Bond Mechanics 101

Here’s a good post on how bonds are calculated: Bond Mechanics 101

Here’s an excerpt:
Bonds generally use a “30/360” convention to determine how interest accrues over time.  This means that interest will be computed on the basis of a 360-day year comprised of twelve 30-day months.  Said a different way, 8.33333% of the annual interest payments on the bonds will accrue during each full month that the bonds remain outstanding (without regard to the actual number of days in the month).  Note that this methodology differs from the “actual/365” convention used in the bank loan market.

When calculating the accrual period, it’s important to know that interest only accrues overnight.  This means, in bondland, you don’t include the end date (i.e., the payment date) when calculating the period within a range of dates, since it is the start date of, and is included in, the next interest accrual period.  For example, during the period “from July 1 to July 24,” a total of 23 nights of interest will accrue.  July 1 counts and July 24 does not.

In bondland, for each calendar month (from the 1st of a month to the 1st of the next month), 30 nights of interest will be deemed to accrue, regardless of the actual number of nights in the month.  Thirty is the magic number.  Note that this produces some interesting results.  For example, the amount of interest accruing during the first 30 nights of a 31-night month is the same as the amount of interest accruing for the entire month (so, no interest accrues on that 31st night).  And the last night of February is a particularly good night for bondholders; during a leap year, two nights of interest accrue during the night of the 29th and, during a normal year, three nights of interest accrue during the night of the 28th.

An example:

  • For bonds with interest payment dates on February 15 and August 15, as of noon on March 3, 2013, even though 16 nights have passed since the last interest payment date, 18/360ths (or 5%) of the annual coupon will have accrued.  This is the math: 16 nights from February 15 to March 1 (14 actual nights, increased by two extra nights on the night of February 28th, to produce a 30-night calendar month), plus 2 nights for the nights of March 1 and 2 = 18.

 

Repost: Best way to start investing

Fantastic post by Lee Musser on Quora

First, don’t count on a finance major or MBA to teach you how to be an intelligent investor.  Most finance curriculum is overly academic and has very little real world application. Most schools base their curriculum on Modern Portfolio Theory and The Efficient Market Hypothesis – two theories that are deeply flawed and have very little real world application.

In essence, a finance major / MBA is not going to make you a good investor.   They will arm you with beautifully complex excel and model building skills, but won’t tech you the first thing about producing alpha or proper business valuation.

A few suggestions on helping you learn and become a better investor:

(1) Read, Read, Read One of the best ways to become good at investing is to learn about companies and different business models. Read SEC filings, Annual Reports, books, hedge fund letters Etc.

Some good investing, finance, and business books for your age and skill level –
(1) The Little Book That Beats The Market by Joel Greenblatt (Greenblatt is a legendary value investor, hedge fund manager, and Columbia University B school prof)
(2) F Wall Street by Joe Ponzio (prolific value investing blogger. Visit his site, which he doesn’t update anymore and read all of the archives. This will teach you 100x more than any finance prof. Link – http://www.fwallstreet.com/)
(3) The Intelligent Investor by Ben Graham (Warren Buffett’s mentor)
(4) One Up On Wall Street and Beating The Street by Peter Lynch (one of the top performing mutual fund manager’s of all time)
(5) Value Investing: From Graham to Buffett And Beyond by Bruce Greenwald, Paul Sonkin, et la (all Columbia B school profs)
(6) The Dhando Investor by Mohnish Pabrai (famous hedge fund manager)
(7) The Essays of Warren Buffett compiled by Lawrence Cunningham
(8) The Checklist Manifesto by Atul Gawande (not really an investing book, but an excellent read on the process of dealing with complexity and limiting mistakes. Highly recommended by Charlie Munger)
(9) Liar’s Poker by Michael Lewis (classic profile of 80’s wall street that somehow inspired a generation)
(10) When Genius Failed by Roger Lowenstein (Fantastic profile of the rise and fall of infamous hedge fund Long Term Capital Management)
(11) Money Masters of Our Times by John Train (Solid profiles of famous investors through history)
(12) Fooling Some Of The People All Of The Time by David Einhorn (Einhorn is my favorite investor and this book is excellent. Might be a bit above your skill level, but still a captivating read)
(13) You Can Be A Stock Market Genius by Joel Greenblatt (another book by super investor Joel Greenblatt. This one is a bit more complex than the one mentioned above, and is all about ‘special situation investing’)
(14) Both Warren Buffett biographies are solid, and will show you how hard Buffett worked and sacrificed to become what he is today. (a) Buffett: The making of an American Capitalist is shorter, but still fasinating (b) Snowball is much longer and detailed, but a very good read.

