Shares: becoming co-owners of a business

Lesson 2
You already know that a stock is a share in a company's business and that you can make money on dividends or on the growth of the stock price. Let's figure out how to make money on shares of American companies and not lose a lot of money.
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What you'll learn:

What you'll learn:

1. Why the stock price rises and falls.
2. Why panic and excitement in the U.S. market is bad.
3. How to invest effectively in stocks in the U.S. market.
How stocks are structured in the U.S. market

How stocks are structured in the U.S. market

Imagine that an American entrepreneur wants to expand his business, but he already has a lot of debt and not enough equity to invest. This means that he has a successful business but lacks the capital to make it even more successful.

In this case, he can issue stock - for example, 1,000 shares. And offer some of those shares for sale on, say, the New York Stock Exchange. If investors also believe that the company has prospects, they will buy shares.

Each share represents a stake in the company. The owner of a share becomes a co-owner of the business: this is not only an opportunity to receive dividends, but also a chance to influence the company's strategic decisions, participate in annual shareholders' meetings and vote for various initiatives. The more shares an investor has, the greater his influence.

The mechanism here is similar to the way bonds work: the company issues shares and sets their initial price. The first investors buy shares directly from the company, and in this way the company raises funds for development. The shares are then traded on the stock exchange, and their market price can vary significantly from the initial price, depending on the current state of the company and investor sentiment. Let's understand this in more detail.

Why stocks in the U.S. market rise and fall

Why stocks in the U.S. market rise and fall

The price of a stock is determined by the relationship between supply and demand. Let me explain.

Imagine a situation: a U.S. company publishes its quarterly financial results, and the report shows that the company is doing much better than expected. Investors, seeing this prospect, are eager to buy the company's stock, increasing demand. But those who already own shares of this company, given its positive performance, will not want to sell them at the old price. As a result, demand outstrips supply.

Conversely, if the company's financial results are poor, many investors may be eager to sell the stock, but there will be no buyers at the old price. In this case, supply will be greater than demand.

Ultimately, the price of a stock is set at a level at which some investors are willing to buy and others are willing to sell. The main function of the stock exchange is to connect buyers and sellers. The price of a stock can change constantly, sometimes slightly in a day or even dramatically in an hour.

Over the long term, the stock price correlates with the potential profit or loss of a company. Investors scrutinize a company's performance, news and management statements, based on which they decide whether to buy or sell shares.

Next, let's look at additional examples of factors that affect the rise or fall of a stock price.
↗ Business growth

If a company opens new stores, launches a new factory or enters a new market, it means it is doing well - investors believe in the company and want to buy its shares.

For example, in 2017, the American technology company Apple introduced the iPhone X, which was a revolutionary product in their smartphone lineup. The device was well received by the market, and in 2018, the sales of this model had a significant impact on the company's overall revenue growth. As a result, Apple's iPhone revenue in 2018 grew by 18% year-on-year. This impressive sales growth in one product category led to revenue and profit growth for the company as a whole.
↗ There is a growing demand for a product or service

In its early days, Tesla produced a limited number of electric cars, mostly the expensive Roadster.

However, over time, interest in electric cars in the US began to grow. Tesla realized that for many Americans, switching to an electric car could be beneficial, especially given rising gasoline prices and environmental trends. This led to the launch of the Model S, Model X, and then the more affordable Model 3.

Today, electric vehicle sales account for a significant share of Tesla's revenue. And although the company continues to diversify by introducing solar panels and energy storage systems, its cars remain a key business area. Investors are watching the dynamics of car sales very closely, as they show the company's ability to meet the growing demand for electric vehicles.
↗ The company reduces debt and starts paying dividends

That is, sharing profits with shareholders. This is a typical phenomenon in the American market. For example, Apple, which started as a startup without dividends, began to actively accumulate cash over the years. In 2012, the company started paying dividends to shareholders again after a long hiatus. This was a sign of confidence in its financial stability and a desire to share profits with shareholders.
↗ Share buyback

This tool is actively used by many large American companies. It allows not only to return money to shareholders, but also to strengthen confidence in their business. For example, in early 2020, Microsoft announced plans to buy back its own shares for up to $60 billion. Such announcements are often seen by investors as a positive signal regarding a company's future prospects.
↗↘ Economic situation

The U.S. economy, like many others, moves in cycles. Take the real estate sector as an example. After an economic downturn, for example after the mortgage crisis of 2008, people start to buy houses again. Demand for real estate rises → construction companies increase construction → demand for construction materials and services rises → prices for these materials rise. Companies involved in the extraction and processing of resources for the construction industry invest in the expansion of their production.

