Stock Basics

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Stocks remain a popular investment vehicle and with good reason – they amount to a wager on the economy’s future.  Equities, as stocks are often called, rise and fall according to all the particulars that affect corporate profits — but basically they rise when the economy has promise and fall during recessions or when investors otherwise doubt the economy’s prospects.  Because stock prices can at times move violently, investors, unless they are lucky timing their purchases and sales, will realize their best payoff over the longer term.  The longer you can wait for the returns, the more stocks you will have in your investment portfolio.  (More on this in a later post.)  

What Are Stocks?

Stocks are a partial ownership in all that the issuing firm owns and earns.  Companies issue stock to raise money, usually for expansion.  This money is called equity capital.  

There is no limit to how many shares a company can issue. Managements that prefer to limit ownership in just a few hands issue relatively few shares.  Companies with expansion plans that require a lot of financial capital often issue thousands of shares.  There are benefits and disadvantages to either approach.  Using equity (stocks) instead of borrowed capital (money) can make the company more financially stable.  In hard times, the firm has to pay lenders even if it makes no money, but shareholders can claim only a share of the profits.  The disadvantage of issuing more shares is that they dilute the value of existing shareholders.

The most common sort of stock is called, not surprisingly, common stock.  These entitle their owners to any distribution of company profits, called dividends.  Owners are also entitled to elect board members and vote on other basic matters of ownership.  Each share gets one vote, not each shareholder.  The largest shareholders generally have control of the company’s decisions.  Companies sometimes issue preferred shares.  These tend to command more generous dividends than common shares and usually stand before common shares should the company suffer bankruptcy, but they typically lack voting rights.

Making Money in Stocks

Stocks offer two ways to make money:

  1. Dividends are periodic cash payments (almost always quarterly) that management pays shareholders out of the firm’s profits, what financial people usually refer to as earnings.  Dividends are entirely at the discretion of the corporation’s board of directors.  Usually, the board makes its decision based on how much the company has earned and what other uses it has for the money — say investing in new facilities.  Companies that are growing fast and need to invest to keep up with their expanding business pay low or no dividends.  Slower growing firms with less need for the money pay higher dividends.
  2. A more important way of making money in stocks is price appreciation.  This is determined solely in the market where investors trade available shares of stock. Neither management nor the board of directors has any direct control over this activity.  If the company is doing well, earnings are growing, and there is a promise of further growth, people will want to own a piece of that action and their buying bids up the price of the stock.  This works in reverse if the firm faces trouble.  Appreciation can also reflect dividends.  Higher dividends will often attract buyers whose demand prompts price appreciation.

The Roots of Price Fluctuations

Stock prices fluctuate as investors alter their expectations of future profits.  Financial theory holds that the fair price of a stock is only a reflection of the flow of future dividends and the earnings that might support future dividends.  That future flow is discounted, because dollars you have today can be invested and earn money, whereas future dollars are inevitably uncertain and cannot earn until they are paid.  A well-regarded algorithm, called the “dividend discount equation” calculates a fair price for a stock by so discounting prospective earnings and dividends.  Anything that improves a company’s profits next to the expectations previously built into its price will to raise that stock’s price.  Anything that makes the future look more problematic tends to drive its price down.

A number of factors can influence these calculations, some general, some specific to the industries in which the company operates, some specific to the company.  A complete list would fill several volumes, but here are seven main issues that move stock prices:

(1) The Economy

Because profits generally follow overall economic activity, an improved economic picture promotes a general rise in stock prices, called a rally or a bull market.  Economic clouds prompt stock price declines, called a correction or a bear market. Because no one can know the future, stock investors continually assess economic trends and revise their opinions accordingly. The flow of news is continual.  The list of indicators, statistical or otherwise, is too long for this space and absorbs the attention of thousands who work in the industry, making it very hard for an individual to get ahead of the market’s regular reassessments.

The movement of interest rates also has an effect.  Because lower interest rates make borrowing cheaper and so more likely that consumers will spend and business expand, they usually signal an economic pickup that tends to lift stock prices.  An interest rate increase, because it has the opposite economic effect, tends to depress stock prices.  Interest rates also feed directly into stock valuations. Because higher interest rates offer better ways for your dollars to earn, they prompt investors to discount future dollars more severely, depressing stock prices.  An interest rate decline has an opposite effect.

