Stock market
SouthUral State
University
The Department of
Economic and Management
Work on subject
The
Student: Velichko O.S.
Group: E&M-263
The Tutor: Sergeeva L.M.
Chelyabinsk
1998
Contents
1.
Market
place
2.
Trading
on the stock exchange floor
3.
Securities.
Categories of common stock
3.1
Growth
stocks
3.2
Cyclical
stocks
3.3
Special
situations
4.
Preferred
stocks
4.1
Bonds-corporate
4.2
Bonds-U.S.
government
4.3
Bonds-municipal
4.4
Convertible
securities
4.5
Option
4.6
Rights
4.7
Warrants
4.8
Commodities
and financial futures
5.
Stock
market averages reading the newspaper quotations
5.1
The
price-earnings ratio
6.
European
stock markets–general trend
6.1
New
ways for old
6.2
Europe,
meet electronics
7.
New
issues
8.
Mutual
funds. A different approach
8.1
Advantages
of mutual funds
8.2
Load
vs. No-load
8.3
Common
stock funds
8.4
Other
types of mutual funds
8.5
The daily
mutual fund prices
8.6
Choosing
a mutual fund
1. MARKET PLACE
The stock market. To some it’s a puzzle. To others
it’s a source of profit and endless fascination. The stock market is the
financial nerve center of any country. It reflects any change in the economy.
It is sensitive to interest rates, inflation and political events. In a very
real sense, it has its fingers on the pulse of the entire world.
Taken in its broadest sense, the stock
market is also a control center. It is the market place where businesses and
governments come to raise money so that they can continue and expend their
operations. It is the market place where giant businesses and institutions come
to make and change their financial commitments. The stock market is also a
place of individual opportunity.
The phrase “the stock
market” means many things. In the narrowest sense, a stock market is a place
where stocks are traded – that is bought and sold. The phrase “the stock
market” is often used to refer to the biggest and most important stock market
in the world, the New York Stock Exchange, which is as well the oldest in the
US. It was founded in 1792. NYSE is located at 11 Wall Street in New York City.
It is also known as the Big Board and the Exchange. In the mid-1980s
NYSE-listed shares made up approximately 60% of the total shares traded on
organized national exchanges in the United States.
AMEX stands for the American Stock
Exchange. It has the second biggest volume of trading in the US. Located at 86
Trinity Place in downtown Manhattan, the AMEX was known until 1921 as the Curb
Exchange, and it is still referred to as the Curb today. Early traders gathered
near Wall Street. Nothing could stop those outdoor brokers. Even in the snow
and rain they put up lists of stocks for sale. The gathering place became known
as the outdoor curb market, hence the name the Curb. In 1921 the Curb finally
moved indoors. For the most part, the stocks and bonds traded on the AMEX are
those of small to medium-size companies, as contrasted with the huge companies
whose shares are traded on the New York Stock Exchange.
The Exchange is non-for-profit corporation
run by a board of directors. Its member firm are subject to a strict and
detailed self-regulatory code. Self-regulation is a matter of self-interest for
stock exchange members. It has built public confidence in the Exchange. It also
required by law. The US Securities and Exchange Commission (SEC) administers
the federal securities laws and supervises all securities exchange in the country.
Whenever self-regulation doesn’t do the job, the SEC is likely to step in
directly. The Exchange doesn’t buy, sell or own any securities nor does it set
stock prices. The Exchange merely is the market place where the public, acting
through member brokers, can buy and sell at prices set by supply and demand.
It costs money it become an Exchange
member. There are about 650 memberships or “seats” on the NYSE, owned by large
and small firms and in some cases by individuals. These seats can be bought and
sold; in 1986 the price of a seat averaged around $600,000. Before you are
permitted to buy a seat you must pass a test that strictly scrutinizes your knowledge
of the securities industry as well as a check of experience and character.
Apart from the NYSE and
the AMEX there are also “regional” exchange in the US, of which the best known
are the Pacific, Midwest, Boston and Philadelphia exchange.
There is one more market place in which the
volume of common stock trading begins to approach that of the NYSE. It is
trading of common stock “over-the-counter” or “OTC”–that is not on any
organized exchange. Most securities other than common stocks are traded
over-the-counter. For example, the vast market in US Government securities is
an over-the-counter market. So is the money market–the market in which all
sorts of short-term debt obligations are traded daily in tremendous quantities.
Like-wise the market for long-and short-term borrowing by state and local
governments. And the bulk of trading in corporate bonds also is accomplished
over-the-counter.
While most of the common stocks traded
over-the-counter are those of smaller companies, many sizable corporations
continue to be found on the “OTC” list, including a large number of banks and
insurance companies.
As there is no physical trading floor,
over-the-counter trading is accomplished through vast telephone and other electronic
networks that link traders as closely as if they were seated in the same room.
With the help of computers, price quotations from dealers in Seattle, San Diego,
Atlanta and Philadelphia can be flashed on a single screen. Dedicated telephone
lines link the more active traders. Confirmations are delivered electronically
rather than through the mail. Dealers thousands of miles apart who are complete
strangers execute trades in the thousands or even millions of dollars based on
thirty seconds of telephone conversation and the knowledge that each is a
securities dealer registered with the National Association of Securities
Dealers (NASD), the industry self-regulatory organization that supervises OTC
trading. No matter which way market prices move subsequently, each knows that
the trade will be honoured.
2. TRADING ON THE STOCK EXCHANGE FLOOR
When an individual wants to place an order
to buy or sell shares, he contacts a brokerage firm that is a member of the
Exchange. A registered representative or “RR” will take his order. He or she is
a trained professional who has passed an examination on many matters including
Exchange rules and producers.
The individual’s order is relayed to a
telephone clerk on the floor of the Exchange and by the telephone clerk to the
floor broker. The floor broker who actually executes the order on the trading
floor has an exhausting and high-pressure job. The trading floor is a larger
than half the size of football field. It is dotted with multiple locations
called “trading posts”. The floor broker proceeds to the post where this or
that particular stock is traded and finds out which other brokers have orders
from clients to buy or sell the stock, and at what prices. If the order the
individual placed is a “market order”–which means an order to buy or sell
without delay at the best price available–the broker size up the market,
decides whether to bargain for a better price or to accept one of the orders
being shown, and executes the trade–all this happens in a matter of seconds.
Usually shares are traded in round lots on securities exchanges. A round lot is
generally 100 shares, called a unit of trading, anything less is called an odd
lot.
When you first see the trading floor, you
might assume all brokers are the same, but they aren’t. There are five categories
of market professionals active on the trading floor.
Commission Brokers, usually floor brokers, work for member
firms. They use their experience, judgment and execution skill to buy and sell
for the firm’s customer for a commission.
Independent Floor Brokers are individual entrepreneurs who act for a
variety of clients. They execute orders for other floor brokers who have more
volume than they can handle, or for firms whose exchange members are not on the
floor.
Registered Competitive Market Makers have specific obligations to trade for
their own or their firm’s accounts–when called upon by an Exchange official–by
making a bid or offer that will narrow the existing quote spread or improve the
depth of an existing quote.
Competitive Traders trade for their own accounts, under strict
rules designed to assure that their activities contribute to market liquidity.
