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This method attempts to ascertain the inherent value of a security based on the present value of future earnings. Fundamental analysis involves predicting the level of those earnings by relying heavily on economic data such as earnings, dividends, and growth rates. Divining the future is no easy task, so practitioners study many factors that could affect a security. For example, in analyzing General Motors stock, the analyst would try to predict how the industry would be affected by social and economics changes.

The analyst would then move to the particulars of Genoral Motors and attempt to forecast the level of GM earnings and dividends over a period of several years.

The object of all this effort is to determine whether or not GM or another stock was undervalued, that is, the market price is lower than the stock’s “intrinsic value,” which would mean that the stock will increase in value. However, such a determination is no guarantee of success.

Other analysts may not agree the stock was undervalued. In addition, significant time delaysbefore others concur and act upon the information-can lead to uninspiring returns for the fundamental analyst because the stock will not reach its “true” value.

This method is based on the examination of patterns, trends, or cycles in the securities market. Technical analysis attempts to predict future prices based on past volume and price changes. Technical analysts believe that all investors have the same information available and that current market prices reflect this information. However, these analysts recognize that there are delays in the spread of new information. Prompt recognition of early trends or changes in direction could produce profits. Unfortunately, one characteristic of technical analysis is prematurely entering the market before it has reached bottom or selling too long after the market has passed its peak.

This is not to say that technical analysts do not recognize price movements. There is evidence to support the theory that security prices move in cyclical phases and the appropriate response could produce profits. Major procedures used by technical analysts to predict cycles and trends include:

Price-trend method. This is the oldest and one of the most popular forms of cyclical analysis. Much technical information and special jargon is associated with price-trend analysis. There is also significant difficulty in interpreting the information gathered in such an analysis. Because the judgment of the analyst is critical, price-trend methods are often considered one of the weakest methods of technical analysis. Nevertheless, it is often used as evidence in confirming a market trend.

Breadth of market. This technique predicts future prices by analyzing price trends of certain stocks. Measurement involves data from the entire market. It gives equal weight to stocks, regardless of their market price.

Monetary methods. Here, the actions of the Federal Reserve Board are paramount. Such measurements as the money supply, reserve requirements, and discount rates have proved to be strong indicators of potential cycle changes. These measurements reflect the availability and cost of money. This, in turn, can reveal how much business will be able to expand and how aggressive investors are willing to invest. For example, the less expensive debt is, the more inclined investors may be to leverage their securities purchases by borrowing money. This leverage is referred to as margin debt, and can be a strong indicator of investor expectations of market prices.

Thousands of intelligent, highly skilled fundamental analysts labor daily in an effort to find undervalued stocks. At least as many individuals pore over charts of stock and commodity price movements in search of hidden buy and sell signals. Their findings are reflected in thousands of brokers’ research reports and investment newsletters. Billions of dollars are positioned in the markets by individuals and money managers on the basis of these recommendations. However, the academic community has introduced two theories that challenge the validity of both fundamental and technical analysis.

No matter what type of investment vehicle is being considered, financial planners and clients must decide whether the price represents a good value and whether the timing is favorable in pricing decision.
While price and timing can often be viewed as a single problem, how this matter is considered differs depending on the theoretical perspective of the analyst. In this context, an investment may be analyzed in several ways.

Check these theories regarding the issue and than follow the links to the Investment Analysis Methods.

Efficient Market Theory

This theory contends that with so many people scrutinizing the value of particular securities, it is not possible for prices to stray too far from true value. Because information about a change affecting a particular stock tends to be disseminated among market watchers almost instantly, that information is quickly reflected in the price of the stock. Thus, according to this theory, the search for significantly undervalued stocks in not produc
tive.

Random Walk

According to this theory, security and commodity prices are not predictable. Future prices are statistically independent of past price and volume data. Thus, the patterns sought by technical analysts are not valid predictors of future prices.
The efficient market and random walk theories suggest that a strategy of buying and holding a portfolio of randomly selected stocks will do better than one that is actively managed (when transaction costs are considered). Computers and data-based information on the market have allowed academics to develop strong arguments for this position.

Investment analysts counter that market inefficiencies exist, that prices are governed as much by emotions as by information, and that price patterns are not random.

Within the controversy, yet another theory exists, one that involves not how the market operates, but how to minimize risk.

