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Investing in Equities Topic 6 I. Common Stock Investments.

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1 Investing in Equities Topic 6 I. Common Stock Investments

2 A. Basic Characteristics n n 1. Equity Capital n n 2. Types – –a. Growth Stock – –b. Income Stock – –c. Speculative Stock – –d. Cyclical Stock – –e. Defensive Stock

3 B. Valuation of Common Stock n n 1. Dividend Valuation Model – –a. Example n n 2. Using the CAPM Process – –a. Assumptions » »1. k m = rate of return on the market » »2. R f = return on the risk free asset » »3. k m - R f = Market Risk Premium – –b. Example

4 C. Other Common Stock Values n n 1. Par Value n n 2. Book Value n n 3. Liquidation Value n n 4. Market Value n n 5. Investment Value

5 D. Common Stock as an Inflation Hedge n n Protection Against Inflation n n Over the last thirty years the S&P 500 has averaged approximately 11% annual compound return. n n Inflation has averaged approximately 5.4% during the same time period.

6 Common Stock as an Inflation Hedge: S&P LT Bonds LT Gov’t Bonds T. Bills CPI Last 10:14.8% 11.3% 11.9% 5.6% 3.5% Last 20:14.6% 10.6% 10.4% 7.3% 5.2% Last 30: 10.7% 8.2% 7.9% 6.7% 5.4% Last 40: 10.8% 6.8% 6.4% 5.7% 4.5% Last 50: 11.9% 5.8% 5.3% 5.7% 4.4% Source: Ibbotson and Sinquefield, “Stocks, Bonds, Bills and Inflation 1997 yearbook,” Chicago.

7 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.

8 Investment Wisdom n n Don’t try to buy at the bottom and sell at the top. This can’t be done - except by liars Bernard Baruch n n Fools and greed usually go hand in hand, which creates a field of opportunity for the rational man. Warren Buffett

9 Investment Wisdom n n When it comes to risk, we’ve done better by avoiding dragons rather than by slaying them. Warren Buffett n n Traditional Wisdom can be long on tradition and short on wisdom. Warren Buffett

10 Investment Wisdom n n 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

11 Investment Wisdom n n On Leaving Management Alone: At Berkshire we don’t tell.400 hitters how to swing. Warren Buffett

12 Warren Buffett on taking Your Time n 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.

13 Investing in Equities Topic 6 II. Principles of Security Analysis

14 Types of Security Analysis n n 1. Fundamental Analysis n n 2. Technical Analysis

15 The Father of Fundamental Analysis: Benjamin Graham n n Who was Benjamin Graham? Sources: Security Analysis (Graham and Dodd); The Intelligent Investor (Graham)

16 Ben Graham and Mr. Market: n n 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.

17 Ben Graham and Mr. Market Continued: n n 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.”

18 B. Graham’s Fundamental Investment Rules n n 1. Adequate Size n n 2. Sufficient Strong Financial Condition n n 3. Earnings Stability n n 4. Dividend Record n n 5. Earnings Growth n n 6. Moderate Price/Earnings Ratio n n 7. Moderate Ratio of Price to Assets

19 C. Terms n n 1. Net Current Assets (NCA) – –Defined as: Current Assets - Current Liabilities - Long-Term Debt - Preferred Stock NCA Total NCA c = NCA/# of Common Shares

20 C. Terms (continued) n n 2. Data Source – –S&P Stock Guide – –Value Line, etc. n n 3. Earnings Per Share (EPS) n n 4. Market Price n n 5. Book Value Per Share n n 6. Dividends Per Share n n 7. Current Ratio

21 C. Terms (continued) n n 8. Total Debt n n 9. Equity n n 10. Growth g = [ (1 + R P,-1 )(1 + R P,-2 )... (1 + R P,-10 )] -1 1/n

22 D. The Graham Model n n 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.)

23 D. The Graham Model (continued) n n 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: G 10 > 7%/YR. (1 pt.) G 5 > 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.

24 Contemporary Fundamentals: n n Peter Lynch’s Ten Golden Rules of Investing: 1. Don’t be intimidated by professionals 2. Look in your own backyard 3. Don’t buy something you can’t illustrate with a crayon 4. Make sure you have the stomach for stocks 5. Avoid hot stocks in hot industries 6. 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.

25 Contemporary Fundamentals: n n 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.

26 Contemporary Fundamentals: n n 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.

27 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

28 Sir John Marks Templeton n 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.

29 Sir John Mark Templeton n 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.

30 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.

31 Warren Buffett-the Sage of Omaha n n 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.

32 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.

33 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.

34 Buffet’s Tenets of Investing: n n 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

35 Buffet’s Tenets (Cont.) n n 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

36 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.

37 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

38 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.

39 Buffet’s Tenets: n n 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 long- term 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

40 Buffet’s Tenets: n n 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

41 A Contemporary Approach for Stock Screening Using Fundamental Methods: n n Ten Summary Criteria: 1. Select those stocks with Value Line Timeliness ratings of 1 or 2 and Safety ratings of 1or 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.

42 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.

43 A Contemporary Approach to Selecting Common Stocks: n Step One: n 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. n Step Two: n 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.

44 A Contemporary Approach Cont.: n Step Three: n 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. n Step Four: n 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. n Step Five: n Step Five: Do a complete investment SCREEN analysis with provided spreadsheet.

45 Investing in Equities Topic 6 IV. Technical Analysis

46 A. Definition n n Technical Analysis is the belief that important information about future stock price movements can be obtained by studying the historical price movement.

47 Technical Analysis Assumptions: n n 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.

48 Types of Technical Charts: n n Bar Charts Trading Days Dollar Price of Stock H L C

49 Types of Technical Charts: n n Line Charts: a graph of successive day’s closing prices. Trading Days Closing Prices

50 B. Approaches to Technical Analysis n 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.

51 B. Approaches to Technical Analysis (continued) n 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.

52 B. Approaches to Technical Analysis (continued) n 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

53 Approaches to Technical Analysis (Continued): n 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.

54 B. Approaches to Technical Analysis (continued) n 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.

55 B. Approaches to Technical Analysis (continued) – –Example » »On June 3, 1985 Advances = 930 Declines = 691 Difference = » »On June 11, 1985 Advances = 651 Declines = 920 Difference = -269 –. –Conclusion: A weak market.

56 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.

57 B. Approaches to Technical Analysis (continued) –c. Short Interest –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.

58 Review Problems: Section 6 n n What are two theoretical ways to determine the value of Common Stock? n n Net Current Asset in the Graham model is defined as? n n Why do we calculate geometric instead of linear growth rates? n n The Graham model is a fundamental valuation model? Explain. n n Define technical analysis. n n What are Bellweather stocks? n n Who was Peter Lynch and what is he primarily known for? n n What are Lynch’s 10 golden rules for investing?


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