FINELE2 Midterm PDF

FINELE-2 – M1 obligation to pay interest to the holder or repay the face value of the stock. INVESTMENT is any vehicle into which funds can be placed with the SHORT-TERM INVESTMENT- maturity is under 1 year expec...

FINELE-2 – M1 obligation to pay interest to the holder or repay the face value of the stock. INVESTMENT is any vehicle into which funds can be placed with the SHORT-TERM INVESTMENT- maturity is under 1 year expectation that they will generate positive income/ their value is preserved Ex: deposit accounts, Treasury bills (T-bills), commercial papers, or increased. certificates of deposit, & promissory notes INVESTMENT PROCESS-The overall investment process is the -temporarily investing idle funds and earning a return (interest) mechanism for bringing together suppliers (those having extra funds) with -for conservative investors because they carry little/no risk at all demanders (those needing funds). - highly liquid since they can be easily converted to cash Financial institutions are organizations through which the savings of Common Stock- buying a share of a business called stockholder/ individuals, corporations, & governments are channeled into loans or shareholder investments. Ex: banks, investment houses, mutual funds, pension funds, & Fixed-Income Securities- fixed periodic return and are quite popular insurance companies. investments during periods of high interest rates since investors like to have -Financial Ins. also participates in the investment process as either a guaranteed high returns supplier/ demander of funds. EX: Bonds- long-term debt instruments that offer the holder a known Financial markets provide the legal and tax framework/environment that interest return along with a return of the bond’s face value (the value stated brings together suppliers and demanders of funds to make safe and quick on the face of the certificate) at maturity (20 years). financial transactions, often through intermediaries such as organized Preferred Stocks- ownership interest in a firm and like common securities exchanges. stocks, has no maturity date w/ specific dividend rate. (no voting rights) -Suppliers/ savers may transfer their funds through financial markets, -investors buy preferred stocks for the possibility of earning capital gains financial institutions, or directly to the demanders/ issuers (property trans). from its sale 2 PARTS OF FM (money market-short-term investment) (capital Convertible Security- special type of fixed-income obligation (bond/ market-long-term) preferred stock) w/ feature permitting the investor the benefit of earning 3 KEY PARTICIPANTS IN THE INVESTMENT PROCESS (they can fixed income such as interest (for bonds)/ dividends (for preferred stocks) either be demander/supplier of funds) while offering the potential of capital gains (like common stocks) 1. GOVERNMENT- Both local and national government need large Mutual Funds- pools money of many investors into a large fund amounts of money. Property- either be in real property/ tangible personal property -Funds are needed to finance capital expenditures like long-term Real Estate- raw land, buildings w/c is permanently affixed to land like infrastructure projects – road building, schools and hospitals through the residential homes, commercial property (capital gains/rental income) issuance of different types of long-term debt securities. Tangibles- gold, metals & gemstones, artwork, antiques, coins & stamps -these funds are sourced from taxes and fees collections. since the price increases. -If govt. has temporary idle cash, it sometimes makes short-term LIFE OF INVESTMENT- short-term investment- within 1 year & long- investments to earn positive returns. term investment – long maturity 2. BUSINESS- require big sums of money to support operations. IMPORTANCE OF INVESTMENT-availability of funds in the economy -short-term, funds are used to meet operating cost like financing inventory largely influences its growth and continuity and accounts receivables. REWARDS- returns or rewards form investing are in the form of -long-term, funds to develop products, build plants and buy equipment. current income or increase in value. 3. INDIVIDUALS- people need money, in the form of loans, to buy - investing in a piece of property entails expectations of an increase in its property like cars and houses. value between the time it was bought and the time it will be sold -supply funds to help meet the needs of both govt.& bus. through deposits PART 2: FINANCIAL MARKET in savings accounts, purchases of debt or equity securities, buy insurance or 1. Money market- short-term funds are raised through the buying and various types of property. selling of short-term debt securities such as commercial papers. -net supplier of funds 2. Capital market- long-term funds are raised through the bond market, TYPES OF INVESTMENT (investor) which deals with long-term debt securities such as bonds, the stock market 1. INDIVIDUAL- handle their funds to meet their financial goals. which deals with equity securities or stocks -Earning interest from idle funds, ensuring the family’s security and PRIMARY & SECONDARY MARKETS building a retirement fund. 1. Primary market- new shares are issued and sold to the investing public 2. INSTITUTIONAL- People with large sums of money for investment/ for the first time. It is where capital is actually raised by the company who are too busy/ lack expertise for investment