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Conglomerates: Cash Cows Or Corporate Chaos?
Conglomerates are companies that either partially or fully own a number of other companies. Not long ago, sprawling conglomerates were a prominent feature of the corporate landscape. Vast empires, such as General Electric (NYSE:GE) and Berkshire Hathaway (NYSE:BRK.A), were built up over many years with interests ranging from jet engine technology to jewelry. Corporate hodgepodges like these pride themselves on their ability to avoid bumpy markets. In some cases, they have produced impressive long-term shareholder returns - but this doesnt mean that corporate conglomerates are always a good thing for investors. If youre interested in investing in these behemoths, there are a few things you should know. Here we explain what conglomerates are and give you an overview of the pros and cons of investing in them.
The Case for Conglomerates
The case for conglomerates can be summed up in one word: diversification. According to financial theory, because the business cycle affects industries in different ways, diversification results in a reduction of investment risk. A downturn suffered by one subsidiary, for instance, can be counterbalanced by stability, or even expansion, in another venture. In other words, if Berkshire Hathaways brick-making division has a bad year, the loss might be offset by a good year in its insurance business.
At the same time, a successful conglomerate can show consistent earnings growth by acquiring companies whose shares are more lowly rated than its own. In fact, GE and Berkshire Hathaway have both promised - and delivered - double-digit earnings growth by applying this investment growth strategy.
The Case Against Conglomerates
However, the prominent success of conglomerates such as GE and Berkshire Hathaway is hardly proof that conglomeration is always a good idea. There are plenty of reasons to think twice about investing in these stocks , particularly in 2009, when both GE and Berkshire suffered as a result of the economic downturn, proving that size does not make a company infallible.
Investment guru Peter Lynch uses the phrase diworsification to describe companies that diversify into areas beyond their core competencies. A conglomerate can often be an inefficient, jumbled affair. No matter how good the management team, its energies and resources will be split over numerous businesses, which may or may not be synergistic.
For investors, conglomerates can be awfully hard to understand, and it can be a challenge to pigeonhole these companies into one category or investment theme. This means that even managers often have a hard time explaining their investment philosophy to shareholders. Furthermore, a conglomerates accounting can leave a lot to be desired and can obscure the performance of the conglomerates separate divisions. Investors inability to understand a conglomerates philosophy, direction, goals and performance can eventually lead to share underperformance.
While the counter-cyclical argument holds, there is also the risk that management will keep hold of businesses with poor performance, hoping to ride the cycle. Ultimately, lower-valued businesses prevent the value of higher-valued businesses from being fully realized in the share price . (For further reading, see The Ups And Downs Of Investing In Cyclical Stocks.)
Whats more, conglomerates do not always offer investors an advantage in terms of diversification. If investors want to diversity risk, they can do so by themselves, by investing in a few focused companies rather than putting all of their money into a single conglomerate. Investors can do this far more cheaply and efficiently than even the most acquisitive conglomerate can.
The Conglomerate Discount
The case against conglomerates is a strong one. Consequently, the market usually applies a haircut to the piecewise, or sum-of-parts, value - that is, it frequently values conglomerates at a discount to more focused companies. This is known as the conglomerate discount. According to a 2001 article in CFO Magazine, academic studies have suggested in the past that this discount could be as much as 10-12%, but more recent academic inquiries have concluded that the discount is closer to 5%. Of course, there are some conglomerates that command a premium but, in general, the market ascribes a discount.
The conglomerate discount gives investors a good idea of how the market values the conglomerate as compared to the sum value of its various parts. A deep discount signals that shareholders would benefit if the company were dismantled and its divisions left to run as separate stocks.
Lets take a shot at calculating the conglomerate discount using a simple example. Well use a fictional conglomerate called DiversiCo, which consists of two unrelated businesses: a beverage division and a biotechnology division.
DiversiCo has a stock market valuation of $2 billion and total debt of $0.75 billion. Its beverage division has balance sheet assets of $1 billion, while its biotechnology division has $0.75 billion worth of assets. Focused companies in the beverage industry have median market-to-book values of 2.5, while pure play biotech firms have market-to-book values of 2. DiversiCos divisions are fairly typical companies in their industries. From this information, we can calculate the conglomerate discount:
Example - Calculating the Conglomerate Discount
Total Market Value DiversiCo:
= Equity Debt
= $2 billion $0.75 billion
= $2.75 billion
Estimated Value Sum of the Parts:
= Value of Biotech Division Value of Beverage Division
= ($0.75 billion X 2) ($1 billion X 2.5)
= $1.5 billion $2.5 billion
= $4.0 billion
So, the conglomerate discount amounts to:
= ($4.0 billion - $2.75 billion)/$4.0 billion
= 31.25%
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DiversiCos conglomerate discount of 31.25% seems unusually deep. Its share price does not reflect the true value of its separate divisions. It becomes clear that this multibusiness company could be worth significantly more if it were broken up into individual businesses. Consequently, investors may push for divesting or spinning off its beverage and biotech divisions to create more value. If that were to happen, Diversico might be worth closer examination as a buying opportunity.
What to Look For
The big question is whether investing in conglomerates makes sense. The conglomerate discount suggests it does not. But there may be a silver lining. If you invest in conglomerates that break up into individual pieces through divestitures and spinoffs, you could capture an increase in value as the conglomerate discount disappears. As a general rule, you stand to get greater returns when conglomerates break up than when they are built.
That said, some conglomerates do command a valuation premium - or at least a slim conglomerate discount. These are extremely well-run companies. They are managed aggressively, with clear targets set for divisions. Underperforming companies are quickly sold, or divested. More importantly, successful conglomerates have financial rather than strategic or operating objectives, adopting strict approaches to portfolio management .
If you choose to invest in conglomerates, look for ones with financial discipline, rigorous analysis and valuation, a refusal to overpay for acquisitions and a willingness to sell off existing businesses. As with any investment decision , think before you buy and dont assume that big companies always come with big returns.
