Investment Basics | Simpson Capital Management

To understand how SCM works for you, here are a few Investment Basics.

An investment is the acquisition of an asset such as a stock or bond where the reasons for parting with your money are more compelling than the alternatives. Your portfolio is an group of assets owned and designed to transfer your purchasing power to the future. The sum of income plus gains earned by your holdings while keeping risk confined to a narrow range is your reward.

The two key risks in investing are

systematic risk comes market-wide movements in stock prices
unsystematic risk deals events affecting a single stock.

Other forms of risk are

business risk
financial risk
market risk
interest rate risk
reinvestment rate risk
purchasing power risk
exchange rate risk.

An efficient financial market implies a stocks price holds all known info about the return and risk of the particular asset. Visit our Intro to Investments page to get a more info.

This page gives an top view of investing. For a more in depth on each topic, click the link at the end of each section.

Markets

Firms gather funds by issuing new shares and selling them to the public. An investment bank serves channels money from you to firms who need it.

Assets are bought and sold every day on either an organized exchange or the informal over-the-counter market through market makers. Market makers quote a price which equates the supply with the demand for the asset.

Investment Basics

You can purchase stocks and bonds through brokers. Once the shares have been purchased and paid for, you receive them into your account at the broker who also acts as your custodian.

The security industry is subject to a high degree of regulation both from fed and state governments. Their purpose is to protect you by ensuring honest and fair dealing and providing full disclosure. To learn more, visit our Markets page.

Info Sources

Public firms are required by both fed and state laws, to give yearly and quarterly reports. The yearly report is key giving

a letter to shareholders
statements including a balance sheet, income statement and statement of cash flows.

One service some brokers offer is research on single stocks. The purpose is to identify stocks with a growth outlook. However, their picks should not be taken at face value, due to their biases.

Newspapers

daily Wall Street Journal
Barron’s is published weekly reporting articles of interest to the community and issuing firm reports

Mags

Money
Business Week
Forbes
Fortune
Journal of Finance
Harvard Business Review
Journal of Portfolio Management
Financial Analysts Journal.

US fed reports

Survey of Current Business
Business Conditions Digest
Economic Report of the President
Annual Report of the Council of Economic Advisers
Federal Reserve Bulletin

To learn more about info sources visit our Info Sources page.

Theory

The time value of money is one of the most crucial concepts in finance. It is the notion a dollar received in the future is worth less than a dollar in hand today. Cash flows occurring in other periods must be adjusted to their value at a common point in time to be compared. Investment Basics

The purpose of portfolio management is to find the combo of risk and return which allows you the highest return for a given level of risk. Risk is concerned with the chance return will not equal what you expect.

Measuring risk focuses either on the extent to which the return varies from the mean return or on the volatility of the return compared to the return on the market. Variability is measured by standard deviation while the volatility is measured by beta.

An account might have achieved smoothness in the past because the single asset returns were not highly related, but this may not be so in the future. Harry Markowitz in 1959 built a model on which an risk-averse investor can put together a diverse basket which maxes their reward by maxing basket returns for a given risk level.

The CAPM model gives us a precise outlook of the relations we should observe between the risk of an asset and its expected return. Risk is measured by the basket’s SD while the single asset’s risk is measured by a beta.

As long as there is a strong relation between the return on a stock and the return on the market, the beta has meaning. The greater the beta, the more risk with the single stock. To learn more about theory Basics, visit our Theory page.

Investment Firms

The rationale for investment firms is simple and appealing. They have appeal through

pro staff
benefit of ownership in a large portfolio
savings in costs
admin services

Fund Types

Closed end funds have traits similar to stocks and bonds traded in the markets. Because of the limited number of shares, you have to buy the shares of an existing holder.
Open ended funds or mutual funds (MFs) are similar to closed ended ones except they don’t trade on a exchange, trade exactly at net asset value and have other fees such as front/ back-end loads and admin fees.
The newest type, exchange traded funds (ETFs), are similar to MFs. Instead of buying the shares from the company, you purchase them on exchanges. This trait gives you flexibility to buy and sell throughout the day rather than only buying at the MF closing price.

Pro management is no promise the funds will outperform the market. In fact, many studies show their results were not much different than an unmanaged basket of similar assets.

You may get a different return than the fund’s reported return due taxes and fees. Also. the MF’s and ETF’s reported returns are before taxes and load charges. To learn more, visit our Investment Firms page.

Stock Values

Because stock means ownership, yous obtain all the rights of owners including the right to vote the shares. But democracy in firms doesn’t work well. Since you have limited say, the rule of thumb and SCM’s policy is ‘vote with your feet’ (sell), if you don’t like what you see. Investment Basics

As with any asset, values involves bringing future cash flows back to the present at the correct discount rate. Generally speaking, this discount rate is the required return you demand to justify buying the stock. Your required return has two parts: the risk-free rate and a risk premium.

With this in mind, the dividend discount model is a formula to estimate the intrinsic value of a firm by figuring the present value of all future payouts. On the other hand, PE ratios (price/earnings) are compared using actual earnings or estimated earnings. The metrics are compared to the stock’s past ranges and industry/market means.

