Q&A with CMMB Securities

Q. I hear investors talk about correction in the stock market. Is there something wrong in the market that it should need correcting?

James, Marabella

A:The primary objective of any market, whether it is for vegetables or stocks, is to achieve price discovery. This simply means that the transfer of ownership of any item must be done at a fair price which is consistent with the value being exchanged. This is best achieved when there is a large group of buyers and sellers exchanging the commodity regularly so that the sum total of the views of all market participants become impounded into the price. However, in the stock market, there are occasions when this process may be derailed due to perceptual distortion. That is, the market may push the price too high or too low due to overreaction to positive or negative news about the stock. In most cases investors tend to selectively absorb good news and discount bad news giving rise to a self-fulfilling prophecy causing the stock to overshoot its fair value. This is where there is something wrong with the market.

But, this situation does not persist forever. Invariably, the market would realize the error and act so as to bring the price back down to its fair value or fundamental level. This process is referred to as a “correction” for as you quite rightly suggested, the wrong price is corrected back to its fundamental level. In financial jargon this is referred to as “regression towards the mean”. This simply says that the price of a stock may float away from its true or mean value, but it will eventually swing back to its fair value.

Q. A few times in this column you have mentioned “psychological accounting”. Can you explain that term?

Gail, Diego Martin

A:Psychological or mental accounting is the process by which individuals develop a system of mentally separating their money into different categories. The most common example of this is the case with savings and bank loans. Individuals view their savings separately from their bank loans, when they should really be viewed together in determining the individual’s net worth. For example an individual with $20,000 on a deposit and an outstanding bank loan of $15,000 when asked the question about the value of his savings in some cases may say it is $20,000, when it is really $5,000.

The reason for this misconception is that in the mind of the individual there are two mental accounts, a savings account and a bank loan account. He does not see the two as integrated and intermingled. This may be harmful if the individual keeps funds in savings at the expense of not paying off debt, which usually commands a much higher interest rate than bank savings accounts. Nevertheless, there could be cases for keeping savings even though there may be outstanding loan balances. An example of this may be the need to keep an emergency fund in case of contingencies.

Q. I recently became self-employed and am building a client base. I have to offer some customers 30 days credit so at the end of the month, I’m in a bad way. Other than increasing my bank overdraft, is there any other way to maintain cash flow while waiting for payments to come in?

Sudesh - Tunapuna

A:There is a way of increasing your cash flow without using your overdraft. A process known as factoring or discounting of your company’s receivables can accomplish this. The way this works is simple. You go to your bank and essentially sell your receivables to them. Depending on the debtor involved, the bank may advance between 70% - 80% of the value of the receivables at a rate of financing which is much lower than that of an overdraft. This would be based on the debtor agreeing to pay, evidenced by their signing to authenticate the invoice as well as indicating satisfaction with delivery of goods and services. The receivables which you sold must be assigned to the bank and your debtor must also be apprised and agree to this via a tripartite agreement. The debtor must also agree to pay the bank directly instead of your company since the beneficial title to the cash flow now passes to the bank.

This is a method that is being used with increasing frequency as companies try to reduce the interest cost of overdraft financing. The time that debtors take to pay is being funded by your company and hence reduces its profitability. Therefore finding a more cost effective mechanism to give your customers this flexibility would help you to maintain good credit terms for them while not bearing a high cost burden. “All information contained in this article has been obtained from sources that CMMB believes to be accurate and reliable. All opinions and estimates constitute the Author’s judgment as of the date of the article; however neither its accuracy and completeness nor the opinions based thereon are guaranteed. As such, no warranty, express or implied, as to the accuracy, timeliness or completeness of this article is given or made by CMMB in any form whatsoever. CMMB and/or it employees or directors may, where applicable, make markets and effect transactions, or have positions in securities or companies mentioned herein. Neither the information nor any opinion expressed, shall be construed to be, or constitute an offer or a solicitation to buy or sell.”