How do stocks create wealth for
people (who we call equity investors?)
The response to this question has many parts. Two are:
a) recognizing the fact that stocks do create wealth for their owners over
the long run
b) understanding the reason (or reasons) why they (stocks) do
Prof Jeremy J Siegel (Stocks For The Long Run, 1998, page 52) said, inter alia
“the gains which accrue so assuredly
to the long term stockholder, must
be the centre of most people’s
investment strategy. The doctrine that
common stocks provide the best way
to accumulate long term wealth, first
expounded by Edgar Lawrence Smith,
nearly 75 years ago, has been reconfirmed
in all subsequent research”
Lets use the selling price of BNS
shares, at different times, to illustrate
point a). At the end of 1995, each
share of BNS was traded on the JSE
for J$6.80. At the end of 2004 (ten
years later) the same BNS share was
traded for J$50.51 If John Brown (or
Mrs. Mary Jane Brown) had bought1,000
of those shares in Dec 1995 he would
have paid (disregarding cess and charges)
J$6,800 for them. If he (or she) had
sold them at Dec 2004, he/she would
have received (disregarding cess and
charges) J$50,510. Disregarding the
effect of inflation (which eats away
the purchasing value of money over
time) the surplus going to Mr Jones’ (or
Mrs. Jones’) bottom line (meaning
bank balance!) would be J$50,510 minus
J$6,800 equal J$43,710. This is a good
illustration of the power of the stock
market to create wealth for people
who own shares of listed companies.
There is, however, a very big caveat
in investing in stocks and shares.
This is, that, unlike when investing
in debt instruments (which have guaranteed
rates of return) there are no guarantees
whatever that an investor will make
any profit (or not lose his total capital)
on his/her investment in stocks and
shares. See Response to Ques # 32
What is
a ‘bull’ market?
The financial industry uses many colourful words/phrases to describe different
happenings in the investment arena. ‘Bull’ and ‘bear’ are
two such. Think of a charging bull and it conveys the essence of a ‘bull’ market’…one
in which the price of stocks are going up and up and creating more wealth for
those who own them! A ‘bullish’ investor is one who thinks that
the price of stocks (or the market or economy) is on a sustained upswing. Low,
or falling interest rates usually tend to encourage ‘bull’ markets.
Most investors would likely agree that Caribbean stock markets have had the
following ‘bull runs’
a) JSE…..Sept. 1988 (1295.73 points to Jan 28, 1993 (32,421.71 points)
a run of 52 weeks and Feb. 23, 2001 (28,026.70 points) and continuing at Dec
2004 (112,6565.51) for a run of 47 months to date
b) T&TSE……….
c) BSE………..
d) ECSE………
See Essay ‘The JSE Is A Winner’
What is a ‘bear’ market?
Bear markets are the opposite of bull markets i.e. sustained very low or falling
stock prices. Investors with different time horizons may have different perspectives
on bear markets. Most seem to agree, however, that a bear market is one that
suffers a drop of 20% or more in market value over a sustained period. Especially
for very short term investors, a bear market is a curse! It destroys equity values ‘over
night’ where this ‘night’ can be months, or even years such
as the ‘decade of the nineties’ when the JSE index hit the floor
and stayed there. For very long term investors, however, (think of parents who
buy stocks for their babies and young people in their 20s, 30, and 40s) falling
stock prices are a ‘godsend’, meaning, it allows the investor to
buy up good stocks on the cheap to sell back when the market is in the next bull
phase! Unfortunately, only the most discerning investors see this opportunity
in bear markets. The NCB Group provides an outstanding illustration of the promise
in bear markets. In early March 1999, these shares dropped to J$0.80 (eighty
cents each) and anybody (who thought NCB and the market would rebound) could
buy truckloads of it for next to nothing, and some did! Since then, the stock
has gone as high as J$31.70 (April 27, 2004) generating a return of 3,862.5%
in exactly five years! Bear markets are generally considered to have two phases…the
first part going down to the lowest level and the second, or recovery part, in
which the market returns to the previous high point. On this basis, the Jamaican
bear of the 1990s started immediately after the highpoint of Jan 28, 1993 (32,421.71
pts) and continued to Jan 26, 1994 (10,648.64 pts) a decline of 21,773.07 pts
or 67.16% over twelve (12) months. From this low point, it took 87 months to
return to the former high point of 32,400+ points, specifically 32,607.58pts
on April 12, 2000. In total therefore, it could be said that this bear was a
monster and lasted from Jan 28, 1993 to April 12, 2000, a period of eight plus
years (99 months). Many investors would probably agree that the Caribbean markets
have experienced the following bears:
a) JSE…..Feb. 01 1993 (32,062.41) down to Jan 26, 1994 (10,648.64) and
back up to April 12, 2000 (32,607.58) a total of 99 months
b) T&TSE….
c) BSE…..
d) ECSE………
See Essay ‘The JSE Is A Winner’
What is a market crash?
