Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


What is a good growth stock?

December 22, 2015

Theme

—profitable companies attract investors—

A good growth stock represents the profitable company that sells desirable products. The company’s business earnings should grow nearly 6% annually so as to match the growth rate of the U.S. Economy (about 3.5%) and compensate the rate of U.S.Inflation (about 2%); otherwise, the company might do well to liquidate its business and reinvest in securities.

Growth stock investors seek an annual rate of return that exceeds the U.S. Stock Market’s historical 8-10% annual rate of return. The basic approach is to buy stocks at a low price and sell them at a high price, but that is easier said than done. Investors can help realize high returns by selecting stocks from well managed companies, holding the stocks through an adequate growth period, to offset price volatility, and diversifying their stock portfolio.

Evaluating the company

Does the company earn respectable profits with a sustainable business? The answer is yes if the company has a:

  • growth rate of earnings that surpasses 6% annually.
  • future growth rate of earnings that surpasses 6% annually.
  • durable business with a sustainable growth rate.

Growth rate. The company that recognizes and satisfies the needs of customers will accumulate sales with the demand for its product. Profitability is the combination of sales growth coupled with efficient management of business expenses. In other words, the profitable company has a respectable growth rate of sales with respect to time, respectable rate of earnings with respect to sales, and consequently, a respectable growth rate of earnings with respect to time.

Earnings are the net income from sales after payment of expenses. The growth rate of earnings matches the growth rate of sales when the company runs its business in a consistent manner. Both sales and earnings should grow annually by at least 6% to outperform the national economy and compensate for the effect of inflation. Growth investors typically monitor the company’s earnings per share (EPS) on a quarterly basis. The EPS should grow at a compound annual growth rate of 6%, or more, as determined from at least 5 years of historical data. When evaluating a company’s earnings, consider the possibility that management is manipulating the EPS to earn higher compensation.

Future growth rate. The earnings estimate is an analyst’s quarterly or annual forecast of the EPS. The estimate is more uncertain when the forecast extends to 3-5 years. Investors use the earnings estimate to track a company’s performance and to derive a future range of share prices. The growth investor should seek companies with earnings estimates above the 6% compound annual growth rate.

Durable business. Any company can be driven out of business by an economic disaster in the entire industry, strong competition, and a declining market for the company’s product. The durable company has sufficient financial strength to survive hard times coupled with the competitive advantages needed to maintain its market position. The sustainable growth rate is a measure of the company’s capacity for earnings growth, assuming there’s room for growth of sales in the product’s market. An analysis of market opportunity is used to estimate the future demand for the company’s product.

Evaluating the stock

If a profitable company attracts investors, its stock price will rise with investors’ demand for shares. The attractive stock may be detected by a:

  • favorable valuation
  • price momentum
  • projected annual return above 10%

Favorable valuation. Growth investors place a high value on the company’s EPS for the simple reason that EPS represents the net income that generates an investment return. The 2 sources of investment return are dividends and capital gains. If the company choses to pay dividends, they are derived from the net income. Capital gains are the amount of profit from an increase in share price generated by investor-demand.

The price of a growth-stock tends to increase with the rise in EPS. This relationship is measured by the price-to-earnings ratio (P/E or PE). The current P/E is today’s price divided by the EPS of the past 12 months. The current P/E reveals what investors are willing to pay for each dollar of company earnings. The relative P/E is a ratio of the current P/E to past P/Es or to some benchmark P/E such as the average P/E of the stock market. At parity, the relative P/E is 1.0. Stocks below parity are undervalued by market participants and may be trading at prices that favor buyers. Conversely, stocks above parity are overvalued and may be trading at prices that favor sellers. There are other ways of assessing the value of a stock such as the calculation of fair value performed by stock analysts.

Price momentum. Another characteristic of the growth stock is that its share price is likely to continue in the direction of an upward trend as long as there’s a demand for shares. A review of historical prices will reveal the direction of price momentum.

Projected annual return. The reason that growth investors should seek returns above the 8%-10% total return of the stock market is that an alternative investment in index funds will capture the market’s return. One way of projecting the stock’s annual return is to multiply the future EPS by a P/E ratio to obtain the future share price. The difference from today’s price represents the future capital gain. Factoring in the stock’s dividend yield will give the projected annual return.

