Investing 101

December 6, 2013

Money Issues

Investing 101

Investing means you are putting your money to work in some type of asset(s) in order to generate a profit. There are plenty of ways to invest money outside of publicly traded securities, such as savings accounts, CDs, annuities, small business ventures, direct real estate holdings, etc. However, this tutorial is written for people seeking to learn more about publicly traded securities such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Before we even get started, I want to make you aware of a comprehensive financial dictionary available on Investopedia.com, in case my definitions aren’t quite clear to you.

In the author’s view, the best investments should pay you income as well as have the potential to increase in value. However, an asset with the potential to increase in value also has the potential to decrease in value. This introduces a concept known as “risk”. Dictionary.com defines risk as “exposure to the chance of injury or loss.” That definition is sufficient for understanding the risk of publicly traded securities. Sometimes, they can go down in value temporarily. Other times, they can become permanently “impaired”. For example, a bond can temporarily lose market value but still pay investors back the full face value when it matures. Other times, a bond can permanently lose value, as in the case of a default (failure to meet financial obligations) by the bond issuer. Stocks can fluctuate in value up or down but tend to move up in value over long periods. Individual stocks can also drop in value all the way to zero, for example, when a company declares bankruptcy.

There are types of investments that only pay you income, but have no chance for an increase in value (for example a bank CD). There are other investments that pay you no income, but have the chance for significant increases in value (e.g. a stock that pays no dividends). There are other investments that pay you income, fluctuate in value while you hold them, but have a set terminal value (a face value amount paid back to investors at maturity), such as corporate bonds. There are still other investments that actually cost you money while you hold them, but could increase in value with time. For example, gold held by a storage facility charges owners to store it, but could increase in value. There is also speculative real estate, or real estate bought to flip for a profit, as opposed to being leased. Such an investment would keep costing you money in the form of taxes, insurance, and maintenance, until it was sold.

Investments that both pay you income while you hold them, and have a very high likelihood of increasing in value over long periods of time would be dividend paying stocks. The author definitely has a preference for those, so please be aware of the bias.

This type of investment is working hard for you all of the time. There is considerable effort involved in choosing the right investments and monitoring them. But still, it's kind of neat to me that dividend paying stocks are earning money for you while you are sleeping or awake, working hard at your job, playing with your kids, or sitting on the john. This is why investing is different from gambling. Investing means you are putting your money to work. With gambling, you are relying solely upon random chance to provide a payoff to the money you put at risk, often with the odds being stacked against you. Wise investing means that there is a rational expectation of increasing your wealth, but it also involves some level of uncertainty. When you walk into a casino, you should rationally expect to walk out with less money. When you invest in the stock or bond market with a long term view, you should rationally expect to exit with a good bit more money.

Before we go any further, let’s make sure we understand some of the terms being used.

There are several main security types in financial markets:

1)  Stocks – stocks are also referred to as “common equities” or simply “equities”. They are claims on a corporation’s assets and earnings. In other words, they are pieces of paper (or now electronic records) that represent a fractional ownership stake in a company. Just like a deed to a house is a piece of paper that represents an ownership claim to a tangible asset, stocks represent claims on tangible assets held within a corporation, as well as future cash flows from the corporation.

2)  Bonds – represent a “debt investment”. When you buy bonds, you are loaning money to the company or government issuing the bonds. They must pay back the bonds according to the terms (also known as covenants) of the bond issue. The terms of the bond issue define things like interest rate payments (also known as coupons), including amount and timing of those payments, and the timing of repayment of the principal amount, which is also known as the “maturity date”. Bondholders have what are known as senior claims on a company’s assets, meaning they are first in line ahead of stock holders. However, their claims are only exercisable upon a default by the company. As long as a company is operating normally, paying its bills, and earning profits, the right to be rewarded with those profits falls to the shareholders.

3)  Preferred Stocks – preferred stocks have characteristics of both bonds and common stocks. That’s why they are sometimes referred to as “hybrid” instruments. If you are just starting out, don’t concern yourself with preferred stocks for the time being. We will cover them in a later lesson.

4) Options, futures, and other derivatives – if you are a beginner, you need to completely ignore these right now. Don’t even think about them. Pretend as though they don’t exist.

