Accumulating Assets

There are 2 main types of brokers available to most individual investors - full service and discount.

Full Service Brokers

Full service brokers are firms like Merrill Lynch and Smith Barney. These firms employ commissioned sales people to work with individual investors. The full service brokers offer investment advice, stock picks and access to exclusive research reports compiled by the brokerage’s in-house research team.

For offering all of these services, the full service brokers charge premium prices. In using these brokers for advice, you pay commissions based on the amount you are investing in a particular stock. This can easily amount to hundreds of dollars just in commissions.

In general, I would advise against choosing a full service stock broker. If you are looking for personalized investment advice, I would look for a fee only financial planner. Fee only financial planners charge you only for their time - not for how much of a particular stock you buy or sell. With fee only financial planners, you can be sure you are getting unbiased advice, unlike the advice you might get from a commissioned salesperson at a full service broker.

Discount Brokers

The discount brokers typically run websites through which you make your trades. The commissions the discount brokers charge are, as you might expect, quite a bit cheaper than the commissions charged by the full service brokers. The discount commissions are as low as $4.95 a trade. That’s quite a difference from the hundreds you may have to pay with a full service broker.

There is a trade-off, though. Instead of getting personal advice and stock picks, the discount brokers provide you with online tools to help you make investment decisions. Typical tools include stock screeners that identify potential stocks for you to invest in based on criteria that you set (e.g. certain industry, maximum amount of debt held by the company, minimum revenue growth rates, etc.), research reports from investment analysts, and analysis of patterns on stock price charts.

Using the information from your discount broker, or through other sources, you make your own investment decisions and execute stock trades over the internet or over the phone at very low prices. Due to the low cost and the wide array of choices investors have for getting good investment advice, using a discount broker is generally the best route to go.

That said, you still must be careful about the broker you chose. For instance, there is frequent speculation that E*Trade, the most well-known online broker, may have to file for bankruptcy due to the problems it is encountering from mortgage loans it made to clients. Many brokers are facing similar financial issues.

Recommended Broker

The broker I recommend is TradeKing.com. TradeKing was ranked best online broker by both SmartMoney Magazine and Barron’s.

It has the lowest commissions available at $4.95 per trade and has no exposure to the mortgage and subprime crisis that is affecting many of the other brokers. In addition, there is no minimum balance required to open an account and there are no inactivity fees, so it is perfect for the beginning investor.

Learn more about TradeKing.com.

Stock exchanges are gathering places that bring buyers and sellers of stocks together, creating a stock market. Prior to computerization, this meant stock trading had to be carried out in person or over the telephone. Different stock exchanges now have differing levels of computerization and human interaction.

The two main stock exchanges in the United States are the New York Stock Exchange (NYSE) and the NASDAQ. Stocks trade on either the NYSE or the NASDAQ, but not on both. The NYSE still relies quite a bit on people (called specialists) to make trades while the NASDAQ matches buyers and sellers electronically over a computer network.

Historically, companies have chosen to be listed on the NYSE rather than the NASDAQ due to the tradition and perceived honor that comes with an NYSE listing. The NASDAQ is traditionally for smaller companies and technology oriented companies.

Where Does Your Money Go When You Buy A Stock?

When you buy stock, your money does not go directly to the company you are buying stock in unless it is the first time the company is offering its shares for sale (which is not common). Instead, your money goes to another investor who currently owns the stock.

Think of stock exchanges as a market for used cars. When you buy a used car, your money does not go to the car manufacturer (GM or Ford), instead, it goes to the dealer or individual car owner.

What Stock Exchanges Do

The role of the stock exchange is to match your offer to buy a stock with another investor’s offer to sell the stock. If there is a difference in what you are willing to pay compared with what another investor is willing to sell at, you will not get to buy the stock.

Take Google as an example. It is trading around $555 per share at the time of this writing. If you put an offer to buy at $550 per share, you are not likely to find anyone willing to sell to you at that price. If you put in an offer at $554.95, you might find a seller willing to come down to that price. Buy prices and sell prices get matched on the stock exchanges and facilitate trades between investors.

If you are buying or selling shares in large companies and have a price in mind that is close to the current price of the stock, it is likely the exchange will find you a buyer or seller to complete your trade. If you are buying or selling shares in small companies, you may find it difficult to make trades quickly because there are fewer investors who invest in many small companies.

