The Bare Necessities: Chapter Two

Chapter Two: Equities and Value Investing Equities, also known as shares, are the most mainstream investment vehicle in today's current market. Financial websites, televisions, and newspapers put a lot of focus on the stock market's ups and downs. The reason why it is so popular amongst people is because of its liquidity, vast information availability, and volatility. The vast amount of money that can be made trading the ups and downs in a typical day is huge. It is possible to double your money in half a year with the average daily movements. Of course, this is not suitable for most people. So, in this chapter, I will try to focus on a method of smart investing called "value investing." When it comes to investing, buying companies of any well-run company that will survive any economic turmoil or crisis is beneficial. Sometimes selecting companies can be a hassle and time consuming, so if this is not for you, I suggest sticking to big companies like McDonald's, Wal-Mart, and Microsoft, but if you have time once a week, or even once a month, consider value investing. Value investing consists of buying stocks that appear to be under-priced. Most people who value invest tend to buy blue-chip companies [1] because they have had a history for comparison. As well, profits and cash-flow are much more stable, limiting volatility and surprises. Another possible reason is the ability to write options, which can add 25 per cent or more a year, through covered calls. I will be going through this in Chapter Five too. Although there are many ways of value investing, I will discuss two common methods, which are also the easiest to research: Dividend Yields and Price-to-Earnings Ratio. Dividend Yields Dividends can add a little bit of income to your account, usually around 3 to 4 per cent annually. Dividends are paid in cash to owners (stock holders). Think of it as a small portion of the company's profits being paid back to its owners. It is like owning your own business. A benefit of dividends is also something called the dividend re-investment program (DRIP). DRIPs allow share holders to take their dividends and purchase more shares of that company, with no fees, at the current market price. This strategy is great for long-term holders because these DRIP shares also pay a dividend too! However, one drawback is that the dividends are still subject to tax. Many big firm traders use the dividend yield to buy and sell. If the yield becomes lower than normal (that is, $1/$50 = 2%), then it could be time to sell. The stock's value has increased too much compared to its dividend. If the dividend yield is high, ($1/$20 = 5%), then it could be time to buy. Stocks that trade in ranges are great for this technique, and prove profitable. But what is considered a respectable yield for a blue-chip company? Below is a table of the Dow Jones 30, as of Feb 16, 2010. (For some reason, blogger keeps putting this huge gap. If you know how to fix, let me know. Thanks!)

NAME	SYMBOL	DIV	STOCK	YIELD	P/E
Alcoa	AA:NYSE	$0.12	$13.74	0.87%	N/A
3M Company	MMM:NYSE	$2.08	$80.47	2.61%	17.85
American Express	AXP:NYSE	$0.72	$39.62	1.82%	25.76
AT&T	T:NYSE	$1.68	$25.32	6.64%	11.96
Bank of America	BAC:NYSE	$0.04	$15.16	0.26%	N/A
Boeing	BA:NYSE	$1.68	$61.26	2.74%	33.54
Caterpillar	CAT:NYSE	$1.68	$57.12	2.94%	40.52
Chevron	CVX:NYSE	$2.72	$72.99	3.73%	13.93
Cisco Systems	CSCO:NASD	$0.00	$24.00	0.00%	23.12
DuPont	DD:NYSE	$1.64	$32.74	5.01%	17.03
Exxon Mobil	XOM:NYSE	$1.68	$66.28	2.53%	16.64
General Electric	GE:NYSE	$0.40	$16.04	2.49%	15.58
Hewlett-Packard	HPQ:NYSE	$0.32	$49.44	0.65%	15.76
Intel	INTC:NASD	$0.63	$20.72	3.10%	26.77
IBM	IBM:NYSE	$2.20	$125.23	1.76%	12.51
Johnson & Johnson	JNJ:NYSE	$1.96	$63.61	3.08%	14.47
JP Morgan & Chase	JPM:NYSE	$0.20	$40.07	0.50%	17.94
Kraft Foods	KFT:NYSE	$1.26	$28.97	4.00%	17.94
McDonald's	MCD:NYSE	$2.20	$64.01	3.44%	15.55
Merk	MRK:NYSE	$1.52	$37.66	4.04%	9.91
Microsoft	MSFT:NASD	$0.52	$28.35	1.83%	15.60
Pfizer	PFE:NYSE	$0.72	$17.72	4.06%	13.07
Coca-Cola	KO:NYSE	$1.64	$54.82	2.99%	18.71
Home Depot	HD:NYSE	$0.88	$29.44	3.06%	21.49
Proctor & Gamble	PG:NYSE	$1.76	$62.83	2.80%	17.39
Travelers Companies	TRV:NYSE	$1.32	$51.61	2.56%	8.07
United Technologies	UTX:NYSE	$1.72	$66.33	2.56%	16.09
Verizon	VZ:NYSE	$1.88	$29.18	6.51%	22.71
Wal-Mart	WMT:NYSE	$1.08	$53.56	2.04%	15.48
Walt Disney	DIS:NYSE	$1.40	$30.47	1.15%	17.36

As we can see, most of the top American companies pay dividends between 2.5 to 4 per cent. This is typical around the world as well. Price-to-Earnings Price-to-Earnings Ratio, or P/E, is a calculation of the companies stock price divided by their annual earnings per share(EPS). Historically, P/E ratios are considered fair value between 12 and 15. A low P/E suggests the company is under valued, where as a high P/E may signal a sell. One problem with using P/E is that it does not factor in growth, and many use the PEG ratio (P/E divided by growth in percent) to fully calculate. For example, if a company announces they expect to double their profits, then an extremely high P/E of 80 may be fair value. A company that can double its profits should, in theory, double its stock as well. That is where it can get sticky, and why I suggested large companies who have stable profits. Now that we have gone through two simple strategies, I must point out the common errors new investors fall prey to. Comparing apples to oranges is a saying we've all heard before, and this runs true with investing. When comparing two companies, you should select companies in the same sector or industry. Chevron and Merck, yes, they are both huge companies, worth over $100 billion each, but they are in different sectors. It is more appropriate to compare Chevron with Exxon and Merck with Pfizer. Varying factors in each industry can lead to substantially higher yields, such as risk and potential sector growth, as proven in the table above. Note that there have been many instances where using high dividend yields and low P/E ratios to invest can backfire. A high dividend yield, especially well above the norm, can be a sign that the company is going to decrease the dividend. This occurred in 2008 when banks were at near all-time dividend yield highs. Banks then slashed their dividend because of cash problems and stocks continued to fall. Low P/E ratios can be a sign the stock will fall, if people do not expect the company's current financial situation to prove positive. A prediction in a bad earnings season could eventually justify the low stock price. Again, investing in blue-chips could offset any unexpected surprises discussed. [1] Market capitalization is used to determine the size of a company. This is calculated by taking all outstanding shares and multiplying it with the value of the stock. Most companies mentioned above are worth at least $50 billion, well above the $5 billion classification.