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Value Investing Strategies PART 2

Value Investing Strategies.

By ADAM HAYES.
The key to buying an undervalued stock is to thoroughly research the company and make common-sense decisions. Value investor Christopher H. Browne recommends asking if a company is likely to increase its revenue via the following methods:

Raising prices on products.
Increasing sales figures.
Decreasing expenses.
Selling off or closing down unprofitable divisions.

Browne also suggests studying a company's competitors to evaluate its future growth prospects. But the answers to all of these questions tend to be speculative, without any real supportive numerical data. Simply put: There are no quantitative software programs yet available to help achieve these answers, which makes value stock investing somewhat of a grand guessing game. For this reason, Warren Buffett recommends investing only in industries you have personally worked in, or whose consumer goods you are familiar with, like cars, clothes, appliances, and food.

One thing investors can do is choose the stocks of companies that sell high-demand products and services. While it's difficult to predict when innovative new products will capture market share, it's easy to gauge how long a company has been in business and study how it has adapted to challenges over time.

Insider Buying and Selling.
For our purposes, insiders are the company’s senior managers and directors, plus any shareholders who own at least 10% of the company’s stock. A company’s managers and directors have unique knowledge about the companies they run, so if they are purchasing its stock, it’s reasonable to assume that the company’s prospects look favorable.

Likewise, investors who own at least 10% of a company’s stock wouldn’t have bought so much if they didn’t see profit potential. Conversely, a sale of stock by an insider doesn’t necessarily point to bad news about the company’s anticipated performance — the insider might simply need cash for any number of personal reasons. Nonetheless, if mass sell-offs are occurring by insiders, such a situation may warrant further in-depth analysis of the reason behind the sale.

Analyze Earnings Reports.
At some point, value investors have to look at a company's financials to see how its performing and compare it to industry peers.

Financial reports present a company’s annual and quarterly performance results. The annual report is SEC form 10-K, and the quarterly report is SEC form 10-Q. Companies are required to file these reports with the Securities and Exchange Commission (SEC). You can find them at the SEC website or the company’s investor relations page on their website.

You can learn a lot from a company’s annual report. It will explain the products and services offered as well as where the company is heading.

Analyze Financial Statements.
A company’s balance sheet provides a big picture of the company’s financial condition. The balance sheet consists of two sections, one listing the company’s assets and another listing its liabilities and equity. The assets section is broken down into a company’s cash and cash equivalents; investments; accounts receivable or money owed from customers, inventories, and fixed assets such as plant and equipment.

The liabilities section lists the company’s accounts payable or money owed, accrued liabilities, short-term debt, and long-term debt. The shareholders’ equity section reflects how much money is invested in the company, how many shares outstanding, and how much the company has as retained earnings. Retained earnings is a type of savings account that holds the cumulative profits from the company. Retained earnings are used to pay dividends, for example, and is considered a sign of a healthy, profitable company.

The income statement tells you how much revenue is being generated, the company's expenses, and profits. Looking at the annual income statement rather than a quarterly statement will give you a better idea of the company’s overall position since many companies experience fluctuations in sales volume during the year.

Studies have consistently found that value stocks outperform growth stocks and the market as a whole, over the long-term.
Couch Potato Value Investing
It is possible to become a value investor without ever reading a 10-K. Couch potato investing is a passive strategy of buying and holding a few investing vehicles for which someone else has already done the investment analysis—i.e., mutual funds or exchange-traded funds. In the case of value investing, those funds would be those that follow the value strategy and buy value stocks—or track the moves of high-profile value investors, like Warren Buffet. Investors can buy shares of his holding company, Berkshire Hathaway, which owns or has an interest in dozens of companies the Oracle of Omaha has researched and evaluated.

Risks with Value Investing.
As with any investment strategy, there's the risk of loss with value investing despite it being a low-to-medium-risk strategy. Below we highlight a few of those risks and why losses can occur.

The Figures are Important.
Many investors use financial statements when they make value investing decisions. So if you rely on your own analysis, make sure you have the most updated information and that your calculations are accurate. If not, you may end up making a poor investment or miss out on a great one. If you aren’t yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don’t place any trades until you’re truly ready. (For more on this subject, learn more about financial statements.)

One strategy is to read the footnotes. These are the notes in a Form 10-K or Form 10-Q that explain a company’s financial statements in greater detail. The notes follow the statements and explain the company’s accounting methods and elaborate on reported results. If the footnotes are unintelligible or the information they present seems unreasonable, you’ll have a better idea of whether to pass on the stock.

Extraordinary Gains or Losses.
There are some incidents that may show up on a company's income statement that should be considered exceptions or extraordinary. These are generally beyond the company's control and are called extraordinary item—gain or extraordinary item—loss. Some examples include lawsuits, restructuring, or even a natural disaster. If you exclude these from your analysis, you can probably get a sense of the company's future performance.

However, think critically about these items, and use your judgment. If a company has a pattern of reporting the same extraordinary item year after year, it might not be too extraordinary. Also, if there are unexpected losses year after year, this can be a sign that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Also, beware of a pattern of write-offs.

Ignoring Ratio Analysis Flaws.
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company’s financial health. There isn't just one way to determine financial ratios, which can be fairly problematic. The following can affect how the ratios can be interpreted:

Ratios can be determined using before-tax or after-tax numbers.
Some ratios don't give accurate results but lead to estimations.
Depending on how the term earnings are defined, a company's earnings per share (EPS) may differ.
Comparing different companies by their ratios—even if the ratios are the same—may be difficult since companies have different accounting practices. (Learn more about when a company recognizes profits in Understanding The Income Statement.)

Buying Overvalued Stock.
Overpaying for a stock is one of the main risks for value investors. You can risk losing part or all of your money if you overpay. The same goes if you buy a stock close to its fair market value. Buying a stock that's undervalued means your risk of losing money is reduced, even when the company doesn't do well.

Recall that one of the fundamental principles of value investing is to build a margin of safety into all your investments. This means purchasing stocks at a price of around two-thirds or less of their intrinsic value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.

Not Diversifying.
Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and different sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book of Value Investing.” According to Benjamin Graham, a famous value investor, you should look at choosing 10 to 30 stocks if you want to diversify your holdings.

Another set of experts, though, say differently. If you want to get big returns, try choosing just a few stocks, according to the authors of the second edition of “Value Investing for Dummies.” They say having more stocks in your portfolio will probably lead to an average return. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.

Listening to Your Emotions.
It is difficult to ignore your emotions when making investment decisions. Even if you can take a detached, critical standpoint when evaluating numbers, fear and excitement may creep in when it comes time to actually use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you may be tempted to sell it if the price falls. Keep in mind that the point of value investing is to resist the temptation to panic and go with the herd. So don't fall into the trap of buying when share prices rise and selling when they drop. Such behavior will obliterate your returns. (Playing follow-the-leader in investing can quickly become a dangerous game.

Example of a Value Investment.
Value investors seek to profit from market overreactions that usually come from the release of a quarterly earnings report. As a historical real example, on May 4, 2016, Fitbit released its Q1 2016 earnings report and saw a sharp decline in after-hours trading. After the flurry was over, the company lost nearly 19% of its value. However, while large decreases in a company's share price are not uncommon after the release of an earnings report, Fitbit not only met analyst expectations for the quarter but even increased guidance for 2016.

The company earned $505.4 million in revenue for the first quarter of 2016, up more than 50% when compared to the same time period from one year ago. Further, Fitbit expects to generate between $565 million and $585 million in the second quarter of 2016, which is above the $531 million forecasted by analysts. The company looks to be strong and growing. However, since Fitbit invested heavily in research and development costs in the first quarter of the year, earnings per share (EPS) declined when compared to a year ago. This is all average investors needed to jump on Fitbit, selling off enough shares to cause the price to decline. However, a value investor looks at the fundamentals of Fitbit and understands it is an undervalued security, poised to potentially increase in the future.

The Bottom Line.
Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with the intention of holding them almost indefinitely. He once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” You will probably want to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and maintaining a long-term outlook, you can sell your stocks only when their price exceeds their fair market value (and the price you paid for them).

July 25, 2020

Ten Ways to Create Shareholder Value (part 2).

by Alfred Rappaport.
Principle 4.
Carry only assets that maximize value.
The fourth principle takes value creation to a new level because it guides the choice of business model that value-conscious companies will adopt. There are two parts to this principle.

