By Joshua Kennon from thebalance.com
Throughout much of modern history, investing in stocks has been one of the most effective and efficient ways for individuals and families to accumulate capital, build wealth, and grow their passive income. Yet stocks remain misunderstood by a vast majority of the population (including those who invest), many of whom look upon a share of stock as being some mysterious force that is beyond rational explanation; a series of letters and numbers that fluctuate on digital ticker tape and cause brokerage and retirement account balances to rise and fall without rhyme or reason.
But the truth is that a well-chosen collection of stocks, particularly as part of a portfolio of diversified assets and asset classes, can provide freedom from financial worry as well as flexibility to pursue your passions on your own time. Here’s what you need to know about investing in stocks.
What Is Stock?
Put simply, a share of stock represents legal ownership in a business. Corporations issue stock, usually in one of two varieties: common stocks and preferred stocks. Stocks are sometimes interchangeably called “securities”, because they are a type of financial security, or “equities,” because they represent ownership (equity) in a business.
Common Stocks: These are the stocks to which everyone is usually referring when they talk about investing. Common stock is entitled to its proportionate share of a company’s profits or losses. The stockholders elect the Board of Directors who (in addition to hiring and firing the CEO) decide whether to retain those profits or send some or all of those profits back to the stockholders in the form of a cash dividend — a physical check or electronic deposit that is sent to the brokerage or retirement account that holds the stock.
Preferred Stocks: Shareholders of preferred stocks receive a specific dividend at predetermined times. This dividend ordinarily has to be paid first, before the common stock can receive any dividends, and if the company goes bankrupt, the preferred stock holders outrank the common stock holders in terms of potentially recouping their investment from any sales or recoveries achieved by the bankruptcy trustee. Some preferred stocks can be converted into common stock.
How Are Stocks Created, and Why Do They Exist?
Stocks exist for several reasons, but among the most important are the following:
- Stocks allow companies to raise capital (money) to turn good ideas into viable businesses. Without capitalism and well-functioning capital markets, most of the modern comforts you take for granted wouldn’t exist or be available to you.
Stocks provide a place for investors to potentially earn satisfactory returns on capital that might allow them to achieve their financial goals more quickly than they otherwise could.
Stocks separate ownership from management, allowing those who have no interest, ability, or time to run an enterprise to still participate economically and through voting rights. This results in a more efficient allocation of resources, including human capital.
With few exceptions, equity capital on the balance sheet doesn’t have a date by which it must be repaid, nor a guaranteed dividend rate. This means that it acts as a cushion for a company’s lenders: They know there are assets on the balance sheet to absorb losses before they have to step in and throw the company into bankruptcy if the bills aren’t paid. Because of this reduced risk, they can offer lower interest rates on money they lend to the business.
How Stocks Work
Imagine you wanted to start a retail store with members of your family. You decide you need $100,000 to get the business off the ground so you incorporate a new company.
You divide the company into 1,000 shares of stock. You price each new share of stock at $100. If you can sell all of the shares to your family members, you should have the $100,000 you need (1,000 shares x $100 contributed capital per share = $100,000 cash raised for the company).
If the store earned $50,000 after taxes during its first year, each share of stock would be entitled to 1/1,000th of the profit. You’d take $50,000 and divide it by 1,000, resulting in $50 earnings per share (or EPS, as it is often called on Wall Street). You could also call a meeting of the company’s Board of Directors and decide whether you should use that money to pay out dividends, repurchase some stock, or expand the company by reinvesting in the retail store.
At some point, you may decide you want to sell your shares of the family retailer. If the company is large enough, you could have an initial public offering, or IPO, allowing you to sell your stock on a stock exchange or the over-the-counter market.
In fact, that is precisely what happens when you buy or sell shares of a company through a stock broker. You are telling the market you are interested in acquiring or selling shares of a certain company, Wall Street matches you up with someone willing to take the other side of the trade, and takes fees and commissions for doing it. Alternatively, shares of stock could be issued to raise millions, or even billions, of dollars for expansion. To provide a real-world, historical illustration, when Sam Walton formed Wal-Mart Stores, Inc., the initial public offering that resulted from him selling newly created shares of stock in his company gave him enough cash to pay off most of his debt and fund Wal-Mart’s nationwide expansion.
