1 c hapters 5, 2, l ecture n otes the stock market (chapter 5) buying and selling securities...

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CHAPTERS 5, 2, Lecture Notes

The Stock Market (Chapter 5)

Buying and Selling Securities (Chapter 2)

Introduction to Stocks (Lecture)

“Don’t gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.”

-- Will Rogers

2

What Are Stocks? 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 growsContrary 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.

Where did the term “Common Stocks” come from? The

investors are “Shareholders in Common.”

3

Historical Performance Over the long-term of modern finance …

The return from the stock market (as measured by the S&P 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% 2008’s 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

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(continued)Historical Performance

5

Rolling 10-Year Period Returns

Source: The unmanaged Dow Jones Industrial Average, based on average annual compound returns over 10-year periods.

00

55

1010

1515

20%20%

RollingRolling10-Year10-YearPeriodsPeriods 1

928–37

2003-12

1933–42

1938–47

1943–52

1948–57

1953–62

1958–67

1963–72

1968–77

1973–82

1978–87

1983–92

1988–97

1993–02

1998–07

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Historical Performance 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 S&P 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 1990’s

The S&P 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

(continued)

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(continued)Historical Performance

0%

2%

4%

6%

8%

10%

12%

14%

16%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Yield on Bonds

Yield on Stocks

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Historical Performance 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 roughly the same as capital gains

(continued)

“Dividends Don’t Lie.” − Geraldine Weiss “Do you know the only thing that gives me pleasure? It’s to see

my dividends coming in.” − attributed to John D. Rockefeller

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ProsAllow general public to share in the rewards of

business enterpriseBest investment returns over time

Dividends and capital gainsEasy to buy & sell – liquid investmentLimited liability Increased standard of living for all

ConsRisky “Volatile” (industry’s popular euphemism for losing money)Corporate and financial industry hanky-panky!

Pros & Cons of Stock Ownership

10

“Volatility” Examined

$10,000

$10,500

$11,000

$11,500

$12,000

$12,500

$13,000

31-Dec-201219-Feb-20138-Apr-201323-May-201311-Jul-201327-Aug-201314-Oct-201329-Nov-2013

S&P 500 for Year 2013

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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 company’s 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 shouldn’t)

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

Primary versus Secondary Market

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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?

Primary Market

What are some of the largest private companies?

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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 10K’s & 10Q’s with the SEC Must have at least one public meeting annually

Primary Market

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.

(continued)

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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.

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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!

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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 were “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 Almost all of the trading is now conducted

electronically Some large trades still involve human interaction

But they now consist of far less than 1% of the total number of trades

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The New York Stock Exchange a.k.a. NYSE, the “Big Board” Traditionally, responsible for over 90% of the

volume of transactions on exchanges – 2,800 companies About $18 trillion of market capitalization

Established as a members-only entity in 1792 When Wall Street really was next to a wall

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

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The New York Stock Exchange 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 When they merged with the Euronext electronic exchange

Phased out face-to-face, double auction trading In favor of exclusively trading electronically

In 2011, Germany’s stock market tried to purchase the NYSE but was blocked by European regulators

On November 13, 2013, the NYSE was acquired for $11 billion by a 13-year-old derivatives trading firm from Atlanta, Intercontinental Exchange

(continued)

In 1992, on their 200th birthday, if you had told the folks at the NYSE that the next 20 years would see far more changes than in their first

200 years, they would have thought that you were quite insane.Press Release from ICE announcing completion of acquisition of NYSE

"The End of the Street" -- The Economist, 16 November 2013

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The New York Stock Exchange

The Floor Brokers House Brokers

Execute orders on behalf of their firm’s customers or occasionally on behalf of their firm’s 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”

(continued)

The floor brokers were very worried that the NYSE’s aggressive moves to all-electronic trading meant the end of their way of life. It was not

really the end; it was just a big change – from face-to-face interaction to sitting in front of a computer screen all day. Sound familiar?

