Presentation on theme: "Economics 12 [Stock Market] Introduction. What is a stock? A stock represents partial ownership of a corporation. When you buy shares of a stock, you."— Presentation transcript:
What is a stock? A stock represents partial ownership of a corporation. When you buy shares of a stock, you effectively own a small fraction of that company. Stocks of public companies are traded on stock exchanges like the NYSE or the NASDAQ. Owning a stock entitles you to share in the future profits of the company. The value of a company is essentially the value of its future cash flows. So the value of a stock is the value of a fraction of the future cash flows of the company. Some companies pay out part of their profits through dividends. You can also benefit from a price increase of the company stock. Buying stocks is a risky investment, as neither dividends not price increases are certain and the stock can even lose part or all of its value.
Why Do Companies Issue Stocks? Companies can decide to make the transition from the private market to the public market for several reasons. When a company "goes public," its first offering of stock is called an Initial Public Offering or IPO. Once a company is public it can also decide to issue more stock. Stocks consist of two markets: primary and secondary. The primary market, also known as the new-issues market, allows new or growing businesses to sell stock to raise money. Investors in IPOs can later sell the new stocks in the secondary market, allowing buyers and sellers to trade stocks quickly and effectively. The New York Stock Exchange (NYSE) and Nasdaq are the major secondary markets in the United States. On these exchanges, investors trade stocks that they already own, and the company which initially issued new stock doesn't receive any additional money from this activity. When a company issues stock it raises money that it can use to expand its business. For instance, a company might build a new factory or hire additional employees with this money. As a result, the business becomes more profitable.
Why Do Companies Issue Stocks? The reasons that a company might want to raise money by issuing stock are: To develop new products To buy more advanced equipment To pay for new buildings and inventories To hire more employees To provide for a merger or acquisition To decrease debt To give company owners greater flexibility To place a value on the company An investment banker usually manages the offering of a company's shares and serves as the link between companies and possible investors. When a company goes public, it also takes on several new responsibilities and must comply with the federal and state regulations for publicly traded companies. In addition, a lot of company information, such as earnings, must be publicly available and a great deal of effort is expended keeping investors informed about the company. The company must also pay independent underwriters, attorneys, and accountants.
Shareholder’s Rights A shareholder rights plan states the rights of shareholders for a company. The management of the company usually proposes the plans, and the shareholders approve them. Shareholders obtain rights when they purchase shares and transfer the rights when the shares are sold. A change of a shareholder rights plan is usually printed in the annual proxy statement and announced publicly. For example, IBM's board adopted a shareholder rights plan under which the company will issue a dividend of one right for each common share held by holders. If you buy a share or shares of stock in a public company, you become a part owner of that company. As a shareholder of one share of Microsoft, you enjoy the same basic privileges and rights as Bill Gates, who owns millions of shares. Most companies use a one-vote-one-share system. Even though your one share of Microsoft does not count much against Mr. Gates' millions of votes, the company takes each vote seriously.
Shareholder’s Rights As a shareholder, you have the privilege to receive quarterly reports and an annual report informing you of the financial health of the company. The quarterly reports inform shareholders how much money the company has made or lost during the reporting period, and also reviews the business activities that have taken place. The annual report is a combination of all quarterly reports and is often published with elaborate charts and photographs. It too provides detailed business and financial information about the company. As a shareholder, you will be invited each year to attend the annual shareholders' meeting, where you can interact with executive management and vote on matters that come before the board. If you cannot go to the annual shareholders' meeting, the company will send you an absentee ballot, allowing you to vote by proxy. The responsibility of the company's board and management is to realize the inherent value in the company's business and maximize shareholders' value. The shareholder rights plan protects the interest of investors.
The Role of the Stock Market Stock Markets are an integral part of all major Western economies. They provide unique services and benefits to corporations, individual investors and governments.
Benefits for Corporations Raising Capital A corporation able to make an Initial Public Offering (IPO) on the stock exchange gains access to a huge universe of investors and a ready supply of new capital for their business. Once listed there is the opportunity for further issuance if needed. Access to the stock markets also facilitates growth by merger or acquisition through share purchases.
Benefits for the Investors Improved Returns = Equities have no maturity data and no fixed rate of return. This makes them a riskier investment than money markets or bonds. What equities provide is the prospect of a combination of income and capital gains, plus a superior rate of return. From the 1930's until 2007 an average return of between 8% and 10% per annum has been achieved (depending how you account for dividend payments) compared with around 5% for bonds. The stock market gives the flexibility to invest small or large amounts and the choice of a vast number of different corporations and industries in which to invest.