To use another example, let’s talk about the world’s largest restaurant chain, McDonald’s Corporation. Years ago, McDonald’s Corporation had divided itself into 1,079,186,614 shares of common stock. During one year of operation, the company had earned net income of $4,176,452,196.18, so management took that profit and divided it by the shares outstanding, resulting in earnings per share of $3.87.
Of that, the company’s Board of Directors voted to pay $2.20 out in the form of a cash dividend, leaving $1.67 per share for the company to devote to other causes such as expansion, debt reduction, share repurchases, or whatever else it decided was necessary to produce a good return for its owners, the stockholders.
At that time, the stock price of McDonald’s was $61.66 per share. The stock market was, and is, nothing more than an auction. Individual men and women working on behalf of themselves and institutions are making decisions with their own money and their institution’s money in a real-time auction. If someone wanted to sell their shares of McDonald’s and there were no buyers at $61.66, the price would have had to continually fall until someone else stepped in and placed a buy order with their broker. If investors thought McDonald’s was going to grow its profits faster than other companies relative to the price they had to pay for that ownership stake, they most likely would be willing to bid up the price of the stock. Likewise, if a large investor were to dump his or her shares on the market, the supply could temporarily overwhelm the demand and drive the stock price lower.
As of April 2017, McDonald’s stock price is $140.87 per share. The reason investors are willing to pay more for it is because management has done a good job of increasing profits and raising dividends. Thanks to the introduction of all-day breakfast and some other initiatives, the world’s largest restaurant earns $5.44 per share after taxes, not $3.87. It sends out $3.76 in per-share cash dividends to owners, not $2.20. Under most probabilistic scenarios, no matter what the stock market does in the short term — whether it be bidding McDonald’s shares up to $200 each, or down to $50 each — ultimately, the experience you are going to have as an owner is tied to the earnings and dividend figures, absent some extraordinary circumstances. If the business, the actual operating company, keeps pumping out more and more cash, and sending more and more of that cash to you, whether it is undervalued or overvalued at any given price doesn’t mean a whole lot to a long-term owner except in the most extreme situations.
How Does an Investor Actually Make Money By Owning Stocks?
If you are an outside, passive stockholder, there are only three ways you can profit from your investment under ordinary circumstances. You can collect cash dividends that are sent to you for your part of any profits generated by the company; you can enjoy any increase in the intrinsic value per share; or you can realize a profit from the change in valuation applied to the firm’s earnings or other assets. Combined, this concept is represented by something known as an investment’s total return.
How Can Someone Invest in Stocks?
Once you’ve decided that you want to own stocks, the next step is to learn how to begin buying them. It’s best to think of stocks as being acquired through one of a handful of ways:
Investing through a 401(k) plan or, if you work for a non-profit, a 403(b) plan
Investing through a Traditional IRA, Roth IRA, SIMPLE IRA or SEP-IRA account
Investing through a direct stock purchase plan or dividend reinvestment plan (DRIP)
How you actually acquire the stocks will depend on the account through which you are making the acquisition. For example, in a taxable brokerage account, Traditional IRA, or Roth IRA, you can actually have your stock broker buy shares of whatever company or companies you want, provided the stock is publicly traded and not privately held. That is, you could decide to become an owner of The Coca-Cola Company by specifically depositing cash and having that cash used to complete a trade. On the other hand, many retirement plans, such as 401(k) accounts, only let you invest in mutual funds or index funds. Those mutual funds and index funds, in turn, invest in stocks, so it’s really only an intermediary mechanism; a legal structure in the middle that is holding your stocks for you.
That decision — whether to hold stocks yourself or whether to do it through a middleman such as an index fund — is a much more expansive topic for another day. The short version: While index funds can be a great choice under the right circumstances for the right investor, they are not a type of investment, as they are still just a collection of individual stocks. Instead of you choosing your stocks yourself, or hiring an asset management company to do it for you, you are outsourcing the task to a committee of men and women who work for one of a handful of Wall Street institutions. It’s all individual stocks. That’s it. That’s the bottom line. You cannot get away from that economic foundation.
