Babeled

Last week’s Market Mondays featured an overview of mutual fund basics and key concepts to fund investing.  There is one correction to last week’s post in regards to the Management Fee explanation.  In actuality, you will typically see what is known as the “expense ratio” of the mutual fund.  Management fees are a piece of this expense ratio but not all of the expenses incurred by the fund are due to manager’s salaries, therefore the broader term of expense ratio is more appropriate.

This week’s Market Mondays virtual portfolio addition is another mutual fund, James Market Neutral (JAMNX).  James Market Neutral is what is referred to as an equity fund.  Equity funds invest primarily in stock, whereas fixed-income funds invest primarily in bonds.  Last week’s mutual fund pick, AIG Retirement I Government Securities (VCGSX), is a fixed-income mutual fund so it seemed appropriate to scour the markets for an equity fund that has fared well through the financial market meltdown of late.

James Market Neutral (JAMNX) is a no-load fund with a very low expense ratio of 1.91%.  The net asset value (NAV) was $12.14 at the time of purchase this morning with total assets of $49 million.  JAMNX is invested in all of the big sectors with the highest percentage of assets invested in Healthcare, Consumer Services (think retail mostly), Industrial Materials, Energy, and Utilities.  JAMNX is performing well in the current environment delivering year-to-date (YTD) returns almost 15% better than its fund category average.  The fund category average is approximately -16.5%, however that is reflective of the broader market.  Over the past five years, JAMNX has outperformed its fund category by 3.2%.  This fund is solid for diversification because it weathers financial market storms well by minimizing losses.

Recap of Market Mondays Virtual Portfolio

Aflac (AFL) incurred losses this week dropping to $43.56 per share at opening this morning.  That is a -4.42% return to date.  Datascope (DSCP) continues to provide a positive return with the per share price of $51.51 at open this morning.  AIG Retirement I Government Securities (VCGSX) increased NAV from $10.73 to $10.78 resulting in a NAV increase of $0.05.  The virtual portfolio has a blended return of 1.0% due mostly in part to the losses incurred this week by Aflac.  Next week’s Market Mondays will feature a downloadable Excel spreadsheet tool to analyze and track the performance of your portfolio.

A mutual fund is a collection of cash pooled by investors that is professionally managed and invested according to the philosophy of that mutual fund.  The major advantage to mutual funds is instant diversification of your portfolio without having to manage the investments directly.  Most mutual funds are a collection of many different stocks, bonds, cash and equivalents.  Some mutual finds are based on a stock index, such as the S&P 500.  These mutual funds invest their portfolio in the exact proportion of every stock in that particular index to produce a return identical to the index.  Index funds are becoming popular because their performance is easily ascertained and the management fees are typically very low because there is no art or skill - only ensuring the portfolio is in line perfectly with the index.

The basic components of a mutual fund are the total assets, the composition of those assets, the net asset value, management fee percentage, load or no-load, and turnover ratio (stock funds only).

• Total Assets: The overall value of all the investments and cash held by a mutual fund.  Mutual funds are usually made up of a combination of stocks and/or bonds and cash.  An important piece of a mutual fund to research is its asset distribution.  This will tell you what percentage of the fund’s total assets are cash, stock (should disclose the percentage from each sector and the top companies’ stock that are held), and any bonds or other investments.
• Net Asset Value (NAV): Is the “share price” of a mutual fund.  Like a company, a mutual fund issues shares to its investors.  The total assets of the mutual fund minus any liabilities divided by the number of shares outstanding for the fund equals the net asset value.
• Management fees: Every mutual fund is managed by finance professionals.  These managers are paid and the cost of their salaries is covered by the management fee of the mutual fund.  Every mutual fund has a different management fee percentage.  A higher fee does not necessarily correlate to higher returns of better management.  This is something that will impact your overall return as an investor because you must first pay for the management before you get to pocket any profits.  Traditionally, savvy investors look for funds with the lowest management fees for their category.
• Load versus No-load: A “load” in mutual fund lingo means a commission.  Funds with a Load carry an additional broker’s commission in the form of a percentage of the NAV, just like the management fee.  There is no data to suggest that funds with a Load outperform No load funds in any way.  This is just another sneaky way for those sneaky brokers to pull one over on less-informed investors.  There is no reason to invest in a mutual fund with a Load, unless all of your 401k options have Loads…then your company is just cruel.
• Turnover ratio (stock funds only): Mutual funds that purchase stock as part of their portfolio have a metric known as the Turnover ratio.  This ratio is meant to show how often the management is making stock trades.  This is important because every time a trade is made, broker’s fees are incurred.  Typically, funds with high turnover ratios also tend to have higher management fees as a result of the costs incurred from the increased trading activity.
• Resources: A great free online tool is available at Morningstar.com.  Morningstar has a plethora of research, data, and a fund screener.  There is, of course, the premium version that requires a paid membership, but I find that the tools available for free are still perfectly adequate.

