VARIETIES OF STOCKS

Just What is a Security, Anyway?

What is a security (or financial instrument)? What makes stock different from other securities? As we mentioned in the previous chapter, a security (such as a stock, bond, or option) can be defined in three different ways:

1. A paper document providing proof of a financial stake of some kind.

2. An electronic/computer system equivalent to such a document.

3. An abstract but verifiable financial stake that may be represented through a paper document or a computer system, but does not disappear just because something happens to the piece of paper (or the computer) on which it was recorded.

The third definition has the advantage of recognizing that 100 shares of IBM do not become a different security when the certificate is turned over to a broker who records the shares in book entry form.

The financial stakes represented by securities are stakes in some business, government, or other legal entity.

• If the security is a stock, then the investor’s role is ownership (together with other investing shareholders, if any). Ownership in a corporation that is divided among a group of shareholders is sometimes referred to as an ownership interest.

Securities representing an ownership interest in a corporation’s undivided assets.

• If the security is a bond, then the investor is a creditor, and the other entity can be corporate or governmental.

bond

Long-term debt securities issued by governments and corporations; also used generically to refer to debt of any maturity.

• If the security is an option, then the investor has certain well-defined rights and the other entity has corresponding obligations. (Some options are not considered securities, because the underlying asset is not a security. Even so, such options are still considered financial instruments.)

• Futures contracts, though they share many of the characteristics of securities, are separately regulated and therefore are generally said not to be securities at all, although they are financial instruments. This may change, especially if the “on-again, off-again” merger between the Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) ever becomes reality.

Bonds, options, and futures will all be discussed in much greater detail in later sections of this book.

Stock is denominated in units called shares. The share-issuing entity is always a corporation (investors cannot buy partial ownership of a government!). Shares in a mutual fund, whether of the open-end or closed-end variety, are a specialized form of stock. Mutual funds have become so important to investors that they are given a section of their own in this book.

Normally, as a shareholder, you have certain basic rights, including the following:

1. A claim, proportional to the number of shares held, to a portion of the corporation’s assets. This does not mean, however, that you can go into corporate headquarters and walk off with a desk! Your claim is on the undivided assets of the corporation, not on any specific piece of property.

2. The power to vote on company business at shareholder meetings, again in proportion to shares held. Specifically, you are entitled to vote for directors, either in person or by proxy. Not all stock, however, comes with voting rights. In any event, relatively few individual investors who are shareholders attend the annual meeting of the corporation. Many do not

Someone to whom you give the right to vote your shares at a shareholder meeting.

even bother to mail in the proxy that accompanies the announcement of a meeting.

3. The right to dividends that may be voted by the board of directors. However, not all stocks pay dividends.

Portion of corporate earnings distributed to shareholders by vote of board of directors.

4. Sometimes, a preemptive right to purchase new shares before they are offered to the general public. This right, however, may be abridged under certain circumstances (e.g., corporate mergers) or by the articles of incorporation.

So what does it really mean to own shares of stock in a corporation? It seems that if there is an essential component to stock ownership, it is a sharing of the underlying assets jointly with other shareholders.

Issuers and Underwriters: Why Does a Corporation Sell Stock to the Public?

Historically, public companies—that is, companies that issue stock to the public—came about in response to the need to finance large commercial enterprises on a scale that was either too grand or too risky for even the wealthiest individuals or families to undertake alone. By reaching out to the public at large, a small group of entrepreneurs can collect the enormous sums of money needed to finance new corporate undertakings, or even entirely new enterprises.

When corporations issue stock (or other securities), they are referred to as issuers. Stock can be issued for sale to the public or for private placement. When issuers prepare to sell securities to the public, they usually call upon investment bankers to act as underwriters. The underwriters’ names are literally “written under” the copy at the bottom of the cover page of the prospectus, a legal document that, together with a registration statement, must be filed with the SEC, the government agency charged with regulating the securities industry. An initial or preliminary prospectus is often referred to as a red herring because of the red ink that connotes its preliminary status (see “Prospectus of IJK Inc.”).

Beginning in the “dot.com” era, some issuers, particularly of initial public offerings (IPOs) have taken advantage of the low marketing costs of the Internet to offer direct IPOs, bypassing underwriters entirely. And some have become a new kind of underwriter, offering direct IPOs over the Internet. Over the last decade, direct public offerings (DPOs), as well as special purpose acquisition companies (SPACs), private investments in public equity (PIPEs), and alternative public offerings (APOs) have transformed the issuing landscape.

initial public offering (IPO)

First offering of a company’s stock to the public.