But over time, as the real estate market overheats, demand for houses may start to fall → construction companies don't need as many materials → demand for construction materials falls → prices fall. Resource extraction and processing companies may start operating at a loss. If such a company has been making losses for a long time, it may be closed down or reorganized → this will reduce the supply of materials on the market → as a result, prices will start to rise again.
↗↘ Legal regulation

New legislative initiatives can constrain the growth of some industries and stimulate others.

In recent years, the U.S. government has begun to actively consider environmental safety and climate change issues. As a result, laws have been passed to reduce greenhouse gas emissions. This has led to a decline in activity in the oil and gas and coal sectors, while the renewable energy market continues to grow strongly. Wind and solar power plants are projected to generate a significant portion of U.S. electricity in the coming decades.

The automotive industry is also facing new environmental requirements. For example, California has passed laws requiring automakers to increase production of low- or zero-emission vehicles. Tesla does stand out in this context, but other manufacturers such as General Motors and Ford are also actively investing in electric vehicle development. Who else is benefiting? Mining companies specializing in nickel. Batteries for electric cars rely heavily on nickel, which creates a high demand for this metal. In this context, it is worth mentioning such companies as the American BHP and the Hungarian MOL Group, which is actively exploring opportunities to mine the metals needed for battery production.
↘ Political sanctions

They may restrict companies' access to foreign markets or increase their costs due to the imposition of increased trade duties.

In April 2018, the U.S. imposed sanctions on several major Chinese technology companies, claiming they posed a threat to national security. These sanctions restricted these companies' access to U.S. technology and market. In response, many investors were concerned about the possible impact on the global economy and began selling stocks en masse.

Shares of Huawei, which was one of the key targets of the sanctions, suffered the most. Despite the company's attempts to adapt to the new conditions and increase its independence from U.S. suppliers, its share price fell throughout the year.
↘ Accidents and other force majeure events

For companies operating in the natural resource extraction and processing sector, there is always a risk of incidents and accidents. The more serious the incident, the more likely it is that profits and shareholder value will fall.

On April 20, 2010, an explosion occurred on the BP-owned Deepwater Horizon oil platform. This disaster led to the largest oil spill in history in the Gulf of Mexico. BP's stock collapsed, and the company spent billions of dollars to clean up the spill and compensate affected parties. The company's stock price did not return to previous levels for several years. Nevertheless, BP continued its operations, implementing projects in other regions and striving for sustainable growth.

Companies from other sectors also face force majeure risks. In 2020, the world was rocked by the COVID-19 pandemic. Factories shut down, shipments were disrupted, trade declined, air travel between countries was suspended, hotels, movie theaters, gyms, amusement parks and many other venues were closed. The International Air Transport Association (IATA) predicted that the airline industry could have lost as much as $314 billion. Company profits plummeted, and so did their stocks.

However, situations change, and stocks of companies that were able to adapt and avoid large debts may recover their positions over time. In this situation, investors should scrutinize the financial condition of companies, especially considering the bank rates in Hungary and their possible impact on corporate borrowings.

The scary truth about stocks

The scary truth about stocks

The problem is that the share price can rise or fall even if nothing good or bad happens in the company itself. Therefore, it is very difficult to predict the dynamics of shares over short time periods, which makes them risky assets.

The reason for sometimes illogical behavior of quotations lies in investors themselves: they create panic and excitement in the market. Some investors start to buy or sell shares of a company, others pick up on it, and it gathers momentum like a snowball. As a result, shares rise in price or, on the contrary, become cheaper.

Let's go back to the 2008 crisis. In September 2008, after the collapse of Lehman Brothers, the stocks of many financial companies, including Goldman Sachs and Morgan Stanley, fell significantly due to investors' fears about the stability of the financial system. Some of these fears were unfounded, but the panic led to massive selling of stocks. Investors who sold in the panic lost significant amounts, while those who held stocks or bought at lower levels were able to make good profits afterward.

An example of the opposite situation is the shares of chip maker NVIDIA. They started to grow actively at the end of 2016 - and not because of the success of the company itself. The reasons for the growth were successful reports from other players in the semiconductor industry and forecasts about the imminent growth of the graphics chip market. Investors believed that as the entire industry's revenues grow, NVIDIA's revenues will grow as well. Therefore, they started actively buying the company's shares. As a result, by 2017, NVIDIA's stock price increased significantly.

