CHAPTER 5 The Stock Market On May 17, 1792, a group of commodity brokers met and signed the now famous Buttonwood Tree Agreement, thereby establishing the forerunner of what soon became the New York Stock Exchange. Today, the NYSE is the world’s largest and best known stock exchange. In 1998, the NYSE transacted more than $7 trillion in stock trades representing over 150 billion shares. Established in 1971, and less well known, Nasdaq executes trades for a similar number of stock shares. Together, the NYSE and Nasdaq account for the majority of stock trading in the United States. With this chapter, we begin in earnest our study of stock markets. This chapter presents a “big picture” overview of who owns stocks, how a stock exchange works, and how to read and understand stock market information reported in the financial press. A good place to start out is by looking at stock ownership. 5.1 Who Owns Stocks? If you invest in common stock, you will find yourself in generally good company. More than one in every three adult Americans owns stock shares directly, or owns them indirectly through a defined contribution pension fund or stock mutual fund. Interestingly, only about 38 percent of all stockholders in 1992 had brokerage accounts, attesting to the importance of mutual funds and defined contribution pension funds. Stock ownership has become increasingly democratic in recent decades. For example, in 1962 the wealthiest 2.5 percent of American households owned 75 percent of all 2 Chapter 5 publicly traded stock. In contrast, by 1992 the wealthiest 18 percent of households owned less than 50 percent of all publicly traded stock.1 While the number of individual investors owning stock has increased in recent decades, the proportion of all outstanding stock shares held directly by all individuals has actually declined. For example, individual investors held about 50 percent of the then $3.2 trillion total value of all publicly traded U.S. stocks in 1992, down from 84 percent in 1965. However, these percentages exclude mutual funds, which in 1992 held almost 9 percent of all U.S. stocks. Since most (but not all) stock mutual fund shares are owned by individual investors, it is appropriate to add in mutual fund shares held by individuals. With this adjustment, individuals held about 56 percent of all U.S. stocks in 1992. The remaining 44 percent of all stock shares was held predominantly by institutional investors, like pension funds or insurance companies, along with a relatively small portion held by foreign investors. Many individuals also hold a substantial investment in the stock market indirectly through one or more financial institutions, such as pension funds and insurance companies. It is very likely that now, or in the near future, you will participate in a pension plan sponsored by your employer. Indeed, pension funds are the dominant type of institutional investor. In 1992, pension funds held $4.4 trillion of funds invested in stocks, bonds, real estate, and other assets. The next three largest categories of institutional investors were insurance companies with $1.6 trillion, investment firms such as mutual funds with $1.4 trillion, and bank trusts with $.9 trillion. While most of this total of over $8 trillion of institutional funds was invested in real estate, bonds, and other assets, about $1.5 trillion was invested in common stocks. As we said, you are in generally good company. 1 Shareownership 1995, New York Stock Exchange The Stock Market 3 CHECK THIS 5.1a Do individuals own a significant portion of publicly traded common stocks in the United States? 5.1b Has the proportion of publicly traded common stocks in the U.S. held by individuals changed through time? 5.1c Has ownership of publicly traded common stocks in the U.S. become more or less concentrated among wealthy individuals in recent decades? 5.2 The Primary and Secondary Stock Markets The stock market consists of a primary market and a secondary market. In the primary, or new issue market, shares of stock are first brought to the market and sold to investors. In the secondary market, existing shares are traded among investors. (marg. def. primary market The market in which new securities are originally sold to investors) (marg. def. secondary market The market in which previously issued securities trade among investors.) In the primary market, companies issue new securities to raise money. In the secondary market, investors are constantly appraising the values of companies by buying and selling shares previously issued by these companies. We next discuss the operation of the primary market for common stocks, and then we turn our attention to the secondary market for stocks. 4 Chapter 5 The Primary Market for Common Stock The primary market for common stock is how new securities are first brought to market. It is best known as the market for initial public offerings (IPOs). An IPO occurs when a company offers stock for sale to the public for the first time. Typically, the company is small and growing, and it needs to raise capital for further expansion. (marg. def. initial public offering (IPO) An initial public offer occurs when a company offers stock for sale to the public for the first time.) To illustrate how an IPO occurs, suppose that several years ago you started a software company. Your company was initially set up as a privately held corporation with 100,000 shares of stock, all sold for one dollar per share. The reason your company is privately held is that shares were not offered for sale to the general public. Instead, you bought 50,000 shares for yourself and sold the remaining 50,000 shares to a few supportive friends and relatives. Fortunately, your company has prospered beyond all expectations. However, company growth is now hampered by a lack of capital. At an informal stockholders’ meeting, it is agreed to take the company public. Not really knowing how to do this, you consult your accountant, who recommends an investment banking firm. An investment banking firm, among other things, specializes in arranging financing for companies by finding investors to buy newly issued securities. (marg. def. investment banking firm A firm specializing in arranging financing for companies.) After lengthy negotiations, including an examination of your company's current financial condition and plans for future growth, your investment banker suggests an issue of 4 million shares of common stock. Two million shares will be distributed to the original stockholders (you and your The Stock Market 5 original investors) in exchange for their old shares. These 2 million shares distributed to the original stockholders assure that effective control of the corporation will remain in their hands. After much haggling, your investment banker agrees to underwrite the stock issue by purchasing the other 2 million shares from your company for $10 per share. The net effect of this transaction is that you have sold half the company to the underwriter for $20 million. The proceeds from the sale will allow your company to construct its own headquarters building and double its staff of programmers and sales consultants. (marg. def. underwrite To assume the risk of buying newly issued securities from a company and reselling them to investors.) Your investment banker will not keep the 2 million shares but instead will resell them in the primary market. She thinks the stock can probably be sold for $12 per share in an IPO. The difference between the $12 the underwriter sells the stock for and the $10 per share you received is called the underwriter spread and is a basic part of the underwriter’s compensation. (marg. def. fixed commitment Underwriting arrangement in which the investment banker guarantees the firm a fixed amount for its securities.) (marg. def. best effort Arrangement in which the investment banker does not guarantee the firm a fixed amount for its securities.) This agreement, under which the underwriter pays the firm a fixed amount, is called a fixed commitment. With a fixed (or firm) commitment, the underwriter assumes the risk that investors cannot be persuaded to buy the stock at a price above $10 per share. The other major type of arrangement, called a best effort, is just that: Here, the investment banker promises to get the best price possible, but does not guarantee the company a specific amount. Strictly speaking, a best-effort 6 Chapter 5 arrangement is therefore not underwritten, but the phrase “best-effort underwriting” is often used nonetheless. As is common with an IPO, some restrictions are imposed on you as part of the underwriting contract. Most important, you and the other original stockholders agree not to sell any of your personal stockholdings for one year after the underwriting. This ties most of your wealth to the company's success and makes selling the stock to investors a more credible undertaking by the underwriter. Essentially, investors are assured that you will be working hard to expand the company and increase its earnings. (marg. def. Securities and Exchange Commission (SEC) Federal regulatory agency charged with enforcing U.S. securities laws and regulations.) After the underwriting terms are decided, much of your time will be devoted to the mechanics of the offering. In particular, before shares can be sold to the public, the issue must obtain an approved registration with the Securities and Exchange Commission (SEC). The SEC is the federal regulatory agency charged with regulating U.S. securities markets. (marg. def. prospectus Document prepared as part of a security offering detailing information about a company's financial position, its operations, and investment plans for the future.) SEC regulations governing IPOs are especially strict.