Monday, December 31, 2012

A Chance To Expand


When I started BBE, there were not many blogging sites on the Internet.  Many more people have joined the blogoshpere since I started posting.  Our staff now includes seven bloggers covering a total of 28 different topics in as many blogs posted every week.  There are many areas of interest we do not cover.  We had decided early on that if we could not provide a quality blog on a topic, we would not put out a second rate post.  We do keep an eye on other sites posting on topics we do not address.  

One such blog site was operated by a company with offices in our city, Blogging Topics, Inc. (BTI).  I had been introduced to Bob, the CEO of BTI, at a blogger convention several years ago.  Finding that we had many mutual interests, we have stayed in touch over the years, getting together for lunch or dinner every few months and sharing stories of the blogging world.  Although his blog site could be considered competition in a general sense, our sites did not have blogs on the same topics.  In reality, there was no direct competition between our sites.

Bob had come to blogging later in life and was now in his late 60s.  In our last two lunch meetings, he had mentioned that the idea of retiring was becoming more and more attractive.  Although his staff and blog writers were very talented and enjoyed working for him, none of them had any interest in running the business.  Bob was faced with a very common problem for older business owners: how to cash in on the business he had created and nurtured to maturity.  Bob and his wife, Mary Pat, were the only shareholders of BTI, having funded the company themselves.

After some discussion with our Board of Directors, I set up a meeting with Bob.  When Alice, our President, and I met him at his offices, we suggested that BBE might have a solution to his problem:  BBE and BTI could enter into a merger, which means that BBE would buy the stock of BTI.  We told him there were several ways to do this.  One way would be for BBE to pay Bob and Mary Pat cash for their stock.  Another option would be a stock swap, i.e., pay for their stock in BTI with shares of BBE stock.  Bob said he and Mary Pat had spoken often about selling the company.  Both of them were in good health and looked forward to many years together in retirement.  He expressed concern over what might happen to his employees if he were to sell BTI.  He promised to get back to us in a few days.

A week later, Bob called and asked for a meeting to discuss how BBE might merge with his company.  We proposed that we get together at BBE's offices to explore various merger options.  We will join that meeting in the next blog.

Comments are always welcome.

Monday, December 24, 2012

Thoughts At Yet Another Year End


I posted my first blog on November 1, 2010, so this is my third year-end message to all of you.  I extend the best of the season to all of you and hope each of you enjoys this time of year in your own special way with family and friends.  I recently discovered that many readers have been sending comments to my posts, but I did not know it.

Apparently, the security settings established by my daughter when she created this site were very high.  Consequently, many of your comments did not make it to me.  Now I know how to find them, and, as I first promised, I will reply to them as I receive them from now on.  There were too many previously undiscovered comments for me to reply to each of them, and for that I apologize.

Your comments are posted on the blog you are reading at the time.  I will reply to the comments on the particular blog on which you left your comment.  So, if you want to see my reply to your message, you will have to return to that particular post to find it.  This blog site is a work in progress, and I continue to learn new things about offering it to you every day.

Again, my apologies for not replying to you earlier, but it won't happen in the future.

The best of the holiday season to each of you.  We will return to the regular blog next Monday, New Year's Eve.

Monday, December 17, 2012

Meeting The Banker


After conferring with the Directors of BBE, Alice met with Sam, the bank officer in charge of the company's accounts.  She explained the company's need for more servers, employees and space and asked him what sort of loan support the bank could provide. Sam offered the company a loan to buy the equipment.  However, he said it would not be an unsecured loan.  The bank would make the loan but would need the company to pledge the new servers being purchased and all of the other hard assets of the company (servers, computers and office furniture).  The interest rate for BBE's secured loan would be fixed for its term with regular monthly payments of principal and interest sufficient to completely amortize (repay) the loan in the loan's five year term. 

If BBE were to default on the loan, the bank would have first right to take the company's pledged assets, the collateral, sell them and apply the proceeds against the debt.  This is a secured loan, i.e., the bank would have first call on the assets of the company ahead of any general creditors of the company if BBE were to go bankrupt. General creditors of a business are usually vendors who sell items or provide services to the company on a regular basis, but do not collect their money immediately.  Such sellers extend short term credit, without charging interest, to the company and expect to be paid at the end of each month.  BBE's utility provider would be a general creditor.  Another example would be the alarm company which provides the security system for BBE's office space and, like the electric utility, is paid monthly.  General creditors do not have a prior claim on the assets of a business.  They share equally in any assets or cash remaining in a business' bankruptcy after any secured creditors have received proceeds from the sale of assets on which they have a security interest.  

Alice and Sam briefly discussed the company's need for more space.  Sam said that she should come back to discuss a mortgage loan if BBE decided to buy a building to house its expanding operations.  A mortgage loan is used to finance a real estate purchase. It is a secured loan with a longer maturity which is secured by a lien (evidenced by a document called a mortgage) on the land and building being financed.  The land and building are collateral, and, like any other pledged assets, a bank would have the right to foreclose a borrower's interest in the real estate and apply the proceeds against its loan ahead of any other creditors.  Since, at this time, BBE intended to lease another floor of the building presently housing its operations, they agreed that this was a topic for another day.

