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A Top-Down Approach To Investing

An area that most investors struggle with is the art of picking stocks. Should they base their decisions solely on what the company does and how well it does it? Or should investors be more concerned about larger macroeconomic trends, such as the strength of the economy, and then determine which stocks to buy? There is no right or wrong answer to these two questions. However, investors should develop systems that help them to achieve their investment goals. The second option mentioned is referred to as the top-down investing approach to the market. This method allows investors to analyze the market from the big picture all the way down to individual stocks. This differs from the bottom-up approach, which begins with individual stocks' fundamentals and eventually expands to include the global economy. This article will concentrate on the process used when investors implement the macro-to-micro style referred to as the top-down approach.
Start at the Top: The Global View
Because the top-down approach begins at the top, the first step is to determine the health of the world economy. This is done by analyzing not only the developed countries of North America and Western Europe, but also emerging countries in Latin America and Asia. A quick way to determine the health of an economy is to look at the amount of gross domestic product (GDP) growth of the past few years and the estimates going forward. Oftentimes, it is the emerging market countries that will have the best growth numbers when compared with their mature counterparts.

Unfortunately, because we live at a time in which war and geopolitical tensions are heightened, we must not forget to be mindful of what is currently affecting each region of the world. There will be a few regions and countries throughout the world that will fall off the radar immediately and will no longer be included in the remainder of the analysis simply due to the amount of financial instability that could wreak havoc on any investments.

Analyze the Trends
After determining which regions present a high reward-to-risk ratio, the next step is to use charts and technical analysis. By looking at a long-term chart of the specific countries' stock index, we can determine whether the corresponding stock market is in an uptrend and is worth taking further time to do some analysis on or is in a downtrend, which would not be an appropriate place to put our money at this time. These first two steps can help you discover the countries that would match your wants and needs for diversification. (Need more information? Read Trader's Corner: Finding The Magic Mix Of Fundamentals And Technicals and Charting Your Way To Better Returns.)

Look to the Economy
The third step is to do a more in-depth analysis of the U.S. economy along with the health of the stock market in particular. By examining the economic numbers such as interest rates, inflation and employment, we are able to determine the current strength of the market and have a better idea of what the future holds. There is often a divergence between the story the economic numbers tell and the trend of the stock market indexes.

The final step in macroanalysis would be to analyze the major U.S. stock indexes such as the S&P 500 and Nasdaq. Both fundamental and technical analysis can be used as barometers to determine the health of the indexes. The fundamentals of the market can be determined by such ratios as price-to-earnings, price-to-sales and dividend yields. By comparing the numbers to past readings, it can help determine whether the market is at a level that is historically overbought or oversold. Technical analysis will help ascertain where the market is in relation to the long-term cycle. Use charts that show the past several decades and zone down the time horizon to a daily view. For example, indicators such as the 50-day and 200-day moving averages are used to help us find the current trend of the market and whether it is appropriate for investors to be invested heavily in equities. (To read more about fundamental analysis, see Advanced Financial Statement Analysis.)

So far, our process has taken a macro approach to the market and has helped us determine our asset allocation If, after the first few steps, we find that the results are bullish, there is a good chance a majority of the investment-worthy assets will be from the equities market. On the other hand, if the outlook is bleak, the allocation will shift its focus from equities to more conservative investments such as fixed income and money markets.

Microanalysis: Is This Investment Right for You?
Deciding on an asset allocation is only half the battle. The next integral step will help investors determine which sectors to focus on when searching for specific investments such as stocks and exchange-traded funds (ETFs). Analyzing the pros and cons of specific sectors (ex. health care, technology and mining) will narrow the search even further. The process of analyzing the sectors involves tactics used in the prior approach such as fundamental and technical analysis. In addition to the mentioned tools, investors also must consider the long-term prospects of the specific sectors. For example, the emergence of an aging baby boom generation over the next decade could serve as a major catalyst for sectors such as healthcare and leisure. Conversely, the increasing demand for energy coupled with higher prices is another long-term theme that could benefit the alternative energy and oil and gas sectors. After the entire amount of information is processed, a number of sectors should rise to the top and offer investors the best opportunities. (To learn more about the different industries, see our Industry Handbook.)

The emergence of ETFs and sector-specific mutual funds has allowed the top-down approach to end at this level in certain situations. If an investor decides the biotech sector is an area that must be represented in the portfolio, he or she has the option of buying an ETF or mutual fund that is composed of a basket of biotech stocks. Instead of moving to the next step in the process and taking on the risk of an individual stock, the investor may choose to invest in the entire sector with an ETF or mutual fund.(For more insight, see How To Use ETFs In Your Portfolio and Advantages Of Exchange-Traded Funds.)

However, if an investor feels the added risk of selecting and buying an individual stock is worth the extra reward, there is an additional step in the process. This final phase of the top-down approach can often be the most intensive because it involves analysis of individual stocks from a number of perspectives.

Fundamental analysis includes a variety of measurements such as price/earnings to growth ratio, return on equity and dividend yield, to name a few. An important aspect of individual stock analysis will be the growth potential of the company over the next few years. Ideally, investors want to own a stock with a high growth potential because it will be more likely to lead to a high stock price.