The term ‘crash’ says it all! Somewhat like a car crash! Everything
comes tumbling down, though not necessarily to a halt. When this happens in a
stock market, stocks lose significant value in a very short time….like
a day!. This means, that a stock market that was selling at a particular index
range just before the crash, could drop to any level 10%, 20% or a lot more and
stay there (or go lower) until the cause for the crash is identified and remedied.
Most people, even if not investors, would have heard of the 1929 stock market
crash in America. It caused many rich men to become poor. Many others would have
heard of the more recent crash of Oct. 19, 1987. On that day, the New York Stock
Exchange lost 508 points or 22.6 % of its value and this sent shivers throughout
the entire American and world economy. Market crashes have causes even if everyone
does not agree on all of them. One generally accepted cause is a highly overpriced
market especially at a time when investors do not have a lot of confidence in
the management of an economy. Most Caribbean investors would likely agree that
although our markets have suffered some important bears, they have not had any
precipitous rapid-fire falls that can be characterized as crashes. For example,
the 1993 fall off in the Jamaican market was as follows:
Ø 1st day after highpoint of 32,421.71..only 359 pts or roughly 1.1%
Ø Fall off for entire month of Feb 1993 only 4,956.92 pts or 15.29%
Against this background, Caribbean Markets have probably not suffered a fall
off that is severe enough to be characterized as a crash. Investors do lose money
in a crash. The important point, though, is that every crashed market rebounds.
And herein lies another ‘secret’ of wealth generation in a stock
market. This happens when long term investors buy up good stocks at good bargains
(heavy price discounts) because they know it is a matter of time (from only months
to many years) before it rebounds. See Essay The JSE is a Winner.
How do bonds create wealth for people
who invest in them?
Bonds are, in essence, loans….a ‘borrows’!!. When a government
(biggest borrowers anywhere) ‘issues’ bonds (that is to say it borrows
money from its citizens….people like you and me) it gives a commitment
to pay back the amount it borrows (principal) plus the money that the lenders
charge (interest) for the use of their money by said government. The key to how
bonds create wealth for lenders (called bondholders) resides in what the lenders
do with the interest when they get it. They can use it for many valid purposes.
Two are:
a) ‘consume’ it! That is, pay living expenses, school expenses or ‘blow
it” on the entertainment circuit, or
b) re-invest all or at least some of it in the same or another investment instrument.
When interest income is re-invested into an instrument bearing the same rate
of interest, the ‘Rule of 72’ predicts how long it will take for
the original principal to be doubled. One way to create wealth is to allow time,
and interest rate, to grow one’s investment through the magic of compounding.
See Ques #69 ‘What is the rule of 72’
Even without further compounding (and more wealth creation), investing in bonds
is a sure way to create wealth. Ralston Hyman, one of Jamaica’s leading
economists, estimates that, over the fiscal five year period of 1997/98 to 2002/3
the government of Jamaica paid out J$595B in bond interest to those of it’s
citizens who had lent their money to it. The question is, were you one of those
citizens who lent your money to the government, and, if not, why not? Lack of
awareness of the opportunities for creating wealth for yourself and your progeny?
How do money market funds create
wealth for people who invest in them?
See at Ques # 26 Money market funds are normally invested in debt and other liquid
instruments which earn interest income. These funds are usually managed by somebody
whose investment objective is to earn as much surplus as possible for the people
who invest their money it. When a person invests directly in a bond, he or she
usually gets the interest chegue directly and can re-invest or spend it as he/she
chooses. With a managed fund, the arrangement is a little different. Here, everybody’s
share of the surplus is lumped and put back into the fund. The net effect of
this is that the value of each unit of investment goes up and, if an investor
wants to ‘get’ his share of that surplus, the way for him/her to
do so is to sell some of his/her units. The difference between the price when
he sells and the price at which he bought will reflect his share of surplus or
profit on his investment. How can money market funds create wealth for small
investors? Leave the units in the fund to keep growing for a very long time
What are the reasons why the ownership
of stocks (and Bonds) are so
strongly recommended?
