Investing in the stock market usually entails making a bet regarding a company. But what is a company, anyways? Says Wikipedia: “A company, abbreviated co., is a legal entity made up of an association of people, be they natural, legal, or a mixture of both, for carrying on a commercial or industrial enterprise.”
This article is the second in a series intended to serve as an introduction to investing in the stock market. If you missed the first article, be sure to go back and read it before proceeding. There, we established that the company is the foundation for all investing in stocks. Here, we will look at what constitutes a company, how one might differ from the next, and what investing in a company means.
As per the Wikipedia-definition in the opening paragraph, a company is simply a legal entity, comprising people gathered with the intent of doing business. And, as established in the first part of this series on getting started with investing, everybody in the western world has a relation of one kind or another to the concept. What two people think instantly think about when hearing the word company, however, will vary wildly. While one person might instinctively mention Apple, the world’s most valuable enterprise, another could very well use their favoured local, laundromat.
While it might seem that these two entities have little in common, the fundamentals of a company still apply to both. Both aim to conduct business and rely on turning a profit over a certain time span to justify its existence. And, likewise, both Apple and the local laundromat is ultimately controlled by its shareholders, all of which want to see a return on the investments they have made in the respective companies. To better understand the likeness and differences between companies, it is important to know the common distinctions made between companies.
Different Types of Companies
This list is not an exhaustive investigation of all known classifications of companies, but rather a primer on some of the most familiar terms and classifications of companies you are likely to come across as you get started with investing.
Big Corporations and Small Companies
The first and most noticeable difference between the two entities in our example is scale. One is the world’s most valuable company, as measured by market capitalisation, employs tens of thousands of people and sees daily sales in the billions. The other is perhaps a business with a single location, employing a handful of individuals, with daily sales in the low thousands.
Startups and Lifestyle Businesses
Not all small companies are created equally. One company employing five people can be radically different regarding scope and ambitions from the next. Small businesses positioned for rapid growth and world domination, typically leveraging technology to add value, are often referred to as “Startups”. Conversely, small and medium businesses without ambitions of global domination are characterised as “Lifestyle Businesses.” The name is derived from the fact that founders and owners, frequently one and the same, start these businesses to generate a living and sustain a particular lifestyle.
While media attention surrounding small businesses focuses primarily on startups, lifestyle businesses are not only profitable companies for thousands of founders and investors, but they are also pivotal providers of work for millions of people in America alone. So be careful not to dismiss the viability and importance of running, investing in, or working for a lifestyle business, even if it might seem less glamorous than the fast-paced life at a startup, or lack the corporate shine of a global megacorporation.
Public and Private Companies
An important distinction between companies, especially as it relates to investing, is that some companies are private, while others are public. A public company is listed on a stock exchange, and anyone with the required capital to purchase a single share of stock can become an investor in a public company. Commonly, shareholders of public companies receive voting rights based on the percentage of issued shares held. If you own 10% of the shares, you control 10% of the votes and thus have a significant say in the composition of the company board.
Conversely, a private company is not listed on an exchange, and, broadly speaking, not a viable investment opportunity for the general populace. Investing in privately held companies is quite a different ball game compared to publicly listed businesses and requires additional skills and know-how.
In other words, when someone refers to investing in “the market” or similar terms, that person is always talking about the universe of publicly listed companies. Remember that adage from legendary investor Warren Buffet, on how you should only invest in what you understand? Well, that goes double and triple for private companies, so make sure you investigate and thoroughly familiarise yourselves with the risks involved before you invest in private companies.
Blue Chips and Penny Stocks
If you were thinking that you were going to play it safe by only investing in public companies, it is good to be aware that not all publicly listed companies are equal. When someone asks you to picture a publicly traded company, you will most likely be imagining a Blue Chip stock. These are the mastodons of the corporate world, nationally or even internationally recognised brands, financially sound and often considered too big to fail. You know better than making a false assumption like that, of course, but generally speaking, Blue Chips are the safest investments when it comes to individual stocks.
On the other end of the spectrum are what is commonly referred to as Penny Stocks. Strictly speaking, Penny Stocks are all companies trading for less than $5 per share, but colloquially they are considered the opposites of Blue Chips. Penny Stocks are often listed on lesser known exchanges, suffer from low volume and liquidity, and are considered severely more risky than their opposites.
Making Money From Investing
As an investor, we commonly make money or see our investments grow, through one of two different ways, both of which we will look at a bit more closely here. Let us start with the most obvious way, which is that company value increases. The result is that the value of your share of the company increases as well, and it is now worth more than you originally paid to acquire it. You have made a profit!
Unfortunately, there is a caveat. Yes, your investment is now worth more than you paid for it, but you no more money in your pocket than you did yesterday before the value of your investment rose. This situation is called sitting on unrealised gains, and it highlights the importance of a stock’s liquidity, which is a measure for how often the shares of a stock is bought and sold. High liquidity stocks, which investors buy and sell frequently, are naturally easier to convert into cold hard cash than those which see lower trading volumes.
Another aspect which affects your true returns when realising your gains is transaction costs. Buying and selling are transactions which incur costs and returns realised through selling shares will be reduced by the cost of the sale. If your volume is large enough, these costs will be negligible, but underestimating the effects of transaction costs on long-term returns is a frequent mistake among investors.
The other way of earning money through investing in stocks is by receiving dividends. Distributing dividends is a way for the management of a company to return money to their shareholders, and it comes in the form of a direct payout. Think of dividends as the stock market equivalent of receiving interest on your bank deposits, and dividends are commonly measured, just like interest, as a percentage of your equity in the company.
Underestimating the effects of transaction costs on long-term returns is a frequent mistake among investors.
While some believe dividend-focused investing is a more efficient way of creating returns for yourself, others will claim alternative strategies to be more effective. With the reasonable assumption of some degree of market efficiency and a long-term investment horizon, sticking to your strategy is more important than which strategy you choose. Incurring transaction costs by making redundant sales and purchases will damage your long-term returns.
How To Pick Stock Market Winners
The million, billion and even trillion dollar question when it comes to investing is how do we pick the winners? How do we identify the companies that will perform best in the long run, and thus secure significant returns and minimise losses?
Unless you have a crystal ball or know someone with one who would be willing to give you some pointers, the boring truth is that it is impossible to know. Making this realisation, however, is the first step towards generating stable, long-term returns from your investments.
It also helps to understand the true nature investing. Circling back to the example at the very beginning of this article, the differences between the giant conglomerate that is a Fortune 500 company and your local laundromat are, at the end of the day, nuances. The one thing that is more important than anything else applies universally to every company out there, and that is that a company is just a collection of people doing business. So, no matter which company you invest in, you are making a bet that this company is run by, and employs the best and brightest people. By investing, you make the bet that the individuals who comprise the company you invest in have what it takes to outperform the competition, and generate superior returns per dollar spent.
By investing, you make the bet that the individuals who comprise the company you invest in have what it takes to outperform the competition.
Understanding this can be a daunting experience. How can you possibly gain enough insight into the people in so many companies, across so many industries, that you can ever feel comfortable assuming the risk investing entails? Fortunately, there is a way to invest which effectively eliminates the risk associated with owning individual shares, while still rewarding us with the upsides of providing capital to an expanding economy. The concept of diversification is an essential part of a well-constructed investment strategy, and it is one of several concepts we will explore in the upcoming instalments of this series, which will centre around modern portfolio theory.
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Title photo by gags9999.