There are a variety of options out there.

This article from Investopedia provides a nice summary of nine such designations.

Not 100% complete – for example, many CFAs also work in Treasury departments as well as in product development for financial instruments – but a good place to get some general ideas for your future.

I do not think it is imperative to possess multiple designations in order to have a successful career. To me, it is what you can do that is the important thing. Practical experience is crucial.

However, when competing for jobs in today’s market, many of your fellow applicants will have more than one certification. And often these are used in initial applicant screening.

As I like to preach, always view education as an investment.

Many of these programs have significant costs. Both in terms of money and time.

When considering pursuing a designation, always do a cost-benefit analysis. Make sure that your investment will result in an appropriate payoff.

Related Posts

• CFA Results
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Whereas value investors seek companies with relatively low price-to-earnings (P/E) and price-to-book (P/B) ratios, they desire companies with high dividend yields.

Today we will look at the dividend yield.

What is Dividend Yield?

There are two ways to think about dividend yield.

First, dividend yield is an indicator of how much annual cash flow an investment generates.

If you own an investment that yields 10% per annum, you know how much cash flow you will receive each year. If you invest $100, you will receive $10 each year.

Second, the dividend yield indicates the payback period on an investment.

That is, how much time is required for repayment of your initial capital. If you invest $1000 in a company with a 10% annual dividend, you will recover your original $1000 in 10 years.

A good analytical tool if you are concerned about the safety of the investment.

Calculating the Dividend Yield

Dividend yield is calculated by taking the amount of dividends paid annually divided by the current share price.

Unless the dividend is increased or decreased by the company, the yield will be constant for existing shareholders.

For example, ABC company pays a steady $1 per year dividend. You bought 100 shares at $12 per share. Your sister bought 200 shares at $8 per share and your brother bought 500 shares at $15 per share.

You will receive $100 in dividends annually with a yield of 8.3%. Your sister will receive $200 annually. But because she bought at a lower share price, her dividend yield is 12.5%. And your brother will receive $500 in dividends each year. However, as he bought his shares at $15 each, his dividend yield is only 6.7%.

Note that some companies pay dividends in terms of percentage payouts. Do not confuse this with the yield. The dividend yield is based on the price you paid for the shares. The stated percentage dividend is based on the share’s par value at issue.

For example, Fixedco issues A Class Preferred Shares at $100 par value with a fixed 6% annual dividend. For each share you own, you receive 6% of the par value. In this example, $6.

If you purchased the shares at $150 each, you will still receive 6% of the par value, not 6% of your purchase price. You will earn $6 annually and your dividend yield will be 4%.

Dividend Yield and Share Price

Assuming a fixed dollar or fixed percentage dividend, investors’ yields will vary dependent on when they purchase the shares. Fixed rate dividends are usually seen in preferred shares.

If investors paid more than the par or issued value for the shares, their yields will be lower than the original fixed yield.

If they paid less than par or issue value, they will receive a higher yield.

We saw this in the examples above.

If the dividend paid varies over time, as is the case of most dividend paying common shares, then a shareholder’s dividend yield will also vary.

Analytical Considerations

As with price-to-earnings, investors consider dividend yields based on actual payouts (e.g. previous year, 5 year average, etc.) and on on expected future payouts.

If assessing whether to invest in shares, I suggest comparing the expected future yield against the 5 year average payout to determine any trend of increasing or decreasing the dividend.

I would also remove any extraordinary or special dividends from my comparative data.

These dividends are paid only on special occasions and are not recurring in nature. Excluding them from the analysis allows for better comparison with normal dividend payments.

I would also review the company’s dividend history.

Have prior year dividends been stable or increasing in amount? Or have there been periods when dividends were reduced or not paid? If the former, there is more comfort that future dividend streams will continue. If the latter, the risk of reduced future income rises.

Why is Dividend Yield Important?

Dividend yield calculations are important in two different areas.

Fixed Income Investing

Some investors seek investments with a steady income flow. They tend to be the more risk averse, fixed income investors.

The dividend yield of a stock allows them to compare the income stream against fixed income alternatives, such as money market or bond investments.

It also lets them review historic and expected dividend payouts to provide some comfort as to future income streams.

Finally, although locking in a (hopefully) fixed income stream, there is also the possibility for capital appreciation should the share price increase.

As with bonds, if general interest rates fall, the price of the shares should rise.

As an example, consider Prefco. When general interest rates were 4%, the unique circumstances for the company (earnings potential, competitors, industry, risk, etc.) required that they issue their preferred shares at $50, with a fixed dividend of 5%. This equates to an annual payout of $2.50.

If general interest rates decrease to 2.5%, there will be an impact on the company’s shares. Probably not an identical impact, but some change. Perhaps the appropriate yield for Prefco based on the lower interest rate is 4%.

As it is paying 5% at $50 per share, investors will buy Prefco as a value play. This will drive the share price up, until it hits $62.50. That is the price that reflects the new appropriate yield of 4% ($2.5 annual cash dividend divided into $62.50 share price).

Had a fixed income investor bought shares during the original offering, he will have an unrealized capital gain of $12.50 per share or 25%.

Value Investing

Value investors seeking capital gains also use dividend yield in their quantitative analysis.

The dividends are nice as they provide a hedge should the shares not appreciate. But the main hope for value shareholders is an increase in share price.

Value investors look for companies with relatively high dividend yields. Relative as compared to benchmark yields, including: company, competitor, industry, sector, stock market. Yields would also be compared to interest rates offered on money market instruments and bonds.

The belief is that high dividend yields results in two possible actions.

One, the high dividend yield may indicate that the share price is undervalued. Over time, the company’s fortunes will improve and the dividend yield will revert to historic lower levels relative to the benchmark employed as the share price increases.

Two, fixed income seekers will identify the high dividend yield stocks as superior investments versus lower yield alternatives.

As the fixed income investors increase demand for shares of the high yield company, the share price will rise, bringing capital gains to the value investor.

As the high dividend yield returns to a lower rate, demand slows and the share price finds equilibrium at a reasonable dividend yield. Reasonable being in line with investor demand based on expectations of the company’s future performance, ability to pay dividends, etc.

The Prefco example above illustrates this principle.

