Reprinted with the permission of the American Association of Individual Investors

In the world of investing, no one piece of financial information tells all. But the price-earnings ratio comes close, containing a wealth of information about the market’s expectations for earnings growth.

However, if you look through any investment information resource commonly used by individual investors, you’ll find numerous definitions of the term.

Because the price-earnings ratio is a powerful summary of market opinion, financial analysts have frequently fiddled with it, producing what may appear to be endless variations on a theme.

Sorting out the different ways price-earnings ratios are quoted and how each different price-earnings ratio technique can be applied and interpreted should aid in your stock selection decisions.

What It Is

Price-earnings ratios (P/Es) are determined by taking a stock’s share price and dividing it by the firm’s earnings per share.

The ratio simply relates share price to earnings: the higher the price-earnings ratio, the more investors are paying for each dollar of earnings. If a stock has a price-earnings ratio of 15, it means that investors are paying $15 for each $1 of earnings.

Other terms for price-earnings ratios are: earnings multiple and price multiple.

The variations on price-earnings ratios occur with the decisions as to what share price to use (current, average, etc.) and which earnings figure to use (trailing 12 months, expected earnings, etc.).

How It Can Be Used

Price-earnings ratios are most commonly used to value future earnings.

In general, the higher the price-earnings ratio (relative to either its historical ratio, an industry ratio or the market ratio) the more the market is confident that earnings will grow in the future.

Low price-earnings ratios reflect expectations of lower growth and greater uncertainty.

All investors should be interested in finding firms that have a high, certain earnings growth rate and a relatively low price-earnings ratio. However, if the market agreed with your estimate of high growth, the price-earnings ratio would not be relatively low; rather, it would be either average, or perhaps even relatively high.

In order to form a judgment as to whether earnings are overvalued, undervalued or fairly valued using P/Es, you must judge whether you agree with the market’s opinion regarding the firm’s growth prospects.

How It Can Be Misused

A simple price-earnings ratio does not convey on its own all the information you need. Instead, it needs to be judged relative to other P/Es—by comparing a firm’s current price-earnings ratio, for instance, to its historical P/E, the industry average P/E or the market P/E.

Since earnings are in the denominator of the calculation, price-earnings ratios are not useful if the firm is not generating earnings (you cannot divide by 0), or if it has negative earnings (the resulting negative multiple is meaningless).

One-time events may also push price-earnings ratios up or down. Special charges or the sale of assets may lead to reported earnings that are below or above their normal levels. As long as the market interprets the earnings deviation as being only a temporary phenomenon, the abnormal P/E will be discounted by the market.

In addition, reported earnings themselves are subject to many assumptions and judgments, so if you are using price-earnings ratios, you must make sure that you understand the quality of the underlying earnings number.

P/E Variations

There are an endless variety of price-earnings ratio calculations. Here are the most common, along with how they can be applied and interpreted.

P/E Trailing Earnings

P/E trailing earnings is calculated using the most recent 12 months of reported earnings. This would give the most current actual earnings figure, but since earnings are reported quarterly, the trailing earnings could be over three months old.

P/E Current Earnings

P/E current earnings, used primarily by Value Line, steps into the future while straddling the past. The earnings used in the denominator are the most recent two quarters of earnings plus the estimated earnings per share for the next two quarters.

A common stock’s price today is based on expectations of future performance, a forward-looking valuation. Relating price to estimated earnings measures value today relative to expectations, and can serve as a guide as to whether a stock is relatively over- or undervalued.

P/E Forward (or Estimated) Earnings

P/E forward earnings uses estimates of annual earnings for the fiscal year in the denominator. An analyst’s forecast or a consensus of analysts is used.

At the beginning of the year, a price-earnings ratio using estimated earnings is completely forward looking, but as the year-end nears, more of the estimate is based on actual earnings and less is a forecast. Earnings estimates for the year are revised as new information is released and quarterly earnings become available.

P/E Average Price

P/E average price divides the average market price of the common stock for the fiscal year by the earnings per share for the fiscal year.

This approach attempts to smooth out the price-earnings ratio by reducing the day-to-day variation in ratios caused by stock price movements that may have been the result of general volatility in the stock market.

P/E Median

P/E median is the mid-value of a series of annual price-earnings ratios, ranked in ascending or descending order. The median is more useful than the average because the median, unlike the average, is not distorted by extreme values. The median of historical price-earnings ratios is valuable for gauging the current price-earnings ratio versus some historical norm.

P/E Normalized

P/E normalized is designed to derive a base, or normal, price-earnings ratio. It is similar in purpose to the forward price-earnings ratio, but with the further adjustment of using the following year’s actual earnings.

This approach is valuable because examining the history of price-earnings ratios using trailing or fiscal-year earnings does not capture the expectational component of the price-earnings ratio.

A normalized price-earnings ratio goes back in time and divides the previous year-end price, or the high or low (or both) for the year, by the following year’s actual earnings per share. These normalized price-earnings ratios can then be averaged.

Rather than looking at today’s price and earnings and determining whether the price-earnings ratio is relatively high or low, many analysts would suggest looking at today’s price and next year’s estimated earnings, so that the price-earnings ratio is based on estimated earnings.

The normalized price-earnings ratio makes the adjustment with actual, rather than estimated, earnings.

P/E Relative

P/E relative allows comparison of the price-earnings ratio of a firm to the price-earnings ratio of the overall market, currently and historically.

By dividing the firm’s price-earnings ratio by the market’s price-earnings ratio, P/E relative is determined. Often the Standard & Poor’s 500 is used as a proxy for the market. Prices and earnings for the firm and the market should reflect the same period.

Looking at these figures historically would generate median and average P/E relative figures for comparison to the current P/E relative. The P/E relative is much like relative strength measures, which relate the change in a stock’s price to the change in value of a market index.

A P/E relative can also be calculated using industry price-earnings ratio data instead of the S&P 500, if it is available.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Reprinted with the permission of the American Association of Individual Investors

Why is it that bright, educated people who come across stocks that could make them wealthy for life, so frequently fail to capitalize on golden opportunities—not enough brains or education?

No, not even close.

Two things are responsible: Beating ourselves, and a lack of knowledge. Beating ourselves is mainly emotions, meaning too much fear or greed. Normally those things take control when investors lack knowledge—they do not know what they own and why they own them in enough depth.

Investing is actually common sense along with a focus on the key factors that drive the greatest stocks.

In fact, investors need focus on only four factors that seem to be common, identifying traits of the greatest companies and stocks, in my experience. I have termed these four factors BASM:

• Business Model: How the company plans to grow, be profitable and protect itself from competitors.
• Assumptions: The key assumptions the company makes about their markets upon which they then develop the business model.
• Strategy: This is simply the plan the company develops to implement the business model.
• Management: These are the actual people who create the great business models, assumptions, execution and all the rest. Great management is also needed, over time, to adjust business models for competitive situations.

One item not mentioned here is earnings. So, what about earnings, you ask?

Earnings are part of the metrics you use in evaluating a company—gross margin, net margin after taxes, and return on capital are just some examples of other metrics. These tell you a lot about the competitive position and how well the company is managed. But these are report-card issues. While you do learn something about management from them, the report card does not tell you about vision and fixing problems.

In short, earnings are the golden eggs that drive stock prices, but BASM is the golden goose that lays those golden eggs—it is the engine of earnings.

