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203-Understanding the News
  Course 203: Understanding the News
  
  "The Dow fell 71 points today…"
  "The S&P 500 continued its recent climb…"
  "ABC Company missed its quarterly earnings target…"
  "XYZ Company's shares jumped $2 as a result of analyst upgrades…"
  
  
  These are common statements you may hear on any given day as you flip past a
  financial news channel on your TV or scan the headlines in your newspaper. But
  what are the Dow and the S&P 500? What is the Nasdaq? What happens when a
  company misses earnings targets or gets upgraded or downgraded by analysts?
  What does any of this stuff mean to you, as an investor?
  
  In this lesson, we are going to focus on building an understanding of some of
  the things you may typically hear in the financial news. Then we are going to
  learn how to separate what actually matters from what is nothing more than
  "noise."
  
  
  Stock Indexes
  A stock index is simply a grouping or a composite of a number of different
  stocks, often with similar characteristics. Stock indexes are typically used
  to discuss the overall performance of the stock market, in terms of changes in
  the market price of the stocks as well as how much trading activity there is
  in any particular period. Three of the most widely followed indexes are the
  Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite.
  
  
  The Dow Jones Industrial Average
  Known as just the "Dow" for short, this index is not really an average, nor
  does it exclusively track heavy industry anymore. The index is composed of 30
  large stocks from a wide spectrum of industries. General Motors GM and General
  Electric GE are the only two companies that have been part of the Dow Jones
  Industrial Average since it was created in 1928. The latest change to the Dow
  was the addition of insurance company American International Group AIG,
  pharmaceutical firm Pfizer PFE, and telecommunications company Verizon VZ in
  April 2004, while AT&T T, Eastman Kodak EK, and International Paper IP were
  dropped to make room.
  
  At the close of business on Jan. 1, 2005, the Dow stood at 10,783. How is this
  figure calculated?
  
  The index is calculated by taking the 30 stocks in the average, adding up
  their prices, and dividing by a divisor. This divisor was originally equal to
  the number of stocks in the average (to give the average price of a stock),
  but this divisor has shrunk steadily over the years. It dropped below one in
  1986 and was equal to 0.135 in January 2005. This shrinkage is needed to
  offset arbitrary events such as stock splits and changes in the roster of
  companies. With the divisor at 0.135, the effect is to multiply the sum of the
  prices by about 7.4. (The numeral one divided by 0.135 is approximately 7.4.)
  To look at it another way, each dollar of price change in any of the 30 Dow
  stocks represents a roughly 7.4-point change in the Dow.
  
  Because the Dow includes only 30 companies, one company can have much more
  influence on it than on more broad-based indexes. Also, since the prices of
  the 30 stocks are added and divided by the common denominator, stocks with
  larger prices have more weight in the index than stocks with lower prices.
  Thus, the Dow is a price-weighted index. It's also useful to remember that the
  30 stocks that make up the Dow are picked by the editors of The Wall Street
  Journal, rather than by any quantitative criteria. The editors try to pick
  stocks that represent the market, but there's an inevitable element of
  subjectivity (and luck) in such a method.
  
  Despite its narrower focus, the Dow tracks quite well with broader indexes
  such as the S&P 500 over the long run.
  
  
  The S&P 500
  The Dow Jones Industrial Average usually gets most of the attention, but the
  S&P 500 Index is much more important to the investment world. Index funds that
  track the S&P 500 hold hundreds of billions of dollars, and thousands of fund
  managers and other financial professionals track their performance against
  this ubiquitous index. But what exactly is the S&P 500, anyway?
  
  The Standard & Poor's 500 as we know it today came into being on March 4,
  1957. The makers of that first index retroactively figured its value going
  back to 1926, and they decided to use an arbitrary base value of 10 for the
  average value of the index during the years 1941 through 1943. This meant that
  in 1957 the index stood at about 45, which was also the average price of a
  share of stock. The companies in the original S&P 500 accounted for about 90%
  of the value of the U.S. stock market, but this percentage has shrunk to just
  more than 80% today as the number of stocks being traded has expanded.
  
  Although it's usually referred to as a large-cap index, the S&P 500 does not
  just consist of the 500 largest companies in the U.S. The companies in the
  index are chosen by a committee at investment company Standard & Poor's. The
  committee meets monthly to discuss possible changes to the list and chooses
  companies on the basis of "market size, liquidity, and group representation."
  New members are added to the 500 only when others drop out because of mergers
  or (less commonly) a faltering business.
  
  Some types of stocks are explicitly excluded from the index, including real
  estate stocks and companies that primarily hold stock in other companies. For
  example, Berkshire Hathaway BRK.B, the holding company of Warren Buffett,
  arguably the world's greatest investor, isn't included, despite having one of
  the largest market values of all U.S. companies. Also, the index is composed
  exclusively of U.S. companies today.
  
  Size matters with the S&P 500. Because the companies chosen for the index tend
  to be leaders in their industries, most are large firms. But the largest of
  the large-capitalization stocks have a much greater effect on the S&P 500 than
  the smaller companies do. That's because the index is market-cap-weighted, so
  that a company's influence on the index is proportional to its size.
  (Remember, a company's market cap is determined by multiplying the number of
  shares outstanding by the price for each share.) Thus, General Electric and
  ExxonMobil XOM, with the two biggest market caps among U.S. companies,
  accounted for 3.4% and 2.9%, respectively, of the S&P 500 as of the beginning
  of 2005. In contrast, other smaller companies can account for less than 0.1%
  of the index.
  
