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Strictly Financials 2014: Understanding Markets by Jimmy Gentry

Oct 22, 2014

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Jimmy Gentry presents "Common Size Analysis" during the Reynolds Center for Business Journalism's annual Business Journalism Week, Jan. 2, 2014. Gentry is the Clyde M. Reed Teaching Professor at the University of Kansas' School of Journalism and Mass Communications.

The annual event features two concurrent seminars, Business Journalism Professors and Strictly Financials for journalists.

For more information about business journalism training, please visit http://businessjournalism.org.

Understanding Markets - Gentry

Understanding Markets

Strictly Financials

Jan. 2, 2014

Donald W. Reynolds National Center For Business Journalism

At Arizona State University

n James K. Gentry, Ph.D. n Clyde M. Reed Teaching Professor n School of Journalism and Mass Communications n University of Kansas n jgentry@ku.edu

Risk-Return Relationship

Basic Types of Risk

n Systematic or market n Unsystematic or nonmarket. Also called business risk. Can be diversified away.

Strictly Financial

Specific Types of Risk n Financial risk, credit risk, default risk n Market risk n Interest rate risk n Purchasing power or inflation risk n Event risk n Exchange-rate or foreign exchange risk n Liquidity risk n Political or sovereign risk n Tax risk

Types of Businesses n Sole proprietorship n Partnership n Corporation

n Limited liability n Greater access to capital n Permanency n Flexibility n Double taxation

Types of Structures

n Private corporations n Public corporations n Non-profits

Types of Investments

n Stocks n Bonds n Other

n Options, futures, commodities, real estate, collectibles, currencies

Types of Markets

n Equity: Stocks n Credit: Bonds, debt or fixed income n Others

n Derivatives (such as options and futures), commodities, real estate, collectibles, currencies

n Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing

Strictly Financial

Stock

n Stockholders want: n Stock price to increase n Dependable dividend stream n Increase in size of dividend

Types of Stock

n Common stock n Preferred stock

Common Stock

n Risk: Lose your money if company falters

n Reward: Owners share in success when company does well n Appreciation n Dividends

Dividends

n Represent a return on capital invested by shareholders.

n Board must declare dividend for it to be paid. n Dividend payment is not a business expense.

It is an after-tax expense. n Usually relationship between companys age

and size, and the dividends it pays.

Preferred Stock n Reduced risk but reward may be limited n Dividend amount is stated and is paid before

dividends on common n If company is liquidated, holders are

preferred over common holders. n Dividends dont necessarily increase if

company prospers.

Bond n Bond is debt a company owes n Individual or company loans money to the

company by buying a bond n Bond pays interest over a fixed period of time n Principal is repaid to the lender or holder of the

bond at end of the term n Interest rate is typically fixed when the bond is

sold (i.e., fixed income security) n Interest rate is comparable to what other

bonds, with that rating, are paying

Bond Terminology n Interest rate: Fixed percentage of the bonds

purchase price that is paid annually to the bond holder

n Yield: Return on investment if bond is held to maturity. Equals interest rate. If bond is traded before maturity date, yield could change although interest rate stays the same.

n Par value: Dollar amount paid for bond at time of issue

n Maturity date: When bond comes due

Issuers Prefer Bonds n When companies need to raise money, they

can issue stock or sell bonds n They often prefer bonds, in part because

issuing more stock can dilute the value of shares investors already own

n Bonds also may have income tax advantages

A Quasi-Bond?

n Is preferred stock debt (i.e., a bond) in disguise?

n Preferred holders have a guaranteed dividend. Is that like the fixed interest rate of a bond?

n Why do investors pick common, preferred or bonds?

Risk and Reward

Yield Curve Y

ield

Maturity

Equity or Securities Markets

n Primary market n Go public n Private placement

n Secondary market

Going Public

n Entrepreneurs have an idea. Company grows with an investment from the private equity market (venture capital).

n Owners decide to go public. n Register with SEC to make an initial

public offering (IPO). n Investment bankers typically underwrite

the offering through a syndicate.

Going Public (cont.)

n Company prepares a prospectus, which is a detailed analysis of the companys financial history, its products and services, as well as managements background and experience.

n Prospectus should identify and assess risk factors the company faces.

IPO Terms

n Prospectus n Road show n Quiet period n Lockup period

Shelf Registration

n Firm can file one registration statement for a relatively large block of stock and sell parts over a two-year period

n This can reduce red tape and costs, and because stock can be sold directly to institutional investors, can eliminate the underwriting fee

Private Placement n New issues can be sold in large lots to a small

group of buyers. Allows start-up firms to show appeal by raising capital on their own.

n Additional shares later can be offered through an underwriter.

n Many debt issues are placed privately, usually to large buyers such as insurance companies.

