of $400.   ‘Red’ sold 100 shares at the very unfavorable price of $41, $4 below the intended $45 Stop.  ‘Red’s’ original market value of $4,900 dropped by $800 instead of $400 after the activated Market order filled at the next available price of $41.

–Lesson: Limit orders protect a preferred range of transaction prices.  Market and Stop orders don’t protect the transaction price.

References

  1. Trading orders, Invsetopedia.com
  2. Supply and demand, Investopedia.com
  3. Stock quote, Investopedia.com
  4. DJIA index methodology, Investopedia.com. 
  5. S&P 500 index methodology, Investopedia.com.
  6. Do ‘Circuit Breakers’ Calm Markets or Panic Them?: QuickTake. Nick Baker & Sam Mamudi.  The Washington Post 3/19/20, WashingtonPost.com 

Appendix: Index methodology

The stock Index is a special sum of weighted prices for many stocks, (w * Price) of many, listed in the stock market. The sum is divided by a special divisor, D.

Index(w * Price) of many ÷ D

The stocks, their weighting factor (w), and the divisor (D) are proprietary definitions of the Index provider.  Repeated calculations of the Index create a string of values that reveal the general volatility and trend of stock prices.

Copyright © 2020 Douglas R. Knight


Language of the Stock Market

February 29, 2020

Summary: New investors might find it helpful to understand the basic language of the Stock Market.  In this article I discuss the basic vocabulary as it relates to practical ideas for personal investing.  Links are provided for further reading about a particular topic.

Investment returns

An investment is the payment of capital to earn a return.  The return is a gain (or loss) of value in the investment.  Taxes on returns are regulated by the Internal Revenue Service (I.R.S.) and local governments.   

  • Principal: the amount of money invested.
  • Capital: the cash or goods used to generate income.
  • Capital gain (or loss): the increase (or decrease) in cash value of an asset.
  • Dividend: a company’s cash payment to its stockowners.   
  • Interest: the borrower’s cash payment to the lender that is added to the principal of the  loan.

Investment portfolio

Financial assets are potential sources of income for investors.  Asset classes are groupings of assets that earn income in uniquely different ways.  The most popular asset classes are Equities and Fixed Income Securities.  Equities earn income by the sale of a security (e.g., shares of a Stock).  Fixed Income Securities earn guaranteed interest (e.g., bonds) or guaranteed dividends (e.g., preferred stocks).  Securities and investors are regulated by the Securities & Exchange Commission (S.E.C.). 

  • Securities: contracts that require an investment of money to generate profits from the efforts of other people. 
  • Stock: a security that represents part ownership of a company.  
  • Common stock: a security that entitles its owner to vote on important issues, collect dividends, and earn capital gains from the stock market.   
  • Preferred stock: a security that entitles its owner to receive dividends before dividends are paid to owners of the company’s common stock.  Preferred stockowners have no voting rights.    
  • Bond: the debt that requires a company to return an investor’s principal, plus interest, by the date of maturity.    

A Portfolio is the investor’s collection of financial assets called holdings.  By comparison, an Investment Fund is a portfolio of financial securities which are professionally managed on behalf of the fund’s investors.  Famous examples are mutual funds and exchange-traded funds (ETFs).  An actively managed portfolio generally seeks to earn higher returns than one which is passively managed.  The passively managed portfolio seeks to duplicate the returns of a market index.  

Glossary:

  • Market index: a hypothetical portfolio designed to measure the value of a market or market segment. 
  • ETF: an Investment Fund that sells shares of the fund in the stock market.  Index ETFs are passively managed. 

Stock market

A new stock is issued in its primary market.  The primary market is a private assembly of the company’s founders, venture capitalists, and third parties such as banks and advisors.  The stock may later be sold by public auction in the secondary market.  The secondary market is the familiar stock market where millions of investors, —like us!—,  trade cash for stocks and other exchange-traded securities (e.g., ETFs). 

