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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
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Lesson # 4
COMMON STOCK
Categories of Stock:
Although all common shares represent an ownership interest in the company, the investment
characteristics of these shares differ widely. Some share are stable, some are volatile. Some
pay dividends, some don't. Some are speculations about events years in the future, other are
investments in current results; investors often place stock into a particular group according
to its investment characteristics.
1. Blue Chip Stocks:
Of all the categories of stock, blue chip stock might be the best known. Deposit its ........
the term lacks precise meaning, investment professionals all fell they know what a blue chip
stock is, but most cannot come up with a fluent definition without using a lot of examples,
in some respects, the imprecision is analogous to the Supreme Court justice who said he "
couldn't define pornography, but knew it when he saw it."
One common definition of a blue chip is a company with a long, uninterrupted history of
dividends payments. This definition is not perfect, but it fits a great many of the consensus
blue chip.
Blue chip is now a colloquial term used to imply high quality, such as blue chip high school
football prospects. While high qualify is itself a different term to define in the investment
business, many high qualify stocks do not meet the uninterrupted dividend history criterion.
Brokerage firm newsletters routinely list recommended stocks, often calling them blue chips
even though some may not even pay a dividend.
No firm likes to omit its dividend. If a company has a long history of paying them, breaking
the tradition would be especially distasteful. Still, circumstances sometimes make dividend
omission in the best interest of the shareholders. Citicorp paid dividends continuously
from1812 to 1990- one of the longest unknown dividend period of any company. The
economic recession and problems in the banking industry caused Citicorp to cut its dividend
44 percent in late 1990 and in October 1991 it was eliminated. The board of directors
resumed the dividend in 1994.
In October 1991, Allied-Signal (ALD, NYSE) announced major corporate streamlining and
reorganization. The board cut the dividend +1 percent from $1.80 to $1. The market cheered
this wise decision and the share price rose 11.8 percent from $ 361/8 to $ 403/8 on the day
of the announcement. Sometimes a dividend makes sense and will actually increase
shareholder value.
2. Income Stock:
By law dividend must be paid out of the company's earning they cannot be paid from
borrowed funds. The bottom line profit a firm makes is its net income after taxes (NIAT).
The firm's board of directors may pay a dividend from the amount if they believe it to be in
the shareholder's best interest. NIAT may be retained in its entirely within the firm the
entire amount may be paid out of more typically a portion of these earnings might be
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Investment Analysis & Portfolio Management (FIN630)
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retained and a portion paid out. The proportion of NIAT paid as a dividend in the firm's
payout ratio.
Income stocks are those that have historically paid a larger than average percentage of their
NIAT as dividend to their shareholders. The best examples of income stocks are public
utilities such as electric companies, telephone companies and natural gas companies.
3. Cyclical Stocks:
A cyclical stock is one whose fortune is directly tied to the state of the overall national
economy. When the economy is booming these stocks do well. During a recession they do
poorly.
The term cyclical has nothing to do with its chart pattern nor does the term imply that the
stock prices are more predictable than other issues. They are cyclical in the sense that they
follow the business cycle. Good examples of cyclical stocks are those in the smokestack
industries such as steel companies' industrial chemical firms and perhaps the auto mobile
producers. Cyclical stocks often have higher than average market risk.
It is interesting to note the motto of U.S. steel (now USXCORP.) used to be " as steel goes
so goes the nation" the company's public relation firm advised this might cause the public
blame U.S steel for future down turn in the economy. As a consequence the motto was
revised to "as the nation goes so goes steel".
4. Defensive Stocks:
A defensive is largely immune to changes in the macro economy. Regardless of whether the
overall market is bullish or bearish, defensive stocks continuo to sell their products. As with
cyclical stocks potential for misunderstanding with this term is note worthy. These issues
have nothing to do whit the national defense.
Four particular industries are especially good example of defensive stocks. The best
example is retail food. Grocery stores continue to sell their products regardless of what is
happing else where in the economy. To of the other categories might be called the vice
stocks. Tobacco and alcohol firms like grocery firms continue to have customers despite
troubles economic times. The final group includes the utilities. People use the telephone and
turn on the water or lights in good times and bad. Defensive stocks usually have lower than
average market risk.
5. Growth Stocks:
While income stocks pay out a relatively high percentage of their earnings as dividends,
growth stocks do not. Like a blue chip stock there is no universally accepted definition of a
growth stocks. Some people define a growth stocks as one in which the company reinvests
most of its earnings into profitable investment opportunities rather than returning them
directly to the shareholders. Others define a growth stock as one in which the investor
expects a total return greater than normally indicated by the level of risk associated with the
stock.
Growth stocks, like beauty are in the eye of beholder. Many times firms have never paid a
dividend and publicity start they have no plans to do so. By default than these stocks should
be growth stocks because the stock that paid no dividends and does not increase in value
would not be attractive investment.
