Investments: Introduction to Equity Analysis

Course Information

• Course code: MN-2066
• Course title: Investments: Assets; Equities and Bonds
• Lecture topic: Introduction to Equity and Industry Analysis
• Lecturer: Rongxin Chen
• Email: [email protected]

Equity Securities

• Common Stocks
• Preferred Stocks
• American Depositary Receipts (ADRs)

Common Stocks

• Represent partial ownership of a company
• Each share typically gives the shareholder one vote
• Holders may or may not receive dividends, depending on company profits

Characteristics of Common Stocks

• Residual claim: Stockholders have the last claim on a firm's assets and income. In liquidation, others (creditors, employees, authorities, suppliers, and bondholders) are paid before stockholders. In non-liquidation, shareholders claim after interest and taxes.
• Limited liability: Maximum loss for shareholders is their original investment. Worst case is a worthless stock. Stockholders are not personally liable for firm obligations. General partners may risk personal assets (house, car, etc.).

Quick Tests

• Question 1: If you buy 100 shares of IBM stock, to what are you entitled?
• Question 2: What is the most money you can make on this investment over the next year?
• Question 3: If you pay $115 per share, what is the most money you could lose over the year?

Preferred Stocks

• Characteristics:
  • Promise to pay a fixed amount of income each year.
  • Not obligated to pay every year; dividends owed accumulate.
  • Have priority over common stocks.
  • Unpaid dividends accumulate and must be cleared before common stock dividends
  • In liquidation: Preferred stockholders have priority over common stockholders, but below debt holders.
  • No voting power in firm management
  • Payments are dividends, not interest; not deductible for the issuing firm. Note: firms may exclude a percentage of dividends from taxable income. Suitable as fixed income investments.

Valuation of Stocks

• Intrinsic value: Expected future cash flows (e.g., dividends).
• Top-down analysis:
  • Global Economy
  • Domestic Macroeconomy
  • Demand and Supply Shocks
  • Federal Government Policy
  • Business Cycles
  • Industry Analysis

Industry Analysis

• Why important?
  • Firms in troubled industries might perform well.
  • Economic performance varies widely across industries.
• Considerable dispersion in stock prices across different industries (e.g. +42% in retail; -34% in coal)
• Defining an Industry: Determining industry boundaries is complex.
• Common methods:
  • North American Industry Classification System (NAICS) codes (replace SIC codes)
  • Standard & Poor
  • Value Line Investment Survey

Business Cycles

• Definition: The recurring pattern of economic recession and recovery.
• Transition points (peaks and troughs)
  • Peaks: Transition from an expansion to a contraction
  • Troughs: Point at the bottom of a recession where recovery begins

Cyclical vs. Defensive Industries

• Cyclical Industries: Above-average sensitivity to the economy's state
  • Examples: Durable goods producers (e.g., automobiles), capital goods
• Defensive Industries: Little sensitivity to the business cycle
  • Examples: Food producers and processors, pharmaceutical firms, and public utilities

Sensitivity to Business Cycles

• Three factors affecting firm earnings sensitivity:
  • Sensitivity of Sales
  • Operating Leverage
  • Financial Leverage

Sensitivity of Sales

• Necessities vs. Non-essentials
  • Necessities: less sensitive (e.g. food, drugs, medical services).
  • Non-essentials: more sensitive (e.g. machine tools, steel, autos, transportation)

Operating Leverage

• Definition: Ratio of fixed to variable costs
  • Fixed Costs: Incurred regardless of production levels.
  • Variable Costs: Vary based on production volume.
• Higher operating leverage: More sensitive to business cycles
• Lower operating leverage: Less sensitive to business cycles

Degree of Operating Leverage (DOL)

• Measure of how profits react to sales changes
• Formula(s):
  • DOL = (Percentage change in profits) / (Percentage change in sales)
  • DOL = 1 + (Fixed costs / Profits)

Example

• Comparing two firms (A & B) in the same industry.
• Similarities: Identical sales, prices per unit, consistent across business cycle phases.
• Differences: Fixed and variable costs per output unit

Example: DOL Calculations

• Using examples with data for the two firms (A and B) during Recession, Normal, and Expansion phases of the business cycle.
• DOLs during different economic periods

Financial Leverage

• Definition: Employing borrowed funds through debt
• Interest on debt: Obligatory, independent of sales
• As a fixed cost: Interest increases profits sensitivity to the business cycle.

Sensitivity to Business Cycles

• Investor preferences for industries
• High-beta stock riskier (firms in sensitive industries)
• Expected return versus risk

Sector Rotation

• Definition: A strategy where analysts adjust portfolios based on the business cycle
• Goal: Prioritize industries or sectors poised to outperform others
• Decisions are grounded in one's evaluation of the business cycle's current phase.
• Challenges: Duration and intensity of each cycle phase are unpredictable; success hinges on accurate anticipation of the next stage.

Industry Life Cycles

• Four stages:
  • Start-up: Extremely rapid growth
  • Consolidation: faster than general economy, but slowing
  • Maturity: Growth aligned with the general economy
  • Relative Decline: Growth slower than, or even contracting to the general economy.
• When investments are most appealing: Consideration of high-growth industries versus the reflection of anticipated growth and competition already factored into the prices.

This quiz covers the basics of equity securities, including common stocks, preferred stocks, and American Depositary Receipts (ADRs). It explores the characteristics of common stocks such as residual claims and limited liability. Test your understanding of how equity functions within investments.