Trading orders

The stock market participants include Investors who make offers, Brokers who generate orders, and Traders who finalize orders.  The broker’s trading platform is a computer program that assists investors with placing trading orders.  The platform provides a market “quote” comprised of the current purchasing price (the “bid”), sales price (the “ask”), last-traded price, and latest number of traded shares (the “volume”).   On any day there may be millions of orders to buy and sell in the stock market.  Orders are filled at the market price determined by an auction of shares conducted by the broker’s trader.  Brokers and traders often charge a fee for their services.  Custodians are hired by brokers to store traded securities in electronic accounts on behalf of investors.   

The simplest trading order, a MARKET ORDER, specifies the number of shares to be traded.  Market orders are filled immediately provided the shares are available; otherwise, the order remains open until shares are available.  Conditional limit- and stop orders are stored in computers until activated or expired at the end of a period called the time-in-force.  The LIMIT ORDER requires an investor to specify a preferred price for the trade.  Limit orders are activated when the market price reaches the preferred price and then filled at the preferred price or a better price. Please be aware that a sudden market event could displace the market price outside the limit range of an activated order, in which case the limit order is cancelled unfilled. The STOP ORDER is activated at a specified price after which it is converted to a market order to be filled immediately regardless of the next available price. 

Stock market index

Analysts like to follow the price trend of stocks by graphing a representative number called the stock market index.  The index rises and falls at any moment according to fluctuations in share prices during stock market transactions.  An influential sales surge moves prices downward and a buying surge generally sends prices upward.

Daily index values are strung together to form an observable trend called the market cycle.  The long market cycle is comprised of a “bull” market followed by a “bear” market.  The short market cycle is either a rally or a correction. Spikes and crashes are brief events caused by a sudden, large change of the index (chart 1).  

  • Bull market: a 20% rise of the market index over 2 months or more.
  • Bear market: a 20% fall of the market index over 2 months or more.  
  • Rally: a rise of the market index due to a burst of buying that subsides after the money is spent.
  • Correction: a 10% decline of the market index over 2-10 days.
  • Spike: a sudden large upward or downward price movement.
  • Crash: a sudden correction that lasts 1-2 days.
  • Circuit breakers: programmed halts of trading designed to offset a downward plunge of stock prices.  

Chart 1. Long and short cycles of the Dow Jones Industrial Average (“DOW”).

market cycles, DJIA

In chart 1, the vertical scale shows values of the DOW Index during a 20 year time period shown by the horizontal scale.  The jagged line represents daily fluctuations of market prices. Green, red, and black symbols illustrate the timing of various market cycles and events.  The horizontal line of green and red segments portrays 4 long cycles of the DOW Index.  After the partial 1st cycle (Jan 2000-Jul. 2001), the complete 2nd (Oct. 2001-Aug. 2002) and 3rd cycles (Sep. 2002-Mar. 2009) show orderly sequences of bull and bear markets.  The nearly complete 4th cycle began with a very long bull market of eleven years (Mar. 2009- Jan. 2020) that recently reverted to a bear market at the time of this writing.  Chart 1 also shows short cycles of rallies (green triangles) and corrections (red triangles).  A few market crashes (black triangles) in Nov. 2008 and Mar. 2020 represent 1-2 day periods of a 10% drop in the Index.  Rapid declines of the Index by 7% in one day triggered temporary halts of trading (black circles) known as “circuit breakers”.

Diversification

Stocks are high risk investments with respect to potential capital gains (upside risk) and losses (downside risk).  Capital loss occurs when the company declares bankruptcy or its share prices decline.  Stock diversification, dollar cost averaging, and dividend reinvestment plans (DRIPs) are effective strategies for managing the common risks of stocks.  Monthly purchases of a Stock-index Fund accomplish these strategies.  Chart 2 illustrates the potential capital gains from investing in a Stock-index Fund that duplicates a broad market index such as the S&P 500.

Chart 2.  Historical prices of the S&P 500 Index.

dividend reinvestment

Assuming that the Fund matches the performance of the S&P 500 Indexthe difference between holding the original investment in the Fund without further action (red graph) and augmenting the holding with reinvested shares (blue graph) illustrates the potential benefit of a dividend reinvestment plan.  In this example, the benefit became ‘significant’ after 6 years.       

Postscript

Stock investing is a time-consuming process that might not interest many people who wish to put their money in the market.  They can save time (and money) by investing in a Stock-index Fund that provides an instant portfolio of diversified stocks for long term investment.

