5 - Equities (fin) Flashcards
Capital structure
Debt
Preference shares - fixed divi, no voting rights
(not all comps have pref)
Ordinary shares - variable divi, voting rights
What does the L in plc mean
public limited companies - limited liability of the shareholders
insolvency - shareholders not liable to pay off debt
How are pref shares similar to loan stock
pref share pay fixed divi if there are sufficient post tax profits
loan stock - interest must be paid even if company is losing money
Reasons to purchase shares?
Income via divis
Capital appreciation via share price increase
Adv and disadv of listing for the company
advantages
- raising capital
- increase liquidity
- raises profile
disadv
- dilution of ownership
-relinquishing control
-hostile takeovers
DR?
benefits?
Depositary receipt
- fin instrument issued by financil intermediary to represent shares in foreign public company in a local domestic market
e.g. ADR - represents ownership in the shares of a non-US company (single or multiple) that trades in US financial markets
Can get EDR (europe) CDR (china) IDR (india etc)
- can purchase foreign shares without cross currency inconveniences
value of a share
fundamental value is NPV of all future divi payments - share value comprises of the discounted expected future growth in earnings and divi
Gordon’s growth model/ divi val model
Share price =NEXT divi / (required return - divi growth)
Advantages= simple method of valuing stock, useful for making cross industry comparisons
Disadvantages = ignores non divi factors (brand loyalty, growth, intangible assets), assumes constant growth rate
Doesnt work if comp doesnt pay divi
how to value companies that dont pay divis
rationale - via reinvestment company will be in a strong future position to pay divi
sharehodler return could be via sale of company or in form of capital gains
Modigliani-Miller theorem (M&M)
subject of theorem = whether shareholders would prefer to receive returns via capital gains or dividends
states MV of company is the PV of assets and future earnings - independent of capital structure (no diff between debt/equity finance)
- comp valuation not affected by divi payment = driven by ability to generate profit and grow
-in perf competitive market - no transaction cost/tax = value is same whether divi paid or held
shareholders indifferent to profit via divi or capital gains
Assumptions are unrealistic
- no tax differences between gains and income which there are
- no borrowing or lending costs
- assumes no transaction costs
-assumes high debt wont impact weighted avg cost of capital
Influences on share price
earning prospects
board memberships
adverse factors - legal action, poor governance reports, product callbacks
industry sentiment
macro (inflation, rates, business cycle) - some more than others i.e housebuilders
gov policy - fiscal and monetary
movements in other markets
geopolitics (particularly commodities)
deviations from traditional divi policy
behavioural weaknesses - following the crowd
Portfolio of equities - what to look for
Diversification - between sectors and geographies to reduce unsystematic risk and concentrated losses
correlation - looking for low or negative corr
beta = measure of stock’s vol relation to the entire market
B = 1 - moves in like with market
B>1 - moves more widely than market
0<B<1 - fluctuates less than wider markets
B=0 - no relationship to market movements
B<0 - inverse relationship with wider market
how can specific risk be removed
systematic risk i.e. market risk cannot be removes
specific risk - removed with diversification
15-20 stock - removes 90%
20-40 = removes 99%
funds hold more than this to prevent them having controlling shares
what is algo trading?
uses?
algo trading = use of algorithims (computer programs) to automatically buy/sell securities on XC; deciding price, quantitiy, AI models etc
to prevent to front running by others on trades placed by large institutional investors which leave large footprints on in the market - frontrunners will benefit from the uplift in price that occurs after instit investors place order
algo trading facilitates the more efficient execution of large orders on the sly
pros and cons of algo trading
pros -
protect instit investors from front running
decreased transparency as order book doesnt show whether small orders are part o large transaction - allows traders to operate with anonymity
creation of dark pols of liquidity
cons -
decreases transparency of order book
unexpected dramatic market moves - 2010 US flash crash 9% fall and rebound in US equities May 2010 - fault of UK day trader using algo systems to generate extreme vol
contrian trades could be market manipulation
prices on XC may not be true representation
HF traders may front run
EMH
3 forms?
