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Knowledge | Skills | Conduct

Equities

7 questions

Chapter 4

Further informationThis chapter looks at shares and explains the relationship between a company and its shareholders. We review how a company is formed and the types of shares that it may issue. We then give the advantages and disadvantages of share ownership. We look at what may happen to a share once it is issued (corporate action). We then look at how shares are listed, traded and settled. Finally we review overseas markets and stock indices.

This chapter has seven questions in the exam.

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A company issues shares in order to raise capital. The investors buy a share in the company’s success.

Points to note:

• Companies maybe Public (PLC) or Private (ltd)

• The board of directors manage the company

• Authorised share capital vs. issued share capital

2. Company Formation and Administration

Shares

Cash

Further informationThe minimum number of people required to create a company is one, i.e. a shareholder. This is for a private company. It used to be two, as all companies were required to have a company secretary, but this is no longer the case. A Public (PLC) company still requires a minimum of two shareholders.

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Memorandum

• Information about the company in relation to the outside world, e.g.:- Name- Country of domicile- Objects- PLC status

Articles

• Detail company’s internal regulations, e.g.:- Proceedings at general and board meetings- Voting rights- Borrowing powers- Powers of directors

2. Company Formation and AdministrationFurther informationThe memorandum and the articles of association are often referred to as the ‘mem and arts’, but although they are spoken of together you can see on the opposite slide that they contain different information and have different target audiences.

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Company meetings – types

• Annual General Meeting (AGM)- Allows shareholders to quiz the management and vote on company business- PLC must call within 6 months of its financial year end

Right-to-call meetings• AGM: The board

Resolutions• Ordinary (more than 50%)• Special (at least 75%)

Voting• Attend the meeting• Appoint a proxy• Proxy voting forms

2. Company Formation and AdministrationKeeping on targetWhich one of the following will appear in a company’s articles of association?A. The borrowing powers of the companyB. The company’s nameC. The objectives of the businessD. The country of domicile

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Companies may issue more than just ordinary shares.

3. Types of Equities

Features Ordinary Shares Preferred Shares

Priority 2nd 1st

Dividends Variable Fixed

Voting Yes No

Special features• Non-voting• Partly paid• Deferred

• Cumulative• Participating• Convertible• Redeemable

Further informationPreference shares make up part of the total share capital but not part of the equity share capital of a company.

In the UK cumulative preferred shares are the default. So unless stated to the contrary, you have to assume that a preference share is cumulative.

Answer to question on previous slideAAll of the others would appear in the Memorandums of Association.

Further informationCharacteristics of preference sharesNon-cumulative: If the dividend is not paid this year, it’s lostCumulative: If the dividend is not paid this year, it rolls up tobe paid in a future yearRedeemable: The issuer can force the holder to relinquish the share in return for the nominal valueConvertible: To ordinary sharesParticipating: May receive a bonus dividend along with ordinary holders

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Reasons for investing in equities:

• Dividend income- Covered – paid from this year’s profits- Uncovered – paid from previous year’s profits

• Capital growth

• Shareholder benefits (perks)

• The right to purchase new shares, e.g. rights issues

• The right to vote at company meetings

4. The Benefits of Owning SharesFurther informationThe average dividend yield of a FTSE 100 hundred company has been approximately 3% to 3.5% pa over the past 100 years. The average capital gain in that period has been 6% pa.

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Dividend yield

• Dividend yield is the rate of return that the shareholders receive based on the current share price and the dividend received

4. The Benefits of Owning Shares

100share per Price Market

share per Dividend

Keeping on targetA company pays a dividend of 7p when its current share price is £3.50. What is the dividend yield?

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Risks:

• Price risk

• Market risk

• Liquidity risk

• Issuer risk

5. The Risks of Owning Shares

Answer to question on previous slideDividend yield = Dividend / Share price x 100

= 7p / 350p x 100 = 2% .

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Mandatory

• Bonus issues

• Mergers

• Cash dividends

Voluntary

• Takeovers

Mandatory with options

• Rights issues

• Dividends

6. Corporate Actions: TypesFurther informationA corporate action is anything that happens to a security other than secondary market trading. As well as the events on the opposite slide, it would also include, for example: issuing new securities; company liquidations; conversions of preference shares or bonds to ordinary.

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Rights issue

• Shareholders offered the right to buy new shares in proportion to existing holdings

• Shares offered at a discount

• May use underwriters

• Description, e.g. 1:5

• Choices for shareholder:- Take up rights: Pay for the new shares.- Sell rights: Sell the right to a third party.- Split rights: Sell some rights to rise enough money to take up some new shares.- Lapse: Do nothing. The issuer will attempt to sell on the investor’s behalf.

6. Corporate Actions: TypesFurther informationA rights issued is designed to ensure that a shareholder can not be diluted, in terms of their ownership, against their will. Therefore, if new shares are to be offered to the market, existing holders must be given a right of first refusal to buy the shares.

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Example: 1:4 @ £1.50. Pre-announcement share price £1.75

Before the rights issue: 4 shares @ £1.75 each = £7.00

During rights issue: 1 share @ £1.50 each = £1.50

After rights issue: 5 shares = £8.50

So, after the rights issue each share is worth:

The theoretical ex-rights price = £1.70 per share

6. Corporate Actions: Types

£8.505 shares = £1.70

HintsYou may be asked to calculate a corporate action including a rights issue.

QuestionA company has a 1:5 rights issue at 60p when the current price is 80p1. What is the theoretical ex-share price?2. What is the value of the nil-paid right?

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Bonus issue• Aka a ‘capitalisation’ or ‘scrip’ issue

• Shares issued free of charge

• Effect: dilute existing share price

• Theoretical ex-bonus price

Example: a company announces a 1:5 bonus issue. The pre-announced price is 120p. What is the theoretical ex-price?

Answer:5 x 120p = 600p

1 x 0p = 0p

600p / 6 = 100p

Note: The value of the company (and any investor’s holding) remains constant –there are simply more shares in issue.

6. Corporate Actions: TypesHintsYou may be asked to calculate a corporate action including a bonus issue.

.

QuestionA company has a 1:5 scrip issue the current price is 800p1. What is the theoretical ex-share price?

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Dividend – terminology

• Record date

6. Corporate Actions: Types

(Usually a Thursday)

Company proposes a dividend

Record date (Friday)

EX-D I V

DATE

CUM-DIV PERIOD EX-DIV PERIOD

Further informationA company announces its dividend and arranges the payment date. The stock exchange declares the ex-date and from this the record date is determined.Standard in the UK is T+2 From October 2014

Keeping on targetWhich of the following is true of a bonus issue?A. It dilutes a company’s share priceB. It raises additional funds for the businessC. Existing shareholders must be given a right of first refusal on the new

sharesD. The shares will be offered at a discount to the existing price

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Takeover and mergers

• Takeover: Where anyone attempts to acquire > 50% of the shares in a company

• Merger: Where two similar-sized companies are joined together

6. Corporate Actions: TypesFurther informationA takeover is often called a merger as it sounds less threatening to staff, clients and shareholders. Also, the accounting treatment of a merger is more favourable to the bottom line than a takeover.

Answer to question on the previous slideAnswer A. It dilutes a share price in order to make the stock more liquid. The other options relate to a rights issue.

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Primary – offer for subscription

Primary – offer for sale

7. Stock Exchanges

Company Issuing house

£ £ £ £ £ £

SharesShares

Investor

Company AInvestorShares

£

Further informationThere are drawbacks to a public offer. There are lots of regulations as the shares are being offered to the general public, who the regulator has a duty to protect. As a result the cost of public offers is high. Finally, there is no guarantee of success. So the issuer may have to withdraw the offer if there is insufficient interest or pay a substantial amount to an issuing house to underwrite the offer.

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Advantages and disadvantages of listing

• Advantages:- Access to wider capital base- Acquisitions and mergers- Public profile and prestige- Offer employees shares

• Disadvantages:- Regulation and cost- Market conditions- Investor power

7. Stock ExchangesFurther informationThe most obvious advantage in achieving a UK listing is that the LSE is Europe’s biggest capital market.

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The official list

• The main market of the London Stock Exchange

• The UK Listing Authority (UKLA) oversees the conditions for listing

• Listing rules: Conditions for listing- Status: Public company- Trading history: Three years- Market capitalisation:

• £700,000 – Shares

- Share ownership: 25% to the public

• Listing rules: Continuing obligations- Disclosure requirements

• 6 monthly accounts• Timely disclosure of price sensitive information

7. Stock ExchangesFurther informationThe UK Listing Authority (UKLA) is a division of the FCA. The regulator took over responsibility for the listing rules when the LSE itself converted into a PLC. The regulator believed there would be a possible conflict of interest between the exchanges duty to maximise profit and its responsibility to ensure a high standard for companies wishing to list.

