Technical Analysis of the Financial Markets_5

44 The Stock Market of this, many professionals believe that stockholders fall into two groups in their decisionson where toinvest. One groupfavorsinvestment returns inthe form of periodic dividend payments. Because these payments occur in a generally predictable fashion, it is like receiving income from the firm. Thus, stocks that favor dividends to reward shareholders generally are referred to as income stocks. Retirees counting on periodic cash flows from dividends represent investors who prefer income stocks. Utility companies, such as your local electric company, generally are income stocks. Also, preferred stock generally is considered a good income stock since its dividends generally are high and must be paid out prior to dividends on common stock. Some investors do not need the predictable cash flows and are quite com-fortable in letting the firm retain the profits to enhance future returns. In-deed, some investors prefer such an investment vehicle since this minimizes their tax obligations. As long as the investor retains their shares, their unre-alized gains come with no tax obligation, unlike dividends that require the stockholder to claim the return on their annual income tax. Stocks that do not pay dividends but reward their shareholders with gain in the form of capital appreciation generally are referred to as capital appreciation or growth stocks. Berkshire Hathaway is a classic example of a capital appreciation stock: it pays no dividend and the price of each share has (and is expected to) increased over time. Of course, some firms find it advantageous to change how they com-pensateinvestors.Microsoftisagoodexample.Foryears,Microsoft,asapublic corporation, paid out no dividends at all, like Berkshire Hathaway. The firm found it could put its profits to good use internally, and their investors showed no evidence that dividends were important to them. However, with recent tax law changes that resulted in dividends being taxed only at a 15 percent rate, Microsoft felt it was better to return monies to the shareholders in the form of dividends. Shareholders who thought they owned a capital appreciation/growth stock found themselves with sizeable dividends (and tax bills) coming to them. But, given the relatively low tax rate that they had to payonthedividends,shareholdersprobablywerenottooupset.Somefinancial observers see this change as Microsoft sending a signal to financial markets that they do not see the good internal investment opportunities that they once predicted. STOCK RETURNS It is important to remember that stockholders can receive economic gain in one of two forms. Too frequently, investors focus on the predictable and timely dividend payments to the exclusion of considering capital Stocks in Today’s Economy 45 appreciation. However, the example of Berkshire Hathaway, which has not paid any dividends at all but has rewarded investors with quite sizeable capital appreciation, is a good one to bear in mind. Investors who did not need the steady cash flow from dividends and kept their money invested in Berkshire Hathaway have been rewarded over time with sizeable stock returns. The best measure of what stockholders gain from their investment is called total return or stock return. The stock return is the sum of all gains from the investment (dividend plus capital appreciation) divided by the amount orig-inally invested. For example, suppose someone bought 100 shares of stock in HancockBankfor$37.00ashareoneyearago.Supposefurtherthattodaythe shares are trading at $39.53. Now assume this investor received a total of $40.45 in dividend payments last year. Over the last year, the total is $253 in capital gain ($3,953.00 minus $3,700.00, and $40.45 from dividends paid out. Dividing the total dollar gain of $293.45 by the original investment of $3,700givesareturnof0.0793,or7.93%.Calculatedonanannualbasisasin this example, this return can be compared to interest rates quoted on bank deposits (such as CDs) and bonds to see how wise the stock purchase was. RISK-RETURN TRADE-OFF Common stock promises shareholders nothing explicitly: common stock-holders are residual claimants and only get what is left after claims by bondholders and preferred stockholders are satisfied. This is very different than a deposit at a bank, which promises investors a fixed return on their monies, or a bond that promises fixed periodic payments. Since common stock does not promiseshareholders any explicit compensation, it is viewed as a relatively risky investment. The risk is that the investor is not certain what they will get back for their investment. If the company does well and is profitable,the commonstockholder willbe compensated.On theother hand, if profits are small or if the firm loses money, the shareholder can lose out on their investment. When profits are small, the amount paid out in dividends and/or retained in earnings will be small. Regardless, the investor is likely to be disappointed with their investment return. Of course, there is very little downside protection and the investor may lose everything. This generally occurs when a business is forced into bankruptcy and finds that the value of their outstanding liabilities exceeds the value of what the firm owns. Com-mon stockholders in a firm that fails receive nothing on their investment. Given this possibility, why would anyone risk losing everything they have invested?Wouldnotitbebettertoinvestinsomethinglikeabankdepositora bond where the investor knows that they will get something back on their investment? With hindsight someone