Dividend Yield Limitations

The Past is Not the Future

What transpired in the past is no guarantee of future events.

Dividends are only paid if the company has adequate free cash flow to pay shareholders.

Company expansion, new debt issues, dealing with lawsuits are all examples of activities that can erode free cash positions.

Just because a company has made payments in the past does not mean that they will continue in the future. This is especially true concerning common shares. Of less concern are preferred shares, but there is still a risk.

Note that companies do not like to slash or cancel dividends if they historically pay them out.

Investors like dividend consistency. Companies that fluctuate their payouts are less attractive to investors. This necessitates the company having to increase their dividends, when they do pay them, to entice investors to accept a risk of periods with smaller or no dividends.

High Yields Can be a Negative

Companies with high dividend yields are often mature companies with minimal opportunities for continued operational growth.

Because of the limited internal investment possibilities, these companies tend to have high dividend payout ratios.

A dividend payout ratio is the amount of dividends paid to shareholders divided by the net earnings of a company. Companies that payout all their earnings in dividends have a 100% payout ratio. Companies that pay no dividends have 0% payout ratios (100% earnings retention ratio).

High dividend payout ratios are good for those who seek dividend income, but less so for those who desire capital appreciation.

Consider a low dividend payout company, or one that does not pay any dividends.

Often these companies prefer to reinvest positive cash flow into growing the business. Purchasing new equipment, conducting research and development of new product lines, spending money to market existing products.

Investors believe that the return from cash reinvested in the company’s operations is a better investment than receiving a dividend and investing it elsewhere.

So as a value investor, you may see limited capital appreciation in a value stock if there are few opportunities for internal growth.

High Yield Indicates Value and Junk

As with low P/E or P/B ratios, high dividend yields may indicate value in a company’s shares.

But it may also indicate that the shares are worth less than previously thought by investors.

An Example of Limitations

On July 1, Junkco traded at $50 per share and had a trailing dividend yield of 4% (so its annual dividend was $2). This yield was considered reasonable as compared to industry and market averages, as well as to prevailing interest rates offered in the bond and money markets.

On July 10, Junkco announced that it lost a key sales contract that provided 85% of its annual revenue. With no replacement sales available, the share price plunged to $20.

Not good for the company, but great for the dividend yield as it rose to 10%. Significantly higher than benchmark comparisons.

But does this make the company a value play?

If Junkco cannot replace the lost 85% of total revenue, then earnings and cash flow will both suffer. Junkco may survive this much lost revenue in the short term, but over the long run they will need to scale back their operations or face bankruptcy.

Without new sources of revenue, Junkco is definitely not a value stock.

The same warning applies to fixed income investors.

If the original 4% yield was considered reasonable, then at 10% Junkco should be very attractive for dividend seekers.

And if Junkco can replace their revenues, it might be a great deal.

But if they cannot, even in the short term, I would expect Junkco to cancel or severely reduce their dividends. If Junkco reduces the dividend from $2 to$0.50, that would lower the dividend yield to 2.5%. Not a good deal versus the old yield of 4%. And if they cancel the dividend due to lack of cash, that would be even worse for fixed income investors.

Final Thoughts

All quantitative analysis – P/E, P/B, and dividend yield – can be a good indicator of a value investment. But they can also lead investors to see poor investments as having value.

You always need to do qualitative analysis to separate the good from the bad. To put the numbers into their proper context.

Try not to ignore the soft side of the analysis and only focus on the numbers.

Related Posts

• Price-to-Book Ratio
• Price-to-Earnings Ratio
• Value Investing
• Market Capitalization
• Ways to Acquire Shares

This is popular among value investors.

While price-to-earnings considers a company’s future earnings potential as a way to determine share price, P/B incorporates what the company owns.

Not a ratio that I find very useful, but many others do, so you shall not suffer for my biases.

We will cover how to calculate and use P/B ratios, followed by limitations in the ratio’s effectiveness. Then I will show you how to make the P/B ratio a little more practical. 

Price-to-Book Ratio

The P/B ratio is used by investors to compare a company’s market capitalization to the book value of its net tangible assets.

Think of it like buying a new car during a slow sales period. According to your research, the car you want has a $30,000 value. You have the choice of two dealers who both sell the model for $30,000. Neither can go below that amount due to price obligations with the manufacturer.

One dealer is firm on the price. The second dealer is more flexible. To get your business, he upgrades the stereo system ($2000 value), adds air conditioning ($1000) and a pair of fuzzy dice for the mirror ($10).

As you are spending $30,000 to get a car now valued at $33,010, you believe you are getting a deal and purchase it from the second dealer.

The same principle holds true for shares. You are trying to buy something for a price less than its worth, as valued by its assets on a per share basis.

If a company’s net assets are worth more than the price of its shares, it may be a value stock.

Book Value

Book value, or as I prefer “net book value”, is found by taking total assets on the balance sheet and then subtracting all liabilities and any intangible assets.

Intangible asset are assets that are not tangible (physical) in nature. Intangible assets include: goodwill, patents, trademarks, intellectual property.

Note that while deducting intangible asset book values is normal practice, I do not do so myself. Some intangibles may have actual value – a patent or brand name, for example – that will be worth something in the event of a company sale. What that value is varies from company to company based on its unique situation. But keep in mind that intangibles may have value even if they generally are excluded from net book value calculations.

Calculating the P/B Ratio

The P/B ratio is found by dividing the share price by the company’s book value per share.

Some investors use the P/B ratio to assess a fire sale scenario. If the company shut its doors tomorrow, what is the value upon dissolution and distribution of assets to shareholders?

In value analysis, low P/B ratios are sought.

Any P/B ratio less than 1.0 indicates that the per share book value of the company is worth more than the share price.

The higher the ratio, the less chance that the company’s net assets can cover the share value.

To continue with the Barclays example from our price-to-earnings post.

Barclays current P/B ratio is 0.72. That means that the company’s net book value is worth more than its market capitalization.

For value investors, this is interesting. It assumes that if the company distributed its net assets tomorrow, the total amount transferred to shareholders would exceed the market capitalization of the shares outstanding. A nice safety cushion for shareholders.

