Textbook Cases

6  Common Stocks

Learning Goals

After studying this chapter, you should be able to:

1. LG 1 Explain the investment appeal of common stocks and why individuals like to invest in them.

2. LG 2 Describe stock returns from a historical perspective and understand how current returns measure up to historical standards of performance.

3. LG 3 Discuss the basic features of common stocks, including issue characteristics, stock quotations, and transaction costs.

4. LG 4 Understand the different kinds of common stock values.

5. LG 5 Discuss common stock dividends, types of dividends, and dividend reinvestment plans.

6. LG 6 Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles.

Over the last 15 years, stock markets in the United States and around the world have been extremely volatile. U.S. stocks, as indicated by the S&P 500 Index, roared into the new millennium achieving a new all-time high value in March 2000. Over the next two years, the market swooned, falling to levels not seen since mid 1997. From September 2002 to October 2007, the S&P500 rallied again, gaining 90% in roughly five years. However, from October 2007 to March 2009, U.S. stocks lost more than half their value, and in many markets around the world, the results were even worse. Those declining stock values mirrored the state of the world economy, as country after country slipped into a deep recession. U.S. firms responded by cutting dividends. Standard and Poor’s reported that a record number of firms cut their dividend payment in the first quarter of 2009, and a record low number announced plans to increase their dividends.

Fortunately, from its March 2009 low, the U.S. stock market nearly doubled over the next two years, hitting a post-recession peak in April 2011. The run-up in stock prices coincided with an increase in dividend payouts. Of the 500 firms included in the S&P 500 stock index, 154 increased their dividend payment in 2010 or 2011, compared to just three firms who cut payments over the same period. Even so, the good news for stocks didn’t last very long. In the spring of 2011, concern about a looming economic crisis in Europe sent U.S. stocks lower again. The S&P 500 Index fell by more than 17% from April to September in 2011. The roller coaster ride wasn’t over because from September 2011 to May 2015 the U.S. stock market, with a few more rough spots along the way, increased in value 88% to achieve yet another all-time high.

Throughout this volatile period, some companies managed to increase their dividends each year. Standard and Poor’s tracks the performance of a portfolio of firms that it calls “dividend aristocrats” because these firms have managed to increase their dividends for at least 25 consecutive years. Including household names such as Johnson & Johnson, Exxon Mobil, and AFLAC, the dividend aristocrat index displays ups and downs that mirror those of the overall market, but at least investors in these firms have enjoyed consistently rising dividends.

(Sources: Stephen Bernard, “S&P: Record Number of Firms Cut Dividends in 1st Quarter,” Pittsburgh Post Gazette, April 7, 2009; “S&P 500 Dividend Payers Rose to Dozen Year High,” May 1, 2012,  http://seekingalpha.com/article/545451-s-p-500-dividend-payers-rise-to-dozen-year-high ;  http://www.standardandpoors.com/indices/sp-500-dividend-aristocrats/en/us/?indexId=spusa-500dusdff--p-us----&ffFix=yes ); Oliver Renick, “S&P 500 Sets New Record High Close,” Bloomberg Business, May 14, 2015,  http://www.bloomberg.com/news/articles/2015-05-14/u-s-stock-index-futures-gain-as-s-p-500-heads-for-weekly-loss )

What Stocks Have to Offer

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Common stock enables you to participate in the profits of a firm. Every shareholder is a part owner of the firm and, as such, has a claim on the wealth created by the company. This claim is not without limitations, however, because common stockholders are really the  residual owners  of the company. That is, their claim is subordinate to the claims of other investors, such as lenders, so for stockholders to get rich, the firm must first meet all its other financial obligations. Accordingly, as residual owners, holders of common stock have no guarantee that they will receive any return on their investment.

The Appeal of Common Stocks

Even in spite of the steep declines in the U.S. stock market in 2002 and 2008, common stocks remain a popular investment choice among both individual and institutional investors. For most investors, the allure of common stocks is the prospect that they will increase in value over time and generate significant capital gains. Many stocks also pay dividends, thereby providing investors with a periodic income stream. For most stocks, however, the dividends paid in any particular year pale in comparison to the capital gains (and capital losses) that are the natural consequence of stock price fluctuations.

Putting Stock Price Behavior in Perspective

Given the nature of common stocks, when the market is strong, you can generally expect to benefit from price appreciation. A good example is the performance that took place in 2013, when the market, as measured by the Dow Jones Industrial Average (DJIA), went up by more than 26%. Unfortunately, when markets falter, so do investor returns. Just look at what happened in 2008, when the market (again, as measured by the DJIA) fell by almost 34%. Excluding dividends, that means a $100,000 investment declined in value to a little more than $66,000. That hurts!

The market does have its bad days, and sometimes those bad days seem to go on for months. Even though it may not always appear to be so, bad days are the exception rather than the rule. That is certainly the case over the 118-year period from 1897 through 2014, when the DJIA went down (for the year) just 40 times—about one-third of the time. The other two-thirds of the time, the market was up—anywhere from less than 1% on the year to nearly 82%. True, there is some risk and price volatility (even in good markets), but that’s the price you pay for all the upside potential. For example, from the end of 1987 to early 2000, in one of the longest bull markets in history, the DJIA grew more than 500% over a 12-year period at an average annual rate of nearly 17%. Yet, even in this market, there were some off days, and even a few off years. But, clearly, they were the exception rather than the rule.

From Stock Prices to Stock Returns

Our discussion so far has centered on stock prices. However, more important than stock prices are stock returns, which take into account both price behavior and dividend income.  Table 6.1  uses the Standard and Poor’s 500 Index (S&P 500) to illustrate how the U.S. stock market has performed since 1930. Like the DJIA, the S&P 500 is a barometer of the overall stock market. As its name implies, the S&P 500 tracks 500 companies (most of which are large firms), so most experts consider it a better indicator of the market’s overall performance than the DJIA, which tracks just 30 industrial firms. In addition to total returns, the table breaks market performance down into the two basic sources of return: dividends and capital gains. These figures, of

Famous Failures in Finance Beware of the Lumbering Bear

Bear markets occur when stock prices are falling. But not all falling markets end up as bears. A drop of 5% or more in one of the major market indexes, like the Dow Jones Industrial Average, is called a “routine decline”. Such declines are considered routine because they typically occur several times a year. A “correction” is a drop of 10% or more in an index, whereas the term bear market is reserved for severe market declines of 20% or more. Bear markets occur every three to four years on average, although that pattern does not make it easy to predict bear markets. For example, the 1990s were totally bear-free. The most recent bear market began in October 2007 when the S&P 500 peaked a little shy of 1,600. The next 20 months witnessed one of the worst bear markets in U.S. history, with the S&P 500 falling almost 57% by March 2009.

course, reflect the general behavior of the market as a whole, not necessarily that of individual stocks. Think of them as the return behavior on a well-balanced portfolio of common stocks.

The table shows several interesting patterns. First, the returns from capital gains range from an average of 16.5% during the booming 1990s to -1.4% in the 1930s. Returns from dividends vary too, but not nearly as much, ranging from 5.8% in the 1940s to 1.8% in the 2000–2009 period. Breaking down the returns into dividends and capital gains reveals, not surprisingly, that the big returns (or losses) come from capital gains.

Second, stocks generally earn positive total returns over long time periods. From 1930 to 2014, the average annual total return on the S&P 500 was 11.4% per year. At that rate, you could double your money every six or seven years. To look at the figures another way, if you had invested $10,000 in the S&P 500 at the beginning of 1930,

Excel@Investing

Table 6.1 Historical Average Annual Returns on the Standard and Poor’s 500, 1930–2014

(Sources:  http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html  and  http://www.multpl.com )

	Rate of Return from Dividends (%)	Rate of Return from Capital Gains (%)	Average Annual Total Return (%)
1930s	5.7%	−1.4%	4.3%
1940s	5.8%	3.8%	9.6%
1950s	4.7%	16.2%	20.9%
1960s	3.2%	5.4%	8.6%
1970s	4.2%	3.3%	7.5%
1980s	4.1%	13.8%	17.9%
1990s	2.4%	16.5%	18.9%
2000–2009	1.8%	−0.7%	1.1%
1900–2014	3.9%	7.5%	11.4%
Note: The S&P 500 annual total returns come from Damodaran Online and the S&P 500 annual dividend returns come from multpl.com. The S&P 500 annual capital gain returns are imputed by the authors by subtracting the annual dividend return from the annual total return.

then based on the yearly annual returns, your investment would have grown to more than $21.9 million over the next 85 years. You can get rich by investing in the stock market, as long as you are patient!

Third, investing in stocks is clearly not without risk. Although during the first seven decades shown in  Table 6.1  the average annual return on stocks was 12.5%, the beginning of the 21st century witnessed several years with double-digit negative returns. In 2008 alone, the S&P 500 lost roughly 36% of its value. From 2000 through 2009, the U.S. stock market’s average annual return was only 1.1% per year! If you had invested $10,000 in stocks in 1930, your portfolio would have grown to more than $13.5 million by the end of 2007, but one year later your portfolio would have fallen to less than $8.6 million, before rising again to almost $22 million by the end of 2014. These figures suggest that stocks may be a very good investment in the long run, but that was little consolation to investors who saw their wealth fall dramatically in the early years of the 21st century.

