Investing 101

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2009-02-16T09:01:00.001-05:00

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Tax free Spin Offs

2009-02-03T16:04:00.000-05:00

When a company is restructuring its operations, it often announces that it wants to exit certain businesses. Sometimes these lines aren’t complimentary to the core mission of the enterprise. Other times, there may be risks inherent in the subsidiary that don’t fit within the risk profile of the parent company. In any event, there are typically two ways to unload a business:

1. Sell it outright and use the cash to pay down debt, buy back stock, or make acquisitions. This includes selling out to other enterprises of sponsoring an initial public offering.

2. Declare a tax free spin off to existing shareholders.The first option may sound the simplest as the transaction is fairly straightforward.

General Electric, for example, recently divested its reinsurance operations through this method by selling them to another corporation in exchange for cash. Typically, however, managements do not like selling a business because it may be forced to pay capital gains taxes. For businesses that have been owned for decades, this tax bite can be huge.That often leads the Board of Directors to consider a tax free spin off. A new company will be created with its own CEO, management team, ticker symbol, financial statements, and facilities. Typically, this can be completed in one of two ways:

1. A Pro-Rate Distribution: Under this scheme, shares of the new company are sent to shareholders proportional to their existing ownership of the parent company (i.e., if an insurance company owned 10% of the parent, it would receive 10% of the spin off).

2. An Exchange Offer: Shareholders are given the choice to give up their existing shares of the parent company in exchange for shares of the new spin off.Value Added Through a Tax Free

Spin Off In many cases, a company that has been spun off and is now independent is more valuable than the same enterprise as part of a conglomerate. This is due to the different economics of the business – things such as return on equity, return on assets, and debt levels. This will also reflect the level of potential future growth; a tiny enterprise with much promise is going to be valued more on its own because investors can directly profit from the action.Consider Coach, a maker of luxury handbags. Originally a division of Sara Lee, Coach was spun off several years ago through an exchange offer made to existing SLE shareholders. Since that time, the stock has appreciated more than 1,000% and now has a market capitalization nearly the same size as its former parent company! Why? Management was able to focus on what was best for Coach – not a parent company that may need excess earnings for debt payments rather than expansion, for example.

How a Tax Free Spin Off Can Make Return Calculations Deceptive Imagine if you had invested $10,000 in Goodrich in January, 2002. Your investment would have purchased approximately 360 shares at an average cost of $27.82. Looking at today’s stock price of $39.50, a stock chart would show that your position was now worth a little over $14,000. A nice gain, to be sure, but it certainly doesn’t show the whole picture because during your holding period, you would have received roughly $1,621 in cash dividends plus 72 shares of EnPro as part of a tax free spin off (today worth $2,022).

In other words, you would have roughly $17,863 from your position – not $14,000 as it would appear at first glance. On an original cost basis of $10,000, that is nearly 40 percent that simply wasn’t on the radar screen.Identifying Tax Free Spin Off OpportunitiesThere is some empirical evidence that suggests that pure spin offs – those that are distributed pro rata to existing stockholders with little fanfare – offer the best opportunity for long term profit.

Think of Your Stocks Like Real Estate

2009-01-28T11:45:00.003-05:00

This past week, I was considering buying a home near my parents so that when I was back in area, I would have a place from which to work and live. With the real estate market falling to 2004 prices, on average, it seemed a good time to buy (value investing is not limited to stocks – it’s a business philosophy). Anyway, I made an opening offer roughly 10.6% below the list price, which was more than reasonable given the current economic environment, the fact that I don’t need a property per se, and my outlook for real estate values over the next five to ten years.

The owners of the property came back with their counteroffer, but refused to budge much. They had in mind a price that they thought appropriate for the property based upon their own analysis of the comparable sales in the neighborhood. They determined that based upon their own financial needs that they couldn’t afford to sell their asset for the price the market was currently indicating it was worth; indeed, they demanded the same appreciation that had been the rule for the past twenty years, not recognizing the new reality. That’s fine. That’s what I’ve been trying to teach you with the thousands of articles that have been published. Although I trust my own analysis (this is what I do for a living – valuing assets, buying them at attractive levels, and generating profit on those capital commitments), they had arrived at their own estimate of replacement value for the property. They will now either have to continue holding the real estate, wait for an offer that they think is more inline with their estimate of value, or be forced into a sale if they can’t hold out until the market recovers.

Now, here’s where most people make huge errors that cost them years, even decades, of wealth building effort. If they had owned a basket of stocks – say, shares of Wal-Mart, General Electric, Johnson & Johnson, and U.S. Bancorp – and they had experienced a drop of 10% or 20%, let alone the 50% drubbing many equities have taken over the past year, it’s unlikely that these same people would apply a rational disposition to their portfolio like they did their house. They wouldn’t research the valuation of comparable businesses to each of those they owned, estimate what they think their share of those businesses was, and then refuse to sell (or better yet, buy more while it was cheap) until it reflected a conservative estimate of intrinsic value.

Instead, it’s likely that they would be more likely to sell the further prices fell because they trusted their neighbor’s estimate of what their property is worth instead of their own, cold, dispassionate calculation. I wrote you a few weeks ago and told you that if you were selling your 401(k) assets, people like me were out there buying them in the midst of all the fear. In a few years, you would wonder why we had gotten substantially richer.

The bottom line: You must assess all of the assets in your life based on their estimated intrinsic value. There’s nothing more irrational than saying, “My accounts are down $10,000 or $100,000 or $500,000! What do I do?” If you are invested in a broad-based, low-cost index fund, falling prices are good for you in the long run. That’s because the dividend yield on your portfolio will increase, allowing you to purchase more shares with your reinvested earnings. Your regular contributions will also purchase more shares. This is the secret to building equity, which is the surefire way to building wealth.

Before You Open a Brokerage Account

2009-01-24T10:03:00.000-05:00

Before you can begin investing, you must open a brokerage account (for those of you who don't know what this is, read the article "What is a Broker" in the Beginner's Corner). As an investor, choosing a broker is one of the most important decisions you'll have to make. Here are five things you want to look for before you open an account.

1. Full Service Broker vs. Discount Broker

There are two different types of brokers; traditional (also known as "full service") and discount. If you open decide to open an account with a traditional brokerage firm, you will work one-on-one with a personal stock broker. He or she will offer investment ideas, prepare reports about your portfolio, give you a run-down of how well your investments are doing, and generally be available with a single phone call or email to buy or sell stocks, bonds, mutual funds, or other investments for your account. In addition, traditional brokers offer a variety of different research sources to their customers. In exchange for this one-on-one service and guidance, you will be charged a significantly higher commission (we talk more about the price consideration below.) A few examples of this type of brokerage firm are A.G. Edwards, Morgan Stanley Dean Witter, and Merrill Lynch. (*Note: Merrill Lynch now offers both full service and discount brokerage accounts to customers.)

