Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
An In-depth Look at Equity Markets (S1 E3)
Are you ready to unlock the secrets of equity markets? Join us on a fascinating tour where we break down the complexities of public and private markets, the indispensable role of shareholders, and the nuances of common and preferred stock. Drawing from my years of Wall Street experience, I will guide you through the importance of limited liability for shareholders and the hierarchy of a firm during liquidation.
Venturing into the realm of private equity markets, we will unravel its pivotal role in raising long-term capital for companies. I walk you through the process, teaching you how companies privately secure funds. From venture capital to growth equity, equity buyouts, and late-stage funding, we illuminate the different stages of a company's life cycle and the corresponding funding they receive.
Switching gears, we traverse into the landscape of public markets. We untangle the process of initial public offerings (IPOs) and follow-on offerings, and even touch upon the benefits of choosing a SPAC for raising capital. As we journey further, we delve into the world of national exchanges that facilitate trading of securities and discuss the different categories of US stock markets. We promise that this episode will not only enrich your understanding of equity markets but also equip you with a new perspective on securities. Don't miss out on this enlightening journey. Buckle up, and let's get started!
Notes - https://1drv.ms/p/s!AqjfuX3WVgp8uGQy9X_KZ6p85xzc?e=T2OBrM
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a Sum Time Professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. Well, today we're going to turn our attention to the second of the long term capital markets in the US at least, the equity market. Just as a reminder, I'll pop up here on the screen the pie chart that we looked at earlier and again. Those of you just listening on the podcast, these are all available on the podcast's website. But you see that of the total US capital markets, we talked about the money market. That's a rather small piece of the pie. Last time we talked about the bond market. That's the largest piece, almost 51 trillion, and today we're going to talk about the equity market a little shy of 50 trillion. What do we have in the equity market? What's the idea here? Well, here the idea is similar to the bond market. This is a place where one can raise long term capital, but in the equity market it's limited exclusively to firms companies, in other words and firms raise long term capital here in exchange, not for a promise to pay less interest, but instead in exchange for a share of the enterprise. Equity capital can be raised by firms in public markets or in private markets. We'll talk about both in this podcast and by October 2023, it was estimated that US publicly traded equity. It was about 45 and a half trillion 106 trillion globally. But in addition to the public markets, of course, we have the private markets, and so I'll pop up an image here for those of you watching on the video, or you can just check it out on the podcast website later. But here's a breakdown of the US equity market. That's just a little shy of 50 trillion and you'll see the vast, vast majority of that capital is in the public markets. It's about 45 and a half, as I just said, the venture capital market, the growth equity market and the buyout market. In the aggregate makeup, the private equity market. That's estimated in the US to be a little shy of $4 trillion and that's what gives us our total value of a little less than 50 trillion.
Speaker 1:So firms raise capital, long-term capital. This is to build their business, grow their business, et cetera in exchange for a share of the enterprise. They can raise that capital publicly or privately, and it's not the largest capital market we've looked at, but it is fairly large. Before we dig in a little bit more on equities markets, I should say we ought to spend a minute or two to first understand some basic language, some basic terminology about the corporate form and about these shareholders, the share of the enterprise that one gets when one provides long-term capital to firms.
Speaker 1:The first and most basic concept is common stock. Common stock in a company entitles each shareholder to one vote. The shareholders elect a board of directors, which in turn selects a management team. Now, that's important to understand because it helps you put into perspective each person's role. The shareholder is an owner, but you'll notice that the shareholder doesn't make any decisions about how the company is being run. Instead, shareholders in the aggregate can elect directors.
Speaker 1:Doors don't run the day-to-day business. Directors make big strategic decisions about the firm and the most important big strategic decision they make is hiring the management team. The management team, in turn, runs the business every day. Now, obviously, all of these people can be shareholders. People that are on the management team can be compensated not just in money but in shares. Directors likewise can be compensated, not just in money but in shares, and so I don't want you to get the idea that there is this very bright line distinction between them, but the roles are definitely very different. Shareholders participate annually in voting on matters that are put to it by the board of directors, including reelection of the members of the board of directors and compensation packages for senior management. The share itself represents a residual claim on the firm's assets, either in the form of cash dividends that are declared by the company periodically, if the company is still in great shape and still functioning well, or a residual claim on the remaining assets of the firm in the event of a liquidation.
Speaker 1:Firms are always organized. When they're organized as corporations like this, with limited liability, it means that a shareholder cannot be held liable for the failure of the company or for its actions and, as we'll discuss on another podcast, when we talk about why markets, we're just understanding what they are now. We will later ask why. This is an important concept limited liability. Publicly traded common stock trades freely on one or more national exchanges or, in some cases, on off exchange markets. Private equity common stock trades privately, either through intermediaries like private equity funds or directly with strategic buyers, other firms, for example. Alright, so you've got.
Speaker 1:Common stock is one way in which you can provide long-term capital in exchange for a share of the enterprise. Another way is something called preferred stock. Preferred stock has features that blend common stock, a residual claim on the assets of the firm with limited liability and bonds entitled to a fixed payment each year. Well, management can determine whether to pay preferred shareholders a dividend or not. That's up to them. However, any dividends that are not paid to the preference stock shareholders accumulate for future payment. That is the preference stock shareholders are entitled to receive, usually a fixed percentage, as a dividend each period. It doesn't have to get paid. Management can determine to defer those payments. However, if they're deferred, then they accumulate for future payment. It's also really important to note that if management decides not to pay preferred shareholders, it can't pay common shareholders a dividend until it's caught the preferred shareholders up. Preferred shareholders don't get a vote, but they are the primary residual owners after their dividend, because they come after the bondholders but before the common shareholders of the firm. In the hierarchy of a firm that's in liquidation, the common shareholders are last, the preferred shareholders are next to last and the bond owners are next in line.
