Latest / How Canadian Markets Work / Episode 47: What You Own When You Own a Share

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Episode 47: What You Own When You Own a Share · How Canadian Markets Work

0:00
You know, if you own, say, 100 shares of a major
0:03
Canadian bank, it really feels like you own a
0:07
piece of it. Absolutely. Yeah. Like, you should
0:09
just be able to walk into your local branch,
0:11
point at a really nice leather chair in the manager's
0:14
office and say, you know, I'll take that. That's
0:16
my chair. Right. I own this place. Exactly. Or
0:19
maybe walk into the vault and demand your specific
0:23
fraction of the cash that they have sitting there.
0:24
Well, you are technically an owner, so it feels
0:28
intuitive. But if you actually try to take that
0:32
chair, security is going to escort you out very,
0:34
very quickly. Security is absolutely tossing
0:36
you out onto the street. Yeah. Which raises a
0:39
pretty weird question. When you press buy on
0:41
your phone, and you aren't actually buying the
0:44
chairs or the cash in the vault or like a bird
0:47
in the wall, what exactly are you buying? So
0:51
today's deep dive is all about looking at the
0:53
actual anatomy of a stock. We're looking at a
0:56
bunch of sources on market mechanics to sort
0:59
of deconstruct what you actually hold when you
1:02
become a shareholder. Yeah, and the first thing
1:05
to really wrap your head around here is that
1:06
you are buying an abstract legal concept. Okay.
1:09
It's not physical. And what often surprises people
1:12
when they're reading through these corporate
1:14
finance sources is that the company actually
1:17
owes you nothing. Wait, nothing? Like, at all?
1:20
I gave them my hard -earned money. Literally
1:22
nothing, yeah. They can stop paying dividends
1:24
tomorrow and you have no legal claim to demand
1:27
a payout. Oh, wow. If a company decides to just
1:30
sit on a massive mountain of cash for a decade,
1:33
like without giving you a single dime, you can't
1:35
sue them for it. You're kidding. No, I mean,
1:36
you don't own a physical asset. You own a highly
1:39
engineered set of legal rights. OK, well, if
1:41
they don't owe me a chair and they don't legally
1:44
have to pay me a dividend, what do I actually
1:48
have in my portfolio then? Basically, you own
1:51
the leftovers. The leftovers. Yeah. The formal
1:53
term you'll see in the sources is the residual
1:55
claim. The residual claim. Right. And to really
1:57
visualize this, you have to look at a company's
2:00
capital structure as a priority queue. OK, like
2:04
a lineup. Exactly. Picture a massive line of
2:07
people just waiting outside a courtroom to get
2:11
paid if the company fails and gets liquidated.
2:13
OK, I am picturing the line. Let's say... Let's
2:17
say this is a huge manufacturing company that
2:19
just went bankrupt. Who gets to stand at the
2:22
very front of that line? Well, at the absolute
2:24
front are the secured lenders. Right. So these
2:27
are institutions that hold a claim on a very
2:29
specific physical asset. Think of a bank that
2:34
gave the company a mortgage to buy their main
2:36
factory. OK. If the company goes under that specific
2:39
bank, gets to seize that specific factory, it's
2:42
theirs. That makes total sense. They collateralized
2:44
the loan. Exactly. So who is right behind them
2:47
in the queue? Next up, you have the senior unsecured
2:50
bondholders. Senior unsecured. They don't have
2:53
a claim on a specific building or a piece of
2:56
equipment, but they do have a legal contract
2:58
saying they were first in line to grab whatever
3:01
general cash or liquid assets the company still
3:04
has left over. Got it. And then right behind
3:06
them, you have subordinated debt. Subordinated
3:10
debt, meaning they agree to be lower down. Right.
