the equity market

The Equity Market

By Ingrid Goodspeed © I Goodspeed: 2008

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The Registered Person Examination (RPE) has been designed as an entry-level qualification for the South African financial markets. It is in modular form with each module addressing a different market. The simplified framework in which the markets are discussed is shown below:

The objective of this module to introduce the student to the vocabulary and mechanics of the equity market in South Africa and internationally and to prepare the student for the South African Institute of Financial Market’s equity market examination. The guide is structured as follows: chapters 1 and 2 define shares and equity markets respectively. Chapter 3 discusses the relationship between share prices and the business cycle. Chapters 4, 5 and 6 focus on fundamental analysis namely the interpretation of financial statements, equity valuation and company analysis. Chapter 7 concentrates on risk and introduces portfolio theory and the capital asset pricing model (CAPM). Chapter 8 deals briefly with technical analysis. Chapter 9 outlines equity derivatives. Chapter 10 describes private equity and private equity markets. Finally chapters 10 and 11 concentrate on the South African equity market by discussing the JSE Ltd and Strate (share transactions totally electronic). Students are advised to keep up to date with local and international equity market developments. The following Internet sites may prove useful: South Africa JSE Ltd www.jse.co.za

Financial Services Board www.fsb.co.za International New York Stock Exchange www.nyse.com

London Stock Exchange www.londonstockexchange.com Euronext • LIFFE www.euronext.com

World Federation Of Exchanges

www.world-exchanges.org

Foreign exchangemarket

Derivatives

Capital market Money market

Derivatives

Derivatives Derivatives

Hybrids

Framework of the financial markets

Commodities

Derivatives

Financial markets

Equity market Bond and long-term

debt marketInterest-bearing markets

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Table of contents 1. Equity defined ............................................................................................................ 4 1.1 Companies ............................................................................................................ 4 1.2 Financing of companies ........................................................................................... 5 2. Equity markets ......................................................................................................... 10 2.1 Characteristics of a good market ............................................................................. 10 2.2 Primary markets ................................................................................................... 10 2.3 Secondary markets ............................................................................................... 11 2.4 Stock market indexes ............................................................................................ 13 3. Equity and the business cycle ................................................................................... 20 3.1 Business and stock market cycles ............................................................................ 20 3.2 Cyclical and defensive shares ................................................................................. 22 3.3 Industry performance ............................................................................................ 23 4. Financial statement interpretation ........................................................................... 26 4.1 Introduction ........................................................................................................ 26 4.2 Income statement ................................................................................................ 27 4.3 Balance sheet ...................................................................................................... 30 4.4 Cash-flow statement ............................................................................................. 32 4.5 Ratio analysis ...................................................................................................... 34 5. Equity valuation ........................................................................................................ 43 5.1 Approaches to valuation ........................................................................................ 43 5.2 Discounted cash-flow valuation ............................................................................... 43 5.3 Relative valuation ................................................................................................. 53 6. Company analysis ..................................................................................................... 57 6.1 Competitive strategy ............................................................................................. 57 6.2 Management – the qualitative element ..................................................................... 59 7. Portfolio theory ........................................................................................................ 62 7.1 Assumptions ........................................................................................................ 63 7.2 Security analysis .................................................................................................. 63 7.3 Portfolio analysis .................................................................................................. 68 7.4 Portfolio selection ................................................................................................. 72 7.5 Portfolio theory models .......................................................................................... 73 8. Technical analysis ..................................................................................................... 92 8.1 Technical and fundamental analysis ......................................................................... 92 8.2 Assumptions ........................................................................................................ 92 9. Equity derivatives ..................................................................................................... 96 9.1 Futures ............................................................................................................... 96 9.2 Options ............................................................................................................... 98 9.3 Swaps ................................................................................................................ 99 9.4 South African listed equity derivatives ..................................................................... 102 10. Private equity ...................................................................................................... 106 10.1 Private equity defined ....................................................................................... 106 10.2 Characteristics of private equity .......................................................................... 106 10.3 Structure of the private equity market ................................................................. 107 10.4 Secondary private equity market ........................................................................ 113 10.5 Size and regional analysis of the private equity market ........................................... 113 11. JSE Ltd ................................................................................................................ 116 11.1 The role of the JSE ........................................................................................... 116 11.2 JSE Membership ............................................................................................... 117 11.3 Trading .......................................................................................................... 118 11.4 Listings .......................................................................................................... 122 12. Strate (share transactions totally electronic) ...................................................... 131 12.1 The roleplayers ................................................................................................ 131 12.2 Clearing and settlement .................................................................................... 132 13. Glossary .............................................................................................................. 136 14. Bibliography ........................................................................................................ 139

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1. Equity defined

Chapter learning objectives: o To define equity; o To differentiate between limited companies and sole traders and partnerships; o To outline the most important types and features of limited companies; o To describe and compare the main sources of long-term funds available to

companies. Equity, also known as shares or stock, represents ownership in a business or company. Chapter one defines equity within the context of the company and its financing.

1.1 Companies

Generally sole traders and partnerships constitute the majority of businesses in the private sector of an economy. However limited companies account for the largest part of economic activity. Limited companies differ from sole traders and partnerships in that ownership and management of the business are separated. Ownership is in the hands of shareholders that have the right to appoint the board of directors. Directors select the managers of the firm to run the business in the best interests of the shareholders. The directors have to report to shareholders at least annually on the performance of the managers. The most important types of limited companies are: o Public limited companies: the shares of public limited companies are listed

(quoted) on and sold to the general public via stock exchanges. o Private limited companies: the shares of private limited companies cannot be

sold on the stock exchange without the approval of other shareholders or without first offering them to existing shareholders.

Important features of limited companies are: o A legal existence separate from their owners i.e., companies can sue and be

sued; and o Long-term business continuity i.e., life of the company is independent of the

owners’ lives. Shareholders own the company through the purchase of shares in the company. A share is one of a number of equal portions of the capital of a company. The liability of shareholders for the debts of the company is limited to their investment in the firm i.e., if the company is wound up the maximum shareholders can lose is the amount paid for the shares.

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1.2 Financing of companies

Each year companies commit large sums of money to capital expenditure. In 2004 South African private business enterprises spent R143 185 million (at constant 2000 prices) on various investments – see table 1.1.

Table 1.1: Gross fixed capital formation (in R million)

Type of asset 2007 2006 ∆%

Residential buildings 26 344 23 821 10.6

Non-residentail buildings 16 136 13 183 22.4

Construction works 9 213 6 912 33.3

Transport equipment 41 286 32 931 25.4Machinery and other equipment 89 208 80 660 10.6

Total 182 187 157 507 15.7

Source: South African Reserve Bank Quarterly Bulletin March 2008 One of the major decisions facing companies is whether to finance investment opportunities by borrowing money (i.e., using debt) or raising funds from shareholders (i.e., using equity). The main sources of long-term funds available to firms are debt, preference shares and ordinary shares. 1.2.1 Debt

Debt is borrowed funds that must be repaid by the issuer. It can be short- or long-term. Short-term debt includes: bank overdrafts; short-term loans; and liabilities such as accounts payable and various accruals that arise out of the company’s operations because of the time lag between when the liability is incurred and when it is discharged or paid. Long-term debt such as a bond involves a loan of a specific principal amount and a promise to repay the principal plus interest. Debt is discussed in depth in RPE module “The bond and long-term debt market”. 1.2.2 Ordinary shares (common stock)

Ordinary shares are a source of equity funding. Common shareholders are owners of the company and have full participation in its success or failure. The most important characteristics of ordinary shares are: o Perpetual claim: ordinary shares have no maturity date. Individual

shareholders can liquidate their investments in the shares of a company only by selling them to another investor;

o Residual claim: ordinary shareholders have a claim on the income and net assets of the company after obligations to creditors, bondholders and preferred shareholders have been met. If the company is profitable this could be substantial - other providers of capital generally receive a fixed amount.

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The residual income of the company may either go to retained earnings or ordinary dividends;

o Pre-emptive right: shareholders have the first option to buy new shares. Thus their voting rights and claim to earnings cannot be diluted without their consent. For example: Rex Ltd owns 10% or 100 of the 1 000 shares of Blob Ltd. If Blob Ltd decides to issue an additional 100 shares, Rex Ltd has the right to purchase 10% or 10 of the new shares issued to maintain its 10% interest in Blob Ltd;

o Limited liability: the most ordinary shareholders can lose if a company is wound up is the amount of their investment in the company.

Returns to ordinary shareholders consist of: o Dividends: dividends are a portion of the company’s profits. They are not

guaranteed until declared by the board of directors; o Capital gains (losses): capital gains (losses) arise through changes in the price

of a company’s shares. A company’s authorised share capital is the number of ordinary shares that the directors of the company are authorised to issue. When the shares are sold to investors, they become issued i.e., issued share capital. 1.2.3 Preference shares

Preference shares are another source of long-term equity funding that have features of both ordinary shares and debt. Like debt, preference shares pay their holders a fixed amount (dividend) per year, have no voting rights and in the event of non-payment of dividends, may have the cumulative dividend feature that requires all dividends to be paid before any payment to common shareholders. Like ordinary shares they are perpetual claims and subordinate to bonds in terms of seniority. Preference shares carry preferential rights over ordinary shares in terms of entitlement to receipt of dividends as well as repayment of capital in the event of the company being wound up. Preference shares offer holders a fixed dividend each year (unlike ordinary shares). For example if company has issued 40 000 preference shares at a par value of R20 each and dividend of 7% p.a., the preference share dividend paid by the company every year will be R56 000 i.e., 40 OOO x R20 x 7%. This is not necessarily guaranteed (see non-cumulative preference shares). There are a number of types of preference shares: o Cumulative: dividend is cumulated if the company does not earn sufficient

profit to pay the dividend i.e., if a dividend is not paid in one year it will be carried forward to successive years;

o Non-cumulative: if the company is unable to pay the dividend on preference shares because of insufficient profits, the dividend is not accumulated. Preference shares are cumulative unless expressly stated otherwise;

o Participating: participating preference shares, in addition to their fixed dividend, share in the profits of a company at a certain rate;

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o Convertible: apart from earning a fixed dividend, convertible preference shares can be converted into ordinary shares on specified terms;

o Redeemable: redeemable preference shares can be redeemed at the option of the company either at a fixed rate on a specified date or over a certain period of time.

1.2.4 Debt, preference shares and ordinary shares compared

The most important differences between debt, preference shares and ordinary shares are summarised in table 1.2.

Table 1.2: Differences between debt, ordinary and preference shares Debt Ordinary shares Preference shares Maturity Finite maturity – debt

usually has a fixed maturity date.

Perpetual claim - ordinary shares have no maturity date

Usually a perpetual claim

Seniority of claim

A contractual claim i.e., an enforceable contract. Claims of debt-holders have priority over ordinary and preference shares

A residual claim i.e., claim to what is left after contractual claims are settled. Claims of ordinary shareholders are subordinate to both debt and preference shares.

A residual claim. Claims of preference shareholders are subordinate to debt but have priority over ordinary shares.

Tax treatment - issuing company

Interest paid is usually deductible for income tax purposes

Dividends paid are usually not deductible for income tax purposes

Dividends paid are usually not deductible for income tax purposes

Tax treatment - investor /debt holders

Income tax is usually payable on interest received

Income tax is usually not payable on dividends received

Income tax is usually not payable on dividends received

Voice in management

Have no right to choose directors or vote on matters of importance to the company.

Have the right to choose directors and vote on matters of importance to the company.

Have a limited voice in management. Voting rights usually concern the issuance of securities with equal or higher seniority.

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Questions for chapter 1 1. How do limited companies differ from sole traders and partnerships? 2. What are the most important types of limited companies? 3. What are the most important features of limited companies? 4 What is the maximum amount a shareholder can lose if a company is

wound up? 5. Name the main sources of long-term funds available to firms. 6. Define long- and short-term debt. 7. Define ordinary shares. 8 What are the most important characteristics of ordinary shares? 9. If a company has issued 10 000 preference shares at a par value of

R10 each and a dividend of 10%, what preference share dividend will the company pay each year?

10 Name the types of preference shares.

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Answers for chapter 1 1. Limited companies differ from sole traders and partnerships in that

ownership and management of the business are separated. 2. The most important types of limited companies are public limited

companies and private limited companies: 3. The most important features of limited companies are that they have:

a legal existence separate from their owners i.e., companies can sue and be sued; and Long-term business continuity i.e., life of the company is independent of the owners’ lives.

4 The maximum amount a shareholder can lose if a company is wound

up is the amount he / she paid for the shares. 5. The main sources of long-term funds available to firms are debt,

preference shares and ordinary shares. 6. Long-term funds are funds with maturities longer than one year such

as bonds (source: RPE module “The bond and long-term debt market”). Short-term debt has a maturity of less than one year and includes bank overdrafts; short-term loans; and liabilities such as accounts payable.

7. Ordinary shares are a source of equity funding i.e., a source of funds

raised from ordinary shareholders 8 The most important characteristics of ordinary shares are that they

are a perpetual claim, a residual claim, give shareholders pre-emptive rights and limited liability.

9. R10 000 i.e., 10 000 x R10 x 10% 10 Types of preference shares are cumulative, non-cumulative,

participating, convertible and redeemable preference shares.

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2. Equity markets

Chapter learning objectives: o To describe the characteristics of a good equity market; o To discuss primary and secondary equity markets; o To differentiate between quote- and order-driven markets; o To sketch the characteristics of equity markets internationally and in South

Africa; o To outline the uses of and methods of constructing market indexes. The stock market is the institutional framework through which: o Public limited companies issue new share capital - the primary market; and o The ownership of shares can change hands – the secondary market. The objective of this chapter is to discuss primary and secondary equity markets. It also deals with the uses and construction of market indictors or indexes. To place the discussion in context, the characteristics of a good market are outlined first.

2.1 Characteristics of a good market

Investors generally consider the following to be attributes of a quality equity market: (i) Timely and accurate price and volume information on past share

transactions and prevailing supply and demand for shares; (ii) Liquidity i.e., the degree to which a share can be quickly and cheaply

turned into cash. Liquidity requires marketability, price continuity and market depth. Marketability is a share’s ability to be sold quickly. Price continuity exists when prices do not change from one transaction to another in the absence of substantial new information. Market depth is the ability of the market to absorb large trade volumes without a significant impact on prices i.e., there are many potential buyers and sellers willing to trade at a price above and below the current market price;

(iii) Internal efficiency i.e., transaction costs as a percentage of the value of the trade are low – even minimal;

(iv) External or informational efficiency i.e., share prices adapt quickly to new information so that current market prices are fair in that they reflect all available information on the share.

2.2 Primary markets

New share issues can be divided into two groups: o Seasoned new issues: the issue of shares for which there is an existing public

market i.e., the company issuing the shares already has shares trading in the market. Seasoned or rights issues are also known as privileged subscriptions as existing shareholders are given the first right of refusal to purchase the

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shares. The rights are offered in a certain proportion to shareholders’ existing holdings e.g., in a one-for-one rights issue, shareholders will be offered a number of shares equal to the number they already hold. To ensure the offer is taken up, shares are generally offered at below the market price of existing shares i.e., at a discount. This may result in a fall in the price of existing shares;

o Initial public offerings: the first-time issue of shares to the public by companies that have no shares trading in the market i.e., there is no existing public market for the share.

New issues (seasoned or IPOs) are usually underwritten by investment bankers i.e., the investment banker buys the entire share issue from the company and re-sells the shares to investors. In this way a large part of the risk of issuing shares due to for example adverse reception due to overpricing or adverse market conditions is borne by the underwriter. In large issues a number of underwriters form a syndicate to spread the risk. Investment bankers are compensated for their selling and risk-bearing services.

2.3 Secondary markets

Secondary markets are markets where existing shares are traded. The proceeds from a sale of shares in the secondary markets do not go to the issuer of the shares but to their sellers (i.e., previous owners). Secondary markets are composed of stock exchanges (national and regional) and over-the-counter markets. Before these are discussed trading systems and methodologies will be outlined. 2.3.1 Trading systems

There are different ways to trade shares on exchange. Stock exchanges tend to be either order- or quote-driven: o Order-driven or auction markets are markets where buyers and sellers submit

bid and ask prices of a particular share to a central location where the orders are matched by a broker. Prices are determined principally by the times of orders arriving at the central marketplace. The JSE Ltd and most US securities exchanges are order-driven; and

o Quote-driven or dealer markets are markets where individual dealers act as market makers by buying and selling shares for themselves. In this type of market investors must go to a dealer and prices are determined principally by dealers bid/offer quotations. NASDAQ is a quote-driven market. The London Stock Exchange has both an order-driven and quote –driven system – its more liquid shares are traded on its order-driven system.

2.3.2 Trading methodology

Exchanges can be call or continuous markets: o Call markets are markets in which individual shares trade at specific times.

Trades, bids and offers, are accumulated for a period and then a single price is set to satisfy the largest number of trades. The method is used in smaller markets and to establish the opening price in larger ones.

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o Continuous markets are markets in which shares trade any time the markets are open.

Many exchanges such as the New York Stock Exchange and the Tokyo Stock Exchange depend on call markets to establish the opening price of a share but use continuous trading mechanisms the rest of the trading day. 2.3.3 National stock exchanges

The characteristics of national stock exchanges internationally and in South Africa are highlighted in table 2.1.

Table 2.1: Characteristics of stock exchanges

Australia Japan South Africa

United Kingdom

United States

National exchange

Sydney Tokyo (TSE)

Johannesburg

(JSE) London (LSE)

New York (NYSE)

Turnover (%) (end 2006)

88.4 125.8 48.9 124.8 134.3

Listed companies (end 2006)

1 829 2 416 389 3 256 2 280

Market capitalisation (USD billion end 2005)

1 095.9 4 614.1 711.2 3 794.3 15 421.1

Principal market index

All ordinaries

Nikkei 225 FTSE JSE All share

index FTSE 100

S&P500 Dow Jones industrial average

Trading system

Order-driven

Order-driven

Order-and quote driven

Order- and quote-driven

Order-driven

Trading methodology

Continuous Mixed Continuous Continuous Mixed

Source: World Federation of Exchanges

2.3.4 Regional stock exchanges

Regional or local stock exchanges generally have less onerous listing requirements than the national exchange. They list companies too small to qualify for a listing on the national exchange. Regional exchanges also list shares that are listed on the national exchange to give local brokers that are not members of the national exchange access to the shares. Examples of regional exchanges are Chicago and Boston in the US, Osaka and Nagoya in Japan and Dublin, Belfast and Glasgow in the United Kingdom.

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2.3.5 Over-the-counter (OTC) market

Any share – listed or unlisted - can be traded on the over-the-counter market as long as a dealer is willing to make a market in the share i.e., stand ready to buy or sell the share outside the stock exchange. The over-the-counter market is not a formal exchange with membership requirements or list of shares that may be dealt in. It is a non-regulated market and is simply a way of trading shares. 2.3.5.1 NASDAQ

NASDAQ (originally an acronym for National Association of Securities Dealers Automated Quotations) is an electronic stock exchange in the U.S. that trades in equities in almost 3 300 companies. It is owned and operated by The Nasdaq Stock Market, Inc., which listed on its own stock exchange in 2002. Although NASDAQ began as a system to store and display quotations on over-the-counter securities it now has inter alia, like most other major national exchanges, formal company listing requirements and electronic surveillance of trading. 2.3.5.2 Third market

The third market describes the over-the-counter trading of exchange-listed shares. It usually involves investment firms that are not members of the exchange making a market in listed shares. 2.3.5.3 Fourth market

The fourth market describes the direct exchange of shares between investors without a broker intermediary.

2.4 Stock market indexes

Market indexes attempt to reflect the overall behaviour of a group of shares. They are used: o As a benchmark to measure portfolio performance; o To create and track index funds; o To estimate market rates of return; o In technical analysis to predict future share price movements; and o As a proxy for the market portfolio when estimating systematic risk (see

chapter 7). 2.4.1 Constructing stock market indexes

The following factors are considered when building a stock market index: (i) The sample of shares used must be representative of the whole

population or else the results may be biased; (ii) What mathematical procedure should be used to combine the

component items into the index e.g., is an arithmetic or geometric

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average used; and (iii) What weighting should be given to the individual items in the sample. There are three predominant weighting schemes used in constructing indexes: price, value and equal weighting. 2.4.1.1 Price-weighted series

A price-weighted series is an arithmetic average of current prices. This means that the differential prices of the component shares influence movements in the index e.g., a high-priced share carries more weight than a low-priced one, a large price change for a small firm will have the same impact as a small price change for a large firm. A price-weighted index sums the market prices of each share in the index and divides the total by the number of shares in the index. The index assumes that an equal number (one) of each share is represented in the index. Once the index is established the denominator must be amended to reflect changes in the sample of shares and share splits. After a share split, the denominator is amended downwards to ensure the index is the same before and after the share split. This can put a downward bias on an index because when companies have share splits, their prices decline and their weight in the index is reduced (even though they may be large and important shares). Because high-growth companies tend to split their shares more often than slow growing ones, they consistently loose weight within the index. Two major price-weighted indexes are: (i) The Dow Jones Industrial Average is a price-weighted index of 30 shares.

Criticisms of the Dow include: • The limited number of shares in the index – a sample of 30 out of a

population of 3 000; • The shares in the index represent the largest shares listed on the New

York Stock Exchange and • The downward bias in the computation of the index;

(ii) The Nikkei Dow Jones Average or Nikkei-225 is an arithmetic average of 225 shares in the first and largest of two sections of the Tokyo Stock Exchange. The index is also a price-weighted index and has the same computational problems as the Dow Jones Industrial Average.

2.4.1.2 Value-weighted series

A value-weighted series is calculated as follows: (i) Sum the value of the shares in the index where value is current share

price multiplied by the number of outstanding shares; (ii) Divide the total derived in (i) by a similar sum calculated in a selected

base period; (iii) Multiply the result in (ii) by the index base’s beginning value.

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Symbolically:

daybaseonsharesdingtanousofnumberq

daybaseonshareofpriceendingp

tdayonsharesdingtanoutsofnumberq

tdayonshareofpriceendingp

where

valueindexbeginningqp

qpIndex

b

b

t

t

bb

tt

t

=

=

=

=

×=∑∑

A value-weighted index assumes that the value of a share in the index is held in proportion to its value in the market. The index automatically adjusts for stock splits because the decrease in the share price is offset by an increase in the number of shares outstanding. The major problem with a value-weighted index is that a firm with a large market capitalisation will have a greater impact on the index than a firm with a small market capitalisation i.e., changes in large market-value shares will dominate changes in the value of the index. Examples of value-weighted indexes are shown in table 2.2.

Table 2.2: Stock market indexes

Name of index Number of shares Source of shares

S&P 500 Composite 500 NYSE, OTC

NYSE Composite 2 280 NYSE

NASDAQ Composite 3 168 OTC

Financial Times Actuaries Index: All share (FTSE all-share)

692 LSE

FTSE100 100 largest LSE

Tokyo Stock Exchange Price Index (Topix)

1 710 TSE

JSE Ltd FTSE/JSE All-share 164 JSE

*Top companies ranked by full market capitalisation before free-float weightings are applied

Source: World Federation of Exchanges

Shares included in value-weighted indexes are weighted according to market capitalisation. This method is being criticised as over representing certain shares. Blocks of shares including share incentive schemes, directors’ shares, cross holdings or strategic holdings by companies are not available for trading. This

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affects the liquidity of the shares. The international trend is towards a free-float weighting basis in terms of which only those shares available for trading (rather than number of shares outstanding) are included in the index. All FTSE / JSE indexes are free-float market capitalisation weighted indexes. 2.4.1.3 Unweighted or equally-weighted series

All shares in an unweighted index carry equal weight regardless of their price or market value. LSE’s Financial Times Ordinary Share Index is an example of an unweighted index. 2.4.1.4 Portfolio performance measurement

To measure the performance of a portfolio use: o A price-weighted index if the portfolio is constructed by including an equal

number of shares of each company; o A value-weighted index if the portfolio is constructed by weighting the shares

according to company capitalisation; o An unweighted index if the portfolio is constructed by investing equal rand

amounts in each share.

