Finding the right spot in that flow: educational about equity-based securities

 

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I am returning to educational content, and more specifically to finance. Incidentally, it is quite connected to my current research – crowdfunding in the market of renewable energies – and I feel like returning to the roots of financial theory. In this update, I am taking on a classical topic in finance: equity-based securities.

First things first, a short revision of what is equity. We have things, and we can have them in two ways. We can sort of have them, or have them actually. When I have something, like a house worth $1 mln, and, in the same time, I owe to somebody $1,2 mln, what is really mine, at the end of the day, is a debt of $1 mln – $1,2 mln = – $0,2 mln. As a matter of fact, I have no equity in this house. I just sort of have it. In the opposite case, when the house is worth $1,2 mln and my debt is just $1 mln, I really have $1,2 – $1 mln = $0,2 mln in equity.

There is a pattern in doing business: when we do a lot of it, we most frequently do it in a relatively closed circle of recurrent business partners. Developing durable business relations is even taught in business studies as one of the fundamental skills. When we recurrently do business with the same people, we have claims on each other. Some people owe me something, I owe something to others. The capital account, which we call « balance sheet », expresses the balance between those two types of claims: those of other people on me, against my claims on other people. The art of doing business consists very largely in having more claims on others than others have on us. That “more” is precisely our equity.

When we do business, people expect us to have and maintain positive equity in it. A business person is expected to have that basic skill of keeping a positive balance between claims they have on other people, and the claims that other people have on them.

There are two types of business people, and, correspondingly, two types of strategies regarding equity in business. Type A is mono-business. We do one business, and have one equity. Type B is multi-business. Type B is a bit ADHDish: those are people who would like to participate in oil drilling, manufacturing of solar modules, space travel to Mars, launching a new smartphone, and growing some marijuana, all in the same or nearly the same time. This is a fact of life that the wealthiest people in any social group are to be found in the second category. There is a recurrent pattern of climbing the ladder of social hierarchy: being restless, or at least open in the pursuit of different business opportunities rather than being consistent in pursuing just one. If you think about it, it is something more general: being open to many opportunities in life offers a special path of personal development. Yes, consistency and perseverance matter, but they matter even more when we can be open to novelty, and consistent in the same time.

We tend to do things together. This is how we survived, over millennia, all kinds of s**t: famine, epidemies, them sabretooth tigers and whatnot. Same for business: over time, we have developed institutions for doing business together.

When we do something again and again, we figure out a way of optimizing the doing of that something. In business law, we (i.e. homo sapiens) have therefore invented institutions for both type A, and type B. You look for doing the same business for a long time, and doing it together with other people, type A just like you? You will look for something like a limited liability partnership. If, on the other hand, you are rather the restless B type, you will need something like a joint stock company, and you will need equity-based securities.

The essential idea of an equity-based security is… well, there is more than one idea inside. This is a good example of what finance is: we invent something akin to a social screwdriver, i.e. a tool which unfolds its many utilities as it is being used. Hence, I start with the initial idea rather than with the essential one, and the initial one is to do business with, or between, those B-type people: restless, open-minded, constantly rearranging their horizon of new ventures. Such people need a predictable way to swing between different businesses and/or to build a complex portfolio thereof.

Thus, we have the basic deal presented graphically above: we set a company, we endow it with an equity of €3 000 000, we divide that equity into 10 000 shares of €300 each, and we distribute those shares among some initial group of shareholders. Question: why anyone should bother to be our shareholder, i.e. to pay those €300 for one share? What do they have in exchange? Well, each shareholder who pays €300, receives in exchange one share, nominally worth €300, a bundle of intangible rights, and the opportunity to trade that share in the so-called « stock market », i.e. the market of shares. Let’s discuss these one by one.

Apparently the most unequivocal thing, i.e. the share in itself, nominally worth €300, is, in itself, the least valuable part. It is important to know: the fact of holding shares in an incorporated company does not give to the shareholder any pre-defined, unconditional claim on the company. This is the big difference between a share, and a corporate bond. The fact of holding one €300 share does not entitle to payback of €300 from the company. You have decided to invest in our equity, bro? That’s great, but investment means risk. There is no refund possible. Well, almost no refund. There are contracts called « buyback schemes », which I discuss further.

