Important Investment Definitions and Principles

Sam Ngooi Comments

The month-end August 2020 US stock and bond market investment results continued to be mostly favorable, even though the declines during the first week in September (3rd, 4th, and 8th) reduced these positive results somewhat. We think this is an opportune time to present certain basic investment definitions and principles that we at Park Piedmont (PPA) consider important to know.

Before doing so, we would like to note another significant August event: the Federal Reserve Board Chairman has “announced a major shift in how the central bank guides the economy, signaling it will make job growth preeminent and will not raise interest rates to guard against coming inflation just because the unemployment rate is low… laying the groundwork for years of low interest rates” (NYT 8/27/20, page A1).

Asset Allocation: the percentage mix of your investment portfolio among riskier assets, generally stocks, and less-risky assets, generally bonds. At PPA, we further divide the less-risky bond asset class into three separate categories: short-term cash equivalents (money markets, or MM); high-credit bonds (HCB); and high-yield bonds (HYB).

Stocks represent an ownership interest in a business. Stock prices change every day, based on the activity of buyers and sellers in the financial markets. Some of these market participants are long-term investors, and others are short-term traders and speculators. History indicates that stock prices vary, up or down, much more than the bond categories over almost every time period (the extent of price changes is referred to as “volatility”). The tradeoff for stock investors accepting more volatility is the opportunity for higher expected returns. In addition to gains/declines from price changes, many stocks pay dividends. Dividends are usually a return of some portion of a company’s profits back to the owners. While dividends are often much appreciated by stockholders, they do raise the question from the paying company’s standpoint as to whether the money is better used reinvesting in and trying to grow the business.

There are many factors that affect stock prices, but over time the most significant one is the profits (also referred to as “earnings”) of the company and the number of shares outstanding that have ownership of those profits. The relationship of one company’s stock price to that of another company, and the reasonableness of the stock price itself, can be examined by knowing the dollar amount of profits, and the number of shares the company has outstanding, and using these figures to develop the P/E ratio (price per share divided by earning per share). Working with simplified numbers, if the company has one million shares outstanding and has $1 million of profits, the earnings per share are $1; if the stock sells for $10 per share, the P/E is 10; at $15 per share, the P/E is 15; and at $20 per share, the P/E is 20.

The higher the P/E, the more profitable investors/speculators believe the company will be in the future. But as you should note, what a reasonable P/E should be for any company is constantly changing, and subject to the many varying views of the financial markets. Knowing past profits is one thing, but the problem with stock pricing based on P/E ratios is that the profits used are most often based on future forecasts, which is how Wall Street earns much of its living. PPA, on the other hand, typically ignores such forecasting as being an impossible effort to predict the unknowable future (as is the case for financial analysts’ attempts to predict the course of the ongoing coronavirus pandemic).

Stocks can be bought in individual companies, or in mutual funds/exchange traded funds (ETFs) that own a diversified portfolio of individual stocks. The diversification can be as narrow as within a specific sector of the broad stock market (e.g., technology or finance), or can be as broad as all the stocks in the world stock market. Stock mutual funds can be actively managed by portfolio managers trying to earn a better investment result for the fund owners than the result of some applicable benchmark. Stock funds can also be passively managed, in which case the fund invests in the stocks contained in the relevant benchmark and accepts the benchmark results. The issue with active management is that the managers frequently underperform the benchmarks, with an underlying tendency to do so because of the higher expenses charged by actively managed funds. ETFs are another type of index fund; they allow for intraday buying and selling, whereas mutual funds are priced at the end of each day. PPA uses index mutual funds and ETFs for almost all stock investments in client portfolios.

Stock splits have been in the news recently, as Apple and Tesla both split their stock. In a typical stock split, the owner receives additional shares, but the price of the stock declines to account for the additional shares, so there is no change in the company’s overall valuation just because there are more shares outstanding. To use a popular food analogy, if you have a whole pizza pie, and it is cut into quarters, you have more slices, but still the same overall amount of the pizza to eat.

