Investing in Stocks Bonds and Commodities - Research Paper Example

 Executive Summary: The current recession has highlighted the importance of commodities as an inclusive item in an investment portfolio, because they tend to fare well when inflationary trends following a recession exist, and they also do well in the long term. The report below summarizes the results from a stock market watch, using a portfolio comprised primarily of commodities and devoid of bond investments, although it does contain some equity shares. A description of the three different kinds of investment instruments, i.e., equity shares, bonds and commodities is provided below, followed by an analysis of a specific portfolio that has registered good gains. Shares, bonds and commodities: Companies issue stock primarily in order to raise capital that is required both in starting up the business as well as in funding new business ventures. The equity that a corporation has is its ownership in the business; the issue of stocks is mainly an exchange of shares in the profits from the firm for monies invested in the business by private or institutional investors. Issuing stocks offers many advantages to Companies because they would not be able to raise much money towards capital and expenses from banks, which are likely to (a) place restrictions on the amount of capital that can be borrowed and (b) charge a very high interest rate on the amounts that are borrowed (Rees, 1997). Borrowing money from banks can be extremely expensive for corporations because corporate borrowers are often charged much higher interest rates on their loans and there are other, more stringent requirements that must also be met. In most corporations, the Chief Financial Officers are likely to resist taking loans from banks because these loans are often associated with restrictive covenants. Some of the conditions associated with restrictive covenants, for example, may be (a) not taking on more debt until the bank loan is paid off (b) no participation in share offerings until bank loan is repaid (c) interest on bank loans to rise if existing CFO quits or if the earnings per share drops over a particular period and (d) restrictions on the purposes for which the corporation can use the proceeds of the loan (The issuing of stock on the other hand, is known as equity financing, which is accomplished through the issue of stocks that offer investors a share in the profits of the Company in proportion to their investment. The advantages offered by equity financing is that the Company does not need to pay back the money invested by the stock holders, neither does it need to make interest payments. Investors are interested in putting their money into stocks because of the chances of gaining large profits on it. Although there is an element of risk involved in buying up stocks in a Company, nevertheless if the Company is successful and makes a profit, then the investors are able to gain a share in the profits in proportion to the extent of their investment. As a result, although there is the element of risk involved, nevertheless, the risk also has a positive side to it; because higher risk levels demand a higher rate of return on the investment. Equity stocks or investments in the stocks of companies carry a higher level of risk but historically, they tend to perform better than other kinds of investments like bonds or savings accounts. When companies try to borrow the money they need to finance their capital requirements from banks, they find it difficult and restrictive. The reasons are that banks tend to charge corporations a high rate of interest on the loans and also to impose several conditions such as restrictive covenants. For instance, restrictive covenants may specify conditions such as (a) not issuing more debt until the bank loan is completely paid off (b) not participating in any share offerings until debt is paid off (c) not acquiring any companies until loan is paid off (d) preparing to face a steep rise in interest rates on the loan if the Chief Financial Officer quits or if the earnings per share of the Company drops substantially within a given period (www.investopedia.com). Thus, in order to raise funds, a Company may resort to the issue of bonds, which is essentially the collection of loan monies to go towards capital, from members of the public through the issue of bonds. A bond is a debt instrument, whereas stocks are equity financing; this is the salient difference between the two different means that a Company has in order to raise funds from the public (www.invesopedia.com/university/bonds). Debt financing from the company’s perspective involves borrowing money from private bond holders for a certain time period; however interest is paid on the amounts borrowed. Bonds differ from equity or stocks in two further aspects, which are (a) investment in equity or stocks provides the investor a stake or ownership in the Company in proportion to his/her investment, a bond purchaser only becomes a creditor to the Company (b) ownership of a bond provides an investor a regular source of income from the interest accruing on the bond although the amount may be small, while the stock owner receives speculative returns, i.e., the returns are assured only when the Company has profits, but these amounts could be very large if the profits of the Company are substantial. Commodities such as oil and metals are yet another kind of instrument which many investors put their money into. By diversifying into commodities and listing their products on the stock exchange, companies have the opportunity to procure funds from yet another source, i.e., speculative investment by private or institutional parties into commodities. For investors, commodities offer the opportunity to diversify the investment portfolio rather than putting all eggs into one basket. Investing in commodities has become more popular in recent years because escalating economic growth in developing countries such as India and China has created an unprecedented demand for commodities (www.whatinvestment.co.uk). As a result, it offers greater opportunities to recover the value of their investments and get a good return on them. Commodities differ from both stocks and bonds in that they are real assets, i.e., specific