CHAPTERS 5, 2, Lecture Notes

1
CHAPTERS 5, 2, Lecture Notes
The Stock Market (Chapter 5) Buying and Selling
Securities (Chapter 2) Introduction to Stocks
(Lecture)
Dont gamble! Take all your savings and buy some
good stock and hold it till it goes up. If it
dont go up, dont buy it. -- Will Rogers
2
What Are Stocks?
Where did the term Common Stocks come from?
The investors are Shareholders in Common.

• Stocks represent ownership in a corporation
• Stocks are Equity Financing Equities
• Enable investors to participate in the profits
  and growth generated by the business enterprise
• But stockholders are limited liability owners
• Can only lose their investment (unlike a sole
  proprietor)
• Stockholders receive
• Dividends
• Optional payments of earnings
• Capital Gains a.k.a. Capital Appreciation
• Value of corporation rises as business grows

Contrary to what many believe (and how many
behave), stocks are not simply millions upon
millions of worthless pieces of paper that people
trade each day for no reason. They represent
ownership in real businesses.
3
Historical Performance

• Over the long-term of modern finance
• The return from the stock market (as measured by
  the SP 500) has averaged around 10 to 11
  annually for the last eighty years
• But in any one year
• It is unlikely that the return will be 10 or 11
• The return has varied from a high of 53.8 to a
  low of -43.4
• 2008s return was -38.5, one of the worst!
• And in any given year
• There has been a one-in-three or one-in-four
  chance of a down market

The major exception was the great run-up from
1982 to 2000
4
Historical Performance
(continued)
5
Rolling 10-Year Period Returns
20
15
10
5
0
Rolling 10-Year Periods
192837
2003-12
193342
193847
194352
194857
195867
196372
196877
197382
197887
198392
198897
199302
199807
195362
Source The unmanaged Dow Jones Industrial
Average, based on average annual compound returns
over 10-year periods.
6
Historical Performance
(continued)

• Traditionally, close to half of the return from
  stocks was from reinvested dividends
• Stockholders used to expect 4 to 6 in dividends
  each year That was as much or more than bonds
  returned in interest since stocks were considered
  much riskier than bonds
• The SP 500 dividend average from 1936 to 2008 is
  3.8
• But dividends fell to less than 2 even 0!
• Capital gains growth were what people wanted in
  the 1990s
• The SP 500 dividend averaged 1.5 from 1997 to
  2007
• Reasons given are varied
• Dividends were taxed at a higher rate than
  capital gains
• People wanted the business to reinvest the
  earnings for growth instead of distributing it to
  the investors
• Stocks were no longer considered riskier than
  bonds
• Savings accounts were also paying less than 2
• People lost track of their senses and bid up the
  prices

7
Historical Performance
(continued)
8
Historical Performance
(continued)

• The Pendulum Swings
• The Bear Markets of 2000-2002 and 2008 have
  changed investors perception about dividends
• We now see investors and companies focusing more
  and more attention on dividends
• Many companies that never paid dividends in the
  past are doing so now
• Example Many tech companies are no longer growth
  stocks. They are mature industries.
• Also, the tax law has changed dividends so that
  they are taxed the same as capital gains

Dividends Dont Lie. - Geraldine Weiss Do you
know the only thing that gives me pleasure? Its
to see my dividends coming in. - John D.
Rockefeller
9
Pros Cons of Stock Ownership

• Pros
• Allow general public to share in the rewards of
  business enterprise
• Best investment returns over time
• Dividends and capital gains
• Easy to buy sell liquid investment
• Limited liability
• Increased standard of living for all
• Cons
• Risky
• Volatile (industrys popular euphemism for
  losing money)
• Corporate and financial industry hanky-panky!

10
Volatility Examined
11
Primary versus Secondary Market

• Primary Market
• The market in which new issues of securities are
  sold to the public
• Initial Public Offering (IPO)
• The first public sale of a companys stock
• a.k.a. Going public, Taking the company
  public
• Most retail investors do not participate in the
  primary market
• (And my recommendation is that we really
  shouldnt)
• Secondary Market
• The market in which securities are traded after
  they have been issued to the public
• The vast majority of transactions take place in
  the secondary market

12
Primary Market

• Why Go Public?
• Why do corporations issue common stock?
• To raise money to start or expand a business
• To help pay for ongoing business expenses
• As a way to gain prestige and respect within the
  investment and industrial communities
• As a reward for those who started the business
• And also simply because once a business becomes
  sufficiently large, it becomes very difficult for
  the owners to divvy up the spoils without going
  public
• If you were one of the people who started GE or
  Coca-Cola or Walmart, how would you sell your
  share of the business?

