Chapter 2
Watching the market operate
IN THIS CHAPTER
Obtaining shares through a float
Perusing a prospectus
Trading, buying and selling
Meeting the major markets
Introducing the futures market
This chapter is about the two different types of market that make up the Australian sharemarket. The primary market is where companies, new or old, offer their shares to investors for the first time. This offer is called a float. Primary refers to the initial issuing of shares, not whether this particular type of market is more important. The secondary market is the day-to-day trading of all shares listed. Both of these markets make up the activity of the Australian stock market.
Floating of new companies is an important part of sharemarket activity, but small in terms of dollar value. Although floats of companies that are worth more than $1 billion are still relatively rare on the sharemarket, a typical day sees just over $6 billion traded on the secondary market ($5 billion through the ASX, and $1 billion transacted through the second exchange, Chi-X.)
Floating: The Primary Market
The primary market is where companies raise money to fund their enterprises. Companies offer shares for sale through a prospectus (see more on the function of a prospectus in the later section ‘Planning the Prospectus’). A prospectus is a legal document that invites the public to subscribe to a share issue, or initial public offering (IPO). As the name suggests, an IPO signifies the first public offering of shares. Investors provide capital for a company by buying shares in the IPO. A company floats on the sharemarket when it lists or quotes its shares for trade. As soon as the first trade takes place, the shares join the secondary market, which is where listed shares are bought and sold, all day on every trading day.
Actually, describing all new companies that come to the sharemarket as floats isn’t strictly accurate because some sink like a stone and don’t get back to the surface without a pretty exhaustive salvage effort.
Understanding why companies float
Companies float to raise money from investors. Like anybody selling anything, companies try to convince you that buying their shares is the greatest thing since sliced bread.
Occasionally you hear a lot of noble-sounding guff about the primary market being the great engine of the capitalist economy, mobilising the funds of the savers in the economy and channelling these funds to the enterprises that can make the best use of them. All that may be true, but it’s still guff. Vendors still want your money. However, you can make their need for funds work for you.
A company that floats is seeking private investment capital, whether from ordinary individual investors or professional investors such as fund managers — the people who manage the big investment companies. The company uses the money raised from the float in its commercial ventures, literally putting the money at risk. The risk is high because you have no guarantee the company is going to be successful. Some companies fail. For this higher risk, investors expect their capital to earn more than it can with less risky investments. In many cases, they also expect an ongoing income from the company in the form of dividends (for more on dividends, refer to Chapter 1).
Raising money
Suppose you want to start a business making furniture. To do this, you employ managers to buy raw materials, and you put together a workforce to make and sell the furniture.
Unless you already have capital set aside to fund the business, you need to find a way to finance your business. Your investment, allowing you to buy the raw materials and to pay the people who make and sell your furniture, probably has to be made with borrowed capital; for example, a normal commercial loan. As you sell the furniture that your company makes, you generate cash, which pays the cost of those sales — your wages, factory rental, marketing and advertising sales. Then, you must pay off the loans that enabled you to get started. Any money left after that is your profit.
The profit that your firm generates is the basis of wealth creation. How this wealth is shared depends on what corporate structure you choose for your furniture-making company. You can be a sole proprietor (own your own business), you can form a partnership (own a business with others), or you can form a company (own a formal legal entity). If your company decides that it wants to tap the private capital market, it may offer shares in itself and float on the stock exchange.
Offering shares to the investing public is a straight swap of capital for the privileges of ownership. Obviously, you, as the company’s owner/founder, are giving up some control, allowing others to have a say in the running of your company. The shareholders of a company limited by shares own the company by law. Some shareholders aren’t shy in expressing this fact. The dilution of control can be disconcerting to the owners of private businesses that have floated, because management’s aims are often different from those of the shareholders — who want to see returns, and pronto!
Often the owners of a business float the company to sell some (or all) of their holdings. The instant liquidity of the sharemarket — that is, the ability to sell shares when a company needs money — is attractive to owners. Selling a stake in a business or a partnership can be as time-consuming as selling a house — offers are made, haggled over and refused. However, on the sharemarket, the business is priced to the cent at any second.
