Market Strength

Market Strength

Table of Contents

1) Market Strength: Introduction

2) Market Strength: S&P 500 Futures

3) Market Strength: Advancers To Decliners

4) Market Strength: Relative Strength Index and Arms

5) Market Strength: Oil and Bonds

6) Market Strength: Conclusion

Introduction

There is an old saying that seems to always apply to the investment world: "hindsight is 20/20". When looking one, three or six months into the past, we can easily tell what the market did and why it happened. But if you are looking to discover the trends of the market today, where do you look?

In this tutorial we will go over various indicators used by traders and brokers to find out where the markets will open and how they will trade throughout the day. This tutorial will include an explanation of S&P 500 futures, the advance/decline line, the Relative Strength Index, the Arms Index, the price of oil and bonds and the ability of these indicators to detect market strength. Long-term investors should be warned, however. Over the long term, these day-to-day fluctuations in the markets are nothing to worry about, and for them, the long-term upward drift is much more important.

S&P 500 Futures

If you've ever watched financial television before or after the markets open you will probably notice that they often quote the latest index futures price on the "bug" in the bottom corner. The futures market is an important concept and can be used to gauge the trend of the market.

Futures There are two types of futures contracts, financial and commodities. No matter which type of contract you buy the basic premise is the same. The buyer of the contract agrees to deliver the product (or cash for financial futures) at the contract price on the expiry date. A contract can be on anything from corn, wheat, oil or, in our case, a stock index. It should be noted that a majority of futures contracts get "closed out" before the delivery date and so no physical delivery actually takes place. The Standard and Poor's 500 index (S&P 500) contains many of the largest companies in the world, so it only makes sense that movement in the direction of the S&P futures is one of the best indicators of overall short-term market direction (Note: The Nasdaq futures are considered a good indicator of technology stocks). The word futures might make this indicator sound confusing but it really isn't. If S&P futures are up, it's an indication that there is upward pressure on the market and the stock market will tend to rise. On the other hand, if S&P futures are down, it's a sign that there is downward pressure on the market and it will likely trend lower. This rise or decline in the futures contract is usually calculated as a change from fair value. Fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest and dividends lost because the investor owns the futures contract rather than the physical stocks. This price is determined over the period of the futures contract. Arbitrageurs Part of the reason that the markets follow the trend of futures contracts is because of arbitrageurs. An arbitrageur is someone who simultaneously purchases and sells a security (or index) in order to profit from a differential in the price, usually on different exchanges or marketplaces. For S&P futures contracts here is what happens: Suppose the futures contract is trading above fair value (higher), before the market is about to open. An arbitrageur will sell (short) the S&P futures contract and go long (buy) on the underlying stocks within the S&P 500 index. Therefore, the stock prices will increase until the S&P 500 index reaches fair value with S&P futures contract. This sounds like a lot of work but really isn't because of program trading. Using software that monitors both a stock index and futures contracts on the index, traders can be notified when there is a larger than normal gap. This strategy is commonly referred to as index arbitrage. Popularity The main reason that S&P futures are so popular for detecting strength is because this contract trades 24 hours a day on financial exchanges around the world. It allows traders and brokers to gauge the futures level before the actual stock markets open for trading which gives a sense of where the market is likely trend at the start of trading.

Advancers to Decliners

The advance/decline line (A/D) is a technical analysis tool and is considered the best indicator of market movement as a whole. Stock indexes such as the Dow Jones Industrial Average (DJIA) only tell us the strength of 30 stocks, whereas the A/D line provides much more insight. The formula is quite simple: it is the ratio between advancing stocks and declining ones. If the markets are up but there are more declining stocks than advancing ones it's usually a sign that the markets are losing their breadth or momentum. If the number of advancing issues is dominating the declining issues, the market is said to be healthy.

Unlike the S&P futures contract, this indicator is not necessarily short term. Looking at the A/D line (not just the advance decline ratio) shows us the cumulative trend of advancers to decliners over a particular period of time. Most of the time, the stock market does not turn around in an instant. Instead, the markets shift slowly, just as economic, business and market cycles would. This is why the general overall trend of the A/D line is important when determining the strength of the market. Even so, the advancers to decliners is a tool and not a crystal ball. Sudden market shocks that result from interest rate movements, war, or other drastic events can't be detected by the A/D.

