Most investors trade in shares of individual companies.
The main method for small investors (i.e. you and me) is to buy and sell shares on the open market through the use of a brokerage account.
However, you can invest in public companies using other means as well.
Some investors acquire shares through a “Direct Public Offering” or “public offering”.
Companies that go public normally have an “Initial Public Offering” (IPO) for their shares.
Existing public companies may have “Subsequent Public Offerings” or “Follow-On Public Offerings” when issuing additional shares to the public. You may also see other derivations of these terms.
In my experience, public offerings have mixed results for small investors.
Stock offerings have a maximum number of shares that are issued. If the offering is popular, there is a good chance that it will be fully or over-subscribed (more investors want shares than are being offered).
In the world of investing, large investors (mutual funds, pensions, wealthy individuals, etc.) are usually accommodated to a greater extent than small investors. For popular offerings, that means you may not be able to get any or all of the shares that you desire.
Because of the potential greater demand than supply, investors that cannot purchase all their shares in an IPO may do so on the open market once the shares begin trading.
I recommend caution if you follow this strategy.
As with everything, when there is excess demand, prices rise. The greater the excess, the higher the price shoots until equilibrium is reached (see, economics can be useful for more than insomnia!).
For very popular issues, the share price may rise simply on the excess demand and not on the fundamentals of the company. If this occurs, it is common to see the company’s share price increase rapidly above the issue price in the initial few days of trading. It is also common in these circumstances to look at the share price a year later and see that it has fallen significantly to reflect reality, rather than hysteria.
For example, The Blackstone Group (symbol: BX) issued an IPO in June of 2007 at $31 per share. Shares traded between $34.25 and $38.00 and closed at $35.06 on June 22, the initial day of trading. If you had been part of the IPO at $31, you could have earned between 10.5% and 22.5% (before transaction costs) in one day. Not a bad return at all.
However, if you were one of the investors who had scrambled to buy this stock in the open market on June 22, your returns might have been a little different. One week later, at the end of June, your shares would only be worth $29.27. At the end of July 2007, $24.01. The end of August 2007, $23.13. And so on.
After an initial frenzy, the shares settled back to where the fundamentals indicated they should trade. As for fundamentals, we shall look at this topic when reviewing how to analyze stock.
I realize that some of you may point out examples where the IPO kept going up in price. I could easily list a few as well. To me though, this further complicates the issue of small investors buying IPOs once they begin to trade.
When investors bought Blackstone on the initial trading day, every one of them believed they were buying the next Google (IPO of $85, closed the initial trading day at $100, never a weekly close over the next 52 weeks below $100, and traded at $280 a year later).
But it does not work out this way very often.
Just remember that when buying an IPO or shares in the open market. Do not pay for the excess demand. Always buy based on the facts, not the hype. You may miss out on a few Googles, but you will also avoid purchasing the many Blackstones.
Open Market Purchases
Most investors buy and sell their shares on the “open market”. This is also known as the “secondary market” or “aftermarket”.
The open market may be a formal stock exchange (e.g. New York Stock Exchange [NYSE]) or “over the counter” (OTC).
OTC shares trade via a dealer network and not on a formal exchange. OTC stocks may also be called “unlisted” shares.
To purchase shares on the open market, you will require a brokerage account. Further, you will need to ensure that the brokerage house where you have your account is entitled to trade shares on the markets you desire.
For example, I deal with one on-line broker that allows me access to all major Canadian and US stock exchanges. However, they do not allow trading on exchanges outside North America. I need to use another broker to conduct transactions in Europe and Asia.
For some thoughts on brokerage firms, please review this post .
As many of you will create and use on-line brokerage accounts, I shall add a separate post this week on selection criteria.
Some investors purchase shares directly from companies. This may be done via Direct Stock Purchase Plans, Dividend Reinvestment Plans, Employee Stock Purchase Plans, and warrants.
Direct Stock Purchase Plan (DSPP)
DSPPs allow individuals to purchase shares directly from a company (or transfer agent).
The benefit of DSPPs is that investors can acquire shares without paying a commission on the transaction. Perhaps in today’s world of low cost on-line brokers this is less important, but every penny saved is useful when compounding your returns for future growth.
Another advantage of DSPPs is that investors can make their initial stock purchases, as well as subsequent ones, directly from the company.
A potential downside of DSPP is that usually there is a minimum purchase amount. But this may be high on the initial purchase and then be lower for subsequent acquisitions.
Dividend Reinvestment Plan (DRIP)
DRIPs are also helpful in avoiding commissions.
DRIPs allow investors to reinvest any cash dividends they are eligible to receive into additional shares of the company. Often this can result in the purchase of fractional shares based on the dividend.
DRIPs are nice as they help investors (hopefully) compound their investment returns by adding to their existing shares in the company. The additional shares, in turn, result in their own future stock dividends, and so on throughout the future.
DRIPs are also an easy way to invest. Without thinking, or taking any action, you automatically acquire additional shares of the company.
One problem with DRIPs is that, in most countries, you are taxed on the dividend as if you received the cash.
For example, you are entitled to receive a dividend of $1000 that is reinvested in additional shares of the company. So you receive shares and not cash. However the tax man usually still wants his share of your earnings. If you have a 30% marginal tax rate, you will need to find $300 to pay for tax on income you did not actually receive.
Another thing to watch with DRIPs (and other investing methods that make automatic purchases) is the lack of thinking required. When using DRIPs you need to still assess the investment potential of the dividend.
Perhaps you are entitled to a $5000 dividend from Omega corporation. You have the option of a cash dividend or stock dividend. Omega shares are expected to return 10% over the next year and carry a risk of 5%.
If you take the DRIP, you may earn 10% on your shares (and the stock that you received in lieu of a cash dividend). But perhaps you had analyzed other investments and had found Alpha company with the same 5% risk, but an expected return of 20%. If you had received a cash dividend from Omega, you would have bought Alpha shares instead.
So while DRIP programs can be useful, do not fall into the trap of blindly reinvesting in underperforming shares through their use. Always look at where your income is being invested and make sure it is the best investment for you, not simply the most convenient.
Note that with Omega, you could sell shares equal to the stock dividend and then use the proceeds to buy Alpha shares.
Employee Stock Purchase Plan (ESPP)
If you work for a public company, you may encounter an ESPP.
ESPPs allow eligible employees to acquire company shares, normally at a discounted price to market value.
The discounted share price provides an incentive for employees to invest in their company versus other investment options.
The benefit for the company is that employees who are shareholders have a vested interest in the company’s performance. As such, they will work harder to ensure that the company does well financially and that its share price increases. Well, that is the idea anyway.
Some ESPPs may have restrictions on the selling of shares (e.g. an initial period of time where shares cannot be sold), but often there are no restrictions on trading.
Warrants are issued by companies, usually as a sweetener to a debt or equity issue.
Warrants give holders the right to purchase shares from the company at a certain price for a specified period of time.
Warrants are much like call options. Both can be traded separately in the secondary market.
Also, options and warrants fluctuate in price based on the value of the underlying shares relative to the exercise price of the warrant/option and the time remaining until expiration.
The difference is that options are not issued by companies. Rather they are exchange traded instruments issued by other investors.
As well, most options expire in under one year, whereas warrants may not expire for years.
I include warrants in this section because often warrants are exercised and company shares are received by the warrant holder.
I do not include options in this section as almost all option contracts relating to shares are closed out for financial consideration (assuming they are “in the money”) prior to expiration. There is no actual exchange of shares between the counterparties.
We will look at options, in brief, in the future.
Next we will review some selection criteria when choosing an on-line broker.