Planning the Prospectus
The document that invites the public to invest in a company is called the prospectus. A prospectus sets out in great detail the company’s background, business, financial accounts, management and prospects. You can make an application for the shares only through the application form contained in the prospectus. The prospectus is a legal document and may read like the very worst of that breed, but the prospectus also contains all the necessary facts to inform and persuade a buyer.
Under the Corporations Law, the requirements of what to include in a prospectus are strict. Unfortunately, this means that a prospectus is a very bulky document, with many pages of material in small, closely packed type. For investors who aren’t also accountants, a prospectus can be a daunting read. However, it’s a vital document. You can find everything you need to know about a company inside the prospectus. Too many investors don’t read it. Don’t make that mistake.
For companies listing on the sharemarket, the prospectus is a marketing document too. The design, artwork and photography are all part of the effect. Many prospectuses resemble an edition of National Geographic. Visually impressive documents they may be, but don’t let that distract you from reading the difficult bits because the difficult bits are where you find the nitty-gritty that tells you whether the shares are worth buying.
Trading: The Secondary Market
The Australian Securities Exchange is the operator of the main Australian sharemarket. The 2,200 companies listed on the Australian market had a total value of $1,600 billion at March 2020 — down from $2,200 billion prior to the COVID-19 Crash — which makes Australia one of the top 15 world sharemarkets.
After a company floats, it joins the secondary market, which is hosted on the Australian Securities Exchange (which is abbreviated to and known colloquially as the ASX), and Chi-X. Every day on these exchanges, about $6 billion worth of these shares are bought and sold. No restriction exists on the number of shares that can change hands during trading hours. Stockbrokers, who are employees of stockbroking firms that are participants of the ASX, do the buying and selling of transactions.
Finding the market action at ASX Trade
All transactions in shares are conducted on the trading screens of the ASX and Chi-X. If a bid is the one that matches the offer, the bid gets transacted immediately. Every user can see the prices of all transactions and the number of shares involved.
Most trading goes through the ASX’s trading system, ASX Trade, to which only authorised stockbroking firms are permitted access. ASX Trade provides individual share information from the Australian sharemarket, and access to the trading venues, even those not operated by ASX. Launched in 2010 — and overhauled in 2020 — ASX Trade provides for the cash market and for every one of the approximately 2,200 stocks listed on the market, among other data, such vital statistics as the last sale price, the buy quote (bid) and the sell quote (offer or ask). ASX Trade places all bids (the prices that buyers are prepared to pay) and offers (the prices that sellers are prepared to accept) on the computer screens of brokers’ clients.
ASX Trade hosts two trading services, or ‘order books’:
- TradeMatch is the main market, and handles retail orders. It handles about 60 per cent of all trading. TradeMatch is a ‘lit’ market, meaning the bids, offers and volumes are displayed, and the market sees each transaction as it is struck.
- Centre Point is a ‘dark’ market, meaning that buyers and sellers are matched anonymously. Centre Point participants do not see the bids and offers before the trade, but all trades are then published immediately. Institutional investors strike ‘block’ trades (trades involving large numbers of shares) in Centre Point to lessen the impact of such large orders hitting the market. But brokers also route retail orders through Centre Point, which is effectively a price improvement service. Retail investors can request that their broker use Centre Point because of the possibility that retail investors will get a better price than in the lit market. Using ASX Sweep, Centre Point users can be seamlessly routed between the two liquidity venues, increasing execution certainty.
Another advantage of Centre Point is that fewer high-frequency traders are present, who use complex algorithms to analyse trading patterns and execute orders based on market conditions in that market.
Chi-X has an ‘integrated order book’, which means its ‘lit’ and ‘dark’ markets work together. So when you place a trade on Chi-X, the trade will look at both its lit and dark markets (its Mid-Point) to fill your trades. Having two exchanges means you can trade on Chi-X if it has a better price, and vice versa — within broking firms, sophisticated smart order router technology sends the order that the investor places to the best place to execute that order (ASX or Chi-X), based on factors such as best price and liquidity. Virtually every broker these days uses such routers.
