Chapter 6 Common Stock Investments

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Chapter 6 Common Stock Investments
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What Stocks Have to Offer

• The Appeal of Common Stocks
• The offer investors a way to tailor their
  investment programs to meet their needs and
  preferences.
• No matter what the investment objective, there
  are common stocks to fit the bill.
• Putting Stock Price Behavior in Perspective (See
  Figure 6.1)
• From Stock Prices to Stock Returns (See Table 6.1
  6.2)
• The Dow, The SP, and the Nasdaq (See Table 6.3
  and Figure 6.2)

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Figure 6.1 The Great Bull Market of 1982-2000
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What Stocks Have to Offer

• The Pros and Cons of Stock Ownership
• Pros
• They have greater return opportunities relative
  to other investments
• Stocks make ideal inflation hedges
• They are easy to buy and sell and transaction
  costs are modest
• Price and market data is widely disseminated
• The cost of a share is within reach of most
  individual investors
• Cons
• Risk (business risk, financial risk, purchasing
  power risk, market risk, and event risk)
• The earnings and performance are subject to wide
  swings making it difficult to consistently pick
  superior stocks.
• In general, common stock investors sacrifice the
  receipt of current income (See Figure 6.3 on the
  following slide).

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Figure 6.3 The Current Income of Stocks and Bonds
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Basic Characteristics of Common Stocks

• Common Stock as a Corporate Security
• Equity Capital. Evidence of ownership position
  in a firm in the form of shares of common stock.
• Publicly Traded Issues. Shares of stock that are
  readily available to the general public and are
  bought and sold in the open market.
• Public Offering. An offering to sell to the
  investing public a set number of shares of a
  firms stock at a specified price (See Figure
  6.4).
• Rights Offering. An offering of a new issue of
  stock to existing stockholders who may purchase
  new shares in proportion to their current
  ownership position.

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Basic Characteristics of Common Stocks

• Common Stock as a Corporate Security (continued)
• Stock Spin-off. The conversion of one of a
  firms subsidiaries to a stand-alone company by
  distribution of stock in that new company to
  existing shareholders.
• Stock Split. A financial maneuver in which a
  company increases the number of shares
  outstanding by exchanging a specified number of
  new shares of stock for each outstanding share.
• Treasury Stock. Shares of stock that have been
  sold and subsequently repurchased by the issuing
  firm.
• Classified Common Stock. Common stock issued by
  a company in different classes each of which
  offers different privileges and benefits to its
  holders.

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Basic Characteristics of Common Stocks

• Buying and Selling Stocks
• Reading the Quotes (See Figure 6.5)
• Transaction Costs
• Round lot. 100 shares or multiples thereof.
  Higher fees are generally charged for odd lot
  transactions.
• Odd Lot Differential. 10 to 25 cents per share in
  addition to the normal fee.
• Brokerage fee. The cost of the transaction paid
  by both the buyer and seller. They generally
  amount to 1 to 5 but can go much higher for
  smaller trades.
• Common Stock Values
• Par Value. The stated or face value of a share of
  stock.

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Basic Characteristics of Common Stocks

• Common Stock Values (continued)
• Book Value. The amount of stockholders equity in
  a firm equals the amount of the firms assets
  minus the firms liabilities and preferred stock.
• Market Value. The prevailing market price of a
  security.
• Investment Value. The amount that investors
  believe a security should be trading for, or what
  they think its worth.

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Common Stock Dividends

• The Dividend Decision
• By paying dividends (usually quarterly),
  companies share with their stockholders the
  profits theyve earned and is decided by the
  Board of Directors (BOD) based on the firms
  performance.
• Corporate Versus Market Factors. When assessing
  whether and how much to pay in dividends, the BOD
  evaluates a number of factors, including
• Current Earnings Per Share (EPS). See Equation
  6.1
• The firms growth prospects.
• Market effects and responses (economic conditions
  and investor expectations).

