Friedman’s Law of the First Thing, as Applied to Investing: Market Caps

Monday, September 24, 2012 at 11am
By John Friedman

Investing, I’ve been known to say, is not, for most people, the key to financial health — probably not even in the Top 5 determinants of financial health (briefly: Numero Uno is savings rate, Numero Dos is making-a-living happiness, Numero Tres is having a feeling of currently being in control, Numero Cuatro is having a feeling of long-term security, and Numero Cinco is, for good measure . . . savings rate) (in which I include dissavings rates for people who have that sort of financial life — where they are spending down their stored money — including the very well-off and folks in their later years).

And then maybe, just maybe, somewhere in the next cinco comes investing prowess (which I mostly think of as avoiding silly loss).

But investing is a big, sizzley, gossipy sort of topic, and gosh knows that the FSIC — thje Financial Services Industrial Complex — wants it to be that way, and I am happy to oblige with my thoughts on it, with today’s piece focusing on Friedman’s Law of the First Thing as applied to investing.

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Friedman’s Law of the First Thing holds that everyone should know, at least, the first thing about each aspect of their financial life. As a corollary, it also holds that, for some people, that’s all they should know.

For taxes, that means understanding what marginal rates are all about. For estate planning, that means understanding what living trusts are all about. For bond investing, it means understanding why The Vice Versa Rule works (and not just knowing that, for some reason, bond prices and interest rates move in opposite directions, all things being equal).

And, the topic for today’s piece, for stock investing, Friedman’s Law of the First Thing means understanding market caps.

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If you look up the term market capitalization in Investopedia, things get pretty wonky pretty fast. For instance, the definition includes the phrase, “outstanding shares” within the first ten words of the definition — a nonstarter for a lot of folks, sufficient to thwart the learning process entirely.

I prefer this definition: a company’s market cap is a rough approximation of how much it would cost you to buy the company, lock, stock ‘n barrel. True, if you were to buy the company by buying all of the shares of its stock (as opposed to buying all of its assets and liabilities and such), then market cap has a whole lot to do with (a) how many shares of stock in the company there are out there, and (b) the price at what each person holding those shares would be willing to sell those shares to you, but, true also, you needn’t go there.

Instead, you need only ask, How much would it cost for me to buy this company?

[Aside for the curious or the particular: In actuality, if you want to buy the whole dern thing, it’ll just about always cost you something more than the market cap figures you’ll see out there on sites like Yahoo Finance. If you’re curious about why that is, you can start on Wikipedia’s article on Control Premium, after which you can spend some good number of years studying corporate finance, and then go on to work at a company in the business of buying and selling companies in toto (not to be confused with Toto too). But that would be well beyond knowing The First Thing.]

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For many folks, the emotions surrounding the size of a company’s market cap are similar to those surrounding the size of most things: braggadocio can come into play, and while big is good, incredibly big is something else entirely.

Right now market caps are in the news again because Apple is reaching market caps entirely heretofore unheard of.

On Yahoo Finance today Apple’s market cap appears as $643 billion. As best I know, that is a global all-time record; a company, measured in this way, has never been more valuable (I leave it to the true wonks to calculate after-inflation equivalencies to see whether, say, Rockefeller’s Standard Oil had a relatively larger market cap) (note: most folks rank articles in Motley Fool as not all that wonky; I did not review that linked-to article to see whether it looked to be wonky-well-done or not).

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A lot of hyperbole and fudge-factor can come into market cap analysis. One thing is clear, though: in a day-to-day investing context, you can do fairly clean Apples to AAPLs (sorry, could not resist) comparisons among companies, at least for market-cap bragging rights and market-cap comparos.

For instance, here is a table of market caps I scraped from Wikipedia that is a tad out of date (speaking of which, though I love love love WordPress, I find its table function to be . . . 1990s at best) but which can make for some great comparos:

 

Company In Billions of $
————- ——————-
Apple Inc. 546.1
Exxon Mobil 400.1
PetroChina 257.7
Microsoft 257.0
Walmart 235.9
IBM 225.6
General Electric 220.8
China Mobile 219.5
Royal Dutch Shell 217.0
Industrial and Commercial Bank of China 211.2

 

 

So what’d’ya say? Shall we go shopping?

For instance, if you combine Microsoft’s market cap with PetroChina’s, you get ballpark-close to the market cap of Apple. Which would you rather buy? All of Apple, or all of Microsoft plus all of PetroChina?

Or, using current Yahoo Finance market cap numbers, here are some other sizzley sorts of companies to consider, and to then use for some comparos:

Facebook‘s market cap: $44 billion

Intel‘s market cap: $113 billion

Google‘s market cap: $244 billion (to emphasize the apples and oranges issue, note that the Wikipedia table set out above did not include Google, even though its market cap would be high enough right now to be on that table — the moral of the story being to make sure that you are always comparing apples and apples when doing comparos, e.g., using the same source for the market cap info, and using it at the same time, and, even then, knowing that things are approximate and fudge-factor’y).

Groupon‘s market cap: $3.3 billion

LinkedIn‘s market cap: $13 billion (Me: Wow. I knew LNKD was doing well, but that is a mighty big market cap)

Zynga‘s market cap: $2.3 billion

Trulia‘s market cap: $160 million — that’s million, with an m (Trulia went public last week, a/k/a it IPO’ed last week, i.e., it sold shares to the general public for the first time) (Me: Wow. That is a low market cap compared to what we’ve been seeing other Internet company’s go out at)

So which would you rather buy: three and a half LinkedIns or one Facebook? That is the ratio of their market caps, roughly.

And how about two Intels versus one Google? Google’s market cap is about two times greater than Intel’s.

Or how ’bout 400 Trulias versus one Apple? That’s a whole lot of Trulii.

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So what does this have to do with being a good investor?

If you want to invest in stocks (as opposed to investing in baskets of stocks, i.e., mutual funds, or the modernized version of mutual funds, ETFs, as you do in 401k plans and as many smart investors do for all their investing), it’s important to understand that a stock price is the result of millions of decisions over time reached, jointly, between sellers owning little slices of a company (called the company’s “shares”) and buyers looking to buy those shares. They haggle and head-fake and swoon and swerve, putting on airs and doing more than a little game-playing — to arrive at a price where they can do a deal.

And all those decisions are, each business day, aggregated over all the shares of the company. When you take that price and apply it to all the shares of the company, you get something close to a real-life price for the whole company (remember: the control premium takes the price higher just about always).

So do you want to try to make decisions that choose one side or the other among all those millions of decision-makers — making a decision about whether the buyer or the seller is, at any given time, doing the right thing? And, if so, how comfortable are you that that right-thing will do you well over the time period over which you want to own (or not own) the stock?

That is what investing — at least at its most fundamental level — is all about (pun intended).

The other sort of investing — technical investing rather than fundamental investing — couldn’t care less about market caps. Instead it looks at lines and graphs and pretty pictures, from which it divines the future, tea-leaf-like.

But technical investing is not a First-Thing topic. Indeed, technical investing is a topic that no one should spend much time on, if any, until they have well taken care of the Numero Uno through Numero Cinco determinants of financial health.

 

1,444 words (leeway given for a First-Thing topic, which I’ll be able to point clients towards for time immemorial)

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