January 2002
Using The Web’s Investment Resources
By Karl B. Putnam and Charles P. Zlatkovich
With the arrival of the Internet, investment information and resources that used to be available only to a fortunate few are now at everyone’s fingertips. What once required enormous patience and persistence to find can now instantly be called to the screen by any web-savvy researcher. But, as more people become their own investment counselors, the challenge becomes understanding this enormous volume of data.
Fortunately, publicly traded companies realize that it is in their best interest to build and maintain websites that help investors. In addition, government agencies such as the SEC and the IRS maintain their own websites, which include a wealth of information that helps investors examine publicly traded companies’ filings and that fosters an informed investor community.
Case Study
Consider an individual who for several years has owned shares in EMC, a provider of computer storage hardware and software. In 2000, he also purchased stock in McData Class B (MCDT), which EMC sold in the open market. In addition, he has received shares of McData Class A (MCDTA), from EMC in a 2001 spinoff. The tax implications can be investigated by going to McData’s website (www.mcdata.com) which links to a form to request the tax basis of the Class A spinoff.
The basis of the EMC stock is apportioned between EMC and the McData Class A spinoff as follows: The tax basis of the McData Class B purchased in the open market will be the purchase price. There will be no taxable gain or loss on the Class A spinoff. This is a relief to the stockholder, because EMC has risen significantly since the original purchase and most investors would prefer not to pay additional taxes unless required. When the Class A stock is sold, the holding period will start with the day of the acquisition of the EMC years prior, making it a long-term gain or loss transaction. The basis of the Class A will likely be small when compared to the sales price (given the small apportioned basis), probably resulting in a long-term gain.
If the relationship between the two kinds of McData stock is confusing, the investor can again go to McData’s website and find an explanation of some of the issues at www.mcdata.com/about/ir/EMCspinoff.pdf. For example, the Class A stock is identical in all respects to the Class B stock, except that the A stock has one vote per share while the B stock has only one-tenth of a vote per share.
An Evolving Strategy
Days later, the McData B shares are selling for 15% more than the A shares. This seems strange, given that the A and B shares differ only in voting rights, with the A the more valuable (but less expensive) security, but such anomalies do occur, and can lead to profits. Because the 15% spread will more than cover the commissions and potential taxes owed, the investor decides to sell his B shares and buy an equal number of replacement A shares. The tax implications of the resulting short-term capital gain are as follows: If a loss would have been realized, the B shares may be considered substantially identical to the A shares. In that case, selling the B while shortly thereafter buying the A may be considered a wash sale. The wash sale rules are explained online at the IRS’s online Publication 550 website (ftp.fedworld.gov/pub/ irs-pdf/p550.pdf).
Weeks later, after the investor sold the more expensive B stock with inferior voting rights and bought the cheaper A stock with more valuable voting rights, the spread between the two has widened instead of narrowing or reversing (as would have been expected). Now, the B shares sell for 25% more than the A shares. The higher price of the B shares is intriguing to some investors, who then consider selling B shares short while buying the same number of A shares. When the price of A comes close to or exceeds the price of B, such an investor would buy back the shorted B shares and sell the A shares. Many investors would be interested in the profit this position could generate.Online Research
McData’s Form 10-K is available at the SEC’s EDGAR website (www.sec.gov/cgi-bin/srch-edgar). According to the website, during a critical 27-month period (from the February 7, 2001, distribution of the A stock by EMC, to May 7, 2003), A and B stock may not be combined into one security unless EMC has obtained assurances (such as an IRS private letter ruling) that such a combination would not jeopardize the tax-free status of the Class A spinoff. An investor can contact McData’s investor relations department from an e-mail link within McData’s website to inquire about a possible combination date of A and B. McData is contacted and responds that November 1, 2002, is the first date of combining the A and B shares without jeopardizing the tax-free status of the A stock spinoff from EMC. This increases the odds the A and B shares will be combined sooner rather than later and improves the chances of an investor’s closing the “short the B, buy the A” position at a profit.
The short position would entail the sale of borrowed B stock. For this to be successful, shares must be available from a broker for shorting. If the lending party needs shares back, the short seller must be ready to purchase shares to return to the lender. (Typically, the lending and shorting parties would not know each other’s identities.) The seller does not get any funds from the short sale proceeds; these funds stay with the broker or party providing the stock to be shorted. When the B stock is shorted, A stock is bought. This would result in interest charged on funds borrowed to buy the A stock. If an investor uses his own funds instead of borrowing to buy the A stock, this would result in an opportunity cost similar to what the interest cost would have been. There could also be an additional interest expense or opportunity cost involved in borrowing the B stock. Specifically, if the price of the shorted B stock rose above the original short sale price, the amount of the increase must either be paid in cash by the short seller or borrowed from the broker on margin.
Margin requirements often get short sellers in trouble. A “short squeeze” occurs when funds borrowed on margin are insufficient to provide collateral to satisfy the brokerage firm. Different firms have different margin requirements. Margin requirements tend to be more stringent when an account is not well diversified, resulting in a higher risk. It is important to know how different brokerage firms handle the margin requirements for a given amount of securities and cash, the interest rates charged on margin balances, and the commissions charged for web, automated telephone, and live telephone–initiated stock transactions. (Typically, web transactions are cheapest, followed by automated telephone and live telephone order, because of the higher cost to the brokerage firm of the latter two.)
A wise investor would check transaction costs at three brokerages and select the one with the lowest margin interest rate, most liberal margin equity requirements (reducing the probability of having to close the position or sell the securities to meet a margin call), and lowest commission rate. Equipped with this information, an investor can decide where to open a brokerage account and whether to transfer funds from one account to another.
The potential profit to be made is the price of the shorted B stock minus the price of the purchased A stock, multiplied by the number of shares, and minus the commissions and interest charged (or opportunity cost of funds provided to the broker). An investor must be aware of the risks of the strategy described above, including the following possibilities:
Using the Tools
Financial, managerial, and tax skills can form the basis of valuable compensatable services or improve one’s own investment results. The web has the potential to be a powerful information and communication tool in this area. Investment analysis can be done for personal use, in connection with other accounting services rendered, or by employees of for-profit or not-for-profit organizations. Registration as an investment advisor is required with the state, if less than $25 million is under management, or with the SEC, if more than $25 million is under management (www.sec.gov/divisions/investment/iaregulation/advfaq.htm).
See the Sidebar for this article. ("Helpful Websites")
Editors:
Milton
Miller, CPA
Consultant William Bregman, CFR, CPA/PFS
Contributing Editors:
Theodore J. Sarenski, CPA
Dermody
Burke & Brown P.C.
David R. Marcus, JD, CPA
Marks, Paneth & Shron LLP
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