Examples of some of the largest private companies.
13
Primary Market
(continued)

• Why Go Public? (continued)
• The corporation does not have to repay the money
• It is under no obligation to repurchase the
  shares of the stock
• The shareholder may or may not be able to find
  someone who will purchase the shares from them
• But the corporation is now a public entity
• As such, it now has many rights and
  responsibilities that private companies do not
  need to worry about
• Must file 10Ks 10Qs with the SEC
• Must have at least one public meeting annually

Chapter 5 goes into much detail about IPOs. IPOs
do not usually live up to their expectations. The
typical IPO loses 50 of its value in one year.
14
Secondary Markets

• Markets in which securities are sold after they
  have been issued
• a.k.a. Aftermarket
• Secondary markets provide
• Liquidity
• Easy method for transferring ownership of
  securities
• Mechanism for pricing and valuation of securities

When people talk about the stock market, they
are almost always referring to the secondary
market.
15
Types of Secondary Markets

• Organized Securities Exchanges
• Centralized institutions in which transactions
  are made in outstanding securities
• Double Auction Market (Face-to-Face)
• Over-the-counter (OTC) Market
• Widely scattered telecommunications network
  through which transactions are made in
  outstanding securities and smaller IPOs
• Quote-based system (On-line)

This is an outdated comparison. Due to
technology advancements, mergers, and
acquisitions, the traditional differences between
the two have been erased. And the changes are
just gettin started!
16
Organized Securities Exchanges

• Historically
• All trading was conducted on an exchange floor
• Trading was conducted using a double auction
• Instead of the one seller, multiple buyers that
  you see at an estate or farm auction, for
  example,
• There are multiple sellers and multiple buyers
• Brokers on the floor call out prices quantities
• But due to both technology the sheer massive
  volume of shares traded, things have changed
• Most of the trading is now conducted
  electronically
• Some large trades still involve significant human
  interaction
• But they now consist of far less than 1 of the
  total number of trades

17
The New York Stock Exchange

• a.k.a. NYSE, the Big Board
• Responsible for over 90 of the volume of
  transactions on exchanges 3,600 companies
• 1,366 members SEATS
• Only members were authorized to make trades
• Most were commission brokers and specialists
• The SEATS were phased out when the NYSE went
  public
• Companies listed on the NYSE must meet stringent
  requirements
• The largest and most prestigious (traditionally)
• Companies can be de-listed (example Kodak)
• If they fail to continue to meet the NYSE
  requirements

Stock Exchange Auction Trading System
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The New York Stock Exchange
(continued)

• Big Changes at the NYSE
• In 2005, purchased Archipelago electronic
  exchange and the Pacific regional exchange
• Became a publicly traded corporation in March of
  2006
• Merged with the Euronext electronic exchange
• Phasing out face-to-face, double auction trading
• In favor of exclusively trading electronically
• In 2011, Germanys stock market tried to purchase
  the NYSE but was blocked by European regulators
• The NYSE is now being acquired for 8 billion by
  a 12-year old derivative trading firm from Atlanta

What will it mean for investors and for trading?
It is difficult to know if the average investor
will be able to notice any big differences soon,
but the oft-mentioned, oft-discussed ultimate
goal is to have 24-hour non-stop electronic
trading. What do you think of this possibility?
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The New York Stock Exchange
(continued)

• The Floor Brokers
• House Brokers
• Execute orders on behalf of their firms
  customers or occasionally on behalf of their
  firms own account
• Independent Brokers
• Provide as-needed execution services to house
  brokers, member or non-member broker-dealers
• Independent of a particular firm
• a.k.a. 2 Brokers

The floor brokers are very worried that the
NYSEs aggressive moves to all-electronic trading
means the end of their way of life. It is not
really the end it is just a big change from
face-to-face interaction to sitting in front of a
computer screen all day. Sound familiar?
20
The New York Stock Exchange
(continued)

• The Specialists
• Stock exchange members who specialize in making
  transactions in one or more stocks
• The job of the specialist is to manage the
  auction process. The specialist buys or sells
  the stock from their own inventory to provide a
  continuous, fair, and orderly market
• The role of the specialists is being squeezed out
  by technology and the tremendous volume of
  trading. They are becoming less and less involved
  in the typical market trading day

From time to time, the specialists are either
praised or maligned. Suffice to say that the
specialists are trying to make a profit just like
everyone else. While their goal may seem
altruistic, they make sure that when the market
receives benefits from their efforts, so do they.
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The American Stock Exchange

• The American Stock Exchange
• a.k.a. the AMEX, the Curb (?)
• Where did that name come from? They started on
  the curb!
• Much smaller than the NYSE
• Only 3 of the volume of all exchanges
• The AMEX started concentrating on securities
  other than stocks about 20 years ago
• Purchased by the NASDAQ in 1998
• Went independent again in 2004
• Acquired by the NYSE in 2008
• They then moved down the street to the same
  building as the NYSE and their name was changed
  to NYSE MKT

The ETFs were first introduced on the AMEX.
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The Regional Stock Exchanges

• The regional stock exchanges were modeled after
  the NYSE and AMEX
• Only account for 4 of exchange volume
• Chicago
• Philadelphia
• Pacific
• Boston
• Denver
• Cincinnati

Many of the securities listed on the regional
exchanges are also available on the NYSE or
NASDAQ. Traditionally, the regional exchanges
were often places where undesirable or unethical
issues were sold. Lately, the regional exchanges
have tried to diversify and differentiate
themselves from the NYSE and NASDAQ in order to
survive.
Plus the regional exchanges have not been immune
to the rush to consolidate. The NYSE bought the
Pacific Exchange and the NASDAQ bought the
Philadelphia Exchange.
23
Options and Futures Exchanges

• Options allow traders to sell or to buy an
  underlying security at a specified price for a
  given time
• The Chicago Board Options Exchange (CBOE)
• Futures are contracts that guarantee the delivery
  of a specified commodity at a specific future
  date at an agreed-on price
• Chicago Board of Trade (CBT)