who loses all their investment of course 46 The Stock Market would prefer something that gave them a return, no matter how small. But hindsight does not work for the investor facing the decision today of how best to use their money. The reason that investors choose to own stock, even if it is risky as an investment, is that they expect to be compensated for bearing the risk. Indeed, history and experience normally show that investors generally are compensatedfor bearing theriskof loss. Investors in commonstock in the United States have realized returns that exceed those on most alternative investments, especially depositing money in a bank or buying bonds either issued by the government or corporations. In other words, investors expect to be compensated with higher returns for bearing the risk of investing in common stock. Note that this comparison uses a large sample of common stocks as a basis of comparison. The large sample tells us that if an investor owns a diversified portfolio that is, a combination of many companies’ stock), they would have receivedbettergainsthanfromthealternativeinvestments.Thisdoesnotmean, however, that all stock investors have gained more than they could have from alternatives.Indeed,recenthistoryisfullofcorporationsthathavefailed,mean-ingthatinvestorsloseeverythinginvestedinthatcompany.Forexample,Enron and WorldCom are instances of investors losing all their invested funds due to corporate failure. PORTFOLIOS AND RISK A basic principle in finance is that investors can reduce their overall fi-nancial risk by investing in a number of different corporations instead of putting all their money in one business. By doing so, the investor attempts to offset losses in one or two companies’ stocks with gains in the other stocks owned. Diversifying one’s investment portfolio puts the ‘‘law of large num-bers’’ (basically, it is easier to predict the average of a large group than to predict one individual occurrence) to work. Investors do not have to worry about one isolated case of loss (owning Enron), and can have greater confi-dence in predicting their stock return. Investingafixedamountofmoneyinjustonestockisriskierthaninvesting the same amount in ten to twenty different stocks. Since it really is not that much more expensive to invest in a number of stocks versus just one (one can invest in a stock index fund, for example), basic finance models presume that investors generally purchase a broad portfolio of common stocks. This means investing in just one stock as opposed to ten increases the risk of loss. But,sincethisriskcanbeavoidedfairlycheaply,thecompensationforbearing this risk is reduced. This is one of the rare instances in finance that risk does not appear to be rewarded. An investment in a diversified portfolio of Stocks in Today’s Economy 47 Stocks are traded in the pharmaceutical industry. Photo courtesy of Corbis. common stock is still more risky than an investment in bonds, but investors can expect to earn a higher return. There is no easy way to avoid this risk, so investors are compensated for bearing it. RISK OVER TIME Investors not only face risk that differs from one stock to another (some stocks are riskier than others), but investors also face risk that changes over time. In certain time periods called bull markets, it is generally found that most stocks increase in value and that stock returns on most stocks yield a higher return than their historical averages. Investors who own a diversified portfolio of stocks are generally happy investors in bull markets. On the other hand, sometimes it appears that most stock prices decline in value and stock returns are abnormally low and even negative. In such markets, referred to as bear markets, investors can lose money even with a well-diversified portfolio. After the fact, it is fairly easy to identify whether a period coincides with a bull or a bear market by comparing returns with historical norms. The Great Depression that followed the Crash of 1929 encompassed a bear market as most investors lost substantial amounts of their investments in the stock market. It often, though mistakenly, is believed that the 1929 stock market 48 The Stock Market crash caused the Great Depression. Although a contributing factor, the crash was not the sole cause of the Great Depression. More recently, the ‘‘bubble’’ correction that began in 2000 represents another bear market in which in-vestors lost substantial paper wealth from their investments in stocks. The mid-1980s and most of the 1990s, on the other hand, are considered bull markets. Investments in diversified portfolios of U.S. stock during these times resulted in not only positive stock returns, but returns that were far higher than historical averages. One of the interesting observations about investing in stocks in the United States is that not only diversification helps smooth out returns and lowers risk, but time also seems to do a similar thing. This is one of the main themes of Jeremy Siegel’s 2002 book Stocks for the Long Run. After examining 200 years of financial market return data for the United States, he points out that there has never been a thirty-year period in the United States in which stocks have yielded lower returns than bonds.1 This statement includes the Great Depression as a part of the sample, in which investors in stocks lost fortunes. History tells us that if these stockholders could have stuck with a diversified stock portfolio through the substantial losses in the early 1930s, over time The coffee industry is a traded stock. 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