"Evolution & Functioning of NASDAQ: Key Investment Arena", Study notes of Investment Management and Portfolio Theory

Download "Evolution & Functioning of NASDAQ: Key Investment Arena" and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 3 INTRODUCTION OF MARKET PLACE Contd… Circuit Breakers and Trading Curbs: In listening to market reports, you will sometimes hear that trading curbs are in effect or that a circuit breaker kicked in”. While both trading curbs and circuit breakers are designed to reduce temporary volatility in the market, they are slightly different. At the NYSE, anytime the Dow Jones industrial average moves up or down more than 2%, computerized trading via the SuperDot system is restricted. This happened 366 times on 277 separate trading days in 1998. Non computerized trading continues despite the circuit breaker having been activated. Trading curbs halt all the trading at the exchange, not just computerized trades. If the Dow Jones industrial average drops 10%, trading stops for an hour or for 30 minutes if the drop was between 2:00 pm and 2:30 pm. After 2:30 pm, trading is not halted. A 20% drop halts trading for two hours if it is before 1:00 pm; for one hour if between 1:00pm and 2:00 pm; and for the rest of the trading day if after 2:00 pm. A 30% drop halts trading for the remainder of the day. Trading has only been halted once because of there provisions. On October 27, 1997 the DJIA was down 350 points at 2:35 pm and down 550 points by 3:30 pm. This shut down trading for the remainder of the day. THE NASDAQ STOCK MARKET: Once a stepchild of the marketplace, the NASDAQ stock market, still sometimes called the over the counter market, is now an important part of the investment arena. Securities trading in this market range from small, unknown firms to some of the largest companies in the world. The NASDAQ National Market: Unlike the national and regional stock exchanges, no actual place is called the over the counter market. Rather, it is a worldwide computerized linkup brokerage firms, investment houses, and large commercial banks. The headquarters of the computer system is in Trumbull, Connecticut, with a backup system in Rockville, Maryland. Bids and offers for individual securities are posted to an electronic bulletin board. These prices appear in the financial press under a heading including the term NASDAQ, shorthand for national association of securities dealer’s automated quotations. NASDAQ price quotations first appeared February 5, 1971. In 1980, NYSE trading outnumbered NASDAQ trading two to one. Today, the numbers of share traded on each of the two systems is approximately equal. Some were very large company’s trade in the NASDAQ market. Including apple computer, sun Microsystems, Microsoft, oracle, MCI communications and Intel. These companies could easily be listed on the NYSE or AMEX of they so close. While many NASDAQ firms are small, start-up companies. In fact, the phrase NASDAQ stock market is increasingly common, emphasizing the growing importance of this part of the marketplace. Trades of up to 100 shares can be executed in less than 1 minute via the small order execution system. For most stocks, SOES historically executed orders of 1000 shares of less docsity.com y g ( ) against the best quotes posted in the market. This essentially means that an investor could place an order to buy or sell 1000 shares of an actively traded NASDAQ stock and be confident of getting the order filled at a single price that is the best prevailing price in the market. After the stock market crash of 1987, member firms were required to participate in the SOES system. There were information and order flow problems during the crash that kept some market makers from honoring quotes maintaining and orderly market. Once the SOES system was put in place, a lazy market maker ran the risk of getting hit by SOES bandits who would “pick off” the slow market maker by trading 1000 shares at the untimely price and instantly earn a profit. Perhaps a stock had been trading at $25, and a market maker had posted a bid of $25. Later of stock falls, perhaps to $24¾, but the market maker fails to adjust the bid. An SOES bandit could spot this, buy 1000 at $24¾, and hit the stale bid of $25. Under SOES, the market maker would be obligated to honor a trade of 1000 at $25. Today the 1000 share rule is no longer absolute. A market maker who posts a bid on 400 shares obliged to honor the bid for an extra 600. For liquid, actively traded stock, however, getting 1000 shares at a single price remains the norm. Tiers of the NASDAQ Market: The largest and most established firms in the NASDAQ market are called national market issues. These securities, which number about 4000, include firms such as Intel and Microsoft. Information about national market issues is usually readily available and normally covered the popular reference sources found in most public libraries. Other NASDAQ securities are small-cap issues, meaning they have a low level of capitalization. There are abut 1250 of these securities, but detailed information about them is substantially more difficult to gather quickly. These firms receive limited coverage in the financial press. Most pay no dividend; many are too new to have any earning from which to pay the dividend. The newspaper listing for small-cap issues is