We will discuss options and futures in detail
later. Options and futures are also traded on
most all the major and regional exchanges now as
well as the two major exchanges noted above.
24
The Over-the-Counter Market

• Widely scattered telecommunications network
  through which transactions of securities are made
  a.k.a. OTC
• There is no single location as with an exchange
• Quote-based system
• As opposed to the double auction of the exchanges
• Three tiers
• NASDAQ National Association of Securities
  Dealers Automated Quotation system over 3,000
  securities
• OTC Bulletin Board 5,000 securities
• Pink sheets, etc. 20,000 thinly traded
  securities

The Nether Worlds Stay Away!
25
The Role of Dealers in the OTC

• Dealers are traders who make markets by
  offering to buy or sell certain securities at
  stated prices a.k.a. market makers
• The dealers offer buy and sell quotes from their
  own inventory of stocks
• Whereas brokers simply serve as a go-between
  between buyers sellers. They keep no inventory
• Ask price retail price
• The price a dealer offers to sell a security
• Bid price wholesale price
• The price a dealer offers to purchase a security
• The spread
• The difference between the bid and the ask prices

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The Role of Dealers in the OTC
(continued)

• Unlike brokers who charge a commission, dealers
  make money from the spread of the bid and ask
  prices
• Just as the Casas de Cambio in San Ysidro make
  money on the difference between the prices in
  which they buy and sell pesos and dollars
• The dealers markups or markdowns are not
  reported to the customers
• Whereas the brokers commissions are reported

How do you think the Internet brokers make money
on only 5 or 7 per trade? (More later)
27
The NASD and the NASDAQ

• National Association of Securities Dealers
  Automated Quotation system NASDAQ
• National Association of Securities Dealers (NASD)
• Non-governmental organization that used to be
  responsible for self-regulation of registered
  representatives (stockbrokers) (Now done by
  FINRA)
• The NASD is now simply called the NASDAQ
• Created the first electronic communications
  network for trading securities in 1971
• Provides up-to-date bid and ask prices on
  approximately 3,200 stocks

The NASDAQ used to be the arena for small
companies to get started. Once they became large
enough, they would move to the NYSE. However,
since the 1980s, many prestigious companies
decided to stay on the NASDAQ rather than move to
the NYSE.
28
The NASD and the NASDAQ
(continued)

• The NASDAQ is now a three-tier system
• NASDAQ Global Select Market
• 1,530 crème de la crème
• Companies that would easily qualify for the NYSE
• NASDAQ Global Market
• nee NASDAQ National Market
• 680 larger companies
• NASDAQ Capital Market
• nee NASDAQ SmallCap Market
• 530 smaller companies

The NASDAQ began positioning itself as the
Securities Market of the Future as it became
apparent that the traditional face-to-face,
double auction model was not adequate to keep up
with the massive increase of trading.
29
Alternative Trading Systems

• Third market
• Over-the-counter transactions made in securities
  listed on the NYSE, AMEX, or one of the other
  organized exchanges
• Institutional investors who trade in large blocks
  of securities get to use the third market
• Mutual funds, insurance companies, pension plans,
  etc.
• Reduced transaction costs
• But still facilitated by a dealer
• Example Intermarket (now NASDAQ Intermarket)

30
Alternative Trading Systems
(continued)

• Fourth market
• Traditionally, transactions made directly between
  large institutional buyers and sellers of
  securities
• Allowed the institutions to bypass the dealers
• Get rid of the middleman
• Electronic Communications Networks (ECNs)
• Privately owned electronic trading networks that
  automatically match buy and sell orders that
  customers place electronically
• Examples Archipelago (now NYSE Arca), BATS

With the advent of the Internet, the third and
fourth markets successfully started to court
retail customers. This got the attention of the
NYSE and the NASDAQ!
31
But Isnt the Stock Market All Just One Big
Malignant Casino?
The Answer is Yes and No

• Yes
• There are many individuals who see the markets as
  one big crap-shoot
• For them, the way to riches is to buy and sell,
  buy and sell, buy and sell
• We call them speculators
• No
• Many others look at the markets as a way to
  participate in the growth prosperity of the
  global economy
• We call them investors

It is very difficult and you are up against the
best in the business. Neophytes become very upset
when the market turns against them.
a.k.a. traders
With a long-term orientation, they are usually
very well rewarded.
An investment operation is one which, upon
thorough analysis promises safety of principal
and an adequate return. Operations not meeting
these requirements are speculative. - Benjamin
Graham
32
Oh, Yeah, But What About Enron? Arent
Corporations All Crooks?

