It did not surprise many when Warren Buffett, while recently hosting a group of business students for a two-hour question-answer session, began by pointing out the folly of the efficient market theory (EMT). After all, his objection to EMT is as legendary as his support for fundamental analysis (FA), as the foundation for smart investing.

But first thing first: what is EMT, and what indeed is FA? (These are my short-hands, by the way.)

Efficient Market Theory (EMT)

EMT holds that the stock market is so efficient in absorbing the latest developments in the industry – company merger, major product launch, corporate scandal etc. – that the stock prices almost instantly reflect these developments. Thus, there is very little time available to an average investor to act on such “inside information”, before it becomes common knowledge so everyone does the same (thereby quickly driving stock prices up or down). In other words, because such developments are unpredictable, stock prices in turn cannot be predicted, and they execute a random walk down Wall Street.

The investing strategy based on EMT is known as portfolio diversification, where the investors buy and hold a range of stock, and bond, funds indexed to broad segments of the financial market (known as index mutual funds). Because the prices of individual securities in a fund do not move in lockstep with each other, the portfolio achieves “diversification” by spreading the risk of asset downturns, where dip in one security is compensated by rise in another.

Fundamental Analysis (FA)

FA holds the contrasting view that although unpredictable market events drive the stock prices over short times (as in EMT), there is a fundamental value of every stock that can be determined by analyzing the company papers – financial statements, annual reports etc. – and other available information on its management policy, competitive edge and so on. The stock price eventually catches up with its value, which is predictable, and the investor can benefit by trading the mispriced stock and waiting till it is “corrected” by the market.

The investing strategy based on FA is known as value investing, where the investor looks to buy undervalued stocks of otherwise healthy companies. Such a portfolio is expected to grow with time despite short-term fluctuations, and so there is no need for diversification. But, because a company does not generally stay healthy forever (management changes, economy takes a hit, and so on), a value investor must tune his portfolio time to time by selling old overvalued stocks and buying new undervalued ones.

Go on to “Part II – Which one of them is correct?”

Unlike a debt type security such as a money market or a bond, a stock is an equity or ownership type security, which entitles its buyer one share in the ownership of the issuing corporation. Because the risk of investing in a stock is significant (you may lose your entire invested asset if the corporation faces bankruptcy), stocks are examples of a variable income type security.

There are two classes of stocks: common stock and preferred stock.

Common Stock

If you buy a common stock, your ownership stake in the company comes in two flavors: you have a claim on the company’s earning, and you also get to cast one vote per stock on the company’s management decision in its yearly meetings. (Stockholders often vote by proxy, instead of attending these meetings.)

The company may either directly pay your share of income as cash dividend, or may reinvest it for business growth to earn you a capital gain (increasing the value of your stock). You have a residual claim on the company’s assets and finances in the event of a bankruptcy, because you are the last in line after others, including tax authorities, employees, bondholders and such creditors, are paid off.

Most common stocks are traded in stock exchanges such as NYSE. The most important feature of a publicly traded stock is its P/E ratio (price-to-earning ratio), which is the current stock price divided by last year’s earning per share. This value tells the investor how much to pay for each dollar the company earns. A low P/E makes a stock “undervalued” (a good buy unless the firm is facing problems), and a high P/E makes it “overvalued” (a good sell).

Preferred Stock

A preferred stock is a stock that retains some features of a bond, because the issuing company pays the investor a fixed amount each year (like a bond that never matures). Also, like a bondholder, owners of a preferred stock does not have a voting right in company management.

But, for tax purposes this payment is treated as a dividend and not an interest, which makes a preferred stock an equity type security. Also, unlike a bond, the company is not obliged to make a regular payment to the investors. In case of a bankruptcy, the preferred stock owners have a right to claim the company’s assets after the bondholders and before the holders of common stocks.

Like money market, a bond market is a debt instrument issued by both the US government and corporations to borrow fund from public. But there are two differences: a bond market has longer term maturity, and bond returns are not always fixed (and so it is not totally correct to categorize them as fixed-income securities).

Following are the common bond market instruments.

Treasury Notes and Bonds

“T-note” and “T-bond” in short, these are government debt securities (like T-bill in money market) sold in denominations of $1000 or more. Maturity of a T-note is up to 10 years, and T-bonds mature between 10 and 30 years. Interests are paid semi-annually based on the specified annual rate. For example, at 4.5% annual rate, a $1000 T-note will pay you $22.5 every 6 months. Because they are backed by the government, these securities are safe investments.

Municipal Bonds

These are issued by the state and local governments, and the interest earned is exempt from the federal income tax and state tax in the issuing state. This makes them an attractive investment choice for people in high income category (they pay higher tax). But you must pay tax on any capital gain (increase in the bond value) at maturity.

To see the tax advantage of municipal bonds, suppose the interest of a taxable security is i, and your income tax bracket is t. Your after-tax earning is then i(1-t). So, if you pay 35% tax on your income, then 4.5% interest of a T-note (which is taxable) reduces to a little over 2.9% after tax. Compared to this, a municipal bond that pays 3.5% tax-free interest is quite attractive. This is also why someone coming into lot of money suddenly (like winning a lottery) finds investing in municipal bonds a good choice.