There are many reasons for this strong recommendation. They all boil down
to the fact that common shares (this is another name for stocks and shares),
have the unique ability to compound or ‘multiply’ their number and/or
value under certain conditions. Some of these ways of multiplying one or both
are via:
a) stock splits
b) bonus shares
c) Dividend re-investment
The net effect of a-c is to multiply or compound a shareholders number of shares
without him necessarily buying anymore from his pocket. John Jackson of the Investor’s
Choice Magazine has giving many illustrations of this going back to the inception
of the JSE. One example is about Courts Jamaica Ltd., one of the market’s
recent star performers. He said that an investment of J$100,000 in this stock
in 1991 would, by the end of 2004, be worth J$29.5 million even without re-investing
the many dollars of dividends that were paid over the period. Many people are
aware of this power of stocks to create wealth and are doing just that. Unfortunately,
many Caribbean people have involuntarily locked ourselves out of the wealth-building
capacity of common stocks because, firstly, we were never schooled in the art
of wealth creation, secondly, our information base is dominated by the stories
of losses (Bear markets) and thirdly, we have not fully accepted that wealth
creation is a long term process versus a one shot event like winning the lotto
jackpot. Accordingly, we have lost out on the over-compensating total returns
of good stock selection over the long term. See Essay # XYZ How Money Grows Parts
1-6
What is meant
by the ‘par
value’ of a stock?
Anyone with clean enough ears might often have heard the expression “age
is just a number” Who cares whether its high or low so long as its owner
is a “regular” guy, easy to get on with and still enjoying all the
fruits down here!.
In a roughly similar way, the par value of a stock is “just a number” It
is supposed to represent the paper value of one share of a company. When people
are building a house (of concrete blocks), everyone knows the price of each block.
This is the amount that was paid for it. A new limited liability company is similarly
made up of a number of “blocks” called shares. However, since these
new shares were created, (in an IPO) versus being bought from somebody else,
there is no hard and fast basis for pricing them and so, in many or most of these
cases, the Directors merely make what could be called an “educated guess” and
assign a dollar value! It’s as simple as this. The par value of a stock
is usually not much more than a conversation piece and has very little to do
with its market price. So much so, that the 2004 Jamaican Companies Act has discarded
par value altogether. Two illustrations of the uselessness of par values will
suffice. NCB Bank first sold its shares to the public in1986. When it reorganized
itself as a Group (NCB Group) in 1994 and resold itself (again to the public
before Michael Lee Chin came in 2002) it assigned itself a par value of J$0.50
(fifty cents) but charged us the public J$5.00 for each of them! Not to be out-done,
in more recent times (Jan 2003) JMMB created 1.463M shares of par value J$0.25
(twenty five cents) but invited us to pay J$4.15 for each (which we did with
much anticipation). What’s the value of par?! Nada! Zilch! Or, as some
guys might say ‘zinc’!! It really is ‘nothing but a number’!
What are stock splits?
When a company is being formed, or an existing one is thinking of expansion,
the directors go through a thinking process that is somewhat like when a family
is thinking of building a house. The family will consider “how many rooms
will be adequate for the number of parents, children and/or in-laws?” If
they can afford it, they will build a house big enough to hold everybody. Many
times however, they have to start where they can, with a one or two bedroom house,
and make additions as more money becomes available. A roughly similar thinking
happens with companies, and many times the directors conclude that they need
to have more “blocks of ownership”, i.e. shares in order to achieve
specific organizational objectives. Accordingly, a company that started with
1,000,000 shares might split each into two or three, to form 2,000,000 or 3,000,000
shares! Two Jamaican illustrations of stock splits are Life of Jamaica in the
1990s and, more recently, Jamaica Money Market Brokers (JMMB), immediately before
they went public in January 2003. In, or about 1991 LOJ, in one fell swoop, created
40 shares where only one existed prior. This was during one of the bull runs
on the JSE (which, incidentally, was a forerunner of a very big ‘bear’ in
1993!) LOJ did this by splitting each J$1.00 share (par value J$1.00) into ten
10 cent shares (J$0.10) and simultaneously giving a 4 for 1 (4:1) bonus. This
four for one (4:1) bonus meant that, if a shareholder had 100 shares right after
the split, (from his original ten shares before the split) it would be multiplied
by four (4) and become four hundred (400). As easy as that! From an original
ten to 400 shares!. How was this possible? Because, at the time, LOJ was a high
flier in a bull market and, in bull markets when everyone tends to be giddy from
high optimism, almost anything goes. This double whammy does not happen everyday!
When it does, it is one of the best illustrations of the wealth-creating capacity
of stock ownership. All this was before the great Jamaican Market correction
of Feb. 01, 1993 when the JSE went from 32,341 points, to13,100 at Dec, continued
to 10,649 at Jan 1994 and stayed low for the rest of the decade.
On the other hand, the JMMB which went public in Jan 2003, did a 4 for one (4:1)
split prior to coming to the market, and thus created 4 shares where only 1 existed
prior. In the space of a breadth, the number of shares in the company went up
by a factor of four from 365,846,688 units to 1,463,386,752 units. An international
illustration of stock splits, is the mighty Microsoft which has made many millionaires
of its initial shareholders and employees. They kept on getting more and more
shares at each stock split and saw the market paying more and more for each of
these “smaller” Microsoft shares! Interestingly, because Microsoft
has an ESOP, many employees also became millionaires
What are ‘bonus’ shares?
The clue is in the word “bonus” – something “extra” When
some companies
(stocks) do well consistently, i.e. make good amounts of profit, the price of
their share usually goes up. Many times, this price goes so high that there is
a tendency for investors to shy away from buying them because, they are looking
at the price instead of looking at the value of the share. When it is perceived
that this is so, many companies will increase the number of shares by offering
(issuing) extra shares to existing shareholders at no cost to these shareholders.
When this happens, the market price of each share will drop and likely bring
it back into the price range where potential buyers are more comfortable in buying
it. The beauty with giving bonus shares is that they increase each shareholder’s
holding by the same percentage so everyone retains their relative ownership rank.
Additionally, overtime, the value of this higher number of shares also goes up.
So the shareholder is now better off if he sells his enlarged holdings at a higher
price and the value of the company (called market capitalization), goes up and
improves its market value ranking among its peer group of companies and on the
stock market as a whole. When companies ‘give’ bonus shares, it does
not cost the shareholder anything from his own pocket. Usually what happens is
that, instead of paying out its entire surplus in dividends, companies will ‘capitalize’ some
of it to pay for the shares that are distributed as bonus shares.
What does the term dividend mean?
When a company is successful and makes profit (surplus), it can do many things
with this profit.
Three of these things are:
a) use all of it to pay off debt (The trade likes to say ‘pay down’ debt
b) use all or some of it to expand its own operations
c) distribute all, or some of it to shareholders in cash
The amount that they distribute at c) is called dividend. Some investors do not
care much, sometimes, about stocks that pay dividend. They prefer what they call
growth stocks. These are stocks whose price tend to keep rising. On the other
hand, many others, including retired people, like dividend paying stocks, especially
those that pay it quarterly because, this way, they can use it to supplement
their living expenses. One of the many attractive things about dividends, especially
in times of high inflation, is that it gives back to a shareholder some of his
investment ‘now’, when the purchasing power of money is X, versus
when he sells his shares many moons down the road and the same purchasing power
is then X minus Y (i.e., the same amount of money will buy less goods and services.
In the USA where the culture of research is well established, they have calculated
(S&P 500 Index) that, since 1926, dividends have contributed fully 42% of
the total returns in stock market investment (and that, over the same period,
an investment in stocks has returned a yield of 10.8% per year compounded with
a corresponding return of only 7.8% where dividends were consumed (taken in cash)
instead of re-invested. In fact, it gets even better. Over the ‘shorter’ period
of 50 years, the yield, with re-invested dividends, goes up to13.6 % per year.
Many investors now load their portfolio with good dividend paying stocks. One
reason is the view that a stock that continually pays dividend is likely to be
one that is generating free cash flow and, this is seen as a major sign of a
successful company. Companies in the CSME who are regular dividend payers are
a) Jamaica ….BNS, etc, etc,
b) T&T…..
c) Barbados…
d) East Caribbean…..
In Jamaica, since 2002, dividends are no longer taxable in the hands of shareholders.
This is a major break for investing in the stock market but, apparently, many
people continue to be unaware of these wealth building benefits. One objective
of ‘TRY’ is to show the Caribbean Diaspora how to become investors
and get these benefits
What is free cash flow?
Free cash flow is the cash left over (to do new things) after a company has taken
care of its ‘must pay’ obligations. Running a large company is really
a bigger version of running a household. In what we sometimes call the ‘old
days’ family heads would ‘pencil out’ how the house money would
share (i.e. budget) for the things that must be done. If any ‘free’ money
was left over, they would use this amount for other things. In much the same
way, companies have commitments (expansion expenses, debt servicing and dividend
payments) Free cash flow is the money they still have after they have set aside
money for these payments (penciled them out)
What is capital gain (appreciation)?
Capital gain is the difference between what an investor gets for a good (lot
of land, house, car or shares in a stock) and what he paid for it. Ownership
of the shares of GraceKennedy Ltd provides a good illustration. At the last trading
day in Dec 1995, John Investor could buy this share for J$11.60. At the last
trading day ten years later (Dec 2004) he would get, if he sold, J$118 for the
same share. Disregarding the loss in purchasing power of money over the period,
John’s capital gain would be J$118.00-$11.60 =J$106.4 or 917.2%, over a
ten year period, not bad in any currency!! Capital gain attracts the attention
of many governments who use it as a basis for taxation. Currently, there is no
capital gain tax on stock market gains in Jamaica.