• Fraud and accounting trickery and gimmicks have
  always been with us
• They are always going to be with us
• Because that is where the money is!
• Normally, but not always, those firms are
  relegated to the nether reaches of the OTC
• But for every one Enron, there are hundreds no,
  thousands! of companies that continue to do
  business with integrity and honesty (uh, usually
  )

Forty years ago, it was Equity Funding.
Twenty-five years ago, it was Ivan Boesky and
Vagabond Inns. Four years ago, it is Fannie,
Freddie, Lehman, Citi, WaMu, and AIG. And dont
forget Madoff! Twenty years from now, during the
next big bull market craze, someone else will
take their place.
33
Recap Securities Markets

• The securities markets exist to allow investors a
  safe, cost-effective method to participate in the
  success of the global economy
• And even with all the underhanded shenanigans,
  they have performed very well
• They are changing at breakneck speed
• And the change is accelerating

Whether or not we ever have one or more global,
24-hour trading markets remains to be seen. But
it is exciting (and, for some, scary) to watch,
especially for those of us who have a stake in
the outcome.
34
Bull Markets vs Bear Markets

• Bull Market
• Favorable markets normally associated with rising
  prices, investor optimism, economic recovery, and
  government stimulus
• Bear Market
• Unfavorable market normally associated with
  falling prices, investor pessimism, economic
  slowdown, and government restraint

• Where did the terms bull market and bear market
  come from?
• Bear Skin Jobbers Dont sell the bear skin
  before the bear is caught.

35
Types of Stock Transactions

• Market Order
• Buy/sell at the current price
• Limit Order
• Buy/sell only at the price you specify
• Stop-loss Order (a.k.a. Stop Order)
• Buy/sell at the current price once a trigger
  point is reached
• Stop-limit Order
• Buy/sell only at the price you specify once a
  trigger point is reached

Although you can use limit orders to buy or sell
at the price you want, and stop-loss and
stop-limit orders to lock-in profits or protect
against losses, remember that they trigger
automatically. If for some reason, you change
your mind, it is often too late to cancel the
order.
36
Types of Stock Transactions
(continued)
I normally use and recommend market orders.
Short-term traders tell me they prefer limit
orders or stop orders on all their trades.
37
Types of Stock Transactions
(continued)

• Buying on Margin
• Borrowing money from your broker to enhance your
  return
• You can borrow up to 50 of the purchase price of
  a stock
• Selling Short
• Borrowing stock and selling it in the hopes that
  the price will go down (Sell stock you do not
  own! Huh?)
• You must buy it back at some time in the future

The book spends much time discussing margin
accounts and selling short in chapter 2. We will
discuss these in detail late in the semester. My
advice to you is never sell short. It is simply
too risky. Using a margin account can be useful
once you have built a substantial portfolio. It
allows you to borrow from your portfolio without
selling your stocks.
38
Transaction Costs

• Traditionally, transaction costs were in the 1
  to 5 range
• Sometimes higher
• The largest percentage of the cost was the
  brokerages commission
• Deep-discount Internet brokers have driven the
  commissions down to as low as 5
• One brokerage firm even offers free trades (?)
• But have transaction costs really gone down?
• Yes, but more and more of the cost is hidden from
  the investor

Especially the Internet garbage brokers. (Those
arent my words!)
39
Transaction Costs
(continued)

• Example
• A deep-discount Internet broker offers trades for
  7
• In the fine print of the client-broker agreement
  is included a provision for allowing the broker
  to solely utilize exclusive stock dealers and
  market makers
• The quoted price is simply the best price
  available but at any one time, there are dozens
  of prices quoted as dealers and market-makers
  compete for buy and sell orders
• The chosen dealer doesnt necessarily have the
  best price
• Instead of paying 20, the investor might pay
  20.05

The investor sees the 7 commission on their
confirmation. The investor does not see the
extra 5 they paid on a 100 share purchase
because of the dealers markup.
40
Transaction Costs
(continued)

• The following disclaimer is included in each
  trade confirmation e-mail from Scottrade

SCOTTRADE INC. RECEIVES REMUNERATION FOR
DIRECTING ORDERS TO PARTICULAR BROKER/DEALERS OR
MARKET CENTERS FOR EXECUTION. SUCH REMUNERATION
IS CONSIDERED COMPENSATION TO THE FIRM AND THE
SOURCE AND AMOUNT OF ANY COMPENSATION RECEIVED BY
THE FIRM IN CONNECTION WITH YOUR TRANSACTION WILL
BE DISCLOSED UPON REQUEST
In Scottrades defense, at least they prominently
disclose this relationship. Many others hide it
in their customer agreement fine print and the
customers are never aware of the relationship.
41
Transaction Costs
(continued)

• The SEC says that your broker has a duty to seek
  the best execution that is reasonably available
  for its customers' orders
• But it is not a guarantee
• the SEC requires broker/dealers to notify
  their customers if their orders are not routed
  for best execution. Typically, this disclosure is
  on the trade confirmation slip you receive
  after placing your order Investopedia
  http//investopedia.com/articles/01/022801.asp
• And determining whether or not a customer got
  best execution can be very difficult

Here is an example of the SEC trying to enforce
the rules http//lawprofessors.typepad.com/secur
ities/2008/06/scottrade-settl.html
42
Transaction Costs
(continued)

• The SEC was looking into making the costs more
  transparent
• Possibly showing the customer the difference
  between the dealers price and the best price
  available at the time of the transaction
• Maybe even gasp! showing the total cost of
  the transaction from the markup/markdown
• Needless to say, the deep-discount brokers cried
  that it would drive up the cost of commissions
  and ultimately hurt the consumer and the proposal
  died
• So it is up to you to check if you are getting
  the best execution

But how can you, a lone investor, determine if
you are getting the best price if even the SEC
has trouble watching over the brokerage companies?
43
Round Lot versus Odd Lot