Speaker 1:Preferred shares can be traded either publicly or privately. In addition to common stock and preferred shares, there's another security that represents a residual interest in the enterprise, and that's something called an ADR or American depository receipt. Simply put, an ADR is a certificate that represents shares of non-US corporations. There's a certificate that represents shares of non-US corporations, but the certificate itself is what trades on a US public market. Each ADR corresponds to a share or a fraction of a share of that underlying non-US corporation. Why do you have ADRs? It's pretty complex for a non-US company to trade on US markets without satisfying some pretty heavy security registration requirements, so ADRs make it a little bit easier for non-US corporations' shares to trade in US markets.
Speaker 1:I'll mention here something that's not very new, but it's newly very interesting, and that is the so-called dual class structure. Some companies, particularly large technology companies, issue two classes of common stock. So we're talking just about common stock here, but two classes. One class, which is usually called class A, is just like typical common stock, with one vote per share. However, it represents a minority of the voting interest, but it has a majority of the economic interest. What does that mean? Well, the class A shareholders, if there were a liquidation, would be entitled to more than half or more than their rateable share of the company's assets in liquidation. However, while the company is ongoing, their voting rights are smaller than their economic rights. Why, well, that's because of the second class, usually called class B. The class B shares have the majority of the voting interest but a minority of the economic interest. While class A is usually issued to the public and trades reminder, class A means they have most of the economic interest but they don't have control of the company. Class B is usually held by founders and executives and it doesn't trade publicly.
Speaker 1:Now, this has been around for a long time, the very early precursor to the American auto company Dodge. When it went public in the 1920s, they wanted to go public with only non-voting common shares in order to retain the control of the company in the founders. The New York Stock Exchange banned a dual-class listing. They said it's just not possible to do that on the New York Stock Exchange. It's interesting to note that in the 1980s, the NASDAQ another exchange we'll talk about these exchanges in a minute the NASDAQ permitted listings of dual-class structure companies. Why, well, nasdaq was really in the 80s, courting technology companies, and this was a very popular way for founders of technology companies to maintain their control while raising capital. The New York Stock Exchange ultimately relented and, in the 1980s, allowed the listing of dual-share class companies.
Speaker 1:Okay, we've got companies that are raising capital for long-term needs. They can raise them either publicly or privately. The basic form of residual interest, the basic form of what you get in exchange for your capital, is a share. We talked about common stock, referred stock, adrs, which are peculiar for non-US companies, and the dual-class structure. Let's now turn our attention to these markets. What's their purpose and how do they work? It might not be intuitive, but I'm going to start with the private equity market, because I think that gives us a nice, clear picture of the purpose behind these long-term capital markets, which is raising long-term capital. The private equity market allows firms to raise capital privately and therefore be subject to much less public scrutiny than would otherwise be the case. What's the quid pro quo? The quid pro quo is that the private equity market is far smaller than the public equity market, and so it has limitations on how much a company can grow, raising money only there.
Speaker 1:Companies that are raising capital in private markets are categorized by the stage in a firm's life cycle and therefore, in a way, the purpose or the capital that they're raising. The main categories are venture capital, growth, equity and buyout. Let's take those apart for a minute. Venture capital, which is about a quarter of the private equity market about $1 trillion out of four are private companies at their very earliest stages in which they're raising capital in this market for very rapid growth. We can break down venture capital into some subsections based on where they are in their life cycle.
Speaker 1:Pre-seed stage is where a founder has an exciting business idea and is just getting the company organized. Pre-seed stage capital fundraising can be done with credit cards or loans from family and friends. The next stage in a company's life cycle is called seed stage. Here the company is ready to prepare or market with competitor research, product development, target demographics and probably the founding management team. The company at this seed stage is still funded mainly from family and friends, but some founders have created enough excitement around their company to attract what's called incubator or angel capital investors. As of 2020, the median enterprise value at the seed stage that is what's the enterprise, the business, worth it was about $6 million. These are really still very small. The median raise of capital when you're raising in the seed stage was about $2 million.
Speaker 1:The next stage in a company's development in the venture capital world is early stage, sometimes called Series A. Here the company has a user base. There are some other key performance indicators. There's probably some consistent revenue, but it's very likely that it's not yet profitable. The company has plans to scale the product across different markets or maybe complementary products. There's a strong management team in place that can execute the plan. These companies at this stage are funded by venture capital funds, usually with an anchor investor. The median enterprise value now, as of 2021, was about $24 million about four times as big and the median raise is $22 million. They're raising a lot more capital relative to the value of the enterprise.
Speaker 1:Next is mid-stage Series B. Here there's good evidence of demand and the company is ready to execute a plan at a much larger scale. Their focus is on business development, advertising, tech support. These companies are fairly well established at this stage, but they're not yet a household name. These guys also get funding from venture capital funds, usually with a continuation from the original venture capital fund investors and probably adding more. The median enterprise of these companies at this stage around $40 million and they raised again $26 million not quite as large as in Series A, but still quite large.
