Shareholder’s Basics

Shareholder’s Basics

A company is a person in the legal sense, thus the concept of limited liability, which means that in the case of bankruptcy only the company’s assets, but not the owner’s assets, are at stake. By the same token, it also means that a shareholder cannot be held responsible for the misdeeds of a company.

Stocks are shares of a company; a company issues shares when it first goes public (IPO – Initial Public Offering). A controlling interest is usually defined as owning upwards of 50% of shares outstanding plus one. The rule is one vote per share. The voters choose a Board of Directors, who then assigns a President; the primary responsibility of the Board of Directors is to ensure the company is making money for the owners (the shareholders).

On the one hand, stock splits keep the ratio constant but increase the overall number of shares outstanding. Splitting stock is done to keep the price per share within an affordable range, approximately between 20 and 40 U.S. dollars. Microsoft Corporation has often split stock since its inception.  On the other hand, dilution occurs when stocks are given to, for instance, a CEO but not to anyone else, therefore reducing others’ ownership percentage.

Ultimately stocks are bought for their dividends, the part of retained earnings a firm pays to its shareholders on a per share basis. Occasionally, the dividends are paid in stock and not in cash. By itself, the effect is meaningless since all participants get the same amount and the ratio is unchanged. But, this practice is usually implemented in one of two cases: either the company wants to pay a cash dividend but cannot (due to limited financial resources) or, there are some breakthrough advances coming up and since the price per share is expected to go up it is purely a commemoration.

Jamaica, Montego Bay. It’s fine to seek professional help, but I urge everyone – no matter how big their portfolio – to truly understand every suggestion they’re given before acting (Suze Orman). Illustration: Megan JorgensenPhoto by Elena

All public companies are regulated by the Securities Exchange Commission (SEC) and post their files in an orderly fashion online, these can be found on Edgar. Although there are many advantages to going public, the mandatory transparency would be detrimental to some companies and so these choose to remain private. Such is the case with many hedge funds. Only accredited investors can participate in hedge funds, for the protection of small investors. Hedging is an investing strategy of playing off two alternatives against each other.

Mergers and acquisitions are an important part of corporate finance, the branch of finance, in turn a subdivision of economics, which studies the management of wealth by corporations. Merging two smaller companies makes, obviously, a large company but the process can also be reversed as in spin-offs and carve-outs. In both a merger and an acquisition, the goal is to increase shareholder value by combining the separate values of each company. An acquisition is when a company buys another; a merger is a “merger of equals” in theory, but in practice often simply a friendly, mutually agreed on acquisition.

An alternative to holding stock is investing in bonds. Bonds are long and short-term debt, governmental bonds being considered the less risky. Unstable governments and cities are an exception; they fail to be riskless since they can go bankrupt

Words to Watch on Wall Street

Words to Watch on Wall Street

Here’s your guide to the terms you need to know before you invest:

Do you know the difference between a “load” a “no-load” fund? What does it mean when a fund labels itself a “growth and income fund?” Even within the mutual funds industry, there is disagreement about what some terms mean. Definitions for different types of mutual funds, described below, are from the Investment Company Institute, the trade association for the mutual fund industry.

However, interpretations of terms, such as “aggressive growth,” may vary from fund to fund. Before picking a mutual fund, read its prospectus for a precise explanation of the fund’s strategy and investment objective. Included below are definitions of some of the other terms that you’re likely to stumble across when reading a prospectus of a mutual fund:

Aggressive growth fund: A fund that seeks maximum capital gains. Current income is not a significant factor. Some may invest in business somewhat out of the mainstream, such as fledling companies, new industries, companies fallen on hard times, or industries temporarily out of favor. Some may also use specialized investment techniques such as option writing or short-term trading.

Buck-and-Load: A sales commission charged when you sell your shares in a mutual fund. Usually ranges from 0.5 to 6.0 percent.

Balanced fund: Generally has a three-part investment objective: to conserve investors’ initial principal; to pay current income; and to promote long-term growth of both principal and income. Balanced funds mix bonds, preferred stocks, and common stocks.

Convertible securities fund: Invests primarily in debt securities that can be converted into equity securities of the issuing corporation.

Corporate bond fund: Purchases bonds of corporations for the majority of portfolio. The rest of the portfolio may be in U.S. Treasury bonds or bonds issued by a federal agency.