First, value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, real estate, and other detachable assets. Such an analysis is clearly a political minefield for businesses that are performing relatively well against projections or competitors but are clearly more valuable in the hands of others. Yet failure to exploit such opportunities can seriously compromise shareholder value.
A recent example is Kmart. ESL Investments, a hedge fund operated by Edward Lampert, gained control of Kmart for less than $1 billion when it was under bankruptcy protection in 2002 and when its shares were trading at less than $1. Lampert was able to recoup almost his entire investment by selling stores to Home Depot and Sears, Roebuck. In addition, he closed underperforming stores, focused on profitability by reducing capital spending and inventory levels, and eliminated Kmart’s traditional clearance sales. By the end of 2003, shares were trading at about $30; in the following year they surged to $100; and, in a deal announced in November 2004, they were used to acquire Sears. Former shareholders of Kmart are justifiably asking why the previous management was unable to similarly reinvigorate the company and why they had to liquidate their shares at distressed prices.
Second, companies can reduce the capital they employ and increase value in two ways: by focusing on high value-added activities (such as research, design, and marketing) where they enjoy a comparative advantage and by outsourcing low value-added activities (like manufacturing) when these activities can be reliably performed by others at lower cost. Examples that come to mind include Apple Computer, whose iPod is designed in Cupertino, California, and manufactured in Taiwan, and hotel companies such as Hilton Hospitality and Marriott International, which manage hotels without owning them. And then there’s Dell’s well-chronicled direct-to-customer, custom PC assembly business model, which minimizes the capital the company needs to invest in a sales force and distribution, as well as the need to carry inventories and invest in manufacturing facilities.

Principle 5.
Return cash to shareholders when there are no credible value-creating opportunities to invest in the business.
Even companies that base their strategic decision making on sound value-creation principles can slip up when it comes to decisions about cash distribution. The importance of adhering to the fifth principle has never been greater: As of the first quarter of 2006, industrial companies in the S&P 500 were sitting on more than $643 billion in cash—an amount that is likely to grow as companies continue to generate positive free cash flows at record levels.

Value-conscious companies with large amounts of excess cash and only limited value-creating investment opportunities return the money to shareholders through dividends and share buybacks. Not only does this give shareholders a chance to earn better returns elsewhere, but it also reduces the risk that management will use the excess cash to make value-destroying investments—in particular, ill-advised, overpriced acquisitions.
Just because a company engages in share buybacks, however, doesn’t mean that it abides by this principle. Many companies buy back shares purely to boost EPS, and, just as in the case of mergers and acquisitions, EPS accretion or dilution has nothing to do with whether or not a buyback makes economic sense. When an immediate boost to EPS rather than value creation dictates share buyback decisions, the selling shareholders gain at the expense of the nontendering shareholders if overvalued shares are repurchased. Especially widespread are buyback programs that offset the EPS dilution from employee stock option programs. In those kinds of situations, employee option exercises, rather than valuation, determine the number of shares the company purchases and the prices it pays.

Value-conscious companies repurchase shares only when the company’s stock is trading below management’s best estimate of value and no better return is available from investing in the business. Companies that follow this guideline serve the interests of the nontendering shareholders, who, if management’s valuation assessment is correct, gain at the expense of the tendering shareholders.

When a company’s shares are expensive and there’s no good long-term value to be had from investing in the business, paying dividends is probably the best option.

Principle 6.
Reward CEOs and other senior executives for delivering superior long-term returns.
Companies need effective pay incentives at every level to maximize the potential for superior returns. Principles 6, 7, and 8 set out appropriate guidelines for top, middle, and lower management compensation. I’ll begin with senior executives. As I’ve already observed, stock options were once widely touted as evidence of a healthy value ethos. The standard option, however, is an imperfect vehicle for motivating long-term, value-maximizing behavior. First, standard stock options reward performance well below superior-return levels. As became painfully evident in the 1990s, in a rising market, executives realize gains from any increase in share price—even one substantially below gains reaped by their competitors or the broad market. Second, the typical vesting period of three or four years, coupled with executives’ propensity to cash out early, significantly diminishes the long-term motivation that options are intended to provide. Finally, when options are hopelessly underwater, they lose their ability to motivate at all. And that happens more frequently than is generally believed. For example, about one-third of all options held by U. S. executives were below strike prices in 1999 at the height of the bull market. But the supposed remedies—increasing cash compensation, granting restricted stock or more options, or lowering the exercise price of existing options—are shareholder-unfriendly responses that rewrite the rules in midstream.

Value-conscious companies can overcome the shortcomings of standard employee stock options by adopting either a discounted indexed-option plan or a discounted equity risk option (DERO) plan. Indexed options reward executives only if the company’s shares outperform the index of the company’s peers—not simply because the market is rising. To provide management with a continuing incentive to maximize value, companies can lower exercise prices for indexed options so that executives profit from performance levels modestly below the index. Companies can address the other shortcoming of standard options—holding periods that are too short—by extending vesting periods and requiring executives to hang on to a meaningful fraction of the equity stakes they obtain from exercising their options.
For companies unable to develop a reasonable peer index, DEROs are a suitable alternative. The DERO exercise price rises annually by the yield to maturity on the ten-year U.S. Treasury note plus a fraction of the expected equity risk premium minus dividends paid to the holders of the underlying shares. Equity investors expect a minimum return consisting of the risk-free rate plus the equity risk premium. But this threshold level of performance may cause many executives to hold underwater options. By incorporating only a fraction of the estimated equity risk premium into the exercise price growth rate, a board is betting that the value added by management will more than offset the costlier options granted. Dividends are deducted from the exercise price to remove the incentive for companies to hold back dividends when they have no value-creating investment opportunities.

Principle 7.

Reward operating-unit executives for adding superior multiyear value.
While properly structured stock options are useful for corporate executives, whose mandate is to raise the performance of the company as a whole—and thus, ultimately, the stock price—such options are usually inappropriate for rewarding operating-unit executives, who have a limited impact on overall performance. A stock price that declines because of disappointing performance in other parts of the company may unfairly penalize the executives of the operating units that are doing exceptionally well. Alternatively, if an operating unit does poorly but the company’s shares rise because of superior performance by other units, the executives of that unit will enjoy an unearned windfall. In neither case do option grants motivate executives to create long-term value. Only when a company’s operating units are truly interdependent can the share price serve as a fair and useful indicator of operating performance.

Companies typically have both annual and long-term (most often three-year) incentive plans that reward operating executives for exceeding goals for financial metrics, such as revenue and operating income, and sometimes for beating nonfinancial targets as well. The trouble is that linking bonuses to the budgeting process induces managers to lowball performance possibilities. More important, the usual earnings and other accounting metrics, particularly when used as quarterly and annual measures, are not reliably linked to the long-term cash flows that produce shareholder value.
To create incentives for an operating unit, companies need to develop metrics such as shareholder value added (SVA). To calculate SVA, apply standard discounting techniques to forecasted operating cash flows that are driven by sales growth and operating margins, then subtract the investments made during the period. Because SVA is based entirely on cash flows, it does not introduce accounting distortions, which gives it a clear advantage over traditional measures. To ensure that the metric captures long-term performance, companies should extend the performance evaluation period to at least, say, a rolling three-year cycle. The program can then retain a portion of the incentive payouts to cover possible future underperformance. This approach eliminates the need for two plans by combining the annual and long-term incentive plans into one. Instead of setting budget-based thresholds for incentive compensation, companies can develop standards for superior year-to-year performance improvement, peer benchmarking, and even performance expectations implied by the share price.

to be continued part 3.

July 25, 2020

How to Create a Profitable Property Portfolio

How to Build a Diversified Portfolio.

“Don’t put all your eggs in one basket” is sound advice in life as well as in finance. Diversifying an investment portfolio can help cushion the ups and downs of the market and the broader economy. You can diversify by investing simultaneously in different asset classes. These classes include stocks (or "equities”), bonds, the money market, commodities, precious metals, real estate, gemstones, fine art and any of several other valuable assets. Because most growth in wealth comes from owning stock, equities also represent the most risk in a portfolio, so you will want to diversify your stock holdings. The following article presents a number of commonly acknowledged steps in building wealth through a diversified investment portfolio.