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Questions for chapter 2 1. What are the attributes of a good equity market? 2. Differentiate between seasoned new issues and initial public offerings. 3. What is a secondary market? 4 Differentiate between order-driven and quote-driven markets. 5. Differentiate between call and continuous markets. 6. Define over-the-counter markets. 7. State the uses of stock market indexes. 8 Name two major price-weighted indexes. 9. How is a value weighted index calculated. 10 When should a price-weighted index be used to measure portfolio

performance?

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Answers for chapter 2

1. The attributes of a good equity market are timely and accurate price and volume information, liquidity, internal efficiency and external or informational efficiency.

2. A seasoned new issue is the issue of shares for which there is an existing

public market i.e., the company issuing the shares already has shares trading in the market. An initial public offering is the first-time issue of shares to the public by a company that has no shares trading in the market i.e., there is no existing public market for the shares.

3. A secondary market is a market where existing shares are traded. 4 Order-driven market Quote-driven market

Description A market where buyers and sellers submit bid and ask prices of a particular share to a central location where the orders are matched by a broker.

A market where individual dealers act as market makers by buying and selling shares for themselves

Price determination

Prices are determined principally by the times at which orders arrive at the central market place

Prices are determined principally by dealers’ bid / offer quotations

Examples JSE Securities Exchange NASDAQ

5. A call market is a market in which individual shares trade at specific times. A continuous market is a market in which shares trade any time the market is open.

6. Over-the-counter markets are non-regulated markets. Any share, whether

listed or unlisted, can be traded on an over-the-counter market as long as a dealer is willing to make a market in the share i.e., stand ready to buy or sell the share outside the stock exchange.

7. Stock market indexes are used as a benchmark to measure portfolio

performance; to create and track index funds; to estimate market rates of return; to predict future share price movements using technical analysis; and as a proxy for the market portfolio when estimating systematic risk.

8 Two major price-weighted indexes are the Dow Jones Industrial Average and

the Nikkei Dow Jones Average.

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9. A value-weighted index is calculated as follows:

(i) Sum the value of the shares in the index where value is current share price multiplied by the number of outstanding shares;

(ii) Divide the total derived in (i) by a similar sum calculated in a selected base period;

(iii) Multiply the result in (ii) by the index base’s beginning value.

10 A price-weighted index should be used to measure portfolio performance if the

portfolio is constructed by including an equal number of shares of each company.

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3. Equity and the business cycle

Chapter learning objectives: o To discuss why stock market cycles anticipate business cycle turning points; o To describe cyclical and defensive shares; o To outline what industries perform well in different stages of the business

cycle. “The stock market has predicted nine out of the last five recessions”

Paul Samuelson, 1991 The objective of this chapter is to highlight the general relationship between share prices and the business cycle.

3.1 Business and stock market cycles

The level of the stock market is one of the best leading (short-term) economic indicators. As shown in figure 3.1 the stock market cycle –anticipates business cycle turning points.

Lowerturning point

Contra

ction

Expansion

Upper turningpoint

Marketbottom

Bull market

Bear m

ark

et

Markettop

Cyclical growthBanksEnergyMediaIT hardwareSoftwareComputer services

Cyclical valueRetailersTransportPropertyHousehold goodsEngineering and MachineryBasic industriesMotor Vehicles

Defensive growthTelecommunicationsPharmaceuticalsInsurance

Defensive valueAerospace and defenseFood retailers and producersUtilitiesTobacco

Business cycleStock market cycle

Figure 3.1: The business and stock market cycles

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There are three possible explanations for this: (i) Investors do not invest based on the present economic environment

but forecast economic variables and invest accordingly. This is because they believe most current economic information has already been incorporated into share prices;

(ii) Investors react to the current economic environment but the indicators that they watch such as company profits and profit margins tend to lead general business activity; and

(iii) By affecting business and consumer confidence and spending decisions, share price reversals assist in causing subsequent economic reversals.

In the United States there have been bear markets that were not followed by recessions. However there has never been a recession that was not preceded by a bear market. The National Bureau of Economic Research (NBER) has established that since 1854 there have been 33 recessions in the U.S. Each was preceded by a bear stock market. In addition the stock market anticipated the end of each recession with bear-market troughs six months on average before the official end of those recessions. A great deal of research has gone into identifying which industries typically perform well in different stages of the business cycle. The broad findings of these studies are: (i) Industries that are sensitive to the expected turning of the business

cycle will outperform the broad market towards the end of a recession. Credit-sensitive shares such as financial shares begin to rise as investors expect banks’ earnings to increase as the economy and loan demand recover;

(ii) Once the economy begins its recovery consumer durables become attractive share investments because a reviving economy will increase consumer confidence and personal income. These shares include industries that produce expensive consumer items such as computer equipment and white goods.

(iii) Once businesses realise the economy is recovering and that levels of consumer spending are sustainable, they begin to consider expanding capacity to meet rising consumer demand. Thus capital good industries such as heavy equipment manufacturers become attractive investments.

(iv) As the economy peaks and turns basic industries, such as gold and timber industries become attractive investments. This is because the rate of inflation, which is increasing, has less of an impact on these industries.

(v) During a recession consumer staples such as pharmaceuticals and food industries tend to perform better than other industries as consumers still need to spend on necessities.

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3.2 Cyclical and defensive shares

The earnings of cyclical companies fluctuate with the business cycle. As a result, the price gains (losses) of cyclical shares typically exceed those of a rising (falling) market. The earnings of defensive firms display stable performance during both up- and downturns in the business cycle. Consequently the prices of defensive shares do not increase (decrease) as much as the overall market. Cyclical and defensive shares can be growth or value. A growth share is a share that has recorded a higher rate of return than shares with similar risk characteristics. A growth company on the other hand is a company the sales, earnings and market share of which are growing at a faster rate than the industry average and overall economy. Growth shares are not necessarily synonymous with growth companies. Value shares are those that appear undervalued for reasons other than earnings-growth potential. The characteristics of value shares include high dividend yields and low price-to-earnings (P/E) or price-to-book (P/B) ratios (see chapter 4 and 5 for explanations of these terms).

23

3.3 Industry performance

Figure 3.1 and table 3.1 indicate which industries typically perform well in different stages of the business cycle.

Table 3.1: Industry performance and the business cycle

Phase of cycle Industry

Characteristics Stock

market cycle

Business cycle

Market bottom / early bull market

Late contraction / lower turning point

Banks Energy Media IT hardware Software Computer services

o Declining interest rates and recovering credit demand.

o Improving advertising spend. o Growing consumer confidence

and disposable income. o Expenditure on expensive

consumer durables increasing.

Bull market Expansion Retailers Transport Property Household goods Engineering and Machinery Motor Vehicles

o Recognition that economy is recovering and improving consumer spending is sustainable.

o High capacity utilisation - companies consider expansion to satisfy rising demand.

o Interest-rate-sensitive and cyclical industries (capital goods or consumer durables) become attractive.

Market top / early bear

Late expansion / upper turning point

Aerospace and defense Food retailers and producers Utilities Tobacco Basic industries

o Inflation increases as demand outstrips supply.

o Large companies with ample liquidity and operating stability and companies producing non-volatile consumer goods become attractive.

Bear market

Contraction Telecommunications Pharmaceuticals Insurance

o High interest rates and slowdown in demand.

o Spending falls in all areas except necessities.

24

Questions for chapter 3 1. Name five cyclical growth industry sectors. 2. Name seven cyclical value industry sectors. 3. Which industry sectors do well at the upper turning point of the

business cycle? 4 Why does the stock market cycle lead the business cycle? 5. Differentiate between cyclical and defensive shares. 6. What are the characteristics of value shares? 7. Describe a growth share. 8 What are the characteristics of the lower turning point of the business

cycle? 9. What are the characteristics of a bear market? 10 Name the industries that do well in the contraction phase of the

business cycle.

25


1. Five cyclical growth industry sectors are banking, media, IT hardware, IT software and computer services.

2. Seven cyclical value industry sectors are retail, transport, property, household

goods, engineering and machinery, basic industries and motor vehicles. 3. The aerospace and defence food retailers and producers, utilities and tobacco

sectors do well at the upper turning point of the business cycle. 4 There are three possible explanations for why the stock market cycle leads

the business cycle: (i) Investors do not invest based on the present economic environment

but forecast economic variables and invest accordingly. This is because they believe most current economic information has already been incorporated into share prices;

(ii) Investors react to the current economic environment but the indicators that they watch such as company profits and profit margins tend to lead general business activity; and

(iii) By affecting business and consumer confidence and spending decisions, share price reversals assist in causing subsequent economic reversals.

5. The earnings of cyclical companies fluctuate with the business cycle. As a

result, the price gains of cyclical shares typically exceed those of a rising market and price losses typically exceed those of a falling market. The earnings of defensive firms display stable performance during both up- and downturns in the business cycle. Consequently the prices of defensive shares do not increase or decrease as much as the overall market.

6. The characteristics of value shares include high dividend yields and low price-

to-earnings (P/E) or price-to-book (P/B) ratios 7. A growth share is a share that has recorded a higher rate of return than

shares with similar risk characteristics. 8 The characteristics of the lower turning point of the business cycle are:

declining interest rates and recovering credit demand, improving advertising spend, growing consumer confidence and disposable income and increasing spend on expensive consumer durables.

9. The characteristics of a bear market are high interest rates and slowdown in

demand and falling spending in all areas except necessities. 10 The industries that do well in the contraction phase of the business cycle are

telecommunications, pharmaceuticals and insurance.

26

4. Financial statement interpretation

Chapter learning objectives: o Understand financial statements – income statements, balance sheets and

cash flow statements o Analyse financial statements by determining trends, industry comparisons and

common-size statements; o Carry out and interpret a ratio analysis. Fundamental analysis focuses on determining the intrinsic value of a share i.e., the present value of all future net cash flows derived from ownership of the share. The starting point for the fundamental analysis of a share is the company’s financial statements. The objective of this chapter is to outline the interpretation of financial statements. Firstly the income statement, balance sheet and cash-flow statement will be discussed. Then ratio analysis will be described.

4.1 Introduction

Financial statements provide descriptive and quantitative information about the company’s current status and past financial performance. Descriptive information on the company’s operating results over the past reporting period is provided by the chairman’s, director’s and auditor’s reports while quantitative information is contained in the balance sheet, income statement and cash-flow statement. The income statement contains information on a company’s income and expenditure over a period of time i.e., the past reporting period of usually one quarter, 6 months or one year. The balance sheet is a snapshot of the financial situation of a company at a specific time. It is divided into two main sections: the source of funds i.e., capital (or equity) and liabilities and the application of funds i.e., assets. The cash-flow statement shows the cash flows in and out of the company during the reporting period. It is made up of net cash flows from operating, financing and investing activities. Value can be added to the analysis of a company’s financial statement by: o Determining trends: comparing the company’s financial statement numbers

over a number of years; o Industry comparisons: evaluating the company’s figures against those for

similar companies or the relevant industry group; o Normalized or common-size statements: a normalised balance sheet

expresses all balance sheet items as a percentage of total assets. A normalised income statement expresses all income statement items as a percentage of sales.

27

4.2 Income statement

An income statement summarises a company’s operating activities over its past reporting period. The statement starts with revenues i.e., inflows from selling goods and services. Expenses or outflows required to generate revenues such as cost of sales, depreciation and any selling or administration expenses are deducted to obtain operating profit. Interest is subtracted from operating profit to arrive at net income before taxes. Thereafter taxes are taken away to get net income/earnings/profits attributable to shareholders. Then preference share dividends are deducted to arrive at net earnings attributable to ordinary shareholders. This is distributed to shareholders in the form of dividends or re-invested in the company as retained earnings. Table 4.1 shows the income statement of Rex Ltd. Comparative figures for the year ending 31 December 2004 and 2003 as well as the percentage change between 2004 and 2003. Table 4.1: Income statement for the year ended 31 December 2004

2004 2003 R 000 R 000 ξξξξ %

Sales 81 000 76 950 5.3 Operating costs 73 818 69 822 5.7 Earnings before interest and tax (EBIT) 7 182 7 128 0.8 Interest paid 1 782 1 269 40.4 Earnings before tax (EBT) 5 400 5 859 -7.8 Tax 1 620 1 758 -7.8 Net profit after tax 3 780 4 101 -7.8 Dividends to preferred shareholders 270 270 0.0 Net income attributable to ordinary shareholders 3 510 3 831 -8.4 Dividend to ordinary shareholders 2 100 2 000 5.0 Addition to retained earnings 1 410 1 831 -23.0

Per share (R) Earnings per share 3.51 3.83 -8.4 Dividends per share 2.10 2.00 5.0 Book value per share 22.47 21.06 6.7 Share price 36.82 38.82 -5.2

Number of shares 1 000 000 1 000 000

Additional information: Purchases 6 750 4 752 42.0 Cost of goods sold (cogs) 69 282 65 691 5.5 Depreciation 2 700 2 440 10.7 Lease payments 756 756 0.0 Rex Ltd has not done as well as expected because their operations were interrupted by strikes during the year. Labour issues were amicably resolved towards the end of 2004. Management is confident that the company will achieve earning growth of at least 30.0% in 2005.

28

A report on earnings, dividends and book value per share is given at the end of the income statement. 4.2.1 Earnings per share

Earnings per share (EPS) is one of the most frequently-used and widely reported measures of corporate performance. It is commonly combined with the share’s market price in the price/earnings (P/E) ratio (see chapter 5). EPS – using Rex Ltd’s 2004 figures as an example - is calculated as follows:

51.3

00000010005103

)(

R

sharesordinaryofnumber

rsshareholdeordinarytoleattributabincomenetEPSshareperEarnings

=

=

=

Rex Ltd earned EPS of R3.51 in 2004 – down 8.4% from R3.83 in 2003. 4.2.2 Dividends per share

Dividends per share (DPS) expresses the dividends paid to ordinary shareholders on a per share basis. Using Rex Ltd’s 2004 DPS as an example, it is calculated as follows:

10.2

00000010001002

)(

R


rsshareholdeordinarytodividendsDPSshareperDividends

=

=

=

Rex Ltd paid dividends to ordinary shareholders of R2.10 per share in 2004 – up 5.0% from R2.00 in 2003. 4.2.3 Book value per share

Book value per share (BVPS) expresses ordinary shareholders equity on a per share basis. It is combined with the share’s market price in the market-to-book ratio (see chapter 5). It is also often compared to the share’s market price to establish if the share is trading at a discount or premium to the book value. BVPS is calculated as follows:

29

47.22

000000100047022

)(

R


equityrsshareholdeordinaryBVPSsharepervalueBook

=

=

=

In 2004 Rex Ltd’s BVPS increased by 6.7% to R22.47. Rex Ltd’s share price on 31 December 2004 was R36.82 – trading at a 63.9% premium to book value (i.e., (36.82-22.47)/22.47). 4.2.4 Normalised income statement

In 2004 Rex Ltd earned net profit after tax of R3 510 000. Very little about Rex Ltd’s performance can be deduced from this number alone. A normalised income statement – see table 4.2 – shows that operating costs has increased compared to previous years. However the majority of this increase is in items other than cost of goods sold. Interest has also increased due to growth in debt – debentures and notes payable. Table 4.2: Normalised income statement Percentage of sales

forecast in R'000

R'000 % of sales R'000 % of sales 2005

Sales 81 000 100.0 76 950 100.0 101 250

Operating costs 73 818 91.1 69 822 90.7 92 239

Earnings before interest and tax (EBIT) 7 182 8.9 7 128 9.3 9 011

Interest paid 1 782 2.2 1 269 1.6 2 160

Earnings before tax (EBT) 5 400 6.7 5 859 7.6 6 851

Tax 1 620 2.0 1 758 2.3 2 055

Net profit after tax 3 780 4.7 4 101 5.3 4 796

Dividends to preferred shareholders 270 0.3 270 0.4 270

Net income attributable to ordinary

shareholders3 510 4.3 3 831 5.0 4 526

Dividend to ordinary shareholders 2 100 2.6 2 000 2.6 2 716

Addition to retained earnings 1 410 1.7 1 831 2.4 1 810

Other operating costs 4 536 5.6 4 131 5.4 5 670

Cost of goods sold (cogs) 69 282 85.5 65 691 85.4 86 569

2004 2003

As shown in table 4.2, the normalised income statement can be used to forecast a future period’s results. Rex Ltd’s results for 2004 have been calculated assuming sales growth of 25.0% in 2005 i.e. 81 000 000 x (1+ 0.25) = 101 250 000. Those income statement items that vary directly with sales have been forecasted - for example operating costs for 2005 are estimated as R92 238 750 i.e., 101 250 000 x 0.911. The forecast in table 4.2 has been rounded to the neared thousand.

30

The items that do not move with sales are forecasted separately. For example: o Interest expenses have been calculated on long-term debt and debentures at

an interest rate of 10.0%; o A tax rate of 30.0% is assumed; and o It has been assumed that dividends will be paid out in the same ratio to

earnings as in 2004 i.e., the dividend payout rate is 60% i.e., 2.10 / 3.51. EPS of R4.53 (i.e., 4 526 000 / 1 000 000) and DPS of R2.71 (i.e., 2 716 000 / 1 000 000) is expected in 2005.

4.3 Balance sheet

The balance sheet records all the assets (what is owned) and liabilities (what is owed) of a company at a point in time. Table 4.3 gives the balance sheet for Rex Ltd. as at 31 December 2004. Comparative figures as at 31 December 2003 as well as the percentage change between 2004 and 2003 are shown. As at 31 December 2004 Rex Ltd had total assets of R54 870 000 and liabilities of R29 700 000. The difference between the two is shareholders equity i.e., 25 170 000 = 54 870 000 – 29 700 000. Shareholders equity is also referred to as the company’s net worth. In as much as the balance sheet shows the net worth of shareholders at a point in time, the income statement measures the change in net worth. The first section of Rex Ltd’s balance sheet details the assets of the company. It begins with fixed assets – plant and equipment – reported at a value of R35 100 00 net of depreciation of R2 700 000. Next current assets (i.e., assets that will be converted into cash within one year) are listed from most liquid – cash – to least liquid – inventories. The first liability on Rex Ltd’s balance sheet is its long-term debt – a loan of R13 500 000 and debentures of R8 100 000. Rex Ltd’s current liabilities (i.e., liabilities that must be paid within a year) total R8 100 000 made up of: Accounts payable – what Rex Ltd owes its suppliers; Short-term debt (notes payable); Amounts owed to employees (wages) and receiver of revenue (taxes). The difference between Rex Ltd’s current assets and current liabilities is referred to as working capital and equals R11 670 000.

31

Table 4.3: Balance sheet as at 31 December 2004

R 000 R 000

2004 2003 ∆∆∆∆%Assets

Fixed assets

Plant and Equipment 35 100 28 890 21.5

Current assets 19 770 16 470 20.0

Cash 2 220 1 485 49.5

Marketable securities 0 675 -100.0

Accounts receivable 9 450 8 505 11.1

Inventories 8 100 5 805 39.5

Total assets 54 870 45 360 21.0

Capital and liabilities

Ordinary shares 1 350 1 350 0.0

Share premium 2 430 2 430 0.0

Retained earnings 18 690 17 280 8.2

Ordinary shareholders equity 22 470 21 060 6.7

Preferred shares 2 700 2 700 0.0

Total shareholders equity 25 170 23 760 5.9

Long-term loans 13 500 14 040 -3.8

Debentures 8 100 1 620 400.0

Current liabilities 8 100 5 940 36.4

Accounts payable 1 620 810 100.0

Notes payable 2 700 1 620 66.7

Accrued wages 270 270 0.0

Accrued taxes 3 510 3 240 8.3

Total liabilities 29 700 21 600 37.5

Total capital and liabilities 54 870 45 360 21.0 In the same way as a normalised income statement was drawn up, so too can a normalised balance sheet i.e., all balance sheet items are shown as a percentage of total assets. An analysis of Rex Ltd’s normalised balance sheet (see table 4.4) reveals that: o Long-term debt (long-term loan plus debentures) has increased to 39.4%

(i.e., 24.6% + 14.8%) of total assets in 2004 from 34.6% in 2003. This explains why in the normalised income statement interest paid increased to 2.2% of sales in 2004 compared to 1.6% in 2003;

o Plant and equipment increased to 64.0% of total assets in 2004 up from 63.7% in 2000. Therefore the long-term debt was raised to finance the purchase of plant and equipment.

32

Table 4.4: Normalised balance sheet

R'000 % of assets R'000 % of assets

Assets 0

Fixed assets 0

Plant and Equipment 35 100 64.0 28 890 63.7

Current assets 19 770 36.0 16 470 36.3

Cash 2 220 4.0 1 485 3.3

Marketable securities 0 0.0 675 1.5

Accounts receivable 9 450 17.2 8 505 18.8

Inventories 8 100 14.8 5 805 12.8

0

Total assets 54 870 100.0 45 360 100.0

0

0

Capital and liabilities 0

Ordinary shares 1 350 2.5 1 350 3.0

Share premium 2 430 4.4 2 430 5.4

Retained earnings 18 690 34.1 17 280 38.1

Ordinary shareholders equity 22 470 41.0 21 060 46.4

Preferred shares 2 700 4.9 2 700 6.0

Total shareholders equity 25 170 45.9 23 760 52.4

0

Long-term loans 13 500 24.6 14 040 31.0

Debentures 8 100 14.8 1 620 3.6

Current liabilities 8 100 14.8 5 940 13.1

Accounts payable 1 620 3.0 810 1.8

Notes payable 2 700 4.9 1 620 3.6

Accrued wages 270 0.5 270 0.6

Accrued taxes 3 510 6.4 3 240 7.1

0

Total liabilities 29 700 54.1 21 600 47.6

0

Total capital and liabilities 54 870 100.0 45 360 100.0

2004 2003

4.4 Cash-flow statement

In contrast to the income statement that shows a company’s revenue and expenses, the cash-flow statement presents all the cash that flowed in and out of a company over its past reporting period. It indicates whether and why the company is building up or drawing down its cash. Table 4.5 details Rex Ltd’s cash-flow statement for the year ending 31 December 2004. It is organised into three sections – operating, investing and financing activities.

33

R 000

2001

Cash flow statement from operating activities

Cash generated from operations 3 780

Add: Depreciation 2 700

Less: Dividends paid (2 370)

Net increase in working capital (other than cash and marketable (2 160)

securities and notes payable)

Net cash flow from operating activities 1 950

Cash flow from investing activities

Acquisition of fixed assets (8 910)

Net cash flow used in investing activities (8 910)

Cash flow from financing activities

Increase in notes payable 1 080

Increase in debentures 6 480

Decrease in long-term loans (540)

Net cash flow from financing activities 7 020

Increase (decrease) in cash and marketable securities 60

Cash and marketable securities at beginning of the year 2 160

Cash and marketable securities at end of the year 2 220

Table 4.5: Cash flow statement for the year ending 31 December 2004

4.4.1 Operating activities

Cash flow generated from operations is obtained from the income statement – net income before preferred dividends. Depreciation is added back because it is a non-cash item deducted from income to obtain net income. The cash outflow for plant and equipment that gave rise to the depreciation charge occurred when the plant and equipment was purchased. Depreciation is recognised as an expense on the income statement over the useful life of the asset. Rex Ltd had cash outflows in terms of: o Dividends paid to preference and ordinary shareholders and o Net increase in working capital (other than cash and marketable securities and

notes payable). Cash flow in respect of notes payable is recorded under financing activities. Net increase in working capital is calculated as follows: • Plus: increase in accounts receivable of R945 000; • Plus: increase in inventories of R2 295 000; • Less: increase in accounts payable of R810 000; • Less: increase in accrued taxes of R270 000.

34

4.4.2 Investing activities

In 2004 Rex Ltd invested in new plant and equipment resulting in a cash outflow of R8 910 000. 4.4.3 Financing activities

Rex Ltd raised financing of R7 560 000 by increasing its short-term debt by R1 080 000 and long-term debt in the form of debentures by R6 480 000. It repaid its long-term loan to the tune of R540 000 – a cash outlay.