In the rest of the CSM the
situation is as follows:
a) T&T
b) Barbados
c) Eastern Caribbean States
What is total returns?
When anyone sells anything that he had bought previously, he wants to know if
he ‘made anything’ on the transaction. This point is illustrated
with the GracKennedy share (at Ques 41) In the same way that one can buy a house,
let it for rental income for a while and then sell at a higher price than he
bought it, investors can similarly earn some income without selling their shares
outright after buying them. This happens if the stock pays dividends as do many
companies. ‘Total returns’ is as the name implies. With stocks, it
is the two sources of ‘earnings’ (dividend and capital gain) compared
against the amount that was paid for the stock. Over the last ten years, each
share in GraceKennedy’s stock earned a total of approx 431 cents (J$4.31)
in dividends. Therefore the ‘total return’ from this investment is
J$106.4+$4.31=$110.71 divided by J$11.60, multiplied by 100=954.4% over the ten
(10) years
What are some of the strategies
through which money can grow (for anyone
who wants to build wealth?
There are many strategies that will grow one’s money. Four of these are:
a) Investing in the buying and selling of real estate either on a raw, or developed
basis (such as building houses or factories for sale or rent)
b) investing in what the trade calls debt instruments. This means lending one’s
money to the government or any reputable borrower such as companies in the private
sector. See at What is a Bond
c) Investing in the equities market which means buying and holding (or selling)
the shares of companies which are listed on a stock exchange.
d) Pursuing one’s own entrepreneurial initiatives
What does
the term ‘compound
interest’ mean?
Compound interest means getting interest on interest. It is one of the wealth
building secrets employed by many people to grow their wealth. It is a secret
that all members of the Caribbean Diaspora should know and practice. To understand
the concept, walk through the following illustration.
The charge for the use of money is called interest. This is what happens when
we borrow money from the bank…they charge us some money every month until
we return the money we borrowed. This charge is what we all call interest.
When we invest our money, however, instead of paying a charge, we are paid
a fee for its use by the person or institution who borrows it. So now, instead
of paying out interest, we receive it for the use of our money. Suppose, for
example, we deposit $100,000 (called the principal) to the bank (through a
Certificate of Deposit) or lend the Government (through one of their many Investment
Debentures) at 10% interest per annum?. Either would pay us $10,000 in interest
payment at year end. When that $10,000 interest is paid, we could either consume
it (as many do), or re-invest it in the same instrument. If we re-invest, our
investment (principal) immediately increases to $110,000. At the end of the
second year, the interest payment will now be $11,000 and, if this interest
is also re-invested in the same instrument at the same rate of 10% per annum,
the principal will now have grown from the original $100,000 to be $110,000
plus $11,000 = $121,000. By the end of the third year, the interest on this
new principal will be $12,100 and the principal will move up to $121,000 +
$12,100 = $133,000. The critical points should be noted here as follows:
a) the original principal of $100,000
keeps getting bigger. It is $133,000
after only three (3) years.
b) The interest earnings keep increasing each year. It has moved from
$10,000 at the end of the first year to $12,100 @ the end of only 3
years
c) The saver’s investment is growing bigger and bigger without him
putting one additional cent himself to his original investment of
$100,000.
Points (a) – (c) demonstrate
one of the biggest secrets of wealth
creation, that is, that when the annual
interest earned on an investment is
re-invested with the principal year
in, year out, (versus being consumed)
money will grow at a much faster rate
than if some or all of that interest
is consumed. This is a secret that
many families use to build wealth for
themselves and their progeny. They
have the discipline to “pledge” an
amount (principal, however small) to
the cause of wealth creation and to
leave it for the two basic elements
of wealth creation to make it grow.
These two basic elements are time (as
measured in decades) and the compounding
magic of interest rate (See at Rule
of 72 later)
What is meant
by the term ‘bonus
share compounding’
To begin with, you will not find this term in any financial text. It’s
an original! Think of compounding as in the case of growing your principal when
you re-invest interest from an investment (versus consuming it). In Q # 44, we
spoke of how a shareholder’s holding of shares in a company can be increased
through the giving of bonus shares without his purchasing any additional shares.
When a shareholder gets these shares, he has two choices about what to do with
them as follows:
a) sell them and consume the ‘windfall’ cash
b) let them stay in his portfolio and multiply or ‘compound’ his
number of shares without him expending any money from his pocket.
