MC Learn | Why markets exist, and should I invest in stocks?
- Jun 28, 2022, 08.45 AM
- DealMoney News Service
Chapter 1: Starting today, we will be publishing a daily article as part of the MC Learn series that seeks to answer commonly asked questions about markets and investing. The first module covers equity, while subsequent modules will be technical analysis, futures and options, and mutual funds.
Why do stock markets exist?
The stock market is a platform that connects those who need money with those who have money to invest. The ones looking to raise money could be small or large companies, while the ones looking to invest could be individual investors or institutions (or simply, money managers).
Stock markets enable businesses to raise what is called in market parlance as equity capital. At the same time, it provides savers with an alternate avenue to invest their money.
Equity carries specific advantages as well as risks for both the issuer and investors, compared to debt, which is the more traditional form of raising capital (as we will learn later).
How do companies raise money from the stock market?
A company issues shares to investors for the first time through a process called an initial public offering (IPO). The investor then becomes a shareholder in the company.
For instance, if a company is looking to raise Rs 1 crore, it can issue one lakh shares of Rs 100 each, or 10 lakh shares of Rs 10 each or one crore shares at a rupee each.
The below screenshot is from Moneycontrol’s IPO section, listing two public offers from the small and medium enterprise (SME) segment.
Q: How does a company decide the price at which to sell shares during an IPO?
A: Short answer: It can decide its own price.
Long answer: Companies hire professionals called investment bankers whose job is to advise the company on what its estimated value will be, based on its profitability, the industry it operates in, future outlook, the value of similar competitors and so on. The bankers also talk to professional investors to understand the price at which they will be willing to purchase shares.
In sum, the investment banker, which manages the IPO process, and the company, just like the seller of any good, will try to derive maximum value out of the share sale. But it is in their interest to not price the shares so high that there are no takers.
Q: Let’s step back. Why do companies come to the stock market? Don’t banks already lend to companies?
A: There are several advantages of raising money through equity capital. The first one is when the company sells a share, it does not have to pay interest to its shareholders.
If the company does well, the shareholder is eligible for a share of the profits in the form of dividends. Of course, it is not mandatory for companies to pay dividends even if they are doing well. If the company does poorly, the shareholder gets nothing.
On the other hand, companies have to pay interest on bank loans irrespective of their financial health.
The absence of an obligation to pay any interest to its shareholders may feel like a win-win for the company but it is not always so. This is because every rise in profit and stock prices means the investor is a claimant on both.
The second advantage is that banks may look at the track record of a company before advancing loans. If the company is not profitable or has not been generating enough money, banks will be reluctant to lend. An equity investor may have a different view from the bank given that their appetite for taking risk is higher.
Besides, there are other advantages. A company’s listed shares almost become like a currency, using which it can buy other companies or reward employees through programmes such as ESOPs.
Q: So if a company does not pay interest and is not obligated to pay a dividend to shareholders, why do they invest? Shouldn’t they invest in other assets like gold, property, or fixed income (bank fixed deposit, company fixed deposit, debentures)?
A: While companies do not pay interest on shares or may not always pay dividend as well, many have strong businesses that grow in sales and profits over time. As companies grow, the share prices also tend to rise as other investors seek a piece of the action.
This allows investors to sell their shares to other investors at a higher price -- in what is called the secondary market -- and make significant returns.
Compare this to real estate, where investors need to put down a large sum of money to participate in it. Then there are other worries of having to ensure possession of the property as well as the risk you may not be able to sell the property in time when you need the money.
Debt instruments such as fixed deposits or debentures offer fixed returns that those returns may sometimes be so low, they barely beat inflation.
For instance, you are not better off if the Rs 100 you have invested becomes Rs 106 in a year (at an interest rate of 6 percent) while the price of a product you want to buy is now Rs 107 (thanks to an inflation rate of 7 percent). Besides, many debt instruments also carry the risk of default, or the borrower not having the ability to pay not just interest, they may not be able to even return the principal.
As for gold, its only advantage is it has historically been used as a medium of exchange, leading many to believe it still has value as a currency. This belief causes gold prices to rise when there is economic uncertainty. This also means that gold prices will tend to stagnate during periods of economic stability, which sometimes last for decades.
Overall, studies show that equity investing, if done sensibly and patiently, can provide better returns than the other asset classes mentioned above. Now, a lot of people may not believe this but to show how is part of the reason why we created this classroom, as you will discover.
Q: Ok, let’s go back to the stock market. How does it work?
A: For a stock market to work efficiently, there have to be buyers and sellers of shares of the companies listed on the stock market. The buyers and sellers participate in the market through brokers who are members of the stock exchange.
If there are more buyers for a stock than there are sellers, the price tends to rise. Conversely, if there are more sellers than buyers, the price tends to fall.
Q: Who are the key participants in the stock market?
A: There is the stock exchange, which provides the platform to connect buyers and sellers of shares.
There are merchant bankers/investment bankers which help companies raise money by finding investors for their shares.
There are stock brokers through whom investors buy and sell shares. The brokers are registered members of the stock exchange.
There are clearing corporations which ensure that the trades are settled, and depositories which keep track of the ownership of shares.
Finally, there are investors and traders.
Q: Good that you brought that last point up. I keep hearing the words investing and trading. What is the difference between the two?
A: Investors are those who buy stocks with the intention of holding them for a reasonably long period of time, so as to sell them after the companies’ sales and profits have grown, and along with them, their share prices.
Traders, on the other hand, buy shares with the sole intention of selling them as soon as they have made a fast return. In effect, their focus is fixated on when the prices will move in their favoured direction – due to whichever reason. Traders use a number of tools to try and gauge this, as we will learn in the later modules.
Q: So is it better to be an investor or a trader?
A: Both investing and trading have their own pros and cons and require different skill sets as well as commitments in terms of learning, practice and time.
Over the course of this classroom series, we will flesh out all the important aspects of how to be a good investor or trader.
Q: How do stock prices change?
A: The stock price mainly depends on fundamental aspects of the company, such as financial performance, competition, management capability, track record, to name a few.
At the same time, demand supply also plays a crucial role. A company may be fundamentally sound, but if investors are not interested in the stock, its price will go nowhere. Conversely, a stock may not have great fundamentals, but if too many investors are interested in it for some reason, the price will go higher.
Q: I have some savings. Should I invest it in the stock market?
A: There is no simple answer to the question. Many factors need to be considered, like your age, is the amount saved the only savings you have. It also depends on when would you need the money back and how big a loss can you take on the money.
Equity is the riskiest asset to invest in. Because of the high risk, the returns are also higher.
However, most investors are drawn to equities having heard stories of stock prices doubling or trebling within a short time. They usually overlook the risks associated with equities. A prudent investor should first look at the risk he is taking for the expected gain.
Having said that, taking risk and investing in equity at an early age is preferable than investing in equities closer to retirement or post-retirement.
Q: My friends and relatives say that the stock market is manipulated by powerful investors. Is it true?
A: It is not really true, though there may be instances when stock markets can be manipulated. But a stock in which many investors participate cannot be manipulated. Even stocks where investor participation is limited, the prices cannot be controlled indefinitely.
This brings us to the point of investing in companies which are financially healthy, well-researched, and have competent management.
Manipulation is possible in the stocks of companies where the promoters are hand-in-glove with a class of players called ‘operators’. The promoters finance the operators, who in turn influence the price of a stock. Without the promoters’ involvement, it is very difficult for operators to manipulate a stock.