4.5 Ratio analysis

A ratio seen in isolation has little if any meaning. However its usefulness increases when it is compared to: o Other ratios in the same set of financial statements; o Similar ratios in previous sets of financial statements; and/or o A standard of performance such as an industry benchmark. A ratio analysis of Rex Ltd is shown in table 4.6. Comparative figures for 2003 and 2004 as well as the industry average are shown. The column called measure indicates the notation of the ratio.

Table 4.6: Ratio analysis

2004 2003 Industry Measure

Liquidity ratios

Current ratio 2.4 2.8 2.9 :

Acid-test ratio 1.4 1.8 1.2 :

Asset-management or activity ratios

Inventory turnover ratio 10.0 12.2 9.3 :

Average collection period 43 40 38 days

Average payment period 88 62 90 days

Fixed asset turnover 2.3 2.7 3.1 :

Total asset turnover 1.5 1.7 1.9 :

Financial-leverage ratios

Total debt to total assets 54.1 47.6 40.5 %

Debt to equity 118.0 90.9 110.2 %

Times interest earned 4.0 5.6 5.7 :

Fixed charge coverage 3.1 3.9 4.9 :

Profitability ratios

Gross margin on sales 14.5 14.6 13.6 %

Profit margin on sales 4.3 5.0 4.6 %

Return on assets 6.4 8.4 8.7 %

Return on equity 15.6 18.2 14.9 %

35

4.5.1 Liquidity ratios

Liquidity ratios indicate the ability of the firm to meet its short-term obligations. Table 4.7 details their calculation and interpretation. Table 4.7: Liquidity ratios Ratio Calculation Interpretation Current

4.2

1008

77019

=

=

=sliabilitiecurrent

assetscurrent

Indicates the ability of the company to meet its short-term commitments with short-term assets.

Acid-test

4.1

1008

100877019

=

−=

−=sliabilitiecurrent

sinventorieassetscurrent

Indicates the ability of the company to meet its current liabilities without having to liquidate inventories (the least liquid of current assets).

4.5.2 Asset-management or activity ratios

Activity ratios (see table 4.8) deal with the efficient use of resources employed in the company’s operations. Table 4.8: Activity ratios Ratio Calculation Interpretation Inventory turnover

( )6.10

2/10088055

73818

cos

=+

=

=sinventorieaverage

soldgoodsoftorsales

Indicates how efficiently a company is managing its stock. A high ratio indicates efficient stock management. An unsatisfactory figure or trend suggests: o Ineffective inventory control; o An accumulation of un-

saleable inventory; o Procurement difficulties that

make it desirable to carry a larger inventory level to ensure the continuity of operations;

o Depressed business conditions among consumers.

36

Average collection period

days

daypersalesaverage

receivableaccounts

43

365/00081

4509

=

=

=

Indicates the number of days before settlement of company’s credit sales. It shows the efficiency of the company’s credit granting and collection policies.

Average payment period

days

dayperpurchasesaverage

payableaccounts

88

365/7506

6201

=

=

=

Indicates the degree to which trade creditors represent current obligations due.

Fixed asset turnover

3.2

10035

00081

=

=

=assetsfixed

sales

Indicates how efficiently the company is using its fixed assets.

Total asset turnover

5.1

87054

00081

=

=

=assetstotal

sales

Indicates the company’s ability to generate sales from its total asset base.

4.5.3 Financial-leverage ratios

Financial-leverage ratios measure the capital structure of a company and the degree to which it is or is not burdened with debt. Rex Ltd is highly leveraged but this is not out of line with the industry. Table 4.9 illustrates how financial leverage affects risk and return. Both companies – leveraged and unleveraged - earn the same EBIT under both expected and negative scenarios. Under expected market conditions the leverage company outperforms the unleveraged firm in terms of return on shareholders equity – 31.5% versus 21.0%. In effect the use of debt has leveraged up the rate of return on equity. However under negative market conditions the leveraged company’s return on equity falls sharply to –7.0% compared to the unleveraged company’s return of 1.8%. This is because the leveraged company must service its debt regardless of the level of sales and earnings. Thus companies with low debt ratios are less risky but they also miss the opportunity to leverage up their return on equity.

37

Table 4.10 shows the calculation and interpretation of financial-leverage ratios for Rex Ltd.

Balance sheet

Fixed assets 500

Current assets 500

Total assets 1 000

Debt 0

Ordinary shareholders equity 1 000

Total liabilities and equity 1 000

Income statement

Expected Negative

Earnings before interest and tax (EBIT) 300 25

Interest 0 0

Earnings before tax (EBT) 300 25

Tax (30%) 90 8

Net income attributable to ordinary shareholders 210 18

Return on equity 21.0% 1.8%

Balance sheet

Fixed assets 500

Current assets 500

Total assets 1 000

Debt (interest at 15.0%) 500

Ordinary shareholders equity 500

Total liabilities and equity 1 000

Income statement

Expected Negative

Earnings before interest and tax (EBIT) 300 25

Interest 75 75

Earnings before tax (EBT) 225 -50

Tax (30%) 68 -15

Net income attributable to ordinary shareholders 158 -35

Return on equity 31.5% -7.0%

Scenario

Table 4.9: The risk / return of financial leverage

Unleveraged company

Leveraged company

Scenario

38

Table 4.10: Financial-leverage ratios Ratio Calculation Interpretation Total debt to total assets ( )

%1.54

87054

1008100850013

=

++=

=assetstotal

debttotal

Indicates the percentage of total assets financed by creditors. The ratio shows the company’s use of financial leverage to expand earnings. A low ratio denotes relatively little use of external funding.

Debt to equity

( )

%0.118

17025

1008100850013

=

++=

=equity

debttotal

Indicates, as does the total debt to assets ratio, the protection afforded creditors in the event of liquidation.

Times interest earned

0.4

7821

1827

int

=

=

=paiderest

EBIT

Indicates by how much EBIT can fall before the company is unable to meet its interest obligations.

Fixed charge coverage

1.3

7567821

7561827

int

arg

=++=

=paiderest

taxandeschfixedEB

Extends the times-interest-earned ratio to include lease and other fixed charges obligations. (To calculate earnings before fixed charges the lease payment must be added back to EBIT)

4.5.4 Profitability ratios

Profitability ratios (table 4.11) indicate the profit-generating ability of a company showing the combined effect of liquidity, asset management and financial-leverage on operating results.

39

Table 4.11: Profitability ratios Ratio Calculation Interpretation Gross profit margin

( )

( )

%8.8

00081

7381800081

=

−=

−=sales

cogssalesprofitgross

Measures gross profit (sales less cost of goods sold) per rand of sales. For example in 2004 for every R1 of sales Rex Ltd generated 8.8 cents gross profit.

Net profit margin

Net income attributable

%3.4

00081

5103

=

=

=sales

rsshareholdeordinaryto

Relates net income attributable to ordinary shareholders to sales. It measures net income per rand of sales. For example in 2001 for every R1 of sales, Rex Ltd generated 3.7cents of net income.

Return on assets (ROA)


%4.6

87054

5103

=

=

=assetstotal


Indicates the overall management efficiency of the company.

Return on equity (ROE)


%6.15

47022

5103

=

=

=equityordinary


The rate of return earned on the capital provided by ordinary shareholders. It indicates how effectively the company is being managed in the interests of shareholders.

Return on equity is an important indicator of performance. The ratio can be divided into its component parts to provide insights into the causes of a company’s ROE.

leveragefinancialturnoverassetinargmprofit

equity

assets

assets

sales

sales

incomenet

equity

incomenetROE

××=

××=

=

The breakdown implies that a company can increase its ROE by:

40

Increasing profit margin i.e., becoming more profitable; and/or Increasing asset turnover i.e., becoming more efficient; and /or Increasing financial leverage i.e., financing assets with a higher percentage of debt. The components of Rex Ltd’s ROE are as follows:

6.15

44.248.133.4

arg

=××=

××= leveragefinancialturnoverassetinmprofitROE

41

Questions for chapter 4 1. Define the income statement. 2. Given net income attributable to ordinary shareholders of R2 970 and

number of ordinary shares of 1 000 calculate the company’s earnings per share.

3. How is the book value per share of a company calculated? 4 What is the difference between a company’s current assets and

current liabilities called? 5. Since a ratio seen in isolation has little if any meaning, how can its

usefulness be increased? 6. Name two liquidity ratios. 7. What is inventory turnover if the cost of goods sold for 2004 is

R69 000 and inventory as at end 2003 is R5 800 and as at end 2004 R8 000?

8 Name three financial-leverage ratios. 9. What is the return on assets if the net income attributable to ordinary

shareholders is R3 000 and total assets is R35 000? 10 How can a company increase its return on equity?

42

Answers for chapter 4 1. The income statement contains information on a company’s income

and expenditure over a period of time i.e., the past reporting period of usually one quarter, 6 months or one year.

2. R2.97 i.e., R2 970 / 1000 3. Book value per share (BVPS) expresses ordinary shareholders equity

on a per share basis i.e., ordinary shareholders equity divided by the number of ordinary shares

4 The difference between a company’s current assets and current

liabilities is called working capital. 5. A ratio’s usefulness is increased by comparing it to other ratios in the

same set of financial statements; similar ratios in previous sets of financial statements; and/or a standard of performance such as an industry benchmark.

6. Two liquidity ratios are the current ratio and acid-test ratio. 7. 10 i.e., R69 000 / ((R5 800 + R8 000) / 2) 8 Three financial-leverage ratios are total debt to total assets, debt to

equity and times interest earned. 9. 8.57% i.e., R3 000 / R35000 10 A company can increase its return on equity by increasing its profit

margin and/or increasing asset turnover and /or increasing financial leverage.

43

5. Equity valuation

Chapter learning objectives: o Outline the approaches to equity valuation; o Describe equity valuation models; o Discuss the advantages and disadvantages of equity valuation models. The objective of this chapter is to discuss the theory and application of valuation models and to outline their strengths and weaknesses. Firstly the approaches to equity valuation will be outlined. Thereafter the models will be discussed.

5.1 Approaches to valuation

Equity valuation attempts to estimate the intrinsic value of a share. The intrinsic value is compared to the prevailing market price of the share to ascertain if the share is a buy or not i.e., if the estimated intrinsic value is greater than the share price the share is a buy. There are two main approaches to the valuation of shares (see table 5.1): o Discounted cash-flow valuation: the value of a share is the present value of

expected future cash-flows. The cash-flows can be dividends or free cash-flows;

o Relative valuation: the value of a share is derived from expressing the current price of a share as a multiple of some quantity seen as relevant to valuation e.g., earnings or book value.

Table 5.1: Approaches to equity valuation Discounted cash-flow valuation Relative valuation Present value of: o Dividends o Free cash-flow to equity

o Price to earnings o Price to book value

5.2 Discounted cash-flow valuation

5.2.1 Dividend discount models

Dividend discount models (DDMs) calculate the value of a share as the present value of its future dividends. Since a share has no maturity i.e., it is a perpetual claim, the value of the share is the present value of dividends through infinity. The general DDM is as follows:

44

( )

ishareonreturnofraterequiredr

shareperdividendsectedexpDPS

ishareofvalueV

where

r

DPSV

i

t

i

t

tt

i

ti

=

=

=

+= ∑

∞=

=1 1

There are two inputs to the model: o Expected dividends: to obtain expected dividends, assumptions about

expected future growth rate in earnings and dividend payout ratios must be made.

o Required rate of return: chapter 7 explains how the rate is determined. In this chapter it is taken as given and denoted by r.

Since the model requires dividends to be forecast over an infinite number of periods, the model is not of much practical use. However it does serve as a basis for the other three types of DDM: o Gordon Growth model; o Two-stage DDM; and o Three-stage DDM. 5.2.1.1 Gordon growth model

The Gordon growth model assumes dividends will growth at a constant rate into the future. Symbolically:

( )

rategrowthdividendttanconsg

retrunofraterequireds'rshareholder

timeyearsoneinshareperdividendsectedexpDPS

ishareofvalueV

where

gr

DPSV

i

i

=

=

=

=

−=

1

1

45

Example: using the Gordon growth model to calculate the value of a share Given: 1. The share is expected to pay a dividend of 97cents per share next year 2. Shareholders required rate of return is 17.5% 3. Dividends are expected to grow at a constant rate of 10.0%

( )93.12

10.0175.0

97.0

R

shareofValue

=−

=

Example: using the Gordon growth model to calculate the value of a share Given: 1. The share paid a dividend 97cents per share this year 2. Shareholders required rate of return is 17.5% 3. Dividends are expected to grow at a constant rate of 10.0% The share paid a dividend of 97 cents in the current year. It is necessary to calculate the dividend that will be paid next year. The formula is:

( )( )10.0197.0

101

+×=+= gDPSDPS

( )( )

( )( )

2314

1001750

100197

10

.R

..

.

gr

gDPSshareofValue

=

−+×=

−+

=

The advantage of the Gordon growth model is its simplicity, convenience and ease of use. Its limitation is that it is extremely sensitive to growth rate input i.e., the value of the share approaches infinity as the growth rate and rate of return converge – see table 5.2.

46

Table 5.2: Value of share as r and g converge (DPS1=106.70) (r-g) Value of share 5.0 21.3

0.5 213.4

0.05 2 134.0

0.005 21 340.0

0.0005 213 400.0

0.00005 2 134 000.0

0.000005 21 340 000.0

5.2.1.2 Two-stage model

The two-stage model assumes two stages of dividend growth: o An initial stage with a high growth rate; and o A second stage with a long-term, stable, growth rate. The drop to a lower

constant growth rate is immediate. The formula to calculate the value of a share:

( ) ( )

nyearafter.,e.iphasegrowthstableinrategrowthdividendg

nyearafter.,e.iphasegrowthstableinreturnofraterequiredr

stagegrowthhighinrategrowthdividendg

stagegrowthhighinreturnofraterequiredr

nyearofendatshareofprice.,e.ivaluealminterP

tyearinshareperdividendectedexpDPS

yearinshareofpriceP

:where

gr

DPSPwhere

r

P

r

DPSP

n

n

n

t

nt

t nn

nnn

n

t

t

−=

−=

−=

−=

=

=

=

−=

++

+= ∑

=

=

+

0

11

0

1

10

For example assume UV Rays Suncream Ltd. had EPS of R1.00 and DPS of R0.20 last year. UV Rays expects earnings to grow at 22.0% p.a. over the next 3 years. The dividend payout rate of 20.0% will be maintained. Thereafter growth will decline to a stable 8% p.a. and the payout ratio will increase to 40.0%. What is the value of UV Rays’s shares if shareholders require a return of 17.5% in the high-growth phase and 15.0% during the steady phase?

47

The calculation of EPS and EPS is shown in table 5.3.

The value of the share is:

( ) ( ) ( )( )( )

51.7

175.01

08.015.0

78.0

175.01

36.0

175.01

30.0

175.01

24.033210

R

P

=+

−++

++

++

=

The limitations of the two-stage DDM model are that: o It is difficult to estimate the length of the high-growth phase; o The immediate fall in growth from initial to second phase is unrealistic; o Most of the value of the share depends on the terminal value. The terminal

value is extremely sensitive to the steady-stage growth rate estimate. The terminal value approaches infinity as the growth rate and rate of return converge.

5.2.1.3 Three-stage model

The three-stage model (see figure 5.1) assumes: o An initial stable high-growth stage; o A transitional period of declining growth - the second stage; and o A final stable-growth stage that lasts forever.

Year EPS Calculation DPS Calculation 0 1.00 0.20 1.00 x 0.20 1 1.22 1.00 x (1+0.22) 0.24 1.22 x 0.20 2 1.49 1.22 x (1+0.22) 0.30 1.49 x 0.20 3 1.82 1.49 x (1+0.22) 0.36 1.82 x 0.20 4 1.96 1.82 x (1+0.08) 0.78 1.96 x 0.40

Table 5.3: UV Ray Suncream Ltd - calculation of EPS and DPS

48

The value of the share is the present value of expected dividends during the high-growth and transitional stages and the terminal value at the beginning of the final stable-growth stage. Symbolically:

( )( ) ( )

( )( )( )

stagegrowthstableinreturnofrater

stagegrowthhighinreturnofrater

stagegrowthstableinratiopayoutPO

stagegrowthhighinratiopayoutPO

stagegrowthstableinrategrowthg

periodsnlaststhatstagegrowthhighinrategrowthg

tyearinshareperdividendsDPS

tyearinshareperearningsEPS

where

rgr

POgEPS

r

DPS

r

POgEPSP

n

n

a

n

a

t

t

nt

ntn

nn

nnn

t

tnt

tt

at

a

−=

−=

−=

−=

−=

−=

=

=

+−×+

++

++

×+= ∑∑

=

+=

=

=

1

1

1

11

1 2

11

21

1

00

For example assume IM Watching Optical Ltd.’s EPS and DPS last year were R2.00 and R0.40 respectively. The dividend payout ratio was 20.0%. IM Watching Optical expects to grow earnings by 30.0% p.a. for the next 5 years. Thereafter growth will decline and dividend payout ratio increases at 6.0% and 10.0% per year respectively for the next four years to a stable-growth rate of 6.0% and

High-growth stage Transition stage Infinite-growth stage

Earnings growth rate

Dividend payout ratio

high growthdecreasing growth

infinite growth

low payout

increa

sing p

ayout

high payout

Figure 5.1: Expected growth rate and dividend payout in three-stage DDM

ga

gn

49

stable-payout ratio of 60.0%. What is the value per share if shareholders expect a 16.0% return in the initial and transitional stage and 15.0% in the steady-growth stage? Table 5.5 shows the calculation of the share value of IM Watching Optical Ltd. It is R35.33.

50

Table 5.5: IM Watching Optical Ltd. – value of share

Year Growth Rate

EPS Calculation of EPS

Payout ratio

DPS Calculation of DPS

Rate of return

PV of dividends

Calculation of present value

0 2.00 20.0 0.40 1 30.0 2.60 2.00x(1+0.30) 20.0 0.52 2.60x0.20 16.0 0.45

( )11601

520

.

.

+

2 30.0 3.38 2.60x(1+0.30) 20.0 0.68 3.38x0.20 16.0 0.50

( )21601

680

.

.

+

3 30.0 4.39 3.38x(1+0.30) 20.0 0.88 4.39x0.20 16.0 0.56

( )31601

880

.

.

+

4 30.0 5.71 4.39x(1+0.30) 20.0 1.14 5.71x0.20 16.0 0.63

( )41601

141

.

.

+

5 30.0 7.43 5.71x(1+0.30) 20.0 1.49 7.43x0.20 16.0 0.71

( )51601

491

.

.

+

6 24.0 9.21 7.43x(1+0.24) 30.0 2.76 9.21x0.30 16.0 1.13

( )61601

762

.

.

+

7 18.0 10.87 9.21x(1+0.18) 40.0 4.35 10.87x0.40 16.0 1.54

( )71601

354

.

.

+

8 12.0 12.17 10.87x(1+0.12) 50.0 6.08 12.17x0.50 16.0 1.86

( )81601

086

.

.

+

9 6.0 12.90 12.17x(1+0.06) 60.0 7.74 12.90x0.60 16.0 2.04

( )91601

747

.

.

+

10 6.0 13.67 12.90x(1+0.06) 60.0 8.20 13.67x0.60 15.0 25.91

( )( )91501060150

208

...

.

+−

Sum of present value of future dividends 35.33

51

Note: this page (page 52) is left blank intentionally for printing purposes

53

5.2.2 Free cash-flow to equity (FCFE) models

The difference between DDMs and FCFE models lies in their definitions of cash flow. DDMs characterise cash flow to equity as expected dividends. FCFE models consider cash flow to equity to be the residual cash flow after: o Meeting interest and principal payments and o Providing for capital expenditures to

• Maintain existing assets and • Invest in new assets for future growth.

FCFE indicates what the company can afford to pay as dividends. Few companies pay out the entire FCFE as dividends because: • Companies are reluctant to change dividends and earnings or cash-

flows are generally more variable than dividends; • Companies may be providing for increases in capital expenditure; and • If dividends are taxed at a higher rate than capital gains, companies

may choose to retain excess cash and pay out less in dividends. FCFE is calculated as follows: FCFE = net income attributable to shareholders + depreciation (non-cash charge to income added back) - capital expenditure - change in working capital - principal repayment + new debt issues. The three FCFE valuation models are simple variants of the DDMs: o The stable-growth FCFE model; o The two-stage FCFE model; and o The three-stage FCFE model. The calculation of a share’s value using FCFE models is identical to that of DDMs except that FCFE is used as cash flow to equity rather than dividends.

5.3 Relative valuation

Relative valuation techniques express the price of a share as a ratio (multiple) of some quantity relevant to a share’s value such as earnings and book value. They are used as an alternative to discounted cash-flow analysis when valuing shares.

54

5.3.1 Price/earnings ratio

The price/earnings (P/E) ratio is calculated by dividing a share’s price by its earnings per share i.e.,

shareperearnings

shareperpriceratio)E/P(earnings/icePr =

On the assumption that a company’s P/E ratio fluctuates around its long-term average value, the share price can be estimated as follows:

ratioearnings/priceshareperearningssharepericePr ×=

Example: Share valuation using the price/earnings ratio Given: 1. The average P/E ratio is 8.0 2. Expected earnings per share is R3.70

6029

08703

.R

..sharepericePr

=

×=

5.3.2 Market (price) to book value

The market to book value (M/B) ratio is calculated by dividing a share’s price by its book value i.e.,

sharepervaluebook

shareperpriceratio)B/M(book/Market =

On the assumption that a company’s M/B ratio fluctuates around its long-term average value, the share price can be estimated as follows:

ratiobook/marketsharepervaluebooksharepericePr ×=

Example: Share valuation using the market/book value ratio Given: 1. The average M/B ratio is 1.3 2. Expected book value per share is R37.20

3648

312037

.R

..sharepericePr

=

×=

55

Questions for chapter 5 1. How is the intrinsic value of a share used to determine if the share is a

buy or not? 2. What are the inputs to the dividend discount model? 3. What is the value of a share that is expected to pay a dividend of

R1.00 per share next year if the shareholders’ required rate of return is 15% and the dividend growth rate is a constant 10%?

4 What are the advantages and disadvantages of the Gordon growth

model? 5. What are the assumptions underlying the two-stage dividend discount

model? 6. What are the assumptions underlying the three-stage dividend

discount model? 7. Differentiate between dividend-discount and free-cash-flow-to-equity

models. 8 Name two relative valuation techniques. 9. What is a share’s P/E ratio if the price per share is R20 and earnings

per share is R2? 10 What is a share’s market / book ratio if the price per share is R20 and

book value per share R22?

56

Answers for chapter 5 1. The intrinsic value of the share is compared to its prevailing market

price to ascertain if the share is a buy or not i.e., if the estimated intrinsic value is greater than the share price, the share is a buy.

2. The inputs to the dividend discount model are expected dividends and

required rate of return. 3. R20 i.e., (1 / (0.15 – 0.10)) 4 The advantages of the Gordon growth model are simplicity,

convenience and ease of use. Its disadvantage is that it is extremely sensitive to growth rate input i.e., the value of the share approaches infinity as the growth rate and rate of return converge.

5. The two-stage dividend discount model assumes two stages of

dividend growth: an initial stage with a high growth rate; and a second stage with a long-term, stable, growth rate. The drop to a lower constant growth rate is immediate.

6. The three-stage dividend discount model assumes three stages of

dividend growth: an initial stable high-growth stage; a transitional period of declining growth; and a final stable-growth stage that lasts forever.

7. The difference between dividend-discount and free-cash-flow-to-equity

models lies in their definitions of cash flow. Dividend-discount models characterise cash flow to equity as expected dividends. Free-cash-flow-to-equity models consider cash flow to equity to be the residual cash flow after meeting interest and principal payments and providing for capital expenditures to maintain existing assets and invest in new assets for future growth. Free-cash-flow-to-equity models indicate what the company can afford to pay as dividends.