Brokers access ASX Trade through a range of interfaces. Brokers and market participants either have their own proprietary systems or rely on third-party interface providers (such as IRESS Trader, provided by ASX-listed financial software company, IRESS Limited). No end-customer connects directly to an ASX product — any functionality that end-customers see is provided by their broker.
Through whichever interface they use, every stockbroker has direct access to the raw sharemarket data from his or her desktop. Investors don’t see or interact with ASX Trade — only brokers do. Clients of online brokers see a re-presented version of ASX Trade based on a direct feeds from the ASX when they log in to their broking account, and how these brokers present the market graphically is up to each broker. I discuss the operation of the market in more detail in Chapter 6.
Buying and selling for everyone
Two kinds of investors use the sharemarket: Institutional and private investors. Institutions, such as superannuation and pension funds, insurance companies, fund managers and investment companies, trustee companies, banks, and other financial institutions, buy shares with other people’s money. Private investors are individuals, like you and me, who buy shares with their own money.
Anyone who has insurance cover, a superannuation plan or a managed investment portfolio is indirectly a sharemarket investor. This means that institutional investors dominate the ownership of the Australian sharemarket and, within that category, the superannuation funds and life insurance companies dominate the institutional investment industry. Because of this, even those people who shun the sharemarket are likely to be involved in share trading indirectly.
When you buy shares as a private investor, you don’t know the identity of the person selling them to you. It may be an institution selling the shares you’re buying, or a cane farmer in Queensland. Your bid (buying) and offer (selling) prices are matched, but you don’t have any contact with the person on the other side of the transaction.
Institutions occasionally trade shares among themselves in transactions called specials, but even these transactions must be struck through a stockbroking firm. The stockbrokers have a monopoly, which so far has avoided the scrutiny of the Australian Competition and Consumer Commission (ACCC).
Working with a go-between
Every transaction on the stock exchange must be conducted by a stockbroking firm that is a corporate member of the ASX. About 60 firms are registered as stockbrokers in Australia, although some of those deal only with institutional or professional investors.
Before you walk into a stockbroking firm with that $4,000 you saved to start your investing career, check with the ASX whether your broker deals with the retail or private investor market.
Stockbroking is now a buyers’ market and brokers are engaged in a price war over fees, helped by the easy access the internet provides. What was once regarded as the model stockbroker–client relationship, where the broker advised the client and provided research and access to floats, was exploded by the cost-cutting brought by the internet. Online brokers have lowered transaction fees considerably. You can get more details on stockbroking in Chapter 9.
Using the Index
Every sharemarket has a major index, a notional portfolio designed to reflect the wider sharemarket as accurately as possible. The index gives investors a means of tracking market performance. The index is also a shorthand way of assessing the performance of the sharemarket on a given day. However, an index is only an indicative number. The index may not tell you whether a share you own has risen or fallen, but only the general trend in the market. Sometimes, some shares rise in price although the index itself has fallen, or vice versa.
In March 2020, the Australian sharemarket was the 15th-largest sharemarket in the world but accounted for only about 1.8 per cent of the total value of world sharemarkets. To put the size of the Australian market in perspective, the largest US stock, Apple, is valued at the time of writing at US$1,409.2 billion (A$2,042 billion) — which is more than the entire ASX market capitalisation.
Table 2-1 shows the world’s top 20 sharemarkets by value as at March 2020.