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Conclusions
Even though many different charting techniques are available, one method is not necessarily better than the other.
These institutions manage portfolios of derivatives involving tens of thousand of positions and aggregate global turnover over $1trillion. The OTC market is an informal network of bilateral counterparty relationships and dynamic, time-varying credit exposures whose size and distribution are tied to important asset markets. International financial institutions have increasingly nurtured the ability to profit from OTC derivatives activities and financial markets participants benefit from them. As a result, OTC derivatives activities play a central and predominantly a beneficial role in modern finance.
Introduction To Investment Diversification
Diversification is a familiar term to most investors. In the most general sense, it can be summed up with this phrase: Dont put all of your eggs in one basket. While that sentiment certainly captures the essence of the issue, it provides little guidance on the practical implications of the role diversification plays in an investors portfolio and offers no insight into how a diversified portfolio is actually created. In this article, well provide an overview of diversification and give you some insight into how you can make it work to your advantage.
What Is Diversification?
Taking a closer look at the concept of diversification, the idea is to create a portfolio that includes multiple investments in order to reduce risk. Consider, for example, an investment that consists of only stock issued by a single company. If that companys stock suffers a serious downturn, your portfolio will sustain the full brunt of the decline. By splitting your investment between the stocks from two different companies, you can reduce the potential risk to your portfolio.
Another way to reduce the risk in your portfolio is to include bonds and cash. Because cash is generally used as a short-term reserve, most investors develop an asset allocation strategy for their portfolios based primarily on the use of stocks and bonds. It is never a bad idea to keep a portion of your invested assets in cash or short-term money-market securities. Cash can be used incase of an emergency, and short-term money-market securities can be liquidated instantly incase an investment opportunity arises, or in the event your usual cash requirements spike and you need to sell investments to make payments. Also, keep in mind that asset allocation and diversification are closely linked concepts; a diversified portfolio is created through the process of asset allocation. When creating a portfolio that contains both stocks and bonds, aggressive investors may lean towards a mix of 80% stocks and 20% bonds, while conservative investors may prefer a 20% stocks to 80% bonds mix.
Regardless of whether you are aggressive or conservative, the use of asset allocation to reduce risk through the selection of a balance of stocks and bonds for your portfolio is a more detailed description of how a diversified portfolio is created rather than the simplistic eggs in one basket concept. With this in mind, you will notice that mutual fund portfolios composed of a mix, which includes both stocks and bonds, are referred to as balanced portfolios. The specific balance of stocks and bonds in a given portfolio is designed to create a specific risk-reward ratio that offers the opportunity to achieve a certain rate of return on your investment in exchange for your willingness to accept a certain amount of risk. In general, the more risk you are willing to take, the greater the potential return on your investment.
What Are My Options?
If you are a person of limited means or if you simply prefer uncomplicated investment scenarios, you could choose a single balanced mutual fund and invest all of your assets in the fund. For most investors, this strategy is far too simplistic. While a given mix of investments may be appropriate for a childs college education fund, that mix may not be a good match for long-term goals, such as retirement or estate planning. Likewise, investors with large sums of money often require strategies designed to address more complex needs, such as minimizing capital gains taxes or generating reliable income streams. Furthermore, while investing in a single mutual fund provides diversification among the basic asset classes of stocks, bonds and cash (funds often hold a small amount of cash from which the fees are taken), the opportunities for diversification go far beyond these basic categories.
With stocks, investors can choose a specific style, such as focusing on large, mid or small caps. In each of these areas are stocks categorized as growth or value. Additional choices include domestic and foreign stocks. Foreign stocks also offer sub-categorizations that include both developed and emerging markets. Both foreign and domestic stocks are also available in specific sectors, such as biotechnology and healthcare.
In addition to the variety of equity investment choices, bonds also offer opportunities for diversification. Investors can choose long-term or short-term issues. They can also select high-yield or municipal bonds. Once again, risk tolerance and personal investment requirements will largely dictate investment selection.
While stocks and bonds represent the traditional tools for portfolio construction, a host of alternative investments provide the opportunity for further diversification. Real estate investment trusts, hedge funds, art and other investments provide the opportunity to invest in vehicles that do not necessarily move in tandem with the traditional financial markets. Yet these investments offer another method of portfolio diversification.
Concerns
With so many investments to choose from, it may seem like diversification is an easy objective to achieve, but that sentiment is only partially true. The need to make wise choices still applies to a diversified portfolio. Furthermore, it is possible to over-diversify your portfolio, which will negatively impact your returns. Many financial experts agree that 20 stocks is the optimal number for a diversified equity portfolio. With that in mind, buying 50 individual stocks or four large-cap mutual funds may do more harm than good. Having too many investments in your portfolio doesnt allow any of the investments to have much of an impact, and an over-diversified portfolio (sometimes called diworsification) often begins to behave like an index fund. In the case of holding a few large-cap mutual funds, multiple funds bring the additional risks of overlapping holdings as well as a variety of expenses, such as low balance fees and varying expense ratios, which could have been avoided through a more careful fund selection.
Tools
Investors have many tools to choose from when creating a portfolio. For those lacking time, money or interest in investing, mutual funds provide a convenient option; there is a fund for nearly every taste, style and asset allocation strategy. For those with an interest in individual securities, there are stocks and bonds to meet every need. Sometimes investors may even add rare coins, art, real estate and other off-the-beaten-track investments to their portfolios.
The Bottom Line
Regardless of your means or method, keep in mind that there is no generic diversification model that will meet the needs of every investor. Your personal time horizon, risk tolerance, investment goals, financial means and level of investment experience will play a large role in dictating your investment mix. Start by figuring out the mix of stocks, bonds and cash that will be required to meet your needs. From there, determine exactly which investments to use in completing the mix, substituting traditional assets for alternatives as needed. If you are too overwhelmed by the choices or simply prefer to delegate, there are plenty of financial services professionals available to assist you.
