Inventory Management

Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.

The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factory would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them.

Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks:

• take up little space,
• minimize stock-holding and
• virtually eliminate the risks of obsolete or damaged stock.

Because JIT manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a good model to strive for as it embraces all the principles of prudent stock management.

The key issue for a business is to identify the fast and slow stock movers with the objectives of :

• establishing optimum stock levels for each category and, thereby,
• minimize the cash tied up in stocks.

Factors to be considered when determining optimum stock levels include:

• What are the projected sales of each product?
• How widely available are raw materials, components etc.?
• How long does it take for delivery by suppliers?
• Can you remove slow movers from your product range without compromising best sellers?

Remember that stock sitting on shelves for long periods of time ties up money which is not working for you.

For better stock control, try the following:

• Review the effectiveness of existing purchasing and inventory systems.
• Know the stock turn for all major items of inventory.
• Apply tight controls to the significant few items and simplify controls for the trivial many.
• Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it.
• Consider having part of your product outsourced to another manufacturer rather than make it yourself.
• Review your security procedures to ensure that no stock "is going out the back door !"

Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.

Our range of financial planners, Exl-Plan and Cashflow Plan, contain extensive facilities for exploring alternative stock-holding strategies. See also the white paper on Making Cashflow Forecasts and Checklist for Improving Cashflow.

http://www.planware.org/workingcapital.htm

Calculating Cashflow and Cashflow Planning

Calculating Cashflow:

Normally, the main sources of cash inflows to a business are

• receipts from sales,
• increases in bank loans,
• proceeds of share issues and asset disposals, and
• other income such as interest earned.

Cash outflows include

• payments to suppliers and staff,
• capital and interest repayments for loans,
• dividends,
• taxation and
• capital expenditure.

Net cash flow is the difference between the inflows and outflows within a given period.

• A projected cumulative positive net cash flow over several periods highlights the capacity of a business to generate surplus cash and, conversely,
• a cumulative negative cash flow indicates the amount of additional cash required to sustain the business.

Cashflow planning:

Cashflow planning entails

• forecasting and tabulating all significant cash inflows relating to sales, new loans, interest received etc. and
• then analyzing in detail the timing of expected payments relating to suppliers, wages, other expenses, capital expenditure, loan repayments, dividends, tax, interest payments etc.
• The difference between the cash in- and out-flows within a given period indicates the net cash flow.
• When this net cash flow is added to or subtracted from opening bank balances, any likely short-term bank funding requirements can be ascertained.
  

If you need to produce regularly-updated cashflow projections, have a look at Cashflow Plan, our range of fully-integrated cashflow planners which generate projections for 12 months ahead and incorporate a roll-forward facility to simplify updating of projections. Details and free/trial version downloads.

http://www.planware.org/cashflowforecast.htm

Key Working Capital Ratios & Sources of Additional Working Capital

Stock Turnover(in days)
Average Stock * 365/Cost of Goods Sold
= x days
On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management.Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.


Receivables Ratio(in days)
Debtors * 365/Sales
= x days
It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ?One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days.


Payables Ratio(in days)
Creditors * 365/Cost of Sales (or Purchases)
= x days
On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.


Current Ratio
Total Current Assets/Total Current Liabilities
= x times
Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.


Quick Ratio
(Total Current Assets - Inventory)/Total Current Liabilities
= x times
Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.


Working Capital Ratio
(Inventory + Receivables - Payables)/Sales
As % Sales
A high percentage means that working capital needs are high relative to your sales.


----


An example:

Company A monthly inventory = $30
Company A annual purchases = $360
Inventory turnover = $30 x12 / $360 = 1 month = 30 days

The bank gives a interest free facility for the first 15 days; after then, interests will be charged on a daily basis from the first day of purchase.

The company presently uses the bank facility of $30.

How can this company manages its cash flow better? How can this company saves on its interest payment?

Company A can continues to enjoy the bank's interest free facility if it can get its inventory turnover to be less than 15 days. This will free up working capital that can be used for other parts of its business.

To save on interest, company can increase its own working capital by injecting cash in the form of equity or a loan from owners. This cash can be used to settle the bank facility at the time period of 15 days, that is, before the facility incurs interest charges. How much cash should be injected into its working capital for this? To do so, would require (15 days/30 days ) x $30 = $15 cash to be injected in the form of equity or loan by the owners, for extra working capital.

