CHAPTER12 Investing in Stocks Popular e-mail circulated about the Internet in 2002: “If you had invested $1,000 in Nortel Networks stock last year, you would have $50. If you had purchased $1,000 of Budweiser beer, drank the beer and returned the cans, you would have $78. Our stock tip for today is to start drinking heavily.” In 2009, the same e-mail was circulating, but Nortel Networks was replaced by AIG and Citigroup.
Investing in Stocks • Stocks represent ownership in a corporation • Stocks are Equity Financing – “Equities” • (Versus Bonds which are Debt Financing) • Why do corporations issue stock? • To raise money to start or expand a business • To help pay for ongoing business expenses • As a way to gain prestige and respect within the industrial community • As a method of payment for those who started the firm • The corporation doesn’t have to repay the money • But the corporation is now a public entity
Why Do Investors Purchase Stock? • Share in success of the corporation • Although you are part owner of the business, your liability is limited only to your investment • Income from dividends • Earnings distributed to the shareholders • Dollar appreciation of stock value • a.k.a. Capital Gains • Possible increased value from Stock Splits (?) total return = dividends + capital gains There is no increased value from stock splits. If you had 1 share at $100, now you have 2 shares at $50; the value is still $100. It is a psychological increase at best. Warren Buffet of Berkshire Hathaway has refused to split his stock since its inception. A single shares now goes for around $185,000!
Historical Returns • Historically, stocks have returned 8% to 10% • However, traditionally, half of that return was from dividends • Stockholders used to expect 4% to 6% in dividends each year – That was as much or often more than bonds returned in interest since stocks were considered much riskier than bonds • In the 1980’s and 1990’s, dividends fell to less than 2% and then down to 1% in 2000 • Capital gains were what people wanted • But recently, dividends have risen to over 2% • This is at a time when savings accounts at banks and credit unions are paying less than ½%
If stocks are the best long-term investment, how come they are considered sorisky? • “For two decades after the Crash of ’29, stocks were regarded as gambling by a majority of the population. This impression wasn’t fully revised until the late 1960’s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments and dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not.” – Peter Lynch • The Cocktail Party Theory
Rolling 10-Year Period Returns 20% 15 10 5 0 Rolling 10-Year Periods 2003-12 1928–37 1933–42 1938–47 1943–52 1948–57 1958–67 1963–72 1968–77 1973–82 1978–87 1983–92 1988–97 1993–02 1998–07 1953–62 Source: The unmanaged Dow Jones Industrial Average, based on average annual compound returns over 10-year periods.
Risks of Stocks • Business Failure Risk – the company could fail • Market Risk – the market as a whole could plummet • Global Investment Risk – a.k.a. Foreign Risk • Traditionally, most other countries did not have the same standards of accounting as the United States • But that has all changed – Many are better now! • Currency Risk • Will the dollar be stronger or weaker over the next 10 to 20 years? • Liquidity Risks • Not usually a problem with stocks • Except for very small company “penny” stocks
Reducing Risks of Stocks • Risk is difficult to measure • Even more difficult to anticipate • Emphasizing large company stocks which pay consistently rising dividends has been one of the best strategies for reducing risk • Diversification is another major strategy for reducing risk • The NAIC Five Stock Rule of Thumb • One will do poorly and make you sad • Three will do average (follow the market) • One will explode and make you very happy • Time is the last and best major strategy • Over time, stocks have done very, very well
Scams • It certainly has not helped the cause of stock investing that there are many, many scams out there ready to take your money • One of the oldest and still most prevalent is called “Pump ‘n’ Dump” • Scam artists pump up the price of a stock • Rumors, Lies, Innuendos and now Spam E-mail! • The Buzz drives up the stock price • The scammers dump their shares at a large profit • Price plummets when the suckers realize they have been taken • Usually reserved for “penny stocks”
Manias • Occasionally, investors get caught up in what are called “manias” (a.k.a. “bubbles”) • The Internet was the latest stock market mania • Before that, there was the “Nifty-Fifty” of the early 1970’s • The mania of the 1920’s caused the Crash of ‘29 • In the 1840’s, there were 400 railroad firms • The “Granddaddy of all Manias” was the Dutch tulip bulb craze of the early 1600’s • Each time, the phrase was… • “It’s a New Era” or • “It’s Different This Time” or • “The old ways of valuing stock are gone” • Each time, they were wrong! “Extraordinary Popular Delusions and the Madness of Crowds” A great read!
