Trillionaire Term of the Day - March 11, 2009 - Uptick Rule

Uptick Rule

In order to gain any sort of understanding about the uptick rule, you need to have a basic appreciation of short selling. Short sellers bet against the success of a stock by selling stocks that they don’t own. If successful, they sell the stock at a high price and then make the payments on the shares at a lower price to cover the sale. If you’re interested in learning more about short selling, read our Term of the Day from January 26. 

The uptick rule was created in 1938 by the Securities and Exchange Commission in an attempt to stop short sellers from driving down the markets. The rule required short sellers to wait for a stock to move upward one-eighth of a percentage point before making a short trade. Before the rule was instated, traders could short a stock at any time, regardless of whether or not someone bought it long (the usual method of purchasing stocks) before them.

The SEC believed that the uptick rule would prevent short sellers from gaining momentum and driving down stock prices. This is because short sellers not only bet that a stock will go down, but the very act of selling a stock short actually moves the price downwards. When investors sell a stock short, the bid price of the stock is lowered. If many people sell short at the same time, a steep decline is very possible.

The uptick rule was successfully enforced from 1938 until June of 2007. The SEC eliminated the uptick rule to determine whether or not the rule actually had any effect on the markets. The SEC’s Office of Economic Analysis determined that the rule wasn’t necessary to prevent short sellers from manipulating the markets.

Well, now that the financial system is tanking, short sellers have been actively trading in the financial sector. Naturally, when things go bad, people start to point fingers to find out why. Many analysts have placed the blame on the elimination of the uptick rule. While the credit crisis and a basic lack of fundamentals have caused investors to sell out of financials, many argue that short sellers have driven the stocks of banks such as Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC) down past appropriate levels.

The advocates of reinstating the uptick rule believe that the regulation would take away a lot of the firepower of short sellers. The shorts would have to wait for long buyers to make a purchase before making their trades. This would take away the momentum that rapidly drives stocks downwards.

People tend to look down upon short selling because it essentially involves betting on failure. Nevertheless, shorting is an important market tool that helps bring stocks down when investors become overly enthusiastic and place too much value in a stock.

There are two main arguments against reinstating the uptick rule: efficiency and freedom. The nature of the uptick rule forces short sellers to wait some time before making a purchase. It is possible for this waiting period to create some lag in the markets. Supporters of free markets dissent to almost every kind of regulation or inhibition of people’s rights. The uptick rule would be a limitation on the right to short sell.

Despite these points, it’s very difficult to argue against the uptick rule, as the stock markets functioned just fine during the 70 years in which it was upheld. It appears that its elimination will be temporary, as Representative Barney Frank of the House Financial Services Committee said yesterday that he hopes the rule will be back in effect within a month.  Part of yesterday’s rally can actually be attributed to Frank’s announcement, showing that most investors want to see the uptick rule come back. It will be very interesting to see what influence the uptick rule, if reinstated, will have on the markets, and especially on the bank stocks.

-Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - March 6, 2009 - Sin Stocks

Sin Stocks

Sin stocks are stocks of companies that produce products that are associated with activities widely considered to be immoral or unethical. Some examples of these sinful activities could include the production and distribution of alcohol, weapons, sex-related products, and tobacco.

Phillip Morris (PM) and Altria (MO) are two of the best-known tobacco companies.  Anheuser-Busch (BUD) and Diageo (DEO) are some of the biggest alcohol companies.  Playboy Enterprises (PLA) is one of the most famous sex-related companies, while MGM Mirage (MGM) and Wynn Resorts (WYNN) are two giant casino companies.  Northrop Grumman (NOC) is also one of the biggest weapons manufacturers. 

Sin stocks have a reputation for being great investments during recession, as these stocks provide a safe haven during slow economic growth periods.  There is a lot of debate as to which stocks and which industries should be put into the “sin” category, and everyone has his own criteria of what should be considered sinful.  But, it is clear to see that some sin stocks do hold up well during recessions.  For example, tobacco companies like Altria (MO) usually hold up very well during economic slumps.  The logic behind Altria’s relative strength can be attributed to the fact that smoking is addictive, and people will not stop smoking because of a weakening economy.  On the contrary, people might actually begin to smoke more during recessions due to increased stress levels.

But, sin stocks don’t always hold up during recessions.  One sin industry that has been crushed due the credit crisis is the resorts and casino industry.  MGM Mirage (MGM) is currently off of its 52-week high by 96.92%, and Wynn Resorts (WYNN) is off of its 52-week high by 82.85%! These huge drops in casino company stock prices are understandable though, as people do not have the extra income to spend on gambling anymore.  So, while some “sinful” industries, like tobacco and alcohol, hold up well during recessions, industries like the casino industry struggle mightily. 

Another important issue to think about with sin stocks is whether or not it is morally right to invest in these companies.  For example, every time someone invests in a weapons company like Northrup Grumman, that investor is essentially providing the company with the money to produce more weapons.  Personally, I have promised myself that I will never invest in a weapons company, as I feel like it is unethical to fund the production of bombs and guns that kill people.  Having said this, I own shares of both Phillip Morris and Altria, so I clearly do not feel like funding the production and distribution of tobacco products is as bad as funding the production and distribution of weapons.  People have their own moral feelings about weapons and tobacco though, so it is every investor’s individual choice as to what types of companies are ethically acceptable to invest in. 

