Investing in Equities
Topic 6
I. Common Stock Investments
A. Basic Characteristics
1. Equity Capital
 2. Types

–
–
–
–
–
a.
b.
c.
d.
e.
Growth Stock
Income Stock
Speculative Stock
Cyclical Stock
Defensive Stock
B. Valuation of Common Stock

1. Dividend Valuation Model
– a. Example

2. Using the CAPM Process
– a. Assumptions
» 1. km = rate of return on the market
» 2. Rf = return on the risk free asset
» 3. km - Rf = Market Risk Premium
– b. Example
C. Other Common Stock Values
1.
 2.
 3.
 4.
 5.

Par Value
Book Value
Liquidation Value
Market Value
Investment Value
D. Common Stock as an Inflation
Hedge
Protection Against Inflation
 Over the last thirty years the S&P 500
has averaged approximately 11% annual
compound return.
 Inflation has averaged approximately
5.4% during the same time period.

Common Stock as an Inflation
Hedge:
S&P
Last 10:
Last 20:
Last 30:
Last 40:
Last 50:
14.8%
14.6%
10.7%
10.8%
11.9%
LT Bonds
11.3%
10.6%
8.2%
6.8%
5.8%
LT Gov’t Bonds
11.9%
10.4%
7.9%
6.4%
5.3%
T. Bills CPI
5.6%
7.3%
6.7%
5.7%
5.7%
3.5%
5.2%
5.4%
4.5%
4.4%
Source: Ibbotson and Sinquefield, “Stocks, Bonds, Bills and Inflation 1997 yearbook,”
Chicago.
The Panic of 1987
Index arbitrage and portfolio insurance (programmed trading)
were the major cause. From Tuesday 10/13/87 to
10/19/87, the DJIA fell 769 points or 31%. On 10/19/87
the DJIA fell508 points or 22.6%. On 10/28/29 the DJIA
fell 11.7%.
Mutual funds and pension funds use portfolio insurance.
Portfolio insurance is a strategy that uses computer based
models to determine an optimal stock/cash ratio at various
market prices. Two insurance users called for sales
equaling 50% in response to a 10% decline in the S&P 500
Index.
Investment Wisdom

Don’t try to buy at the bottom and sell at the
top. This can’t be done - except by liars
Bernard Baruch

Fools and greed usually go hand in hand,
which creates a field of opportunity for the
rational man.
Warren Buffett
Investment Wisdom
When it comes to risk, we’ve done better by
avoiding dragons rather than by slaying
them.
Warren Buffett
 Traditional Wisdom can be long on tradition
and short on wisdom.
Warren Buffett

Investment Wisdom

Investing is the greatest business in the
world because you never have to swing.
You stand at the plate; the pitcher throws
you GM at 47! U.S. Steel at 39! And
nobody calls a strike on you. There’s no
penalty except opportunity. All day you
wait for the pitch you like; then, when the
fielders are asleep, you step up and hit it.
Warren Buffett
Investment Wisdom
 On
Leaving Management
Alone:
At Berkshire we don’t tell .400 hitters how
to swing.
Warren Buffett
Warren Buffett on taking Your Time

An investor should act as though he/she had
a lifetime decision card with just twenty
punches on it. With every investment
decision his card is punched, and he/she has
one fewer available for the rest of his/her
life.
Investing in Equities
Topic 6
II. Principles of Security Analysis
Types of Security Analysis
 1.
Fundamental Analysis
 2.
Technical Analysis
The Father of Fundamental
Analysis: Benjamin Graham

Who was Benjamin Graham?
Sources:
Security Analysis (Graham and Dodd); The Intelligent Investor (Graham)
Ben Graham and Mr. Market:

Ben Graham long ago described the mental attitude toward market fluctuations
that I believe to be most conducive to investment success. He said that you
should imagine market quotations as coming from a remarkably
accommodating fellow named Mr. Market who is your partner in a private
business. Without fail, Mr. Market appears daily and names a price at which he
will either buy your interest or sell you his. Even though the business that the
two of you own may have economic characteristics that are stable, Mr.
Market’s quotations will be anything but stable. For, it is sad to say, Mr.
Market is a fellow who has incurable emotional problems. At times he falls
euphoric and can see only the favorable factors affecting the business. When in
that mood, he names a very high buy-sell price because he fears that you will
snap up his interest and rob him of imminent gains. At other times he is
depressed and can see nothing but trouble ahead for both the business and the
world. On these occasions he will name a very low price, since he is terrified
that you will unload your interest on him.
Ben Graham and Mr. Market
Continued:

Mr. Market has another endearing characteristic: He doesn’t mind
being ignored. If his quotation is uninteresting to you today, he will be
back with a new one tomorrow. Transactions are strictly at your
option. Under these conditions, the more manic-depressive his
behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or
everything will turn into pumpkins and mice: Mr. Market is there to
serve you, not to guide you. It is his pocketbook, not his wisdom, that
you will find useful. If he shows up someday in a particularly foolish
mood, you are free to either ignore him or to take advantage of him,
but it will be disastrous if you fall under his influence. Indeed, if you
aren’t certain that you understand and can value your business far
better than Mr. Market, you don’t belong in the game. As they say in
poker, “If you’ve been in the game 30 minutes and you don’t know
who the patsy is, you’re the patsy.”
B. Graham’s Fundamental
Investment Rules
1.
 2.
 3.
 4.
 5.
 6.
 7.

Adequate Size
Sufficient Strong Financial Condition
Earnings Stability
Dividend Record
Earnings Growth
Moderate Price/Earnings Ratio
Moderate Ratio of Price to Assets
C. Terms

1. Net Current Assets (NCA)
– Defined as:
Current Assets
- Current Liabilities
- Long-Term Debt
- Preferred Stock
NCA Total
NCAc = NCA/# of Common Shares
C. Terms (continued)

2. Data Source
– S&P Stock Guide
– Value Line, etc.
3.
 4.
 5.
 6.
 7.

Earnings Per Share (EPS)
Market Price
Book Value Per Share
Dividends Per Share
Current Ratio
C. Terms (continued)
8. Total Debt
 9. Equity
 10. Growth

g = [ (1 + RP,-1)(1 + RP,-2) ... (1 + RP,-10)]
1/n
-1
D. The Graham Model

1. Group A Criteria
#1: E/P > 2 (AAA Yield) (1 pt.)
E/P > 1.33 (AAA Yield) (1/2 pt.)
#2: P/E < .4 (Avg. P/E in last 3 yrs.) (1 pt.)
P/E < .4 (Avg. P/E in last 10 yrs.) (1/2 pt.)
#3: P/Bk < 2/3 (1 pt.)
P/Bk < 1 (1/2 pt.)
#4: D/P > .67 (AAA Yield) (1 pt.)
D/P > .50 (AAA Yield) (1/2 pt)
#5: P/NCA < 1 (1 pt.)
P/NCA < 1.33 (1/2 pt.)
D. The Graham Model
(continued)

2. Group B Criteria
#6: CR > 2 (1 pt.)
CR > 1.8 (1/2 pt.)
#7: TD/E < 1.0 (1 pt.)
TD/E < 1.2 (1/2 pt)
#8: TD/NCA < 2 (1 pt.)
NCA > 0 (1/2 pt.)
#9: G10 > 7%/YR. (1 pt.)
G5 > 7%/YR. (1/2 pt.)
#10: No more than 2 declines in earnings of 5% each over the last 10
years for one full point.
No more than 3 declines in earnings of 5% or more in last 10 years
for one-half point.
Contemporary Fundamentals:

Peter Lynch’s Ten Golden Rules of Investing:
1. Don’t be intimidated by professionals
2.
3.
4.
5.
6.
Look in your own backyard
Don’t buy something you can’t illustrate with a crayon
Make sure you have the stomach for stocks
Avoid hot stocks in hot industries
Owning stocks is like having children. Do not have more than you
can handle.
7. Don’t even try to predict the future.
8. Avoid weekend worrying. Do not get scared out of good stocks.
Own your mind.
9. Never invest in a company without first understanding its finances.
10. Do not expect too much, too soon. Think long-term.
Contemporary Fundamentals:

Peter Lynch’s mistakes to avoid:
1. Thinking that this year will be any different
than any other year.
2. Becoming too concerned over whether the
stock market is going up or down.
3. Trying to time the market.
4. Not knowing the story behind the company in
which you are buying stock.
5. Buying stocks for the short-term.
Contemporary Fundamentals:

Lynch Maxim’s:
1. A good company usually increases its dividends every
year.
2. You can lose money in a very short time, but it takes a
long time to make money.
3. The stock market isn’t a gamble, as long as you pick
good companies that you think will do well, and not
just because of the stock price.
4. You have to research the company before you put
money into it.
Lynch Maxim’s (cont.)
5. When you invest in the stock market you should always
diversify.
6. You should invest in several stocks (5).
7. Never fall in love with a stock, always have an open mind.
8. Do your homework.
9. Just because a stock goes down doesn’t mean it can’t go
lower.
10. Over the long-term it is generally better to buy stocks in
small companies.
11. Never buy a stock because it is cheap, but because you
know a lot about it.
Source: One Up On Wallstreet, by Peter Lynch
Sir John Marks Templeton

Who is Sir John Marks Templeton?
John Templeton borrowed $10,000 and started a brilliant investment
career, which enabled him to be one of two investors to become
billionaires solely through their investment prowess. Templeton has
had decade after decade of 20% plus annual returns and managed over
$6 Billion in assets. Templeton is generally regarded as one of the
world’s wisest and most successful investors. Forbes Magazine said,
“Templeton is one of a handful of true investment greats in a field of
crowed mediocrity and bloated reputations.” Templeton holds that the
common denominator connecting successful people with successful
enterprises is a devotion to ethical and spiritual principles. Many
regard Sir John as the greatest Wallstreet Investor of all time.
Sir John Mark Templeton

Sir John’s 16 Rules for Investment
Success:
1. Invest for maximum total real return including taxes and inflation.
2. Invest. Don’t trade or speculate.
3. Remain flexible and open-minded about types of investments. No
one kind of investment is always best.
4. Buy low. Buy what others are despondently selling. Then sell
what others are despondently buying.
5. Search for bargains among quality stocks.
6. Buy value not market trends or economic value.
7. Diversify. There is safety in numbers.
8. Do your homework. Do not take the word of experts. Investigate
before you invest.
Templeton’s 16 Rules (Cont.)
9. Aggressively monitor your investments.
10. Don’t panic. Sometimes you won’t have everything sold as the
market crashes. Once the market has crashed, don’t sell unless you
find another more attractive undervalued stock to buy.
11. Learn from your mistakes, but do not dwell on them.
12. Begin with prayer, you will think more clearly.
13. Outperforming the market is a difficult task, you must outthink the
managers of the largest institutions.
14. Success is a process of continually seeking answers to new questions.
15. There is no free lunch. Do not invest on sentiment. Never invest in
an IPO. Never invest on a tip. Run the numbers and research the
quality of management.
16. Do not be fearful or negative too ofter. For 100 years optimists have
carried the day in U.S. Stocks.
Warren Buffett-the Sage of
Omaha

Buffett’s Four Steps to Investing:
1. Turn off the stock market.
2. Don’t worry about the economy.
3. Buy a business, not a stock. Change your
perspective to that of a business owner and
learn as much as possible about the business
and industry.
4. Manage a portfolio of businesses. Don’t
diversify for diversification’s sake.
Buffett on Diversification
You can’t be a Bo Jackson in investing. Spread your energies
and your capital too many ways, and you are courting
disaster. If you have really taken your time and only
picked stocks that are bona-fide doozies, there’s no need to
diversify for safety. If you’re not supremely confident
about the future of each stock in your small portfolio,
perhaps you should never have invested in it. Remember,
the fewer stocks you have, the more time you can spend
becoming an expert in them . You should never own more
than ten stocks.
We don’t believe in the Noah’s Ark principle of investing,
winding up with two of everything. Then you have a zoo.
Buffett on the Ideal Investor
Personality
The most important quality for an investor is
temperament, not intellect. You don’t need tons of
IQ in this business. You don’t have to be able to
play three-dimensional chess or duplicate bridge.
You need a temperament that derives great
pleasure neither from being with the crowd nor
against the crowd. You know you’re right, not
because of the position of others but because your
facts and your reasoning are right.
Buffet’s Tenets of Investing:

Buffet’s Business Tenets for Investing:
1. Is the business simple and understandable?
2. Does the business have an identifiable consumer
monopoly or franchise product?
3. Does the business have a consistent operating history
over time. Are earnings (net income) increasing and
is the ROE consistently high (25-30%).
4. Does the business have favorable long-term prospects?
Is it a franchise or least cost commodity producer?
Look for “Goodwill”
Invest within your circle of competence. It’s not how big the circle is that counts, it’s how well you define
the parameters. -- Warren Buffett
“Good Businesses are the ones that in some way are reasonably sheltered from competition. That gets to
having what I call a franchise of some sort.” - Warren Buffett
Buffet’s Tenets (Cont.)

Buffet’s Management Tenets:
5. Is management rational? Does the management use
excess cash to “buy back” stock and issue dividends,
or expand company into low return investments. Does
management express that they are committed to the
best interests of the shareholder’s total return on
investment.
6. Is management candid with its shareholders? Does
management do things the way that everyone else
does or do they think and look at their environment
before doing things?
Business schools reward complex behavior more than simple behavior; but simple
behavior is more effective. -- Warren Buffett
Buffett’s Tenets (Continued):
7. Does the Company have less than 30% debt?
8. How much does the business have to spend on
maintaining operations (check out operating
ratios).
9. Can the Company adjust prices during
inflation?
“Our favorite holding period is forever.” -- Warren Buffett
“The Margin of error is the cornerstone of our investment philosophy: Never count on making a good
sale. Have the purchase price be so attractive that even a mediocre sale gives good results.” Warren Buffett.
“A great investment opportunity occurs when a marvelous business encounters a onetime huge but
solvable problem.” - Warren Buffett.
Buffet’s Tenets:
10. Focus on return on equity, not earnings per
share. EPS is meaningless, since the equity base can
expand over time due to increased retained earnings.
Therefore, EPS does not necessarily reflect good
managerial performance.
11. Calculate owner earnings. Seek out companies that
produce cash in excess. Owner earnings is equal to net
income plus depreciation, depletion, and amortization,
minus capital expenditures necessary to maintain its
economic position and unit volume.
I’d rather have a $10 million business making 15% than a $100 million business making
5%. I have other places I can put the money. -- Warren Buffett
We like to buy Businesses, but we don’t like to sell them. --Warren Buffett
Buffet’s Tenets:
12. Look for companies with high profit
margins. Companies with tenacious cost-cutters.
Remember companies with high costs will always
come up with new ways to spend more.
13. For every dollar retained, make sure the
company has created at least three dollars of
market value. Calculate the retained earnings to
market value ratio (use a 10 year trend). Dollar
created/Dollar retained.
Buffet’s Tenets:

Buffet’s Market Value Tenets:
- What is the value of the business? The cash flows of a
business discounted back to today’s present value
determines the intrinsic value. Discounted by the longterm treasury rate plus 2% to 4% depending on your risk
preference (Buffett uses 15%).
- Can the business be purchased at a significant discount to
its value? Look at the stock price. Can you purchase the
stock at a significant discount to the stock price. The
greater the difference, the greater the allowance for a
margin of error. (At least 50%).
It is far better to buy a wonderful company at a fair price than a fair company at a
wonderful price. -- Warren Buffett
Buffet’s Tenets:

Buffet’s Yearly Check-up:
- Calculate return on beginning
shareholder’s equity
- Check the changes in operating margins,
debt levels, and capital expenditures.
- Check the company’s cash generating
ability
A Contemporary Approach for Stock
Screening Using Fundamental Methods:

Ten Summary Criteria:
1. Select those stocks with Value Line Timeliness ratings of 1 or 2 and
Safety ratings of 1or 2.
2. Select companies with a franchise product or service.
3. Select companies with a long-term record and high prospects for
continued growth well into the future. Look for regional or
international expansion to maintain their growth.
4. Look for a company with relatively low risk. A beta of no more
than 1.05; a capital structure with less than 1/3 debt. Check the value
line in relation to price fluctuations. Find a company with low capital
expenditures, this eliminates the costly potential of retooling every 5 to
8 years.
A Contemporary Approach (Cont.)
5. Look for an efficient company. This is one that adds more than a
dollars worth of market value to every dollar retained in earnings each
year. One dollar in retained earnings should equal three plus dollars in
added market value.
6. Study the business and its franchise potential, not just the financial
numbers. Is management looking at new and creative ways to exploit
opportunity or are they trying to do what everyone else is doing?
7. The important financials to look at are: ROE, Owners Earnings, High
profit margins, and the dollar-retained-dollar added test.
8. Calculate the intrinsic value. Can the stock be purchased below the
intrinsic value with a significant margin of safety?
9. Is management committed to its shareholders. Look for buybacks with
excess cash.
10. Don’t follow the crowd. Buy when the value and discount to intrinsic
value warrant a buy.
A Contemporary Approach to
Selecting Common Stocks:


Step One: Find those companies that meet the
Value-Line rank criteria of 1 or 2 on timeliness
and safety. Or analyze a company given to you by
your Professor.
Step Two: Determine if the products offered by
the firm are franchise products, i.e. no close
substitutes, not heavily regulated, needed and
desired. Consider the existing substitutes, the
substitutes that are down and upline, new entrants
and barriers to entry, and new technologies.
A Contemporary Approach Cont.:

Step Three: Do a complete financial statement
analysis as discussed in the first section of this
course. This should include a complete ratio and
DuPont analysis.