Note the the above books are anti-market trends / trading / speculating and all espouse some form of value investing. I believe this form of investing to be far superior to all of the rest. If you read all of the above next year you will be well on your way to becoming a very solid investor, and well ahead of your peers.

Once you have the ethos of value investing down then it is time to dig in and get to work on research. Investing is not day trading, it should be viewed as an intellectual pursuit requiring years of fine tuning.

After you have read a couple dozen annual reports and other assorted articles, books, etc it would be a good idea to start a blog. The blog is a good idea for an assortment of reasons, among them:

(1) A score card that tracks all of your hard work
(2) A way to develop and hone your writing and communication skills
(3) A way to network
(4) A portfolio for future jobs

So start researching and write out a thesis for why you think people should buy the stock. A good resource to see some wall street level investment thesis’s is by registering as a guest at http://www.valueinvestorsclub.co…. This site is basically a ultra selective online investment club for hedge fund manager’s and analysts. It is truly an amazing resource and will show you the important things that need to be included in your write ups, and perhaps give you a few good stock ideas.

Above all you need to remember that a stock is more that just a ticker symbol or piece of paper. It represents partial ownership in an enterprise. The price of a stock does not equal the true value of the company, and this price will surely fluctuate. This is hard to stomach for most, but it is essential to be unemotional when investing. Greed and fear are your biggest enemies.

Never invest money that you think you will need to use in the next year. True investing is long – term, and should always be looked at with a 2-5 year time horizon unless it’s a special situation investment.

Forgot to mention something. You should definitely subscribe via email to Howard Marks (chairman of Oaktree Capital) Memo’s to investors. Mark’s is prolific in his analysis and his ability to understand history and how it will affect the future. He has become a sort of legend on Wall Street through these memo’s and he is certainly someone who should be listened to.

Per Warren Buffett, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something”

Go to the Oaktree site and sign up for the email blast to alert when a new one comes out. Also, the complete archive since 95 is on the site and I recommend going through all the old one’s when you have time bc they are filled with wisdom for all times.
link – http://www.oaktreecapital.com/me…

As far as what exactly to invest in –

You need to decide if you’re going to invest in individual securities or some kind of actively managed mutual fund or a low-cost index fund.   I would strongly advise against investing in the vast majority of actively managed mutual funds.  Most actively managed funds underperform the market & passive index funds over the long term.

I suggest Either learning how to invest yourself of go with vanguard. Pretty much all investment reps are worthless and will just put you into a handful of shitty mutual funds that will under perform the market over the long term. The average mutual fund holds over 100 positions, which is already about 70-80 positions too large if you want to consistently outperform the market. Add in five more of those 100 stock portfolio’s and you know have essentially payed your rep and the mutual fund manager to craft you a de facto index fund with the added kicker of high fees, which will ensure you will underperform.

If you don’t have an interest in learning about investing I strongly suggest buying a passively managed index fund with a very low expense ratio. There are other options that will give you better returns than this, but please don’t give you’re money to some hack IR rep or active mutual fund manager.

There are some good mutual fund companies out there, but doubtful that a generic Merrill rep will recommend those. For a solid equity mutual fund company check out Third Avenue Funds (http://www.thirdavenuefunds.com/ta/).

Third Avenue was founded by Marty Whitman, one of the most famous investors of all time.  They have a solid long term track record, although 3k might not be enough to invest with them.