8 Two relative valuation techniques are the price earnings ratio and the

market price to book value ratio. 9. 10 i.e., R20 / R2 10 0.91 i.e., R20 / R22?

57

6. Company analysis

Chapter learning objectives: o Analyse individual companies; o Discuss the competitive strategy of a company; o Describe the quality of a company’s management. Fundamental analysis focuses on determining the intrinsic value of a share i.e., the present value of all future net cash flows derived from ownership of the share. The emphasis on future earnings requires the analysis of all variables that affect the level and growth rate of a company’s earnings including: o Quality and depth of management; o Competitive position of the company; o Strength of the company’s balance sheet; o Economic, technical, political and legal environment in which the

company operates; and o Industry environment and characteristics. Chapter 3 dealt with the relationship between economic developments embodied in the business cycle and industry performance. Against this background the objective of this chapter is to discuss the analysis of individual companies. Central to this process is the competitive strategy of the company as well as quality of a company’s management.

6.1 Competitive strategy

Competitive strategy is a company’s search for a competitive position in an industry to establish a profitable, sustainable position relative to industry competitors. The foundations for competitive strategy are: o The five forces that determine the long-term profitability potential of

an industry – Porter’s five forces model; o The three strategies for achieving competitive advantage - the

company’s relative competitive position within an industry. 6.1.1 Five forces model

The attractiveness of an industry is determined by the interchange between five competitive forces. These are listed below and detailed in figure 6.1: o Threats of entry limited by barriers; o Supplier power; o Buyer power; o Degree of rivalry among existing competitors; and o Threat of substitutes.

58

Companies that face intense competition and are threatened by substitute products and entry of new competitors generally do not earn attractive returns.

6.1.2 Competitive strategies

The overall profitability of a company is determined by its relative position in an industry. A company with sustainable competitive advantage is likely to generate superior performance. Successful and profitable competitive strategies involve one or more of the following three elements: o Cost leadership i.e., achieving the lowest cost in the industry. This

strategy often depends on achieving a sufficiently high volume of sales to exploit available economies of scale;

o Product differentiation aims at achieving higher profit margins by making customers less sensitive to price. The strategy depends on having distinct product features that distinguish the company’s product from the products of its competitors; and

o Specialisation by focussing on a specific market segment. This strategy is designed to ensure that what the company does in for example customer service or product design is done exceptionally well. This is because the company focuses on specific needs to which it is better tuned than any of its competitors.

Low profitability is often associated with failure to develop in one of these three directions.

Supplier powerSupplier concentrationImportance of volume to suppliersDifferentiation of inputsImpact of inputs on cost or differentiationSwitching costs Presence of substitute inputsThreat of forward integrationCost relative to total purchases in industry

Threat of substitutesSwitching costsBuyer propensity to substitutesRelative price of substitutes

Degree of rivalryExit barriersConcentration and balanceFixed costs / value addedIndustry growthIntermittent overcapacityProduct differencesSwitching costsBrand identityDiversity of rivalsCorporate stakes

Threats of entry limited by barriersAbsolute cost advantageProprietary learning curveAccess to inputsGovernment policyEconomies of scaleCapital requirementsBrand identitySwitching costsAccess to distributionExpected retaliationProprietary product differences

Buyer powerBargaining leverageBuyer volumeBuyer informationBrand identityPrice sensitivityThreat of backward integrationProduct differentiationBuyer concentration versus industryAvailability of substitutesBuyers incentives

Rivalry

Figure 6.1: Porter’s five-forces model

59

6.2 Management – the qualitative element

Management quality is important when estimating the value of a share. Generally current company results reflect decisions made by earlier management while future company performance will reflect decisions made by present management. Tom Peters in his book In search of excellence identified the following eight characteristics as being typical of successful business management: o Intimate knowledge of the needs of the customer and exceptional

attention to these needs. Customer needs are at the forefront of the company’s activities;

o Exceptional attention to the creative potential of individual employees. Entrepreneurship is encouraged, autonomy decentralised and innovation rewarded;

o Corporate values are well-articulated and understood. Corporate values typically include product quality, low-cost production, innovation;

o The company sticks to the knitting i.e., it does not wander far from its realm of expertise;

o Administration is lean, organisation structure simple and lines of responsibility clear;

o Employees are made to feel essential to the success of the company; o The decision-making process is action orientated; o Decisive central direction and maximum individual autonomy reinforce

each other. Danger signals in respect of management quality include: o Product lines that remain the same year after year; o Regularly recruiting executives from outside the company. This may

indicate a lack of attention to personnel development; o Higher compensation for chief executive officer i.e. may be a one-man

show; o A board of directors with a limited number of non-executive directors; o Low allocation of funds to research and development. This indicates

that innovation is unlikely to be encouraged; o Careless treatment of social responsibility matters.

60

Questions for chapter 6 1. What variables affect the level and growth rate of a company’s

earnings? 2. Define competitive strategy. 3. What are the foundations for competitive strategy? 4 The attractiveness of an industry is determined by the interchange

between what five competitive forces? 5. Name five components of supplier power. 6. Name seven components of buyer power. 7. What are the generic types of competitive advantage? 8 Name Peters’ eight characteristics typical of successful business

management. 9. Name six red flags in respect of management quality. 10 How is the overall profitability of a company determined?

61


1. Variables that affect the level and growth rate of a company’s earnings include quality and depth of management; competitive position of the company; strength of the company’s balance sheet; economic, technical, political and legal environment in which the company operates; and the characteristics of the industry in which the company operates.

2. Competitive strategy is a company’s search for a competitive position in an

industry to establish a profitable, sustainable position relative to industry competitors.

3. The foundations for competitive strategy are: the five forces that determine the

long-term profitability potential of an industry (i.e., threats of entry limited by barriers; supplier power; buyer power; degree of rivalry among existing competitors; and threat of substitutes) and the three strategies for achieving competitive advantage (cost leadership, product differentiation and specialisation).

4 The attractiveness of an industry is determined by the interchange between threats

of entry limited by barriers; supplier power; buyer power; degree of rivalry among existing competitors; and threat of substitutes.

5. Five components of supplier power are supplier concentration, importance of

volume to suppliers, differentiation of inputs, impact of inputs on costs or differentiation and switching costs.

6. Seven components of buyer power are bargaining leverage, buyers volume, buyer

information, brand identity, price sensitivity, threat of backward integration and product differentiation.

7. The generic types of competitive advantage are cost leadership, product

differentiation and specialisation 8 Peters’ eight characteristics typical of successful business management are

knowledge of the needs of the customer and attention to these needs; attention to the creative potential of individual employees; entrepreneurship; well-articulated and understood corporate values; the company does not deviate far from its realm of expertise; lean administration, simple organisation structure and clear lines of responsibility; employees are made to feel essential to the success of the company; the decision-making process is action orientated; decisive central direction and maximum individual autonomy.

9. Six red flags in respect of management quality are product lines that remain the

same year after year; the regular recruitment of executives from outside the company; higher compensation for chief executive officer; a board of directors with a limited number of non-executive directors; low allocation of funds to research and development; and careless treatment of social responsibility matters.

10 The overall profitability of a company is determined by its relative position in an

industry. A company with sustainable competitive advantage is likely to generate superior performance.

62

7. Portfolio theory

Chapter learning objectives: o Define the assumptions on which portfolio theory is based; o Explain security analysis; o Discuss portfolio analysis; o Describe portfolio selection – the problem of selecting an optimum

portfolio for an investor; o Outline the following portfolio theory models: the Markowitz model,

Sharpe’s index models and the capital asset pricing model (CAPM). Portfolio management (see figure 7.0) is a three-phase process as follows: o Security analysis: predicts the risk and return of individual securities; o Portfolio analysis: produces risk and return predictions about portfolios

– derived from those determined about securities – and establishes the set of efficient portfolios i.e., the efficient portfolio; and

o Portfolio selection: selects from those portfolios deemed efficient the single portfolio most suitable for the investor.

This chapter outlines the basic principles of portfolio theory. The contents are as follows: section 1 specifies the assumptions upon which portfolio theory is based, sections 2, 3 and 4 discuss security analysis, portfolio analysis and portfolio selection respectively; and section 5 examines the major portfolio theory models.

63

7.1 Assumptions

The following assumptions underlie portfolio theory: o When choosing portfolios, rational investors attempt to maximise utility

and are willing to base their decision solely in terms of risk and return; o Investors are risk adverse; o The risk of a portfolio is measured by the variability of its return; and o For any given level of risk an investor prefers a higher rate of return to

a lower one or for any given level of return an investor prefers less risk to more risk.

7.2 Security analysis

A portfolio consists of one or more securities. If the actual rate of return on each security could be accurately predicted, so could the rate of return of every portfolio. However neither the rate of return of a portfolio nor each of its component securities can be foreseen with certainty. The aim of security analysis is to produce the following estimates about securities that can be used to make predictions about portfolios: o Expected return; o Variance and standard deviation i.e., the variability of return or risk.

The variance of a security is a measure of the dispersion of the returns of the security. The square root of the variance is the standard deviation and is often used in practice because it measures dispersion in the same units in which the underlying return is measured. The greater the variance / standard deviation of a security’s returns, the larger the risk;

o The covariances and correlation coefficients between securities. It is not only the security’s own risk that is important but also the contribution it makes to the variance of the entire portfolio, and this is primarily a question of its correlation with all other securities in the portfolio.

7.2.1 Expected return

The future rate of return of a security is not known for certain. Instead there are several possible rates of return each with a possibility of materialising. The expected rate of return is the weighted average rate of return. It is calculated by weighting each possible rate of return with its probability of occurrence. For example, assume a share has the following possible rates of return. The rates as well as the probability of them happening are shown in table 7.1 below; Table 7.1: Rates and probabilities Rate of return % Probability 5.0 0.20 10.0 0.30 15.0 0.30 18.0 0.20 Total 1.00

64

Graphically:

The formula for calculating the expected return is:

The expected rate of return of the share is12.1% calculated as follows: Table 7.2: Calculating the expected rate of return Rate of return % (Xi)

Probability (Pi)

Expected return E(X) (PiXi)

5.0 0.20 1.0 10.0 0.30 3.0 15.0 0.30 4.5 18.0 0.20 3.6 Total 1.00 12.1 The expected rate of return is also referred to as the mean of the probability distribution.

( )

i

ii

ii

n

i

ii

Xreturnofratespossibleofnumberthen

XreturnofratewithassociatedyprobabilittheP

XreturnofrateX

returnectedexptheXE

:where

XP)X(E

=

=

=

=

= ∑=1

Figure 7.1: Probability distribution of rates of return

0

0.1

0.2

0.3

0.4

5.00 10.00 15.00 18.00

Rates of return %

Probability

65

7.2.2 Variability of return

The variance and standard deviation (i.e., square root of the variance) are measures of the dispersion or spread of the probability distribution around the expected rate of return. The less spread out the distribution is i.e., the more closely concentrated round the expected value the probability distribution is, the smaller the variance and standard deviation and the smaller the risk that the expected rate of return will not materialise. Thus the variance and standard deviation indicate the variability of return i.e., the risk that the expected rate of return will not occur. The formula for calculating the variance is:

( )[ ]∑=

−=n

i

ii )X(EXP)Xvar(1

2

uritysectheofreturnofrateectedexpthe)X(E

returnofrateiththeX

occuringreturnofrateiththeofyprobabilitP

iancevar)Xvar(

where

i

i

=

=

=

=

A disadvantage of using the variance is that it is expressed in terms of squared units of the rate of return. Thus the square root of the variance - the standard deviation - is a more meaningful measure of the dispersion of the probability distribution. More formally:

)Xvar()X(std =

For example the variance of the share is 20.890 and the standard

deviation is 4.571 i.e., 89020.

Table 7.3: Calculating the variance Rate of return (Xi)

Probability (Pi)

Pi (Xi-E(X))2

5.0 0.20 0.20(5.0-12.1)2 = 10.082 10.0 0.30 0.30(10.0-12.1)2= 1.323 15.0 0.30 0.30(15.0-12.1)2= 2.523 18.0 0.20 0.20(18.0-12.1)2= 6.962 Total 1.00 20.890 7.2.3 The normal probability distribution

The most widely used probability distribution is the normal probability distribution with its bell-shaped curve (see figure 7.2). The normal probability distribution has the following characteristics:

66

o The mid-point of the normal curve is the expected value (or mean) of the distribution;

o The distribution is symmetric around the expected value i.e., 50% of the values are less than the expected value and 50% greater;

o The probability of obtaining a value within one standard deviation of the expected value is approximately 68%;

o The probability of obtaining a value within two standard deviations of the expected value is approximately 95%;

o The probability of obtaining a value within three standard deviation of the expected value is approximately 99.7%;

For example assuming the rate of return of the share is normally distributed and given that the expected value of the share is 12.1% and the standard deviation 4.571 the probability is roughly 68% that the actual rate of return of the share will be between 16.671% and 7.529% (i.e., between (12.1 + 4.571) and (12.1 – 4.571)). Similarly the probability is about 95% that the actual rate of return of the share will be between 21.85% and 2.96% (i.e., 12.1 ± (2 x 4.571)) and approximately 99.7% that the actual rate of return of the share will be between 25.81% and –1.61% (i.e., 12.1 ± (3 x 4.571). In general this may not hold because there is no reason to expect the distribution of a security’s rates of return to be normal. However the function of the standard deviation is the same in every case – to measure the likely divergence of the actual rate of return from the expected rate of return. 7.2.4 Covariances and correlation coefficients

A major attribute of portfolio theory is the requirement that interrelationships between securities’ rates of return be taken into

Figure 7.2: Normal probability distribution

Mean

Volatility

67

account. These relationships can be stated in terms of correlation coefficients and covariances. The covariance is a measure of the extent to which two variables (i.e., securities’ rates of return) move together linearly. If two variables are independent their covariance is equal to zero. A positive covariance indicates that the two variables move in the same direction and a negative covariance that they move in opposite directions. The covariance is given by:

For example the calculation of the covariance between the share prices of Telkom (X) and Altech (Y) from a sample of monthly historic data is shown in table 7.3. Table 7.4: Calculation of the covariance between the share prices of Telkom and Altech

Month n

Telkom Xi

Altech Yi

(Xi-E(X)) (Yi-E(Y))

(XiE(X)) x (Yi-E(Y))

1 167 60 6.00 4.67 28.00 2 170 64 9.00 8.67 78.00 3 160 57 -1.00 1.67 -1.66 4 152 46 -9.00 -9.33 84.00 5 157 55 -4.00 -0.33 1.33 6 160 50 -1.00 -5.33 5.33 Total 966 332 0.00 0.00 195.00 Expected value (or mean)

161.0

55.3

Note on calculation of the expected value: Each of the 6 share price occurrences has the same probability of occurrence. Thus the expected value is simply the average of the data series i.e., Telkom 966 / 6 and Altech 332 / 6.

Standard deviation

6.573

6.563

Thus

No significance can be attached to the magnitude of the covariance. A positive covariance means that on average the rates of return of the two securities move in the same direction. The correlation coefficient is a more convenient measure of linear dependence. It measures the strength of the linear association between two variables. The correlation coefficient is given by:

( )( )∑=

−−−

=n

i

ii )Y(EY)X(EXn

)Y,Xcov(11

1

00395

00195.

.)Y,Xcov( ==

68

Correlation coefficients range between -1 and 1 with: o +1 indicating an exact positive linear relationship between the two

variables X and Y i.e., an increasing X is associated with an increasing Y;

o -1 indicating that although the variables move in perfect unison, they move in opposite directions i.e., an increasing X is associated with a decreasing Y; and

o 0 indicating that there is no linear relationship between the two variables.

For example, the correlation coefficient between Telkom and Altech is:

Since both shares are in the telecommunications sector, it is not surprising that there is a strong positive linear relationship between the two shares. The correlation coefficient measures the extent of the linear association between two variables. This association does not imply causation - both variables may be affected by a third variable. For example, there is a strong correlation between human birth rates and stork population sizes!

7.3 Portfolio analysis

The attractiveness of a portfolio depends upon both its expected return and its risk. 7.3.1 Expected return

A portfolio’s expected return is the weighted average of the expected returns of its component securities using the proportions invested as weights. Symbolically:

deviationdardtansstd

where

)Y(std)X(std

)Y,Xcov()Y,X(cor

=

=

904056365736

0039.

).)(.(

.)Y,X(cor ==

portfoliotheinuritiessecofnumberthen

urityseciththeofreturnectedexptheE

urityseciththeininvestedproportiontheX

returnectedexps'portfoliotheE

where

EXE

i

i

p

i

n

i

ip

=

=

=

=

= ∑=1

69

For example, the expected rate of return of the portfolio shown in table 2 is 17.98%. Table 7.5: Calculation of the expected rate of return of a portfolio Security (i)

Proportion invested (Xi)

Rate of return (Ei)

XiEi

Bond 50% 17.5% 8.75% Shares 30% 20.5% 6.15% NCD 20% 15.4% 3.08% Total 17.98% 7.3.2 Variance and standard deviation

The risk of a portfolio is measured by the variability of its expected return. The variance and standard deviation of the portfolio depend on the proportion of the portfolio invested in each security as well as the component securities’ standard deviations and correlation coefficients. The variance is given by:

The standard deviation of the portfolio is calculated as follows:

For example (see table 7.6) the portfolio variance is 60.36 and its standard deviation is 7.76%.

jandiuritiessecbetween)stdstdcor.,e.i(ariancecovthecov

uritysecjththeininvestedproportiontheX

urityseciththeininvestedproportiontheX

portfoliotheofiancevarthevar

where

covXXvar

jiijij

j

i

p

n

i

ijj

n

j

ip

=

=

=

=

= ∑∑= =1 1

pp varstd =

70

Table 7.6: Calculation of the variance of a portfolio Terms Component securities Total Bond Shares NCD Std * 5.0 15.0 10.0 X * 0.5 0.3 0.2 1.0 Bond Shrs NCD Bond Shrs NCD Bond Shrs NCD corij * 1.00 0.50 0.60 0.50 1.00 0.7 0.60 0.70 1.00

covij (1) 25.00 37.50 30.00 37.50 225.0 105.0 30.00 105.0 100.0

XiXjcovij

(2)

6.25 5.63 3.00 5.63 20.25 6.30 3.00 6.30 4.00 60.36

Terms denoted by * are assumed to be given. Calculations for the first three terms are shown (where covij = corij stdi stdj) 25.0 = 1.0 x 5.0 x 5.0 37.5 = 0.5 x 5.0 x 15.0 30.0 = 0.6 x 5.0 x 10.0 Calculations for the first three terms are shown: 6.3 = 0.5 x 0.5 x 25.0 5.6 = 0.5 x 0.3 x 37.5 3.0 = 0.5 x 0.2 x 30.0 Thus, assuming a normal distribution, given that the expected return of the portfolio is 17.98% and the standard deviation 7.76% the probability is roughly 68% that the actual return of the portfolio will be between 25.74% and 10.22% (i.e.. between (17.98 + 7.76) and (17.98 - 7.76)). To illustrate how different correlation values effect the variance of a portfolio, consider the following example. Assume that a portfolio consists of two securities. The securities have the same expected rates of return of 16%, the same variances of 2% and equal amounts are invested in each. The expected return of the portfolio will be 16%. The variance of the portfolio will be (where n = 2):

If there is no correlation (corij = 0), the variance of the portfolio is 1%, or less than that of a portfolio invested in only one of the securities. If the correlation is perfect and positive (corij = 1), the portfolio variance is 2%, the same as that of a single security. If the correlation is perfect and negative (corij = -1), the variance of the portfolio is zero. As investors generally wish to avoid risk (given return) and since the negative correlation between a security and a portfolio reduces the variance of a portfolio, such securities would be highly valued. However

ijp

ijp

jiijjijjiip

cor,,var

,,cor),)(,(),)(,(),)(,(var

stdstdcorXXvarXvarXvar

010010

02002050502020250020250

222

+=

++=

++=

71

securities that are highly correlated with a portfolio do not contribute much to the kind of risk reduction that is the purpose of diversification. 7.3.3 The efficient frontier

A portfolio can consist of one or more securities. For any group of securities the feasible set of portfolios consists of all single-security portfolios and all possible combinations of them. Figure 7.3 indicates the risk and rates of return for 10 portfolios each consisting of a single different portfolio.

Clearly portfolio 3 is preferred to portfolio 1 as it offers a higher return for the same risk. Portfolio 1 is preferred to portfolio 2 as it offers a lower risk for the same return. It the securities are perfectly correlated, portfolios made up of combinations of these securities can have smaller variances for given returns or larger returns for given variances than the single-security portfolios and would lie in the region above and to the left of the single-security portfolios. For example portfolio P could represent a combination of portfolios 3 and 4. Therefore efficient portfolios will plot along the upper border of the feasibility set of portfolios. This border is called the efficient frontier and is represented by curve ABC in figure 7.4.

Figure 7.3: Expected return and risk of portfolios

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18 20

Risk

Expecte

d retu

rn

5

4

P

3

1

6

2

8

7

9

10

72

Efficient portfolios are fully diversified in that for any given rate of return no portfolio has less risk and for a given level of risk no other portfolio provides superior returns.

7.4 Portfolio selection

Portfolio theory is based on the assumption that most investors prefer high rates of return and dislike risk and the definition of efficient portfolios follows from this. The efficient set of portfolios is the same for all investors and rational investors will select portfolios along this efficient frontier. However investors' preferences for return vis-à-vis risk differ. Investors who would like to have low levels of risk in their portfolio, pick portfolios close to point A on the curve. Investors willing to bear more risk will choose portfolios closer to point B on the curve. Investors willing to tolerate high levels of risk to earn higher returns may select portfolios near to point C. The problem of choosing an optimum portfolio for an individual investor from those that are efficient is the subject of portfolio selection. The underlying behaviour that guides the behaviour of investors is the maximisation of expected utility. Utility is maximised when a given combination of expected return and risk is preferred to all other combinations. Since investors wish to increase expected return and avoid risk it is possible to establish different combinations of expected return and risk that will be equally valued by an investor. These combinations will lie on so-called indifference curves – see figure 7.5.

Figure 7.4: The efficient frontier

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18 20

Risk

Expecte

d retu

rn

A

B

C

73

Each investor has an infinitely large family of indifference curves. Each curve represents the set of expected return and risk that are equally valued. The investor will seek to maximise utility i.e., with reference to figure 7.5, the investor will prefer indifference curve U3 to U2 and U2 to U1. Conceptually the investor is now in a position to select the optimum portfolio from those making up the efficient set. The optimum portfolio is the one at point of tangency between the efficient frontier (curve ABC in figure 7.5) and an indifference curve, The portfolio at point B on the efficient frontier is optimal as no other portfolio is on as high an indifference curve.

7.5 Portfolio theory models

7.5.1 Markowitz model

The basic elements of portfolio theory as described in sections 7.1 to 7.4 were developed by Dr Harry Markowitz in 1952. To define Markowitz’s efficient set of portfolios it is necessary to know the following for each security: o Expected return; o Variance; and o Covariance with every other security. If the efficient set were to be selected from a list of 1 000 securities, it would be necessary to have 1 000 estimates of expected return, 1 000 variances and 99 500 covariances. Because of this practical difficulty the

Figure 7.5: Indifference curves - risk/return preferences

0

2

4

6

8

10

12

14

16

18

20

0 2 4 6 8 10 12 14 16 18 20

Risk

Expecte

d retu

rn

A

B

C

Efficient frontierIncreasing utility

U1

U2

U3

74

Markowitz portfolio model was mainly of academic interest until William Sharpe (see 7.5.2) simplified it. 7.5.2 Sharpe’s index models

7.5.2.1 Introduction

Sharpe’s index models are based on the assumption that the returns of all securities are related only through their individual relationship to one or other indexes of business activity such as GDP, Dow-Jones Index, Standard and Poor’s Index, FTSE JSE all-share Index. The return on a security can be written as follows:

Iorbylainedexpnotiurityseconreturnthetermerrorresidualc

indexmarkettheonreturnofratetheI

Iinchangeagivenrinchangethemeasuringttanconsa

iuritysecoftcoefficienbetathe

Igiveniurityseconreturntheindicatingttanconsa

iuritysecoftcoefficienalphathe

urityiseconreturnr

where

cIr

ii

i

i

i

i

iiii

α

β

α

βα

−=

=

−

=

−

=

=

++=

The equation breaks down the return on a security into two components: o The part that is independent of the market (αi and ci); and o The part that is due to the market (βiI). βi measures the sensitivity of

the security’s return to the return on the market index. For example if βi equals 2, the return on the security is expected to increase (decrease) by 2% when the market index increases (decreases) by 1%.

