4 The trading of equities
4.3 Basic facts about equities: common and preferred stock
Sound exchange governance is most important. The board of governors of the NYSE comprises persons whose terms of service are staggered in order to ensure consistency in policy. They represent various interests, including active brokers and traders, partners of members (allied members), and some people selected to represent the general public.
Scandals can occur, however, either among the members of the exchange or some of its managers. The latest scandal regarding the governance of an exchange, which happened in late 2003, concerned the golden parachute of $140 million awarded by the board of NYSE to its retiring president. The aftermath has been a public outcry, as well as action by supervisory authorities.
Some of the members of the exchange are partners incommission housesexecuting orders for purchase or sale of securities received from non-member customers. They are the connecting link between the floor of the exchange, and investors and traders. In their offices are registered representatives who deal with customers. Many commission houses operate branches.
Other members of the exchange act asfloor brokers. They have no direct contact with the public, their mission being to execute orders on the floor for other brokers.
Still other members of the exchange are thespecialistswho concentrate their activity on one or a few stocks at a single trading post on the floor (see Chapter 5). Their primary responsibility is that of fostering an orderly and continuous market, absorbing a temporary excess of demand or supply. The specialists act as floor brokers andfloor traders.
As brokers, they receive from other brokers, mainly commission houses, orders in issues unsuitable for immediate execution.
As floor traders, they buy and sell for their own account, subject to certain restrictions aimed at protection of outside customers.
At any moment, the specialistsbook, which is available on the exchange, shows the prospective demand and supply for the stock or stocks in which they specialize. There is, however, a certain controversy concerning the specialists book (more on this in Chapter 5). One of the services provided by specialists is that they make it possible for brokers to leave orders with them at prices above or below the current market price of an equity. Such orders are subsequently executed if and when the stock touches the specified price level.
convertible to common stock; hence, it has a similarity with convertible bonds (see section 4.4); and there are alsodeeply subordinated bonds.6
On the upside, preferred stock offers protection against dividend cuts. Much of its attraction comes from the fact that the cash-strapped issuer is required to cut the dividend on its common stock before it cuts the preferred payout. This provides not only a cushion but also a forewarning sign to preferred stockholders; however, they may have problems unloading their assets since common and preferred stock prices tend to correlate.
Common stock offered in exchanges may come from new companies perhaps with a great future but a weak current base and more or less precarious financial conditions, or it may belong to well-established companies whose future may be better secured but less brilliant. The latter are known asblue chips, a term which has its origin in the color of the most expensive chip in the casino in Monte Carlo.
Note that the advantage from purchasing company shares as a commodity can also be a disadvantage. Common shares are a familiar investment tool, but the commodity nature of a share can be diluted by a variety of factors including the company’s poor management.7‘They don’t know their ass from their elbow about running companies’, said an analyst about the top management of a given listed firm, adding that when the board finally decided to fire the chief executive officer (CEO), ‘It was like taking candy from a baby.’
High leveraging is one of the signs of poor management, and it is also a high risk on its own. Leveraging is not only the assumption of an inordinate amount of debt.
Typically, high marginal cost companies offer a high leverage to commodity price movement, but also represent a fragile structure which cannot afford to meet with adversity.
Each company’s ability or inability to control costs and translate conditions into profits, affects its performance in a significant manner. The same is true of the com- pany’s consistent and well-directed efforts to innovate products, and be ahead of the game in terms of:
Market appeal, Cash flow, and Profit margins.
The market appeal of a company’s equity may slide when investors find out how leveraged this entity is. If we leave aside for a moment the risk associated with leverage, there is no simple trade-off in choosing between debt- and equity-financing. Theo- retically, debt-finance is cheaper than equity-financing, because investors take on less risk when purchasing debt, and this requires a lower return. Practically, this argument forgets that a debt-laden company is a weak counterpart:
Its equity has a volatility, and
Its debt is more generally seen as a burden.
When the firm becomes too heavily indebted, equity-holders and debt-holders alike will start demanding higher returns to compensate them for the risk they are assuming.
This reaction means that the firm’s cost of capital will rise – a fact some economists
In their original paper, and in a later one, Dr Franco Modigliani and Dr Merton Miller favored debt over equity, to a large extent because of tax laws. Generally, a company that issues debt can deduct interest from profits before paying taxes, while it cannot deduct dividend payments or the capital appreciation of shares from profits.
It can also play with creative accounting like pro forma reporting, giving shareholders a biased view of earnings before interest.8Debt, however, is by no means void of other risks, particularly so when the company:
Becomes overleveraged, or
Operates in a market which make it difficult to service its debt out of current cash flow and profits.
Because indebtedness and quality of management affect in a significant way a company’s financial staying power, and they correlate with the market’s response to the company’s equity and debt, let us look a little more carefully into this theme.
When a company needs cash, it issues equity or debt, or obtains bank loans. In this connection, investors need to remember some basic facts:
Common stock pays a variable dividend, Preferred stock pays a fixed dividend, Bonds pay a fixed interest,
Convertible bonds can be converted into stock, Warrants give rights to buy stocks at a given price, Bank debt, usually pays a fixed interest,
Senior debt is served first, and
Preferred stocks are senior to common stocks.
When a firm issues new equity, the price tends to fall for two reasons. New equity as well as options given to managers and employees are a dilution of old equity.
Moreover, investors appreciate that the company’s managers, who (usually) are also shareholders, have better information than the common shareholders, and are likely to sell when stock is overvalued.
A listed entity’s share price may also fall for other reasons: too much debt, loss of market share, obsolete products or a decrease in dividends. Dividends are a barometer because they affect shareholders’ bottom line and, generally, they are smoother than earnings as management does not like to increase dividends if it must decrease them later on (and vice versa).
In conclusion, equity is like anoptionon a company and its assets. Acting on behalf of equity-holders, management may undertake very risky projects which turn these assets into ashes; look at Enron, Global Crossing, WorldCom and Parmalat, among many other firms, for how supposed success stories were like castles built on sand.
Buying a company’s debt instruments looks as if it is less risky than buying its equity, but it involves credit exposure and does not have a great deal of market upside.
Moreover, because management cares mainly about the shareholders’ response, some projects regarding bondholders may be neglected, creating debt overhang problems.
Also, generally but not always, debt imposes more discipline on managers than