I nvesting in Equities

Topic 6
I. Common Stock Investments
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. k
m
= rate of return on the market
2. R
f
= return on the risk free asset
3. k
m
- R
f
= 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 I nflation
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 I nflation
Hedge:
S&P LT Bonds LT Govt 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 1997 yearbook,
Chicago.
The 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.
I nvestment Wisdom
Dont try to buy at the bottom and sell at the
top. This cant be done - except by liars
Bernard Baruch

Fools and greed usually go hand in hand,
which creates a field of opportunity for the
rational man.
Warren Buffett
I nvestment Wisdom
When it comes to risk, weve done better by
avoiding dragons rather than by slaying
them.
Warren Buffett
Traditional Wisdom can be long on
tradition and short on wisdom.
Warren Buffett
I nvestment Wisdom
Investing is the greatest business in the
world because you never have to swing.
You stand at the plate; the pitcher throws
you GM at 47! U.S. Steel at 39! And
nobody calls a strike on you. Theres no
penalty except opportunity. All day you
wait for the pitch you like; then, when the
fielders are asleep, you step up and hit it.
Warren Buffett
I nvestment Wisdom
On Leaving Management
Alone:
At Berkshire we dont tell .400 hitters how
to swing.
Warren Buffett
Warren Buffett on taking Your
Time
An investor should act as though he/she had
a lifetime decision card with just twenty
punches on it. With every investment
decision his card is punched, and he/she has
one fewer available for the rest of his/her
life.
I nvesting in Equities
Topic 6
II. Principles of Security Analysis
Types of Security Analysis

1. Fundamental Analysis

2. Technical Analysis
The Father of Fundamental
Analysis: Benjamin Graham
Who was Benjamin Graham?






Sources: Security Analysis (Graham and Dodd); The I ntelligent I nvestor (Graham)
Ben Graham and Mr. Market:
Ben Graham long ago 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 as 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.
Markets 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 affecting 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 doesnt 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
arent certain that you understand and can value your business far
better than Mr. Market, you dont belong in the game. As they say in
poker, If youve been in the game 30 minutes and you dont know
who the patsy is, youre the patsy.
B. Grahams Fundamental
I nvestment 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

NCA
c
= 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 + R
P,-1
)(1 + R
P,-2
) ... (1 + R
P,-10
)] -1
1/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: G
10
> 7%/YR. (1 pt.)
G
5
> 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.
Contemporary Fundamentals:
Peter Lynchs Ten Golden Rules of Investing:
1. Dont be intimidated by professionals
2. Look in your own backyard
3. Dont buy something you cant 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. Dont 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.
Contemporary Fundamentals:
Peter Lynchs mistakes to avoid:
1. Thinking that this year will be any different
than any other year.
2. Becoming too concerned over whether the
stock market is going up or down.
3. Trying to time the market.
4. Not knowing the story behind the company in
which you are buying stock.
5. Buying stocks for the short-term.
Contemporary Fundamentals:
Lynch Maxims:
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 isnt 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 Maxims (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 doesnt mean it cant 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 J ohn Marks Templeton
Who is Sir J ohn 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
worlds wisest and most successful investors. Forbes Magazine said,
Templeton is one of a handful of true investment greats in a field of
crowed 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 J ohn Mark Templeton
Sir Johns 16 Rules for Investment
Success:
1. Invest for maximum total real return including taxes and inflation.
2. Invest. Dont trade or speculate.
3. Remain flexible and open-minded about types of investments. No
one kind of investment is always best.
4. Buy low. 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.
Templetons 16 Rules (Cont.)
9. Aggressively monitor your investments.
10. Dont panic. Sometimes you wont have everything sold as the
market crashes. Once the market has crashed, dont 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 ofter. For 100 years optimists have
carried the day in U.S. Stocks.
Warren Buffett-the Sage of
Omaha
Buffetts Four Steps to Investing:
1. Turn off the stock market.
2. Dont worry about the economy.
3. Buy a business, not a stock. Change your
perspective to that of a business owner and
learn as much as possible about the business
and industry.
4. Manage a portfolio of businesses. Dont
diversify for diversifications sake.

