Stock Market Investment Primer

This primer is aimed at the long-term investor. But this does not mean that you should necessarily hold all of the stocks and funds in your portfolio for a long time.

WHY STOCK PRICES GO UP

The movement of a stock index such as the S&P 500 or an individual stock depends on two things:

Earning per share (EPS) and changes in EPS.

Stock price/earnings per share ratio (PE ratio) and changes in the PE ratio.

If the PE ratio stays the same, an increase in EPS often leads to an increase in the stock price. The same is true of a stock index. Rising EPS combined with a rising PE ratio is often the reason why a stock goes up more than the average stock.

Since 2009, the beginning of the stock market recovery from the last recession, most of the increase in stock prices has been due to the increase in earnings per share (EPS).

Well, that was easy. Well, not really.

The stock market is “forward-looking,” that is, it tries to anticipate change, especially change in EPS and the PE ratio. There is a great amount of forecasting. But since the forecasted changes are in the future, they are inherently uncertain. The forecasts of some companies’ EPS are more uncertain than others. Some are very uncertain. For example, the future sales and earnings of a small biotech company may depend on the success of a clinial trial and FDA approval. If one or both fail, the company could go bankrupt. 

The EPS of a stock can go up for a number of reasons:

The economy is expanding. This has been the usual situation in the United States and also for the global economy for decades. So there is an upward trend in the economy leading to an upward trend in income and spending. Most companies can usually expect expanding sales and profits (earnings). This is the main reason why you can expect to make money in the long run; it is also one of the reasons why you should buy a stock index fund, either as a mutual fund or an ETF.

Corporate earnings and EPS are more volatile (bigger percent changes) than the economy’s GDP changes or a company’s changes in sales. Part of the reason is that for most companies, their EPS is leveraged by debt (see below). So, for example, a 5% increase in nominal GDP might lead to a 10% increase in a company’s sales and a 20% rise in earnings per share. The same relationship works in reverse when an economy goes into recession.

A company’s stock price does not entirely depend on economic expansion or other influences external to the company. Some factors are internal. It may have a successful new technology, successful new products or become more efficient. 

If you find yourself buying new products or services, you might want to look at the company as a potential investment. The first time you or your tax accountant used Turbo Tax, when you had your teeth fixed with Invisalign, when you bought your first iPhone, when you started looking for “organic” foods, when you go on your first space flight, you might investigate the company behind these new products or services as potential investments.

A company’s PE ratio depends on the market’s consensus on the rate of increase in the company’s EPS. A company with a higher than average expected EPS growth rate will generally have a higher than average PE ratio. Both the market’s PE ratio and a stock’s PE ratio can change if there is a change in expectations of the future growth rate. A company’s PE ratio and stock price may go down even if its EPS grows but at a slower rate than expected. This is one reason why higher potential reward (percent gain) comes with higher risk.

Generally, PE ratios rise over a business cycle. Earnings have been growing for a long time and investors expect earnings to continue growing at least as fast as over the cycle. But a large and sudden increase in the market’s PE ratio may indicate that the market has developed a speculative bubble. This increaes the chances of large downturn.   

OTHER REASONS STOCK PRICES GO UP

If you are a long-term investor, you might consider investments based on a long-term

demographic or social change. The aging of the national and global population presents opportunities for certain categories of companies, the most obvious being health care. Some leisure activities, such as cruise lines, should do well. Another trend is that most of the increases in income and wealth is going to high-income households. Companies that sell luxury products to this income group have done well.

  

Whether or not a company pays a dividend and changes in the dividend influence the price of a stock. Not all companies pay dividends. On the other hand, some companies have a history of increasing dividends over time. A good strategy if you own such a company is to reinvest the dividend. The company will then pay rising compound interest, which over time can be an important part of the total return of owning the stock. Check to see if the company has rising earnings to cover the rising dividend. There are also ETFs and funds that only contain these types of companies.

Another way you can make money in the long run is corporate acquisitions. The acquiring company has to pay a premium over the acquired company’s stock price to obtain all the shares. Premiums are usually between 30% and 50%. Certain types of companies tend to get bought out – specialty food producers, local and regional banks, small biotechs with a FDA approved drug or good clinical results. Small tech companies tend to get bought out while still private.

Companies can influence their stock price through financial planning. One strategy, noted above, is to increase the dividend. A company can also buy back some of its outstanding stock, raising EPS by reducing the number of shares outstanding. Or a company can fund its expansion through taking on more debt. The two can be combined; much of the cost of share buybacks over the last 10 years has been financed by new debt.

Earning per share is leveraged by debt. Interest rate expense on the debt is fixed. Imagine two companies both making $1,000,000 a year from operations and do not pay income taxes. One has 1,000,000 shares, so its EPS is $1.00/share. The other company has more debt and only 500,000 shares. Its EPS is $2.00/share. Well, not quite. It has to pay interest on the debt, which is subtracted from the $1 million in operating earnings. But typically its EPS is still higher than $1.00/share. And its share price is probably higher. Also, its EPS growth rate will be higher for a given amount of increase in earnings.

In a period of low interest rates, corporations will tend to take on more debt and buy back shares. This increases EPS. If done over time, this combination of financial strategies might increase the growth rate of EPS and the PE ratio.

Your long-term rate of return on buying a stock or an index will depend on when you buy the stock or the index. It you bought the stock at the end of a business cycle or bull market and then the stock's price went down, your rate of return for years might be low or even zero. At the extreme, if you bought a group of stocks like the Dow Jones Industry 30 in 1929 you would have waited until 1953 to get even. On the other hand, if you buy stock at or near the bottom of a market downturn, it is likely that your rate of return for the next 3-7 years will be substantially higher than the long-run average rate of return.

A word about market downturns. There are two general types – with and without recession. A market downturn not caused by a recession tends to reverse quickly. A market downturn caused by a recession tends to be deeper and takes longer to recover. 

WHAT SHOULD YOU BUY? AND WHY.

Should you buy an index fund or ETF, a managed fund or ETF, or individual stocks? The three are not mutually exclusive. You might start with an index fund or ETF; the most popular is an index fund that mirrors the S&P 500 (the 500 stocks with the largest market value). Then you might like a particular industry or a set of similar stocks. It may be difficult for an outside investor to pick potential winners and avoid hyped probable losers. Choose a managed fund. You are paying for their research and their keeping up with changes. But be careful; many managed funds are very similar to index funds. Also, do not chase funds with outstanding recent results. Research indicates that the funds with the best results over three years are likely to exhibit below average returns over the next three years. 

Index funds and managed funds are good for ignorant investors. Index funds beat most managed funds over the long run, mostly because their costs are lower. If you buy a lot of individual stocks or a lot of specialized funds, you may have a disguised index fund. At a higher cost.

A few words about index funds. An index fund contains many stocks but they are not equal. The greater the total market value of a stock – “market cap” (capitalization) – the greater the weight of the stock in the index. So right now monster tech companies are the five largest companies in the S&P 500; the ten largest companies account for about 23% of the total market value of the index. To some extent, these and other really big corporations have become very large and very profitable because of innovation and high growth in the past. You are betting they will have higher than average growth in the future. This is a poor bet. If you look at the tech companies that dominated the indexes 20 years ago (or 10 years ago, or 30 years ago), they have been poor investments since then, although a few tech companies have made a recent comeback by getting into new businesses. 

The indexes contain companies that are losing money and many companies whose sales and earnings growth depend mostly on overall economic growth. If you believe that the U.S. economy is in for a period of low growth, then the rate of return on an index fund will probably be below the historic rate of return. In addition, many of the companies in a market index will be hurt or destroyed by technological change and innovation from new companies.

The index fund becomes “the market.” You would not buy a managed fund or an individual stock unless you expected your total return (capital gains plus dividends) was going to be greater than the total return of the index fund. This tends to rule out older, mature companies whose sales and earnings depend mostly on the total income growth of the entire economy; the change in their stock prices tend to closely followed the change in the market index.

Which gets us to the idea of risk. Research indicates that on average 60-70% of a stock price’s movement is correlated with the movement of the market. When you buy an individual stock, you are buying the other 30-40%. The question is:  Why do you think this stock will have higher EPS growth than the market? Or in the words of Dirty Harry, “Do you feel lucky?”

What kinds of stocks have a chance to outperform the market? One group is sometimes called “disruptor” companies. These are innovative companies that are creating new demand or disrupting existing industries or markets. For example, my beloved local electric utility, whose main service seems to be service interruptions and blackouts, is installing “smart” meters. Who makes the meters? My dentist raves about this new digital imaging system that replaced X-rays and gummy impressions. Who makes the digital imaging system? Again, avoid the stock of companies that are getting hurt (losing sales and market share) by new competitors with new technology or new products and services.

If you are thinking of buying individual stocks, the warning here is that a good company – a company that you admire – may not be a good stock. I once worked for a very well-run company. But it produces a commodity in a competitive, price-sensitive market. Its earnings vary widely and are unpredictable. Its stock has underperformed the market for decades. It is financial performance that counts.
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But first, you have to learn how to make enough income to start saving and investing. See my The 10 Minute MBA - Almost Everything You Need to Know to Manage Organizations, People and Yourself.

A good place to learn the basics and mechanics of investing in the stock market and other financial markets is the Investopedia website.

For an analysis of the stock market crash of 1929 and the start of the Great Depression, see my The Stock Market Crash of 1929 and the Beginning of the Great Depression. This essay questions the conventional wisdom that the stock market crash of 1929 "caused" or "triggered" the Great Depression.

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