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Why Diversify?

Investment managers frequently discuss the concept of portfolio diversification. Unfortunately, they rarely explain what this means. Diversification can be...well...rather diverse. Let's consider the basic principles surrounding diversification. For starters, markets tend to be cyclical which is why when the stock market is soaring, the bond market could be collapsing. Also, rarely do security prices move in tandem. In other words, it's unlikely that stocks bonds, commodities, real estate, etc. would all move up or all move down at the same time.   A diversified portfolio contains securities from different classes. For example, a well-diversified portfolio might include a mix of...

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Volatility-Why It's Important

Volatility is one of the most potent forces in the global financial system. Based on the movements in an asset’s price, volatility implies the pricing movements of an asset relative to the overall market. In other words, it measures price variation over time. Suppose company ABC is considered to be extremely volatile. This implies that market movements are magnified in the movement of company ABC's stock price. For example, if the stock market increases one percent in a day, ABC's stock might increase two percent in the same day. Similarly, if the stock market decreases one percent in a day,...

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Futures Explained

Investors are often driven to invest in something that has yet to happen. While buying securities today and holding them in anticipation of a price movement can involve locking up capital, buying a futures contract instead can be a lower cost alternative. Futures are, in essence, contracts that allow you to buy something at a certain price at a specific point in the future. This is particularly useful since the holder can capitalize on the power of leverage. In other words, by putting a relatively small amount down to buy the future, the investor still benefits from any upside movement. ...

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Gross Margin Explained

One of the most important performance numbers is the gross margin. The gross margin is calculated by taking a company’s gross profit and dividing it by total sales. Gross profit is the highest profit number on an income statement and is calculated by taking the total sales and subtracting cost of goods sold (the costs of purchasing or producing the items or services sold). In other words, gross profit assesses how much is earned on the products and services sold by the company. Gross margin, looks at the percentage of sales that this accounts for. Suppose you have a company...

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Managing Stock Market Corrections

The term “stock market correction” implies that something is wrong with the stock market and that a massive selloff is needed to bring stock prices back to reality. What is most troubling about these situations is the speed at which they occur. In a matter of weeks, a market index can lose five percent or more which is enough to scare even the boldest of investors. A correction, however, does not necessarily need to spell doom. Think of it as a chance to purchase your favorite companies at discount prices. When the stock market sells off, oftentimes good companies are...

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Operating Margins Explained

The term “margin” is tossed around in board rooms as well as chat rooms when discussing the performance of a company. Rarely, however, does anyone take the time to explain it. In fact, in some instances the type of margin being discussed isn’t even specified! Gross margins, operating margins, and profit margins are three common ways to measure a company’s performance. In essence, a company’s margin measures some level of profit relative to total sales. This is particularly useful when comparing one company against another. For example, to say that Company A earns $1 million per year and Company B...

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The Risks of IPOs

It sounds like a one way ticket to financial glory. Buy stock in a company that goes public and you can't lose, right? Guess again. An initial public offering (IPO) allows a company to access capital from the public markets. The capital raised can be used to pay down debt or to grow the business. From management’s perspective, it can be a good thing. On the other hand, an investor needs to understand the risks before diving into an IPO. When discussing IPOs, it's important to distinguish between the IPO price and the opening price. The IPO price is determined...

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The PEG Ratio Explained

When it comes to stock valuation, one man's bargain is another man's ripoff. Many stock pickers rely on the popular Price to Earnings (PE) ratio. The PE ratio divides a company's share price by its earnings per share to give a rough indication of relative value. The problem with the PE ratio is that it measures one company against an industry average. If the industry is overvalued to begin with, a relatively low PE doesn't necessarily translate to an investment opportunity. For this reason, some stock analysts prefer the Price to Earnings to Earnings Growth (PEG) ratio. The PEG ratio...

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Why Product Announcements are as Important as Products

Apple has built a reputation as a formidable technology and multi-media company. While much of this has been driven by the company's innovative products, some credit is due to how Apple positions these products long before they are even launched. Apple mastered the art of building buzz around these products and answering just enough questions to keep people guessing. Apple’s product launch strategy serves two purposes. First, it allows nearly every technology reporter a chance to write about the product and hopefully, fuel additional buzz in the process. Simply put, you cannot put a price on this kind of free...

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Why Cash Flow?

Companies across industries do nearly everything possible to maximize earnings. Earnings are widely regarded as the gold standard when assessing a company’s performance. Calculated based on the difference between a company’s sales and all costs and expenses, earnings offer insights as to whether the company is performing effectively. The number carries significant weight in assessing everything from shareholder value to dividend paying capacity. There is, however, a line item within the financial statements that is gaining momentum: cash flow.   The earnings number incorporates cash as well as non-cash numbers in its calculation; cash flow looks at pure cash generated...

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Why EBITDA?