EMH - developed by Eguene Fama
- financial markets are informationally efficient - all information discounted by market participants and current price is theoretically correct price
WEAK FORM
prices reflect historical info
tests whether publicly available info contained in historical prices is reflected in current prices
SEMI STRONG
current price reflects all public info, including all market info
tests seeks to confirm whether public info is reflected in price
STRONG FORM
current price reflect all relevant info, including historic, both public and private
strong form tests attempt to find out if all info is fully compounded in price and whether any investor can make excess profit
Believers posit best to invest in low cost, passive portfolio because of randomness of market
Opponents believe stocks can deviate from fair market val and poss to beat market
- asset bubbles are evidence stocks prices can deviate from their fair value
share price random walk
share price movements follow random pattern - where previous day’s movement uncorrelated to today’s
subscribers to random walk dont believe future price movements can be predicted from past
pros
- prices change on basis on new info - which is random by def - so follows price movement is random
-if price cycles were predictable, arbitrage and speculation would force prices to their efficient val
- plot of daily and lagged daily (t -1) of sp500 2020-2022 shows no correlation
cons
- presence of cyclical and season patterns in stock price
- Monday effect - Frank Cross - significant decline in prices on monday vs other weekdays
-january effect - Sidnet Watchel - tendency for prices to rise in jan following year end sell off for tax purposes
Behavioural finance
4 examples of biases
Investors don’t behave rationally according to BF, which is a key EMH assumption
- EMH states new info in markets processed quickly and rationally
loss aversion - losses and gains not experienced with same intensity, more discomfort with loss - can overcome by not being emotionally attached to investment.
overconfidence bias - exaggerated views of own ability, more frequent trading and less diversification - overcome by having a more LT view
anchoring bias - fixation on initial value as reference point when making decision - overcome by taking time with decision making
her behaviour - tendency to follow majority, pressure to conform, benchmark awareness, overcome through self discipline.
press and broker effects on share price
press - can effect price in short term - this could be due to natural demand flow or as result of report or speculation on result of report
broker recommendations
same as for press - potentially bigger names have more pull
takeover effect of share price
firm being acquired price tends to rise - due to premium normally paid over share price by acquiring company at time of announcement
risk of failing to generate returns required to justify premium makes it harder for acquirer share price to rise this munch
risk of takeover not occurring also dampens
new share issue effect on price
can drop if there is not enough demand in market
depends on reason for capital raise tho
index membership effect on share price
simply - as companies drop out of an index their share price falls as passive index funds sell out of them
simultaneously - traders identified such changes e.g. stock going in to index and purchase it to make a profit once stock is in index by reversing the position
equity crowdfunding
Crowdfunding refers to raising money from the public (i.e., the “crowd”), primarily through online forums.
Equity crowdfunding = In exchange for relatively small amounts of cash, public investors get a proportionate slice of equity in the business venture
e.g. Seedrs and crowdcube
online platforms allow people to invest in a bis in exchange for equity
can also provide non mainstream options e.g. Tielders - UK Shariah compliant platform enabling investment in real estate via SPVs
cons
- often bis v early stage and investment is risky
little recourse in case of fraud
dilution of investment as more shares are issued - startups undergo multiple funding rounds
long time to return on investment - bis takes which to generate income
securities not transferable (tho Seedrs has a secondary market)
Fintech in equity markets
Primarybid - regulated capital markets tech firm
wants to democratize public market offerings
partner of LSE and Euronext
automates aggregation of retail demand - giving access to stock issuances previously only avail to instit or profesh
allows comps to offer IPO shares to retail investors
Internet trading accounts/companies have existed for some time
eToro - concept of social trading - allows retail investors to follow trading strat of peers and experts using copy trading - low cost alternative to wealth management
characteristics of ordinary vs preference shares
Ord shares = most common type, represent permanent capital for a company. risk capital - last to be paid if comp goes into liquidation (typically nothing left
Preference shares: stock with divi paid to shareholders before common stock dividends are paid out
VOTING RIGHTS
ord - voting rights
pref - usually no voting rights (typically exception if havent received divi in 5 + years)
DIVI
ord - variable (discretionary, only paid out of profits and distributable reserves after prev divi)
pref - fixed
pref shares preferred because
- divi is paid in full before ord divi
- on wind up - higher repayment priority than ord
pref :( because
= divi fixed so wont benefit from sig increase in profit but more downside divi protection than ord
typical types of ordinary shares
Ord shares carry voting rights
Variable, discretionary divi paid after pref shares
Lower priority than pref shares in repayment
‘A’ SHARES
- non voting ord shares - issued often by family companies to avoid loss of control
- likely trade at discount to voting shares
GOLDEN SHARES
- special voting rights, can outvote other shareholders in certain circumstances
often introduced by founders - ‘founder shares’
often used by comps that the government privatized, held by gov giving effective control
used in brazil to maintain control of state run companies
DEFERRED
- not entitled to divi payment until certain condition met
e.g.
