What Is a Stock?
Definition. A stock is an ownership share in a company entitling the owner of that stock to a percentage of that company’s assets and earnings.
Lemonade Stand Example: Jane and Billy have a lemonade stand that is doing pretty well, making lots of profits on Elm Street. They are thinking about opening another stand on Main Street, possibly even Oak Street as well. You really want to be a part of their story and share the upside of its success, but you don’t have time to buy lemons or fill cups or work the lemon press. Meanwhile, Billy and Jane could use some cash to open that Main Street stand. So they offer you a stock certificate for $1.00 per certificate entitling you to 1% of their company. You can buy up to 10 certificates, or 10% of the business. Voilla! You now have stock (or an “equity stake”) in the lemonade stand.
Well, buying shares/stock in Macy’s, American Airlines, Google or any other listed company is no different in concept than the lemonade stand. Is the company solid? Do you trust the owners? Is the product any good? Does it have a future?
The Exchange. Now imagine a group of kids who meet in the park to trade marbles and haggle over baseball cards. One of the more clever kids, a chap named Bert, has set up a desk in the park where people put their marbles and baseball cards on a single platform to be bought and sold. Bert does a great job of organizing all the marbles by color and type and the baseball cards by league and year. He makes it a really easy place to shop for stuff—he calls it “The Bert Exchange.” And the kids are so pleased with Bert that they agree to pay him a small percentage of their sale proceeds for every card or marble he helps sell. Bert calls this his “brokerage fee.”
Meanwhile, Bert realizes he can add these stock certificates to his Bert Exchange and sell them along with the marbles and baseball cards.
(As you can tell by now, a modern stock exchange is really no different than the Bert Exchange. It’s simply a platform where goods can be bought or sold. The New York Stock Exchange (NYSE) or the NASDAQ are just fancier versions of this simple concept. Each exchange specializes in a different kind of “marble” or “lemonade” operation—i.e. the NASDAQ deals primarily in technology companies, while the NYSE is an exchange that primarily sells a wide range of large company stocks.)
Market Forces. Rumor on the street (and lunchroom) is that Billy and Jane’s lemonade stand is just the best thing since Elvis. Everyone wants a piece of their action. So a bunch of 3rd graders go over to Bert after school and offer to buy your lemonade shares on the Bert Exchange. The mania around Billy and Jane’s lemonade stand is so crazy that the 3rd graders are willing to pay you $2.00 per share for the very same stock you paid $1.00 for a week earlier. The lemonade stand itself hasn’t earned more money or done anything exceptional; there’s just so much buzz (and thus “demand”) and talk about it that the share price is going up (as demand goes up, prices go up) despite no earnings growth. This is called momentum-driven stock “appreciation” and it was fed entirely by “market exuberance” and the buzz in town around Jane and Billy’s lemonade. The same phenomenon is true in the real stock market, which explains why TESLA stock is so “successful,” going up in value (due to buzz, momentum and demand) even when its business has more debt than earnings.
Fancy/Alternative Names: “Equity,” or “share.”
Advantages: If you understand value and momentum investing and thus buy stocks smart and the company excels, your stock will increase in value.
If, for example, Billy and Jane are exceptional owners of the lemonade stand and are also knowledgeable about getting lemons and sugar and paper cups cheaply and efficiently, then it’s likely that their revenues are exceeding their costs and thus they are earning rather than losing money. The value of their lemonade stand is easy to determine, and thus you know that the share price of $1.00 is a good price. Thus, you have looked at their balance sheet and income statements and know the value of their lemonade stand and the stock price relative to that value. Based on your insights and Billy and Jane’s hard work, you can assume that as the company grows and makes more earnings, your percentage of the company’s improved earnings will result in more money for you. After all, 10% of a $100.00 earnings report is better than 10% of $10.00 earnings report.
