A Primer On Stocks

It is no secret that Americans are fascinated with money. In fact, the allure has been growing. In a renowned book called “Bowling Alone: The Collapse and Revival of American Community”[i], Robert D. Putnam highlights results from an interview that asked Americans to identify elements of the “good life”. When the book was released in the year 2000, over 65% chose “a lot of money” (compared to 38% of people in 1975). Furthermore, according to the Gallop Poll[ii], over 50% of American’s currently invest in the stock market (high of 67% in 2002). This figure is compared to a meager 4% of people in 1950 and 1% in 1900. Today there are numerous reputable newspapers, television channels, radio stations, podcasts, blogs, magazines and books that appeal to over 35 million Americans who currently invest in stocks.

Companies like to issue equity just as much as investors like to buy stock because it helps the business grow. When a company issues stock, it hires an investment banker to split up its equity into identical pieces called shares of stock. Shares of stock are sold to public investors in what is known as an initial public offering, or IPO. Proceeds of the offering are used to invest in things that create revenue including employees, buildings, machinery and raw materials. There are two types of shares of stock but, individual investors should only be concerned with one, Common stock. Each share of common stock represents a claim on a certain percentage of company earnings.

Why People are Fascinated with the Stock Market

People are fascinated with the stock market because stocks have historically been good investments and as we discussed before, can make us rich. This is for two reasons; first, stocks offer investors the opportunity to own legitimate, well-known and successful companies and second, they have historically outperformed all other liquid alternatives because they are the only investment that realizes intrinsic growth.

The majority of wealthy people got that way not from having a great job, but from owning companies. Jay-Z made most of his fortune through his clothing company Rocawear. Sam Walton grew his empire through Walmart and Mark Zuckerberg became the youngest billionaire in the world through Facebook. While these individuals have made high income by taking a salary and signing endorsements, the majority of their wealth was built through owning equity in their respected companies.

It is the same for the average Joe. In high school, I worked part time as a clerk at a local CVS pharmacy. I didn’t get rich because I didn’t own CVS. Because I didn’t own CVS, I didn’t receive a portion of each dollar that was taken from the cash register each evening.

At the time I was employed at CVS, their stock was trading at $12 per share. Instead of spending my wages on Phish tickets, fast food, and overpriced designer jeans, I could have purchased 165 shares of CVS stock with the $2,500 I earned over the course of the summer. If I had chosen the latter, my ownership would be worth nearly $13,000 today. While not all stocks might perform as well as CVS, my point is that equity is one of the few investments that realize growth. Since there is no ceiling on growth, there is no ceiling on the amount of money you can make through owning stocks.

To better understand the performance of stocks over time let’s look at historical data. Over the past 80 years, the stock market has returned, on average, 10.5 percent per year. In comparison, corporate bonds have returned an average of 4.5 percent per year and government bonds 3.2 percent per year. Over this time, the average inflation rate was 3.3 percent per year[iii].

 

If you invested in stocks you would have increased your wealth by an average of 7 percent per year[1]. If you invested only in corporate bonds you would have made about 1 percent real return per year and with government bonds, you would have actually lost money (even more so after taxes and other costs). Historically, stocks are the only investment that has made adequate return in the long haul.

The Bigger the Better

A statement that many American’s will agree with: the bigger the better. This is no different in regards to the Stock Market. The most valuable component in the stock market is liquidity. Liquidity is the ability to sell as asset at a fair price in a timely manner. The larger the stock market, the more liquid and the easier it is to sell assets at fair value.

Liquidity plays a vital role in a well-functioning financial market. If investors are unable to buy or sell at a fair price, investment demand drops and companies have trouble raising money. Additionally, liquidity comforts investors, as they understand that if needed, they can quickly convert investments into cash.

The more people trading a specific stock, the greater the amount of shares changing hands and the easier it is for investors to buy or sell at the fair market price. Additionally, highly liquid stocks save investors’ money through economies of scale. Firms that are set up to fulfill investor’s trades will be willing to charge a smaller incremental fee per transaction if they are able to make more transactions. Therefore, individual investors are better off by investing in big stock markets and trading highly liquid stocks.

An Easier Way to Follow the Stock Market

Since the stock market is so large, following every stock, let alone sector, is difficult. To better understand what is going on in the markets, investor’s group companies together in what is called a market index. By tracking a group of securities, you can better understand what is going on in the market.

