FUNDAMENTALS OF INVESTING
January 15, 2011
TERMS and PRINCIPALS
The four Principals of Investing from BetterInvesting:
Invest regularly
Re-invest earnings
Invest in Quality, Growth Companies
Diversify
Another set of principals is on www.fool.com – See “13 Steps to Investing Foolishly”. The names are
different but the overall message is very similar.
INVESTING defined: Using money to make money
Contrast with: Saving, difference is risk
Trading, difference is timing
WHY INVEST?
What is being “rich”? Suggest that the goal is “financial independence”, the ability to choose
what to do in life, or the ability to fund a life style from investment income.
TYPES OF INVESTMENTS (some examples – will not look at “others”)
Equities
Fixed Income
Stocks, Mutual Funds, ETFs,
Bonds, CDs, Money Market
Options, REITs, Publicly Traded
funds, Cash
Partnerships, etc
Others
Gold and other precious metals,
Commodities, Real estate
(personal home and rental
properties), Fine art, etc.
Types of risk
Market / volatility
Purchasing Power
Interest Rate
Currency
Inflation
TIME AND COMPOUND INTEREST
Chart showing the effect of $5000 invested at age 20, 30, and 40 with same compound growth
rate. The amount invested at age 20 accumulates to more than two times as much as the amount
invested 10 years later.
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INVESTING TERMS
Equity -- Ownership in a company
Bonds --A loan to a company
Options
A contract between two parties
Right, not the obligation, to buy or sell a security within specified time period
Call – the right to buy at a certain price
Put – the right to sell at a certain price
FUNDAMENTAL ANALYSIS
Study of a company’s financial performance
History of sales and earnings
Quality of management
Analysis of PE ratio
Forecast future growth
Analysis of company’s market and competitors
Goal: to determine if current price of stock is a good value
Financial Statements Documents used for Fundamental analysis
Balance Sheet: Snapshot of company at a specific time
Assets – what the company owns. Includes cash, receivables, inventory, property, etc
Liabilities – what the company owes. Examples: Accounts payable, debt, etc.
Shareholders’ Equity
Assets = Liabilities + Shareholders’ Equity
Balance sheet example APPL
Income Statement: Measures financial performance over specific accounting period
Income Statement example APPL
Statement of Cash Flows: Cash generated and used over accounting period
Broken out by: Operating Activities, Investing Activities, Financing Activities
Cash Flow statement example APPL
Price to Earnings ratio (PE) Price ∕ Earnings per share
PEG ratio (Price Earnings to Growth ratio):
Price / Earnings ratio divided by Annual EPS Growth
Relative Value: Current PE ratio divided by 5 year historical PE
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Technical Analysis
Forecast price movement of a stock
Use models and trading rules
Track Price and volume
Ignores the actual nature of a company
Examples of Technical Analysis:
Comparison of a ‘trailing’ moving average (e.g. 50 day average) with closing price
Point and Figure chart. See stockcharts.com/charts/pointFigure/ for more information
“THE MARKET”
Dow Jones Industrial Average
A price weighted average of 30 “Blue Chip” stocks
Higher priced stocks more influence on average
List of Dow Jones Industrial Companies:
http://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average
S&P (Standard & Poors) 500 Index
Chosen for market size, liquidity and industry grouping
Meant to reflect risk/return of large US stocks
NASDAQ
Electronic exchange for more than 5000 actively traded stocks
The change in “points” of these three numbers is often used as a “summary” of “the market.”
A more significant measure is the percentage change of the numbers.
HOW TO DIFFERENTIATE SIZE OF COMPANY
Market Cap (Capitalization)
A measure of size of a company
Price x Shares outstanding
Example: price and outstanding shares on 4/30/10
WMT -- $54 x 3.76 B shares = $203 B market cap
APPL -- $260 x .91 B shares = $239 B market cap
BI uses annual sales as measure of size
Example: using 2009 sales
WMT -- $405 B
APPL – $ 43 B
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Small company
Medium size company
Large company
Sales (annual)
Sales Growth (annual)
Less than $500 M
Greater than 12%
Between $500 M and $5 B
Between 7% and 12%
Greater than $5 B
Less than 7%
Approximate values
Mutual Fund
Managed pool of funds
Specific investment objective – stated in Prospectus
Types of funds
Managed vs. Index
Broad Market vs. Sector
Equity vs. Fixed Income
Target Date
Etc.
ETFs (Exchange Traded Fund)
Security that tracks an index, a commodity, or basket of assets
Components publicly available
Broad market, sector, country, commodity, etc.