• Round Lot
• 100 shares or multiples of 100 shares
• Odd Lot
• Less than 100 shares
• Odd-lot Differential
• Extra cost of trading an odd lot
• Traditionally, the odd-lot differential was 12½
  - 25
• It is now typically 5 - 10 or less

Some people recommend against odd-lot purchases
because of the higher cost. On 10 shares, an
odd-lot differential might be 1. On 80 shares,
it might be 4. Big deal.
44
Reading Stock Quotes

• Current price during trading hours
• The bid and the ask
• Open, High, Low, Close (a.k.a. Last)
• 52-Week High and Low
• Dividend Yield
• P/E Ratio
• Volume
• Net Change
• Year-to-Date Change

Different sources will contain some, all or more
of these statistics. But always remember that
the quoted prices are not the only prices
available. At any one time, there are many
prices available from many different
dealers/market-makers. The quoted prices are the
best prices available. Plus, usually you are
seeing the current prices 15 to 20 minutes ago.
45
Reading Stock Quotes
(continued)

• Wall
• Street
• Journal
• Example

Omigod! You mean you actually wait until the
next day to find out how much your stock is
worth?! How Twentieth Century!
46
Reading Stock Quotes
(continued)

• On-line Examples
• Yahoo!
• Bloombergs
• CBS Marketwatch
• Any others you want to check out?

The biggest reasons I use Yahoo! are because I
believe it is the easiest to use and is also the
easiest on the eyes. The newer version of Yahoo!
is harder on the eyes, IMHO. However, some of
the other sites have started to add more white
space (which is easier on the eyes). I literally
recoil from the sites that fill every square
centimeter with information. (Note to online
students Please see the accompanying
presentation on how to use Yahoo! Finance to do
your research.)
47
Market Averages and Indexes

• How can we say that stocks have returned
  approximately 10 over the past 70 years?
• The industry uses market averages and indexes
• Benchmarks used to measure the general behavior
  of securities prices by reflecting either the
  average price behavior (market average) or
  relational price behavior (market index) of
  representative groups of securities at a given
  point in time
• You can not help but hear about these every day
  in the news
• The Dow went down! The NASDAQ went up!

The differences between a market average and
market index are subtle. Most people do not even
know there are differences.
48
Market Averages and Indexes
(continued)

• Share price calculation (Market Average)
• Looks solely at the price of the stock without
  regard to the market value
• Example Dow Jones Industry Average
• Market-weighted calculation (Market Index)
• Stock price times number of shares outstanding
• Takes into account the market value of the stock
  in the index
• The larger the market share, the more influence
  the security will have in the index
• Example Standard Poors 500 Stock Index

Market-weighted calculations were generally
regarded as a better measure until the bubble of
the late 1990s.
49
The Dow Jones Industrial Average

• Stock market average made up of 30 high-quality
  stocks selected for total market value and broad
  public ownership and believed to reflect overall
  market activity
• Share price calculation
• Most famous of the stock market measures
• a.k.a. the Dow, the Dow Average, the DJIA
• Changes from time to time as companies and
  industries evolve
• As such, it now has more non-industrial stocks
  than industrial stocks

Dow Jones is the company that publishes the Wall
Street Journal. It was recently purchased by
Rupert Murdoch of Fox News fame.
50
The Dow Jones Industrial Average
(continued)
The Thirty Stocks in the Dow Jones Industrial Average The Thirty Stocks in the Dow Jones Industrial Average The Thirty Stocks in the Dow Jones Industrial Average
Alcoa Dupont Merck
American Express ExxonMobil Microsoft
ATT General Electric Pfizer
Bank of America Hewlett Packard Proctor Gamble
Boeing Home Depot 3M
Caterpillar IBM Travelers
Chevron Intel United Healthcare
Cisco Johnson Johnson United Technologies
Coca Cola J. P. Morgan Chase Verizon
Disney McDonalds Walmart
51
The Dow Jones Industrial Average
(continued)
Years Dow Jones Average Rise
1906 - 1924 100 ? 100 -
1924 - 1929 100 ? 300 3x
1929 - 1954 300 ? 300 -
1954 - 1966 300 ? 1000 3x
1966 - 1982 1000 ? 1000 -
1982 - 2000 1000 ? 11000 11x
2000 - 2011 11000 ? 11000 -
So, how do you make money in stocks during times
when the markets and capital gains are flat? The
answer depends upon whether you are an investor
or a speculator/trader.
52
Other Dow Jones Averages

• Dow Jones Transportation Average
• 20 railroad, airline, freight, etc.
• Dow Jones Utilities Average
• 15 public utilities
• Dow Jones 65 Stocks Composite Average
• Industrial, Transportation Utilities stocks
• Dow Jones U.S. Total Stock Market Index
• nee Dow Jones Wilshire 5000 Total Market Index
• nee Wilshire 5000
• Dow Jones U.S. Completion Total Stock Market
  Index
• nee Dow Jones Wilshire 4500, nee Wilshire 4500
• It is the Wilshire 5000 minus the 500 stocks in
  the SP 500
• Dow Jones Internet Index