 

There are also many types of "investment vehicles" in financial markets. I will define a few of them:

1) Mutual funds – mutual funds are investment vehicles made up by pooling funds from many different investors for the purpose of investing in primary security types, such as stocks and bonds. Some of them also use derivatives to enhance return or hedge certain risks. Most of them have well defined strategies, and are restricted in regard to what they can or cannot buy. The argument for mutual funds is that they give small investors access to professionally managed, diversified portfolios, which would be difficult to create on one’s own with only a small amount of capital to invest. Investors purchase units, or shares, of the mutual fund, which are backed by the other securities held by the fund. The fund calculates a daily “NAV” or net asset value per share, and investors can sell or purchase shares each day at the net asset value.

The argument against actively managed mutual funds, is that typically around 80% of them underperform their benchmark indexes each year. So, investors, on average, are better off buying index funds. But actively managed mutual funds do provide a roughly 20% chance of outperforming the broader market indices. In spite of mutual fund managers typically having Ivy League MBAs and other impressive credentials, the vast majority of them fail even to match the performance of the indices. Keep that in mind when deciding whether or not you think you have a good chance, based on your own abilities, of outperforming the broader market by taking on more risk. My point is not that you can’t or shouldn’t try to do well with your investing. The point is that you need to be aware of the dangers of overconfidence as they relate to risk taking.

2) Index funds – index funds are technically a subset of mutual funds. But the differences between actively managed mutual funds and index funds are significant. An index fund provides access to diversified portfolios of the stocks and/or bonds that make up passive indexes. By the way, when I say "passive" I mean that indices are built according to pre-set rules. There is no active trading or investing strategy. There is no fund manager, no team of stock analysts making a living by taking a cut of your money every year, etc. Index funds allow investors to partake in the "passive" strategy of buying and holding many different stocks over long periods.  In the United States stock market, the major passive indexes have provided very good returns to investors over long periods. Therefore, investors who have taken the strategy of buying and holding index funds over long periods have gotten much better results, on average, than those that invested in actively managed mutual funds. The reason index funds outperform actively managed mutual funds (on average!) is because they charge investors a much lower expense rate than do actively managed funds. While no one knows for sure what the future holds, the past has been good to passive index fund investors who held onto them through all of the market ups and downs. However, there are a few downsides. Index fund investors give up any chance at outperforming the broader market. They also ignore any moral component to selecting investments. Further, there really is no opportunity for direct shareholder activism among holders of index funds, given that the fund administrator votes proxies in place of the individual investor. Further, the fund administrators cannot “vote with their feet” meaning they can’t sell a stock if they don’t like something about the corporate governance of the company. They are stuck buying and holding whatever is in the index. I will discuss index funds more in depth in a later lesson.

3) Exchange-Traded Funds (ETFs) – ETFs have become very popular over the last 10-15 years. They cover many different asset classes, and come with many varieties of strategies and trading rules now. But, they started out mostly with passive index strategies that attempt to match the returns of major, well-known indexes. Therefore, many ETFs are basically like the index funds I describe above, except that they trade and are taxed the same as stocks. So, for tax purposes, they offer a small advantage over index funds, since the investor can completely control the timing of capital gains (index funds are very passive, meaning they buy and hold most of their securities for very long periods anyway). However, especially with tax-advantaged retirement accounts, investors may still prefer index funds over ETFs as the expenses are typically a little lower. Also, you won't pay a $6-7 commission when buying or selling units in a mutual fund (depending on the broker). But, you will when buying or selling an ETF. It should also be noted that there are a lot of ETFs that carry different types of risk. An ETF such as VOO fits the bill of low cost, passive investing tied to a major index, the S&P 500. But, there are other ETFs that are designed to follow the change in certain variables or other indexes using leverage. Just ignore those when starting out.

Also, I want to note here that some investors may see all moral screening as an exercise in gnat straining morality. If that's the case for you AND you have no interest in researching and analyzing individual companies and stocks, it would be wise for you to consider building a portfolio of index funds and ETFs, and ignore all of the other types of strategies that exist. I will cover how to do that in a later lesson. However, if you already know you want to build a portfolio of passive investments such as index funds and ETFs, and are ready to do so, consider choosing Vanguard for your funds. Don't let somebody sell you on an ETF that offers a similar investment strategy as a Vanguard fund, but with fees that are, on average, almost 10 times higher than Vanguard's. Vanguard is a beacon of truth, transparency, client-first mentality, and overall integrity amidst an ocean of greed and underhanded attempts to grab people's money. No, I don't have any business relationship with Vanguard. They don't pay me anything or give me any sort of benefits to say these things. It's just my honest assessment of them.