3:12
These are lenders who explicitly signed a contract
3:15
agreeing to take a backseat in the queue. But
3:18
in exchange, the company pays them a higher interest
3:21
rate while things are running smoothly. Oh, I
3:23
see. So they took a bit more risk for a bit more
3:26
yield on the front end. Exactly. And I assume
3:28
preferred chairs are somewhere way back there,
3:30
too. Yeah, they sit right behind the subordinated
3:32
debt. And finally, standing completely alone
3:36
at the absolute back of this massive line, just
3:39
looking at whatever tiny crumbs are left on the
3:42
floor. This is me, the common shareholder. Is
3:44
the common shareholder, yes. So everyone else
3:46
has to be made entirely whole. every bank, every
3:49
bond holder, every supplier, before I see a single
3:52
cent of my initial investment back. Every single
3:55
one. Which means, practically speaking, in a
3:58
true corporate failure, common shares are frequently
4:02
just wiped out entirely. They go to zero. Geez.
4:05
I mean, it sounds like showing up to a buffet
4:07
after everyone else in the entire restaurant
4:09
has already eaten. That's a great way to put
4:11
it, actually. Like... The secured lenders, they
4:15
took the entire carving station. The bondholders
4:18
basically scraped all the side dishes into their
4:20
little to -go boxes. The preferred shareholders
4:23
took the very last dinner rolls. And I'm just
4:27
left standing there in the back holding a paper
4:29
plate, looking at the bottom of an empty salad
4:31
bowl. An empty salad bowl, exactly. Why would
4:34
anyone sign up to be dead last in line for that?
4:36
Well, because you're only scraping the salad
4:38
bowl in a worst -case scenario, right? But let's...
4:41
Let's extend your buffet analogy for a second.
4:43
OK, let's do it. What if the kitchen suddenly
4:45
brings out, I don't know, 20 extra chocolate
4:49
fountains and an endless supply of truffles?
4:53
That is amazing. A literal mountain of caviar.
4:55
Well, the guys at the carving station, the secured
4:58
lenders, they don't get any of it. Wait, really?
5:01
No. Their portion is strictly capped at what
5:03
they're owed. As the person at the absolute end
5:06
of the line, you get all the unlimited desserts.
5:09
Okay, so it's an asymmetric bet. It is the defining
5:12
feature of corporate finance. Like, think about
5:16
the fundamental difference between a bond and
5:18
a share. Right. A bond is a promise with legal
5:21
force. The company promises to pay you, say,
5:25
a 5 % interest rate every year, and then eventually
5:28
return your principal. That's a fantastic certainty.
5:31
I mean, you can plan your entire retirement around
5:33
that kind of math. You can, but your upside is
5:36
completely locked in a cage. Because if the company,
5:39
I don't know, invents a cure for a major disease
5:43
and their valuation just jumps from $1 billion
5:46
to $50 billion overnight, the bond holder doesn't
5:49
get a bonus check for that, do they? Not a dime.
5:51
They still just get their little 5 % coupon.
5:54
Wow. Okay. But a share. A share is not a promise.
5:57
A share is a hope. A hope? Because you hold that
5:59
residual claim because you own the leftovers.
6:01
The actual size of those leftovers is... theoretically
6:04
infinite. Right. If the company triples in value,
6:07
the bondholder gets no extra money. But the shareholder
6:09
captures absolutely all of the unlimited upside
6:13
above what is owed to the creditors. So being
6:16
last in line means you take the hit first. if
6:19
things go badly. But you also get to keep every
6:21
single dollar of growth if things go well. Exactly.
6:25
A massive trade -off. It is. But, you know, being
6:27
at the back of the queue, it doesn't just mean
6:29
waiting your turn in bankruptcy court. It actually
6:31
actively changes how your investment behaves
6:35
day to day. Day to day? Yeah. Yeah. I noticed
6:38
this in the reading, actually. The sources stress
6:40
that your position at the bottom of the capital
6:42
structure heavily amplifies your return. Oh.
6:46
Wildly, yeah. This brings in the concept of financial
6:49
leverage. Right, leverage. When a company borrows
6:51
money, when it issues those bonds to the people
6:55
at the front of the line, it basically creates
6:57
fixed costs. Because they have to pay the interest.
6:59
Exactly. The bank does not care if the company
7:02
is having a good month or a bad month. They just
7:04
want their interest payment. They want their
7:06
check. Right. And those fixed costs act as a
7:09
massive amplifier for the shareholders sitting
7:11
way at the back. Okay. Let's ground this in a
7:13
real -world scenario so I can picture it. Say
7:15
I'm running a freelance graphic design business.
