Stock Market Terms

Question 1

fungible–

Answer 1

meaning that it can be purchased or traded.

Question 2

true margin of safety

Answer 2

is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience.”

Question 3

To evaluate co. Graham looked at

Answer 3

the value of existing assets, such as cash, inventory, and property, by examining a target company’s financial statements.

Question 4

Graham also looked at

Answer 4

looked at current earnings.

Question 5

Lastly, and only in rare circumstances, Graham considered

Answer 5

future profits, but only in the core competence area of a firm with a sustainable competitive advantage.

Question 6

The concept of mean reversion is a major underpinning of the value- investing philosophy. It means

Answer 6

that past winners often become future losers, while past losers often become future winners.

Question 7

behavioral finance.

Answer 7

the role of market psychology in investing.

Question 8

Graham’s deep value strategy Net–Net.

Answer 8

pick investments was to find companies selling for less than their cash- liquidation value.

Question 9

Graham would consider it a bargain under his Net–Net deep-value approach if when

Answer 9

compared this aggregate amount of cash and hard assets to the stock market value of the firm, the company was selling for less than market value

Question 10

Graham’s distinction between the enterprising investor and the defensive investor.

Answer 10

The difference was based on the ability of the investor to put time and effort into the research process.

Question 11

For the defensive investor, Graham suggested

Answer 11

7 factors in selecting a common stock.

Question 12

Adequate Size.

Answer 12

Graham reasoned that larger firms are less likely to go out of business; that they probably have resources, scale, and experience to weather any storm.

Question 13

Sufficiently Strong Financial Condition.

Answer 13

Graham defined this term as current assets at least twice the size of current liabilities. He also thought total liabilities should not be higher than working capital (that is, current assets minus current liabilities).

Question 14

Earnings Stability. Graham defined earnings stability as

Answer 14

positive earnings for at least 10 consecutive years. This rule eliminates many cyclical firms and those younger than 10 years.

Question 15

A Strong Dividend Record. This criterion recommends

Answer 15

20 years or more of uninterrupted dividends. This rule eliminates most growth stocks, since the vast majority don’t pay dividends.

Question 16

Organic Earnings Growth

Answer 16

of at Least 33% over the Past 10 Years And eliminate businesses that are stagnant or shrinking, even if they pay dividends or generate a lot of cash.

Question 17

Moderate Price-to-Earnings Ratio.

Answer 17

the current price of the stock as not more than 15 times its average earnings over the past 3 years. This number makes sense to many investors, since the long-term P/E ratio for U.S. stocks is about 15.

Question 18

A Moderate Ratio of Price to Assets.

Answer 18

a moderate price-to-assets ratio as a firm trading for less than 1.5 times its book value.

Question 19

Book value

Answer 19

is also known as accounting net worth. It’s equal to all of the firm’s assets minus all of its liabilities. This factor of less than 1.5 times book value also rules out most growth stocks since they often trade at a high multiple of Price to Book.

Question 20

another simple Graham

Answer 20

Create a portfolio that consists of at least 30 stocks with P/E ratios less than 10 and debt-to-equity ratios less than 50%. Hold each stock until it returns 50%. If it doesn’t achieve a 50% return after 2 years, sell it no matter.

Question 21

Buffett’s contribution to the concept of value investing

Answer 21

find high- quality companies selling at a discount and to let the moat around these companies protect his investment, enabling him to hold them for his favorite holding period—forever.

Question 22

This time-value of money, called the “float,” is a boon to an investor

Answer 22

An insurer has the use of every insurance premium for a period of time—from a day to months to forever—before it has to pay a claim on someone’s behalf.

Question 23

Buffett’s moat—a

Answer 23

a durable competitive advantage— a buffer around a company’s core business that makes attack difficult for the competition. Two popular approaches to analyzing a company’s moat are Porter’s 5 Forces and Morningstar’s Economic Moat Framework. bargaining power when dealing with jewelry merchants. Conversely, clothes can be manufactured fairly cheaply in many places around the world, so companies like Nike have a lot of power in their supplier relationships.

Question 24

Porter’s 5 Forces.

Answer 24

a framework to help explain the impact of industry structure on performance, generally referred to as

Question 25

The threat of new entrants.

Answer 25

Certain businesses require massive capital to get started. The harder it is for a new firm to enter a market, the greater the competitive advantage of the firms already in that market.

Question 26

The threat of substitute products or services.

Answer 26

Although some products have no substitute, most industries offer a variety of substitutes. The fewer substitute products or services, the greater the competitive advantage.

Question 27

The bargaining power of customers.

Answer 27

The Internet has given customers great power. Best Buy went from being a dominant company to one struggling to survive because customers could search for better prices on Amazon.com and other websites.

Question 28

The bargaining power of suppliers.