When we review the Financial sector, the average P/B ratio is 1.57. Within the Foreign Money Center Banks industry, the P/B is 1.09. These are both positives for value investors as Barclays ratio is significantly lower than either.

Based on the P/B ratio, it appears Barclays may be undervalued in price as compared to its industry and sector. So it may be a value stock.

But is it?

Problems With Book Values

There are a few problems with using book values when assessing company value.

Book Value is Not Liquidation Value

The book value of a company’s net assets may not be the same as upon liquidation.

As a general rule, the closer an asset is to cash, the closer the asset’s book value is to its liquidation value.

For example, cash is cash. Current assets such as trade receivables and inventory are relatively close to cash realization value. But for fixed assets like vehicles, equipment, and real estate, there might be large differences between book and realizable values.

At times this may be a positive, such as when the real estate market is strong and a 20 year old factory is listed at its original purchase price.

Often though, it is a negative.

Perhaps the company owns a fleet of vehicles that it is depreciating straight-line over 5 years with zero residual value. That means that after year one, the vehicles are still valued at 80% of the purchase price (divide price of vehicle by 5 years of straight-line depreciation. End of first year, vehicles will have a book value of 80%. Second year, 60%. Third, 40%, etc.). But if one needs to sell them at the end of year one, it may be difficult to get that high a sales price.

And in today’s depressed real estate market, maybe a forced sale of the company factory will result in significantly less than book value.

Book Value is a Balance Sheet Concept

Book values are based on balance sheet values that took place at a single point in time.

But what happens when most companies need to liquidate?

Liquidation is usually due to poor operating results that cause losses and negative cash flows. Even if the current balance sheet appears strong, losses and net cash outflows will quickly erode the future book value of a company.

There may be lawsuits from customers, shareholders, governments, or other parties that force the company to ultimately liquidate. Fines, lawyers fees, etc. will also lower book value.

Employees may need termination packages upon liquidation. As a going concern, a company would not account for these costs on its books. But they may need to be paid.

Just because a company’s book value is currently greater than its market capitalization, it does not guarantee anything about the future book value.

As the business deteriorates, so too will its book value. If you invest today, based simply on a P/B less than 1.0, you may find in a year or two, the ratio has increased significantly.

A Company’s Value Should be More than a Sum of its Parts

A company’s value should be based on how it employs its assets and less on the assets themselves.

A company could own a large factory filled with manufacturing equipment. But if it does not produce a product that meets the needs and desires of its customer base, it will have no sales.

That is why the “whole should be greater than the sum of the parts.”

When considering companies, look at how they use their scarce resources to strengthen the business. Not simply whether they have resources.

Low Book Values May Be Deceptive

A low book value is usually seen as a positive to the value investor.

As with the price-to-earnings ratio, you need to ask yourself why other investors believe the company is worth less than its net assets. Often it is because the company’s expected performance is such that over time its asset base will deteriorate.

As we saw above, if a company’s net earnings and cash flow cannot pay its ongoing obligations, the company will have to liquidate existing current and fixed assets to pay its debts. This will reduce future book value and make the company much less of a value.

Adjusted P/B Ratios

While I do not use P/B ratios in my analysis, I do use an adjusted P/B ratio.

First, I start with a company’s net book value as traditionally calculated.

Second, I add back any intangible assets that I believe hold some residual value.

Third, I review the balance sheet and try to adjust any assets to better reflect realizable values.

For example, if a fleet of vehicles is on the books at 80% of their purchase price, I may attempt to assess their proper value if sold on the open market. Usually I consider both a normal sale and any price change should there require a distress selling price. Maybe an ordered sale will provide 60% of the original price and 40% for a distress sale.

In short I am attempting to perform a business valuation on the company to assess its real value, not simply a book value.

Then I use that data in comparison with the company’s market capitalization.

If I am concerned about a company’s potential bankruptcy, I would probably skip it as investment. But if I did attempt to value the business, I would also factor in any costs normally associated with liquidations.

Not a fool-proof method, but infinitely better that using net book value alone.

Note that if you use an adjusted P/B, you must be careful when comparing it against competitors, industry, or market averages. The reason is that the other metrics are not adjusted, so you need to avoid comparing apples to oranges.

Never Forget the Qualitative Analysis

Exactly the same advice as with the price-to-earnings analysis.

Low P/B stocks may indicate value investments.

But they may also indicate junk companies on a short road to bankruptcy.

You must always consider the qualitative side to help separate the good from the bad.

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• Dividend Yield
• Price-to-Earnings Ratio
• Value Investing
• Market Capitalization
• Ways to Acquire Shares

Key to any analytical style, it is one of the cornerstones for value investing.

Today we will look at the concept and its uses. We will also review some of the limitations of the price-to-earnings ratio.

Note that the examples below use real data from Yahoo Finance as at August 25, 2010.

Price-to-Earnings Ratio

Price-to-earnings (also seen as Price/Earnings or P/E) is a widely used fundamental.

To calculate, divide a company’s earnings per share (EPS) into its current share price.

For example, on August 25, 2010, Barclays PLC (stock symbol: BCS) traded at $18.46 per share. Barclays has trailing 12 month diluted EPS of $5.06. Therefore, the P/E ratio is 3.65.

Is that good or bad? I have no idea.

Never Look at P/E Ratios in Isolation

We need to look at comparative data.

That may be the company’s historic or expected future P/E ratios.

It may also be comparisons to key competitors, it’s industry, and sector of operation. Perhaps even to the market as a whole.

With Barclays, let us compare its P/E against competitors, industry and its business sector.

In the Financial sector, the average P/E ratio is 13.08. If Barclays traded at the same multiple, it share price should be $66 (BCS EPS of $5.06 * 13.08 Sector P/E).

In the more specific industry, Foreign Money Center Banks have an average P/E ratio of 7.4. That would translate to a share price of $37.

And of the 10 listed industry competitors, all but 2 have higher P/E ratios than Barclays.

Based on these comparatives, Barclays shares may have some value. Barclays $18.46 share price is vastly below both the sector ($66) and industry averages ($37).

But let’s look a little further.

In Investing, the Future is Always More Important than the Past

While the past is interesting, you need to always focus on the future.

