Long-Term Investments

What Are Long-Term Investments?

• A long-term investment is an account on the asset side of a
company's balance sheet that represents the company's
investments, including stocks, bonds, real estate and cash.
• Long-term investments are assets that a company intends to
hold for more than a year.
• Being a long-term investor means that you are willing to accept
a certain amount of risk in pursuit of potentially higher rewards
and that you can afford to be patient for a longer period of
time.
• It also suggests that you have enough capital available that you
can afford to tie up a set amount for a long period of time.
Common Stock
• Is a type of security that represents ownership of equity in a
company.
• Holders of common stock exercise control by electing a board of
directors and voting on corporate policy.
• Common stockholders are on the bottom of the priority ladder
for ownership structure; in the event of liquidation, common
shareholders have rights to a company's assets only after
bondholders, preferred shareholders and other debtholders are
paid in full.
Advantages of Stock Ownership
• Provide opportunity for higher returns than other investments
• Over past 50 years, stocks averaged 10% and high-grade
corporate bonds averaged 6%
• Good inflation hedge since returns typically exceed the rate of
inflation
• Easy to buy and sell stocks
• Price and market information is easy to find in financial media
• Unit cost per share of stock is low enough to encourage
ownership
Disadvantages of Stock Ownership
• Stocks are subject to many different kinds of risk:
o Business risk
o Financial risk
o Purchasing power risk
o Market risk
o Event risk

• Hard to predict which stocks will go up in value due to wide

swings in profits and general stock market performance
• Low current income compared to other investment alternatives
Basic Characteristics of Common Stock
• Equity Capital: evidence of ownership position in a firm, in the
form of shares of common stock. This is why stocks are
sometimes called “equities”

• Publicly Traded Issues: shares of stock that are readily available

to the general market and are bought and sold in the open
market
• Public Offering: an offering to sell to the investing public a set
number of shares of a firm’s stock at a specified price
Basic Characteristics of Common Stock (cont’d)

• Rights Offering: an offering of a new issue of stock to existing

stockholders, who may purchase new shares in proportion to
their current ownership

• Stock Spin-Off: conversion of one of a firm’s subsidiaries to a

stand-alone company by distribution of stock in the new
company to existing shareholders
Basic Characteristics of Common Stock (cont’d)

• Stock Split: when a company increases the number of shares

outstanding by exchanging a specified number of new shares of
stock for each outstanding share
o Usually done to lower the stock price to make it more attractive
to investors
o Stockholders end up with more shares of stock that sells for a
lower price
o Investor with 200 shares in a 2-for-1 stock split would have 400
shares after the stock split
o If the stock price was $100 before the split, the price would be
near $50 after the split
Basic Characteristics of Common Stock (cont’d)

• Treasury Stock: shares of stock that were originally sold by the

company and have been repurchased by the company. Share
repurchases are often called “buybacks.”
o Reduces the number of shares outstanding to public
o Companies buyback when they believe stock is undervalued and
a good buy
o Companies may try to raise undervalued stock price or prop up
overvalued stock price
o May be used for mergers, acquisitions or employee stock option
plans
Basic Characteristics of Common Stock (cont’d)

• Classified Common Stock: common stock issued in different

classes, each of which offers different privileges and benefits to
its holders
o Different shares may have different voting rights
o Often used to allow a relatively small group to control the voting
of a publicly-trade company
o May have different dividend payout schedules
Common Stock Values
• Par Value: the stated, or face, value of a stock
− Mainly an accounting term and not very useful to investors

• Book Value: the amount of stockholders’ equity

− The difference between the company’s assets minus the
company’s liabilities and preferred stock

• Market Value: the current price of the stock in the stock market
• Market Capitalization: the overall current value of the company
in the stock market
− Total number of shares outstanding multiplied by the market
value per share

• Investment Value: the amount that investors believe the stock

should be trading for, or what they think it’s worth
− Probably the most important measure for a stockholder
Dividends
• Dividend income is one of the two basic sources of return to
investors

• Dividend income is more predictable than capital gains, so

preferred by investors seeking lower risk

• Dividends represent the return of part of the profit of the

company to the owners, the stockholders
Dividends and Earnings Per Share
• Earnings Per Share: the amount of annual earnings available to
common stockholders, stated on a per-share basis
− Earnings are important to stock price
− Earnings help determine dividend payouts
Dividends and Dividend Yield
• Dividend Yield: a measure to relate dividends to share price on a
percentage basis
− Convenient method to compare income return to other
investment alternatives
Other Dividend Characteristics
• Stock Dividend: payment of a dividend in the form of additional
shares of stock

• Dividend Reinvestment Plans (DRIPs): plans where cash

dividends are automatically reinvested into additional shares of
the firm’s common stock
Types of Stock
Stocks are classified according to types and classes,
depending on the characteristics and earnings potential.

