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A share, in the investment sense, refers to a small slice of a company. If somebody wants to sell part of their company, they can sell it as one piece to one buyer, or they can sell it as many pieces to many buyers. These 'slices' of the company are called shares. By dividing the company into many shares, sometimes billions of shares, almost anyone can buy part of a company, large or small.
The place where people can buy and sell these shares is called the stock market. The stock market traditionally has been a 'physical place' where people meet face to face, either transacting shares for themselves or on behalf of clients. The scenes of large trading floors with many people in brightly coloured jackets, shouting and screaming, are synonymous with the stock market. There is actually method behind this madness.
The number of different stock markets and the different ways in which they operate are too numerous to mention. However, the following passage describes the basic system behind most markets.
A person who wishes to buy or sell a share contacts a stock broker who will advise them of the current price of that share. The stock broker then rings one of their employees on the trading floor of the stock exchange and asks them to buy or sell at the price the client wants (if available). The employee then runs out to the pit, shouts out the order and if an employee from another stock broking firm agrees with the price (because they have a client who wishes to transact at that price), the transaction is recorded on a notepad, the confirmation is phoned back to the broker in the office and the broker then advises the client on the state of the order. This system is known as the open outcry system. It is still used in many countries but no longer in Australia where it has been replaced by electronic (computer) trading. This system still works with brokers who are the contact point for the client (the person buying or selling the share). The broker then places the order on a computer screen and this screen can be seen by all the other brokers around Australia. If another broker sees the order and wishes to trade at that price, they will transact through the computer. Money and records of share ownership can also be exchanged electronically.
In both systems, the buyer and seller will be charged a fee by the stockbroker called a brokerage fee. Additional charges such as stamp Duty and tax also usually apply. In Australia, the biggest exchange is The Australian Stock Exchange Ltd., or The ASX. They make money, among other methods, by charging the stockbrokers for use of their computer trading systems and charging fees to companies that are listed on the exchange (listing fees)
So why do people list their companies on the stock exchange? One answer is that it is just a way of selling all or part of the company which may have been difficult to do with just one or a few buyers. This is often the approach by governments who sell off public assets. Large utility companies are usually too large to sell to just a single buyer. By breaking the company up into many small parts, it is often easier to sell (to many different buyers). The government then keeps this money to do with as they wish.
A more common reason for listing a company on the stock exchange is to raise finances so the company may undertake whatever project they plan on doing. In this scenario, the existing shareholders will ISSUE more shares but keep the ones they already own. By issuing more shares, they dilute their own shareholding but all the funds raised go into the company so it may pursue its business objectives. For example, say Joe Bloggs TV rentals is a company with 10 million shares owned by Joe Bloggs. Joe may wish to expand his chain of stores around the country but this will cost 5 million dollars that Joe does not have. The bank will not lend him the money because they believe the risk is too much that he won't be able to pay the money back. However, there may be a few investors who will pay $1.00 per share so Joe can raise the $5 million. The company share structure will then be as follows:
No. of shares before issue: 10,000,000
No. of shares after issue: 15,000,000
So Joe owned 100% of the shares before the issue but after the issue only owns 66% of the shares. However, it must be remembered, the company now has an extra $5 million in the bank and no debt. The zero debt part is very important.
Many investors are prepared to take higher risks in return for very high returns. For example, people may be happy to invest in a company that is about to drill for gold if there is chance the stock may triple if they actually find gold. This is a 300% return on investment. A bank on the other hand is probably not going to lend money with their only profit coming from basic interest payments (say 15%) if there is a good chance the company won't find gold. The ability to raise money is what attracts company owners to the market and the opportunity for superior returns is what attracts the investors.
The concept of raising money by an initial public offering (IPO) is a little more complex than the example given and the raising of capital is strictly regulated by the relevant authorities. In Australia, capital raisings are governed by Chapter 6D of the Corporations Act 2001 and regulated by the Australian Securities and Investments Commission.
Shares are issued via a form known as a PROSPECTUS. The prospectus outlines all the details of the company that the investor should consider before applying for shares. If the investor wishes to buy shares in the issue, they will complete their details on the form and make a payment to the company by cheque or some other method. If the issue is popular, the issue may be oversubscribed which means there are more people wanting to buy the shares than there are shares available. In this case, some subscribers to the shares will miss out on obtaining shares. Choosing the people who miss out is usually at the discretion of the directors of the company. In the case that an issue is undersubscribed, (there is less applications for shares than there are available), the issue may be cancelled and investors have their money returned. A more common scenario is that the shortfall of shares is bought by a party who has previously agreed to buy any shares in the issue that have not been subscribed for by the due date. These parties are known as UNDERWRITERS and they are paid a fee for the risk they take in case they have to buy the shortfall of shares. What they do with the shares from that point on is entirely up to them.