Now keep in mind that the numbers here represent market performance. Individual stocks can and often do perform quite differently. But at least the averages give us a benchmark against which we can assess current stock returns and our own expectations. For example, if a return of about 11% can be considered a good long-term estimate for stocks, then sustained returns of 16% to 18% should definitely be viewed as extraordinary. (These higher returns are possible, of course, but to get them, you very likely will have to take on more risk.) Likewise, long-run stock returns of only 4% to 6% should probably be viewed as substandard. If that’s the best you think you can do, then you may want to consider sticking with bonds, where you’ll earn almost as much, but with less risk.

A Real Estate Bubble Goes Bust and So Does the Market

An old investment tip is, “Buy land because they aren’t making any more of it.” For many years, it appeared that this advice applied to housing in the United States, as home prices enjoyed a long, upward march. According to the Standard and Poor’s Case-Shiller Home Price Index, a measure of the average value of a single-family home in the United States, the average home price peaked in July 2006. Over the next three years, home prices fell sharply, falling 31% by the summer of 2009. As prices fell, some homeowners realized that they owed more on their mortgages than their homes were worth, and mortgage defaults began to rise. Unfortunately, some of the biggest investors in home mortgages were U.S. commercial and investment banks. As homeowners fell behind on their mortgage payments, the stock prices of financial institutions began to drop, raising serious concerns about the health of the entire U.S. financial system. Those fears seemed to have been realized when a top-tier investment bank, Lehman Brothers, filed for bankruptcy in September 2008. That event sparked a free fall in the stock market.

The House Price Puzzle

Figure 6.1  shows that U.S. stocks rose along with housing prices for many years, but when weakness in the housing sector spilled over into banking, stock prices plummeted. Over the same three-year period the S&P 500 Index lost 28% of its value, and the U.S. economy fell into a deep recession. In the spring of 2009 the stock and housing markets signaled that a recovery might be on the horizon. Indeed, the recession officially ended in June 2009, but by historical standards the economic recovery was somewhat anemic and the housing market continued to languish for another three years. In early 2012 the housing market began a sustained recovery and by the end of 2014 values had climbed back to 84% of their peak values.

Watch Your Behavior

Not Cutting Their Losses Research has shown that homeowners are very reluctant to sell their houses at a loss. During a period of falling home prices, homeowners who put their homes up for sale tend to set asking prices that are too high to avoid taking a loss, and as a result homes remain unsold for a very long time.

Figure 6.1 A Snapshot of U.S. Stock and Housing Indexes (2003 through 2014)

From the start of 2003 until the summer of 2006, U.S. stocks rose along with housing prices, but when crumbling U.S. housing prices began to spill over into banking, stock prices plummeted, wiping out all the gains accumulated over the prior six years. Three years after the stock market hit bottom, it had still not reached its precrisis peak, nor had house prices rebounded from their crisis lows to any significant degree. In the summer of 2012 the housing market began a sustained appreciation and in early 2013 stock market surged past its precrisis peak.

(Source: Data from S&P Dow Jones Indices LLC.)

The Pros and Cons of Stock Ownership

Investors own stocks for all sorts of reasons. Some buy stock for the potential for capital gains, while others seek dividend income. Still others appreciate the high degree of liquidity in the stock market. But as with any investment, there are pros and cons to these securities.

The Advantages of Stock Ownership

One reason stocks are so appealing is the possibility for substantial returns that they offer. As we just saw, stocks generally provide relatively high returns over the long haul. Indeed, common stock returns compare very favorably to other investments such as long-term corporate bonds and U.S. Treasury securities. For example, over the last century, high-grade corporate bonds earned annual returns that were about half as large as the returns on common stocks. Although long-term bonds outperform stocks in some years, the opposite is true more often than not. Stocks typically outperform bonds, and usually by a wide margin. Stocks also provide protection from inflation because over time their returns exceed the inflation rate. In other words, by purchasing stocks, you gradually increase your purchasing power.

Stocks offer other benefits as well. They are easy to buy and sell, and the costs associated with trading stocks are modest. Moreover, information about stock prices and the stock market is widely disseminated in the news and financial media. A final advantage is that the unit cost of a share of common stock is typically fairly low. Unlike bonds, which normally carry minimum denominations of at least $1,000, and some mutual funds that have fairly hefty minimum investments, common stocks don’t have such minimums. Instead, most stocks today are priced at less than $50 or $60 a share—and you can buy any number of shares that you want.

The Disadvantages of Stock Ownership

There are also some disadvantages to common stock ownership. Risk is perhaps the most significant. Stocks are subject to various types of risk, including business and financial risk, purchasing power risk, market risk, and event risk. All of these can adversely affect a stock’s earnings and dividends, its price appreciation, and, of course, the rate of return that you earn. Even the best of stocks possess elements of risk that are difficult to eliminate because company earnings are subject to many factors, including government control and regulation, foreign competition, and the state of the economy. Because such factors affect sales and profits, they also affect stock prices and (to a lesser degree) dividend payments.

All of this leads to another disadvantage. Stock returns are highly volatile and very hard to predict, so it is difficult to consistently select top performers. The stock

Figure 6.2 The Current Income of Stocks and Bonds

The current income (dividends) paid to stockholders falls far short of interest income paid to bondholders. The dividend yield is the average dividend yield for stocks in the S&P 500 Index, and the bond yield is for high-quality corporate bonds.

(Source: Data from Federal Reserve Board of Governors and  http://www.multpl.com/s-p-500-dividend-yield/table .)

selection process is complex because so many elements affect how a company will perform. In addition, the price of a company’s stock today reflects investors’ expectations about how the company will perform. In other words, identifying a stock that will earn high returns requires that you not only identify a company that will exhibit strong future financial performance (in terms of sales and earnings) but also that you can spot that opportunity before other investors do and bid up the stock price.

A final disadvantage is that stocks generally distribute less current income than some other investments. Several types of investments—bonds, for instance—pay more current income and do so with much greater certainty.  Figure 6.2  compares the dividend yield on common stocks with the coupon yield on high-grade corporate bonds. It shows the degree of sacrifice common stock investors make in terms of current income. Clearly, even though the yield gap has narrowed a great deal in the past few years, common stocks still have a long way to go before they catch up with the current income levels available from bonds and most other types of fixed-income securities.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 6.1 What is a common stock? What is meant by the statement that holders of common stock are the residual owners of the firm?

2. 6.2 What are two or three of the major investment attributes of common stocks?

3. 6.3 Briefly describe the behavior of the U.S. stock market over the last half of the 20th century and the early part of the 21st century.

4. 6.4 How important are dividends as a source of return to common stock? What about capital gains? Which is more important to total return? Which causes wider swings in total return?

5. 6.5 What are some of the advantages and disadvantages of owning common stock? What are the major types of risks to which stockholders are exposed?

Basic Characteristics of Common Stock

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Each share of common stock represents an equity (or ownership) position in a company. It’s this equity position that explains why common stocks are often referred to as equity securities or  equity capital . Every share entitles the holder to an equal ownership position and participation in the corporation’s earnings and dividends, an equal vote (usually), and an equal voice in management. Together the common stockholders own the company. The more shares an investor owns, the bigger his or her ownership position. Common stock has no maturity date—it remains outstanding indefinitely.

Common Stock as a Corporate Security

All corporations issue common stock of one type or another. But the shares of many, if not most, corporations are never traded because the firms either are too small or are family controlled. The stocks of interest to us in this book are  publicly traded issues —the shares that are readily available to the general public and that are bought and sold in the open market. The firms issuing such shares range from giants like Apple Inc. and Exxon Mobil Corporation to much smaller regional and local firms. The market for publicly traded stocks is enormous. According to the World Federation of Exchanges, the value of all U.S. stocks in early 2015 was more than $26.6 trillion.

Issuing New Shares

Companies can issue shares of common stock in several ways. The most widely used procedure is the  public offering . When using this procedure, the corporation offers the investing public a certain number of shares of its stock at a certain price.  Figure 6.3  shows an announcement for such an offering. In this case Box is offering 12,500,000 shares of its Class A stock at a price of $14 per share. At $14 per share, the offering will raise $175 million and after underwriting fees Box will receive $162.75 million. Notice that each of the newly issued shares of Class A stock sold by the company to public investors will be entitled to one vote, whereas the Class B shares that remain in the hands of the Box’s founders have 10 votes per share. The result of this dual-class stock structure is that following the IPO the new investors will control fewer than 2% of the votes compared to the founders, who will control more than 98% of the votes.

Companies also can issue new shares of stock using what is known as a  rights offering . In a rights offering, existing stockholders are given the first opportunity to buy the new issue. In essence, a stock right gives a shareholder the right (but not the obligation) to purchase new shares of the company’s stock in proportion to his or her current ownership position.

For instance, if a stockholder currently owns 1% of a firm’s stock and the firm issues 10,000 additional shares, the rights offering will give that stockholder the opportunity to purchase 1% (100 shares) of the new issue. If the investor does not want to use the rights, he or she can sell them to someone who does. The net result of a rights offering is the same as that of a public offering. The firm ends up with more equity in its capital structure, and the number of shares outstanding increases.

Stock Spin-Offs

Perhaps one of the most creative ways of bringing a new issue to the market is through a  stock spin-off . Basically, a spin-off occurs when a company gets rid of one of its subsidiaries or divisions. For example, Time Warner did this when it spun off its Time Inc. subsidiary in June 2014. The company doesn’t just sell the subsidiary to some other firm. Rather, it creates a new stand-alone company and then distributes stock in that company to its existing stockholders. Thus, every Time Warner shareholder received 1 share in the newly created, and now publicly traded, Time Inc. for every 8 shares of Time Warner stock that he or she held.

