The Difference Between Stocks and Bonds

Many people don’t quite understand the differences between stocks and bonds. It occurred to me recently that even those who invest in these types of securities through either personal investment accounts or retirement plans can’t really articulate what the differences are. I’ve noticed that people have a general idea- such as associating stocks more with risk and bonds more with safety, but that’s about the extent of it. While both are types of investments which can earn you money, they are different as night and day in terms of the potential risks and rewards.

When you buy a share of stock, you are actually taking ownership in the company in which you are investing. For example, consider the hypothetical example of Russell’s Fast Food Palace. If it were a publicly traded company divided into 1 million shares and you bought 1,000 of them, you’d be a .01% shareholder of the Fast Food Palace. As a result, you’d share in both the profits and losses of the company throughout the years. You’d probably want to pay attention to news that affects both the Fast Food market and the economy in general. One of the potential risks in buying 1,000 shares of the Fast Food Palace is that it will experience some sort of problem, such as people realizing fast food is very unhealthy. If this news was publicized enough, less people might come into the stores. This could potentially decrease the company’s revenues and, ultimately, the stock price would decline. The opposite would be if my food became so popular that every airport in the United States decided to put a Fast Food Palace inside. This would be incredible news for shareholders because it would generate much more foot traffic, higher revenues, and higher profits.

A bond does not represent ownership in a corporation. Let’s say Russell’s Food Palace wanted to raise money to open 10 more stores, but they didn’t want to divide up the company any further. They might sell bonds instead of issuing stock. Rather than owning a piece of the company, the bondholder becomes a creditor of Russell’s Food Palace who will be paid back over the life of the bond. The difference is that the return you will earn on your money as a bondholder is generally a fixed percentage such as 5% or 7% annually. If the bond lasts for 10 years, you will get interest each year for the 10 years, and then your principal investment returned to you at expiration date. If you buy a bond from a small, risky company, there is the possibility that the company will
go under and you’ll never see some of your interest payments or principal investment ever again. This is rare however, and it’s more likely, in the short term, to lose money in the stock market than the bond market.

Which is better investment? Well, it totally depends on where you are in life and what your tolerance for risk is. I’d rather own something for a period of years in hope for growth, then lend somebody 200 thousand naira and know I’m getting 250 thousand naira back in 5 years. Thus, I would probably consider myself more of a stock investor. However, the bondholder may very well feel safer and more secure with his/her investment choice. The ideal long-term portfolio would probably have a little bit of each.

Article by a Financial Advisor. Article is slightly modified.


Nigerian Stock Exchange

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Penny/Micro Stocks

Micro-cap stocks are classified as such based on their market capitalization while penny stocks (also known as pennies) are looked at in terms of their price. Definitions of what stocks qualify as penny / micro-cap vary. In the U.S, stock with market capitalization between $50m and $300 m (N6b to N36b) is a micro-cap while less than $50 m (N6b) is a nano-cap. According to the U.S Securities & Exchange Commission any stock under $5 is a penny stock. While all these categorisations are not outlined in any formal/regulatory guidelines in the Nigerian context, but generally as a norm or market perception, a stock trading at a price range of N1 and N10 is usually considered penny.

The main thing you have to know about penny/micro stocks is that they are much riskier than regular stocks. For instance, junk bonds (bonds with a rating lower than BBB) are considered a much higher risk than those of investment grade (bonds with a rating higher than BBB). In the stock market parlance, equivalent comparison is penny stocks and blue-chip.

What is the problem with pennies? Market analysts have identified four major issues which make penny stocks riskier compared to other stocks. These are:

Lack of information access by the public: A fundamental principle that is always preached by many professional analysts is that the key to any successful investment strategy is acquiring enough tangible information to make informed decisions. For micro-cap stocks, information is much more difficult to find. Companies listed on the Second Tier and Third Tier markets have less stringent requirements especially in relation to disclosures and filling of operational reports with the regulators and are thus not as publicly scrutinized or regulated as those on the first tier board. Furthermore, much of the information available about micro-cap stocks is typically not from credible sources.

No minimum standards: Stocks on the Second and Third Tier markets do not have to fulfill minimum standard requirements to remain on the Exchange. Sometimes, this is why the stock is on one of these markets. Minimum standards act as a safety cushion for some investors and as a benchmark for some companies.

Lack of history: Many of the companies considered to be micro-cap stocks are either newly formed or approaching bankruptcy. These companies generally have a poor track record or none at all. As you can imagine, the lack of histories of companies only magnifies the difficulty in picking the right stock.