abbreviated; generally only trading volume and closing price appears. THE OVER THE COUNTER MARKET: Some investors view the terms NASDAQ and OTC synonymously. This may have been accurate at one time, but not any more. Today the term OTC equity security refer to an equity security that is not listed or traded on NASDAQ or national securities exchange. On NASDAQ, there are listing standards, automated trade executions, formal corporate relationships with the underlying firms, and substantial market maker obligations. This is not true of over-the-counter securities. These trade two ways, either via the OTC bulletin board or via the pink sheets. Over-the-Counter Bulletin Board (OTCBB): The OTC bulletin board is a regulated quotation service providing real-time information on OTC equity securities. The OTCBB came about largely because of the penny stock reform act of 1990, which required the SEC to establish a system facilitating widespread dissemination of piece quotation on OTC equities. Since December 1993 firms have been required to report trades in these securities within 90 seconds of the transaction. There are approximately 5500 OTCBB securities and about 400 firms making a market in them. It is important to note that the OTCBB is only the means of providing price docsity.com y g ( ) The primary purpose of the SEC is to ensure that investors have adequate information to make an informed investment decision. Primary acts: Perhaps the two most important security acts as influencing the investment industry today are the securities act 1933 and the securities exchange act of 1934. Both acts were part of President Roosevelt’s new deal legislation. The securities act of 1933 is specifically designed to protect investors against characters such as Charles Ponzi. It provides for the regulation of the initial sale of virtually all securities. It does not cover the secondary market nor does it apply to the primary market offerings of US government debt securities or to municipal or state security offerings. The act is sometimes called the truth in securities law, and is really about accurate disclosure. The securities exchange act of 1934 deals with the secondary market. Like its forerunner, it focuses on accurate disclosure surrounding listed securities. In1964 the act was amended to cover most NASDAQ securities. Its major features include registration of exchanges and brokers, prohibition of misleading trading practices, the establishment of proxy procedures for shareholder votes, and a protocol for handling tender offers. The NASD: The National Association of Securities Dealers (NASD) is a self-regulatory body that licenses brokers and generally oversees trading practices. Congress provided for the creation of such a national securities association in a 1938 amendment to the Securities Exchange Act of 1934. The NASD is the owner and proponent of the NASDAQ price quotation system. The SEC specifically overseas the trading of listed securities, while the NASD overseas all trading. The SEC also oversees the NASD. A central theme of the 1938 amendment is the promotion of a voluntary code of business ethics. SIPC: In 1970 Congress passed the Securities Investor Protection Act, which established the Securities Investor Protection Corporation SIPC. This organization protects investors from loss due to brokerage firm failure, fraud, natural disaster, or theft. Since its inception, the SIPC has liquidated more than 200 firms and distributed nearly $1 billion in claims to more than 200,000 investors. It does no provide protection against loss due to bad investors, however. Brokerage firms provide a minimum of $500000 protection to each of their customers. For an added insurance premium, firms can increase their protection level. The division of market regulation of the Securities and Exchange Commission supervises the SIPC. ETHICS: One characteristic of the marketplace that should be mentioned in the discussion is the growing sensitivity to the importance of ethical behavior of those who can deal with the public’s money. Much of the regulatory history of the markets stems from attempts to curtail questionable or downright corked behavior on the part of unscrupulous characters who seek to take advantage of those who are financially unsophisticated docsity.com y g ( ) Illegal vs. unethical: A wide range of investment activities may be legal, but these activities carry substantial ethical baggage. Suppose, for instance, someone asks a finance professor about the potential of Gillette common stock. “I think it is a great investment’ the company’s sales will go up forever” may be the professor’s opinion, which is not illegal to express. From an ethical perspective, however, an important aspect is the basis for the opinion. If the professor knows nothing about the company but is simply stating a preference for the company’ razors, then the opinion is quite different from one formed from careful company’s analysis. It might not be illegal for the professor to like Gillette or to state a personal opinion, but many people would consider it unethical to give the impression that such an opinion is the result of careful analytical study. Suppose the professor likes Gillette after reading a research report in which an analyst recommended the stock. Does this make the opinion more reasoned, and therefore give the response more ethical credibility? Take for instance, another consideration with ethical overtones. Suppose the professor has researched Gillette and does believe it as a common stock with above average potential. Can the professor now comfortably recommend Gillette when someone asks about it? Even now the answer is not clear cut. Who is asking? 