You have all your equity tied up in your home, which is a “non performing” asset, and so you aren’t diversified enough. We can take $100,000 line of credit out on your home and use that money to buy a balanced portfolio that’ll increase your diversification. You’ll be borrowing at 3%, but your portfolio will be earning you 6% 7%, 8%, 9% or even more, so you’ll really be making at $100,000 work hard to make you rich!

It sounds so good, doesn’t it? Makes perfect sense when the person “in the know” says it like it’s the most sensible move you could make. And yet, people’s little red flags are all over the field because they write to me and ask me to say, “Yah! DO IT!

You can’t trick me!  If you’re writing to me to check it means you’re not convinced this is the best idea.

And you’d be dead right.

The next time someone comes a’callin’ with a great investment spiel about how you can use your home equity to diversify your investment portfolio and make more money, ask some questions.

•          How likely is it that you’ll be able to earn the return being quoted? Historically, you have to be fully invested in stocks to earn a return of 9%. Are you ready to take on that much risk? Do you have the time (and guts) to wait out the dips that come with equity investing? If there are any fixed-income investments in your portfolio, borrowing to buy them makes no sense because their returns are likely to be so very close to what you’re paying in interest on the loan.

•          How long will the loan stay at the interest rate quoted? Sure, you can get a loan at 3% today, but that rate will fluctuate over time. If the rate goes up 1%, that’ll eat into whatever return projection you’ve been given. And it’ll eat into your cash flow – the money you’re using to have a life – unless you choose to sell some of your investments to cover the higher payments.

•          What does a “non-performing asset” actually mean? If you’re living in a home, it’s providing you with shelter. Real estate may not be ratcheting up as quickly as the stock market, but you got to House Rich through your home’s appreciation over time.  And, for goodness sakes, you’re living in it! That’s got to be worth something. I do agree that having a home as your only asset is not as smart as having a more diversified portfolio, which is why I tell people not to delay their long-term savings (RRSPs, TFSAs) for the sake of mortgage pay-down.

•          If you stick $100,000 in the market all at once, doesn’t that go against the concept of “dollar cost averaging?” It sure does. You be better off keeping your sticky fingers off your home’s equity, and using the money you would have to cough up to repay the line of credit you’re being encourage to take out to invest monthly.

•          What’s the downside of “leveraging”? When you borrow against your home to invest, it might be positioned as “diversifying”, but it’s actually “leveraging”.  The upside of leveraging is that you can make more money by using borrowed funds to increase your returns. The downside is that you can lose your shirt. Are you ready for the downside?

If you’re wobbly on the math you’re being shown, if you’re not convinced this is the right tactic for you, if you’re being “sold” this idea, step away from the table and take some time to think. You should only use your home equity to invest if you are absolutely convinced you’ll make money. Otherwise you’re putting your home at risk for something you may not really understand.

There are a lot of people searching for answers as they watch the market swing high, swing lo. They’re second-guessing themselves and their advisors. They’re frightened, angry, worried. If this sounds like you, it’s time to take a deep breath and do a reality check.

The key to any portfolio’s sleep quotient is how well mixed the assets are, and how well suited that asset mix is to your investment personality. When a bump, slump or gallump comes along in the market, that volatility is an opportunity to test your mix and your emotional commitment to your investment strategy.

Remember your investment strategy? It’s the blueprint for your portfolio. It’s the reason you bought XYZ stock, or LMN mutual fund to begin with. And along with the following steps, it’s the path to a solid night’s sleep.

Step #1: Review your risk tolerance. If you have the asset allocation the text book says you should have but it’s keeping you up at night, that’s not the right investment mix for you. As the market tip-toes, slip-sides, and waddles all over the map you need to feel secure in the decisions you’ve made. While you may have had a moment or two of doubt, you’re pretty much okay.

Step #2: Rebalance your asset allocation. If you’re not feeling as dreamy as you should, there are many ways to adjust your mix until you’ve figured out your very own recipe for sleep. If you’re invested in equities and find the volatility too severe, it may be time to move at least some of your money to safer shores. A money market fund will let you tread water for a while till you decide where you want to invest next.

Step #3: Dollar cost average. If you’ve been sitting on the fence counting sheep, wondering when to get into the fray, and think that the latest in a series of market corrections is your sign, be careful. It’s false security to think that now that we’ve had a correction, there won’t be another one. It all comes back to dollar cost averaging: buying a little each month so that you aren’t attempting to practice the nefarious art of market timing.

Step #4: Don’t leverage. I don’t care if you’re being promised the magic of margin or the tax savings of the Smith Maneuver, when people think they can borrow to invest and make a quick buck, they end up adding to their risk. Leveraging adds more risk to your portfolio since a jump in interest rates will cause the cost of the loan to go up. And a decrease in the value of your collateral means the lender may call in that collateral. You could end up having to come up with extra money to meet your financing commitments. That’s fine if you have extra money, but it’s not fine if you have mortgaged the house or have to sell investments at an all time low.

Step #5: Have a long-term horizon. Before you sell in a panic, you need to ask yourself why you want to sell. Is your stomach in knots? Do you feel like you’ve stepped in bear poop? The intrinsic value of a stock may be no different at $50 when you bought it than at $30 after a market correction. It’s the market perception that has changed. If you believe holding that stock is a good investment for your portfolio over the long-term, stick to your buy-and-hold strategy.

Don’t deny your gut. Your flip-flopping stomach may be telling you that your asset mix is wrong. Take the time to review the realities of your investment strategies in light of the new information your adrenaline glands are sending. And if you find all in order, might I recommend a warm glass of milk before bed.

It’s easy to be a successful investor if you follow these seven rules:

1. Stay Your Course. While others are bailing out of a stock because some news report foreshadows doom (Can that stock really be worth 35% less simply because it missed it’s whisper number by one cent?) you will hold to your course. The number one mistake most investors make is to sell too early: either when a stock is on its way up, but hasn’t hit it’s top, or when it’s on its way down in a temporary downdraft. Having created a plan, understood your risk tolerance and chosen investments that suit your time horizon, you can ignore the crowd and stick with your plan. No company can avoid the occasional bad quarter. And an increase in value isn’t an automatic indicator to sell. Patience and a belief in the stocks you’ve bought (assuming the fundamentals haven’t changed) will pay off in the long run. A rare commodity on The Street, your patience will be highly rewarded. Hold tight.

2. Max Your Mix. Concentrating your portfolio on one or two sectors or stocks is a great way to lose your shirt. Diversification not only brings a higher level of portfolio safety, it minimizes the impact of violent swings. It may be thrilling to put it all on black thirteen, but that isn’t investing. It’s gambling or whatever else you want to call it. Make sure you’re diversified not only by asset type, but also by industry and region. You’ll sleep much better at night.

3. Sell Up and Buy Down. A twist on the old phrase, “buy low, sell high”. It sounds simple enough, but it’s not at all simple. When you add in the emotions involved, it seems easier to sell and hide than to ride out the storm. Besides, if you start buying now, you could lose your shirt and then wouldn’t you feel like a fool for pouring money into that stock everyone else was dumping. And when everyone else is jumping into a hot market, it can take a lot of self-control to stay on the sidelines. Remember, counter to the current belief when there seems to be no top to the market, the sky is not the limit. Just as what goes down will bounce up, so too what goes up will eventually fall. As much as possible you’ve got to take the subjectivity out of the decisions to buy and sell. Regardless of the market itself (it always moving in one direction or another), you’ve got to do your homework, set some targets for buying and selling, and make adjustments as the markets move. Investing on your terms, not the markets.

