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Investing in securities

What is a stock

Most investors buy a stock with the idea of selling it for a profit at a later date (or, in the case of day traders, in a few hours). The result is that common stock prices rise and fall primarily on investor confidence about future stock prices.

 A share of common stock represents partial ownership of a corporation (usually a very, very small part). You can calculate the percentage of the company you own by dividing your number of shares by the total number of shares of common stock issued by the company.


As a Stock holder (owner), you are entitled to:  All the rights of ownership.  You share in the profit as well as vote your number of shares on all issues that the Board of Directors presents to the owners as well as the directors themselves( assuming that you own voting stock, most share are). You are also entitled to receive any dividends declared by the Board of Directors.   During the 90's  the role of dividends has been minimized by investors in search of capital gains, and dividend payout is currently at the lowest  rate of the twentieth century.  According to Dow Jones & Company web site dowjones  historically dividends have accounted for 40% of the total return on securities. 

You are entitled to receive a portion of the remaining assets if the company goes out of business. This sounds good in theory, but,  all bondholders and preferred stockholders are stand ahead of you in line to receive their share first.  Consider the fact that if a company is going out of business they are probably bankrupt, so there is not much left for the stockholders.

There are other kinds of stock other than common; preferred, convertible, restricted, but who cares!  The important thing to remember is that you are buying into a company not just swapping paper.  Buy companies that you are comfortable with, are willing to hold for a long period, and not stay awake nights worrying about your investments.

How you make money owning stock

You can make money two ways: an investor may receive dividends and or profit from an increase in the stocks price.

A dividend is a payout to the investor a share of the corporations profit.  Some companies and industries have a high dividend payout, utilities and tobacco companies to name two.  Some companies do not pay dividends but use all of its profits to reinvest and grow the company, or use a share of the profits to repurchase its own stock.  By repurchasing its own stock a company is making its remaining publicly traded stock more valuable and increasing the percentage of ownership of the company among its stockholders.  Dividends are taxed at your normal marginal rate.

Share price growth is a capital gain.  If a company is seen by investors as having an a bright future they will bid the price up.  Stock prices follow over time the investors perception of the companies long term earning prospects.  Stock prices are not fixed and fluctuates according to the laws of supply and demand.  If you hold a stock longer than six months and you sell at a profit, you will receive favorable capital gains treatment.  Long term capital gains are taxed at a very favorable rate.


Investment approaches to researching a stock

  • Fundamentals - 
    •  Fundamental investors are often called value investors.  They are concerned with finding and identifying value.  Stocks with good prospects that they believe, for some reason, is selling below its true value usually defined as a low P/E ratio.  Value investors hope that sometime in the future the market will recognize this and bid the stock up to its full value.  Fundamental investors consider what does the company do and how well does it do it relative to the other companies in its industry.  Is it in an industry with great prospects, or a commodity business steady but dependent on the economy with little chance of innovation or greatness.  What are the companies financials, free cash flow, and its ability to spend on growth and research.  What about the current economy its future and how it will impact the companies prospects.  Value investors believe in buying low and selling higher.
      • This is the older more established  investment approach.  One interesting observation is that price movement occurs more from expectations and analysis reports than from actual earnings reports.
      • The classic work in fundamental analysis is the Intelligent Investor by Benjamin Graham

       

  • Technical Analysis -
    • Technicians are more concerned with price history and price fluctuations, relative strength, support and resistance, relative price earnings, and volume than they are with current price and price earnings ratios relative to the market.  Technicians are often active traders more interested in proper timing of an investment than in the value of the investment itself.  Many technicians use a chart i.e. a picture of price volume patterns of stock and market performance and try to predict future movement from the past.  This is often criticized as voodoo or a non-scientific procedure.  I have found technical analysis very useful in helping to select entry and exit points.  Chart reading is also a useful way to screen a large list of stocks to help identify interesting stock patterns to further time consuming fundamental research. This kind of information can be gathered from any number of chart books or internet sites such as Daily Graphs, TC2000 and Big Charts.  Technical investors believe in buying high and selling higher. This is because one of the most common techniques they use is to buy a stock as it is making a new market high, believing that since everyone who owns the stock is now making a profit and is less welling to sell it.
      • The Classic work in technical analysis is titled Technical Analysis of Stock Trends by Edwards and McGee.

    These investment styles need not be mutually exclusive. Flipping through a chart book or scanning charts or searching data basis for selected criteria can allow you to review a great many stocks in a short period of time.  You can select a small handful to then do further in depth analysis to identify the investment that best meets your needs.

    Link to a good web address to learn the basics of investing learn about investing Step by Step.

    The greatest asset an investor can possess is the ability to know the difference between an investments price and value.  

