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Investing in Equities
Topic 6
I. Common Stock Investments
Professor James Kuhle 1
Common Stock
Common Shareholder's Six Main Rights
1) Voting Power on Major Issues
This includes electing directors and proposals for fundamental changes
affecting the company such as mergers or liquidation. Voting takes
place at the company’s annual meeting. If you can’t attend, you can by
proxy and mail in your vote.
2) Ownership in a proportional interest of the Company
3) Right to Transfer Ownership
4) Dividend Entitlement
5) Opportunity to Inspect Corporate Books and Records
6) Suing for Wrongful Acts
Professor James Kuhle 2
A. Basic Characteristics
1. Equity Capital
2. Types
– a. Growth Stock
– b. Income Stock
– c. Speculative Stock
– d. Cyclical Stock
– e. Defensive Stock
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B. Valuation of Common Stock
1. Dividend Valuation Model
– a. Example
2. Using the CAPM Process
– a. Assumptions
» 1. km = rate of return on the market
» 2. Rf = return on the risk free asset
» 3. km - Rf = Market Risk Premium
– b. Example
Professor James Kuhle 4
C. Other Common Stock Values
1. Par Value
2. Book Value
3. Liquidation Value
4. Market Value
5. Investment Value
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D. Common Stock as an Inflation Hedge
Protection Against Inflation
Over the last thirty years the S&P 500
has averaged approximately 11% annual
compound return.
Inflation has averaged approximately
5.4% during the same time period.
Professor James Kuhle 6
Common Stock as an Inflation Hedge:
S&P LT Bonds LT Gov’t Bonds T. Bills CPI
Last 10: 14.8% 11.3% 11.9% 5.6% 3.5%
Last 20: 14.6% 10.6% 10.4% 7.3% 5.2%
Last 30: 10.7% 8.2% 7.9% 6.7% 5.4%
Last 40: 10.8% 6.8% 6.4% 5.7% 4.5%
Last 50: 11.9% 5.8% 5.3% 5.7% 4.4%
Source: Ibbotson and Sinquefield, “Stocks, Bonds, Bills and Inflation 2004 yearbook,”
Chicago.
Professor James Kuhle 7
The Panic of 1987
Index arbitrage and portfolio insurance (programmed trading)
were the major cause. From Tuesday 10/13/87 to
10/19/87, the DJIA fell 769 points or 31%. On 10/19/87
the DJIA fell508 points or 22.6%. On 10/28/29 the DJIA
fell 11.7%.
Mutual funds and pension funds use portfolio insurance.
Portfolio insurance is a strategy that uses computer based
models to determine an optimal stock/cash ratio at various
market prices. Two insurance users called for sales
equaling 50% in response to a 10% decline in the S&P 500
Index.
Professor James Kuhle 8
Investing in Equities
Wisdom from the Masters
Topic 6
II. Principles of Security Analysis
Professor James Kuhle 9
Types of Security Analysis
1. Fundamental Analysis
2. Technical Analysis
Professor James Kuhle 10
The Father of Fundamental
Analysis: Benjamin Graham
Who was Benjamin Graham?
Sources: Security Analysis (Graham and Dodd); The Intelligent Investor (Graham)
Professor James Kuhle 11
Ben Graham and Mr. Market:
Long ago Ben Graham described the mental attitude toward market fluctuations
that I believe to be most conducive to investment success. He said that you
should imagine market quotations coming from a remarkably accommodating
fellow named Mr. Market who is your partner in a private business. Without
fail, Mr. Market appears daily and names a price at which he will either buy
your interest or sell you his. Even though the business that the two of you own
may have economic characteristics that are stable, Mr. Market’s quotations will
be anything but stable. For, it is sad to say, Mr. Market is a fellow who has
incurable emotional problems. At times he falls euphoric and can see only the
favorable factors effecting the business. When in that mood, he names a very
high buy-sell price because he fears that you will snap up his interest and rob
him of imminent gains. At other times he is depressed and can see nothing but
trouble ahead for both the business and the world. On these occasions he will
name a very low price, since he is terrified that you will unload your interest on
him.
Professor James Kuhle 12
Ben Graham and Mr. Market
Continued:
Mr. Market has another endearing characteristic: He doesn’t mind
being ignored. If his quotation is uninteresting to you today, he will be
back with a new one tomorrow. Transactions are strictly at your
option. Under these conditions, the more manic-depressive his
behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or
everything will turn into pumpkins and mice: Mr. Market is there to
serve you, not to guide you. It is his pocketbook, not his wisdom, that
you will find useful. If he shows up someday in a particularly foolish
mood, you are free to either ignore him or to take advantage of him,
but it will be disastrous if you fall under his influence. Indeed, if you
aren’t certain that you understand and can value your business far
better than Mr. Market, you don’t belong in the game. As they say in
poker, “If you’ve been in the game 30 minutes and you don’t know
who the patsy is, you’re the patsy.”
Professor James Kuhle 13
B. Graham’s Fundamental
Investment Rules
1. Adequate Size
2. Sufficient Strong Financial Condition
3. Earnings Stability
4. Dividend Record
5. Earnings Growth
6. Moderate Price/Earnings Ratio
7. Moderate Ratio of Price to Assets
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C. Terms
1. Net Current Assets (NCA)
– Defined as:
Current Assets
- Current Liabilities
- Long-Term Debt
- Preferred Stock
NCA Total
NCAc = NCA/# of Common Shares
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C. Terms (continued)
2. Data Source
– S&P Stock Guide
– Value Line, etc.
