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Book title: Understanding
Financial Markets & Instruments
Author: Braam
van den Berg
Chapter 2: The Equity Market
2.1 Introduction to equity
and the JSE
2.2 The structure and
role of the JSE
2.3 Trading of listed
equity
2.3.1 The JET system
2.3.2
Single and dual trading capacity
2.3.3
Purchasing and selling shares
2.4
The listing of a company's shares on the
JSE
2.4.1 The Main Board
2.4.1.1 Financial redevelopment sector
2.4.1.2
Industrial development sector
2.4.2
Development capital market (DCM)
2.4.3
The venture capital market (VCM)
2.4.4
Warrants
2.5 Investment and share prices
2.1 Introduction to equity and the JSE
In the definition of the equity of a company,
equity is often referred to as being the shares of a company. It is, however,
much broader than just the shares of a company, since equity includes
all the risk capital of a company. The risk capital includes the reserves,
irredeemable preference capital in issue, minority interests less goodwill
and, in some cases, debentures. This chapter concerns shares as a part
of equity.
A share in a company is defined as being
a right in the assets, profits and management of the company, equal to
the rights of any other similar share, and this right is indivisible.
A share is represented by a share certificate
(see appendix 2 for an example), and gives the owner of the certificate,
among others, the above rights and a vote at the annual general meeting
of the company in matters concerning the company. The owner of the certificate
may share in the financial benefits of the company (e.g. the profit),
but cannot incur a liability (as shareholder) beyond his interest in the
company as represented by his shareholding. The JSE expresses the rights
of a shareholder on their Internet home page as follows:
- Shareholders may vote at shareholder meetings
and general meetings of the company. The company may also be forced
by the shareholders to hold a meeting under certain circumstances where
they can influence the agenda or voice their opinions.
- Although not explicitly expressed in
the Companies Act, shareholders must be kept informed at all times.
A prospectus must be distributed when a company wants to raise capital.
- Shareholders have the right to receive
dividends but this is a legitimate expectation and not a legal right.
- Shareholders are entitled to expect a
high degree of diligence, competence and integrity from the directors
of the company.
- Shareholders have the right to be informed
by the company regarding any information or developments that might
influence its share price.
The Johannesburg Stock Exchange (JSE) was
formed to create an orderly market for the optimal allocation of capital
resources in the country. The JSE was initiated in response to among others,
the demand for capital to develop the goldmines. The JSE is the 19th largest
formal capital market in the world based on market capitalisation and
offers a means of raising capital to companies, government and semi-government
bodies, acting as a primary market. It also acts as a secondary market
where shares and equity securities are bought and sold.
The most common types of securities issued
and traded on the stock exchange are the following:
- Ordinary shares
Shares with voting power, representing one vote per share, and earning
dividends if the profit is sufficient
- N-shares, A-shares and B-shares
These shares often have different rights compared to ordinary shares,
for instance, different voting power. They often have less voting power
than ordinary shares and are issued to raise additional capital without
affecting control of major shareholders
- Preference shares, convertible preference
shares, cumulative preference shares, redeemable preference shares and
debentures. These are securities normally without voting power but with
a preference to a dividend or interest above the ordinary shares
- Nil paid letters
When a listed company wants to raise additional capital it may give
existing shareholders the first right to buy the new shares issued in
proportion to the shareholding. For this right, a letter is issued which
is called a nil paid letter (NPL). This letter (representing the right
to take up shares) can be sold in the market.
Currently the JSE is housed at 17 Diagonal
Street - the heart of South Africa's financial markets, where on 12 December
1978 the historic old hand bell was rung to signify the start of trading
at these premises. However, at 4 p.m. on Friday, 7 June 1996, the final
bell was rung for the close of trade on the trading floor, thus ending
a 108-year era of open outcry trading and giving way to a new era of high-tech
computer trading.