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Investors everyday transfer their accounts from one brokerage firm to another. Account transfers are generally completed without a problem, often within two to three weeks. If you are planning on transferring your account, read our publication, Transferring Your Brokerage Account: Tips on Avoiding Delays.
Everything Investors Need To Know About Earnings
You cant get far in the stock market without understanding earnings. Everybody from CEOs to research analysts is infatuated with this often-quoted number. But what exactly do earnings represent? Why do they attract so much attention? Well answer these questions and more in this primer on earnings.
What Are Earnings?
A companys earnings are, quite simply, its profits. Take a companys revenue from selling something, subtract all the costs to produce that product, and, voila, you have earnings! Of course, the details of accounting get a lot more complicated, but underneath all the financial jargon what is really being measured is how much money a company makes.
Part of the confusion associated with earnings is caused by its many synonyms. The terms profit, net income, bottom line and earnings all refer to the same thing.
Earnings Per Share
To compare the earnings of different companies, investors and analysts often use the ratio earnings per share (EPS). To calculate EPS you take the earnings left over for shareholders and divide by the number of shares outstanding. You can think of EPS as a per-capita way of describing earnings. Because every company has a different number of shares owned by the public, comparing only companies earnings figures does not indicate how much money each company made for each of its shares, so we need EPS to make valid comparisons.
For example, take two companies: ABC Corp. and XYZ Corp. They both have earnings of $1 million but ABC Corp has 1 million shares outstanding while XYZ Corp. only has 100,000 shares outstanding. ABC Corp. has EPS of $1 per share ($1 million/1 million shares) while XYZ Corp. has EPS of $10 per share ($1 million/100,000 shares).
Earnings Season
Earnings season is Wall Streets equivalent to a school report card. It happens four times per year; publicly traded companies in the U.S. are required by law to report their financial results on a quarterly basis. Most companies follow the calendar year for reporting, but they do have the option of reporting based on their own fiscal calendars.
Although it is important to remember that investors look at all financial results, you might have guessed that earnings (or EPS) is the most important number released during earnings season, attracting the most attention and media coverage. Before earnings reports come out, stock analysts issue earnings estimates - what they think earnings will come in at. These forecasts are then compiled by research firms into the consensus earnings estimate.
When a company beats this estimate its called an earnings surprise, and the stock usually moves higher. If a company releases earnings below these estimates it is said to disappoint, and the price typically moves lower. All this makes it hard to try to guess how a stock will move during earnings season: its really all about expectations. (For more on this phenonmenon, see Surprising Earnings Results.)
Why Do Investors Care About Earnings?
Investors care about earnings because they ultimately drive stock prices . Strong earnings generally result in the stock price moving up (and vice versa). Sometimes a company with a rocketing stock price might not be making much money, but the rising price means that investors are hoping that the company will be profitable in the future - of course, there are no guarantees that the company will fulfill investors current expectations.
The dotcom boom and bust is a perfect example of company earnings coming in significantly short of the numbers investors imagined. When the boom started, everybody got excited about the prospects for any company involved in the internet, and stock prices soared. Over time, it became clear that the dotcoms werent going to make nearly as much money as many had predicted. It simply wasnt possible for the market to support these companies high valuations without any earnings; as a result, the stock prices of these companies collapsed.
When a company is making money it has two options. First, it can improve its products and develop new ones. Second, it can pass the money onto shareholders in the form of a dividend or a share buyback (see The Lowdown on Stock Buybacks). It really is this simple!
In the first case, you trust the management to re-invest profits in the hope of making more profits. In the second case, you get your money right away. Typically, smaller companies attempt to create shareholder value by reinvesting profits, while more mature companies pay out dividends. Neither method is necessarily better, but both rely on the same idea: in the long run, earnings provide a return on shareholders investments .
Summary
Earnings means profit; its the money a company makes. It is often evaluated in terms of earnings per share (EPS) - this is the most important indicator of a companys financial health. Earnings reports are released four times per year and are followed very closely by Wall Street. In the end, growing earnings are a good indication that a company is on the right path to providing a solid return for investors.
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In an efficient market, deviations above and below fair value are possible, but these deviations are considered to be random.
What Are SRI Funds?
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You dont have to check your values at the door when investing in the market. An increasing number of investors are choosing to put their money to work in companies that not only have a profitable future, but also reflect their values, like those committed to environmental sustainability or ones that give back to the community. But this isnt charity, it is Socially or Sustainable and Responsible Investing (SRI), and investors still expect and seek a strong return on their money – just one that balances their values with their investment goals.
The Rise of the SRI Fund
The first SRI fund of its kind started in the early 1990s with very few assets. But at the end of 2010 there were over 250 SRI-focused funds for investors to choose from. Funds earmarked for SRI investments now make up around 12%, or $3 trillion, out of the $25.2 trillion invested in the market today, according to The Forum for Sustainable and Responsible Investment (US SIF), a trade group representing SRI funds. Inside the funds, which are managed by professional money managers, are a collection of companies and investments that comply with a certain SRI cause. They usually follow some sort of environmental, social or corporate governance theme, which are collectively known as ESG issues.
Several of the large money managers offer several SRI products for their clients, ranging from simple passive index funds that track large or small SRI compliant companies, to actively managed funds that invest in companies focused on one of the three main ESG themes. Investors can also put their money in one of a number of exchange traded funds (ETFs) that track SRI compliant companies.
What Does It Mean to Be SRI Compliant?
The large funds may be a bit too broad for many investors, money managers screen and add or eliminate companies that normally do not comply with the general idea of what makes up an SRI company, but peoples values arent usually that simple. In general, money managers choose to avoid adding companies that deal in things that kill (defense
Volatility makes it possible for market makers to lose money providing liquidity to both sides of the market. Security purchases at the bid price can become unprofitable if the price quickly or significantly moves lower. Therefore, spreads tend to be wider (larger) in very volatile or illiquid (not easily tradable) securities.
