Strategic Capital Group Workshop #3: Split-Second Trading

AgendaReview of Multiples

How A Market Works

Earnings Reports and Surprises

Company Size and Industry

Flash Crash

Multiples Review

• We touched on three multiples in the previous workshops: NAME THEM!

• How are they calculated?

P/E P/BP/S

Buy, sell or hold?

P/E = 15.81P/B = 11.24P/S = 5.43

Drink IndustryP/E = 22.34P/B = 15.62P/S = 7.54

The drink business is typically medium/slow growing, but consistent. When we see stocks undervalued in this kind of industry, it is typically a great time to buy.

Buy, sell, or hold?

Aerospace Industry

P/E = 12.18P/B = 14.70P/S = 0.76

P/E = 8.75P/B = 9.24P/S = 0.65

The aerospace industry is slow growing and very stable, when we see stocks trading at higher multiples, they tend to be overvalued.

Buy, sell, or hold?

Tech Industry

P/E = 967.21xP/B = 16.12xP/S = 17.51x

P/E = 58.43xP/B = 8.34xP/S = 9.92x

The technology industry is very fast growing and unpredictable, rendering relative valuation next to useless. We can only assume a high multiple represents expectations of future success.

So…

• Low price multiples designate an undervalued company in industries that grow steadily, but not at huge rates

• High price multiples represent a market’s expectations of future success in high growth industries like technology.

• High price multiples in industries with low year-to-year growth are indicative of a company that is overvalued.

Sanity Check Episode I

• We just reviewed the three multiples taught in previous workshops

• In most cases, a low multiple in an industry that has steady, consistent growth is a buy signal. Where as a high multiple in an industry with rapid growth doesn’t tell us much.

Why Do Stock Prices Move?

• Supply and demand!• When there are more buyers of a stock than

sellers, the sellers realize they can charge a higher price and get away with it, increasing the stock price

• The same holds true for when there are more sellers than buyers, driving stock price down

What am I looking at?

A stock’s price line is actually a series of data

points that are plotted and connected. These data points each represent a

single transaction of someone buying a stock another person is selling.

Check for understanding:

• If a stock opened at $50.15 per share and there were no trades for the rest of the day, what is the stock price at the closing of the day?

• If a stock opened at $50.15 per share and the only 3 trades were $51.42, $49.15, and $50.23, in that order, what is the stock price at the end of the day?

What Moves Stock Prices?

3 big factors that affect a stock’s price:

FundamentalIs the company

qualitatively strong?

TechnicalDoes the company make

relatively strong revenues and profits?

Overall Market SentimentDoes the market think this

company will be strong/profitable in the

future?

How does news affect a stock’s price?

• Remember back to how stock prices move: Through the number of buyers and sellers of the stock (supply and demand)– News changes the number of people who want to

buy or sell a stock, thus changing the stock’s price

How does news affect a stock’s price?

• Negative news reduces a stock’s price because investors think the stock will be negatively affected by the news and more investors begin to sell the stock to either lock-in gains or protect against losses.

• Positive news increases a stock’s price because investors believe that the company will do better than previously thought and want to capture some of this potential.

Check for understanding:

• Target Company:

BREAKING NEWS: Airline industry under fire as FAA increases taxes on flying customers!

Buyers:500

Sellers:400

Stock Price

Sellers:700

Buyers:200

Earnings Reports

• Every quarter companies issue a report in which they show how much revenue, costs, profit they made, much like an annual report.

• Before these quarterly statements, equity analysts predict the earnings per share the company will announce.

• Investors “price in” these predictions leading into the earnings report.

“Pricing In”

• An assumption of the markets that says at any given time, a company’s stock price is a reflection of all available information and a combination of all future expectations of that company.

• In English, this means we expect a stock price to stay where it is unless something the market (all other investors) isn’t expecting suddenly occurs.

Back to Earnings Reports

• So let’s now apply the concept of pricing in to a stock leading into an earnings report…

UAL, currently trading at $20.16 per share with $1.17 EPS

Goldman Sach’s equity analysts come out and say they expect UAL to earn $1.50 EPS

Because this is new information to the market, investors scramble to adjust the market price of UAL to reflect the potential to earn $1.50 EPS, coming out to $29.72

Back to Earnings ReportsUAL, currently trading at $20.16 per share with $1.17 EPS

When the earnings report comes out, investors see that UAL earned only $1.22 EPS, a gain of $.05 from last report’s, but $.28 less than expected.

Will the stock price go up or down from $29.72?

DOWN! The market had already priced in that UAL was going to earn $1.50, so the fact that it still beat the $1.17 doesn’t matter to investors.

What if…

• What would happen if UAL earned $1.51 per share? Would the share price go up or down?

• What would happen if UAL earned $1.50 per share? Would share price go up or down?