Method 1 Diversifying in Stocks.
1. Invest in many different companies. When you buy stock, you buy a share of the ownership of a company. You can buy stock in individual companies by using an online broker, such as E-Trade, Charles Schwab or TD Ameritrade (among many others). Do not, however, commit a large portion of your money to any single company. If such a company were to get in trouble, you could lose most of your money.
For example, Snap Inc. received a lot of press when it went public in March 2017 with shares priced at $27. However, by the following August the stock price had fallen to $11 per share. That's a drop of about 60%, which would have really hurt someone who had invested a large amount of money at the opening price.
To avoid such a disaster, limit your investment in any one stock to 5% or (preferably) less of your total portfolio.
2. Invest in different sectors. Entire industries often rise and fall as a unit. If the price of oil surges, most oil-related stocks will rise as a group. When the price of oil dips, oil-company stocks tend to fall together. You can protect yourself against this risk by investing in several different industries or sectors of the economy.
Major sectors include technology, health care, financial services, energy, communication services, utilities and agriculture.
The industries or sectors you choose should have a low correlation to each other. That is, invest in various sectors whose stock prices tend to fall at different times. For example, technology and communication services might be too closely related. On the other hand, energy and health care are not closely related and might be expected to rise or fall separately.
3. Look at foreign stocks. As the economy in one country falters, the economy in other countries might be doing well. For this reason some experts recommend that you diversify by buying foreign stocks in addition to the domestic stocks you own.
Buying stock in multinational corporations automatically exposes you to international markets. For example, if you buy McDonald’s stock, you are already investing in foreign markets, since McDonald’s has expanded into more than 100 countries.

Method 2 Investing in Other Assets.
1. Diversify with bonds. When a company or government need to raise money, they may borrow it by issuing bonds to the public. A bond is a promise to repay borrowed money, accompanied by a certain amount of interest. Owning bonds is a good way to hedge against equity risks, because bond values tend to move in a direction opposite to stock values in general.
You can buy individual bonds or invest in a bond mutual fund. A bond fund holds a portfolio of many different corporate or government bonds. Research a fund to see how diversified its holdings are before buying shares. As with equities, bond diversification is very desirable.
Bonds are rated based on the issuer’s creditworthiness. Find bond ratings at Moody’s or Standard & Poor’s credit-rating services. A highly-rated bond will offer a lower interest rate but a higher likelihood of repayment. Choose bonds or bond funds that reflect your tolerance for risk. An aggressive investor (whose risk tolerance is high) might choose bonds with a higher interest rate but a lower safety rating.
2. Invest in U.S. Treasury bonds or bills for increased safety. U.S. Treasuries are the safest securities you can own. You lend money to the U.S. government and receive a promise for repayment. Treasury bonds often rise when the stock market falls, so they are a good way to diversify your portfolio.
3. Consider money market funds. Such a fund is similar to a savings account. The fund invests money in low-risk vehicles such as certificates of deposit and government securities. You can buy CDs and government bonds yourself, but a money market account can be more convenient, because it will do the investing for you at a nominal fee.
As an added benefit, some money market accounts let you write checks (or use a debit card) on the account. However, you will be limited in the number of withdrawals you can make per year.
4. Forget commodities. Some experts recommend diversifying by buying commodities such as oil, wheat, gold, and livestock. These commodities have no correlation to the stock market, so the value of these commodities should be unaffected if the stock market collapses. However, commodities are a poor bet if you are looking to buy and hold investments. Commodities are meant to be traded regularly and are therefore considered speculation (gambling) rather than investment.
5. Invest in real estate. One way to do this is to buy an apartment building and rent it to tenants. However, you may not have the time or energy to involve yourself in what can be a complicated endeavor. Instead you might invest in REITs, real estate investment trusts. With this option you invest in companies that own real estate. In exchange for your investment, you receive a share of the companies' income.
Many REITs charge very high fees, so they might not be the best way to diversify your portfolio.
Another option is to invest in a mutual fund that invests in REITs. This can save you a lot of research time by letting the fund managers do the research for you. You do pay for that service, of course, but it may be worth it to you if you value your time.

Method 3 Investing in Mutual and Other Funds for Diversity.
1. Diversify easily with mutual funds. A mutual fund is a portfolio operated by a fund manager. Buying into a mutual fund is a great way to diversify because each portfolio can hold multiple equities and other assets. For example, a mutual fund might hold stocks and/or bonds from 40 companies in various sectors. By buying into a fund, you can get instant diversification.
However, mutual funds are not automatically diversified. Everything depends on the assets held in the portfolio. Carefully analyze the individual holdings in the portfolio. Some mutual funds will be better diversified than others.
If you invest through an employer-sponsored plan (such as a 401k or an IRA), chances are you are investing in mutual funds.
2. Invest in an exchange traded fund (ETF). An ETF is like a mutual fund, except you buy it on a stock exchange, not from a fund. ETFs generally have lower fees than mutual funds, so they are a good option for investors.
As with mutual funds, an ETF is not automatically diversified. For example, you might buy an oil ETF, which is concentrated in one industry. Carefully analyze the underlying investments to make sure the ETF has the necessary diversity.
3. Consider an index fund. An index fund is a mutual fund designed to track an index, such as the Standard & Poor’s 500 Index or the DJ Wilshire 5000, which tracks the entire U.S. stock market. It is an easy way to get broad market exposure and thus diversify.
Remember that you want to diversify across asset classes. Don't forget bonds, Treasuries and the money market. Some funds do invest in these other assets.
Remember, too, that all mutual funds and ETFs charge fees for their service. Investigate the size of those fees before committing money. There are many good funds that charge total fees of less than 1% of your account balance, so there is no valid reason to pay more than that. If you do your research, you should be able to find funds that are properly diversified.
With respect to equities, aim to hold at least 20 stocks spread across various sectors. You can invest by picking individual stocks, or you can more easily diversify by investing in a fund that contains hundreds of stocks and/or bonds.
4. Get expert advice. Every person’s situation is different, and there’s no one right diversification approach for everyone. Instead, you should meet with a "fee-only" financial advisor who can help you analyze your situation. Look for an advisor who is a certified financial planner (CFP). To earn this designation, candidates must meet certain experience, education, and ethics standards. The advisor should also be a fiduciary, someone legally bound to work primarily in your best interests. (Just ask, "Are you a fiduciary?" If you don't get an immediate "yes" for an answer, find another advisor.)
You can find a fee-only financial advisor through the National Association of Personal Financial Advisors. A fee-only advisor is one who does not earn a commission by recommending the purchase of specific financial products.
Discuss your investment goals with your advisor. Many people invest for retirement, and what qualifies as a well constructed portfolio will change over time. As an investor gets older, they will want to increase the ratio of bonds to stocks in their portfolio in order to diminish risk. (Some mutual funds can do that for you automatically.)

Method 4 Buying and Selling Intelligently.
1. Analyze your risk tolerance. How comfortable are you in taking financial risks? The more aggressive an investor is (the larger the rewards they hope to achieve), the larger the stock portion of their portfolio -- and the greater their risk tolerance -- will have to be.
A conservative portfolio might have only 20% in equities, 70% in bonds and 10% in cash and cash equivalents (including certificates of deposit, banker's acceptances, treasury bills and other money-market instruments).
A person more tolerant of risk might invest 70% in equities, 20% in bonds, and 10% in cash or cash equivalents.
2. Invest on a periodic basis. Let’s say you have $6,000 to invest in a year. If you invest all of that money at once, you might inadvertently buy into the market at a moment when equities are priced relatively high. A better option is to invest $500 a month. You would invest the same amount of money in a year's time, but as prices rise and fall, it's likely you would acquire a larger number of shares by year's end.
This type of investing is called “dollar-cost averaging,” and it allows you to take advantage of the inevitable price dips that regularly occur in the market.
3. Avoid market timing. You might dream of getting into the stock market at a price bottom and then selling at a peak. Many people who try to "time" the market in this way end up losing money, because recognizing a market peak or bottom isn't possible until after the fact.
4. Choose appropriate assets based on when you plan to withdraw investment income. For example, if you have 40 years before you plan on retiring, you can ride out peaks and valleys in the stock market. There’s less reason to worry if the market falls when you are in your 30s, because you have plenty of time to recoup your losses. A younger person can afford to be more aggressive in their investing than an older person.
5. Rebalance your portfolio when necessary. Building a diverse portfolio is not a one-time event. Instead, you may need to rebalance your portfolio periodically. Review your investments once a year, and see if they still align with your investment goals.
You might need to rebalance if some assets outperform others. For example, your equities might be on a hot streak for six years. Although they were 50% of your portfolio when you started investing, they now make up 70% through price appreciation. Assuming you still want stocks to form 50% of your portfolio, you’ll need to sell some stocks and replace them with bonds or other assets in order to maintain your preferred ratio.
Rebalancing might trigger tax consequences or transaction fees. Carefully analyze the process with your financial advisor before going ahead.
If you invest through a "balanced" mutual fund, they will typically do this rebalancing for you automatically. (A "balanced" fund invests in both stocks and bonds.)

Warnings.