decisions often hire an selling stock directly to investors typically through an initial public offering institutional investor (fund managers)- investment professionals paid to 2. Secondary market- where securities can be bought and sold after they manage the funds of others using their expertise and sophistication in both have been issued to the public in the primary market. investment knowledge and method. STOCK MARKET is an organized activity involving the buying and/or - trade in large amounts of securities to earn high returns that can be used as selling of securities done within a stock exchange. additional sources of interest payments (for banks) and benefits to STOCK EXCHANGE brings buyers and sellers together. policyholders or beneficiaries (for insurance companies). -It is an organization whose function is to facilitate the purchase and sale of SECURITIES- investments that represent evidence of debt or ownership stocks and other securities. interest in a business or other assets. (stock & bonds) -It is a market where investors can buy and sell securities after they have Debt- funds borrowed in exchange for receiving interest income and the been offered in the primary market. promise that the loan will be repaid at a given future date. - This is the organization that oversees the transactions of the buyers and -Debt securities- bonds & commercial papers sellers placed through the member brokers. Equity-current ownership interest in a specific business or property. Over the Counter Market- Stocks of corporations not listed and therefore -Debt securities are similar to bank loans, in that the corporation promises not traded in the stock exchange but registered and licensed by the to pay the face value on the maturity date together with interest payments at Securities and Exchange Commission for sale to the public are only regular intervals. available in the so-called over-the-counter (OTC) market. -But unlike a bank loan, bonds and commercial papers are represented by -This market is not a specific organization but another way of trading certificates, which are handed over to the buyer who becomes the holder of securities. the certificates. -OTC transactions are carried out by direct inquiries and negotiations -In this way, stocks are also similar to debt securities – a stock certificate is among the buyers and sellers through the use of mail, telephone, telegraph, issued – but differ in a way that the issuing company does not have the Teletype, or other forms of communications ADVANTAGES OF THE STOCK MARKET the security owner, for the value may be largely dependent upon the acts of 1. Most accessible market- Through the offices of member firms located the management. everywhere, even in the provinces, stocks are available to millions of M2: BEHAVIOR OF SECURITY MARKET people T1: INVESTMENT & SPECULATION 2. Ready market- simple phone call, an investor can buy and sell stock, virtually within minutes. BASIC INVESTMENT SPECULATION -Market transactions are done swiftly, conveniently and at a fair price Time Horizon Long term - beyond Short term holding assets 3. Liquidity of the market- Hundreds of different stocks are available to 12 months from one day to one year thousands of buyers and sellers and can readily be turned into cash due to Risk Limited High the large number of market players. -The OTC market is generally much thinner or less liquid which makes it more difficult to sell at a certain time in a failing market due to lack of Source of Income Earnings of Change in market price buyers enterprise 4. Operates in full public view- transactions and price data are readily Stability of Income Very Stable Uncertain available through newspapers, radio, television and information networks. -Unlike the stock exchange, the over-the-counter stock prices are not Use of Funds Own Funds Own Funds, borrowed funds published daily in the newspapers, which makes it more difficult for an investor to keep track of his investment Type of Contract Creditor Ownership PLAYERS IN THE STOCK MARKET 1. Stockbroker- Anyone who wishes to buy shares of stocks or bonds must The psychological Cautious and Aggressive and daring have a stockbroker. attitude of participants conservative -He acts as an agent or middleman between the investor and other buyers/sellers. -The safety cannot be judged by the result, but must be posited in advance -As an intermediary, the stockbroker executes orders for clients, purchasing and that it can only be useful if it is based on something more tangible than or selling the stocks on the stock exchange. the psychology of the purchaser. The safety must be assured or at least -He is the only person or corporation authorized and licensed by the strongly indicated, by the application of definite and well-established Securities and Exchange Commission to trade in securities. standards. An investment operation is one that, upon thorough analysis, -they are commonly known as members, member-brokers, or member-firms promises the safety of the principal and a satisfactory return. Operations not of the Philippine Stock Exchange meeting these requirements are speculative. 