Technical analysis will concentrate on the long-term weekly charts, as well as daily charts, for an entry price. At this point in time, the individual stocks are chosen and the buying process begins.

The Positives of Top-Down
The proponents of the top-down approach argue the system can help investors determine an ideal asset allocation for a portfolio in any type of market environment. Oftentimes a top-down approach will uncover a situation that may not be appropriate for large investments into equities. The ability to keep investors from over-investing in equities during a bear market is the biggest pro for the system. When a market is in a downtrend, the probability of picking winning investments drops dramatically even if the stock meets all the required conditions. When using the bottom-up system, an investor will determine which stocks to buy before taking into consideration the state of the market. This type of approach can lead to investors being overly exposed to equities and the portfolio will likely suffer. Other benefits to the top-down approach include the diversification among not only top sectors, but also the leading foreign markets. This results in a portfolio that is diversified within the top investment worthy sectors and regions. This type of investing is referred to in some small circles as "conversification", a mixture between concentration and diversification.
The Not-So-Positives of Top-Down Investing
So far, the top-down approach may sound foolproof; however, there are a few factors investors must consider. First and foremost, there is the possibility that your research will be incorrect, causing you to miss out on an opportunity. For example, if the top-down approach indicates that the market is set to continue lower in the near future, it may result in a lesser exposure to equities. However, if your analysis is wrong and the market rallies, the portfolio will be underexposed to the market and will miss out on the rally gains. Then there's the problem of being under-invested in a bull market, which can prove to be costly over the long term. Another downfall to the system occurs when sectors are eliminated from the analysis. As a result, all stocks in the sector are not included as possible investments. Oftentimes there will be a leader in the sector that is overlooked due to this process and will never make its way into the portfolio. Finally, investors could miss out on "bargain" stocks when the market is near lows.

Find What You've Been Looking For
In the end, investors must remember there is no single approach to investing and that every approach has its own pros and cons. One of the keys to becoming a successful long-term investor is finding a system that best fits your goals and objectives. Maybe the top-down approach is just what you've been looking for!
Surprising Earnings Results

When companies deliver their quarterly results, investors are watching - not just for improvements, but also for how these results compare to analysts' estimates. If the company surprises the market with better-than-expected earnings, the stock usually jumps. On the other hand, disappointing results can cause the stock to tumble. In this article, we'll show you how understanding surprises in earnings can help you as an investor cope with quarterly earnings seasons.
Surprise!
Earnings surprises occur when a company's results differ from so-called consensus estimates. How earnings results measure up to Wall Street analysts' estimates are important to the price of stocks. Keenly watched and widely disseminated, quarterly earnings announcements made by companies are key triggers for short-term stock price behavior.

Stocks of companies that surprise the market with better-than-expected quarterly numbers are swiftly ratcheted-up in value. By contrast, a negative earnings surprise will usually cause the stock to be sold off by the market, especially if there are high growth expectations factored into its share price and it is expensive relative to those expectations.

Even a strong set of quarterly results, if they fail to beat or exceed analysts' expectations, can send a stock tumbling. Consider Advanced Micro Devices. For the first quarter of 2006, the chip technology company saw a delivered earnings per share (EPS) profit of $0.38 - 50% higher than the first quarter in the previous year. Nonetheless, because the consensus EPS expectations for Advanced Micro Devices were pegged at the higher profit of $0.43, the stock plummeted by 9% when the earnings results were released. (To learn more, read Types Of EPS, Earnings Forecasts: A Primer and How To Evaluate The Quality Of EPS.)

How Earnings Surprises Occur
Earnings surprises can be seen as a measure of analyst error. While a few analysts tend to make remarkably accurate forecasts, others miss earnings by a mile. There are plenty of good reasons why analysts' estimates come in wide of the mark. These include:

1. Forecasting Is Difficult
For starters, forecasting is a tricky business. Companies are subject to hard-to-predict forces, and these can have a big impact on their financial performance. With only publicly-available information to rely on, it's awfully difficult for analysts to predict precisely how many products a company will sell and the cost of doing business in the future. Expecting analysts to hit the bulls-eye with their earnings estimates may be unrealistic.

2. Herd Behavior
Research shows that analysts tend to exhibit herding behavior, shifting their forecasts over time to be more in line with their peers. A study by Robert Olsen, titled "Implications Of Herding Behavior" (1996) in the Financial Analysts Journal, shows that analysts tend to prefer not to make earnings predictions that differ greatly from consensus estimates for fear that they will be proved wrong. Unfortunately, the herd is not always correct.

3. Confirmed Optimists
Over-optimism increases the chance of analyst error. The trouble is, analysts' earnings forecasts generally err on the high side rather than the low side. More often than not, analysts start the year estimating too high, and then spend the period revising their estimates downward.

Analysts prefer to remain positive on a stock for fear that if they get on a company's wrong side they will be cut off from management and information flows. Brokerage houses are inclined to be optimistic to encourage investor clients to buy into stocks. According to Mark Bradshaw of Harvard Business School, stock analysts are persistently optimistic in their forecasts of corporate clients that issue equity and debt.

4. Managing Expectations
Companies are getting better at avoiding negative earnings surprises. Company executives can influence analysts' expectations through pro-forma earnings forecasts or "guidance" information they provide at press conferences, conferences and other meetings they arrange. The goal is to manage analysts' expectations to ensure earnings results and, at the very least, meet consensus estimates. (For further reading, check out Understanding Pro-Forma Earnings.)