Modern Portfolio Theory

One of the foremost investment theorists is Harry Markowitz. In his book, Portfolio Selection, he laid the groundwork for what has come to be known as the Modern Portfolio Theory. This is a framework by which risk can be reduced through comprehensive and efficient diversification.
The model divides risk into two components: risk due to market fluctuation and risk inherent in a particular security. With this procedure, the goal is to search out securities that (a) have the same level of risk as other investments, but offer a higher expected rate of return, or (b) offer a similar rate of return as other investments at a lower risk. The selection of these types of securities in a portfolio is called efficient.

To implement this theory, the planner first determines the client’s desired level of risk (or the degree of risk necessary for achieving the client’s stated objectives). The next step is to select stocks with the correct risk characteristics. Those with return potential that is not commensurate with the desired level of risk are eliminated.
Eventually, the planner constructs an e fficient portfolio-one that has the highest possible return for a given level of risk.

This quantitative approach requires the use of graphs, charts, and figures, which may or may not be interpreted accurately. Unfortunately, Modern Portfolio Theory does not take into account the effects of taxation and other interesting variables.

As with all scientific approaches, Modern Portfolio Theory is based on quantifiable elements. “Return” is expresssed as a percentage; “risk” is defined by beta, a systematic measurement of the relationship between a stock’s price volatility and the volatility of the general market. A beta of 1.00 means the risk is average and correlates with overall market risk. In this case, if the market goes up 15 percent, the stock will also increase 15 percent. A beta above 1.00 means more volatility than the market’s and more risk. The opposite is true for a beta of less than 1.0.
Betas for particular stocks are derived from past price behavior relative to the market. Betas are available from Value Line and other data sources. By knowing the betas of a portfolio’s component stocks, the planner can ascertain the risk level of the overall portfolio.

The tactical significance of betas is important. When a bullish market is expected, portfolios of high beta stocks will perform even better than the market. A portfolio with a beta of 2.00 should do twice as well as the general stock market. On the other hand, a pessimistic market outlook calls for betas of less than 1.00.
There is also an alpha score that measures how an investment performs as compared to expected volatility. An alpha of 0.0 is considered neutral. If an investment moves up 5 percent, while the market moves up 3 percent, the investment’s alpha is 2.0.

Regardless of the technique used, inadequate or inaccurate information and lack of uniformity in disclosure make projecting risks and returns difficult. Many rely on the idea that current and past expectations play a significant role in determining future results.

A common concern for small investors is the difficulty of purchasing a diversified group of assets in order to minimize risk. However, for small investors, the cost of diversification may be prohibitive. For example, most bonds have face values of $1,000 and are sold in blocks of five units. The typical trading unit of stock listed on an exchange is 100 shares. Trading smaller blocks of stock is disproportionately more expensive. Thus, investors with a few thousand dollars could wind up placing all their eggs in one basket.
Without diversification the risk of loss can be high. Statistically it is more common for one stock to produce a significant loss than for a portfolio of 50 different stocks to all show a loss. In the multistock portfolio, “winners” tend to cancel out “losers,” and portfolio performance tends to emulate that of the overall stock market.

Investors with limited funds can diversify by purchasing shares in an investment company. An investment company is a corporation or trust through which investors pool their capital to achieve the benefits of diversification and management of their investments. Shares in such a pool represent ownership in many different companies-often in different industry groups. In addition to providing “instant” diversification, these shares are readily tradable or redeemable. Shares in an investment company represent an interest in all the assets of the company. As the market value of those assets fluctuates, so does the value of the shares.

The two most common types of investment companies are
management companies and unit trusts.

Management Companies

The portfolio of securities in these companies is managed on behalf of the shareholders with specific goals in mind. These objectives are described in the investment company’s prospectus, which also lists the securities actually held by the fund when the prospectus was issued.

Funds can be structured for “aggressive growth,” “income,” “growth and income,” “tax-exempt income,” etc. Moreover some investment companies narrow the focus of their activities to investments in specific industry groups, such as information science and medical technology. There are over 500 investment companies to choose from. Thus, it is not difficult for planners to find several with objectives that correspond to those of a particular client.
There are two types of management companies: closed end
and open end.

Closed end. Closed-end companies have a fixed number of shares outstanding that trade in the OTC market. Closed-end funds fluctuate in value and are usually redeemed for a price below the value of the net assets.

Open end. Open-end companies-or mutual funds-are so named because they make a continuous offering of new shares to the public. As capital comes in from the sale of new shares, it is invested by the fund’s managers.

