Government Credit Crisis

One of the hottest topics on Wall Street (other than bank bailouts, healthcare reform, and how it looks like we've narrowly avoided the sequel to the Great Depression) has been government debt. It may seem obvious, but the way it works is that governments (e.g. federal governments or municipalities, etc.) issue more debt during recessions. This is generally done to offset the loss of tax revenue due to the slower economy. Furthermore, many economic theories suggest that government spending is a tool that can be used to lessen the severity of recessions. In effect, a government can increase spending to offset the loss of corporate and consumer spending. This is the rational behind the government stimulus package passed earlier this year.

Since this economic downturn has been particularly strong (we avoided the Great Depression Part Deux, but we got pretty darn close), government spending has also increased markedly. This is not only a US phenomenon, but a global one. This debt, known as sovereign debt, has been the source of much concern and controversy. I recently stumbled on a listing of the countries whose sovereign is considered to be the riskiest based on credit rating (countries have a debt rating just like you and I and companies). Check out the slideshow here. Here's the list of the riskiest countries starting by the highest risk.

1. Venezuela - The socialist government set by Hugo Chavez is expensive to manage. Estimates are that the oil rich country needs to have oil prices at at least $100 a barrel to be fiscally sound. Oil's been below $100 for quite a while now, meaning the country's in trouble.
   
2. Ukraine
3. Argentina
4. Pakistan
5. Republic of Latvia
6. Dubai - Many of you may have heard of the recent debt troubles Dubai has been having. Over Thanksgiving weekend, Dubai requested a freeze on all debt payments to its creditors - a rarely performed action. The once booming emirate was recently bailed out (again) by it's Oil rich neighbor, Abu Dhabi. But the conditions are much tighter this time and there's certainly a crisis of confidence that will likely have lasting ramifications.
   
7. Iceland - This island nation was the first poster child for the credit crisis. It defaulted on its debts early after getting caught up in sub-prime investments, and has since been in emergency mode to recover.
8. Lithuania
9. California - Remember when I mentioned earlier that government debt includes municipalities? Here you go. California is the 8th largest economy in the world. When it has issues, ripples ensue.
10. Greece

What's it to you?

So that's all well and good, but you're probably thinking how this applied to investingdecoded readers. You guys are here to learn about investing. Unless you're a government official (and I don't think Tim Geithner reads this blog), you can't really invest off this information, can you? Well, thanks to the world of ETF's, now you can! As I've mentioned in the past, one of the advantages of ETFs is that they give the average investor access to unique investments. The PowerShares Emerging Markets Sovereign Debt ETF (PCY) gives investors access to the government debt of up-and-coming economies. Of course, there's a good amount of risk here because it is focused on emerging markets (i.e. non fully industrialized nations). But a nice 6%+ dividend yield is a good compensation for that.

Bottom line, a lot of countries have been having issues with managing their debt loads. That usually would be an indicator to stay away from Sovereign Debt ETFs. However, being that contrarian investor that I am, I think there's some good value propositions in sovereign debt - big investors are still nervous to get in. This is usually a great entrance opportunity. I think PCY is a great way to play the sovereign debt market while also diversifying away from stocks.


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

A Bumpy Road for GM

Check out the comment posted by a InvestingDecoded reader on the previous post about Motorola's DROID. Definitely some good insights there. Feel free to share your thoughts on that or any other post as well!

Yesterday it was announced the GM's deal to sell its Saab brand had fallen apart because the buyer pulled out. Koenigsegg, the Swedish sports car maker who had initially agreed to buy the struggling brand, said that it was having trouble coming to a consensus with partner investors on how to take the brand forward once the acquisition was complete.

Whether that was the actual reason or not, I believe that this incident is just another example of the challenges that GM will continue to face as it tries to conecntrate its efforts on its core brands (i.e. Buick, Chevy, Cadillac, and GMC) and shed non-core assets. It also provides further evidence of what I've though for several months already - there's opportunities here that competing carmakers can take advantage of here and opportunities where investors can capitalize.

It's Been a Long Year

2009 has been the toughest year in the century long history for the American automakers. 2 of "The Big 3" have declared bankruptcy, and government money was injected to keep them from going completely under. I've written extensively on what I think is the reason behind the downfall, so I won't rehash previous posts. But what has happened here with GM I think is a good example of how bankruptcy restructuring can't cure all the ailments of a troubled company.

The Saab deal is the 3rd deal this year that has fallen through for GM. Earlier this year, a deal to sell Saturn to Penske Automotive Group (owned by Indycar racing legend Roger Penske) fell through due to financing troubles. Furthermore, a deal to sell GM's German brand - Opel - fell through because GM decided it was more prudent to keep the brand in house and restructure.

