Getting Started Understanding A Company - FS - #1

To make organizationi easier, if you do not wish to read anything other than my financial statement analysis posts I will numnber that as shown above so you can be sure you haven't missed one...moving on....

A lot of people don't know where to start when they want to start investing.  A finance degree gives you a lot of the tools that you can use to analyze companies, but still many finance majors and investors everywhere forget the one basic tenant of long-term stock investing.  Do your homework!

You can run all sorts of analysis and do all sorts of different types of investing but in the most general sense you want to invest in a company that you understand and believe in.  The best way to understand a company is by sitting down and reading an annual report (aka the 10k, a 10q is a quarterly filing).  You can get an annual report online from the website of any public company (usually through the "About" or "Investor Relations" section of their website) or if you like holding paper in your hands order them for free here Annual Reports.  They deliver the report if they have it in stock, if they don't have it in stock they will have the company mail it to you.

Now in the future I will detail more specific ways of analyzing a companies prospects but the big one is actually working your own way and mucking through an annual report.  The more you read finance the more you realize, understanding a good company is mostly common sense:


General Motors had trouble because it paid too much in health benefits through years of union concessions and had too large a product line which lead to added costs, other companies that didn't have these issues could easily undercut General Motors with better quality cars at lower prices.  It doesn't take a finance whiz to come to that conclusion.  General motors cost per car number was through the roof compared to its rivals - I recall working through analysis and attributing an extra $2000+ costs in health benefits to each GM car that was made over its foreign competitors (a conclusion many others also came to).  In addition, the quality of their cars started to deteriorate and management began to get complacent.

On another note a lot of time Wall Street analysts also get caught up in companies and issue positive ratings or "buy" recommendations because that makes the companies happy.  They also may nix an analyst that issues unfavorable ratings.  In the case of Enron, nobody understood how they made their money, they were what industry folks call a "black box," it was too good to be true - and subsequently it wasn't true.  Again, common sense, if now one can understand the company, something strange is going on.

Like anything else it will take a while to get through your first 40-50 annual reports and you will not understand much at first, but google your questions and continue to try - there are learning curves to everything and it does take time.  I would recommend that you start with a simple company though, steer clear of any finance and high-tech companies as they engage in complex activities, a manufacturer or a retailer would work well for starters.  Lastly, once you find a company you like trust your analysis - you will have looked at many different ones and know more about them than most investors.  It may take a while to reap your benefits, but over the long time if the company is solid and it is not overpriced it will show in your returns (later we will see how to spot overpriced stocks).

Ahhh! WTF Happens Inside an Investment Bank!?!

So they had a huge hand in the financial crisis, they have most of Washington in their pockets, they are really confusing and everyone that works at one seems to be a millionaire.  They have names like Morgan Stanley, Goldman Sachs, Lazard and in the recent past Lehman Brothers, Merrill Lynch and Bear Stearns.  It takes about '100' years to make a good one and they are the envy of ivy league business majors and MBA's all over the world.  They are investment banks, not to be confused with your mom and pop banks and below is what they look like inside.

So lets talk about what we are looking at, hopefully in a way that won't make you cringe.  At first glance we have four main sections in our picture:

1) Investment Banking
2) Sales and Trading
3) Operations
4) Capital Markets

*In reality you will see many other functions such a prime brokerage, asset management etc. but the big players are above.

Lets discuss what they do and to make it more interesting we can also discuss their personalities and how much money they make!

Our first stop will be the investment banker, the investment banker usually specializes in an industry and may specialize or fall into another group such as Mergers & Acquisitions.  These are like financial advisors for companies.  They help companies raise capital (through debt/equity offerings), tell companies to buy other companies and bring private companies public; and they do not do this for free, they charge hefty fees.  The general character of an investment banker is calm and reserved.  Unlike traders (who we will discuss later) they don't use brash words and never unbutton a shirt collar. 