Buffett on Diversification
You cant be a Bo Jackson in investing. Spread your energies
and your capital too many ways, and you are courting
disaster. If you have really taken your time and only
picked stocks that are bona-fide doozies, theres no need to
diversify for safety. If youre not supremely confident
about the future of each stock in your small portfolio,
perhaps you should never have invested in it. Remember,
the fewer stocks you have, the more time you can spend
becoming an expert in them . You should never own more
than ten stocks.
We dont believe in the Noahs Ark principle of investing,
winding up with two of everything. Then you have a zoo.
Buffett on the I deal I nvestor
Personality
The most important quality for an investor is
temperament, not intellect. You dont need tons
of IQ in this business. You dont have to be able
to play three-dimensional chess or duplicate
bridge. You need a temperament that derives
great pleasure neither from being with the crowd
nor against the crowd. You know youre right, not
because of the position of others but because your
facts and your reasoning are right.
Buffets Tenets of Investing:
Buffets Business Tenets for Investing:
1. Is the business simple and understandable?
2. Does the business have an identifiable consumer
monopoly or franchise product?
3. Does the business have a consistent operating history
over time. Are earnings (net income) increasing and
is the ROE consistently high (25-30%).
4. Does the business have favorable long-term prospects?
Is it a franchise or least cost commodity producer?
Look for Goodwill
Invest within your circle of competence. Its not how big the circle is that counts, its how well you define
the parameters. -- Warren Buffett
Good Businesses are the ones that in some way are reasonably sheltered from competition. That gets to
having what I call a franchise of some sort. - Warren Buffett
Buffets Tenets (Cont.)
Buffets Management Tenets:
5. Is management rational? Does the management use
excess cash to buy back stock and issue dividends,
or expand company into low return investments. Does
management express that they are committed to the
best interests of the shareholders total return on
investment.
6. Is management candid with its shareholders? Does
management do things the way that everyone else
does or do they think and look at their environment
before doing things?
Business schools reward complex behavior more than simple behavior; but simple
behavior is more effective. -- Warren Buffett
Buffetts Tenets (Continued):
7. Does the Company have less than 30% debt?
8. How much does the business have to spend on
maintaining operations (check out operating
ratios).
9. Can the Company adjust prices during
inflation?
Our favorite holding period is forever. -- Warren Buffett
The Margin of error is the cornerstone of our investment philosophy: Never count on making a good
sale. Have the purchase price be so attractive that even a mediocre sale gives good results. -
Warren Buffett.
A great investment opportunity occurs when a marvelous business encounters a onetime huge but
solvable problem. - Warren Buffett.

Buffets Tenets:
10. Focus on return on equity, not earnings per
share. EPS is meaningless, since the equity base can
expand over time due to increased retained earnings.
Therefore, EPS does not necessarily reflect good
managerial performance.
11. Calculate owner earnings. Seek out companies that
produce cash in excess. Owner earnings is equal to net
income plus depreciation, depletion, and amortization,
minus capital expenditures necessary to maintain its
economic position and unit volume.
Id rather have a $10 million business making 15% than a $100 million business making
5%. I have other places I can put the money. -- Warren Buffett
We like to buy Businesses, but we dont like to sell them. --Warren Buffett