Let us illustrate with Courts Ja, one of the star performers on the JSE over
the last many years. Over the five years of 1999 to 2003 Courts Ja gave bonus
units to its shareholders as follows: 1999, 5 new ones for every 1 held; 2000,
2 new for every 1 held; 2001, 2 new for every 1 held; 2002, 1 new for every 4
held. Lets also look at a shareholder who had 1,000 units in 1999 and has kept
all his bonus units. His tally of shares would grow as follows: 1999, 1,000+5,000=6,000;
2000, 6,000+ 12,000=18,000; 2001, 18,000+36,000=54,000; 2002, 54,000+13,500=67,500.By
not selling any of his bonus units, this shareholder could have moved his original
1,000 shares to 67,500 without taking one red cent from his pocket. What’s
the implication for the state of his wealth? The last price at Dec 31, 2004 was
J$3.90 Thus, the shareholder who kept all his bonus shares would get J$3.90 times
67,500=J$263,250 whereas another who consumed his bonus shares would only get
J$3,900! Want another illustration of the power of stocks to build wealth? According
to John Jackson of the Investor’s Choice Magazine, an investment of J$100,000
in this stock at the end of 1991 was worth J$29.5M at the end of 2004 without
adding in the many thousands of dollars of dividend that were paid to shareholders
over the period. This is another ‘secret’ way through which many
investors build their wealth over time
Question: How many of the thousands of householders who buy furniture from Courts
Ja own any of its shares and are benefiting from dividend payments and bonus
shares?
What is meant
by the term ‘dividend
compounding’
See Q # 45 What is dividend?
‘ Dividend compounding’ is another original term. You won’t
find it in any business text. As with the compounding of interest (Q # 51) and
the compounding of bonus shares (Q # 52, shareholders can multiply their shareholding
from dividend paying companies without taking another dollar from their pocket.
When a shareholder gets dividends, two of the ways he can use it are
a) spend it i.e. consume it, or
b) use all or some of it to buy more shares in the company that paid it or in
any other company of his choice. This technique is known by the acronym D-R-I-P
(Dividend re-investment plan)
This facility is very common in many stock markets and, to encourage their shareholders
acquiring more shares, some companies even subsidize the cost of the purchase.
Here in Jamaica, the National Commercial Bank (NCB) has initiated a D-R-I-P for
its shareholders. NCB and Dehring Bunting & Golding (DB&G) offer the
facility to all their stock broking clients. Even if a company does not offer
this re-investing facility, investors in the Caribbean Diaspora are encouraged
to use it, especially in the early stages of the wealth building process, to
increase their shareholding in stocks “without putting in another cent
from their pocket”
What is meant
by a ‘portfolio
of stocks’?
Most investors own more than one stock based on a range of reasons that might
be as many as there are different stockholders. Some people might just have,
say, 5 stocks. Others 10. Still others much more than 10. Each person’s
holding is referred to as a portfolio whether it is made up of 5, 10, 50 or any
other amount of different companies. One reason that most people have a portfolio
of many stocks is the need to diversify their holding as a hedge against any
one stock (or class of stocks) experiencing serious difficulty and losing the
favour (and price/share) of the market
What is a growth stock
Investors have a way of classifying stocks on a number of different bases to
suit their investment objective. One classification is ‘growth stock’.
Simply put, a growth stock is one whose share price is expected to keep rising
faster than other companies in its class, or the total market as a whole because
of the prospects for profit that investors perceive in it. Many things could
inform this expectation of rapid share price growth. Some of these are:
a) performance results vis a vie the age of the company
b) profit growth over last 5 -10 years
c) company focus
d) reputation of management
e) number of shares outstanding versus that of peers. Those with lower number
tend to have better prospects for stock splits and bonus issues
Traditionally, new issues of stocks tend to be regarded as growth stocks and
usually have very high P/E ratios and many times do not pay dividends (which
is an important consideration especially for pensioners who need the dividend
to supplement their income) Most or all of the high tech stocks in America in
their recent near 20 year bull run are regarded as growth stocks with P/E ratios
up to 50. One stock that must have been seen as a growth stock by many at the
time was Ford Motor Co. The story is told that in 1903, Henry Ford’s Atty.,
one Horace Rackman, sought the advice of the then president of the Michigan Savings
Bank about buying some of the shares of the new auto company. The banker’s
response was that “the horse is here to stay and the automobile is only
a novelty…a passing fad!” Happily, the Atty ignored this advice,
bought US$5,000 of stock and, in a few years, sold his portfolio for US$12.5M!!
Moral:
a) everyone will not see the same thing in the ‘same thing’ (It’s
that vision thing again!!)
b) growth stocks can multiply your wealth overnight
c) in stock market investing, as in other areas of life, beware the advice of
experts
What is a value stock?
