Stock Market

Contents

What is the stock market?

While the stock market can be a complex place, the principles upon which it rests are straightforward. The stock market is one of the most important ways that a company can raise money for its various needs, typically the capital required for further growth and expansion.

By issuing shares in the company at a pre-determined price, the company exchanges ownership with potential investors in return for their money. This is called Equity. Investors hope that the company will be successful with the money raised, as if it is, they will receive a return on their equity investment.

This can be in two ways:

  • Firstly, if the value of the company rises, this is an increase in the share price of the company. If an investor then chooses to sell their shares they will have made a profit, known as a capital gain.  
  • Secondly, the company may also pay a regular return to its shareholders out of its profits - this is called a dividend.

Of course, this shareholder investment involves risk and the company’s share price can fall as well as rise. In that case investors would make a loss if they sold their shares in that position. Stock exchanges were invented to enable the buying and selling of shares quickly and easily in a centralised way. This mechanism engages all market participants; a large number of companies together with a large number of buyers and sellers.

Trading in stocks and shares was typically centered on large national stock exchanges such as the London Stock Exchange (LSE). However since 2007, the regulations covering European stock markets have become standardised within the European Union. As well as these traditional exchanges, these rules opened the UK market up to a new kind of competition from multilateral trading facilities (MTFs). These are regulated companies that compete with the traditional stock exchanges for trading shares and have had considerable impact on where market trades are carried out, with trading venues such as BATS Chi-X Europe now accounting for a significant share of trade volume. This has meant that although trading venues have become more fragmented, the cost of trading has fallen. 

What are the UK stock exchanges?

There are a number of regulated stock markets in the UK but the two of primary interest to individual equity share traders and investors are the LSE main market, and its subsidiary, the Alternative Investment Market (AIM). Between them they provide access to nearly 3,000 companies. We have seen that the UK stock market has become more competitive, with MTFs such as BATS Chi-X Europe proving alternative venues for trading shares.

As we have seen, to join the London Stock Exchange, companies must meet certain entry criteria for corporate governance and financial strength to be admitted to trading and potentially join the official list. These criteria include a minimum market value of at least 25% of the company to be floated, and a minimum three year period of audited historical financial accounts.

The stock market itself has several established performance indices, i.e. a benchmark value of the shares in the index. This gives a measure of the overall market performance and how an individual share compares. The FTSE 100 (or “footsie”) is the most familiar, it is the index of the largest 100 UK companies by value, the FTSE 250 lists the next largest 250 companies, while the FTSE350 is a listing that combines the FTSE100 and FTSE250. The listings are evaluated each quarter. You may also see the All Share Index which covers most companies that are admitted to trading and can be divided down into different industry sectors.

Many smaller and younger companies need investors with the capital they can use to grow their business, however, they may not meet the requirements to be admitted for trading and potentially be listed on the LSE.

For these shares there is a market where the listing requirements are less stringent, and here the shares are quoted on the AIM. This is operated by the LSE and was launched in 1995 to help small young companies gain access to capital. While it is possible to transfer both ways between the main market and AIM, companies quoted on AIM are typically more risky investments because they cannot meet the more stringent requirements of the main market.

The NEX Exchange (formerly known as ICAP) is also based in London and is run in competition to the LSE/AIM exchanges for small and medium sized companies coming to market. 

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What are the different types of shares?

Not all shares are created equally and there are a number of different types although all confer ownership of the company. The two most common ones are ordinary shares and preference shares:

  • Ordinary shares are usually the shares that people refer to when talking about shares and prices. They give the owner rights to dividends, voting, attendance at annual general meetings and receiving accounts. There may also be an entitlement to specific perks such as company discounts.
  • Preference shares are a special preferential class that will pay a fixed dividend before any remaining dividend is paid to ordinary shareholders. Sometimes these can also be redeemed for a set price or they may be convertible to ordinary shares in the future. 

How are shares traded and priced?

The UK has a hybrid market structure for buying and selling shares which can be confusing for the novice. This structure has developed over time and combines traditional features with modern technologies.

It combines an electronic order book with a number of competing firms known as market makers. Market makers are specialist firms that are licenced to deal in a specialised range of shares on the London Stock Exchange and they also match buys and sells. This situation is different to stock markets in many other countries where all trades are automatically matched on a centralised electronic order book.

The traditional way to trade was via the market maker. This still has benefits today, and not just in less frequently traded or less liquid shares. The market makers act as middlemen that are obliged to offer prices on these shares subject to a maximum size. Each market maker will offer what it considers its best price to compete for the business. In effect the market maker acts as a wholesaler, quoting buy and sell prices for shares to brokers and institutional clients. Those market makers that deal with stock brokers are also known as Retail Service Providers (RSPs).

Order book systems need a steady flow of trades; hence the electronic order book trades only the most liquid shares, generally the FTSE 350, electronically matching the many thousands of buy instructions with sell instructions automatically, without the need for a middleman.

All prices are quoted with a “two way price” known as the bid/ offer spread. The offer is the higher price, being the price at which you can buy and the bid (the lower) is the price at which you can sell. This price is constantly updated during market hours. The difference between the offer and the bid is known as the spread. The spread reflects the liquidity of the share and how wide the spread is will be different for particular shares depending on this liquidity i.e. how easy it is to buy and sell them and how much is being traded. Popular shares have very narrow spreads. The spread therefore contains the market makers profit margin, received in return for risking their capital in the shares to be traded.