Because the investment bankers only make money when a business moves money around, either to purchase a company or raise money - they constantly want corporations to move money.  To do this they have to give the companies ideas of what they should do at all times in the form of neat little presentations called pitch-books (in industry terms PIBS).  Many of these ideas never see the light of day but because the bankers have to think up 100's of pitches for every one that comes to fruition they never sleep and are at the beck and call of a company that is processing a deal - the lower you are on the totem pole the less you sleep.  You start as an analyst, then become an associate, if you are good the following step is vice president and if you can make it rain a Director or even Managing Director. 

In 2010 as a starting analyst you can expect to get a $70,000 salary and get a bonus of about 80% and up of that, you can also expect to work 90-120 hour weeks during deals.  After two years of being an analyst you go back to get your MBA and become an Associate.  Now you have a salary of about $100,000 and your bonus structure remains the same.  If you are good you make VP and are crushing half a million bucks a year and a good Managing Director that can really make it rain could be making eight, nine or ten million a year (there are those poor suckers who only make a couple million).  Ohh and what about that little red line in the picture,  that is called "The Chinese Wall."  Because bankers have access to private client information (they need it for their pitches) they aren't allowed to be around other people in the bank who could profit from that information.  Hence all banks have two big escalators and two big elevator banks that never mix.

Traders are a whole other entity not to be confused with bankers or salesman.  Traders and salesman work together on a trading floor but that is the only thing they have in common.  Traders for the most part specialize in a certain product or region and trade for either clients (flow trading/market making) or for the bank itself (proprietary traders) although these are a dying breed thanks to the Dodd-Frank bill and the Volcker Rule.


Because Frank Partnoy already described the difference between a trader and a salesman in his book "FIASCO," I can just steal his work!

"The traders are the men with rolled up sleeves and loosened ties who hold several phones each and periodically smash one phone against a desk, a computer or a trading assistant, and then grab another donut out of a monstrous box."

"In contrast the salesman calmly adjust their cuff links while they hold one phone to each ear and, by alternatively squeezing hidden mute buttons in their handsets, carry on several composed conversations at once.  A good salesman can simultaneously schmooze a client, discuss tonight's Knicks game with his bookie, order his assistant to steal a donut from the traders, and explain to his wife where he had been last night until 4:00am - and none will be aware of the other conversations or the nearby pandemonium." (of the trading floor).

Folks in sales and trading get similar salaries to their counterparts in banking but their bonuses are based on the number of clients and how much they trade or how their trades fair in the market.  This allows them to be ridiculously profitable.  A good proprietary trader can make more than the CEO of a large bank in a good year and the guy that controls the money is the one that really runs the bank.  Think Michael Milken of Soloman Brothers in the 1980's.  Best of all for proprietary traders (the high-flying jocks of the traders), you are gambling with the firms money!

Capital markets guys are there to help feel out the markets when the bankers need to raise debt.  An investment banker will say something like "Johnson & Johnson wants to raise $10 billion in debt, they want something that has a pretty short maturity.  How much will it cost them?"  Capital markets will work with a group called "Syndicate" to price the security in the market for the bankers.  Of course this is after the investment banker has pitched to '100' different companies that they need to raise debt and one has finally listened.  A good capital markets guy keeps his pulse on the market and knows how much everything costs at the time.  A capital market workers salary is slightly below a bankers mainly because they lie further from the clients.

Then there are the Operations guys.  This is everything that the bank has that slightly resembles a normal company.  This is management, legal and administration.  Most banks have huge seperate buildings to house the real gritty operations people that actually work out their trades as well as clear their accounts and make sure everything goes through.  These buildings aren't nearly as glamorous as to the buildings for the bankers and traders (ie. Goldman Sachs shuffles all of its operations people off to a large building in New Jersey) and the pay is a fraction of every other position.

So those are the basics of an investment bank, it can be as complicated as you make it but the knowledge above will put you leagues ahead of the average person!

How Does a Bank Make Money?

Often times I find myself wanting to write articles that are not necessarily directly related to personal investing but I feel help to round out the skill set that every investor should have such as How Does a Bank Make Money.  Having knowledge of how what I call a "normal bank" but what we can also call a "retail bank" (a bank that takes deposits from people like you and I and makes loans to small businesses as well as individuals) helps one better understand how the economy operates.

The idea of a simple retail bank centers on a couple big concepts; many people probably use different names to describe the functions that allow a bank to make money without getting too technical.