7:18
Okay. If I have a slow month, my income drops,
7:21
obviously. But my rent stays exactly the same.
7:24
Rent is fixed. Right. And that fixed rent payment
7:27
hurts a lot more when my overall revenue is down.
7:30
It really squeezes whatever money is left over
7:33
for my own... you know, groceries. Right. So
7:36
let's run the corporate math on that exact dynamic,
7:38
because seeing the numbers actually play out
7:41
is usually a huge revelation for investors. OK,
7:43
let's hear the math. Let's invent a fictional
7:45
company. Say they have an operating profit of
7:48
$40 million in a really good year. $40 million
7:51
of profit. just from running their day -to -day
7:53
business. Right. But they borrowed a ton of money
7:56
to, let's say, build out their entire logistics
7:59
network. OK. So they owe $5 million in fixed
8:02
bond interest every single year. Got it. So $40
8:05
million in operating profit minus the $5 million
8:09
interest they are absolutely legally obligated
8:11
to hand over to the bondholders. Yeah. That leaves
8:13
$35 million pre -tax for the shareholders. 35
8:17
million exactly. Now, let's say a nasty recession
8:21
hits. Supply chains completely freeze up. Consumers
8:25
just stop buying their stuff. It's a brutal year.
8:28
A bad time for everyone. Yeah. And the company's
8:30
operating profit falls by 40 percent. Ouch. OK,
8:34
so a 40 percent drop on 40 million. Right. That
8:37
means operating profit plunges all the way down
8:39
to 24 million dollars. 24 million. So what happens
8:43
to the bondholders during this awful recession?
8:46
Well, they don't care about the recession at
8:48
all. They have an ironclad legal contract. They're
8:51
taking their $5 million right off the top no
8:54
matter what happened. Right. That $5 million
8:55
is a completely fixed obligation. It is rigid.
8:58
Right. So what is actually left for the shareholders
9:02
now? Let me do the math. We take the new $24
9:05
million in operating profit. Yeah. We subtract
9:08
the unmoving $5 million fixed interest, which
9:11
leaves $19 million pre -tax for the shareholders.
9:15
Wait a minute. Ah, look at the difference in
9:17
the percentages there. Yeah, because the actual
9:20
business, the operating profit, that dropped
9:22
by 40%. Right. But the shareholders cut dropped
9:26
from $35 million all the way down to $19 million.
9:31
That is a $16 million hit on a $35 million base.
9:35
Exactly. That's roughly a 36 % plunge. Yeah.
9:39
Nearly half. Right. So a 40 % decline in the
9:42
day -to -day business translated into a 46 %
9:45
drop in the earnings available to the actual
9:47
owners. Wow. The fixed obligation of the debt
9:51
basically squeezed the residual claim. So the
9:54
stock is fundamentally more volatile than the
9:56
company itself. Oh, absolutely. Because the business
9:58
only dropped 40%, but the stock's underlying
10:01
earnings fell nearly half. It's like the stock
10:04
price is just a magnifying glass for the business's
10:07
actual performance. A magnifying glass is a great
10:09
analogy because financial leverage acts as a
10:12
massive amplifier in both directions. Right,
10:14
because if things go well. Right, if the economy
10:16
booms and operating profit surges by 40 percent.
10:19
The bondholders still only get their measly five
10:22
million. Exactly. So the shareholders cut skyrockets
10:25
by far more than 40 percent in that scenario.
10:28
Because the fixed costs don't scale up. They
10:31
don't. And this dynamic is the primary reason
10:34
why equities just jump around so much more violently
10:36
on the daily ticker than the underlying businesses
10:39
they actually represent. That makes total sense.
10:41
You know, the business itself might be steady,
10:43
but the leverage creates wild, wild swings in
10:47
the leftovers. It makes sense, but it also paints
10:49
a pretty terrifying picture for an investor.
10:52
Yeah. You're dead last in line. Your returns
10:54
are violently amplified up and down. And if things
10:57
go truly south, your entire investment can be
11:00
wiped out completely. It can. So wait, if I buy
11:02
a share of, let's say, a chemical company, and
11:05
they accidentally dump toxic waste into a local
11:08
river, and they get sued for, I don't know, $3
11:11
billion. Right. They go bankrupt. They absolutely
11:14
go bankrupt. But here's my question. If my dog
11:16
bites the mailman, I get sued personally, right?
