Monday, January 31, 2011

Birth of a Business


Almost every area of study has its specialized vocabulary.  Medicine, law, engineering and science each have special terms.  Although unfamiliar to those outside the profession, they have meaning and significance to those who practice in the field.  The same is true of investing.  Those who want to invest must know the terms used on Wall Street.  For readers familiar with investment/business terms, the following may be tedious, but I have to assume that some visitors to this blog may not understand some or all of them.  Vocabulary exercises tend to be boring, so we'll avoid the dictionary style of defining words.  I started this blog to share information with individual investors.  But, what if I was in it for the money?  The business/investment terms you as an investor must understand will be highlighted in bold in the story below.  Here is how a business comes into being.

Assume I have an idea for a new business.  The only problem is that I don't have enough money to get it off the ground.  I want to run a blog site and charge people a subscription fee to read my blogs.  I will need an office to work in;  a powerful, fast computer to work from; lots of servers to handle the traffic I expect to generate with my blogs; professional help with the design and launch of the site, and employees to keep the site up and running.  All of that takes money, also called capital.  No bank is going to lend me the money to launch my dream.  Therefore, I have to find people who share my belief that the site can make a profit.  They would want to own a piece of the company I want to start; to buy shares of the corporation I will form.  They are providing venture capital for the new business. They agree with me that my blog site will be so informative that it will attract lots of visitors from the web who would pay a subscription fee in order to read my blogs.

There are companies, venture capital firms, who make a business of investing money in start up businesses.  They provide the initial capital to an entrepreneur to get his or her business going.  They make this investment with the goal of getting in on the ground floor of a business which will be so successful that the venture capitalists, or VCs, can sell their shares, once the business is successful, to other investors at a  big profit.  It is possible that some lucky folks gave Bill Gates his start up money for Microsoft.  Too bad it wasn't you or me.  My blog site idea would not qualify as a business that the VCs would be interested in as an investment; it's too small.  So, I contact people I know, asking for the money I will need for my blog site business.  For our purposes, we will assume the needed capitalization to be $5,000.

After badgering my friends and family, I get 5 people to commit to buying shares.  They could be called angel investors, since their money seems almost heaven sent.  However, not everyone is willing to invest an equal amount, in this case, $1,000 from each of the 5 investors to raise the necessary $5,000.  Some are willing to invest only $200, while others may have more money to risk.  I have $1,000 to put into the business.  Having secured investment commitments, I organize a corporation and call it Best Blogs Ever, Inc. We will call it BBE for short.  BBE will issue (sell to the investors) shares of its common stock for $10 per share.  The price per share is called the stock's par value.  Someone with $200 to invest will get 20 shares.  I get 100 shares for my $1,000 investment and so on with each of the other investors.  For their money, the investors each get a stock certificate indicating the number of shares they own in BBE.  The corporate papers I file with the state, the Articles of Incorporation, provide that the company has the right to issue up to 1,000 shares.  Those shares are authorized, but only 500 of them are needed at this time in order to raise the $5,000.  The 500 shares sold by the corporation at $10 each to the investors are now outstanding.  Each investor owns a percentage of the corporation equal to the percentage his or her cash investment represents of the total $5,000 of capital raised.  Since I put in $1,000 of the $5,000, I have a 20% interest in the business and its profits or losses.  The money raised is the equity in the company.  It is invested in, not loaned to, the company.  The company need not pay it back.

With the $5,000 in the bank, the business is ready to go.  The corporation can rent the office, buy the needed equipment, get the blog site up and running and hire employees to keep it going.  My job will be to write those money making blogs.  The capital will keep the company going and pay its expenses until the blog subscriptions start rolling in.  My 5 investors were willing to invest money, but they have no interest in spending time running the day to day operations.  However, they do want to remain involved to a certain extent.  Therefore, the shareholders elect a  board of directors to keep an eye on the company.  Each shareholder has one vote per share, so the person who bought 20 shares gets 20 votes, and I have 100 votes for my 100 shares.  Let's assume that, since I will be involved in the operations, I get elected to the board with two other investors who agree to maintain some level of involvement.  The corporation now has three directors on its board of directors.  The directors elect me to be in charge of the board,  the Chairman of the Board.  The board then elects officers to manage the operations, typically a president, vice president, secretary and treasurer.