What is a bond

Bonds have been and will remain disappointing investments.  Barron's Allen Ableson once remarked "What distinguishes bonds from all other investments is that they are a fool proof hedge against capital gains."

Bonds represent corporate or institutional (government) debt.  They are essentially IOU's . Companies can raise needed capital by selling stock ( shares of ownership) but also by selling IOU's.  Long term IOU's are called bonds short term IOU's are called paper , notes. The issuing party promises to repay these instruments, with interest, by a certain time. Bonds are seen as less risky than stocks because they pay interest and at a pre determined date promise to return the face value of a bond.  Less risk for investors does not mean no risk the possibility that an issuing company will be unable to meet its payments to bondholders always exists. To assist investors in assessing the risk of default or not being paid back several independent agencies list debt ratings for various companies and their bonds.  The lower the rating, the riskier the bond and the riskier the bond, the higher the yield tends to be to investors.

Bond yield can be stated as current yield or yield to maturity.

Current yield - This is the yield you will see in the newspaper.  This is the dividend rate adjusted for the current price of the bond.

Yield to maturity - factors in the gain or loss you will receive when the bond matures and you are paid the face value of the bond adjusted for the amount of time remaining on the bond.

The value of bonds is largely dependent upon the market level of interest rates.  As interest rates rise the face value of the bonds fall.  This is necessary in order to increase the relative bond yield to competitive market levels.  If interest rates, fall the face value of the bonds rises as the income stream the bond represents becomes more valuable.  There are pocket calculators that readily adjust price and yield of a bond under different scenarios.  My personal favorite is the Hewlett Packard model 12C. 

Bonds are usually issued for periods of ten to forty years.  In general the longer the term of the bond the higher the interest rate should be to reward the holder for the increased time risk.   Risk is measured by commercial rating services that issue a risk rating of AAA which is the highest rating issued to the most credit worthy borrowers.  The lowest rated borrowers are given a D.  these companies are in default on their financial obligations and/or in bankruptcy with debt service in jeopardy.

Investors should avoid bonds where the issuer has the right to call the bonds on a basis favorable to the issuer.  This stacks the deck in the favor of the issuer and deprives the investor of possible market rate gains associated with the risk they have taken..  The investor commits for a twenty to forty year period and accepts the risks (company and market) and  if the market turns in the investors favor the investor the issuer simply buys the bonds back at a small premium.  Bonds with an unattractive call feature sell at virtually the same yield as bonds that do not have this feature.


Investors can also invest in bond mutual funds and receive professional management and diversification.

What is a mutual fund

Mutual funds are pools of money that are invested is the various markets. the Funds are professionally managed by a portfolio manager or a management team.  Purchasing shares of a mutual fund can be an excellent savings vehicle for beginning investors.  Many funds allow you to invest with as little as fifty dollars with a automatic investment plan.  Mutual funds are traded much like stocks and closed-end funds are even traded on the major exchanges.  Mutual funds can be good for the beginning investor because they can provide instant diversification among many stocks and industries that the beginning investor may not be able to afford.  There are additional expenses associated with funds, load, fees, and often commissions on top of the fees.  Because there are more funds than stocks on the New York Exchange, there is a lot of different types with various investment goals i.e. growth, income, International, bond, and even real estate funds some even further divided between mortgage participation, and asset participation.  I am not overly enthusiastic about mutual funds comprising the majority of an experienced and knowledgeable investor, because I do not like to turn my investment decisions over to others.  This is not to say that I do not invest in funds.  I find them very useful for diversification.  I also find funds especially useful to invest in industry specific funds where I can invest in say for example bio-technology or the communication industry, and let the managers who follow the industry make the specific stock purchases while I trade the industry.  Remember that one of the most important strategic decisions investors need to make is to be in the right industry at the right time, and with funds I can diversify the company specific risk from the industry risk for a small  fee to the fund.

Following mutual fund purchases and sales is a useful source of information to gain insight as to where professional fund managers (the smart money) are placing their money.  What industries and specific companies are the successful managers buying and selling.  The funds are now so large that their purchases and sales can have major impact on individual stocks and markets in general.  Much information can be gained from financial newspapers and from popular web sites such as Morningstar and Microsoft Investor.

The following table gives an average return for the major averages for the past seventy years

Asset Average Return (Arithmetic)

Large company stocks

13.2%
Small company stocks 17.4
Long-term corporate bonds   6.1
Long-term government bonds   5.7
U.S. Treasury bills   3.8
Inflation   3.2

The most important advice I can give an investor here is: Think for yourself.  Learn, research and invest .  Do not let anyone sell you something, learn to make your own decisions.  Set realistic goals. Get started NOW. 

 

 Reading List:

    How to Make Money in Stocks - William J. O'Neil

    Intelligent Investor - Benjamin Graham

 

 

 

 
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