The Business Model

The business model is the core of how a successful company operates. But most investors cannot tell you much or anything about their best investments and the business models. So let’s start here—on the first big element in BASM.

A good company normally describes and discusses their business model in several places including what they file with the Securities and Exchange Commission when they go public or have successive stock offerings, and the annual reports, all of which are easy to access from the company and the Internet. Here are the three elements of a strong business model:

1) The company describes how they are going to make a lot of money (or why they already are). If they are young and embryonic, they describe the specific path to get to great profitability.

2) The company describes how they will grow for a long time in the future, and how they will retain great profit margins and overall profit growth.

3) The company describes how it will protect itself from the competitors that want to get a piece of their markets and profits. They must talk about competition and how they will compete, protect and win—in other words, how the first two things in the business model will stay that way and not fall prey to strong competitor companies that may come along.

That’s it, and as simple as this is, it is amazing how many companies overly complicate it or write a poor business model and show us that they may not be going great places.

Thus, if an investor does not see anything of a clear, straightforward business model in filings or the annual report, he or she will have spent five minutes wisely, but then can move on and not bother with anything else.

One of the best examples of a great business model is Home Depot. When Home Depot came public, many people said it was just another big discount retailer. Many others challenged Bernie Marcus’ (co-founder) plans to pay workers in his stores more and spend more than competitors on training. Bernie understood that discount retailing was going to be dog-eat-dog competitively, and yet there could be ways other than price to differentiate between companies.

The big thing for Home Depot was a business model that was designed to attract customers on the basis of customer service while being price competitive. Low prices often meant that people felt adrift and could not get enough help to purchase anywhere near what their potential might be.

Well, paying help more than the minimum wage and the extra spending on training as part of the do-it-yourself business model concept of Home Depot did bring them the customers, and that eventually was reflected in the stock price.

Assumptions

Any strategy that a company settles upon to achieve its business plan is built on a set of assumptions, or projections, about how big a market is for a company or a product. Assumptions also must be made concerning anticipated competition and demand over the next year or three years. The assumptions part of BASM is best illustrated with an example.

Bill Gates came into the software spreadsheet market facing skeptics who told him that, since Lotus Development had 70% of the spreadsheet market, he could do nothing, and it was already “game over.” (“Game over” is one of the great syndromes of ordinary investing that ignores the elements of BASM.) So Lotus ran the hot product race without any real worries about Microsoft.

But Gates made huge assumptions about the way people and companies would buy and use software.

His biggest assumption was that customers would have a critical need for standard software—in other words, consumers were looking for uniformity and continuity in software so they would not have to relearn everything from ground zero when new products came out.

Gates also assumed that consumers would stay with one company’s products cycle after cycle if those products met their needs and were competitive in new technologies.

Setting standards and achieving early domination flowed from those assumptions as the core company strategy was formulated.

Eventually, Lotus lost, and Microsoft (need I add?) won. Now it really is “game over.”

Strategy

Management may have a great business model, but it has to have a strategy to execute the details of its plans.

Operational differentiation and excellence are concepts that apply to many great companies.

For instance, Intel has excelled over the years by continually coming out with the best new microprocessor chips to serve as the brains for personal computers. But aside from great product research and development, Intel spends a fortune on research and development in production methods and systems.

To reach back a bit further, McDonald’s is one of the truly great companies. And it is clear the core secret to McDonald’s great management success was operations. In fact, the McDonald’s business model went into great detail about how consistency and quality would flow from great operations management, and those factors would bring in the customers and control costs—and it did work, just as the company said.

Management

The best management demonstrates that it can envision a great future for the company and articulate a cohesive and logical strategy for getting there. The strategy cannot be pie in the sky—it has to be based on resources—human, financial, technological—within the grasp of the company.

Management also has to show it can execute the details, so you must watch carefully.

Great managers make promises and projections to you, the stockholder, that they can deliver on. They are driven to stay ahead of the pack and understand how to lead. While they truly want to win, they are realists in terms of the goals they can execute.

Lastly, great managers admit mistakes early and move aggressively to fix them.

Investing for the Big Money

Most investors spend too much time chasing the wrong information.

Focus is the key, and the simplicity and focus of BASM really has worked to develop some of the greatest all-time investment records and wealth for many people. They do not always call it BASM, but they concentrate on what the golden goose is that creates the golden eggs of earnings.

Great Business Model Descriptions: eBay vs. Google

How does eBay differ from Google?

They are both the darlings of our time, very successful, and both household words.

But eBay has a great business model in which—instead of concentrating on the powerful technology that was making them the best—they concentrated on a way to build true community and bring in all the customers and retain them. That was all spelled out in the prospectus they printed when going public. Google, on the other hand, was fuzzy about their business model. We know it was a great buy on the technology lead and popularity. However, they are now experimenting with so many things at once, and yet still derive almost all of their revenues from search engines that will be further assaulted by competition.

These differences could be seen by investors who scrutinized the public offering documents. eBay had great business model descriptions when it went public; Google did not.

Here is how eBay described their strategy at the time of the initial public offering (IPO):

“The Company’s objective is to build upon its position as the world’s leading online person-to-person trading community. The key elements of eBay’s strategy are:

“GROW THE EBAY COMMUNITY AND THE EBAY BRAND. The Company believes that building greater awareness of the eBay brand within and beyond the eBay community is critical to expanding its user base and to maintaining the vitality of the eBay community.

“Although the Company’s historical growth has been largely attributable to word-of-mouth, the Company intends to build its user base and its brand name aggressively…

“BROADEN THE EBAY TRADING PLATFORM. The Company intends to pursue a multi-pronged strategy for growing the eBay platform within existing product categories, across new product categories and internationally. The Company will target key vertical markets in its user programs and marketing activities.”

There are many more details and components of the business plan, but the key thing was that they all held together logically. They described in straightforward terms how they would grow and make money, and they presented something of a roadmap for both the company and its investors. This is what you want to find.

Google, in contrast, seems to have a good model for generating advertising revenues on its search pages, and it is very profitable. Moreover, the marketing and mind share aspect of its ubiquity, such that people use “Google” both as a verb and a noun—“googling” is a part of the language these days––means that Google has some major assets as it strives to become a dominant leader.

So, Google does have the first part of a good business model, the profitability. But it lacks the second and third parts of a great business model—a plan for growing the profits into the future and protecting them from competition. On these parts there is a blank slate.

Interestingly enough, the filings from its 2004 public offering contain language that concedes that Microsoft will be a competitor to contend with. But also very important is that those filings—unlike eBay’s filings—have very little in them about competitive strategy and the details of the business plan.

Even in late 2005, Google was still adding to what their core service had been. This only makes it a bit tougher for management to define their ultimate strategy and business plan.

The stock has done well, but the jury is out—and based on the BASM yardsticks, the clarity of strategy when they went public is lacking.

Fred Kobrick managed mutual funds for Wellington Management and State Street Research & Management before founding his own firm in 1998. Under his management, the State Street Research Capital Fund was ranked by USA Today as one of the top five performing funds over a 15-year period. He currently provides investment advice to nonprofit institutions and lives in Sudbury, Massachusetts. His book, “The Big Money” (Simon & Schuster, 2006), provides case histories, written to teach the simple guiding principles from which his investment record was generated.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Reprinted with the permission of the American Association of Individual Investors

What can you learn from three decades of monitoring investment newsletter performance?

Plenty.