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Investment Analysis & Portfolio Management (FIN630)
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Few experience investors would be happy with this "by default" definition of a growth
stocks. A great deal of a stock analyst's time is spent trying to discover a little known
growth stocks. A better definition might be a stock that is expected to shoe above average
capital appreciation in the future. Still such a judgment is a subjective one and one person's
growth stock is another person's long shot.
6. Speculative Stocks:
There is a relationship between risk and expected return, as we have seen. Speculation by
definition involves a short time horizon, and a speculative stock is one with the potential to
make its owners a lot of money quickly. At the same time it carries an unusually high
degree of risk. In other words a speculative stock has a high probability of a loss and a small
probability of a large profit. The potential for a large profit is the attraction.
Some analysts consider speculative stocks to be a growth stock at the far end of the risks
spectrum. Most people would classify the computer company DELL (DELL, NASDAQ) as
a growth stock rather than a speculative stock. DELL has never paid a dividend so it clearly
is not an income stock. A new formal computer software company also paying not
dividends would probably be considered a speculative rather than a growth stock by most
investors. Speculative stocks tend to be relatively new companies and in recent years have
been heavily represented by electronic and technology terms.
7. Penny Stocks:
Penny stocks fall into a catch all category that refers to unusually risky specially in
expensive share. Shares that sell for less than dollar 1 each would be considered penny
stocks.
For example one graduate student on 250000 shares in the small companies an impressive
statistics. In reality however every time he mailed a letter to a firm the stamp cost him the
equivalent of 960 shares. This firm would satisfy anyone's definition of a penny stock.
MARKET MECHANICS PLACING ORDERS:
The economic function of the capital markets is to facilitate the flow of capital between
suppliers and users. When someone decides to buy a security (that is, to provide capital) or
sell one (take capital back), the action follows a precise protocol, both with the instructions
given the broker and with the subsequent paperwork.
Order Information Flow:
Individual investors are not normally members of the stock exchanges. Consequently, they
must use an agent, called a stock broker, to make trades on their behalf.
Types of Orders:
When investors place orders to buy or sell securities, they expect their instructions to be
precisely understood by the people involved in processing the order. A number of standard
packets of instructions are used in the brokerage business to aid in this process.
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Investment Analysis & Portfolio Management (FIN630)
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1. Market Order:
The most common type of order is the market order. With this order, the investor trusts the
fair pricing function of the marketplace. The broker is to buy or sell at the best price
prevailing at the moment. The key element of a market order is that the order is to be
executed as soon as possible.
Market orders are to be executed as soon as possible after reaching the exchange floor.
2. Limit Order:
Sometimes an investor is not willing to trade at the market price, preferring to set his or her
own price and not trade until that price is obtainable. Limit order must specify a price and a
time limit. The time limit is most commonly either for the day or good till canceled (GTC).
Day orders expire at the close of business if they are not executed. GTC orders remain open
either until they are executed or the investor cancels them. Limit orders are useful, but they
should be used reasonably. A limit order with a limit price distant from the prevailing
market price is said to be away from the market.
Limit order must specify a price and a time limit.
3. Stop Order:
A Stop Order specifies a price and time limit, just like a limit order. The difference is that a
stop order is only executed if a specified price, called the stop price is touched.
Stop orders become market order when the stop price is reached. Therefore, it is possible for
the actual sales price to be different from the stop price. The most important use of a stop
order is to protect a profit and minimize losses. There is no cost to placing a stop order or
raising the stop price; you only pay a brokerage commission when a trade occurs.
Moving a stop up behind a rising stock is called using a crawling stop order. The question
of where to place the stop price is a difficult one. If the stop is too far away from the current
market price, an investor risks absorbing larger losses or giving up a good portion of any
gains. Set too close to the current price, random movements across the bid-ask spread might
trigger the stop in the absence of an adverse price movement.
A recent article in the Journal of Portfolio Management suggest a methodology whereby the
investor sets a stop based on the volatility of the underlying asset, using a standard deviation
of returns as a decision-making aid.
Stop orders become market order when the stop price is reached.
The most important use of a stop order is to protect a profit.
Other Orders:
Although much less common than the three discussed so far, a number of other types of
orders might be placed.
·
One cancels the others
·
All or none
·
Fill or kill
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Investment Analysis & Portfolio Management (FIN630)
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·  Stop limit
·  Market if triggered order (MIT)
·  Good till cancel (GTC)
·
Settlement Procedures:
When people buy securities, they must pay for them. Similarly, when people sell securities
they expect to receive cash from the sale in a timely fashion. The new owner of the security
expects to receive future dividends, annual reports and the proxy statement, and anything
else other shareholders receive.
The activities surrounding the transfer of ownership are called settlement procedures. Stock
and bond transactions in the United States settle three business days after the trade date,
the date the order was actually executed. Sellers have three days to deliver the stock
certificates, and buyers have the same period of time to deliver a check for the purchase
price.
A number of market speculators engage in a practice known as a day trade, which involves
buying and selling securities on the same day. This practice is attractive for two reasons.