Speaker 1:Lastly, in venture capital we talked about late stage. This is Series C and beyond. We say beyond because it used to end at Series C and companies would go public, but lately there are a lot of advantages to companies remaining private and there's quite a lot of capital in the venture capital market available for companies to stay private. There's not a lot of incentive to go public until you're absolutely ready and sure that you need to raise that much capital. Late stage, series C and beyond. These are successful companies. They are probably profitable, though not necessarily. They're looking to scale up, either by entering new markets, developing new products or some combination. Usually at this stage it involves a strategic acquisition of one or more other companies that are either in the same business or complementary businesses. They're preparing the company for size and competitive advantages so that they'll be able to raise capital, which will be a lot of capital in public markets. The funders of late stage venture capital companies are venture capital funds, again, that specialize in late stage. Now we also have, we see, some funders from hedge funds and investment banks, because we are increasingly getting closer to entering public markets, which is where hedge funds and investment banks will play. The median enterprise value in 2021 of late stage venture capital companies was about $68 million and the median raise was about $53 million. You see that these are companies that are starting to become a lot more valuable and they're raising a lot more capital.
Speaker 1:The second category of private equity is growth equity. That's a pretty small part of the $4 trillion market. It's about a half a billion dollars. It's pretty small, and it's pretty small because it's kind of new. It's kind of new because it really has grown a lot in the last decade or two by the demand of companies to raise more capital but not to do so publicly, and venture capital funds have reached the end of their investment limit and there need to be opportunities to sell it to someone else. Firms can raise capital in the growth equity private market in order to provide scale as they get close to accessing public markets. These companies are more mature than those funded by venture capital. They sometimes might start adding debt in order to anticipate creating a capital structure that'll be attractive in public markets, but otherwise it's very, very similar to venture capital.
Speaker 1:Last but not least, in private markets we have buyout, which includes turnaround and some other categories. This is by far the largest part of the private equity market. Buyout is about $2.4 trillion of the force, a little more than half In the case of buyout. Here. This is a market in which companies are able to access long-term capital, but which companies are accessing long-term capital are usually underperforming public firms that investors take control of and delist, in other words, take private. As you could see, off the bat, buyout is really different than the venture capital or growth equity phases, where just everyone's private. The company is private, they haven't raised money in public markets. Buyout is really when you're talking about companies that have already gone public but, for whatever reasons, they're struggling in public markets. The opportunity is here in buyout for investors to provide additional capital to those companies, but that capital comes at a cost, which is to take the company private and try to repair the company.
Speaker 1:There are generally two ways in which buyout investors try to repair a company after they take it private. The first is called leveraged buyout. This is usually much more mature companies, successful companies, but companies that probably have not completely optimized their balance sheet. What does it mean to optimize your balance sheet? Well, in finance speak, and we'll talk a little bit about this decision in another episode. There's a good, healthy mixture of raising capital in debt and raising capital in equity. Everyone wants to get the mixture right.
Speaker 1:These public companies are thought to not be efficient enough, that is to say they don't have enough debt on their balance sheets. In leveraged buyout they acquire control of a public company, they take it private and then they add debt to the company's balance sheet in order to make the company more efficient and to boost their growth. Then typically they will sell that company either to a strategic buyer or they'll take the company public again. The second category of buyout is called traditional buyout. These are also mature companies. They've gone public, they've been around for a while, but maybe they're not quite as mature. Not necessarily the case that they're immature, but they might not be quite as mature. They're struggling, just like the companies that are the target of leveraged buyouts. But the struggling here is thought to be a problem of management. It's maybe a company that has grown too much too fast. They are out of whack. It may be a company that did not successfully grow even though they should have been, and therefore they face a lot of competitive pressure in their different markets. For whatever reason, investors here see the opportunity to add capital, long-term capital to this company, then, via taking control and then delisting and making it private, they don't really add a whole lot of debt, but they add capital and they focus more on operational efficiencies to boost growth, like the leveraged buyout guys. Once this company has reached its potential, either it will be sold to a strategic buyer or it will be taken public.
Speaker 1:If you're reading the newspaper and you're trying to figure out, when you're reading about some buyout that's happening, you're trying to figure out what in the world is it? A good way to figure it out if you don't really have much information is to look to see whether the buyout investors kept management in place or not. If they kept management in place, typically it means they think the company is very well run. It just doesn't have enough debt and so it's leveraged buyout. If you read a story where a buyout firm acquires a company and they fire senior management and put in new management, that is traditional buyout. That chances are that that's a company that they think is just mismanaged and they need to bring capital in the form of equity capital and new management to help turn it around. Right, those are the private equity markets.
Speaker 1:How about the public equity markets? Well, they're not really very different, except in scale and in the sorts of things that one can do. Public equity markets allow firms to raise massive amounts of capital for themselves or their shareholders More on that in a minute Because there is a large number of investors in public markets who want to trade and own these shares. So the market in which they raise capital for themselves or their shareholders is called the primary market, and then the number of investors who want to own these shares and trade them publicly is called the secondary market. In the first case, in the primary market, these operations are facilitated typically by the existence of exchanges, and we'll talk about the exchanges in a minute. But in the second category, in the secondary market, trading of these shares often does happen on exchanges, but it doesn't have to. Let's think about the primary market first, in public markets, and think about those transactions in which companies raise capital.
Speaker 1:The first and the most obvious example that is probably known to most people is the initial public offering, or IPO. In an initial public offering, a company issues new shares. That means that it dilutes the value of the shareholders who contributed capital earlier. They may be founders. They may be venture capital funds, they may be growth equity funds. They own the shares of the company. They've committed and contributed a certain amount of capital to the company, but now the company will issue new shares that are going to raise even more capital and that will dilute their ownership interest in the company. Now you might think to yourself well, why would anybody ever do that? And the answer is because, if they're able to raise so much additional capital in public markets as is typically the case that the company will then grow much more quickly. Its value will be a lot higher, and if the value is a lot higher, a rising tide raises all ships. So even though it's dilutive of the earlier investors, it still might be financially remunerative. All right. So in an IPO, the company issues new shares it's always dilutive and those shares are sold with the help of what are called underwriters. Underwriters are typically investment banks.
