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.

3% 6.4% 4.9% 6.4% 7.6% 8. Bills CPI 5.5% 5. Bills and Inflation 1997 yearbook.3% T.2% 5.Common Stock as an Inflation Hedge: S&P Last 10: Last 20: Last 30: Last 40: Last 50: 14.7% 10.8% 5. Bonds.6% 10.7% 5.3% 10.6% 7. .4% Source: Ibbotson and Sinquefield.9% LT Bonds 11.7% 5. “Stocks.” Chicago.8% 14.4% 5.2% 6.7% 3.8% LT Gov’t Bonds 11.9% 10.8% 11.5% 4.

The Panic of 1987 Index arbitrage and portfolio insurance (programmed trading) were the major cause. Mutual funds and pension funds use portfolio insurance. On 10/28/29 the DJIA fell 11.6%. . Portfolio insurance is a strategy that uses computer based models to determine an optimal stock/cash ratio at various market prices. From Tuesday 10/13/87 to 10/19/87. Two insurance users called for sales equaling 50% in response to a 10% decline in the S&P 500 Index. the DJIA fell 769 points or 31%.7%. On 10/19/87 the DJIA fell508 points or 22.

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

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

Steel at 39! And nobody calls a strike on you. then.S. You stand at the plate. Warren Buffett . when the fielders are asleep. the pitcher throws you GM at 47! U.Investment Wisdom  Investing is the greatest business in the world because you never have to swing. you step up and hit it. All day you wait for the pitch you like. There’s no penalty except opportunity.

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

With every investment decision his card is punched.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. and he/she has one fewer available for the rest of his/her life. .

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

Fundamental Analysis Technical Analysis  2. .Types of Security Analysis  1.

The Father of Fundamental Analysis: Benjamin Graham  Who was Benjamin Graham? Sources: Security Analysis (Graham and Dodd). The Intelligent Investor (Graham) .

He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. On these occasions he will name a very low price. Even though the business that the two of you own may have economic characteristics that are stable. Market’s quotations will be anything but stable. Market:  Ben Graham long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.Ben Graham and Mr. Mr. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. since he is terrified that you will unload your interest on him. At times he falls euphoric and can see only the favorable factors affecting the business. it is sad to say. Mr. Market who is your partner in a private business. Market appears daily and names a price at which he will either buy your interest or sell you his. Market is a fellow who has incurable emotional problems. When in that mood. . Mr. For. Without fail.

he will be back with a new one tomorrow. It is his pocketbook. you must heed one warning or everything will turn into pumpkins and mice: Mr. “If you’ve been in the game 30 minutes and you don’t know who the patsy is. Market is there to serve you. If his quotation is uninteresting to you today. If he shows up someday in a particularly foolish mood. Market Continued:  Mr. if you aren’t certain that you understand and can value your business far better than Mr. the better for you. that you will find useful. Market. But. Under these conditions. Transactions are strictly at your option. but it will be disastrous if you fall under his influence. not his wisdom. the more manic-depressive his behavior.Ben Graham and Mr. you’re the patsy. Market has another endearing characteristic: He doesn’t mind being ignored. you don’t belong in the game.” . Indeed. you are free to either ignore him or to take advantage of him. like Cinderella at the ball. not to guide you. As they say in poker.

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

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

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

Terms (continued) 8. Equity  10.C. (1 + RP.-1)(1 + RP.-10)] 1/n -1 .. Growth  g = [ (1 + RP. Total Debt  9..-2) .

) P/Bk < 1 (1/2 pt.) (1/2 pt.50 (AAA Yield) (1/2 pt) #5: P/NCA < 1 (1 pt.67 (AAA Yield) (1 pt.33 (AAA Yield) (1/2 pt.4 (Avg.) P/E < .) #4: D/P > .33 (1/2 pt.) #3: P/Bk < 2/3 (1 pt.) P/NCA < 1. P/E in last 3 yrs.) D/P > .D.) E/P > 1.) .) (1 pt. Group A Criteria #1: E/P > 2 (AAA Yield) (1 pt. P/E in last 10 yrs.4 (Avg.) #2: P/E < . The Graham Model  1.