If you don’t have a moral problem with investing in sin stocks, you should definitely check out some of the industries and companies that I have mentioned throughout this article.  I highly suggest Altria (MO), and you can expect a Stock of the Day for the company next week.  

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - March 3, 2009 - REITs

Thank you for the article Ramin! Remember, if you want to write an article on a specific stock, a term that interests you, or anything else that relates to the stock market, do not hesitate to send your article to collegetrillionaires@gmail.com so that it can be posted on College Trillionaires!

Real Estate Investment Trust (REIT)

During the 1960’s, congress created the Real Estate Investment Trust (REIT) with the intention to allow everyday investors to invest in large-scale real estate properties through the stock market.  REITs (pronounced Reets) essentially act like normal stocks, and they are traded on major stock exchanges such as the NASDAQ.  The one key difference that sets them apart from normal stocks is that REITs invest in real estate, with at least 75% of their income coming from real estate endeavors. REITs normally act as promising investments, as they usually receive a high yield of return (between 5-10% per year). These high returns come partly from the numerous tax benefits that these companies receive during the process of buying, selling, and holding real estate. These corporations are required to distribute 95% of their income, which allows them to avoid the corporate income tax.

Equity REITs invest in multiple real estate properties ranging from shopping centers, large shopping malls, apartment complexes, office buildings, warehouses, etc. These REITs can hold the property while producing income through rent and they can sell the property as it appreciates in value. REITs can also purchase old, rundown, undervalued properties with the intention to fix them. With the right moves, this can be a highly lucrative and quick investment. Lastly, the REIT can purchase a high income producing property such as a shopping mall or apartment complex at a low price and be able to receive large amounts of income through rent. 

A Mortgage REIT is an investment fund that deals with property mortgages in three different ways. The first and most simple way of investing in mortgages is to loan out money to property owners for their mortgages (like a bank). The money made through the compound interest that these loans earn makes up a majority of the income for REITs. The REIT is also able to purchase packages of existing mortgages from banks or other REITs. This allows corporations to buy, sell, and trade huge amounts of mortgages, and the prices of these mortgage packages depend on the credit of the property owner and size of the loan. Similar to purchasing mass amounts of mortgages, REITs can also purchase mortgage-backed securities, which is essentially purchasing pools of mortgages. All three ways produce revenue through collecting on the interest of the loans.

And then there is the hybrid, which is the combination of the Equity REIT and the Mortgage REIT. These REITs hold investments in properties and mortgages.

A few examples of REITs include American Century Investments (ACIVX), Vanguard (VNQ), Boston Properties (BXP).  You can find a list of the top REITs in the NASDAQ using this link: http://www.forbes.com/2008/02/20/reit-perfomance-grades-biz-cx_dp_0220reit_table.html.

Unfortunately, due to the recent economic crisis combined with the massive drop in real estate prices, nearly all of the REITs have taken beatings the past two years and have dropped in share price by an average of 40-70%.

 

Ramin Ghaneeian

College Trillionaire

Trillionaire Term of the Day - February 26, 2009 - Economic Moat

Economic Moat

An economic moat refers to the long-term competitive advantage that one company has over other companies in the same industry. Just as a water moat would keep enemy soldiers from a castle, an economic moat keeps competitors from stealing profits from the industry-leading company. 

Clearly, the bigger economic moat a company has, the larger its competitive advantages are.  Economic moats could come in the form of a strong brand name, lower production costs, and many other factors that give a business the ability to maintain competitive advantages over competitors in order to protect long-term profits. 

Some of the biggest and most stable companies, such as Coca-Cola and Wal-Mart, are famous for their giant economic moats.  Because Wal-Mart has so many competitive advantages over its competitors, it is very hard for other retailers to compete directly with Wal-Mart. 

Warren Buffet actually made the concept of economic moats famous, and much of his long-term investing success is due to his ability to find companies with large economic moats and by taking advantage of the fact that these companies would stay safe from intense competition.  So, as a young investor, make it a point to find companies that you think have large economic moats, and try to find companies that perform a certain aspect of their businesses much better than the competitors in the same industry.  By doing this, you can ensure that the company you have invested in will continue to bring in large profits, and your investment will surely bring you profits as well.  

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 25, 2009 - Earnings

Earnings Estimates

Earnings estimates are analysts’ predictions of a company’s future quarterly or annual earnings. Investors, companies, and analysts alike have recognized the enormous effects that earnings estimates have on stock prices. It is absolutely critical to have a good understanding of what estimates are, how they are made and influenced, and how they are compared to actual earnings.

Earnings are after-tax net income. Earnings are incredibly important because they directly indicate a company’s profitability. Financial professionals, called analysts, create estimates in the process of determining stock recommendations. These recommendations include “buy”, “sell”, and “hold.” By recommending hold on a security, an analyst means you shouldn’t buy, and if you already own it, don’t sell. Other ratings include “outperform”, which means a security is expected to do slightly better than the overall market. Similar to outperform is “overweight”, which means that the security should fare better than its particular industry, sector, or possibly the entire market.