Speaker 1:There are a couple of steps in the process of selling a company's newly issued shares with the help of underwriters. First, there is something called the roadshow. No one's allowed to make any forecasts about the future of this company. Instead, you can share historical information about the company and you kind of go around the country talking to whom? Talking to big institutional investors, mutual funds, large institutional investors. Second stage is what's called book building. Book building is where the underwriters get on the phone and start having conversations with their clients, who are big institutional investors, about their interest. Here they're permitted to make some private forecasts. They're permitted to share with their clients what they think the company will be worth after they get this additional capital.
Speaker 1:Third step is placement. Well, why placement? Well, because when you're building this book of interest, you take orders from the institutional clients that are their kind of parameters. They say well, I'd be perfectly happy to take 100 shares at $20 a share, but I would only want 50 shares at $30 a share, or something like that. Every institutional investor puts his or her interests in the book. Why it's called book building? So that the underwriters, when it comes time to actually sell the stock that's the placement can decide who's going to get what. Now here's a big, big aha that most people aren't really aware of. Who gets the stock when the company is first placed is really in the discretion of the underwriter, and the underwriter is clearly got some incentive on behalf of the company to make sure that they take those orders at the higher price. However, the underwriters have relationships with these big institutional clients that extend far beyond their IPO and their incentives might not be completely pure about price. They may have institutional incentives of keeping others happy and ready to do other sorts of business with them.
Speaker 1:Once the shares are placed, that is to say, the institutional investors give the money to the company, the company gives the new shares to the institutional investors. It's only at that moment that the shares begin trading publicly. Sometimes underwriters will offer what's called price maintenance agreements, that is to say, sometimes they will promise to intervene in the public market to keep the stock price at a certain level, but that's not typical. Well, what is the net effect of this kind of transaction, this initial public offering? Well, we said it's dilutive. That's a pretty important effect.
Speaker 1:Second, the company, not the shareholders, receive the capital. So the founders, the venture capital investors, the growth equity investors they don't receive any of the capital. When the company goes public, the company receives the capital. Typically, the underwriters will push for a price that they feel is below what they can sell the shares for, because they want the offering to be successful. If they're right, what we generally see is when the shares start trading publicly, there's a so-called pop, and the pop meaning an increase in the share price benefits the underwriters and benefits the institutional investors with whom the shares were first placed, but it doesn't benefit the company. So if the placement takes place at $20 a share, then that's how much capital the company gets is $20 a share and it doesn't matter that when it starts trading publicly it pops to $30 a share. Who gets the benefit of that $10 jump in price are the underwriters and the initial institutional investors. Insiders, namely employees. Early investors, like venture capital investors, are restricted from selling their shares within six months of the initial public offering. Why they're prevented from selling their shares? Because you can imagine that once the shares start trading publicly, all of the early investors might rush to sell their shares, putting downward pressure on the price, and that might put the underwriter in a difficult position. So initial public offering really the primary way in which firms raise new capital in public markets and not terribly complicated, but there are sort of a few surprises, I think, in there for people who don't really have a sense for how this works.
Speaker 1:A second way for firms to raise capital on public markets is called the follow on offering. What's the follow on offering? Well, here the company is going to issue new shares again, but that will be dilutive. But it also could have existing shares that it didn't sell to the public when it went public. That would be non-dilutive In either case, whether they're issuing new shares or whether they held on to some shares when they went public, the public company is then selling these shares, and so it's a sale by the company of these shares. How do you have some existing shares? Well, the company might have just held some in reserve as what's called treasury stock when it went public. Typically, firms use a follow on offering to refinance expensive debt or to finance an expansion, and it's just another way for the company to raise additional capital. But, importantly, it is not the shareholders themselves who earn any additional capital here, it's just the company.
Speaker 1:A third way that's possible for companies to raise capital in public markets, which has garnered a little bit of attention in the recent years, is something called a special purpose acquisition company or a SPAC. Sometimes this is called a blank check company. What is SPAC? Spac is really a combination of venture capital or growth equity and IPO a merger, a merge of the two things. How does this SPAC work Well.
Speaker 1:Investors with very special expertise and that's an important point to make is that investors typically have a long track record of either investing in public companies or investing in private companies and taking them public or running companies. Investors with some sort of special expertise form a shell company. A shell company just means it has no operations, and it forms this shell company with the intention of buying at least one company. So the SPAC itself is the shell company, and it's formed by an investor with some special skill for the intention of buying at least one company. The SPAC initially raises capital from institutional investors underwriters in order to get the first bit of capital behind it before it takes the next step, which is it takes the SPAC public. But what's interesting is, in all cases it does not disclose what company it intends to buy. In fact, it's a very well-guarded secret what company it intends to buy, and so it takes the SPAC public and that's just like an IPO. There's no difference.
Speaker 1:So all of the steps that I just described before then apply to taking the SPAC public. So that is, underwriters find institutional investors who build a book. They then choose which of them are going to get shares, at what price. The shares are then sold and that capital comes to the company, to the SPAC itself, and the SPAC then takes that money that is raised both privately initially and then publicly, and then it makes an acquisition of a company and at that point the target company is just merged upward into the SPAC and now the target company is a public company. A lot of words, a lot of ideas, but I hope you get the idea that this is just another way for a company that's private to raise capital publicly, but without the help of direct underwriters and so on.