Discount brokers, on the other hand, are geared toward the do-it-yourself investor. Generally, they will not offer investment advice. They will simply execute orders once you've decided to buy or sell an investment. Instead of working with the same stock broker, you will do most of your trading online, or if you decide to call in your order, with the first available broker. Recently, discount firms have been offering research that is on par with those offered at the traditional brokerage firms. Some excellent examples of these types of brokers are E-Trade, Ameritrade, and TD Waterhouse, to name a few. In exchange for giving up personal contact with a regular broker, investors will be charged a significantly lower commission.

Commissions

Although the largest difference in between traditional and discount brokers is the cost of each transaction, differences in commission prices between two firms of the same kind can be tremendous. One discount broker may charge $30 per trade, whereas another may charge no more than $8. In some cases, the higher price means higher service, faster execution (i.e., your buy and sell orders are carried out in a shorter period of time), and more perks, but this is not always the case. That is why it is important to look around and compare brokerage firms before you open an account.

Minimum Opening Balance and Maintenance Fees

Each broker has a minimum opening balance requirement. Some are as low as $500, most are around $1,000, and several are higher. The general rule of thumb is you should have at least $1,000 when you go to open an account. Be careful though; some brokerage firms may have a low opening balance but will charge you a maintenance fee if your balance falls below a certain amount. Although the fee may be as little as five to fifteen dollars per quarter, it can significantly eat up your investment returns if you are just starting out (e.g., $60 per year in fees on $1,000 account balance is equal to 6% interest!)

Services, Perks, Research, and Investment Tools

No broker offers the exact same set of tools, research, and perks to their customers. Some will allow you to instantly log in to your account via the Internet and print out an analysis of your portfolio, view the balance of your account for the past six months, check your realized and unrealized gains, and view dividend records for the past few years. Others may be slim on features such as this, but offer amazing research that you can't get elsewhere. If execution time is important to you, check out the firm's policies. One online discount broker promises to execute your trade in 60 seconds or less, or you will not be charged a commission.
Lately, a lot of brokerages have begun offering Visa Check Cards which work exactly like a credit card. The difference is, the money you spend is taken directly out of your brokerage account. This way, you have the combined functionality of a checking / savings / money market account with a stocks / bonds investment account. It is tremendously convenient and can help simplify your finances. If you are looking for an all-in-one solution, an asset management account may be a more attractive alternative.

Online Availability - Interface and Ease Of Use

Before you open an account, you should fire up your favorite Internet browser and visit the web page of each of the brokerage firms you are considering. If you plan on doing a lot of your research or trading online, the feel of the site is going to be almost as important as the other benefits and services offered.

Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations

2009-01-21T13:02:00.001-05:00

Readers of this site know that I’m an unabashed, dyed-in-the-wool value investor. Yet, a mistake many people tend to make is to associate this with only buying low price-to-earnings ratio stocks. While this approach has certainly generated above-average returns over long-periods of time (see Tweedy, Browne & Company’s publication What Has Worked in Investing), it is not the ideal situation.

Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations

At its core, the basic definition for the intrinsic value of every asset in the world is simple: It is all of the cash flows that will be generated by that asset discounted back to the present moment at an appropriate rate that factors in opportunity cost (typically measured against the risk-free U.S. Treasury) and inflation. Figuring out how to apply that to individual stocks can be extremely difficult depending upon the nature and economics of the particular business. As Benjamin Graham, the father of the security analysis industry, entreated his disciples, however, one need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. By focusing only on those opportunities that are clearly and squarely in your circle of competence and you know to be better than average, you have a much higher likelihood of experiences good, if not great, results over long periods of time.

All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollar or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price to earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment. This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit, or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere or spend on diamonds, houses, planes, charitable donations, or gold-plated fine china.

In other words, it doesn’t matter what the reported net income is, but rather, how many hamburgers the owner can buy relative to his investment in the business. That’s why capital-intensive enterprises are typically anathema to long-term investors as they realize very little of their reported income will translate into tangible, liquid wealth because of a very, very important basic truth: Over the long-term, the rise in an investor’s net worth is limited to the return on equity generated by the underlying company. Anything else, such as relying on a bull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative. I don’t know about you, but I don’t want to be in doubt about my ability to retire comfortably.

The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings”. Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same value.

The Importance of a Margin of Safety

The danger with this approach is that, if taken too far as human psychology is apt to do, is that any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15x earnings for a company, you need to seriously examine the underlying assumptions you have for its future profitable and intrinsic value. With that said, a wholesale rejection of shares over that price is not wise. A year ago, I remember reading a story detailing that in the 1990’s, the cheapest stock in retrospect was Dell Computers at 50x earnings. That’s right – had you bought it at that price, you would have absolutely crushed nearly every other investment because the underlying profits really did live up to Wall Street’s expectations, and then some! However, would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry, the future drivers of demand, the commodity nature of the PC and the low-cost structure that gives Dell a superior advantage over competitors, and the distinct possibility that one fatal mistake could wipeout a huge portion of your net worth? Probably not.

The Ideal Compromise

The perfect situation is when you get an excellent business that generates copious amounts of cash with little or no capital investment on the part of the owners relative to the profits at a steep discount to intrinsic value, such as American Express during the Salad Oil scandal or Wells Fargo when it traded at 5x earnings during the real estate crash of the late 1980’s and early 1990’s. A nice test you can use is to close your eyes and try to imagine what a business will look like in ten years; do you think it will be bigger and more profitable? What about the profits – how will they be generated? What are the threats to the competitive landscape? An example that might help: Do you think Blockbuster will still be the dominant video rental franchise? Personally, it is my belief that the model of delivering plastic disks is entirely antiquated and as broadband becomes faster and faster, the content will eventually be streamed, rented, or purchased directly from the studios without any need for a middle man at all, allowing the creators of content to keep the entire capital. That would certainly cause me to require a much larger margin of safety before buying into an enterprise that faces such a very real technological obsolesce problem.

10 reasons to invest in gold coins

2009-01-14T15:17:00.001-05:00

There are many reasons today in this global economy to invest in Gold. I’m not just talking gold stocks but actual physical gold coins, jewelry, ingots, & gold stocks. Since ancient times gold coins have been a accepted and valid form of currency. Gold in time will always increase in value due to devaluation of paper money. So a good way to improve your portfolio is to invest inn new and old gold coins. You can purchase them from pawn shops to online market places including EBay. Thus by keeping coins or gold investments with in your portfolio you can be assured that the value of your portfolio will increase over time. Look at the top Ten reasons to invest in gold today

Here is a list of the top 10 reasons to invest in gold coins:

1. Gold coins are a liquid investment. You can sell the metal to anyone and receive cash for it.

2. You are almost guaranteed a profit from having gold investments. The investment of gold coins increases in value. In February of 2004 gold was going for 400 an ounce. Just four short years later its trading in the 800-1000 dollar range per ounce. If your investment is in coins over time coins become scarce so investment will always increase.

