Intro to Investments and Securities

Education Program Lecture 2

October 3rd, 2024

Tejas Iyer & Daniel Wang

What is an Investment?

• Ownership of some asset
• Delay present benefit for future gain

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• (spend cash now, get cash later)
• (buy low, sell high)

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Asset Classes Pt. 1

Cash & Equivalents

Represents: Liquidity and power to buy anything

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Examples:

• Cash
• Saving Accounts
• Liquid Funds

Fixed Income

Represents:

Repayments of money lent to someone

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Examples:

• Bonds
• Debt Mutual Funds
• Fixed Deposits

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Real Estate

Represents:

Ownership of a physical space

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Examples:

• Commercial Properties
• Flats
• Apartments

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Commodities

Represents:

Ownership of a good which has an end use (often physical)

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Examples:

• Gold
• Silver
• Wheat
• Oil

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Equities

Represents:

Ownership into a business

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Examples:

• Stocks
• ETFs
• Equity Mutual Funds
• Index Funds

What is an Security?

• A security is a negotiable financial instrument that represents some type of financial value.

What’s the point of securities?

• For companies:
• Fundraising
• For investors:
• Own stuff => express ideas
• Get liquidity
• Diversification
• For the market:
• Find fair value of asset
• Efficient allocation of resources (talk about exchanges later)
• “If it exists it’s probably useful”

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Example:

• Paw points to cash securitization

Derivative Assets

Derivatives

Securities that derive their value from an underlying asset.

• Options (Calls/Puts)
• Forwards
• Futures
• Swaps

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How are securities traded?

• Privately/Over the counter (OTC)
• Public exchanges => liquidity!

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Why is liquidity lit

• Give investors flexibility and confidence
• Promotes investment
• Reduces risk (e.g. Covid-19)

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Company Capital Structure

Company

Equity

Everything Owned by the Company

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• Cash
• Inventory
• Properties, Plant, and Equipment (PP&E)
• Investments
• Intangibles
• Etc.

Residual Claim on Assets:

Fixed Claim on Assets:

Owned by Shareholders

Money Owed to Creditors

Equity

Debt

Company Capital Structure Cont.

Equity

Debt

Two ways to raise capital

Bonds Issued in exchange for cash

Stocks issued in exchange for cash

Profits

Reinvested in business and excess cash is returned to debt (interest and principal) and equity holders (dividends and buybacks)

What are Stocks?

• Stocks are ownership claims on a fraction of a business
• Stock price tells you how much one ownership claim costs, not if a stock is at a good value
• A stock is a productive asset that generates cash flow
• As the underlying business generates more cash, it can reinvest those excess earnings to generate even more cash
• Some stocks also pay dividends, which are distributions of company earnings directly to shareholders

A stock is an ownership share in a business

What are Bonds?

Why do company issue bonds?

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• Firm wants to raise capital
• Does not want to dilute ownership
• Can earn more money on the use of the funds in the business than the cost of interest on the debt

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A bond is a borrowing arrangement through which the borrower (or seller of a bond) issues or sells an IOU document to the investor (or buyer of the bond).

Why invest in bonds?

• To distribute risk across a diversity of investments holdings
• Investors want steady reliable interest payments and return of their full capital or investment at the end of the term of the bond

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Bond Ratings

• Bond rating services are provided by, among others, Standard & Poor's, Moody's Investors Service, and Fitch Investors Service.
• Bond ratings start at AAA (being the highest investment quality) and usually end at D (in payment default).
• Treasury Bonds (AAA)
• High-Yield Bonds (Typically below BBB- / Non-investment grade)

A bond’s rating is an evaluation of the possibility of default by a bond issuer based on an analysis of the issuer's financial condition and profit potential

An example from The Big Short

Collateralized Debt Obligations (CDOs)

Pricing Debt

The Interest Rate: Two rates are crucial for the pricing of a debt

• Coupon Rate:
• The rate stated in the bond contract
• Used to compute the amount of interest paid to bondholders
• Aka. Contract Rate or Stated Rate
• Market Rate:
• The rate the investors expect to earn on a debt
• Used to price a bond issue
• Aka. Yield Rate

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Face value is the principal value of the bond, which is repaid (typically) to investors at maturity.

Periodic interest payments are usually paid semi-annually.

Cash Flow: Two different cash flows associated with most bonds

• Periodic interest payment during the bond’s life
• Often semi-annual
• Referred to an interest annuity
• Rate is printed on the bond certificate
• Single payment of the principal amount of the bonds at maturity:
• Face value
• Also printed on the bond certificate

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Stock vs. Bond (Bond Example)

When you own a bond, you know exactly how much the future coupon payments will be and when you get your principal.

Stock vs. Bond (Stock Example)

A stock is like a bond, but it is up to you to estimate what the future cash flows will be and what the stock is worth.

Note: ROIC is Return on Invested Capital

Example: a stock will produce $50/share of cash flow. It reinvests all profits returns 20% on every $1 invested.

Investing is Hard

• Investing is hard because the market is very competitive and it’s psychologically counterintuitive in practice
• It can be difficult to identify what is simply noise and what is fundamentally impacting a business
• Having good information that other investors don’t have is a reliable way to make money

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Efficient Market Hypothesis

• Strong Form: All information—both the information available to the public and any information not publicly known—is completely accounted for in current stock prices, and there is no type of information that can give an investor an advantage on the market.
• Semi-Weak Form: Contends that a security's price movements reflect publicly-available material information. It suggests that fundamental and technical analysis are useless in predicting a stock's future price movement.
• Weak Form: Assumes that the prices of securities reflect all available public market information but may not reflect new information that is not yet publicly available. It additionally assumes that past information regarding price, volume, and returns is independent of future prices.

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In the Strong Form of the Efficient Market Hypothesis, all information is priced into an asset’s price

• In that case, no one would bother collecting and analyzing information! Investors usually don’t believe in the Strong Form because that means they can’t generate market beating returns by doing any kind of work.

What’s your Edge?

Information

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• Getting better/more information than others
• Proprietary research (going out and researching the world)
• Expert calls (Tegus)
• Credit card data, satellite photos, web scrapes etc.

Analytical

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• Think about businesses/industries different than others
• Evolving business models (Disney)

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Thank you!

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• If you have questions, please feel free to reach out to us:
• Tejas Iyer (tejas.iyer@princeton.edu)
• Daniel Wang (danielwang@princeton.edu)
• Reminder: We do take consistent attendance at Open Education sessions into consideration as demonstrated interest for our next Investment Team recruiting season.

Attendance: