When the stock market is falling, investors look like obvious losers. But sometimes what looks obvious may conceal what may be lying beneath. Did you ever realize that if bad really comes to worst, shareholders may in fact have nothing more to lose at a time when other stakeholders may find themselves in neck-deep water? There are certain situations in which stock owners enjoy a better deal than other stakeholders of a company. Today, our friends Jinny and Johnny are looking at the positive side of becoming a stockholder.
Johnny: Do shareholders really enjoy a better deal? Could you elaborate on how shareholders may have nothing more to lose when other stakeholders are losing everything?
Jinny: Let’s go into the details. Consider the first situation, when the price of a company’s shares is falling excessively. It is true that with each fall in stock price, existing shareholders lose the value of their investment.
But look at the other side. If the fall is really not justified by the fundamentals, then sooner or later the tide is going to reverse. The positive aspect is that stock market tides are fully reversible. Existing shareholders battered by the falling market just need to wait and watch.
Once the market has hit bottom, the only way for prices to go is up. Some of them can even think of consolidating their existing shareholding by buying at a cheaper price. Long-term investors keep looking for such a bargain.
Illustration: Jayachandran / Mint
So, what might have looked like a misfortune for shareholders in the beginning could, in fact, be an opportunity for someone who wanted to own stocks but found the price prohibitively high. So, once in a while, the lowering of branches by a falling market greatly helps in better distribution of high-hanging fruits. Many investors who hurriedly get out of the stock market when prices are falling may not like it but this is how the wheel of the stock market keeps distributing wealth between old and new investors.
Johnny: You are sounding like a preacher trying to avert a panic. But tell me, Jinny, what if the fall in stock price is fully justified by the fundamentals and the company is really in trouble?
Jinny: Then, too, there is a limit. Prices of stocks below a certain level look absurd. This is so because the shares of a company are always intrinsically worth something unless the company goes completely bankrupt. Many a time even bankrupt companies have good assets.
It means that shareholders of even bankrupt companies can afford to be optimistic. In the end, the shareholders may not go home empty-handed. But there could be situations in which shareholders may not get anything when a company goes bankrupt. That’s because as per law shareholders are the last to lay their hands on company assets. In such a situation, the value of the stock would be zero. But here also, you can look at the brighter side. As I said, if bad really comes to worst, shareholders may in fact have nothing more to lose. For instance, the value of a share can never fall below zero.
Johnny: That’s fantastic. You are now really sounding like a preacher saying that you should not be afraid of dying because you can’t die more than once. What are you actually trying to emphasize, Jinny?
Jinny: The point is that the law imposes only limited liability on shareholders. So, as per law, shareholders can’t lose more money than the value of their shares. For instance, shareholders have no personal liability to pay off the company’s creditors or suppliers, or the tax authorities. The thing to be noted here is that shareholders, as owners of a company, enjoy the potential of unlimited gain if their company hits a gold mine, but their liability is limited if things really go wrong. Nobody can send a recovery agent to the home of a shareholder.
Compare that with the situation of creditors of companies who enjoy the potential of only limited gains in the form of whatever interest is payable to them but carry the risk of losing their money if the company goes down. In fact, shareholders can make the life of creditors more miserable by borrowing many times more than their own capital, which we call leverage. Highly leveraged companies greatly increase the potential of return for shareholders whereas creditors take home only a fixed return, albeit at a much higher risk. Highly leveraged bankrupt companies can hardly pay back creditors in full even if they sell themselves many times over.
Claimants of the company have to sort out among themselves who gets how much of the company’s assets. Amid all the chaos of downfalls, shareholders can simply choose to walk away and start a new life. They don’t have to be afraid of dying because there is always a possibility of a second life.
Johnny: That sounds true, Jinny. Sometimes obvious losers are actually winners.
What: In certain situations, a company’s shareholders are better placed than other stakeholders.
Why: Shareholders enjoy the potential of unlimited gains but their liability is limited by law.
How: By leveraging the capital of the company, the potential for gain can be greatly increased for shareholders.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com