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Morningstar.com's Interactive Classroom

Course 203
Understanding the News

Introduction

"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 Electric (GE) is the longest-tenured constituent of the Dow, which has changed substantially over time. The latest change to the Dow was UnitedHealth Group (UNH) replacing Kraft Foods (KFT) in 2012. In 2009, former constituents General Motors (GM) and Citigroup (C) were replaced with Travelers (TRV) and Cisco (CSCO).

At the close of business on Oct. 26, 2012, the Dow stood at 13,107. 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 0.1302 in October 2012. This shrinkage is needed to offset arbitrary events such as stock splits and changes in the roster of companies. With the divisor at 0.1302, the effect is to multiply the sum of the prices by about 7.7. (The numeral one divided by 0.1302 is approximately 7.7.) To look at it another way, each dollar of price change in any of the 30 Dow stocks represents a roughly 7.7-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 75% 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, ExxonMobil (XOM)and General Electric (GE), with the two biggest market caps among U.S. companies, accounted for 4.2% and 2.4%, respectively, of the S&P 500 as of June 2008. 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? In recent history, plenty of investors have been burned badly by such investigations, including Enron, Tyco (TYC), and WorldCom in the early 2000s, scandals at Countrywide and other firms in the wake of the financial crisis, and a string of more-recent scandals at Chesapeake Energy.

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.

Changes in regulation can also affect the value and future prospects of a company. For instance, in addition to facing thousands of lawsuits, cigarette maker Lorillard (LO) also faces the threat of potential increased regulation of menthol cigarettes (which account for roughly 90% of its volume) from the Food and Drug Administration. Should the FDA choose to meaningfully restrict or ban menthol cigarettes (which the agency has been investigating), Lorillard's financial performance would likely collapse catastrophically.

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.

Quiz 203
There is only one correct answer to each question.

1 The divisor used to calculate the Dow:
a. Has been constant.
b. Has been shrinking steadily in recent years.
c. Has been rising steadily in recent years.
2 Which one of the following three companies is a member of the S&P 500?
a. Software giant Microsoft.
b. Warren Buffett's holding company Berkshire Hathaway.
c. Dutch oil giant Royal Dutch Petroleum.
3 Which of the following stock indexes is price-weighted?
a. Dow Jones Industrial Average.
b. Nasdaq Composite Index.
c. S&P 500 Index.
4 If a company's actual earnings results are different than what analysts expect, this is known as:
a. An analyst revision.
b. An earnings surprise.
c. A stock split.
5 Which of the following would most likely affect a company's long-term investment outlook?
a. The company missed analyst estimates by a penny.
b. The company's stock was recently downgraded by a Wall Street analyst from "Buy" to "Hold."
c. The SEC is investigating the company to determine if it fraudulently misstated its financial results for the past several years.
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