Benefits for the Economy Putting Peoples' Savings to Work If individuals keep their savings in cash, or even a bank account, there is little or no benefit to the economy. Investment in stocks, however, is a direct investment in the success of individual businesses and helps promote stronger economic growth. Measure of the Economy's Performance Although the health of the economy can not be directly correlated with the performance of the Stock Market, it is true that the performance of share prices in general will be a good indication of it's current condition and of the confidence of individuals within that economy.
Benefits for the Economy Corporate Governance The regulations required for a corporation's stock to be listed on the Stock Exchange and the ongoing requirements to maintain that listing are a good way to ensure that management standards and standards of record keeping within that corporation are maintained at a high level. There have been notable exceptions, but generally record keeping of publicly quoted companies has been shown to be better than that of private companies. Access to Funds for Governments In addition to corporations, governments themselves may issue bonds that are quoted on the Stock Market to raise money for infrastructure, or other major projects. The stock exchange allows individuals to lend money to their government to fund their programs.
Trade Types At the most basic level, there are only two ways you can trade stocks; you either buy them or you sell them. If you think share prices are going up, you buy. You close your position by selling the shares. You can also bet on falling share prices by selling short. That is, selling shares you do not own. You essentially borrow shares from your broker and then sell them. You close your position by buying back the shares (buy to cover) and giving them back to your broker. Typically, not all stocks can be shorted, depending on the inventory of shares your broker holds.
Commissions When trading stocks, the commission charged can make the difference between a profit and a loss. A full service stockbroker will charge up to 2% commission on every trade done. That may not sound much, but it means that if you buy a stock at $20, you have to sell it at $20.80 just to cover his commission. Although online brokers are far cheaper, their commissions can still add up, particularly for an active, or day trading account. Even with the introduction by at least one major online broking service of a fixed commission amount, regardless of the number of shares traded; deal costs can still be a major factor in your success or failure. This is particularly true for traders executing smaller deals, meaning the commissions form a larger percentage of their funds at risk. An active day trader, or a scalper, doing twenty or thirty trades a day would need to clear at least $4,000 profit a month just to cover commissions. Remember you get charged just as much commission on a losing trade as on a profitable one. The broker is the one person guaranteed to make money whenever you deal with him.
Advanced Trade Types You can use the following trading techniques to improve your portfolio's. These compare to a market order, which is executed at the best price available at the time of the trade. If the market order is placed when the exchange is closed it is executed at the best price available when the next trading session opens. Limit Orders To limit the execution price of a trade, you can place a limit order. This way, you can define a maximum price you will buy at, or a minimum price you will sell at. Remember that if nobody is willing to trade at your price, your order will not be executed. As long as the trade has not been executed, you can then cancel the order or change the limit price.
Advanced Trade Types Stop Loss If you want to protect your profit on an open position, you can place a stop loss order. If the stock drops below your stop loss price, your shares will be sold. For example, if you have bought a stock at $10 and the price has risen to $11, you could place a stop loss order at $10.50. If the price falls below $10.50 your selling order will be executed. You are not guaranteed $10.50 as an execution price, your trade is the next one done after the price falls to $10.50, so could be lower. Trailing Stop-Loss This is a refinement of the above technique. You set the stop loss at a variable price, at a discount to the highest price the stock reaches after you put in the trailing stop loss. For example, you could set the stop loss at 50 cents below the stock price. As long as the stock price rises, the stop loss price does, too. But the stop loss level never falls, so if the price drops by 50 cents at any time your stop loss is activated.
Trade Execution and Partial Fills Many investors think that when they place an order, the execution is instantaneous, but this is not so. Even when placing an order on-line that order goes to the office of the broker, who then places it with the exchange. This means that, for a market order, the price quoted, or seen on screen, is not necessarily the price you will trade at. Your broker has a duty of best execution on any orders received, which means if he can improve on the price quoted to you, he will. There is no guarantee he will be able to do this though. A speedy execution is another part of this duty. There are circumstances where he may have several choices of where to execute your order. Some may take more time but possibly offer a better price. Here, the chance of the price improvement would have to be weighed against the slower execution meaning there was more risk the price will move against you.
Trade Execution and Partial Fills Partial Fills: When placing a market order the risk of only obtaining a partial fill is removed, as if there is not enough market depth at the original quote the balance will be traded at the next best prices available until the order is completed. The exception would be small or illiquid stocks where there may only be a few shares bid or offered at any price. In smaller stocks he risk of market orders is that fills may be obtained at widely different prices. With limit orders a partial fill may occur, as less favourable prices cannot be accepted. You have the option to leave the order balance at the same price, cancel it or change the limit for the remaining shares.
