Stocks 101

I bet this scenario is familiar: you are sitting with your doctor while he reads through your charts. He’s talking a million miles per hour using words you barely understand.  Suddenly, he stops to ask if you have any questions.  By the look on your face, it should be obvious that you do.  But all you say is, “Can you repeat that… in English?”

I pride myself on the education of my clients.  I do this so they can make informed decisions about investments.  However, I sometimes take for granted the primary reason individuals engage my services. While very knowledgeable in other areas, many clients are less savvy (or not at all aware) about this financial “stuff.”  Realizing that, it makes me think about this wonderful tool (my blogs) as an educational platform.

So, what should this “far from world-famous” financial blogger do, you may ask?  That’s right!  I’ll write a series of blogs on the very basics of investing!

To start at the beginning, the first topic on my list seemed rather obvious.  What are stocks (or equities) anyway?  Let’s dig a little deeper to get a better understanding of the basics – the who, what, where, and why of a stock.

What is a stock?

A stock is essentially ownership in a company.  You can have stock in a small company (like my partners and I do with Diversified, LLC) or, for the focus of this blog, you can own stock in an enormous, publicly traded company.  When you own stock in a publicly traded company, you actually own a claim on their assets and earnings.

As the company becomes more profitable (i.e. generates more earnings), your shares become more valuable.  This happens in one of two ways:

1. There are more earnings to distribute to the shareholders in the form of a dividend.
2. They can reinvest those dollars into profitable projects to grow even larger. Thus, it makes the value of your shares worth more on the open market.

Think of it this way — would you rather have ownership in my World Champion Philadelphia Eagles, or the not so World Champion Cleveland Browns?  For which team would you simply pay more?

Another key component to owning shares of stock is you normally receive voting rights in proportion to the percentage of stocks you own.  Thus, if a company has 1,000,000 shares outstanding and you own 1,000 shares, you basically get 1,000/1,000,000=.10% voting rights.

These voting shares don’t grant you permission, for example, to walk into a Monday morning meeting and instantly start voting on what color pens the company gives out.  Typically, these shares entitle you to vote on larger, shareholder level issues. These decisions are generally corporate level, such as voting on members for the board of directors.

As I mention above, common shareholders normally have some sort of voting rights.  There are, however, some instances where owning company stock won’t carry those same rights.  The two most common examples are when a corporation issues preferred stock and when they split the common shares into multiple share classes.

Preferred stock comes with a fixed dividend (which is different than the variable dividend of common shares) but can also appreciate in value. These properties give way to the idea that preferred stock acts as a hybrid between a traditional stock and bonds. As a preferred shareholder, you have a higher priority than common shareholders on the assets of a company in the event of liquidation. By investing in preferred stock, you aren’t granted voting rights and typically take less growth potential in favor of more security and consistency on dividends.

Lastly, there are also companies that split outstanding shares into two separate share classes. This is done so there are shares with a more favorable voting structure. These usually are given to board members (or founders) where their votes can have a disproportionally greater say than a common stock holder. A good example of this is with Alphabet (formerly Google), which has two ticker symbols in GOOG and GOOGL. While both are ownership shares of the company, only GOOGL actually carries any voting rights.

Why do companies go public?

Almost all companies start private and remain so for many years.  At some point, however, they grow to a level where a choice must be made:

• Maintain full control and not answer to outside stock holders. This can also make acquiring capital more difficult or costly.
• Or, go public and lose some of this control for the benefit of having easier access to funding and the world markets. It also can make mergers and acquisitions much more attainable.

What is a stock exchange?

Publicly traded stocks are traded on an exchange, which acts like a market place.  An exchange organization allows individuals to freely buy, sell, or trade stocks with someone else.  To purchase a stock you need someone willing to sell that stock. To sell a stock, you need someone willing to buy it.  A stock exchange is designed to bring buyers and sellers together to efficiently make these transactions.

There are many stock exchanges across the world, some of which you’ve probably heard of before.  The most common exchanges are the New York Stock Exchange (the largest with a $19.223 trillion market cap), the NASDAQ (with $6.831 trillion market cap, mostly in tech stocks), and the London Stock Exchange (with $6.187 trillion in listed market cap).