The Role Of The Stock Broker

The average person cannot just call up the NYSE or NASDAQ and start making trades. Only registered members of the stock exchanges can make trades. This is where the role of a stock broker comes in. Your broker makes stock trades on your behalf based on your instructions. Some brokers also offer investment advice.

Your broker also serves as a record keeper to track all of your buying, selling and dividends. Decades ago, paper stock certificates were registered and issued to investors. Now, stock certificates are all held and registered electronically by your broker. In exchange for these services and for executing trades, you pay your broker a commission.

Seeing The Whole Picture

An entire buying and selling transaction has these steps:

1. You call your broker or log onto the broker’s website and give the broker buying instructions (e.g. which stock, number of shares, price, etc.).
2. Your broker sends the order electronically to the stock exchange.
3. The stock exchange matches your buy order with another investor’s order to sell.
4. Your completed order hits the “tape” and shows up on the stock ticker you see commonly running at the bottom of your TV screen.
5. The trade gets validated by either the NYSE or NASDAQ computer systems
6. The exchange sends details of the trade to the National Securities Clearing Corp. (NSCC). The NSCC records the details to the appropriate brokers’ accounts.
7. The NSCC forwards the details to the Depository Trust Co. (DTC). The DTC stores the stock electronically.
8. Your broker records the trade in your account. Your broker’s record keeping system is what identifies stock held by the DTC as yours.
9. Within 3 days after the trade, you “settle” the transaction by paying your broker for the stock and the related commission.

Many people are intimidated by the stock market. Arcane symbols scrolling across the bottom of the TV screen, unfamiliar terminology, shouting and chaos on the stock market floor…All contribute to a situation very unfriendly to beginners.

We are going to run through a series of posts that will take you from a beginner to an investor with a firm foundation grounded in fundamental stock market principles so that you will have good grasp on how these markets work.

What Are Stocks?

Stocks, also called equities, are ownership interests in a corporation. You own a portion of a company. The percentage you own depends on how many shares you buy compared to the total number of shares other investors own. For instance, at the time of this writing, Google has around 314 million shares of stock outstanding owned by investors. If you buy 100 shares, you own .00003% of Google’s assets, debts and profits.

That doesn’t sound like much, but consider that Google’s profits were $4.5 billion last year and a .00003% share of that is $1,423. To get your .00003% share, you would pay close to $55,200 as of the time of this writing. Is that a good deal? That is the quintessential question investors must answer.

Capital Gains and Dividends - How Investors Make Money With Stocks

Prior to getting heavily into investing, it is important to know how you can make money. There are 2 ways to make money with stocks - (1) Capital Gains, which are increases in the price of the stock; and (2) Dividends, which are periodic payments corporations make to their shareholders out of the corporation’s profits.

Traditionally, corporations paid stockholders a dividend. Each quarter the corporation made money, investors would get checks in the mail or deposits into their accounts for the dividends paid out.

As profits and dividends increase, so too does the price of the stock, meaning the stock increases in value in addition to providing the stockholder with dividend income (the best of both worlds). From 1980 to 2003; however, there was a steady declining trend in dividends paid.

That trend reversed a bit starting in 2004 with changes to the tax law that gave favorable tax treatment to certain dividends, but dividend payouts are still far below where they were prior to 1980. This means investors are increasingly reliant on only one way to make money with stocks - capital gains.

What Makes a Stock’s Price Move?

According to financial theory, a stock’s price is equal to the net present value of all future cash flows. In plain English, this means a stock’s price is a reflection of what investors believe will happen to the corporation in the future. If investors believe a corporation has good potential to make a lot of money in the future, they will be willing to pay more for the stock of that corporation.

This means stock prices are impacted by new information that changes investors’ opinions over how much money a company will make in the future. Let’s break that down. Stock prices are impacted by:

1. Information about the company (e.g. new product release, lawsuit, earnings announcements, etc.)
2. Peoples’ opinions
3. Expectations of future results

Greed & Fear
Stock prices on a day-to-day basis are impacted by human beings voting with their wallets. When people buy a stock, they are “voting for” it. When they sell a stock, they are “voting against” it. On any given day, if a stock is up, it means more money was used to vote for it than against it.