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Alternative Investment Market (AIM)

• Market for smaller growing companies

• The LSE oversees the AIM rules

• AIM: Conditions for entry

• AIM: Continuing obligations

• Key roles- Nominated advisor (NOMAD)- Nominated broker

7. Stock ExchangesFurther informationThe AIM is for those companies that do not meet or want to meet the entry requirement for listing, for example a company coming to market may only want to offer 10% of shares to the market not 25%.

Keeping on targetFor a company to apply for a UK listing they need to meet a minimum criteria. What is it in terms of: 1. How many years of financial statements?2. Number of shares offered in the free float?3. Minimum capital raised through the share issue?4. How often do they need to publish accounts?

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Introduction• A simple way of summarising market movements

• Role in performance analysis- Helps determine whether portfolio manager is more successful at stock selection or

sector allocation

Construction of indices and weighting

• Price weighted- The sum of the market price per shares/number of companies- Biased towards higher priced shares

• Value weighting- The sum of market capitalisation/number of companies

• Market cap = Market price of share x Number of shares

- Biased towards the performance of larger companies

8. Stock Market IndicesFurther informationA stock market index is a method of measuring a section of the market. Indices are cited by news or financial services firms and are used as benchmarks to measure the performance of portfolios and to provide the general public with an easy overview of the state of equity investments. Their methods of construction vary according to whether they are capitalisation weighted or price weighted.

HintsFloat-adjusted market-capitalisation weightingMost value weighted indices are free-float (or market-float) adjusted. Rather than look at the total market capitalisation of the company, these indices consider only the number of shares of the constituent security available to investing public.Most indices are float adjusted.

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• UK: FTSE 100

• US: Dow Jones Industrial Average (DJIA) – 30 constituents

• US: Standard & Poor’s (S&P) 500

• US: Nasdaq composite – Tech bias

• Japan: Nikkei 225

• Germany: Xetra Dax – 30 constituents

• France: CAC 40

• Hong Kong: Hang Seng

• China: Shanghai Stock Exchange (SSE) Composite Index

• China: Shanghai Shenzhen CSI 300 Index – top 300 A-share stocks

8. Stock Market IndicesFurther informationThe London stock exchanges trades in excess of 3000 different companies’ shares, whereas the FTSE All Share Index consists of approximately 800 of those companies.

Further informationAn index may reflect:• Asset class• Geographic region• Stock exchange • Securities selected from target market

– Fixed number, e.g. S&P 500– Varying number to represent % of target market, e.g. FTSE All Share

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Order- vs. quote-driven systemsOrder-driven

• Negotiated prices

• Electronic trading

• E.g. Tokyo Stock Exchange (TSE) and LSE’s SETS

Quote-driven

• Market makers (price makers)

• Bid/offer spreads

• Screen and phone-based

• E.g. Nasdaq and LSE’s SEAQ

9. TradingFurther informationWhere a company has natural liquidity, i.e. lots of buyers and sellers, it is possible to use an order driven system which will match the two sides.Where there is not natural liquidity, it is the job of the market maker to create the liquidity by guaranteeing to act as the counterparty to a trade.

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Introduction to the LSE’s Stock Exchange Trading Service (SETS)

• FTSE All Share Index

• Some euro-denominated Irish securities

• ETFs (Exchange-Traded Funds)

9. TradingFurther informationSETS is the main trading system of the LSE. Anyone can pay to view the screen but only LSE members may enter orders on behalf of their own account or that of their clients.

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SETS screen

9. Trading

Tesco TSCO Currency GBX

NMS 50 000

Previous 210 209 211 210 210

SETS volume 3.41m

Total volume 10.2m

Buy Total volume 22,000 Total volume 22,000 Sell

5,000 210 – 214 3,000

5,000 210

1,000 209

11,000 208

3,000 207

2,000 206

214 3,000

215 5,000

216 7,000

217 6,000

218 1,000

Further informationIt is possible for market makers to enter orders into the SETS system, in which case the name of the market maker will appear next to the quote. The market makers’ orders are ‘named’ as opposed to all other orders which are ‘anonymous’.

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9. Trading – SEAQ

ABN 100 – 105 5 X 5 08.50 MLSB 101 – 106 5 X 5 08.37

CAZN 100 – 105 10 X 10 08.44 WINS 99 – 104 10 X 10 08.44

KBCS 99 – 104 5 X 5 08.26

1 MLSB 101 - 104 KBCS WINS 2

ABC ORD 5p ABC Currency GBX

NMS 5 000 CRESTLast 103

Previous 101.5M 106 105 105.5X

Volume 340 000

Further informationThe SEAQ screen looks similar to the SETS screen, but the main difference is that the bottom half of the screen does not show buy orders on the right and sells on the left, rather it is an alphabetical list of the market makers with their bid and offers.