It was nearly three decades ago that the Hulbert Financial Digest (HFD) began independently monitoring the performance of investment advisory newsletters. I’m devoting this column to a couple of the most important investment lessons that emerge from the list of newsletters that dominate the rankings of top performers.

The investment world today couldn’t be more different than the world that existed when the HFD set out to track newsletters, in mid-1980, at least on the surface. Back then, for example:

• The Dow Jones industrial average stood below 900—lower than where it had stood in 1966, 14 years earlier;
• Gold bullion, on the other hand, was just coming off a high of just under $900 per ounce—a record level that remains unbroken today, more than 27 years later (though gold is getting close);
• Inflation was in the double digits, as was the interest rate on long-term government bonds.

Given this stark contrast, it would seem that caution should be exercised in drawing any investment lessons based on which newsletters have performed the best since 1980. Why should anyone think that strategies appropriate to the investment world in 1980 would be appropriate today?

But I would argue that a closer look shows that, on average, the period encompassing the nearly 30 years since 1980 is not really all that different than what came before.

Down Memory Lane

Imagine, if you will, that you have traveled back in time to the early 1980s, and you are perusing the data in the 1980 Ibbotson Associates yearbook. This firm was created in 1977 by Professor Roger Ibbotson, and its yearbooks of historical data have become a must-have for financial planners and advisers. Those yearbooks, of course, contain the year-by-year performances back to 1926 of stocks, bonds and Treasury bills, and inflation rates.

What conclusions would you have reached? Here are two:

• Over the period of 1926 through 1979 (the period that would have been covered in the 1980 yearbook), stocks provided a handsome return, in both nominal and inflation-adjusted term;
• In addition, there was a healthy equity premium—that is, stocks outperformed bonds, compensating investors for the additional risk associated with investing in stocks.

But these same conclusions hold for the period since 1980, as is illustrated in Table 1.

To be sure, stocks in recent decades have produced higher returns (both in nominal and inflation-adjusted terms) than the returns they produced before 1980. But the real difference is not stock performance but rather bond performance—bonds did much better after 1980 than they did before. Because of this, the equity premium since 1980 has actually been less than the longer-term average, despite stocks themselves providing better overall returns.

This stock/bond relative performance difference between these two long-term time periods indicates, to me, that any “lessons learned” from the list of long-term top performers would have questionable relevance to the future if any of those top performers were highly ranked because they were heavily invested in bonds.

However, this is not the case—none of the newsletters at the top of the HFD’s rankings for performance since 1980 (see Table 2) derived a significant portion of their investment earnings from bonds.

All of which leads me to be fairly confident in drawing the following lessons.

Lesson 1: Long-term investors need not lose sleep over the markets’ short-term gyrations because the markets’ long-term patterns will eventually assert themselves.

To be sure, I am under no illusions that my drawing of this lesson will change many investors’ behaviors. For whatever psychological reasons, many are obsessed about the short-term and therefore can’t imagine not paying it the closest of attention.

What my data show, however, is that investors need not focus on the very short term to perform very well over the long term, thank you.

Consider The Prudent Speculator, the newsletter in first place on the HFD’s ranking for performance since mid-1980. Of any of the newsletters I monitor, this service has been the most buffeted by short-term market gyrations. And yet, none surpasses it in its willingness to either ignore or tolerate those gyrations.

Consider what happened to it in the crash of 1987, which just celebrated its 20th anniversary. On that day, according to the HFD’s calculations, the newsletter’s model portfolio lost 57%. And yet, far from panicking, Al Frank (the newsletter’s editor at the time) maintained his fully invested (and heavily margined) posture, patiently faithful that the stock market’s long-term uptrend would eventually win out. The newsletter’s long-term top ranking is a testament to that faith.

Lesson 2: Worrying about the short term can work against you.

Another lesson that emerges from my tracking of investment newsletters is related to the first: Constantly monitoring your investment performance can cause you to unnecessarily reduce the amount of risk you are willing to incur, causing your long-term performance to suffer.

According to behavioral finance researchers, constantly looking at how your portfolio is performing is not a benign act. It leads you to focus more of your attention on the short term than you would otherwise, leading you in turn to miss the veritable forest for the trees.

One researcher who has extensively studied this behavioral pattern, Richard Thaler of the University of Chicago, calls it “myopic risk aversion.” He hypothesizes that the more frequency with which an investor re-evaluates how he is doing, the more frequently he will experience loss, since any risky asset will not infrequently be exhibiting a short-term losing streak. No investor (except the occasional masochist) enjoys the experience of loss, and most investors prefer to avoid losses; therefore, this greater frequency of re-evaluation will tend to cause investors to own less risky assets and avoid stocks.

To test this hypothesis, Professor Thaler and fellow researchers several years ago constructed an elaborate simulation that imitated the many decisions that investors make over their lifetimes. One group was able to look at how they were doing every month, another group every year, and the third group got to take a look just once every five years. Just as Professor Thaler hypothesized, the investors who re-evaluated their portfolio every month had the lowest average equity exposure.

So, why does my own newsletter that reports investment newsletter performance come out monthly?

It’s a good question. The problem, of course, is that I wouldn’t be in business if I had a subscription product that came out infrequently. But the tension exists nonetheless.

One way I try to resolve this tension is by focusing my monthly newsletter on long-term performance. For example, none of the performance rankings in my monthly newsletter cover periods of less than five years. And most of my scoreboards cover much longer periods.

My hope is that, in the very act of responding to investors’ desire for constant re-evaluation, I can get them to focus on the long term. After all, a ranking covering performance over the last five years, or especially the last 10 or 20 years, doesn’t change that much from month to month.

Conclusion

If investors nevertheless want to obsess about the short term, they can be my guest.

But these short-term traders shouldn’t fool themselves into thinking that this obsession is necessary to build long-term health. On the contrary, it is probably standing in their way.

Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter that ranks the performance of investment advisory newsletters. It is published monthly and is located at 5051B Backlick Rd., Annandale, Va. 22003; 703/750-9060; www.hulbertdigest.com. This column appears quarterly and is copyrighted by HFD and AAII.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

The fundamental difference between a closed end mutual fund and an open end mutual fund is that with an open end mutual fund the fund manager stands ready at all times to exchange shares with an investor at NAV while closed end investors have to make the exchange with each other at whatever price “the market” requires. By itself this difference wouldn’t result in a discount (or a premium) except in some special cases I’ll cover later. However, when you combine this arrangement with the fact that there are costs to managing these portfolios you get an asymmetry. In theory the value of a mutual fund should be equal to the present value of future cash flows, which derive from a combination of the investment returns minus the management expenses. In the case of a closed end fund the value should be discounted to reflect the present value of all future management expenses. In other words, at any point in time the value of the fund should be the present value of the investment returns, which is just the NAV of the portfolio, MINUS the present value of the management expenses. Let’s look at a hypothetical example where a fund distributes all of its investment returns each year, less a 1% management fee. If you discount the 1% fee at a 10% rate that would result in a 10% discount to NAV. Sound about right?

However, for an open end fund the value is just the NAV of the portfolio for two reasons. First, because of management’s guarantee that they will always pay you NAV your shares HAVE to be worth NAV. But there’s another equally valid way to think about the economics of this arrangement. Open end fund investors “pay” for management expenses on an annual basis. When they decide to sell their investment the management fees essentially go away - or at least there is no adjustment for the present value of future management expenses because the next investor who comes along agrees that they will pick up the expenses during the time period they own the shares. The fund manager essentially enforces a “transfer” of responsibility for the management expenses from one investor to the next.

