How to Invest in the Stock Market – The Ultimate Beginners Guide
This blog is written to equip you with all the knowledge you’ll need to invest in high quality companies in the stock market. Everything you need you need step by step to buy and profit from high quality shares is laid out step by step for free in a series of blogs on this site and it all starts with this guide !
This blog is written to equip you with all the knowledge you’ll need to invest in high quality companies in the stock market … from the opening of an online trading account through to company evaluation, company selection for your investment account, income generating strategies, timing entry and exit decisions and investment capital protection techniques (which isn’t nearly as complicated as it might sound, and I’ll explain all the ins and outs of each stage as we come to it).
I will give you access and full training in using my personal way to evaluate the fundamentals of almost any company which you may be considering for an investment. I will also show you how to use a tool called ‘charting’ to easily identify the optimum times to either buy or sell your shares so that you buy them cheap and sell them at the highest prices possible. I’m also going to reveal one of the biggest secrets of investing and show you how to ‘rent out’ your shares for an additional income using a special market called the options market.
I will teach everything you need to know about the opportunities and risks of investing and trading in shares and options. I will show you exactly how I invest and how to protect your assets. This will help you achieve your goal whether that is ultimate financial freedom or to simply take control and earn healthy returns on yourinvestments.
Renting out shares you own for a weekly profit is Investings ‘Best Kept Secret’
Revealing Investings best kept secret
I will teach you about the ‘Best Kept Secret’ in the stock market,
namely, how to collect a monthly rent from your shares (much easier than collecting rent from property and no troublesome tenants to deal with either!). Quite shockingly, most high street brokers know little if anything about this secret. But before we delve into the detailed education material, let’s first discuss some basic financial education and concepts…
Why do people wish to invest?
Before we get down to the nitty gritty, it is important to consider some basic financial concepts. The idea behind investing to make a return or an income is easy to understand for most people. If you invest £10,000 and earn a 15% return on your investment this means you have earned a return of £1,500.
Multiple Income Streams is the Key to My Success
I strongly believe everyone should have multiple income streams so as to avoid being dependent on just one single source of income. For example, think of those who worked all their lives but when the financial crisis struck many lost their jobs, which was for most their only income source. Suddenly their homes were at risk of being repossessed by the banks as they could not pay their mortgages. The problem for most employees is they are only one pay cheque away from being financially broke.
Golden Eggs not One Golden Goose
It is only sensible to invest in assets which can earn you passive income or an alternative source of income. Passive income means you do not need to exchange your time for money, so no clocking in for work every day for seven hours or more five days a week.
Having a passive income means putting your assets to work for you.
Many retired people live from the income generated from their investment assets. The aim of course is not to use up the investment pot. We do not need to kill the proverbial ‘Golden Goose’ … instead we simply live off the income earned i.e. the ‘Golden Eggs’.
We all have individual reasons for wishing to invest. Maybe you wish to be in a position to provide a better quality of life for you and your family, or even be able to support your parents should they need professional care when they are elderly.
Whatever your reason … I will teach you exactly how to select stock market assets which can earn you the passive income we all desire.
Financial Independence (i.e. Financial Freedom)
I want you to expand on the basic concept above and to really think about what you wish to achieve from your investments. I encourage everyone I meet to aim for financial freedom. This is described as a position where your investments or assets are generating sufficient income to cover your living expenses. When you reach this stage you can decide whether or not to continue to work. There is no doubt your quality of life will improve enormously if you can apply yourself to the achievement of this goal.
Maybe you wish to retire early, or ensure you earn sufficient income passively from your assets without having to go to work every day! Everyone can have different motivations.
Like all good things, however, you must design a plan or a roadmap to success to follow to reach your goal(s). We have all heard the expression ‘Fail to Plan, Prepare to Fail’ … so to help you form your plan there are a few basic steps you need to take.
To help you achieve financial freedom I strongly urge you to firstly analyse your current personal financial situation.
Try out the following exercise for your own specific situation:
1. Identify your monthly income stream(s)
2. What is your monthly spending – split this between normal living costs,
savings, personal development/training, charity, treats and investment. See
broad guidelines below.
3. What are your assets? These need to be increasing over time.
4. What are your liabilities or debts? These should decrease over time.
You cannot plan get where you want to be in the future without knowing where you are TODAY
The four items above need to be fully explored so you are clear of the current position. The central idea is to increase your holdings of assets which earn you a passive income stream. This can often involve difficult decisions such as near term spending cuts to boost your investment pot … especially in the early days of your investment journey.
How Much Do You Have to Invest in Your Future ?
When I work with people at workshops it can show up some alarming issues. I often explore the idea that people are spending most of their income each month on simply getting by leaving little room for savings and investments.
I suggest everyone makes a conscious decision to move towards this plan with your monthly income:
Allocate 60% for day to day living costs
Allocate 10% for saving for contingencies or unexpected costs
Spend 5% on yourself and loved ones in the form of treats etc as a reward for your hard work. This is important so you develop a positive association with hard work and achievement.
Spend 5% on charity, giving to others. This helps you form a positive association with money. All too often people think negatively about money and feel the accumulation of wealth is not a worthwhile goal. However, think about all the good you can achieve if you are successful. Giving to others reinforces the positive aspects of successful investing.
Spend 5% on personal development, education or training to add skills to help further your success
Allocate 15% for contributions to your investment portfolio. You need to build up your assets to a level which can provide financial freedom.
If you find you are consistently spending too much which leaves too little to invest then you really need to explore ways to reduce your spending and/or increase your income.
Boosting Your Immediate Income so you have more to Invest for your Future
There is a superb blog here about lots of ways you can boost your immediate income.
People usually spend too much, no matter what they earn. It is usually the case that the higher your income – the flashier the car, the bigger the house, the more expensive the holidays … but there are exceptions to this rule. For instance, Warren Buffett (widely considered the most successful investor in the stock market) rarely changes his car or house. Instead he maximises the amount of capital he can add to his investment account each and every month. He has a plan and is driven to adhere to it.
Unfortunately people who consistently spend more than they earn will never become financially free. When you rely on a job for your only income you are generally one pay cheque away from being broke!
This ‘self exposure’ will help encourage you to cut your spending to maximise the amount you can invest each month. Not everyone has a
large capital or cash pot from which to start investing. Do not fret. Simply work out the maximum you can invest each month and start building your portfolio TODAY!