----

Sources of Additional Working Capital

Sources of additional working capital include the following:

• Existing cash reserves
• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loans

If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading.

Early warning signs include:

• Pressure on existing cash
  
• Exceptional cash generating activities e.g. offering high discounts for early cash payment
  
• Bank overdraft exceeds authorized limit
  
• Seeking greater overdrafts or lines of credit
  
• Part-paying suppliers or other creditors
  
• Paying bills in cash to secure additional supplies
  
• Management pre-occupation with surviving rather than managing
  
• Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
  

For information on cash flow planning, see Making Cash Flow Forecasts, Cashflow Plan software and Checklist for Improving Cash Flow.

http://www.planware.org/workingcapital.htm

Short-term gain, long-term pain

Just reviewing my transactions in one of my stocks which I have invested since the 1990s. This review starts from May 2006.

The bought and sold transactions since May 2006

15-May-06 xx Bought at 3.98 Present price 8.35 Gain 4.370
31-May-06 xx Bought at 4.06 Present price 8.35 Gain 4.290
13-Jun-06 xx Bought at 3.92 Present price 8.35 Gain 4.430
26-Mar-07 xx Bought at 5.75 Present price 8.35 Gain 2.600
29-Mar-07 xx Bought at 5.95 Present price 8.35 Gain 2.400
03-Jun-07 xx Sold some at 5.3
28-Aug-07 xx Bought at 8.25 Present price 8.35 Gain 0.100
28-Jan-08 xx Sold some at 8.05
06-May-09 xx Bought at 7.70 Present price 8.35 Gain 0.650
05-Jun-09 xx Bought at 7.95 Present price 8.35 Gain 0.400

Stock xxx Avg Price --- Present price 8.35 Gain ---

The present price of this stock is 8.35.

The annual dividend yield of this stock is better than the present FD rate.

Its share price peaked at 9.25 in second half of 2007.

During the severe 2007 - 2008 bear market, the share price was at the lowest of $6.30 in September 2008.



Observations:

There were 10 transactions: 10 buys and 2 sells (partial).

Buying this stock at regular intervals has been profitable.

The prices of the stock bought in the early years were lower than those bought in the later years.

The share price of this stock (good quality company) has reflected its eps and eps growth rate over time.

At the lowest share price of $6.30, the average price of all the transactions were still lower than this market price.

Some stocks were sold for various reasons (e.g. to lock in gains/ or in anticipation of market downturn/ asset allocation/ etc.) in Jun 07 and Jan 08 for 5.30 and 8.05. The present price of this stock at 8.35 is higher than these selling prices.


DISCUSSION:

1. Buying this stock for the long term is safe and profitable.

2. Short term volatilities offer opportunities to buy this stock at bargain prices.

3. The above buying is almost akin to dollar cost averaging (upwards) and it is safe. Dollar cost averaging (downwards) is also safe and probably can give even better returns.

4. Selling this stock at anytime during the 2007-2009 severe bear market and not reinvesting into the same stock at lower prices, gives a lower return than the investor who held onto his stocks during the same period.

5. Lump sum investing into this stock at bargain prices in the earlier years, may give a better return, than dollar cost averaging the same amount over a very long time frame. Dollar cost averaging over a few months (for example 6 months) is almost equivalent to lump sum investing.

6. Timing the market is difficult. Study the above transactions:

• Did this investor buy during the depth of the 2007 - 2009 severe bear market? (This investor has to put in more work on this topic!)
• Did this investor sell at the height of the bull market?

7. In the transactions above, ''buy and hold' strategy can be likened as short term pain for long term gain. In the transactions above, 'buy, sell, and buy back at higher price', can be likened to short term gain for long term pain. ;-)

8. The average price of all the above transactions were significantly lower than the market price almost all the time. This is so even when the market price was at its lowest of $6.30. This gain provides a significant buffer and confidence to the investor of this stock. A value investor would be happy to hold or even load up on this share at the low prices.


CONCLUSION:
It is safe and profitable to buy and hold this and selective stocks.

Selective stocks can be held safely for the long term, even in a severe bear market.

Selling a good quality stock for short-term gain, generates cash which will need to be reinvested. This is not without its associated risks, including, that of not achieving your objective of superior gains in your investments (for example, 15% per year, doubling in 5 years).

Timing the market to buy and to sell is tempting, but is difficult. (trust me on this).

Selling and buying incurs some costs, and when are done frequently, will reduce your returns.