53
Standard Poors 500 Composite Index a.k.a.
the SP 500, the SP

• 500 stocks chosen for market size, liquidity, and
  industry group representation
• Market-value weighted index
• Traditionally, the largest 500 companies based in
  the United States (can now contain foreign
  stocks)
• Very popular index although has lost some of its
  original focus
• Used by many index mutual funds

Because the SP 500 is market-weighted, it was
affected by the bubble of the late 1990s in a
bizarre manner. The market values of a small
percentage of technology companies were inflated
to extremes. This skewed the index even more
toward those companies. Consequently, in 1998,
10 of the gain in the SP 500 was due to one
stock.
54
Other Standard Poors Indices

• Standard Poors Industrial 400
• Standard Poors Midcap 400
• Medium-sized companies
• Standard Poors Smallcap 600
• Small companies
• Standard Poors 1500 Index
• Includes 500 Index, Midcap 400 and Smallcap 600
• Other Standard Poors Indices
• Transportation, Utilities, Financials
• Many other global, international sector indices

55
NYSE, AMEX and NASDAQ Indices

• NYSE Composite Index
• Measure of the current price behavior of
  approximately 2,000 stocks listed on the NYSE
• AMEX Composite Index
• Now called the NYSE MKT Composite Index
• NASDAQ Composite Index (a.k.a. tech index)
• Ditto for the NASDAQ
• NASDAQ 100 Index
• Top 100 non-financial firms listed on the NASDAQ

The NASDAQ Composite went from 800 in 1995 to
5000 in 2000 and then dropped to 1200 in 2002
before starting to recover in 2003. The NASDAQ
indices are technology laden.
56
Other Popular Stock Market Indices

• Total Stock Market Indices
• Dow Jones U.S. Total Stock Market Index
• nee Dow Jones Wilshire 5000 Index
• nee Wilshire 5000
• Now competing with SP Total Market Index and
• MSCI US Broad Market Index
• Extended / Completion Stock Market Indices
• Dow Jones U.S. Completion Total Stock Market
  Index
• nee Dow Jones Wilshire 4500
• nee Wilshire 4500
• Now competing with the SP Completion Index

57
Other Popular Stock Market Indices
(continued)

• Russell 2000
• Meant to measure small company performance in the
  United States
• Russell 1000 is the top 1,000 largest companies
• Russell 3000 is the top 3,000 companies
• Russell 2000 is the top 3,000 without the top
  1,000
• MSCI Indices
• Morgan Stanley Capital International
• MSCI World Index (Global developed world)
• The MSCI All Country World Index is replacing the
  World Index
• Includes developing world countries
• MSCI EAFE Index (International developed world)
• The MSCI All Country World ex-USA Index is
  replacing the EAFE Index (again, includes
  developing countries)

Stock Worksheet 1 contains the indices you
should know by name
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(No Transcript)
59
stock market index ennui
60
Volatility Re-examined
You will not see this graph on the news!
61
Common Stock Characteristics

• Stock Spin-off
• Conversion of one of a firms subsidiaries to a
  stand-alone company by distribution of stock in
  that new company to existing shareholders
• Sometimes, the new company is still
  majority-owned by the company that spun it off
• Recently, Kraft was spun off from Altria (Philip
  Morris). Altria then divested itself of its
  international tobacco business (now called Philip
  Morris International)

The history of spin-offs has been checkered.
Some spin-offs have done better than the
companies that spun them off. Examples of this
are the Baby Bells after being spun off from
ATT. Some spin-offs have not fared so well.
Coca-Cola Enterprises (spun off from Coca-Cola)
and Lucent Technologies (spun off from ATT) are
examples of disappointments.
62
Common Stock Characteristics
(continued)

• Stock Split
• A 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
• Example 2 for 1 split You had 100 shares you
  now have 200 shares
• Big Deal! the price went from 20 down to 10
• There are 3 for 1 splits, 3 for 2 splits, 1 for 5
  splits

There is no increased value from stock splits.
If you had 1 share at 20, now you have 2 shares
at 10 the value is still 20. It is a
psychological increase at best. Warren Buffet of
Berkshire Hathaway has refused to split his stock
since its inception. A single share now goes for
over 145,000!
63
Common Stock Characteristics
(continued)

• Treasury Stock
• Shares of stock that have been sold and
  subsequently repurchased by the issuing firm
• a.k.a. Share Buybacks, Buybacks
• Share buybacks reduce the number of outstanding
  shares
• The logic being that after the buyback, there is
  less supply of outstanding stock
• Existing shareholders now have a larger
  percentage ownership of the corporation

During the run-up of the 1990s, share buybacks
were often seen as a better alternative to
dividend increases. The belief was that
investors were more interested in capital gains
than dividends and that buybacks increased the
potential for capital gains by reducing the
supply of stock.
64
Common Stock Characteristics
(continued)

• Classified Common Stock
• Common stock issued by a company in different
  classes, each of which offers different
  privileges and benefits to its holders
• Class A, Class B, etc.
• Example Berkshire Hathaway
• Class A are the original shares
• Recall that they are selling for over 145,000
  each
• The financial world pressed Warren Buffet to
  offer a lower cost version of his stock
• Class B shares sold for around 3,300 each
• In the prospectus, Buffet said he wouldnt buy
  them!
• They recently split 40 for 1 and now sell for
  around 98