2. Transfer agent- When shares are purchased and transferred from the - An investment operation is used instead of an issue because it is unsound seller to the buyer, the transaction should be recorded in the stock books of to think of investment character as inhering in an issue since the price is an every listed company which record the complete shareholdings of each essential element. So, stock may have investment merit at one price level stockholder of the company. but not at another. In addition, an investment might be justified in a group -But most companies have his record keeping done by separate agency, of issues, which would not be sufficiently safe if made in any one of them called the transfer agent. singly. 3. Clearing house- To facilitate transactions and make the market more - Satisfactory return covers any rate or amount of return, however low, orderly, all payments by all stockbrokers are done to a centralized which the investor is willing to accept, provided he acts with reasonable institution intelligence. An investment operation can be justified on both qualitative 4. Listed company- corporation that offers and lists its shares in the stock and quantitative grounds. This is an additional criterion for investment. exchange is called a listed company or issuer. The investment must always consider price as well as the quality of the -listed company is also known as a publicly owned company in view of the security. Strictly speaking, there can be no such thing as an investment fact that its shares were sold to the investing public. issue in the absolute sense, i.e., implying that it remains an investment -These are the companies that raised their required funds through such regardless of price. In his opinion, the great majority of common stocks of issuance of securities to the public. strong companies must be considered speculative a good part of the time, MODULE 1 Objectives of Security Analysis simply because their price is too high to warrant the safety of principal in 1. The ultimate objective of security analysis is to develop theoretical any intelligible sense of the phrase. It may be thought that sound analysis models that determine the value of financial instruments to compare with should produce successful results in any type of situation, including the prices quoted in the market. Using these theoretical models, security confessedly speculative i.e. those subject to substantial uncertainty and risk. analysts try to look for undervalued or overvalued situations. Undervalued The mechanics of speculation causes increased transaction costs. situations, where theoretical value is higher than the present market value, Underlying analytical factors in speculative situations are subject to swift offer the opportunity to invest in instruments that are expected to have and sudden revision i.e. may change before market price reflects that value above-average returns. Overvalued situations, where theoretical value is even more so in speculative situations. The impact of unknown factors is below the current market value, offer the opportunity to sell instruments skewed negatively in speculative situations. Those on the inside often have whose prices are expected to fall. an advantage of this kind which nullifies and loads the dice against the 2. To present important facts regarding stock or bond in a manner most analyst working with some of the facts concealed from him The value of informing and useful to an actual or potential owner. analysis diminishes as the element of chance increases. It would be prudent 3. Seeks to reach dependable conclusions, based upon facts and applicable to consider analysis as auxiliary rather than as a guide in speculation. It is standards as to safety and attractiveness of a given security at the current only where chance plays a subordinate role that the analyst can properly /assumed price speak in an authoritative voice and accept responsibility for the results of FUNCTION OF SECURITY ANALYSIS his judgments. For investment, the future is essentially something to be 1. Descriptive Function: Limits itself to marshaling the important facts guarded against rather than to be profited from. If the future brings relating to an issue and presenting them in a coherent, readily intelligible improvement, so much the better; but an investment as such cannot be manner. founded in any important degree upon the expectation of improvement. 2. The Selective Function: analyst must be ready to pass judgment on the Speculation, on the other hand, may always properly –and often soundly – merits of securities and is expected to advise others on their sale, purchase, drive its basis and its justification from prospective developments that retention, or exchange. differ from past performance. A great deal of common stock buying is done 3. The Critical Function: analyst must be highly critical of accounting with reasonable care and maybe called intelligent speculation; a great is methods. He must also concern himself with all corporate policies affecting done upon inadequate consideration and for unsound reasons and thus must be called unintelligent; in exceptional cases, common stock may be bought 4. Security: Character of the Enterprise and the Terms of the Commitment. on such attractive terms, qualitative and quantitative, as to set the inherent The roles played by the security and its price in an investment decision may risk at a minimum and justify the title of investment It is possible to argue be set forth more clearly if we restate the problem in a somewhat different that issues with a high degree of speculative risk individually may be made form. Instead of asking, (1) In what security? and (2) At what price? We can part of an investment operation