The efficient market hypothesis suggests you cannot expect to outperform the market all the time on a risk-adjusted basis. Also, the term random walk means price changes are unpredictable and patterns formed are by chancel. Since the markets digest info efficiently, it is the unpredictability of new info being revealed which causes the randomness. To learn more, visit our Stock Values page.

Macroeconomics

Financial analysis has a logical progression from general to specific.

First, the analyst looks at the economic landscape which may give a hint on where stock prices are headed.
Then, the analyst considers the industry since industries react differently to changes in the economy
At the single stock level, what’s happening at the macro level may not apply

The business cycle is an economic pattern of growth and decline lasting three to ten years. GDP measures the total value of transactions in a cycle. A recession is a period of rising unemployment and declining GDP where the economy doesn’t grow for two quarters.

Investment Basics The Fed hold a large weight on the economy through its monetary policy. Given these points, their goals are to stabilize price levels and ensure full employment. When the Fed drains money out of the system and tightens credit, the cost of capital and earnings are adverse.

Industries go through life cycles much like humans, sometimes independent of the economy. With this in mind, a new innovation might spawn an industry, attracting new players and making it more competitive. The timing of these life cycles can be very short or there can be many barriers to entry which can extend the health of the cycle.

Though the linkage between the economy and share prices is complex, forming an opinion about the future economic landscape is key. Areas of focus include interest rates, inflation, jobs and GDP growth. To learn more, visit our Macroeconomics page.

Statements

Statement ratios are probably the most frequently used tool to analyze a company because they are readily understood and can be computed with ease. The ratios are used to perceive trends in a time series of an individual firm or comparing peers in cross sectional analysis. Investment Basics

Liquidity Ratios Liquidity is the ease a firm converts their assets to cash. Given these points, a highly liquid firm pays their bills without loss. The liquidity ratios are useful to creditors who are concerned with getting paid on a timely basis.
Activity Ratios Activity ratios indicate the rate a firm is turns its inventory and accounts receivable into cash. High turnover signals the firm is in better position to handle liabilities, but does not indicate it’s maximizing profitability.
Profitability Ratios The amount a firm earns is most important to investors. Earnings accrue to shareholders and fuel dividends. Profitability ratios measure earnings relative to a base such as sales, assets or equity.
Debt Ratios Financial leverage, measured by debt ratios, indicate how the firm can magnify the shareholder’s investment. Because debt financing can have such an impact on the firm, these ratios are extremely valuable in analyzing the financial position.

An investor does not need a ton of ratios to get a good idea of a firm’s financial condition. Therefore, performance metrics are more relevant to investors

distribution of earnings
growth in earnings
market valuation of the stock.

There can be variations in ratios from year to year or things can remain stable. If there are deviations from benchmarks or from peers, the investor must ask why. Even if past performance is repeated, the investor needs to have an idea of the firm’s worth. To learn more, visit our Statement Analysis page.

Bond Market

A bond is a security issued by a borrower which obligates the issuer to make specified payments to the holder over a specific period. A coupon bond obligates the issuer to make interest payments called coupon payments over the life of the bond, then to repay the principal at maturity.

The bond market market is about a third larger than the stock market. Bonds are purchased like stocks, either from a broker/dealer or on an exchange.The price of any bond is primarily related to the interest paid by the bond, the interest rate investors may receive on comparable competitive bonds and the maturity date.

Governments at all levels issue bonds to cover the shortfall from tax receipts and expenditures. Corporations issue many types of bonds, either secured or unsecured. Legally, preferred stock is considered an equity. But, due to its fixed payout nature it has the characteristics of a bond.

Computing yield to maturity is used to compare bonds but doesn’t work when bonds have different maturities and coupons. An alternate technique, duration, compares bonds with varying maturities and coupons by determining each bond’s sensitivity to interest rate changes.

Since bonds pay a fixed income and mature at a specified date, they are conducive to passive management. The market value of the portfolio fluctuates but the investor is assured of a specified return of principal if the issues are held to maturity. To learn more, visit our Bond Market page.

Foreign

The value of global market is currently $69 trillion with 60% of it traded on exchanges outside North America. Given the growth of Europe and Asia, it suggests the US market is becoming a declining part of the total.

US residents invest in foreign securities to earn a return through receipt of income, price appreciation and currency exchange fluctuation. Additionally, olitical risk and local taxation must be considered in the investment decision.

Investment Basics There would be little risk associated with currency price fluctuations if the prices of currencies were stable, but this is not the case. Consequently, investors can reduce the risk of loss by hedging with derivatives, such as futures contracts.

In the case of foreign investments, capital gains occur because the value of the asset rises or the value of the currency in which the asset is denominated, rises. The value of currencies responds to changes in demand and supply for the currencies.

The most obvious advantage of investing in foreign investments is investing in economies and firms experiencing economic growth. While growth is not unique to foreign markets, there are two other advantages– market inefficiency and diversification.

The basic types of mutual funds and ETFs which invest in foreign securities are:

Global funds, which invest in foreign and US
International funds, which only invest in foreign
Regional funds invests in a singular geo area
Emerging funds invests in less-developed nations.

For a more in-depth look, visit our Foreign page.

Other Basics

Also, visit these topics for further detail on Investment Basics:

The info on this Intro page and other Basics pages were from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades on the job. Also, see our Site Credits page for sources.