Compounding and Investing
This is really just a concept which refers to the fact you can earn even higher percentage returns on your initial investment capital if you reinvest your returns to acquire even more income generating assets. This really accelerates you along your roadmap to financial freedom. Depending on your personal financial situation and your age etc your ability to reinvest the income you generate from your investment assets will vary.
The key to massive growth is to NOT touch your profits and leave them to reinvest as well
Lets look at an example so you can get a better feel for just how much this turbo charges your wealth.
Modest returns each year of 12% on an initial lump sum of £10,000 will result in a whopping £300,000 in just thirty years. In simple terms that is averaging 100% per annum due to compounding.
Investing and Tax
As with all sources of income the more tax efficient your investment vehicle the quicker you will reach your goal of financial freedom. Tax reduces the amount of capital you have available to invest and hence reduces the compounding power of your investment portfolio.
While tax is outside the remit of this particular blog please feel free to talk to us about potential structures available which will help minimise taxation of your income.
How to Set a Target for Investment Returns
We need to set targets for the income we wish to earn from our financial investments. Typically targets are expressed as a percentage of our capital per year. When you consider the most successful investor in the world, Warren Buffett, typically earns 20% per year you will sense where you should set your targets. Of course there will be years he will earn higher than this but there are also years when he earns less.
A person who is new to investing in the stock market should set a target for returns from the stock market at 10-15% per annum. As you become more experienced and skilled you can set your targets closer to that of Warren Buffett. Walk before you try to run!
Earning 20% return on Your Shares Every Year Even if the Price Stays the Same
I will teach you how to earn up to 20% (sometimes more) from shares, even if their price remains flat for the full year!! I have no intention of teaching you how to make a fast buck. This usually involves high levels of risk taking for short term trades. This is often referred to as ‘day trading’, where over 90% of people lose money consistently.
Is Investing Hard Work?
You are probably getting the sense there is going to be some hard work required to achieve the financial goals you have just set for yourself. You are correct. Dedication and commitment are essential to achieve success – ask any successful footballer or businessman or woman! You will encounter setbacks along the way. Learn from the mistakes and experiences to enhance your knowledge and skills to improve performance in the future.
All the knowledge and skills you need to be a successful investor are here for free on my site
I will certainly be here to encourage you, share my knowledge with you and
crucially support you in your investment efforts.
In summary, practice, education, support and experience are all
required along your road to success especially in the beginning while you learn to earn. Do not be alarmed, it gets easier as you become more aware of your own style, goals and acquire the necessary skills and confidence to be successful. I just need you to be clear that success will not happen overnight (unless you hope to win the lotto). Hope is not a valid investment strategy though!
So what are the best shares to invest in ?
Now let’s explore how to choose which type of assets into which we should invest our hard earned money.
So What Exactly is Investing?
If you look in a dictionary, ‘Investing’ is defined as: to put (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.
However, it can be illustrated best with the help of some
Examples of Typical Investment Choices
Investors simply wish to earn an adequate return on their assets over time. Asset choices vary in both risk and return. Usually higher returns are only possible by choosing higher risk. This is often referred to as the risk reward trade-off. On the other hand very low risk assets will deliver very low returns and vice versa (e.g. US treasuries, government backed bonds).
Here are some investment examples:
A. Bank Deposits – These give a very low return on investment; hence a lot of capital is required to earn a sufficient income to become financially free. There is little capital risk unless the bank goes bust and the government guarantee limit is exceeded. Ask the unfortunate savers in Cypriot banks how safe their bank deposits turned out to be. Typical returns can be as low as 1% per year. Not enough to keep pace with inflation!! Some banks offer higher rates but impose restrictions on access.
B. Property (Buy to Let)
Property gives a modest yield on investment after costs such as interest and
running expenses are taken into account. The return is earned by purchasing the asset and collecting ONE income stream or rent (cash) from tenants. Property can be difficult and slow to sell, and can also be difficult to value fairly. It can also be time consuming to manage. Often, this type of investment is highly leveraged as most people will require a mortgage (i.e. debt!). Additionally, there are high transaction costs and investors find it can be very slow to cash in the investment (low liquidity).
Investments in property in the past decade have suffered significant losses
Unfortunately investors in property over the past decade have suffered
significant capital losses (negative equity). We will not go into Capital Gains(which are available from investments in both property & shares), as we expect to keep our assets working long term just like long term property investors. The value of the house or the share is not our main concern. Of course it is nice to see it rise but its price does not actually change the income yield we earn so in a sense it is not relevant unless we are short term holders who will need to cash in the investment at short notice.
C. Stock Market Investment
Shares are a highly liquid investment as they can be bought or sold online
immediately. Unlike property, there is no shortage of buyers or sellers. Real
time pricing is available at any time, which offers high transparency on asset valuation (again, unlike property). Shares offer an average return over the long term (including dividends) of 10% per annum after costs. If you think about this over a 10 year plan your typical high quality share can be owned for free if you earn 10% per year over 10 years (in a tax free account).
In these investment blogs , I will also teach you how to insure your assets in the stock market. This gives you a major advantage over property investment. Shares can be protected using options (see Covered Call and Put options later in a related blog.
With stock market investments, income returns are earned both from dividends and from collecting ‘rent’ online – all from the comfort of your home or even on your mobile device, phone or tablet! I will explain this in another blog.
Generating Income from Stocks and Shares
Stock market investment is a very low transaction cost enterprise compared to the costs involved in property investment. Additionally, multiple income
streams can be collected from shares. These blogs will teach you exactly how to do this.
Investing vs. Speculating
Some investors are cautious or conservative. Others are speculators and like to take big risks. Which are you?
A. Investing (high success rate)
Investing involves buying assets which have a sufficient current business,
earnings and cash flow to support the purchase price today. Investors plan to hold the asset long term, but the key is the numbers must make sense from Day 1! Capital appreciation will only be the ‘icing on the cake’. It is not our primary goal. We are focused on earning a cash flow income from all of our assets/shares.
Don’t Believe the Hype
B. Speculation (low success rate)
Speculating involves buying assets (shares or property) which do not yield
sufficient cash flow today to merit or justify the purchase price. Rather, the
purchase price is only deemed acceptable based on expectations that the price will head higher in the future either by expectations of further speculation byothers driving up demand and hence prices of the asset or by virtue of some expectation that the profits and hence future cash flows will increase significantly.
