Cash Flow

A company reports its net income after tax (net profit) on the income statement. That net income is reduced if the company is subtracting large amounts for depreciation/amortization. If a company bought a printing press for $1 million cash a while ago, they might be subtracting $100,000 a year until they've written down the cost to zero, in order to spread the cost over the useful life of the equipment. But those subtractions now are not cash--they are a reality check. Since depreciation/amortization is a non-cash subtraction on the income statement, analysts often add back that subtraction to the net income in order to estimate how much cash the company is generating.

In the 10K, the company shows its balance sheet and income statement, and also a statement of cash flows. There are three ways a company can use or generate cash each year: operations, investing, financing. A company can generate or use up cash operating its business, but also by investing in equipment (or selling it off) or issuing securities (or buying them back). So, if the company's cash position increases, analysts would note perhaps that it's simply due to a recent offer of stock or convertible debentures (financing). If the cash position drops this year, maybe it's only because the company wisely invested cash into better equipment (investing). For extra credit "google" a public company's 10K and read thru the consolidated financial statement and the notes to it. It could REALLY help you on a few test questions. NEED HELP with your exam?

Self-Directed IRAs and 401Ks

Some folks might pretend they know the ins and outs of all available retirement plans, but that is not likely. For example, few people know that within an IRA account, an individual can actually invest in real estate, private placements, notes, and other investment options far outside the typical CDs and mutual funds. Self-directed IRAs allow individuals to invest in the typical securities investments that typical IRAs do but also expand into real estate, or possibly even providing start-up capital to a speculative company. Only certain companies can act as the administrator for the self-directed IRA account, but you can certainly find a few if you google the term "self-directed ira" or "self-directed 401K." I guess if I were impressed with my returns on real estate thus far, I might consider switching my Traditional or my Roth IRA to a self-directed account. But, since I prefer to buy REITS to financing and managing my own properties, I will continue to let my current broker-dealer/custodian hold the assets. But, who knows, some investors may want to explore the opportunity of investing in, for example, real estate or start-up companies. The test might even bring up the expanded investment options allowed in "self-directed IRAs" or "self-directed 401Ks."more help CLICK here

How to think about SECURITIES

When confronting tough questions concerning securities, try to process the information like this:


1. Is the INVESTMENT of money a SECURITY? 
     If so, it is subject to the state's anti-fraud authority.
2. Is the security exempt? 

3. Is the transaction exempt? 
      If no on both questions--somebody forgot to get the thing registered!


Okay, let's apply that little list. An indexed annuity is outside the scope of the SECURITIES act, so it's not even subject to the Uniform Securities Act's anti-fraud statutes. On the other hand, a church bond is merely an exempt SECURITY. That means it escapes registration fees and paperwork but is still subject to the Uniform Securities Act's anti-fraud statutes. Finally, a private placement involves a NON-exempt security being offered/sold in a special way. The people connected to the offer, sale, or purchase of this security are all subject to the state's anti-fraud authority.


Now you see why the Howey Decision was so important--if the respondent's lawyers can convince the hearing officer or judge that the investment was not a security, the client walks. Right? If it's not a security . . . it's not a security. If it IS a security it IS subject to anti-fraud rules AND will either need to be registered or exempted from registration.