The term value stock could be changed to ‘bargain stock’ because
that is what it means…buying stocks at knock down prices, the more ‘knocked
down’ the better. This way, when these knocked down stocks ‘get up’,
the margin between the ‘get-up’ price and the knocked down price
at which they were bought will be substantial. Many investors might agree that
a good example of a value stock was NCB before the purchase by Michael Lee Chin
in March 2002. This stock languishd in the J$1.00-2.00 range for many months,
going as far down as J$0.80 in March 1999. Fewer might see Carreras in the same
light. At time of writing (March 2005) and primarily because of an unfavourable
near J$6B ruling by the Tax authorities, this stock, the country’s best
dividend payer, was trading at almost half the forward P/E of it’s peer
group (6.48 vs. 11.78 @ Dec 30, 2004) and less than half that of the full market,
6.48 vs. 14.81) Warren Buffett of the Berkshire Hathaway Fund is the second richest
man in the world after Bill Gates of Microsoft. Next to the man who is regarded
as the father of value investing (Benjamin Graham) he (Buffett) is also generally
regarded as the leading current proponent of value investing and many observers
make a direct link between his legendary success and this investing technique.
Who is a Stockbroker?
A stockbroker is a person who is approved or licensed by an appropriate regulatory
body to advise investors and do their investing transactions. The regulation
usually states the range of fees that they can charge for their services. The
regulatory bodies in the CSME are as follows:
a) Jamaica…….Financial Services Commission www.fscjamaica.org
b) T&T………..
c) Barbados
d) Eastern Caribbean
What is ‘dollar
cost averaging’
Dollar cost averaging is a technique that many investors (new and old) use to
squeeze out a better average cost for their purchase. In practice, it means giving
one’s Broker a fixed amount of money to purchase what one (investor) wants,
at regular intervals, (e.g. monthly) be it individual shares, bonds, units in
a unit trust/mutual fund or index fund. This fixed amount could be, e.g., post
dated cheques over a full year. Everyone knows that the price of both shares
and debt instruments vary over time. Experience has shown, however, that if one
spends the same amount over an extended time to buy the same instrument, at the
end of the period it will be seen that the average cost per unit is lower than
if a fixed number of units were bought using the same purchase interval over
the same period. This is another investment secret that many investors use to
get the most out of their investment dollar.
59.What is meant by index investing?
See also Q # 34 & 35
Index investing means investing in a bundle of stocks as opposed to investing
in individual stocks. The JSE itself has three different indexes but these are
not arranged on a fund basis; that is, investors can buy the individual stocks
in these indices separately. This is how most investors buy shares. When, however,
any of these stocks are bundled together into one unit, they then become an index
fund and so, when an investor buys the index he in effect buys a little bit of
all the stocks that are bundled together. There are two important views on index
funds. One is that Index investing is the ideal investing strategy for new investors
in stocks. The other is the reason for this view. It is that the stocks in an
Index Fund are more likely to produce superior returns because, they are bundled
and are not traded regularly. Since transaction costs are significant costs,
when these are backed out, (as they are in Index Fund investing), they impact
positively on performance results which is good for investors. At time of writing
(March 2005) there were the following Index Funds:
a) Jamaica: JMMB Select Index, Mayberry Performance Index
b) T&T
c) Barbados
d) Eastern Caribbean
How does an investment in stocks
generally grow in value over time
See Q # 36 How do stocks create wealth
As mentioned, in the case of the American Market, which has been tracked continuously
for more than 70 years, it has been computed (Ibbotson et al) that, on average,
the value in stocks grow at the following rates compounded
a) without dividend reinvested 7.8% per year
b) with divided re-invested….10.2%per year
Interestingly enough, a study by Leo Williams of JMMB Securities, Jamaica has
indicated that, adjusted for exchange parity, the rate of growth on the Jamaican
Stock Market is almost exactly the same as in the American experience. John Jackson
has shown, repeatedly in his Investor’s Choice Magazine, (See ‘How
Money Grows Part X) how far ahead some Jamaican Stocks have exceeded this growth
rate. In another world famous Fund (Berkshire Hathaway/Warren Buffett), the rate
is such that US$50,000 invested in the 1960s is today, (2004) worth US$750M.
In the field of investing, time can indeed be money.
What does
the term ‘dividend
yield’ mean?