30 years old professional earning $75000 per year or a 75 years old widow was living on a fixed income? It is not possible to discuss the merits of a particular investment without knowing the context in which the potential investor is asking the question. The capital markets serve three primary functions. The economic function brings buyers and sellers together. The continuous pricing function enables traders to get market prices quickly. The fair pricing function is related to the continuous pricing function and assures both buyers and sellers of getting a market-determined price when they trade. The two national exchanges in the United States are the New York Stock Exchange and the American Stock Exchange. The AMEX recently merged with the NASDAQ stock market, the latter having historically been called over-the-counter market. Thirteen other smaller exchanges are known as regional exchanges. Worldwide, approximately 150 exchanges exist in more than 50 countries. Many securities trade in the over-the-counter market via the NASDAQ system. In this electronic linkup of brokerage firms, orders are placed by computer. Some very large companies are National Market Issues, with smaller firms listed as small-cap stocks. The over-the counter market is distinct from the NASDAQ Stock Market. OTC securities trade as either OTC Bulletin Board stocks or as Pink Sheet issues. Shares are initially sold in the primary market. The sales of listed securities via the NASDAQ system are called the third market, while direct institutional trading via the Internet system is the fourth market. Numerous organizations regulate the securities industry. The most important pieces of legislation are probably the Securities Act of 1933 and the Securities exchange Act of 1934, which significantly improved the required level of financial disclosure for public securities. The Securities Investor Protection Corporation provides protection against fraud or brokerage firm failure. The Chartered Financial Analyst (CFA) designation is a prestigious credential for those involved in the money management business. In many businesses, enrollment in the CFA program is a prerequisite for employment. docsity.com y g ( ) Of all securities, common stock is probably the most familiar. Sill, many people know comparatively little about stock, why it exists, how Company A’s shares differ from Company B’s, and how the potential investor decides among them. CORPORATIONS, SHARES, AND SHAREHOLDER RIGHTS Common stock is the hallmark of the capitalist systems. Millions of people directly own a portion of U.S. business through their investment in common stock; millions more have an indirect ownership interest through their investments in mutual funds, insurance contracts and retirement annuities. People own stock have an equity interest in the organization. Corporations: If a business has shares of stock, it is organized as a corporation rather than a proprietorship or a partnership. Corporations very widely in their complexity and size General Motors (GM NYSE) and Intel (INTC, NASDAQ) are corporations, but so are many doctors professional athletes and inventors. All corporations issue common stock, but it is not always possible for the general public to buy the shares. The stock of some corporations is closely held, meaning the people who own the stock do not routinely offer it for sale. The stock of outdoor sporting gear Giant L.L. Bean is closely held and not available to the public. The professional golfer Jack Nicklaus operates as “Golden Bear Golf.” Until recently an individual investor could not buy shares in Golden Bear. (These shares now trade with the ticker symbol JACK) Investors can however buy shares in the Boston Celtics; they trade on the New York Stock Exchange. People who own stock in the Boston Celtics (BOS, NYSE) are part owners of the basketball organization and share in its success. You can also buy shares in the Cleveland Indians (GLEV, NASDAQ). These shares are publicly held because any investor can acquire them with a simple phone call to a stockbroker. Shares: In the United States, those two types of stock are common stock and preferred stock. Both are equity securities and both represent a partial ownership interest in the firm. Don’t be misled by the term common. It does not mean the stock is average or routine. Common stock is really a single term rather than an adjective and a noun. In formal terms, common shareholders have a residual claim on the assets of the firm after the bondholders and other creditors. Preferred stock (also called preference stock) has priority over common stock in the event the firm goes bankrupt and the courts direct the distribution of the remaining firm assets. To an individual investor, this is probably preferred stock only advantage. Most preferred stock pays a perpetual fixed dividend stream; it is more like a consol bond than a share fo common stock. If market interest rates change the value of existing preferred stock, moves significantly. Preferred shares actually have more interest rate risk than bonds, because they have no maturity date at which their price will return to par. Most preferred stock is owned by other corporation because of tax advantage. A corporation avoids taxation on most of its dividend income, and preferred stock tends to pay more in dividends than common stock. The appendix to Chapter Nineteen elaborates on this point. docsity.com y g ( ) Type of dividends: The three types of dividends that corporations may pay to their shareholders include cash dividends stock dividends, and property dividends. 