The Risks And Rewards Of Investing In The Stock Market

Investing in the stock market can be both very risky (because you can lose the money invested) or very rewarding (because you can earn multiples times your initial investment.) This article explores both of these.

There are some ways of investing that are much riskier than others. The main risk is that you never know what is going to happen. On any given day, the stock market could take a dive and your portfolio could go up in flames. Of course, the market usually recovers to a certain level, but even then you could lose a lot of money along the way. And to make things even more risky, the more money that you invest the more money you stand to lose should something bad happen.

It is also risky to invest in stocks if you do not know what you are doing. Many people have heard the stories of getting rich this way. In turn, they think that the process is easy and dump all of their money into it. Just like anything else that has to do with investing money, there are huge risks putting money in the stock market. The bottom line is that you should start out with small investments if you do not have a lot of trading experience.

On the other hand, the rewards can greatly outweigh the risks if you know what you are doing.

The main reward of investing in the stock market comes in the form of money. If you pick the right investments, it is safe to say that you can make a lot of money both in the short and long term. As you begin to learn more and more about investing, you will find that choosing the best stocks becomes simpler. This is not to say that you will easily make money, but you should get a feel for what is right and what is wrong. And don’t forget that in the long run the stock market return is always around 8-10% so even temporary hiccups such as the dot com bubble bursting in the late 90’s can easily be avoided if you are careful and play it smart.

Another great benefit is the fun factor. Sure, you could store away your money in an online savings account, but what fun is that? When you get involved with the stock market you will feel as if you are giving yourself the best possible chance of hitting it big. And with so much on the line, you will definitely be excited each and every time you check the progress of your investments.

There are some risks and large rewards associated with investing in stocks. If you are careful then you can minimize the risks and maximize your rewards. What are you going to do with your money?

Financial Analysis on an Oil Corporation Takeover

Gulf Oil Corp.–Takeover

Summary of Facts

o George Keller of the Standard Oil Company of California (Socal) is trying to determine how much he wants to bid on Gulf Oil Corporation. Gulf will not consider bids below $70 per share even though their last closing price per share was valued at $43.

o Between 1978 and 1982, Gulf doubled its exploration and development expenses to increase their oil reserves. In 1983, Gulf began reducing exploration expenditures considerably due to declining oil prices as Gulf management repurchased 30 million of their 195 million shares outstanding.

o The Gulf Oil takeover was due to a recent takeover attempt by Boone Pickens, Jr. of Mesa Petroleum Company. He and a group of investors had spent $638 million and had obtained around 9% of all Gulf shares outstanding. Pickens engaged in a proxy fight for control of the company but Gulf executives fought Boone’s takeover as he followed up with a partial tender offer at $65 per share. Gulf then decided to liquidate on its own terms and contacted several firms to participate in this sale.

o The opportunity for improvement was Keller’s principal attraction to Gulf and now he has to decide whether Gulf, if liquidated, is worth $70 per share and how much he will bid on the company.

Problems

o What is Gulf Oil worth per share if the company is liquidated?

o Who is Socal’s competition and how are they a threat?

o What should Socal bid on Gulf Oil?

o What can be done to prevent Socal from operating Gulf Oil as a going concern?

Competition

Major competitors for obtaining Gulf Oil include Mesa Oil, Kohlberg Kravis, ARCO, and, of course, Socal.

Mesa Oil:

o Currently holds 13.2% of Gulf’s stock at an average purchase price of $43.

o Borrowed $300 million against Mesa securities, and made an offer of $65/share for 13.5 million shares, which would increase Mesa’s holdings to 21.3%.

o Under the re-incorporation, they would have to borrow an amount many times the value of Mesa’s net worth to gain the majority needed to gain a seat on the board.

o Mesa is unlikely to raise that much capital. Regardless, Boone Pickens and his investor group will make a substantial profit if they sell their current shares to the winner of the bidding.

ARCO:

o Offer price is likely less than $75/share since a bid of $75 will send its debt proportion soaring, thus making it difficult to borrow anything more.

o Socal’s debt is only 14% (Exhibit 3) of total capital, and banks are willing to lend enough to make bids into the $90’s possible.