It's Not As Simple As You May Think

When GM initially declared bankruptcy, it stated that selling these 'non-core' assets was integral in their restructuring efforts. The thought on the street was that a bankruptcy would allow GM to clean its balance sheet and make these assets more attractive to buyers. Some even went as far as to say they would come out with a competitive advantage of other automakers because they will have paid down their debt levels drastically through the bankruptcy process.

I think it's obvious now that bankruptcy is not a magic ticket as some may have thought. If the company still makes poor products that continues to lose market share as is the case with GM, it will be a long, difficult process to come out of it. In the case of Saab, sales are down 61% over the past year. I find it hard to believe this little tidbit didn't scare Koenigsegg at all.

Where You Can Capitalize

So, we now know plenty about GM's troubles, but what does that mean to you? Well, like I said, you need to make great cars to be successful in the auto industry. A pre-packaged bankruptcy won't solve all your problems. Enter Ford. The only American automaker to not take government money, Ford took steps to sell some of its non-core assets before the economic downturn. It sold Jaguar to Tata Motors on what now seems to be a very very good price for the seller. It has also continued to invest heavily in new products while competitors were forced to cut back. It now has, by far, the freshest pipeline of new cars coming out of the Big 3.

Because of this and what I believe is the best management group in the industry (CEO Allan Mullaly was the head of Boeing Commercial Aircraft and got the hugely successful 787 program going before taking the Ford job), I feel that Ford is a great investment at its current price. I bought the stock a few months ago at $6.70 and it now trades near $9. That's a long way from the $1 it traded at in March. It continues to take marketshare from both domestic and foreign competition and I believe has great potential to capitalize on opportunities when auto sales finally recover. I would sell if the stock got close to $10, but would still keep a close eye on it.

The car industry is one of the most complex and challenging out there. Just ask Private Equity firm Cerberus, who's investment in Chrysler fell flat on its face in a real hurry. Because of this, picking winners and losers can (ironically) be a little easier because it's so hard to recover from a bad situation. GM still has a long way to go in its restructuring and will continue to hit bumps on this road. Long term I think it can succeed as well, but for now, Ford has a big leg up in the domestic auto market.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

The Deal with DROID

In my last post, I talked about Motorola's attempted resurgence with the new line of Android based phones known as the DROID. My thoughts were that the DROID would be the first and crucial step in Motorola finally returning to being a serious player in the handset market. I recommended MOT on the basis that the stock price/sales ratio is much cheaper than the industry, and, should the DROID be successful, the stock could easily move up to be comparable to its peers.

Well, the numbers are in! As John Paczkowski mentions in his article, there were 100,000 DROIDS sold during the launch weekend. Respectable numbers for a company that hasn't had a hit in a long time. However, there are some concerns I have about the future of the DROID. During the launch weekend, my brother-in-law and I made a trip to a local Verizon store to check out the DROID. He is out of contract with Verizon and, as a professional in the banking industry, is a perfect candidate for the DROID. I wanted to see the phone in person as well as talk to the store manager about traffic he's seen in an effort to gain insights on if my stock recommendation was accurate. Here's a few tidbits:

1. According to the store manager, traffic was fairly quiet that weekend. I initially treated that as a negative for the DROID's prospects, but now it looks like that anecdotal data was an anomaly.
   
2. The DROID itself was very heavy. Significantly heavier than the iPhone. My brother-in-law saw that as the biggest weakness for the phone, but not a deal breaker.

Unfortunately we weren't able to turn the phone on (something about it not being activate and the menu being locked out). Since user interface is a huge compenent of the phone's quality we had to leave with only half the picture. However, my brother-in-law left being somewhat uncertain about the phone.

So the first experience with the DROID caused me to take pause on my recommendation and re-evaluate - something I recommend any investor to do, especially for riskier investments like MOT.

But then my brother-in-law sent me this. You can basically get the DROID 35% off if you sign a 2 year contract extension with VZN. This type of discounting so early in the products launch really caused me to take pause. If the DROID was doing really well, Verizon would have the pricing power to not offer these kinds of promotions...at elast for a while.

So, with all this information processed, my updated reommendation is a more cautious one for MOT. Yes the DROID has been selling well. It's launch weekend did fairly well. But there are indications that sales may drop of dramatically post-launch weekend. The stock closed on Friday at $8.78/share. I think that still gives the company fairly cheap valuation for a company that has a phone that's doing well. I would reccomend watching the DROID numbers very very closely during the holiday season. If this type of discounting continues and the sales are harder to keep up, then I would consider selling. At the very least, a close trailing stop should be applied to any positions to protect against potential bad news (I'd say around $8.50).

