Investing in Equities

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Investing in Equities

• Topic 6
• I. Common Stock Investments

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A. Basic Characteristics

• 1. Equity Capital
• 2. Types
• a. Growth Stock
• b. Income Stock
• c. Speculative Stock
• d. Cyclical Stock
• e. Defensive Stock

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B. Valuation of Common Stock

• 1. Dividend Valuation Model
• a. Example
• 2. Using the CAPM Process
• a. Assumptions
• 1. km rate of return on the market
• 2. Rf return on the risk free asset
• 3. km - Rf Market Risk Premium
• b. Example

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C. Other Common Stock Values

• 1. Par Value
• 2. Book Value
• 3. Liquidation Value
• 4. Market Value
• 5. Investment Value

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D. Common Stock as an Inflation Hedge

• Protection Against Inflation
• Over the last thirty years the SP 500
• has averaged approximately 11 annual
• compound return.
• Inflation has averaged approximately
• 5.4 during the same time period.

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Common Stock as an Inflation Hedge

• SP LT Bonds LT Govt Bonds T. Bills
  CPI
• Last 10 14.8 11.3 11.9 5.6
  3.5
• Last 20 14.6 10.6 10.4 7.3
  5.2
• Last 30 10.7 8.2
  7.9 6.7 5.4
• Last 40 10.8 6.8 6.4
  5.7 4.5
• Last 50 11.9 5.8 5.3
  5.7 4.4
• Source Ibbotson and Sinquefield, Stocks,
  Bonds, Bills and Inflation 1997 yearbook,
  Chicago.

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The Panic of 1987

• Index arbitrage and portfolio insurance
  (programmed trading) were the major cause. From
  Tuesday 10/13/87 to 10/19/87, the DJIA fell 769
  points or 31. On 10/19/87 the DJIA fell508
  points or 22.6. On 10/28/29 the DJIA fell
  11.7.
• Mutual funds and pension funds use portfolio
  insurance. Portfolio insurance is a strategy
  that uses computer based models to determine an
  optimal stock/cash ratio at various market
  prices. Two insurance users called for sales
  equaling 50 in response to a 10 decline in the
  SP 500 Index.

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Investment Wisdom

• Dont try to buy at the bottom and sell at the
  top. This cant be done - except by liars
• Bernard Baruch
• Fools and greed usually go hand in hand, which
  creates a field of opportunity for the rational
  man.
• Warren Buffett

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Investment Wisdom

• When it comes to risk, weve done better by
  avoiding dragons rather than by slaying them.
• Warren Buffett
• Traditional Wisdom can be long on tradition and
  short on wisdom.
• Warren Buffett

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Investment Wisdom

• Investing is the greatest business in the world
  because you never have to swing. You stand at
  the plate the pitcher throws you GM at 47! U.S.
  Steel at 39! And nobody calls a strike on you.
  Theres no penalty except opportunity. All day
  you wait for the pitch you like then, when the
  fielders are asleep, you step up and hit it.
• Warren Buffett

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Investment Wisdom

• On Leaving Management Alone
• At Berkshire we dont tell .400 hitters how to
  swing.
• Warren Buffett

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Warren Buffett on taking Your Time

• An investor should act as though he/she had a
  lifetime decision card with just twenty punches
  on it. With every investment decision his card
  is punched, and he/she has one fewer available
  for the rest of his/her life.