An index is a mathematical product, not a specific security. While it can’t be directly bought or sold, it is closely tracked by stock-funds. Therefore, if one wanted to invest in a specific index, they could purchase a stock-fund that’s mandate is to track it. These funds are called index funds.

In addition to trading large sections of the market, indexes are often used as a benchmark to compare performance to either individual stocks or an investors’ portfolio. For instance, when investors talk about the word “outperforming”, they are referring to performing better than a specific index.

To provide a comprehensive analysis of the market, indexes must cover all corners of the market. Throughout the years, investors have created indexes that track diverse areas of the market such as multi-national companies, specific exchanges, industries or a type of security such as hedge funds or real estate investment trusts (REITS). The most popular indexes are:

The S&P 500

Ticker Symbol: ^GSPC

When people refer to “the market”, they are usually speaking about the S&P 500, which represents the 500 largest stocks listed on domestic exchanges. It is useful because it makes up about 70% of the United States [iv] public stock market, or $11 trillion. In addition, the S&P excludes companies that are considered outliers or ones that generally don’t reflect what is happening throughout the general economy. To be listed in the S&P 500, companies must meet the following criteria[v]:

· Issue shares that have a minimum market value of $5.3 billion.

· Shares should trade above 250,000 per month

· Have four consecutive quarters of positive earnings.

· Have at least 50 percent of shares held by public investors.

· Have shares of stock that trade at a minimum of $1 per share.

· Have operations that contribute to one of the sectors of the S&P rather than an unknown industry.

· Have stock listed on the NYSE or NASDAQ[2].

It is safe to say that the other 30 percent of publicly-traded equities strongly correlate with the S&P. When the general market is booming, even poor-quality companies benefit from investor optimism and easy access to capital.

The Dow Jones Industrial Average

Ticker Symbol: ^DJI

The Dow Jones Industrial Average or simply “The Dow” represents 30 large companies, most of them well-known captains of industry. Since it only represents about 25 percent of all stocks, the Dow isn’t considered an optimal proxy for the total United States stock market. However, just because it might not be the best index for benchmarking doesn’t mean it’s not valuable. While many investors use the S&P 500 to benchmark performance, the media tends to focus on the Dow for its simplicity and because it reflects companies that are familiar to individual investors. The following is a list of companies in the Dow Jones Industrial Average at the time of writing this book:

Both the S&P 500 and the DJIA have maintained a similar long-term return of 10.5 percent per annum over the past 75 years. In addition to the S&P 500 and the DJIA, other popular indexes include the Russell 3000, the NASDAQ composite, the S&P Mid-cap 400 and the S&P Small-cap 600.

Russell 3000: Tracks 3,000 companies trading on domestic markets. It represents 98 percent of the investible market.

NASDAQ Composite: The acronym NASDAQ can describe both an electronic over-the-counter exchange and an index. The NASDAQ Composite tracks companies trading on the NASDAQ exchange, which is composed primarily of tech companies and those that draw foreign interest. The NASDAQ Composite is closely followed by investors trying to capitalize on the hottest trends.

S&P Midcap 400 and S&P Small cap 600: Standard & Poor’s created these two indexes to track 400 medium-sized and 600 small-sized companies[3].

 

Indexes help us analyze historical performance more efficiently and effectively. Notice that since 2002, small-size and medium-size companies represented in the S&P Mid-Cap 400 and the Dow Jones U.S. Small-Cap Index outperformed both the Dow Jones Industrial Average and the S&P 500 (figure 7). Without the use of indexing, investors would be unable to quickly analyze the historical performance of small, medium or large company’s stocks. While this relationship might not hold in the future, it is important to factor in to future investment decisions.

Note that the companies in these indexes constantly change, but the index itself always represents the same universe. For instance, when the DJIA was created, it tracked only twelve companies. Today, it tracks thirty but still represents captains of industry. The most recent change was in March of 2015, when Apple replaced AT&T.

How Do Stocks Make Money For Us?

Rod Tidwell (Star Wide Receiver from the blockbuster film Jerry McGwire) might conclude that holding stocks means nothing unless we are “shown the money”. In regards to stocks, the most direct way we see actual money is through cash dividends or disbursements of cash to shareholders.