The DROID is an interesting phone and still has the potential of saving MOT's handset division. The company has already stated it wants to spin-off the unit, but it needs to be financially viable for it to do so. Hopefully the DROID sales can keep up and these indications I've been seeing are wrong. But there's no reason for everyday investors to get caught off-guard if the indications are right after all.


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Is Moto Getting Its Mojo Back?

A few weeks ago, a good friend of mine asked me what I thought of Motorola (MOT) as a stock pick. My initial response was a resounding 'Run...run far far away'. For years, the company has been getting beaten up in the cell phone market by the likes of Apple and Research in Motion (the makers of Blackberry). Not since the MotoQ has MOT been able to come out with a phone that generated any sort of buzz. Not since the Razr has the company come out with a phone with significant buzz. Over the past 5 years, the company's earnings have declined by 29%. Why would anyone want to invest in in something like this??? I told my friend that I'd have to do more research, but my initial thought was stay away.

How Bad Is It?

Since that email, I've started reading up on MOT. From my readings, on paper, this company is a mess. Here's a few of the tidbits that are especially scary:

1. Sales growth of -27% during the last quarter (much worse than the industry avg of approx -10%).
   
2. Sales growth of -25% over the last twelve months (industry avg of -1.7%)
3. Gross Margin of 28% compared to the industry avg of 53.6%
4. Profit Margin of -16.9% compared to the industry avg of 5.6%

In case the listed numbers aren't enough. Take a look at these:

Even if you don't entirely know what these numbers mean, you can probably see that they're pretty ugly. But as I looked deeper into these numbers, I found something interesting. There's a classic theory in investing that Warren Buffet states best - "Be fearful when others are greedy. Be greedy when others are fearful." From the looks of it this saying can really apply to MOT. The numbers are so bad for this company that the market has a generally negative sentiment on the stock built in. You're going to be hard pressed to find someone (until very recently) that really likes the stock. Usually, this is the BEST time to buy that stock! Why? Because all the selling has already happened. Over-arching negativity usually signals a bottom for a stock. I think this applies to MOT right now. The stock is fairly cheap in terms of valuation (Price/Sales is 2.05 vs. 3.17 for the industry and Price/Book is similarly ratioed), and I don't think the market has factored in a successful product launch.

The New Buzz

But I'm not going to recommend a stock just because everyone hates it. Everyone hating the stock doesn't mean that the stock will go up. It just means there's a good chance it'll stop going down. What you need for the stock to go up is some sort of revamp at the company. For a company like MOT, this means new products. Over the last week I've been hearing A LOT about MOT's new phone - the Droid. This phone is supposed to be strong competition to the all powerful iPhone as well as the Blackberry. Coming out on 11/6, there's a few reasons why I think this phone is going to be a game changer:

1. Viral Marketing - The fact that someone like me - by no means a techie - is hearing so much about this phone already means something. The blogs out there are overwhelmingly positive about the phone, and these guys are usually right.
   
2. Android - The phone will be using Google's Android OS. MOT has always been weak in the OS field. Android will help right that ship while also making apps easy to create like AAPL and unlike Windows Mobile and Blackberry.
3. Verizon's Hero - Cell phone carriers often pick a single phone to strongly promote in the hopes that it will bring in new customers while also forcing other phone makers to step up their marketing efforts. These so called 'Hero Programs' often help the phone makers by reducing marketing costs and increasing exposure. Verizon has selected Droid as a Hero Phone.
4. Enterprise Email - Being able to get your work email on your phone is obviously important. But not all work email is the same. Getting your email to your blackberry costs your company a lot more than getting email to your Windows mobile phone. That's because Blackberry uses it's own proprietary technology to accomplish this. Android will use exchange server (same as Windows) for enterprise email. This will make corporate adoption significantly easier than was the case for Blackberry
   

Gotta Be Careful

There's a lot that MOT has going for it right now with Droid. But, as always, there's real risks associated with the stock

1. MOT's new co-CEO has basically put all the company's R&D efforts on this phone. If it fails (think Palm Pre who had similar buzz), it can be catastrophic to the company.
2. Read the numbers I mentioned above. They're still bad. They haven't shown much signs of improvement. Buying the stock means you're betting those numbers will improve, which may be more difficult than just one good product.

Bottom Line

I think MOT is a very intriguing investment at this point. You really have an opportunity here to buy a company that's trying to rebuild its brand and again become the leader it once was. Recently, an analyst at Citi upgraded MOT to a "Buy" AND downgraded RIMM and Palm to "Sell" because of the Droid. That's going out on a limb right there! But I don't totally disagree.