As in any human endeavor, the stock market is significantly impacted by peoples’ emotions. The primary emotions at work in stock market investing are greed and fear. They can cause wild and illogical swings in share prices, so determining the price to pay for a particular stock is not as easy as a math formula to calculate its value. Greed and fear have always been at work in financial markets and they will continue to play central roles in the future.

This is where the critical skills of an investor come into play. Successful investors can evaluate information logically with a minimum of emotion, determine whether any new information about a company differs from current expectations (either good or bad), and anticipate other investors’ reaction to the news. Are other investors currently acting out of greed or fear?

Said differently, news does not move stock prices. Investor reaction to the news does move prices. If Apple comes out tomorrow and announces it sold 10 million iPhones, is that good or bad? It depends on what investors expect. If most investors expected 15 million, the stock price is going to go down. If most investors expected 7 million, the stock is going to go up.

This is what makes investing inherently risky and potentially very rewarding. People are placing bets on the future results of a company using imperfect information. As an investor, you not only have to anticipate what a company will do, but you also have to anticipate how other investors will react.

Churning Below Resistance

We are at a critical level in the S&P 500. In November, the S&P held just above the 1400 level and bounced for nice gain above 1500 in December. In January, however, we broke down below 1400 and have remained there ever since. As we open the week at about 1395, we sit just below the former support level of 1405, which has now become resistance from a technical perspective.

If the S&P 500 can break above 1405 on significant volume, it should clear the way for more upside.

Still in Earnings Season

Keep in mind we are also still in earning season with notables such as Countrywide, Visa, General Motors, Flextronics, Kraft, Kellogg, Colgate and Procter & Gamble reporting this week. Watch for further signs of inflation or problems in the credit and financial space.

Positive Trends

1. The S&P has been trending steadily higher since early March

2. Warren Buffett/Berkshire Hathaway just announced a deal to buy Wrigley signaling Buffett sees some value there

3. The first of the tax rebate checks go out this week

4. Expected further rate cuts from the Fed on Wednesday

Negative Trends

1. Inflation in commodities (food, oil, metals)

2. Ongoing crisis in the financials

3. Still trading below resistance in the S&P 500

Final Thoughts

There is likely to be a lot of “noise” prior to the Fed meeting on Wednesday. The latter half of the week may trade very differently from the beginning as the meeting hits smack dab in the middle.

If we break above 1405 in the S&P and get the anticipated rate cut, we could be in for a decent rally, barring any negative earnings surprises from the big guys.

It is in Wall Street’s best interest to obscure the true value of stocks. Why do so many talk about price per share and price to earnings ratios, but so few talk about market capitalization - the real price of a business?

“Buying stocks means buying a business and requires the same discipline.” - The Warren Buffett Way

Why do we even care about price to earnings ratios? What do price to earnings ratios mean? I know, I know. “A price to earnings ratio is the price per share divided by the earnings per share. It is a ratio that can be used to compare different stocks to show how expensive or how cheap a stock is.” Blah, blah, blah…

The Straight Skinny

The price to earnings ratio also represents the number of years it would take to get your money back as a business owner based on the current stock price and current level of earnings. Analysts love to say stuff like, “This stock is trading at only 25 times earnings. It is very cheap.”

Try this instead, “If you buy this stock now, it will take 25 years to get your initial investment back if earnings stay consistent. If they lose money, it will take even longer. If they grow consistently at 10% a year, it will take 13 years to earn your money back.” Puts things into a different perspective, doesn’t it?

Imagine you see this ad in your local paper for a business for sale:

Great Business For Sale!
Annual earnings of $4 million,
growing at 35% per year. Will
make $5.4 million next year.
Priced to sell at $205 million!

The numbers above are based on Google’s financial data at the time of this writing (converted to millions instead of billions).

Doing some quick math, that is about 51 years to get your money back based on the current year’s earnings.  Based on next year’s earnings, you’ll get your money back in about 38 years.

Not a very compelling story, is it? Now compare that fictional ad to recent a recent article that described this business as cheap based on the price to earnings ratio, projected growth rate, and “history.”

For this stock to be cheap, the company would have to grow earnings at near its 35% growth rate for several years.

What This Means For You

The point is that when evaluating whether or not to buy a stock, follow Warren Buffett’s advice and invest like you are buying a business (because you are!). Do not fall victim to the fancy ratios and confusing language Wall Street analysts and pundits use to obscure basic business facts on the hopes you’ll buy what they are selling.