LECTURE 3:

BASICS OF INVESTING II
Economics 98/198 Decal Spring 2008
Today’s Schedule
Administrative Issues
Last Week’s Lecture
Lecture Content
Basics of Investing
 Market capitalization
 Earning reports
 Stocks splits / stock buybacks
 Investing on Margin
 Short-selling
 Industries / Sectors
Current Events
Assigned Reading / Next Week
Administrative Issues
Enrollment
Make sure you’re signed up on Tele-Bears

Investopedia Simulation Competition

Submit your $5 into the class envelope
Make sure you write username on sign-up sheet
Start trading!

Investor’s Business Daily online subscription

New Presentation
Lecture Content
Market Capitalization
Market Capitalization
Also known as “market cap”
Refers to the value of ALL company outstanding
shares (shares owned by investors)
Useful for gauging a company’s size and therefore,
some of the risk characteristics associated

Market Cap =

Stock Price X # of shares outstanding

(stock held by investors, officers, & insiders)

Market Capitalization: Example
Example. Amazing DeCal Cookies Co., Ltd.
Share Price $20
Shares Outstanding: 50,000,000 shares
Market cap?

Example. Berkeley Traders Co., Ltd.

Share Price $100
Shares Outstanding: 1,000,000 shares
Market Cap?
Different Capitalizations
 Not exact, but general guidelines for size categories

 Large Cap
 Companies with $10b - $200b market cap
 Often referred to as “blue-chip” stocks (low volatility, dividends)
 “Mega-Cap” - $200b+ (HUGE)

 Mid Cap
 Companies with $2b - $10b market cap

 Small Cap
 Companies with $300m - $2b market cap
 Typically newer, relatively younger companies
 Can present potential for greater capital gains, but at greater risk
 “Micro-cap” - $50m-$300m market cap – VERY SMALL
Market Capitalization Perspective
Large Cap
 Microsoft (Nasdaq: MSFT) $264 billion
 Wal-Mart (NYSE: WMT) $201 billion
 Coca-Cola (NYSE: KO) $138 billion
 Walt Disney (NYSE: DIS) $60 billion
 Yahoo! (Nasdaq: YHOO) $39.5 billion

Small/Mid - Cap
 Logitech International (Nasdaq: LOGI) $5 billion
 J Crew Group Inc. (NYSE: JCG) $2.6 billion
 Barnes & Noble (NYSE: BKS) $1.9 billion
 Papa Johns (PZZA) $694 million
 TradeStation Group (TRAD) $471 million

Source: Google Finance as of 2/12/2008 closing prices

 Comparing Small and Large Caps
(S&P 500 vs. S&P 600) – last decade

Black line = S&P 500 Orange line = S&P 600

 Comparing Small and Large Caps
(S&P500 vs. S&P 600) – Past 2 Years

Black line = S&P500 Orange line = S&P 600

Stock Splits
Stock Buybacks
Stock Splits
When a company divides the number of its
existing stocks into multiple shares

In 2-for-1 split, each stockholder gets an

additional share for each share he or she
holds
Also, value of each share is reduced in half:

2 shares now equal original value of 1 share

before split (total value not changed)
Stock Splits
If you still don’t get it, think of it this way..

If you have a $100 bill, and I exchange with you two
$50 bills

How many bills do you have?

What is the total value of money you have?
Stock Splits
Why do companies do this?

Brings the share price down to a more “attractive” level

for smaller investors (purely psychological)
 Can potentially result in price increase because these small
investors will be more likely to buy the stock
 Some also say stock split will increase price because it is a
signal of strong growth

Increases stock’s liquidity (What is liquidity?)

Stock Splits
Effects

Excessive stock splits may hurt a stock’s price

 Pros and shrewd traders sometimes use excitement
generated by oversized or excessive split as an opportunity
to sell and take their profits

Oversized splits create substantially larger supply

Stock Buybacks
When a company buys back its own shares in the
market place
Also known as “share repurchase”

Why do it?
Management believes its stock value is discounted too
steeply (its too cheap)
Management has confidence in the company and want
to send a message the market
Stock Buybacks
# of shares outstanding go down as these shares are
bought by the company

Major impact is that it affects important financial

ratios (ROA, ROE, P/E, EPS)
 What do these ratios mean?
 Briefly, we use them to value or analyze a company
 We’ll discuss this more later

Are they good or bad?