Working Capital Cycle & Working Capital Management

Working Capital

This measures the funds that are readily available to operate a business.

Working capital comprises the total net current assets of a business, which are its stocks, debtors and cash - minus its creditors.



Why it is important

It is vital for a company to have sufficient working capital to meet all its requirements. The faster a business expands, the greater will be its working capital needs.

If current assets do not exceed current liabilities, a company may well run into trouble paying creditors who want their money quickly.

Indeed, the leading cause of business failure is not lack of profitability, but rather lack of working capital, which helps to explain why some experts advise: 'Use someone else's money every chance you get and don't let anyone else use yours.'



How it works in practice

Working capital is also called net current assets or current capital.

Working capital = Current assets - Current liabilities

Current assets are cash and assets that can be converted to cash within one year or a normal operating cycle; current liabilities are monies owed that are due within one year.



What is working capital cycle

The working capital cycle describes capital (usually cash) as it moves through a company:

• it first flows from a company to pay for supplies, materials, finished goods inventory, and wages to workers who produce goods and services.


• It then flows into a company as goods and services are sold and as new investment equity and loans are received.

Each stage of the cycle consumers time.

The more time the stages consume, the greater the demand on working capital.

Cash ----> pay for supplies, materials, finished goods inventory and wages to workers who produce goods and services ---> goods and services are sold and new investment equity and loans are received ---> Cash



Tricks of the trade

- Good management of working capital includes action like collecting receivables faster and moving inventory more quickly; generating more cash increases working capital.

- While it can be tempting to use cash to pay for fixed assets like computers or vehicles, doing so reduces the amount of cash available for working capital.

- If working capital is tight, consider other ways of financing capital investment, such as loans, fresh equity, or leasing.

- Early warning signs of insufficient working capital include:

• pressure on existing cash;
  
• exceptional cash generating activities such as offering high discounts for early payment;
  
• increasing lines of credit;
  
• partial payments to suppliers and creditors;
  
• a preoccupation with surviving rather than managing;
  
• frequent short-term emergency requests to the bank, for example, to help pay wages, pending receipt of a cheque.

- Several ratios measure how effectively and efficiently working capital is being used. (Key Working Capital Ratios : Stock Turnover(in days), Receivables Ratio(in days) , Payables Ratio(in days) , Current Ratio, Quick Ratio, Working Capital Ratio)



Also read:

http://www.studyfinance.com/

Working Capital Management

• Why Firms Hold Cash
• Float
• Ways to Manage Cash

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

http://www.planware.org/workingcapital.htm

• Working Capital Cycle
• Sources of Additional Working Capital
• Handling Receivables (Debtors)
• Managing Payables (Creditors)
• Inventory Management
• Key Working Capital Ratios
• Introducing PlanWare
• Copyright & Legal Stuff
  

How to assess a banking stock

Nett Interest Income
- Loan Loss & Prov.
+ Non-Interest Income
-----------------------
Net Revenue
- Non-Interest Expense
-----------------------
Profit Before Tax
-----------------------
Profit After Tax (Earnings)


How well is the bank managing these risks: interest rate risk, credit risk and liquidity risk?
Is the bank conservatively managed and consistently delivering solid but not knockout profits?

Get a feel for,

• the kind of lending they do,
• the way that risk is managed,
• the quality of management, and
• the amount of equity capital the bank holds.

Here's a list of some major metrics to consider:
1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book


Find the answers to the following questions before investing into a banking stock:

What is the bank's capital ratio (equity-to-assets ratio)? Compare this to the industry average.

What is the level of loan loss reserves relative to non-performing assets?

Is the ROE in the mid to high-teen?

Is the ROA in the 1.2% to 1.4% range?

Is the efficiency ratio (non-interest expense/net revenues) under 55%?

What is its net interest margin (net interest income/average earning assets? (Most banks' margin fall into the 3% - 4% range. )

Track the net interest margins and ask what is the trend? Is it rising? If yes, why?

• Is falling interest rates pushing up net interest margins?
• Examine the bank's loan categories. Is the bank moving into different lending areas pushing up net interest margins?
  

What is the revenue growth? Is this above-average revenue growth?

• Is this revenue growth due to growth in the non-interest income (fee income)?
• What is the percentage of fee income to the net revenue? How fast is this growing? (Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.)
• Is this revenue growth due to growth in interest income? Is this due to paying slightly lower rate on deposits and charging slightly higher rate on loans?