Risk management

The primary hazards of incurring a loss are,

  • company risk
  • market risk
  • portfolio risk

Company risk. Poor management can weaken the company and reduce its profitability. A fundamental analysis of the company, which includes a review of the financial statements, can help reduce the possibility of investing in a poorly managed company. Periodic reviews of financial statements and company news are needed to reassess the company’s management efficiency and help prevent a serious capital loss from investment.

Market risk. Volatility is the moment-to-moment fluctuation in share price that results from trading activity in the stock market. Greater volatility produces greater upside and downside risks. Upside risk is the potential gain from an investment. It represents a reasoned guess of the future peak share price. Downside risk is the potential loss. Volatility, upside risk, and downside risk are calculated in several ways. Generally speaking, riskier investments should be held for longer time periods to improve the chance of earning an estimated return.

Portfolio risk. A concentrated portfolio has a large investment in one stock compared to others. Any capital loss from the largest holding could seriously degrade the investment return of the whole portfolio. The potential impact of capital loss from a large investment can be reduced by re-allocating the principal among stocks that are diversified with respect to industry and company size.

Conclusions

A good growth stock outperforms the stock market because the company’s earnings grow faster than the Economy. One way detecting a good growth stock is to find the company that has a good sales record, bright future for earnings, and durability. Then determine what value other investors place on the stock in today’s market and future years. A potential capital gain of 10% or higher is a good growth investment.

Copyright © 2015 Douglas R. Knight


Business stories in financial statements

December 11, 2015

[updated on 2/6/2016]

Companies report their business results in financial statements on a regular basis.  Otherwise, how could they, the companies, attract serious investors?

Financial statements describe the use of money to sell products and grow a business.  The statements are prepared by accountants who consolidate business transactions into standardized measurements of profitability, cash flow, and net worth.  Those measurements represent stories of business success. The purpose of this article is to describe the framework and core stories of financial statements.

Accounting

Companies use financial accounts to perform a large variety of business functions. The effective use of accounts generates a profit for the company and its investors.

There are accounts for banking, payroll, supplies, customers, investors, shipping, advisors, taxes, and many other essential functions. Non-cash and cash transactions are recorded in the appropriate accounts. For example, each sale to a customer is initially recorded as a non-cash transaction in the customer’s account based on the price in the shipping statement. Later, the customer’s payment is recorded as a cash transaction in the company’s bank statement. In another example, the company initially records its purchase of supplies as an non-cash transaction recorded on a receipt. Later, the company’s payment to the supplier is recorded as a cash transaction in the company’s bank statement.

Accrual accounting. Accrual accounting is the practice of recording non-cash transactions at the time of transaction. The data are collected from invoices, promissory notes, and other documents of unpaid transactions.

Non-accrual accounting. Non-accrual accounting is the practice of recording cash payments. Data for cash payments are collected from bank statements and other documents of paid transactions.

GAAP. U.S. stock companies are required to publish financial statements that conform to Generally Accepted Accounting Principles (GAAP). Foreign countries may allow companies to publish financial statements using non-GAAP methods.

Framework

framework.001

Numerous financial transactions during the entire fiscal period are consolidated into line items of the income and cash flow statements. The values of all assets and liabilities at the end of the fiscal period are consolidated into line items of the balance sheet.

Income statement. The unpaid transactions of business operations are organized into revenues, expenses, and net income (Eq. 1). The statement’s top line is called total revenues and represents all recorded sales during the fiscal period. Every sale is typically recorded at the time the product is shipped to a customer. Cash payment is expected at a different time and is not recorded in the income statement. The statement’s bottom line is called net income and represents the residual value of all sales after deduction of all the expenses incurred during the fiscal period.

net Income = Total revenues – Total expenses          (Eq. 1)

Cash flow statement. The company’s payments are separated into categories of net operating cash flow (CFO or OCF), net investing (CFI), and net finance (CFF). The net value of each category is the balance between total cash inflow and outflow for the entire fiscal period. All cash surpluses and deficits are relegated to the category called net Cash Flow (Eq. 2). Companies that focus on growth attempt to maintain their net Cash Flow close to a zero balance. Investments in growth are paid through the CFI with funds obtained from the CFO or the CFF.

net Cash Flow = net CFO + net CFI + net CFF          (Eq. 2)

Balance sheet. The total book value is the net value of all corporate assets and liabilities at the end of the fiscal period (Eq. 3). The total book value is sometimes called the shareholders’ equity, net worth, or net asset value.