3. Earnings Per Share (EPS)
4. Market Price
5. Book Value Per Share
6. Dividends Per Share
7. Current Ratio
Professor James Kuhle 16
C. Terms (continued)
8. Total Debt
9. Equity
10. Growth
g = [ (1 + RP,-1)(1 + RP,-2) ... (1 + RP,-10)] 1/n -1
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D. The Graham Model
1. Group A Criteria
#1: E/P > 2 (AAA Yield)(1 pt.)
E/P > 1.33 (AAA Yield) (1/2 pt.)
#2: P/E < .4 (Avg. P/E in last 3 yrs.) (1 pt.)
P/E < .4 (Avg. P/E in last 10 yrs.) (1/2 pt.)
#3: P/Bk < 2/3 (1 pt.)
P/Bk < 1 (1/2 pt.)
#4: D/P > .67 (AAA Yield) (1 pt.)
D/P > .50 (AAA Yield) (1/2 pt.)
#5: P/NCA < 1 (1 pt.)
P/NCA < 1.33 (1/2 pt.)
Professor James Kuhle 18
D. The Graham Model
(continued)
2. Group B Criteria
#6: CR > 2 (1 pt.)
CR > 1.8 (1/2 pt.)
#7: TD/E < 1.0 (1 pt.)
TD/E < 1.2 (1/2 pt.)
#8: TD/NCA < 2 (1 pt.)
NCA > 0 (1/2 pt.)
#9: G10 > 7%/YR. (1 pt.)
G5 > 7%/YR. (1/2 pt.)
#10: No more than 2 declines in earnings of 5% each over the last 10
years for one full point.
No more than 3 declines in earnings of 5% or more in last 10 years
for one-half point.
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The Influence of Philip Fisher
1. Fisher was led to believe that superior profits could be made by (1)
investing in companies with above average potential and (2) by
aligning oneself with the most capable management.
2. Fisher developed a “point system” that qualified a company by the
characteristics of its business and its management.
3. The characteristic of a business that most impressed Fisher was a
company’s ability to grow sales and profits over the years at rates
greater than the industry average.
4. The two types of companies that could expect to achieve above-
average growth were companies that, were (1) “fortunate and able”
and were (2) “fortunate because they are able.”
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Contemporary Fundamentals:
Peter Lynch’s Ten Golden Rules of Investing:
1. Don’t be intimidated by experts (ex spurts).
2. Look in your own backyard.
3. Don’t buy something you can’t illustrate with a crayon.
4. Make sure you have the stomach for stocks.
5. Avoid hot stocks in hot industries.
6. Owning stocks is like having children. Do not have more than you
can handle.
7. Don’t even try to predict the future.
8. Avoid weekend worrying. Do not get scared out of good stocks.
Own your mind.
9. Never invest in a company without first understanding its finances.
10. Do not expect too much, too soon. Think long-term.
Professor James Kuhle 21
Contemporary Fundamentals:
Peter Lynch’s mistakes to avoid:
1. Thinking that this year will be any different
than any other year
2. Becoming too concerned over whether the
stock market is going up or down
3. Trying to time the market
4. Not knowing the story behind the company in
which you are buying stock
5. Buying stocks for the short-term
Professor James Kuhle 22
Contemporary Fundamentals:
Lynch Maxim’s:
1. A good company usually increases its dividends every
year.
2. You can lose money in a very short time, but it takes a
long time to make money.
3. The stock market isn’t a gamble as long as you pick
good companies that you think will do well and not
just because of the stock price.
4. You have to research the company before you put
money into it.
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Lynch Maxim’s (cont.)
5. When you invest in the stock market you should always
diversify.
6. You should invest in several stocks (5).
7. Never fall in love with a stock, always have an open mind.
8. Do your homework.
9. Just because a stock goes down doesn’t mean it can’t go
lower.
10. Over the long-term it is generally better to buy stocks in
small companies.
11. Never buy a stock because it is cheap, but because you
know a lot about it.
Source: One Up On Wallstreet, by Peter Lynch
Professor James Kuhle 24
Sir John Marks Templeton
Who is Sir John Marks Templeton?
John Templeton borrowed $10,000 and started a brilliant investment
career, which enabled him to be one of two investors to become
billionaires solely through their investment prowess. Templeton has
had decade after decade of 20% plus annual returns and managed over
$6 Billion in assets. Templeton is generally regarded as one of the
world’s wisest and most successful investors. Forbes Magazine said,
“Templeton is one of a handful of true investment greats in a field of
crowded mediocrity and bloated reputations.” Templeton holds that
the common denominator connecting successful people with successful
enterprises is a devotion to ethical and spiritual principles. Many
regard Sir John as the greatest Wallstreet Investor of all time.
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Sir John Mark Templeton
Sir John’s 16 Rules for Investment Success:
1. Invest for maximum total real return including taxes and inflation.
2. Invest. Don’t trade or speculate.
3. Remain flexible and open-minded about types of investments. No
one kind of investment is always best.
4. Buy at a low price. Buy what others are despondently selling. Then
sell what others are despondently buying.
5. Search for bargains among quality stocks.
6. Buy value not market trends or economic value.
7. Diversify. There is safety in numbers.
8. Do your homework. Do not take the word of experts. Investigate
before you invest.
Professor James Kuhle 26
Templeton’s 16 Rules (Cont.)