11:19
Because I own the dog. If I own a piece of this
11:21
chemical plant and it destroys a river, how am
11:24
I not personally on the hook for that $3 billion
11:27
cleanup? I'm an owner. Well, because of one of
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the greatest historical legal innovations of
11:33
all time, it's a true superpower for investors.
11:36
It's called limited liability. Limited liability.
11:39
OK, let's dig into that. Because honestly, without
11:42
it, I cannot imagine anyone ever buying a single
11:44
stock. No. Without limited liability, the modern
11:48
global economy simply would not exist. Period.
11:51
Seriously. Think about it. If that chemical company
11:53
fails spectacularly and owes creditors $3 billion,
11:57
you, as a partial owner, owe exactly zero. Zero.
12:01
Your maximum loss is strictly capped at what
12:04
you paid for the shares. So if I bought $1 ,000
12:06
worth of stock, I just lose my $1 ,000. And not
12:10
a single penny more. The creditors cannot come
12:12
after your house, they can't take your car, or
12:15
drain your personal bank account to settle the
12:17
company's debts. Which, I mean, we take that
12:19
entirely for granted today. Yeah. But to the
12:21
full of this point out, this is actually a relatively
12:23
modern invention, isn't it? It is. Historically,
12:26
doing business was incredibly dangerous for an
12:28
investor. Really? Yeah. Before the widespread
12:31
adoption of the joint stock company and limited
12:33
liability in the 19th century, if you invested
12:37
in a business as a partner, and it failed, you
12:40
were personally liable for all of its debts.
12:43
Oh, wow. Creditors could literally seize your
12:45
farm, take your family estate, and in some areas,
12:48
they could actually throw you into debtor's prison.
12:50
Debtor's prison. Jeez. I really want the listener
12:54
to just imagine the alternative for a second
12:56
here. Yeah. Imagine I come to you with a pitch.
12:59
I have a great investment. OK. We're going to
13:02
build a massive offshore wind farm. It's 2 ,000
13:05
kilometers away. and it is going to be run by
13:08
a management team you will literally never ever
13:11
meet in your entire life. Do you want to buy
13:13
a hundred dollars worth of shares? I mean, if
13:15
limited liability didn't exist, I am running
13:17
away from that pitch as fast as I can. Because
13:19
if that wind farm mismanages its construction,
13:23
causes an environmental disaster, and goes bankrupt
13:25
owing a billion dollars... They could take your
13:27
house. They could take your house. For a hundred
13:31
dollar investment. Exactly. Nobody would ever
13:33
invest in anything they couldn't personally supervise
13:35
on a daily basis. You just keep your money under
13:37
a mattress. Pretty much. Limited liability is
13:40
the foundational rule that allows complete strangers
13:42
to fund distant enterprises. Right. It solves
13:45
this massive information and control mismatch
13:48
by using the law to permanently cap your downside
13:51
risk. It's the only reason ordinary people can
13:54
safely provide capital to massive global corporations
13:57
like, I don't know, Apple or Toyota. Without
14:01
losing sleep over the possibility of personal
14:03
financial ruin. Exactly. So, okay, I am completely
14:06
shielded from personal ruin, my house is safe,
14:09
but my money is still tied up in this giant enterprise
14:12
run by total strangers. Yeah, it is. If I'm last
14:15
in line for the leftovers... and management isn't
14:18
even legally required to pay me a dividend. What
14:21
is actually stopping them from just throwing
14:23
my money into a bonfire by buying corporate jets
14:26
and paying themselves massive unearned bonuses?
14:29
Well, that is where your voting rights come in.
14:31
Voting rights. Right. When you buy a common share,
14:35
you aren't just buying a set of economic outcomes.
14:38
You are literally buying a vote. You get to vote
14:41
for the board of directors, the auditors, and
14:43
any major corporate transactions. Let's be real.