Total book value = Total assets – Total liabilities          (Eq. 3)

Core stories

Financial statements are designed to measure profitability and cash flow during the fiscal period and net worth at the end of the fiscal period. A simple analysis of measurements can reveal the company’s business performance.

Profitability.  The income statement describes how the company used sales and expenses to earn a profit during the fiscal period. The income statement might reveal that expensive business operations forced the company to sell a large number of products in order to be profitable.

Cash flow.  The cash flow statement describes how the company used its money during the fiscal period. If the company paid for growth, the basic scheme was to use its cash from customers or investors to grow by purchasing more assets for the business or investing in other companies.

Net worth.  Net worth is measured by the total book value at the end of the reporting period and provides a momentary valuation of the company. A company with considerable net worth has much greater value in total assets than in obligations to pay future expenses. The investor would judge that company to be financially strong.

Publications

Companies distribute their financial statements to the U.S. Securities and Exchange Commission (SEC), investors, financial services companies, and brokerage firms. Free copies can be obtained from the SEC.gov website, corporate websites, financial websites, and brokerage firms.

Domestic companies listed in U.S. stock markets file forms 10-K and 10-Q with the SEC. Form 10-K is an annual filing that contains financial statements for the fiscal year. 10-K is useful for performing a fundamental analysis of the company. Form 10-Q is a quarterly filing that also contains financial statements. 10-Q is useful for making quarterly reviews of the company.

Summary

Financial statements measure a company’s profitability, cash flow, and net worth. These measurements reveal the company’s business performance as a factor for making investment decisions. Free copies of financial statements are available in the internet.

Copyright © 2015 Douglas R. Knight


Lessons from ”Black Monday”

September 19, 2015

August 24, 2015: Stock prices in China’s Shanghai Exchange had the biggest one-day fall of nearly -9% since 2007, earning that event the title of “Black Monday”. Exchanges around the world followed suit. Next day, the Shanghai crashed below -15% (ref 1,2). Stunned investors worried about sliding into a bear market, then into a recession. Crashes, bear markets, and recessions produce losses of investment earnings. What are they and how do they occur?

Cycles

The stock market is one component of the larger economy. Both systems expand and contract in cycles governed by the net influence of buying and selling in diverse markets. Stock market cycles are gaged by real-time and historical stock prices. The real-time prices fluctuate according to traders’ demands for shares at any moment in time. The historical prices are chosen from four real-time prices: the Open and Close are the first and last prices of the trading day”; the High and Low are maximum and minimum prices of the day; and, the adj Close is an adjustment of the Close to account for a cumulative effect of stock splits and dividends.

Stock prices are compiled into market indices.  A market index measures the collective value of prices from a given group of stocks. The index Close changes from day to day, but when successive Closes are strung together over a period of weeks to months they form an observable trend called a market cycle. In chart 1, the market cycles of two indices are plotted over 25 years. Both plots show that the collective value of stock prices expanded in three “Bull markets” (1990-2000, 2003-2007, and 2009-2015) and contracted in two “Bear markets” (2000-2003 and 2007-2009). Orange circles identify recent trends and events leading up to the writing of this post on September 11, 2015.

chart 1

chart 1

Long market cycles

A long market cycle is comprised of a bull market and bear market (ref 3).
Bull market– a period of rising prices, by 20% for at least 2 months
Bear market– a period of falling prices, by -20% for at least 2 months

Short market cycles and brief events

Short cycles and brief events are tremendously exciting interruptions of the long market cycle. They represent an extraordinary change in market behavior caused by flows of investment capital or responses to influential news.

The short market cycle is either a rally or correction. Both are brief changes in the Close that interrupt a bull or bear market.
rally– an increase in stock prices due to a burst of buying that subsides when the money is spent.
correction– a 10% price decline (ref 3).