Alice then brought up another issue the company faced.  Cash flow was occasionally a problem.  The blog readers paid for their subscriptions at various times.  Some subscribers paid annually, some monthly and some weekly.  New blog readers sometimes paid daily with a credit card until they decided that they would subscribe to their favorite blog.  Consequently, cash flow was uneven, which, at times, resulted in difficulties meeting recurring  obligations.  Although the company received adequate revenues to pay its expenses over the year, the income stream was not steady.  Some months, the company received small amounts of subscription payments.  Other months, large amounts of money would flow in.  The company, however, had rent, utilities, payroll and other recurring expenses to pay each month.  On two occasions, the company had had just barely enough cash on hand to make those payments.

Sam said that cash flow was a common problem with small businesses.  The bank could make a specific type of loan to address BBE's cash flow problems, one very similar to a credit card loan.  Sam suggested a revolving loan, commonly called a "revolver".  The bank establishes a fixed amount of money BBE can borrow, but the company can take out the money if and when it is needed to meet its obligations and then pay the loan back when subscriptions were received.  BBE can then reborrow the money when it is needed again.  Interest is charged only on the amounts actually borrowed at a variable interest rate, which is based on the bank's prime rate.  A prime rate is the publicly announced lowest interest rate which the bank offers to eligible borrowers.  BBE's interest rate would be prime plus 1%.  If the bank's  prime rate, which can change daily, is 4% when BBE draws down money from the revolving loan, it would pay interest at 5% on that amount.  If BBE made a second draw on the revolver later when the prime rate was 3%, then its interest rate for that amount of money would be 4%.  A revolving loan is typically secured by a pledge of the borrower's accounts receivable.  Accounts receivable are the amounts which the BBE's customers owe but have not yet paid.  If a borrower defaults on a loan secured by receivables, the bank has the right to collect the receivables from the customers.  A revolving loan provides a company with the necessary funds to meet its obligations before customer payments have been received.  The loan "evens out" the company's cash flow over the year.  The bank generally makes the loan with a one year term for a first time borrower, such as BBE.  If the bank is satisfied with the company's performance under the loan, i.e., prompt repayment of borrowed funds when BBE receives its subscribers' payments, it will probably renew the revolver after the first year for a longer term.

Alice reported all of this to the Board, which immediately approved BBE's entering into the secured loan for the new equipment of $50,000 and the revolving loan of $25,000.  The loan documents were signed, and the company used the borrowed funds to expand its business yet again.  The revolver immediately improved its cash flow.  As with the first expansion, revenues did not increase immediately, but BBE was able to make its new loan payments and continue distributing dividends on both the preferred and common stock.

We will continue with BBE in the next blog.

Comments are always welcome.

Monday, December 10, 2012

Growth Leads To The Same Old Problem.


For several years after the VFI investment, BBE's business continued to grow.  In the early days, I had been the only blogger, initially posting a blog once a week.  Those weekly blogs had evolved into daily blogs on various topics.  Between my blogging duties and managing the business, I found myself unable to adequately meet all of the demands on my time.  I realized that I should cut back on my responsibilities and devote my time to what I did best, writing the material for the blogs.  I shared my thoughts with the Board of Directors.  They appointed Alice, a representative of VFI, the new President of BBE, and she took over day to day management of operations.

Over time, we had realized that there was a growing demand for blogs on some issues with which I had no familiarity.  Consequently, we had hired additional employees to write blogs.  BBE was now posting 4 different blogs every day.  This led to higher revenues and earnings, which brought us back to the same place we had been before:  once again, we needed to buy more servers, add more office space and expand our staff.  The VFI investment had been the right decision, but it had simply bought us time.  Ever more growth requires ever more equipment, employees and the space to house them all.

This time, however, the shareholders, including VFI, did not want BBE to issue (sell) any more shares, neither preferred nor common.  Alice, our President, and Mary Jo, our financial consultant, suggested that it was time for BBE to add debt to its capital structureHere is a link to a more detailed explanation of the term capital structure.  

Put simply, a company's capital structure has two components.  First is the equity capital contributed by the shareholders, whether common or preferred, plus the company's retained earnings.   A company's retained earnings are those earnings remaining at the end of each year after all expenses, loan payments, dividends and taxes are paid: its net profit.  Anything left over is "retained" by the company for future use. Here is a link to the calculation of retained earnings

The second component of a company's capital structure is its debt capital, i.e., money the company borrows from lenders.  There are various types of loans available to a business, each of which can be tailored for a specific need of the borrower.  The simplest type of loan is an unsecured loan.  This type of loan is made by a bank or other lending institution based solely on the financial strength of the borrowing company and the lender's belief that the company can and will repay the debt.  Such a loan is evidenced by a promissory note, a written document signed by the company which contains the borrower's promise to repay the loan and the terms of the loan, i.e., the amount borrowed (the principal), the interest rate charged, the repayment schedule (monthly, quarterly, semi-annual or annual repayments) and the maturity of the note, the date by which all principal and interest must be repaid in full.  An unsecured loan is generally a short term obligation which usually requires monthly payments of interest and, possibly, a portion of the principal.  Such a loan matures within a year or so, generally no longer than 3 years.  

