Omaha, Somewhere in Middle America

Sitting in a hotel room in Lincoln, Nebraska getting ready to speak at an Omaha Public Library at noon about how securities regulations affect both industry professionals and investors. Hoping for a good turnout, but one never knows.
On Saturday, the turnout at the Berkshire-Hathaway annual shareholder meeting is expected to be about 35,000, or about 5,000 more than the White Sox usually draw even when still in playoff contention. If you want to learn about investing and perhaps pick up some good information related to the exam, check out Buffett's shareholder letters, starting with 2008. You'll find them at: http://www.berkshirehathaway.com/letters/letters.html
If you open the 2008 letter, you'll see an amazing track record stretching back to 1965 (the year after I was born) and showing a percentage gain of 362,319% for Berkshire-Hathaway vs. the S & P 500's 4,276% gain. In other words, although few people can beat the S & P 500, the few who do can trounce the thing. And, those who invest simply in the S & P 500 index funds can also expect to do pretty well.
I'll let you read the 22-page masterpiece that discusses Berkshire's business model, its recent forays into municipal bond insurance, and how it expects to do in 2009 after having its worst year ever in 2008.

Economic Indicators

Bond yields would be expected to rise due to a drop in which of the following indicators?
A. prime rate
B. unemployment claims
C. GDP
D. building permits

EXPLANATION: remember that bond yields rise as economic activity increases. So, a drop in GDP is associated with falling yields, as is a drop in building permits. If the prime rate is dropping, we would assume other interest rates are dropping. But, when unemployment claims are dropping, that means people are going back to work, which is the only indicator that might point toward an increase in economic activity.

ANSWER: B

Bond yields

Let's look at a possible exam question on everybody's favorite topic: bond yields.

S&P just downgraded a corporate bond, pushing the bond’s yield
A. down
B. sideways
C. up
D. in a bond-ladder direction

EXPLANATION: if the rating goes down, so does the “quality,” which means the price falls. And, when the price falls, the yield rises. Would you pay as much for a junk bond as you'd pay for a Treasury bond? Not a chance--the riskier bonds cost less and yield more.


ANSWER: C

Growth vs. Value

A share of stock is just a share of a company's earnings. The question is, how much are you willing to pay for those earnings? Stocks trade at some multiple to their earnings. For example, if GE is earning $1 per share, investors might pay $10 or even $20 per share to buy the stock. In the first case, the price-to-earnings ratio would be 10 and in the second 20. The higher the price-to-earnings ratio, the more enthusiasm investors have for the company's profits. Stocks trading at high price-to-earnings ratios are considered "growth" stocks. A lot of hope and speculation is built into their price, so they are dangerous to hold--one mis-step by the company, and the stock price could drop by half or more in a hurry, as we've seen with Starbucks recently. A value stock, on the other hand, is already trading on the cheap. GE right now is trading at maybe 5 times earnings, which is almost insane. The stock pays a fat dividend, the company does not appear to be headed to bankruptcy, but the market expresses no enthusiasm for the company's profits and is willing to offer just 5 times the earnings for the stock. A value investor might load up his basket with shares of GE right now, enjoying a high dividend yield and waiting for the profits and the stock price to rise slowly over time. If you recall the Morningstar equity style box, growth is considered more volatile than value. Small cap is also more volatile than large cap, so in terms of volatility, the lowest would be "large cap value," while the highest volatility would be expected in the "small cap growth" fund.
What if a mutual fund manager won't stick to either growth or value stocks? The industry just shoves him into the "blend" category and keeps moving. And let's do the same, as there are so many more testable points you need to know for the Series 65 or 66.

Discretionary Authorization

Which of the following orders would require written discretionary authorization?
A. Buy 1,000 shares of XYZ today
B. Buy 1,000 shares of XYZ when the price is right
C. Buy as many shares of XYZ as you think I should buy when the price is right
D. All of the choices given

ANSWER: C

WHY: written discretionary authorization for the account is only required if the customer lets the rep choose the Action (buy/sell), the Asset (which stock?), or the Amount (# of shares). If the rep is merely choosing the time/price at which to enter an order where the customer has already named the 3 A's . . . that doesn't require written discretionary authorization. So any rep can choose time/price, but only those with discretionary authorization over the account can choose ANY of the three A's.

Bond Yields - The "Yield Spread"

Let's enjoy a difficult practice question on a Saturday, shall we?

One of your customers, Joe Myers, calls to inquire about something he heard but did not quite understand on CNBC. "Why is the price differential between low-risk and high-risk debt securities smaller than usual?" he asks. You would respond
A. turn off the TV and get a life, Joe
B. it means investors are confident in the overall economy
C. it means investors are not insisting on safety to the same degree
D. both B and C


ANSWER: D
EXPLANATION: right now, investors will accept tiny yields on Tbills, Tnotes, and Tbonds and won't touch junk bonds (corporate and muni) unless the bonds offer ridiculously high rates. The "yield spread" has widened in other words because investors are freaking out. For a few days, investors dumped everything and ran to Treasuries, accepting NEGATIVE yields on Tbills. Seriously--people were giving Uncle Sam $1,005 in order to receive $1,000 in 3 months, essentially, which is known in financial textbooks as "really stupid."
Now, if the difference in yields between ultrasafe Treasuries and junk bonds narrows, that expresses confidence. Investors aren't so worried about companies defaulting on them and will pay more for the bonds/accept lower yields.