There have been hundreds of stock spin-offs in the last 10 to 15 years. Some of the more notable recent ones are the spin-off of Land’s End by Sears Holdings, News Corporation by 21st Century Fox, and TripAdvisor by Expedia. Normally, companies execute stock spin-offs if they believe the subsidiary is no longer a good fit or if they feel they’ve become too diversified and want to focus on their core products. The good news is that such spin-offs often work very well for investors, too.

Stock Splits

Companies can also increase the number of shares outstanding by executing a  stock split . In declaring a split, a firm merely announces that it will increase the number of shares outstanding by exchanging a specified number of new shares for each outstanding share of stock. For example, in a two-for-one stock split, two new shares of stock are exchanged for each old share. In a three-for-two split, three new shares are exchanged for every two old shares outstanding. Thus, a stockholder who owned 200 shares of stock before a two-for-one split becomes the owner of 400 shares; the same investor would hold 300 shares if there had been a three-for-two split.

A company uses a stock split when it wants to enhance its stock’s trading appeal by lowering its market price. Normally, the price of the stock falls roughly in proportion to the terms of the split (unless the stock split is accompanied by a big increase in the level of dividends). For example, using the ratio of the number of old shares to new, we

Figure 6.3 An Announcement of a New Stock Issue

This announcement indicates that the company—Box—is issuing 12,500,000 shares of stock at a price of $14 per share. For this cloud-based file-sharing and document-management company, the new issue will mean $162.75 million in fresh capital.

(Source: Box Inc., Initial Public Offer prospectus, http://www.nasdaq.com/markets/ipos/filing.ashx?filingid=9961051.)

can expect a $100 stock to trade at or close to $50 a share after a two-for-one split. Specifically, we divide the original price per share by the ratio of new shares to old. That same $100 stock would trade at about $67 after a three-for-two split—that is, $100÷3/2=$100÷1.5=$67$100÷3/2=$100÷1.5=$67.

Example

On April 9, 2015, Starbucks Corporation split its shares two-for-one. On the day before the split, Starbucks shares closed at $95.23. Theoretically, after the split the stock price should fall by half to $47.62. In fact, once the split went into effect on April 9th, the opening price of 1 Starbucks share fell to $47.65.

Treasury Stock

Instead of increasing the number of outstanding shares, corporations sometimes find it desirable to reduce the number of shares by buying back their own stock. Firms may repurchase their own stock when they view it as undervalued in the marketplace. When that happens, the company’s own stock becomes an attractive investment candidate. Firms also repurchase shares as an alternative to paying dividends. Paying dividends may force some shareholders to pay taxes on the income they receive, while repurchasing shares may have different tax consequences for shareholders.

Firms usually purchase their stock in the open market, like any other individual or institution. When acquired, these shares become known as  treasury stock . Technically, treasury stocks are simply shares of stock that have been issued and subsequently repurchased by the issuing firm. Treasury stocks are kept by the corporation and can be used at a later date for several purposes. For example, they could be used to pay for mergers and acquisitions, to meet employee stock option plans, or as a means of paying stock dividends. Or the shares can simply be held in treasury for an indefinite time.

The short-term impact of these share repurchases—or buybacks, as they’re sometimes called—is generally positive, meaning that stock prices generally go up when firms announce their intentions to conduct share repurchases. The long-term impact is less settled, with some research indicating that share repurchases are followed by periods of above-average stock returns and other research contesting that conclusion.

Classified Common Stock

For the most part, all the stockholders in a corporation enjoy the same benefits of ownership. Occasionally, however, a company will issue different classes of common stock, each of which entitles holders to different privileges and benefits. These issues are known as  classified common stock . Hundreds of publicly traded firms, including well-known tech companies such as Google and Facebook, have created such stock classes. Although issued by the same company, each class of common stock may have unique characteristics.

Firms that issue multiple classes of stock usually do so to grant different voting rights to different groups of investors. For instance, when Facebook conducted its 2012 IPO, it issued Class A and Class B shares. The Class A shares, available for purchase by the public, were entitled to 1 vote per share. Class B shares, held by Facebook CEO and founder Mark Zuckerberg (and other Facebook insiders) were entitled to 10 votes per share. This ensured that Zuckerberg would have voting control of the company even if Facebook issued many more Class A shares over time in subsequent stock offerings. On rare occasions firms may use classified stock to grant different dividend rights to different investors.

Regardless of the specifics, whenever there is more than one class of common stock outstanding, you should take the time to determine the privileges, benefits, and limitations of each class.

Buying and Selling Stocks

To be an informed stock trader, you need a basic awareness of how to read stock-price quotes. You also need to understand the transaction costs associated with buying and selling stock. Certainly, keeping track of current prices is an essential element in buy-and-sell decisions. Prices help you monitor the market performance of your security holdings. Similarly, transaction costs are important because of the impact they have on investment returns. Indeed, the costs of executing stock transactions can sometimes consume most (or all) of the profits from an investment. You should not take these costs lightly.

Reading the Quotes

Investors in the stock market have come to rely on a highly efficient information system that quickly disseminates market prices to the public. The stock quotes that appear daily in the financial press and online are a vital part of that information system. To see how to read and interpret stock price quotations, consider the quotes that appear at Yahoo! Finance. These quotes give not only the most recent price of each stock but also a great deal of additional information.

Figure 6.4  illustrates a basic quote for Abercrombie & Fitch Co. stock, which trades under the ticker symbol ANF. The quote was taken after trading hours on Friday, May 15, 2015. On that day, the price of Abercrombie common stock closed at $21.42 per share, up $0.17 (or 0.8%) from the previous day’s close of $21.25. Notice that the stock opened on Friday at $21.27, reaching an intraday high of $21.55 and an intraday low of $21.17 (see “Day’s Range”).  Figure 6.4  also reveals that during the preceding 52 weeks Abercrombie stock traded as high as $45.50 and as low as $19.34 (see “52wk Range”). Trading volume for the stock on May 15 was 1.245 million shares, considerably less than the average daily volume over the previous three months of just under three million shares.

A few other items from  Figure 6.4  are noteworthy. Abercrombie’s stock has a beta of 2.2, meaning that it is more than twice as risky (i.e., has more than twice as much systematic risk) as the average stock in the market (as the very wide trading range over the past year would also indicate). Abercrombie’s total market capitalization (or market cap) is $1.49 billion. Remember, a company’s market cap is simply its share price times

Figure 6.4 A Stock Quote for Abercrombie & Fitch

This figure shows a stock quote for Abercrombie & Fitch on May 15, 2015.

(Source: Yahoo! Finance,  http://finance.yahoo.com/q?uhb=uh3_finance_vert&fr=&type=2button&s=anf .)

the number of shares outstanding. In its most recent reporting period, the company earned $0.71 per share, and given the closing price of $21.42, the price-to-earnings ratio of Abercrombie stock was just over 30.

Transaction Costs

Investors can buy and sell common stock in round or odd lots. A round lot is 100 shares of stock or multiples thereof. An odd lot is a transaction involving fewer than 100 shares. For example, the sale of 400 shares of stock would be a round-lot transaction, and the sale of 75 shares would be an odd-lot transaction. Trading 250 shares of stock would involve a combination of two round lots and an odd lot.

An investor incurs certain transaction costs when buying or selling stock. In addition to some modest transfer fees and taxes paid by the seller, the major cost is the brokerage fee paid—by both buyer and seller—at the time of the transaction. As a rule, brokerage fees can amount to just a fraction of 1% to as much as 2% or more, depending on whether you use the services of a discount broker or full-service broker. But they can go even higher, particularly for very small trades. Historically, transactions involving odd lots required a specialist called an odd-lot dealer and triggered an extra cost called an odd-lot differential. Today, electronic trading systems make it easier to process odd-lot transactions, so these trades do not increase trading costs as much as they once did. Not surprisingly, odd-lot trades have become more common in recent years. For example, roughly one-third of all trades of Google shares involve odd lots.

An Advisor’s Perspective

Steve Wright Managing Member, The Wright Legacy Group

“Over the past 20 years, the costs for an average individual to buy and sell stocks have gone down dramatically.”

MyFinanceLab

Another type of transaction cost is the bid-ask spread, the difference between the bid and ask prices for a stock. In  Figure 6.4 , you can see that the last quoted ask price for Abercrombie stock was $21.42 and the bid price was $21.41, so the spread between these two prices was $0.01. Remember that the ask price represents what you would pay to buy the stock and the bid price is what you receive if you sell the stock, so the difference between them is a kind of transaction cost that you incur when you make a roundtrip (i.e., a purchase and then later a sale) trade. Of course, these prices change throughout the trading day, as does the spread between them, but the current bid-ask spread gives you at least a rough idea of the transaction cost that you pay to the market maker or dealer who makes a living buying and selling shares every day.

Common Stock Values

The worth of a share of common stock can be described in a number of ways. Terms such as par value, book value, market value, and investment value are all found in the financial media. Each designates some accounting, investment, or monetary attribute of a stock.

Par Value

A stock’s  par value  is an arbitrary amount assigned to the stock when it is first issued. It has nothing to do with the stock’s market price, but instead represents a minimum value below which the corporate charter does not allow a company to sell shares. Because par value establishes a kind of floor for the value of a stock, companies set par values very low. For example, in Facebook’s IPO, the par value of its shares was set at $0.000006. Except for accounting purposes, par value is of little consequence. Par value is a throwback to the early days of corporate law, when it was used as a basis for assessing the extent of a stockholder’s legal liability. Because the term has little or no significance for investors, many stocks today are issued without a par value.

