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CHAPTER 12Investing in Stocks

Popular e-mail circulated about the Internet in 2002:

“If you had invested $1,000 in Nortel Networks stock last year, you would have $50.

If you had purchased $1,000 of Budweiser beer, drank the beer and returned the cans, you would have $78.

Our stock tip for today is to start drinking heavily.”

In 2009, the same e-mail was circulating, but Nortel Networks was replaced by AIG and Citigroup.

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Stocks represent ownership in a corporation Stocks are Equity Financing – “Equities” (Versus Bonds which are Debt Financing)

Why do corporations issue 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

industrial community As a method of payment for those who started the

firm The corporation doesn’t have to repay the money

But the corporation is now a public entity

Investing in Stocks

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Why Do Investors Purchase Stock? Share in success of the corporation Although you are part owner of the business,

your liability is limited only to your investment Income from dividends

Earnings distributed to the shareholders Dollar appreciation of stock value

a.k.a. Capital Gains Possible increased value from Stock Splits (?)

There is no increased value from stock splits. If you had 1 share at $100, now you have 2 shares at $50; the value is still $100. It is a psychological increase at best. Warren Buffet of Berkshire Hathaway has refused to split

his stock since its inception. A single shares now goes for around $185,000!

total return = dividends +

capital gains

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Historical Returns Historically, stocks have returned 8% to 10% However, traditionally, half of that return was

from dividends Stockholders used to expect 4% to 6% in dividends

each year – That was as much or often more than bonds returned in interest since stocks were considered much riskier than bonds

In the 1980’s and 1990’s, dividends fell to less than 2% and then down to 1% in 2000 Capital gains were what people wanted

But recently, dividends have risen to over 2% This is at a time when savings accounts at banks and

credit unions are paying less than ½%

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If stocks are the best long-term investment, how come they are considered so risky?

“For two decades after the Crash of ’29, stocks were regarded as gambling by a majority of the population. This impression wasn’t fully revised until the late 1960’s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments and dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not.” – Peter Lynch

The Cocktail Party Theory

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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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Risks of Stocks Business Failure Risk – the company could fail

Market Risk – the market as a whole could plummet

Global Investment Risk – a.k.a. Foreign Risk Traditionally, most other countries did not have the

same standards of accounting as the United States But that has all changed – Many are better now!

Currency Risk Will the dollar be stronger or weaker over the next 10

to 20 years? Liquidity Risks

Not usually a problem with stocks Except for very small company “penny” stocks

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Reducing Risks of Stocks Risk is difficult to measure

Even more difficult to anticipate Emphasizing large company stocks which pay

consistently rising dividends has been one of the best strategies for reducing risk

Diversification is another major strategy for reducing risk The NAIC Five Stock Rule of Thumb

One will do poorly and make you sad Three will do average (follow the market) One will explode and make you very happy

Time is the last and best major strategy Over time, stocks have done very, very well

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Scams It certainly has not helped the cause of stock

investing that there are many, many scams out there ready to take your money

One of the oldest and still most prevalent is called “Pump ‘n’ Dump” Scam artists pump up the price of a stock

Rumors, Lies, Innuendos and now Spam E-mail! The Buzz drives up the stock price The scammers dump their shares at a large profit Price plummets when the suckers realize they have

been taken Usually reserved for “penny stocks”

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Manias Occasionally, investors get caught up in what are

called “manias” (a.k.a. “bubbles”) The Internet was the latest stock market mania Before that, there was the “Nifty-Fifty” of the early 1970’s The mania of the 1920’s caused the Crash of ‘29 In the 1840’s, there were 400 railroad firms The “Granddaddy of all Manias” was the Dutch tulip bulb

craze of the early 1600’s Each time, the phrase was…

“It’s a New Era” or “It’s Different This Time” or “The old ways of valuing stock are gone”

Each time, they were wrong!

“Extraordinary Popular Delusions

and the Madness of Crowds”

A great read!