Kohlberg Kravis:

o Specializes in leveraged buyouts. Keller feels theirs is the bid to beat since the heart of their offer lies in the preservation of Gulf’s name, assets and jobs. Gulf will essentially be a going concern until a longer-term solution can be found.

Socal’s offer will be based on how much Gulf’s reserves are worth without further exploration. Gulf’s other assets and liabilities will be absorbed into Socal’s balance sheet.

Gulf Oil’s Weighted-Average Cost of Capital

o Gulf’s WACC was determined to be 13.75% using the following assumptions:

o CAPM used to calculate cost of equity using beta of 1.5, risk-free rate of 10% (1 year T-bond), market risk premium of 7% (Ibbotson Associates’ data of arithmetic mean from 1926 – 1995). Cost of equity: 18.05%.

o Market value of equity was determined by multiplying the number of shares outstanding by the 1982 share price of $30. This price was used because it is the un-inflated value before the price was driven up by the takeover attempts. Market value of equity: $4,959 million, weight: 68%.

o Value of debt was determined by using the book value of long-term debt, $2,291. Weight: 32%.

o Cost of debt: 13.5% (given)

o Tax rate: 67% calculated by net income before taxes divided by income tax expense.

Valuation of Gulf Oil

Gulf’s value is comprised of two components: the value of Gulf’s oil reserves and the value of the firm as a going concern.

o A projection was made going forward from 1983 estimating oil production until all of the reserves were depleted (Exhibit 2). Production in 1983 was 290 million composite barrels, and this was assumed to be constant until 1991 when the remaining 283 million barrels are produced.

o Production costs were held constant relative to the production amount, including depreciation due to the unit-of-production method currently used by Gulf (Production will be the same, so depreciation amount will be the same)

o Because Gulf uses the LIFO method to account for inventory, it is assumed that new reserves are expensed the same year that they are discovered and all other exploratory costs, including geological and geophysical costs are charged against income as incurred.

o Since there will be no more exploration going forward, the only expenses that will be considered are the costs involved with production to deplete the reserves.

o The price of oil was not expected to rise in the next ten years, and since inflation affects both the selling price of oil and the cost of production, it cancels itself out and was negated in the cash flow analysis.

o Revenues minus expenses determined the cash flows for years 1984-1991. The cash flows cease in 1991 after all oil and gas reserves are liquidated. The cash flows derived account for the liquidation of the oil and gas assets only, and do not account for liquidating other assets such as current assets or net properties. The cash flows were then discounted by net present value using Gulf’s cost of capital as the discount rate. Total cash flows until liquidation is complete, discounted by Gulf’s 13.75% discount rate (WACC), come to $9,981 million.

Gulf’s value as a going concern

o The second component of Gulf’s value is its value as a going concern.

o Relevant to the valuation because Socal does not plan to sell any of Gulf’s assets other than its oil under the liquidation plan. Instead, Socal will utilize Gulf’s other assets.

o Socal can choose to turn Gulf back into a going concern at any time during the liquidation process, all that is needed is for Gulf to start exploration process again.

o Value as a going concern was calculated by multiplying the number of shares outstanding by the 1982 share price of $30. Value: $4,959 million.

o 1982 share price chosen because this is the value the market assigned before the price was driven up by the takeover attempts.

Bidding Strategy

o When two companies merge it is common practice for the purchasing company to overpay for the purchased firm.

o Results in the shareholders of the purchased company profiting from the over-payment, and the shareholders of the purchasing company losing value.

o Socal’s responsibility is to their shareholders, not the shareholders of Gulf Oil.

o Socal has determined the value of Gulf oil, in liquidation, to be $90.39 per share. To pay anything over this amount would result in a loss for Socal shareholders.

o Maximum bid amount per share was determined by finding the value per share with Socal’s WACC, 16.20%. The resulting price was $85.72 per share.

1. This is the price per share that Socal must not exceed to still obtain profit from the merger, because Socal’s WACC of 16.2% is closer to what Socal will expect to pay their shareholders.

o The minimum bid is usually determined by the price the stock is currently selling at, which would be $43 per share.

1. However, Gulf Oil will not accept a bid lower than $70 per share.

2. Also, the addition of the competitor’s willingness to bid at least $75 per share drives the winning bid price up.

o Socal took the average of the maximum and minimum bid prices, resulting in a bid price of $80 per share.

