Corporate spin off opportunity from Xerox: Conduent

This week will look at a corporate spin off.  Earlier this month, Xerox (XRX) spun off their Business Process arm into a new company called Conduent (CNDT).  The interest in this particular situation is partly from reading a book by Joel Greenblatt, a value investor and hedge fund manager who is also an adjunct professor at Columbia University’s Graduate School of Business.

(Some investment areas are) surprisingly unappetizing. (One such) area of discarded corporate refuse is usually referred to as “spinoffs.” – Joel Greenblatt

Companies sometimes grow so much that they realize that they have business arms that are no longer part of their core business.  The business leaders realize that they need to get back to their roots and find that they need to rid themselves of the business that is not part of their core business.  When this happens, they can sell that portion of the business to another company or they can spin it off into its own entity.  Hewlett Packard did this a couple of years ago and plans to do so again on April 1st. Since they split Hewlett Packard, the company has done well as management has been able to focus on their core business.  The spinoff is usually out of favor with institutional investors when it is first created primarily because it could be too small of a company for the mutual fund or in a different sector than that of the parent company.  The company may also have few analysts covering it making an opportunity to purchase it at a lower price than normal.  The interesting fact is that these situations typically create opportunity for superior returns.

Let us apply this thought process to CNDT.

CNDT is the world’s largest provider of diversified business process services.  When looking at the SEC Form 10 (the SEC form a company files when it creates a spinoff), it is surprising to find that this company serves 19 of the 20 top commercial healthcare payers in the United States.  They also have contracts with 49 of the 50 states for regulatory compliance and data needs. They provide services to government healthcare programs in 29 states, and services for 9 of the top 10 global pharmaceutical and life science companies in the world. In the public sector segment, CNDT provides services for 25 countries for transportation.  In their commercial industries segment, they provide end-to-end business-to-business and business-to-customer services in order to optimize their processes.

These contracts provide recurring revenue to CNDT.  The Form 10 talked about the company’s target renewal rate of 85-90% which was met for the past two years.  The company consistently generates cash flow according to its Cash Flow Sheet.  The company seems to have been put into a precarious position with a very low current ratio.  This appears to be XRX’s path to success-to unload it’s debt onto the spinoff so that XRX can return to profitability a normal action by many companies participating in spinoffs.  The most recent quarterly filing with the SEC indicates that the company is reducing its debt load improving the current ratio.  The quarterly statement does show that the company is heading for a cash flow loss in this first year of existence with a $38M loss in the nine months ended September 30, 2016.  In short the company should begin its life struggling to exist.

This is reflected in the number of institutional investors: 9.77% of the company’s stock is held by them.  The company’s first year results (due around the 10th of next month) should help determine if this will change.  This presents an opportunity to get into this company at a very low relative price.

The company’s new CEO should be considered, his name is Ashok Vemuri.  Vemuri’s experience is with Infosys and IGATE. At IGATE, Vemuri kept the company afloat when the prior CEO was embroiled in a sexual harassment lawsuit. When he worked at Infosys, he had mixed results, some say that he was successful, others state he was not a star player and contributed to Infosys’ weak results when a member of the board.  The question to ask is, “Will Vemuri be motivated to make CNDT a successful organization?” His fortunes are tied to the success of the company amounting for approximately $5M in recompense over the next two years if he makes the company profitable.  Vemuri appears to be a multi millionaire already, he is probably worth around $30M, so the $5M appears sufficient to keep him focused.

Another person to consider is Carl Icahn, he has control over three of the board seats in this new company.  The activist investor is finding a way to get his money’s worth out of his investment in XRX.  Icahn’s investment style should be considered to see what he is doing.  It is important to know that he orchestrated this spinoff to have three seats on the board the investor should want to know why he wanted so much control over the new company.

Annual results next month should help identify what the company is worth. $14/share may or may not be the best price for the company.  Is this corporate refuse or a diamond in the rough?  The company’s first annual statement should help determine this.

Possible Investment: Mylan @ $40/share

Mylan NV is a large pharmaceutical company based in the United Kingdom.  The company has been featured in the news recently because of its EpiPen pricing.  This recent poor publicity has restricted the company’s share price.