A more familiar form of unsecured loan is the credit card, which can be used for daily expenses by companies and individuals.  Some of the amount borrowed on the credit card plus interest is repaid monthly.  The borrower/card holder has the option to repay the entire amount at any time.  The terms of the credit card loan (a form of promissory note) are contained in the borrower's application and the explanatory materials (a form of promissory note) received at the time the card is issued.  The terms of a credit card loan can be modified by the card issuer (the lender) upon prior notice.  Because the risk of nonpayment or default is high on credit cards, the interest rates charged are also high, 12% or more in most instances.

BBE now has an established business with revenues of $75,000 and a good financial history at this point.  It is already using credit cards for some of its routine expenses, but it would be a mistake to use a high interest credit card for a major purchase of the servers it needs.  Alice decides to approach the bank where BBE has its checking and payroll accounts for a loan.  Because of this relationship, the bank is already familiar with BBE's business.

We will pick up with her meeting with the banker in the next blog.

Comments are always welcome.

Monday, December 3, 2012

BBE Continues To Grow....Slowly


Having revisited Best Blogs Ever, Inc. (BBE) in the last few blogs, we return to the story.  The story of BBE is patterned after a narrative about a fictional business contained in How to Buy Stocks, a guide to successful investing, written by Louis Engel and first published in 1953 followed by revised editions every few years ever since.  New financial terms introduced in the story will be highlighted in bold when we meet them.  I realize that for many readers much of the information and terms may be old news, but some readers may not be familiar with many of the terms used in the financial world, so this story is for them and, hopefully, a refresher course for the more experienced of you.  We pick up the story after the investment in BBE by VFI.

The $70,000 invested in Best Blogs Ever, Inc. (BBE) by Venture Funds, Inc. (VFI) allowed BBE to set in motion its purchase of new servers, its office expansion and the hiring of additional employees.  However, all of this took time and effort to accomplish.  The delays experienced in taking delivery of the additional equipment, getting it installed in the newly built out floor of office space and training the new hires meant that the anticipated increase in revenues did not begin for many months after VFI's investment.  Despite these delays, the Board of Directors had to pay the required dividend of 2% on BBE's preferred shares, $1,200 on the first anniversary of their purchase by VFI.

The year's operations before the VFI investment had resulted in $5,000 of earnings with a distribution of $1,500 to the original shareholders.  Although BBE was able to maintain that level of earnings during the expansion, the money was needed to support the increased operational costs.  The preferred shares' dividend of $1,200 was paid as required, leaving $3,800 in earnings, which had to be plowed back into the business.  The Board of Directors felt that they could not prudently declare a cash dividend on the common shares.  In other words, the Directors would have to pass the dividend and keep the earnings in the company.  This is not the sort of news that shareholders want to receive.

After the Articles of Incorporation of BBE had been amended, the common stock split 10 for 1 and the VFI investment received, BBE had 41,000 authorized but unissued shares remaining.  After securing the consent of the shareholders, the Board declared a stock dividend on a 3 for 2 basis.  Each shareholder received 1/2 of a share of stock, at no cost, for each share he or she already owned.  It may take some time for financial benefits to be realized from a stock dividend, but if BBE continues to prosper, some benefit should be received down the road. 

In a way, a stock dividend is similar to a stock split because everyone ends up with more shares resulting in the same percentages of ownership.  However, those extra shares may result, ultimately, in extra dividends being paid to the shareholders since they now have additional shares on which additional dividends could be paid at a later date.  If prior to the stock dividend, a BBE shareholder had 1000 shares and was to receive a cash dividend of 5 cents a share, then he or she would receive $50.  After the 3 for 2 stock dividend, that same shareholder would have 1500 shares.  That same 5 cents a share dividend would net the individual $75, and the shareholder would not have spent any money for the extra shares and the larger cash dividends. In the case of a stock split, the dividend per share is reduced in inverse proportion to the stock split.  If there is a 3 for 2 stock split, the shareholder with 1,000 original shares also ends up with 1500 shares; however, the dividend per share is reduced from 5 cents per share to 3.3 cents per share, so the dividend remains $50. 

After several years, the hoped for benefits of the expansion were realized, and BBE now had annual revenues of $10,000, which allowed the Directors to pay the preferred share dividends ($1,200); provide a dividend of 50 cents a share on the common stock ($6,750), and keep the rest of the income in the company to support operations.  This was a good rate of dividend growth since the dividends paid at the time of the VFI investment had been 30 cents a share after the stock split.  Now the benefit of the stock dividend was enjoyed by the owners of the common stock.  VFI received its fixed dividend on its preferred shares, and it also participated in the benefits of BBE's increasing revenues and dividends through its common shares.

BBE now had 13,500 shares of issued common stock, i.e., the 9,000 shares owned by the original shareholders and by VFI, which were increased by 50% as a result of the stock dividend.  This left the company with 27,500 authorized but unissued shares of common stock.  This unissued stock will prove to be very useful when BBE is presented with an investment opportunity, which we will learn about in a future blog.

Comments are always welcome.

Monday, November 26, 2012

A Return to the Story of Best Blogs Ever, Inc. (4)


We will conclude our look back at the story of BBE with the final previously posted chapter.  Here is a  portion of the seventh blog, which was called The Final Monday With The Venture Capitalists:

"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."

Here is a link to the entire blog, which was posted on March 14, 2011.

We will now continue BBE's story in the next blog.

Comments are always welcome.

