Financial Espresso

It takes a person 15 minutes to drink a cup of coffee on average. Now you can get a healthy dose of financial fundamentals to go with it. Rest assured that all blog posts are short enough to go with your caffeine kick. 

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Investing in style: Understanding the style box

Source: Flickr

The style box is a way to visual certain characteristics of a bond, stock and the funds that hold them. It was created by Morningstar to help investors and advisors determine the investment style of a fund. Here, we’ll explore how the style box is used for its original purpose, analysing funds. (Bonds and stocks have slightly different style boxes, but the principles behind them are largely the same.)

How it works

The style box is a nine-square grid that categorises securities by size (along the vertical axis) and by value/growth characteristics (along the horizontal axis). A fund is evaluated based on the portfolio of securities it holds. So each security is placed in the style box. Once all securities have been categorised, their attributes are ‘rolled up’ to determine the overall style of the fund.

Source: Investopedia

Company size

The size of a company is calculated using market capitalisation (number of shares outstanding x share price). There are no exact definitions of ‘market caps’, but the general rule of thumb is as follows:

Large cap: over £10bn

Mid cap: £2bn to £10bn

Small cap: Below £2bn

Why is it good to know a company’s size? In investment circles, it is widely believed that the company size and its risk are related. Although there are exceptions, large companies are perceived as safer while small companies are seen as riskier. It’s worth noting that it is also widely believed that risk and return are related: the lower the risk, the lower the return. As a result, investors should expect higher returns from smaller companies and less spectacular returns from large companies.

Value/growth characteristics

There are three broad equity investment styles for funds: value, growth and blend (a mix of value and growth strategies). Funds with a value investing style tend to invest in value stocks; those with growth investing style will mostly invest in growth stocks.

A blend investing style is a mix of value and growth stocks.

As a refresher, growth stocks are those whose earnings are expected to grow faster than the market. They usually don’t pay any dividends; instead, the company reinvests earnings into its expansion. A good example of growth stocks would be most technology companies.

So a fund with a growth investing style tends to have above average risk since not all growth companies will outpace the market and succeed (e.g. the tech bubble). Investors in a growth investing fund should also not expect high dividend yields (if any).

A value stock, on the other hand, is a stock which the investor believes to be undervalued. Such investors (called value investors) take the stance that the market can be inefficient and hence fail to recognise a company’s good prospects. This leads to some companies being traded for less than their worth. Common characteristics of value stocks include high dividend yields, low price-to-book ratios and low price-to-earnings ratio.

A fund with a value investing style tends to have low risk. Value stocks are unpopular; the market is not as excited about them as it is about growth stocks. The key is to understand why they are unpopular – are they unpopular because the company has fundamental problems and can go bust, or is it because the market is simply not very interested or excited about it? You would hope that it’s the latter. It may take years (even decades, but sometimes never) for the market to come round to a value investor’s point of view. If this happens, there could be fantastic rewards at the end of a long and modest road.

Value investing involves waiting for the market to come round to your point of view.

Why bother

Why is knowing a fund’s investment style important anyway? Three main reasons:

When building an investment portfolio, knowing a fund’s style will stop you from putting all of your eggs into one basket (e.g. investing only in small-cap growth funds). In other words, it helps to diversify the risk and return of your portfolio.

It also helps avoid duplication in investment categories. If you already invest in a small-cap growth fund, do you really need to invest in another one since they will probably overlap in what they invest? Having another small-cap growth fund may not add anything (higher return nor diversification) to your portfolio.

The style box allows you to track a fund’s style. Some funds would stay in one of the nine boxes for years. Others would move from one box to another. If you are trying to diversify your portfolio of funds then it is important to bear in mind that a small-cap growth fund today may not be a small-cap growth fund next year.

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Book review: Fundology by John Chatfeild-Roberts

‘To be honest I just follow the rest of the market.’

In the preface of Fundology, The Independent’s former investment columnist, Jonathan Davis, wrote that in his career he has ‘often been struck by the almost total absence of good books about the art of investing in funds’. This was in complete contrast to the number of books on stockpicking and trading. A decade on, fund investing is yet to capture the public’s attention, never mind imagination.

This is clearly evidenced on my bookshelf. The 127-page Fundology is dwarfed by Benjamin Graham and David Dodd’s Security Analysis, a 700-page classic on picking individual securities. Even compared to the more digestible Intelligent Investor, Fundology is still half the length.

But its brevity is part of Fundology’s appeal. John Chatfeild-Roberts provides an easy-to-read guide to fund investing and in so doing makes a very convincing case for it. (For complete novices, he has even included a glossary.)

One of the most telling observations and compelling reasons in favour of fund investing is that many professional investors have all of their own money invested in funds. This is probably to take advantage of diversification and, if you find some good fund managers, the attractive returns.

You won’t become a fund expert after reading Fundology however. The book is peppered with statements of what Chatfeild-Roberts believes in and why (for instance, that asset allocation is important). But it rarely delves into how you would actually go about practically implementing his principles. Therefore, Fundology is more of a springboard of ideas rather than a detailed guide to analysing funds and fund managers.