Spikes and crashes are brief events . Both are characterized by a large, sudden shift of the index value from its previous Close.
Spike– a large upward or downward price movement (ref 3)
Crash– a 10% decline in market value lasting 1-2 days (ref 4)
Crashes are precipitated by the sellout of inflated stock prices. Chart 2 shows both a correction and a crash of the NASDAQ Composite Index during the six-month period leading into September 11, 2015. Blue squares depict the daily Close of the NASDAQ. There was a 4-week correction of –13.5% (solid black line) from July 17th to August 25th. The 12% crash (dashed red line) occurred between the Close of August 21st and the Low of August 24th (the market was closed on 2 intervening days). August 24th was “Black Monday”.

chart 2

chart 2

Circuit breakers

Circuit breakers are automatic pauses in trading that enable market participants to evaluate their trading orders in a rapidly changing environment. SEC Rule 80B defines the following halt provisions and circuit-breaker levels that impose a pause on trading (ref 5):
• the S&P 500 is the benchmark index for measuring a market decline below the prior day’s closing price
• 7%, 13%, and 20% market-decline percentages initiate trading pauses of 15 min, 15 min, and rest of the trading day.

Business cycles

Business Cycles are broad fluctuations of business activity that affect the entire economy. The total value of business production is measured by the gross domestic product (GDP). The Real GDP is “the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production, adjusted for price changes” (ref 6). The main components of GDP are personal spending, investment (e.g., the stock market), net exports, and government spending (ref 3). Swings of the GDP are produced by the net buying and selling within these business categories. An upswing signifies economic expansion and a downswing signifies economic recession. Expansion is the default mode of the economy that typically outlasts a recession and ends when overproduction leads to general economic decline. Recession (ref 3) is the decline in economic activity lasting about 6-18 months. Interest rates usually fall during a recession and stimulate the next expansion by easing the cost of borrowing money. In technical terms, a recession is 2 consecutive quarters of decline in the GDP (Chart 3).

chart 3

chart 3

While a recession occurs with every business cycle, depressions happen very infrequently. A depression is an extreme fall in economic activity lasting for a number of years. In a depression, consumer confidence and investments decrease as the economy collapses (ref 3).

Economic Recovery is the period of increasing business activity signaling the end of a recession (ref 3). Similar to a recession, an economic recovery may be unrecognizable for the first several months. The stock market may be a leading indicator of economic recovery because stocks are priced on the basis of future expectations. Unemployment often remains high in early recovery until employers determine the long-term need for hiring.

Conclusion

Market sentiment is “the overall attitude of investors toward a particular security or larger financial market” (ref 3). Investors become optimistic (“bullish”) during a bull market and pessimistic (“bearish”) during a bear market. Optimism encourages stock purchases and pessimism stimulates stock sales. Crashes generate panic and a rush to sell stocks in the declining market.

Opportunistic investors incur an upside risk and downside risk when timing the market cycle for profitable trades. The upside risk is a gain in profit by selling shares at a high price and buying them at a low price at the appropriate time. But don’t bet on it, especially not with big bets. Successful timing requires a big dose of good luck and crashes are always unpredictable. Conditional trading orders may be helpful in timing the market if a limit price is included in the order; otherwise, any unexpected market event could trigger an undesired order. The best upside risk in a bear market or economic recession is taken by buying good stocks of financially stable companies at low prices.

The famous downside risks of a recession are speculative buying and frustrated selling. Speculators, beware of the falling share prices of high-risk stocks. The worst possible outcome is to suffer a steep capital loss by repeatedly purchasing shares until the recession drives an unstable company into bankruptcy (I know from personal experience). Some frustrated investors suffer a steep loss by selling out a good stock at bottom prices, only to miss the eventual recovery of their investment earnings after the recession.