Monday, 10 June 1996, saw all trade being
conducted on the JET (Johannesburg Equities Trading) system, a system
which had been gradually phased in over the previous three month period,
since March 1996.
2.2 The structure and role of the JSE
The JSE belongs to and is governed by its
members but, through their use of JSE services and facilities, these members
are also customers of the exchange. Many of its members also trade in
bonds through the bond exchange (BESA) and financial futures through the
futures exchange (SAFREX). Traditional options are traded on an OTC basis,
although some standardised options have been listed on certain exchanges.
Corporate limited liability membership with
ownership by non-stockbrokers was introduced on 8 November 1995, where
the member firm is the trading entity and not the individual. Foreigners
may also operate as member firms, while most of South Africa's major banks
have become member firms of the JSE and can now offer stockbroking services
through their branches.
Aspiring stockbrokers must pass the examination
of the South African Institute of Stockbrokers, founded in November 1995,
and has to have been employed by a member firm for a period of at least
six months. There are two categories of membership: practising and non-practising
stockbrokers.
Although there is only one stock exchange
in South Africa, the Stock Exchanges Control Act (1985) does allow for
the existence and operation of more than one exchange, Financial Services
Board. There has been talk of establishing regional exchanges as a means
for small to medium-sized companies to raise capital, as this cannot be
done effectively on the JSE because of stringent listing requirements.
Amendments to the Stock Exchanges Control
Amendment Act was approved by parliament in September 1995 and had a profound
effect on the functioning of the JSE. The amendments and subsequent restrucEagle
Tradersg had an impact on membership (as seen above), trading principles
and systems, clearing and settlement, transfer and registration, capital
requirements of member firms and the financial structure of the JSE.
The main function of the JSE is the raining
of primary capital by rechannelling cash resources into productive economic
activity, thus building up the economy while enhancing job opportunities
and wealth creation. As mentioned previously, it also acts as a secondary
market and liquidity is perhaps the most important objective of any stock
exchange. The success with which the primary market fulfils its function
of raising new investment capital is, among other elements, dependent
upon the liquidity in that market. A listing on the JSE enables companies
to raise capital for expansion and for the financing of new business.
To the person in the street it represents, in the medium to long term,
a means of investment in the corporate companies of a country. The capital
appreciation from holding shares over a period of time often exceeds the
rate of inflation. For those who are knowledgeable about the performance
of selected shares, speculative buying and selling may be appealing, but
the risk is high.
2.3 Trading of listed equity
Listed shares are traded through authorised
brokers, and settled through the computerised clearing system on the JSE.
In terms of the Stock Exchanges Control Act 1985 (as amended), it is mandatory
for a client purchasing shares to pay his stockbroker within seven business
days after the date of the purchase. (A practice used by stockbrokers
on the JSE is to settle on the Tuesday following the deal). A client in
possession of shares may request his stockbroker to sell these shares,
which the client must deliver within seven days after the date of the
sale. In terms of the Companies Act, the buyer must sign a transfer form
(see appendix 4 for an example).
This entire manual process is being changed
to electronic transactions through the STRATE (Share transactions totally
electronic) project. Share certificates will eventually be obsolete and
transfer of ownership will be by electronic means.
The first 10 companies on the JSE to switch
to electronic transactions will do so by the end of 1998, to be followed
by 50 companies per month. The project should be completed by 1999.
In March 1996 the JSE commenced automated
trading converting the first group of stocks from floor trading. Using
the JET (Johannesburg Equities Trading) system, the structure then changed
to
- A continuous order-driven system with
central market principles
- Dual trading capacity, complemented by
member firms voluntarily acting as market makers
- Fully negotiable brokerage with clients.
The JET system gave rise to significant
improvements for investors, listed companies and the JSE itself, through
improved transparency, liquidity, security and audit trails which greatly
enhance investor protection.
The ease of trading and increased liquidity
made the cost of raising capital cheaper.
