LECTURE 3 BASICS OF INVESTING II Economics 98 198

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

Today’s Schedule Lecture Content Basics of Investing Market capitalization Earning reports Stocks splits / stock buybacks Investing on Margin Short-selling Industries / Sectors Current Events Assigned Reading / Next Week

Lecture Content

Market Capitalization

Market Capitalization Also 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: Example. Amazing De. Cal Cookies Co. , Ltd. Share Price $20 Shares Outstanding: 50, 000 shares Market cap? Example. Berkeley Traders Co. , Ltd. Share Price $100 Shares Outstanding: 1, 000 shares Market Cap?

Different Capitalizations Not exact, but general guidelines for size categories Large Cap Companies with $10 b - $200 b market cap Often referred to as “blue-chip” stocks (low volatility, dividends) “Mega-Cap” - $200 b+ (HUGE) Mid Cap Companies with $2 b - $10 b market cap Small Cap Companies with $300 m - $2 b market cap Typically newer, relatively younger companies Can present potential for greater capital gains, but at greater risk “Micro-cap” - $50 m-$300 m market cap – VERY SMALL

Market Capitalization Perspective Large 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 Trade. Station 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 Large Caps Orange line = S&P 600 Small Caps

Comparing Small and Large Caps (S&P 500 vs. S&P 600) – Past 2 Years Black line = S&P 500 Orange line = S&P 600

Stock Splits Stock Buybacks

Stock Splits When 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?

Objective 24. 1: Explain stock splits Stock splits are the process of replacing each single share of outstanding stock with multiple new shares of stock. For example a 2 for 1 stock split would result in every single share of “old” stock being replaced with 2 shares of “new” stock. 1 “Old” Share O 24. 1 1 “New” Share The corporation “calls in” all outstanding old shares and issues new ones.

Why Stock splits? When stock is split, the market must re-price the new shares. Management hopes that in the re-pricing process, the market will increase the total market value for the stock. Example: With a 2 for 1 split, the hope is that the new price will be greater than half of the previous price This would benefit existing stockholders, their holdings would be worth more. It also helps the corporation. Investors are paying more for the same projected returns than they were prior to the stock split.

Stock Splits Why 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 Splits Effects Excessive stock splits may hurt a stock’s price Pros 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 Buybacks When a company buys back its own shares in the market place Also 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 company We’ll discuss this more later Are they good or bad? Not definitive answer, depends on the situation

Stock Repurchases (Stock Buyback) Stock repurchase is when a firm uses its cash to repurchase some of its own stock. This results in a reduction in the firm’s cash balance as well as the number of shares of stock outstanding. Firms use one of three methods to purchase the shares: Open market repurchase, tender offer, and direct purchase.

How do Firms Repurchase Their Shares? Open Market Repurchase Here the firm acquires the stock on the market, often buying a relatively small number of shares everyday. This will put upward pressure on share prices. This is the most widely used method for stock repurchase.

How do Firms Repurchase Their Shares? (cont. ) Tender Offer A company uses this method when it wants to buy a relatively large number of shares very quickly. The company makes a formal offer to buy a specified number of shares at a stated price. The price is set above the market price to attract sellers.

How do Firms Repurchase Their Shares? (cont. ) Direct Purchase from a large investor Here the firm purchases the stock from one or more major stockholders on a negotiated basis. This method is not used frequently.

Investing on Margin / Short Selling

Investing on Margin Borrowing money from brokerages to invest Generally, maximum 50% of a purchase can be on margin (borrowed money) 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 Margin PROS Potential to get greater profits than investing with only cash because you profit from money you don’t have CONS Works against you when you lose money – can get really ugly with losses Charged 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 continued SMRT goes through the roof and increases 100% in 10 months to $100. Joe smartly sells and takes profits. SMRT Investment (200 sh@$100) Money borrowed from brokerage Interest on borrowed money Original Investment +$20, 000 -$500 -$5, 000 ---------------------------------- Profit % Return ($9, 500/$5, 000) vs. % Return (cash investment only) $9, 500 190% 100%

Homework Research companies that you might be interested in purchasing tomorrow. As well as some of your current holding that you might be willing to sell tomorrow. Remember you have to hold at least 4 stocks each week. You are not required to sell or buy howevery other week there must be one trade. Week 2 READINGS are on my web site Quiz December 8 if you read you will have no trouble with the quiz. https: //bccbusinessstudies. wikispaces. com/ Vocab Quiz (15 Minutes) tomorrow in Dean’s computer lab. Weeks 1 -4.

Rubric Organization Research/Effort Grammar/Flow Vocabulary/Concepts Believability

Shorting Stocks Betting 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 price 3. You then wait and root for the stock price to tumble 4. Then you cash out, whether at a profit of loss 5. You then buy the shares at the new market price and return the shares to their owner

Shorting Example Scenario 1 Mr. Giant shorts 1000 shares of FORD Co. at $20 a share – his account gets credited with $20, 000 FORD 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 2 Mr. Giant shorts 1000 shares of FORD Co. at $20 a share – his account gets credited with $20, 000 FORD 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%

Different types of Orders Market Order (Buy at Sell at the Market) Limit Order executes to buy / sell at specified price of better (lower). Limit orders usually cost more, but useful for getting specified price. Trying to get a better entry or exit price. Stop Order executes when the price surpasses a particular point, which helps buy or sell at a particular price. Trying limiting loss or locking profits

Different Types of Orders Stop Limit Order Executed at a specified price (or better) after a given stop price has been reached. Order becomes then a limit order to buy (or sell) at the limit price or better Precision purposes Good Until Cancelled (GTC) An order to buy or sell a security at a set price that is active until the investor decides to cancel it or the trade is executed. If an order does not have a good-'til-canceled instruction the order will expire at the end of the trading day the order was placed. Good Until End of Day

Sector / Industries Cyclical vs. Non-Cyclical

Sector vs Industry Often 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. Industries Top sectors / industries rotate every cycle Important to know which sectors / industries are leading the market and performing well Why? Let’s think back to 1998 Technology, software, telecom: leading industries then If 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 CORRELATION! Pay attention to competitors!

Recent Industry Performance (http: //stockcharts. com/charts/performance/Industry 1. html)

Cyclical Stocks / Industries The term refers to how correlated a company’s price (or industry) is relative to economic fluctuations (general economy) Non-cyclical stocks (also called defensive stocks) refer to companies not as susceptible to economic fluctuations Example. Household durables, tobacco, utilities (Things people buy regardless of the economy) These are often goods that necessities rather than luxuries

Cyclical vs. Non-Cyclical Stocks Ford = Blue Red – Florida Public Utilities

Summary Market Capitalization Small caps vs. large caps Stock Splits Stock Buybacks Earning Reports Shorting Stocks Margin Industries vs. Sectors Cyclical Stocks / Industries

TOMORROW MIDTERM WEDNESDAY DECEMBER 16 Accounting Basics Chapter 18 from text. First 3 Power Point Presentations from Website Quiz December 16 on readings from website