Speculators generally have no plan to hold the asset long term.
The housing bubbles of the past decade are great examples of people buying housing which would never deliver acceptable rental yields to provide an adequate profit above the interest expense and running costs of the property. This speculation resulted in massive over valuations and these bubbles always burst dramatically in the end.
US house prices fell over 50% in 4 years, while in Ireland house prices fell 60% in 3 years. The recovery is happening very slowly.
WHAT IS THE STOCK MARKET?
The stock market is simply a ‘place’ (usually online), for people to buy and sell shares in companies. Shares, or ‘stocks’ are categorised under Stock Indices.
The most popular US Stock Indices are :
Dow Jones 30 (DJ-30) – This is Stock Index of 30 of the major blue chip
American companies. It is weighted by price, and adjusted to take account ofstock splits to aid consistent comparisons over time.
Standard & Poor’s 500 (S&P 500) – This is a Stock Index of 500 top American companies. It is weighted by market capitalisation
NASDAQ Composite Index – tracks over 3,000 technology and growth stocks
listed on the Nasdaq Stock Market. It includes both US and non-US companies.
Russell 2000 Index – tracks the value of 2,000 small cap companies
Stocks trade on the exchanges with ticker symbols – usually 3 or 4 letters. For example, the technology company Apple trades under the ticker AAPL, while Microsoft trades as MSFT. Pharmaceutical company Pfizer trades under the ticker PFE.
In the UK, there is the FTSE index. In Ireland there is the ISEQ index.
You can buy and sell each index just as you would any shares.
Who Trades the Stock Market?
Institutional investors such as banks, insurance companies, hedge funds, and pension funds all trade the stock market and Retail or individual investors – like you and me.
The biggest market by far is the US stock market, although nearly all developed and developing countries have a stock market.
Most trading on the stock market is now done online.
Put a Tax Free Wrapper Round Your Investing
Investing in the stock market should be done in the most tax efficient manner that is available to you – for example, SIPPs, SSAPs, and Trusts etc. This ensures that you gain the maximum benefits from compounding.
Why does the Stock Market exist?
The primary purpose of the stock market is for companies to raise funds to invest in their business and grow their business. Companies do this by issuing shares in the company and then selling them to the public using Initial Public Offerings (I.P.O.). For example, Facebook (FB) was a very high profile IPO in 2012. A share represents a fraction of ownership in the company. Once shares are listed on a stock exchange they can be freely bought and sold by market participants.
Prices move every second of the trading day. Investors buy for two reasons: capital gains and income gains. I am often driven by the income potential from owning the shares. Capital gains are a bonus. Companies pay their owners (shareholders) an income when they pay dividends – these are income gains.
Companies also reward their owners (shareholders) when they grow the business profits and this raises the value of the company thereby increasing the share price (capital gains). Dividend paying stocks tend to outperform the price gains of non dividend paying stocks over the long term, as I’ll illustrate on the next page, and each investor must devise a plan for what they wish to achieve, and select their stocks accordingly.
In trading circles, these principles are called ‘Portfolio Design’ and ‘Allocation’ – I’ll explain these in more detail in another blog.
Why do people invest in the Stock Market?
Simply put people invest in the stock market to build a better future for
themselves and their family.
Successful investors have a plan and they research before investing.
The two sources of profits are capital gains and income gains. If you wish to invest your capital to earn a steady stream of passive income then you will most likely purchase dividend-paying stocks. There are many of these although the quality of each company will vary.
This chart illustrates clearly the importance of investing in good quality, regular and consistent dividend paying stocks.
However, most investors simply buy shares and hope to make a profit by selling them at a higher price in the future for capital gains.
Which method to use however is a choice each individual needs to make. It will depend on your chosen financial plan and goals, taking into account what target return you need to achieve your plan.
Financial freedom is achieved when the returns from your assets (investments) exceeds your living costs. This means you do not need a job!
I will teach you how to earn a second PASSIVE income stream on your stocks by collecting rent from your stocks … easily the Best Kept Secret in the Stock Market!
The Stock Market Always Outperforms Property in the Long Term
It’s an interesting point that stock prices tend to recover much faster than
property after a price crash. The stock market crashed in late 2008 early 2009 and just over 3 years later it had risen to new all time high prices. Additionally, ‘Buy to Let’ properties actually cost you money when they are vacant.
People often view investing in the Stock Market as ‘risky’, but in reality it’s likely to be much more sensible that investing in property especially over the long run. Property prices in the UK are still down over 50% following the bust unlike the stock market which has fully recovered.
Shares with Dividends and Options payouts
When you build a share portfolio you will collect income through dividends and options. Dividends are payable no matter what the share price. Options will provide higher income returns the higher your share price. Options are explained in detail later in another blog here.
At times the shares you have bought will be lower in value than what you paid for them. However, assuming you have invested in quality stocks at reasonable prices, there is no need to panic. With a diversified portfolio the probability of any one or two shares going down leading to a significant loss in your overall account value is greatly reduced which is why it’s so important to diversify.
Another advantage of a diversified portfolio is that you will be unfortunate should you find yourself unable to collect rent on your shares in any particular month.
Think of it like buying a hotel – sometimes there will be big demand for your rooms and people will pay high prices. You will therefore collect high rents on most of your rooms. At other times the rent rates will be low and you will have fewer rooms rented.
The value of the hotel goes up and down but you can always collect rent or
income (and dividends)! Buy-to-let investors don’t check the value of the house every day! It is not important because they have invested for the yield. So don’t get over-excited about the current market value or liquidation value of your stock portfolio in the early years as you build your portfolio.
Trade the plan.
Keep collecting your income streams.
Skills for Successful Stock Market Investing
My blogs will cover all the skills below:
1. Online Trading – how to open a stock trading account and how to trade online
2. How to Select Top Quality Companies – Fundamental Analysis using my Stock Selecting Checklist which will help you rate and identify top quality
3. How to Generate Regular Monthly Income from your Shares (assets) – Rent.
4. Capital Protection Techniques – ‘Insurance’ : how to protect your assets from downside moves in the market.
5. Stock Price Patterns and Investor Emotions – we use Technical Analysis or charting to compliment our fundamental analysis.
