Beginners Article 2: What Are You Actually Buying?
What are you actually buying?
Now that we know how the stock market was born, let’s have a look at what it actually means to own a share.
Stocks, shares, equities, securities. Lots of different words for a slice of the pie. We hear the words, see the news and buy the codes, but what are you actually signing yourself up for when you click on the little ‘BUY’ button.
A share is a portion of a company that is sold at a certain price in order to raise capital to establish their operations, pay off debt, make acquisitions or expand. A company can sell its shares to raise funds when they transition from a private to a public company in an initial public offering (IPO), or at any time after if they choose to sell additional stock. When a company sells its shares, it does so with a fixed amount at a set price, often to institutional investors (banks, brokers, investment firms, etc). Once the shares are initially sold they can then be freely traded on an exchange such as the Australian Stock Exchange (ASX). On an exchange the price is agile, responding to news and representing the point of current fair value between buyers and sellers, where buyers are happy to buy and sellers are happy to sell. Simple supply and demand.
When you buy a share as a retail investor (purchasing for yourself) there are no limits to the amount you can buy (except for the size of your wallet) or the time you can hold it. There are tax and dividend implications that may come in to play, but we won’t get into that right now. For all intents and purposes you are able to buy and sell as you please.
You might not realise it but owning shares means more than just having the code come up when you check your portfolio – and getting a little wealthier when the price goes up.
Being a shareholder of a company gives you certain rights. Most shares that you will trade on the ASX are ‘ordinary’ shares (we’ll get to other types of shares and instruments later). These shares hold no special or preferred rights, but they do usually hold voting rights in matters of corporate policy such as board appointments, renumeration and major changes in corporate policy. However, as a retail investor the level of impact you can have on the company is minimal, with the decision often lying in the hands of a majority shareholder (50% or greater ownership), and/or substantial shareholders (5% or greater ownership, often institutions).
The reason for the low impact level is that as retail investors, it is unlikely we will be able to purchase enough stock to have an impactful stake. For example, a $10,000 investment by you or I in a company with a $100m market cap (stock price x number of shares on offer) will amount to just 0.01% ownership. Not exactly a dominant vote. For this reason, many retail investors either forego their vote, or chose to vote by appointing a proxy to act on their behalf.
A little more fun (and profitable) right as a shareholder is the right to a share in company profits. Profits are either reinvested to help grow the business or are paid out to shareholders in the form of a dividend. Whether a company pays out a dividend or not, as well as the size of a potential dividend, depends on a number of things including the life stage, strategy and goals of the company. A young ‘growth’ company (think Afterpay (APT), Xero (XRO)) will not pay out a dividend as it is looking to use the profits to maximise its growth and expand its operations. Whereas a large established company that is past its days of rapid expansion (think the ‘Big 4’ banks and the big miners) will pay out much of its profits as a dividend to shareholders (the percentage of the net income paid to shareholders is called the dividend payout ratio).
As a shareholder you get the benefits of a vote, a share in the profits, an invite to the AGM and will often be offered extra shares in the event of a share placement (further funds raising from the company), but there must be some downsides too? Surely?
While the structure of a public company means you can never be liable for their actions, meaning you won’t have the repo man come knocking on your door to cover their debts, you are still exposed to company actions as a shareholder in the form of the stock price.
Chapter one of any ‘Introduction to Finance’ textbook will tell you that a company’s number one objective is to maximise shareholder wealth. While management should be acting in your best interests as a shareholder, this isn’t always the case. Senior management will often have large share holding as part of their salary package. This aligns their best interests with yours but can lead to actions that benefit the share price in the short term (strategy changes or even corrupt behaviour) at the detriment of the long-term success, and ultimately the value of your investment.
Larger companies tend to carry less risk of collapse or corruption than smaller companies, as the latter are under less scrutiny. Although you only have to look at the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry to see that big companies aren’t exempt to sinister actions. While the Royal Commission resulted in numerous layoffs and financial penalties which shareholders avoided, the value of bank shares fell dramatically through the process as the skeletons were brought out of the closet.
The price of shares rise and fall to reflect news (macroeconomic and microeconomic) or changes in the company. As an investor, the worst-case scenario is the value of your share going to zero. The upside however, is unlimited.