 Liquidity: When stocks do not have much liquidity, two problems arise: first, there is the possibility that the stock you purchased cannot be sold. If there is a low level of liquidity, it may be hard to find a buyer for a particular stock, and you may be required to lower your price until it is considered attractive by another buyer. Second, low liquidity levels provide opportunities for some traders to manipulate stock prices, which is done in many different ways - the easiest is to buy large amounts of stock, hype it up and then sell it after other investors find it attractive (also known as pump and dump strategy).

The problem for investors

Penny stocks have been a thorn in the side of the regulators for some time because micro-cap stocks‘ lack of available information and poor liquidity make these groups of stocks an easy target for fraudsters. There are many different ways these people will try to part you from your money, but here are two of the most common: Biased recommendations-Some micro-cap companies pay individual analysts to recommend the company stock in different media, that is, financial newsletters, television and radio shows. Look to see if the issuers of the recommendations are being paid for their services as this is a giveaway of a bad investment and make sure that any press releases are not given falsely by people looking to influence the price of a stock.

Buying these stocks

Two common fallacies pertaining to penny stocks are:

Some people thinks that many of today‘s stocks were once penny stocks and that there is a positive correlation between the units of stocks a person owns and his/her returns. Investors who have fallen into the trap of the first fallacy believe NESTLE, OANDO,FIRSTBANK, WAPCO, ACCESS, OCEANIC, ZENITH and many other large companies were once penny stocks that have appreciated to double/triple digit values. Many investors make this mistake because they are looking at the ”adjusted stock price”, which takes into account all stock splits. Rather than starting at a low market price, many of these companies actually started pretty high, continually rising until they needed to be split.

The second reason that many investors may be attracted to penny stocks is the conception that there is more room for appreciation and more opportunity to own more stock. If a stock is at N2 and rises by N1, you will have made a 50 per cent return. This together with the fact that a N20, 000 investment can buy 10,000 shares convinces investors that micro cap stocks are a rapid surefire way to increase profits. For some reason, people think of the upside but forget about the downside. A N5 stock can just as easily go down N2.50k and lose half its value. Most often, these stocks do not succeed, and there is a high probability that you will lose your entire investment.

Tricks involved in trading in pennies

Many people often inquire about how does one trade penny stocks and they wonder if there are any techniques that work best. Technical analysis that uses indicators and statistics to forecast price movements is one possible approach. But due to the novelty of the penny phenomenon, many technicians have not had the time to design a strategy if at all anyone is interested in doing so.

Trading this type of stocks is like throwing darts. Place your order and hope you hit the bull‘s-eye. Technical analysts do normally shun pennies as they trade less often and with meager volumes which defy trend analysis and makes analysis unreliable and liquidity a challenge for trading any size. But as volumes explode, this problem will be mitigated. However, a set of analysts opines that as long as trading is not concentrated in the hands of a few and mass-market psychology is dominant, there is no reason why charting technical trend analysis should not work.

Accomplished and experienced speculators posit that news and rumors are the major forces driving penny stock price movement. Print media hypes, internet message and market hearsays play a significant part, and press releases have the potential to cause large price swings. They argue that traditional charting methods just do not work. Speculators in pennies prefer trading technique which involves getting to know the stock and how it responds to news and rumors. The greater the bustling on the street/investment arenas, the more potential there is for a large price move.

Another strategy employed by these specialists is to dig dip into how many market makers are involved and how they are working the stock. This is reflected in how much stock is trading at various price levels and who is buying or selling. It helps determine which direction the stock may be heading. Meanwhile, dogged adherents of pennies opine that technical analysis begins to make sense in studying pennies when there is sufficient volume traded on daily basis. However, this depends largely on whether the stock has a tight price spread.

However, it is possible to make money on wider spreads buying at the bid (huge demand) and selling at the offer (huge supply) for a small profit, but that is a riskier strategy. Most retail investors often prefer to take position in penny stocks because they can take much larger position sizes than on the larger cap stocks. But it is a different strategy, more akin to gambling than investing or trading.

The final group of penny players is amateur investors who have not heard of technical trend analysis and are buying to hold in hopes that the stock makes a big discovery. But while an investment in the vast majority of penny stocks will never hit a home run, it is fun to dream.

Conclusion: Sure, some pennies might be good quality, and many Second and Third Tier companies are working extremely hard to make their way up to the more reputable First Tier Securities. However, the flip-side is that there many good opportunities in stocks that are not trading for pennies. You need to understand that this is a high risk area that is not suitable for all investors. If you can not resist the lure of micro-caps, make sure you do extensive research and understand what you are getting into.