9. Aggressively monitor your investments.
10. Don’t panic. Sometimes you won’t have everything sold as the market
crashes. Once the market has crashed, don’t sell unless you find another more
attractive undervalued stock to buy.
11. Learn from your mistakes, but do not dwell on them.
12. Begin with prayer, you will think more clearly.
13. Outperforming the market is a difficult task, you must outthink the
managers of the largest institutions.
14. Success is a process of continually seeking answers to new questions.
15. There is no free lunch. Do not invest on sentiment. Never invest in an IPO.
Never invest on a tip. Run the numbers and research the quality of
management.
16. Do not be fearful or negative too often. For 100 years optimists have carried
the day in U.S. Stocks.
Professor James Kuhle 27
Common Stock Issues
Understanding Rights Issues
A rights issue is an invitation to existing shareholders to purchase additional
new shares in the company. The company is giving shareholders a chance
to increase their exposure to the stock at a discount price.
You can (1) subscribe to the rights issue in full, (2) ignore your rights or (3)
sell the rights to someone else.
An Example
Let's say you own 1,000 shares in Wobble Telecom, each of which are
worth $5.50. The company is in a bit of financial trouble and sorely needs
to raise cash to cover its debt obligations. Wobble therefore announces a
rights offering, in which it plans to raise $30 million by issuing three
million shares to existing investors at a price of $3 each. But this issue is a
three-for-10 rights issue. In other words, for every 10 shares you hold,
Wobble is offering you another three at a deeply discounted price of $3.
This price is 45% less than the $5.50 price at which Wobble stock trades.
Professor James Kuhle 28
Rights Issue
Exercising the right: As you hold 1,000 shares, you can buy up to 300 new shares
(three shares for every 10 you already own) at this discounted price of $3, giving a
total price of $900. The market price of Wobble shares will not be able to stay at
$5.50. The theoretical ex-rights price can be estimated as follows:
After the rights issue is complete:
1,000 existing shares at $5.50 $5,500
300 news shares for cash at $3 $900
Value of 1,300 shares $6,400
Ex-rights value per share $4.92 ($6,400.00/1,300 shares)
So, in theory, as a result of the introduction of new shares at the deeply discounted
price, the value of each of your existing shares will decline from $5.50 to $4.92.
Professor James Kuhle 29
Rights Issue
Ignore the rights issue: You may not have the $900 to purchase the additional
300 shares at $3 each, so you can always let your rights expire. But this is not
normally recommended. If you choose to do nothing, your shareholding will be
diluted thanks to the extra shares issued.
Sell your rights to other investors: In some cases, rights are not transferable.
These are known as "non-renounceable rights". But in most cases, your rights
allow you to decide whether you want to take up the option to buy the shares or
sell your rights to other investors or to the underwriter. Rights that can be traded
are called "renounceable rights", and after they have been traded, the rights are
known as "nil-paid rights".
To determine how much you may gain by selling the rights, you need to estimate a
value on the nil-paid rights ahead of time. Again, a precise number is difficult, but
you can get a rough value by taking the value of ex-rights price and subtracting the
rights issue price. So, at the adjusted ex-rights price of $4.92 less $3, your nil-paid
rights are worth $1.92 per share. Selling these rights will create a capital gain for
you.
Professor James Kuhle 30
Evaluating Corporate Management
1. Price Isn't Always a Reflection of Good Management.
Strong stock performance alone doesn't mean you can assume the
management is of high quality.
2. Length of Tenure
The 14A will list among other factors background information on the
managers, their compensation (including options), inside ownership.
3. Strategy & Goals
what kind of goals has the management set out for the company? Does the
company have a mission statement? How concise is the mission statement?
A good mission statement creates goals for management, employees,
stockholders and even partners. It's a bad sign when companies lace their
mission statement with the latest buzz words and corporate jargon.
4. Insider Buying & Stock Buybacks
Insiders buying stock regularly show investors that managers are willing to
put their money where their mouth is. The key here is to pay attention to
how long the management holds shares.
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Evaluating Corporate Management
5. Compensation
One thing to consider is that managements in different industries take in different
amounts. As a general rule you want to make sure that CEOs in the same industries
have similar compensation. You have to be suspicious if a manager makes an
obscene amount of money while the company suffers. If a manager really cares about
the shareholders in the long term, would this manager be paying him/herself
exorbitant amounts of money during tough times? It all comes down to the agency
problem. If a CEO is making millions of dollars when the company is going
bankrupt, what incentive does she/he have to do a good job?
6. Conclusion
Looking at the financial results each quarter is important, but it doesn't tell the whole
story. Spend a little time investigating the people who fill those financial statements
with numbers.
Professor James Kuhle 32
Understanding Pro-Forma
Earning
Pro-Forma Earnings: are estimates of the potential profitability of a company in
the future when non-recurring expenses are eliminated from the forecast.
A Pro-forma income statement can exclude anything the company deems as a
distortion on future earnings.
Some companies therefore strip out certain costs that get in the way. This kind of
earnings information can be very useful to investors who want an accurate
view of a company's normal earnings outlook, but by omitting items that
reduce reported earnings, this process can make a company appear profitable
even when it is losing money.
Companies all too often release positive earnings reports that exclude things like
stock-based compensation and acquisition-related expenses.
This isn't to say companies are always dishonest with pro-forma earnings - pro
forma doesn't mean the numbers are automatically being manipulated. But by
being skeptical when reading pro-forma earnings, you may end up saving
yourself big money.