According to RIGHTS
a. Common stock – Most of the issues traded in the local stock
market are common stocks.

b. Preferred stock – It is a security whereby the holder has a higher

claim on the assets and earnings of the company.
According to OWNERSHIP
Common shares may further be classified into:
a. Class A – These are stocks that can be exclusively traded by
Filipino investors.
b. Class B – These are stocks that can be bought and sold by both
Filipino and foreign investors.

Both classes have the same privilege and receive the same
amount of dividends. Such classification of common shares is done
to monitor the equity ownership of both local and foreign
investors.
According to SECTORS
Stocks listed and traded on the PSE are classified into six (6)
sectors:
1. Financials Sector – includes companies engaged in banking,
investments, and finance.

2. Industrial Sector – includes companies involved in the following:

a. Electricity, Energy, Power, and Water
b. Food, Beverage, and Tobacco
c. Construction, Infrastructure, and Allied Services
d. Chemicals
3. Holding Firms Sector – includes companies or firms that control
or manage partial or complete interest in another company or
other companies. Usually, these companies do not produce
goods or services itself; rather, its purpose is to own shares of
other companies.

4. Property Sector – includes companies involved in land and

property development
5. Services Sector – includes companies involved in the following
a. Media
b. Telecommunications
c. Information Technology
d. Transportation Services
e. Hotel and Leisure
f. Education

6. Mining and Oil Sector – includes companies engaged in mineral

extraction, oil exploration, extraction and production
According to CHARACTERISTICS
Though there is no formal definition or criteria to classify a
stock according to its characteristics, analysts generally describe
stocks as:

a. Blue Chip stocks – are shares of well-established and financially

sound companies that have demonstrated their ability to pay
dividends in both good and bad times. They also exhibit more
modest but dependable returns and are relatively of lower risk.
b. Income stocks – are shares of those companies with good
dividend payment history due to steady profits. Since they are
stable, income stocks generally have a lower level of volatility.

c. Growth stocks – are shares of corporations whose earnings are

expected to grow at an above-average rate relative to the
market. A growth stock does not usually issue dividends as
earnings are reinvested in capital projects.
d. Defensive stocks – are shares that provide regular dividends
and stable earnings, regardless of the overall condition of the
stock market. Defensive stocks remain stable under difficult
economic conditions. Generally, these are stocks of food, oil,
and utilities companies, which are characterized by steady
demand amidst hard times.

e. Cyclical stocks – are those sensitive to business conditions or

cycles strongly tied with the economy’s performance. These
companies produce or offer services that are low in demand
during slowdown and increase when business peaks.
f. Speculative stocks – are those that rise quickly when economic
growth is strong and falls rapidly when growth is slowing down.
A speculative stock is considered very risky because of its
volatility. It increases or decreases rapidly depending on the
economic conditions.
Fixed-Income Security
• Is an investment that provides a return in the form of fixed
periodic payments and the eventual return of principal at
maturity.
• Is a debt instrument that generates fixed returns in the form of
interest payments to investors.
• Firms raise capital from issuing fixed-income products to lenders
who are compensated with interest payments. The issuer
promises to repay the principal on an agreed date in the future.
What Are Bonds?
• The most common type of fixed-income securities.
• In very simple terms, a bond is an obligation by the borrower
(bond issuer) to pay the lender (bondholder) a specific amount
of money in the future.
• Is an investment product that is issued by corporate and
governmental entities to raise capital to finance and expand
their operations and projects.
What’s the Difference between Stocks and Bonds?
• A major difference between a stock and a bond is that stocks do
not guarantee any future payment while bonds have a known
and specific payment in the future.
How to make money with Bonds
There are two ways to earn in bond investing:

• Through coupon interest payments; and

• Bond trading

In Coupon Interest Payment - the coupon rate is the interest rate

that the bond pays. This translates to the income the holder of the
bond will be receiving. This rate is usually fixed for the duration of
the life of the bond
• The rate is always quoted in percent, and the interest payment is
simply the coupon rate multiplied by the par value of the bond.

• Some bonds have varying dates of payments. Some pay annually

(once a year), some pay semi-annually (every 6 months), while
some pay quarterly (every 3 months)
Fixed-Income Instruments
Technically, bonds refer to debt instruments with maturities
of 10 years or more. Most people, however, use the term “bonds”
loosely to refer to almost any debt instrument regardless of
maturity.