3. There is a small comfort level in having coins or bullion in you portfolio. You can rest assured even if the economy is tough, you have a safer investment.

4. Certified gold coins, have limited mintages, governments only release small quantities of coins at one time to help increase the value of each individual coin

5. Coins are easily transportable either in a small bag or if selling them you are able to ship them worldwide for a lower cost.

6. Gold coins are simply stunning to look at. The greatest design is considered that of Augustus St. Gaudens who was commissioned by the American Mint to design the famous Double Eagle Coin from 1905-1907. In my opinion all the American coins are stunning, look for Indian Heads, Quarter Eagles; Eagles, and Double Eagles, coins are always a great investment.

7. Certified gold coins cannot be confiscated by any government agency just based on the premise that it needs them. “Should something like madoff happen they probably will take them away pending legal issues.”

8. Gold is also a legal asset to own where regular money is owned by the government and gold is the last legal asset to own in the world.

9. Gold coins are easily obtained easy to purchase and easy to sell. There are many places online and in your local markets to purchase and trade them.

10. Gold coins are fun to collect, so collect them first and foremost for the enjoyment.

2009-01-09T16:25:00.001-05:00

There are three categories of financial capital that are important for you to know when analyzing your business or a potential investment. They each have their own benefits and characteristics.
Equity Capital

Otherwise known as “net worth” or “book value”, this figure represents assets minus liabilities. There are some businesses that are funded entirely with equity capital (cash written by the shareholders or owners into the company that have no offsetting liabilities.) Although it is the favored form for most people because you cannot go bankrupt, it can be extraordinarily expensive and require massive amounts of work to grow your enterprise. Microsoft is an example of such an operation because it generates high enough returns to justify a pure equity capital structure.

Debt Capital

This type of capital is infused into a business with the understanding that it must be paid back at a predetermined future date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agree to accept interest in exchange for you using their money. Think of interest expense as the cost of “renting” the capital to expand your business; it is often known as the cost of capital. For many young businesses, debt can be the easiest way to expand because it is relatively easy to access and is understood by the average American worker thanks to widespread home ownership and the community-based nature of banks. The profits for the owners is the difference between the return on capital and the cost of capital; for example, if you borrow $100,000 and pay 10% interest yet earn 15% after taxes, the profit of 5%, or $5,000, would not have existed without the debt capital infused into the business.
Specialty Capital

This is the gold standard. There are a few sources of capital that have almost no economic cost and can take the limits off of growth. They include things such as a negative cash conversion cycle (vendor financing), insurance float, etc.

· Negative Cash Conversion (Vendor Financing) Imagine you own a retail store. To expand your business, you need $1 million in capital to open a new location. Most of this is the result of needing to go out, buy your inventory, and stock your shelves with merchandise. You wait and hope that one day customers come in and pay you. In the meantime, you have capital (either debt or equity capital) tied up in the business in the form of inventory.

Now, imagine if you could get your customers to pay you before you had to pay for your merchandise. This would allow you to carry far more merchandise than your capitalization structure would otherwise allow. AutoZone is a great example; it has convinced its vendors to put their products on its shelves and retain ownership until the moment that a customer walks up to the front of one of AutoZone’s stores and pays for the goods. At that precise second, the vendor sells it to AutoZone which in turn sells it to the customer.

This allows them to expand far more rapidly and return more money to the owners of the business in the form of share repurchases (cash dividends would also be an option) because they don’t have to tie up hundreds of millions of dollars in inventory. In the meantime, the increased cash in the business as a result of more favorable vendor terms and / or getting your customers to pay you sooner allows you to generate more income than your equity or debt alone would permit. Typically, vendor financing can be measured in part by looking at the percentage of inventories to accounts payable (the higher the percentage, the better), and analyzing the cash conversion cycle; the more days “negative”, the better. Dell Computer was famous for its nearly two or three week negative cash conversion cycle which allowed it to grow from a college dorm room to the largest computer company in the world with little or no debt in less than a single generation.

· FloatInsurance companies that collect money and can generate income by investing the funds before paying it them out in the future in the form of policyholder payouts when a car is damaged, or replacing a home when destroyed in a tornado, are in a very good place. As Buffett describes it, float is money that a company holds but does not own. It has all of the benefits of debt but none of the drawbacks; the most important consideration is the cost of capital – that is, how much money it costs the owners of a business to generate float. In exceptional cases, the cost can actually be negative; that is, you are paid to invest other people’s money plus you get to keep the income from the investments. Other businesses can develop forms of float but it can be very difficult.

Sweat Equity

There is also a form of capital known as sweat equity which is when an owner bootstraps operations by putting in long hours at a low rate of pay per hour making up for the lack of capital necessary to hire sufficient employees to do the job well and let them work an ordinarily forty hour workweek. Although it is largely intangible and does not count as financial capital, it can be estimated as the cost of payroll saved as a result of excess hours worked by the owners. The hope is that the business will grow fast enough to compensate the owner for the low-pay, long-hour sweat equity infused into the enterprise.

Are You Gambling or Investing?

2009-01-05T16:47:00.001-05:00

Mention the stock market or investments and some families or organizations will react with loathing and disgust, likely drawing parallels between a trip to Vegas and a call to a broker. A good deal of this is due to the cultural aftermath of the Great Depression and the simultaneous drop in the financial markets as a result from the excess of the 1920’s. Yet, the primary reason for this attitude is a complete lack of understanding regarding accounting, finance, economics, and basic compounding. Yet, this attitude isn’t entirely irrational. Gasoline, for example, can be extraordinarily helpful if you are trying to power a tractor that will provide food to thousands of people. But in the hands of rash, uninformed people, you could end up with horrific physical damage and even the loss of life. Without an understanding of what exactly a stock is, outside of an indexing strategy, the market can be a very dangerous place. (For information on what stocks are and how they are created.

How do you know if you are gambling or investing? Here are a few simple tests to give you a clue.

1. Do you have a clear reason for investing in a particular stock or security, or are you just going on your “gut”?

In every case, you should be able to write out a short, simple explanation that makes sense to the average high school student as to why you are purchasing a specific investment. It should lay bare your expectations and they should be reasonable.