Maintaining Socal’s Value

o If Socal purchases Gulf at $80 it is based on the company’s liquidation value and not as a going concern. Therefore, if Socal operates Gulf as a going concern their stock will be devalued by approximately half. Socal stockholder’s fear that management might takeover Gulf and control the company as is which is only valued at its current stock price of $30.

o After the acquisition, there will be large interest payments that could force management to improve performance and operating efficiency. The use of debt in takeovers serves not only as a financing technique but as a tool to hopefully force changes in managerial behavior.

o There are a few strategies Socal could employ to ensure stockholders and other relevant parties that Socal will takeover and use Gulf at the appropriate value.

o A covenant could be executed on or before the time of the bid. It would specify the future obligations of Socal management and include their liquidation strategy and projected cash flows. Although management might respect the covenant, there is no real motivation to prevent them from implementing their own agenda.

o Management could be monitored by an executive; however, this is often costly and an ineffective process.

o Another way to ensure shareholders, especially when monitoring is too expensive or too difficult, is to make the interests of the management more like those of the stockholders. For instance, an increasingly common solution towards the difficulties arising from the separation of ownership and management of public companies is to pay managers partly with shares and share options in the company. This gives the managers a powerful incentive to act in the interests of the owners by maximizing shareholder value. This is not a perfect solution because some managers with lots of share options have engaged in accounting fraud in order to increase the value of those options long enough for them to cash some of them in, but to the detriment of their firm and its other shareholders.

o It would probably be the most beneficial and the least costly for Socal to align its managers concerns with that of the stockholders by paying their managers partly with shares and share options. There are risks associated with this strategy but it will definitely be an incentive for management to liquidate Gulf Oil.

Recommendation

o Socal will place a bid for Gulf Oil because its cash flows reveal that it is worth $90.39 in a liquidated state.

o Socal will bid $80 per share but limits further bidding to a ceiling of $85.72 because paying a higher price would hurt Socal’s shareholders.

A Test to Find the Best Moving Average Sell Strategy

In order to develop or refine our trading systems and algorithms, our traders often conduct experiments, tests, optimizations, and so on. One of our traders tested a variety of moving average-based sell strategies and we are now sharing some of those findings. Richard Donchian popularized the system in which a sale occurs if the 5-day moving average crosses below the 20-day moving average. R.C. Allen popularized the system in which a sale occurs if the 9-day moving average crosses below the 18-day moving average. Some traders feel they give up less of the gains they achieve if they use a shorter long moving average. These people prefer to sell if the 5-day moving average crosses below the 10-day moving average. Traders have used variations on these ideas (some touting the benefits of one variation and others touting the benefits of another). A friend told me about the crossover of the 7-day and 13-day exponential moving averages. Because that system was highly recommended, it was included in the tests for comparison purposes.

The strategies covered in this particular series of tests were as follows and all involved simple moving averages except where otherwise noted.

Sell if the stock’s 9-day average crosses below its 18-day average,

Sell if the stock’s 10-day average crosses below its 18-day average,

Sell if the stock’s 10-day average crosses below its 19-day average,

Sell if the stock’s 9-day average crosses below its 19-day average,

Sell if the stock’s 9-day average crosses below its 20-day average,

Sell if the stock’s 10-day average crosses below its 20-day average,

Sell if the stock’s 4-day average crosses below its 18-day average,

Sell if the stock’s 5-day average crosses below its 18-day average,

Sell if the stock’s 4-day average crosses below its 20-day average,

Sell if the stock’s 5-day average crosses below its 20-day average,

Sell if the stock’s 5-day average crosses below its 9-day average,

Sell if the stock’s 4-day average crosses below its 9-day average,

Sell if the stock’s 4-day average crosses below its 10-day average,

Sell if the stock’s 5-day average crosses below its 10-day average,

Sell if the stock’s 7-day average crosses below its 13-day average (exponential),

Sell if the stock’s 7-day average crosses below its 14-day average (exponential).