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Investing in Equities

• Topic 6
• II. Principles of Security Analysis

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Types of Security Analysis

• 1. Fundamental Analysis
• 2. Technical Analysis

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The Father of Fundamental Analysis Benjamin
Graham

• Who was Benjamin Graham?
• Sources Security Analysis (Graham and Dodd)
  The Intelligent Investor (Graham)

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Ben Graham and Mr. Market

• Ben Graham long ago described the mental attitude
  toward market fluctuations that I believe to be
  most conducive to investment success. He said
  that you should imagine market quotations as
  coming from a remarkably accommodating fellow
  named Mr. Market who is your partner in a private
  business. Without fail, Mr. Market appears daily
  and names a price at which he will either buy
  your interest or sell you his. Even though the
  business that the two of you own may have
  economic characteristics that are stable, Mr.
  Markets quotations will be anything but stable.
  For, it is sad to say, Mr. Market is a fellow who
  has incurable emotional problems. At times he
  falls euphoric and can see only the favorable
  factors affecting the business. When in that
  mood, he names a very high buy-sell price because
  he fears that you will snap up his interest and
  rob him of imminent gains. At other times he is
  depressed and can see nothing but trouble ahead
  for both the business and the world. On these
  occasions he will name a very low price, since he
  is terrified that you will unload your interest
  on him.

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Ben Graham and Mr. Market Continued

• Mr. Market has another endearing characteristic
  He doesnt mind being ignored. If his quotation
  is uninteresting to you today, he will be back
  with a new one tomorrow. Transactions are
  strictly at your option. Under these conditions,
  the more manic-depressive his behavior, the
  better for you.
• But, like Cinderella at the ball, you must heed
  one warning or everything will turn into pumpkins
  and mice Mr. Market is there to serve you, not
  to guide you. It is his pocketbook, not his
  wisdom, that you will find useful. If he shows
  up someday in a particularly foolish mood, you
  are free to either ignore him or to take
  advantage of him, but it will be disastrous if
  you fall under his influence. Indeed, if you
  arent certain that you understand and can value
  your business far better than Mr. Market, you
  dont belong in the game. As they say in poker,
  If youve been in the game 30 minutes and you
  dont know who the patsy is, youre the patsy.

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B. Grahams Fundamental Investment Rules

• 1. Adequate Size
• 2. Sufficient Strong Financial Condition
• 3. Earnings Stability
• 4. Dividend Record
• 5. Earnings Growth
• 6. Moderate Price/Earnings Ratio
• 7. Moderate Ratio of Price to Assets

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C. Terms

• 1. Net Current Assets (NCA)
• Defined as
• Current Assets
• - Current Liabilities
• - Long-Term Debt
• - Preferred Stock
• NCA Total
• NCAc NCA/ of Common Shares

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C. Terms (continued)

• 2. Data Source
• SP Stock Guide
• Value Line, etc.
• 3. Earnings Per Share (EPS)
• 4. Market Price
• 5. Book Value Per Share
• 6. Dividends Per Share
• 7. Current Ratio

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C. Terms (continued)

• 8. Total Debt
• 9. Equity
• 10. Growth
• g (1 RP,-1)(1 RP,-2) ... (1 RP,-10)
  -1

1/n
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D. The Graham Model

• 1. Group A Criteria
• 1 E/P gt 2 (AAA Yield) (1 pt.)
• E/P gt 1.33 (AAA Yield) (1/2 pt.)
• 2 P/E lt .4 (Avg. P/E in last 3 yrs.) (1 pt.)
• P/E lt .4 (Avg. P/E in last 10 yrs.) (1/2
  pt.)
• 3 P/Bk lt 2/3 (1 pt.)
• P/Bk lt 1 (1/2 pt.)
• 4 D/P gt .67 (AAA Yield) (1 pt.)
• D/P gt .50 (AAA Yield) (1/2 pt)
• 5 P/NCA lt 1 (1 pt.)
• P/NCA lt 1.33 (1/2 pt.)

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D. The Graham Model (continued)

• 2. Group B Criteria
• 6 CR gt 2 (1 pt.)
• CR gt 1.8 (1/2 pt.)
• 7 TD/E lt 1.0 (1 pt.)
• TD/E lt 1.2 (1/2 pt)
• 8 TD/NCA lt 2 (1 pt.)
• NCA gt 0 (1/2 pt.)
• 9 G10 gt 7/YR. (1 pt.)
• G5 gt 7/YR. (1/2 pt.)
• 10 No more than 2 declines in earnings of 5
  each over the last 10 years for one full point.
• No more than 3 declines in earnings of 5 or more
  in last 10 years for one-half point.