And last, but not least, come Stock
Specialists. The Exchange tries to preserve price continuity– which means
that if a stock has been trading at, say, 35, the next buyer or seller should
be able to an order within a fraction of that price. But what if a buyer comes
in when no other broker wants to sell close to the last price? Or vice versa
for a seller? How is price continuity preserved? At this point enters the
Specialist. The specialist is charged with a special function, that of
maintaining continuity in the price of specific stocks. The specialist does
this by standing ready to buy shares at a price reasonably close to the last
recorded sale price when someone wants to sell and there is a lack of buyers,
and to sell when there is a lack of sellers and someone wants to buy. For each listed
stock, there are one or more specialist firms assigned to perform this
stabilizing function. The specialist also acts as a broker, executing public
orders for the stock, and keeping a record of limit orders to be executed if
the price of the stock reaches a specified level. Some of the specialist firms
are large and assigned to many different stocks. The Exchange and the SEC are
particularly interested in the specialist function, and trading by the
specialists is closely monitored to make sure that they are giving precedence
to public orders and helping to stabilize the markets, not merely trying to
make profits for themselves. Since a specialist may at any time be called on to
buy and hold substantial amounts of stock, the specialist firms must be well
capitalized.
In today's markets, where
multi-million-dollar trades by institutions (i. e. banks, pension funds, mutual
funds, etc.) have become common, the specialist can no longer absorb all of the
large blocks of stock offered for sale, nor supply the large blocks being
sought by institutional buyers. Over the last several years, there has been a
rapid growth in block trading by large brokerage firms and other firms in the
securities industry. If an institution wants to sell a large block of stock, these
firms will conduct an expert and rapid search for possible buyers; if not
enough buying interest is found, the block trading firm will fill the gap by
buying shares itself, taking the risk of owning the shares and being able to
dispose of them subsequently at a profit. If the institution wants to buy
rather than sell, the process is reversed. In a sense, these firms are
fulfilling the same function as the specialist, but on a much larger scale.
They are stepping in to buy and own stock temporarily when offerings exceed
demand, and vice versa.
So the specialists and the block traders
perform similar stabilizing functions, though the block traders have no official
role and have no motive other than to make a profit.
3. SECURITIES. CATEGORIES OF COMMON STOCK
There is a lot to be said about securities.
Security is an instrument that signifies (1) an ownership position in a corporation
(a stock), (2) a creditor relationship with a corporation or governmental body
(a bond), or (3) rights to ownership such as those represented by an option,
subsription right, and subsription warrant.
People who own stocks and bonds are referred to as
investors or, respectively, stockholders (shareholders) and bondholders. In
other words a share of stock is a share of a business. When you hold a stock in
a corporation you are part owner of the corporation. As a proof of ownership
you may ask for a certificate with your name and the number of shares you hold.
By law, no one under 21 can buy or sell stock. But minors can own stock if kept
in trust for them by an adult. A bond represents a promise by the company or
government to pay back a loan plus a certain amount of interest over a definite
period of time.
We have said that common stocks are shares
of ownership in corporations. A corporation is a separate legal entity that is
responsible for its own debts and obligations. The individual owners of the
corporation are not liable for the corporation's obligations. This concept,
known as limited liability, has made possible the growth of giant corporations.
It has allowed millions of stockholders to feel secure in their position as
corporate owners. All that they have risked is what they paid for their shares.
A stockholder (owner) of a corporation has
certain basic rights in proportion to the number of shares he or she owns. A
stockholder has the right to vote for the election of directors, who control
the company and appoint management. If the company makes profits and the
directors decide to pay part of these profits to shareholders as dividends, a
stockholder has a right to receive his proportionate share. And if the
corporation is sold or liquidates, he has a right to his proportionate share of
the proceeds.
What type of stocks can be found on stock
exchanges? The question can be answered in different ways. One way is by
industry groupings. There are companies in every industry, from aerospace to
wholesale distributers. The oil and gas companies, telephone companies,
computer companies, autocompanies and electric utilities are among the biggest
groupings in terms of total earnings and market value. Perhaps a more useful
way to distinguish stocks is according to the qualities and values investors
want.
3.1 Growth
Stocks.
The phrase
"growth stock" is widely used as a term to describe what many
investors are looking for. People who are willing to take greater-than-average
risks often invest in what is often called "high-growth"
stocks—stocks of companies that are clearly growing much faster than average and where the stock commands
a premium price in the market. The rationale is that the company's earnings
will continue to grow rapidly for at least a few more years to a level that
justifies the premium price. An investor should keep in mind that only a small
minority of companies really succeed in making earnings grow rapidly and
consistently over any long period. The potential rewards are high, but the
stocks can drop in price at incredible rates when earnings don't grow as
expected. For example, the companies in the video game industry boomed in the
early 1980s, when it appeared that the whole world was about to turn into one
vast video arcade. But when public interest shifted to personal computers, the
companies found themselves stuck with hundreds of millions of dollars in video
game inventories, and the stock collapsed.
There is less glamour, but also less risk,
in what we will call—for lack of a better phrase—"moderate-growth"
stocks. Typically, these might be stocks that do not sell at premium, but where
it appears that the company's earnings will grow at a faster-than-average rate
for its industry. The trick, of course, is in forecasting which companies
really will show better-than-average growth; but even if the forecast is wrong,
the risk should not be great, assuming that the price was fair to begin with.
There's a broad category of stocks that has
no particular name but that is attractive to many investors, especially those
who prefer to stay on the conservative side. These are stocks of companies that
are not glamorous, but that grow in line with the economy. Some examples are
food companies, beverage companies, paper and packaging manufacturers, retail
stores, and many companies in assorted consumer fields.
As long as the economy is healthy and
growing, these companies are perfectly reasonable investments; and at certain
times when everyone is interested in "glamour" stocks, these
"non-glamour" issues may be neglected and available at bargain
prices. Their growth may not be rapid, but it usually is reasonably consistent.
Also, since these companies generally do not need to plow all their earnings
back into the business, they tend to pay sizable dividends to their
stockholders. In addition to the real growth that these companies achieve,
their values should adjust upward over time in line with inflation—a general
advantage of common stocks that is worth repeating.
3.2 Cyclical Stocks.
3.3 Special Situations.
There’s a type of investment that
professionals usually refer to as “special situations”. These are cases where
some particular corporate development–perhaps a merger, change of control, sale
of property, etc.– seems likely to raise the value of a stock.
Special situation investments may be less affected by general stock market
movements than the average stock investment; but if the expected development
doesn’t occur, an investor may suffer a loss, sometimes sizable. Here the
investor has to judge the odds of the expected development’s actually coming to
pass.
4. PREFERRED STOCKS
A preferred stock is a stock which bears
some resemblances to a bond (see below). A preferred stockholder is entitled to
dividends at a specified rate, and these dividends must be paid before any
dividends can be paid on the company's common stock. In most cases the
preferred dividend is cumulative, which means that if it isn't paid in a given
year, it is owed by the company to the preferred stockholder. If the
corporation is sold or liquidates, the preferred stockholders have a claim on a
certain portion of the assets ahead of the common stockholders. But while a
bond is scheduled to be redeemed by the corporation on a certain
"maturity" date, a preferred stock is ordinarily a permanent part of
the corporation's capital structure. In exchange for receiving an assured
dividend, the preferred stockholder generally does not share in the progress of
the company; the preferred stock is only entitled to the fixed dividend and no
more (except in a small minority of cases where the preferred stock is
"participating" and receives higher dividends on some basis as the
company's earnings grow).