Explaining Share Offers: IPO, Private Placement, Rights Issue and Offer for Subscription

 Initial Public Offering (IPO)
This refers to a companies first-ever sale of shares to the public. It is the first offer a company makes to the public to raise money through a stock exchange. Take ABC Transport's offer in 2006. Prior to that IPO, the company had not been to the Nigerian Stock Exchange to raise money, previously. An IPO will therefore necessarily come from a previously private company, now ready to go public by allowing other investors to introduce capital and become members.

Cons: The company bringing such offer is hardly well-known, in the sense that, as a previously private company, it had no obligation to publish its accounts or meet any of the corporate governance obligations of public companies. In terms of market trading, there is no track record to rely on to evaluate and project. Various other parameters are absent: for instance, no dividend payment history to judge dividend policy. The implication of all this: an IPO inherently is a high-risk investment, largely a shot into the dark. Take Onwuka High-Tec Plc - dead as soon as the public had bought into the company through its IPO.

Pros: The flip side is also possible. Not having a track record and other factors could lead to a depressed pricing, meaning that significant appreciation can occur, post-offer. The IPO could therefore represent a hidden investment opportunity. Associated Bus Transport IPO came to the market at N1.50. As at 18th July, 2007, that stock had risen to N3.88. That's a 159% growth in . If you don't get that clearly, it just means that a N1 million investment would have grown in value to N2.59 million. Then consider some of the banks that came to the market with IPOs during the banks consolidation programme. Many of the investments have so far proved exceedingly successful.

It all boils down to vigorous scrutiny. What is the business behind the offer? Do the fundamentals look solid? Unless you are speculating on price, you will need to be satisfied about the business you are investing in. Otherwise, let the IPO go, knowing that if the company proves successful, you can always still invest by buying in the secondary market.

Private Placement
This is another avenue for a company to raise capital. In private placement, the offer is privately presented to a limited number of investors, as opposed to an open offer to the public. Usually, this is targeted at well-heeled investors, including fund managers and institutional investors. Overall, this is more flexible for the issuing company since the cost of marketing and administering the offer is obviously lower. It also offers a relatively quiet way of testing the market the first time out.

Pros: If you do get invited as an investor, it obviously means you match the profile of investors the offer is targeting, which is good for you. Considering that they are usually quality investors, the offer is likely to meet a standard that should appeal to such savvy investors. A company will not go for this limited option if it has no inherent investment appeal to attract enough funds from the group. The pricing may also reflect the savings in issue costs, giving some benefit to the investors.

Cons: When used by a new entrant, the challenge of evaluation, given the absence of track record and previous public information on its operation, will have to be dealt with.

As with any investment, you still have the responsibility to ensure you understand the company and its business and that the prospects meet your expectation.

Public Offer
This is obviously the king of all offers, the one for everybody and where you most likely have a good basis for evaluation. That it is not an IPO means the company is already listed and traded on the stock exchange. That readily implies that there is a market history and its operational results are usually made available to the public. A public offer is an offer of shares to the public at large, meaning that any interested investor can buy into the company.

Pros: Usually more screened by the regulators since the general public is expected to invest. Much more is known about the company and its antecedents, improving your investment appraisal beyond figures churned out in a prospectus. A public offer is hardly a quiet affair, assuring that you cannot easily be conned into a phoney offer, a minor risk with a private placement.

Cons: Nothing special, except that you have to evaluate an offer to decide if you want to be part of it.

Rights Issue
This is close to a public offer, only with the limitation that only existing shareholders of the company can buy. Here, a company wants to raise money exclusively from its existing owners. This may be designed to avoid diluting ownership or to keep benefits 'within the family'. Usually, such offers are at a discount (below the current market price), which gives the shareholders an immediate benefit. It must be stated though, that rights are now traded (sold and bought), meaning that the existing shareholders can still sell their rights to persons not previously shareholders. Rights are offered to shareholders in a certain proportion to what they already own (examples 1:2; 1:5) and each shareholders' entitlement is advised him through a rights circular. It's common to have a hybrid offer - a combination of pubic offer and rights issue, as in the case of First Bank's May, 2007 offer.

Pros: Most times, there is a pricing benefit with rights issues being made at a discount. Besides, the rights beneficiary is already a shareholder and presumably familiar and comfortable with the company. It's therefore easier to evaluate the offer. Also, a rights issuer is, by implication, already a public company subject to higher regulatory scrutiny. A rights issue immediately gives a benefit since you can sell your rights even when, for any reason, you cannot invest in the current offer.

Cons: No special challenge, since you can opt out and still sell your rights.

So, the share investment opportunities may come in these various forms. These options all fall into what is referred to as the primary share market. None should be strange now. When they arise, assess them and see if they make good investment for you. Always know that if you can't buy in a primary offer, you can always buy the same stock in the secondary market 

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