If you want to start investing in individual companies all I can suggest is to learn everything you can about the company and start with easy to understand business models with small cap market values.  Take a class in accounting and valuation.  Read the companies last 5-10 years of of annual reports / financial statements and try to understand a few of the below points:

1) How do they make money?  Measure the company’s profitability.  Is this a good business that will be around for a long time?  Do they have high returns on invested capital?  Do they have have a long term trend in growing EBITDA, FCF, Owner Earnings, etc.  Is the industry the company operates in cyclical?  Are the current earnings depressed, normalized, or peak? If depressed do you feel comfortable modeling out normalized earnings?  Does he current market value / EV justify these earnings?  What is the “market” missing?  Is there hidden value or a future catalyst that will unlock value?  Be confident and back up that confidence with deep due diligence.

2) Does the company possess any long term competitive advantages?  A low cost producer, killer brand, high switching costs, etc.  or are the high ROIC going to revert to the mean once competitors realize there are no barriers to entry and will eventually drive down excess earnings or ROC?

3). What is managements capital allocation history?  Are they shareholder friendly with stock buybacks, dividends, making smart acquisitions, etc.  Do they act like owners?  Is management heavily invested along side shareholders?  If not, why he hell would you invest?

4) How does the company fund its operations?  Debt , equity, FCF, etc.  Ensure company is not over levered and can safely cover its financial obligations.  On average the best type of business is one that earns high returns on capital and can then in turn continually reinvest those earnings at incrementally high rates of return.  Study the companies past investments to get a sense of managements abilities.

5) what are similar companies with similar business charicteristics trading at?  Why is XYZ corp trading at 15X FCF and the business you are analyzing is trading at 5X?  What is the market missing?  Maybe you’re analyzing a retail / fashion company and they missed big during a specific season and all the analyst are focused on monthly same store sales numbers.  Your company is screwed in the Short term but management has a good track record and you believe the margins are depressed for a,b, and c reasons.  Once margins expand to normalized rates and the cash hits the bottom line then that speaks for itself.  In the short term the market is a voting machine in the long term it’s a weighing machine.  Long term FCF / cash earnings growth will eventually be recognized by the market and a proper multiple will be assigned.

There are a ton more “checklist” items that will help you eliminate mistakes when dealing with huge amounts of data but I think you get the point – learn how to value businesses and don’t get taken advantage of by the vagaries of short term market volatility.  Have deep conviction in your analysis; so much so that you want the stock to go down so you can acquire more for a discounted price.

Basically your goal with investing should be to figure out what something is worth and then pay a lot less.  You will do well for yourself if you live by that credo.

Good luck you are about to embark on a fulfilling journey.

EDIT # 1 – I have added some of my favorite value investing documents below.  

(1). Class Notes From Joel Greenblatt’s Special Situations Class @ Columbia B School.  These will change your life.

https://www.dropbox.com/s/gunkw7…

(2) Buffett Partnership Letters from 1957-1970.  These are fantastic.

https://www.dropbox.com/s/fawbas…

(3) Misc Charlie Munger Speeches / Essays.  Needless to say Munger knows how to think.

1 / On The Psychology Of Human Misjudgment

https://www.dropbox.com/s/zeku7j…

2 / Commencementaddress at USC School of Law 2007

https://www.dropbox.com/s/z0qu90…

(4) Michael Burry’s Commencement Speech: UCLA Economics 2012

http://www.marketfolly.com/2012/…

EDIT # 2 – I would like to address in detail one of the comments on my original post.  I have reprinted Patrick Keener’s comment below.  His comments on academic finance and risk management were troubling to me, and I think further discussion is warranted. 

Here is Patrick Keener’s Comment copied in full, I have added emphasis on the particular points I will be digging into and discussing:

First, this was a very well written and thoughtful comment.  Nice job on that-  I also agree with about 95% of what was said. 

What I disagree with though is the value of a finance degree.  Yes, they teach you theory, but the point of the theory is to help understand the world easier.   Note the two key words:  help, as in: they won’t do it alone; and easier, as in: it’s not going to provide perfect clarity.

Regardless, there are three things you need to know to be a good investor:  what to trade, when to trade, and how to manage risk.  Every book includes the first, many include the second, but the third is rarely talked about which to me is fascinating since return on investment is a function of risk. 

