Guide to Foreign Stock Investments

Many more stocks trade outside of the United States than within. Depending on which stock markets one includes or excludes and the criteria one uses to select stocks, the universe of available investments may be three or four times as large.

This guide is for people who are interested in the idea of investing in foreign stocks but are uncertain of how to proceed.

Table of Contents

Which Countries?
Choosing a Broker
What Types of Accounts
How to Find Foreign Stock Ideas
Researching Foreign Stocks
Trading Foreign Stocks
Foreign Currency Transactions and Exposures
Currency Exposure Management
Taxes and Paperwork

Which Countries?

The best stock foreign stock markets are the ones that are best positioned to help you meet your investment and financial objectives.  While there are many variables to consider, we would begin the process of investing in foreign stocks by focusing on three variables:  transaction costs, counterparty risk and regulatory risk.


Does foreign stock investing make sense for both short-term and long-term investors?  The cost of trading varies tremendously from market to market.  In some cases, the trading of foreign shares does not cost much more than the cost of trading shares in the United States.

If one is a momentum investor who expects to trade frequently, one will want to focus on the stock markets that have the lowest trading costs.  If one’s investment strategy focuses on undervalued stocks and one does not expect to trade frequently, higher trading costs may not represent a significant barrier to investing in a specific stock market.

The cost of trading varies tremendously from market to market.  In some cases, the trading of foreign shares does not cost much more than the cost of trading shares in the United States.  One typically finds low costs if the stock exchange is all-electronic and the settlement of trades is by book- entry only.

In other cases, the market structure may involve floor brokers and the exchange of physical stock certificates.  Trading such markets may cost much more than what one expects in the United States.

One must also consider the cost of converting currencies.  Currency conversion costs range from negligible to a multiple of the commissions one pays to trade a stock.


Counterparty risk pertains to getting paid.  For example, one executes a trade to sell a stock at $50.00 per share.  One sends the shares to the buyer’s broker.  Do they send the cash immediately, or days later according to local business regulations?  Alternatively, one agrees to buy stock for $50.00 per share.  One sends the cash to the seller’s broker. Do they send back the shares immediately, or later?

What happens if the counterparty goes bankrupt after they have received the shares one sold, but before they have sent back the cash?

For the typical U.S.-based investor who uses a U.S.-registered broker to buy or sell U.S.-registered stocks, the U.S. regulatory and market structure reduces counterparty risk to the bare minimum.

One cannot assume the same if one invests in foreign stocks.  There may substantial delays between the movement of cash and the movement of shares.

Wealthier countries tend to have structures in place to reduce this type of counterparty risk.


Although far from perfect, the United States maintains a fairly rigorous regulatory structure for stocks.

The same cannot be said for other countries.  Foreign stock regulators may not have a well-developed regulatory structure to protect the interests of investors.

Where ample regulations exist, the funding to enforce the regulations may not.  If the foreign government does not provide adequate funding, there may not be a sufficient number of regulatory personnel to discourage unethical or criminal behavior.

One should also consider account insurance.  Brokerage accounts in the United States are insured against certain types of theft and similar losses by the broker.  A foreign broker may not protect the investor in that way.


In deciding what foreign stock markets in which to invest, one can design a due diligence process to bring some clarity to the issues of transaction costs, counterparty risk and regulatory risk.

Alternatively, one can limit oneself to trading only those markets that are available through a U.S.-registered broker.  Doing business with a U.S.-registered broker does not eliminate the need to do research on foreign markets.  But we believe doing so will narrow some of the risks because most reputable U.S.-registered brokers will have due diligence processes in place to protect their customers.

Choosing a Broker

One’s choice of a stock broker is an important consideration.  One should think about the range of offerings and the likely transaction costs.


No single broker offers access to the top 30 or 40 stock exchanges.  In the United States, the broadest offering covers stocks traded in 25 different foreign countries.  The least costly broker offers access to stocks traded in 15 foreign countries.

The U.S.-registered brokers offer access to almost all of the economically advanced countries.  They exclude certain important developed ones, notably Taiwan, South Korea and Israel.  They also exclude some less developed countries, such as Philippines, Thailand, Malaysia, Indonesia, Russia, Egypt and Hungary.  Some of these foreign markets may offer outstanding value or momentum stocks.