14:46
here for a second. If I own a hundred shares
14:49
of a national bank, and there are, I don't know,
14:53
a billion shares outstanding, my hundred votes
14:56
are entirely decorative. I mean, I could vote
14:59
that the CEO has to wear a clown suit to the
15:01
annual meeting, and it's definitely not going
15:03
to happen. No, the clown suit is not going to
15:05
happen. Individually, your vote is negligible.
15:08
It's true. Right. But collectively, the vote
15:10
is the only real mechanism by which the owners
15:13
of the company can actually control the managers
15:15
of the company. Oh, I see. If a management team
15:18
performs poorly enough or long enough, the collective
15:20
voting power of the shareholders, which is usually
15:23
led by these massive institutional investors,
15:25
They can vote out the board of directors. And
15:27
then the new board fires the CEO. Exactly. The
15:30
new board cleans house. Yeah. So the lingering
15:33
threat of that collective vote is the ultimate
15:35
discipline on corporate management. OK, so we've
15:38
established the defense mechanisms. You're at
15:40
the bottom of the barrel in bankruptcy, sure.
15:42
But you have limited liability to protect your
15:44
house. And you have collective voting power to
15:47
keep management somewhat honest. Right. But let's
15:50
talk about the offense now. When that infinite
15:53
upside actually materializes and the company
15:56
finally starts handing you real cash, how much
15:59
of it is the government taking? Well, this brings
16:01
us to the Canadian tax advantage. Yes, the taxes.
16:05
The way Canada taxes investment income is a massive
16:08
part of why informed investors actually choose
16:11
to take the residual risk of equities over the
16:14
quote unquote safety of debt. Because a share
16:17
produces two different kinds of returns, right?
16:19
You've got dividends when they hand you cash
16:21
and capital gains when the stock price itself
16:23
goes up. Exactly. Let's tackle dividends first.
16:25
So to really understand the dividend advantage,
16:28
we have to contrast it with the return you get
16:30
from a standard bond. Okay. A bond pays interest.
16:34
And in Canada, interest income is fully taxable
16:38
at your marginal rate. Meaning the highest tax
16:40
bracket you fall into based on your salary from
16:43
your day job. Exactly that. Every single year,
16:47
a dollar of interest from a bond is taxed just
16:51
like a dollar you earned at the office. Which
16:53
is brutal. Is the least favorably taxed investment
16:56
income. If a bond pays you $1 ,000 in interest,
17:00
the government just takes a massive bite out
17:01
of that immediately. Right. Which severely drags
17:04
down your ability to compound that money over
17:07
time. But... Dividends are treated differently.
17:10
The sources mention this thing called the Eligible
17:12
Dividend Tax Credit. Why does the government
17:15
give us a credit just for owning a Canadian stock?
17:18
Well, think about it from the government's perspective.
17:20
They want you to take that dead last in line
17:23
risk. Taking risks, funding new businesses, building
17:25
factories, that builds the eponymy. If they taxed
17:28
you to death on the dividends, no one would ever
17:31
fund these companies. But more importantly, the
17:33
credit actually exists to prevent double taxation.
17:37
Double taxation. Walk me through the mechanics
17:39
of that. Who is being taxed twice here? Well,
17:42
the corporation itself is a separate legal entity,
17:45
right? Right. Right. So when it makes a profit,
17:47
it has to pay corporate income tax to the government.
17:50
OK, so the company pays its taxes. Yes. So the
17:54
money it uses to pay you a dividend is what's
17:57
left over after it has already paid taxes on
17:59
that income. Oh, I see. So if the government
18:01
turned around and taxed you at your full personal
18:04
rate on that dividend check, they would literally
18:07
be taxing the exact same pool of money twice.
18:10
Once at the corporate level and once at the personal
18:12
level. Exactly. So the dividend tax credit basically
18:15
adjusts for the corporate tax that was already
18:18
paid. Meaning your personal tax rate on eligible
18:20
Canadian dividends is significantly lower than
18:24
it is on standard interest. Way lower, yeah.
18:26
That is a critical distinction to make. I mean,
18:28
identical pre -tax returns from a bond and a
18:31
dividend stock leave you with drastically different
18:34
amounts of actual money in your checking account
18:36
to spend. Huge difference. And the tax treatment
18:39
gets even more powerful when we talk about the
18:41
second type of return from a share. Capital gains.