Answer 28

The less a firm is impacted by its suppliers, the greater its competitive advantage. The De Beers cartel of South Africa controls about 35% of the diamonds produced in the world. De Beers has extraordinary bargaining power when dealing with jewelry merchants. Conversely, clothes can be manufactured fairly cheaply in many places around the world, so companies like Nike have a lot of power in their supplier relationships.

Question 29

The intensity of competitive rivalry.

Answer 29

Firms in the airline industry, such as U.S. Airways, went bankrupt because of intense competition. Conversely, the less intense the rivalry, the greater the competitive advantage.

Question 30

Morningstar identified

Answer 30

5 factors that are a framework for its research rating based to a large extent on a company’s moat.

Question 31

The first factor is the network effect.

Answer 31

Morningstar believes a network effect occurs when the value of a company’s service increases, as more people use the service.

Question 32

The second factor is intangible assets.

Answer 32

A patent is an intangible asset that provides legal protection lasting up to 20 years. A brand name is an invaluable asset that can be hard to quantify, but easy to see in action.

Question 33

The third factor is cost advantage.

Answer 33

The concept of a cost advantage can easily apply to many industries. For example, stories abound of Wal-Mart and Home Depot driving their smaller competitors out of business because they couldn’t match the larger firms’ low prices. Having a cost advantage also gives these companies the opportunity to raise prices without worrying about losing the bulk of their customers.

Question 34

The fourth factor is switching cost.

Answer 34

Imagine if you had a new alarm system installed in your house. It would be expensive to switch it for a new system, even if the new system had lower monthly fees. The same concept applies to other products.

Question 35

The fifth factor is efficient scale.

Answer 35

Efficient scale relates to a niche market served by a small number of companies—in some cases, only one. For example, building a hospital is a massive undertaking, so there is likely to be only one in each town or county.

Question 36

Buffett came to believe that a better approach to value investing

Answer 36

would be to buy high-quality companies with a moat around their businesses.

Question 37

Fisher-Price (FP) on growth stock

Answer 37

is like a first-round draft pick: A lot is expected and it is in great demand, so it usually sells at a high price. One reason is that a stock can split.

Question 38

The two most common tools to differentiate growth stocks from value stocks are

Answer 38

the price-to-earnings ratio (P/E) and the price-to-book ratio.

Question 39

P/E ratio is

Answer 39

the price of a share divided by its annual earnings per share. If the P/E of the market is at 15, any stock with a P/E of less than 15 would be considered a value stock, while a stock with a P/E higher than 15 would be considered a growth stock.

Question 40

price-to-book ratio

Answer 40

is the price per share of the stock divided by the book value—that is, the accounting value or net worth figure on the balance sheet—per share.

Question 41

high price-to-book ratio

Answer 41

suggests a growth stock: It’s valued in part on its future potential.

Question 42

Low price-to-book ratio indicates

Answer 42

a value stock: It might be undervalued relative to its intrinsic worth.

Question 43

Another way to differentiate growth from value stocks is

Answer 43

the average valuation level of the market. Anything above the current market average is considered to be a growth stock, while anything below average is considered a value stock.

Question 44

As a growth investor, Fisher looked for companies

Answer 44

with the potential to significantly grow sales for several years into the future. The quality of a firm’s sales force was one of the factors that Fisher assessed. A firm that grows sales at a faster rate than the industry is one sign of a good quality sales organization.

Question 45

Fisher also

Answer 45

the integrity of a target company’s management.

Question 46

Signs of quality management included the following factors:

Answer 46

Management talks freely to investors about its affairs when things are going well and when they’re not.
The firm is able to keep growing when a product has run its course.
The company’s research and development function, or R&D is robust

Question 47

Growth stocks typically have

Answer 47

above-average profit margins.

Question 48

Price is

Answer 48

best known for his life-cycle approach to investing. He felt that the risks of owning a stock increase when the industry it competes in matures. He wanted to buy stocks when earnings were increasing or accelerating.

Question 49

The industry life cycle typically has 4 stages

Answer 49

• A period of rapid and increasing sales growth.
• A period of stable growth. Consolidation tends to occur during this phase.
• Slowing growth or maturity.
• Minimal or negative growth. The industry revenues and earnings are in relative decline.

Question 50

Price’s preferred hunting ground

Answer 50

was the stable growth phase since

Question 51

Price differentiated between two types of growth.

Answer 51

The first is cyclical, where the magnitude of the industry’s growth is tied strongly to the economy. For example, during the 1950s auto sales grew sharply.

The other type is stable growth. In this case, sales are not highly dependent on the specific phase of the economic cycle. For example, health care stocks can grow strongly during a recession.

Question 52

When considering growth, Price also looked at a range of criteria:

Answer 52

• Superior research and development activities likely to spur future growth.
• Avoidance of cutthroat competition.
• Relative immunity from government regulation
• Low total labor costs but fair employee compensation.