Book Value

Another accounting measure,  book value  is the stockholders’ equity in the firm as reported on the balance sheet (and sometimes expressed on a per share basis). Remember that on the balance sheet, stockholders’ equity is just the difference between the value of the firm’s assets and its liabilities (less any preferred stock). The book value represents the amount of capital that shareholders contributed to the firm when it initially sold shares as well as any profits that have been reinvested in the company over time.

Example

Social Networks Incorporated (SNI) lists assets worth $100 million on its balance sheet along with $60 million in liabilities. There is no preferred stock, but the company has 10 million common shares outstanding. The book value of SNI’s stockholders’ equity is $40 million, or $4 per common share. Of the $40 million in stockholders’ equity, $30 million was raised in the company’s initial public offering of common stock and the other $10 million represents profits that the company earned and reinvested in the business since its IPO.

A stock’s book value is inherently a backward-looking estimate of its value because it focuses on things that happened in the past (like the original sale of stock and profits earned and reinvested in earlier periods). In contrast, a stock’s market value is forward-looking and reflects investors’ expectations about how the company will perform in the future.

Market Value

A stock’s  market value  is simply its prevailing market price. It reflects what investors are willing to pay to acquire the company today, and it is essentially independent of the book value. In fact, stocks usually trade at market prices that exceed their book values, sometimes to a very great degree.

As you have already learned, by multiplying the market price of the stock by the number of shares outstanding, you can calculate a firm’s market capitalization, which represents the total market value of claims held by shareholders. A firm’s market capitalization is somewhat analogous to the stockholders’ equity figure on the balance sheet, except that the market capitalization represents what the firm’s equity is actually worth in today’s market, whereas the stockholders’ equity balance is a backward-looking assessment of shareholders’ claims.

Example

Investors believe that prospects for Social Networking Incorporated are very bright and that the company will rapidly increase its revenues and earnings for the next several years. As a result, investors have bid up the market price of SNI’s stock to $20, which is five times greater than the company’s book value per share. With 10 million common shares outstanding, SNI’s market capitalization is $200 million compared to the book value of stockholders’ equity of just $40 million.

When a stock’s market value drops below its book value, it is usually because the firm is dealing with some kind of financial distress and does not have good prospects for growth. Some investors like to seek out stocks that are trading below book value in the hope that the stocks will recover and earn very high returns in the process. While such a strategy may offer the prospect of high returns, it also entails significant risks.

Investment Value

Investment value  is probably the most important measure for a stockholder. It indicates the worth investors place on the stock—in effect, what they think the stock should be trading for. Determining a security’s investment value is a complex process based on expectations of the return and risk characteristics of a stock. Any stock has two potential sources of return: dividend payments and capital gains. In establishing investment value, investors try to determine how much money they will make from these two sources. They then use those estimates as the basis for formulating the return potential of the stock. At the same time, they try to assess the amount of risk to which they will be exposed by holding the stock. Such return and risk information helps them place an investment value on the stock. This value represents the maximum price an investor should be willing to pay for the issue.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 6.6 What is a stock split? How does a stock split affect the market value of a share of stock? Do you think it would make any difference (in price behavior) if the company also changed the dividend rate on the stock? Explain.

2. 6.7 What is a stock spin-off? In very general terms, explain how a stock spin-off works. Are these spin-offs of any value to investors? Explain.

3. 6.8 Define and differentiate between the following pairs of terms.

a. Treasury stock versus classified stock

b. Round lot versus odd lot

c. Par value versus market value

d. Book value versus investment value

4. 6.9 What is an odd-lot differential? How can you avoid odd-lot differentials? Which of the following transactions would involve an odd-lot differential?

a. Buy 90 shares of stock

b. Sell 200 shares of stock

c. Sell 125 shares of stock

Common Stock Dividends

1. LG 5

In 2014, U.S. corporations paid out billions in dividends. Counting only the companies included in the S&P 500 stock index, dividends that year totaled more than $375 billion. Yet, in spite of these numbers, dividends still don’t get much attention. Many investors, particularly younger ones, often put very little value on dividends. To a large extent, that’s because capital gains provide a much bigger source of return than dividends—at least over the long haul.

Investor Facts

A Steady Stream York Water Company raised its dividend for the 17th consecutive year in February 2015. That’s an impressive run, but it’s not the most notable fact about York’s dividend stream. The company paid dividends without missing a single year since 1816, the year that Indiana was admitted as the 19th U.S. state! No other U.S. company can match York’s record of nearly two centuries of uninterrupted dividend payments.

But attitudes toward dividends are changing. The protracted bear market of 2007 through 2009 revealed just how uncertain capital gains can be and, indeed, that all those potential profits can turn into substantial capital losses. Dividend payments do not fluctuate as much as stock prices do. Plus, dividends provide a nice cushion when the market stumbles (or falls flat on its face). Moreover, current tax laws put dividends on the same plane as capital gains. Both now are taxed at the same tax rate. Dividends are tax-free for taxpayers in the 10% and 15% brackets, taxed at a 15% rate for the 25% to 35% tax brackets, and taxed at a 20% rate for taxpayers whose income surpasses the 35% tax bracket. Single taxpayers with modified adjusted gross income of $200,000 and married couples exceeding $250,000 are also subject to a 3.8% Medicare surtax on investment income, including dividend income.

The Dividend Decision

By paying out dividends, typically on a quarterly basis, companies share some of their profits with stockholders. Actually, a firm’s board of directors decides how much to pay in dividends. The directors evaluate the firm’s operating results and financial condition to determine whether dividends should be paid and, if so, in what amount. They also consider whether the firm should distribute some of its cash to investors by paying a dividend or by repurchasing some of the firm’s outstanding stock. If the directors decide to pay dividends, they also establish several important payment dates. In this section we’ll look at the corporate and market factors that go into the dividend decision. Then we’ll briefly examine some of the key payment dates.

Corporate versus Market Factors

When the board of directors assembles to consider the question of paying dividends, it weighs a variety of factors. First, the board looks at the firm’s earnings. Even though a company does not have to show a profit to pay dividends, profits are still considered a vital link in the dividend decision.

With common stocks, the annual earnings of a firm are usually measured and reported in terms of  earnings per share (EPS) . Basically, EPS translates aggregate corporate profits into profits per share. It provides a convenient measure of the amount of earnings available to stockholders. Earnings per share is found by using the following formula.

EPS=Netprofitaftertaxes−PreferreddividendsNumberofsharesofcommonstockoutstandingEPS =Net profit after taxes−Preferred dividendsNumber of shares of common stock outstandingEquation6.1

For example, if a firm reports a net profit of $1.25 million, pays $250,000 in dividends to preferred stockholders, and has 500,000 shares of common stock outstanding, it has an EPS of $2 (($1,250,000 − $250,000)/500,000). Note in  Equation 6.1  that preferred dividends are subtracted from profits because they must be paid before any funds can be made available to common stockholders.

While assessing profits, the board also looks at the firm’s growth prospects. It’s very likely that the firm will need some of its earnings for investment purposes and to help finance future growth. In addition, the board will take a close look at the firm’s cash position, making sure that paying dividends will not lead to a cash shortfall. Furthermore, the firm may be subject to a loan agreement that legally limits the amount of dividends it can pay.

After looking at internal matters, the board will consider certain market effects and responses. Most investors feel that if a company is going to retain earnings rather than pay them out in dividends, it should reinvest those funds to achieve faster growth and higher profits. If the company retains earnings but cannot reinvest them at a favorable rate of return, investors begin to clamor for the firm to distribute those earnings through dividends.

Moreover, to the extent that different types of investors tend to be attracted to different types of firms, the board must make every effort to meet the dividend expectations of its shareholders. For example, income-oriented investors are attracted to firms that generally pay high dividends. Failure to meet those expectations might prompt some investors to sell their shares, putting downward pressure on the stock price. In addition, some institutional investors (e.g., certain mutual funds and pension funds) are restricted to investing only in companies that pay a dividend. This is a factor in some companies’ decisions to initiate a dividend payment.

Some Important Dates

Let’s assume the directors decide to declare a dividend. Once that’s done, they must indicate the date of payment and other important dates associated with the dividend. Three dates are particularly important to the stockholders: date of record, payment date, and ex-dividend date. The  date of record  is the date on which the investor must be a registered shareholder of the firm to be entitled to a dividend. All investors who are official stockholders as of the close of business on that date will receive the dividends that have just been declared. These stockholders are often referred to as holders of record. The  payment date , also set by the board of directors, generally follows the date of record by a week or two. It is the actual date on which the company will mail dividend checks to holders of record (and is also known as the payable date).

Because of the time needed to make bookkeeping entries after a stock is traded, the stock will sell without the dividend (ex-dividend) for three business days up to and including the date of record. The  ex-dividend date  will dictate whether you were an official shareholder and therefore eligible to receive the declared dividend. If you sell a stock on or after the ex-dividend date, you receive the dividend. The reason is that the buyer of the stock (the new shareholder) will not have held the stock on the date of record. Instead, you (the seller) will still be the holder of record. Just the opposite will occur if you sell the stock before the ex-dividend date. In this case, the new shareholder (the buyer of the stock) will receive the dividend because he or she will be the holder of record.

