Frequently Asked Questions - Investing

 

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Frequently Asked Questions

How do I invest for the long term?

What is meant by a stock's ex-dividend date?  
What is asset allocation? How does a stock dividend differ from a cash dividend?   
What does "investment style" mean? Should I sell my stock when it makes up more than 10% of my portfolio?
What is a market capitalization? Should I sell my stock when management changes?  
How do I build a diversified portfolio? My brokerage firm downgraded the stock. What should I do?  
Where can I find good, consistent information on companies?   What is the significance of analysts' consensus earnings estimates?
What is a stock split and how does it affect my shares' value?    How do I analyze earnings estimates?
What are reverse splits? What causes revisions to earnings estimates?
What is the impact on the market of cash dividends?    
 

Q:   How do I invest for the long term?  

A:   Funds are very popular with the majority of investors, but are they giving their money's worth? Only if you pick the best of the best. And also if the investor keeps the funds for the long term and doesn't touch them unless something happens to the fund that gives out a danger signal. We maintain the position that most investors can outperform the professionals with a diversified portfolio of common stocks, a little common sense, and a lot of homework. But, you must commit the same diligence to your securities portfolio as you would any other endeavor.

 

1)      Review your portfolio. Most professional money managers claim that an investor should review their portfolio once a year. The average investor tends to buy and sell at the wrong times. The solution would be to hold on for the long haul.

2)      You need a long term investment plan for retirement because social security will not be enough, neither will pension plans. Choose investments with a level of risk that makes you feel comfortable and that are appropriate for your long term goals.

3)      There is a wealth generating power of stocks. It has been proven over time that stocks have been the winner over anything else. Bonds and cash are used as a safe guard for most people, but they do not grow and only pay interest.

4)      You need patience and discipline to hold onto or add investments through down markets as well as up markets.

5)      Remember to create a broadly diverse portfolio spreading risk over a variety of investments with asset allocation and mutual funds.

6)      Do not stop investing when you retire. You do not have to shift all your stock or stock funds into fixed-income investments or even money market funds.

7)      A balanced portfolio is still the better way. If you are over 65 years old, you should have at least 60% in stocks and or stock mutual funds. Remember, you still have a lot of great years left ahead of you to enjoy life.  

Q:   What is asset allocation?

A:   Asset allocation, or spreading your investments across asset classes (stocks, bonds and money markets), is a great first step in diversifying, but it shouldn't end with that. The next step is to diversify within each asset class. Stocks, in particular, hold many opportunities to mix different types and styles to help ensure that you're always invested in at least one area of the market that may be enjoying an upswing.

Q:   What does "investment style" mean?
A:   This generally refers to two types of stock: growth or value. A growth stock is one whose earnings potential is considered above average, based on such factors as earnings history and competitive position in its industry. A value stock is one that is considered under-priced—or, quite simply, a bargain—given its company's fundamental strengths. Many stock mutual funds are referred to as growth or value funds, and investment professionals consider such styles to have different cycles. Growth stocks, for instance, tend to lead other stocks when the market and economy are strong. Value stocks, on the other hand, are favored when the market is in a slump and good stocks may be under-priced because many investors aren't buying or "bidding up" stocks. Holding both value and growth stock funds allows you to participate in each market cycle.

Q:   What is a market capitalization?
A:   Another way to diversify your stock holdings is to invest in funds that focus on companies of a particular size. Size in the stock market is measured by market capitalization (often referred to as market cap), which is the total market value of a company's issued and outstanding stock. Large cap funds tend to hold the stock of well-known companies, such as IBM or Coca-Cola. Conversely, small cap funds are likely to invest in more obscure companies serving a market niche not often visible to the consumer.

 

Smaller cap stocks may offer the potential for greater long-term results. However, they are also generally associated with a higher risk of failure because small companies are sometimes under-funded and may not be well-established in the marketplace. As a result, small cap stocks tend to enjoy favor when the economy is strong and smaller companies are less likely to struggle financially. On the other hand, large cap stocks may be favored when the economy and market are in a downturn, because larger companies are perceived as more able to weather difficult times than their smaller counterparts.