Margin and Margin Calls Margin is a form of leverage. Margin accounts allow you to buy stock by borrowing a percentage of the cost from your brokerage house. The brokerage house will lend you the money and charge you interest. This increases your buying power, but also increases your risk. There are minimum equity levels required in a margin account at all times. Initial Margin Requirements: This is the minimum amount of the security’s purchase price you are required to have in your margin account at the time of the trade. Current regulations for stock purchases require 50% of the cost to be in your account, with a minimum cash balance of $2,000 required. For a short sale, the full trade proceeds plus an extra 50% must be in your account.
Margin and Margin Calls Maintenance Margin Requirements: After the trade is done a minimum balance must be maintained in the account at all times. This is the maintenance margin. Margin Call: When the amount of margin within your account falls below minimum levels, the broker will ask you for extra funds to be deposited. This is a margin call. The alternative is to close some positions to reduce the margin requirement in the account.
Investing vs. Trading What is the difference between investing and trading?
Investing Investing Investing is for the long term. You are buying stocks to exploit the long-term growth rates generally available in equities. With the exception of occasional bear markets like the one seen in 2007-09, that growth rate has consistently beaten bonds, cash or other mainstream investments. Through research and fundamental analysis one tries to create a balanced portfolio of different stocks. Some sorts of portfolios are: Index Tracker portfolios Set up to mirror the Dow Jones or S&P 500 index, they will be constructed to exactly follow movements in those indices. High Dividend Portfolios: Made up of stocks with above average dividend yields. Blue Chip investment portfolios Not limited as strictly as the tracker portfolios, but comprising only the largest and top rated stocks. Generally strategies will either be focused on maximizing income or long term capital growth.
Trading Trading Trading is a more active, short-term strategy. Buying and selling frequently to take profits rather than accumulate long term growth. Some sorts of traders are: Day Traders They look to buy a stock at the low point of the day (or sell at the high) and close that position for a profit the same day. They aim to have no open positions overnight. Scalpers Make dozens of trades every day and try to make a very small profit on each. They will also close the position quickly if it goes the wrong way, to limit losses. Momentum Traders Look for a situation where there is high volume in a stock that is moving decisively one way or the other and trade in line with that trend. They will watch for that momentum to ease and then take profits. Fundamental, or swing Traders Look at a company's fundamentals and will hold positions longer than the traders above, but are still looking for short to medium term profits and buy and sell actively in the market.
Investing and Trading Strategies Investing Equity investing involves building a portfolio of stocks and monitoring and managing its performance over time. The main aim will be to create income, growth, or a combination of the two. Income vs. Growth Income portfolios maximize the annual yield or cash flow and commonly look at stocks with high dividend yields. A growth-targeted portfolio buys undervalued stocks to obtain high rates of long-term capital growth for the portfolio. Dividends or other cash flow would commonly be reinvested to increase this growth rate. Active or Passive Management Passively managed portfolios As few investment decisions as possible are made and trading is kept to a minimum. The most popular sort of passive portfolio is an index portfolio, which tracks movements in a stock market index like the S&P 500. Long term performance is more predictable is the sense that it will be close to the performance of the index tracked. Actively managed portfolios Actively managed portfolios will trade more often, exploiting anomalies and inefficiencies in market pricing to outperform the indices. Performance is less certain as it depends on the quality of decision making by the portfolio manager.
Investing and Trading Strategies Trading Trading focuses on short to medium term gains, rather than long-term growth. Whether a day trader, holding zero risk by each market close, or willing to hold positions longer, a trader is looking to take profits frequently. This may be done in individual stocks or within a larger portfolio. Individual Stock Picking Whether singly, or within a portfolio, analyzing individual stocks to pick the cheapest to buy or overvalued stocks to short to beat market performance. Stocks vs. Index Holding core long or short positions in a stock index, or index based portfolio and taking a contrary view in individual stocks that will outperform, or underperform, the index to increase returns. Market neutral trading Taking opposing positions in pairs of stocks. As the price of your long position outperforms your short, you make a profit. This keeps your cash position low (or at zero) and your exposure to overall market moves to a minimum, whilst exploiting pricing anomalies in the market.
Fundamental Analysis Investors use fundamental analysis is to determine the value of a stock and predict its likely future market performance. The process can be carried out on three levels: macro, sector and individual stock analysis. Macro Examines the global and domestic economic factors and overall market trends to determine likely directions for stock markets as a whole. Factors such as GDP, economic growth, inflation, interest rates and energy prices will be considered. The analyst will then move on to: Sector Analysis Identifies which sectors of the economy will outperform in the current macro economic conditions. This may be based on regional or industry specific factors. Finally, the focus moves to: Individual Stock Analysis Which business within the selected region or industry will show the best performance? The method of starting with macro economic factors and working down to individual businesses is called the top-down approach. If the order in which the research is done is reversed, that is the bottom- up approach. Once the analysis is focused on individual stocks the financial and business health of that company will be considered and compared to its peer group. The assumption behind fundamental analysis is that markets can incorrectly price a security in the short term, but in the longer term these anomalies will be corrected and the stock re-priced. The goal is to identify these situations and exploit them. The main alternative to fundamental analysis is technical analysis, which is discussed here.
