Chapter 13
IN THIS CHAPTER
Analyzing a customer’s needs
Understanding fundamental analysis
Looking at the job of a technical analyst
In terms of choosing securities, throwing darts at a list of stocks seems to have fallen out of favor. So has drawing company names out of a hat. But hey, no problem. Your psychic powers may not be the most reliable, but you still have tons of tools that can help you get a good idea of where the market’s heading and how certain securities may perform.
One of your main jobs as a registered representative is to figure out the best investments for your customers. To help lead people down the path of riches, you have to analyze your customer’s portfolio and the market and try to find a good fit. In many cases firms hire analysts to provide registered reps with investment information, which helps you determine the best recommendations for each customer.
In this chapter, I cover topics relating to portfolio analysis and securities analysis. The majority of this chapter is about analyzing a customer’s financial conditions and seeing what happens with the money supply. Don’t worry, though — I don’t leave out technical and fundamental analysis; I just focus on the information that can help you get the best score on the Series 7. As with most of the other chapters, you'll notice that there's a little overlap from the Securities Industry Essentials exam.
Not all investors are able to take the same amount of risk, so what constitutes an excellent recommendation for one customer may be disastrous for another. When opening an account with a new customer, creating a portfolio analysis of the client’s current holdings and needs and updating it as needed (due diligence) is important so you can help more effectively. When you open such an account, you fill out a new account form with your customer’s help (for details on the info that appears here, see Chapter 16). One important element on the form is the customer’s investment objectives, which tell you how much risk the customer is willing to take. Of course, a customer’s investment objectives aren’t written in stone — they can change during his lifetime, so you also need to keep up with the customer’s life changes.
Part of the know-your-customers (KYC) rule is knowing whether they're a foreign or domestic resident as well as whether they are a U.S. citizen or not, whether they're a corporate insider, and whether they are an employee of a broker-dealer or self-regulatory organization (SRO).
The Series 7 exam takes your ability to evaluate a customer’s needs into consideration — so naturally, you get tested on it. The following sections explain investment objectives, what factors impact these goals, and how you can allocate assets and appropriately manage portfolios so the investments are right in line with the customer’s needs.
Investments aren’t exactly one-size-fits-all, so asking a client about his investment objectives can be a real help. As a financial expert, you’ll likely have to help clients pin down what their goals should be. I help you find out how in the next section, but for now, here are some possible investment objectives:
Note: Even though it will likely cost you a commission, there are going to be times where you are going to make recommendations to hold securities. If you feel that one of your clients is invested in securities that you believe are the right ones for him and you believe that they are in a position to perform well, you should probably tell that client to hold his position for now.
The following question tests your ability to answer a question about investment objectives.
Mr. Johnson is a 60-year-old investor who is heavily invested in the market. Mr. Johnson is looking to invest in more securities with a high degree of liquidity. Which of the following investments are you LEAST likely to recommend?
(A) DPPs
(B) Blue-chip stocks
(C) T-bills
(D) Mutual funds
The correct answer is Choice (A). Because Mr. Johnson is looking for securities with a high degree of liquidity, you’re least likely to recommend DPPs (direct participation programs), or limited partnerships, because they’re the most difficult investments to get in and out of. Not only do you need to prequalify the investor, but the investor also has to be accepted by the general partner (see Chapter 11 for details). However, blue-chip stocks, T-bills, and mutual funds can all be bought and sold fairly easily.
If an investor is clueless about how much risk he should be taking, your job is to help your client figure it out. Think of yourself as the Sherlock Holmes of the investing world and use the information you have available, such as your client’s age, whether he has a family, how much money he has, and so on. Additionally, feel your client out to try to get an idea of how much risk he’s comfortable taking.