What is the book value of the bank? What is the Price-to-Book ratio? (The base value for a bank should be the book value. For any premium above that, investors are paying for future growth and excess earnings. Typically, big banks have traded in the 2x or 3x book range over the past decade; regionals have often traded for less than that.)

Hallmarks of Success for Banks: Price-to-Book

Banks' balance sheets consist mostly of financial assets with varying degrees of liquidity.

Book value is a good proxy for the value of a banking stock.

Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value. For any premium above that, investors are paying for future growth and excess earnings.

Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.

Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.

A solid bank trading at less than 2x book value is often worth a closer look. Remember, there is almost always a reason the bank is selling at a discount, so be sure you understood the risks.

On the other hand, some banks are worth 3x book value or more, but we would exercise caution before paying that much.

Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.

Lying up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Strong Revenues

Above-average revenue growth: Historically, many of the best performing bank investments have been those that have proven capable of above-average revenue growth.

Wide margins have generally been elusive in a commodity industry that competes on service quality.

• But, some of the most successful banks have been able to cross-sell new services, which adds to fee income, or
• pay a slightly lower rate on deposits and charge a slightly higher rate on loans.

Keep an eye on 3 major metrics:

• 1. net interest margin
• 2. fee income as a percent of total revenues, and
• 3. fee income growth.

The net interest margin can vary widely depending on

• economic factors,
• the interest rate environment, and
• the type of business the lender focuses on,

so it's best to compare the bank you're interested in to other similar institutions.

Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.

A large and diversified company such as Fifth Third generates more than 40% of its net revenues from fee income, whereas smaller, less diversified companies such as thrifts (e.g. Golden West) get just 10% to 12% of income from fees.

Make sure, therefore, that you're comparing similar companies and that you understand the company's strategy. As always, examine the number over a period of time to get a sense of the trend.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Net Interest Margins

Another simple measure to watch is net interest margin.

Net interest margin
= net interest income / average earning assets

Virtually all banks report net interest margins because it measures lending profitability.

There is a wide variety of net interest margins, depending on the type of lending a bank engages in.

Most banks' margins fall into the 3% - 4% range.

Track margins over time to get a feel for the trend.

If margins are rising:

• Check to see what's been happening with interest rates. (Falling rates generally push up net interest margins.)
• In addition, examine the bank's loan categories to see whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Efficiency Ratios

The efficiency ratio measures non-interest expense, or operating costs, as a percentage of net revenues.

Efficiency ratio
= non-interest expense / net revenues
= operating costs / net revenues

Basically, it tells how efficiently the bank is managed.

Many good banks have efficiency ratios under 55% (lower is better).


For comparison, the average efficiency ratio of all insured institutions in the fourth quarter of 2002 was 58.4%, according to the FDIC.

Look for banks with low efficiency ratios as evidence that costs are being kept in check.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: ROE and ROA

Return on Equity (ROE) and Return on Assets (ROA) are useful for gauging bank profitability.

ROE:

Investors should look for banks that can consistently generate mid- to high-teen ROE.

Investors should be concerned if a bank earns a level of ROE too far below this industry benchmark.

Ironically, investors should also be concerned if the ROE is too far above the industry benchmark too.

• Many fast-growing lenders have thrown off 30% or more ROEs just by provisioning too little for loan losses.
• Remember, it can be very easy to boost bank's earnings in the short term by underprovisioning or leveraging up the balance sheet, but this can be unduly risky over the long term.

ROA:

Besides looking for a consistent mid- to high-teen ROE, it is good to see a high level of ROA as well.

For banks, a top ROA would be in the 1.2% to 1.4% range.

Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks: Strong Capital Base

A strong capital base is the number one issue to consider before investing in a lender.

The investors can look at several metrics. The simplest is the equity-to-assets ratio; the higher, the better.

The level of capital should vary with each institution based on a number of factors including the riskiness of its loans, but most of the bigger banks have capital ratios in the 8% to 9% range.

Also look for a high level of loan loss reserves relative to non-performing assets.

These equity-to-assets ratio vary depending on

• the type of lending an institution does, as well as,
• the point of the business cycle in which they are taken.

All of these metrics are found in banks' financial reports, and they can be compared to the industry average.

In the US you can get these figures by logging on to the FDIC Web site, http://www.fdic.gov/.


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Hallmarks of Success for Banks

What should investors look for when investing in banks and other financiers?

