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Chapter 9 Picking the Equity Players Portfolio Construction, Management, & Protection, 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved. 1 You buy a stock, and when it goes up, you sell it. If it doesn’t go up, don’t buy it. Will Rogers 2 Introduction Today’s focus is toward the overall characteristics of portfolios • What principles in security selection are particularly important in the construction and management of a portfolio? • What are the principal categories of common stock? • What are dividends? • What is preferred stock? 3 Stock Selection Philosophy: Fundamental and Technical Analysis A fundamental analyst tries to discern the logical worth of a security based on its anticipated earnings stream The fundamental analyst considers: • Financial statements • Industry conditions • Prospects for the economy 4 Stock Selection Philosophy: Fundamental and Technical Analysts (cont’d) A technical analyst is firmly convinced that: • Supply and demand determine prices • Changes in supply and demand cause changes in prices • The changes in supply and demand can be predicted by observing the past series of stock prices Financial statements and market conditions are of secondary importance to the technical analyst 5 Dividends and Why They Really Do Not Matter Types of Dividends Why Dividends Do Not Matter Theory Versus Practice Stock Splits Versus Stock Dividends 6 Cash Dividends Cash dividends are distributions of the firm’s profits paid to the shareholders via a check from the company Cash dividends can sometimes be reinvested via dividend reinvestment plans (DRIPs) • Sometimes allow for purchase of additional company shares at a discount 7 Stock Dividends Stock dividends are paid in additional shares of stock rather than in cash Typically announced as a percentage • e.g., 10 percent stock dividend Popular when a firm lacks the funds to pay a cash dividend Popular early in the firm’s life cycle 8 Rights The preemptive right means shareholders have the ability to maintain the same percentage share of ownership in a corporation when the firm sells new shares Existing shareholders can buy new stock at a discount from market price 9 Rights (cont’d) Rights are actual securities that investors can buy or sell Rights have a limited life • Usually expire a few weeks after issued 10 Rights (cont’d) Shareholders can do three things with rights: • Sell the rights to someone else • Use the rights to buy more shares • Allow the rights to expire – Like throwing away money 11 Dividend Growth Rates Corporations like to establish predictable dividend payout patterns including an annual increase in their dividends Many fundamental analysts focus on the dividend growth rate to determine value 12 Dividend Growth Rates (cont’d) The dividend discount model: D0 (1 g ) D1 P0 kg kg where D0 = the current dividend D1 = the dividend to be paid next year g the expected dividend growth rate k the discount factor according to the riskiness of the stock P0 the current stock price 13 Dividend Growth Rates (cont’d) You can solve for the required rate of return, k: • Observe the current dividend and price • Obtain the growth rate using historical information and analysts’ estimates • Solve for k: D0 (1 g ) k g P0 14 Dividend Growth Rates (cont’d) Example Assume a company just paid a dividend of $1.20 per share. Historically, the company has increased its dividends by 3 percent annually with great consistency. No analyst estimates regarding the next dividend are available. The firm’s current stock price is $20 per share. What is an estimate of the required rate of return for this stock? 15 Dividend Growth Rates (cont’d) Example (cont’d) Solution: Using the numbers in the dividend discount model: D0 (1 g ) k g P0 1.20(1.03) 0.03 20 0.0918 9.18% 16 Why Dividends Do Not Matter Payment of dividends reduces the balance in the firm’s checking account • The firm should not be worth as much after paying a dividend The ex-dividend date determines whether or not you get the dividend • On the ex-dividend date, the price of a share of stock tends to fall by about the amount of the dividend to be paid 17 Theory Versus Practice Dividend policy is very important in practice Unexpected changes in dividend policy can result in significant changes in the market price of the associated common stock 18 Theory Versus Practice (cont’d) Most firms increase their dividend annually, and the market expects this • If management does not increase the dividend as expected, the market views it as bad news Reducing or omitting a dividend is a very bad signal An increase in dividends above what the market expects is a good signal 19 Stock Splits Versus Stock Dividends Stock Splits Why Stock Splits Do Not Matter Why Firms Split Their Stock Stock Dividends 20 Stock Splits A stock split occurs when a firm changes the number of shares of its capital stock without changing the aggregate value of these shares A stock split is generally a neutral occurrence • The primary motivation is to reduce the price of shares to bring it into an optimal trading range 21 Stock Splits (cont’d) In a forward split (regular way split or direct split), shareholders