• DPOs are means by which companies may raise capital by marketing directly to their own employees, customers, and friends, without the need for an underwriter. SPACs are publicly traded shell companies created with the goal of acquiring a private company with the capital raised through an IPO.

• PIPEs are deals that involve publicly traded stock, which may or may not be registered with the SEC.

• APOs combine a PIPE deal with a so-called “reverse merger” to create yet another alternative to a traditional IPO.

The idea behind the Internet investment banking business is simple yet potentially powerful. Instead of seeing IPOs as the permanent preserve of institutional insiders, the Internet is used as an enabling technology to bring issuers into contact with a broad group of potential individual investors. This could be a good thing for individuals. Until now, studies have shown that most individuals investing in IPOs get in too late to share in the early price run-ups. And who stands to lose? Traditional underwriters, who stay away from this technology, and institutions, who will lose their monopoly on IPOs and, perhaps more important, may lose some of their ability to “juice” portfolios with issues that almost always go up—initially.

Prospectus of “IJK Inc.”

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Why Investors Buy Stock

All well and good for the entrepreneur and the corporation. But why should anyone buy stock? It all goes back to the investor’s current mix of assets and liabilities, along with his or her financial goals and expectation of future needs. An investor with available cash or credit will buy stock if such a purchase fits his or her financial framework. In broad terms, most investors are motivated by both long-term and short-term needs.

• Long-term capital appreciation. As a long-term investor, you want the total value of your stocks to increase. The value of your stock position can increase in a number of ways, including a rise in the price per share, a share split which gives you additional shares at the same price, or the reinvestment of dividends. Reinvestment can be done automatically through a dividend reinvestment program (DRIP).

• Short-term income. Aside from your needs as a long-term investor, you may have an immediate need for income from your investments. For short-term income, many investors choose bonds (or bond mutual funds) rather than dividend-paying stocks, because dividend payments are not as reliable as interest payments.

Other, more specific motivating factors may include the following:

• Attraction to a company or one of its products or services

• Confidence in an entrepreneur, portfolio manager, or stock analyst

• Recommendation of friend or financial advisor

• Results of personal research

A dividend reinvestment program (DRIP), a service offered by an increasing number of public companies, automatically uses your cash dividend to purchase additional shares of the company’s stock without the involvement of a broker. Starting with a trickle of companies in the 1970s—AT&T was among the first—today DRIPs have flooded the marketplace, with about 1,000 public companies sponsoring programs. (Continued)

Many sponsoring companies allow you to purchase additional shares directly from them. This has led to a major new kind of stock investing, known as no-load stocks, which are offered to the public directly by the issuing corporation, bypassing brokers even for the initial purchase of shares. We will discuss this phenomenon in detail in Chapter Eight (buying and selling stock).

What unites these and other motivating factors? For some investors, it is the belief that the potential return from investing in stock is worth the risk of loss of capital. Others may have just taken the plunge without reflecting on the possibility of loss.

We turn now to consider the two potential components of return on an investment in shares of stock: dividends and capital gains.

Summing Up Total Return: Dividends and Capital Gains

Traditionally, one of the defining characteristics of common stock is that it pays dividends to its shareholders. The word dividend means “that which is divided.” Dividends, then, are a dividing up and distribution to shareholders of a portion of the corporation’s earnings. The amount and timing of dividend payments, if any, is voted upon by the board of directors of the corporation.

The importance of dividends as a component of return to an investor varies from stock to stock. Stocks that have been around a long time are more likely to pay dividends than is the latest IPO. You might think that this means stocks paying regular dividends have a higher survival rate, but paying dividends is no guarantee of survival.

Perhaps companies that have been around a long time are, on average, more able to pay dividends. If so, this would be a reflection of the life cycle of a corporation. In the early years, when a company is growing fast, its need for capital is likely to be greater than its desire to pay dividends. More mature companies, whose growth prospects are diminished, need less capital and can return more to investors in the form of dividends. While you may feel good getting that dividend check, the board of directors owes it to you to make sure that the company is not missing out on worthwhile investment opportunities that would make your investment more profitable.

There is an argument made by some financial analysts that dividend payments are not in the best interest of shareholders. The reason? Dividend payments are taxed as ordinary income in the year that they are received. For most shareholders, ordinary income is taxed at a higher rate than capital gains, giving those investors an incentive to seek out stocks that do not pay dividends at all, generating returns to shareholders exclusively through capital appreciation—that is, increases in the value of the stock itself.

capital gain

Increase in the market value of an asset.