Once the money has successfully been raised, the shares are usually listed on the stock exchange. Holders of the shares can then contact their stockbrokers and sell their shares. Buyers are then able to buy the shares instantly on the market instead of having to go through the prospectus procedure. The price is dynamic in that it can change very quickly. The market is very transparent and the prices of shares can change dramatically when information concerning the company, or the market as a whole, is released. The total value of the company is called its market capitalisation. This is simply calculated by multiplying the number of shares in the company by its current share price.
It is strange to think that companies with billions of shares change their value by millions of dollars every cent the share price moves.
Once the investor has bought shares, they are entitled to certain rights. For example, if an investor owned 1% of the company, they would (usually) have the right to 1% of the vote on certain decisions the company may make. This is an interesting part of share ownership. Sometimes, what the directors believe is in the interest of the company is not always what the shareholders believe is in the best interests of the company, for example, directors salaries. Voting is restricted to 'major decisions' of the company. These decisions may include the issue of more shares, change of business for the company, a new name, new directors, acceptance of a takeover bid or merging with another company. The 'daily running of the company' is left to the directors (elected by the shareholders). Imagine if a shareholder had to be held each time someone wanted to buy new staples! Directors are either executive directors where they work full time for the company or non-executive directors where they usually limit themselves to attending board meetings and having input into some of the more major decisions of the company. Non-executive directors are usually employed because of certain experience or skills they may bring to the company but where it is not prudent (or possible) for the company to employ them full time.
A successful company will make profits and some of these profits will be distributed to shareholders as a dividend. It is largely up to the directors to decide just how much of the profits will be paid out in dividends. Not all companies pay dividends instead preferring to keep the cash to fund future company projects so that the share price may increase. Dividends are paid on a per share basis. For example, the party that owned 1% of the company will receive 1% of all the dividends paid. Dividends can be paid in cash or can be paid in shares (where the equivalent value of shares is given to the shareholder instead of cash). The payment of dividends by the issue of more shares is known as a dividend reinvestment plan (DRP).
When the directors decide the dividend payment, they are basing the amount on the profit the company has made. This profit is usually the after tax profit. If the company has already paid the tax on the earnings it has made, is it fair that the shareholder should pay income tax again when they are paid the profit as dividends? Luckily, for shareholders in Australia, the government has decided that it is unfair. When a company pays the tax on its earnings, it keeps a note of how much tax it has paid and this amount is grouped with the dividend and termed a FRANKING CREDIT. If a company has paid all the tax it owes then the dividend is said to be 100% franked. It has had all the tax paid on it that the company owed to the Tax Office. In Australia, the current company tax rate is 30% (2002). This means if a company has paid all the tax on the dividend (100% franked) then it has paid a tax rate of 30%. If the dividend holder has a personal tax rate of 40% then the Australian Tax Office expects another 10% of income tax to be paid on the dividend. If the tax rate of the shareholder is 20% then that person may use the extra 10% of franking credits as a deduction against other tax they owe. This is a rather simplified explanation of franking credits and dividend franking varies between companies and effects shareholders in different ways. Investors should seek advice from an accountant should they wish to claim franking credits.
Shares are not the only securities that can be traded on the stock market. Some companies may not wish to dilute their shareholders by issuing more shares so they borrow the money. If they are unable to borrow from a bank or a limited number of parties, they may approach the mass market to borrow money. In this case, an investor will subscribe for the 'debt security' issue and in return they will be paid an interest amount at various times (say 8% of the principle amount every six months) and have the entire original amount returned at some point in the future (say 5 years). The debt securities are usually listed so the investor may 'sell the loan' at any time. Debt securities come in different forms. Debentures, bonds and convertible notes are all types of debt securities. Securities that pay a fixed amount at fixed points in time are known as fixed interest securities. Bonds are the most common type of fixed interest security.
Derivatives are also traded in the stock market (as well as all the other markets). A derivative is a security that has its value derived from the value of something else. For example, most of the derivatives on the stock market will derive their value from the price of a particular share. The most common forms of derivatives are futures, options and warrants. These are essentially contracts between the buyer and the seller that involves the underlying security. Futures are usually traded in a separate market (the futures market).
A Newscorp futures contract will essentially trade at the same price as Newscorp. However, if a trader purchased 1000 Newscorp futures at $15.00 (also the current price of Newscorp, the trader does not have to pay the full amount ($15,000) as they would have had to do if they had bought the fully paid shares. The trader only has to pay a 'margin'. This margin may be 10% of the full value ($1,500). The futures contract stipulates that the buyer of the future will buy the Newscorp shares in 3 months (or whatever time frame is stipulated) at $15.00. In three months time, Newscorp may be trading at $18.00. The seller of the futures contact will still have to sell the Newscorp shares to the buyer at $15.00. In other words, the buyer has successfully locked in the lower price of the shares. In reality, the trader would have sold the futures contract at around $18.00. Remember that the trader bought $15,000 worth of shares but only paid a margin. Now those shares are worth $18,000. The profit is $3,000. The trader also receives the margin back so the $1,500 investment is now worth $4,500. It is this leverage and the opportunity to make massive profits from a small outlay that attract people to the futures market. The futures market also allows the trader to lose a lot of money. If the Newscorp shares had fallen to $12.00, the value of the shares is worth $12,000. The trader is obliged to pay the full amount of $15,000. This represents a loss of $3,000. The futures broker would have taken the $1,500 margin and asked the trader for another $1,500 to make up the entire payment for the loss. In other words, the initial investment of $1,500 became a loss of $3,000. This is a strange concept - the fact that the initial investment is not the maximum amount that can be lost. The maximum loss is virtually unlimited.
Options and warrants are similar to futures but the maximum loss can be limited to the initial investment. Options also differ in that there is a set price at which the shares will be bought in the future and there is no obligation by the purchaser of the option to purchase the shares at the end of the time period. This is different to futures where the buyer must buy the underlying shares at the end of the period (if they are still holding the futures contract) regardless of the current price of the underlying share. For example, an option buyer may wish to buy an option in Newscorp that gives him the right, but NOT THE OBLIGATION to purchase the shares at $15.00 in three months time. The cost of the option is 50 cents. In three months, if the shares are trading at $18.00, the contract is essentially worth $3.00 because the option allows him to purchase stock $3.00 below where it is currently trading. This is a 500% return (50 cents to $3). If the stock fell to any price below $15.00 then the option would be worthless. What is the point of exercising the right to buy stock at $15.00 when it can be bought on the market for less? This would then represent a 100% loss on the original capital. However, unlike futures, this is the maximum the trader can lose. He is not obliged to purchase the shares at $15.00.
In some instances, investors may prefer to have other people invest their money for them and make all the decisions in regards to buying and selling of various securities. This involves investing in a MANAGED FUND. Managed funds are operated by fund managers - professionals in their field and supposedly able to provide superior returns than other market participants. The investor still has to make some decisions in regards to the managed fund. A managed fund will have a category such as 'Australian Shares', 'Balanced Growth', 'European Shares' or 'North American Fixed Interest'. The investor must decide which category or categories they would like to invest in. The different categories will also carry different risks. These risks are assessed by the fund manager or by an independent party. Managed funds usually have an entry fee (similar to a brokerage fee when buying shares) and sometimes an exit fee. Funds also have a management fee, which is calculated as a percentage of the value of the investment at the time the fee is taken out (usually once a year). Investors are attracted to managed funds because they allow them to get exposure to markets in which they may not otherwise be able to invest. This is particularly relevant to the fixed interest markets where the price of one bond may be in excess of $100,000. By being able to pool many investors together, the fund is able to invest in such securities and diversify the fund over many different markets. The disadvantage of funds is the management fees that are subtracted from the investment. However, these are often at a rate that is comparable to brokerage fees if the investor were to invest directly into the market.
Two other important security types have not yet been mentioned - property and currency. Even property has found its way into the stock market in the form of property trusts. These are traded exactly the same as shares but all of the profits are usually paid out to the shareholders. In other words, the rental incomes are distributed as dividends and the increase or decrease in the value of the property over time is reflected in the share price. This allows smaller investors the opportunity to invest in large property portfolios, commercial properties and properties in various locations including overseas.