The Quebec Bank. Photo by Elena

Derivatives: Financial instruments with values linked to some underlying asset, such as a bond, stock, or index.

Emerging markets fund: Invests primarily in the equity securities of companies in, or doing business in, emerging countries and markets.

Energy stock fund: Invests in the energy sector, which may include companies developing new energy-efficient technologies.

Environmental securities fund: Generally invests in environment-related firms. May include companies involved in hazardous waste treatment, waste recycling, and other related areas. Such funds may or may not screen companies to determine whether they also meet specific social objectives.

Flexible portfolio fund: A fund that may be 100 percent invested in stocks, bonds or money market instruments, depending on market conditions. These funds give the money managers the greatest flexibility in anticipating or responding to economic changes.

Front-end Load: A sales commission charged when you buy your shares. Some funds charge up to 8.5 percent. Usual range: 1 to 3 percent of your investment.

Ginnie Mae or GNMA fund: Invests in mortgage securities backed by the Government National Mortgage Association (GNMA). To qualify for this category, the majority of the portfolio must always be invested in mortgage-backed securities.

Global bond fund: Invests in bonds of companies and countries worldwide.

Global equity fund: Invests in securities traded worldwide, including the United States. Compared to direct investments, global funds offer investors an easier avenue to investing abroad. Professional money managers handle trading and record-keeping details and deal with differences in currencies, languages, time zones, regulations, and business customs. In addition to another layer of diversification, global funds add another layer of risk – the exchange rate factor.

Growth and income fund: Invests mainly in the common stock of companies that have had increasing share value as well as a solid record of paying dividends, Attempts to combine long-term capital growth with a steady stream of income.

Health and biotechnology securities fund: Invests in stocks of companies in the medical industry individual funds may emphasize a limited portion of the broad health care and biotechnology field, which ranges from large pharmaceutical companies to hospitals, to start-up medical research firms.

High-yield bond fund: Maintains at least two-third of its portfolio in lower-rated corporate bonds (BAA or lower by Moody’s rating service and BBB or lower by Standard and Poor’s rating service). In return for generally higher yield, investors bear a greater degree of risk than for higher-rated bonds.

Income-bond fund: Seeks a high level of current income by investing at all times in a mix of corporate and government bonds.

Income-equity fund: Invests primarily in equity securities of companies with good dividend-paying records.

Income-mixed fund: Invests in income-producing securities, including both equities and debt instruments.

Index funds: Constructs portfolios to mirror a specific market index. They are expected to provide a rate of return that will approximate or match, but not exceed, that of the market they are mirroring. Index funds offer a number of investment choices that include various stock market indexes or indexes of international or bond portfolios.

International fund: Invests in equity securities of companies outside the United States. Two-thirds of its portfolio must be so invested at all times to be categorized as international.

Load: A fee or commission imposed by a mutual fund. Some loads are a flat percentage, others are based on the amount you invest or how long you remain in the fund. A load can be as high as 8.5 percent. Low loads run between 1 and 3 percent.

Management fee: A yearly charge for managing the fund. Ranges from 0.2 to 1.6 percent of fund assets.

Mutual fund: Pools shareholder cash to invest in a variety of securities, including stocks, bonds, and money market instruments.

NAV or net asset value: The market value of one share of a mutual fund, calculated at the close of each business day.

No load fund: Mutual fund that doesn’t charge a fee or commission to buy or sell its shares.

Redemption fee: One to two percent charge when you sell your shares. Often waived if you hold shares for given number of years.

Small company growth fund: Seeks aggressive growth of capital by investing primarily in equity securities of small companies – usually in the developing stages of their life cycle – with rapid-growth potential. Shares of such companies are often thinly traded and may be subject to more abrupt market movements than those of larger firms.

Specific social objectives fund: Screens companies for compliance with certain social or ethical criteria, in addition to using traditional measures of financial value when choosing securities for their portfolios.

Taxable money market fund: Invests in the short-term, high-grade securities sold in the money market. Generally the safest, most stable securities available, including Treasury bills, certificates of deposit of large banks and commercial paper (the short-term IOUs of large U.S. corporations.) Money market funds limit the average maturity of their portfolio to 90 days or less.

Tax-exempt money market fund: Invests in municipal securities with relatively short maturities. Investors who use them seek tax-free investments with minimum risk.