Stocks and Taxes • Short-term Capital Gains • Gains from holding a stock less than one year • Taxed at the investor’s marginal tax rate (like income) • Long-term Capital Gains are taxed at a much lower rate • Reward investor for having a long-term perspective • Big difference for the very wealthy • Dividends were traditionally taxed as income • Traditionally, taxed at your marginal tax rate • But now they are taxed at the same low rate as long-term capital gains • Has been a huge windfall for the very wealthy
Stock Accounts • Traditional brokerage firms • Full-service Brokers versus Discount Brokers • Internet brokerage firms • Sometimes called “Deep Discount Brokers” • Other low-cost options • Low Cost Direct Investment Plans • DRIPs – Dividend Reinvestment Plans • NAIC – National Association of Investors Corp • Certificate form • Only if you are the kind of person who stuffs their money in the mattress Stock Certificate Examples
Brokerage Firms and Account Executives • Traditional brokerage firms will assign you to an account executive (a.k.a. stockbroker, financial planner, financial representative) • Licensed individual who buys and sells securities for his or her clients • Brokers are paid by commission • Sometimes accused of churning • Excessive buying and selling of securities to generate commissions • Discount broker versus full service brokers • How much advice do you want? You can research your potential broker or brokerage firm at www.finra.org
Classification of Stock Investments • Blue chip stock • Safe investment in strong and respected companies • Often referred to as value stocks • Attracts conservative investors • Examples: General Electric, AT&T, Coca-Cola • Income stock • Pays higher than average dividends • Normally slow growth company in a mature industry • Examples: Utility stocks, Banks
Classification of Stock Investments (continued) • Growth stock • Earns above average profits of all firms in the economy • Growth rate 15% to 20% or higher • Often no dividends at all • Or a very small token amount • Most of profits are reinvested into the company • Stock price should go up as business grows • But usually very volatile • Examples: Intel, Dell, Microsoft Wait a minute! Are Intel, Dell, & Microsoft growth stocks anymore?
Classification of Stock Investments (continued) • Cyclical stock • Follows the business cycle of advances and declines in the economy • Examples: automobiles, timber, and steel • Now, computer chips! • Defensive stock • Remains stable during declines in the economy • Examples: Kellogg’s, Procter & Gamble, Pfizer
Classification of Stock Investments (continued) • Turnaround stock – a.k.a. “Goner” • A company that has fallen on hard times • Is there potential for a rebound? • Example: Chrysler in the early ’80s, GM now • Asset play stock • A company this is sitting on an asset that could be sold or spun off • Example: Several years ago, JCPenney was not doing well but it has an insurance division that it could have easily sold to raise cash to have kept the company afloat if it had gotten into trouble • Penny stock • Butterfly.com, Flim-Flam Inc., etc.
What Type of Stock is … ? • Johnson & Johnson • ExxonMobil • Google • Sempra (SDG&E) • General Mills • International Paper • Union Pacific Railroad • General Motors • Flim-Flam, Incorporated • General Dynamics Blue Chip Stock Income Stock Growth Stock Cyclical stock Defensive Stock Turn-around Stock Asset Play Stock Penny Stock
Securities Marketplaces • A marketplace where brokers who represent investors meet to buy and sell securities • New York Stock Exchange (NYSE) – The Big Board • Now owned by a derivatives trading firm in Atlanta! • American Stock Exchange (AMEX) – The Curb • Now called the NYSE MKT (?) • NASDAQ • The Over-the-Counter (OTC) markets • Bulletin Board & Pink Sheets (Stay far away from these!) For hundreds of years, marketplaces were (and still are for the NYSE and NYSE MKT, nee AMEX) centralized locations. With today’s technology, the vast majority of transactions now occur electronically. Eventually, the centralized locations will probably disappear.
