The Neatest Little Guide to Stock Market Investing: Fifth Edition

1

Speak the

Language of Stocks

Anybody can make money in the stock market. By picking up the phone or turning on the computer, you can own a piece of a company—and all of its fortune or folly—without ever attending a board meeting, developing a product, or devising a marketing strategy. When I was eleven years old, my grandfather explained to me in less than ten seconds why he invested in stocks. We sat by his pool in Arcadia, California, and he read the stock tables. I asked why he looked at all that fine print on such a beautiful day. He said, Because it takes only $10,000 and two tenbaggers to become a millionaire. That didn’t mean much to me at the time, but it does now. A tenbagger is a stock that grows tenfold. Invest $10,000 in your first tenbagger and you have $100,000. Invest that $100,000 in your second tenbagger and you have $1 million. That, in less than ten seconds, is why everybody should invest in stocks.

This chapter further explains why investing in stocks is a good idea, then covers some basic information you’ll use in the rest of the book when you begin investing.

Why Stocks Are Good Investments

You should know why stocks are good investments before you start investing in them. There are two reasons to own stocks. First, because they allow you to own successful companies and, second, because they’ve been the best investments over time.

Stocks Allow You to Own Successful Companies

Stocks are good investments because they allow you to own successful companies. Just like you can have equity in your home, you can have equity in a company by owning its stock. That’s why stocks are sometimes called equities.

Think of all the rich people you’ve read about. How did they get rich? Was it by lending money to relatives who never repay? No. Was it by winning the lottery? Not very often. Was it by inheriting money? In some cases, but it’s irrelevant because nobody has control over this factor. In most cases, rich people got rich by owning something.

That something might have been real estate. You learned the first time you watched Gone with the Wind that land has value and that owning some is a good idea. In most cases, though, people get rich by owning a business. Schoolchildren learn about John D. Rockefeller, Andrew Carnegie, and J.P. Morgan. They all owned businesses. Henry Ford sold cars, Ray Kroc sold hamburgers from McDonald’s, Thomas Watson sold business machines from IBM, Steve Jobs sold iPhones from Apple, Scott Cook and Tom Proulx sold financial software from Intuit, Howard Schultz sold coffee from Il Giornale. What’s that, you never heard of Il Giornale? Oh, but you have, just not by that name. Schultz rebranded it Starbucks after buying the company from its original owners in 1987. All these people owned their companies. I sold magazine subscriptions door-to-door in school to raise money for the student council. I didn’t get rich because I didn’t own the subscription company. See the difference?

I could have taken some of that money I earned pawning off another copy of Reader’s Digest on Mrs. Klein and bought shares of the subscription company. Suddenly, I would have been a business owner encouraging my classmates to sell, sell, sell! even if it meant they would win the portable radio instead of me winning it. The business they generated would have improved the subscription company’s bottom line and, as a shareholder, I would have profited. If all went as planned, I could have bought a dozen portable radios.

That’s why owning stocks is a good idea. They make you an owner of a company. Not an employee or a lender—an owner. When a company prospers, so do its owners.

Stocks Have Been the Best Investments over Time

That’s cute, you’re thinking, but does it really work that way? Let’s take a look at history and a few hard numbers.

The stock market has returned about 10.5 percent a year for the past 75 years or so. Corporate bonds returned 4.5 percent, U.S. Treasuries returned 3.3 percent, and inflation grew at 3.3 percent. Notice that Treasuries and inflation ran neck and neck? That means your investment in Treasuries returned nothing to you after inflation. When you include the drain of taxes, you lost money by investing in Treasuries. You need stocks. Everybody who intends to be around longer than ten years needs to invest in stocks. That’s where the money is.

Investing in stocks helps both the investor and the company. Take McDonald’s, for instance. It went public in 1965 at $22.50 per share. If you bought 100 shares, the company would have had an extra $2,250 to put toward new restaurants and better hamburgers. Maybe your money would have funded the research and development of the Big Mac, one of America’s great inventions. Forty-seven years and twelve stock splits later, your 100 shares of McDonald’s would have become 74,360 shares worth more than $7.4 million. Both you and McDonald’s prospered, thanks to the stock market.

How Stocks Trade

When stocks are bought and sold, it’s called trading. So a person might say IBM is trading at $140. That means if you wanted to buy IBM stock, you’d pay $140 for one share.

Every company has a ticker symbol, which is the unique code used to identify its stock. In articles and reports, the ticker symbol is usually shown in parentheses after the first instance of the company name, for example, Facebook (FB), Google (GOOG), Harley-Davidson (HOG), IBM (IBM), and Toyota (TM).

A $1 move in stock price is called a point. If IBM goes from $140 to $143, you’d say that it rose three points. In the real world, IBM doesn’t usually trade in such clean increments as $140 and $143. Instead, it would trade for, say, $143.38.

Some investors purchase shares of stock in blocks of 100. A block of 100 shares is called a round lot. Round lots provide a convenient way to track your stock investments because for every round lot you own, a one-point move up or down adds or subtracts $100 from the value of your investment. If you own 100 shares of IBM at $143, it’s worth $14,300. If it rises two points to $145, your investment is worth $200 more, for a total of $14,500. Simple, eh?

Preferred Stock vs. Common Stock

There are two types of stock, preferred and common. Both represent ownership in a company. Preferred stock has a set dividend that does not fluctuate based on how well the company is performing. Preferred stockholders receive their dividends before common stockholders. Finally, preferred stockholders are paid first if the company fails and is liquidated.

Common stock is what most of us own. That’s what you get when you place a standard order for some number of shares. Common stock entitles you to voting rights and any dividends that the company decides to pay. The dividends will fluctuate with the company’s success or failure.

How You Make Money Owning Stocks

This is really the bottom line to investors. The only reason you own a business is to profit from it. The way you profit by owning stocks is through capital appreciation and dividends.

Through Capital Appreciation

Sometimes called capital gains, capital appreciation is the profit you keep after you buy a stock and sell it at a higher price. Buy low, sell high is a common investment aphorism but it is just as legitimate to buy high, sell higher.

Expressed as a percentage, the difference between your purchase price and your sell price is your return. For example, if you buy a stock at $30 and sell it later for $60, your return is 100 percent. Sell it later for $90 and your return is 200 percent. If you bought Cisco in 1990 at 10 cents and sold it in 2000 at $70, your return was 69,900 percent. If you bought Hansen Natural in February 2003 at 40 cents and sold it in July 2006 at $50, your return was 12,400 percent. If you bought Green Mountain Coffee Roasters in October 2008 at $6 and sold it in August 2011 at $100, your return was 1,567 percent.

The goal is appreciation, but sometimes investors end up with depreciation by mistake. If you bought Citigroup in November 2007 at $35 and sold it in November 2008 at $6, your return was -83 percent.

Through Dividends

As an owner of a company, you might share in the company’s profits in the form of a stock dividend taken from company earnings. Companies report earnings every quarter and determine whether to pay a dividend. If earnings are low or the company loses money, dividends are usually the first thing to get cut. On a declaration date in each quarter, the company decides what the dividend payout will be.

To receive a dividend, you must own the stock by the ex-dividend date, which is four business days before the company looks at the list of shareholders to see who gets the dividend. The day the company actually looks at the list of shareholders is called the record date.

If you own the stock by the ex-dividend date, and are therefore on the list of shareholders by the record date, you get a dividend check. The company decides how much the dividend will be per share, multiplies the number of shares you own by the dividend, and deposits the total amount into your brokerage account. If you own 10,000 shares and the dividend is $.35, the company will deposit $3,500 on the payment date. It’s that simple.

Most publications report a company’s annual dividend, not the quarterly. The company that just paid you a $.35 per share quarterly dividend would be listed in most publications as having a dividend of $1.40. That’s just the $.35 quarterly dividend multiplied by the four quarters in the year.

Total Return

The money you make from a stock’s capital appreciation combined with the money you make from the stock’s dividend is your total return. Just add the rise in the stock price to the dividends you received, then divide by the stock’s purchase price.

For instance, let’s say you bought IBM at $45 and sold it two years later at $110. IBM paid an annual dividend of $1 the first year and $1.40 the second year. The rise in the stock’s price was $65, and the total dividend paid per share was $2.40. Add those to get $67.40. Divide that by the stock’s purchase price of $45 and you get 1.5, or 150 percent total return.

All About Stock Splits

A stock split occurs when a company increases the number of its stock shares outstanding without increasing shareholders’ equity. To you as an investor, that means you’ll own a different number of shares but they’ll add up to the same amount of money. A common stock split is 2-for-1. Say you own 100 shares of a stock trading at $180. Your account is worth $18,000. If the stock splits 2-for-1 you will own 200 shares that trade at $90. Your account is still worth $18,000. What’s the point? The point is that you now have something to do with your spare time: Adjust your financial statements to account for the split.

Not really. Companies split their stock to make it affordable to more investors. Many people would shy away from a $180 stock, but would consider a $90 one. Perhaps that’s still too expensive. The company could approve a 4-for-1 split and take the $180 stock down to $45. Your 100 shares would become 400 shares, but would still be worth $18,000. People considering the stock might be more likely to buy at $45 than at $180, even though they’re getting the same amount of ownership in the company for each dollar they invest. It’s a psychological thing, and who are we to question it?

Mathematically, stock splits are completely irrelevant to investors but they are often a sign of good things to come. A company usually won’t split its stock unless it’s optimistic about the future. Think about it. Would you cut your stock price in half or more if the market was about to do the same? Of course not. Headlines would declare the end of your fortunes and lawsuits might pile up. Stock splits tend to happen when a company has done well, driven up the price of its stock, expects to continue doing well, drops the price of its stock through a split, and expects to keep driving up the stock price after the split.

Stock splits were everyday occurrences in the 1990s bull market. IBM split twice, Oracle split five times, Microsoft split seven times, and Cisco split eight times. A $10,000 investment in Microsoft in January 1990 was worth about $900,000 in January 2000. The stock didn’t just run straight up 90-fold, however. It made five 2-for-1 splits and two 3-for-2 splits along the way. It rose and split, rose and split, rose and split, rose and split, rose and split, rose and split, and rose and split until voilà! $10 grand turned into $900 grand. You can be sure that Microsoft wouldn’t have been splitting its stock if it wasn’t excited about its future.

Remember that a stock split drops the price of the stock. Lower prices tend to move quicker than higher prices. Also, the fluctuations of a lower-priced stock have a greater percentage impact on return than they do against higher-priced stocks. A $2 increase is a 4 percent gain for a $50 stock, but only a 2 percent gain for a $100 stock.

More important than all this, however, is that splits are downright fun. You’ll love it when your 100 shares become 200 and every $1 gain in price puts $200 in your pocket instead of the previous $100. You’ll feel like a real pro when revealing your performance to friends and need to toss in the phrase split-adjusted at the end. I recommend raising one eyebrow and lowering your voice for effect.

Why and How a Company Sells Stock

Companies want you to buy their stock so they can use your money to get new equipment, develop better products, and expand their operations. Your investment money strengthens the company. But first the company needs to make its stock available. This section describes how.

The magazine subscription selling job I held in school made me think a lot about becoming a business owner. I imagined teaching all the other kids how to sell subscriptions, collecting their money at the end of the day, using some of it to buy a prize for the top seller, sending a small amount to the magazines, and depositing the rest into my bank account. Pretty simple business model, right? Pretend for a minute that I did it. I called my business Mister Magazine.

I realized early on that Mister Magazine needed office space. A treehouse would do. I needed lumber to build it, and I needed to get electricity and phones installed. That takes money that I didn’t have. After all, that’s why I went into business: to make money. If I already had it, I wouldn’t have needed to go into business! There are two ways I could have raised money for Mister Magazine.

First, I could have drawn up a business plan and pleaded with my local bank. When I showed the officer the sketches of corporate headquarters in a tree, my guess is that our interview would have been quite short. A lot of fledgling businesses face just that problem. They aren’t established enough to get a loan, or if they do get one it comes with such a high interest rate to offset the risk that it ends up strangling the business anyway. Nope, a loan wouldn’t do it for Mister Magazine.

Selling Stock Is a Great Way to Raise Money

My second option was to sell shares of Mister Magazine to investors who wanted a piece of the upcoming profits. By selling shares I would raise money, I wouldn’t owe anybody anything, and I would acquire a bunch of people who really wanted Mister Magazine to succeed. They would own part of it after all! I chose this second option to raise money, and I decided that 10 shares comprised Mister Magazine’s entire operation. I could have chosen 100 shares or 100,000 shares. The amount doesn’t matter. The only thing investors care about is what percentage of Mister Magazine they’ll own. I decided to keep 6 shares for myself to retain majority ownership and sell 4 shares to parents in my community for $100 each. The parents were my venture capitalists in this case. After the sale, I owned 60 percent of Mister Magazine and four parents in the community owned 40 percent. It was a private deal, though. You couldn’t find Mister Magazine listed in the paper yet.

The first year of operation at Mister Magazine went great. I hired 20 kids to sell magazines door-to-door, I negotiated a cheap deal with the magazines, and I found a wholesale prize distributor who sold gadgets for half their usual price. My employees were happy and Mister Magazine grew to be worth $5,000. How did my investors fare? Quite well. Those initial $100 shares became $500 shares in one year. That’s a 400 percent annual return!

Clearly there was only one thing for me to do. I needed to immediately drop out of school and expand Mister Magazine to outlying communities, and then the entire United States. It was time to come down out of the treehouse and establish a ground-based headquarters, evolving as a business just as humanity evolved as a species. To fund this ambitious expansion, I decided to take Mister Magazine public.

Going Public Raises Even More Money

Instead of selling shares to just four parents in my community, my next step was to sell Mister Magazine to millions of investors by getting listed on a stock exchange. Stock exchanges provide a place for investors to trade stock. The most famous from U.S. history are the New York Stock Exchange (NYSE, founded 1792), the American Stock Exchange (Amex, founded 1842), and the National Association of Securities Dealers Automated Quotations (NASDAQ, founded 1971).

In 2007, the NYSE Group bought Paris-based Euronext to become the first global equities exchange, called NYSE Euronext. The new entity then went on to acquire the American Stock Exchange in 2008, combine it with the Alternext European small-company exchange, rename it NYSE Alternext US with a focus on small companies, and move all of its trading floor operations to the NYSE’s Wall Street trading floor. Yet another merger was in the works as this edition went to press: Germany’s Deutsche Borse attempted a $10 billion acquisition of NYSE Euronext to create the world’s biggest stock exchange operator. The U.S. Securities and Exchange Commission approved the deal, but European Union officials hesitated to do so for fear of quashing competition.

Let’s see our chances of getting Mister Magazine listed on the New York Stock Exchange, the NASDAQ, and the NYSE Alternext US:

New York Stock Exchange

This is the biggest and oldest of America’s exchanges. Its famous floor is located along Wall Street in Manhattan. It caters to well-established companies like IBM, Ford, and McDonald’s. To be listed, a company must have at least 400 U.S. shareholders and at least 1.1 million shares of stock outstanding, and then pass an earnings or valuation test with criteria such as pretax income of $10 million or more over the past three years, and a global market capitalization of at least $750 million. As you can see, it’s a big deal to be listed on the NYSE. Outstanding, by the way, refers to stock owned by shareholders.

NASDAQ

The NASDAQ rose to prominence by trading cool high-tech companies like Microsoft, Intuit, and Dell. It’s sometimes called the over the counter (OTC) market because there’s no floor to see on Wall Street or any other street. Instead, the NASDAQ comprises brokers networked together around the country who trade stocks back and forth with computers. Some of the brokers are known as market makers because they supply the stock when you want to buy it. You’ll never know which broker supplied the stock you’re buying, and you won’t care. To be listed on the NASDAQ Global Market, a company must have at least 400 shareholders, at least 1.1 million shares of outstanding stock worth $8 million or more, and pretax income of $1 million or more in the latest fiscal year or in two of the past three fiscal years.

NYSE Alternext US

With its focus on emerging companies that want simplified market access, NYSE Alternext US offers the most lenient listing requirements. A company must have pretax income of at least $750,000 over the past fiscal year or two of the three most recent fiscal years; publicly held shares valued at $3 million or more; shareholders’ equity of at least $4 million; and either 800 shareholders with 500,000 shares outstanding or 400 shareholders with 1,000,000 shares outstanding.

Working with an Investment Banker

Obviously, Mister Magazine didn’t have a prayer of making any of the three primary exchanges. But let’s say a colossal exception was made and I worked with the investment banking side of a large firm like Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, or Wells Fargo to make an initial public offering, or IPO. That’s what a company’s first offering of stock to the public is called. I told the investment banker how much money I wanted to raise and the banker determined how many shares to sell at what price. I wanted to raise $10 million. The banker could have sold 5 million shares at $2 each, 10 million at $1 each, or 2 million at $5 each. As long as the combination produced the target amount, it didn’t matter.

The investment banker committed to buy the shares if nobody else did and got to keep a small amount of profit per share for this risk. The banker initially sold shares of Mister Magazine to the primary market, which consists of the banker’s preferred private accounts. After the primary market had dibs on the tantalizing new shares of Mister Magazine, the investment banker offered the remaining shares to the secondary market, which consists of everyday shmoes like you and me who read a stock’s price in the paper or online and buy it.

Making a Secondary Offering

Once the banker made the initial public offering, I had my money and a bunch of new investors in the company. When it came time to raise more money, I sold additional shares of stock in what’s called a secondary offering. No matter how many additional times I sell more stock, it’s always called a secondary offering. I would also have the option of selling bonds to investors. When an investor buys a corporate bond, he or she is lending money to the corporation and will be paid back with interest. That means bonds have the same drawbacks that bank loans do. Mister Magazine would be forced to pay interest on the money it borrowed from investors instead of just selling them a share of stock in the company through a secondary offering.

Secondary offerings are sometimes necessary because companies don’t receive a dime in profit from shares once they’re being traded on the open market. After a company issues and sells a share of stock, all profits and losses generated by that stock belong to the investors trading it. Even if the price of the stock quadruples in value and it’s bought and sold 10 times in a day, the issuing company doesn’t make any money off it. The reason is simple: the investor who buys a share of stock owns it. He or she can sell that share for whatever price the market will pay. The company isn’t entitled to any of the profits from the sale because the investor is the sole owner of that share of stock until it’s sold to a buyer who then becomes the new owner. Unless the company buys back its own stock, it won’t own the shares again.

It’s no different than you selling your car. Do you owe Ford a share of the sale price when you finally get rid of that old Pinto in your garage? Of course not. You place an ad in the paper, deposit the buyer’s check, and go on your way. It’s the same situation if you own shares of Ford Motor Company. You place the sell order, take the buyer’s money, pay a brokerage commission, and go on your way. Ford doesn’t even know it happened.

Now, the shrewder among you might be wondering why companies care what happens to their stock price once they’ve got their dough. After all, they don’t see any profit from you selling to me and me selling to another guy. That’s true, but remember that companies might want to make another secondary offering later, and another, and another, and another. If a company issues 1,000,000 new shares at $40 it makes $40 million. If it issues 1,000,000 new shares at $10 it makes $10 million. Do you suppose most companies would rather make $40 million than $10 million? Of course they would, and that’s why companies like to see their stock prices high. Not to mention that a falling stock price breeds ugly headlines.

What People Mean by The Market

You hear every day that the market is up or down. Have you ever paused to wonder what the market is? Usually, that phrase refers to the U.S. stock market as measured by the Dow Jones Industrial Average, often abbreviated DJIA or called simply the Dow. The Dow is not the entire market at all, but rather an average of 30 well-known companies such as Coca-Cola, Exxon Mobil, McDonald’s, Microsoft, and Wal-Mart. The companies tracked by the Dow are chosen by the editors of The Wall Street Journal. The list changes occasionally as companies merge, lose prominence, or rise to the top of their industry.

The Dow is an average. Averages and indexes are just ways for us to judge the trend of the overall market by looking at a piece of it. The Dow is the most widely cited measurement, but not the only gauge of the market. A more popular index among investors is the Standard & Poor’s 500, or just the S&P 500. It tracks 500 large companies that together account for some 75 percent of the entire U.S. stock market. The S&P MidCap 400 tracks 400 medium-sized companies while the S&P SmallCap 600 tracks 600 small companies. The NASDAQ 100 follows 100 top stocks from the NASDAQ such as Adobe, Amazon.com, Apple, Costco, eBay, Intel, Netflix, Oracle, Starbucks, Urban Outfitters, and Whole Foods Market. It’s one of the hippest indexes around, although, with its focus on tech and biotech, also one of the most volatile. Here’s the total return of these five indexes as of December 31, 2008:

Fun decade, eh?

What a difference a bear market makes. The subprime crash of 2008 did all the damage above. For proof, look at the total return of those same five indexes just two years prior, as of December 29, 2006:

Then three years after, as of December 30, 2011:

I want to draw your attention to the medium and small companies. Notice how much stronger than the others they were over the 5- and 10-year periods. They’re good places to focus, and in Chapter 4 I’ll show you how to use them to your long-term advantage.

There are dozens of other indexes that you will encounter as you dig deeper into the world of investing. Each is an attempt to monitor the progress of a market by looking at a sliver of that market.

You probably already use indexes in other parts of your life, although you might not know it. We create them all the time to help ourselves compare different values. For example, let’s say you are interested in buying a new Toyota Camry. If one of your main selection criteria is fuel economy, how do you know if the Camry performs well in that area? You compare its miles-per-gallon number with the average miles-per-gallon number of other midsize passenger cars, such as the Ford Fusion and the Honda Accord. After several comparisons, you know what is a good number, what is average, and what is below average. Notice that you don’t compare the Camry with a Hyundai Accent or a Chevy Suburban. Those vehicles are in different classes and are irrelevant to your comparison. Thus, in this case, midsize passenger cars comprise your index.

As you encounter different market indexes, just remember that each looks at a piece of the market to monitor how that part of the market is performing.

How to Choose a Broker to Buy Stocks

You buy stocks through a brokerage firm. A brokerage firm is a business licensed by the government to trade securities for investors. Brokerage firms join different stock exchanges and abide by their rules as well as the rules laid down by the Securities and Exchange Commission, or SEC.

Two Types of Brokerage Firms

There are full-service brokerage firms and discount brokerage firms. Here’s a description of each:

Full-Service Brokerage Firms

These are the largest, best-known brokerage firms in the world, who spend millions of dollars a year advertising their names. You’ve probably heard of Bank of America, Goldman Sachs, Morgan Stanley, Smith Barney, UBS, and others of their ilk. They’re all the same. Regardless of their advertising slogans, the two words that should immediately come to mind when you hear the names of full-service brokerage firms are expensive and misleading. Other than that, they’re great. Most full-service brokerage firms are divided into an investment banking division, a research division, and a retail division.

The investment banking division is what helps young companies make their initial public offering of stock and sell additional shares in secondary offerings. The brokerage firm keeps a profit on each share of stock sold. This is where the firm makes most of its money. Therefore, every one of the full-service brokerages wants to keep solid investment banking relationships with their public companies. Never forget that full-service brokerage firms make their money by