Make sure you learn all three equally-  you can have great returns but if you lose them all every time then there’s no point in doing it.

And since we’re all talking about our styles, mine is:

Long/short (minimized delta) for risk mgmt (also certain restrictions on allocation based on firm risk exposures), using fundamental investing (value and growth) for valuation, and trend following for entering & exiting trades (or expected events if they occur).

Here is my response:

Patrick I appreciate the time you took to comment, but I take issue with almost everything that you said.  In fact, I categorically disagree with all of your main points.

All I can think about after reading your comment is the famous bar scene in the movie Good Will Hunting.  In particular, Will’s quote,

you dropped a hundred and fifty grand on a fuckin’ education you coulda’ got for a dollar fifty in late charges at the Public Library.”

What I disagree with though is the value of a finance degree.  Yes, they teach you theory, but the point of the theory is to help understand the world easier.   Note the two key words:  help, as in: they won’t do it alone; and easier, as in: it’s not going to provide perfect clarity.”

I never said a finance degree isn’t valuable.  If you want to work at a bulge-bracket investment bank or sell-side Wall Street shop it will provide all the tools you need.  But, to say that a finance degree from most major business schools will teach you to be an intelligent investor is simply incorrect.

For everyone who isn’t aware — The basic premise of most academic theory is this: It is not possible to beat the market consistently, other than by chance or luck. 

EMT and Modern Portfolio Theory are both an integral part of the finance and investment curriculum at almost all major business schools.  The theories are highly fashionable in academic circles, yet no intelligent investor on wall street or main street currently utilizes them when making buy / sell decisions for shares of stock or whole enterprises.

The EMT / Modern Portfolio theory doctrine are anti-intelligent investing.  Instead of ignoring the vagaries of “Mr. Market” they say the market is everything.  That analyzing businesses and stocks is pointless, because all available public information about the business entities is already reflected in the stock price.  Further, the theory goes further stating that people like Buffett, or Klarman, or Einhorn, or Greenblatt are an anomaly, the beneficiaries of luck.  In their world, capital managed and allocated by the likes of Buffett, Einhorn, Munger, etc. has the same chance of outperforming the market as a random portfolio picked out by throwing darts at a stock table.

Is it pure chance that among all these investors of different backgrounds that there is one common theme?  They constantly have exploited the divergence between  the value of a business and the price at which that business is selling for on the open market.

“Regardless, there are three things you need to know to be a good investor:  what to trade, when to trade, and how to manage risk.  Every book includes the first, many include the second, but the third is rarely talked about which to me is fascinating since return on investment is a function of risk.”

This paragraph just outed you as someone who has never read any of the books I recommended.  If you had read these you would know they are constantly discussing risk in the proper sense.

Before I give you a proper definition of risk as it pertains to intelligent investing I think it will be beneficial to talk about what risk isn’t.

Academic defined risk

Your academics like to define risk as the relative volatility of a stock’s share price, i.e it’s volatility as it compares to that of a large basket of stocks.

With the aid of the previously mentioned beautiful complex excel models, statistical skills, and data bases these academics are able to compute with absolute and absurd precision the “beta” of a particular stock, with “beta” representing the stocks relative price volatility in the past.  They then build laughably complex capital-allocation theories around this calculation.

For value investors and business owners, this academic measure of risk categorically misses the mark and is laughable when viewed in the context of intelligent investing and capital allocation.

Under this view of risk a stock that has dropped very sharply compared to the market becomes “risker” at a lower price than it was at the higher price.  Would that make any sense to an actual business owner?  Would they think this lower quoted price made the enterprise more risky?  NO NO NO – they would think of it as a tremendous buying opportunity; they were now being offered an entire company at a reduced price.

In fact I will go as far as to say that the true investor encourages and welcomes volatility.

A few of the commenters on here have recommended Ben Graham’s fantastic book, “The Intelligent Investor.”  This is indeed required reading for any young investor just getting his feet wet in the markets.  In particular, Chapter 8 is especially useful to recall when thinking about investment risk defined by academics, stock price volatility, and why the enterprising business investor should welcome these huge price fluctuations.

