My last post led to some interesting comments. Canadianmdinvestor argued that Apple’s price is more influenced by “ETF computers” than “average investors.” Which prompted another commentator to ask “What is an ETF?”
An ETF is an “Exchange-Traded Fund.” There are several different companies that offer a wide variety to choose from. The most popular brands of ETFs are SPDRS and iShares. Each ETF has its own ticker and it trades, like a stock, on an exchange. When you buy a share of an ETF you are purchasing an asset that mirrors a pre-determined basket of securities. Usually the basket is an index (e.g. the S&P 500 or the Russell 2000) or a sector (e.g. financials, energy, etc) or a region (e.g. emerging markets or Japan). An ETF may contain stocks, bonds or currency or all of the above. They are a low cost alternative to mutual funds.
Why are they cheaper than mutual funds?
The way an ETF is managed is different than the way a mutual fund is managed. At the inception point of an ETF it generally announces the basket of securities it is going to track. From that point forward the folks running it simply need to make sure that the assets in the ETF match the basket of securities they are modeling. It is not complicated. This type of management is called “passive” management. The cost of administering a fund passively is quite low. A mutual fund might state that it will focus on a particular type of security or sector of the economy, but the people managing it have discretion over how to invest the money. Funds with investment discretion are said to be “actively” managed. Since the mutual fund managers will be researching and making decisions to buy and sell they are paid more money…..and there is an expectation that they will deliver results that beat the market.
Can you be more specific about different types of ETFs?
There are so many ETFs out there that it is almost silly to narrow down the possibilities. Commentator Marc shared one company, Wisdom Tree, that has a large variety of ETFs tracking currencies, equities, and bonds. They have developed a unique system to maximize the return (at least that is what their website says). Here are some examples of other funds out there: you could buy coal producers (ticker KOL) or wind energy (ticker FAN) or companies in Brazil, Russia, India, China (aka BRIC ticker BKF) or pharmaceutical companies (ticker PPH) or literally anything you can imagine. As the scope of the ETF gets more technical the expense of managing it goes up. Further, the more obscure it is, the less liquid it will be.
Why would I invest in an ETF instead of a mutual fund?
Well the cost of investing in an ETF is lower than a mutual fund. Sometimes the difference can amount to as much as 2% a year. Over time that annual 2% difference will really add up. As I stated before, mutual fund managers will tell you that they can outperform the market. This may be true in the short run. But in the long run most everybody reverts to market. So if I am going to invest for a long period of time I’m going with the lower cost alternative that will likely return an equivalent amount anyway. And to show I’m not kidding around, you can see on my disclosure page I own several different ETFs: SPY, RSP, XLF and XLK.
Apple is the largest company in the world based on market capitalization. Their great run over the past few years has many investors giddy, speculating over how they will deploy their cash hoard. But there is one side effect to this explosive growth that some investors may not be aware of: the risk of over-concentration. Many indices and ETFs calculate their holdings based on the market capitalization of companies. Given Apple’s recent growth, the weighting of popular ETFs may surprise some investors.
that’s a complicated way of saying: The meteoric rise of Apple means it represents a larger portion of ETFs and market indices than some investors might realize. One of the most basic tenets of investing is portfolio diversification. Some investors who think they are following that edict will be surprised to learn that Apple still dictates how these “diversified” investments perform. One example: over 17% of the very popular spdr technology sector ETF (ticker XLK) is invested in Apple. Should something terrible happen to Apple, the XLK would be disproportionately effected. Conversely, if Apple continues to rocket higher, XLK will climb too. An investor is certainly more diversified holding XLK instead of shares of Apple. But if she owns Apple and thinks, “I need to add some diversity. I’ll add XLK,” she may not realize how much more Apple she is adding to her portfolio.
