Equities Flashcards
Market
Alternative Trading System (ATS)
Definition
Dark Pool definition
Non-exchange trading venues.
Do not have regulatory authority over subscribers, do not discipline other than exclusion from trading.
Examples are electronic communication networks.
A dark pool is a type which doesn’t display orders (usually very large).
Market
Dealer
Definition
A dealer is somebody who trades for their own accounts.
They provide liquidity by trading securities for themselves.
Market
Leveraged Positions
If you buy a stock on margin, what is the investors equity amount?
This is the market value of the stock minus the amount borrowed.
Market
Orders
How does a stop order work?
Also known as a stop-loss order, this basically sells your position if the market falls below a certain level. So if the market is at $20, you bought at $10, you can place a stop order to sell at $15. If the market falls to $15 the broker will exit your position at around a $5 profit.
Market
Primary Markets
What is rule 415?
Rule 415 says that large firms can register primary security issues and sell the shares over the next 2 years. Called shelf-registration. Allows a single registration to be filed for the issuance of multiple securities.
Market
Primary Markets
What is rule 144A?
144A - Private Placement
This allows corporations (including non-US) to place securities privately with large, sophisticated investors.
This is a private placement with lower issuing costs due to low marketing and registration requirements.
A higher return is likely to be required due to the lack of a secondary issue.
Market
What is a call market?
What is the opposite called?
A call market is when trading takes place at specified times. Bids and asks are gathered together and a single price is determined to match them off.
The alternative is the more usual continuous market. This is where securities are traded continuously during market open hours.
Note that exchanges are usually continuous markets but employ call market mechanisms (eg closing auctions).
Market
4 features of a well functioning market
CLOI
- Complete markets - Instruments needed to solve investment and risk management problems are available to trade
- Liquidity
- Operating efficiency - low transaction costs
- Information (or external) efficiency
Indices
What is float-adjusted market cap weighting?
This is when the free-float portion of the market capitalisation of the company is used to calculate the weighting, rather than the full market cap.
Indices
What is fundamental weighting?
This is when some fundamental measure such as an accounting figure is used to weight the stocks in an index.
Indices
What is “reconstitution”?
As opposed to rebalancing, which is adjusting weights of index constituents to maintain the weighting of the index. Note price weighted indices never need rebalancing.
Changing the composition of the index (i.e. kicking stocks out and adding new ones) to ensure the index represents the desired target market, is called reconstitution.
Efficiency
Define an efficient capital market
Alternative name
An efficient capital market is one in which:
- securities prices adjust rapidly to the arrival of new information and
- current prices of securities reflect all information about the security.
Thus it is also known as an informationally efficient capital market.
Efficiency
Intrinsic Value of stocks
Market Value of stocks
Relevance to market efficiency
Intrinsic value is the true, actual value of an asset, what it is really worth.
Market value is the market price of the asset, what buyers are willing to pay for it.
In an efficient market the two values should always be very close or the same.
Efficiency
Efficient Markets Hypothesis
What are the weak, semi-strong and strong forms?
Weak form says that stock prices reflect all information that can be derived by examining market trading data. Therefore technical analysis is pointless
Semi-strong form says all publicly available information is reflected in prices.
Strong form says that all information relevant to the firm is reflected in prices.
Efficiency
Market Anomaly
Definition
A market anomoly is a security price distortion in the market which seems to contradict efficient market hypothesis.
These basically looks like inefficiencies in the market and present trading strategies to investors who spot them.
Efficiency
Market Anomoly
Calendar Anomalies
An example
Calendar anomalies suggest that there are regularities in rates of return during the calendar year which allow investors to predict returns.
The January anomaly suggests that people sell loss making stocks towards the end of the year for CGT purposes and wait until Jan to put their money back in. The effect is stronger for smaller stocks. Could also be caused by portfolio managers getting loss-makers out of their portfolio before their annual reports at year end.
Efficiency
Market Anomoly
Momentum/Overreaction anomalies
Suggests that selling stocks that have performed well in the last 3 to 5 years, and buying poor performers over that period, will give good returns.
The anomoly seems to exist but researchers argue that the existence of momentum is rational and that the extra return is at the expense of increased risk.
Efficiency
Cross-sectional anomalies
Size effect
Value effect
The size effect says that small firms outperform large firms after considering risk and transaction costs.
The value effect says that risk-adjusted returns for stocks in the lowest P/E ratio quintile are superior to those in the highest P/E ratio quintile.
These two effects can have a dramatic effect when considered together.
Efficiency
Market Anomaly
Closed-end investment fund discounts
Closed-end investment funds tend to trade at a discount to net asset values.
This can partially be explained by capital gains taxes (taxes still need to be paid on unrealised gains held by the fund), agency costs and underlying stock liquidity.
However there still appears to be an unexplained discount.
Efficiency
Market Anomaly
Earning Surprises
IPOs
After earning surprises stocks tend to continue to drift in that direction. This could be due to the fact that positive and negative surprises tend to come in groups rather than being unique events.
IPOs tend to be under-priced by underwriters, however the price tends to adjust within the first days trading.
Efficiency
Behavioural finance
Definition
Examples
Behavioural finance considers that investors behave irrationally and make predictable errors.
Examples include:
- Loss Aversion
- Overconfidence
- Gambler’s fallacy
Efficiency
Behavioural finance
What is information cascading?
Information cascading is when an individual imitates the trades of other market participants, disregarding their own private information. Herding is a related concept.
Some researchers argue that information cascades help promote market efficiency.
Equities
Common Shares
Two important characteristics
Residual claim means that the common shareholders are the last in the line of people with a claim on the assets or income of a company
Limited liability means that the greatest amount shareholders can lose is their initial investment.