1) Credit Knowledge - banks gather together employees that are knowledgeable of the credit quality of the clients they lend to and thus are better able than the average person to price and make a loan based on the loan customers credit quality.  Logically, if a bank made bad loans all the time to businesses and individuals that could not repay them the bank would ultimately go bankrupt.

2) Banks take deposits from individuals, aggregate them and lend those deposits out to customers at different maturities to profit from an upward sloping yield curve (this should be sound confusing right now).

The first concept allows banks to operate in a manner which allows them to be profitable in engaging in the second concept.  Lets now focus on breaking down the second topic.

We all understand the concept of a bank taking deposits, we all have some form of a bank account (checking, savings etc.) and we all put our paychecks into a bank or at least cash them at the bank.  What this does is leave the bank with a significant amount of cash that they can then lend out.

I will now introduce a second concept that will be detailed in a later post, it is something called the yield curve.  There are many other names for this curve and there are many other similar sounding curves but the yield curve for United States Treasury Securities (what 99% of people mean when they reference the "yield curve"), is the most important.  The yield curve is just what it sounds like, a listing of different debt that the United States government has outstanding for different maturities and what the yield rate (or interest rate) on each of those securities is.  Usually the it is upward sloping because longer maturity debt almost always carries a premium (higher interest rate) because the longer the term of a loan, the greater the risk that an investor will fail to collect on it.  Below is am image of what the yield curve may look like at any given time.

For a current yield curve navigate to the "Rates" section of http://www.bloomberg.com

So we see from above that as the maturity of United States' debt increases, so does the yield.  In short, if Japan purchases a 30-year United States Federal Government bond, they demand more yield than if they purchase a 5-year bond because a lot more can happen over the 30-year period (more uncertainty) than over the five year period.  I'll introduce the concept of spread later (not all of us can borrow at the same rate as the U.S. government due to credit quality) but in general longer loans have higher interest rates.

So back to how does a bank make money.  We give them our deposits - because we can pretty much demand our money from the bank at any point in time, they are short term deposits and thus offer very little interest.  Everyone can recall that putting your money in a CD (Certificate of Deposit) for a lock-up period of a year or more will usually result in higher interest than a regular deposit account. Many savings accounts yield less than half a percentage point.

The bank takes all those small deposits, bundles them together and makes a large long-term loan to a business in the area.  Because the loan is long-term it demands a higher rate.  The difference in what the bank pays on deposits and what they lend at is called the "Net Interest Margin" and is a key metric in analyzing a banks profitability.  Below is an example illustrating the importance of a bank's "Net Interest Margin."

Suppose a bank pays interest to consumers on their deposits at an average annual rate of say .35% and lends out those deposits at an annual rate of 3.4% they have a NIM (Net Interest Margin) of 3.05%.  Assume their total loans outstanding are two billion dollars.  A little math ($2,000,000,000 * .0305% = $70,000,000) nets the bank a cool $70,000,000 over the course of a year, and two billion dollars in deposits may sound like a lot but in reality that is a rather small bank.  To put it in perspective J.P. Morgan has over two trillion in assets.

So what have we learned?  First off, a bank makes money by borrowing short-term and lending long-term.  In addition, the steeper the yield curve the better for a bank because that means they can get a wider Net Interest Margin.  Lastly, a bank has to be able to analyze credit because if too many customers default on loans, the bank will go bankrupt.  In the future we will discuss more of the inner-workings of more complex banks.  In short, we have now figured out how a bank makes money!

The Rule of 70

Quick post just to give everyone a quick estimation method for figuring out how long it takes money to double.  It is called the "Rule of 70" and this is how it works.

1) Take an interest rate (say 5%)
2) Divide that into 70 (70/5=14)
3) The number you receive is roughly how long it will take in years for your money to double at that interest rate or rate of return.

In this case at an interest rate of 5% your money will double in about '14' years.  This is a quick, often impressive, method that can be used to ballpark how many years it will take your investment to double.

For our math nerds the method comes by taking the natural logarithm of two.  This gives you '.7' which is where the '70' integer is derived from.  In other words if you wanted to see how long it would take your money to triple simply take the natural logarithm of three and multiply by ten.  Then you have the "Rule of 110," to divide your interest rate into and find how long it will take your money to triple!