Copyright © 2014 Douglas R. Knight

References

1. Financial markets. The Great Fall of China. The Economist, page 11, Aug 29th 2015 |
2. Briefing, China and the world economy. Taking a tumble. The Economist. Pages 19-22, Aug 29th 2015.
3. Investopedia Dictionary. www . Investopedia . com / terms. © 2015, Investopedia, LLC.
4. Kimberly Amadeo. Stock Market Crash. What Not to Do in a Stock Market Crash. © 2015 About.com. http://useconomy.about.com/od/glossary/g/Market_Crash.htm
5. SECURITIES AND EXCHANGE COMMISSION. (Release No. 34-68784; File No. SR-NYSE-2013-10), January 31, 2013. https://www.sec.gov/rules/sro/nyse/2013/34-68784.pdf
6. U.S. Department of Commerce. Bureau of Economic Analysis. Gross Domestic Product. http://www.bea.gov/


Good companies attract investors

August 21, 2015

Our economy is based on the fact that good companies attract lenders and stock holders. The lenders are confident of receiving a full payback plus interest. The stockholders are confident of earning future capital gains. More stock buyers are attracted as the company grows in value and profitability. These buyers are called ‘growth’ investors.

corollary 1. If good companies fail to attract investors, the stock price will fall. Bargain hunters then wait for the stock price to approach historically low values (“fire sale”) to scoop up shares for a potentially large capital gain. The bargain hunter is a ‘value’ investor.

corollary 2. Bad companies may attract investors when stock market participants are in a euphoric mood. For example, frenzied investors bought shares of technology companies that were selling unproven products during the 2001 dot com crisis. Those investors who sold out at the right time made fortunes and those who held shares lost fortunes when the market crashed.


Frugality

August 18, 2015

No individual can avoid paying fees for investing in securities. The basic costs of investing are:

  1. brokerage fees
  2. taxes

High costs of participation will erode investment returns. Potentially high costs include:

  1. middle manager’s fees (e.g., fund managers, investment advisers)
  2. subscriptions (e.g., memberships, tool kits)

Tips for minimizing costs

  1. use a discount brokerage firm that provides accounting services (e.g., cost basis, tax reports)
  2. enroll in tax-deferred, retirement savings plans
  3. avoid middle managers.  do your own research by starting in the library and using search engines.
  4. invest in index funds designed to capture the market’s returns
  5. choose your membership subscription wisely (review the benefits; seek ratings and recommendations, etc.)  use trial subscripts first.

Where do good stocks come from? From good companies!

July 17, 2015

Good companies issue good stocks!
There’s a strong relationship between good companies and their stocks. That’s why some of the most successful investors rely almost exclusively on picking good companies for investment (ref. 1). Conversely, companies on the verge of bankruptcy are very risky investments. Some investors don’t understand this. Case in point was the declaration of bankruptcy by Lehman Brothers. After Lehman declared bankruptcy and its stock was delisted from the New York Stock Exchange, some investors continued to trade Lehman’s stock in the over-the-counter market at pennies per share; it was a big loss for them.

References
1. Growing Rich with Growth Stocks, by Kirk Kazanjian. New York Institute of Finance, Paramus, ©1999.


Investment styles

June 14, 2015

An investment style describes the way an investor earns a total return. The many possible investment styles can be characterized by the holding period (i.e., length of ownership) and method of valuation. Individual investors typically choose between the cyclic, growth, and value styles. Day traders hold stocks less than a day to earn small change from each share. This style is favored by a group of professional speculators and will not be discussed in this article.

A stock investor’s total return is an accumulation of dividends and capital gains. Dividends are the company’s occasional cash distributions to shareholders. Dividends can be withdrawn from the investor’s brokerage account, saved in the brokerage account as cash, or reinvested in stock. Capital gains (‘price appreciation’) are the increase in market value of a stock as calculated by the change in price since purchase multiplied by the number of shares owned. Conversely, capital losses (‘price depreciation’) are the decrease in market value caused by a price change. Capital gains(losses) are realized or unrealized cash flows. The realized gain(loss) produces an actual change the investor’s cash balance resulting from a sale. The unrealized gain(loss) is a theoretical change in cash balance at the moment of accounting.