1. Cash Dividends: A cash dividend not surprisingly, is paid in cash and is the most common type of dividend. Most firms have an established dividend payment schedule through which a portion of the firm’s profits are returned to the shareholders. These dividends may be received as cash (via a check form the company) or they can sometimes be reinvested in additional shares of stock in the firm. This latter option is accomplished via a dividend reinvestment plan, often called a DRIP. Such a plan virtually always provides for the purchase of fractional shares with the reinvested check. If the current share price is $25, $30 dividend check would buy 1.2 shares. More than 1,000 firms have a dividend reinvestment plan. Reinvested dividends can make a significant difference in the growth of an investment, particularly if the additional shares are acquired at a discount form the prevailing market price. About 100 firms, especially bank and utilities encourage dividend reinvestment by offering such a discount. To see the potential impact of dividend reinvestment over the long run supposes two firms are identical in every respect except that one reinvests dividends at a 5 percent discount while the other has no dividend reinvestment plan. Assume cash earns 4 percent the two firms have a constant 5 percent dividend yield both shares initially sell for $25 and the share price rises by $1 per year for ten years. At the end of the period the account value with reinvestment would be $61.38 compared to $38.52 without reinvestment. If an investor securities with a broker for safekeeping rather than taking them home, they are said to be held in a street name. In this case the company paying dividends pays them to the brokerage firm. The firm’s subsidiary accounting then allocates the large dividend check appropriately among the clients owning this stock. Most brokerage firms have arrangements whereby any excess cash in an account is automatically transferred into an interest earning fund of some type. One of the minor inconveniences with dividend reinvestment is that the shares usually must be registered in the individual investor name they cannot be held in a street name. Also dividend re-investment results in the holding of odd lots. An odd lot is a quantity of shares not divisible by 100. holding are either odd lots or round lots (quantities that are divisible by 100.) the opportunity to be able to buy shares at a discount from the prevailing market price through makes up for any odd lot in convenience. There is really nothing wrong with holding an odd lot anyway. At the 1995 annual meeting of the Walt Disney Company (DIS, NYSE) shareholders voted on a stockholder proposal to reinstate the dividend reinvestment plan the firm terminated in 1990. a husband and wife owing 108 shares made the proposal in accordance with their rights as shareholders and the proposal appeared in the meeting announcement. The company recommended voting against the proposal on cost effectiveness grounds. The company had more than 470,000 stockholders and incredibly 69 percent owned 25 shares or less 78 percent owned 50 shares or less and 83 percent owned 100 or less. The clerical task and associated expenses of the dividend reinvestment plan would be significant. The proposal failed. docsity.com y g ( ) 2. Stock Dividends: Stock dividends are paid in additional shares of stock rather than in cash. Firms announce these a as percentage such as a 10 percent stock dividend, which means the holder of 1000 shares would receive an additional stock certificate for 100 shares. The person who holds 100 shares would get 10 more. If you hold an odd lot you will receive a check for the value of any fractional shares that cannot be distributed. Suppose you hold 221 shares worth $25 each. A 10 percent stock dividend means you are entitled to 22.1 shares. In practice you would receive an additional 22 shares plus a check for 10 percent of $25 or $2.50. It is unclear why firms issue stock dividends but we do know several things about them. First, they are often used when firms lack the funds to pay a cash dividend. They are especially common in the infancy or adolescent stages of a firms life cycle. Second, many shareholders seem to like them. A young firm may establish a pattern of paying a cash dividend and a stock dividend on a regular basis. 