provided (1) the changes of gain outweigh ask, (1) In what enterprise? and (2) On what terms is the commitment those of loss and (2) there is ample diversification. Ex. Low-priced proposed? This gives us a more comprehensive and evenly balanced common stocks meeting certain conditions and even long-term calls to buy contrast between two basic elements in the analysis. By the terms of the at prices much above their current levels. This is a marginal area in which investment or speculation, we mean not only the price but also the distinctions between investment and speculation become blurred. A provisions of the issue and its status or showing at the time. proposed purchase that cannot qualify as an investment automatically falls Character of the Enterprise and the Terms of the Commitment. into the speculative category. But at times it may be useful to view such Example of a Commitment on Attractive Terms. The investment here purchase somewhat differently and to divide the price paid into an might well make it a satisfactory commitment, as shown by the following: investment component and a speculative component. 1. Provisions of the Issue. By contract between the operating company and INVESTMENT POLICY- There are guidelines in investing, we can call the government, this can give positive output on the earnings of the that an investment policy. This describes the parameters for investing in combined company and government, representing an investment government funds and identifies the investment objectives, preferences or enormously greater than the size of this issue. tolerance for risk, constraints on the investment portfolio, and how the 2. Status of the Issue. Apart from the very exceptional specific protection investment program will be managed and monitored. The document itself just described, the bonds were obligations of a company with stable and serves as a communication tool for the staff, elected officials, the public, apparently fully adequate earning power. rating agencies, bondholders, and any other stakeholders on investment 3. Price of Issue. It could be purchased to yield somewhat more than the guidelines and priorities. An investment policy enhances the quality of market price of the stock exchange. decision-making and demonstrates a commitment to the fiduciary care of Example of Commitment on Unattractive Terms. The stock offering public funds, making it the most important element in a public funds could be summarized as follows : investment program. (Republic Act 9267) 1. Provisions of the Issue. A preferred stock, ranking junior to a large first T3: NATURE AND SOURCES OF ANALYST INFORMATION mortgage and without unqualified rights to dividend or principal payments. Sources of Investment Information It ranked ahead of a common stock which represented no cash investment Newspaper, business periodicals, govt. publications, corporate reports, so that the common stockholders had nothing to lose and a great deal to statistical averages, investor services & newsletters (standard & poor’s gain, while the preferred stockholders had everything to lose and only a stock reports, value line, &moody’s investment service) small share in the possible gain. Obstacles to Success of the Analyst 2. Status of the Issue. A commitment to a new building, constructed at an 1. Inadequate or Incorrect Data: analyst cannot be right all the time. exceedingly high level of costs, with no reserves or junior capital to fall -least important of the 3 back upon in case of trouble. - Deliberate falsification of the data is rare; most of the misrepresentation 3. Price of the Issue. At par, the dividend return is much less than the yield flows from the use of accounting artifices which is the function of the obtainable on real-estate second mortgages. capable analyst to detect. Concealment is more common than a QUANTITATIVE AND QUALITATIVE FACTORS IN SECURITY misstatement. ANALYSIS 2. Uncertainties of the Future. Of much greater moment is the element of Quantitative vs. Qualitative Elements in Analysis. The former might be future change. A conclusion warranted by the facts and by the apparent called the company’s statistical exhibit. Included in it would be all the prospects may be vitiated by new developments. This raises the question of useful items in the income account and balance sheet, together with such how far it is the function of security analysis to anticipate change additional specific data as may be provided concerning production and unit conditions. We shall defer consideration of this point until our discussion of prices, costs, capacity, unfilled orders, etc. various factors entering into the processes of analysis. These various items may be subclassified under the headings: 3. The Irrational Behavior of the Market. The third handicap to security (1) capitalization, (2) earnings and dividends, (3) assets and liabilities, and analysis is found in the market itself. In a sense, the market and the future (4) operating statistics. present the same kind of difficulties. Neither can be predicted or controlled The qualitative factors, deal with such matters as the nature of the business; by the analyst, yet his success is largely dependent upon them both. The the relative position of the individual company in the industry; its physical, major activities of the investment analyst may be thought to have little or geographical, and operating characteristics; the character of the no