The ultimate Q&A to Stock Market 101

Investing tips 08: This post is about the stock market that has been collated from my Quora responses. 

"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."  George Soros

The stock market serves two very important purposes.
  • To provide capital to companies that they can use to fund and expand their businesses. 
  • To give investors the opportunity to share in the profits of publicly-traded companies through dividends as well as to profit from the buying and selling of shares. 

As a retail investor, your main interest is in the latter and especially how to make money from the stock market.  In this regard, there are two basic market conditions - the “bull” and “bear” markets. 
  • The term bull market is used to refer to a stock market in which the price of stocks is generally rising. 
  • A bear market exists when stock prices are overall declining.

Why do they call a rising market a “bull run”? Have you seen a raging bull? It runs around full of emotion, acting excitedly and gathering speed as it runs. When a market goes up, there are lots of people getting excited and wanting to buy more pushing the market higher.

That is why it is called a bull market. I am being facetious but in hindsight, the person who coined the term must have subconsciously thought of this analogy. Unfortunately, I cannot think of a humorous story on why it is called a bear market. 

The reality is that for most retail investors, price movement is at the heart of making money from the stock market. You should not be surprised to see many questions on this post that covers this subject.

This post is part of a series meant for newbies. I focussed on answering the questions from the view of a bottom-up, stock-picking, long-term value investor.  

I am coming from the perspective that you are interested to learn how to invest based on fundamentals.  This requires you eventually to analyze and value companies. 

If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is  The Motley Fool. Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you. Learn more.



Questions

1. Why do private companies need to go public?

2. How does the company performance add value to the stock?

3. What makes a stock price increase? 

4. Does the stock market go up in the long run because people demand higher prices over time?

5. Why are stock markets not crashing? Stocks are at an all-time high, and the economy is at the lowest in years ie the stock market seems detached from the economy.

6. If a technical recession hits Singapore, what sectors in the stock market can drop badly?

7. Do you lose money if a company does a reverse split?

8. Is it true that buying fraction shares of stocks is a gimmick for beginning investors just to raise stock values for the professional stock investor?

9. Why are we letting people be lazy and make money from the stock market just by being wealthy?

10. Is the stock market a form of usury or gambling?

11. Why is the stock market not a reliable source of income?

12. If I had 1000$, should I invest it in penny stocks, play the lottery or invest in an index fund?

1. Why do private companies need to go public?
The main reason is of course to raise money for business expansions. Sometimes companies go public so that the founders can cash out.

In the Malaysian context, there are 3 reasons why a company would want to go public.

a) when it comes to undertaking joint ventures, mergers, or other corporate exercises, I have found that being a public company gives you a certain level of credibility. This is critical if you are competing with other parties to form the joint venture, etc

b) when your company needs to borrow monies, financial institutions will require directors of private companies to give a personal undertaking. As a public company, you do not have to do this.

c) as a public company, it is easier to attract high-caliber staff.



2. How does the company performance add value to the stock?
You have to differentiate between stock price and value. Price is determined by market sentiments. The value of a stock is not dependent on the stock price. Rather it depends on the business performance.

However, a company that is doing well is likely to generate positive sentiments. 

From a fundamental perspective, company performance will impact its free cash flow, which in turn affects its valuation. All things being equal a larger free cash flow equates to a higher value. 

Then from a growth perspective, whether growth will create shareholders’ value will depend on what you mean by doing well.  If the returns are better than the company's cost of funds then it would create value. But if the return is less then it won’t be adding value.

Finally, from a valuation perspective, a company that performs well is likely to have strong financials. To a certain extent, this will reduce the cost of capital.  



3. What makes a stock price increase? 
The simplistic answer is when the number of buyers exceeds the number of sellers, the stock price increase. No price movement means either no buyers or sellers or alternatively there is no change in the perceived price.

But I think you are asking for something more profound.

Stock prices are driven in the short term by market sentiments. In the long term is a mix of market sentiments and fundamentals.

To complicate matters, fundamentals also affect market sentiments. This is because while the fundamentals are there for all to see, different people will interpret it differently. Coupled with their respective biases, these will affect how they view the prospects of the company ie sentiment will come into play.