Diversifying your savings by holding various types of stock funds keeps you invested opportunistically as the market cycles up and down. Growth stock funds versus value, large cap funds versus small all may offer potential at one time or another during a long-term investment horizon.

Q:   How do I build a diversified portfolio?
A:   Mix it up! It's wise to hold a variety of stock types to ensure your portfolio is well-diversified. A diversified portfolio does not concentrate in one or two investment categories. Instead, it includes some investments whose returns zig while the returns of other investments zag. The net effect is lower volatility in returns.

  1. Large cap stock: Stock of a large company with a market capitalization (total market value of issued and outstanding stock) generally over $10 billion.

  2. Mid cap stock: Stock of a mid-size company with a market capitalization generally between $2.5 billionand $10 billion.

  3. Small cap stock: Stock of a small company with a market capitalization generally under $2.5 billion.

  4. Value stock: Stock trading at a discount to its perceived true market value.

  5. Growth stock: Stock of a company that has historically experienced above-average earnings growth rates.

Q:   Where can I find good, consistent information on companies? 

A:   The U.S. Securities and Exchange Commission's EDGAR database of filings for all U.S. public companies is your best bet for detailed financial statements.

Q:   What is a stock split and how does it affect my shares' value?

A:   A stock split is an increase in a corporation's number of outstanding shares of stock without any change in the shareholder's equity or the aggregate market value at the time of the split. The share price and dividends per share are adjusted proportionately.

But what does that mean to you? After all, theoretically a split is a "non-event." This means that, unlike most other firm-specific "events," there is no change in the cash flows of the firm or in the relative strengths of the various interested parties of the firm. Since no real change has occurred within the firm, you would think that the stock market would show little reaction to a stock split announcement. Yet research shows that the market does indeed react directly to a split.

 

It is obvious that, unless the splits or dividends make the shares more desirable, they represent nothing but paper shuffling for which the corporation must pay. The usual argument for splits is that investors prefer stocks of companies that trade within some common range, such as $20 to $100. With the company's price in a more accessible range, the theory goes, more investors should flock to the stock, bidding up its price. Furthermore, many companies would argue that by allowing more shareholders to purchase and sell shares in round lots, transaction costs would go down.

 

Research studies indicate, however, that transaction costs increase after splits. These costs include both commissions and the bid-ask spread, which is the difference between the price you have to pay to buy the stock and the price you can receive when selling the stock. Commissions per share of stock would typically decrease after a split, but not enough to compensate for the additional shares that need to be sold or purchased to meet the previous dollar amount of the complete transaction. One would expect the spread, when measured as a percentage of price, to remain the same before and after a split. In reality, the spread usually widens, increasing transaction costs. This is mainly attributed to a proportionate decrease in trading volume after most splits.

Q:   What are reverse splits?

A:   A reverse split is a decrease in a corporation's number of outstanding shares of stock without any change in the shareholder's equity or the aggregate market value at the time of the split. The share price and dividends per share are adjusted proportionately.

A reverse split will decrease the number of outstanding shares. A 1-for-5 split would leave an investor with one share of a company stock for every five owned, boosting the share price by a factor of five. Stock distributions in the form of dividends or splits would be used for stocks priced too high, while reverse splits would be used for low-priced stocks.

Reverse splits have interesting consequences for the stock price. In these instances, studies have found substantial negative price performance when the announcement is made, approved and executed. In a large number of cases, the stock price continued to decline even in the long run. Reverse splits often occur when a company trading over-the-counter with a low priced stock is trying to meet the listing requirements of exchanges, which typically carry minimum price requirements.

Q:   What is the impact on the market of cash dividends?

A:   A cash dividend is cash payment to a corporation's shareholders, distributed from current earnings or accumulated profits.

An announcement of cash dividends would intuitively seem to have some impact on a stock's return. To move a stock's price, however, the amount of the dividend or the nature of the dividend must be a surprise.

