The Short Answer

What's a Benchmark? Or Buyback? Or Moat?

By Adam Zoll | 04-08-14 | 06:00 AM | Email Article
A recent Short Answer column explained some commonly used but occasionally
misunderstood financial jargon, and at the end we asked users to submit their own
nominations for the list. We received lots of great suggestions, and this week we
take on some of these reader-submitted items. So here we go:
Annual dividend/yield: The amount of a security's income that is distributed to
its shareholders during the course of a year. Some stocks pay shareholders a
portion of company profits in the form of dividends while bond shareholders
typically receive interest payments. Both may be referred to as the investment's
yield. (On Morningstar.com's mutual fund and exchange-traded fund quote pages,
this is represented by the "TTM Yield" metric, which stands for trailing 12-month
yield. A 30-day SEC yield is also included for funds and ETFs, and you can read
about how to use these two yield measures here. Yields at the top of stock quote
pages also are TTM.) To calculate a security's annual yield, simply divide the
amount of income paid out to investors during the past year by its share price.
Asset class: A broadly defined group of assets that have similar characteristics.
Often these classes are broken down into stocks, bonds, cash, and commodities,
but the term could also be used to refer to nonsecuritized assets such as real
estate and collectibles (such as fine art or rare coins).
Benchmark: Quite simply, a yardstick used to measure the performance of a
security. For example, the S&P 500 Index, which tracks 500 of the largest U.S.
companies, is commonly used as a benchmark with which to compare the
performances of U.S.-equity mutual funds. Other indexes, such as the Barclays
Aggregate Bond Index, which tracks investment-grade U.S. bonds, and the Russell
2000, which tracks U.S. small-cap stocks, are used as benchmarks for bond and
small-cap funds, respectively. Other uses for benchmarks include assessing a
fund's allocation relative to an index. A fund's management team may also
establish its own internal benchmarks, for example as a way to hew to
self-imposed allocation guidelines.
Buyback: When a company uses cash to buy back shares of its stock. This may be
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done as a way to return value to shareholders (because buying back shares
reduces the number of them outstanding, meaning that existing shareholders own
a larger share of the business). Buybacks often occur when company management
believes its shares are underpriced and expects them to rise in value, or when the
company seeks to offset the impact of stock options and stock grants.
Cyclical stock: The stock of a company whose performance tends to rise and fall
depending on the economic environment. For example, a maker of luxury goods
might see its biggest profits when the economy is booming--meaning that more
people can afford its products--but experience reduced profits or even losses during
times of economic distress. Examples of consumer cyclical stocks include: Home
Depot (HD), Las Vegas Sands (LVS), McDonald's (MCD), and Daimler
(DDAIY).
Defensive stock: The stock of a company whose performance is less sensitive
than most to the ups and downs of the economy because it sells products and
services that people need to buy no matter what. This includes many consumer
staples, health-care, and utilities stocks.
Exchange: A marketplace where securities are traded, such as the New York Stock
Exchange (part of IntercontinentalExchange Group (ICE)) or Nasdaq (part of
NASDAQ OMX Group (NDAQ)). Many major financial centers around the world
have their own exchanges, including Hong Kong, London, Shanghai, and Tokyo,
where domestic or regional shares are traded. Exchanges may be physical trading
spaces (NYSE) or virtual ones that exist only in cyberspace (Nasdaq).
Fundamentals: In investing parlance, this refers to a company's performance as
measured by core statistics such as revenue, net income, and cash flow as opposed
to nonfundamental factors such as the performance of its stock price.
Economic moat: Coined by Warren Buffett and widely used by Morningstar, this
term refers to a company's sustainable competitive advantages over its
competitors. This can be achieved in one of five ways: cost advantage, efficient
scale, intangible assets, network effect, or switching costs (you can find out more
about each of these moat sources in this article). Morningstar assigns its Economic
Moat Rating (wide, narrow, or no moat) to all the companies its equity analysts
cover. Morningstar research has shown that companies with wide moats tend to be
better at sustaining profitability over time than those with narrow or no moats.
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Real return: An asset's return after accounting for inflation. For example, a fund
that returns 10% in a given year in which inflation runs at 2% has a real return of
8%.
Sector: A segment of the economy, used to classify stocks. Morningstar groups
stocks into the following sectors: basic materials, communication services,
consumer cyclical, consumer defensive, energy, financial services, health care,
industrials, real estate, utilities, and technology. A fund whose portfolio is more
heavily allocated to a given sector than its benchmark may be said to have a sector
bias.
Security: A financial instrument representing ownership of an asset (as with
stocks) or debt owed (as with bonds). Other examples include mutual funds, ETFs,
Treasuries, futures, options, and swaps.
Share class: Type of fund share, typically differentiated by its distribution channel
and/or fees charged. Retail or investor share classes may be purchased directly
from fund companies or brokerages by individual investors. Advisor share classes
are sold through financial advisors, and institutional share classes are offered
through institutions, including company 401(k) plans. Also, a letter designation
may indicate whether a fund carries a sales charge. For example, class A shares
typically charge a front-end load. (Morningstar's Christine Benz makes sense of
share-class alphabet soup in this article.) Some stocks also have different share
classes, as explained in this Short Answer column.
Underweight/overweight: Refers to whether a fund's allocation to a given type
of asset is greater than (overweight) or less than (underweight) that of its
benchmark. For example, a large-blend fund that holds 30% of assets in financial-
services stocks may be said to be overweight that sector relative to a benchmark
such as the S&P 500.
Are there additional investing terms you've wondered about? Email them to the
Short Answer for possible use in a future article.
Have a personal finance question you'd like answered? Send it to
TheShortAnswer@morningstar.com.
Adam Zoll is an assistant site editor with Morningstar.com
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