I would rate this stock a "Buy" long term. However, I think the stock has had a great run over the last couple of weeks (up 12%+ on Droid rumors). I would buy on a pullback to hopefully around $8.75 and sell if any indication comes up that Droid isn't selling well.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Healthcare in the News (Part II)

Now that we have a little bit of an idea of the current issues prevalent in the healthcare industry, let’s take a look at what the government is currently proposing to solve them. Different congressional offices have their own versions of healthcare reform. Although each is different and has its own nuances, there’s a fundamental goal within each – to reduce the overall cost of healthcare in the US by reducing the number of uinsured people. Furthermore, there are a few underlying trends in each of the proposals, and you can expect a few changes to certainly when one of them passes:

1. Increased competition for insurance companies – In order to provide consumers with more choice, the regional tendancies of indurance companies will likely change. In fact, you can already see this change occurring. Recently the justice department repealed the decades old immunity that insurance companies had from antitrust action. This will make it more difficult for a single insurance company to have a stranglehold on a given region of the country.
2. More Insured People – This is the fundamental basis of the whole proposal – getting more people insurance. Either through changes in the tax structure or a public option, the government aims to significantly increase access to health insurance.

The Winners and Losers

Like any other major government implemented reform, there will be winners and losers in the process. I was recently reading an article in BusinessWeek about who stands to gain and lose in the reform. The article (link below) had an excellent breakdown of how the estimated $900 billion program will be paid for.

Winners

1. Providers (i.e. Doctors and Hospitals) – The healthcare providers are being asked to give up very little in this reform. At the same time, they stand to gain a great deal if more Americans have easier access to healthcare. This combination bodes very well for the industry and can potentially help ensure that quality of care does not suffer. However, the fact still remains (as mentioned in the article) a vast majority of health spending still occurs at the providers, and with the reform, that percentage will likely increase.
2. The uninsured – Obviously…

Losers

1. Insurance Companies – The health insurance companies are squarely in the crosshairs of the government. They will be asked to sacrifice the most in order to bring the cost of healthcare down. The companies have recently come out to say that the cuts they’ll have to make will inevitably result in increase premiums for those who are already insured. However, the counterargument here is that the government will help create a whole new group of potential customers that were previously uninsurable. I personally think the jury is still out in if that will actually help the companies. Right now I feel that they will be big losers in the battle.
2. Drug Companies and Device Makers – This pharmaceutical and device industries has already committed to absorbing $120 billion in the cost of the reform. The cost of prescription medication and equipment will have to go down to provide the reasonable cost access to medical care that the government is hoping for. Margins look like they’re going to be tighter for big pharma.
3. The Taxpayer – Yes, you and I are going to have to pay at least somewhat for the reform. Some people may disagree with me, but it’s still unclear exactly how much they will have to pay. Pres. Obama has emphasized the notion that any reform must not add to the federal deficit, but instead the reform must be paiud through cutting of wasteful spending in existing programs. I’m not sure if that’ll be possible with the political process, however.

Investing in the Reform

A change with this magnitude obviously has major implications. This is especially true for the companies that are involved in the reform. I think there are several ways to play the market that can help you capitalize on the upcoming changes.

When I was thinking about how to invest for the reform, I thought about the fundamental factors that are most likely to be largely impacted with the looming changes. Here are a few of the assumptions I made:

1. Something’s actually going to change – there’s way too much invested politically in the process so far for nothing to occur. Something’s definitely going to happen.
2. More people will be insured – That’s the whole point of the reform – make healthcare more affordable and accessible to the masses. I think you’ll see more people going to the doctor, and taking more medication.

With these assumptions I did some digging into the healthcare industry to see who would succeed. It’s actually somewhat difficult to do this because many sectors are making concessions as part of the reform; pharmaceutical, insurance, and medical device makers all stand to lose out to varying degrees. The easiest potential winner here would the providers as I had mentioned earlier. I like Lifepoint Hospitals (LPNT) and Community Health Systems (CYA) in this situation.

However, there is another industry that I think stands to benefit hugely from this specific type of reform. Because the fundamental change I see occurring more insured people and tighter margins for the insurers, insurance companies will be aggressively looking for ways to cut costs. One of the easiest ways for this to occur is to cut prescription drug costs, and there are companies out there that specifically focus on making drugs more affordable for consumers – Pharmacy Benefit Managers (PBM’s). PBM’s use the economies of scale to negotiate better prices for drugs for their members. They enroll members and work with pharmacies and pharmaceutical companies. They also leverage more efficient distribution systems for delivery of the drugs. Instead of going to a local pharmacy, a member can get his/her medication through the mail, thereby reducing the cost of the medication.