Unlike those of closed-end companies, mutual fund shares do not trade on exchanges or in the OTC market. Rather, shares are redeemed by selling them back to the fund-usually at the net asset value (NAV). The NAV is simply the market value of the fund’s assets, less liabilities, expressed on a per-share basis. Securities regulations require that redemption requests be honored within seven days.

In addition to the current value of the shares, it is important to look at a fund’s long-term performance. The prospectus usually includes 10-years of financial data. Of course, for newer funds, a shorter period is listed. To determine performance, start with the fund’s NAV for the period and add net income. Then add the gain or subtract the losses. Any distributions from realized capital gains should be subtracted. The result is the NAV for the end of the period. This figure can be compared to the NAV for each year to determine profit or loss. Table 9.3 provides an example of NAV calculation for a mutual fund.

The example shows the NAV at the beginning of 1983 as $11.05 and an ending value of $12.49, for an increase of 13.03 percent. In 1984, the beginning NAV was $12.49 and the ending NAV was $12.08, for a loss in NAV of 3.28 percent.
Load and no-load funds. Some mutual funds include a load, or sales charge, for the purchase of shares. The maximum allowable charge is 8.5 percent of the offering price (the price at which the client purchases the shares). With no-load funds, no such charge is involved. To date, there is no statistical information indicating that load funds outperform no-load funds. In the financial press, price quotes for mutual funds are usually shown as follows:

Investors could have purchased shares of A Fund for $10 per share. These shares have a net asset value of $9.15. The difference between the cost and NAV figures is the 8.5 percent sales charge ($10 less 8.5% _$9.15). The C Fund is a no-load fund because there is no sales charge. Thus, the NAV and offering price are the same.

Other fees
When selecting funds, planners should be cognizant of withdrawal charges and redemption fees that are taken out of the proceeds of some funds, both load and no-load when they are redeemed.

Recently a new fee, known as 12b-1, has been charged. This fee stems from a 1980 Securities and Exchange Commission (SEC) ruling that allows a mutual fund to use assets to pay for distribution or sales expenses, such as advertising or mailing material to customers. The SEC has not placed a limit on the percentage involved. Currently 12b-1 funds charge fees ranging from 1 percent to over 2 percent.

Some critics conclude that existing shareholders are financing the growth of 12b-1 funds. The concern of others is the fact that no separate expense category is listed in the prospectus of such funds. So checking for this hidden fee is not easy. However, future SEC regulations may change how the fee is shown.
All mutual funds charge a management fee, usually in the range of .05 percent to 1 percent of the total assets of the fund. This fee is a major source of revenues to the investment companies. In return, shareholders receive professional selection and management of a portfolio of securities, safekeeping of certificates, and regular reports and distributions.

Mutual fund selection
When selecting a mutual fund for a particular client, the planner has two tasks: (1) determining which funds have objectives and risk characteristics that match those of the client; and (2) selecting from this limited group of candidates the ones most likely to perform well in the future. It is the second of these tasks that presents the greater challenge to the planner.

When selecting stock, the characteristics and earnings prospects of particular firms are analyzed. Mutual fund selection comes down to finding those money managers who are better than others at trading securities. Picking mutual funds is like going to a race where bets are placed on the jockeys, not on the horses l
In making decisions about the future, it is often necessary to look to the past. The historical performance of individual funds are documented in several places. Lipper Analytical Services, the Weisenberger Report, the United Mutual Fund Selector, and the Standard & Poor’s Stock Guide all track performance over many years. But some funds are so new that past data are not helpful. Also, successful fund managers often move from employer to employer; this information is never available through regular sources.

Dollar-cost averaging. Besides the obvious benefits of professional management and shareholder services, mutual funds make regular investing of modest amounts both convenient and possible. In this sense they are useful to clients whose financial plans call for channeling discretionary funds into a pool for longterm accumulation. Clients who can discipline themselves to channel funds in this way find mutual funds a fairly painless way to build an investment portfolio over time. Such systematic investing results in dollar-cost averaging. Fund share prices fluct,uate over time. So committing a fixed dollar amount to purchasing shares on a regular basis results in an average purchase price somewhere between the highs and lows. For instance, when share prices are at $10, a $100 purchase adds 10 shares to the portfolio; when prices are at $5, a$100 purchase adds 20 shares. The investor then has 30 shares at an average price of $6.66.

As mentioned, there is a second type of investment company. These companies issue redeemable shares that represent an undivided interest in a fixed portfolio of specific assets and are called unit investment trusts. They are similar to mutual funds in that monies generated through the sale of shares are used to acquire specific assets. Mutual funds, however, are managedi.e., securities in the funds are traded in response to economic conditions. Unit trusts make no attempt to manage assets, except in unusual situations. Typically, a unit trust will buy a stated portfolio of securities and deposit them with a trustee.