If one wants access to countries that are not available through a U.S.-registered broker, one must open an account with a foreign broker. Foreign brokers operate under a different regulatory scheme.  Investor protections may differ.


The cost of trading foreign stocks is higher than what one generally encounters trading U.S.-registered stocks in the United States.

The higher cost may simply reflect a higher cost of doing business that the broker passes on to the customer.  If the foreign stock market employs large numbers of people rather than relying on digital trading technology, trading costs will be high.  Similarly, if the local business practices require the recording of share ownership changes by exchanging physical stock certificates rather than electronic entries into the shareholder register, trading costs will be high.

Currency trading costs must be considered separately.  Foreign stock exchanges settle trades in their own currency.  For the U.S. investor to buy the foreign stock, one must come up with foreign currency either by converting U.S. Dollars into the foreign currency or by borrowing the foreign currency.  The cost of converting or borrowing ranges from de minimus to exorbitant, depending on the broker.

Certain types of investment strategies may become untenable in the face of high transaction costs.  In that case, a strategy focusing on undervalued stocks may be best.

Finally, due to burdensome U.S. financial regulations, many foreign brokers refuse to allow Americans to open financial accounts.

What Types of Accounts?

What type of account should one use to fund investments in foreign stocks?

Should one use personal funds or the funds in one’s retirement account? If one has a trust account, should one use it to make the investments?  What about another structure – perhaps a corporation, a partnership, a limited liability company or something similar?

As one can imagine, the answer depends on the circumstances and what kinds of costs and uncertainty one is willing to accommodate.  Most of the challenges relate to taxes and to tax paperwork in particular.

Based on our research, we believe using a personal account to invest in foreign stocks minimizes the tax and paperwork hassles.  If one chooses the countries carefully, the tax compliance obligations could be as little as filing an extra form or two with the Internal Revenue Service.

Trust accounts can be tricky.  The basic problem is one of legal status or lack thereof.  Many countries are unfamiliar with trusts and have made no accommodation for them in their tax laws.  Lack of status can create unpredictable tax results.  Specifically, in such countries the foreign tax authorities may assign the trust income to someone other than the trust – perhaps a beneficiary, but maybe not.  In addition, the tax paperwork requirements for a foreign trust may be more onerous than for a natural person.

Individual retirement accounts face many of the problems of trusts because individual retirement accounts are trusts, too.  See Section 408(a) of the Internal Revenue Code:  “… the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries …” [emphasis added].  In addition, foreign governments may or may not recognize the tax deferral features of a U.S. individual retirement account.  

Corporations, partnerships, LLCs and similar entities introduce another layer of complexity.  You may face additional filing requirements based on the specifics of the structure, perhaps so the foreign governments can track the income of the owners of the entity.

How to Find Foreign Stock Ideas

How does one find a list of stocks that might be worthy of further research?

If one has large amounts of money to spend, one can subscribe to an institutional-quality research database.  The cost of such databases likely exceeds the resources of most small institutions or individual investors.

A cost-free alternative is the global stock screener offered by the Financial Times.  FT offers some predefined screens plus the ability for one to create a custom screen.  While the FT screener offers relatively few variables on which to screen, they offer enough to reduce the research list down to dozens of stocks from tens of thousands.

In some countries – particularly the Anglophone ones in which investing in stocks is a popular past time – active discussion boards and chat rooms can provide investment ideas.

Stock exchanges sometimes provide financial information about the shares they trade.  They may offer a simple screener to identify the more promising potential investments.

Newsletters focusing on foreign stocks are rare.  We searched hard for them and came up with nothing that met our requirements.  To plug this hole, we stepped up and created our own.  We offer two newsletters, designed to meet different investment styles:

  • The Global Deep Value Letter which focuses on undervalued stocks with good quality.  This letter is designed for the classic “value” investor.
  • The Global Value-Momentum-Quality Letter.  As suggested by the title, this letter looks for stocks that are attractive on three metrics – value, momentum, and quality.  This letter is designed for “momentum” investors who want stocks that have performed well.  Because investors can get carried away on the upside, this letter includes value as a stock selection criteria.  The stocks in this portfolio are not as undervalued as the stocks in the Global Deep Value Letter, but they nonetheless seem undervalued to us.

