Equities 2: The Stock Market

Equities 2: The Stock Market Jan 2016 Week 3, FNCE102 R. Loh Raising Stock Stock 1 Equities 2 overview Raising Stock Initial public offering Understanding IPO tombstone ads IPO underpricing offering Pricing rights rights Stock Types of orders Margin trading and short selling Sources: SC Chap. 8 Stock Markets; Extra handouts on IPO ads, underpricing. 2

Revision: Characteristics of Equity Definition of an equity claim They have a residual claim to all earnings and assets after debt claims are satisfied. Therefore stock is riskier than debt. Shareholders collectively own the company, but have limited liability. If they invest $1, they cannot lose >$1 (unlike say a sole proprietor). Managing the company (The study of corporate finance) Stockholders do not exercise control directly. They vote to elect a Board of directors to act for their interests. The Board chooses the CEO, and other key managers. Pricing stock: (The study of equity asset pricing) Present value of all future dividends. or if dividends grow at a constant rate g, The new technology in asset pricing. Factor/characteristics-based investing (smart beta, see eq1 article: all powerful index transforms investing ). Revisit relevant early sections of textbook chapter 8. 3 Revision: Pros and cons of being public Visibility Marketing/publicity benefits; Increased shareholder base Valuation Command higher valuations than private firms; Higher liquidity in shares; Investors/managers can observe daily stock price changes and infer information about the future. Capital raising Lower cost of debt; Easier to raise future equity; Can use more liquid shares to acquire other firms. Ownership and control Allow existing owners to cash-out; Loss of flexibility/control; Forced to cater to short-term demands of Wall Street. Costs of being public Lawsuits; Listing fees; Strategy leakage to competitors; Lost interest tax shields from debt. 4

IPO process: Role of investment bank An investment bank underwrites and places the IPO. Underwriter: takes up the balance of shares not subscribed by the public. Placement agent: conducts book-building exercise. Runs road shows to garner interest in IPO from institutional investors and brokers. After book-building, the agent determines an issue price and offer size. See articles on recent. Investment bank also provides analyst coverage. 5 Applying for in Singapore The public can apply directly for. Most other countries, public gets allocation only through brokers. Need CDP (Central Depository) and brokerage account. Apply through ATM or Internet, pay upfront for shares applied. Balloting if there is over-subscription. Successful applications may get fewer shares than applied and unsuccessful allotments will be refunded. commences the day after balloting. Summary of balloting results are reported in the press. (see CapMalls tombstone Ad and supplement). Things to note: Note the size of the public offer Oversubscription rate is a measure of demand for the IPO Note spread of placement to the public where balloting ratios determine your probability of getting allocations See first day performance 6

Well-known facts about 1. Underpricing of. Typical first day returns of is positive. The IPO firm effectively left money on the table since they could have priced their offering at a high price and raised more money. 2. Hot and cold markets. Number of follow hot and cold markets. Firms try to time the market to sell their equity stakes to the public when valuations are high. Blackstone in 2007, Goldman in 1999. Facebook in 2012. 3. Long-run underperformance. perform poorer than their peers post-ipo. 7 First day return, US Source: Professor Jay Ritter s https://site.warrington.ufl.edu/ritter/files/2016/01/2015statistics_jan6_2016.pdf Fig 5 8

Why are underpriced? Refer to extra readings Reasons for IPO underpricing. Highlights below. 1. Winner s curse Informed investors will apply only if IPO is underpriced. So, uninformed investors know that they will get IPO shares only when informed investors don t want to invest. Uninformed will get shares ( win ) only when the IPO is lousy. Suppose to raise enough capital the firm needs to raise capital from both informed and uninformed. So, on average have to be underpriced to get the uninformed to apply. 2. Bandwagon hypothesis Firm underprices to get first few investors to participate. Subsequent investors blindly follow the first few investors. Generates more demand for IPO more underpricing. 3. Market feedback hypothesis To induce investors with positive information to reveal their performance, the bank underprices the IPO in the initial range given. This incentivizes investors to provide positive information. The firm does not fully incorporate the positive information when revising the IPO price. Evidence is that that revise the offer prices upwards are typically more underpriced. E.g. Twitter.,Ali Baba. 9 Why are underpriced? 4. Investment bank power hypothesis Banks have superior information and have power to underprice. They allocate to their favorite clients and expect future favors from those clients. Evidence: in the internet bubble, underwriters set up personal brokerage accounts for venture capitalists and the executives of issuing firms in order to allocate hot to them. 5. Lawsuit avoidance/signaling hypothesis Peoplewhomademoneyarelessliketoexaminetheprospectusfor false statements. Firms signal they are good by underpricing. Leaves a good taste in the mouth. 6. Firms may want underpricing Want to share money left on the table with their friends. See CapMalls IPO article we want to leave something behind for our stakeholders Want investment bank to supply bullish analyst coverage. 7. Irrational investors explanation Overoptimistic investors pay too much for the IPO on the first day of trading. Consistent with evidence of poor future long run performance. 10

Long run performance of IPO firms usually underperform peer firms in the industry. http://bear.warrington.ufl.edu/ritter/2012longrun.pdf 11 Why long run underperformance? Convergence of opinion. Only optimistic investors buy on the first day. Pessimistic investors cannot short. Subsequently, the views of the pessimists get incorporated and the price drops. Passing of a fad Investors slowly realize the potential of the firm was overstated. E.g., the technology bubble. Firms timing the IPO market Firms try to time the market and do an IPO during times when their equity is the most overvalued. E.g. Facebook. 12