Classifications of stocks.

Issued stocks are categorized so investors can determine their risk level and compare similar company’s performance or growth. At a high level, I’ll break this down by size, style, and location.

Size:

Most common sizes refer to large-cap, mid-cap, or small-cap stocks (capitalization is shorted to “cap” for ease of reference). Capitalization is calculated by multiplying the number of shares outstanding by the price per share of a stock.

• Large cap stocks are naturally the largest valued stocks on the market. They have $10 billion, or more, in market cap.  These stocks are generally the most stable in the investment world.
• Mid-Cap stocks are companies ranging anywhere between $2 billion and $10 billion. Presumably, mid-cap stocks are less stable than their large-cap counterparts.
• Small-Cap stocks are those with under $2 billion. As one would expect with smaller companies, they carry more risk than their large-cap stock counterparts. In return, investors hope to be rewarded with large returns resulting from these smaller companies growing in success.

Conventional wisdom suggests the larger the company, the less “risky” (and thus smaller returns) over the long term.  For example, in order to double your investment in Walmart, a mature large-cap company, you would need Walmart’s value to basically double.  Not that it can’t be done, but think how hard it is for this major company to grow twice its already massive size.  On the flipside, the likelihood of Walmart going bankrupt is less. Compare this to a small-cap regional retail store. There is massive growth potential, but also a higher likelihood of failure.

Style:

You’ll sometimes see stocks described in terms of a style box.  The three most common are growth, value, and core.

• Growth stocks are companies whose main focus and expectation is to grow faster than other style boxes. They usually opt for reinvesting their earnings, rather than paying out to shareholders as dividends.  Therefore, investors are subject to more risk, especially if the company reinvests into unprofitable projects. Most often, you’ll see sectors like technology fall into the growth style box.
• Value stocks are companies selling at bargain prices–meaning its price is below what the fundamentals suggest it should be trading at based on historical multiples or similar type companies. This happens for a variety of reasons such as bad press, scandals, or market skepticism.  At its basic level, a value investor identifies underpriced stocks and waits patiently for the price to appreciate to its intrinsic value.  Patience is key because these stocks also carry a fair amount of risk, as they are out of favor for a reason.  It’s typical for value stocks to be mature companies paying higher (or more stable) dividends.  In terms of sectors, you’ll find many value companies from financial services, utilities, and consumer staples.
• Core stocks slide into the middle of value and growth and may exhibit properties of both. One would expect a normal level of growth and dividend alignment with the overall market on these stocks. They are financially strong and very well-balanced companies.  Many times, you’ll see a mutual fund classified as core/blend, which is designed to inform investors it will contain stocks from both growth and value styles.  You’ll often see investments listed as core containing a blend of all sectors, rather than leaning towards a select few.

Location:

The final determinant of stock classification is from where it is based.  We have domestic (U.S.) based companies and international companies, either coming from developed or emerging countries.

• Domestic stocks are considered the least risky of them all and the reasoning is vast, but justified. For starters, we are the largest and most established economy in the world.  Additionally, our markets are very large and contain a sufficient amount of liquidity.
• Companies from developed countries are right behind us on risk level. We associate them as fairly stable and established. When thinking about developed countries, the largest and most common are Japan, U.K., Germany, France, and Canada. It’s important to note a company is considered “international” if that’s where it is domiciled, rather than where their sales are generated (even if they’re mostly from the U.S.). In reality, this may determine the risk factor of an international company.
• The riskiest of the big three are companies from emerging/developing markets. These companies are in economies newer to the markets and modern society.  China is the biggest emerging market country, which seems odd since they are one of the oldest and largest economies in the world.  Despite the country’s size, many of them are still developing their own markets and industries. A few characteristics of emerging countries are low per capita income, political instability, high currency volatility, and rapid growth. The major countries classified as emerging/developing are China, India, Russia, and Brazil.

Summary

I’ve only scratched the surface on the depth and sophistication of stocks, the markets surrounding them, and how value is assigned. I caution you to tread carefully when investing. Make sure you know what you are doing, or at least work with someone who understands the intricacies.  From there, you can determine how stocks may or may not be a resource in helping you grow your assets in hopes of achieving your financial goals.