Many preferred stocks are listed for
trading on the NYSE and other exchanges, but they are usually not priced very
attractively for individual buyers. The reason is that for corporations
desiring to invest for fixed income, preferred stocks carry a tax advantage
over bonds. As a result, such corporations generally bid the prices of
preferred stocks up above the price that would have to be paid for a bond
providing the same income. For the individual buyer, a bond may often be a
better buy.
4.1 Bonds-Corporate
Unlike a stock, a bond is evidence not of
ownership, but of a loan to a company (or to a government, or to some other
organization). It is a debt obligation. When you buy a corporate bond, you have
bought a portion of a large loan, and your rights are those of a lender. You
are entitled to interest payments at a specified rate, and to repayment of the
full "face amount" of the bond on a specified date. The fixed
interest payments are usually made semiannually. The quality of a corporate
bond depends on the financial strength of the issuing corporation.
Bonds are usually issued in units of $1,000
or $5,000, but bond prices are quoted on the basis of 100 as "par"
value. A bond price of 96 means that a bond of $1,000 face value is actually
selling at $960 And so on.
Many corporate bonds are traded on the
NYSE, and newspapers carry a separate daily table showing bond trading. The
major trading in corporate bonds, however, takes place in large blocks of
$100,000 or more traded off the Exchange by brokers and dealers acting for
their own account or for institutions.
4.2 Bonds-U. S. Government
U.S. Treasury bonds
(long-term), notes (intermediate-term) and bills (short-term), as well as
obligations of the various U. S. government agencies, are traded away from the
exchanges in a vast professional market where the basic unit of trading is
often $ 1 million face value in amount. However, trades are also done in
smaller amounts, and you can buy Treasuries in lots of $5,000 or $10,000
through a regular broker. U. S. government bonds are regarded as providing
investors with the ultimate in safety.
4.3 Bonds-Municipal
Bonds issued by state and local governments
and governmental units are generally referred to as "municipals" or
"tax-exempts", since the income from these bonds is largely exempt
from federal income tax.
Tax-exempt bonds are attractive to individuals in
higher tax brackets and to certain institutions. There are many different
issues and the newspapers generally list only a small number of actively traded
municipals. The trading takes place in a vast, specialized over-the-counter
market. As an offset to the tax advantage, interest rates on these bonds are
generally lower than on U. S. government or corporate bonds. Quality is usually
high, but there are variations according to the financial soundness of the
various states and communities.
4.4 Convertible Securities
A convertible bond (or convertible
debenture) is a corporate bond that can be converted into the company's common
stock under certain terms. Convertible preferred stock carries a similar
"conversion privilege". These securities are intended to combine the
reduced risk of a bond or preferred stock with the advantage of conversion to
common stock if the company is successful. The market price of a convertible
security generally represents a combination of a pure bond price (or a pure
preferred stock price) plus a premium for the conversion privilege. Many
convertible issues are listed on the NYSE and other exchanges, and many others
are traded over-the-counter
4.5 Options
An option is a piece of paper that gives
you the right to buy or sell a given security at a specified price for a
specified period of time. A "call" is an option to buy, a
"put" is an option to sell. In simplest form, these have become an
extremely popular way to speculate on the expectation that the price of a stock
will go up or down. In recent years a new type of option has become extremely
popular: options related to the various stock market averages, which let you
speculate on the direction of the whole market rather than on individual
stocks. Many trading techniques used by expert investors are built around
options; some of these techniques are intended to reduce risks rather than for
speculation.
4.6 Rights
When a corporation wants to sell new
securities to raise additional capital, it often gives its stockholders rights
to buy the new securities (most often additional shares of stock) at an
attractive price. The right is in the nature of an option to buy, with a very
short life. The holder can use ("exercise") the right or can sell it
to someone else. When rights are issued, they are usually traded (for the short
period until they expire) on the same exchange as the stock or other security
to which they apply.
4.7 Warrants
A warrant resembles a right in that it is
issued by a company and gives the holder the option of buying the stock (or
other security) of the company from the company itself for a specified price.
But a warrant has a longer life—often several years, sometimes without limit As
with rights, warrants are negotiable (meaning that they can be sold by the
owner to someone else), and several warrants are traded on the major exchanges.
4.8 Commodities and Financial
Futures
The commodity markets, where foodstuffs and
industrial commodities are traded in vast quantities, are outside the scope of
this text. But because the commodity markets deal in "futures"—that
is, contracts for delivery of a certain good at a specified future date— they
have also become the center of trading for "financial futures",
which, by any logical definition, are not commodities at all.
Financial futures are relatively new, but they have
rapidly zoomed in importance and in trading activity. Like options, the futures
can be used for protective purposes as well as for speculation. Making the most
headlines have been stock index futures, which permit investors to speculate on
the future direction of the stock market averages. Two other types of financial
futures are also of great importance: interest rate futures, which are based
primarily on the prices of U.S. Treasury bonds, notes, and bills, and which
fluctuate according to the level of interest rates; and foreign currency
futures, which are based on the exchange rates between foreign currencies and
the U.S. dollar. Although, futures can be used for protective purposes, they
are generally a highly speculative area intended for professionals and other
expert investors.
5. STOCK MARKET AVERAGES READING
THE NEWSPAPER QUOTATIONS
The financial pages of
the newspaper are mystery to many people. But dramatic movements in the stock
market often make the front page. In newspaper headlines, TV news summaries,
and elsewhere, almost everyone has been exposed to the stock market averages.
In a brokerage firm
office, it’s common to hear the question “How’s the market?” and answer, “Up
five dollars”, or “Down a dollar”. With 1500 common stocks listed on the NYSE,
there has to be some easy way to express the price trend of the day. Market
averages are a way of summarizing that information.
Despite all competition,
the popularity crown still does to an average that has some of the qualities of
an antique–the Dow Jones Industrial Average, an average of 30 prominent stocks
dating back to the 1890s. This average is named for Charles Dow–one of the
earliest stock market theorists, and a founder of Dow Jones & Company, a
leading financial news service and publisher of the Wall Street Journal.
In the days before
computers, an average of 30 stocks was perhaps as much as anyone could
calculate on a practical basis at intervals throughout the day. Now, the
Standard & Poor’s 500 Stock Index (500 leading stocks) and the New York
Stock Exchange Composite Index (all stocks on the NYSE) provide a much more
accurate picture of the total market. The professionals are likely to focus
their attention on these “broad” market indexes. But old habits die slowly, and
someone calls out, “How’s the market?” and someone else answers, “Up five
dollars,” or “Up five”–it’s still the Dow Jones Industrial Average (the “Dow”
for short) that they’re talking about.
The importance of daily
changes in the averages will be clear if you view them in percentage terms.
When the market is not changing rapidly, the normal daily change is less than
½ of 1%. A change of ½% is still moderate; 1% is large but not
extraordinary; 2% is dramatic. From the market averages, it’s a short step to
the thousands of detailed listings of stock prices and related data that you’ll
find in the daily newspaper financial tables. These tables include complete
reports on the previous day’s trading on the NYSE and other leading exchanges.
They can also give you a surprising amount of extra information.
