Zaks Investment Advisory Service

Common and preferred stocks

Last time, we started to talk about stocks and stock markets. But before we go on any further, I would like to take note of two recent pieces of news: one concerns the Chicago exchanges, and the other – stocks. First: Chicago’s two largest and rivaling stock exchanges for futures and options trading, the Chicago Mercantile Exchange and the Chicago Board of Trade, have decided to merge. Both were created in the 19^th century to trade agricultural futures. The combined exchange will become the world’s largest center of trade for derivate securities.

The second piece of news is that the Dow Jones index has for the first time broken through the 12,000-point mark. This piece of news is more of a curiosity that anything of great significance, since price averages for all stocks are still a long way off their records reached in 2000, especially if inflation is taken into account. Nevertheless, this developed is being discussed with great excitement by the press.

But let us get back to the subject of today’s program. So, what is a “stock?” A common stock is a contractual document that gives you the right to own a part of a company and, correspondingly, a part of its profits, including, for example, dividend payments. As the owner of common stock, you may also vote for the Board of Directors. The Board of Directors is selected by shareholders and is responsible to them. And the company chief – the president or the Chief Executive Officer – answers to the Board of Directors.

Investors earn a return from stocks in two manners: either when the stock price goes up and investor sells it at a price that is higher than the purchase price (something called a “capital gain”), or through dividends. Some companies distribute a part of their profits through dividends payments, but many do not, preferring instead to reinvest their profits into company development. The Board of Directors decides whether to make dividend payments based on the long-term interests of its shareholders, so the very fact the one company makes these payments and another does not is not that important in and of itself. Until recently, for example, Microsoft never paid dividends and then decided to start doing so. Usually, fast-growing companies prefer to reinvest their profits into development rather than making dividend payments. On the other hand, more stable but slowly growing companies usually do pay them.

I mentioned that being a stock owner, you are also a partial owner of the company. However, if a company goes bankrupt, all that you may lose is the value of your stock. Stockholders are not responsible for the company’s debts. This very important stock feature is called “limited liability.”

Of course, it would all be too simple if matters just rested with common stock. In reality, there is also something called a “preferred stock.” These differ from common stocks by having fixed dividend payments that the company is obligated to make, regardless of the circumstances. When a company is unable to make dividend payments on its preferred stock, they start to accumulate. When the company’s affairs improve, it first pays back the outstanding preferred stock dividend payments and then pays those due for common shares (if it has those payments to make). Moreover, if God forbid the company’s affairs turn completely sour and it goes broke, the holders of preferred shares will have the advantage over the common share owners by being able to make the first claims to the remains of the company’s assets during liquidation. But at the same time, preferred stockholders have no vote in selecting the company’s Board of Directors.

As we have already said, you buy stocks in hopes of earning a return. Companies sells stock in order to obtain capital. All growing companies need capital; the money they make in the initial stages of their development is usually not enough. Up to a certain point, companies grow using the initial capital investments made by the company’s founders, by using “venture capital” (more on that later), or by taking out small loans at the bank. But the time comes when a company needs additional capital to continue growing. If a company is successful, then one of its options is to issue stocks. In this respect, the stock exchange is one of the most fundamental instruments of our economy. It joins people that would like to invest money (and, accordingly, risk it) in order to earn a profit, with companies that need this money in order to continue their development. The process of issuing shares occurs with the help of investment banks through so-called initial public offering (IPO). You have probably heard about the famous Google IPO. IPOs occur constantly: last year, there were about 230 of them. These companies joined the several other thousand whose shares are traded on the US stocks exchanges. Unfortunately, several dozen public companies annually declare bankruptcy, too (there were 86 such cases last year), and their stock is eventually removed from trading: the companies either manage to claw their way back to life and issue new shares, or simply cease to exist.

The initial price of the stock is set by the investment bank, and after that the stock is bought and sold on the open market (exchange), where its price is determined by supply and demand. Not every IPO come off as successfully as Google’s, whose shares multiplies several times over after the IPO: the stock of Vonage, an Internet telephony company, fell on the secondary market after its IPO.

And with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.