The Question of What Is A Stock?

This became a topic of sharing coincidentally when someone asked me, what is a stock? Does it go up and down, because of certain factors? In reality many people do not have a proper understanding of the stock market. What they really know is just about the price and that piece of news. These people are what we call speculators, people who take financial action (buying or selling) in a manner that has not been given thorough analysis OR have thoughts on their margin of safety (no investment strategy).

Investing in stocks is not the same as gambling! I need to repeat this many times. Certainly there are risks involved in nearly all financial investments that include fixed deposits as well. It differs from gambling because the shareholder has purchased a fraction of a company. Gambling faces the situation of win or lose, you are against the odds. I would also agree that gambling has their own winning strategies but this is a separate topic but just to point out that investing in stocks is not gambling unless you speculate like most people do with little knowledge.

So What Is A Stock or Share?
It represents part ownership of a company, I call it a piece (you) of the big pie (the company). You invest a part of your money into a business and the result is you are a stockholder or shareholder of the company. I will use shareholder from now onwards.

With that, you are entitled to dividends, bonus issues, right issues and be invited to their Annual General Meeting (AGM). Given the total amount of money invested in a business, a share has a certain declared value which is known as par value of a share. This par value of a share was the share price upon initial public offering (when the pie was first presented and distributed for others to grab). Pie presented would mean the company goes public and listed in the stock exchange. This is called Initial Public Offering (IPO).

Referring to the above diagram, Aboi is the major shareholder because I hold 33% of the units, followed by Ahmad. The rest could be considered minor shareholders. You need to know that major shareholders play a BIG role when decisions to be made for the company that requires voting.

Now How Does it Go Up and Down? (Emotionally)
There are two common quotes that are misleading in stock exchange and those are being quoted many times again with little knowledge even by the so called experts and sadly a lot of people accept them immediately at face value.

• "For every buyer there has to be a seller"
• "All that is needed is when two traders are willing to trade at the correct price"

It is true that when you buy, somebody may be willing to sell to you. BUT when you are willing to buy, you are only buying a small portion of large blocks of sell orders that have been placed on the market-makers' books long before you took your actions. These sell orders are stock waiting to be distributed at a certain price levels and never lower. Who are these market-maker's? Professional private syndicate traders that work to sell or buy large blocks of stocks.

Say the company is promising, the lower prices at RM1 looks attractive. Not all issued stock can be accumulated by the market-makers, some are tied up like to aboi who is the major shareholder. Hence they look for the floating supply, the remaining 3000 units of the total 30k issued stock. Once there is no more supply, only demand to buy at higher prices will we see share price increase. So now you have the making of a bull run!

Now let's coin that Ahbeng wants to sell all his 3000 units at RM1.2 and Ahlian her 2000 units at RM1.1, these are sell orders and the market price will be supported until these are exercised. Once sold will weaken the market. Any selling has to be absorbed by the market-makers so some of it will be executed immediately while some will go into their books, again accumulating floating supply. If selling happens to be so great that prices fall fast, the market-makers will usually stop the selling by buying so the price will be supported. They will then very sneakily take the chance to sell more stock on the next wave up for short profit taking. This process takes time to slowly complete.

GENM is a good example especially the last selldown, very high sell volume but the price did not went down as hard as the previous selldown. WHY? There are market-makers who are buying to support it and they are buying at extremely large blocks, this is done behind the scenes.

Once these market-makers and other professionals like fund traders have sold all their holdings, we will see what we call a bear run because there is no professional money supporting the high price. This will happen when they think that there is no more demand to "char a.k.a fry" for higher prices. 

If you like to speculate, I call it gamble, this is the game you will be playing against, tough ugh? Now do you see the reason why so many people lose money in the stock exchange, become discourage and then spread news saying that you can't make money there. Stock market is simply a tool where rich people designed it to take money from not-so-rich people. So please learn, think like them and have an investment strategy. It's not just all about price. Think about the volume, the news going around and economic conditions!

So let's recall the earlier two quotes:

• "For every buyer there has to be a seller" - partially correct but it's never a one buyer one seller scenario. You can be buying a part of the large blocks being ready to be sold at a certain price and vice versa.
• "All that is needed is when two traders are willing to trade at the correct price" - wrong, the market is not a balancing scale. If so you won't be able to see a bull or a bear run. Prices are real time and they fluctuate based on volume either being executed immediately or still floating around.

Now How Does it Go Up and Down? (Rationally)
Now we look at the fundamental side. The keyword here is called shareholders' equity which represents the amount a company is financed and is defined by the following formula.

• Shareholders' Equity = Total Assets - Total Liabilities OR
• Shareholders' Equity = Share Capital + Retained Earnings - Treasury Shares (ignore this for simplification)
• **Share Price = Shareholders' Equity / Outstanding No. of Shares**

As you can see, the equity comes from two main sources. The first being the original source of money that was invested in the company during IPO plus some additional investments made thereafter. The second comes from retained earnings where the company is able to accumulate wealth over time through its successful operations or ventures. 

The most important factor that affects the value of a company is its earnings (the second source). It is crucial to pick a fundamentally strong company with a sustainable business model. This also brings back to my earlier post in Dutch Lady which mentions that a boring stock (little trade volume activity), can grow in price as long as the company is growing shareholder equity through retained earnings. If the company makes money you are certain to see share price increase, if the company has net losses you are also certain to see a drop in share price.


Bonus and rights exercise also affects the share price. In example, say a bonus of 1:1, this means you are given one share for every one share you own right now. You will say WOW but think again, you have the same pie just that the pieces are now being broken even smaller. Thus, the value is the still same, we call this share price has been diluted by bonus issue. 

Why do companies do this then? Issue bonus shares convert part of the reserves into capital where the company can use for various reasons such as expansion or etc & also to make the share more trade-able to more people because the share price has diluted. Again this can entice people to invest and the company gets more capital funding.

Bonus issues are taken as a sign of the good health of the company and is a part of my criteria of a fundamentally strong company unless there is a good exception. That's because the stock is now more liquid, more shares, easy to buy and sell. By issuing bonus a company is in a position to service its larger equity now. Company is confident of being able to increase its profits and maybe distribute dividends in the future.

Conclusion
Having said so much, of course it is not just earnings that can change the sentiment towards a stock and its price. It is also affected by investors' attitude and expectations of the future value of the company. Many times we see hot stocks go up and down fast, mainly driven by speculators. This is the emotional side of investing and market-makers take such advantage of the conditions. Some times we see less of that in other stocks and they quietly grow in value in the long term.

Someone even told me that in year 2000 tech companies were doing so well but let me tell you that the prices are not justified by their earnings as you can see below. The prices of these hot stocks were fried up so high by speculators and guess who made money? The market-makers. If you were one who did not sell your tech stocks at that time, well too bad you won't be able to see it again not until the next generation assuming history repeats itself.

So the key is to estimate the actual value of the company (I use DCF as you know in my previous posts) instead of looking at the perceived value (share price). This is what I call investing with knowledge. I hope I answered your question of what is a stock :)