Professor James Kuhle 33
Pro-Forma Earnings (Cont.)
The dotcom era of the late 90s saw some of the worst abusers of pro-forma earnings
manipulations.
Network Associates went so far as to exclude its dotcom department's operating earnings.
So why did the company exclude these numbers? No doubt the department was losing
money and decided to hide this important fact from investors, who need to know about
those numbers reflecting poor company strategy.
The impetus to report pro-forma numbers is usually a result of industry characteristics. For
example, some cable and telephone companies almost never make a net operating profit
because they are constantly writing down big depreciation costs.
When a company undergoes substantial restructuring or completes a merger, significant one-
time charges can occur as a result.
To sum up, pro-forma earnings are informative when official earnings are blurred by large
amounts of asset depreciation and goodwill. But, when you see pro forma, it's up to you
to dig deeper to see why the company is treating its earnings as such. Remember that
when you read pro-forma figures, they have not undergone the same level of scrutiny as
GAAP earnings and are not subject to the same level of regulation.
Professor James Kuhle 34
Insider Ownership
Insiders are a company's officers, directors, relatives or anyone else with access to key
company information before it's made available to the public. Savvy investors, making
the reasonable assumption that insiders know a lot more about their company's prospects
than the rest of us, pay close attention to what insiders do with company shares.
the Securities and Exchange Commission (SEC) requires companies to file reports on
these matters, giving investors the opportunity to have some insight into insider activity.
You can retrieve reporting forms from the SEC's EDGAR database or the SEC Info Insider
Trading Reports. Form 14A is the proxy statement in which you will find a list of
directors and officers and the number of shares they each own. There is also a list of
beneficial owners, or people or entities owning more than 5% of a company's stock.
The other relevant forms are 13D and 13G for disclosure of outside beneficial ownership,
and Forms 3, 4 and 5 for disclosure of insider beneficial ownership. Insiders with more
than 10% of the voting power file Forms 3, 4 or 5, and outsiders owning more than 5%
file schedule 13D or its amendment form 13F.
High inside ownership typically signals confidence in the company's prospects, and the
ownership in its shares in turn gives management an incentive to make the company
profitable and maximize shareholder value.
Professor James Kuhle 35
Insider Ownership
On the other hand, you can have too much insider ownership. When insiders gain corporate
control, management may not feel responsible to shareholders. This occurs frequently at
companies with multiple classes of stock, which means one class carries more voting
power than another. For example, Google's much publicized IPO in the fall of 2004 was
criticized for issuing a special class of "super voting shares" to certain company
executives.
While insider buying is usually a good sign, don't be alarmed by insider selling, unless there
is a lot of it - Look for clusters of activity by several insiders.
It's important to know which insiders to watch. Insiders with proven track records with their
Form 4 activity should be watched more closely than those with little or poor past
records.
Finally, be careful about placing too much emphasis in insider trading since the documents
reporting them can be hard to interpret. A lot of Form 4 trades do not represent buying
and selling that relate to future stock performance. The exercise of stock options, for
instance, shows up as both a buy and a sell on Form 4 documents, so it is a dubious
signal to follow.
Professor James Kuhle 36
Five Pitfalls to Avoid
1. Buying Low-Priced Stocks
low-priced stocks are generally missing a key ingredient of past stock market
winners: institutional sponsorship. Cheap stocks are cheap for a reason. Stocks sell
for what they’re worth.
2. Avoiding Stocks With High P/E Ratios
Leaders in an industry group often trade at a higher premium than their peers for a
simple reason: They're expanding their market share faster because of outstanding
earnings and sales growth prospects.
3. Letting Small Losses Turn Into Big Ones
Cut your losses in any stock at 7% or 8% and you'll never get hit with a big loss.
4. Averaging Down
Averaging down means you're buying stock as the price falls in the hopes of getting a
bargain. It's also known as throwing good money after bad or trying to catch a falling
knife.
5. Buying Stocks In A Down Market
When you're buying stocks, make sure you're swimming with the market tide, not
against it.
Professor James Kuhle 37
Measuring Company Efficiency
1. Analyzing a company’s inventories and receivables is
a reliable means of helping to determine whether it is
a good investment play or not. Companies stay
efficient and competitive by keeping inventory levels
down and speeding up collection of what they are
owed.
2. Inventory Turnover = Sales/Inventory
3. Broadly speaking, the smaller number of days, the
more efficient a company - inventory is held for less
time and less money is tied up in inventory.
4. Finding out where a firm’s cash is tied up in
inventories and receivables can help shed light on its
how efficiently it is being managed.
Professor James Kuhle 38
Biomet Example
Asset Utilization 2002 2003 2004
Inventory Turnover 3.90 4.15 5.24
Fixed Asset Turnover 5.43 5.92 6.61
Total Asset Turnover 0.85 0.90 1.15
Biomet has clearly gotten more efficient over the last three
years. The trend in all three asset utilization ratios has
increased thereby suggesting a more efficient use of company
resources.
Professor James Kuhle 39
Efficiency: the Sales/Employees
Ratio
The sales-per-employee ratio provides a broad
indication of how expensive a company is to
run. It can be especially insightful when
measuring the efficiency of businesses such as
banks, retailers, consultants, software
companies, and media groups. "People
businesses" lend themselves to the sales per
employee ratio.
Companies with higher sales-per-employee
figures are generally considered more efficient
than those with lower figures.
