professor james kuhle 1 investing in equities

Professor James Kuhle 1

Investing in EquitiesInvesting in Equities

Topic 6Topic 6I. Common Stock Investments


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 Company3) Right to Transfer Ownership4) Dividend Entitlement 5) Opportunity to Inspect Corporate Books and Records 6) Suing for Wrongful Acts


A. Basic Characteristics

1. Equity Capital 2. Types

– a. Growth Stock– b. Income Stock– c. Speculative Stock– d. Cyclical Stock– e. Defensive Stock


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


C. Other Common Stock Values

1. Par Value 2. Book Value 3. Liquidation Value 4. Market Value 5. Investment Value


D. Common Stock as an Inflation HedgeD. 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.


Common Stock as an Inflation Hedge: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.


The Panic of 1987The 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.


Investing in EquitiesWisdom from the Masters

Topic 6II. Principles of Security Analysis


Types of Security Analysis

1. Fundamental Analysis

2. Technical Analysis


The Father of Fundamental The Father of Fundamental Analysis: Benjamin GrahamAnalysis: Benjamin Graham

Who was Benjamin Graham?

Sources: Security Analysis (Graham and Dodd); The Intelligent Investor (Graham)


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.


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.”


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


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


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


C. Terms (continued)

8. Total Debt 9. Equity 10. Growth

g = [ (1 + RP,-1)(1 + RP,-2) ... (1 + RP,-10)] -11/n


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.)


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.


The Influence of Philip FisherThe 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.”


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.



Peter Lynch’s mistakes to avoid:1. Thinking that this year will be any different

than any other year2. Becoming too concerned over whether the

stock market is going up or down3. Trying to time the market4. Not knowing the story behind the company in

which you are buying stock5. Buying stocks for the short-term



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.


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


Sir John Marks TempletonSir John Marks Templeton

Who is 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.


Sir John Mark TempletonSir John Mark Templeton

Sir John’s 16 Rules for Investment Success: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.


Templeton’s 16 Rules (Cont.)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.


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.


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 $900Value of 1,300 shares $6,400Ex-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.


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.


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 TenureThe 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.


Evaluating Corporate Management

5. CompensationOne 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. ConclusionLooking 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.


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.

Understanding Pro-Forma Earning


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.


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.


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.


Five Pitfalls to Avoid

1. Buying Low-Priced Stockslow-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 RatiosLeaders 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 OnesCut your losses in any stock at 7% or 8% and you'll never get hit with a big loss.

4. Averaging DownAveraging 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 MarketWhen you're buying stocks, make sure you're swimming with the market tide, not against it.


Measuring Company Efficiency

1.1. Analyzing a company’s Analyzing a company’s inventories and receivables is and receivables is a reliable means of helping to determine whether it is a reliable means of helping to determine whether it is a good investment play or not. Companies stay a good investment play or not. Companies stay efficient and competitive by keeping inventory levels efficient and competitive by keeping inventory levels down and speeding up collection of what they are down and speeding up collection of what they are owed.owed.

2.2. Inventory Turnover = Sales/InventoryInventory Turnover = Sales/Inventory3.3. Broadly speaking, the smaller number of days, the Broadly speaking, the smaller number of days, the

more efficient a company - inventory is held for less more efficient a company - inventory is held for less time and less money is tied up in inventory.time and less money is tied up in inventory.

4.4. Finding out where a firm’s cash is tied up in Finding out where a firm’s cash is tied up in inventories and receivables can help shed light on its inventories and receivables can help shed light on its how efficiently it is being managed.how efficiently it is being managed.


Biomet Example

Asset Utilization 2002 2003 2004Inventory Turnover 3.90 4.15 5.24Fixed Asset Turnover 5.43 5.92 6.61Total 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.


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.


Biomet Example

Profitability ratios:Profitability ratios:

20022002 20032003 20042004

Profit Margin (NI/Sales)Profit Margin (NI/Sales) 20% 20% 19% 19% 19% 19%

ROAROA 16.79%16.79% 17.60% 22.40%17.60% 22.40%

ROEROE 22.22%22.22% 22.69%22.69% 26.55% 26.55%

ROCEROCE 29.01%29.01% 28.64%28.64% 33.22% 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.


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.


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.



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.



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.



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.


Reading the Footnotes

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.

Read the article on Investopedia, under stocks entitled Reading the footnotes – Part 1


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.


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.


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.


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.


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.


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.


Accounting Changes

Determining What the Disclosures RevealThe 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 FlagThe 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 FlagThe 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.

Read the entire article: “How to Read Footnotes – Part 2, on Investopia - Stock articles


Reading Footnotes

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 BoardA 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.

Read the article entitled: How to Read Footnotes Part 3 – Evaluating the Board of Directors


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. CommitteesThere 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:


Three Main Committees

The Audit CommitteeThe 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 CommitteeThe 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 CommitteeThis 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.


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.


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.


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).


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


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.


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.

ResignationsThe 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 InvestigationsFormal 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.


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.


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.


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.


Cooking the Books

Delaying ExpensesDelaying 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.


Investing in Equities Investing in Equities

Topic 6Topic 6IV. Technical AnalysisIV. Technical Analysis


A. DefinitionA. Definition

Technical Analysis is the belief that important information about future stock price movements can be obtained by studying the historical price movement.

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Technical Analysis Technical Analysis Assumptions: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.


Types of Technical Charts:Types of Technical Charts:

Bar Charts

Trading Days

DollarPrice ofStock

H

L

C


Types of Technical Charts:Types of Technical Charts:

Line Charts: a graph of successive day’s closing prices

Trading Days

ClosingPrices


B. Approaches to Technical B. Approaches to Technical AnalysisAnalysis

1. The Dow Theory1. The Dow Theory– The Dow theory views the movement of market The Dow theory views the movement of market

prices as occurring in three categoriesprices as occurring in three categories

1. 1. Primary Movements:Primary Movements: bull and bear markets bull and bear markets

2.2.Secondary Movements:Secondary Movements: up and down up and down movements of stock prices that last for a few movements of stock prices that last for a few months and are called correctionsmonths and are called corrections

3. 3. Daily Movements: Daily Movements: meaningless random daily meaningless random daily fluctuationsfluctuations


B. Approaches to Technical Analysis (continued)

2. Trading Action2. 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.


B. Approaches to Technical B. Approaches to Technical Analysis (continuedAnalysis (continued))

3. Bellwether Stocks3. 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


Approaches to Technical Analysis (Continued):

4. Relative Strength4. 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.


B. Approaches to Technical B. Approaches to Technical Analysis (continued)Analysis (continued)

5. Technical Indicators5. 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



– 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..



– 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.



– c. Short Interestc. 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 Opiniond. 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.


Review Problems: Section 6Review 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?


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 1 investing in equities

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