Step Four: Do a complete strategic audit as
discussed in the second part of this course. This
should include the five forces model and a
S.W.O.T. analysis.

Step Five: Do a complete investment SCREEN
analysis with provided spreadsheet.
Investing in Equities
Topic 6
IV. Technical Analysis
A. Definition

Technical Analysis is the belief that important
information about future stock price movements can be
obtained by studying the historical price movement.
90
80
70
60
50
40
30
20
10
0
1st Qtr
2nd Qtr
3rd Qtr
4th Qtr
Technical Analysis
Assumptions:

Technical analysts base their buy and sell decisions on the
charts they prepare of recorded financial data
1. Market value is determined by the interaction of supply and demand.
2. Supply and demand are governed by numerous factors, both rational
and irrational.
3. Security prices tend to move in trends that persist for an appreciable
length of time, despite minor fluctuations in the market.
4. Changes in a trend are caused by shifts in supply and demand.
5. Shifts in supply and demand, no matter why they occur, can be
detected sooner or later in charts of market transactions
6. Some chart patterns tend to repeat themselves.
Types of Technical Charts:

Bar Charts
H
C
Dollar
Price of
Stock
L
Trading Days
Types of Technical Charts:

Line Charts: a graph of successive day’s closing
prices.
Closing
Prices
Trading Days
B. Approaches to Technical
Analysis
 1.
The Dow Theory
– The Dow theory views the movement of market
prices as occurring in three categories
1. Primary Movements: These are called bull
and bear markets.
2.Secondary Movements: These are up and
down movements of stock prices that last for a
few months and are called corrections.
3. Daily Movements: These are meaningless
random daily fluctuations.
B. Approaches to Technical
Analysis (continued)

2. Trading Action
– a. Concentrates on minor trading
characteristics in the market
– b. Examples include:
» 1. Monday is the worst day to buy stocks, Friday is
the best.
» 2. If January is a good month for the market then
chances are good a good year will occur.
B. Approaches to Technical
Analysis (continued)

3. Bellwether Stocks
– a. A few major stocks in the market are
consistently highly accurate in reflecting the
current state of the market.
» IBM
» DuPont
» AT&T
» Exxon
» GM
Approaches to Technical
Analysis (Continued):

4. Relative Strength
– The basic idea behind relative strength is that
some securities will increase more, relative to
the market, in bull markets and decline less,
relative to the market, in bear markets.
Technicians believe that by investing in those
securities that exhibit relative strength higher
returns can be earned.
B. Approaches to Technical
Analysis (continued)

5. Technical Indicators
– a. Market Volume -- is a measure of investor
interest
» 1. STRONG when volume goes up in rising market
or drops during declining market.
» 2. WEAK when volume goes up in declining
market or decreases during a rally.
B. Approaches to Technical
Analysis (continued)
– Example
» On June 3, 1985
• Advances = 930
• Declines = 691
• Difference = + 239
» On June 11, 1985
• Advances = 651
• Declines = 920
• Difference = -269
– Conclusion: A weak market.
B. Approaches to Technical
Analysis (continued)
– b. Breadth of the Market
» 1. Considers the advances and declines in
the market.
» 2. As long as advances outnumber declines a
strong market exists.
» 3. The spread is used as an indicator of
market strength.
B. Approaches to Technical
Analysis (continued)
– c. Short Interest -- measures the number of
stocks sold short
» when the level of short interest is high, by historical
standards, then the situation is optimistic.
– d. Odd-Lot Trading: Theory of Contrary
Opinion
» if the amount of odd-lot purchases start to exceed
odd-lot sales by a widening margin, it may suggest
that speculation is occurring among small investors.
This is the first signal of an upcoming bear
market.
Review Problems: Section 6








What are two theoretical ways to determine the value of
Common Stock?
Net Current Asset in the Graham model is defined as?
Why do we calculate geometric instead of linear growth
rates?
The Graham model is a fundamental valuation model?
Explain.
Define technical analysis.
What are Bellweather stocks?
Who was Peter Lynch and what is he primarily known for?
What are Lynch’s 10 golden rules for investing?