Stocks are one of several investable asset classes.  People with short term goals should consider diversifying their portfolio with different asset classes.

Copyright © 2020 Douglas R. Knight 


2019

January 5, 2020

The SmallTrades Portfolio holds cash plus an exchange-traded fund (ETF) and a folder of stocks (figure 1).

SmallTrades Portfolio, 2019

Figure 1 displays 2019’s year-end composition of the SmallTrades Portfolio. COLUMN HEADINGS: “Ticker” is the trading symbol of the “Security” as listed in the U.S stock exchange.  “Mkt Cap” stands for ‘market capitalization’, which is the total market value for all tradable shares of a given security.  “Allocation” is the percentage market value of each holding relative to the market value of all holdings in the Portfolio.  “Strategy” is the investment strategy.  STRATEGY: “Passive” strategy relies on the ETF’s computers to track the value of a selected market index.  “Drip” signifies the automatic reinvestment of dividends earned from long term investments in ETFs and stocks.  “Growth” stocks are expected to earn long term capital gains.  “Swing” stocks are expected to earn short- or long term capital gains based on a pre-defined range of price growth.

Strategy

The investment goal of the Portfolio is to earn an annual rate-of-return that surpasses the performance of the benchmark Standard & Poors 500 Stock Index.  One index-ETF dominates the Portfolio’s return with an expectation of matching the benchmark’s rate of return.  A subordinate folder of selected stocks is expected to outperform the benchmark’s annual rate-of-return.

Performance

The Portfolio earned a 29.7% total rate-of-return during calendar year 2019.  Although the Standard & Poors 500 Index earned a higher rate of 31.5% in 2019, I’m pleased with the Portfolio’s performance for these reasons:

  1. 2019 was the first year that the Portfolio’s market value surpassed the initial market value at year-end 2007 (figure 2).  As reported in an earlier post, the market value declined in 2008 due to mismanagement, then took 12 years to recover by the process of employing trial-and-error strategies of management. The strategies gradually improved to the current idea of using an index-ETF to earn the benchmark return and supplementing that return with a subfolder of growth stocks.
  2. Converting 2018’s diversified ETF folder to 2019’s single ETF successfully raised the ETF folder’s market value by 33.9% in a single year (figure 3).
  3. Revising both the investment strategy and the composition of 2018’s stock folder raised its market value by 54.9% (figure 3).

 

2008-19 portfolios

Figure 2.

 

2014-19 stocks & ETFs

Figure 3.

Copyright © 2020 Douglas R. Knight

 

 

 

 

 

 


What is a stock and how much is it worth?

August 21, 2018

A stock is an offering of part ownership in a company.  Each part, — called a share—, is worth the price that buyers are willing to pay.  

A new stock is sold for the first time in the primary market.  The primary market is a private one comprised of the company’s founders, venture capitalists, and third parties such as banks and advisors.  Venture capitalists take a big risk that the company might fail.  In return, they have considerable influence on how the company is governed and operated.  They hope to earn a generous profit from selling their shares.

The stock may be sold again in the secondary market by public auction.  The secondary market is the familiar stock market where thousands of investors, —like us—,  trade cash for stocks and other exchange-traded securities.  We also hope to earn a generous profit from selling shares. Some companies may occasionally choose to pay us a cash bonus called a dividend.

Wise buyers seek the best price for a good company.  The best price is determined by ‘valuation’ and the quality of the company is assessed by ‘fundamental analysis’.

Copyright © 2018 Douglas R. Knight


The joy of stock returns

August 5, 2018

A good reason for investing in stocks is to earn more money than the interest paid by a bank account or savings bonds.  Some investors ignore their stocks until it’s time to cash in.  Most prefer to watch the growth of returns, in which case they need to know the total return and holding period.   

Total Return

Stock profits depend on the capital gains and dividends.  A capital gain is the amount earned when the current stock price exceeds its purchase price.  A capital loss is the amount lost when a current price is below the purchase price.  The capital gain (or loss) is “unrealized” if the investor doesn’t sell the stock or “realized” if the investor sold the stock.  Some companies make occasional cash payments, called dividends, to their stock holders.  