Researching Foreign Stocks

Let’s imagine that one has a list of foreign undervalued stocks that appear to have some potential.  Some people will throw caution to the wind and just buy them.  But most people will want to do additional research.

In the United States, obtaining financial information about U.S.-registered stocks is not difficult.  One can start with a company’s website.  Most companies having securities traded by the public include an “investor relations” page on their websites.  The page usually includes information about the stock and copies of important corporate filings.

If a company’s investor relations outreach is insufficient or non-existent, one can turn to the Federal government.  The EDGAR system of the United States Securities and Exchange Commission warehouses an enormous number of corporate filings.  If one knows the name or the trading symbol, one can obtain an indexed listing of a company’s filings.

One can also go to websites like Yahoo! or Morningstar to find financial information about U.S.-registered stocks.

If one is investing in foreign stocks, the research process is similar.  Many foreign companies maintain an investor relations page on their website.  If the company website does not provide adequate information, one may be able to find official corporate filings online, possibly with the Ministry of Finance (or equivalent), the securities regulator or the stock exchange that makes a market in the stock.

One should expect that foreign websites and financial filings likely will be in a foreign language.  If one cannot read the foreign language, one can obtain a translation for free by using Google Translate.  Simply cut and paste the text into Google Translate.  Even better, Chrome Browser users can click on the translate button in the right corner of the browser’s address bar.

Undervalued Stocks

When one clicks on the icon, this will appear:

Undervalued stocks

The translation may be of mediocre quality, but one can get the gist of what the page says.

If does not want to bother with document translation, one can consider websites that aggregate information about global stock opportunities.  For example, the Financial Times website can be searched for detailed financial and other information on specific stocks.

Trading Foreign Stocks

While not difficult to master, the mechanics of trading foreign stocks are a little different than trading U.S. stocks.  People investing in foreign stocks should plan accordingly.


The most obvious difference is that foreign stocks are priced in a foreign currency.  For countries with currencies that have little value per unit, one should expect to see stocks trading for very large amounts of currency.  In the U.S., it would be unusual to see a stock trading for more than $2,000 per share.  In contrast, many Japanese stocks trade for more than 2,000 Yen per share.  With an exchange rate of more than 100 Yen per U.S. dollar, a Yen price of 2,000 is the equivalent of less than US$20.00.


The U.S. stock markets are open from 9:30 AM to 4:00 PM – a full six and a half hours.  Other markets may be open for shorter periods of time or may have more than one session during the day.  For example, the Tokyo Stock Exchange has two 150-minute sessions, one in the morning and one in the afternoon with a one-hour break between the two.


If one lives on the East Coast of the United States, trading in Japan is about one-half of a day ahead.  Thus, to trade Tokyo on Monday morning, one trades in New York on Sunday evening.  To trade Tokyo on Friday morning, one trades in New York on Thursday evening.  The Tokyo market is closed for the weekend during Friday New York regular business hours.

Europe’s regular trading hours are the equivalent of early morning for East Coast United States investors.


Countries may have different types of symbols for stocks.  In the U.S. we use the letters of the alphabet.  Many countries have adopted the same practice.  In Japan, the symbols are numbers – e.g., “6160” or “6161.” Other countries use a combination of letters and numbers.


In the U.S. and in many other countries, the minimum trade size is one share.  Other countries may require minimum trades of one hundred or even one thousand shares.

Foreign Currency Transactions and Exposures

When one starts investing in foreign stocks, one must learn to work with foreign currencies.

Foreign currency is an issue not just in the buying and in the selling of foreign stocks. If the stock does not rise or fall but the currency moves, one’s net worth (expressed in U.S. Dollars) will move solely because of the movement of the currency.

If one opens an account with a brokerage firm like Interactive Brokers, one has three options for managing currency exposure:

  • Exchange currencies;
  • Borrow currencies;
  • Hedge currencies using futures.


