1. Chapter 6
Common Stocks

2. The Appeal of Common Stocks
Residual Owners: stockholders of a firm are the owners, who are entitled to dividend income and a prorated share of the firm’s earnings only after all the firm’s other obligations have been met
Stocks allow investors to tailor investments to meet individual needs and preferences
Stocks may provide a steady stream of current income through dividends
Stocks may increase in value over time through capital gains

3. Sometimes You Win, Sometimes You Lose: Five years of the S&P 500 Index and the Nasdaq Composite
FIGURE 6.1 A Snapshot of U.S. Stock and Housing Indexes (mid-2003 through mid-2009)

4. Sometimes You Win, Sometimes You Lose
Table Years of Annual Returns in the Stock Market, 1956–2005
(returns based on performance of the DJIA)
13 years of negative total returns (6 double digit); 37 years of positive total returns (25 double digit)

5. From Stock Prices to Stock Returns
Stock Returns: take into account both price changes and dividend income
Returns from capital gains range from an average of 15.3% during the 1990s to -5.3% from 2000–2008
Returns from dividends vary too, but not nearly as much, ranging from 5.4% in the 1950s to 1.7% since 2000
The big returns (or losses) come from capital gains

6. Figure 6.2 The Current Income of Stocks and Bonds

7. Basic Characteristics of Common Stock
Equity Capital: evidence of ownership position in a firm, in the form of shares of common stock. This is why stocks are sometimes called “equities”
Publicly Traded Issues: shares of stock that are readily available to the general market and are bought and sold in the open market
Public Offering: an offering to sell to the investing public a set number of shares of a firm’s stock at a specified price

8. Basic Characteristics of Common Stock (cont’d)
Rights Offering: an offering of a new issue of stock to existing stockholders, who may purchase new shares in proportion to their current ownership
Stock Spin-Off: conversion of one of a firm’s subsidiaries to a stand-alone company by distribution of stock in the new company to existing shareholders

9. Basic Characteristics of Common Stock (cont’d)
Stock Split: when a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share
Usually done to lower the stock price to make it more attractive to investors
Stockholders end up with more shares of stock that sells for a lower price
Investor with 200 shares in a 2-for-1 stock split would have 400 shares after the stock split
If the stock price was $100 before the split, the price would be near $50 after the split

10. Basic Characteristics of Common Stock (cont’d)
Treasury Stock: shares of stock that were originally sold by the company and have been repurchased by the company. Share repurchases are often called “buybacks.”
Reduces the number of shares outstanding to public
Companies buyback when they believe stock is undervalued and a good buy
Companies may try to raise undervalued stock price or prop up overvalued stock price
May be used for mergers, acquisitions or employee stock option plans

11. Basic Characteristics of Common Stock (cont’d)
Classified Common Stock: common stock issued in different classes, each of which offers different privileges and benefits to its holders
Different shares may have different voting rights
Often used to allow a relatively small group to control the voting of a publicly-trade company
Ford family owns “B” shares and other investors own “A” shares; Ford family controls 40% of Ford Motor Company
May have different dividend payout schedules

12. Watch Those Transaction Costs
Round-Lot: buying 100 shares of stock or multiples of 100 shares
Odd-Lot: buying less than 100 shares of stock
Buying odd lots or small numbers of shares can result in higher costs to buy and sell shares
Frequent trading can increase transactions costs substantially

13. Common Stock Values
Market Capitalization: the overall current value of the company in the stock market
Total number of shares outstanding multiplied by the market value per share
Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth
Probably the most important measure for a stockholder

14. Dividends
Dividend income is one of the two basic sources of return to investors
Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk
Dividends are taxed at maximum 15% tax rate, same as capital gains
Dividends tend to increase over time as companies’ earnings grow; average annual increase around 3% to 5%
Dividends represent the return of part of the profit of the company to the owners, the stockholders

15. Dividends and Earnings Per Share
Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis
Earnings are important to stock price
Earnings help determine dividend payouts

16. Dividends and Dividend Yield
Dividend Yield: a measure to relate dividends to share price on a percentage basis
Indicates the rate of current income earned on the investment dollar
Convenient method to compare income return to other investment alternatives

17. Dividends and Dividend Payout Ratio
Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends
Companies are not required to pay dividends
Some companies have high EPS, but reinvest all money back into company

18. Other Dividend Characteristics
Stock Dividend: payment of a dividend in the form of additional shares of stock
Dividend Reinvestment Plans (DRIPs): plans where cash dividends are automatically reinvested into additional shares of the firm’s common stock
Over 1,000 companies offer DRIPs
Usually have no brokerage fees
Uses dollar-cost averaging

19. Three Reasons to Love Dividends
Stocks that pay dividends tend to produce higher returns than those that do not
S&P dividend payers were up 6.5% vs. 3.6% for non-dividend payers
Since 1928, dividends have accounted for 40% of total return on stocks
Since 1980, dividend-payers have averaged annualized returns of 15.1% vs. 12.8% for non- payers
* New tax code changes: tax dividends are a much lower rate than ordinary income and interest income

20. Types of Stock
Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends
Companies are leaders in their industries
Relatively lower risk due to financial stability of company
Popular with investing public looking for steady growth potential, perhaps dividend income
Provide shelter during unsettled markets
Examples: AT&T, Chevron, Johnson & Johnson, McDonald’s, Pfizer