Secondary Offering

n If company already is public, it can sell more stock through a secondary offering. n Causes dilution

n Major owners sell their shares. They get the funds so no dilution.

Wall Street

n Got its name from a wall of brush and mud built by early settlers to protect the city of New York from attacks (1609)

n Site of New Yorks first organized stock trading

New York Stock Exchange

n In March 1792, Wall Street leaders met to establish an improved auction market

n In May 1792, 24 men signed an agreement to trade securities only among themselves, maintain fixed commission rates and avoid other auctions

n Considered the origination of NYSE

NYSE (cont.)

n Until March 2006, was owned by 1,366 seat-holding members

n Highest price ever paid for a seat was $4 million

n Price was determined by auction.

NYSE Members n Floor brokers

n House brokers n Independent brokers

n Specialists n Manage auction process n Execute orders for brokers n Serve as catalysts n Provide capital n Stabilize prices

In The Day, Buy or Sell Order

n Tell your broker or registered representative to buy or sell a stock at the current price, or market price. Called a market order.

n If you name the price to buy or sell, youre making a limit order.

n Tell your broker to buy or sell once the price hits a specific price, youre placing a stop order at a stop price.

Trading on the NYSE Floor

n Trading occurs in the Big Room n Numerous stations, each with a roughly

figure-eight shape, with counters and screens above. Called trading posts.

n Each counter is a specialists post

NYSE Floor (cont.)

n Order comes to the booth that is rented by a brokerage house

n Floor broker takes order to appropriate specialists post

n Specialist keeps a list of unfilled orders. Processes orders as prices move.

n Specialists job is to maintain an orderly market in the stock (match buyers/sellers)

NYSE Floor (cont.)

n Stocks or groups of stocks are traded at trading posts near the specialists positions.

n Floor brokers can use a specialist or trade between themselves, called trading in the crowd

n Terminals display the stocks activity. n After every trade, a reporter records the stock

symbol, price and initiating broker. n Successful trades are confirmed.

NYSE Floor (Then & Now)

Round or Odd Lots

n Round lots: Buying or selling stock in multiples of 100 shares

n Odd lots: Buying or selling stock in other quantities

Who Holds Your Stock?

n Virtually all investors leave shares in their brokerage account in whats called the street name. Investor retains beneficial ownership, though.

n This offers safe storage. n You can get tangible certificates if you

want them. Typically, you must pay for them.

Super DOT System

n Designated Order Turnaround n Allows orders to be transmitted

electronically to specialist. n Now makes up a substantial percentage

of NYSE trading, particularly smaller orders

American Stock Exchange

n Non-members of NYSE couldnt afford office space so traded in the street

n 1842: New York Curb Exchange n By late 1870s known as curbstone

brokers and their market was known as the Curb.

n Merged with NASDAQ in 1998 n Acquired by NYSE Euronext in 2009

NASDAQ

n National Association of Securities Dealers Automated Quotations system

n NASDAQ is a computer network with no physical location for trading

n Uses a multiple market maker system, not the specialist system

n About 4,000-plus companies

Trading on the NASDAQ

n Trading is through an open market, multiple dealer system, with many market makers competing to handle each transaction.

n The computer network checks for matches, which can be handled instantly.

In Which Market?

n In general, but with exceptions: n NYSE: Oldest, largest, best known n AMEX: Smaller, younger n NASDAQ: Youngest, least experienced n Some of NYSEs most actively traded

stocks are also quoted on the NASDAQ

ECNs

n Electronic Communications Networks n Are basically Web sites that allow

investors to trade directly with one another

n Archipelago and Instinet were best known

n BATS Trading

NYSE - Archipelago Marriage

n Merged in March 2006 to create NYSE Group, Inc., a publicly-held company.

n Largest merger ever between securities exchanges.

n Combined leading equities market with most successful electronic exchange.

n Archipelago: low fees, user-friendly technology

NYSE Euronext

n Merged April 2007 n Operates worlds largest, most liquid

exchange with diverse products and services

n Six equities exchanges in five countries and six derivatives exchanges

Deutsche Borse Seeks To Buy NYSE Euronext

n Worked on a deal from 2011 to 2012. n Would have created worlds largest

trading exchange. n European Union regulators rejected the

deal in February 2012.