Relative Strength Index and Arms

Relative Strength When talking about the strength of a stock or overall market, one great tool is the relative strength index (RSI) which is a comparison between the days a stock finishes up against the days it finishes down. It is a big tool in momentum trading. Depending on the type of investor, the RSI can be used to detect strength over a couple hours or over several months. Obviously, the longer trends are more valuable to long-term investors, whereas short-term trends in the RSI are popular with traders.

RSI = 100 - [100/(1 + RS)] where: RS = (Avg. of n-day up closes)/(Avg. of n-day down closes)

n= days (most analysts use 9 - 15 day RSI)

The RSI ranges from 0 to 100. A stock is considered overbought around the 70 level - a reason to consider selling. This number is not written in stone, in a bull market 80 is a better level because stocks often trade at higher valuations. Likewise, if the RSI approaches 30, a stock is considered oversold - a cause consider buying it. Again, make the adjustment to 20 in a bear market. A long-term RSI is more rolling and it fluctuates a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks of some industries will go as high as 75-80 before dropping back and others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (one year or more) to determine at what level the RSI has traded in the past.

This chart was supplied by Barchart.com

Here we have an RSI chart for AT&T (T). The RSI is the green line and its scale is the numbers that go from 0 to 100. Notice that the RSI was approaching the 60-70 level and then the stock (blue line) sold off, both in December and January. Also notice around October when the RSI dropped to 25 the stock climbed up nearly 30% in just a couple of weeks. Arms Index (TRIN) The Arms Index is commonly referred to on financial television and short-term trading websites. Arms is a market performance indicator that varies from the A/D and RSI because instead of simply looking at the number of up and down ticks (or stocks) the Arms Index weighs each stock by the volume traded for each issue. A ratio of one means that the market is in balance. A ratio above one indicates that more volume is moving into declining stocks. A ratio below one indicates that more volume is moving into advancing stocks. Both the RSI and Arms are great little indicators that can help you detect the overall strength of the market. Most investors agree that the RSI and Arms is most effective in "backing up" or increasing confidence before making an investment decision.

Oil and Bonds

The price of oil and bonds as they relate to market strength is a wide topic, but these are two areas tend to have a large influence over the markets. In this section, we will address the basics of using the prices of these commodities to determine market strength.

Oil Energy is one commodity that affects every company in one way or another. For example, the price of wheat makes a greater impact on agriculture stocks, but oil influences everything from the cost of electricity and heating, to the cost of production and transportation. When the price of commodities, and particularly oil, is on the rise it signals that inflation is starting to become apparent. The day-to-day price fluctuations won't cause inflation fears, but the long-term trend will. If the price of oil has been steadily increasing, it could cause investors to be fearful that inflating energy prices will slow company profits. The price of oil has an opposite effect on those stocks directly influenced by the price of oil. Drilling, pipeline and retail distribution of energy stocks tend to have an extremely high correlation to the price of oil. Bond Prices Ten and 30 year bonds, along with interest rate futures are another indicator used by many investors to gauge the strength of the stock market. As you may already know, if bond prices are going up, then yields are decreasing. This decrease in yields causes investors to search for other areas in which to invest their money at a higher return - this usually means the stock market. On the other end of the equation, lower bond yields means that interest rates are low and companies will find it much cheaper to borrow money and finance expansion or growth. While bond and oil prices might not be as accurate and current as the S&P 500 futures, they are the useful when looking at the overall condition of the economy and, more importantly, at the trend of the stock market.

Conclusion

The usefulness of these indicators depends on what type of investor you are. Long-term investors shouldn't care too much if the S&P futures are up or down before the markets open, whereas traders and short-term investors find this type of information key. Regardless of what type of investor you are, knowing the overall trend of the market over several months is beneficial. It doesn't mean you should trade on the basis of this trend, but if you are informed you may be able to protect your assets. Here's a quick recap of what we've learned:

 The S&P 500 index contains many of the largest companies in the world, making it a good indicator of overall, short-term market direction

 If S&P futures are up, this indicates an upward trend in the stock market. If S&P futures are down, it's a sign that the market will trend lower.

 This rise or decline in a futures contract is usually calculated as a change from fair value, or the equilibrium price for a futures contract.