Securities placed in this type of trust include GNMAs, corporate and municipal bonds, preferred stocks, and equity ownership in real estate. The fixed-interest securities are of course, sensitive to interest-rate fluctuations. For example, as interest rates decrease, the value of a unit trust holding bonds will increase and vice versa. Interest and dividends are paid out periodically to unit holders according to their share of ownership. The unit investment trust terminates when the last asset matures.

Real estate has long been the backbone of many investment portfolios. In point of fact, statistics show that more money has been placed in real estate partnership than in other types of investment partnerships. Motion pictures and television programs have dramatized the fear, excitement, greed, riches, and scarcity factors which this vehicle can produce. This was especially evident in the latter half of the 1970s when an enormous amount of profit was made in real estate.
Whether real estate partnerships are very conservative or extremely aggressive in terms of potential risks, rewards, and tax deductions depends on the use of debt. Real estate is not currently subject to the at-risk rules, so financing can be obtained through nonrecourse loans. This type of debt can lead to a great deal of abuse. To minimize inappropriate creativity in financing real estate investments, Congress enacted the overvaluation rules. These rules penalize investments that increase the cost of property by creating fictitious nonrecourse debt. Previously, unscrupulous promoters were able to offer high write-offs, such as depreciation and interest deductions, because the basis was dramatically increased through the use of debt. At the same time, the fair market value of the real estate was significantly below the value of the stated nonrecourse debt.

As an illustration, consider the case where Promoter A buys an office building under these terms:

Purchase price $1,000,000 Down payment 300,000 Assumes 9% loan 700,000
The value of the building itself is $900,000, and an 18-year ACRS depreciation is used. If the building was purchased on January 1, the depreciation would be $90,000 the first year.
To create artificial deductions, Promoter A restructus es the terms and sells the building to the partnership under these conditions:

Purchase price $3,000,000 Down payment 300,000 Wraparound mortgage 2,550,000
If the value of the building is recomputed to $2.7 million, depreciation under the accelerated cost recovery system would be $270,000 the first year, versus $90,000 under the original purchase price. The financing also produces enormous interest expenses, which will be accrued but not paid. To eliminate this type of transaction and to encourage the accurate valuation of property, Congress enacted the penalties listed in Table 10.2. The penalties are applied to the underpayment of taxes, because the tax shelter produced more deductions than were legitimately allowable.

There are many different categories of real estate, such as raw land, residential property, and commercial property. The key with any type of real estate investment is to remember that the more debt placed on real property, the greater the benefits of appreciation and the greater the risk of loss or need for further capital infusions.

Raw land. The purpose of investing in unimproved property is the potential growth in value. There are minimal tax deductions associated with raw land, unless it is leveraged. For example, land itself cannot be depreciated, but any interest paid due to debt is deductible.

A well-located parcel of raw land in the path of progress can produce an excellent return through appreciation. If the property is leveraged, the profit could be spectacular and would be taxed at long-term capital gain rates. (Note: The holding period must be at least six months if the property is purchased after June 22. 1982. Also, the investor cannot be classified as a dealer, or the gain is treated as ordinary income.)

Leasing limited partnership can provide significant benefits and surprises. Investors need to know the purpose of the investment, its tax consequences, the level of risk involved, and the potential yield.
The leasing of office equipment, machinery, and vehicles has become a big part of the national economy. The person or entity owning such equipment is called the lessor. The lessee is the person or business leasing the equipment.
Individuals may lease a car because they do not want to purchase, or cannot afford the down payment for a new car. Corporations may lease equipment rather than buying it because they:

• Can minimize the obsolescence factor.
• Can avoid spending the capital necessary to purchase equipment.
• Can better use their money through leasing rather than
buying equipment.
• Can enhance their corporate financial statement by leas
ing.
• Are unable to utilize the tax deductions and credits associated with ownership because they are already in a low tax bracket.

Why would investors participate in programs designed to lease equipment to businesses? The answer depends on which type of leasing venture an investor chooses. Leasing programs can be structured to produce income or high tax deductions and tax credits or, of course, both.
Where a specific program falls on the continuum is a direct function of the amount of debt involved.