This is true for any analysis, not just the P/E.

Barclays average estimated EPS for the year ended December 31, 2010 is expected to be $2.02. For 2011, the estimates are not much better at $2.73. Compare this at the $5.06 EPS today. A rather large decrease.

Even if we calculated the P/E ratio for Barclays using sector or industry averages, we might see the value in BCS begin to evaporate.

At an industry average P/E of 7.4, BCS would trade at $14.95 and $20.20 based on 2010 and 2011 estimates respectively. And at the sector level, BCS would trade at $26.42 and $35.71.

In this calculation, there appears to be some upside in Barclays’ share price over the next year.

Problems with the P/E Ratio

Garbage In – Garbage Out

Calculations are only as good as the quality of inputs.

If it were easy to properly estimate future earnings and price-earning multiples, one would be able to accurately chart future share price. And if this could be done, all the analysts would be at home getting rich, not crunching numbers all day in a tiny office or cubicle.

There are so many variables that need to be factored into a company’s future earnings that it is impossible to get them all right, or even close to right.

And there are always unforeseen events that take place to complicate things further. On September 10, 2001, I do not imagine many analysts factored in the next day’s terrorist attacks that impacted share prices across the board.

Both the number of variables and the possibility of unforeseen events occurring makes it very tough to accurately estimate EPS.

And the farther away the estimate, the greater the probability of error.

So when relying on someone’s estimates, never take them as the absolute truth.

Data is Fluid

The data impacting future earnings is always changing.

Each day new information is uncovered that affects a company’s future performance. The departure or a key executive, the announcement of a new contract for sales to China, a lawsuit against the company, etc.

With each piece of new data, the expected future results will change. As such, both future expected EPS and P/E for a company may be fluid and shift up and down over time.

No One Sees Things the Same

Different analysts may arrive at completely different conclusions, even given the same facts.

JPMorgan Chase has 25 analysts estimating its 2011 EPS. On August 25, the average estimate was $4.59. However, the lowest estimate was $3.30 and the highest was $5.35.

The difference is due to how each analyst interprets each variable.

Note that as to my point on data fluidity, if you review Yahoo Finance for the 2011 EPS estimates for JPMorgan, they may have already shifted by mid-September.

JPMorgan trades at a 10.59 trailing P/E ratio. If the ratio holds, one analyst has a target share price for the company at December 31, 2011 of $34.95. Another believes it will be $56.65.

Quite the different outcome for two investment professionals assessing the same raw data.

This is why investors religiously follow specific analysts who have excellent track records. And why these same analysts earn extremely high compensation.

Sometimes All Stocks Are Down

Even strong companies may fall in price.

In a bear (down) market, many stocks appear undervalued. But until the market, as a whole, improves and investors start to invest in equities again, the undervalued stocks may not increase in price.

In fact, they may fall even further.

Just because a good company has a low P/E does not mean it will rise in price anytime soon.

One needs to have patience when value investing.

Undervalued or Junk?

Investors value a company’s growth potential in the P/E calculation.

If investors believe the growth potential for a company is strong, it will have a higher P/E than one whose prospects are weak.

If you focus only on stocks with low P/Es, you may find some undervalued companies. But you may also end up investing in firms whose earnings potential is seen as weaker than in comparative companies.

Separating the value plays from the dogs is always a challenge.

The quantitative analysis may give the same results to two companies. But one may be a value stock, the other a piece of junk. That is why investors should never rely on P/E, or any ratios, on their own. They need to be combined with qualitative analysis.

It is the qualitative, not the quantitative, analysis that separates the good from the bad.

I suggest you never forget that.

Next up, the price-to-book ratio.

Related Posts

• Dividend Yield
• Price-to-Book Ratio
• Value Investing
• Market Capitalization
• Ways to Acquire Shares

This is especially true when reviewing different investment styles for equity funds. 

Today we will take a look at value investing.

Value Stocks

Stocks in this category are seen as value buys.

That is, the stock is considered undervalued based on quantitative and qualitative analysis.

The objective is to identify companies that trade below their intrinsic (i.e. true) value. Then purchase shares and wait patiently for the rest of the world to see what they have missed.

Companies in this category tend to be: established companies that have fallen out of favour and been beaten down in price due to poor performance, bad news, lawsuits, management changes, etc.; smaller companies that are not extensively followed by analysts and the investing public; mature companies that have minimal upside for internal growth, so they pay out their earnings in dividends rather than reinvest in the company’s operations.

In theory, this is an excellent way to invest. And in any other investment you make (house, art, coins, etc.) you always are trying to find acquisitions being sold at a discount to market value.

Benjamin Graham and David Dodd are considered the fathers of this investment style. Warren Buffett uses this approach in a slightly modified form. Hard to argue with those investors.

I like value investing. But it is not an easy process.

Given the amount of publicly available data, the number of analytical tools one can use to screen stocks, and the sheer volume of investors searching for the next great value stock, it is not simple to find a hidden gem all on your own.

If you lack the time or expertise to do your own in-depth analysis, value equity funds are a good way to invest. Many are professionally managed. And by purchasing a number of companies that meet the value criteria, funds spread out the risk of the individual stocks.

Quantitative Analysis

In analyzing companies under a value approach, analysts look at quantitative data.

This data is known as a company’s “fundamentals”.

The fundamentals of a company are compared against its historic results and expected future performance. A company is also compared against the fundamentals of its peers, the industry and sector in which it operates, and the stock market as a whole.

Common fundamentals include: price/earnings; price/book; dividend yields. We will look at each in separate posts.

It is relatively easy to perform quantitative analysis.

Find the correct data – not always a simple thing to do, especially for small companies -, plug it into the appropriate equation, and you have your result.

But if it were that easy we would all be very wealthy.

Qualitative Analysis

Investors tend to do a decent job on quantitative analysis.

What usually trips them up is the qualitative side.

I believe that qualitative analysis is the key to any investing decisions. Whether they be stocks, buying a home, or lending money to a friend. So pay close attention to this area.

In respect of value investing, the qualitative analysis is what (hopefully) separates the value stocks from the junk.