Speaker 1:Here there's the intersection with a very skilled investor who has a company in mind that they want to raise public capital for. So if you're a private company and you want to raise capital in public markets, why would you choose a SPAC? Oftentimes the target companies receive a premium when being acquired by a SPAC, compared to, say, what they would get if they sold themselves or sold shares to a private equity fund. So it can be attractive to some private companies to raise public capital like that, even if they're not didn't think they were quite ready to go public. It's far faster than a typical IPO. So that's attractive to a lot of private companies and it doesn't really have any of the risks of swing in market sentiment. That pot that I described, etc. Doesn't have much of the risk of that swing in public sentiment because typically the target company is announced immediately after it goes public.
Speaker 1:All right, we're going to talk about a couple of transactions that you can undertake in primary markets but that don't raise capital. You might recall, I said at the outset that when we have public equity markets, it allows companies to raise capital for themselves or for their shareholders in the primary market. And so the first few categories we talked about is where the company's raising capital for itself initial public offering, follow on offering and SPAC Now in the primary market. What if we want to raise capital for our shareholders? Well, the first type, the most typical type, is called a secondary public offering. Here the company will have again either newly issued shares, which will make it dilutive, or it might have existing shares, which makes it non-dilutive, but it's a sale of those shares not by the company but by its shareholders. These are typically insiders, employees, early investors. Those are the typical sellers of stock in a secondary offering. Typically, the secondary offering is used to provide liquidity to those early investors.
Speaker 1:A second kind of public primary market transaction that doesn't raise capital for the company but provides liquidity for shareholders is what's called a direct listing. Now, direct listings are kind of quirky and interesting in their own way because they're really designed to be in lieu of an IPO and they had a lot of popularity when some very famous large tech companies initially went public. But direct listings are a pretty special category and so I want you to understand it in the sense that it's something that can be done, but it's pretty unusual. Surprisingly, companies, especially very successful tech companies, consider a direct listing in which the company sells shares to the public directly, not using an underwriter. How does it work? Well, it is non-dilutive by design because the company is selling shares that already exist to the public, so it's not dilutive at all. It's in lieu of an IPO. It's cheaper because there are no enormous fees that they have to pay to underwriters. As you'll see in a minute, they still have to pay underwriters to do something, but just not to underwrite. There's no lockup for insiders. So if you do a direct listing, all of those insiders employees, founders, early investors are free to sell those shares in public markets. They pop in the value if the listing takes place at $20 a share, but there's a lot of public excitement and it pops to $30 a share. Unlike an IPO, the benefit here is to the company, not to the underwriters. There's no new capital that's raised. You could do that after a direct listing with a follow-on offering, but there's no new capital raised. This is just really making your shares public. You need to disclose a full year of financials before you list.
Speaker 1:The big catch and why I think this is more narrow than a lot of people give it any credit for is because in order for any institutional investor to buy these shares on public markets, there has to be analyst coverage. Analysts are just specialized people who usually work for investment banks and they study stocks and they have opinions about the health of the stock and the growth potential of the public stock, etc. The problem is that most investment banks only assign analysts to cover companies that they hope to get the business from to take the public. If an investment bank feels like you're likely to do a direct listing, there's a pretty good chance that you're not going to have any analyst coverage. If you don't have any analyst coverage, you're not going to be able to shell your shares publicly to any institutional buyers, so it's kind of a limited case study, all right.
Speaker 1:Well, we have these public markets where we can see the opportunity. They're very, very large, as we saw from the numbers. That gives us lots and lots of opportunity to raise capital far in excess of what you can raise in private markets. That is what will give the energy and the juice to a company to grow massively beyond where it was when it was private. There are these methods of raising that capital in public markets where the company is raising new capital so that's the IPO, follow-on offering or a SPAC. There are opportunities to sell shares publicly where you're not raising capital for the company, that's a secondary public offering or a direct listing.
Speaker 1:The other thing that's really useful about public markets is that it creates the opportunity for reorganizations of companies on exchanges. Now, it doesn't mean that they can't do this on their own. Of course they can do it on their own, but it happens in a very public way and it's worth at least understanding the language here of reorganizations, whether they're on exchanges or not. It's a good time to just understand the words. So there are three. Excuse me, there are four Merger, acquisition, spin-off and stock split. So let's just take them up in turn.
Speaker 1:What's a merger? A merger is when two companies combine to form a new company. It's that simple. Two companies combine to form a completely brand new company. Usually the shareholders of each original company get shares of the new company at a fixed rate of exchange. Recent mergers Exxon and Mobile merged become Exxon Mobile, pines and Kraft, ab, inbev and Miller Beer, aol and Time Warner. These were all mergers.
Speaker 1:Second acquisition One company acquires all the shares of another company and if the target was public, it's delisted and the acquired company's shareholders get cash or shares of the acquiring company or both. So again, an acquisition is one public company acquires all the shares of another public company and that second company, the target, is delisted. Most shareholders either get cash shares in the surviving public company or some combination. Very recent example of that is AT&T and Time Warner. Third spin-off here, instead of adding companies together like mergers and acquisitions, a spin-off is when a company chooses to sell a unit either to a private buyer or to take a public in an IPO or a secondary placement.
