The Stock Market

LECTURER NAMETITLE

COMPANY

smartwomansecurities

© 2007 Smart Woman Securities. Materials are for SWS members’ use

only. All rights reserved.

October 10, 2007

the stock market

• Last week we learned about individual stocks and what they were. This week, we’ll talk about the market for stocks.

• The stock market is exactly what it sounds like… the aggregate market for stocks.– Like anything else, stocks are bought and sold,

and these market forces of supply and demand determine the price.

– In this sense, it is not very different than a market for groceries, except that there are thousands of different products that can be sold in the stock market.oThe estimated size of the stock market is $51

trillion.

market participants

key market participants– Investors

o Individualso Institutions

– Issuers– Exchanges– Analysts/I-banks– The Fed– SEC– Other

Source: SWS Nov. 15, 2006 presentation by John Copeland, Lehman Brothers

stock exchanges

• Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price.

• Some exchanges are physical locations where transactions are carried out on a trading floor. – You've probably seen pictures of a trading floor, in which traders

are wildly throwing their arms up, waving, yelling, and signaling to each other.

– The other type of exchange is virtual, composed of a network of computers where trades are made electronically.

Source: Investopedia, Wikipedia

stock exchanges

• Officially, a stock exchange is an organization that provides a marketplace for either physical or virtual trading shares, bonds and warrants and other financial products where investors (represented by stock brokers) may buy and sell shares of a wide range of companies. – Really, it is nothing more than a super-

sophisticated farmers' market linking buyers and sellers.

– A company will usually list its shares by meeting and maintaining the listing requirements of a particular stock exchange.

stock market vs. stock exchange

• Stock market vs. stock exchange:– Think of the exchange as the grocery store where

you can actually the buy goods… the “market” is the overarching structure, whereas the “exchange” is where you go to actually make the transaction.

– The stock market in the United States includes the trading of all securities listed on the NYSE, the NASDAQ, the AMEX, and other stock exchanges.

• Major US stock exchanges:– New York Stock

Exchange (NYSE)– NASDAQ– American Stock

Exchange (AMEX)

• Other stock exchanges:– London Stock Exchange– Euronext (part of NYSE)

• There are many other big exchanges in the US and around the world; Chicago Mercantile Exchange (CME) in the US primarily deals with stock derivatives. Chicago Board of Trade (CBOT) deals with commodities and futures. Check out this link from Investopedia: http://www.investopedia.com/articles/basics/04/092404.asp

life of a trade

making a trade

* You can also place additional specifications to your broker; different types of orders will be discussed in Week 3.

• You want to buy two stocks (say, SBUX and GE)– You call up a broker, and tell him to buy

fifty shares of SBUX and GE at market price*. OR, you go online, and put in an order at an online brokerage firm to buy SBUX and GE.

– Trades happen when the best bid meets the lowest offer to sell.o SBUX is traded on NASDAQ, which is completely

electronic. The broker accesses the electronic exchange network and the system finds a seller, thereby matching the two up and completing the deal.

o GE is traded on the NYSE. The broker’s order department sends the order to a floor broker on the stock exchange. The floor broker finds a floor trader who is willing to sell fifty shares of GE. The two agree on a price, and complete the deal.

trading on the NYSE

• The NYSE is unique because it still operates like a live auction.• Must be a “member” of the NYSE to have the right to

trade on the exchange. Most of these “seats” (membership) are owned by brokerage houses and investment firms.

• Stocks are traded by highly skilled market professional who have seats on the NYSE– Floor brokers

o Receive electronic orders on the Trading Floor– Specialists

o Contact point between brokers with buy and sell orders in the auction

o Each NYSE stock is allocated to a specialist who only trades that stock at a designated trading post

o Oversee orderly trading of specific stocks for fairness and efficiency purposes

stock market indices

measuring the market

• So, we know that the stock market is just a giant marketplace of securities

• But, how do we determine how big the market is? Whether it is going up or down? What the market return is?– Size of the stock market = market cap of

all stocks listed on the various exchanges (all money invested in the market)

– Whether it is going up or down: more buyers than sellers, prices rise, market goes up.

– Market return equals the change in the size of the stock market over a period of time.

stock market indices

• Measuring the market is difficult, especially as there are thousands of stocks listed on various exchanges throughout the world.– More importantly, sometimes we want to see how

the general economy is doing, or how parts of the stock market are doing.

• Stock market indices track a group of stocks, and can give us a clearer picture of what is going on in the market.

• They can serve as a benchmark for your investments…– A stock market index is a collection of stocks whose

value is a benchmark for the overall movement of a particular type of stock. The major indices are used to proxy for what is happening in the economy and the stock market in general.

major stock market indices

• Dow Jones Industrial Average (DJIA)– The Dow is comprised of 30 blue chip (largest and most

influential) stocks from the NYSE and NASDAQ, as selected by the editors of The Wall Street Journal.

– The Dow serves as a benchmark for the entire market; however, there are several weaknesses in interpreting movements in the Dow, including the fact that the Dow only consists of the top 30 companies.

o The DJIA includes companies like General Electric, Disney, and Microsoft.

• Standard & Poor’s 500 (S&P 500)– The S&P 500 is comprised of the 500 most widely held

American corporations, chosen with respect to market size, liquidity, and industry sector, by the S&P Index committee.

o Many consider the S&P 500 as better than the Dow in serving as a benchmark for the whole US stock market.

major stock market indices (cont.)

• Wilshire 5000 (TMWX)– The Wilshire 5000 Index contains over 6,500 stocks

that trade in the US. This is known as the “total market index” because it includes all stocks traded on the NYSE, and most on Nasdaq and Amex. It covers most of the public companies traded in the US.

o The Wilshire, however, only contains companies headquartered in the US, leaving out several strong foreign companies which trade in the US.

• Russell 2000– The Russell 2000 measures the performance of small-

cap stocks that are usually not included in the big indices. This allows investors to measure performance of smaller companies that usually have higher growth potential. The average market cap of stocks included in the Russell 2000 is approximately $530 million (in comparison, Microsoft had a market cap of $280 billion as of July 2007).

o Small caps are often very streaky.

• There are thousands of other indices that are followed by investors. – Each index includes its own specifications that may

be helpful in different situations. – In reality, anyone can create a stock index; some

popular indices in recent years include Fortune Magazine’s “Fortune 500”

– Many of these alternative indices serve mainly as a benchmark in specific scenarios, whereas the major indices (S&P 500, Dow, Wilshire) are seen as benchmarks for the market as a whole.

• Other indices around the world:– FTSE 100 (United Kingdom)– Hang Seng (Hong Kong)– Nikkei (Japan)

other stock indices

investors

investing in stocks• From our last seminar, we know that stocks

are just one aspect of investing• We also know that different types of stock

offer different risk…and therefore different return– Size of stocks matter: large-cap, or big

companies, are usually more stable; small-cap are usually more volatile but may offer greater return

– Growth vs. value vs. income… and deciding where companies fit within these distinctions is also important and can be highly debated

– Industry sector also makes a difference: Tech stocks are usually more volatile but are potentially more lucrative; some industries, like utilities, is relatively stable

other considerations

• Furthermore, other considerations are also important, besides risk and return:– One consideration is your time frame of the

investment (this relates directly to taxes as well, which we will talk about later). The other is, how much money do you have already in the bank? Can you afford to put your money in the market, or will you need it for other reasons?

o Time frame: How long you wish to hold your stockso Money: How much you wish to invest may affect what you

can buy; do you need your stocks to pay dividends?, etc.o Risk: How risky are such investments… is there a high

probability of failure? Are you OK with that?o Return: What kind of return will you expect from your

investments?

risk profile of investors• Just as there are different investments,

there are different types of investors. Good stock investments vary from person to person, depending on your risk profile– Are you comfortable making different

investments?– Are you able to tolerate market fluctuations?– What is the lowest return that you are willing to

accept?• And even before investing in the stock

market, you should also ask:– Do I need this money sometime in the near

future (less than one year)? If so, you may think about putting off investing until you have the capital to do so, when you are more comfortable.

profiles of investors

Source: Fidelity.com

profiles of investors

• Again, we see that stocks are just one part of the investing picture.

• However, within the decision to buy stocks, we can choose the right kind of investments for our portfolio.– Growth stocks– Income– Blue-chip– Value

If we are more conservative we may want to buy large-cap stocks and hold on to

them for a longer time frame; if we want to “get rich quick”, we might want

to buy more growth stocks…but understand that there may be a high

probability of failure... And that the plan might unravel into “get poor quick”!

college students

• Investing as college students– Again, it depends on your priorities; some

people will not (and should not, based on their risk profile) want to invest in the stock market

• Typical college students:– Little disposable income, but high consumption– More aggressive as investors; perhaps looking

more toward growth– 1-3 year time frame

• Potential investments

risks of investing

• Market risk– The entire market could go down, perhaps do to

a failing economy, poor performance by the industry sector, or an increasingly obsolete market.

• Inflation risk– As inflation rises, it erodes the value of your

income. Bonds are actually more susceptible to inflation risk, especially because they are linked to the interest rate, but stocks are as well.

• Company risk– The company could perform poorly and the

market value of the stock could go down in value.

risks of investing

• Besides these other aspects of risk, you must also deal with investor sentiment, and the inevitable risk of something unexpected happening.– In a global world, there is so much that can

affect the US stock market that is out of our control.

– We can never know what will happen, but being aware of these risks, diversifying assets, and understanding our investment positions are all important.

________________Source: Strategic Insight.Indices are unmanaged, and the figures for the index shown include reinvestment of all dividends and capital gain distributions and do not reflect any fees or expenses.Investors cannot invest directly in an index. We strongly recommend that these factors be considered before an investment decision is made. The data presented herein represents securities industry market data as of the date specified. It does not represent Neuberger Berman performance nor does it reflect the fees and expenses associated with managing a portfolio. Past performance is not indicative of future results.

Mutual Fund Flows – Tech / Telecom

– At the height of the technology market bubble, investors flocked to tech funds at precisely the wrong moment

-20

0

20

40

60

Jun-99 Dec-99 Jun-00 Dec-00

($ billions)

March 13, 2000: NASDAQ peaks at 5049

don’t follow the herd

examples

S&P 500 – 10 years

Source: Bigcharts.com

Nasdaq – 10 years

Source: Bigcharts.com

S&P 500 – 3 years

Source: Bigcharts.com

DJIA – 5 Years

Source: Bigcharts.com

DJIA – from the 1970s

Source: Bigcharts.com

Merck – 3 Years

Source: Bigcharts.com

Other stocks

case study: Peter Lynch

background

• Went to BC and then Wharton for his MBA• Hired as intern with Fidelity in 1966 because he was

caddying for Fidelity’s president• Started full-time in 1969 and covered textiles, metals,

mining, and chemicals industries• In 1977, Lynch was named head of the obscure Magellan

Fund which had $18 million in assets. • By the time Lynch resigned as a fund manager in 1990, the

fund had grown to more than $14 billion in assets with more than 1,000 individual stock positions.

• Lynch reportedly beat the S&P 500 Index benchmark in 11 of those 13 years, achieving an annual average return of 29% – Lynch's achieved dollar successes in a range of stocks

including (by order of profit achieved - source is Beating the Street): Fannie Mae, Ford, Philip Morris, MCI, Volvo, General Electric, General Public Utilities, Student Loan Marketing, Kemper, and Loews.

Source: Wikipedia.com

his investment tenets• Know what you own. • It's futile to predict the economy and

interest rates. • You have plenty of time to identify and

recognize exceptional companies. • Avoid long shots. • Good management is very important -

buy good businesses. • Be flexible and humble, and learn from

mistakes. • Before you make a purchase, you

should be able to explain why you're buying. "Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it."

"If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them."

Lynch chose one company, Hanes,

in the 1970s because his wife bought and loved

its new L’Eggs pantyhose line —

the first department-store-quality pantyhose sold to American

women via supermarkets.

