Topic 5 - Investors in the Share Market (Equity Markets)

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 206-239.

Share Market Investment

[1] Investors buy shares to receive returns via dividends or capital gains. Other factors encouraging or facilitating investment are:

  • Depth - the extent to which large orders disturb or don’t disturb prices (measured by market capitalisation)
  • Liquidity - ability to convert to cash at current market prices, volume of trading relative to size of the market
  • Efficient Price Discovery - speed & efficiency with which new information is reflected in the current share price

There is a wide range of choice as the ASX has 2000 listed stocks in different industries as well as equity based managed products (ETF, CFD, & Derivatives)

Types of Risk

There are two types of risks that impact on security returns:

  • Systematic - factors that generally impact the whole market, e.g. changes in economic growth or interest rates
  • Unsystematic - factors that impact specifically on the share price of a corporation e.g. CEO resignation, operations

Diversifying a portfolio usually reduces unsystematic risk – but investors won’t receive higher returns for bearing unsystematic risk. This leaves only systematic risk which is measured by β which measures of the sensitivity of the price of an asset relative to the market. Expected portfolio return is the weighted average of expected returns of each share. Portfolio variance (risk) is correlation (covariance) of pairs of securities within the portfolio.

Types of Approaches

Investors must take 1 of 2 approaches:

  • Active Investment Approach - portfolio structured on fundamental or technical analysis (strategic stock picking)
  • Passive Investment Approach - portfolio structured to replicate (or partially) a specific share-market index

Investors must also consider portfolio asset allocation (particularly with diversification): risk & return(un/systematic risk, diversification & beta), investment time horizon, income or capital growth (tax implication), liquidity, domestic or international.

Buying And Selling Shares

  • Direct Investment in Shares – the investor buy & sells directly via a stockbroker
    • Discount broker(transactions – usually online), $25-40
    • Full service broker (transaction, advice, recommendations, financial planning & research),
    • In stock picking, investor must consider liquidity, return, risk, charges, taxation, social security, integrity
  • Indirect Investment in Shares – by purchasing units in a managed fund or unit trust e.g. equity trust, REITS
  • Trustee allocates funds to prof. fund managers. Fees (entry, exit, mgmt, admin) higher than direct investment

Taxation

[2] Prior to 1987, dividends were taxed twice, first at company level then at the investor’s marginal tax rate (MRT). A dividend imputation system was introduced to avoid the double taxation of dividends. Investors receive a franking credit for the tax a company pays (on a franked dividend).

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Franked Dividend + Franking Credits = Gross Dividend → Multiply by MRT = Tax Liability → Less Franking Credits = Tax Payable

Financial Performance Indicators

[3] Investors are concerned with the profitability & variability of future cash flows that are determined by company performance.

  • Capital Structureproportion of assets funded via debt & equity, measured by D/E Ratio or E/A proprietorship ratio
    • Higher debt levels increase financial risk – not meeting interest repayments & more dependent on external funding
    • Risk is derived from the nature of debt – interest & principal repayments must be made when due
  • LiquidityAbility to meet short term financial obligations, measured by current or liquid ratio
  • Debt Servicing – Ability to meet debt related obligations (interest & repayments)
    • Measured by the Debt to Gross Cash Flow ratio (# of years required to repay total debt) or interest coverage ratio EBIT/Interest Charges
  • Profitability – wide variation in the measurement of profitability - Use EBIT/Total Funds to compare across Capital Structures
    • EBIT/(Total Funds) or EPS or EBIT/Total Funds Employed or EBIT/(Long Term Funds (Total Funds - Short Term Debt)) → look at seasonal effects or ROE
  • Share Price – represents an investors view of the present values of future net cash flows, P/E (higher = growth expected) or Price/Net Tangible Assets
  • Riskvariability or uncertainty of the share price. Comprised of systematic & unsystematic risk (diversify to reduce)

Pricing of Shares

[4] Share prices are a function of supply & demand for the stock. Supply & demand is influenced by information & is considered the PV of future dividend (or earnings). New information that changes future expectations will change share prices.

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Cum–Dividend And Ex–Dividend

For the period between the declaration of a dividend & its payment, the share has a future dividend entitlement attached – cum dividend. Once the dividend has been paid, it is traded ex-dividend & usually the price falls by the size of the dividend.

Bonus Share Issues

A company who has accumulated reserves may distribute it to existing shareholders by making a bonus issue of additional shares ‘capitalising reserves into equity’. Similarly to dividends, the share price will fall when shares are ex-bonus. This is because no new capital is raised, there is no change in assets or expected earnings, just an increase in shares outstanding. May signal an increase in profitability if the dividend is to be maintained, as total dividends paid must increase.

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Share Splits

Share splits involve dividing the number of shares on issue. There is no fundamental change in the structure or asset value of the company. The share price will fall in the proportion of the split. May increase liquidity.

Pro-rate Rights Issue

A rights issue involves issuing additional ordinary shares to existing shareholders at a discount to the market price. It increases issued capital. The market price will fall an amount dependent upon the number of shares issued & the size of the discount.

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Stock Market Indices And Published Share Information

[5]

Stock Market Indices

A Stock Market Index provides a measure of the price performance of a share market or industry sector. Stock exchanges around the world publish a standard set of indices known as Global Industry Classification Standard (GICS) comprising of 10 standard international industries. E.g. energy, materials, industrials, financials, health care, consumer staples, IT, Utilities etc.

  • Performance benchmark index measures broad share-market performance & risk listing based on market cap & liquidity
  • Tradeable benchmark index is a narrower performance benchmark index used as the basis for pricing certain derivatives products. E.g. Equity index futures contracts
  • Market indicator index’s measures overall share market performance. E.g. DJIA, Hang Seng, All Ordinaries

It can be price weighted (weighting of a company proportional to share price) e.g. DJIA or capitalisation weighted (weighting of a company proportional to market capitalisation) e.g. S&P/ASX All Ords. Share Price index’s measures capital gains/losses from investing in an index-related portfolio. An Accumulation index includes share price changes & reinvestment of dividends

End

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References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 208-214
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 214-216
  3. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 217-223
  4. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 223-228
  5. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 228-233
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