“Drug pricing drama helped cause pharmaceuticals stocks to badly trail the market in 2016” – Charley Grant, Wall Street Journal, R12, 3 January 2017

The pricing drama Grant is talking about was centered on Mylan’s EpiPen, pharma fell last year when most of the industries had a banner return.  The company booked a $465 million charge last quarter to settle the ensuing Justice Department investigation.  This charge, combined with lower EpiPen volumes resulted in a loss last quarter.

This dramatic series of events presents a possible investment opportunity.  This post will analyze the company for such an investment.  In a disclosure up front, I have a personal interest on one call option in this company to purchase it at $60/share January, 2019.

Mylan NV

Company Profile (Adapted from TDAmeritrade’s website)

Mylan N.V. is a global pharmaceutical company. The Company develops, licenses, manufactures, markets and distributes generic and branded generic products for resale by others; specialty pharmaceuticals, and active pharmaceutical ingredients (APIs). It operates through two segments: Generics and Specialty.

Generics segment

Mylan’s Generics segment primarily develops, manufactures, sells and distributes generic or branded generic pharmaceutical products in tablet, capsule, injectable, transdermal patch, gel, cream or ointment form, as well as API.

Specialty segment

Mylan’s Specialty segment is focused on respiratory and allergy therapies. The EpiPen Auto-Injector, which is used in the treatment of severe allergic reactions, is an epinephrine auto-injector. The Company’s Perforomist Inhalation Solution is a long-acting beta2-adrenergic agonist indicated for the maintenance treatment of bronchoconstriction in chronic obstructive pulmonary disorder (COPD) patients.  The Specialty segment was bolstered by the recent acquisition of Meda.

Growth prospects

The 7 October 2016 Value Line review indicates that the company has two major blockbusters that it is pursuing in the generics business for Advair and Herceptin.  Just 20% of these two markets last year would represent $3 billion in revenue.

Market threat

Although government entities are up in arms over the pricing of products like EpiPen, the fact remains that until another company is able to make a generic the company will have the ability to maintain pricing power.  The company’s fortunes are not solely based on the EpiPen however, much of its recent price performance appears to be correlated with how this product is performing.

The recent settlement with the Department of Justice represents a significant blow to the company because it’s quarterly earnings that were to be significant, turned into a loss.  This settlement represented just over 100% of the company’s quarterly earnings.  The company’s share price suffered as a result and has hovered under $40/share  for the last two months.

The following table compares key information about the company compared to Pfizer, I find that comparing companies to industry leaders helps identify a company’s value.

Ticker MYL PFE
Top 1 or 2 in individual industry No 2
Positive annual Cash Flows since ’08 since ’00
P/E ratio 22.6 30.2
Invesment size ~2% of portfoli0 $330 NA
Management consistently
reduces shares (10 year change)
9% -2%
Consistent earnings growth, 10 year change Mylan posted earnings losses for two years ten years ago, it may not perform well in a recession -4% earnings growth rate negative
Year over year positive growth during the past 10 years 60% 60%
Interest and preferred dividend expense coverage 2.71 2.90
Earnings or cash flow
losses in the past 10 years
2 yrs’ earnings losses and one year cash loss during the financial crisis No losses
Dividend growth rate -100% 5%
Current Ratio 3.23 1.37
Debt to Capital 203% 263%
Price as a % of Net Tangible Assets 173% 304%
Number of superior elements 4 6

Mylan has better current ratio, debt to capital ratio, and P/E ratio.  Pfizer, an industry leader has better earnings history and interest coverage.  This places Mylan as a peer to one of the respected industry leaders and DJIA component.  The price of Mylan is what makes it a superior investment it has a P/E that is roughly 2/3 of Pfizer’s.  Value Line projects the share price to be 80-120 in three to five years’s time a double or triple its value. I want to see more on how the settlement may affect future earnings but I expect to add to my investment later this week.  My call purchase is anticipating over 50% return over the next two years.

Price to Earnings Ratio

This post will discuss one of the most used financial ratios-the price to earnings ratio, or P/E ratio.  Benjamin Graham preferred companies that did not have a P/E above 15.  The inverse of the P/E is the anticipated “yield” of a stock, meaning a P/E of 15 represents a 6.7% earnings represented by the current price of the stock.

