Probably the most important thing I have learned as an investor is that, for the most part, being successful is about keeping it simple. I think it was Warren Buffett who once said that smart investing really only requires about 100 IQ points - anything more is just a waste of brain cells.
And, as is often the case, Buffett is right - you don’t need a Ph.D. in Econometrics or Finance to be successful in the market. What you do need, however, is discipline and the right work ethic. That is, you need to be willing to do your homework and apply some tried and true business principles when evaluating stocks and other potential investments. So, let’s start with some stock investing basics - then we’ll move on to more specific approaches to picking good stocks.
What is a Stock?
What is a share of stock? In a nutshell, it’s simply partial ownership of the company itself. That is, when an individual or an institution purchases stock in a company, they are essentially buying a “slice” of the corporation. In fact, it’s easier to understand if you think of a public company as a pie or pizza, split up into many very small slices (each representing a claim on ownership of the company). Some shareholders may own many pieces of the pie, and therefore have a more significant claim on the company, while others only have 1 or 2 small slices. So, how and why is there public ownership of the company? Good question - the reason lies in the difference between stocks and bonds.
Stocks and Bonds
When you start a business, whether it is making doggie doors or high performance aircraft parts, you need money to get going. An entrepreneur may have the most revolutionary idea in the world, but without some sort of financial backing (usually referred to as “capital”) it will likely never leave the drawing board. Similarly, if you are the CEO of an existing company needing to expand operations, you also need capital to build more factories, fund additional research, or increase the size of your sales force. On the flip side, if you are an investor looking to use extra money on hand to make even more money, you might want to put it to “work” by investing in a new or existing company. For the most part, there are two main ways to do this.
Bonds: Just a Fancier “IOU”
Investors often “lend” money to companies who need capital by buying bonds. That is, you give the company a certain amount of money today, and they agree to pay you back the original amount plus interest sometime in the future (just think of it as an IOU). The key here is that the return is fixed (note that bonds are often referred to as “fixed income” investments) - that is, even if the company becomes the next Google, at the end of the loan term the investor only gets back what he loaned plus the interest that was agreed upon. A company typically works with an investment bank to issue the bonds. Thus, one of the functions of an investment bank is to bring corporations who need capital together with institutions who have capital to lend (for a generous fee, of course).
In addition, it is important to note that one of the attractive features of bonds is that bondholders have priority when it comes to claiming the assets of a bankrupt company. This is something very important to understand if you are the owner of common stock.
Stocks: Owning the Business
As an alternative to lending a company money at a fixed rate, investors can also purchase stock in a company and become partial owners of that business. This means that they have fractional ownership of both the assets and future earnings of the corporation. The advantage here is that the “upside” is unlimited. That is, as opposed to bonds, if the earnings of the business continue to grow, so does the return on your investment. For example, if ABC widget company starts out as a small “mom and pop” chain of stores that you own stock in, but then ends up becoming one of the largest retailers in the nation - you make a landslide profit as a shareholder of the business (and can probably retire to the golf course!). However, you can also lose all of your money as well (don’t forget that). And, unlike bondholders, owners of common stock are essentially “last in line” if a company goes bankrupt. That is, you can pretty much bet on not getting a dime if the company you invest in goes out of business.
Like bonds, stock is usually issued through an investment bank in an “Initial Public Offering” (or IPO for short). This initial offering takes place in what is called the primary capital market. The average investor typically does not have the opportunity to purchase shares at IPO, as the players in the primary capital market are usually larger institutions or other companies. The secondary capital market, on the other hand, is where most investors purchase stock in a company through a broker or other intermediary. Shares of a company move from the primary to secondary capital market when the original purchaser of stock in a company (i.e., the purchaser at IPO) sells it to other investors.
Stock vs. Bonds: In Sum
So, the bottom line is:
- Companies typically raise money to fund expansion and new projects by issuing either bonds or stocks
- Bonds represent money lent to a corporation by investors for a fixed term and at a fixed interest rate
- Stocks represent capital invested in the company by investors, and represent the ownership those investors have in the business
- In the case of bankruptcy, bondholders trump common stockholders when it comes to recovering money invested in the company
We’ve talked a little bit about the differences between stocks and bonds. We know that, fundamentally, bonds offer a fixed rate of return on money loaned to companies. Stocks, on the other hand, give us unlimited upside when it comes to returns (as well as unlimited downside). However, stocks have historically been a better investment in the long run than bonds and (despite what you may have heard) have also been less risky over the long term.
Related Links: Before you Get Started, The Case for Stocks