Investors often have a miserable time. That’s been especially true these last few years. Stock markets have been toing and froing, but going nowhere in the end. People who were hoping to grow their retirement savings by buying shares ended up losing money instead. Even when they’re making hay, many people feel like a fish out of water with their money in the stock market. A big part of that feeling is a lack of understanding. What is investing really all about? What earns investors their return?
Investing isn’t a zero sum game. It’s not about some idiot on the other side of each trade. It’s not magic or a conspiracy either. It’s the process of wealth creation.
More on what that means, and how to make money from it, in a moment. But first, it’s important to understand that most of what people now call investing doesn’t live up to the name. Consider the thought process a typical investor goes through when choosing a stock to pour their savings into.
‘Should I buy Commonwealth Bank of Australia (CBA) shares? They’re trading at a P/E of 14. And the price has reached new highs since the onset of the financial crisis. What about BHP with its P/E of 13, EPS of 2.897 and P/B of 3.07?’
Most investors get caught up in questions and analysis like this. Whenever they find themselves with cash to invest, they go hunting for an undervalued stock, or a company with a good looking chart. They’re trying to pick the stock that goes up in price. But all of this just isn’t what investing is really all about. And, to be honest, it’s making life far too difficult for yourself. You’re dealing in too many metrics that are too difficult to understand, especially if you’re not interesting in stock tipping as a full time job.
So what’s the simple, understandable and profitable alternative? Well, while most investors were pondering on their next punt, on Wednesday ASX listed Indochine Mining Limited (IDC) raised around $7 million dollars from investors. The money will be used to fund its gold drilling operations in Cambodia and PNG. It will go to replacing drilling equipment and paying miner’s salaries. Would you give your money to this company in exchange for a share of its ownership?
That sounds like a much more straight forward proposition than CBA’s PE ratio and BHP’s EPS, right? You know what the money is for, and where it will go. Most importantly, you can understand whether those activities have a chance of paying off. If IDC finds gold, your money will have been put to good use. The share price of IDC will rise and you’ll make a profit.
Now that’s investing! It’s simple, understandable and avoids all the finance babble that makes you feel like you’re outside your comfort zone.
The Next Stock You Buy
The next time you find yourself with excess cash and looking for a quality investment, try a whole new angle. Shift your mindset to this way of thinking: Investors have to fund productive investments to get a return. You have to be involved in achieving something of value. That’s what earns you a return.
In other words, invest like an entrepreneur.
Sure, you could make money as a speculator. Gambling on which stock goes up can make you wealthy. But you can do the same thing at a casino. If you’re going to spend time on real investing, and you want to make a big buck, you should focus on creating value.
The investor’s part in the process of ‘creating value’ is to fund projects that will deliver something of value to customers. In a simple economy this is easy to understand. It means using your savings to set up your business and then running it yourself. Whether it’s a shoe shop or a bookstore, you are doing it all yourself.
The modern economy splits up the process. The people who fund the business by providing capital are different from those who run it and those who work in it. Don’t let that confuse you though. The effort is still a combined one where each person is involved in creating something of value. But what does that even mean?
Only businesses that create value will be successful. Where does that value come from? Well, the factors at play are cost and price. If you can create something at a cost which is lower than the price people are willing to pay, you’ve created value. Combining apples and pastry at a cost of $1 can create an apple pie worth $10. That’s $9 of value created for the customer, and $9 of profit for you.
Entrepreneurs look for opportunities like this. They seek to bridge the gap between cost and value. The difference is profit. And that profit is what feeds your return as an investor too. Without it, your investment won’t make you money.
It’s worth noting that when you produce something at a loss, that’s the economy telling you you’re wasting resources that could be used better somewhere else. That’s the great thing about capitalism and the profit system. Personal interest is aligned with trying to use resources in the best way to serve customers.
As the financial world has increasingly focused on speculating, this relationship between self-interest and serving customers has broken down. Investment banks used to be about the good investment process we’re describing – creating value. But that’s another story.
The line between investment and speculation gets obfuscated in the stock market we hear about every day. People have completely lost touch of the link between investing and being entrepreneurial. They care about how much the All Ords is going up or down, not how much capital companies raised to create new factories, jobs and products for their customers.
The thing is, that might just mean there’s an overlooked investment opportunity in the making. But where?
An Investment Market for Entrepreneurs
The stock market exists to raise capital for growing businesses. Well, that’s why it’s supposed to exist. But only a small fraction of its goings on actually relate to raising capital. There is a very good reason for this.
Would you invest in something if you weren’t sure you could sell out easily, quickly and at a fair price? You’d probably be willing to invest far less of your wealth. The secret of the stock market is that it makes it easy to cash out on your investments when you need to. That allows people to invest far more, which should mean a better economy if the cash is used well.
Buying and selling investments between investors is called the ‘secondary market’. The ‘primary market’ is when investments are created to raise money for businesses. Both the primary and secondary market are part of the stock market, it’s just a different type of transaction. Without the secondary market making it easy for investors to sell out, the primary market wouldn’t function nearly as well.
The problem is, all the focus is on the secondary market these days. People care about stock market prices, not capital raisings. But there are plenty of reasons to focus on better opportunities in the primary market.
What are some examples of investing in the primary market? The obvious example is an IPO, or Initial Public Offering. This is when a company wants to raise capital to invest and so it issues shares on the stock market. ‘Issues’ is the key word here. When a stock is issued, that’s not the same as selling it. Issuing is the creation of a share. The cash you hand over when you buy an issued share goes to the company, not a previous investor. And the company uses that cash to grow its business.
There are other ways of participating in the primary market. Companies often raise more capital once they’ve been on the stock market for some time. They do this by issuing more shares to willing buyers. That’s the opportunity this article will focus on.
Cheap Investment Pickings
You see, when a company announces it will issue shares, that usually causes its share price to crash. People panic because more shares mean each share’s claim on the company becomes smaller. Imagine a company worth $10 with 10 shares. Each share is worth $1. If the company issues another 10 shares, each share will now only be worth $0.5. That’s a 50% drop in price for the owners of the original 10 shares. The thing is, this crash in the price is often unjustified.
If the company uses the new money it obtained from investors who ‘bought’ the newly issued shares in a profitable way, like buying a machine that increases production, that could make the company worth more. Let’s say it makes the $10 company worth $25. Each share would now be worth $1.25, even though there are more of them. That’s a 25% return for investors who invested at $1, which is pretty good.
But here’s the better opportunity. Because share prices tend to fall when a company issues more shares, the company has to issue those shares below the market price. Otherwise, people won’t be willing to buy them. So say they issue the new 10 shares at $0.75, which is below the $1 price the original 10 shares were trading at. Investors who buy these newly issued shares at that price would make a 67% return if the company grew in value to $25 as described above.
Now this example is a simplified and optimistic one. There are risks to investing in the primary market. We’ll get to some in a moment. But it’s interesting to keep in mind that these risks are slightly different to the ones you face in the secondary market. The risks you face in the primary market are the kind of risks that an entrepreneur faces. That might sound like a wishy washy thing to say, but it really does matter.
When you hand your cash over to the company you are investing in, rather than buying a share off another investor, you can see your cash being put to work. The company will use the cash to employ people, build a factory, buy a machine, and so on. The money is put to work doing something. When you buy a share off another investor, that cash goes into … well, who knows where it goes. There is some genuine non-monetary value in investing in projects that create something, rather than shuffling cash around between investors. But it’s also a profitable strategy done well.
The Risks and Opportunities of Investing in the Primary Market
So what are some of the specific risks to investing in the primary market? Well, companies don’t just raise capital to invest in good projects. Sometimes they make bad investments, or use the cash to pay off their debt. In other words, the new cash won’t be generating a return if it’s poorly used. And that makes those shares a poor investment to make.
Most of the world’s banks are going through a process of trying to raise more cash to make their business less risky. In fact, new international regulations called Basel III are requiring them to do so. The new cash won’t be going to new loans, which means it won’t be used profitably. That’s the kind of capital raising you should avoid. It can take some time to sift out these kinds of bad eggs. But it’s possible.
The next time you hear about a company’s share price falling because it announced a capital raising, why not take a look at what they plan to use the cash for? Will they be paying off debt, covering up poor decisions of the past, or using the new capital to generate new profits? If you’re optimistic about the management’s ability to use the cash well, why not take advantage of the opportunity to buy a stock on the cheap?
Perhaps the most important thing to keep in mind is that, if you can’t understand where your precious money will go, don’t invest. That’s the biggest lesson we learned from Warren Buffet, by the way. It’s not his understanding of balance sheets and profit and loss statements that makes him great. It’s his ability to understand what a business will do with the money he invests.
Imagine making an investment decision where you understand what’s going to be done with your money. How would that make you feel about your investment decision? A lot more confident and at ease. You’d understand that you made your investment decision based on whether you expect a business to create value, not whether its PE ratio, EPS and P/B value are enticing.
Always remember, just because you are only participating in the investment part of the process of running a business, that doesn’t mean you should be removed from what investing is all about. It’s about funding efforts to create a profit by serving customers. You can only do that in the primary market. And you can still do it at a profit.
Stay on the lookout for those capital raisings.
Editor, The Money for Life Letter
P.S. By the way, there’s an even better way of participating in the primary market than a capital raising. Actually, it’s probably not even called the primary market, but the effect is the same. It allows you to steadily invest in newly issued shares of the companies you already own. Best of all, you don’t actually have to pay for the newly issued shares.
That probably sounds a bit odd. But it’s incredibly profitable. Investors who used this strategy on ANZ turned a $10,000 investment into a $10,000 a year dividend payment!
To find out what the strategy is, how it works, and which four stocks make ideal investments for you to use it, just watch this video.