In a previous attempt to make investing easy, I used P/E lower than 15 as a single and only reason to invest.  This is not a good way to do so, I experienced mixed results at best.  However, P/E is a good starting point on investing.  I agree with Graham’s perspective on P/E and avoid purchasing a stock if it trades at a price higher than a P/E ratio of 15.  This typically causes me to avoid companies like Nvidia (current P/E 55.78) and Google (current P/E of 29) but it did allow me to purchase Apple last year when it traded at 96.42 (P/E of 12.85 at that time).  Since that purchase, the share price has risen to 115.82 as of this writing, not bad for a one year return on investment.

Being Paid to Invest

What if someone paid you to invest in securities you already wanted to own?  This post will cover one strategy that allows the investor to receive payment on investments they want to purchase.

Tom said to himself that it was not such a hollow world, after all. He had discovered a great law of human action, without knowing it – namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.

-The Adventures of Tom Sawyer, Mark Twain

This is Tom’s light bulb moment for the fence painting episode.  This is the same type of light bulb moment I had when I first learned about cash secured puts.  Such a strategy is not for everyone, please understand that options trading adds an element of risk much greater than the normal stock or mutual fund investor is willing to assume.

What is a Cash Secured Put?

A cash secured put is created when an investor provides an option to sell a security at a fixed price.  The investor is paid for providing this service by the individual that buys the right to sell the security at the strike price (think sale price), this investor assumes the responsibility to purchase it at the strike price if the buyer wants to sell it.  The investor using cash secured puts is selling the put.  The individual purchasing the put is usually trying to lock in a price to sell and pays the seller a fee for tying up the underlying cash required to purchase the security.  Sellers use this strategy to provide income on a regular basis when they wish to keep their cash on hand.  Buyers use this strategy to lock in profits on an investment that has appreciated in value.

How to use Cash Secured Puts 

Selling a cash secured put to be paid to invest should start with an understanding of what price you want to purchase the underlying security.  When you determine such a price, then you sell the put at that price.  If the security falls below the price of the put, then it is considered in the money.  If it stays in the money upon expiration, then the purchase will be “put” to you and you will be required to purchase at the price indicated by the option.  Your purchase price is the stock price discounted by the sale price of the put.

A word of Caution

All option trading can be highly volatile.  Most professionals use options only as a small portion of their portfolios (1-3%).  However, this strategy can lock up a large portion of your portfolio in cash until you close out of the position.  Using this strategy to purchase an option when a company is high that later falls often forces the investor to purchase the stock at a premium to what it current price is causing them to assume the risk of the falling stock.  This makes it an extremely risky strategy to use when purchasing companies that are not investment grade.  I do not recommend using such a strategy to purchase anything but investments with the least risk.  Limiting cash secured put sales to stocks found in the Dow Jones Averages including the Industrial Average, Transport Average, and Utility average would mitigate some of this risk.  

The opportunity

A conservative application of this strategy offers an opportunity to earn approximately 2% annually while preserving cash for specific entry points.  This may not seem like a lot, however, it provides income when the investor thinks the market is overpriced.  It is a great way to make your money continue to earn when the market seems overpriced.  Your efforts are rewarded by a constant stream of cash for the security you offer the investor.

ACTION ITEM: Determine for yourself if you are willing to assume the risk of a stock falling.  Is this the right strategy for you?  If so, what will you do to limit the risk involved?

Stock Market Forecast 12/17/2016

Stock market value determination is fundamental to an investor interested in purchasing portions of the market at a reasonable price.  Forecasting is an important part of any active investment style.

“The cost of a thing is the amount of what I will call life which is required to be exchanged for it, immediately or in the long run.”
― Henry David Thoreau, Walden

The time spent understanding a situation is the ‘life’ Thoreau mentions in the preceding quote.  When considering the cost required to value the market, lets look at ways that capitalize on the amount of time required in exchange.  This post will discuss a little wisdom from Benjamin Graham, some analyst reports one might consider, and some current trends in the news.

