Stocks - Basics

Perhaps we should start by looking at the basics: What is stock? Why does a company issue stock? Why do investors pay good money for little pieces of paper called stock certificates? What do investors look for? What about Value Line ratings and what about dividends?

Stock is nothing but a piece of ownership of a company. The owner of a stock is owner of the company to the extent of his/her holding as a percentage of the total stock floating in the market. Since the stockholder is the owner of the company, he obviously has right on the profit of the company. At the end of the year when the profit gets distributed, he/she also gets some booty depending upon his/her share. This we call as dividend. Now this is more of bookish definition. Let us understand stock in more detail.

To start with, if a company wants to raise capital (money) one of its options is to issue stock. It has other methods, such as issuing bonds and getting a loan from the bank. But stock raises capital without creating debt, without creating a legal obligation to repay those funds.

What do the buyers of the stock -- the new owners of the company -- expect for their investment? The popular answer, the answer many people would give is: they expect to make lots of money; they expect other people to pay them more than they paid themselves. Well, that doesn't just happen randomly or by chance (well, maybe sometimes it does, who knows?)

The less popular, less simple answer is: shareholders -- the company's owners -- expect their investment to earn more, for the company, than other forms of investment. If that happens, if the return on investment is high, the price tends to increase. Why?

Who really knows? But it is true that within an industry the Price/Earnings (i.e., P/E) ratio tends to stay within a narrow range over any reasonable period of time -- measured in months or a year or so.

So if the earnings go up, the price goes up. And investors look for companies whose earnings are likely to go up. How much?

There's a number -- the accountants call it Shareholder Equity -- which in some magical sense represents the amount of money the investors have invested in the company. I say magical because while it translates to (Assets - Liabilities) there is often a lot of accounting trickery that goes into determining Assets and Liabilities.

But looking at Shareholder Equity, (and dividing that by the number of shares held to get the book value per share) if a company is able to earn, say, $1.50 on a stock whose book value is $10, that's a 15% return. That's actually a good return these days, much better than you can get in a bank or C/D or Treasury bond, and so people might be more encouraged to buy, while sellers are anxious to hold on. So the price might be bid up to the point where sellers might be persuaded to sell.

A measure that is also sometimes used to assess the price is the Price/Book (i.e., P/B) ratio. This is just the stock price at a particular time divided by the book value.

What about dividends? Dividends are certainly more tangible income than potential earnings increases and stock price increases, so what does it mean when a dividend is non-existent or very low? And what do people mean when they talk about a stock's yield?

To begin with the easy question first, the yield is the annual dividend divided by the stock price. For example, if company XYZ is paying $.25 per quarter ($1.00 per year and XYZ is trading at $10 per share, the yield is 10%.  A company paying no or low dividends (zero or low yield) is really saying to its investors -- its owners, "We believe we can earn more, and return more value to shareholders by retaining the earnings, by putting that money to work, than by paying it out and not having it to invest in new plant or goods or salaries." And having said that, they are expected to earn a good return on not only their previous equity, but on the increased equity represented by retained earnings.

So a company whose book value last year was $10 and who retains its entire $1.50 earnings increases its book value to 11.50 less certain expenses. That increased book value - let's say it is now $11 -- means the company must earn at least $1.65 this year Just to keep up with its 15% return on equity. If the company earns $1.80, the owners have indeed made a good investment, and other investors, seeking to get in on a good thing, bid up the price.

That's the theory anyway. In spite of that, many investors still buy or sell based on what some commentator says or on announcement of a new product or on the hiring (or resignation) of a key officer, or on general sexiness of the company's products. And that will always happen.

Preferred Shares

Preferred stocks combine characteristics of common stocks and bonds. Garden-variety preferred shares are a lot like general obligation bonds/debentures; they are called shares, but carry with them a set dividend, much like the interest on a bond. Preferred shares also do not normally vote, which distinguishes them from the common shares. While today there are a lot of different kinds of hybrid preferred issues, such as a call on the gold production of Freeport McMoran Copper and Gold to the point where they will deliver it, we will consider characteristics of the most ordinary variety of preferred shares.  In general, a preferred has a fixed dividend (as a bond pays interest), a redemption price (as a bond), and perhaps a redemption date (like a bond). Unlike a stock, it normally does not participate in the appreciation (or drop) of the common stock (it trades like a bond). Preferreds can be thought of as the lowest-possible grade bonds. The big point is that the dividend must be paid from after-tax money, making them a very expensive form of capitalization.

