When markets are tumbling and the financial media are pumping out one scary headline after another, it's easy to lose sight of what those two- or three-letter stock symbols in your brokerage account actually mean.
If you think a stock is just a piece of paper or collection of pixels on your computer screen to be bought and sold in the hope of making a profit – or, in the case of this week's exceptionally volatile trading, avoiding a loss – you're missing the point.
When you hold shares of a company, you are a part owner of a business. As a stockholder, you are entitled to share in the earnings the business generates. The earnings might be paid out as dividends or reinvested in the business to produce even more earnings down the road.
It's a simple concept, yet many investors don't think like business owners at all. They think like traders. Instead of focusing on the underlying health of the company and the long-term trajectory of its earnings – which is what really matters – they obsess about short-term movements in its stock price.
Why? Well, because they can. Thanks to modern technology, investors can trade part interests in businesses by clicking a mouse or pushing a few buttons on a smartphone. It takes longer to buy a coffee at Tim Hortons than it does to trade 100 shares of its parent company, Restaurant Brands International (QSR) – a transaction whose dollar value is nearly 5,000 times as large. Further stoking the short-term mentality of investors, the stock-market records, second by second, the price of every trade and broadcasts it to the world.
A liquid marketplace is necessary, of course, but it can also encourage self-defeating behaviour.
Imagine that, instead of owning shares of a publicly listed company that you can trade on a whim, you own a small business or a rental apartment building whose earnings have been growing more or less steadily over the years. You wouldn't be able to look up the market price of your business in real time because there is no mechanism for doing so. And you almost certainly wouldn't pick up the phone and list the business for sale just because you heard that other businesses were suddenly selling at lower prices than before.
Yet, that is exactly what some investors do when they're rattled by a 1,000-point sell-off on the Dow and their portfolios are bathed in red. Instead of focusing on the long-term potential of the businesses they own, they try to head off short-term losses in their share prices. This may make them feel better temporarily, but it's the wrong way to build wealth.
One way to avoid this trap is to focus on a company's earnings and dividends. Even as markets were spiralling lower this week, many companies were reporting solid earnings and raising their payouts to shareholders.
Consider BCE Inc. (BCE). The telecom giant reported better-than-expected results for the fourth quarter, including the addition of more than 175,000 postpaid wireless customers – the best performance in 15 years. BCE also raised its dividend by 5.2 per cent, extending a long string of annual increases. Despite all of this positive news, as of Friday afternoon, BCE's shares were down on the week after a brief rally fizzled.
Plenty of other companies also raised their dividends this week, including Brookfield Infrastructure Partners LP (BIP.UN), Manulife Financial Corp. (MFC) and Intact Financial Corp. (IFC). (Disclosure: I own shares of BCE, BIP.UN and MFC personally and in my model Yield Hog Dividend Growth Portfolio. View the portfolio here.)
If businesses are still performing well, why are their share prices falling? Lots of reasons. Fears that inflation is heating up and that interest rates might rise faster than previously expected are sparking worries that higher borrowing costs could dent corporate profits. Higher interest rates also affect stock valuations based on financial models that analysts use to calculate the present value of a company's estimated future cash flows.
Interest rates aren't the only factor driving stock prices. Algorithmic trading, institutional money flows, economic headlines and good old-fashioned fear and greed also come into play.
Successful investors are able to tune out most of this noise and focus on the underlying business. Are earnings and dividends growing? Is management allocating capital wisely? Is competition reasonable? Is there a clear path for the business to grow? If the business is thriving, its value should ultimately rise – regardless of what the stock market happens to be saying on any particular day.
As Warren Buffett said: "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years."
Lots of investors probably wish the stock market had been closed this week, if only to avoid the pain of seeing their portfolios sink in value. But if you think like an owner instead of a trader, you'll realize that the health of the business is what matters – not the price that a panicky market is temporarily putting on it.