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Stocks and Taxes Short-term Capital Gains

Gains from holding a stock less than one year Taxed at the investor’s marginal tax rate (like income)

Long-term Capital Gains are taxed at a much lower rate Reward investor for having a long-term perspective

Big difference for the very wealthy Dividends were traditionally taxed as income

Traditionally, taxed at your marginal tax rate But now they are taxed at the same low rate as

long-term capital gains Has been a huge windfall for the very wealthy

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Stock Accounts Traditional brokerage firms

Full-service Brokers versus Discount Brokers

Internet brokerage firms Sometimes called “Deep Discount Brokers”

Other low-cost options Low Cost Direct Investment Plans DRIPs – Dividend Reinvestment Plans NAIC – National Association of Investors Corp

Certificate form Only if you are the kind of person who stuffs their

money in the mattress Stock Certificate Examples

13 Brokerage Firms and Account Executives Traditional brokerage firms will assign you to

an account executive (a.k.a. stockbroker, financial planner, financial representative) Licensed individual who buys and sells securities for

his or her clients Brokers are paid by commission Sometimes accused of churning

Excessive buying and selling of securities to generate commissions

Discount broker versus full service brokers How much advice do you want?

You can research your potential broker or brokerage firm at www.finra.org

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Classification of Stock Investments

Blue chip stock Safe investment in strong and respected

companies Often referred to as value stocks Attracts conservative investors Examples: General Electric, AT&T, Coca-Cola

Income stock Pays higher than average dividends Normally slow growth company in a mature

industry Examples: Utility stocks, Banks

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Growth stock Earns above average profits of all firms in the

economy Growth rate 15% to 20% or higher Often no dividends at all

Or a very small token amount Most of profits are reinvested into the company Stock price should go up as business grows

But usually very volatile Examples: Intel, Dell, Microsoft

(continued)Classification of Stock Investments

Wait a minute! Are Intel, Dell, & Microsoft growth stocks anymore?

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Cyclical stock Follows the business cycle of advances and

declines in the economy Examples: automobiles, timber, and steel

Now, computer chips!

Defensive stock Remains stable during declines in the economy Examples: Kellogg’s, Procter & Gamble, Pfizer

(continued)Classification of Stock Investments

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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 early ’80s, GM now

Asset play stock A company this is sitting on an asset that could

be sold or spun off Example: Several years ago, JCPenney was not

doing well but it has an insurance division that it could have easily sold to raise cash to have kept the company afloat if it had gotten into trouble

Penny stock Butterfly.com, Flim-Flam Inc., etc.

(continued)Classification of Stock Investments

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What Type of Stock is … ?

Blue Chip Stock

Income Stock

Growth Stock

Cyclical stock

Defensive Stock

Turn-around Stock

Asset Play Stock

Penny Stock

Johnson & Johnson ExxonMobil Google Sempra (SDG&E) General Mills International Paper Union Pacific Railroad General Motors Flim-Flam, Incorporated General Dynamics

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Securities Marketplaces A marketplace where brokers who represent

investors meet to buy and sell securities New York Stock Exchange (NYSE) – The Big Board

Now owned by a derivatives trading firm in Atlanta! American Stock Exchange (AMEX) – The Curb

Now called the NYSE MKT (?) NASDAQ The Over-the-Counter (OTC) markets

Bulletin Board & Pink Sheets (Stay far away from these!)

For hundreds of years, marketplaces were (and still are for the NYSE and NYSE MKT, nee AMEX) centralized locations. With today’s

technology, the vast majority of transactions now occur electronically. Eventually, the centralized locations will probably disappear.

