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January 25, 2022

What is the Stock Market?

Bulls and bears, Dow and Nasdaq, bubbles and crashes, Greenspan and economic numbers. You've probably heard these terms as well as many others associated with the stock market but do you really know what it is? Why do we have one? This course will answer all your questions on this mysterious system that has created fortune as well as ruin.

Public and Private Companies

In order to understand why we have a stock market, it helps to understand some basic forms of business. If you start a business, there are several routes you can take. First, you can start a private company and there are many forms it could take. The simplest is called a sole proprietorship. This is typically the way that many small, mom and pop, corner stores are formed. The owner makes all the decisions and reaps all the rewards. Sole proprietorships are the cheapest to form and easy to dissolve. However, they have a big disadvantage in that they expose the owner to potentially unlimited liability. The owner is legally responsible for all debts and even has personal assets exposed if a big enough lawsuit should arise. Sole proprietorships also have difficulty in raising funds to start or operate the business and are often limited to using their own savings or small business loans.

In order to overcome some of the disadvantages with sole proprietorships, entrepreneurs sometimes start a partnership. These are businesses that are run by two or more people. By allowing others into the business, they have greater access to money and diverse talents to run the company. But just like a sole proprietorship, partnerships have unlimited liability. What's worse is that partnerships are liable for the actions of other partners. If you start a partnership and one partner orders lots of inventory on credit and flees the country, you and the other partners are liable for his actions. Also, partners may disagree on how to run the business, which can result in a lot of time wasted resolving issues rather than running the day-to-day activities.

The major drawback to each of these forms of ownership is the unlimited liability to which the owners are exposed. In order to resolve that problem, corporations were created. Corporate owners usually have limited liability, which is usually limited to the amount they have invested into the company. When the corporation is formed, shares of stock are issued and you sell these shares to those you want to be owners. If you can only buy shares through other owners of the corporation, then it is privately held, or a private corporation.

Because owners can always issue more shares, another nice benefit of corporations is that they can easily raise additional money by selling shares of stock. By selling shares, they bring in money in exchange for having to split the profits with more owners. While splitting profits is not a good thing, raising additional capital certainly is. It's possible that, by taking on additional owners, the corporation becomes bigger and stronger thus making all owners are better off. Another reason that owners may desire to sell shares is to diversify their holdings. What does this mean? An example will help to illustrate. Assume that your family owns an expensive Renoir painting worth $5,000,000. You want to keep it in the family as it is has drastically increased in value and is expected to continue to do so. At the same time, there is risk in holding it. It could get stolen, lost in a fire, or the art market could collapse and drive its price down well below the current value. How can you protect yourself from having so much wealth wrapped up into one thing without having to sell it? One way is to offer a fraction of the painting for sale. You may, for example, offer an investor a 1/10th ownership in the painting in exchange for money, say $2,000,000 cash. All you have to do is have a contract drawn that states that the owner of the contract owns 10% of the painting and then sell them the contract. You get immediate possession of the cash and still get to keep 90% of all future increases in the painting. In the worst case scenario, the painting gets destroyed but at least you have $2,000,000 cash to show for it. That's the idea behind diversifying assets - giving up some of the future gains in exchange for reducing the risk of holding it. When Bill Gates started Microsoft, he was confident it would be a huge success. Why would he offer part of the company for sale? Because he didn't want all of his future wealth sitting in one company. He was more comfortable in selling some of the company in exchange for cash.

With the Renoir painting example, notice that the contract you have drawn up states that this new person has a 10% stake, or share, in the value of the painting. And this is exactly what a share of stock designates. A share of stock is simply a certificate printed on a piece of paper - a contract - that states that the owner is entitled to their share of the profits in the corporation.

Assume that the 10% Renoir painting owner, at a later time, needs the cash and cannot wait until the painting is sold. Even though the painting has not been sold, the contract, or 10% share, certainly has value. He could sell that 10% ownership to someone else at whatever price they can agree upon. Notice that your family would never get any of this money. You sold the 10% share for two million dollars and that's all you will ever get from it. However, there could be many other owners, hundreds or thousands, which keep selling that same certificate. Whether they make gains or losses is of no consequence to your family; the two million is yours to keep and that's all you will get. Your family just knows that it owes 10% of the profits to whoever is holding that certificate and it doesn't really matter who that person is.