When analysts create these recommendations, they also estimate earnings to an exact dollar amount. Right now, analysts estimate that The Coca-Cola Company (KO) will report earnings of $1.5 billion (an earnings per share of $.65) for the current quarter. They come to this dollar amount by estimating revenues and costs. They take the estimated revenue and subtract estimated costs to come to estimated earnings.

Accurately estimating earnings for a company of any size is a complicated and imperfect process. Analysts attempt to predict revenue by implementing forecasting models that implement growth rates, macroeconomic factors, and fundamental information. They predict costs by looking for any possible expected changes of cost including wages, raw materials, sales expenses, interest expenses… the list goes on. Some analysts will even talk to a company’s customers, competitors, and suppliers. The main question that runs through an analyst’s head is, “What might cause revenue and costs to be greater or less than last quarter?” They are looking for change.

Estimating earnings is not a perfect science. Ten different analysts can easily come to ten different dollar amounts for earnings. Even if they come to the same number, they probably considered different factors to get there. To illustrate this point, the lowest analyst estimate for Coke is $1.43 billion and the highest is $1.6 billion. Wall Street factors in the differences of opinion by considering the ‘consensus estimate.’ The consensus estimate is simply the average of all analysts’ estimates. Wall Street adds the estimates together, and then divides them by the total number of estimates. The current consensus estimate for KO is $1.5 billion. The consensus is the number being considered when you read articles or hear the word “estimate”.

When you hear people say, “a company beat earnings” they mean that the company’s actual earnings were higher than earnings estimates. The comparison of actual earnings to earnings estimates is the single greatest short-term driver of stock prices. In most circumstances, if a company beats earnings, stock price will shoot up. Likewise, if a company falls short of expected earnings, the stock price normally falls. This direct impact is why estimates are considered to be so important.

Successful companies usually have a lot of smart people working for them. Smart people know that the estimates are important, and they’ve done a lot to try to alter or influence them. Companies often attempt to drive estimates lower! While at first this strategy may seem counterintuitive, it’s much easier to beat estimates when they are lower than they should be. Companies can influence earnings estimates by delivering ‘guidance’ or reporting bad news early. If a company gives negative feedback on itself or reports bad news, analysts will factor the information into their estimates.

The necessity to beat estimates has become such an essential element of a company’s success on Wall Street that some businesses are driven to acts of desperation. The use of accounting manipulation to boost earnings is widespread. While ethically questionable, companies can use a wide variety of techniques that are legal under GAAP (the set of financial rules all publicly traded companies must comply with) in order to alter their earnings and financial statements in order to make them more suitable for their various agendas.

There is a vast wealth of information regarding earnings and earnings estimates. I hope that this article has helped you gain a basic understanding of estimates and why they are so important in the world of investing. I encourage you to read more articles about estimates by searching for them on our favorite financial websites.

 

-Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - February 24, 2009 - Order Methods

Market Orders vs. Limit Orders

When placing an order to your broker to either buy or sell a stock, there are two main methods that you can use in order to complete the transaction.  A market order is a buy or sell order in which the broker will execute the order at the best possible market price currently available.  A limit order is an order to a broker to buy or sell a specified number of shares at a specified price.

For a market order, your stock order will automatically be matched up with the current market price.  Let’s say you want to buy 100 shares of McDonald’s (MCD).  If you place a market order to buy 100 shares, your order will be executed at the current market price at the time of the transaction.  While market orders are simple due to the fact that you allow the market prices to determine the price you will buy or sell the stock at, the problem with market orders is that you might not get the price you originally wanted when the transaction finally goes through.  Because stock prices rise and fall almost continuously, especially for very volatile and highly traded stocks, it often happens that you place an order to buy shares at a certain price, but in the few seconds after you placed your order, the stock price has either increased or decreased.  For example, if you placed your order to buy MCD when it was trading at $55 per share, and your order gets executed after MCD has jumped 50 cents to $55.50 per share, you will be forced to pay $55.50 per share instead of the desired $55.00.  While this might not sound like a big deal, if you are buying large amounts of shares, the 50 cent fluctuation can translate into a lot of money.   

A limit order is different than a market order, as it is an order to a broker to buy shares at or below a specified price or to sell shares at or above a specified price.  Let’s say you want to buy 100 shares of McDonald’s (MCD) at $53.00, but shares of MCD are currently trading at $54.95.  So, instead of patiently waiting and staring at your computer until the price falls to $53, you can simply put a limit order to buy 100 shares of MCD at $53.  Once MCD reaches $53, the transaction will automatically be executed and you will have 100 shares of MCD at $53.  Limit orders are great because they insure the price that you will buy and sell shares for, and you do not have to worry about a stock’s volatility when making a transaction.  The big downside for limit orders is the possibility that an order will never be executed.  For example, you if you really wanted MCD at $53 and it never fell to that level, you would never get your shares of MCD. 

Overall, limit orders are much better for investors than market orders.  Limit orders provide investors with a sense of certainty, and they allow investors to dictate the prices at which they want to buy and sell instead of having the market determine the prices for them.

 

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 23, 2009 - Free Cash Flow

Free Cash Flow

One of the single greatest tools you can use to determine the profitability of a company is Free Cash Flow. Free cash flow is a measure of a company’s cash after it has taken care of all expenses. It represents the money that a company can use to expand, improve, and advance.