It is important to remember that mutual funds are regulated by the SEC but each one has free reign within the SEC guidelines to invest the cash contributed by its investors in whatever combination of investment instruments they feel provides the best portfolio.  When looking to purchase a mutual fund, be sure of what you are looking to get out of the investment.  Obviously, the first and foremost objective is to make a return.  To that end, think broadly about what types of investments you expect to perform well over the time period you wish to invest.  Then seek out mutual funds that contain portfolios similar to your tastes with the right management fee, NO LOAD, and take the plunge.

Tracking the performance of the Market Mondays virtual portfolio has yielded a positive return to date.  Aflac (AFL) and Datascope (DSCP) have returns of 5.94% and 5.81% respectively.  The portfolio value has increased by $540 on a $9,197 initial investment.  This week’s pick is a mutual fund, going along with the theme of the post, and is meant to bring some balance to this portfolio.  AIG Retirement I Government Securities (VCGSX) has a NAV of $10.73 with total assets of $203 million.  This is a NO LOAD fund and has a ridiculously low management fee of 0.66%.  The assets are 78% government bonds, 4% mortgage bonds, 4% corporate bonds, 1% foreign bonds, and 13% cash.

This is an all-in-one guide for those considering investing in the stock market.  Beginning with explaining what the stock market is and how its ebbs and flows impact investors and then moving into explanations of different stock market metrics including a handy commonly used acronym guide, this will be meant for total subject matter coverage while allowing for quick reference.

What is the stock market?

As with most things in life, this question has both a short and an in-depth answer.  The short answer is a collection of companies and investors that are constantly buying and selling shares of corporations’ stock.  Every company traded on the stock market has agreed on a certain amount of shares of their stock to be sold to an investment community in return for  cash to finance their businesses.  Once the stock has been issued initially by the investment bank, the corporation issuing the stock has already received an agreed upon sum of cash for the investment bank to have the right to sell the company’s stock to investors.  Theoretically, the per share price fluctuations of a corporation’s stock may have no direct correlation to the business’ performance or profitability.  However, investors are betting on the fact that the corporation whose stock was purchased will financially perform well and produce a return for the investor.

What does it mean when the stock market goes down (or up)?

Share price fluctuations for an individual corporation as well as overall stock markets depends solely on the principle of supply and demand.  There is a total pool of stock shares from every company.  Not all of these shares are owned by investors at the same time; meaning there is a pool of un-owned shares in circulation.  As this number of un-owned shares increases (supply increases) the overall market value is decreased.  The more granular level would be an individual company’s stock, for which the same exact principles apply.  When the number of un-owned shares increases (investors selling stock) the share price (usually) proportionally decreases; if the number of un-owned shares decreases (investors purchasing stock) then the share price (usually) proportionally increases.

Why does a stock’s price go up or down?

You may be thinking this is redundant given that it was just explained that supply and demand of shares answers the question.  While that is true mechanically, it does not explain what causes investors to buy and sell a stock, thereby affecting the supply and demand all the way to the share price.  Typically someone invests in a corporation’s stock because it is believed that stock price will increase over time creating a return on the investment.  The most simplistic concept is that the expected future profitability of a corporation is the driver of the share price.  The two most troubling and ambiguous words in that sentence are “expected future”.  The expected future is rarely accurate and even less frequently precise.  Therefore, psychology and other types of qualitative information that can not be measured through financial analysis or performance comes into the fold of stock valuation.

What factors should I consider when making a decision to invest in a corporation’s stock?

One must always consider a more global perspective when considering a corporation’s stock as an investment than just the numbers.  The suggestion is to understand more about the corporation’s direction, market position, products, and future market growth information than the financial metrics.  Profitability and financial health are important, however it is more important to understand the challenges and assets a corporation has to meet those challenges in the future as that will determine future performance.  Remember, accounting is all historical reporting.  Any numbers you see published in SEC releases and financial analysis are based off of business events that have already occurred.

How do I measure the success of my investment?