Diversification can manage risk, but it cannot completely eliminate it. Diversification won’t save you if the entire market goes into a tailspin, as it did in 2008 and 2009. Nonetheless, diversifying is a critically important tool for all investors

April 01, 2020

How the Blockchain Will Impact the Financial Sector

How the Blockchain Will Impact the Financial Sector.

Cryptocurrencies and their underlying blockchain technology are being touted as the next-big-thing after the creation of the internet. One area where these technologies are likely to have a major impact is the financial sector. The blockchain, as a form of distributed ledger technology (DLT), has the potential to transform well-established financial institutions and bring lower costs, faster execution of transactions, improved transparency, auditability of operations, and other benefits. Cryptocurrencies hold the promise of a new native digital asset class without a central authority.

So what do these technological developments mean for the various players in the sector and end users? “Blockchains have the potential to displace any business activity built on transactions occurring on traditional corporate databases, which is what underlies nearly every financial service function. Any financial operation that has low transparency and limited traceability is vulnerable to disruption by blockchain applications. DLT is therefore both a great opportunity and also a disruptive threat,” according to Bruce Weber, dean of Lerner College and business administration professor, and Andrew Novocin, professor of electrical and computer engineering, both at the University of Delaware.

Earlier this year, Weber, Novocin, and graduate student Jonathan Wood conducted a literature review on cryptocurrencies and DLT for the SWIFT Institute. Based on this review, the SWIFT institute recently issued a grant to conduct new research on DLT and cryptocurrencies in the financial sector. Weber and Novocin noted that just as disruptors like Amazon, Google, Facebook and Uber built software platforms and thriving businesses thanks to the connectivity provided by internet standards, next-generation startups will build new services and businesses with blockchains. “Many pundits expect blockchain, as a distributed technology, to become the foundation for new services and applications that have completely different rules from those running on hierarchical and controlled databases. Cryptocurrencies are an early example but many others will follow,” they added.

Kartik Hosanagar, a Wharton professor of marketing and operations, information and decisions, pointed out that the financial services sector is full of intermediaries such as banks that help create trust among transacting parties like lenders and borrowers. Blockchain, he said, is a mechanism to create trust without centralized control. “The power of eliminating intermediaries is the ability to lower transaction costs and take back control from powerful financial intermediaries.”

Regarding cryptocurrencies, Hosanagar pointed out that most of the value today is tied to speculative buying rather than actual use cases. But having a currency without a central authority offers “certain unique kinds of protections especially in countries with troubled central banks.” For example, Venezuela’s currency is rapidly losing value. For people who stored their savings in crypto, there was greater protection against such rapid currency devaluations. “Of course, cryptocurrencies have their own instabilities, but they aren’t tied to actions by central banks and that’s particularly relevant in countries and economies where citizens don’t trust their governments and central banks,” he said.

“Any financial operation that has low transparency and limited traceability is vulnerable to disruption by blockchain applications.”–Bruce Weber and Andrew Novocin

Hosanagar expects the first wave of applications to be rolled out in “private” blockchains where a central authority such as a financial institution and its partners are the only ones with the permission to participate (as opposed to public, permissionless blockchains where participants are anonymous and there is no central authority). Applications in the private blockchains, he said, will be more secure and will offer some of the benefits of decentralized ledgers but will not be radically different from the way things work at present. However, over time, he expects smart contracts (self-executing contracts when requirements are met) to be offered on public blockchain networks like Ethereum. “When securities are traded, intermediaries provide trust, and they charge commissions. Blockchains can help provide such trust in a low-cost manner. But trade of securities is governed by securities laws. Smart contracts offer a way to ensure compliance with the laws. They have great potential because of their ability to reduce costs while being compliant,” says Hosanagar.

According to Weber and Novocin, one area ripe for transformation is reaching consensus on important benchmark rates and prices. At present, they point out, different proprietary indexes are used to determine interest rates and the price of many mainstream assets. Blockchain can transform this. “Think of the London Interbank Offered Rate (LIBOR) and the recent scandals involving manipulation of benchmark values when they are controlled by a single entity that may not be capable of detecting false or fraudulent data. Blockchain could provide greater transparency around the process of creating agreed upon reference prices, and allow more people to participate in the consensus process.”

Weber and Novocin expect that in some areas intermediaries will find their roles reduced as blockchain allows for automation through greater transparency and traceability. In other areas, intermediaries will find themselves well-placed to take advantage of changing needs of their clients, as firms will need help to manage the shift to new standards as well as the greater complexity of open and traceable blockchain infrastructure. Intermediaries in areas that could potentially be disrupted, they said, “should get involved with projects seeking to set the standards, so that they can stay informed and position themselves to profit from becoming the leaders in the operations of the new markets that will emerge.”

Kevin Werbach, Wharton professor of legal studies and business ethics, and author of a forthcoming book The Blockchain and the New Architecture of Trust, said that it’s usually not helpful to focus on what aspects of a major existing market will be “transformed” or “disrupted” by new technologies. Important technologies, he said, are far more likely to be integrated into the system than replace it. According to Werbach, while some firms will fail to make the transition and some new ones will take hold, “over the long-run, virtually every historic innovation that eliminated some forms of intermediation also created new forms.”

Blockchain will reduce the massive duplication of information that creates delays, conflicts and confusion in many aspects of financial services, Werbach added. For example, when a syndicate of lenders participates in a loan, having one shared ledger means they don’t all need to keep track of it independently. International payments and corporate stock records are other examples where there are huge inefficiencies due to duplicate record-keeping and intermediaries. “End users won’t see the changes in the deep plumbing of financial services, but it will allow new service providers to emerge and new products to be offered,” said Werbach.

Bumps Along the Way

Angela Walch, professor of law at St. Mary’s University School of Law and a research fellow at the Centre for Blockchain Technologies at University College London, offered another perspective. She said there is a lot of excitement about blockchain as a distributed ledger technology for the financial sector because many believe that it offers a better, more efficient and more resilient form of recordkeeping. However, making use of the blockchain is not as simple as just buying new software and running it. “Blockchain technology is, at core, group recordkeeping. To reap its full benefits, one needs all the relevant members of the group to join the system. This requires collaboration with and across businesses, which is a potentially big hurdle, and may be the hurdle that most limits adoption.”

Governance is the biggest challenge in decentralized organizations, said Weber and Novocin. Members participating in a blockchain-supported financial function may have misaligned incentives, and can end up in gridlock, or with a chaotic outcome. They cite the example of the ‘DAO Hack,’ which was the first prominent smart contract project on the Ethereum network to suffer a large loss of funds. The Ethereum community voted to conduct a hard fork (a radical change to the protocol that makes previously invalid blocks/transactions valid or vice-versa) — reversing the transactions after the hack and essentially refunding the DAO investors. This was in effect a breach of Ethereum’s immutability and it left a sizeable minority of the community bitterly dissatisfied. This group viewed the Ethereum community as forsaking its commitment to immutable, permanent records. They refused to acknowledge the hard fork, and maintained the original Ethereum blockchain, now known as Ethereum Classic (whereas the forked version supported by the Ethereum Foundation is simply Ethereum).

“The power of eliminating intermediaries is the ability to lower transaction costs and take back control from powerful financial intermediaries.”–Kartik Hosanagar

“Distributed organizations serving an open community need to take care to design their governance systems, incentive structures and decision-making processes to create consensus without unduly slowing down the decision-making,” said Weber and Novocin. “Scenario planning or war gaming are worth exploring at the beginning of blockchain projects. Forward planning enables organizations to swiftly respond in a predictable way that is supportive of stakeholders. Publicizing these plans in advance can also build trust and user confidence.”

Cryptocurrency Risks.

Werbach listed a variety of risks and vulnerabilities related to cryptocurrencies: Bitcoin has shown that the fundamental security of its proof-of-work system is sound, but it has major limitations such as limited scalability, massive energy usage and concentration of mining pools. There has been massive theft of cryptocurrencies from the centralized intermediaries that most people use to hold it, and massive fraud by promoters of initial coin offerings and other schemes. Manipulation is widespread on lightly-regulated cryptocurrency exchanges.

For example, roughly half of Bitcoin transactions are with Tether, a “stablecoin” that claims to be backed by U.S. dollars but has never been audited and is involved in highly suspicious behavior. Money laundering and other criminal activity is a serious problem if transactions do not require some check of real-world identities. “There are major efforts to address all of these risks and vulnerabilities. Some are technical, some are business opportunities, and some are regulatory questions. There must be recognition among cryptocurrency proponents that maturation of the industry will require cooperation in many cases with incumbents and regulators,” added Werbach.