Sanity Check Episode II: Attack of the Clones

• We discussed what moves a stock price: supply and demand of the actual stock.

• We looked at how a stock price is calculated: by looking the last completed trade.

• We talked about how the market “prices in” all available information into a stock’s price

• We looked at how earnings reports and news can change a stock’s price by forcing the market to price in new information

Introduction to Market Cap

• Market cap is a quick way to “size” a company• Calculated by multiplying share price and

shares outstanding• Generally, anything with a large market cap is

considered a safer investment because a large company is less likely to fail than a small one

Market Cap, Continued

Mega-Cap

Large-Cap

Mid-Cap

Small-Cap

Micro-Cap

Nano-Cap

Anything over $200B (General Electric, IBM)

$10B-$200B (McDonalds, Bank of America)

$2B-$10B (United Airlines)

$250M-$2B (First Solar)

$250M or less (Tiny biomedical tech companies)

Remember the T-shirt company in my dad’s garage?

What’s a big problem with using market cap as a size metric?

• Doesn’t take into account debt! What if I have a company that makes billions of dollars every year but is funded entirely by debt?

Different Industries• Financial Services- Medium Growth, depends on consumer confidence• Global Industrials- Low Growth, Stable (Boeing, DuPont)• Technology/Telecommunications- High Growth, High Margin, Risky,

constantly evolving (Apple, AT&T)• Health Care- Lots of M&A activity, medium growth, dependent on

patent timelines (Pfizer, Eli Lilly)• Consumer Goods (Discretionary and Staples)-Stable, low growth,

dependent on “blockbuster goods” (Kellogg, P&G)• Energy- Medium growth, moves with oil prices, energy demand is used

as an indicator of the overall market• Materials- Strong indicator of the overall market, demand for materials

shows growth

Financial Services

• Examples: Goldman Sachs, Bank of America, JP Morgan Chase, Wells Fargo, Citigroup

• Typically have mid to low growth year to year• Dependent on interest rates to make money (higher

interest rates mean they make more money)• Very dependent on the overall consumer confidence

in the economy

Global Industrials

• Produce goods related to manufacturing, aerospace and defense, and construction

• Examples: Caterpillar, Boeing, 3M • Largely driven by supply and demand for building

construction, which is also a measure of growth in the economy (more buildings being built shows healthy spending which typically occurs in times of prosperity)

Technology and Telecommunications

• Covers both sellers to consumers and businesses of technology products and services

• Depending on the technology, may be cut in economic downturn

• Historically high growth for technology products and medium to low growth for telecommunications.

• Examples: AT&T, Samsung, Apple

Health Care

• Design, manufacture, and sell drugs to hospitals, governments, and pharmacies

• Reliant upon patent timelines (once a patent expires, the company has to compete with other generic drugs, driving down profit)

• Very active in Mergers and Acquisitions to get new patents, as well as in lawsuits disputing patents.

• Examples: Pfizer, Eli Lilly, Abbott Labs

Consumer Goods

• Split into discretionary (which are higher growth, less stable in economic downturn) and staples (which are more stable with very low growth).

• These companies follow the overall market fairly closely.

• Examples: McDonalds, Kellogg, Coca-Cola

Energy

• Companies that create and/or supply energy• Follow oil prices closely, and are good measures of

global demand for energy (thus are good indicators of the overall economy)

• Examples: Noble Energy, Exxon Mobil, Conoco

Materials

• Companies that discover, develop, and process raw materials. Covers the mining and refining process, as well as chemicals.

• These companies are good indicators of global growth because demand for raw materials reflects spending on construction.

• Examples: DuPont, Rio Tinto, BHP Billiton

The Flash Crash

The Flash Crash

• Why is the flash crash important? • High frequency trading and trading algorithms can throw

the buyer/seller proportion of the markets out of balance, causing massive dips and jumps in stock prices.

• It’s important to note that the same effect on the market can be achieved by a human. By buying a significant stake in a company (1%-5% or more) all at once, you can skyrocket the company’s price. Make sure you buy in increments if you plan on making a large position!

Sanity Check Episode III: It’s Over

• You survived 7 of the industry sectors, there’s a few more, but nobody likes to learn this stuff.

• We talked about what market cap is and how it is used to describe the size of a company

• We had a 30 second history lesson over the Flash Crash this past May.

Announcements

• SimComp is next Thursday in the EDS lab instead of the SCG Workshop- MUCH MORE FUN!

• If you didn’t like today’s workshop, then next time’s will probably be more investing and less trading/theory/markets.

• If you did like today’s workshop, then go to SIMCOMP!• PAY DUES IF YOU HAVEN’T ALREADY!• Good luck to anyone competing in UIA’s Stock Pitch

Competition!