6. Portfolio Design – What are YOUR Personal Objectives? How do you build a portfolio?
7. Goal Setting – Financial Freedom Plan (see earlier section)
In this manual, I am passing on the huge benefit of y experiences in the
markets over the past 10 years. This has taught me many lessons (sometimes very expensive ones!).
Please pay close attention to these blogs and you can achieve financial freedom while saving yourself from costly mistakes.
Education is essential to become a successful investor. Invest in yourself first!
Efficient Markets Theory of Investing
The Theory of Efficient Markets assumes that current share prices represent a full appreciation of all publicly available information. Hence it concludes it is not possible to earn above average returns. In this case any movement in prices will only occur if some new information is released which impacts the earnings potential of the company.
However, we often see situations of extreme behaviour in prices when stock markets move too high as in the Tech Dot Com bubble back in 2000 or too low as the 1987 crash and the 2008 financial crisis. This is caused by the emotions of investors who often simply over-react.
The key point to remember is that the stock market does tend to recover to
reasonable valuations over time.
Do not panic if you are in a crisis low price stage as that is the point of maximum financial loss should you sell at that stage. So don’t do that!
How to Buy Low and Sell High In Stock Market Investing
The rule of thumb is to buy LOW and sell HIGH. Not vice versa! When there is panic in the markets there are few buyers but many sellers and hence prices drop lower. Basic supply and demand rules apply to the price of shares just like any other asset or product. Irrational behaviour in the markets is common and presents opportunities to well informed investors.
Remember the price of a share is more affected by expectations of the company’s future performance than by its historic performance.
It’s important that you treat Stock Market investing as if it were your business. Most successful businesspeople Plan their Trade and Trade their Plan. They also have a backup plan otherwise known as a Plan B. This is discussed in more detail in a later blog post.
The Psychology of Trading
Figure 4. Typical Investor Emotions
It will take some effort – you need to do the research before opening positions and then monitor & maintain those positions once they are opened. You will need to fit your research in around your personal daily schedule. Some multi- tasking may be required!
Now, we know that most people do not like the thought of research, which is why I have designed a system to help you research efficiently so you do not waste your valuable time. We’ve called the system our ‘Stock Selection Model’
What type of investment style are you ?
There are several ways to approach stock investing. Choose the option below that best represents your situation:
- “I’m the DIY type and am interested in choosing stocks and stock funds for myself.” Keep reading; this article breaks down things hands-on investors need to know. Or, if you already know the stock-buying game and just need a brokerage, see our roundup of the best online stock brokers.
- “I know stocks can be a great investment, but I’d like someone to manage the process for me.” You may be a good candidate for a robo-advisor, a service that offers low-cost investment management. Virtually all of the major brokerage firms offer these services, which invest your money for you based on your specific goals. See our top picks for robo-advisors.
Once you have a preference in mind, you’re ready to shop for an account.
The Difference Between Stocks and Stock Mutual Funds
Stock investing doesn’t have to be complicated. For most people, stock market investing means choosing among these two investment types:
- Stock mutual funds or exchange-traded funds. These mutual funds let you purchase small pieces of many different stocks in a single transaction. Index funds and ETFs are a kind of mutual fund that track an index; for example, a Standard & Poor’s 500 fund replicates that index by buying the stock of the companies in it. When you invest in a fund, you also own small pieces of each of those companies. You can put several funds together to build a diversified portfolio. Note that stock mutual funds are also sometimes called equity mutual funds.
- Individual stocks. If you’re after a specific company, you can buy a single share or a few shares as a way to dip your toe into the stock-trading waters. Building a diversified portfolio out of many individual stocks is possible, but it takes a significant investment.
The upside of stock mutual funds is that they are inherently diversified, which lessens your risk. But they’re unlikely to rise in meteoric fashion as some individual stocks might. The upside of individual stocks is that a wise pick can pay off handsomely, but the odds that any individual stock will make you rich are exceedingly slim.
For the vast majority of investors — particularly those who are investing their retirement savings — building a portfolio composed primarily of mutual funds is the clear choice. (New to this? Read more about how to build a good investment portfolio.)
Understand that for both beginning investors and seasoned stock market pros, it’s impossible to always buy and sell the best stocks at exactly the right time. But also understand that you don’t have to be right every time to make money. You just need to learn some basic rules for how to identify the best stocks to watch, the ideal time to buy them, and when to sell stocks to lock in your profits or quickly cut any losses. My series of blogs here will show you all these skills.
How To Invest In Stocks: How To Time The Stock Market
Most Wall Street pundits will tell you it’s impossible to time the stock market. While it’s unrealistic to think you’ll get in at the very bottom and out at the very top of a market cycle, there are ways to spot major changes in market trends as they emerge. And by spotting those changes, you can position yourself to capture solid profits in a new market uptrend and keep the bulk of those gains when the market eventually enters a downturn.
The recent market turbulence has reinforced the importance of this approach. The stock market has gone through each of the three possible stages in recent months: market in confirmed uptrend, uptrend under pressure and market in correction. To stay protected throughout these changes, follow the No. 1 rule of investing: Always cut your losses short. While you can’t control what the stock market does, this basic rule lets you control how you react.
Know When to Sell Stocks
Beginning investors often spend more time focusing on which stocks to buy and ignore the equally — if not more — important issue of when to sell. Big mistake! Without a sound set of sell rules, you may end up giving back all of your hard-earned gains or, even worse, taking a larger-than-necessary loss.
There are essentially two types of sell rules: offensive rules for locking in your profits, and defensive rules for cutting short any losses. To make, keep and compound your stock market profits, it’s crucial that you learn to use both types of sell rules.
So What is a Stock
Have you ever asked yourself, “What is stock?” or wondered why shares of stock exist? This introduction to the world of investing in stocks will provide answers to those questions and show you just how simple Wall Street really is. It may turn out to be one of the most important articles you’ve ever read if you don’t understand what stocks represent.
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 taxable brokerage 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.
Why Do stock prices fluctuate?
Ask anyone about the stock market and it’s clear that almost everyone can agree on one thing: the prices of stock fluctuate frequently, increasing and decreasing in value sometimes by shocking amounts in a single trading day.
Why do stock prices fluctuate? Who or what is causing them? Those are great questions and most often asked by novice investors. To help you understand, I’m going to give you a basic overview of some of the forces that cause this volatility. Some of this will be a bit of an oversimplification but by the time you’re done reading it, you’ll know a lot more than the general public about the way the stock market works and how stock prices are set.
