Title: Investing in Stocks
1CHAPTER 12
Investing 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.
2Investing in Stocks
- 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 doesnt have to repay the money
- But the corporation is now a public entity
3Why 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 (?)
total return dividends capital gains
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 130,000!
4Historical 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 1980s and 1990s, 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
5If 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 wasnt fully revised
until the late 1960s 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 theyre not. Peter Lynch - The Cocktail Party Theory
6Rolling 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.
7Risks 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
8Reducing 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
9Scams
- 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
10Manias
- 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 1970s - The mania of the 1920s caused the Crash of 29
- In the 1840s, there were 400 railroad firms
- The Granddaddy of all Manias was the Dutch
tulip bulb craze of the early 1600s - Each time, the phrase was
- Its a New Era or
- Its 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!
11Stocks and Taxes
- Short-term Capital Gains
- Gains from holding a stock less than one year
- Taxed at the investors 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
12Stock 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
13Brokerage 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
14Classification 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, ATT, Coca-Cola
- Income stock
- Pays higher than average dividends
- Normally slow growth company in a mature industry
- Examples Utility stocks, Banks
15Classification of Stock Investments
(continued)
- 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
Wait a minute! Are Intel, Dell, Microsoft
growth stocks anymore?
16Classification of Stock Investments
(continued)
- 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 Kelloggs, Procter Gamble, Pfizer
17Classification of Stock Investments
(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 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.
18What Type of Stock is ?
- Johnson Johnson
- ExxonMobil
- Google
- Sempra (SDGE)
- General Mills
- International Paper
- Union Pacific Railroad
- General Motors
- Flim-Flam, Incorporated
- General Dynamics
Blue Chip Stock Income Stock Growth
Stock Cyclical stock Defensive Stock Turn-around
Stock Asset Play Stock Penny Stock
19Securities Marketplaces
- A marketplace where brokers who represent
investors meet to buy and sell securities - New York Stock Exchange (NYSE)
- Being purchased by a trading firm in Atlanta!
- American Stock Exchange (AMEX)
- 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) centralized
locations. With todays technology, the vast
majority of transactions now occur
electronically. Eventually, the centralized
locations will probably disappear.
20Stock 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 Poors 500 the SP 500
- The 500 largest companies in the United States
- NASDAQ Composite the NASDAQ
- Mostly comprised of high-tech companies
21Other 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
22Bull 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
23Stock 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)
24Capitalization
- 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 100s of billions (GE,
WalMart) - 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
25Capitalization
(continued)
- 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.
26Numeric Measures to Consider When Evaluating a
Stock
- Book Value
- Net worth of company determined by deducting all
liabilities from the corporations 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?
27Numeric Measures to Consider When Evaluating a
Stock
(continued)
- Earnings Per Share
- Corporations 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
Why would we want to own a business? Because
businesses are in business to earn money!
28Earnings 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
29Price / Earnings Ratio
- Example
- Price 10.00
- Earnings per Share 0.50
- 10.00
- Price / Earnings Ratio
- 0.50
- Price / Earnings Ratio 20
- a.k.a. P/E, PE
Example Page 384
30Price / 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, eBays P/E was
10,000! - P/Es 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
31Dividend 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
32Dividend 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
33Numeric Measures Examples
Price () Earn / Share () P/E Book Value () Div / Share () Div Yield () Market Cap ()
Walmart 76.91 5.14 15.0 21.94 1.88 2.4 250B
Target 65.71 4.15 15.8 25.39 1.72 2.7 41.5B
Data as of October 30, 2013. 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!
34Numeric Measures Examples
(continued)
- McDonalds versus Yum Brands
Price () Earn / Share () P/E Book Value () Div / Share () Div Yield () Market Cap ()
McD 96.03 5.54 17.3 15.18 3.24 3.4 96.0B
Yum 68.16 2.39 28.6 4.93 1.48 2.2 30.4B
Data as of October 30, 2013.
35Numeric Measures Examples
(continued)
Price () Earn / Share () P/E Book Value () Div / Share () Div Yield () Market Cap ()
ATT 36.26 1.36 26.7 16.23 1.80 5.1 191B
Verizon 50.53 0.77 65.8 11.79 2.12 4.2 145B
Data as of October 30, 2013. Although it looks as
if Verizon is worth more, ATT is worth 46
billion more than Verizon. Would you invest in
either of these companies? Consider Do you think
people will ever give up their mobile phones?
36Investment Theories
- Fundamental Analysis
- Based on the assumption that a stocks intrinsic
or real value is determined by the companys
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.
37Investment Theories
(continued)
- Technical Analysis
- Based on the assumption that a stocks 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 stocks future value
I think these folks are all wet.
38Investment Theories
(continued)
- Efficient Market Theory
- Sometimes called the random walk theory
- Based on the assumption that stock price
movements are purely random - A stocks current market price reflects its true
value - Wall Street Journals 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.
39Stock 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.
40Stock Buying Strategies
(continued)
- 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
Investors like Warren Buffet are contrarians.
41Stock 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
42Asset 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)
- Thats the percentage of stocks you should own
- The 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
43Rebalancing
- 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
44Stocks 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.
45Other 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 dont take my word for it! Example
Optionetics.com
46Information 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 Poors, Moodys, etc.
- Literally hundreds no! thousands of other
services - NAIC National Association of Investors
Corporation www.better-investing.org - Investment Clubs
Example Yahoo!
47Information Sources
(continued)
- 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
48All Stars of Investing
- Peter Lynch
- Fund Manager of Fidelitys Magellan mutual fund
- Buy what you know
- Warren Buffet
- Dont buy a stock buy a company
- Puts emphasis on the value of the entire company
- Benjamin Graham
- He was Warren Buffets teacher
- Father of Value Investing
- John Templeton
- One of the first mutual fund managers to invest
globally
49All Stars of Investing
(continued)
- Bill Miller
- Fund Manager of Legg Mason Value Trust
- For 15 calendar years in a row, he beat the SP
500, an unprecedented record! - He became (unfortunately for him, as far as I was
concerned) the financial medias mega-star - But then he did not beat the SP 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 SP 500 - But then again trailed the SP 500 badly in 2010
and 2011 - He retired late 2012
- I was surprised Legg Mason let him stay as long
as they did. Its a tough business
50All Stars of Investing
(continued)
- 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
51All Stars of Investing
(continued)
- 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
52Warren 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.
53John 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.
54Famous Myths Stupid Sayings
- It cant go any lower
- Oh, yes it can! It can go to zero!
- It cant 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 doesnt 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?
55Famous Myths Stupid Sayings
(continued)
- When it rebounds to 10, I will sell
- A stock has no idea you bought it at 10
- If you wouldnt 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 investors most important trait
- Besides, it gives you a chance to buy more!
56Famous Myths Stupid Sayings
(continued)
- Its 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 - Its a New Era
- Ditto (When you hear this one, it is time to
sell) - Its a Permanent Trend
- Aint 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
57Careers 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!
58Wanna Swap Some War Stories?
- Alliance Pharmaceuticals
- Advanced Tissue
- CINAR Films
- CardioDynamics
- Any volunteers?
59Bottom 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