Speaker 1:Then, last, a stock split. Stock splits are interesting. So usually when a company's shares become too expensive to attract the maximum number of investors, companies will announce that they're going to have a split, meaning they'll exchange their shares, or a new number of shares, at a given exchange rate. What do I mean when I say too expensive? Well, just think about it from your own point of view. Just imagine there's a publicly traded company that you think is great company and each share trades at $5,000 a share, and you've got a little bit of money to invest. Well, $5,000, unless you're pretty rich, $5,000 is probably too much to put in one company. You would want to own a much more diversified portfolio of companies, but you really want to own this company and it trades at $5,000 a share. Well, there's just going to be a lot of investors who don't buy those shares. If there are a lot of investors who don't buy those shares, what do we know? Well, we know the laws of supply and demand tell us that if there are fewer buyers and then there are sellers, then the price is going to be lower than it could otherwise be. So how do you increase the buyers? Well, imagine if you announced that every share is going to be exchanged for 500 shares. Well, now, if I owned one share that was $5,000 and I'm going to get 500 shares, each share is worth $10. I think I did that math right. I have a share one share of $5,000, and shares are going to be split so that there's 500 shares for each share. Then each of those new shares that I get is worth $10. Well, now, at $10 a share, there are lots more investors who can afford to buy a share in that company and so, as a result, more demand means a higher price.
Speaker 1:Okay, let's talk a little bit about national exchanges. National exchanges are something that differentiate equity markets from the bond market. In the bond market, there really isn't a national exchange. Bonds are traded by people who want to buy and sell bonds, and that trading is facilitated in what are called clearing houses. We'll talk about that for a second. Because that in a second, because that also exists in equity public equity markets. But in public equity markets there is a specific entity that plays a very important role, and these are called national exchanges. In the US, there are seven national exchanges. The New York Stock Exchange owns three of the national exchanges, including itself, and the NASDAQ owns three, including itself, and those are the largest exchanges in the US. The Chicago Board of Exchange runs the seventh national exchange and it's designed very specifically to trade exchange traded funds, or ETFs. We'll talk more about ETFs in the future. Outside the US, there are also many national exchanges, the largest of which are the Shanghai Exchange and the Euronext Exchange.
Speaker 1:Once a company's shares are listed on a national exchange, the securities generally can trade on any other exchange. The national exchanges act for themselves as a clearing house to clear trades of securities on their exchange. What does that mean? Well, it's as simple as if. I'm buying shares of a company from you, I'm giving money and you're giving me your shares. Well, who's going to make sure that transaction happens and that everybody gets what they want and there's no confusion? Well, what you need is somebody to clear the trade, somebody who acts as a middleman and arranges for the transfer of money and the transfer of securities in order to finalize the sale.
Speaker 1:National exchanges, in addition to providing a place where a trader and we'll talk about these just in a minute providing a place where the shares can be traded, has a bigger role in the sense that they act as clearing houses for the trades that take place on their exchange. Listed securities on a national exchange can, and often do, trade. Quote over the counter and quote. So we're on a non-exchange market, and we'll talk about that in a little bit. In that case, if shares trade on an over the counter market, the national securities clearing corporation is probably the biggest one that clears those trades, but there are several others. Okay, so let's take the biggest US national exchange by volume, and that's the New York Stock Exchange. The New York Stock Exchange is responsible for about 55% of all trading volume in US equities the New York Stock Exchange. How does it get to be that? What's the value add? Well, we talked a little bit about clearing, which we'll get to again in a minute, but there's more to it than that. If you're the New York Stock Exchange and if companies are trying to figure out where do they want to list their shares, they pay attention to these things because they can have value. So the New York Stock Exchange obviously provides a means by which buyers and sellers can trade shares of stock in companies that are listed for public trading.
Speaker 1:The New York Stock Exchange has a very definite day, a very definite period during which stock is traded. The day begins at 9.30 AM. That's so-called opening bell. If any of you watch or listen to CNBC, there's a morning program called Opening Bell. That's where that name comes from. So the New York Stock Exchange trading begins at 9.30 AM and ends at 4.00 PM the so-called closing bell and again, cnbc has a show called the closing bell.
Speaker 1:The New York Stock Exchange is what's known as a continuous auction format. This auction formats mean that traders execute transactions on behalf of investors all day all during that time period from 9.30 to 4. A specialist broker who is employed by the New York Stock Exchange brings buyers and sellers together in order to manage the auction, the trading of those shares. You've ever seen images in the movies or in print media of people wearing different colored coats on top of their suit and their shouting, or they're raising their hands with tickets in their hands. Those are the traders on the Stock Exchange and the person in the middle is the specialist broker who is brokering all of those different trades. Beginning in 2007, all New York Stock Exchange stocks were permitted to be traded via its electronic trading platform. That is to say, it's a hybrid format. It still includes specialist brokers for customers who want them. If it's a big enough trade and you want someone to manage that, you can certainly route that trade to the floor and allow a specialist broker to arrange for the sale of those shares. But if you just wanted it to be executed electronically at whatever the market price is at that moment, the electronic trading platform of the New York Stock Exchange allows you to do that.
Speaker 1:Until 2005, the right to directly trade shares was limited to owners of so-called seats on the exchange. In 2005, the New York Stock Exchange began selling. By the way, I should say the reason I said until 2005 is because it was a big deal until 2005 to have a seat on the exchange. No one could trade stock listed on the New York Stock Exchange unless you had a seat, and that, like all monopolies, provides the opportunity for profits and that makes those seats very valuable. The New York Stock Exchange changed its format in 2005. And in 2005, it began selling one-year licenses that allowed someone to trade directly on the exchange. $40,000 is the cost if you wanted the one-year license to trade stocks and $1,000 if you wanted to trade bonds, and so $40,000 is just not a lot of money, think about it. And so there's some reason to think that the New York Stock Exchange was trying to make more relevant the floor and for people to use it, the other thing that stock exchanges do that I think are rather important is they can be safety mechanisms to prevent a massive all-out if there's some form of panic.