You can easily calculate free cash flow by using statements of cash flows. These statements can be found on many investing websites, as well as the investor relations portion of any company’s website you’re researching. The equation used is simple:

Cash Flow from Operations – Capital Expenditures = Free Cash Flow

A good way of analyzing a company’s performance over time is to calculate the free cash flows over several years. By discovering trends, you can gather insight as to how a company has generated profits for specific periods of time.

Before a company can invest and make capital expenditures, it has to pay the bills. Free cash flow represents the cash that a company has after paying off all expenses. The “cash flow from operations” portion of the equation above is generated in statements by slightly altering net income. This means that when you look at a free cash flow number, you’re looking at a company’s cash after all expenses are paid and investments are considered.

You should also know that a negative, or low, free cash flow may not always spell trouble. Free cash flow can become negative if a company makes many capital expenditures. Capital expenditures are funds used by a company to obtain or improve assets. In other words, a low free cash flow can be attributed to a company’s investments.

So what does a company do with its extra cash? It can be used to increase shareholder in a number of ways. If deemed profitable, a company can use the extra profits to expand or diversify. It can increase the value of its stock by buying back stock at prices considered to be low. Companies can also use the cash to increase dividends. All of these options are incredibly beneficial to you as a current shareholder or potential buyer of stock.

Analysis of free cash flow should be a staple in your process of purchasing stock. Although it is a simple number to calculate, the knowledge you can gain from it is invaluable. You will instantly benefit by adding free cash flow to your arsenal of investing tools.

-Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - February 20, 2009 - Capitulation

Capitulation

Capitulation is defined in the dictionary as “the act of surrendering or giving up.”  On Wall Street, capitulation is also associated with giving up, as the term refers to times when almost all investors sell their stocks in order to get out of the market and into safer investments such as bonds.  True capitulation is characterized as having very high volume and steep declines.  Capitulations are also very quick, and it usually takes at most a few days for the sell-off to occur.

Capitulation is basically a form of panic selling, as investors who have stayed in the game and continued to slowly lose money in the hopes of a rebound give up all hope for a turnaround and decide to just give up on stocks and move into other investments.  To explain capitulation through a sports scenario, imagine a basketball team that has been losing the whole game by around 15.  The coach is the investor, the starting players are the coach’s individual stocks, the reserves are the bonds, and the basketball game is the stock market.  The coach will keep his losing stocks (starters) in the game (market) until he finally gives up hope that there is a chance for a comeback.  After surrendering and seeing no hope, the coach will take out his starters (stocks) and put in his reserves (bonds), because he knows that it is not worth getting his starters (stocks) hurt more than they already have (That last analogy might have been a little bit of a stretch). 

Because of the panic selling that goes along with capitulation, many people believe that it is the true sign of a bottom in the market.  Thus, a lot of investors think that there are great bargains to be had right after a capitulation, as the price of stocks should bounce off the exaggerated lows. 

 

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 19, 2009 - CS vs. PS

Common Stock vs. Preferred Stock

Common stock and preferred stock both represent partial ownership of a company. While both variations serve a similar purpose, there are key differences that distinguish the two forms of stock.

The biggest distinction between the two is priority of dividend payments. Dividends are paid out to preferred stockholders before common stockholders. Additionally, if a company goes bankrupt, the preferred shareholders have priority in the distribution of a liquidated company’s assets. If a company goes under, the preferred shareholders will usually get a piece of the assets and common shareholders will be left in the dust.

Common shareholders have voting rights that go along with holding common stock. For each stock they hold, they get one vote for various types of decisions. Examples of issues that companies use votes for include approval of stock splits, election of board members, and support of general company movements. Preferred stockholders don’t have the right to vote. Those that hold preferred stock sacrifice the right to vote for priority in dividend payments.

In general, investing in preferred stock is less risky than investing in common stock. The fluctuation of preferred stock prices is based mostly on changing interest rates, while the rise and fall of common stock prices is based on investor demand for the stock. This means that common stock prices will be much more volatile than preferred stock prices. Buying preferred stock can be a great method of defensive investing, as investing in preferred stock instantly adds stability to your portfolio. You can avoid the volatility that goes along with common stock and guarantee dividend payments in harsh times.

With this said, it’s important to know that common shares are true to their name… they are much more common than preferred shares. When you see a stock on a ticker or look at a stock index, you are looking at common stock.  At this point in your investing career, when you consider buying shares of a company you will generally be buying common shares.  Nevertheless, it’s important to understand the difference between common shares and preferred shares if you will be investing in either variation.

Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - February 17, 2009 - ROA

Return on Assets (ROA)

The Return on Assets (ROA) ratio describes how well a company uses its total assets to make a profit.  The ratio is a great indicator of a company’s efficiency, as a higher number indicates that a company is generating a higher profit relative to its total assets.  The formula is simple, as it compares net income to total assets:

Net Income

                            ROA =   ------------------- 

Total Assets

 

A company’s ROA is highly dependent on its industry, so when using ROA as a comparative measure, it is most useful to compare a company’s ROA against its own historical ROA numbers or to compare it against the ROA from another company in the same industry.   A higher ROA number is better, as it implies that the company is earning more money with fewer assets.  If a company’s ROA is low, it means that the company is not using its assets to bring in enough income.  For example, if company A has a net income of $2 million and total assets of $10 million, it has an ROA of 20%.  If company B has a net income of $1 million and total assets of $10 million, it has an ROA of 10%.  So, it is clear that company A has a higher ROA.  Company A is using its $10 million worth of assets more efficiently, as it is making two times more income than company B, even though it spends the same amount on assets. 