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The New York Stock Exchange 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 & less involved in the typical trading day

The specialists were replaced by “designated market makers” and “supplementary liquidity providers” in 2009

(continued)

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 receive benefits from their efforts, so do they.

http://www.investopedia.com/university/electronictrading/trading2.asp

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The American Stock Exchange

The American Stock Exchange a.k.a. the AMEX, the “Curb” (?) – Now the NYSE MKT!

Where did that name come from? They started on the curb outside the NYSE!

Much smaller than the NYSE Only 3% of the volume of all exchanges

The AMEX started concentrating on securities other than stocks over 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.

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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.

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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 The NASDAQ does not want to be associated with the OTC anymore

OTC Bulletin Board – 5,000 securities OTC Markets Group

nee Pink Sheets – 20,000+ thinly traded securities It appears that they are trying to clean up their act: OTC Markets

The Nether WorldsStay Away!

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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 pricesThe dealers / market makers on the NASDAQ perform roughly

the same role as the specialists on the NYSE.http://www.investopedia.com/university/electronictrading/trading3.asp

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The Role of Dealers in the OTC

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 dealer’s markups or markdowns are not reported to the customers Whereas the broker’s commissions are reported

(continued)

How do you think the Internet brokers make money on only $5 or $7 per trade? (More later)

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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 2,800 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 1980’s, many prestigious companies decided to stay on the NASDAQ rather than move to the NYSE.

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The NASD and the NASDAQ The NASDAQ is now a three-tier system

NASDAQ Global Select Market 1,629 “crème de la crème”

Companies that would easily qualify for the NYSE NASDAQ Global Market

nee NASDAQ National Market 565 larger companies

NASDAQ Capital Market nee NASDAQ SmallCap Market 603 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. The NASDAQ market capitalization is roughly $6 trillion.

http://www.nasdaq.com/screening/companies-by-industry.aspx?industry=ALL&exchange=NASDAQ&market=NASDAQ

(continued)

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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)

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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!

(continued)Alternative Trading Systems

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“But Isn’t the Stock Market All Just One Big Malignant Casino?”

“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 capital markets as a way to

participate in the growth & prosperity of the global economy

We call them investors

The Answer is “Yes” and “No”

It is very difficult and you are up against the best in the business.

Neophytes become very upset when the market turns against them.

With a long-term orientation, investors 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.” − The Intelligent Investor, Benjamin Graham

a.k.a. traders

32 “Oh, Yeah, But What About Enron? Aren’t 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. Five years ago, it was Fannie, Freddie, Lehman,

Citi, WaMu, & AIG. And don’t forget Madoff! Twenty years from now, during the next big bull market craze, someone else will take their place.

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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.

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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: “Don’t sell the bear skin before the bear is caught.”

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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.

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(continued)

I normally use and recommend market orders. Short-term traders tell me they prefer limit orders or stop orders on all their trades.

Types of Stock Transactions

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Types of Stock Transactions 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.

(continued)

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Traditionally, transaction costs were in the 1% to 5% range Sometimes higher The largest percentage of the cost was the

brokerage’s commission Deep-discount Internet brokers have driven the

commissions down to as low as $5 per trade A few firms used to offer free trades (?)

But have transaction costs really gone down? Yes, but more and more of the cost is hidden from

the investor

Transaction Costs

Especially the “Internet garbage” brokers. (Those aren’t my words!)

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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 doesn’t necessarily have the best price Instead of paying $20, the investor might pay $20.05

Transaction Costs

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 dealer’s markup.

(continued)

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

Transaction Costs

In Scottrade’s 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.

(continued)

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

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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

Transaction Costs

Here is an example of the SEC trying to enforce the rules: http://lawprofessors.typepad.com/securities/2008/06/scottrade-settl.html

(continued)

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The SEC was looking into making the costs more transparent Possibly showing the customer the difference

between the dealer’s 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”

Transaction Costs

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?

(continued)

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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

Round Lot versus Odd Lot

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.

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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

Reading Stock Quotes

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.

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Reading Stock Quotes

Wall

Street

Journal

Example

(continued)

“Omigod! You mean you actually wait until the next day to find out how much your stock is worth?! How Twentieth Century!”