18:44
Capital gains? So if you buy a stock for $10
18:47
and it goes up to $15, you have a $5 capital
18:51
gain. Right. In Canada, capital gains are only
18:54
partially included in your taxable income. meaning
18:57
I'm only paying tax on a portion of that $5 profit,
19:00
not the whole thing. Right. But that partial
19:03
inclusion is great. But the real superpower of
19:06
equities for a taxable investor is deferral.
19:09
Deferral, meaning you just wait. Right. You aren't
19:12
taxed on that capital gain as the stock goes
19:15
up year after year. OK. You are only taxed when
19:18
you actually pull the trigger and sell the share.
19:20
So the deferral is basically giving you total
19:22
control over your tax bill. Total control. You
19:25
dictate the timeline entirely. I mean, you could
19:27
hold a fantastic growing business for 30 years.
19:30
You just watch the share price compound year
19:32
after year. And the government doesn't take a
19:34
single cent of capital gains tax until the year
19:37
you finally decide. to press sell. Exactly. Whereas
19:40
with a bond, they are taxing your interest every
19:44
single year, bleeding away your compounding power
19:46
continuously. Right. It's like trying to fill
19:49
a bucket with a hole in the bottom. That's exactly
19:51
what it is. The ability to defer capital gains
19:53
allows your money to compound tax free for decades.
19:57
It is arguably the most valuable wealth building
20:00
tool available to the everyday investor. That
20:03
is amazing. So bringing this entire mechanical
20:06
journey together. Buying a share is so much more
20:09
than just owning a microscopic fraction of a
20:11
corporate logo on a building somewhere. Oh much
20:14
more. you are consciously embracing the residual
20:17
claim. Like you're signing up to be dead last
20:20
in the bankruptcy line in exchange for limitless
20:22
upside. Right. And you are riding the volatile
20:25
waves of financial leverage, fully aware that
20:27
the company's fixed debt costs will violently
20:30
amplify your returns in both directions. Up and
20:32
down. And you're relying on the superpower of
20:35
limited liability to make sure your personal
20:37
assets, you know, your house and your car are
20:40
completely insulated from corporate disasters.
20:42
And finally, you are utilizing Canadian and tax
20:44
advantages, specifically the dividend tax credit
20:47
to avoid double taxation and capital gains deferral
20:50
to protect your compounding. All to maximize
20:52
the actual wealth you had to keep. Exactly. It
20:55
completely reframed how you look at a stock ticker.
20:58
It's not just a blinking green or red light on
21:00
your phone. It's this incredibly complex, highly
21:03
engineered bundle of legal protections and financial
21:07
rights. It really is, which leads to a final
21:11
somewhat sobering thought from the source material
21:13
that I think is really worth mulling over. Okay,
21:16
let's hear it. We have spent this entire deep
21:19
dive talking about ownership. What it means to
21:22
own a share. Right. But there is a vast gulf
21:25
between ownership and control. The illusion of
21:27
control. Exactly, the illusion of control. While
21:31
you are legally a part owner of the company,
21:33
holding a public share gives you essentially
21:35
zero real influence over what the company actually
21:38
does on a daily basis. That's true. You can't
21:41
tell them what to produce, you can't tell them
21:42
who to hire, and you certainly can't influence
21:45
their pricing strategy. I can't even take a chair
21:47
from the lobby. No chairs for you. This massive
21:51
gap between owning the asset and controlling
21:53
the asset is really the central unresolved tension
21:56
of modern corporate governance. It is a reality
21:59
every single investor simply has to accept. When
22:03
you press buy, you are handing over your hard
22:06
-earned capital, accepting all the residual risk
22:08
and entirely trusting a group of executives you
22:11
will literally never meet to run the machine
22:13
on your behalf. Man, it really is a profound
22:16
leap of faith when you frame it like that. A
22:18
leap of faith backed by a very specific centuries
22:21
-old set of legal rules. Perfectly said. So the
22:24
next time you open your portfolio, remember,
22:26
you don't own the vault, and you certainly don't
22:28
call the shots. But you do own the leftovers.
22:31
And if the machine works the way it's supposed
22:32
to, well, those leftovers can be worth a fortune.