Question 53

Besides high growth in sales and earnings per share, Price also wanted

Answer 53

stocks with at least a 10% return on invested capital

Question 54

Return on invested capital can be calculated a few ways, but one popular approach

Answer 54

divides net income by capital, basically the value on its balance sheet of its debt and equity.

Question 55

Return on invested capital can be calculated a few ways, but one popular approach divides net income by capital, basically the value on its balance sheet of its debt and equity.
Many industries are defined by a sort of Darwinian process of elimination for achieving high profits. Price recognized this dynamic and suggested finding the most promising company or companies in a growth industry. He also provided some insight on how to determine when a firm was losing its edge

Answer 55

• Companies lose patents and new inventions may make old
• The legislative or legal environment can get worse for a firm, affecting its ability to grow
• The costs of labor and raw materials also affect a firm’s profitability significantly.

Question 56

He fleshed out his ideas by carefully looking at

Answer 56

sales growth, earnings growth, profit margins, and return on invested capital.

Question 57

Modern portfolio theory has its roots

Answer 57

in Markowitz’s work in the early 1950s. It’s still called modern portfolio theory

Question 58

The Theory of Investment Value,

Answer 58

The price of a stock is equal to the value of its future dividends, adjusted for the time value of money. That is, a dividend of $1 today is worth more than a dividend of $1 in the future.

Question 59

formula for the variance of a weighted sum essentially

Answer 59

is used to calculate the variance of a portfolio—a popular measure of risk.

Question 60

Markowitz also learned about the production possibility frontier concept,

Answer 60

which posits that an economy makes tradeoffs in what it produces.

Question 61

The standard deviation—

Answer 61

the square root of variance—is one widely used measure of volatility.

Question 62

risk of a portfolio is primarily based

Answer 62

on the interaction of the portfolio’s holdings, not on the risk of the securities individually or in isolation.

Question 63

correlation

Answer 63

The mathematical term for the way two assets move with or against each other

Question 64

The art of picking a diversified portfolio

Answer 64

is to select securities that have low correlation and positive expected returns.

Question 65

Markowitz’s efficient frontier

Markowitz called this curve the

Answer 65

the notion of the production possibility frontier and imagined a graphed curve that shows the range of portfolios that maximize return for a given level or tolerance of risk.

Question 66

The optimal portfolio

Answer 66

for you is the place where your indifference curve matches the efficient set of portfolios.

Question 67

Capital Asset Pricing Model or CAPM

Answer 67

model showing that the expected return on any risk asset is equal to the risk-free rate of interest plus the market risk of the asset (beta) times the market risk premium as a whole.

Question 68

risk-free rate,

Answer 68

fixed-income security issued by the government, is virtually free of default. say a fixed-income security issued by the government, is virtually free of default

Question 69

To this risk-free rate add

Answer 69

The beta

Question 70

The average beta of the market as a whole is

Answer 70

one . Therefore, stocks with a beta lower than one are less risky than the market. Stocks with a beta greater than one are riskier than the market.

Question 71

The market risk premium

Answer 71

the expected return on the market minus the risk-free rate. The market premium is tied to market psychology, so it can expand or contract. On average, it tends to be around 6% or 7%.

Question 72

According to the theory, a portfolio of high beta stocks yields

Answer 72

high return. When the market goes up, such portfolios tend to outperform the market and low beta portfolios tend to underperform the market. But when stocks go down, portfolios of low beta stocks tend to lose less than high beta portfolios.

Question 73

from 1966 to the present, the theory held up less well.

Answer 73

High beta stocks returned less than expected and low beta stocks returned more than expected. In some respects, the theory was turned upside-down: Many low-risk investments outperformed many high-risk investments.

Question 74

Fama and French set out to better explain the relationship between risk and return. They found two factors that mattered greatly:

Answer 74

size and style

Question 75

Size is the

Answer 75

market value or market capitalization of the firm. It equals the stock price times the number of shares outstanding. Over long periods, small cap stocks outperform large cap stocks. This finding makes intuitive sense, since small firms are nimbler and can grow quickly from a smaller.

Question 76

Style refers

Answer 76

to growth or value. Value stocks historically return more than growth stocks over long periods because growth stocks tend to be glamorous, and investors often bid them up. Eventually, some run into competition or have missteps and fall back down to earth. Since not much is expected of value stocks, they often fix their problems and show a surprise upside.

Question 77

Professors Fama and French

Answer 77

used the price-to-book variable to differentiate between growth and value.

Question 78

The price part of the ratio is

Answer 78

the market capitalization that measures size.

