INVESTMENT PRIMER–BASIC TOOLS FOR YOUR INVESTMENT JOURNEY

The securities industry is interested in taking control of your investable funds–yes, to relieve you of the worry; but also, to generate profits for themselves.  The best way to protect yourself is to have a basic understanding of the investment landscape. That’s what Investment Boot Camp is all about. So, let’s start with the basics. That is, the basic tools that are available, in one form or another.

STOCKS:  Stocks represent ownership in a company, and they are traded in units called “shares”, generally on exchanges, but not necessarily so.  When a company grows and requires more capital, the original owners may offer some shares to the general public, in what is called an “IPO”, or initial public offering.  New companies, which are in an expansion mode, generally do not pay dividends.  Other companies may pay dividends out of their earnings, which can be distributed in cash or re-invested in additional shares, at each individual investor’s option.  The Corporate Board of Directors votes quarterly as to whether it will pay (“declare”) a dividend, how much, or whether to pay any dividend at all. Dividends are not necessarily guaranteed in any quarter, regardless of whether they were paid in any prior quarter(s).

BONDS:  When a company issues bonds (sometimes referred to as “debentures”), it is incurring debt. Bonds are traded in what are called “par value”, which is the redemption value of specified units, and they are generally denominated in thousand dollar (or Euro, Pound, Yen, etc.) amounts, such as: $1,000, $10,000, $25,000, etc.  Most bonds have a stated “coupon” rate, which represents the percentage of interest that the corporation is contractually required to pay annually, and a maturity (or termination) date.  Bonds are generally assigned credit ratings by any of a number of rating agencies; however, the three primary ones are:  Moody’s; S & P (Standard and Poor’s) and Fitch.  Generally, bonds trade on an “over-the-counter” basis, rather than on an exchange.

NOTE:  Why do companies issue bonds–and incur contractual payment obligations–rather than stock, when they need additional capital?  Let’s say that a company has one million shares of stock outstanding, and the company has “Equity Capital” of (is valued at) $10 million.  The stock would then be trading at $10.00 per share.   Someone who owns 1,000 shares, worth $10,000, would own one-tenth of one percent of the company.  If the company issued another one million shares, however, the ownership of each and every shareholder in that company would be cut (“diluted”) in half.  The 1,000 share owner, assuming no change in his/her shares owned or the market price per share, would still own $10,000 in value, but of a (then) $20 million company.

Stocks and bonds are the two basic types of securities.  Over the past century, the securities industry has devised other ways to offer “packaged investments” that can provide a diversified assortment of stocks and/or bonds, and sometimes derivatives that may include investments in  he commodities and/or foreign exchange markets.  With derivatives, you own  part  of a futures or option contract, but not the actual underlying securities.  These include:  mutual funds; ETFs (exchange-traded funds); UITs (unit investment trusts); variable and indexed annuities; closed-end funds; market-linked CDs; etc.

For this blog post, I will stick to mutual funds and ETFs.  The other investment options, which I have cited, may have some of the same benefits as funds and ETFs; however, there might also be additional risks, hidden fees and excessive disclosure documentation.  I had avoided some of these products when I was working as a financial advisor; because, with more than 30 years in the securities business, I just couldn’t feel comfortable with offering them to some clients.  That’s especially the case for market-linked CDs, which seem to be targeted to more conservative investors.

Mutual Funds:  Mutual funds enable the investor to purchase one or several investments, each of which offers a diversified portfolio, that are usually professionally-managed, as noted above.  Some funds, however, are not actively-managed and are merely composed of a stock and/or bond index.  Although funds can be purchased as a specific quantity of shares, they are generally traded in dollar amounts.  All purchases and sales are executed through the issuing company (i.e. American Funds, Fidelity, Franklin Templeton, Vanguard, etc.).  The price of most transactions is set at the close-of-business (4PM EST or EDT in the U.S.)  Funds that are issued in other countries would be executed during the respective normal business hours in those countries.

Some funds are purchased with a fee (“load”), while other (“No-Load”) funds do not have one. I believe that a fund’s consistent performance over a period of years, within its category ( i.e. large company, utilities, global, etc.) is more important than whether there is a fee involved in the purchase.  For instance, a fee of, let’s say five percent, for a consistently good-performing fund, spread over a ten or twenty year investment horizon may very well outweigh the initial fee.  On the other hand, an investor with a very short time horizon, say two or three years, probably shouldn’t be assuming market risk anyway.

ETFs:  are mutual funds that trade on an exchange and, just like stocks, the price changes throughout the day.  Purchases and sales are always transacted in a specified number of shares.  Like stocks and mutual funds, if there are dividends paid, they usually can be taken in cash or reinvested to buy additional shares. Oftentimes, ETFs are based on a specific stock and/or bond index and, as such, the portfolio would contain the good and bad components within the particular index.

I have found ETFs to be an excellent way to invest in a specific country, such as Australia or Israel, where there may not be any mutual funds available.  Likewise, it is a good way to fill-in a particular market segment, such as health care or technology, which your portfolio might be somewhat lacking, or you wish to add to.  I fully believe in the value of ETFs in a portfolio; however, for some of the primary indices (i.e. Dow Jones Industrial Index, S & P 500, NASDAQ, or EAFE*, etc.), the respective ETFs are often used by institutions to make a quick purchase or sale of a particular market segment.  So, at times, there can be some volatility.