Obviously, financial factors influence future investments. To get an idea of your client’s needs, you can start by looking at your customer’s financial profile, which includes
In addition to the customer’s financial profile (see the preceding section), you need to be aware of nonfinancial considerations so you can choose appropriate investments. These considerations may include whether this customer is responsible for his family, the customer’s age, the employment of other family members (for example, whether they work for a bank, broker-dealer, or insurance company), educational plans the customer has for himself or his children, and so on. Here’s how such factors can affect an investor’s objectives and liquidity needs:
Asset allocation is the process of dividing an investor’s portfolio among different asset classes, such as bonds, stock, and cash. The main purpose of asset allocation is to reduce risk by diversifying the investor’s portfolio. Asset allocation differs from investor to investor depending on the investor’s risk tolerance.
Strategic asset allocation refers to the types of investments that should make up a long-term investment portfolio. Typically, the normal strategic asset allocation model suggests that you subtract the investor’s age from 100 to determine the percentage of the portfolio that should be invested in stocks. For example, a 40-year-old investor should have 60 percent invested in stocks and 40 percent invested in bonds and cash or cash equivalents (such as a money market fund). A 70-year-old investor should have 30 percent invested in stocks and 70 percent invested in bonds and cash or cash equivalents.
Tactical asset allocation refers to rebalancing a customer’s portfolio due to market conditions. For example, if the stock market is expected to do well in the short-term, you put a higher percentage into stocks. If the stock market is expected to do poorly over the short-term, you lower the percentage of stocks and purchase more fixed-income securities (bonds). Later sections in this chapter give you more info on how to analyze securities and markets.
The modern portfolio theory (MPT) or portfolio theory takes into account these risk measurements: alpha, beta, standard deviation, Sharpe ratio, and R-squared. Fortunately for you, you won't need to know all of them to pass the Series 7. However, if you should decide to become an investment adviser, you will need to know and understand them all. Decades ago, stockbrokers and the like were mainly concerned with attempting to bring in the highest returns in an investor's portfolio. However, they eventually caught on and realized that most investors are risk averse, so they had to change their thinking. The idea of the modern portfolio theory is to optimize a portfolio and maximize returns for the risk each investor is willing to take. MPT attempts to create a diversified portfolio by purchasing securities that aren't directly linked to each other. In other words, some securities may go up while others are going down. This is obviously preferable to having all the securities go down at the same time. Hopefully, over the long haul, the value of the portfolio will be up while the risk was minimized.
Alpha is how a security performs as compared to a certain benchmark. Let's say that a particular mutual fund somewhat mirrors the S&P 500. Now, let's say that the S&P 500 increased 10 percent over a period of time but that fund only increased 7 percent over that same period of time. Your mutual fund would have a negative alpha, which would be bad. If the fund increased more than the S&P 500 over that same period of time, the fund would have a positive alpha, which is good. Alpha can also be used for individual company stocks, such as pharmaceutical stocks. In this case, you could compare how a particular pharmaceutical stock is doing compared to all similar pharmaceutical stocks.
Beta is a measure of how volatile a stock or portfolio is in relation to the overall market (typically the S&P 500). Securities with a beta coefficient of 1 are equally volatile as the market. Securities with a beta coefficient of 0, such as a money market security, are not tied to the movement of the market.
Unlike the modern portfolio theory, which looks at the risk versus reward of the whole portfolio, CAPM looks at the risk versus reward of an individual security. The CAPM takes into consideration the time value of money as well as the risk. U.S. Treasury securities are considered risk-free investments believe it or not. So starting with what you'd be making on a U.S. Treasury by way of interest, you would need to compare the risk you'd be taking on a particular security by looking at its beta coefficient and how much you'd expect to make above the return on the U.S. Treasury security. In order for a security to be worth the risk, it should meet or beat the return on a risk-free treasury security plus the risk premium (the extra return you'd expect for taking the risk).