NYSE and ICE

n ICE or the Intercontinental Exchange took over NYSE Euronext on Nov. 13.

n ICE is a 13-year-old company based in Atlanta. Derivatives in general and energy futures in particular have fuelled ICEs rapid growth.

n Questions surround NYSE future

Strictly Financial

NYSE Hybrid Market

n Floor trading and automated trading n Specialists or Archipelago strengths n Why? Customers desire for faster

access to liquidity and greater anonymity

NASDAQ Response

n NASDAQ acquired Instinet Group Inc., another ECN

Exchanges v. OTC Market

n Stocks in almost 10,000 companies arent listed on any exchanges

n They are traded over the counter (OTC)

n Typically handled by phone or computer n Generally, comparatively inexpensive

and infrequently, or thinly, traded

BATS Global Markets

n Newer exchange, founded in 2005 n Located in Kansas City n Competes on technology and cost n Developed its own software platform n Also offers an options trading platform n Has entered Europe

Strictly Financial

Direct Edge

n Another ECN with exchange status n Merging with BATS n Has DOJ approval; awaiting SEC n Expected to close Q1 2014 n BATS-Edge combo will be No. 2 exchange in

market share n Some days BATS-Edge combo has exceeded

NYSE trading

U.S. Equities Market Share n NYSE Floor 11 n NYSE Arca 12 n Nasdaq 16 n Nasdaq Bx 3 n BATS BZX, BYZ 10 n Direct Edge X, A 10 n TRF 37 n Other 3

November 2013

Dark Pools n Also Dark Liquidity or Dark Pool Liquidity n Lightly regulated trading not open to the public. n Mostly involves block trades by institutions away from

public exchanges so trades are anonymous. n Main advantage to institutional investors: Can buy or

sell in large blocks without other investors knowing since neither size of trade or traders identity are revealed. Prices are reported after trades completed.

n Also means some market participants are disadvantaged since they cant see trades executed and prices paid so this market is not transparent.

Strictly Financial

High-Frequency Trading

n Also known as high-speed trading. n Electronic trading strategies driven by

statistics and algorithms. n WSJ reported in October 2012 that by some

measures, such firms make up 5 of every 10 stock trades in the U.S. each day.

Strictly Financial

High-Frequency Trading

n Research has shown that algorithmic trading broadly makes prices less volatile and reduces the overall cost of trading.

n These firms ability to buy and sell large blocks of securities in fractions of a second has raised fears that ordinary investors are being left behind.

n Is drawing criticism.

Strictly Financial

Cyclical, Income, Growth

n Cyclical: Highly dependent on the state of the economy. When things slow, earnings and stock price fall. When economy recovers, earnings and stock prices rise.

n Income: Stocks that pay dividends regularly. n Growth: Pay little or no dividend while profits

are reinvested.

Stock Ownership

n In 2011, 54% of Americans said they had money in the stock market, either in an individual stock, a mutual fund or self-directed 401(k) or IRA

n This was down from 56% in 10 and 57% in 09. High in the 21st Century was 67% in 02 and 65% in 07.

Gallup, April 2011

Stock Ownership

n 87% of upper-income Americans ($75,000 or more annually) own stocks.

n 83% of postgraduates and 73% of college graduates own stocks.

n 64% of Republicans hold stocks, compared with half of Democrats and independents.

n Ages 50 to 64 are most likely to say they have money in the stock market.

Gallup, April 2011

Institutional Investors

n Organizations that invest their own assets or pool those it holds in trust for others.

n Examples: Investment companies (including mutual funds), pension systems, insurance companies, universities and banks.

n Trade regularly and in tremendous volume. n Must buy or sell at least 10,000 shares for a

transaction to be an institutional trade.

Changing Attitudes

n Institutional investors who own large blocks of stock are increasingly demanding a say in corporate management.

n Socially or environmentally conscious individual shareholders also are becoming more involved.

Stock Market Averages n Dow Jones Industrial Average: Best known

and most widely reported market indicator n Made up of 30 industrial companies n Dow Jones Transportation Average: 20

airlines, railroads and trucking companies n Dow Jones Utility Average: 15 gas, electric

and power companies n Dow Jones 65 Composite Average: all 65

companies in the other three averages

Stock Market Indexes n NYSE Composite Index: All stocks traded on

the NYSE. n Standard & Poors 500 Index: Broad base of

500 stocks. Considered benchmark for large-stock investors.

n NASDAQ Stock Market Composite Index: Stocks traded through its electronic system. Often more volatile because of types of companies it covers.

