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    Someone asks the other day about Bonds and other investment types. I though it might be worth publishing a few rantings, purely so you’d have something to read on the toilet…

    There are a substantial number of types of Investments around. I’d like to cover a range of these to promote discussion. I’m only going to focus on securitised investments (not Stamps Wine etc), which fall into three broad categories:
    1. Cash (Safest/Liquid): Deposits, Notes, Bills, Bonds.
    2. Property (Safe/Low Liquidity): Listed and unlisted Property Trusts
    3. Shares (High Risk/Liquid): Equities, Derivatives

    Each of these stem from a need to raise money (with the exception of Derivatives which I’ll discuss later). In the last 25 years, Bonds (and the Investment Banks that issue them) have become hot ticket items. Why? Historically if a company needed a loan they would go to the (Retail) Bank and get a loan, at say 6%. The Bank would take deposits, paying say 4% from people like us (investors) to cover the loan. This worked for many years and the banks made lots of money. Eventually the company’s felt they were being ripped off, and so did the people/institutions putting their money on deposit. Along came Investment Banks. They said to the companies, ”We’ll charge you 5%, plus a fee” and to the people said, “We will pay you 5% interest if you invest in this bond (instead of putting your money in the bank)”. The companies got their money cheaper (<6%), the retail investors got paid 5% instead of 4% and the IB got a fee (but due to the large size of the loans, it’s more commonly Superannuation Funds that buy Bonds rather than retail investors). Everyone was happy and a massive Bonds market was born. The Retail banks were unhappy until they setup their own Investment Banking arms thanks to government help.

    That’s enough background to start us off. I’ll walk through Investment types starting at the safest and end at the riskiest.

    Investing Safely:
    The safest investment is a Government Bill or Note (called Treasury Notes in the states). These are Discount Securities. A discount Security is sold for a price less than its face value e.g. It’s face value is $US10,000, but it is sold for (say) $US9,923. The difference in price $77, is the interest you receive for holding it for the period (normally 3 months). This is completely Government guaranteed.

    The next safest investment is an “at call” bank deposit. The interest is not government guaranteed like a T-Note, only the principle. Term deposits are next, but their lower liquidity increases risk. Then Government “Aussie” Bonds (2,5 then 10 year), then Bank Bills (not as safe as Com Gov Bills).

    Listed Property Trusts slide in next, followed by unlisted property trusts (you cannot invest directly through the Stock Market). Then offshore Bonds (such as Samurai, Yankee and Kangaroo bonds (Kangaroo’s are safest due to the lack of currency exposure). Then you’d look to the range of Company Bonds through to Low quality Company Bonds (called Junk bonds).

    Almost lastly comes Ordinary Shares (aka Equities). These are very unsafe and even rate lower then the taxman in the case of liquidation. When a company needs to raise money but cannot (or doesn’t want to) get a loan or issue a Bond, they can sell part of themselves (a bit like one of us selling a kidney) to get money. If you value a company at $1million dollars and want to raise $100,000, then you can issue (subject to a prospectus) 10% of the company as shares (ignoring the fees). Then, according to Company Law, you can trade that part of the company on an exchange such as the ASX.

    Lastly (ignore Company options and hybrid investments) are Derivatives (have I told you all the avoid these yet?). In the case of derivatives (“Investments” derived from another Asset), such as ETO’s (Exchange Traded Options (not company options), Warrants (simplified ETO’s (you can’t write)), or Futures. If you didn't already know everything in this post, stay away from these. The safest are warrants, because you can only lose 100% of your capital. The only type of warrant that is allowable for a SMSF (Self Managed Super Fund) is a installment Warrant. No other derivatives are allowed unless you can show it's purely a hedging strategy. You can get more details on ETO's from the asx website or Futures from the SFE website.

    It's better to start investing from the top of this list. Any expert will tell you you should not have more than 10% of you portfolio in the derivatives market (a higher level if fully exposed).

    Many of the Traders/Punters here (you need to hold your shares for at least a year to be called an investor) seem to be interested in Small Market Cap(Capitalisation) stock, which could generally be referred to as a company that has a total shareholder value (Market Cap = No of Shares x Price) of less than $AUD10Million. These are also called the “Penny Dreadfuls” and hence the Copper in HotCopper.
    However these have become investments with a poor return. For each one that does take off, many fade into nothingness. Despite supposed deposits of massive Diamonds, gold and other mineral finds as well as miracle medical claims (with the best recently being the Solbec cure for cancer, narrowly beating the old 1987 Private blood bank Cure for AIDS), the Institutions have turned significantly away from these stocks and they no longer grow up into big companies. Why? The reason for this change is the stringent guidelines the institutions have to follow in relation to Attribution.
    Attribution has become as key to an Investment Manager as Performance. Attribution requires an IM to prove where they made the profits, to show they can consistently do it again. All Investment Management mandates require IM’s to have Attribution to cover the OPM against risk. The problem with Small Caps is that they are inconsistent (most will fall below their issue price within the first financial year and never reach it again – Fin Review on IPO’s Mon 20th July 2003). This indicates a significant risk or doing it consistently and deters IM from investing.

    The problem with no Institutions investing in Small Companies is that the research available on the companies is then limited as there are no analysts following these Stocks (shares). Knowledge is power, and therefore lack of knowledge is a poor way to investment. (You can tell if Investment Managers holds the stock by looking for a nominee company in the top 20 shareholders from the company announcements at the ASX web site e.g. Perpetual Nominees. This is because most IM’s can’t invest OPM in their own name due to Trust arrangements). The only way for companies to grow up is by issuing more shares, generally via a Placement (shares placed off market at a discount to the current share price) or by issuing a bond.

    The question I always have for investors at HC is, “Why they would you be interested in investing in (small Cap) companies that professionals with more knowledge, time, experience, leverage, management access and capability always steer clear of ?”

    Cheers
 
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