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Common Stock Dividends

• The Dividend Decision (continued)
• Some Important Dates (See Figure 6.6)
• Date of Record. The date on which an investor
  must be a registered shareholder of a firm to be
  entitled to receive a dividend.
• Payment Date. The actual date on which the
  company will mail dividend checks to shareholders
  (a.k.a. the payable date).
• Ex-Dividend Date. Three business days before the
  date of record determines whether one is an
  official shareholder of a firm and thus eligible
  to receive a declared dividend (See page 241).
• Types of Dividends
• Cash Dividend. Payment of a dividend in the form
  of cash.
• Stock Dividend. Payment of a dividend in the
  form of shares of stock.

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Common Stock Dividends

• The Dividend Decision (continued)
• Cash or Stock
• Most firms use cash dividends and they tend to
  grow with as their companies grow (the average is
  about 3 to 5 annually).
• Dividend Yield. The dividend yield is a measure
  that relates dividends to share price and puts
  common stock dividends on a relative percentage
  basis rather than on a dollar basis (See Equation
  6.2).
• Dividend Payout Ratio. The dividend payout ratio
  is the portion of earnings per share (EPS) that a
  firm pays out as dividends (See Equation 6.3).
• Stock Dividend. A stock dividend is a dividend
  paid out in additional share rather than in cash
  (for example, a 10 stock dividend) in
  actuality, stock dividend have no real value.

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Common Stock Dividends

• Dividend Reinvestment Plans (DRIPs). DRIPs are
  plans in which stockholders have cash dividends
  automatically reinvested into additional share of
  the firms common stock (See Table 6.4 for an
  illustration).

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Types and Uses of Common Stocks

• Types of Stocks
• Blue Chip Stocks. Financially strong,
  high-quality stocks with long and stable records
  of earnings and dividends (See Figure 6.7).
• Income Stocks. Stocks with long and sustained
  records of paying higher-than-average dividends.
• Growth Stocks. Stocks that experience high rates
  of growth in operations and earnings (See Figure
  6.8).
• Tech Stocks. Stocks that represent the
  technology, new-economy sector of the market
  (See Figure 6.9).
• Speculative Stocks. Stocks that offer the
  potential for substantial price appreciation but
  lack sustained records of success.

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Types and Uses of Common Stocks

• Types of Stocks
• Cyclical Stocks. Stocks whose earnings and
  overall market performance are closely linked to
  the general state of the economy.
• Defensive Stocks. Stocks that tend to hold their
  own, and even do well, when the economy starts to
  falter.
• Mid-Cap Stocks. Medium-sized stocks, generally
  with market values of less than 4 or 5 billion
  but more than 1 billion (See Figure 6.10).
• Small-Cap Stocks. Stocks that generally have
  market values of less than 1 billion but can
  offer above-average returns (See Figure 6.11).

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Types and Uses of Common Stocks

• Investing in Foreign Stocks
• World Equity Markets (See table on page 252)
• Comparative World Equity Market Returns (See
  Table 6.5)
• Going Global Direct Investments in ADRs
• Easier and safer than investing directly
• Each ADR represents a specific number of shares
  in a specific foreign firm.
• ADRs are bought and sold on U.S. markets like any
  other stock and prices are quoted in dollars, not
  in foreign currencies.
• Although there are 400 companies (200 of them
  Canadian) whose shares are listed directly on
  U.S. exchanges, there are more than 1,000
  companies from more than 40 countries traded as
  ADRs on U.S. exchanges.
• How they work

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Types and Uses of Common Stocks

• Investing in Foreign Stocks (continued)
• Putting Returns in a Global Perspective
• When investing globally, you have to pick both
  the right stock and the right market.
• The same variables that U.S. stock prices
  (earnings, dividends, etc.) and markets
  (inflation, interest rates, etc.) also drive
  foreign share prices.
• In addition to dividends and capital gains,
  currency exchange rates also affect the return on
  foreign shares (See Equation 6.4, 6.5, and 6.6)
• A stronger dollar has a negative impact on total
  returns to U.S. investors, and a weaker dollar
  has a positive impact.
• Thus, you want both the foreign stock and the
  foreign currency values to go up over the life of
  your investment.

