Chapter 3: Learn the Language of Stocks

1. Chapter 3: Learn the Language of Stocks By: Mariangelí Lugo Zayas

2. TIP A strong stock market vocabulary will help you learn and grow into a strong stock investor… Guide to the Stock Market - Chapter 3

3. Introduction • Equity Security: A stock in a publicly traded company. Is evidence that you have a claim to whatever residual value would be left in a company if it were liquidated and all of its debts and any associated fees were paid. • Security:An evidence of debt (bonds) or property (stock). • Equity:Monetary value of a property or business by any amounts owed on it in mortgages, claims, and so on. Guide to the Stock Market - Chapter 3

4. Introduction(Cont) • Stocks: the are two kinds: • Common Stocks: An ownership claim against a corporation. • Preferred Stocks:Also an ownership claim against a corporation, with a preferred treatment in certain events (discussed later on). • Convertible Securities: A security that can be converted into another type of security, such as when converting preferred stock into common stock or vice versa. Guide to the Stock Market - Chapter 3

5. Common Stock, Characteristics • Equity security with no special dividend rights • Lowest priority claim if the company goes broke, called residual claim right, or what is the same, receives the leftovers: residual value of a firm. • The most common type of stock. • Owners of this stock are called common stockholders. • Makes you a part owner of a corporation. Guide to the Stock Market - Chapter 3

6. Common Stock, Characteristics • Limited liability:Stockholder’s losses are limited to the original amount invested and personal assets cannot be taken away to satisfy any obligation of the corporation. Corporate Managers decide if any profits are paid. Guide to the Stock Market - Chapter 3

7. Common Stocks, Dividends • Dividends are corporate payments from profits to the stockholders. • Are not guaranteed: they are a prerogative of the managers of the company. • Paid out of the firm’s after-tax cash flows. • It’s taxable for most investors. • Corporations are double taxed, first on profits and second on investor’s income tax (when receiving dividends, that is). Guide to the Stock Market - Chapter 3

8. Common Stocks, Dividends • Growth Stocks: a way to avoid double taxation, it uses accumulated earnings from company and reinvest instead of paying dividends. Allows the company to: • Accumulate capital • Grow faster • Benefit comes from an expectative of growth in earnings and eventually rise the stock price, though it can be tricky, since both increases might not go hand in hand. Guide to the Stock Market - Chapter 3

9. Common Stocks, Tax Treatment • Since 1997, the Tax Reduction Act (“TRA”), tax rates on capital gains are lower than dividends. • Capital gains is the amount by which an asset’s selling price exceeds its initial purchase price. • Because taxes on capital gains are paid when a sale is effected, a way to reduce tax bills may be the dilation of the sale of stocks so that a capital gain is not realized. Guide to the Stock Market - Chapter 3

10. Trap Do not ever buy shares of stock because you are attracted to the company’s product or some report about the quality of the company. Focus on buying stock in companies that, mysteriously, nobody seems to be paying attention to. Guide to the Stock Market - Chapter 3

11. Common Stocks, Voting Rights • A company’s control over day-to-day activities rest in the hands of not the owner’s (stockholder’s) but in the Board of Directors, inside corporate executives concerned about shareholder’s financial welfare, elected by the shareholder’s themselves. • Board of directors are elected in annual meetings of the shareholder’s, though most shareholder’s cannot attend those, and instead vote by absentee ballot or endorsing a representative. Guide to the Stock Market - Chapter 3

12. Common Stocks, Election Process • There are two ways of voting: Cumulative and straight voting. • Cumulative: directors are elected at the same time and shareholders are given a number of votes equal to the number of directors being elected times the number of shares owned. • The effect of this way of voting is to give minority shareholders a voice in the company’s decision. Guide to the Stock Market - Chapter 3

13. Common Stocks, Election Process • Straight Voting: directors are elected one by one. The maximum number of votes for each director equals the number of shares owned. • This technique is the less favorable to minority shareholders since any shareholders owns a large number of shares, say 50% of a number around it, can elect the entire board. Guide to the Stock Market - Chapter 3

14. Common Stocks, Election Process • Dual-Class Firms: companies that among the stocks offered, there are some that let them raise equity capital but have limited voting rights. • The control of these companies rests on the hands of the original investors who would not let corporate executives do what they want, or what they should do. Guide to the Stock Market - Chapter 3