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Stock Market Indexes To gauge the current condition of stocks in

general, financial professionals have created various stock market indexes An market index is essentially just a list of stocks

Dow Jones Industrial Average – the “Dow” 30 of the largest & best-known U.S. companies

Standard & Poor’s 500 – the “S&P 500” The 500 largest companies in the United States

NASDAQ Composite – the “NASDAQ” Mostly comprised of high-tech companies

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Other Stock Market Indexes Dow Jones U.S. Total Stock Market Index

(nee Wilshire 5000) Approximately 5,000 stocks (large, medium, & small) Designed to be a gauge of the entire stock market a.k.a. Total Market Index

Russell 2000 Represents small to medium sized companies

MSCI World Index ( MSCI All Country World Index) Designed to represent the global stock market

Being replaced by the MSCI All Country World Index MSCI EAFE ( MSCI All Country World Index ex-USA)

“Europe, Australia, and the Far East” Represents foreign markets (without the U.S.)

Being replaced by the MSCI ACWI ex-USA

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Bull Markets versus Bear Markets

Bull market Investors are optimistic More investors are buying stock and the

stock market increases Bear market

Investors are pessimistic More investors are selling stock so the stock

market declines Normally defined as a 20% or more decline Versus a “market correction”

5%, 10% or 15% decline

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Stock Analysis: Where do you start? “Show me the numbers”

Benjamin Graham, Author of The Intelligent Investor

There are dozens and dozens of numeric measures

Some of the most popular over the years have been… Capitalization Book Value Earnings per Share Price / Earnings Ratio Dividend Yield (a.k.a. Current Yield)

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Market Capitalization The number of shares outstanding times the current

price of the stock What the company is actually worth (according to investors)

Large-cap stocks Greater than $10 billion “Mega cap” stocks – $100’s of billions (GE, Wal*Mart)

Mid-cap stocks $1 or $2 billion to $10 billion

Small-cap stocks $50 million (“micro cap”) to $1 or $2 billion

Penny stocks Typically sell from less than $1.00 to $5.00 per share

Capitalization

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Capitalization

Example: Price $50.00 Number of Shares * 2,000,000

——————— 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.

Examples follow when we get to numeric measures.

(continued)

26 Numeric Measures to Consider When Evaluating a Stock Book Value

Net worth of company determined by deducting all liabilities from the corporation’s assets and dividing the remainder by the number of outstanding shares of common stock

For many years, it was rarely close to the stock price – often one-fifth or one-sixth less Now much closer to the stock price (often ½ less)

If the stock price is lower than the book value, then there is the danger of the company being “raided” for the assets and put out of business

Remember our net worth statements?

27 Numeric Measures to Consider When Evaluating a Stock Earnings Per Share

Corporation’s after-tax earnings divided by the number of outstanding shares of common stock Look for growing earnings per share!

Price-Earnings (P/E) ratio Price of one share of stock divided by the earnings

per share of stock over the last 12 months A low price-earnings ratio usually means the stock is

a less risky investment

(continued)

Why would we want to own a business?Because businesses are in business to earn money!

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Earnings Per Share

Example: Earnings $2,500,000 Number of Shares 5,000,000

$2,500,000 Earnings Per Share = ———————— = 5,000,000

Earnings Per Share = $0.50

Example: Page 384

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Price / Earnings Ratio

Example: Price $10.00 Earnings per Share $0.50

$10.00 Price / Earnings Ratio = ——————— = $0.50

Price / Earnings Ratio = 20a.k.a. P/E, PE Example: Page 384

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Price / Earnings Ratio Historically

A P/E Ratio of 20 or above was considered high and reserved only for the fastest growing stocks

A P/E Ratio of 5 to 15 was considered average

Currently For almost thirty years, a P/E Ratio of 40 to 50 was not

uncommon among growth stocks (i.e. $tarbuck$, Google) Once during the Internet mania, eBay’s P/E was 10,000! P/E’s ratios fall dramatically when the market falls

The P/E Ratio essentially tells you what the market believes the prospects for a company are Also gives you an idea of how long in years it will take the

company to earn its price P/E of 20 means it will take 20 years to earn the price

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Dividend Yield Dividend Yield

Yearly dollar amount of income generated by a stock divided by the current market price