Here’s an example. Say you were interested in acquiring shares of U.S. Bank for your IRA. You might write something like this, “As of the market close on Sunday, July 1, 2007, the stock traded at $32.95 per share, or a price-to-earnings ratio of 12.66 as a result of $2.60 earnings per share. Taking 1 divided by the p/e ratio of 12.66, we get .0789, or 7.89%. This figure is known as the earnings yield. When compared to the long-term yield on the risk-free U.S. Treasury bonds of 5.22%, this amounts to a 2.67% higher rate for the stock. This is supposed to compensate me for inflation and the risk of investing in a stock. In and of itself, this is insufficient. However, management has vowed to return 80% of earnings to shareholders each year and expects to maintain growth in earnings per share of 10%. In other words, I am buying an ‘equity bond’, to borrow a phrase from Warren Buffett, that currently yield 7.89%, which will grow earnings per share of no more than 10% for the next few years (and probably top out at 3% thereafter.) In the meantime, the 4.8% dividend yield can be used to acquire more shares and, because they are held in an IRA, will not have taxes assessed against them. Compared to the S&P 500, this appears to offer an attractive value. I’m not particularly concerned about competition as the bank has an enormous base of branches throughout communities in the Midwest and beyond. With metrics that are typically the highest in the big banking field – return on assets, return on equity, and a stellar efficiency ratio – it appears management is clearly doing right by owners. It’s unlikely I’ll have a lollapalooza bonanza on an investment like this, but it does offer a conservative way to compound my capital in a manner that appears to be above average compared to the broader index if left alone in an account with instructions that all dividends be reinvested.

2. Are you hoping to profit from a move in share price over the short-term, or from the long-term performance of the business?

If you ultimately expect to earn your profits in the market because a stock is going to go up as investors find it more fashionable, rather than an improvement in the long-term performance of the underlying business, you are gambling. One of the stupidest reasons to buy a stock is because you believe one of the company’s products or services is going to be a huge hit. That alone could be a reason if you believed it would result in underlying profits increasing on a per-share basis.

When you bank on someone else paying a higher price (the so-called “greater fool” theory), rather than selecting a demonstrably superior business, you are putting your financial well being in jeopardy.

3. Do you utilize leverage to amplify your return?

Margin debt is dangerous because it’s so easy to access. If you approach a traditional bank, you’re going to have to complete a myriad of paperwork, prove you have the cash flow to repay the loan, post collateral in the event you are unable to meet your obligation, go through a background check, and a whole lot more. With a brokerage firm, you may have $100,000 in assets in an account and instantly be able to borrow another $100,000, effectively leveraging your funds on a 2-1 basis. The problem, of course, comes if stocks fall – which they are often prone to do. In this example, a 20% drop would result in $40,000 of losses for you on your $100,000 equity, bringing your net account equity balance to $60,000.

With results like that, you may be right in the long-run, but, as the Wall Street expression goes, you’ll be explaining it to someone in the poor house. You must play your hand in a way that no matter what happens in the financial markets, you and your family will still have enough chips to participate in the recovery when it comes. We’re big fans of another Buffett assertion, “Don’t risk what you have and need for what you don’t have and don’t need.” It just doesn’t make sense to put yourself in a position where being wrong can cost you your standard of living.
If you are determined to put as much capital to work for you as possible, focus your energy on generating more cash in your professional life either by working more hours, starting a side business, cutting expenses, etc. It may take you a bit longer to get to your ultimate goal. But it will still be a much shorter journey than if you are completely or partially wiped out as a result of borrowing against your securities.

The Biggest Rip-Off Fees of All

2008-12-28T14:00:00.001-05:00

A few days ago, I was reading through the commission schedule of a major East Coast bank and was shocked to find that customers were charged $25 per position, up to ten stocks for a maximum of $250, for “safe keeping” fees on the stocks in their account.

Now that we are in an age where stock certificates are rare, there is virtually no effort involved with a broker keeping track of the companies in which you hold shares. For an investor with, say, $50,000 in assets, this represents a frictional expense of 1/2 of 1%! Add on the management fees that are taken out of mutual funds that you never see directly, and it’s not hard to understand why so many investors have a difficult time matching, much less beating, the market.

To add insult to injury, if you wanted to avoid these fees and request a paper certificate, the same firm would likely charge you $25 to $50 to get what rightfully belongs to you! Even more salt in the wound? Many companies offer direct stock purchase plans and dividend reinvestment plans that won’t charge you a penny for having stocks safely held with the transfer agent.
The bottom line is this: You should not be paying custodial or safe keeping fees for the right to hold stocks in your account. This is simply a way for hidden charges to ring the cash register at the broker, banks, or wealth management firm at your expense. Demand these fees be waived or you might just need to consider taking your business elsewhere.

Junk Bonds - The Sexiest Investment

2008-12-19T13:13:00.002-05:00

A Short & Simple Lesson in the Danger and Allure of Junk Bonds

You know you shouldn't. Your CPA wouldn't approve. Your wife would be furious if she found out. The guilt would consume you. Still, you can't help casting a lustful glance at junk bonds with their 10-12% coupons. Just remember flashy investments usually go up in smoke, and when these babies fall, they fall hard. They're called "junk" for a reason.
Lately, I've received a lot of emails about junk bonds and how (if) to invest in them. Here's a short and to-the-point lesson in what they are and whether you should add them to your portfolio.

The Fundamentals of Junk Bonds

Bond rating agencies such as Fitch, Standard and Poors, and Moody's assign ratings to debt issues. So-called investment grade bonds have a rating of BBB or higher. By assigning such a rating, the agency is saying that it believes, based on the company's current financial position, interest coverage ratio, and economic outlook, that the chance is default is not substantial. These issues often have a history of long, uninterrupted interest payments to bondholders.

Non-investment grade issues, on the other hand, are those that have been assigned a rating of BB or lower. These obligations possess a much higher risk for default or loss of principal. The companies that issue these "junk" bonds must somehow entice investors to risk their money. In order to do this, they offer a much higher coupon rate (e.g., 10%) than their investment
counterparts (e.g., 5 1/2%). Ironically, this increases the inherent risk because the companies that are least able to afford high interest charges pay double or triple their better-capitalized counterparts. Every bond in the world falls into one of two categories... investment and non-investment grade. There is a huge of difference between the two. Investment grade usually have a rating of BBB or higher. It is a safe bet to assume that they posses solid fundamentals, a stable balance sheet, and are not in serious risk of default or bankruptcy. Most have a long track record of making steady interest payments to their bondholders.

Junk bonds were tremendously popular in the generation of leveraged buyouts and corporate liquidations (otherwise known as the 1980's). Lately, they have staged a slight comeback with a potentially disastrous outcome. Small investors are buying them without fully understanding the risks they carry (and once they do figure it out, it will already be too late.)