To see how this works, consider the following sequence of events. On June 3, the board of directors of Cash Cow, Inc., declares a quarterly dividend of 50 cents per share to holders of record on June 18. Checks will be mailed out on the payment date, June 30. The calendar below shows these dividend dates. In this case, if you bought 200 shares of the stock on June 15, you would receive a check in the mail sometime after June 30 in the amount of $100. On the other hand, if you purchased the stock on June 16, the seller of the stock would receive the check because he or she, not you, would be recognized as the holder of record.

Types of Dividends

Normally, companies pay dividends in the form of cash. Sometimes they pay dividends by issuing additional shares of stock. The first type of distribution is known as a  cash dividend , and the second is a  stock dividend . Occasionally, companies pay dividends in other forms, such as a stock spin-off (discussed earlier) or perhaps even samples of the company’s products. But these other forms of dividend payments are relatively rare compared to cash dividends.

Cash Dividends

More firms pay cash dividends than any other type of dividend. A nice by-product of cash dividends is that they tend to increase over time, as companies’ earnings grow. In fact, for companies that pay cash dividends, the average annual increase in dividends is around 3% to 5%. This trend represents good news for investors because a steadily increasing stream of dividends tends to shore up stock returns in soft markets.

A convenient way of assessing the amount of dividends received is to measure the stock’s  dividend yield . Basically, this is a measure of dividends on a relative (percentage) basis rather than on an absolute (dollar) basis. A stock’s dividend yield measures its current income as a percentage of its price. The dividend yield is computed as follows:

Dividend yield=Annual dividends received per shareCurrent market price of the stockDividend yield =Annual dividends received per shareCurrent market price of the stockEquation6.2

Thus, a company that annually pays $2 per share in dividends to its stockholders, and whose stock is trading at $40, has a dividend yield of 5%.

Example

In May 2015 Nordic American Tankers (NAT) paid its quarterly dividend of $0.38 per share, which translates into an annual dividend of $1.52. At that time, NAT’s share price was $11.40, so its dividend yield was 13.3% ($1.52 ÷, $11.40), which is an unusually high level for common stock.

Firms generally do not pay out all of their earnings as dividends. Instead, they distribute some of their earnings as dividends and retain some to reinvest in the business. The  dividend payout ratio  measures the percentage of earnings that a firm pays in dividends. It is computed as follows:

Dividend payout ratio=Dividends per shareEarnings per shareDividend payout ratio =Dividends per shareEarnings per shareEquation6.3

A company would have a payout ratio of 50% if it had earnings of $4 a share and paid annual dividends of $2 a share. Although stockholders like to receive dividends, they normally do not like to see payout ratios over 60%. Payout ratios that high are difficult to maintain and may lead the company into trouble.

Example

In the 12 months ending in May 2015, Pepsico Inc. paid dividends of $2.81 per share to investors. Over the same period, the company’s earnings per share were $4.30, so Pepsico’s dividend payout ratio was about 65%. In other words, Pepsico used almost two-thirds of its earnings to pay dividends and it reinvested the other third.

The appeal of cash dividends took a giant leap forward in 2003 when the federal tax code changed to reduce the tax on dividends. Prior to this time, cash dividends were taxed as ordinary income, meaning at that time they could be taxed at rates as high as 35%. For that reason, many investors viewed cash dividends as a relatively unattractive source of income, especially because capital gains (when realized) were taxed at much lower preferential rates. After 2003 both dividends and capital gains were taxed at the same rate. That, of course, makes dividend-paying stocks far more attractive, even to investors in higher tax brackets. Firms responded to the tax change in two ways. First, firms that already paid dividends increased them. Total dividends paid by U.S. companies increased by 30% from 2003 to 2005. Second, many firms that had never paid dividends began paying them. In the year leading up to the tax cut, about four firms per quarter announced plans to initiate dividend payments. In the following year, the number of firms initiating dividends surged to 29 companies per quarter, an increase of roughly 700%! The dividend paying trend resumed as the economy began to recover from the most recent recession. In 2010 U.S. companies paid out $197 billion worth of dividends and for 2013 the amount grew to $302 billion, a 50% increase. Paying dividends is fashionable not only in the United States but around the world as well. In 2013 publicly traded companies worldwide paid over $1 trillion in dividends for the first time and between 2009 and 2013 companies worldwide paid about $4.4 trillion in cash dividends.

Stock Dividends

Occasionally, a firm may declare a stock dividend. A stock dividend simply means that the firm pays its dividend by distributing additional shares of stock. For instance, if the board declares a 10% stock dividend, then you will receive 1 new share of stock for each 10 shares that you currently own.

Stock dividends are similar to stock splits in the sense that when you receive a stock dividend, you receive no cash. As the number of shares outstanding increases due to the dividend, the share price falls, leaving the total value of your holdings in the company basically unchanged. As with a stock split, a stock dividend represents primarily a cosmetic change because the market responds to such dividends by adjusting share prices downward according to the terms of the stock dividend. Thus, in the example above, a 10% stock dividend normally leads to a decline of around 10% in the stock’s share price. If you owned 200 shares of stock that were trading at $100 per share, the total market value of your investment would be $20,000. After a 10% stock dividend, you would own 220 shares of stock (i.e., 200 shares : 1.10), but each share would be worth about $90.91. You would own more shares, but they would be trading at lower prices, so the total market value of your investment would remain about the same (i.e., 220 × $90.91 = $20,000.20). There is, however, one bright spot in all this. Unlike cash dividends, stock dividends are not taxed until you actually sell the stocks.

Dividend Reinvestment Plans

For investors who plan to reinvest any dividends that they receive, a  dividend reinvestment plan (DRIP)  may be attractive. In these corporate-sponsored programs, shareholders can have their cash dividends automatically reinvested into additional shares of the company’s common stock. (Similar reinvestment programs are offered by mutual funds and by some brokerage houses such as Bank of America and Fidelity.) The basic investment philosophy is that if the company is good enough to invest in, it’s good enough to reinvest in. As  Table 6.2  demonstrates, such an approach can have a tremendous impact on your investment position over time.

Today more than 1,000 companies (including most major corporations) offer dividend reinvestment plans. These plans provide investors with a convenient and inexpensive way to accumulate capital. Stocks in most DRIPs are acquired free of brokerage commissions, and most plans allow partial participation. That is, participants may specify a portion of their shares for dividend reinvestment and receive cash dividends

Table 6.2 Cash or Reinvested Dividends?

Situation: You buy 100 shares of stock at $25 a share (total investment, $2,500); the stock currently pays $1 a share in annual dividends. The price of the stock increases at 8% per year; dividends grow at 5% per year.

Investment Period (yr.)	Number of Shares Held	Market Value of Stock Holdings ($)	Total Cash Dividends Received ($)
Take Dividends in Cash
5	100	$ 3,672	$   552
10	100	$ 5,397	$1,258
15	100	$ 7,930	$2,158
20	100	$11,652	$3,307
Full Participation in Dividend Reinvestment Plan (100% of cash dividends reinvested)
5	115.59	$ 4,245	0
10	135.66	$  7,322	0
15	155.92	$12,364	0
20	176.00	$20,508	0

on the rest. Some plans even sell stocks to their DRIP investors at below-market prices—often at discounts of 3% to 5%. In addition, most plans will credit fractional shares to the investor’s account, and many will even allow investors to buy additional shares of the company’s stock. For example, once enrolled in the General Mills plan, investors can purchase up to $3,000 worth of the company’s stock each quarter, free of commissions.

Shareholders can join dividend reinvestment plans by simply sending a completed authorization form to the company. Once you’re enrolled, the number of shares you hold will begin to grow with each dividend. There is a catch, however. Even though these dividends take the form of additional shares of stock, you must still pay taxes on them as though they were cash dividends. Don’t confuse these dividends with stock dividends—reinvested dividends are treated as taxable income in the year they’re received, just as though they had been received in cash. But as long as the preferential tax rate on dividends remains in effect, paying taxes on stock dividends, will be much less of a burden than it used to be.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 6.10 Briefly explain how the dividend decision is made. What corporate and market factors are important in deciding whether, and in what amount, to pay dividends?

2. 6.11 Why is the ex-dividend date important to stockholders? If a stock is sold on the ex-dividend date, who receives the dividend—the buyer or the seller? Explain.

3. 6.12 What is the difference between a cash dividend and a stock dividend? Which would be more valuable to you? How does a stock dividend compare to a stock split? Is a 200% stock dividend the same as a two-for-one stock split? Explain.

4. 6.13 What are dividend reinvestment plans, and what benefits do they offer to investors? Are there any disadvantages?

Types and Uses of Common Stock

1. LG 6

Common stocks appeal to investors because they offer the potential for everything from current income and stability of capital to attractive capital gains. The market contains a wide range of stocks, from the most conservative to the highly speculative. Generally, the kinds of stocks that investors seek depend on their investment objectives and investment programs. We will examine several of the more popular types of common stocks here, as well as the various ways such securities can be used in different types of investment programs.

Types of Stocks

Not all stocks are alike, and the risk and return profile of each stock depends on the characteristics of the company that issued it. Some of the characteristics include whether the company pays a dividend, the company’s size, how rapidly the company is growing, and how susceptible its earnings are to changes in the business cycle. Over time, investors have developed a classification scheme that helps them place a particular stock into one of several categories. Investors use these categories to help design their portfolios to achieve a good balance of risk and return. Some of the categories that you hear about most often are blue chip stocks, income stocks, growth stocks, tech stocks, cyclical stocks, defensive stocks, large-cap stocks, mid-cap stocks, and small-cap stocks.