Some newspapers provide more extensive tables, some less. Since the Wall
Street Journal is available world wide, we’ll use it as a source of
convenient examples. You’ll find a prominent page headed “New York Stock
Exchange Composite Transactions”. This table covers the day’s trading for all
stocks listed on the NYSE. “Composite” means that it also includes trades in
those same stocks on certain other exchanges (Pacific, Midwest, etc.) where the
stocks are “dually listed”. Here are some sample entries:
52 Weeks
|
|
|
Yld
|
P-E
|
Sales
|
|
|
|
Net
|
High
|
Low
|
Stock
|
Div
|
%
|
Ratio
|
100s
|
High
|
Low
|
Close
|
Chg.
|
52 7/8
|
37 5/8
|
Cons Ed
|
2.68
|
5.4
|
12
|
909
|
49 3/8
|
48 7/8
|
49 1/4
|
+1/4
|
91 1/8
|
66 1/2
|
Gen El
|
2.52
|
2.8
|
17
|
11924
|
91 3/8
|
89 5/8
|
90
|
-1
|
41 3/8
|
26 1/4
|
Mobil
|
2.20
|
5.4
|
10
|
15713
|
41
|
40 1/2
|
40 7/8
|
Some of the abbreviated
company names in the listings can be a considerable puzzle, but you will get
used to them.
While some of the columns contain
longer-term information about the stocks and the companies, we'll look first at
the columns that actually report on the day's trading. Near the center of the
table you will see a column headed "Sales 100s". Stock trading
generally takes place in units of 100 shares and is tabulated that way; the
figures mean, for example, that 90,900 shares of Consolidated Edison, 1,192,400
shares of General Electric, and 1,571,300 shares of Mobil traded on January 8.
(Mobil actually was the 12th "most active" stock on the NYSE that
day, meaning that it ranked 12th in number of shares traded.)
The next three columns show the highest
price for the day, the lowest, and the last or "closing" price. The
"Net Chg." (net change) column to the far right shows how the closing
price differed from the previous day's close—in this case, January 7.
Prices are traditionally calibrated in
eighths of a dollar. In case you aren't familiar with the equivalents, they
are:
1/8 =$.125
1/4=$.25
3/8 =$.375
1/2 =$.50
5/8 =$.625
3/4=$.75
7/8
=$.875
Con Edison traded on January 8 at a high of
$49.375 per share and a low of $48 875, it closed at $49.25, which was a gain
of $0.25 from the day before. General Electric closed down $1.00 per share at
$90 00, but it earned a "u" notation by trading during the day at $91
375, which was a new high price for the stock during the most recent 52 weeks
(a new low price would have been denoted by a "d").
The two columns to the far left show the high
and low prices recorded in the latest 52 weeks, not including the latest day.
(Note that the high for General Electric is shown as 91 1/8,
not 91 3/8.) You will note that
while neither Con Edison nor Mobil reached a new high on January 8, each was
near the top of its "price range" for the latest 52 weeks.
(Individual stock price charts, which are published by several financial services,
would show the price history of each stock in detail.)
The other three columns in the table give
you information of use in making judgments about stocks as investments. Just to
the right of the name, the "Div." (dividend) column shows the current
annual dividend rate on the stock — or, if there's no clear regular rate, then
the actual dividend total for the latest 12 months. The dividend rates shown
here are $2.68 annually for Con Edison, $2.52 for GE, and $2.20 for Mobil.
(Most companies that pay regular dividends pay them quarterly: it's actually
$0.67 quarterly for Con Edison, etc.) The "Yid." (Yield) column
relates tie annual dividend to the latest stock price. In the case of Con
Edison, for example, $2.68 (annual dividend)/$49.25 (stock price) ==5.4%, which
represents the current yield on the stock.
5.1 The Price-Earnings Ratio
Finally, we have the "P-E ratio",
or price-earnings ratio, which represents a key figure in judging the value of
a stock. The price-earnings ratio—also referred to as the "price-earnings
multiple", or sometimes simply as the "multiple"—is the ratio of
the price of a stock to the earnings per share behind the stock.
This concept is
important. In simplest terms (and without taking possible complicating factors
into account), "earnings per share" of a company are calculated by
taking the company's net profits for the year, and dividing by the number of
shares outstanding. The result is, in a very real sense, what each share earned
in the business for the year — not to be confused with the dividends that the
company may or may not have paid out. The board of directors of the company may
decide to plow the earnings back into the business, or to pay them out to
shareholders as dividends, or (more likely) a combination of both; but in any
case, it is the earnings that are usually considered as the key measure of the
company's success and the value of the stock.
The price-earnings ratio tells you a great
deal about how investors view a stock. Investors will bid a stock price up to a
higher multiple if a company's earnings are expected to grow rapidly in the
future. The multiple may look too high in relation to current earnings, but not
in relation to expected future earnings. On the other hand, if a company's
future looks uninteresting, and earnings are not expected to grow
substantially, the market price will decline to a point where the multiple is
low.
Multiples also change
with the broad cycles of the stock market, as investors become willing to pay
more or less for certain values and potentials. Between 1966 and 1972, a period
of enthusiasm and speculation, the average multiple was usually 15 or higher.
In the late 1970s, when investors were generally cautious and skeptical, the
average multiple was below 10. However, note that these figures refer to
average multiples–whatever the average multiple is at any given time, the multiples
on individual stocks will range above and below it.
Now we can return to the
table. The P-E ratio for each stock is based on the latest price of the stock
and on earnings for the latest reported 12 months. The multiples, as you can
see, were 12 for Con Edison, 17 for GE, and 10 for Mobil. In January 1987, the
average multiple for all stocks was very roughly around 15. Con Edison is
viewed by investors as a relatively good-quality utility company, but one that
by the nature if its business cannot grow much more rapidly that the economy as
a whole. GE, on the other hand, is generally given a premium rating as a
company that is expected to outpace the economy.
You can't buy a stock on the P-E ratio
alone, but the ratio tells you much that is useful. For stocks where no P-E
ratio is shown, it often means that the company showed a loss for the latest 12
months, and that no P-E ratio can be calculated. Somewhere near the main NYSE
table, you'll find a few small tables that also relate to the day's
NYSE-Composite trading. There's the table showing the 15 stocks that traded the
greatest number of shares for the day (the "most active" list), a
table of the stocks that showed the greatest percentage of gains or declines
(low-priced stocks generally predominate here); and one showing stocks that
made new price highs or lows relative to the latest 52 weeks.
You'll find a large table of "American Stock
Exchange Composite Transactions", which does for stocks listed on the AMEX
just what the NYSE-Composite table does for NYSE-listed stocks. There are
smaller tables covering the Pacific Stock Exchange, Boston Exchange, and other
regional exchanges.
The tables showing over-the-counter stock
trading are generally divided into two or three sections. For the major
over-the-counter stocks covered by the NASDAQ quotation and reporting system,
actual sales for the day are reported and tabulated just as for stocks on the
NYSE and AMEX. For less active over-the-counter stocks, the paper lists only
"bid" and "asked" prices, as reported by dealers to the
NASD.
It is worth becoming familiar with the
daily table of prices of U.S. Treasury and agency securities. The Treasury
issues are shown not only in terms of price, but in terms of the yield
represented by the current price. This is the simplest way to get a bird's-eye
view of the current interest rate situation—you can see at a glance the current
rates on long-term Treasury bonds, intermediate-term notes, and short-term
bills.
