Selected excerpts from the Knowledgebase -11

Selected excerpts from the Knowledgebase -11

I’ve decided to do a daily small excerpt from the Knowledgebase as sort of a thought for the day. In many cases they will have extra thoughts of mine, or small updates. I hope you’ll find them interesting.


Here’s the eleventh: We have members of this board with all different levels of investing experience, and from some recent questions, we have some members who are just starting out, and some with more experience. I had prepared this primer for my wife, but I also put it in the Knowledgebase. You are all welcome to read it. This is the beginning of it.

## Investment Primer:

The Difference between Stocks and Bonds

Bonds: If you “buy” a bond, it means you actually lend money to the company. You receive interest payments for the term of the bond and then get your money back at the end of the loan.

For example, if you buy a thousand dollar, 5.6%, 20-year bond from GM, that means GM owes you a thousand dollars which they promise to pay back in twenty years from the issue date, and will pay 5.6% per year interest in the meanwhile ($56 per year).

Bonds trade on exchanges on Wall Street, just like stocks, so if you want to sell the bond and get your cash before the due date you can sell it just like a stock. The price will vary though and won’t always be exactly $1000. The following are very simplified examples:

For example if interest rates are very low (like now), and all you can get from the savings bank is 1% or less, that 5.6% can look very good to someone who is interested in income.

She might say to herself “I’d be willing to pay $1040, $1050, or even $1080 for that bond. It still has 18 years to run, and I’ll get $56 per year in interest. That’s $46 per year more than I’ll get from the bank. I know that I’ll only get $1000 back in 18 years when the bond matures, but even if I pay $1080 I’ll more than make the difference back within the first two years.”

On the other hand, if interest rates are high, at 7% or 8% for a fully guaranteed treasury bond, for example, the same person might say, “I’m not willing to pay $1000 for a GM bond paying 5.6% when I can get a better rate from the Treasury. I’m only willing to pay $920 for it. That way the $56 per year I get will actually be 6.1% on the money I’ve invested. It’s less than I’d get on a 7% bond, but when the bond matures, I’ll get a full $1000 back and make $80 profit.”

Also if there is any question that the company may fail, the value of their bonds will fall in value, because they may not be able to pay you back that $1000.

Note that if it’s closer to the maturity date, the price that people will pay will be closer to $1000, because they are about to get $1000 for the bond.

A new company starting out, or one whose finances are shaky, in order to interest people in lending them the money, will have to offer their bonds paying a higher rate of interest, than say a company like General Electric, for example. The question is “Is this company sure to be able to pay back the $1000 in 20 years?”

I personally never buy bonds. You have no chance of profiting in the success of the company, but all the risk if the company fails or goes out of business. In twenty years the company’s stock could be worth 50 times what it is now, but the bond is just a loan, and you’ll just get back what you loaned them - which will be worth only a small fraction of what you actually loaned them due to inflation.

My father called bonds “guaranteed confiscation,” because the money was guaranteed to lose value over time.

Stocks: about which we will talk at length, are ownership of a piece of the company. If the company has a million shares and you own one hundred shares, you own one ten thousandth of the company. If the company is successful and increases in value, your shares will go up proportionally.

If a company has 1 million shares of stock and each share happens to be trading today for $80, the company is valued by the market at $80 times 1 million, or $80 million. This is called the Market Cap, which is short for market capitalization.

Since the market sets the price of the stock, the price, and thus the Market Cap, can be more, or it can be less, than what you think it’s worth. It varies from day to day and can go up or down depending on how people estimate the company’s chances for success, or just for irrelevant reasons such as a big mutual fund deciding to buy the stock or sell it, or even because a large holder of the stock decides to buy an apartment in New York, and thus sells $1.5 million worth of shares.

Several factors go into how the public values a stock. One is growth, another is profit, a third is how much publicity a company gets, and a fourth is how much the company is in the public eye. Let me touch on these:

Growth is very important and people will almost always pay more for a company that is growing rapidly, even, usually, if it isn’t yet making money. (That is, they’ll value the fast growing company higher for a given amount of sales and earnings than they will another company with identical sales and earnings but which is not growing. They value the first company higher because they figure that it will be worth more next year).

Profitability. I generally won’t buy a company until it’s profitable, but I do make occasional exceptions. A company can be quite profitable, but can be making the same nice amount of money each year, or be growing very slowly. In the slow growth case it won’t be valued as highly as a rapidly growing company. Its P/E ratio - how high its stock is priced relative to its earnings or profits - will be lots lower. (More on P/E ratios later)

Publicity is important because people have to hear about a stock before they can buy it. The stock is like a product that needs advertising. For example, if a newsletter recommends a stock, or if a brokerage house like Morgan Stanley recommends a stock, the price will go up because more people will be bidding for the same supply of stocks after the recommendation. There are even newsletters which make paid recommendations (recommendations for a fee)!

In the Public Eye. Everybody knows Google, for instance, and Amazon, so they will sell for higher multiples than a company like Ellie Mae, which automates the mortgage origination business. Everyone in the mortgage origination business may know Ellie Mae but that is a tiny fraction of the number of people who are familiar with Google or Amazon.

Size of the company. In general, smaller companies can grow faster and therefore often sell for higher valuations in relation to the size of their sales and earnings. In other words, they often sell at higher PE ratios. Part of the reason is “The Law of Large Numbers.” A little company, say with $20 million in sales, which is doubling each year but controls only a 1% share of its potential market, can double again next year, and the year after, and the year after that, and still have only an 8% share of its potential market. Maybe even less, if the potential market has grown in the meanwhile.

On the other hand, a big company with $20 billion in sales, which controls, say, a 40% share of its market, will have a very difficult time doubling its sales even once. (It’s hard to find $20 billion in new sales, and it’s almost impossible to go from a 40% share of the market to an 80% share).

Note that you can easily find a small company that has no room to grow. If it sells widgets and has $20 million in sales, but there are only $30 million in worldwide sales of widgets, where’s it going to go? Or if it has nothing special about its widgets, how is it going to get more sales, etc.

Similarly, a larger company with $5 billion in sales, may be facing a $200 billion worldwide opportunity, and thus have plenty of growing room. Rules about size are not hard and fast.


For Knowledgebase for this board,
please go to Post #17774, 17775 and 17776.
We had to post it in three parts this time.

A link to the Knowledgebase is also at the top of the Announcements column
on the right side of every page on this board