Equity Securities

Equity securities represent ownership interests in corporations. As an owner, you share in the company's profits and losses, and your investment value fluctuates with the company's performance and market conditions.

Common Stock vs. Preferred Stock

Common stock represents basic ownership in a corporation. Common stockholders have the following rights:

• Voting rights: Elect the board of directors and vote on major corporate decisions
• Dividend rights: Receive dividends when declared by the board (not guaranteed)
• Residual claim: Last in line for assets during liquidation (after creditors and preferred shareholders)
• Preemptive rights: Right to maintain proportional ownership when new shares are issued

Preferred stock is a hybrid security with characteristics of both stocks and bonds:

• Fixed dividends: Paid at a stated rate as a percentage of par value
• Priority: Dividends and liquidation claims come before common stockholders
• No voting rights: Typically cannot vote on corporate matters
• No maturity date: Unlike bonds, preferred stock has no set maturity
• Price sensitivity: Prices move inversely with interest rates, similar to bonds

Types of Preferred Stock

• Cumulative preferred: If dividends are skipped, they accumulate and must be paid before any common dividends. Most preferred stock is cumulative.
• Participating preferred: Shareholders may receive additional dividends beyond the stated rate if the company performs exceptionally well.
• Convertible preferred: Can be exchanged for common stock at a predetermined ratio.
• Callable preferred: The issuer can redeem shares at a specified price after a certain date.

Growth Stocks vs. Value Stocks

Growth stocks are shares of companies expected to grow earnings faster than the market average:

• Higher price-to-earnings (P/E) ratios
• Little or no dividends (earnings reinvested for expansion)
• Higher volatility
• Examples: Technology companies, emerging market leaders

Value stocks trade at prices below their intrinsic value based on fundamental analysis:

• Lower P/E ratios
• Often pay dividends
• May be temporarily out of favor or in mature industries
• Examples: Financial institutions, utilities, established manufacturers

Market Capitalization Categories

Market capitalization (market cap) equals the stock price multiplied by shares outstanding. Categories help investors understand company size and risk profiles:

Voting Methods

Statutory (regular) voting: Each share receives one vote per director position. Favors majority shareholders.

Cumulative voting: Total votes equal shares owned times number of directors being elected. Shareholders can concentrate votes on fewer candidates, helping minority shareholders gain board representation.

Example: An investor owns 100 shares and 5 directors are being elected.

• Statutory voting: 100 votes per director position (cannot combine)
• Cumulative voting: 500 total votes that can be allocated however the shareholder chooses

American Depositary Receipts (ADRs)

ADRs are negotiable certificates representing shares of foreign companies, issued by U.S. banks. They allow U.S. investors to invest in foreign companies without dealing with foreign exchanges or currencies directly.

Key characteristics:

• Trade on U.S. exchanges in U.S. dollars
• Dividends paid in U.S. dollars
• Subject to U.S. securities regulations
• Do NOT eliminate currency risk: The underlying foreign stock's value changes with exchange rates

Types of ADRs:

• Sponsored ADRs: Created with cooperation from the foreign company; can trade on major exchanges; translated financial documents provided
• Unsponsored ADRs: Created without company involvement; trade only in OTC markets; limited disclosure

CFP Exam Tip: ADRs provide convenience but do not eliminate exchange rate risk. Currency fluctuations affect returns.

Dividends

Cash dividends are distributions of corporate earnings to shareholders:

• Qualified dividends: Taxed at preferential capital gains rates (0%, 15%, or 20%)
• Requirements for qualified status: Paid by U.S. or qualifying foreign company; stock held for more than 60 days during the 121-day period around the ex-dividend date

Stock dividends are additional shares distributed to existing shareholders. They are not taxable when received but reduce cost basis per share.

Important dividend dates:

• Declaration date: Board announces dividend
• Ex-dividend date: First day stock trades without the dividend; must own shares before this date to receive dividend
• Record date: Company determines shareholders eligible for dividend
• Payment date: Dividend is distributed

CFP Exam Tip: As of May 28, 2024, trade settlement is T+1. To receive the dividend, you must purchase the stock before the ex-dividend date.

Stock Splits

A stock split increases shares outstanding while proportionally reducing the stock price. Total market value remains unchanged.

Example: An investor owns 100 shares at $60 per share ($6,000 total value).

• After 3-for-2 split: 150 shares at $40 per share ($6,000 total value)

Reverse stock splits reduce shares outstanding and increase the stock price. Companies use them to:

• Meet exchange minimum price requirements (avoid delisting)
• Attract institutional investors with minimum price requirements
• Improve perception of the stock

Tax implications: Splits do not trigger taxable events. Cost basis per share adjusts proportionally, but total cost basis remains unchanged.

Corporate Dividend Tax Advantage

Corporations that receive dividends from stock investments can exclude a portion from taxation:

• 50% dividends-received deduction for most corporate investments
• 65% deduction for corporations owning 20% or more of the paying company

This tax advantage makes preferred stock particularly attractive for corporate investors seeking income.