Equities - Overview

Equities are perhaps the most liquid (can be easily traded) of all asset classes. They are the common stock of publicly listed companies. In essence they represent an ownership stake in a publicly listed company proportionate to the amout of shares held. Baring notable exceptions (IKEA, Mars Candies, Bechtel, Fidelity Investments, etc.) an overwhelming majority of world's top companies are public. The common stock (i.e. shares) of these companies are traded on various stock exchanges around the world. Although a primer on equities is too basic a topic for this blog, I think discussing it might still help some readers.

How does the shares come into existence? In a typical example, an entrepreneur (say Dhirubhai Ambani) comes up with a business idea and initially grows the business (Reliance Industries) with his own capital. After reaching a certain size most of these companies need a sizeable amount of capital to grow further. So the entrepreneurs (i.e. promoters) comes out with an IPO (public issue) allowing the general public to own a piece of the company and benefit from its future growth. During the initial stages, most public companies reinvest their profits back into the business for expansion purposes and after few years when they start generating excess profits the money is distributed back to the shareholders in the form of dividends.

At what prices do the shares trade on exchanges? Ideally the value of a company (also known as its intrinsic value) is equal to the present value of the future cash flows the company is expected to generate during its lifetime or alternatively it is the replacement cost of building an equivalent company. The problem is that it is very difficult to know these values with a high degree of accuracy because they depend on several factors (future demand of company's products, competition, interest rates, inflation, exchange rates, government policies, management smarts & honesty, etc.). So invariably the shares of a company trade at wide divergence to its instrinsic value based on investors perception of the value of these factors and the degree to which each factor affects the intrinsic value. Additionally the value of these factors keeps changing with time. Due to so many moving parts in the valuation equation, the share price of a company becomes quite volatile (atleast in the short-run). With prices being so volatile any wrong judgement call by an investor can lead to huge losses thus giving stock investing a connotation of gambling.

So how does one come out ahead in the stock investing game? Most people think the obvious answer is to form better insights on the plethora of variables that impact stock prices. Naturally they turn to watching CNBC as much as possible, devouring the business journals like WSJ (or Economic Times in India), reading a ton of stock posts at Yahoo Finance (or Moneycontrol) and forming an opinion about the numerous economic & financial indicators that the media throws at them. Over long term (i.e. 10+ years) the unfortunate ones drop out after suffering early losses, the reasonably smart ones (which includes a majority of investors) end up earning a return which equates to the growth rate of underlying companies profit they invest in minus the cost of playing the stock market game (i.e. brokerage & custodian charges, taxes, penalty for improperly timing their investments & investing disproportionately large sums to fiascos like Enron, Satyam & AOL-Time Warner at their peak prices). Only the incredibly LUCKY and very smart ones (< 1% of the investing population) end up multiplying their wealth several times more than reasonably smart ones (i.e. the majority). The media zealously portrays eloquent stories of these elite investors to sell more news which again breeds a new wave of aspirants for the brutal game I just explained.

I know I am again sounding like a broken record and I need to quickly tell you how a sensible investor can use the equities asset class to his/her advantage without expending a lot of effort. For that you will have to wait for the next post as we are out of time.