The officers may or may not be directors or shareholders, but they are in charge of the business and report the results of the business periodically to the board of directors.  Similarly, the board will inform the shareholders how the business is doing.  The shareholders will want to know if the company is making or losing money and, in either case, what the directors and officers intend to do about it.  This usually happens once a year at an annual meeting of the shareholders.  The officers and directors provide this information to the shareholders in what is called the annual report.  The annual report is usually mailed to all shareholders before the annual meeting so everyone gets the information even if they can not attend the meeting.  At the annual meeting, the shareholders have the right to reelect the directors or, if they don't like how things are going, to vote new ones into office.  They may also vote on any other items of business which require a shareholder vote under the law or for which the directors and officers want shareholder input.  It is, after all, the shareholders' company, and they ultimately call the shots.

Now that BBE has been started, we will follow its progress in the next post.

Feel free to leave a comment by clicking the comments link below.  It is easiest to choose the "Anonymous" profile to send it.  It will be posted within 24 hours of receipt.  I reply to any comments on Fridays and  post on Mondays.

Monday, January 24, 2011

Wanna' Bet?


In order to rationally participate in the market, you need a strategy.  In deciding on a strategy that works for you as an individual investor, you first must decide what making an investment means to you.  Is it all about investing your money in a well run publicly traded corporation?  Or is it more like placing a bet at a black jack table in Vegas?  It is best if you know which type you are.  We return to The Money Game by Adam Smith for some insight into Vegas style gamblers and Wall Street style investors.  He wrote about the legendary English economist and investor, John Maynard Keynes, as follows: 

We are taught - at least those of us who grew up without a great deal of it - that money is A Very Serious Business, that the stewardship of capital is holy, and that the handler of money must conduct himself as a Prudent Man.  It is all part of the Protestant ethic and the spirit of Capitalism and I suppose it all helped to make this country what it is.  Penny saved, penny earned, waste not, want not, Summer Sale, Save 10 Percent, and so on.  Then I came across this sentence in "Long-Term Expectation" of Keynes' General Theory:

The game of professional investment is intolerably boring and overexacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.

Game? Game? Why did the Master say Game?  He could have said business or profession or occupation or what have you.  What is a Game?  It is "sport, play, frolic, or fun"; "a scheme or art employed in the pursuit of an object of purpose"; "a contest, conducted according to set rules, for amusement or recreation or winning a stake."  Does that sound like Owning a Share of American Industry?  Participating in the Long-Term Growth of the American Economy?  No, but it sounds like the stock market.

Buying stock in a company, regardless of the amount of study and careful investigation, remains, at its essence, a bet on the future performance of the company.  A bet is a bet, no matter how you dress it up.  The fact that there does not appear to be a particular person on the other side, in effect betting against you, does not change the fact that you are making a wager.  With a nod to Ben Graham, you might want to think of Mr. Market as putting down the bet against you.

Justin Mamis also discusses the gambling aspects of stock investing.  We have already spent time with his book, The Nature of Risk, Stock Market Survival and the Meaning of Life, exploring the effect on us of our childhood angels, or demons if you prefer.  You may remember that he characterized Americans not as basically optimistic, but rather as perpetually hopeful.  He compared an investor to a sports fan in a search for excitement as follows:

The cliches of daily life are those of routine, discouragement, tiredness; of the rat race; of a cold, the IRS.  Guys root for dreadful teams for years - keep buying season tickets in the hope that eventually they'll own seats for the Super Bowl or World Series.  And better than being a sports fan - because you can actually participate - and even better than gambling - because it is socially acceptable - playing the stock market becomes a way out of an otherwise mundane and stressful environment.  It has glamour, plus the chance of improving one's lot without being an overt bet.  There's an excitement to it, along with the illusion that a successful investment is almost within reach, if one only knew how to use it.  The market seems to represent hope itself.

I must take issue with Mr. Mamis' comment that an investment is not an overt bet.  It most certainly is.  The fact that it is a bet does not make it illegal, immoral or fattening.  It is what it is, and an investor should just accept it.  If however, an investment is made, regardless of the rationalization behind it, just to participate in the market's excitement, then losses will almost surely follow.

Fishing, to those who don't, looks to be a rather dull activity consisting of either throwing a lure into the water repeatedly or just sitting and watching a floating bobber.  Those who fish know the slight, hopeful tension experienced with each cast or with each dip of the bobber - maybe this time a fish will take your bait and run with it.  Regardless of the degree of professionalism behind a stock purchase, I suspect that many investors share that same hopeful excitement with the fisherman - maybe this time the market will take your stock and run with it.

Making a stock purchase or waiting for that last card - they both have a common element, each is a bet on the future.  Facing the unknown always generates a certain level of emotion.  It's just part of Professor Keynes' Game.