Another argument against paying dividends stems from their tax status from the point of view of the corporation. A corporation cannot deduct the amount it pays in dividends from its income. The situation is different when a corporation issues bonds. Interest payments on corporate bonds are considered deductible expenses of the corporation. This may create an incentive to issue bonds instead of stock and to avoid paying dividends altogether.

Though linked to the earnings of the corporation, dividend payments in practice are a combination of tradition, shareholder expectation, and corporate strategy. In earlier days, examination of a stock’s dividend record was high on most investors’ checklists. Some stocks have unbroken records of decades of quarterly dividend payments.

Regular dividend payments are historically associated with large, blue chip companies and stocks of electric power, gas, and other utility sector companies. But things have changed dramatically in recent years. IBM, the bluest of blue chips, drastically cut its dividend some years ago as part of its aggressive restructuring program. Microsoft, which now has a market value greater than IBM, did not pay a dividend until 2003.

blue chip

Stock of a large-capitalization, financially sound corporation.

While most dividends are paid in cash, there are also stock dividends, so-called scrip dividends, and occasionally even dividends in the form of company products or other property. When voting on the amount and form of a dividend, the board of directors also provides two dates: a record date and a pay date. The record date is the point of reference for determining shareholder eligibility for the dividend. The pay date is typically a couple of weeks after the record date.

Three days before the record date, and about three weeks before the pay date, the stock goes ex-dividend. Investors who purchase shares between the ex-dividend date (sometimes just called the ex date) and the pay date are not entitled to the dividend. Instead, it is paid to the previous shareholder. When a stock goes ex-dividend, its price usually drops by the (after tax) amount of the anticipated payment.

ex-dividend

No longer eligible for a dividend, because dividend has been announced and payment date scheduled.

Many investors keep a sharp lookout for changes in dividend payouts. A popular view is that dividend increases are an indicator of a stock that will outperform the market, while stocks that decrease or eliminate the dividend tend to underperform. A recent study challenged this view, arguing that at least some of the time, the exact opposite is true. If so, it is not hard to imagine an explanation. Some companies may pay too high a dividend, leaving little money to reinvest in the business. And companies that cut their dividends may be about to embark on an aggressive turnaround. IBM comes to mind as a recent example of a company that cut its dividend, took its lumps, and then rebounded nicely. Other companies that got a positive response from the market after cutting dividend payments include SPX Corporation, Florida Power & Light, and IPALCO Enterprises.

The contrasting theories of the impact of changes in dividend payouts highlights an important insight about dividends. Beyond any easily quantifiable difference between dividends and capital gains, there seems to be a significant psychological dimension to the dividend controversy. Some people just like dividends. We can speculate about why this is so (getting money without having to make a decision about selling stock is one possibility). No doubt, tradition also plays an important role.

If dividends make little financial sense—and many corporations act as though this is the case—how do these corporations reward you as the investor? The answer is capital gains. One way that capital gains can be offered to shareholders is through share repurchase programs, sometimes called stock buyback programs. When a company buys back its stock, this reduces the number of shares outstanding (shares held by investors), which tends to boost the price of the stock. Sometimes, the stock price rises because the company has announced (or is expected to announce) that it will be buying back shares. The underlying reason for the price change is that the remaining individual shares have become more valuable.

A company’s earnings are either paid out as dividends or retained. Retained earnings increase the company’s value to investors, which (all other things being equal) translates into a higher price for the stock. If you sell a stock purchased outside of a tax deferral vehicle (such as a pension plan) at a profit, a realized capital gain is created whereas before there was only an unrealized capital gain or paper profit. For most investors, capital gains are taxed at a lower rate than dividends or interest. The latter two are considered forms of ordinary income.

tax deferral vehicle

IRA, 401(k), variable annuity, or other mechanism for deferring taxes.

If the stock you sold was in an individual retirement account (IRA) or some other tax-deferred investment plan, then this distinction between capital gains and ordinary income no longer applies. We will explore the impact of taxes on investment performance in Chapter Fifteen.

Over time, the price of a successful company’s stock can get very high. This can discourage new investors from purchasing the stock, because individual shares look expensive. An extreme example is the stock of Berkshire Hathaway, Warren Buffett’s company, whose closing price on September 19, 2008, was $147,000 per share.