The intangible rights attached to an equity-based security (share) fall into two categories: voting power on the one hand, and conditional claims on assets on the other hand.

Joint stock companies have official, decision-making bodies: the General Assembly, the Board of Directors, the Executive Management, and they can have additional committees, defined by the statute of the company. As a shareholder, I can directly execute my voting power at the General Assembly of Shareholders. Normally, one share means one vote. There are privileged shares, with more than one vote attached to them. These are usually reserved to the founders of a company. There can also be shares with a reduced voting power, when the company wants to reward someone, with its own shares, but does not want to give them influence on the course of the business.

The General Assembly is the corporate equivalent of Parliament. It is the source of all decisional power in the company. General Assembly appoints the Board of Directors, and, depending on the exact phrasing of the company’s statute, has various competences in appointing the Executive Management. The Board of Directors directs, i.e. it makes the strategic, long-term decisions, whilst the Executive Management is for current things. Now, long story short: the voting power attached to equity-based securities, in a company, is any good only if it is decisive in the appointment of Directors. This is what much of corporate law sums up to. If my shares give me direct leverage upon who will be in the Board of Directors, then I really have voting power.

Sometimes, when holding a small parcel of shares in a company, you can be approached by nice people, who will offer you money (not much, really) in exchange of granting them the power of attorney in the General Assembly, i.e. to vote there in your name. In corporate language it is called power of proxy, and those people, after having collected a lot of such small, individual powers of attorney, can run the so-called proxy votes. Believe me or not, but proxy powers are sort of tradable, too. If you have accumulated enough proxy power in the General Assembly of a company, you, in turn, might be approached by even nicer people, who will propose you (even more) money in exchange of having that conglomerate, proxy voting power of yours on their side when appointing a good friend of theirs to the Board of Directors.

Here you have a glimpse of what equity-based securities are in essence: they are tradable, abstract building blocks of an incorporated business structure. Knowing that, let’s have a look at the conditional claims on assets that come with a corporate share. The company makes some net profit at the end of the year, and happens even to have free cash corresponding to that profit, and the General Assembly decides to have 50% of net profit paid to shareholders, as dividend. Still, voting in a company is based on majority, and, as I already said, majority is there when it can back someone to be member of the Board of Directors. In practical terms it means that decisions about dividend are taken by a majority in the Board of Directors, who, in turn, represent a majority in the General Assembly.

The claim on dividend that you can have, as a shareholder, is conditional on: a) the fact of the company having any profit after tax, b) the company having any free cash in the balance sheet, corresponding to that profit after tax, and c) the majority of voting power in the General Assembly backing the idea of paying a dividend to shareholders. Summing up, the dividend is your conditional claim on the liquid assets of the company. Why do I say it is a conditional claim on assets, and not on net profit? Well, profit is a result. It is an abstract value. What is really there, to distribute, is some cash. That cash can come from many sources. It is just its arithmetical value that must correspond to a voted percentage of net profit after tax. Your dividend might be actually paid with cash that comes from the selling of some used equipment, previously owned by the company.

Another typical case of conditional claim on assets is that of liquidation and dissolvence. When business goes really bad, the company might be forced to sell out its fixed assets in order to pay its debts. When really a lot of debt is there to pay, the shareholders of the company might decide to sell out everything, and to dissolve the incorporation. In such case, should any assets be left at the moment of dissolvence, free of other claims, the proceeds from their sales can be distributed among the incumbent shareholders.

Right, but voting, giving or receiving proxy power, claiming the dividend or proceeds from dissolvence, it is all about staying in a company, and we were talking about the utility of equity-based securities for those B-type capitalists, who would rather trade their shares than hold them. These people can use the stock market.

