Chapter 6: The Stock Market

Question 1

L01. The differences between private and public equity and primary and secondary stock markets.

Answer 1

6. 1 Private Equity vs Selling Securities to Public
   * Private Equity is often used to label the financing for nonprofit companies.
   * Venture Capital (VC): Financing for new, often high-risk ventures (Banks are not interested in making loans to start-up companies with no assets).
   * In addition to VC other areas of of private equity include middle-market firms and large leveraged buyouts.
   * A private equity fund raises money from investors and invests in private companies.

Structure of Private Equity Funds:

• Private equity funds and hedge funds share share some characteristics (even though) they are very different. Both are investment companies set up as limited partnerships that pool money from investors and then invest the money on behalf of these investors (investors pay a management and performance fee). Both have built in constraints to prevent fund managers from taking excessive compensation, a “claw-back” provision makes sure the manager receives only the agreed-upon performance fee. In both, the fees paid to the equity managers reduce net return so the benefit of such investments is debated. The benefit of having these in a portfolio depends on whether private equity funds provide diversification benefit for investors.
• Why private equity funds are not a reasonable choice for investors? 1. Investor must be “rich”, 2. Funds are really illiquid (process is too long).

Types of Private Equity Funds:

1. Venture Capital: refers to financing for new (often high-risk) ventures. Individual venture capitalists invest their own money, whereas venture capital firms specialize in pooling funds from various sources and invest them. Most of new venture will not fly, but the occasional will with enormous potential profits, so to limit risk venture capitalists provide financing in stages. Venture capital firms often specialize in different stages. Early stages are called “seed money” or ground floor financing, later stages are called “mezzanine-level” financing which comes through debt or equity such as preferred stock (common stock or bond that has options).
2. Middle Market: Small and possibly family owned and operated companies with ongoing concerns (not start-ups) with a known performance history. Many times these established companies are in the market for more capital if they wish to expand beyond their existing region, or the founders want to retire from the business. Private equity fund might be interested in purchasing a portion or all of the business so that others can take over running the company.
3. Leveraged Buyouts (LBO): Is taking a company private using borrowed money. Is the opposite of “going public” where a privately owned company sells ownership/shares to the public.

Selling Securities to the public:
The goal of a private equity fund is to invest in a private company, improve its performance, and exit the business with a profit. Exiting the business can be accomplished by selling to another investor, but typically is preferred to sell the firm to the general public. Managers of private companies that do not have private equity investors might decide to raise additional capital by selling shares to the general investing public (shares of stock would be listed on a stock exchange).
The Stock market refers to securities that are sold publicly and consists of a primary and a secondary market.
*Primary Market: Market in which new securities are originally sold to investors.
*Secondary Market: Market in which previously issued securities trade among investors.
*Third Market: Off-exchange market for securities listed on an organized exchange. An example is Bernard L. Madoff Investment Securities.
*Fourth Market: Investors trade directly with other investors through a computer network.
*Primary Market:
->Initial Public Offering (Unseasoned Equity Offering): Occurs when a company offers stock for sale to the public for the first time. Typically the company is small and growing and it needs to raise capital for expansion.
->Seasoned Equity Offering: Sale of additional shares of stock by a company whose shares already publicly traded.
->General Cash Offer: Issue of securities offered for sale to the general public on a “first come first served” cash basis.
->Rights Offer: Public issue of securities in which securities are first offered only to existing shareholders.
->Investment Banking Firm: Firm specializing in arranging financing for companies.
->Underwrite: Assuming the risk of buying newly issued securities from a company and reselling them to investors.
->Underwriter Spread: Compensation to the underwriter, determined by the difference between the underwriter’s buying prince and offering price (in IPO).
->Syndicate: Group of underwriters formed to share the risk and to help sell an issue.
->Types of underwriting:
1. Firm commitment: The underwriter buys the entire issue, assuming full financial responsibility for any unsold shares. (Most dominant of the 3)
2. Best efforts: The underwriter sells as much of the issue as possible, but can return any unsold shares to the issuer without financial responsibility.
3. Dutch auction underwriting (Uniform price auction): The offer price is set based on competitive bidding by investors. It is very common in the bond markets.
->Ontario Securities Commission (OSC): The provincial regulatory agency charged with regulating Toronto Stock Exchange listed securities and the companies. After the underwriting terms are decided, much of the time is devoted to the mechanics of offering; in particular, before shares can be sold publicly the issue must obtain approval registration with the OSC.
->Prospectus: Document prepared as part of a security offering detailing a company’s financial position, its operations, and investment plans for the future. OSC regulations are strict, to gain OSC approval a prospectus must be prepared (with outside accounting, auditing, and legal experts).
->Red Herring: Preliminary prospectus not yet approved by the OSC.
*Secondary Market:
Here investors buy and sell shares with other investors. Secondary market stock trading is directed through 3 channels: 1. Directly with other investors, 2. Indirectly through a broker, 3. Directly with a dealer.
->Dealer: Trader who buys and sells securities from inventory and is ready to buy or sell at any time.
*Bid Price: Price a dealer is willing to pay.
*Ask Price (Offer or Offering Price): Price at which a dealer is willing to sell.
*Spread: Difference between the bid and ask prices.
->Broker: Intermediary who arranges security transactions among investors. (no inventory).