But readers won’t be left disappointed. Chatfeild-Roberts points the curious to sites that can provide some answers such as Independent Investor, Reuters Breakingviews and Gloom Boom & Doom. For him, readers would benefit more from reading widely and thinking laterally (which is probably why The FT and The Economist did not feature in the list) as opposed to following a set framework.

Following Chatfeild-Roberts’s nudges could prove worthwhile. After all, he is an award-winning professional fund investor. In Fundology he points out that past performance is no guide to future performance, but it can provide a clue. I think there is no better clue than his evaluation of the UK economy in 2006. He wrote that, due to the increase in the Bank of England base rate from 3.5% in November 2003 to 4.5% in August 2005, he expected more people to struggle to pay their mortgages. He also thought that the rate at which house prices were increasing was unsustainable and expected them to fall ‘in due course’.

Two years after Fundology was published, the world was in the midst of a financial crisis.

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Interview: Assistant Manager, real estate

I caught up with an Assistant Manager from a bank’s real estate team to find out how they go about making loans for property purchases.

What kind of bank do you work for?

I work for a Sharia compliant bank that offers corporate finance and wealth management services.

What is the role of the real estate team within the bank?

We lend to people who want to purchase commercial or residential property. On most residential purchases the intention is then to develop the property and sell the finished units. Externally, we are the face of the bank; internally, we are the face of the client.

We do everything from origination to repayment which is quite different to other banks where the process is split up and different people are responsible for different stages. This has the benefit of the team getting to know the transaction – the facility agreement – better than anyone else in the bank. Where I work, you get to see it all.

At some banks, you can see the whole process from the loan’s origination to repayment (Photo: Pietro Borzì/Flickr)

What does your typical working day entail?

I look after the day to day management of our client transactions. A typical day would include processing drawdowns (which is the process by which we pay money out to the client), writing credit applications (for new business or amendments to existing transactions) and closing transactions (working with the client to satisfy all the conditions that need to be met before money can be paid out).

In commercial transactions, we would generally provide the full facility amount in one payment to purchase the property. However, with development transactions we would pay money out on a monthly basis as the work is completed. Someone is hired by the bank to report how much has been spent and how much money the client needs. Our team would then review this. 

If the facility needs to change for some reason – the client needs more time or more money for instance – the bank would need to make an amendment to the legal documentation. I would discuss with the client exactly what they need and what the bank can offer them. Then, I would need to write a credit application and present this to our credit committee for them to approve.

For development transactions, money is paid out on a monthly basis

How do you approve transactions?

Our team conducts analysis of the market as well as the individual or the company that needs the finance. So if someone wants to buy a commercial property for £10m for instance, our team would need to determine whether the price is reasonable for the given area and whether the client has the experience to manage such a property. If the loan is for property development, we also need to consider whether the price that the developer aims to sell for in future is reasonable.

How do you analyse the market?

We read up on research to form an informed opinion. We look at research published by certain companies, such as real estate agents. It’s important to be aware that some companies might have an interest in the real estate market going up, so you have to make sure you take research from a variety of different sources.

It’s also useful to look at what prices properties in that particular area have sold for. These prices can be obtained from sites like Zoopla.

Research needs to be taken from a variety of sources

What are your working hours like?

The day usually starts at 8.30am and finishes around 6pm.

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Hedge funds: Due diligence

You may have noticed hedge funds being mentioned in the news, but have you noticed that there is actually little information available about them? Even if you try really hard? It certainly adds to their allure. But there is also a reason for it. Not everyone has access to detailed information about hedge funds. It is only available to accredited investors; those who the regulatory authority deems financially sophisticated and in less need of government protection. Why? Because hedge funds deal with complex products which, it is argued, only sophisticated investors can fully understand.

So when an investor requests information from a hedge fund manager, they must demonstrate their accredited status. Once proven, investors can start an evaluation of the fund to determine whether it is worth investing in. Here is what they tend to look at during their due diligence.

Fund overview

A pitchbook is one of the simplest documents to review. It is a presentation that describes the firm and its fund strategy. Usually, it also provides the fund’s performance history and staff biographies. The pitchbook is a good resource to determine where a fully fledged due diligence is warranted.

If the fund looks interesting, the investor would then review the offering memorandum. This is a legal document which outlines the risks, objectives and terms of investment. Close attention should be paid to the investment objectives (as these indicate the fund’s risk appetite) and the description of securities in which the fund is allowed to invest (because different securities have different liquidity implications).  

Investment terms

The investment terms contain very useful information such as minimum investment amounts, fee terms, share classes, redemption terms and notice periods.

Items outlined in the investment terms can have a significant impact on liquidity

Minimum investment

Minimum investment can aid the investor in determining how much money to allocate to the fund. It can also indicate the types of investors that are already in the fund. Higher minimums suggest institutional investors and ultra-high net worth individuals.

Fee terms

The industry norm is a ‘2 and 20’ fee structure (2% of assets under management and 20% of the profits). The fee terms will also include a high-water mark. (See Hedge funds: An introduction.)

Share classes

The terms should outline what kind of securities the fund invests in. This is important as some share classes are less liquid than others.

Redemption terms and notice period

Hedge funds tend to have a lock-up period when investors cannot withdraw their money. This allows the fund manager to pursue the investment strategy without worrying about funds being pulled out. 

