Portfolio Management- Chapter 10

8/3/2019 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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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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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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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:


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:


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:


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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