more help

JP Morgan's $2 billion boner

So, obviously, we don't wanna tick off employees of JP Morgan, especially as no one reading this blog had a darned thing to do with the loss of $2 billion from bad derivatives trading. But, there is a tie-in to a couple of testable points, and all public companies are fair game, so here goes. When/if you see the term "forward" on your exam, you'll need to remember that these derivatives are private, unregulated arrangements between two parties. Because forwards--unlike options and futures--do not trade on regulated exchanges, with settlement dates and margin requirements enforced, we occasionally end up hearing about some tsunami-like effect when one side finally has to admit to themselves, their trading partners, and the regulators--uhhhhhhhhhh, we really screwed up here--wtf? Even though the housing crash was inherently linked to the speculation in mortgage-based derivatives, here we are four years later with the same stuff still happening. Why? Way beyond the scope of the exam and this blog. I just want you to associate the term "forwards" with "unregulated derivatives" and remember that they are private arrangements between two parties.
And, man, do some of these contracts get creative. You're afraid that a corporation you lent $300 million to might default? Structure a derivative in which the other side agrees to pay you X amount if that happens. You find yourself sitting on a portfolio of $5 billion worth of "sovereign debt" issued by OPEC nations and start to worry they maybe cannot or will not pay? Structure a derivative that works like an insurance contract that pays out if that disaster strikes. Or, just make wild speculative bets that X, Y, or Z will occur across the globe, whether it's a bond default, a weather-based event, or probably a hundred things my limited imagination has never considered. Unfortunately, not everyone fully understands what they're getting into, and they frequently forget that the things in life that will "never happen" always do eventually. Only worse.
In any case, I'm not worried about the survival of JP Morgan, but I definitely understand the concerns of the regulators trying to avoid another credit crunch or series of big bank failures. The "banks" these days get to take FDIC insured deposits and then use those funds to make esoteric bets using unregulated derivatives few seem to understand. Obviously, it doesn't work out so well sometimes. Who should pay the price? Shareholders, in my opinion. And then the you-know-what needs to roll UPhill--the shareholders need to organize, vote down the executive compensation packages and even remove the members of the board of directors who don't seem to have any more ability to avoid a $2 billion loss than any random person swearing at an ATM at any Chase(TM) location this afternoon.  More Help Click HERE

Mutual Fund Prospectus, SAI, Shareholder Reports

To REALLY understand mutual funds--and investment vehicles in general--download a mutual fund prospectus, and an SAI, and a shareholder report. If you want the scaled-down, bare-bones disclosure document, download the prospectus or the even slimmer summary prospectus. You'll find the risks and objectives and policies of the fund, the fees and expenses, the taxation issues, etc. But if you want to see precisely what's in the portfolio, download the statement of additional information or SAI. For example, when I look at the prospectus for the American Balanced Fund, I see that: "The fund invests in a broad range of securities, including common stocks and investment-grade bonds (rated Baa3 or better or BBB- or better by Nationally Recognized Statistical Rating Organizations designated by the fund’s investment adviser or unrated but determined to be of equivalent quality). The fund also invests in securities issued and guaranteed by the U.S. government and by federal agencies and instrumentalities. In addition, the fund may invest a portion of its   assets in common stocks, most of which have a history of paying dividends, bonds and other securities of issuers domiciled outside the United States." Okay, that's a good general statement that could attract or repel from an investment in this conservative mutual fund. But if I'm willing to download the statement of additional information/SAI, I can get more detail on the portfolio. For example, I see that within the 69.73% of the portfolio devoted to common stock, there are some 45,386,600 shares of Wells Fargo worth at the time $1.25 billion. The portfolio holds 16 stocks in the "financials" sector, which represents both 10.8% of the fund's industry allocation and approximately $5.3 billion of market value.  By the way, I notice that this mutual fund holds large positions in at least four other companies that issue and/or manage mutual funds. Hey--why not--it's a great business? So, the SAI gives a much more detailed look at the mutual fund portfolio than the prospectus or summary prospectus.  If I want to know that and also how much money the fund pays in expenses to all the various service providers, I need to download the shareholder report--either semi-annual or annual. In this report, I discover that the following parties were paid the following amounts:
  Investment advisory services   121,350,000
  Distribution services  182,738,000
  Transfer agent services  42,807,000
  Administrative services   30,064,000
  Reports to shareholders  2,393,000
  Registration statement and prospectus  762,000
  Trustees’ compensation  458,000
  Auditing and legal   133,000
  Custodian   278,000
  Other   2,214,000
TOTAL EXPENSES $383,197,000

So, the fund's income statement shows that the portfolio earned $1,306,571,000 in dividends and interest, and after deducting $383,197,000 for expenses, the net investment income was $923,374,000. Notice that the adviser earned about $121 million managing the portfolio; the distributor earned about $182 million marketing the shares and providing other services. Heck, just generating the semi-annual and annual reports themselves cost about $2.4 million a year! In any case, I find this stuff interesting. It's painful to dig in at first, but the rewards are pretty high. I mean, if you understand mutual funds to this level, how hard are the test questions really going to be?