This is critical, because based on the quantitative data, terrible investments often look like value opportunities. No one wants shares in the bad companies. Weak demand and excess supply drive the share price of a junk company lower. Unfortunately, the fundamentals (being a function of the share price) tend to look very good, when instead they should be a warning to potential investors.

When we cover the common fundamentals later, we will go through some examples.

Qualitative analysis uses non-numeric data to assist in separating the wheat from the chaff. It includes an assessment of: company management; operations; competitors and the industry.

Management

Management is the number one driver when I consider companies.

Management makes the decisions that impact operating performance and ultimately the share price. As an investor, you want to invest in well-run companies. If you do, you will increase your probability of positive returns.

Who is on the management team?

Review their credentials and experience in the industry. What is their track record of success?

With key management, past performance is an indicator of future results. Both good and bad.

How long has the current management team been in place?

If a successful company has recently lost key management, it may be a sign of problems or changes in the approach to running the company.

If management is new, were they successful in their previous ventures?

These are some of the questions you should consider.

Operations

What does the company do? Does the business model make sense in today’s world?

A few years ago, manufacturers of floppy disks were profitable. Today, if they have not evolved into making flash drives, they are no longer in business.

What is your experience with the company’s product?

Consider something as simple as cola products. Let’s pretend that Coke, Pepsi, and RC Cola are all separate companies with only one product, cola.

When you are at the grocery store, in a restaurant, or at an event, what do you see? A lot of Coke and Pepsi for sale, but much less for RC. Intuitively, who do you think sells more cola?

When you plan to invest in a company, think about how its products are seen in the world.

The same is true for your personal likes and dislikes.

For the most part, you are the “average” consumer. Trust your judgement when investing.

Say you plan to buy a smartphone and options include iPhones, Blackberries, and Droids.

Which one is getting the best reviews? Which one did you purchase or would like to buy? What are your friends buying?

If you are a typical consumer, then there is a high probability that other consumers are making the same choices as you and your friends. This results in stronger sales than competitors, which should enhance profitability and the share price.

When assessing if a particular company is a value play, always consider its products. If the product is junk, there is a good chance that the stock is also junk and not a value investment.

Industry and Competitors

Just because your quantitative analysis indicates a stock has potential value does not mean it is a great investment.

If the industry is in a downturn, even good investments may suffer.

Consider the real estate market. In North America, it is currently in a major slump. If you intend to sell your home, you may have to accept less than you believe to be its true value. It is not the fault of the house, rather it is an industry wide issue.

Often you will find a well-managed company that sells quality products. But in their market segment, they cannot compete against even stronger competitors.

If one intends to buy an MP3 player, most people look no farther than the various iPods. That makes it difficult for other manufacturers to make inroads into the industry.

You may love a product, but always review it in light of the industry before investing.

Intrinsic Value

By conducting both quantitative and qualitative analysis, you attempt to determine a stock’s intrinsic value.

But what is this true value?

And that is the problem with value investing.

What exactly is a stock’s intrinsic value?

Based on your analysis, you will arrive at one number. Other investors, using the same publicly available data, will arrive at different valuations. Some will be higher, some lower.

No matter how good the analysis, many investors will be incorrect.

And no matter how poor the analysis, some investors will get lucky.

Further, unforeseen events may render even the perfect analysis irrelevant.

Consider the September 11, 2001 terrorist attacks in the US.

On September 10, certain assumptions were made in respect of investments. Interest rates, government spending, oil prices, consumer demand, company revenues, to list a few variables.

On September 11, many factors changed completely. Share prices across the board fell. The US government launched a long and costly war. And so on.

As you can see, determining the “real” value for a company is difficult, if not impossible.

Should You Value Invest?

While it may be impossible to accurately predict a company’s intrinsic value, does that mean you should ignore value investing?

Not at all.

Studies often show that value investing outperforms growth strategies.

I do not agree with this as a general statement as other data I have reviewed show mixed results. But there are some who believe value investing is the only way to go.

I do believe that investors following any investment strategy (e.g. growth, balanced, Japanese equities) must follow the tenets of a value strategy. After all, when you get to the heart of value investing, it is simply common sense.

Find companies that are undervalued relative to what you believe is their true worth.

Then buy their shares.

At its basis, it is that simple.

And even if you follow a growth strategy you need to adhere to these principles.

Implementing a value investing program requires investing skill. It also takes time and luck to do well picking individual value stocks.

It is difficult, but not impossible. As the success of Warren Buffet and others can attest to.

Many mutual funds follow a value investing pattern. I suggest you consider initially using them if you wish to follow a value strategy in your portfolio.

As you develop experience and confidence, then consider trading individual stocks.

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• Dividend Yield
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• Price-to-Earnings Ratio
• Nonsystematic and Systematic Risk
• Market Capitalization

109,705 students wrote one of the three exams this June.

The pass rates were: Level I, 42%; Level II, 39%; Level III, 46%.

The CFA designation is an excellent program if you want to work in the investment industry.

Based on the results, it is not an easy process.

For any current CFA candidates reading this post, congratulations to those who passed. For those who did not, best of luck on your next attempt.

But while difficult, it is extremely rewarding once you are done.

And by showing the world that it is a tough process, it makes the CFA holder appear stronger in the eyes of the public. Something that is important for both professional credibility and when you are being considered for a new job.

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Market capitalization is useful in comparing companies of similar size.

It is also used as a tool by mutual funds when determining investment style.

So what are the different market capitalization segments?

Market Capitalization Segments

You will always see three market capitalization segments: large-cap, mid-cap, small-cap.

Less common are three additional categories: mega-cap, micro-cap, nano-cap.

All these terms have some flexibility in their usage and in the ranges for each segment. I will provide the common categorizations, but be aware that you may see slightly different terminology and different ranges at times.

Segment Ranges

Over $200 billion are the mega-cap companies. Microsoft (current market capitalization of $208 billion), Apple ($220 billion), and Exxon ($300 billion) are examples of these extremely large companies.

Between $10 billion and $200 billion are large-cap. If mega-cap is not used by the rater, they will be included in the large-cap segment. Cisco Systems ($121 billion), AT&T ($158 billion), and Amazon ($55 billion) would fall into this grouping.