ROA is extremely important in judging a company, as you should invest in a company that spends its money wisely on its assets and knows how to use its assets efficiently.  A company that can make two times more income from the same amount of assets clearly understands how to allocate resources and knows how to make large profits from little investments.  While a company’s ROA should not be the only factor that you consider when doing research on a company you are thinking about investing in, this crucial ratio should definitely make a difference in your final decision.  

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 11, 2009 - GDP

Gross Domestic Product (GDP)

Simply put, gross domestic product (GDP) gauges the size and health of a country’s economy.  GDP represents the total dollar value of all goods and services produced over a specific time period.  GDP is calculated in two ways: The income approach and the expenditure method.  The income approach adds up what everyone (companies and people) earned in a year, and the expenditure method adds up what everyone spent (roughly similar numbers). 

Knowing a country’s GDP is important because it allows people to compare the sizes of different countries.  The European Union, as a whole, now has the largest GDP in the world.  The U.S. is number two, with a 2008 GDP of $14,580,000,000,000. China is also right behind the U.S. at number three now, with a GDP of $7,800,000,000,000. According to these GDP numbers, the United States produces almost two times as many goods and services than China in 2008. Obviously, these GDP numbers will be huge, as they account for all of the goods and services produced in a country throughout an entire year.

But, GDP is also very useful in determining the health of a country.  By comparing a country’s GDP yearly or quarterly trends, one can learn a lot about the country’s economic situation.  For example, if the year-over-year GDP increases by 5%, that is interpreted to mean that the economy has grown by 5% compared to the previous year.  When a country’s GDP increases at a higher rate than the period before, it usually signifies a growing economy.  In a growing economy, the unemployment rate is usually low as more businesses are thriving and hiring more people.  But, if a country’s GDP declines compared to the previous period, it means that the country’s economy is shrinking.  For example, U.S. GDP fell 3.8% in the 4^th quarter of 2008.  As most of you know, our economy is shrinking, people are losing jobs, and we are in a recession.  A recession is actually defined as two consecutive quarters of negative growth in GDP.  The U.S. had a declining growth rate of -.5% in the 3^rd quarter of 2008 as well, which explains why everyone says we are now officially in a recession. 

How does a change in GDP affect the stock market? As you can imagine, a shrinking GDP will have an adverse affect on the markets, as businesses and people are producing and spending less than the period before.  An increase in GDP will have positive affects on the markets, as businesses are growing and increasing profits and consumers are spending more. 

Knowing what GDP is and understanding how GDP trends affect the stock market are crucial concepts for any investor to understand. 

 

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 10, 2009 - SEC

Securities & Exchange Commission (SEC)

In reaction to the Crash of 1929 and the Great Depression, Congress passed the Securities Act of 1933.  Many people believed that a lack of regulation was the main cause for the crash that led the Depression, and the Securities Act of 1933 was made to cure this issue. In 1934, Congress also passed the Securities Exchange Act, which created the Securities and Exchange Commission (SEC) to enforce the rules of the Securities Act of 1933.

The responsibilities of the Securities and Exchange Commission are diverse and numerous. Every security that is traded on any stock market must be registered with the SEC. If you want to your company to become a publicly traded company, the SEC is responsible for analyzing and permitting an Initial Public Offering (see Trillionaire Term of the Day for IPO’s). If you ever purchase over 5% of a company’s shares, you would also have to report the transaction to the SEC.

The Securities and Exchange Commission’s main purpose is to regulate the securities markets and prevent companies from committing fraud and manipulation. The SEC requires publicly traded companies to submit quarterly and annual reports that contain financial statements. The publication of financial statements prevents fraud: having millions of eyes inspecting them makes it much harder to lie. These reports allow common and institutional investors alike to gain insight on the inner workings of a company.

Interestingly, the SEC requires publicly traded companies to publish a management discussion and analysis (MD&A) each year. In these statements, a selected executive will discuss the events of the year leading up to the report. The best part about these statements is that the executive usually explains the tough process behind major decisions. These statements are available to everyone (that means you), and they are a great way of understanding how a company does business and how it reacts to specific events.

The recent economic crisis has put the SEC in the public spotlight. The SEC has the power to bring civil enforcement actions against individuals and corporations that commit fraud. In the aftermath of the crash of the housing market they used this power to bring over $51 billion in settlements to individuals and institutions that bought auction rate securities from banks including Merrill Lynch, Bank of America, and Citigroup. Recently, the failure to discover Bernard Madoff’s $50 billion Ponzi scheme has been attributed to the SEC. Congress and the SEC are looking to change the rules that govern the Commission to prevent more fraudulent activity from occurring.

As a future investor and market player, you will constantly be dealing with the actions and regulations of the SEC. The legitimacy of the markets and investments lies in the Commision’s hands. It’s important to learn about the SEC because to play by the rules, you must first know them.