The Stock Market is an Auction
First, realize that the stock market is basically an auction, with one party wanting to sell its ownership, and one party wanting to buy ownership. When the two agree upon a price, the trade is matched and that becomes the new market quotation. These buyers and sellers can be individuals, corporations, institutions, governments, or asset management companies that are managing money for private clients, mutual funds, index funds, or pension plans. In many cases, you won’t have any idea who is on the other side of the trade.
Because the stock market functions like an auction, when there are more buyers than there are sellers, the price has to adapt or no trades are made. This tends to drive the price upwards, increasing the market quotation at which investors can sell their shares, enticing investors who had previously not been interested in selling to sell. On the other hand, when sellers outnumber buyers, there is a rush to dump stock and whoever is willing to take the lowest bid sets the price resulting in a race-to-the-bottom.
This can be a problem, particularly during periods like the collapse of 2007-2009 because firms such as Lehman Brothers were forced to dump anything and everything they could to try and raise cash. This flooded the market with securities that were worth far more to a long-term buyer than the price at which Lehman was willing to sell.
What Influences Buyer and Sellers
On a typical day, the value of shares of stock don’t move much. You’ll see prices go up and down by a percentage point or two with occasional larger swings. On most days, investors choose to buy or sell shares based on their evaluation of the company’s balance sheet, and their overall impression of whether a company is fairly priced. But sometimes, events can occur to cause shares to rise or fall sharply. It could be an earnings report that shows good or bad financial news. It may be a major financial news event, like an interest rate hike.
It could even be a natural disaster, such as a hurricane.
There are a myriad of factors that can cause the relationship between buyers and sellers to change.
In some cases, stock prices fluctuate because a requisite percentage of money flows in the market at any given time aren’t taking a long-term view of an enterprise. An illustration I used was the equity valuation assigned to renowned jeweler Tiffany & Company. The volatility of Tiffany’s share price years ago when I originally wrote this article was entirely unwarranted by the long-term value of the firm. First, hedge funds pushed the price far beyond what any conservative buyer would want to pay and when it looked like the world might struggle for a bit, dumped it, driving it down below what the same conservative investors might want to pay.
This volatility can cause the journey to be rough but that is the reason it is important to have a diversified portfolio and focus on the look-through earnings.
Stock MArket Capitalisation
A company’s stock market capitalization is an important concept that every investor should understand. Although market capitalization is often discussed on the nightly news and used in financial textbooks, you may not know how stock market capitalization is calculated. You may also be confused as to how it differs from or how it differs from the figures that arise in discussions of mergers and acquisitions. In the next few moments, I’m going to help change that.
The Definition of Stock Market Capitalization
Put simply, stock market capitalization is the amount of money it would cost if you were to buy every single share of stock a company had issued at the then-current market price.
How to Calculate Stock Market Capitalization
The formula for calculating stock market capitalization is as simple as it sounds. There are no tricks or weird quirks to consider. It’s this straightforward:
Stock Market Capitalization = Current Shares Outstanding x Current Stock Market Price.
Real-World Examples of How to Calculate Stock Market Capitalization
As of July 31, 2018, The Coca-Cola Company [NYSE: KO] has 4,252,922,000 shares of stock outstanding and the stock traded at $46 per share. If you wanted to buy every single share of Coca-Cola stock in the world, it would cost you 4,252,922,000 shares x $46 = $195,634,412,000. That is more than $195 billion. On Wall Street, people would have referred to Coca-Cola’s market capitalization as $195 billion.
The Strengths and Weaknesses of Stock Market Capitalization
Stock market capitalization can allow investors to understand the relative size of one company versus another, ignoring specifics about capital structure that cause the share price of one firm to be higher than another firm. For example, compare Coca-Cola at $46 per share with retailer Netflix at $341 per share. Despite having an exponentially larger share price, the latter has a stock market capitalization of $161 billion, more than $30 billion smaller than Coke’s.
On the flip side, stock market capitalization is limited in what it can tell you. The biggest downfall of this particular metric is that it does not factor into consideration a company’s debt. Consider Coca-Cola once more. The company has around $27 billion in liabilities that, were you to buy the entire business, you would be responsible for servicing and repaying. That means, while Coke’s stock market capitalization is $195 billion, it’s enterprise value is $222 billion because, simplified and all else equal, the latter figure is what you would need to not only buy all of the common stock but pay off all the debt, too.
Another major weakness of using stock market capitalization as a proxy for a company’s performance is that it does not factor in distributions such as spin-offs, split-offs, or dividends, which are extremely important in calculating a concept known as total return. It seems strange to many new investors, but total return can result in an investor making money even if the company itself goes bankrupt. For one historical example, look at the long-term performance of the collapse of Eastman Kodak. Aside from dividends collected over the years, the owners ended up with shares of a chemical company, so the fact market capitalization went to zero didn’t mean they necessarily lost everything.
Using Market Capitalization to Build a Portfolio
Many professional investors divide their portfolio by market capitalization size. These investors do this because they believe that it allows them to take advantage of the fact smaller companies have historically grown faster but larger companies have more stability and pay fatter dividends.
Here is a breakdown of the type of market capitalization categories you are likely to see referenced when you begin investing. The exact definitions tend to be a bit fuzzy around the edges, but this is a pretty good guideline.
- Micro Cap: The term micro cap refers to a company with a stock market capitalization of less than $250 million.
- Small Cap: The term small cap refers to a company with a stock market capitalization of $250 million to $2 billion.
- Mid Cap: The term mid cap refers to a company with a stock market capitalization of $2 billion to $10 billion.
- Large Cap: The term large cap refers to a company with a stock market capitalization of $10 billion to $100 billion.
- Mega Cap: The term mega cap refers to a company with a stock market capitalization of more than $100 billion.
Again, be sure to check the specifics when using these definitions. For example, a person might refer to a company with a stock market capitalization of $5 billion as being large cap under certain circumstances.
So What is a Stock SPlit ?
When you begin to invest in stocks, you will someday encounter something known as a stock split. New and inexperienced investors tend to mistakenly believe stock splits are inherently a good thing in and of themselves, as if a stock split alone somehow makes them wealthier, which simply isn’t true. A stock split is nothing more than an accounting transaction designed to make the nominal quoted market value of shares more affordable. In the case of something like a 2-for-1 stock split, it’s economically akin to walking into a bank and exchanging a $20 bill for two $10 bills.