If you buy my explanation then the claim by some of the charlatans out there that closed end funds allow you to buy assets at bargain prices is totally bogus. Would a gallon of milk discounted by 10% be a bargain if 10% of the milk was leaking out? Besides, what kind of bargain is it if your best bet is that you could never sell it at full price anyway?

The real mystery is why closed end funds sometimes trade at enormous discounts, don’t trade at bigger discounts than they do, and why they sometimes even trade at a premium. Usually this comes down to some kind of inefficiency in the market. A few examples:

• The Morgan Stanley China A Fund (CAF) is currently at a 29% discount. As I’ve written before, China A shares are ridiculously inflated because of restrictions placed upon this market by the Chinese government. Consequently, there is no way to arbitrage these inflated prices away and non-Chinese investors do not want to own these shares. So the fund trades at an enormous discount and most certainly does not represent a bargain.
• The First Israel Fund (ISL) is currently at almost a 7% premium but since this fund is one of the few ways to invest in this country it commands a premium.
• During 2006, when Indonesia was really hot, the Indonesia Fund (IF) briefly traded at a premium as high as 40% because there really weren’t good alternatives. Currently, as the country has fallen out of favor, it’s now trading at a 12.4% discount.

However, sometimes the discounts and premiums defy explanation and represent a temporary anomaly that you can profit from. A great example of this that I’ve written about recently is The Spain Fund (SNF), which is currently at an 18.5% premium (it’s come down from a high of 25% and, yes, I’ve racked up profits from that) despite the fact that there is a Spain ETF available that is not at a premium.

The key to earning outsized profits in closed end funds is to understand what’s driving the premiums or discounts and to carefully place bets in those cases where things don’t make sense.

Reprinted with the permission of the American Association of Individual Investors (AAII)

Yield is a term that is used quite often in the investment universe. But it is frequently a source of investor confusion.

The problem is that “yield” has many different meanings, and thus many different implications for investors.

The basic dilemma is that yield may or may not be synonymous with total return-the bottom line for investors.

What It Is

The term “yield,” on its own, is an imprecise term that can mean any number of things-ranging, for instance, from:

• A security’s annual percentage rate of return, to
• The annual income from an investment as a percentage of the price at a particular point in time (for example, the current price).

The more precise definition of yield becomes apparent when a qualifier is used-for instance, dividend yield, current yield, or yield to maturity.

How It Can Be Used

Investors who seek an income component from their investments often look at various yields to indicate which investments will provide a higher amount of their return in the form of annual income payments. Thus, for example, income-seeking investors may prefer a stock with a higher dividend yield than one with a lower dividend yield.

Yields also can be used to indicate the relative risk of different securities. Typically, securities with higher risk must offer higher yields to compensate for the greater risk. Thus, for example, dividend-paying stocks whose firms are having financial troubles will tend to have higher dividend yields than the stocks of financially secure firms, and the bonds of companies with lower credit ratings will have higher current yields than those with higher credit ratings.

How It Can Be Misused

Yield is also sometimes used to indicate a security’s total return. However, it is important for investors to understand the difference between “total return” and most uses of the term “yield.” The bottom line for any investor, for any investment, is total return.

Total return incorporates capital gains and losses, as well as any annual income thrown off by the investment in the form of dividends or interest payments.

Total return is also specific to the individual investor’s particular experience-the purchase price paid for the investment, the holding period, the sales price, and the actual income payments received. Most uses of the term “yield” refer only to the income component and do not include a gain or loss component.

Investors-particularly those individuals who are interested in bonds-sometimes make the mistake of equating quoted yields with total return. However, most quoted bond yields ignore gains or losses in the market value of the bonds, an important component of total return even in a bond holding. Although there is one bond yield measure, as we shall see, that comes close to the total return concept (yield to maturity), it is only an estimate of total return based on assumptions that may or may not apply to the individual investor who has purchased the bond.

Yields for Stock Investors

Dividend Yield

A dividend yield is calculated by dividing the indicated annual dividend (the expected dividend for the next four quarters) by the closing price of the stock. It simply provides the historical annual dividend relative to the current market price in percentage form.

How is it useful?

When compared to other dividend yields measured over the same time period, it tells you the annual income you can expect from this stock relative to other stocks: If you invested today at the current price, you will receive more annual income as a percentage of your original investment from a stock with a higher dividend yield than one with a lower dividend yield. The higher dividend yield also indicates there is a greater risk that dividends may be reduced or not paid in the future. Dividend yield reflects only income, and does not take into consideration gains or losses.

Yields for Bond Investors

Current Yield

A bond’s current yield is calculated by dividing the annual interest payment by the current market price of the bond. Like a dividend yield, it only captures one aspect of total return-the income generated by the investment. It ignores any changes in value from gains or losses.

How is it useful?

The current yield will tell you how much interest income you will receive each year from the bond relative to the price you are paying for the bond, assuming you were purchasing it today at the bond’s current price.

Coupon Yield

A bond’s coupon yield is the simple interest paid by a bond annually as a percentage of maturity value. The coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued.

How is it useful?

The coupon yield tells how much income you will receive each year you own the bond, expressed as a percentage of the maturity value of the bond. For example, a bond that is issued with a $1,000 value at maturity and a 4.5% coupon yield will pay $45 in annual interest payments.

This amount is figured as a percentage of the bond’s maturity value and will not change during the lifespan of the bond, regardless of how the price of the bond fluctuates in the secondary markets. This is unlike the bond’s current yield, which fluctuates based on the bond’s current market price.

Yield to Maturity

A bond’s yield to maturity is one yield figure that comes close to a total rate of return concept. However, it makes a number of assumptions. It assumes that the bond is held to maturity, and that all interest payments are reinvested at a rate that is equivalent to the yield to maturity.

Yield to maturity comes close to the total return concept because it takes into account all possible sources of income from a bond, including coupon income, earnings on reinvested income, and capital gains or losses due to the difference between the price paid when the bond was purchased and the return of principal at maturity.

However, it is not a return you will actually receive on a bond, but a rate of return you could expect to receive if you held the bond to maturity and were able to reinvest all income at the yield-to-maturity rate. Your actual return will be determined by a number of factors, including whether you actually do reinvest income, the actual rate of return you receive on any reinvested income, and the difference between the price you paid originally and your selling price (if you sell before it matures) or the value at maturity.

How is it useful?

Yield-to-maturity quotes are useful because they allow you to compare different kinds of bonds-those with dissimilar coupon yields, bonds selling at a discount or premium, and different maturities. For example, how do you compare a 20-year zero-coupon bond that provides no annual income payments but is purchased at a deep discount to its value at maturity, with a 15-year bond that has a 6% coupon yield and is selling at a premium to its maturity value? Looking at the current yield to maturity of the two bonds allows you to make an apples-to-apples comparison of their relative “expected” rates of return. But remember, you would only receive the “expected” rates of return if all of the assumptions held true-you held the bond to maturity, and were able to reinvest all income at the same rate as the yield to maturity.