Fallen Angels vs. Junk Bonds

In the course of business history, good companies have sometime experienced troubles that caused their debt ratings to be slashed. The company's bond issues plummet as a result. These type of issues are known as "fallen angels". They differ from junk bonds in that they were issued as investment grade and fell from grace. Purchasing fallen angels, if done intelligently, is far less speculative than acquiring junk bonds with the hope of holding them until maturity. This type of operation should be left to those who are able to evaluate a corporation's financials and reasonably estimate the potential outcome of the situation.
The Bottom Line on Junk Bonds
Avoid them like the plague unless you know what you are doing. If you do purchase them, do so with full understanding that unless you have substantial quantitative reasons to believe your purchase promises a safety of principal, you are speculating, not investing.

ting Non-Cash Producing Assets

2008-12-08T13:09:00.000-05:00

On November 25th, The Wall Street Journal reported that Great Britain was refining the rules for its personal retirement savings accounts to include collectibles such as fine wine, vacation homes, and art. The new guidelines, set to take effect on April 6th, 2006, raise interesting questions about investing in non-traditional asset classes regardless of your nationality. Are such commitments intelligent or playing with fire?

Investing Non-Cash Producing Assets

As you learnt in the Time Value of Money articles, the intrinsic value of any asset is all of the free, unrestricted future cash that it will generate discounted back to the present at an

appropriate rate. What about assets that don’t generate any cash, such as bottles of wine or fine art? In this case, you must consider the total net price you think you can command at the time of the sale. You must then calculate your Compound Annual Growth Rate based upon how long it takes you to sell. If the figure is substantially more than you expect to make from any of your other investments, it may be worth considering as long as it is within your circle of competence (more on that later).

The danger is that collectibles are subject, to a large degree, to the individual tastes and preferences of the populace at the time. What makes a Rembrandt or a Picasso worth $20 million, $50 million, or $100 million? Simply the fact that others will pay such prices. Unlike a car wash or chain of burger restaurants, there is no underlying cash stream upon which the value is based. With the latter type of investment, it doesn’t matter if the real estate market crashes – you can still rely upon the customers who are generating cash for you. There’s also the issue of theft; you can’t exactly throw a building into the back of a pickup truck and make a break for it like you can with a case of valuable wine.

For that reason, you may want to insist upon an additional margin of safety. A rare book set that you follow, normally trading at $2,000, may be compelling at $1,800. If you come across it for $900, however, you have left yourself ample room for attractive investment returns even if the item were to suffer a substantial shrinkage in value. Such opportunities are ephemeral, yet they do occur from time to time.

Your Circle of Competence

Long-time readers of the site know that I am a big fan of Warren Buffett’s concept of the “circle of competence”. The basic crux of the philosophy is that you never stray beyond your level of understanding when allocating capital. A person who works in the oil industry probably understands exploration and the economics of refining. A person who works in entertainment can probably have an intelligent idea of the direction of content delivery in the next ten years and how it will affect the major networks and media conglomerates. Both individuals have clear circles of competence; if they focus their investments on those areas they understand, they are likely to do better than if they blindly accepted a portfolio of stocks recommended by a high pressure broker. On Wall Street, there is a well-told story about a man who became so familiar with the economics of the American Water Works Company that he knew the cost and profit every time a toilette flushed. He spent his entire life buying and selling this one, single stock and died a multi-millionaire.

Obviously, it is not a wise policy to hold your entire net worth in a single stock. The idea of focusing your attention on areas that you are likely to have an advantage over the competition, however, is likely to serve you well. If you are a molecular biologist, you are probably going to have a much easier time evaluating than research and development pipeline at a major pharmaceutical company than you are estimating the excavation costs for gold mining stocks.

Your asset allocation should reflect that – including in the area of rare collectibles.
A few tips to remember:

1. Do your homework well before you are confronted with the opportunity to buy.
2. Be honest with yourself about where your circle of competence ends. Flattering yourself by imaging your expertise to be larger than it really is exposes you to the risk of overpayment.
3. Don’t allow yourself to be afraid of missing an opportunity. Far better to miss riches than ruin yourself.
4. Cynicism can be a very profitable trait in investing. Always ask yourself, “What Could Go Wrong?” before making any investment.

The Five Components of an Investors Required Rate of Return

2008-12-04T11:12:00.001-05:00

In financial theory, the rate of return at which an investment trades is the sum of five different components. They are:

1. The Real Risk-Free Interest Rate

This is the rate to which all other investments are compared. It is the rate of return an investor can earn without any risk in a world with no inflation.

2. An Inflation Premium

This is the rate that is added to an investment to adjust it for the market’s expectation of future inflation. For example, the inflation premium required for a one year corporate bond might be a lot lower than a thirty year corporate bond by the same company because investors think that inflation will be low over the short-run, but pick up in the future as a result of the trade and budget deficits of years past.

3. A Liquidity Premium

Thinly traded investments such as stocks and bonds in a family controlled company require a liquidity premium. That is, investors are not going to pay the full value of the asset if there is a very real possibility that they will not be able to dump the stock or bond in a short period of time because buyers are scarce. This is expected to compensate them for that potential loss. The size of the liquidity premium is the dependent upon an investor’s perception of how active a particular market is.

4. Default Risk Premium

How likely do investors believe it is that a company will default on its obligation or go bankrupt? Often, when signs of trouble appear, a company’s shares or bonds will collapse as a result of investors demanding a default risk premium. If someone were able to acquire assets that were trading at a huge discount as a result of a default risk premium that was too large, they could make a great deal of money. Many professional money managers actually bought shares of Enron’s corporate debt during the now-famous meltdown of the energy-trading giant. In essence, they bought $1 of debt for only a few pennies. If they can get more than they paid in the event of a liquidation or reorganization, it can make them very, very rich.

K-Mart is a wonderful example. Prior to its bankruptcy, hedge fund manager Eddie Lampert and distressed debt expert Marty Whitman of Third Avenue Funds, bought an enormous portion of the retailer’s debt. When the company was reorganized in bankruptcy court, the debt holders were given equity in the new company. Lampert then used his new controlling block of K-Mart stock with its improved balance sheet to start investing in other assets.

3. Maturity PremiumThe further in the future the maturity of a company’s bonds, the greater the price will fluctuate when interest rates change. That’s because of the maturity premium. Here’s a very simplified version to illustrate the concept: Imagine you own a $10,000 bond with a 7% yield when it is issued that will mature in 30 years. Each year, you will receive $700 in interest in the mail. Thirty years in the future, you will get your original $10,000 back. Now, if you were going to sell your bond the next day, you

Four Investing Mistakes to Avoid

2008-11-25T13:33:00.001-05:00

Investing Mistake 1: Spreading your investments too thin

Over the past several decades, Wall Street has preached the virtues of diversification, drilling it into the minds of every investor within earshot. Everyone from the CEO to the delivery boy knows that you shouldn't keep all your eggs in one basket - but there's much more to it than that. In fact, many people are doing more damage than good in their effort to diversify. Like everything in life, diversification can be taken too far. If you split up $100 into one hundred different companies, each of those companies can, at best, have a tiny impact on your portfolio. In the end, the brokerage fees and other transaction costs may even exceed the profit from your investments. Investors that are prone to this "dig-a-thousand-holes-and-put-a-dollar-in-each" philosophy would be better served by investing in an index fund which, by its very nature, is made up of many companies. Additionally, your returns will mimic those of the overall market in almost perfect lockstep.