It is a historical fact that whenever and wherever it became a common practice to incorporate business in the form of companies, and to issue equity-based securities corresponding to shares, a market for those securities arose. Military legions in Ancient Rome were incorporated businesses, which would issue (something akin to) equity-based securities, and there were special places, called ‘counters’, where those securities would be traded. This is a peculiar pattern in human civilisation: when we practice some kind of repetitive deals, whose structure can be standardized, we tend to single out some claims out of those contracts, and turn those claims into tradable financial instruments. We call them ‘financial instruments’, because they are traded as goods, whilst not having any intrinsic utility, besides the fact of representing some claims.

Probably the first modern stock exchange in Europe was founded in Angers, France, somehow in the 15th century. At the time, there were (virtually) no incorporated companies. Still, there was another type of equity. Goods used to be transported slowly. A cargo of wheat could take weeks to sail from port A to port B, and then to be transported inland by barges or carts pulled by oxen. If you were the restless type of capitalist, you could eat your fingernails out of restlessness when waiting for your money, invested in that wheat, to come back to you. Thus, merchants invented securities, which represented abstract arithmetical fraction of the market value ascribed to such a stock of wheat. They were called different names, and usually fell under the general category of warrants, i.e. securities that give the right to pick up something from somewhere. Those warrants were massively traded in that stock exchange in Angers, and in other similar places, like Cadiz, in Spain. Thus, I bought a stock of wheat in Poland (excellent quality and good price), and I had it shipped (horribly slowly) to Italy, and as soon as I had that stock, I made a series of warrants on it, like one warrant per 100 pounds of wheat, and I started trading those warrants.

By the way, this is where the name ‘stock market’ comes from. The word ‘stock’ initially meant, and still means, a large quantity of some tradable goods. Places, such as Angers o Cadiz, where warrants on such goods were being traded, were commonly called ‘stock markets’. When you think of it, those warrants on corn, cotton, wool, wine etc. were equity-based securities. As long as the issuer of warrants had any equity in that stock, i.e. as long as their debt was not exceeding the value of that stock, said value was equity and warrants on those goods were securities backed with equity.

That little historical sketch gives an idea of what finance is. This is a set of institutionalized, behavioural patterns and rituals, which allow faster reaction to changing conditions, by creating something like a social hormone: symbols subject to exchange, and markets of those symbols.

Here comes an important behavioural pattern, observable in the capital market. There are companies, which are recommended by analysts and brokers as ‘dividend companies’ or ‘dividend stock’. It is recommended to hold their stock for a long time, as a long-term investment. The fact of recommending them comes from another fact: in these companies, a substantial percentage of shares stays, for years, in the hands of the same people. This is how they can have their dividend. We can observe relatively low liquidity in their stock. Here is a typical loop, peculiar for financial markets. Some people like holding the stock of some companies for a long time. That creates little liquidity in that stock, and, indirectly, little variation in the market price of that stock. Little variation in price means that whatever you can expect to gain on that stock, you will not really make those gains overnight. Thus, you hold. As you hold, and as other people do the same, there is little liquidity on that stock, and little variation in its price, and analysts recommend it as ‘dividend stock’. And so the loop spins.

I generalize. You have some equity-based securities, whose market value comes mostly from the fact that we have a market for them. People do something specific about those securities, and their behavioural pattern creates a pattern in prices and quantities of trade in that stock. Other people watch those prices and quantities, and conclude that the best thing to do regarding those securities is to clone the behavioural pattern, which made those prices and quantities. The financial market works as a market for strategies. Prices and quantities become signals as for what strategy is recommended.

On the other hand, there are shares just made for being traded. Holding them for more than two weeks seems like preventing a race horse from having a run on the track. People buy and sell them quickly, there is a lot of turnover and liquidity, we are having fun with trade, and the price swings madly. Other people are having a look at the market, and they conclude that with those swings in price, they should buy and sell that stock really quickly. Another loop spins. The stock market gives two types of signals, for two distinct strategies. And thus, two types of capitalists are in the game: the calm and consistent A type, and the restless B type. The financial market and the behavioural patterns observable in business people mutually reinforce and sharpen each other.