2.3.1 The JET system
The central order book ("The book")
is the corner-stone of, and is managed by, the JET system. The book is
accessed via trading work-stations (computer terminals) which are linked
to the JET system through a computer network Dealers enter buy and sell
orders on the work-stations.
The orders are immediately included anonymously
in the summary display of the aggregate of orders in the order book for
all dealers to view (see appendix
3). All that can be seen on the screen regarding the bid to buy or
the offer to sell, is the number of shares and the price. Neither the
name of the dealer nor that of the company appears in the book until the
transaction has been concluded.
The order book is divided into a bid side
and offer side and organised on the principle of priority where orders,
when registered in the book, are ranked in priority of price first and
then time within price.
The bid with the highest price is placed
on the top left of the order book and the offer with the lowest price
at the top right. The system continuously seeks to match the bids and
offers, comparing new orders and those in the book to one another and
executing trades whenever the terms of the orders match.
When the price of a bid and an offer matches,
the system will match the transaction in time order, that is, the deal
that was entered first at the same price, is matched first. Dealers are
advised immediately of matched trades, and a code number is recorded for
client identification purposes.
With the implementation of the new system,
the satisfaction rule was introduced, implying in principle that all orders
in the order book which are at a better price than the price for any proposed
negotiated trade, must be satisfied at their respective bid/offer prices
by any stockbroker before the negotiated trade can take place.
The JET principles and trading rules have
been developed following principles aimed at optimising investor protection.
The system allows for maximum efficiency and equal participation by all
players, both large and small.
2.3.2 Single and dual trading capacity
The JSE's rules also allow member firms
the choice of dealing in either single or dual capacity:
- Single trading capacity is where a firm
acts only as an agent between the buyer and the seller
- Dual trading capacity is where a member
firm acts as an agent, or on behalf of, or as a principal with a client.
The member firm may therefore sell shares
to a client from its own holding of shares. However, the member firm must
inform the client of the capacity in which it is acting prior to the transaction
being effected. If no information is provided beforehand, it will
be assumed that the member firm is dealing as an agent.
The introduction of dual trading capacity
and fully negotiable commissions was made simultaneously with the automation
of trading in March 1996.
2.3.3 Purchasing and selling shares
Investors buy shares listed on the JSE through
member firms. When a potential investor approaches a member firm, an account
is opened and discussion takes place with one of its stockbrokers about
the proposed investment. (It is likely that the stockbroker will also
advise the investor.) Decisions need to be made about the shares to be
purchased and the amount to be invested, taking into account the fundamentals
of the share such as the quality of the company, the price/earnings ratio
(P/E ratio) of the share, the quality of the company's board of directors,
etc.
Shares are normally traded in multiples
of 100. Special provisions are made for the trading of odd lots, that
is, share quantities under 100. A specialist firm is appointed which administers
all odd-lot trading, and this ensures that trades take place at current
market values.
On instruction from the stockbroker, a
dealer executes the order of the client at the price agreed upon, by entering
the order in the book. This order immediately appears on the screens of
all other dealers of members as described in section 3.1.
As an alternative to doing the transaction
at one given price, the client may have imposed certain price limits within
which the dealer must buy or sell the shares, but these limits should
be reasonable with regard to time and ruling price (normally the price
at which the last transaction was done). From the date of purchase there
are seven business days within which to pay for the shares, and a share
certificate will follow later. The transfer secretary who records share
ownership also issues share certificates. The client will receive an invoice
or a note from the broker, with details of the transaction.
Selling shares is almost a reversal of
buying shares. The seller may ask his stockbroker to sell all or part
of his shareholding at the best price possible or within certain limits.
Buying or selling limits are usually set when the client wants to obtain
a certain price for the shares and is prepared to wait until this price
is met. Sellers hand over their share certificates to the member firm
and sign a transfer deed, which allows the shares to be transferred to
the buyer. Once the sale is executed, sellers receive the proceeds from
the sale within seven working days.