Note: Member firms may provide interactive investment analysis tools to their clients. These investment analysis tools produce simulations and analysis which will help investors see the likelihood of investment outcomes if they make certain investments. However, no member may make any statement or in any way imply that FINRA approves or endorses (“FINRA does not approve or endorse”) the use of the investment analysis tool or any recommendations made by the tool. If a member firm does offer an investment analysis tool, it must let customers know either in retail communication or if the tool provides a written report:
In addition to all the other investment choices, investors may have a defensive investment strategy, an aggressive investment strategy, or some combination of the two. An investor who adopts a defensive investment strategy has safety of principal and interest as a top priority. A defensive investment strategy includes investments such as
An investor who adopts an aggressive investment strategy is attempting to maximize gains by investing in securities with higher risk. An aggressive portfolio strategy includes
Although many brokerage firms have their own analysts, you do need to know some of the basics of securities analysis to pass the Series 7. In this section, I cover investment risks that your customers face and show you the differences between technical and fundamental analysis.
Investors face many risks (and hopefully many rewards) when investing in the market. You need to understand the risks because not only can this knowledge make you sound like a genius, but it can also help you score higher on the Series 7:
Certainly, all investments have a certain degree of risk. Younger investors, sophisticated investors, and wealthy investors can all afford to take more risk than the average investor. However, when you are talking to your clients, you should examine their portfolio and help them make decisions that will help them mitigate their risk. You should help them invest in securities that aren't too volatile for their situation and make them aware of the potential tax ramifications of certain investments.
You’ve probably heard the expression, “Don’t put all your eggs in one basket.” Well, the same holds true for investing. Suppose for instance that one of your customers has everything invested in DIMP Corporation common stock. All of a sudden, DIMP Corporation loses a big contract or is being investigated. Your customer could be wiped out. However, if your customer had a diversified portfolio, DIMP Corporation would likely only be a small part of her investments and she wouldn’t be ruined. This is the reason that having a diversified portfolio is so important.
There are many ways to diversify:
Although most analysts use some combination of fundamental analysis and technical analysis to make their securities recommendations, for Series 7 exam purposes, you need to be able to differentiate between the two types. This section discusses fundamental analysis; I cover technical analysis later in the section “Technical analysis.”
Fundamental analysts perform an in-depth analysis of companies. They look at the management of a company and its financial condition (balance sheets, income statements, the industry, management, earnings, and so on) and compare it to other companies in the same industry. In addition, fundamental analysts even look at the overall economy and industry conditions to determine whether an investment is good to buy.
A fundamental analyst’s goal is to determine the value of a particular security and decide whether it’s underpriced or overpriced. If the security is underpriced, a fundamental analyst recommends buying the security; if the security is overpriced, he recommends selling or selling the security short.
The following sections explain some of the fundamental analyst’s tools of the trade and how to use them.
The balance sheet provides an image of a company’s financial position at a given point in time. The Series 7 exam tests your ability to understand the components (see Figure 13-1) and how financial moves that the company makes (buying equipment, issuing stock, issuing bonds, paying off bonds, and so on) affect the balance sheet. In general, understanding how a balance sheet works is more important than being able to name all the components.
Assets are items that a company owns. They include
Current assets: Owned items that are easily converted into cash within the next 12 months; included in current assets are cash, securities, accounts receivable, inventory, and any prepaid expenses (like rent or advertising).
Note: Fundamental analysts also look at methods of inventory valuation, such as LIFO (last in first out) or FIFO (first in first out). In addition, they look at the methods of depreciation, which are either straight line (depreciating an equal amount each year) or accelerated (depreciating more in earlier years and less in later years).
Liabilities are what a company owes. They may be current or long-term:
Stockholders’ equity (net worth) is the difference between the assets and the liabilities (basically, what the company is worth). This value includes
If I were to give you all the calculations that fundamental analysts derive from the balance sheet, you’d likely be cursing under your breath (or possibly out loud). The good news is that the likelihood of your having to perform these calculations on the Series 7 is remote. The most important thing for you to know is what happens to components of the balance sheet when the company makes certain transactions (sells stock or bonds, redeems bonds, and so on).
There are many tools that fundamental analysts can use to measure the financial health of a company. Fundamental analysts will compare companies based on liquidity, risk of bankruptcy, efficiency, profitability, earnings per share, competitiveness, and so on. The following balance sheet formulas help fundamental analysts measure the liquidity of a company:
Net worth of a company is pretty self explanatory. It is determined the same way you would determine your net worth: by subtracting everything you owe from everything you own.
