Pardon the Jargon #2: 5 more terms you should know

Investing jargon. We hate it. Nothing makes it harder for new investors to get started than overcoming the wave of acronyms and terminology that comes with investing. In episode 67 (listen here) we broke down 5 key investing terms. In this blog post we break them down further, and include a lot of the detail we couldn’t include in the podcast.

 

1. Alpha

Alpha can simply be understood as outsized returns. You’ll hear fund managers and investing professionals use the term as they try and prove they can achieve ‘alpha’ through their strategies (basically, beat the market and their competition).

Alpha is measured against a benchmark. This is usually a market index – so in Australia it may be the ASX200 (200 largest public companies in Australia) or the All Ords (500 largest public companies in Australia). In America, the index may be the S&P 500 (500 biggest public companies in America), or if the fund is focused more on technology and growth stocks a more appropriate baseline may be the NASDAQ (the stock exchange will most technology stocks listed).

Alpha is generally represented as a single number (e.g. Alpha of 3, Alpha of -2). This refers to the percentage of outperformance against the benchmark. So for example if a fund manager returns 20% in a year, while the ASX200 returns 5% – then that fund manager would have achieved alpha of 15. However, if the ASX200 returns 10% and the fund manager only achieves a 5% return, then the fund manager’s alpha is -5.

When you hear or read the term ‘alpha’ or hear of an investor ‘chasing alpha’ or ‘achieving alpha’ just think of market-beating returns.

 

2. Beta

The flip side of Alpha (measuring returns) is Beta – a measurement of risk. In this case risk is measured by comparing volatility (the amount the price moves up and down) relative to a benchmark. Similar to Alpha, this is a comparative measure and the benchmark is usually a major market index but can change.

Beta is also represented as a single number. However, unlike alpha is represents a multiple (whereas alpha’s single number represents percentage of outperformance). A beta of 2 for a stock means the stock moves 2x as much as the benchmarket. If the beta is -2 then the stock has moved 2x as much, but in the opposite direction.

For example, Amazon has a beta of around 1.6. This means it is more volatile than the market but moves in the same direction. So when the market moves up 1%, Amazon moves up 1.6% and when the market moves down 1%, Amazon moves down 1.6%. On the other hand, US Government Bonds have close to zero beta, because their price moves far less than the benchmark index.

The problem with calling beta a measure of risk is volatility and risk are not the same thing. Volatility measures how much the price of an asset moves (so the more volatile, the more likely a stock is to lose value). However, risk shouldn’t be thought of as day-to-day gains and losses. Instead risk should be thought of as the chance you can lose everything – that is the real risk you want to protect yourself against. When you think of risk like that volatility becomes less important. It isn’t true that the more volatile a stock, the more likely it is to go to lose all its value. Therefore, volatility and risk shouldn’t be thought of as the same thing.

 

3. Blue Chip

Blue chip is a label given to stocks that are generally nationally-recognised, well-established and financially-sound companies. They are considered reliable investments and are thought to be able to weather market downturns and continue to operate profitably despite poor economic conditions. Due to these characteristics they are often thought as excellent long term investments.

In Australia common examples of blue chip stocks are; the Big 4 Banks, Wesfarmers, Woolworths, BHP, Rio Tinto, CSL, Macquarie Bank and Transurban. One company that was often labelled a blue chip was Telstra, however, given the company’s recent troubles we wouldn’t include it anymore. This is a good example of how a company that blue chips come and go, and no company lasts forever. Other examples of former blue chip stocks are newspaper stocks around the world and stocks of bricks and mortar retailers in Amazon-ravaged countries.

 

4. Market Capitalisation

Market Capitalisation, often shortened to Market Cap, is a measure of the total value of a company. It is calculated using the following:

Total number of shares x Share price = Market Cap

 

Market cap shows the value the market is giving a company. The market cap of a company changes every day as the share price moves. However, it also changes when a company issues more shares (to raise money) or buys back shares. This is why you’ll see the share price adjust up or down when the company either buys back or issues more shares. The value of the company hasn’t changed (it is still doing the same business it did the day before), there are just more/less shares in the company to be traded. You can think of it but changing the formula above to:

Share price = Market cap / Total number of shares

 

It is important to look at the market cap of a company to properly value it. For example, as of 10 August 2018 a share in Amazon is $1,887 while a share in Apple is $207. So if you’re just looking at share price, you’d think Berkshire is far more valuable. However, Apple is worth almost double Berkshire. Their market cap formulas are below:

Apple: $207 share price x 4.83 billion shares = $1.01 trillion market cap

Amazon: $1,887 share price x 487 million = $920 billion market cap

 

So by virtue of having 4 billion more shares on issue, Apple is a higher value company despite having a lower share price. In this way, investors must look beyond share price to understand what the market is telling us a company is worth.

 

5. Index

An index is simply a way of tracking a basket of underlying stocks. An index can be created to track any asset or basket of stocks and they are generally weighted by market cap. A market cap weighted index means the larger companies move the index more, whereas an equal weighted index gives each component in the index an equal weighting.

Think about the ASX200 index. It is an index of the 200 largest publicly traded stocks in Australia. If the index was equal weighted then each of the 200 companies would be given a 0.5% weighting and their combined % changes would move the index. In this version Sigma Health – the 200th largest company would have as much influence on the movement of the index as Commonwealth Bank – the largest public company in Australia.

In the more traditional market cap weighted index, the larger companies have more influence on the movement of the index as a whole. The way to conceptualise this is if you were to add up the market cap (market value) of each company in the ASX200 you would get $1.8 trillion. Then the index weighting is distributed based on how much each company added to that $1.8 trillion. So Commonwealth Bank with $132 billion market cap gets 7.23%, and Sigma Health with a market cap of $519 million gets 0.03% of the index weighting. To calculate the movement of the index think of again adding up all 200 companies’ market caps and seeing how much the total had changed from the day before – that was the movement of the index that day.

In this way it is important to understand that the index is just the basket of underlying stocks or assets. When you’re investing in the index you are investing in the underlying stocks. With passive and ETF investing growing so fast these days, it is important to keep that in mind.

 

If you missed our first Pardon the Jargon check out the podcast (listen to the episode here) or read the blog post (read it here).

If there are terms that you’re struggling to understand that you want included in the next Pardon the Jargon, write them in the comments below.

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