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On-line Examples finance.yahoo.com bloomberg.com marketwatch.com (owned by Wall Street Journal)

morningstar.com Any others you want to check out?

Reading Stock Quotes(continued)

Yahoo! used to be my favorite web site but just recently, they have literally destroyed the Finance home page (after destroying the

Yahoo! home page several months earlier). I still use Yahoo! to research individual stocks.

(Note to online students: Please see the accompanying presentation on how to use Yahoo! Finance to do your research.)

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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.

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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 & Poor’s 500 Stock Index

Market Averages and Indexes(continued)

Market-weighted calculations were generally regarded as a better measure until the bubble of the late 1990’s.

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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 stocksDow Jones is the company that publishes the Wall Street Journal. In 2007, it was purchased by Rupert Murdoch of Fox News fame.

They sold it and all their indices to Standard & Poor’s.

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(continued)

The Thirty Stocks in the Dow Jones Industrial Average

American Express General Electric Nike

AT&T Goldman Sachs Pfizer

Boeing Home Depot Proctor & Gamble

Caterpillar IBM 3M

Chevron Intel Travelers

Cisco Systems Johnson & Johnson United Healthcare

Coca Cola J. P. Morgan Chase United Technologies

Disney McDonald’s Verizon

Dupont Merck Visa

ExxonMobil Microsoft Walmart

The Dow Jones Industrial Average

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The Dow Jones Industrial Average

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.

(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 -

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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 S&P 500

Dow Jones Internet Index

53 Standard & Poor’s 500 Composite Index – a.k.a. the S&P 500, the S&P 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 S&P 500 is market-weighted, it was affected by the tech bubble of the late 1990’s 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 S&P 500 was due to one stock.

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Other Standard & Poor’s Indices Standard & Poor’s Industrial 400 Standard & Poor’s Midcap 400

Medium-sized companies

Standard & Poor’s Smallcap 600 Small companies

Standard & Poor’s 1500 Index Includes 500 Index, Midcap 400 and Smallcap 600

Other Standard & Poor’s Indices Transportation, Utilities, Financials Many other global, international & sector indices

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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.

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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 S&P 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 S&P Completion Index

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Other Popular Stock Market Indices 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

(continued)

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17,105

17,110

17,115

17,120

17,125

17,130

10am 11am 12am 1pm 2pm 3pm 4pm

Today's Unstable Stock Market

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stock market index ennui

0

4,000

8,000

12,000

16,000

20,000

10am 11am 12am 1pm 2pm 3pm 4pm

Today's Stable Stock Market

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“Volatility” Re-examined

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

31-Dec-201219-Feb-20138-Apr-201323-May-201311-Jul-201327-Aug-201314-Oct-201329-Nov-2013

S&P 500 for Year 2013 - Boring VersionYou will not see this graph in the news!

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Stock Spin-off Conversion of one of a firm’s 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)

Common Stock Characteristics

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 AT&T. Some spin-offs have not fared so well. Coca-Cola Enterprises (spun off from Coca-Cola) and Lucent Technologies

(spun off from AT&T) are examples of disappointments.

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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…

Common Stock Characteristics(continued)

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 Buffett of Berkshire Hathaway has refused to split his stock since its inception. A single share now goes for over $200,000!

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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 1990’s, 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.

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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 $200,000 each The financial world pressed Warren Buffett to offer

a lower cost version of his stock Class B shares initially sold for around $1,160 each

In the prospectus, Buffett said he wouldn’t buy them! They recently split 40 for 1 and now sell for around $138


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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 firm’s assets minus the firm’s liabilities and preferred stock

Market Value The prevailing market value of a security

Common Stock Values

More about valuation in Chapter 6

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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

Common Stock Dividends

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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

Common Stock Dividends(continued)

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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


$1 dividend––––––––––––– = 5% dividend yield $20 price

Traditionally, 3% to 6% was normal. In the 1990’s dividends

went to 2% or less. Dividends went above 3% in the 2008/2009 turmoil and are now back down

to approximately 2%.

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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


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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


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“Don’t 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


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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!