Increasingly, companies will report bad news well ahead of earnings announcements. Management will try to get any unpleasant news out in the open so that there are no nasty surprises at report time. In fact, many companies now try to talk down expectations just enough so that there will be positive earnings surprise when results are announced.

Talking down expectations is getting so prevalent, it's arguable that positive earnings are having less of an impact on share prices. Big public companies, such as General Electric, Microsoft and Walmart regularly beat analysts' consensus estimates. Beating estimates by a penny or two no longer surprises the market.

In a bid to manage earnings, companies have been known to reserve extra earnings in a good quarter to inflate earnings in a future bad quarter. Companies anxious to hit aggressive analyst expectations may try to inflate earnings through easing credit policies, or "stuffing" customers with more product than they need. Even worse, the need to meet or beat consensus estimates has prompted some companies to turn to illegal accounting practices. (For more insight, see Earnings Guidance: The Good, The Bad And Good Riddance and Getting The Real Earnings.)

Conclusion
Quarterly earnings surprises can impact share prices - certainly in the short-run. If you are interested in how a stock moves after its quarterly results, it's worth keeping track of surprises. But as an investor, you probably shouldn't put too much stock into surprises as indicators of a company's long-term investment prospects. In essence, surprises tell us about analysts' ability to predict earnings and company's ability to manage those predictions - neither of which says much about whether the company's stock is worth buying.
Cashing In On Corporate Restructuring
Companies use mergers, acquisitions and spinoffs to increase their profits. Strategic mergers and acquisitions can help a company become more competitive in its field and improve its bottom line, while spinoffs are a way to get rid of underperforming or non-core business divisions that can drag down profits. While mergers, acquisitions and spinoffs can be great moves for companies, they can be even better for the enterprising investor willing to do a little research! If you do your homework, you can find profitable opportunities in these corporate actions - we'll take you through this process step by step.
Spinoffs
Why are spinoffs such a great investment opportunity? Typically, underperforming business divisions are loaded with debt. When they are cut off from the parent company, that company can become more valuable as a result. (For more insight, check out Conglomerates: Cash Cows Or Corporate Chaos?)

The Process
Here's how a typical spinoff situation works:
1. The company decides to spin off a business division.
2. The parent company files the necessary paperwork with the Securities and Exchange Commission (SEC).
3. The spinoff becomes a company of its own and must also file paperwork with the SEC.
4. Shares in the new company are distributed to parent company shareholders.
5. The spinoff company goes public.
Notice that the spinoff shares are distributed to parent company shareholders. There are two reasons why this creates value:
1. Parent company shareholders rarely want anything to do with the new spinoff. After all, it's an underperforming division that was cut off to improve the bottom line. As a result, many new shareholders sell immediately after the new company goes public.
2. Large institutions are often forbidden to hold shares in spinoffs due to the smaller market capitalization, increased risk, or poor financials of the new company. Therefore, many large institutions automatically sell their shares immediately after the new company goes public.
Simple supply and demand logic will tell you that such a large number of shares on the market will naturally decrease the price, even if it is not fundamentally justified. It is this temporary mispricing that gives the enterprising investor an opportunity for profit.

The Homework
Information is easy to find when it comes to spinoffs. Every parent company is forced to file paperwork with the SEC outlining everything that an investor needs to know (and then some). The most important form to look for is Form 10, which outlines the spinoff distribution terms. This document contains a few key things to look for:

Basic Company, Share and Pricing Information
Look at the new company's market cap. If it's smaller, large funds are more likely to sell it. Also look at the share distribution terms to see whether it makes sense to buy the parent company shares or to buy on the open market after the company goes public.

Distribution Type
Oftentimes, spinoff shares are distributed to parent company stockholders; however, in some cases partial spinoffs, rights offerings or other formats are used. This can provide increased leverage, or other advantages.

Insider Distributions
Insider holdings and activity are key when determining the value of a spinoff. High insider ownership gives management incentive to perform well and drives shareholder value. (For more on this, see When Insiders Buy, Should Investors Join Them? and Can Insiders Help You Make Better Trades?)

It is also a good idea to read press releases, related news coverage and other available media to determine how the public is going to react to the new spinoff. Press releases can be found under the company's ticker on Yahoo! Finance and company news can be found on Google News.

Overall, spinoffs outperform the market because of the inherent flaws in the spinoff process. Although not every spinoff opportunity represents an attractive investment, investors willing to dig a little deeper into SEC filings and press releases can find those that are with relative ease.

Mergers and Acquisitions (M&A)
Companies are notorious for failing at mergers and acquisitions - especially the mergers where two extremely large companies join forces. Add to that the fact that the M&A field is heavily dominated by arbitrage funds and other big players, and you may wonder how any small investor can make a profit. In fact, M&As can provide good opportunities for investors - it's just a matter of knowing how to find them. (For further reading, see The Basics Of Mergers And Acquisitions and The Wacky World Of M&As.)