You still have exactly what you did before it occurred despite it being measured differently. Here’s an overview of what stock splits are, how they happen, what purpose they are intended to serve, and how you should feel about them.
What Is a Stock Split?
When a corporation’s common equity is divided into pieces, these pieces are known as shares of common stock. Let’s imagine you start a lemonade stand. You capitalize the business by having your newly formed enterprise issue 100 shares of stock for $100 per share. This gives the business $10,000 in start-up capital: capital used to buy ingredients, lease a little space in the nearest shopping mall, pay for signage and hire your first employee.
Your lemonade stand does extraordinarily well, and before long, you expand it into a line of fruit juices. You open additional locations. You franchise the concept and are suddenly collecting royalties on hundreds of units throughout the world. Ten years later, you find your company generating operating income of $1,000,000 per year. At a reasonable valuation rate, and with your current growth trajectory, you might be worth $12,000,000 should you decide to sell it. You’ve never issued more stock so each of those 100 shares, which represent 1/100th ownership of the business, or 1 percent, are really worth $120,000 despite having $100 in original paid-in capital and capital contributed in excess of par behind it.
You have five children to whom you want to gift shares; however, you don’t want to give each of them a full share worth $120,000, in part because it would exceed the annual gift tax exclusion allowance. Instead, you call a meeting of the board of directors and decide to declare a 10-for-1 stock split. In essence, the corporate decides to divide itself into more pieces and sends out the newly issued shares as a type of special dividend to the existing owners in proportion with their ownership of the firm.
By the time it is all done, for every one share you owned before the stock split, you will own 10 shares after the stock split (hence the “10-for-1” part). In this case, you’d get freshly printed stock certificates for 900 new shares, bringing your total to 1,000 shares, which represents 100 percent of the company’s outstanding stock.
The business is still worth $12,000,000. However, it is divided into 1,000 shares. That means each share is worth 1/1,000th of the company, or 0.10 percent, which works out to $12,000. Each share’s original paid in capital and capital in excess of par value is $10, since that was adjusted, too.
You gift one share of the post-split stock to each of your 5 children, keeping the other 995 shares for yourself.
Publicly traded companies, including multi-billion dollar blue chip stocks, do this all the time. The firms grow in value thanks to acquisitions, new product launches and share repurchases. At some point, the quoted market value of the stock becomes too expensive for investors to afford, which begins to influence the market liquidity as there are fewer and fewer people capable of buying a share.
The most extreme example in history is Warren Buffett’s holding company, Berkshire Hathaway. When Buffett began buying the stock to take control back in the 1960’s, he paid $8 or less for some of his shares. He never split the stock. In the past year, those shares have traded between $186,900 and $227,450 each, far outside of the realm of a vast majority of investors in the United States and, indeed, world. Instead, he eventually created a special Class B shares and called the original shares Class A.
This is an example of a dual-class structure. The B shares originally began at 1/30th of the Class A share value (you could convert Class A shares into Class B shares but not the other way around). Eventually, when Berkshire Hathaway acquired one of the largest railroads in the nation, the Burlington Northern Santa Fe, it split the Class B shares 50-for-1 so that each Class B share now represents 1/1,500th of the Class A shares. The Class A shares have voting rights, the Class B shares have none.
Companies can split their stock on almost any mathematical ratio they desire. The most common type of stock split is a 2-for-1 stock split, though other formulas are used such as a 3-for-1 stock split, a 2-for-3 stock split and 10-for-1 stock split.
What Are Some Reasons for a Stock Split?
Aside from the per-share nominal affordability we’ve discussed, there are a handful of other benefits of stock splits, including the aforementioned liquidity increase (more shares being bought and sold in the market so investors can increase or decrease their position without having to wait extended periods of time or experiencing large bid and ask spreads).
The important thing to understand is that the stock split itself does not make you, the owner of the common stock, any richer. You still own the same percentage of the firm you did before — the same pro rata cut of the sales and profits.
Many inexperienced investors mistakenly believe stock splits are a good thing is because they tend to mistake correlation and causation. When a company is doing really well, a stock split is almost always an inevitability as book value and dividends grow. If a person sees or hears about this pattern frequently enough, the two may become associated in the mind.
What Is a Reverse Stock Split?
Much rarer, and almost always occurring due to a disaster or struggle with the business to avoid being delisted from a major stock exchange, a reverse stock split is the opposite of an ordinary stock split. The purpose is to raise the nominal price of each share.
Never Buy Stock on Share Price Alone
Time for an investing pop-quiz. If you had $1,000 to invest and were given a choice between buying 100 shares of company ABC at $10 per share, or 5 shares of company XYZ at $125, which one would you choose? Many investors would go for the one hundred shares of ABC because the share price is lower. “The $10 stock looks cheap,” they argue, “the $125 per share price for the other stock is too risky and rich for my taste.”
If you agree with this reasoning, you’re in for a shock. The truth is, you don’t have enough information to determine which stock should be purchased based on share price alone. you may find, after careful analysis, the $125 stock is cheaper than the $10 stock! How? Let’s take a closer look.
A Practical Example of How to Evaluate Share Price
Every share of stock in your portfolio represents a fractional ownership in a business. In 2001, Coca-Cola earned $3.696 billion in profit. The soft drink giant had approximately 2.5 billion shares outstanding.
It means that each of those shares represents ownership of 1/2,500,000,000 of the business (or 0.0000000004%) and entitles you to $1.48 of the profits ($3.696 profit divided by 2.5 billion shares = $1.48 per share).
Assume that the company’s stock trades at $50 per share and Coca-Cola’s board of directors thinks that is a bit too pricey for average investors. As a result, they announce a stock split. If Coke announced a 2-1 stock split, the company would double the number of shares outstanding (in this case the number of shares would increase to 5 billion from 2.5 billion).
The company would issue one share for each share an investor already owned, cutting the share price in half (e.g., if you had 100 shares at $50 in your portfolio on Monday, after the split, you would have 200 shares at $25 each).
Each of the shares is now only worth 1/5,000,000,000 of the company, or 0.0000000002%. Due to the fact that each share now represents half of the ownership it did before the split, it is only entitled to half the profits, or $0.74.