In Chapter 8, Graham introduces the infamous allegory of “Mr. Market,” to help illustrate how a smart investor can take advantage of the market.

Graham told the reader to imagine market price quotations coming from a very emotional, and manic-depressive individual named, “Mr. Market,” who happens to be your partner in a business venture. Every day Mr. Market will offer to buy your share of the business or sell you his share of the business at a particular price.

The economic characteristics of your business enterprise are stable, but Mr. Market’s daily buy and sell offers are certainly not since this poor fellow is driven by his pesky emotions, e.g.  greed, fear, panic, euphoria.  Sometimes Mr. Market is feeling particularly euphoric about the future and can only see the positive factors affecting your enterprise.  In these times of Euphoria and greed he will quote a very high price.  At other times he is very fearful, scared, and in a HUGE PANIC about the trouble ahead for your business.  On these particular occasions he will quote a very low price.

Perhaps the best quality of Mr. Market is he doesn’t mind being ignored.  If the price he quotes to buy or sell the enterprise is of no interest to you, fear not he will be back with a new quote tomorrow.  Buy and sell decisions are solely up to you, and indeed under these circumstances the more manic-depressive Mr. market is, the more opportunities there are for the intelligent investor.  This is true because a market with wide, and erratic price fluctuations means that on occasion irrationally low prices will be attached to excellent business operations. 

Just remember – Mr. Market is there to serve you.  DO NOT LET HIM GUIDE YOU.  DO NOT FALL UNDER HIS INFLUENCE.  If you aren’t CERTAIN that you can understand and value a business better than Mr. Market then you don’t belong in the ring, and YOU ARE THE PATSY AT THE POKER TABLE.

Back to those academics and purveyors of beta and their assessment of risk.  What is it that they do assess aside from past price movement?  Do they care what a company produces?  NO.  Do they care about the company’s competition, or ability to earn high ROIC?  NO.  Or how much debt the company employs?  NO NO NO.  All they need is the PRICE HISTORY OF THE STOCK.

So let’s take a step back and see which investment operation and theory really care about risk management.

1 / The beta purists don’t care anything about the company’s economics, capital structure, future prospects, competitive position, financial results.  All they need to calculate RISK is price history of the stock.

2 / The business investor –  Does not care at all about price history or price fluctuations in a particular stock.  Will constantly seek out only the information and data which will further their understanding of the company’s business operations.  Will only buy security when price being offered by the market is well below their estimated value of the business.

Now we can discuss a more adequate definition of risk, which as I said above, is discussed at length in my reading recommendations. 

The proper definition of risk should be as follows:

The chance of permanent capital loss on an investment

Put in context, this can be understood further.  The following is summarized from one of my favorite books, “The Essays of Warren Buffett” —

“The real risk a investor must assess is wether his after tax returns from a potential investment will, over his prospective period of holding, give him at least as much purchasing power as he had to begin with, plus a modest rate of return on the initial stake.”

“And while this can’t be calculated with complete precision like beta, you can use the below factors to meaningfully evaluate the riskiness of a particular investment:

1 / The certainty with which the long-term economic characteristics of the business can be evaluated;

2 / The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cashflows;

3 / The certainty with which management can be counted on to channel the reward from the business to the shareholders rather than to itself;

4 / The purchase price of the business”

The best way I have found to ensure you won’t loose money is to always have a large MARGIN OF SAFETY.  Meaning, only buy shares in a company when the market price is well below your conservative valuation of the whole business.   Indeed, MARGIN OF SAFETY, is a cornerstone of investment success and will help to manage risk better than any greek letter a finance academic throws at you.    Learn it and live by it.

If you limit your search to company’s with easy to understand, mouth-watering, and enduring economic characteristics that are run by competent and shareholder friendly managements your time will be well spent and you will find some excellent investment opportunities.  If you limit your search and analytic endeavors to those businesses which possess these favorable long-term economic characteristics and you consistently buy those businesses at sensible prices relative to conservatively calculated business value you will have a tremendous long-term track record.