Whoever can find out the equation for this relationship between fundamentals, sentiments, and stock prices would have found the holy grail of stock trading. Well people are still looking although quants would say that some of them have come close (at least for certain periods of time)

4. Does the stock market go up in the long run because people demand higher prices over time?
If you are a value investor, you believe that the intrinsic value of a stock is due to the cash flow generated by the business over its life and the market price will reflect this intrinsic value.

So, it is not surprising that if the business has some proprietary products or services, etc it will continue to grow its profits over time. Furthermore, if management is good capital allocators, they would be able to reinvest some of the earnings to grow the business.

The result is that the intrinsic value of the business will grow over time. Correspondingly the price of the stock will increase over time.

I will then argue that people will want more of this company and hence drive up the demand.

While you are technically correct to say that people will demand a higher price, it is because the company becomes more valuable. If you have a company that does not grow eg Kodak, people will not demand a higher price. So, the demand by people is a derived demand.



5. Why are stock markets not crashing? Stocks are at an all-time high, and the economy is at the lowest in years ie the stock market seems detached from the economy.
Stock prices are driven by a combination of sentiments and fundamentals. In the immediate term sentiments probably have a bigger impact while in the long run fundamentals have a bigger impact.

But sentiments are affected by both fundamentals (economic conditions) and behavioral issues (personal outlook, fear, greed, etc) and other socio-political issues.

So, you should not be surprised that the stock market is sometimes detached from the economy.

These 2 factors have given rise to 2 investing styles:
  • Technical which uses price and transaction volume info as proxies for market sentiments.
  • Fundamentals that look at business prospects

If you are a fundamental investor you see high or low stock prices as selling and buying opportunities respectively and you don't lose sleep trying to figure out the market behavior eg why the market is high or is not crashing.

But if you are a technical investor, you probably should try to understand market sentiments. Unfortunately, it is not so simple because if it is, a lot of the technical investors would have overwhelmed the fundamental investors.



6. If a technical recession hits Singapore, what sectors in the stock market can drop badly?
Your question assumes that the majority of the companies listed on the Singapore stock market have their operations in Singapore.

If this is true, then any recession in Singapore would have a direct impact on the Singapore stock market.

But for those companies whose operations are not in Singapore, a Singapore recession (assuming that the rest of the world does not have a recession) may not affect the stock market performance.

I recently did an analysis of UOA Ltd, an Australia-listed company that has a secondary listing in Singapore. But all the operations are in Malaysia.

So, business analysis and valuation have to be based on what is happening in Malaysia rather than what is happening in Australia or Singapore.
 

7. Do you lose money if a company does a reverse split?
Imagine $ 100. This can be one note of $100 or two notes of $ 50. Is there a difference in value if you have one $100 note or two $ 50 notes?

This is the concept of stock split or reverse split/consolidation.

The intrinsic value of the company remains the same pre and post-split although the face value/price of the stock script changes.
  • As a shareholder before the split, you owned one share with $X per-share intrinsic value.
  • After the split eg into 2, you own two shares with $ x/2 per share intrinsic value.

The total intrinsic value of your investment is unchanged at $X per share.

However, the stock market is sentiment-driven. Sometimes if a share price is very high, not many would be able to buy. So, companies do a stock split to make it more affordable. Because of this, more people may buy driving the price up. While the intrinsic value remains unchanged, the share price goes up.

There is an equivalent story for reverse split/consolidation. The stocks may be penny stocks but by consolidating them, it is no longer penny stocks. With this stigma removed, some may buy. Again, this is market sentiment driving the stock price. The intrinsic value remains the same.

If you are a value investor, you look at intrinsic values so you should not be bothered by splits or consolidation. However, you should take advantage so that if the exercise causes the price to exceed the intrinsic value, this is an opportunity to make some money.

Will stock splits and/or consolidation cause the market price to drop? Since price is sentiment-driven, there is no reason why it cannot happen.

But the likelihood is that companies undertake the split and/or consolidation to drive the price higher and not lower. I can't imagine any investment bank advising a company to undertake the exercise to reduce the stock price.



8. Is it true that buying fraction shares of stocks is a gimmick for beginning investors just to raise stock values for the professional stock investor?
There are many ways to engage with the stock market.

One way is to be a value investor where you buy when price < intrinsic value. This requires you to look at the business of the company. Having fractional share does not change the intrinsic value.