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Contemporary Fundamentals

• Peter Lynchs Ten Golden Rules of Investing
• 1. Dont be intimidated by professionals
• 2. Look in your own backyard
• 3. Dont buy something you cant illustrate
  with a crayon
• 4. Make sure you have the stomach for stocks
• 5. Avoid hot stocks in hot industries
• 6. Owning stocks is like having children. Do
  not have more than you can handle.
• 7. Dont even try to predict the future.
• 8. Avoid weekend worrying. Do not get scared
  out of good stocks. Own your mind.
• 9. Never invest in a company without first
  understanding its finances.
• 10. Do not expect too much, too soon. Think
  long-term.

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Contemporary Fundamentals

• Peter Lynchs mistakes to avoid
• 1. Thinking that this year will be any
  different than any other year.
• 2. Becoming too concerned over whether the
  stock market is going up or down.
• 3. Trying to time the market.
• 4. Not knowing the story behind the company in
• which you are buying stock.
• 5. Buying stocks for the short-term.

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Contemporary Fundamentals

• Lynch Maxims
• 1. A good company usually increases its
  dividends every year.
• 2. You can lose money in a very short time,
  but it takes a long time to make money.
• 3. The stock market isnt a gamble, as long as
  you pick good companies that you think will do
  well, and not just because of the stock price.
• 4. You have to research the company before you
  put money into it.

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Lynch Maxims (cont.)

• 5. When you invest in the stock market you
  should always diversify.
• 6. You should invest in several stocks (5).
• 7. Never fall in love with a stock, always have
  an open mind.
• 8. Do your homework.
• 9. Just because a stock goes down doesnt mean
  it cant go lower.
• 10. Over the long-term it is generally better to
  buy stocks in small companies.
• 11. Never buy a stock because it is cheap, but
  because you know a lot about it.
• Source One Up On Wallstreet, by Peter Lynch

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Sir John Marks Templeton

• Who is Sir John Marks Templeton?
• John Templeton borrowed 10,000 and started a
  brilliant investment career, which enabled him to
  be one of two investors to become billionaires
  solely through their investment prowess.
  Templeton has had decade after decade of 20 plus
  annual returns and managed over 6 Billion in
  assets. Templeton is generally regarded as one
  of the worlds wisest and most successful
  investors. Forbes Magazine said,
• Templeton is one of a handful of true
  investment greats in a field of crowed mediocrity
  and bloated reputations. Templeton holds that
  the common denominator connecting successful
  people with successful enterprises is a devotion
  to ethical and spiritual principles. Many regard
  Sir John as the greatest Wallstreet Investor of
  all time.

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Sir John Mark Templeton

• Sir Johns 16 Rules for Investment Success
• 1. Invest for maximum total real return
  including taxes and inflation.
• 2. Invest. Dont trade or speculate.
• 3. Remain flexible and open-minded about types
  of investments. No one kind of investment is
  always best.
• 4. Buy low. Buy what others are despondently
  selling. Then sell what others are
  despondently buying.
• 5. Search for bargains among quality stocks.
• 6. Buy value not market trends or economic
  value.
• 7. Diversify. There is safety in numbers.
• 8. Do your homework. Do not take the word of
  experts. Investigate
• before you invest.

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Templetons 16 Rules (Cont.)

• 9. Aggressively monitor your investments.
• 10. Dont panic. Sometimes you wont have
  everything sold as the market crashes. Once the
  market has crashed, dont sell unless you find
  another more attractive undervalued stock to buy.
• 11. Learn from your mistakes, but do not dwell
  on them.
• 12. Begin with prayer, you will think more
  clearly.
• 13. Outperforming the market is a difficult
  task, you must outthink the
• managers of the largest institutions.
• 14. Success is a process of continually seeking
  answers to new questions.
• 15. There is no free lunch. Do not invest on
  sentiment. Never invest in an IPO. Never invest
  on a tip. Run the numbers and research the
  quality of management.
• 16. Do not be fearful or negative too ofter.
  For 100 years optimists have carried the day in
  U.S. Stocks.