21. Types of Stock (cont’d)
Income Stocks: stocks with long and sustained records of paying higher-than average dividends
Good for investors looking for relatively safe and high level of current income
Dividends tend to increase over time (unlike interest payments on bonds)
Some companies pay high dividends because they offer limited growth potential
More subject to interest rate risk
Examples: Duke Energy, Conagra Foods, Sara Lee, Altria Group

22. Types of Stock (cont’d)
Growth Stocks: stocks that experience high rates of growth in operations and earnings
Have sustained rate of growth in earnings above general market
Investors expect higher price appreciation due to increasing earnings
Riskier investment because price may fall if earnings growth cannot be maintained
May include blue chip stocks as well as speculative stocks
Typically pay little or no dividends
Examples: Netflix, eBay, Research in Motion, Berkshire Hathaway, Starbucks

23. Types of Stock (cont’d)
Tech Stocks: stocks representing the technology sector of the market
Range from speculative stocks of small companies that have never shown a profit to blue chip stocks of large companies that are growth-oriented
Potential for attractive returns
Considerable risk and volatility
Difficult to put value on due to erratic or no earnings
Examples: Microsoft, Cisco Systems, Yahoo!, NVIDIA, SanDisk, Electronic Arts

24. Types of Stock (cont’d)
Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product
Companies lack sustained track record of business and financial success
Earnings may be uncertain or highly unstable
Potential for substantial price appreciation
Stock price subject to wide swings up and down in value
Examples: Sirius XM Radio, Dreamworks Animation, Liberty Media, NitroMed, Under Armour

25. Types of Stock (cont’d)
Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy
Stock price tends to move up and down with the business cycle
Tend to do well when economy is growing, especially in early stages of economic recovery
Tend to do poorly in slowing economy
Best for investors willing to move in and out of market as economy changes
Examples: Alcoa, Caterpillar, Genuine Parts, Lennar, Brunswick, Timken

26. Types of Stock (cont’d)
Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter
Stock price remains stable or increases when general economy is slowing
Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs
Gold stocks are a form of defensive stock
Best for aggressive investors looking for “parking place” during slow economy
Examples: Walmart, Checkpoint Systems, WD-40

27. Types of Stock (cont’d)
Large-Cap Stocks: large companies with market capitalizations over $10 billion
Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities
Bigger is not necessarily better
Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility
Examples: Walmart, Home Depot, Comcast, Microsoft

28. Types of Stock (cont’d)
Mid-Cap Stocks: medium-sized companies with market capitalizations between $2 billion and $10 billion
Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than Small-Cap stocks
Usually have long-term track records for profits and stock valuation
“Baby Blues” offer same characteristics of Blue Chip stocks except size
Examples: Abercrombie & Fitch, Dollar Tree, Hasbro, Nordstrom, Whole Foods

29. Types of Stock (cont’d)
Small-Cap Stocks: small companies with market capitalizations less than $2 billion
Provide opportunity for above-average returns (or losses)
Usually do not have a financial track record
Earnings tend to grow in spurts and can have dramatic impact on stock price
Usually not widely-traded; liquidity is an issue
“Initial Public Offerings” (IPOs)
Examples: Callaway Golf, California Pizza Kitchen, Winn-Dixie Stores, Shoe Carnival

30. Alternative Investment Strategies
Storehouse of Value
Safety of investment is primary goal
Investors use high-quality blue chip and non-speculative stocks
To Accumulate Capital
Growth of investment is primary goal
Investors use growth-oriented stocks to generate capital gains
Source of Income
Current income is primary goal
Investors use stocks with dependable flow of dividends

31. Stock Investment Strategies
Buy-and-Hold
Investors buy high-quality stocks and hold them for extended time periods
Goal may be current income and/or capital gains
Investors often add to existing stocks over time
Very conservative approach; value-oriented

32. Stock Investment Strategies (cont’d)
Current Income
Investors buy stocks that have high dividend yields
Safety of principal and stability of income are primary goals
May be preferable to bonds because dividends levels tend to increase over time
Often used to provide to supplement other income, such as in retirement

33. Stock Investment Strategies (cont’d)
Quality Long-Term Growth
Investors buy high-quality growth stocks, mid-cap stocks and tech stocks
Capital gains are primary goal
Higher level of risk due to emphasis on capital gains
Significant trading of stocks may occur over time
Diversification is used to spread risk
“Total Return Approach” is version that emphasizes both capital gains and high income

34. Stock Investment Strategies (cont’d)
Aggressive Stock Management
Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks
Capital gains are primary goal
High level of risk due to emphasis on capital gains
Investors aggressively trade in and out of stocks, often holding for short periods
Timing the market is key element
Time consuming to manage

35. Stock Investment Strategies (cont’d)
Speculation and Short-Term Trading
Also called “day trading”
Investors buy speculative stocks, small-cap stocks and tech stocks
Capital gains are primary goal
Highest level of risk due to emphasis on capital gains in short time period
Investors aggressively trade in and out of stocks, often holding for extremely short periods
Looking for “big score” on unknown stock
Time consuming & high trading costs