7.5.2.2 Single index model

Sharp’s index models state that the only reason the return of two securities move together is common co-movement with the market. This is equivalent to assuming that the residual error term ci for any security i is unrelated to the residual error term cj for a second security j. Therefore the covariance between any two securities i and j is equal to βiβjσI

2 where σI

2 is the variance of the market index. If the residual risk of the return of a security (that variation in a security’s return that is unrelated to the market) is defined as σci

2, the expected return and variance of a portfolio are:

75

( )

indexmarkettheonreturnofrateI

iuritysecofbeta

iuritysecofalpha

iuritysecininvestedproportionx

returnportfolioR

where

Ixx

IxR

i

i

i

p

n

i

n

i

iiii

n

iiiip

=

=

=

=

=

+=

=

∑ ∑

∑

= =

=

β

α

βα

βα

1 1

1

iuritysecofreturnofriskresidual

indexmarkettheofiancevar

iancevarportfolio

where

xx

ci

I

p

n

i

n

iciiIiip

=

=

=

+= ∑ ∑− =

2

2

2

1 1

2222

σ

σ

σ

σσβσ

The portfolio variance now only depends on: o the weight of each share in the portfolio (xi); o The beta of each share (βi); o The variance of the index (σI

2); and o The variance of the residual error for each share (σci

2). This represents a considerable saving in terms of data input. For example a 1 000 securities portfolio will require 3 001 inputs – approximately 0.6% of the inputs required for the Markowitz model. If the beta of a portfolio is defined as the weighted average of the betas of each security in the portfolio then the portfolio beta is calculated as follows:

iuritysecofbeta


betaportfolio

where

x

i

i

P

n

i

iiP

=

=

=

= ∑=

β

β

ββ1

76

Similarly the alpha of a portfolio can be defined as

iuritysecofalpha


alphaportfolio

where

x

i

i

P

n

i

iiP

=

=

=

= ∑=

α

α

αα1

The expected return of a portfolio can then be re-written as:

markettheofreturnofrateI

betaportfolio

alphaportfolio

returnportfolioR

where

IR

P

P

P

PPP

=

=

=

=

+=

β

α

βα

The risk of a portfolio can also be re-written as:

2

1

2222ci

n

i

iIPP x σσβσ ∑=

+=

If it is assumed that the portfolio consists of equal proportions of each of n securities then the risk of the portfolio could be written as:

2

12

222 1ci

n

i

IPPn

σσβσ ∑=

+=

The last term can be expressed as n times the average residual risk of a security. As the number of securities in the portfolio increases, the importance of the residual risk – the non-beta risk – diminishes rapidly as illustrated in table 7.7.

77

Table 7.7: Importance of residual risk Number of securities Residual risk expressed as a % of the residual risk

of a one-security portfolio 1 100.0 2 50.0 3 33.0 4 25.0 5 20.0 10 10.0 20 5.0 100 1.0 1 000 0.1

The risk that is not eliminated as the number of securities in a portfolio increases is the risk associated with the portfolio beta. If the residual risk is assumed to be zero then the risk of a portfolio can be re-stated as follows:

∑=

=

=

=

n

iiiI

IPP

IPP

x1

222

βσ

σβσ

σβσ

Due to the residual risk (σci

2) of a portfolio moving to zero as the number of securities in a portfolio increases, it is commonly referred to as diversifiable or unsystematic risk. However the effect of the securities’ betas (βi) on the risk of a portfolio does not decrease as the number of securities in the portfolio (n) increases. Therefore it is a measure of a security’s non-diversifiable or systematic risk i.e.,

g

riskblediversifiariskiableundiversif

riskicunsystematrisksystematic

xx ci

n

i

iIi

n

i

iP

+=

+=

+= ∑∑==

2

1

22

1

2 σσβσ

Investors cannot avoid systematic risk as it affects all financial indexes/markets e.g., general economic conditions, fiscal and monetary policy. Unsystematic risk is the variability not explained by general market movements and is peculiar to the security concerned. It can be avoided through diversification. This implies that only inefficient portfolios have unsystematic risk. This is illustrated by figure 7.6.

78

7.5.2.3 Alphas and betas

If portfolio p in the equation Rp = αp + βp I is taken to be the market portfolio i.e., all securities are held in the same proportions as they are represented in the market then the expected return on p (Rp) must be equal to the expected return of the market index (I). The only values that ensure Rp = I are alpha (αp) equal to zero and βp equal to one. Therefore the beta of the market is one and securities are considered to be more or less risky than the market according to whether their beta is larger or smaller than one. If the return on a security moves exactly as the market does, it would have a beta of one. If it were more volatile than the market its beta would be more than one and less than one if it were less volatile. However securities seldom behave as indicated by their betas, which is where alphas come in. They are used to account for changes in securities’ prices not attributable to their betas. There are two ways of achieving superior portfolio performance: (i) Forecast the market accurately and adjust the beta of the portfolio

accordingly. For example if a market upswing is expected high beta securities could be bought and low beta securities sold to raise the portfolio beta to a level of say 2. If expectations materialise the portfolio will rise twice as much as the market. If the expectations are incorrect the portfolio will decline twice as fast as the market.

(ii) Achieve a positive alpha or excess return. If a security has a higher or lower rate of return than another security with the same beta i.e., it does better against the market than its beta would have suggested this could be due to its alpha or various residual non-market influences

Figure 7.6: Systematic and unsystematic risk

Number of securities (i.e., level of diversification)

Risk

systematic risk

unsystematic riskTotal risk

unsystematic (diversifiable) risk decreases as

number of securities increases

systematic (undiversifiable) risk is unchanged

as the number of securities increases

79

unique to each stock. If sufficient securities with positive alphas can be selected, the portfolio will perform better than its beta would have indicated for a given market movement. For example assume a security has an alpha of 1% and a beta of 1.50. If the market return is 12.0% the most likely return on the stock is 19.0% i.e., 1+ 12 x1.5.

As more securities are added to a portfolio, the chances of obtaining a positive alpha and the risk of getting a negative alpha are diversified away. The portfolio’s volatility will become similar to that of the market. Conceptually a fully diversified portfolio would have a beta of one and alpha of zero. 7.5.2.4 Multi-index models

Multi-index models assume that relationships between securities are due to common associations with more than one index. The additional sources of covariance between securities resulting from the introduction of additional indexes can simply be added to the general return equation as follows:

equationthebylainedexpnotiurityseconreturnthetermresidualc

IindexinchangestoRofnessresponsive

IindexoflevelI

returnuniquethe.,e.izerotoequalwereindicesallifreturn

iurityseconreturnR

where

cIIIR

i

ii

i

i

i

ininiiii

−=

=

=

=

=

+++=

11

1

2211

β

α

βββα K

Therefore to use multi-index models the following estimates will be required: o Expected return for each security; o Variance of each security’s return; o Beta of each security’s return in relation to each index; o Expected return and variance of each index. For example: in South Africa the gold mining and industrial sectors each comprise a significant proportion of the total market capitalisation of the JSE Ltd. The prosperity of gold mining companies depends on a gold price established by international, political and economic events often divorced from developments in the South African economy. Therefore it is reasonable to assume that the returns on mining and industrial shares will at times be influenced by different underlying factors. Consequently a two-index model using the mining and industrial indexes (see table 7.8) has been used to estimate the risk and return of a portfolio comprising the shares detailed in table 7.9.

80

Table 7.8: Index statistics Index Return

RI

Standard deviation σI

Gold mining (GLDI) 12.00 0.03063 Industrial (INDI) 11.50 0.02096 Table 7.9: Share statistics Share Proportion

invested (%) xi

Alpha

αi

Beta (GLDI)

βGLDIi

Beta (INDI)

βINDIi

Residual risk

σci Harmony (Har) 20.0 -0.002 1.655 -0.302 0.036 AngloGold (Ang) 30.0 0.000 0.763 0.436 0.029 Barlows (Bar) 50.0 -0.001 0.060 1.197 0.027 The alpha and beta of the portfolio are:

( ) ( ) ( )0001,0

001.050.0000.030.0002.020.01

==

=

−++−

∑=

xxx

n

iiip x αα

( ) ( ) ( )5900

060050076303006551200

1

.

......

xn

i

GLDIiiGLDIp

=

×+×+×=

= ∑=

ββ

( ) ( ) ( )6690

197150043603003020200

1

.

......

xn

i

INDIiiINDIp

=

×+×+−×=

= ∑=

ββ

The portfolio risk and return will be:

( ) ( )%78.14

115.0669.012.0590.0001.01

=×+×+=

+= ∑=

n

iIIpp RR βα

81

028860

0008330

0008330

000309700052310 22

20270

2500

20290

2300

20360

2200

2020960

26690

2030630

25900

1

222222

.

.

.

..

x

p

..........

n

iciiINDIINDIGLDIGLDIp

=

=

=

+=

=

++=

×+×+×+×+×

=∑

σ

σσβσβσ

The total risk of the portfolio is 2.886%. Therefore 68% of the time (refer 7.2.3) the portfolio return will be between 17.556% (i.e., 14.67% + 2.886%) and 11.784% (i.e., 14.67% - 2.886%). The systematic risk of the portfolio is

2.29% i.e., 00052310. and the unsystematic risk is 1.76% i.e.,

00030970. . The degree of diversification is 62.81% i.e.,

0.0005231/0.0008328, which is to be expected from a portfolio containing only three securities. Alternative portfolios can be calculated in different proportions and with different securities to construct a table such as table 7.9. Table 7.10: Alternative portfolios Parameter Portfolio 1 Portfolio 2 Unsystematic risk 1.76% 0.58% Systematic risk 2.29% 0.92% Total risk 2.89% 1.09% Degree of diversification 62.81% 71.43% Expected return 14.67% 13.27% Downside potential 11.78% 12.18% Upside potential 17.56% 14.36% The choice facing the investor is clearly quantified. Portfolio 1 with an expected return 1.4% more than portfolio 2 can be chosen. However in doing so downside risk is increased. The choice will depend on the investor’s attitude to risk as it relates to return.

82

7.5.3 Capital asset pricing model

7.5.3.1 Introduction

The capital asset pricing model (CAPM) is a refinement of portfolio theory. It attempts to describe the market relationships if investors behave is the manner prescribed by portfolio theory. These relationships give an indication of the relevant measures of risk for portfolios and individual assets. 7.5.3.2 Assumptions

The simplifying assumptions of the CAPM are: (i) Investors have homogeneous expectations; (ii) Investors have identical time horizons; (iii) Perfect competition exists i.e., there are no transaction costs or

taxes, costless information is available to all investors, investors are price takers;

(iv) Investors are able to lend or borrow unlimited funds at the risk-free market interest rate;

(v) Assets are infinitely divisible; and (vi) All investors attempt to hold Markowitz-efficient portfolios. 7.5.3.3 The capital market line

The CAPM states that by optimally diversifying, all investors will hold the same portfolio – the market portfolio. The market consists of risky securities only and is the best diversified portfolio that can be held. It is the portfolio constructed by holding every security in equal proportion to its portion of the total market value of all available securities. The market portfolio is one portfolio on the efficient frontier (point M in figure 7.7).

83

In addition to risky investments the CAPM recognises another investment vehicle – a risk-free asset i.e., an asset that can be borrowed or lent without risk of default e.g., treasury bills. Point Rf in graph 7.7 is the rate of return on a risk-free asset. The line segment RfM shows the various portfolios available through combinations of risk-free and risky assets. Possible portfolio combinations range from a totally invested position in risk-free assets to one that exactly mirrors the market. Portfolios on the line segment RfM will be preferred to portfolios on the curve AM as they offer more return for the same risk. It is possible to hold efficient portfolios on the line RfM beyond the point of tangency with curve AMC since borrowing is allowed. Given the simplifying (unrealistic) assumption that investors can borrow to purchase financial assets at the same rate that investors receive on a risk-free asset, efficient portfolios beyond the point of tangency lie on a linear extrapolation of the line RfM – line segment MN in figure 7.7. Any point on the line RfMN is achievable by combining the portfolio of risky assets at M with the risk-less asset or by leveraging the portfolio at M i.e., by borrowing funds and investing them in portfolio M. Portfolios on line RfMN are preferred to portfolios on the curves between A and M and M and C since they offer greater return for a given level of risk or less risk for a given rate of return. The efficient frontier is now linear and is referred to as the capital market line. Symbolically:

Figure 7.7: The capital market line

Risk

Expecte

d retu

rn

M

A

C

Efficient frontier

Lending portfolios

Leveraged portfolios

N

Rf

84

markettheonreturnsofdeviationdardtans

portfoliotheonreturnsofdeviationdardtans

markettheonreturnectedexpE

ratefreeriskR

portfolioaonreturnectedexpE

where

RERE

m

p

m

f

p

pm

fmfp

=

=

=

−=

=

×−

+=

σ

σ

σσ

The formula states that the expected return on an efficient portfolio is a linear function of its risk as measured by the standard deviation. The slope of the line can be considered the price of risk i.e., the additional expected return for each additional unit of risk. For example assume that the risk-free rate of return is 10.0%, the expected return on the market portfolio is 16.0%, the standard deviation of the market portfolio’s return is 12% and the standard deviation of the portfolio is 13%.

13.012.0

10.016.010.0Ep ×−+=

The investor will expect to earn a return of 16.5% for bearing risk equivalent to a standard deviation of 13.0%. The slope of the line is 0.5 i.e., (0.06 / 0.12). Therefore an extra unit of risk is rewarded with an additional half a unit of return. The CAPM states that an investor’s choice of an optimum portfolio is separate from the optimal combination of risky assets. This combination is identical for all investors. Individual investor’s requirements determine only the amount of borrowing and lending. This is referred to as the separation theorem. The theorem allows the development of valuation under uncertainty that does not depend directly on knowledge of the degree of risk aversion of investors. 7.5.3.4 The security market line

The capital market line holds only for efficient portfolios. It does not describe the relationship between the return on inefficient portfolios or individual securities and their standard deviations. The CAPM states that the expected return on any portfolio or security is related to the risk-free rate and return on the market as follows:

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( )

portfoliotheoftcoefficienbeta

markettheonreturnR

ratefreeriskR

portfoliotheonreturnE

where

RERE

p

m

f

p

fmpfp

=

=

−=

=

−+=

β

β

The relationship is similar but not identical to the capital market line. Here beta rather than standard deviation measures risk. For efficient portfolios the relationship is the same i.e., βp = σp / σm = 1. The security market line is represented graphically by figure 7.8. For example assume the risk-free rate is 10.0%, the expected return on the market 16.0% and the beta of the portfolio is 0.5, then the expected return on the portfolio is:

( )%.

....Ep

013

10016050100

=

−+=

The expected return on any portfolio or security can be determined by the relationship described by the security market line. Since market return (Rm) and risk-free return (Rf) are not functions of portfolio returns, the expected return on any portfolio or security can be related to its beta. The higher the beta of any portfolio or security, the greater must be its expected return.

Figure 7.8: The security market line

Risk

Expecte

d retu

rn

Rf

Rpi

Rm

1

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As previously stated the risk of any portfolio or security can be divided into systematic (as measured by beta) and unsystematic risk. According to the security market line, systematic risk is the only determinant of expected portfolio returns i.e., unsystematic risk plays no role. Therefore investors are rewarded for bearing systematic risk i.e., it is not total variance that affects returns – only that part that cannot be diversified away. Since investors can eliminate all unsystematic risk through diversification, there is no reason why they should be rewarded (in the form of returns) for bearing it. 7.5.3.5 Applications of the CAPM

(i) Cost of equity – the required rate of return on equity The required rate of return is the minimum rate of return that prospective investors will accept from an investment to compensate them for deferring consumption. The rate of return that investors require to make an equity investment in a firm is generally referred to as the cost of equity. It can be calculated by using the security market line as follows:

( )

ishareofbeta

markettheonreturnR

ratefreeriskR

ishareonreturnofraterequiredk

where

RRRk

p

m

f

i

fmifi

=

=

−=

=

−+=

β

β

The term (Rm-Rf) is known as the market risk premium. It is generally based on historic data and indicates the difference between the average return on shares and average return on risk-free securities over a measurement period. The term βi(Rm-Rf) is a share’s risk premium and when added to the risk-free rate gives the required rate of return of a share. Example: calculating the required rate of return on a share Given: 1. The share’s beta is 1.4 2. The risk free-rate is 9.7% (the current treasury bill rate) 3. The return on the market (FTSE JSE All share index) is 17.5%

%.

)..(..k i

620

09701750410970

=

−+=

87

Example: calculating the required rate of return on a share Given: 1. The share’s beta is 1.4 2. The risk free-rate is 9.7% (the current treasury bill rate) 3. The market risk premium is 7.8%

%.

).(..k i

620

0780410970

=

+=

Example: calculating the required rate of return on a share Given: 1. The risk free-rate is 9.7% (the current treasury bill rate) 2. The share’s risk premium is 10.9%

%.

)..k i

620

10900970

=

+=

(ii) Judging the reasonableness of investment objectives The investment objective of Peoples Pension Fund is “to attain maximum growth of assets and income consistent with overall quality investments and preservation of assets in a portfolio consisting primarily of blue-chip shares and preferred bonds and debentures. The fund requires for the equity-related portion of the portfolio a return of 25% above the FTSE JSE all-share index. The trustees are aware that this objective entails more volatility than the overall market. If unfavorable market conditions are foreseen, a reduction in volatility is acceptable and desirable. At least 15% superior performance relative to the all-share index on the downside will be expected. Thus the expectation for the equity-related portion of the portfolio in relation to the rate of return of the all-share index is as follows: FTSE JSE All-share index Peoples Pension Fund % above index 30.0 37.5 25.0 20.0 25.0 25.0 10.0 12.5 25.0 0.0 2.5 -10.0 -8.5 15.0 -20.0 -17.0 15.0 -30.0 -25.5 15.0 Figure 7.9 illustrates expected returns in terms of the various levels of risk as expressed by the portfolio’s beta. A portfolio with a beta of 1 would represent the market (represented by the all-share index). It is assumed

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that the average rate of return on the all-share index is 10.0%, that bear markets produce negative market returns of 10.0% and that the average risk-free rate is 5%. Using the security market line the expected rates of return of the portfolio with a beta other than 1 can be calculated and market lines Rf A and Rf B – reflecting respectively long-term expectations and bear-market vulnerability – can be drawn. For example if the portfolio beta is 0.5, the portfolio’s expected rate of return will be 7.5% i.e., 5.0 + 0.5 (10.0 - 5.0). The fund’s trustees require a return of 12.5% when the market return is 10.0%. To achieve this return the portfolio’s beta will have to be 1.5 – see figure 7.9 – a position more risky than the market and probably in violation of the investment objective of “a diversified portfolio of quality investments with the preservation of capital”. This incompatibility is further emphasised when expected portfolio results during a bear market are considered. When the market declines to –10.0% a loss of 8.5% is required. However a portfolio with a beta of 1.5 is expected to return –17.5% if the market declines to –10.0%. The objective of outperforming the market by 25.0% on the upside (12.5% when market returns are 10.0%) implies an exposure to under-performing it on the downside by substantially larger proportions (–17.5% when market returns are –10.0%). To achieve a return of –8.5% when the market return is -10.0% the beta will have to be reduced from 1.5 to 0.9 i.e., β = ((0.05 + 0.085) / (0.10 + 0.05)).

To shift the portfolio from a beta of 1.5 to 0.9, the portfolio manager must be able to forecast a bear market well in advance and be willing to incur

Figure 7.9: Investment objectives of Peoples Pension Fund

5.0

7.510.0

15.012.5

-25.0

-17.5

-10.0

-2.5

-30

-25

-20

-15

-10

-5

0

5

10

15

20

0 0.5 1 1.5 2

Beta

Expecte

d retu

rn

Long-term expectations

Bear-market vunerability

Rf

A

B

89

high transaction costs. Alternatively security selection must be so proficient that sufficient alpha is achieved to offset the inappropriate beta. The CAPM can be used to specify precise and remove undefined and subjective investment objectives. By illustrating how a portfolio may behave during severe market fluctuations, it indicates what is required in terms of market timing (adjustment of beta) and the ability to secure gains (alphas) from the astute selection of undervalued securities.

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Questions for chapter 7 1. What assumptions underlie portfolio theory? 2. What estimates about securities can be used to make predictions

about portfolios? 3. What is the expected return of a security that has possible returns of

10% and 15%? The possible returns have an equal probability of occurring.

4 What is the significance of a correlation coefficient of 0.9 between

Anglo Platinum and Impala Platinum? 5. Calculate the expected rate of return of the following portfolio: Security Proportion invested Rate of return Bonds 50% 8.0% Shares 50% 20.0% 6. Differentiate between systematic and unsystematic risk. 7. Define multi-index models. 8 Differentiate between the capital and security market lines. 9. According to CAPM, what is the expected return on a portfolio if

The risk-free rate of return is 10%, The expected return on the market portfolio is 15%, The standard deviation of the market portfolio’s return is 12% and The standard deviation of the portfolio’s return is 14%?

10 According to CAPM, what is the expected return on a portfolio if

The risk-free rate of return is 10.0%, The expected return on the market portfolio is 15.5%, The standard deviation of the market portfolio’s return is 11.2% and The beta coefficient of the portfolio is 1.2?

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Answers for chapter 7 1. The assumptions underlying portfolio theory are rational investors

choosing portfolios attempt to maximise utility and are willing to base their decision solely in terms of risk and return; investors are risk adverse; the risk of a portfolio is measured by the variability of its return; and for any given level of risk an investor prefers a higher rate of return to a lower one and for any given level of return an investor prefers less risk to more risk.

2. The estimates about securities used to make predictions about

portfolios are expected return; the variability of return (risk); and the covariances and correlation coefficients between securities.

3. 12.5% i.e., (10.0% X 0.50%) + (15.0% X 0.50%) 4 There is a positive linear relationship between Anglo Platinum and

Impala Platinum i.e., an increasing Anglo Platinum share price is associated with an increasing Impala Platinum share price. However the relationship is not exact i.e., 100% but 90%. This association does not imply causation - both variables may be affected by a third variable.

5. 14.0% i.e., (8.0% X 0.50%) + (20.0% X 0.50%) 6. Systematic risk as it affects all financial indexes/markets e.g., general

economic conditions, fiscal and monetary policy and as such cannot be avoided by investors. Unsystematic risk is the variability not explained by general market movements and is peculiar to the security concerned. It can be avoided through diversification i.e., unsystematic risk decreases as the number of securities in the portfolio increases. This implies that only inefficient portfolios have unsystematic risk.

7. Multi-index models are models that assume that relationships between

securities are due to common associations with more than one index. 8 The capital market line holds only for efficient portfolios. The

relationship described by the security market line can be used to determine the expected return on any portfolio or security. Beta measures risk in respect of the security market line while standard deviation measures risk in respect of the capital market line.