Monday, November 19, 2012

A Return to the Story of Best Blogs Ever, Inc. (3)


We will continue the story of BBE with the next two previously posted chapters.  Here is a  portion of the fifth blog, which was called Venture Capitalists at the Door:

Before the meeting, Venture Funds, Inc. ("VFI") had asked for copies of BBE's  Articles of Incorporation, Bylaws and BBE's financial statements for each year of operation.  Those statements consist of three different accounting reports.  At the end of each year, our Treasurer prepares a balance sheet, which shows the assets, liabilities and equity of the company as of year end; a profit and loss or income statement, which shows the income and expenses of the company and any profit or loss for the year; and a cash flow statement which shows the cash held by the company at the beginning of the year, the cash generated during the year from all sources of cash: operations, loans, stock sales or any other cash generators; how cash was spent during the year for the purchase of equipment or other assets, investments, loan payments and dividends; and the cash position of the company at year end.  The financial statements provide the information needed to determine how a company is doing financially.

Here is a link to the entire blog, which was posted on February 28, 2011.

Here is a  portion of the sixth blog, which was called Round Two of Negotiations with the VCs:

"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.

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."

Here is a link to the entire blog, which was posted on March 7, 2011.

We will look at the final chapter of BBE's story in the next blog.

Comments are always welcome.

Monday, November 12, 2012

A Return to the Story of Best Blogs Ever, Inc. (2)


We will continue the story of BBE with the next two previously posted chapters.  Here is a  portion of the third blog, which was called Middle Years - Success Brings Problems:

"After some discussion, it is decided that the company should issue more stock to raise the necessary capital.  Some of the stock might be bought by the existing shareholders, but to raise the entire $70,000, new investors must be found.  We might be able to find some more individuals to invest in BBE, but securities laws would make such a stock offering complicated.  One of the shareholders suggests that BBE contact a venture capital firm to see if there would be any interest in an investment.  A venture capital firm is considered a sophisticated investor, which would make it easier and cheaper to meet the requirements for a stock sale under state and federal securities laws.

Both the venture capitalists and the private equity operators have the same ultimate goal, which is to sell the company to another group of investors at a profit after a few years or to take the company public.   That means the company's stock is sold to investors in an initial public offering or IPO on a stock exchange.  Because everyone is satisfied with the way the directors and officers of BBE are running the company, the decision is made that new management from private equity is neither needed nor wanted.  Therefore, BBE will approach a venture capital firm."

Here is a link to the entire blog, which was posted on February 14, 2011.

Here is a  portion of the fourth blog, which was called Preparing for the Venture Capitalists:

"For purposes of our story, the following financial numbers will apply:  annual earnings of $5,000 for the last 12 months of operations; retained earnings of $10,000 ($20 per share); most recent annual dividends of $1,500 paid on the 500 outstanding shares ($3 per share).  At the end of our last post, everyone had decided that BBE would issue more shares of stock to raise the $70,000 for new servers, additional employees and an expansion of office space to house the company's operations.  Since the existing shareholders do not have that kind of money to invest in the company, the decision was reached to approach a venture capital firm ('VC') for an investment in BBE.

Assuming the par value remains the same, BBE would have to issue 7,000 new shares of common stock to raise the $70,000.  BBE still has 500 authorized but unissued shares it could sell.  The Articles of Incorporation would have to be amended to authorize an additional 6,500 common shares in order to have enough shares to sell.  If the venture capital firm bought that many shares of BBE common stock, the original shareholders will no longer have control of the company.  The VCs could outvote them on all corporate issues.  Continued control of the company is very important to us.  We do not mind sharing profits with the VCs, but we do not want to lose the right to control the management of BBE.

In this sort of situation, many corporations issue a different form of stock, one which does not have voting rights, but does have some rights not enjoyed by the voting common stock.  The nonvoting shares could have a preference over the voting shares in one way or another; in effect a trade off of one right for another.  Such a form of stock is called preferred stock."

Here is a link to the entire blog, which was posted on February 21, 2011.

We will look at the next two chapters of BBE's story in the next blog.

Comments are always welcome.

Monday, November 5, 2012

A Return to the Story Of Best Blogs Ever, Inc. (1)


Starting at the end of January of last year, I wrote a series of blogs on the formation of a business.  The purpose of the series was to introduce readers to investment and financial terms, including some accounting concepts.  After several blogs chronicling the progress of the business, I turned to other topics, but promised to pick up the story again at some point.  Now is the time to return to the story of the blog company, which I called Best Blogs Ever, Inc. ("BBE").   The business terms are highlighted in bold and are explained as the story of the business unfolds.  Before I pick up the story where I left off, I think it is appropriate to acquaint new readers who may not have read the earlier blogs with the story of BBE.   I will include small sections of each blog and provide a link to the entire blog.  I will include sections from two blogs in each of the next few blogs until I bring the readers up to the point at which I stopped the story.  Then we will continue to follow the course of this fictional business learning more terms as we proceed.

Here is a  portion of the first blog, which was called Birth of a Business:

"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."

Here is a link to the entire blog, which was posted on January 31, 2011.