Following the lock-up period, investors must typically follow a redemption schedule to withdraw their money. Funds can be taken out at specific intervals (e.g. quarterly) which would be outlined in the investment terms. If an investor would like to withdraw their money, they must give a notice period (usually between 30 to 90 days). This gives the fund manager time to properly adjust the portfolio and liquidate investments. The notice period along with the redemption terms have a significant impact on liquidity.

The ease with which funds can be withdrawn should be outlined in the investment terms

Conference call

After reviewing the documents, investors would usually schedule a conference call with the hedge fund manager. The aim of the call is to have an in-depth conversation about the manager’s past experience, their strategy and vision for the future. They should be able to explain the factors which inform the current investment process and how the process will generate returns in the current and future environment.

Following a documents review, investors usually have a conference call with the hedge fund manager

Office visit

As part of the due diligence process, investors should visit the hedge fund’s office to assess the environment and the workforce. It is an opportunity to get a deeper insight into the fund’s processes. It is also an opportunity to meet the staff face-to-face and observe any physical signs of stress.

The quality of the due diligence process depends on effectively gathering and analysing information about the hedge fund. The process must be stringent. There must be a realistic chance for a fund to fail the due diligence analysis. If there isn’t, then the process is not thorough enough.

It is also important to keep in mind that the information gathering process presumes a hedge fund manager’s honesty in providing complete and accurate information. If there are any misleading or even fraudulent claims, a thorough due diligence process is more likely to uncover them.

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Hedge fund strategy: Directional/tactical

As the name suggests, the directional strategy (which is sometimes called tactical) is one that bets on the direction of the overall market. To make the bet, you will take a net long position (if you think the market is going to go up) or a net short position (if you believe the market will go down).

In order for these strategies to be successful, the hedge fund manager must be adept at not only forecasting market movements, but also predicting the timing of such movements.

For simplicity, let’s focus on equities. Hedge funds with a directional strategy within a particular equity market can be categorised as follows:

Dedicated short

Dedicated long

Dedicated short bias

Dedicated long bias

Long/short directional strategy

The dedicated long and dedicated short strategies represent two ends of the spectrum. A dedicated long strategy means you exclusively take long positions. In the same vein, the dedicated short strategy entails taking only short positions.

It is rare for hedge funds to follow either of these strategies because they are quite extreme. Most long-term investors follow a dedicated long strategy. However, it would make little sense for investors to choose a hedge fund for this. Dedicated long strategies are within the realm of mutual funds which generally charge lower fees than hedge funds. (See Hedge funds: An introduction)

Dedicated short strategies are rare because they predict the decline of the equities market (which, historically, has moved upwards in the long run).

Instead, hedge funds opt for strategies that are somewhere in between; namely dedicated short bias and dedicated long bias. These strategies combine long and short positions but will have a net long or a net short exposure to the market.

A dedicated long bias is when you believe that, although there will be winners and losers, the market will go up

For instance, say you have £100,000 to invest and you are looking at the beverages market. If you have a dedicated long bias strategy you believe that, although there will be winners and losers, the market in general will go up. In particular, you think Diageo will do well, but Carlsberg would do poorly. So you long Diageo and short Carlsberg. To have a long bias, you’d invest more money in the long position (Diageo) than in the short position (Carlsberg). For instance, you could invest £70,000 in Diageo and use £30,000 to short Carlsberg. That will give you a net market exposure of 40% (70% – 30%).

If you have a dedicated short bias, you’d invest more in the short position than in the long position to give you a negative net market exposure.

A long/short directional strategy is one where you opportunistically switch between a net long and a net short position. Not only do you pick which stocks to go long or short, you also try to decide when to go net long or net short in the market. For instance, you may think that the beverages market will go up in the long run, but in the next three years it will decline. So you would go for a short bias for the first three years before switching to net long.

Long/short strategy is when you opportunistically switch between net long and net short market exposure

Please note that directional strategies are the opposite of market neutral strategies. With market neutral strategies you invest an equal amount of money in the long and short positions (i.e. you’d put £50,000 into Diageo stock and use the other £50,000 to short Carlsberg.) Your net exposure to the market is zero (50% from buying Diageo stock – 50% from shorting Carlsberg = zero exposure to the beverages market). You are betting on the relative performance of the stocks as opposed to the direction of the market. (More on this in Hedge fund strategy: Long/short equity.)

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Hedge fund strategy: Long/short equity

Launched in 1949 by Alfred W. Jones, the first hedge fund used a long/short equity strategy. The concept is simple: Investment research suggests expected winners and losers, so why not bet on both? The combined portfolio creates more opportunities for stock-specific gains and reduces market risk (because the shorts offset the long market exposure).

Let’s take a hypothetical example. Say I go long and short two competing companies in the same industry based on their relative valuations. If Sainsbury’s looks cheap relative to Tesco, for instance, I could buy £100,000 worth of Sainsbury’s and short an equal value of Tesco shares.

Investment research turns up expected winners and losers so why not bet on both?