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Alternative Ways To Invest In Debt
Investing in debt has long been practiced by many smart investors - those who are risk averse and others willing to accept some degree of risk for a correspondingly higher expected rate of return. (For assistance in achieving high returns, check out Disciplined Strategy Key To High Returns.)
By mid-August, 2011, U.S. government debt had been downgraded by Standard
OTC Markets Group does not regulate the OTC marketplace. It is neither a stock exchange nor self-regulatory organization (SRO) and is not itself regulated by FINRA or the SEC.
Arithmetic scales are useful for short-term charts and trading. Price movements (particularly for stocks) are shown in absolute dollar terms and reflect movements dollar for dollar.
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Key Reasons To Invest In Real Estate
The global economic recession of 2008 is often linked to the United States housing bubble and subprime mortgages. In the aftermath of the recession, there was much negative sentiment over the real estate sector and few were inclined to consider investments into the sector, in a positive sense.
However, real estate investment is simply the purchase of a future income stream from property and quite undeserving of the tarnish to its reputation. Here are some of the key reasons to invest in real estate. (For a complete look back at the mortgage meltdown, check out ourInvestopedia Special Feature – Subprime Mortgages.)
Competitive Risk-Adjusted Returns
Based on data from the National Council of Real Estate Investment Fiduciaries (NCREIF), private market commercial real estate returned an average of 8.4% over the 10-year period from 2000 to 2010. This credible performance was achieved, together with low volatility relative to equities and bonds, for highly competitive risk-adjusted returns.
Critics would argue that the low volatility characteristic of real estate is the result of infrequent real estate transactions. This means that property values are often determined by third-party appraisals, which tend to lag the market. The infrequent transactions and appraisals result in a smoothing of returns, as reported property values underestimate market values in an upturn and overestimate market values in a downturn.
While its true that historic estimates of real estate volatility should be adjusted upward, real time markets are vulnerable to sudden unexpected shocks. A good example of this would be the Flash Crash of May 2010, when $1 trillion in stock market value was erased in just 15 minutes. In an environment where market volatility is an issue and the dynamics of algorithmic trading are murky, the more stable pricing of real estate is attractive. (For more, see Did ETFs Cause The Flash Crash?)
NCREIF U.S. National Property Index Returns
Source: NCREIF, http://www.ncreif.org/property-index-returns.aspx, 14 July 2011
High Tangible Asset Value
Unlike stocks and, to some extent, bonds, an investment in real estate is backed by a high level of brick and mortar. This helps reduce the principal-agent conflict, or the extent to which the interest of the investor is dependent on the integrity and competence of managers and debtors. Even real estate investment trusts (REITs), which are listed real estate securities, often have regulations that mandate a minimum percentage of profits be paid out as dividends.
Attractive and Stable Income Return
A key feature of real estate investment is the significant proportion of total return, accruing from rental income over the long term. Over a 30 year period from 1977 to 2007, close to 80% of total U.S. real estate return was derived from income flows. This helps reduce volatility as investments that rely more on income return, tend to be less volatile than those that rely more on capital value return. (For more, check out Take Advantage Of A Housing Crisis – Rent!)
Real estate is also attractive when compared with more traditional sources of income return. The asset class typically trades at a yield premium to U.S. Treasuries and is especially attractive in an environment where Treasury rates are low.
Portfolio Diversification
Another benefit of investing in real estate is its diversification potential. Real estate has a low, and in some cases, negative, correlation with other major asset classes. This means the addition of real estate to a portfolio of diversified assets can lower portfolio volatility and provide a higher return per unit of risk.
Inflation Hedging
The inflation hedging capability of real estate, stems from the positive relationship between GDP growth and demand for real estate. As economies expand, the demand for real estate drives rents higher and this, in turn, translates into higher capital values. Therefore, real estate tends to maintain the purchasing power of capital, by passing some of the inflationary pressure on to tenants and by incorporating some of the inflationary pressure, in the form of capital appreciation.
The Drawback: Illiquidity
The main drawback of investing in real estate is illiquidity, or the relative difficulty in converting an asset into cash and cash into an asset. Unlike a stock or bond transaction, which can be completed in seconds, a real estate transaction can take months to close. Even with the help of a broker, simply finding the right counterparty can be a few weeks of work.
That said, advances in financial innovation have presented a solution to the issue of illiquidity, in the form of listed REITs and real estate companies. These provide indirect ownership of real estate assets and are structured as listed corporations. They offer better liquidity and market pricing, but come at the price of higher volatility and lower diversification benefits.
The Bottom Line
Real estate is a distinct asset class that is simple to understand and can enhance the risk and return profile of an investors portfolio. On its own, real estate offers competitive risk-adjusted returns, with less principal-agent conflict and attractive income streams. It can also enhance a portfolio, by lowering volatility through diversification. Though illiquidity can be a concern for some investors, there are ways to gain exposure to real estate, such that illiquidity is reduced, if not brought on-par with that of traditional asset classes.
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Candlestick Chart
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Alternative Assets For Average Investors
Alternative assets can bring significant benefits to investment portfolios through diversifying exposure away from traditional fixed income and equity assets. Moreover, alternative assets are no longer the exclusive province of the super-wealthy; if fact, the average retail investor can avail him- or herself of a wide range of alternative asset strategies through traditional vehicles, including mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs). This article will serve as a guide to understanding the different types of alternative assets, and how they can be effectively used to enhance portfolio diversification. (For more on the basics of asset allocation, read Asset Allocation Strategies.)