4. Investor, Know Thyself. Perhaps the most important of the Golden Rules of investing is this one: Know what kind of investor you are and stick to your profile. It’s so easy to become engrossed, attracted, enthralled by the stories you hear of wonderful performance, sure things, and better than average returns. But as you focus on putting your portfolio together, and as you add to it and adjust it over time, you’ve got to be true to yourself and your investment personality. There’s no point in going into small caps if you can’t stand the kind of volatility that is inherent in smaller companies. If you’re a conservative investor, the stocks you buy should pay good dividends and shouldn’t be outrageously valued. Remember, too, that there are times when the market corrects (here comes that dead cat) and you can’t avoid a fall in your assets. You must hold tight to your portfolio plan and stick it out.

5. Don’t buy on margin. If you have to borrow to buy stocks, you’re increasing your exposure to risk. The potential loss due to a short- or medium-term downturn can be devastating to your whole financial picture. I know it’s a strategy that’s often touted as a great way to turn a profit. And I know the idea of using someone else’s money to make a killing is extremely enticing. But you don’t often hear the horror stories. People don’t like to talk about having lost their shirts. Don’t buy on margin if you aren’t prepared to eat the loss.

6. Let Go of Losers. You won’t always buy a winner, so you have to come up with criteria for getting rid of the junk. If a company can’t make money no matter what it does, give up on it. Don’t get suckered in emotionally. Of course to do this you have to…

7. Stay informed. Check how your stocks are doing regularly. You’re not doing this because you’re trying to time the market. But since you’re your own advisor, you have to keep up with the current news on your company — no one’s going to call you with it. If you check in on your stocks daily, you’ll probably spend about half-an-hour a day keeping up-to-date. If you don’t have the time to stay current, keep your full service broker.

—–

Sticky Situation: Some of the other parents want to get an expensive group gift for the class’s teacher, but it’s more than you can afford to spend. Do you speak up or bite the bullet and cut back elsewhere so you can put in your “share”?

So what’s the big deal? Well, corporations like to keep their stock within a certain price range so that it’s accessible to investors. And, technically speaking, the split shouldn’t have any effect on anything, since absolutely nothing has changed except for the number of share outstanding.

Well, that’s not exactly true. Since the price of the shares has come down, the stock is now accessible to smaller investors. And since the media make a big deal about splits, the company has had some positive attention. Investor sentiment has no small role in this either. After all, if investors think the stock will split and bounce up, then by golly gosh they’ll make it so. It’s a self-fulfilling prophecy. And no one can argue with the reasonableness of this since there’s nothing reasonable about the markets.

While, in the long term, splits don’t cause stock prices to go up, it’s the rise in price that causes the split, the split is still a good sign since past price appreciation and regular splits often go hand in hand.

Some companies are very predictable when it comes to splitting, although there’s no formula and every company has it’s own “price” that it likes to split at. If you want to start tracking splits, try the splits calendar on the Yahoo! finance site.

The opposite of a share split is a share buyback. Here, a company repurchases its shares on the open market. Aside from all the legal mumbo jumbo that’s part of the buyback process, the short and sweet on the benefits to investors is this: this could be good or not.

Companies buy back shares for all sorts of reasons. Sometimes they are trying to change the bond financing to stock financing (or “capital structure”) to make distributions more tax efficient. (While interest payments to bondholders are completely tax-deductible to the corporation, stock holder distributions are taxed at the full corporate tax rate.)If a company’s stock has appreciated over time, it’s capital structure can become over-weighted, and the company ends up with a higher proportion of equity to debt than it likes. The fix includes selling more bonds, buying back shares, or a combination of the two.

When a company does a buyback, it usually pays a premium over the market price to entice shareholders to sell. However, if the buyback is simply a minor adjustment to keep the firm’s capital structure in line there won’t be much effect in the market. Investors expect the company to make these kinds of adjustments and so it’s no biggie. However, if the buyback signals a major change in policy — the company decides to alter its capital structure — the stock could rise in anticipation of the added tax benefit of a new bond issue, for example. And if a company initiates a buyback to get rid of a stash of cash it has been hoarding, the Street might see this as a bullish signal: since the company sees its stock as a good investment (it’s buying it, isn’t it?), then perhaps we’ve undervalued it. Companies also buy back shares to fund employee stock purchases and other incentive programs so you can’t always assume that the buyback automatically means the market will be hotter.

Next week: Buying the Index

Last week: Establish Your Own Rules

————

Sticky Situation: I am wondering what to do about gifts! Such a quandry for me as I love to celebrate birthdays and special occasions with my friends and family but I seem to spend most of my money on gifts. I have 20 nieces, nephews, 30 family adult relations and many friends with children! It really is overwhelming. Any suggestions?! Thinking of trying to start up some ‘tradition’ ideas instead of presents.

————

An update on Maureen: It has been a tough haul but Maureen is kicking like a mule.  She is finally off dialysis and no longer needs a feeding tube although Mark says everything she consumes “has to be purred to a nectar texture…yuk!” She still has a long way to go. Hopefully she is being flown back to Whitehorse this week. Mark says that your cards and letters have meant the world to Maureen. If you wish to continue to write to her, here is an address for you in Whitehorse:

Maureen Nowosad, 6 Black Bear Lane, Whitehorse YT, Y1A 6J4.

I thank you all for your thoughts and prayers. You are good people and your kindness moves me deeply.

Rule #1: Don’t overreact. A good rule to start with is that you should never sell your stock in reaction to a fall in price. People do this when they’re not sure why they bought the stock in the first place. Along comes a change and they panic. If you’ve done your homework before buying the stock, you’ll know that stock movements are often random since they can be affected by all sorts of variables. Since short-term changes usually have no bearing on the true value of a company, at most it should be a signal to look at the company to see if anything else has changed.

Rule #2: Don’t get emotional about a stock. It’s okay to like a stock. It’s deadly to fall in love. One way to do this is to establish a realistic target for the stock’s growth. When you hit that target, as a value investor you would sell. As a momentum investor, you’d look at the stock to see if the moment signals are for further growth. A year-to-year comparison of net earnings will show the company’s growth overall. If you’re looking at quarterly results, make sure you’re comparing fourth-quarter results with fourth-quarter results. Since many companies are susceptible to cyclical changes — retailers typically post very high profits in the final quarter of the year because of the holiday season — a comparison of different quarters won’t paint an accurate picture.

Rule #3: Sell when the market is up. Sounds like an obvious statement, doesn’t it. Yet tons of people jump out when the market takes a downturn. Smart investors use these downturns in the market to find value or to retrench their positions. Selling in a down market is a sure way to generate a loss, which is okay if you need the write-off, but not so okay if you’re just scared.

Rule #4: Dump wildly popular stocks. If your stock suddenly becomes the analyst’s darling, it’s probably time to unload it. The stock’s popularity has likely already been built into the price, so it’s questionable if that stock has a lot more up in it.

Rule #5: Management matters. If you have any reason to doubt the honesty or integrity of a company’s management, sell immediately. The management team is as important as all the numbers you look at in choosing a stock. While good management can turn around a company that’s been suffering, nothing can wreck a company faster than bad management. This rule also applies when the management of a company you’re already holding changes. Whether it is through an acquisition or merger, or through the seasonal comings-and-goings of management, if you’re not sure about the new management team that could be a signal to sell.

Rule #6: Look at P/E ratios relative to growth. If the P/E is higher than the projected growth rate, it’s a signal that the stock price could decline. The question to ask yourself is this “Would I buy this stock today?” If you answer “no”, sell the stock.

Rule #7: Assess significant changes in the industry. A strong new competitor may be a good reason to sell a stock. So may new legislation that changes the environment within which your company must do business.