Speaker 1:Beginning in 1987, certain circuit breakers were instituted at the New York Stock Exchange in order to do just that. The stock exchange circuit breakers were set, most recently in 2011, at three different levels Level one, level two, level three. Are the three different levels. Level one is a fallen price of 7%. Level two is a fallen price of 13%. Level three is a fall of price in 20%. Well, until 325, remember, the exchange trades until 430, until 325,. If there are any level one and level two declines, the stock exchange halts trading for 15 minutes and then resumes trading again. So if there's some sort of momentary panic or some glitch, it doesn't mean that the price of the stock is just going to tumble into freefall. So, level one, level two, that is say, 7% to 13% declines in price, there's a pause 15 minutes and then it will start trading again. If it hits a level one and level two decline after 325, then they just halt trading for the day. It will reopen tomorrow at 930. But if there's a level three decline of 20% in the value of the shares, there's a halt to trading for the rest of the day. And so you see, the exchanges not only provide opportunity for listing shares and selling shares and sort of mechanical things like settlement, but the exchanges really try to offer themselves as having a service that's valuable and relevant to those people who want to list their shares and have them trade publicly.
Speaker 1:The NASDAQ is a smaller exchange. It's 30% of all volume NASDAQ. By the way, just an interesting little point, nasdaq stands for National Association of Securities Dealers, automated Quotations A mouthful NASDAQ's a lot easier to say. It was founded in 1971 as the first electronic trading market and so, as a result, it's a very different market than the New York Stock Exchange. It offers a different value proposition. One significant difference is that NASDAQ trades a lot more than just during the normal 930 to 430 hours of the New York Stock Exchange. Nasdaq trades from 4 AM to 930 AM in what's called pre-market trading, and then it trades from 930 AM to 4 PM, what's called normal trading, and finally it trades between 4 PM and 8 PM, post-market trading All of their.
Speaker 1:There are three different tiers in the NASDAQ that have different types of listings and trading restrictions. So one tier is just called the capital market. This is a trading platform for small companies with very low levels of market capitalization. For years and years, unless you were large enough to list in the New York Stock Exchange, there was no opportunity for you to raise capital in public markets. The capital market of the NASDAQ provided that opportunity for small companies. Listing requirements are less stringent than other markets. It's just easier. Second, nasdaq has what it calls its global market platform. That's for mid-size and large companies. There are about 1,500 stocks that meet the financial and liquidity requirements in order to be listed on the NASDAQ global market, but that's how NASDAQ regulates who can be listed and who can't be listed. And then, lastly, there's the global select market. That is a subset of about 1,200 stocks that meet the same requirements as the global market, but they're just a lot larger capitalization, more liquidity, more buyers and sellers.
Speaker 1:Okay, so we've got the national exchanges that perform functions that are pretty important, but what about trading shares that are not listed on a national exchange? Or, as I had mentioned earlier, even if they're listed, you want to find an alternative way to trade them. Here. What we're talking about are off-exchange markets, or otherwise known as over-the-counter. It's a very small part of US equity capital markets, responsible only for about 15% of all volume. These are typically securities of smaller firms that can't be listed on major exchanges. Of course, it also can handle trading shares that are listed on national exchanges. There are different levels of electronic trading with increasingly less liquidity, but what's key about the over-the-counter market is that market makers probably one of the biggest is a firm called Citadel. There are several others, and what market makers do is they act much like an exchange would act, but they're not an exchange. They make a market in securities that want to be traded off-exchange, and so market makers use electronic, very, very sophisticated electronic algorithms in order to match buyers and sellers over-the-counter. It is a very, very big business. It's a business where, typically, if you're one of a fintech startups like Robinhood, betterment or one of these, and your clients are going to be trading stock, odds are those trades are going to happen off-exchange, not on the New York Stock Exchange or the NASDAQ.
Speaker 1:In the public markets we categorize firms primarily by distinguishing US versus the rest of the world and then, secondarily, within the US, we distinguish it by the size of the firm's market capitalization. Well, what's market capitalization? It just means the price per share times the total number of shares outstanding. That's the market capitalization. And so here are the categories for US companies, and again this is sort of a vocabulary exercise so we really understand what we're talking about later when we dig much more deeply into equities as investors. The first category is called large capitalization. Large capitalization cap is just short for capitalization. Generally speaking, this would be a company with market capitalization of more than $10 billion. That is a big number $10 billion. This size large cap represents 91% of the US public equity market. I'm going to repeat that just to let it sink in. Large cap companies have market capitalization of more than $10 billion each and in the aggregate they represent 91% of the equities that are traded in public equity markets. So what's a good index to measure US large cap? The Wilshire 5000 is a good index to measure US large cap, or sometimes you see the S&P 500.
Speaker 1:What's an example of a US large cap company? Well, these are going to be household names Apple, google, microsoft. These are US companies. So what's the profile, what's the characteristic of these companies? Companies are large and global, even though they might be formed in the US and they might be listed on a US exchange. Their businesses are truly global. They are transparent. Everything they do is subject to public scrutiny. They tend to pay dividends, though not exclusively. They are stable businesses that tend to move the economy and lead markets, and recently in the news, we've heard many reports talk about how the increase in the value of the US stock market from the beginning of 2023 until I'm recording now, in November of 2023, is largely due to just seven stocks. So this is what we're talking about. Right, these are stable businesses that tend to move the economy and lead markets.