Dividends are the only cash payments that are regularly distributed by corporations to their shareholders. The board of directors decides upon the dividend, which is declared and distributed quarterly. The dividend can be of almost any amount and shareholders have no guarantee of dividend payments. However, dividend policies tend to be one of the more stable and predictable elements of a company. Decreasing or eliminating a dividend is tantamount to an announcement that the firm is financially distressed. Directors weigh dividend policies very carefully, rarely lowering dividends unless they have to, and not raising dividends unless they are confident that they can be sustained. When a company announces a larger than expected dividend or unexpectedly announces a dividend cut or omission, the market reaction is dramatic and sudden. Studies indicate that stock prices typically change to reflect dividend policy changes within the trading day of the announcement. With market reaction this quick, it is difficult, if not impossible for investors to make extra money after the announcement has been made. The only way for an individual to take advantage of a positive or negative surprise dividend announcement is to be positioned prior to the announcement.

Q:   What is meant by a stock's ex-dividend date? 

A:   In order to receive a declared dividend, a shareholder must be on the company's shareholder list on the holder-of-record date. The ex-dividend date is four days prior to the record date. Therefore, any shares purchased prior to the ex-dividend date are entitled to the dividend, while any shares purchased on or after the ex-dividend date are not.

On the ex-dividend date, you would expect the price of the stock to fall by the amount of the dividend. Several research reports reveal, however, that on the ex-dividend date prices tend to fall slightly less than the dividend payment would dictate. While transaction costs and taxes would wipe out this excess return for most individual investors pursuing just this dividend capture strategy, if you are planning to transact in a stock and it is very near the ex-dividend date, then you might consider selling on the ex-date or buying it just prior to the ex-date. Stock dividends are distributions of additional shares of stock to shareholders instead of cash. For an investor holding 100 shares of stock, a 5% stock dividend would entitle the investor to another five shares of stock. If the stock were selling at $100, after the stock dividend it will open at about 95 1/4, making the market value (price times number of shares) the same before and after the stock dividend.

Q:   How does a stock dividend differ from a cash dividend?

A:   A stock dividend is the payment of a corporate dividend in the form of stock rather than cash. It is usually expressed as a percentage of the shares held by a shareholder, and is 25% or less than the total number of shares outstanding. The share price and dividends per share are adjusted proportionately.

When stock dividends are over 25%, they are typically called splits. If the same stock had a 2-for-1 stock split instead of a stock dividend, the investor would have 200 shares of stock but they would be trading at $50—half their previous price.

Prices will typically rise prior to a stock dividend announcement; after the announcement there will be little or no further increase in price. Generally, stock dividends create a positive impact on prices in cases where there is an increase in the cash dividend along with stock dividend.

Q:   Should I sell my stock when it makes up more than 10% of my portfolio?

A:   A price increase in and of itself is no reason to dump a stock. On the other hand, you should also be analyzing your individual holdings in the context of your total portfolio. Your portfolio should always be diversified; if you own more than 10 stocks in equal weights that are in various industries, or you have holdings in diversified mutual funds, you can consider yourself diversified. If a stock holding has become a large percentage of your total portfolio holdings due to good price performance, causing an over-concentration in a sector or industry, you may want to consider paring back the position, taking some profits and redistributing the wealth. But don't unload a stock just because you have already made money on it. Always consider the future merits of a stock before you sell due to a price movement—use the same analysis that led you to buy the stock originally, and reassess based on current market conditions and price levels. If the outlook still looks good, keep the stock, but pare it back.

Q:   Should I sell my stock when management changes?

A:   It depends on the company: Does one person rule or can the company thrive under management changes?

Management changes may signal the need for another analysis of the company and should not automatically trigger a sell unless the company is ruled by one personality or it is so small that the only pool of talent is the individual who has left. This one-person show is often the case in start-up ventures and the smallest companies that started out as entrepreneur ventures. Rarely does the management of a multi-national company stand alone, without capable underlings who can step in and continue or expand the present businesses. As part of any investment analysis, you should familiarize yourself with the pool of management talent and their tenure at a company. This information is available in the company's 10-K proxy and statement.

Q:   My brokerage firm downgraded the stock. What should I do?