Equities
Voting
Statutory voting
Cumulative Voting
Statutory (or straight) voting is one vote per share.
Cumulative voting is where each shareholder gets one vote per share times the number of directors to be elected.
Equities
Participating Preferred Shares
These offer additional dividends if the company reaches predetermined financial goals.
Equities
Depositary Receipts
What is a sponsored depositary receipt
A depositary receipt issued with the cooperation of the foreign company whose stock underlies the DR. These carry voting rights.
Equities
ADRs
Level I
Level II
Lever III
SEC Rule 144A ADR
Level I are used when the issuer isn’t looking to raise capital and are not listed on an exchange (OTC trading).
Level II are listed on exchanges (or quoted on Nasdaq) and must comply with registration and reporting requirements of SEC’s exchange act.
Level III is most high profile and allows the issuer to raise capital.
SEC Rule 144A ADRs allow foreign companies to raise capital privately with qualified institutional investors, without SEC registration.
Analysis
3 approaches to identifying similar companies
- Products and/or service supplied (i.e. sectors)
- Business-cycle sensitivities (eg devensive/stable vs growth)
- Statistical similarities
Analysis
Industry Classification
Global Industry Classification Standard (GICS)
Method
Useage
GICS assigns each company to a sub-industry and a corresponding industry, industry group and sector, according to the definition of its principal business activity.
It is used by the global financial community, for example as a basis for the S&P and MSCI indices.
Analysis
Industry Classification
Russell Global Sectors
Method
RGS sysmtem uses a three-tier structure to classify global companies, based on the products or services a company offers.
Analysis
Industry Classification
Industry Classification Benchmark (ICB)
MEthod
ICB: PSR
ICB categorises companies into subsectors based on a company’s primary source of revenue.
Analysis
Peer Group Analysis
Description
3 useful questions to identify peer group
Peer group analysis is the process of comparing a firms results with those of similar firms. Commerical industry classification systems provide a starting point.
Look at companies in the same industry, review the company and its competitors annual reports and confirm each company’s primary business activity is similar to the subject company.
- What proportion of revenue/operating profit is derived from similar business activities?
- Similar demand environment?
- Does it have a finance subsidiary?
Analysis
Strategic Analysis
Porters 5 forces
- Bargaining power of suppliers
- Bargaining power of customers
- Threat of new entrants
- Threat of substitutes
- Intensity of rivalry/competition
Valuation
Valuation Models
3 valuation models
- Present Value models - includes dividend discount models and free-cash-flow-to-equity models
- Multiplier models - these are relative valuation models
- Asset-based valuation models
Valuation
Discounted Dividends
Gordon Growth Formula
How to estimate the inputs
V0 = D1 / (r - g)
Where r is the required rate of return and g is the expected dividend growth rate.
Rate of return: Calculate the risk-free rate based on real risk-free rate and expected inflation, then add an estimate of risk premium for the stock.
Growth: Estimate firms retention ratio and expected return on equity, growth rate is retention rate * ROE.
Valuation
FCFE Valulation Model
Definition of free cash flow to equity
This is cash available to stockholders after payments to and inflows from bondholders.
STart with net income and adjust for capital expenditure and debt payments (including interest and principal repayments).
Valuation
P/E
Trailing vs Leading P/E
Trailing P/E is based on earnings over the last four full quarters.
Leading P/E is based on the forecasted earnings for the next full fiscal year, or the next four quarters.
Valuation
P/E
Calculate P/E from Div payout ratio
From DDM: P = D1 / (r - g)
So P/E1 = (D1 / E1) / (r - g)
where D1 / E1 is the dividend payout ratio.
Since the payout ratio is fairly stable, the real determinant of P/E is the difference between the expected rate of return and expected growth rate of dividends.
Valuation
P/S Multiple
Definition
Divides price per share by the last 12 months net sales per share.
Valuation
Enterprise Value
Definition
EV uses EBITDA, but since EBIDTA is distributed between common & preferred shareholders and bond holders, it needs to be compared the total value of the company not just market cap.
EV = MV of common stock + MV of preferred stock + MV of debt - cash and investments
Then EV/EBITDA gives an indication of company value (not equity value).
Sectors
Global Industry Classification Standards (GICS)
Russel Global Sectors
Industry Classification Benchmark (ICB)
GICS - Principal business activities (used by S&P and MSCI indices)
Russel - 3 tier structure, products and servies
ICB - Primary Source of Revenue
Buying on Margin
Buy stock worth $100 at margin rate of 40% when borrow rate is 10%, what interest do you pay?
You pay $100 * (1 - 40%) * 10% = $6
You have to pay interest on the value of the stock not covered by your margin. The opportunity cost of putting the $40 on margin for a year is not part of the question.
Short Sales
Cash and Margin practicalities
Proceeds of the short sale must be held in the brokers account, don’t go to the short seller.
Additional margin must be posted by the investor to cover losses.
Systematic Risk
Systematic risk = market related risk.
Caused by macroecnomic variables such as IR volatility, industrial production etc.
Unsystematic = company specific.
EBITDA
Start with net income or continuing net income?
EBITDA uses continuing net income
Cyclical stocks
Cyclical stocks can be cyclical with anything.
So a stock that is not cyclical with the economy, but trends against stock prices, is still called cyclical.
Indices
Types of tilt seen in price/market cap weighted indices and fundamental weighted indices
Price weighted gives momentum tilt since a stock whose price increased recently will have a higher price.
Fundamental weighting gives a value tilt (even if weighted by earnings, having high weight of high earnings company is considered a value tilt).
What is a specialist?
On NYSE, a specialist can act as a dealer (own account) or a broker (executes trades for others).
