Chapter 10

Picking the Equity Players

Prof. Rushen Chahal

Prof. Rushen Chahal

You buy a stock, and when it goes up, you sell it. If it doesn t go up, don t buy it.

- Will Rogers

Prof. Rushen Chahal

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

Prof. Rushen Chahal

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?

Prof. Rushen Chahal

Stock Selection Philosophy

Fundamental analysis Technical analysis

Prof. Rushen Chahal

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.

Prof. Rushen Chahal

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

Prof. Rushen Chahal

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

Prof. Rushen Chahal

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

Prof. Rushen Chahal

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

Prof. Rushen Chahal

10

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

Prof. Rushen Chahal

11

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 or They are paid as income to the fund beneficiary

Prof. Rushen Chahal

12

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 firm s life cycle

Prof. Rushen Chahal

13

Property Dividends
A property dividend is the distribution of physical goods to shareholders
E.g. a firm s products

Property dividends are rare

Prof. Rushen Chahal

14

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
Prof. Rushen Chahal 15

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

Prof. Rushen Chahal

16

Rights (cont d)
Rights are actual securities that shareholders can buy or sell Rights have a limited life
Usually expire a few weeks after issued

Prof. Rushen Chahal

17

Rights (cont d)
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

Prof. Rushen Chahal

18

Issues Surrounding the Payment of Dividends

Chronology of events Dividend growth rates

Prof. Rushen Chahal

19

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

Prof. Rushen Chahal

20

Chronology of Events (cont d)

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

Prof. Rushen Chahal

21

Chronology of Events (cont d)

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

Prof. Rushen Chahal

22

Chronology of Events (cont d)

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.

Prof. Rushen Chahal

23

Chronology of Events (cont d)

Example (cont d)
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.

Prof. Rushen Chahal

24

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

Prof. Rushen Chahal

25

Dividend Growth Rates (cont d)

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
Prof. Rushen Chahal 26

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:

D0 (1  g ) k! g P0
Prof. Rushen Chahal 27

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?

Prof. Rushen Chahal

28

Dividend Growth Rates (cont d)

Example (cont d)
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%

Prof. Rushen Chahal 29

Why Dividends Do Not Matter

Payment of dividends reduces the balance in the firm s 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

Prof. Rushen Chahal

30

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

Prof. Rushen Chahal

31

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

Prof. Rushen Chahal

32

Stock Splits Versus Stock Dividends

Stock splits Why stock splits do not matter Why firms split their stock Stock dividends

Prof. Rushen Chahal

33

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

Prof. Rushen Chahal

34

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

Prof. Rushen Chahal

35

Stock Splits (cont d)

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

Prof. Rushen Chahal

36

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

Prof. Rushen Chahal

37

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 splits eliminates all shareholders holding fewer than 200 shares

Prof. Rushen Chahal

38

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
Prof. Rushen Chahal 39

Investment Styles
Value investing Growth investing Capitalization Integrating style and size

Prof. Rushen Chahal

40

Value Investing
Definition Price/earnings ratio Price/book ratio

Prof. Rushen Chahal

41

Definition
Value investors look for undervalued stock Utilize the firm s earnings history and balance sheet
PE ratio, price/book ratio

Place much emphasis on known facts

Prof. Rushen Chahal 42

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

Prof. Rushen Chahal

43

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

Prof. Rushen Chahal

44

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

Prof. Rushen Chahal

45

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

Prof. Rushen Chahal

46

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

Prof. Rushen Chahal

47

Categories of Stock
Blue chip stock Income stocks Cyclical stocks Defensive stocks Growth stocks Speculative stocks Penny stocks
Prof. Rushen Chahal 48

Categories of Stock (cont d)

Categories are not mutually exclusive A note on stock symbols

Prof. Rushen Chahal

49

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

Prof. Rushen Chahal

50

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

Examples include Consolidated Edison and Allegheny Energy

Prof. Rushen Chahal 51

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

Prof. Rushen Chahal

52

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

Prof. Rushen Chahal

53

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

Prof. Rushen Chahal

54

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

Prof. Rushen Chahal

55

Penny Stocks
Penny stocks are inexpensive shares Penny stocks sell for $1 per share or less

Prof. Rushen Chahal

56

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

Prof. Rushen Chahal

57

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

Prof. Rushen Chahal

58