Why Do People Buy Stocks?
It's not a trick question.
Seriously, why do people (you and me, say) buy shares of companies on the stock market?
Presumably, the answer is, To make money! I can assure you, that’s why I buy stocks.
My next question is perhaps harder to answer: why do stocks go up? Or, to get a little philosophical: what determines what a stock is worth?
Obviously, I can’t claim to have the definitive “answer” to this question (although I believe I have a reasonable answer, or I wouldn’t invest in stocks, or write about investing), but I wanted to put some ideas on paper to get you thinking about your assumptions regarding the stock market and individual stock performance.
I thought about this topic as I was writing issue #8 about Netflix and it’s (lack of) potential as a Value Investing possibility. As a value investor, I believe that individual stocks have an intrinsic value. In contrast to this, I believe that most people, including most “professional” stock pickers or financial advisors, don’t really believe that stocks have a particular value. When considering Netflix, the implications of this fact reminded me that if you don’t believe that shares of a company have a “real” value, then you’re not really investing; you’re speculating. I’m hardly the first person to make this point, but it’s really important to keep this thought in mind because the consequences are tragic for the average retail investor. Witness the current bear market sell-off.
So let’s go back a few steps to get the bigger picture; there are only two ways to make money when you purchase a stock (without incorporating stock options):
From dividend payments received
From increases in the share price
Dividend payments are fairly self-explanatory, but why would the share price increase? Share price increases happen because of one or more of the following:
The company is acquired by another company, either via merger or outright purchase, and the purchase price is at a higher price per share than you paid
The company liquidates and distributes assets to shareholders, and the amount distributed per share is more than the price you paid for your shares
People believe (possibly due to the potential for either of the first two scenarios to occur, or perhaps because the company increases its dividend) that shares of the company will be worth more than the price for which they’re currently trading, and purchase shares at a higher price per share
While there is always speculation about companies being bought, taken private, or merging, the actual instances of this happening are pretty rare compared to the total number of companies listed on stock exchanges.
As far as companies being liquidated (outside of bankruptcy), that almost never happens.
This leaves the third possibility. People have an expectation that the value of a share of a company will be higher in the future. Companies do, of course, pay dividends and raise them over time, but most of them don’t pay dividends large enough to justify their current share price on a discounted cash flow basis, and they haven’t done so in a long, long time, with the possible exception of Master Limited Partnerships.
That must mean: if most companies aren’t acquired by other companies, if they don’t liquidate assets except in cases of bankruptcy, and if they don’t distribute a large percentage of their earnings as dividends, then the market price of shares in a company increase due to the hope that one of those events will occur in the future.
A simpler way of looking at it is like this: people pay increasingly higher prices for a stock because they hope that one of those events will occur in the future. Or, because they believe that someone else will buy them for a higher price because this other person believes that one of those events will happen in the future.
In other words, people buy shares of a company with the implicit expectation that others will buy them for more in the future. Candidly, this expectation amounts to no more than hope that something good happens.
Now, you might say, Isn’t that why people buy art work? Or precious metals and gemstones? Or real estate? Because they think they’ll be able to sell them for more later?
Of course they do.
The problem is, people don’t really understand that that’s why they’re buying shares in a company. They tend to buy shares because they think a particular issue is a “good company.” Also, people tend to hold onto hard assets like gold, gems, and real estate longer than they do stocks (although real estate flipping has, of course, been on the rise). The longer holding periods allow them to actually participate in the long-term gains in those assets. Individual’s stock market performance, on the other hand, is generally terrible.
As with so many other things, Keynes got here first when he described investing in the stock market as a beauty contest (The General Theory Of Employment, Interest and Money). But, it’s not a beauty contest where you pick the most beautiful contestant, but rather a beauty contest where you pick the contestant you think the other judges will pick as the winner. (Though I disagree with Keynes on almost all points, you have to give him credit for some of the best quotes among economists).
If you haven’t considered why, exactly, stocks “go up,” and you own shares, either directly or through mutual funds, you should spend at least a few minutes thinking about this. About the fact that whether consciously or not, you bought shares with the expectation that other people’s opinions about stock prices would allow you to sell for a higher price.
Now, I have to say straightaway here that I’m not immune. Though I follow a deep Value Investing strategy (both personally, and at Barrier Island Capital Partners), and I believe that I have a realistic understanding of what the true “value” of a company is, I’m still buying in the expectation that other investors will eventually recognize that value, too. My belief may be more grounded in reality than the average investor, but I’m still dependent upon other people to pay a higher price than I paid.
So, what’s the relevance?
Simply this: when you only own something because you expect other people will buy it from you for a higher price, since that’s how things have worked for a long time, you’re asking for trouble.
Like owning Netflix:
Netflix’s 52 week closing high was $691 per share, on November 17, 2021. Today (May 9, 2022), it’s trading for $174. Within the last (not quite) 6 months, Netflix has lost more than 74% of its value. Why? It’s part of an overall stock market decline, obviously, but NFLX has actually been a primary cause of the decline, or at least a trigger, rather than a victim. In essence, as people realized they had a declining appetite for risk, they simultaneously realized that they were extremely unlikely to find other people to buy their NFLX shares for a higher price. These people soon came to understand that when everyone has the same realization at the same time, no one wants to buy, for any price.
It’s interesting to contrast Netflix’s performance with the other stock that I’ve discussed here in Tactical Luddite: Ruger (RGR). Here’s the performance of these two companies since the day I opened my position in RGR (3/10/22):
It’s hard to see it there, but you’ll notice that NFLX is down 51.05% since March 10th. RGR is down 5.77%.
This issue of Tactical Luddite isn’t about trumpeting RGR as an awesome pick (hello, it’s down almost 6% since I bought it, after all!). It’s meant to start a conversation about the dangers of buying securities because you think there will be another buyer to take it off of your hands for a tidy profit.
Especially if you’re an individual investor and you use any kind of paid advisor (unless they’re paid only based on performance). Traditional commissioned financial advisors are famous for always believing that now is a great time to be long the stock market. Never, ever is this a more dangerous mantra than when stocks are at or near all-time highs (like in November of 2021).
Whether you invest on your own, or rely on an advisor of some kind, you should use the current downdraft in the stock market to develop a sound understanding of what it really means to invest in the stock market in the first place. Also consider the extent to which you’re dependent on other people’s willingness to pay higher prices for the stocks you own.
If you’re interested in learning about the specifics of Value Investing, I heartily recommend The Little Book That Beats The Market, by Joel Greenblatt. It gives a super simple explanation of Value Investing (as in, he explains it to a child). If you want a little more advanced information, consider reading The Intelligent Investor, by Benjamin Graham (Warren Buffet’s mentor). And, if you want an understanding of why these stock market blowups keep happening (and how the supposed “experts” are also caught off-guard), read The Black Swan, by Nassim Nicholas Taleb. Or anything else from Taleb, for that matter. (Note: I earn zero affiliate income from the links. I just think they’re great resources).
Let me know if you read any of them, or if you already have!
Until next time!