With Program A, investors receive $22,000 net income after expenses. However, depreciation provides deductions totaling $14,250, leaving taxable income of $7,750. In a 50 percent tax bracket there is $3,875 of taxable income. In addition, there is $10,000 of investment tax credit (ITC), which shelters one dollar for one dollar of taxes owed. Investors in Program A receive a tax-free cash flow and tax benefits according to their percentage of ownership. Cash flows in subsequent years will be sheltered only through depreciation, and the 10 percent ITC is available for the year the equipment is purchased and placed in service. If the credit cannot be utilized then it is carried back three years and any remaining balance is carried forward on the tax return.
With Program B, the investor’s total cash contribution is only $10,000 and the net income is $1,000. The tax deductions amount to $31,250, and the ITC is $10,000. The main motivation for investors in Program B is not income, but deductions and credits that would shelter other income.
The tax benefits are received in direct proportion to the percentage of ownership each investor has in the partnership. Therefore, if five limited partners who are in the 50 percent tax bracket each invest $2,000 in Program B, the limited partners would have excess deductions of $1,050 (net income of $22,000, minus interest of $13,000, minus depreciation of $14,250, divided by 5). The tax savings for each limited partner is $525 ($1,050 x
50% tax bracket) and $2,000 ITC (1/5th of $10,000 ITC) for a total in-pocket savings of $2,525 for each $2,000 of original investment. These limited partners also received their percentage of the $1,000 net cash flow: $200 each.
To obtain all of these tax deductions and credits, the investment must be structured to conform to the requirements imposed by the Tax Reform Act (TRA) of 1984. The concept of “at risk” is especially important to claim the maximum investment tax credit allowed.
At all times, investors must be at risk to the extent of at least 20 percent of the basis of the qualified property. The 20 percent at risk provision includes all cash and the amount of recourse financing for which the investor is personally liable. Therefore, nonrecourse financing may not exceed 80 percent of the property basis. However, the remaining financing must be from a “qualified, nonrelated” source, such as a bank, savings and loan, or credit union, because, in theory, lending institutions loan money only to those who will be able to pay it back and go to great lengths to enforce repayment. And, of course, the property must not be acquired from a “related” person or entity.
An important feature is that the $10,000 investment interest rules apply. Highly leveraged leasing programs also produce ordinary income, and recapture any phantom income. (Phantom income is described in Chapter 7.)

With leasing arrangements, certain key questions must be answered.

• What is the financial strength of the company leasing the equipment? Without the continued flow of leasing payments, both programs in Table 10.5 would leave the investors in a negative position. However, the B investors would be devastated by debt payments coming directly from their own pockets. Once again, tax benefits are never enough if a deal turns sour.
• How easy will it be to re-lease the equipment in subsequent years?
• How quickly does the equipment lose its value? One essential factor in determining the overall yield is the residual value of the equipment. If the obsolescence factor is 1ligh, the remaining value could be less than 10 percent of the original cost.

The economics of a leasing program will always hinge on the level of income that can be generated by the equipment. In a short-term (operating) lease, the total income received is less than the purchase price of the equipment. The type of lease is important because of a quirk in the structure of leasing programs: to obtain the investment tax credit, the lease cannot be for more than one half of the equipment’s depreciable life.

During periods of inflation, gold, silver, gems, stamps, coins, art, antiques, and other collectibles have produced significant increases in value. In periods of political unrest or economic uncertainty, such investments may also show impressive profits.
Investors who purchase these assets will receive the benefits of long-term capital gains if they hold the investments for at least six months. However, generally speaking, no significant tax deductions are available. For example, gold, diamonds, and art cannot be depreciated. (Antiques used as furniture in a trade or business are depreciable.)

Price fluctuations can be dangerous. For example, gold reached a high of almost $200 per ounce in January of 1975, before declining 50 percent. The metal increased again to over $800 an ounce in January of 1980, before falling to $300 a few years later. Silver also showed a spectacular rise, from $2 per ounce in the early 1970s to over $50 per ounce by the spring of 1980. But it subsequently declined to $5 per ounce.

However, gold and silver are immediately liquid, while there may be frustrating delays in selling other hard assets and collectibles without discounting the price. Bullion may also involve liquidity problems, because it must be assayed prior to resale. This is not typically the case with coins such as the krugerrand, maple leaf, or Mexican 50 peso. However, caution should be exercised in purchasing coins. As an example, a few years ago, a large number of U.S. $20 double eagles were counterfeited in Lebanon. Examination by a coin expert before purchase is advisable.