Sort of in the shade of those ‘big’ strategies, there is another one. We have ambitions, but we have no capital. We convince other people to finance the equity of a company, where we become Directors or Executive Management. With time, we attribute ourselves so-called ‘management packages’, i.e. parcels of the company’s stock, paid to us as additional compensation. We reasonably assume that the value of those management packages is defined by the price we can sell this stock in. The best price is the price we make: this is one of the basic lessons in the course of macroeconomics. Hence, we make a price for our stock. As Board of Directors, we officially decide to buy some stock from shareholders, at a price which accidentally hits the market maximums or even higher. The company buys some stock from its own shareholders. That stock is usually specified. Just some stock is being bought back, in what we call a buyback scheme. Accidentally, that ‘just some stock’ is the stock contained in the management packages we hold as Directors. Pure coincidence. In some legal orders, an incorporated company cannot hold its own stock, and the shares purchased back must be nullified and terminated. Thus, the company makes some shares, issues them, gives them to selected people, who later vote to sell them back to the company, with a juicy surplus, and ultimately those shares disappear. In other countries, the shares acquired back by the company pass into the category of ‘treasury shares’, i.e. they become assets, without voting power or claim on dividend. This is the Dark Side of the stock market. When there is a lot of hormones flowing, you can have a position of power just by finding the right spot in that flow. Brains know it better than anyone else.

Now, some macroeconomics, thus the bird’s eye view. The bird is lazy, and it prefers having a look at the website of the World Bank, and there it picks two metrics: a) Gross Capital Formation as % of GDP and b) Stock traded as % of GDP. The former measures the value of new fixed assets that pop up in the economic system, the latter estimates the value of all corporate stock traded in capital markets. Both are denominated in units of real output, i.e. as % of GDP, and both have a line labelled ‘World’, i.e. the value estimated for the whole planet taken as an economic system. Here comes a table, and a graph. The latter calculates the liquidity of capital formation, measured as the value of stock traded divided by the gross value of fixed capital formed. Some sort of ascending cycle emerges, just as if we, humans, were experimenting with more and more financial liquidity in new fixed assets, and as if, from time to time, we had to back off a bit on that liquidity.

 

Year Gross capital formation (% of GDP), World Stocks traded, total value (% of GDP), World Year Gross capital formation (% of GDP), World Stocks traded, total value (% of GDP), World
1984 25,4% 17,7% 2001 24,0% 104,8%
1985 25,4% 23,7% 2002 23,4% 82,8%
1986 25,1% 32,4% 2003 23,9% 76,0%
1987 25,4% 46,8% 2004 24,7% 83,8%
1988 26,2% 38,1% 2005 25,0% 99,8%
1989 26,6% 44,5% 2006 25,4% 118,5%
1990 26,0% 31,9% 2007 25,8% 161,9%
1991 25,4% 24,1% 2008 25,6% 140,3%
1992 25,2% 22,5% 2009 23,4% 117,3%
1993 25,0% 30,7% 2010 24,2% 112,5%
1994 25,0% 34,0% 2011 24,5% 104,8%
1995 24,8% 34,1% 2012 24,3% 82,4%
1996 24,7% 41,2% 2013 24,2% 87,7%
1997 24,7% 58,9% 2014 24,4% 101,2%
1998 24,5% 73,1% 2015 24,2% 163,4%
1999 24,1% 103,5% 2016 23,8% 124,5%
2000 24,5% 145,7%

I am consistently delivering good, almost new science to my readers, and love doing it, and I am working on crowdfunding this activity of mine. As we talk business plans, I remind you that you can download, from the library of my blog, the business plan I prepared for my semi-scientific project Befund  (and you can access the French version as well). You can also get a free e-copy of my book ‘Capitalism and Political Power’ You can support my research by donating directly, any amount you consider appropriate, to my PayPal account. You can also consider going to my Patreon page and become my patron. If you decide so, I will be grateful for suggesting me two things that Patreon suggests me to suggest you. Firstly, what kind of reward would you expect in exchange of supporting me? Secondly, what kind of phases would you like to see in the development of my research, and of the corresponding educational tools?

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