A Basic Guide to Stocks

For financially savvy Singaporeans, investing might already be a familiar territory. However, a lot of people still perceive stocks and bonds as arcane terms associated with mania, risks, gambling and lottery-like winnings. To help Singaporeans understand what investing is really about, we have prepared an introductory guide to stocks. Here, you can learn about what stocks are, how to think about investing in them, and different strategies commonly seen in the market.

What Are Stocks?

Also known as equities, stocks represent a piece ownership of a company. This entitles the stockholder to a certain portion of the company’s votes, profits and assets. Every company, even restaurants and hawker stalls, has one or more owners. For instance, you might have own a café with a friend of yours, and both of you own 50% of the café. This ownership entitles each of you to 50% of the voting power, profits and assets of the café. In this example, you would be owning 50% of the café’s stocks.

In cases where there are a number of owners, it becomes easier to keep track of who owns how much by dividing the ownership into an arbitrary number of shares. For instance, you and your friend may decide that the company is going to have 10,000 shares of the stock. Then, each of you will own 5,000 shares.

Sometimes, large companies sell some of their shares to the public to raise capital, thereby allowing anyone to buy their shares in the stock market. This process is called an initial public offering (IPO), and the company will become a “public company” instead of a “private company.” These are what we typically refer to when we are talking about investing in stocks. Essentially, when you invest in a stock, you get to own a piece of a large business that is listed in the stock market.

Understanding Stock Prices

In the stock market, you can trade these stocks with other people at prices that are determined by supply and demand. If everyone wants to buy shares of Company A, then Company A’s stock price will continue to go up. If everyone wants to sell shares of Company B, then Company b’s stock price will continue to decline.

Ultimately, the stock market is trying to arrive at a fair value of each company whose stocks trade in the market. A company’s value is determined by the market capitalization of a company, which is the stock price multiplied by the number of shares outstanding. For example, if a company has 100 million shares of stock outstanding and each share is priced at $10 in the stock market, that means the entire company is valued at $1 billion (100 million shares x $10 per share).

This also means that a stock that is worth $100 may not necessarily be more “expensive” than a stock that has a price of $50. For example, let’s assume that Company A and Company B both make $100mn of profit every year. Also, Company A has 100mn shares of stock that is trading at $10 while Company B has 10mn shares of stock that is trading at $100. Although Company B’s stock is 10x higher than Company A’s stock, it does not mean that Company B’s stock is more expensive than Company A’s stock. What truly matters is the companies’ market capitalization. By multiplying number of shares by the price of each share, we can see that both Company A and B are worth $1 billion. Since both companies make $100mn of profit, they are both trading at 10x their incomes (Price to Earnings Ratio or PE ratio) and therefore are equally expensive as each other.

Market Cap ($ mn) Stock Price Shares Outstanding (mn) Profit ($ mn) PE Ratio
Company A 1,000 $10 100 100 10x
Company B 1,000 $100 10 100 10x

Common Equity vs Preferred Stock

Companies can issue a variety of stocks based on the ownership rights a shareholder has. The two most frequent types are called common stocks and preferred stocks. Most stocks issued are common stocks. Preferred stocks are a bit different. They lie in an area between a common stock and a bond. Preferred stocks usually come with a fixed dividend payment, while common stocks may or may not receive a dividend. Also, preferred shareholders must also be paid in full for any dividends before common shareholders can receive theirs. Not only that, they also will be paid before common shareholders if a company declares bankruptcy and liquidates its assets.

CommonReceive voting rights, and bigger upside as stock price appreciates and dividends increase over timeDividends are not guaranteed, and can change at any given time. Also lower prioirty than preferred shareholders in payback or bankruptcy. Higher risk of losing money.
PreferredHigher priority than common shareholders, fixed dividends, lower downsideLimited upside: No voting rights, and dividends do not increase.

Companies may also choose to issue other types of stocks based on ownership rights of shareholders. For example, Google issues Class A, Class B and Class C shares. Class A shareholders receive one vote per share, Class B shareholders receive 10 votes per share and Class C shareholders receive no voting rights. This type of structure is used to control the voting power of the company. In Google’s case, the Class B shares are not available on the public markets, but are instead owned by management within the company.

Stock Market Index

Stock market indexes track the value of a large number of stocks. One of the best known indexes is the Standard and Poor’s 500 (S&P 500), which tracks performances of 500 large companies listed in the US. Stock market indexes typically serve as a benchmark for performance of specific investments. In a way, they represent the “market performance,” if one were to buy all the stocks that are available to an investor. To see if your stock picking ability is god, you can compare your portfolio’s performance against an index’s performance over time and see if you’ve been beating the market.

Different Strategies in Investing in Stocks

To put it simply, the goal of investing in stocks is to buy low and sell high. You want to buy things that will go up, and sell things that will go down. It may sound easy, but to most of us who can’t predict the future, this is an extremely difficult process. Even the best professional hedge fund managers are known to do it well only 60% of the time. Is there any strategies to help us do it better?

The two main branches of investing are fundamental and quantitative investing. The former is based on fundamental value of a business. By understanding how a business makes money, competes against competitors and evolves over time, fundamental investors try to estimate a true worth of each businesses. This can be done in a variety of ways including Discounted Cash Flow method, peer comparison and strategic value. Then, the investor buys a stock when its market price dips significantly below the fair value, hoping that the price fluctuation is temporary and returns to a rational level.

Quantitative traders (or algorithmic traders) take a different approach. They assess a lot of different factors and variables to find correlations between stocks and other securities. By programming an algorithm that processes millions of data points every second, they try to predict how stock prices will behave based on historical data. As a hypothetical example, a trader might have found that a multi-variable calculation that includes Thailand’s interest rates, oil price, and Hong Kong stock market has a meaningful correlation with a Singaporean shipping company’s stock prices. Then, he may be able to use this correlation to make profit on his trade.

Whichever method you choose, what is crucial is that you understand and believe in the strategy that you employ. To do this, you have to do a lot of homework to understand your investments. Only when you have done enough work to build conviction on your trading strategies can you withstand the inevitable losses that you will occasional face and know how to respond to different situations and maybe even adjust your strategy.

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