TABLE 2-1 The Top 20 Sharemarkets by Value
Sharemarket |
Market Value (US$ billion) |
1. New York Stock Exchange |
25,532 |
2. Nasdaq |
11,227 |
3. Japan Exchange Group |
5,098 |
4. Shanghai Stock Exchange |
4,672 |
5. Hong Kong Exchange |
4,232 |
6. Euronext* |
3,669 |
7. Shenzhen Stock Exchange |
3,275 |
8. LSE Group^ (London Stock Exchange) |
2,917 |
9. Saudi Stock Exchange |
2,009 |
10. TMX Group (Toronto) |
1,747 |
11. SIX Swiss Exchange |
1,606 |
12. Deutsche Boerse (Germany) |
1,578 |
13. BSE India (Mumbai) |
1,506 |
14. Korea Exchange (Seoul) |
1,137 |
15. Australian Securities Exchange (ASX) |
978 |
16. Taiwan Stock Exchange |
975 |
17. Johannesburg Stock Exchange |
671 |
18. Brasil Bolsa Balcao |
605 |
19. BME Spanish Exchanges |
572 |
20. Singapore Exchange |
538 |
* Paris, Amsterdam, Brussels, Lisbon, Dublin and Oslo stock exchanges
^ London and Milan stock exchanges
Source: International Federation of Stock Exchanges
The All Ordinaries index
The long-standing indicator of the Australian Securities Exchange is the S&P/ASX All Ordinaries index, which contains the 500 largest companies by market capitalisation or value. The All Ordinaries index covers more than 95 per cent of the value of the Australian market, making it relatively broad in scope when compared to its international peers.
As a junior market, the ASX barely cracks a mention in the world’s financial press, but its international peers make headlines over here. The global indices are the equivalents of the All Ordinaries in the overseas markets. However, not many international indices have market coverage that is as broad as the Australian index, which gives you, as an Australian investor, a decided leg-up.
The S&P/ASX 200 index
In 2000, the S&P/ASX 200 index was introduced as a replacement benchmark index for the Australian market, and is now more widely followed than the All Ordinaries. It comprises the 200 largest companies by market value and is used by investment managers as a proxy for the Australian market to build portfolios and compare performance. The S&P/ASX 200 index is a subset of the All Ordinaries and covers about 80 per cent of the Australian market by value. You can follow the ups and downs of the S&P/ASX 200 index in newspapers and media reports.
The Dow Jones
The venerable Dow Jones Industrial Average has been tracking the industrial heavyweights of the New York Stock Exchange (NYSE) since Charles Dow first calculated it in May 1896. Since then, the index has chopped and changed many times, with the last original constituent, General Electric, dropping out in June 2018. The top ten of the Dow Jones in June 2020, by market value, were Apple, Microsoft, Visa, Johnson & Johnson, Walmart, Procter & Gamble, JP Morgan Chase & Co., UnitedHealth, Home Depot and Intel.
The Dow Jones is, unfortunately, an unrepresentative index, comprising only 30 industrial stocks at any time. It was criticised in the late 1990s for not adequately reflecting the technology-based new economy. The only technology-related companies in the Dow Jones at the time were Hewlett-Packard (now split into HP Inc. and Hewlett Packard Enterprise) and IBM because they were the only tech stocks old enough to qualify, having been established in 1939 and 1911 respectively. In the famous ‘new economy’ shake-up of November 1999, stalwarts Goodyear, Sears Roebuck, Union Carbide and Chevron were ditched and Microsoft, Intel, SBC Communications and Home Depot added.
Three companies in the Dow Jones — Cisco Systems, Microsoft and Intel — actually trade on the Nasdaq (see the following section), not the NYSE. The third-largest US stock by market value, Amazon (worth US$1.2 trillion), is not a Dow Jones member, nor are the fourth-largest (Alphabet, Google’s parent company, worth US$982 billion), and the fifth-largest (Facebook, worth US$656 billion). The main reason these companies are not included in the Dow Jones is that their share prices are just too high for an index that is calculated based on share price — including them would mean that their price changes would swing the index up or down, no matter how the other stocks performed.
The Nasdaq
The Nasdaq is the acronym for the National Association of Securities Dealers Automated Quotation, the other US sharemarket. Today it’s known as the Nasdaq Stock Market.
The Nasdaq was formed in 1971 to provide a screen-based marketplace for shares that didn’t meet the listing requirements of the NYSE but were widely owned and had outgrown the smaller, local markets on which they traded.
From the beginning, the Nasdaq hosted the technology start-ups that have gone on to become well known and larger, in some cases, than the industrial giants that make up the Dow Jones. The tech giants dominate the Nasdaq — that’s where Amazon, Alphabet and Facebook hang out. Valued at US$11.2 trillion, the Nasdaq has become known as the technology market, and its major index, the Nasdaq Composite, as the prime technology indicator and most widely followed indicator of the US ‘tech’ stock market.