In addition to receiving dividends, investors make money through capital appreciation, or when we sell a stock for a price higher than the one we purchased it for. Gains from capital appreciation are either realized, or unrealized. If the market value is greater than the purchased price, it is known as an unrealized gain. The gain becomes realized when the owner actually sells their stock.

The phrase “buy low, sell high” describes capital appreciation, or the percentage change in the price of a stock. For instance, if we buy one share of stock at $45 and sell it at $50, we recognize an 11 percent gain. Note that buying a share of stock for $45 and selling it for $50 is a gain of 11 percent but buying a stock at $50 and selling at $45 creates only a 10 percent loss. Mathematically, you need a greater amount of gains to make up for losses. This is one reason why I emphasize that investors should focus on preventing losses rather than finding winners.

While many investors are attracted to the stock market for capital appreciation, dividends are extremely beneficial in the long run. In fact since 1940, more a third of the S&P 500 total return can be attributed to reinvested dividends[vi]. However, experts argue that chasing dividends is a poor strategy because recently, more companies are paying back its shareholders by repurchasing shares of stock. We will discuss share buybacks soon.

Many companies offer Dividend Reinvestment Plans (DRIPs). These plans allow the investor to take advantage of the law of compound returns by automatically reinvesting dividends to purchase additional shares of stock. If available, it is standard that online brokers make these plans the default option for shareholders. Note that stockholders still pay tax on DRIP dividends as if they were disbursed in cash. While they offer a great opportunity to automate reinvestment, they are not required. If an investor is in need of current income, DRIP plans might best be ignored.

To Distribute Dividend or Not, That Is the Question!

Not all companies issue dividends. Berkshire Hathaway, one of the world’s most successful companies has been managed by Warren Buffet for half a century and has only issued a dividend once (Berkshire has over $60 billion in cash[vii]). Companies such as Berkshire that decide to reinvest all of their earnings are considered to be “self-financing”.

During periods of high inflation (actual or expected), companies tend to reinvest a larger percentage of earnings, by paying lower dividends because their cost of capital increases. We can think of cost of capital as the cost of raising money through capital markets (a function of the interest rate on borrowed money and the expected return demanded by stockholders). A higher cost of capital means that it is more expensive for companies to finance operations through debt or equity.

Projects that are financed at a high cost of capital are more risky as they must yield greater results to break even. By reinvesting earnings, companies can self-finance projects without paying a higher cost to satisfy the demand of investors who fear inflation.

At the time that management determines their quarterly net income, they consider both the costs and benefits of issuing dividends. Determining this is difficult, as the market reacts negatively when companies stop paying or reduce their dividend. If management is uncertain they can sustain their payout, they may be best off reinvesting retained earnings. However, if there are limited growth opportunities, reinvesting what could have been paid out in dividends will only hurt the company.

To determine the benefit of reinvesting, management forecasts the company’s return on invested capital, or ROIC. ROIC[4] can be thought of as the return that a company will make on their reinvested capital. When management expects higher ROIC, usually due to an abundance of quality growth opportunities, companies have more incentive to reinvest earnings.

Analyzing a firm’s profitability by their dividend is tricky. On one end, the market reacts positively to an improved dividend while on the other, it might indirectly communicate that the company has difficulty locating growth opportunities. In addition, companies with higher dividend payments will often witness positive pressure in price, thereby reducing the dividend yield[5] per share of stock. A stock with a high dividend yield might mean that the market believes that the company is overvalued or expects it to cut their dividend. Due to the ambiguity with analyzing dividends, investors shouldn’t choose stocks based on dividend yield.

Stock Splits and Buybacks (Repurchases)

Other notable events are stock splits and share buybacks. A stock split increases the number of outstanding shares, while adjusting the price accordingly. For example a 2 for 1 stock split will change the price per share from $100 to $50. If we owned 50 shares at $100 per share prior to the split, we would own 100 shares at $50 per share after. Companies conduct stock splits for various reasons, most commonly, to make shares more affordable to smaller investors.

The market normally reacts positively because splits tend to occur when a company has experienced a great deal of capital appreciation and expects it to continue. While splitting the stock does not directly affect company fundamentals and is mathematically irrelevant, investors often bid up short-term prices[viii].

A share buyback is when a company repurchases its own shares from the existing shareholders. The company will either retire the acquired shares or leave them in an account called treasury stock, which can be reissued in the future.