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Types of Dividends (continued) Dividend Reinvestment Plans (DRIPs)

Plans in which shareholders have cash dividends automatically reinvested into additional shares of the firm’s common stock

This is a taxable transaction No additional shares were issued

Hence, no dilution of ownership occurred

(continued)

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.

Common Stock Dividends

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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

Common Stock Valuation

We will spend a great deal of time learning P/E and other valuation techniques in the next few chapters.

1980’s & 1990’s

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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

Types of Common Stock

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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, HP (?)

Types of Common Stock(continued)

Wait a minute! Are Intel, Microsoft, and HP still growth stocks?

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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

“Growth” versus “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 over $1,100 (split adjusted, with a much lower P/E) and the old GM stock (a.k.a. Motors Liquidation) last sold for $0.04 in March of 2011 and is now worthless. Which one was the better value?

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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: Kellogg’s, Procter & Gamble


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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: JCPenney’s 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)


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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?

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Capitalization The current price of the stock times the number of

shares outstanding Large cap stocks

$10 billion and up Mega cap stocks – $100’s 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

Capitalization

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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 Buffett’s Berkshire Hathaway?)

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Capitalization Examples

Walmart versus Target

Price($)

Number of shares outstanding

MarketCapitalization ($)

Walmart $77.35 3.23 billion $249.84 billion

Target $61.01 633.72 million $38.67 billion

Note: As of 5 September 2014 – Values change daily

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AT&T versus Verizon

Price($)

Number of shares outstanding

MarketCapitalization ($)

AT&T $35.10 5.19 billion $181.98 billion

Verizon $48.83 4.15 billion $206.64 billion

Capitalization Examples

(continued)

Note: As of 5 September 2014 – Values change daily

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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 Buffett

Investment Strategies

My personal favorite! “Don’t Lose Perspective” example.

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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

Investment Strategies(continued)

Stocks which have had histories of consistent dividend increases have often been the market’s best long-term investments

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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

Investment Strategies

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 appears, the stock price

is often brutally punished.

(continued)

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Aggressive Growth Strategya.k.a. Speculation, Short-term Trading Investor aggressively trades in and out of stocks in

order to achieve eye-catching returns Instead of waiting 3 to 5 years for a stock to move,

an aggressive stock trader would go after the same investment return in 6 months to a year or lessSome traders have time horizons in the weeks or days

And now, there are companies who are using computers to make millions of trades per day


This is the strategy that many people think they are supposed to use when they start investing in stocks. It is fraught with perils and

drawbacks, not the least of which are the serious transaction costs that can be generated as a result of frequent trading. Stockbrokers

simply adore suckers … uh, I mean … traders who use this strategy.

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Contrarian Strategy Investing in stocks that are out of favor with the

market for some reason, as reflected by low price to earnings ratios and low prices compared to their fundamentals

Contrarian investors actively seek stocks from companies with sound financial statements that the market has undervalued

“I always try to be accommodating. I buy when others want to sell; I sell when others want to buy.”


Being a contrarian is difficult since historically the market rises about three times as much as it falls.

“[It’s] not a steady business.” Howard Marks, CEO, Oaktree Capital, when asked about what it was like to be a contrarian.

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Sector Rotation Buy stocks in hot sectors; sell stocks in stale ones

Momentum Investing Buy stocks as they go up; sell stocks as they go

down (often involves selling stocks short) Uses the “Greater Fool” Theory

“Buy High, Sell Higher” Market Timing

Attempting to predict the future direction of the market “Don’t try to buy at the bottom and sell at the top. It

can’t be done except by liars.” – Bernard Baruch


Can you identify the risks inherent in each of these strategies?

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Buy-and-Hold Income Growth Aggressive Growth Contrarian Sector Rotation Momentum Investing Market Timing


Which strategy do you favor?

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CHAPTERS 5, 2, Lecture Notes

Next week: Chapter 6, Common Stock Valuations

The Stock Market (Chapter 5)

Buying and Selling Securities (Chapter 2)

Introduction to Stocks (Lecture)

1 c hapters 5, 2, l ecture n otes the stock market (chapter 5) buying and selling securities...

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