Understanding the importance of corporate profits

The goal of most companies is to make a profit, or earnings. Earnings result from the difference between what a company takes in (revenue) and what it spends (costs). I say most companies because some organizations’ primary purpose is not to maximize profits.

Nonprofit organizations — such as the American Cancer Society, Goodwill, Red Cross, and numerous medical centers, colleges, and universities — are well-known examples. However, even nonprofits can’t thrive and prosper over the long haul without a steady flow of money.

Companies that trade publicly on the stock exchanges seek to maximize their profit; that’s what their shareholders want. Higher profits generally make stock prices increase. Most private companies seek to maximize their profits as well, but they retain much more latitude to pursue other goals.

Among the major ways that successful companies increase profits are

• Building (or buying) a brand name: What comes to mind when you think of Amazon, Apple, Cheesecake Factory, CVS, eBay, McDonald’s, Microsoft, Target, and UPS? These are all powerful brand names that have taken their respective companies many years and many dollars to build. Companies with recognizable and positive brand images enjoy more consumer traffic, sales, and profits.
• Containing costs: Well-managed companies continually search for ways to control costs. Lowering the cost of manufacturing their products or providing their services allows companies to offer their products and services at lower prices. Managing costs may help boost a company’s profits. The marketplace and a company’s reputation (and the threat of lawsuits) keep companies from cutting corners and making their products and services dangerous in some way.
• Developing superior products or services: Some companies develop or promote an invention or innovation that better meets customer needs. Smartphones, 3-D printers, home gutters that don’t require cleaning, hybrid vehicles, numerous biotechnology offerings — the list goes on. This progress is what keeps the American economy resilient and strong, regardless of the parade of knuckleheads in Washington.
• Monitoring competitors: Successful companies don’t follow the herd, but they do keep an eye on what their competition is up to. If lots of competitors target one part of the market, some companies target a less-pursued segment that, if they can capture it, may produce higher profits thanks to reduced competition.
• Selling products and services in new markets: Many successful U.S.-based companies, for example, have been expanding into foreign countries to sell their products. Although some product or service adaptation is generally required to sell overseas, selling a proven, developed product or service to new markets generally increases a company’s chances for success.

Making sense of how you profit with stocks

Company stock prices tend to rise over time as the company’s profits increase. So how do you make money investing in the company’s stock? When you purchase a share of a company’s stock, you can profit from your ownership in two ways:

• Price appreciation: When the price per share of your stock rises to a higher price than you originally paid for it, you can make money. This profit, however, is only on paper until you sell the stock, at which time you realize a capital gain. Such gains realized over periods longer than one year are taxed at the lower long-term capital gains tax rate (see Chapter 4). Of course, the stock price per share can fall below what you originally paid, in which case you have a loss on paper unless you realize that loss by selling at a lower price than you paid for the stock.
• Dividends: Most stocks pay dividends. Companies generally make some profits during the year. Some high-growth companies reinvest most or all of their profits right back into the business. Many companies, however, pay out some of their profits to shareholders in the form of dividends.

Your total return from investing in a stock, then, comes from dividends and stock price appreciation. Stocks differ in the dimensions of these possible returns, particularly with respect to dividends. (See the sections on stock funds and exchange-traded funds in Chapter 10 for more information.)

Following market indexes

You invest in stocks to share in the rewards of capitalistic economies. When you invest in stocks, you do so through the stock market. In the United States, when folks talk about “the market,” they’re usually referring to the Dow Jones Industrial Average (DJIA), a widely watched U.S. stock market index created by Charles Dow and Eddie Jones of The Wall Street Journal. The DJIA market index tracks the performance of 30 large companies that are headquartered in the United States, but it’s not the only index.

Indexes serve the following purposes:

• They can quickly give you an idea of how particular types of stocks are doing at the moment and over time.
• They enable you to compare or benchmark the performance of your stock market investments. If you invest primarily in large-company U.S. stocks, for example, you should compare the overall return of the stocks in your portfolio to a comparable index — in this case, the S&P 500 (which I define later in this chapter).

