TL;DR

[TL;DR = Too Long; Didn’t Read. That is, it’s the executive summary]

• Owning a stock is owning a piece of the company
• As an owner, you get to vote
• As an owner, you get a share of the profits when profits are distributed
• It’s hard to predict which stocks will do OK, which will do terrible, and which will do fantastic
• A large number of stocks, however, will tend to do quite well

[Full Article]

The stock market makes the news every single workday. There are some people who understand stocks, but a good percentage of people don’t really know what a stock is, why it’s worth money, and why the value would go up or down.

So, first some background. Historically, most businesses have been owned by a single person or family. However, with the industrial revolution, it really became possible to have an enterprise that was beyond the scale of what a single owner could manage or even own. Raising the funds to build factories was beyond the means of most entrepreneurs. So, the legal structure of a corporation was born. In a corporation, many owners can pool their money to start a business. Depending on how much money they put in, they’d own a bigger or smaller share of the business and get that share of the profits. They could hire managers to actually run the business if they preferred, and just get profits because they funded the business. They can also sell some or all of their portion of the business to others.

Businesses scaled up even further than what a small group of owners could handle. So, public stock exchanges became popular for that reason. To raise funds, portions of the business are sold to the public and anyone can become a part owner of the business.

Let’s do a concrete example. I live in the Seattle area. One big player in the local economy is Boeing. Boeing is a major company. It’s far too vast to be owned effectively by a single person or even a family. As of this writing, ownership of Boeing has been divided into 564 million parts. I bought one share of Boeing. I am now an owner of Boeing. I own 1/564,000,000 of Boeing. Not much, but something!

What does this entitle me to? Well, for one, being an owner, I get to vote on the management. I just got an e-mail that the annual shareholder meeting is coming up. I can attend the meeting in person if I want. But even if I don’t attend, I can vote on company matters. The biggest matter is voting in the board of directors (who are in charge of hiring top management and watching out for shareholders). Because I own one share, I get one vote. The former CEO of Boeing, W. James McNerney, Jr, owns 437,689 shares of Boeing, so he gets 437,689 votes.

Voting is fun and lets me partially (very partially) control the destiny of Boeing. But I don’t just get to vote in the board of directors. I get a share of the profits. Boeing’s net profit in 2018 was $10.46 billion. Companies can do two things with their net profits – they can put it back into the business for growth, or they can pay it out to the owners, that is, the shareholders. When they pay out profits, that’s called a dividend. Boeing does some of both. In 2018, Boeing issued payments to their shareholders 3 times, each time paying $1.71 per share. So, my single share (had I owned it all year) would have gotten me 3 x $1.71 = $5.13 of profit sharing from Boeing. (W. James McNerney’s shares would have brought him $2,245,345 – nice!). Boeing also announced for 2019, they intend to have a higher dividend of $2.055 per share and pay that out 4 times. That means they intend to pay out about $4.63 billion to their shareholders in 2019. If their profits are similar to last year, that will leave them with nearly $6 billion in profit to turn around and put into growth.

Some companies don’t pay dividends yet. For example, the e-commerce giant Amazon.com has never paid a dividend. The first years of their existence, they actually lost money. There was no profit to share with stock holders. Rather, they went out and sold more stock to raise more money from investors, and used that money to continue selling goods at a loss and building out fulfillment centers and computer infrastructure in order to gain more customers. Now, many years later, they have started making large profits, but they are still taking 100% of those profits and reinvesting them into business growth. But investors are speculating that after decades of growth and profit, Amazon will start sharing its profit with its owners, which is what accounts for the value of the stock.

So, Boeing stock clearly has some value because they company has money, regular profits, and a history of sharing those profits with owners. So, it’s desirable to become an owner, and you become an owner by buying stock. Amazon.com has value not because of their track record of sharing profits, but rather their track record of growth, which investors speculate will continue until they finally start sharing profits. Other companies, like the soon-to-IPO Lyft have never made any profit, but investors speculate about the future profit and wager that will have future value.

However, individual stocks are super risky. Who is to say that Boeing will continue operating? There are always existential threats to a company: competitors, regulatory changes, poor management, changing market conditions, materials cost, earthquakes, fires and floods, labor strikes, fraud, etc. Remember Enron? Back when it was a company, it seemed to be a high-flying success. But, Enron was built on fraud, and went to $0. Remember Toys R Us? It was a great business for a time, but conditions changed and they didn’t adapt. Now it’s gone. But things can go the other way too. Apple’s stock was trading at the equivalent of $0.50 per share in December of 1997 shortly after Steve Jobs came back to the company. If you had put in $100 back then – about a day’s wages for 1997, it would be $37,000 now – enough to buy a car! (That’s the equivalent of over 30% per year!)

Can you pick the winners? Probably not. In fact, experts are pretty bad at picking winners. The good news is that if you take a large number of companies (either randomly picked or “expertly” picked), they tend to average out to be winners over the long haul. For example, the S&P500 is a list of the biggest 500 US-based companies weighted by market cap. (So, if Widget Co is twice as big as Sparks and Cables Inc, then there would be twice as much of it in the S&P 500.) This simple list of stocks, based only on market size, has had an average return of over 11% per year over long periods of time. There are up years and down years, but the ups beat the downs by a huge margin.