15. Common Stocks, Corporate Governance • The task of the manager of a corporation is, in general, to create and work with different growth strategies like reinvesting profits or payout profits by making dividend payments to shareholders. • Managerial inefficiencies (also called shirking): • Misfeasance: agency costs associated with laziness among top corporate executives. • Malfeasance: agency costs associated with use of perks, lavish executive goddies that cost the corporation lots of money. Guide to the Stock Market - Chapter 3

16. Common Stocks, Corporate Governance • The mayor goal of Corporate Governance is to “align as nearly as possible the interests of individuals, corporations, and society”. Is supposed to encourage the efficient use of resources and to require accountability for the stewardship of said resources. • The importance of knowing the truth about corporate governance can take you, not to dislike the system altogether, but to use it in your advantage. Guide to the Stock Market - Chapter 3

17. Common Stocks, Corporate Governance • Chief Executive Office: Top manager of the company, hired by the board of directors. • Chairman: (of the board) presides the meetings and recommends members of the board to the shareholders. • Shareholder Pool Dilution:When a group of shareholders change from a familiar (or related people) group to a more diverse group, allowing external people to become owners of the company. Guide to the Stock Market - Chapter 3

18. Common Stocks, Corporate Governance • It is common to a company that as the company develops and grows, family grasp becomes more loose and external interests might come first, making them control less and less number of shares. • Shareholders eventually cease to be relevant to make decisions, because some of this power (ownership) they have to let go in order to allow the firm to grow (for investments to arrive). Guide to the Stock Market - Chapter 3

19. Common Stocks, Corporate Governance • Voluntary Shareholder Absenteeism: situation created when shareholders power is so small they cannot make good, informed decisions, making them loose interest and eventually throw the proxy in the wastebasket. • The practice nowadays is to spot CEO’s in the Chairman’s chair, making it even more difficult to make impartial rules and take advantage of the company, since it opens up the door to cronyism, the practice of allowing close friends be on the board, without any real merits. Guide to the Stock Market - Chapter 3

20. Common Stocks, Takeovers • Takeovers: when a company (bidder) acquires another company (target), making a bid. • Friendly Takeovers: is a welcomed takeover approved by the corporate executives from the target company. • Hostile Takeovers: is an unwelcome takeover that, even though management may resist or disapprove of the offer, the acquisition of the target company is carried out anyway. Guide to the Stock Market - Chapter 3

21. Common Stocks, Hostile Takeover • This takeover might be unwelcomed simply because top managers are afraid their positions might be jeopardized. • Poison Pill: a technique used by deadwoods (corrupt or incompetent corporate executives) to stop a bidder from acquiring the target company. Is a clause in the by laws triggered when an investor acquires 15% share of the company: all new purchases, except the 15% investor, are priced at an arbitrary low amount. Guide to the Stock Market - Chapter 3

22. Common Stocks, Hostile Takeover • Moran v. Household International (1985): a Delaware Supreme Court decision where the court upheld the board’s right to refuse to remove a poison pill, saying inside corporate executive employees had more power essentially than shareholders. • Through history, hostile takeovers have transformed lots of poorly managed companies into well business machines. After 1985, no hostile takeovers have gone through. Guide to the Stock Market - Chapter 3

23. Common Stocks, A New Hope • In recent years, after the upsetting situation in investment pools, where inside corporate executives continue to enjoy of enormous amounts of control and “goodies” at owner’s expense, absentee shareholders have regained a voice on the board again. • Starting with the Disney case, where CEO Michael Eisner was forced to step down after having dug almost 1 billion from the company, among other cases. Guide to the Stock Market - Chapter 3

24. Common Stock, Flaws in Voting Process • When shareholders receive the ballot, the only options for the propositions are “yes” or “abstain”. This way, CEO may propose a candidate of his interest. • An proposal was presented to the Congress of the US, when Arthur Levitt fought to force corporate executives to report certain benefits received as part of their functions as a cost in accounting books. But he was no successful and the idea rejected. Guide to the Stock Market - Chapter 3

25. The Disney Case • Michael Eisner filled Disney’s corporate governance with his personal cronies, and made poorly judged decisions, as well took advantage of his position by making many millions in profits despite the industry overall being performing so poorly over the first years of the millennium. • Some improvements were introduced in 2002. • In the end, voting never made any serious effect in the board. Guide to the Stock Market - Chapter 3