Historically (review) Dividend Yields were in the 4% to 6% range

Currently (review) Dividend Yields are typically in the 2% to 3%

range (Many are 0% − they pay no dividends) The Dividend Yield allows you to compare

stocks to other investments Such as savings accounts or bonds

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Dividend Yield

Example: Dividends per Year $1.40 Current Market Price $87.50

$1.40 Dividend Yield = ————————— = $87.50

Dividend Yield = 0.016 = 1.6%

Example: Page 386

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Numeric Measures Examples

Walmart versus Target

Price($)

Earn / Share

($) P/E

Book Value

($)

Div / Share

($)

DivYield(%)

MarketCap($)

Walmart 76.43 $4.91 15.6 $21.94 $1.92 2.5% $247B

Target 60.51 $3.17 19.1 $25.70 $1.72 2.8% $38.3B

Data as of March 31, 2014.If you just looked at the price, you would think Target is worth about

the same as Walmart. Look at the market capitalization.Walmart is worth over 6 times more than Target!

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Numeric Measures Examples

McDonald’s versus Yum Brands

Price($)

Earn / Share

($) P/E

Book Value

($)

Div / Share

($)

DivYield(%)

MarketCap($)

McD $96.03 $5.54 17.6 $16.18 $3.24 3.3% $97.0B

Yum 75.83 2.84 26.6 4.88 1.48 2.0% $33.3B

(continued)

Data as of March 31, 2014.

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Numeric Measures Examples

AT&T versus Verizon

Price($)

Earn / Share

($) P/E

Book Value

($)

Div / Share

($)

DivYield(%)

MarketCap($)

AT&T $34.95 $2.50 14.0 $18.40 $1.84 5.3% $183B

Verizon 47.58 2.84 16.8 13.61 2.12 4.5% $196B

(continued)

Data as of March 31, 2014.Look at those dividends! Would you invest in either of these companies?

Consider: Do you think people will ever give up their mobile phones?

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Investment Theories Fundamental Analysis

Based on the assumption that a stock’s intrinsic or real value is determined by the company’s future earnings

Fundamentalists consider the… Financial strength of the company Type of industry company is in New-product development Economic growth of the overall economy

I side with the fundamental analysts.

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Technical Analysis Based on the assumption that a stock’s value

is determined by the forces of supply and demand in the stock market as a whole

Not based on expected earnings or the intrinsic value of a stock but rather on factors found in the market as a whole

Chartists plot past price movements and other market averages to observe trends they use to predict a stock’s future value

(continued)

I think these folks are all wet.

Investment Theories

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Efficient Market Theory Sometimes called the random walk theory Based on the assumption that stock price

movements are purely random A stock’s current market price reflects its true value Wall Street Journal’s “darts vs the experts” finds

sometimes experts win, sometimes not They believe it is impossible for someone to

outperform the stock market over the long-term Yet there are many long-term investors who do (?)

These people believe that the folks who do beat the market are just lucky. That may be true for short-term investors, but not for the

long-term investors who consistently beat the market.

Investment Theories(continued)

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Stock Buying Strategies Buy and Hold

Use fundamental analysis to identify high-quality companies at reasonable prices

“Hold it forever” Warren Buffet

The Buy and Hold Strategy works well with… Dollar Cost Averaging (Remember this?)

Dividend Reinvestment Plans (a.k.a. DRIPs)

Low cost investment plans that bypass brokers

I am a “Buy and Hold” kinda’ guy.

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Stock Buying Strategies Momentum Trading – Dumb

Uses what is called the “Greater Fool” Theory “Buy High, Sell Higher”

Sector Analysis – Dumber Buy stocks in hot sectors; sell stocks in stale ones

Market Timing – Dumbest Buy as interest rates decline; sell before rates rise

Contrarian – Very smart but also very difficult

Buy when others are selling; sell when others are buying

(continued)

Investors like Warren Buffet are contrarians.

