Chroma Investing » Investing terms

Beginning Value Investor Terms – Exchange Traded Fund (ETF)

chroma — Sun, 07 Aug 2011 02:55:30 +0000

Although this site is largely geared toward individual stocks, it seems to me, to better serve the beginning investors I need to address the more passive investment strategies that may be attractive to individual investors without much time on their hands to investigate individual companies but want to understand their investments.

ETF Defined

An Exchange Traded Fund (ETF) is similar to a mutual fund, but has similarities to purchasing stocks. The SEC says that ETF’s are “investment companies that are legally classified as open-end companies or Unit investment Trusts (UITs).” An open-ended investment company is one of the three primary groups of companies as described by the SEC. Unlike a close-end investment company, an open-end investment company can offer to buy back its shares from the investors.

A normal mutual fund is a pooled investment where the money from thousands of investors are joined together and invested in whatever the focus of a mutual fund is, such as equities, bonds or commodities. Conversely, a common stock is traded on a stock exchange. An exchange traded fund tracks a stock index, a commodity or pool of stocks, but is also traded on a stock exchange like a stock; the price variations occurring as people buy and sell the fund over the day.

ETF – Good Value Investing Tool

ETF’s are very popular with value investors since they often have tax advantaged status. That is you don’t pay on the capital gains with the ETF only when you sell your investment. In the current law if you sell after one year that means long term capital gains which as of this writing is only 15%. Another reason ETF’s should be popular amongst the value investing crowd is that unlike mutual funds Exchange Traded Funds can trade at the same price as a stock Trade. Both TradeKing and Zecco charge $4.95 for an ETF trade the same as an individual stock.

ETF the Nitty Gritty

An ETF often represents a set of stocks. For example the SPDR 500, the oldest ETF follows the Standard & Poor’s 500 Index, which is an index of the 500 largest companies in the US. ETF’s portfolio would not change over the course of their lifetime and that means that investors are aware what they are investing into. If an ETF says that it is investing in energy stocks, then it is investing in energy stocks.

An ETF’s price is determined by their daily trade volume which is not the case with other funds. Because of the inherent benefits of Exchange Traded Fund, they are widely used as a preferred mode of trading across the globe with more than a few hundred Billion dollars having been invested in various funds across hundreds of indices.

ETFs do not sell individual shares to investors like Mutual Funds., large blocks of shares known as creation units are issued. The creation units are not purchased by the investors in cash, rather they are purchased in the form of a portfolio of shares which would represent the portfolio of the ETF. Investors after purchasing the creation units can either sell the shares in the secondary market or sell them back to the Exchange traded fund.

Another difference between a Mutual Fund and an ETF is that Mutual Funds have their Net Asset Values computed at the end of a trading day based upon the values of their holdings; they constantly trade in the market to reflect a better price. However Exchange Traded Fund gets their prices determined by the push and pull of the market since they follow a fixed basket of stocks.

Mutual Funds – Beginning Value Investor Terms

chroma — Sun, 31 Jul 2011 05:14:00 +0000

Mutual Funds are investment vehicles that are designed for people who do not want to spend a lot of time researching individual stocks, bonds or other assets, but still want part of their portfolio investment in these markets. It is not quite so simple as you will see. Your money is pooled with that of other sheep, er, investors, then stocks, bonds, or whatever is the focus of the mutual fund are purchased. These purchased assets make up the portfolio of the mutual fund. The money you invest in a mutual fund are shares of the fund.

The mechanics of investing in a mutual can be simple. Say you decide on particular mutual fund, you sign onto your online brokerage account and purchase. Oh wait. This is where the not so simple part comes. There a couple of type of Mutual Funds. The first and most important is what is called a No-load Mutual Fund. Load stands for Load of crap or commissions. A No-Load Mutual Fund doesn’t charge commissions. There is no advantage to loaded Mutual Funds (pun intended). The take can be as high 5% or in the case of a level load fund, be an ongoing tax on your returns. There is no advantage to paying the commission in terms of investment returns, since mutual funds with loads don’t outperform no load funds as a group over time.