Rule #8: Insiders are trading large blocks of the company. If they are buying, great. But if they are selling, you have to wonder what they know that you don’t.

Rule #9: Its time to rebalance your portfolio. Here’s a great opportunity to weed out the non-performers and take some of the profit you’ve accumulated in shares you’ve been holding for a while.

Rule #10: Don’t forget the taxman. There are times when it makes sense to take a loss or crystallize a gain for tax purposes.

Knowing when to sell is easier if you review your portfolio each quarter. And occasionally you must subject them to detailed scrutiny — the kind of analysis you would do if you were trying to decide if you should add them to your portfolio. In analyzing the company’s numbers, look to see if net earnings are growing as fast as you thought they would when you bought the stock? If results are a lot higher or lower, find out why. It may be that this year’s stellar results have put the company in a tough position for follow-up in subsequent years. That may not bode well for the stock’s price when future less-than-stellar results cause investors to be disappointed and to react by driving down the share’s price. This might prompt you to sell the stock. However, if better results are because the company has increased it’s operating efficiency, the company is likely to carry that through for the long term, in which case you’d hang on to the stock.

Companies do all sorts of things to make their figures look good. An understanding of how the industry in which the company operates works is a good thing. Manufacturers of packaged goods regularly put a big sales effort into meeting quarterly results. When they overachieve one month, it’s not unusual for them to have disappointing results later. Having whipped their sales force into a frenzy and pushed as much product into channel as the channel will hold, a quarter or two later they’re unable to shove any more stuff into an already over-stuffed market. Or worse, returns catch up with them, and they can’t sell as much as retailers are sending back to them.

Having done your review of the figures and familiarized yourself with the executive’s statements on the company’s strategies, you may well find that you’re still partial to the stock. Then, by all means, do like Warren Buffet and keep holding. However, if the hairs on the back of your neck bristle, trust your intuition in at least so far as checking what the experts think.

Next week: Stock Splits & Buybacks

Last week: Holding & Folding

Doesn’t it make just make sense to set the price you’re going to sell for when you first buy a stock? Some people say yes, some people say no.

On the yes side there are all those people who as long term investors believe you should ignore the day-to-day price movements as long as you believe the company’s fundamentals are sound. They cite the fact that if you’re trading outside of a retirement account, you’re going to generate gains that will be eroded by tax. And every time you buy and sell, there are those commissions — albeit small ones these days — that must be paid. So your next investment choice had best be stellar since your account has to overcome the tax and trading costs.

On the no side, selling just because you’ve set a price is dumb, dumb, dumb. Just ask any momentum player who watched their stock picks double, triple, or even turn into a ten-bagger. Had they set a price and stuck to it, they would have walked away leaving huge profits on the table. (Hey! Is that another gambling reference?)

Since there’s no way to predict when you’ve reached the market peak on a stock, you’ve got to resign yourself to either selling too soon or too late. Too soon and you’ll miss the next upswing. Too late and you’ll lose the value of the last upswing.

If you’re a momentum player, you’ll likely wait until the stock changes its momentum before you sell — which means you’ll be willing to give up the last gain to ensure you didn’t leave anything on the table. If you’re a value player, you’re probably going to set the price before you buy, in which case you should sell at least half when you hit your price. If you’re a growth player, you might want to use the rule of thumb using a mental stop to preserve 80 percent of your profits. And if you’re into charts, you’ll be looking to see what the prior support level was, and you’ll set a stop just below it.

The worst thing of all is to have no hold’ em/fold’ em strategy at all. Most people are emotional sellers. They sell because they’re afraid of losing the gains they have made, or losing more than they’ve already lost. They sell because the marketplace is skittish and they can’t remember why they bought the stock in the first place. They sell because they know that if they don’t, they’re going to regret it. Instead of being motivated by fear of loss and fear of regret, you need to establish a sell discipline so that you have signals that prompt you when to sell.

Everyone makes investment mistakes. And everyone gets frustrated when the market reacts in totally unexpected ways. But smart people don’t run and hide from their mistakes. They analyze them and learn. And they keep learning. Knowing when to cut and run can be as important as knowing what to buy.

There’s no question that determining when to sell is tough. First, there are the psychological barriers. No one wants to admit they’ve made a mistake. Or the stock is doing so well, you’d just hate to miss out on the next surge in prices. Or it’s dropped 20 percent, and you can’t afford to sell; you’ve got to wait until it at least breaks even.

Second, the investment world changes so quickly, it’s pretty hard to keep abreast of all the changes that can affect your individual investments, particularly if you are holding dozens and dozens of stocks. There’s a good reason why mutual fund managers usually stick to a specific number of stocks in there portfolios: it’s easier to manage 20 or 30 stocks than it is to keep abreast of all the things that can affect 40 or 50 companies.

Next week: Establish Your Own Rules

Last week: Position, Prospects and Price

———-

Sticky Situation: I contacted a mortgage broker whose business portrait I had done a few years previous. I wanted some guidance on renewing our mortgage and also was hoping to roll some of our debts into the renewal and renew early. She decided to book new headshots for her and team (3 in total) and I billed her accordingly for my time and the files etc. Now here’s where it gets sticky. She wasn’t able to do what we where hoping after she repeatedly promised us the moon and that all would be good as gold. While we’ve followed through on her suggestions to set ourselves up better for renewal time in October she has left a seriously bad taste in our mouths from her unprofessional approach of telling us not to worry and she could make this and that happen when she didn’t take a very close look at the whole picture. We released permission to her to check credit scores but we will not be moving forward with her to renew our mortgage BUT I still have a print job (group photo/framed etc) she’s sent my way to complete and I want to make sure she doesn’t check our credit scores after all this time without our permission. My thinking is to tell her we just decided to stay with the same company and won’t be moving forward on any mortgage shopping this time around. What do you think?

———-

An update: Maureen is getting stronger. She’s not out of the woods yet, but the stem cell transplant is beginning to work. Mark says “She is sort of talking, like a cross between Alvin and the chipmonks and Kermit the frog.” He’s very funny too. She loves all the cards you’ve been sending so thank you to all her friends who have reached out to send her good wishes. If you wish to send her a card, you can address it to Maureen Nowosad c/o Jean C. Barber Cancer Lodge, 575 West 10th Avenue, Vancouver, BC V5Z 4C3. Keep praying. It’s working.

Once you have a good feel for a company’s purpose, you’ll want to look at the company’s competitive position relative to others in the same industry. Is it the market leader or the market trailer? Does it have clear advantages or disadvantages? What level of market share does it have? How much does its overall business depend on a single customer or on general economic conditions?

While a company’s brand may seem intangible, there’s no question that it is important factor in the company’s ability to prosper. Think hamburger and you probably think McDonalds. Think soft drinks and Coca Cola will pop to mind. Think software and Microsoft will be on the tip of your tongue. And since a brand’s value is transferable from product to product, it doesn’t really matter how many pieces they split Microsoft into, the brand will virtually ensure the recognition and attractiveness of new product offerings, whatever they are called in the future.

Over the long term, a stock’s price will be driven by the company’s earnings growth. If earnings are to increase, revenues must increase. Sometimes short-term earnings can be achieved through cost-cutting measures, but over the long term (and you are buying for the long-term, right?) the company’s sales must increase. If this is happening year after year, it’s a sign that the company is on track and it’s prospects are good. It may have a great product. It may have a great sales force. Whatever the reason, steady growth is a good sign. If sales begin to flag, it may be a sign of trouble.

Keep in mind that while established companies should be showing consistent results, young companies might show strong revenue growth with little or no earnings because of the costs associated with start-up. You will have to weigh these strong revenue signals against the company’s projected ability to turn a profit.

