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Saturday, January 21, 2012
Understanding Stock Prices
Understanding Stock Prices
Many people think that all they have to know about a stock is its share price. While this is an important piece of information, it’s only one piece of the puzzle. Nevertheless, stock price is important. After all, since the stock market is an auction, you should know how much a stock costs, and most important, what it’s worth before you buy or sell it.
Basic Stock Quote
A stock quote (or quotation) is simply the current price of a stock. An example of a stock quote is given in Figure 5-1. If you don’t know the current price of a stock, you can simply ask your broker, for example, “Could you give me a quote for Cisco?” In the example in Figure 5-1, the person will reply, “$15.04.” This simply means that if you wanted to buy one share of Cisco at that moment, it would cost you $15.04. For many people, the stock quote is the most important piece of information they can receive about a stock; it tells them exactly how much it will cost them to buy the stock, or what they will receive if they sell it.
Figure 5-1
For years, some stock exchanges were unwilling to give out real-time stock quotes and news unless they were paid exorbitant fees for the information. Individual investors who didn’t pay the fees received free stock quotes, but with a 20-minute delay.
Today, however, it’s very easy to get free real-time stock quotes any time of the day or night. You can look on financial television programs like CNBC, Bloomberg, or CNNfn. If that is inconvenient, you can pick up the phone and call your stockbroker (if you have one). If you are patient, you can always wait for tomorrow’s newspaper. The easiest way of checking stock quotes is by logging on to the Internet. There are hundreds of financial sites that provide real-time quotes.
As you can see in Figure 5-1, each stock has it own ticker symbol. (In addition to stocks, mutual funds, index funds, bonds, and options have ticker symbols.) Some are easy; for example, the stock symbol for IBM is IBM. The symbol for Microsoft is MSFT, that for AT&T is T, that for General Electric is GE, and that for Cisco Systems is CSCO. If you aren’t sure of the exact ticker symbol, type in the name of the com-pany, and the computer will give you the ticker symbol in seconds.
Most people refer to a stock by its symbol rather than its full name. Every experienced investor has memorized the ticker symbols for the most popular stocks. You can tell what exchange the stock is listed
on by counting the number of letters in the symbol. If the stock is on the Nasdaq, the symbol will have 4 or 5 letters. If the stock is on the NYSE, it will have 1, 2, or 3 letters.
Detailed Stock Quote
Let’s take a look at a detailed stock quote for Cisco Systems (CSCO), shown in Figure 5-2.
Figure 5-2
Bid: This is the price you will receive if you want to sell the stock. Ask: This is the price you will pay if you want to buy the stock. Previous Close: The stock closed at this price on the previous day.
When you look at the detailed stock quote in Figure 5-2, you will see two stock prices, one higher than the other. These are the bid price and the ask price. The bid and ask prices are extremely important but also confusing (at least they were to me). The lower price (the one on the left) is the bid price (or offer price), which is the price you will receive if you own the stock and want to sell it. In Figure 5-2, the bid price for Cisco is $15.05. The higher price (on the right) is the ask price, the price you will have to pay if you want to buy this stock. The ask price for Cisco is $15.07. The difference between the bid and ask prices is called the spread. In Figure5-2, the difference between the bid price ($15.05) and the ask price ($15.07) is 0.02. A few years ago, when stock quotes were in fractions, the spread on some stocks was very high, sometimes as much as a dollar.
When the spreads were very wide, if you bought a stock and then sold it quickly, you would immediately lose money on the spread.The lower the spread, the better for investors. Because of decimalization (instead of displaying stock quotes in fractions, the exchanges now dis-play them in decimals), the spread between the bid and ask prices is often quite small, sometimes only a penny or two. That makes it fairer for investors.
Other important information is how much the stock has risen or fallen in both absolute and percentage terms during the day. In Figure 5-2, Cisco is up 0.23, or 1.55 percent. Many people also look at the 52-week lows and highs to get an idea of where the stock price has been in the past.
The detailed stock quote also gives the market capitalization, the outstanding shares, how much dividend the company pays (if any), and the volume. (In the detailed stock quote example, note that you can do a historical price search as well as do extensive research on any stock or mutual fund.) You can learn a lot by studying the detailed stock quote.