Companies can go about this in a few ways. Most commonly, they will purchase shares on the open market[ix] or offer current stockholders a chance to sell at a fixed price. Post repurchase, each share of outstanding stock holds a larger claim on future earnings. Because the earnings per share increases, buybacks are considered a type of payout (similar to a dividend).

While it sounds appealing, stock buybacks are not always beneficial[x]. The source of money used to repurchase stock, the trading volume of its shares and price offered are all factors in determining whether a buyback is a good decision. However historically, the market has reacted positively to share buybacks as they send strong signal that management believes its own shares are a good investment. In other words, they consider themselves undervalued.

Earnings

While buybacks and splits are generally unexpected events, earnings announcements always occur at the end of each calendar quarter. Prior to the announcement, research analysts release their earnings estimates.

Since unexpected earnings growth or failure to meet expectations can sway stock price, investors pay close attention. Because of this increased attention, it is common for the stock to experience large price swings in the weeks prior to earnings announcements[xi].

The fast money culture that exists within financial institutions creates a sense of importance and urgency prior to the release of each period’s earnings. However, performance in one quarter doesn’t always lead to a trend. Even more so, companies often try to diminish large price swings in their stock by attempting to smooth out earnings. Through the use of different accounting methods, companies can shift a portion of their earnings from one quarter to the next. Since some investors might prefer more stable stocks, smoother earnings often benefit stockholders.

On the declaration date, earnings are released either before the market opens or after it has closed. At this time, a conference call occurs where company executives speak about the specific factors that led to the earnings’ performance, then answer questions from prominent research analysts in the field ask the company’s executives questions.

Executives carefully rehearse these conference calls and do their best to only provide positive insight into the company’s future. However, on occasion management slips and offers insight into the future of their company in ways financial statements do not. This may be done through the use of specific wording or by their tone of voice. Actually, there are many companies who develop technologies that try to analyze conference calls.

Market Capitalization

Not all stocks are created equal. Different stocks exhibit different characteristics. Furthermore, in some markets, one sub-asset class[6] may perform better than others while in other markets, that same sub-asset class might perform worse. To categorize stocks into similar groups we will focus on the size of the company and whether or not the stock is a popular, fast growing, highly demanded company. By splitting stocks into categories, we can better determine which types are right for us.

A proxy for size, market capitalization reflects the value that the market attaches to a company’s equity. It is calculated by multiplying the price per share by the amount of outstanding shares in that category. While market cap assigns a value to a company, it is not optimal to use this figure for analysis as it is somewhat controlled by management. By lowering the amount of shares outstanding, the company can put artificial upward pressure on the price of its stock (however market cap should theoretically remain the same).

In addition, market cap only measures the value of equity to market participants. Recall that firms often finance using a mixture of debt, equity and hybrid securities such as preferred stock. Focusing on equity alone leaves out half the picture. While it is not a good measure of intrinsic value, market cap works well for categorizing stocks based on size.

Growth vs. Value

While market cap represents size, growth and value represents general characteristics of a stock. To better explain the difference between growth and value stocks, let’s look at the types of investors who are usually attracted to each.

Growth investors look for flashy investment opportunities while value investors search for bargains. A good example of a growth investor was George Steinbrenner, former owner of the New York Yankees. Steinbrenner went after the best players, no matter the cost. Most of the time, these were young players in the prime of their career. In investment terms, Steinbrenner purchased high, and sold higher. He focused on young, innovative companies, regardless of the price tag. These companies are often mentioned in the media, offer a one of a kind product or service, and have abundant untapped growth opportunities such as domestic and international expansion.

Today’s most popular growth companies are Twitter or Facebook but they are not limited to high tech. In the past, Starbucks was considered a valuable growth stock as they were expanding both domestically and abroad.

Individuals invest in growth companies primarily for capital appreciation. Abundant untapped growth opportunities create a high-expected return on investment capital (ROIC), which gives the company incentive to reinvest their earnings instead of distributing them in the form of dividends. These high expectations often attract investors, making shares relatively expensive.

Famous value investor Warren Buffet proclaims, “It is better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Instead of looking for high growth and excitement, value investors prefer cheap companies, often ignored by the general market.