65
Common Stock Values

• Par Value
• The stated, or face, value of a stock
• Maybe only 1 per share, fairly meaningless
• Book Value
• The amount of shareholders equity in a firm
  equals the amount of the firms assets minus the
  firms liabilities and preferred stock
• Market Value
• The prevailing market value of a security

More about valuation in Chapter 6
66
Common Stock Dividends

• Share of earnings given to stock holders
• Normally paid quarterly
• Board of Directors decides how much, if any,
  dividends should be paid and when to pay them
• Dividends are usually a percentage of the
  earnings per share
• Earnings Per Share (a.k.a. EPS)
• The amount of annual earnings available to common
  stockholders, as stated on a per share basis

67
Common Stock Dividends
(continued)

• Earnings Per Share Example
• Company reports net profit of 1 million
• There are 500,000 shares outstanding
• Earnings Per Share 1,000,000 earnings /
  500,000 shares 2.00 earnings per share
• The Board of Directors might decide to pay out
  50 of the earnings per share in the form of
  dividends
• Therefore, each shareholder would receive a 1.00
  dividend for each share they owned
• This is called the dividend payout ratio
• The company is paying out 50 of their earnings
  to shareholders in the form of dividends

68
Common Stock Dividends
(continued)

• Dividend Yield
• A measure that relates dividends to share price
  and puts stock dividends on a relative
  (percentage) basis rather than an absolute
  (dollar) basis
• Example If the stock in the previous slide that
  was paying a 1 dividend were selling for 20,
  the dividend yield would be 5
• Makes it easier to compare stocks with other
  income-oriented vehicles such as bonds or saving
  accounts

Traditionally, 3 to 6 was normal. In the 1990s
dividends went to 2 or less. Dividends went
above 3 in the 2008/2009 turmoil and are now
back down to just above 2.
1 dividend 5 dividend yield
20 price
69
Common Stock Dividends
(continued)

• Important Dates
• Declaration Date
• Date that Board of Directors declares dividend
• Date of Record
• The date on which an investor must be a
  registered shareholder of a firm to be entitled
  to receive a dividend
• 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
• Payment Date
• The actual date on which the company pays the
  dividend

70
Common Stock Dividends
(continued)

• Why is the ex-dividend date three days before the
  date of record?
• Because stock transactions close in three days
• If you purchase a stock on June 15, you do not
  actually get the stock until June 18
• Theoretically, the opening share price on the
  ex-dividend date should reflect a drop in price
  commensurate with the amount of the dividend
• Example If there is a 1 per share dividend, the
  opening stock price should be reduced by 1
• Of course, it never really works that way in the
  marketplace since prices are changing all the time

71
Common Stock Dividends
(continued)

• Dont Buy the Dividend
• is a common saying in the industry
• Translation You are often better off waiting
  until the ex-dividend date before buying a stock
• The logic follows thusly
• Dividends are taxable transactions
• If you buy the dividend buy the stock just
  before the ex-dividend date you will be
  responsible for paying the tax, and
• Presumably, the stock price will fall
  commensurate with the amount of the dividend, so
• You are better off waiting until after the
  ex-dividend date so that you will get the stock
  at a better price and not generate a taxable
  transaction

72
Common Stock Dividends
(continued)

• Types of Dividends
• Cash Dividends
• Payment of a dividend in the form of cash
• Stock Dividends
• Payment of a dividend in the form of additional
  shares of stock
• All else equal, stock dividends have no value
  because they constitute a dilution of ownership
• Example The Board of Directors declares a 10
  stock dividend
• For every 10 shares, you receive 1 extra share
• Correspondingly, the price of the shares drop 10
• But, unlike a cash dividend, a stock dividend is
  not taxed
• No taxes? Big Deal! It is not worth anything
  anyway!

Please know this important difference!
73
Common Stock Dividends
(continued)

• Types of Dividends (continued)
• Dividend Reinvestment Plans (DRIPs)
• Plans in which shareholders have cash dividends
  automatically reinvested into additional shares
  of the firms common stock
• This is a taxable transaction
• No additional shares were issued
• Hence, no dilution of ownership occurred

DRIPs are an excellent way to own stock for those
interested in long-term growth and not interested
in current income. It allows the investor to
take advantage of compounding automatically with
normally no (or very small) transaction costs.
Investing in a company like General Electric or
Johnson Johnson in this way is almost like
investing in a mutual fund.
74
Common Stock Valuation

• Price to Earnings Ratio
• a.k.a. P/E, PE
• The price of the stock divided by the earnings
  per share
• Previous example 20 price, 2 earnings per
  share
• 20 / 2 10 Price to Earnings Ratio (a.k.a. 10
  P/E)
• Traditionally, stocks sold for P/E ratios of 5 to
  14
• A P/E of 20 was only reserved for the fastest
  growing stocks
• For many years, a P/E of 20 was not unusual
• In the 2008 turmoil, P/E ratios came down greatly

1980s 1990s
We will spend a great deal of time learning P/E
and other valuation techniques in the next few
chapters.
75
Types of Common Stock

• Blue-chip Stocks
• Financially strong, high-quality stocks with long
  and stable records of earnings and dividends
• Often referred to as value stocks
• Attracts conservative investors
• Examples General Electric (?), General Motors
  (?!)
• Income Stocks
• Stocks with long and sustained records of paying
  higher-than-average dividends
• Also often referred to as value stocks
• Normally slow growth company in a mature industry
• Examples Utility stocks, Banks

76
Types of Common Stock
(continued)

• Growth Stocks
• Stocks that experience high rates of growth in
  operations and earnings
• Growth rate 15 to 20 or higher
• Often associated with high P/E ratios
• Often no dividends at all
• Or a very small token amount
• Most of the profits are reinvested into the
  company
• Stock price should go up
• But usually very volatile
• Examples Intel, Microsoft, Dell (?)