Here are some of the financial ratios you’ll find useful in analyzing and comparing companies. While the ratios for a given company don’t mean much by themselves, what they reveal when compared with the company’s historical figures and other companies in the same industry can be very insightful. Some of these ratios are particularly useful in the initial screening process.

Price-to-Earnings (P/E) Ratio: The granddaddy of ratios, this is the most-quoted number in trying to determine the value of a stock. It is calculated by dividing the current price of the stock by the earnings generated. So if a $25 stock generates earnings of $1.25 a share, the P/E multiple would be 20.  It is useful to compare a stock’s P/E with the P/Es of the past, and with P/Es of other stocks of similar companies.

Price-to-Book Value: Some people like to look at price-to-book value to see the value set by the stock market on the company’s assets. To calculate price-to-book, divide the price of the share by the assets per share. One problem with this ratio is that if a company’s assets are carried on its books at far below their actual current value while another company’s assets are overstated, a comparison of the two companies’ price-to-book ratios will be distorted.

Price/Sales Ratio: As long as a company is doing business it has revenues. Even if the company is losing money, it has revenues assuming it’s pushing product out the door. The price/sales ratio divides a company’s current market capitalization by the last 12 months trailing revenues. Some investors like companies with low PSR because with a turnaround in circumstances, or the amortization of huge initial costs, the company’s prospects are good. Another common use of the PSR is to compare companies in the same line of business with each other, using the PSR in conjunction with the P/E in order to confirm value. A low P/E combined with a high PSR should send up flares that there may be one-time gains that have pumped up the earnings per share over the last year.

EBITDA: One of my favorite acronyms in the industry, whose value is hotly debated. EBITDA stands for “earnings before interest, tax, depreciation and amortization”. Wow! Talk about a mouthful. Often used by investment bankers and other financial eggheads, EBITDA translates simply into “cash flow”. Since cash flow is designed to focus on the operating business and not secondary costs or profit, interest income and expenses as well as taxes are tossed aside, as are depreciation and amortization since the company isn’t actually spending any money on them. EBITDA is commonly used for companies that have incurred huge up-front costs and are carrying enormous amortization burdens. Think cinema. Think telecommunications. Think cable TV. Companies in these industries report negative earnings for eons because of the huge capital expenses involved in getting started, upgrading, or creating new facilities. So even though their cash flows may be growing, their depreciation and amortization charges mask their growth. It’s also important to see how the company uses that cash. Sift through the cash flow statement to see where the money’s going. This can shed light on management’s strategy and the company’s future. Is it opening new stores or building new facilities? Is it buying other firms? Is it paying off debt, buying back stock, building up cash reserves, or paying dividends?

Dividend Yield: A ratio of a company’s annual cash dividends divided by its current stock price. Multiply the next expected quarterly dividend payment by four (to get the annual dividend), and then divide this by the share price. So a stock trading at $35 with a declared quarterly dividend of $1.25 would have a dividend yield of (1.05 x 4 = $4.20 ÷ 35 =) 12%. Yield is important to income-oriented investors. And some people look to yield as a predictor of where a share’s price is going. So if a company has historically yielded 2.5 percent and is currently paying $4 in dividends, the stock should trade in the (4 ÷ 2.5 x 100 =) $160 range.

Earnings Per Share (EPS): Also known as net income or net profit, this calculation shows the money remaining after a company has paid all its bills. Earnings are an important factor in analyzing a company, but the only way to compare earnings of different companies that have different numbers of share outstanding is to do so using the EPS calculation. Divide the dollar amount of earnings for the year by the number of shares outstanding. So if your company had 5 million shares outstanding had earnings of $25 million, it’s EPS would be ($25 ÷ 5) = $5.

ROA and ROE: Return on Assets is the net income of the company (less preferred stock dividends) divided by the average total assets. Return on assets shows how well it a company manages to translate a dollar of its asset base into a dollar of profit. If a company’s return on assets is 25%, that means it produced .25¢ of earnings for every dollar it had in assets. To calculate Return on Equity, divide net income by average total common equity. Return on equity measures how good a company is at turning the money shareholders have invested into earnings. Both those measures help to show a company’s ability to allocate resources efficiently. If they’re doing a good job, then their ROE will be higher than their ROA. Two companies with the same earnings figures might in fact have a significantly different ROE or ROA depending on how capable they were of turning assets into profits.

Market Capitalization: This is the current market value of all of a company’s shares outstanding, which is calculated by multiplying the number of shares outstanding by the current share price. So if a company has 20 million shares outstanding and trades at $29 per share, the market capitalization is $580 million.

Long-term Debt to Total Capital: Companies issue debt to finance expansions, to pay for research and to bail themselves out of cash flow problems. There’s no hard-and-fast rule for how much debt is most appropriate. But too much borrowing can force the company to use its cash to pay interest, instead of applying it to more-productive ends. And when interest rates are rising, heavy debt burdens coming up for refinancing will eat more from cash flow. A “clean” balance sheet has little or no debt. Companies capitalized with 50% debt (a debt to equity ratio of 1:1) or more might be over-leveraged.

And now we come to the issue of PRICE. Sometimes, no matter how attractive a stock looks, no matter how great the company’s purpose, no matter how well positioned the company is, when you get to the price, the company is too darned expensive. When compared with other companies in its industry and with the market as a whole, the stock just seems to be overvalued. (Or maybe it’s that the market as a whole seems to be too hot.) It very well might be. After all, investor sentiment, demand and supply, and the overall heat of the market all have an impact on price. When the fundamentals say a stock looks good, but should be priced at 10, 15 or 20 percent less, believe them. Stocks with high P/E ratios or high P/B ratios can fall dramatically at the mere mention of a market correction. And if they — that would be the media, the experts, the world — are trying to tell you that the fundamentals just don’t matter, that it’s a new game, that we’re re-writing the rules, remember we’ve heard this story before. Just say no.

Next week: Holding & Folding

Last week: Picking Stocks

———-

The big news this week is the airing of the first episode of Princess on Slice at 9 p.m. I’m going to be blogging at Slice right along with the show’s airing so drop on by if your keyboard is near your TV. Tune in. I’m expecting lots of feedback tonight or tomorrow.

I’ve talked Glenn Cooke of Insurance Squared into writing a series (3 part) on insurance. He’s going to make the whole thing as plain as day and give you some tools to help you make what can be a tough decision. That’ll be up Wed-Fri this week.

I dropped Alex at university this weekend and have some stories to share, particularly about the RESP program. I’ll get to work on those today. And, of course, we’re shooting 14 new episodes of TDDUP right now. We’ve got the first 3 done, next four lined up, and 2 of the final seven in line. So if you or anyone you know wants this last opportunity to participate in TDDUP, get your application in PDQ. Remember, these are for the special Baby Busted & House Poor editions. Please fill out an application or email Mia, our lovely and talented casting director, at franticfilmscasting@gmail.com for more information.

———-

Sticky Situation: An acquaintance is an accountant or a lawyer and you want her expert opinion. Would you insist on paying her?

Do you have a sticky situation you need help with? Send it to getgvo@gmail.com with Sticky in the subject line and you can hear what everyone has to offer by way of suggestions.

———-

Question 6 in our feature called Thinking Things Through is up. Head on over and add your 2 bits. And remember to vote on this week’s poll.

Trying to decide between the thousands of publicly traded companies in just North America? First you have to narrow the field to the 10 or 15 (or 20 or 25) stocks that capture your interest. The easiest way to do that is to “screen” for those companies.