Stock Price
Keep in mind that the detailed stock quote is just a quick snapshot of what is happening with the stock. Although these numbers can be useful, if you want to really get to know a stock, you’ll have to dig deeper, as you’ll learn as you read the rest of the book. A lot of people don’t realize that the stock price is just one small piece of information you need to know about a stock. Some claim that it’s the least important piece!
Too many people believe that the stock price determines whether a stock is a bargain or not. What many people don’t realize is that a stock selling for $50 can be a better value than a stock selling for $10.
If the $10 stock has little or no earnings and loads of debt, you’d be better off buying fewer shares of the $50 stock rather than more shares of the $10 stock. (Warren Buffett once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”) That’s why some investors spend so much time looking at ratios like the P/E (when you divide a stock price by its earnings per share, you end up with a P/E, or price/earnings, ratio) to determine what is a fair price.
After all, you don’t want to be the kind of person who knows the price of everything but the value of nothing (to paraphrase Oscar Wilde).
After-Hours Trading:
Making Money 24 Hours a Day
During the bull market, a lot of people, myself included, thought that people would flock to the after-hours market. We figured that people who couldn’t trade during the day would be eager to trade at night. As the markets fell, so did interest in after-hours trading. In the middle of the bull market, online and traditional brokerage houses were aggressively offering clients the ability to trade at any time of the day or night. But as the market plum-meted and investors lost money, the after-hours market fizzled out. Although professional traders continue to trade at night, only a handful of investors still participate in the after-hours market.
(The after-hours market also includes the premarket, which usually begins around 8:00 a.m. EST.)
After-hours trading works like this: The major stock exchanges remain open for electronic trading through electronic communication networks (ECNs) so that investors can trade outside of regular hours.
Only a few million shares are traded in the after-hours market, unlike the regular market, where billions of shares are traded during the day. In fact, the volume is so small that most investors would be well advised to avoid night trading altogether (unless you take the time to thoroughly understand how it works). The low volume can cause strange things to happen to stock prices. If you are unfamiliar with after-hours trading,you can end up buying or selling a stock for a terrible price. Trading after hours is a tricky strategy, and my advice is to do most of your investing and trading during the regular market.
Fun Things You Can Do (with Stocks)
Fun Things You Can Do (with Stocks)
You can do a number of interesting things with stocks: You can diversify, allocate, compound, split them, and short them. Let’s look at each of these concepts in turn.
Diversification: Avoiding Putting All of Your Eggs in One Basket
I’ve already mentioned the importance of diversification, meaning that instead of betting your entire portfolio on one or two stocks, you spread the risk by investing in a variety of securities, with the number and the specific securities depending on how much risk you want to take and how long you will stick with your investment. (A portfolio is a list of the securities, including stocks, mutual funds, bonds, and cash, that you own.) The idea behind diversification is that even if one investment goes sour, your other investments might soar.
Many people’s portfolios were destroyed during the recent bear market because they invested all of their money in one stock, often that of the company for which they worked. For example, if the only stock you owned was Enron because you worked there, not only did you lose your job when Enron filed for bankruptcy, but you lost your investment as well.
Let’s see how diversification works when you are 100 percent invested in the stock market. First of all, you need a lot of money to properly diversify, more than most people can afford. That’s because you need to own at least 25 to 50 stocks in various industries to be properly diversified (now you understand why mutual funds are such a good idea). Many financial experts suggest that you own a mixture of growth, value, and income stocks, along with a smattering of international stocks. You might also own stocks in both large companies and smaller ones.
It takes considerable skill to determine how you should diversify because so much depends on how much risk you are comfortable with (called risk tolerance), your age, and your investment goals. For example, when the Internet stocks were going up, many people put 100 per-cent of their money into those stocks. Unfortunately, this wasn’t proper diversification. Although putting all their eggs in one basket did make some people rich on paper, most of the people who did this didn’t understand the risks they were taking until it was too late. (Many people thought they were properly diversified until all of their investments went down at once.)