Technical Analysis Technical analysts, also known as chartists, maintain that all relevant information is already reflected in a share price. This differs from fundamental analysis, which seeks to exploit pricing anomalies. Technical analysts believe that analyzing outside factors and ratios is irrelevant. Instead they look at the history of the price movement of a stock and at indications of current market trends to determine when to buy and sell. The assumptions are that historical movements will repeat themselves as they are indications of behaviour to set circumstances. Here are some of the most popular trends and indicators that chartists will study. Head and Shoulders: This is formed when a share price peaks and falls back three times, with the second peak being at the highest level. When seen on a chart, this looks like a head and two shoulders. This is a bearish price trend, suggesting the third fall back will continue through the "neckline" indicated by the price troughs and on to lower levels. Double top, or double bottom: Where a price twice falls back from, or bounces up from, the same level. This suggests strong support or resistance exists at those levels. The trend suggested is for the price to continue to move away from those levels, rather than breaking through. Moving Averages: When the share price, usually measured as the price of the stock at close of business on a trading day, breaks through the average closing price from a set number of previous days (say 50) then that is an indication that the price trend is in that direction. Sometimes two averages are used, for instance, 5 day and 50 day and the trend is set by the shorter average breaking through the longer one. Relative Strength Index: This index measures whether a stock is overbought or oversold. The RSI measures the stock movement from one close to the next and therefore, the strength of the prevailing stock trend.
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Stock Dividends Dividends are like a small reward that a company pays you for owning shares of its stock. Each year, many companies return a portion of their earnings to their shareholders through dividends. In general, a company that has a slow growth rate pays high dividends. On the other hand, a company with a high growth rate usually pays no dividends at all. Historically, large corporations and utility stocks have paid regular dividends. Companies with a growth rate of less than 10%, for instance, might have a high cash flow but a slowly appreciating stock. They choose to pay dividends to investors in order to attract income because stocks that pay dividends are very appealing to certain investors. In contrast, some large corporations with high growth rates and stock prices that appreciate rapidly probably do not pay dividends. The reason is that these companies reinvest their earnings into the company to grow their businesses. The board of directors votes on the various aspects of dividends such as their approval and dates of distribution. Dividends are usually paid quarterly and sometimes annually or semiannually. However, many companies don't pay dividends at all. Older stocks are more likely to pay dividends than the latest IPO.
Stock Dividends If the board of directors does decide to issue dividends, it will be announced at a set amount and will be paid to the shareholders as of a record date. Dividends will be paid on the distribution date, sometimes called the payable date. In order to receive the dividend, you must own shares of the stock on the record date. An increasing number of public companies offer a dividend reinvestment program (DRIP). It automatically uses your cash dividends to purchase additional shares of the stock without a broker. Shareholders not participating in a DRIP will receive a check from the company when the dividends are distributed. The importance of dividends depends on your investing strategy. If your main objective is to find stocks that are likely to appreciate quickly, dividends probably will not play a large role in your investment decisions. On the other hand, if your objective is to generate a steady return on your investment, stocks that pay dividends could become a central part of your strategy.
Stock Splits Stock splits occur when a public company issues more shares of stock to existing shareholders. In a 2-for-1 stock split, a company issues another share for every one already sold. After the split, 1 pre-split share will be replaced with 2 shares, and the share price is halved. For example, pretend you own 100 shares of IBM trading at $120. If IBM announces a 2-for-1 split, then you would now have 200 shares at a stock price of $60. A stock split doesn't change the value of the shares you own. A stock split is just like trading in a dollar for 4 quarters. Splits can either be "ordinary" or "reversed". In ordinary splits, the share price lowers while the number of outstanding shares increases. A 2-for-1 split, for instance, is an ordinary split. Companies usually perform ordinary splits to reward the shareholders. In reverse splits, the share price increases while the number of outstanding shares decreases. A low-priced stock may have a reverse split so it looks like a more valuable company. A company may also perform a reverse split to eliminate small shareholders. For example, a penny stock worth $1 may have a 1-for-10 split and be worth $10. After the split, 10 old shares would be needed to equal 1 new share. Ordinary splits usually occur among high-growth technology stocks, while reverse splits happen among low- priced stocks. For accounting purposes, a stock split is a non-event because the market value of the company stays the same, and each shareholder's total fraction of the company owned remains the same. In general, the share price of a company goes up after a split. The split happens in the first place because of a high stock price. After the stock split, investors may anticipate more upside in the share price.
