Week 3 - Stocks

After last week's post about TFSAs, I thought I should start giving a few ideas for what we can buy in our investment accounts, whether they are TFSAs, RRSPs, non-registered accounts, etc. Since they are at the heart of investing in Canada, I think one of the first things to go over is exactly how public companies are structured at the most basic level; common stock. In the coming weeks, I will touch on other methods of investment, including bonds, mutual funds, etc.

Let's start by considering our own fictitious company. For simplicity's sake, let's say we make the world's best baseball caps and everyone wants them. We are able to make a profit of a hundred million dollars per year. We are on our way to success! Because there are only two of us that own the company (you and me), right now, there are two shares (yours and mine) and for this example, we will say that we are equal partners. The problem is that since our company is privately owned (by us), we don't really know how much our business is worth. We know how much profit we make each year ($50 million each) but that's about as far as it goes.

So, we decide that our cap-making enterprise is big enough that we should sell it. But instead of looking for one buyer (which would be difficult if our company is this big), we decide to take it public, which means splitting our shares into many smaller shares and selling them on a stock exchange. In Canada, we have two stock exchanges: the Toronto Stock Exchange (TSX) and the TSX Venture Exchange, which was formerly the Vancouver Stock Exchange. The Venture is normally reserved for much smaller, more speculative companies.

Since our company is fairly big, we are going to list our shares on the TSX to try and sell them. We decide for simplicity's sake that we are going to divide each of our two shares (yours and mine) into 50 million shares, for a total of 100 million shares. So now comes the tough part. How much do we sell our shares for? If you recall, our business earns $100 million per year in profit, which is $1 of profit per share, since we now have 100 million shares in total. I don't know about you, but I'm not ready to sell this money-making machine for $1 per share, since that means someone who buys it gets all their money back in the first year!!! No sir. We need to sell our business for a multiple of how much profit our business makes. Here comes the good part: on the TSX today, there are companies that sell for as much as 30 times their profit or more!! That means we could sell our 50 million shares each for $30/share or as much as $1.5 billion each in cash money!!! Oh baby!!! The problem is that 30 times profit (or earnings, as it is more commonly known) is expensive. I think to be safe, we will sell our shares at fifteen times earnings; a common multiple for Canadian companies. This means our shares are going to sell for $15 each. Still, this makes our company worth $1.5 billion in total, or $750 million to each of us. Not a bad take for ball caps.

So we go to the TSX to sell our shares at $15 each and people all over the world buy them at that price. People paid a Price/Earnings (PE) multiple of 15 for our company. They deposit cash into their RRSP, TFSA, etc and use that cash to buy our stock.

The good thing for our original buyers is that because our business is so successful and odds are we will earn even more money in the future for our caps, people are actually willing to pay $16 for our stock now! This is known as a bid; the price people are willing to buy our stock for. If you own stock in any company, you can sell it on the TSX at the bid price, provided there is a bid for as much stock as you want to sell.

So what if a friend of yours wasn't one of the people lucky enough to get our stock at the original $15 price but he still wants to buy it? He can go on the TSX and buy our stock at the lowest price that people are willing to sell it for. If you recall, people are already willing to buy our stock for $16 (bid) but if you want to buy it badly enough, you will have to pay what people are willing to SELL their stock for; the ask price, which is always higher than the bid.

For simplicity's sake, let's say the current ask price for our company is $17. If your friend buys stock at the ask price (or the offering price), then the last price our stock traded for was $17. Every stock has these three prices, while the market is open (9:30am until 4:00pm each weekday); the bid (what I could sell my stock at today if I had to), the ask (what I could buy the shares at today if I had to) and the last (what the last price the shares traded at was).

Ideally, we want to buy shares in companies that make a good profit each year, and have good potential to grow their profit in the future. That way, hopefully we can sell our shares for more than we bought them for, down the road. Make sense? You can try it. Here are some easy steps to look for a stock to buy.

1) Go to a financial website (www.google.com/finance is a great one)

2) Enter the name of the company you want to look up in the search bar. You will need to know the stock symbol to look up your company more easily in the future, or if you want to follow it on TV, etc. Stock symbols are normally one, two or three letters, and will sometimes have an exchange code on the end. As an example, Shoppers Drug Mart trades on the TSX. Its symbol is SC-T, or just SC, depending on the website.

3) Once you've found your company and know the symbol, click it and you will see a page that has a bunch of information on it, including names of guys that run the company, price information, and more. If the markets are open, you should see a big bold price, which is the LAST price that the shares traded for. You should also see a bid and ask price. If you look closely, you can also see the price/earnings multiple that these shares are trading for (normally P/E on the websites). That will show you how much you would have to pay for the shares, relative to how much profit they make.

If we are going to buy some stock, we probably want to buy stock in more than just one company, in case something bad happens to our company (new competition in the baseball cap market, fire at the factory, whatever). We want to own stock in many companies so we can try to insulate ourselves against these negative events. We also probably don't want to own stock in too many companies that do the same thing, because if something bad happens to one, it could affect the others. Just think if you owned a portfolio full of stock in US banks in 2008. You may have owned many different banks but they were all in trouble for the same reasons, so your portfolio would have taken a beating. Here are some guidelines for buying stocks, if that's the way you want to go with your investment dollars:

1) Buy stocks in companies that make money, as opposed to lose it. This seems obvious but wait until you see how many of the companies you know out there aren't making money. They could be victims of the poor economy, tough competition or bad management. There are also companies that are losing money today to do research or development to make a profit in the future. These aren't necessarily bad investments but are more risky, since there always is a chance that their work doesn't pay off.

2) Buy lots of different companies. As we talked about, this is called diversification. You will get different answers about what the right number of companies is to own. I think 15-25 is pretty sufficient. Any more than 25 and you're going to start owning too many companies that do the same thing. You would be over-diversified!

3) Take advantage of professional advice. Researching these companies takes a lot of time. A good financial advisor or portfolio manager will know which companies are good ones and be able to follow them once you have purchased the shares. Mutual funds are one way of doing this - we will come to that. Yes, it will cost you - we will come to that, too.

4) Don't fall in love with your stocks! Companies that are great today may not be great tomorrow. Be sure to keep informed about your stocks and how their businesses are progressing.

There is obviously a lot of information about stocks but hopefully you will be able to gain a simple understanding from this piece. I have 52 weeks to elaborate, so more information will follow, including tidbits on dividends, splits, bankruptcy and many other really stimulating topics, if you aren't already falling asleep! In my opinion, stocks are probably the best way to make money investing over the long term. It's picking the right ones that is the tricky part.

Thanks for reading. See you next week.