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 has now been updated to include the link between the stock market and the economy. It also covered the drivers of stock prices and on how to make money from the stock market. Revision date: 2 Dec 2021

"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 focused 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 Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

1. Stock market and the economy

2. Stock Prices

3. Making money from the stock market

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1. Stock market and the economy

Investopedia described the stock market as follows:

“The stock market broadly refers to the collection of exchanges and other venues where the buying, selling, and issuance of shares of publicly held companies take place. Such financial activities are conducted through institutionalized formal exchanges (whether physical or electronic) or via over-the-counter (OTC) marketplaces that operate under a defined set of regulations.

The terms “stock market” and “stock exchange” are often used interchangeably. The latter term generally comprises a subset of the former. If one trades in the stock market, it means that they buy or sell shares on one (or more) of the stock exchange(s) that are part of the overall stock market.”

The stock market serves two very important purposes.

To provide capital to companies to fund their businesses. If a company issues 10 million shares that initially sell for $1 a share, it provides the company with $10 million of capital.

To give investors the opportunity to share in the profits of publicly-traded companies. Investors can profit in 2 ways - capital gain from buying and selling the stocks and dividends.

Today in most stock exchanges, the volume of transactions from the latter overshadows that of the former.

In practice because listing requirements, the stock market comprises the better companies in an economy. An economy is about the production of goods and services. For an economy to grow, there should be growth in the production of goods and services. You should not surprise to see the link between economic growth and the growth in the business of the companies under the stock market.

However, the performance of a stock market is not measured by the economic performance of the companies under the stock exchange. Rather it is measured by the stock price and the number of shares listed.

And stock prices are dependent not just on business performance alone. They are often in the immediate term affected by market sentiments. There are many factors that affect market sentiments, where business outlook is just one of them.

As such in the immediate to short term, there is little correlation between the performance of the stock market and business performance.

The following charts taken from the article “Should you invest in the KLCI or let the EPF manage your savings?” illustrate these points:

The KLCI had grown at 6.8 % CAGR from 1976 to 2020. During the period the Malaysian GDP had grown at 5.6 %.

Over the past 11 years, the performance of the KLCI does not reflect the business performance.

Chart 1: Index Performance

Chart 2: ROE vs KLCI

1.1 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.

1.2 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.

1.3 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.

1.4 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.

2. Stock Prices

“Long ago, Ben Graham taught me that Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Warren Buffett.

If you are a stock trader, price and volume data are critical information because the focus is on trading pieces of paper. The fundamentals and/or intrinsic values of the companies are not important

But, if you are a value investor, market prices are also important. You are buying and selling based on how the market price compares to the intrinsic values

Both price and value are the two sides of the same coin. Understanding the difference between price and value is the core principle of value investing.

While you can get the price of a stock (for listed companies), there are no quoted intrinsic values. In practice, you have to estimate the intrinsic values yourself.

Different investors will have different estimates of the intrinsic value of a company. Contrast this with the stock price. While the stock price may fluctuate, at any one point, there is one price representing the thinking of the crowd at that time.

Relative value is not intrinsic value. Relative value is assessing the worth of a company by comparing it with its peers. Intrinsic value is based on the company’s fundamentals and is related to the discounted cash flow generated by the business over its life. So, the market price represents the perceived value by the crowd and is not the intrinsic value.

Market price changes very whereas intrinsic value does not change on a daily basis.

Technically market prices are set by supply and demand. According to economic theory:

If there are more buyers than sellers then the price will adjust upwards until we have the situation where the number of buyers = number of sellers.

If there are more sellers than buyers, the price will adjust downwards until we have an equal number of sellers and buyers.

Of course, this is an economic model that works in a competitive environment and may not reflect what is happening in the stock market. I prefer to look at the reasons why people buy or sell. For every transaction, there are people of opposite sides:

The buyers are those that expect the price to give up so that they can make money.

The sellers are those that think they will lose money or that they have made enough as they don’t expect the price to go up in the future.

The real question is what drives the expectation. I believe that it is a combination of sentiments and business fundamentals. In the short run, sentiments rule while in the long run business fundamentals have more influence. The challenge is that sentiments are also influenced by fundamentals

The 2 views of what drives stock prices have given rise to 2 investing methods:

Those that invest based on technical. They use price and volume information as a proxy for market sentiments. These people trade pieces of paper.

Those that invest based on fundamentals. We have value investors as one good example. They consider investing as being part-shareholder of a company.

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, it will continue to grow its profits over time. Furthermore, if management is good at capital allocation, 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. The price of the stock will increase over time. Can you think of a less risk-averse way to invest?

2.1 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)

2.2 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.

2.3 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.

2.4 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.

3. Making money from the stock market

A stock market can be considered as a place where people buy and sell pieces of paper representing part ownership of companies.

As such there are two ways to engage with the stock market:

Buy and sell pieces of paper. Those who following this investment approach believe that the stock market is mainly sentiments driven. Making money then boils down to chasing after popular stocks. They believe that this will cause stock prices to rise. Many use charts and technical indicators to gauge market sentiments. The success here depends on your ability to read crowd behaviour.

Buy and sell part ownership of companies. Those who follow this investment style buy when prices are less than the value of the business as determined by the fundamentals. They sell when prices are more than the business values. The belief is that price will eventually reflect business value enabling them to make money. The success here depends on your ability to understand businesses and to value them.

Irrespective of the investing approach, you make money from the stock market through the power of compounding.

Compounding is the ability of an asset to generate earnings, which are then reinvested or remain invested. The goal is for the earnings to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

This requires you to generate consistent returns over decades of investing.

Conceptually you are experiencing exponential growth. The amount you have at the end will depend on the annual rate of return and the investment period. The chart below shows how the $ 1,000 will grow based on 3 different rates of turn over a period of up to 60 years.

Chart 3: Investment Returns

In summary there are 3 factors that affect how you can make money and get rich from the stock market

The investment periods.

The amount you invest.

The annual return you achieve for the investments

The pattern of investment also affects the final sum you get. If you invest the same amount every year, you will have significantly more than with a one-off investment.

How can you get rich from the stock market?

Invest when young so that you have at least a 50 years investment horizon.

Invest at least $ 2,000 every year.

Learn to invest so that you can achieve an annual return of at least 8 %

3.1 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.

3.2 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.

3.3 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.

3.4 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.

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