Mutual funds are like stock investments in that they are not guaranteed to hold their value by any governmental agency like the FDIC does for bank accounts.

I use the word sheep earlier to describe investors in mutual funds. That is not quite fair. Warren Buffett has famously said that for an investor who does not have the time understand equities investments a good index fund is a good place to invest your money. The problem is that the majority of index funds under-perform the market over time. Even when a mutual fund out performs the general market, most individual investors still do worse than the market as a whole. They tend to buy right after a manager has had a great year or two and sell when the manager has had a bad year or two. In other words they buy at the top and sell at the bottom. In general, you can expect to under-perform the market by the amount of fees and expenses the mutual fund charges. This varies. Zecco, one of the discount online brokers I use, charges $10 for a no-load mutual fund purchased on line. TradeKing charges $9.95, this compares to $4.95 for a stock trade.

And don’t forget the tax ramifications. If you buy an active fund, every time they sell for a gain (assuming the holding period is less than a year) the fund will pass along the capital gains to you. This takes away the control of when you want to have capital gains or losses. This may be fine with you. It isn’t for me. If you are interested in someone else managing your money.

Margin of Safety – Beginning Investor Terms

chroma — Thu, 25 Feb 2010 05:39:22 +0000

Margin of Safety is a concept I write about a lot. It is the make or break for any investment. While I may fudge the amount from time to time, all investments have to have a margin of safety to be worth shelling out my cash. But what is a Margin of Safety?

It is a term that Benjamin Graham and David Dodd coined in their seminal book, Security Analysis. First Graham began with the idea of intrinsic value. Or how much a company is worth (in opposition to how much it costs). If the price of a companies’ share is lower than the intrinsic value of that share then the difference is a margin of safety. Graham argued for a minimum margin of safety of 33%. More is better, but harder to find. The purpose is to protect an investor in case some part of your analysis in determining the intrinsic value is incorrect, or to help protect if the market or luck turns against you.

In a recent example VOXX, my NCAV value was $9.82/share. By my reckoning this would be VOXX’s intrinsic value. The price when I bought VOXX was $6.60/share. This gave me a Margin of Safety of about right under 33%. Any questions? Please post in the comments or email me chroma@chromainvesting.com

Does a Risk Free Rate Really Exist?

chroma — Fri, 19 Feb 2010 04:51:14 +0000

I was perusing Musings on the Markets, Damodaran’s blog and came across a post entitled Thoughts on the Risk Free Rate. Perhaps, because I am not an academic, I usually reject ideas that seem contrary to logic or that seem designed for an academic and not practical use. The Risk Free rate is one of these notions. This is of course not a reflection on Damodaran’s work. I am a fan. The concept of the risk free rate does not originate with him. It seems to be part of the whole Modern Portfolio Theory bag of tricks. And although it is used as a basis for the Black Scholes option price model and for calculating the Sharpe Ratio, I do not think the risk free rate actually exists. It is a theoretical construct that enables people to compare rates of return, on a theoretical risk adjusted basis. As I have written before, I am not interested in theoretical returns on my capital, but real returns.

What is the risk free rate? It is the rate of return that you can get without any default risk, that would be guaranteed for certain period of time. Investopedia says, “In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.” Ordinarily, in the United States our 3 month government t-bills act as the risk free rate, according to Investopedia.

I prefer not to divorce myself from the concept that long tail or Black Swan Events are always possible, if unlikely. By definition, risk cannot be assumed away in the real world, without ignoring unlikely events. I like them to be included in all my thinking. It forces me to always think of the downside. I am fairly risk averse. I look for a margin of safety, because I am likely at some point, to be wrong, or not have analyzed some aspect of an investment correctly.

In a post on Investing Risk, I laid out a couple of ideas concerning investment risk, including the concept that there are some risks that we may not know, or anticipate. Because we are unaware of a risk does not mean it doesn’t exist. That is the problem with risk free rate, it assumes away the unknown, or unknowable. That does not mean risk has disappeared, just that we are ignoring it.