Working capital is the amount of money a company has to work with right now. The company brings in cash by issuing the bonds, which is a current asset, but doesn’t have to pay off the bonds for several years, so the current liabilities remain the same. If the current assets increase and the current liabilities remain the same, the working capital increases:
Current ratio is determining how many times your current assets (assets convertible into cash in a one-year period) covers your current liabilities (liabilities owed in a one-year period). Current ratios vary from industry to industry and from company to company but certainly the higher the current ratio, the healthier the company.
Quick or acid-test ratio is similar to the formula for current ratio but looks at how a company could handle its debt in a 3-5 month period instead of a one-year period.
Note: Quick assets include all current assets except for inventory.
If, for instance, ABC Corp. issues 10,000 bonds at par value, you can use these formulas to figure out what’ll happen to the net worth and working capital. You may not even have to plug in numbers. As far as the net worth goes, you can see that it remains unchanged. The company brings in $10 million by issuing 10,000 bonds at $1,000 par. However, because ABC has to pay off the $10 million at maturity, the liabilities go up by the same amount:
The following question tests your ability to answer a balance-sheet-equation question.
DEF Corp. is in the process of buying a new $50,000 computer system. If it is paying for the computer system with available cash, what is the effect on the balance sheet?
(A) The net worth decreases and the working capital remains the same.
(B) The net worth remains the same and the working capital remains the same.
(C) The net worth decreases and the working capital decreases.
(D) The net worth remains the same and the working capital decreases.
The right answer is Choice (D). The company is exchanging one asset for another, and the overall liabilities remain the same, so the net worth of the company doesn’t change. However, the company is using a current asset (cash) to purchase a fixed asset (the computer system), so the working capital (the amount of money that the company has to work with) decreases:
Take a look at the following scenarios and see whether you can determine how the balance sheet is affected. Here’s what happens when a company
If something is increasing, use an up arrow, and if something is decreasing, use a down arrow. Hopefully, this notation can help you solve a majority of the balance sheet problems.
An income statement tells you how profitable a company is right now. Income statements list a corporation’s expenses and revenues for a specific period of time (quarterly, year-to-date, or yearly). When comparing revenues to expenses, you should be able to see the efficiency of the company and how profitable it is. I don’t think you need to actually see a detailed balance sheet from a company, but knowing the components of an income statement is important. Take a look at Figure 13-2 to see the way an income statement is laid out. Most of the items are self-explanatory.
Here are calculations you need to know for the Series 7 that you can derive from the income statement:
The following two formulas help fundamental analysts determine a company's risk of bankruptcy:
The bond ratio measures the amount of company indebtedness. Highly leveraged companies issue a take on a lot of debt in comparison to other companies.
The following two formulas help fundamental analysts determine how efficiently a company uses its assets:
The following formulas help fundamental analysts determine a company's profitability:
As part of a company's profitability, there are a few formulas that help fundamental analysts determine the asset coverage and safety of income:
One of the major factors that could affect the market price of a stock is its earnings per share (EPS). In other words, if broken down on a per share basis, how much did the company make for each outstanding share. Obviously, the higher the better:
Note: If a company has convertible bonds, convertible stock, warrants, and/or rights outstanding, the potential for the common stock to be diluted (that is, with more shares outstanding is high). A calculation can also be done for fully diluted earnings per share, which takes into consideration the companies earnings per share if all convertible securities have been converted into common stock.
Once you've determined the EPS, you can calculate the price/earnings ratio, which compares the market price of the security to the earnings per share. In this case, the lower the P/E ratio, the better.
The dividend payout ratio tells analysts how much the corporation is paying out in dividends per share as compared to how much it’s earning per share.
The current yield, which is covered in Chapter 6, tells analysts how much the company is paying out in dividends in comparison to the market price.