Why is over-concentration a bad thing? When you are managing your portfolio it is a cardinal sin to invest everything into one company. Should something happen to that company, think BP’s Deepwater Horizon or Exxon Valdez or the sub-prime mortgage market taking down Bank America, GE and many, many others, your portfolio could be in tatters, worth only a fraction of what it was the previous week. When things go bad, it happens really quickly and there is no way to take it back. So the best way to prevent this from happening is to diversify. Buy quality companies in different areas of the economy. If you really like one sector, buy several companies within that sector. The point is, spread your money around so your portfolio is not relying on one company to do all the work.
Is the risk that Apple could collapse really so bad? Apple seems to have a stranglehold on the tablet market and continues to gain share with its macbook air. The iPhone is a favorite, as is the iPod. And they are working on new products. (eg google “apple tv”) None of these products seems likely to lose their luster. Apple can not make them fast enough. They have dedicated consumers who will wait in line for hours to be the first to acquire some new gadget. But it is lonely at the top. Everybody is gunning for them. Samsung and HTC are creating new phones that look awesome. At some point the well of new ideas will run dry. Expectations will reach unattainable levels. And people will have enough devices that demand will slow. Apple is not disappearing tomorrow, but there is a case to be made it will some day.
I guess what I’m trying to say is not IF, but WHEN. Given that we can surmise Apple will at some point in the future fail to live up to expectation and decline, we should be weary of loading up our portfolios with ETFs that heavily rely on Apple; especially if you already own shares of Apple directly. The last 24 months have seen Apple’s share price increase by nearly $350. It might be time to take some of those gains and look for other investment opportunities.
The Chinese government announced this morning that it was lowering the economic growth target for the country from 8% down to 7.5% a year. Prime Minister Wen Jiabao called for a rebalancing of the economy to a more sustainable, consumer based system.
that’s a complicated way of saying: China has been one of the fastest growing economies in the world for the past several decades. Economists argue over why the high growth rate has been sustainable for so long. Undoubtedly two factors have played a significant role. First, the government has liberalized many different aspects of the economy and encouraged rural farmers to begin working in new industries. This has fostered competition and increased the labor supply for companies who operate within China’s borders. Less government control of markets usually leads to greater business innovation. Second, there have been, and continues to be, large infusions of investment by the Chinese government and companies. New machinery, building factories, and improving infrastructure (airports, roads, ports, railroads, electrical grids, etc), as well as acquiring new technologies to improve efficiency all contribute to higher economic growth.
Why would China want to grow at a slower pace? At some point the rate of growth for China will slow. A country can not grow at elevated levels forever. China may be tamping down the engine of growth in anticipation of the fact that they are closing in on an economic output that is ideal. Growing any larger would be very costly. Producing new buildings or universities would just be a waste of money and effort. No individuals would have the capacity to utilize the tools.
How can the Chinese government slow growth? The government can slow growth by using both fiscal and monetary policies. Fiscal policy would mean less government expenditures. “Expenditures” is construed broadly to include government subsidized research and development, less funding to repave roads or build new bridges, and reducing the number of government employees. Monetary policy might mean increasing the bank reserve requirements for banks or allowing higher inflation. The goal of either fiscal or monetary policy is to reduce the amount of money flowing into the economy from the government.
What repercussions will the decision to slow growth have for the United States and Eurozone? Lower growth in the Chinese economy almost certainly means less demand for developed world products. Companies that specialize in producing machinery used to build factories and roads will be hurt. For example, Caterpillar exports many heavy duty machines around the world. With lower Chinese growth expectations it is likely CAT will find it more difficult to export their goods to China. Companies that are trying to gain a foothold in the Chinese market will have to work harder to find Chinese customers. This means that those companies will need to find demand in other countries which will not be easy to do. If they can not find replacement customers, they will have hard times meeting payroll and revenue targets.
Will the Chinese be successful in lowering the growth rate to 7.5%? Most likely no. While the government will use various monetary and fiscal policies to reduce the amount of growth, other factors that go into the GDP figure will continue to grow rapidly. However, the lower growth target will negatively impact the world economies. Psychologically investors will think there is less opportunity in China. Ultimately, when China reports their actual growth numbers, I predict world markets will rise.
