Allocation of capital

Mr_Mumble

Having some central planner determining "pure speculation" fills me with dread. If they start doing it with investments why not every other facet of life? You can't go to the cinema to see Super 8 because it is "pure speculation" whether it's good or not! You can't haggle at the car boot: it is "pure speculation" whether either party will agree to the new price!

Speculation is a very good thing, aiding price discovery is of utmost importance in a market. Of course most individual speculations are going to be off to some extent but cumulatively they're a far better indicator than any single person or organisation can come up with.

How much longer would the credit and housing bubble have lasted if it wasn't for the shorters? It took nearly 18 months from the first hedge funds to blow up until the likes of RBS and HBOS needed a bailout. Without these evil speculating short sellers you'd have had an even greater bubble and bust.

HAMISH_MCTAVISH wrote: »

"Investing" in a company that has already floated (usually) does no good for that company, it already accessed the funds from the float. So it's just speculation, paying off a previous speculator.

This ignores everything from secondary offerings and rights issues to credit worthiness and borrowing ability to bid/ask spreads and liquidity to the benefits of inclusion in indicies ... there are huge benefits to companies that see their share price increase.

Loughton_Monkey wrote: »

.. forgive my pedantry, but I did think this one through before writing it. It does not involve transfer of ownership. It involves 'borrowing' which is a different thing. That's why I 'consider' it to be a derivative. The share itself has legal ownership. Any form of borrowing on it involves 'promises' and is hence not physically tangible.

I don't see why physical tangibility matters if you have strong contract law and, yep, the first - sloppy - analogy to come to my mind was mortgages too.

I disagree with your thinking on the likes of CFDs and other derivatives. Most publicly traded equity is illiquid - i.e. most AIM and FTSE small cap firms - and not traded often enough. The liquidity provided by derivatives helps in creating orderly markets.

Loughton_Monkey

Generali wrote: »

<pedant mode>The price of the share that the buyer bought is set by price discovery in the market place. The term 'derivative' is used because the price of it is derived from that of the underlying asset rather than being that of the underlying asset. The price of the share is the same whether it was bought or borrowed to be sold, it isn't derived. </pedant mode>

<Even more pedant mode>Surely this proves my point? At the exact moment that I short, you own 100 shares in Barclays [Bid 186.75 Offer 186.95]. So you lend me that specific block of 100 shares - through an intermediary. Since my intermediary needs to make money, he derives a price of Bid 186.65 Offer 187.15. Thus the exact price I 'sell' [short] is indeed different from the price at which you could have sold [at that precise moment]. Naturally it is based upon (and derived from) the official price, but is slightly different from it.</Even more pedant mode>

Mr_Mumble wrote: »

I disagree with your thinking on the likes of CFDs and other derivatives. Most publicly traded equity is illiquid - i.e. most AIM and FTSE small cap firms - and not traded often enough. The liquidity provided by derivatives helps in creating orderly markets.

OK, I'm no expert, but will bow to better informed people. But I don't fully understand. Surely 'most' publicly traded equity (measured by No. of Shares and Value) surely must be FTSE 250 - all of which couldn't be more 'liquid'? Yes, most small cap and Aim indeed use Market Makers to offer 'liquidity'. That's their job. But I've never heard of derivatives in these 'market made' small shares - so isn't that a bit academic? Hence I struggle to understand why derivatives help liquidity other than extremely marginally on big shares that are already perfectly 'liquid'.

Generali

Loughton_Monkey wrote: »

<Even more pedant mode>Surely this proves my point? At the exact moment that I short, you own 100 shares in Barclays [Bid 186.75 Offer 186.95]. So you lend me that specific block of 100 shares - through an intermediary. Since my intermediary needs to make money, he derives a price of Bid 186.65 Offer 187.15. Thus the exact price I 'sell' [short] is indeed different from the price at which you could have sold [at that precise moment]. Naturally it is based upon (and derived from) the official price, but is slightly different from it.</Even more pedant mode>

It's a good point but I think it slightly misunderstands how exchanges work and also how lenders make money from stock lending.

Let's say I'm a hedge fund and I want to short 100 Barclays. I go to my banker (Prime Broker in the jargon) and ask to borrow 100 BARC. He will then tell me that borrowing BARC will cost me 0.5% (annually, pro rated) plus I also need to make good on any dividends that are paid plus I need to return the shares on demand. I then put a sell order into the market via my broker at a price of 186.75 pence, the lowest sale price in the market. The next lowest sale price (aka offer) is 186.95.

Now let's say that you are a big mutual fund looking to add to your position of BARC by 200 shares and you have already put a buy order into the market at a price of 186.75. That is the highest price anyone is prepared to pay so at the LSE the bid price will be shown as 186.75. At that moment the LSE would show bid being 186.75 (the highest price a buyer will pay) and offer of 186.95.