Rare and/or historic coins are also a popular investment. Value is based on a numerical grading scale created by the American Numismatist Association. Accurate grading is essential because, in addition to the risk of counterfeit, many coins are overgraded. An investor should be able to sell a coin at the same grade at which the coin was originally purchased.

Physical characteristics are basic to evaluating coins. The same holds true for diamonds. The most important feature of these stones include:

• Carat weight. The value of a stone increases disproportionately with its weight. For example, a one-carat stone can be worth significantly more than a 0.80 carat diamond.
• Clarity. This is the ability of light to pass through the stone without being interrupted by flaws or inclusions. Investment grades include F.L.-Flawless; I.F.-Internally flawless; V V S-Very very small inclusions; and V. S.Very small inclusions.
• Color. The most valuable diamonds are colorless or almost colorless. The color of investment grade stones is classified by the letters D through H, with D being the most valuable.
• Cut. This is the shape of the stone. A well-proportioned cut can significantly increase the value of the stone.
• Certification. The Gemological Institute of America certifies diamonds, while the American Gemological Laboratory typically certifies other gems.
To value rare coins, stamps, art, and/or gemstones, requires considerable knowledge and skill. If financial planners are to recommend these types of investments, more than superficial familiarity is essential. The following questions may be of assistance:
• What is the origin of the appraisal?
• Is the item being purchased from a dealer with long experience and a solid reputation? Has there been a major turnover in the selling organization, and if so why?
• Is there a consistent, reliable, and active market for trading or selling the asset?
• What is the amount of markup or premium on the item?
• Is the potential of appreciation due strictly to inflation, or to either a supply shortage or eager and numerous collectors?
• Can the investor take possession of the asset without enormous risk or cost?
• How dramatic are the economic cycles affecting the specific asset?
• Is the client really investing or simply collecting? Has the investor fallen in love with the asset?

Gold and silver, among the more popular hard assets, have decreased dramatically from their high point in the early 1980s. However, if the public perceives that the United States is changing monetary policy-printing new paper money or eliminating direct ownership or other forms of currency as well as precious metals-then the price of gold and silver will rise dramatically. The threat of inflation also has a positive effect on the value of precious metals.

The longevity of the financial planning profession will be directly related to the service it provides. Whether a financial planner receives fees or commissions, it is essential that the risks and rewards of various investments be evaluated. One of the more common terms in describing this process is due diligence. Gathering the information for a thorough evaluation is extremely difficult and costly. Financial planning firms and brokerdealers may have their own in-house team to accomplish this task. Nonetheless, financial planners must at some time do their own investigations. The degree and complexity of this endeavor may vary, but planners must still take full responsibility for the investment recommendations they make.

Alternatives to the necessary research are to ignore the questions, to simply trust the opinion of the company’s representative, or to trust the opinion of a good friend.

The essential elements and techniques of an investment evaluation include:

• Investigating an offering company-becoming familiar with the company’s track record, existing or potential problems, and strengths.
• Calculating the rate of return on previous investments of the offering company and projected potential rates of return.
• Determining the level of risk involved and evaluating alternate uses of money.
• Aligning a product with a client’s objectives.
• Reviewing the tax ramifications of the potential investment.
• Monitoring the investment’s on-going performance.

Whether individual stocks and bonds or investment partnerships are analyzed, it is necessary to first look at the type of business. What is the economic climate for this industry? Under what circumstances would performance be devastating? How likely is this to occur? Under what type of government regulations does this business function? How will the business be affected by current taxes or the never-ending changes in tax legislation? The questions could continue ad infinitum.

Many resources can be used in evaluating an investment. There are numerous computer software programs that analyze various stocks and bonds. There are also hundreds of newsletters that attempt to forecast market direction, and some recommend individual securities, among the better known are Des
sauer’s Journa4 Value Line Report, and the Zeig Report. The Hulbert Financial Digest ranks various investment services ac cording to their performance over various time periods. The Stanger Register and the Brenovan Reports analyze limited partnerships.

There are also services that track the performance of mutual funds. Some of the most popular are Wiesenberger Report, Lipper A naly tical Services, United Mutual Fund Selector, and Johnson Charts. Periodicals must not be overlooked. Some of the more important are: The Wall StreetJourna4 Financial Planning Magazine, Chartered Financial Analyst Digest, Business Week, Journal of Taxation, The Practical Accountant, Barrons, Forbes, Fortune, Inc., and U.S. News & WorldReport.

These lists are not exhaustive, and obviously, no one resource has all the answers. However, by utilizing a variety of sources, financial planners can minimize a client’s risk.