 

-Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - February 9, 2009 - Ponzi Schemes

Ponzi Schemes

Ponzi Schemes are a type of illegal pyramid scheme that basically take money from new investors to pay off earlier investors until the whole scheme collapses.  The fraudulent investing scam promises high rates of return at little risk, and works on the “rob peter to pay paul” principle.  The scam actually works if you are an early investor and new investors continue to be duped into joining the pyramid scheme.  The problem with the scheme is that eventually there are not enough new investors coming in to produce enough money for the earlier investors.  At this point, the whole scheme unravels and the people that came into the scheme late lose everything. 

Let’s do an example of a Ponzi Scheme with 4 investors (Investor A, B, C, and D), and me as the head of the whole illegal operation.  I go to Investors A, B, and C and tell them, “I promise you will each make a 30% rate of return on your investments if you each invest $1,000 with me.  So, at this point, I owe Investors A, B, and C their $1,000 principle plus $300 worth of returns each.  I know I can’t possibly make $900 ($300 in returns X 3 investors) to pay them their promised returns by doing anything legal, so I go to investor D and tell him the same thing I told the previous three investors.  I tell investor D, “I promise you will make a 30% rate of return on your investment if you invest $1,000 with me.” So, I use Investor D’s $1,000 investment to pay off the $900 in returns that I owed to Investors A, B, and C.  Now, in order to continue paying Investors A, B, and C their 30% returns every year, and now also Investor D’s 30% return, I have to keep on bringing new investors into my Ponzi Scheme to pay them their promised returns. 

As you can tell from the example, the only way that this system can continue to work is if the head of the scheme consistently brings in new investors to pay off the earlier investors.  Also, it is clear that the early investors can earn a lot of money through Ponzi Schemes, and later investors can be ruined.  In the previous example, Investors A, B, and C all got their 30% returns from Investor D’s initial investment, so they are happy.  But, let’s say that I could not find another investor to join my Ponzi Scheme after Investor D.  In this case, Investor D would end up with only $100 left to his name, as $900 of his initial $1,000 investment went to paying the 30% returns promised to Investors A, B, and C.   

This illegal practice is named after Charles Ponzi, who cheated thousands of people back in the 1920s with a fraudulent postage stamp scheme.  Ponzi Schemes are unfortunately still used today to swindle investors, and as many of you know, Bernie Madoff was recently arrested for orchestrating a $50 billion Ponzi Scheme.  Ponzi Schemes are extremely illegal, but they are definitely interesting to think about.

Don’t get any crazy ideas.

 

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 6, 2009 - Beta

Beta

Beta is a measure of the amount of correlation between a stock and the overall financial markets. The number provides an understanding of the performance of a specific security in comparison to the movement of an entire market. The benchmark for markets, the S&P 500, is the most common choice for calculating beta.

Stocks with positive betas follow the movements of the market. If the market improves the stock will rise. If the market falls the stock will decrease in value. Stocks with negative betas move inversely when compared to the market. If the market goes up, the stock loses value, and vice versa.

The exact numerical value of beta is important to understand as well, because it allows us to interpret the volatility of a stock compared to the market. Because the number is calculated by comparing a stock to the market, the market has an unchanging beta of 1. If the beta of a stock is less than 1 it is less volatile than the general market. If the beta of a stock is greater than 1 it is more volatile than the market.

A stock with a beta of 2 will rise when the market rises, but twice as much. A stock that has a beta of -2 will gain as the market declines at double the rate. Let’s compare the betas of previous Trillionaire Stocks of the Day, WuXi PharmaTech (WX) and The Coca-Cola Company (KO), to understand the use of beta.

WuXi is a speculative stock: it has a very low market capitalization of 397M and hasn’t been around for a long time. Its beta is 2.3. If the market were to increase by 3%, then WX should increase by 6.9% (2.3 X 3). Coke is a stable blue chip stock: it has a very high market cap of 100B and is an established company. KO has a beta of .63. If the market were to increase by 3%, Coke would increase by 1.89% (.63 X 3).

Stocks with higher positive betas or lower negative betas are volatile. So we would consider WX to be a volatile stock, as it exaggerates the movements of the market, up or down. KO is less volatile than the general market, and it increases less than the market increases and decreases less than the market decreases.

A stock with a high beta can provide higher returns, but also bigger losses. So when you buy a stock with a greater beta you take on more risk with the intention of larger profits. A stock with a low beta will provide smaller returns and lesser losses. Buying stocks with lower betas can help you add more stability to your portfolio and allow you to invest defensively.

 

-Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - February 5 2009 - After-Hours Trading

After-Hours Trading

After-hours trading refers to the buying and selling of stocks before and after the markets normal operating hours.  Most stock exchanges, such as the Nasdaq and the New York Stock Exchange, are open for normal operating hours between 9:30 a.m. to 4:00 p.m. EST.  After-hours trading happens on most exchanges from 7:30 a.m. EST until the markets open, and also from the time the markets close until around 8:00 p.m. EST. 

Until the summer of 1999, After-hours trading was open only to institutional investors, such as hedge funds and mutual funds, and individuals with high net worth.  But now, a law has been passed that allows even average investors like you and me to trade after-hours.  But even with fewer restrictions than ever on who can invest before and after the markets are closed, after-hours trading only accounts for about 1% of overall trading activity.

