often raise funds through the sale of stocks. Unlike bondholders, who are creditors of the corporation, stockholders are its owners. This entitles them to a share of the potential profits, when and if the board of directors elects to distribute them.
Common and Preferred Stock. All corporations issue common stock, but some also issue preferred stock. Common stockholders receive a share of the profits and have a voice in a corporation's management. They are entitled to vote during the election of a board of directors. But preferred stockholders usually do not have voting rights. Instead, preferred stockholders receive preferential treatment in two ways: 1) they receive a specified dividend before dividends are paid to common stockholders, and 2) they receive their share of the assets ahead of the common stockholders if the corporation is liquidated.
The XYZ Corporation has issued 100,000 shares of common stock and 50,000 shares of $5 preferred stock (stock that pays $5 in dividends). Last year the board of directors declared dividends of $500,000. $250,000 of this sum went to the preferred stockholders (because 50,000 x $5 = $250,000). The rest of the money went to the common stockholders, who received $2.50 for every share of stock they held (because $250,000 -400,000 = $2.50). This year, the company lost money (it earned no profits). Therefore, the board of directors had to decide whether to:
• pay the preferred stockholders a dividend out of savings and skip paying a dividend to the common stockholders,
• pay their regular dividend to the preferred stock-
holders and another dividend to the common stockholders out of savings, or
• skip paying dividends to both the preferred and
The board chose the third alternative.
Buying and selling open corporations' corporate securities (stocks and bonds) takes place in a "stock market" or "bond market." The attention given to the stock market by radio, TV, and the newspapers is evidence of the interest in stock ownership. So, too, is the fact that more than 47 million people now own stock in America's corporations.
Protecting the Investing Public. The Securities
and Exchange Commission (SEC), an agency of the federal government, is responsible for protecting investors in the sale of securities. It operates on the principle of caveat emptor, a Latin phrase meaning "let the buyer beware." In applying this principle, the SEC requires corporations to provide the public with essential information about their operations and finances in a prospectus. A prospectus is prepared for any new issue of securities. It contains important information about the company selling its stock or other securities and describes the risks involved in purchasing them. Having done that, the SEC lets investors determine whether to buy the security.
How Stocks and Bonds Are First Offered to the Public. Corporations sell stocks and bonds (securities) as a way of raising capital. Once a corporation decides to sell its securities, it will look for a firm willing to buy the entire issue and sell it to the public. The securities firm underwrites -advances the agreed-upon price for the stocks or bonds to the corporation -then sells the securities to the public. It makes a profit if sales go well, but must absorb any losses if sales are weak. Often a securities firm will join with other similar firms to spread its risk by forming a syndicate to sell the stocks or bonds.
Securities Exchanges and the Over-the-Counter Market. Proceeds from the sale of new stocks and bonds go to the companies issuing them. After that, sales are handled either in a securities exchange or the over-the-counter market. When stocks and other securities are sold in a market, the proceeds go to the sellers, or brokers, not the corporation.
A securities exchange is a market where brokers meet to buy and sell stocks and bonds for their customers. Securities exchanges list the securities of approximately 3,000 of the nation's largest publicly owned corporations.
Largest of the securities exchanges are the New York Stock Exchange and the American Stock Exchange. The New York Stock Exchange handles about 80 percent of all securities transactions; the American Stock Exchange handles 10 percent. The remaining transactions are made at many regional exchanges located around the nation.
If you want to buy or sell corporate securities, you will probably call on the services of a local brokerage firm. An account executive (salesperson licensed to sell securities) would take your order and transmit it to the company's representative on the floor of the exchange. The exchange works like an auction. Brokers representing buyers and sellers bid against one another for the best possible price. The process of buying or selling securities is summarized in Figure 6-4.
The over-the-counter market consists of brokerage firms around the nation that buy securities of smaller, unlisted firms and sell them to the public.
There are more than 40,000 corporations whose securities are traded over the counter.
Investing and Speculating. Those who buy stocks to share in the profits and growth of a corporation for a long time are described as investors. Those who buy or sell stocks to earn a fast profit are known as speculators.
Investing in Corporate Stocks. Investors share in a corporation's profits by receiving dividends. In addition, if the corporation prospers over the years, its stock will increase in value. Investors will be able to sell the stock for more than they paid for it and earn a capital gain or profit from the sale.
Speculating in Corporate Stocks. Stock market speculators fall into two groups. One group, commonly known as bulls, hopes to profit by correctly predicting an increase in the value of a stock. The other group, bears, hopes to profit by correctly predicting a decrease in the value of a stock.
Bulls are said to "buy long." That is, they buy stocks intending to hold them until they can be sold at a higher price.
Brent Brahma thought that the stock of the ABC Corporation, then selling at $5 a share, would soon increase in value. He told his broker to buy 200 shares. Two months later, the price of ABC stood at $6. Mr. Brahma told his broker to sell his shares. Before subtracting the commissions that he had to pay his broker, Brahma made a profit of $200. Had the price gone down to $3.50 a share at the time he sold, he would have lost $300.
Bears "sell short." Expecting the price of a stock to fall, bears borrow the stock from their brokers and sell it at today's price. If and when the price does fall, they buy back the stock at the lower price, return it to their brokers, and pocket the difference. The broker is paid a fee for these services.
Grace Grizzly feels that the stock of the DEF Corporation is due for a fall. DEF is currently selling for $13 a share. She instructs her broker to sell 300 shares of DEF short. Grizzly's broker lends her 300 shares of DEF which she then sells for $3,900. Two weeks later DEF is selling for $10 a share. Ms. Grizzly tells her broker to complete her transaction. The broker buys back the 300 shares of DEF (that had been loaned to Grizzly) for $3,000. As a result of her short sale, Grizzly has earned a profit of $900, less brokerage fees. If, instead of falling, the price of DEF had risen. Grizzly would have lost money.
Buying and Selling Corporate Bonds. When a corporation sells its bonds to the public, it makes two important promises: to pay the bondholder a fixed rate of interest for a specific number of years and to repay the face value of the bond when it conies due.
The sale of bonds is handled in the same way as the sale of stocks. Corporations needing capital sell their bonds to underwriters for a fixed sum. The underwriter then sells the issue to the public. Once the bonds are in the hands of the public, future sales are handled by the stock exchanges and the over-the-counter market. As with stocks, the market value of bonds depends on supply-and-demand conditions at the time. Individuals thinking of investing in corporate bonds should compare the safety and yield of those securities with those offered by thrift institutions. There is some risk of default (failure to pay interest or principal) on the bonds of even the strongest corporations, while most checking and savings accounts are government insured.
Mutual Funds. How do you know which stocks to buy?
Once you've bought them, don't you have to keep an eye on them? How would you know when to sell your stocks?
In fact, no one really knows the best stocks to buy or exactly when to sell them. For that reason many people invest in mutual funds. Mutual funds are corporations that sell stock and use the proceeds to invest or speculate in the securities markets. Because they work with large sums of money, they can afford to buy many securities, to spread the risk of investment. Risk is spread because a loss in one or two securities would, hopefully, be offset by gains in the others.
The mutual funds also can afford to hire professional
managers to look after their investments.
Mutual funds vary from one another in terms of their objectives, costs, and performance.
• Objectives. Some investors are interested in long-term growth, others want to earn the greatest possible return now, while others are interested in safety and stability. Mutual fund managers mon stocks, longer-term bonds, or a combination of the two.
• Costs. Some, but not all, mutual funds charge a fee when they are bought or sold. In addition, all deduct an annual fee for their services. The amount of these fees varies from one fund to another.
• Performance. Some mutual funds achieve their objectives more successfully than others. As an investor, it is possible for you to study the performance of these funds just as you can study the performance of businesses listed on the New York or American Stock Exchanges.
But how can investors obtain the information they need to make investment decisions-in a mutual fund or in a company? The truth is that there is a tremendous amount of information available. Your local library has magazines such as Fortune and Business Week filled with information about business and the stock market. The Wall Street Journal publishes useful information about the market every day, and references like Value Line provide detailed information about specific companies. Whatever sources you explore, they are likely to include information from technical financial reports, balance sheets, and income statements.
The final section of this chapter will describe these reports, and an exercise in the Study Guide will help you learn to interpret them.