Because their entire business - their strengths and their opportunities - is built on risk, it's a good idea to focus on conservatively managed institutions that consistently deliver solid - but not knockout - profits. Here's a list of some major metrics to consider:

1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book

These metrics should serve as a starting point for seeking out quality bank stocks.

Overall, we think the best defense for investors who want to pick their own financial services stocks is patience and a healthy sense of skepticism.

Build a paper portfolio of core companies that look promising and learn the businesses over time. Get a feel for,

• the kind of lending they do,
• the way that risk is managed,
• the quality of management, and
• the amount of equity capital the bank holds.

When an opportunity presents itself - and one always does - you'll be in a much better position to act.

Ref: The Five Rules for Successful Stock Investing by Pat Dorsey


Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book

Banks - It's All about Risk

Whether a financial institution specializes in making commercial loans or consumer loans, banking is centered on: risk management.

Bank accepts 3 types of risks:

• credit,
• liquidity, and,
• interest rate,

and they get paid to take on this risk.

Borrowers and lenders pay banks through interest or fees because they are unwilling to manage the risk on their own, or because banks can do it more cheaply.

But just as their advantage lies in mitigating others' risk, banks' greatest strength - the ability to earn a premium for managing credit and interest rate risk - can quickly become their greatest weakness if, for example, loan loss grow faster than expected.

How banks report their revenue and income

Let us look at how banks report their revenue and income.

Unlike traditional firms, there is no explicit "revenue" or "sales" line. Instead, there are four major components to examine:

1. Interest income
2. Interest expense
3. Non-interest (or fee) income
4. Provisions for loan losses


Here's an example of how the top of a bank income statement will look:

$1000 Interest income
- $ 500 (less) Interest expense
----------------
$500 Net interest income
- $ 100 (less) Provisions from loan loss
+ $ 500 (add) Non-interest income
----------------
$ 900 Net Revenue



Let's ignore the non-interest income component in our further discussion because this is generally steadier than interest income and interest expense.

Interest income
less Interest expense
----------------
Net interest income
less Provisions from loan loss
----------------
$ X


We can see that banks have a natural hedge built into their business.


Consider the following as a base case for a bank operating in a strong economy:

$1000 Interest income
-$500 Interest expense
----------------
$ 500 Net interest income
-$100 Provisions from loan loss
----------------
$400

Suppose now that the Federal Reserve cuts rates. Because the Fed understands the benefit of maintaining a strong balance system, subtle cues are generally communicated before any cut. In the meantime, the banks reposition their balance sheets so that they're liability sensitive, thus allowing net interest income to widen.

However, if a cut happens, it's for a good reason. A recession might be causing unemployment to rise and bankruptcies to increase. That in turn, leads to higher provisions for loan losses for banks. Here's what might happen in a weak economy:

$1000 Interest income
-$400 Interest expense
----------------
$ 600 Net interest income
-$200 Provisions from loan loss
----------------
$400


Have interest rates impacted the bank? Yes and no. Sure, net interest income widened, but this number is meaningless in isolation. After all, the weak economy caused provisioning to double, thereby wiping out the wider interest spread.

In the real world, this relationship doesn't come out to the perfect round numbers laid out here, but it can be close.

• From 2000 to 2001, for example, FDIC data shows that net interest income grew $16.1 billion for the banking industry, mostly because of lower rates.
• However, the weakening economy caused banks to give most of that benefit back in the form of $13.8 billion of increased provisioning.

Virtually all banks can benefit in this type of scenario. However, big banks also have additional tools at their disposal.

• For starters, the breadth of their business lines makes it easier for them to reposition their balance sheet to focus on one sector versus another, depending on the operating environment.
• Perhaps, most importantly, big banks have the ability to access the capital markets to pass the buck by letting investors purchase the loans (much like a bond) and assume the interest rate risk. Then banks - which still service the loans and collect a fee doing so - can focus on their strengths: credit and liquidity risk management.

At the end of 2002, for example, Bank One owned just $11.6 billion of credit card loans - those it held on its balance sheet - yet it managed a total card portfolio of $74 billion. This has happened industrywide and highlights the strength of larger lenders. For instance, although commercial banks and savings banks held 56% of all US consumer loans on their balance sheets in 1990, that number had fallen to 37% by the end of 2002. Why? Because securitized assets - those that are sold off to investors and that banks continue to service - had risen from 6% of loans outstanding to 35%, according to the Federal Reserve.