Screening can be as simple as thinking about the products and services you use, and finding out more about those companies, to as complex as determining specific criteria for your investment prospects. On my desk I’ve got my telephone (Bell) and computer (Apple), a Pier One ginger peach candle (Pier 1 Imports), and a package to go to my publishers (Federal Express). Alex’s bank statement (CIBC) is sitting on top of my software manual (Microsoft) and Malcolm’s new chessboard (Mattel) is perched precariously and perilously close to my chair. There, that looks like a nice investment portfolio.

You can also pay close attention to the news. When you hear that Apple is launching a new toy that’s twice as fast as anything currently available, or that your local supermarket has just be bought by a bigger-and-better competitor who has plans to create a new shopping experience, your antennae may quiver. Or if a company makes an announcement that sends it’s stock plummeting, and you believe it is a case of investor over-reaction, which may present a neat opportunity to take advantage of the rebound that typically follows a sell-off.

Of course, screens can also be far more complex and happily there are a ton of tools available on the web, which allow you to quickly see who meets your criteria. Having determined the two or three vectors along which you’ll measure potential picks, you then run the entire world of stocks through those criteria. Magically, your computer spits out the name of the companies that match. You could, for example, screen all stocks for those with a dividend above 4%. Or you could look for companies with revenues of $3 billion or more, or with a price per share of $12, or with earnings growth of 20% or with $1billion or more in sales or a P/E ratio of 20 or… well, you get the idea.

Screens are a great way to narrow your prospects so you can focus in tightly on the ten or twelve that seem to meet most of your criteria.

The first thing you’ll want to do when considering a particular stock for your portfolio is find out the answers to some very important questions relating to the company’s purpose, position, prospects and price.

Let’s start with Purpose. Before you invest you must invest-igate. Read as much as you can about the companies you’re interested in. Call the company, ask for investor relations and request an investor information packet. You’ll get everything from the annual report, to securities filings, to press releases to analysts’ reports.

The idea is to build a feel for the company, to develop at least a general understanding of what the company does for a living. You don’t have to be an expert — there’s an analyst out there who can provide expert opinion for you — but you’ve at least got to get the gist of what the company is all about. What is the primary business of the company? Is the company selling tried-and-true products for which there will always be a demand (think toilet paper and shampoo) or is it offering new products that are expected to capture the imagination of consumers (RIM and Apple)? Does management have a vision for the future or is the firm beset with fleeing employees? Are sales rising or falling? Is management moving forward or too busy cleaning up the mistakes of the past?

Getting to know a company is an art. There are no hard and fast questions to ask or answers that are right or wrong. It’s a little bit intuition and a lot of investigation. And the more you know about a company, the more likely you are to see the potential for the future.

Most companies offer more than one product; a conglomerate might offer hundreds of different products in a range of industries. You want to develop a sense of the forces that will drive the company’s financial results. What percentage of profits does a particular product or division account for? How much of a company’s earnings are tied to a particular product? The annual report is a good source for this kind of information.

If you’re in the position of being a specialist in a particularly industry, use your expertise within that industry to your advantage. Knowing the major players, trends in the industry and a little history will help you bring a deeper level of understanding to the analysis of stocks in your industry.

If you can find someone who is in the industry, offer him or her a burger in exchange for a brain-dump. Then ask one billion questions about what’s happening in the industry, where they see change coming from, who the major players are, what’s new, and what the rumors are in the trenches.

Full service brokerage houses can be a good source of additional research, which is why it’s always a good idea to have a least part of your money there. But weigh what you read carefully if the brokerage house also does business with the company. Houses that underwrite companies are not unbiased in their analysis of those companies’ potential. That being said, analysts know how to evaluate a particular company’s prospects for growth — that’s their job. But not every assertion deserves to be taken to heart. The idea is to read as many takes on the situation as you can find and then form an opinion.

As an aside, don’t pay much attention to the analyst’s ratings on securities. Their judgements have been known to be flawed — sometimes terribly flawed — and I’ve met many a broker who’s given up on buy or sell recommendations provided by their own analysts. Because the language you see doesn’t translate directly. While “Hold” may sound like “hang on to the stock”, it’s really code for “dump this caca.”

Next week: Position, Prospects and Price

Last week: Types of Stocks

—–

Sticky Situation: A friend of ours left her partner and moved in with us.  When she first got here we told her not to worry about paying rent or helping out with the chores.  It’s 5 months later and we wish we’d started off by putting some expectations on her.  What do we do now to get out of this mess?  How much should she be contributing anyway?

Hey, do you have a sticky situation you need help with? Send it to me at getgvo@gmail.com with SS in the subject line and we’ll see what everyone has to say about the best way to handle it.

There is a classification system that applies to all shares depending on the level of risk they carry. This classification ranges from “blue-chip” referring to well-established companies to “speculative” referring to companies whose performance tends to the volatile. Where a share falls on the “blue chip/speculative” scale depends on the company’s longevity, history, and past performance during different business cycles. Companies that have a good track record with steady performance are referred to as blue-chip. Companies with highly erratic earnings records, or no record of earnings at all, are referred to as speculative. They might be newly established with few tangible assets. Or it could be a company with a product that has not yet been proven but has huge potential. Typically, newly formed mining companies and new companies in the relatively young bio-technical industry are classified as speculative.

Blue-Chip Shares: This is the common stock for well-known national companies with a reputation for earnings growth and dividend increases. The most familiar names fall into this category: IBM, AT & T, GM. (See, I don’t even have to spell out their names and you know who they are.) While it’s been rumored that “blue chip” shares took their moniker from “Big Blue” who is a perfect example of one, that’s not so. The label actually comes from casinos where blue chips are the ones that are typically of greatest value. And we wonder why people keep comparing investing to gambling? Go figure. Of course, time and bad management have a way of bringing even the bluest companies to their knees. So, I’ll repeat the investing mantra once again: Past performance is no indication of future performance.

Income Shares: Shares of companies that have relatively stable growth in terms of sales, earnings and dividends are referred to as income shares because they generate a steady flow of income for investors. Dividend payouts are usually higher than the average current return in the market, though growth prospects may be somewhat lower. These types of stocks — utilities and regulated companies are good examples — used to be seen as less risky because they are less volatile. Deregulation has changed some of that. Alternatives such as Real Estate Investment Trusts (REITs) as the latest innovation in the income category.  Income stocks tend to be interest rate sensitive. Inflation does them in too.

Cyclical Shares: Cyclical companies are those that are particularly sensitive to the general economy and to changes in the price of commodities. The share prices of companies that fall into this category move in and out of favour with their entire industry sector. Buy them at the right time and you can take advantage of enormous growth. Miss the boat and you’ll either have to take the loss or you’ll be stuck until the cycle comes round again. Cyclicals are the first to be affected when consumer spending falls off. They include automobile, machinery and construction industries. (A stock can have more than one moniker, as you’ve now see with a company like GM.) Another good example of a cyclical industry is the forest products industry. When the economy slumps, newspaper advertising drops sharply. Pulp and paper companies sell less newsprint, so their earnings drop. When the economy picks up, so does the demand for newsprint. Eventually, both earnings and share prices recover. Some industries are more sensitive to economic cycles than others. The airline industry has boom-and-bust cycles. Electronics go through big swings because introductions of new-generation chips cause enormous changes in profitability. If you’ve got the guts to buy early when the outlook is still bleak, you can enjoy a nice ride up on a cyclical stock.

Seasonal Shares: Some companies are affected by seasonal factors that create more product demand at certain times of the year. For example, while the brewing industry is a relatively stable one, sales tend to be higher during the summer months than during other periods of the year.

Defensive Shares: Defensive shares are those that are affected very little by down turns in the economy because they provide essential services or products to consumers. Banks are a great example of defensive shares. Regardless of what the economy does, people need a place to keep their money. Food companies, established pharmaceuticals and beverage makers are also defensive because we’ve all got to eat, and you’ll need a Coke to swallow your Aspirin. While these stocks weather downturns well, they tend to be poor performers when the markets heat up.