Buffets Tenets:
12. Look for companies with high profit
margins. Companies with tenacious cost-cutters.
Remember companies with high costs will always
come up with new ways to spend more.
13. For every dollar retained, make sure the
company has created at least three dollars of
market value. Calculate the retained earnings to
market value ratio (use a 10 year trend). Dollar
created/Dollar retained.
Buffets Tenets:
Buffets Market Value Tenets:
- What is the value of the business? The cash flows of a
business discounted back to todays present value
determines the intrinsic value. Discounted by the long-
term treasury rate plus 2% to 4% depending on your risk
preference (Buffett uses 15%).
- Can the business be purchased at a significant discount to
its value? Look at the stock price. Can you purchase the
stock at a significant discount to the stock price. The
greater the difference, the greater the allowance for a
margin of error. (At least 50%).
I t is far better to buy a wonderful company at a fair price than a fair company at a
wonderful price. -- Warren Buffett
Buffets Tenets:
Buffets Yearly Check-up:
- Calculate return on beginning
shareholders equity
- Check the changes in operating margins,
debt levels, and capital expenditures.
- Check the companys cash generating
ability
A Contemporary Approach for Stock
Screening Using Fundamental Methods:
Ten Summary Criteria:
1. Select those stocks with Value Line Timeliness ratings of 1 or 2 and
Safety ratings of 1or 2.
2. Select companies with a franchise product or service.
3. Select companies with a long-term record and high prospects for
continued growth well into the future. Look for regional or
international expansion to maintain their growth.
4. Look for a company with relatively low risk. A beta of no more
than 1.05; a capital structure with less than 1/3 debt. Check the value
line in relation to price fluctuations. Find a company with low capital
expenditures, this eliminates the costly potential of retooling every 5 to
8 years.
A Contemporary Approach (Cont.)
5. Look for an efficient company. This is one that adds more than a
dollars worth of market value to every dollar retained in earnings each
year. One dollar in retained earnings should equal three plus dollars in
added market value.
6. Study the business and its franchise potential, not just the financial
numbers. Is management looking at new and creative ways to exploit
opportunity or are they trying to do what everyone else is doing?
7. The important financials to look at are: ROE, Owners Earnings, High
profit margins, and the dollar-retained-dollar added test.
8. Calculate the intrinsic value. Can the stock be purchased below the
intrinsic value with a significant margin of safety?
9. Is management committed to its shareholders. Look for buybacks with
excess cash.
10. Dont follow the crowd. Buy when the value and discount to intrinsic
value warrant a buy.
A Contemporary Approach to
Selecting Common Stocks:
Step One: Find those companies that meet the
Value-Line rank criteria of 1 or 2 on timeliness
and safety. Or analyze a company given to you by
your Professor.
Step Two: Determine if the products offered by
the firm are franchise products, i.e. no close
substitutes, not heavily regulated, needed and
desired. Consider the existing substitutes, the
substitutes that are down and upline, new entrants
and barriers to entry, and new technologies.
A Contemporary Approach Cont.:
Step Three: Do a complete financial statement
analysis as discussed in the first section of this
course. This should include a complete ratio and
DuPont analysis.
Step Four: Do a complete strategic audit as
discussed in the second part of this course. This
should include the five forces model and a
S.W.O.T. analysis.
Step Five: Do a complete investment SCREEN
analysis with provided spreadsheet.


I nvesting in Equities
Topic 6
IV. Technical Analysis
A. Definition
Technical Analysis is the belief that important
information about future stock price movements can be
obtained by studying the historical price movement.
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
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1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Technical Analysis
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:
Bar Charts
Trading Days
Dollar
Price of
Stock
H
L
C
Types of Technical Charts:
Line Charts: a graph of successive days closing
prices.
Trading Days
Closing
Prices
B. Approaches to Technical
Analysis
1. The Dow Theory
The Dow theory views the movement of market
prices as occurring in three categories
1. Primary Movements: These are called bull
and bear markets.
2.Secondary Movements: These are up and
down movements of stock prices that last for a
few months and are called corrections.
3. Daily Movements: These are meaningless
random daily fluctuations.
B. Approaches to Technical
Analysis (continued)
2. 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
Analysis (continued)
3. 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 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
Analysis (continued)
5. Technical Indicators
a. Market Volume -- is 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.
B. Approaches to Technical
Analysis (continued)
Example
On June 3, 1985
Advances = 930
Declines = 691
Difference = + 239
On June 11, 1985
Advances = 651
Declines = 920
Difference = -269
Conclusion: A weak market.
B. Approaches to Technical
Analysis (continued)
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.
B. Approaches to Technical
Analysis (continued)
c. 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
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 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 Lynchs 10 golden rules for investing?