One difference from bonds is that in liquidation (e.g. following bankruptcy), bondholder claims have priority over preferred shares, which in turn have priority over common shares (in that sense, the preferred shares are "preferred"). These shares are also preferred (hence the name) with respect to payment of dividends, while common shares may have a rising, falling or omitted dividends. Normally a common dividend may not be paid unless the preferred shares are fully paid. In many

cases (sometimes called "cumulative preferred"), not only must the current preferred dividend be paid, but also any missed preferred dividends (from earlier time periods) must be made up before any common dividend may be paid.

Basically, preferreds stand between the bonds and the common shares in the pecking order. So if a company goes bankrupt, and the bondholders get paid off, the preferreds have next call on the assets - and unless they get something, the common shareholders don't either.

Some preferred shares also carry with them a conversion privilege (and hence may be called "convertible preferred"), normally at a fixed number of shares of common per share of preferred. If the value of the common shares into which a preferred share maybe converted is low, the preferred will perform price-wise as if it were a bond; that is often the case soon after issue. If, however, the common shares rise in value enough, the value of the preferred will be determined more by the conversion feature than by its value as a pseudo-bond. Thus, convertible preferred might perform like a bond early in its life (and its value as a pseudo-bond will be a floor under its price) and, if all goes well, as a (multiple of) common stock later in its life when the conversion value governs.

And as time has gone on, even more elaborate variations have been introduced. The primary reason is that a firm can tailor its cost of funds between that of the common stock and bonds by tailoring a preferred issue. But it isn't a bond on the books - and it costs more than common stock.

American Depositary Receipts (ADRs)

An American Depositary Receipt (ADR) is a share of stock of an investment in shares of a non-US corporation. The shares of the non-US corporation trade on a non-US exchange, while the ADRs, perhaps somewhat obviously, trade on a US exchange. This mechanism makes it straightforward for a US investor to invest in a foreign issue. ADRs were first introduced in 1927.

Two banks are generally involved in maintaining an ADR on a US exchange: an investment bank and a depositary bank. The investment bank purchases the foreign shares and offers them for sale in the US. The depositary bank handles the issuance and cancellation of ADRs certificates backed by ordinary shares based on investor orders, as well as other services provided to an issuer of ADRs, but is not involved in selling the ADRs.

To establish an ADR, an investment bank arranges to buy the shares on a foreign market and issue the ADRs on the US markets.

For example, BigCitibank might purchase 25 million shares of a non-US stock. Call it Infosys Technologies Limited (INFOSYS). Perhaps INFOSYS trades on the Paris exchange, where BigCitibank bought them. BigCitibank would then register with the SEC and offer for sale shares of INFOSYS ADRs.

INFOSYS ADRs are valued in dollars, and BigCitibank could apply to the NYSE to list them.  In effect, they are repackaged INFOSYS shares, backed by INFOSYS shares owned by BigCitibank, and they would then trade like any other stock on the NYSE.

BigCitibank would take a management fee for their efforts, and the number of INFOSYS shares represented by INFOSYS ADRs would effectively decrease, so the price would go down a slight amount; or INFOSYS itself might pay BigCitibank their fee in return for helping to establish a US market for INFOSYS. Naturally, currency fluctuations will affect the US Dollar price of the ADR.

BigCitibank would set up an arrangement with another large financial institution for that institution to act as the depositary bank for the ADRs. The depositary would handle the day-to-day interaction with holders of the ADRs.

Dividends paid by INFOSYS are received by BigCitibank and distributed proportionally to INFOSYS ADR holders. If INFOSYS withholds (foreign) tax on the dividends before this distribution, then BigCitibank will withhold a proportional amount before distributing the dividend to ADR holders, and will report on a Form 1099-Div both the gross dividend and the amount of foreign tax withheld.

Dividends

Dividend, as discussed earlier, is nothing but the portion of the profit, which is distributed among the shareholders. Dividend is always a percentage of the face value of the share. If the face value of the stock is $10, and the company declares 10% dividend, then you get $1 for each share you hold.  Now remember that, not all of profit is distributed. Part of it is retained so that it can be used for further growth of the company or some contingency. This part is aptly called Reserve.

A company may periodically declare cash and/or stock dividendsy. This article deals with cash dividends on common stock. Two paragraphs also discuss dividends on Mutual Fund shares. A separate article elsewhere in this manual discusses stock splits and stock dividends.