Yields for Muni Bond Investors

Taxable-Equivalent Yield

The taxable-equivalent yield is the yield on a taxable bond (or taxable bond mutual fund) that would result in the same after-federal-tax yield to an investor as a given tax-exempt bond (or tax-exempt bond mutual fund). It is calculated by dividing the tax-exempt yield by 1.00 minus your marginal federal income tax rate (in decimal form).

How is it useful?

The bottom line for taxable investors is not just total return, but total return after taxes. This yield is useful for high tax bracket investors who may receive a higher aftertax rate of return by investing in tax-exempt municipal bonds rather than taxable bonds. It is used to compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher aftertax yield.

Yields for Mutual Fund Investors

30-Day SEC Yield

A yield quoted by bond mutual funds, the 30-day SEC yield is calculated according to a formula determined by the Securities and Exchange Commission (SEC). It is primarily a snapshot of the interest distributions from the fund over the prior 30 days, with some adjustments.

How is it useful?

The 30-day SEC yield is a standardized yield calculation for bond funds that allows investors to compare the yield performance of one bond fund to another. However, the figure is a reflection of the past 30 days and is not necessarily an indication of future yield.

In addition, the calculation implies the bonds will be held until maturity, and in practice bonds funds tend to trade actively and do not hold bonds to maturity. For this reason, a mutual fund’s income yield (see below) may be a better measure of a bond fund’s income-generating potential.

Yield

A mutual fund’s yield is the per share annual income distribution (which could include interest, dividends and short-term gains net of expenses) made by a mutual fund, divided by its year-ending net asset value, plus any capital gains distributions made during the year.

How is it useful?

This yield is similar to a dividend yield and would be higher for income-oriented stock funds and lower for growth-oriented stock funds.

The figure only reflects income-it is not total return. The yield also may be distorted if the fund reports short-term capital gains as income.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

http://www.aaii.com/

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Reprinted with the permission of the American Association of Individual Investors (AAII)

If you’ve ever been to the track, you know that big winnings come from betting against the crowd.

Bet on the favorites and you may cash in a couple of small winning tickets; but scope out an underdog the crowd doesn’t believe can win and you collect a big payoff. There simply isn’t much reward in betting with the consensus.

The same holds true in the investing universe. To be consistently successful, you must adopt a contrarian’s mentality and bet against the crowd. There are a host of good businesses out there-even a lot of great businesses-you might invest in, but if you want substantial returns, you have to place less emphasis on the prospects for the business, and more on the prospects for the investment.

Investors commonly confuse a good business with a good investment. Many good businesses have expectations embedded in their stock prices that are just too high. The reason is that investors tend to extrapolate events forward in a linear fashion-that is, they believe a company doing well will continue to do well and if performing poorly, will continue to perform poorly.

Cisco Systems (CSCO) and Microsoft (MSFT) are highly successful companies, but their stock-implied growth expectations in the late 1990s would have translated into sales in excess of the U.S. gross domestic product. As an investor, you face the task of recognizing whether current expectations are overly optimistic or overly pessimistic. Changes in expectations-not earnings growth-move stock prices.

The advantage lies in being able to determine whether the deficiencies in current expectations are too optimistic or too pessimistic.

Good Companies

What makes a business a “good” business?

There are certain characteristics inherent in all good businesses. In particular, good businesses are not only profitable, but they also generate free cash flow net of capital reinvestment (capital expenditure).

Good businesses also generate a return on their invested capital over and above their cost of capital. They continue to grow their business-reinvesting in new assets-for as long as their return on their invested capital exceeds their cost of capital.

Good businesses are able to sustain or increase their rate of return on their invested capital. A fading return on invested capital indicates the business is becoming average and no longer special; a choppy return on their invested capital indicates a cyclical business model.

Investors should prefer businesses with revenue growth, operating margins and asset turnovers that are above average relative to others in their industry, since these drivers are the financial impetus behind return on invested capital. Accelerating dividend payments are also preferable, since they are a sign that the company’s management is interested in paying shareholders income while maintaining sufficient cash flow to run operations.

Good Investments

While there are many factors that constitute a good business, there is one primary consideration when it comes to a good investment: expectations.

A business is worth the present value of its existing assets plus the net present value of its future investments. So the current price of a stock is based on what investors collectively (”the market”) expect the business’ future to be.

Of course, no one can predict the future, so when analyzing a stock’s price you are left with two choices.

One is to take a crack at forecasting a company’s future performance, translate that into annual cash flows and calculate the firm’s “warranted price.”

As an alternative, one can analyze stock-implied expectations (the cash flow expectations embedded in a stock’s current price), back out the cash flows, and determine whether the market’s assessment of the future seems reasonable (see below ). This helps determine whether the consensus view is sensible, and whether the company will meet, beat or miss expectations.

Since changes in expectations drive stock prices, it only makes sense to start out by investigating what those expectations are.

Divergent Opinion Rules

Just because a company happens to run a good business, doesn’t mean investing in it will be profitable. Remember, as an investor, you aren’t rewarded for betting with the consensus. You need a divergent opinion, cultivated by an informational or analytical advantage. More often then not, it is information combined with common sense that contributes to outwitting the consensus. Here are two examples:

• Dell Inc. (DELL) has consistently operated a great business, generating returns on invested capital in excess of 20% per year since 1996. Given the track record, investors focusing on the economics of the business instead of the embedded expectations would have thought this a prime candidate for investment. But if they had put their money into Dell in 2005, they would have lost over 30% of their capital-despite the fact that return on invested capital increased to a near all-time-high level-because stock-implied expectations were calling for returns to be much higher.
• Century Aluminum Co. (CENX), another great business, has enjoyed an upward return trend since 1999-indicating an improving business-and generated returns nearly twice their cost of capital for the past three years. Investors have earned over 50% year-to-date 2006 because previous stock-implied expectations calling for the business to generate cost of capital returns have since been readjusted upward.

A Different Kind of Risk

Market forecasters must accurately predict future cash flows and discount rates and then determine a fair market price.

Expectations analysts take the current market price and back out market implied cash flows, asset growth rates (reinvestment rates), and return on invested capital.

While somewhat complicated, this can be done repeatedly with surprising accuracy. The reliability of the conclusions drawn from expectations analysis is also based on the ability to assess the market’s expectations as reasonable or unreasonable, which determines the direction of market error- either too optimistic or too pessimistic. The approach forgoes the exceedingly high level of accuracy required in market forecasting in favor of a more philosophical look at the investment’s prospective future (i.e., will margins expand or contract, will revenues grow faster or slower, etc.).

The level of risk can be further reduced by limiting the companies to those that trade at or below cash and book value.

For example, if you choose to buy a stock with market expectations for negative future cash flow because you think the business will generate positive cash flow, and the stock trades slightly above cash, your downside risk is limited because if you are wrong, the stock will fall only to cash value (unless management spends that cash).

Calculating Implied Expectations

Expectations analysis involves taking the current market price and backing out market implied expectations. How is this accomplished?

The foundation for the pricing equation is that the value of a firm today is the value of its stream of expected cash flows over its life, discounted back at a specific rate of return. So you need to do the same kind of analysis as you would for any cash flow valuation method. The key components are the firm’s current asset base, the return on investments the firm generates on its assets, the firm’s future asset growth rates (reinvestment rates) and the degree to which these returns change as the company’s life cycle matures.

But by reverse engineering the calculation, you can determine the stock-implied expectations based upon current stock price, as well as put in your own assumptions to better understand what the stock should be trading at in the future. You can also compare these assumptions to those embedded in a company’s peers, as well as against a company’s own historical performance, to better understand where the most uncertain assumptions lie.

