As you gain experience, you can better plan your trades. Then trade this plan until you refine your strategy.
Start by Building a Foundation of Knowledge
Many years ago, when just starting out as an equity analyst, I discovered that many clients in general had a completely incorrect understanding of how stock markets work. Often I was asked if I was a stockbroker or a trader, and if I can buy XYZ shares for them? Tell me about this particular share, bond, or economic scenario for the next year?
The essence of a stockbroking firm is that it is just like any other firm. There are clerks, administrators, bosses, secretaries, divisions of traders, sales teams, and researchers. There are executive-director meetings, morning meetings, client visits, strategies, shareholders, and partners.
The importance to the novice trader is an understanding of the different types of positions that make up a broking firm. Not everyone is a stockbroker, nor is everyone a trader! The following section adopts a threefold approach.
• First, a general understanding of how stock markets work.
• This is followed by a brief breakdown of how a stockbroking firm operates.
• Finally, a brief description of securities available through stock exchanges.
Defining Stock Markets
Watching people throw their arms up, wave, yell, and signal to each other on stock exchanges around the world can be very intimidating to beginners. Called the Open Outcry System, these have mostly been replaced by electronic trading systems around the world, which is even more intimidating and it is extremely difficult to imagine how the market works in all that chaos. You need not worry, it really is not that complicated.
Time to Demystify Stock Exchanges
The fact is, most people do not truly understand what a share actually is or what it means to trade shares. Contrary to what many think, the stock market is not there to get rich quickly.
Stock markets are just that—markets. In this case, a market to facilitate in an organized manner the exchange of shares between buyers and sellers. Just imagine how difficult it would be to sell shares if you had to call around to friends, neighbors, or total strangers and attempt to find a buyer. So, just think of exchanges as sophisticated methods of linking buyers and sellers from anywhere in the world.
The mechanism is relatively basic. A company that needs cash flow goes to the exchange and asks the public for money to help it in its venture. To obtain these funds, the owner effectively sells a part of his company to these many investors. They do not actually break up the company, but supply the investor with a piece of paper (share certificate or, as is the case in modern exchanges, an electronic share certificate number), which certifies that he or she owns a stated number of share in a specific company. It must be noted that these certificates are disappearing in modern exchanges, being replaced under a “dematerialization” of share certificates, which are effectively being swopped for electronic numbers to facilitate a quicker exchange of shares. It also makes way for quicker payment for shares, as no certificates have to be issued.
This type of electronic share certificates is the future face of trading around the world. The system effects settlement for both share transactions on the exchange and for off-market trades. The norm in the world of trading is that it takes 3 days for the exchange to transfer to you funds received from the sale of shares. This is called T+3.
The result of electronic trading has been an increase in trading volumes, which also highlighted the deficiencies in the paper-based settlement system. Ultimately, the screen-based system contributes to a significant rise in daily trading turnover. For example, in 1990, the daily trading volume on the JSE was R5 million, and today it is over R1 billion.
Let me reiterate. The stock exchange is just a market place. It is a place where people who want to buy shares can meet with people who want to sell them—through a stockbroker. A stockbroker’s job is to bring the seller and buyer of a particular share together, using computer systems. Buyers and sellers just phone their broker and tell him how many of what share they want to buy or sell. Or, with online trading, traders can execute trades via an online trading platform.
The broker then executes the transaction (usually within the next few minutes) by entering it onto the computer system. The online trading platform is continuously searching for those buyers and sellers of any particular share that can agree on a price. As soon a price suits both the buyer and the seller, the transaction is instantly and automatically completed.
Transactions can also be placed electronically over the Internet with most broking firms.
Get Your Part of a Listed Company
A share is a part ownership of a company. All companies have shares—but the only ones which we are interested in are the ordinary shares of public companies that are listed on an exchange. If you look at the price page of newspapers or online trading websites, you will see that these companies are grouped into “sectors,” mostly according to what industry they are in.
Each of these companies has a quantity of “issued shares”—meaning shares which have been sold to members of the public (in the primary market) in exchange for the money needed to start or expand the company.
Once you own shares, you can then trade these in the market, that is sell the shares to unknown buyers and use the funds to buy shares in other listed company shares; this time from unknown sellers.
Take note that electronic trading systems match buyers and sellers on price, but also on volumes of shares to be traded. This means that you may only get some of your order.
These transactions take place in the secondary market and have no direct impact on the company itself. If the company is perceived to be profitable and growing then the shares should rise in value—and, if not, then the share price could fall. You should also note that I use the words should and could as share prices move on two fundamental principles; namely the company’s financial health and investor and trader sentiments. These traders may or may not be informed, educated, and experienced enough to evaluate the company correctly—and, even if they are, they will usually have different opinions about what it is worth.