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Warren Buffett-the Sage of Omaha

• Buffetts Four Steps to Investing
• 1. Turn off the stock market.
• 2. Dont worry about the economy.
• 3. Buy a business, not a stock. Change your
  perspective to that of a business owner and
  learn as much as possible about the business
  and industry.
• 4. Manage a portfolio of businesses. Dont
  diversify for diversifications sake.

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Buffett on Diversification

• You cant be a Bo Jackson in investing. Spread
  your energies and your capital too many ways, and
  you are courting disaster. If you have really
  taken your time and only picked stocks that are
  bona-fide doozies, theres no need to diversify
  for safety. If youre not supremely confident
  about the future of each stock in your small
  portfolio, perhaps you should never have invested
  in it. Remember, the fewer stocks you have, the
  more time you can spend becoming an expert in
  them . You should never own more than ten
  stocks.
• We dont believe in the Noahs Ark principle of
  investing, winding up with two of everything.
  Then you have a zoo.

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Buffett on the Ideal Investor Personality

• The most important quality for an investor is
  temperament, not intellect. You dont need tons
  of IQ in this business. You dont have to be
  able to play three-dimensional chess or duplicate
  bridge. You need a temperament that derives
  great pleasure neither from being with the crowd
  nor against the crowd. You know youre right,
  not because of the position of others but because
  your facts and your reasoning are right.

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Buffets Tenets of Investing

• Buffets Business Tenets for Investing
• 1. Is the business simple and understandable?
• 2. Does the business have an identifiable
  consumer monopoly or franchise product?
• 3. Does the business have a consistent
  operating history over time. Are earnings (net
  income) increasing and is the ROE consistently
  high (25-30).
• 4. Does the business have favorable long-term
  prospects? Is it a franchise or least cost
  commodity producer? Look for Goodwill
• Invest within your circle of competence. Its
  not how big the circle is that counts, its how
  well you define the parameters. -- Warren
  Buffett
• Good Businesses are the ones that in some way
  are reasonably sheltered from competition. That
  gets to having what I call a franchise of some
  sort. - Warren Buffett

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Buffets Tenets (Cont.)

• Buffets Management Tenets
• 5. Is management rational? Does the management
  use excess cash to buy back stock and issue
  dividends, or expand company into low return
  investments. Does management express that they
  are committed to the best interests of the
  shareholders total return on investment.
• 6. Is management candid with its shareholders?
  Does management do things the way that everyone
  else does or do they think and look at their
  environment before doing things?
• Business schools reward complex behavior more
  than simple behavior but simple behavior is more
  effective. -- Warren Buffett

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Buffetts Tenets (Continued)

• 7. Does the Company have less than 30 debt?
• 8. How much does the business have to spend on
  maintaining operations (check out operating
  ratios).
• 9. Can the Company adjust prices during
  inflation?
• Our favorite holding period is forever. --
  Warren Buffett
• The Margin of error is the cornerstone of our
  investment philosophy Never count on making a
  good sale. Have the purchase price be so
  attractive that even a mediocre sale gives good
  results. - Warren Buffett.
• A great investment opportunity occurs when a
  marvelous business encounters a onetime huge but
  solvable problem. - Warren Buffett.