Why so little after-hours activity? Simply put, there are a lot of risks and dangers that come with trading during off-hours.  First of all, because there is not as much trading activity compared to regular-hours trading, the price fluctuations for share prices become much more severe and volatile.  Also, because of the lower trading volume during after-hours trading, there is usually a wide spread between bid and ask prices for stocks.  As a result of the wide spread between bid and ask prices, it becomes harder for investors to buy and sell stocks at a favorable and predictable price.  There are also many more risks, such as less liquidity, competition with professional traders, and potential for computer delays.

After-hours trading is a pretty confusing concept to grasp, and there are a lot of specific rules and issues that must be acknowledged in order to fully understand the process.  But, as long as you have a simple understanding of after-hours trading, you should be confident enough to make the occasional investment after the market closes or before it opens. 

 

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - February 4, 2009 - ETFs

Exchange Traded Fund (ETF)

In order to have a solid understanding of Exchange Traded Funds (ETFs) you must have a good grasp on Indexes. If you aren’t sure what an index is, or how indexes are created and run, feel free to check out our Trillionaire Term of the Day on Indexes (January 9, 2009).

An index is a group of securities, such as stocks or bonds. An Exchange Traded Fund is basically all of the stocks that are in an index grouped into one tradable stock. You can buy and sell ETFs just as you would buy any other company’s stock. Simply put, an ETF is a representation of all of the individual stocks that you would find in an index.

Take SPDRs (SPY) as an example. This particular ETF tracks the S&P 500, which is a benchmark index for large cap U.S. stocks. Investors buy and sell SPY when they see value or a lack of value in the S&P 500. PowerShares QQQ (QQQQ) is another ETF, and this fund holds all of the stocks in the Nasdaq-100 Index (e.g. Apple, Intel, Amgen, etc…).  So, when you buy QQQQ, you are basically buying a little bit of each stock in the Nasdaq-100.

Adding an ETF to your portfolio is a great way to diversify quickly. One share of an ETF essentially contains the all of the different shares in an entire index, so when you invest in an ETF, you’re investing in numerous distinct companies.

 

Matt Schwartz

-College Trillionaire

Trillionaire Term of the Day - February 3, 2009 - Average Down

Average Down

Averaging down is an investing technique for bold investors who really have confidence in their stocks.  Averaging down is essentially the process of buying additional shares in a company at lower prices than you originally purchased.  By using this strategy and buying on weakness, the average price you paid for all your shares comes down. 

For example, if I bought 100 shares of Intel (INTC) at $20 per share, the average cost per share for me would be $20.  Let’s say after owning it for a couple of weeks, Intel’s share price drops to $15.  If I really believe that Intel’s share price will rebound, should I sell the stock at $15, or should I take advantage of the drop in share price?  If I employed the averaging down technique, I would buy 100 more shares of Intel at $15.  As a result of my new purchase, my average cost per share of Intel would be $17.50 (100 shares X $20 + 100 X $15 all divided by 200).  Now, instead of Intel having to come back up to $20 for me to break even, I just need the stock to reach $17.50.

Is averaging down a good or bad strategy? Well, if you average down and buy more shares as the stock price goes lower, you will increase your profits if the stock makes a rebound.  You will increase your profits because, not only do you have more shares of the company, but your new average cost per share is lower than your original cost per share.  So, if you really trust the company that you are investing in and believe that its stock price will eventually come back up, then averaging down is great.  But, how about if you keep averaging down and buying more shares on weakness, and the stock just keeps going down without ever rebounding? This is the danger of averaging down, as you will continue to lose more and more money every time the stock price dips. 

Averaging down definitely takes a lot of courage, and you have to be willing to go against the market and buy when others are selling.  But, if you are investing in a solid company for the long term and are confident that its stock price will rebound, averaging down is one of the best ways to increase your profits.

 

Niki Pezeshki

College Trillionaire  

Trillionaire Term of the Day - February 2, 2009 - Blue Chip

Blue Chip

A company that is nationally acclaimed, well founded, and financially secure is a blue chip company. A blue chip company that issues shares provides blue chip stock.

Blue chip companies sell products and services that are bought by a very large number of people. They are characterized by deep balance sheets with a large amount of assets. Blue chips tend to succeed, or at least consistently bring in revenue, even in times of economic downturn. Coca Cola (KO), McDonald’s (MCD), and IBM (IBM) are some examples of blue chip companies that provide blue chip stock.

The term was coined by workers on Wall Street who compared the stocks seen on tickers to blue chips in casinos. Blue chips have the highest value in casinos. Analysts and common investors alike analyze the actions of blue chips and their stocks to estimate the general trends of the markets.  So, the next time you here someone talk about a “blue chip stock”, just know that is even more simple than it sounds.

-Matt Schwartz

College Trillionaire

Trillionaire Term of the Day - January 30, 2009 - PEG Ratio

Price/Earnings to Growth (PEG) Ratio

The PEG ratio is a ratio used to determine a stock’s value while taking into account earnings growth.  The PEG ratio is actually the more in-depth and telling version of the P/E ratio, as it compares a company’s P/E ratio to its projected earnings growth (to learn about P/E ratios, see the Trillionaire Term of the Day for January 7^th, 2009).  The calculation to find the PEG ratio is:

Price/Earnings Ratio

--------------------------

Annual EPS Growth 

The PEG ratio takes into account the fact that a company with a higher P/E ratio is usually growing at a faster pace, and it shows that companies with high P/E ratios are not always overvalued.  So, the PEG ratio is a much better method of comparing companies with different growth rates.  According to Peter Lynch, a very famous investor, “The P/E ratio of any company that’s fairly priced will equal its growth rate.” This quote essentially says that a fairly valued company will have a PEG ratio of 1.  For example, if a company has a P/E ratio of 15 and is growing its earnings at a 15% rate, this company would be fairly valued because its PEG ratio would be 1. 