(2) The Industry

Even more than changing perceptions of the general economy, industry-specific considerations move stock prices.  Are oil prices rising?  That’s good for those who produce oil and who service the oilrigs.  It’s bad for those who use oil — airlines and truckers, for instance.  A technological breakthrough may benefit some at the expense of others.  A bumper wheat crop abroad will hurt American wheat farmers by depressing the prices their harvest can command, but it could help food processing firms who buy grain. These few examples only hint at the constant flow of industry information that just as constantly changes market opinion and moves stock prices.

(3) Legislation and Regulation

Here, too, the flow of news is endless.  If Washington, for instance, were to support a major infrastructure-rebuilding program, prospects for construction firms would improve and their stock prices would rise accordingly.  A decision to step up defense spending would definitely boost prospects among defense contractors and so the prices of their stocks.  The Affordable Care Act (ACA) improved prospects for health care insurers (at least initially) by driving millions of new customers their way.  But such news can cut the opposite way.  The adverse effect of such spending on Washington’s finances might negatively impact stock prices by threatening to push up interest rates or taxes or both.

Regulation, at the national, state, or city level, can have its own effects.  Environmental rules will enhance the prospects of some firms at the expense of others, say solar over coal.  Stricter financial regulations after the crash of 2008-09 had a powerful effect on financial firms, especially smaller ones.  Safety regulations raise costs for some firms and industries but create opportunities to those that sell products to help other firms comply with those regulations.  Here, too, the flow of information constantly changes investor assessments of the future and thus stock prices.

(4) News About Staff

If a company hires someone with widely recognized ability, investors may expect an improvement in the company’s fortunes and buy its stock, pushing up its price.  The loss of a key executive can raise questions about the future and so depress the company’s stock price.  A large number of departures, even of not-so-famous, middle-level employees, can raise questions about the firm’s ability to manage and so push down its stock price.

Scandals also move prices.  A staff member who runs afoul of the law can depress the company’s stock price by increasing investor worries over fines or other legal actions. This sort of news tends to break suddenly, creating violent swings in stock prices.  Bad news for one firm, of course, might also lift the prospects of its competitors and so of their stock prices.

(5) The Firm’s Product Line

Any change in product line, positive or negative, will move the company’s stock in a sympathetic direction.  Drug companies are particularly vulnerable.  Bringing new drugs to market is a very lengthy process, and failure could cost these firms dearly.  Lawsuits involving pharmaceutical companies are more expensive than in other industries. But a successful new drug, sometimes referred to as a “blockbuster drug,” can lift profit prospects dramatically and the company’s stock price with it. Drugs are just one example.

(6) Natural and Political Events

Stock prices also respond to geopolitics and natural events. Revolution, war, elections, and natural disasters anywhere can disrupt business and affect stock prices.  Tariffs, much in the news today, can help the firms protected by them and hurt those who have to face them.  An earthquake could wipe out an industrial operation.  Even if insured, the firm’s stock price would suffer because the company would have lost its ability to engage in otherwise lucrative businesses.  If the disaster is large enough, that company’s insurers might find themselves facing huge payouts that could bring down their stock prices.  For investors, reassessment is always continual as is the movement of stock prices.

(7) Buybacks, Mergers, and Acquisitions

Management may from time to time decide to use retained earnings to buy back their own stock on the market.  Typically, it is done in lieu of raising dividends.  Such additional demand for the stock will tend to raise its price.  But when the buyback program ends, the sudden drop in demand for the stock can depress its price.

Mergers and acquisitions (M&A) happen for all sorts of reasons.  They usually generate a lot of drama and so a great deal of media attention. Sometimes the buyer sees what the financial community calls “synergies,” meaning that the business of the acquired firm has many similarities to that of the acquirer and hence opportunities for efficiencies or market dominance.  Sometimes the merger occurs between two quite different parties that see a way to diversify their respective product lines.  Some acquisitions are hostile— meaning that the firm being bought resists the transaction.   Others are amicable— meaning that both parties like the idea of merging.  The effect on stock prices varies depending on the structure of the deal, which can become very complicated.  Generally, the buyer’s stock suffers and the stock they are buying rises, at least initially.  This often happens in a hostile acquisition, as the buyers will try to blunt opposition by raising the price they offer for the other’s stock.

Getting into the Action

Taking all this into account, you might well ask why any individual investor would risk stock ownership.  Such a hesitation is understandable.  But an investor who will not need the money for a long time and has basic confidence in the firm’s management and its products can feel secure that its stock will rise over the long term.  There are also ways to enlist professional help in making all these continual assessments. More on these options in subsequent posts

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