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Chapter 9

Picking the Equity Players

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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You buy a stock, and when it goes up, you sell it. If it doesn’t go up, don’t buy it.

Will Rogers

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Outline Introduction Stock Selection Philosophy: Fundamental

and Technical Analysis Dividends and Why They Really Do Not

Matter Investment Styles Categories of Stock

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Introduction Today’s focus is toward the overall

characteristics of portfolios• What principles in security selection are

particularly important in the construction and management of a portfolio?

• What are the principal categories of common stock?

• What are dividends?• What is preferred stock?

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Stock Selection Philosophy: Fundamental and Technical 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

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Stock Selection Philosophy: Fundamental and Technical Analysts (cont’d)

A technical analyst is firmly convinced that: • Supply and demand determine prices

• Changes in supply and demand cause changes in prices

• The changes in supply and demand can be predicted 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 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 Dividend Growth Rates

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Cash Dividends Cash dividends are distributions of the

firm’s profits to the shareholders paid via a check from the company

Cash dividends can sometimes be reinvested via dividend reinvestment plans (DRIPs)• Sometimes allow for purchase of additional

company shares at a discount

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Cash Dividends (cont’d) If shares are held in street name:

• The brokerage firm receives the dividend check

• The brokerage firm may automatically transfer funds to a money market account

• The brokerage firm ultimately allocates dividends to the shareholders

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Cash Dividends (cont’d) If the portfolio manager receives the

dividend check:• The funds are temporarily invested in a money

market instrument until:– They accumulate sufficiently to finance the

purchase of more securities

– 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 dividend Popular when a firm lacks the funds to pay

a cash dividend Popular early in the firm’s life cycle

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Property Dividends A property dividend is the distribution of

physical goods to shareholders• e.g. a firm’s products

Property dividends are rare

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Spin-Offs In a spin-off, a parent firm divests itself of a

subsidiary and distributes all shares in the subsidiary proportionally to the parent firm’s shareholders

The parent gives away the subsidiary

Spin-offs are rare

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Rights The preemptive right means shareholders

have the ability to maintain the same percentage share of ownership in a corporation when the firm sells new shares

Existing shareholders can buy new stock at a discount from market price

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Rights (cont’d) Rights are actual securities that investors

can buy or sell

Rights have a limited life• Usually expire a few weeks after issued

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Rights (cont’d) Shareholders can do three things with

rights:• Sell the rights to someone else

• Use the rights to buy more shares

• Allow the rights to expire– Like throwing away money

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Dividend Growth Rates Corporations like to establish predictable

dividend payout patterns including an annual increase in their dividends

Many fundamental analysts focus on the dividend growth rate to determine value

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Dividend Growth Rates (cont’d)

The dividend discount model:

0 10

0

1

0

(1 )

where = the current dividend

= the dividend to be paid next year

the expected dividend growth rate

the discount factor according to the riskiness of the stock

the current

D g DP

k g k g

D

D

g

k

P

stock price

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Dividend Growth Rates (cont’d)

You can solve for the required rate of return, k:• Observe the current dividend and price• Obtain the growth rate using historical

information and analysts’ estimates• Solve for k:

0

0

(1 )D gk g

P

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Dividend Growth Rates (cont’d)

Example

Assume a company just paid a dividend of $1.20 per share. Historically, the company has increased its dividends by 3 percent annually with great consistency. No analyst estimates regarding the next dividend are available. The firm’s current stock price is $20 per share.

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

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Dividend Growth Rates (cont’d)

Example (cont’d)

Solution: Using the numbers in the dividend discount model:

0

0

(1 )

1.20(1.03)0.03

200.0918 9.18%

D gk g

P

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Why Dividends Do Not Matter Payment of dividends reduces the balance in the

firm’s checking account• The firm should not be worth as much after paying a

dividend

The ex-dividend date determines whether or not you get the dividend• On the ex-dividend date, the price of a share of stock

tends to fall by about the amount of the dividend to be paid

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Theory Versus Practice Dividend policy is very important in

practice

Unexpected changes in dividend policy can result in significant changes in the market price of the associated common stock

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Theory Versus Practice (cont’d)

Most firms increase their dividend annually, and the market expects this• If management does not increase the dividend

as expected, the market views it as bad news Reducing or omitting a dividend is a very

bad signal An increase in dividends above what the

market expects is a good signal

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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 (cont’d) In a forward split (regular way split or

direct split), shareholders receive more shares as a result of the split• e.g., a two-for-one split

In a reverse split, the number of shares is reduced• e.g., 1-for-10 split

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Stock Splits (cont’d) An odd lot-generating split is a stock split

likely to result in many small investors holding odd lots• e.g., a 3-for-2 split

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Why Stock Splits Do Not Matter

Stock splits neither increase nor decrease investor’s wealth• You cannot increase the total amount available

by increasing the pieces of a pie

• e.g., a 2-for-1 split simply doubles the number of shares

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Why Firms Split Their Stock Some literature supports the existence of an

optimal trading range• A principal reason for splitting shares is “to

broaden the ownership base” Reverse splits are sometimes used to reduce

the number of shareholders• e.g., a 1-for-200 split 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 The difference between stock dividends and

stock split is an accounting phenomenon• A split alters the par value• A stock dividend means new shares are issued

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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 firm’s earnings history and balance sheet• Price/earnings 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 its

earnings per share

A forward-looking PE uses earnings forecasts

A trailing PE uses historical earnings

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Price/Book Ratio The price/book ratio is the stock price

divided by book value per share• Book value is the firm’s assets minus its

liabilities• Book value is different from market value

Value investors look for low price/book ratios

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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 company’s common stock

Typical divisions are:• Large cap ($1 billion or more)• Mid cap (between $500 million and $1 billion)• Small cap (less than $500 million)• Micro cap

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Capitalization (cont’d) If you rank large, mid, and small caps in

order of performance, the mid-cap stocks tend to stay in the middle• If you can buy only one group, it might be best

to put your money in “averaged-sized” companies rather than the large or small

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Integrating Style and Size Many money managers distribute their

assets across size and style spectrums

http://www.morningstar.com provides a style box that can classify a portfolio

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Categories of Stock Blue Chip Stock Income Stocks Cyclical Stocks Defensive Stocks Growth Stocks Speculative Stocks Penny Stocks

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Categories of Stock (cont’d) Categories Are Not Mutually Exclusive A Note on Stock Symbols

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Blue Chip Stock Blue chip has become a colloquial term

meaning “high quality”• Some define blue chips as firms with a long,

uninterrupted history of dividend payments• The term blue chip lacks precise meaning, but

some examples are:– Coca-Cola– Union Pacific– General Mills

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Income Stocks Income stocks are those that historically

have paid a larger-than-average percentage of their net income after taxes as dividends• The proportion of net income after taxes paid

out as dividends is the payout ratio• The proportion of net income after taxes

retained is the retention ratio Examples include Consolidated Edison and

Allegheny Energy

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Cyclical Stocks Cyclical stocks are stocks whose fortunes

are directly tied to the state of the overall national economy

Examples include steel companies, industrial chemical firms, and automobile producers

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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