LECTURE 3:BASICS OF INVESTING IIEconomics 98/198 Decal Spring 2008

Today’s ScheduleAdministrative IssuesLast Week’s LectureLecture Content

Basics of InvestingMarket capitalizationEarning reportsStocks splits / stock buybacks Investing on MarginShort-selling Industries / Sectors

Current EventsAssigned Reading / Next Week

Administrative IssuesEnrollment

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Lecture Content

Market Capitalization

Market CapitalizationAlso known as “market cap”Refers to the value of ALL company

outstanding shares (shares owned by investors)

Useful for gauging a company’s size and therefore, some of the risk characteristics associated

Market Cap =

Stock Price X # of shares outstanding

(stock held by investors, officers, & insiders)

Market Capitalization: ExampleExample. Amazing DeCal Cookies Co., Ltd.

Share Price $20Shares Outstanding: 50,000,000 sharesMarket cap?

Example. Berkeley Traders Co., Ltd.Share Price $100Shares Outstanding: 1,000,000 sharesMarket Cap?

Different CapitalizationsNot exact, but general guidelines for size

categories

Large Cap Companies with $10b - $200b market cap Often referred to as “blue-chip” stocks (low volatility,

dividends) “Mega-Cap” - $200b+ (HUGE)

Mid Cap Companies with $2b - $10b market cap

Small Cap Companies with $300m - $2b market cap Typically newer, relatively younger companies Can present potential for greater capital gains, but at

greater risk “Micro-cap” - $50m-$300m market cap – VERY SMALL

Market Capitalization PerspectiveLarge Cap Microsoft (Nasdaq: MSFT) $264 billion Wal-Mart (NYSE: WMT) $201 billion Coca-Cola (NYSE: KO) $138 billion Walt Disney (NYSE: DIS) $60 billion Yahoo! (Nasdaq: YHOO) $39.5 billion

Small/Mid - Cap Logitech International (Nasdaq: LOGI) $5 billion J Crew Group Inc. (NYSE: JCG) $2.6 billion Barnes & Noble (NYSE: BKS) $1.9 billion Papa Johns (PZZA) $694 million TradeStation Group (TRAD) $471 million

Source: Google Finance as of 2/12/2008 closing prices

Comparing Small and Large Caps(S&P 500 vs. S&P 600) – last decade

Black line = S&P 500 Orange line = S&P 600

Comparing Small and Large Caps(S&P500 vs. S&P 600) – Past 2 Years

Black line = S&P500 Orange line = S&P 600

Stock SplitsStock Buybacks

Stock SplitsWhen a company divides the number of its

existing stocks into multiple shares

In 2-for-1 split, each stockholder gets an additional share for each share he or she holds

Also, value of each share is reduced in half:

2 shares now equal original value of 1 share before split (total value not changed)

Stock Splits

If you still don’t get it, think of it this way..

If you have a $100 bill, and I exchange with you two $50 bills

How many bills do you have?What is the total value of money you have?

Stock SplitsWhy do companies do this?

Brings the share price down to a more “attractive” level for smaller investors (purely psychological)Can potentially result in price increase because

these small investors will be more likely to buy the stock

Some also say stock split will increase price because it is a signal of strong growth

Increases stock’s liquidity (What is liquidity?)

Stock SplitsEffects

Excessive stock splits may hurt a stock’s pricePros and shrewd traders sometimes use

excitement generated by oversized or excessive split as an opportunity to sell and take their profits

Oversized splits create substantially larger supply

Stock BuybacksWhen a company buys back its own shares

in the market placeAlso known as “share repurchase”

Why do it?Management believes its stock value is

discounted too steeply (its too cheap)Management has confidence in the company

and want to send a message the market

Stock Buybacks# of shares outstanding go down as these

shares are bought by the company

Major impact is that it affects important financial ratios (ROA, ROE, P/E, EPS)

What do these ratios mean? Briefly, we use them to value or analyze a companyWe’ll discuss this more later

Are they good or bad?Not definitive answer, depends on the situation

Investing on Margin / Short Selling

Investing on MarginBorrowing money from brokerages to

invest

Generally, maximum 50% of a purchase can be on margin

However, when borrow money, have to pay an interest rate on money borrowed

Ex. I borrow $10,000 and broker charges 5% rate.

I have to pay $500 (10,00 x 0.05) to borrow that

money.