Mergers and De-listings In order to be listed on a major stock exchange here are certain minimum conditions that must be met. These vary by exchange, but typically include: minimum number of shares outstanding, minimum market capitalization and/or minimum annual income of the corporation. A prolonged breach of any of these conditions can cause a delisting of that corporation's stock. Some of the main reasons for de-listings are: Mergers & Takeovers: Once completed, the listing of the company that was subject to the takeover or merger must be de-listed and the shares of that corporation are no longer publicly traded. These shares will have been exchanged for cash, shares in the corporation making the bid, or shares in the new company formed by the deal, dependant on the terms of the deal. Details are sent to all stockholders confirming the terms of the deal, its success and what they are required to do with their holdings of the de-listed company. Share Price falls: In addition to minimum market capitalization requirements, major exchanges like the New York Stock Exchange and the NASDAQ will de-list a company whose share price stays below $1 for more than a set period of time. Breach of Regulations: If a corporation fails to file the necessary forms, earning statements or similar documentation with the SEC, then delisting of their stock is one punitive measure that can be taken. Bankruptcy: Often, stocks will be de-listed well before bankruptcy occurs. Any such circumstances resulting in a business ceasing to trade will result in suspension from trading on exchanges, followed by delisting. Voluntary De-Listing: On occasion, a corporation may decide that being publicly traded is not the right course for them. They may wish to consolidate the company's ownership, change the nature of their business or carry out a corporate restructuring. They may opt to buy back shares, de-list and take the company private. As with bankruptcy, removing a stock from the exchange for this reason does not allow trading in "over the counter" markets after the delisting is complete.
Types of Stock Stocks may seem complicated, but they can be broken down into two basic groups: common and preferred stock. In addition to these two groups, a company may issue classes of stock, sometimes Class A and B. Common stock is the most common form of stock you will encounter. It represents fractional ownership of a company. Common stocks are easy to transfer. When the market opens, a common stock may be sold or bought at whatever price another investor is willing to pay. Common stockholders usually have voting rights and have a higher potential for return than preferred stockholders. The second type of stock is preferred stock. It not only represents partial ownership of a company (like common stock) but also pays dividends at specified rates. In addition, dividends are paid to preferred stockholders before common stockholders. Also, if a company is performing poorly, common stock dividends are usually removed first. Moreover, if a company sells its assets because of bankruptcy, preferred stockholders have a claim on the assets before common stockholders. However, preferred stockholders do not usually have voting rights, and the dividends on preferred shares are not increased if the company performs well. Companies sometimes offer "convertible preferred stocks" which allow shareholders to convert their shares to common stocks at a set price.
Types of Stock In addition to common and preferred stock, a company may have classes of stock, usually Class A or Class B. Classes of stock are used to separate ownership and control. A company may issue a new class of stock for a specific purpose, such as financing an acquisition or merger. Some classes of stock may not come with voting rights. Stocks can be broken down into common and preferred or even Class A and Class B. Owning any type means you are a part owner of a business, but some classes have limited privileges.
Blue Chip Stocks v. Penny Stocks Blue chips, like in poker and other card games, are the most expensive chips. Similarly, blue chip stocks are worth the most and come from larger companies. Penny stocks are very low priced stocks that trade anywhere from a fraction of a cent to a few dollars. Blue chip stocks are the most valuable stocks on Wall Street and are usually from companies that are household names, such as AT&T, McDonald's, and Starbucks and tend to be large or mid-cap stocks. Blue chips have a long operating history, steady earnings, and a good reputation. They also have high liquidity, or the ability to trade large amounts of a stock without any problems. Blue chips are considered safe bets, especially if the market is falling. However, some blue chips do not always perform well. Penny stocks often belong to newer companies with little operating history and tend to be small-cap or even mini- cap stocks. They are usually indicated with an.OB or OTC (over-the-counter) after the stock symbol, which means that their shares are not traded on the major exchanges.