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Buffets Tenets

• 10. Focus on return on equity, not earnings per
  share. EPS is meaningless, since the equity base
  can expand over time due to increased retained
  earnings. Therefore, EPS does not necessarily
  reflect good managerial performance.
• 11. Calculate owner earnings. Seek out
  companies that produce cash in excess. Owner
  earnings is equal to net income plus
  depreciation, depletion, and amortization, minus
  capital expenditures necessary to maintain its
  economic position and unit volume.
• Id rather have a 10 million business making 15
  than a 100 million business making 5. I have
  other places I can put the money. -- Warren
  Buffett
• We like to buy Businesses, but we dont like to
  sell them. --Warren Buffett

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Buffets Tenets

• 12. Look for companies with high profit
  margins. Companies with tenacious cost-cutters.
  Remember companies with high costs will always
  come up with new ways to spend more.
• 13. For every dollar retained, make sure the
  company has created at least three dollars of
  market value. Calculate the retained earnings
  to market value ratio (use a 10 year trend).
  Dollar created/Dollar retained.

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Buffets Tenets

• Buffets Market Value Tenets
• - What is the value of the business? The cash
  flows of a business discounted back to todays
  present value determines the intrinsic value.
  Discounted by the long-term treasury rate plus 2
  to 4 depending on your risk preference (Buffett
  uses 15).
• - Can the business be purchased at a significant
  discount to its value? Look at the stock price.
  Can you purchase the stock at a significant
  discount to the stock price. The greater the
  difference, the greater the allowance for a
  margin of error. (At least 50).
• It is far better to buy a wonderful company at a
  fair price than a fair company at a wonderful
  price. -- Warren Buffett

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Buffets Tenets

• Buffets Yearly Check-up
• - Calculate return on beginning shareholders
  equity
• - Check the changes in operating margins, debt
  levels, and capital expenditures.
• - Check the companys cash generating ability

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A Contemporary Approach for Stock Screening Using
Fundamental Methods

• Ten Summary Criteria
• 1. Select those stocks with Value Line
  Timeliness ratings of 1 or 2 and Safety ratings
  of 1or 2.
• 2. Select companies with a franchise product or
  service.
• 3. Select companies with a long-term record and
  high prospects for
• continued growth well into the future. Look for
  regional or
• international expansion to maintain their
  growth.
• 4. Look for a company with relatively low risk.
  A beta of no more
• than 1.05 a capital structure with less than
  1/3 debt. Check the value line in relation to
  price fluctuations. Find a company with low
  capital expenditures, this eliminates the costly
  potential of retooling every 5 to 8 years.

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A Contemporary Approach (Cont.)

• 5. Look for an efficient company. This is one
  that adds more than a dollars worth of market
  value to every dollar retained in earnings each
  year. One dollar in retained earnings should
  equal three plus dollars in added market value.
• 6. Study the business and its franchise
  potential, not just the financial numbers. Is
  management looking at new and creative ways to
  exploit opportunity or are they trying to do what
  everyone else is doing?
• 7. The important financials to look at are
  ROE, Owners Earnings, High profit margins, and
  the dollar-retained-dollar added test.
• 8. Calculate the intrinsic value. Can the stock
  be purchased below the intrinsic value with a
  significant margin of safety?
• 9. Is management committed to its shareholders.
  Look for buybacks with excess cash.
• 10. Dont follow the crowd. Buy when the value
  and discount to intrinsic value warrant a buy.

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A Contemporary Approach to Selecting Common
Stocks

• Step One Find those companies that meet the
  Value-Line rank criteria of 1 or 2 on timeliness
  and safety. Or analyze a company given to you by
  your Professor.
• Step Two Determine if the products offered by
  the firm are franchise products, i.e. no close
  substitutes, not heavily regulated, needed and
  desired. Consider the existing substitutes, the
  substitutes that are down and upline, new
  entrants and barriers to entry, and new
  technologies.

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A Contemporary Approach Cont.

• Step Three Do a complete financial statement
  analysis as discussed in the first section of
  this course. This should include a complete
  ratio and DuPont analysis.
• Step Four Do a complete strategic audit as
  discussed in the second part of this course.
  This should include the five forces model and a
  S.W.O.T. analysis.
• Step Five Do a complete investment SCREEN
  analysis with provided spreadsheet.