) TD/E < 1.0 (1 pt.D. (1/2 pt. Group B Criteria #6: CR > 2 (1 pt.) #7: TD/E < 1. No more than 3 declines in earnings of 5% or more in last 10 years for one-half point.) G5 > 7%/YR. .2 (1/2 pt) #8: TD/NCA < 2 (1 pt.) #9: G10 > 7%/YR.) #10: No more than 2 declines in earnings of 5% each over the last 10 years for one full point. (1 pt.8 (1/2 pt.) NCA > 0 (1/2 pt. The Graham Model (continued)  2.) CR > 1.

10. Avoid weekend worrying. 4. Don’t be intimidated by professionals 2. 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 expect too much. 6. Think long-term. 8. 3. too soon. Do not get scared out of good stocks. Own your mind. Never invest in a company without first understanding its finances. Do not have more than you can handle. . 9. 7. Don’t even try to predict the future.Contemporary Fundamentals:  Peter Lynch’s Ten Golden Rules of Investing: 1. 5.

4. 3. Trying to time the market.Contemporary Fundamentals:  Peter Lynch’s mistakes to avoid: 1. Becoming too concerned over whether the stock market is going up or down. 5. . Not knowing the story behind the company in which you are buying stock. Thinking that this year will be any different than any other year. 2. Buying stocks for the short-term.

The stock market isn’t a gamble. but it takes a long time to make money. You have to research the company before you put money into it. A good company usually increases its dividends every year. You can lose money in a very short time. 3.Contemporary Fundamentals:  Lynch Maxim’s: 1. 4. and not just because of the stock price. as long as you pick good companies that you think will do well. . 2.

but because you know a lot about it. by Peter Lynch .) 5. always have an open mind. 7.Lynch Maxim’s (cont. Over the long-term it is generally better to buy stocks in small companies. 8. When you invest in the stock market you should always diversify. 9. Never buy a stock because it is cheap. 11. You should invest in several stocks (5). Source: One Up On Wallstreet. Never fall in love with a stock. Do your homework. 10. 6. Just because a stock goes down doesn’t mean it can’t go lower.

000 and started a brilliant investment career. Forbes Magazine said. Templeton is generally regarded as one of the world’s wisest and most successful investors. . Many regard Sir John as the greatest Wallstreet Investor of all time. “Templeton is one of a handful of true investment greats in a field of crowed mediocrity and bloated reputations. which enabled him to be one of two investors to become billionaires solely through their investment prowess.Sir John Marks Templeton  Who is Sir John Marks Templeton? John Templeton borrowed $10.” Templeton holds that the common denominator connecting successful people with successful enterprises is a devotion to ethical and spiritual principles. Templeton has had decade after decade of 20% plus annual returns and managed over $6 Billion in assets.

Buy low. 8. Search for bargains among quality stocks. Do not take the word of experts. Invest for maximum total real return including taxes and inflation. Buy what others are despondently selling. Do your homework. There is safety in numbers. Invest. 3. . Remain flexible and open-minded about types of investments. 7. 6. Investigate before you invest. 2. 4. Diversify. Don’t trade or speculate. No one kind of investment is always best. Then sell what others are despondently buying. Buy value not market trends or economic value. 5.Sir John Mark Templeton  Sir John’s 16 Rules for Investment Success: 1.

11. Never invest in an IPO. Begin with prayer. Aggressively monitor your investments. Outperforming the market is a difficult task. Sometimes you won’t have everything sold as the market crashes. Stocks.S. 14. 13. . Once the market has crashed. 16. Success is a process of continually seeking answers to new questions. 15. 12. Do not be fearful or negative too ofter. 10. Learn from your mistakes. Never invest on a tip.Templeton’s 16 Rules (Cont. you will think more clearly. don’t sell unless you find another more attractive undervalued stock to buy. but do not dwell on them. you must outthink the managers of the largest institutions. For 100 years optimists have carried the day in U. Do not invest on sentiment. Run the numbers and research the quality of management. Don’t panic. There is no free lunch.) 9.

Change your perspective to that of a business owner and learn as much as possible about the business and industry. Manage a portfolio of businesses.Warren Buffett-the Sage of Omaha  Buffett’s Four Steps to Investing: 1. Don’t worry about the economy. 2. . 3. Buy a business. not a stock. Turn off the stock market. 4. Don’t diversify for diversification’s sake.

and you are courting disaster. If you’re not supremely confident about the future of each stock in your small portfolio. We don’t believe in the Noah’s Ark principle of investing. the fewer stocks you have. there’s no need to diversify for safety.Buffett on Diversification You can’t be a Bo Jackson in investing. . You should never own more than ten stocks. perhaps you should never have invested in it. Then you have a zoo. Remember. the more time you can spend becoming an expert in them . winding up with two of everything. Spread your energies and your capital too many ways. If you have really taken your time and only picked stocks that are bona-fide doozies.

not because of the position of others but because your facts and your reasoning are right. . You need a temperament that derives great pleasure neither from being with the crowd nor against the crowd.Buffett on the Ideal Investor Personality The most important quality for an investor is temperament. You don’t have to be able to play three-dimensional chess or duplicate bridge. You know you’re right. not intellect. You don’t need tons of IQ in this business.

Buffet’s Tenets of Investing:  Buffet’s Business Tenets for Investing: 1. Are earnings (net income) increasing and is the ROE consistently high (25-30%).” . Does the business have a consistent operating history over time. Does the business have an identifiable consumer monopoly or franchise product? 3. -. 4. it’s how well you define the parameters.Warren Buffett . That gets to having what I call a franchise of some sort. 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. Is the business simple and understandable? 2. It’s not how big the circle is that counts.Warren Buffett “Good Businesses are the ones that in some way are reasonably sheltered from competition.

but simple behavior is more effective. 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.)  Buffet’s Management Tenets: 5. Does management express that they are committed to the best interests of the shareholder’s total return on investment. Is management rational? Does the management use excess cash to “buy back” stock and issue dividends. or expand company into low return investments.Warren Buffett .Buffet’s Tenets (Cont. -. 6.

.Warren Buffett “The Margin of error is the cornerstone of our investment philosophy: Never count on making a good sale. 9.” Warren Buffett. Have the purchase price be so attractive that even a mediocre sale gives good results. “A great investment opportunity occurs when a marvelous business encounters a onetime huge but solvable problem.Buffett’s Tenets (Continued): 7. How much does the business have to spend on maintaining operations (check out operating ratios).Warren Buffett.” .” -. Can the Company adjust prices during inflation? “Our favorite holding period is forever. Does the Company have less than 30% debt? 8.

Seek out companies that produce cash in excess. depletion. Calculate owner earnings. -. and amortization. EPS is meaningless. Therefore. Owner earnings is equal to net income plus depreciation. since the equity base can expand over time due to increased retained earnings. not earnings per share.Warren Buffett We like to buy Businesses.Buffet’s Tenets: 10. I’d rather have a $10 million business making 15% than a $100 million business making 5%. but we don’t like to sell them. 11. I have other places I can put the money. EPS does not necessarily reflect good managerial performance. Focus on return on equity. minus capital expenditures necessary to maintain its economic position and unit volume. --Warren Buffett .

. For every dollar retained.Buffet’s Tenets: 12. Remember companies with high costs will always come up with new ways to spend more. Calculate the retained earnings to market value ratio (use a 10 year trend). Companies with tenacious cost-cutters. Look for companies with high profit margins. Dollar created/Dollar retained. 13. make sure the company has created at least three dollars of market value.

the greater the allowance for a margin of error. The greater the difference.What is the value of the business? The cash flows of a business discounted back to today’s present value determines the intrinsic value. It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price. (At least 50%). -. .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.Buffet’s Tenets:  Buffet’s Market Value Tenets: .Warren Buffett . Discounted by the longterm treasury rate plus 2% to 4% depending on your risk preference (Buffett uses 15%).

Check the changes in operating margins.Check the company’s cash generating ability . debt levels. . and capital expenditures.Buffet’s Tenets:  Buffet’s Yearly Check-up: .Calculate return on beginning shareholder’s equity .

3. Select those stocks with Value Line Timeliness ratings of 1 or 2 and Safety ratings of 1or 2. .05. a capital structure with less than 1/3 debt. 4. Select companies with a franchise product or service. A beta of no more than 1. Look for regional or international expansion to maintain their growth. 2. Find a company with low capital expenditures. Look for a company with relatively low risk. Select companies with a long-term record and high prospects for continued growth well into the future. this eliminates the costly potential of retooling every 5 to 8 years. Check the value line in relation to price fluctuations.A Contemporary Approach for Stock Screening Using Fundamental Methods:  Ten Summary Criteria: 1.

This is one that adds more than a dollars worth of market value to every dollar retained in earnings each year. Look for an efficient company. Calculate the intrinsic value. Is management committed to its shareholders. Study the business and its franchise potential. Can the stock be purchased below the intrinsic value with a significant margin of safety? 9. 6. High profit margins. Look for buybacks with excess cash. 8. Buy when the value and discount to intrinsic value warrant a buy.) 5. and the dollar-retained-dollar added test. One dollar in retained earnings should equal three plus dollars in added market value.A Contemporary Approach (Cont. not just the financial numbers. Don’t follow the crowd. . 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. 10. Owners Earnings.

not heavily regulated.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. the substitutes that are down and upline. needed and desired. new entrants and barriers to entry. i.e. and new technologies. . Consider the existing substitutes. Or analyze a company given to you by your Professor. Step Two: Determine if the products offered by the firm are franchise products. no close substitutes.

A Contemporary Approach Cont. This should include a complete ratio and DuPont analysis.O. This should include the five forces model and a S.T. analysis.:  Step Three: Do a complete financial statement analysis as discussed in the first section of this course.  Step Four: Do a complete strategic audit as discussed in the second part of this course.  Step Five: Do a complete investment SCREEN analysis with provided spreadsheet. .W.

Investing in Equities Topic 6 IV. Technical Analysis .

90 80 70 60 50 40 30 20 10 0 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr . Definition  Technical Analysis is the belief that important information about future stock price movements can be obtained by studying the historical price movement.A.

both rational and irrational.Technical Analysis Assumptions:  Technical analysts base their buy and sell decisions on the charts they prepare of recorded financial data 1. . Changes in a trend are caused by shifts in supply and demand. despite minor fluctuations in the market. no matter why they occur. Supply and demand are governed by numerous factors. Some chart patterns tend to repeat themselves. Shifts in supply and demand. 4. Market value is determined by the interaction of supply and demand. can be detected sooner or later in charts of market transactions 6. 2. 5. 3. Security prices tend to move in trends that persist for an appreciable length of time.

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 .

Approaches to Technical Analysis  1. Daily Movements: These are meaningless random daily fluctuations. 3. The Dow Theory – The Dow theory views the movement of market prices as occurring in three categories 1.B. . 2.Secondary Movements: These are up and down movements of stock prices that last for a few months and are called corrections. Primary Movements: These are called bull and bear markets.

Approaches to Technical Analysis (continued)  2. Friday is the best. » 2. Monday is the worst day to buy stocks. If January is a good month for the market then chances are good a good year will occur. Trading Action – a. Examples include: » 1. Concentrates on minor trading characteristics in the market – b. .B.

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 . Bellwether Stocks – a. Approaches to Technical Analysis (continued)  3.B.

relative to the market. . in bear markets. Technicians believe that by investing in those securities that exhibit relative strength higher returns can be earned.Approaches to Technical Analysis (Continued):  4. in bull markets and decline less. relative to the market. Relative Strength – The basic idea behind relative strength is that some securities will increase more.

is a measure of investor interest » 1. Technical Indicators – a. STRONG when volume goes up in rising market or drops during declining market.B. . WEAK when volume goes up in declining market or decreases during a rally. Approaches to Technical Analysis (continued)  5. Market Volume -. » 2.

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. .

» 3. . » 2. Breadth of the Market » 1.B. As long as advances outnumber declines a strong market exists. The spread is used as an indicator of market strength. Considers the advances and declines in the market. Approaches to Technical Analysis (continued) – b.

it may suggest that speculation is occurring among small investors. Odd-Lot Trading: Theory of Contrary Opinion » if the amount of odd-lot purchases start to exceed odd-lot sales by a widening margin. . then the situation is optimistic. – d. Approaches to Technical Analysis (continued) – c. by historical standards. Short Interest -. This is the first signal of an upcoming bear market.B.measures the number of stocks sold short » when the level of short interest is high.

What are Bellweather stocks? Who was Peter Lynch and what is he primarily known for? What are Lynch’s 10 golden rules for investing? . Define technical analysis.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.