When the order is executed the client will
receive a broker's note (see
appendix 5) containing relevant details of the transaction and will
then be asked to pay for the shares or deliver the shares and sign a transfer
deed.
Special kinds of deals are sometimes done
on the JSE, two of which are:
- Bear sales or short sales
The sale of securities of which the seller is not the owner. The short
seller still has to purchase these securities at a later date to be
able to deliver the shares to the buyer. Securities are normally sold
short when there is an expectation that prices will drop, resulting
in the purchase of these securities at a later date at a lower price.
- Bookover
A trade where the buyer and the seller do their deals through the same
stockbroker. The satisfaction rule applies in this case, stating that
bids and offers already on the order book must be honoured before the
bookover can take place.
Dependence on paper in the form of share
certificates and transfer documents will eventually be eliminated. The
first step is the institution of electronic settlements which take place
via computer networks and databases, instead of a physical certificate
and a cheque being exchanged before a transaction takes place. Share certificates
will be kept in a central depository (CD) and registers of owners will
be on computer. This means a shorter settlement period (eventually T +
1 - one day after the trade). The JSE, in consultation with other interested
parties, is also investigating the implementation of an electronic scrip
registry that will initially be facilitated through a central depository
but later by means of electronic share registers. This will be known as
"share transactions totally electronic" (Strate).
2.4 The listing of a company's shares on the JSE
A public company registered under the Companies'
Act and having been in existence for a number of years, may list its ordinary
shares on the JSE if the company qualifies under certain requirements.
The nature of business of listed companies varies greatly, ranging from
mining and industrial concerns through textiles, fishing and entertainment.
Closed corporations, partnerships, sole proprietorships and proprietary
limited companies are not allowed to list.
There are many different reasons why a
company will try to list its shares. By listing on the JSE a company can
raise additional primary capital by means of a public issue of shares.
Additional capital can also be raised after the first listing by means
of a rights issue of new shares to existing shareholders. Companies listed
on the JSE tend to receive more coverage in the media, and if this coverage
is positive, it could be a means of marketing.
When applying for a listing a company will
qualify for one of three possible listings:
- the Main Board
- the Development Capital Market
- the Venture Capital Market.
The listing requirements for the three categories
are detailed in the following sections.
2.4.1 The Main Board
The requirements for listing on the Main
Board are
- a subscribed capital, excluding revaluation
of assets, of at least R2 million in the form of not less than one million
shares in issue
- a satisfactory profit history for the
preceding three years, the last of which had to report an audited profit
before taxation of at least R1 million
- a minimum of 10% of each class of equity
shares to be held by the public
- a minimum of 3000 public shareholders
for equity shares
- the minimum initial issue price of shares
to be not less than 100 cents per share.
The JSE may list companies that do not
strictly comply with the above requirements, but this will only occur
in exceptional circumstances.
To promote the socio-economic development
of South Africa, the JSE has introduced the Financial Redevelopment sector
to the Main Board, and to promote industrial development in South Africa,
the Industrial Development Stage sector was introduced to the Main Board.
2.4.1.1 Financial redevelopment sector
In evaluating a listing of a redevelopment
entity, the JSE will have to consider, inter alia, the fundamental principle
that the principal objective of the redevelopment entity must be the provision
of assistance, whether through investment, loan or other means acceptable
to the JSE, to persons, communities or undertakings which, in the opinion
of the JSE, are of a socio- economic development nature.
The JSE may admit the securities of a redevelopment
entity to listing, subject to whatever conditions it deems necessary which
may include requirements that are different from those contained in the
listing requirements. One of the aspects that the JSE will look at is
whether the applicant's assets consist wholly or substantially of cash
or short-dated securities.
2.4.1.2 Industrial development sector
The JSE may list the securities of substantial
industrial companies that are in the developmental stage and, accordingly,
do not have the profit history required for a Main Board listing.