Statistical analysis of a company can prove very informative. But, as the numbers are reviewed, a planner must also ask whether the people responsible for past performance are still with the company. If they are not, why not? And what is the experiences of current management? People are a company’s strongest resource. Thus, it is necessary to know the backgrounds and levels of experience of key personnel. Also, are key employees being competitively compensated? (What is the industry norm?) The problem of retention cannot be overlooked.

Home-office assistance must also be evaluated. Is the company’s sales force so strong the home office cannot keep up with all the orders? Home-office problems can also include inaccurate registration, missing dividend checks, and improper crediting to or withdrawals from accounts, to name just a few. Mistakes will always occur, but frustration is directly related to the responsiveness of home-ofice staff. With other factors being equal, most financial planners will choose to work with companies that minimize logjams.
It is enlightening to review a company’s history and how it evolved, as well as the organizations associated with a given company, e.g., accounting, legal and banking firms. Will these associated organizations provide references or documentation? If there is a turnover in outside accounting firms, what is the reason? (Is the company in question simply growing and expanding, or is it displeased with the audit results? Accounting practices should not materially alter investment returns.) Also, are the company’s results comparable with those of other companies in the field?

Stocks and bonds have been the subject of extensive analysis over several decades. The same is not true of investments structured as partnerships. Yet, over the last 15 years, this form of investing has grown significantly. Nonetheless, these forms of investment must also be analyzed. To begin an analysis of a partnership, the prospectus must be reviewed. This rather thick document should reveal all information necessary to investors. However, unscrupulous promoters may declare that their investments are not structured as partnerships, but as sole proprietorships. If this is done and an investment is not deemed a security, then full disclosure will not be required.
The definition of a security can be complex. For example, abusive tax shelters are often sold as sole proprietorships in an attempt to avoid the legal and accounting required in a prospectus. If promoters are attempting to sell products without conforming to security regulations, a planner should obtain a qualified legal opinion. If any doubt remains, contact federal and state agencies that deal with security violations.

With these caveats in mind, this section emphasizes the analysis of investment partnerships, rather than other securities. This is because there are unusual components in these types of offerings. The prospectus is only a starting point, a vehicle to screen out inappropriate investments.

The best place to begin a prospectus analysis is with the table of contents, if it has been included. In addition, the following elements should be examined.
Summary of the offering. This highlights the purpose and terms of the offering. It will reveal whether investors will be treated as general or limited partners. This is important information because investors may enter programs with the idea of limited liability only to find that they have been included as general partners with full liability exposure.

Use of proceeds. From this section financial planners can determine where the money is going. Problems can occur because the terms used are unclear and footnotes do not clarify the questions. Contacting the offering company should clear up the confusion. Once the planner knows exactly where each dollar is going, a comparison can be made. Do other programs have lower fees and commissions? Are the fees realistic? How large are commissions to sales representatives? Are they within a normal range?

Major questions should be raised if the commission structure is abnormally high. How general partners are being compensated should also be noted. Is their level of remuneration within the industry average? Do general partners receive most of the benefits from up-front fees and commissions? On sale, are the profits divided so the investors receive their original investment plus a minimum return before the promoters receive their rewards? Is the minimum return comprised of cash or are tax deductions included in this figure?

Track record. This is where financial planners should look to determine how well previous investors have fared. “Plowing through” the record should show planners the amount of benefits received for each dollar invested. This, of course, is easier said than done.

Securities and Exchange Commission regulations do not require listing the results of all previous offerings. Furthermore, footnotes explaining the sales price of investments do not show the terms of any mortgages taken back by the partnership. Therefore, on most occasions, to determine the true yield, it is necessary to obtain backup figures dirctly from the promoters. To confirm the reliability of these figures, a Statement of Authenticity can be provided by the company’s independent accounting firm.

Sometimes there is no track record because none of the previous investments have gone full cycle (acquisition, management, and sale). In such instances, the expertise of the management team will be the deciding factor in terms of how profitable the investment will eventually be. Management’s expertise and investment strategy are important.

Management. Within this category, the prospectus will give a brief description of the company’s key employees or general partners. It is essential to know whether the general partners have been subject to previous securities violations or fraud charges. This information, as well as the net worth of the general partners, should be listed. Do the general partners have any real assets, or only inflated assets? Any other pertinent information should ae obtained from the promoters.

Throughout this “due diligence” process, financial planners must be aware of danger signals. One red flag is a company that does not send information requested. If repeated requests are ignored, investors should be steered clear of the company.