Intrinsic Value – Beginning Investing Terms

chroma — Fri, 05 Feb 2010 04:24:39 +0000

Intrinsic value may be the most important concept in value investing. It is the foundation of everything else. Value Investors all agree that you start with the intrinsic value of a company. Now, how you arrive at that value is a different proposition, there you will have a lot of disagreement.

In their landmark book on Investing, Security Analysis, Ben Graham and Dodd describe intrinsic value in its opposition to market value. The notion of market value is clear: what the market is offering for the company today. However, intrinsic value takes a bit of work to tease out. I found the definition of intrinsic value at both investopedia and wikipedia unsatisfying. Graham describes it like this, “that value which is justified by the facts e.g., assets, earnings, dividends, definite prospects.” While the modern notion of this has been mostly relegated to Discount Cash Flow Models or “Owner Earnings,” if you follow Buffett, Graham had a more broadly based idea of Intrinsic value. You may value a company on Assets if it you are looking at traditional Net Net companies, or future earnings if you consider yourself a fundamental investor, or ability of a company to generate dividends if you are an income investor. Ultimately, you have a value of the company that is apart from price of the stock.

Ideally, you would only buy stocks whose market price is below its intrinsic value/ share. And commonly when the price of the stock reaches its fair value, or intrinsic value you might sell. Of course if the intrinsic value of a company keeps rising, you could also continue to hold it.

Beginning Investor Terms – Quick Ratio or Acid Test

chroma — Thu, 21 Jan 2010 07:01:23 +0000

The Quick Ratio, also known affectionately as the “Acid Test” is a metric used to measure short term solvency. In non jargon it is a formula used to figure out whether or not a company can meet its short term obligations. If a company fails the test, it would be wise to watch.

Here is the math, The Acid Test = (Current Assets-Inventory)/Current Liabilities. Should be greater than 1, although like any metric, it can vary from industry to industry.

To provide a comparison the Current Ratio = Current Assets/Current Liabilities. Should be greater than 1.5

Dollar Cost Averaging (DCA) – Beginning Investor Terms

chroma — Thu, 14 Jan 2010 03:54:17 +0000

Dollar Cost averaging is one of those perennially stupid ideas like Efficient Market Theory, that is so dumb, that I wonder how anyone could buy into it. It is completely contrary to the logic of Value Investing. But my opinion aside, it is a popular idea among investment advisers, so good to know what it is.

Dollar Cost averaging assumes that since we can’t know the direction of the market we should continue to invest the same amount of money spread out over a particular period of time. It works like this: you put $100 every month into GE stock regardless of the price, so that over time, theoretically, you are lowering the overall price basis you pay for a stock. Investopedia says, “Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time.” This of course assume that stock prices are moving up over time.

Really? What if GE stock is overvalued two months into this investing plan? Who wants to invest at the top of the market? You might as well say buy high, sell low. No one knows with certainty the top or bottom of a market, but anyone can determine whether or not buying particular stock, at a particular time is a good or bad deal, the current price is above or below the intrinsic value of the stock. If GE is a bad deal why would you dollar cost average? Avoid the stock. If it is a good deal why would you dollar cost average? Load up the truck. Warren Buffett, according to Alice Shroeder, the biographer of “Snowball,” said that Buffett doesn’t support Dollar Cost averaging. Me either.

Altman Z score Redux – Covering your back side better

chroma — Sat, 09 Jan 2010 18:12:43 +0000

Altman Z score has been around since the 1960′s and I have posted about it previously. Originally it was set up and measured the risk of bankruptcy among manufacturing firms. It turns out that in subsequent studies it was found that the original Altman Z score might be under reporting bankruptcies among non-manufacturing firms. Given that used correctly it has a 80%-90% accuracy of predicting bankruptcy in the next year, Altman Z is a great tool, but it must be used correctly.

Here is a review of the area’s that Altman tracked:

Altman’s original formula is a weighted sum of different elements, which are as follows.