Investing on MarginPROS

Potential to get greater profits than investing with only cash because you profit from money you don’t have

CONSWorks against you when you lose

money – can get really ugly with lossesCharged interest for money you

borrow

Margin Example

Joe buys 100 shares priced at $50 of Smart Inc. (SMRT) and is allowed to buy another 100 shares on margin at 10% interest.

100 shares @ $50 (cash) +$5,000

100 shares @ $50 (margin) +$5,000

---------------------------------------------------Total Investment $10,000

(200 shares @ $50)

Margin Example continuedSMRT goes through the roof and increases 100% in 10

months to $100. Joe smartly sells and takes profits.

SMRT Investment (200sh@$100) +$20,000Money borrowed from brokerage -$5,000Interest on borrowed money -$500Original Investment -$5,000

-------------------------------------------------------------------Profit $9,500% Return ($9,500/$5,000) 190%vs. % Return (cash investment only) 100%

Shorting StocksBetting a stock will go down and attempting

to profit from that downward movement

1. You essentially “borrow” shares from another investor (account must be able to trade on margin)

2. You sell those shares at the market price3. You then wait and root for the stock price to

tumble4. Then you cash out, whether at a profit of loss5. You then buy the shares at the new market

price and return the shares to their owner

Shorting Example

Scenario 1Mr. Giant shorts 1000 shares of Lampere Co. at

$20 a share – his account gets credited with $20,000

Lampere Co. stock plummets to $10 a share

Borrowed and sold short 1000 shares at $20 +$20,000

Bought back and returned 1000 shares at $10 -$10,000

-----------------------------------------------------------------------------

Profit +$10,000

% Gain 100%

Shorting Example

Scenario 2Mr. Giant shorts 1000 shares of Lampere Co. at

$20 a share – his account gets credited with $20,000

Lampere Co. stock skyrockets to $60 a share

Borrowed and sold short 1000 shares at $20 +$20,000

Bought back and returned 1000 shares at $60 -$60,000

-----------------------------------------------------------------------------

Profit -$40,000

% Loss -200%

Sector / IndustriesCyclical vs. Non-Cyclical

Sector vs. IndustryOften used interchangeably, but actually mean

slightly different things

Sectors are the general segments in the economy within which large groups of companies can be categorized into About a dozen sectors in the economy Example. Financial Sector, Technology, Basic Materials

Industry describes a much more specific grouping of companies with highly similar business activities Break down sectors into much more defined groups Can be small, but also very large in numbers Example. Financial Sector Asset Management,

Insurance, Banks, etc.

Sector vs. IndustriesTop sectors / industries rotate every cycle

Important to know which sectors / industries are leading the market and performing well

Why? Let’s think back to 1998Technology, software, telecom: leading industries

thenIf you invested in a company in those industries ,

the price would have likely made a solid, if not major, price increase

Stock prices of companies in the same / similar industry usually (not always) move in a similar fashion

Recent Industry Performance(http://stockcharts.com/charts/performance/Industry1.html)

Cyclical Stocks / IndustriesThe term refers to how correlated a

company’s price (or industry) is relative to economic fluctuations

Non-cyclical stocks (also called defensive stocks) refer to companies not as susceptible to economic fluctuationsExample. Household durables, tobacco, utilitiesThese are often goods that necessities rather

than luxuries

Cyclical vs. Non-Cyclical Stocks

Ford = Blue Red – Florida Public Utilities

SummaryMarket Capitalization

Small caps vs. large caps

Stock SplitsStock BuybacksEarning ReportsShorting StocksMarginIndustries vs. SectorsCyclical Stocks / Industries

For Next WeekQuiz on Stock Market Basics

Introduction to Other Investment SecuritiesBonds / Mutual Funds / Exchange-Traded Funds

Market PsychologyEmotions involved with stock investing

Basic Investing ConceptCompoundingInvesting versus SpeculatingDetermining your own financial goalsInvestment Style – Risk/Reward, Active/Passive

Managing your Portfolio

Current Events

Reading / HomeworkMaster Your Trading Mindtraps (Investopedia)How Interest Rates Affect the Market

(Investopedia)

Quiz next week: Basics of Stocks & investmentsMarket ExchangesMajor indexesTicker SymbolsTypes of ordersMarket CapitalizationEtc.