Monday, March 28, 2011

Gold Mining, Hang Gliding and Power Walking


You can roughly divide investment strategies into three overall types: fundamental analysis, technical analysis and efficient market theory.  Each one has subsets, but a majority of fundamental investors study the financial condition and prospects of a company in which they might invest.  Most technical investors pay attention to price levels either of the market in general or of a particular stock and try to determine the probable direction in which either or both of them might be headed.  Proponents of efficient market theory reject the other two and believe a stock's price says it all.

Those investors who make investments based on fundamental analysis, the gold miners, spend the majority of their time looking for public companies with financial characteristics they feel will lead to an investment profit.  They analyze things like the company's price earnings ratio, debt to equity level, asset to liability ratio, revenue and earnings growth rates, return on assets or on equity, profit margins, dividend payout ratios, interest coverage ratios, quality of management, overall prospects of the general industry in which the company does business and the like.  The goal is to find a company whose financial strength and business prospects are such that an investment in its stock will increase over time with the anticipated growth of the company's finances, business and profits.  They are searching for gold nuggets in a mine full of financial data.

Those investors who look to technical analysis, the hang gliders, spend the majority of their time looking at either the state of the market in general and the way its overall price level is acting or a stock in particular and its price movement.  They pay attention to the price action of a stock, not its financial characteristics.  They analyze things like 65 and 200 day average price movements, trading volumes, advances and declines in prices, prices being held at or breaking through resistance levels, price charts and the like.  The goal is to find a company whose stock price is behaving in a way that signals the opportunity to profit from its anticipated momentum.  They want to catch the wind and ride it to a profit.

Those investors who rely on the efficient market theory, which was developed by academics in university economics and business schools, believe that markets constantly and efficiently set the price of each and every stock in the market.  Since the market price reflects everything known about a stock at the time, neither fundamental nor technical analysis provides an investor with any benefit or advantage.  This is popularly referred to as the random walk theory of investing.

Fundamental investors see a stock as an investment in and an ownership of a company's business.  Technical investors see a stock mainly in terms of its price and the probable direction in which that price will move.  Random walk investors see a stock price as revealing everything there is to know about a company and its stock at that moment.

We will examine each of these schools of thought, their proponents and heroes in subsequent blogs.  We will start with a famous fundamental stock analyst, Philip L. Carret, in the next blog.

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Monday, March 21, 2011

Some Simple Truths



There are days when the market declines for no apparent reason.  When asked why, someone will invariably say, "More sellers than buyers."  I must admit to being guilty of that comment a time or two.  But I finally realized the comment was wrong.  When the market is open, each stock has a bid quote from a buyer and an ask quote from a seller.  There is a buyer for every seller; the people are there.  However, a person can not be a seller if no one takes the other side of the trade at the seller's price.  There is a bidder on the other side, but his or her bid is not at the price the seller is asking.  If a seller wants or needs to sell and the price is not rising, then sooner or later he or she will have to accept a lower price.  That is what makes for a decline.  Perhaps the more accurate way to explain a market decline is to say, "More desire to sell than appetite to buy."  The same holds true, in reverse, for a market rising for no apparent reason.  Then it's, "More appetite to buy than desire to sell."


One stock; one price; one moment in time.  For someone who bought the stock at a lower price, that price represents a profit, albeit on paper.  For someone who bought it at a higher price, the same price represents a paper loss.  Someone who decides to sell at a profit, in many instances, thinks the stock has gotten as high as it might and wants to lock in the gain before it drops.  That seller's buyer, on the other hand, thinks the stock will go to a much higher price.  Someone who sells at a loss, in many instances, thinks the stock will continue to go lower and wants to stop the bleeding.  That seller's buyer, on the other hand, thinks the stock is ready to turn around and head higher.  One stock; one price; one moment in time.  With a nod to Albert Einstein, the price is, indeed, relative, dependent on an investor's position in relation to the current price and his or her idea of its next movement.  Each price generates two different views of the same stock's relative value at that time and its future.


Adam Smith in his book, The Money Game, warns about becoming emotionally invested in a stock you own in the following passage:

You can see that all this is leading to another of Smith's Irregular Rules, this one that the identity of the investor and that of the investing action must be coldly separate.  A stock is, for all practical purposes, a piece of paper that sits in a bank vault.  Most likely you will never see it.  It may or may not have an Intrinsic Value, what it is worth on any given day depends on the confluence of buyers and sellers that day.  The most important thing to realize is simple:  The stock doesn't know you own it.  All those marvelous things, or those terrible things, that you feel about a stock, or a list of stocks, or an amount of money represented by a list of stocks, all of those things are unreciprocated by the stock or group of stocks.  You can be in love if you want to, but that piece of paper doesn't love you, and unreciprocated love can turn into masochism, narcissism, or, even worse, market losses and unreciprocated hate.