materials and property, as opposed to shares in the profits of the Company or getting a steady supply of interest in return. Since they are real assets, they tend to retain their value even during a time of inflation, whereas stocks and bonds automatically drop as investors anticipate a rise in interest rates to counteract the effects of inflation (www.whatinvestment.co.uk). As a result, the benefits they offer to investors are two fold: (a) they retain their value during an inflation because, being in scarce supply they are always in demand and (b) they offer investors the opportunity to diversify their portfolios while also benefitting from the long term scarcity and consequent performance of the asset, i.e, the commodity. Analysis/ Diary: My player number is H0021072@hct.ac.ae and I’m currently ranked at number 3 out of 28 players as of December 22, 2009. As may be noted from my portfolio, most of the stocks I hold are in the long position, or bought with the intent of holding on to, in order to benefit from their long term rise in value. My reason for choosing to take on most of the stocks in the long position is the current recessionary environment, where the likelihood of making any big gains from my stocks in the short term does not appear likely. Most companies are struggling just to survive and in general, the stock exchange has been slow and pessimistic in outlook. Gains if any, from the stocks, appear most likely to be realized after the recession is over and the economy has recovered, so that businesses can start posting the kind of levels of profit that would ensure that stocks and shares provide healthy returns. Secondly, I have also selected mostly commodities and included them within my profile; for example, The rationale behind selection of commodities for investment and notably the oil, energy and natural gas sector, is that commodities help to offset the detrimental effects that arise after inflation. Commodities have a negative correlation to stocks; as a result, when share prices of stocks and bonds are declining due to rising interest rates in an inflation, commodities tend to benefit both in the short and long term (Dolan, 2006). The Centre for international securities and derivatives markets has pointed out the benefits of commodity investments for investor portfolios (www.cisdm.som.umass.edu). It has provided theoretical evidence and empirical data which suggests that direct investment in commodities provides risk and return opportunities which are over and beyond simple inflation hedging. The selection of commodities like oil, energy and natural gas were driven by the recent recession, which revealed how oil could play such a significant role in determining the value of other shares in the market. By choosing to invest large amounts of equity in solar and natural gas companies as well as refineries, there was a good chance that the investment was being made into shares that would be strong in the future. This is corroborated when noting that among the real players, the most significant gainer is EFA, which has registered a gain of 0.29% by 8th December, so that its share value is at 55.00. The average volume of stocks traded in a day was 18.05 million and over a period of 52 weeks, the lowest the stock value has dropped to is 31.56, while the highest value was 57.66. Assessing the value of this equity stock over a period of the last three months, it is significant to note that the value of the stocks have been fluctuating between 52.50 and 57.50, which suggests a bullish trend. EFA is one of the largest exchange traded funds and one of the best established with a large cap index. The excellent volume at which foreign based funds have been trading suggests that they are a good addition to an investment portfolio. As Kay (no date) points out, this fund not only has a low expense ratio, it also offers liquidity and enhances the prospects for gain from the shares because hidden costs such as market impact or tracking errors can be eliminated. Several of the oil and natural gas companies I have chosen to invest in are dealing in and working among emerging markets in oil exploration and refining, as well as in developing new energy sources such as solar energy and natural gas. It is also worthwhile to note that more investors are choosing to invest internationally in what are classed as emerging market funds, due to the increasing trend towards globalization and the better performance of the developing economies during the current recession, as products are able to reach more remote countries of the earth (Dion, 2009). As Dave has pointed out however EFA’s are at a tentative place and continued good performances may not necessarily be assured, because the lower Euro rates as shown in the figure below, have not proved profitable to U.S. investors. On the other hand however, the rising value of the dollar is beneficial in terms of pushing equity prices higher. Moreover, as Kay (no date) points out, the shares represented under this category are core foreign stock holding ones, which have demonstrated relative stability over a long term period and therefore are a valuable addition to the portfolio package because they do well during inflationary periods that follow a recession. The above was the rationale that prompted me to divert a substantial portion of my million dollar investment into commodities. The recession was also the reason why I decided not to include any bonds in my portfolio. Since bonds are based upon the payment of interest, companies that are generally under strain during these recessionary times are finding it difficult to sustain interest payments on the bonds and there was a danger that in the long term, they could have proved to be a total loss as companies phased out or went out of business. I did however, select some companies to invest in their shares, because of the high returns that were being demonstrated through the EFA index. One of these was Canadian Solar, Inc which is also involved in generation of solar power and devices using such power. This company has shown some decline in share prices in October but otherwise has been faring well, as shown in the chart below: (Source: Market watch: Canadian Solar, Inc) July Aug Sept Oct Nov Conclusions: On the