Between $1 billion and $10 billion are mid-cap. Polo Ralph Lauren ($8 billion), H&R Block ($4 billion), and Office Depot ($1 billion) are examples.

Between $300 million and $1 billion are small-cap. K-Swiss ($394 million), Ruby Tuesday ($608 million), and Quicksilver ($471 million) are small-cap stocks.

Between $50 million and $300 million are micro-cap. Arctic Cat ($142 million), THQ ($238 million), and Winnebago ($244 million) are in this category.

Below $50 million are nano-cap. Athersys ($50 million), Aastrom Biosciences ($40 million), and China Logistics ($3 million) are non-cap stocks.

If micro or nano are not utilized, these segments will be part of the small-cap segment.

Ranges May Differ

As I stated above, some investment professionals, mutual fund companies, or ratings agencies may use different terms and/or ranges for the market segments.

For example, Investopedia includes all companies up to $2 billion in size as part of the small-cap segment.

Morningstar utilizes percentages to segment their stocks. Equities are divided into 7 geographic regions. Within each region, the top 70% of stocks are classified as large-cap. The next 20% are mid-cap and the last 10% are deemed small-cap.

Note that with this Morningstar system, internal and external comparisons may be difficult.

Perhaps a stock that is construed as a large-cap in Latin America is only a mid-cap in the Greater Europe region. This makes internal comparisons of global companies within the Morningstar system harder than by using a fixed dollar calculation.

Second, it makes external comparisons between rating organizations difficult. Morningstar has Canada as a unique region, so the bottom 10% of Canadian companies in size are considered small-cap. But unless I know the exact cut-off point, it is hard to compare to someone that uses a threshold of $1 or $2 billion for Canadian firms.

So when assessing stocks as large, mid, or small-cap, do not blindly accept the classification by the organization that segments the equity. Do your own analysis to ensure that, in your own mind, you know what type of company it is.

Market Capitalization Investing Caveats

First, market capitalization may fluctuate over time based on how a company’s share price performs, as well as the number of outstanding shares it has. Small-cap companies aspire to increase their share price so as to move up into mid, or even large-cap, segments.

Also, some companies slip over time to lower segments. Being large is not protection from declines in value.

For example, consider the Canadian telecommunications company, Nortel. In September 2000, its market capitalization was CAD 398 billion. In less than two years, Nortel was worth under CAD 5 billion. If you had wanted to invest only in large or mega-cap equities, you would have found yourself owning (almost) a small-cap stock very quickly.

Second, the larger the capitalization, the more shares are outstanding, which normally translates into increased liquidity for investors.

If investing in nano or micro-cap companies, you may find it difficult to buy or sell shares on a timely basis and/or at your target price. This may also be the case for small-cap stocks.

Reduced liquidity can increase the volatility (risk) of an investment. That is why smaller capitalized companies are generally considered riskier than larger companies.

Third, the smaller the companies, the less publicly available information exists. I am not necessarily referring to corporate filings, such as annual reports and statutory documents. More in respect of investing information.

Many small firms are not actively followed by stock analysts, so getting research or recommendations is difficult. This is compounded by the fact that industry peers are also small firms with relatively little investment information.

Fourth, small-cap firms may be closely held by insiders or other persons or groups connected to the company. While one cannot legally trade on inside information, insiders do have better access to company data and tend to do better than non-insiders.

So when considering investments in small-cap or smaller stocks, be careful.

We will see how market capitalization segments are used extensively in mutual funds.

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• Dividend Yield
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Why my interest in writing about mutual funds?

First, mutual funds are extremely popular and there are many funds in existence. So whether you intend to or not, you will come across funds in your investment travels.  

Second, I believe mutual funds, along with exchange traded funds, should form the cornerstone in any investment portfolio. Hopefully, you will come to share that view.

Third, some of the things I read about mutual funds are not entirely accurate. I want to pass on some caveats and considerations for you when assessing funds.

Let us get started.

There are Many Funds to Choose From

The first thing you notice about mutual funds is the huge number that exist in the market.

Fortunately, this means that whatever your investment strategy, you will be able to find a fund that helps achieve your objectives.

Unfortunately, it also means that there are a lot of funds to wade through.

According to the Investment Company Institute’s 2010 Investment Company Fact Book, in 2009, US mutual funds numbered 7691 and were worth $11 trillion dollars. Globally there were 65,735 mutual funds valued at $23 trillion.

Given the sheer volume, how does one pick a fund that is right for his needs?

There are three key ways to reduce your search and find an appropriate fund.

Investment Style

Mutual funds are grouped by investment style or categorization.

Fixed income or equities would be two very broad styles. Likely too general to be useful in practical fund comparisons.

Within a category, funds are often broken down into smaller sub-categories. These are the investment styles that make it easier to find funds that meet your investment strategy.

If you want a fund that invests solely in Japanese equities, you can find a grouping of funds that meet that objective. If you want to invest in high yield (“junk”) bonds from U.S. corporations, you can find a listing of these funds as well.

While there may be almost 66,000 mutual funds out there, those that meet your specific search criteria will be significantly less.

Comparing Performance By Style is Important

Besides reducing the number of funds to research, style is crucial in assessing funds.

As the old saying goes, you must always compare apples to apples, not apples to oranges. So too is it true with mutual funds.

Like any asset, mutual funds have their own risk-return profiles. One style may have lower risk than another. This will result in a lower expected return. If you only compare actual performance, you may invest solely in high risk funds and ignore more secure alternatives.

For example, shares of companies in emerging markets are traditionally riskier than shares from American “blue chip” firms. As they are higher risk, the expected return on emerging market shares should be higher than for “blue chips”.

In comparing two funds, Bluechipfund and EMMAfund, you see that last year EMMAfund experienced an annual return of 12% versus 10% for Bluechipfund. That might cause you conclude EMMAfund is the better investment.

But what if you knew that the risk associated with EMMAfund was 20% versus 5% for Bluechipfund. If you recall our look at investment risk, you will remember that an investment with a 20% standard deviation is significantly more volatile in price, both upwards and down, than one with 5%. That might make you think twice about your decision.

By sorting funds by style, funds within a specific category should have similar risk-return characteristics. That allows for better assessment of true performance by the fund managers.