An investor should try to keep all of this in mind when coming to the market.  In the next blog, we will start exploring the ways investors approach investing in stocks.

The passage from The Money Game by Adam Smith, copyright 1967, 1968 by Adam Smith is reprinted with permission of Random House, Inc.

Your comments are always welcome and will be posted within 24 hours of receipt.


Monday, March 14, 2011

The Final Monday With The Venture Capitalists


This Monday we are again meeting with the folks from Venture Funds, Inc. (VFI) to wrap up the negotiations for their investment in Best Blogs Ever, Inc. (BBE). We have agreed that VFI's $70,000 investment will be divided between a minority interest in the common stock of BBE and its new issue of preferred shares.  Provisions in BBE's Articles of Incorporation establishing the preferred shares will provide for the cumulative and convertible rights negotiated last Monday.  Today, VFI's representatives suggest that the preferred shares also share in any future increase in dividends declared by the board of directors for the common stock.  In most instances,  preferred shares receive a fixed dividend regardless of the amount of earnings of a company, much like interest to be paid on a bank loan.  Increased earnings can translate into increased dividends for common shares.  Preferred stock sharing in dividend increases paid on common shares is called  participating preferred stock.  We reject this proposal.  Our treasurer points out that since VFI will own common shares, it will participate, to a certain extent, in any future increase in common stock dividends.

After some further discussion, the deal is reached.  Everyone agrees that BBE will amend its Articles of Incorporation to increase the number of authorized shares from the original 1,000 shares of common stock to 10,000 authorized shares with a par value of $1 each.  There had been earlier discussions about more shares being authorized, but to keep the math simple, 10,000 shares at $1 par value is the agreed upon number.  This is equivalent to the original 1,000 authorized shares with $10 par value.  BBE will have 9,500 shares authorized, but unissued shares of common stock plus the original 500 issued and outstanding sharesWith that many shares now authorized, the board of directors will declare a stock split of the issued shares on a 10 for 1 basis.  The original 500 outstanding shares with a par value of $10 each will become 5,000 shares with a par value of $1 each.  The existing shareholders will continue to own the increased number of issued shares in their original percentages.

Based on BBE's earnings of $5,000 for the last year of operations and its retained earnings of $10,000, the old 500 shares might be valued at $30 per share ($10 par value and $20 per share of retained earnings).  Those figures are reduced for the 5,000 split shares by a factor of 10.  The new 5,000 shares could be valued at $3 per share.  The $1,500 of dividends would now be shared in the same proportion.  Before the stock split, each of the original shares received a $3 dividend.  The 5,000 shares would now receive a 30 cent per share dividend.  Someone recalls our president's previous joke about the customer asking for his pizza to be cut into 4 slices as opposed to 8 because he is not that hungry.  The income and dividend numbers continue to apply; they are just spread among more shares.

When VFI purchases common shares, those numbers will be divided among even more shares.  In order to allow the original shareholders to retain control of BBE, VFI will purchase 4,000 shares of common stock.  Although the par value for the new shares is $1, VFI agrees to pay $2.50 for each share of common stock.  The par value has continued to lose its meaning, and it now becomes even less important.  The value of a share of common stock is not its par value or its book value, but rather what someone will pay for it.  Consequently, BBE will issue 4,000 shares of common stock to VFI for a purchase price of $10,000.  After that, BBE will still have 1,000 authorized but unissued shares of common stock.  VFI will also purchase 600 shares of cumulative, convertible preferred stock with a par value of $100 per share.  Unlike par value for the common shares, the par value for the preferred shares does matter.  The preferred shares will have a yield (their fixed dividend) of 2% per share.  BBE will pay $1200 in annual dividends on the 600 preferred shares.  Based on the most recent declared dividend of $1,500, this leaves only $300 in dividends for the common shares.  Everyone hopes that the earnings will continue to increase, resulting in an increase in the dividend paid on the larger number of issued shares.  The original shareholders retain the control they want, but they have to give up dividends to get it.  If the directors of  BBE were to decide, for financial reasons, not to pay the preferred dividend for three consecutive years, VFI will have the right to convert its preferred shares into common stock, again on a 10 to 1 basis.