The investor must ask himself which is better: paying $50 for $1.48 in earnings, or paying $25 for $0.74 in earnings? Neither! In the end, the investor comes out exactly the same.
The transaction is akin to a man with a $100 bill asking for two $50s. Although it now looks like he has more money, his economic reality hasn’t changed. It, incidentally, should prove it is pointless to wait for a stock split before buying shares of a company.
An Example Illustrating Share Price Relative to Value
It all serves to make one very important point: the share price by itself means nothing. It is share price in relation to earnings and net assets that determine if a stock is over or undervalued. Going back to the question posed at the beginning of this article, assume the following:
- Company ABC is trading at $10 per share and has EPS of $0.15.
- Company XYZ is trading at $125 per share and has EPS of $35.
The ABC stock is trading at a price to earnings ratio (p/e ratio) of 67 ($10 per share divided by $0.15 EPS = 66.67). The XYZ stock, on the other hand, is trading at a p/e of 3.57 ($125 per share divided by $35 EPS = 3.57 p/e).
In other words, you are paying $66.67 for every $1 in earnings from company ABC, while company XYZ is offering you the same $1 in earnings for only $3.57. All else being equal, the higher multiple is unjustified unless company ABC is expanding rapidly.
Some companies have a policy of never splitting their shares, giving the share price the appearance of gross overvaluation to less-informed investors. The Washington Post, for example, has recently traded between $500 and $700 per share with EPS of over $22. Berkshire Hathaway has traded as high as $70,000 per share with EPS of over $2,000. Hence, Berkshire Hathaway, if it fell to $45,000 per share, may be a far better buy than Wal-Mart at $70 per share. Share price is entirely relative.
Investing in blue chip stocks may have a reputation for being boring, stodgy, and perhaps even a little outdated. However, it isn’t an accident that they are overwhelmingly preferred by wealthy investors and rock-solid financial institutions. Anyone with common sense would want a stake in businesses they not only understand but that have a demonstrated record of extreme profitability over generations, and blue chips certainly fit the description. Measured across long periods, blue-chip stocks have minted money for owners prudent enough to hang on to them with tenacity through thick and thin, good times and bad times, war and peace, inflation and deflation.
And it isn’t as if they are unknown. They are ubiquitous; taken for granted. Blue chip stocks often represent companies residing at the core of American and global business; firms boasting pasts every bit as colorful as any novel and interwoven with politics and history. Their products and services permeate nearly every aspect of our lives.
How is it possible, then, that blue chip stocks have long reigned supreme in the investment portfolios of retirees, non-profit foundations, as well as members of the top 1% and the capitalist class, while being almost entirely ignored by smaller, poorer investors? This conundrum gives us a glimpse into the problem of investment management as it is and even requires some discussion of behavioral economics. Blue chip stocks don’t belong exclusively to the realm of widows and insurance companies, and here’s why.
What Is a Blue Chip Stock?
A blue chip stock is a nickname given to the common stock of a company that has several quantitative and qualitative characteristics. The term “blue chip stock” comes from the card game, Poker, where the highest and most valuable playing chip color is blue.
There is no universal agreement on what, precisely, makes up a blue-chip stock, and there are always individual exceptions to one or more rules, but generally speaking blue-chip stocks/companies:
- Have an established record of stable earning power over several decades.
- Boast an equally long record of uninterrupted dividend payments to common stockholders.
- Reward shareholders by growing the dividend at a rate equal to or substantially more than the rate of inflation so that the owner’s income is increasing at least every twelve months even if he or she never buys another share.
- Enjoy high returns on capital, particularly as measured by return on equity.
- Sport a rock-solid balance sheet and income statement, especially when measured by things such as the interest coverage ratio and the geographic and product line diversity of the cash flows.
- Regularly repurchase stock when the share price is attractive relative to owner earnings;
- Are substantially larger than the typical corporation, often ranking among the largest enterprises in the world as measured by both stock market capitalizationand enterprise value.
- Possess some sort of major competitive advantage that makes it extraordinarily difficult to unseat market share from them (which can come in the form of a cost advantage achieved through economies of scale, a franchise value in the mind of the consumer, or ownership of strategically important assets such as choice oil fields.)
- Issue bonds that are considered investment grade with the best of the best being Triple-A rated.
- Are included, domestically at least, in the component list of the S&P 500 index. Many of the bluest of the blue chips are included in the more selective Dow Jones Industrial Average.
Why Blue Chip Stocks Are Popular With Wealthy Investors
One of the reasons wealthy investors love blue-chip stocks so much is because they tend to compound at acceptable rates of return – typically between 8% and 12% historically with dividends reinvested – decade after decade. The journey isn’t smooth by any means, with drops of 50% or more lasting several years along the way, but over time, the economic engine that produces the profits exerts its extraordinary power. It shows up in the total return of the shareholder, presuming that the shareholder paid a reasonable price.
(Even then, that isn’t always a requisite. As history has shown, even if you paid stupidly high prices for the so-called Nifty Fifty, a group of amazing companies that was bid up to the sky, 25 years later, you beat the stock market indices despite several of the firms on the list going bankrupt.)
By holding the stock directly, and allowing enormous deferred tax liabilities to build up, the wealthy can die with the individual stocks still in their estate, passing them to their children using something known as the stepped-up basis loophole. Effectively, as long as you are still under the estate tax limits when this happens, all of the deferred capital gains taxes that would have been owed are forgiven. It’s one of the most incredible, long-standing, traditional benefits available to reward investors.
For example, if you and your spouse acquired $500,000 worth of blue-chip stocks and held on to them, dying after they had grown in value to $10,000,000, you could arrange your estate in a way that the capital gains that would have been owed on the $9,500,000 unrealized gains ($10,000,000 current value – $500,000 purchase price) are instantly forgiven. You would have never paid them. Your children will never have to pay them. It’s such a big deal that you’re often better compounding at a lower rate with a holding you can maintain for decades than trying to flit in and out from position to position, always chasing after a few extra percentage points.
Another reason blue chip stocks are popular is that they offer somewhat of a relatively safe harbor during economic catastrophes (especially if coupled with gilt-edged bonds and cash reserves). Inexperienced and poorer investors don’t think about this too much because they’re almost always trying to get rich too quickly, shooting for the moon, looking for that one thing that will instantly make them rich. It hardly ever ends well. Markets will collapse. You will see your holdings drop by substantial amounts no matter what you own.