One can exchange currencies as part of one’s investment program.  This means if one needs Japanese Yen to settle a trade, one sells U.S. Dollars to buy Japanese Yen.

The sale of a Japanese stock will settle in Japanese Yen.  If one needs U.S. Dollars, one sells the Japanese Yen to buy the needed U.S. Dollars.

Interactive Brokers charges a commission every time it exchanges currencies.  The commission is small.


Companies like Interactive Brokers also provide foreign currency margin loans.  Instead of having to convert U.S. Dollars into Japanese Yen in order to settle the purchase of a Japanese stock, one simply borrows as many Yen as one needs to settle the trade.  When one sells the stock, the proceeds from the sale (in Japanese Yen) are used to pay down the Japanese Yen margin loan.

Margin loans are a natural currency hedge.  One owns a foreign currency asset (the foreign stock) and incurs an offsetting foreign currency liability (the margin loan).

The brokerage firm charges interest on outstanding loan balances.  One must maintain sufficient collateral to avoid margin calls.


One can use futures to hedge currency exposures.  When one enters into a futures contract, one agrees to receive or to deliver foreign currency at a specific time in the future.

If one has a long futures position, one agrees to receive the foreign currency.  Economically, this is equivalent to owning the foreign currency. If one has a short futures position, one agrees to deliver foreign currency. Economically, this is the equivalent of having borrowed the currency.

Generally, one may hedge the currency exposure of a foreign stock position by going short a foreign currency futures position.

Trading futures incurs commission costs.  One must maintain adequate collateral to avoid margin calls on the future position.

Currency Exposure Management

Ownership of a foreign stock does not require one to assume the risk of the foreign currency.  One can easily reduce or eliminate altogether the risk of owning the currency while preserving exposure to the performance of the foreign stock.

If the prospects for a currency look good, then one might consider having an unhedged position.  This means taking on the full exposure to the currency.  In contrast, if the prospects for a currency do not look good, one might consider hedging the risk.

How does one decide whether a currency has good or not good prospects? While one can never know for sure what will happen to the price of a currency, we look at three variables:  price trend, interest rates and purchasing power parity.


We believe that a trend in place may have a tendency to continue.  Thus, if the trend of a currency is upwards (meaning it is becoming more valuable over time), we assume that the odds may be a little better that the currency will become more valuable in the near term.  Contrariwise, if the trend of a currency is downwards (meaning has been losing value over time), we tend to think that it may continue to lose value.


In our view, currencies with higher yielding short-term investment opportunities may be more attractive than currencies with lower yielding short-term investment opportunities.  By short-term investment opportunities, we mean the highest quality government short-term bills, notes or bonds available to investors.

In comparing yields, one must make appropriate adjustments for differences in credit risk.  Governments with speculative credit grades should yield more than investment grade governments.

One should also make adjustments for inflation rates.  The currencies of high inflation economies may lose value faster than the currencies of low inflation economies.  Consequently, one should consider looking at the real interest rate by deducting from the interest rate the rate of inflation.  Currencies with higher real interest rates may perform better than currencies with lower real interest rates.


Another approach is to consider what equivalent amounts of currency can buy in each country.  If US$ 100 buys a nice gift, does the same amount of money converted into Euros buy two nice gifts?  If yes, then owning Euros may be a better idea than owning U.S. Dollars.

Taxes and Paperwork

Investing in foreign stocks likely will create additional tax paperwork and – possibly – some new tax liabilities for the investor. The nature of one’s new compliance responsibilities depends in part on the countries in which one chooses to invest.  For a number of countries, the foreign individual investor faces a light incremental tax compliance burden.  For a few countries, the hassles are significant.


Tax compliance includes two distinct concepts:

  1. Paying the correct amount of tax, and
  2. Filing the correct income declaration forms.

In many countries, one must do both correctly.  One can be fined for not paying the tax.  Even if one has paid the correct amount of tax, one may still have to file forms declaring the income that gave rise to the tax.  A failure to declare income on the correct form may itself give rise to a fine. If unpaid the fine can compound over time.