We wanted to avoid “curve-fitting.” That is, we wanted to test these strategies over a wide range of stocks representing a variety of industries and market sectors. Also, we wanted to test over a variety of market conditions. Therefore, we tested the strategies on each of about 3000 stocks over a period of about 9 years (or over the period during which the stock has traded if it has traded for less than 9 years), factoring in commissions but not “slippage.” Slippage results when the sell order is for $30 but the price at which the sale is executed is $29.99. In this case, the slippage would be one penny a share. The same “buy” strategy was consistently used for each test. The only variable was the rule for selling. For each strategy, we totaled the returns on all stocks. We performed a total of 47,312 tests.

The idea behind this experiment was to find out which of these sell strategies achieved the best results most of the time for most stocks. Remember that the profitability of a system that is applied to a single stock (even if this is repeated for 3000 stocks as in our test) does not paint the whole picture. Profitability per unit of time invested is a better way to compare systems. In designing this test, we required that each system had to wait for a new buy signal in the particular stock being tested. In real life, a trader could jump to another stock immediately after a sale. Therefore the trader would have little or no “dead time” while waiting to make the next purchase. A system that is less profitable when trading a single stock but that exits a position earlier could therefore generate greater profits over a year by enabling a person to reinvest in a different security as soon as the first one is sold. On the other hand, it would be a poorer performer if it had to wait for the next buy signal on the same stock while another slower system was still holding and making money.

The various sell systems were arranged in order of their profitability. We set up a table in which the left column was the short moving average and the middle column was the long moving average. The sell signals were generated when the short average crossed below the long average. The right column was the total profitability for all stocks tested. However, the key item of comparison was not the actual magnitude of gain for each sell system. This would vary considerably with different “buy” and “sell” system combinations. We were not testing for the profitability of any complete system, but for the relative merit of the various “sell” systems in isolation from their respective optimum “buy” systems. The main points can be briefly stated as follows. Any one of these systems may be the most profitable when trading a particular stock at a particular time. However, this experiment has shown to our satisfaction that selling when the 9-day moving average crossed below the 18-day moving average was generally not as profitable as selling when the 10-day moving average crossed below the 20-day moving average. Donchian’s 5-day moving average cross of the 20-day average was also generally more profitable than the 9-day average cross of the 18-day average. All tests were identical. The only variable was the combination of moving averages selected for the selling system.

This study supports the notion that a triple moving average system based on the 5-, 10-, and 20-day moving averages is likely to be more profitable than the similar 4-, 9-, 18-day moving average combination. It has the additional advantage of enabling a person to monitor the crossing of the 5-day moving average with the 20-day moving average. The latter is Donchian’s system, and it is a strong system in its own right. It also gives earlier signals than either the 9-18 or the 10-20 combinations, though the 10-20 combination tends to generate higher average returns. Therefore, including the 5-, 10-, and 20-day moving averages on your chart gives you an additional option. You can use the 5-, 10-, and 20-day triple moving average system or you can use Donchian’s 5-, 20-day dual moving average system. If the stock pattern does not look or “feel” right to you, the 5-day moving average cross will give you an earlier exit. Otherwise, you can wait for the 10-20 crossover. Either will likely give a more profitable signal than the 9-, 18-day combination. The decision of which to use can be based on separate considerations related to stock behavior.

Copyright 2009, by Stock Disciplines, LLC. a.k.a. StockDisciplines.com

Sourcing Strategy – 7 Reasons You Should Consider Global Sourcing

Global sourcing is a term used to describe a strategy for buying goods and services from countries other than your own so that you can access significant benefits. This is because different parts of the world will be at different stages in their development and so have different cost structures. It can also be because other countries may own raw materials that are not available in your own country or are in short supply.

Here are seven reasons you should consider global sourcing.

1. Access to raw materials. If your company uses raw materials that are not abundant in your own country then you can lower your supply risk by sourcing globally if availability of those materials is greater elsewhere. Economies of scale in extraction can also mean lower prices even with the extra cost of transport and duties factored in.