Rating Agencies

Ratings agencies rank fund performance on a risk-adjusted basis. This assists investors in narrowing choices for their own investment decisions.

Morningstar is the main rating agency, but there are others to consider using, including Lipper. Also, websites, such as TheStreet.com and Businessweek, review and grade funds.

How do agencies rate mutual funds?

Morningstar, for example, plots each fund’s risk-adjusted return for a variety of time periods. These are then compared with other funds on a traditional bell curve. A fund that falls within the top 10% of all funds merits a 5 star rating. If the fund sits in the next 22.5%, it earns a 4 star rating. And so on until the bottom 10% receive only 1 star.

In addition to 3, 5, and 10 year ratings, Morningstar also provides an Overall Morningstar Rating. This is a weighted average of all individual ratings for a fund.

In theory, by choosing funds that are rated as 4 and 5 stars, you are narrowing your options to funds that are in the top third of their style based on risk-adjusted performance.

That should help make better investment decisions.

While ratings help find above average performers, they are not foolproof.

Rankings are based on historic results and not the future. As circumstances change in the marketplace or in the fund itself, future performance may differ from the past.

Also, agencies and reviewers do not cover all available funds. Some are more comprehensive than others. For example, Forbes rates approximately 2600 funds. This is less than half the 7691 available in the US.

Be aware of the limitations in the ratings before investing.

Screening Tools

In assessing funds, there are a variety of tools available to assist you.

These tools allow investors to screen funds by many different criteria.

Most brokers provide screening tools, many with ties to rating agency or internal rankings.

As well, fund rating agencies like Morningstar have their own screeners. And many investment or finance websites (e.g. YahooFinance, Forbes, etc.) have screening tools available.

Different screening tools may allow you to search by slightly different criteria.

However, the key criteria should be the same from tool to tool. These include fund performance over varying periods, investment style, sales charges, annual expenses, etc.

I shall try to expand on some of the above items over some upcoming posts. So if you have questions, hopefully I will address them shortly.

Next up, I will look at a few common investment styles.

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• Investment Funds

That means that many investors aggregate their money in a single investment vehicle.

In theory, aggregation allows some or all of the following to individual investors: a simple way to create and maintain an investment portfolio; better portfolio diversification through asset classes and time; access to investments that cannot be bought by small investors; improved liquidity; fund management by investment professionals; economies of scales on expenses that reduce costs allocated to any one investor; consolidation of tax information.

Today we will review four types of investment funds.

Closed-End Investment Fund (CEF)

This fund is established as a corporation with a limited number of shares initially issued to investors via an Initial Public Offering (IPO). The proceeds are then invested according to the objectives and fund policies as stated in the prospectus.

Occasionally CEFs may have subsequent public offerings. But normally there are no other issues after the IPO has been completed.

The CEF is listed on a stock exchange and all acquisitions or dispositions by investors takes place in this secondary market. Transactions occur during normal trading hours of the exchange.

Note that shares are not redeemed by the company. An exception would be if the CEF decides to either reorganize and redeems a portion of shares or liquidate the company itself.

The value of shares is determined in two ways.

Share price is based primarily on the net asset value (NAV) of the investment fund. The NAV is the value of the fund’s investment portfolio (its only assets) less any liabilities that exist. To calculate the NAV per share, divide the net assets of the fund by the number of shares.

For example, Omega Investment Fund has an investment portfolio with a market value of $100 million, short term liabilities of $1 million, and 9 million shares outstanding. The NAV of Omega’s shares is $11 per share.

The key point with NAV is the market value of the investment portfolio. As the portfolio is made up of common shares, bonds, money market instruments, etc. whose own valuations fluctuate daily, an investment fund’s NAV will also change daily.

In our example, Omega’s NAV is $11 per share. If this was a real company and I checked the actual share price, I would expect to see it somewhere around $11 per share.

Somewhere, that is, but not exactly.

The second component of a CEF’s share price is based on investor supply and demand.

Investors who want the stock must buy it on the secondary market. The greater the number of investors who want the stock, the more competition there is for available shares. This stronger demand will increase the share price above the NAV value.

The difference between the NAV and market price of the shares is known as the “premium”.

Other CEFs may trade below their NAV. This is because there are more shareholders who wish to sell (supply) than there are new investors wanting to buy (demand).

Why are there premiums and discounts for investment portfolios?

The main reasons are twofold.

Investors look at the securities within CEF portfolio and believe these investments will increase or decrease. Based on perceptions about the returns on the investment portfolio, investors will be bullish (optimistic) or bearish (pessimistic) about the future.

Secondly, investors look at the fund management. If management is seen as strong, investors believe that management will find new investments that will bring superior returns versus other funds. This will also create a premium.

As an example, consider Warren Buffett. If Mr. Buffett managed a CEF, I expect there would be a nice premium on the share price. And with Berkshire Hathaway (a conglomerate, not a CEF), there is usually a healthy premium to the share price.

Note that these are the same principles that drive the share price of operating companies.

Open-End Investment Fund (Mutual Fund)

Mutual funds, as the formal name indicates, are open-end funds.

Like closed-end funds, a new mutual fund issues shares (or units) to investors and invests the proceeds according to the fund’s stated objectives.

However, a mutual fund continuously sells new shares to the public. The issue price of the shares is equal to the NAV of the fund.

There is no premium or discount associated with the share price.

Shares of an open-end fund are not traded on a stock exchange. Investors purchase shares directly from the fund. As there is no secondary market, the fund itself must buy back any shares that investors wish to sell. This is known as “redemption of shares”.

For most funds, the NAV is calculated daily and investors purchase or redeem shares at the close of day NAV. There are some funds though that do not allow purchases or redemptions on a daily basis. Investors may only have the option of buying or selling on a weekly, monthly, or quarterly basis. This can create liquidity problems for investors in these funds. Be certain you know the frequency of possible transactions before investing in any funds.

Over time, an open-end fund may become a “closed fund”. Do not confuse a “closed-end fund” with a “closed fund”.

A closed fund is an open-end fund that has been shut to new investors. Closure may be permanent or for a temporary period. While the fund may not accept new investors, often existing investors can still acquire additional shares of the fund.