Most companies would find it difficult to attract investors with such a high per-share price. Eventually, if the price of an individual share gets too high, the board of directors may vote for a stock split, which increases the total number of shares outstanding without changing the total market value of shares.

For example, in a 2-for-1 stock split, a holder of 100 shares of IJK Corporation common stock receives an additional 100 shares (usually, in book entry form, although investors can request a stock certificate). If the price of IJK was $144 just before the split, it is $72 after it. For a time, investors purchased stocks right after a split, having noticed a tendency for stocks to rise. After enough investors began to take advantage of this pattern, the pattern changed. The price rise occurred before the split, and the price actually tended to sink after the fact. Such is the self-referential nature of markets.

When a stock’s price sags, a reverse split may prevent it from being delisted—removed from the list of stocks allowed to be traded on an exchange. This might happen because an exchange sets a minimum price requirement, or simply because investors shy away from stocks with low share prices. What happens if you own, say 100 shares of XYZ Corporation common stock, and the company does a 1-for-12 reverse split? You would be entitled to 100 divided by 12, or 8^1/3 shares. Common stocks, unlike mutual funds, do not generally issue fractional shares. So you would receive the cash value of the fractional share.

What if the corporation goes belly-up? Recall that part of a shareholder’s ownership interest is a claim on the (undivided) underlying assets of the corporation. In the event that the corporation declares bankruptcy, however, the corporation will either get reorganized or undergo liquidation. In the former case, a reverse split may result. If liquidation happens, though, holders of common stock are not in a strong position. They have a residual claim on any assets that are left over after the corporation has paid its creditors. Generally speaking, bondholders fare better in a corporate bankruptcy, as they have a prior claim. So do holders of preferred stock. Stockholders tend to be far down on the list when it comes to getting paid anything for the shares of a bankrupt corporation.

Priority of Claims in the Event of Bankruptcy

If you own common stock in a company that goes bankrupt, there are a lot of people in line ahead of you whose claim on the corporation’s assets takes precedence over yours. This is known as a creditor hierarchy. First priorities include accrued wages and salaries to employees, employee benefit plans, and taxes. Next come the secured creditors, usually banks and other financial institutions that have loaned the corporation money. Directly behind them are the bondholders, whose claims vary in strength depending on whether the debt they hold is senior debt or subordinated debt. If there are any assets left after the creditors and bondholders have all been paid in full, there may still be people in line ahead of you. Holders of preferred stock have priority over holders of common shares. As a result, common shareholders seldom recover any money from a corporation in bankruptcy.

preferred stock

Stock that offers some bondlike characteristics such as income and safety of principal.

Stock splits and reverse splits are two types of capital events, which may be defined as changes in the capital structure of a corporation. Other capital events that can result in capital gains include rights offerings, corporate mergers, and spin-offs:

• Rights offerings give existing shareholders an opportunity to purchase (or subscribe to) additional shares of stock at a discount from the public offering price when the company prepares to issue new shares. These rights, which are also called subscription rights, are transferrable securities. The right to purchase at a discount is valid only for a short time period. After this period, the right has no further value.

• Mergers combine two (or more) companies to form a larger company. Frequently, the acquiring company pays shareholders of the acquired company in shares. For example, Company A may purchase all of Company B’s shares on the basis of a predetermined ratio of shares, say two shares of Company A stock for every share of Company B stock outstanding. If you own 100 shares of Company B stock, after the acquisition is complete (and Company B no longer exists as a separate entity) you will own 200 shares of Company A stock.

• Spin-offs are like mergers in reverse. Company C decides to split off part of its operations into a separate organization. Let’s say the new organization is called Company D. How are shareholders in Company C compensated for the splitting off of part of their ownership interest into a new enterprise? Usually, through issuance of stock at some preset ratio. Let’s say you own 100 shares of Company C. After the spin-off of Company D, you still own 100 shares of C, but you also own, say, 50 shares of Company D.

In recent years, most stocks have done very well indeed, as stock market returns have far exceeded their historical averages. In these circumstances, a note of caution is warranted. Corporations do not guarantee that they will pay dividends, nor do they guarantee the price of their stock. Some stocks, of course, are safer than others, and a diversified stock portfolio is safer than the average stock contained in it. In fact, a properly diversified portfolio is safer (as judged by standard measures of risk) than the safest individual stock contained in the portfolio. Even so, there is no guarantee on any of the money you invest in stocks.

