Tuesday, September 14, 2010

5 Beginner Misconceptions About Stocks

There are a lot of misconceptions about what it means to own a stock and how the market works, so in this post I'm going to debunk 5 of the most common ones.

1) If you own a stock, you own part of the underlying company.

This is the biggest bubble we need to burst, so let's get to it right away. As someone who's just starting out, never forget that a stock is a piece of paper with an arbitrary value assigned to it. Furthermore, nowadays with electronic trading, you don't even get the piece of paper! To be fair, a stock gives you a piece of the action when/if everything goes well. This may come in the form of a higher dividend, a buyout that drives the price of the stock up, or simply a higher number of people wanting to buy it. When things go bad, however, the company goes bankrupt or is sold for dirt cheap, you own nothing, and you're entitled to nothing. Some people think that in this case the company owes them for owning its stock. In fact, it is much more likely that someone else will take whatever little belongs to you. Never forget that.

2) If a stock costs more, it is more expensive.

This falls under financial analysis and look for a dedicated post to explain it thoroughly, but for now think about this: the price of a stock is affected by how much the company earned over the last year, and how much people are expecting it to earn in the next (As you might have guessed, forecasting is a huge ordeal in the stock market). To buy into this kind of growth, people will pay a premium that varies with each company. Some stocks are just more attractive, more reliable, more promising, 'hotter', it's a mentality that's not too different from clothing, for example. Since the earnings and this premium vary for every single stock, Wall Street is the only place where a stock trading at $200 might actually be a better bargain than one trading at $80! This is not always true, but it happens more often that you might think. As I said, I will talk about this more specifically in the near future.

3) Tech is the best sector to invest in.

I guess you could replace Tech with any single sector, and I'm not exactly sure why it is Tech that gets most of the attention, but I've seen a lot of friends own nothing but Apple, Google, Oracle, Cisco, Intel, and maybe a VoIP company and think they're diversified. Everyone seems to want to make a killing in Tech, and let me tell you, it's not going to happen. Yes, you can hit the occasional home run if you end up owning everything across the board, but once things go bad in a specific sector (and they will, they always do), your only saving grace will be that none of the stocks you own can go below zero.

4) If business is good, the stock will go up.

This is partially true, but it is also the reason that companies like AMD have a stock that's pretty much trash in the face of decent action. Stocks are affected by much more than how well the company is doing. You have to remember that a company can do well, but if nobody is buying the stock, the price won't budge, or even worse it'll go down. At the same time, people might be willing to pay more for a certain stock, but if nobody is selling, the price won't move. This can come in handy when the general public is shying away from a perfectly fine stock, or one that you know is going to do well in the upcoming reports. It happens very rarely, but when it does it's a good way to make some cash on the side. For now, remember that the change in supply and demand is the main catalyst for a price move. It might happen *because* of some piece of news or unexpected event, but unless you see this change in buying and selling, no piece of news on its own will change the price of a stock.

5) Speculating is bad. Buy and hold is the way to go.

I would suggest the buy and hold strategy if you plan on buying some big conglomerates that pay dividend (General Electric, Altria, Dupont, Pfizer, etc.), as long as you plan to reinvest that dividend into the company. The compound effect of this process alone can get you pretty far. I also think, however, that everyone should set aside a little bit of money for the speculative plays, maybe 10-20% of their total working capital. Look at it as a calculated risk, where you can allow to lose some money, with a bit of downside (potential loss) but with a huge upside (potential gain). If you're really unsure about what to do, put this 20% in gold. It'll cushion your fall when things go bad.

Why Companies Enter The Stock Market

Before we get to stock analysis and what makes a stock go up or down in price, let's look at why a company would want to be traded in the first place. There must be a reason if thousands of companies want a piece of the daily action.

The way it normally begins is that someone owns a business that is well off financially, either at the moment or is setting up good returns in the near future. The company's doing ok, but more money is needed to take it to the next level.

The amount of money that the owner wants to raise is far above what regular people like you and me could offer. This is where Venture Capitalists (VCs) come in. VCs earn their living exactly fronting money (capital) to young and upcoming companies (ventures) in exchange for part ownership. Don't be fooled though, it is hardly a friendly donation. Further down the line, VCs expect their stake in the company they financed to be worth more than what they paid for it. If the owner of the company is in it for the enterprise, VCs are in it for the payoff.

There might be a second round of financing from other, publicly traded companies, maybe companies that work in the same field as the business being financed. The point is, most if not all of these organizations will want a chunk of the company they put their money in. Up until now, this was all in the hands of the founders: they went around making the presentations and phone calls to look for outside investors.

To mediate the distribution of ownership that's part of the deal, an investment firm will come in and help in a process called IPO (initial public offering). The firm will look at the company's finances, the outside financing it received and the general interest it could drum up once it goes public (that is, starts trading in the market). Once the value of the company is estimated, it is divided among an arbitrary amount of shares, normally in the millions.

So, for example, someone at Company XYZ has received money from VCs and another company that's already trading publicly. XYZ hires Goldman Sachs to overlook their IPO. GS decides, after doing their research, that XYZ is worth $250M, and decides that ownership will be divided among 20M shares at $12.50 each. However, there is no reason why they shouldn't pick 50M shares at $5 or 250M at $1. That's just part of the analysis. Furthermore, it is decided how many of the total shares are for the original investors, and how many will 'float' to the public and will be available for trading the moment XYZ hits the Stock Exchange. With 20M total shares, this might be in the ratio of 15M private and 5M floating. Once again, no reason why these ratios shouldn't be different. It is normal, however, to see the bigger chunk go to the original investors.

Let's keep with the 20M shares at $12.50 each. Company XYZ, at this point, needs to slice up the private 15M among the founders and the investors that asked for a piece of the company back when they financed operations. Based on the money that was fronted to value the company at $250M, the process of subdivision starts with 100% of the ownership split equally among founders, who then have to give up a proportionate amount to the VCs and other investors. This normally causes the founders to end up with a stake that's about 10-20% of the total, which might not seem like much, but value wise it is more than what they started with.

The last step is for the investment firm to fly around and stir up demand on this new, upcoming stock. This entails writing up what the company does and how well off it is doing financially. Sometimes the company is already well known and demand will already be high without the need of a prospect, but it is required by law along with a long list of disclaimers as to why you shouldn't buy the company. Pretty crazy, I know, but that's just how it is.

A second pricing is set after demand has been generated, and once the shares go public, the company has little to do with the shares for the rest of its existence. The original investors must wait 18 months before they can start selling the shares they had since day 1, and little by little (due to limitations on how much you can sell at once), the founders, VCs and other investors will be putting back their shares into the market, hopefully for a hefty profit.