It is also a good idea for financial planners to form a small group to investigate the general partner. This may make it possible to screen out inappropriate investments. This informal association can also save time and review more programs than could one financial planner alone.

Legal opinion. Typically a legal section of the prospectus supports the investment potential in terms of structure and tax deductions. If there are numerous “hedge” words, caution should be exercised. If the legal opinion doesn’t “stand for” the investment, why should a finanical planner?

Tax aspects. This section should explain how the investment can be affected by the tax code, regulations, rulings, and court cases. Occasionally, the tax section of a prospectus will consist of 12 to 20 pages documenting why the company should be taxed as a partnership. This, of course, is important. However, if no more than one page is allocated to significant tax issues, financial planners should be extremely wary. Does the prospectus address all the important tax issues? Are questionable tax deductions taken? Are legitimate deductions expensed in one year, rather than amortized over 60 months?

There are sections in a typical prospectus that contain information similar to that described above and, with experience, it will be easy to quickly go through those sections. A careful review of the sections on Risk Factors and Conflicts of Interest should highlight any unusual problems. It is especially important to know the debt structure and who is responsible for paying the debt. Are there any letters of credit? Is the value of the debt less than the value of the assets held? Will the level of debt prevent a realistic return on investors’ money?

Remember that government regulations do not require prior performance to be expressed in compound after-tax rates of return. Adjusted rates of return, shown in Chapter 5, would be the most appropriate. Perhaps some day the regulating agencies will be more responsive, requiring general partners to present all rates of return in the same manner.

Partnerships are categorized as either public or private offerings. Public offerings must be registered with the SEC. If the investment can only be sold within a specific state, then the offering may be registered with the appropriate agency in that state. (An example is the Department of Corporations in California.) Government agencies do not rule on the merits of any offering. Their purpose is to review the investment to see that all essential information is disclosed.

Private offering. Private offerings are investment partnerships for 35 or fewer individuals. They do not have to be registered with government agencies. However, the investor must be given the same information provided with a public offering. The 35-investor limit can be superseded if there are accredited investors. Under Regulation D, an accredited investor is one who has at least $200,000 of income or a net worth of $1 million.

After a planner thoroughly investigates a specific investment, a determination must be made as to whether it is appropriate in a client’s investment portfolio. To accomplish this, planners must: 1. Know the client’s specific objectives and the length of time necessary to fulfill them. Is the client investing for growth, children’s education, retirement, or a vacation?

2. Understand the client’s investment temperament, including risk tolerance.

3. Match investments with the client’s positions in the life cycle: income for those who are retired, growth for younger people.

4. Review the client’s investment management skills. Is monitoring and trading stocks a hobby of the client’s?

5. Determine how much is available to invest, and whether it is available as a periodic investment or in a lump sum.

6. Identify the economic and tax ramifications of the investment: ordinary income versus capital gains; investments that respond to inflation or deflation.

7. Ascertain how investments relate to the client’s total portfolio.

There is no single investment that solves all of a client’s financial needs. Nevertheless, dealing with the issues above helps planners determine which investments fit a given client’s selection criteria.

The final step is to review the characteristics of specific investments to confirm that they are appropriate.

As a summary of the analysis process, the following examples illustrate the steps involved for two different clients.

EXAMPLE
Clients: Retired, ages 70 and 72, risk tolerance is low, taxes are low, they are seeking income.
Investments to consider-high-yielding saving accounts, Treasury bills, and conservative income-oriented stocks and mutual funds.
Investments to avoid-highly leveraged real estate rentals, aggressive growth stocks, oil and gas exploration programs, and leveraged equipment leasing programs.

EXAMPLE
Client: Single, age 38, no dependents, risk tolerance high, high tax bracket, seeking to retire at age 55, desires growth. Investments to consider-personal residence, real estate rentals, municipal bonds, oil and gas exploration, market-timed growth stocks and mutual funds.

Investments to avoid-low-yielding savings accounts, minimal growth-oriented stocks and mutual funds, treasury bills.
There are no hard-and-fast rules for selecting the most suitable investment. Rather, the characteristics of investments will change in response to the economic climate and new tax laws. Thus, the guidelines will change and be revised as conditions warrant.

In summary, due diligence must emphasize the initial phases of investigation. However, research must continue after a client has purchased the investments. Periodic reviews and assessments of performance in relation to other investment products are essential. This ongoing process will better enable financial planners to assist their clients in achieving financial objectives.