If Sainsbury’s outperforms Tesco, I will make money no matter what happens to the overall market. For instance, suppose Tesco rises by 30% and Sainsbury’s by 38%, I can sell Sainsbury’s for £138,000 and cover the Tesco short for £130,000, pocketing £8,000. If Sainsbury’s falls by 10% but Tesco falls by 18%, I call sell Sainsbury’s for £90,000, cover the Tesco short with £82,000 and still pocket £8,000. But, if I’m wrong and Tesco outperforms Sainsbury’s, I’ll lose money.  

This is known as a market neutral strategy; it does not depend on a specific market movement. All that matters is that Sainsbury’s outperforms Tesco. To be market neutral, I need to place the same amount of money in the long position as I do in the short position. 

Usually however, long/short equity hedge funds have a net long market exposure (i.e. they put more money in their long positions than into their short ones). Why? Equity markets tend to go up in the long run.

For instance, you could engage in the 130-30 strategy. 130-30 refers to the long/short ratio: 130% of the portfolio’s value will be used to take a long position and 30% to short stocks. How would you do it? Take a portfolio with the value of £100,000. You find some stocks that you are confident will increase in value and so you invest £100,000 in these stocks. Now you have 100% of your portfolio in the long position.

But you quickly find some stocks which you are confident will decline in value. You already have all of your portfolio’s value in the long position. Since you believe that your long position will bring you excellent returns, you don’t want to take money out of it. At the same time, you want to take advantage of the potentially good short position.

Spotting a good shorting opportunity, but realising that all of your portfolio’s value is in a long position

So what can you do? You could borrow. You could borrow an extra £30,000 and use that to short some stocks. This would give us a ratio of 100-30.

Take a moment to think about what you are doing when you’re shorting stocks. You are borrowing shares from person A and selling them to person B. You hope by the time you have to return the shares to person A, the value of the shares would have declined. You’d then buy the shares (at the lower price) and return them to person A.

That’s fine. But think about what happens once you’ve sold the shares to person B. You are holding cash. You’re holding cash while you are waiting for the share price to decline. Instead of putting your money under the mattress, you could invest it in something. Make the money work instead of lying around idle. You could take the cash (£30,000) and invest it in stocks.

Instead of putting cash under your mattress, you could invest in something

What is the ratio of your portfolio now? You still have a short position (30%) which you’ve financed by borrowing money. But now you also have a long position that is worth £130,000 (= £100,000 from original portfolio + £30,000 from selling your shorts).

Please note that the ratio doesn’t have to be 130-30. It can be 120-20, 140-40, 150-50 etc. The key is that you are investing the proceeds from your short sale into stocks.

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Hedge funds: An introduction

There is a lot of mystique around hedge funds because they can be extremely lucrative and, in the past, they used to be unregulated. So what is a hedge fund?

A hedge fund is a pool of money from different investors for the purpose of investing in securities (such as stocks and bonds). If this sounds very similar to a mutual fund, that’s because it is. However, hedge funds’ similarities with mutual funds end here.

Absolute returns

The key difference between mutual funds and hedge funds is that investors give hedge funds the freedom to pursue absolute return strategies. (Absolute return is the return that an asset achieves over a certain period of time.) Absolute returns are concerned with the performance of a particular asset and do not compare it to a benchmark.

The absolute return goals of hedge funds vary, but a goal might be stated as something like ‘6-9% annualized return regardless of the market conditions’.

Hedge funds seek absolute returns

More than long

Traditionally, mutual funds have been long-only. A long position means having a positive investment balance in a financial asset (i.e. simply owning an asset). Investors take a long position when they believe the value of their asset (e.g. a stock) will go up. Once the price has risen, investors can sell the asset at a profit.

Hedge funds engage in more diverse and aggressive strategies and positions such as short selling, trading in derivative instruments (like options) and borrowing money to increase their positions further.

In fact the term ‘hedge fund’ was originally used because the purpose of the first hedge funds was to make money regardless of whether the market went up or down (since the funds could buy stocks or short them). 

Hedge funds engage in more aggressive positions and strategies than mutual funds © Nigel Jones 

Liquidity

Liquidity is a key concern for investors. Although liquidity provisions vary, invested funds may be difficult to withdraw at short notice. Many hedge funds have a lock-out period. This is an initial period of time during which investors cannot remove their money.

Fee structure

Typically, there are two fees charged by hedge funds: the management fee and the incentive fee. The management fee, by definition, is for managing the assets. It is usually 2% of assets managed. The incentive fee is the share of profits that the manager receives. It is usually between 10-20% of profits. The idea behind the fee is to reward the hedge fund manager for good performance.

Managers can only collect the incentive fee if profits exceed the high-water mark

However, there is a caveat to the incentive fee. It can only be collected by the manager if profits exceed the highest value that the fund has reached. This is called a high-water mark. Essentially, if a fund loses 10% from its previous high, the manager cannot collect an incentive fee until they have first made up the 10% loss.

Sometimes managers have to clear a hurdle rate (a minimum rate of return) such as the return on government bonds, before they can collect any incentive fees.

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Common stock vs preferred stock

Common stock and preferred stock are terms that are thrown around very often, but what is the difference? (For an overview of stocks’ features, see Stocks: A short introduction)

The two types differ in three key ways: voting rights, dividends and pecking order.