Question 79

Style refers to

Answer 79

Value stocks historically return more than growth stocks over long periods because growth stocks tend to be glamorous, and investors often bid them up. Eventually, some run into competition or have missteps and fall back down to earth. Since not much is expected of value stocks, they often fix their problems and show a surprise upside.

Question 80

Fama and French used

Answer 80

the price-to-book variable to differentiate between growth and value. The price part of the ratio is the market capitalization that measures size. The book part of the ratio in the denominator is the net worth item on the balance sheet.

Question 81

Book value equals

Answer 81

all the assets on a firm’s balance sheet minus all its liabilities. A firm with a lower than average price- to book-ratio is considered to be a value stock, while a firm with a higher than average price-to-book ratio is considered to be a growth stock.

Question 82

The historical average price-to-book ratio of the Standard and Poor 500 is.

Answer 82

about 2.5

Question 83

Combining the two factors results in the following historical results:

Answer 83

• Small cap value stocks usually have the best performance over long periods.
• Large cap growth stocks usually have the worst performance over long periods. In the short run, investors might gravitate toward the safety of large cap growth stocks, especially during times of market distress, but over the long term, fear usually fades, and these investments tend to provide lower returns.

Question 84

Momentum investors

Answer 84

buy stocks that have been rising and sell or sell short investments that have been falling. In the short run, say a year or less, researchers have found that momentum works. High flyers keep flying and losers keep falling.

Question 85

Liquidity refers

Answer 85

to the ability to sell an asset quickly and at fair market value: Your house is probably not liquid, but blue-chip stock, U.S. Treasury bonds, notes, and bills are liquid.

Question 86

Researchers have found

Answer 86

that over long periods, investors get paid to own illiquid assets. These assets are basically another type of risk.

○ During times of distress, the opposite usually holds. That is, people gravitate towards the safety of liquid investments.

Question 87

you want to make the most money,

Answer 87

buy illiquid, small cap, value stocks that have upward momentum.

Question 88

The stocks that tend to have the lowest return are the

Answer 88

most liquid, large cap growth names, with downward momentum.

Question 89

you follow this approach,

Answer 89

be prepared to hold onto your hat when the market is falling, because in the short run you will lose a lot of money

Question 90

Eugene Fama breaks the efficient market hypothesis into 3 forms, or information sets:

Answer 90

Weak-form efficiency,

Semi-strong form efficiency,

Strong-form efficiency,

Question 91

Weak-form efficiency

Answer 91

wherein investors can’t consistently beat the market using historical price and volume data.

Question 92

Semi-strong form efficiency,

Answer 92

wherein investors can’t consistently beat the market using any public information; not only the historical price and volume information, but also a company’s financial statements, and whatever other information is available.

Question 93

Strong-form efficiency,

Answer 93

wherein investors can’t consistently beat the market using any information, whether historical price and volume data; public information; or private, inside information.

Question 94

The bulk of the academic studies of the efficient-market hypothesis find

Answer 94

that the market is both weak form and semi-strong form efficient, but that the market is not strong-form efficient.

Question 95

An index fund helps answer at least two important questions.

Answer 95

The first is, “How did the market do today?” You need to measure market performance to answer that question.
The second is, “How is my portfolio doing?” To answer that question, you probably want to compare the performance of your portfolio to a benchmark like a market index such as the S&P.

Question 96

equal-weighted index fund means

Answer 96

the price changes in the smallest stock have the same impact on the index returns as the price changes in the largest stock.

Question 97

a fund that owns mostly utility and consumer staples stocks

Answer 97

is likely to have less risk than the market as a whole over long periods, assuming the fund doesn’t materially change its strategy or types of holdings.

Question 98

cautions awareness of the law of large numbers for actively managed funds.

Answer 98

That is, the bigger a fund gets, the harder is it to outperform. One reason is that large funds are generally tilted towards large stocks that are widely followed; the manager is unlikely to uncover something unknown by the market, generally a precondition for outperformance.

Question 99

Bogle suggests

Answer 99

a long-term buy and hold approach. He advises looking at your portfolio once a year so you can have the miracle of compound interest and returns work in your favor

Question 100

target (or horizon date) funds, and tax-advantaged funds.

Answer 100

As you gradually approach retirement age, the horizon As you gradually approach retirement age, the horizon fund will increase your allocation to fixed-income index funds, because they tend to be steadier, and decrease your exposure to more variable equity investments.

Question 101

Index funds are best suited for people

Answer 101

who don’t have a background in financial investments or who are too busy to devote time to picking individual securities or funds.

Question 102

academic studies have found that over long periods,

Answer 102

small-cap stocks tend to outperform large-cap stocks by wide margins. That said, small stocks sometimes
also experience huge volatility swings, especially in declining markets.

Question 103

first measure is market risk, known as beta,

Answer 103

which measures the risk of one investment against the market as a whole.

