Stock investing became all the rage during the 1990s. Investors watched their stock portfolios and mutual funds skyrocket as the stock market experienced an 18-year rising market (or bull market). Investment activity in the United States is a great example of the popularity that stocks experienced during that time period. By 1999, over half of U.S. households became participants in the stock market. Yet millions lost money during the stock market's decline in 2000. People invested. Yet they really didn't know exactly what they were investing in. If they had a rudimentary understanding of what stock really is, perhaps they could have avoided some expensive mistakes. The purpose of this book is not only to tell you about the basics of stock investing but also to let you in on some sharp tactics that can help you profit from the stock market. Before you invest your first dollar, you need to understand the basics of stock investing.
The stock market is a market of stocks; it is a market like any other market, such as a grocery store or a flea market. A grocery store, for instance, is a place that offers soup to nuts along with numerous other things for shoppers to buy. The stock market is an established market where people (investors) can freely buy and sell millions of shares issued by thousands of companies. Investors buy stocks because they seek gain in the form of appreciation (their stock, if held long enough, goes up in value) or income (some stocks pay income in the form of dividends) or both. Those who already own stock may sell it to cash in and use the money for other purposes. Companies issue stock because they want money for a particular purpose.
The underwriter sets a time frame to start selling the issued stock (the window of time that the primary market is taking place). The underwriter also helps the company prepare a preliminary prospectus that details the required financial and business information for investors, such as the amount of money being sought in the IPO and who is seeking the money and why. (For details, see the section "The watchdog role of the SEC," later in this chapter.)
The preliminary prospectus is referred to as the "red herring" because it usually comes stamped with a warning in red letters that identifies this as preliminary - a kind of disclaimer that the stock's price may or may not be changed as the final issue price.
The IPO stock usually isn't available directly to the public. Interested investors must purchase the initial shares through the underwriters authorized to sell the IPO shares during the primary market. After the primary market period - at the start of the secondary market - you can ask your own stockbroker to buy you shares of that stock. The secondary market is more familiar to the public and includes established, orderly public markets such as the New York Stock Exchange, the American Stock Exchange, and Nasdaq.
The watchdog role of the SEC
The market for IPOs and all public stocks is regulated by the Securities and Exchange Commission (SEC) under the Securities Act of 1933, also known as the Full Disclosure Act. The SEC sets the standard for disclosure and governs the creation of the prospectus. The prospectus must contain information such as the description of the issuer's business, names and addresses of the key company officers, key information relating to the company's financial condition, and how the proceeds from the stock offering will be used. For more on the SEC - what reports companies must file and how investors can benefit from this information - see Chapters 6 and 11.
SEC approval of the sale of stock doesn't mean that the SEC recommends the stock. SEC approval only means that the sale of stock can go forward legally. The SEC ensures only that all necessary information and documentation have been filed and are available to the public.
Knowing What You're Buying: Defining Stock
Stock represents ownership in a corporation (or company). Just like the owner of a car has a title that says he has ownership of a car, a stock certificate shows that you own a piece of a company. If a company issues stock of, say, 1 million shares and you own 100 shares, this means you have ownership equivalent to 1/10,000th of the company.
The physical evidence of ownership is a stock certificate that shows what stock you own and how many shares. These days, investors rarely get the certificates in hand, direct from the company; instead, they simply trade through brokerage accounts (see Chapter 7 for tons of information on brokers) and shareholder service departments that hold the stock. Your brokerage statements tell you what you have - kind of like a bank statement. Such statements are sufficient today, when producing the actual stock certificate has become less necessary in our modern technological era than in the early days of stock investing.
There is a real distinction between the stock and the company. The company is what you invest in, and the stock is the means by which you invest. Many investors get confused and think that the company and its stock act as one entity.
Adjusting to your role as a stockholder
When you own stock, you become a stockholder (also known as a shareholder). The benefit of owning stock in a corporation is that whenever the corporation profits, you profit as well. For example, if you buy stock in General Electric and it comes out with an exciting new consumer electronics product that the public buys in massive quantities, not only does the company succeed, but so do you, depending on how much stock you own.
Just because you own a piece of that company, don't expect to go to the company's headquarters and say, "Hi! I'm a part owner. I'd like to pick up some office supplies since I'm running low. Thank you and keep up the good work." No, it's not quite like that.
As a regular stockholder, you generally do not have the privilege of intervening in the company's day-to-day operations. Instead, you participate in the company's overall performance at a distance.
As an owner, you participate in the overall success (or failure) of a given company along with thousands or millions of others who are co-owners (other investors who own stock in the company). The flip side is that if the company is sued or gets on the wrong side of the law, you won't be in trouble - at least not directly. The company's stock will be negatively affected and you'd most likely see a decline in the value of your stock, but you won't go to jail.
Exerting your stockholder's influence
A stock also gives you the right to make decisions that may influence the company, such as determining the stock price. Each stock you own has a little bit of voting power, so the more shares of stock you own, the more decision-making power you have.
In order to vote, you must either attend a corporate meeting or fill out a proxy ballot. (See Chapter 11 for information about participating in these meetings - in person or by proxy.) The ballot contains a series of proposals that you may either vote for or against. Common questions concern who should be on the board of directors, whether to issue additional stock, and whether the stock should split. (See Chapter 18 for more on stock splits.)
Recognizing stock value
Imagine that you like eggs and you're willing to buy them at the grocery store. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies' stock. The grocery store is the stock market. What if two brands of eggs are very similar, but one costs 50 cents while the other costs 75 cents? Which would you choose? Odds are that you would look at both brands, judge their quality, and, if they were indeed similar, take the cheaper eggs. The eggs at 75 cents are overpriced. The same with stocks. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But there is another side to the egg example.
What if the quality of the two brands of eggs is significantly different but their prices are the same? If one brand of eggs is stale and poor quality and priced at 50 cents and the other brand is fresh and superior quality and also priced at 50 cents, which would you get? I'd take the good brand because they're better eggs. Perhaps the lesser eggs might make an acceptable purchase at 10 cents. However, the inferior eggs are definitely overpriced at 50 cents. The same example works with stocks. A badly run company isn't a good choice if a better company in the marketplace can be bought at the same - or a better - price.
Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of stock investing. Eggs and egg prices can be as varied as companies and stock prices. As an investor, you must make it your job to find the best value for your investment dollars.
Understanding how market capitalization affects stock value
You can determine the value of a company (and thus the value of its stock) in many ways. The most basic way to measure this is to look at a company's market value, also known as market capitalization (or market cap). Market capitalization is simply the value you get when you multiply all the outstanding shares of a stock by the price of a single share.
Calculating the market cap is easy. It is the number of shares outstanding multiplied by the current share price. If the company has 1 million shares outstanding and its share price is $10, the market cap is $10 million.
Small cap, mid cap, and large cap aren't references to headgear; they're references to how large the company is as measured by its market value. Here are the five basic stock categories of market capitalization:
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