2. Access to cheaper wages. Manufacturing processes that are labour-intensive can be sourced more cheaply from countries where wages are lower than in your own country. This is particularly true if the technology used has a life cycle. As the technology matures, high wage cost producers tend to move on to new technology as the features and benefits it brings can be used to charge a premium price that offsets the higher labour costs. Low cost countries then tend to adopt the older technology to produce products for the “late majority” of users who buy on price. Even without this technology effect, some services can be operated at lower cost overseas due to the lower wage rates – for example, the number of call centres and software developers that are now located in India and Eastern Europe.

3. Reciprocal trading. Global sourcing works both ways as it involves both a buying organisation and a selling organisation. If your company sells its products to a country that can also provide products that you want to buy then there may be an opportunity for doing a deal that offsets your sales and purchases to give you a better overall economic benefit.

4. Learning how to do business in another country. Knowing the culture and ways of working of other countries can be a significant benefit when you want to sell to them. Buying from those countries can be an effective way of learning about how to trade with that country before you start your sales and marketing effort to win business there.

5. Stimulating competition domestically. Sometimes suppliers in your own country can become complacent if they think that they have a major share of the local market. Finding alternatives overseas can be a good way of attracting new entrants (or just threatening to do so) and shaking up the local market.

6. Increasing supply capacity. If there is a current or potential shortage of a key material or component for your own manufacturing operation then you may have a serious supply risk. Finding alternative sources of supply overseas can increase the available capacity and so reduce the risk.

7. Take advantage of having a global organisation. If your own organisation is a global one then sourcing via your subsidiaries can be an excellent way to access global sources that may be difficult to tap into on your own.

Forex Trading Strategies – What Are Your Options?

Forex trading revolves around currency trading. The value of the currency can rise and fall as a result of different factors that include economics and geopolitics. The changes in the currency value are what factor in the profits for Forex traders and this is the main objective of getting into the trades. The trading strategies are sets of analysis used by the traders to determine whether they should sell or buy currency pairs at a given period of time.

These strategies can be technical analysis charting tools based or news based. They are made of a multiple of signals that trigger the decisions whether to buy or sell the currencies a trader is interested in. The strategies are free for use or they can also be offered at a fee and are usually developed by the Forex traders themselves.

The strategies can also be automated or manual. Manual systems require a trader to sit and look for signals and also interpret them so they can decide whether to sell or buy. Automated systems on the other give traders more flexibility because they can customize software to look out for specific signals and interpret them. Trading strategies may not be all that perfect in making money, but when you have a sound understanding of what they are all about, it becomes easier to adopt reliable approaches when trading in the currencies.

Forex Trading Strategy Types

There are so many strategies out there that can be used by Forex traders. The most important thing would be for the trader to decide what strategy matches the kind of trading experience they wish to have and what strategies offer the best signals for interpretation so the best trading moves can be taken. Below are some of the top strategies most traders use and some you should consider if you are a beginner in the markets.

Forex volatility strategies – The Forex market can be volatile, meaning that the prices can make very sharp jumps. Volatility systems are created to take advantage of the price actions and are usually best for short term and quick trades. The systems are also based on volatility increase and whereas their winning percentage of trades may be higher, the profits earned per trade can be comparatively low. This strategy is best for traders and investors who understand the volatility perception.

Forex trend following strategies – These strategies use market trend marketing to guide traders towards their long term trading goals. Moving average, current market price calculation and channel breakouts are commonly used to generate signals and decide the best market direction to take. Instead of predicting or forecasting prices, traders using these strategies only follow the market trend.

Forex scalping strategies – Scalping in Forex involves making multiple trades with each of the trades making small profits individually. When using the scalping strategies of trading, the profits are usually anywhere between 5 to 10 pips for each trade. These strategies require constant Forex market analysis and the trader also need to place multiple trades at once. They can be pretty demanding and traders need to be relatively fast in predicting where the markets are headed so they can open and close positions in the shortest time possible.

Forex pivot point strategies – Pivots make it possible to identity entry points especially for range bound traders. These points are also helpful to breakout traders and trend traders in spotting key points that need breaking for given trading move so they qualify as breakout. Traders who understand pivot and calculations around it will find these strategies quite helpful in trading currencies. It is important to remember that calculating pivot using closing prices of the short time frame reduces significance and accuracy of the point of rotation. The calculations need to be precise because they make the Forex market backbone.