Like I mentoned,the bare bones reform that will occur is the reduction in margin for insurance companies. Cost cutting will become a huge part of the game for both the insurance companies, and the employers that hure those companies to provide insurance for their employees. I think you’ll see PBM’s playing a much larger part in helping drive costs lower. Companies like Express Scripts and Medco Health Solutions stand to benefit hugely with this increased demand for their services, and I believe investing in either can make you money in the longer run.

The healthcare reform that’s in the works will be one of the biggest reforms we’ve had in a long time. But in change, there is opportunity. I think there will be many winners over the next few years, and, as a whole, I think the reform will be good for the country. Nonetheless, it never hurts to capitalize on it for yourself and try to make some money out of it J Take a look at PBM’s – I think it’ll be worth your while.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Healthcare in the News (Part I)

Yep, I’m going there. I’m sure everyone has been hearing about it. Well, at least the readers in the US have been. Healthcare reform – President Obama’s top domestic priority – has been in the forefront of people’s minds these days. Understandably, many people understandably have strong opinions about it. So, I figured I’d share my thoughts on the topic and provide insights on potential investments opportunities that can come of the inevitably sweeping changes.

The Problem

The issue with healthcare today is, in my mind, very simple – it’s too expensive and not enough people have it. The US has one of the highest levels of uninsured people of all industrialized nations. That seems a little strange considering one would think in an open market economy, businesses would find a way to tap into so many potential customers. Furthermore, when inflation for healthcare costs is well into the 20%+, many times overall inflation, you know there’s a problem. Like any problem with this level of complexity and magnitude, there’s more than one reason for it. Here’s what I think are some of the major reasons:

Why I Think Costs are High

1. Tort Reform – I’m a firm believer that the way healthcare lawsuits are treated in US courts is a major contributor to rising costs. The reason I believe this is because of the cascading effect that healthcare litigation costs has on cost of care. When a doctor is afraid that a mistake he makes can cost him/her millions in lawsuits, he’ll always play it on the safe side. This means ordering potentially unnecessary tests that may have already been performed. This in turn creates additional costs for insurance companies that have to pay for these tests and eventually trickles down to the consumer. Furthermore, malpractice insurance rates become a huge factor in the costs for providers. Again, when a doctor has to pay $100,000+ a year in malpractice insurance premiums, these costs will also trickle down to you, the consumer in higher prices for doctor visits and procedures.
2. College, I went to a lecture given by the CEO of the Carle Hospital System – one of the biggest healthcare providers in central Illinois. His take on healthcare costs, one that I agree with, was that the cost of healthcare is largely driven by who can pay. In other words, there’s a vicious cycle going on where uninsured people cannot afford for the healthcare that they inevitably need. When they can’t pay, the hospitals must make up the difference through charging those who can pay more. Well, eventually the insurance premiums of those who can pay will go up, and this will likely lead to more people being uninsured and the cycle continuing. The reason why you have to pay $400 for that night in the hospital isn’t because it’s the Four Seasons. It’s because the guy in the room next to you can’t pay the $400, so you have to make up the cost.
3. Inefficiencies – Take this from someone who’s been consulting for healthcare companies for a few years now – there are TONS of inefficiencies out there, especially in insurance. These companies are 10+ years behind on the innovation curve as most other industries, and that is adding significantly to costs. Leveraging technology to increase the efficiency of this admittedly complex industry, I feel, will definitely help solve the problem.

Why I Think the Number of Uninsured is High

1. The Catch-22 Again – Like I mentioned in point 2 above, there’s a vicious cycle of the uninsured driving costs up thereby leading to more uninsured is never-ending. This needs to be addressed directly before any improvement can be expected
2. Lack of Competition – The health insurance industry is very regional. I was reading recently that 80% of people in the US have 5 or less health insurance companies to choose from. This is despite the fact that there are literally dozens out there. The primary reason for this is regulation differences from state to state. This leads to difficulty for companies to reach outside their respective region to compete with others and needs to change. The regulatory landscape needs to become more uniform, and insurance companies need to stretch out and compete with each other more. This will help bring down costs and get more people insured. Just look at what competition has done with pharmaceutical retailers. With the advent of Pharmacy Benefit Mangers and the fierce competition between retailers like Wal-Mart and Walgreen’s, you can now get a generic prescription filled for $5….ten years ago, that would’ve been unheard of! We need to be able to get this type of competition in place for insurance as well.