In most cases, calculating and paying the foreign tax is the easy part. Frequently, the foreign governments tax only the income from one’s foreign stocks.  The tax likely will be withheld fully from the dividends.  The dividend payor remits the tax directly to the foreign government.  In many cases (but not all), capital gains are entirely exempt from foreign tax.

Filing the correct paperwork is less clear.  A number of governments do not want the foreign investor to file forms if the investor’s income tax liabilities have been covered through the divided withholding system.  The dividend payor already has provided the information to the government when the payor remitted the withholding.  For the taxpayer to submit an additional return would impose an unnecessary cost on the foreign government’s tax administration.

However, not all governments feel this way.  One must take care to understand what paperwork the various governments require.  A review of the details vastly exceeds the scope of this post.  My book covers this information for a large number of countries.


While foreign governments may impose a light or no tax on the income and capital gains of U.S. investors in foreign stocks, the U.S. taxing authorities will fully tax such earnings.

The tax code provides for tax credits to offset taxes paid to foreign governments.  Thus, it is highly likely that one will not have to pay duplicative taxes to the U.S. and to foreign governments.  One may have to file an additional form in order to claim the foreign tax credit.

In fulfilling one’s U.S. tax compliance responsibilities, one will also have to pay attention to FATCA and FBAR.  These forms are less about measuring and taxing income than making sure that the taxpayer is not hiding foreign income from the U.S. tax authorities.  One does not want to make mistakes with these forms … the fines for non-compliance can be astonishing.  FATCA and FBAR mostly (but not entirely) apply to people who have foreign financial accounts.  Depending on the types of securities in which one invests, carrying on one’s foreign investment activities through a U.S. brokerage account may relieve one of having to file FATCA and FBAR forms.


What we are reading on 12/29/2016

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
India’s experiment with cash is turning out badly.
On fighting cognitive decline.
The prospects for inflation.
2016 alts review
A look at emerging markets stocks.
Honesty – at times tough but always worth it.
A list of mind hacks.
Hussman’s latest
Diversification can test one’s patience.
Indexation can distort markets.

What we are reading on 12/28/2016

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Are the odds of a trade war rising quickly?
Why is Germany taking back its gold?
Is there any opportunity in Emerging Markets bonds?
An explanation would be nice … Antarctic ice volumes hit a 35-year high.
Exercising in the winter … how about Crossfit?
College career counseling leaves something to be desired.
A little wisdom on spending.
One person’s new year’s resolutions.
Japan demographics are poor. Germany could be worse.
Farm Tech developments.
An old interview with John Neff.

Sustainable Income

If the income investor focuses too heavily on maximizing his income and then spends it all, he risks diminishing his purchasing power over the long-term. To maintain purchasing power, some portion of the income must be reinvested in productive assets. The importance of reinvestment cannot be overstated. Compounded over many years, even modest rates of inflation will erode significantly the value of a fixed income.

For the investor who wants income from investments in companies, there are two basic reinvestment approaches:

  1. The investor reinvests on behalf of himself.
  1. The company reinvests on behalf of the investor.

Each approach has certain advantages and disadvantages:

The Investor Reinvests

The investor owns shares in companies that pay out all of their income. Rather than spending every last penny of income, the investor reinvests a fraction of the dividend. The reinvestment hopefully leads to more income in the following years, which offsets the effects of inflation on purchasing power.

For an investor in stocks, the success of the reinvestment depends on the ability of the investor to identify attractive investment opportunities. If the investor can reinvest at high rates of return, he will have good prospects for maintaining his purchasing power. On the other hand, if the investor cannot find attractive opportunities, he may fail to maintain his purchasing power notwithstanding his reinvestment program. He might as well have just spent the money on his lifestyle.

Finding attractive investment opportunities may depend on circumstances beyond the investor’s control. The price paid for the investment may be the single most important variable. The higher the price paid, the lower the future return. Sometimes prices for most assets are too high and future returns are unattractive. In those cases, it may be very difficult to sustain purchasing power.

The Company Reinvests

In this approach, the investor owns shares in companies that pay out just a portion of their income. The companies reinvest the remainder in their respective businesses in order to grow; if successful, their growth leads to future increases in revenue, cash flow, earnings and dividends that offset the effect of inflation.