Elsewhere in the paper you will also find a
large table showing prices of corporate bonds traded on the NYSE, and a small
table of selected tax-exempt bonds (traded OTC). But unless you have a specific
interest in any of these issues, the table of Treasury prices is the best way
to follow the bond market.
There are other tables listed. These are
generally for more experienced investors and those interested in taking higher
risks. For example, there are tables showing the trading on several different
exchanges in listed options—primarily options to buy or sell common stocks
(call options and put options). There are futures prices— commodity futures and
also interest rate futures, foreign currency futures, and stock index futures.
There are also options relating to interest rates and options relating to the
stock index futures.
6. EUROPEAN STOCKMARKETS–GENERAL
TREND
Competition among Europe’s securities exchanges is
fierce. Yet most investors and companies would prefer fewer, bigger markets. If
the exchanges do not get together to provide them, electronic usurpers will.
How many stock exchanges
does a Europe with a single capital market need? Nobody knows. But a
part-answer is clear: fewer than it has today. America has eight stock
exchanges, and seven futures and options exchanges. Of these only the New York
Stock Exchange, the American Stock Exchange, NASDAQ (the over-the-counter
market), and the two Chicago futures exchanges have substantial turnover and
nationwide pretensions.
The 12 member countries
of the European Community (EC), in contrast, boast 32 stock exchanges and 23
futures and options exchanges. Of these, the market in London, Frankfurt,
Paris, Amsterdam, Milan and Madrid–at least–aspire to significant roles on the
European and world stages. And the number of exchanges is growing. Recent
arrivals include exchanges in Italy and Spain. In eastern Germany, Leipzig
wants to reopen the stock exchange that was closed in 1945.
Admittedly, the EC is not as integrated as
the United States. Most intermediaries, investors and companies are still national
rather than pan-European in character. So is the job of regulating securities
markets; there is no European equivalent of America’s Securities and Exchange
Commission (SEC). Taxes, company law and accounting practices vary widely. Several
regulatory barriers to cross-border investment, for instance by pension funds,
remain in place. Recent turmoil in Europe’s exchange rate mechanics has
reminded cross0border investors about currency risk. Despite the Maastricht
treaty, talk of a common currency is little more than that
Yet the local loyalties that sustain so
many European exchanges look increasingly out-of-date. Countries that once had
regional stock exchanges have seen them merged into one. A single European
market for financial services is on its way. The EC's investment services
directive, which should come into force in 1996, will permit cross-border
stockbroking without the need to set up local subsidiaries. Jean-Francois
Theodore, chairman of the Paris Bourse, says this will lead to another European
Big Bang. And finance is the multinational business par excellence: electronics
and the end of most capital controls mean that securities traders roam not just
Europe but the globe in search of the best returns.
This affects more than just stock
exchanges. Investors want financial market that are cheap, accessible and of
high liquidity (the ability to buy or sell shares without moving the price).
Businesses, large and small, need a capital market in which they can raise
finance at the lowest possible cost If European exchanges do not meet these
requirements, Europe's economy suffers.
In the past few years the favoured way of
shaking up bourses has been competition. The event that triggered this was
London's Big Bang in October 1986, which opened its stock exchange to banks and
foreigners, and introduced a screen-plus-telephone system of securities trading
known as SEAQ. Within weeks the trading floor had been abandoned. At the time,
other European bourses saw Big Bang as a British eccentricity. Their markets
matched buy and sell orders (order-driven trading), whereas London is a market
in which dealers quote firm prices for trades (quote-driven trading). Yet
many continental markets soon found themselves forced to copy London's example.
That was because Big Bang had strengthened
London's grip on international equity-trading. SEAQ's international arm quickly
grabbed chunks of European business. Today the London exchange reckons to handle
around 95% of all European cross-border share-trading It claims to handle
three-quarters of the trading in blue-chip shares based in Holland, half of
those in France and Italy and a quarter of those in Germany—though, as will
become clear, there is some dispute about these figures.
London's market-making tradition and the
presence of many international fund managers helped it to win this business. So
did three other factors. One was stamp duties on share deals done in their home
countries, which SEAQ usually avoided. Another was the shortness of trading
hours on continental bourses. The third was the ability of SEAQ, with market-makers
quoting two-way prices for business in large amounts, to handle trades in big
blocks of stock that can be fed through order-driven markets only when they
find counterparts.
A similar tussle for business has been seen
among the exchanges that trade futures and options. Here, the market which
first trades a given product tends to corner the business in it. The European
Options Exchange (EOE) in Amsterdam was the first derivatives exchange in
Europe; today it is the only one to trade a European equity-index option.
London's LIFFE, which opened in 1982 and is now Europe's biggest derivatives
exchange, has kept a two-to-one lead in German government-bond futures (its
most active contract) over Frankfurt's DTB, which opened only in 1990. LIFFE
competes with several other European exchanges, not always successfully: it
lost the market in ecu-bond futures to Paris's MATIF.
European exchanges armoured themselves for
this battle in three ways. The first was to fend off foreign competition with
rules. In three years of wrangling over the EC's investment-services directive,
several member-countries pushed for rules that would require securities to be
traded only on a recognized exchange. They also demanded rules for the
disclosure of trades and prices that would have hamstrung SEAQ's quote-driven
trading system. They were beaten off in the eventual compromise, partly because
governments realized they risked driving business outside the EC. But residual
attempts to stifle competition remain. Italy passed a law in 1991 requiring
trades in Italian shares to be conducted through a firm based in Italy. Under
pressure from the European Commission, it may have to repeal it.
6.1 New Ways for Old
The second response to competition has been
frantic efforts by bourses to modernize systems, improve services and cut
costs. This has meant investing in new trading systems, improving the way deals
are settled, and pressing governments to scrap stamp duties. It has also
increasingly meant trying to beat London at its own game, for instance by
searching for ways of matching London's prowess in block trading.
Paris, which galvanized itself in 1988, is a good
example. Its bourse is now open to outsiders. It has a computerized trading
system based on continuous auctions, and settlement of most of its deals is
computerized. Efforts to set up a block-trading mechanism continue, although
slowly. Meanwhile, MATIF, the French futures exchange, has become the
continent's biggest. It is especially proud of its ecu-bond contract, which
should grow in importance if and when monetary union looms.
Frankfurt, the continent's biggest
stock-market, has moved more ponderously, partly because Germany's federal system
has kept regional stock exchange in being, and left
much of the regulation of its markets at Land (state) level. Since January 1st
1993 all German exchanges (including the DTB) have been grouped under a firm
called Deutsche Borse AG, chaired by Rolf Breuer, a member of Deutsche Bank’s
board. But there is still some way to go in centralizing German share-trading.
German floor brokers continue to resist the inroads made by the bank’s
screen-based IBIS trading system. A law to set up a federal securities
regulator (and make insider-dealing illegal) still lies becalmed in Bonn.
Other bourses are moving too. Milan is
pushing forward with screen-based trading and speeding up its settlement. Spain
and Belgium are reforming their stock-markets and launching new futures
exchanges. Amsterdam plans an especially determined attack on SEAQ. It is implementing
a McKinsey report that recommended a screen-based system for wholesale deals, a
special mechanism for big block trades and a bigger market-making role for
brokers.