The problems associated with healthcare are obviously more complicated than the 5 points I mentioned above. But I feel that if we just address these 5 points, we can go a long way to solving one of the most prevalent social issues of our generation. For my next post, I’ll discuss the solutions that the government is proposing and where those solutions are addressing those 5 points. I’ll also talk about how you can invest to take advantage of the reform.

In the meantime, what do you think the solution should be? Do you agree with the 5 points above? Why or why not? I’d be happy to start a dialogue for any comments that you guys make.

Playing the Dividend Game

Before I get started, I wanted to first apologize to the InvestingDecoded world for my recent absence. I know I haven’t posted in over a month. I assure you that I remain committed to InvestingDecoded and helping everyone learn as much as possible about investing. Many of you may already know the reason for my absence, but I’m back now, and I promise to be posting away regularly :-)

Now, let’s get to the fun stuff – dividends! I wanted to talk about dividends today because in a market like this, investing in stocks that pay dividends is a common ‘safe’ strategy. Investing in a stock due to its dividend (or potential dividend) is usually called a ‘Dividend Play’. Let’s discuss what a dividend is and how you can make your own plays.

Sharing the Love

A dividend, in its simplest form, is a piece of the profits from a company paid out to its investors. When a company makes money, it has options on what to do with it. It can take that money and reinvest it in the hope that it’ll make a return in the form of a higher stock price in the future. This reinvestment can be anything ranging from expansion to paying down debt. Or, the company can return the money to investors in the form of a dividend.

When looking at a stock, you can easily see if it pays a dividend. These are displayed on a per share basis. You should also look at what’s known as the “Dividend Yield”. This is merely the annual amount paid as a dividend as a percentage of the stock price. The yield basically tells you how much of an annual return to expect from the dividend along if you bought the stock right now.

Who Pays Dividends?

You may have inferred from the above paragraph that not all companies pay dividends, and you’d be exactly right (pat yourself on the back :-)). A company is not required to pay a dividend, and many don’t. The ones that don’t generally tend to be companies that are significantly growing which requires them to reinvest their profits (a lot of cutting edge technology companies fall into this category). The companies that tend to pay dividends are those that are matured and are in relatively low growth industries. Examples include Coca-Cola, Altria Group (formerly known as Phillip Morris), and Boeing. These guys have been around long enough and have reinvested so much of their money that they can now afford to give some it of it back to investors.

There’s also another class of companies that pays dividends – and these guys tend to pay a lot. These are companies that tend to pay most or all of their earnings as dividends as a way to attract investors and are usually specific to certain industries. One such example is the Oil Shipping Industry. This is a very cyclical industry, and during good times, dividend yields can run as high as 20% - that’s right you’ll get a 20% return on your investment from dividends (the price of the stock can obviously affect the actual return). That makes for a very interesting proposition for investors!

How To Play Dividends.

Investing in dividend paying companies isn’t hard. You can just see the dividend amount and yield and decide if it fits with your investing strategy. But there are some things that you should be aware of before investing in a company primarily due to its dividend:

• Companies aren’t required to pay a dividend. They can cancel it at any time and doing that usually causes the stock prices to drop significantly. The primary reason is obvious – the risk/reward profile of the stock changes without the dividend, causing investors to sell. Another, more subtle reason is that there are many mutual and ETF’s that primarily invest in dividend paying companies. If one the companies they own cancels that dividend, they are forced to sell, sending the price down.
• Dividends are paid at a set schedule, usually quarterly. To qualify for receiving a dividend on a given quarter, you have to be a holder of the stock on a given date known as the Dividend Expiration Date. Only shareholders on record as of the Dividend Expiration Date are eligible to receive the payment.
• Focus on the dividend yield of the company more than the actual amount paid. Companies tend to try to keep the yield constant and consistent with industry standards. That means that if the price is going down, the chances that the dividend will be cut is increased.
• Take a look at the dividend history of the company. This usually gives a strong indicator of how the company will pay dividends in the future. Companies that pay dividends erratically may not be the way you want to go. On the other hand, there are companies (Altria is a great example) who not only pay dividends regularly, but also have a consistent record of increasing their dividends. Those are the guys you want to get into for dividend plays.
• Companies can also declare Special Dividends. These are one-time disbursements of profits to investors and are usually difficult to predict. I would tend to stay away from playing the Special Dividend game where you buy a stock in the hopes you’ll get a special dividend payment.
• Many companies offer Dividend Reinvestment Plans (DRIPs). This allows you to automatically reinvest your dividend to buy more stock and not receive the actual cash payment. You can decide to participate in a DRIP through your broker on a per company basis.
• Dividends are usually treated as ordinary income for tax purposes. That means that you have to pay taxes on them just like the taxes you pay for interest accrued from a savings account. You should receive a report from your broker telling you how much you were paid in dividends for tax reporting purposes.

Overall, dividends are a great way to get predictable income form your investments. In my investing, I try to invest more in companies paying dividends because that shows me a certain amount of stability in the business. In this environment, that’s worth a lot more than usual.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

I Admit It – I missed the Boat on that One

During the recent turmoil in the financial sector, there were a few companies that were particularly hit hard with massive losses (we’re talking tens of billions of dollars here). As many of you probably already know, several of those companies required huge cash infusions from the federal government to stay alive and prevent the entire financial system from collapsing. A crashing stock price was a natural consequence of these problems. Investors don’t like it when their companies need bailouts from the government.

This is exactly what happened to two of the worst culprits of the financial crisis – AIG and Citigroup. I’ve mentioned both companies several times in previous posts as some of the most severely affected names in the crisis. AIG, one of the world’s biggest insurance companies, was impacted through selling insurance policies against the very mortgage backed securities that caused the crisis. When those securities began to wither in value, it was left with billions in claims obligations from banks that it could ill afford. Citi, on the other hand, became deeply involved in the selling of mortgage backed securities. The company eventually became a hugely complex and slow-to-react institution that was unable to handle the downturn in the very products it sold.

Eventually the stock of both companies fell…and they fell hard. We’re talking declines of 95%+ from their highs. At one point, Citi was trading under $1 a share! But somehow, some way, after billions of dollars of bailout money from Uncle Sam, both companies were able to survive the crisis.

Time for the Runup

So at the height of the crisis earlier this year, both Citi and AIG were down in the dumps in terms of stock price. Eventually, after seeing some stabilization in the market, they were able to crawl back a few dollars per share. Citi went from its lows of $0.90 a share to almost $3. That’s a gain of over 300%, and the brave few that chose to invest during that time made out like bandits!

It was around that time that certain family members of mine encouraged me to buy Citi stock. Their logic was that since the company wasn’t going bankrupt, how much lower could the stock go? I thought otherwise. Forever the skeptic on huge runups that companies like this had, my thoughts were the following:

1. The government had HUGE stakes in these companies now (that’s right, fellow tax payers, you own 30%+ of Citigroup right now). This creates a huge conflict of interest for the company that many of Citi’s biggest competitors didn’t have.
2. Citi had to issue massive sums of new stock to stay alive during the crisis - meaning that the stock was so diluted, $3 could very well be a fair value for it, even if $30 was fair before.
3. This one is just common sense, the stock had already gone up 300%! How much more running room could it have?

Because of these (what I thought were logical) reasons, I refused to play with fire and buy Citi stock. Low and behold, the stock has continued to skyrocket since hitting $3 a share. In fact, it has gone up almost another 100% and is hovering around $6 a share.

Why Was I so Wrong?

OK, so I made a mistake. My family was on to something, and I missed an opportunity for an easy 100% gain. But, to me, the more important thing here is to understand where I was wrong. What did I miss about Citi that has caused the stock to go up six fold in a matter of months.

Well, what I was missing was what’s known as the ‘Short Squeeze’. This highly technical and not so much fundamental concept is when traders who are shorting the stock are forced to buy the stock in order to cover their short positions, thereby bidding up the price.

I’ve talked about shorting a few times before, but I’ll do a quick refresher. Shorting is basically betting that a stock will go down. You accomplish it by borrowing the stock from your broker and selling it. You then hope the stock will go down so you can buy it back later at a lower price. However, if the stock goes up, traders often have to buy the stock anyway to pay back their brokers and cover their losses (this is called ‘covering’ a short position). Sometimes when a stock is going up rapidly, there is a large amount of short covering that occurs, thereby driving up the stock price even higher due to the buying that must be done for the short covering. This is eventually known as a ‘short squeeze’, because the shorts are being ‘squeezed’ out of the stock and the stock price is vaulting even higher.

Well, during the worst times of the market, there was HUGE amounts of short positions on both Citi and AIG. At one point, Citi’s short ratio was 18% of float. That means that 18% of Citi’s total stock was being held as a short position – an absolutely massive amount.

Well, with that much short interest being squeezed out of the market after it became apparent that Citi and AIG would survive the downturn, the stock just rocketed up. And I totally underestimated just how short the market was on these stocks. The past few months have been a massive short squeeze for both Citi and AIG. Although there are also some more fundamental reasons for the runup, they’re few and far between.

My Lesson

So, my parents were right, and I was wrong (isn’t the first time). Citi was still a good buy at $3 a share because the short squeeze was very much still in progress. Unwinding 18% of short interest just takes some time. However, another interesting aspect here is that, because the runup in the stock is to a large extent a short squeeze, it’s not driven by fundamentals. This could very much indicate that the price is now artificially inflated and will eventually have to correct. Where that will be, I’m not sure. But maybe it’s time to actually short Citi and AIG….?

