Introduction to the Stock Market and Investing

 

 

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:

 

Earnings 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 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.

 

Well, that was easy. Well, not really.

 

The stock market is “forward-looking,” that is, it tries to anticipate changes, especially changes 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 clinical trial and FDA approval. If one or both fail, the company could go bankrupt. As is true of companies trying to develop any new technology.

 

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. An upward trend in the economy leads to an upward trend in total income and total spending. Most companies can usually expect expanding sales, usually rising faster than total expenses, and thus increasing 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. You are betting the U.S. economy, and the global economy, will continue to expand and public companies will become larger and more profitable.

 

Corporate earnings and EPS are more volatile (bigger percent changes) than the economy’s GDP changes or a company’s changes in sales. 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. 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 to the company or its industry. It may have a successful new technology, successful new products or become more efficient (lower unit costs).

 

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 increases the chances of a large downturn in stock prices.   

 

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 very low birth rates seem to indicate that many couples and singles are substituting pets for children (they’re cheaper unless they need an operation). The aging of the national and global population presents opportunities for certain categories of companies, the most obvious being health care. Some leisure activities beloved of senior citizens, such as cruise lines, were doing well before Covid. 

 

Another trend is that most of the increases in income and wealth are going to high-income households. Companies that sell services and luxury products to this income group have done well. When you buy your first Ferrari with your stock market winnings, you might think about buying stock in the company.

  

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.

 

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% above current market price. Certain types of companies tend to get bought out – specialty food producers, local and regional banks, small biotechs with an FDA approved drug or good clinical results. Small tech companies tend to get bought out while still private. If the venture capital companies then take the company public through an IPO (Initial Public Offering) or a SPAC (IPO light), you should probably stay away. Usually, the early investors are cashing in. The stock price may rise quickly, often followed by a major fall in the stock price. If you like the company as a long-term investment, this is probably the time to buy.

 

Companies can influence their stock price through financial planning (aka “financial engineering”). One strategy, noted above, is to increase the dividend. A company can also buy back some of its outstanding stock, raising EPS by lowering the number of shares. Or a company can fund its expansion through taking on more debt. This is called leverage. 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 debt and only 500,000 shares. Its EPS is $2.00/share. Well, not quite. It pays 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 total earnings.

 

In a period of low interest rates, corporations will tend to take on more debt and buy back shares. Both have been happening at record levels for years. This increases EPS. If done over time, this combination of financial strategies might increase the growth rate of EPS and the PE ratio, even if there is little change in the underlying business.

 

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 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. The same thing happened in the 1970s. 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 followed by a recession tends to reverse quickly. A market downturn followed by a recession tends to be deeper and takes longer to recover.

 

This is not very helpful since a market downturn occurs before a recession as investors anticipate a coming recession. Sometimes a market downturn anticipates a recession that does not happen or is milder or shorter than expected. 

 

WHAT SHOULD YOU BUY?

 

Should you buy an index fund or an ETF based on some index, an actively managed fund or individual stocks? The three are not mutually exclusive. You might start with an index fund; the most popular is an index fund or ETF that mirrors the S&P 500 (the 500 stocks with the largest total market value). Then you might like a particular industry, maybe an industry you work in, or a set of similar stocks (gene editing, for example). 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. One reason is that the fund may have an unusual and risky investment strategy. This is your introduction to the concept of risk.

 

Index funds and index-based ETFs are good for ignorant investors. The stock market is one of the few places where being totally ignorant in the Information Economy is an advantage. Index funds beat most managed funds over the long run, partly 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 have a disproportionate influence on the price movement of an 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, most 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.

 

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 follow 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 overall 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 fuzzy X-rays and gummy impressions. Who makes the digital imaging system? You might also avoid the stock of companies that are getting hurt (losing sales and market share) by new competitors with new technology.

 

It is natural that beginning investors look at companies they are familiar with, usually companies that sell branded consumer goods and services. But many companies sell inputs (parts, components, IT, capital goods, software services) to other companies. They make their products and services available to all other companies, so their success is not tied to any one company. These are sometimes called “picks and shovels” companies. Who got rich during the California gold rush of 1849? A few gold miners. Most went bust. But companies that sold “picks and shovels” (and blue jeans) to the miners made money. 

 

What to look for in a small, high-tech, innovative, “disruptor” company? First of all, it is probably losing money (burning cash). It may need further rounds of financing in the future. This means more debt or more shares sold, which dilutes future EPS. You need patience. What you look for are indications the company might be a winner. Are its sales growing rapidly? Is its loss per share (negative EPS) getting smaller? How long before it has positive cash flow? Is it putting most of its money into a critical growth function, such as R&D or customer acquisition and retention?

 

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 produced a commodity in a competitive, price-sensitive market. Its earnings rose over time but varied widely and were unpredictable. Investors discounted the uncertainty and volatility. Its stock underperformed the market. It’s financial performance that counts.

Generally avoid “inside information”, tips, and recommendations of hot stocks from your brother-in-law. By the time you hear about them, it’s probably too late.  

 

GLOBAL INVESTING

 

If you are thinking of buying a foreign company or country ETF, you must consider political risk. In many “emerging” economies, equity markets are thin and manipulated by locals. There are hidden costs such as extortion and bribery. The Japanese stock market and economy never recovered from the early 1990s meltdown. Japanese governments have resisted any structural reforms. With price-fixing cartels controlling much of the economy, restrictions on imports, an aging and declining population, and limited immigration, the Japanese seem content to quietly commit demographic and economic suicide. 

 

China is a special case. To me, the political risks were always too high. I’ve never owned any Chinese stocks (with one exception, which I quickly sold). Political risk increased after Obama “pivoted” American foreign policy and military assets to confront China, Trump imposed tariffs, and Xi established political control on the Chinese economy, especially the large corporations, destroy $2 trillion in market value.

 

One of the ways American corporations have grown is to go international. Some expanded sales to other countries, others outsourced production. American companies have become multinational companies with much of their growth in sales and earnings outside the U.S. When looking at a company, especially notice what percent of their sales and sales growth is in China. Do they depend on a critical input from Chinese companies? Can production be easily moved to other countries?

 

There are many attractive foreign companies, particularly in Europe. One of my favorite companies started in Rumania. These companies are mostly large consumer product multinationals or smaller technology companies that sell globally to other technology companies.

 

WHEN TO SELL

 

You might have different strategies for different types of holdings. 

 

For an index ETF, you might expect to hold it for a long time. This might be part of your retirement fund (or your kids college tuition fund). Which brings me to a digression on retirement planning. Think about the assets you may have when you retire. Maybe equity in a house. Maybe a 401(k) and/or a rollover IRA. Maybe other income or assets. Also, you will have one or two Social Security income streams. Medicare (an insurance policy). So, the question is:  How much consumption are you willing to give up now to have some expected amount of additional income later? Or, to paraphrase the White Queen, more jam today or more jam tomorrow?

 

A managed fund often is a bet on some industry or sub-sector of the economy that you believe will do well (better than the overall market) in the future. Current examples - homebuilders, cybersecurity, renewable energy, large or small biotech. There are approximately 8,000 mutual funds and ETFs. Many of these funds mirror an industry index. Some don’t. You might sell the fund if something bad changes in the industry, you lose faith in the expertise of the fund managers, or the market turns down (many managed funds, being specialized, will fall a larger percent than the overall market).

 

If you have the time, like to play games, and are not seriously risk-averse (hate to lose money, even if only temporarily), you might want to look for and buy some individual stocks. Build you own portfolio.

 

A FEW STATISTICAL TRENDS THAT MIGHT HELP YOU WITH INVESTMENT/PORTFOLIO DECISIONS

 

In the long run, the more investors trade, the lower their rate of return.

 

Men trade more than women. 

 

Your chances of finding that one stock that will make you rich are very low. And you have to buy it at or near when it goes public and hold onto it for a long time. Of all the U.S. stocks that have existed since 1926, 4% (1,000 out of 25,000) accounted for all of the market’s gain over time. The other 96% percent – some with lower gains and a lot with losses – averaged out to no gain. Even tougher, only 83 stocks out of the 1,000 fabulous winners accounted for half of the long-term gain. And you can’t buy and hold forever – some of the monster winners got that way selling fossil fuels; they have done poorly over the last few decades and will probably join the losers group in the future.

A recent similar study of the period 1980-2020 by J. P. Morgan came to a similar conclusion.

 

A MODEST INVESTING PROPOSAL

 

You might want to have a portfolio something like:

 

60% index funds/ETFs. Information and time requirement – casually following general economic and political news. Avoid watching CNBC.

 

25% narrow index funds/ETFs or managed funds specialized by industry, country, or region. Information and time requirement – occasionally checking industry news, studies, or websites. Avoid watching CNBC.

 

10% individual stocks of companies that you think will beat the averages, with moderate risk. Information and time requirement – time and effort finding stocks. Maybe a watchlist on your phone from Yahoo Finance or some similar source of information.

 

5% high risk/high potential gain stocks, such as small biotechs. Information and time requirement – time and effort finding and following stocks. Suggest stop loss orders.

 

You could change the percents depending on your investment goals, your time horizon, risk aversion, and time spent managing your portfolio. If your time has high “opportunity cost” (making a lot of money working or doing something that is important to you), you might want to pay a financial planner to watch your portfolio for you.

Probably the best first book to read about the stock market and investment is the classic Burton G. Malkiel A Random Walk Down Wall Street. Make sure you buy the latest edition. Helped to start Vanguard; argues that investing in index funds/ETFs is the best long-term strategy. But presents alternative points of view.