The Process
While most M&A transactions are handled through stock and cash offerings, others are handled through the use of merger securities. These can include bonds, warrants, preferred stock, rights, and many others. Here's how the process works:
1. The acquiring company decides that it wants to buy or merge with another company.
2. It announces this intention either privately or publicly in a statement, hostile acquisition of stock, rumor, offering, or other means.
3. The company being acquired then considers the bid. The board of directors advises shareholders of the company's recommended vote and then sends out a proxy to all shareholders who vote on whether or not to sell the company.
4. If the merger is approved, both companies file the necessary paperwork with the SEC outlining the terms, time and other details of the sale.
5. The company is bought and integrated into the acquiring company, and the acquired company's shareholders are compensated.
The Homework
As mentioned above, these M&A transactions take place with cash, stock or other instruments. Cash transactions provide limited opportunity for retail investors because any value has already been taken away from arbitrageurs well before the transaction takes place. The same is often true with M&A's that take place with stock offerings because these provide the opportunity to short or buy the acquiring company's stock.

Merger securities are another story. Oftentimes, nobody wants to deal with merger securities for the same reasons they don't want to deal with spinoffs - because they aren't allowed to (as is the case for larger funds) or because they don't care for or understand the new securities. This presents another great opportunity for investors to profit.

The most important forms to look at when researching merger securities are:
• Form S4 - This form covers any new securities issued as a result of a merger.
• Schedule 14D - This form covers tender offers filed by public acquiring companies.
• Schedule 13E - This form covers tender offers when a company is going private.
M&A deals vary greatly in what's offered; therefore, it is important to carefully analyze each deal. Mathematics can tell you the fair value of the securities being offered and a look at management can show how serious the company is about maintaining performance.

Overall, M&A deals involving merger securities rather than cash or stock present a great investment opportunity for the same reason as spinoffs - they are ignored by the majority of the public. However, like spinoffs, it is important to carefully research each opportunity before buying.

Conclusion
Both spinoffs and M&A activity present great investment opportunities for investors willing to dig in to the SEC filings and press releases to find the information they need. In best of situations, spinoffs continue to outperform the market, while mergers involving obscure offerings continue to cause unjustified selling.

Resources
-"You Can Be A Stock Market Genius" by Joel Greenblatt (1997) - This is one of the best books on mergers, acquisitions, spinoffs, rights offerings, bankruptcies and other unique investment opportunities for retail investors.

-Edgar Database - This is the SEC's database where investors can find all company filings free of charge.

-SECFilings.com - This is a free website that lets you sign up for email alerts whenever certain types of filings are made - an excellent way to have investment opportunities delivered to your inbox every day!

Earnings Forecasts: A Primer

Anyone who reads the financial press or watches CNBC on television will have heard the term "beat the street", which really just means to beat Wall Street earnings forecasts. Wall Street analysts' consensus earnings estimates are used by the market to judge stock performance. Here we offer a brief overview of the consensus earnings and what they mean to investors.
What are Consensus Earnings?
Consensus earnings estimates are far from perfect, but they are watched by many investors and play an important role in measuring the appropriate valuation for a stock. Investors measure stock performance on the basis of a company's earnings power. To make a proper assessment, investors seek a sound estimate of this year's and next year's earnings per share (EPS), as well as a strong sense of how much the company will earn even farther down the road. (For further reading, see Earnings Guidance: The Good, The Bad And Good Riddance?)

That's why, as part of their services to clients, large brokerage firms such as Citigroup and Merrill Lynch (the "sell side" of Wall Street and other investment communities) employ legions of stock analysts to publish forecast reports on companies' earnings over the coming years.

A consensus forecast number is normally an average or median of all the forecasts from individual analysts tracking a particular stock. So, when you hear that a company is expected to earn $1.50 per-share this year, that number could be the average of 30 different forecasts. On the other hand, if it's a smaller company, the estimate could be the average of just one or two stock analyst forecasts.

A few companies, such as Thomson First Call, Reuters and Zacks Investment Research, compile estimates and compute the average or consensus. Consensus numbers can also be found at a number of financial websites, including Yahoo! Finance and MSN MoneyCentral. Some of these sites also show how estimates get revised upwards or downwards.

Consensus estimates of quarterly earnings are published for the current quarter, the next quarter and so on for about eight quarters. In some cases, forecasts are available beyond the first few quarters. Forecasts are also compiled for the current and next 12-month periods.

A consensus forecast for the current year is reported once actual results for the previous year are released. As actual numbers are made available, analysts typically revise their projections within the quarter or year they are forecasting.

Even the most sophisticated investors - such as mutual fund and pension fund managers - rely heavily on consensus estimates. Most of them do not have the resources to track thousands of publicly-listed companies in detail - or even to keep tabs on a fraction of them, for that matter. (For more insight, see Everything You Need To Know About Earnings.)

On Earnings
Many investors rely on earnings performance to make their investment decisions. Stocks are assessed according to their ability to increase earnings as well as to meet or beat analysts' consensus estimates. (For more on this, see Why would my stock's value decline despite good news being released?)

The basic measurement of earnings is earnings per share. This metric is calculated as the company's net earnings - or net income found on its income statement - less dividends on preferred stock, divided by the number of outstanding shares. For example, if a company (with no preferred stock) produces a net income of $12 million in the third quarter and has 8 million shares outstanding, its EPS would be $1.50 ($12 million /8 million). (To read more, see Types Of EPS, How To Evaluate The Quality Of EPS and Getting The Real Earnings.)

