Stocks

Valuation

The par value of a preferred stock is not related to market value, except that it is often used to define the dividend. Since the cash flow of dividends to preferred stockholders is specified, valuation of preferred stock is much simpler than for common stock. The valuation techniques are actually similar to those used for bonds, drawing heavily on the present value concept. The required rate of return on preferred stock is closely correlated with interest rates, but is above that of bonds because the bond payments are contractual obligations. As a result, preferred stock prices fluctuate with interest rates. The introduction of adjustable-rate preferred stock is an attempt to reduce this price sensitivity to interest rates.

FOREIGN STOCK

Purchases of foreign stock have greatly increased in recent years. One motivation behind this increase is that national economies are not perfectly correlated, so that greater diversification is possible than with a purely domestic portfolio. Another reason is that a number of foreign economies are growing, or are expected to grow, rapidly. Additionally, a number of developing countries have consciously promoted the development of secondary markets as an aid to economic development. Finally, developments in communications and an increasing familiarity with international affairs and opportunities has reduced the hesitance of investors to venture into what once was unfamiliar territory.

Foreign investment is not without problems. International communication is still more expensive and sometimes slower than domestic communication. Social and business customs often vary greatly between countries. Trading practices on some foreign exchanges are different than in the United States. Accounting differs not only in procedures, but often in degree of information disclosed. Although double taxation is generally avoided by international treaties, procedures are cumbersome. Political instability can be a consideration, particularly in developing countries. Finally, the investor faces exchange rate risk. A handsome gain in a foreign currency can be diminished, or even turned into a loss, by shifting exchange rates. These difficulties are felt less by professional managers of large institutions, and much of the foreign investment is through this channel.

An alternative vehicle for foreign investing is the American Depositary Receipt (ADR). This is simply a certificate of ownership of foreign stock that is deposited with a U.S. trustee. The depository institution also exchanges and distributes any dividends, and provides other administrative chores. ADRs are appealing to individual investors. It has also been suggested that the benefits of international investing can be obtained by investing in international firms.

INVESTMENT CHARACTERISTICS

Stocks are diverse in nature and can be classified many ways for investment purposes. For example, stocks can be classified according to the level of risk. Risky stocks are sometimes referred to as aggressive or speculative. They may also be growth stocks, which are expected to experience high rates of growth in size and earnings. If risk is measured by the beta (systematic or nondiversifiable risk), then the term applies to a stock with a beta greater than one. These stocks are quite sensitive to economic cycles, and are also called cyclical. Contrasted are the blue-chip stocks—high-quality stocks of major firms that have long and stable records of earnings and dividends. Stocks with low risk, or a beta of less than one, are referred to as defensive. One form of investment strategy, called timing, is to switch among cyclical and defensive stocks according to expected evolution of the economic cycle. This strategy is sometimes refined to movement among various types of stock or sectors of the economy. Another stock category is income stocks—stocks that have a long and stable record of comparatively high dividends.

Common stock has been suggested as a hedge against inflation. This suggestion arises from two lines of thought. The first is that stocks ultimately are claims to real assets and productivity, and the prices of such claims should rise with inflation. The second line of thought is that the total returns to common stock are high enough to overcome inflation. While this is apparently true over longer periods, it has not held true over shorter periods.

Preferred stock is generally not considered a desirable investment for individuals. While the junior position of preferred stockholders as compared to bondholders indicates that the required rate of return on preferred will be above that of bonds, observation indicates that the yield on bonds has generally been above that of preferred stock of similar quality. The reason for this is a provision of the tax codes that 70 percent of the preferred dividends received by a corporation are tax exempt. This provision is intended to avoid double taxation. Because of the tax exemption, the effective after-tax yield on preferred stock is higher for corporations, and buying of preferred stock by corporations drives the yields down. The resulting realized return for individuals, who cannot take advantage of this tax treatment, would generally be below acceptable levels.

 PREV  1 | 2 | 3 | 4