Hosanagar cautions that while decentralization offers significant value — and a significant number of miners/validators must verify the transaction for it to be validated — it is still susceptible to collusion. If one or a few companies running lots of miners/validators in a small network collude, they can affect the sanctity of the network. The big risk with cryptocurrencies, he added, is that most activity as of today is ultimately tied to speculation. It’s important for cryptocurrencies to discover a “killer app soon so there is some underlying value created beyond speculation of its future value,” Hosanagar concludes.

The Way Ahead?

Given all these challenges, what is the current mindset in the financial sector towards adopting these new technologies? And, importantly, should one push for wide acceptance and deployment, or is there need for them to stabilize first?

According to Werbach, “It’s not an either-or” choice. Cryptocurrencies and blockchain technology in general, he noted, are immature currently. However, there are some areas where they are already able to be deployed effectively. The best way to work through today’s problems, is “to build working systems and see where difficulties arise,” Werbach said. Looking ahead, integration with law, regulation and governance will be critical. Blockchain and cryptocurrencies represent a new form of trust, he added. They will only succeed if they become sufficiently trustworthy, beyond the basic security of the distributed ledgers. “Law, regulation and governance are three major mechanisms to produce trustworthy systems that scale up to society-wide adoption. We need to find ways to address the legitimate concerns of governments without overly restricting the innovations that blockchain technology enables. I’m optimistic about that process over time.”

“We need to find ways to address the legitimate concerns of governments without overly restricting the innovations that blockchain technology enables.”–Kevin Werbach

Walch noted that while there are claims that some consortia are putting ‘blockchain’ systems into production, in many cases it appears that what they are calling a blockchain bears little to no resemblance to the original blockchain technology behind Bitcoin. In many instances, she said, existing shared databases are being called ‘blockchain’ for marketing purposes. “If people do use something they call DLT or blockchain technology in important financial systems, my hope is that they make the decision based on actual capabilities of the tech rather than its widely hyped and generally overstated capabilities,” Walch said. “Permissioned blockchains, which are the variation most likely to be used for financial systems recordkeeping, are very different from public blockchains like Bitcoin or Ethereum. I hope that a more modest and accurate understanding of the actual characteristics of permissioned blockchains sinks in before they are widely adopted.”

Regarding cryptocurrencies or cryptoassets, Walch said that the financial sector’s interest is “less about recordkeeping and more about a new financial asset that it can make money off of.” She pointed out that at present there is no clarity on how power and accountability work in these systems. The ongoing operation of crypto systems and the value they embed and support is reliant on the competence of, and ethical behavior by, unaccountable software developers and validators. “The financial sector believes it understands and can manage the risks of cryptoassets, but I am less certain and worry that hubris and greed are driving the push to create cryptoassets as a real asset class. This has been a bad mixture in the past,” says Walch. “I think it would be more responsible to let cryptosystems exist on their own for a while longer to let more of the kinks get worked out — if they can be; I’m not sure the governance ones can — rather than to rapidly integrate them into the financial system as we seem to be doing.”

“I … worry that hubris and greed are driving the push to create cryptoassets as a real asset class.”–Angela Walch

Conversely, Weber and Novocin feel that the financial industry is cautious about the new DLT technology. According to them, to build confidence in new blockchain systems there needs to be transparency around how the processes work and what the benefits are, and in order to secure adoption, they need to be straightforward to use. “Pundits have drawn parallels to the open source Linux operating system. Although only a few individuals use Linux directly, it quietly runs the vast majority of servers and cloud processors across the world. Similarly, early adoption of blockchain will likely happen in the background of business processes. Companies should get involved now, even if it is just to experiment with the concepts. By gaining familiarity with these new tools, they will be ready as the space continues to develop.”

Weber and Novocin expect that in the next few years, many more businesses will implement private blockchains to improve the transparency and traceability of their financial operations, supply chains, inventory management systems and other internal business systems. Clearer standards will be adopted and a few high-profile projects will emerge. Meanwhile, they said, R&D will continue among the many decentralized blockchain projects to invent more scalable public ledgers whether it be blockchain, Tangle, Hashgraph or something new. “Work is needed on better and more efficient consensus models, whether it be a new form of proof-of-stake or proof-of-work, or something else. There are many established groups, startups, companies and research teams that organizations can join, partner with, or support in order to contribute to research and expand their capabilities.”

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July 16, 2020

How Bitcoin Disrupts the Finance Industry

How Bitcoin Disrupts the Finance Industry .

Bumps Along the Way

Angela Walch, professor of law at St. Mary’s University School of Law and a research fellow at the Centre for Blockchain Technologies at University College London, offered another perspective. She said there is a lot of excitement about blockchain as a distributed ledger technology for the financial sector because many believe that it offers a better, more efficient and more resilient form of recordkeeping. However, making use of the blockchain is not as simple as just buying new software and running it. “Blockchain technology is, at core, group recordkeeping. To reap its full benefits, one needs all the relevant members of the group to join the system. This requires collaboration with and across businesses, which is a potentially big hurdle, and may be the hurdle that most limits adoption.”

Governance is the biggest challenge in decentralized organizations, said Weber and Novocin. Members participating in a blockchain-supported financial function may have misaligned incentives, and can end up in gridlock, or with a chaotic outcome. They cite the example of the ‘DAO Hack,’ which was the first prominent smart contract project on the Ethereum network to suffer a large loss of funds. The Ethereum community voted to conduct a hard fork (a radical change to the protocol that makes previously invalid blocks/transactions valid or vice-versa) — reversing the transactions after the hack and essentially refunding the DAO investors. This was in effect a breach of Ethereum’s immutability and it left a sizeable minority of the community bitterly dissatisfied. This group viewed the Ethereum community as forsaking its commitment to immutable, permanent records. They refused to acknowledge the hard fork, and maintained the original Ethereum blockchain, now known as Ethereum Classic (whereas the forked version supported by the Ethereum Foundation is simply Ethereum).

“The power of eliminating intermediaries is the ability to lower transaction costs and take back control from powerful financial intermediaries.”–Kartik Hosanagar

“Distributed organizations serving an open community need to take care to design their governance systems, incentive structures and decision-making processes to create consensus without unduly slowing down the decision-making,” said Weber and Novocin. “Scenario planning or war gaming are worth exploring at the beginning of blockchain projects. Forward planning enables organizations to swiftly respond in a predictable way that is supportive of stakeholders. Publicizing these plans in advance can also build trust and user confidence.”

Cryptocurrency Risks.

The Way Ahead?

July 16, 2020

Ten Ways to Create Shareholder Value (part 1).

by Alfred Rappaport.

It’s become fashionable to blame the pursuit of shareholder value for the ills besetting corporate America: managers and investors obsessed with next quarter’s results, failure to invest in long-term growth, and even the accounting scandals that have grabbed headlines. When executives destroy the value they are supposed to be creating, they almost always claim that stock market pressure made them do it.

The reality is that the shareholder value principle has not failed management; rather, it is management that has betrayed the principle. In the 1990s, for example, many companies introduced stock options as a major component of executive compensation. The idea was to align the interests of management with those of shareholders. But the generous distribution of options largely failed to motivate value-friendly behavior because their design almost guaranteed that they would produce the opposite result. To start with, relatively short vesting periods, combined with a belief that short-term earnings fuel stock prices, encouraged executives to manage earnings, exercise their options early, and cash out opportunistically. The common practice of accelerating the vesting date for a CEO’s options at retirement added yet another incentive to focus on short-term performance.

Of course, these shortcomings were obscured during much of that decade, and corporate governance took a backseat as investors watched stock prices rise at a double-digit clip. The climate changed dramatically in the new millennium, however, as accounting scandals and a steep stock market decline triggered a rash of corporate collapses. The ensuing erosion of public trust prompted a swift regulatory response—most notably, the 2002 passage of the Sarbanes-Oxley Act (SOX), which requires companies to institute elaborate internal controls and makes corporate executives directly accountable for the accuracy of financial statements. Nonetheless, despite SOX and other measures, the focus on short-term performance persists.

In their defense, some executives contend that they have no choice but to adopt a short-term orientation, given that the average holding period for stocks in professionally managed funds has dropped from about seven years in the 1960s to less than one year today. Why consider the interests of long-term shareholders when there are none? This reasoning is deeply flawed. What matters is not investor holding periods but rather the market’s valuation horizon—the number of years of expected cash flows required to justify the stock price. While investors may focus unduly on near-term goals and hold shares for a relatively short time, stock prices reflect the market’s long view. Studies suggest that it takes more than ten years of value-creating cash flows to justify the stock prices of most companies. Management’s responsibility, therefore, is to deliver those flows—that is, to pursue long-term value maximization regardless of the mix of high- and low-turnover shareholders. And no one could reasonably argue that an absence of long-term shareholders gives management the license to maximize short-term performance and risk endangering the company’s future. The competitive landscape, not the shareholder list, should shape business strategies.