Question 104

small-cap stocks

Answer 104

tend to be more volatile and usually have a higher level of beta than large-cap stocks.
have higher liquidity risk.

Question 105

One way to determine if a stock has been “discovered,” so to speak,

Answer 105

is to look at the percentage of the stock owned by institutions. This statistic can easily be found at no cost on many financial websites.

Question 106

As a rule of thumb, if institutional ownership is less than 50%,

Answer 106

the stock is not widely followed by larger investors such as mutual funds, hedge funds, and pension funds.

Question 107

Lynch likes small companies that

Answer 107

have proved that their concept can be replicated. Starbucks

Question 108

ADRs are.

Answer 108

negotiable certificates that represent an interest in the shares of a non-U.S. company, are deposited with a U.S. bank, and trade on the major U.S. stock exchanges

Question 109

Selling short

Answer 109

involves the same transaction but in the reverse order: The stock is sold first and purchased later—hopefully at a lower price. If you sold the stock short for $50, and then bought it back later for $40, you made a gross profit of $10.

Question 110

Yale method of asset allocation, a

Answer 110

strategy of mean reversion or rebalancing by trimming winning asset classes and adding to underperforming asset classes. The Yale method that Templeton used is different from what is known today as the Yale Model employed by Yale University’s endowment.

Question 111

A good investment

Answer 111

goes up more than the market on a risk-adjusted basis.

Question 112

Dremen looks for in companies to invest in, he likes

Answer 112

to buy solid or quality companies with high dividends and low price-to-earnings ratios, price-to-cash flow, and/or price- to-book value—at least 30% less than the market as a whole.

Question 113

a quality company, but it usually has several characteristics:

Answer 113

It’s likely to have been in business for a while, to be profitable, to pay a dividend at least 0.5% higher than the average for the market as a whole and with a history of rising payouts, and to have strong management.

Question 114

Dreman prefers to hold

Answer 114

a more concentrated portfolio than the typical mutual fund or index fund. He advises investing equally in 20 to 30 stocks, diversified among 15 or more industries.

Question 115

Dremen

Answer 115

recommends selling a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable its prospects may appear, replacing it with another contrarian stock. Dreman’s approach is always to be a disciplined value investor.

Question 116

mutual fund is

Answer 116

an investment managed for the mutual benefit of its shareholders.

Question 117

expense ratio is

Answer 117

the “all in” number that expresses the fees you pay as a percentage of your overall investment.

Question 118

Growth firms trade

Answer 118

at above-average valuations relative to the market as a whole. For example, their price to earnings or price to book ratios may be higher than the S&P 500’s. By comparison, value firms trade at below-average multiples.

Question 119

Growth investors are often trying to find

Answer 119

rapidly growing smaller firms that have the potential to become large firms like the next Amazon. In contrast, value investors search for stocks trading at a low price relative to the company’s earnings or cash flow or paying an above-average dividend.

Question 120

Value stocks are companies that typically

Answer 120

are growing sales and earnings more slowly than growth firms. They also might be going through some problems, explaining why they may be trading at below-average valuations.

Question 121

Small-cap companies are valued

Answer 121

at less than $1 billion.

Question 122

company’s credit rating.

Answer 122

Standard and Poor, Moody’s, Fitch, and other credit-rating services evaluate the debt of most public companies. A bond rated below BBB– is considered high-yield or junk. If you are a stock investor, you’ll want to have a high level of conviction before investing in a company with a junk credit rating.

Question 123

Lynch had a portfolio liked

Answer 123

to buy baskets of companies in an entire industry. His logic was that when you are looking at small firms or a new industry, you might not know which will emerge as winners. Therefore, if you are right on the industry at large—and buy a basket of its stocks—then the winners will go up in multiples; if you avoid borrowing, you won’t lose more than 100% of your

Question 124

He looked for companies that consistently

Answer 124

bought back their own shares. If a company buys back its own shares, it tells the market that it thinks its stock is undervalued.

Question 125

Lynch Looked for companies that started out with

Answer 125

little or no institutional ownership. If the amount of institutional ownership is less than 50% of the total number of shares outstanding, the institutions haven’t piled in yet. Once the institutions pile in, the stock price can take off.

Question 126

Lynch viewed insider buying by management

Answer 126

as a positive sign. Corporate insiders should know more about the firm than almost anyone else.

Question 127

Interest-rate risk.

Answer 127

When interest rates go up, traditional bonds fall in value because the bond is viewed as riskier and is valued less. When interest rates fall, traditional bonds usually rise in value because the risk is perceived to be lower.

Question 128

Reinvestment rate risk.

Answer 128

When rates rise, the coupons and maturing face value or bond principal can be reinvested at higher rates in newer securities, drawing investor interest away from the older instrument.

Question 129

Default risk.