Professor James Kuhle 40
Biomet Example
Profitability ratios:
2002 2003 2004
Profit Margin (NI/Sales) 20% 19% 19%
ROA 16.79% 17.60% 22.40%
ROE 22.22% 22.69% 26.55%
ROCE 29.01% 28.64% 33.22%
In the case of Biomet, we have the profit margin decreasing by 1% from 2002 to
2003, but then leveling out in 2004. This would not appear to be a concern. The
ROE is consistently increasing over the three year time period. A minor concern
might be the dip in the ROCE ratio in 2003. However, even this ratio rebounds
nicely in 2004.
Professor James Kuhle 41
Return on Invested Capital
ROIC = Net Operating Profits After Tax (NOPAT) / Invested Capital.
In an nutshell, ROIC is the measure of cash-on-cash yield and the
effectiveness of the company's employment of capital.
Invested Capital = Total Assets less Cash - Short Term Investments -
Long Term Investments - Non-Interest Bearing Current Liabilities.
NOPAT = Reported Net Income - Investment and Interest Income - Tax
Shield from Interest Expenses (effective tax rate x interest expense) +
Goodwill Amortization + Non-Recurring Costs plus Interest Expenses
+ Tax Paid on Investments and Interest Income (effective tax rate x
investment income)
If the final ROIC figure, which is expressed as a percentage, is greater
than the company's working asset cost of capital, or WACC, the
company is creating value for investors.
Professor James Kuhle 42
Uncovering Hidden Debt
Most of the information about debt can be found on the
balance sheet--but many debt obligations are not
disclosed there.
A lot of investors don't know that there are two kinds of
leases: capital leases (the lessee acquires the property
in substance but not in legal form) which show up on
the balance sheet, and operating leases (The lessee
leases property that is owned by the lessor) which do
not.
Synthetic Leases: Building or buying an office building
can load up a company's debt on the balance sheet. A
lot of businesses therefore avoid the liability by using
synthetic leases to finance their property: a bank or
other third party purchases the property and rents it to
the company.
Professor James Kuhle 43
Uncovering Hidden Debt
Synthetic Leases (continued): For accounting
purposes, the company is treated like a tenant
in a traditional operating lease. So, neither the
building asset nor the lease liability appears
on the firm's balance sheet. However, a
synthetic lease, unlike a traditional lease,
gives the company some benefits of
ownership, including the right to deduct
interest payments and the depreciation of the
property from its tax bill. Details about
synthetic leases normally appear in the
footnotes.
Professor James Kuhle 44
Uncovering Hidden Debt
Securitizations:
Banks and other financial organizations often hold
assets--like credit card receivables--that third parties
might be willing to buy. To distinguish the assets it sells
from the ones it keeps, the company creates a special
purpose entity (SPE). The SPE purchases the credit card
receivables from the company with the proceeds from a
bond offering backed by the receivables themselves.
The SPE then uses the money received from cardholders
to repay the bond investors. Since much of the credit
risk gets offloaded along with the assets, these liabilities
are taken off the company's balance sheet.
Professor James Kuhle 45
Uncovering Hidden Debt
Conclusion:
Companies argue that off-balance-sheet
techniques benefit investors because they
allow management to tap extra sources of
financing and reduce liability risk that could
hurt earnings. That's true, but off-balance-
sheet finance also has the power to make
companies and their management teams look
better than they are.
It's important for investors to get the full story
on company liabilities.
Professor James Kuhle 46
Reading the Footnotes
Read the article on Investopedia, under stocks entitled
Reading the footnotes – Part 1
Not all disclosures are created equal:
Disclosures in 10-K filings are much more informative than in 10-Qs. This
difference is an anachronistic holdover from the pre-digital age, when
companies argued that it was too costly to provide full disclosure every
quarter. Even though everything is now digital, regulators still haven't made
quarterly updates a requirement, so some important information on key areas
such as pension data is not updated each quarter.
Rules are meant to be bent:
In the beginning the SEC made the rules, but shortly thereafter came lawyers,
accountants and other high-paid financial engineers who find ways to
circumvent the new disclosure and tax laws. Each economic cycle is followed
by a new wave of reform, which helps perpetuate this cycle.
Professor James Kuhle 47
Reading the Footnotes
Potential rewards require high effort:
If analyzing companies were easy, everybody would do it
and there would be nothing disputing the existence of an
efficient market. But it takes a good deal of hard work to
gain a competitive advantage in business and investing.
The harder you work, the more you know. The more you
know, the more you can avoid the mistakes of the past and
make money.
Professor James Kuhle 48
Reading Footnotes
Rule # 1: Know the company, industry and weaknesses of both:
In order to find the warning signs, you have to know where in the footnotes to focus
your reading. To do this, you need to be aware of the possible areas wherein
trouble could first develop. For example, the auto industry (and any heavily-
unionized industry) carries more of the type of risk created by under-funded
pension plans than a high-tech industry. When evaluating a company in the auto
industry you would want to spend more time analyzing the pension footnote than
the options disclosures (although an auto company may also have 'option risk').
To know how to streamline your approach to any particular company's footnotes, you
need to do some primary research, which means reading not just one SEC filing
but several years of a company's SEC filings, from cover to cover. This primary
research will give you a better feel for how management communicates and how it
obfuscates. Don't trust anyone else's summary. Your own experience gained from
this preliminary reading will not only cure insomnia but will provide you with a
perspective that will make it easier to spot the red flags.