A:   While the downgrade a stock may cause a price drop temporarily, you need to analyze why the analysts changed their mind. Wall Street brokerage firms employ thousands of analysts and research personnel to issue "expert" opinions on the stocks that they are following. Become your own analyst and examine what caused the change. Did they meet with management? Conversations with management by an analyst may have merely resulted in a changed impression rather than any real change in financial data. Were new earnings released? This is public information that you can analyze by examining the company's 10-Q statement. Are sales and earnings declining? Are margins shrinking? Is competition increasing along with inventories? Only after you have examined these and other factors yourself should you decide to sell a stock. Don't simply take a broker's recommendation; your own analysis will mean more in the long run.

Q:   What is the significance of analysts' consensus earnings estimates?

A:   For an investor in common stock, knowledge of expected earnings, changes in expected earnings, and actual earnings is crucial for understanding stock price behavior. Earnings surprise is the key. Positive earnings surprises occur when actual reported earnings are significantly above earnings per share forecasts; negative earnings surprises occur when reported earnings are significantly below earnings per share forecasts. Both have lingering long-term effects.

Consequently, a very rewarding investment strategy is one that avoids stocks you believe will have negative earnings surprises or that have had negative earnings surprises. Selecting positive earnings surprise stocks before and even after the earnings come in may be similarly profitable. Even a strategy of simply selling after negative earnings surprises and buying after positive earnings surprises probably has some merit.

Q:   How do I analyze earnings estimates? 

A:   Three factors are important in looking at earnings estimates:

  1. The earnings per share forecast;

  2. The level of agreement among analysts following the company on expected earnings; and

  3. Any significant revisions in estimates.

All of these earnings estimate factors are embedded in current stock prices, and revisions in earnings forecasts will affect stock prices immediately, as will any significant surprise in actual versus expected earnings. As would be expected, more distant forecasts have greater variability, less consensus, and have fewer analysts making estimates.

 

There are potential rewards for disagreeing with the consensus and being correct. The trap that investors often fall into is that, upon hearing robust forecasts of earnings sung by a choir of analysts, they purchase the stock and are disappointed as the stock fails to soar when the consensus proves correct. Why did the stock fail to soar? Because its price already reflected the consensus viewpoint.

 

A few points on earnings estimates worth keeping in mind:

  1. Know the earnings forecast consensus of a stock you own or are interested in.

  2. Realize that the stock price already reflects the general consensus about future earnings.

  3. Be aware that if a stock is highly touted, the basis for the recommendation should be an earnings forecast significantly above the prevailing opinion.

  4. Ask for and carefully evaluate the foundation of an earnings forecast that deviates substantially from the consensus before investing.

  5. Be sensitive to revisions in forecasts and monitor actual quarterly earnings relative to forecasted earnings.

  6. Significant earnings surprises, positive or negative, probably have a fairly long-term effect on a stock's price as analysts revise long-term earnings forecasts accordingly.

  7. Don't expect extraordinary gains (gains beyond market returns) if you agree with the earnings consensus.

  8. Stocks that are followed by fewer analysts and with fewer estimates will provide more opportunity for you to benefit from your research efforts.

 

Many investing Web sites report earnings estimates and earnings surprises and Yahoo! Finance is one of the best.

Q:   What causes revisions to earnings estimates?

A:   Earnings are announced for quarters based on the firm's fiscal year. As the fiscal year-end approaches, fiscal-year consensus estimates converge toward the actual fiscal-year earnings and there is less divergence. However, the focus does not abruptly shift to the next fiscal year as the previous one ends. Instead, stock prices probably, but not precisely, incorporate a rolling four-quarter earnings forecast perspective. Earnings forecasts are a moving target.

 

Also, analysts change their forecasts in reaction to a changing firm, industry, and economic environment. New information drives analysts' expectations and stock prices. Following the trend of changes in analysts' earnings forecasts for a firm and determining the root causes of those changes should prove valuable.

If you are unsure of why earnings forecasts are changing, it is not a bad idea to simply call the firm itself and ask for the investor relations department. They will tell you about all the information the company has released or any public information they are aware of that has been published.

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