In a previous post, Investing Basics, it was discussed what investments are and how they should be valued. When talking about investments in personal finance, what this usually means is investments that are publicly available. What ‘publicly available’ means:
- The investment is offered to the general public. It is possible to buy private stocks and bonds but they are not available to the general public.
- Registration with the Securities and Exchange Commission (SEC) an agency of the U.S. Federal Government. The company must abide by some rules for communicating information. This includes documents such as quarterly reporting and annual reports.
- The investment was offered for sale through a public offering. Sometimes this can be a spinoff of an existing company or typically a new offering where a portion of the company is sold.
- The investment is available to buy through a network of brokerages using standardized mechanisms to name them, trade them and transfer them.
There are great businesses that never go to the public markets as well as horrible ones that make it to the public stock markets. However, there are a lot of advantages to buying public investments. These advantages primarily can be categorized as ‘soft criteria’ because they do not refer to the financial or fundamental aspects of the business, but facilitate in increasing confidence and ease of transacting.
Here are some of the advantages which can be categorized as ‘soft criteria’.
When a company or other investment vehicle registers to become a public company, it must open up its books for regulators and investors. This information includes all its financial information, its near term outlook and usually an assessment of the risks that are inherent in its business and future prospects. Additionally, the financial statements must be audited by an accredited third party auditor.
These documents are available for viewing at the SEC as well as at the website of the business (for a stock) or investment company (perhaps if it’s a bond).
Businesses that you would want to invest in (excluding very small companies on small exchanges) have some level of maturity as a private company before they go public. A track record of success as a private company can lead to demands by investors and others to go public.
A listing on the public markets provides liquidity, which means the ability to trade the investment easily and efficiently based upon a frequently updated fair assessment of its value by the marketplace. If, e.g., you owned an oil well, this investment is less liquid because the marketplace for it is smaller and it may be difficult to accurately assess its value over the short term.
The lack of liquidity in the credit markets has increased costs and prevents financial institutions from conducting their normal business activities (even if that activity is sound and credit worthy).
Sustainable Business Model
As an investor, one of your goals is to make money year after year. Public investments will have sustainable business models that has been proven as a private company as well as when the company is public. There needs to be some business advantage that enables sustainabilty, this could be a unique technology, providing a better quality product, or providing a useful service in an efficient manner.
And, Most Importantly, Earnings
A developing business usually doesn’t earn a profit in the beginning because it is consuming all of its capital and revenues on building the business. It is during the early phases of the business where the risks are highest. Its business model may not be sustainable or viable, or it may not be able to find the right market, or earn a decent return on its invested capital.
Fortunately, investments that in the public markets will already have earnings (or I should say, the ones that you want to invest in) so these risks are reduced. This doesn’t mean that every company will succeed or earn money all the time of course (some fail), but the fact that the business made it to the public market indicates a higher potential to sustainably earn money.