So first, what is an IPO?

Every company that trades on an exchange such as the New-York Stock Exchange or the NASDAQ, has at some point or another, gone through an initial public offering.

99.99999999999999% of all companies start out as privately held. Maybe there was a founder and a group of private investors that all went in together or something. You can learn more about this kind of financing here. But eventually, those initial financiers want to get their money back. They have a few options, but they basically boil down to selling to some other private investor or selling to the public. Selling to the public is the IPO.

When you go public, you will usually hire 1 or more investment banks to underwrite the IPO. The investment bank will evaluate how much your company may be worth, and then goes and finds investors for you. These investors are not you are me, they are usually institutional investors with enough money to plop down millions of dollars worth of shares. They get the initial allotment of shares and then on the first day of trading these are the shares that go up for sale for buyers such as you or me.

But why would a company go public?

This is why it’s best to explain IPOs in the context of a company actually doing it. IPOs are not just a way for initial investors to exit the company, they’re also a way to raise money to continue the company’s operations. Tesla has been bleeding cash from the very beginning. Its founder made his millions selling PayPal to eBay. And he’s thrown many millions back into Tesla to keep it alive. He’s learned why the auto business is second only airlines in the “industries only a idiot would start a company in” category. Through himself and other investors, they financed the development and production of their first car, the sexy Tesla Roadster (pictured above). It starts at a few ticks over $100k. But the Tesla team knows that in order to put their all electric car company on the map they need a car that more favors the masses. So they designed the Tesla Model S (pictured below).

But getting this car to the masses is going to take some serious development money. And even though they’ve gotten some investments from a couple of car companies, and a nice chunk of cash from the government, they don’t have enough. So this is where the IPO comes in. It allows Tesla to raise cash from people that they don’t have to pay back. The stock could go to $0 and they go bankrupt. It’s unlikely, but it could happen. IPOs are great ways to raise cash.

There are other reasons for doing the IPO as well. It’s kind of a coming out party. It gets you a lot of press, and you now have to power spread out over many more investors and the CEO is able to maintain some extra level of control (sometimes). In this case the CEO is actually going through a divorce as well. He needs to cash in some of his Tesla stock to pay the settlement no doubt.

There are some concluding questions I’d like to answer as well. How does the investment bank get paid? Their job is to drum up interest and the more interest there is the higher the share price will be. They get a cut of each sale. So if Tesla sells for $18 a share, maybe they take $2 of that. Spread that out over tens of millions of shares and you have a nice cut at the end of the day. Also, how does a stock perform in its first few days of IPO. There are a lot of articles on the web you can Google about this, but more times than not, the stock takes off in the first few days due to intense demand. But there are some studies that show after a few years it tends to fizzle out and stay flat. I’d recommend that individual investors stay away form IPOs because they are risky. Especially for a company like Tesla which has never turned a profit. Do what I do, buy IPO stocks through fantasy trading. I bought TSLA and it’s done good things for my fantasy portfolio.

So that’s an IPO, I want to take a minute and talk about Tesla though too. I’m really excited about this company. As I said before, it’s been a long time since an American car company has done an IPO. And to top it off it’s an all electric company named after the awesomest dude you’ve never heard of. If I had the money, I’d already own a Roadster and would be on the waiting list for a Model S when it goes on sale (in 2012 I think). I love when startup companies take on the big guys. I can’t wait for the day that electric cars are the norm.

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But sometimes the news is less significant. It might just be something small like a new president of a division, or the launch of a new product. These announcements happen all the time, and don’t seem to have an observable impact on the stock price in the short run, at least the same way something big does like CVS. But these days on Wall Street, it’s not about making 10% in a day off some significant news, it’s about making fractions of a percent dozens of times a day. The buying and selling happens so fast, that a human could never make the moves fast enough. But, where there’s a will there’s a way nerd with some programming skills that designs a system to capitalize on these fluctuations.  And they have shown they can make good money by doing it.

And those nerds (called ‘Quants’ on Wall Street) are Robert Shumaker and Hsinchun Chen, and they think they’ve figure out a way to make money on even the slightest news item. Through a process that is probably best described in a Professor Frink voice and makes Einstein roll in his grave for wasted brainpower, they’ve identified key words in news stories that allow them to predict temporary price moves in a stock. They have to act fast, within about 20 minutes, and the moves are only a few pennies. But in typical professor fashion, they tested it against some of the biggest quant funds on Wall Street and it works. The way it works is their program scans news stories and looks for key words. Certain words have a bigger impact on price than others. Depending on the words coming in to the algorithm, the program will either short a stock or buy it.

So the question then is, what words make the algorithm short a stock and what words make it buy? You couldn’t guess them even with 1000 tries.