Thus, while margins can be impacted by interest rates, large financial institutions are making progress toward managing the interest rate cycle. As you're thinking about interest rate risk, remember that the impact it has on a bank's balance sheet is complex, dynamic, and varies from institution to institution.

The Stock Expert Who's Saying "Buy"

The Stock Expert Who's Saying "Buy"
By Selena Maranjian
June 18, 2009





Jeremy Siegel, business professor at the Wharton Business School, has given us investors a lot to learn from. He's the author, for example, of Stocks for the Long Run, and also of The Future for Investors. He's also shown us how to find great stocks and demonstrated the power of dividends.

So when he speaks, we should at least listen, right? Well, he was recently interviewed on public radio, and he advocated investing in stocks for the long haul. "In March,” he said, “we were down more than 50%. And I looked all the way back [over the] last hundred years. Once you're down 50%, your prospects are very good." That's from a guy who has spent a big part of his life studying the stock market's performance over the past 200 years.

Indeed, many well-known stocks are down 50% or more over the past 12 months:

Company
52-Week Return

Alcoa (NYSE: AA)
(72%)

MEMC Electronic Materials (NYSE: WFR)
(71%)

Valero Energy (NYSE: VLO)
(60%)

Chesapeake Energy (NYSE: CHK)
(66%)

Mosaic (NYSE: MOS)
(71%)

Caterpillar (NYSE: CAT)
(55%)

Freeport-McMoRan Copper & Gold (NYSE: FCX)
(58%)


Source: Yahoo! Finance.


One objection I have to Siegel's argument, though, is that it depends entirely on past experience projecting into the future. Think back 100 years to 1909. I know there's much to be learned from the past, but I still worry that we sometimes draw too many parallels. After all, the world was very different then. Our workforce looked different. Our industries were different. Global trade patterns were very different. Business and securities regulation was very different.

He's probably right, though
Nevertheless, I'm not betting against him. Previous bear markets have happened for a variety of different reasons, yet they've all been followed by recoveries. Sure, there's a chance that this time will be the exception. But those who've believed that in the past have gotten burned every time.

As I look at my portfolio, many of my stocks are also down substantially, and I certainly think they're more likely to recover than they are to lose more value over the long run. That's not to say that those share prices won't drop tomorrow, or even over the next year. But over the coming years, I believe these current prices will look like a bargain -- and anyone buying at current levels will be glad they did.



http://www.fool.com/investing/value/2009/06/18/the-stock-expert-whos-saying-buy.aspx





Learn more:
The Best Opportunity in 35 Years
An Opportunity to Jump On
The Next Incredible Buying Opportunity
How to find great stocks
The power of dividends.

Long-Term Buy and Hold Only Works in Bull Markets

Long-Term Buy and Hold Only Works in Bull Markets
By Jennifer Schonberger
June 17, 2009


Long-term buy and hold only works if you can predict a long-term bull market -- or so says Bernie Schaeffer, chairman and founder of Schaeffer's Investment Research.

Since stocks of all walks have been torpedoed in the wake of the financial crisis, pundits are calling into question the viability of the decades-old strategy. Long gone may be the times our grandparents and parents were able to invest in stocks for 10-plus years without rebalancing or cleaning their portfolios.

As part of The Motley Fool's series that seeks to answer the question, "Is long-term buy and hold dead?" Schaeffer weighed in. What follows is an edited transcript of our interview.

Jennifer Schonberger: Do you think long-term buy and hold is dead?

Bernie Schaeffer: I don't see it as a viable strategy, unless you have a way of predicting long-term bull markets.

In March 2000, the S&P peaked at more than 15 times its August 1982 lows. On the other hand, anyone who invested in the S&P from the middle of 1997 to date is very likely losing money. So if you believe we're about to embark upon a 1982-to-2000 run, "buy and hold" will work. In a much more challenging environment, such as the one we've experienced over the past dozen years, it will not work.

The lesson here is never to confuse genius with a bull market, and that powerful bull markets make almost any strategy that involves buying stocks look "smart." What's "dead" is the immutable belief that dominated the investment world as recently as a few years ago -- that buying stocks for the "long term" is always a good deal and the idea that a 100% portfolio exposure to stocks makes good sense.

Schonberger: Do major gyrations in stalwart stocks like General Electric (NYSE: GE) call into question the strategy? Are the days of the blue chip over?