 An arbitrageur is someone who simultaneously purchases and sells a security (or index) in order to profit from a differential in the price - they are part of the reason that the market follows the trend in futures contracts.

 Index arbitrage is an investment strategy that attempts to profit from the differences between actual and theoretical futures prices of the same stock index. This is done by simultaneously buying (or selling) a stock index future while selling (or buying) the stocks in that index.

 The A/D line is a technical analysis tool. It is the ratio between advancing stocks and declining ones.

 The A/D line is not a short-term indicator; it shows us the cumulative trend of advancers to decliners over a particular period of time.

 Relative Strength Index (RSI) is a technical analysis indicator that compares the days that a stock finishes up against when it finishes lower.

 The RSI ranges from 0 to 100, but a stock is considered overbought if it reaches the 70 level, meaning that you should consider selling. When it is a true bull market, an RSI of 80 might be a better level since stocks often trade at higher valuations. Likewise, if the RSI approaches 30, it is a strong buying indicator (20 in a strong bear market).

 The Arms Index is a market performance indicator that weighs each stock by the volume traded for each issue. A ratio of one means the market is in balance. A ratio above one indicates that more volume is moving into declining stocks. A ratio below one indicates that more volume is moving into advancing stocks.

 Oil is an energy commodity; its price can affect many companies.

 The day to day price fluctuations in oil won't cause inflation fears, but if its price increases steadily it could cause investors to be fearful that inflating energy prices will slow company profits.

 The price of oil has an opposite effect on those stocks directly influenced by the price of oil such as drilling, pipeline and retail distribution of energy stocks.

 Bond prices can also be used to gauge the strength of the stock market.

 An increase in bond prices means a decrease in yields, which may cause more investors to move their money to the stock market for higher returns.

 Lower bond yields also tend to lead to lower interest rates, making it cheaper for companies to borrow money to finance growth.

Lifetime Payout Annuity

What Does Lifetime Payout Annuity Mean?

A type of insurance product that pays out a portion of the underlying portfolio of assets over the life of the investor. A lifetime payout annuity can provide fixed or variable payments. In a fixed payout scheme, the investor receives a fixed dollar amount for each payment, potentially with cost of living adjustments (COLA). Payouts under a variable payout scheme will fluctuate because payments are based on the value of the investments held in the annuity's portfolio.

Investors may choose a lifetime payout annuity to head off the risk of outliving the amount of money set aside for retirement. Basically, the guaranteed payments for life reduce a person's longevity risk. However, this payout scheme can cause problems for those wanting to leave estates to heirs. Payouts from a lifetime payout annuity typically end with the death of the policyholder. The policyholder can purchase adjustments which allow payments to continue to an estate or which allow for a guaranteed number of payments, but these can result in a different payout.

Earnings Manangement

Before diving into what earnings management is, it is important to have a solid understanding of what we mean when we refer to earnings. Earnings are the profits of a company. Investors and analysts look to earnings to determine the attractiveness of a particular stock. Companies with poor earnings prospects will typically have lower share prices than those with good prospects. Remember that a company's ability to generate profit in the future plays a very important role in determining a stock's price.

That said, earnings management is a strategy used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target. This practice is carried out for the purpose of income smoothing. Thus, rather than having years of exceptionally good or bad earnings, companies will try to keep the figures relatively stable by adding and removing cash from reserve accounts (known colloquially as "cookie jar" accounts).

Abusive earnings management is deemed by the Securities & Exchange Commission to be "a material and intentional misrepresentation of results". When income smoothing becomes excessive, the SEC may issue fines. Unfortunately, there's not much individual investors can do. Accounting laws for large corporations are extremely complex, which makes it very difficult for regular investors to pick up on accounting scandals before they happen.

Although the different methods used by managers to smooth earnings can be very complex and confusing, the important thing to remember is that the driving force behind managing earnings is to meet a pre-specified target (often an analyst's consensus on earnings). As the great investor Warren Buffett once said, "Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers".

The Oracle of Omaha

What Does Oracle Of Omaha Mean?

A nickname for Warren Buffett, who is arguably one of the greatest investors of all time. He is called the "Oracle of Omaha" because his investment picks and comments on the market are very closely followed by the investment community, and he lives and works in Omaha, Nebraska.

