The Stock Market — An Introduction for New Investors

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You are a company called Fresh Paws that sells scented dog shampoo.

You’ve been operating for some years now, but recently you have seen an enormous increase in demand and you just can’t keep up with the orders. You need sales to make profit, but you need profit in order to make product for more sales. How are you ever going to make enough dog scented shampoo? How will you keep your customers from getting frustrated waiting and leaving for your competition?

Going Over The Basics

Worry not, my puppy-loving shampoo entrepreneur, for we live in a capitalist society with the wonders of the stock market. What you’re going to do is this: create an Initial Public Offering (IPO) for your business, listing it in a stock exchange. From there, you will sell equity in your business in the form of priced shares through that listing where each share is equivalent to a small fraction of ownership in your company. Only days after listing on the stock market, you’ve suddenly gained mass amounts of capital, and your business’s market value has shot up! Congratulations, you now have enough liquid cash to satisfy all of your dog shampoo orders without a hitch.

Wait just one second. Where did all that money come from? Who bought those shares? Why? Now what? It’s actually not that complicated, but to explain we’ll look at the same situation from the shareholders’ perspective. Shareholders can include institutional or retail investors — which you can learn more about here — but for the purpose of this example, we will be looking from a retail investor’s point-of-view.

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You are an individual investor who has worked hard at your 9 to 5 job over the past couple of years and saved a few grand to put into the stock market. You see a listing for a scented dog shampoo company called Fresh Paws that had its IPO very recently. You do some research, and see that the business has so much demand that they simply can’t keep up, and have a solid plan for long-term growth and sustainable returns. You make the decision to buy shares in the company, with the hopes of making a return on your investment (ROI), through an increase in the overall market value of the company (which subsequently increases the value of each individual share). It turns out that a lot of people see the same potential that you do in the company, and as with any asset, as demand increases, so does the price. Any increase in price per share on top of what you paid for it is referred to as unrealized profit. It is unrealized because you haven’t converted the shares into liquid cash, so it can be lost at any point if the stock price drops. In this form of return, you are betting on capital gains, though there is also another way that shareholders can make ROI, and that’s through dividends.

Let’s move a few years into the future, where Fresh Paws has become the largest player in scented dog shampoo industry, and has less room to grow, and thus less need to reinvest all of the profits back into the business. What the company can do now is begin to give out a portion of its earnings to shareholders in the form of dividends. That specific portion is chosen because the company sees a larger marginal benefit in giving that amount of money to keep shareholders happy, than in investing it into the business. The size of these dividends can be adjusted over time based on future changes in circumstances for Fresh Paws, financial or otherwise.

There are two types of stocks sold on the stock exchange, common stock and preferred stock. The major difference is that common shares offer their shareholders with voting rights at usually one vote per share, whilst preferred shares do not. This means that preferred shareholders do not have a say in a company’s decision making or electing the board of directors. Where preferred stock has the advantage though is in dividends, where they are generally guaranteed a fixed dividend, whereas common shareholders are not given first priority when they are distributed. It is rare for this to be done, but the board can decide to withhold dividends from being paid out to common shareholders. In the case that the company becomes insolvent and has to liquidate, common shareholders are still given last priority over the assets. On the bright side, common stock makes up a vast majority of issued shares and tends to outperform its preferred counterpart.

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Divide and Conquer

Before you go off and begin pouring your savings into newly listed dog shampoos, you need to understand how to divide stocks into different categories and classify them through their characteristics. There are many ways to classify stocks, and you will learn more specific and complex labelling systems in the future, though for now we will only be using four broad categories:

1. Growth Stocks
2. High Yield/Income Stocks
3. New Issue Stocks
4. Defensive Stocks

Growth stocks are usually the ones that make the most headlines over a sustained period, whether it be for innovation or catastrophe. Growth stocks are what investors buy for capital gains. They expect the perceived value of the company to increase and plan on selling their shares at the date at which they are most-valuable, pocketing the difference. Growth stocks are known to innovate at a faster rate relative to other companies in the market, with high year-over-year (YoY) increases in revenue and/or profit. Tech stock like Facebook, Apple, Amazon, Netflix, and Google — known as FAANG stocks — are some of the most famous growth stocks. Tech stocks have massively changed market sentiment over the past decade, and that’s because of a shift in investor appetite. No, not in their diet, but in their appetite for losses. Publicly traded companies have historically been heavily punished for delivering losses, and not turning around their businesses to make them profitable fast enough. This is changing. Companies like Uber, Lyft, Shopify, Spotify, and Tesla clearly tell us that Wall Street could care less whether such companies are making any profits, or losing billions of dollars each year, as is the case with most of the corporations listed. What they care about a lot more is scale — number of users. The new mindset is: volume first, monetization later. This sentiment has become so popular, that according to Recode, Money-losing companies that went public in 2018 did better than profitable ones. Critics say that companies like these are doomed to fail, and much of the tech sector is one big bubble that could burst at any moment. Regardless of whether that’s true or not, no one denies that there is a lot of money to be made in growth stocks.

Income stocks, also known as high-yield stocks, are in many cases of companies that have been around for many years. This is because income stocks are defined for having high-rate dividend yields and thus are bought by investors seeking stable returns. Examples of income stocks include many oil companies like ExxonMobil and Imperial Oil, Real Estate Investment Trusts (REITs) like American Tower, and other blue-chip companies like Coca-Cola and Microsoft. With high-dividend stocks, it is important to look at how sustainable the dividend pay-out is based on company financials and whether it has a history of not paying dividends or decreasing the rate. If you simply pick the stock with the highest yield, you will most likely end up losing more money on the share price then you make from the dividend.

New issues are more plainly referred to as recent IPOs. Our example company Fresh Paws would fit into this category in its early stages. New issues are by far the riskiest of the four categories we are going over. That’s because the share price has been arbitrarily set, and the market has just gotten its hands on the stock. It takes time for a general sentiment to form, and investors to become educated on the new player. There is little to no price history due to the nature of these stocks, so there is also no general trend to look at or analyze which is another risk factor. With this high risk, also come high returns. If we look at a recent IPO that got a lot of attention like Beyond Meat, we can see this high-risk, high-reward in action, with a 500% post-IPO rally. At the same time, it has been, and remains extremely volatile, with double-digit drops not an uncommon site even months after the IPO.

Defensive stocks tend to remain under-the-radar most of the time, but have been gaining traction, as fears of a looming recession are growing. As you may expect, defensive stocks are defined as being more protected and a safer bet during economic downturn. They are able to hold their ground because they sell more necessities rather than luxuries, and have diversified assets. Such stocks often also come with a constant fair dividend, increasing very steadily. It makes sense that defensive stocks are popular in tough times. Examples include companies like Kraft Heinz Company and Johnson & Johnson.

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Indices and Exchange-Traded Funds

A stock index measures the change in the value of a collection of stocks, like a hypothetical portfolio of a specific market or market segment. They are strictly hypotheticals because an investor cannot invest in an index directly. Composite indices are used to represent the performance of an overall market, like the NASDAQ Composite and TSX Composite Index.

The Standard & Poor’s 500, or S&P 500 as it’s often called, is one of the most popular and referenced indices. It represents a portfolio of the 500 largest companies by market cap in the United States, and is a good indicator of where large-cap stocks are heading as a whole.

An Exchange-Traded Fund (ETF) is one of the newest investing instruments as it was only introduced in the 1990s and is becoming increasingly popular. An ETF is like a container holding a variety of securities within it, whether they be equities, bonds, or commodities. For now, we will be focusing only on stock ETFs. These ETFs can track overall markets, or specific industries just like an index, though the difference is that you can buy shares of an ETF. One share of an ETF is equivalent to buying a small portion of the overall value of the fund, meaning you can heavily diversify your portfolio with much less capital. For example, If you would like to invest in all S&P 500 companies, you would have to spend thousands of dollars just to buy one share of each, though if you buy one share of the S&P 500 ETF (NYSEARCA: SPY), it will only run you a few hundred. Unlike a mutual fund, that only accepts trades once per day, an ETF is considered more liquid as it trades the same as any other stock would, allowing buying and selling at any point in the trading day. ETFs also generally also have lower fees of 0.1% to 1% whereas mutual funds can be anywhere from 0.5% to 2.5%.

The first type of ETF encompasses our example of the S&P 500 ETF, and they are referred to as Index ETFs. Each one tracks a specific benchmark index and allows its shareholders to diversify to an extent that may otherwise be unattainable, or even just impractical. With this level of diversification, investors avoid the risk factor of relying entirely on one company, making them especially attractive for people who don’t have experience investing or don’t have the time to trade actively. Warren Buffet goes as far as to say that the best retirement plan includes putting 90% of your funds in an S&P 500 tracking ETF.

The next type of ETF is an actively managed ETF. These ETFs are, as the name suggests, actively managed, whether it be by one manager or an entire team. This is in contrast to an index ETF, which would be referred to as “passive management”. The goal of an actively managed ETF is to “beat the market” by taking bullish or bearish positions in specific sectors. Bullish and bearish is terminology you will get used to, meaning bet for, and betting against respectively. Actively managed ETFs are riskier than passively managed ETFs as the underlying securities are chosen selectively, which will always lead to it either outperforming or underperforming the broader market. An actively managed ETF has a fee rate on the higher end of the spectrum for ETFs due to its nature of requiring one or many people to, well, manage it.

Synthetic ETFs are Exchange-Traded Funds that replicate the performance of a benchmark, not by holding the securities of the benchmark, but by replicating them via swap contracts with an investment bank. Swap contracts are a form of derivatives where two entities agree to swap two cash-flows or liabilities over a period of time for mutual benefit. In the case of synthetically-backed ETFs, the swap would be between the ETFs value and the benchmark that it is meant to be tracking. There are risks that come along with this, but you will learn more about them once you have a good understanding of derivative contracts.

Conclusion

Congratulations! You now have a good understanding of how the stock market functions and the types of equities traded within it. You have a strong grasp on the fundamentals of equities and are ready to learn about other common securities. But how? Who will you teach you about fixed-income trading, derivative contracts, commodities and foreign exchange? Worry not, my puppy-loving shampoo entrepreneur, for investBETA is here. We will be covering all of those things over the coming weeks. Stay tuned!

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Key Takeaways

1. The stock market is where stocks and ETFs are traded on specific stock exchanges
2. Initial Public Offerings (IPOs) are how companies list on an exchange and sell small portions of ownership in the company in the form of shares
3. Shares are issued to raise capital for the business, and bought by investors for a return on their investment (ROI)
4. ROI can be made through capital gains or dividend payments
5. Common stock comes with voting rights, but given lower priority in comparison to preferred stock for dividend payments
6. Growth stocks are those that increase in value at a rate outpacing the rest of their industry
7. Income stocks offer high-yielding dividends, though can be dangerous if the payments are unsustainable
8. New issues are recently companies who have recently had an IPO and are some of the most volatile stocks
9. Defensive stocks are more protected during economic downturn as they generally sell necessities that are bought regardless of economic conditions
10. A stock index tracks the value of a collection of stocks of a specific market or market segment, though cannot be bought
11. An Exchange-Traded Fund (ETF) like an index but can be traded just like a regular stock
12. An ETF can be classified as an index ETF, actively managed ETF, and/or a synthetic ETF

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