Total Return is the total profit from your stock investment.  It represents the stock’s change in market value combined with all dividends you received from the company.  In equation 1, the change in market value is equal to “market value – total cost”.  

total return = market value – total cost + dividends

  • Market value is the combined value of all shares owned at the current market price (market value = current price * volume; volume is the number of shares).  
  • Total cost is the value of all shares purchased (cost = purchase price * volume) during the holding period 
  • Holding period is the period of stock ownership.  

Trading fees are ignored in order to simplify this discussion. In actual transactions, trading fees reduce the market value and increase the cost by small amounts so as to reduce the total return by a small amount.  The impact of trading fees on profits is lower in larger transactions.  For example, a $5.00 trading fee is 5% of a $100 purchase compared to 0.5% of a $1,000 purchase. 

Return on Investment (ROI)

ROI is the basic measurement of profitability (ref 1).  It is the ratio of total return to total cost (equation 2).

ROI = total return/total cost

Significance: the ROI shows how much profit you earned from every invested dollar.  If the ROI were 0.2/1, which is 20%, then you earned 20 cents per invested dollar.

“Price performance” (equation 3) may not measure the ROI.  Price performance = (price2 – price1)/price1, where price1 is the earlier number and price2 is the later number.  Price 1 may neither be the purchase price nor the only purchase price.  ROI includes all purchase prices.

Rate of Return

The rate of return measures profitability with respect to time.  Think of if it as the ROI for the holding period (equation 4). 

Rate of Return = ROI/holding period

Don’t forget that the ROI compares profit to cost when the time period is anchored to the date of the initial purchase.

ISSUE: The rate of return is most precise when there is just one purchase.  Serial purchases require a more complicated calculation of the “annual return”.  

Annual return

The annual return is a number that represents the average rate of growth per year of the holding period.  The annual return has several important properties:

  1. It doesn’t change during the holding period.
  2. It’s a geometric average, not an arithmetic average.  The graph of geometric growth is a curved line (“exponential”) rather than a straight line (“linear”).
  3. The geometric average represents the phenomenon of compounded growth known as “compounded interest”.

Stock investors are interested in 2 types of compounded growth:

  1. The compound annual growth rate (“CAGR”) of a single purchase.
  2. The internal rate of return (“IRR”) for a series of purchases.  

There are free calculators which are posted online to determine the CAGR (ref 2) and the IRR (ref 3).  

ISSUE: The annual return is usually inaccurate during the first year of compounded growth and becomes more accurate over longer time periods.  

Rule of 72 

The payback period is something to celebrate!  It’s the point when the investment doubles your money.  Payback is measured by the ratio of total cost to the rate of return.  Or, it can be estimated by the Rule of 72 (equation 5).  

Rule of 72 = 72/assumed annual return

Significance: the Rule of 72 is used to forecast the holding period needed to double your money (ref. 4).  For example, assume that your total return will grow at a constant rate of 10% per year [approximately the same rate as the growth of the U.S. Stock Market].  The expected payback period is 7.2 years (7.2 = 72/10).  

Summary

The total profit of your stock investment is called the total return.  The simplest way to measure profitability is to calculate the ROI with equation 2.  The ROI is insensitive to time until you calculate the rate of return with equation 4, which allows you to compare the profitability of several stocks in your portfolio.  The annual return of compounded growth is a refined measurement of your calculated rate of return.  After a holding period beyond one year [to avoid the chance of considerable inaccuracy], the annual return may be determined with an online calculator for a single investment (CAGR) or serial investments (IRR).    

References

1. Return on Investment (ROI). https://www.investopedia.com/terms/r/returnoninvestment.asp 

2. Compound annual growth rate (CAGR) calculator.  http://www.moneychimp.com/calculator/discount_rate_calculator.htm  . 

3. XIRR calculator to calculate IRR of non-periodic cash flows. https://www.free-online-calculator-use.com/xirr-calculator.html   . 

4. Brian Beers. What is the Rule of 72? https://www.investopedia.com/ask/answers/what-is-the-rule-72/ , 1/2/2018.

Copyright © 2018 Douglas R. Knight


Ways to invest in stocks

July 19, 2018

There are thousands of  investors who want to own ‘good’ companies that avoid ‘trouble’.

