The Stock Market
for Beginners Part 2

Understanding Equities & Derivatives

Now let’s look at little closer at each class, starting with equities and derivatives.

This is without a doubt the most glamorous of all the asset classes. You’ve probably heard tales about investors hitting the jackpot on the stock market — and also horror stories about those who have lost it all.

Equities, or stocks, have gained the most public attention in recent years because they have far outperformed traditional fixed-income (debt type) investments. The term “equity” refers to securities that represent ownership in companies, purchased in the form of shares. But an equity investment can also include real estate, precious metals, and even artwork. The main objective of the equity asset class is capital growth.

Some equity investments can generate income; for instance, preferred shares and stocks paying dividends. Generally, however, equities are seen as growth investments where the potential returns come once the security is sold. Equity investments can fluctuate in value, and they do. Since many variables can damage a company’s profitability, investing in equities tends to be riskier than investing in bonds or cash. Share prices will vary from day to day and can rise or fall dramatically in a day’s trading. Different types of equities involve different levels of risk. From highly speculative “penny” stocks to solid “blue-chip” companies, there is a wide spectrum of equities to consider.

When you purchase common shares of a company, you become a part owner. You are, therefore, exposed to the risks and rewards that come with ownership. When a company performs well, the share value generally rises. When the company performs poorly, the share price will level off or slide downwards.

A common share is a security that grants the holder an “ownership claim” in a company. Shareholders of common stock are granted greater participation in the company’s decisions. Owners of common stock elect the Board of Directors, appoint senior officers and an auditor for the corporate financial statements, and determine dividend policy and other related matters. You may cede your right to vote to a third party by proxy. But should the company go bankrupt, common shareholders are the last creditors to be paid, after the bank, bondholders and preferred shareholders. Companies with publicly traded shares are, however, required to provide information or disclosure to their shareholders in exchange for being able to trade publicly.

Also in this class of assets are “derivatives” — a name given to equity investments that are more complex than a simple share. Often derivative investments are a “proxy” for a more complex sort of investment. For example, buying one unit of a mutual “index” fund actually buys smaller portions of all the stocks tracked in that Index. Or, buying an “option on a Futures contract” gives you theoretical control for a limited time over a fixed quantity of heating oil, or soybeans. Derivatives are powerful tools for making money — and losing it. All derivatives require you to do much more research than you would with a simple common share. The hallmark of a derivative is “what you see may not be what you get!”

Types of Shares

Stocks have a language all their own — blue chip, large cap, small cap, junior, penny and growth stocks. Not all shares are created equal. Some shares are a gambler’s dream, while others are almost as conservative as a Treasury Bill. Small cap, mid cap and large cap refers to the relative size of the company. The term cap is short for capitalization.

Let’s say ABC Corp. has two million shares outstanding and trades at roughly $15 per share. The market capitalization would be $30 million — the share price multiplied by the number of shares outstanding. Our hypothetical ABC Corp. would be considered a “small cap” company. A small cap company is generally valued between $25 million and $250 million.

A mid cap company is usually valued at $250 million to $1 billion.
Companies with a market capitalization more than $1 billion are called large cap companies.

Market watchers and industry types use a number of terms to describe particular stocks.

A blue chip stock refers to the shares of large, mature profitable companies that pay dividends and consistently meet profit targets, regardless of economic factors. They tend to be the major players in their industry group and have strong management and solid earnings. Some examples of blue chip companies include Petro Canada, IBM and Royal Bank of Canada. Generally the shares of blue chip companies don’t rise and fall as dramatically as those of smaller companies. Blue-chip companies are usually large cap companies, since they have more access to capital.

Junior stocks, on the other hand, are companies with limited earnings history and no market dominance. These shares rarely pay dividends and can be quite volatile in the short term. Junior companies issue stock to reap capital infusions that are used to finance an idea or product that has yet to take off. Many small companies in emerging industries such as technology are considered juniors. Only the most experienced and risk-tolerant investors should own this type of security.

Penny stocks are considered the riskiest form of equity investment and are most frequently associated with oil and gas, precious metals or base metals companies. Penny stocks typically trade for less than $5 on smaller exchanges or on over-the-counter exchanges. The over-the-counter market consists of dealers who make trades over the phone or Internet. Other names for this market include the “unlisted,” “street” or “inter-dealer” market. Unless you are the type of person who absolutely thrives on risk, you should never have more than a tiny portion of your portfolio invested in junior or penny stocks. Among other worries, a lack of liquidity can result in your stock having no buyers when you are ready to sell — making it hard to redeem whatever value you feel is in the company.

Two Types of Equities

Shares are further divided into groups according to their objectives; industry; and susceptibility to business cycles. The two best-known groups are equities dedicated to growth, and equities dedicated to income. While the two are not incompatible, generally you will find that stocks tend to favor one over the other.

Focus on “Growth”

Growth stocks have above-average market growth as a result of high earnings and future high-earnings potential. Emerging stocks can deliver sensational results, but they’re also the most likely to suffer from volatility. The risks are high — for every winner, there are a dozen losers. You need a fairly risk resistant if you’re planning to go this route. Junior growth stocks are usually the hardest hit during market setbacks (also called “consolidations,” “corrections,” and “downdrafts”) and even senior companies can nosedive during these periods. Proceed with caution.

Focus on “Income”

While preferred shares are the premier income stocks, some common shares also qualify as income stocks. Companies that pay out a large percentage of their earnings in the form of dividends can be considered income stocks. This type of company typically has solid earnings without much potential for earnings growth. Income stocks are characterized by a low price/earnings multiple and above average yields. Telephone and utility stocks are classic examples of income stocks. Enbridge, TransAlta and Telus fit into this category. Many of these companies manage regulated monopolies and as a result are regarded as having limited growth potential (this situation is changing in some areas, such as telecommunications). The upside is that these stocks pay generous, increasing dividends.

Stock Splits

What is a split?

Most companies like to keep their share prices within an affordable range for most investors. If the price rises too high, the company may split its shares and reduce the stock price by increasing the number of shares outstanding. When a company announces a split, dividends are usually also increased to ensure that investors remain interested in the stock.

Say that ABC has seen a stellar rise from $5 a share to $50 - a not uncommon phenomenon in bull markets.
At $50, the company is worried that its stock will be perceived as “expensive” by potential investors, since ABC is really a small cap company, albeit with large aspirations.

Of course, mathematically, the actual value per share is not as important as the value of the company represented by the share. But knowing is one thing and perception another, so the company decides to “split” its stock 5-to-1, meaning that everyone who owned one $50 share as of the date of the split will instead receive 5 shares valued at $10.

The value of the company and the stock has not changed. All that has changed is the perception of the value of the stock. But if perception does indeed rule the day, a stock that is seemingly “less expensive” after a split will attract many more buyers than if the stock had not split, all things being equal.

As the markets move higher, stock splits tend to become commonplace. Splits bring new investors into the marketplace to buy shares and ultimately drive the share price higher because they effectively draw investor attention to stocks that are in “growth mode.”

Click here for The Stock Market for Beginners Part 3.