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Stock Selling Strategies “Sell when the stock hits its Target Price”

Analysts often set a “target price” for a stock using whatever numeric metric they believe in

“Sell when the stock is overvalued” You have to decide what “overvalued” means

“Sell when the story changes” Peter Lynch If the reason or reasons you bought the stock change,

then consider selling “Sell when you have a better investment offer”

If another stock is a better buy, swap investments “Sell when you need the money”

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Asset Allocation Fancy term for…

“How much should I have in stocks, bonds, etc.?” Many advisors suggest a formula such as…

Subtract your age from 100 (or 110 or 120)That’s the percentage of stocks you should ownThe rest should be in bonds and “cash”

Example: A 40-year-old would have 100-40 or 60% invested in stocks and the rest (40%) in bonds

“Poppy-cock!” say others (myself included) Buy high-quality stocks Once you near retirement, start buying bonds

But do not give up on stocks entirely

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Rebalancing Some of those same advisors that suggest

asset allocation also suggest the technique of rebalancing

Every year, check to see if your percentages are still in balance If stocks have had a banner year, you might now

be at 70/30 instead of 60/40 Sell stocks and buy bonds to bring the balance

back to 60/40 Likewise, if stocks have tanked, sell bonds & buy

stocks to bring the percentage back up to 60/40 Forces you to “Do the right thing”

“Buy Low, Sell High”

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Stocks in Retirement Many advisors suggest that retirees shed the

bulk of their stock investments in favor of bonds and cash investments

The only problem is… People are living much, much longer

A 50-year-old living today has a 50/50 chance of living to see 100 years old!

We will revisit this when we get to mutual funds Inflation does not retire just because you do

As you near retirement, start migrating your investments from stocks to bonds But do not abandon stocks entirely!

We will revisit this when we get to mutual funds.

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Other Stock Strategies (?) Over the years, the financial world has come

up with other “strategies” to help you exploit the Wonderful World of Finance Also, they are excellent sources of high

commissions for stockbrokers (Surprise!)

These “strategies” include… Options Futures Margin accounts Selling short

Please stay far, far away from these so-called strategies. You

are virtually guaranteed to lose.But don’t take my word for it!

Example: Optionetics.com

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Information Sources Media

Deluge of information from TV, radio, newspapers, magazines and, of course, the Internet

Most of it is extremely sensational and of highly questionable value for investment purposes

“Wisdom Sold Separately” – Nick Murray “My advice? Turn the damned things off!”

Stock Advisory Services Charge a fee for their reports – Available at libraries for free

Value Line, Standard & Poor’s, Moody’s, etc. Literally hundreds – no! – thousands of other services

NAIC – National Association of Investors Corporation – www.better-investing.org Investment Clubs Example: Yahoo!

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Information Sources BUS-123, Introduction to Investments

Hint, hint! Wink, wink! Nudge, nudge! Books

One Up On Wall Street, Peter Lynch Beating the Street, Peter Lynch A Random Walk Down Wall Street, Burton Malkiel The Intelligent Investor, Benjamin Graham Security Analysis, Benjamin Graham

Annual and quarterly reports from companies 10-K and 10-Q

(continued)

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All Stars of Investing Peter Lynch

Fund Manager of Fidelity’s Magellan mutual fund “Buy what you know”

Warren Buffet “Don’t buy a stock; buy a company” Puts emphasis on the value of the entire company

Benjamin Graham He was Warren Buffet’s teacher “Father of Value Investing”

John Templeton One of the first mutual fund managers to invest

globally

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All Stars of Investing(continued)

Bill Miller Fund Manager of Legg Mason Value Trust For 15 calendar years in a row, he beat the S&P

500, an unprecedented record! He became (unfortunately for him, as far as I was

concerned) the financial media’s mega-star But then he did not beat the S&P 500 in 2006 and

lagged badly in 2007 and 2008 during the turmoil He seemed to redeem himself in 2009 when he was

up over 40% beating the 26% return of the S&P 500 But then again trailed the S&P 500 badly in 2010 and 2011

He retired late 2012 I was surprised Legg Mason let him stay as long as they

did. It’s a tough business

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All Stars of Investing What do all these people have in common?