Management has the important task of determining how much to reinvest. Most managements will make the decision based on their ability to find investments that offer a return in excess of the cost of capital. Management determines the cost of capital. In theory, it is the rate of return “required” by the investors in the company. Management attempts to guess intelligently the what minimum rate of return the investors require.

If the cost of capital is 8%, management will invest in projects that yield better than 8%. In a perfect world, they will start with the highest return projects and work down the list, stopping once the return equals the cost of capital.

If management has excess cash and cannot find opportunities with a return in excess of the cost of capital (in this case 8%), they may hold on to the cash in hopes of finding a suitable opportunity in the near future. Since the cash likely will earn far less than 8%, holding cash will reduce the average returns of the corporation.

Alternatively, management may decide to give the excess cash back to the shareholders through a dividend. This passes the responsibility for finding an attractive investment to the shareholders. Some shareholders may be successful at finding attractive ways to invest the cash. Others will not, and those shareholders likely would prefer that management had invested at a lower rate of return (6% or 7%) because it was better than what the shareholder himself could find.

Management can also dispose of excess cash through stock repurchases. In this case, the company simply buys its own stock in the open market. The return on the investment depends on the price of the stock. If the company repurchases its stocks at a price significant below intrinsic value, the rate of return could exceed the 8% cost of capital. On the other hand, repurchases of overvalued stock could result in a rate of return far less than the 8%.

A repurchase allows the shareholders to tailor their decisions according to their own opportunity set. Stockholders with access to better opportunities than the company could choose to sell their stock during the repurchase and invest elsewhere. Other stockholders can stay put.

A Tentative Conclusion

If we assume a reinvestment requirement, we think most investors would benefit by delegating the responsibility to company management for two reasons:

  1. The company can reinvest directly in its business or in its own stock, whereas the investor can only invest in the stock.
  1. Management has access to proprietary information that should position them to make a better decision than the investor.

What we are reading on 12/23/2016

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Thoughts on how to choose stock picking factors.
There’s more to getting rich than IQ.
How about saving more?
Wisdom from an experienced investor.
Trump could have a lot of influence on the Fed.
Greece still has problems.
2029 – the year Social Security is expected to run out of money.
Health care is a very strange business.
Thoughts on investing and meaning.
Rebalancing might not be a bad idea.
Own your mistakes.
This is an insight?
Sayonara Yen

What we are reading on 12/22/2016

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Works helps create a feeling of dignity
Tax reform might be hard to accomplish
Reviewing your trading records can be an eye-opener
A very long term outlook can have its benefits.
Let the 2017 forecasts begin!
Problems = opportunities
Commodities futures for newbies.
Evaluating investment performance is really hard.
Fixed income is starting to experience the smart beta revolution.
Housing expenditures are way up over the past few decades.
Does purpose affect performance?
Tensions over currencies may rise
Who knew? Magnets can affect memory!

Income, Growth and Total Return

Some people believe there are two basic investing goals: income from capital or growth of capital. Retirees tend to favor income; people who are accumulating savings tend to favor growth.

The Income Investor

With this approach, the income-oriented investor may eschew certain types of opportunities. Understandably, the income investor will ignore a company with neither earnings nor dividends but with a promising future. In contrast, the income investor might look favorably on the opportunity to invest in a dividend-paying utility.

But the income-oriented approach may lead to nonsensical results in some cases. For example, imagine a company that historically has made profits and paid a dividend consistently over many years. The company hits a rough patch, loses money and eliminates the dividend. Now profitability is recovering and the company is expected to reinstate the dividend. The stock is deeply undervalued. Instead of getting in early, the income investor may delay because the stock has no dividend now and miss the opportunity.

Or consider the opposite: a company that is in long term decline and no longer has the earnings to support the payment of the dividend. The stock has a high yield because the investment community collectively believes it is only a matter of time before the dividend is cut. Some income investors will buy such a stock strictly because of its high yield, notwithstanding the poor prospects of the investment.

The Growth Investor

The growth investor may focus on investing in growing companies. He hopes to grow his capital by investing early in the next Facebook or Google. As the company’s revenues, cash flow and earnings multiply ten-, twenty- or one hundred-fold, the growth investor anticipates his capital growing by many multiples of his original investment.

