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

First Steps for a New Investor

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For many, investing seems to happen in a foreign place where the inhabitants speak a strange language.  Most don’t know where to begin, and it’s easy to understand why:  They don’t teach this stuff in school.  One thing, however, is clear.  Unless you entered life with a trust fund, investing starts with small savings and the cultivation of the savings habit.  So let’s start at the beginning, with techniques for saving and how to plan your investment scheme.

Developing the Saving Habit

Too many of us procrastinate.  It’s easy to convince yourself that setting aside only a few dollars will make little difference compared to some “urgent” household or personal need. While sometimes these needs can be genuinely important, most are usually an excuse to put off saving and seek immediate gratification instead.  It might help you resist temptation to realize that every dollar you save each week or even each month will start growing beyond what you are depositing, what I call building on itself.  And soon the increased savings will offer their own gratifications.  The effort will also help you strengthen your saving habit, which, in most cases, is more than half the battle.

Here are seven tips to get in the habit of saving:

  1. Put aside all your loose change in a jar at the end of the day.  Better yet, add a dollar or five dollars into the jar each evening.  Such small amounts can quickly become a significant contribution to your savings. And most of the time it’s money that you won’t miss.
  2. Leave your credit cards at home.  Paying with cash will put a cap on how much you spend at a given time.  And if you have to run home to get the card, it might give you time to rethink an unnecessary expenditure.
  3. Contribute to stock purchase plans and reinvest the dividends.  Many companies allow employees to use part of their paychecks to buy the firm’s stock through automatic deductions.  This is money you might otherwise spend.  If you are in such a program, reinvest the dividends instead of taking them in cash.  This is a good rule to follow with any stock you own.
  4. Consider savings as you would any regular expense — like bills from the electric company or mortgage payments.  Set a dollar amount, say 1 percent of your take-home pay, or better yet 5 percent if you can, and “pay” that into your savings account each paycheck.
  5. Use automatic savings plans.  Some employers offer plans that take a designated amount of your paycheck to buy you U.S. government savings bonds (more on these in later posts).  Ask your bank if it can automatically transfer a designated amount each month from your checking to your savings account.
  6. Keep putting money aside even after you have paid off a loan or a mortgage.  Continue to write a check every month for the same amount, or at least a good portion of it, and put it into your savings.  This is money that you have long learned to live without, so you can increase your wealth painlessly.
  7. Occasionally give yourself a reward.  Saving is hard, and its payoff is often years in the future.  So once or twice a year, designate one month’s set aside for a little extra spending. Take the family out to dinner or buy something special for yourself or someone you love. It will give you something to look forward to that is nearer in time than the ultimate use of your savings.

Make a Plan 

Though saving and investment plans vary as much as individual desires and goals, one element should appear in every plan: an emergency fund, a pool of cash for unforeseen events, like sudden medical problems, appliance repairs, or possible unemployment. Ideally, set aside 3 to 6 months income to cover such needs. The money should go into what financial people call a “liquid vehicle,” one that you can access immediately such as a bank savings account or other easily accessible vehicles that I will describe in subsequent posts.  Once in place, this saved money will work for you: by building on itself through bank interest and by protecting you and your loved ones from harm.  Importantly, it will also give you confidence to take the next steps.

Once you have established this basic source of security, and the habit of saving, you can begin focusing on personal wants and needs. There is no right answer here. Much depends on your age, income, family circumstances, and interests. The money should serve your desires as well as your needs.  Some goals are very long term, like a young person saving for retirement.  Others are not quite that far off, like college for a newborn or buying a home, or starting a new business.  Still others may be more immediate, like buying a new car or kitchen.  All are legitimate, but each requires a different investment strategy.

To organize your thinking, create a small chart like the one at the end of this section.  It can link each need to an investment goal.  List your savings goals on the left.  I offer a few examples.  Yours will be different.  Next, fill in the likely cost.  You can research this on the Internet but in the case of housing for example, you may also want to do a bit more research about what it will cost when you are ready to buy.  Next, determine when you expect to need the money.  Count the months to that date and divide the cost by the number of months to see how much you’ll have to put aside each month.