U.S. Government income fund: Invests in variety of government securities, including U.S. Treasury bonds, federally guaranteed mortgage-backed securities, and other government notes.

Utilities fund: Generally invests about two-thirds of its portfolios in securities issued by companies in the utilities industry.

Variable annuities: Insurance products, mainly used for retirement income, that offer investors some advantages of mutual funds, in addition to tax-deterred earnings.

What Is the Warren Buffett Way

What Is the Warren Buffett Way

How the world’s champion stockpicker makes his picks

Robert G. Hagstrom Jr., in his bestseller The Warren Buffett Way (John Wiley & Sons, 1994), synthesizes the formula that made Warren Buffett the world’s greatest investor. We asked Hagstrom, who manages the Focus Trust in Philadelphia, to explain how Buffett does it.

Turn off the stock market: Warren Buffett doesn’t; have a stock quote machine in his office and he seems to get by fine without it. If you plan on owing shares in an outstanding business for a number of years, what happens in the market on a day-to-day basis is inconsequential.

Don’t worry about the economy: If you find yourself discussing and debating whether the economy is poised for growth or tilting toward a recession, stop! Except for his preconceived notions that the economy inherently has an inflation bias, Buffett dedicates no time or energy to analyzing the economy.

Buy a business, not a stock: Consider first if the business is easy to understand. Then determine if the business has a consistent operation history and favorable long-term prospects. What about its management? Is it rational, candid with shareholders, and able to avoid the herd mentality? Look at the financials, focusing on return, on equity, not earnings per share. Buffett seeks out companies that generate cash in excess of their needs and companies with high profit margins, which reflect not only a strong business but a management with a tenacious spirit for controlling costs. Other financials to look at: retained earnings, estimated cash flows, and the value of a business. Once you have determined the value of a business, the next step is to look at the stock price. Buffett’s rule is to buy the business only when the stock price is at a significant discount to its value. Note that only at this final step does Buffett look at the stock market price.

Manage a portfolio of businesses. Buffett does not believe that wide diversification is required, so long as you understand business economics and can find 5 to 10 sensible priced companies that have long-term competitive potential. In Buffett’s mind, it is too difficult to make hundreds of smart decisions in a lifetime. He would rather position his portfolio so he only has to make a few smart decisions.

Can you buy a building investing in a good stock? Photo by Elena

As January Goes, so Goes the Year

As January Goes, so Goes the Year

This indicator is almost always right. Here’s why:

Yale Hirsch’s theory about the stock market is simple enough. If the Standard & Poor’s composite index is up in the month of January, the market average for the rest of the year also will be up. And if the S&P index is down in January, it also will be down over the rest of the year. Since 1950, the indicator has predicted the annual course of the market with astonishing accuracy. According to Hirsch, a publisher of financial newsletters, his indicator has been right 49 of 54 years, or 89 percent of the time.

There’s no great mystery, Hirsch believes, about why January is such an accurate barometer of the year. In fact, January is the month that many major economic and national policy decisions are announced by the government to kick off the new year. Congress convenes on January 3 and, every four years, a president is inaugurated less than three weeks later. More often than not, the president delivers his State of the Union message before the end of the month, laying out the year’s national goals. And the government budget also is released early in the year. “Switch these releases to any other month and chances are the January barometer would become a memory,” Hirsch says.

Here are some of Hirsch’s conclusions after studying a lot of Januarys:

• The top 23 Januarys launched the best marked years, had gains of 1 percent.
• Twenty Januarys were losers or had very small gains. All bear markets were preceded or accompanied by downbeat Januarys. Only one good year, 1992, followed a January loss.
• There were only three major errors in 54 years. They were in 1996, 1968, and 1982. Hirsch can account for the first two, citing the Vietnam War. He doesn’t have an explanation for 1982.

What can we expect in the next years? Nobody knows. There has not been a losing pre-election year for the stock market in almost a century. New presidents generally get rid of the tough jobs in the first year or two, then pull out all the stops to make things look good for the election. This has been going on for at least 170 years. We can see prosperous times and bull markets ahead one of those years, but who knows, we can always see slow years to come. One year can be very good and the next one just the reverse. Anyway, in 9 of every ten years, gains logged in January on the Standard & Poor’s 500 stock index roughly telegraphed a good year ahead.