So, why does the investment community focus on earnings, rather than other metrics such as sales or cash flow? Any finance professor will tell you that the only proper way to value a stock is to predict the long-term free cash flows of a company, discount those free cash flows to the present day and then divide by the number of shares. But this is much easier said than done, so investors often shortcut the process by using accounting earnings as a "good enough" substitute for free cash flow. Accounting earnings certainly are a much better proxy for free cash flow than sales. Besides, accounting earnings are fairly well defined and public companies' earnings statements must go through rigorous accounting audits before they are released. As a result, the investment community views earnings as a fairly reliable - not to mention convenient - measure.

Basis of Analysts' Forecasts
Earnings forecasts are based on analysts' expectations of company growth and profitability. To predict earnings, most analysts build financial models that estimate prospective revenues and costs.

Many analysts will incorporate top-down factors such as economic growth rates, currencies and other macroeconomic factors that influence corporate growth. They use market research reports to get a sense of underlying growth trends. To understand the dynamics of the individual companies they cover, really good analysts will speak to customers, suppliers and competitors. The companies themselves offer earnings guidance that analysts build into the models. (For more information, read Macroeconomic Analysis.)

To predict revenues, analysts estimate sales volume growth and estimate the prices that companies can charge for the products. On the cost side, analysts look at expected changes in the costs of running the business. Costs include wages, materials used in production, marketing and sales costs, interest on loans, etc.

Analysts' forecasts are critical because they contribute to investors' valuation models. Big institutional investors, who can move markets due to the volume of assets they manage, follow analysts at big brokerage houses to varying degrees.


Conclusion: Implications for Investors
Consensus estimates are so powerful that even small deviations can send a stock higher or lower. If a company exceeds its consensus estimates, it is usually rewarded with an increase in stock price. If a company falls short of consensus numbers - or sometimes if it only meets expectations - its share price can take a hit.

With so many investors watching consensus numbers, the difference between actual and consensus earnings is perhaps the single most important factor driving share-price performance over the short term. This should come as little surprise to anyone who has owned a stock that "missed the consensus" by a few pennies per share and, as a result, tumbled in value.

For better or for worse, the investment community relies on earnings as its key metric. Stocks are judged not only by their ability to increase earnings quarter-over-quarter, but also by whether they are able to meet or beat a consensus earnings estimate. Like it or not, investors need to keep an eye on consensus numbers in order to keep tabs on how a stock is likely to perform.
A Primer On Preferred Stocks

Within the vast spectrum of financial instruments, preferred stocks occupy a unique place. Because of their characteristics, they straddle the line between stocks and bonds. Technically, they are equity securities, but they share many characteristics with debt instruments. Some investment commentators refer to them as hybrid securities. In this article, we provide a thorough overview of preferred shares and compare them to some better-known investment vehicles.
Because so much of the commentary about preferreds compares them to bonds and other debt instruments, let's first look at the similarities and differences between preferreds and bonds.

Bonds and Preferreds: Similarities

Interest Rate Sensitivity
Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares would need to fall to offer investors a better rate. If rates fall, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds. (For further reading, check out Trying To Predict Interest Rates.)

Callability
Preferreds technically have an unlimited life because they have no fixed maturity date, but they may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds; a company calls securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability. (To read more, see Call Features: Don't Get Caught Off Guard.)

Senior Securities
Like bonds, preferreds are senior to common stock; however, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders, although not by much.

Convertibility
As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock. (For further reading, see Introduction To Convertible Preferred Shares and Convertible Bonds: An Introduction.)

Ratings
Like bonds, preferred stocks are rated by the major credit rating companies, such as Standard & Poor's and Moody's. The rating for preferreds is generally one or two tiers below that of the same company's bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors. (For more insight, read What Is A Corporate Credit Rating?)

Bonds and Preferreds: Differences

Type of Security
As observed earlier, preferred stock is equity; bonds are debt. Most debt instruments, along with most creditors, are senior to any equity.

Payments
Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. This is because bonds are issued with the protection of an indenture. With preferreds, if a company has a cash problem, the board of directors can decide to withhold preferred dividends; the trust indenture prevents companies from taking the same action on bonds. Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for the issuing company to issue and pay dividends on preferred stocks. (To read more, see How And Why Do Companies Pay Dividends?)

Yields
Computing current yields on preferreds is similar to performing the same calculation on bonds: the annual dividend is divided by the price. For example, if a preferred stock is paying an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75/$25 = 7%. In the market, however, yields on preferreds are typically higher than those of bonds from the same issuer, reflecting the higher risk the preferreds present for investors.

Volatility
While preferreds are interest rate sensitive, they are not as price sensitive to interest rate fluctuations as bonds. However, their prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds.

Accessibility for the Average Investor
Information about a company's preferred shares is easier to access than information about the company's bonds, making preferreds, in a general sense, easier to trade (and perhaps more liquid). The low par values of the preferred shares also make investing easier because bonds, with par values around $1,000, often have minimum purchase amounts (i.e. five bonds).

Common and Preferred Stocks: Similarities

Payments
Both are equity instruments that pay dividends from the company's after-tax profits.

