Wednesday, March 4, 2009

Trading vs. Investing 2: What a stock market investment really means (stock)

Way back when I wrote a post about what I thought was the difference between trading and investing and I have generally received pretty positive feedback on it.

While having dinner with a friend last week, the topic came up of what market capitalization actually means. I thought this was interesting from a trading vs. investing perspective, and that this might be an issue that some people are confused about. Simply put, market capitalization represents the market value of all the outstanding shares of a company's stock. The two key points to take away from this are that it is the open market value of the outstanding shares.

The reason I emphasize these two points is that people often don't understand what they're actually investing in when they buy shares of stock on the open market. Yes, you theoretically have a piece of the company. You may have a right to vote. You may be entitled to dividends. However, your investment does not actually go to the company. Investing x amount of money on a purchase of stock does not mean that you're adding to the company's books and funding their R&D or their employees' salaries. The company already got their money from the initial offering of the stock, and can't make any more money from the same shares they already sold. So unless you are a subscriber to the initial offering, your money isn't a direct investment in the company itself.

Of course the company can issue more stock in a secondary offering. Again, if you are one of the actual subscribers, your money is going directly to the company. Secondary offerings are important because it is one of the few ways in which the company can take advantage of the market and their market capitalization to strengthen itself. However, sometimes a company doesn't take advantage and it becomes a big missed opportunity. For example, imagine a stock that was at $100 and exploded up to $300 within a year. As the market turned for worse, the stock returned to its $100 price, but if the company did not issue a secondary offering or use its shares in an acquisition, that tripling of the market cap meant nothing to the actual company's day-to-day operations.

A great example of an excellent secondary was Wynn Resorts (WYNN). Steve Wynn is a smart guy and the kind of shrewd CEO who knows what to do for the company without just being selfish and greedy. Back during the late summer of 2007, the stock WYNN ran up 60% in a 2 month span. The company came out with a secondary and raised $700 million in capital. Now the stock price is down at around $17.5 today (he managed to raise money again when WYNN fell to the mid$40s in the fall of 2008). When asked about the secondary back in 2007, he basically said the equivalent of, "The stock's gone up by more than half in 2 months, we figured we'd take advantage of it." (not a quote, I remember hearing this mentioned somewhere but I don't remember the source)

So the point I'm trying to make here is that when you invest in a growth stock by buying shares in the secondary market, you are essentially making a trade. The money you put in doesn't go to the company, any money the company makes probably goes back to R&D, and so you end up needing the company to become big enough such that someone else is willing to pay higher for it. An investment in a mature, dividend paying stock is a different matter I feel. Because you are constantly getting returns, it becomes an investment in the company's ability to make money, which cycles back to you instead of to the company itself.

This leads me to think about certain basic stock manipulations like stock splits. One of the reasons I always heard about why companies do stock splits is that by having a cheaper nominal value for a share of stock, it allows more people to invest in the company. But wait, this whole entire post is about how the money is not going to the company. So... the only thing it allows more people to do... is pay off the existing shareholders. You gotta wonder who's in those offices making these decisions.

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