When interest rates are low for bonds, as they are now (see below), stock prices often move higher because the competing returns from bonds are low. But how high stock prices should go is of course an unknown, especially in times when the overall economy is doing poorly, as it is now.

Bonds represent a promise by a borrower to repay money plus interest over time. A bond is a loan from the bond owner to the borrowing entity, which can be a government or company. Unlike stocks, there is a date when the original amount invested (referred to as “principal”) is to be repaid (referred to as a bond’s “maturity”). That maturity can be measured in years or days, depending on the terms of the loan. Bond prices change during the time they are outstanding prior to maturity, also based on the activity of buyers and sellers in the financial markets. But history indicates that bond prices change much less than stock prices, and that within the broad category of bonds, the extent of price changes varies based on bond maturities (also referred to as “term”), credit quality, and interest rate changes. The prevailing rate of inflation has a major influence on interest rates, which in turn has a major influence on bond prices. Typically, the higher the inflation rate, the higher interest rates need to rise to provide bond investors with a positive return adjusted for inflation. (Note however the Fed’s recent policy statement on interest rates and inflation, all related to job growth; NYT 8/27/20, page A1). Inflation is defined as the declining value of the purchasing power of money over time.

Short-term high-credit bonds, the shortest of which are money markets, have the least price change and smallest interest payments. The further out in time the maturity, the greater the price change while the bond is outstanding (that is, not paid off), but the higher the interest received (another investing tradeoff). The usual correlation between interest rates and the prices of outstanding bonds is that as rates increase (good for the investor), the price of the bond should decline (not good for the investor). Conversely, as rates decline, bond prices increase. So even if bonds are bought with the expectation that the initial principal will be returned plus interest, if the bonds need to be sold prior to maturity, there is a chance the investor will receive less than the initial principal.

The other significant wrinkle with bond pricing is their credit quality, which refers to the likelihood the bond issuing entity has/will have enough money to pay the interest and repay the initial principal at the maturity date. Credit ratings can change while the bond is outstanding; if the credit rating is lowered, the bond price almost always declines. At the beginning of the 2020 pandemic, many companies faced credit downgrades, even those thought to be good credits. The Federal Reserve stepped in and gave assurances to the marketplace that it would not allow large scale defaults. At that point, prices stabilized. A low credit rating at the time the bond is issued forces the issuer to pay more interest (these are called high-yield bonds), which is good for the investor, but not good at all if the issuer cannot make the interest/principal payments.

Bonds, like stocks, can be bought in the specific name of the issuing company or governmental entity (federal, state, and local). Mutual funds and ETFs, both actively- and passively-managed, are also available to bond buyers, with similar characteristics as discussed above with stock mutual funds and ETFs. There are times when investments are described only as mutual funds or ETFs, without identifying them as owning stocks or bonds, and this can cause confusion for investors. PPA uses almost all bond index and index-like mutual funds and ETFs for our clients’ bond investments.

One other point worth noting: if you own an individual bond, there is a specific maturity date when you are scheduled get your money back. If you own a bond mutual fund or ETF, by contrast, the bonds owned by the fund mature, but the fund itself typically does not. The fund takes the proceeds of maturing bonds and reinvests the money in bonds with similar maturity and credit quality characteristics. The major difficulty with owning individual bonds is not being able to determine the underlying current and likely future financial health of the issuer. Even though there are credit agencies that purport to do this, their advice can be flawed (the mortgage crisis of 2007-2009 provided a serious recent example of the failure of credit agencies). With mutual funds and ETFs, the investor relies on the fund managers to do an adequate job of ongoing credit checking, at least under normal circumstances, which is also an important caveat.

As you can see, there are many points of investment definitions and principles, even in the brief discussion above. In future Comments, we plan to present additional detail on indexed investing, which is the predominant way PPA invests our clients’ portfolios. While we encourage clients to be as knowledgeable as possible on these matters, PPA is of course available to provide additional assistance as needed.