Common and Preferred Stocks: Differences

Payments
Preferreds have fixed dividends and, although they are never guaranteed, the issuer has a greater obligation to pay them. Common stock dividends, if they exist at all, are paid after the company's obligations to all preferred stockholders have been satisfied.

Appreciation
This is where preferreds lose their luster for many investors. If, for example, a pharmaceutical research company discovers an effective cure for the flu, its common stock will soar, while the preferreds in the same company might only increase by a few points. The lower volatility of preferred stocks may look attractive, but preferreds will not share in a company's success to the same degree as common stock.

Voting
Whereas common stock is often called voting equity, preferred stocks usually have no voting rights.

Types of Preferred Stock
Although the possibilities are nearly endless, these are the basic types of preferred stocks:
• Cumulative: Most preferred stock is cumulative, meaning that if the company withholds part, or all, of the expected dividends, these are considered dividends in arrears and must be paid before any other dividends. Preferred stock that doesn't carry the cumulative feature is called straight, or noncumulative, preferred.
• Callable: The majority of preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus.
• Convertible: The timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus.
• Participating: Preferred stock has a fixed dividend rate. If the company issues participating preferreds, those stocks gain the potential to earn more than their stated rate. The exact formula for participation will be found in the prospectus. Most preferreds are non-participating.
• Adjustable-Rate Preferred Stock (ARPS): These relatively recent additions to the spectrum pay dividends based on several factors stipulated by the company. Dividends for ARPSs are keyed to yields on U.S. government issues, providing the investor limited protection against adverse interest rate markets.
Why Preferreds?
A company may choose to issue preferreds for a couple of reasons:
• Flexibility of payments: Preferred dividends may be suspended in case of corporate cash problems.
• Easier to market: The majority of preferred stock is bought and held by institutions, which may make it easier to market at the initial public offering.

Institutions tend to invest in preferred stock because IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income. This is known as the dividend received deduction, and it is the primary reason why investors in preferreds are primarily institutions.
The fact that individuals are not eligible for such favorable tax treatment should not automatically exclude preferreds from consideration. In many cases, the individual tax rate under the new rules is 15%. That compares favorably with paying taxes at the ordinary rate on interest received from corporate bonds. However, because the 15% rate is not an across-the-board fact, investors should seek competent tax advice before diving into preferreds. (For more insight, see The JGTRRA: Reducing Dividend Tax Rates.)

Preferred Stock Pros
• Higher fixed-income payments than bonds or common stock
• Lower investment per share compared to bonds
• Priority over common stocks for dividend payments and liquidation proceeds
• Greater price stability than common stocks
• Greater liquidity than corporate bonds of similar quality
Preferred Stock Cons
• Callability
• Lack of specific maturity date makes recovery of invested principal uncertain
• Limited appreciation potential
• Interest rate sensitivity
• Lack of voting rights
Conclusion
An individual investor looking into preferred stocks should carefully examine both their advantages and drawbacks. There are a number of strong companies in stable industries that issue preferred stocks that pay dividends above investment-grade bonds. The starting point for research on a specific preferred is the stock's prospectus, which you can often find online. If you're looking for relatively safe returns, you shouldn't overlook the preferred stock market.

Equity Premiums: Looking Back And Looking Ahead
Stocks are commonly touted as being safe (real returns greater than 0) over the long run. If you look only at the United States over the past century, this has been the case for any period greater than 20 years. However, in many other countries, stocks needed to be held for a much longer period in order for this statement to hold true. Furthermore, social and economic conditions in the U.S. today are very different from those at the beginning of the last century. In the future, the U.S. may have more difficulty claiming that stocks are safe over the long run - an issue that has important implications for building portfolios in the twenty-first century. In this article, we examine the reasons behind this change and discuss what it means for the equity premium (defined as equity return - cash return). (For further reading, see The Equity Risk Premium - Part 1 and Part 2.)
The U.S. and Uncommon Returns
All too often, investors look at historical U.S. returns as a gauge for future returns. Given that the U.S. saw the largest economic and market growth of any country in the twentieth century, this might not be a prudent strategy, as countries, just like sectors, eventually rotate in and out of favor. Because of its success, however, the U.S. has been the most researched market; more long-term quality financial data exists on it than on any other market. This resulting success bias has strongly influenced investors' projected returns. The bull market of 1982 to 2000 also had an effect on investors' expectations, but given that it was the greatest combined bull market (equities and fixed income) in history, it may be difficult to repeat any time soon. At the beginning of the twenty-first century, valuation levels on stocks were higher and, therefore, not as compelling as they were at the start of the previous century, and investors hurt during the last bubble may be much less likely to pay such high premiums in the future. (For background info, read Digging Deeper Into Bull And Bear Markets.)


Other countries did not share the unprecedented degree of success enjoyed by the U.S. over the twentieth century. According to Elroy Dimson, Paul Marsh and Mike Staunton in their book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002), the U.S. has seen positive real equity returns for every 20-year period in the last century. The same cannot be said for many other markets; countries such as Japan, France and Italy required 50 to 75 years before the same statement could hold true, while the markets of Russia, China and Germany saw total collapse through confiscation, nationalization and hyperinflation in the same period. (See What Is An Emerging Market Economy?) Even though these countries were ravaged by events that were no longer common at the beginning of the twenty-first century, we can't assume that a future global catastrophe (i.e. war, depression or pandemic) could not seriously disrupt the world markets again. (For insight, read The Biggest Market Crashes In History.)