Ironically, London now finds itself a
laggard in some respects. Its share settlement remains prehistoric; the computerized
project to modernize it has just been scrapped. The SEAQ trading system is
falling apart; only recently has the exchange, belatedly, approves plans draw
up by Arthur Andersen for a replacement, and there is plenty of skepticism in
the City about its ability to deliver. Yet the exchange’s claimed figures for
its share of trading in continental equities suggest that London is holding up
well against its competition.
Are these figures correct? Not necessarily:
deals done through an agent based in London often get counted as SEAQ business
even when the counterpart is based elsewhere and the order has been executed
through a continental bourse. In today’s electronic age, with many firms
members of most European exchanges, the true location of a deal can be
impossible to pin down. Continental bourses claim, anyway, to be winning back
business lost to London.
Financiers in London
agree that the glory-days of SEAQ’s international arm, when other European exchanges
were moribund, are gone. Dealing in London is now more often a complement to,
rather than a substitute for, dealing at home. Big blocks of stock may be
bought or sold through London, but broken apart or assembled through local
bourses. Prices tend to be derived from the domestic exchanges; it is notable
that trading on SEAQ drops when they are closed. Baron van Ittersum, chairman
of the Amsterdam exchange, calls this the “queen’s birthday effect”: trading in
Dutch equities in London slows to a trickle on Dutch public holidays.
Such competition-through-diversity has encourage European exchanges to cut
out the red tape that protected their members from outside competition, to
embrace electronics, and to adapt themselves to the wishes of investors and
issuers. Yet the diversity may also have had a cost in lower liquidity.
Investors, especially from outside Europe, are deterred if liquidity remains
divided among different exchanges. Companies suffer too: they grumble about the
costs of listing on several different markets.
So the third response of Europe’s bourses
to their battle has been pan-European co-operative ventures that could anticipate
a bigger European market. There are more wishful words here than deeds. Work on
two joint EC projects to pool market information, Pipe and Euroquote, was
abandoned, thanks mainly to hostility from Frankfurt and London. Eurolist,
under which a company meeting the listing requirements for one stock exchange
will be entitled to a listing on all, is going forward–but this is hardly a
single market. As Paris’s Mr Theodore puts it, "there is a
compelling business case for the big European exchanges building the European-regulated
market of to-morrow" Sir Andrew Hugh-Smith, chairman of the London exchange
has also long advocated one European market for professional investors
One reason little has been done is that
bourses have been coping with so many reforms at home. Many wanted to push
these through before thinking about Europe. But there is also atavistic
nationalism. London, for example, is unwilling to give up the leading role it
has acquired in cross-border trading between institutions; and other exchanges
are unwilling to accept that it keeps it. Mr. Theodore says there is no future
for the European bourses if they are forced to row in a boat with one helmsman.
Amsterdam's Baron van Ittersum also emphasises that a joint European market
must not be one under London's control.
Hence the latest, lesser notion gripping
Europe's exchanges: bilateral or multilateral links. The futures exchanges have
shown the way. Last year four smaller exchanges led by Amsterdam's EOE and OM,
an options exchange based in Sweden and London, joined together in a federation
called FEX In January of this year the continent's two biggest exchanges, MATIF
and the DTB, announced a link-up that was clearly aimed at toppling London's
LIFFE from its dominant position Gerard Pfauwadel, MATIF's chairman, trumpets
the deal as a precedent for other European exchanges. Mr Breuer, the Deutsche
Borse's chairman, reckons that a network of European exchanges is the way
forward, though he concedes that London will not warm to the idea. The bourses
of France and Germany can be expected to follow the MATIF/DTB lead.
It remains unclear how such link-ups will
work, however. The notion is that members of one exchange should be able to
trade products listed on another. So a Frenchman wanting to buy German government-bond
futures could do so through a dealer on MATIF, even though the contract is
actually traded in Frankfurt. That is easy to arrange via screen-based trading:
all that are needed are local terminals. But linking an electronic market such
as the DTB to a floorbased market with open-outcry trading such as MATIF is
harder Nor have any exchanges thought through an efficient way of pooling their
settlement systems
In any case, linkages and networks will do
nothing to reduce the plethora of European exchanges, or to build a single
market for the main European blue-chip stocks. For that a bigger joint effort
is needed It would not mean the death of national exchanges, for there will
always be business for individual investors, and in securities issued locally
Mr Breuer observes that ultimately all business is local. Small investors will
no doubt go on worrying about currency
risk unless and until monetary union
happens. Yet large wholesale investors are already used to hedging against it.
For them, investment in big European blue-chip securities would be much simpler
on a single wholesale European market, probably subject to a single regulator
More to the point, if investors and issuers
want such a market, it will emerge—whether today's exchanges provide it or not.
What, after all, is an exchange? It is no more than a system to bring together
as many buyers and sellers as possible, preferably under an agreed set of
rules. That used to mean a physically supervised trading floor. But computers
have made it possible to replicate the features of a physical exchange
electronically. And they make the dissemination of prices and the job of
applying rules to a market easier.
Most users of exchanges do not know or care
which exchange they are using: they deal through brokers or dealers. Their
concern is to deal with a reputable firm such as S. G. Warburg, Gold-man Sachs
or Deutsche Bank, not a reputable exchange. Since big firms are now members of
most exchanges, they can choose where to trade and where to resort to
off-exchange deals—which is why there is so much dispute over market shares
within Europe This fluidity creates much scope for new rivals to undercut
established stock exchanges.
6.2 Europe, Meet Electronics
Consider the experience of the New York
Stock Exchange, which has remained stalwartly loyal to its trading floor. It
has been losing business steadily for two decades, even in its own listed
stocks. The winners have included NASDAQ and cheaper regional exchanges. New
York's trading has also migrated to electronic trading systems, such as
Jeffries & Co's Posit, Reuters's Instinct and Wunsch (a computer grandly
renamed the Arizona Stock Exchange).
Something similar may happen in Europe. OM,
the Swedish options exchange, has an electronic trading system it calls Click.
It recently renamed itself the London Securities and Derivatives Exchange. Its
chief executive, Lynton Jones, dreams of offering clients side-by-side on a
screen a choice of cash products, options and futures, some of them customised
to suit particular clients The Chicago futures exchanges, worried like all
established exchanges about losing market share, have recently launched
"flex" contracts that combine the virtues of homogeneous exchange-traded
products with tailor-made over-the-counter ones.
American electronic trading systems are
trying to break into European markets with similarly imaginative products Instinet
and Posit are already active, though they have had limited success so far. NASDAQ
has an international arm in Europe. And there are homegrown systems, too.
Tradepoint, a new electronic order-driver trading system for British equities,
is about to open in London. Even bond-dealers could play a part. Their trade
association, ISMA, is recognized British exchange for trading in Eurobonds; it
has a computerized reporting system known as TRAX; most of its members use the
international clearing-houses Euroclear and Cedel for trade settlement. It
would not be hard for ISMA to widen its scope to include equities or futures
and options. The association has recently announced a link with the Amsterdam
Stock Exchange.
Electronics poses a threat to established
exchanges that they will never meet by trying to go it alone. A single European
securities market (or derivatives market) need not look like an established
stock exchange at all. It could be a network of the diverse trading and
settlement systems that already exists, with the necessary computer terminals
scattered across the EC. It will need to be regulated at the European level to
provide uniform reporting; an audit trail to allow deals to be retraced from
seller to buyer; and a way of making sure that investors can reach the market
makers offering the best prices. Existing national regulators would prefer to
do all this through co-operation; but some financiers already talk of need for
a European SEC. An analogy is European civil aviation’s reluctant inching
towards a European system of air-traffic control.
