Transcript Equity Players chapter 09

Chapter 9
Picking the Equity Players
Portfolio Construction, Management, & Protection, 4e, Robert A. Strong
Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.
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You buy a stock, and when it goes up, you sell
it. If it doesn’t go up, don’t buy it.
Will Rogers
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Outline
 Introduction
 Stock
Selection Philosophy: Fundamental
and Technical Analysis
 Dividends and Why They Really Do Not
Matter
 Investment Styles
 Categories of Stock
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Introduction
 Today’s
focus is toward the overall
characteristics of portfolios
• What principles in security selection are
particularly important in the construction and
management of a portfolio?
• What are the principal categories of common
stock?
• What are dividends?
• What is preferred stock?
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Stock Selection Philosophy:
Fundamental and Technical Analysis
 A fundamental
analyst tries to discern the
logical worth of a security based on its
anticipated earnings stream
 The
fundamental analyst considers:
• Financial statements
• Industry conditions
• Prospects for the economy
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Stock Selection Philosophy: Fundamental
and Technical Analysts (cont’d)

A technical analyst is firmly convinced that:
• Supply and demand determine prices
• Changes in supply and demand cause changes in prices
• The changes in supply and demand can be predicted by
observing the past series of stock prices

Financial statements and market conditions are of
secondary importance to the technical analyst
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Dividends and Why They
Really Do Not Matter
 Types
of Dividends
 Why Dividends Do Not Matter
 Theory Versus Practice
 Stock Splits Versus Stock Dividends
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Types of Dividends
 Cash
Dividends
 Stock Dividends
 Property Dividends
 Spin-Offs
 Rights
 Dividend Growth Rates
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Cash Dividends
 Cash
dividends are distributions of the
firm’s profits to the shareholders paid via a
check from the company
 Cash dividends can sometimes be
reinvested via dividend reinvestment
plans (DRIPs)
• Sometimes allow for purchase of additional
company shares at a discount
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Cash Dividends (cont’d)
 If
shares are held in street name:
• The brokerage firm receives the dividend check
• The brokerage firm may automatically transfer
funds to a money market account
• The brokerage firm ultimately allocates
dividends to the shareholders
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Cash Dividends (cont’d)
 If
the portfolio manager receives the
dividend check:
• The funds are temporarily invested in a money
market instrument until:
– They accumulate sufficiently to finance the purchase
of more securities
– They are paid as income to the fund beneficiary
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Stock Dividends
 Stock
dividends are paid in additional
shares of stock rather than in cash
 Typically announced as a percentage
• e.g., 10 percent stock dividend
 Popular
when a firm lacks the funds to pay
a cash dividend
 Popular early in the firm’s life cycle
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Property Dividends
 A property
dividend is the distribution of
physical goods to shareholders
• e.g. a firm’s products
 Property
dividends are rare
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Spin-Offs
 In
a spin-off, a parent firm divests itself of a
subsidiary and distributes all shares in the
subsidiary proportionally to the parent
firm’s shareholders
 The
parent gives away the subsidiary
 Spin-offs
are rare
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Rights
 The
preemptive right means shareholders
have the ability to maintain the same
percentage share of ownership in a
corporation when the firm sells new shares
 Existing
shareholders can buy new stock at
a discount from market price
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Rights (cont’d)
 Rights
are actual securities that investors
can buy or sell
 Rights
have a limited life
• Usually expire a few weeks after issued
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Rights (cont’d)
 Shareholders
can do three things with
rights:
• Sell the rights to someone else
• Use the rights to buy more shares
• Allow the rights to expire
– Like throwing away money
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Dividend Growth Rates
 Corporations
like to establish predictable
dividend payout patterns including an
annual increase in their dividends
 Many
fundamental analysts focus on the
dividend growth rate to determine value
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Dividend Growth
Rates (cont’d)
 The
dividend discount model:
D0 (1  g )
D1
P0 

kg
kg
where D0 = the current dividend
D1 = the dividend to be paid next year
g  the expected dividend growth rate
k  the discount factor according to the riskiness of the stock
P0  the current stock price
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Dividend Growth
Rates (cont’d)
 You
can solve for the required rate of return,
k:
• Observe the current dividend and price
• Obtain the growth rate using historical
information and analysts’ estimates
• Solve for k:
D0 (1  g )
k
g
P0
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Dividend Growth
Rates (cont’d)
Example
Assume a company just paid a dividend of $1.20 per
share. Historically, the company has increased its
dividends by 3 percent annually with great consistency.
No analyst estimates regarding the next dividend are
available. The firm’s current stock price is $20 per share.
What is an estimate of the required rate of return for this
stock?
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Dividend Growth
Rates (cont’d)
Example (cont’d)
Solution: Using the numbers in the dividend discount
model:
D0 (1  g )
k
g
P0
1.20(1.03)

 0.03
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 0.0918  9.18%
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Why Dividends Do Not Matter

Payment of dividends reduces the balance in the
firm’s checking account
• The firm should not be worth as much after paying a
dividend