Courage to not follow the crowd The “conventional wisdom” is usually not very wise!

A eye for unrecognized value Almost a “sixth sense”

Gary Kasparov was once asked why he and Anatoly Karpov were the two best chess players in the world His answer was astonishingly simple and direct

“We attack better than anybody else and we defend better than anybody else”

These people bought the best companies and avoided the worst companies

(continued)

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All Stars of Investing Speaking of avoidance…

As a mutual fund investor, I am not looking to find the next Peter Lynch

I am looking to avoid the next Charles Steadman

Charles Steadman ran his own mutual fund, the Steadman American Industry Fund, from December 1959 until his death in late 1997 His cumulative total return was -42.9% He would have done much better simply placing his

investors’ funds into a savings account at a bank He would have done better putting it in a mattress!

Maybe he came from the life insurance industry…

(continued)

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Warren Buffet sez…

“Be fearful when others are greedy. Be greedy when others are fearful.”

His mentor, Benjamin Graham said it this way, “Buy when most people including experts are overly pessimistic, and sell

when they are actively optimistic.”

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John Templeton sez…

“Bear markets are born of pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy.”

On a similar note, he also said, “To buy when others are despondently selling and sell when others are avidly buying

requires the greatest fortitude and pays the greatest reward.”

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Famous Myths & Stupid Sayings “It can’t go any lower”

Oh, yes it can! It can go to zero! “It can’t go any higher”

Oh, yes it can! If the earnings are continuing to grow, there is no limit to how high the price can go

“It is only $3 a share – What can I lose?” It doesn’t matter how low the price is, the price can

go to zero and you can lose all your money Remember: Price is irrelevant; valuation is the key

“It has to come back” Have any of you ever heard of Penn Central?

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Famous Myths & Stupid Sayings “When it rebounds to $10, I will sell”

A stock has no idea you bought it at $10 If you wouldn’t buy it now at this price, sell it now!

“The stock has gone up, I must be a genius” “Never mistake a bull market for brains”

Old Wall Street saying “The stock has gone down, I must be an idiot”

Ditto (but in reverse) “It is taking too long”

Patience is an investor’s most important trait Besides, it gives you a chance to buy more!

(continued)

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Famous Myths & Stupid Sayings “It’s Different This Time”

Well, technically, yes. It is different every time. But that does not mean you should not pay close

attention to the realistic future prospects for the earnings of a company, good or bad

“It’s a New Era” Ditto (When you hear this one, it is time to sell)

“It’s a Permanent Trend” Ain’t No Such Thing! Markets move in cycles.

“Stocks are too risky” Even with all the shenanigans and stupidity, they

are still the best financial long-term investment

(continued)

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Careers in Stocks Registered Representative

a.k.a. Stockbroker, Financial Representative, Account Executive, Financial Planner

Background check No shenanigans with other peoples’ money

Must take Series 7 and Series 66 Series 7 is difficult, 6 hours, 2 months of studying Series 66 is much easier, 2 to 4 weeks study

Must be sponsored by a brokerage firm Some brokerages exist simply to sponsor people

Expect to pay a fee to them for the privilege of being sponsored

Many brokerages now sponsoring new recruits!

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Wanna’ Swap Some War Stories?

Alliance Pharmaceuticals Advanced Tissue CINAR Films CardioDynamics Any volunteers?

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Bottom Line

Stocks are the best long-term financial investment available

Leave the stock picking to the pros In other words, find a good stock mutual fund!

As “bullish” as I might appear to be, my wife and I have 99% of our stock investments through high-quality mutual funds. I

believe it is simply unrealistic to think I could do better than professionals armed with an entire global research

organization at their disposal.I stopped trying as my “Vega$ Fund” lived down to its name…