Voting rights

When you buy common stock, you receive voting rights to elect the board of directors who make decisions on major corporate issues. There is usually one vote per share. With preferred stock, this is not the case. Usually, preferred stockholders have no voting rights.

Common stocks usually have one vote per share

Dividends

A dividend is a portion of a company’s earnings that is distributed among its shareholders usually on an annual basis. With common stock, there is no guarantee that a company will pay out dividends even if it has a long history of doing so. There is also no guarantee on the size of the dividend as it depends on how much the board of directors agrees to pay out.

With preferred stock, it’s different. Preferred stock has a guaranteed, fixed dividend. You know in advance how much money you will get from the stock. Having a fixed dividend is an advantage when the fixed dividend is higher than the dividend paid to common stockholders (because you are getting more for your money if you invested in preferred stocks). Equally, a fixed dividend is a disadvantage if it is lower than the dividend paid to common stockholders.

A fixed dividend can be an advantage or a disadvantage depending on the returns of other investments

The fixed dividend is also the reason why preferred stock is sometimes referred to as a fixed-income security. It acts in a similar way to a bond: you give a company your money (£1,000 for instance) and the company pays you fixed sums on a regular basis (£10 every year i.e. 1% of the principal).

Hence, the price of preferred stocks is sensitive to interest rates. A preferred stockholder would want their fixed dividend to be higher than the interest rate payment received by bondholders.

Say an investor had the choice between buying £1,000-worth of preferred stock and putting £1,000 into a savings account. If the fixed dividend on the preferred stock was 1% (i.e. £10), the investor would choose to buy preferred stock as long as the interest rate on the savings account was less than 1%. The higher demand for the preferred stock would lead to an increase in its price. If the interest rate on the savings account rose to 2% (i.e. £20), the investor would choose the savings account over the preferred stock. This would lead to a decline in the preferred stock price.

Pecking order

Preferred stockholders have a greater claim on the company’s assets and earnings than common stockholders. Essentially they are paid before the common stockholders – they are higher up the pecking order. This is true during the good times and the bad times. During the good times when a company has excess cash and wants to distribute it as dividends among investors, the preferred stockholders must receive their dividends before the common stockholders.

Preferred stocks are higher up the pecking order than common stocks

During the bad times – when a company needs to liquidate its assets – the company has to pay its creditors and bondholders first, then preferred stockholders and only then the common stockholders. Only when all preferred stockholders have been paid (and if there is any money left) do the common stockholders get paid.

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Stocks: A short introduction

Stocks and shares – have you ever wondered what the difference is? Well, here it is. A share is a unit of ownership in a company. If you own a share, you become a shareholder; one of the many owners of the company who have a (small) claim on the company’s assets.

What about stocks? Stocks is a catchall term used to refer to an unspecified number of shares. You may own some shares in company X and company Y. Or you can just say that you own stocks.

Voting

When you own shares, you become a small owner of the company. This does not mean that you have a say in the day-to-day management of the firm however. You can’t pick up the phone and tell Bill Gates how to run Microsoft. The way shareholders can influence the running of a company is by exercising their voting rights. This is a key feature of stocks. Usually, you get one vote per share.

Owning shares does not mean you have a say in the day-to-day management of the firm

You can vote to elect the board of directors who make decisions on major issues concerning the company and who represent the shareholders. Voting to elect board members is the extent of a shareholder’s say in the running of the company.

The management is supposed to increase the value of the firm for shareholders. If it does not, shareholders can vote them out.

Making money

So why all the fuss about stocks?  Why all the films of traders frantically waving, shouting, pounding, fist-punching? It’s because you can make (and lose) money with stocks. You can do this in two ways:

Change in the principal value

Say you bought a share for £10. The share price (£10) is the principal value. You hope that the share price will increase in the future. It may go up to £12 and you could make £2 profit. Nice. But it could also go down to, say, £6. In this case you would lose £4. Not so nice.

Dividends

Some companies pay out dividends. A dividend is a portion of the firm’s earnings that is distributed among its shareholders (usually annually). The decision to pay out dividends lies with the board of directors. There is no obligation to pay out dividends. Even if a company has a long history of paying out dividends, it doesn’t have to carry on paying them out.

Limited liability

So you can make money with stocks. But if things don’t go your way how much can you lose? This brings us to another important feature of stocks; limited liability. This means that, if a company goes bankrupt, you are not personally liable to pay the company’s debt. The creditors won’t go after you personally and make you sell your personal assets (house, car, etc.) to pay off the loans. With limited liability, the most you can lose is what you have invested.

If a company goes bankrupt, it will pay off its creditors and bondholders first. If there is anything left over, then the firm will pay its shareholders.

Shareholders have limited liability

Why bother

Why would a company choose to carve itself up into little pieces and sell them off? If the owners of a firm believe that it is going to be successful, would they not want to keep ownership and profits all to themselves? Companies issue stock to raise money. When a company is growing, the biggest hurdle is to raise money to fund the expansion. For instance, a small bakery may want to buy a huge factory to bake more bread. But where will it get the money from?