Here is a portion of the second blog, which was called Early Days:

"On the other hand, let's assume that my blogs have been well received on the Web, and BBE made some money over and above the expenses of the business, a profit.  Gross revenue is the term for all of the money paid by the subscribers to read the blogs.  The goal is for gross revenue to be greater than the rent, payroll, utilities, advertising, computer maintenance and the like.  Once those expenses are deducted from the revenue, the remaining funds are the company's income or earnings.

The shareholders will want to know what the board of directors proposes to do with the earnings for the year.  For purposes of our story and to keep the math simple, let's assume BBE had earnings of $1,000 after the first year.  Remember that the shareholders put in a total of $5,000 of equity or capitalization in the company.  If however, the shareholders had said no to my requests for their money, they might have put that cash into a savings account at a bank and earned some interest on it.  Unless they can get a return on investment, some money back on their stock investment, the bank account might look like the better decision.  To reward the shareholders for buying stock in BBE, the directors could decide to pay some or all of the earnings out to the shareholders.  Since BBE might need some of that money in the future, the directors decide to pay the shareholders a dividend of $1 per share. Since each share was purchased for $10 and a $1 dividend is paid per share, the rate of return on the investment of the shareholders is 10%, which far exceeds the interest rates paid on bank savings accounts these days.  A 10% return should make the shareholders very happy.  For my $1,000 investment, I receive $100 after only one year.  The other shareholders receive the same return, $1 for each share of stock they own."

Here is a link to the entire blog, which was posted on February 7, 2011.

We will look at the next two chapters of BBE's story in the next blog.

Comments are always welcome.

Monday, October 29, 2012

Acknowledgments on a Second Anniversary


I posted the first blog on Wall Street Smarts on November 1, 2010.  During the first year, there were more than 2,200 visits from people in 54 countries.  Since November, 2011, there have been another 4,625 visits from folks in the original 54 countries and readers from following additional countries (alphabetical order):

Algeria                                     Austria                                 Barbados                           
Botswana                                Brunei                                  Bulgaria
Cambodia                               Chile                                    Czech Republic                            
Columbia                                 Denmark                             Dominican Republic 
El Salvador                              Ethiopia                              Gabon                                                          Honduras                                 Iceland                                 Israel
Jordan                                     Kuwait                                  Lebanon                             
Luxembourg                            Macedonia                          Mauritius
Nepal                                       Norway                                Panama
Paraguay                                Rwanda                               Saudi Arabia
Serbia                                     Slovakia                              Trinidad & Tobago
Uganda                                   Venezuela                           Vietnam

Heartfelt thanks to all 6,825 of you for supporting my blog.  I apologize for the staggered columns in this one, but I can't seem to straighten them out.

We will return to a regular blog next Monday.

Monday, October 22, 2012

The Dark Side of Markets (3)


We will continue the description of a "manipulation" by Larry Livingston to sell a large block of stock, as recounted in Edwin Lefevre's Reminiscences of a Stock Operator.  The last blog ended with him starting his campaign by generating trading activity in the stock to attract the attention of the professional traders on the floor of the exchange (the New York Stock Exchange, in this case).  We will pick up the story at that point.

To get a professional following, I myself have never had to do more than to make a stock active.  Traders don't ask for more.  It is well, of course, to remember that these professionals on the floor of the Exchange buy stocks with the intention of selling them at a profit.  They do not insist on its being a big profit; but it must be a quick profit.

I make the stock active in order to draw the attention of speculators to it, for the reasons I have given.  I buy it and I sell it and the traders follow suit.  The selling pressure is not apt to be strong where a man has as much speculatively held stock sewed up -- in calls -- as I insist on having.  The buying, therefore, prevails over the selling, and the public follows the lead not so much of the manipulator as of the room traders.  This highly desirable demand I fill -- that is, I sell stock on balance.  If the demand is what it ought to be it will absorb more than the amount of stock I was compelled to  accumulate in the earlier stages of the manipulation; and when this happens I sell the stock short -- that is technically.  In other words, I sell more stock than I actually hold.  It is perfectly safe for me to do so since I am really selling against my calls.  Of course, when the demand from the public slackens, the stock ceases to advance.  Then I wait.

Say, then, the stock has ceased to advance.  Whatever the reason may be, my stock starts to go down.  Well, I begin to buy it.  I give it the support that a stock ought to have if it is good odour with its own sponsors.  And more:  I am able to support it without accumulating it -- that is, without increasing the amount I shall have to sell later on.  Of course what I am really doing is covering the stock I sold short at higher prices when the demand from the public or from the traders or from both enabled me to do it.  It is always well to make it plain to the traders -- and to the public, also -- that there is a demand for the stock on the way down.

As the market broadens I of course sell stock on the way up, but never enough to check the rise.  It is obvious that the more stock I sell on a reasonable and orderly advance the more I encourage the conservative speculators, who are more numerous that the reckless room traders; and in addition the more support I shall be able to give the stock on the inevitable weak days.  By always being short, I always am in a position to support the stock without danger to myself.  As a rule I begin my selling at a price that will show me a profit.  but I often sell without having a profit, simply to create or to increase what I may call my riskless buying power.  My business is not alone to put up the price or to sell a big block of stock for a client but to make money for myself.  That is why I do not ask any clients to finance my operations.  My fee is contingent upon my success.