When I put my offer into the market we have a situation where my offer = your bid so our trade is struck. You have just bought 100 shares from me at 186.75 pence plus whatever commission and market fees you pay to your broker plus stamp duty and I have sold 100 shares at 186.75 less broker's commission and market fees.

Now the market would return to where it was before with bid being 186.75 (being the remaining 100 shares you want to buy) and offer being 186.95 (the next lowest sale price).

If I hadn't sold short, you would still be looking to buy with the lowest market price being 186.95. If I want to buy back to cover my position I have to take a loss because I have to pay .2 pence more to cover my position. I have added liquidity by taking on risk. You have benefited from that added liquidity.

Yes we have changed the market position but that will happen every time a trade is struck, regardless of whether I sell from inventory or borrowed stock.

If you want to see a straightforward example of how this works, look at the Premiership match betting Betfair. Betfair works on identical principals to the LSE only with bets rather than shares being traded.

Loughton_Monkey wrote: »

OK, I'm no expert, but will bow to better informed people. But I don't fully understand. Surely 'most' publicly traded equity (measured by No. of Shares and Value) surely must be FTSE 250 - all of which couldn't be more 'liquid'? Yes, most small cap and Aim indeed use Market Makers to offer 'liquidity'. That's their job. But I've never heard of derivatives in these 'market made' small shares - so isn't that a bit academic? Hence I struggle to understand why derivatives help liquidity other than extremely marginally on big shares that are already perfectly 'liquid'.

The FTSE100 is pretty liquid but perfect liquidity (which means that you can buy or sell any amount without changing the price) doesn't exist.

Once you get past the 100 into the rest of the 350 (ie the FTSE250) you'd be surprised how quickly liquidity dries up. For example, BARC had about 65,880,000 shares traded yesterday whereas Britvic (BVIC) had about 850,000 shares traded yesterday.

You can buy derivatives on smaller shares. For example there is a CFD on Britvic (link). While there aren't exchange traded options and futures if you had a good relationship with a broker they would probably provide you with an OTC one.

Thrugelmir

michaels wrote: »

More funds in the stock market = higher share prices = cheaper capital for companies = more investment.

Doesn't work as simply as that. As issuing more shares has the effect of diluting existing shareholdings. In recent years companies predominantly taken on debt than have rights issues or a placing. Though as capital markets tighten highly possible that the trend will reverse.

Generali

Thrugelmir wrote: »

Doesn't work as simply as that. As issuing more shares has the effect of diluting existing shareholdings. In recent years companies predominantly taken on debt than have rights issues or a placing. Though as capital markets tighten highly possible that the trend will reverse.

It depends on the price of the new issue. It's only dilutative if it's below the market price.

Wookster

Generali wrote: »

It depends on the price of the new issue. It's only dilutative if it's below the market price.

Correct, but how many rights issues are at market price? I'd say most are at a discount.

Generali

Wookster wrote: »

Correct, but how many rights issues are at market price? I'd say most are at a discount.

Most are at a discount but they needn't be.

By the time companies are listed on FTSE350 they are usually so bloated that most deals will destroy value. As a result buyers will want a discount to the market price. The norm for firms like that is to raise funds in the debt market so rights issues and other forms of equity-based capital raising will tend to be dilutative.

Smaller companies will often place new shares into the market at the market price or even above it. Private (ie non-traded company shares) will sometimes place shares at a premium to net asset value per share which is a proxy for a share price for a non-traded company AIUI.

Thrugelmir

Generali wrote: »

It depends on the price of the new issue. It's only dilutative if it's below the market price.

In term of the underlying asset. The value has only increased by the net cash injection, i.e. gross funds raised less cost of raising finance.

The Company is no more profitable than it was pre the additional share capital. As the return on the capital injected will be generated in the future if at all.

So EPS will be diluted by the increased issued share capital.

Generali

Thrugelmir wrote: »

In term of the underlying asset. The value has only increased by the net cash injection, i.e. gross funds raised less cost of raising finance.

The Company is no more profitable than it was pre the additional share capital. As the return on the capital injected will be generated in the future if at all.

So EPS will be diluted by the increased issued share capital.

EPS will be diluted but net asset value/share won't.

You'd hope that a company raising money would do so in order to make more money. I realise that most large companies are run to enrich directors rather than the owners but I live in hope.

Thrugelmir

Generali wrote: »

You'd hope that a company raising money would do so in order to make more money. I realise that most large companies are run to enrich directors rather than the owners but I live in hope.

Another era that I feel has passed. As boards become more accountable to shareholders for performance. The availability of cheap debt to finance acquisitions is diminishing. So measurement of operational performance will come to the fore. Something that private equity investors are waking up to. No longer will boards be dominated by financiers rather than experts in the Company's given field.