A street in New York. Photo by Elena

A Get-Rich Slowly Scheme

A Get-Rich Slowly Scheme

Consider the case of Louie the Loser: stocks made him a winner

Buy low, sell high, it’s a dream of all investors hoping to strike gold in the stock market. The strategy sounds simple enough, but, as most investors know timing the market is elusive at best. Now it turns out timing may not matter much after all. Analysts at Capital Research and Management Co, a mutual fund company, created Louis the Loser, an investor with the world’s worst timing. Every year for twenty years Louie pumped five thousand dollars into Investment Co of America, an actual fund managed by Capital Research. Each year Louie invested at the worst possible time – the day that the Dow Jones average hit its peak for the year.

How did Louie fare? He was hardly a loser. After twenty years, Louie’s $100,000 grew to $441,000 – a respectable average annual return of 13.3 percent. By comparison, if a Willie the Winner had invested $5,000 a year on the day the market hit its annual low, he would have shown 14/9 percent return, only slightly better than Louie’s. Small wonder that shrewd investors, like Warren Buffett, advise ignoring the day-to-day gyrations of the market, preferring a simple buy-and-hold strategy for stock investing.

When devising your overall investment strategy, the best approach is to allocate your money among different investments, based on factors like your age, income and when you’ll need the money. To manage the risk of stock market ups and downs, a basic buy-and-hold strategy known as dollar cost averaging can help. By investing a set dollar amount regularly, say $200 once a month, you get more shares when stock prices are low and fewer when prices are high. Over time, the strategy reduces your average cost per share, improving your chances of becoming a slow but steady winner.

New York. Photo by Elena

History shows that stocks are sturdy. Measure stocks against bonds, cash in houses, oil, gold, or in collectables like stamps and diamonds, for example, is considered smart during times of high inflation, which can hurt stocks and bonds. But not over the long haul. After tracking the returns of different assets, R.S. Salomon Jr, founder of the Stamford, Conn. Investment management firm STI Management, found that returns on tangible assets fluctuate wildly from year to year. Silver may be hot one year, farmland the next. But in the long run, financial assets – bonds, stocks, even plain old cash – beat out collectibles and hard assets. This exercise proves that how you allocate your portfolio among broad categories is important, probably more so than which stocks or bond or hard assets you buy.

What happens if you pit stocks against cash over the long term? Again, stocks are tops. A cash investment is money invested in three-month Treasuries or a first-rate money market fund, not the emergency reserve you keep on hand for a rainy day. Looking back 50 years, cash has beat out stocks only 10 times, according to Ibbotson Associates. One of those rare periods was between August 1983 and the end of 1984, when the returns of the 30-day Treasury bill outperformed the Standard & Poor 500 stock index by three percentage points and the 20-year Treasury bond by 15 percentage points. Usually, though, periods when cash is king have not lasted longer than 24 months. Over the long term, cash has been a loser. After accounting for inflation, cash has returned an average 0.5 percent per year since 1926, compared with 6.9 percent after inflation for the S&P 500, according to Ibbotson.

How about stocks versus bonds? You could compare returns of small company stocks, large company stocks, long-term government bonds, U.S. Treasury bills and inflation going back to 1926. Assume you invested $1 in each of the four instruments at the end of 1925.

Through wars, depressions, bouts of high inflation and recessions, oil embargoes and market crashes, that dollar would have grown most if you had invested in small-company stocks. It would have ballooned to about $5,000 by now. By comparison, a $1 investment in ultra-safe Treasury bills would have returned a mere $20 (these number assume income from the investments is reinvested and do not consider commission costs or taxes).

Together, returns on large and small company stocks averaged 11.3 a year. Long-term Treasury bonds did less well, yielding an average 5.02 percent. Bond yields generally don’t match stock returns in the long race, but then again, bond investors experience fewer hairpin turns than stock market riders.

Is the past prologue to the future? Many investment analysts seem to think so. Some investors steer clear of consumer stocks and move toward bank and other financial stocks. Some other like economically-sensitive stocks such as airlines, railroads, paper companies, electronic manufacturers, and other technology stocks. We can strike a cautious note, however: Stocks and bonds are sometimes overreacting, and odds are they will underperform in the future. If so, the Louies and Willies may have to muster a bit more patience