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If you listened to the financial media or investing press, you might get the mistaken impression that making money from buying stocks is a matter of "picking" the right stocks, trading rapidly, being glued to a computer screen or television set, and spending your days obsessing about what the Dow Jones Industrial Average or S&P 500 did recently. Nothing could be further from the truth. It's certainly not how I run my own portfolio nor the portfolios that we control at my family's asset management company.
In reality, the secret to making money from buying stocks and investing in bonds was summed up by the late father of value investing Benjamin Graham when he wrote, "The real money in investing will have to be made – as most of it has been in the past – not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value." To be more specific, as an investor in common stocks you need to focus on total return and make a decision to invest for the long-term, which means at an absolute minimum, expecting to hold each new position for five years provided you've selected well-run companies with strong finances and a history of shareholder-friendly management practices.
That is the way real wealth is built in the stock market for outside, passive investors. That is how:
Still, many new investors don't understand the actual mechanics behind making money from stocks; where the wealth actually originates or how the entire process works. If you’ve spent a lot of time on the site, you see that we provide resources on some pretty advanced topics – financial statement analysis, financial ratios, capital gains tax strategies, just to name a few, but this is an important thing to clear up so grab a hot cup of coffee, get comfortable in your favorite reading chair, and let me walk you through a simplified version of how the whole picture fits together.
To raise money for expansion, the company’s founders approached an investment bank had them sell stock to the public in an Initial Public Offering, or IPO. They might have said, “Okay, we don’t think your growth rate is great so we are going to price this so that future investors will earn 9% on their investment plus whatever growth you generate … that works out to around $11,000,000+ value for the whole company ($11 million divided by $1 million net income = 9% return on initial investment.)” Now, we’re going to assume that the founders sold out completely instead of issuing stock to the public (for an explanation of the difference, see Investing Lesson 1: Introduction to Wall Street.)
The underwriters could have said, “You know, we want the stock to sell for $25 per share because that seems affordable so we are going to cut the company into 440,000 pieces, or shares of stock (440,000 shares x $25 = $11,000,000.) That means that each “piece” or share of stock is entitled to $2.72 of the profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per share.) This figure is known as Basic EPS (short for earnings per share.) In other words, when you buy a share of Harrison Fudge Company, you are buying the right to your pro-rata profits.
Were you to acquire 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated. If you thought that a new management could cause fudge sales to explode so that your pro-rata profits would be 5x higher in a few years, then this would be an extremely attractive investment.
What muddies up the situation is that you don’t actually see that $2.72 in profit that belongs to you. Instead, management and the Board of Directors have a few options available to them, which will determine the success of your holdings to a large degree:
Which is best for you as an owner? That depends entirely on the rate of returnmanagement can earn by reinvesting your money. If you have a phenomenal business – think Microsoft or Wal-Mart in the early days when they were both a tiny fraction of their current size - paying out any cash dividend is likely to be a mistake because those funds could be reinvested at a high rate. There were actually times during the first decade after Wal-Mart went public that it earned more than 60% on shareholder equity. That’s unbelievable. (Check out the DuPont desegregation of ROEfor a simple way to understand what this means.) Those kinds of returns typically only exist in fairy tales yet, under the direction of Sam Walton, the Bentonville-based retailer was able to pull it off and make a lot of associates, truck drivers, and outside shareholders rich in the process.
Berkshire Hathaway pays out no cash dividends while U.S. Bancorp has resolved to return more 80% of capital to shareholders in the form of dividends and stock buy backs each year. Despite these differences, they both have the potential to be very attractive holdings at the right price (and particularly if you pay attention to asset placement) provided they trade at the right price; e.g., a reasonable dividend adjusted PEG ratio. Personally, I own both of these companies as of the time this article was published and I’d be upset if USB started following the same capital allocation practices as Berkshire because it doesn’t have the same opportunities available to it as a result of the prohibition in place for bank holding companies.
Now that you see this, it’s easy to understand that your wealth is built primarily from:
Occasionally, during market bubbles, you may have the opportunity to make a profit by selling to someone for more than the company is worth. In the long-run, however, the investor’s returns are inextricably bound to the underlying profits generated by the operations of the businesses which he or she owns.
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