Problems with Selling

Okay, the idea sounds good so far but there is a problem. If you are the one holding the 10% certificate, how easy will it be for you to find a buyer? Will you have to go knocking on doors? Will you have to take out an expensive ad in the Wall Street Journal? And if you can't find a buyer quickly, you may have to drastically reduce your price in order to entice someone to buy. This means there could be a great deal of value lost between what you think the certificate is worth and what you actually get from selling it.

There is another problem created by not readily finding buyers. That is, how much is the certificate worth? If the first person offers you $2.5 million, is that a fair price? If there is no trustworthy, accurate way to determine a fair price, then you will probably have to settle for less than you think it is worth. And If it's difficult to find buyers, it's not going to be easy being a seller. If there is no easy way for others to sell the 10% certificate at a later time, your family may not be able to get the $2,000,000 they think the certificate is worth. If potential buyers think they will be stuck holding it, you won't be able to sell it. This problem extends to the buyers: If you are in the market to become a part owner of an expensive painting, how can you find a seller? Will you have to go knocking on doors or take out an ad in the Wall Street Journal?

Centralized Meeting Place

The two problems we face then are 1) Finding buyers and sellers and 2) Determining the value of the certificate. In order to get rid of the first problem, it would be nice to have a centralized "meeting place" where all buyers and sellers could get together. To overcome the second problem, we'd need a way for all buyers and sellers to broadcast their opinions as to the value of the certificate. Well, we do have such a system in place, and that is called the stock market. It is a market for selling stock certificates of publicly traded corporations, which we'll talk about in the next section. At any given time, you can find buyers and sellers for all publicly traded companies at one location. In addition, you can look up the price of any publicly traded company to see the price at which people are willing to buy and sell. It is nothing more than a live auction house where the public can participate in the buying and selling of shares. Having a centralized meeting place where people can line up to buy or sell and broadcast prices is always a beneficial from an economic perspective. You can think of eBay as a modern day version of a stock exchange. They are an online auction company, which allows individuals to sell nearly anything. Here's why eBay is economically beneficial. Assume you have a camera you'd like to sell - maybe a Nikon F1 camera. How much is it worth? Prior to eBay, you'd have no way of knowing. To find out, you might ask a local camera shop owner or a few friends who know about cameras. But their opinions are a far cry from knowing what the world thinks it is worth. Even if the camera shop owner offers to buy it, he will have to bid far less than it is worth so that he can mark it up and sell it. So this presents a dilemma for you. Do you sell it at an unfavorable price or do you just let it sit in the closet and never use it? Notice that it takes a lot of work to gather information if you wish to get a good price. You can either travel all over town gathering opinions or you can take your chances by selling to the first person willing to buy it. That does not sound too efficient. But now you can just go to eBay and type "Nikon F1" and see what the world is willing to pay for that model. Nearly every buyer of used cameras will be watching the site, which means that all sellers will show up too. Whenever you have all buyers and sellers in one place, you've gotten rid of all the problems we would otherwise encounter. Larger numbers of buyers means that they must compete and bid prices higher, which is good for you as a camera seller. At the same time, other camera sellers will be present, which means they must compete by offering lower prices and that is good for the buyers. When people are confident in prices, they are eager to transact. And that's the idea behind a centralized meeting place and the very reason we have a stock market.

Publicly Traded Companies

A publicly traded corporation is one where anybody can be an owner. Unlike a private corporation, you do not need to be an insider or know one of the owners in order to participate. For example, the package courier United Parcel Service (UPS) used to be a privately held corporation. The only way to own shares was by being an employee. A share of stock traded through the company is called the primary market.

