Knowing what you are reading when you read a prospectus

Each time you invest in a mutual fund or buy a new issue you should receive a document that explains the investment, including the risks and related charges, in detail.

That document is called a prospectus. While it may look intimidating, it should be read carefully and saved for future reference.

Although it is important to read the entire document, what should you look for specifically when reading a prospectus? Here are a few hints.

Risks – What are the sources of investment risk to the portfolio – i.e. lower quality; smaller, less proven investments? Also, are there any structural risks to the investment – that is, does it rely on an insurance company’s backing – and what are the risks that the fund may not meet its stated objective?

Expenses – What are the costs of owning the investment – sales charges, internal administrative expenses, etc.? Are these costs reasonable in relation to the fund’s asset size and investment objective?

Management experience – What is the background of the management team? How long have they been in that position? Do they have extensive experience managing money within the fund’s stated objective?

If consideration is being given to purchasing stock in an initial public offering or secondary offering, you should understand the:

Company’s business model – A potential investor should be comfortable with the issuer’s business model including the company’s actual products or services provided, strengths and weaknesses within its industry, the diversity of the company’s customer base, the competitive landscape and strategies for future growth.

Offering composition – Determine if the offering is 100% primary stock (coming from the issuing company) or if there are any selling shareholders. If there is a selling shareholder component, analyze the shareholders’ stock positions before and after the offering and determine the reason for the shareholders’ desire to liquidate.

Financial statements and management’s discussion – Develop a general understanding of the trends in the company’s top and bottom line. Review the company’s capital structure and accounting methods. Also check for any pending legal matters.

Risk factors – Potential investors should review this section of the prospectus very closely. Understand each point in-depth and determine whether the risk of the offering is tolerable considering your own risk tolerance profile.

Use of proceeds – Determine the use of the proceeds from the offering. There should be a defined use of proceeds that will improve the issuing company’s fundamental story in some way, whether it is through funding an acquisition or future growth, improving the capital structure or another reason.

Management – Educate yourself on the issuer’s management team. Focus on their experience within the industry, their compensation structure, the level of insider ownership and other incentives they have.

Board of directors – Also research the company’s board of directors for level of experience and how they are compensated. Determine the number of outsiders on the board.

Underwriters and accountants/auditors – Determine the experience and reputation of both the underwriters of the offering and the company’s accountants/auditors.

Before making an investment that involves a prospectus, read the prospectus carefully. If you have questions, please feel free to contact me for an explanation.