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Investing in Equities

• Topic 6
• IV. Technical Analysis

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A. Definition

• Technical Analysis is the belief that important
  information about future stock price movements
  can be obtained by studying the historical price
  movement.

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Technical Analysis Assumptions

• Technical analysts base their buy and sell
  decisions on the charts they prepare of recorded
  financial data
• 1. Market value is determined by the interaction
  of supply and demand.
• 2. Supply and demand are governed by numerous
  factors, both rational and irrational.
• 3. Security prices tend to move in trends that
  persist for an appreciable length of time,
  despite minor fluctuations in the market.
• 4. Changes in a trend are caused by shifts in
  supply and demand.
• 5. Shifts in supply and demand, no matter why
  they occur, can be detected sooner or later in
  charts of market transactions
• 6. Some chart patterns tend to repeat themselves.

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Types of Technical Charts

• Bar Charts

H
C
Dollar Price of Stock
L
Trading Days
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Types of Technical Charts

• Line Charts a graph of successive days closing
  prices.

Closing Prices
Trading Days
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B. Approaches to Technical Analysis

• 1. The Dow Theory
• The Dow theory views the movement of market
  prices as occurring in three categories
• 1. Primary Movements These are called bull
  and bear markets.
• 2.Secondary Movements These are up and down
  movements of stock prices that last for a few
  months and are called corrections.
• 3. Daily Movements These are meaningless
  random daily fluctuations.

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B. Approaches to Technical Analysis (continued)

• 2. Trading Action
• a. Concentrates on minor trading characteristics
  in the market
• b. Examples include
• 1. Monday is the worst day to buy stocks, Friday
  is the best.
• 2. If January is a good month for the market
  then chances are good a good year will occur.

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B. Approaches to Technical Analysis (continued)

• 3. Bellwether Stocks
• a. A few major stocks in the market are
  consistently highly accurate in reflecting the
  current state of the market.
• IBM
• DuPont
• ATT
• Exxon
• GM

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Approaches to Technical Analysis (Continued)

• 4. Relative Strength
• The basic idea behind relative strength is that
  some securities will increase more, relative to
  the market, in bull markets and decline less,
  relative to the market, in bear markets.
  Technicians believe that by investing in those
  securities that exhibit relative strength higher
  returns can be earned.

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B. Approaches to Technical Analysis (continued)

• 5. Technical Indicators
• a. Market Volume -- is a measure of investor
  interest
• 1. STRONG when volume goes up in rising market
  or drops during declining market.
• 2. WEAK when volume goes up in declining market
  or decreases during a rally.

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B. Approaches to Technical Analysis (continued)

• Example
• On June 3, 1985
• Advances 930
• Declines 691
• Difference 239
• On June 11, 1985
• Advances 651
• Declines 920
• Difference -269
• Conclusion A weak market.

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B. Approaches to Technical Analysis (continued)

• b. Breadth of the Market
• 1. Considers the advances and declines in the
  market.
• 2. As long as advances outnumber declines a
  strong market exists.
• 3. The spread is used as an indicator of market
  strength.

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B. Approaches to Technical Analysis (continued)

• c. Short Interest -- measures the number of
  stocks sold short
• when the level of short interest is high, by
  historical standards, then the situation is
  optimistic.
• d. Odd-Lot Trading Theory of Contrary Opinion
• if the amount of odd-lot purchases start to
  exceed odd-lot sales by a widening margin, it may
  suggest that speculation is occurring among small
  investors. This is the first signal of an
  upcoming bear market.

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Review Problems Section 6

• What are two theoretical ways to determine the
  value of Common Stock?
• Net Current Asset in the Graham model is defined
  as?
• Why do we calculate geometric instead of linear
  growth rates?
• The Graham model is a fundamental valuation
  model? Explain.
• Define technical analysis.
• What are Bellweather stocks?
• Who was Peter Lynch and what is he primarily
  known for?
• What are Lynchs 10 golden rules for investing?