But that all changed in 1999 when they decided to "go public," which simply means UPS began offering their shares to the public through the stock market. They were now a publicly traded company. By going public, they greatly increased the ease and speed at which they could convert their shares to cash. Investors are also more willing to buy the shares since they are now confident that they have an outlet to sell. More buyers mean higher selling prices for the owners. Another benefit of becoming publicly traded is that UPS can always raise more cash by simply issuing more shares of stock. But the tradeoff to all of these benefits is that UPS is now publicly exposed. They must publicly announce earnings, outlooks, and many other data that they previously tried to keep away from competitors.

If you buy shares of Microsoft, you are buying a piece of the company; you are a part owner of Microsoft! Many people think that Bill Gates owns Microsoft and that's not true. He owns the majority of the shares so that he still controls the final decisions of the company; however, if you even own one share of Microsoft, then you are technically a partner of Bill Gates.

Figure 1: Microsoft Stock Certificate

Stock certificate

Unlike the 10% certificate in the Renoir painting example, stock certificates do not state 10% or some other number. Instead, they just state the number of shares they are worth. Your percentage ownership is determined by how many shares you own relative to how many are issued by the corporation. If a corporation has 1,000,000 shares available for sale and you own 100,000 shares, then you are a 10% owner and are entitled to 10% of the profits. If you own 100 shares, then you own 1/100th of 1% of the company.

Taking it Public

When a company first offers its shares for sale to the public, it is called an initial public offering, or IPO. Shares sold on the IPO are called the primary market, since those are shares traded through the company. It is the only time that the company receives money from the transaction much like your family did in the painting example when they first sold the 10% Renoir certificate. IPOs are often met with much fanfare since there is often a lot of buying pressure on the opening day and the stock's price can increase quickly. In 1995, the web browser company Netscape had its IPO and was priced at $28 per share. That means that all the people who were able to get into the IPO paid $28 per share. However, the first trade of the day on the secondary market was around $75! IPOs often are often associated with wild price swings, up and down, largely due to big discrepancies between the number of buyers and sellers.

Any sales of those stock certificates after that point are out of the control of the issuing company. They are traded on the secondary market, which is the stock exchange. If you wish to buy shares of stock such as Microsoft, IBM, Intel, or any of the other hundreds of names you're familiar with, you are trading them through the secondary market. In other words, you are not getting those shares directly through the company; instead, you are buying from other investors. The secondary market is similar to the used car market. When Ford sells a Mustang to a dealership, Ford collects the money for that car. That's similar to the IPO market. Once that car is sold by the dealership though, it is on the secondary market and can be resold numerous times and Ford never sees a penny of that money.

Benefits of Secondary Markets

Why have secondary markets? Wouldn't Microsoft be better off by only allowing investors to buy through them? That's a big myth in many market places. Fortunately, many businesses are discovering that they are better off with a secondary market. For example, you can buy new books through Amazon.com. Recently though, they allow anybody to sell used books through their site. Why would they allow you to compete with them on their own site? If the used books weren't there, wouldn't you be forced to buy a new book through Amazon? The answer to that is not so easy to see but it turns out that Amazon is better off by allowing you to compete. For example, assume you find a book you'd like to have but it's rather expensive and sells for $60 new. Because of the high price, Amazon will sell fewer of these books as compared to the lower priced books. However, if you can buy the book for $60 and possibly sell it for $40 when you're done, then your cost is only $20, which means you're now more likely to buy it. But where will you sell it? Now you see why Amazon offers a secondary market. It encourages others to buy new books through them. Overall, Amazon's profits will rise by offering a secondary market, which at first glance, may seem counterintuitive. Car dealers do the same thing. Why does your local dealer have used cars on their lot? Wouldn't they be better off "forcing" you to buy a new one? By creating a secondary market, they are encouraging others to buy new cars since they now have an easy way - a secondary market - to sell it if they wish.