The Board of Directors of a company decides if it will declare a dividend, how often it will declare it, and the dates associated with the dividend. Quarterly payment of dividends is very common, annually or semiannually is less common, and many companies don't pay dividends at all. Other companies from time to time will declare an extra or special dividend. Mutual funds sometimes declare a year-end dividend and maybe one or more other dividends.

If the Board declares a dividend, it will announce that the dividend (of a set amount) will be paid to

Shareholders of record as of the RECORD DATE* and will be paid or distributed on the

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y Stock dividend is nothing but the dividend in forms of stock and is the distribution of stocks to the existing stockholders as a percentage of the present holding. If the stock dividend is 1:2, you will get 1 stock extra  for every 2 stocks you hold.

* Record Date: The date on which the tally is taken for who the shareholders are. The shareholders as of that date are eligible for dividend. So if you buy some stock and sold it just before the record date, you can as well forget the dividend. So bad !!!

DISTRIBUTION DATE (sometimes called the Payable Date).

Before we begin the discussion of dates and date cutoffs, it's important to note that three-day settlements (T+3) became effective 7 June 1995. In other words, the SEC's T+3 rule states that all stock trades must be settled within 3 business days.

In order to be a shareholder of record on the RECORD DATE you must own the shares on that date (when the books close for that day). Since virtually all stock trades by brokers on exchanges are settled in 3 (business) days, you must buy the shares at least 3 days before the RECORD DATE in order to be the shareholder of record on the RECORD DATE. So the (RECORD DATE - 3 days) is the day that the shareholder of record needs to own the stock to collect the dividend. He can sell it the very next day and still get the dividend.

 If you bought it at least 3 business days before the RECORD date and still owned it at the end of the RECORD DATE, you get the dividend. (Even if you ask your broker to sell it the day after the (RECORD DATE - 3 days), it will not have settled until after the RECORD DATE so you will own it on the RECORD DATE.)

 So someone who buys the stock on the (RECORD DATE - 2 days) does not get the dividend. A stock paying a 50c quarterly dividend might well be expected to trade for 50c less on that date, all things being equal. In other words, it trades for its previous price, Except for the Dividend. So the (RECORD DATE - 2 days) is often called the EX-DIV date. In the financial listings, an x indicates that.

How can you try to predict what the dividend will be before it is declared?

Many companies declare regular dividends every quarter, so if you look at the last dividend paid, you can guess the next dividend will be the same. Exception: when the Board of IBM, for example, announces it can no longer guarantee to maintain the dividend, you might well expect the dividend to drop, drastically, next quarter. The financial listings in the newspapers show the expected annual dividend, and other listings show the dividends declared by Boards of directors the previous day, along with their dates.

Other companies declare less regular dividends. Companies, whose shares trade as are very dependent on currency market fluctuations, so will pay differing amounts from time to time.

Some companies may be temporarily prohibited from paying dividends on their common stock, usually because they have missed payments on their bonds and/or preferred stock.

On the DISTRIBUTION DATE shareholders of record on the RECORD date will get the dividend. If you own the shares yourself, the company will mail you a check. If you participate in a DRIP (Dividend reinvestment Plan, see article on DRIPs elsewhere in this manual) and elect to reinvest

the dividend, you will have the dividend credited to your  DRIP account and purchase shares, and if your stock is held by your broker for you, the broker will receive the dividend from the company and credit it to your account.

Dividends on preferred stock work very much like common stock, except they are much more predictable. Since most of the time they are mentioned at the time of issue.

Finally, just a bit of accounting information. Earnings are always calculated first, and then the directors of a company decide what to do with those earnings. They can distribute the earnings to the stockholders in the form of dividends, retain the earnings, or take the money and head for Brazil (NB: the last option tends to make the stockholders angry and get the local district attorney on the case :-). Utilities and seasonal companies often pay out dividends that exceed earnings - this tends to prop up the stock price nicely - but of course no company can do that year after year.

Types of Indexes:   

Indexes are the barometers of the market and are indicators of how the market is moving. They are constructed by taking some of the stocks, which are indicative of the market. The sample is such that they represent various sectors of economy. The better the sampling, the better is the indication. They are constructed by taking n number of stocks. The examples below give idea about various indexes. This list is by no way exhaustive. Investors use different indexes depending upon their requirements. For example the mutual funds use indexes, which are fairly broad based (That is in index, which is constructed by taking more number of shares into consideration. The reason - Better sample which will represent the market better).