  
  The Nasdaq Composite
  The Nasdaq Composite was formed in 1971 and includes the stocks of more than
  3,000 companies today. It includes stocks that are listed on the
  technology-company-heavy Nasdaq stock exchange, one of the market's largest
  exchanges. (Other major stock exchanges include the New York Stock Exchange,
  or the NYSE, and the American Stock Exchange, or AMEX.) Like the S&P 500, the
  Nasdaq is a market-cap-weighted index. For a stock to be included in the
  Nasdaq Composite, it must trade on the Nasdaq stock exchange and meet other
  specific criteria. If a company fails to meet all of the criteria at any time,
  it is then removed from the composite.
  
  
  "Noise" Versus News
  Anyone interested in keeping up with current business events has plenty of
  opportunity. Walk into any newsstand, and you'll see all kinds of newspapers
  and magazine titles dedicated to the business world. Cable television offers
  several business news channels. And the Internet provides countless business
  and financial Web sites.
  
  Oftentimes, events in the news cause stock prices to move both up and down,
  sometimes dramatically. Sometimes the market's reaction to the headlines is
  warranted; many other times, it's not. For an investor, the real challenge is
  deciphering all of the headlines and stories to determine what is really
  relevant for your stocks.
  
  Here at Morningstar, we practice the discipline of scouting out great
  companies with long-term competitive advantages that we expect will create
  shareholder value for the foreseeable future. Then we wait until their stocks
  become cheap before investing in them for the long haul. In keeping a watchful
  eye out for solid investment opportunities, we constantly monitor and evaluate
  the ever-changing business environment. As we digest the events that affect
  any given company, we continually ask ourselves, "Does this information affect
  the long-term competitive advantages and resulting cash flow of this company?
  Does it change the stock's long-term investing prospects?"
  
  This is key to understanding the investment process. Periodically, news will
  break that does not affect a company's long-term competitive advantages, but
  its stock price will fall anyway. This may lead to a buying opportunity.
  Remember, "Mr. Market" tends to be quite temperamental, and not always
  rightfully so.
  
  
  Negative Earnings Surprises
  Wall Street is full of professionals whose job is to analyze companies and
  provide opinions about them and estimates about their future financial
  results. While most of them are very intelligent individuals who have a wealth
  of information and experience, they tend to be much too shortsighted. These
  analysts typically will come up with "earnings estimates" for the upcoming
  three-month period. If a company's actual results fall short of analysts'
  expectations, this is known as a "negative earnings surprise." On such
  disappointing news, the company's stock price may fall. (Conversely, if a
  company performs better than what analysts expect, it will have a "positive
  earnings surprise," which may cause the stock price to increase.)
  
  Let's pretend that Wal-Mart WMT announced earnings that fell short of
  analysts' estimates by a measly two cents a share because it didn't sell as
  many widgets during the holiday season as people expected. Let's also assume
  that the stock fell on the disappointment. Does this disappointing shopping
  season mean that Wal-Mart's long-term competitive advantages have been eroded?
  Probably not. Wal-Mart remains the largest retailer in the world, with great
  economies of scale and a remarkable distribution network, which allows the
  company to pass huge cost savings on to customers, which, in turn, keeps
  customers coming back. So it fell slightly below analysts' estimates in one
  particular quarter…big deal!
  
  
  Analyst Upgrades/Downgrades
  In addition to providing estimates of what they think a company's sales and
  earnings will be, Wall Street analysts also provide recommendations for stocks
  they cover, such as "Buy," "Hold," or "Sell." When an analyst changes his or
  her rating for a company's stock, the stock price often moves in the direction
  of the change. Does this upgrade or downgrade affect the business prospects of
  the company? No, the opinion of one person does not alter the intrinsic value
  of the firm, which is determined by the company's cash flows. But maybe the
  analyst made the change because he or she thought the company's business
  prospects have deteriorated. Maybe that's right, maybe not. Check it out, and
  decide for yourself.
  
  
  Newsworthy Events
  Other times investors will hear about events that have them running for cover,
  and rightfully so. One such event is the announcement of a regulatory
  investigation by an organization such as the Securities and Exchange
  Commission or the Department of Justice. While such announcements by
  themselves by no means predict impending doom, who knows what nasty surprises
  may lurk for investors as regulators start turning over rocks? Plenty of
  investors have been burned badly by the results of such investigations--just
  ask the shareholders of Enron, Tyco TYC, or WorldCom.
  
  Another item to be wary of is a significant lawsuit. Corporate litigation is
  almost everywhere you look (these days, it's almost a normal part of doing
  business), and estimates of any significant legal damage are usually already
  priced into a stock. However, lawsuits often attract others, which could place
  very large uncertainties on a company's performance.
  
  A great example of how such legal issues can affect the true value of a
  company is occurring at the time of this writing. Bellwether drug manufacturer
  Merck MRK is experiencing a double-whammy related to litigation. Vioxx,
  Merck's arthritis-pain-relieving drug that was once perceived as a
  blockbuster, has been linked to heart problems in patients taking it. The
  company had to recall Vioxx from the market, and it is facing serious legal
  liabilities. Shortly thereafter, a court ruling shortened the patent life on
  Merck's number-two-selling drug Fosamax, meaning competitors can introduce a
  substitute much quicker than previously thought. Both situations have the
  ability to seriously reduce Merck's future cash flows.
  
  
  The Bottom Line
  Successful investing requires you to keep a steady hand. Your patience and
  willpower will get regularly tested as the stock market reacts to news,
  sometimes justifiably, other times not. Just remember that not every bump in
  the road is the edge of a cliff. If you react by racing to sell your stocks on
  every little piece of bad news, you will find yourself trading far too
  frequently (with the requisite taxes and commissions), and often selling at
  the worst possible time. But by using focused discipline in separating the
  news that matters from the noise that doesn't, you should emerge with
  satisfactory investment results.