On the other hand, if you are a short-term trader, the business fundamentals are not important as they are unlikely to change within the trading period. In such a case buying pieces of paper makes more sense. Having fractional shares makes the stock more accessible and this may affect the stock price. 

Actually, the issue is not whether it is fractional share, or any other concept when it comes to the professionals taking money away from beginners.

It is about having skills winning over those who don’t know what they are doing. Those who know what they are doing will be able to make use of all the concepts.



9. Why are we letting people be lazy and make money from the stock market just by being wealthy?
I think many confuse between making money from the stock market and being wealthy.

Most people become wealthy by being an entrepreneur and then they look for ways to protect their wealth from inflation. So, they invest. But this does not mean that they will automatically get better investment returns than others.

Investment returns are not related to how much money you start investing with. If you invest blindly even if you are very rich, you will eventually lose all your money.

You have to learn to invest just like you have to learn how to drive. And you have to put in the time to learn and practice before you are good enough to get consistent good returns. If investing is a lazy activity, then everyone will be a millionaire.

The reason that there are not that many successful investors among the retail investors is because it takes effort to develop the necessary investment skills.


10. Is the stock market a form of usury or gambling?
According to the Oxford dictionary, usury relates to getting interests from lending money.

If you think that you can just put your money into the stock market and simply earn some interest, well good luck to you.

To be successful in the stock market in the long run, you need investing skills. This requires you to learn about investing and about developing the appropriate analytical skills.

Yes, some people speculate in the stock market. If so, this is a form of gambling. But like all gamblers, is it sustainable over the long term?

To be successful long term, you cannot depend just on luck. Skills come in. I am sure if you look at the stock market from this perspective, it is not usury.

If by stock trading you mean buy and sell stocks daily, then I would agree that it is like gambling.

But if you are investing for the long term eg buy and hold for a few years, there are ways to analyze stocks that will give a good chance of making money. I wouldn't call this gambling as you are not basing it all on luck alone.

Consider this if you think of the stock market as a casino. 
  • There are those who want to play the slot machine because it is a mindless game of luck.  If you are likely to play the slot machine, don’t invest in stocks as you are pure gambling and are likely to lose.
  • There are those who play poker as there are some skills involved. But if you develop certain skills first before investing, you have a better chance of making it.

To take the casino analogy further, if you want to invest, be the casino and not the guests.



11. Why is the stock market not a reliable source of income?
The stock market can be a reliable source of income. The question is what is the expected income you want.

From a value investment perspective, there are two ways to benefit from the stock market

a) from dividends

b) from capital gains

My personal experience is that about 1/3 of my returns from the stock market have been from dividends with the balance from capital gains. Whether the returns are sufficient for you depends on how much you have invested.

But if you save and invest for the long term, it is likely that you can reach a day when the passive income from the stock market can enable you to stop work. The real challenge is how to do this.



12. If I had 1000$, should I invest it in penny stocks, play the lottery or invest in an index fund?
It all boils down to probability.

If you are treating investing in penny stocks as a game of chance, then the best way is to compare the probability of winning the lottery with that of striking it with the penny stock.

But if you don't want the penny stocks to be a game of chance, then you have to analyze why they are penny stocks
  • If it is because they have no future, then buying the lottery has better odds.
  • If it is because the market has overswung on the way down and thus turned good companies into penny stocks, then you have a better chance of investing in them.

The real question is whether you have the skills to do this assessment. If you don’t have one, I suggest that you donate the money to some charity as it would serve a better purpose.

If you buy a lottery with for example a million numbers to choose from, your chance of getting the first price is 1 in a million. OK, you may win a large sum, but the expected return is very low. Mathematically, if the winning ticket gets a million-dollar, your expected return is only 1 dollar.

But if you invest in an index fund over a long period, your expected return is more than 1 dollar - you get your principal and the returns.

But we all dream of striking the lottery. Invest 99% of your “spare money” into an index fund and use the 1% to buy the lottery. You may happen to be the lucky guy, but if not, you still benefit from the index fund.


END



Investment books that I have read.

Books


Comments




The book provides a good rationale on why I continue to "reverse engineer" the current market price as part of my valuation analysis.  

 

 

 

I find that Dr. Crosby has good practical advice on the behavioral aspects of investing.



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