9. 16.60% i.e., 0.10+ 1.2 X (0.155 – 0.10) 10 14.29% i.e., 0.10 + (0.15 – 0.10) / 0.14 X 0.12

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8. Technical analysis

Chapter learning objectives: o Define technical analysis; o Contrast technical and fundamental analysis; o Discuss the assumptions underlying technical analysis; o Understand a typical stock-market chart and how it can be used to

determine share price trends. “Today’s technical analyst is as much a social philosopher and observer of world events as his fundamentalist colleague. The distinguishing feature of the technical analyst continues to be his belief that the market tells its own story, but he has found new and different ways of defining precisely what story it is that the market is telling. The chartist sought to define price trends, which were assumed to be intact until evidence of a change emerged; today’s technical analyst is more of a contrary thinker who goes behind the price trends and seeks to define investor sentiment, partly in price behaviour but perhaps more in readings from the market environment itself”

Peter Bernstein, 1978 Technical analysis is the study of past stock market price-trend behaviour to estimate future price trends in an attempt to profit from periodic changes in these trends. Technical analysis is an extensive subject and the purpose of this chapter is merely to introduce it by highlighting its underlying assumptions and briefly describing a typical stock-market chart and how it is used by technical analysts to determine share price trends.

8.1 Technical and fundamental analysis

Technical and fundamental analysis are often seen as contrary but generally they complement one another. Fundamental analysis can be used to determine what shares to buy and sell while technical analysis can be applied to ascertain when the purchases / sales should take place.

8.2 Assumptions

The following assumptions underlie technical analysis: (i) Supply and demand determine share prices; (ii) Supply and demand are driven by both rational and irrational investor

behaviour; (iii) Share prices move in trends – these trends persist for long periods of

time; (iv) Current trends change in reaction to fluctuations in supply and

demand. Trend changes can be identified in time by the action of the market.

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8.2.1 Typical stock market chart

With reference to figure 8.1, the graph begins in a bear market with a declining trend channel that ends in a trough. This is followed by an upward trend. Confirmation that the bear trend has reversed is a buy signal. The share would be held as long as the share price remained in the rising trend channel. Ideally the share should be sold at the peak of the cycle but this point cannot usually be identified until the trend changes. Should the share price ‘s rising trend end in a flat trend channel, it may be necessary to wait until the price breaks out into either a new upward or downward trend. If the share price breaks out of the flat trend channel on the downside, it would be a sell signal.

Time

Share

price

Source: Reilly pp 875 and Falkena pp 107

Figure 8.1:Typical stock market chart

Declining trendchannel

Trough

Buy point

Rising trendchannel

Peak Flat trendchannel

Sell point


Trough

Buy point

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Questions for chapter 8 1. According to Peter Bernstein, what is the ‘distinguishing feature’ of a

technical analyst? 2. Define technical analysis. 3. Differentiate between technical and fundamental analysis. (Hint: see

chapter 4 for the definition of fundamental analysis) 4 What assumptions underlie technical analysis? Answer the next 6 questions using figure 8.1:

5. Does the graph begin in a bull or bear market? 6. What would confirm that a bear trend has reversed? 7. After a rising trend channel, when is the best time to sell the share? 8 Why is it not generally possible to sell a share at the peak and buy a

share in a trough? 9. In a flat trend channel would the technical analysts recommend a buy,

sell or hold? 10 If the share price breaks out of a flat trend channel on the downside

would the technical analyst recommend a buy, sell or hold?

Time

Share

price

Source: Reilly pp 875 and Falkena pp 107

Figure 8.1:Typical stock market chart


Trough

Buy point

Rising trendchannel

Peak Flat trendchannel

Sell point


Trough

Buy point

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Answers for chapter 8 1. According to Peter Bernstein, the distinguishing feature of a technical

analyst is his belief that the market tells its own story. 2. Technical analysis is the study of past stock market price-trend

behaviour to estimate future price trends in an attempt to profit from periodic changes in these trends.

3. Fundamental analysis focuses on determining the intrinsic value of a

share i.e., on determining what share to buy. Technical analysis focuses on determining future price trends in an attempt to profit from periodic changes in these trends i.e., on determining when to buy or sell a share.

4 The assumptions underlying technical analysis are supply and demand

determine share prices; supply and demand are driven by both rational and irrational investor behaviour; share prices move in trends and these trends persist for long periods of time; current trends change in reaction to fluctuations in supply and demand and trend changes can be identified in time by the action of the market.

5. The graph begins in a bear market. 6. A buy signal is confirmation that a bear trend has reversed. 7. Ideally a share should be sold at the peak of cycle i.e., at the end of

the rising trend channel. 8 Because this point i.e., peak or trough cannot usually be identified

until the trend changes. 9. In a flat trend channel the technical analysts would usually

recommend a hold until the price breaks out into a new trend. 10 The technical analyst would recommend a sell.

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9. Equity derivatives

Chapter learning objectives: o Define a futures contract; o Define an options contract; o Define a swap; o Describe how arbitrageurs, hedgers, investors and speculators use

equity derivatives; and o Outline equity derivatives listed in South Africa. Equity derivatives are financial instruments that derive their value from the prices of shares and share indexes. They can be grouped under three general headings: o Futures; o Options; and o Swaps. Derivatives market participants can be divided into four groups: arbitrageurs, hedgers, investors and speculators. With reference to these groups equity futures, options and swaps will be discussed.

9.1 Futures

A futures contract is an agreement to buy or sell, on an organised exchange, a standard quantity and quality of an asset at a future date at a price determined at the time of trading the contract. 9.1.1 Hedging with stock indexes futures

On 15 December 2004 an investor decides to liquidate part of his gold share portfolio in three months time (on 15 March 2005). The value of the portfolio is R203 860. The investor expects the FTSE JSE all-gold index to fall over the next three months. The spot FTSE JSE all-gold index is 1901 while the March all-gold index futures contracts are quoted at 1930/1960. He decides to sell 10 futures contracts expiring 15 March 2005. By 15 March 2005 the FTSE JSE all-gold index has fallen by 101 points to 1800 while the market value of the investor's portfolio has declined to R189 804 - a loss of R14 056 (i.e., 189 804 – 203 860). However, because the investor sold 10 all-gold index futures contracts, he makes a profit of R13 000 (i.e., (19 300-18 000) x10) on the futures transaction (note that on the futures expiry date the futures price becomes equal to the cash price). Therefore the net loss to the portfolio is R1 056 (i.e., 13 000-14 056).

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9.1.2 Arbitraging with share futures

With reference to table 9.1, assume the spot price of Anglogold shares is R290 per share and the price of the futures contract expiring in 3 months is R295 per share. The arbitrageur calculates the fair value of the futures contract as R297 per share (the calculation of fair value is detailed in RPE module “The derivatives market”). The current 3-month borrowing / lending rate is 10%. As the fair value is greater than the market futures price, the arbitrageur: o Buys the futures contract; o Shorts the shares and invests the proceeds at 10% per annum. In 3 months time, the investment would be realised, delivery of the shares in terms of the futures contract would take place and the short cash position closed. The arbitrageur would make a risk-less profit of R2 per share. Table 9.1: Arbitrage example Given Current share price 290 Futures price 295 Fair-value futures price 297 Current 3-month interest rate 10.0% Cash-flow Now 3-month Long futures contract -295 Short Anglogold share +290 Invest proceeds -290 +297 Take delivery on futures and close short share position

Net cash-flow 0 2 If on the other hand – see table 9.2 – the market futures price is less than the fair value price, the arbitrageur would: o Sell the 3-month R300 futures contract; o Borrow R290 at 10% p.a.; o Buy spot Anglogold shares at R290.

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Table 9.2: Arbitrage example Given Current share price 290 Futures price 300 Fair-value futures price 297 Current 3-month interest rate 10.0% Cash-flow Now 3-month Short futures contract +300 Borrow +290 Long Anglogold shares -290 Repay loan and interest and deliver shares to the futures market

-297

Net cash-flow 0 3 In 3 months time the futures contract would be realised at R300 per share and the shares delivered to the futures market. The loan plus interest would be repaid. The arbitrageur would realise a R3 per share risk-less profit. The example is for illustrative purposes only. It has ignored transaction costs and the margin between borrowing and lending interest rates. Both these could make the arbitrage play unprofitable.

9.2 Options

An option contract conveys the right to buy or sell a specific quantity of a share or share index at a specified price at or before a known date in the future. As such an option has certain important characteristics: o It conveys upon the buyer (or holder) a right – not an obligation. Since

the option can be abandoned without further penalty, the maximum loss the buyer faces is the cost of the option;

o By contrast, if the buyer chooses to exercise his right to buy or sell the underlying asset or derivative, the seller (or writer) has an obligation to deliver or take delivery of the underlying asset or derivative. Therefore the potential loss of the seller is theoretically unlimited.

The simplest derivatives strategies for an investor that is bullish about a company’s share would be to buy call options or buy futures. In contrast a bearish investor would buy put options or sell futures. In neither case is it necessary to buy or sell the underlying share – although this is an alternative strategy.

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9.2.1 Speculating with call options

Assume a speculator believes Sallies shares – currently trading at R1.00 - will stay static over the next couple of months. Therefore she writes 2-month at-the-money call options on Sallies shares for premium income of R0.05 per share. At expiry there are three possible outcomes: (i) Sallies shares stay static at R1.00 as expected. The options will

expire worthless and the speculator will realise R0.05 premium income per share;

(ii) Sallies shares rise to R1.10 per share and the options expire in the money. The speculator will buy the shares in the cash market at R1.10 for delivery to the options market and realise a loss of R0.05 per share.

(iii) Sallies shares fall to R0.90 per share. The options as in outcome (i) will expire worthless and the speculator will realise R0.05 premium income per share.

9.2.2 Speculating with put options

Assume a speculator is bullish about Sallies shares – currently trading at R1.00. She writes 2-month at-the-money put options on Sallies shares for premium income of R0.03 per share. At expiry there are three possible outcomes: (i) Sallies shares stay static at R1.00. The options will expire

worthless and the speculator will realise R0.03 premium income per share;

(ii) Sallies shares rise to R1.10 per share as expected and the puts expire out the money. Once again the speculator will realise R0.03 premium income per share;

(iii) Sallies shares fall to R0.90 per share and the option is exercised against the speculator. The speculator will buy the shares from the option holder at R1.00 and sell them in the cash market at R0.90. The speculator will realise a loss of R0.07 (i.e., R0.90 – R1.00 + R0.03) per share.

9.3 Swaps

The vanilla equity swap (fixed-for-equity equity swap), like any other basic swap, involves a notional principal, a specified tenor, pre-specified payment intervals, a fixed rate (swap coupon), and a floating rate pegged to some well-defined share index. The innovative twist in these swaps is that the floating rate is linked to the total return (i.e., dividend and capital appreciation) on a stock index. The stock index can be broadly based such as the S&P500, the London Financial Times Index, the Nikkei index, the

100

FTSE JSE All-Share index or narrowly based such as that for a specific industry group e.g., the FTSE JSE gold index. Several variants of the vanilla swap exist. These are described in the table below.

Variant Description

Floating-for-equity equity swap

Equity swap with one side pegged to a floating rate of interest and the other to an equity index.

Asset-allocation equity swap

Equity swaps where the equity return is pegged to the greater of two stock indexes.

Quattro equity swap

Swaps with two equity legs rather than one i.e., one counterparty pays the total return on one stock index and receives the total return on another stock index.

Blended-index equity swap

Equity swaps using a blended index i.e., a weighted average of two or more indexes, on the equity-pay leg. A blended-index consisting of many indexes from different countries is also called a rainbow.

Variable- or fixed-notional equity swaps

Equity swaps, the notional principal of which is reset at each payment date, implying a constant number of stocks; or fixed, representing a constant cash value invested in equity regardless of price movements.

The most important uses for equity swaps are: to hedge equity positions, to gain entry to foreign equity markets and to benefit from market imperfections via synthetic equity portfolios. (i) Hedging equity positions Equity swaps can be used to convert volatile equity returns into stable fixed-income returns. For example, assume a unit trust holds a diversified equity portfolio highly correlated with the return on the FTSE JSE All-share index (ALSI). It wishes to pay the ALSI return and to receive a fixed rate thereby hedging the pre-existing equity position against downside market risk over the tenor of the swap. It enters into a swap agreement with its bank for a tenor of three years on a notional principal of R400million with quarterly payments. The bank prices the swap at 10,95% p.a. payable quarterly. The resultant cash-flows are shown on the next page.

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It is important to note that because an equity return can be positive or negative, the cash flow on the equity-linked side of the swap can go in either direction. If the equity return for the quarter is negative, the bank pays the unit trust the negative sum as well as the swap coupon on the fixed leg. (ii) Gaining entry to foreign equity markets Equity swaps eliminate the problems associated with different settlement, accounting and reporting procedures among countries. They allow international investors to gain access to the high potential growth in foreign equity markets without the problems associated with a lack of knowledge about local market conditions, exchange control stipulations and foreign ownership regulations. (iii) Benefiting from market imperfections By circumventing market imperfections it is possible for a synthetic equity portfolio created via a swap to outperform a real equity portfolio. A dominant source of savings is the elimination of the transactions costs associated with acquiring the cash portfolio - the transaction costs of acquiring a synthetic equity portfolio via an equity swap are significantly less than the transaction costs of obtaining a real equity portfolio. Besides initial transaction costs, there are numerous potential savings based on regulatory or tax arbitrage. For example many countries attach a withholding tax to dividends paid to foreign investors e.g., United States, Germany and South Africa. In other countries the underlying equities included in an index are often illiquid or, through monopoly control, bid-offer spreads are kept large. Some countries, including South Africa, impose a turnover tax on transactions in equity. In most countries, foreign equity is held through custodial banks, as is the case with American Depository Receipts (ADRs) in the United States. This results in the payment of custodial fees. There are also transaction costs to rebalancing a cash equity portfolio when there is a change in the composition of an index. Substantial benefits could accrue to the extent that equity swaps eliminate or reduce these costs.

Equity portfolio Unit trust BankALSI return

ALSI return

10.95%

Figure 9.1: Equity swap

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9.4 South African listed equity derivatives

Listed equity derivatives include: o Futures contracts and options on futures contracts on equity indexes

listed and traded on the Financial Derivatives Division of the JSE Ltd; o Futures contracts and options on futures contracts on single shares

(called single stock futures) listed and traded on the Financial Derivatives Division of the JSE Ltd; and

o Warrants listed and traded on the JSE. 9.4.1 Equity indexes

Safex lists futures contracts and American-style options on futures contracts on the following FTSE / JSE Africa tradable indexes: Index Description

FTSE/JSE Top40 Index The top forty companies that are constituents of the FTSE/JSE All Share Index ranked by full market capitalisation (before free float weightings are applied)

FTSE/JSE Gold Mining Index

All companies that are constituents of both the FTSE/JSE All Share Index and the gold mining sub sector.

FTSE/JSE INDI25 Index The top twenty-five companies that are constituents of either the basic or general industrial economic groups ranked by full market capitalisation (before free float weightings are applied)

FTSE/JSE FNDI 30 Index The top thirty companies that are constituents of either the financial or industrial (basic or general) economic groups ranked by full market capitalisation (before free float weightings are applied)

FTSE/JSE RESI 20 Index The top twenty companies that are constituents of the resources economic group ranked by full market capitalisation (before free float weightings are applied)

FTSE/JSE FINI 15 Index The top fifteen companies that are constituents of the financial economic group ranked by full market capitalisation (before free float weightings are applied)

The value of the contract is 10x the Index Level and the minimum price movement (tick) is 1. 9.4.2 Single stock futures

A single stock future (SSF) is a futures contract on a single share i.e., the underlying security of the futures contract is an equity listed on an exchange – the JSE in South Africa’s case. The value of an SSF contract is

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equal to 100 times the share’s futures price. The minimum price movement is R1 i.e., R0.01 move in the share price. The Financial Derivatives Division of the JSE Ltd lists American-style options on SSFs exercisable into SSFs i.e., on exercise of the option contract, the buyer or seller becomes the buyer or seller of an SSF contract. On expiry each SSF contract is physically settled i.e., buyer of the futures contract takes delivery of the actual scrip from the seller. 9.4.3 Warrants

Warrants are derivatives that closely resemble options. They give the buyer the right but not the obligation to buy (in the case of a call warrant) and sell (in the case of a put warrant) a specific underlying instrument at a particular price (the exercise or strike price) on or before the expiry date. The following warrants trade on the JSE: (i) Vanilla call and put warrants are warrants issued on the shares of

a single company listed on the JSE. These warrants can be American- or European-style options. If exercised they are cash settled or settled by delivery of the underlying share.

(ii) Index warrants are warrants based on the level of a specific index. Index warrants are usually cash settled.

(iii) Basket warrants are warrants comprising a basket of shares. (iv) Discount warrants are warrants that allow holders to buy the

underlying security at a discount to the current market price. (v) Capital protection warrants are warrants that give holders a

guaranteed return on the underlying security. Not only are holders guaranteed a specific return but they can also benefit if the underlying security increases beyond the capital protection level.

(vi) Barrier warrants are the same as vanilla warrants except they have barrier levels. If the price of the underlying security breaches the barrier level the barrier warrant lapses i.e., the listing is terminated and the holder has no more rights.

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Questions for chapter 9 1. Name four groups of derivatives market participants. 2. Define a futures contract. 3. Define an option contract. 4 Define a plain vanilla equity swap. 5. If equity prices are expected to fall, speculators will (buy / sell) futures

contracts. 6. If equity prices are expected to rise, speculators will (buy / sell)

futures contracts. 7. If the market price of the futures contract is greater than the fair value

of the futures contract the arbitrageur will (buy / sell) the futures contract (buy / sell) the shares in the cash market.

8 If the market price of the futures contract is less than the fair value of

the futures contract the arbitrageur will (buy / sell) the futures contract (buy / sell) the shares in the cash market.

9. An investor that is bullish about a company’s share will buy (call / put)

options. 10 What is a single stock future?

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Answers for chapter 9 1. Four groups of derivatives market participants are arbitrageurs,

hedgers, investors and speculators. 2. A futures contract is an agreement to buy or sell, on an organised

exchange, a standard quantity and quality of an asset at a future date at a price determined at the time of trading the contract

3. An option contract conveys the right to buy or sell a specific quantity

of a share or share index at a specified price at or before a known date in the future.

4 In the vanilla equity swap one party receives a cash flow equal to the

total return on a notional amount of the stock index and pays a cash flow equal to interest at the fixed rate on the same notional principal.

5. If equity prices are expected to fall, speculators will (buy / sell) futures

contracts. 6. If equity prices are expected to fall, speculators will sell futures

contracts. 7. If the market price of the futures contract is greater than the fair value

of the futures contract the arbitrageur will sell the futures contract and buy the shares in the cash market.

8 If the market price of the futures contract is less than the fair value of

the futures contract the arbitrageur will buy the futures contract and sell the shares in the cash market.

9. An investor that is bullish about a company’s share will buy call

options. 10 A single stock future is a futures contract on a single share.

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10. Private equity

Chapter learning objectives: • To define private equity; • To examine the characteristics of private equity; • To explain the structure of the private equity market and identify and

describe market participants i.e., investors, intermediaries, issuers, agents and advisors.

Finally, for background purposes, the size and regional breakdown of the private equity market will be given.

Private equity is an important source of funding for start-up firms, established private companies, firms in financial distress, and public firms seeking buyout financing. The objective of this chapter is to describe the private equity market. Firstly private equity will be defined and the characteristics thereof examined. Thereafter the structure of the private equity market will be explained focusing in turn on investors, intermediaries, issuers, agents and advisors. A brief outline of the secondary private equity market will follow. Finally the size and regional breakdown of the market will be given. In South Africa, black economic empowerment plays a significant role in the private equity industry. A significant number of private equity firms are becoming black-empowered or black-owned and many private equity deals have an aspect of black economic empowerment in them.

10.1 Private equity defined

Private equity is medium to long-term finance provided by investors in return for an equity stake in potentially high-growth companies. The companies are generally not quoted on a public stock exchange and need financing to fund growth, development or business improvement. In addition to providing capital, the private equity investment encompasses hands-on application of skills, expertise and strategic vision to the privately owned companies. The investment is often realised through flotation on the public markets. Private equity investments take the form of any security that has an equity participation feature. The most common forms are ordinary shares, preference shares and subordinated debt with conversion privileges or warrants.

10.2 Characteristics of private equity

The key characteristics of private equity are: o Private equity investments are privately held as opposed to publicly

traded; o Private equity investment entails active involvement in identifying the

investment, negotiating and structuring the transaction and monitoring

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the company once the investment is made. This often requires serving as a board member of the company;

o Private equity investments are not intended to be held indefinitely. Generally alternative exit strategies are evaluated at the time the initial investment in the company is made. One such strategy would be to take the company public and sell the shares into the public market; and

o Private equity investments are high risk and high reward. Private equity investors seek a high return on their capital when the company prospers as they risk to lose most, if not all of their investment if the company fails.

10.3 Structure of the private equity market

The private equity market has three major types of participants – investors, intermediaries and issuers. Figure 10.1 illustrates how these participants interact. The left-hand column lists the major investors, the middle column the major intermediaries, and the right-hand column the major issuers in the private equity market. Arrows pointing from left to right indicate the flow of funds and other services. The bottom of the figure shows a variety of agents and investment advisors that help issuers or intermediaries raise money or advise investors on the best intermediaries or issuers in which to invest.

10.3.1 Investors

In the late 1970s the private equity market consisted mainly of affluent individuals, called business angels, who provided capital for early-stage

Independent private equity firms• Pension funds

• Endowment funds and foundations

• Insurance companies

• Banks

• Non-financial corporations

• Wealthy families and individuals

Private equity fund

Private equity fund

Private equity fund

Private equity fund

of funds

Captives

IntermediariesInvestors Issuers

New ventures

• Seed / early stage

• Start-up

Private company

• Expansion

• Replacement capital

• Turnaround

Public company

• Turnaround

• Buyout

• Special situations

Investment advisors to investors

Placement agents for funds

Placement agents for issuers

Figure 10.1: The private equity market

Direct investment

Independent private equity firms• Pension funds

• Endowment funds and foundations

• Insurance companies

• Banks

• Non-financial corporations

• Wealthy families and individuals

Private equity fund

Private equity fund

Private equity fund

Private equity fund

of funds

Captives

IntermediariesInvestors Issuers

New ventures

• Seed / early stage

• Start-up

Private company

• Expansion

• Replacement capital

• Turnaround

Public company

• Turnaround

• Buyout

• Special situations

Investment advisors to investors

Placement agents for funds

Placement agents for issuers

Figure 10.1: The private equity market

Direct investment

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and business start-ups. Today institutional investors such as pension funds and insurance companies are the largest investors. In general investors invest in private equity because: o the risk-adjusted returns on private equity are expected to be higher

than that on other investments and o there are potential diversification benefits. The principal means of investing in private equity are: o indirectly in a new private equity fund (see 10.3.2.1); o indirectly in a private equity funds of funds (see 10.3.2.1); o directly in a private equity transaction (see 10.3.3); or o through a secondary purchase of an existing private equity interest

(see 10.4). 10.3.1.1 Pension funds

Pension funds, whether corporate or public pension funds, are attracted by the market’s high returns and diversification benefits. Consequently they have large investments in private equity mainly through private equity funds and fund of funds. However this is expected to change as many pension plans shift from defined benefit pension plans to defined contribution pension plans, which generally must invest in assets that are more liquid than private equity. From a regulatory perspective, Regulation 28 of the Pension Funds Act specifies a maximum limit in unlisted shares of 5% of total pension fund assets. 10.3.1.2 Endowments and foundations

Endowments and foundations can be defined as funds or property donated to an institution, individual, or group as a source of income. The most well-know endowments and foundations are university endowments and foundations. Endowments and foundations have a very long time horizon when investing. Because of this they are less sensitive to market volatility. Thus the long-term and illiquid nature of private equity is attractive to them. 10.3.1.3 Insurance companies

Insurance companies invest in private equity both directly and indirectly through private equity funds and funds of funds. In terms of direct investing, insurance companies are less involved than banks since they provide less expertise in terms of advisory or financial services. 10.3.1.4 Banks

Banks invest in the private equity market to take advantage of economies of scope between private equity investing and the provision of other bank products, especially loans. The economies of scope are explained by the

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bank’s ability to use the same delivery mechanism to provide two or more separate products and / or services. Banks are estimated to be the largest direct investors in the private equity market generally through separately capitalised bank holding company subsidiaries. 10.3.1.5 Non-financial corporations

Non-financial corporations generally invest in high-risk early-stage development enterprises that slot in with their competitive and strategic objectives. 10.3.1.6 Wealthy families and individuals

Wealthy families and individuals, who include the wealthy clients of commercial and investment banks, still invest in the private equity market but their relative importance in the market has been reduced by the growth of investment by institutional investors. Like other investors, wealthy families and individuals are attracted to private equity by its high returns. 10.3.2 Intermediaries

There are two types of private equity firms: independent private equity firms (“independents”) and captive private equity firms (“captives”) 10.3.2.1 Independent private equity firms

Independents raise their funds for investment from external sources such as institutional investors. The vehicles used by intermediaries to perform their intermediation role are private equity funds and private equity funds of funds. (i) Private equity funds Since the 1980s private equity funds have emerged as the dominant form of intermediary for four main reasons: o Efficiency: Delegating the intensive pre-investment due diligence and

post-investment monitoring required for direct investing is efficient; o Diversification: A single investor will require a great deal of invested

capital to achieve diversification and exposure similar to that of a private equity fund;

o Expertise: Gaining the expertise to select, structure and manage private equity investments requires experiential critical mass that most investors cannot gain on their own; and

o Assistance to issuers: Specialised intermediaries can better provide business expertise to the issuers they invest in than most investors.