In my opinion, if you insist on investing 100 percent of your money in stocks (and even if you add mutual funds, bonds, and cash to the mix), you should speak to a financial planner or adviser about proper diversification. There are so many possible combinations that diversifying your money can be mind-boggling. On the one hand, you don’t want to play it too safe by being over diversified. On the other hand, you don’t want to expose yourself to too much risk.
Asset Allocation: Deciding How Much Money to Allot to Each Investment
Once you have diversified, you have to decide what percentage of your money you want to allocate (or distribute) to each investment. For example, if you are 30 years away from retirement, you might invest 65 percent in individual stocks and stock mutual funds and 25 percent in bonds, and keep 10 percent in cash. This is asset allocation.
As with diversification, the correct asset allocation depends on your age, your risk tolerance, and when you’ll need the money. In the old days, you were told to subtract your age from 100 to determine the percentage to put into stocks. Unfortunately, it’s a lot more complicated than that. Once again, it is a good idea to seek professional help in determining the ideal asset allocation for you.
In a real-life example, one 80-year-old man I know had 90 percent of his portfolio in only two stocks, Lucent and Cisco Systems. When these stocks plummeted, his two-stock portfolio was ruined. Now he’s worried that he won’t have enough money to survive, and he’s right. The goal for this man is to protect his original investment. On the other hand, I have a 21-year-old friend who is putting much of
her money in stocks and stock mutual funds, and she can afford to do so because her time horizon is so much longer.
Compounding: Creating Earnings on Your Earnings
There is something you can do with stocks that can make you rich, according to the mathematicians who dream up this stuff. The idea behind compounding is the reason that people began to buy and hold stocks in the first place. Compounding works like this: You reinvest any money you make on your savings or investments: interest, dividends, or capital gains. The longer you keep reinvesting your earnings, the more money you’ll make.
For example, if you invest $100 and it grows by 10 percent in one year, at the end of the year you’ll have a total of $110. If you leave the money alone, you’ll have $121 by the end of the next year. The extra $11 is called compound earnings, or the earnings that are earned on earnings. The more your investment is earning, the faster the com-pounding. The advocates of compounding remind you to invest
early if you want to have more money later. Compounding is a neat accounting maneuver that can make you rich if you live long enough to see it work. The idea is that as the stock you own goes up, it compounds in value, bringing you even greater profits. The longer you leave your money in a stock, the more it compounds over time. John Bogle, ex-chairman of the mutual fund company Van-guard, called compounding “the greatest mathematical discovery of all time for the investor seeking maximum reward.”
The only problem with compounding formulas is that they make assumptions that may not occur in real life. Compounding works like a charm as long as your stock goes up in price. The problem with the stock market (and compounding) is that there are no guarantees that your stock will go up in price or that you’ll make 8 percent or more a year in the market.
The Stock Split: Convincing People to Buy Your Stock When a corporation announces a 2-for-1 stock split, this simply means that the price of the stock is cut in half but the number of shares you own is doubled. For example, let’s say you own 100 shares of IBM at $80. If IBM announces a 2-for-1 stock split, the price of IBM would be cut in half, to $40 a share. Now, instead of owning 100 shares of IBM, you’d own 200 shares. From a mathematical perspective, nothing has changed at all. You own twice as many shares, but since the price of the stock is reduced by half, the value of your investment is exactly the same. (You can also have a 3-for-1 or 4-for-1 stock split.)
A stock split is often done for psychological reasons more than anything else. In this example, the price of IBM has dropped from $80 to $40 a share. Investors who are primarily focused on price might consider the $40 price a bargain, something like a half-off sale. In reality, a stock split doesn’t change the corporation’s financial condition at all. Instead, the biggest advantage of a stock split is that it
may lure more investors—those who felt that they couldn’t afford to buy IBM at $80. During the bull market, after a company announced a stock split, the stock price often went up.
Nevertheless, there are practical reasons for a company to split its stock. For example, do you know what would happen if a corporation never split its stock? Think about Berkshire Hathaway, Warren Buffett’s corporation. As I write this book, his stock is trading at $70,000 a share. That is not a typo! Most people couldn’t afford even one share of stock at that price. So from a practical standpoint, stock splits do make sense for corporations. They do nothing to increase the value of the corporation, however. Splitting the stock is purely an accounting (or marketing!) procedure designed to make a stock more enticing to investors.
Some companies with low stock prices have used another type of maneuver, the reverse split, to artificially pump up the price of their stock so that they aren’t delisted from a stock exchange.
For example, if a stock is trading for $1 a share, after a 1-for-5 reverse split, the price will rise to $5 a share. Just as with the regular stock split, fundamentally nothing has changed in the company. If you are a shareholder, the value of your shares remains the same, but you now own fewer shares. (Let’s say you own 100 shares of a $1 stock. After a 1-for-5 reverse split, the stock rises to $5, but the 100 shares you own are reduced to 20 shares. From an accounting standpoint, you still own $100 worth of stock.) The bad news about reverse splits is that most of the time the higher stock price doesn’t last. Before long, the stock may return to $1 a share.
Selling Short: Profiting from a Falling Stock
When you invest in a stock hoping that it will rise in price, you are said to be “long” the stock. Your goal is to buy low and sell high. Your profit is the difference between the price at which you bought the stock and your selling price. On the other hand, if you hope that a stock will go down in price, you are said to be “short” the stock. When you short a stock, you first sell the stock, hoping to buy it back at a lower price. Your profit is the difference between the price at which you sold the stock and the price at which you bought it back. If you’ve never shorted stocks, it sounds strange until you do it a few times.
Imagine making money when a stock goes down in price! For many people, it sounds almost un-American or unethical to profit from a falling stock. In reality, you’re in the market for only one reason: to make money. It doesn’t matter whether you go long or short as long as you make profits. It’s neither un-American nor unethical to short stocks. It’s a sophisticated strategy that allows you to profit even
during dismal economic conditions.
For example, let’s say you are watching Bright Light, and you believe that over the next month it will go down in price. Perhaps there is negative news about the industry, or perhaps you notice that the company has a lot of debt. You account and decide to short 100 shares of Bright Light at the current market price of $20 a share, so you call your brokerage firm or use your online account. When you place the order, the brokerage firm will lend you 100 shares of Bright Light (since you don’t own it). Let’s say Bright Light falls to $18 a share. You now buy back the shares that you borrowed for a point profit.
There are a few rules that you must follow in order to short stocks. First, you must buy when the stock is temporarily rising, which is called an uptick. If a stock is falling quickly and buyers have abandoned it, you may not be allowed to short it. You have to wait for the next uptick, when buyers have taken a position on the stock, a technical rule that prevents short sellers from piling onto a losing stock. Another rule is that you can’t short a stock whose price is less than $5 a share.
Although selling short sounds like an easy strategy, a lot of things can go wrong. First, when you go long a stock, the most you can lose is everything you invested. I know, that’s pretty bad. On the other hand, when you short a stock, you can lose more than you invested, which is why shorting can be risky. Let’s see how this works.
If you sell short 100 shares of Bright Light at $20 a share, you receive $2000. If Bright Light drops to $18 a share, you made 2 points, or a $200 profit. Let’s say you are wrong and Bright Light goes higher. For every point Bright Light goes up, you lose $100. How high can Bright Light rise? The answer is frightening: infinitely! The problem with shorting is that if the stock goes up, not down, your losses are incalculable. I knew a group of guys who shorted Yahoo! in 1997 when it reached $90 a share. They were convinced that Yahoo! was overpriced. Perhaps they were technically correct, but that didn’t stop the stock from soaring to as high as $400 one year later.(It actually went over $1000 in 1999, or a split-adjusted price of $445.) These guys were forced to buy back the shares early, losing over 100 points, because the losses grew so large. A few years later, after the market came to its senses, Yahoo! dropped to less than $20 a share (adjusted for splits), but it was too late for my acquaintances.
Personally, I find it very enlightening to listen to short sellers. Too often, investors delude themselves into thinking that the market will always go higher. Professional short sellers are good at poking holes in the “too-good-to-be-true” proclamations of market bulls. In my opinion, you should listen to both sides of an argument, but in the end you should do what you think makes the most sense.
Other Ways to Classify Stocks
Outstanding Shares
As you remember, corporations issue shares of stock, which are made available to investors through a stock exchange. The total number of shares that a corporation has issued is called its outstanding shares. (I agree it’s not the most exciting name.) In a real-life example, you might ask someone in the corporation, “What is the number of outstanding shares?”
To save yourself time, you could also look up the number of out-standing shares on the Internet—for example, at Yahoo! Finance. Keep in mind that the bigger the corporation, the more outstanding shares there are. Because the stock market goes up and down based on supply and demand, a corporation doesn’t want to issue too many shares unless it is pretty sure that people will scoop them up.
Let’s say that over a 10-year period, Microsoft issues a total of 1 bil-lion shares to the public and to corporate insiders; therefore, the number of outstanding shares for Microsoft is 1 billion shares. (It is up to the board of directors of Microsoft to decide how many shares it wants to issue.) Obviously, the board keeps millions of shares of the stock for the company’s officers and employees. Because they are
company insiders, they got the shares at extremely low prices, perhaps for a few dollars a share. (This is one of the reasons that so many people who worked at Microsoft became millionaires.) In addition, the board of directors also sets aside millions of shares to be used for equipment, computers, and research and development.
The Float
The total number of shares issued by the corporation is called the out-standing shares. Can you guess what the shares are called when we refer only to those owned by outside investors like you and me? Those shares are called the float.
I’ll explain this as simply as possible. Let’s say a corporation has a total of 5 million outstanding shares. Of those 5 million shares, corporate insiders hold 3 million. The question of the day: How many shares have been allocated to outside investors to be actively traded? If you guessed 2 million shares, you’re right. The float is 2 million shares. These are the shares that are traded every day on the stock
exchange by investors and traders.
Why Outstanding Shares and Float Are Important
Although some people don’t care how many shares are outstanding or what the float is, others think this information is extremely important. Why? Keep in mind that the market is all about supply and demand. If you know how many shares are outstanding and what the float is, you can calculate whether there is too little supply and too much demand (the stock will go up in price) or too much supply
and not enough demand (the stock price will go down). Also, it’s a good idea for new investors to become familiar with market vocabulary.
Market Capitalization
Another way to classify stocks is by size. The market capitalization (market cap) of a stock tells you how large the corporation is. (To calculate market cap, you multiply the number of outstanding shares by the current stock price. Therefore, the market cap of a stock varies depending on both the number of outstanding shares and the stock price. For example, a large corporation with 10 billion outstanding shares and a stock price of $50 has a market cap of $500 billion.)
Some people will invest only in large-cap stocks (those of large corporations worth more than $5 billion), which include the stocks of corporations like Coca-Cola, Alcoa, and Johnson & Johnson, because they feel that the stocks of these corporations are safer and the corporations will never go bankrupt. (This isn’t always true, however, since the fifth largest company in the country, Enron Corporation, filed for bankruptcy in 2002.) Other investors are attracted to mid-cap stocks (those of medium-sized corporations worth between $1 and $5 billion), while still others invest in small-cap or microcap stocks (those of small corporations worth between $250 million and $1 billion) because they cost less and their price often moves quickly.
When you compare the stock price to the market cap, you can see how difficult it is for large-cap stocks to double or triple. For example, let’s say you own shares in a $50 large-cap stock of a company with a market cap of $500 billion. In order for the stock price to double, the company would have to increase in value from $500 billion to $1 tril-lion—not impossible, but extremely difficult and time-consuming.
One reason some investors prefer small-cap stocks is that there is a better chance that they will double or triple. On the other hand, the smaller the stock’s markets cap, the higher the risk.
The IPO
Stocks that are being sold to the public for the first time are called initial public offerings, or IPOs. (Wall Street refers to this process as “going public.”) The IPO is an exciting time for the corporation. The biggest advantage of going public for a company is that it allows the company to raise money. It can use this money to expand, to pay off debt, or to pay for research and development of a new product. In addition, if the IPO is successful, it can make company insiders extremely rich. There are two types of IPOs, the start-up (a company that never existed before) and the private company that decides to go public.
The corporation will appoint a major Wall Street stock brokerage firm (identified as the lead underwriter) to manage the IPO process and bring the stock to market. Investment bankers who work for the brokerage
firm will determine how many shares of stock to issue to the public and what price to set.
Before the company goes public, early investors are given a chance to buy the stock at cut-rate prices. For example, corporate insiders could get thousands of shares of the stock for a dollar. Meanwhile, investment bankers will work with the underwriters to try to create investor interest in the corporation. Once the company goes public, research analysts that work for the underwriter may issue buy recommendations on the stock and make positive comments about the corporation.
We all saw the power of the Internet stocks when Netscape went public in April 1995. The lead underwriter, a major New York brokerage firm, calculated that the stock would be worth $28 a share. Minutes after
the stock opened for the day, it rose to $75 a share, a price move that surprised many on Wall Street (although in later years some Internet IPOs rose by even more— for example, in 1998 TheGlobe.com went from $9 to $87 in one day, and in 1999, an IPO called VA Linux jumped 700 percent in one day, opening at $30 and rising to a high of $299). For the next 5 years, any stock that had anything to do with the Internet was given a robust reception by Wall Street. The demand for these Internet stocks was nothing short of phenomenal.
Like all good things, however, the fun ended after a few years. Most of the Internet stocks made a round trip back to their original price, and many went out of business. For example, a few years after its IPO, VA Linux was trading for less than $5, and TheGlobe.com was recently at less than a dollar. In addition, many of those who bought Internet IPOs on the first day lost thousands of dollars because they bought too high.
As an individual investor without inside connections, it is probably best if you avoid buying IPOs. More than likely, you will end up buying at the top and be forced to sell at a loss. Although some traders made small fortunes on IPOs on the way up, the IPO game is difficult to win, unless you are a company insider and buy early shares.
If you do want to participate in an IPO, however, be sure you read the prospectus, a legally binding document filed with the SEC that includes the company’s future plans as well as its cur-rent financial condition.
To cover themselves, startup companies will mention, often in small print, that there are no guarantees the company will succeed and there are tremendous risks. After reading all the risks, you may decide not to
How to Classify Stocks
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How to Classify Stocks
If you want to understand the stock market, you should learn the different ways in which people classify and identify stocks.
Stock Sectors
A sector is a group of companies that loosely belong to the same industry and provide the same product or service. Examples of stock sectors include airlines, software, chemicals, oil, retail, automobiles, and pharmaceuticals, to name just a few. Understanding sectors is important if you want to make money in the stock market. The reason is simple: No matter how the market is doing and no matter what the condition of the economy, there are always sectors that are doing well and sectors that are struggling.
For example, during the recent bear market, the semiconductor sec-tor, the Internet sector, and the computer sector were going down on a regular basis. A lot of savvy investors shifted their money out of these losing sectors and moved into the retail and housing sectors. That’s right, the retail and housing sectors soared during 2001 and 2002. (WalMart was particularly strong.)
Some professional traders shift their money into and out of sectors every day. Once they identify the strongest sectors for the day, they pick what they think is the most profitable stock in each of these sectors. Like anything connected to the stock market, shifting into and out of sectors sounds easier on paper than it is in real life. It’s always easier to look in the rearview mirror to figure out what sectors were most profitable.
It’s very easy for me to say that you should have shifted out of technology in March 2000 and moved into the housing sector. But now, right now, how confident are you that housing stocks will continue to go up in price? It’s a lot harder to pick successful sectors than many people think. Nevertheless, it’s worth taking the time to understand and identify the various sectors and to be aware of which sectors are strong and which are weak. This could give you a clue as to where the economy is headed.
Classifying Stocks: Income, Value, and Growth
Income Stocks
The first category of stocks is income stocks, which include shares of corporations that give money back to shareholders in the form of dividends (some people call these stocks dividend stocks). Some investors, usually older individuals who are near retirement, are attracted to income stocks because they live off the income in the form of dividends and interest on the stocks and bonds they own. In addition, stocks that pay a regular dividend are less volatile. They may not rise or fall as quickly as other stocks, which is fine with the conservative investors who tend to buy income stocks. Another advantage of stocks that pay dividends is that the dividends reduce the loss if the stock price goes down.
There are also a number of disadvantages of buying income stocks. First, dividends are considered taxable income, so you have to report the money you receive to the IRS. Second, if the company doesn’t raise its dividend each year—and many don’t—inflation can cut into your prof-its. Finally, income stocks can fall just as quickly as other stocks. Just because you own stock in a so-called conservative company doesn’t mean you will be protected if the stock market falls.
Value Stocks
Value stocks are stocks of profitable companies that are selling at a reasonable price compared with their true worth, or value. The trick, of course, is determining what a company is really worth what investors call its intrinsic value. Some low-priced stocks that seem like bargains are low-priced for a reason.
Value stocks are often those of old-fashioned companies, such as insurance companies and banks, which are likely to increase in price in the future, even if not as quickly as other stocks. It takes a lot of research to find a company whose price is a bargain compared to its value. Investors who are attracted to value stocks have a number of fundamental tools (e.g., P/E ratios) that they use to find these bargain stocks. (I’ll discuss many of these tools in Chapter 9.)
Growth Stocks
Growth stocks are the stocks of companies that consistently earn a lot of money (usually 15 percent or more per year) and are expected to grow faster than the competition. They are often in high tech industries. The price of growth stocks can be very high even if the company’s earnings aren’t spectacular. This is because growth investors believe that the corporation will earn money in the future and are willing to take the risk.
Most of the time, growth stocks won’t pay a dividend, as the corporation wants to use every cent it earns to improve or grow the business. Because growth stocks are so volatile, they can make sudden price moves in either direction. This is ideal for short-term traders but unnerving for many investors. During the 1990s, when growth stocks were all the rage, even buy-and-hold investors couldn’t resist investing in growth companies like Cisco, Sun Microsystems, and Dell Computer.
Dividends: Another Way to Make Money
You already know that many investors are attracted to income stocks because they pay dividends. Let’s take a closer look at exactly how dividends work.
As mentioned before, a corporation that has made a lot of profits passes some of those profits to shareholders in the form of a payment called a dividend. It is usually given to shareholders in cash (in fact, by check), or, if desired, it can be used to buy more shares of the stock.
Dividends are a great idea. Not only do you make money as the price of your stock goes up, but you can also receive a bonus from the corporation in the form of a dividend every quarter. Keep in mind that the corporation’s board of directors is not required to distribute a dividend but often does so when the corporation is doing well.
If you own a lot of shares of a stock, perhaps 5000 shares or more, your dividend payments can add up substantially. Let’s say, for example, that a corporation pays $0.25 per share quarterly dividend on your 5000 shares, which adds up to $1 in dividends each year. That means that every 3 months you will receive $1250, for a total of $5000 a year. In addition, if the stock you own goes up in price, then you also make money on the gain (assuming you sell the stock).
People used to talk a lot about dividends, especially investors who were nearing retirement age, because so many investors depended on their dividend checks to live. Some people will buy only stocks that pay hefty dividends. The corporations that traditionally paid dividends were the large blue-chip companies that are included in the Dow Jones Industrial Average (in the game of poker, blue chips are the most valuable). Corporations of these types tended to attract older investors who were more interested in the dividends than in the stock price.
Unfortunately, a lot of corporations, even the blue chips, have lowered or eliminated their dividends. In the go-go 1990s, corporations wanted to use every cent they had to enlarge or improve their business and weren’t willing to give some of that money back to their share-holders. Technology corporations in particular weren’t in the habit of paying dividends. You can easily find out the amount of the dividend, if any, that a corporation pays by looking in the newspaper.
Penny Stocks
Just as their name suggests, penny stocks are stocks that usually sell for less than a dollar a share (although some people define a penny stock as one selling for less than $5 a share). Because the stocks of these small corporations usually don’t meet the minimum requirements for listing on a major stock exchange, they trade in the over-the-counter market (OTC) on the Nasdaq. They are also called pink sheet stocks because at one time the names and prices of these stocks were printed on pink paper. (To check the prices of unlisted OTC stocks, try the Web site www.otcbb.com.)
The advantage of trading penny stocks is that the share price is so low that almost everyone can afford to buy shares. For example, with only $1000 you can buy 2000 shares of a $0.50 penny stock. If the stock ever makes it to a dollar, you made a 100 percent profit. That is the beauty of penny stocks. On the other hand, you could put your order in at $0.75 a share, and a couple of days later the stock could fall to $0.50. It happens all the time. A number of traders specialize in these stocks, although this is not easy.
After all, penny stocks are so cheap for a reason. That reason could be poor management, no earnings, or too much debt, but whatever it is, there usually aren’t enough buyers to make the stock go higher.
Even with their low price, the trading volume on penny stocks is exception-ally low. (For example, a stock like Microsoft will trade millions of shares per day, whereas a penny stock might trade 10,000 shares, or sometimes even less.)
With a low-volume stock, it’s easy for someone to manipulate the price. Manipulation? Yes, it happens, especially with penny stocks. If you have a $1 stock that is trading only 25,000 shares a day, when someone comes in to buy 10,000 shares, that trade is likely to affect the price. (That’s also why some people prefer trading penny stocks.)
Because of their low volume, penny stocks are also the favorite investment of unethical people who work in boiler rooms. A boiler room is an operation that hires a team of people to make phone calls to people they don’t know in order to convince them to buy a nearly worthless stock. As the stock price goes up (because people are urged to buy the stock), the workers (the insiders) in the boiler room sell their shares for a substantial gain. By the time you want to sell, it is often too late. More than likely, you’ll lose most or all of your investment.
A bit of advice: If a cold-calling salesperson begs you to buy a penny stock, just hang up. “Hey, buddy, the stock is only $0.10 a share. For $1000, you can buy 10,000 shares. If the stock goes to a dollar, you could make $10,000. How does that sound? So can I count on you for 10,000 shares? Trust me, this stock is hot.” It is reported that thousands of people fall for this scam every sin-gle day. The boiler room brokers are skilled at making you feel that you are going to miss out on the deal of a lifetime if you don’t buy in the next 10 minutes. In reality, it’s unlikely that the penny stock will ever claw its way out of the basement. (An entertaining movie called Boiler Room described some of the tactics used to convince unsuspecting investors to buy penny stocks.)
Like anything connected to the stock market, exceptions can be found. There are a number of once high-flying companies that trade for less than a dollar. Because of these companies’ history and book value (how much the company is worth), they are generally better buys than unknown penny stocks with no price history and negative earnings. However, it is essential that you do your homework before you purchase your first penny stock.
The SEC: Protecting Investors against Fraud
You may wonder whether there is a government organization that protects the needs and interests of the individual investor. Actually, there is. Congress created the U.S. Securities and Exchange Commission (SEC) in 1934 to regulate the securities industry after the disastrous 1929 crash. The SEC is something like the police officer for the investment industry. It sets the rules and regulations and standards that Wall Street must follow. The purpose of the SEC (paid for by your tax dollars) is to protect individual investors against fraud and to make sure the markets are run fairly and honestly. Its Web site, www.sec.gov, contains help-ful articles and resources about the SEC’s mission and about individual companies. It’s worth mentioning that knowledge is your best weapon against fraud, and the SEC does its best to keep you informed. It will also make life miserable for anyone it catches breaking the securities laws.
Unfortunately, not everyone wants a government organization like the SEC breathing down the necks of corporations. Although Congress created the SEC, there are powerful people with special interests who want to keep the SEC as weak as possible. To make sure that the SEC is ineffective, some politicians see to it that the SEC doesn’t have the funds or resources it needs to go after companies that break securities laws.
A weak SEC is nothing but an invitation to corporate crooks to use the stock market to finance their illegal trading activities. It may take a market crash or some other financial disaster before the SEC gets the tools it needs to rid the market of crooks. As an individual investor or trader, however, it pays to know your rights (and what is allowed by law), especially if you are a victim of fraud by anyone connected with the securities industry.
In the next chapter, you will learn about all the things that people do with stocks, including other ways to classify stocks.
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