Investing Mistake 2: Not accounting for time horizon

The type of asset in which you invest should be chosen based upon your time frame. Regardless of your age, if you have capital that you will need in a short period of time (one or two years, for example), you should not invest that money in the stock market or equity based mutual funds. Although these types of investments offer the greatest chance for long-term wealth building, they frequently experience short-term gyrations that can wipe out your holdings if you are forced to liquidate. Likewise, if your horizon is greater than ten years, it makes no sense for you to invest a majority of your funds in bonds or fixed income investments unless you believe the stock market is grossly overvalued.

Investing Mistake 3: Frequent trading

I can name ten investors on the Forbes list, but not one person who made their fortune from frequent trading. When you invest, your fortune is tied to the fortune of the company. You are a part-owner of a business; as the company prospers, so do you. Hence, the investor who takes the time to select a great company has to do nothing more than sit back, develop a dollar cost averaging plan, enroll in the DRV or dividend reinvestment programand live his life. Daily quotations are of no interest to him because he has no desire to sell. Over time, his intelligent decision will pay off handsomely as the value of his shares appreciates.

A trader, on the other hand, is one who buys a company because he expects the stock to jump in price, at which point he will quickly dump it and move on to his next target. Because it is not tied to the economics of a company, but rather chance and human emotion, trading is a form of gambling that has earned its reputation as a money maker because of the few success stories (they never tell you about the millionaire who lost it all on his next bet... traders, like gamblers, have a very poor memory when it comes to how much they have lost).

Investing Mistake 4: Fear based decisions

The costliest mistakes are usually fear based. Many investors do their research, select a great company, and when the market hits a bump in the road - dump their stock for fear of losing money. This behavior is absolutely foolish. The company is the same company as it was before the market as a whole fell, only now it is selling for a cheaper price. Common sense would dictate that you would purchase more at these lower levels (indeed, companies such as Wal-Mart have become giants because people like a bargain. It seems this behavior extends to everything but their portfolio). The key to being a successful investor is to, as one very wise man said, "..buy when blood is running in the streets."

The simple formula of "buy low / sell high" has been around forever, and most people can recite it to you. In practice, only a handful of investors do it. Most see the crowd heading for the exit door and fire escapes, and instead of staying around and buying up a company for ridiculous levels, panic and run out with them. True money is made when you, as an investor, are willing to sit down in the empty room that everyone else has left, and wait until they recognize the value they left behind. When they do run back in, you will be holding all of the cards. Your patience will be rewarded with profit and you will be considered "brilliant" (ironically by the same people that called you an idiot for holding on to the company's stock in the first place).

Surviving a Roller Coaster Stock Market

2008-11-19T16:14:00.002-05:00

Surviving a Roller Coaster Stock Market

There have been a number of research papers proving that investors, as a whole, experience far lower returns than the stock market itself as a result of frequent trading. It's not difficult to see why: Men and women, with no training in finance, attempting to manage their own 401k, Roth IRA, or Traditional IRA, or retirement accounts, panic when faced with volatility. After building up an investment portfolio over decades of work, a drop in stock prices of only ten or twenty percent can lead to tens, or even hundreds, of thousands of dollars in paper losses.

For an experienced investor with little or no debt, such a drop would be a non-event. They would know why they own the companies they hold, have estimated the future profitability, and calculated that into a discounted cash flow formula that gives them a rough idea of what their rate of return should be provided the variables they plugged in are accurate or conservatively projected. In fact, these investors (what have been called "true" investors) would welcome price drops, even if it meant half of their net worth disappeared from their monthly statements. I can tell you with absolute certainty that, all else being equal, if Berkshire Hathaway were to fall from $120,000 per share to $50,000 per share compared to its $72,000 per share book value, I would not for a moment lament the paper loss in my net worth, but rather back up the truck and attempt to buy as many shares as possible, even selling off other assets to fund the acquisition. There's a good chance the folks at my office would have to stop me from doing cartwheels. That's because I know the company, how it generates its cash, and have a rough approximation, adjusted on a rolling basis, of its intrinsic value.

In this article, I'm going to attempt to lay an intellectual foundation to help you think differently about stock market volatility, as well as provide you with some tips and tricks that might help traversing the stormy seas of Wall Street a whole lot easier.

Lay the Foundation

First, and please correct me if I'm wrong here, but you probably want to retire comfortably. You work hard, and want to be rewarded for that work; because of that, I want you to bookmark your page right here and take a moment to lay the foundation of what we're going to discuss by reading How to Think About Stock Prices, Price is Paramount, and Defensive Investing: Building a Portfolio for Volatile Markets. These three pieces of content will arm you with some background that allows me to go further in this discussion, making it easier to serve you better.
It's All About the History Books

Bill Gross, arguably the greatest pure bond investor alive today, has said that if he were only able to study one book, it would be a comprehensive history of the financial markets. That's because it can provide a framework for understanding financial psychology. Most people make the mistake of thinking that investing success is related to intelligence. I want you to repeat after me: Being a successful investor isn't about intelligence. Isaac Newton, one of the most brilliant minds the human race has ever produced, was wiped out in the Dutch Tulip Bubble.
A good place to start is the Ibbotson & Associates Stocks, Bonds, Bills, and Inflation Classic Yearbook. Although it costs around $100 per hard bound copy, it provides data about market levels and returns for more than a century. A quick glance, and you'll be comforted to see that over periods of ten years or longer, the stock market almost always performs well, especially when coupled with a dollar cost averaging plan that allows you to take advantage of low prices and fat dividend yields.

Some Checkpoints to Lower Your Risk

If you are worried about risk management and not necessarily generating maximum returns (which most likely describes 99% of the readers), here are some things to consider:

· The price-to-earnings ratio of your portfolio is no more than 10% higher than the market as a whole.

· The price-to-earnings ratio of your portfolio is no higher than twenty.

· You have a diversified base of stocks and bonds appropriate for your distance from
retirement (you should own more and more fixed income or cash equivalents as you approach the end of your working career).

· Focus on mutual funds with low expense ratios, good historical performance ratings and established management who invest in the funds they manage.