Stock Markets Make it Easy for Corporations to Raise Money

The biggest benefit of having a well-run stock market is that it makes it easy for corporations to raise money. The formation of capital is one of the most important functions of the stock market. For example, when Bill Gates started Microsoft, he could have walked door-to-door pitching the benefits of his idea, trying to get investors to buy into it. But who would hand over a sizeable check to a total stranger? You're starting to see the idea that it would be very hard to get the big companies, the ones that run America, off the ground. Instead, Bill Gates can file with the Securities and Exchange Commission (SEC) stating that he wants to start a publicly traded company. He can also state how many shares he's willing to sell. In fact, Microsoft had its IPO in March, 1986 and sold 2.8 million shares for $21 per share. Who did they sell them to? Microsoft will seek out an underwriter for the deal. In this case, it was Goldman Sachs that landed the deal. Goldman Sachs can quickly raise capital by reaching out to all of their account holders who agreed to pay $21 per share. That amounted to an instant check for $58,800,000 for Microsoft. In this case, Goldman Sachs acts like the Ford car dealership that cuts a large check to the Ford factory. In turn, Goldman's clients get to either hold the shares or can immediately sell them (usually at a hefty profit) on the secondary market. The point is that in a relatively short time and very efficiently, Microsoft created nearly 59 million dollars for them to grow. In return, they split the company into 2.8 million pieces and have to share to profits among all those owners. Yes, that's a lot of pieces but it can still be profitable. If you had purchased 100 shares at $21, you'd have 28,800 shares at $28, or a total of $806,400. (The increase in shares from 100 to 28,800 is due to stock splits. So even though the $28 price isn't very different from your original purchase price of $21, your total profit is enormously higher.)

Again, one of the reasons that investors were willing to pay $21 per share is because they knew there was a secondary market. If they wanted to sell, they could immediately see the going price of Microsoft and sell their stock within seconds. All they had to do was pull up a quote and place a trade through their broker. The stock market creates a way for every investor in the world to see exactly what the price is of a publicly traded share of stock. It is the eBay for shares of stock. No more knocking on doors or wondering if there's someone out there willing to pay more. The stock market, therefore, makes it very easy for large corporations to form, which in turn creates jobs. It is the quick formation of capital that allows the U.S. economy to grow strong. In fact, the presence of a well-functioning stock exchange is one of the factors that separate developed countries from the rest. Many small, lesser developed countries have great resources, products, or ideas to export but they just can't raise the money to get them off the ground.

Martha Stewart

You've probably heard about the Martha Stewart case where she was sent to prison for "insider trading," which means she was selling shares of stock based on information that was not publicly available. Actually, she didn't get pinned for the illegal sale but rather for lying to the authorities about it. They weren't able to prove the insider trading so they went after her for her dishonest statements about the sale. Many people wonder why we bother to prosecute someone for such a "victimless" crime. After all, who cares that she sold her shares illegally? She's a good citizen and has created lots of jobs so leave her alone. Hopefully, you're starting to see why it's not a victimless crime. Her dishonest sale undermines the confidence that investors have in the markets and that means people aren't going to be so willing to buy and sell anymore. If that happens, corporations cannot raise money and ultimately our entire financial system would collapse. If you don't believe it, think about this: What would happen if nobody was ever prosecuted for insider selling? What if it was perfectly legal to do? Martha Stewart walks out of prison and the general public is very happy to hear that we've all come to our senses.

Now assume that you invest $100,000 for your kids' college and to buy a new house in the future. You invest it in the biggest and best performing stock that we've seen in decades since you don't want to take a lot of risk. Three months later, your investment is worth pennies - your $100k is gone. It turns out that you invested in a company called Enron. How were you able to get such a good deal on the shares? The insiders knew the company was collapsing and were dumping their shares so that YOU would be left with the damage. They needed to unload those shares so they could maintain their 60-room mansions while your family is devastated. You decide to never touch the stock market again - and so does everybody else. That's why the authorities went after all the Enron insiders as well as Martha Stewart. If you shake the confidence in the market, then no more corporations are created. In fact, the corporation you may work for now could go under if it is not able to raise new capital by selling shares.

Confidence is a necessary ingredient to make the system work. That's why eBay gives users the ability to leave feedback about every transaction with each person. If you have no idea about the reliability of the other person, or heard that most of the items for sale are scams, would you trade through eBay? The ability to leave feedback allows eBay to weed out the bad users and keep the good users and is one of the main reasons it works.