In the next post, we will learn the vocabulary of Wall Street.  For some, this will be old hat.  For others, this will explain the terms we'll use when we explore strategies of investing.

Feel free to click the comment link below, add your thoughts and pick the "Anonymous" profile.  You can also add your name.  All comments are posted within 24 hours of receipt and replied to on Fridays.

Excerpts from The Money Game by Adam Smith, copyright 1967, 1968, are used with permission of Random House, Inc.  Excerpts from The Nature of Risk, Stock Market Survival and the Meaning of Life by Justin Mamis, copyright 1991, are used with permission of Mr. Mamis and Fraser Publishing Company.

Monday, January 17, 2011

A Lone Wolf Does Not Call Home


Once a wolf pup reaches maturity around the age of two years, in some instances the leader of the pack, the alpha wolf, will see it as a threat to its leadership and drive it away.  After that,  the lone wolf must look out for itself without the support and companionship of the pack.  Similarly, a child eventually grows up and moves out on his or her own to make a way in life.  As Mr. Mamis pointed out, parental cautions go with you and quietly but strongly affect how you conduct your life, including your investing.

An investor should pattern his or her investing methods along the lines of a lone wolf.  Become comfortable with making your own decisions and investment choices.  The individual investor must not only ignore the clamoring of the crowd, but also lower the volume on those lingering cautions from childhood.  There are many in the investment community who will want to "help" an individual make investments, whether purchases or sales.  You must keep foremost in your mind that, unlike Mom, it is not your best interests which are closest to their hearts, but rather your investable funds.  There is an old saying on Wall Street: "Stocks are sold, not bought."  Someone is always ready, indeed eager, to give advice and sell you something, for a fee.  Remember, though, it may or may not be the best thing for your investment portfolio.

Al Frank is a well respected investment professional.  He has achieved fame as the editor and publisher of the investment newsletter, The Prudent Speculator.  His newsletter has been read by investors for the past 30 years.  Mr. Frank wrote a book, The Prudent Speculator, on investing in 1989, which he updated it in 1996.  The latest book, Al Frank's New Prudent Speculator, is still in print.  His investing philosophy is value investing in businesses undervalued or overlooked by the market.  We will explore his book in greater depth in later posts, but for now his message about belief is pertinent.  He tells investors to ask themselves, "Does this system generally make sense to me?"  Although the goals are entirely different, your investment strategy is similar, in one respect, to your religious beliefs.   If you are not a true believer, you will not follow the religion's teachings when you must choose a course of behavior.  If you do not truly believe in the investing strategy you pick, you will not follow it when you must choose an investment.

There are many investment strategies:  fundamental analysis, technical analysis, value, growth and contrarian styles of investing, to name but a few.  Many Wall Street professionals bill themselves as followers of one or another of these investment styles.  They promise you investing success and wealth if you pay them a fee to invest your money for you.  You can avoid the cost of the professional if you decide to make your own investments and rely solely on an investment strategy which makes sense to you.  You will be free of the crowd roar and the childhood whispers.  The multitude of ways to invest provide an individual with a smorgasbord of choices.  The investor's task is to find the one that works best for him or her.

Surprisingly, it is not difficult for a person to make investments which are appropriate for the investor's goals once he or she has formulated a comprehensive, coherent and cohesive investment strategy and implements it consistently.

Wolves are instinctively pack animals and hunt together.  The lone wolf must fend for itself and hunt alone.  Once the individual investor can make his or her investment decisions based on a strategy he or she believes in, both the noise of the crowd and the inner parental warnings will fade away.  At that point, the individual will find the self confidence to also hunt alone.

In the next and subsequent posts, we will explore all sorts of investment strategies.  Hopefully we will find one that appeals to you.  You can leave a comment by clicking on the comments link below.  Add your comment and pick the "Anonymous" profile for posting.  If you wish, feel free to add your name to your comment.  It will be posted within 24 hours of receipt.

Al Frank's New Prudent Speculator by Al Frank, copyright 1989 and 1996, is published by Irwin Professional Publishing.

Monday, January 10, 2011

Say Hello to Mr. Market


First, let me apologize for any inconvenience you may have experienced by my missing last Monday's post.  I was out of town for the Christmas Holiday and goofed up the "timed" post publishing feature on the blog site.  I published it as soon as I realized this on Wednesday.  That post received a comment from Sam, one of our readers.  You can click his comment and my reply at the bottom of the January 5th post.  As I told him, he had anticipated this post.  Dr. Le Bon showed how any investor, including Sam's cynic, can be affected by the irrationality of the market, but only if the investor lets the market crowd sway his investment convictions.  The way to avoid these external influences is to think of the market in the terms used by Benjamin Graham in his seminal book on investing, The Intelligent Investor.  Mr. Graham, who taught Warren Buffett at Columbia University, described the market as follows: 

Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.  If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise?  Only in case you agree with him, or in case you want to trade with him.  You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

And, as they say, no one has ever said it any better.

