Q&A with CMMB Securities

Q. I once read that the best time to buy shares is when everyone else is selling.
Does that make sense and if so, how does it work?

Milton, Scarborough

A: There is a school of thought in the financial markets that investors possess a herd mentality. That is, they all tend to buy shares at the same time and sell at the same time.
However, the majority catch on late so there is a last round of bulk buying before the price settles. Similarly in case of a price decline there is a last round of bulk selling by the herd which decides to offload late.
As a result of this phenomenon the price of the share in a rally usually overshoots its fair value. Similarly when a share is declining the herd causes the price to overshoot equilibrium on the downside.
In the financial markets when shares overshoot on the upside or downside the imbalances are usually corrected in short order. That is, the inflated price usually comes down or the low price usually goes back up to fundamental value.
This is why it may be good to buy shares when everyone is selling because if the share temporarily dips below fair value due to herd selling, it would then be a good buy as the share would eventually go back up to its fair value.
The key is to talk to a broker and get an idea of what the fair value of a particular share may be. However, different brokers may have different ideas about what a particular share’s fair value may be as it is an estimation process, which depends on the company’s growth rate and projected dividend payout. Talk to a number of brokers and try to get a consensus estimate.

Q. How are bond prices affected by changes in interest rates?

Kenny, Princes Town

A: A plain vanilla bond is one which pays a fixed rate of interest or coupon rate over its term. This rate is agreed upon from the issue date of the bond and does not change over the life of the bond.
 However, interest rates in the bond market do not stay static, but can change due to many different factors.
Let us assume Bond A is issued at the beginning of September 1993 at a coupon of 10% for 10 years.
Then rates fall in the market such that the coupon rate required on a 10 year Bond B of the same issuer now falls to 8% at the end of September 1993. However, the rate on Bond A is 10%, which was fixed at inception, while that of a similar or equivalent Bond B is 8%.
In order to reflect the new interest rate environment the price of Bond A would appreciate such that an investor buying Bond A would receive 8%, same as that of Bond B.
The way this works is that since we receive the same interest proceeds as before, but with a new higher initial outlay, the percentage return would fall. In financial markets the price of the bond would move up so as to yield a return of 8% on Bond A.
In other words, a new investor would receive the same overall return of 8% whether he bought Bond A or Bond B. If this did not occur then the return on two instruments with very similar characteristics would have markedly different returns. By Bond A appreciating there is now price equilibrium in the market. Conversely, if market rates had increased at the end of September 1993 such that Bond B had been issued at a coupon of 12% then the price of Bond A would have had to fall such that an investor would receive the same return of 12% as that of Bond B.
The investor in Bond A with a coupon of 10% receives a return of 12% by virtue of him paying a lower price than that at which it was originally issued. At the same time the yields on two similar instruments equalise, restoring market equilibrium.
Therefore, there is an inverse relationship between bond prices and interest rates. As rates fall, bond prices appreciate while when interest rates increase bond prices depreciate.

Q. Please explain the difference between a lending investment and an ownership investment.
Nisha, Couva

A: A lending investment is when the investor has a “creditor-type” relationship with the borrower or the company in which he is investing. This type of relationship is achieved through a fixed income type instrument where the investor is promised a fixed rate of return from the borrower with principal protection. Examples of this are a fixed deposit, money market account or bond.
An investor in any of these is basically a creditor or lender to the institution that issues these instruments. The agreement is a fixed rate of return and principal protection. In some cases there is collateral or security backing the investment. In other cases the investment is unsecured and the lender has a high priority of claim against the assets of the firm in case of bankruptcy.
In the case of an ownership type investment the investor has an unsecured ownership stake in the company in which he is investing.
An example of this is investment in the company’s stock. In such an investment the investor is a shareholder and in the event of bankruptcy would only be entitled to the share of assets after all creditors, or the investors who have “lending type” investments in the firm, have been paid off.
In an “ownership” type investment there is no principal protection and so the risk is much higher than “lending type” investments. As a result the return is also much higher. The type of investment you choose would depend on your own risk tolerance.

Questions can be sent to PO Box, 1830,
Wrighston Road, Port-of-Spain
E-mail : cmmbsecurities@mycmmb.com