See Q # 46
Investors like to compare what they get from investing in bonds with what they
get as dividend from dividend paying companies. To do this they have devised
a formula called dividend yield. That formula is ‘dividend (cents) divided
by the current price of the stock and multiplied by 100’ so that it can
be expressed as a percentage. To illustrate, by the end of 2004, Carreras Ltd,
arguably our best dividend payer, had paid 700 cents in dividend and the stock
was selling at J$32.00 (3200 cents). Applying the formula gives a dividend yield
of 21.9%. which compares very well with the rate of interest being paid on some
recent investment debentures by the Government of Jamaica. Within certain parameters,
the higher the dividend yield the better. However, this is not necessarily so
because, even if two different companies pay the same amount of cents in dividend,
the one with the lowest current market price will show a higher dividend yield
and, this will be so even if the low market price is because the company is not
doing well. Dividend yields must always be seen in the context of how well a
company is doing.
What is a
Bond yield (par, premium & discount)?
See Q 30
The first thing to remember about bonds is that they are ‘debt instruments’.(loans,
a ‘borrows’) made to governments and companies by big investors on
their own or by small investors through unit trusts and mutual funds. The second
thing (among many others) is that bonds have what may be called specific loan
times, called tenure, such as one year, ten years or even thirty years like the
bond that is helping to finance Jamaica’s toll roads. The third important
thing to realize is that, after a person ‘buys’ a bond, that is,
lend his money to the government or another borrower, he might want to ‘sell’ it
and get back his money before the ‘loan time ‘ expires. With this
background, the rest is cheese as the boys like to say! As would be expected,
there is a charge for the use of the bondholder’s money. Traditionally,
we call this charge interest. In the bond business, they prefer to use the term ‘yield’.
The main reason for this is the 3rd point made above. What they call the ‘yield
to maturity’ (the amount of profit a new buyer will get) is determined
by how much time is left in the tenure. To compute this, they use special tables
that give them the answer very easily. For our purpose, we will keep it simple
and look at the basic computation of yield and why and, in the process explain
what is meant when a bond is sold at par, premium and discount.
For example, if we invest J$100 and get back $110 after a year, this means that
we made a yield of 10/100 x 100 = 10%. However, the more familiar way to express
this $10 that we made on our $100 investment is to say that we made 10% on our
money. So far, the two terms “yield” and “interest rate” mean
exactly the same. As it happens however, the term “yield” has become
associated primarily with the money-lending business and, in particular Bonds.
There is a special reason for this. Yields on Bonds have an inverse relationship
with interest rate. Accordingly, when buying or selling a bond, the price can
be described as follows:
a) par …meaning that it is traded at its original issue
price which is usually $1,000
b) premium…if interest rate has fallen, anyone selling this original $1,000
Bond will ask a higher price for it, say $1,200
c) discount…if interest has increased, the buyer of this original $1,000
Bond
may not be willing to pay more than say, $800 for it, a discount of $200 to the
seller.
How is the yield on bonds calculated
The interesting thing is that where a Bond is traded at its par value, both its
interest rate and its yield are identical. If the $1,000 Bond earns $100/year,
this is an interest rate of 100/1000 x 100 = 10%. Similarly, in this specific
case, it is a yield rate of 10% also because yield is calculated the same way
as interest rate, i.e. Return/Investment x 100. There comes a time, however,
when both interest rate and yield rate will differ. This is when a Bond is traded
either at a premium or at a discount to its original price. All Bonds (other
than Zero Coupons) come with a specified interest rate (say 10%), which normally
does not change for the life (tenure) of that Bond. What may change is interest
rate, in general, since the bond was issued and, as a consequence, the yield
to the person who is now holding that bond (call it the original 10% bond for
this discussion). If interest rate changes, and the bondholder (lender) wants
to sell, the price at which he can do so will vary depending on the coupon attached
to new bonds. If a new bond is issued at a higher interest rate, say to 12%,
it means this new bond would earn more interest than his 10% bond and hence the
price of the 10% bond would fall and it would have to be sold at a discount.
If, on the other hand, the new bond was issued at 8%, it would earn less interest
than the original 10% bond and hence, the price of the 10% bond would go up and
a new buyer would have to pay a premium price for it. It should be noted that,
throughout it’s trading, the original coupon (10% in this case) on a particular
bond does not change. What changes is the price at which a new person will buy
it and the yield (how much ‘profit) to that person
Illustration of Yield to the buyer
(Bond at par, premium and discount)
(a) Bought at par our 10% $1,000 Bond yields 100/1000 x 100 = 10%
(b) Bought at premium our 10% $1,000 Bond (now $1,200) yields
100/1200 x 100 = 8.3%
(c) Bought at discount our 10% $1,000 Bond (now $800) yields
100/800 x 100 = 12.5%
Trading in Bonds is a very big business. The outstanding Jamaica Money Market
Brokers (JMMB) which is now spreading its wings throughout the CSME, has its
genesis in the Bond business and is credited with developing it, almost single
handedly, into the multi-billion dollar market it is today.