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Types and Uses of Common Stocks

• Alternative Investment Strategies
• Buy and Hold
• The objective is to place money in a secure
  investment (safety of principal is vital) and
  watch it grow over time.
• Investors select high quality stocks that offer
  current income and/or capital gains and hold them
  for extended periods (as long as 10 to 15 years).
• Often used to finance retirement and child
  education funds.
• Investors regularly add fresh capital and
  reinvest dividends back into their portfolios.
• High Income
• The objective is to select stocks with high and
  growing dividend levels.
• Safety of principle and stability of income are
  vital (not capital gains).

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Types and Uses of Common Stocks

• Alternative Investment Strategies (continued)
• Quality Long-Term Growth
• This strategy is less conservative than the first
  two in that it seeks capital gains as the primary
  source of return.
• Most of the considerable amount of trading is
  confined to quality growth stocks that offer the
  chance for considerable price appreciation.
• This strategy is risky due to the reliance on
  capital gains so considerable diversification is
  also often employed.
• The Total Return Approach is a variation of this
  approach which combines quality long-term growth
  with high income.
• Aggressive Stock Management
• Aggressive stock management also uses quality
  stocks but seeks attractive rates of return
  through fully-managed portfolios.

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Types and Uses of Common Stocks

• Alternative Investment Strategies (continued)
• Aggressive Stock Management (continued)
• Investors aggressively trade in and out of stocks
  in an attempt to achieve superior returns through
  capital gains.
• This strategy may even include small cap stocks
  and investment horizons are often shorter (6
  months to a year).
• Speculation and Short-Term Trading
• Speculation and short-term trading characterize
  the least conservative of all investment
  strategies where the sole objective is strictly
  short-term capital gains.
• Investors primarily trade in small-cap, tech
  stocks, and foreign shares.
• Many speculators find that information about the
  industry or company is much less important the
  market psychology or mood of the market.

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Types and Uses of Common Stocks

• Some Popular Investment Styles
• Defined
• Investment styles depend in large part on ones
  investment objectives and risk tolerance.
• It defines the types of securities you want to
  hold in your portfolio.
• Growth investing and Value investing depend
  primarily on fundamental analysis while Sector
  Rotation and Momentum Investing are based more on
  perceived market conditions.
• Growth Investing
• Investing in stocks with above-average forecasts
  of earnings growth and high price/earnings ratios
  in expectation of higher returns.
• Growth investors believe that investing in stocks
  with high earnings growth rates (15 - 20 per
  year) should ultimately yield higher returns.
• These companies have high prices, high
  price-to-book ratios and high price/earnings
  ratios.

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Types and Uses of Common Stocks

• Some Popular Investment Styles
• Growth Investing (continued)
• Most growth stocks depend on capital gains and
  pay little or no dividends.
• They are much riskier in that their prices tend
  to rise and fall much faster than the average
  stock.
• Growth investors typically employ the Quality
  Long-Term Growth Strategy, the Aggressive Stock
  Management Strategy, and possibly Speculation.
• Value Investing
• Value investing focuses on stocks that are out of
  favor with the market as reflected by low
  price/earnings ratios and low prices compared to
  their fundamentals (utilizes the Buy-and-Hold
  Strategy).
• Value investors evaluate why a stock is low and
  invest if they think some sort of corrective
  action will result in a higher price.
• Value companies are often in older/cyclical
  industries such as automobiles, chemicals, steel,
  and financial services.

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Types and Uses of Common Stocks

• Some Popular Investment Styles
• Sector Rotation
• With Sector Rotation, investors select stocks
  based on the premise that certain industry
  sectors perform better during specific stages of
  the economic cycle.
• These investors start by forecasting the economy
  as a whole, then identify industries that should
  perform well in such an economy, and then finally
  identify superior companies within those
  industries.
• Ways of defining sectors include
  Interest-Sensitive, Consumer Durables, Capital
  Goods Manufacturers, and Defensive Stocks.
• Momentum Investing
• Momentum investing relies heavily on technical
  analysis (how market forces affect stock prices)
  to determine when to buy and sell.

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Types and Uses of Common Stocks

• Some Popular Investment Styles
• Momentum Investing (continued)
• Momentum investors focus on relative price
  movements in the market rather than on the
  fundamentals of the underlying companies.
• Momentum investors look for stocks in high-growth
  industries that have high trading volume and
  price movements.
• They tend to follow the Aggressive Stock
  Management or Speculation and Short-Term Trading
  Strategies.