The graph below charts the relative risk and return for various countries in the twentieth century:

It All Comes Down to the Equity Premium
Considering the historical information, what will happen to the equity premium going forward? A strong case can be made for a lower equity premium in the future. Valuations for stocks in the twenty-first century, which far exceed those that existed at the beginning of the last century, provide some evidence of this. For instance, according to Dimson, Marsh and Staunton, the global dividend yield in 1900 was 4.5% - very different from the 1.5% recorded at the end of 2005. Although some of this can be attributed to a shift away from dividend-paying companies, this difference in valuation could explain the high equity premiums realized in the last century, as higher valuations worked their way into those returns. There is also the possibility that valuations could creep back to the lower, historical levels, which would be devastating for future returns.

Statistically, sampling errors exist when return data is limited to only 100 years. For example, there are only five non-overlapping 20-year periods sampled over the last century, and because the data only accounts for one 100-year period, there is no other data to which we can compare it. In other words, 100 years' worth of data may not be enough to be statistically confident about the predictive use of long-term returns from the last century. Finally, proceeding with a lower equity premium and the same historical amount of volatility will mean longer periods before stocks can be considered safe over the long run.

According to Dimson, Marsh and Staunton, the equity premium in the second half of the twentieth century was twice that of the first half. The post-war years saw unprecedented growth and trade in the global economy, while central bankers came to better understand the intricacies of monetary policy. During this time, global investing was a true "free lunch", where you could pick up additional return with little additional risk. This was due to the poor correlation of financial market returns. The financial markets and the world economy were not as integrated as they are today; this has changed dramatically since the 1970s, and global market returns have become more closely correlated. Therefore, this "free lunch" may be harder to realize now. (For further reading see, Broadening The Borders Of Your Portfolio and Investing Beyond Your Borders.)

Some argue that long-term equity returns can even be more certain than bond returns. According to Peter L. Bernstein in his article "What Rate Of Return Can You Reasonably Expect ... Or What Can The Long Run Tell Us About The Short Run?" (1997), stock market returns are historically mean reverting (returns ultimately coming back to their long-run averages), while bonds have not been mean reverting on either a nominal or a real basis. For example, the bond market in the twentieth century was basically two secular bull markets and bear markets - there was no mean reversion about it.

Despite this argument, the yields on inflation-protected securities (another basis for calculating equity premium) were actually dramatically compressed at the beginning of this century, as a glut of global savings resonated throughout the world. Since that time, the world has generally become a much safer place to invest. Shouldn't this relative safety be reflected in lower equity premiums required by investors? At any rate, it certainly helps to explain the increase in valuations in the last half of the twentieth century.

Assuming a lower equity premium in the future, people will need to change the way they invest. Personal savings will have to increase to offset lower real returns and real assets may offer a more viable alternative to financial assets. Finally, sector and stock selection will become even more important.

Conclusion
In terms of market returns, the twentieth century was more favorable to the U.S. than to most other countries. For these countries, the risk-return tradeoff for stocks has not been as attractive, and it is more difficult for them to make well-supported claims about the success of holding stocks long term. The conditions that existed for the U.S. at the beginning of the last century did not exist at the beginning of this century. This may mean a lower equity premium, requiring changes to how much you save and how you invest your money.
Using DCF In Biotech Valuation

It can be tricky to put a price tag on biotechnology companies that offer little more than the promise of success in the future. Just because someone in the lab cries "Eureka!", that doesn't necessarily mean that a cure has been found. In the biotech sector, it can take many years to determine whether all the effort will translate into returns for a company. But while valuation may appear to be more guesswork than science, there is a generally accepted approach to valuing biotech companies that are years away from payoff. In this article, we explain this valuation approach, which relies on discounted cash flow (DCF) analysis, and take you through the process step by step.
Portfolio Valuation Approach
Think of a biotech company as a collection of one or more experimental drugs, each representing a potential market opportunity. The idea is to treat each promising drug as a mini-company within a portfolio. Using DCF analysis, you can determine what someone would be willing to pay for that drug portfolio.

In other words, you determine the forecasted free cash flow of each drug to establish its separate present value. Then, you add together the net present value of each drug, along with any cash in the bank, and come up with a fair value for what the whole company is worth today. (To learn more, see our Discounted Cash Flow Analysis tutorial.)

A biotech company can have dozens, or even hundreds, of drugs in its developmental pipeline. But that does not mean you should include them all in your valuation. Generally speaking, you should only include those drugs that are already in one of the three clinical trial stages. (For more information, visit the U.S. Food and Drug Administration's website.) As an investment, a drug that is in the discovery or pre-clinical stage is a very risky proposition, with less than a 1% chance of getting to market (according to an industry report published in 2003 by the Pharmaceutical Research and Manufacturers of America). So, drugs in the pre-clinical stage are usually assigned zero value by public market investors.