A Thought from Ben Graham

Benjamin Graham used the price to earnings (P/E) ratio to identify when a security was over priced or priced at a discount.  A simple way to look at this is to compare the P/E ratio’s current level to that of the security’s average.  When the P/E is lower than the historical average P/E, then Graham proposed that the price of the underlying security is trading at a discount.  Historical data that identifies the monthly average P/E of the S&P 500 to be roughly 15.60 (from data found on www.multpl.com).  This is the average of over 100 years’ of data.  Note that over the past 20 years this average is trending upward.  This indicates that if the S&P 500 drops below a P/E of 15.60, then it is at an appropriate entry price.  The S&P 500’s current P/E ratio of 24.98 (found on wsj.com) would indicate that the average is about 60% overpriced.

Professional Advice

Professional services share their perspective of where they expect the market to be heading.  My personal favorite is the Value Line Investment Survey, but there are others to consider.  Warren Buffet was once quoted stating that he liked the S&P report.  These companies that do this type of work are not all the same so if you are using their information make sure it is from a reputable organization.

Value Line’s weekly report indicates the anticipated price change for the stocks in the Value Line survey will be over the next five years.  The highest expected five year return was 185% during the financial crisis, last week it was 35%.  Value Line uses a proprietary arithmetic formula for its calculation and the investor will have to pay for such advice-or get access to it at a local public library.  Most public libraries will have this in their section on investing.

The S&P Capital IQ Outlook report is another paid service.  This report is free to those with a TDAmeritrade account.  The S&P outlook for 2017 states that the current bull market is the second most expensive market top since WWII with a trailing (meaning the last 12 months) P/E of more than 25x! The Outlook report also points out that the S&P 500 fell an average of 2.7% during the first year of a new Republican president.  The report states that only once did the year following the election of a new Republican president end with a gain.  Finally, S&P predicts that this market will continue to stay ‘aloft’ through the next year.

The Argus Market Watch Report is also free with an account from TDAmeritrade.  This report compiles several different analysts and provides a diary of a 12-month forecast for the S&P 500.  This forecast puts the price of the S&P 500 to be somewhere between 1,800 and 2,250.  The S&P 500 is currently trading just over the high end of this range.  Argus does not appear to have updated this range since December 2015, making any confidence in this prediction low and leading the reader to question how current it is.

These agencies can be wrong they provide predictions because their customers ask for it.  In fact there exists a strong argument to anyone wanting to lay some blame of the financial crisis at various rating agency’s feet.  They also use words that try to make their predictions less clear like the S&P report use of the word aloft.  However, they do give a good idea of the sentiment that is current in the market and most of their customers want to see the logic behind such predictions.

Current News

Stories in the news talk of the way people are piling in on the purported “Trump trade”.  The “Trump trade” is the price jump that occurred in the US stock market after the election.  This price jump was sharp and had very few losses over the past few weeks.  This indicates that the index may be overpriced.

Assessment

My experience with P/E ratios, professional advice, and news articles teaches me that this data needs confirmatory evidence.  The evidence I considered for this post causes me to conclude that the stock market is currently trading at a premium.  This post ends with my personal assessment of the S&P 500 price expectation in the next six months.  Confidence level: MODERATE, I assess that the S&P 500 has a 70% chance of retreating at least 10% (or to $2,033.07) at some time in the next six to twelve months.  Note: this assessment is my attempt to identify market prices over the given period, I use this type of conclusion for my own investing. Before you commit funds to any investment or trade, I encourage you to do your own analysis of the investment vehicles you are looking at.

ACTION ITEM: What price changes do you think will happen in the stock market over the next six months to a year?

Investment Plans, Part 3: ETF Example

“Now, what should happen when you make a mistake is this: You take your knocks, you learn your lessons, and then you move on. That’s the healthiest way to deal with a problem… You know, by the time you reach my age, you’ve made plenty of mistakes. And if you’ve lived your life properly — so, you learn. You put things in perspective. You pull your energies together. You change. You go forward”

– Ronald Reagan regarding the Iran-Contra Scandal

This quote begins this week’s post because it is how I felt about the results of my analysis of a stock investment strategy.  I hope you find the following data useful.  This is a result of over 2,000 data points and my submission of the

This graph shows how an investor would apply their capital over the past ten years in IJH, a mid-cap ETF.  The green represents the weekly closing price of the ETF.  The blue indicates the monthly shares purchased from the ETF under the Dollar Cost Averaging (DCA) method.  Finally, the yellow represents the number of shares purchased under the Price/Volume method (PV) discussed last week.