Market Indexes (cont.) n AMEX Composite: Companies on the AMEX. n Russell 2000: Follows smallest two-thirds of

the 3,000 largest U.S. companies. Includes many IPOs of past few years. Benchmark for small-company stocks.

n Value-Line: 1,700 common stocks. n Wilshire 5000: Broadest index, including

nearly all stocks traded in U.S. markets.

Reg FD, Disclosure and Guidance

n Regulation Fair Disclosure, October 2000

n Bars public issuers from selectively revealing material nonpublic information to securities analysts, broker-dealers, investment advisers, and institutional investors, before disclosing it to the public.

Blue-Chip Stock

n Company with national reputation for quality, reliability and ability to be profitable in good or bad times

Classes of Stock

n Some firms have more than one class n Primarily done to assure control of the

firm by one group, such as Ford Motor Companys Class B, which isnt publicly traded (held by family) but has 40 percent of voting power, although it represents less than 10 percent of total shares outstanding.

Stock Split

n If stock price increases significantly, a company might do a split to lower the price, which it expects to stimulate trading.

n In a split, more shares are available but total market value is still the same.

n Price may move up after split, therefore increasing the value of your stock.

n Reverse split: Exchange more shares for fewer, say 10 for five. To boost share price.

Stock Split

n Number of splits is down notably. Just 10 split in 13, compared with an average of 48 annually since 1980.

n Researchers say its partly because retail investors are increasingly turning investing over to professionals.

n Cache in having high-priced stocks, some say.

Strictly Financial

Insider Trading

n Buying and selling of company stock by officers, directors, employees, family members, etc. Person or trust owning 10 percent or more of a company's stock also considered an "insider."

n SEC calls them "insiders" because of access to early and potentially key company events.

Option

n On an organized exchange, the right to buy or sell securities, commodities, etc. at some point for an agreed upon amount.

n In a company, stock options are granted to corporate executives and others as part of their compensation packages.

Warrant

n Type of security, usually issued with a bond or preferred stock, that entitles holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at time of issuance, for a period of time.

n Also called a Subscription Warrant

Owning International Stocks

n Rewards n Diversification, capital gains, dividends,

countrys currency rises against dollar

n Risks n Tax treatments differ by country,

accounting and trading rules can be different, converting dividends can add expenses, distance and language barriers

Credit or Debt Markets

n Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing

n Short-term or money market n Bond market

Terminology

n Bills Maturity dates up to one year n Notes Maturity dates of two to 10

years n Bonds 10 years or longer

Who Issues Bonds

n Issued by U.S. companies n Issued by the U.S. Treasury n Issued by federal, state and local

government agencies n Issued by overseas companies and

governments. When sold in dollars, are sometimes called Yankee Bonds.

Issuers Prefer Bonds

n When companies need to raise money, they can issue stock or sell bonds

n They often prefer bonds, in part because issuing more stock tends to dilute the value of shares investors already own

n Bonds also may have income tax advantages

Treasury Issues

n Life, or term, is fixed at time of issue n Treasury bill: One year or less n Treasury note: One to 10 years n Treasury bond: 10 years or more n Generally, the longer the term the

higher the interest rate

Uses of Bonds

n Corporations use bonds: n Pay for expansion or modernization, cover

operating expenses finance takeovers or other changes in management structure

n U.S. Treasury uses bonds: n Finance government activities, pay off (refinance)

national debt

n States, cities, counties, towns use bonds: n Pay for public projects, supplement budgets

How Bonds Are Traded

n Most already-issued bonds are traded over the counter

n Bonds also can be purchased from the inventory of a brokerage firm that might make a market in the bonds

n Commissions and markups

Bonds Then and Today n Until 1983, all bondholders received

certificates n Some of these Bearer Bonds had coupons

attached to the certificate n To collect interest, investor detached the

coupon and exchanged it for cash. Hence, the bond interest rate is called the Coupon Rate.

n Today most new bonds are called Book Entry bonds and are registered electronically

Rating Bonds

n Standard & Poors, Moodys Investors Services and Fitch are best known

n Corporate, international and municipal bonds are rated

n Credit ratings influence interest rates n If a companys rating is downgraded,

investors demand a higher yield

Bond Rating Code n Aaa/AAA: Best quality n Aa/AA: High quality n A/A: High-medium quality n Baa/BBB: Medium quality n Ba/BB: Some speculative element n B/B: Future default risk n Caa/CCC: Poor quality, default danger n Ca/CC: Highly speculative n C/C: Lowest rated, poor prospects

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