“the perfect stock”• From “One Up on Wall Street” (1989)

– It sounds dull,--or even better, ridiculous– It does something dull– It does something disagreeable– It’s a spinoff– The institutions don’t own it, and the analysts don’t follow it– The rumors abound: it’s involved with toxic waste and/or the

Mafia– There’s something depressing about it– It’s in a no-growth industry– It’s got a niche– It’s got a product people need to keep on buying– It’s a user of technology– The insiders are buyers– The company is buying back shares

• However, one must take into consideration the time Lynch was writing; now, information is more open, the “dull” may no longer by “dull”, and even if something has all these characteristics, it must be a good company as well. – From Weeks 4 on, we will discuss what makes a good company a good

investment, because sometimes they are not the same thing!

case study: Warren Buffett

background

• Attended Wharton, transferred and graduated from University of Nebraska in 1950; earned a MS in Business from Columbia

• After reading “he Intelligent Investor” by Benjamin Graham, decided he wanted to study under Graham

• Started a family investment partnership at age 25 with $100,000. By the end of the year, was managing $300,000.– Over the course of the next five years, the Buffett partnerships

racked up an impressive 251.0% profit, while the Dow was up only 74.3%.

– Ten years after its founding, the Buffett Partnership assets were up more than 1,156% compared to the Dow's 122.9%. Acting as lord over assets that had ballooned to $44 million dollars,

• Today he is the second richest man alive, after Bill Gates, with $52 billion. He has made plans to give away his fortune to the Bill and Melinda Gates Foundation.

berkshire hathaway

• Acquired Berkshire Hathaway, a textile company in Massachusetts, in 1965

• Turned it around and made it a holding company for other investments

• You could buy a share of Berkshire Hathaway for $8 in the 1960s.• From 1965 to 1975, the company's book value rose from $20 per

share to around $95 – By the late '70s, his reputation had grown to the point that the rumor

Warren Buffett was buying a stock was enough to shoot its price up 10%. Berkshire Hathaway's stock was trading at more than $290 a share, and Buffett's personal wealth was almost $140 million. The irony was that Warren never sold a single share of his company, meaning his entire available cash was the $50,000 salary he received.

• Buffett bought into Coca-Cola in the late 1980s. Within a few months, Berkshire owned 7% of the company, or $1.02 billion dollars worth of the stock. – Within three years, Buffett's Coca-Cola stock would be worth more

than the entire value of Berkshire when he made the investment. • Price of Berkshire Hathaway shares today: $110,875 (as of July

2007)

berkshire hathaway (BRK-A)

investment philosophy• Buffett is a proponent of value investing; finding undervalued

companies and investing in them. • Warren Buffett's investing style of discipline, patience and value

has consistently outperformed the market for decades. – John Train, author of "The Money Masters"(1980):: "The essence of Warren's

thinking is that the business world is divided into a tiny number of wonderful businesses – well worth investing in at a price – and a large number of bad or mediocre businesses that are not attractive as long-term investments. Most of the time, most businesses are not worth what they are selling for, but on rare occasions the wonderful businesses are almost given away. When that happens, buy boldly, paying no attention to current gloomy economic and stock market forecasts."

• Buffett’s criteria for “wonderful businesses” include, among others, the following:– They have a good return on capital without a lot of debt. – They are understandable. – They see their profits in cash flow. – They have strong franchises and, therefore, freedom to price. – They don't take a genius to run. – Their earnings are predictable. – The management is owner-oriented.

Source: Wikipedia.com, investopedia.com

“If, when making a stock

investment, you're not

considering holding it at

least ten years, don't waste

more than ten minutes

considering it."

consensus

• Buy into companies that are simple and easy to understand

• Buy companies that are undervalued or undiscovered (easier said than done!)

• Buy companies that anyone can run• Don’t go with the market; sometimes

the best opportunities are when you go against it

• RESEARCH is necessary in making smart stock picks!!!

recommended reading

• One up on Wall Street by Peter Lynch• Buffett: The Making of an American

Capitalist by Roger Lowenstein• Other:

– The Intelligent Investor by Benjamin Graham

– Beating the Street by Peter Lynch– ANY OTHER BOOKS?

Week 3• Why do stock prices move?• Opening your personal investment account• Comparing brokers, fees, etc.• Understanding taxes and other practical considerations

Week 4-10• Researching stocks: Picking the stocks to invest in

– Financial statement analysis– Basic valuation– Making recommendations

“Investing without research is like playing stud poker and never looking at the cards."

- Peter Lynch

Remember: to sign up for the rest of the weeks, you must go online to ____. You will be notified as to your status as of ____.

You must sign up online to become an SWS Member. SWS Members can then apply for positions as Analysts and Associates on Research Teams, make investment recommendations, and help manage a real investment portfolio.

Coming up in our next seminars…

Q&A