To see through the noise of the markets, it’s important to understand why owning a stock is like owning a gold coin…
We’ve been getting a lot of great comments from readers lately talking about how they are handling this market.
Some know they own great stocks, so simply holding those positions is the key.
Others see this as an opportunity to add to positions because they see the long-term opportunity.
A few are glad to simply be reminded that market downturns don’t last. They all have an end date, after which stocks resume their upward trend.
But one comment, in particular, made a core point about stock investing.
One that everyone should understand to see through the noise of the markets more clearly.
And with the markets taking everyone for a ride, I’m going to use this comment to help anchor everyone in the basic reason to own stocks in the first place.
The comment came from Mike S., who wrote:
“Owning a stock is kind of like owning a gold coin, the price can and will go up and down but that doesn’t change the fact that you still have a gold coin, wait long enough and the price will change.”
Spot on comment, Mike! Owning a stock is like owning a gold coin.
But what exactly is that gold coin?
What is the thing that you own that doesn’t change with the stock price?
Well, the thing that is like a gold coin is the very point of equity markets.
What It Means to Own a Company’s Capital
Stock gives you equity – or ownership – in a company.
Ownership means you own the company’s capital.
And capital is the part of the company that actually makes you money.
The term capital gets thrown around a lot, and it’s not always used to mean the same thing.
But, for today, this is what I mean by capital.
Broadly defined, capital is anything you own that can be used to make money.
It includes things like the land, buildings, machinery, or trucks that a company owns or leases.
It’s the sum of a company’s research and development expenditures to develop patents, new products, and trade secrets.
It’s the exploration, mining, and drilling that’s used to develop resources.
It’s the marketing and advertising that builds brands.
And the knowledge base of its employees.
These things, and more, make up a company’s gold coin.
These forms of capital are the result of investments that a company makes to produce a return.
This is what you own when you buy a stock.
And these things endure.
Like a gold coin, it’s very hard to wipe them out.
But better than a gold coin, capital has a tendency to build upon itself.
Just look at capital formation for publicly traded companies around the globe in the chart above.
This goes back to 1996. And you can see that year after year, recession or not, capital steadily builds.
Investments that companies make accumulate and get refreshed. Those investments in capital produce a return that gets reinvested, expanding the capital base.
In fact, since the end of the Great Financial Crisis, around the world, that base has been growing at a steady rate of 7% per year.
When you buy a stock, you don’t just pay for the capital. You pay a premium on the cost of that capital to earn the returns that capital generates.
We’ve added that premium to the chart below. The blue area on top of the capital is how much you are paying for stocks in excess of that capital.
And despite all the moving around that stock prices do, capital is unaffected.
It goes along generating profits. And the way stock prices move around, it sometimes lets you pick up those profits for cheap.
Also, you should know that this chart covers a time frame that includes the Asian Financial Contagion of the late 1990s, the tech bubble bursting and 9/11, the Great Financial Crises of 2008 and 2009, and COVID-19.
And always, through every downturn, stocks maintained their premium to capital.
I’d call capital the floor, but it’s a floor that stock prices never reach. The floor is far above that.
In the chart above, I’ve zoomed in on United States markets.
Note that, for U.S. companies, the capital base has grown steadily at about 8% per year, despite ups and downs.
When markets get spooked, stocks sell off.
But they quickly reach a point where the fear has faded, the bargain is too big to ignore, and they shoot higher.
And that’s what is happening today.
Have we reached that point yet?
I don’t know.
It’s unprecedented – but then again, financial crises always are. The cause is always different, we react and learn, and we move on.
But the point is that the damage to your long-term financial health, while nerve-wracking, is superficial.
Capital, the thing that pays the owner a return, endures – just like gold.
It is equipment, patents, and know-how – and those things last bubbles, bad banks, and viruses.
And when the markets take their inevitable downturn, it’s your opportunity to own that capital on the cheap.
If you’d like to learn more about how the coronavirus is affecting the cannabis market, check out my recent article, “Why Cannabis Stocks Are the Best Defensive Stocks.”
Don Yocham, CFA
Executive Director, National Institute for Cannabis Investors
4 responses to “This Is the Point of Owning Stocks”
March 17 2020