Companies issue stocks to raise money

Companies can raise money in two ways:

Debt financing; borrowing a loan from a bank or issuing bonds

Equity financing; issuing stocks

A company may prefer equity financing to debt financing because:

It doesn’t have to pay the money back. Unlike a loan, in exchange for shareholders’ money, the company gives them a small claim to ownership.

It doesn’t have to make regular interest payments. The firm can pay out dividends if it is enjoying high earnings, but it is not obliged to do so.

So stocks have an important role to play in our economy. Without them, companies would find it harder to expand. (And films about the City would be far less entertaining.)

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The Snowball: Warren Buffett and the Business of Life book review

Picking up a 707-page book is daunting. Picking up a book about Warren Buffett can be even more intimidating. But for anyone with any interest in investing, ignoring one of the most successful investors in the world is a great mistake. He is bound to have at least some good advice.

The Snowball: Warren Buffett and the Business of Life by Alice Schroeder is not an investment guide however. It is Warren Buffett’s biography. It of course follows the formation of his holding company, Berkshire Hathaway, but it doesn’t give you stock picks.

And that is probably a good thing. One of the earliest lessons that Buffett learnt and which has guided his investment strategy was about having your own judgement. The episode is wonderfully illustrated in the book. Warren, then a student at Columbia Business School, was having lunch with a then-well-known investor and a man after his own heart, Lou Green, after the Marshall-Wells shareholder meeting:

‘He [Lou Green] said to me [Warren Buffett], “Why did you buy Marshall-Wells?”

‘And I said, “Because Ben Graham bought it.”   

‘Lou looked at me and said, “Strike one!”

‘I’ll never forget the way he looked at me when he said it.’

It dawned on him: ‘Warren, think for yourself.’

Distraught at having made such a mistake, Buffett responded by learning as much as he could about the method Ben Graham used to make his investments.

This, I believe, is also the best way to respond to The Snowball. The book lists the investments that Buffett has made over time, but it is his method that should be of the most interest. Although Schroeder doesn’t reveal the exact rules by which Buffett makes his selections, she reveals the philosophy that has guided him over the decades. (And there are some hints as to where to go if you wanted to find out the rules too.)

As we follow Buffett from a young boy who calculated the average life span of hymn composers during church service to a multi-billionaire business magnate, we also see the emergence of his Buffettisms (such as Twenty Punches). These are brilliantly succinct tales and sayings which give an insight into his business and life philosophy – the underpinning of his investment decisions.  

Alice Schroeder

It would also be a great mistake to think that The Snowball is a Valentine book. For once I agree with Piers Morgan when he described it as ‘brutally honest’. I cannot think of a better way to sum it up myself. Alice Schroeder has spent over 2,000 hours with Buffett and had access to over 70 years’ worth of collected material. Only when she was well into the project did Alice realise what a unique position she was in: Buffett has rarely revealed his inner world to even those closest to him. She is one of the very few people who really know him.

He also asked her to ‘use the less flattering version’ if his version differed from anyone else’s. This makes for a very truthful book about the rewards, but also the great costs of Buffett’s intensity. Schroeder and her agent even told Buffett on numerous occasions that there will be parts of the book that he won’t like.  

Schroeder’s writing style is delightfully smooth. When she started work on The Snowball, Alice had already been following Berkshire Hathaway for five years and had been an investment analyst for ten. Her experience means that when reading about the more complex issues about investment, you can cut through them like a hot knife through butter. In fact, you can pace through the whole book with such ease that even when you finish the last page, you are left wanting more.

Which, I am told, is a sign of a brilliant writer.  

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Buffettism: Twenty Punches

Warren Buffett is one of (if not the) most successful investor in the world, a major philanthropist and one of the wealthiest men living. It is no surprise then that so many have tried to emulate him; study his biography and copy his investment decisions. Warren Buffett is an icon.

What is surprising is that I keep finding more and more people who have brushed him off (or shied away from getting to know him). With decades of success, it seems that everything that there is to know about Buffett has been sliced, diced and learnt by heart. Getting to know him can seem daunting.

However, to understand investing without Buffett is like reading literature and ignoring Shakespeare or learning maths without Pythagoras. You will be missing out big time.

President Barack Obama and Warren Buffett in the Oval Office, July 14, 2010

There are various ways in which people have tried to understand Buffett; memorising his biography, trying to mirror his portfolio, and  studying his key influences. However, I think the best way to understand and learn from Warren Buffett is through his Buffettisms; little pieces of wisdom that have been acquired over many years of many successes and many failures.

One of the best Buffettisms is about Twenty Punches. Buffett has often said himself that he has a cautious approach to life. Here’s why:  

‘You’d get very rich if you thought of yourself as having a card with only twenty punches in a lifetime, and every financial decision used up one punch. You’d resist the temptation to dabble. You’d make more good decisions and you’d make more big decision.’

Buffett has been living his life on Twenty Punches with as few significant changes as possible. He has lived in the same house since the 1950s, he was with the same wife for over fifty years, he hasn’t jumped from city to city or from career to career.

Is there wisdom in inertia? Is the fast pace always the best pace? For Buffett, it pays to the take the time to do something you’re sure about instead of doing many things that you are half-sure about.