· If you are interested in long-term (five years or more) returns that are competitive, stop moving assets around in your retirement account. You don't know more than the market, and you aren't experienced enough to make rational judgment calls. Stick to your plan, continue your contributions, and wait until retirement. Unless there is a fundamental deterioration in the underlying asset, the stupidest time to sell anything is after it has fallen in price.
Get Competent Professional Advice

If you don't know what to do or feel completely lost, seek out a competent, well respected, and conservative financial adviser or planner. You want someone who has a good record and can explain, in one short paragraph, the rational for each investment held in your portfolio. You want someone who values your needs and listens to you; what good is it to have someone managing the money for which you work so hard if they don't understand what it is you are trying to accomplish?

Why It Might Be a Horrible Mistake to Sell Out During a Down Market

2008-11-14T16:33:00.000-05:00

f you are more than five years away from retirement, your 401(k) was invested in a broadly diversified, low-cost index fund, and you’ve sold off your assets as the market has collapsed, you have made a very, very stupid long-term decision. Believe me, I wish it could be sugar coated, but you’ve effectively just dumped your ownership of great American businesses such as Johnson & Johnson, Coca-Cola, Wal-Mart Stores, and General Electric to value investors at a fraction of their intrinsic value. After years of diligently building your wealth, you’ve turned them over to hedge fund managers, well-heeled executives, and disciplined personal investors that have the emotional strength to ignore volatility and instead do what makes sense five or ten years from now.

The worst part: You sold because other people were selling their stocks (many of them involuntarily due to margin calls). It’s the grown up version of the classic question posed by nearly every mother in history – if your friends jumped off a bridge, would you? Do you really think that Pepsi is going to sell less soft drinks and potato chips over the next twenty years because of a recession? Sure, as Warren Buffett has said, short-term profits are going to get hit at nearly all companies throughout the economy. The long-term health of the United States should continue to trend upward given our social, economic, and legal structures. Just as stocks have been the greatest source of wealth since the market meltdown in 1973 and 1974, they should continue to be the best vehicle for long-term over the next thirty years.

Instead, for those of you who have time to wait out the volatility, it might be a good idea to consider drastically increasing your retirement contributions while the market is falling. Of course, this is only a possibility if you’ve been following all the rules that are constantly espoused by financial advisors such as Suze Orman by establishing an emergency fund, staying out of credit card debt, owning your home, and living well within your means. Otherwise, you simply won’t be able to afford to take advantage of the current prices. (This, it should be noted, is one of the reasons by the rich get richer – when things go south, they can pick up assets on the cheap.)

How do I actually make money from a stock?

2008-11-03T12:27:00.000-05:00

How do I actually make money from a stock?” If you’ve ever wondered how the mechanics actually work, print this article, grab a hot cup of coffee, get comfortable in your favorite reading chair, and prepare to learn the basics of common stock.

It's Simple, Really
When you buy a share of stock, you are buying a piece of a company. Imagine that Harrison Fudge Company, a fictional business, has sales of $10,000,000 and net income of $1,000,000. To raise money for expansion, the company’s founders approached a Wall Street underwriting firm (an investment banker) and had them sell stock to the public. They might have said, “Okay, we don’t think your growth rate is great so we are going to price this so that future investors will earn 9% on their investment plus whatever growth you generate … that works out to around $11,000,000+ value for the whole company ($11 million divided by $1 million net income = 9% return on initial investment.)” Now, we’re going to assume that the founders sold out completely instead of issuing stock to the public

The underwriters may say, “You know, we want the stock to sell for $25 per share because that seems affordable so we are going to cut the company into 440,000 pieces, or shares of stock (440,000 shares x $25 = $11,000,000.) That means that each “piece” or share of stock is entitled to $2.72 of the profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per share.) This figure is known as Basic EPS (short for earnings per share.) In other words, when you buy a share of Harrison Fudge Company, you are buying the right to your pro-rata profits. Were you to acquire 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated. If you thought that a new management could cause fudge sales to explode so that your pro-rata profits would be 5x higher in a few years, then this would be an extremely attractive investment.

What Makes It a Bit More Complicated

What muddies up the situation is that you don’t actually see that $2.72 in profit that belongs to you. Instead, management and the Board of Directors have a few options available to them, which will to a large degree determine the success of your holdings:

1. It can send you a cash dividend for some portion or the entirety of your profit. This is one way to “return capital to shareholders.” You could either use this cash to buy more shares or go spend it any way you see fit.

2. It can repurchase shares on the open market and destroy them. For a great explanation of how this can make you very, very rich in the long-run, read Stock Buy Backs: The Golden Egg of Shareholder Value.

3. It can reinvest the funds into future growth by building more factories, stores, hiring more employees, increasing advertising, or any number of additional capital expenditures that are
expected to increase profits. Sometimes, this may include seeking out acquisitions and mergers.

4. It can strengthen the balance sheet by reducing debt or building up liquid assets.

Which way is best for you? That depends entirely upon the rate of return management can earn by reinvesting your money. If you have a phenomenal business – think Microsoft or Wal-Mart in the early days when they were both a tiny fraction of their current size, paying out any cash dividend is likely to be a mistake because those funds could be reinvested at a high rate. There were actually times during the first decade after Wal-Mart went public that it earned more than 60% on shareholder equity. That’s unbelievable. (Check out the DuPont desegregation of ROE for a simple way to understand what this means.) Those kinds of returns typically only exist in fairy tales yet, under the direction of Sam Walton, the Bentonville-based retailer was able to pull it off and make a lot of associates and stockholders rich in the process.

Mutual Funds 101: What They are and How They Work

2008-10-15T10:00:00.002-04:00

The brain-child of Wall Street, mutual funds are perhaps the easiest and least stressful way to invest in the market. In fact, more new money has been introduced into funds during the past few years than at any time in history. Before you jump into the pool and select a mutual fund in which to invest, you should know exactly what they are and how they work.

What is a mutual fund?

Put simply, a mutual fund is a pool of money provided by individual investors, companies, and other organizations. A fund manager is hired to invest the cash the investors have contributed. The goal of the manager depends upon the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk. A long-term growth manager, on the other hand, should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year (very few funds actually achieve this; to find out why, read Index Funds - The Dumb Money Almost Always Wins).

Closed vs. Open-Ended Funds, Load vs. No-Load

Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.

· Closed-End Funds This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market; this, combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.

· Open-End Funds A majority of mutual funds are open-ended. In simple terms, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.

Load vs. No Load A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares. No load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.

What are the benefits of investing through a mutual fund?

Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is his or her primary occupation, they can devote considerably more time to selecting investments than an individual investor. This provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.

How do I select a fund that's right for me?

Every fund has a particular investing strategy, style or purpose; some, for instance, invest only in blue chip companies. Others invest in start-up businesses or specific sectors. Finding a mutual fund that fits your investment criteria and style is absolutely vital; if you don't know anything about biotechnology, you have no business investing in a biotech fund. You must know and understand your investment.