Risks:
Bad Fundementals. If, however, the lemonade stand loses earnings, suffers a lemon shortage due to a storm in Florida or is taking on too much debt, the stock will lose value as the company’s profits and losses get out of balance. You will have an ownership stake in a rotten lemon rather than a healthy one. This is “business risk.” (Macy’s has it, Alcoa has it, and so do a lot of shale oil companies…which all operate under the same principles of a corner lemonade stand: they are either making money or losing it, healthy or unhealthy.)
Operational Risk. Billy and Jane may turn out to be total knuckleheads. Maybe Billy gets bored with lemonade and starts to ignore the Main Street stand, or totally fails to get the Oak Street stand enough paper cups. Or what if Jane gets a little too sure of herself and decides to buy a red bike with her own company earnings rather than re-invest this money in more cups and straws. She might even add some debt to the lemonade stand by asking her parents for money. They give her $100.00 and she gives them a nice little “I-Owe-You” in which she promises to repay them out of the lemonade stand earnings. This IOU of debt has to be paid before earnings are determined, which means you, as a share-holder (stock-holder, or equity holder) take a back seat to the debt-holding parents. Earnings are down, management is lazy and debt is on the books. Your 10% of the company is now 10% of 0.00 rather than 10% of $100.00.
Market Forces. Similarly, if rumor around the park or neighborhood gets out that Billy and Jane’s lemonade stand is a big joke and that their lemonade tastes like water not lemons, there will likely be a rush to the Bert Exchange where all the first and second graders will try to sell their lemonade stock at a huge discount to some other kid (maybe a kniave kindergartener) who may not realize how bad the lemonade stand is. This is called a “market sell off” (or “bearish sentiment”) and it too can create a huge impact on the stock price. Equally possible, and equally emotional, is market optimism, where everyone in the neighborhood thinks that the Billy and Jane lemonade stand is a must-have and they are thus willing to pay more than the current price just to get their hands on it. This is called a “bull market” buy-in. Both bearish and bullish psychology can send stock prices up or down regardless of the underlying strength or weakness of the business.
Macro Risks. Sometimes, despite all the best efforts of folks like Billy and Jane to produce lemonade, larger forces beyond their control can directly impact the profits of their juice stands and the pricing of their stocks. For example, if Bert and Jane and Billy and all their friends live in a town where all of their parents work for the same bank, say Bear Sterns, and then suddenly that bank vanishes, well a lot of parents are gonna be cutting back on allowances. The kids who once had a lot of pocket money and thus bought a lot of marbles and lemonade will suddenly have less cash to buy juice or baseball cards. In fact, they’ll be broke and looking for money. So all these kids race over to the Bert Exchange and try to sell as much of their stuff as they can at the best price possible. Suddenly, everyone is selling but now few kids are buying—even the kindergartener’s aren’t bidding/buying. The Bert Exchange now has what the markets call a “Liquidity Crisis”--that is: no buyers and lots of sellers. The price of marbles and lemonade stand stock just keeps going down as demand shrinks and selling pressure increases—all because the allowances dried up at school because of some big scary event at their parents’ bank. The town is in crisis. Incomes are falling. Moving trucks are everywhere. Billy and Jane’s lemonade stand is in trouble. We call this a “macro crisis”—i.e. a larger event unrelated to the underlying value of the lemonade stand that nevertheless impacts its business and the mood at the exchange.
Different kinds of stocks: Stocks can be issued by large companies (like Google), or by medium sized companies or small sized companies. Not surprisingly, portfolio managers describe these kinds of stocks as Large Cap, Medium Cap, and Small Cap. Traditionally, large cap stocks (think juggernaughts) go up and down slower than small cap stocks (think speed boats). In bull markets, small caps speed ahead of others to the top, in bear markets they speed ahead of others to the bottom. Portfolio Managers also refer to stocks as either “growth stocks” or “value stocks”--which as their titles suggest, respectively refer (at least theoretically) to companies that have potential for rapid growing share prices, or are companies that are priced at attractive or even discounted valuations—i.e. “good deals.”
Further Reading: For more on value investing see, “A Primer on Value Investing;” for more on stocks in a portfolio, see, Section 6 of “The Six Portfolio Secrets." Also see, “Asset Allocation and Portfolio Construction.”