Forecasting Sales Revenue
Forecasting the sales revenue from each of a biotech company's drugs is probably the most important estimate you can make about future cash flows, but it can also be the most difficult. The key is to determine what expected peak sales would be if - and this is a big "if" - a drug successfully makes it all the way through clinical trials. Normally, you will forecast sales for the first 10 years of the drug's life. (For further reading, see Great Expectations: Forecasting Sales Growth.)

Market Potential
You need to start by making assumptions about the drug's market potential. Look at information provided by the company and market research reports to determine the size of the patient group that will use the drug. Analysts typically focus on market potential in the industrialized countries, where people will pay the market price for drugs.

When making assumptions about a drug's potential market penetration, you have to use your own best judgment. If there is a competitive drug market, with limited advantage offered by the new drug in terms of increased effectiveness or reduced side effects, the drug will probably not win substantial market share in its product category. You might assume that it will capture 10% of that total market, or even less. On the other hand, if no other drug addresses the same needs, you might assume the drug will enjoy market penetration of 50% or more.

Estimated Price Tag
Once you have established a sales market size, you need to come up with an estimated sales price. Of course, putting a price tag on a drug that addresses an unmet need will involve some guesswork. But for a drug that will compete with existing products, you should look at the price of the competition. For instance, pharmaceutical giant Roche's recently introduced HIV-inhibitor drug, Fuzeon, costs just over $20,000 per year. Multiplying that price by the estimated number of patients gives you estimated annual peak sales.

The biotech company won't necessarily receive all of this sales revenue. Many biotech firms - especially the smaller ones with little capital - do not have sales and marketing divisions capable of selling high volumes of drugs. They often license promising drugs to bigger pharmaceutical companies, which help pay for development and become responsible for making sales. In return, the biotech firm normally receives royalty on future sales. According to an article written by Medius Associates ("Royalty Rates: Current Issues and Trends", October 2001), the royalty rate for drugs currently in Phase I of clinical trials is normally a percentage in the single digits. As they move along the development pipeline, royalty rates get higher.

In Figure 1, we break down an estimate of the peak annual sales revenues for a hypothetical biotech drug in a competitive market with a potential market size of 1 million patients, an estimated sales price of $20,000 per year and a royalty rate of 10%.
Potential Market Size 1 million patients
Market Penetration Rate -Competition High 10%
Estimated Market Size 100,000 patients
Sales Price $20,000 per year
Peak Sales $2 billion per year
Royalty Rate 10%
Peak Annual Sales Revenues $200 million
Figure 1 - Calculating drug sales revenue

Drug patents usually last about 10 years. In our hypothetical example, we assume that for the first five years after commercial launch, sales revenues from the drug will increase until they hit their peak. Thereafter, peak sales continue for the remaining life of the patent.
Figure 2 - Hypothetical estimate of sales revenue for the chosen forecast period of 10 years

Estimating Costs
When forecasting future cash flows for a drug, you need to consider the costs of discovery and bringing the drug to market.

For starters, there are operating costs associated with the discovery phase, including efforts to discover the drug's molecular basis, followed by lab and animal tests. Then there is the cost of running clinical trials. This includes the cost of manufacturing the drug, recruiting, treating and caring for the participants, and other administrative expenses. Expenses increase in each development phase. All the while, there is ongoing capital investment in items such as laboratory equipment and facilities. Taxation and working capital costs also need to be factored in. Investors should expect operating and capital costs to represent no less than 30% of the drug's royalty-based sales.

Deducting the drug's operating costs, taxes, net investment and working capital requirements from its sales revenues, you arrive at the amount of free cash flow generated by the drug if it becomes commercial.

Accounting for Risk
Our free cash flow forecast assumes that the drug makes it all the way through clinical trials and is approved by regulators. But we know this doesn't always happen. So, depending on the drug's stage of development, we must apply a probability factor to account for its probability of success.

As the drug moves through the development process, the risk decreases with each major milestone. The Pharmaceutical Research and Manufacturers of America reported in 2003 that drugs entering Phase I clinical trials have a 15% probability of becoming a marketable product. For those in Phase II, the odds of success rise to 30%, and for Phase III, they climb to 60%. Once clinical trials are complete and the drug enters the final FDA approval phase, it has a 90% chance of success. These improvements in the odds of success translate directly into stock value.

By multiplying the drug's estimated free cash flow by the stage-appropriate probability of success, you get a forecast of free cash flows that accounts for development risk.


The next step is to discount the drug's expected 10-year free cash flows to determine what they are worth today. Because you have already factored in risk by applying the clinical trial probability of success, you do not need to include development risk in the discount rate. You can rely on normal means of calculating the discount rate, such as the weighted average cost of capital (WACC) approach, to come up with the drug's final discounted cash flow valuation. (To learn more, see Investors Need A Good WACC.)

What's the Firm Worth?
Finally, you want to calculate the total value of the biotech firm. Once you have gone through all the steps outlined above to calculate the discounted cash flow for each of the biotech firm's drugs, you simply need to add them all up to get a total value for the firm's drug portfolio.

DCF Value Drug A + DCF Value Drug B + DCF Drug C … … = Total Firm Value

Conclusion
As you can see, valuing early-stage biotech companies is not entirely a black art. Intelligent investors can come up with solid stock valuation estimates if they are familiar with DCF analysis and are equipped with a basic understanding of the industry and how major developmental milestones can impact the value of a biotech firm.