The “months to go” will reflect where you are in your financial life.  A parent starting a college fund for a newborn, will be looking at an 18-year time horizon (216 months) before he or she needs the money.  Other goals will reflect more personal preferences.  If you think your car will last only another year, you’ll have to save for the replacement in only twelve months.  Plans to marry in two years will give you 24 months to accumulate the desired funds.  If planning reveals that your goal requires more savings a month than you can support, you might have to adjust your lifestyle, delay the target date, or even abandon this particular goal.  Harsh as these tradeoffs may seem, they are simply facts of life that no one can ignore.

                                                               Planning Guide                   

Goal Cost Date Months to Go Set Aside Each Month
Car Purchase:
Purchase of Home Entertainment System:
Money for a Good Vacation:
Funds to Buy a New Kitchen:
Purchase of a Home:
Money for a Retirement Nest Egg:  

 

 

Executing the Plan — Time is on Your Side

The further in the future your target date is, the less harsh the tradeoffs.  Remember that everything you save earns interest or dividends that over time will build the fund alongside your monthly savings contributions.  Because you are paid this interest not only on your contributions but also on the interest previously accumulated, what financial people call compounding, the longer you can wait before using the money, the more your savings or investment plan will help you accumulate.  These earnings will defray the burden of the monthly set aside.  Two examples:

One:  You need $20,000 for a car and a year to get the money.  Here, returns from investments will contribute only a small part of the total. In this example, it will require a set aside of about $1,629 a month.  Even if the savings account pays 5 percent, it would earn only about $88 over the course of the year. So most of the money would have to come from your monthly savings contributions.

Two:  With longer-term projects, however, earnings from savings and investments can contribute considerably more.  Say you are one of a newly married couple that wants to buy a $250,000 home in 15 years. To meet your goal entirely from setting money aside, you would have to save $1,389 a month.  But after five years of saving at that rate, your accumulated investment account would amount to $83,333.  At 5 percent interest, it would earn $4,723 a year from then on and more each successive year from the accumulated interest as well as your contributions.  That income alone would effectively substitute for over three months of future savings every year.  After ten years, you would have accumulated $166,666.  At a 5 percent interest return, it would earn $10,784 a year, enough to pay over seven months’ required savings.  These would amount to a major contribution toward your goal of home ownership. This is why time is on your side. The table at the end of this post lays out the accumulations of savings and interest year by year.

With even longer time horizons — say retirement savings — the contribution from investment income becomes even more significant. Over 30 years, in fact, the accumulated earnings from the investments would actually exceed the total of monthly set-asides.  In the example of the home purchase, the annual earnings from accumulated savings already by the fifteenth year would have come close to surpassing the annual savings need originally calculated.

 

                                    Interest Earnings Help Savings Accumulate

Years Yearly Savings Set Aside[1] Earnings on Savings[2] Total Available[3]
1 $16,667 $16,667
2 $16,667 $833 $34,167
3 $16,667 $1,708 $52,542
4 $16,667 $2,627 $71,835
5 $16,667 $3,592 $92,094
6 $16,667 $4,605 $113,365
7 $16,667 $5,668 $135,700
8 $16,667 $6,785 $159,152
9 $16,667 $7,958 $183,776
10 $16,667 $9,189 $209,632
11 $16,667 $10,482 $236,780
12 $16,667 $11,840 $265,285
13 $16,667 $13,264 $295,216
14 $16,667 $14,762 $326,644
15 $16,667 $16,332 $359,643

 

[1]$1,389 a month for 12 months = $16,667.

[2]Five percent on the account amount of the previous year.

[3]Savings set aside plus the earnings on the accumulated savings.

 

How Private Is Private Equity?