Stock Market Indexes • To gauge the current condition of stocks in general, financial professionals have created various stock market indexes • An market index is essentially just a list of stocks • Dow Jones Industrial Average – the “Dow” • 30 of the largest & best-known U.S. companies • Standard & Poor’s 500 – the “S&P 500” • The 500 largest companies in the United States • NASDAQ Composite – the “NASDAQ” • Mostly comprised of high-tech companies
Other Stock Market Indexes • Dow Jones U.S. Total Stock Market Index • (nee Wilshire 5000) • Approximately 5,000 stocks (large, medium, & small) • Designed to be a gauge of the entire stock market • a.k.a. Total Market Index • Russell 2000 • Represents small to medium sized companies • MSCI World Index ( MSCI All Country World Index) • Designed to represent the global stock market • Being replaced by the MSCI All Country World Index • MSCI EAFE ( MSCI All Country World Index ex-USA) • “Europe, Australia, and the Far East” • Represents foreign markets (without the U.S.) • Being replaced by the MSCI ACWI ex-USA
Bull Markets versus Bear Markets • Bull market • Investors are optimistic • More investors are buying stock and the stock market increases • Bear market • Investors are pessimistic • More investors are selling stock so the stock market declines • Normally defined as a 20% or more decline • Versus a “market correction” • 5%, 10% or 15% decline
Stock Analysis: Where do you start? • “Show me the numbers” • Benjamin Graham, Author of The Intelligent Investor • There are dozens and dozens of numeric measures • Some of the most popular over the years have been… • Capitalization • Book Value • Earnings per Share • Price / Earnings Ratio • Dividend Yield (a.k.a. Current Yield)
Capitalization • Market Capitalization • The number of shares outstanding times the current price of the stock • What the company is actually worth (according to investors) • Large-cap stocks • Greater than $10 billion • “Mega cap” stocks – $100’s of billions (GE, Wal*Mart) • Mid-cap stocks • $1 or $2 billion to $10 billion • Small-cap stocks • $50 million (“micro cap”) to $1 or $2 billion • Penny stocks • Typically sell from less than $1.00 to $5.00 per share
Capitalization (continued) • Example: • Price $50.00 • Number of Shares * 2,000,000 ——————— • Market capitalization = $100,000,000 • This is a small-cap stock The stock price is (for the most part) irrelevant. You must look at the market cap to see what the value of the company is. Examples follow when we get to numeric measures.
Numeric Measures to Consider When Evaluating a Stock • Book Value • Net worth of company determined by deducting all liabilities from the corporation’s assets and dividing the remainder by the number of outstanding shares of common stock • For many years, it was rarely close to the stock price – often one-fifth or one-sixth less • Now much closer to the stock price (often ½ less) • If the stock price is lower than the book value, then there is the danger of the company being “raided” for the assets and put out of business Remember our net worth statements?
Numeric Measures to Consider When Evaluating a Stock (continued) • Earnings Per Share • Corporation’s after-tax earnings divided by the number of outstanding shares of common stock • Look for growing earnings per share! • Price-Earnings (P/E) ratio • Price of one share of stock divided by the earnings per share of stock over the last 12 months • A low price-earnings ratio usually means the stock is a less risky investment Why would we want to own a business? Because businesses are in business to earn money!