The competitive landscape, not the shareholder list, should shape business strategies.

What do companies have to do if they are to be serious about creating value? In this article, I draw on my research and several decades of consulting experience to set out ten basic governance principles for value creation that collectively will help any company with a sound, well-executed business model to better realize its potential for creating shareholder value. Though the principles will not surprise readers, applying some of them calls for practices that run deeply counter to prevailing norms. I should point out that no company—with the possible exception of Berkshire Hathaway—gets anywhere near to implementing all these principles. That’s a pity for investors because, as CEO Warren Buffett’s fellow shareholders have found, there’s a lot to be gained from owning shares in what I call a level 10 company—one that applies all ten principles. (For more on Berkshire Hathaway’s application of the ten principles, please read my colleague Michael Mauboussin’s analysis in the sidebar “Approaching Level 10: The Story of Berkshire Hathaway.”).

Principle 1.

Do not manage earnings or provide earnings guidance.
Companies that fail to embrace this first principle of shareholder value will almost certainly be unable to follow the rest. Unfortunately, that rules out most corporations because virtually all public companies play the earnings expectations game. A 2006 National Investor Relations Institute study found that 66% of 654 surveyed companies provide regular profit guidance to Wall Street analysts. A 2005 survey of 401 financial executives by Duke University’s John Graham and Campbell R. Harvey, and University of Washington’s Shivaram Rajgopal, reveals that companies manage earnings with more than just accounting gimmicks: A startling 80% of respondents said they would decrease value-creating spending on research and development, advertising, maintenance, and hiring in order to meet earnings benchmarks. More than half the executives would delay a new project even if it entailed sacrificing value.

What’s so bad about focusing on earnings? First, the accountant’s bottom line approximates neither a company’s value nor its change in value over the reporting period. Second, organizations compromise value when they invest at rates below the cost of capital (overinvestment) or forgo investment in value-creating opportunities (underinvestment) in an attempt to boost short-term earnings. Third, the practice of reporting rosy earnings via value-destroying operating decisions or by stretching permissible accounting to the limit eventually catches up with companies. Those that can no longer meet investor expectations end up destroying a substantial portion, if not all, of their market value. WorldCom, Enron, and Nortel Networks are notable examples.

Principle 2.

Make strategic decisions that maximize expected value, even at the expense of lowering near-term earnings.
Companies that manage earnings are almost bound to break this second cardinal principle. Indeed, most companies evaluate and compare strategic decisions in terms of the estimated impact on reported earnings when they should be measuring against the expected incremental value of future cash flows instead. Expected value is the weighted average value for a range of plausible scenarios. (To calculate it, multiply the value added for each scenario by the probability that that scenario will materialize, then sum up the results.) A sound strategic analysis by a company’s operating units should produce informed responses to three questions: First, how do alternative strategies affect value? Second, which strategy is most likely to create the greatest value? Third, for the selected strategy, how sensitive is the value of the most likely scenario to potential shifts in competitive dynamics and assumptions about technology life cycles, the regulatory environment, and other relevant variables?

At the corporate level, executives must also address three questions: Do any of the operating units have sufficient value-creation potential to warrant additional capital? Which units have limited potential and therefore should be candidates for restructuring or divestiture? And what mix of investments in operating units is likely to produce the most overall value?

Principle 3.

Make acquisitions that maximize expected value, even at the expense of lowering near-term earnings.
Companies typically create most of their value through day-to-day operations, but a major acquisition can create or destroy value faster than any other corporate activity. With record levels of cash and relatively low debt levels, companies increasingly use mergers and acquisitions to improve their competitive positions: M&A announcements worldwide exceeded $2.7 trillion in 2005.

Companies (even those that follow Principle 2 in other respects) and their investment bankers usually consider price/earnings multiples for comparable acquisitions and the immediate impact of earnings per share (EPS) to assess the attractiveness of a deal. They view EPS accretion as good news and its dilution as bad news. When it comes to exchange-of-shares mergers, a narrow focus on EPS poses an additional problem on top of the normal shortcomings of earnings. Whenever the acquiring company’s price/earnings multiple is greater than the selling company’s multiple, EPS rises. The inverse is also true. If the acquiring company’s multiple is lower than the selling company’s multiple, earnings per share decline. In neither case does EPS tell us anything about the deal’s long-term potential to add value.

Sound decisions about M&A deals are based on their prospects for creating value, not on their immediate EPS impact, and this is the foundation for the third principle of value creation. Management needs to identify clearly where, when, and how it can accomplish real performance gains by estimating the present value of the resulting incremental cash flows and then subtracting the acquisition premium.

Value-oriented managements and boards also carefully evaluate the risk that anticipated synergies may not materialize. They recognize the challenge of postmerger integration and the likelihood that competitors will not stand idly by while the acquiring company attempts to generate synergies at their expense. If it is financially feasible, acquiring companies confident of achieving synergies greater than the premium will pay cash so that their shareholders will not have to give up any anticipated merger gains to the selling companies’ shareholders. If management is uncertain whether the deal will generate synergies, it can hedge its bets by offering stock. This reduces potential losses for the acquiring company’s shareholders by diluting their ownership interest in the postmerger company.

to be continued part 2.

July 25, 2020

How to Build a Stock Portfolio

How to Build a Stock Portfolio.

The stock market and its potential for risk intimidates many people. Nonetheless, a well-built stock portfolio is likely to outperform other investments over time. It is possible to build a stock portfolio alone, but a qualified financial planner can help. Knowing your goals and your willingness to take risks in advance, as well as understanding the nature of the market, can help you build a successful portfolio.

Part 1 Designing Your Portfolio.
1. Know what you're willing to invest. As you invest, you'll need to balance your potential risks against your potential rewards. A portfolio's assets are typically determined by the investor's goals, willingness to take risks, and the length of time the investor intends to hold his portfolio. Some of the most important factors to consider in making these decisions are:
The investor's age.
How much time the investor is willing to spend allowing his investments to grow.
Amount of capital the investor is willing to invest.
Projected capital needs for the future.
Other resources investor may have.
2. Decide what kind of investor you'll be. Portfolios usually fall somewhere in the spectrum between aggressive, or high-risk portfolios, and conservative, or low-risk portfolios. Conservative investors simply try to protect and maintain the value of a portfolio, while aggressive investors tend to take risks with the expectation that some of those risks will pay off. There are various online risk assessment tools you can utilize to help assess your risk tolerance.
Understand that your financial goals may change over time, and adjust your portfolio accordingly. Generally, the younger you are, the more risk you can afford or are willing to take. You may be better served with a growth-oriented portfolio. The older you become, the more you'll think about retirement income, and may be better served with an income-oriented portfolio.
Even during retirement, many still need some portion of their portfolio for growth, as many people are living 20, 30 or more years beyond their retirement date.
3. Divide your capital. Once you've decided what kind of investor you'd like to be and what type of portfolio you want to build, you'll need to determine how you intend to allocate (spread around) your capital. Most investors who are new to the market don't know how to pick stocks. Some important factors include:
Determining which sector(s) to invest in. A sector is the category a given industry is placed in.[8] Examples include telecommunications, financial, information technology, transportation and utilities.
Knowing the market capitalization (aka market cap), which is determined by multiplying a given company's outstanding shares by the current price of one share on the market (large-cap, mid-cap, small-cap, etc.).
It is important to diversify holdings across a variety of sectors and market capitalization to lower a portfolio's overall risk.