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Asset Management: Meet the clients

The structure of the asset management (also known as investment management) industry may seem a little overwhelming. But fear not, this breakdown will be able to help.

Asset management firms are usually categorised according to the kind of clients that they serve. There are typically three categories:

Mutual fund (or retail)

Institutional investors

High-net-worth individuals

Firms can specialise in serving one type of client. Usually however, firms serve all three but set them up as three distinct and separate divisions within the company. Let’s take a look at each one.

Mutual funds

Mutual funds are a collection of assets held by multiple investors. The investors invest in a diverse portfolio – pooling their money together. As a result, each investor owns a share of the fund.

Who are these investors? Usually individuals who are below the status of a high-net-worth individual. These investors opt for a mutual fund because it requires lower initial investments and has lower management-expense ratios.

Mutual funds account for around 20% of assets under management (AUM) in Europe.

Investors in mutual funds pool their money together 

Institutional investors

These represent large pools of assets for government pension funds, corporate pension funds, endowments and foundations. In the industry, institutional investors are referred to as ‘sophisticated investors’ and are usually represented by corporate treasurers, chief financial officers (CFOs) and pension boards.

Institutional investors have a fiduciary responsibility. This is the legal responsibility of managing somebody else's money in their best interest (the institutional investor must put aside any personal motives or conflicts of interest). As a result of being a fiduciary, institutional investors tend to be more conservative and diversified than mutual funds. 

Unlike investors in mutual funds, institutional investors have separately managed portfolios and are exempt from capital gains investment income.  

Institutional investors represent almost 75% of AUM in Europe.

Children or elderly people typically need a fiduciary.

High-net-worth individuals (HNWIs)

A HNWI is, generally speaking, someone who has a minimum of £1million’s worth of investable assets. They are typically taxable and their portfolios are managed separately.

The asset management division that deals with HNWIs is called wealth management.

In 2008, HNWIs in USA, Japan and Germany represented 54% of the global HNW population. That year, China’s HNW population overtook that of the UK for the first time to become the world’s fourth-largest.

Asset management for HNWIs is discussed in more detail in What is Wealth Management.

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Interview: Assistant Portfolio Manager

I met up with an Assistant Portfolio Manager to find out what it’s like to work in wealth management.

What does wealth management involve?

It involves working with wealthy individuals or families and enhancing their financial situation. They give you their money, complete discretionary control over it and some requirements. You, as their trusted advisor, invest it.

The idea is to create a balanced portfolio with a bit in stocks and shares, a bit in bonds, a bit in hedge funds, a bit in commodities and so on. You aim to create a portfolio that, over an investment cycle, is less volatile than the market but produces a higher return. Over time, you hope to generate a return which is somewhere between 5 to 7% a year, on average.

Do you pick the specific stocks, bonds and so on, yourselves?

No we usually invest in funds. An old-fashioned stock broker would be someone who would read all of the companies’ information, pick up the phone to his client and say ‘I think today is a great day to invest in such-and-such a company. Do you want to go it for?’ and the client may or may not agree.

For us to be experts in every single stock in the market, plus all the bonds, plus all the hedge funds, plus everything else that you can invest in – it would be ridiculous. We, personally, can’t have that knowledge. So instead of saying ‘right, I’m going to know every stock in the FTSE100 inside out’, we pick a fund manager who runs a UK equity fund (for instance) and he does all of that research, stock picking and portfolio management all day.

Old-fashioned stockbrokers used to phone their clients with investment ideas

How do you choose your fund manager?

It’s a lot of work because there are hundreds of them out there. Usually there is an internal team that helps with choosing the funds. If we need a specific type of fund, say a global equity fund, the internal team will look at all the global equity funds out there and come to us with a shortlist. Generally, you want a fund that has a long track record, good performance, a management team we think are sensible and one which is large enough to be able to cope with sizeable inflows. Once we have a few that we are particularly interested in, we invite them to present to us.

What are your working hours like?

Normally, 8am until 6pm.

Working hours are standard

And what does a typical working day entail?

It starts with general admin. If we have a client meeting, I would prepare a performance report on how their portfolios have been doing over the last few years, any recent transactions and any relevant regulatory updates. Usually, there is also a summary of the client’s financial situation; who they are, who their partner is, how many kids they have, what their job is, how much their house is worth and so on. The Portfolio Manager will then take that to their client meeting and update it if needs be.

Some days I have fund meetings. I meet both existing and potential fund managers. If it’s an existing fund, you should try to see them at least once or twice a year because you need to know what that manager is thinking and what their performance has been like – simply to get an update.

A wealth management firm will invest in dozens of funds for the clients. If there are say 40 funds that you have client money invested in, then you’d be visiting one a week already. There will be even more funds that are just monitored and you might meet with some of them as well.

Family members are taken into account when assessing a client’s financial situation

How did you get a job in wealth management?    

When I left university, I had no experience of finance apart from one week’s worth of work experience at a wealth management firm. So I took the first part of the basic qualification – the IMC. That was the first finance that I had done – ever. I was starting at the very bottom. By the time I finished the first unit, I secured my job and later completed the second unit of the IMC.