Wait a minute! Are Intel, Microsoft, and Dell
still growth stocks?
77
Growth versus Value

• The investment world loves to use the terms
  growth and value
• But the meanings of the terms are not exact
• Typically, investors often use growth to
  designate a high P/E stock while they use value
  to denote a low P/E stock
• But a high P/E stock might be a great value while
  a low P/E stock might not be a good value

In January of 2005, Google was selling for around
200 with a sky-high P/E while the old GM was
selling for 34 with a very low P/E. Today,
Google sells for around 755 (with a much lower
P/E) and the old GM stock (a.k.a. Motors
Liquidation) last sold for 0.04 March of 2011
and is now worthless. Which one was the better
value?
78
Types of Common Stock
(continued)

• Cyclical Stocks
• Stocks whose earnings and overall market
  performance are closely linked to the general
  state of the economy
• Follow the business cycle of advances declines
• Examples automobiles, timber, and steel
• Defensive Stocks
• Stocks that tend to hold their own, and even do
  well, when the economy starts to falter
• Remain stable during declines in the market
• Often associated with income stocks
• Examples Kelloggs, Procter Gamble

79
Types of Common Stock
(continued)

• Turnaround Stock a.k.a. Goner
• A company that has fallen on hard times
• Is there potential for a rebound?
• Example Chrysler in the 80s, Ford GM now
• Asset Play Stock
• A company this is sitting on an asset that could
  be sold or spun off
• Example JCPenneys retail business was not doing
  well several years ago but it had an insurance
  division that could easily have been sold to
  raise cash to have kept the company afloat
• Penny Stock
• Butterfly.com, Flim-Flam Inc. (examples)

80
Types of Common Stock
(continued)

• Foreign Stocks / International Stocks
• Direct Investments
• Traditionally, difficult to impossible to
  transact
• American Depository Receipts (ADRs)
• Global and International Mutual Funds
• Global Everyone including the United States
• International Everyone except the United States
• Currency Issues
• Stronger U.S. dollar has a negative impact on
  U.S. investors investing in foreign markets
• Weaker U.S. dollar has a positive impact

Will the dollar be stronger or weaker in the
coming years?
81
Capitalization

• Capitalization
• The current price of the stock times the number
  of shares outstanding
• Large cap stocks
• 10 billion and up
• Mega cap stocks 100s of billions (GE,
  Walmart)
• Mid cap stocks
• 2 billion to 10 billion
• Small cap stocks
• 100 million to 2 billion
• Micro cap stocks 10 million to 50 million
• Penny stocks
• Typically sell from less than 1.00 to 5.00 per
  share

82
Capitalization
(continued)

• Example
• Price 20.00
• Number of Shares ? 5,000,000
• Market capitalization 100,000,000
• This is a small cap stock

The stock price is (for the most part)
irrelevant. You must look at the market cap to
see what the value of the company is. (Remember
Warren Buffets Berkshire Hathaway?)
83
Capitalization Examples

• Walmart versus Target

Price () Number of shares outstanding Market Capitalization ()
Walmart 71.48 3.35 billion 239.12 billion
Target 62.49 650.79 million 40.67 billion
Note As of February 8th Values change daily
84
Capitalization Examples
(continued)

• ATT versus Verizon

Price () Number of shares outstanding Market Capitalization ()
ATT 35.27 5.58 billion 196.84 billion
Verizon 44.35 2.86 billion 126.80 billion

Note As of February 8th Values change daily
85
Investment Strategies

• Buy-and-Hold Strategy
• Use fundamental analysis to identify high-quality
  companies with good growth prospects and
  potential for dividends at reasonable prices
• a.k.a. Value Investing
• a.k.a. Growth-At-a-Reasonable-Price (GARP)
• Hold it forever
• Warren Buffet

My personal favorite! Dont Lose Perspective
example.
86
Investment Strategies
(continued)

• Income Strategy
• a.k.a. Equity-Income
• Emphasize dividends over capital appreciation
• Ideally, looking for growth of dividends
• As noted beforehand, companies that pay
  consistently-growing dividends tend to do well
  when the market as a whole does poorly
• In general, appropriate for conservative stock
  investors
• This strategy works well with DRIPs

Stocks which have had histories of consistent
dividend increases have often been the markets
best long-term investments
87
Investment Strategies
(continued)

• Growth Strategy
• Investing in stocks with above-average forecasts
  of earnings growth
• Dividends are a secondary concern
• Usually have high price to earnings ratios in
  expectation of higher earnings in the future

Growth stocks are stars! Everyone wants to jump
on the bandwagon as a company is experiencing
strong growth. Subsequently, the stock price is
bid up to very high levels. Typically, they are
also the stocks that are the riskiest. When the
slightest hint of a slow down in the growth