Blue-Chip Stocks

Blue chips are the cream of the common stock crop. They are stocks issued by companies that have a long track record of earning profits and paying dividends.  Blue-chip stocks  are issued by large, well-established firms that have impeccable financial credentials. These companies are often the leaders in their industries.

An Advisor’s Perspective

Bill Harris Founder, WH Cornerstone Investments

“Blue chips are companies that pay a dividend and increase it over time.”

MyFinanceLab

Not all blue chips are alike, however. Some provide consistently high dividend yields; others are more growth-oriented. Good examples of blue-chip growth stocks are Nike, Procter & Gamble, Home Depot, Walgreen’s, Lowe’s Companies, and United Parcel Service.  Figure 6.5  shows some basic operating and market information about P&G’s stock, as obtained from the introductory part of a typical Zacks Investment Research report. Notice that in addition to a real-time quotation and hold recommendation, the Zacks report provides a company summary, price chart, consensus recommendations, EPS information, and more for P&G. Examples of high-yielding blue chips include such companies as AT&T, Chevron, Merck, Johnson & Johnson, McDonald’s, and Pfizer.

While blue-chip stocks are not immune from bear markets, they are less risky than most stocks. They tend to appeal to investors who are looking for quality, dividend-paying investments with some growth potential. Blue chips appeal to investors who want to earn higher returns than bonds typically offer without taking a great deal of risk.

Income Stocks

Some stocks are appealing simply because of the dividends they pay. This is the case with  income stocks . These issues have a long history of regularly paying higher-than-average dividends. Income stocks are ideal for those who seek a relatively safe and high level of current income from their investment capital. Holders of income stocks (unlike bonds and preferred stocks) can expect the dividends they receive to increase regularly over time. Thus, a company that paid, say, $1.00 a share in dividends in 2000 would be paying just over $1.80 a share in 2015, if dividends had been

Figure 6.5 A Blue-Chip Stock

(Source: Copyright ©2015 Zacks Investment Research. All rights reserved.  http://www.zacks.com , May 18, 2015.)

growing at around 4% per year. Dividends that grow over time provide investors with some protection from the effects of inflation.

The major disadvantage of income stocks is that some of them may be paying high dividends because of limited growth potential. Indeed, it’s not unusual for income securities to exhibit relatively low earnings growth. This does not mean that such firms are unprofitable or lack future prospects. Quite the contrary: Most firms whose shares qualify as income stocks are highly profitable organizations with excellent prospects. A number of income stocks are among the giants of U.S. industry, and many are also classified as quality blue chips. Many public utilities, such as American Electric Power, Duke Energy, Oneok, Scana, DTE Energy, and Southern Company, are in this group. Also in this group are selected industrial and financial issues like Conagra Foods, General Mills, and Altria Group. By their very nature, income stocks are not exposed to a great deal of business and market risk. They are, however, subject to a fair amount of interest rate risk.

Growth Stocks

Shares issued by companies that are experiencing rapid growth in revenues and earnings are known as  growth stocks . A good growth stock might exhibit a sustained earnings growth of 15% to 18% when most common stocks are growing at 6% to 8% per year. Generally speaking, established growth companies combine steady earnings growth with high returns on equity. They also have high operating margins and plenty of cash flow to service their debt. Amazon.com, Apple, Google, eBay, Berkshire Hathaway, and Starbucks are all prime examples of growth stocks. As this list suggests, some growth stocks also rate as blue chips and provide quality growth, whereas others represent higher levels of speculation.

Growth stocks normally pay little or no dividends. Their payout ratios seldom exceed 10% to 15% of earnings. Instead, these companies reinvest most of their profits to help finance additional growth. Thus, investors in growth stocks earn their returns through price appreciation rather than dividends—and that can have both a good side and a bad side. When the economy is strong and the stock market is generally rising, these stocks are particularly hot. When the markets turn down, so do these stocks, often in a big way. Growth shares generally appeal to investors who are looking for attractive capital gains rather than dividends and who are willing to bear more risk.

Tech Stocks

Over the past 20 years or so, tech stocks have become such a dominant force in the market (both positive and negative) that they deserve to be put in a class all their own.  Tech stocks  basically represent the technology sector of the market. They include companies that produce computers, semiconductors, data storage devices, and software. They also include companies that provide Internet services, networking equipment, and wireless communications. Some of these stocks are listed on the NYSE, although the vast majority of them are traded on the Nasdaq. Tech stocks, in fact, dominate the Nasdaq market and, thus, the Nasdaq Composite Index.

These stocks would probably fall into either the growth stock category or the speculative stock class, although some of them are legitimate blue chips. Tech stocks may offer the potential for very high returns, but they also involve considerable risk and are probably most suitable for the more risk-tolerant investor. Included in the tech-stock category you’ll find some big names, like Apple, Cisco Systems, Google, and Intel. You’ll also find many not-so-big names, like NVIDIA, Marvell Technology, LinkedIn, SanDisk, Advantest, L-3 Communications, and Electronic Arts.

Speculative Stocks

Shares that lack sustained records of success but still offer the potential for substantial price appreciation are known as  speculative stocks . Perhaps investors’ hopes are spurred by a new management team that has taken over a troubled company or by the introduction of a promising new product. Other times, it’s the hint that some new information, discovery, or production technique will favorably affect the growth prospects of the firm. Speculative stocks are a special breed of securities, and they enjoy a wide following, particularly when the market is bullish.

Generally speaking, the earnings of speculative stocks are uncertain and highly unstable. These stocks are subject to wide swings in price, and they usually pay little or nothing in dividends. On the plus side, speculative stocks such as Sirius XM Radio, Bona Film Group, Destination Maternity, Global Power Equipment Group, and Iridium Communications offer attractive growth prospects and the chance to “hit it big” in the market. To be successful, however, an investor has to identify the big-money winners before the rest of the market does. Speculative stocks are highly risky; they require not only a strong stomach but also a considerable amount of investor know-how. They are used to seek capital gains, and investors will often aggressively trade in and out of these securities as the situation demands.

Cyclical Stocks

Cyclical stocks  are issued by companies whose earnings are closely linked to the overall economy. They tend to move up and down with the business cycle. Companies that serve markets tied to capital equipment spending by business or to consumer spending for big-ticket, durable items like houses and cars typically head the list of cyclical stocks. Examples include Alcoa, Caterpillar, Genuine Parts, Lennar, Brunswick, and Timken.

Cyclical stocks generally do well when the economy is moving ahead, but they tend to do especially well when the country is in the early stages of economic recovery. Likewise, they perform poorly when the economy begins to weaken. Cyclical stocks are probably most suitable for investors who are willing to trade in and out of these stocks as the economic outlook dictates and who can tolerate the accompanying exposure to risk.

Defensive Stocks

Sometimes it is possible to find stocks whose prices remain stable or even increase when general economic activity is tapering off. These securities are known as  defensive stocks . They tend to be less susceptible to downswings in the business cycle than the average stock.

Defensive stocks include the shares of many public utilities, as well as industrial and consumer goods companies that produce or market such staples as beverages, foods, and drugs. An excellent example of a defensive stock is Walmart. This recession-resistant company is the world’s leading retailer. Other examples are Checkpoint Systems, a manufacturer of antitheft clothing security clips, WD-40, the maker of that famous all-purpose lubricant, and Extendicare, a leading provider of long-term care and assisted-living facilities. Defensive shares are commonly used by more aggressive investors, who tend to “park” their funds temporarily in defensive stocks while the economy remains soft or until the investment atmosphere improves.

Market-Cap Stocks

A stock’s size is based on its market value—or, more commonly, its market capitalization. This value is calculated as the market price of the stock times the number of shares outstanding. Generally speaking, the U.S. stock market can be broken into three segments, as measured by a stock’s market cap:

Small-cap	less than $2 billion
Mid-cap	$2 billion up to $10 billion
Large-cap	more than $10 billion

The large-cap stocks are the corporate giants such as Walmart, Exxon Mobil, and Apple. Although large-cap stocks are few in number, these companies account for more than 75% of the market value of all U.S. equities. But as the saying goes, bigger isn’t necessarily better. Nowhere is that statement more accurate than in the stock market. On average, small-cap stocks tend to earn higher returns than do large-caps.

Mid-cap stocks  offer investors some attractive return opportunities. They provide much of the sizzle of small-stock returns, without as much price volatility. At the same time, because mid-caps are fairly good-sized companies and many of them have been around for a long time, they offer some of the safety of the big, established stocks. Among the ranks of the mid-caps are such well-known companies as Dick’s Sporting Goods, Hasbro, Wendy’s, and Williams-Sonoma. Although these securities offer a nice alternative to large stocks without the uncertainties of small-caps, they probably are most appropriate for investors who are willing to tolerate a bit more risk and price volatility than large-caps have.

One type of mid-cap stock of particular interest is the so-called baby blue chip. Also known as “baby blues,” these companies have all the characteristics of a regular blue chip except size. Like their larger counterparts, baby blues have rock-solid balance sheets, modest levels of debt, and several years of steady profit growth. Baby blues normally pay a modest level of dividends, but like most mid-caps, they tend to emphasize growth. Thus, they’re considered ideal for investors seeking quality long-term growth. Some well-known baby blues are Logitech, American Eagle Outfitters, and Garmin Ltd.