The inputs into this model are as follows:

  1. The DCA method invested a set amount the first Monday of each month over the ten years.
  2. The DCA method invested the full amount of the investment funds, this is a bit unrealistic because an ETF would require the purchase of at least one full share.  However, this was used to develop the chart because many investors use the DCA method in their personal investment accounts and their investment accounts with their employers.  The reader should note that many employers deposit their investment funds into a holding account until a set date and then apply it into their preferred investments.
  3. The DCA method determined the amount of money to be used by the PV method.
  4. The PV method invested 2.55% of the total investment balance each time the market dropped on high volume and the next week’s share prices included a 2.5% discount to the previous week’s close.  This allows the investor to place an order at the conclusion of the past week at a discount and only purchase if the market drops to that price level.
  5. A buy and hold method was used as a base line investment style.

Key assumptions that may change future application of these methods:

  1. During these ten years, the market had the financial crisis associated with the housing bubble.
  2. This market drop was significant and occurred in the first half of the investment application period.
  3. The investor would require financial stability in order keep the money invested in any of the methods.

Results of these methods are as follows off of a $100,000 investment:

  1. The DCA method purchased a total of 1063.608 shares and the ending value of the investment not including dividends was a respectable $174,570.01.
  2. The PV method purchased a total of 1,392 shares and the ending value of the investment not including dividends was an amazing $225,888.18!
  3. Placing the entire $100,000 into the ETF at the beginning of the ten years purchased 1,226 shares and the ending price not including dividends was $201,223.38.

Conclusions:

  1. Technical investing can add value to your portfolio.
  2. This metric does not seem to be as successful for investment amounts smaller than roughly $20,000.  This is probably due to the economy of scale involved with the larger investment values.
  3. The PV outperformed the tried and true and widely accepted DCA by a gain of more than 58%.
  4. A complete application of investment funds doubled the investment over a ten year period.

The most surprising of these conclusions for me was the first.  I have spent most of my life thinking that technical investing is like reading tea leaves.  This was a very surprising result to me and makes me want to question some of my other mindsets with respect to investing.

ACTION ITEM: Determine what will be the best investment plan for you-DCA, PV or buy and hold.

 

Investment Plans, Part 2

Investment plans can benefit from being quite simple. In last week’s post, we discussed the simple no-hands approach called dollar cost averaging.  This is a great way to get average results.

Average people take average actions.  Average actions bring average results. – Average is an Addiction, Deborah Dubree, Chapter 6

This post will discuss a possible way to get better than average results.  Business schools teach that the best way to make money in the stock market is to buy low and sell high.  Then the business students that go on to tell the world that the best way to make money in the stock market is to dollar cost average.  I think that this is good advice but lacks the thought process to make great advice.  This post will include my opinion of what might be considered as great advice.

Exchange Traded Funds vs Regular Index Funds

In the last post, if you took the second action item, you would have looked at the ETF IVV and the Index Fund SVSPX.  The table below shows some of the performance and other distinguishing data of the two funds.  Consider that IVV and SVSPX returned approximately the same amount over the past five years.  They also had the exact same top 10 holdings at the time of this writing.  The key differences one should consider is the investment amount required and the ability to use options.

Fund SVSPX IVV
Description SSgA S&P 500 Index Fund N Class iShares Core S&P 500 ETF
Category Large Blend Large Blend
Expense Ratio 0.16% 0.04%
Sales Load with TDAmeritrade Account No Load No Load, commission free trading available
Fund Type Regular Index Index ETF
Average Asset Market Capitalization 76.8B 77.2B
Costs over 5 years 0.56% 0.39%
Minimum investment (Initial/Additional) 10000/100 NA/NA
Options available? No Yes
Market return (2012) 16.03% 16.06%
Market return (2013) 32.14% 32.30%
Market return (2014) 13.50% 13.56%
Market return (2015) 1.27% 1.30%
Market return (2016) YTD as of 12/3/2016 5.73% 5.91%

How can an individual capitalize on these index funds?

