PODCAST 173
Safe Dividend Investing
Greetings to listeners all around the world. Welcome to Safe Dividend Investing’s Podcast # 173, on June 20th of 2024.
My name is Ian Duncan MacDonald. In today’s podcast, I will be answering 2 interesting investment questions.
The objective of my books, my website and my podcasts are to show all those seeking financial independence how to become informed, confident, successful, self-directed investors.
QUESTION #1
IS INVESTING IN IPOs A QUICK WAY TO GET RICH?
The idea of getting rich quickly has a great appeal. You may have been told by a friend that your best chance to get rich quick is to invest in a new stock that is about to be listed for the first time on a stock market. Your friend may be a speculator who is always bragging about the killing he is making on his stock investments. Which is a good thing because he may always seem to be short of money and maxed out on his credit cards.
It may have taken ten years to save the $100,000 that is now burning a hole in an investor’s pocket. It needs to be invested. Knowing little about investing you may approach a friend’s investment advisor and tell him of your dream to invest in a stock that is soon to be listed on a stock market for the first time.
The investment advisor will greet you with open arms and assure you that you have made an excellent decision. It just so happens that he can get you into a new stock at a low bargain price before it is listed on the NASDAQ. Once it is listed, he assures you it will double in price almost immediately. He says this new listing is going to be another Tesla or Microsoft.
You buy into this trusted investment advisor’s advice and agree to invest all $100,000 into this initial placement offering for a company called NXTSURETING. You pay $25 a share Being trusting, naïve and knowing little about investing or IPOs you open a trading account and transfer the $100,000 into it to pay for the 4,000 shares.
The day the stock is listed it climbs to $27.50. You have just made 10% on your investment. You are elated and sure you are on your way to doubling your money.
The second day the stock drops down $26.00. You are still ahead. Your investment advisor says this is not unusual. Stocks go up and stocks go down. He advises you to be patient. The next day it is down to $23. Within a week it is down to $2.50 You have now lost $75,000 of your $100,000.
The investment advisor says you can only lose if you sell your 4,000 shares and that it is just a paper loss and is sure to rebound. You still want to sell it. It is then that you learn that in the paperwork you signed for the IPO purchase you agreed to a “lock up period” of 25 days and until that ends you cannot sell your shares.
Why is the investment advisor not concerned about your loss? Because your loss has little impact upon his income. His bank was the underwriter for the stock issue. The agreement that they signed with NXTSURETING gave the bank a commission of 7% of the value of all the shares that they were able to sell at $25 before the company was listed on the stock market. The shares were sold to individual investors, pension funds, mutual funds and insurance companies. The bank has already made their money from which the investment advisor got his piece of the pie for selling the shares to you.
Well surely NXTSURETING is suffering because of the quick drop in the share price. No, they are not suffering. The bank and all the other banks who signed into the underwriting syndicate agreement were sharing in the sale of 20,000,000 shares at $25 each. It raised $500,000,000 for the company while only costing NXTSURETING an underwriting charge of only $35,000,000.
NXTSURETING executives are happy with the $465,000,000 that investors have given them. They can now afford to give themselves nice salaries, pay themselves bonuses for completion of the IPO, buy new company cars, and still have a millions to invest in the development costs that they need as a new company.
Even if they fail to earn one dollar in sales revenue for the next few years, they can still go merrily along as if they were a successful financially strong company listed on the stock exchange making profits. Eventually they may eat through the money raised by the IPO but today they will party as if tomorrow is never going to come.
Sometimes, those who bought the initial shares do come out well ahead in the IPO game, but it rarely happens overnight. For example, looking at historical records I see that Tesla first was listed on the stock market in June of 2010 for $1.59. Two months later the stock had dropped to $1.27. Two years later the stock was at $1.95. It did not start to really take off until 2014 when it was up to $15.72. In February of 2020, just before the market crash, it was at $57.22. The market crash had little impact on it as the shares rose to $302.20 by October of 2021. It reached its all-time high a few months later in 2021 when it hit $404.21. Three years later in 2024 it is currently down to $187.41.
How many of you were brave enough to put your life savings into a new stock called Tesla in 2010. How many of you would have held that stock after it dropped shortly after its initial listing. How many of you would still be holding it in 2012 when it was only at $1.95?
Human nature is such that that investors want to hold onto stocks that are climbing. They are not about to take a small gain and be satisfied when they expected to realize great wealth. If they do take their small gain and see the stock go from a few dollars to hundreds of dollars, they then kick themselves for not having held on to the stock. They vow and they will wait until they at least get double their money back on the next IPO they invest in,
It also works in reverse if a stock that has risen to $404 falls to $187, as Tesla has now done, shareholders are sure that Tesla will again double in value, and they hold onto it. Those that failed to get into Tesla in the early years will now buy the stock at its current $187. They are sure it will again rise beyond $404.
In a podcast about 2 years ago I said that Tesla would eventually be eclipsed by electric vehicles now being manufactured in China. These Chinese companies have now become the largest electric vehicle manufacturers in the world. They are selling EV cars in China for $10,000. Even with a proposed 100% tariff by the US government they could still undercut Tesla be selling electric vehicles at a profit in the USA for $20,000.
The assembly cost of constructing electric vehicles is a fraction of the cost of cars with internal combustion engines. Tesla, being first into that EV market, was able to charge a premium price and realize great profits. However, high profits are like bait for sharks. Monopolies in our capitalistic society do not survive for long. It shall be very interesting to see how long Tesla survives because like all businesses it too will eventually disappear.
The harsh reality is that no one can accurately predict future share prices. When a bank syndicate is underwriting an initial IPO, they are gambling that the initial share price is not too high to discourage IPO investors and will appeal to stock buyers once it is in play in the open market. Its IPO price must be high enough so the bank and the company being listed can make generous profits for their efforts.
The banks are gambling that on the day they list the stocks that no unexpected disasters or surprises that day, totally unrelated to the IPO sale will disrupt its launch. The IPO price is set just hours before it is listed for the first time.
It takes at least 6 months to put together an IPO. This preliminary work incurs several million dollars in expense to make the stock acceptable to the Securities Exchange Commission and to the listing stock exchange. After doing all that work and spending all that money it is possible for the bank to walk away from launching the IPO. They add a clause to their IPO agreement that allows them to cancel the IPO at the last minute if they have been unable to sell enough of the shares.
After the IPO launch there is usually a twenty-five day “quiet period” in which no new information can be released by the listing company or the bank syndicate. This makes it hard to react to any negative information surfacing that could drive the share price down just after the launch.
Obviously, you are a lot wiser than the investor in the NXTSURETING IPO. You would never put all your money into one stock. You believe in stock diversification. You recognize that with all the free investment information available there is no need to gamble on a stock without a track record of profits and stock market success.
I am sure all your investments are in financially strong companies with high operating margins, book values close to their share price, with low price-to-earnings ratios and who over the last 25 years have had ever rising share prices accompanied by ever rising dividend payouts. The kind of stocks with high IDM scores over 50 selected from the reference guide books “New York Stock Exchange’s 106 Best High Dividend Stocks” and in the “Canadian High Dividend Investing 215 Scored Stocks”.
Several well-known stocks like Etsy and Uber have had their share price drop quickly below their IPO listing price. I think you can see that an IPO is not a sure way to quick riches.
QUESTION 2
WHO SETS THE PRICES OF STOCKS TRADED ON A STOCK EXCHANGE?
There is no genius (or perhaps an idiot) sitting in a small room somewhere setting prices for shares of the 16,000 North American publicly traded companies on several stock exchanges. These 16,000 businesses represent far less than 1% of the 25,000,000 businesses operating in North America. So, who is it that determines, for example, that the price for Tesla is currently $187?
It is you, the investors who buy shares of these companies in the stock market. The stock market is not like a supermarket with a set price per pound for bananas. It is an auction house where whether you buy one share or one million shares of a public company, you must place a bid for those shares and hope that your bid is attractive enough for someone who owns that stock to sell it to you at your bid price.
Before you make your bid, you can see what the share price was when the stock market opened that day, what the last price was in its last completed share price sale today and you can see the highest and lowest bid it has been at so far on that day.
Usually share prices will change by only a few cents or not at all in the next few minutes. Your objective is to buy the stock at the lowest price from a seller. To do this you may price your bid just a few cents lower than the last bid. This is done with the hope that if the stock price is declining and you will catch it a lower price.
The bidding reverses when you are selling a stock. Now you want to get the most for your stock. You may then price you sell bid a few cents higher than the last sale.
The two big motivators for participating in this auction process are the fear of missing out on a rising stock which will increase your wealth and the fear of losing wealth if you do not sell a stock to retain your current wealth.
Is it possible to manipulate buyers of stocks to pay more for a stock than normal stock bidding allows? It is.
You will find the executives of some large companies taking billions of dollars from the profits of their company and buying shares of their company on the stock market at a higher price per share than investors are then paying for the stock. Such an action is called a stock buyback. It is meant to fool investors into thinking the stock is in great demand because the price is rising. A rising stock encourages investors to bid more for the stock than they would without the influence of the buyback.
This manipulation is often done by companies who give their executives stock options which allows them to buy the company stock at a set price a year in the future. If that set price is not exceeded the option is worthless because it makes no sense to buy the stock at the option price if it can be bought on the open market at a lower price.
These annual stock option grants are supposed to motivate executives to put in the extra effort that will result in such impressive profits for the company that investors will eagerly buy shares in that company at a higher price. If the executive efforts over the year are not sufficient to raise prices, then a buyback is interjected into the so-called free market system.
During the Great Depression in the 1930s, buy backs were seen as an illegal manipulation of stock prices and outlawed. This ban lasted until the 1980s when Ronal Regan passed legislation that once again made buybacks legal.
I personally stay away from companies who think buybacks are acceptable. Such companies are taking money that could have been paid as dividends to investors to reward them for their investment loyalty. Shareholders are the owners of the company and many of them want to share in the company’s financial success without having to be forced to sell their shares.
Taking the money from profits also removes money that could have been invested in new technologies and other improvements for the company that could keep the company ahead of its competitors. Investing in the infrastructure provides for long-term growth and stability.
I always like to invest in companies with steadily rising share prices accompanied by steadily rising dividend payouts. This to me is a sign that these companies are going to be providing me with a steady dividend income for decades to come. Often, such companies allocate 40% of the profits to dividends and 60% to capital improvements.
Since I live off my dividend income, seeing rising share prices without dividend payments insures, guarantees that I will not be investing in that company.
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