Buy: planted, announcing, front, smaller, crude
Short: hereto, comparable, charge, summit, green

Why these words? I can explain some. ‘Announcing’ makes sense, companies make announcements all the time; a good announcement could mean an increase in buying. ‘Charge’ also makes sense, as it could mean a criminal investigation, or an additional expense that eats into profits. And I guess investors don’t like it when companies go ‘green’. But I can’t really explain any of the other ones.

But like any computer system, it potentially has flaws. Flaws that caused the flash crash a few weeks ago. Computers can’t reason, so they can’t tell if news is legitimate or not. In 2008 a newspaper accidentally ran a story from 2002 about a United Airlines bankruptcy. It sparked a huge selloff and investors lost a ton of money. An enterprising hacker could launch a PR release campaign that causes this algorithm to trigger buys or sells. I’m not saying this system isn’t sophisticated, but there isn’t a system on the planet that can’t be tricked or hacked.

This kind of develop sure is interesting, and I think there’s a place for it in the future. Maybe if I have $1 million to invest I’d put $50k in a fund that does this. But I’d never trust all my money to a computer; not in a world with flash crashes, hackers, and humans writing code.

Via The Reformed Broker

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This is basically a combination of things that are bothering me.  I would have probably written a post about them individually but instead decided to just throw them up here and move on to other topics.

1. I like the new iPhone plans, I’ll save money when I upgrade. But with media rich iAds coming to the iPhone, I’m worried I’m going to end up paying AT&T in data fees to have Apple serve me ads. I think I shouldn’t be charged for iAds data.
2. Fannie Mae and Freddie Mac are being delisted from the New York Stock Exchange. These companies are now more or less worthless. Yet they’ll continue to exist throughout the rest of this administration. Time to shut them down.
3. There’s been talk of a double-dip recession for a while now, but those talkers are starting to get my attention. I give it a 31% chance right now.
4. The primary reason GDP has been up (and thus kind of not being in a recession anymore) has been due to increases in business inventories. This increase is now kind of gone. So what is going to happen to GDP? I consider this issue separate from the risk of a double-dip
5. I’ve met with a number of interns from well known business schools lately. Almost everyone one of them introduces themselves as “Philip Weakonomist, Anderson, UCLA”. That is to say they introduce themselves with their name followed by business school name, and university name (just for the record I picked UCLA because you know I didn’t go there). Introducing yourself in such a manor basically says, “I’m me, now respect me because I go to a good school”. I’m not sure if the school makes them do this or what, but if I want to know what school you go to, I’ll ask. Earn respect, don’t reference your school and expect it.
6. When will they introduce “at-home lipo kits”?
7. Operation Repo is the dumbest show on TV. That’s saying a lot because I’ve seen all the “real housewives” shows.
8. Congress is having one fundamental fight right now. Do we continue to run up the deficit to help individuals and the economy at the risk of long-term problems or do we cut spending now because we may lose our ability to borrow shortly. I don’t even know exactly where I stand anymore. I understand why politicians feel they must vote in favor of it to represent their constituency, but what are the long term costs?
9. I still can’t believe the price of gold.  It’s more than $1200 an ounce.  If you want to invest in something in case the world collapses, take a survival training class.
10. Why is TLC so obsessed with big families and small people?  It’s The Learning Channel, what is there to be learned?  Use contraception perhaps?
11. Universities should require career preparation classes.  Students need to graduate with some kind of certification that shows they can do a specific job.  Gone are the days when you can just get a degree and enter the workforce.
12. Banks should be allowed to engage in prop trading, positions should be disclosed on quarterly reports and the use of funds restricted so an investment can’t bankrupt the company.

That’s it for me, what’s been on your mind?

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Jersey Politician Draws Total Disability Pay yet Runs Marathons

New Jersey Woman Charged in $45 Million Ponzi Scheme

Both are good reads.

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A stock buy-back program is exactly what it sounds like. Companies issue stock to raise money for their business. Sometimes they’ll buy some of that stock back from shareholders. In more official channels buybacks are referred to as share repurchases. Companies do this all the time, CVS has been working on it, so has Autozone and Cablevision.

How does a buyback work? In essence, the company will have some cash and go into the open market and purchase shares just like anyone else. They usually purchase a large number of shares and so they do it over a period of a few weeks or months. Otherwise there will be a huge surge in prices as there are many more buyers than sellers. Sometimes they might buy it directly from a major shareholder, if they are interested in selling. However I suspect this is less common.

Why would a company buyback stock? So there’s a running theory in business, you got to spend money to make money. In other words, growing profits requires investment. That’s new people, new equipment, maybe buying a competing company, advertising, etc etc etc. So when a company wants to grow, but doesn’t have any money, they have to go and borrow it. This is a time when they have to get a loan or maybe issue new shares to raise new cash. So in essence, when a company says they’re going to repurchase shares, they’re literally saying they have more money than they know what to do with. In the business world, this isn’t really a good thing. It’s kind of like saying, “we’re out of ideas”. So an existing shareholder can be happy that their shares will be less diluted (and thus worth more). But they can also ask “where is the future growth going to come from?”