Independents often manage several private equity funds concurrently, raising a new fund three to five years after the closing of the fund-raising process for the previous fund. A private equity fund is usually structured as a limited-liability partnership with investors as limited partners and the

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independent as general partner. Most private equity funds are closed-end funds with a finite life of 10 to 12 years. During the life of the fund the general partner undertakes private equity investments of behalf of the fund with the obligation to liquidate / exit all investments and return the proceeds to the investors at the end of the fund’s life. For its services the general partner receives compensation, generally in the form of: o An annual management fee, which is calculated as a percentage of

total fund size; o Fees for each transaction or deal performed, which is calculated as a

percentage of deal value and o Carried interest, which is a share in the net gains of the fund and is

calculated as a percentage of net gains, or gains beyond a certain hurdle rate.

(ii) Private equity fund of funds A private equity fund of funds is a private equity fund that invests in other private equity funds. The fund of fund manager co-mingles the investments of many investors into a single pool, and then uses it to assemble a portfolio of private equity funds. Funds of funds are an increasingly popular route for investing because they offer the advantages of increased diversification and lower entry amounts compared with private equity funds. The major disadvantage of investing through funds of funds is the additional layer of fees. 10.3.2.2 Captive private equity firms

Captives, which are usually subsidiaries of large banks or insurance companies, obtain funds for investment in issuers exclusively or primarily from their parent organisations i.e., they do not generally solicit funding externally. 10.3.3 Direct investing

Direct investments are private equity investments made directly by investors i.e., not through intermediaries such as private equity funds and funds of funds. Investing directly in private equity requires: o Considerable expertise and skills in discovering, analysing, structuring,

managing and exiting from private equity investments; and o Deal-flow i.e., a broad stream of private equity investment prospects. Several investors that invest directly also invest in private equity funds and funds of funds. 10.3.4 Issuers

Issuers in the private equity market differ widely in size, industry, phase of growth cycle and reasons for raising equity capital. However they have

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one characteristic in common: since private equity is one of the most expensive forms of finance, it is unlikely that issuers have access to financing in the debt market (directly or indirectly) or the public equity market. For simplicity, issuers have been classified into 3 major groups: o New ventures; o Established private companies; and o Public companies. 10.3.4.1 New ventures

Issuers seeking venture capital are typically young firms that are projected to show high growth rates. Venture capital includes: o Seed or early-stage financing, which provides funding to research,

assess or develop a concept. A relatively small amount of capital is provided to an inventor or entrepreneur to prove the concept and qualify for start-up financing.

o Start-up financing, which is provided to companies, whether already set up or in the process of being set up, that have not yet sold their products commercially and are not yet profitable. Start-up funds are required for product development and initial marketing.

10.3.4.2 Established private companies

Established private companies use private equity funding to raise finance for expansion, change their capital structure or to bring about a turnaround. Expansion financing provides funding for growth and expansion of a company, which is breaking even or trading profitably. The funds may be used for plant expansion, market development, development of a new product, additional working capital and bridging finance. Bridging finance is to be repaid from the proceeds of an initial public offering (IPO). Replacement capital financing provides funding for o changing ownership e.g., sale of family-owned and closely-held private

companies to the heirs of founding member or new management team or

o changing capital structure i.e., proportion of debt and equity. Turnaround financing is provided to private companies in financial or operational distress with the intention of improving the company’s performance and restoring its profitability. 10.3.4.3 Public companies

Public companies can also be issuers in the private equity market. They use private equity funding to effect a turnaround, implement a management or leveraged buyout, and provide financing in special situations.

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Turnaround financing is provided to public companies in financial distress. Public companies in financial distress are unlikely to be able to issue public equity except at a large discount and will generally have no access to debt markets. The intention of turnaround financing is to improve the company’s performance and restore its profitability. Buyout financing is used to acquire a significant portion or majority control of a company. The company is generally a mature public company with established business plans to finance expansions, consolidations, spinouts of divisions or subsidiaries. Buyouts of public firms are the most familiar, most publicised use of private equity. A leveraged buyout (LBO) is a strategy involving the acquisition of a major portion or majority control of a company using a significant amount of debt to meet the cost of acquisition. The equity component of the acquisition price is typically provided by a pool of private equity capital. The loan capital is borrowed through a combination of bank facilities and / or public or privately placed bonds classified as high-yield debt (or junk bonds). The debt generally appears on the acquired company's balance sheet and its cash flow will be used to repay the debt. A management buyout enables a management team to acquire a company from the existing owners. Management buyouts may be leveraged. Special situations: o To finance activities such as planned acquisitions that the companies

want to keep confidential; o temporary interruption of access to the public equity market due to

investor perceptions e.g., the industry is temporarily out of favour with public equity markets;

o to save all-in costs when issuing small amounts of equity. 10.3.5 Agents and advisors

There are three groups of agents and advisors: o Advisors to investors: Investment advisors evaluate and recommend

private equity investments to investors. The investments could take the form of private equity funds, private equity funds of funds and direct investments in private equity;

o Agents for private equity funds: Agents assist private equity firms to raise funds from investors. The success of these fund-raising agents depends on their reputation among investors for bringing high-quality offerings. Consequentially they are selective about which funds they raise funds for; and

o Agents for issuers: Agents help issuers raise equity capital from private equity funds or directly from investors. These agents identify potential private equity issuers, compile information about the company, distribute the information to possible investors and provide negotiation services to their client issuers.

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10.4 Secondary private equity market

Private equity investments are considered illiquid. There are no stock exchanges, as there are for publicly-traded securities, on which to buy and sell interests in private equity funds. However a secondary market for these interests is developing, which will give investors the chance to sell if they wish to. A secondary market is a market where investments in existing private equity funds are made by buying an existing investor’s share of the fund. Although secondary markets in the US and Europe are well developed, South Africa has not yet seen the establishment of an effective and sustainable secondary market.

10.5 Size and regional analysis of the private equity market

According to International Financial Services, London (IFSL), global equity investments amounted to USD134.8 billion in 2005 up 22.6% from 2004 (USD 110 billion) (see table 10.1 below).

The U.S. had the largest share of global equity market investments at 39.5%, followed by the U.K. at 22.0%. According to the South African Venture Capital Association South Africa’s private equity investments were USD4.9billion in 2005, which amounts to 1.9% of GDP.

Table 10.1: Analysis of the global private equity market

Country 2004 2005(USD bn) (USD bn)

United States 43.8 53.3 39.5 0.4United Kingdom 22.4 29.6 22.0 1.3France 6.1 9.1 6.8 0.4Sweden 1.9 3.7 2.7 1.0Spain 2.3 3.4 2.5 0.3Germany 4.4 3.4 2.5 0.1Netherlands 1.9 2.9 2.2 0.5Japan 7.1 2.1 1.6 0.0South Africa 3.8 4.9 3.6 1.9Others 16.3 22.4 16.6 0.2Total 110.0 134.8Source: International Financial Services, London (www.ifsl.org.uk) (international)

South African Venture Capital Association (South Africa)

% of total % of GDP

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Questions for chapter 10 1. What are the most common forms of private equity securities? 2. Give two reasons why investors invest in private equity. 3. Name four ways of investing in private equity. 4 Why would the long-term and illiquid nature of private equity be

attractive to a university endowment? 5. Why do banks invest in private equity? 6. What vehicles are used by intermediaries to perform their

intermediation role? 7. What compensation does the general partner receive for its services? 8 What does an investor have to have to invest directly in private

equity? 9. What characteristic does all private equity issuers have in common? 10 Public companies can also be issuers in the private equity market.

What do they use private equity funding for?

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Answers for chapter 10 1. Private equity investments take the form of any security that has an

equity participation feature. The most common forms are ordinary shares, preference shares and subordinated debt with conversion privileges or warrants.

2. Investors invest in private equity because:

o the risk-adjusted returns on private equity are expected to be higher than that on other investments and

o there are potential diversification benefits. 3. The principal means of investing in private equity are:

o indirectly in a new private equity fund; o indirectly in a private equity funds of funds; o directly in a private equity transaction; and o through a secondary purchase of an existing private equity

interest. 4 They are attractive to a university endowment because the

endowment has a very long time horizon when investing and is consequently less sensitive to market volatility.

5. Banks invest in the private equity market to take advantage of

economies of scope between private equity investing and the provision of other bank products, especially loans.

6. The vehicles used by intermediaries to perform their intermediation

role are private equity funds and private equity funds of funds.

7. The general partner receives compensation in the form of an annual

management fee, fees for each deal performed, and carried interest. 8 Investing directly in private equity requires considerable expertise and

skills in discovering, analysing, structuring, managing and exiting from private equity investments and deal-flow.

9. Since private equity is one of the most expensive forms of finance, it is

unlikely that issuers have access to financing in the debt market (directly or indirectly) or the public equity market.

10 Public companies use private equity funding to achieve a turnaround,

implement a management or leveraged buyout, or provide financing in special situations such as a temporary interruption of access to the public equity market due to investor perceptions.

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11. JSE Ltd

Chapter learning objectives: o Define the role of the JSE Ltd; o Discuss the categories of members and the requirements with which

they must comply; o Describe the trading functions of the JSE Ltd; o Discuss the initial and ongoing requirements for listing shares on the

JSE Ltd. The JSE Ltd (JSE) is an exchange licensed in terms of the Securities Services Act, 2005 (SSA). It regulates the trading, clearing and settlement of inter alia equities, warrants and Krugerrand coins. Although the JSE is the only stock exchange in South Africa, SSA allows for the existence and operation of more than one exchange. JSE is governed externally by SSA, which is administered by the Financial Services Board (FSB). The exchange is governed internally by its own rules and directives, which must be approved by the FSB. On 1 July 2005, the JSE demutualised in terms of section 53 of the SSA ending its 118 year history as a tax-exempt, member owned, voluntary association to become JSE Limited a public but unlisted company with a share capital. JSE Ltd listed on the exchange in June 2006. The structure of this chapter is firstly to define the role of the JSE. Then the JSE’s membership requirements, trading functions and listing requirements will be described The information in this chapter has been sourced predominantly from the JSE Ltd.

11.1 The role of the JSE

While the JSE was established in 1887 to enable new mines and their financiers to raise funds for the development of the mining industry, the majority of the companies currently listed are non-mining organisations. The primary functions of the exchange are: o To generate risk capital i.e., provide a means for companies to issue

new shares in order to raise primary capital; and o To provide an orderly market for trading in shares that have already

been issued.

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11.2 JSE Membership

11.2.1 Categories of members

The JSE authorises the following members: o a trading services provider (TSP) is a member who is authorised to

perform trading services. Trading services is the execution of transactions in equity securities by a member for the member’s own account; and with or on behalf of a client;

o a custody services provider (CSP) is a member who is authorised to perform custody services. Custody services are services provided by a custody services provider on behalf of its clients or another member and that member’s clients, in relation to the exercising of control over uncertificated equity securities and funds intended for the purchase of equity securities held by a member on behalf of controlled clients; and

o an investment services provider (ISP) is a member who is authorised to perform investment services. A member may apply to perform investment services only if it has also applied to perform trading services. Investment services are services provided by an investment services provider to its clients, and includes: • exercising discretion in the management of JSE authorised

investments on behalf of clients; • providing investment advice to a client in respect of JSE

authorised investments; and • safeguarding JSE authorised investments, other than

uncertificated equity securities and funds intended for the purchase of equity securities.

11.2.2 Requirements

Members of the exchange must observe the following general requirements: o be incorporated and registered as a domestic company under the

Companies Act; o only appoint executive and non-executive directors who comply with

the fit and proper requirements; o ensure that a shareholder who is a natural person and who directly or

indirectly holds in excess of 10% of the issued shares of the applicant or member complies with the fit and proper requirements;

o appoint a compliance officer who complies with the fit and proper requirements;

o appoint a settlement officer and an alternate settlement officer who comply with the fit and proper requirements;

o appoint a CSDP, unless it only performs, or intends to perform, custody services and it does not require a CSDP in order to perform such services; and

o meet the specific conditions of membership such as: � employ adequate resources, procedures and systems necessary

for the effective performance of regulated services that the member provides and for ensuring compliance with SSA Act and

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the rules and directives that are relevant to the performance of such regulated services;

� ensure that its employees are suitable, adequately trained and properly supervised;

� ensure that it maintains adequate financial resources to meet its business commitments and to withstand the risks to which its business is subject.

11.3 Trading

The JSE’s automated trading system is called JSE TradElect™ (TradElect). TradElect is operated under license from the London Stock Exchange. The JSE operates an order-driven, central order book trading system with opening, intra-day and closing auctions. TradElect provides for the hierarchical organization of the market into segments, sectors and securities (see figure 11.1).

A market segment identifies a set of securities traded according to a common micro structural model (e.g. opening auction, continuous trading and closing auction). An example of a segment is ZA01 – JSE Top 40 Companies. A market segment is characterised by a number of specific rules, which govern the trading activities that may take place within that segment. Similar tradable instruments and participants are assigned to a particular segment. A market segment is divided into market sectors. A market sector defines the group of instruments within a segment that follow the same trading schedule i.e., it identifies a set of securities characterized by a common sequence of market phases and market

Figure 11.1: JSE equities market structure

JSE Top Companies

ZA01

JSE Top Companies

ZA01

JSE Medium LiquidZA02

TOP40 equities and related instruments.Functional sectors obey the same trading schedules and similar trade period rules.

Liquid and Medium liquid equities and related instruments which are not part of the TOP40.Functional sectors obey the same trading schedules and similar trade period rules.

JSE Less LiquidZA03

Less liquid equities and related instruments.Functional sectors obey the same trading schedules and trade period rules.Intra-day liquidity auctions are used to facilitate trade.

NSXZA11

NSX instruments. Functional sectors may obey different trading schedules and trade period rules.Intra-day liquidity auctions will be used to facilitate trade.

Specialist ProductsZA04

Warrant InstrumentsInvestment productsOther productsFunctional sectors obey the same trading schedules and trade period rules.

AltX

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periods. This enables different rules to come into operation at different times of the day. An example of a market sector is J1H1, which includes high-priced (greater than R30) United Kingdom dual-listed South African equities in market segment ZA01 - JSE Top 40 Companies. The security is the instrument with which the trading book is associated (e.g. ordinary shares of Anglo American “AGL”) The official trading hours of the JSE are 09h00 to 17h00. The trading day is divided into phases for securities in ZA01, ZA02, ZA03 & ZA11 (see figure 11.2) and ZA04 (see figure 11.3) to facilitate liquidity, price formation and market integrity through volatility interruptions. Orders are entered and ranked in price time priority. Market participants have the ability to submit “parked orders”. This allows for the entry and removal of orders to be based upon a specific period based transition.

There are six main trading phases and one administration phase. These are described in table 11.1. Table 11.1: Trading and administration phases Phase Details Open (08h30) This period allows for the automatic deletion of all

orders that expired overnight. No participant activity is allowed. Once the order deletions have been processed, it enables traders to view their valid orders on the order book.

Opening Auction (08:35)

each auction begins will a call period. The market participants are able to enter new orders and modify or

Figure 11.2: JSE trading phases for securities in ZA01, ZA02, ZA03 & ZA11

Opening Auction

Closing Auction

Continuous TradingLiquidity Intra-day

AuctionVolatility Auction

Post-trade run-off

09h00-16h50

VW

AP

08h35-09h00 16h50-17h00 17h00-18h00

Op

en

08h30

12h00-12h15

Figure 11.3: JSE trading phases for securities in ZA04

Opening Auction

End of Continuous Trading

Continuous Trading

09h10-16h4908h35-09h10 16h49-18h00

Op

en

08h30

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delete existing orders. Throughout this period, an indicative uncrossing price is published as and when the bids and offers are updated.

There are certain times when unusual events occur in auction calls and to minimise their impact and lead to optimal price formation and auction execution the events need to be brought to the attention of the market. This is achieved through auction call extensions.

There are two types of extensions: • Price Monitoring Extension - if the likely execution

price at the end of the normal auction call, lies outside defined tolerances from the last traded price, then the auction call could be extended for a certain period of time to increase the likelihood that the price movement might be reduced. If no execution can take place during price determination, it is not possible to enter a price monitoring extension.

• Market Order Extension - if market orders within the order book are not executable or only partially executable (i.e. there is a market order surplus) at the end of the call period, the call period could be extended for a certain time in order to increase the execution probability of market orders in auctions. It is then followed by a Price Determination Period - the auction price is the price with the maximum executable volume. If this is not unique, the minimum surplus, the market pressure and, if necessary, the reference price are additionally taken into account in establishing the auction price.

Continuous Trading (09:00)

All un-executed orders from the Opening Auction are forwarded to continuous trading unless otherwise restricted by the market participant through use of an expiry time field. During Continuous Trading, each new incoming order is checked for matching against orders already on the book. If a match is found, orders in the order book are matched according to price-time priority. Following an order match, details of the trade (but not the details of the participants involved) will be published to the market. Continuous Trading can be interrupted by Volatility Auctions, dynamically triggered by excessive trade by trade price movements

Intra-day auction (12:00 – 12:15)

A 15 minute period during the day scheduled to focus liquidity on the less-liquid instruments.

End of continuous trading (16:49)

End of Continuous trading is a period much the same as the closing auction during which the closing prices for warrants and investment products are determined. The difference lies in the price determination methodology which is based on the best bid or offer. During this period persistent orders can be deleted, and new orders

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to be injected on the next trading day can be entered. Only the Client Reference field for existing orders can be modified. The closing price for all instruments in ZA04 e.g. warrants and investment products is calculated using the mid of the best bid and offer. The mid price is equal to the sum of the best bid price and the best offer price divided by two, rounded up to be consistent with the relevant price format.

The closing auction call period (16:50)

The Closing Auction is very similar to the Opening Auction and is used to determine the closing price for the day. One difference lies in the number of auction call extensions that are possible; there can be up to three extensions following the call period to ensure optimum price discovery. If no price can be determined during a Closing Auction (i.e. no volume can execute), then the volume-weighted average price (VWAP) is used as the closing price. If no VWAP could be determined during the VWAP period, then the last automated trade (LAT) price is used as the closing price.

Post trade run-off (17:00)

Runoff is an order book administration or management period in which market participants can perform housekeeping activities. During this period persistent orders can be deleted, and new orders to be injected on the next trading day can be entered. Only the Client Reference field of existing orders can be modified. All persistent orders on the book that have not been deleted, expired or fully matched will be carried forward to participate in the next day's Opening Auction. Manual Reported Trades (those negotiated off market and reported to the Exchange in accordance with the JSE rules and directives) can be entered till the end of the post trade run-off period (18:00).

11.3.1 Characteristics of the Order Book

o Buy and sell orders are placed into a central order book o Full depth of the order book is visible i.e. every buy and sell order is

displayed o During continuous trading, orders are matched continuously on a

price-time priority basis o Matching (uncrossing) of the order book occurs at the end of auction

periods o Pre and post trade anonymity o Standard settlement terms only (T+5) i.e. no same day settlement

and other special terms.

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o 2 main order types – Limit (LO) and Market Orders (MO) o They can be subject to:

� Execution based validity (execute and eliminate/ Fill or kill) � Time based validity - Good till Time (GTT) and Good till cancelled

(GTC) � Period based validity – Good for Day (GFD), At the Open (ATO),

At the Close (ATC), Good for Auction (GFA), Good for Intra-day Auction (GFX)

o No Market Orders (MO) without execution based validity or period based validity is accepted during the Continuous Trading phase.

11.3.2 Broker Deal Accounting System

The JSE operates a back-office system that members are obliged to use. This is called the Broker Deal Accounting System (BDA) and is used to confirm and clear trades, settle trades between members and their clients, perform back office accounting and draw up financial statements.

11.4 Listings

11.4.1 Listing requirements

A company that wishes to have its shares traded on a stock exchange must apply for a listing on that exchange. A listing on the exchange will greatly improve the tradability of a company’s shares, which would in turn enable it to raise capital from the public for expansion or acquisitions. An exchange has certain legal responsibilities towards the public at large for example ensuring an orderly market, distributing information, guaranteeing the transactions on the exchange, facilitating clearing and settlement of transactions and protecting the interests of investors. Consequently the exchange will lay down certain requirements that a company must comply with before it will be allowed to list. These requirements are designed to aid the exchange in meeting the above objectives. Rules relating to new applications for listing, the marketing of shares and obligations of the company issuing the shares form the main body of these requirements. The listings requirements of the JSE are built around some general principles, which will determine the interpretation of specific requirements should the need arise. They are as follows: o The Committee of the JSE must be satisfied that the applicant is

suitable and that it is appropriate for those securities to be listed: o All material activities of the issuing company should timeously be

disclosed to shareholders and the public. o Shareholders must receive full information and the opportunity to vote

upon substantial changes in the issuer’s business operations and matters affecting the company’s constitution or shareholders’ rights.

o Persons disseminating information into the market place must observe the highest standards of care.

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o Holders of the same class of securities of an issuer must enjoy fair and equal treatment in respect of their securities; and

o The listings requirements and the continuing obligations should promote investor confidence in standards of disclosure in the conduct of issuers’ affairs and in the market as a whole.

An application for listing must be made by a sponsor and submitted to the Committee of the JSE. They are normally corporate brokers, investment banks and other professional advisers. They must however be approved by the JSE and included in the Committee’s Register of Sponsors before they will be allowed to act as sponsor. Sponsors not only assist the applicant with the application, but also advise on a continuous basis on the application of the listing requirements, including the continuing obligations. 11.4.2 Choice of board or market

The JSE operated 4 boards or markets: o The Main Board; o The Venture Capital Market (VCM); o The Development Capital Market (DCM); and o AltX is an alternative exchange running parallel to the Main Board. The

primary purpose of the exchange is to facilitate capital raising for the business expansion and development of small to medium and growing companies.

VCM and DCM boards were previously alternative markets to the Main Board. This has changed. Although VCM and DCM listings will continue to exist, AltX is the only current alternative to the Main Board for new listings. A company wishing to list on one of theses boards must comply with the JSE listings requirements. These include not only initial requirements, but also continuing obligations designed to ensure a fair, transparent and orderly market. Failure to comply with the listings requirements may lead to certain penalties including possible suspension or termination of the listing. Requirements relating to the specific boards are: Listing

Requirements

Main

Board

VCM DCM AltX

Share Capital R25 million R500 000 R1 million R2 million Profit history 3 Years None 2 years None

Pre-tax Profit R8 million Not

applicable R500 000 Not

applicable Shareholder spread i.e., the percentage of shares held by the public

20% 10% 10% 10%

Sponsor/Designated Sponsor Sponsor Sponsor Designated

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Advisor Adviser Publication of financial results in the press

Compulsory Compulsory Compulsory Voluntary

Education Requirements

Not applicable

Not applicable

Not applicable

All directors to

attend Directors Induction

Programme The agreement with the LSE contemplates the creation of an international board whose listing requirements will comply with the listings requirements of the United Kingdom (UK). South African companies complying therewith may be admitted to trading on the JSE and the LSE, provided they comply with the UK admission requirements. Securities allowed to trade in this manner will be regarded as having a primary listing on both exchanges. 11.4.3 Listing requirements applicable to all boards

11.4.3.1 The applicant

o He applicant must be incorporated or otherwise legally validly established.

o The applicant must be operating in conformity with its memorandum and articles of association and all laws its country of incorporation or establishment.

o Directors and senior management must have appropriate expertise and experience of the applicant and its business.

o Directors must declare themselves free of any conflicts of interest between directors’ duties and their private interests.