Answer 129

If a bond defaults, it may be forced into bankruptcy, and the bondholders may seize the assets of the issuer—often after a long and protracted bankruptcy court battle.

Question 130

Liquidity risk. A liquid asset is one that can be sold quickly, and at fair market value.

Answer 130

During times of market distress, such as the Great Recession in 2008, illiquid assets often take a big hit. In the bond market, they tend to be bonds that have less trading volume; bonds with low credit ratings; emerging markets bonds; and bonds with wide bid-ask spreads—the difference in price between when you buy and when you sell.

Question 131

Gross believes that successful investment over the long run, whether in bonds or in equities,

Answer 131

depends on developing a long- term outlook and acquiring the right mix of securities within an asset class. he believes that 3- to 5-year forecast horizons force an investor to avoid the near-term fluctuations that lead to panic and bad investment decisions. This focus makes him a top-down investor.

Question 132

The expected return on a bond over its term should be

Answer 132

pretty close to its yield to maturity—that is, the return from the coupon payment and the capital gain or loss on the instrument, together known as the bond’s total return. Gross focuses on yield-to-call estimates, as opposed to yield-to-maturity calculations, when estimating the most probable total return on a bond held until maturity.

Question 133

Gundlach believes

Answer 133

that if you buy bonds during periods of illiquidity and drops in price, you are likely to profit after the fear subsides and normalized market-levels return.

Question 134

Fannie Mae and Freddie Mac are

Answer 134

government-sponsored entities backed by the credit rating of the U.S. government and designed to facilitate the functioning of the mortgage market. In 1981, Fannie Mae issued the first mortgage-backed security. Think of it as a bond in which the cash flows are a group of individual mortgage payments rolled into a single security.

Question 135

Gundlach specializes in buying

Answer 135

Gunlach likes securities that appear to give a higher return than their credit risk might indicate. Like Freddie and Fannie Usually they trade at close to AAA or AAA- ratings while providing a slightly higher yield than U.S. Treasury securities.

Question 136

Gundlach usually starts

Answer 136

with a top-down view and sets a macroeconomic horizon of about 3 years when he enters a position.
*
This top-down analysis—taking into account the general state of the

Question 137

When conducting his top-down analysis, Gundlach looks at a few variables.

Answer 137

• One is the yield curve
• Gundlach also looks at what is happening in the economy
• looks at the credit cycle, which refers to bank lending and customer-default rates. Historically, as the economy approaches recession, credit gets tight and defaults go up.

Question 138

the yield curve—

Answer 138

a graph of the relationship between time to maturity and yield to maturity. The yield curve typically slopes upward, with long-term interest rates higher than short-term rates.

Question 139

Gundlach also looks at what is happening in the economy.

Answer 139

Gross domestic product growth might be a useful measure of how the economy is doing as a whole.

he also looks at the credit cycle, which refers to bank lending and customer-default rates. Historically, as the economy approaches recession, credit gets tight and defaults go up.

Question 140

This top-down analysis—taking into account

Answer 140

the general state of the economy, liquidity in the debt market, and borrower health—gives Gundlach a sense of the credit and interest rate risk in his portfolio.

Question 141

This top-down analysis—

Answer 141

taking into account the general state of the economy, liquidity in the debt market, and borrower health—gives Gundlach a sense of the credit and interest rate risk in his portfolio.

Question 142

Then Gundlach and his team turn to

Answer 142

a bottom-up analysis for bonds

Question 143

a bottom-up analysis for bonds,

Answer 143

which might include looking at loan-level details and specific geographic areas. They check relative value among different credit sectors in fixed-income, at horizons of about 3 years and do a rich/cheap analysis on the various bond sectors, including emerging and foreign markets.

Question 144

Why should we care about sovereign wealth funds?

Answer 144

The answer is because they control more financial assets than hedge funds and private equity funds combined, amounting to more than $7 trillion. As sovereign wealth funds grow in size and importance, they have come to play larger roles both in their own countries’ affairs and in market battles between traditional, independent companies and state-owned and -controlled companies.

Question 145

The U.S. Treasury Department defines a sovereign wealth fund as “

Answer 145

A Government Investment Vehicle which is funded by foreign exchange assets and which manages those assets separately from the official reserves of the monetary authorities, (the Central Bank and reserve-related functions of the Finance Ministry).”

Question 146

The distinction is intended to clarify

Answer 146

the difference between official reserves managed by a country’s central bank, with short-term horizons, focused on liquidity and security, and the longer horizons associated with, for example, national pension systems.

Question 147

Three main drivers behind the creation and growth of sovereign wealth funds

Answer 147

are balance of trade, economic stability, and the desire of sovereign nations to diversify their assets.