RIMM, Research In Motion, BlackBerry

I've been tutoring series 65/66 exam candidates a LOT lately, and one area most seem to struggle with is fundamental analysis. Not sure why so many people are intimidated by the income statement, balance sheet, or statement of cash flows. If you're a business owner, pull up Quickbooks and print your financial statments--how did you do last quarter or last year in terms of sales and profits? That's your income statement. What's your current financial condition in terms of assets and liabilities? That's your balance sheet. If you took a lot of depreciation expenses on your income statement, you might want to see how much cash you generated on the statement of cash flows; or, you can just take your net income after tax on the income statement and add back the depreciation you took on equipment, real estate or other fixed asset.
What's any of this got to do with RIMM/Research In Motion/BlackBerry? Take a look at this scary snippet from a recent headline on the company: "Following quarter after quarter of slashed financial outlooks and missed targets, the company made the ominous choice to discontinue making future predictions about its BlackBerry sales or profit." Huh? What IS a share of common stock? As your exam might say, it's merely a claim on any earnings/profits/dividends the company might have. Well, at RIM right now, there's none of that going on. Last year they made a profit of $934 million; this year they LOST $125 million. So, a share of RIMM right now is a share of a profit that comes in just south of ZERO. Will the company turn around? Here's another snippet: The new CEO said the next several quarters will be difficult ones as the company transitions to a new, bet-the-house platform called BlackBerry 10. That is still on track to become available at the end of the year -- far later than RIM initally planned." Oh, great--so it all comes down to this new platform, and that platform is already suffering release delays. Even if the thing does work out, there will almost certainly be negative news items pushing this stock down indefinitely. Then again, maybe you're a value investor, and you see hidden assets on the balance sheet. Maybe you just feel that sales will improve again, that this "loss" is really due to a one-time event, and as the news drags the stock price down, you load up your shopping cart and just wait for the inevitable turnaround that inconveniently hasn't taken place yet.
Or, you care NOTHING about the COMPANY called Research In Motion because you use technical analysis. Regardless of what the company does, you just trade the stock RIMM based on its price patterns, volume levels, 200-day moving average, what have you. Whatever the case, try to use the financial news to help clarify what you're studying. If you go into the testing center with no real-world understanding whatsoever .. . well, try not to do that. The passing score on the Series 65 exam is 72%; the passing score on the Series 66 exam is 75%. Overstudy?
How?

How do I set up my own RIA?

Most people taking the Series 65 exam are going to work for an investment adviser, but some are actually setting up their own RIA/registered investment advisory firm. Either way, first understand that passing the Series 65 exam is just a pre-requisite. If you pass the Series 65, you can then apply for a license from your state. IARs (investment adviser reps) register with a Form U4; investment advisers register via Form ADV. Criminal and regulatory disclosure is provided on both forms, and this is where it all goes wrong for a handful of people, as you might have seen from other blog posts. For example, some people pass the exam with flying colors but then have to answer "yes" they were convicted of a felony, or convicted of a misdemeanor involving money or dishonesty. For some, this is a game-over.
Of course, most of you have no criminal or regulatory issues, so you can go ahead and take the Series 65 exam all on your own, knowing that the test is really the only issue. Use a U10, pay your money, buy your materials and study, then schedule your exam and pass it.
That would be Step 1.
If setting up your own RIA, you should also be focusing on all of that, and many people choose to use compliance consultants to do so. RIA Registrar includes our materials in their package to folks setting up RIAs. Google them if interested. Our exam materials, btw, are at www.passthe65.com