On that note, if you decide to select your own stock holdings, how do you determine which ones make it into your portfolio?
Deciding Which Stocks Might Be Worth Owning
Determining which stocks you want to hold in an investment portfolio is going to depend upon numerous factors. It is a common error for beginners to think that the objective of any given stock portfolio is to maximize absolute return; in some cases, it might be to attempt to achieve satisfactory returns while minimizing risk, while in other cases, it might be to attempt to increase cash income by focusing on higher-than-average-yielding securities, such as blue-chip stocks with rich dividends.
As a steadfast believer in a philosophy known as value investing, I spend most of my day looking for companies that have one or more of a handful of characteristics. These characteristics might include things such as:
Stocks of businesses that possess a long, established history of sustained or increasing profitability through an entire business cycle, which includes at least one recession.
Stocks of businesses that have a shareholder-friendly management and Board of Directors willing to return excess capital to owners through ever-increasing dividends and share repurchases. (A share repurchase program is when a company buys back its own stock, reducing the total shares outstanding. This means future profits and losses are divided among fewer shares.)
Stocks of businesses that have high returns on tangible capital (meaning it doesn’t take a lot of investment in property, plant, and equipment, or large amounts of restricted working capital, to generate a dollar of earnings).
Stocks of businesses that have some sort of significant competitive advantage that makes it difficult for competitors to unseat the enterprises.
Stocks of businesses that are trading at cyclically-adjusted low p/e ratios, PEG ratios, and/or dividend-adjusted PEG ratios.
We then look at how different stocks fit together as part of an overall portfolio. You wouldn’t want all of your money in, say, banking or industrial manufacturing. Rather, you want to look for ways to attempt to offset things like correlated risk.
What Is the Ultimate Goal of Investing in Stocks?
Wise investors understand that the end game for most owners of stocks is to end up with a collection of wonderful businesses that throw off large gushers of cash they can use to enjoy their life. In fact, I’d go so far as to argue that a truly great investment in stocks is not a company you buy at one price and quickly sell at another, hoping for an outsized profit in a short amount of time; but, rather, one that you can buy and then sit on for 25+ years as the underlying earnings per share continue to grow towards the sky even while the stock price itself is volatile.
That is precisely what happens when you hear stories of people like Anne Scheiber, a retired IRS agent who amasses tens of millions of dollars from her apartment by spending her free time studying and analyzing stocks, which she then acquired and sat on for decades. I’ve done numerous case studies of these secret millionaires; janitor Ronald Read with his $8 million fortune, Lewis David Zagor with his $18 million fortune, Jack MacDonald with his $188 million fortune. Over and over again, the same pattern emerges: It was rarely a case of luck. Instead, these people loved spending their free time finding businesses they wanted to acquire — businesses that many people would consider to be boring, but that had real sales with real profits.
And importantly, these were not investments that were going to make them rich overnight. They bought them and locked them away, letting time do the heavy lifting while making sure to never put too much of their personal net worth in a single enterprise. That way, if one or more failed, the compounding machine they built kept churning out increases in intrinsic value.
It’s a wonderful feeling. Through my family’s investment holdings, we are indirectly enjoying the fruits from the companies we own selling jet engines, insurance policies, chocolate bars, automobiles, coffee, tea, soda, hot cocoa, elevators, escalators, doughnuts, ice cream, oil, natural gas, mortgages, credit cards, student loans, athletic shoes, automobile parks, whiskey, vodka, wind turbines, lumber, diamond rings, watches, freight and logistic services, spices, pharmaceuticals, and much, much more. Even though it’s unlikely you’ve ever met us, you can hardly live or work anywhere in the developed world without somehow putting cash into our pockets.
That is the power of investing in stocks.
Note: Any specific stocks mentioned here are solely for illustrative purposes and not a recommendation to buy or sell any specific security. You need to talk with your own qualified advisers to determine if an investment is right for your unique circumstances, risk tolerance, needs, and preferences.