Question 2

L02. The workings of the New York Stock Exchange.

Answer 2

6. 2 The New York Stock Exchange (NYSE).
   * Popularly known as “the Big Board”. U.S companies that wish to have their stocks listed for trading in the NYSE must apply. If the application is approved, the company must pay an initial fee of ($50,000 in 2009) plus a per share listing fee of $.0032 ($3,200 per million shares).
   * NYSE’s minimum requirements for applying companies (2010):
7. Company must have at least 2,200 shareholders, average monthly trading volume of 100,000 shares.
8. At least 1.1 million shares must be held in public hands.
9. Publicly held shares must have at least $100 million in market value ($40 million for IPOs).
10. Company must have aggregate earnings of $10 million before taxes in the previous 3 years and $2 million pretax earnings in each of the preceding 2 years.

Question 3

L03. The workings of the Toronto Stock Exchange.

Answer 3

The TSX unlike the NYSE is a computerized exchange. The TSX group is the global leader exchange in oil and gas sector, is the global leader in mining industry as well.
*Market Order: A customer order to buy or sell securities marked for immediate execution at the current market price.

Special Order Types:

• > Limit Order: Custom order to buy or sell securities with a specified “limit” price. The order can be executed only at the limit price or better.
• > Stop Order: Customer order to buy or sell securities when a preset “stop” price is reached.
• There is an important difference between a limit and a stop order, with a stop order the customer specifies a “stop” price that serves as a trigger point. No trade occurs until stock price reaches stop price, when this happens the stop order is immediately converted into a market order, so the customer may get a price that is better or worse than stop price. Thus, the stop price only serves as a trigger point for the conversion into a market order. Unlike a limit price, the stop price places no limit on the price at which trade can occur. Once converted to market order the trade is executed just like any other market order.
• The most common type of stop order is “stop-sell” order which is an order to sell shares if the stock price falls to a specified stop price below current stock price. This type of order is called a “stop-loss” because it is usually intended to limit losses on a long position. The order type is a “stop-buy” order which is an order to buy shares if the price rises to a specified stop price above the current stock price. Stop-buy orders are often placed in conjunction with short sales as a means of limiting losses. ** See table 6.1 page 178**
• A limit price can be attached to a stop order to create a “stop-limit” order so that once the stock price reaches the preset stop price the order is converted into a limit order. By contrast, a simple stop order is converted into a market order. With a stop-limit order there must be 2 prices specified: the stop price and the limit price (they can be the same price or different).
• Another type of order is the “short-sale” oder, involves borrowing stock shares and then selling the borrowed shares in hope of buying them back later at a lower price.

Question 4

L04. How to calculate index returns.

Answer 4

6.5 Stock Market Information
Stock Market Indexes
->Price-weighted Index: Index in which stocks are held in proportion to their share price.
->Value-weighted Index: Index in which stocks are held in proportion to their total company market value.
->Index Staleness: Condition that occurs when an index does not reflect all current price information because some of the stocks in the index have not been traded recently.