Of course, there are many factors that can affect a firm’s cash flows, and institutional investors like our firm use sophisticated (and expensive) software that can crunch a wide variety of factors into consideration to determine the implied expectations.

For individual investors performing expectations analysis on a stock, the analysis can be performed using spreadsheet software and the equation:

Steven Holt Abernathy is principal and chairman and Brian Luster is a senior analyst and portfolio co-manager at The Abernathy Group in New York, NY. The firm specializes in asset protection and wealth management. You can contact the authors at 800-342-0956, info@abernathyfinancial.com or at http://www.abernathyfinancial.com/.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.AAII.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

So what is a preferred stock anyway? It’s capital stock, issued by a corporation, just like its better known counterpart, so-called common stock. But unlike common stock, preferred stock doesn’t participate in shareholder votes, and it doesn’t normally benefit (or suffer) from changes in earnings.

Like a bond, preferred stock pays a fixed cash payment. If companies have enough money to pay the preferred dividend, they must do so. Prices of preferred stocks also trade similarly to the prices of corporate bonds. At the same time, preferred stocks are stocks, in that companies may suspend the preferred dividend if they hit tough times. And, like common stock, preferred stock doesn’t give owners dibs on assets if the company fails and liquidates.[1] (USA Today)

Most preferred issues technically exist forever. That means you take on some interest-rate risk — your stock will drop if interest rates rise. Unlike bonds, which will be paid back at face value eventually, high interest rates could keep preferred stock prices low for a long time.

Thus, there are both pluses and minuses when considering preferred shares for investment. Preferred shareholders have priority over common stockholders on earnings and assets in the event of liquidation and they have a fixed dividend (paid before common stockholders), but investors must weigh these positives against the negatives, including giving up their voting rights and less potential for appreciation than common stock.[2] As well, preferred stocks have greater price stability than common stocks and greater liquidity than corporate bonds of similar quality. Other considerations, the lack of specific maturity date makes recovery of invested principal uncertain and appreciation potential is limited. (Investopedia)

What are some of the common indenture terms for preferred stock? Preferred stock may or may not be “convertible,” giving shareholders the right to take an ownership stake in the company by allowing them to convert preferred shares into common shares. Convertible preferred includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. As well, the dividend payment can be either cumulative or noncumulative. In the case of cumulative preferred, a provision in the shareholder prospectus will stipulate that if any dividends have been omitted in the past, they must be paid out to preferred shareholders first, before common shareholders can receive dividends.

Who are the primary issuers and purchasers of preferred stocks? Businesses and corporations, such as utilities and banks, that rely heavily on debt financing are the primary issuers of preferred stocks. The equity of highly leveraged firms tends to carry greater financial risk premium (risk of default). As a consequence, the equity is valued at a discount to where it might trade if the firm was not so highly leveraged. Under this scenario, managers do not like to issue equity at a perceived discount. However, they can run out of room in their capital structure for issuing debt. At some point, it becomes too expensive to issue debt. As an alternative to debt and equity, these businesses issue preferred stock.

The natural buyers of preferred stock are corporations. IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income. This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions.

So…why would an individual investor care to own them? In her article entitled “Uncovering Preferred Stocks“, personal finance expert Jennifer Openshaw claims there are three reasons:

High, steady yield. Because they are subordinate to bonds, and because their existence may be indefinite (no required date for a company to pay back, for most), their yields are higher. For high-quality issues, effective yields can run 5.5% to 6% and higher.

As investors pull back from chasing higher junk-bond yields, preferreds make more sense as an alternative. Also worth noting is that most preferred dividends are paid quarterly, whereas bond interest is only paid twice a year.

Better tax consequences. According to fixed-income portal QuantumOnline, dividends for more than half (some 536 issues in all) pay qualified dividends — that is, they are subject to the 15% maximum tax rate. Especially since that rate survives AMT, qualified preferred dividends can have tax advantages for high-income recipients.

Exchange traded. As obscure as preferred stocks are, the bond market is hardly any better. At least most preferred stocks trade on major exchanges, usually in smaller $25 increments instead of the $1,000 increments typical of bonds.

Those are the pros — now here (according to Openshaw) are the cons. First, because they are hardly a consumer investment product, preferred stocks are notoriously hard to research. QuantumOnline is the best site and is free (you do have to register). Another portal, ePreferreds Online, offers a nice tool but charges $29.95 a month or, more handily, $10.49 for a single-day use.

Preferred stocks are issued in many varieties and flavors. Although in principle all preferred stocks are a variation on debt and equity, terms specific to an individual issue can vary significantly. Some of the basic features and types of preferred stocks include callable, cumulative, participating, convertible, and adjustable rate. Therefore, when buying preferreds, it is important that investors read the offering prospectus issued when the shares IPO. If you are not comfortable diving into prospectuses or indenture agreements in order to identify promising preferred stock investments, you might want to consider a mutual fund or ETF that specializes specifically in preferred holdings for investment.

If you decide to do it yourself, as mentioned above one place to find out which preferred shares are available is Income Investing Information at quantumonline.com. The site is free, but you need to register. Another way to invest in preferred stock is by buying a basket of them through an exchange-traded fund (ETF). The S&P U.S. Preferred Stock Index fund (PFF) owns the preferred stocks in the S&P index.

As a rule of thumb, cumulative preferred stocks trade 50 to 75 basis points over comparably rated corporate bonds and noncumulative preferred stocks trade another 100 to 150 basis points over cumulative preferreds. By going from corporate bonds to quality rated noncumulative preferred stocks, investors may be able to pick up as much as an additional 200 basis points in yield in today’s market.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Although not without its critics, it is common wisdom among investment professionals that asset allocation is the most important investment decision. The vast majority of variation in returns can be explained by asset allocation.[1] (For more on this subject, see my article, “Asset Allocation: A Most Important Investment Decision.” posted here.)

Since Brinson et al published their landmark study, numerous academic studies have largely reached the conclusion that professional money managers add very little value by their selection of individual stocks or attempts at market timing. However the asset classes are defined, the allocation of funds among them is the most important decision an investor can make, not in picking individual investments within the classes.

Increasingly ordinary investors accept those findings. Contrary to the constant admonition from professional money managers that “it’s a stock picker’s market”; picking stocks is often a fool’s errand. ETFs allow you to easily target an asset class, with more flexibility and accuracy than either index or actively-managed mutual funds, and often cheaper as well. That is why they are soaring in popularity among small investors.

There are more than 400 ETFs listed in the U.S. and more likely to be offered. Some might call this overkill. Typically, most ETFs are passively managed and set up to track major market indexes (The Dow, The S&P, and the Nasdaq or some subset thereof). In most cases (there are exceptions), ETFs seek to achieve the same return as a particular market index. Such an ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. Index funds, such as those available through such mutual fund companies as Vanguard, were predecessors to today’s ETFs.

In many ways, ETFs incorporate the best features of all investment funds. ETFs offer investors an inexpensive way to index. Investors can purchase and sell ETFs through a broker at any time of the trading day and employ stock-trading techniques, such as limit orders, buying on margin (with borrowed money), and selling short (selling borrowed shares). Unlike index funds or mutual funds, investors must buy or sell ETF shares in the secondary market with the assistance of a stockbroker. Because your broker will charge a commission, trading costs may offset other cost advantages of ETFs. However, when designing an investment portfolio with a long-term passive investment strategy, and using a discount broker to buy the shares, the cost is nominal and far less than the costs associated with competing methods (mutual funds or buying individual stocks).