But not always. There are other reasons a company might buy back shares. For example, let’s say a company has an ideal ratio of debt to equity of 30% debt and 70% equity. This kind of leverage isn’t much different than from you borrowing money to buy a home. But what if the value of the equity has increased because they raised money issuing new shares. They might simply borrow money (by selling corporate bonds) and use the cash from that sales to buy back shares. Personal finance mavens might gawk at such a move, but it’s actually cheaper to borrow money than it is to have shareholders. The effective interest rate on a bond might be 7%, but on a stock it could be twice that.

They could also want to buy back shares because they think their stock price is cheap. Who is going to know better than them what their company is worth? By purchasing shares back when it’s cheap, they can reissue those shares at a later date without further diluting the company.

Do share repurchases matter to people that buy index funds and ignore regular financial news? No, but I think you like reading about this stuff anyway.

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But should Apple really be worth more than Microsoft? In their latest quarterly results, Microsoft had Apple beat hands down.  The three statistics below are the companies’ revenue (aka sales), net income (aka profit), and cash flow (from operating activities).  The cash flow is basically how much cash they brought in that quarter, which is different than profit.

By these measures (and many others) Microsoft is clearly doing better than Apple.  If you were to value Apple based on these metrics Apple would actually be worth quite a bit less than Microsoft.  Not equal, not kind of close, but billions of dollars less.  So what gives?

When an investor values a stock, they aren’t just looking at how well a company is currently doing, they’re also looking at how well it may do in the future.  A fundamental valuation of a stock is the present value of all future cash flows.  Future cash flows may be difficult to predict, but someone can be reasonably sure of something.  Investors are speaking with their money and saying they expect Apple to make more in the future than Microsoft.

And I have to agree with them.  Microsoft has done very well with products like Windows and Xbox.  But the industry expects the future to be with mobile products.  Microsoft has mobile products on the market and more very close to release, but they aren’t getting the sales Apple gets.  And Apple has a other sources of future earnings other than the products themselves: money from apps and music, and coming soon to an iPhone near you – ads.

This blog doesn’t exist to talk much more about such things, but Apple’s passing of Microsoft in total company value did give me a good opportunity to talk about market capitalization and explain a bit more about how institutional investors look at stocks.  But, I wouldn’t place bets on either of these guys losing this race yet, and actually love that they are both on the market.  My house is split down the middle with Apple and Microsoft products, and I can’t wait to see what’s next from both of them.

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Are you married? Does your spouse have life insurance? Do you want your spouse to die so you can get the money? If you answered “YES, YES, and YES!!!” please turn yourself into the authorities. But I suspect most of you have a “yes, yes, no” response. And the unmarried ones may still have life insurance but probably aren’t worried about their benefactor killing them or hoping for a timely death. So if we don’t have insurance so we can make a boatload upon killing someone, then why do we have it? We have it because if we die, someone needs to replace our income. I have value to my wife, just as my wife has value to me. If either of us dies, insurance would help fill the economic void left behind. You take out insurance on your neighbor’s house for a good reason. If it burns down, the value of your property declines as well.

So in my conversation with my mother I came up with a great analogy that better fits the purpose of a CDS. Imagine your neighbor is running a meth lab in the garage. The process of making crystal meth is chemically intensive and can result in explosions. If the garage explodes, the house burns down, and the fire/explosion may damage your house as well. Either way, this meth lab poses a threat to the value of your home. So what do you do then?

You take out a small insurance policy on your neighbor’s house. The insurer thinks this is crazy but is glad to sell you a policy for a pittance. Even your neighbor thinks you’re crazy; only you know what the danger is with the meth lab. If the lab explodes, through some manner or another, the value of your home will decline. Sure enough, the lab explodes and the house burns down. Now the neighborhood is scarred with a giant burnt property and everyone knows drugs were being sold in the neighborhood. Naturally, the value of your home declines.

So how does this related to a CDS? Someone like John Paulson knew two things about mortgages, the first was they there were overvalued. The second was that when everyone else started to realize that, it was going to cause problems that went far beyond real estate prices. As this happens, even Paulson would lose money unless he did something to protect himself. So he started a fund that was specifically designed to purchase the type of insurance I described above (note, he also used other resources with similar payoffs). Investors in the fund were just people that wanted the same kind of insurance. If the meth lab burned down and you made a bunch of money, main street and Congress would now be mad at you.

A credit default swap is simply insurance against the risk of someone defaulting on their loan. It’s most commonly purchased by people that would directly lose money if a specific loan defaults, but an argument can be made that anyone should have a right to make that purchase. Paulson didn’t want these mortgages to fail, he just knew that many of them would. I don’t want this to turn into a conversation about whether or not investors should be allowed to buy CDSs, but I wanted to at least make sure my readers understand how a CDS works. If you have questions or more to add, please toss it in the comments. But try to keep them away from whether or not investors should be allowed to buy CDSs, we’ll do that another day.