Focusing on the possibility of  such a conversion, we realize that the Articles of Incorporation must authorize more common shares than the 10,000 we had initially proposed in order to keep the par value in balance.  Everyone agrees that the par value is not that important any more except for accounting purposes.  Our treasurer assures us that it is not a problem to get rid of par value for the common stock.  Both sides agree that the Articles will authorize a total of 50,000 common shares with no par value and 600 preferred shares each with a $100 par value.  If the preferred stock were to be converted because no dividend had been paid for three years, the 600 shares of preferred could be converted by VFI into 6,000 shares of common.  This would give VFI a total of 10,000 shares of common stock, enough to outvote the 5,000 shares held by the original shareholders.  Since the preferred shares always remain worth their par value, VFI would also have the right to convert the preferred shares into common if BBE is sold to other investors or taken public.  By converting the preferred to common, VFI can share in any increase in the value of BBE and, consequently, its common stock.  With final agreement reached, the legal papers are completed, and VFI's money is received.  BBE buys the servers, expands the office and hires new employees.

We will end BBE's story here.  We may return to it in the future if we need to learn more financial terms.  I patterned this vocabulary lesson on a similar but much more detailed story contained in an excellent investment book, How to Buy Stocks, a guide to successful investing, written by Louis Engel in 1953.  Since its initial publication, this book, which was the first one I ever read, has gone through 8 revised editions.  With each edition, the book is updated to reflect changes in the stock market and the investments one can find there.  Despite this, the basic message of Mr. Engel's classic has been retained through all these years.  The most recent edition, which is still in print, was revised by Henry R. Hecht in 1994.  In light of its many editions over the last 50+ years, it is obvious that both beginning and veteran investors find it to be a great resource for learning about investing.  You can click on the Amazon link above to buy a paperback copy.

Comments are always welcome (best to use the Anonymous profile).  All are posted within 24 hours of receipt.  I reply to comments on Fridays.

Monday, March 7, 2011

Round Two of Negotiations with the VCs


Another Monday and another meeting with Kate, Daniel and Susan, the representatives of Venture Funds, Inc. (VFI).  This time we are meeting at their offices to continue discussions about a VFI investment in Best Blogs Ever, Inc. (BBE).  At the end of our last meeting with the venture capitalists, everyone had agreed that they would purchase a minority interest in BBE's common stock.  They would invest the balance of the needed $70,000 in BBE by purchasing its new issue of preferred stock.

The discussion quickly became focused on the rights the preferred stock would have in exchange for not having a vote.  Daniel said that preferred stock receives a fixed dividend that the company would be required to pay annually.  That would make the preferred stock dividend much like a loan payment to a bank.  Mary Jo, our financial consultant, indicated that the earnings of BBE were not steady.  They fluctuated yearly.  What should happen if there were not enough earnings in a year to pay any dividend?  The board of directors of BBE had to have the discretion not to declare a dividend.  They had to have the ability to pass on the dividend for the preferred and the common stock in a year in which BBE had either poor earnings or a loss.  Our treasurer proposed that the preferred stock dividend would have to be paid before any dividend could be declared by the board of directors for the common shares.  This is a fairly common right granted to preferred stock holders.

It was agreed that the directors of BBE would have the right not declare any dividends; however, there would be a cumulative dividend provision in the Articles of Incorporation.  If a company has cumulative preferred stock, then any and all unpaid dividends on the preferred shares must be repaid before the common shares could receive any dividends.  Kate suggested that if the company was unable to pay the preferred stock dividend for a number of years, this would be an indication that the company was not being run properly.  In that case, VFI should have a right to take control of the company and install a new board of directors.  The new board could elect new officers to manage the company.  New managers might be able to increase earnings and restore the dividend.  Since VFI had agreed to buy a minority of the common stock so the original shareholders could maintain control, it would need to gain more common shares in order to outvote the original shareholders.

Susan said that a way to provide VFI with additional shares of common stock would be to add a convertibility provision to the Articles.  If the preferred stock dividend was not paid for a number of consecutive years, then VFI would have the right to convert some or all of its preferred shares into common shares with voting rights.  Preferred shares with that type of right are called convertible preferred shares.  The convertibility provision would set forth how and when the preferred shares could be converted.  She also pointed out that if BBE were to be sold to another company or group of investors, VFI's preferred shares would not share in any increase in the value of the company.  Preferred shares do not appreciate in value.  Their value remains at the original purchase price, and the owners receive their investment back if the shares are redeemed.  She proposed that the VFI's preferred shares should also be convertible into common shares if the shareholders voted to sell BBE or take it public at some point in the future.  By converting the preferred shares into common, VFI would share in any increase in the value of BBE and any consequent appreciation in the common shares.

The parties agree to meet again next Monday.  This will give each side the opportunity to consider the issues raised in today's discussions.

If there is any financial term you would like explained, please submit it in a comment and I will try to answer your question.

Comments are always welcome and are posted within 24 hours of receipt.