The emergence of ETFs are the latest in a long list of solutions to the problem “Main Street” (individual) investors faced in building a diversified investment portfolio of risky assets efficiently and economically. The mutual fund industry essentially grew up out of the need by individuals to achieve portfolio diversification economically. At the time when mutual funds were entering the investment scene, brokerage commissions were prohibitive for the amount of money available to individual investors to build diversfied portfolios. Since mutual fund companies could get the benefits of scale and transact at wholesale rates, they could pass the savings onto their investors. Individuals were willing to pool their assets in these funds.

With advances in electronic trading and the demise of fixed rate brokerage commissions, online discount brokers have emerged significantly reducing the cost to transact on the various national exchanges. At the same time, individual’s assets have grown while mutual fund expense ratios have remained relatively unchanged. In addition to fund expense ratios, mutual fund investing can include other costs such as distribution, marketing and sales charges. Relative to the index they are designed to track, the performance for funds that are passively managed (strive to track certain market indexes), has been at best marginal primarily due to excessive fees.

Due to the nature and construction of mutual funds, shares can only be purchased and redeemed by the fund. The price investors pay for mutual fund shares is the fund’s approximate per share net asset value (NAV). When mutual fund investors want to sell their fund shares, they have to sell them back to the fund at their approximate per share NAV. The investor only gets the end of the day closing price for their shares. Conversely, ETFs can be bought and sold in the secondary market at any time throughout the trading day.

Mutual funds are managed by investment advisors. These advisors pick and choose when and what goes into the portfolio. Though managers often strive to balance individual share gains and loses in the fund, the distribution of gains can trigger untimely tax events for investors. For tax-exempt accounts, such as IRAs and 401K plans, this has not been a problem. As IRAs and 401K plans have grown to be the primary retirement vehicle for Main Street investors, mutual funds have emerged as the principle investment product for retires. With ETFs, investors have the option to choose when to buy and sell giving investors control over timing gains and losses.

With mutual funds, investors have very little say in directing investments. As individual investors have become more knowledgeable in the ways of managing their personal assets, and as those assets have grown both inside and outside their retirement accounts, they have become more interested in managing and constructing their own portfolios. As a consequence, ETFs have emerged as an efficient and inexpensive way to manage and build an investment portfolio. In addition to building “market” tracking portfolios, investors are also interested in targeting specific investment themes. As financial commentator Jennifer Openshaw (The Millionaire Zone) points out, the real story for ETFs lies in the growing sophistication and new investor choices that result. Openshaw correctly informs that “ETFs are rolling out with more specialized and strategic designs as they sail beyond traditional index-fund roots towards the horizon of true active management. Until recently, ETFs only gave the ability to buy a broad industry or sector as defined by broad S&P or Dow Jones Sector Indexes like Technology, Consumer Cyclicals, Energy, Biotechnology, etc. You were out of luck if interested in Canadian oil sands energy exploration, but now there’s the Canadian Oil Sands ETF ( CLO: TSX). If you think water is the next oil, check out the PowerShares Water Resources Portfolio (PHO: AMEX).”[2]

Below is a list of advantages for using ETFs in place of mutual funds and stocks:[3]

• Tax efficiency

• Lower costs (ordinary brokerage commissions apply)

• Transparency

• Buying and selling flexibility

• All day tracking and trading

• Diversification

• Dividend opportunities

• Wide array of investment strategies

  • Core investment

  • Portfolio diversification

  • Hedging

  • Cash management

  • Rebalancing

  • Tax loss strategy

And where do you look to learn more about ETFs? The Yahoo! Finance ETF Center is an excellent place to start. The Yahoo! Finance ETF Center contains an extensive list of listed ETFs along with performance history. You may find it helpful to check out the ETF Education Center at Yahoo. Other sources of information can be garnered at ETF manager sites - iShares, PowerShares, Rydex Investments, and Claymore. Each of these sites contain tons of information on ETF basics and the use of ETFs as an asset allocation tool.

A word of caution. Not all ETFs are created equal. It is important to read the prospectus and understand the basket of stocks or other assets that underlie a particular ETF. As well, shorting, hedging and buying and selling options on ETFs is not advisable to the uninitiated or novice investor. Many of the newer ETFs (especially those managed by Proshares, Rydex and Claymore) use leverage and sophisticated trading strategies designed to achieve a certain trading or investment objective (such as shorting oil, currencies, or emerging markets). Some ETFs are designed to perform in the inverse direction of the underlying market they track. For instance, the Proshare Short S&P 500 make money in a declining stock market and lose money in a rising market. Thus, if you think the market is primed to decline and you want to hedge your portfolio for a decline in the market, you would buy (yes buy, not sell) the Proshare Short S&P 500. Remember, in the case of the Proshare Short S&P 500, the value rises when the market falls. You might ask, why would you want to buy a Proshare Short ETF when you could just short the index itself using SPDRs (SPYs), an ETF on the S&P 500. Well as it turns out, it is not possible to sell short in some retirement accounts such as IRAs so buying a Proshare Short ETF is a good way to hedge your stock portfolio from market risk in an IRA. For more on this topic, take a look at the following article at SeekingAlpha, “A Closer Look at the Proshare Inverse ETFs.”

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Tax efficiency
ETFs, like index funds in general, tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that the sale of an ETF will generate capital gains/losses for the investor liquidating shares.
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Lower costs
Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs are less likely to experience high management fees because they are index-based, not “actively” managed. And, since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. Of course, an investor selling ETF shares may realize capital gains or losses, as with common stocks. Purchases or sales of exchange traded funds are subject to brokerage commissions.
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Transparency
ETFs generally are designed to correspond to the performance of their underlying index or commodity.
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Buying and selling flexibility
Because they are exchange traded, ETFs can be:bought and sold at intraday market prices

purchased on margin

sold short

traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade
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All day tracking and trading
ETFs are priced and traded throughout the day, and are not restricted to once-a-day trading at the end of the day. And because the pricing of ETFs is continuous during trading hours, investors will always be able to obtain up-to-the-minute share prices from their broker or financial adviser.
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Diversification
Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Additionally, the expanding universe of ETFs available at the American Stock Exchange offers exposure to a diverse variety of markets, including:

• broad-based equity indexes (such as total market, large-cap growth, and small-cap value)

• broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan)

• industry sector-specific equity indexes (such as healthcare, energy, and real estate)

• U.S. bond indexes (such as long-term Treasury bonds and corporate bonds)

• commodities (such as gold, silver, and oil)
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Dividend opportunities
Dividends paid by companies and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses, on a pro rata basis. Of course, not all companies will pay dividends. Based on past performance, few, if any, distributions can be expected from certain ETFs. There may also be opportunities for reinvestment of distributions.
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Wide array of investment strategies
Investors can capitalize on the convenience and flexibility of ETFs to pursue a wide variety of investment strategies.

Core investment-Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure for long-term holding that is easy to establish, easy to track, inexpensive, and tax efficient.

Portfolio diversification-ETFs cover virtually every segment of the equity market and several segments of the U.S. bond market and commodities, providing an easy and convenient way to adjust the investment mix of a core portfolio.