Investors generally expect capital gains to exceed dividends. Capital gains are only earned by selling shares above the purchase price [this is the principle of ‘buy LOW’, ‘sell HIGH’; remember that a trading fee is charged for each transaction]. The following chart illustrates 3 strategies for earning capital gains:

styles

The “share price” (built into the Y axis) is what traders quote for one share of stock at a particular moment in time. The smooth curves show 3 different trends as the share price moves into the future (along the X axis). In reality, the share price oscillates throughout the trading day as a result of various market forces. However, the curves are drawn as smooth lines for the purpose of forecasting the share price. The future price can’t be predicted with absolute certainty. It’s always true that the further into the future, the less certain an investor can be about predicting the price. Investors can choose to manage the uncertainty in different ways as illustrated by the position and shape of the curves in the graph. The first way (red curve) is to earn a quick profit from a cyclic market. This method requires a gift for timing the market so that the investor can buy at a low price and sell at a high price in a relatively short time period of weeks to months. Second (blue curve), the investor can place a future value on the stock by forecasting the long term growth of company earnings in the belief that stock market participants will pay a higher price for the growth of earnings. If the investor’s analysis is correct, the future selling price will be higher than the present purchasing price. Third (black curve), the unit price may be ‘beaten down’ by a market panic or by other mechanisms causing market participants to lose interest in the stock. The analyst may find that the economic value of the company is worth more than the value of the stock by an amount called the ‘margin of error’. If that margin of error is 50%, then ‘value investors’ are fond of describing their stock purchase as buying a dollar for 50 cents. They will hold the stock as long as it takes for market participants to restore the stock price to the intrinsic value of the company. They are taking a risk that the stock price continues to fall as the company goes out of business.

Analysts make a distinction between the economic value of a company and the market value of that company’s stock. The cyclic investor pays more attention to market value. Growth and Value investors analyze the relationship between company and market value. They believe that over a period of years, the market value of the stock will rise with the economic value of the company. During the holding period they will accumulate any dividend payouts in their cash account or reinvest the dividends in more shares of stock. The accumulation of dividends and capital gains is called compounding the returns.

The future is uncertain. Many unexpected events can affect the share price following the initial purchase. Re-valuation of the company and its stock are essential to managing the risk of a long-term stock investment.


What is a stock?

June 12, 2015

A stock certifies an investor’s share of beneficial ownership in a company.  Beneficial owners are entitled to protection from liability for any of the company’s actions while receiving dividend payments from the company (at the pleasure of the company), voting on issues of corporate governance, and either selling their shares in the stock market or sharing proceeds from a liquidation of the company.

Each share is equally valued in proportion to the total number of outstanding shares issued by the company. Capitalists initially obtain shares in a private market known as the primary market and can chose to sell their shares to individual investors in a public market known as the secondary market. The secondary market is better known as the Stock market.

Here’s an example of an old fashioned stock certificate:

stockcertificate

Stock certificates were printed and distributed to shareholders who then assumed responsibility for safekeeping and transferring the certificate. The loss or destruction of a certificate meant the loss of an investment and stock transfers were a time-consuming, administrative process. Owners generally held their certificate for a long time in order to earn a satisfactory profit from dividends and growth of the stock’s price. Speed trading was unheard of before today’s methods of electronic bookkeeping and online trading platforms. Now, a responsible custodian maintains all records of stock ownership on behalf of the investor.  Confirmation messages and periodic statements provided by the investor’s brokerage firm serve as proof of ownership.

The reason that investors buy stock is to earn a profit by accumulating dividends and selling shares. Investors can protect their interest by voting on corporate matters such as board membership and executive compensation. In case the company files for bankruptcy, the proceeds from liquidation are theoretically distributed equally among stock holders according to the number of shares they own. In fact, the court-ordered company must first pay its debts, which means that corporate bondholders have priority over stockholders in receiving repayments of debt. Then owners of preferred stock have priority over common stock holders in receiving the residual funds.

Preferred stock is a hybrid form of bond and stock. The bond portion represents corporate debt to be repaid with guaranteed fixed-dividends and the stock portion represents an equity opportunity to earn capital gains without the privilege of voting rights.  Common stock represents an equity opportunity without guaranteed dividends but with voting rights. Preferred shareholders typically earn more dividends and common shareholders typically earn more capital gains.


Products become obsolete.

April 18, 2015

Innovation is essential to survival.  Don’t expect any company to sell its product forever.  Don’t expect the stock return to grow forever.


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