Blue Chip Stocks v. Penny Stocks Penny stocks can be difficult to trade because of low liquidity and volume issues, but they can still attract investment capital from certain types of investors. Penny stocks are a very risky investment and there is no guarantee against bankruptcy, but they represent an interesting opportunity to speculators who benefit from the incredibly low share price and the potential for enormous upside. Not all large-cap stocks are considered blue chip stocks. Shares of the high-flying Internet stock VA Linux went up 300% on the date of the initial public offering (IPO) and had a high enough market capitalization to be considered large cap, but it didn't have a long enough operating history to be considered blue chip. In addition, numerous IPOs start out strong but drop drastically in the following months. Blue chips and penny stocks are basically opposites, but there is no guarantee that either one is a great investment at a given time. Investors must always be careful when buying any kind of stock. Investors sometimes have the misconception that penny stocks are cheap and therefore will eventually have upside potential. A low share price does not actually mean that a stock is cheap. Only by researching a company's earnings reports is it possible to determine whether a stock's current price over- or under-valued.
Market Cap As an investor, you have to make decisions about buying stocks in large or small companies. In the stock quote table on the Internet, a column called market capitalization indicates the market value of a company. The market capitalization, also known as market value or market cap, is found by multiplying the share price by the number of shares outstanding. For example, a company at $10 with 20 million shares outstanding has a market cap of $200 million. Stock market experts do not have set numbers for small, mid, and large cap stocks, but the following table gives you an idea of the market caps for small, medium, and large companies: Market Capitalization Small-cap: Under $500 Million Small-cap stocks are usually those with a market cap less than $500 million. Investing in small-cap stocks can be risky because they are usually newer stocks and their companies have not proven to be stable or profitable. However, small-cap stocks can have very high growth potential compared to large-cap stocks. A small-cap stock is much more likely to double or triple than a large-cap stock. Overall, small-cap stocks have high risk but may result in high returns. Mid-cap: $500 Million-$1 Billion Mid-cap stocks are those with a market cap usually between $500 million and $1 billion. These stocks are just in between small and large cap stocks. Mid-cap stocks are not as risky as small-cap stocks but are not as stable as large-cap stocks. They can provide fair profit in the long run. Large-cap: Above $1 Billion Large-cap stocks are those with a market cap usually above $1 billion. Investing in large-cap stocks can be quite safe because those companies have proven to produce consistently good earnings and be very stable in growth. However, large-cap stocks grow more slowly than small- and mid-cap stocks. In the long run, large-cap stocks have low risk but slow growth. The tradeoff between small and large cap stocks is between risk and return.
Size Segmentation When constructing a balanced portfolio, an investor may look at diversifying in various ways: by industry sector, by cyclical factors, to include international corporations, or by the size of the corporation's market capitalization. Stocks can be divided into the following categories, based on the size of the corporation: Blue Chips: Also known as Bellwether Issues. Not defined by size, a Blue Chip company is a market leader, one of the safest investments available. To attain Blue Chip status the corporation will have produced consistently strong results over a period of time. By their nature, Blue Chip stocks will include some of the largest companies traded, such as: Wal-mart, GE, Coca Cola and IBM. The largest of these are known as Mega Cap stocks, having a market capitalization of over $200 billion.
Size Segmentation Other divisions based on the value of a corporation's market capitalisation are: Large Caps: Defined as a corporation with a market capitalization in excess of $10 billion. Mid Caps: Are capitalized at between $2 billion and $10 billion. Small Caps: Are capitalized between $300 million and $2 billion. Micro Cap: Those between $50 million and $300 million Nano Caps: Those under $50 million Penny Stocks: A definition based not on market size but on share price, these tend, however to be amongst the smallest companies traded and are often only available on over the counter markets. The definition of a penny stock is any stock trading below $5 a share, regardless of overall capitalization. Good stock selection between large and smaller cap companies will give stability to your portfolio, whilst profiting from sharper price movements (in percentage terms) of outperforming smaller cap issues.
Cyclical Stocks The price of a cyclical stock rises and falls with the business cycle. Predicting a business cycle is not an easy task, and cyclical stocks tend to lead the business cycle by six to ten months. This means that some cyclical stocks will start doing well six months before the economy comes out of a recession. Cyclical stocks usually come from companies whose products experience flexible demand in market. For example, automobile stocks can be cyclical because people do not constantly need to buy cars. If interest rates increase, buyers will not have enough money to afford the cars, which causes the profits of automobile companies to fall. Conversely a non-cyclical stock's product experiences constant demand. Coca Cola is a non-cyclical stock because even if interest rates rise, people will probably continue to buy beverages. The difference between a cyclical and non- cyclical stock is tied closely to consumer need and demand.
Cyclical Stocks The business cycle, along with cyclical stocks, involves interest, inflation, and unemployment rates. If these factors increase, businesses will do poorly and have lower profits. A decrease in these factors will cause businesses to expand and have very strong earnings. This rise and fall can be unpredictable and last for a constantly changing number of years. A change in the economy usually happens during election years when the new president can change policies. Buying cyclical stocks can have certain risk factors. Investors may not be able to judge whether the economy will perform well or poorly. It is very challenging to predict when the next change in the business cycle will take place. Investing in cyclicals is thus a risky strategy because of how unpredictable the economy can be. On account of the information they have access to, Wall Street professionals are usually better at predicting changes in the economy and business cycle than individual investors. Still, buying cyclical stocks can be very profitable for anyone confident about what will happen to the economy in the future.