One of Steinbrenner’s contemporaries was a man named Billy Beane who managed one of the Yankees American League rivals, the Oakland Athletics. He looked for players who demonstrated skills that were ignored by other owners. While the Yankees focused on home run hitters and base stealers, the Athletics focused on a less exciting stat, On Base Percentage[7].

Beane noticed that veteran players were largely ignored by the rest of the league, and could be purchased at bargain prices. While they might not have the strength to hit many home runs, they had the experience and knowledge to get on base when necessary.

In relation to stocks, value investors are more attracted to high dividend yields, bargain prices and high net asset value. Because growth opportunities may be few and far between, value companies generally disburse a greater percentage of earnings in dividends.

Howard Marks, prominent hedge fund manager of Oaktree Capital Management, explains the difference between growth and value as the measurement “between value today and value tomorrow”. Value investors focus on past and current value while growth investors expect value in the future. Incorporating that expectation adds risk that is not certain to pay off. Due to this extra layer of risk, I suggest that individuals are best off focusing their portfolio on value stocks.

The Power of Small-Cap and Mid-Cap Stocks

The categorizations mentioned above are popular for a reason. Historically speaking, value stocks have outperformed growth stocks[xii] and small and medium sized companies have outperformed large[xiii]. Recall that small cap stocks represent companies with a market cap between $250 million and $2 billion and mid cap stocks represent ones with a market cap under $10 billion. Not only have small-cap and mid-cap companies historically outperformed alternatives, but also, they provide the individual investor great opportunities not usually found in larger companies.

1. Growth Potential

Small-cap and mid-cap stocks provide an opportunity to invest in companies that are ahead of their peak. At one point in time, many of today’s most successful companies have been small cap stocks. These investments reflect what famous value investor Peter Lynch calls a “10 Bagger” or a stock that can grow to ten times its original value. As Lynch promotes in his book “One Up on Wall Street”, $10,000 and two ten baggers can make you a million dollars.

Since large-cap companies are more mature and have already experienced great growth, they rarely grow to 10x their value within an ordinary investors’ lifespan. While large-cap stocks may offer stable dividends and downside protection, they have limited upside. Therefore, investors who are searching for outperformers might be best off focusing their search on smaller companies.

2. Low Institutional Ownership

As we discussed, institutional investors such as mutual funds, hedge funds and pension funds invest large sums of money into individual companies. Owning a large portion of a company gives these investors specific benefits, such as having a greater ability to communicate with company management. However, many funds are restricted to purchase such a large stake in small company stocks for two main reasons which we discussed earlier. First, the SEC does not allow mutual funds to own such a large percentage of one company and second, there are rarely enough sellers that want to sell such a large stake at the market price; therefore large purchases drive up the price to levels that might be considered too expensive. Due to these impediments, the market for small companies is less efficient than the market for large companies (remember the small company effect).

These impediments offer a great advantage to individual investors because it allows us to get in ahead of institutions. If the company begins to see success, institutional demand picks up and eventually puts powerful upward pressure on the price of the company’s shares.

3. Ignored by Analysts and the Financial Media

Data shows that small-cap and mid-cap stocks receive less recognition than large-cap stocks[xiv]. Many media outlets, such as CNBC and Bloomberg, do not cover small companies because they are unfamiliar to their audience. In addition, sell-side analysts rarely cover small-cap stocks since they are unable to generate sufficient commissions from investment banking fees and institutional trading[xv]. This lack of recognition creates inefficiencies in the market and often promotes an environment of low demand, leading to a greater amount of undervalued stocks.

Due to inefficiencies that exist in the small-cap and mid-cap market, prices can vary greatly from their intrinsic value. This may mean the company is undervalued or overvalued. To resist from investing in overvalued stocks, ample analysis is necessary. In the next section, we will learn a simple method to weed out poor quality, overpriced stocks.

Stock Price vs. Stock Value

“Most of the time a security’s price will be affected at least as much and its short-term fluctuations determined primarily by two other factors: psychology and technicals…These are non-fundamental factors, that is, things unrelated to value that affect the supply and demand for securities.” — Howard Marks, Oaktree Capital

In Economics 101 we learn that price is a function of supply and demand. Since the stock market is made up of millions of investors (some rational, some not), supply and demand is sometimes unclear.

As Howard Marks notes, stock price is influenced by various elements, including non-fundamental factors such as market technical (we will discuss this later) and investor emotions. This complexity makes it extremely difficult, if not impossible to forecast short-term price movements. While this is the case in the short-run, ultimately stock prices should strongly reflect intrinsic value.