Some investors consider small companies to be in a class by themselves in terms of attractive return opportunities. In many cases, this has turned out to be true. Known as  small-cap stocks , these companies generally have annual revenues of less than $250 million. But because of their size, spurts of growth can have dramatic effects on their earnings and stock prices. Callaway Golf, MannKind, and Shoe Carnival are some of the better-known small-cap stocks.

An Advisor’s Perspective

Thomas O’Connell President, International Financial Advisory Group

“Unless you’re a high net worth client, you’re not getting in at the IPO price.”

MyFinanceLab

Although some small-caps are solid companies with equally solid financials, that’s not the case with most of them. Indeed, because many of these companies are so small, they don’t have a lot of stock outstanding, and their shares are not widely traded. In addition, small-cap stocks have a tendency to be “here today and gone tomorrow.” Although some of these stocks may hold the potential for high returns, investors should also be aware of the very high-risk exposure that comes with many of them.

A special category of small-cap stocks is the initial public offering (IPO). Most IPOs are small, relatively new companies that are going public for the first time. (Prior to their public offering, these stocks were privately held and not publicly traded.) Like other small-company stocks, IPOs are attractive because of the substantial capital gains that investors can earn. Of course, there’s a catch: To stand a chance of buying some of the better, more attractive IPOs, you need to be either an active trader or a preferred client of the broker. Otherwise, the only IPOs you’re likely to hear of will be the ones these investors don’t want. Without a doubt, IPOs are high-risk investments, with the odds stacked against the investor. Because there’s no market record to rely on, only investors who know what to look for in a company and who can tolerate substantial risk should buy these stocks.

Investing in Foreign Stocks

One of the most dramatic changes to occur in U.S. financial markets in the past 25 years was the trend toward globalization. Indeed, globalization became the buzzword of the 1990s, and nowhere was that more evident than in the world’s equity markets. Consider, for example, that in 1970 the U.S. stock market accounted for fully two-thirds of the world market. In essence, the U.S. stock market was twice as big as all the rest of the world’s stock markets combined. That’s no longer true: According to the World Federation of Exchanges in 2015, the U.S. share of the world equity market value had dropped to 40%.

Today the world equity markets are dominated by just six markets, which together account for about 75% of the global total. The United States, by far, has the biggest equity market, which in 2015 had a total value approaching $27 trillion. China is in second place with nearly $8 trillion in total equity market value, and if you include the Hong Kong Exchanges, then China’s total is more than $11 trillion. Japan is in third place with nearly $5 trillion and is followed by Euronext, which includes exchanges in Belgium, France, the Netherlands, Portugal, and the United Kingdom. The last of the markets valued above $3 trillion is India with its two major exchanges. Other equity markets worth more than $1 trillion can be found in Canada, Germany, Switzerland, Australia, and Korea.

Comparative Returns

The United States still dominates the world equity markets in terms of sheer size. But that leaves unanswered an important question: How has the U.S. equity market performed in comparison to the rest of the world’s major stock markets? In 2014, which was generally a good year for stock returns, the U.S. market produced a 13.5% gain (as measured by the S&P 500 Index). One year is probably not the best way to judge the performance of a country’s stock market, so Figure 6.6 plots the average annual return on stocks from 1900 to 2014 for 19 countries. Over that period the U.S. stock market earned an average annual return of 9.6%, a performance equal to the average for the countries listed. In other words, over a long period of time, stock returns in the United States have been unremarkable relative to stock returns in

Figure 6.6 Average Annual Stock Returns around the World (1900 to 2014)

(Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2015,  https://www.credit-suisse.com/investment_banking/doc/cs_global_investment_returns_yearbook.pdf .)

other markets around the world. If we looked on a year-by-year basis, we would see that U.S. stocks rarely earn the highest returns in any given year. Translated, that means there definitely are attractive returns awaiting those investors who are willing to venture beyond our borders.

Going Global: Direct Investments

Basically, there are two ways to invest in foreign stocks: through direct investments or through ADRs.

Without a doubt, the most adventuresome way is to buy shares directly in foreign markets. Investing directly is not for the uninitiated, however. You have to know what you’re doing and be prepared to tolerate a good deal of market risk. Although most major U.S. brokerage houses are set up to accommodate investors interested in buying foreign securities, there are still many logistical problems to face. To begin with, you have to cope with currency fluctuations that can have a dramatic impact on your returns. But that’s just the start. You also have to deal with different regulatory and accounting standards. The fact is that most foreign markets, even the bigger ones, are not as closely regulated as U.S. exchanges. Investors in foreign markets, therefore, may have to put up with insider trading and other practices that can create disadvantages for foreign investors. Finally, there are the obvious language barriers, tax issues, and general “red tape” that all too often plague international transactions. The returns from direct foreign investments can be substantial, but so can the obstacles.

Going Global with ADRs

Fortunately, there is an easier way to invest in foreign stocks, and that is to buy American Depositary Receipts (ADRs). ADRs are dollar-denominated instruments (or certificates) that represent ownership interest in American Depositary Shares (ADSs). ADSs, in turn, represent a certain number of shares in a non-U.S. company that have been deposited with a U.S. bank (the number of shares can range from a fraction of a share to 20 shares or more). The first ADR was created in 1927 by a U.S. bank to allow U.S. investors to invest in shares of a British department store. ADRs are great for investors who want to own foreign stocks but don’t want the hassles that often come with them. For example, because ADRs trade in U.S. dollars and are cleared through U.S. settlement system, ADR holders avoid having to transact in a foreign currency.

How Do ADRs Work?

American depositary receipts are bought and sold on U.S. markets just like stocks in U.S. companies. Their prices are quoted in U.S. dollars. Furthermore, dividends are paid in U.S. dollars. Today, there are more than 3,700 ADRs available in the U.S. representing shares of companies located in more than 100 countries around the world.

To see how ADRs are structured, take a look at BP, the British oil and gas firm whose ADRs trade on the NYSE. Each BP ADR represents ownership of 6 shares of BP stock. These shares are held in a custodial account by a U.S. bank (or its foreign correspondent), which receives dividends, pays any foreign withholding taxes, and then converts the net proceeds to U.S. dollars, which it passes on to investors. Other foreign stocks that can be purchased as ADRs include Sony (Japan), Ericsson Telephone (Sweden), Nokia (Finland), Royal Dutch Shell (Netherlands), Nestle (Switzerland), Elan Corporation (Ireland), Suntech Power (China), BASF (Germany), Hutchison Wampoa, Ltd. (Hong Kong), Teva Pharmaceuticals (Israel), Norsk Hydro (Norway), Diageo (U.K.), and Grupo Televisa (Mexico). You can even buy ADRs on Russian companies, such as Vimpel-Communications, a Moscow-based cellular phone company whose shares trade (as ADRs) on the NYSE.

Putting Global Returns in Perspective

Whether you buy foreign stocks directly or through ADRs, the whole process of global investing is a bit more complicated and more risky than domestic investing. When investing globally, you have to pick both the right stock and the right market. Basically, foreign stocks are valued much the same way as U.S. stocks. Indeed, the same variables that drive U.S. share prices (earnings, dividends, and so on) also drive stock values in foreign markets. On top of this, each market reacts to its own set of economic forces (inflation, interest rates, level of economic activity), which set the tone of the market. At any given time, some markets are performing better than others. The challenge facing global investors is to be in the right market at the right time.

As with U.S. stocks, foreign shares produce the same two basic sources of returns: dividends and capital gains (or losses). But with global investing, there is a third variable—currency exchange rates—that affects returns to U.S. investors. In particular, as the U.S. dollar weakens or strengthens relative to a foreign currency, the returns to U.S. investors from foreign stocks increase or decrease accordingly. In a global context, total return to U.S. investors in foreign securities is defined as follows:

Total returns(in U.S. dollars)=Current income(dividends)+Capital gains(or losses)±Changes in currencyexchange ratesTotal returns (in U.S. dollars)=Current income (dividends)+Capital gains (or losses)±Changes in currency exchange ratesEquation6.4

Because current income and capital gains are in the “local currency” (the currency in which the foreign stock is denominated, such as the euro or the Japanese yen), we can shorten the total return formula to:

Totalreturn(in U.S. dollars)=Returnsfrom currentincome and capital gains(in local currency)±Returns fromchanges in currencyexchange ratesTotal return (in U.S. dollars)=Returns from current income and capital gains (in local currency)± Returns from changes in currency exchange ratesEquation6.5

Thus, the two basic components of total return are those generated by the stocks themselves (dividends plus change in share prices) and those derived from movements in currency exchange rates.

Measuring Global Returns

Employing the same two basic components noted in  Equation 6.5 , we can compute total return in U.S. dollars by using the following holding period return (HPR) formula, as modified for changes in currency exchange rates.

Total return(in U.S. dollars)=[Ending value ofstock in foreigncurrency+Amount of dividendsreceived inforeign currencyBeginning value of stockin foreign currency×Exchange rate at end of holding periodExchange rate at beginning of holding period]−1Total return (in U.S. dollars)=[Ending value of stock in foreign currency+Amount of dividends received in foreign currencyBeginning value of stock in foreign currency×Exchange rate at end of holding periodExchange rate at beginning of holding period]−1Equation6.6

In  Equation 6.6 , the “exchange rate” represents the value of the foreign currency in U.S. dollars—that is, how much one unit of the foreign currency is worth in U.S. money.