The following formula helps fundamental analysts determine the competitiveness (comparative performance) of a company:
The following question tests your ability to answer a question on earnings per share.
Zazzoo Corp. has 1 million common shares outstanding. If Zazzoo’s net income is $14 million, what are the earnings per share?
(A) $0.07
(B) $0.70
(C) $14.00
(D) Cannot be determined without knowing the preferred dividends
The answer you want is Choice (C). “Cannot be determined” is almost never the answer on the Series 7. Remember that a corporation doesn’t need to issue preferred stock, only common stock. Because the question doesn’t mention anything about Zazzoo having preferred stock, you can’t assume that it does; the preferred dividends are equal to zero. Therefore, solving this problem is as easy as dividing the net income by the number of common shares outstanding:
Fundamental analysts use annual reports distributed to shareholders by most public companies to help them determine investment recommendations. Annual reports are used to help determine the company's financial position. Typically included in a company's annual report are financial data (income statements, balance sheets, footnotes), research and development activities, future plans, subsidiary information, and so on. Besides being mailed, annual reports are typically available on the issuer's website.
Financial statements such as income statements and balance sheets also contain footnotes. Footnotes are added so that investors and analysts will more clearly understand how a corporation came up with its numbers. Included are the methods of depreciation, the inventory valuation used, fully diluted earnings per share (EPS), the market price of the securities, and so on. In addition, the footnotes may include items which may affect the company's performance, such as management or financial issues, management philosophy, and pending litigation. Separated out may also be specifics about the company's debt, including the amount of outstanding debt, call dates, maturity dates, interest rates, conversion privileges, assets backing the debt (if any), and so on. In addition, the footnotes may contain information regarding depreciation and/or depletion deductions (which is covered in Chapter 11).
Technical analysts look at the market to determine whether the market is bullish or bearish. They look at:
Technical analysts believe that history tends to repeat itself and that past performance of securities and the market indicate its future performance.
Not only do technical analysts chart the market, but they also chart individual securities. Technical analysts try to identify market patterns and patterns of particular stocks in an attempt to determine the best time to purchase or sell. Even though a stock’s price may vary a lot from one day to another, when plotting out stock prices over a long period of time, the prices tend to head in a particular direction (up, down, or sideways) and create a trendline.
Moving averages measure the movement of stock indexes and individual stocks over a certain period of time (5 days, 10, days, 30 days, 6 months, and so on). By charting the security or index over a period of time, it helps technical analysts focus more on long-term trends rather than short-term price fluctuations.
Consolidation is occurring when a stock stays within a narrow trading range or trading channel. When plotted out on a graph, the trendline is moving horizontally (neither up nor down). If a stock stays within a narrow trading range for a long period of time (months or even years), it creates a support (bottom of the trading range) and resistance level (top of the trading range). For example, say that XYZ common stock has been trading between $40 and $42 per share for several months; the lower number ($40) is the support, and the higher number ($42) is the resistance.
When a stock declines below its support level or increases above its resistance level, a breakout is occurring. When a stock has been trading horizontally (sideways) for a long period of time, a breakout is considered significant. Breakouts are usually a sign that the stock is beginning a new downward or upward trend.
If a stock price is gradually moving down over a period of time, the stock’s in a downtrend. Conversely, if the stock price is gradually moving upward over a period of time, you’re looking at an uptrend. Here are a couple patterns technical analysts recognize as reversals of such trends:
The market is said to be oversold if a market index such as the DJIA or the S&P 500 is declining but fewer stocks are declining than advancing. If the market is oversold, it’s likely a good time to buy. On the other hand, the market’s overbought if a market index such as the DJIA or the S&P 500 is increasing but fewer stocks are advancing than declining. If the market is overbought, it’s likely a good time to sell or sell short (borrow securities to sell on margin).
Typically, brokerage firms send out research reports to their customers (and potential customers) with certain recommendations. Research reports are documents prepared by an analyst who is part of a brokerage or investment banking firm. As with pretty much everything on the Series 7, research reports are subject to several rules: