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Chapter 10

Picking the Equity Players

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You buy a stock, and when it goes up, you sell
it. If it doesnt go up, dont buy it.

- Will Rogers

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Outline
Introduction
Stock selection philosophy
Dividends and why they really do not
matter
Investment styles
Categories of stock

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Introduction
Todaysfocus is toward the overall
characteristics of portfolios
What principles in security selection are
particularly important in the construction and
management of a portfolio?
What are the principal categories of common
stock?
What are dividends?
What is preferred stock?
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Stock Selection Philosophy
Fundamental analysis
Technical analysis

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Fundamental Analysis
A fundamental analyst tries to discern the logical
worth of a security based on its anticipated
earnings stream

The fundamental analyst considers:


Financial statements
Industry conditions
Prospects for the economy
Etc.

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Technical Analysis
A technical analyst attempts to predict the
supply and demand for a stock by observing
the past series of stock prices

Financial statements and market conditions


are of secondary importance to the technical
analyst

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Dividends and Why They
Really Do Not Matter
Types of dividends
Issues surrounding the payment of
dividends
Why dividends do not matter
Theory versus practice
Stock splits versus stock dividends

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Types of Dividends
Cash dividends
Stock dividends
Property dividends
Spin-offs
Rights

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Cash Dividends
Cash dividends are distributions of the
firms profits to the shareholders paid via a
check from the company
Cash dividends can sometimes be
reinvested via dividend reinvestment
plans (DRIPs)
Sometimes allow for purchase of additional
company shares at a discount
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Cash Dividends (contd)
If shares are held in street name:
The brokerage firm receives the dividend check

The brokerage firm may automatically transfer


funds to a money market account

The brokerage firm ultimately allocates


dividends to the shareholders
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Cash Dividends (contd)
Ifthe portfolio manager receives the
dividend check:
The funds are temporarily invested in a money
market instrument until:
They accumulate sufficiently to finance the purchase
of more securities or

They are paid as income to the fund beneficiary

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Stock Dividends
Stock dividends are paid in additional
shares of stock rather than in cash
Typically announced as a percentage
E.g., 10 percent stock dividends
Popular when a firm lacks the funds to pay
a cash dividend
Popular early in the firms life cycle

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Property Dividends
A propertydividend is the distribution of
physical goods to shareholders
E.g. a firms products

Property dividends are rare

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Spin-Offs
In a spin-off, a parent firm divests itself of a
subsidiary and distributes all shares in the
subsidiary proportionally to the parent
firms shareholders

The parent gives away the subsidiary

Spin-offs are rare


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Rights
The preemptive right means shareholders
have the ability to maintain the same
percentage share of ownership in a
corporation when the firm sells new shares

Existing shareholders can buy new stock at


a discount from market price

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Rights (contd)
Rights
are actual securities that shareholders
can buy or sell

Rights have a limited life


Usually expire a few weeks after issued

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Rights (contd)
Shareholders can do three things with
rights:
Sell the rights to someone else

Use the rights to buy more share

Allow the rights to expire


Like throwing away money
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Issues Surrounding the
Payment of Dividends
Chronology of events
Dividend growth rates

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Chronology of Events
Date of declaration
The day the board announces the dividend
Once declared, the dividend becomes a legal
liability of the company

Date of payment
The company mails dividend checks

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Chronology of Events (contd)
Date of record
Establishes who will receive dividend checks

Shareholders of record are listed on the


company records as being owners of the
company on the date of record

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Chronology of Events (contd)
Ex-dividend date
Two business days prior to the date of record
If you buy the stock before the ex-dividend
date, you will get the next dividend
If you buy the stock on the ex-dividend date,
you will not get the next dividend
Eliminates any ambiguity about who is entitled
to the dividend
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Chronology of Events (contd)
Example

Consider the following dividend announcement by AECI (a specialty


chemical company) on August 2, 2000:

Notice is hereby given that an interim dividend of 30 cents per share, in


respect of the year ending 31 December 2000, has been declared to
holders of ordinary shares registered in the books of the Company at the
close of business on 18 August 2000. Payment will be made from the
office of the transfer secretaries in Johannesburg on 27 September
2000.

Identify the four relevant dividend dates.


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Chronology of Events (contd)
Example (contd)

Solution:
The date of declaration is August 2, 2000.

The date of record is August 18, 2000.

The date of payment is September 27, 2000.

The ex-dividend date is August 16, 2000.


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Dividend Growth Rates
Corporationslike to establish predictable
dividend payout patterns including an
annual increase in their dividends

Many fundamental analysts focus on the


dividend growth rate to determine value

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Dividend Growth
Rates (contd)
The dividend discount model:
D0 (1 g ) D1
P0
kg kg
where D0 = the current dividend
D1 = the dividend to be paid next year
g the expected dividend growth rate
k the discount factor according to the riskiness of the stock
P0 the current stock price

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Dividend Growth
Rates (contd)
You can solve for the required rate of return,
k:
Observe the current dividend and price
Obtain the growth rate using historical
information and analysts estimates
Solve for k:
D0 (1 g )
k g
P0
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Dividend Growth
Rates (contd)
Example

Assume a company just paid a dividend of $1.20 per


share. Historically, the company has increased its
dividends by 3 percent annually with great consistency.
No analyst estimates regarding the next dividend are
available. The firms current stock price is $20 per share.

What is an estimate of the required rate of return for this


stock?

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Dividend Growth
Rates (contd)
Example (contd)

Solution: Using the numbers in the dividend discount


model:
D0 (1 g )
k g
P0
1.20(1.03)
0.03
20
0.0918 9.18%
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Why Dividends Do Not Matter
Payment of dividends reduces the balance in the
firms cash account
The firm should not be worth as much after paying a
dividend

The ex-dividend date determines whether or not


you get the dividend
On the ex-dividend date, the price of a share of stock
tends to fall by about the amount of the dividend to be
paid
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Theory Versus Practice
Dividend policy is very important in
practice

Unexpected changes in dividend policy can


result in significant changes in the market
price of the associated common stock

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Theory Versus
Practice (contd)
Most firms increase their dividend annually,
and the market expects this
If management does not increase the dividend
as expected, the market views it as bad news
Reducing or omitting a dividend is a very
bad signal
An increase in dividends above what the
market expects is a good signal
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Stock Splits Versus
Stock Dividends
Stock splits
Why stock splits do not matter
Why firms split their stock
Stock dividends

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Stock Splits
A stock split occurs when a firm changes
the number of shares of its capital stock
without changing the aggregate value of
these shares
A stock split is generally a neutral
occurrence
The primary motivation is to reduce the price of
shares to bring it into an optimal trading range
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Stock Splits (contd)
In a forward split (regular way split or
direct split), shareholders receive more
shares as a result of the split
E.g., a two-for-one split
In a reverse split, the number of shares is
reduced
E.g., 1-for-10 split

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Stock Splits (contd)
Odd lot-generating splits are stock split
likely to result in many small investors
holding odd lots
E.g., a 3-for-2 split

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Why Stock Splits
Do Not Matter
Stocksplits neither increase nor decrease
investors wealth
You cannot increase the total amount available
by increasing the pieces of a pie

E.g., a 2-for-1 split simply doubles the number


of shares

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Why Firms Split Their Stock
Someliterature supports the existence of an
optimal trading range
A principal reason for splitting shares is to
broaden the ownership base
Reverse
splits are sometimes used to reduce
the number of shareholders
E.g., a 1-for-200 splits eliminates all
shareholders holding fewer than 200 shares
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Stock Dividends
Stock dividends are not different from stock
splits for the investor
E.g., a 100 percent stock dividend is the same
as a 2-for-1split
Thedifference between stock dividends and
stock split is an accounting phenomenon
A split alters the par value
A stock dividend means new shares are issued
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Investment Styles
Value investing
Growth investing
Capitalization
Integrating style and size

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Value Investing
Definition
Price/earnings ratio
Price/book ratio

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Definition
Value investors look for undervalued stock

Utilize the firms earnings history and


balance sheet
PE ratio, price/book ratio

Place much emphasis on known facts


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Price/Earnings Ratio
The PE ratio is stock price divided by EPS

A forward-looking PE uses earnings


forecasts

A trailing PE uses historical earnings

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Price/Book Ratio
Theprice/book ratio is the stock price
divided by book value per share
Book value is the firms assets minus its
liabilities
Book value is different from market value

Value investors look for low price/book


ratios
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Growth Investing
Growth investors look for price momentum
Look for stocks that are in favor and have been
advancing
Look for stocks that are likely to be propelled
even higher
The market moves in cycles
Many investors own both growth and value
stocks
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Capitalization
Capitalization
refers to the aggregate value
of a companys common stock

Typical divisions are:


Large cap ($1 billion or more)
Mid-cap (between $500 million and $1 billion)
Small cap (less than $500 million)
Micro cap
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Integrating Style and Size
Many money managers distribute their
assets across size and style spectrums

www.morningstar.com provides a style box


that can classify a portfolio

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Categories of Stock
Blue chip stock
Income stocks
Cyclical stocks
Defensive stocks
Growth stocks
Speculative stocks
Penny stocks
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Categories of Stock (contd)
Categories are not mutually exclusive
A note on stock symbols

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Blue Chip Stock
Blue
chip has become a colloquial term
meaning high quality
Some define blue chips as firms with a long,
uninterrupted history of dividend payments
The term blue chip lacks precise meaning, but
some examples are:
Coca-Cola
Union Pacific
General Mills

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Income Stocks
Income stocks are those that historically
have paid a larger-than-average percentage
of their net income as dividends
The proportion of net income paid out as
dividends is the payout ratio
The proportion of net income retained is the
retention ratio
Examplesinclude Consolidated Edison and
Allegheny Energy
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Cyclical Stocks
Cyclical stocks are stocks whose fortunes
are directly tied to the state of the overall
national economy

Examples include steel companies,


industrial chemical firms, and automobile
producers

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Defensive Stocks
Defensive stocks are the opposite of
cyclical stocks
They are largely immune to changes in the
macroeconomy and have low betas

Examples include retail food chains,


tobacco and alcohol firms, and utilities

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Growth Stocks
Growth stocks do not pay out a high
percentage of their earnings as dividends
They reinvest most of their earnings into
investment opportunities

Many growth stocks do pay dividends

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Speculative Stocks
Speculative stocks are those that have the
potential to make their owners rich quickly
Speculative stocks carry an above-average
level of risk
Most speculative stocks are relatively new
companies with representation in the
technology, bioresearch, and pharmaceutical
industries
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Penny Stocks
Penny stocks are inexpensive shares

Penny stocks sell for $1 per share or less

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Categories Are Not
Mutually Exclusive
An income stock or a growth stock can also
be a blue chip
E.g., Potomac Electric Power

Defensive or cyclical stocks can be growth


stocks
E.g., Dow Chemical is a cyclical growth stock

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A Note on Stock Symbols
Ticker symbols are identification codes
Stock symbols have one to four letters
One, two, or three letters identifies a stock
listed on either the NYSE or the AMEX

Four-digit symbols identify firms traded on the


Nasdaq

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