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Investing classroom: Understanding the news

Stocks lesson 2.2: The latest in our stocks investment lessons aims to help you come to

Morningstar 13.11.2009

"The FTSE 100 fell 71 points today…"

"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 programme on your TV or scan the headlines in your newspaper. But what is the FTSE? What happens when a company misses earnings targets or gets upgraded or downgraded by analysts? What does any of this 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 Indices
A stock index is simply a grouping or a composite of a number of different stocks, often with similar characteristics. Stock indices 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.

The FTSE 100
The FTSE 100 is the most widely used UK stock market indicator. The constituents of the UK FTSE indices are ranked by market capitalisation -- the value of all the shares added together. The FTSE 100, as its name suggests, has a fixed number of constituents –100 -- and it tracks the performance of these highly-capitalised companies.

The constituents of the index are determined quarterly; the largest companies in the FTSE 250 Index are promoted if their market capitalisation would place them in the top ninety firms of the FTSE 100 and, similarly, FTSE 100 companies whose market capitalisation drops to below that of the 100 highest performing constituents will be moved out of the FTSE 100. The index is calculated in real time, so the FTSE moves up and down continually as the prices of its constituent stocks change.

When the index started in 1984, its value was 1,000 points. Every time the shares of a FTSE 100 company change price, the index moves up or down. So given it is now worth just over 5,000 points, the movement over the years has been upward – albeit with a few setbacks along the way, the 18 months between September 2007 and March 2009 being one of them. The highest value the FTSE has ever reached was 6,950 points in December 1999 amid the dotcom boom.

Within the FTSE 100, the size of the companies varies. And size buys influence. The larger the company the more percentage weighting it is given in the index, so when its shares move in price it will have a greater influence on the movement of the index than that of a smaller company. For example, a 1.0% move by oil & gas producer BP will have considerably more impact on the overall index than will a 1.0% move by cruise operator Carnival. Given that two of the FTSE 100 index’s ‘heaviest’ stocks are oil-related—BP and Royal Dutch Shell—movements in the price of oil often has a positive correlation with the overall move of the index, despite higher oil prices otherwise having a tendency to dampen investor sentiment.

‘Noise’ versus news
Anyone interested in keeping up with current business events has plenty of opportunity. Walk into any newsagent, and you'll see all kinds of newspapers and magazine titles dedicated to the business world. Digital television offers several business news channels. And the Internet provides countless business and financial websites.

Often, 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
The City is full of professionals whose job it is to analyse 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 Company ABC announced earnings that fell short of analysts' estimates by a tiny two pence a share. Let's also assume that the stock fell on the disappointment. Does this disappointing period mean that ABC’s long-term competitive advantages have been eroded? Probably not. So, it had a measly quarter – big deal! What is of more importance is whether its long-term prospects, strategy and industry outlook, among other factors, have been irreparably damaged.

Analyst upgrades / downgrades
In addition to providing estimates of what they think a company's sales and earnings will be, 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.

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.

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