Earnings Per Share • Example: • Earnings $2,500,000 • Number of Shares 5,000,000 $2,500,000 • Earnings Per Share = ———————— = 5,000,000 • Earnings Per Share = $0.50 Example: Page 384
Price / Earnings Ratio • Example: • Price $10.00 • Earnings per Share $0.50 $10.00 • Price / Earnings Ratio = ——————— = $0.50 • Price / Earnings Ratio = 20 • a.k.a. P/E, PE Example: Page 384
Price / Earnings Ratio • Historically • A P/E Ratio of 20 or above was considered high and reserved only for the fastest growing stocks • A P/E Ratio of 5 to 15 was considered average • Currently • For almost thirty years, a P/E Ratio of 40 to 50 was not uncommon among growth stocks (i.e. $tarbuck$, Google) • Once during the Internet mania, eBay’s P/E was 10,000! • P/E’s ratios fall dramatically when the market falls • The P/E Ratio essentially tells you what the market believes the prospects for a company are • Also gives you an idea of how long in years it will take the company to earn its price • P/E of 20 means it will take 20 years to earn the price
Dividend Yield • Dividend Yield • Yearly dollar amount of income generated by a stock divided by the current market price • Historically (review) • Dividend Yields were in the 4% to 6% range • Currently(review) • Dividend Yields are typically in the 2% to 3% range (Many are 0% − they pay no dividends) • The Dividend Yield allows you to compare stocks to other investments • Such as savings accounts or bonds
Dividend Yield • Example: • Dividends per Year $1.40 • Current Market Price $87.50 $1.40 • Dividend Yield = ————————— = $87.50 • Dividend Yield = 0.016 = 1.6% Example: Page 386
Numeric Measures Examples Walmart versus Target Data as of March 31, 2014. If you just looked at the price, you would think Target is worth about the same as Walmart. Look at the market capitalization. Walmart is worth over 6 times more than Target!
Numeric Measures Examples (continued) McDonald’s versus Yum Brands Data as of March 31, 2014.
Numeric Measures Examples (continued) AT&T versus Verizon Data as of March 31, 2014. Look at those dividends! Would you invest in either of these companies? Consider: Do you think people will ever give up their mobile phones?
Investment Theories • Fundamental Analysis • Based on the assumption that a stock’s intrinsic or real value is determined by the company’s future earnings • Fundamentalists consider the… • Financial strength of the company • Type of industry company is in • New-product development • Economic growth of the overall economy I side with the fundamental analysts.
Investment Theories (continued) • Technical Analysis • Based on the assumption that a stock’s value is determined by the forces of supply and demand in the stock market as a whole • Not based on expected earnings or the intrinsic value of a stock but rather on factors found in the market as a whole • Chartists plot past price movements and other market averages to observe trends they use to predict a stock’s future value I think these folks are all wet.
Investment Theories (continued) • Efficient Market Theory • Sometimes called the random walk theory • Based on the assumption that stock price movements are purely random • A stock’s current market price reflects its true value • Wall Street Journal’s “darts vs the experts” finds sometimes experts win, sometimes not • They believe it is impossible for someone to outperform the stock market over the long-term • Yet there are many long-term investors who do (?) These people believe that the folks who do beat the market are just lucky. That may be true for short-term investors, but not for the long-term investors who consistently beat the market.
Stock Buying Strategies • Buy and Hold • Use fundamental analysis to identify high-quality companies at reasonable prices • “Hold it forever” • Warren Buffet • The Buy and Hold Strategy works well with… • Dollar Cost Averaging (Remember this?) • Dividend Reinvestment Plans (a.k.a. DRIPs) • Low cost investment plans that bypass brokers I am a “Buy and Hold” kinda’ guy.
Stock Buying Strategies (continued) • Momentum Trading – Dumb • Uses what is called the “Greater Fool” Theory • “Buy High, Sell Higher” • Sector Analysis – Dumber • Buy stocks in hot sectors; sell stocks in stale ones • Market Timing – Dumbest • Buy as interest rates decline; sell before rates rise • Contrarian – Very smart but also very difficult • Buy when others are selling; sell when others are buying Investors like Warren Buffet are contrarians.