The ex-dividend date determines whether or not
you get the dividend
• On the ex-dividend date, the price of a share of stock
tends to fall by about the amount of the dividend to be
paid
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Theory Versus Practice
 Dividend
policy is very important in
practice
 Unexpected
changes in dividend policy can
result in significant changes in the market
price of the associated common stock
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Theory Versus
Practice (cont’d)
 Most
firms increase their dividend annually,
and the market expects this
• If management does not increase the dividend
as expected, the market views it as bad news
 Reducing
or omitting a dividend is a very
bad signal
 An increase in dividends above what the
market expects is a good signal
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Stock Splits Versus
Stock Dividends
 Stock
Splits
 Why Stock Splits Do Not Matter
 Why Firms Split Their Stock
 Stock Dividends
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Stock Splits
 A stock
split occurs when a firm changes
the number of shares of its capital stock
without changing the aggregate value of
these shares
 A stock split is generally a neutral
occurrence
• The primary motivation is to reduce the price of
shares to bring it into an optimal trading range
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Stock Splits (cont’d)
 In
a forward split (regular way split or
direct split), shareholders receive more
shares as a result of the split
• e.g., a two-for-one split
 In
a reverse split, the number of shares is
reduced
• e.g., 1-for-10 split
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Stock Splits (cont’d)
 An
odd lot-generating split is a stock split
likely to result in many small investors
holding odd lots
• e.g., a 3-for-2 split
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Why Stock Splits
Do Not Matter
 Stock
splits neither increase nor decrease
investor’s wealth
• You cannot increase the total amount available
by increasing the pieces of a pie
• e.g., a 2-for-1 split simply doubles the number
of shares
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Why Firms Split Their Stock
 Some
literature supports the existence of an
optimal trading range
• A principal reason for splitting shares is “to
broaden the ownership base”
 Reverse
splits are sometimes used to reduce
the number of shareholders
• e.g., a 1-for-200 split eliminates all
shareholders holding fewer than 200 shares
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Stock Dividends
 Stock
dividends are not different from stock
splits for the investor
• e.g., a 100 percent stock dividend is the same as
a 2-for-1split
 The
difference between stock dividends and
stock split is an accounting phenomenon
• A split alters the par value
• A stock dividend means new shares are issued
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Investment Styles
 Value
Investing
 Growth Investing
 Capitalization
 Integrating Style and Size
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Value Investing
 Definition
 Price/Earnings
Ratio
 Price/Book Ratio
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Definition
 Value
investors look for undervalued stock
 Utilize
the firm’s earnings history and
balance sheet
• Price/earnings ratio, price/book ratio
 Place
much emphasis on known facts
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Price/Earnings Ratio
 The
PE ratio is stock price divided by its
earnings per share
 A forward-looking
PE uses earnings
forecasts
 A trailing
PE uses historical earnings
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Price/Book Ratio
 The
price/book ratio is the stock price
divided by book value per share
• Book value is the firm’s assets minus its
liabilities
• Book value is different from market value
 Value
investors look for low price/book
ratios
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Growth Investing
 Growth
investors look for price
momentum
• Look for stocks that are in favor and have been
advancing
• Look for stocks that are likely to be propelled
even higher
 The
market moves in cycles
• Many investors own both growth and value
stocks
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Capitalization
 Capitalization
refers to the aggregate value
of a company’s common stock
 Typical
•
•
•
•
divisions are:
Large cap ($1 billion or more)
Mid cap (between $500 million and $1 billion)
Small cap (less than $500 million)
Micro cap
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Capitalization (cont’d)
 If
you rank large, mid, and small caps in
order of performance, the mid-cap stocks
tend to stay in the middle
• If you can buy only one group, it might be best
to put your money in “averaged-sized”
companies rather than the large or small
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Integrating Style and Size
 Many
money managers distribute their
assets across size and style spectrums
 http://www.morningstar.com
provides a
style box that can classify a portfolio
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Categories of Stock
 Blue
Chip Stock
 Income Stocks
 Cyclical Stocks
 Defensive Stocks
 Growth Stocks
 Speculative Stocks
 Penny Stocks
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Categories of Stock (cont’d)
 Categories Are
Not Mutually Exclusive
 A Note on Stock Symbols
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Blue Chip Stock
 Blue
chip has become a colloquial term
meaning “high quality”
• Some define blue chips as firms with a long,
uninterrupted history of dividend payments
• The term blue chip lacks precise meaning, but
some examples are:
– Coca-Cola
– Union Pacific
– General Mills
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Income Stocks
 Income
stocks are those that historically
have paid a larger-than-average percentage
of their net income after taxes as dividends
• The proportion of net income after taxes paid
out as dividends is the payout ratio
• The proportion of net income after taxes
retained is the retention ratio
 Examples
include Consolidated Edison and
Allegheny Energy
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Cyclical Stocks
 Cyclical
stocks are stocks whose fortunes
are directly tied to the state of the overall
national economy
 Examples
include steel companies,
industrial chemical firms, and automobile
producers
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Defensive Stocks
 Defensive
stocks are the opposite of
cyclical stocks
• They are largely immune to changes in the
macroeconomy and have low betas
 Examples
include retail food chains,
tobacco and alcohol firms, and utilities
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Growth Stocks
 Growth
stocks do not pay out a high
percentage of their earnings as dividends
• They reinvest most of their earnings into
investment opportunities
• Many growth stocks do pay dividends
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Speculative Stocks
 Speculative
stocks are those that have the
potential to make their owners rich quickly
 Speculative stocks carry an above-average
level of risk
 Most speculative stocks are relatively new
companies with representation in the
technology, bioresearch, and pharmaceutical
industries
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Penny Stocks
 Penny
stocks are inexpensive shares
 Penny
stocks sell for $1 per share or less
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Categories Are Not
Mutually Exclusive
 An
income stock or a growth stock can also
be a blue chip
• e.g., Potomac Electric Power
 Defensive
or cyclical stocks can be growth
stocks
• e.g., Dow Chemical is a cyclical growth stock
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A Note on Stock Symbols
 Ticker
symbols are identification codes
 Stock symbols have one to four letters
• One, two, or three letters identifies a stock
listed on either the NYSE or the AMEX
• Four-digit symbols identify firms traded on the
Nasdaq
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