Hedging-Exchange traded funds can be purchased on margin and sold short, which has opened up risk management strategies for individual investors that were once available only to large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting them from market losses. In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. (Investors are required to make arrangements to borrow securities before selling short.) Listed options, available on some ETFs, also offer opportunities for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements. To view a list of ETF options that are listed at the Amex, click here.

Cash management-ETFs have often been used to “equitize” cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term.

Rebalancing-Investors can adjust ETF positions at any time throughout the trading day, without redemption fees or short-term restrictions. Again, usual brokerage commissions will apply.

Tax loss strategy-An investor can sell a security that is under performing and claim a tax loss but retain exposure to its sector by investing in an ETF. Consult a tax advisor about a tax loss strategy.
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[1]Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986.
[2]ETFs: From Niche Market to Supermarket
[3]American Stock Exchange, Education, Individual Investors

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The stock market has risen relentlessly, and real estate and commodity markets have peaked. It’s a good chance to park some cash, as a lucky few did in the late 1990’s. Are bonds the answer? That’s for you to decide. But just as the Internet and e-broker platforms revolutionized stock investing ten years ago, now it’s becoming easier for individual investors to invest in individual bonds. Here’s why.

Historically, bond investing has been the domain of institutions and a handful of elite brokers. Try to buy an individual bond and you’ll be amazed at what you will - or won’t find. Wholly designed for institutional players, bond investing tools resemble a visit to the dungeon in Hogwart’s Castle: weird terminology and acronyms flying around like energized bats and a strong sense that many bond features, research or record of previous trading are forever hidden behind closed trap doors.

And if you happen to find a bond you like you won’t necessarily be able to buy it - unless some dealer just happens to have a few lying around.

As a result, bond mutual funds have been the “push” of most investment advisors. But it’s a steep 20 percent admission charge to attend the party - 80 to 150 basis points (0.8%-1.5%) in management fees on an investment designed to earn about 5 percent in the first place.

This is hardly a consumer friendly choice. I’ve always thought it odd that one of the market’s safest havens is so difficult for the individual investor - at least until now.

An Open Bond Market

For years, individuals could buy U.S. Treasury savings bonds online easily through Treasury Direct (see www.savingsbonds.gov) . But that was about it. Discount and so-called “premium discount” brokers have made what’s best described as a slow push into electronic individual bond investing. Of those I checked out, Fidelity and its Open Bond Market platform introduced in late 2004 seem to have come the farthest.

The Open Bond Market brings many of the features sought by stock traders to an individual’s fingertips: research capability, selection tools, price transparency and trading history. Further, the Fidelity platform provides liquidity by adding the inventory of some 80 plus dealers and some 10,000 issues, cutting out the painful search for a dealer with inventory at an acceptable price.

What’s Under the Hood

The Internet stock trading platforms of the late 1990’s were made possible by repackaging tools previously used by professional traders. And so it is with Fidelity and most of the others. A rapidly growing Wall Street firm known as MarketAxess (NASDAQ: MKTX) has built a electronic bond trading platform incorporating information, analytics, and price and trade history for investment grade and high-yield corporate bonds for institutional investing clients. Known as Corporate BondTickerTM, platform elements are now being adapted to retail by Fidelity and others.

The appearance of real time information has had a tremendous impact on price transparency and trading efficiency in the market. According to MarketAxess spokesman Stephen Davidson, quoting a recent study, some $1 billion in trading cost savings has been realized by institutional clients annually. He adds: “The secret is providing transparency, price discovery and superior liquidity investors seek.” MarketAxess currently handles some 90% of electronic investment-grade corporate bond trading today, of which only 8-10% currently is brought in through the retail channel. While MarketAxess itself currently has no plans to enter the retail trade, you’re likely to see a growing presence of efficient and retail-friendly e-platforms built upon new the functionality that supports Corporate BondTickerTM.

Using The Tools

I’ll be the first to point out that, even with better tools, buying individual bonds isn’t for everyone. Credit risk makes bond diversification very important. That combined with the use of laddering to spread maturities and reduce interest rate risk means that individual bond investing probably isn’t for smaller portfolios.

But if you have a larger portfolio, say $100,000 or more, it’s worth checking out these tools. Even if you’re not at that “number,” it’s not a bad idea to learn about these tools and bonds in general.

Fidelity has done a nice job of bundling the tools and making them easy to use. The Bond Selector, found at http://fixedincome.fidelity.com/fi/FISearchIndividualBonds lets you select among a wide assortment of issuers and bond types. Important features include:

• Screener. Narrows the search to certain types of bonds, yield ranges, and risk ratings. Also allows selection of Fidelity “Tier 1″ - a group of issues pre-screened by Fidelity for quality.

• Industry selector. For corporate bonds, you can choose one or more industries

• Risk-reward tools. The handy “scatter graph” lets you visually pick you spot on the yield curve. Mouseovers reveal the individual bond and agency rating for each point on the scatter graph.

• Laddering tool. Visually construct a bond portfolio to meet income needs and risk parameters over a longer term.

• Reduced commissions. Online trades cost $0.50 each for U.S. Treasuries (free for initial auction Treasuries) to $2 for corporates with a minimum of $19.95 per trade.

Anyone intending to buy individual bonds should take the time to learn bond investing techniques and strategies. E-broker educational tools are a good place to start. I also recommend the instructive American Association of Individual Investors frequently-asked-questions page, found at http://www.aaii.com/faqs/bonds.cfm.

Reinventing the Bond Market

Creating a friendlier and more level playing field for do-it-yourself individual investors is the whole idea, and there are signs it’s working. According to Fidelity Senior Vice President for Retail Fixed Income Securities Andy Wrobel, some 80 percent of Fidelity’s retail client bond trades are now done online rather than through brokers. This compares to 30 percent when the Open Bond Market started out. Customer response has been “overwhelming.”

Wrobel adds: “Our goal was to reinvent the bond market for the retail customer. The bond market was like buying a car 10 years ago; with no real time Blue Book or any other tool you never knew if you were getting a good deal. That’s changed now.”

It’s still in the early stages, and I don’t expect people to ever trade bonds like stocks. But so far as expanding possibilities for individual investors, I believe he’s right.

The stock market has risen relentlessly, and real estate and commodity markets have peaked. It’s a good chance to park some cash, as a lucky few did in the late 1990’s. Are bonds the answer? That’s for you to decide. But just as the Internet and e-broker platforms revolutionized stock investing ten years ago, now it’s becoming easier for individual investors to invest in individual bonds. Here’s why.

Historically, bond investing has been the domain of institutions and a handful of elite brokers. Try to buy an individual bond and you’ll be amazed at what you will - or won’t find. Wholly designed for institutional players, bond investing tools resemble a visit to the dungeon in Hogwart’s Castle: weird terminology and acronyms flying around like energized bats and a strong sense that many bond features, research or record of previous trading are forever hidden behind closed trap doors.

And if you happen to find a bond you like you won’t necessarily be able to buy it - unless some dealer just happens to have a few lying around.

As a result, bond mutual funds have been the “push” of most investment advisors. But it’s a steep 20 percent admission charge to attend the party - 80 to 150 basis points (0.8%-1.5%) in management fees on an investment designed to earn about 5 percent in the first place.

This is hardly a consumer friendly choice. I’ve always thought it odd that one of the market’s safest havens is so difficult for the individual investor - at least until now.

An Open Bond Market