By Maturity Period
• A fixed income instrument that matures in 1 year or less is called
a bill. A popular example is the short-term debt obligation of
governments, usually called Treasury Bill or T-Bills.
• A debt obligation that matures between 2 and 10 years is called
a note. An example is the government’s Treasury Note or T-
Notes.

• A fixed income instrument that matures in 10 years or more is

called a bond.
By the Issuer
• A fixed-income instrument issued by the national government
through its Treasury Department is called Treasury Securities.
Depending on the maturity period.

• Government agencies can also issue bonds to raise funds.

Examples of these agencies in the US include:
− Government National Mortgage Association (GNMA) or
Ginnie Mae
− government-sponsored enterprises Federal National
Mortgage Association (Fannie Mae) Federal Home Loan Bank
Corporation (Freddie Mac), and Student Loan Marketing
• In the Philippines, PAG-IBIG or the Home Development Mutual
Fund also issues bonds to raise needed capital.

• Local government units sometimes also use debt instruments to

acquire funds. Municipal bonds backed by the full taxing power
of the municipality is called a General Obligation Bond.

• Bonds issued by the municipality to finance a government

project whose interest and principal payments are dependent on
the income of that project are called Revenue Bonds.
• In the Philippines, examples of municipal bonds are the Puerto
Princesa Green Bonds, Boracay-Aklan Provincial Bonds, and
Tagaytay City Tourism Bonds.

• Lastly, a bond issued by a business entity is called a Corporate

Bond. Corporations use bonds as an alternative to stocks in
raising capital.
By Interest Coupon Structure
• A bond that does not pay any interest rate is called a Zero-
Coupon Bond. Since investors don’t receive interest payments,
the only way for them to earn is to buy these bonds at huge
discounts so they can profit afterwards when the bonds are
redeemed at their par value.

• Bonds with a stated interest rate but are not paid until maturity
are called Accrual Bonds. Investors don’t receive interest prior to
maturity but they accrue and compound and are paid during the
maturity period.
• A bond that pays an initial interest rate for the first period then a
higher rate after that period is called a Step-Up Bond. For example,
a 10-year maturity bond may offer 5% fixed interest for the first 4
years then starting on the 5th year, the interest rate is 7%.

• Floating-Rate Bonds are bonds whose coupon rate is linked to a

benchmark rate. This benchmark rate may be the country’s
inflation rate, the London Interbank Offered Rate (LIBOR) or other
rates. A floating-rate bond, for example, that pays a coupon rate
equal to 2% plus the inflation rate will pay 5% if the inflation rate is
3%. If the interest rate is 5%, the bond will pay 7%.
Risks in Bond Investing
Like any other financial instrument, a bond also has risks.
Compared to other investment classes such as stocks or real estate,
the risk in bonds is generally lower.

• Reinvestment Risk is the risk that the bondholder will reinvest the
cash flows received from a bond at lower interest rates. This usually
happens when coupon interest payments have been received or
when a bond is called or when it is prepaid and interest rates have
declined in the economy causing the bondholder to lose out on the
higher interest rate of the original bond.
• A specific type of reinvestment risk is Call Risk, or the risk that the
bond issuer will call the bond causing the bondholder to reinvest the
payment received at lower rates.
− Some bonds are callable, meaning, the issuer of a bond has
the option to “pre-terminate” the bond prior to maturity date.
This usually happens when interest rates have fallen.

• Another specific example of reinvestment risk is Prepayment Risk,

wherein the bond issuer returns the principal at an early,
unscheduled date to take advantage of declining interest rates in the
economy. When this happens, the bondholder is at risk to reinvest
the returned principal in other bonds that pay lower interest rates.
• This risk associated with rising prices caused by a higher inflation
rate which decreases the amount of real goods and services that
bond payments will be able to purchase is called Inflation Risk.

• Exchange Rate Risk emerges when a bond makes payments in a

foreign currency. For a Filipino investor who purchases a bond
that pays coupon interest in US Dollar, a depreciation of the
Dollar versus the Philippine Peso will reduce the returns to the
peso-based investor.
• Bonds with high credit rating are generally considered low-risk. If
they are “downgraded” to a lower credit rating, they are assumed
to be riskier than before. Investors of a downgraded bond will be
faced with a higher risk of default and lower price of the bond.
This is called Downgrade Risk.

• Bonds issued by a sovereign entity (more specifically, a country)

are almost always low-risk. That’s because they can always raise
taxes or print more money just to be able to pay its bond
obligations. If, however, the country’s attitude towards repayment
changes or its ability to repay worsens, the government bond
becomes riskier. This risk is called Sovereign Risk.
• Any risk outside the risks of financial markets which can have a
sudden and substantial financial impact on the bond issuer’s
financial condition is called Event Risk.