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I have received a lot of questions on private equity: what is it, and can an ordinary investor get involved?  The answer to the second question is Yes, and I will return to it at the end of this post.  As for the first question: Both private equity (PE) and its cousin venture capital (VC) are at base a lot more straightforward than they appear in the financial media.

How Do They Work? 

Both PE and VC take a large enough stake in a company to run it and, presumably, use their expertise to make that company more profitable, all with an eye to selling it in the future at a substantial profit.

Venture capital firms usually focus on smaller startups in less mature industries.  They help the operation prosper by bringing financial, administrative, and operational skills that the firm’s founders may lack.  Once they have the fledgling firm operating properly, VC investors sell their stake at a profit, often when the firm lists itself on one of the world’s stock exchanges as a publicly traded company in what is called an initial public offering (IPO).  Most VC firms work with their own capital and borrowed funds and do not take on outside investors

Private equity firms do essentially the same thing but on a bigger playing field.  They take a large enough stake, often in a publicly traded firm, to bring the firm into private ownership, at which point they no longer have to make the public disclosures demanded by the organized stock exchanges.  This, incidentally, is where the “private” in private equity comes from. It does not necessarily imply that the PE firms themselves are private or secretive or exclusive, though some of them are.  They take their purchases off the public exchanges to make big changes over sometimes long periods while avoiding the questions and complaints that the management of a public company would have to endure.  Once the improvements become evident and it is running smoothly and presumably now far more profitably, the PE company reintroduces it as a publicly traded firm, presumably at a substantial profit.

How Do They Do It?

Because PE firms, unlike VC operations, target established, publicly traded firms, you might wonder what special expertise they can add — after all, these targets have run their businesses more or less successfully for years.  PE firms can improve profitability in four major ways:

  1. PE investors have experience with other firms that can bring new and useful practices to the management of the target.
  2. By aligning the interests of management with that of ownership, they can overcome institutional resistance to these supposedly more efficient and profitable practices.
  3. By taking companies private, they can focus on needed, longer-term projects by removing the scrutiny imposed on publicly traded companies, in particular the publication of their quarterly earnings.
  4. They can pare down bloated management compensation schemes.

Participation and Financing

Most PE firms only allow investors considered qualified by the Securities Exchange Commission (SEC).  These are people with sufficient background or investment experience to, in the SEC’s estimation, make informed judgments on whether the firms involved and deals arranged are suitable for them.   Even given these strictures and the big bucks involved, smaller investors can participate in private equity operations because several actually list as public companies.  You can buy stock in them.  Two of the most prominent are The Blackstone Group and Kohlberg Kravis Roberts.

 

What Is ‘Bite-Size’ Investing?

My approach here contradicts to the get-rich-quick schemes promised preposterously by so many websites and the jargon-laden technical discussions designed intentionally to confuse.  Instead, I offer the individual investor a step-by-step approach to investment success, served up in understandable, easily digestible, bite-sized pieces.

I begin small, as do most individual investors, offering a system for saving and choosing a bank or alternative institution.  From this straightforward base, we continue to investment clubs and other ways to get better returns on your savings.

Once you have accumulated enough capital, you can proceed to stocks and bonds.  I explain their fundamental nature and properties, how markets value them and why prices fluctuate from day to day and year to year. From that base, I explain a reliable and low-maintenance approach to investing in stocks and bonds.  From here, I move on to explain in straightforward and simple language more exotic investment devices, including options, futures, foreign investment, currencies, private equity, hedge funds, venture capital and more.

Along the way, I offer warnings, generally against too much emotion and the temptation to be too much clever.  I also describe popular scams, some of which Hollywood has dramatized such as the pump-and-dump scheme of The Wolf of Wall Street, and others that have made headlines, such as Bernie Madoff’s Ponzi scheme.

The blog posts will not necessarily “go in order” because not every investor starts from the same place. But each will instruct.  Some posts will describe how to choose a bank. Others will answer the question what does a hedge fund hedge or how private is private equity.  One will explain how to start an investment club. A more systematic approach is better suited to a book than a blog.