26. Survival Rule Learn to Think Fiercely Independently Guide to the Stock Market - Chapter 3

27. Preferred Stock • Preferred treatment when receiving dividends or a cash payout, if the company goes broke. • If the company decides to spread dividends, they get paid before common stock stockholders. • Owners of this stock are called preferred stockholders. • Because is a fixed obligation of the company, it cannot decide not pay or change any amount previously arranged to do it. Guide to the Stock Market - Chapter 3

28. Preferred Stock Dividends • Not to be confused with bonds, which are a debt that the company has with an investor, where they have to pay (according to the terms) interest payments and then one final sum (principal) when the bond comes due. • Most preferred stocks are cumulative and nonparticipating. Guide to the Stock Market - Chapter 3

29. Preferred Stocks • Non-Participating:Preferred dividends remains constant regardless any increase in the firm’s earnings. Also, the firm can decide not to pay dividends on this stock without going into default (going bad on a loan). • Cumulative:Means that the company cannot pay dividends to common stock until it has paid the preferred stockholders the dividends in arrears. Guide to the Stock Market - Chapter 3

30. Preferred Stocks • Adjustable-rate Preferred Stock: popular in early 1980s, are preferred stock rate adjusted periodically according to the change in market interest rate. • Preferred stock, in general, do not vote for the board of directors. But this rule may have some exceptions including, when the corporation is in arrears on its dividend payments. Guide to the Stock Market - Chapter 3

31. Convertible Securities • Convertible Preferred Stock: Preferred stocks that can be converted to common stock at a predetermined ratio. Once you choose to convert to common stock, you may no get any preferred dividend payment. • Convertible Bond:Bonds that can be exchanged for shares of common stock. It is an obligation that the corporation must pay until it converts. Guide to the Stock Market - Chapter 3

32. Convertible Bonds • Claims on this security ranks lower against corporate profits than other debts, but ranks higher than stockholders. • Increases value with rising stock prices and provide a fixed income and security of the bonds, making it a popular security among investors. • When converted in stock, the company does not have to repay the initial loan made when the bond was bought. Guide to the Stock Market - Chapter 3

33. Equity Markets • When a company issues for the first time (goes public), this first offering is called Initial Public Offering, or IPO. • After going public, a company must decide if financing is cheaper by getting a bank loan, selling bonds, or issuing more stock. • Primary Market: stock purchases through primary offerings; new issuance of securities. Companies use this money to expand, develop grow. Guide to the Stock Market - Chapter 3

34. Equity Markets • Secondary Market:Purchasing of securities after an IPO is offered. • Securities are identified by a ticker symbol, a system used in Wall Street to identify each and every one company that issues stock and mutual funds. Three letters used on NYSE and four letters used in NASDAQ. Five letters are used for NASDAQ stocks that are not single issues of common stock. Symbols of five letters ending in X are mutual funds. Guide to the Stock Market - Chapter 3

35. Equity Markets • Seasoned Offering:When a public company trades securities to raise money for operations. Company chooses to, either issue bonds or stocks. • Investment Banker: Direct distributor (to investors) of new issues of equity securities by three methods: • Underwritten Offering • Private Placement • Shelf Registration Guide to the Stock Market - Chapter 3

36. Equity Markets • Underwritten Offering: the most common of the three, here the investment banker purchases securities from the firm at a guaranteed amount (net proceeds), then resells securities for a greater amount (gross proceeds). • Private Placement: investment banker acts only as an agent for the firm and receives a commission for placing equity securities with investors. Guide to the Stock Market - Chapter 3

37. Equity Markets • Shelf Registration: permits a corporation to register a quantity of securities with the SEC and sell them over time, instead of all at once. • Rights offering: right of the stockholders to purchase additional shares at a below market price in proportion to its current ownership in the firm, but they may not want to exercise this right and let another investor have to opportunity. Guide to the Stock Market - Chapter 3

38. Equity Markets • Underwriter Spread:Difference between the net and gross proceeds (in other words, the profit). Several factors affects its size: • Inversely related to the size of offering: the larger the offering, the smaller the spread tends to be. • The more uncertain the market price of share securities, the larger the spread tends to be. Investment banker bears all the price risk on unseasoned offerings. • Shelf registrations tend to have lower spreads: stock is already trading so there is less price risk to the underwriter. Guide to the Stock Market - Chapter 3