So, investors effectively own a portion of the company to the extent of the shares they hold, for example, if James buys 10 percent of all shares issued by the company, he then owns 10 percent of that company. For his part ownership he may receive, at the directors’ discretion, an interim and an annual dividend payment (compared to a bank interest rate). Of course, the more he owns, the greater his control of the company.
As markets developed, investors were able to sell these shares to other investors and thus the exchange has a dual purpose. Not only were companies able to acquire funds, but the public has another means of investing directly into a company’s growth.
Another way to define stock markets is as a forecast or precursor of future general economic activity. Exchanges are thus systems that promote public participation in the economic decision-making process through their ownership of corporations listed. As a consequence of investors’ freedom to choose shares, they indicate how national resources can be better utilized.
Conclusion: The stock market is the leading indicator of economic performance of a country.
Let me explain it. Exchanges tend to have the largest companies in a country as listed entities. Therefore, as these companies start to earn higher profits, their employees tend to benefit from higher wages, which in turn creates higher demand for goods. This results in growth in economic activity. At some point the supply cannot meet that demand and prices rise.
The increase in prices, in turn, results in higher inflation. When that inflation reaches that country’s inflation target, the State Bank (or Reserve Bank) will increase interest rates to dampen demand for goods.
The cycle starts all over again, with company debt rising, so companies lay off staff and so on.
Meanwhile, all you need to know now is that demand and supply for shares reflects the public’s sentiment toward a particular company, different sectors, and thus the market as a whole. In this manner the stock market is thus a leading indicator of the overall economy, by about 9 to 12 months.
In addition to owning part of a company via a shareholding, owning shares also allows you to utilize the power of compounding to earn a return on top of returns. Compounding is part of the reason that for decades stocks have outperformed practically every other investment tool.
A question I’ve been asked in the past is why would a company want to issue shares? Why share the profits with thousands of people when they could keep profits to themselves? The reason companies issue shares—aside from needing money (called equity financing) for expansion, upgrading equipment, or marketing—is that raising money through debt financing (bonds or credit) is simply more expensive. Effectively, equity is more popular for raising money, as there are no interest payments like there are from taking on debt.
Another benefit, as part owner of a company, is that the investor is able to vote in the running of the company. This means that he or she can attend meetings, ask questions, and get to know the company better, enabling him to make a more informed decision on the future prospects of the company.
Other Roles of Stock Exchanges
Stock exchanges have more than just one role in the economy. In addition to funding businesses and providing individuals with a direct investment opportunity, these may include the following.
Venture Capital and Associated Higher Risk
Listed venture firms obtain funds from the public and use these funds to invest in higher risk or start-up firms. While there are such firms on all exchanges, you find that the cost of using such firms is expensive as they tend to take a large portion of equity for providing funds.
Research and Development Funding
Over the years, some companies raised significant capital to conduct research for the more complex industries, such as defense force, astrophysics, and chemical industries. Note that numerous tax laws have been changed to remove or limit the level at which tax can be deducted.
So, remember that you are an investor or trader and your interest is return on investment and not whether a company has a research division, unless that division is a strong profit generator.
Finding Big Brother
Yet another source of raising capital for a private company is to find a corporate partner by offering shares in your listed company in return for assistance in marketing, sales, and diversification into new areas.
Corporate partnerships have been extremely effective in many cases.
Create Your Own Pension
When people draw their savings and buy shares, they promote business activity.
This directs (and in certain cases, redirects) flow of funds and thus promotes specific economic sectors such as agriculture and commerce, which results in improved economic growth and higher productivity levels.
Growth via Acquisition
Listed companies sometimes use rights issues (issuing more shares) to acquire competitors, or as an opportunity to expand product lines or divisions, or hedge against volatility.
A takeover bid or a merger agreement through the stock market is effective and relatively simple and today is quiet common. As a trader, you have to decide whether the additional profits will more than offset the added shares. For instance, if a company’s attributable profit is $1,000 and the company has 1,000 shares in issue, then the EPS (Earnings per share is calculated by dividing the company’s attributable profits by the companies’ ordinary share in issue) will be one dollar.
If the company’s PE ratio is 10 times, then the company has a share price of $10.
So, if the company issues an additional 1,000 shares to buy a competitor with profits of $500, is this a profitable share acquisition? A Price: Earnings Ratio is used for valuing a company by measuring its current share price relative to its EPS.
Aside from potential future growth, here is the current value of the share:
• Shares in issue rise to 2,000 shares.
• The net profit (ignoring restructuring costs) will be $1,500.
• The EPS is now $0.75.
• The share price on a 10 PE is now $7.50.
As a trader, would you make a profit in this investment opportunity?
Share Incentive Schemes
The listing of a company enables entrepreneurs to retain key staff members and hire and appoint additional professional managers, thus improving managerial standards, efficiency, and productivity. They do this by offering directors and key staff members’ shares in the company. Consequently, it can be stated that listed companies have better management records than privately held companies.
Chapter 2 outlines who owns the major world exchanges.