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Stock Exchange Automated Quotation (SEAQ)

• Quote-driven system –- Bonds and AIM securities not on SETSqx- Market makers

Stock Exchange Trading Service Quotes and Crosses (SETSqx)

• Hybrid system for domestic listed securities that are not listed on SETS.

Order Book for Retail Bonds (ORB)

• The electronic order book, offers continuous two-way pricing for trading in UK gilts and retail-size corporate bonds.

9. TradingFurther informationThe letter ’Q’ in SEAQ and Nasdaq means ‘quote’. This tells you that this is a market making market. Also on the screen will appear the Mandatory Quote Period (MQP) and a time. Market makers are obliged to make two quotes during the MQP hours.

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Multilateral Trading Facilities (MTFs)

• ‘Alternative trading systems’

• Allows electronic trading of securities listed on exchange such as the LSE, for example:- CBOE Europe Equities- Turquoise

Retail Service Providers (RSP)

• Electronic quotation and dealing services for retail stockbrokers

• Quote driven with market makers competing for the brokers trades

9. TradingKeeping on targetWhich of the following is not true of SETS?A. It is an order driven systemB. Only shares on the FTSE 100 appear on the systemC. Market makers may quote on SETSD. ETFs trade on the SETS system

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Registered securities

• Registered in the owner’s name

• Registered in the name of a nominee

• Holdings- Certificated- Dematerialised

Bearer securities

• Anonymous, freely transferable securities

• Holdings- Physical possession of a certificate- Immobilised at a Central Securities Depository

10. Holding TitleFurther informationThe name on the register is conclusive proof of ownership. If the market also allows security certificates, this is prima facie evidence of ownership. In other words, on first appearance the certificate looks correct, but the name on the register is proof of legal ownership. By contrast, in a bearer market the certificate itself is proof of legal ownership.

Answer to question on the previous slideAnswer B. SETS shows shares on the FTSE All Share Index, not just the FTSE 100.

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Novation

• CCPs used by LSE include the LCH.Clearnet

11. Clearing and Central Counterparties (CCPs)

1. Initial trade

2. Novation

Buyer(clearing member of LCH)

Deal

Seller(clearing member of LCH)

SellBuy Buy SellLCH

Further informationNovation is where, post trade, a counterparty is changed. In this case the Central Counterparty (CCP) or clearing house becomes the buyer to the seller and the seller to buyer. The CCP takes over the risk of settlement to both parties. In order to protect itself against a default, the CCP demands a margin, i.e. a deposit of cash or securities from both the buyer and seller until settlement is complete.

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CREST – structure

12. Settlement

CREST

MembersSponsored/Personal members

Payment banks

Regulators and tax authorities

Registrars

Further informationCREST is owned by Euroclear UK and Ireland. It is the Central Securities Depositary (CSD) for the UK and Eire. It only records ownership for dematerialised positions. It does this through the Electronic Transfer of Title (ETT). Therefore, if a shareholder wants to have a certificate, their holding will be recorded by a registrar but not by CREST.

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CREST – settlement process

12. Settlement

Member 1 Member 2

Member 1 account

CMA 1

Headroom decreases

Buyer Seller

R.U.R

Member 1’s payment bank

Deal

CMA 2

Headroom increases

Member 2 account

Book-entry transfer

Member 2’s payment bank

£

Out

side

CR

EST

Insi

de C

RES

TO

utsi

deC

RES

T

Further informationAn RUR is a Register Update Request. This is an instruction from CREST telling a registrar to update their records as CREST is going to change ownership in the CREST system, through Electronic Transfer of Title (ETT). The registrar has two hours to respond to the RUR from CREST.

A CMA is a Cash Memorandum Account. It is a record of the payments into and out of a member’s bank account. CREST uses it to monitor how close a member is to reaching their bank account limit.

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Certificated transactions – background

• Organised through the CREST courier and sorting service (CCSS)

• Process initiated by a ‘deposit set’- Signed CREST transfer form- Relevant share certificates

• Most certificated transactions settle on a T+10 basis

12. SettlementFurther informationThe checking and validating of a share certificate is more time consuming than for dematerialised settlement. This is why a registrar has 27 hours to accept or reject a delivered certificate rather than the RUR time limit of two hours.

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