Friday, October 8, 2010

Exploring Ethical Investing - Owning Shares of a Company

I remember once I had a brief conversation with someone about how investing in a company's stock is equivalent to putting your money in the company.  In effect, you are part owner and are partly responsible for the actions of the company.  Therefore, it would be problematic if the company, whose shares you own, engaged in questionable dealings.  That particular person disagreed with me.  His reasoning was that the shares were already in the free market, and that you are buying the shares from someone other than the company.  So, the company doesn't actually get your money, but only the money of the person who initially paid for them.  There's some false logic in this argument.  I will show you why.

Mechanics of Stock Offerings
Before I get right down into the details, let's start with the basics.  How do stock shares work?  I'm sure you all have heard of the term, IPO, or initial public offering.  This is when a company "goes public".  What that means is that the company is selling portions of the company as shares that will be traded on a stock exchange.  A share represent an actual, albeit small, portion of the company.  The money received from these shares goes directly into the bank account of the company and the executives will then decide what to do with this money.

If the company is a successful one, it would be rare for it to create shares and sell them again in an offering.  However, if the company fails to make money and gets deeper and deeper into debt, one of the ways to get out of debt would be create shares again, out of thin air, and sell them to the public.  This is called a "secondary offering".  As you can guess, the initial shareholders aren't going to be happy about this, because they initially owned a  large piece of the pie, but after the companies created more shares, their piece of pie just got cut and sold to another person.  Secondary offerings are called "dilutive", because, as the term implies, the value of your original shares are diluted.

Aside from these 2 types of offerings, companies do regularly issue shares to their employees or to fund acquisitions of other companies.  So, everyday operations do depend on the value of a company's shares.

How Do Ethics Come In?
For the majority of us, we're not privy to buying shares from either IPOs or secondary offerings.  Institutional investors are the ones that get invited to that party.  We typically buy shares that are traded on the open market.  So, it is true your money does not go directly to the company itself, but to whomever currently is trying to sell those shares.  However, that does not mean your money is not invested in the company.  Here are a few reasons:

  1. Let's start off with an analogy.  You're living in the ghettos of South Central LA and have befriended some drug dealers for whatever reason.  Drug dealing is a big business and the local drug lord recently decided that he was going to grow his business even more.  He split his "company" into 5 parts and sold 4 parts to 4 individuals, so that he could use that money to build up his inventory.  The drug lord was still doing the hard work, buying cocaine from other drug lords in Columbia and then selling them to highschool kids.  So, the 4 other owners really don't do much work.  They just sit around and collect cash once a month.  One of them is the drug dealer you just befriended.  However, he just had a baby and decided he was going to call it quits in this risky business.  So, seeing that you've made some money in the stock market, he proposes that he sell you his part of the business.  You're a little iffy, because you don't really like the idea of owning a business that sells drugs to kids, but he assures you that the money you give him will never get into the hands of the drug lord, because the money that was used to buy that share of the business was already paid.  Seeing how logical this is, you agree and buy that part of the drug dealing business.

    So, you see how ridiculous this story is, right?  There is absolutely no difference between this story and you buying shares in any company on the stock market!  None!
  2. When you place an order to buy shares of a company, you have just created more demand for the stock.  This new demand increases the stock price by a small fraction.  What happens when the stock price of the company goes up?  As I mentioned before, a company can issue new shares to do a number of things: obtain new funding, reward its employees, buy other companies, etc.  As a result, your action of buying the stock shares just gave the company more buying power because its shares are now worth more than if you had not bought them.  Your money does affect the way the company operates!
  3. You benefit directly by owning the shares of the company.  If the company grew significantly between the time you first bought your shares and now, it is likely the share price would have increased.  By selling the shares, you stand to make a good monetary gain.  Likewise, you can also make money if the company issues dividends, because it had made money from its operations.  You benefit directly from the operations of the company.  Regardless of how removed your money is from the company, there is an undeniable tie between the operations and you.  If the company makes abortifacient drugs and you benefit from it, I would say you are pretty responsible for the death of the fetuses.
Tread Carefully
So, I hope I have convinced you that by owning shares of a company, you bear the responsibility of the actions of the company.  There are many great companies out there, including ones that strive to be morally responsible.  Do make good moral principles a requirement when selecting a company to own.  Just as you wouldn't want to own a drug dealing business, make sure you don't own a company that violates your moral principles!