This modified HPR formula is best used over investment periods of one year or less. Essentially, the first component of  Equation 6.6  provides returns on the stock in local currency, and the second element accounts for the impact of changes in currency exchange rates.

To see how this formula works, consider a U.S. investor who buys several hundred shares of Siemens AG, the German electrical engineering and electronics company that trades on the Frankfurt Stock Exchange. Since Germany is part of the European Community (EC), its currency is the euro. Let’s assume that the investor paid a price per share of 90.48 euros for the stock, at a time when the exchange rate between the U.S. dollar and the euro (US$/€) was $0.945, meaning one euro was worth almost 95 (U.S.) cents. The stock paid annual dividends of 5 euros per share. Twelve months later, the stock was trading at 94.00 euros, when the US$/€ exchange rate was $1.083. Clearly, the stock went up in price and so did the euro, so the investor must have done all right. To find out just what kind of return this investment generated (in U.S. dollars), we’ll have to use  Equation 6.6 .

Total return(in U.S. dollars)=[€94.00+€5.00€90.48×$1.083$0.945]−1=[1.0942×1.1460]−1=[1.2540]−125.4%Total return (in U.S. dollars)=[€94.00+€5.00€90.48×$1.083$0.945]−1=[1.0942×1.1460]−1=[1.2540]−125.4%

With a return of 25.4%, the investor obviously did quite well. However, most of this return was due to currency movements, not to the behavior of the stock. Look at just the first part of the equation, which shows the return (in local currency) earned on the stock from dividends and capital gains: 1.0942 − 1 = 9.42. Thus, the stock itself produced a return of less than 9.50%. All the rest of the return—about 16% (i.e., 25.40 − 9.42)—came from the change in currency values. In this case, the value of the U.S. dollar went down relative to the euro and thus added to the return.

Currency Exchange Rates

As we’ve just seen, exchange rates can have a dramatic impact on investor returns. They can convert mediocre returns or even losses into very attractive returns—and vice versa. Only one thing determines whether the so-called currency effect is going to be positive or negative: the behavior of the U.S. dollar relative to the currency in which the security is denominated. In essence, a stronger dollar has a negative impact on total returns to U.S. investors, and a weaker dollar has a positive impact. Thus, other things being equal, the best time to be in foreign securities is when the dollar is falling.

Of course, the greater the amount of fluctuation in the currency exchange rate, the greater the impact on total returns. The challenge facing global investors is to find not only the best-performing foreign stock(s) but also the best-performing foreign currencies. You want the value of both the foreign stock and the foreign currency to go up over your investment horizon. And note that this rule applies both to direct investment in foreign stocks and to the purchase of ADRs. (Even though ADRs are denominated in dollars, their quoted prices vary with ongoing changes in currency exchange rates.)

Alternative Investment Strategies

Basically, common stocks can be used as (1) a “storehouse” of value, (2) a way to accumulate capital, and (3) a source of income. Storage of value is important to all investors, as nobody likes to lose money. However, some investors are more concerned than others about losses. They rank safety of principal as their most important stock selection criterion. These investors are more quality-conscious and tend to gravitate toward blue chips and other nonspeculative shares.

Accumulation of capital, in contrast, is generally an important goal to those with long-term investment horizons. These investors use the capital gains and/or dividends that stocks provide to build up their wealth. Some use growth stocks for this purpose, while others do it with income shares, and still others use a little of both.

Finally, some investors use stocks as a source of income. To them, a dependable flow of dividends is essential. High-yielding, good-quality income shares are usually their preferred investment vehicle.

Individual investors can use various investment strategies to reach their investment goals. These include buy-and-hold, current income, quality long-term growth, aggressive stock management, and speculation and short-term trading. The first three strategies appeal to investors who consider storage of value important. Depending on the temperament of the investor and the time he or she has to devote to an investment program, any of these strategies might be used to accumulate capital. In contrast, the current-income strategy is the logical choice for those using stocks as a source of income.

We discuss these strategies in more detail below. You should understand these strategies so that you can choose which one suits your needs.

Buy-and-Hold

Buy-and-hold is the most basic of all investment strategies and certainly one of the most conservative. The objective is to place money in a secure investment (safety of principal is vital) and watch it grow over time. In this strategy, investors select high-quality stocks that offer attractive current income and/or capital gains and hold them for extended periods—perhaps as long as 10 to 15 years. This strategy is often used to finance retirement funds, to meet the educational needs of children, or simply to accumulate capital over the long haul. Generally, investors pick a portfolio of good stocks and invest in them on a regular basis for long periods of time—until either the investment climate or corporate conditions change dramatically.

Buy-and-hold investors regularly add fresh capital to their portfolios (many treat them like savings plans). Most also plow the income from annual dividends back into the portfolio and reinvest in additional shares (often through dividend reinvestment plans). Long popular with so-called value-oriented investors, this approach is used by quality-conscious individuals who are looking for competitive returns over the long haul.

Current Income

Some investors use common stocks to seek high current income. Common stocks are desirable for this purpose, not so much for their high dividend yields but because their dividends tend to increase over time. In this strategy, safety of principal and stability of income are vital; capital gains are of secondary importance. Quality income shares are the obvious choice for this strategy. Some investors adopt it simply as a way of earning high (and relatively safe) returns on their investment capital. More often, however, the current-income strategy is used by those who are trying to supplement their income. Indeed, many of these investors plan to use the added income for consumption purposes, such as a retired couple supplementing their retirement benefits.

Quality Long-Term Growth

This strategy is less conservative than either of the first two in that it seeks capital gains as the primary source of return. A fair amount of trading takes place with this approach. Most of the trading is confined to quality growth stocks (including some of the better tech stocks, as well as baby blues and other mid-caps). These stocks offer attractive growth prospects and the chance for considerable price appreciation. Although a number of growth stocks also pay dividends, this strategy emphasizes capital gains as the principal way to earn big returns.

This approach involves greater risk because of its heavy reliance on capital gains. Therefore, a good deal of diversification is often used. Long-term accumulation of capital is the most common reason for using this approach, but compared to the buy-and-hold tactic, the investor aggressively seeks a bigger payoff by doing considerably more trading and assuming more market risk.

A variation of this investment strategy combines quality long-term growth with high income. This is the total-return approach to investing. Although solidly anchored in long-term growth, this approach also considers dividend income as a source of return. Investors who use the total-return approach seek attractive long-term returns from both dividend income and capital gains by holding both income stocks and growth stocks in their portfolios. Or they may hold stocks that provide both dividends and capital gains. In the latter case, the investor doesn’t necessarily look for high-yielding stocks but for stocks that offer the potential for high rates of growth in their dividend streams.

Total-return investors are very concerned about quality. Indeed, about the only thing that separates them from current-income and quality long-term growth investors is that total-return investors care more about the amount of return than about the source of return. For this reason, total-return investors seek the most attractive returns wherever they can find them, be it from a growing stream of dividends or from appreciation in the price of a stock.

Aggressive Stock Management

Aggressive stock management also seeks attractive rates of return through a fully managed portfolio. An investor using this strategy aggressively trades in and out of stocks to achieve eye-catching returns, primarily from capital gains. Blue chips, growth stocks, big-name tech stocks, mid-caps, and cyclical issues are the primary investments. More aggressive investors might even consider small-cap stocks, including some of the more speculative tech stocks, foreign shares, and ADRs.

This approach is similar to the quality long-term growth strategy. However, it involves considerably more trading, and the investment horizon is generally much shorter. For example, rather than waiting 2 or 3 years for a stock to move, an aggressive stock trader would go after the same investment payoff in 6 to 12 months. Timing security transactions and turning investment capital over fairly rapidly are both key elements of this strategy. These investors try to stay fully invested in stocks when the market is bullish. When the market weakens, they put a big chunk of their money into defensive stocks or even into cash and other short-term debt instruments.

This aggressive strategy has substantial risks and trading costs. It also places real demands on the individual’s time and investment skills. But the rewards can be substantial.

Speculation and Short-Term Trading

Speculation and short-term trading characterize the least conservative of all investment strategies. The sole objective of this strategy is capital gains. The shorter the time in which the objective can be achieved, the better. Although investors who use this strategy confine most of their attention to speculative or small-cap stocks and tech stocks, they are not averse to using foreign shares (especially those in so-called emerging markets) or other forms of common stock if they offer attractive short-term opportunities. Many speculators feel that information about the industry or company is less important than market psychology or the general tone of the market. It is a process of constantly switching from one position to another, as new opportunities appear.

Because the strategy involves so much risk, many transactions yield little or no profit, or even substantial losses. The hope is, of course, that when one does hit, it will be in a big way, and returns will be more than sufficient to offset losses. This strategy obviously requires considerable knowledge and time. Perhaps most important, it also requires the psychological and financial fortitude to withstand the shock of financial losses.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 6.14 Define and briefly discuss the investment merits of each of the following.

a. Blue chips

b. Income stocks

c. Mid-cap stocks

d. American depositary receipts

e. IPOs

f. Tech stocks

2. 6.15 Why do most income stocks offer only limited capital gains potential? Does this mean the outlook for continued profitability is also limited? Explain.

3. 6.16 With all the securities available in this country, why would a U.S. investor want to buy foreign stocks? Briefly describe the two ways in which a U.S. investor can buy stocks in a foreign company. As a U.S. investor, which approach would you prefer? Explain.

4. 6.17 Which investment approach (or approaches) do you feel would be most appropriate for a quality-conscious investor? What kind of investment approach do you think you’d be most comfortable with? Explain.