Schaeffer: Let's not forget that GE turned out to be a case of financial engineering in blue-chip clothing. There's also the recent transformation of American International Group (NYSE: AIG) and General Motors -- two stalwarts of the Dow Jones Industrial Average of 30 "blue chip" stocks [that turned] into penny stocks. Before that, there was Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) and before that, WorldCom and Enron.

I think the days that a company can remain dominant in the markets for decades at a time are over. Life simply moves too fast these days. There are no "permanent blue chips." Even Wal-Mart (NYSE: WMT), while still dominant in retailing, has been dead money for stock investors for a decade.

Schonberger: What do you say to investors who have implemented the long-term buy and hold strategy for years and have seen their holdings simply evaporate in the wake of the market meltdown? And it could be years before any of it comes back ... (Good question)

Schaeffer: Always keep a significant portion of your holdings in cash or in bonds -- at least 30%. Stocks are risky investments, even over the "long term." Investors should never be 100% invested in the stock market. ... Asset allocation is critical. There should always be a mixture of stocks, Treasury bonds, and cash. (Nothing new - safety first)

Schonberger: What about diversification?

Schaeffer: Diversification is overrated and gives investors a false sense of security. In bad times, stocks all move down together and in good times you don't need to be very diversified. One of the biggest jokes on investors over the years has been "diversifying" into many stock mutual funds only to find these funds basically own the same stocks.

Schonberger: Should investors do more active managing now than in the past? For example, if you are going to follow the long-term buy and hold strategy, should you have an exit strategy for the short term in case the bet goes south, maybe fundamentals deteriorate?

Schaeffer: Active managing is only worthwhile if you've got the skills to do this. ... [You should only have an exit strategy] if you're going to figure out ahead of the crowd if fundamentals are deteriorating. If you're the last to figure this out, you'll be selling at the bottom.

Schonberger: How long are we talking about here? How long is the "long" in long-term buy and hold?

Schaeffer: Warren Buffett says "forever," and shares in his company [Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B)] dropped by almost 60% from late 2007 to early 2009.

Schonberger: Is index investing still a viable strategy? How has it evolved? There are indexes for everything today -- not just the S&P and the Dow.

Schaeffer: The pitfalls of "buy and hold" represent exactly the pitfalls of index investing, though index investing does have the advantage of keeping expenses such as transaction costs low.

Schonberger: Are we entering an era where if you buy and hold stocks for the next decade, you earn subpar returns? Is it possible that the upcoming decade mirrors the rather lackluster stock market returns of the 1970s, where you saw a couple runs, but on the whole it wasn't so great?

Schaeffer: This is certainly possible. Returning to the huge returns of 1982 to 2000 is also possible. The only way to play these possibilities is to maintain enough exposure to cash and bonds to sufficiently protect yourself against weak periods in the market, while having enough equity exposure to participate in the big rallies.


http://www.fool.com/investing/value/2009/06/17/long-term-buy-and-hold-only-works-in-bull-markets.aspx



More from our experts on the future of buy-and-hold investing:

So Is Buy and Hold Dead or What?
Long-Term Investing Doesn't Work
How to Invest Using the "New" Buy and Hold
Long-Term Buy and Hold May Not Be the Smartest Investing Strategy
If Buy and Hold Ever Lived, It's Dead Now
Bogle on Buy and Hold and the "Long" of Long-Term Investing





Comment: Buy and Hold is only for selected stocks bought at a bargain price.

4 Reasons to Sell a Stock

4 Reasons to Sell a Stock
By Jeff Fischer
June 18, 2009



The hope of profits and the joy of ownership make buying stocks a fairly simple decision, especially in comparison to the tormented hair-pulling that's often associated with selling.

When to jettison a stock is a difficult decision, so we won't pretend there's a one-size-fits-all formula. However, guidelines can make selling decisions easier. At Motley Fool Pro, the following are four key factors in any sell considerations.

1. Valuation
The most cited reason to sell – a fairly valued stock – is also the most difficult to nail down.

We estimate the fair value of a company before plunking money down to buy, determining intrinsic value by digging into financial statements, analyzing business prospects and free cash flow, and making conservative assumptions about future growth.

Buying undervalued stocks, we wait patiently for a price that's close to our estimate of fair value, reassess at that point, and then ruthlessly sell if the stock looks fairly priced. Having personally bought MasterCard (NYSE: MA) in the past around $150, after it cleared $220 -- nearly a 50% gain for a large company -- the stock looked fairly priced. It was difficult to sell such a strong business, but it was the right move. With the stock at $163 one year later, I can consider buying again.