  • they invest in stock shares [stock shares are equal units of part ownership]
  • a good company
    • operates a profitable, growing business
    • avoids financial distress and regulatory penalties

Investors purchase and sell shares in the stock market.  They hope to sell their stock at a desirable price and may also receive cash rewards from companies that pay dividends.  Investors earn a profit (called a capital gain) when the sales price is above their cost of investment or lose money (called a capital loss) when the sales price is below cost.  

Stock Analysis

Two ways of evaluating a stock are called technical analysis and fundamental analysis.  Technical analysis measures the performance of share prices and share volumes in the stock market.

  • Shares are units of part ownership which are traded in the stock market.
  • Price: the price of a share in the stock market.
  • Volume: the total number of shares traded in the stock market 

Fundamental analysis evaluates the business performance of a company by way of searching through its quarterly and annual filings.  The business description, financial statements, and CEO’s annual letter to shareholders are important sections of the filings.

  • CEO: Chief Executive Officer; top manager of the company.
  • Filings: periodic reports to shareholders that are required by the U.S. Securities and Exchange Commission (SEC).

Business performance is also assessed by the company’s market share and competitive advantage within its industry.  This information is available online.

Investment Strategies

The most common investment strategies for stocks are swing trading, value investing, and growth investing.  

Swing trading (cyclic trading) uses brief upward or downward trends in share prices to determine when to buy or sell stocks.  The typical holding period is from one day to several weeks.  The investor hopes to earn a capital gain (–if seeking a profit–) or capital loss (–if seeking to reduce the short term capital gains tax–).  The investor uses either a technical analysis or guesswork to judge the price trend.  The main risks of incurring a loss are due to price volatility and taxation of returns.

  • Hold: to own.
  • Short term: one year or less.
  • Short term capital gains tax: the taxation of a capital gain at the regular income tax rate.
  • Price volatility: the random fluctuation of prices based on the market forces of supply and demand.
  • Return: the profit or loss from an investment.

Value investing seeks a capital gain by purchasing the stock at an unusually low price (e.g., 60% of intrinsic value) and then selling it at approximately double the purchase price.  The holding period depends on the length of time for the stock price to become profitable. During the holding period, an investor will receive any dividends paid by the company.  The informed investor uses a fundamental analysis to assess the quality of the company and the intrinsic value of its stock.  The causes of an unusually low price include a market downtrend (e.g., economic recession) and poor company performance.  The main risks of incurring a loss are due to an eventual delisting of the company and taxation of returns.  

  • Intrinsic value: the share price calculated by a professional analyst’s secret formula.  However, you can estimate the intrinsic value as the net worth of the company (book value) per share, based on the idea that a wealthy investor could acquire the company at its intrinsic price by puchasing all shares of stock at the book value per share.   
  • Dividend: a cash reward paid to share holders from the company’s profits or cash reserves.
  • Delisting: removal of the stock from the stock market for various regulatory reasons, including bankruptcy of the company.    

Growth investing is a long term strategy for using the upward momentum of share prices to earn a capital gain. The capital gain is earned by simply holding the stock and reinvesting all dividends.  The rule of 72 estimates the holding period needed to double the purchase price of the stock at an assumed rate of annual return.  The growth investor uses a fundamental analysis of the company and market valuation to judge the fairness of the stock price.  The main risks of incurring a loss are due to deterioration of the company, decline in market value, and taxation of the returns.

  • Long term: after one year.
  • Momentum: an upward trend of share prices.
  • Rule of 72: [ Years to double the price = 72/percentage annual rate of return ] For example, a 15% annual rate of return will double the share price in 4.8 years. 
  • Annual rate of return: a constant percentage change in value every year that accelerates the growth of an investment; CAGR is an acronym for the annual rate of return.
  • Valuation: the art of judging if the price is low (discounted, undervalued) or high (expensive, overvalued). 

disclaimer: this article may not increase your investment profits.

Copyright © 2018 Douglas R. Knight


2017

January 1, 2018

My SmallTrades Portfolio holds stocks and broad-market index ETFs (chart 1).

chart 1. SmallTrades Portfolio in 2017.