The most common reason for a fund to close is that its assets under management has become too large for the fund to properly invest under its stated objectives and strategies.

Exchange Traded Fund (ETF)

An ETF is much like a closed-end investment fund in that it trades on a stock exchange and does not issue new shares to the public.

An ETF is a security that tracks a specific index or benchmark. There are many different ETFs that track a wide variety of areas.

For example, an ETF may track a: country (IShares MSCI Brazil Index); region (Vanguard Emerging Markets Stock ETF); stock exchange index (SPDR for the Standard & Poors 500 Index); industry sector (United States Oil); commodity (SPDR Gold Shares).

ETFs trade like shares and there is no NAV calculation.

In attempting to replicate an index or benchmark, there are a few different methods employed. ETFs may hold the index fully in its proper proportion. This may be accomplished for smaller indices such as the Dow Jones 30.

ETFs may use representative sampling techniques to replicate performance with less than 100% of the index components.

ETFs may also utilize derivatives such as options, futures, and swaps, to try and mirror an index’s performance.

Hedge Fund

A hedge fund can be a variety of investment creatures. Some more scary than others.

In general, a hedge fund is a pooled structure of investments that uses a wide variety of strategies to achieve its stated investment objectives.

Sounds much like a CEF or mutual fund.

The main difference between hedge funds and other funds is the level of regulation.

Hedge funds are intended for (supposedly) sophisticated investors who understand the world of investments. Especially the concept of investment risk.

In many jurisdictions, there are rules governing who is and is not a sophisticated investor. Usually this is linked to the investor’s net worth, annual earnings, investment experience, etc.

Because hedge fund investors are supposed to be experienced and knowledgeable, hedge funds invest in a wide variety of investments and utilize strategies and tactics not found in mutual funds. For example, hedge funds may take short positions, invest in derivatives, and utilize leverage.

A common perception of hedge funds is that they are out of control investment vehicles, engaging in high risk (hopefully high reward) activities.

Some hedge funds are indeed very risky. But other hedge funds use derivatives, short sales, etc. to reduce portfolio risk. In fact, the term “hedge” is used for activities that attempt to decrease investment risk in an asset or portfolio.

If you ever get to the point where you want to invest in a hedge fund, make sure you read the prospectus or offering documents very carefully. Know the level of risk that the fund will accept in their investment plans.

Another consideration with hedge funds is the cost.

Hedge funds tend to be actively managed by fund managers, so the management expense ratio is usually high relative to other funds types. Not always, some open and closed-ended funds also require extensive management, but usually.

And it is not uncommon to find “performance fees” (also called “incentive fees”) paid to fund managers for returns in excess of agreed upon hurdle rates (i.e. benchmark or minimum return). These can be extremely generous, so know in advance what you might be paying to the fund managers for their efforts.

Strangely, while I have seen many performance fees in hedge funds for superior returns, I have yet to come across any funds that offer refunds for underperformance. Funny how it always works that way.

I believe management expense ratios and other fund costs should be the key consideration when selecting any type of fund. As a result, we will spend some time a little later on this topic.

That should give you a sense for investment funds. Not too deep, but an idea of what they are and how they differ from one another.

I am a big proponent of using mutual funds and ETFs in one’s investment portfolio.

We will consider these two investment funds in greater detail over the next week.

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Being Long

A long position is the norm in investing.

You buy an asset in anticipation of an increase in value. In future, if the market price rises, you sell the asset and realize the profit. You are long because you own the asset.

For example, you invest $5000 in shares of Microsoft at $25. You are long 200 shares.

Being Short

Short positions are the opposite of long.

A short sale involves selling an asset that is not actually owned by the investor.

The aim is to “sell” the asset at a high price in anticipation of a future decrease in value. To “sell” an asset not owned requires the short seller to borrow the asset from a third party. For financial assets, one’s broker normally lends the assets to the client.

Margin Accounts

The use of a margin account at the brokerage firm is required for short sales.

Note that a margin account involves the broker lending an investor cash for leverage purposes (like a bank loan) or securities for short selling. Margin accounts require adequate reserves  as collateral to cover the open margin position. If funds fall below the minimum margin requirements – which are calculated based on asset type, asset price, etc. – the investor will need to deposit additional cash or securities to cover the margin call. If unable to do so, the broker will sell assets within the account to cover the shortfall.

When the asset price falls sufficiently, the short seller buys it on the open market. The short seller then returns the borrowed assets to the broker and the transaction is completed. If successful, the difference between the higher selling and the lower purchase price is profit.

Short Selling is Risky

Short selling is a risky activity as you do not own the asset. If you are long, your potential loss is the capital initially invested. But if you are short, in theory, your loss can be infinite.

For example, you invest $1000 in shares of Growthco at $10. Because you own the shares, you are long. If the shares rise to $25, you can sell for a profit of $1500. If the company goes bankrupt and the shares fall to $0, the most you can lose is your initial $1000.

But if you decide to short the stock, the risk increases significantly.

A friend of a friend’s second cousin’s girlfriend heard from her hairdresser that SkystheLimit will file for bankruptcy next month. You decide to borrow 100 shares of SkystheLimit from your brokerage house and sell them for $10 per share. You now have $1000 in cash. If the shares fall in price to $1, you will purchase the 100 shares you borrowed on the open market for $100, deliver them to the broker, and net a $900 profit on the deal before commissions and the interest charged on the margin account.

A month later, SkystheLimit did file. Unfortunately, they filed a patent for an amazing new product and not for bankruptcy. The share price immediately rose to $100.

Your broker, concerned about your ability to repay your debt, demands an increase in your account assets to cover the new minimum margin (i.e. margin call). You now need to find available cash or securities to cover the margin call.

You realize that if you buy the shares and close the short position you will lose $9000. Nine times what you invested! But if the share price continues to rise and you do not close the position, your losses will be worse. If the share price rises to $1000, you would lose $99,000.

As you can see, short selling can be very risky. Anytime you have limited potential gain but unlimited potential loss, you should be very wary about investing.

Unless you are an extremely experienced investor, I would not recommend short selling as an investment strategy. And even for experienced investors, I would not recommend extensive shorting and that one should have a sound strategy in place before attempting.

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