Warren Buffett is one of the richest men in the world. He built his fortune using a simple yet powerful investment strategy. His investments are long-term positions, accomplished by the purchase of strong companies that are trading well below their intrinsic value. Some of his most well-known investments include Coca-Cola and Gillette.

What Does Berkshire Hathaway Mean?

A holding company for a multitude of businesses run by Chairman and CEO Warren Buffett. Berkshire Hathaway is headquartered in Omaha, Nebraska and began as just a group of textile milling plants, but when Buffett became the controlling shareholder in the mid 1960s he began a progressive strategy of diverting cash flows from the core business into other investments.

Insurance subsidiaries tend to represent the largest pieces of Berkshire Hathaway, but the company manages hundreds of diverse businesses all over the world.

Because of Berkshire Hathaway's long history of operating success and keen stock market investments, the company has grown to be one of the largest in the world in terms of market capitalization. Berkshire stock trades on the New York Stock Exchange in two classes, A shares and B shares. The A shares are noted for their very high prices - in excess of $100,000 per share in 2007.

Early in his career Buffett came across the novel idea to use the "float" from his insurance subsidiaries to invest elsewhere, mainly into focused stock picks that would be held for the long term. Buffett has long eschewed a diversified stock portfolio in favor of a handful of trusted investments that would be overweighted in order to leverage the anticipated return. Over time, his investing prowess became so noted that Berkshire's annual shareholder meetings became a mecca for value investing proponents and the focus of intense media scrutiny.

Warren Buffett is widely considered to be one of the greatest investors of all time, but if you were to ask him who he thinks is the greatest investor he would probably mention one man: his teacher, Benjamin Graham. Graham was an investor and investing mentor who is generally considered to be the father of security analysis and value investing.

His ideas and methods on investing are well documented in his books, "Security Analysis" (1934), and "The Intelligent Investor" (1949), which are two of the most famous investing texts. These texts are often considered to be requisite reading material for any investor, but they aren't easy reads. Here, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.

Principle No.1: Always Invest with a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities, but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for $0.50. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks where the liquid assets on the balance sheet (net of all debt) were worth more than the total market cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham.

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and ups its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When chosen carefully, Graham found that a further decline in these undervalued stocks occurred infrequently.

While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety".

Principle No.2: Expect Volatility and Profit from It

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market", the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. At other times, he is depressed about the business's prospects and will quote a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions, or worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate - sometimes wildly - but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:

Dollar-Cost Averaging

Dollar-cost averaging is achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions.

Investing in Stocks and Bonds

Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25-75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e. speculating).

Principle No.3: Know What Kind of Investor You Are

Graham advised that investors know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active Vs. Passive

Graham referred to active and passive investors as "enterprising investors" and "defensive investors".

You only have two real choices: The first is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive, and possibly lower, return but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "Work = Return". The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones Industrial Average in equal amounts. Both Graham and Buffett said that getting even an average return - for example, equaling the return of the S&P 500 - is more of an accomplishment than it might seem. The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market.

Speculator Vs. Investor

Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: an investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper, with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing - just be sure you understand which you are good at.

Commentary

Graham's basic ideas are timeless and essential for long-term success. He bought into the notion of buying stocks based on the underlying value of a business and turned it into a science at a time when almost all investors viewed stocks as speculative. Graham served as the first great teacher of the investment discipline, as evidenced by those in his intellectual bloodline who developed their own. If you want to improve your investing skills, it doesn't hurt to learn from the best; Graham continues to prove his worth in his disciples, such as Warren Buffett, who have made a habit of beating the market.

Think Like Warren Buffett

Back in 1999, Robert G. Hagstrom wrote a book about the legendary investor Warren Buffett, entitled "The Warren Buffett Portfolio". What's so great about the book, and what makes it different from the countless other books and articles written about the "Oracle of Omaha" is that it offers the reader valuable insight into how Buffett actually thinks about investments. In other words, the book delves into the psychological mindset that has made Buffett so fabulously wealthy.

Although investors could benefit from reading the entire book, we've selected a bite-sized sampling of the tips and suggestions regarding the investor mindset and ways that an investor can improve their stock selection that will help you get inside Buffett's head.

1. Think of Stocks as a Business

Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions.