In future articles and lessons, I will also be exploring the lowest cost options available for investors looking for morally screened mutual funds and ETFs.

 

Bonds

Bonds carry different types of risk than stocks. They primarily carry two types of risk:

1) Credit risk – credit risk is the risk of loss of principal stemming from a borrower’s failure to repay a loan. If a borrower fails to repay, a default is triggered and bondholders then start the legal process of claiming the assets of the company. Typically, bondholders recover some percentage of their original investment ranging from an average of around 60% for senior secured bonds, 40-50% for senior unsecured bonds, and 20-30% for subordinated bonds. But, recovery rates on corporate bonds can theoretically go as low as zero.

2) Interest rate risk – this refers to the risk that the market value of existing bonds will go down due to a general rise in the level of interest rates. Interest rate risk increases as maturity increases. In other words, longer dated bonds carry more interest rate risk than shorter dated bonds, all else equal.

Fixed income isn’t terribly interesting to most individual investors at the moment (12/2013) because the Federal Reserve has done a good job of making sure there is very little value to be found in the bond market right now. This also causes the valuation of stocks to rise, all else equal, as individual investors are driven away from the bond market and toward stocks.

However, bonds still have their place, even with the paltry yields available today. Bonds offer some distinct advantages over stocks. They are more appropriate for people who are already in or very near to retirement, and needing a fixed amount of income each year. If you buy a diversified portfolio of investment grade bonds and hold them until they mature, there is a low probability that you will lose money. Of course, lower risk also means lower reward. Government bonds significantly underperform (result in lower returns than) stocks over the long run. Corporate bonds also fall very short of stock returns historically, averaging 5.5% from 1926-2012. Of course, this is all backward looking, and the future is uncertain. What we can say for sure, is that the long term average return on stocks is about 9.5%, and US intermediate term corporate bonds are currently only yielding 3.2% (as of 12/5/2013). This link should show the current yield of relevant indices at any given time. This link also shows the yield available on Vanguard Bond ETFs.

Unfortunately, Wisdom’s Reward does not currently have any tools, research, commentary, etc. for those seeking to invest in bonds or fixed income mutual funds. Hopefully, we will be able to add that in the future. But for now, we are focused primarily on stocks. Again, I would point in the general direction of Vanguard funds for those who have no desire to implement moral screening for their investments. Even for the ones that do, government bond funds are available. Further, some of the corporate bond funds may not hold any investments which would make you uncomfortable. You would just have to investigate them further to find out.

 

 

Stocks

Stocks are the area in which most beginning investors are interested. Most people have some familiarity with the concept of the stock market. However, my conversations with people indicate to me that unless someone has a business degree, or has taken the time to read books or study information available on the web, they may not have a very good understanding of how the stock market actually works. I believe God allowed me to have some of those conversations with people as the idea for Wisdom’s Reward was taking shape, so that I could see the need for some basic education on the topic. I also noticed in some of those conversations, that a lack of understanding was sometimes combined with enthusiasm, which is not a good thing.

It’s probably best to illustrate with some examples. Let’s look at a couple of examples that most will find familiar. PepsiCo Inc. stock trades on the New York Stock Exchange (NYSE) under the ticker symbol, PEP. As of 12/5/2013, PEP is trading at $82.36 per share.

The Coca-Cola Company stock trades on the NYSE under the ticker symbol, KO. As of 12/5/2013, KO is changing hands on the open market for $40.12 per share.

If you just thought to yourself, “Wow, PepsiCo is worth more than double Coca-Cola company?”, don’t start trading just yet. The number of shares outstanding is a function of the original number of shares issued to the public, how many were held by insiders, how many times the stock has split, how many shares have been created in new issues, and how many have been “retired” through stock buybacks. In other words, there is no rhyme or reason that dictates the number of shares publicly traded companies have outstanding.

This is why Coca-Cola Company stock, as a whole, can be valued at more than PepsiCo despite having a lower per share price. KO has a “market cap” of roughly $177 billion whereas PEP has a market cap of roughly $126 billion. The market capitalization (“market cap” for short) of a company, is equal to the number of shares outstanding multiplied by the price per share of stock. KO has roughly 4.4 billion shares outstanding whereas PEP has only 1.5 billion.

This is why investors look at many financial metrics on a “per share” basis, such as Earnings Per Share. Dividing measures by the number of shares outstanding, or by other measures, gives us a basis for comparing the different stocks of different companies to see how they are valued relative to one another.

Now would be a good time to review some common investment terms. You need to know and understand these terms before you start reviewing and investing in stocks.

Net Income – Net Income is the accounting term for the profit of publicly traded companies. It is also commonly referred to as earnings. So, the terms “profit” “net income” and “earnings” are all used interchangeably in reference to publicly traded companies. PEP’s net income, or earnings, over the last year was $6.66 billion (because clearly, they worship Satan). I'm kidding! I couldn't resist. KO’s net income over the last year was $8.74 billion. You will sometimes see data from the last year annotated with (TTM). TTM stands for “Trailing Twelve Months”, which just alerts you that you are looking at the past 12 months numbers as opposed to the latest quarter’s results, or a forecast of future earnings.

Earnings Per Share – Net Income / The number of shares outstanding. Take a minute to calculate KO’s earnings per share. Go ahead, I’ll wait. Okay, I hope you got it right. I’m only kidding. The answer is at the bottom of this page.

Financial Statements – these refer to the quarterly and annual accounting statements of publicly traded companies, filed with the Securities and Exchange Commission, commonly referred to as the SEC (S-E-C! S-E-C! S-E-C!... wait, maybe that's a different SEC). They include the Income Statement, the Statement of Cash Flows (also known as the Cash Flow Statement), and the Balance Sheet. You can directly access these financial statements for any public company on the SEC's website here. Go there now, type PEP into the Fast Search box, and hit Search. That should have brought up this page. The 10-Q is the quarterly statement. The 10-K is the annual statement. You can just ignore the other types of filings for now. Also, don't worry about trying to read or navigate those statements for the time being. We will cover that later. For now, at least you know where to find them.  

Income Statement – this is the statement that shows revenues, expenses, and profits.

Cash Flow Statement – this is the statement that shows you how the money is flowing. It breaks cash flow into three components: Cash from Operations, Cash from Investing, and Cash from Financing. We will go over each of those in more detail in a later lesson.

Balance Sheet – this statement gives details of a company’s assets and liabilities. The difference between the two is called “Shareholder’s Equity”. It is called a balance sheet because the equation: Assets – Liabilities = Shareholder’s Equity must always be in balance.

Price to Earnings Ratio – This should be thought of as the price of a stock divided by the earnings per share of that stock. It can also be thought of as the total value (market cap) divided by last year’s profit (net income). It is a valuation measure. If you flip the PE ratio, what you get is an earnings yield. It may be best to keep a calculator handy and always convert PE ratios to an earnings yield number until you get used to thinking in terms of a PE ratio. But to further explain earnings yield, a PE ratio of 10 means that the company generated a profit last year equal to 10% of the outstanding value of the company’s stock. A PE ratio of 20 means that the company generated profits equal to 5% of the outstanding value of the company’s stock. Obviously, a lower PE ratio means that there is a higher earnings yield available on the stock, using last year’s earnings as a proxy for future earnings. So, it might seem obvious that a stock trading at a PE of 10 represents better value than a stock trading at a PE of 20.

However, the market is forward looking. Valuations are typically based more on what analysts and institutional investors believe about the earnings and dividends of a company over the next 1-3 years. Companies with high growth rates will typically trade at much higher PE ratios because the market is banking on much larger profits in the future. Companies can trade at very low PE ratios if the market is expecting that a company’s profits will go down in the future. As a relevant starting point, the historical average PE ratio of the market is 15.5. However, the market average PE fluctuates up and down and is affected by investor sentiment and expectations regarding future earnings and future rates of inflation. The PE ratio, like any other financial measure, should be considered as one of many relevant pieces of data.