basis of the returns the investment portfolio has been generating, it appears that the selection of commodities for investment may have been well advised, especially in the recessionary environment. There has been a steady and positive rate of return that has been sustained on the portfolio package from November 12 to December 21, 2009. I started off with purchases in a range of oil and natural gas companies, putting down cash worth $459,909.00. I purchased 25,000 shares in Conocophillips, an integrated energy company and refiner of oil, 10,000 shares in Helmerich and Payne, which is an energy exploration and production company, 4000 shares in United States Natural gas fund, 1400 shares in Atmos energy corp, 2000 shares in Alon USA Energy Inc., 2000 shares in United States oil fund and a 100 shares in Exxon. While I started off with an overwhelming proportion of commodities in my portfolio, I also added on equity shares in Canadian Solar Inc, Cabot Corporation which produces speciality chemicals and performance materials, and a telecom company – Telecom Italia. My positive experience of trading was in the buying of shares in Conocophilipps, which is showing a good healthy rate of return of 118.17% equity, with a current market value of $1,269,500.00. Secondly, the choice to buy 1500 shares in Canadian Solar Inc appears to be well founded where the equity seems to be recoverable with a solid profit added on, because the shares have yielded an overall gain of $17, 745.15. Yet another good trading move was the choice to dispose of my investment in First Solar, the Arizona company, which was enjoying a healthy market position earlier through the advantage it had on its manufacturing process for solar photovoltaic cells. Most of the Company’s sales however derives primarily from a few customers; as may be noted from its SEC filings, 74% of its customer base is from solar module sales mostly in Germany (www.investor.firstsolar.com). Since solar power is now emerging as one of the new markets that many companies are likely to be entering into in the future, First Solar did have the First Mover advantage; however more competitors are coming in and the concentration of sales on a few customers could impact detrimentally on the Company if even one of these regular customers was to drop off. The NYSE has also registered a drop in share value of FSLR by 24.19% over the period from 15th June to 15th December. Based on these considerations, selling off the shares before they incurred further losses may have been a good idea. Another mistake was in trying to sell my shares in the Apollo Group at too high a price. The Apollo group is an education company that provides higher education to working adults. As may be noted from the chart below, the Company has demonstrated a steady decline in its price/earnings ratio, although its earnings per share has been going up. This does not bode well for the Company’s future, because the P/E ratio determines how the stock is likely to sustain over the long term. My decision to sell the shares at a minimum price of $76.10 per share had to be cancelled because the shares were not moving fast enough; it was only when the individual share price was reduced to $41.50 that they could be sold at market price. APOL Fundamentals (Source: www.digitallook.com) Year Ending Revenue ($m) Pre-tax ($m) EPS P/E PEG EPS Grth. Div Yield 31-08-05 2,251.47 729.84 243.00¢ 32.4 0.2 +212% n/a 0.0% 31-08-06 2,477.53 668.09 238.00¢ 21.1 n/a -2% n/a 0.0% 31-08-07 2,723.79 657.30 237.00¢ 24.8 n/a -0% n/a 0.0% 31-08-08 3,140.93 782.85 290.00¢ 22.0 1.0 +22% n/a 0.0% 31-08-09 3,974.20 1,039.81 379.00¢ 17.1 0.6 +31% n/a 0.0% The choice to buy more shares in Cabot Corporation was however a good one, because this Company has demonstrated a steady rise in stock prices, which also bodes well for the long term. It may be noted that this is also one of the EFA shares because although it is based in Boston, its operations are carried out primarily in China, hence it qualifies as one of the companies that is capitalizing on the emerging markets. On an overall basis, it appears that while the general principle to invest in commodities may have been a good one, the portfolio should have been more evenly balanced with the addition of more equity shares and possibly some bond investments as well, in order to generate a steady source of revenue through interest. The substantial investment in United States Oil Fund of 2000 shares proved to be a loss because it generated a loss of $10,722. Similarly, the large investment of 4000 shares in United States Natural Gas fund generated a loss of $4308. On the one hand, it is possible to justify these investments in the long term, because they are companies developing alternative sources of power, therefore I chose not to sell them off. But in retrospect, it may have enhanced my portfolio to have included a greater selection of equity shares in more EFAs, since my portfolio may have been somewhat unbalanced and too much in favour of commodities. References: Dion, Don, 2009. “Emerging market ETFs to watch”, The Street.com, Retrieved December 20, 2009 from: http://www.thestreet.com/story/10639027/1/emerging-market-etfs-to-watch.html Dolan, Karen, 2006. “Should you add commodities to your investment mix?”, MorningStar, Retrieved December 20, 2009 from: http://news.morningstar.com/articlenet/article.aspx?id=166781 Kay, Bradley, No date. “ETF research and analysis”, Morningstar, Retrieved December 20, 2009 from: http://quicktake.morningstar.com/s/etf/analysis.aspx?t=EFA Market Watch: Canadian Solar, Inc. Retrieved December 20, 2009 from: http://www.marketwatch.com/investing/stock/CSIQ Rees, William P, 1997. “The arrival rate of initial public offers in the U.K.”, European Financial Management, 3(1): 45-62 SEC Filings, Retrieved December 20m 2009 from: http://investor.firstsolar.com/phoenix.zhtml?c=201491&p=irol-sec&secCat01.1_rs=51&secCat01.1_rc=10 “What are commodities?”, Retrieved December 20, 2009 from: http://www.whatinvestment.co.uk/making-money/share-dealing/guides/262393/what-are-commodities.thtml “Why do companies issue debt and bonds? Can’t they just borrow from the bank?”, Retrieved December 20, 2009 from: http://www.investopedia.com/ask/answers/05/reasonforcorporatebonds.asp Read More