Thankfully, the business schools out there were very helpful-they said to buy low!  Here is a simple way to purchase shares of a regular index fund at a low price, it is not full proof but over time should improve one’s return.  It seems to work best with an ETF because the investor can purchase at a set amount shares based on what they want to risk like the dollar cost averaging technique, but it could work with a regular mutual fund as long as you can meet the minimum requirements.

Plan 2: Price Change with High Volume ETF investing.

Criteria:

  1. When the weekly price of the Index ETF declines.
  2. The volume of the Index ETF for the week exceeds its 50 day moving average.
  3. Purchase Index ETF shares the next week at a 2.5% discount from the closing price of the mutual fund after that week of high volume decline.
  4. Only purchase at a set percentage of cash available for investing, like the equivalent of 1-3 month’s investment account contribution or 2-5% of a windfall over several months.

Purchasing in this manner will improve the chances of buying low like the business schools out there love to advertise but seem to give little direction on how to do this.  You should note that this method will mean that you invest during some of the scariest times of the market.  It would have placed a purchase during the market downturn associated with the housing bubble in two consecutive weeks at least twice for an ETF I tested it on.  This means that the investor would be purchasing shares during some of the most volatile parts of that crisis and they would have to be disciplined enough to purchase a second time when the market fell the subsequent week after considerable losses the week before.  Most investors would consider this a gut wrenching probability; however, it seems to outperform the dollar cost average approach by a significant margin.

ACTION ITEM: This week’s action item is for you to test this hypothesis on your own and find mistakes in it.  I would love to hear if you find this method working or if you find it not working.  Pick an index fund and determine how this method stands up over time in your opinion.

Investment Plans, Part 1

After we understand investing risk, the next thing to focus on are ways to limit our exposure to it. To limit our exposure, we use an investment plan. Let’s identify the main elements of an investment plan. An appropriate plan will consider the uncertainty that Kahneman described in the following quote.
What hindsight does is it blinds us to the uncertainty with which we live. That is, we always exaggerate how much certainty there is. Because after the fact, everything is explained. Everything is obvious. And the presence of hindsight in a way mitigates against the careful design of decision making under conditions of uncertainty.
– Daniel Kahneman; 2002 Nobel Prize winner in Economic Sciences; Emeritus Professor, Princeton University (WSJ CEO Council; Wall Street Journal, R2; 22 November 2016)

Savings program

A savings program should constantly place new funds into your investment portfolio and prevent the need to take money out of it. Many individuals help provide ways to improve this portion of our lives and a deep dive into their work is beyond the scope of this post. However, you can look them up if interested-Dave Ramsey and Suze Orman come to mind. The principles that one should focus on are these: lower your monthly outflows to free cash for personal savings by reducing debt obligations, create and maintain a rainy-day fund in an accessible savings account of at least three months’ expenses, and only then put money into an account for long term investment purposes.

When considering an investment savings program, make sure that the recurring savings is appropriate for your situation. One facing unstable employment should reconsider saving a large portion of their income unless they already have the security of a rainy-day fund. The more stable our situation became, the more we tried to push this number up. The goal is to commit between 10-15% of our household take home pay into an investment account after the rainy-day fund is completed.

ACTION ITEM: Before reading on, if you haven’t already started some form of recurring savings plan and you don’t have income issues-I implore you to set up a recurring deposit into some investment account. This account can be savings that will be used for real estate investment, stock investment, small business investment or paying down debts to free additional cash. However, this is so important to your investing future that if you don’t do anything else recommended in this blog, I will consider our interaction a success if you act now and commit to a recurring savings plan and follow it for the rest of your life.

Where and when to put funds to work

The first place to consider putting this money is into an employer funded retirement account like a 401(k) or other tax sheltered account. This is important because most employers will match a certain percentage of your savings commitment find out what this commitment is and make sure that the amount you contribute will take maximum advantage of their match program. The maximum match allows you to get immediate return on your investment that is usually unparalleled in any investment for example, some employers match 100% of contributions made into their 401(k). This is free money and typically is the equivalent of a raise for merely participating in the employer’s retirement account.

An employer’s retirement account may have poor options for the investor and it is important to note this when you participate. If this is the case with your employer-that they place their funds into accounts that are not as investor friendly as one would like, then take advantage of their match and then place the rest of your savings into a self-directed, tax-sheltered account like an Individual Retirement Account (IRA). Finally, if you leave that employer, make sure that you roll that money into a personal, self-directed IRA.