In case you were wondering, currently KO’s TTM PE Ratio is 20.65. That would imply an earnings yield of 4.84%. PEP’s TTM PE Ratio is 19.20. That would imply an earnings yield of 5.21%.

Forward PE ratio – This is the price of the stock divided by a forecast of earnings per share over the next 12 months. The forecast will typically be based on the “guidance” of the company itself, or upon an analyst’s forecast, or a composite of many analysts’ forecasts.

Dividend Yield – Most companies pay out some amount of dividend payments to common shareholders each year. Commonly, companies pay out dividends on a quarterly basis, but some pay annually, and some semi-annually. Fewer still pay monthly dividends. The dividend yield typically is quoted as an “indicated yield” and will be equal to the latest dividend indicated by the company times the number of payments per year, divided by the price of the stock. So, if a company’s last quarterly dividend was $1.00 per share, or it has indicated that it expects to pay out $1.00 as a quarterly dividend payment going forward, and the price of the stock is $100 per share, the dividend yield on that stock would be 4%. As long as the dividend appears to be made regularly and appears to be “safe”, investors can expect the company to return 4% in cash on the amount they invest with the company today. Dividends are subject to change or to be eliminated at any time, but there are quite a few companies with stable, long term dividend policies and track records, such that investors can reasonably expect to continue to receive the current level of dividends, or an increased amount going forward.

Free Cash Flow – Free cash flow is measured as Cash Flow from Operations minus capital expenditures. It is just another way to try to gauge the return investors can expect from a stock. If a company is producing a lot of accounting “profit” but having to redeploy all of the cash flow from operations back into maintaining its asset base, what good is the profit? In other words, if Exxon Mobil is generating $40 billion a year in profit, and then putting $39 billion back into maintaining its equipment, purchasing new oil reserves to replace the ones being depleted, etc. then the profit isn’t doing shareholders a lot of good. If however, the company is investing in new growth opportunities that are expected to pay off well in the future, maybe the relatively low level of FCF is not a bad thing. Like any measure, it must be further scrutinized before any real value is derived from it. But, very large amounts of positive or negative free cash flow can alert you that something could be either really right or really wrong with the company, and warrant further investigation.

Free Cash Flow Yield – This is just the amount of free cash flow divided by the market cap of the company. It tells you how much free cash flow is being generated by the company as a percentage of the amount you are investing with them.

Payout Ratio – This measures the amount paid out in dividends divided by the amount of profit a company generated last year. So, if the payout ratio is 40%, that means that a company returned 40% of its profits back to shareholders in the form of dividends last year. A more forward looking payout ratio can be determined by using the most recent dividend rate and forward earnings estimates. Like all measures, it is used in different ways by different people. Some investors look for payout ratios below 60%, for example, reasoning that a company paying out only 60% of its profits has left itself a margin of safety in regard to maintaining its dividend going forward. Others may look for extremely low payout ratios in the hopes that more dividend growth is on the horizon. At the same time, a higher payout ratio means that a company prefers to reward its shareholders directly with dividends. But there is a natural limit to their ability to reward shareholders. Anything over 100% means that they aren't currently generating enough profit to cover the dividend. However, profits can fluctuate up and down in the short run such that the payout ratio can become skewed. Again, what we have is just one piece of information that should be viewed as part of a whole picture.

Debt/Equity – Leverage refers to the use of debt to increase returns to equity holders. The Debt/Equity ratio is one measure which gives you an idea of the amount of leverage being used by the company. It is defined as the total amount of long term debt divided by shareholder’s equity (either book value or market value). Obviously companies with higher debt levels carry more risk, all else equal. Companies with lower debt levels are in a better position to be able to weather the inevitable storms brought about by business cycles, competition, various risks, etc.

This concludes the Investing 101 Lesson. There will be many more lessons to come. Also be aware of the educational value in our free report What Every Christian Investor Needs to Know. It is designed to help the reader understand what scripture teaches about investing. Oh, and you should have gotten an answer of $1.99 per share for KO's EPS, based on the rounded numbers used in the article. Maybe I will be able to incorporate quizzes into future lessons. Thank you for taking the time to read!

 

 

Ready for more? Check out our second lesson here.

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