Transcript ch9strong
Chapter 9
Picking the Equity Players
Portfolio Construction, Management, & Protection, 5e, Robert A. Strong
Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
1
You buy a stock, and when it goes up, you sell
it. If it doesn’t go up, don’t buy it.
Will Rogers
2
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?
3
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
4
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
5
Dividends and Why They
Really Do Not Matter
Types
of Dividends
Why Dividends Do Not Matter
Theory Versus Practice
Stock Splits Versus Stock Dividends
6
Cash Dividends
Cash
dividends are distributions of the
firm’s profits paid to the shareholders 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
7
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
8
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
9
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
10
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
11
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
12
Dividend Growth
Rates (cont’d)
The
dividend discount model:
D0 (1 g )
D1
P0
kg
kg
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
13
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
14
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?
15
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
20
0.0918 9.18%
16
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
17
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
18
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
19
Stock Splits Versus
Stock Dividends
Stock
Splits
Why Stock Splits Do Not Matter
Why Firms Split Their Stock
Stock Dividends
20
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
21
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
22
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
23
Why Stock Splits
Do Not Matter
Stock
splits neither increase nor decrease an
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, but doesn’t affect wealth
24
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
25
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
26
Investment Styles
Value
Investing
Growth Investing
Capitalization
Integrating Style and Size
27
Value Investing
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
28
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
29
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
30
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
31
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
32
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
33
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
34
Categories of Stock
Blue-Chip Stock
Income Stocks
Cyclical Stocks
Defensive Stocks
Growth Stocks
Speculative Stocks
Penny Stocks
Note: Categories are not mutually exclusive
35
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
36
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
37
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
38
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
39
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
40
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
41
Penny Stocks
Penny
stocks are inexpensive shares
Penny
stocks sell for $1 per share or less,
but the definition is imprecise
42
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
43
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
44