Micro-cap, Small-cap, Mid-cap, and Large-cap Shares: Market capitalization refers to the market value of a company’s outstanding equity.  It is calculated by multiplying the price of the stock by the number of shares outstanding. The larger a company’s capitalization, the more heft or stability it has. Small-caps, on the other hand, tend to offer greater opportunity for spectacular growth. The classifications themselves may shift over time based on the performance of the markets. Where the categories fall is less important that understanding why the categories exist at all. Companies tend to perform differently as their size changes. The smaller the capitalization of a company, the less liquid that share tends to be. Since stocks move in cycles, there are periods when small caps outperform large caps and vice versa.

Next week: Picking Stocks

Last week: Technical Analysis

———-

Sticky Situation: Your mother-in-law wants to invite a bunch of your friends to your wedding, but you have a very strict budget. What do you say to her?

Hey, do you have a sticky situation you need help with? Send it to me at getgvo@gmail.com with SS in the subject line and we’ll see what everyone has to say about the best way to handle it.

1. You can contribute up to $5,000 a year to a TFSA and if you miss a year, you lose that contribution room.

2. As with an RRSP, the interest on your TFSA is tax-deferred.

3. If you take money out of your TFSA you can put it back at any time.

4. A TFSA is a better way to save for a downpayment on a home than an RRSP.

5. Contributions to a TFSA are tax deductible.

6. TFSA can only hold investments that generate interest income.

7. You can only have one TFSA at a time.

8. Putting money in a TFSA for your spouse reduces your contribution amount for the year by the same amount.

9. You can transfer money directly from your RRSP to your TFSA.

10. TFSA beat RRSPs hands down as a way to save for the future.

11. Any Canadian with money to save can open up a TFSA.

12. If I borrow to invest in stocks inside my TFSA, I can deduct the interest on the investment loan on my tax return.

Add up your Trues and your Falses and let’s see how you did…

—————–

1. You can contribute up to $5,000 a year to a TFSA and if you miss a year, you lose that contribution room.

FALSE. While the contribution limit is $5,000 currently, you don’t lose your contribution room if you fail to make a contribution.

2. As with an RRSP, the interest on your TFSA is tax-deferred.

FALSE. All income earned in a TFSA is tax free.

3. If you take money out of your TFSA you can put it back at any time.

FALSE. You can’t put the amount withdrawn back until the next calendar year. If you try and you’ve already reached your limit for the year you’ll be hit with an over-contribution penalty. There are loads of people who haven’t figured out this rule who will pay dearly. The government seems willing to allow for first year ignorance, but that won’t last long.

4. A TFSA is a better way to save for a downpayment on a home than an RRSP.

FALSE. Since an RRSP comes with higher contribution limits, depending on your income, you could be able to save more quickly using an RRSP and the Home Buyers’ Plan than you could with a TFSA. Of course, you’d then have to pay the RRSP back, but only at a rate of 1/15 of the amount borrowed each year.

5. Contributions to a TFSA are tax deductible.

FALSE. Nope.

6. TFSA can only hold investments that generate interest income.

FALSE.  A huge range of investment options are available within a TFSA including stocks, bonds, and mutual funds. In fact, a TFSA can hold anything an RRSP can hold.

7. You can only have one TFSA at a time.

FALSE. You can have as many of these puppies as you’d like, but you can’t go over the annual contribution limit.

8. Putting money in a TFSA for your spouse reduces your contribution amount for the year by the same amount.

FALSE. Contributing to a spouse’s TFSA will not affect your own contribution room. Income attribution rules, which currently apply to RRSPs, do not apply to TFSAs.

9. You can transfer money directly from your RRSP to your TFSA.

FALSE. If only. That would let you avoid the tax hit on RRSP withdrawals. Wouldn’t that be sweet?

10. TFSA beat RRSPs hands down as a way to save for the future.

FALSE. Hey, as with everything about money, there are no hard and fast rules about what will work best. If you’re in a low income tax bracket, a TFSA may be better for you. Ditto if you’ve got a great pension plan at work. But if you’re young, earning good money, and looking for a way to build retirement savings, an RRSP may still be your best bet for saving on taxes now, and growing your money for the future.

11. Any Canadian with money to save can open up a TFSA.

FALSE. Unlike an RRSP where you just have to have earned some income, with a TFSA you have to be 18 years old to open up a plan.

12. If I borrow to invest in stocks inside my TFSA, I can deduct the interest on the investment loan on my tax return.

FALSE. Interest expenses related to a loan for investments held in a TFSA are NOT tax-deductible.

If you’re looking for stocks that will outpace other companies in earnings — and so the share value will appreciate by a wider margin — you’re shopping for growth.

Some companies show a lot of promise but fail to ever achieve their goals. Dot coms and biotechs are famous for this. That’s why you have to be careful just how speculative you’re willing to be when it comes to choosing growth stocks. If you’re very aggressive, you may pick companies that never realize their potential. But you may also hit the next 724 Solutions that was a “ten-bagger”: it grew tenfold. It opened at $26ish?? in early 2000 and by March it had hit almost $300! And if you were an early entry into the RIM experience, well, you’re laughing.

What you’ll focus on as a growth investor is how fast a company is growing. Typically, investors who choose companies that are growing exponentially care not one whit what they have to pay for them. Witness the huge jump in price-to-earnings ratios, which have taken many an expert’s breath away. You want a company whose quarterly growth beats the same quarter for the previous year. Or you want a company that manages to beat analyst’s earnings estimates. If a company surprises once, it could surprise twice or three times and cause investor-fever and a run up in the stock price.

Some growth investors don’t believe in, “growth at any price.” They want to be more reasonable about their decision making. They look for how Company A might grow, and what it is worth, compared to the growth in Company B, and it’s stock appreciation. If this is your game, you might want to familiarize yourself with the PEG (projected earnings growth) ratio. (Yes, there are more ratios in heaven and hell than you have heard of.) This is calculated by dividing a stock’s P/E ratio by its earnings growth rate over the previous 12 months. Growth stocks typically have a PEG ratio of 1.5 or less.

The price-to-earnings ratio measures the ratio of a stock’s prices relative to its earnings. If a stock was selling at $30 a share, with earnings of $2.50 a share, the P/E ratio would be 12 (30 ÷ 2.5 = 12)

As a growth investor, don’t fall into the trap of thinking that the company’s growth cycle will last forever. It’s pretty easy to believe there’s no end in sight when growth stocks are soaring. But if you don’t limit how high you’re prepared to go, you may find yourself buying just before growth comes to an end, in which case you’ll be holding stock that has a long way to fall before it reaches solid ground. That’s what happened when technology stocks nose-dived as if to prove that you can’t keep going up forever. As a growth investor, you’ll need to keep a close eye on the market so that at the first sign of a slowdown in growth you can trade out of those high-performance stocks.

Don’t have the patience for a buy and hold strategy? Like to see a stock’s price rising before you’re prepared to jump on the bandwagon? You’re a momentum player. You’re of the belief that a body in motion will continue to stay in motion until another force acts upon it. Okay, that’s Newton’s First Law of Motion — which some people call inertia — but it applies to the momentum play. Typically momentum investors buy the top 20 percent of stocks in terms of price momentum and earnings momentum. You believe that stocks that are hitting new highs are far more interesting than stocks that are holding steady or just creeping along.