I repeat that at no time during the manipulation do I forget to be a stock trader.  My problems as a manipulator, after all, are the same that confront me as an operator.  All manipulation comes to an end when the manipulator cannot make a stock do what he wants it to do.  When the stock you are manipulating doesn't act as it should, quit.  Don't argue with the tape.  Do not seek to lure the profit back.  Quit while the quitting is good -- and cheap.

The book also contains an account of an actual stock that the operator, the fictional Larry Livingston, manipulated.  This is yet another reason for you to read this classic of investment literature.

In January, 2011, I wrote a series of blogs in which I introduced my readers to various financial terms by chronicling the organization of a fictional business, Best Blogs Ever, Inc., and the story of its operations and financial growth.  I did not conclude the story at that time, but promised to do so at a later date.  That time has arrived.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, copyright 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series, pages 248 - 250

Comments are always welcome.

Monday, October 15, 2012

The Dark Side of Markets (2)


In his classic, Reminiscences of a Stock Operator, Edwin Lefevre tells the story of a market trader named Larry Livingston, who, in reality, was Jesse Lauriston Livermore, a famous market trader of the 1920s.  In the book, the operator, Livingston, recounts several market manipulations he was involved in over the years.  I should point out that, at that time, there were few rules in effect concerning various market strategies which today would violate securities laws and the rules of the Securities & Exchange Commission.  In any event, the following is a sort of road map for moving large blocks of stock in the bad good old days or the good bad old days, depending on your perspective.  Several times over his market career, Livingston was hired by people to sell their large blocks of stock for them without affecting the price.  Remember the basic rule governing share prices: supply and demand.  If a large number of shares are offered for sale at one time, the price will drop and the seller's profits vanish.  Here is what Mr. Livingston had to say:

The word "manipulation" has come to have an ugly sound.  It needs an alias.  I do not think there is anything so very mysterious or crooked about the process itself when it has for an object the selling of a stock in bulk, provided, of course, that such operations are not accompanied by misrepresentation.  Usually the object of manipulation is to develop marketability -- that is, the ability to dispose of fair-sized blocks at some price at any time.

In the majority of cases the object of manipulation is, as I said, to sell stock to the public at the best possible price.  It is not alone a question of selling, but of distributing.  There is no sense in marking up the price to a very high level if you cannot induce the public to take it off your hands later.  Let me start at the beginning.  Assume that there is some one --an underwriting syndicate or a pool or an individual --that has a block of stock which it is desired to sell at the best price possible.  The best place for selling it ought to be the open market, and the best buyer ought to be the general public.  Suppose he has heard of me as a man who knows the game.  Well, I take it that he tries to find out all he can about me.  He then arranges for an interview, and in due time calls at my office.  My visitor tells me what he and his associates wish to do, and asks me to undertake the deal.

I generally ask and receive calls (call options) on a block of stock. I insist upon graduated calls as the fairest to all concerned.  The price of the call begins at a little below the prevailing market price and goes up; say, for example, that I get calls on one hundred thousand shares and the stock is quoted at 40.  I begin with a call for some thousands of shares at 35, another at 37, another at 40, and at 45 and 50, and so on up to 75 or 80.  If as the result of my professional work -- my manipulation -- the price goes up, and if at the highest level there is a good demand for the stock so that I can sell fair-sized blocks of it I of course call the stock.  I am making money; but so are my clients making money.  This is as it should be.

The first step in a bull movement in a stock is to advertise the fact that there is a bull movement on.  Sounds silly, doesn't it?  Well, think a moment.  it isn't as silly as it sounded, is it?  The most effective way to advertise what, in effect, are your honorable intentions is to make the stock active and strong.  After all is said and done, the greatest publicity agent in the wide world is the ticker, and by far the best advertising medium is the tape.  I accomplish all these highly desirable things by merely making the stock active.  When there is activity there is a synchronous demand for explanations; and that means, of course, that the necessary reasons -- for publication--supply themselves without the slightest aid from me.

Activity is all that the floor traders ask.  They will buy or sell any stock at any level if only there is a free market for it.  They will deal in thousands of shares wherever they see activity, and their aggregate capacity is considerable.  It necessarily happens that they constitute the manipulator's first crop of buyers.

We will continue with this story in the next blog.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, copyright 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series, pages 244 - 248

Comments are always welcome.

Monday, October 8, 2012

The Dark Side Of Markets (1)


Any time you mix people, money and uncertain outcomes (sounds like Wall Street, doesn't it?), there will always be a certain number of those participants who look for the easy (illegal) way to make money.  Bradbury Thurlow admitted that there were instances of Wall Street dishonesty when he touched on market shenanigans in his book, Rediscovering the Wheel: Contrary Thinking & Investment Strategy, as follows: 

In the stock market practically everybody with any trading experience will feel he has been fleeced, not once but repeatedly.  This does not mean that the market is filled with or run by unscrupulous people -- although there are always a few of those around waiting to take us in.*

Fred Schwed, Jr. also discussed the issue of fraud on Wall Street in his book, Where Are the Customers' Yachts? or A Good Hard Look At Wall Street.  He felt that the public's widely held feeling that their losses were the result of dishonesty were overblown and, to a certain extent, self-serving.  He wrote the following about the public's feelings about Wall Street:

The public feels that Wall Streeters are not dunces at all; that they are crooks and scoundrels and very clever ones at that; that they sell for millions what they know is worthless; in short, that they are villains, not children.