receive more shares as a result of the split • e.g., a two-for-one split In a reverse split, the number of shares is reduced • e.g., 1-for-10 split 22 Stock Splits (cont’d) An odd lot-generating split is a stock split likely to result in many small investors holding odd lots • e.g., a 3-for-2 split 23 Why Stock Splits Do Not Matter Stock splits neither increase nor decrease an investor’s wealth • You cannot increase the total amount available by increasing the pieces of a pie • e.g., a 2-for-1 split simply doubles the number of shares, but doesn’t affect wealth 24 Why Firms Split Their Stock Some literature supports the existence of an optimal trading range • A principal reason for splitting shares is “to broaden the ownership base” Reverse splits are sometimes used to reduce the number of shareholders • e.g., a 1-for-200 split eliminates all shareholders holding fewer than 200 shares 25 Stock Dividends Stock dividends are not different from stock splits for the investor • e.g., a 100 percent stock dividend is the same as a 2-for-1split The difference between stock dividends and stock split is an accounting phenomenon • A split alters the par value • A stock dividend means new shares are issued 26 Investment Styles Value Investing Growth Investing Capitalization Integrating Style and Size 27 Value Investing Value investors look for undervalued stock Utilize the firm’s earnings history and balance sheet • Price/earnings ratio, price/book ratio Place much emphasis on known facts 28 Price/Earnings Ratio The PE ratio is stock price divided by its earnings per share A forward-looking PE uses earnings forecasts A trailing PE uses historical earnings 29 Price/Book Ratio The price/book ratio is the stock price divided by book value per share • Book value is the firm’s assets minus its liabilities • Book value is different from market value Value investors look for low price/book ratios 30 Growth Investing Growth investors look for price momentum • Look for stocks that are in favor and have been advancing • Look for stocks that are likely to be propelled even higher The market moves in cycles • Many investors own both growth and value stocks 31 Capitalization Capitalization refers to the aggregate value of a company’s common stock Typical • • • • divisions are: Large cap ($1 billion or more) Mid cap (between $500 million and $1 billion) Small cap (less than $500 million) Micro cap 32 Capitalization (cont’d) If you rank large, mid, and small caps in order of performance, the mid-cap stocks tend to stay in the middle • If you can buy only one group, it might be best to put your money in “averaged-sized” companies rather than the large or small 33 Integrating Style and Size Many money managers distribute their assets across size and style spectrums http://www.morningstar.com provides a style box that can classify a portfolio 34 Categories of Stock Blue-Chip Stock Income Stocks Cyclical Stocks Defensive Stocks Growth Stocks Speculative Stocks Penny Stocks Note: Categories are not mutually exclusive 35 Blue Chip Stock Blue-chip has become a colloquial term meaning “high quality” • Some define blue chips as firms with a long, uninterrupted history of dividend payments • The term blue chip lacks precise meaning, but some examples are: – Coca-Cola – Union Pacific – General Mills 36 Income Stocks Income stocks are those that historically have paid a larger-than-average percentage of their net income after taxes as dividends • The proportion of net income after taxes paid out as dividends is the payout ratio • The proportion of net income after taxes retained is the retention ratio Examples include Consolidated Edison and Allegheny Energy 37 Cyclical Stocks Cyclical stocks are stocks whose fortunes are directly tied to the state of the overall national economy Examples include steel companies, industrial chemical firms, and automobile producers 38 Defensive Stocks Defensive stocks are the opposite of cyclical stocks • They are largely immune to changes in the macroeconomy and have low betas Examples include retail food chains, tobacco and alcohol firms, and utilities 39 Growth Stocks Growth stocks do not pay out a high percentage of their earnings as dividends • They reinvest most of their earnings into investment opportunities • Many growth stocks do pay dividends 40 Speculative Stocks Speculative stocks are those that have the potential to make their owners rich quickly Speculative stocks carry an above-average level of risk Most speculative stocks are relatively new companies with representation in the technology, bioresearch, and pharmaceutical industries 41 Penny Stocks Penny stocks are inexpensive shares Penny stocks sell for $1 per share or less, but the definition is imprecise 42 Categories Are Not Mutually Exclusive An income stock or a growth stock can also be a blue chip • e.g., Potomac Electric Power Defensive or cyclical stocks can be growth stocks • e.g., Dow Chemical is a cyclical growth stock 43 A Note on Stock Symbols Ticker symbols are identification codes Stock symbols have one to four letters • One, two, or three letters identifies a stock listed on either the NYSE or the AMEX • Four-digit symbols identify firms traded on the Nasdaq 44