That's why Buffett has stated he believes stockholders should think of themselves as "part owners" of the business in which they are investing. By thinking that way, both Hagstrom and Buffett argue that investors will tend to avoid making off-the-cuff investment decisions, and become more focused on the longer term. Furthermore, longer-term "owners" also tend to analyze situations in greater detail and then put a great eal of thought into buy and sell decisions. Hagstrom says this increased thought and analysis tends to lead to improved investment returns.

2. Increase the Size of Your Investment

While it rarely - if ever - makes sense for investors to "put all of their eggs in one basket," putting all your eggs in too many baskets may not be a good thing either. Buffett contends that over-diversification can hamper returns as much as a lack of diversification. That's why he doesn't invest in mutual funds. It's also why he prefers to make significant investments in just a handful of companies.

Buffett is a firm believer that an investor must first do his or her homework before investing in any security. But after that due diligence process is completed, an investor should feel comfortable enough to dedicate a sizable portion of assets to that stock. They should also feel comfortable in winnowing down their overall investment portfolio to a handful of good companies with excellent growth prospects.

Buffett's stance on taking time to properly allocate your funds is furthered with his comment that it's not just about the best company, but how you feel about the company. If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?

3. Reduce Portfolio Turnover

Rapidly trading in and out of stocks can potentially make an individual a lot of money, but according to Buffett this trader is actually hampering his or her investment returns. That's because portfolio turnover increases the amount of taxes that must be paid on capital gains and boosts the total amount of commission dollars that must be paid in a given year.

The "Oracle" contends that what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.

Investors must think long term. By having that mindset, they can avoid paying huge commission fees and lofty short-term capital gains taxes. They'll also be more apt to ride out any short-term fluctuations in the business, and to ultimately reap the rewards of increased earnings and/or dividends over time.

4. Develop Alternative Benchmarks

While stock prices may be the ultimate barometer of the success or failure of a given investment choice, Buffett does not focus on this metric. Instead, he analyzes and pores over the underlying economics of a given business or group of businesses. If a company is doing what it takes to grow itself on a profitable basis, then the share price will ultimately take care of itself.

Successful investors must look at the companies they own and study their true earnings potential. If the fundamentals are solid and the company is enhancing shareholder value by generating consistent bottom-line growth, the share price, in the long term, should reflect that.

5. Learn to Think in Probabilities

Bridge is a card game in which the most successful players are able to judge mathematical probabilities to beat their opponents. Perhaps not surprisingly, Buffett loves and actively plays the game, and he takes the strategies beyond the game into the investing world.

Buffett suggests that investors focus on the economics of the companies they own (in other words the underlying businesses), and then try to weigh the probability that certain events will or will not transpire, much like a Bridge player checking the probabilities of his opponents' hands. He adds that by focusing on the economic aspect of the equation and not the stock price, an investor will be more accurate in his or her ability to judge probability.

Thinking in probabilities has its advantages. For example, an investor that ponders the probability that a company will report a certain rate of earnings growth over a period of five or 10 years is much more apt to ride out short-term fluctuations in the share price. By extension, this means that his investment returns are likely to be superior and that he will also realize fewer transaction and/or capital gains costs.

6. Recognize the Psychological Aspects of Investing

Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking.

More than anything, investors' own emotions can be their worst enemy. Buffett contends that the key to overcoming emotions is being able to "retain your belief in the real fundamentals of the business and to not get too concerned about the stock market."

Investors should realize that there is a certain psychological mindset that they should have if they want to be successful and try to implement that mindset.

7. Ignore Market Forecasts

There is an old saying that the Dow "climbs a wall of worry". In other words, in spite of the negativity in the marketplace, and those who perpetually contend that a recession is "just around the corner", the markets have fared quite well over time. Therefore, doomsayers should be ignored.

On the other side of the coin, there are just as many eternal optimists who argue that the stock market is headed perpetually higher. These should be ignored as well.

In all this confusion, Buffett suggests that investors should focus their efforts of isolating and investing in shares that are not currently being accurately valued by the market. The logic here is that as the stock market begins to realize the company's intrinsic value (through higher prices and greater demand), the investor will stand to make a lot of money.

8. Wait for the Fat Pitch

Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player.

Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

Bottom Line

"The Warren Buffett Portfolio" is a timeless book that offers valuable insight into the psychological mindset of the legendary investor Warren Buffett. Of course, if learning how to invest like Warren Buffett were as easy as reading a book, everyone would be rich! But if you take that time and effort to implement some of Buffett's proven strategies, you could be on your way to better stock selection and greater returns.