Defining Alternative Assets
Whats an alternative asset? We can, perhaps, start by explaining what an alternative asset is not: it is not a direct fixed-income or equity claim on the assets of an issuing entity. For example, a holder of a senior secured bond owns a claim on certain specified assets of the issuer, like residential property or farm equipment. In the event of liquidation, an issuers secured and unsecured bondholders are paid off according to the seniority of their claims. Equity investors, by definition, own a claim on the residual net worth of the company after all its liabilities have been paid off, whether this amount is a lot or nothing at all.
Single-Asset Alternatives
Alternative assets are none of the above, which is why they are called alternative. An example of an alternative asset is a commodity futures contract. The contract gives its owner the obligation to take delivery of some object of value, like gold or pork bellies or Japanese yen, at some specified point in the future. An option on this futures contract would confer the right (not the obligation) to exercise the contract at one or more defined times during its life, or to let the option expire as worthless. Options and futures are derivatives: they derive their value from an underlying source, such as gold or pork bellies. (To learn the basics of derivatives, read The Barnyard Basics Of Derivatives and Are Derivatives Safe For Retail Investors?)
Pooled Vehicles
In addition to single-asset instruments, the term alternative assets also refers to pooled investment vehicles (multiple investors money is pooled by one manager) constructed to possess a different risk and reward matrix from traditional debt or equity investments. Pooled alternative vehicles can come in the same forms as their traditional counterparts - such as SEC-registered mutual funds or separately managed accounts (SMAs). They can also be unregistered vehicles like hedge funds, venture capitals or private-equity funds. These funds typically employ a combination of securities, some standard and some alternative. (For more on SMAs, read Separately Managed Accounts: A Mutual Fund Alternative.)
Low Correlation and Absolute Return
Alternative assets come in many varieties, but a common thread is their low correlation coefficients with both equities and fixed income. Consider the following chart:
Figure 1
Source: Zephyr
The most difficult decision is the investment decision which should be based on thorough research on the company and security. OTCMarkets.com provides investors with comprehensive, in-depth data, including trade data, company news, and company financials to help facilitate an investor’s investment decisions.
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However, there is other information not readily available to the public that is not fully reflected in the price.
The Importance Of Diversification
Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true, and how to accomplish diversification in your portfolio. (To learn more, see Diversification: Protecting Portfolios From Mass Destruction.)
Different Types of Risk
Investors confront two main types of risk when investing:
• Undiversifiable - Also known as systematic or market risk, undiversifiable risk is associated with every company. Causes are things like inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated, or reduced, through diversification; it is just a risk that investors must accept.
• Diversifiable - This risk is also known as unsystematic risk, and it is specific to a company, industry, market, economy or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events.
Why You Should Diversify
Lets say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike, and that all flights are canceled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value. If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.
But, you could diversify even further because there are many risks that affect both rail and air, because each is involved in transportation. An event that reduces any form of travel hurts both types of companies - statisticians would say that rail and air stocks have a strong correlation. Therefore, to achieve superior diversification, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.
Its also important that you diversify among different asset classes. Different assets - such as bonds and stocks - will not react in the same way to adverse events. A combination of asset classes will reduce your portfolios sensitivity to market swings. Generally, the bond and equity markets move in opposite directions, so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another. (To learn more about asset class, see Five Things To Know About Asset Allocation.)
There are additional types of diversification, and many synthetic investment products have been created to accommodate investors risk tolerance levels; however, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market.
Unfortunately, even the best analysis of a company and its financial statements cannot guarantee that it wont be a losing investment. Diversification wont prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.
How Many Stocks You Should Have
Obviously owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries. (To learn more about what constitutes a properly diversified stock portfolio, see Over-Diversification Yields Diminishing Returns. To learn about how to determine what kind of asset mix is appropriate for your risk tolerance, see Achieving Optimal Asset Allocation.)
Conclusion
Diversification can help an investor manage risk and reduce the volatility of an assets price movements. Remember though, that no matter how diversified your portfolio is, risk can never be eliminated completely. You can reduce risk associated with individual stocks, but general market risks affect nearly every stock, so it is important to diversify also among different asset classes. The key is to find a medium between risk and return; this ensures that you achieve your financial goals while still getting a good nights rest.
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This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced the price back down. Even after this selling pressure, the close remained above the open.
Short selling is a trading strategy where an investor, believing that a security is over-valued, borrows (from a broker-dealer or institutional investor) and sells a security and then repurchases and returns (to the broker-dealer or institutional investor) the security at a lower price. The difference between the sale price and the purchase price is the investor’s profit.
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Why Expense Ratios Are Important To Investors
The most valuable pieces of advice ever shared regarding investing of any kind, in ascending order of importance:
1. Fundamental analysis is crucial. Technical analysis is akin to fortune telling by interpreting patterns in tea leaves.
2. Its not a game or a hobby. Spend hours researching an investment when others are spending minutes. Spend days when others are spending hours. Done right, youll still enjoy a stupendous return on your time.
3. You make your money going in.
Its straightforward math, and easy to overlook or dismiss in its simplicity. An overpriced asset is that much harder to gain a return on than an underpriced or properly priced one. Wait for a real estate bubble (or, say, the hoopla surrounding a social networking sites much-anticipated initial public offering) to subside and then buy; yourmargin for error and potential for return should increase correspondingly.
The Price of Management
Were not talking about normal price fluctuations, here, or the inherent unpredictability that comes with almost any investment. Rather, were looking at whats essentially a surcharge on the price of the investment, levied before you buy. For example, take two new cars with the same model, same color and same options. One dealer sells the first vehicle for $22,000, out the door. The other sells the identical vehicle for $22,000, but with a $495 non-negotiable advertising and marketing assessment. Do you need to be told to buy the former? Its like purchasing a residential air filter in Vancouver, Washington (and paying 8% state sales tax) instead of going across the river and buying the same thing in Portland (Oregon levies no sales tax).
This is how it goes with mutual funds, the financial product of choice for most casual and many sophisticated investors. While no two funds are indistinguishable, two similarly constituted funds can come with price tags that differ considerably. Why? Varying expense ratios.