Once a Europe-wide market with agreed
regulation is in place, competition will window out the winners and losers
among the member- bourses, on the basis of services and cost, or of the rival
charms of the immediacy and size of quote-driven trading set against the keener
prices of order-driven trading. Not a cosy prospect; but if the EC’s existing
exchanges do not submit to such a European framework, other artists will step
in to deny them the adventure.
7. NEW ISSUES
Up to now, we have
talked about the function of securities markets as trading markets, where one investor
who wants to move out of a particular investment can easily sell to another
investor who wishes to buy. We have not talked about another function of the
securities markets, which is to raise new capital for corporations–and for the
federal government and state and local governments.
When you buy shares of
stock on one of the exchanges, you are not buying a “new issue”. In the case of
an old established company, the stock may have been issued decades ago, and the
company has no direct interest in your trade today, except to register the
change in ownership on its books. You have taken over the investment from
another investor, and you know that when you are ready to sell, another
investor will buy it from you at some price.
New issues are
different. You have probably noticed the advertisements in the newspaper
financial pages for new issues of stocks or bonds–large advertising which,
because of the very tight restrictions on advertising new issues, state virtually
nothing except the name of the security, the quantity being offered, and the
names of the firms which are “underwriting” the security or bringing it to
market.
Sometimes there is only
a single underwriter; more often, especially if the offering is a large one,
many firms participate in the underwriting group. The underwriters plan and
manage the offering. They negotiate with the offering company to arrive at a
price arrangement which will be high enough to satisfy the company but low
enough to bring in buyers. In the case of untested companies, the underwriters
may work for a prearranged fee. In the case of established companies, the underwriters
usually take on a risk function by actually buying the securities from the
company at a certain price and reoffering them to the public at a slightly
higher price; the difference, which is usually between 1% and 7%, is the
underwriters’ profit. Usually the underwriters have very carefully sounded out
the demand is disappointing–or if the general market takes a turn for the worse
while the offering is under way–the underwriters may be left with securities
that can’t be sold at the scheduled offering price. In this case the
underwriting “syndicate” is dissolved and the underwriters sell the securities
for whatever they can get, occasionally at a substantial loss.
The new issue process is
critical for the economy. It’s important that both old and new companies have
the ability to raise additional capital to meet expanding business needs. For
you, the individual investor, the area may be a dangerous one. If a privately
owned company is “going public” for the fist time by offering securities in the
public market, it is usually does so at a time when its earnings have been rising
and everything looks particularly rosy. The offering also may come at a time
when the general market is optimistic and prices are relatively high. Even
experienced investors can have great difficulty in assessing the real value of
a new offering under these conditions.
Also, it may be hard for your broker to
give you impartial advice. If the brokerage firm is in the underwriting group,
or in the “selling group” of dealers that supplements the underwriting group,
it has a vested interest in seeing the securities sold. Also, the commissions
are likely to be substantially higher than on an ordinary stock. On the other
hand, if the stock is a “hot issue” in great demand, it may be sold only
through small individual allocations to favored customers (who will benefit if
the stock then trades in the open market at a price well
above the fixed offering price)
If you are considering buying a new issue,
one protective step you can take is to read the prospectus The prospectus is a
legal document describing the company and offering the securities to the
public. Unless the offering is a very small one, it can't be made without
passing through a registration process with the SEC. The SEC can't vouch for
the value of the offering, but it does act to make sure that essential facts
about the company and the offering are disclosed in the prospectus.
This requirement of full disclosure was
part of the securities laws of the 1930s and has been a great boon to investors
and to the securities markets. It works because both the underwriters and the
offering companies know that if any material information is omitted or
misstated in the prospectus, the way is open to lawsuits from investors who
have bought the securities.
In a typical new offering, the final
prospectus isn't ready until the day the securities are offered. But before
that date you can get a "preliminary prospectus" or "red
herring"—so named because it carries red lettering warning that the
prospectus hasn't yet been cleared by the SEC as meeting disclosure requirements
The red herring will not contain the
offering price or the final underwriting arrangements But it will give you a
description of the company's business, and financial statements showing just
what the company's growth and profitability have been over the last several
years It will also tell you something about the management. If the management
group is taking the occasion to sell any large percentage of its stock to the
public, be particularly wary.
It is a very different case when an
established public company is selling additional stock to raise new capital.
Here the company and the stock have track records that you can study, and it's
not so difficult to make an estimate of what might be a reasonable price for
the stock The offering price has to be close to the current market price, and
the underwriters' profit margin will generally be smaller But you still need to
be careful. While the SEC has strict rules against promoting any new offering,
the securities industry often manages to create an aura of enthusiasm about a
company when an offering is on the way On the other hand, the knowledge that a
large offering is coming may depress the market price of a stock, and there are
times when the offering price turns out to have been a bargain
New bond offerings are a different animal
altogether. The bond markets are highly professional, and there is nothing
glamorous about a new bond offering. Everyone knows that a new A-rated
corporate
bond will be very similar to all the old
A-rated bonds. In fact, to sell the new issue effectively, it is usually priced
at a slightly higher "effective yield" than the current market for
comparable older bonds—either at a slightly higher interest rate, or a slightly
lower dollar price, or both. So for a bond buyer, new issues often offer a
slight price advantage.
8. MUTUAL FUNDS. A DIFFERENT
APPROACH
Up until now, we have
described the ways in which securities are bought directly, and we have discussed
how you can make such investments through a brokerage account.
But a brokerage account is not the only way
to invest. For many investors, a brokerage has disadvantages–the difficulty of selecting an individual broker, the commission costs (especially on
small transactions), and the need to be involved in decisions that many would
prefer to leave to professionals. For people who feel this way, there is an excellent
alternative available—mutual funds.
It isn't easy to manage a small investment
account effectively. A mutual fund gets around this problem by pooling the
money of many investors so that it can be managed efficiently and economically
as a single large unit. The best-known type of mutual fund is probably the
money market fund, where the pool is invested for complete safety in the
shortest-term income-producing investments. Another large group of mutual funds
invest in common stocks, and still others invest in long-term bonds, tax-exempt
securities, and more specialized types of investments.
The mutual fund principle has been so
successful that the funds now manage over $400 billion of investors' money—not
including over $250 billion in the money market funds.
8.1 Advantages of Mutual Funds
Mutual funds have several advantages. The
first is professional management. Decisions as to which securities to buy, when
to buy and when to sell are made for you by professionals. The size of the pool
makes it possible to pay for the highest quality management, and many of the
individuals and organizations that manage mutual funds have acquired
reputations for being among the finest managers in the profession.
Another of the advantages of a mutual fund
is diversification. Because of the size of the fund, the managers can easily
diversify its investments, which means that they can reduce risk by spreading
the total dollars in the pool over many different securities. (In a common
stock mutual fund, this means holding different stocks representing many varied
companies and industries.)
The size of the pool gives you other
advantages. Because the fund buys and sells securities in large amounts, commission
costs on portfolio transactions are relatively low And in some cases the fund
can invest in types of securities that are not practical for the small investor.