It's not always that easy. Amazon.com (Nasdaq: AMZN) has looked expensive for years, but continues to reward shareholders. If valuation is perplexing you, you need to consider selling just some of your shares (to lock in profits), or protect your gains through other means, and then consider other factors in your sell decision.

2. Fundamental Change in the Underlying Business
Companies are always undergoing change — sometimes for the better, oftentimes not. As patient investors, we're willing to tolerate minor, fixable hiccups along the lines of a weak quarter or delayed product launch. We're not so forgiving of major blunders — think acquisitions that undermine the core business, getting surpassed by a competitor, or a string of failed expansion attempts. Pfizer's (NYSE: PFE) acquisition of Wyeth (NYSE: WYE) was questionable enough to make many sell. Whenever a business undergoes a significant change, you need to put on your thinking cap and reassess.

3. Challenges to Your Investing Thesis
When you make a buy decision, you should write down your reasons and keep them handy. Knowing the most important drivers behind your buys, you can reassess your decision if any part of your thesis is challenged.

Because valuation is part of any thesis, threatening changes can include dividend cuts, deterioration of margins, weakening free cash flow --- or economic shifts. At Pro, we keep the Big Picture in mind. If you'd bought Home Depot (NYSE: HD) believing a housing boom would continue, you'd follow housing news closely and may have seen your thesis falling apart -- forcing a timely sale. So, what's the thesis behind each stock you own? Write it down.

4. Better Places for Your Money
Sometimes a sell decision has little to do with the holding itself — you may simply see better opportunities elsewhere and lack the funds to take advantage. Just as a soccer coach will swap tired players for fresh ones in order to win the game, your portfolio can benefit from shuffling some players, too. In the late 1990s, it was becoming apparent PepsiCo (NYSE: PEP) was making headway while Coca-Cola (NYSE: KO) was struggling – and Pepsi was the cheaper stock. Since 1998, Pepsi has gained 50% while Coca-Cola has lost 24%. That was a great swap.

Just like the five traits of great stocks we keep in mind when we buy, these are some of the criteria at the forefront of our sell decisions at Motley Fool Pro. We launched in October 2008, so we're young, but each position we've closed has been profitable and market-beating.

http://www.fool.com/investing/general/2009/06/18/4-reasons-to-sell-a-stock.aspx

Only 37 stocks in KLSE main board are suitable for long term portfolio

The latest Stock Performance Guide (2009 March Edition) was available recently. I screened for those counters based on certain criterias for possible buy and hold for the long term. Of the 603 counters in the Main Board, only 37 counters are deemed worth further research. 7 of these 37 are small-cap or mid-cap stocks.

The Bursa Malaysia is truly a dangerous play ground for the uninformed. Only a small percentage (37/603 = 6%) are possible candidates for buy and hold for the long term. Also these should be bought when they are not overpriced.

The investors in the market vary from the financial professionals to those without any knowledge on investing. Interestingly, there are some professionals who are losers in the market big time and yet there are some of these novice investors who are surprising winners. These could be accounted for by probabilities and also by certain other reasons. In general, those who are financially knowledgeable are expected and probably do better than those who are less financially knowledgeable as a group.

It behoves the investor who wishes to build a portfolio, using the buy, hold and selective selling strategy, to pick the appropriate stocks at a good bargain price.

It should be an interesting exercise to dissect why so many counters in the Bursa are not suitable for buy and hold for the long term.

Telling an old story

The last 2 years, before the onset of this severe bear market, the following stocks of mine were taken private: Maxis, MOX, VADS, ICP.

These were viewed with some annoyance then, as they were carefully selected stocks for the long term.

Maxis and MOX were privatised before the downturn started. During the downturn, VADS share price was well supported near to the privatisation offer price.

On the other hand, each ICP was exchanged for 30c cash and 0.6 shares of IJM priced at 5.80. Even before the privatisation, the price of IJM went down significantly. Fortunately, the price of IJM subsequently rebounded back to around $5.80 recently and those who held onto the IJM shares obtained through the privatisation of their ICP shares were able to cash out at close to the original offer.

In retrospect, the privatisation of these good companies by the major shareholders, probably saved the minority shareholders from short-term losses, as these shares would definitely have gone down lower with the overall bear market.

Sometimes, we are saved or rewarded by the swings of the market. :-)