Question 148

The International Monetary Fund further classifies sovereign wealth funds in 5 categories, according to their form and function:

Answer 148

Stabilization funds
Savings funds 
Development funds
Pension reserve funds
Reserve Investment Corporations

Question 149

Stabilization funds

Answer 149

are formed to insulate a state budget and economy from commodity price volatility and external shocks. These investments sometimes are designed to move in the direction opposite the commodity prices against which a government wishes to insulate its economy.

Question 150

Savings funds

Answer 150

are designed to transform nonrenewable assets into financial assets that can be shared across generations. These portfolios are invested primarily in equities and other

Question 151

Pension reserve funds, as in Australia, Ireland, and New Zealand,

Answer 151

invest in equities and other investments to offset rising retirement liabilities.

Question 152

Reserve Investment Corporations are more

Answer 152

complex funds designed to earn higher returns on foreign reserves or to reduce the negative carrying costs of holding them. They may invest in equities and alternative investments to achieve higher returns.

Question 153

Axiomatic in the United States and the United Kingdom is that the goal of an investment fund is

Answer 153

to appreciate in value and maximize shareholder wealth.

Question 154

In many countries, the goal of an investment fund is not only to appreciate in value and maximize shareholder but also

Answer 154

That other stakeholders receive important consideration, including customers, employees, the local community, and the government itself.

Question 155

The balance of payments includes

Answer 155

all payments and obligations to foreigners balanced against all payments and obligations received from foreigners. The balance of payments must balance.

Question 156

If one country runs a persistent trade deficit with another, something must happen on the other side of the international ledger to square it away.

Answer 156

The typical transaction of the country with the trade surplus is to invest trade proceeds in securities or some other asset. Thus a trade deficit is usually offset by a positive financial account—including holdings such as foreign investments in stocks, bonds, commodities and real estate— or capital account balance including holdings such as foreign direct investment, which can include physical investments in equipment, buildings, and factories.

Question 157

The term “hedge” in a financial context.

Answer 157

means to reduce risk

Question 158

Although no uniformly agreed definition of a hedge fund exists,

Answer 158

a good working definition is a private investment vehicle that charges two types of fees: an asset-based fee assessed as a percentage of assets under management and a profit-sharing or incentive fee taken from the fund’s earnings, if any.

Question 159

Hedge funds typically

Answer 159

charge 1% or 2% of assets, plus a percentage of the profits they earn on your investment. The standard profit sharing fee is 20%, but some funds take as much as 50%

Question 160

These 3 characteristics—

Answer 160

limiting regulation, taking 20% or more of the profits and dynamically adjusting the long to short ratio— describe the bulk of hedge funds today.
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Question 161

Loeb says that most of his investments share the following characteristics:

Answer 161

They have talented management teams.

They are businesses with strong and growing free cash flows. Free cash flow is money remaining after reinvesting in the business.

They are firms with a proven track record of capital allocation; that is, the company has invested its money wisely over the long term, whether in new projects or in mergers or acquisitions. Capital allocation also includes returning capital to shareholders in the form of stock buybacks or dividends.

Question 162

Ackman prefers companies that generate a lot of free cash flow, an important and recurring concept.
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Answer 162

The cash-flow statement has 3 parts: cash flow from operations, generated by a company’s core business; cash flow from investing activities, which mainly refers to capital expenditures or long term investments; and cash flow from financing activities, relating to the issuance or repurchase of stock or debt. The net increase (or decrease) in cash is the sum of the 3 parts of the cash-flow statement.

Question 163

Value investing is the investment strategy

Answer 163

that selects stocks based on a belief that they trade for less than their intrinsic value. That is, value investors seek stocks they believe the market has undervalued.

Question 164

Selling short: is called

Answer 164

Selling a stock in which you have no current position selling selling borrowed shares and hoping to buy them back later at a lower price.

Question 165

hypothecation agreement,

Answer 165

which allows the firm to lend your shares to other investors, usually hedge funds. To help a client sell short, the firm investors, usually hedge funds. To help a client sell short, the firm borrows the shares from another client of the firm.

Question 166

To engage in this short trading means

Answer 166

establishing a margin account using borrowed funds. While you have the ability to buy and sell stocks on margin, custody remains with the brokerage firm until the transaction is complete and you’ve fulfilled your obligation.

Question 167

for short sales An example is a stock that is overvalued: Investors rightly

Answer 167

expect to profit by selling it short, pocketing today’s price on the expectation the price will fall and completing the purchase after the price has dropped.

Question 168

Soros posits

Answer 168

a feedback loop between prices and fundamentals—earnings, dividends, and interest rates— wherein the price itself impacts the fundamentals.

Question 169

Soros’s investment thoughts were influenced in part by Werner Heisenberg, one of the pioneers of quantum mechanics, best known for the Heisenberg Uncertainty Principle,

Answer 169

which says that that the act of measuring influences the measurement.