Trades like a stock
Price is known when traded
Pay a commission on trade
May sell at premium or discount
Mutual Funds
ETFs
Investment objective Portfolio “drift”
Investments known
“Load” or “No-Load”
Traded like stocks
Commission on trade
Tax Efficient
Dividends and Capital Gains Distributed
Lower management costs
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Income Investments
Fixed income – CDs, Money Market funds (cash equivalents)
Principal guaranteed, lower interest rate (less risk)
Dividend Paying Stocks
Bonds – Corporate and Municipal
Corporate – taxable income
Municipal – tax free income
Market price related to interest rates
Price vs. Interest rate example
A bond paying 5% interest sells for $1,000
Pays $50 interest each year until maturity
Can be sold on the open market
If interest rate in the market place increases to 6%,
A $1,000 bond pays $60 a year
Market value of a bond paying $50 / year
$50 / .06 = $833
Similar change in value if interest rate decreases
Market value of bond paying $50 / year would be $1,250 if rate was 4%
The remainder of the presentation is about applying investing fundamentals to personal investments.
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Getting Started in Investing
Get your financial house in order
Know where your money is going
Spend less than you earn
Eliminate debt
Credit cards / Car Payments
Build Emergency Fund
Automatic saving
401(k) or equivalent
Investment Club
Personal Assets
Investments
Equity – Stocks and Mutual Funds
Income Producing
Cash – Emergency fund
Retirement Plans (ex. 401(k), 403(b))
Personal Residence
Pension, Social Security, Insurance, Annuities, etc
Asset Allocation
An investment strategy that aims to balance risk and reward by apportioning a portfolio's
assets according to an individual's goals, risk tolerance and investment horizon.
Investopedia.com
Three main asset classes:
equities,
income,
cash and equivalents
Different levels of risk and return
Asset Allocation
Money needed within 1 year:
Cash or cash equivalent
Money that you won’t need for 5 to 10 years
Stocks or stock funds
Everything else
Investments with less market volatility
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Asset Allocation – by asset class
Example on Fidelity.com
Asset Allocation – by age of investor Example on Fidelity.com
Asset Allocation – the Couch Potato Portfolio (Scott Burns)
Use Mutual Funds and/or ETFs to allocate assets
Various “recipes”
Couch Potato
½ Vanguard Inflation Protected Securities (VIPSX)
½ Vanguard Total Stock Market Index (VTSMX)
Add one “ingredient” at a time up to:
Ten Speed – 10 different funds for maximum allocation
Retirement Accounts
Tax Deferred Contributions – taxed upon withdrawal
Employment based
401(k), 403(b), others
Individual Retirement Accounts (IRA)
Tax free withdrawals (with exceptions)
Roth IRA
Non-deductible (traditional) IRA
Contributions limited: age, income, and amount
Retirement Plan Limits
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Income Taxes
How income taxes are calculated
Income Tax Calculation. (Form 1040, page 1)
Income
Wages
Interest & Dividends
Business and Farm Income (net)
Capital Gains
Pensions, Annuities, Social Security
Etc
Adjustments to Income
IRA contribution
Student Loan Interest
And more
Adjusted Gross Income
Calculate the tax (Form 1040, p. 2)
Adjusted Gross Income
Less: Deductions (Standard or Itemized)
Exemptions (Filer(s) and dependents)
Taxable Income
Use Tax Rate Schedule to calculate tax
Note: receipt of a refund does not imply that no income tax paid
Tax bracket
The rate paid on the “last” dollar of income
Also called “marginal” tax rate
Overall tax rate is lower than tax bracket
Important to know if income will increase
Affects tax rate on dividends and capital gains
Tax Rates for Investors (expire at the end of 2010, unless changed by Congress)
Tax Bracket
10 % and 15%
25% and higher
Long term capital gain
0%
15%
(investment owned more than 1 year)
Qualified Dividends
5%
15%
(stock owned more than 60 days)
Non-qualified dividends and interest
Same as tax bracket
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Tax efficient allocation of investments (based on tax considerations)
Bonds and interest paying
Dividend Stocks
Short Term gains
Long Term gains
Tax Efficient funds (ETFs)
Tax inefficient funds
Tax free bonds
Tax Deferred Accounts
x
x
x
Taxable Accounts
Roth IRA
x
x
x
x
Tax Deferred Accounts (withdrawals at marginal rate)
Roth IRA (withdrawals not taxed)
Taxable Accounts
Total Portfolio Analysis
All Assets = One Portfolio
Cash – emergency fund and near term needs
Stocks
Long term return and inflation protection
“Rule of thumb” – (100 – age) % in stocks
Income investments
Less price volatility
Summary
Focus on what you can control
Asset Allocation
Keep expenses low
Saving enough
Don’t panic, avoid market turmoil
No one cares about your money more than you do!
Examples of on-line resources
www.betterinvesting.org
www.fool.com
www.getrichslowly.org
Book suggestions
The Richest Man in Babylon, George S. Clason
The Millionaire Next Door, Thomas J. Stanley
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