Corporate Bonds

Corporate bonds are a mean by which corporations borrow fund directly from investors. As in T-notes and T-bonds, these too pay interest in semi-annual installments and return the principal at maturity. The important difference is that a corporate bond has relatively higher risk of defaulting (in the event of the issuing firm facing bankruptcy).

Callable bonds are those that can be bought back by the issuing firm at a stipulated call price. Convertible bonds allow the bondholder to exchange each bond for a specific number company stocks.

Mortgage-backed securities

These securities, as the name suggests, are built on a pool of mortgage loans that are securitized and sold in secondary markets. Investors earn from the cash inflow as more and more loans are paid off. Because the mortgage lender collects the interest and principal payments from borrowers (home-owners) and pass them to the investors, these securities are also known as pass-throughs.

They are issued by the Government National Mortgage Association (GNMA, or Ginnie Mae), which is owned by the US government, and also by federally sponsored organizations such as the Federal National Mortgage Association (FNMA, or Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) and Federal Home Loan Bank (FHLB).

We will discuss “Stock Market” in a later post.

A money market, or “cash”, is a low-risk, short-term, liquid, debt type security. Reading from left to right, the italicized words mean – the risk of losing the principal (money you paid for the security) is low, it matures typically in a year or less, you can sell it quick, and corporations (and the government) issue these securities to borrow funds. Because of the low risk and fixed returns, a money market is an example of a fixed-income security. Following are the three major types of money markets.

Treasury bill

“T-bill” or just “bill” for short, these are securities that the US government sells to borrow fund. They are issued weekly at a minimum denomination of $1000 for 4-week, 13-week and 26-week maturation periods. You can either buy them directly from Treasury, or at a secondary market from a government securities dealer. Because they are backed by the government itself, there is almost no risk.

The way this works is that you buy T-bills at a discount from the face-value, and get back the face-value price at maturity. The discounted amount is your earning over that period (this is different from periodic earnings until maturity). For example, if you pay $9800 for a $10000 T-bill that has a 13-week maturity, you get $10000 back after 13 weeks, and therefore earn a 2.04%(=200×100/9800) interest over this period.

Certificate of Deposit

A certificate of deposit, or “CD”, is a debt instrument issued by banks. Your principal is locked for a fixed time period, which can be a few months to a few years. You get both the accrued interests and your principal back at maturity, and cannot withdraw any money until then. In this sense, a CD is different from a bank savings account (another difference is that the interest paid on a CD is usually higher than what you can get from a savings account). Bank CDs up to $100,000 are insured with FDIC, and so your investment is safe.

Commercial paper

Commercial papers are short-term debt instruments issued by large corporations to finance their businesses. They are not secure unlike bank deposits, and therefore only firms with high credit ratings can find investors without having to offer large discounts. Maturity of a commercial paper ranges up to 270 days (9 months); longer maturities require approval from SEC. Denominations are in multiples of $100,000, which makes these securities inaccessible to small investors (they can invest indirectly via money market mutual funds, which we will discuss in a later post).

Besides these three common types, other money markets are bankers’ acceptance, eurodollar, and repos.

Next we look at a Bond.

Merriam-Webster Online Dictionary defines the word security as “the state of being secure”. Then further down, “an instrument of investment in the form of a document (as a stock certificate or bond) providing evidence of its ownership”. These two definitions are not unrelated. A security is an investment instrument that is supposed to secure your financial future.

There are two broad classes of securities, depending on the nature of returns on their investment and the risk involved.

Fixed-income security

A fixed-income security, from its name, pays a fixed periodic return until maturity, when the principal (the amount originally paid to buy the security) is also returned. Fixed-income securities involve very low risk of devaluation/loss of the invested principal. An example is a Money Market instrument such as a Treasury bill.

Variable-income security

A variable-income security, by contrast, is one whose returns as well as the value of the principal vary based on underlying conditions, such as changes in the short-term interest rates. Because the principal itself can go up and down, investing in variable-income securities usually involves considerable risk. Examples include company stocks.

Why should I invest in high-risk assets?

A sensible question. Why? Because it is a fundamental fact of investing that taking more risk will reward you with higher long-term growth of your invested asset. For example, buying a 5-year CD (Certificate of Deposit) – a fixed-income security – at 5% annual interest will guarantee you a risk-free periodic return plus the principal after 5 years. On the other hand, investing in the S&P stock Index fund – a variable-income security with large short-term fluctuations – involves high risk, but your asset would grow at over 10% during most 5-year intervals.

The key phrase here is “long-term” (italicized above). If you want your money quickly, you are better off with low-risk fixed-income type investing. On the other hand, if you can wait several years (the more the better), investing with variable-income securities will smooth out the short-term fluctuations, and get you much higher returns at the end.

We continue with Money Market in the next post.