So while Martha Stewart is not a "hardened criminal" nor a threat to society, her prison stint serves as a warning to other insiders who may decide to shake investors' confidence and undermine the money machine that funds America. When you think about it, it's kind of ironic that she attempted to weaken the very system that made her a billionaire.

New York Stock Exchange vs. Nasdaq

There are several stock exchanges and each one operates a little differently but the ideas are the same. The two most popular are the New York Stock Exchange (NYSE) and the Nasdaq. The NYSE, also called "The Big Board", operates as a live auction market where people shout buy and sell orders received from brokerage firms. The Nasdaq is a computerized system that links many "market makers" together. It is purely an electronic system with no trading floor. In fact, NASDAQ was an acronym that stood for "National Association of Securities Dealers Automated Quotations". However, in recent years, it has become recognized as an entity and the spelling has shifted from the all-caps spelling to Nasdaq. To make a comparison, the NYSE is similar to attending a live auction such as at Sotheby's while the Nasdaq is similar to eBay, which is an auction conducted through computer links.

Every publicly traded company has a unique symbol that identifies its shares. If that symbol contains three letters or less, it is traded on the NYSE. If it contains four or more, it is traded on the Nasdaq. For example, IBM Computer trades under the symbol "IBM" and that tells you it's traded on the NYSE. Microsoft, on the other hand, trades under "MSFT," which means it trades through the Nasdaq. There are some pros and cons to each exchange but they mostly apply to the corporations themselves rather than to investors. Years ago, it used to be prestigious to be listed on the NYSE because of the tougher listing requirements. Many new companies start trading on the Nasdaq but shifted to the NYSE once they met the new requirements. But that impression is fading. Most corporations that start on Nasdaq just end up staying there no matter how big they get. In fact, the NYSE still reserves the symbol "I" and "M" in hopes that Intel and Microsoft will list with them in the future. It hasn't happened so far and Intel continues to trade under "INTC" and Microsoft under "MSFT" on the Nasdaq.

Most quotation systems will bring up quotes from either exchange and you don't need to tell it the exchange where it is listed. All you have to do is type in the symbol of the company and it immediately shows you what the price of that certificate is at that moment in time. Unlike most prices, stock prices are never constant. The price you see right now will likely be a little different one minute later.

Hopefully you now have a better understanding of what the stock market is and why we have one. It is a centralized meeting place where buyers and sellers can trade shares of publicly traded companies. This secondary market creates investor confidence, which allows corporations, new or existing, to raise money. If you wish to become part owner of a public company, you can pull up a quote and see the going price. In a matter of seconds, you can either be a part owner or sell your share in the company to someone else.

[Judy Alster - Senior Analyst]

"My three rules of investment writing: Clarity. Brevity. Profit."

What I do is analyze and recommend stocks - stocks that are headed up for at least a few months and sometimes longer. Every month I recommend buying about eight or 10 of them in the 21st Century Investor newsletter. When I think they've maximized their profit potential I recommend selling them. My profit record is good; in fact it's quite good. I'll get to that in a moment.

Mainly, I'm a "fundamentalist." I look at the company itself. I find companies in growing sectors of the economy, or sectors that look like they're about to grow, with the chance of dominating that sector for a while. The companies I like are usually making a profit on increasing revenue - or what's sometimes even better as far as the stock market is concerned, they're just beginning to make a profit after several quarters of losses. I prefer earnings that are solid operating profit, not tax benefits or proceeds from asset sales.

Here are the profits subscribers have taken on some of my recommendations just since October 2003:

  • 68% on IDX Systems
  • 101% on Central European Distribution
  • 53% on Vimpel Communications
  • 34% on Arthrocare Corp.
  • 77% on China Yuchai
  • 20% on Closure Medical
  • 69% on Cyberonics
  • 31% on Diodes, Inc.
  • 28% on PetroKazakhstan
  • 58% on F5 Networks

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