Photo: DVS

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Okay, so maybe I wasn’t the cause of this event. But what did happen yesterday? If you haven’t heard yet or don’t understand the chart, sometime after 2:30 yesterday a massive selloff occurred in the market. The level of selling the happened is a once in a decade kind of stock market crash. The Dow Jones Industrial average lost almost 1000 points in a matter of minutes. Fortunately, the market actually bounced back and instead of it being an absolute disaster, the market simply ended as a very bad day.

So what happened? Details were still fuzzy last night as of this writing, but it looks like the event will become known as the fat finger event. A trader at Citi entered an order to sell 15 million shares of a security (not an outrageous amount), but accidental typed billion. Traders all over the globe saw the huge sell order and followed suit assuming Citi knew something. A massive selloff ensued. Part of the issue is because a lot of sophisticated traders use stop-loss order to limit themselves from losing too much in a massive selloff. Say I owned stock in Google and wanted to protect myself from losing too much money if the stock lost value. Earlier this week Google was trading around $530. So maybe I decided if the price dropped to $500 I’d sell my position. When the massive selloff occurred Google dropped to $500 so my stop loss order was triggered. All over the world millions of stop-loss orders like this were triggered so the market was flooded with sell orders and the price of everything tanked. Though it was fantasy trading, I had quite a few stop loss orders triggered as well.

In the high paced world of trading, with lightning fast computers, and herd mentalities, in a matter of minutes almost 10% of the value of the US stock market was wiped out. This 2.5 minute video shows how quickly it happened, and makes Jim Cramer look like the savior of the market. He literally calls the selloff ridiculous, and then people just started buying.

There are some issues that will need to get cleared up tomorrow. The NASDAQ exchange and NYSE has said they are going to invalidate some sales that happened at outlandish prices, which they have a right to do. Citi will likely have to issue some kind of statement providing more details of what happened. The dude that made the mistake has likely already been removed from the existence of this planet. I hope his name is Freddy. People will call him Freddy Fat Fingers.

But all is not well in the world of Wall Street. The market was already having a bad day due to worries about Greece, financial reform, and the oil in the gulf. Those are all realities that are still happening. The economy is still on a rocky recovery, and 10% of the population is still unemployed. The market could very well head further south, and I half expect it to for the next few days.

This was one hell of a ride, the stocks app on my iPhone froze as I followed the chart south. Google and Yahoo! finance pages crashed, and the world collectively held its breath for a few minutes. Behavioral finance researchers just got a wealth of new events to study, they should probably start with the massive influence I had with my post from yesterday.

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Don’t know what I’m talking about? It’s probably for the best since you are a smart buy and hold investor and don’t try to time the market. *Good boy*

So what is this “Sell in May” stuff all about? It’s an investment phenomenon that believes you can make more money buy selling all your stocks in May, and buying them back some time in the fall. It’s based on observations of market returns from November-April vs May-October of every year. As it turns out, the market does really well from November to April and stays basically flat during the summer months. Scary stuff right?

But there’s no way this can be true right? Well, it all depends on what you believe really moves the market. So the feeling is that people often vacation and are otherwise distracted during the summer months. There’s always SOMEONE in your department on vacation. Productivity is down and everyone is focused on getting through the day so they can go home and enjoy the long summer evenings. Behavioral finance studies would agree with such ideas. There’s also the idea that the money managers sell off their holdings because they don’t want to have to think about fluctuations in the market while they’re catching rays on the sandy shores of West Palm Beach. And then when the Sun sets on summer people go back to work and start getting serious about making money again. But I believe that if people really want to win at this game they should stay away until All Saint’s Day, which is November 1st. Why? If you avoid October you miss the awfulness of 2008, Black Monday in 1987, and even the stock market crash of 1929. But is all this stuff legit?

This chart comes from one of my favorite blogs, EconomPic (don’t hate me for borrowing your picture buddy). It shows the return of the S&P 500 vs a version of the sell in May phenomenon called “The Special Sauce”. In the special sauce you take the money from selling stocks and put it in bonds, which many of us would do anyway. So you tell me if it works or not.

Now of course this post is not meant to recommend this as an investment philosophy. I do not do this myself, nor do I recommend you do it either. However, if a reputable mutual fund company came to me with a mutual fund that did this, I’d consider putting 5-10% of my portfolio in it.

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Five Cent Nickel was gracious enough to allow me to publish this post on his blog. Today, I’d like to share it with you. Bear in mind, I don’t pick stocks for my own portfolio, this post merely serves as food for thought. So please go and read:

How Many Stocks Do You Need to Be Diversified?

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