Today, computerised systems are used to trade shares, making it quicker, efficient and far cheaper, with continuously updated (“real-time”) prices. With electronic systems this activity takes fractions of a second and ensures that you, the client, receive the best price available at that point in time.

Since 1997 and “Big Bang” there is no longer a trading floor, or “pit” for human traders to meet, this was replaced by SEAQ. SEAQ stands for the stock exchange automated quotation system. This lists all of the market makers’ bid and offer prices electronically. Shares traded using SEAQ are said to be traded on the ‘quote book’.

Instead of SEAQ, the very largest companies quoted on the London Stock Exchange, usually the FTSE350, are traded on the Stock Exchange Electronic Trading Service (SETS). Also introduced in 1997, the shares have sufficient liquidity so that buyers and sellers can be matched automatically without the need for a market maker. This is known as the ‘order book’ and the shares are sometimes called order book stocks. In theory this system makes the bid/offer price even narrower, and market makers can still compete for business using this system.

To complicate matters, a further development was launched in 2003, known as SETSmm. This was introduced to extend the SETS concept to include smaller AIM companies, with the market makers providing the liquidity. 

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What are the different investing styles?

Investing is a very broad topic and there are many different types of investment strategy, most of which are designed for a medium to long time period.

Value investing is a strategy whereby you select stocks to invest in that you believe are trading for less than their real value. In other words the stocks have been undervalued by the market.

Value investors believe that the market overreacts to good and bad news causing price movements that are not fully representative of the company's long term potential.

The main problem for value investors is that because there is no correct intrinsic value of a company, it is always open to interpretation Typically, investors select stocks with lower than average price to earnings ratios and/or by looking at the future growth and forecasted cash flows. Whatever methodology is used it all comes down to trying to buy something for less than it is worth.

Income investing involves picking stocks that provide a steady stream of income. Fixed income products such as Bonds provide a steady stream of income but so do stocks by offering a frequent payment rewarding you for your investment, in the form of a dividend.

There are some sectors and companies that have historically paid higher dividends. For example, older, more established firms no longer maintain high levels of growth, so instead of reinvesting into themselves they pay out earnings to provide shareholders with a return.

Rather than looking at companies with the highest dividend payments in monetary figures, it is more important to look at the dividend yield, which is calculating the dividend paid as a percentage of the company's share price.

There are factors to be aware of when income investing using dividends:

Companies are not obliged to pay out a dividend because profits can be reinvested into the company if they choose.

Past dividends are not a guarantee that the company will pay out dividends in the future.

Growth investing involves investing in companies that you expect to grow at an above average rate compared to their industry or overall market. This is even if the stock's current price seems expensive relative to its underlying value.

Rather than purely seeking stocks with high growth rates and inflated prices, it is now considered sensible to look for stocks with high growth rates that are trading at reasonable valuations. This had given rise to the strategy called 'Growth at a Reasonable Price (GARP).

GARP combines the doctrines of both growth and value investing. GARP investors select companies that are slightly undervalued, that have good, but more realistic future earnings prospects rather than targeting those companies with very high forecasted growth.

This strategy avoids the extremes of growth and value investing, leading investors to seek growth stocks with relatively low price/earnings (P/E).

What are the different order types?

A market order is the simplest and will be dealt by your broker at the next available opportunity at the best price available.

Because market prices are constantly and rapidly moving, most platforms usually offer a range of optional order types when buying and selling shares. These can be used to help you limit the potential amount of financial losses if market prices fall, particularly when you may be unable to monitor your share prices. They are best seen as risk management tools, although they cannot remove risk completely. 

This is a type of order that is triggered to sell your shares at your chosen pre-set price if the market moves against you. Stop Losses are particularly beneficial where your shares are left unmonitored because the Stop Loss will be activated if the share trades at the price set. Although the order will be dealt as soon as possible, the price you receive may still be lower or higher than your stop loss price, so your loss could therefore be bigger than you anticipated.

Some brokers also offer trailing stop loss. These act in a similar way to a stop loss but move in tandem with the market price to protect profits as prices move up.  

A buy limit order enables your order to be placed automatically if a share falls to your target price. You can usually set these as being “Good for the Day” (GFD) or “Good until Cancelled” (GTC) or GTD (“Good until a specified future Date during the next 90 days”). A sell limit order instructs your broker to sell your shares if the price rises to your specified pre-set level.

A fill or kill order is effectively an all or nothing instruction. A fill or kill lets you place an order with a limit price, and if the brokerage can get this limit price or better, your order will be placed (filled). If it is not possible to get your desired limit price it will instead lapse.

What are corporate actions?

When you are holding shares you may encounter events that are collectively known as Corporate Actions. These are undertaken by the Company and they will affect your shareholding. These can be grouped into three main types:

Corporate restructuring. These are usually mergers between companies or break-ups of a large company into smaller ones;

Company share splits, rights issues and buy-backs are ways that a company will seek to influence its share price by increasing or decreasing the number of shares on offer;

Payment of regular cash dividends or bonuses to reward shareholders from company profits.

If you hold the shares in nominee form the broker will contact you giving details about the specific Corporate Action and the options open to you, which may be mandatory or optional. For example, in the case of Dividend payments, you may have the option to choose how the value of the dividend is paid to you, either as Cash or alternatively as further shares (SCRIP dividend). A broker may also be able to reinvest a cash dividend into further company shares for you (known as a DRIP). 

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The value of your investments may go down as well as up. You may not get back all the money that you invest.  If you're unsure about the suitability of a particular investment or think you need a personal recommendation, you should speak to a suitably qualified financial adviser.

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