Why You Should Refinance

A big mistake that I often see, is people that are not taking advantage of the opportunity to refinance there homes.  I decided to work out some numbers for fixed rate mortgages that could prove how much interest can be saved over the life of the loan (technically you should present value the future interest to get a better gauge but we won't worry about it at this point).  Remember this only applies to fixed rate mortgages (not I/O interest only teaser loans, Option-ARMS adjustable rate mortgage or Reverse-ams which actually grow principal over time).

Most people realize the notion that when you get a 30-year fixed mortgage (the Cadillac of mortgages) you will be paying a lot of interest over the course of the loan - but how much interest?  Below is an image to show on a yearly basis roughly how much of your payments are interest over each year of a 10-year fixed mortgage (with an interest rate of around 8%), a thirty year would be even worse in interest!

Email me for a spreadsheet that can work out different rates and maturities!

You can see from the image above that during your first year of payments you are almost paying entirely interest and barely any principal on your loan.  Most people know not to run up credit card debt inter-monthly because you end up paying dear in interest but look what your house is costing you if you pay the minimum mortgage payment.  This should be a red light to pay off your house as fast as possible (after you have settled any debt with higher interest rates).  Below I've worked through some numbers that compare the interest paid over the life of a loan of different maturities over a couple different interest rates.

Suppose you got a $200,000 thirty year fixed mortgage with a 7.5% monthly interest rate.  Your monthly payments would be $1,400 and over the course of the loan you would pay a whopping $300,000 in interest,  what a waste!  Lowering that to a 20 year increases payments to $1,600 but lowers lifetime interest to $184,000.  A ten year increases payments to $2,400 but reduces lifetime interest to $83,000.  Remember, extra interest doesn't get you anything extra.

I had talked about refinancing so lets take a look at the benefits of refinancing to a 5% loan at each of these maturities from that 7.5% interest loan.  Remember, mortgage refinancing requires paperwork and does cost money, usually $3,000-$5,000 which is worth some attention.  Many people are refinancing right now, if you go to bloomberg.com, bankrate.com or any real-estate website you could probably see 30-year averages below 5% (historically this is extremely low).  In the future I will discuss what changes this rate (entities such as Fannie Mae, Freddie Mac and United States Federal Reserve), but at this point assume you get that $200,000 30yr-fixed mortgage at 5% as opposed to 7.5%.

This new loan results in $1,100 payments per month (a savings of $300 per month) and lifetime interest of $184,000 (a savings of $116,000 over the life of a loan).  If you had started with a 20 year 7.5% loan on that $200,000 and converted to a 5% loan you would pay$1,300 a month (a savings of $300 again) and lifetime interest of $115,000 (a savings of $69,000 in lifetime interest).  If you had the ten year your monthly payments would be $2,100 and over the life of the loan you would save $30,000 and only pay $53,000 total.

This should show you that if you can afford the payments, your best bet is to go for a shorter term loan.  If you can refinance, work through some numbers and taking to cost into consideration figure out if the lower payments and interest savings are worth it to you, feel free to email me if you want a spreadsheet to compare different rates a loan terms.  Don't forget to keep that credit rate up, you still have to get approved at your lower rate!  Feel free to email me with any questions - unmaskingfinance@yahoo.com

A Holistic View

The reason I initially decided to make this website was because I realized many of my friends coming out of college didn't have an overall view of how they should be planning their finances.  Many people were missing simple concepts that were making their financial future extremely risky for minuscule additional returns in investing. 

Examples of problems I saw included people that were thinking about playing the stock market before they had sufficient health care benefits, people that were thinking they needed life insurance before they were married, as well as people who were putting all their money in investments without a sufficient cash cushion for emergencies.

In the future I will surely discuss stock, bond, mutual fund, etc. investing but I think before that people need to understand some risk basics and evaluate whether they are in a position to invest. 

I would like to make it clear as well, if someone would like a specific question answered just comment or sent me an email and I will be happy to either answer it or if it is a common question make an entire post about it.