The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools.  Even Wall Street men themselves tend to encourage the idea.

The crookedness of Wall Street is in my opinion an overrated phenomenon.  The hearts of Wall Street men are not more or less black than the hearts of the men in the sausage-cover game.  There is probably the same percentage of malpractice, but the Wall Street depredations are more spectacular.  They involve vastly greater sums, and they make more interesting reading.  Best of all, they suggest to the public an excuse for the public's own folly.**

Both men acknowledged the fact that fraud is, indeed, practiced on Wall Street; however, they felt that much larger losses were incurred much more frequently by thoughtless, emotional investing by the public.  Schwed made the following comments concerning the Securities & Exchange Commission, established after the 1929 market crash and subsequent depression in the USA:

Wall Street needed the S.E.C. just like baseball after 1919 needed Commissioner Landis.  But people who are interested in baseball are more realistic than people interested in Wall Street.  The fans did not expect Judge Landis would do more for the game than keep it reasonably honest.  They did not expect him to improve the quality of the fielding and hitting.  Nevertheless, a considerable part of the public seems to be expecting the S.E.C. will make speculation and investment safer.

These hopeful individuals are reminiscent of the benevolent soul who said at the beginning of the poker game, "Now, boys, if we all play carefully we can all win a little." **

In the next blog, we will look at a classic form of market manipulation, what would be frowned upon by the securities regulators today, but was fairly common in the 1920s.

* Excerpt from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, copyright ©1981, published by Fraser Publishing Company, is used by permission of the current copyright holder.

**Excerpts from Where Are the Customer's Yachts? or A Good Hard Look At Wall Street, Fred Schwed, Jr., copyright © 1940, republished by John Wiley & Sons, Inc, pages 195-196 & 211-212

Comments are always welcome.

Monday, October 1, 2012

The Computer: Investment Tool Or Time Bomb (3)


One of the largest financial disasters which can be traced to computer investing/trading in the 1990s was the collapse of the hedge fund, Long-Term Capital Management ("LTCM").  LTCM was organized in February, 1994 with a $1.25 billion equity base, raised from wealthy investors and financial institutions by a group of Wall Street professionals and several Nobel Laureate economists.  These disparate individuals combined to create a computer trading and hedging program which focused on the differences between interest rates on various types of bonds.  Those differences are called "spreads."  Two famous economists, Robert C. Merton of Harvard, and Myron S. Scholes, one of the developers of the Black-Scholes model for pricing options, were initial partners in LTCM.  They were proponents of the Efficient Market Hypothesis, popularly called the Random Walk Theory.  We have looked at this investment theory in a past blog

The fund's initial investment strategy was based on the theory that any unusual spreads between the interest rates of different bonds would, in a rational and efficient market, ultimately narrow and converge.  LTCM's computers were programed to seek out and identify these spreads, which allowed LTCM to take market positions in the bonds which would be profitable if and when those spreads narrowed as predicted.  When LTCM started, it was the only market player investing in such a way, which resulted in its spectacular early success.  Based on that success, LTCM was able to borrow billions of dollars from large banks in order to make its investments on margin.  Its early annual returns on equity were astronomical (28% in its first year of operation and 59% in 1995 before fees).  Such returns led to more money coming in from investors and more money made available from lenders, a sort of virtuous circle.

There is an old saying that "imitation is the best form of flattery."  As is so often the case, LTCM's success on Wall Street attracted attention and led other market professionals and their companies to figure out and copy LTCM's profitable trading strategy.  Soon there were many funds and traders playing LTCM's game.  This led to problems for LTCM because, with the new competition, it was more difficult to establish positions and profit from the spreads which LTCM previously had all to itself.  As a result, LTCM started to trade other financial assets, hoping to garner the same profits as in the past including an asset called equity volatility (which is too complicated for me to understand other than to say it was a naked bet not an investment).

Unfortunately, expanding its trading horizons was not the answer.  One of these new trades by LTCM was in Russian bonds.  They believed that Russia would be able to pay its bonds, a belief they held right up to August 17, 1998, when the Russian government announced a debt moratorium and defaulted on its bonds.  At this point, to make matters worse, Russia also devalued its currency, the ruble, which LTCM had also bet would not happen.  During this time of market turmoil, almost all the other trades LTCM had set in place also turned against them.  Since LTCM used so much leverage (margin loans at a ratio of $28 debt to $1 equity in 1997), its losses were staggering. It all came to a grinding halt for LTCM in August, 1998.  Bond spreads had increased to levels never seen before, much wider than the computers at LTCM had been programmed to anticipate.  LTCM lost $1.9 billion of its capital in one month.  Its remaining capital, $2.8 billion was dwarfed by its $125 billion of assets.  These numbers do not include the other LTCM positions in derivatives and swap spreads, which added to its unsustainable debt load.  To make matters worse, the loans which had been so freely extended early on were being called and finding new loans became impossible, all at the worst possible moment for the fund.