A Letter to Our Shareholders: Annual and Quarterly Reports (and Filings)

In addition to the prospectus, shareholders are entitled to regular reports from corporate management and the board of directors. These include the company’s annual report and other periodic (e.g., quarterly, semiannual) and occasional communications. Shareholders and other interested investors can generally get copies of the corporation’s press releases from its investor relations or public relations departments. Last but certainly not least, required quarterly and annual filings with the SEC (Forms 10-K and 10-Q) contain a wealth of additional information on the company’s operations and financial condition. Form 10-K contains more financial details than the annual report that is mailed to shareholders. If you are a shareholder, you can request a 10-K directly from the company. The 10-K and related filings are also available at many libraries, through commercial databases, or directly from the SEC via the Internet (www.sec.gov).

Making Sense of Types, Classes, and Other Stock Categories: A Map of the World of Stock

Stocks come in a sometimes bewildering variety. There are many issuers of stock, from small companies to global giants. Many of these issuers offer preferred stock in addition to common stock.

Common stock is, as its name suggests, far more common than preferred. So who prefers preferred stock, and why? Preferred stock has several features that make it more attractive to some investors. First, it pays dividends at a specified rate. Second, payment of those dividends takes precedence over payment of common stock dividends. No common stock dividends can be paid out until the preferred shareholders have been paid what they were promised. Furthermore, if the assets of a company are sold, or liquidated, due to bankruptcy, preferred stock shareholders take precedence over owners of common stock in their claim on the assets. The main reason for the existence of preferred stock is the tax advantage it provides to corporate investors. When a corporation buys stock in another corporation, a large portion of the dividend payments it receives is tax-exempt. Therefore, when corporations have excess cash they want to invest, they typically look for high-dividend-paying stocks. Because preferred stock pays more dividends than common stock, that is what they buy. If this tax advantage did not exist, few corporations would even issue preferred stock.

Both kinds of stock, however, take a backseat to the bondholders, who have a prior claim both with respect to their interest payments (which are paid before any dividends) and in a bankruptcy. So preferred stock is sort of a hybrid security, something like a common stock, but also resembling a bond. The term capital stock is sometimes used informally as a synonym for common stock; at other times, it includes common and preferred stock. It has another, more precise, meaning when it appears on a corporation’s balance sheet. Balance sheets are discussed in Chapter Six.

Issuers of stock decide how many shares will be authorized and how many of those will be issued (made available for sale), and they keep track of how many are outstanding (sold). Authorized shares (or stock) are the maximum number of shares that a corporation is allowed to create. The number of authorized shares is specified in the articles of incorporation of the company and is legally binding. It can be increased only by shareholder vote. Authorized stock is the total of issued and unissued stock. Since issuing stock costs money, corporations may issue only a small portion of authorized shares to keep down expenses. Issued stock is divided into stock that is owned by investors and stock that is owned by the corporation. The former is referred to as (issued and) outstanding, while the latter is called treasury stock. Treasury stock is stock that was sold and then repurchased as part of a stock buyback.

The amount of shares available for trading in the public markets is called the float. The float is important, because thinly traded stocks tend to be more volatile, while stocks with large trading volume tend to be less volatile. The float of a closely held corporation, with most of the equity in the hands of a few people or institutions, is likely to be significantly lower than the float of a company whose stock is widely held by a large number of shareholders. Even so, closely held corporations are still public companies, in contrast to closed corporations, which are also referred to as close or privately held corporations. (See “Publicly Held versus Closed (Close or Privately Held) Corporations.”) Sometimes, one class of a company’s stock—the nonvoting shares—has a large float, while the voting shares are closely held.

Publicly Held versus Closed (Close or Privately Held) Corporations

The rights of shareholders are set forth in a legal document. For a closed (or close or privately held) corporation, this document may simply be the articles of incorporation, setting forth the purpose of the corporation, number of shares issued, number of shares outstanding, who owns shares, officers and directors of the corporation, and so forth.

For a public company, there are much stricter disclosure requirements, corresponding to the greater need for information when investments are offered to the general public. For example, investors in a public offering must receive a document called a prospectus, which is a formal written offer to sell stock, either in a proposed new enterprise or in an existing company.

A note of caution: The term closely held refers to a kind of publicly held corporation. Confusingly, the term private corporation is also sometimes used to refer to a publicly held corporation to emphasize that it is owned by private shareholders (a category that includes individuals, corporations, and other private institutions) and not by the government. For example, the Federal National Mortgage Association (Fannie Mae) refers to itself as a “private corporation” to distinguish itself from the Government National Mortgage Association (Ginnie Mae), a corporation owned by the federal government. In this sense, Fannie Mae is a “private” corporation—but with over 300,000 shareholders and $400 billion in assets, it is not “privately held”! Both of these companies will be described in more detail in Chapter Fifteen.

