Most readers have traded common shares of individual companies.
The main method is to buy and sell shares on the open market through a brokerage account.
However, you can invest in public companies using other means. Many investors acquire common shares through public offerings, direct stock purchase plans, dividend reinvestment plans, employee stock purchase plans, and warrants. Often, these methods can be excellent ways to save costs, while building your investment portfolio.
Public Offerings
Investors may acquire shares through a “Direct Public Offering” or “public offering”.
Companies that go public for the first time have an “Initial Public Offering” (IPO) for its shares.
Existing public companies may have “Subsequent Public Offerings” or “Follow-On Public Offerings” when issuing additional shares to the public. You may also see other derivations of these terms.
In my experience, public offerings have mixed results for small investors.
Stock offerings have a maximum number of shares issued. If the offering is popular, there is a good chance that it will be fully or over-subscribed (more investors want shares than are being offered).
In the investing realm, large investors (mutual funds, pensions, wealthy individuals, etc.) are usually accommodated to a greater extent than small. For popular offerings, you may not be able to get any or all of the shares you desire.
If there is greater demand than supply, investors that cannot purchase all their shares in an IPO may do so on the open market once the shares begin trading.
Use caution if you follow this strategy. As with everything, when there is excess demand, prices rise. The greater the excess, the higher the price shoots until equilibrium is reached.
For very popular issues, the share price may rise simply on the excess demand and not on the company’s fundamentals. When this occurs, it is common to see the share price increase rapidly above the issue price in the initial few days of trading. It is also typical in these circumstances to look at the share price a year later and see that it has fallen significantly to reflect reality, rather than hysteria.
For example, The Blackstone Group (symbol: BX) issued an IPO in June of 2007 at $31 per share. Shares traded between $34.25 and $38.00 and closed at $35.06 on June 22, the initial day of trading. If you had been part of the IPO at $31, you could have earned between 10.5% and 22.5% (before transaction costs) in one day. A very nice return.
However, if you were one of the investors who had scrambled to buy this stock in the open market on June 22, your returns might have been a little different. One week later, at the end of June, your shares were only worth $29.27. At the end of July 2007, $24.01. The end of August 2007, $23.13. And so on.
After an initial frenzy, the shares settled back to where the fundamentals indicated they should trade. As for fundamentals, we shall look at this topic when reviewing how to analyze stock.
Over time, Blackstone shares have had ups and downs. As low as $4.51 in January 2009. As high as $43.80 in April 2015. In December 2016, Blackstone traded just under $30.00. Had you bought in the IPO or on the initial trading date, you would hold an unrealized capital loss after all this time. Not as nice as flipping the IPO immediately.
Yes, there are many examples where the IPO kept going up in price. This further complicates the issue of small investors buying IPOs once they begin to trade.
When investors bought Blackstone on the initial trading day, every one of them believed they were buying the next Alphabet Inc. Better known as Google (symbol: GOOGL). Google issued its IPO in 2004 at $85 and closed its opening day at $100. Over the next 52 weeks, Google never traded below $100. It traded at $280 a year later, and sat in December 2016 at $808. That also does not factor in the 2014 stock split which brought shareholders substantially more value.
But it does not work out this way very often.
When buying an IPO or shares in the open market, do not pay for the excess demand. Always buy based on facts, not hype. You may miss out on a few Googles, but you will also avoid purchasing the many Blackstones.
As an aside, Blackstone is a decent company. A reason I chose it here. Easy to take a fly by night company selling vapour-ware and see why it fell from favour. But plenty of real and profitable companies whose shares still suffer from IPO over-enthusiasm. Every stock looks very promising at IPO time. Be careful.
Open Market Purchases
Most investors buy and sell shares on the “open market”. Also known as the “secondary market” or “aftermarket”.
The open market may be a formal stock exchange (e.g., New York Stock Exchange [NYSE]) or “over the counter” (OTC).
OTC shares trade via a dealer network and not on a formal exchange. OTC stocks may also be called “unlisted” shares.
To purchase shares on the open market, you require a brokerage account. Further, you need to ensure that the brokerage house where you have your account is entitled to trade shares on the markets you desire.
For example, I use one on-line broker that allows me access to all major Canadian and US stock exchanges. But they do not have access to exchanges outside North America. I must use another broker to trade equities in Europe and Asia.
I believe most investors should trade via low-cost, on-line accounts. I see little value, for most investors, in using premium, full-service brokers. Your bank likely offers relatively easy to use on-line brokerage accounts.
Online brokers tend to offer adequate products and services to meet most investors’ needs. It is not difficult to trade on your own via your own bank. Just be wary if they try to “help” you purchase their own in-house products.
Direct Stock Purchase Plan (DSPP)
DSPPs allow individuals to purchase shares directly from a company (or transfer agent).
The benefit of DSPPs is that investors can acquire shares without paying a commission on the transaction. In today’s low cost on-line broker world this is less important, but every penny saved is useful in compounding returns for future growth.
A potential downside of DSPPs is that usually there is a minimum purchase amount. This may be higher on the initial purchase and then lower for subsequent acquisitions.
Employee Stock Purchase Plan (ESPP)
If you work for a public company, you may encounter an ESPP.
ESPPs allow eligible employees to acquire company shares with no transaction costs. Even better, the shares are normally offered at a discounted price to market value. This can be a very nice perk for staff.
The discounted share price incentivizes employees to invest in their company versus other investment options.
In return, the company has shareholder employees with a vested interest in the firm’s performance. As such, staff will work harder to ensure that the company does well financially and that its share price increases. Well, that is the idea.
Some ESPPs have restrictions on selling shares (e.g., an initial period of time where shares cannot be sold), but often there are no restrictions on trading. Also, depending on the discount value, there may be tax implications at purchase.
Dividend Reinvestment Plan (DRIP)
DRIPs are also helpful in avoiding commissions. One of my favourite investing recommendations.
DRIPs allow investors to reinvest any cash dividends, they are eligible to receive, into additional shares of the company. Often this results in the purchase of fractional shares based on the dividend amount.
DRIPs are nice as they help investors (hopefully) compound investment returns by adding to their existing shares in the company. The additional shares, in turn, result in their own future stock dividends, and so on throughout the future.
DRIPs are an easy way to invest. Without thinking or acting, you automatically acquire additional shares of the company.
One problem with DRIPs is that, in most countries, you are taxed on the dividend as if you received the cash.
For example, you are entitled to receive a dividend of $1000 that is reinvested in additional shares of the company. You receive shares and not cash. However the tax man usually still wants his share of your earnings. If you have a 30% marginal tax rate, you must find $300 to pay for tax on income you did not actually receive.
Another thing to watch with DRIPs (and other investing methods that make automatic purchases) is the lack of thinking required. When using DRIPs you need to still assess the investment potential of the dividend.
Perhaps you are entitled to a $5000 dividend from Omega corporation. You have the option of a cash dividend or stock dividend. Omega shares are expected to return 10% over the next year and carry a risk of 5%.
If you take the DRIP, you may earn 10% on your shares (and the stock that you received in lieu of a cash dividend). But perhaps you analyzed other investments and found Alpha company with the same 5% risk, but an expected return of 20%. If you received a cash dividend from Omega, you could have bought Alpha shares instead.
DRIP programs can be useful, but do not fall into the trap of blindly reinvesting in underperforming shares. Always look at where your income is being invested. Ensure it is the best investment for you, not simply the most convenient.
Note that with Omega, you could sell shares equal to the stock dividend and then use the proceeds to buy Alpha shares. But then you will incur transaction costs and possibly capital gains tax payable.
Warrants
Warrants are issued by companies, usually as a sweetener to an offering.
Warrants give holders the right to purchase shares from the company at a certain price for a specified period of time.
Warrants are much like call options. Both can be traded separately in the secondary market.
Also, options and warrants fluctuate in price based on the value of the underlying shares relative to the exercise price of the warrant/option and the time remaining until expiration.
However, options are not issued by companies. They are exchange traded instruments created by other investors.
As well, most options expire in under one year, whereas warrants may not expire for years.
I include warrants in this section as warrants are often exercised and company shares received by the warrant holder.
I do not include options here as almost all common share option contracts are closed out for financial consideration (assuming they are “in the money”) prior to expiration. There is no actual exchange of shares between the counterparties.
We will look at options, in brief, in the future.