39. Secondary Markets • Most secondary market transactions are made through the New York Stock Exchange (NYSE) or Over-the-Counter Market (OTC). • Principal function of these markets is to provide liquidity (the speed which an asset can be converted into cash) at fair prices. • Asset: item of economic value owned by an individual or a corporation, that can be converted into cash. Guide to the Stock Market - Chapter 3

40. Secondary Markets • Liquidity exists if investors can trade large amounts of securities without affecting prices. • Liquidity characteristics desirable to investors: • Depth: When there are people waiting on the sidelines to enter the market if the prices go up or down. • Breadth:When orders in large volume give its market depth. The broader the market for a stock, the greater the potential for stabilization of temporary price changes arisen from order imbalances. • Resiliency:When new orders pour in promptly in response to price changes resulting from temporary order imbalances, and investors quickly buy of sell when stock prices moves up or down. Guide to the Stock Market - Chapter 3

41. Direct Search Secondary Markets • Offers the least complete price information, where buyers and sellers must find each other directly. • Is an infrequently “visited” market. There is no broker or dealer making any profits. • Highly relies on word of mouth information to attract trading partners to buy or sell. Guide to the Stock Market - Chapter 3

42. Brokered Secondary Markets • Where trading transactions happen through the work of brokers. • For a fee, brokers help find trading partners and negotiate acceptable transaction prices for their clients. • Brokers are more likely seen in markets where there are economies of scale: when there are lots of investors in the market. Guide to the Stock Market - Chapter 3

43. Brokered Secondary Markets • Because the broker gives special information away when trading securities (and of course, is doing a job), they will only accept when commission is greater than the cost of direct search. • Brokers are likely to know what a fair price of a transaction is. They take advantage of the extensive contact information, providing them with a pool price information too costly for individual investors to know on their own. Guide to the Stock Market - Chapter 3

44. Dealer Secondary Markets • Dealers: buy and sell their own inventory at their own quoted price, eliminating time consuming searches among other trading partners. • Contrary to brokered markets, a dealer can guarantee that an investor’s orders will be executed promptly. • They earn commissions when they sell at an asking price greater than the bid they paid. It compensates them for the liquidity provided. Guide to the Stock Market - Chapter 3

45. Dealer Secondary Markets • Bid-ask spread: is the commission dealers get. It also pays the risk the dealer incurs by holding stock in their inventory and have it ready for any client. Is formed by two prices. • Bid price: The highest price someone is willing to pay to by your shares of stock. • Ask Price: The lowest price you can pay for a stock. Guide to the Stock Market - Chapter 3

46. Dealer Secondary Markets • Disadvantages: • There’s no guarantee that the quotation of a dealer could be improved by contacting another dealer, so investors on dealer markets will have to bear anyway some cost for searching for the best price. • Dealer’s bid-ask spread might be more expensive than if the investor himself would’ve known another investor’s interest (and good price). But investors are willing to sell at a lower cost or buy at a higher price for a quick transaction. Guide to the Stock Market - Chapter 3

47. Auction Secondary Markets • Provides purchase or sale of a security to market participants simultaneously. • Virtually eliminate the expense of looking for trading partners and bargaining a favorable price. Guide to the Stock Market - Chapter 3

48. Bid-Ask Spreads • Spread prices are not the same to all equity securities because of differences in trading costs. • Factors that may affect the spread includes: price of the stock, size of the transaction, frequency of the transaction, and presence in the market of investors trading on inside information. But overall, the spread for a stock should be proportional to its stock price. Guide to the Stock Market - Chapter 3

49. Bid-Ask Spreads, Size of Transaction • Extremely small or extremely large transactions tend to have higher spreads in percentage terms. • Extremely Small: Because of the hassle in filling small orders in less than a round lot of 100 shares. • Extremely Large:Because it requires a lot of small buyers the broker has to find. Guide to the Stock Market - Chapter 3

50. Bid-Ask Spreads, Frequency of Transaction • The most frequently a stock is traded, the less costly for the dealer, because is easier to find buyers and sellers, decreasing inventory costs. • Short-term insiders, on the other hand, will cause dealers to get a higher spread, because is information that only dealer have access to (as opposed to an individual investor). • Traders and investors without short-term inside information are known as uninformed. Guide to the Stock Market - Chapter 3