concern with market prices. management; and, finally, the outlook for the unit, for the industry, and M3: THE MARGIN OF SAFETY CONCEPT business in general. The analyst must look for their answers to FUNDAMENTAL ELEMENTS IN THE PROBLEM OF ANALYSIS miscellaneous sources of information of greatly varying dependability— 1. Personal Element. The personal element enters to a greater or lesser including a large admixture of mere opinion. Moreover, quantitative factors extent into every security purchase. The aspect of chief importance is lend themselves far better to thoroughgoing analysis than do the qualitative usually the financial position of the intending buyer. What might be factors. The former are fewer in number, more easily obtainable, and much attractive speculation for a businessman should under no circumstances be better suited to the forming of definite and dependable conclusions. attempted by a trustee or a widow with limited income. T2: THE TREND OF FUTURE EARNINGS 2. Time. The time at which an issue is analyzed may affect the conclusion A record of increasing profits is a favorable sign. Financial theory has gone in various ways. The changing circumstances are bound to exert a varying further, however, and has sought to estimate future earnings by projecting influence on the analyst’s viewpoint toward the issue. Furthermore, the past trend into the future and then used this projection as a basis for securities are selected by the application of standards of quality and yield, valuing the business. Because figures are used in this process, people and both of these—particularly the latter—will vary with financial mistakenly believe that it is “mathematically sound.” But while a trend conditions in general. shown in the past is a fact, a “future trend” is only an assumption. 3. Price. The price is an integral part of every complete judgment relating Trend Essentially a Qualitative Factor to securities. In the selection of prime investment bonds, the price is usually -emphasis on the trend is likely to result in errors of overvaluation or a subordinate factor, not because it is a matter of indifference but because in undervaluation. This is true because no limit may be fixed on how far ahead actual practice the price is rarely unreasonably high. But in a special case, the trend should be projected; and therefore the process of valuation, while such as the purchase of high-grade convertible bonds, the price may be a seemingly mathematical, is, in reality, psychological and quite arbitrary. For factor fully as important as the degree of security. this reason, that we consider the trend as a qualitative factor in its practical implications, even though it may be stated in quantitative terms. Qualitative Factors Resist Even Reasonably Accurate Appraisal T3: CLASSIFICATION OF SECURITIES The trend is, in fact, a statement of future prospects in the form of an exact SECURITIES are divided into the two main groups of bonds and stocks, prediction. In a similar situation, conclusions as to the nature of the with the latter subdivided into preferred stocks and common stocks. The business and the abilities of the management have their chief significance first and basic division recognizes and conforms to the fundamental legal in their bearing on the outlook. These qualitative factors are therefore all of distinction between the creditors’ position and the partners’ position. The the same general characters. They all involve the same basic difficulty for bondholder has a fixed and prior claim for principal and interest; the the analyst, viz., that it is impossible to judge how far they may properly stockholder assumes the major risks and shares in the profits of ownership. reflect themselves in the price of a given security. In most cases, if they are It follows that a higher degree of safety should inhere in bonds as a class, recognized at all, they tend to be overemphasized. We see the same while the greater opportunity of speculative gain—to offset the greater influence constantly at work in the general market. The recurrent excesses hazard—is to be found in the field of stocks. of its advances and declines are due at the bottom to the fact that, when Objections to the Conventional Grouping: values are determined chiefly by the outlook, the resultant judgments are 1. Preferred Stock Grouped with Common. While this approach is not subject to any mathematical controls and are almost inevitably carried hallowed by tradition, it is open to several serious objections. Of these the to extremes. most obvious is that it places preferred stocks with common stocks, THE METHODS OF BOND INVESTMENT whereas, so far as investment practice is concerned, the former undoubtedly 1. The entire approach is based on recognition of the asymmetry that belong with bonds. The typical or standard preferred stock is bought for underlies all nondistressed bond investing. Gains are limited to the fixed income and the safety of the principal. Its owner considers himself promised yield plus perhaps a few points of appreciation, while credit not as a partner in the business but as the holder of a claim ranking ahead of losses can cause the disappearance of most or all of one’s principal. Thus the interest of the partners, i.e., the common stockholders. Preferred the key to success lies in avoiding losers, not in searching for winners. stockholders are partners or owners of the business only in a technical, 2. The