Not definitive answer, depends on the situation
Investing on Margin / Short Selling
Investing on Margin
Borrowing money from brokerages to invest

Generally, maximum 50% of a purchase can be on

margin

However, when borrow money, have to pay an

interest rate on money borrowed
 Ex. I borrow $10,000 and broker charges 5% rate. I have to
pay $500 (10,00 x 0.05) to borrow that money.
Investing on Margin
PROS
Potential to get greater profits than investing
with only cash because you profit from money
you don’t have

CONS
Works against you when you lose money –
can get really ugly with losses
Charged interest for money you borrow
Margin Example
Joe buys 100 shares priced at $50 of Smart Inc.
(SMRT) and is allowed to buy another 100 shares
on margin at 10% interest.

100 shares @ $50 (cash) +$5,000

100 shares @ $50 (margin) +$5,000
---------------------------------------------------
Total Investment $10,000
(200 shares @ $50)
 Margin Example continued
SMRT goes through the roof and increases 100% in 10
months to $100. Joe smartly sells and takes profits.

SMRT Investment (200sh@$100) +$20,000

Money borrowed from brokerage -$5,000
Interest on borrowed money -$500
Original Investment -$5,000

-------------------------------------------------------------------
Profit $9,500
% Return ($9,500/$5,000) 190%
vs. % Return (cash investment only) 100%
Shorting Stocks
Betting a stock will go down and attempting to
profit from that downward movement

1. You essentially “borrow” shares from another

investor (account must be able to trade on margin)
2. You sell those shares at the market price
3. You then wait and root for the stock price to tumble
4. Then you cash out, whether at a profit of loss
5. You then buy the shares at the new market price
and return the shares to their owner
Shorting Example
Scenario 1
Mr. Giant shorts 1000 shares of Lampere Co. at $20 a
share – his account gets credited with $20,000
Lampere Co. stock plummets to $10 a share

Borrowed and sold short 1000 shares at $20 +$20,000

Bought back and returned 1000 shares at $10 -$10,000
-----------------------------------------------------------------------------
Profit +$10,000
% Gain 100%
Shorting Example
Scenario 2
Mr. Giant shorts 1000 shares of Lampere Co. at $20 a
share – his account gets credited with $20,000
Lampere Co. stock skyrockets to $60 a share

Borrowed and sold short 1000 shares at $20 +$20,000

Bought back and returned 1000 shares at $60 -$60,000
-----------------------------------------------------------------------------
Profit -$40,000
% Loss -200%
Sector / Industries
Cyclical vs. Non-Cyclical
Sector vs. Industry
 Often used interchangeably, but actually mean slightly
different things

 Sectors are the general segments in the economy within

which large groups of companies can be categorized into
 About a dozen sectors in the economy
 Example. Financial Sector, Technology, Basic Materials

 Industry describes a much more specific grouping of

companies with highly similar business activities
 Break down sectors into much more defined groups
 Can be small, but also very large in numbers
 Example. Financial Sector  Asset Management, Insurance,
Banks, etc.
Sector vs. Industries
Top sectors / industries rotate every cycle
 Important to know which sectors / industries are leading
the market and performing well

Why? Let’s think back to 1998

 Technology, software, telecom: leading industries then
 If you invested in a company in those industries , the price
would have likely made a solid, if not major, price increase

Stock prices of companies in the same / similar

industry usually (not always) move in a similar fashion
Recent Industry Performance
(http://stockcharts.com/charts/performance/Industry1.html)
Cyclical Stocks / Industries
The term refers to how correlated a company’s
price (or industry) is relative to economic
fluctuations

Non-cyclical stocks (also called defensive stocks)

refer to companies not as susceptible to economic
fluctuations
Example. Household durables, tobacco, utilities
These are often goods that necessities rather than
luxuries
Cyclical vs. Non-Cyclical Stocks

Ford = Blue Red – Florida Public Utilities

Summary
Market Capitalization
 Small caps vs. large caps

Stock Splits
Stock Buybacks
Earning Reports
Shorting Stocks
Margin
Industries vs. Sectors
Cyclical Stocks / Industries
For Next Week
Quiz on Stock Market Basics

Introduction to Other Investment Securities

 Bonds / Mutual Funds / Exchange-Traded Funds
Market Psychology
 Emotions involved with stock investing
Basic Investing Concept
 Compounding
 Investing versus Speculating
 Determining your own financial goals
 Investment Style – Risk/Reward, Active/Passive
Managing your Portfolio
Current Events
Reading / Homework
Master Your Trading Mindtraps (Investopedia)
How Interest Rates Affect the Market (Investopedia)

Quiz next week: Basics of Stocks & investments

 Market Exchanges
 Major indexes
 Ticker Symbols
 Types of orders
 Market Capitalization
 Etc.