This does not mean that price fluctuations will eventually cease. There is no reason to believe that market noise will diminish or that investors psyche will change. Instead, future stock prices will fluctuate around a market price that reflects, but will never equal intrinsic value.

Since the worth of a company is affected by improvements in its ability to create earnings and growth in the general economy, intrinsic value is naturally growing. Undervalued stocks will eventually be bought and overvalued stocks will eventually be sold but price per share will grow alongside earnings growth. This theory is reflected by a mathematical concept called mean reversion, which says that prices may fluctuate in the short-term, but eventually they will revert to their average. Since a company’s earnings are expected to grow, investors expect prices to revert not to the historical average, but its moving average.

 

The moving average refers to the rolling average of a series of data points. By using a long-term data series, the moving average can reflect investor’s perception of intrinsic value, or what a company is truly worth.

The moving average is a powerful tool because not only does it smooth out erratic data, but it also gives the investor a framework for growth. For example, in an inefficient, weak-form and semi-strong efficient market, investors can assume that stock price per share will grow at a rate above its moving average, not its current stock price. As you can see in figure 8, the current price of the Dow is trading well above its moving average. Mean reversion states that price will eventually revert toward the moving average (as seen by the diagonal line).

The Easiest Way to Lose Money

The easiest way to prevent losing large sums of money in the stock market is to ignore penny stocks. These securities are generally illiquid and exist for speculation purposes only. In some cases, penny stocks are highly manipulated companies that do not offer any substantial long-term value.

The term “penny stock” refers to nano-cap or micro-cap stocks (market cap of $50 — $300 million) that aren’t traded on well-known exchanges. In addition to being small to begin with, penny stock bankers attract interest from speculators by keeping the share price under one dollar. Many trade over the counter on private exchange called the Pink OTC market which is known for having lenient listing requirements. For instance, companies can list themselves on either exchange without providing investors with audited financial statements. Penny stocks are risky for four reasons:

1. Public information is rarely available: Investors can’t perform necessary analysis, let alone truly understand a company, without audited financial statements.

2. No historical data: Most penny stocks are either new companies or ones that are currently in bankruptcy.

3. No minimum standards: Companies do not have to meet any stringent criteria to list on an OTCBB and Pink Sheets exchange.

4. Low Liquidity: Finding a buyer might often mean substantially lowering asking price. In addition, the bid-ask spreads for liquidity providers are much wider than stocks trading on well-known exchanges, making purchasing or selling relatively expensive.

The Float

Due to less stringent listing requirements, exchanges such as the Pink OTC market have become grounds for companies who intend to manipulate their stock price. To better understand how the price of a penny stock can be manipulated[8], we must understand the concept of the float.

Corporations are only allowed to issue the number of authorized shares declared in its charter. When it goes public, management often holds back a certain percentage of authorized shares to be issued at a later date. The float describes the number of shares freely traded on the market and does not take into account non-issued authorized shares, locked-up stock (held by insiders), and treasury stock (stock that has been repurchased). A “low float” means that the percentage of shares of stock available to the public represents a small percentage of the total authorized stock. When this occurs, demand for shares are often much greater than supply, which may inflate prices to unreasonable levels. Additionally, the illiquidity associated with low floats may inflate prices further.

The first decision a company makes in regards to its float is deciding the amount of shares to issue the first time they offer stock to the public. Going public with a low float might create artificial demand and an imbalance in market pricing.

A recent example of a popular company that chose to employ this strategy was LinkedIn. LinkedIn went public through issuing 7.8 million shares (10 percent of total equity). The result was a demand imbalance, artificially inflating its price[9] (LinkedIn’s stock doubled its first day). With such a low float, a relatively small amount of trading volume could cause a large drop in stock price. To prevent this, LinkedIn quietly increased its float to a level of around 65 million shares (about 80 percent of total equity). At a larger float, LinkedIn’s stock price becomes more difficult to move.

Penny stocks tend to start with a low float and slowly increase the number of issued shares, which dilutes the value of each current share of stock (penny stocks are notoriously known for increasing authorized shares also). This is because there are more shares that split the same amount of earnings. At inflated levels, insiders can slowly release non-issued, authorized shares and their own shares at inflated prices. While the effect of dilution plays out with time, the market reacts by selling, which will dramatically lower the price of an illiquid penny stock. Even at low prices, insiders may still profit by selling shares because they acquired these shares for next to nothing (they are original owners).