Bonus Issue

Bonus Issue

What Does Bonus Issue Mean?

An offer of free additional shares to existing shareholders. A company may decide to distribute further shares as an alternative to increasing the dividend payout.

Also known as a "scrip issue" or "capitalization issue".

New shares are issued to shareholders in proportion to their holdings. For example, the company may give one bonus share for every five shares held.

What is a Book closure/Record date?

The registered shareholders of the company are entitled to corporate benefits such as dividend, bonus, rights etc. announced by the company from time to time. Since, the ownership of shares of companies traded on the stock exchange is freely transferable and to enable the company to know the persons entitled to the benefits, all transfers of securities have to be registered with the company (this is required in case of transfer of shares in physical form). Since transfer of securities is a continuous process open any time, the company announces cut off dates from time to time and members on the register of shareholders as of these cut off dates are entitled to the benefits. Such cut-off dates are record dates. Alternatively, the company might choose the close the register of shareholders for registration of transfer during a specified period. All transfer requests received before the commencement of the book closure or on or before the record date are considered for the purpose of transfer. A Company cannot close its books for more than 30 days at stretch for a book closure, and not more 45 days in a year. The period between two Book Closure cannot be less than 90 days

What is the difference between book-closure and record-date?

ACC announced a Book Closure (BC) for the period 6th July to 30th July'96. During this period, the company had closed its register of security holders. This was done to determine the number of registered members who were eligible for the Bonus 3:5 and a dividend of 40%. The process of transfer of shares was operational till 5th July'96. The company announced a No Delivery period from 12th June to 9th July'96 before the Book Closure. During this period, trading was permitted in the securities but the trades were settled only after 9th July. Hence, the buyers of the shares were not be eligible for the Bonus 3:5 and a 40% dividend. The first day of the No Delivery period is considered as an Ex - Date since the buyer of the shares is not eligible for the corporate benefits for this BC.

The same logic holds good for Record date, but the two main differences are that : In case of a record date, the company does not close its register of security holders. Record date is a cut off date ( in the above example '5th july96) for determining the number of registered members who are eligible for the corporate benefits [Interim dividend (30%) ].

What is a 'No Delivery' period?

Whenever, a book closure or a record date is announced by a company, the exchange sets up a 'No Delivery' period for that security. During this period, trading is permitted in the security. However, these trades are settled only after the No-Delivery period is over. The start of No-Delivery period is the ex-date of the settlement.The settlement is clubbed with the settlement of the week whose pay-out date falls just after the end of the no-delivery period. This is done to ensure that investor's entitlement for the corporate benefits is clearly determined. No-delivery period generally extends to all weekly cycles touched from 15 days prior to the record date and 4 days subsequent to the record date (both inclusive).

What is an ex-date?

The first day of the 'No Delivery' period is the ex-date viz., if there is any corporate benefit such as rights, bonus, dividend etc. announced for which book closure/record date is fixed, the buyer of the shares on or after the ex-date will not be eligible for the benefits while the seller would be eligible for the same.

What Are Depositary Receipts?

A depositary receipt (DR) is a type of negotiable (transferable) financial security that is traded on a local stock exchange but represents a security, usually in the form of equity, that is issued by a foreign publicly listed company. The DR, which is a physical certificate, allows investors to hold shares in equity of other countries. One of the most common types of DRs is the American depositary receipt (ADR), which has been offering companies, investors and traders global investment opportunities since the 1920s.

Since then, DRs have spread to other parts of the globe in the form of global depositary receipts (GDRs) (the other most common type of DR), European DRs and international DRs. ADRs are typically traded on a U.S. national stock exchange, such as the New York Stock Exchange (NYSE) or the American Stock Exchange, while GDRs are commonly listed on European stock exchanges such as the London Stock Exchange. Both ADRs and GDRs are usually denominated in U.S. dollars, but can also be denominated in euros.

How Does the DR Work?