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.

Yet Another OPTION To Invest! (Pun Intended)

In the spirit of exposing the Investing Decoded world to new ideas and methods of investing, today I’d like to talk about options. If learning to buy stocks was like getting a bachelor’s degree, options trading is like getting a master’s. There’s a whole new layer of complexity associated with options that change the entire risk/reward profile of the instrument. In fact, I would advise most new investors to stay away from options. But at the same time, options can contain valuable information about a stock that you may already own or are thinking about buying.

What Is an Option?

Imagine that you’re looking into buying a stock (let’s just say GE for example). You’ve read all those awesome InvestingDecoded articles and have done your homework on GE. After all that, you’ve decide that GE should be up 10% by the end of the year. But there’s one slight problem, you don’t have the money to buy a significant amount of stock. Not to worry – all you have to do is take the money you have and buy a ‘call’ option for GE. The option will allow you to take advantage of upside (or downside if you buy what’s known as a ‘put’ option).

Conceptually an option is pretty simple – it’s a contract that give you the right – but not the obligation – to buy (call option) or sell (put option) a stock at a pre-determined price (the strike price). In our GE example, since you think the stock is going to go up by 10% by the end of the year, you can buy a call option that gives you the right to buy the stock.

Here’s the catch, though. Like most contracts, options eventually expire. So the option might give you the right to buy the stock at a certain price, but you will also have to ‘exercise’ that option by a certain date.

At this point you might be thoroughly confused, so let’s go through an example. Say you want to buy the GE stock because you think it’ll go up 10% to approx $17 by the end of the year, but you only have $100 to invest (not really enough to make a big impact). Instead of buying the stock itself, you start looking into buying call options for GE stock. Just like stocks, you can pull up a quote for GE options (they’re known as option chains). This option chain will show you what the various option contracts (various strike price/expiration data combinations) are trading at.

Looking at the GE option chain you can see that the December 17 Call options (meaning options that expire in December and have a $17 strike price) are trading at $0.50 per contract. This means that you can reserve the right to buy 100 shares of the stock for $17 at the 3^rd Friday of December (options contracts generally expire on the 3^rd Friday of the month and trade at 100 share increments).

So let’s say you buy a December 17 contract for GE while the stock is trading its current price of approx $14.50. As the third Friday of December approaches, if the stock is trading below $14.50 the option will likely also be worth closer and closer to $0 – until the actual expiry date, at which point it expires worthless. If you had bought the option, you would’ve lost exactly $0.50 – nothing more.

If the stock goes up as December approaches, the option will also trade higher. If the stock trades around $19, then you could expect the stock to trade more like $0.70 – that’s a 40% jump! You can then trade out of the option (sell the contract to someone else) and run. OR, you can wait until the option expires. Assuming the stock is still trading at $19, you’ll have the right to buy the stock at $17 and can then immediately turn around and sell it.

How Options Are Useful

As you can probably see by now, options can be somewhat complicated. That’s why I suggest that if you’re not wholly comfortable with them. To be honest, I tend to stay away from them myself. There are a few serious risks you should understand about them before you try your hand at them:

1. When you buy an option, all you do is own a contract – not a real asset. The contract is merely a piece of paper with an implied value. This is different from a stock where you actually own a piece of the company (a hard asset) and the dividend and voting rights that go along with them.
2. Options are used by a leveraging mechanism – they multiply the effect of a stock’s movement. This means that you can get into real dangerous situations if the stock goes the opposite way from where you expect. If the stock goes below the strike price of the call option, the option will be worthless and you'll lose 100% of your money.

But All’s Not Lost!

Even if you don’t invest in options, you can still benefit from them. This is because options can give you really good insights as to where the stock of the option is headed. For example, if on a given day there’s heavy buying for call options for a given strike/date combination, that indicates that investors are betting the stock will be going up by that date. It might be a risky bet because if it was really going up, many of the investors would probably actually buy the stock. But as an equity investor, you can look at the options of the company as a sort of barometer for where the stock is headed.

Recently I bought Ford stock (F). Since then the following article came out about a bullish sentiment on the stock based on its option activity. This is a great example of how options trading impacts the actual stocks and you, as an individual investor who doesn’t directly invest in options, can benefit!

http://messageboards.aol.com/aol/en_us/articles.php?boardId=70219&articleId=63835&func=6&channel=Money+%26+Finance&filterRead=false&filterHidden=true&filterUnhidden=false

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.