Forex chart pattern strategies – Charts are vital in Forex trading in assisting traders in the markets. There are different chart patterns that can be used when trading, but the most common patterns are triangle and head and shoulder. Triangle patterns occur mostly in short-term time frames and can descend, ascend or be symmetrical. Price converges with low and high creates the triangle leading into the tight price area. The head and shoulder pattern on the other hand is more like topping formation when an uptrend occurs and bottoming formation when there is downtrend. The pattern will usually complete in Head and Shoulder when the trend line is broken.

Forex Renko chart strategies – Renko charts are constructed when price surpasses bottom or top of the previous brick by pre-defined amounts. When this happens, the brick is moved in the next column. White bricks are usually used when the trend is up, whereas the black ones are used when the trend is down. This type of charting is useful in identifying key resistance and also support levels. In Renko charts, time and volume really have no major role. You will find all kinds of trading strategies that are Renko chart based to assist your trades.

Other Forex trading strategies you can use are the Bollinger Bands, Forex breakout, Forex support and resistance, Forex candlestick and Forex swing trading strategies.

Picking the best Forex trading strategy

With so many trading strategies available it can be challenging for traders, especially beginners, to decide which way to take. But using a few tips you can have an easier time choosing the best.

Set trading goals and decide whether to go long term or short term. It also helps to decide whether to trade full time or part time. This way you will be able to choose the strategy that best suits you as a trading individual.

Choose a unique strategy by comparing strategies and what they have in store for you. If a strategy does not seem to lie in your best interest, then it is not the right one for you.

Experiment on the strategy you prefer before settling for it. Experimenting first gives a chance to have a deeper understanding of what the strategy is all about and see whether it has worked for other traders in the past or not.

It is also important that you get familiar with trading styles so you can choose the perfect strategy for your trading. For instance, short term traders should consider trading styles like day trading, scalping, position trading and swing trading among others.

5 Technical Indicators Used By Experts

If you have just learned technical analysis, you may be overwhelmed by all the indicators that you have to base your predictions on. You may not be able to use all the indicators and be able to make a decision on time, so we’re listing down the 5 best technical indicators used by forex trading experts.

Moving averages

If you are a beginning trader, you may want to start with the simplest indicator. The moving average, though simple, is one of the preferred technical indicators of experts. With moving averages, you compare the averages of charts that span two different ranges. For example, you may compare a 7-day average with a 30-day average. Look at the way the two averages cross over. You can predict a bearish market, if the crossover comes from up to down, and you can predict a bullish market, if the crossover comes from down to up.

Bollinger bands

This technical indicator operates on the belief that a market’s value can go up or down depending on two standard deviations. Each of the standard deviations is plotted on either side of a moving average graph of the prices. So basically, Bollinger bands are used to gauge whether a price is considered high or low based on the price history.

Relative strength index (RSI)

The relative strength index, or RSI, is the relative strength of the security’s price when compared to past prices of that same security. The RSI is used to determine whether a security is being overbought or being oversold. In a period of usually 14 days, you will be looking at bearish and bullish changes in the prices. You have to divide the sum of the bullish trades by the sum of the bearish trades. The answer is an index from 0 to 100. If the number is above 70, then the security is overbought (bearish). Similarly, if the number is below 30, then the security is oversold (bullish).

Stochastic

The stochastic indicator is a good tool for determining whether the market is strong or weak. This technical indicator shows that if the price is rising during the trading day, it is more likely that it will end up near the maximum price for the day. Accordingly, if the price is falling during the trading day, it is also more likely that it will end up near the minimum price for the day. This indicator is best used as a timing tool and can show trend changes where you can base your investment moves on. The stochastic indicator is best used together with the RSI.

Moving Average Convergence Divergence (MACD)

The MACD is a momentum gauge that can be computed through finding the difference between two exponential moving averages. The MACD closely follows the trends. The MACD is different from moving averages in the sense that with exponential moving averages (EMA), much more weight is given on the more recent prices than the rest of the prices plotted on the graph.

If you look further, you will find many other helpful indicators. However, the ones we’ve listed here have been the most tried and tested by experts. By using or combining any of these technical indicators, you can zero in on the best trading move.

And, you can discover key forex technical indicators experienced traders use by visiting my Technical Analysis Tips website.