Some companies offer numerous classes of stocks, varying in price and voting rights. When stock is described as classified, this does not refer to secrecy, but rather to different classes of stock authorized by the articles of incorporation. For example, a corporation may authorize the creation of two classes of stock, Class A and Class B. Classified stock is used to preserve certain rights for shareholders of one class of stock. Typically, this is done by restricting the voting rights to shareholders of a particular class, thereby keeping control of the corporation in the hands of those shareholders. Classified stock, which was widespread in the 1920s, fell out of favor after the crash of 1929 and the Great Depression of the 1930s, but it has been making a comeback in recent years. Control stock is the stock owned by a shareholder or group of shareholders who own a sufficient number of voting shares to control the corporation. While, theoretically, control can require more than half of the voting shares of a corporation, in many cases a much smaller percentage is sufficient, as long as most of the other shares are held by inactive shareholders.

Voting, Nonvoting, and the Rights of Minority Shareholders

Ownership of common stock ordinarily entitles the shareholder to vote on issues affecting the corporation or to designate a proxy to vote on his or her behalf. Sometimes, however, the founders of a company create more than one class of stock, using the voting stock to retain control for themselves, while selling nonvoting stock to raise capital.

Most public companies have only one class of stock—with voting rights. These rights are in proportion to the amount of common stock owned. Even so, the most common method of voting, known as statutory voting, gives a majority shareholder the ability to elect directors of his or her own choosing, by giving each share one vote for each open position on the board of directors. Votes cannot be accumulated to be cast for a single director, who might be an advocate of other, minority shareholders.

An alternative system, known as cumulative voting, works as follows. Say there are six open positions on the board of IJK Corporation. A holder of 100 shares would have a total of 100 votes for each of six positions. Under statutory voting, such a shareholder could not vote more than 100 shares for any position, but under cumulative voting, that individual could vote all 600 shares for one candidate, making it more likely that the shareholder would have at least one director representing his or her interests.

Under certain circumstances, a shareholder or bondholder may be given coupons or other means to receive special “sweet deals,” whether discounts on additional purchases of the same security or incentives to buy or trade for another security offered by the same company. Shareholders, and frequently bondholders, may have certain rights to exchange one security for another. This makes extra work for investors, who have to figure out how much the stock is really worth. Various other investments, including convertible preferred stock, convertible bonds, stock options, and warrants, can all be converted into common stock. The conditions under which conversion is both possible and advantageous to the owner of the convertible instrument vary from instrument to instrument and from owner to owner. For example, an executive may hold a significant number of options that can be exercised only at certain times. New accounting rules guide a corporation’s accountants (and industry analysts) in calculating the earnings per share (EPS) on a diluted basis.

earnings per share (EPS)

Measure of a stock’s profitability, either historically (trailing EPS) or prospectively (forecast EPS).

There are many more varieties of stocks. Some are blue chip, others red chip. Blue chip stocks are stocks in the largest public companies with high name recognition. Traditionally, blue chips have appealed to individuals seeking both long-term growth and current income through dividends, and to institutions as one of the two pillars of their investment portfolios (the other being bonds). Red chips, in contrast, refer to the shares of smaller, newer companies, which may be both riskier and potentially more rewarding than their blue chip brethren. The term red chip has also been used in a more specialized context, to refer to the shares of companies based in (the People’s Republic of) China. Some of these companies are quite large; the red chip label stems from the risk of investing in an emerging market without a well-developed regulatory and legal framework (as well as a word-play, of course, on the old term “Red China”).

We will encounter even more varieties of stock in the remaining chapters of this section. A brief mention will suffice for now. Some companies offer additional shares of stock through dividend reinvestment programs, or DRIPs. An increasing number of companies large and small are taking advantage of new technologies to sell their stock directly to the public, bypassing brokers and sometimes even underwriters. These are discussed in Chapter Eight (on buying and selling stock). American Depository Receipts (ADRs) are making it easier for U.S. investors to own foreign stock. ADRs are described in the section on sources of information about stocks (Chapter Seven). Finally, all this growth and change has brought with it a new wave of scamsters, selling chop stocks to defraud the unwary public. These dangers are explained in Chapter Eight.