Professor James Kuhle 49
Reading Footnotes
Rule #2: The good stuff is always buried
Rarely does a company admit its mistakes in headlines and
tables or make them easily found in required disclosures.
Generally, the red flags are buried in long paragraphs filled
with legal boilerplate that takes a pot of strong coffee to
read and understand. But the hard work it takes to do some
digging does pay off with an insight that is often
overlooked even by the pros.
Professor James Kuhle 50
Reading Footnotes
Rule # 3: Consistency is NOT the rule; you need to
compare disclosures
Because disclosures change from filing to filing as the result of events
or changed assumptions, you can't read just one disclosure and expect
to have the whole story. You need to analyze any changes, which will
provide an insight into the quality/credibility of management thinking.
Take for example the assumptions used in healthcare cost estimations,
which are usually found in a section about other post retirement
benefits. Start in 2000 and you may see a company whose management
assumes that healthcare costs will rise in the mid single-digit range and
decline to low single-digits during the next five to seven years.
Professor James Kuhle 51
Reading Footnotes
Now, read the latest 10-K and you may see that these
assumptions, including the assumed steady decline, have
not changed even though healthcare costs have actually
increased in the 15-20% range and are expected to increase
in the low double-digit range in 2004. The company's
failure to adjust its assumptions indicates that management
is either (1) keeping estimates low to minimize the adverse
impact on earnings, (2) are out of touch with reality and/or
(3) plan to shift more than half of the increase to the
employees. A company that assumed increases in the
double digit range would have more credibility than the
company with the single digit growth assumption.
Professor James Kuhle 52
Reading Footnotes – Accounting
Changes
Being able to understand accounting disclosures gives investors an ability to recognize
early warning signs that can help prevent investment disasters. Companies are required to
disclose the impact of adopting new accounting rules and this information sometimes
reveals some bad news that could hurt stock prices. The adverse reaction could come
from the revelation of off-balance-sheet entities, reduced EPS or increased debt load.
Accounting disclosures sometimes have their own footnote and/or are discussed in
another footnote that is impacted by the new rule (like Pension or Goodwill). Some
companies also repeat the disclosures in the "Management Discussion and Analysis"
(MD&A) section of their SEC filings (10-K and 10-Q filings). In 10-K filings, the
disclosure may be addressed in several areas but the main one is usually one of the
footnotes with a title like "Summary of Significant Accounting Policies". In 10-Qs, the
discussion of new accounting rules will most likely be limited to a footnote entitled
"Recently Adopted Accounting Pronouncements". Generally, each new rule is discussed
in its own paragraph.
The quick and dirty way to read these disclosures is to focus on the second and last
sentence. The second sentence will talk about what the rule does and the last sentence
discloses management's expectation of what impact the new rule will have.
Professor James Kuhle 53
Accounting Changes
Read the entire article: “How to Read Footnotes – Part 2,
on Investopia - Stock articles
Determining What the Disclosures Reveal
The last sentence, where management discusses the likely impact of the new
accounting techniques on the company, is the key spot on which investors
want to focus. There are three key phrases that will be either a green, yellow or
red flag to investors:
The Green Flag
'No material impact' indicates the best of all worlds because it means that the
change will have no impact on financial reporting.
The Yellow Flag
The phrases may vary, but generally you want to pay attention if the last
sentence tells you there will be an impact of the new rule.
The Red Flag
The absence of any conclusive statement indicating the impact of the
accounting changes is a big red flag. If the disclosure is missing this statement,
it could mean that management either has not determined the effect of the new
accounting or has chosen simply not to break any bad news to investors.
Professor James Kuhle 54
Reading Footnotes
Read the article entitled: How to Read Footnotes Part 3 –
Evaluating the Board of Directors
There is a checklist that investors can use to evaluate the objectivity and effectiveness of a
board. This list was developed from a study done by the Corporate Library ("the study")
and was reported in the Oct 27, 2003, edition of the Wall Street Journal (page R7).
1. Size of the Board
A large board is a sign that membership is a payback of some kind, a "thank you" for
good service or for getting the CEO on another board. On the other hand, a small board
could be just as ineffective if it is stacked with sycophants. According to the Corporate
Library's study, the average board size is 9.2 members, ranging from 3 to 31 members.
The ideal number is 7 and here’s why. There are two critical board committees that must
be comprised of independent members: the compensation committee and the audit
committee. Based upon our research, the minimum number for each committee is three.
This means a minimum of six board members is needed so that no one is on more than
one committee - having members doing double duty may compromise the important
wall between audit and compensation, which should help avoid any conflicts of interest.
It's the responsibility of the chairperson to make sure the board is functioning properly
and the CEO is fulfilling his or her duty and following the directives of the board.
Professor James Kuhle 55
Reading Footnotes
2. Insider/Outsider (Degree of Independence)
A key attribute of an effective board is that it is comprised of
independent outsiders. An outsider is someone who has never worked
at the company, is not related to any of the key employees and does
not/did not work for a major supplier or customer. The WSJ study
found that independent outsiders comprised 66% of all boards and
72% of S&P boards.
3. Committees
There are three important committees that each board should have:
audit, compensation and nominating. There may be more committees
depending on corporate philosophy (which is determined by an ethics
committee) or if the company wants to combat current negative
headlines. Let's take a closer look at the three main committees:
Professor James Kuhle 56
Three Main Committees
The Audit Committee
The audit committee is charged with working with the auditors to make sure
that the books are correct and that there are no conflicts of interest between the
auditors and the other consulting firms employed by the company.