Stock Selling Strategies • “Sell when the stock hits its Target Price” • Analysts often set a “target price” for a stock using whatever numeric metric they believe in • “Sell when the stock is overvalued” • You have to decide what “overvalued” means • “Sell when the story changes” • Peter Lynch • If the reason or reasons you bought the stock change, then consider selling • “Sell when you have a better investment offer” • If another stock is a better buy, swap investments • “Sell when you need the money”
Asset Allocation • Fancy term for… • “How much should I have in stocks, bonds, etc.?” • Many advisors suggest a formula such as… • Subtract your age from 100 (or 110 or 120) • That’s the percentage of stocks you should own • The rest should be in bonds and “cash” • Example: A 40-year-old would have 100-40 or 60% invested in stocks and the rest (40%) in bonds • “Poppy-cock!” say others (myself included) • Buy high-quality stocks • Once you near retirement, start buying bonds • But do not give up on stocks entirely
Rebalancing • Some of those same advisors that suggest asset allocation also suggest the technique of rebalancing • Every year, check to see if your percentages are still in balance • If stocks have had a banner year, you might now be at 70/30 instead of 60/40 • Sell stocks and buy bonds to bring the balance back to 60/40 • Likewise, if stocks have tanked, sell bonds & buy stocks to bring the percentage back up to 60/40 • Forces you to “Do the right thing” • “Buy Low, Sell High”
Stocks in Retirement • Many advisors suggest that retirees shed the bulk of their stock investments in favor of bonds and cash investments • The only problem is… • People are living much, much longer • A 50-year-old living today has a 50/50 chance of living to see 100 years old! • We will revisit this when we get to mutual funds • Inflation does not retire just because you do • As you near retirement, start migrating your investments from stocks to bonds • But do not abandon stocks entirely! We will revisit this when we get to mutual funds.
Other Stock Strategies (?) • Over the years, the financial world has come up with other “strategies” to help you exploit the Wonderful World of Finance • Also, they are excellent sources of high commissions for stockbrokers (Surprise!) • These “strategies” include… • Options • Futures • Margin accounts • Selling short Please stay far, far away from these so-called strategies. You are virtually guaranteed to lose. But don’t take my word for it! Example: Optionetics.com
Information Sources • Media • Deluge of information from TV, radio, newspapers, magazines and, of course, the Internet • Most of it is extremely sensational and of highly questionable value for investment purposes • “Wisdom Sold Separately” – Nick Murray • “My advice? Turn the damned things off!” • Stock Advisory Services • Charge a fee for their reports – Available at libraries for free • Value Line, Standard & Poor’s, Moody’s, etc. • Literally hundreds – no! – thousands of other services • NAIC – National Association of Investors Corporation – www.better-investing.org • Investment Clubs Example: Yahoo!
Information Sources (continued) • BUS-123, Introduction to Investments • Hint, hint! Wink, wink! Nudge, nudge! • Books • One Up On Wall Street, Peter Lynch • Beating the Street, Peter Lynch • A Random Walk Down Wall Street, Burton Malkiel • The Intelligent Investor, Benjamin Graham • Security Analysis, Benjamin Graham • Annual and quarterly reports from companies • 10-K and 10-Q
All Stars of Investing • Peter Lynch • Fund Manager of Fidelity’s Magellan mutual fund • “Buy what you know” • Warren Buffet • “Don’t buy a stock; buy a company” • Puts emphasis on the value of the entire company • Benjamin Graham • He was Warren Buffet’s teacher • “Father of Value Investing” • John Templeton • One of the first mutual fund managers to invest globally
All Stars of Investing (continued) • Bill Miller • Fund Manager of Legg Mason Value Trust • For 15 calendar years in a row, he beat the S&P 500, an unprecedented record! • He became (unfortunately for him, as far as I was concerned) the financial media’s mega-star • But then he did not beat the S&P 500 in 2006 and lagged badly in 2007 and 2008 during the turmoil • He seemed to redeem himself in 2009 when he was up over 40% beating the 26% return of the S&P 500 • But then again trailed the S&P 500 badly in 2010 and 2011 • He retired late 2012 • I was surprised Legg Mason let him stay as long as they did. It’s a tough business
All Stars of Investing (continued) • What do all these people have in common? • Courage to not follow the crowd • The “conventional wisdom” is usually not very wise! • A eye for unrecognized value • Almost a “sixth sense” • Gary Kasparov was once asked why he and Anatoly Karpov were the two best chess players in the world • His answer was astonishingly simple and direct • “We attack better than anybody else and we defend better than anybody else” • These people bought the best companies and avoided the worst companies