The danger with a momentum play is just about any “force that acts upon” your stock can change the direction in which it’s moving. An increase in inflation and an accompanying increase in interest rates will cause the money to flow to economically sensitive stocks because of low valuations and improved earnings potential. And a trend-less market — up today, down tomorrow — is anathema for momentum players.

Oh, please, please, if you’re going the momentum play, don’t fall into the trap of overriding your sell-points because you’ve fallen in love with a stock and you just can’t let it go even after it has lost its momentum.

Next week: Technical Analysis

Last week: Investing in Equities – Looking for Value

____________

Sticky Situation:

You lent a hefty sum to a friend. After she misses a payment or two, she shows up with an expensive new pair of shoes. And you say…

In choosing a stock to trade, you could simply follow the herd, buying what’s tipped as hot in the newspaper, on your local investment television show, or through an expensive investor newsletter. However, those sources are far less accountable if their suggestions prove to be worthless or, worse, damaging to your portfolio. If you’re taking your role of investment manager to yourself seriously, you’d do well to heed the wise words of Mark Twain:

“There are two times in a man’s life when he should not speculate:
when he can’t afford it, and when he can.”

You’ll actually want to learn about stocks and determine what your investment style is so you can not only enjoy your online activities, but profit from them.

Your investment style speaks to how you like to buy and sell stocks. Are you the type of investor who likes to pick a good stock and hold it forever? Or do you like to see a stock’s price rising before you jump on to take advantage of the upward trend? Or maybe you enjoy trying to find the trend that shows where the market’s going next? Knowing your style is key to being able to develop an investment strategy that works for you. The stock market works in cycles: sometimes small cap stocks do great, other times it’s the large caps that are The Street’s darlings; sometimes momentum is the ticket to success, other times value pays off. So it’s important to know how you “feel” about investing, what intrigues you about the market, how you like to analyze your choices.

In the old days, you’re the guy who was willing to load up the pick-ax, ride the mule, and work for hours in the broiling sun to hit the jackpot. Today, you’re looking for companies whose stock prices are lower than that of comparable companies’. The shares may have simply fallen out of favour with The Street. Or maybe the company has been through a tough time and investors got bored, impatient, or angry and punished the company by dumping their shares and driving their share-value way, way down. Whatever the reason, this stock is On Sale at 25-, 40-, 60% off. And you know it’s only a matter of time before The Street recognizes it’s true value an runs up the price.

If you’re picking a stock because you can’t believe a stock that good is trading at a price that low, you’re making a value play. You’ve been attracted because this company’s price-to-earnings ratio is trailing other stocks in its peer group. Or you’ve been attracted because when you add up the individual components that make up the company — the cash in the bank, it’s inventory and the land it occupies — the company is worth more than reflected in the current share price.

Value investing is hard work. It takes time to study the figures and decide if the sum of the parts is greater than the whole. That’s why a whack of strategies have developed around value investing. There’s the Dogs of the Dow which encourage investors to buy the worst performers on the Dow Jones Industrial Average hold them for a year. The SAPI Slugs follows the same strategy for the Standard & Poor’s 500 Index. Other strategies suggest you look for low price-to-sales ratios, or low price-to-book value ratio. Whatever the strategy, the objective is to find cheap stocks, buy them and then hold on until they make good.

Since you’ll be buying when everyone else is selling, you’re the contrarian. So you really have to believe in this strategy. You’ll take a lot of flack from other investors because you’ll be out of step with the market. And since you’re likely to be out of step for more than a few weeks, you’ve got to make like Jason and close your ears to the cacophony from The Street.

A word of warning: sometimes companies are On Sale because they’re about to tank completely. You have to be sure that the company you’re buying has the ability to turn around. The story its management is telling must make sense. The management itself must be strong (perhaps it has just changed). And it can’t be burdened by an albatross of debt if it’s going to succeed in meeting its goals. Long-term debt is bad. Short-term debt is worse. Low debt is best. Remember, not everything that’s On Sale offers value. Be discerning.

Also keep in mind that a value play doesn’t work well when the economy is slowing down or when the market can’t make up it’s mind what’s good and what’s bad news. And if the whole world is in love with the Fad Of The Moment, your value stocks will languish. Be patient. If you’ve chosen wisely, you will be rewarded over the long term.

Next Week: Investing for Growth

Last Week: The Risks with Bonds

Since a bond’s return is based on time and interest rates, bonds suffer from interest rate risk. If rates fall, a bond’s price rises because it becomes more valuable as a source of higher interest rates. So you can sell it for a capital gain. Or you can hold it till maturity for a great (higher) source of interest income. On the opposite side, when rates go up, the bond you bought last Thursday loses value — but only in so far as what people would pay to take it off your hands in a higher-interest-rate environment. If your plan was to hold the bond to maturity, what you’ve lost is the opportunity to have the money invested in that bond earn more at the current higher rates.

Changes in interest rates don’t affect all bonds equally. Long-term bonds experience greater price volatility than short-term bonds. Since the fluctuations will be greater, investors expect to be compensated for taking the extra risk.

There is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest to longest. You’re looking at a yield curve.

A consistently increasing spread between the one-year term and the five-year term reflects a very stable market with a likelihood of increasing rates. In financial lingo this is referred to as a normal yield curve. With a normal yield curve, the longer the term, the higher the rate of interest earned. Sometimes the economy goes through periods when long-term rates are lower than short-term rates, referred to as an inverted yield curve. Then you have to decide whether to take a shorter term at a higher rate and run the risk that rates will be lower when it’s time to renew, or choose a longer term at a lower rate at which point you hope rates will have risen. An inverted yield curve is sometimes considered to be a harbinger of recession. When interest rates remain the same regardless of the amount of time that the money is invested, the yield curve is referred to as being flat. In a flat interest-rate environment, the reward for choosing a long-term maturity is relatively small so investors tend to stay in the short end of the maturity range.

By watching the yield curve, which is reported in the financial press, you’ll get a sense of where the market believes interest rates are headed, an important factor that could affect your bonds’ prices.

Bonds also suffer from credit risk — the risk that the bond issuer won’t come through with the interest payments or will default completely on the bond so you’ll lose your capital too. The trade-off when assessing credit risk is that a lower quality or junk bond (such as one offered by a company in financial trouble or in countries that can’t borrow from anybody else because they’ve used up their good will or their debt service) must offer a higher yield than a bond of superior quality. And this must be measured against the likelihood that this higher yielding bond exposes you to a greater risk of default.

The ideal time to be a long-bond investor is during periods of falling interest rates. When interest rates are rising, stick with short-term bonds in order to maximize capital preservation and to reinvest more quickly as rates move higher.

A key determinant of bond price movements is inflation. And that’s not just the Bank of Canada’s perception of inflation, but also investors’ perceptions and, therefore, their demand.  When inflationary fears strike, bond prices fall to increase yields enough to entice new bond buyers to accept this potential risk.

Some people in the biz believe that because gold has historically been considered a hedge against inflation, monitoring changes in gold-stock prices can give you an insight into where inflation, and therefore bond prices, are going. A gold mining index such as Barron’s GMI can be both a good indicator for stock investment purposes and for bond prices.

Just as investment diversification is important to equity investing, so too does it play a role in choosing the quality, type and term of the bonds in your portfolio. Remember, diversification helps to protect your portfolio from the ravages in the market — whether the market is in equities or fixed-income securities. Investment-grade bonds, which have lower yields, will offset the potential credit risk on high-yield bonds. Balancing corporate issues with government issues is another way to diversify.

You should also buy securities of various maturities. Buying bonds with a range of maturities, referred to as laddering, reduces your portfolio’s sensitivity to interest rate risk. Invest only in short-term securities and while you’ll have a high degree of stability, you’ll be sacrificing yield. Invest only in long-term securities and your portfolio will be far more volatile, exposing you to losses should you have to sell before maturity.