The applicant should have a subscribed
permanent capital, prior to the offering of securities to the public,
of at least R20 million, and will have to provide a forecast of future
profits/losses during and at least one year after the development stage.
2.4.2 Development capital market (DCM)
Recognising the need to encourage the growth
of small to medium-sized businesses and companies that are unable to list
on the Main Board, the JSE created the DCM in 1984. While still demanding
quality and stability of a DCM company, the criteria to be met are less
onerous than those of the Main Board.
It is expected that DCM companies will
use the capital raised to expand to a level where they meet the requirements
for a Main Board listing.
The principal requirements for a DCM listing
include
- a subscribed capital, excluding revaluation
of assets, of at least R1million, in the form of not less than one million
shares in issue
- a satisfactory profit history for the
preceding two years (or in exceptional circumstances, a lesser period),
the last of which had to show a reported and audited profit level of
at least R500 000 before taxation (mineral companies are exempt from
this requirement)
- a minimum of 10% of each class of equity
shares in issue to be held by the public
- a minimum of 75 public shareholders for
equity shares
- the minimum initial issue price to be
not less than 50 cents per share.
The creation of and listing on the DCM
seems not to have been received well by the business world. Companies
tend to wait until they qualify for a listing on the Main Board before
listing at all. In May 1998 only nine companies were listed in this section.
2.4.3 The venture capital market (VCM)
To assist companies specialising in venture
capital projects (venture capital conglomerates) or single venture companies,
the JSE formed the VCM in 1989.
Prior to the submission of an application
for listing, the JSE requires a memorandum giving a summary of the nature
of the business of the applicant, its modus operandi, its business plans
and prospects. If the memorandum is approved, the company may make a formal
application for listing.
A single venture company must draw up an
analysis of its prospects, based on its market segment growth, competitive
analysis and market share. From this, it should present a three year business
plan with forecasts of balance sheets, profit and loss accounts and cash
flows.
A venture capital conglomerate must have
as its dominant business the professional operation of a company which
holds and will in future hold a portfolio of investments in ventures,
each of which is characterised by the fact that the venture capital conglomerate:
- has an investment in each underlying venture
which is substantially an equity venture
- is able to add value to each of its underlying
venture projects through providing support services and proper financial
disciplines
- has conducted adequate research into the
management strength and commercial viability of each of its underlying
ventures
- has drawn up a business plan for the next
three years in respect of each underlying venture and of the combined
portfolio, with forecasts of balance sheets, profit and loss accounts
and cash flow statements.
The principal requirements of a VCM listing
include
- a subscribed capital, excluding revaluation
of assets, of at least R500 000, in the form of not less than one million
shares in issue
- the assurance that the entrepreneurs
will remain financially committed to the VCM company. Accordingly, the
JCE will not list securities held by the entrepreneurs of the VCM company
amounting to 75% of their share holdings (as held immediately prior
to any marketing of securities in conjunction with the application for
listing) for a period of at least two years subsequent to listing being
granted that no profit history is required, but the company should,
in its analyses of future earnings, indicate credible returns on capital
which, on a time-weighted basis, are above average
- a minimum of 5% of each class of equity
shares to be held by the public
- a minimum of 75 public shareholders for
equity shares
- the minimum initial price of shares to
be not less than 50 cents per share
- the majority of directors and managers
to have successful records of achievement in their respective CVs
- a warning to be issued at the beginning
of its prospectus, or pre-listing statement, concerning the speculative
nature of investment in such a company.
A company may be de-listed as a result
of a take-over or merger, or in the case of a "cash shell" if
it has not acquired new business within eight months of becoming a "cash
shell" in terms of JSE criteria.
In May 1998 20 companies were listed under
this section.
2.4.4 Warrants
Warrants were first listed on the JSE to
give the small investor an opportunity to be exposed to expensive shares
without having to buy 100 of the physical shares. Normally 10 warrants
represent an exposure on 1 share and 100 warrants will thus cost much
less than 100 shares. A warrant is a long call or put option on a share
or a basket of shares and it will be discussed in detail in the chapter
on options (chapter 7).