- time elapsed since issue
- profits exceeding certain level
-other classes paid x level of divi
REDEEMABLE
- can issue so long as comp has at least one other share class
-may be bought back by the comp either at option of comp or holder on specified date
types of pref share
Pref shares pay fixed rate of divi which is paid before ord shares
Repaid on wind up before ord shareholders
No security attached
Usually no voting rights (exception if no divi for 5 years)
CUMULATIVE - most pref shares = this
- if divi not paid due to insufficient profits - next divi cant be paid to ord shareholders until any pref arrears have been made up - divi rights baso carried forwards
NON CUMULATIVE
- divi rights not carried forward -arrears dont have to be made up
PARTICIPATING
- right to receive additional divi when profits exceed certain level - participate in good performance
- additional amount usually expressed as % of ord divi
REDEEMABLE
- will be bought back by company at agreed price on agreed date (in title)
CONVERTIBLE
- option to convert to ord shares
shareholder rights
basic
- to receive general accounts
- to be notified of AGM and extraordinary meetings
- to attend above and vote
- to share in profits
- to share in surplus on wind up
statutory
- companies must hold meeting once a year hence AGM
- >10% voting rights - can call an EGM (extraordinary general meeting)
- >5% voting rights - can propose resolutions
- can peition courts on grounds comp is conduct is prejudicial to shareholder interest
preemptive rights
- must be offered shares before they are made available publicly - prevents dilution
bonus/scrip/capitalisation issue
effect of balance sheet
free/bonus issue of shares paid for by company issuing shares out of capital reserves
- not raising finance
-main purpose = increase liquidity and reduce price
‘5 for 2’ = 5 new shares for every 2 existing
vale of SH holding remains same but price of each share decreases.
(US = 2 shares converted into 5)
Balance sheet (100m shares @ £1)
- net assets = same : no increase in val
-share capital is up to reflect increase NV issued +100m
- share prem account down to fund NV issue -100m
- shareholders funds and revenue reserves the same
rights issue
effect on balance sheet
issue of new shares to existing holders for cash - pro rata for existing holding (holder has right to buy not obligation)
- usually heavily discounted vs market price
- raises finance for company
-requires publication of prospectus, uw by IB who will buy unsubscribed shares
-if shareholders dont want rights - they can trade it for the nil paid price to compensate them for the dilution
-pre emption rights are required by law in UK to protect shareholders from dilution
Balance sheet
- net assets = up - increase in total val of assets
- share capital up - more shares issued
premium acc and rev reserves = same
- shareholders funds = up (funding increase in net assets)
Options shareholder has with rights issue
TERP = theoretical ex rights price = share price adjusted down post issue
Exercise rights and buy shares @ discounted price
Let rights lapse - receive lapsed rights proceeds
Sell rights nil paid in market + receive nil paid price
nil paid = TERP - subscription price
Sell some rights nil paid and use proceeds to purchase remainder of discounted shares (costless take up)
no. to sell = (no. of rights x sub price)/TERP
TERP
Theoretical ex rights price = share price adjusted down post issue
corporate actions
divis
share buyback
stock split
reverse split
bonus issue
rights issue
private equity
Equity not listed on an exchange (or a plc with the intention of delisting)
often PE investment funds are limited partnerships and not publicly traded but there are XC traded funds giving indirect exposure
investors can influence direction unlike plcs where board and management make key decisions
higher risk and return than public equity
known for extensive use of debt financing
info asymmetry
adverse selection - fewer public disclosure requirements. different info available to managers vs shareholders - leads to adverse selection as true risk of investment can be hidden
moral hazard - post transaction - managers may alter behaviour to run bis to benefit themselves at expense of SH, absence of regulatory reporting
underlying investment activities of PE fund
- venture capital startups
- private medium-sized firms seeking expansion finance
- public firms seeking finance for a management buyout or an LBO
- firms in financial distress – known as ‘special situations’, or
- public financing of infrastructure projects.
Reasons PE market size has increased in recent years
- potential for higher returns vs public equity (higher risk and lower liquidity in investments)
- development of limited partnership as intermediary - has mitigated some probss with regard to info asymmetry and conflicts of interest with regard to incentives
-regulatory changes allowing more PE investment by pension funds
PE categories
VC
- early stage (e.g startup) or later (rapid growth or exit route) w/ revenue <50mn
- comps have limited access to bank lending (smaller = less access)
- investors = normally partnerships but sometimes bis angels for smaller companies
distressed comps
- balance sheet showing high gearing via debt, often bonds and eq will be high yielding
- investors - seek to restructure debt and strategic direction, improve CF, asset sales of non core bis - improving distressed bond price in process
LBOs
- rely on large syndicate of banks, hedge funds, PE groups to lend money to LBO vehicle - in exchange for LBO bonds
- LBOV seeks to buy controlling interest in comp equity using high amount of borrowed capital
- LBO bonds = high yielding as high risk
- new management installed, reduce cost, improve profitability via non core disposals
mezzanine finance
- expensive way for comp to raise money - debt is unsecured and subordinated
- debt is high yielding as high risk
- ranks between ord shares and secured debt on wind up
why would a PE firm buyout a public company
Investors are typically partnerships
management buyouts - for comps with strong CF
LBO - comps with strong CF
financial distress - turnaround if bank credit not available
to avoid company registration costs and disclosure requirements
raising funds if industry out of favour with public
motive for PE finance in middle market company
e.g. profitable company in stable industrial areas
- likely have bank credit and equity finance
Why?