The Pawn Shop for Stocks

Sometimes, it isn’t the original owner who is directly manipulating the stock price. If a small company needs money, they may be inclined to borrow from a private investor because commercial banks are either too expensive or restricted from doing business with them. Private investors who lend to these companies often require a conversion provision, meaning that if the company can’t pay back the loan, it must offer the lender common stock (insider shares) at a discount to market price. By issuing convertible debt, the company borrows the money for much less than if it was to take out a loan from a bank. Over time, the company fails to pay back its debt and issues stock to the lender. Because this stock is issued at a discount, the lender will immediately sell, sending the market price down to nothing. For these reasons, individual investors may want to stay clear of low-float stocks.

Key Takeaways

· Stocks have historically been the best investment because stocks realize intrinsic growth.

· Liquidity plays an important role in a well-functioning market. A liquid market ensures that investors can quickly and cheaply sell their investments at a fair price.

· Indexes help investors analyze market data more efficiently. The most popular indexes are the Standard and Poor’s 500 (S&P 500) and the Dow Jones Industrial Average (simply, the Dow).

· Stocks make us money in two ways: Capital appreciation and dividends.

· Companies choose to reinvest earnings so they can finance growth projects without having to raise new money.

· Market Capitalization is a good proxy for size but not for intrinsic value.

· Value stocks have historically outperformed growth stocks because growth stocks incorporate an extra layer of risk.

· Small-Cap and Mid-Cap stocks have historically outperformed large-cap stocks.

· Impediments prevent institutions from buying small-cap stocks and offer individual investors a chance to buy small companies before they experience great growth.

· Stock prices in the short-term are based on a variety of factors, many of them impossible to quantify. In the long-term, stock prices reflect a company’s intrinsic value.

· In a mean reverting market, stock price will eventually revert to its intrinsic value which can be represented by a moving average.

· Penny stocks are the easiest way to love large sums of money in the stock market. They exist for speculation purposes only and may be heavily manipulated.

[1] Increase in wealth = rate of return — rate of price growth (inflation) = 10.5%-3.3% inflation

[2] Exception to Real Estate securities.

[3] Small-size and medium-size companies represent ones that’s equity is valued at an amount less than $10 billion (less than $2 billion for small size companies).

[4] ROIC = (Net Income — Dividends) / Total Capital

[5] Dividend Yield = Annual Dividend/Price Per Share

[6] An asset class refers to a general type of security such as: Stocks, bonds and cash. A sub-asset class refers to similar characteristics within asset classes, such as large-cap stocks, small-cap stocks and growth stocks.

[7] On base percentage (OBP) refers to the probability of a batter getting on base, most likely from a hit or walk.

[8] Due to their small size and lenient listing requirements, penny stock prices are often manipulated by insiders in what is called a “pump and dump” scheme. This occurs when insiders generate upside momentum only to sell at the top, causing shares to spiral downward for those that bought in at higher prices.

[9] LinkedIn’s stock doubled its first day.

[i] Putnam, R. (2001). Bowling alone. New York [u.a.]: Simon & Schuster.

[ii] Gallup.com,. Gallup. Retrieved from http://www.gallup.com/home.aspx

[iii] Morningstar, Online Database

[iv] Us.spindices.com,. S&P 500® — S&P Dow Jones Indices. Retrieved from http://us.spindices.com/indices/equity/sp-500

[v] “Eligibility Requirements.” (n.d.): n. pag. Standard and Poor’s. Standard and Poor’s, 15 Jan. 2015. Web. 23 Feb. 2015.

[vi] The Power of Dividends. (2014). Retrieved from https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/WP106.pdf

[vii] “What to Expect From Buffett’s 50th Anniversary Letter.” Bloomberg.com. Bloomberg, 25 Feb. 2015. Web. 25 Feb. 2015.

[viii] Grinblatt, M., Masulis, R., & Titman, S. (1984). The Valuation Effects of Stock Splits and Stock Dividends. Journal Of Financial Economics. Retrieved from http://164.67.163.139/Documents/areas/fac/finance/valuation_splits.pdf

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