3. Property dividends: A property dividend is the prorate distribution of a physical asset. The asset is usually something the firms produce. Property dividends were popular in the early days of the capital markets when the number of shareholders in a particular company was small and the company produced something that could conveniently be distributed. The London East Indies Company is an example. In 1928 the company distributed a dividend in pepper and calico interesting shareholder discussions followed regarding the merits of commodity dividends versus traditional cash dividends. Discussions frequently occurred whether the distribution should be incommodities or money. The former was preferred by the merchant shareholders as they could realize additional profits by selling the commodities the gentry on the other hand preferred money. Subsequently there was a kind of alternation; in 1647 there was a dividend in indigo in 1649 in money, in 1650 in both pepper and money, in 1651 and 1652 in money, in 1653 in paper and money. As late as 1678, the East India Company paid a dividend in damaged calico for which it could find no market. Early U.S. railroad companies occasionally distributed parcels of land form their land grants to their shareholders. During World War II the government rationed consumer goods. Distillers and the manufacturers of women’s nylon stockings got around the ration laws by issuing these products as property dividends. Each November Swissair issues a voucher for 15 Swiss francs per shares. These can be accumulated and used as credit toward ticket prices (up to a maximum reduction of 50 percent). Why Dividends Do Not Matter: The company’s decision to pay or not to pay dividends is a complex issue. As we will see, dividends play a role in security valuation, especially with mature Industries. Public utilities, Insurance companies, and banking still, widespread understanding exists about economic value of dividends to shareholders. In many distances, a strong case can be made for the notion that dividend do not matter at all. docsity.com y g ( ) When people are first told that dividends do not matter they are often skeptical; how can a check that can be cashed and spent not matter? Suppose a professor appears before a group of finance students and claims to be able to prove that dividends so not matter. The professor produces a shoe box and sets it on to the table in the front of the room but does not show the contents (if any); however a neutral party is chosen to verify that box contains nothing bad. The neutral party essentially fulfils the role of an outside audition. As students watch, the professor counts out 100$ and place them into the shoe box. After replacing the lid on the box, the professor announces an intention to ownership interest in the show box by going public and issuing 100 shares. Anyone who buys all 100share will own the entire company. Naturally the professor wants to sell the company for as much as possible, but the marketplace will determine how much the box is worth. Each share must be worth at least one dollar. If it were worth less, a risk less profit would exist because any purchaser could be certain of receiving the $100(at least) contents of the box for less than this amount. In practical, the share will probably sell at a sight premium over $1 exactly. Some students buy one share, other buy more, some won’t buy any. Collectively though, they acquire all 100 shares. The professor takes the $100 they paid, issued the shares. And then no longer owns the shoe box or its contents. Now the board of directors of the shoe box decides to pay a 10-cent per- share cash dividend. The outside audition reaches into the box, take out ten one dollar bills exchange them for two rolls of dimes, and proceeds to distribute the dimes to the students according to the number of shares they own. Folks who bought one share get one dime, those who bought five get dimes, the 100 dimes are distributed this way. How will the marketplace view this activity? Will the shares in the shoe box still command a price of $1? They will not of course, because there may only be $90 left in the box, without knowing precisely what is in the box, investors/students know that its value is less now than it was before the payment of dividend. What will happen is that the market price of the shoebox shares will fall by the amount of the dividend. Shares that previously sold for $1 will now sell for 90 cents. This scenario is generally what happens in the real world. Dividends do not fall from the sky; they are real money paid from the firm’s checking account. If the firm gives the money away in this fashion, the firm is simply not worth as much after writing the checks. A person once said, “I don’t understand it; every time this stupid stock pays a dividend its price goes down. You would think it would go up.” That person obviously had not heard the shoe box story. As stated previously, the ex-dividend date determines whether a stockholder receive the dividends; consequently, on the ex-dividend date the price of a share of stock lends to fall by about the amount of dividend to be paid. Stock is normally priced in sixteenths of a dollar, so the share price may not be fall by exactly the right amount. Research into this question is also confounded by a variety of other factors that affect the price of the stock, making it difficult to isolate a pure dividend effect. There is some evidence that the stock price drop lends to be less than full amount of the dividends especially with “low dividend” stock. One study find that while high dividend stock fall by 98% of the dividend amount, low dividend stocks fall by only 16%. See Frank Murray, and Ravi Jagannathan, “Why Do Stock Price Drop by Less than the Value of the docsity.com