Part 2 Making Investments.
1. Understand the different kinds of stocks. Stocks represent an ownership stake in the company that issues them. The money generated from the sale of stock is used by the company for its capital projects, and the profits generated by the company's operation may be returned to investors in the form of dividends. Stocks come in two varieties: common and preferred. Preferred stocks are so called because holders of these stocks are paid dividends before owners of common stocks. Most stocks, however, are common stocks, which can be subdivided into the categories below:
Growth stocks are those projected to increase in value faster than the rest of the market, based on their prior performance record. They may entail more risk over time but offer greater potential rewards in the end.
Income stocks are those that do not fluctuate much but have a history of paying out better dividends than other stocks. This category can include both common and preferred stocks.
Value stocks are those that are "undervalued" by the market and can be purchased at a price lower than the underlying worth of the company would suggest. The theory is that when the market "comes to its senses," the owner of such a stock would stand to make a lot of money.
Blue-chip stocks are those that have performed well for a long enough period of time that they are considered fairly stable investments. They may not grow as rapidly as growth stocks or pay as well as income stocks, but they can be depended upon for steady growth or steady income. They are not, however, immune from the fortunes of the market.
Defensive stocks are shares in companies whose products and services people buy, no matter what the economy is doing. They include the stocks of food and beverage companies, pharmaceutical companies and utilities (among others).
Cyclical stocks, in contrast, rise and fall with the economy. They include stocks in such industries as airlines, chemicals, home building and steel manufacturers.
Speculative stocks include the offerings of young companies with new technologies and older companies with new executive talent. They draw investors looking for something new or a way to beat the market. The performance of these stocks is especially unpredictable, and they are sometimes considered to be a high-risk investment.
2. Analyze stock fundamentals. Fundamentals is the term given to the pool of qualitative and quantitative data that are used to determine whether or not a stock is a worthwhile investment in a long-term analysis of the market. Analyzing a company's fundamentals is usually the first step in determining whether or not an investor will buy shares in that company. It is imperative to analyze fundamentals in order to arrive at a company's intrinsic value - that is, the company's actual value as based on perception of all the tangible and intangible aspects of the business, beyond the current market value.
In analyzing the fundamentals of a company, the investor is trying to determine the future value of a company, with all of its projected profits and losses factored in.
3. Analyze qualitative factors. Qualitative factors, such as the expertise and experience of a company's management, various courses of industry cycles, the strength of a company's research and development incentives, and a company's relationship with its workers, are important to take into account when deciding whether or not to invest in a company's stock. It's also important to understand how the company generates its profits and what that company's business model look like in order to have a broad spectrum of qualitative information about that company's stock options.
Try researching companies online before you invest. You should be able to find information about the company's managers, CEO, and board of directors.
4. Look at the price-to-earnings ratio. The P/E ratio can be figured as either the stock's current price against its earnings per share for the last 12 months ("trailing P/E") or its projected earnings for the next 12 months ("anticipated P/E"). A stock selling for $10 per share that earns 10 cents per share has a P/E ratio of 10 divided by 0.1 or 100; a stock selling for $50 per share that earns $2 per share has a P/E ratio of 50 divided by 2 or 25. You want to buy stock with a relatively low P/E ratio.
When looking at P/E ratio, figure the ratio for the stock for several years and compare it to the P/E ratio for other companies in the same industry as well as for indexes representing the entire market, such as the Dow Jones Industrial Average or the Standard and Poor's (S&P) 500.
Comparing the P/E of a stock in one sector to that of a stock in another sector is however, not informative since P/E's vary widely from industry to industry.
5. Look at the return on equity. Also called return on book value, this figure is the company's income after taxes as a percentage of its total book value. It represents how well shareholders are profiting from the company's success. As with P/E ratio, you need to look at several years' worth of returns on equity to get an accurate picture.
6. Look at total return. Total return includes earnings from dividends as well as changes in the value of the stock. This provides a means of comparing the stock with other types of investments.
7. Try investing in companies trading below their current worth. While a broad spectrum of stock investments is important, analysts often recommend buying stock in companies that are trading for lower than they are worth. This sort of value investing does not, however, mean buying "junk" stocks, or stocks that are steadily declining. Value investments are determined by comparing intrinsic market value against the company's current stock share price, without looking at the short-term market fluctuations.
8. Try investing in growth stocks. Growth stocks are investments in companies that exhibit or are predicted to grow significantly faster than other stocks in the market. This involves analyzing a given company's present performance against its past performance amid the industry's ever-fluctuating climate.

Part 3 Maintaining Your Portfolio.
1. Avoid dipping into investments. Once you've invested capital in a stock, it's important to let the stock grow for at least a year without selling your shares. Consider for all intents and purposes that this money cannot be withdrawn and spent elsewhere.
As part of investing for the long term, determine the amount of money you can afford to commit to the stock market for five years or longer, and set that aside for investing. Money you'll need in a shorter period of time should be invested in shorter-term investments such as money-market accounts, CDs or U.S. Treasury bonds, bills or notes.
2. Diversify your portfolio. No matter how well a stock might be doing at the moment, the price and value of stocks are bound to fluctuate. Diversifying your investment portfolio can help you avoid this pitfall by spreading around your money to a number of stocks.
A well-diversified portfolio is important because in the event that one or more sectors of the economy start to decline, it will remain strong over time and reduce the likelihood of taking a significant hit as the market fluctuates.
Don't just diversify across the spectrum of asset classes. Some experts recommend you should also diversify your stock picks within each asset class represented in your portfolio.
3. Review your portfolio (but not too often). Anticipate that the market will fluctuate. If you check your stocks every day, you might end up feeling anxious over the value of your investments as things go up or down. But by the same token, you should check on your investments periodically.
Checking your portfolio at least once or twice a year is a good idea but research has shown that making rebalancing changes (selling the gains from those holdings which have been profitable and buying shares of those which have lost value) more than twice per year does not offer any benefit.
Some experts recommend checking on the quarterly earnings reports of a given company to see if your predictions for that company are holding true. Make changes as necessary, but don't jump ship every time a share reports a minor decrease in value.
Also important to keep in mind is tax implications of selling: if this is an account into which you've invested after-tax dollars (non-IRA or similar type of brokerage account), then try not to sell anything at a gain for at least one year in order to receive long-term capital gains rather than ordinary income tax treatment on your profits. For most people, the capital gains rate is more favorable than their income tax rate.

FAQ

Question : How do I create an imaginary portfolio ?
Answer : Follow these same steps without investing any money. Follow the progress of the stocks you chose.
Question : Where do I go to invest in marijuana stocks?
Answer : Ask a stockbroker who does business in an area where marijuana is legal.
Question : What does a gain or loss mean in a portfolio chart?
Answer : It refers to an increase or a decrease in the value of an investment.
Question : Which sector does better for next 3 years? In this sector, what are the names of the top 2 companies?
Answer : Anyone who tells you s/he knows what a given economic sector is going to do in the next three years is delusional. Your best bet is to invest in most or all sectors and in various companies with strong reputations.
Question : How do I calculate my returns in my diversified portfolio? And will my returns be lesser if I diversify my investments versus investing a lump sum in a single investment?
Answer : The easiest way to calculate total return on a diversified portfolio is to compare the total current value with the total value at the beginning of whatever period of time you're examining. If the value has risen, you would subtract the original value from the current value, then divide the difference by the original value. You would then multiply the quotient by 100 to get a percentage of return. Divide that percentage by the number of years you're considering to arrive at an annual percentage (which is the most commonly used percentage for the sake of comparison). Diversified portfolios often deliver better results than do single investments over a long period of time.
Question : How do I purchase stocks in South Africa?
Answer : Make online contact with any South African stockbroker registered to trade on the Johannesburg Stock Exchange. Ask if they do business with foreign investors.
Question : How do I open an account so that I can buy stocks?
Answer : Go to any local or online broker, fill out an application, and deposit some money.
Question : Will the initial money I deposit to open an account to buy or sell stocks be used toward buying or selling, or is it just the fee for opening the account?
Answer : Typically it is for buying stock. Brokers' terms may vary: some may remove part of your deposit to cover fees if you fail to pay them separately.

Tips.
Be aware of wash sale rules: if you decide to sell a stock or stock fund at a loss and buy into a stock or stock fund which is considered substantially similar within a 30-day period, you will not be able to claim that loss on your taxes.
Consult with a qualified financial planner if you're unsure of how to invest or what stocks are safe to invest in.
Be aware of tax consequences (see comments about long-term vs. short-term capital gains under "Maintaining your portfolio" above), and be aware that you will owe taxes on the dividends you earn on those stocks which pay them to you in the year they are earned, whether they were paid out to you or not.
Warnings.
Be aware that not all common stocks pay dividends. Whether a stock pays dividends should be only one factor in choosing it, not necessarily the only factor.

March 30, 2020

Value Investing Strategies. PART 1

Value Investing.

By ADAM HAYES.

What Is Value Investing?
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices—on sale.

Warren Buffett is probably the best-known value investor today, but there are many others, including Benjamin Graham (Buffet's professor and mentor), David Dodd, Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-fund manager, Seth Klarman.

KEY TAKEAWAYS.
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
Value investors actively ferret out stocks they think the stock market is underestimating.
Value investors use financial analysis, don't follow the herd, and are long-term investors of quality companies.
How Value Investing Works
The basic concept behind every-day value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale. Most folks would agree that whether you buy a new TV on sale, or at full price, you’re getting the same TV with the same screen size and picture quality.