Another conclusion we can make from this equation is that a lower PEG ratio is better/cheaper and a higher ratio is worse/expensive.  For example, a company with a P/E ratio of 10 that is growing its earnings at a 20% rate will have a PEG ratio of .5.  This PEG ratio of .5 is basically saying that the company’s earnings are growing two times faster than people are giving it credit for.  On the other hand, if a company had a P/E ratio of 30 and was growing its earnings at a 15% rate, the company’s PEG ratio would be 2.  This company would be considered overvalued and expensive, as investors are paying 30 times earnings, while earnings are growing only at a 15% rate. 

Let’s do a real-world example, and let’s compare two internet companies, Yahoo (YHOO) and Google (GOOG).    Yahoo currently has a 38.71 P/E ratio, meaning that investors are paying 38.71 times the company’s earnings for the stock.  But the company is only expected to grow earnings around 18.25% in the next five years.  Thus, the PEG (5 yr) ratio for Yahoo is 2.12 (38.71/18.25).  Google currently has a 25.43 P/E ratio, and the company is expected to grow earnings around 29% over the next five years.  Thus, the PEG (5 yr) ratio for Google is .88 (25.43/29).  So what do these numbers tell us about both Yahoo and Google? First, just by looking at the P/E ratios, we can tell that Yahoo is more overvalued than Google, as its P/E ratio is 38.71 compared to Google’s 25.43.  But, is Yahoo’s higher P/E ratio justified by a higher growth rate.  The answer is no, as Google is expected to grow its earnings 29% over the next five years, and Yahoo is only expected to grow 18.25%.  So, it seems that Yahoo is definitely more overvalued and expensive than Google is, based on both of the companies’ earnings growth expectations and current P/E ratios.  The PEG ratios tell the story, as Google’s is an affordable .88 and Yahoo’s is an expensive 2.12. 

The biggest problem with PEG ratios is the fact that the EPS growth rates are assumptions, and the growth rates might not pan out the way analysts expect them to.  For example, how about if Google doesn’t grow 29% in the next 5 years, but only grows 10% due to some external factors.  Then, the PEG ratio would be totally different, and Google might not be as cheap as it looks. 

Knowing and understanding PEG ratios is crucial for all investors who want to find companies that are undervalued and avoid companies that are overvalued.  Do not judge the P/E ratio on first glance, but instead understand why a P/E ratio is high or low.  Is a company expected to grow at a high rate in the future? And, if so, have investors already factored this expected growth into the stock price? PEG ratios are extremely important, and I hope that you will use them to find great deals on the market. 

 

Niki Pezeshki

College Trillionaire

Trillionaire Term of the Day - January 29, 2009 - Bulls and Bears

Bulls and Bears

If you’ve ever turned on CNBC or opened the Wall Street Journal you’ve heard analysts talk incessantly about bulls and bears. And, you probably questioned the sanity of people who relate animals to the stock market. But, bulls and bears are actually a simple part of everyday Wall Street lingo.

Bulls are investors that are optimistic about a certain stock, a market, or a general economic trend. They aggressively believe that a stock will rise or a market is on the way up, so they tend to buy on their beliefs. If I say that I am bullish on a stock, I mean that I believe the stock will increase in price in the future.

Bears, on the other hand, are pessimistic about a stock or the markets. They believe that trouble is looming around the bend, and that one ought to stay away from the danger. If someone is bearish on a stock, they’ll tend to sell, avoid buying it, or even short sell the stock (Check out our Trillionaire Term of the Day on Short Selling).

The terminology can also be applied to the entire stock market. For example, you’ve probably heard many investors saying that we are currently in a bear market. A bear market is usually characterized by recessionary economic trends, fearful investors, and falling stock prices. A bull market is the exact opposite: in a bull market you should expect expansion of the economy, aggressive investors, and rising stock prices. Famed hedge fund manager and Mad Money host Jim Cramer loves to say, “there is always a Bull Market somewhere.” By this he means that there will always be a group of stocks, currencies, or commodities that are on the rise.

Why bulls and bears? Although the true origin of their use has been lost in investor lore, people have come up with some clever guesses. One theory is that the term bear is based on ‘bearskin jobbers’ who sold bearskins before they received them, in hopes that the price would decrease and they would make a profit. So in a sense, they were the first short sellers. Another guess refers to the ways that the two animals attack their prey. Bulls aggressively charge and thrust their horns upwards, hence the aggressive nature of investors and the upward swing in the markets. Bears attack by downwardly swiping with their paws like the downward direction of a bear market.

Regardless of the true source of the terminology, it’s of the utmost importance for you to understand what people mean when they talk about bulls and bears. At the very least, you’ll gain appreciation for how investors are thinking. And now you can add a dash of flavor to your financial vocabulary. Enjoy

 

-Matt Schwartz

College Trillionaire