The Compensation Committee
The compensation committee is responsible for setting the pay of top
executives. While it seems obvious that the CEO (or other people with
conflicts of interest) should not be on this committee, you'd be surprised at the
number of companies that allow just that.
The Nominating Committee
This committee is responsible for nominating people to the board. The
nomination process should aim to bring on people with independence and a
skill set currently lacking on the board.
Professor James Kuhle 57
Dual Class Shares
Dual-Class Shares: Designed to give specific shareholders
voting control, unequal voting shares are primarily
created to satisfy owners who don't want to give up
control but do want the public equity market to provide
financing.
Many companies list dual-class shares.
Berkshire Hathaway Inc., which has Warren Buffett as a
majority shareholder, offers a B share with 1/30th the
interest of its A-class shares, but 1/200th of the voting
power.
It’s argued that “B” shares insulate managers from Wall
Street's short-term mindset. Founders often have a
longer-term vision than investors focused on the most
recent quarterly figures.
Professor James Kuhle 58
Dual Class Shares
They create an inferior class of shareholder and hand over
power to a select few, who are then allowed to pass the
financial risk onto others.
Not every dual-class company is destined to perform
poorly--Berkshire Hathaway, for one, has consistently
delivered great fundamentals and shareholder value.
Controlling shareholders normally have an interest in
maintaining a good reputation with investors.
Investors should keep in mind the effects of dual-class
ownership on company fundamentals.
Professor James Kuhle 59
Spotting Disaster
Cash flows:
Keeping a close eye on cash flow, which is a company's life line, this can
guard against holding a worthless share certificate. When a company's
cash payments exceed its cash receipts, the company's cash flow is
negative. If this occurs over a sustained period, it's a sign that cash in
the bank may become dangerously low. Without fresh injections of
capital from shareholders or lenders, a company in this situation can
quickly find itself insolvent. Examine the company's cash burn rate. If
a company burns cash too fast, it runs the risk of going out of business.
Burn rate is usually quoted in terms of cash spent per month. For
example, a burn rate of 1 million would mean the company is spending
1 million per month. When the burn rate begins to exceed forecasts, or
revenue fails to meet expectations, the usual recourse is to reduce the
burn rate (which, in most companies, means reducing staff).
Professor James Kuhle 60
Calculating Cash Flow
The natural
cash flows fit
into the
classifications
of the
statement of
cash flows.
Inflows are
displayed in
green and
outflows
displayed in
red:
Read the article: Advanced Financial Statement Analysis: Cash Flow by David Harper
Professor James Kuhle 61
Spotting Disaster
Debt Levels:
Interest repayments place pressure on cash flow, and this pressure is
likely to be exacerbated for distressed companies. Because they a
higher risk of default to banks, struggling companies must pay a
higher interest rate. Debt therefore tends to shrink their returns.
Total debt-to-equity (D/E) ratio: is a useful measure of
bankruptcy risk. It compares a company's combined long- and short-
term debt to shareholders' equity or book value.
Share Price Decline:
The savvy investor should also watch out for unusual share price
declines. Almost all corporate collapses are preceded by a sustained
share price decline.
Profit Warnings:
Investors should take profit warnings very, very seriously. While
market reaction to a profit warning may appear swift and brutal, there
is growing academic evidence to suggest the market systematically
under-reacts to bad news.
Professor James Kuhle 62
Spotting Disaster
Insider Trading: Executives and directors have the most
up-to-date information on their company's prospects, so
heavy selling by one or both groups can be a sign of
trouble ahead.
Resignations
The sudden departure of key executives (or directors)
can also signal bad news. You should also be wary of
the resignation or replacement of auditors.
SEC Investigations
Formal investigations by the Securities and Exchange
Commission (SEC)normally precede corporate collapses.
That's not surprising since, many companies guilty of
breaking SEC and accounting rules do so because they
are facing financial difficulties.
Professor James Kuhle 63
Spotting Disasters
Conclusions:
Some very sick companies can make miraculous recoveries
while apparently thriving ones can collapse overnight. But
the probability of this is very low. Typically, when a
company is struggling, the warning signs are there. Your
best line of defense as an investor is to be informed - ask
questions, do your research, be alert to unusual activities.
Make it your business to know a company's business and
you'll minimize your chances of getting caught in a
corporate train wreck.
Professor James Kuhle 64
The Bottom Line on
Profitability Ratios
The bottom line is the first thing many investors look at to gauge a
company's profitability. It's awfully tempting to rely on net earnings
alone to gauge profitability, but it doesn't always provide a clear
picture of the company, and using it as the sole measure of profitability
can have big repercussions.
profit-margin ratios, on the other hand, can give investors deeper
insight into management efficiency. But instead of measuring how
much managers earn from assets, equity or invested capital, these
ratios measure how much money a company squeezes from its total
revenue or total sales.
Margins, quite simply, are earnings expressed as a ratio - a percentage
of sales. A percentage allows investors to compare the profitability of
different companies, while net earnings - an absolute number - cannot.
Professor James Kuhle 65
Cooking the Books
Accelerating Revenues
1. One way to accelerate revenue is booking lump-sum payment as current
sales when services will be provided over a number of years. For example, a
software service provider receives upfront payment for a four-year service
contract but records the full payment as sales of only the period that the
payment is received. The correct, more accurate, way is to amortize the
revenue over the life of the service contract.