Speaker 1:Second category is mid cap. Mid cap generally is a company with market capitalization between $2 billion and $10 billion. By the way, there's no rule, right? There's no one that sits around saying, oh, $9.97 billion, you're mid cap. It's just a general guideline. So, mid cap companies market capitalization between $2 billion and $10 billion. What's a good example of a mid cap company? Coca-cola bottling. Now, it's important. Coca-cola itself is a large cap company, big global, much more than $10 billion in market cap. Coca-cola bottling is its own public company and it bottles Coca-Cola sodas. It's just in the US. It's where its business is, and Coca-Cola bottling is a mid cap company. That tells you a lot about mid cap companies. They look a lot like large cap companies. I mean, let's be honest, $5 billion market capitalization versus $10 billion. These are enormous companies, except nearly all of their revenue is derived in the US. They are not global companies. Global index for the mid cap space is the S&P 400.
Speaker 1:Small cap here we're talking about companies that you would think are small, but they're not so small. The average small cap company has a market capitalization somewhere between $300 million and $2 billion. These are really big companies that you have heard of before Remember from earlier in the podcast when we talked about what the median enterprise value is for venture capital companies. Those are small. Those are companies with $100 million in market capitalization. Here this is $302 billion. Amc is a small cap company. Avis is a small cap company. These are names you know. They're pretty big. They're just not nearly as big as the large and mid cap players. These cap companies look a lot like mid cap stocks, that is to say, most of their revenue is derived in the US. They're transparent. They probably pay dividends, but maybe less in dividends. They're stable businesses, but they don't move the economy or the market. They're just a lot smaller. The typical index for the small cap companies is the Russell 2000.
Speaker 1:I said we divide public companies by first, us and non-US. We've broken down the US category. Now let's turn our attention to the non-US category. Non-us category these companies are typically categorized by the state of development of the market where the company is based. Notice, where a company is based doesn't necessarily mean they do business there, but it's how we decide what to call something. There are two principle categories of non-US companies One we call developed markets and the second we call developing markets.
Speaker 1:Let's talk about the developed markets first. Who decides whether the market where a company is based is a developed market or not? The answer is some financial data providers have their own criteria and investors generally follow them. The Financial Times, a large global newspaper and also the owner of a public equity exchange, the Financial Times Stock Exchange, also is a data provider. They have a set of criteria for what markets would qualify as developed markets. Morgan Stanley, a big investment bank, has an operation called Morgan Stanley Capital International or MSCI. They also have a criteria for what ranks for inclusion in developed markets or should be called a developing market. Likewise, standard and Poor's S&P. You heard me mention earlier S&P 500. What's the typical criteria.
Speaker 1:The typical criteria for a developed market is that the countries in that market have very high national income, very robust regulatory environment, reliable custody and settlement of trades and sufficient competition in brokers and dealers and securities. To assure quality, liquidity and reasonable costs, these markets have to permit short sales and private transactions. If you don't know what a short sale is, trust me you will when we listen to a core episode on how securities trade. These markets have to have sufficiently large capitalization in order to make it rank in the developed market. I hope what you can see is that these qualities are really helping investors decide. Nothing about the substance of a particular company, but everything about the environment of owning shares of that company, trading those shares and having a level of sophistication and reliability and consistency to be an owner in those companies Primarily. That's what the distinction boils down to.
Speaker 1:I'm going to throw up a chart. That that's a terrible use of a phrase. I'm going to put up a chart that shows you what the MSCI thinks are the developed markets. If you're just listening to the podcast, I'll walk you through it. There are four different regions. There are about 20 countries. There are about 900 constituents. But what are the really big ones Australia, most of the European Union, france alone forms a 10% portion of the index for developed markets. Canada, hong Kong, iceland but only the MSCI considers Iceland a developed market. Brazil, japan, new Zealand, poland but only the FTSE considers Poland a developed market. South Korea everybody but MSCI. Switzerland, the UK you get the idea. These are countries that you would not be surprised to see someone describe as having the qualities that we mentioned before. I have another chart here for those of you watching on YouTube to see some of the rough divisions. But what are the really big constituents in, say, a classic developed market index, japan is almost 25%, the UK about 17%, france about 11%, germany about 9%, switzerland about 9%. These markets, I think I want you to take away the idea that the idea here is that these are not telling you something concrete about the companies or themselves or anything like it, but instead it's just telling you about the predictability and the reliability of where it trades. Then we can talk about the developing markets. I will say that the MSCI still calls its index emerging markets. Most people think that that carries a little bit too much of a stigma. What we're talking about here is again those same financial data.
Speaker 1:Firms provide criteria for inclusion in the developing market. By the way, the developing market is not everybody else In addition to those firms like FTSE and S&P and MSCI. Also, dow Jones and Russell provides a criteria for what is a developing market. Some developing markets can be developing from a command and control economy to a market-based economy Think China. Other developing markets can be shifting from an agrarian or productive economy that's mainly exports to having a robust middle class and therefore a self-sustaining consumer economy Think India. A lot of emerging markets or developing markets are smaller markets where they're still developing more sophisticated or reliable legal systems, market mechanisms. Don't be surprised to learn that these countries have anywhere from 10% to 75% of the GDP of the developed markets. They're a lot smaller markets, but they represent 60% of the world's population. This is a big big deal. While different firms have different constituents, most typically what you expect to see in the developing markets is Latin America, china, india and Eastern Europe.
Speaker 1:Again, if you're watching on YouTube, I've just flipped through a slide as of the end of 2020 that shows that MSCI's emerging market index is primarily China. 41% of that index is China. Taiwan is about 12%, korea about 12%, india 8%, brazil 5% and so on. You get the idea. Well, that's all I have for us today in terms of talking about equity markets. Thanks a lot for listening. We'll come back next time and we'll focus our attention on why do we have these markets. Thanks for listening. You've been listening to Not Another Investment Podcast hosted by me, edward Finley. You can find research links and charts at NotAnotherInvestmentPodcastcom, and don't forget to subscribe and leave a review of the podcast. Thanks for listening.
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