Chapter 10
Picking the Equity Players
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
Outline
 Introduction
 Stock
selection philosophy
 Dividends and why they really do not
matter
 Investment styles
 Categories of stock
3
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?
4
Stock Selection Philosophy
 Fundamental
analysis
 Technical analysis
5
Fundamental 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
Etc.
6
Technical Analysis
 A technical
analyst attempts to predict the
supply and demand for a stock by observing
the past series of stock prices
 Financial
statements and market conditions
are of secondary importance to the technical
analyst
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Dividends and Why They
Really Do Not Matter
 Types
of dividends
 Issues surrounding the payment of
dividends
 Why dividends do not matter
 Theory versus practice
 Stock splits versus stock dividends
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Types of Dividends
 Cash
dividends
 Stock dividends
 Property dividends
 Spin-offs
 Rights
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Cash Dividends
 Cash
dividends are distributions of the
firm’s profits to the shareholders paid 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
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Cash Dividends (cont’d)
 If
shares are held in street name:
• The brokerage firm receives the dividend check
• The brokerage firm may automatically transfer
funds to a money market account
• The brokerage firm ultimately allocates
dividends to the shareholders
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Cash Dividends (cont’d)
 If
the portfolio manager receives the
dividend check:
• The funds are temporarily invested in a money
market instrument until:
– They accumulate sufficiently to finance the purchase
of more securities or
– They are paid as income to the fund beneficiary
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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 dividends
 Popular
when a firm lacks the funds to pay
a cash dividend
 Popular early in the firm’s life cycle
13
Property Dividends
 A property
dividend is the distribution of
physical goods to shareholders
• E.g. a firm’s products
 Property
dividends are rare
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Spin-Offs
 In
a spin-off, a parent firm divests itself of a
subsidiary and distributes all shares in the
subsidiary proportionally to the parent
firm’s shareholders
 The
parent gives away the subsidiary
 Spin-offs
are rare
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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
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Rights (cont’d)
 Rights
are actual securities that shareholders
can buy or sell
 Rights
have a limited life
• Usually expire a few weeks after issued
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Rights (cont’d)
 Shareholders
can do three things with
rights:
• Sell the rights to someone else
• Use the rights to buy more share
• Allow the rights to expire
– Like throwing away money
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Issues Surrounding the
Payment of Dividends
 Chronology
of events
 Dividend growth rates
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Chronology of Events
 Date
of declaration
• The day the board announces the dividend
• Once declared, the dividend becomes a legal
liability of the company
 Date
of payment
• The company mails dividend checks
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Chronology of Events (cont’d)
 Date
of record
• Establishes who will receive dividend checks
• Shareholders of record are listed on the
company records as being owners of the
company on the date of record
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Chronology of Events (cont’d)
 Ex-dividend
date
• Two business days prior to the date of record
• If you buy the stock before the ex-dividend
date, you will get the next dividend
• If you buy the stock on the ex-dividend date,
you will not get the next dividend
• Eliminates any ambiguity about who is entitled
to the dividend
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Chronology of Events (cont’d)
Example
Consider the following dividend announcement by AECI (a specialty
chemical company) on August 2, 2000:
Notice is hereby given that an interim dividend of 30 cents per share, in
respect of the year ending 31 December 2000, has been declared to
holders of ordinary shares registered in the books of the Company at the
close of business on 18 August 2000. Payment will be made from the
office of the transfer secretaries in Johannesburg on 27 September
2000.
Identify the four relevant dividend dates.
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Chronology of Events (cont’d)
Example (cont’d)
Solution:
The date of declaration is August 2, 2000.
The date of record is August 18, 2000.
The date of payment is September 27, 2000.
The ex-dividend date is August 16, 2000.
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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
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Dividend Growth
Rates (cont’d)
 The
dividend discount model:
D0 (1  g )
D1
P0 

kg
kg
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
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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
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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?
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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%
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Why Dividends Do Not Matter

Payment of dividends reduces the balance in the
firm’s cash 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
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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
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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
32
Stock Splits Versus
Stock Dividends
 Stock
splits
 Why stock splits do not matter
 Why firms split their stock
 Stock dividends
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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
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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
35
Stock Splits (cont’d)
 Odd
lot-generating splits are stock split
likely to result in many small investors
holding odd lots
• E.g., a 3-for-2 split
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Why Stock Splits
Do Not Matter
 Stock
splits neither increase nor decrease
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
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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 splits eliminates all
shareholders holding fewer than 200 shares
38
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
39
Investment Styles
 Value
investing
 Growth investing
 Capitalization
 Integrating style and size
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Value Investing
 Definition
 Price/earnings
ratio
 Price/book ratio
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Definition
 Value
investors look for undervalued stock
 Utilize
the firm’s earnings history and
balance sheet
• PE ratio, price/book ratio
 Place
much emphasis on known facts
42
Price/Earnings Ratio
 The
PE ratio is stock price divided by EPS
 A forward-looking
PE uses earnings
forecasts
 A trailing
PE uses historical earnings
43
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
44
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
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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
46
Integrating Style and Size
 Many
money managers distribute their
assets across size and style spectrums
 www.morningstar.com
provides a style box
that can classify a portfolio
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Categories of Stock
 Blue
chip stock
 Income stocks
 Cyclical stocks
 Defensive stocks
 Growth stocks
 Speculative stocks
 Penny stocks
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Categories of Stock (cont’d)
 Categories
are not mutually exclusive
 A note on stock symbols
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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
50
Income Stocks
 Income
stocks are those that historically
have paid a larger-than-average percentage
of their net income as dividends
• The proportion of net income paid out as
dividends is the payout ratio
• The proportion of net income retained is the
retention ratio
 Examples
include Consolidated Edison and
Allegheny Energy
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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
52
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
53
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
54
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
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Penny Stocks
 Penny
stocks are inexpensive shares
 Penny
stocks sell for $1 per share or less
56
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
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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
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