2. A second tactic is called channel stuffing. Here, a manufacturer makes a
large shipment to a distributor at the end of a quarter and records the shipment
as sales; however, the distributor has the right to return any unsold
merchandise. Because the goods can be returned and are not guaranteed as a
sale, the manufacturer should keep the products classified as a type of
inventory until the distributor has sold the product.
Professor James Kuhle 66
Cooking the Books
Delaying Expenses
AOL got in trouble for this in the early 1990s when it capitalized the costs of making
and distributing its CDs. AOL viewed this marketing campaign as a long-term
investment and capitalized the expense. This transferred the costs from the income
statement to the balance sheet where it was going to be expensed over a period of years.
The more conservative (and appropriate) treatment is to expense the cost in the period
the CDs were shipped.
Accelerating Expenses Preceding an Acquisition
This may sound a little counterintuitive, but bear with me. Before a merger is
completed, the company that is being acquired will pay, possibly prepay, as many
expenses as possible. Then, after the merger, the EPS growth rate of the combined entity
will be easily boosted when compared to past quarters; furthermore, the company will
have already booked the expense in the previous period.
Professor James Kuhle 67
Investing in Equities
Topic 6
IV. Technical Analysis
Professor James Kuhle 68
A. Definition
Technical Analysis is the belief that important
information about future stock price movements can be
obtained by studying the historical price movement.
90
80
70
60
50
40
30
20
10
0
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Professor James Kuhle 69
Technical Analysis
Assumptions:
Technical analysts base their buy and sell decisions on the
charts they prepare of recorded financial data
1. Market value is determined by the interaction of supply and demand.
2. Supply and demand are governed by numerous factors, both rational
and irrational.
3. Security prices tend to move in trends that persist for an appreciable
length of time, despite minor fluctuations in the market.
4. Changes in a trend are caused by shifts in supply and demand.
5. Shifts in supply and demand, no matter why they occur, can be
detected sooner or later in charts of market transactions
6. Some chart patterns tend to repeat themselves.
Professor James Kuhle 70
Types of Technical Charts:
Bar Charts
H
C
Dollar L
Price of
Stock
Trading Days
Professor James Kuhle 71
Types of Technical Charts:
Line Charts: a graph of successive day’s closing
prices
Closing
Prices
Trading Days
Professor James Kuhle 72
B. Approaches to Technical
Analysis
1. The Dow Theory
– The Dow theory views the movement of market
prices as occurring in three categories
1. Primary Movements: bull and bear markets
2.Secondary Movements: up and down
movements of stock prices that last for a few
months and are called corrections
3. Daily Movements: meaningless random
daily fluctuations
Professor James Kuhle 73
B. Approaches to Technical
Analysis (continued)
2. Trading Action
– a. Concentrates on minor trading
characteristics in the market
– b. Examples include:
» 1. Monday is the worst day to buy stocks, Friday is
the best.
» 2. If January is a good month for the market then
chances are good a good year will occur.
Professor James Kuhle 74
B. Approaches to Technical
Analysis (continued)
3. Bellwether Stocks
– a. A few major stocks in the market are
consistently highly accurate in reflecting the
current state of the market.
» IBM
» DuPont
» AT&T
» Exxon
» GM
Professor James Kuhle 75
Approaches to Technical
Analysis (Continued):
4. Relative Strength
– The basic idea behind relative strength is that
some securities will increase more, relative to
the market, in bull markets and decline less,
relative to the market, in bear markets.
Technicians believe that by investing in those
securities that exhibit relative strength higher
returns can be earned.
Professor James Kuhle 76
B. Approaches to Technical
Analysis (continued)
5. Technical Indicators
– a. Market Volume -- a measure of investor interest
» 1. STRONG when volume goes up in rising market or
drops during declining market
» 2. WEAK when volume goes up in declining market or
decreases during a rally
Professor James Kuhle 77
B. Approaches to Technical
Analysis (continued)
– Example
» On June 3, 2003
• Advances = 930
• Declines = 691
• Difference = + 239
» On June 11, 2003
• Advances = 651
• Declines = 920
• Difference = -269
– Conclusion: A weak market.
Professor James Kuhle 78
B. Approaches to Technical
Analysis (continued)
– b. Breadth of the Market
» 1. Considers the advances and declines in
the market.
» 2. As long as advances outnumber declines
a strong market exists.
» 3. The spread is used as an indicator of
market strength.
Professor James Kuhle 79
B. Approaches to Technical
Analysis (continued)
– c. Short Interest -- measures the number of stocks
sold short
» When the level of short interest is high, by historical
standards, then the situation is optimistic.
– d. Odd-Lot Trading: Theory of Contrary Opinion
» If the amount of odd-lot purchases start to exceed odd-lot
sales by a widening margin, it may suggest that
speculation is occurring among small investors. This is
the first signal of an upcoming bear market.
Professor James Kuhle 80
Review Problems: Section 6
What are two theoretical ways to determine the value of
Common Stock?
Net Current Asset in the Graham model is defined as?
Why do we calculate geometric instead of linear growth
rates?
The Graham model is a fundamental valuation model?
Explain.
Define technical analysis.
What are Bellweather stocks?
Who was Peter Lynch and what is he primarily known for?
What are Lynch’s 10 golden rules for investing?
Professor James Kuhle 81
XYZ Corp. has a debt to equity ratio of 42%. If net income is $200,000
and assets are reported as $1.8 million, what is the ROE?
a) 15.8%
b) 9.8%
c) 17.4%
d) 11.7%
Professor James Kuhle 82