You may also hear about some other types of more narrowly focused indexes, including those that track the performance of stocks in particular industries, such as airlines, banking, energy, health care, retail, semiconductors, technology, and utilities. Other indexes cover other stock markets, such as those in the United Kingdom, Germany, France, Canada, and Hong Kong.

Focusing your investments on the stocks of just one or two industries, especially those that aren’t major ones, or smaller countries is dangerous due to the lack of diversification and your lack of expertise in making the difficult decision about what to invest in and when. Thus, I suggest that you ignore these narrower indexes.

In addition to the DJIA, important market indexes and the types of stocks they track include

• Standard & Poor’s (S&P) 500: Like the DJIA, the S&P 500 tracks the price of 500 larger-company U.S. stocks. These 500 big companies account for about 75 percent of the total market value of the tens of thousands of stocks traded in the United States. Thus, the S&P 500 is a much broader and more representative index of the larger-company stocks in the United States than is the DJIA.
• Russell 2000: This index tracks the market value of 2,000 smaller U.S. company stocks of various industries. Although small-company stocks tend to move in tandem with larger-company stocks over the longer term, it’s not unusual for one to rise or fall more than the other or for one index to fall while the other rises in a given year.
• Wilshire 5000: Despite its name, the Wilshire 5000 index actually tracks the prices of about 3,600 stocks of U.S. companies of all sizes — small, medium, and large. Thus, many people consider this index to be the broadest and most representative of the overall U.S. stock market.
• MSCI EAFE: Stocks don’t exist only in the United States. MSCI’s EAFE (Europe, Australasia, and Far East) index tracks the prices of stocks in the other major developed countries of the world.
• MSCI Emerging Markets: This index follows the value of stocks in less economically developed but emerging countries, such as South Korea, Brazil, China, Russia, Taiwan, India, South Africa, and Mexico. These stock markets tend to be more volatile than those in established economies. During good economic times, emerging markets usually reward investors with higher returns, but stocks can fall farther and faster than stocks in developed markets.

Using price/earnings ratios to value stocks

You can’t compare different companies’ stock prices and determine from that which one(s) might be a better investment. The level of a company’s stock price relative to its earnings or profits per share helps you measure how expensively, cheaply, or fairly a stock price is valued.

Over the long term, stock prices and corporate profits tend to move in tandem. The price/earnings (P/E) ratio compares the level of stock prices to the level of corporate profits, giving you a good sense of the stock’s value. Over shorter periods of time, investors’ emotions as well as fundamentals (data that can affect the perceived value or price of a stock) move stocks, but over longer terms, fundamentals possess a far greater influence on stock prices.

P/E ratios can be calculated for individual stocks as well as entire stock indexes, portfolios, or funds. The P/E ratio of U.S. stocks has averaged around 15 over the past century. During times of low inflation, the ratio has tended to be higher — in the high teens to low twenties.

Just because U.S. stocks have historically averaged P/E ratios of about 15 doesn’t mean that every individual stock will trade at that P/E level. Faster-growing companies usually command higher P/E ratios.

Though a stock price or an entire stock market may appear to be at a high price level, that doesn’t necessarily mean that the stock or market is overpriced. Compare the price of a stock to that company’s profits per share or the overall market’s price level to the overall corporate profits. The P/E ratio captures this comparison. Faster-growing and more-profitable companies generally have higher P/E ratios (meaning that they sell for a premium). Also remember that future expected earnings, which are difficult to predict, influence stock prices more than current earnings, which are old news.

Most of the time, the stock market is reasonably efficient. By that, I mean that a company’s stock price normally reflects many smart people’s assessments as to what is a fair price. Thus, it’s not realistic for an investor to expect to discover a system for how to “buy low and sell high.” Few investors may have some ability to spot good times to buy and sell particular stocks, but doing so consistently is enormously difficult.

The simplest and best way to make money in the stock market is to regularly feed new money into building a diversified and larger portfolio. If the market drops, you can use your new investment dollars to buy more shares. The danger of trying to time the market is that you may be out of the market when it appreciates greatly and in the market when it plummets.