NOTE:  EAFE is the major global developed markets stock index, excluding the U.S.  Canada is also excluded due to its close linkage with the U.S. markets.

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  1. #1 by MidcapAdvisor on July 26, 2015 - 8:31 PM

    Regarding issuing debt or equity by companies, debt is cheaper than equity as finance costs are tax deductible. Furthermore profits do not have to be distributed to debt holders.

    • #2 by cheekos on July 27, 2015 - 1:57 AM

      MidcapAdvisor, thanks for visiting my blog, and commenting.

      I don’t understand your rationale. It is not a case of equity or debt necessarily being cheaper–or even one better or worse than the other. They are two totally different entities. Debt requires contractual interest payments to the bondholders, while dividends are not required at all on stock. So, the tax-deductibility of interest payments is a meaningless point in this context. Furthermore, bond interest is paid out as cash, and where it came from is irrelevant.

      Generally, at least in the U.S, if a company fails to pay any required debt service–principal or interest–all of its debt–bonds or bank loans–generally (according to debt covenants) becomes immediately due and payable. Also, failing to pay its bills on time could place the company into bankruptcy, would cause its debt ratings to drop considerably (perhaps into “junk” bond status) and make it impossible to borrow in either the bond or bank loan markets for years to come.

      • #3 by MidcapAdvisor on July 27, 2015 - 3:34 AM

        Yes I completely agree with your comment, repaying debt is far more constraining for a company, hence for a startup this would not be ideal, to be loaded up with debt. But for larger established companies debt is cheaper than equity as its repaid before tax. Depending on the tax rate of the company this saves a considerable amount. See here for M&M with tax:
        http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/modigliani-miller.aspx

      • #4 by cheekos on July 27, 2015 - 10:20 AM

        MidcapAdvisor, once again, this is not a question of larger or smaller companies, young or old, new or old. It is a question of whether to dilute or not when raising additional capital? Equity capital or leverage? There is no such thing as the repayment of Equity! And, taxation should not even be a concern. Simple Finance 101.

      • #5 by cheekos on July 27, 2015 - 10:50 AM

        The M & M study that you cite, from the 1950s, is based on a hypothetical world in which there are no taxes, transaction fees, assumedly legal fees, etc. It appears to purely be a “what if” academic exercise. From what I can ascertain, it has nothing to do with the question of the pros and cons of whether to use leverage, or not, in raising capital. In today’s global corporate (real) world, however, that study doesn’t appear to have much direct relevance, other than as it might have been intended–as an academic consideration.

        Also, keep in mind that the whole concept of “Investment Boot Camp” is to present the very basics of investing, in order that complete novices may gain the initial investment tools to build upon. I did touch upon the concept of leverage since it is key in understanding the verify basic difference between stock and bond ownership.

      • #6 by MidcapAdvisor on July 27, 2015 - 12:24 PM

        The M&M study is basic corporate finance theory, hence why is say it’s relevant and it is still true today, equity finance is extremely expensive, you give away equity after all. You seem averse to comments, which is surprising for someone writing a blog.

      • #7 by cheekos on July 27, 2015 - 4:28 PM

        MidcapAdvisor, I don’t mind comments as long as they keep the context of the blog post–meant to be very basic investing–and the main point in explaining why many corporations issue both stocks and bonds. Sure, there are advantages in issuing both stocks and bonds, as well as negative ones. And, I do not recall Professor Modigliani ever suggesting that debt is “better” than stock (when I studied him in business school), and/or that corporations should focus mostly on issuing debt. Perhaps that was not your point; however, when I read your initial comment, at least to me, that was my inference.

        I do welcome comments and, when a reader accurately points out my error, I have acknowledged such. But at the same time, there are a number of commenters on blogs who don’t really understand the subject matter at hand. The purpose of this blog is to write about anything and everything. Yes, I do write a good bit about financial topics; but, not necessarily about finance, as such.

        Thanks gain for visiting my blog, and for commenting.

  2. #8 by MidcapAdvisor on July 27, 2015 - 7:16 PM

    Hi Cheekos, I’ve come back to your blog and taken the time to re-read (and in front of my PC screen rather than on my phone this time). I commented in response to your ‘Note’ section, but I can see what you describe is a brief overview of investment types, so no offence intended from my comment.

    I read your bio with interest. You clearly have a lot of experience, which is always of interest to younger less experienced investors. I am fortunate enough to have boss who has also seen a lot over the years and I greatly value his opinion and learn a lot from him on a day-to-day basis. I will follow your blog, I look forward to hearing and learning more. All the best

    • #9 by cheekos on July 28, 2015 - 12:50 AM

      MadcapInvestor, no offense was taken–or meant, on my part. One time, by the way, I was sitting at a bar, watching a football game (actually, about twelve of them), while being more focused on reading some long articles on my notebook. Somebody sat down next to me, started scanning his smartphone, and he commented that the way I was reading was like a dinosaur. He just didn’t understand that, sometimes, you get more out of something by just reading on a large page, rather than constantly scrolling and squinting. To each his own, eh?

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