Currencies are traded in a similar way to stocks and shares. Investors contact a currency dealer who will execute the trade on their behalf. There is usually no brokerage on currency deals. The dealer will usually sell the currency to the customer slightly higher than it is currently trading on the market and when buying back the currency, purchase the currency at a slightly lower price than the current price. The dealer is able to make money out of this small difference in price. Naturally, the bigger the difference, the more the dealer is able to make. Currency traders usually have access to a number of other different dealers so they can 'shop around' for the best price.
So far in this lesson, we have covered various types of securities that can be traded and how those securities are bought and sold. Having seen the many securities available to investors, the question now is which security to trade? For the purposes of these lessons, we are only going to cover ordinary shares. Most of the concepts can be transferred to other markets but for the sake of continuity, only shares will be covered (with the exception of lesson 6 that deals with derivatives).
No one should dive randomly into the market and buys the first share they come across. All buyers possess some information on the share, which they believe will cause the share price to rise. The information comes from analysing the company. There are essentially two forms of analysis when dealing with the stock market - fundamental and technical.
Fundamental analysis involves looking at the company itself whereas technical analysis involves analysing the share price and the way the company has traded. Among other factors, the fundamental analyst is concerned with the business of the company itself, the financial situation of the company, its cash flow, the economy of the area the company operates in, the management and the potential growth of the company. This information is gained by visiting the company, interviewing people within the company and inspecting the financial accounts. From this information, fundamental analysts try to build a picture of the value of the company. If the current share price is below their valuation, they will consider buying the share. Many people are obviously not in a position where they can go and carry out in depth analysis of companies. Analysts employed by broking firms and banks will conduct the analysis and they will write a recommendation to the clients. If their valuation of the company is greater than its current share price, they will write a BUY Recommendation report and send this report to various clients of the broking firm who may then act on the recommendation.
Proponents of fundamental analysis believe that through analysing the financial statements, economic outlook etc., an accurate picture of the value of the company can be determined. Technical analysts are not concerned with the activities of the company, its financial position or who the management is. Technical analysts are only concerned with the trading patterns of the share. The three main pieces of information a technical analyst requires are price, time and volume. These three pieces of information can be put into a chart format for easier analysis. The following chart shows an example of Newscorp trading between 3rd Sept. and 20 Nov. 2002 (time - horizontal axis). The various prices that the share traded at can be seen by the line going across the chart. This is the price that the share closed at on each particular date. The vertical bars at the base of the chart are the volume bars and this shows how many shares were traded in each of the time periods. From this chart, a technical analyst can gather enough information to make an investment decision.
At this point, a sensible question would be, 'How could this be so?' How can knowledge of price/time/volume give an indication to the future direction of the share? How can this information be superior to knowing the financial state of the company? The answer lies in the psychology of the market as a whole. The market is fuelled by fear and greed. What other explanation is there for a company's value to change by (sometimes) billions of dollars without any new fundamental information being released to the market? People panic sell because they fear they will lose money if they don't sell. Likewise, people panic buy because they can be greedy and/or fear missing out on making money. Technical analysts use various techniques to determine when these fluctuations may occur. Professional investors and people 'in the know' are usually going to be the first traders to buy or sell shares. Technical analysts are often able to 'see' when this is occurring and join the professionals in whatever they may be trading. When the professionals begin to sell, the technical analysts can usually spot this and also sell. More often than not, when information is released to the market, the market has already factored in the information and the stock price will not move too far from when the information was released. Technical analysts can often see the price movement well before the information is released.
For example, a large bank may have huge investments in oil. If the oil price suddenly rises, the market will naturally pour money into the oil stocks because they should make more money out of the oil price increase. However, a few analysts at a managed fund know about the large investments the bank has in oil and they begin to purchase shares in the bank. In three months time when the bank reports its annual profit, it turns out they have made a lot of money out of some oil investments. The market is now fully informed and the stock price adjusts accordingly. However, the fund has already bought many shares and makes a large profit.
So isn't this supporting fundamental analysis by the mere fact that the fund analyst knew the information about the company? For the fund, this is most definitely a case of fundamental analysis working at its best. However, could the average person in the market have made money out of the bank price move without knowing the information? Technical analysts will most likely answer, 'Yes, they can.' When the fund began to buy the share, the buying could possibly have been spotted in the chart and a technical analyst, no matter how much money they had to invest, could have joined in on the buying.
Although fundamental information is important, the aim of these lessons is to teach the reader some methods of technical analysis. Armed with this knowledge, the reader should be able to better time their buying and selling to achieve maximum profits.