To ladder your bond portfolio, buy an assortment of bonds with maturities distributed over time — equal amounts in bonds maturing in two, four, six, eight and 10 years. When the first bonds mature, reinvest the money in a 10-year maturity to maintain the ladder.

Next week: Equity Investing

Last week: Types of Bonds

____________

Sticky Situation:

This in from S: My partner does not fully support the “getting out of debt” plan.  He says he does but then really doesn’t embrace it.  We have no joint debt however we do have our own from our past lives. We also have a joint bank account for “joint expenses”.  I am just starting this journey and am quite able to do it on my own, but how do you deal with this situation effectively while contributing jointly?

Callable bonds can be redeemed or “called” by the issuer before they mature, usually for a stated price and at a particular time.When interest rates fall and issuers know they could float (or sell) new bonds with substantially lower rates, they redeemed their callable bonds. When you’re buying a bond, always check whether it is callable, and if so, when and where. If you hold registered bonds, you will be notified of a call directly. However, if you hold bearer bonds, you need to keep on eye on the financial press so that you don’t inadvertently continue expecting interest to be paid on a coupon for a bond that has been redeemed. (Bearer bonds are unregistered bonds which are payable to the person who presents them. While bonds are no longer issued in bearer form, there are some older bearer bonds that are still in circulation.)

Convertible bonds, which are sometimes issued by corporations, allow you to exchange the bond for common shares of the corporation. This gives you the opportunity for capital appreciation should the common shares of the company increase in value. However, this types of bonds usually pay a lower rate of interest than a nonconvertible bond would.

When investment dealers buy blocks of long-term, high-quality government bonds, detach interest coupons from the bonds and sell the interest coupons and bond residues separately to investors at a discount, these are referred to as strip (or zero coupon) bonds. The term “strip” is an acronym for “separately traded residual and interest payments.”  Strip bonds provide an investment vehicle that meets investors’ needs of safe, high-yield fixed-income investments that offer automatic reinvestment of interest. Sometimes referred to as TIGRs (term investment growth receipts) or sentinals, these are secure investments that avoid the reinvesting of small amounts of semiannual earned interest. With a strip bond, you know exactly what the yield will be on your investment at the time of purchase. Maturity dates range from 60 days to 20 years.

While there is a secondary market for the liquidation of strips, here are a few points to note:

•   If the interest rate at the time of purchase is higher than the current interest rate, it will be easy to sell the strip bond. However, if the interest rate is lower than the current interest rate, there is less likely to be a market for this investment. It will probably have to be held until maturity (or until interest rates fall below the rate guaranteed by the strip bond).

•    Strip bonds are far more susceptible to interest-rate moves than are regular bonds. This is great if you’re planning to use interest-rate moves to your advantage. For example, if interest rates declined from ten percent to eight percent, the price of a conventional government bond would rise by about 20%. However, the equivalent strip would appreciate by about 45%.

•   Since strip bonds offer security of principal and guaranteed interest payout, they appeal to people looking for high levels of security with a better return than investments such as certificates offer. However, that security should be further defined. Strip bonds issued by the federal government are very secure. Those issued by other government bodies are usually less secure and, as a compensating factor, offer a higher rate of interest.

Just as you can play the interest-rate game to earn a higher return on your bonds, so too can you play the foreign-exchange game using foreign bonds. Bond trading goes on 24 hours a day, every day, so there’s no need to limit your bond buying to North American bonds. Foreign markets provide opportunities, as well. At any given point in time, some countries have low interest rates, while others have high rates. You can, therefore, get a higher current return on your bond investments by buying bonds denominated in other currencies. But be warned! Playing the currency game can have both a positive and a negative effect on your overall return. Make sure you seek advice from someone very knowledgeable about foreign bonds before you decide to jump in.

Bonds pay out regular amounts, usually twice a year on a semiannual basis. But bond trades are constantly taking place. The registered owner of the bond at the date the interest is paid out will receive all the interest. This means if the bonds were purchased just a few days before the interest payout, most of that interest would have been earned by the previous owner, but paid to the new owner. As a result, there is a mechanism for ensuring that all bondholders receive the accrued interest to which they are entitled.

Let’s suppose you have a $1,000 bond paying ten percent, which you decide to sell. You sell your bond on June 15. The next interest payment date is September 15, at which point the buyer will receive the full six-month interest payment of $50. To ensure each bondholder gets a fair share of the interest pie, however — after all, the buyer only owned the bond for half the time — when the buyer purchases the bond from you, he will also have to pay you three months’ interest, or $25. You’ll get your share of the interest, and so will the buyer.

Next week: The Risks with Bonds

Last week: Bond Quotes

—————

Sticky Situation: You’re a natural-born fundraiser and you support several charities that are near and dear to your heart. How many times can you hit up the same people for support?

Do you have a sticky situation that you need help with? Send it along to getgvo@gmail with Sticky Situation in the subject line and we’ll see what our great community has to say.

When you set out to buy a bond, the price quoted is made up of a bid and an ask price. The bid is the price you would get if you were selling a bond. The asked price is what you would pay when buying a bond. Here’s an example of a bond quotation so you can see what all the numbers mean:

1.  The “Issuer/Bond” category indicates who is issuing the bond. This sometimes includes the original interest rate offered (8 1/4) and the date the bond matures (2024).

2. If the original rate isn’t listed under the “Issuer” category, it will be listed under “Coupon” (8 1/4). A $1,000  bond with a coupon yield of 8.25% pays annual interest of $82.50. The coupon yield on a bond does not change during the life of the bond.

3. If the maturity date isn’t listed under the Issuer category, it will be listed under the “Maturity” category. This bond matures April 15, 2024.

4.  In this example, the price is $122.80. Usually when only one price is shown, it is the midpoint between the bid and asked prices. A full quote, in this example, might have been “122.60 bid, 123.00 asked.” Despite the fact a bond may have a face value of $1,000, they are always quoted based on 100. To figure the actual value of the bond, you must multiply the quote price by 10. So in this example, the quote price would actually be $1,228.00.

5. The yield quote refers to the yield to maturity. This takes into account both the interest received when the bond comes due, as well as the difference between the current price of the bond and its price at maturity. If a bond is trading at a premium (or at more than par value), the yield to maturity is less than the current yield. If the bond is trading at a discount (or at less than par value), the yield to maturity is more than the current yield.

The current yield on a bond is simply the annual interest divided by its current market price, multiplied by 100 to make a percentage. While the coupon yield never changes, the current yield will fluctuate based on the market price of the bond. In the case of this bond, the coupon rate is 8.25. However,bonds always have a maturity value of $1,000. Now, let’s assume the bond has been quoted at 122.80 as shown. This means its value is $1,228. The current yield is the annual interest ($82.50) divided by the current market price ($1,228), multiplied by 100 for a total of 6.71%. Despite the fact that the stated coupon yield is 8.25%, if you were to buy this bond in this market, you would earn only 6.71%.

6.  The “Change” category simply shows the movement of the price of the bond during the most recent trading day. Again, this figure needs to be multiplied by 10 and indicates the value of the bond had increased by $5.

As you can see from this example, the yield on a bond can differ widely depending on what kind of yield we’re talking about. You have to understand what return you’re getting on your bond investment by understanding how the coupon yield, current yield and yield-to-maturity differ.

Next Week: Types of Bonds

Last Week: More About Bonds

———————-

Sticky Situation: The check arrives. You had a salad and water. Everyone else had steak, wine and dessert. It looks like everyone just wants to split the bill evenly. What would you do? Don’t forget the tip!

Don’t forget to vote on this week’s poll.