The European Central Bank (ECB), in an effort to stimulate the economy, agreed to lend 800 Euro-area banks 529.5 billion euros ($712.2 billion) for three years. These loans will hopefully improve credit conditions within Europe and stabilize the Eurozone economy. This is the second time the ECB has made loans available on these terms.
that’s a complicated way of saying: Banks in Europe have been reluctant to lend money to governments, businesses and individuals because credit is very tight. The ECB, in an effort to encourage more lending by banks, agreed to loan money at very favorable terms for the borrowers. (The cost being the average of the ECB benchmark interest rate.) This is currently around one percent. Banks are now free to take that money and deploy it however they want. The goal is that they will re-invest the funds into higher yielding positions.
This is not the first time the ECB has made 3-year loans like this available. In December 2011, the same program was instituted. Banks who borrowed money there re-invested the money into government bonds, especially in Spain and Italy. This increase of demand for government debt significantly reduced the borrowing costs of those countries. The hope now is that banks will continue to invest/loan money in government bonds and also expand lending to businesses in order to fuel research and capital development within the Eurozone.
Is it bad that there was record demand for the program? Yes and no. On the one hand it means banks are still struggling to raise money through conventional methods. Further, there is a concern that banks will become reliant on receiving loans on such favorable terms that they will not be able to successfully operate without them. Conversely, such a large number of banks borrowing large sums of money suggests that banks think they have opportunity to make profits. They would not borrow the money if they did not think they would be able to turn around and lend it out at higher rates. More money will be flowing into the economy.
Will this clean up the mess in Europe? Probably not. This is the ECB, an independent arm of the Eurozone, lending money to banks, who are lending money back to governments and some businesses. If you remove the middle man, the government is essentially lending money to itself. The ECB is taking most of the risk and in exchange they get almost none of the profits. On its face, this seems like a ridiculous way to solve a financial crisis. But the profits on those trades are going into the private sector. And when profits increase, people within the economy begin to feel more confident. And where there is more investor confidence, momentum starts to build. And if there is enough momentum, everything will stabilize, economies will grow, governments will collect enough taxes to pay their bills and everybody is happy. That is what the bankers in the ECB (and also the Fed) are trying to accomplish.
Investors looking for “safe” securities have driven down the cost of money for the United States government. The Treasury Department is contemplating whether to issue bonds with a negative interest rate. Many experts have been predicting that this low cost environment is not sustainable. When rates rise, the deficit will balloon without any additional spending.
that’s a complicated way of saying: In order to raise money to pay for the various programs and services it provides, the United States government, through the Treasury department, sells treasury securities. These securities are bonds where the investor gives money to the government in exchange for a fixed rate of return over a period of time. Today, there is high demand among investors (individuals, foreign governments, banks, corporations, etc.) for these securities because they are believed to be “the safest investment in the world.” Because demand is so high, the Treasury Department is able to offer — and sell — treasury securities which cost the government less and less. To be clear, the “cost” is the amount of interest the government agrees to pay to the investor. Because so many investors want to put their money in government bonds (aka treasury securities) the Treasury Department does not need to offer high interest rates to induce investment.
This low cost environment will not last forever for two reasons. First, when an entity borrows more and more money, the normal market reaction is for the lenders (in this case the investors) to demand an increase in the amount of return. The United States has increased her deficit quite substantially in the past decade. It is close to double the size today. At some point, investors will look at the United States and say to themselves, “I am not confident that they will be able to pay back the money I loan to them.” When that happens, the government will need to induce folks to invest by offering higher rates of return. This increases the cost to borrow. You may remember Standard and Poors downgraded the US debt last summer? This is one indicator that the market is growing concerned about the level of the United States debt and whether the government will be able to pay back all that it owes. If this becomes wide spread, borrowing costs will eventually rise. Second, investor’s risk appetite will increase. Treasury securities are very boring investments. On the day you buy them, you know exactly how much money you will make and the exact day you will make it! In any economic environment, the expected yield on an investment in a treasury security will always be among the lowest of all investment opportunities. Given the market crash in 2008, many investors have taken their money out of the stock market and put it into treasuries. As investors get more comfortable investing in the stock market, there will be less demand for government debt. The Treasury Department, in order to attract investment, will need to offer higher rates of return and, therefore, borrowing costs will eventually rise.