Stocks work in a similar manner, meaning the company’s stock price can change even when the company’s value or valuation has remained the same. Stocks, like TVs, go through periods of higher and lower demand leading to price fluctuations—but that doesn't change what you’re getting for your money.

Just like savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year, savvy value investors believe stocks work the same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year such as Black Friday, and their sale prices won’t be advertised.

Value investing is the process of doing detective work to find these secret sales on stocks and buying them at a discount compared to how the market values them. In return for buying and holding these value stocks for the long-term, investors can be rewarded handsomely.

Value investing developed from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934 and was popularized in Graham's 1949 book, The Intelligent Investor.
Intrinsic Value and Value Investing
In the stock market, the equivalent of a stock being cheap or discounted is when its shares are undervalued. Value investors hope to profit from shares they perceive to be deeply discounted.

Investors use various metrics to attempt to find the valuation or intrinsic value of a stock. Intrinsic value is a combination of using financial analysis such as studying a company's financial performance, revenue, earnings, cash flow, and profit as well as fundamental factors, including the company's brand, business model, target market, and competitive advantage. Some metrics used to value a company's stock include:

Price-to-book (P/B) or book value or, which measures the value of a company's assets and compares them to the stock price. If the price is lower than the value of the assets, the stock is undervalued, assuming the company is not in financial hardship.

Price-to-earnings (P/E), which shows the company's track record for earnings to determine if the stock price is not reflecting all of the earnings or undervalued.

Free cash flow, which is the cash generated from a company's revenue or operations after the costs of expenditures have been subtracted. Free cash flow is the cash remaining after expenses have been paid, including operating expenses and large purchases called capital expenditures, which is the purchase of assets like equipment or upgrading a manufacturing plant. If a company is generating free cash flow, it'll have money left over to invest in the future of the business, pay off debt, pay dividends or rewards to shareholders, and issue share buybacks.

Of course, there are many other metrics used in the analysis, including analyzing debt, equity, sales, and revenue growth. After reviewing these metrics, the value investor can decide to purchase shares if the comparative value—the stock's current price vis-a-vis its company's intrinsic worth—is attractive enough.

Margin of Safety.
Value investors require some room for error in their estimation of value, and they often set their own "margin of safety," based on their particular risk tolerance. The margin of safety principle, one of the keys to successful value investing, is based on the premise that buying stocks at bargain prices gives you a better chance at earning a profit later when you sell them. The margin of safety also makes you less likely to lose money if the stock doesn’t perform as you had expected.

Value investors use the same sort of reasoning. If a stock is worth $100 and you buy it for $66, you’ll make a profit of $34 simply by waiting for the stock’s price to rise to the $100 true value. On top of that, the company might grow and become more valuable, giving you a chance to make even more money. If the stock’s price rises to $110, you’ll make $44 since you bought the stock on sale. If you had purchased it at its full price of $100, you would only make a $10 profit. Benjamin Graham, the father of value investing, only bought stocks when they were priced at two-thirds or less of their intrinsic value. This was the margin of safety he felt was necessary to earn the best returns while minimizing investment downside.

Markets are not Efficient.
Value investors don’t believe in the efficient-market hypothesis, which says that stock prices already take all information about a company into account, so their price always reflects their value. Instead, value investors believe that stocks may be over- or underpriced for a variety of reasons.

For example, a stock might be underpriced because the economy is performing poorly and investors are panicking and selling (as was the case during the Great Recession). Or a stock might be overpriced because investors have gotten too excited about an unproven new technology (as was the case of the dot-com bubble). Psychological biases can push a stock price up or down based on news, such as disappointing or unexpected earnings announcements, product recalls, or litigation. Stocks may also be undervalued because they trade under the radar, meaning they're inadequately covered by analysts and the media.

Don't Follow the Herd.
Value investors possess many characteristics of contrarians —they don’t follow the herd. Not only do they reject the efficient-market hypothesis, but when everyone else is buying, they’re often selling or standing back. When everyone else is selling, they’re buying or holding. Value investors don’t buy trendy stocks (because they’re typically overpriced). Instead, they invest in companies that aren’t household names if the financials check out. They also take a second look at stocks that are household names when those stocks’ prices have plummeted, believing such companies can recover from setbacks if their fundamentals remain strong and their products and services still have quality.

Value investors only care about a stock’s intrinsic value. They think about buying a stock for what it actually is: a percentage of ownership in a company. They want to own companies that they know have sound principles and sound financials, regardless of what everyone else is saying or doing.

Value Investing Requires Diligence & Patience.
Estimating the true intrinsic value of a stock involves some financial analysis but also involves a fair amount of subjectivity—meaning at times, it can be more of an art than a science. Two different investors can analyze the exact same valuation data on a company and arrive at different decisions.

Some investors, who look only at existing financials, don't put much faith in estimating future growth. Other value investors focus primarily on a company's future growth potential and estimated cash flows. And some do both: Noted value investment gurus Warren Buffett and Peter Lynch, who ran Fidelity Investment's Magellan Fund for several years are both known for analyzing financial statements and looking at valuation multiples, in order to identify cases where the market has mispriced stocks.

Despite different approaches, the underlying logic of value investing is to purchase assets for less than they are currently worth, hold them for the long-term, and profit when they return to the intrinsic value or above. It doesn't provide instant gratification. You can’t expect to buy a stock for $50 on Tuesday and sell it for $100 on Thursday. Instead, you may have to wait years before your stock investments pay off, and you will occasionally lose money. The good news is that, for most investors, long-term capital gains are taxed at a lower rate than short-term investment gains.

Like all investment strategies, you must have the patience and diligence to stick with your investment philosophy. Some stocks you might want to buy because the fundamentals are sound, but you’ll have to wait if it’s overpriced. You’ll want to buy the stock that is most attractively priced at that moment, and if no stocks meet your criteria, you'll have to sit and wait and let your cash sit idle until an opportunity arises.

One-Third.
Value investing guru Benjamin Graham argued that an undervalued stock is priced at least a third below its intrinsic value.

Why Stocks Become Undervalued.
If you don’t believe in the efficient market hypothesis, you can identify reasons why stocks might be trading below their intrinsic value. Here are a few factors that can drag a stock’s price down and make it undervalued.

Market Moves and Herd Mentality.
Sometimes people invest irrationally based on psychological biases rather than market fundamentals. When a specific stock’s price is rising or when the overall market is rising, they buy. They see that if they had invested 12 weeks ago, they could have earned 15% by now, and they develop a fear of missing out. Conversely, when a stock’s price is falling or when the overall market is declining, loss aversion compels people to sell their stocks. So instead of keeping their losses on paper and waiting for the market to change directions, they accept a certain loss by selling. Such investor behavior is so widespread that it affects the prices of individual stocks, exacerbating both upward and downward market movements creating excessive moves.

Market Crashes.
When the market reaches an unbelievable high, it usually results in a bubble. But because the levels are unsustainable, investors end up panicking, leading to a massive selloff. This results in a market crash. That's what happened in the early 2000s with the dotcom bubble, when the values of tech stocks shot up beyond what the companies were worth. We saw the same thing happened when the housing bubble burst and the market crashed in the mid-2000s.

Unnoticed and Unglamorous Stocks.
Look beyond what you're hearing in the news. You may find really great investment opportunities in undervalued stocks that may not be on people's radars like small caps or even foreign stocks. Most investors want in on the next big thing such as a technology startup instead of a boring, established consumer durables manufacturer. For example, stocks like Facebook, Apple, and Google are more likely to be affected by herd-mentality investing than conglomerates like Proctor & Gamble or Johnson & Johnson.

Bad News.
Even good companies face setbacks, such as litigation and recalls. However, just because a company experiences one negative event doesn’t mean that the company isn’t still fundamentally valuable or that its stock won’t bounce back. In other cases, there may be a segment or division that puts a dent in a company's profitability. But that can change if the company decides to dispose of or close that arm of the business.

Analysts do not have a great track record for predicting the future, and yet investors often panic and sell when a company announces earnings that are lower than analysts’ expectations. But value investors who can see beyond the downgrades and negative news can buy stock at deeper discounts because they are able to recognize a company's long-term value.

Cyclicality.
Cyclicality is defined as the fluctuations that affect a business. Companies are not immune to ups and downs in the economic cycle, whether that's seasonality and the time of year, or consumer attitudes and moods. All of this can affect profit levels and the price of a company's stock, but it doesn't affect the company's value in the long term.

July 25, 2020

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