- expansion - either through capex or acquisitions
- changing capital structure with refinancing
- changing ownershio
risks of PE investment
illiquidity - investments dont trade in market, restricted ability to withdraw investments from fund
LT commitment - PE investment takes longer time to provide returns, and these arent guaranteed
Specific risk is greater - portfolio must be large enough to diversify this standalone risk
Typically commitment is over period of years - so investor must be prepared to supply cash over this time period
Returns on PE
Generally higher than many other asset classes - higher risk and low liquidity tho
Returns tend to be highest for VC, then distressed comps, then LBOs, then mezzanine capital
Avg PE firm has generated annual return of c.14% in 25 years to march 22 - 4% higher than US stock market
PE investments vs public
PE = deal price negotiated directly between 2 parties whereas general is on XC facilitated by brokers and bid/offer spreads
PE= less visible, whereas public = prices quoted on highly regulated market making system
PE investor becomes limited partner - gets access to internal info and policy whereas public = info only available via publicly released info in market
PE funds - buyout funds
most investors invest via PE funds - largest sector of PE funds = buyout funds
large cap BO fund
- purchase company then delist it (comp usually seeking asset sale of non performing bis unit or spin off)
- restore profitability of comp then relist via SIPO
intermediate cap BO fund
- often stock is not publicly listed - so purchased w/o need to delist
- improve performance and then list
Divi Capitalization : alternative way buyout firms can realize value (not sale/listing)
issue debt to finance a special divi to the general and limited
partners
control mechanisms and incentives for PE partnership
often manager paid % of NAV - aligning interests with partnership
board membership
GPs on board can have significant influence on comp direction
voting rights
partnership stake may be sufficiently large to give majority control, may ensure that its shares have special voting rights
access to additional financing
partnership will give company financing in rounds - giving ability to withhold funds if it thinks necessary
PE partnership company selection
initial screening
- type of investment (startuo vs middle market)
-industry
-location
-partnership’s area of expertise
DD for final selection
-visits to comp
-discussions with employee/customers
-lawyers, accountants, consultants to examine accounts
Startups: management qual and feasibility of product
Established = understanding existing bis
Distressed= meeting with lenders
Management buyout = focus on succession issues
LBOs= focus on CF forecast and ability to repay debt
MTF
Introduced by MiFID for transparent, competitive markets in EU
equity and non equity instruments traded
generally cross matching systems where buyers and sellers are paired and contracts exchanged
operated by market operater or investment firm
pre and post trade transparency
firms cannot execute orders against own order book or engage in matched principal trading
fast transaction speeds and lower costs
e.g Turqoise - adopted by LSE and launched in 2010 as enhanced processing system for its order flow
many secs trade on MTF and XC, leading to fragmentation of financial markets and increasing competition
non discretionary
OTF
ORGANISED TRADING FACILITY
Introduced by MiFID II
multilateral system which is not an MTF or a regulated market
OTF cannot offer equities while MTF can
OTF must e operated by investment firm while MTF can be investment firm or market operator
OTF discretionary while MTF non discretionary
matched principal trading permitted on instruments not subject to EMIR clearing obligation and with client consent
other trading venues
systematic internalizers
- e.g. large IB that can match orders between clients
- investment firms making markets outside RIE or MTF
dark pools
- non displayed/hidden nature of orders that reside within a crossing platform
biggest sources of dark liquidity are within IB and major brokers
ping pools
- similar to dark pools but brokers can ask qs about where order is from
- fewer controls with regards to transparency
dark pools
types? adv and disadv?
Types
- broker dealer owned
- agency broker or XC owned
- electronic market makers
adv
- effect of large deals on markets reduced
- reduced transparency - can execute large deals without displaying to market - hiding strategy
- may be cheaper
disadv
- price on XC may not be representative
- lack of transparency
- front running by HF traders
DD for PE fund
- visits to the company
- discussions with employers, suppliers and customers
- use of lawyers, accountants and consultants to examine the company
- for new startups, examining the management quality and feasibility of the product
- for established firms, understanding the existing business in detail
- for distressed companies, meetings with lenders
- for management buyouts, focus on succession issues, and
- for LBOs, focus on cash flow forecasts and the ability to repay debt.