It is important to understand the performance of your investment no matter if it is a loss or a gain.  The recommended approach to valuing your investment is to take the total number of shares purchased multiplied by the per share price at which the stock was sold divided by the total number of shares purchased multiplied by the per share price at which the stock was acquired plus any broker’s fees and commissions.  This will result in a percentage that represents your return on investment percentage.  Should you choose to compare this return on investment with another type of investment (savings account, CD, etc), make sure that the time scales are equivalent.  For instance, if you wanted to compare your return on a stock versus your savings account, you would need to perform the calculation above adjusting for time.  As an example, your return on investment percentage from above was calculated to be 4% and you sold the stock four months after it was purchased.  The 4% return represents the 120 day percentage.  To annualize it, multiply 4% by three (number of four month periods in a year).  This means the example annual return percentage is 12%.

Acronym Guide

• EPS: Earnings per share
• TTM: Traling twelve months
• MRQ: Most recent quarter
• β:  Beta
• ROE: Return on equity
• ROA: Return on assets
• P/E: Price to earnings ratio
• PEG: Price to earnings-growth
• ROCE: Return on capital employed
• EBITDA: Earnings before interest, taxes, depreciation and amortization
• EBIT: Earnings before taxes
• OPEX: Operating expenses
• CAPEX: Capital expenditures
• AR: Accounts receivables
• AP: Accounts payable

Explanation of Ratios and other analysis tools

Return on Assets (ROA): this metric is meant to show how effectively the management of a company is using the money it raises from debt and equity financing to generate income.  The calculation = Net Income / Total Assets.  Sometimes investors may use Operating Income / Total Assets to take out the effect of interest (cost of financing) and taxes.

Return on Equity (ROE): measures how profitable a company is relative to the amount invested by shareholders.  The calculation = Net Income / Total Shareholder’s Equity.

Return on Capital Employed (ROCE): measures the efficiency and profitability of a company’s capital investments.  The calculation = EBIT / [Total Assets - Current Liabilities].  The calculation can also take the form of = EBIT / Fixed Assets (fixed assets are the property, plant and equipment of a company or depreciable assets).

Cost of Goods Sold (COGS): this number may also be seen as ‘Cost of Revenue” or ‘Cost of Sales” or something similar.  This represents the cost to manufacture and/or purchase the goods or services that the company sells.  Net sales minus COGS equals a company’s gross margin.

Fixed Assets: assets that are depreciable usually having a useful life of greater than one year and a minimum per unit purchase price that varies by company (typically at least $1,000 or greater).  Examples include land, leasehold improvements, machinery & equipment, buildings, vehicles, computer equipment, and furniture.

Earnings per share (EPS): is the total net earnings of a company divided by the number of shares of common stock outstanding.  This is a measure of how much income a company generates relative to one share of common stock.

Price/earnings (P/E) ratio: this ratio’s output is a number that represents a multiple of the earnings per share number.  The calculation = Share price / EPS.  Typically, if a stock has a higher P/E than the industry average P/E, then the stock is over-valued and you should not invest.  There are some exceptions, however, that will be discussed with the PEG ratio.

Price/earnings to growth (PEG) ratio: P/E ratios are usually calculated over a time period (TTM most common).  If a company has experienced significant growth over that time period, the stock will appear over-valued with the P/E ratio when that might not necessarily be the case.  For companies with high earnings growth, it is recommended to use the PEG ratio to determine if the stock’s value is appropriate as opposed to the standard P/E ratio.  The PEG ratio calculation = Price/Earnings ratio / Annual EPS growth.  Similar to the P/E ratio, the lower the PEG ratio, the more undervalued the stock.  The higher the PEG ratio, the more over-valued the stock.

Profit Margin: this represents the Net Income divided by Net sales of a company.  This is the standard metric for determining how profitable a company is as a percentage of their total revenue.  The profit margin gives a percentage answer that can be directly correlated to $1.  If a company has a profit margin of 10%, then that company is making 10% X $1 = $0.10 for every dollar of net sales.

Receivables turnover: demonstrates the speed the company is collecting cash for sales.  The output is a number that represents the number of times in a year that the total receivables balance will completely turn over.  Once this figure is calculated, one can determine the Days Sales Oustanding.  The calculation for Receivables Turnover = Net sales / Gross receivables (add back bad debt reserve).

Days Sales Outstanding (DSO): equals the number of days on average it takes a company to collect cash from sales on credit.  The calculation = 365 / Receivables Turnover.  This metric is useful to analyze a company’s predicted cash flow if you subtract the Days Payables Outstanding.  The goal of a company is to collect cash as quickly as possible while laying out cash as slowly as possible in order to manipulate the time value of money concept to their favor.

Payables Turnover: the number of times in a year that the company’s Accounts Payable balance will completely turn over.  This is calculated as an approximation because detailed purchasing information for a company is not generally available to the public.  The estimate is calculated by: [COGS + Change in Inventory] / Accounts Payable balance.  If you have access to purchasing information, the calculation’s precise form is = Total Purchases / Accounts Payable balance.