Based at Times Square in New York, the Nasdaq Stock Market trades about the same dollar value in shares as its (US$25.5 trillion) cross-town rival, the NYSE — about US$90 billion a day — but the NYSE trades more shares, at about 2.2 billion a day to the Nasdaq’s 2.1 billion.
The S&P
The S&P 500 index, calculated using the value of the top 500 US stocks by market value, is the broadest of the big three US indices — and has recently elbowed the Dow Jones aside to assume ‘star index’ status with the Nasdaq. The S&P 500 is the main proxy for the US sharemarket when fund managers need a benchmark against which to compare the performance of their portfolios. Calculated by Standard & Poor’s, a 160-year-old financial data and analysis firm, the S&P 500 was introduced in 1957. Only 60 of the original companies still remain in the index, which actually contains 505 stocks.
The Footsie and the rest
The Financial Times Stock Exchange 100 (FTSE 100), better known as the Footsie, is the major indicator of the London Stock Exchange, representing about 81 per cent of total market value. The Footsie, which comprises the 100 largest British stocks by market value, was introduced in 1984. Only 27 of the original 100 constituents remain members.
All sharemarkets have a major index. Here are some of the other global heavyweights:
- Shanghai Composite for the Shanghai Stock Exchange
- EURO STOXX 50 for Euronext
- Nikkei Index for the Tokyo Stock Exchange
- Hang Seng Index for the Hong Kong Stock Exchange
These indices operate in the same way as the S&P/ASX 200 index. Anywhere a stock market exists, somebody has developed an index to track it.
The mighty MSCI
Now that you have the basics of the market covered, you can move on to how to use it. Before the rise of index funds, which put together portfolios to follow or track a particular index and mirror its performance faithfully, the major indices were merely indicators of the sharemarket. Now these indices represent guaranteed buying on the part of the index funds. If a company is included in one of the major indices, its shares will find instant buyers. If they leave that index, the index funds will sell them. For smaller companies, graduation into the major indices is a rite of passage and exclusion sends their share price plunging.
In Australia, we think of our own benchmark index, the S&P/ASX 200, as the ultimate in status, but it’s not. Global fund managers want to know whether an Australian stock is part of the Morgan Stanley Capital International (MSCI) World Index, which is market capitalisation–weighted, meaning bigger companies have more clout. The MSCI World Index comprises the 1,637 largest companies in the world’s 23 most developed economies — and 77 ASX-listed stocks make the grade. MSCI calculates more than 225,000 sharemarket indices every day, and estimates that more than US$13.1 trillion is benchmarked to its indices on a worldwide basis.
Stepping into the Futures Market
The sharemarket has a double that exists in future time, although this sharemarket, the futures market, trades in the present. Futures markets are a long-established and legal way to buy or sell a specified commodity at a fixed time in the future. Futures markets began in the agricultural commodities markets of mediaeval Europe and have grown in sophistication since then.
Futures markets allow producers and consumers of commodities to lock in their prices. Producers like to know what price they will get for their product in six months’ time. Users like to know what they will have to pay for that product in six months’ time in order to plan their budget accordingly. Speculators want to make money either way, by picking which way the price will go. These three players are the essential oil that lubricates the futures market.
Late last century, the technique of trading commodities was applied to the sharemarket. In this situation, a certain value of shares becomes the commodity being traded. This value is the notional value of a market index, multiplied by a certain dollar value per point on the index. In the US, the main index on which futures contracts are traded is the S&P 500. In Australia, it’s the Share Price Index 200, or SPI 200, which is the S&P/ASX 200 index’s futures market twin. The actual sharemarket represents the spot market, the term used in the commodity markets to denote today’s price. The futures market anticipates what that spot value will be in the future. If investors expect the spot price of the S&P/ASX 200 to rise, they will pay a premium for the future value. If, on the other hand, they expect the S&P/ASX 200 to fall, the SPI will trade at a discount to its actual twin.
The futures market is a specialised area, and you need a lot of experience and information before you venture into it. The futures market is also a leveraged investment, meaning that losses as well as profits are magnified, and you can lose more than you invest.