The funds also give you convenience First,
it's easy to put money in and take it out The funds technically are
"open-end" investment companies, so called because they stand ready
to sell additional new shares to investors at any time or buy back
("redeem") shares sold previously You can invest in some mutual funds
with as little as $250, and your investment participates fully in any growth in
value of the fund and in any dividends paid out. You can arrange to have
dividends reinvested automatically.
If the fund is part of a larger fund group,
you can usually arrange to switch by telephone within the funds in the
group—say from
a common stock fund to a money market fund
or tax-exempt bond fund, and back again at will. You may have to pay a small
charge for the switch. Most funds have toll-free "800" numbers that
make it easy to get service and have your questions answered.
8.2 Load vs. No-load
There are "load" mutual funds and
"no-load" funds. A load fund is bought through a broker or salesperson
who helps you with your selection and charges a commission
("load")—typically (but not always) 8.5% of the total amount you
invest. This means that only 91.5% of the money you invest is actually applied
to buy shares in the pool. You choose a no-load fund yourself without the help
of a broker or salesperson, but 100% of your investment dollars go into the
pool for your account.
Which are better—load or no-load funds?
That really depends on how much time and effort you want to devote to fund
selection and supervision of your investment. Some people have neither the
time, inclination nor aptitude to devote to the task—for them, a load fund may
be the answer. The load may be well justified by long-term results if your
broker or salesperson helps you invest in a fund that performs outstandingly
well.
In recent years, some successful funds that
were previously no-load have introduced small sales charges of 2% or 3%. Often,
these "low-load" funds are still grouped together with the no-loads,
you generally still buy directly from the fund rather than through a broker. If
you are going to buy a high-quality fund and hold it a number of years, a 2% or
3% sales charge shouldn't discourage you.
8.3 Common Stock
Funds
Apart from the money market funds, common
stock funds make up the largest and most important fund group. Some common
stock funds take more risk and some take less, and there is a wide range of
funds available to meet the needs of different investors.
When you see funds "classified by
objective", the classifications are really according to the risk of the
investments selected, though the word "risk" doesn't appear in the
headings. "Aggressive growth" or "maximum capital gain"
funds are those that take the greatest risks in pursuit of maximum growth.
"Growth" or "long-term growth" funds may be a shade lower
on the risk scale. "Growth-income" funds are generally considered
middle-of-the-road. There are also common stock "income" funds, which
try for some growth as well as income, but stay on the conservative side by
investing mainly in established companies that pay sizable dividends to their
owners. These are also termed "equity income" funds, and the best of
them have achieved excellent growth records.
Some common stock funds concentrate their
investments in particular industries or sectors of the economy. There are
funds that invest in energy or natural resource stocks; several that invest in
gold-mining stocks, others that specialize in technology, health care, and
other fields. Formation of this type of specialized or "sector" fund
has been on the increase.
8.4 Other Types of Mutual Funds
There are several types of mutual funds
other than the money market funds and common stock funds. There are a large
number of bond funds, investing in various assortments of corporate and government
bonds There are tax-exempt bond funds, both long-term and shorter-term, for the
high-bracket investor There are "balanced" funds which maintain portfolios
including both stocks and bonds, with the objective of reducing risk And there
are specialized funds which invest in options, foreign securities, etc.
8.5 The Daily Mutual Fund Prices
One advantage of a mutual fund is the ease
with which you can follow a fund's performance and the daily value of your
investment. Every day, mutual fund prices are listed in a special table in the
financial section of many newspapers, including the Wall Street Journal.
Stock funds and bond funds are listed together in a single alphabetical table,
except that funds which are part of a major fund group are usually listed under
the group heading (Dreyfus, Fidelity, Oppenheimer, Vanguard, etc.).
The listings somewhat resemble those for
inactive over-the-counter stocks. But instead of "bid" and
"asked", the columns are usually headed "NAV" and
"Offer Price". "NAV" is the net asset value per share of
the fund. it is each share's proportionate interest in the total market value
of the fund's portfolio of securities, as calculated each night It is also,
generally, the price per share at which the fund redeemed (bought back) shares
submitted on that day by shareholders who wished to sell The "Offer
Price" (offering price) column shows the price paid by investors who
bought shares from the fund on that day. In the case of a load fund, this price
is the net asset value plus the commission 01 "load" In the case of a
no-load fund, the symbol "N.L." appears in the offering price column,
which means that shares of the fund were sold to investors at net asset value
per share, without commission. Finally, there is a column on the far right
which shows the change in net asset value compared with the previous day.
8.6 Choosing a Mutual Fund
Very few investments of any type have
surpassed the long-term growth records of the best-performing common stock
funds. It may help to say more about how you can use these funds.
If you intend to buy load funds through a
broker or fund salesperson, you may choose to rely completely on this person's
recommendations. Even in this case, it may be useful to know something about
sources of information on the funds.
If you have decided in favor of no-load
funds and intend to make your own selections, some careful study is obviously a
necessity. The more you intend to concentrate on growth and accept the risks
that go with it, the more important it is that you entrust your money only to
high-quality, tested managements.
There are several publications that compile
figures on mutual fund performance for periods as long as 10 or even 20 years,
with emphasis on common stock funds. One that is found in many libraries is the
Wiesenberger Investment Companies Annual Handbook. The Wiesen-berger
Yearbook is the bible of the fund industry, with extensive descriptions of
funds, all sorts of other data, and plentiful performance statistics. You may
also have access to the Lipper Mutual Fund Performance Analysis, an
exhaustive service subscribed to mainly by professionals. It is issued weekly,
with special quarterly issues showing longer-term performance. On the
newsstands, Money magazine publishes regular surveys of mutual fund
performance; Barren's weekly has quarterly mutual fund issues in
mid-February, May, August and November; and Forbes magazine runs an
excellent annual mutual fund survey issue in August.
These sources (especially Wiesenberger)
will also give you description of the funds, their investment policies and objectives.
When you have selected several funds that look promising, call each fund (most
have toll-free "800" numbers) to get its prospectus and recent
financial reports. The prospectus for a mutual fund plays the same role as that
described in "New Issues." It is the legal document describing the
fund's history and policies and offering the fund's shares for sale. It may be
dry reading, but the prospectus and financial reports together should give you
a picture of what the fund is trying to do and how well it has succeeded over
the latest 10 years.
In studying the records of the funds, and in
requesting material, don't necessarily restrict yourself to a single
"risk" group. The best investment managers sometimes operate in ways
that aren't easily classified. What counts is the individual fund's record.
Obviously, you will want to narrow your
choice to one or more funds that have performed well in relation to other funds
in the same risk group, or to other funds in general. But don't rush to invest
in the fund that happens to have performed best in the previous year;
concentrate on the record over five or ten years. A fund that leads the pack
for a single year may have taken substantial risks to do so. But a fund that
has made its shareholders' money grow favorably over a ten-year period,
covering both up and down periods
in the stock market, can be
considered well tested. It’s also worth looking at the year-to-year record to
see how consistent management has been.
You will note that the range of fund
performance over most periods is quite wide. Don’t be surprised. As we have
stressed, managing investments is a difficult art. Fund managers are generally
experienced professionals, but their records have nevertheless ranged from
remarkably good to mediocre and, in a few cases, quite poor. Pick carefully.