After you’ve settled upon a type of fund, turn to Morningstar or Standard and Poors (S&P). Both of these companies issue fund rankings based on past record. You must take these rankings with a grain of salt. Past success is no indication of the future, especially if the fund manager has recently changed.

How do I begin investing in a fund?

If you already have a brokerage account, you can purchase mutual fund shares as you would a share of stock. If you don't, you can visit the fund's web page or call them and request information and an application. Most funds have a minimum initial investment which can vary from $25 - $100,000+ with most in the $1,000 - $5,000 range (the minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account such as a 401k, traditional IRA or Roth IRA, and / or the investor agrees to automatic, reoccurring deductions from a checking or savings account to invest in the fund.
The importance of dollar-cost averaging

The dollar-cost averaging strategy is just as applicable to mutual funds as it is to common stock. Establishing such a plan can substantially reduce your long-term market risk and result in a higher net worth over a period of ten years or more.

Understanding Bond Duration

2008-10-15T09:31:00.001-04:00

Holders of bonds face a distinct set of risks that may be less obvious to the uninitiated. Thankfully, one of the biggest risks in the bond market - interest rate risk - is easy to determine, using a concept called duration. It's possible to approximate how much a bond's price is likely to rise or fall when interest rates change, a level of certainty that stock investors will appreciate. So before you go out and buy a 30-year Treasury bond in the mistaken belief that it's risk-free, consider its duration.

A Basic Bond

Before diving in, let's take a simple example of a company that wants to borrow $100. It issues a bond that it sells for $100. To attract investors, the issuer of the bond offers to pay $4 a year to holders of the bond, and will do so for 10 years. At that time, the bond matures, and the bold holder gets $100 back. In the parlance of the world of fixed income, we can say that the bond has a face value of $100, a coupon rate of 4% and a maturity of 10 years.

There are many risks to the holder of the bond. The best known may be the risk that the issuer of the bond can't afford to make interest payments or return the principal. But a default, as this scenario is known, isn't the only risk.

Interest Rate Risk
But even a bond with virtually no chance of default - for instance, bonds issued and backed by the US Government - still have risks. Going back to our simple example, let's say that the day after the bond is issued, interest rates rise to 5%. The owner of that bond might kick herself. If she had waited a day, she could have bought a bond that paid 5% a year. That makes her bond less valuable, and this will be reflected if she tries to sell the bond to someone else. She may not be able to get back her $100.

The seesaw relationship between interest rates and bond prices is a fundamental concept of bonds. But some bonds have greater sensitivity to changes in interest rates. Bond investors don't have to guess at this exposure. A bond's modified duration, a figure derived from several factors, measures this risk and tells the investor how its price is likely to change when market interest rates go up or down. A bond with a duration of six years would be expected to fall 6% in price for every 1% increase in market interest rates.

Elements of Duration
The concept of duration is straightforward: It measures how quickly a bond will repay its true cost. The longer it takes, the greater exposure the bond has to changes in the interest rate environment.

Here are some of factors that affect a bond's duration:

· Time to maturity: Consider two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.

· Coupon rate: A bond's payment is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.
Using Duration to Your Advantage

Knowing the duration of a bond, or a portfolio of bonds, gives an investor an advantage in two important ways:

· Speculating on interest rates: Investors who anticipate a decline in market interest rates - as a result of, for instance, a simulative rate cut by the Federal Reserve - would try to increase the average duration of their bond portfolio. Likewise, investors who expect the Fed to raise interest rates would want to lower their average duration.

· Matching risk to your tastes: When selecting from bonds of different maturities and yields, or comparing bond mutual funds, duration allows you to quickly determine which bonds are more sensitive to changes in market interest rates, and to what degree.

Calculating Duration

Start by determining the value of a bond's yearly cash flow, adjusted to give greater value to payments that are made sooner rather than later. Divide that figure by its price to calculate its duration. Online calculators make this easy.

Bonds 101

2008-10-15T09:30:00.001-04:00

What Are They?

Say you are in the grocery store with a friend on a Thursday afternoon and see something you need for your house; a broom for example. Although you get your paycheck the next day, you ask your shopping buddy to borrow a few dollars so you can purchase the broom now, in return for which you will not only pay them back tomorrow, but buy them dinner as well. Your friend, finding these terms acceptable, loans you the money and you purchase the item.

This is, in essence, what happens in the corporate world when a company issues bonds. Generally, as a business grows, it doesn't generate enough cash internally to pay for the supplies and equipment necessary to keep it growing. Because of this, most businesses have one of two options. They can either 1.) sell a portion of the company to the general public by issuing additional shares of stock, or they can 2.) issue bonds. When a company issues bonds, it is borrowing money from investors in exchange for which it agrees to pay them interest at set intervals for a predetermined amount of time. In essence, it is the same thing as a mortgage only you, the investor, are the bank.

Why Would Anyone Invest in Bonds?

Most everyone knows that over the long-run, nothing beats the stock market. This being the case, why would anyone invest in bonds? Although they pale in comparison to equities in the long run, bonds have several traits that stocks simply can't match.

First, capital preservation. Unless a company goes bankrupt, a bondholder can be almost completely certain that they will receive the amount they originally invested. Stocks, which are subordinate to bonds, bear the brunt of unfavorable developments.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income for retired couples, individuals, or those who need the cash flow. For instance, if someone owned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000 yearly), a fraction of that interest would be sent to the bondholder either monthly or quarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government or municipality issues various types of bonds to raise money to build bridges, roads, etc., the interest that is earned is tax exempt. This can be especially advantageous for those whom are retired or want to minimize their total tax liability.

Bracketed Orders

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One thing to consider: If you're planning on holding a particular investment for an extended period of time because you believe its long-term potential is substantial or that it is undervalued, placing a trailing stop order may not be a sensible course of action. As an asset class, stocks are notorious for their collective and individual volatility; the road is certainly bumpy. Yet, you may not be able to profit from your convictions because your trailing stop orders could be triggered as a result of ordinary volatility. If you have any doubts or questions, consult your financial advisor.

Bracketed Orders

Bracketed orders go one step further than trailing stop orders. Just like the latter, you set a trailing stop as either a percentage or fixed spread (recall that on the previous page, our trailing stop was $2 for Hershey). In addition, however, you can establish an upper limit that, when reached, will result in the stock being sold.
Going back to our Hershey Chocolate example, let’s now assume you placed a bracketed order with a trailing stop level of $2 per share and an upper limit of $65 per share. The bracketed order will behave exactly the same as the trailing stop order, with the $2 trailing stop automatically ratcheting up as the price increases. The difference? When and if Hershey hits $65, the bracketed order will automatically convert into a market order and should be immediately executed by your broker.