But when the company itself reported showing good financial results, some investors decided to lock in profits, leading to a correction in the stock. Why? By the time NVIDIA released its reports, the stock was already too overbought, and investor expectations were too high. The company's average performance did not satisfy many people.

Panic and excitement can concern not only a particular company, but also an industry and sometimes the market as a whole. The "dot-com bubble" comes immediately to mind - the explosive growth of stocks of companies in the Internet sector in the late 90s, which ended with the biggest market crash in the early 2000s.

In the late nineties, investors began to invest massively in new technology companies in the United States, based on the potential of the Internet. In just a few years, the shares of these companies appreciated many times over. However, the high share prices were not supported by the companies' actual revenues, but were based on optimistic forecasts. In 2000, investors realized that many of these companies were not profitable. This "Internet company bubble" burst in March of that year. Many new companies went bankrupt and investors lost trillions of dollars. Shares of technology leaders such as Cisco, Intel, and Oracle fell more than 80%.

A similar situation unfolded in the US stock market in 2019-2020. Investors believed that an economic slowdown could be averted if the U.S. and China resolved their trade differences. When the two countries began to come to an agreement in late 2019, investors saw this as a positive signal. In February 2020, major indexes such as the S&P 500 and Dow Jones hit record highs. However, a coronavirus pandemic caused the market to plummet. By March 23, 2020, the indices had lost more than 30% of their value.

These examples demonstrate that investors should be careful not to blindly follow the crowd. It is necessary to analyze the real economic situation and the potential of the company before investing in the stock.

How do you buy stocks?

How do you buy stocks?

To make an independent and informed choice of individual stocks, you will have to look at company reports, compare them with competitors, and follow the news. The reward, if you do it right, is a higher yield than bonds and deposits.

A simpler way to invest in stocks is not to choose one company at a time, but to buy a bunch of stocks at once with the help of exchange-traded funds (ETFs). This way you kill two birds with one stone: you insure yourself against the fall of shares of a particular company and get a higher yield than bonds and deposits. We will talk about ETFs in detail in the next lesson.

If you do want to try buying stocks on your own, you should adhere to the following principles for better results.

Don't spend all of your money buying stocks. Often professional investors, such as investment funds and management companies, invest 60% in stocks and the remaining 40% in funds or bonds. This ratio is roughly the same as the proportions of liquid stocks and bonds in the global financial market.

But for a beginning investor, keeping more than half of your funds in stocks may be too risky. Their share in the portfolio also depends on how long you invest for and at what point in the economy you do so. We'll talk about this in more detail in the lesson on diversification.

Diversify. Invest in stocks of different companies from different industries and countries. Stocks of one company should not take up more than 5% of your portfolio. Diversification will help you offset losses from what:

one company reported poorly or faced a force majeure situation (e.g., an accident);
demand in one of the industries has fallen;
one of the countries is in crisis or under sanctions.

Do not fall for the hype and panic. The shares of the next "new Uber", which is being shouted about from every tire, are most likely highly overvalued and are being sold for much more than their real value. The result will be the same as it has been hundreds of times before: there will be a correction and the stock will fall.

So always look at the company's financials. Where can I see them? In the Vita Markets app. In the share card of the company you're interested in, under the 'All Indicators' tab, you can view revenue, net profit, cash on accounts and dividend yield.

The net profit figure is especially important if the company pays dividends. If the company is consistently generating profits, you can count on regular payments. And if profits are also growing, there is a chance that dividends may be increased.

Dividends also indicate the financial stability of the company - it has enough money to invest in the business and still give part of it back to shareholders. The amount of cash in the company's accounts is also important. It is a financial safety cushion that the company can use to cover unexpected expenses, buy back shares from the market or increase dividends.

Don't try to speculate. Speculation is short-term buying in the style of "I'll buy 100 shares of Ford stock today and sell them in a couple of days when each one goes up 5 cents. In reality, it may not work out that way: you'll either have to sell the stock at a loss or wait months for a profit.

Read analysts. Investment banks and brokers have departments of analysts who study stocks and suggest investment ideas. But remember that only you will be responsible for your actions: analysts cannot guarantee 100% that an investment idea will work.

Bottom line

Bottom line
  • The market is unpredictable: no one knows exactly how the shares of a particular company will behave tomorrow.
  • To increase the chances of success, you need to study the company's business, follow the news and economic environment, and read analysts.
  • You shouldn't buy a stock just because everyone around you is buying it.
  • Don't invest all your money in one company or industry.
  • If you're not ready to take risks but want to invest in stocks, start with ETFs. More about them in the next lesson.
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