portfolio management- chapter 10
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Chapter 10
Picking the Equity Players
Prof. Rushen Chahal 1
Prof. Rushen Chahal
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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
Todays focus is toward the overallcharacteristics of portfolios
What principles in security selection are
particularly important inthe construction andmanagement of a portfolio?
What are the principal categories of commonstock?
What are dividends?
What is preferred stock?
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StockSelection Philosophy
Fundamental analysis
Technical analysis
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Fundamental Analysis
Afundamental analysttries to discernthe logicalworth of a security based on its anticipated earningsstream
The fundamental analyst considers:
Financial statements
Industry conditions
Prospects for the economy Etc.
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Technical Analysis
Atechnical analystattempts to predictthe
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 ofDividends
Cash dividends
Stock dividends
Property dividends
Spin-offs
Rights
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Cash Dividends
Cash dividends are distributions ofthe 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 instreet 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 dividendsto 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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StockDividends
Stock dividends are paid in additional shares
of stock rather than in cash
Typically a
nnou
nced as a perce
ntage
E.g., 10 percent stock dividends
Popular when a firm lacks the funds to pay a
cash dividend
Popular early inthe firms life cycle
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Property Dividends
Aproperty dividendis the distribution of
physical goods to shareholders
E.g. a firms products
Property dividends are rare
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Rights
Thepreemptive rightmeans shareholders
have the ability to maintainthe same
percentage share of ownership in a
corporation whenthe 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
ofD
ividends Chronology of events
Dividend growth rates
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Chronology of Events
Date ofdeclaration
The day the board announces the dividend
Once declared, the dividend becomes a legal
liability ofthe company
Date ofpayment
The company mails dividend checks
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Chronology of Events (contd)
Date ofrecord
Establishes who will receive dividend checks
Shareholders of record are listed onthe company
records as being owners ofthe company onthe
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 getthe next dividend
If you buy the stock onthe ex-dividend date, you
will not getthe next dividend
Eliminates any ambiguity about who is entitled tothe dividend
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Chronology of Events (contd)
Example
Consider the following dividend announcement by AECI (a specialtychemical company) on August 2, 2000:
Notice is hereby given that an interim dividend of30 centsper share, inrespect ofthe year ending 31 December 2000, has been declared to holders
ofordinary shares registered in the books ofthe Company at the close ofbusiness on 18 August 2000. Payment will be made from the office ofthetransfer secretaries in Johannesburg on 27September 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
Corporations like to establish predictable
dividend payout patterns including an annual
increase intheir dividends
Many fundamental analysts focus onthe
dividend growth rate to determine value
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Dividend Growth
Rates (c
ontd) The dividend discount model:
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0 10
0
1
0
(1 )
where = the current dividend
= the dividend to be paid next year
the expected dividend growth ratethe discount factor according to the riskiness of the stock
the current
D g DPk g k g
D
D
gk
P
! !
!
!
! stock price
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Dividend Growth
Rates (c
ontd) You can solve for the required rate of return,
k:
Observe the current dividend and price
Obtainthe growth rate using historical
information and analysts estimates
Solve for k:
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0
0
(1 )D gk g
P
!
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Dividend Growth
Rates (c
ontd)Example
Assume a company just paid a dividend of $1.20 per share.
Historically, the company has increased its dividends by 3percent annually with great consistency. No analyst estimatesregarding the next dividend are available. The firms currentstock price is $20 per share.
What is an estimate of the required rate of return for thisstock?
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Dividend Growth
Rates (c
ontd)Example (contd)
Solution: Using the numbers in the dividend discount model:
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0
0
(1 )
1.20(1.03)0.03
20
0.0918 9.18%
D gk g
P
!
!
! !
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Why Dividends Do Not Matter
Payment of dividends reduces the balance inthefirms cash account
The firm should not be worth as much after paying adividend
The ex-dividend date determines whether or not yougetthe dividend
On
t
he ex-dividen
d dat
e,t
he price of a share of st
ockt
en
dsto fall by aboutthe amount ofthe dividend to be paid
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Theory Versus Practice
Dividend policy is very important in practice
Unexpected changes in dividend policy canresult in significant changes inthe market
price ofthe 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
in
crease in
dividen
ds above what
t
hemarket expects is a good signal
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StockSplits Versus
StockDividends
Stock splits
Why stock splits do not matter
Why firms splittheir stock Stock dividends
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StockSplits
Astock splitoccurs when a firm changes the
number of shares of its capital stock without
changing the aggregate value ofthese 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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StockSplits (contd)
In a forward split(regular way splitor direct
split), shareholders receive more shares as a
result ofthe 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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StockSplits (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 StockSplits
Do Not Matter
Stock splits 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
Some literature supports the existence of an
optimal trading range
A principal reason for splitting shares is to
broadenthe ownership base
Reverse splits are sometimes used to reduce
the number of shareholders
E.g., a 1-for-200 splits eliminates all shareholdersholding fewer than 200 shares
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StockDividends
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 firms earnings history and balancesheet
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
Aforward-looking PEuses earnings forecasts
Atrailing PEuses 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 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 ofa 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 ofStock
Blue chip stock
Income stocks
Cyclical stocks Defensive stocks
Growth stocks
Speculative stocks
Penny stocks
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Categories ofStock (contd)
Categories are not mutually exclusive
Anote on stock symbols
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Blue Chip Stock
Blue chip has become a colloquial termmeaning 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 havepaid a larger-than-average percentage oftheirnet income as dividends
The proportion ofnet income paid out asdividends is thepayout ratio
The proportion ofnet income retained is theretention ratio
Examples include Consolidated Edison andAllegheny Energy
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Cyclical Stocks
Cyclical stocks are stocks whose fortunes are
directly tied to the state ofthe 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 inthe
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 oftheir earnings as dividends
They reinvest most oftheir earnings into
investment opportunities
Many growth stocks do pay dividends
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Speculative Stocks
Speculative stocks are those that have thepotential to make their owners rich quickly
Speculative stocks carry an above-average
level of risk Most speculative stocks are relatively new
companies with representation inthetechnology, bioresearch, and pharmaceuticalindustries
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Penny Stocks
Penny stocks are inexpensive shares
Penn
y 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 StockSymbols
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 onthe
Nasdaq
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