3 Reasons Why Shareholders Are Not Fit to Manage the Company They Own

Owning Deere & Company stock differs considerably from owning a heard of livestock.

Buying livestock, a car or a house is a complete possession of an asset with total control over its routine management and full rights to sell or trade the asset at will. Ownership in a company gives individual shareholders fractional stakes in an organization.

Therefore, ownership is considerably more complicated in the case of a public company than the traditional ownership concept. In addition to posing a complex relationship with the other stock “owners,” share ownership imposes multiple limitations and restrictions on daily use and management of those jointly owned assets.

When you need money to purchase something you currently cannot afford, such as a car, house, or new appliance, you can go to a bank for a loan. In return for receiving a loan from the bank, you agree to make an interest payment every few months until you have paid the loan in full. When a company needs to purchase something it cannot afford, such as a new factory or piece of equipment, it has the additional option of bypassing banks and going directly to investors who have extra money they want to invest to produce a profit.

There are two ways an agreement between a company and its investors can be structured so that each side gets what it wants. The first option is a bond. A bond is similar to a bank loan in that the company agrees to pay the investors interest regularly (usually every six months), as well as to repay the original loan amount in full at the end of the bond’s term. The second option is to issue stock.

Issuing stock involves selling partial ownership of the company to investors. If the company is successful in its investments, it will earn additional profits in the future. After investing a portion of these profits back into the business to build even more factories or buy even more equipment, the company may split the remaining earnings among all the owners, in equal proportion to the percentage of the company each investor owns.

A key difference between stocks and bonds for investors is the risk/reward equation. With a bond, the investors’ upside is limited — the best they can do is receive fixed interest payments and get their money back at the end of the term. With a stock, the upside is unlimited, because investors can share in the profit growth of the company.

The company’s view, of course, is precisely the opposite. For a company, issuing stock may be a more flexible and less risky source of funding if it is planning a project that may have uncertain results. If a project is unsuccessful and a company has taken out loans or bonds to finance it, the company may not have enough cash to pay back its debt. It may have to declare bankruptcy and, in effect, be taken over by its creditors (including the purchasers of the bonds).

On the other hand, if the company issues stock to finance the project, it can just stop paying any dividends for a few years. This situation is very important. Bond holders expect to get their money back from a loan on a fixed schedule, but stockholders accept the chance of losses in exchange for the potential for higher returns. This makes stocks more risky for investors than bonds, but less risky for the company issuing them.

So if I am an owner of McDonald’s, why do I still have to pay for hamburgers?

It is important to understand just what owning shares of a company like McDonald’s means. Ownership is not an altogether clear concept in the modern economic system. While it is true that owning shares of a stock like McDonald’s does mean that you own part of the company, your rights and privileges as an “owner” are pretty much limited to collecting dividend checks. There are a few good reasons for this:

1. The amount of the company that you own likely will be miniscule. Say McDonald’s has 1 billion shares outstanding as of its last reporting quarter. If you own 100 shares, then you own one ten-millionth of the company. It is not quite enough of a stake for employees at the cash registers to remember your name.
2. There will be hundreds of thousands of other “owners” like you who invariably will have different ideas about how the business should be run. It would be a massive coordination problem to involve everyone in any kind of business decision.
3. Many of the “owners” know nothing about the fast-food business. It would not make sense to channel business decisions through them.

If the owners are not the best choice to manage the company; who is? Watch for an answer to that question in a separate article.

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Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.