There are two things to take away from Mr. Graham's analysis of Mr. Market.  First, the quotes made by the market for stock are transitory - the quote is only the stock's price at that moment.  And that is a price you can choose to accept or ignore at that moment.  Like buses, there will be another one along in a few minutes.  Second, the individual investor should always keep in mind what he or she believes the value of the stock to be when that momentary price is presented and not confuse price with value.

The price of a stock at any given moment usually has no relation to the value of the business represented by the stock.  If Mr. Market's offer to buy is at a price which, in your estimation of true value, is foolishly inflated, you can sell and pocket the money.  Conversely, if his offer to sell is at a price which, in your estimation of true value, is ludicrously low, you can buy from him.  Then just wait for his subsequent buy bid to exceed the price he previously sold it for by an amount you find attractive.  Then sell it back to him.  Continue to repeat this process.  All an investor has to do is wait for Mr. Market to turn irrationally happy or sad over and over again.  If his quote seems sane and close to value, well just walk away and do nothing.  There is no obligation to sell on your part.

If you personify those millions of individuals involved in the stock market every day as just one person, Mr. Market, it makes it easier to decide whether you buy, sell or ignore his price completely.  That will significantly reduce the external pressures exerted by the crowd.  If you assume Mr. Market is usually nuts, then it's easy to ignore him.  If he happens to be right, you can nod your head in agreement and go for a walk.

Sam also asked about the internal pressures discussed by Mr. Mamis.  We will discuss how to deal with them in the next post.

Like Sam, you can leave a comment without going through the process of signing in.  Click the comments link, add your comment and pick the "Anonymous" profile.  Add your name if you wish.  Your comment will be posted within 24 hours of receipt.  Sam and I would enjoy hearing from you.

The Intelligent Investor - Revised Edition by Benjamin Graham, copyright 1973, is published by HarperCollins Publishers, Inc. in their HarperBusiness Essentials series. 

Wednesday, January 5, 2011

Gustave Le Bon & Justin Mamis - A Reprise


There is a common thread running through Dr. Le Bon's discussion of crowds and Mr. Mamis' treatment of an individual's wrestling with riskDr. Le Bon reveals the "psychological" crowd, moving almost as one person who has been hypnotized.  Mr. Mamis reveals that a crowd of subconscious parental lessons and emotions from childhood can impact an person's decisions and actions for a life time.

Dr. Le Bon believes that a person in a crowd (either real or psychological) loses his or her sense of individual responsibility and becomes very susceptible to the contagion of the idea or image embraced by the crowdIn effect, the person becomes subject to a level of suggestibility which draws him or her into the crowd.  Once subject to the force of the crowd, the person becomes impetuous and takes up the crowd's vision with abandon.

Mr. Mamis says that each person has an inner voice warning him or her of the risks in life and suggesting that they be avoided.  Careful thought and preparation for every risk in life is the inner parental answer.  Unfortunately, neither life nor the market will always give a person sufficient time to fully ponder the choices nor all of the information needed to make the best choice.  As Mr. Mamis explained about the market, Because it is a process, there is no one moment or single point, at which one can make an obvious "sure" decision.

So, what is the lesson to be learned from these two authors?  It would seem that the individual investor making what is intended to be a long term investment must be able to recognize not only the external crowd (market) influences trying to take over his or her thought process, but also those inner voices and emotions demanding a moment-to-moment choice be made on that long term decision.

If you, the investor, can keep in mind the image of the grain of sand being moved about on a beach by wind or waves as depicted by both Dr. Le Bon and Mr. Mamis, you may be able to reduce the external as well as the internal pressures you may experience in the hurly burly of the market.  Those pressures, to a certain extent, depend on how you approach the market and investment decisions.  We will begin to explore that approach to the market in the next post.

You can leave a comment without going through the process of signing in.  Click the comments link, add your comment and pick the "Anonymous" profile.  Add your name if you wish.  Your comment will be posted within 24 hours of receipt.

Excerpt from The Nature of Risk, Stock Market Survival and the Meaning of Life by Justin Mamis, copyright 1991, is used with permission of Mr. Mamis and Fraser Publishing Company.