Monday, February 24, 2014

Capital Stock, Common Stock

There is really only one place the average American can save for very expensive long term goals like a college education or retirement, stock markets. While it is very important to maintain an age appropriate cushion of bonds, Certificates of Deposit (CD), and cash to protect against market crashes, most of the growth in your investment portfolio will come from shares of stocks. You may choose to hold these equity instruments as shares in individual companies, in mutual funds, or their younger cousins Exchange Traded Funds (ETF).

In this blog, I have never tried to answer the question, “What is a stock?” as I expected that my readers already knew the answer. However, let’s take a minute to define exactly what it is that we are buying and selling.

In Wikipedia, I learned that the Roman Republic had the first stock market, at least in the Western world. Groups of individuals would join together to lease the right to provide different kinds of services controlled by the Government. They were called publicani or societas publicanorum. They issued shares to the owners. Polybius, a Greek historian notes that almost every citizen participated in owning some portion of these government leases. Cicero complains that some of these shares sold at a very high price. Some things never change.

After the fall of the Roman Empire, stock companies did not really take off again until the creation of the Dutch and English East India Companies around 1600. Prior to this only national governments or very rich families could afford to build ships that could participate in the very lucrative trade with the orient. Now both small and large amounts of money could be pooled into potentially profitable ventures. Shares in these enterprises could be bought and sold in open markets, increasing the liquidity of a nation’s wealth and hence the velocity of money as it moved through the underlying economies. These innovations made England and Holland the economic superpowers of the day. Stock companies shifted wealth and ultimately political power away from the feudal nobility into the hands of the rising middle class. I believe that this shift also fueled the Protestant Reformation. The ebb and flow of money generated by profitable corporations continues to fuel the wealth of the world, as well as the growth or decline of the political and military power of nations.

A share of stock (properly called capital stock) is an equity instrument that gives the owner a “piece of the action.” That is they own a portion of the company based on the total number of shares issued by the company. In the case of common stock, the owners possess voting rights to elect the board of directors, as well as certain other rights specific to that particular company.

There are two reasons to buy stock, capital gains and dividends.

When you purchase a share of stock you hope that it will go up in value. Most likely it will go up in value if it becomes more profitable. A little company is more likely to become significantly more profitable in a shorter time period than a very large company. The small company is more likely to go bankrupt than an ancient multinational giant like Exxon. Generally speaking the giants are slow moving but safer. Normally big wins come from small companies. A properly balanced portfolio needs both kinds of shares. Over time, the value of your shares should increase. The term for this growth is capital gains.

Dividends are your share of the profits. Not every company pays a dividend. Small, new companies need to plow their profits back into growing the business. Once established and profitable a company should share its money with its owners. Typically, once every three months, your company will cut you a check for the dividend multiplied by the number of shares that you own. This is your money. You can keep it, spend it, or invest it in something else. You can also choose DRIP (Dividend Reinvestment Program). For no cost, you can reinvest your dividends into more shares of the stock that paid you the dividend. This is a very cool way to make the power of compound interest your servant.

Fortunately for you the shareholder, you do not own shares in a corporation in exactly the same way you own your car. Under law, a company is considered a separate legal entity. In fact it is consider a “person” under the law. This means the company can sue or be sued without the repo man coming in the night for your personal automobile. Private companies that are owned by individuals or small groups of individuals can go public. That is they can issue large numbers of shares that are then sold to the general public. This is the big payday that is the dream of every entrepreneur. A publicly owned company can go private. That is a small group of investors can pony up the money to buy out all the shareholders. This decision is usually made by the board of directors with a lot of input from the major shareholders and sometimes with a lawsuit or two.

In the case of bankruptcy, the bondholders and the other creditors will be made whole before the shareholders get anything. If after this “senior” debt is satisfied, the court will supervise the sale of what is left. Once the lawyers are properly enriched, you the shareholder will get what is ever left. In such an instance expect nothing.

These shares are generally bought and sold through your brokerage house accounts or on your behalf by the managers of your mutual funds. It is important to remember that studies have demonstrated that over the course of a lifetime two concerns will prove most important to the outcome of the average investor’s efforts. First, maintaining a properly balanced diverse portfolio over a long time period is more likely to deliver a good result than picking particular stocks at just the right time. Secondly, the cost of brokerage fees, sales commissions, and management fees are enormously important factors in the ultimate growth of your money. Whatever path you choose to follow be relentless in your efforts to control these expenses.

Remember, that while computers, cell phones, lowered brokerage fees, and the Internet have certainly evened the playing field, the big boys will always have the edge. Don’t ever forget they play by a different set of rules.

In the words of the infamous card shark and conman, Canada Bill Williams, “Yeah, the game is crooked but it is the only game in town.”

Now let’s be careful out there!

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