The DR is created when a foreign company wishes to list its already publicly traded shares or debt securities on a foreign stock exchange. Before it can be listed to a particular stock exchange, the company in question will first have to meet certain requirements put forth by the exchange. Initial public offerings, however, can also issue a DR. DRs can be traded publicly or over-the-counter. Let us look at an example of how an ADR is created and traded:

Example

Say a gas company in Russia has fulfilled the requirements for DR listing and now wants to list its publicly traded shares on the NYSE in the form of an ADR. Before the gas company's shares are traded freely on the exchange, a U.S. broker, through an international office or a local brokerage house in Russia, would purchase the domestic shares from the Russian market and then have them delivered to the local (Russian) custodian bank of the depository bank. The depository bank is the American institution that issues the ADRs in America. In this example, the depository bank is the Bank of New York. Once the Bank of New York's local custodian bank in Russia receives the shares, this custodian bank verifies the delivery of the shares by informing the Bank of New York that the shares can now be issued in the United States. The Bank of New York then delivers the ADRs to the broker who initially purchased them.

Based on a determined ADR ratio, each ADR may be issued as representing one or more of the Russian local shares, and the price of each ADR would be issued in U.S. dollars converted from the equivalent Russian price of the shares being held by the depository bank. The ADRs now represent the local Russian shares held by the depository, and can now be freely traded equity on the NYSE.

After the process whereby the new ADR of the Russian gas company is issued, the ADR can be traded freely among investors and transferred from the buyer to the seller on the NYSE, through a procedure known as intra-market trading. All ADR transactions of the Russian gas company will now take place in U.S. dollars and are settled like any other U.S. transaction on the NYSE. The ADR investor holds privileges like those granted to shareholders of ordinary shares, such as voting rights and cash dividends. The rights of the ADR holder are stated on the ADR certificate.

Pricing and Cross-Trading

When any DR is traded, the broker will aim to find the best price of the share in question. He or she will therefore compare the U.S. dollar price of the ADR with the U.S. dollar equivalent price of the local share on the domestic market. If the ADR of the Russian gas company is trading at US$12 per share and the share trading on the Russian market is trading at $11 per share (converted from Russian rubles to dollars), a broker would aim to buy more local shares from Russia and issue ADRs on the U.S. market. This action then causes the local Russian price and the price of the ADR to reach parity. The continual buying and selling in both markets, however, usually keeps the prices of the ADR and the security on the home market in close range of one another. Because of this minimal price differential, most ADRs are traded by means of intramarket trading.

A U.S. broker may also sell ADRs back into the local Russian market. This is known as cross-border trading. When this happens, an amount of ADRs is canceled by the depository and the local shares are released from the custodian bank and delivered back to the Russian broker who bought them. The Russian broker pays for them in roubles, which are converted into dollars by the U.S. broker.

The Benefits of Depositary Receipts

The DR functions as a means to increase global trade, which in turn can help increase not only volumes on local and foreign markets but also the exchange of information, technology, regulatory procedures as well as market transparency. Thus, instead of being faced with impediments to foreign investment, as is often the case in many emerging markets, the DR investor and company can both benefit from investment abroad. Let's take a closer a look at the benefits:

For the Company

A company may opt to issue a DR to obtain greater exposure and raise capital in the world market. Issuing DRs has the added benefit of increasing the share's liquidity while boosting the company's prestige on its local market ("the company is traded internationally"). Depositary receipts encourage an international shareholder base, and provide expatriates living abroad with an easier opportunity to invest in their home countries. Moreover, in many countries, especially those with emerging markets, obstacles often prevent foreign investors from entering the local market. By issuing a DR, a company can still encourage investment from abroad without having to worry about barriers to entry that a foreign investor might face.

For the Investor

Buying into a DR immediately turns an investors' portfolio into a global one. Investors gain the benefits of diversification while trading in their own market under familiar settlement and clearance conditions. More importantly, DR investors will be able to reap the benefits of these usually higher risk, higher return equities, without having to endure the added risks of going directly into foreign markets, which may pose lack of transparency or instability resulting from changing regulatory procedures. It is important to remember that an investor will still bear some foreign-exchange risk, stemming from uncertainties in emerging economies and societies. On the other hand, the investor can also benefit from competitive rates the U.S. dollar and euro have to most foreign currencies.

Conclusion

Giving you the opportunity to add the benefits of foreign investment while bypassing the unnecessary risks of investing outside your own borders, you may want to consider adding these securities to your portfolio. As with any security, however, investing in ADRs requires an understanding of why they are used, and how they are issued and traded.