high yield bond portfolios are focused. We work mostly in that legalistic sense; but they resemble bondholders in the purpose and expected part of the curve where healthy yields on B-rated bonds can be earned and results of their investment. where the risk of default is limited. For us, higher-rated bonds don’t have 2. Bond Form Identified with Safety. A weightier though less patent enough yield, and lower-rated bonds have too much uncertainty. This B objection to the radical separation of bonds from stocks is that it tends to zone is where our clients expect us to operate. It would be sounder identify the bond form with the idea of safety. Hence investors are led to procedure to start with minimum standards of safety, which all bonds must believe that the very name “bond” must carry some especial assurance be required to meet in order to be eligible for further consideration. Issues against loss. This attitude is unsound, and on frequent occasions is failing to meet these minimum requirements should be automatically responsible for serious mistakes and losses. The investor has been spared disqualified as straight investments, regardless of high yield, attractive even greater penalties for this error by the rather accidental fact that prospects, or other grounds for partiality. Essentially, bond selection should fraudulent security promoters have rarely taken advantage of the consist of working upward from a definite minimum standard rather than investment prestige attaching to the bond form. working downward in a haphazard fashion from some ideal but 3. Failure of Titles to Describe Issues with Accuracy. The basic unacceptable level of maximum security. classification of securities into bonds and stocks—or even into three main 3. Credit risk stems primarily from the quantum of leverage and the classes of bonds, preferred stocks, and common stocks—is open to the third firm’s basic instability, the interaction of which in tough times can objection that in many cases these titles fail to supply an accurate erode the margin by which interest coverage exceeds debt service description of the issue. This is the consequence of the steadily mounting requirements. A company with very stable cash flows can support high percentage of securities that do not conform to the standard patterns but leverage and heavy debt service. By the same token, a company with instead modify or mingle the customary provisions. limited leverage and modest debt service requirements can survive severe The standard patterns are as follows: fluctuations in its cash flow. But the combination of high leverage and I. The bond pattern comprises undependable cash flow can result in a failure to service debt, as investors A. The unqualified right to a fixed interest payment on fixed dates. are reminded painfully from time to time. B. The unqualified right to repayment of a fixed principal amount on a 4. Analysis of individual issues calls for a multifaceted approach. The fixed date. concerns are with industry, company standing, management, interest C. No further interest in assets or profits, and no voice in the management. coverage, capital structure, alternative sources of liquidity, liquidation II. The preferred-stock pattern comprises: value, and covenants. A. A stated rate of dividend in priority to any payment on the common. Security Analysis reflects many of these same concerns. (Hence full preferred dividends are mandatory if the common receives any 1. On company standing: “The experience of the past decade indicates that dividend; but if nothing is paid on the common, the preferred dividend is dominant or at least substantial size affords an element of subject to the discretion of the directors). protection against the hazards of instability.” B. The right to a stated principal amount in the event of dissolution, in 2. On interest coverage: “The present-day investor is accustomed to regard priority to any payments to the common stock. the ratio of earnings to interest charges as the most important specific test C. Either no voting rights or voting power shared with the common. of safety.” III. The common-stock pattern comprises: 3. On capital structure: “The biggest company may be the weakest if its A. A pro-rata ownership of the company’s assets in excess of its debts and bonded debt is disproportionately large.” preferred stock issues. 5. “Buy-and-hold” investing is inconsistent with the responsibilities of the B. A pro-rata interest in all profits in excess of prior deductions. professional investor and the creditworthiness of every issuer represented in C. A pro-rata votes for the election of directors and for other purposes. the portfolio must be revisited no less than quarterly. Bonds and preferred stocks conforming to the above standard patterns will 6. Don’t engage in market timing based on interest rate forecasts. sometimes be referred to as straight bonds or straight preferred stocks. Instead, we confine our efforts to “knowing the knowable,” which can result only from superior efforts to understand industries, companies, and securities. 7. Despite our best efforts, defaults will creep into our portfolios, whether due to failings in credit analysis or bad luck. In order for the incremental yield gained from taking risks to regularly exceed the losses incurred as a result of defaults, individual holdings have to be small enough so that a single default won’t dissipate a large amount of the portfolio.