There is a hard truth about lending money.  If you lend someone $1,000, you are a creditor; however, if you lend someone $100 million, you are a partner.  As LTCM moved ever closer to the bankruptcy cliff, it became apparent to everyone on Wall Street and in the Federal Reserve that a collapse of LTCM would have devastating effects upon the financial system, not only in the US, but around the world.  It had so many outstanding trades with so many other institutions that its failure would have damaging ripple effects around the world.  By September 21, LTCM had racked up additional losses of $553 million, and the markets continued to move against its trading positions.  Something had to be done.  The Federal Reserve brought together the biggest investment firms on Wall Street, including LTCM's lenders, in emergency meetings over several days to address the problems.  The Fed forged an agreement which, with other countries, would provide $3.65 billion in equity to LTCM, which with its remaining $400 million in equity, would provide the fund with the needed capital to remain in existence until it could be liquidated in an orderly fashion.

The entire saga of LTCM is told in remarkable detail by Roger Lowenstein in his 2000 book, The Rise and Fall of Long-Term Capital Management, When Genius Failed.   In summing up the little over four year run of LTCM with its arcane computer modeling and efficient market philosophy, Lowenstein said it best with the following:

Reared on Merton's and Scholes' teachings of efficient markets, the professors actually believed that prices would go and go directly where the models said they should.  The professors' conceit was to think that models could forecast the limits of behavior.  In fact, the models could tell them what was reasonable or what was predictable based on the past.  The professors overlooked the fact that people, traders included, are not always reasonable.  This is the true lesson of Long-Term's demise.  No matter what the models say, traders are not machines guided by silicon chips; they are impressionable and imitative; they run in flocks and retreat in hordes.

The next time a Merton proposes an elegant model to manage risks and foretell odds, the next time a computer with a perfect memory of the past is said to quantify risks in the future, investors should run -- and quickly -- the other way.

Excerpts from The Rise and Fall of Long-Term Capital Management, When Genius Failed. Roger Lowenstein, copyright 2000, published by Random House, pages 234 & 235

Comments are always welcome.

Monday, September 24, 2012

The Computer: Investment Tool Or Time Bomb (2)


We will continue our look at the use of computers on Wall Street.  A new form of computer trading started several years ago, and some of its more spectacular effects have been reported in the financial press.  There are firms, referred to as high frequency traders (HFT), which program their computers with complicated algorithms to identify small profit opportunities in the market.  These traders make thousands of trades in rapid succession within seconds.  Some trades are completed and others are cancelled.  Although the actual profit per trade is small, the huge volume of trading can result in overall gains.  It has been reported that, in the past, as much as two-thirds of daily  trading volume on some stock, options and futures exchanges is the result of the computer trading programs employed by such firms.   Much of this trading occurs on electronic trading exchanges, which are separate from the more established exchanges used by individual investors and their brokers, but trades on one exchange are monitored by traders on all exchanges and can have an effect on prices on other exchanges.

Although the true causes may never be agreed upon, the HFT firms are alleged to have played a role in the May 6, 2010 Flash Crash, during which the Dow Jones Industrial Average fell almost 1,000 points and then recovered most of that decline in a matter of minutes.  A joint report by the US Securities and Exchange Commission and the Commodity Futures Trading Commission, agencies which investigated the event, indicated that May 6th was "unusually turbulent" with a widely negative trend.  In the afternoon, a mutual fund was trying to sell a large number of S&P 500 futures contracts to hedge its other equity positions.  Several HFT traders began buying them and then quickly reselling them to other HFT firms.  This buying and selling picked up steam, resulting in what was termed a "hot potato" effect on exceptionally large volume.  The result of this repeated back and forth trading sent the price of the particular contract down 4% in about four minutes.  This precipitous drop spilled over into the equity markets and the price of an S&P 500 exchange traded fund also plunged.  The New York Times reported that, "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling."  The Times went on to state that, as traders moved to the sidelines (which meant there were no buyers), this, "caused shares of some prominent companies like Proctor & Gamble and Accenture to trade down as low as a penny or as high as $100,000."

All of the volume and price changes triggered a 5 second pause in the trading of the S&P 500 futures contracts on the Chicago Mercantile Exchange.  This short break in the action allowed the markets to stabilize and once the computers were stopped and human decisions again played a role, the prices of most assets recovered almost completely.

The Flash Crash is one example of computers run amok affecting the entire market.  Sometimes the damage is isolated and wreaks havoc only on the HFT running the computer program.  The poster child for this sort of self inflicted financial wound is Knight Capital Group.  Knight Capital is a Wall Street trading firm which on August 1, 2012 was rolling out a new computer program designed to give it an advantage in the world of HFT traders.  The new software started at the opening of the New York Stock Exchange and, in the 45 minutes before the NYSE closed down Knight's trading, resulted in trades that ultimately cost Knight Capital approximately $440 Million in losses.  On that Wednesday, the stock of publicly traded Knight Capital Group dropped 32%.  The stock continued to fall the next day, ultimately closing down that day 63%.  Without a quick bailout from other Wall Street firms, the company would have ended up in bankruptcy.  All of this damage was caused by a bug in the new software, which obviously had not been tested enough before being put into action.

As you can well imagine, this form of trading has come under a great deal of scrutiny by regulators.  In addition, many Wall Street professionals are beginning to criticize HFT as providing an unfair advantage over less computer reliant market participants.  Here is a link to a very enlightening article in the New York Times on HFT traders and their critics.

We will look at one more example of computer investing gone awry in the next blog.

Comments are always welcome.