Chart 2 shows the diversification of ETFs as measured by percentages of year-end market values among ETF classes.

chart 2. Diversification of ETFs in 2017.

Chart 3 shows the diversification of stocks among 8 market sectors as measured by percentages of year-end market value for each stock sector and the ETFs.

Chart 3. Distribution of stocks and ETFs by market sectors.

Chart 4 shows the distribution of stocks according to market capitalization.

Chart 4. Combined market capitalizations.

Performance

My investment goal is to outperform the “Benchmark” Standard & Poors 500 Total Return Index, yet my portfolio has never outperformed the Benchmark (chart 5).

Chart 5. Portfolio performance.

Chart 5 shows growth trends for the benchmark (blue dashed line) and portfolio (solid blue line) since 2007 [the benchmark represents a passively managed, buy-and-hold investment; my portfolio is an actively managed investment].  On the Y axis, a unit value of $1.00 was assigned to both the total market value of the Portfolio and the Benchmark on December 31, 2007. Ratios of subsequent market- and benchmark values to the 2007 baseline are displayed line plots on the chart.

In 2014, my investment policy was modified to buy stocks of good companies and hold them for the long term. Chart 6 shows the result of my stock investments (red line) compared to the Benchmark Index (blue line) and ETF investments (red dashed line). The unit value of $1.00 was calculated on December 31, 2013. Since then, the stock group clearly outperformed the Benchmark and ETFs.

Chart 6. Stock and ETF performances.

Risk Management of ETFs

Broad-market index ETFs are primarily protected against stock losses by the passive management of investment portfolios which mimic the composition and performace of reputable market indices.

ETFs are secondarily protected by rebalancing significant allocation errors as described in the SmallTrades Portfolio’s strategies for risk management. In theory, a significant drift of asset classes occurs when one asset class surpasses a 24-28% allocation error. My preferred allocation of ETF market values is 30% stocks, 30% REITs, 20% bonds, and 20% gold bullion.

A perfect allocation of ETFs would result in 0% allocation error.  Furthermore, allocation errors would reflect disproportional gains or losses of market value.  Chart 7 shows the year-end allocation errors (blue bars) and error limits (red dashed lines) of my ETFs. There was growth of the Global Stocks ETF and decline of the remaining ETFs. Any allocation error that exceeds an error limit (red dashed line) should trigger trades that rebalance the ETFs to the preferred allocation.  My ETFs were not rebalanced in 2017.

Chart 7. ETF allocation errors in 2017.

Risk management of Stocks

My stocks are primarily protected against risks of steep loss by diversification of the market sectors, as illustrated in the preceding chart 3. The second line of defense is stop-loss orders.  In keeping with the investment goal of holding good stocks for the long run, I set ‘stops’ at a wide margin to prevent recent market fluctuations from triggering an unwanted sale.

Plan

The SmallTades Portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. In 2017, I failed to sell large cap stocks in order to buy good small cap and mid cap stocks. Consequently, 60% of the total market capitalization of my stock portfolio was in the Large Cap category.  In 2018, I would like to reduce the Large Cap category to 40% total market capitalization and boost the market capitalization of small- and mid cap stocks issued by good companies with potential growth of earnings.

Portfolio history

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in a Roth account.
  2. During 2007-2010 the actively managed mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’.  Four mistakes led to a big loss:
  3. mistake #1: after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of the company’s large debt and lost $45,000 during Lehman’s decline to bankruptcy.
  4. mistake #2: substantial long term profits from good companies were lost by selling holdings for short term profits. My strategy was to earn a quick 30% in the first year and re-invest in the next winners. It was too difficult to identify the next winners.
  5. mistake #3: day-trading was a game of chance that I played and managed to break even; meanwhile, good stocks grew in value.
  6. mistake #4: a trial of investing in leveraged ETFs resulted in losses due to negative compounding.
  7. I abandoned the goal of a 30% annual return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad-market index ETFs and 20% stocks for the long term. ‘Good’ companies attract and retain investors for many years. I will search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, partiicipating in an investment club, using stock screeners, and attending investor conferences. Then I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  8. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since my retirement income didn’t depend on making withdrawals from the SmallTrades Portfolio, I increased my ETF exposures to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

What is a good company?