11.4.3.2 Financial Information

o Financial statements must conform to the law as well as the South African Statements of Generally Accepted Accounting Practice (GAAP) and International Financial Reporting Standards (IFRS) and must be audited.

o If a listed company has subsidiaries, the statements must be in consolidated form.

o Profit forecasts, if any, must be accompanied by a report by the auditors and sponsor.

o A working capital statement stating that adequate working capital exists or containing proposals to obtain the necessary working capital must be provided. This does not apply to financial institutions suitably regulated by another authority with regard to solvency and capital adequacy requirements.

11.4.3.3 The securities

o The issue of securities must adhere to the law, memorandum and articles of association and authorisations and documentation required.

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o Securities already listed elsewhere, must comply with the law of that country and the rules of that exchange.

o Securities must be fully paid up and freely transferable. o Low or high voting securities i.e. securities with reduced or enhanced

voting rights are not allowed. o Convertible securities will only be allowed if there are enough

authorised but unissued shares to cater for the conversion. 11.4.3.4 Public shareholders

Shareholders that are directors of the company or its subsidiaries or associates of them, a pension fund for those directors, persons entitled to nominate directors or persons or persons holding more than 10% of the shares of a company shall not be regarded as part of the public shareholding. This does not however apply to fund managers, depositary receipt holders or nominees. 11.4.4 Continuing obligations of listed companies

Compliance with continuous obligations ensures that the securities market is conducted in an orderly fashion and that all market participants have simultaneous access to information. A listed company must, subject to the approval of the JSE, release without delay any circumstances, events or new developments that may affect the financial position of the company to prevent the creation of a false market in the securities. This information as well as any other price sensitive information may not be released to a third party until such time as the information has been released through SENS. (Stock Exchange News Service) Cautionary announcements must be approved by the JSE before they are released through SENS. Other information like dividend declarations and interim financial reports must also be released through SENS. A listed company is obliged to supply its shareholders as well as the JSE with the notice of its annual general meeting and the audited financial statements. Alterations to the capital structure, changes of rights attaching to securities, the basis of allotment, aspects affecting conversion rights and the results of new issues must be announced without delay through SENS. A listed company must ensure fair and equal treatment among shareholders. Shares with voting rights differing from other securities in a particular class will not be allowed. Issues for cash must first be offered by way of a rights offer to existing shareholders proportionately to their current shareholding. This is known as a pre-emptive right. This right may however be waived by an ordinary resolution of shareholders.

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The spread of shareholders required by the listing requirements relating to each board or market, must be maintained. If not, the company’s listing may be suspended. Listed companies must provide all the facilities and information to enable shareholders to exercise their rights e.g. attending meetings and exercising their votes. The JSE must be advised of any change to the board. This information must also be released through SENS. The JSE must be notified of all transactions in the securities of the company by any director or on behalf of a director or any associate of that director. The JSE will then release the information through SENS. The JSE must be informed should the appointment of the auditors of a listed company be terminated or they resign. A letter from the auditors must accompany this notice stating the reasons for the termination or resignation. 11.4.5 Corporate Governance

In terms of corporate governance the listing requirements specify the following: � there must be a policy detailing the procedures for appointments to the

board. Such appointments must be formal and transparent, and a matter for the board as a whole

� there must be a policy evidencing a clear division of responsibilities at board level to ensure a balance of power and authority, such that that no one individual has unfettered powers of decision-making;

� the chief executive officer must not also hold the position of chairperson (this requirement does not apply to companies listed on AltX );

� an audit committee and remuneration committee should be appointed in compliance with the King II report on Corporate Governance. If required, given the nature of the company’s business and composition of its board, a risk committee and nomination committee may be appointed. The composition of such committees, a brief description of their mandates, the number of meetings held and other relevant information must be disclosed in the annual report (this requirement does not apply to companies listed on AltX );

� a brief CV of each director standing for election or re-election at the annual general meeting should accompany the notice of annual general meeting contained in the annual report; and

� the capacity of each director must be categorised as executive, non-executive or independent:

executive directors

directors that are involved in the day to day management and running of the business and are in full time salaried employment of the company and/or any of its subsidiaries;

non-executive

directors that are not involved in the day to day management of the business and are not full-time

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directors salaried employee of the company and/or any of its subsidiaries

independent directors

non executive directors who: • are not representatives of any shareholder who has

the ability to control or materially influence management and/or the board;

• have not been employed by the company or the group of which it currently forms part in any executive capacity for the preceding three financial years;

• are not members of the immediate family of an individual who is, or has been in any of the past three financial years, employed by the company or the group in an executive capacity;

• are not professional advisors to the company or the group, other than in the capacity as a director;

• are not material suppliers to, or customers of the company or group;

• have no material contractual relationship with the company or group; and

• are free from any business or other relationship which could be seen to materially interfere with the individual’s capacity to act in an independent manner;

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Questions for chapter 11 1. What are the primary functions of the JSE? 2. Name the categories of member of the JSE? 3. What special conditions must members comply with? 4 What is the JSE’s automated trading system called? 5. What are the main trading functions of the JSE’s trading system? 6. Name the general principles around which the listing requirements of

the JSE are built. 7. Name the boards operated by the JSE. 8 What are the subscribed capital requirements for the boards operated

by the JSE? 9. What is AltX? 10 What is the primary purpose of AltX?

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Answers for chapter 11 1. The primary functions of the JSE are to generate risk capital and

provide an orderly market for trading in shares that have already been issued.

2. The categories of member of the JSE are trading services provider,

custody services provider and investment services provider. 3. The special conditions that members must comply with are employing

adequate resources, procedures and systems; ensuring that its employees are suitable, adequately trained and properly and ensuring that it maintains adequate financial resources.

4 The JSE’s automated trading system is called TradElect. 5. The main trading functions of the JSE’s trading system are the entry of

orders into the order book and the display of the books either as agents or market makers ; the market opening period and auction call period; automated trading period; intra-day call period or volatility auction period in certain cases; the closing auction call period; and after-hours trading.

6. The general principles are that the Committee of the JSE must be

satisfied that the applicant is suitable and that it is appropriate for those securities to be listed: all material activities of the issuing company should timeously be disclosed to shareholders and the public; shareholders must receive full information and the opportunity to vote upon substantial changes in the issuer’s business operations and matters affecting the company’s constitution or shareholders’ rights; persons disseminating information into the market place must observe the highest standards of care; holders of the same class of securities of an issuer must enjoy fair and equal treatment in respect of their securities; and the listings requirements and the continuing obligations should promote investor confidence in standards of disclosure in the conduct of issuers’ affairs and in the market as a whole.

7. The boards are the main board; the venture capital market; the

development capital market and AltX . 8 Board Subscribed capital

Main board R25million Venture capital market R500 000 Development Capital Market R1million AltX R2million

9. AltX is an alternative exchange established by the JSE running parallel

to the JSE’s main board. 10 The primary purpose of the exchange is to facilitate capital raising for

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the business expansion and development of small to medium and growing companies.

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12. Strate (share transactions totally electronic)

Chapter learning objectives: o Describe the roleplayers in equities clearing and settlement in South

Africa; o Outline the equities clearance and settlement process. Strate Ltd provides clearing, settlement and electronic safekeeping for all listed company equities and warrants in South Africa. Strate Ltd is owned by the JSE, five domestic banks and one international bank. From May 2002 the JSE Ltd outsourced settlement of all on-market trades, including all listed equities and warrants to Strate Ltd. In 2003 Strate merged with UNEXcor and Central Depository Ltd (CDL). CDL provided settlement and depositary services for all government debt and UNEXcor was the clearing house for the Bond Exchange of South Africa. As a result of the merger the bonds and money market instruments also settle via Strate. The objective of this chapter is to describe Strate and other roleplayers in equities clearing and settlement in South Africa. The information in this chapter has been sourced predominantly from the Strate’s web site (www.strate.co.za).

12.1 The roleplayers

Strate is the authorised Central Securities Depository (CSD) for equities, warrants and bonds in South Africa. It operates an electronic settlement system that achieves secure and efficient electronic settlement of share transactions on the JSE and for off-market trades. It also maintains an electronic register for all Strate-approved securities. Shares in companies listed on the JSE can now only be bought and sold if they have been dematerialised on the Strate system. Dematerialisation is the process by which paper share certificates are replaced with electronic records of share ownership. To dematerialise their shares investors hand their share certificates to either their stockbroker or Central Securities Depository Participant (CSDP). CSDPs are the only market players who can liaise directly with Strate. To qualify for CSDP status entry criteria set out by Strate and approved by the Financial Services Board must be fulfilled. There are currently (March 2008) six CSDPs: ABSA Bank, First National Bank, Nedbank, Standard Bank, Société Générale and Computershare. Under the Strate system there are two types of clients: controlled and non-controlled: o Controlled broker clients elect to keep their shares and cash in the

custody of their broker and, therefore, indirectly in the custody of the broker’s chosen CSDP. Because CSDPs are the only market players

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who liaise directly with Strate, all brokers must have accounts with CSDPs and communicate electronically with them using an international network called SWIFT (Society for Worldwide Inter-bank Financial Telecommunications).

o Controlled clients deal directly and exclusively with their broker and their share statements comes from their broker.

o Non-controlled broker clients appoint their own CSDP to act on their behalf. The investors surrender their certificates and open accounts with their selected CSDP while dealing with their brokers only when they want to trade. They would have to provide their broker with the details of their share accounts at the CSDP when trading. Non-controlled clients receive share statements directly from their CSDP.

12.2 Clearing and settlement

Equities clearing and settlement in South Africa is shown in figure 11.1.

In the equities settlement environment, there are three levels of netting: o The first takes place at Broker level within the BDA (Broker Deal

Accounting) system, where the transactions of all the Controlled Clients and Proprietary Accounts of the Broker are netted. This net balance of securities and funds is processed by the Broker’s CSDP as if it was one Non-controlled Client transaction.

o The second takes place at CSDP level within SAFIRES (the system run by Strate Ltd) and involves securities only. The net long or short

Figure 12.1: Clearing and settlement

TradElect

BDA

CSDP

Broker B

Client A(Buyer)

SAFIRES

Client B(Seller)

Buy Order Sell Order

Buy Order

Matched

Trade

Contract Note

CSDP

Broker A

Sell Order

Settlement Order

AllegementAllegement

CommitmentCommitment

SAMOS

Payment ConfirmationPayment Order

Set

tlem

ent C

onfir

mat

ion

/ Affi

rmat

ion S

ettlement C

onfirmation / A

ffirmation

StatusIntimations

Settlement Order

Status IntimationsStatus Intimations

Allocations Allocations

Contract Note

Funding of Amount

Payment of Amount

TradeMonitoring

System

Source: www.strate.co.zaSAFIRES – South African Financial Instruments Real-time Settlement

Figure 12.1: Clearing and settlement

TradElect

BDA

CSDP

Broker B

Client A(Buyer)

SAFIRES

Client B(Seller)


Buy Order

Matched

Trade

Contract Note

CSDP

Broker A

Sell Order

Settlement Order



SAMOS


Set

tlem

ent C

onfir

mat

ion

/ Affi

rmat

ion S

ettlement C

onfirmation / A

ffirmation

StatusIntimations

Settlement Order



Contract Note

Funding of Amount

Payment of Amount

TradeMonitoring

System

TradElect

BDA

CSDP

Broker B

Client A(Buyer)

SAFIRES

Client B(Seller)


Buy Order

Matched

Trade

Contract Note

CSDP

Broker A

Sell Order

Settlement Order



SAMOS


Set

tlem

ent C

onfir

mat

ion

/ Affi

rmat

ion S

ettlement C

onfirmation / A

ffirmation

StatusIntimations

Settlement Order



Contract Note

Funding of Amount

Payment of Amount

TradeMonitoring

System

Source: www.strate.co.zaSAFIRES – South African Financial Instruments Real-time Settlement

133

position of each CSDP is established and only the net short positions are reserved for transfer by Strate.

o The third level of netting takes place also within SAFIRES, with funds. For all net batches “ready for settlement” when the SARB Real Time Gross Settlement system (SAMOS) opens, the net pay/receive positions are aggregated and only the net cash positions are settled between the commercial banks on a multi-lateral net basis

The method of settlement is that: o The net securities balance due from the delivering CSDPs is reserved

by Strate; o The funds are transferred from paying banks to receiving banks. Cash

is settled through the National Payment System (NPS) through the real-time South African Multiple Option system (SAMOS) operated by the South African Reserve Bank using Central Bank funds;

o The reservation on the securities is lifted and the securities transferred from the net deliverers to the net receivers thereby achieving SFI DvP (simultaneous, final and irrevocable, delivery versus payment in Central Bank funds);

o The CSDPs update the sub-registers and nominee registers and the brokers update their nominee registers as well.

All JSE trades are conducted on the basis of T+5 settlement. Once the net batches have settled between the CSDPs on an SFI DvP basis, transfer of beneficial ownership of securities at client level takes place. This occurs electronically either within the sub-register maintained by the CSDP or within the nominee register maintained by the CSDP or the Broker.

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Questions for chapter 12 1. What is a CSD? 2. What is a CSDP? 3. Who are the CSDPs? 4 What is dematerialisation? 5. Define a controlled broker client. 6. Define a controlled client. 7. Define a non-controlled broker client. 8 Outline the three levels of netting that occur in the equity settlement

environment. 9. Outline the method of equity settlement. 10 On what settlement basis are all JSE trades conducted?

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Answers for chapter 12 1. A CSD is a central securities depository. Strate is the authorised CSD

for equities in South Africa. It operates an electronic settlement system that achieves secure and efficient electronic settlement of share transactions on the JSE and for off-market trades.

2. A CSDP is a Central Securities Depository Participant. To dematerialise

their shares investors hand their share certificates to their CSDP, which are the only market players who can liaise directly with Strate.

3. The CSDPs are ABSA Bank, First National Bank, Nedbank, Standard

Bank, Société Générale and Computershare. 4 Dematerialisation is the process by which paper share certificates are

replaced with electronic records of share ownership. 5. Controlled broker clients are clients that elect to keep their shares and

cash in the custody of their broker and, therefore, indirectly in the custody of the broker’s chosen CSDP.

6. Controlled clients are clients that deal directly and exclusively with

their broker and their share statements comes from their broker 7. Non-controlled broker clients are clients that appoint their own CSDP

to act on their behalf. 8 The three levels of netting are at broker level within the BDA system;

at CSDP level within SAFIRES with securities only and within SAFIRES with funds.

9. The method of equity settlement is the net securities balance due from

the delivering CSDPs is reserved by STRATE; the funds are transferred from paying banks to receiving banks; the reservation on the securities is lifted and the securities transferred from the net deliverers to the net receivers; and the CSDPs update the sub-registers and nominee registers and the brokers update their nominee registers..

10 All JSE trades are conducted on the basis of T+5 settlement.

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13. Glossary

agent one who acts on behalf of another (i.e., the principal)

alpha (α) the rate of return produced on average by a security or portfolio independent of the return on the market.

Arbitrage: simultaneously buying and selling a security at different prices in different markets to make risk-less profits. There are no arbitrage opportunities in perfectly efficient markets. Transaction costs often preclude arbitrage opportunities.

At-the-money If an option’s exercise price is approximately equal to the current market price of the underlying.

Beta (β) Measures the sensitivity to general market movements of rates of return on a security or portfolio.

Broker An agent that acts as intermediary between buyers and sellers in trading securities, commodities or other property. Brokers charge commission for their services.

Clearing house A division or subsidiary of an exchange that verifies trades, guarantees the trade against default risk, and transfers margin amounts. Legally a market participant makes a futures or traded-options transaction with the clearing house.

Clearing system: A system set up to expedite the transfer of ownership of securities

Clearing: The settlement of a transaction often involving the exchange of payments and / or documentation.

Closed-end fund A fund with a fixed number of shares

Convertible security A security that gives its owner the right to exchange the security for common shares in a company at a preset conversion ratio. The security is typically preference shares, warrants or debt.

Dealer A firm (or individual) that buys and sells securities as a principal rather than as an agent. The dealer’s profit or loss is the difference between the price paid and the price received for the same security. The dealer must disclose to the customer that it has acted as principal. The same firm may function, at different times, either as either broker or dealer.

Debentures – callable

Debentures that can be repaid on a periodic basis at the discretion of the issuer.

Debentures – convertible

Debentures that carry the right to exchange all or part thereof for other securities, usually shares, at previously specified terms.

Debentures – guaranteed

Debentures of a subsidiary or associated company guaranteed by the holding or controlling company.

Debentures – income

Debentures on which the payment of interest is contingent on the earnings of the company.

Debentures – participation or profit-sharing

Debentures that pay their holders interest as well as a stipulated share of the profits of the company.

Debentures – Debentures that can be redeemed prior to maturity or at

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redeemable specific intervals.

Debentures – secured

Debentures secured by the immovable property of a company.

Debentures – variable-rate

Debentures on which the rates are tied to the rates on other capital or money market instruments.

Delivery versus payment

Under this settlement rule, the delivery of and payment for bonds are simultaneous.

Dematerialisation The process by which paper share certificates are replaced with electronic records of ownership.

Diversification The spreading of investments over more than one security to reduce the uncertainty of future returns caused by unsystematic risk.

Economies of scope Economies of scope exist when the average cost falls as more products are produced jointly. In other words, banks providing multiple products and services produce them at a lower cost than banks providing specialised products and services. Therefore there is competitive advantage by selling a broader rather than narrower range of products. Economies of scope are explained by the bank’s ability to use the same delivery mechanism to provide two or more separate products and / or services.

Exchange The organised market in which the purchases or sales of securities such as shares, futures and options take place.

Financial leverage The use of debt financing.

Free float The amount of shares of a company freely available to investors. It excludes those shares where shareholding is restricted to specific individuals or groups of individuals. The use of free float weightings when calculating indexes gives a more representative view of what is available in the market.

Hedge A position taken to offset the risk associated with some other position. Most often, the initial position is a cash position and the hedge position involves a risk-management instrument such as a forward, futures, option or swap.

Institutional investors

Comprises the non-depository financial institutions, sometimes referred to as the financial “contractual savings and investment” institutions such as pension and endowment funds, insurance companies, collective investment schemes.

Legs The two sides of a swap.

Leverage The magnification of gains and losses by only paying for a part of the underlying value of the instrument or asset; the smaller the amount of funds invested, the greater the leverage.

Long To own a financial instrument. Maturity See tenor.

Maturity date The date on which an instrument terminates, if any.

Notional principal The amount of principal on which the interest is calculated in terms of an interest-rate swap. In the case of interest-rate swaps the principal is purely notional in that no exchange of principal takes place.

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Notionals Commodities, equities or principals that exist primarily for purposes of calculating service payments.

Preference shares – convertible

Preference shares that carry a right to have all or part thereof exchanged for other securities, usually shares, on previously specified terms.

Preference shares – participating

Preference shares that, in addition their dividend rate, share in the profits of the company according to a predetermined formula.

Preference shares – redeemable

Preference shares redeemable at the option of the company at a specific price on a specified date or over a stated period.

Primary market The market in which securities are first issued.

Secondary market The market in which previously issued securities are traded.

Security A generic term encompassing all forms of financial instruments such as shares, bonds, NCDs, debentures and mortgages.

Settlement: The delivery of payment for a security

Short Selling a financial instrument without owning it. Speculating Buying or selling financial instruments in the hope of

profiting from subsequent price movements. Strip A series of futures with consecutive expirations.

Subordinated debt A loan that has a lower priority than a senior loan should the asset or company be liquidated. It is also known as junior debt.

Swap coupon The interest payment on the fixed-rate side of a swap Systematic risk The volatility of rates of return on securities or portfolios

associated with changes in rates of return of the market as a whole.

Tenor The time remaining to maturity of a financial instrument. Termination date See maturity date.

Transaction costs The costs associated with engaging in a financial transaction.

underwriting The process of placing a newly issued security, such as shares or bonds, with investors. An underwriter of such a transaction is usually a bank or a syndicate of banks. Underwriters assume the risk of placing the securities i.e., should they not be able to find enough investors, then they hold the unplaced securities themselves.

Unsystematic risk The variability of rates of return on securities or portfolios not explained by general market movements. It is avoidable through diversification.

Volatility The degree to which the price of a financial instrument tends to fluctuate over time.

Warrant A security that gives the holder the right to purchase shares in a company at a pre-determined price. A warrant is a long term option, usually valid for several years or indefinitely. Typically, warrants are issued concurrently with preference shares, subordinated debt or bonds to increase the appeal of the shares or bonds to potential investors.

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14. Bibliography

Absa Bank, 1997, The Business cycle, Economic spotlight number 21. Bodie, Z. and Merton, Robert C., 1998, Finance, preliminary edition, London:Prentice-Hall. Brigham, Eugene F, and Houston, Joel F., 1998, Fundamentals of Financial Management, 8th edition, New York:Dryden. Dear, Keith, SurfStat australia, July 1998, www.surfstat.newcastle.edu.au/surfstat/main/surfstat-main.html Falkena, H.B., Kok, W.J. and Meijer, J.H (editors), 1995, The South African Financial System, Halfway House:Southern Books. Fenn, George W, Liang, Nellie and Prowse, Stephen, 1995, The Economics of Private Equity, Washington: Board of Governors of the Federal Reserve System.. Goodspeed, I., 1990. Theory of Portfolio Management, ABSA Bank research report no 90/06. Goodspeed, I., December 1997, Currency options in SA Treasurer. Goodspeed, I., March 1998, The foundations of financial risk management in SA Treasurer. Goodspeed, I., September 1997, The basics of foreign exchange management: spot and forwards in SA Treasurer. Gwartney, James D and Stroup, Richard L. and Sobel, Russell S., 2000, Economics Private and Public Choice, 9th edition, New York:Dryden. KPMG and South African Venture Capital Association, 2006, Venture Capital and Private Equity Industry Performance Survey of South Africa covering the 2005 calendar year. Livingston, M., 1993, Money and capital markets, Miami:Kolb. Lorie, J.H. and M.T. Hamilton, 1973. The Stock Exchange, London: Yale University Press. Mohr, P.J., van der Merwe, C., Bothe, Z.C. & Inggs, J. 1988. The practical guide to South African economic indicators. Johannesburg:Lexicon Publishers. Newton, H.J., J.H. Carroll, N. Wang and D. Whiting, Statistics 30X Class Notes, Fall 1996. www.stat.tamu.edu/stat30x/trydouble2.html.

Niemira, Michael P. & Klein, Philip A. 1994. Forecasting financial and economic cycles. New York:John Wiley & Sons Inc.

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Reilly, Frank K. and Brown, Keith C, 2000, Investment Analysis and Portfolio Management, 6th edition, New York:Dryden. Sharpe, W.F., 1970. Portfolio theory and capital markets, New York: McGraw-Hill. The Economist, 1997,Guide to economic indicators, New York:John Wiley United Building Society Ltd. 1989. Recent financial innovations abroad and their impact on the South African financial system, in Financial risk management in South Africa, edited by H.B. Falkena, W.J. Kok & J.H. Meijer. London: The Macmillan Press Ltd.

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Document control Update Description Reference

Feb-2007 o Update statistics o Add chapter on Private Equity

Ingrid Goodspeed

Mar-2007 o Update statistics o Minor changes to chapters 7

and 12 o Major changes to chapter 11

(JSE Ltd) regarding rules, boards, TradElect

Ingrid Goodspeed

the equity market

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