Growth v. Value Stocks As an investor, you want to buy low and sell high. But you can also buy high and sell even higher to make a profitable investment. How is this possible? The usual buy low, sell high takes place with value stocks, but a type of stock called "growth stocks" enables you to buy stocks at an expensive price and sell at an even higher price. Now, the real question is how you can determine if a stock is cheap or expensive. Its value is not how much it's selling for?that is its share price?but rather its price-to-earnings ratio (P/E) in relationship to the benchmarks for the U.S. stock market (such as the Standard and Poor's 500 Index, known simply as the S&P 500). For example, if the P/E for the S&P 500 is 25, a 150 P/E for a particular company is considered expensive. P/E is the price-to-earnings ratio. The P/E is found by taking the share price of a company and dividing it by the company's earnings per share (EPS). If the P/E is used correctly, it is a good indicator of whether you are paying too low or too high a price for a given stock.
Growth v. Value Stocks Growth stocks tend to grow faster than the S&P and have a higher P/E than that of the S&P. Unlike value investors, growth investors look for stocks with high growth potential. They often buy stocks with high P/E ratios or even negative earnings. The most profitable situation would be if a generally fast-growing company has a dip on account of a temporary setback. It is then possible to buy the stock at the low price and make a profit when the company resumes its usual, fast growth. Growth and value stocks are two types of stocks from which you can make a respectable profit. Value stocks will be selling at a lower P/E than usual and can sometimes stay at lower prices for a long time. Investors may have to wait patiently for the stock market to realize the intrinsic value of the company. Growth stocks can sell at very high P/Es but still have plenty of room for growth.
Income Stocks Wouldn't it be nice to earn income in addition to the capital appreciation on your investment? Income stocks appreciate like other stocks, but they also pay a relatively large dividend. It is helpful to compare an income stock investment with a conservative investment in Treasury bonds or a savings account where capital appreciation is impossible but income is guaranteed. For example, if you put $1,000 in the bank at 4% interest, you will get $40 interest annually, but the original $1,000 is unchanged. Income stocks might pay similar dividends but potentially provide capital gain on top of the dividends if the share price rises. As with all stock investments, however, income or gains are not guaranteed. An important term when investing in income stocks is "yield", which is the percentage of the share price that a company pays in dividends annually. To calculate the yield, take the dividend amount you will receive for the year divided by the share price of the company. For example, if Disney pays a $0.25 dividend quarterly, you will receive $1 in dividend annually. If Disney is trading at $40, the yield would be 1/40, or 2.5%. If the share price drops to $20, the yield would be 1/20, or 5%. In other words, if the annual dividend remains constant and the share price decreases, the yield will increase.
Income Stocks High income stocks, or those paying high dividends, are usually the utility stocks or Real Estate Investment Trust (REIT). Traditionally, REITs have high cash flow from real estate rental, which they distribute to shareholders quarterly as dividends. Utilities and REITs usually have yields between 5% and 10%. When buying income stocks, shareholders could make money from the quarterly dividends as well from as an increase in share price. But if the company loses money, it could stop paying dividends. One strategy for buying income stocks is investing in large- cap, high-yielding stocks. An easy way to pick these stocks is using a method called Dogs of the Dow. It involves buying the ten Dow stocks with high yields and good dividends because the share price is having a temporary setback. If the company resumes upward growth, investors will profit. By looking at the historical data and investing in Dogs of the Dow, investors can get a better return and higher yield on their investment.
Tech Stocks Technology stocks are very volatile and, although they can sometimes experience explosive growth, they may also depreciate very rapidly. The world of technology stocks can be very profitable compared to putting money in the bank, but the risk associated with investing in tech stocks should be taken very seriously. Share prices of technology stocks can skyrocket because of the rapid growth experienced by internet and information technology companies. The tech sector is comprised of many new markets, including e-commerce, content providers, business to business, fiber optics, telecommunications, Web site providers, as well as "dot coms" (individual web companies). All of these markets are constantly producing innovative products, and the stocks can see tremendous profits.
Tech Stocks While technology stocks can be very profitable, the fast-growing industry has led to many new, unstable companies. Sometimes new technology stocks have no real earnings, or the possibility of securing future earnings can vary greatly. In the past, investors have rushed to invest in new technology stocks because of the popularity of the.com initial public offerings (IPOs). These new companies may have a 200%-300% increase on the opening day of the IPO but drop quickly afterwards. The companies have no fundamentals or earnings, causing investors to lose patience, sell the stock, and this causes the share price to drop. Investing in tech stocks can thus result in high percentage losses if you choose the wrong stocks. On account of their volatility, tech stocks are an exciting place to invest and may result in superior returns. If you make an informed investment decision by researching companies to learn about their fundamentals and earnings outlooks, it may be possible to pick the winners that will lead to high returns. But by picking losers you can ultimately lose your entire investment.
Industry Segmentation One method for obtaining balance in a portfolio is diversification across different industry sectors. Different agencies use different sector lists to divide the market, but most lists are very similar. Standard and Poor's uses ten sector headings: Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities This is known as the Global Industry Classification Standard (GICS).
Industry Segmentation Dividing stocks in this way helps analysis of individual stock performance. If the energy sector is generally up 10%, but your share is down 5% you can measure its underperformance against its peer group. Then you must decide whether there is good reason for that underperformance, or whether this represents a buying opportunity. Long-term performance can also be measured between companies in the same industry to determine which are historically the best performers in that sector. Secondly, the performance of whole sectors can be compared. At a macro level there are sectors that tend to outperform the market when it is falling and those that historically outperform in rising markets. Utilities and Consumer Staples are considered "defensive" sectors for the market and tend to outperform in falling markets. People still need to buy food and pay their electric bills when times are hard, so sales in these sectors are more stable. Conversely, they will not see the same gains in rising markets as some others. Some analysts also include Health Care as a defensive sector. The other sectors are called "cyclical". The performance of these industries depends more on market conditions and economic cycles. There is more volatility inherent in these sectors. There are no firm rules as to how sectors are classified; different analysts will award different weightings to each sector.
EFTs ETF's, or Exchange Traded Funds, came into being in the USA in 1993 and in Europe in 1999. They are an investment vehicle made up of a basket of individual stocks and are traded on major stock exchanges. They have some of the characteristics of a mutual fund, as the closing price is calculated by the net asset value of its constituent securities. Unlike mutual funds however, they can be freely traded throughout the trading day. Demand factors will sometimes move the price away from the net asset value, creating possible arbitrage possibilities. Until recently ETFs were all index funds, but in 2008 the SEC began to allow actively managed ETFs to be traded. You can now also buy commodity ETFs, sometimes known as ETCs, and Currency ETFs. Since 2008, Leveraged ETFs have also been issued.
EFTs The advantages of ETF's for the investor are the diversification and low expense costs they provide, whilst enabling you to employ techniques used in trading individual stocks, like the ability to place limit orders or carry out short selling. With over a thousand different funds available by early 2009, there is plenty of choice available. Retail investors do not trade directly with the fund manager running the ETF. He trades large blocks of shares with major financial institutions. Holders of these large blocks can trade them throughout the day on the exchange. It is this secondary market that other investors trade with.
Leverages ETFs The first Leveraged ETFs were issued in June 2006. They use equity swaps, derivatives and a daily rebalancing of the basket of stocks to reduce a multiple of leveraging over the performance of an indexed ETF, based on either the S&P 500 or the Dow Jones Industrial Average. The most frequent leveraging is to double the return on the selected index. These are known as 2X funds. However, 3X funds are now becoming more common. It is important to note that the leverage works on the daily returns of the index, not the annual return. This makes leveraged ETFs more suitable for short-term investors than long term. To illustrate why the leveraged returns are not accurate over the longer term, take this example of a 3X fund based on the S&P 500 Assume both have a starting price of 100 and the underlying index rises by 10% on day 1 The S&P price would now be 110 and the ETF price 130, reflecting the leveraging. The next day the index falls by 10% The S&P now stands at 99, giving a fall of 1% over the two days The ETF would stand at 91, because of the leverage, meaning a two day fall of 9%, or nine times as large as the underlying index. Remember that leverage always increases risk, but gives the potential for better rewards as well.
Leverages ETFs Here are the main advantages and disadvantages of Leveraged ETFs Advantages: A simple way of obtaining leverage, not requiring derivatives or multiple trades A good way of leveraging short-term market gains, particularly intra day Disadvantages: The pricing mechanisms mean that longer-term performance cannot be accurately predicted and may under perform the expected leverage significantly. Liquidity is, as yet, comparatively poor and trading volumes low.
Some Definitions Standard & Poor's (S&P) is a division of McGraw-Hill that publishes financial research and analysis on stocks and bonds. It is well known for the stock market indexes, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian S&P/TSX, the Italian S&P/MIB and India's S&P CNX Nifty.