Avoiding temptations and hype

Because the financial markets move on the financial realities of the economy and companies, as well as on people’s expectations and emotions (particularly fear and greed), you shouldn’t try to time the markets. Knowing when to buy and sell is much harder than you may think.

As a young adult, you’re in a position to take more risks because you’re investing for the long haul. However, you should be careful that you don’t get sucked into investing a lot of your money in aggressive investments that seem to be in a hyped state. Many people don’t become aware of an investment until it receives lots of attention. By the time everyone else talks about an investment, it’s often nearing or at its peak.

Before you invest in any individual stock, no matter how great a company you think it is, you need to understand the company’s line of business, strategies, competitors, financial statements, and P/E ratio versus the competition, among many other issues. Selecting and monitoring good companies take research, time, and discipline.

Also, remember that if a company taps into a product line or way of doing business that proves to be highly successful, that success invites competition. So you need to understand the barriers to entry that a leading company has erected and how difficult or easy it is for competitors to join the fray.

Be wary of analysts’ predictions about earnings and stock prices. Investment banking firm analysts, who are too optimistic (as shown in numerous independent studies), have a conflict of interest because the investment banks that they work for seek to cultivate the business (new stock and bond issues) of the companies that they purport to rate and analyze.

Simply buying today’s rising and analyst-recommended stocks often leads to future disappointment. If the company’s growth slows or the profits don’t materialize as expected, the underlying stock price can nosedive.

Psychologically, it’s easier for many folks to buy stocks after those stocks have had a huge increase in price. Just as you shouldn’t attempt to drive your car looking solely through your rearview mirror, basing investments solely on past performance usually leads novice investors into overpriced investments. If many people are talking about the stunning rise in the market, and new investors pile in based on the expectation of hefty profits, tread carefully.

I’m not saying that you need to sell your current stock holdings if you see an investment market getting frothy and speculative. As long as you diversify your stocks worldwide and hold other investments, such as real estate and bonds, the stocks that you hold in one market need to be only a portion of your total holdings.

Timing the markets is difficult: You can never know how high is high and when it’s time to sell, and then how low is low and when it’s time to buy. And if you sell non-retirement-account investments at a profit, you end up sacrificing a lot of the profit to federal and state taxes.

Getting past the gloom

During the 2008 financial crisis, panic (and talk of another Great Depression) was in the air, and stock prices dropped sharply. Peak to trough, global stock prices plunged more than 50 percent. While some companies went under (and garnered lots of news headlines), those firms were few and were the exception rather than the norm. Many terrific companies weathered the storm, and their stock could be scooped up by investors with cash and courage at attractive prices and valuations.

When bad news and pessimism abound and the stock market has dropped, it’s actually a much safer and better time to buy stocks. You may even consider shifting some of your money out of your safer investments, such as bonds, and invest more aggressively in stocks. During these times, investors often feel that prices can drop farther, but if you buy and wait, you’ll likely be amply rewarded.

Sidestepping common investing minefields

Shares of stock, which represent fractional ownership in companies, offer a way for people of all economic means to invest in companies and build wealth. History shows that long-term investors can win in the stock market because it appreciates over the years. That said, some people who remain active in the market over many years manage to lose some money because of easily avoidable mistakes, which I can keep you from making in the future.

You can greatly increase your chances of investing success and earning higher returns if you avoid the following common stock investing mistakes:

• Broker conflicts: Some investors make the mistake of investing in individual stocks through a broker who earns commissions. The standard pitch of these firms and their brokers is that they maintain research departments that monitor and report on stocks. Their brokers use this research to tell you when to buy, sell, or hold. It sounds good in theory, but this system has significant problems. Many brokerage firms happen to be in another business that creates enormous conflicts of interest in producing objective company reviews. These investment firms also solicit companies to help them sell new stock and bond issues. To gain this business, the brokerage firms need to demonstrate enthusiasm and optimism for the company’s future prospects. Studies of brokerage firms’ stock ratings have shown that from a predictive perspective, most of their research is barely worth the cost of the paper that it’s printed on.
• Short-term trading: Unfortunately (for themselves), some investors track their stock investments closely and believe that they need to sell after short holding periods — months, weeks, or even days. With the growth of Internet and computerized trading, such shortsightedness has taken a turn for the worse as more investors now engage in a foolish process known as day trading, in which they buy and sell a stock within the same day! Whether you hold a stock for only a few hours or a few months, you’re not investing; you’re gambling. Specifically, the numerous drawbacks that I see to short-term trading include higher trading costs, more taxes and tax headaches, lower returns from being out of the market when it moves up, and inordinate amounts of time spent researching and monitoring your investments.
• Following gurus: It’s tempting to wish that you could consult a guru who could foresee an impending major decline and get you out of an investment before it tanks. Believe me when I say that plenty of these pundits are talking up such supposed prowess. From having researched many such claims (see the “Guru Watch” section of my website, www.erictyson.com), I can tell you that nearly all these folks significantly misrepresent their past predictions and recommendations. Also, the few who made some halfway-decent predictions in the recent short term had poor or unremarkable longer-term track records. As you develop your investment portfolio, take a level of risk and aggressiveness with which you’re comfortable. No pundit has a working crystal ball that can tell you what’s going to happen with the economy and financial markets in the future.

Investing in stock mutual funds and exchange-traded funds

Mutual funds take money invested by people like you and me and pool it into professionally managed investment portfolios in securities, such as stocks and bonds. Stock mutual funds, as the name suggests, invest primarily or exclusively in stocks. (Some stock funds sometimes invest a bit in other stuff, such as bonds.)

If you’re busy and realize your lack of expertise analyzing and picking stocks, you’ll love the best stock mutual funds. Investing in stocks through mutual funds can be as simple as dialing a toll-free phone number or logging on to a fund company’s website, completing some application forms, and zapping off the money you want to invest.

Exchange-traded funds (ETFs) are newer versions of mutual funds. The best ETFs are in many ways similar to mutual funds except that they trade on a stock exchange. The chief attractions are those ETFs that offer investors the potential for even lower operating expenses than those of comparable mutual funds.

The best stock mutual funds and ETFs offer numerous advantages:

• Diversification: Buying individual stocks on your own is relatively costly unless you buy reasonable chunks (100 shares or so) of each stock. But to buy 100 shares each of, say, a dozen companies’ stocks to ensure diversification, you may need about $60,000 if the stocks you buy average $50 per share.
• Professional management: Even if you have big bucks to invest, funds offer something that you can’t deliver: professional, full-time management. Mutual fund managers peruse a company’s financial statements and otherwise track and analyze its business strategy and market position. The best managers put in long hours and possess lots of expertise and experience in the field.
• Low costs: To convince you that mutual funds and ETFs aren’t good ways for you to invest, those with a vested interest, such as stock-picking pundits, may point out the high fees that some funds charge. But high-cost funds aren’t the only ones out there. Through a no-load (commission-free) mutual fund or ETF, you can hire a professional, full-time money manager to invest $10,000 for a mere $10 to $50 per year.

Mutual funds and ETFs, of course, have drawbacks:

• Less control: If you like being in control, sending your investment dollars to a seemingly black-box process in which others decide when and in what to invest your money may unnerve you. However, you should be more concerned about the potential blunders that you may make investing in individual stocks of your own choosing or, even worse, those stocks pitched to you by a broker.
• Taxes: Taxes are a concern when you invest in mutual funds and ETFs outside retirement accounts. Because the fund manager decides when to sell specific stock holdings, some funds may produce relatively high levels of taxable distributions. But you can use tax-friendly funds and ETFs if taxes concern you.

Picking your own stocks

Plenty of investing blogs, gurus, and books enthusiastically encourage people to do their own stock picking. However, the vast majority of investors are better off not picking their own stocks.

I’ve long been an advocate of people educating themselves and taking responsibility for their own financial affairs, but taking responsibility for your own finances doesn’t mean you should do everything yourself.

Some popular investing websites and books try to convince investors that they can do a better job than the professionals at picking their own stocks. Amateur investors, however, need to devote a lot of study to become proficient at stock selection. Many professional investors work 80 hours a week at investing, but you’re unlikely to be willing or able to spend that much time on it.