Days Payables Outstanding (DPO): equals the number of days on average it takes for a company to pay its suppliers.  The calculation = 365 / Payables Turnover.  This figure can then be compared against the DSO for the same company to determine the effectiveness of the company’s cash management.  Remember, the goal is to collect cash as quickly as possible while distributing cash as slowly as possible.

Inventory Turnover: measures how many times in a year that a company will turn over its inventory balance.  The calculation = Net sales / Inventory.  It is important to understand this number for cash flow purposes.  The greater the inventory turnover (relative to industry averages) the better working capital management a company is demonstrating.  Inventory is a cash investment, and the more inventory a company has on hand the less cash is available for other uses.

Days Inventory on Hand: is the average number of days of inventory that the company keeps.  The calculation = 365 / Inventory turnover.  The less inventory on hand, the better working capital management (usually).

Working Capital: equals a company’s current assets minus current liabilities.  This represents how liquid a company is, or in other words, how able a company is to meet current financial obligations with current financial assets on hand.

Current Ratio: is calculated as current assets / current liabilities.  This is another measure of a company’s ability to meet short term financial obligations.  A current ratio of less than 1 usually indicates that the company is not financially healthy.  The caveat to this is every industry is different, and in some it may be common for the companies to have current ratios of less than one.

Quick Ratio: this ratio is similar to the Current ratio except inventory is subtracted from the current asset number.  Inventory has cash generation potential, however it takes time to acquire, process, sell, and collect cash associated with the sale of inventory.  Some investors choose to remove inventory because it may not be turned into cash quickly enough to meet short term financial obligations.  The calculation takes the following form: [Current assets - inventory] / Current liabilities.

Debt/Equity ratio: measures the degree of financial leverage a company employs to finance its assets.  The calculation takes several forms depending on the philosophy of the person crunching the numbers:  (A) = Total Liabilities / Total Shareholder’s Equity; (B) = [Current portion of Long term debt + Long term debt] / Total Shareholder’s Equity.  I personally prefer B because it takes out current liabilities such as accrued expenses that are not really a form of debt-financing.  Accounts Payable is arguable - it is technically a form of short-term debt financing, however there is not interest expense associated.

Wrap-up

The above information is meant to get you started from scratch on investing in the stock market or as a quick reference guide for an acronym or ratio you may come across that requires further explanation.  Investing in the stock market is full of ups and downs, no matter how tight your analysis or how well you understand the finance side.  Stock prices ultimately are a combination of financials, market potential, future expectations, and the ever-changing psychology of other investors.  While no one can control for all of these factors, you can arm yourself with as much knowledge and know-how as possible to make an informed decision.

“Este sistema americana de nosostros - llama lo americanismo, llama lo capitalismo, llama lo que te gusta - le da a todos y cada uno de nosostros una gran oportunidad si solo aprovechamos con ambas manos y sacamos el maximo partido de ella.”

Translation

“This American system of ours - call it Americanism, call it capitalism, call it what you like - gives to each and every one of us a great opportunity if we only seize it with both hands and make the most of it.” - Al Capone

This week’s stock pick is Datascope Corp (DSCP-NASDAQ), a medical-device company that develops, manufacturers, and markets products in the cardiovascular and vascular surgery and interventional cardiology and radiology health care markets.  The majority of Datascope’s sales (87%) are from products in the cardio-assist business segment, which includes the Intra-Aortic Balloon Pump (IABP) system that is used in a large portion of cardiovascular surgical procedures.  Datascope’s value proposition for growth is a cutting-edge IABP that utilizes fiber-optic technology in collaboration with an auto-calibration feature.  This combination of technologies reduces adverse cardiac events through quicker and safer patient monitoring, thus reducing complications and recovery time from surgeries.

Datascope’s financial position is strong.  Some financial highlights are:

Datascope has experienced significant profitability and sales growth over the last twelve months.  Since cardiovascular conditions are not economically elastic, meaning that people will not stop having heart conditions simply because the economy is not strong, the sales and earnings growth should continue.  The new IABP system should contribute to the strong earnings growth to come.  For more in-depth financial statement analysis including five year historical income statments and balance sheets, download the Excel Workbook by clicking the icon at the left.

Last week’s stock pick of AFLAC, Inc has experienced a loss.  The per share purchase price in the virtual portfolio was $43.56 and the closing price today was $36.21, a 17% loss to date.  AFLAC’s third quarter earnings per share dropped 76% due to losses on investments.  However, management, and I, are bullish on the company’s strong balance sheet and capital position.  One week is never enough to evaluate a purchase.