Question 170

Soros’s theory of reflexivity states that

Answer 170

the connection between participants’ thinking and the situation in which they participate reflects two functional relationships: cognitive and participating.

Question 171

The cognitive function is

Answer 171

the participants’ efforts to understand the situation.

Question 172

The participating function is the

Answer 172

impact of their thinking on the real world.

Question 173

Because these two functions interact with one another in a recursive process,

Answer 173

markets are rarely in equilibrium, or balance. And yet, equilibrium is one of the central concepts of economics. The market is prone to boom-and-bust cycles.

Question 174

Soros provides some guidance on how a boom-bust cycle usually plays out. He says it

Answer 174

consists of seven stages.

Question 175

Soros seven stage

Answer 175

1. trend that is not yet recognized by the public 2. other people act on news and make the same trades. Soros calls this the initial phase. 3. surge in prices peters out. if the stocks that attracted attention survive this initial phase, they emerge strengthened. Soros calls this a period of acceleration. 4. large gap emerges between public perceptions and a company’s fundamentals, and the market also recognizes this reality. Soros calls this the moment of truth. 5. Stocks can stay inflated for a long time; they are overvalued. Soros calls this the period of stagnation, or twilight period. 6. something causes a broad loss of belief in the stock. This widespread loss of belief causes a reversal in the popular buying trend. Soros calls this the crossover point. 7. Selling results in more selling. causing an accelerating downward trend. Soros calls this phase a crash.

Question 176

Soros came to believe that modern economic theory has a fundamental problem:

Answer 176

that it is based on the assumption of a market usually in equilibrium, where fundamentals almost always drive prices.

Question 177

Soros believed

Answer 177

the market is rarely in equilibrium, and he added an element of thinking previously all but unaccounted for in market dynamics. And that is that investors impact market fundamentals through the feedback loop of their own thinking and trading in the market.

Question 178

several lessons from Soros and his theories:

Answer 178

1. have a global outlook.
2. try to understand how our own investing decisions are based on market movements and the actions of others and not simply on the market fundamentals.
3. be cognizant of the market’s tendency to gravitate toward boom-and-bust-cycles and the opportunities that these movements might afford.
4. if you are a trader, as opposed to being a long-term investor, be as willing to go short as you are willing to go long.
5. for the more adventurous and less risk averse—if you have high conviction in an idea, be willing to bet big.

Question 179

Bridgewater’s focus is

Answer 179

global macro- and multi-strategy. That is, the firm searches the world for investment opportunities and uses a range of strategies, both long and short, with a variety of financial instruments.

Question 180

Dario All-Weather strategy is

Answer 180

divided into 4 quadrants, driven by growth and inflation. It is managed by using trading models that historically have worked in each of the 4 quadrants. Thus, regardless of the general state of the economy and financial markets, usually at least something is working well in this portfolio.
Another unique facto

Question 181

technical analysis, which

Answer 181

relies on historical patterns in price and volume data in the belief they have some predictive value.

Question 182

moving average,

Answer 182

averages a stock’s data over different time periods and has the benefit of smoothing out erratic data. A stock trading above its moving average is considered bullish, while a stock trading below its moving average is considered bearish.

Question 183

Jones uses the

Answer 183

200-day moving average of closing prices. By keeping an eye on the 200-day moving average, an investor can sell quickly if the trend is down. Jones advises never averaging losers. In other words, if a position starts losing money, either sell or wait for the trade to be profitable before adding more capital.

Question 184

fundamental analysis:

Answer 184

examining such factors as earnings, interest rates, and industry gossip.

Question 185

Quantitative analysts

Answer 185

build financial models to estimate the value of security prices.

Question 186

fundamental analysis,

Answer 186

which focuses on looking at a company’s financials, along with its management, and factors affecting the industry, and

Question 187

technical analysis which

Answer 187

focuses on changes in security prices and their corresponding trading volume.

Question 188

Quants might look

Answer 188

at price and volume data, but also at a host of other data—including interest rates, currency values, financial statement data, and much more—to create their own quantitative models.

Question 189

the term black swan

Answer 189

describe an unforeseen and perhaps unpredictable event.

Question 190

One widely used technique is called a factor model,

Answer 190

which estimates the relationship between two variables. Independent variables are used to help predict dependent variables, and it’s not uncommon for quant models to contain dozens of independent variables.

Question 191

The term risk off refers

Answer 191

to an environment in which fear pervades the market, and investors are selling assets that are traditionally risky: such as stocks, high yield bonds, and emerging market securities. In a risk off trade, safe haven assets like U.S. Treasury notes or gold often outperform.

Question 192

The term risk on indicates that

Answer 192

investors are willing to increase the risk of their portfolio by purchasing more volatile securities, which they deem to have significant upside. High yield bonds and the stocks of smaller or speculative firms may also do well in a risk on environment.