T1- Working Capital/Total Assets

T2- Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4

You will note that there is no T5 included in this version of the Altman Z score. It seems that including the T5 increased the likelihood of missing a potential bankrupt company for non manufacturing firms. The revised Altman Z score cannot be used for Manufacturing companies, which requires the original Altman Z score. Nor can it be used for privately held, or publicly traded financial companies. Also, beware that companies with one time charge offs may show up negatively. Finally the Z score cannot be accurately used for companies with less than $1 million in assets and reportedly more accuracy may be obtained by using companies with more than $100 million in assets. The Altman Z score is probably not all that accurate in the small camp universe I usually tread. It has more narrowly defined uses than I originally realized.

But as the formula was adjusted for non- manufacturing corporations, so were were the weightings for the individual elements.

Greater than 2.6 is considered safe, financially for the next couple of years.

1.1 – 2.6 Gray Zone. Could go either way.

Below 1.1 Distress Zone. Bad. Likely that the company will bankrupt within two years. Not a lock, but you are warned.

As with any other tool, the Altman Z score has its limitations. But it can be a powerful tool both for avoiding stocks with a high probability of failure and increase the probability of avoiding

Beginning Investor Terms – Return on Assets (ROA)

chroma — Tue, 29 Dec 2009 05:48:13 +0000

This week’s Beginning Investor Term is Return on Assets (ROA). ROA is another investing concept, like last weeks ROE, that helps determine if Management is running a company effeciently. Or in this case specifically the assets it has at it disposable. Assets include both shareholder equity and debt. Thus a company with no debt would have an ROE and ROA that were virtually identical.

Return on Assets may be even more industry specific that ROE. It is usually used as a comparison within an industry or compared to a companies own historic ROA. The reason for this is pretty straight forward. Some industries require very different resources. A telecom company needs larger outlays of financial resources to produce $1 of income than a software company.

Some of you were hoping I would skip this part. Here is the math. ROA=Net Income/Total Assets or an alternative equation is ROA = (Net Income + Interest Expense)/Total Assets. The latter equation includes the costs of debt and thus, to me, is a better metric, although the first is more common.

When making investment decisions if you discover that a company has a higher ROA than its industry peers, that is good. If it is generating a smaller ROA that is brethren, management is not doing as well. Use the information as part of your overall investment strategy when evaluation management.

Return on Equity (ROE) – Investing Terms

chroma — Thu, 24 Dec 2009 05:57:43 +0000

Return on Equity (ROE) is one of those fundamental concepts of investing. The principle is simple. What is the return on the stock holders equity invested in a company. As with almost everything else, there is an equation involved. ROE=Net Income/Shareholder’s Equity. Net income in this case is after Preferred shareholder’s dividends have been paid but before common stockholders dividends. Shareholder equity is common shares only, not preferred shares.

This is a concept that falls into the more is better category. The higher the return on equity the more attractive a company is to investors. It is known that Warren Buffett likes high ROE companies. The reason to favor high ROE companies is that ROE can be used as rough measure of management efficiency. If management is able to consistently reinvest shareholder equity at high rates it leads to growth. And to most investors Growth is god.

ROE is one of those metrics that is worth looking at, but then comparing within an industry. High Return on Equity alone is not a valid reason to invest in a company. Companies with high debt or leverage, can conceiably have higher a ROE because debt is fueling the company not shareholder equity. But the additional leverage carries with it risk.

Chroma Investing » Investing terms

Beginning Value Investor Terms – Exchange Traded Fund (ETF)

ETF Defined

ETF – Good Value Investing Tool

ETF the Nitty Gritty

Related Posts:

Mutual Funds – Beginning Value Investor Terms

Related Posts:

Margin of Safety – Beginning Investor Terms

Related Posts:

Does a Risk Free Rate Really Exist?

Related Posts:

Intrinsic Value – Beginning Investing Terms

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Beginning Investor Terms – Quick Ratio or Acid Test

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Dollar Cost Averaging (DCA) – Beginning Investor Terms

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Altman Z score Redux – Covering your back side better

Related Posts:

Beginning Investor Terms – Return on Assets (ROA)

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Return on Equity (ROE) – Investing Terms

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