Its understandable that a mutual funds price costs more than the prices of its components. It costs money to create a fund. The fund has to be set up, registered and maintained. The firm that created it and that hired its managers has to be compensated. However, to what tune? The U.S. Securities
A resistance breakout signals that demand (bulls) has gained the upper hand and a support break signals that supply (bears) has won the battle.
Compliance with the Information Requirement of SEA Rule 15c2-11 – To initiate quotations on an inter-dealer quotation system for an OTC security not currently being quoted or to resume quotations after a four day absence or SEC suspension, a market maker must submit a Form 211 to FINRA. Once FINRA approves the 211, the market maker may submit a quotation to the applicable inter-dealer quotation system(s) they selected on the Form 211.
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7 Lessons To Learn From A Market Downturn
You can never really understand investing until you weather a market downturn. The valuable lessons learned can help you through the bad times and can be applied to your portfolio when the economy recovers. Listed below are some common investor experiences during tough economic times and the lessons each investor can come away with after surviving the events.
Lesson #1: Evaluate Your Egg Baskets
Youre pulling your hair out because everything you invest in goes down. The lesson: Always keep a diversified portfolio, regardless of current market conditions.
If everything you own is moving in the same direction, at the same rate, your portfolio is probably not well diversified, and you could stand to reconsider your asset-allocation choices. The specific assets in your portfolio will depend on your objectives and risk-tolerance level, but you should always include multiple types of investments. (Read Personalizing Risk Tolerance to find out how much uncertainty you can stand.)
Taking a more conservative stance to preserve capital should mean changing the percentages of holdings from aggressive, risky stocks to more conservative holdings, not moving everything to a single investment type. For example, increasing bonds and decreasing small-cap growth holdings maintains diversification, whereas liquidating everything to money market securities does not. Under normal market conditions, a diversified portfolio reduces big swings in performance over time. (For more information, read Diversification: Its All About (Asset) Class.)
Lesson #2: No Such Thing as a Sure Thing
That stock you thought was a sure thing just tanked. The lesson: Sometimes the unpredictable happens. It happens to the best analysts, the best fund managers, the best advisors, and, it can happen to you.
The perfect chart interpretation, fundamental analysis, or tarot card reading wont predict every possible incident that can impact your investment.
• Use due diligence to mitigate risk as much as possible.
• Review quarterly and annual reports for clues on risks to the companys business as well as their responses to the risks.
• You can also glean industry weaknesses from current events and industry associations.
More often, an investment is impacted by a combination of events. Dont kick yourself over unpredictable or extraordinary events like supply-chain failures, mergers, lawsuits, product failures, etc. (Learn how to find companies that manage risk well in The Evolution Of Enterprise Risk Management.)
Lesson #3: Proper Risk Management
You thought an investment was risk-free, but it wasnt. The lesson: Every investment has some type of risk.
You can attempt to measure the risk and try to offset it, but you must acknowledge that risk is inherent in each trade. Evaluate your willingness to take each risk. (See Measuring And Managing Investment Risk for information on keeping necessary risk under control.)
Lesson #4: Liquidity Matters
You always stay fully invested, so you miss out on opportunities requiring accessible cash. The lesson: Having cash in a certificate of deposit (CD) or money market account enables you to take advantage of high-quality investments at fire sale prices. It also decreases overall portfolio risk.
Penny stocks are the secret to 2000% profits!
Plan ahead to replenish cash accounts. For example, use the proceeds from a called bond to invest in the money market instead of purchasing a new bond.Sometimes cash can be obtained by reorganizing debt or trimming discretionary spending. Set a specific percentage of your overall portfolio to hold in cash. (Learn how to take advantage of the safety of the money market in our Money Market tutorial.)
Lesson #5: Patience
Your account balance is lower than it was last quarter, so you overhaul your investment strategy before taking advantage of your current investments. The lesson: Sometimes it takes the market an extended period of time to bounce back.
Your overall portfolio balance on a given date is not as important as the direction it is trending and expected returns for the future. The key is preparedness for the impending market upturn based on an estimated lag time behind market indicators. Evaluate your strategy, but remember that sometimes patience is the solution. (Doing nothing can mean good returns. Find out more in Patience Is A Traders Virtue.)
Lesson #6: Be Your Own Advisor
The market news gets bleaker every day - now youre paralyzed with fear! The lesson: Market news has to be interpreted relative to your situation.
Sometimes investors overreact, particularly with large or popular stocks, because bad news is replayed continuously via every news outlet. Here are some steps you can follow to help you keep your head in the face of bad news:
• Pay attention and understand the news, then analyze the financials yourself. (Read What You Need To Know About Financial Statements for help.)
• Determine if the information represents a significant downward financial trend, a major negative shift in a companys business, or just a temporary blip.
• Listen for cues the company may be downgrading its own expected returns. Find out if the downgrade is for one quarter, one year or if it is so abstract you cant tell.
• Conduct an industry analysis of the companys competitors.
After a thorough evaluation, you can decide if your portfolio needs a change. (For more information, read Do You Need a Financial Advisor?)
Lesson #7: When to Sell and When to Hold
The market indicators dont seem to have a silver lining. The lesson: Know when to sell existing positions and when to hold on.
Dont be afraid to cut your losses. If the current value of your portfolio is lower than your cost basis and showing signs of dropping further, consider taking some losses now. Remember, those losses can be carried forward to offset capital gains for up to seven years. (For more information, read Selling Losing Securities For A Tax Advantage.)
Selective selling can produce cash needed to buy investments with better earnings potential. On the other hand, maintain investments with solid financials that are experiencing price corrections based on expected price-earnings ratios. Make decisions on each investment, but dont forget to evaluate your overall asset allocation. (Read more in Asset Allocation: One Decision To Rule Them All.)
Conclusion
Downward stock market swings are inevitable. The better-prepared you are to deal with them, the better your portfolio will endure them. You may have already learned some of these lessons the hard way, but if not, take the time to learn from others mistakes before they become yours.
Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company's business and being able to place it in a group can make a huge difference in relative valuations.
Investors must define the order they wish the broker-dealer to execute. There are two main order types: the Limit Order and the Market Order.
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At this point though, we are still unsure if a large trading range will develop. The subsequent low in December, which was just higher than the October low, offers evidence that a trading range is forming, and we are ready to set the support zone.
10 Tips For The Successful Long-Term Investor
While it may be true that in the stock market there is no rule without an exception, there are some principles that are tough to dispute. Lets review 10 general principles to help investors get a better grasp of how to approach the market from a long-term view. Every point embodies some fundamental concept every investor should know.
1. Sell the losers and let the winners ride!
Time and time again, investors take profits by selling their appreciated investments, but they hold onto stocks that have declined in the hope of a rebound. If an investor doesnt know when its time to let go of hopeless stocks, he or she can, in the worst-case scenario, see the stock sink to the point where it is almost worthless. Of course, the idea of holding onto high-quality investments while selling the poor ones is great in theory, but hard to put into practice. The following information might help:
• Riding a Winner - Peter Lynch was famous for talking about tenbaggers, or investments that increased tenfold in value. The theory is that much of his overall success was due to a small number of stocks in his portfolio that returned big. If you have a personal policy to sell after a stock has increased by a certain multiple - say three, for instance - you may never fully ride out a winner. No one in the history of investing with a sell-after-I-have-tripled-my-money mentality has ever had a tenbagger. Dont underestimate a stock that is performing well by sticking to some rigid personal rule - if you dont have a good understanding of the potential of your investments , your personal rules may end up being arbitrary and too limiting. (For more insight, see Pick Stocks Like Peter Lynch.)
• Selling a Loser - There is no guarantee that a stock will bounce back after a protracted decline. While its important not to underestimate good stocks, its equally important to be realistic about investments that are performing badly. Recognizing your losers is hard because its also an acknowledgment of your mistake. But its important to be honest when you realize that a stock is not performing as well as you expected it to. Dont be afraid to swallow your pride and move on before your losses become even greater.
In both cases, the point is to judge companies on their merits according to your research. In each situation, you still have to decide whether a price justifies future potential. Just remember not to let your fears limit your returns or inflate your losses. (For related reading, check out To Sell Or Not To Sell.)
2. Dont chase a hot tip.
Whether the tip comes from your brother, your cousin, your neighbor or even your broker, you shouldnt accept it as law. When you make an investment, its important you know the reasons for doing so; do your own research and analysis of any company before you even consider investing your hard-earned money. Relying on a tidbit of information from someone else is not only an attempt at taking the easy way out, its also a type of gambling. Sure, with some luck, tips sometimes pan out. But they will never make you an informed investor, which is what you need to be to be successful in the long run. (Find what you should pay attention to - and what you should ignore in Listen To The Markets, Not Its Pundits.)
3. Dont sweat the small stuff.
As a long-term investor, you shouldnt panic when your investments experience short-term movements. When tracking the activities of your investments, you should look at the big picture. Remember to be confident in the quality of your investments rather than nervous about the inevitablevolatility of the short term. Also, dont overemphasize the few cents difference you might save from using a limit versus market order.
Granted, active traders will use these day-to-day and even minute-to-minute fluctuations as a way to make gains. But the gains of a long-term investor come from a completely different market movement - the one that occurs over many years - so keep your focus on developing your overall investment philosophy by educating yourself. (Learn the difference between passive investing and apathy in Ostrich Approach To Investing A Bird-Brained Idea.)
4. Dont overemphasize the P/E ratio.
Investors often place too much importance on the price-earnings ratio (P/E ratio). Because it is one key tool among many, using only this ratio to make buy or sell decisions is dangerous and ill-advised. The P/E ratio must be interpreted within a context, and it should be used in conjunction with other analytical processes. So, a low P/E ratio doesnt necessarily mean a security is undervalued, nor does a high P/E ratio necessarily mean a company is overvalued. (For further reading, see our tutorial Understanding the P/E Ratio.)
4. Resist the lure of penny stocks .
A common misconception is that there is less to lose in buying a low-priced stock. But whether you buy a $5 stock that plunges to $0 or a $75 stock that does the same, either way youve lost 100% of your initial investment . A lousy $5 company has just as much downside risk as a lousy $75 company. In fact, a penny stock is probably riskier than a company with a higher share price, which would have more regulations placed on it.
6. Pick a strategy and stick with it.
Different people use different methods to pick stocks and fulfill investing goals. There are many ways to be successful and no one strategy is inherently better than any other. However, once you find your style, stick with it. An investor who flounders between different stock-picking strategies will probably experience the worst, rather than the best, of each. Constantly switching strategies effectively makes you a market timer, and this is definitely territory most investors should avoid. Take Warren Buffetts actions during the dotcom boom of the late 90s as an example. Buffetts value-oriented strategy had worked for him for decades, and - despite criticism from the media - it prevented him from getting sucked into tech startups that had no earnings and eventually crashed. (Want to adopt the Oracle of Omahas investing style? See Think Like Warren Buffett.)
7. Focus on the future.
The tough part about investing is that we are trying to make informed decisions based on things that have yet to happen. Its important to keep in mind that even though we use past data as an indication of things to come, its what happens in the future that matters most.
A quote from Peter Lynchs book One Up on Wall Street (1990) about his experience with Subaru demonstrates this: If Id bothered to ask myself, How can this stock go any higher? I would have never bought Subaru after it already went up twentyfold. But I checked the fundamentals, realized that Subaru was still cheap, bought the stock, and made sevenfold after that. The point is to base a decision on future potential rather than on what has already happened in the past.
8. Adopt a long-term perspective.
Large short-term profits can often entice those who are new to the market. But adopting a long-term horizon and dismissing the get in, get out and make a killing mentality is a must for any investor. This doesnt mean that its impossible to make money by actively trading in the short term. But, as we already mentioned, investing and trading are very different ways of making gains from the market. Trading involves very different risks that buy-and-hold investors dont experience. As such, active trading requires certain specialized skills.
Neither investing style is necessarily better than the other - both have their pros and cons. But active trading can be wrong for someone without the appropriate time, financial resources, education and desire.
9. Be open-minded.
Many great companies are household names, but many good investments are not household names. Thousands of smaller companies have the potential to turn into the large blue chips of tomorrow. In fact, historically, small-caps have had greater returns than large-caps; over the decades from 1926-2001, small-cap stocks in the U.S. returned an average of 12.27% while the Standard
Firms may also negotiate trades over the phone. While the same process and rules apply, the speed with which trades are executed is inherently slower than OTC Link.
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After we have explored this area, we will then take a closer look at the random walk theory, fundamental analysis and technical analysis.
An Introduction To Securities Markets
The global securities market has been constantly evolving over the years to serve the needs of traders. Traders require markets that are liquid, with minimal transaction and delay costs, in addition to transparency and assured completion of the transaction. Based on these core requirements, a handful of securities market structures have become the dominant trade execution structures in the world. In this article, well take a look at some of the most popular market structures currently in use.
Quote-Driven Markets
Also called dealer markets, quote-driven markets are those in which the buyers and sellers engage in transactions with market makers, or dealers. The market makers post the bid and ask quotes for an inventory of stocks that they are willing to buy from, and sell to traders. Only certain dealers are allowed to perform the market making function and in return, they receive privileges, such as the right to post quotes, the ability to get information on the order flow and book, and generally lower or no fees paid to the exchanges.
Quote-driven markets are common in over-the-counter (OTC) markets such as bond markets, the forex market and some equity markets. The Nasdaq and London SEAQ are two examples of equity markets that have their roots as a quote-driven market. It should be noted that the Nasdaq structure also contains aspects of an order driven market.
The advantages of a quote driven market are typically best seen in illiquid markets. In securities that are thinly traded (low volume), dealers can step in to improve liquidity for traders, by maintaining an inventory of the security. In exchange for providing this liquidity, dealers make money from the spread between the bid and ask quotes. To generate profits, dealers will attempt to buy low (at the bid) and sell high (at the ask) and have high turnover.
Order Driven Markets
Another major dominant market structure type is an order driven market. In this type of market, the exchange matches buyers and sellers with each other and there is no middle man, like there is with quote driven markets. Price discovery is determined by the limit order of traders in the particular security. Most order-driven markets are based on an auction process, where buyers are looking for the lowest prices and sellers are looking for the highest prices. A match between these two parties results in a trade execution.
The biggest benefit of an order driven market in liquid markets, is the large number of traders willing to buy and sell the security. Generally, the larger the number of traders in a market, the more competitive the prices become; this theoretically translates into better prices for traders. The downside to this type of market is that in securities with few traders, the liquidity can be poor. An example of an order-driven market is the Toronto Stock Exchange (TSX), in Canada.
In addition, there are two main types of order driven markets, a call auction and a continuous auction market. In a call auction market, orders are collected during the day and at specified times an auction takes place, to determine the price. On the other hand, a continuous market, as the name suggests, operates continuously during trading hours and trades are executed whenever a buy and sell order match up. (For additional reading, check out: What Is The Difference Between A Quote Driven Market And An Order Driven One?)
Hybrid Markets
A third popular market structure, a category in which the New York Stock Exchange (NYSE) falls in, is the hybrid market, also known as a mixed market structure. The hybrid market combines features from both a quote-driven market and an order driven market. Although dominantly an order driven market that matches buyers and sellers, the NYSE also utilizes dealers to provide liquidity, in the event of low liquidity periods. In addition to being a hybrid market, the NYSE is also a continuous auction market.
Brokered Markets
The last market structure well look at in this article is the brokered market. In this market, brokers are the middle men who find counterparties for trades. When a client asks their broker to fill an order, the broker will search their network for a suitable trading partner. Often, brokered markets are only used for securities that have no public market, these are generally unique or illiquid securities, or both. Common uses of the brokered markets are for large block trades in bonds or illiquid stocks. (To know more about broker, read: What Is The Difference Between A Broker And A Market Maker?)
The direct real estate market is also a good example of a brokered market. This market contains assets that are relatively unique and illiquid. Clients generally require the assistance of real estate brokers to find buyers for their home. In these types of markets, a dealer wouldnt be able to hold an inventory of the asset, like in a quote-driven market, and the illiquidity and low frequency of transactions in the market would make an order-driven market infeasible, as well.
The Bottom Line
There are different types of market structures simply because traders have different needs. The type of market structure can be very important in determining overall transaction costs of a large trade and can affect the profitability of a trade. In addition, if you are developing trading strategies, sometimes the strategy may not work well across all market structures. Knowledge of these different market structures can help you determine the best market for your trades.
The large number of American Depositary Receipts (ADRs) and Foreign Ordinaries that trade in the OTC market (e.g., Roche – RHHBY, adidas – ADDYY) make price imbalance a concern for OTC traders and investors. ADRs represent a set ratio of home market shares; thus, movement in the home market price and foreign exchange considerations will directly affect the price of the ADR. Foreign Ordinaries should theoretically mirror home market trading once currency rates are considered.
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As new information becomes available, the market assimilates the information by adjusting the security's price up (buying) and down (selling).
The OTC market and broker-dealers’ activities in the market are regulated by The Financial Industry Regulatory Authority (FINRA), the U.S. Securities and Exchange Commission (SEC) and various state securities regulators. As well, companies with SEC-registered securities are regulated by the SEC. OTC Markets Group is neither a stock exchange nor a self-regulatory organization (SRO).
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