The first reason is debatable. It is likely the government will never default on their debts. But, it is not impossible that investors will get skittish and demand higher returns. The second reason is inevitable. Investors will always cycle between the stock market and the treasury market. The flow of money is constant.
What do higher borrowing costs mean for the government? If something costs the government more, that means there is less money to spend on the programs and services it provides. In other words, higher borrowing costs simply mean the government will either have less money to spend (assuming they are unable to borrow more) or the government will have to borrow even more money to pay their debts and pay for the programs and services. I would bet the government borrows more and that the national debt will creep up even more.
At the annual Apple shareholder meeting it was confirmed that the company had over $97 billion of cash and investments. When asked what they planned to do with it Apple CEO Tim Cook said they “have been thinking about this very deeply.” Speculation of how the company will deploy the cash is rampant. Will they institute a dividend? Buy back shares?
that’s a complicated way of saying: Apple is a successful company. Ok, major understatement there. Right now, Apple is probably the most profitable company on Earth. In terms of market capitalization it is the largest company around. In the last twelve months the price of Apple’s stock has gone from around $350 per share to over $500. (As of Friday 2/24/12 it was $522!)
When a company is successful they generate profits. A lot of them. Apple shareholders at the meeting are asking CEO Tim Cook and the board of directors, “How are you going to give those profits to us?” There are 3 general methods for a company to “return value” to their investors. 1) Pay a dividend. This is a direct payment to shareholders. It can be a one time payment or a regular distribution. 2) Buy back company shares. The company will buy shares on the open market and put them into their vault. This has the effect of reducing the float and should cause the price of the stock to go up. 3) Reinvest the money in the company. This could mean buying new machinery or hiring more employees. Or something grander like, buying out a competitor or a related business. If the investments do well the company grows larger, generates more profits and the price of the stock continues to go up.
For the last while (well since 1995, the last time Apple paid a dividend) Apple has firmly belonged in category number 3. They have used the revenue they made to develop new products like iPod, iPhone, and iPad. And the next big thing could be AppleTV which currently is a set-top box, but might morph into another piece of hardware every hip person needs to own. This strategy of holding onto their profits, developing new products and rolling them out to great success has been a winner. The stock price definitely reflects that. That being said, it is not easy to come up with homerun after homerun. At some point Apple will say, we have innovated enough, we have invented enough, we are just going to focus on the business we currently do. When they reach this point, they will need to give the cash on their balance sheet to the investors through the other categories. Probably both of them.
Why wouldn’t Apple want to pay a dividend now? It signals to investors that the board and management no longer expect the explosive growth the company has enjoyed to continue. They are saying, “we expect profits to stabilize and remain steady.” This might alienate those investors who are looking for stocks that will go up in value quickly. On the other hand, instituting a dividend will bring in a whole new class of investor. Those who are seeking regular income in the form of dividend checks. In the short run, Apple announcing that they will pay a dividend should have a positive effect on the stock. (NOTE: some analysts might argue this is already accounted for in the value of the stock as all markets are “forward looking.”)
What will Apple do? My gut tells me Apple will be paying a dividend by Jan 2013. Almost $100 billion of cash is just too much money. It represents more than $100 of cash per OUTSTANDING share. Trust me when I say this is a lot. There is no realistic way the company could use all that money. So they might as well distribute it to the shareholders.
Osborne Hazel
tacwos 