Lecture 1: Investments, Assets, Equities, and Bonds PDF

MN-2066: Investments: Assets; Equities and Bonds Introduction to Equity and Industry Analysis Lecture 1 Rongxin Chen [email protected] 1 Equity Securities Common Stocks Preferred Stocks...

MN-2066: Investments: Assets; Equities and Bonds Introduction to Equity and Industry Analysis Lecture 1 Rongxin Chen [email protected] 1 Equity Securities Common Stocks Preferred Stocks American Depositary Receipts (ADRs) … 2 Equity Securities: Common Stocks Represent partial ownership of a company. Each share typically entitles shareholder to one vote. The holder may or not receive dividends depending on profits. 3 Characteristics of Common stocks Residual claim o Stockholders have the last claim on a firm’s assets and income. § In liquidation: Others (secured creditors, employees, tax authorities, suppliers, and bondholders) paid first. § In non-liquidation: Shareholders can claim part of operating income after interest and taxes. 4 Characteristics of Common stocks Limited liability o Shareholders’ max loss: original investment. o Worst case: worthless stock. o They are not personally liable for the firm’s obligations. § General Partners can risk personal assets (house, car, etc.). 5 Quick Tests 1. If you buy 100 shares of IBM stock, to what are you entitled? 6 Quick Tests 2. What is the most money you can make on this investment over the next year? 7 Quick Tests 3. If you pay $115 per share, what is the most money you could lose over the year? 8 Equity Securities: Preferred Stocks Characteristics: o Promises to pay a fixed amount of income each year. § Not obligated to pay every year, but dividends owed accumulate. o Have priority over common stocks. § Unpaid dividends cumulate and must be cleared before common stock dividends. § In liquidation: Priority over common stockholders but below debt holders. 9 Equity Securities: Preferred Stocks Characteristics: o No voting power in firm management. o Payments are dividends rather than interest è Not tax- deductible for the issuing firm. § Note: firms may exclude 50% of dividends from domestic taxable income; Suitable as fixed income investments for some firms. 10 Valuation of Stocks Intrinsic value: Expected future cash flows (e.g., dividends). Top-down analysis: o Global Economy o Domestic Macroeconomy o Demand and Supply Shocks o Federal Government Policy o Business Cycles o Industry Analysis 11 Industry Analysis Why important? o Unusually for a firm in a troubled industry to perform well. o Economic performance varies widely across industries. 12 Industry Analysis Considerable dispersion in stock price performance. For example: o +42% in the retail industry; o -34% in the coal industry. Figure 17.6 Industry stock price performance, 2020. Source: Prof. Kenneth French’s website. 13 Industry Analysis Defining an Industry o Challenging to determine industry boundaries. Common methods: § North American Industry Classification System (NAICS codes) q Replace Standard Industry Classification (SIC codes) previously used in the U.S. § Standard & Poor § The Value Line Investment Survey … 14  First two digits è Very broad industry classifications. Next digit è Narrower... Up to 6 digits 15 Business Cycles Definition: The recurring pattern of economic recession and recovery. Transition points across cycles: Peaks and Troughs. o Peaks: The transition from the end of an expansion to the start of a contraction. o Troughs: The point at the bottom of a recession as the economy begins to recover. 16 Cyclical vs. Defensive Cyclical Industries: Above-average sensitivity to the economy’s state o Examples: § Durable goods producers (e.g., automobiles) § Capital goods (e.g., items used by firms for production) Defensive Industries: Little sensitivity to the business cycle o Examples: § Food producers and processors § Pharmaceutical firms and public utilities 17 Sensitivity to the Business Cycles Three factors affecting firm’s earnings sensitivity: o Sensitivity of Sales o Operating Leverage o Financial Leverage 18 Sensitivity of Sales Necessities vs. Non-essentials o Necessities: Less sensitive to business cycles § Examples: Food, drugs, medical services, etc. o Non-essentials: More sensitive to business cycles § Examples: Machine tools, steel, autos, transportation, etc. 19  Sensitivity of Sales Figure 17.8 Industry cyclically: Growth of sales, year over year, in two industries; sales of jewellery show much greater variation than sales of groceries. 20 Source: U.S. Census Bureau. Operating Leverage Definition: Ratio of fixed to variable costs o Fixed Costs: Incurred regardless of production levels. o Variable Costs: Vary based on production volume. Higher operating leverage è More sensitive to business cycles. Lower operating leverage è Less sensitive to business cycles. 21 Degree of Operating Leverage (DOL) Measure of how profits react to sales changes. Formula(s): Percentage change in profits o DOL = Percentage change in sales Fixed costs o DOL = 1 + Profits 22 Example Let’s consider two firms: Firms A and B: o Similarities: § Operate in the same industry § Have identical sales and price per unit. § Consistent across three phases of the business cycle: recession, normal, and expansion o Differences: § Fixed costs § Variable costs per unit of output. 23 Example N.B. Variable costs for A: $1 per unit; Variable costs for B: $0.50 per unit 24 Example Q: If the economy shifts from a normal state to a recession, what are the DOLs for Firms A and B? 25 Example Findings: o Firm A’s fixed costs are lower than Firm B’s. o Firm A’s DOL is lower than Firm B’s. § Firm A is less sensitive to business cycles § Firm A outperforms Firm B during recessions but lags in expansions. 26 Financial Leverage Definition: Employing borrowed funds through debt. Interest on debt is obligatory, independent of sales. As a fixed cost, interest increases profits sensitivity to the business cycle. 27 Sensitivity to the Business Cycles Do you prefer an industry that is more sensitive or less sensitive? o Investors shouldn’t always prefer industries with lower cycle sensitivity. o Firms in sensitive industries possess high-beta stocks and are riskier. § Such firms may decline sharply in downturns but surge in upturns. The critical factor: Is the expected return apt compensation for the risks taken? 28 Sector Rotation Definition: A strategy where analysts adjust portfolios based on the business cycle. The goal: prioritise industries or sectors poised to outperform others. Decisions are grounded in one’s evaluation of the business cycle’s current phase. 29 Business Cycle Sector Rotation Figure 17.9 A stylized depiction of the business cycle Figure 17.10 Sector rotation 30 Sector Rotation Challenges in Application: o In reality, the duration and intensity of each cycle phase are unpredictable. o Success hinges on anticipating the business cycle’s next stage more accurately than other investors. 31 Industry Life Cycles Four stages: o Start-up: Extremely rapid growth. o Consolidation: Growth faster than the general economy but slowing. o Maturity: Growth aligned with the general economy. o Relative Decline: Growth slower than the general economy or even contraction. 32 Industry Life Cycles When are investments in an industry most appealing? Targeting high-growth industries? Maybe not, because: 1) Prices might already reflect anticipated growth. 2) High growth and substantial profits attract competition. Figure 17.11 The industry life cycle 33