I have been studying for different qualifications ever since – the IAD and Chartered Wealth Management exams. It’s a continuous learning process. Experience is, of course, invaluable but the exams give you a good grounding in the sector.

Professional qualifications give a good grounding in the sector

Where can you expect to start in wealth management and what is the career progression?

At my company, depending on your experience and university grades, you may start in admin or as an Assistant Portfolio Manager. As an Assistant Portfolio Manager, by definition, you start assisting a Portfolio Manager. You’re expected to be growing your investment knowledge constantly; starting your own client relationships, starting to think about the ways in which you can win new business and so on. There are some exams that you are also expected to take. If you pass these the first time round, it will take you about two years to do them all.

Once you’ve done the exams, you can become an Associate Portfolio Manager. It’s the step before a Portfolio Manager. So at this level you need to enhance and consolidate all of your investment knowledge and client-handling skills. You can expect to be at this level for about three to four years, depending on your experience. 

Before promoting you to a Portfolio Manager, the firm needs to make sure that if you were plonked in front of a client, then you’d be able to answer any possible question that they could fire at you. If you don’t know the answer, you’d need to act professionally. You’ll need to be knowledgeable, confident and demonstrate to the client that you know what you are doing. From Portfolio Manager, you’d expect to be promoted to Portfolio Director.  

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Be who you are and say what you feel, because those who mind don't matter, and those who matter don't mind.

Bernard M. Baruch

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What is asset management?

Asset management (also known as investment management) is pretty much what it sounds like: a client gives money to an asset manager, who then invests it to meet the client’s objectives. So asset management seeks to grow capital and generate income for their clients.

Is it on the buy side or the sell side?

First off, what is the difference? The buy side refers to asset managers who represent individual and institutional investors. The buy side purchases investment products (such as stocks, bonds and derivatives) on behalf of their clients.

The sell side, on the other hand, refers to the functions of an investment bank. Sell-side professionals issue, recommend, trade and sell securities to investors on the buy side. So the sell side can be thought of primarily as a facilitator of buy-side investments. It makes money not through a growth in value of the investment, but through fees and commissions for its services.

So asset management lives on the buy side.

BlackRock is the largest asset management company, based on assets under management, March 2015.

But the two sides interact with each other. Sell-side firms (investment banks) earn a fee every time securities are bought or sold in a buy-side firm’s portfolio. As a result, sell-side firms have an incentive to develop relationships with asset managers. 

Through its salespeople, investment banks provide asset managers with services such as analysts recommendations, access to firm-sponsored IPOs, debt offerings and, of course, perks (expensive dinners, sports tickets etc.).

It’s very similar to other industries, such as marketing, where you have the client (equivalent of buy side) and the agency (equivalent of sell side). Clients are big companies such as Unilever, Coca Cola and Sky who have their own internal marketing teams. However, the internal team may use a marketing agency for ideas and recommendations for their campaigns.

Asset management divisions within investment banks

You may have noticed that some investment banks have their own asset management divisions. These operate like an internal buy-side asset management firms within the banks.

In recent years, investment banks have made efforts to grow their asset management businesses. That’s because investment managers’ fees are based on the amount of money they’re given to invest (‘assets under management’) – so as long as you have clients, you’ll be making money for the bank.

This is very different to other investment banks divisions such as mergers and acquisitions advisory which are one-off payments for the project. As a result, asset management is considered to be a more stable source of income than other businesses of an investment bank.

UBS is the third largest asset management company, based on assets under management, June 2015.

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Competition makes you better, always, always makes you better, even if the competitor wins.

Carlos Slim

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What is wealth management?

Wealth management is part of asset management; a term used to describe the process of handling and managing the money of clients. (Note, the terms investment management and asset management are interchangeable so you may hear people referring to wealth management as part of investment management.)

It works by a client giving money to the asset manager, who then invests it to meet the client’s objectives. Asset management can be broken down into three areas based on the type of client being served (because the type client will dictate the investment style):

Retail fund

Institutional investor (e.g. government pension funds, corporate pension funds, foundations)

High-net-worth individuals

Wealth management deals with high-net-worth individuals. These individuals are taxed on capital gains and investment income (like retail fund, unlike institutional investors). They have portfolios that are managed separately (i.e. not pooled together with other investors) – unlike retail funds, like institutional investors.

High-net-worth investors need a high level of customer service as they may not be the savviest investors.

Sir Philip Green, Chairman of Arcadia Group (centre), is the sixth richest person in Britain according to Forbes, 2014.

What is high net worth?

Definitions differ, but a good rule of thumb is an individual with minimum investable assets of £1 million.  In reality, there are two classes of high-net-worth clients:

Those who have £250,000 to £1 million investable assets: These clients receive much more personal attention than they would if the invested into a retail fund. However, their portfolio management is derived from cookie-cutter products and strategies.

Those who have over £1 million investable assets: These clients receive customised and separately managed portfolios.

Who is on the team?

Portfolio managers who invest money on behalf of their clients.

Research analysts who provide portfolio managers with potential investment recommendations and, in some cases, invest money in their respective sectors

Account and product managers who manage client relationships and distribute the investment products to the clients

Operations staff who carry out back-office roles ranging from systems developers to risk analysts.