December 15, 2017

Good companies attract investors.  They do so by selling a desirable product that sustains the company’s growth of sales and earnings.  The growth of sales is a good measure of market success.  Durable companies convert their sales invoices into cash and use the cash wisely.  Accounting items such as the free cash flow, sustainable growth rate, quick ratio, and debt-to-equity ratio are easy measures of the company’s health and durability.  Growth stocks should be assessed by the quality of the company.


Book review: Make Your Kid a Money Genius (even if you’re not)

October 16, 2017

Beth Kobliner, Simon & Schuster, New York, 2017.

about the author

Beth Kobliner is an authority on personal finance for youth as shown by her successful publications of a NY Times best-seller book (Get a Fiancial Life), staff writer for Money Magazine, and contributing author to national newspapers. She served on President Obama’s Advisory Council on Financial Capability for Young Americans.

In this book she offers financial advice for 6 age groups: pre-school, elementary school, middle school, high school, college, and young adult. Much of her advice is based on academic studies. It’s not a textbook for children.

relevant topics for children

Most parents will discuss any topic except money; yet parents are the principal influence on their kids’ financial behavior. Many of a child’s money habits are set by age 7. This book discribes useful ways (called “teachable moments”) for talking about money with children as they grow from age 3 to young adult. Here are the author’s general comments about relevant topics for all ages:

TRUST: Parents need to build the trust of their pre-school children by following through on parental promises.
PATIENCE: Some children are impulsive, others are patient. Patient people tend to save more money! Pre-schoolers can be taught to wait for things.
CHARITY: Raise a generous child. Sharing time and money allows children to feel grateful for what they have. They are ready to show kindness by age 4. Elementary school children begin to understand the needs of others. Teen volunteers can engage in community service for their school and community. Most college students won’t have spare money, but they can donate their time. It allows them to explore the nonprofit world. Parents should honor their child’s charitable work with the same committment as other achievements in life; but, don’t overpraise their charitable efforts.
ALLOWANCE: It doesn’t matter if you give your elementary school child an allowance, but if you do, don’t make household chores a pre-requisite for receiving the allowance, use the allowance to set spending rules, and give them control of their spending decisions.
WORK: Children need to do unpaid chores and do well in school. Advanced chores such as raking leaves and doing laundry are essential to raising a self-reliant child. Elementary school children want to earn money, in which case the parent decides whether or not to pay the child for special chores. Middle school children are able to earn money. Limit the high school student’s work week to 15 hours; school is more important.
DEBT: Start teaching the basic concepts of debt to pre-school children. Middle school children need to understand the minimum monthly payments of credit card debt and protect themselves from identity theft. High schoolers are interested in car loans and credit cards; prepare them for wise use of credit cards. Parents, don’t buy your child a car or cosign for a car loan! After college, adult children are likely to have student-loan debt, car debt, or credit card debt. Parents should neither dip into their own retirement savings nor cosign for a loan as ways of helping young adults manage debt!
SHOPPING: Children want to buy stuff without limits, so parents need to start setting spending limits on pre-school children and teach the concept of ‘living within your means’. Elementary school children how to avoid being victimized by advertising and peer pressure. Tweens should spend their own money, not their parents’. If a teen prefers to spend for personal items rather than save money, they should learn from mistaken purchases. The ‘money culture’ among college students with different incomes can produce embarassment, resentment, and other strong feelings. Emphasize that college-related expenses are essential and everything else is extra.
SAVING: Parents should not raid their child’s savings. Middle school children should have a supersafe account (e.g., savings account, money market account, or CD). High school students should save for college, it will boost their motivation. Young adults should have an emergency fund and make maximal 401K deposits.
INSURANCE: Insurance is necessary for financial protection against devastating expenses. Most bankruptcies result from unpaid medical bills. Teens should pay for their car insurance and minimize their insurance rate with a good driving record. College students must have health insurance for the rest of their lives.
INVESTING: Don’t postpone the habit of investing in stocks; it’s a good way to protect against inflation. Children should learn the fundamentals and start saving small amounts at a young age. When they are old enough to understand numbers and show an interest in how money ‘grows,’ provide them with numeric examples of compound interest. High schoolers should open a Roth IRA to begin growing money.
COLLEGE: Attending college is the best pathway to earning higher wages compared to entering the workforce with a high school diploma. Middle school is the time to start talking about college and high school is the time to prepare for the college admissions process. High schoolers are advised to save for college; their chores should give way to college prep and testing. Avoid large student loans by chosing a good, inexpensive college and doing a better search for grants and scholarships. There are 3 ways to save for college:

  1. 529 Savings Plan. the earnings are tax-free for educational purposes and there is no income cap for donations. If your child rejects the plan’s participating schools, then rollover the savings to another education account, change the beneficiary to another child, or withdraw the savings with penalties.
  2. Coverdell Account. the earnings are tax-free for educational purposes, but the annual contribution is limited to $2,000 when a married couple earns less than $220,000 annually. The savings can be used for elementary school and high school educational purposes.
  3. Custodial accounts are available at banks and mutual funds. If the child’s earnings exceed $1,050, they are taxed at the child’s tax rate for the next $1,050, then at the parent’s tax rate for higher amounts until age 19 (age 24 for full time students). Colleges count the account balance as the child’s asset and expect 20% of the balance to go toward college expenses. That means less aid for the family.

The college student’s priorities are studies, a paying job [working students feel more invested in their education!], and employment after college. Does your college graduate want to start a career or go to grad school? Parents, don’t jeopardize your financial security to pay for their grad school.

the author’s curriculum and activities for pre-school children

Curriculum

EXPLAIN PATIENCE.  Patience, trust, and generosity are personal traits that facilitate financial success; pre-school training should help develop those traits.  Impulse buying reduces funds for tomorrow’s purchase! Always consider tomorrow’s purchases before buying on impulse.
Teach your children to perservere. Explain that you can’t always get what you want! Advise them to be patient (‘self control’) and wait for something.

EXPLAIN WORK.  Instill a work ethic; chores are a part of life.  Explain how you work to earn money  Convey the idea that a job is a source of pride and dignity

EXPLAIN SHOPPING.  Explain that you have to pay for things in cash (money, check) or card (debit, credit); the credit card is one way to pay (at the risk of incurring debt!).  Teach them to distrust advertising!   Explain how ads are produced with actors, scripts, colors, etc.  Explain the risks of materialism

DISCUSS CHARITY.  Be respectful of families with different levels of household income by explaining that “some people have plenty and others not enough”. Help bring your child closer to people of need by avoiding the terms “poor” and “rich” when discussing family wealth.
Worthy causes? Maybe your child needs guidance. What would they like to change in the world? Who would they like to help?

DESCRIBE THE HISTORY OF INSURANCE.  Ancient shipowners created a fund to pay for losses from shipwrecks. Their bookkeeper became the insurance company.

INTRODUCE INVESTING.  The basic concept of investing is to spend time and effort to produce something good (e.g., turning flour into bread).

Activities

PRACTICE PATIENCE.  Encourage them against skipping to the head of the line.  Discuss a communal effort (e.g., family savings pot) to save for a family reward (pizza, water park, etc.)

LEARN ABOUT WORK.  Perform household chores.  Discuss the jobs of people you know.

DISCUSS CHARITY.  Consider these charities: heifer.org , nokidhungry.org , kaboom.org , nature.org , pencilsofpromise.org , donorschoose.org.

general goals after pre-school

ELEMENTARY SCHOOL. Continue the development of personal traits by adding an adult perspective on respect for other people. School children need to start managing their money and protecting it. They are vulnerable to harmful attack from many directions, including identity theft from their online accounts. Give parental guidance.

MIDDLE SCHOOL. Tweens are vulnerable to marketing campaigns, overspending, and credit card debt. Give parental guidance.

HIGH SCHOOL. Reduce the time spent on household chores. The teen’s main job is graduating from high school with a good education. Teen’s also need to prepare for higher education or entering the workforce. Give parental guidance.

conclusion

Kobliner’s book contains credible advice for the homeshooling of children in financial matters. There is much more information in her book than I’ve been able to summarize in this article. Be sure to visit her web site, “Money as You Grow”, for additional help and perspective (https://www.consumerfinance.gov/consumer-tools/money-as-you-grow/.


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