Sure, it's important to understand how much a company earns. A company's earnings, formed by subtracting costs and expenses from from total revenue, provide a good indicator of business performance. And while shareholders and management alike care about this bottom line number, it's just as important to understand the company's EBITDA. EBITDA measures a company's earnings before interest, taxes, depreciation, and amortization. In other words, it assesses the company's operating income. This is important for a couple of reasons.   First, because EBITDA assesses earnings before depreciation and amortization, both non-cash expenses, EBITDA is the income statement’s answer to cash...

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Share Buybacks

Companies have been known to repurchase their own shares when the company’s stock price has fallen significantly. When this occurs, it's a way for management to express that they believe that the stock is undervalued. More importantly, it can push the stock price higher. The gains, however, can be short lived.   Suppose company ABC has one million shares outstanding and a stock price of $100. The company's stock price has fallen significantly over the past year. As a result, management decides to implement a share buyback program. They issue debt to fund the program and over the next several...

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Revenue Guidance is the New Earnings

Stock investors live for the quarterly earnings report. A few weeks after the quarter ends, a company releases its quarterly report in which it discloses its balance sheet, cash flow statement and income statement. Among other things, analysts pay close attention to the much anticipated earnings number that appears at the bottom of the income statement. When this number is greater than what the analysts had predicted, the stock price will often move higher. And of course, if this number is less than what the analysts predicted, the stock price moves lower. Nowadays, however, analysts tend to give as much...

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Selling Put Otions

Selling Put Options We recently learned that options are a nice way to capitalize on the price movement of an underlying asset while limiting risk. They can, however, offer a source of income when sold. For example, on can sell a put option and collect the premium. As long as the stock price remains above the strike price, the option holder makes money. Suppose company ABC has a put option with a premium of $5. The option expires in December and has a strike price of $20. The stock currently trades at $22. If you sold the put option today, you...

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Selling Call Options

In earlier articles, we explored the basics of call options and put options. We learned that call options increase in value when the value of the underlying asset increases. We also learned that put options increase in value when the value of the underlying asset decreases. Option investors can profit by buying options but they can also profit from options by selling them.   Consider a call option on company ABC that has a premium of $5. The option expires in December and has a strike price of $20. The stock currently trades at $18. If you sold the call...

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Put Options 101

You may already know that a call option is a contract that gives the holder the right, but not the obligation, to buy something at a certain price within a certain amount of time. A put option is similar in form and structure with the major difference being that it gives the holder the right to sell something at a certain price, within a certain amount of time. Put options allow the holder the opportunity to profit from a decline in price of the underlying asset or hedge a position held in an underlying asset.     Suppose we believe...

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Call Options 101

Options, while complex and sometimes difficult to understand, play a major role in the global financial system. Used for hedging and speculation, options offer a low risk means to building a position. Let’s explore the call option; one of the most commonly used options. A call option allows someone to buy a certain amount of something, say shares of stock, at a certain price within a certain amount of time. In essence, it's a contract without an obligation. The basic components of a call option include the following:   Strike price: the price at which a share of stock can...

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The Dividend Question

To pay or not to pay, that is the question. Well, at least for many corporate managers, it is often one of the most important questions to ask. Cash rich corporations face the critical decision of whether to retain cash or to pay it back to investors in the form of a dividend. The real answer to this question has to do with whether or not a company is growing.   Suppose company ABC has significant cash reserves and continues to grow at a double digit rate. Assuming that the company will continue to grow, it probably makes sense to...

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Accretive Mergers Explained

As merger mania heats up, corporate managers can be found in boardrooms around the world extolling the virtues of each deal. Among other things, they stress the accretive nature of the merger. What this means is that the deal will create an increase in earnings per share. Sure, combining the earnings of one company with that of another company increases earnings overall but that doesn't necessarily mean that shareholders will earn more on each share of stock. For example, if I own ten shares of stock and I earn one dollar per share, I would hope that after the merger,...

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The Short Squeeze Explained

It’s not uncommon to see a dramatic spike in a company’s stock price based on tepid news. This can leave the average investor baffled but the reason for this is quite simple: a classic short squeeze. A short squeeze occurs when short sellers of a company’s stock are forced to cover their short positions in the midst of positive news. More on that in a minute. Let’s review the basics of short selling. Publicly traded companies issue shares of stock and investors buy and sell them. In some cases, investors seeking to profit from the downward movement in a company's...

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Rigged or Not, You Can’t Afford to Ignore the Stock Market

Is the stock market rigged? If you bought a stock like Twitter at $70 when the analysts were telling you to buy, then sold it four months later at $30 when the analysts told you to sell, you just might think so. The idea that the stock market is rigged is as old as the stock market itself. There are most certainly individuals and institutions who maintain an advantage over others due to their size or access to information. And while these advantages are questionable, it doesn't necessarily mean that the average investor should avoid stocks altogether. The fact is,...

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