There are three major classes of indexes in use today in the US. They are:

      A - equally weighted price index

      An example is the Dow Jones Industrial Average

      B - market-capitalization-weighted index

      An example is the S&P Industrial Average

      C - equally-weighted returns index

      The only one of its kind is the Value-Line index.

Of these, A and B are widely used.

Type A index

      As the name suggests, the index is calculated by taking the average of the prices of a set of  companies:

      Index =  Sum(Prices of N companies) / N

 Type B index

      In this index, each of the N company's price is weighted by the market capitalization of the  company.

                             Sum (Company market capitalization * Price) over N companies

      Index =                      ------------------------------------------------------------

                                              Market capitalization for these N companies

Type C index

      Here the index is the average of the returns of a certain set of companies. Value Line publishes two versions of it:

           the arithmetic index : (VLAI/N) = 1 * Sum(N returns)

           the geometric index : VLGI = {Product(1 + return) over N}^{1/n}, which is just the geometric mean of the N returns.

The Dow Jones Industrial Average

The Dow Jones averages are computed by summing the prices of the stocks in the average and then dividing by a constant called the "divisor". The divisor for the Dow Jones Industrial Average (DJIA) is adjusted periodically to reflect splits in the stocks making up the average. The divisor was originally 30 but has been reduced over the years to a value far less than one. The current value of the divisor is about 0.35; the precise value is published in the Wall Street Journal and Barron's.

According to Dow Jones, the industrial average started out with 12 stocks in 1896. Those original stocks, for all of you trivia buffs out there, were American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling and Cattle Feeding, General  Electric (the only survivor), Laclede Gas, National Lead, North American, Tennesee Coal and Iron, U.S. Leather preferred, and U.S. Rubber. The number of stocks was increased to 20 in 1916. The 30-stock average made its debut in 1928, and the number has remained constant ever since.

The most recent change was made effective 17 March 1997, when Hewlett-Packard, Johnson & Johnson, Travelers Group, and Wal-Mart joined the average, replacing Bethlehem Steel, Texaco, Westinghouse Electric and Woolworth.

Other Indexes

US Indexes:

AMEX Composite

A capitalization-weighted index of all stocks trading on the ASE.

NASDAQ 100

The 100 largest non-financial stocks on the NASDAQ exchange.

NASDAQ Composite

Midcap index made up of all the OTC stocks that trade on the NASDAQ Market System. 15% of the US market.

NYSE Composite

A capitalization-weighted index of all stocks trading on the NYSE.

Standard & Poor's 500

Made up of 400 industrial stocks, 20 transportation stocks, 40 utility, and 40 financial. Market value (#of common shares * price per share) weighted. Dividend returns not included in index. Represents about 70% of US stock market. Cap range 73 to 75,000 million.

Value Line Composite

It is a price-weighted index as opposed to a capitalization index. Many think this gives better tracking of investment results, since it is not over-weighted in IBM, for example, and most individuals are likewise not weighted by market cap in their portfolios (unless they buy index funds).

Non-US Indexes:

CAC-40 (France)

The CAC-Quarante, this is 40 stocks on the Paris Stock Exchange formed into an index. The futures contract on this index is probably the most heavily traded futures contract in the world.

DAX (Germany)

The German share index DAX tracks the 30 most heavily traded stocks (based on the past three years of data) on the Frankfurt exchange.

FTSE-100 (Great Britain)

Commonly known as 'footsie'. Consists of a weighted arithmetical index of 100 leading UK equities by market capitalization. Calculated on a minute-by-minute basis. The footsie basically represents the bulk of the UK market activity.

Nikkei (Japan)

"Nikkei" is an abbreviation of "nihon keizai" -- "nihon" is Japanese for "Japan", while "keizai" is "business, finance, economy" etc. Nikkei is also the name of Japan's version of the WSJ. The nikkei is sometimes called the "Japanese Dow," in that it is the most popular and commonly quoted Japanese market index.

BSE (Sensex)

 A capitalization weighted index, which is constructed by taking 30 blue chip shares into consideration. The selection of the shares is done one basis of various parameters. Some of them are market capitalization, Number of floating shares, Volume of transaction etc.

NSE (Nifty)

A capitalization weighted index, which has been constructed by taking 50 shares into consideration.