What is a stock?

Back to stocks, the same business model is used in every company; the difference is that the larger companies continue to grow in size until it makes sense for the OWNERS EQUITY to be divided into shares, which are offered for sale to the public through the STOCK MARKET (using the appropriate exchange – TSX, DOW JONES, etc. – more on those later). In companies that start privately, becoming a public company and issuing shares generates cash to pay the owner reducing his personal OWNERS EQUITY.

And the same thing continues to happen. Let’s pretend the value at this point (Owners Equity) of the Widget business has grown to $2,000,000. The owner decides to issue 100,000 shares at $20 each; since he wants to maintain interest in the business, he will keep 50,000 shares for himself. I won’t get into the process of becoming a public company and the legalities of listing their shares for anyone to purchase – its way too complicated. Basically, he will sell off the other 50,000 shares and end up with $1,000,000 cash which is his whether he takes it out of the company or not. And business continues to operate in exactly the same way – more supplies are bought for more widgets, and the profit continues to increase. And subsequently, the value of the business increases. Let’s say the value is now $4,000,000. So every share is now worth $40 (you’ve doubled your money) . . . . and the cycle continues!

I’ve just showed you, in the most simple form, how making money in stocks work. The real story is more complicated; there are many scenarios at play - the company is now hiring more staff, increasing their production and storage facilities; keeping more inventory on hand. They are faced with higher supply costs, rent costs, production costs; labor shortages; gas prices and the list goes on. Any of these factors can cut into their profit margin. They can sign huge contracts to supply retailers and manufacture the product only to have that retailer declare bankruptcy. More competitors come into the market. They are getting their widgets made in China at a WAY lower cost (if you don’t believe this, just watch Shark Tank or Dragon’s Den) Widgets are no longer in demand; the company has a ton of supplies and finished products on hand. What does this do to their value? They may now be selling them at a loss in order to recover some cash or to compete in the marketplace. This obviously reduces their value and therefore the value of the shares. In these situations, the price may decrease even faster than the value as investors look to sell off in fear that the company won’t survive. It creates a case of supply being higher than demand (for the shares) so shareholders will sell cheap and buyers want a discount. Keep in mind, MARKET PRICE is really what a buyer is willing to pay.

And if that isn’t enough for any company, there are other factors out of their control. Perhaps the government decides to regulate widgets. New rule and regulations that add to the company’s cost. The value of our dollar as compared to the American dollar. A lot of manufacturing companies rely heavily on shipping to and from the states. Any fluctuation in dollar value can have a huge impact.

So why would anyone invest in stocks?

A lot of money has been made in stocks. But like anything else, there are good quality stocks that are very stable with positive growth potential (and yes, they can be very boring). Those are the stocks that need to make up the majority of your portfolio. Now we all want to be part of the excitement, and we all know the money that’s been made with the Amazons and Facebooks and Teslas – today they are very large companies that can still make you money but NOT even close to the huge profits of those who invested at the very beginning or better still, Jeff Bezos, Mark Zuckerberg and Elon Musk, the founders with net worth in the billions of dollars. The new and exciting shares should only make up a small portion of your portfolio.

Then there’s the hot tips! What I’ve learned from “hot tips” is that when you get the tip, it’s probably too late. And penny stocks – a huge gamble but if you can afford to lose the $100 you invest there, then that’s fine – there’s a very small chance you will make money. That’s probably the best advise I can give. If you are going to play with very high risk stocks, make sure you can afford to lose that amount of money.

And on that note, I had a client who had received a “hot tip” from a friend. A friend that was known to make a lot of money in stocks. Some of the profits were pretty substantial. My client went to a stock broker and wanted to buy $20,000 worth of this stock. This was before the age of online investment accounts that you manage yourself. The stock broker refused to sell him $20,000 worth of a “hot tip”. He simply asked how the client would feel if he lost $20,000. NOT VERY GOOD. If he still insisted on buying the stock, what amount could he afford to lose? The client felt that he could live with a $2,000 loss; keep in mind, he still thought he was going to make a bundle on this purchase. Why? Because his friend always got it right. Guess what? Not this time; the company failed and the client lost his $2,000 investment. For starters, he was VERY happy that the stock broker talked him out of the $20,000. Secondly, I wondered if the “friend” just didn’t share the stories of stocks he lost money on!

Next week – we will dive more into what constitutes good quality stocks and what to watch for in other stocks.