First many brokerage firms only charge one commission on a day trade. Second because
the purchase and sale settle on the same day, technically it is not necessary to pay for the
securities being purchased. If an investor buys stock and day trades it on an up day, the
investor's account will be credited with the gain (three days later) without ever writing a
check. If, instead, the stock declines, the investor's account will be charged difference. The
merits of day trading became a lively topic in the late1990s with increased access to the
internet and online brokerage accounts. The media routinely reports on fortunes made and
lost by people using the stock market like a slot machine over the lunch hour. A true day
trader speculates short term on the basis of some informed decision regarding a company.
He or she does not merely roll the dice and hope a volatile stock moves in the desired
direction.
Some people who call themselves day traders are really just gamblers. Psychologists know
that a gambler who scores a big win is often prone to gamble even more, sometimes
considers his or her winnings "free money" and may develop a more relaxed attitudes
toward risk.
Some brokerage firms charge a single commission on a day trade.
The Specialist and the Book:
Many people misunderstand the role of the specialist. To some, the concept of a single
individual through which orders must suggests monopoly power. This image is not the case,
however. The specialist performs several useful functions and is instrumental in fulfilling
the continuous market function of the exchange.
The Specialist and the Spread:
A common phrase associated with the specialist is the maintenance of a fair and orderly
market. This worthy goal is the exchange's charge to the specialist and the primary reason
for having specialists.
Specialists help maintain a fair and orderly market.
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Investment Analysis & Portfolio Management (FIN630)
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Adjusting limit and stop prices for dividend:
Limit and stock orders are normally automatically adjusted for the payment of the cash
dividend. On the ex-dividend ate the share price tend to fall by the amount of the dividend
about to be paid. Unless a customer indicates a contrary wish, limit and stop prices are
automatically adjusted downward to reflect the dividend. If a customer elects not to have the
limit or stop prices adjusted because of dividends, the broker will circle this item and he
order would be recorded accordingly. People often ask why security prices in United States
have been quoted in interval of 1/8 of a Dollar for so long. Frankly, there is no particular no
good reason for this practice other than tradition. In September 1999 Wall Street Leaders
proposed phasing in a conversion to a decimal trading beginning in July 2000. This means
investor would see a stock price such as $ 56.05. The first phase of transition would last
about five weeks and would involve trading in five-cent intervals for a group of 30 or40
selected securities. The second phase, expected to last about eight weeks, would allow
nickel increment trading in all stocks. The third phase, beginning in October 2000, would
allow stocks to trade in whatever increment market demands. This could conceivably be in
pennies.
The Ticker Tape:
The ticker tape is perhaps the most widely known symbol of the investment business. It
appears on cable television stations, computer monitors, in restaurants and bars in financial
centers, and on handheld receivers on golf courses through out the world. Customers who
place an order while in the broker office enjoy watching the tape and looking for their trade.
Normally a trade crosses the ticker tape within five minutes of placing a market order,
Format:
At one time the ticker tape actually appeared on paper tape, coming out of domed bell jar
and piling on to the floor. Today the tape is electronic, passing by on the screen but
generally not preserved for subsequent retrieval. For Active well known companies, ticker
tape some time eliminates leading numbers in the price under the presumption that people
who are following that particular stock know its approximate current price. The decimals
separate the two trades; whole the dollars are omitted from the second trade. Information
arrives on the ticker tape continuously throughout the trading day as trade occurs at the
various specialist posts. An entry such as this one appears when two trades happen to be
entered without any other intervening trade in another security. This may well have been a
market order to buy 800 shares, with the trade filled at two prices. Different information
venders use slightly different ticker tape formats. Some, for instance, also show the daily
price change for each security.
Accuracy:
On heavy trading days the ticker tap cannot keep up. While electronics can work at the
speed of light, the human eye cannot. There is a practical upper speed at which the tape can
move. When this limit is reached, incoming trade information gets backlogged awaiting its
passage across the monitor. The system is able to monitor the buffered data in queue, and on
a busy day periodic notices on the ticker display indicate the length of the current delay. At
a brokerage firm, some might say, "The tape is 10 minutes late." This indication of heavy
volume implies that the tape should not be relied on for current price information. Punching
up individual quotations on the terminal will be more accurate. Errors some time occur
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Investment Analysis & Portfolio Management (FIN630)
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when people input data into the price reporting system. Clerks correct these when they
discover them.
Other ticker tape information:
Notices other than price and volume sometime appear on the ticker tape. On one day in
early 1981, the ticker tape announced the ominous news: "Shots fired at Reagan."
Information of this type is clearly of interest to virtually all people watching the ticker tape,
and there is probably no better way to get the word out quickly.
On busy days, notices may indicate that volume is being omitted from the tape that
duplicate prices are omitted, or that leading member's numerals in security prices are being
left out. These omissions help the tape from becoming delayed; a delayed tape is little use.
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