If anyone tells you otherwise, they are either a fool or trying to deceive you. Part of the reason blue chips are relatively safe is that dividend-paying stocks tend to fall less in bear markets due to something known as yield support. Additionally, profitable blue chips sometimes benefit over the long-run from economic trouble as they can buy, or drive out, weakened or bankrupt competitors at attractive prices. As I explained in a long essay on the nature of investing in the oil majors, a company like Exxon Mobil paradoxically sets the stage for much better results decades down the line whenever there is a major oil collapse.
Finally, wealthy and successful investors tend to love blue-chip stocks because the stability and strength of the financial statements mean that the passive income is hardly ever in danger, especially if there is broad diversification in the portfolio. If we ever get to the point that America’s premier blue-chips are cutting dividends en masse across the board, investors probably have much bigger things to worry about than the stock market. We’re most likely looking at a civilization-ending-as-we-know-it set of circumstances.
What Are the Names of Some Blue Chip Stocks?
Despite there not being universal agreement about what constitutes a blue-chip stock. Generally, some names you are going to find on most people’s list, as well as the rosters of white-glove asset management firms, include corporations such as:
- American Express
- Berkshire Hathaway
- The Clorox Company
- The Coca-Cola Company
- Exxon Mobil
- General Electric
- The Hershey Company
- Johnson & Johnson
- Kraft Heinz
- McDonald’s Corporation
- Nestle SA
- Procter & Gamble
- United Technologies
- Wal-Mart Stores
- The Walt Disney Company
- Wells Fargo & Company
From time to time, you’ll find a situation where a former blue-chip stock goes bankrupt, such as the demise of Eastman Kodak. However, as surprising as it may sound, even in cases like that, long-term owners can end up making money due to a combination of dividends, spin-offs, and tax credits.
The reality is that if you are reasonably diversified, hold for a long enough period, and buy at a price, so the normalized earnings yield of the blue-chip stocks is reasonable relative to U.S. Treasury bond yield, short of a catastrophic war or outside context event, there has never been a time in American history where you’d have gone broke buying blue-chip stocks as a class. Sure, you had periods like 1929-1933, 1973-1974, and 2007-2009; periods during which you watched 1/3 or 1/2 of your wealth disappear right before your eyes in terms of quoted market value.
That’s part of the trade-off. Those times will return, again and again. If you hold equities, you will experience that pain. Deal with it. Get over it. If you think it can be avoided, you shouldn’t own stocks. To the true buy-and-hold investor, it doesn’t mean much; a blip on the multi-generational holding chart that will eventually be forgotten. After all, who remembers Coca-Cola losing around 50% of its value due to the sugar crisis shortly after its IPO? A single share bought for $40, which crashed down to $19, is now worth more than $15,000,000 with dividends reinvested.
Preferred Stock V Common Stock
If you don’t know much about investing, the ins and outs can seem complicated. But once you break everything down, it becomes much easier, and the first question for the novice investor is likely “What can I invest in?” Let’s start at the absolute most basic, and the most prominent of the investment classes: stocks.
You may have heard stocks referred to as equities or securities. The reason they’re called equities is that you purchase an equity, or ownership, share of a company. Stock is also called a security for the same reason, because you’re securing a share of ownership in the company.
When you buy stock, you become part owner of the company — maybe only a very small part, but still an owner. In a sense, you’re finally a business owner just like you’ve always dreamed!
Make sure, then, that you’ve done plenty of research into a company if you plan on investing or trading their shares. We’ve all seen terrifically run businesses and atrociously run businesses in our time, but a company’s outlook isn’t always as good as they’re trying to make it seem. Give as in depth a look as you can into their financial situation and forecasts for the future; there’s no such thing as too thorough when it comes to figuring out the right stock to buy.ADVERTISING
We can also use “stocks” as a broader categorization of two specific types of stocks you have the opportunity to invest in. These are preferred stocks and common stocks. Each brings its own unique pros and cons, and not every company offers both. You’ll have to decide for yourself, should you even have the option, which to choose.
Regardless of which type of stock you buy, though, purchasing stock makes you a part owner, or shareholder, of a company.
What is a Preferred Stock?
Preferred shareholders, true to the name, are given a higher priority than common shareholders in a number of regards. For example, companies pay dividends to preferred stock shareholders before they pay dividends to common-stock shareholders.
Companies that sell preferred stock are actually offering a blend of a more aggressive investment (stock) and a more conservative one (bond). This combination means that while the price of preferred stock can appreciate, it doesn’t fluctuate as much as the price of common stock. That’s why many risk-averse investors favor preferred stock.
Another advantage to owning preferred stock is that it almost always pays a dividend to shareholders. While it’s possible to succeed with stocks that don’t offer dividends, they can really come in handy – especially if the company isn’t doing so well.
Dividends accumulate if the company’s board of directors decides to put a freeze on divvying up profits because it doesn’t have the financial resources. If the company goes bankrupt, preferred stockholders also have a claim to any assets ahead of common stockholders.
On the other hand, preferred stockholders don’t usually have any voting rights. To many investors, this doesn’t really matter. But if, as an owner, you are passionate about management decisions at the company, you may want the right to vote. If so, then preferred stock is not for you.
What is a Common Stock?
Common stock, which is sold by most companies, is the only “pure” form of stock in the market. It’s what people are talking about when they just mention “stocks.” Because common stock has the potential for greater returns, investors buy it more often than they do preferred stock.
Common stock represents an equity ownership in the company and entitles shareholders the right to vote on management issues at the annual shareholder’s meeting. Common stockholders may, or may not, receive dividends, depending on management’s decision about distributing profits. And should the company go bankrupt, these shareholders have to wait until preferred ones claim their assets.
Many beginning investors believe that preferred stock is better than common stock, but that’s not necessarily the case. Your decision to purchase one over the other depends upon your financial goals, your tolerance for risk, and your interest in voting rights in the company.
Because most investors are interested in price appreciation, they usually purchase common stock. It’s higher risk, but higher reward too. You get more “bang for your buck.”
From this point on, whenever we refer to “stock,” we mean common stock. It is, after all, much more commonly purchased.
In The Next Blog …
In the next blog I will teach you how to set up your online trading account, and how to use an online platform, and really get the ball rolling…