Common stocks provide investors with an ownership interest in a company.
Shares of stock represent company equity and are often called just that,
equities. As discussed in Chapter 2, investors can buy and sell stocks on
exchanges—entities that exist mostly to create a marketplace for the shares.
Stocks trade constantly during business hours—9:30 a.m. to 4.00 p.m.
Eastern time most weekdays—with prices changing from second to second.
As the value of a company rises and falls, so does the value of an
investor’s stock. Over the long haul, stock prices tend to rise when
companies increase their sales and profits. But in the short term, stocks can
gyrate, moved by things like overall economic trends, news from rival
companies, government action, and a host of other factors.
For example, at the end of August 2013, Microsoft shares sold for
$33.40, with about 8.44 billion shares outstanding. If you multiply the
number of shares by the per-share price you get $282 billion—the stock’s
market capitalization, often abbreviated to market cap. An investor who
purchases 50 shares of Microsoft for roughly $1,670 would own a tiny
fraction of one of the world’s largest companies. When more people wish to
buy a certain stock than to sell it, prices tend to rise. As any economics
textbook will tell you, when products become scarce and the demand for
them increases, prices often increase in response. The stock market won’t
run out of Microsoft shares should they become popular for any reason, but
when buyers outnumber sellers, the disparity creates scarcity and drives
the price up. The same principle applies on the downside—where an excess
of shares and a dearth of buyers leads to falling prices.
Stock-price movements illustrate the importance of the market—the
importance of you, the investor—because markets set stock values. The
World Bank estimated the value of all U.S. companies’ stock at $18.7 trillion
at the end of 2012—more than five times the value of companies in each of
the next-largest markets, China and Japan. With more than 5,000 U.S.
companies trading their stock—not to mention hundreds of foreign
companies with stocks that trade in this country—equity investors can tap
into just about any facet of the economy.
Not all stocks behave the same way, which means they can play different
roles in your portfolio. Here are some classifications every stock investor
should understand:
Value stocks. Investors tend to set values for stocks relative to their
earnings (or sales, or cash flows, etc). If a stock that earned $100
million over the last year trades at 10 times earnings, its market cap is
10 times $100 million, or $1 billion. In most cases, investors focus on
per-share numbers. For example, if the company earning $100 million
has 100 million shares outstanding, it earns $1 per share. A
price/earnings ratio of 10 prices the stock at $10 per share. Many
academic studies have shown that stocks with low price/earnings
ratios relative to the rest of the market tend to outperform. Valueoriented investors gravitate toward value stocks—companies that
trade at a discount relative to their earnings or some other operating
statistic.
Growth stocks. Stocks with above-market growth of sales or profits
tend to outperform their peers. These stocks tend to cost more (higher
price/earnings ratios, etc.) than other stocks, as many investors will
pay a premium for growth.
At first blush, the idea that both high-growth stocks and value stocks can
outperform sounds like a contradiction. But within such a massive system
as the stock market, investors have found more than one way to make a
profit. You may hear pundits touting the benefits of growth over value, or
vice versa. While everyone is entitled to an opinion, this choice mostly
comes down to personal preference.
Over the very long haul, value stocks tend to outperform growth stocks.
Growth stocks have outperformed value stocks over the last decade, yet
value stocks have managed higher returns in 7 of the last 10 years, as shown
in Table 3.1. Whether you invest in value stocks, growth stocks, or both, the
beauty is that you can make money, regardless of personal preference, if
you choose wisely.
Year Large-company growth
stocks
Large-company value
stocks
2012 15.4% 23
Types Of Investments: Stocks.