The past couple of decades have confirmed that one of the most simple and effective strategies is to match the market return of the S&P 500 by investing in Index funds. Ironically, this strategy was lauded by Benjamin Graham mentor to some of the greatest investors of our time like Warren Buffett and his partner Charlie Munger. Graham suggested that for the individual investor that does not have the time or perhaps the desire to pick individual stocks the best way to participate in the stock market would be to purchase shares of an index fund, thus bringing us to the first strategy one should consider.

Plan 1: Purchase shares of an index fund that matches closely the performance of the S&P 500 index using dollar cost averaging. Dollar cost averaging means that the investor places the same amount of money into a mutual fund periodically allowing purchase of more shares during market downturns and limiting exposure to purchasing shares when the market is up. This is the best set up and forget model and returns an adequate appreciation of principal for the investor.

ACTION ITEM: Become familiar with various mutual funds. A great place to start is an index mutual fund. The ticker symbols SVSPX and IVV are for index mutual funds you may find interesting. SVSPX is an actively managed mutual fund that attempts to track the performance of S&P 500. IVV also attempts to track the performance of the S&P 500 but differs as an exchange traded fund or ETF. Both index funds have pros and cons. When looking at the two funds, consider the differences they possess. How did they perform with relation to the S&P 500 and to each other? What are the fees associated with each fund?

Stock Investment Risk

This post will be focused on understanding the risks associated with investing in the stock market.

Before you entrust your investments into any field, acquaint yourself with the dangers which may befall your principal.

-Arkad, The Richest Man in Babylon, p34.

What losses do we encounter when investing in stocks?

Although this is not an exhaustive list, it should acquaint us with the risks associated with investing:

1. Principal losses

Principal (not principle) is the term used to identify the initial money used in an investment. The investment industry seems to leave this concept on the side when they attempt to get us the lay investor to place money into their investment accounts. Stock investing has some of the least protection to the original principal. Dangers to your original investment include the possibility that the company you invest with is forced into bankruptcy. This is no small matter for the investor because if a bankrupt company’s assets are liquidated, the proceeds are first used to pay any debt obligations the company had.

Complete principal loss is fortunately not too common in the stock market but it does happen, some examples that come to mind are Enron, WorldCom, Lehman Brothers, General Motors and recently Hanjin Shipping. Unfortunately, some companies don’t declare bankruptcy but still lose a lot of their value for their investors and this can be more common. Companies that find themselves in this later category should make any investor leary of stock investing: Nokia  which dropped from a high on 04/01/2000 of $50.38 to $4.45 on 11/01/2016 and Xerox heading from a high of $59.06 01/01/1999 (party likes its 1999 anyone?) to $9.78 on November 1st. This information is not shared to scare us away from investing in the market or even investing in individual stocks-it is shared to illustrate the possibility and potential scope of stock losses.

2. Opportunity losses

The other side of potential losses is the main selling point of the investment community: opportunity loss. The potential to miss out on the rise of the stock market as it has proceeded to increase in value for the majority of our lives is very alluring. For example, the Dow Jones Industrial Average has  increased approximately three times its value on 12/1/1996-this includes the losses incurred in the financial crisis and the dot com bubble. This is even more pronounced when we consider the price of Google since its initial public offering. The company opened at $50.05 on 8/1/2004 and on 11/1/2016 it closed at $775.97. This would mean that investing $10,000 in August with Google would be worth over $155,000 today. A quick analysis of Netflix, Facebook, and Amazon would garner similar results. No wonder this is such a great sales technique for the would be investor.

Other opportunities should also be considered. Investing your hard earned money with the stock market may prevent you from purchasing other sound investments like real estate or owning a business. The money placed in the market should create returns that are superior to these and other investments.

3. Time losses

The last consideration of potential loss in the stock market is time loss. Investing in the market when principal is lost can cause us to worry often about what the future holds. This may be the most painful loss to consider because it could include lost time with family and friends and a loss of health due to the additional stress it can cause. In my opinion, this is one loss that can make investing not worth it.

Although this list is not exhaustive, it should help us understand the risks that we face when considering investing in the stock market. What other risks might an investor need to consider in your opinion? I appreciate your comments.