The growth investor may be just as self-limiting as the income investor, but in a different way. It is true that one can multiply capital by investing in a growing company. But one can also multiply one’s capital by investing in stocks at prices that are significantly less than intrinsic value.

For example, imagine a company that dominates a low growth business. The company’s real estate and other non-core assets are recorded on the balance sheet at values significantly less than fair market value. After many years of dithering, management is ready to monetize these non-core assets for the benefit of the shareholders. The stock does not reflect any of the good news. Concerned only with revenue growth, the growth investor might pass on this stock even though it has the potential to appreciate significantly.

The Total Return Investor

Both income and growth investing have limitations. Therefore, we favor a third approach: investing for total return. We want to see our money produce even more money. We don’t really care if the new money we get is called a dividend, an interest payment or a capital gain. We just want to increase our money as much as possible (after taxes) for a given level of risk.

What we are reading on 12/21/2016

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Newbie intro to distressed debt.
The small cap universe is getting squeezed.
One sign of a stronger labor market …
Truth v. perceptions of truth
Deep spending cuts are in order …
It’s hard for the investor to understand the inside of a company.
The Fed has a difficult role.

Dividends and Mental Accounting

Cash is fungible – my $20 bill is worth exactly the same amount as someone else’s $20 bill. Thus, a $20 cash dividend is in reality exactly the same as:

Thus, a $20 cash dividend is in reality exactly the same as:

  • $20 of cash earned through one’s labors,
  • a cash gift of $20,
  • $20 of cash received from a scratch lotto ticket,
  • $20 of cash received from the sale of real property, and
  • $20 of cash received from the sale of a common stock.

Yet some investors believe that cash from one source is somehow different than cash from another source. It is “reasonable” to spend $100 of dividend income, but a very bad idea to spend $100 received from the sale of an investment. Mentally, people account for the two differently – spending income is OK, spending capital is not OK.

The trick here is that most people assume that dividends are income, but in reality dividends and income are unrelated. Some less-than-scrupulous Wall Street companies exploit this misunderstanding to profit at the expense of the unsophisticated investor.

They do this by creating securities that have artificially inflated dividends and selling them to unsophisticated investors. The investors who buy the securities are desperate for income but do not want to spend capital. The thought is that the spending of capital is like eating the seed corn. Once the seed corn is gone, one cannot plant a new crop of corn. By spending only the dividend, the investor thinks he is preserving his seed corn for year after year of crops. However, in

However, the investor makes the error of assuming that the dividend is income.  In some cases, the dividend is not entirely income, but is partly a return of the investor’s capital. Thus, Wall Street feeds the seed corn to the investor while the investor thinks that he is eating something else.

The Components of a Dividend

Some people think of a dividend as income from an investment. That may be true and often is true, but it is not always accurate. This inaccuracy can result in bad investment choices.

A better way to think of a dividend (one that could reduce the likelihood of making a bad investment decision) is as follows:

  • A dividend is a distribution of property to the owners of an equity security;
  • The distributed property may take one of several forms including cash, securities and tangible property; and
  • From an accounting perspective, the distribution could be income, a capital gain or a return of capital, or some combination of the three.

Distribution of Property

We define a dividend broadly as the distribution of property to the owners of an equity security. An “equity security” could mean common or preferred stock in a corporation or a partnership interest.

“Equity security” does not mean a loan, note or bond issued by a corporation or partnership. Loan holder, note holders and bond holders can receive distributions of property; however, such distributions usually are characterized (for tax purposes) as interest income.

Form of the Distributed Property

A distribution of property often takes the form of cash, but not always. Subject to its own bylaws and possibly to other laws and regulations, a corporation in theory could distribute any corporate asset: not just cash, but other securities owned by the company, accounts receivable, inventory, real property and equipment.

Characterization of the Distributed Property

From an income tax accounting perspective, the distributed property may be income, a capital gain or a return of capital. If the security is held in a taxable account, distributions characterized as income or capital gains may be taxable. In contrast, a return of capital is not likely to be taxed.