2.5 Investment and share prices
Initially, the pre-listing statement or
prospectus, financial statements and any projected profits are the investor's
guide in determining the value of the share.
The share price, from the day of listing,
is influenced by supply and demand based on the value which investors
place on that equity. Where demand for a share exceeds supply, the price
tends to rise. On the other hand, where supply exceeds demand the price
tends to fall. The price of a commodity in which the listed company trades,
such as gold and oil, also influences the price of that share. The general
tendency, particularly where gold is concerned, is for share prices to
rise or fall in line with changes in the rand price of gold.
In forming an opinion about the performance
of various equities, one should study the most recent interim and annual
reports published by the relevant companies. Stockbroking firms have research
departments which do extensive research on companies listed on the JSE.
They are often able to supply information about the forecast for a company,
its share performance in the past and its dividend yield.
A further valuable source of information
is the JSE monthly bulletin, which contains current and historical information
on companies' shares. The stock market handbook is updated and published
twice a year and covers the nature of the business, the names of the directors,
share capital information, forecasts and dividend dates, financial statistics
and shareholding percentages for each listed company. Various financial
newspapers and magazines are available as sources of information.
Some of the factors in addition to the
information mentioned above, which should be considered are the following:
- The specific sector in which the company
operates
In evaluating possible investments an investor must try and determine
which sector of the economy will perform best. Having selected a sector,
he will then have to select a company in whose shares he wants to invest.
To do this properly, he has to consider a host of things, namely the
products manufactured or services offered, the financial stability of
the company, the quality of management, the competition faced by the
company and its overall track record.
Mining shares are, by their very nature,
more volatile than other shares, hence the timing of the purchase or
sale decision is of the utmost importance. For example, gold shares
are affected by the international gold price, quoted in US dollars and
the rand/dollar exchange rate.
- Global and local market trends and influences
Since the beginning of the new political era in South Africa, the local
market has become part of a 24-hour global market. Our stock market
is influenced by the trends of the world's major stock markets and by
world events.
Domestic determinants such as economic
cycles, interest rates, the exchange rate and inflation in the country
will most likely also have an influence on the prices of shares on the
stock market.
- Risk and return ratios
Different shares have different characteristics of risk and return.
A new company with a new product carries more risk than an established
company with established products. The new company could, however, be
the first and only company with the new product and show superb profits
for a few seasons if the product is a success in the market.
An investor must decide how much risk he is willing to take in his investment
(known as an investor's risk appetite). By investing in a few companies
rather than in one only, the risk will be spread, and would normally
be lower.
- Comparative analysis with the company's
competitors
Other companies in the same sector must be compared with the company
in which the investor wants to invest. Comparing financial data and
information available from the sources mentioned, the investor will
be able to form an idea of the success and prospects of the company
relative to its competitors. The relative marketability of the shares
in comparison to those of the competitors can also be assessed.
A good indicator towards an assessment
of the general opinion of investors regarding the company, is the price/earnings
ratio. This ratio expresses the price per share divided by the historical
(previous financial year-end) earnings per share. This ratio should
be recalculated, using the forecasted earnings per share to make an
assessment of the investment's merit.
- The indicators of the specific company
The variables concerning the specific company must also be considered,
such as the growth record and history of the company. Expectations of
future earnings and the quality of management are essential for an assessment
of a company. Special factors such as acquisitions, mergers and possible
unbundlings must also be considered.
Courses and training
in Financial Markets, Instruments, Investments and Derivatives
are supplied by the Academy of Financial Markets. They can
be contacted on info@academyfm.co.za
or via their web site. New developments in the Financial
Markets are incorporated in updates (see
index) of this book and can be obtained from The
Academy of Financial Markets. |
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