Lecture 3: BASICs of INVESTING II

1. Lecture 3:BASICs of INVESTING II Economics 98/198 Decal Spring 2008

2. Today’s Schedule • Administrative Issues • Last Week’s Lecture • 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

3. Administrative Issues • Enrollment • Make sure you’re signed up on Tele-Bears • Investopedia Simulation Competition • Submit your $5 into the class envelope • Make sure you write username on sign-up sheet • Start trading! • Investor’s Business Daily online subscription • New Presentation

4. Lecture Content

5. Market Capitalization

6. 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)

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

8. Different Capitalizations • Not 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

9. 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 • TradeStation Group (TRAD) $471 million Source: Google Finance as of 2/12/2008 closing prices

10. Comparing Small and Large Caps(S&P 500 vs. S&P 600) – last decade Black line = S&P 500 Orange line = S&P 600

11. Comparing Small and Large Caps(S&P500 vs. S&P 600) – Past 2 Years Black line = S&P500 Orange line = S&P 600

12. Stock SplitsStock Buybacks

13. 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)

14. 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?

15. 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?)

16. 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

17. 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

18. 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

19. Investing on Margin / Short Selling

20. Investing on Margin • Borrowing 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.

21. 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

22. 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)

23. Margin Example continued SMRT goes through the roof and increases 100% in 10 months to $100. Joe smartly sells and takes profits. SMRT Investment (200sh@$100) +$20,000 Money borrowed from brokerage -$5,000 Interest on borrowed money -$500 Original Investment -$5,000 ------------------------------------------------------------------- Profit $9,500 % Return ($9,500/$5,000) 190% vs. % Return (cash investment only) 100%

24. 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

25. Shorting Example Scenario 1 Mr. 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%

26. Shorting Example Scenario 2 Mr. 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%

27. Sector / IndustriesCyclical vs. Non-Cyclical

28. 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.

29. 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

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

31. Cyclical Stocks / Industries • The 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 fluctuations • Example. Household durables, tobacco, utilities • These are often goods that necessities rather than luxuries

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

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

34. For Next Week • Quiz on Stock Market Basics • Introduction to Other Investment Securities • Bonds / Mutual Funds / Exchange-Traded Funds • Market Psychology • Emotions involved with stock investing • Basic Investing Concept • Compounding • Investing versus Speculating • Determining your own financial goals • Investment Style – Risk/Reward, Active/Passive • Managing your Portfolio

35. Current Events

36. Reading / Homework • Master Your Trading Mindtraps (Investopedia) • How Interest Rates Affect the Market (Investopedia) • Quiz next week: Basics of Stocks & investments • Market Exchanges • Major indexes • Ticker Symbols • Types of orders • Market Capitalization • Etc.