Offering After an IPO, firms may need more funds for new investment opportunities or to tide over a financial crisis. Firms can raise more equity by either a seasoned equity offering (SEO) or a rights issue. SEOs raise funds by issuing new shares to new shareholders. This dilutes existing shareholders., i.e. (reduces the percentage of the company they own). SEOs are more common in the US. issues raise funds from existing shareholders. No dilution if existing shareholders subscribe to new shares. issues are more common in non-us countries. 13 Example of DBS offering 14

Important dates in timeline Cum rights date: The date that the shares have rights attached to it. Anyone who owns the shares just prior to the ex rights date is entitled to receive the rights to buy the new discounted shares. E.g., a 1 for 2 rights issue an investor holding 2 shares gets 1 right that can be exchanged for one new share priced at $5.42. Investor must pay $5.42 to buy this new share. Ex rights date Anyone who buys shares on this date or after is no longer entitled the rights. Price of the mother share should fall to the theoretical ex-rights price (defined in next slide) based on the stock price at the most recent close of trading before the ex-rights date. Period for trading of rights. After ex-rights date, rights can be traded between investors for this period. After this period, the rights are exchanged for new shares at the discounted price and the new shares are officially listed. 15 Theoretical ex-rights price On 19 Dec evening, DBS announced the rights issue. Ex-rights date is set at 29 Dec. So, if you own 2 shares of DBS before 29 Dec, you will get a right to buy 1 new share at $5.42. On 29 Dec there will effectively be 3 shares for every original 2 shares. Let P is the price of DBS at the close of the market before the ex rights date of 29 Dec. $P $P $5.42 Since all three shares have the same underlying claim on the company, on the ex rights date DBS should fall to (P+P+5.42)/3 = (9.25+9.25+5.42)/3= $7.97. This is the theoretical ex-rights price. The price falls because on the ex-rights date, investors buying DBS no longer have rights to buy new discounted shares. 16

Value of rights during trading period A right allows an investor to purchase of one DBS share at the discounted price of $5.42. So these rights have value. The window for trading rights is indicated in the announcement. Usually about a week. If an existing shareholder of DBS does not want to buy new shares, she can sell the rights in the stock market to other investors. What is the value of a traded right in the period where rights are traded? E.g. see 12jan09, when DBS share price is $8.11, then the value of R is: $8.11= R+ $5.42 R=$2.69. See DBS rights issue data sheet. 17 DBS stock price around rights issue DBS Issue 10.5 10 Cum Ex 9.5 9 8.5 8 Theoretical ex rights price plotted here is based on final closing price before ex rights date. 7.5 Price Theoretical 7 Date 18

Stock Source: nyxdata.com 19 Liquid stock markets Stock markets are extremely liquid. Stock holders trade shares with one another on stock exchanges. Liquidity is the ability to buy or sell shares without much cost, time, difficulty, or price concession. Most investors hold a stock for less than one year. Hedge fund and algorithmic trading accounts for about one third of NYSE volume. Why do investors trade? Exogenous reasons (e.g. they need funds to buy something) Differences of opinion about fundamentals Investment Speculation 20

Types of stock markets Conventional stock exchanges Specialist system in NYSE Broker system in most other exchanges, e.g. SGX. Nasdaq and OTC (over-the-counter) markets In Nasdaq, dealers are market makers who stand ready to buy and sell particular securities OTC bulletin boards and pink sheets: These trade very small stocks. (e.g. also delisted stocks). ECNs (Electronic Communications Networks) Computerized systems that match buyers and sellers without going through an exchange. E.g. BATS. 21 Orders Limit orders Transact at the limit price or better. Non urgent execution. Queuing for a better price. E.g. Buy at a price lower than the market price. Market order Immediate execution. Executing a trade at the prevailing market price or whatever price available. Stop loss order To protect against losses from existing positions. When the market price reaches the stop loss price, the stop order becomes a market order. See BATS (an ECN) example. 22

Bats screen shot, 11Jan2016 23 Bats screen shot, possible orders We can submit a Limit buy of: Limit sell: Market buy will transact at: Market sell will transact at: Stop loss buy at: Stop loss sell at: 24

Transaction costs on SGX Transactions costs depends on brokerage commission and tick size. Commissions in SGX are 0.2%-0.3% of the trade dollar value. Minimum commission is about $25. A trade must be settled in cash in T+3 days. In USA the commission is much lower: e.g. etrade.com charges $10 per trade regardless of trade size. Usual lot size was1000 shares. But was reduced to 100 shares in January 2015 to help retail investors to trade large priced stocks. 25 Tick Size on SGX from July 2011 Tick size is how much the price of a share can move. Investors often forget that this is also part of the transaction cost. For a S$1 stock (typical in SGX), if the bid-ask spread is1.000 bid and 1.005 ask, this is about a 0.5% spread (the bid-ask spread expressed in percentage is. ). Tick size in the USA is $0.01. For a US$20 stock (typical in US), if the bid-ask spread is 20.00 bid and 20.01 ask, this is about a 0.05% spread. 26

Margin Borrowing money from broker to buy shares to magnify returns. Requires collateral of either cash or securities In Singapore, the borrowing limit is determined by the (collateral+assets)/debt ratio, called the maintenance limit. Initial value at 150% (akin to two times leverage) Margin call at 140% Liquidation at 130% In USA, Regulation T also mandates two times leverage as the maximum margin allowed. 27 Short Selling Adds to market efficiency, so that investors can profit from price declines. Assets that cannot be shorted are usually inefficiently priced, larger bid-ask spreads. E.g. real estate. Short-selling is sometimes banned during crises to prevent further price declines. But no clear evidence that bans helped the stocks involved. In SGX, Securities borrowing and lending (SBL) was introduced in Nov 2001. To short sell, you first need to borrow shares. Investors can make their shares available to be lent out. This gives extra income for long-term investors. Refer to extra notes on Margin trading and shorting for detailed examples. 28