Sunday, December 14, 2008

What is the purpose of a Stock Exchange ?

It seems with the daily barrage of news, forecasts, predictions and commentaries by pundits, professionals and "sooth-sayers", perhaps no one has really realized the purpose of having a stock exchange in the first place ! The way the newspapers and publications go about it, you would not be blamed for mistaking the stock market as some national lottery game or gambling den, or even some fast-paced high-octane game where "The Winner Takes It All" (as ABBA sang it so succinctly some 30 years ago).

Nothing could be further from the truth though. The stock exchange's true purpose is for purely business reasons and it is merely one method which companies can use to raise funds for business expansion. Let's examine the main reasons in more detail:-

1) Private Companies sell shares to the public to raise funds for business expansion, using the stock exchange as a platform. They thus become "public" or "listed" companies from then on.

The main purpose of the stock market is to let aspiring companies sell shares to the general public in order to raise funds to expand their business. These are also known as "Initial Public Offerings" or IPO. A company needs to have some track record usually (3 years of consecutive revenue and profit growth) as well as fulfill several other conditions before it is allowed to list. Note that this is just ONE of the methods which a company can utilize to raise funds, others will include bank borrowings or issuance of debentures (bonds or notes) which are a form of debt. Listing on an exchange is a way of raising funds through equity, and it involves an expansion of a company's share capital. In a way, one can argue that it dilutes the stakes of existing owners but it also makes the company's shares liquid, thereby ascribing a market value to them almost as soon as the shares begin to trade.

2) Secondary Offering - Additional funds raised through a secondary offering of shares using the stock exchange as a medium

Even after being listed, companies can utilize the stock exchange (called the "capital markets") to issue more shares to raise even more funds for future business expansion, assuming there are buyers to take up the additional shares. This is known as a secondary offering and is most popular when share prices are HIGH, therefore this method is very common during a bull market. When share prices are high, companies can raise higher amounts of money through the issuance of less shares, thereby raising more capital with less dilution to existing shareholders. Notice now in the current bear market, no company is using a secondary offering to raise funds ? At the most, we hear of companies doing rights issues which ensures proportional participation in the company's fund raising and ownership.

3) A listing status may raise the profile of companies which may enable them to widen their scope of business expansion and get better recognition from suppliers/banks.

An intangible benefit of being listed (on the Singapore Stock Exchange at least) is that it confers to companies a certain status which is recognized by suppliers, customers, banks and other stakeholders. Knowing that the requirements for being listed are pretty stringent, this would imply that the company has "what it takes" to make it as a listed entity, and thus it would accorded a fair amount of respect. This would enable it to raise its profile and use its listed status as a "marketing" tool to reach out to more potential customers and to expand its business. Of course, one must also recognize that the quality of listing aspirants drops drastically as the market goes on a bull run, up to the point where the quality of those listed just at the apex of the bull market really gets very questionable ! I won't pinpoint names but suffice to say that certain China companies (S-Shares) fall under this dubious category.

4) A stock exchange gives the intelligent investor the opportunity to be a part-owner of companies.

This is the part I love best about the stock exchange. Aside from the hullabaloo and nonsense being spouted daily about the stock market and whether it is going up or down, the intelligent investor need only be concerned about one thing - the ownership of good companies at reasonable prices for the long-term. The stock exchange is a medium which makes this possible, as it allows sellers and buyers to transact. Without this medium, investors would not be able to partake in the profits and growth of companies (which is actually partaking in the growth of a slice of the economy). Provided one researches companies well and does not overpay for a piece of a wonderful business, one can enjoy many good long years of fabulous returns (much higher than the bank FD rate, trust me !) with little or no risk. One may argue that blue chips are a sure way of achieving this, but be aware that in the current economic crisis, the USA has proven that even blue chips may not be that "blue" after all and can be prone to total collapse (like AIG, Fannie Mae, Lehman Brothers). Thus, it is always prudent to do a thorough analysis of any investment before purchasing it, whether it is small-cap, mid-cap or blue chip.

And so I hope that the rationale for a stock exchange has been adequately explained in the above 4 points. Anyone who has more to add, please feel free to use the comments box or to discuss/debate over the 4 points which I brought up.


PC said...

"I believe in stocks for the long run – but only if purchased at the right price." - Bill Gross

patrick ho said...

Hi MW,
the exchange also provides guidance and legislation to the "invisible hand" of the markets to ensure order.

==> ensure that shares and orders are delivered.

without the exchange, u'll be looking at a chaotic market where brokers will fail to deliver shares, or worse still, hold onto the shares for self-profits.

This is akin to the government where law and order is maintained so that physical exchange of goods are monitored and there's no laudering or any other form on unlawful behaviour which will result in a dearth of confidence in the trading mechanism of the markets.The invisible hand works, but u need to have someone to govern over it to make sure everybody abides by the rules.

financialfreedom said...

A stock exchange is where people exchange stocks =)

The person buying thinks he is getting a bargain while the person selling thinks he too is getting a good deal.

Alisa said...

It would be interesting if we could, for a short while, imagine what it would be like investing without the technology we have today. I mean think about it. I think I read that the Stock Exchange began in the 1700's. How did outsiders become familiar with the businesses? How where purchases transacted? Who was tracking all these transactions? How were people protected from fraudulent activity? Where there any accounting standards? Or standards period? I am new on this investment journey, but I must say that I am extremely grateful for technology and the easy access to information, reports, news, etc.!
Be Well.

Anonymous said...

Stock market is for people like me to setup business and sell it to the public for a big profit, Retire and live happy ever after...

musicwhiz said...

Hi PC,

Thanks for visiting. A very good quote indeed from Bill Gross !


musicwhiz said...

Hi Patrick Ho,

Yep, thanks for adding that extra point in. An exchange does function as a medium to facilitate transactions between buyer and seller, this helps to keep everything orderly (most of the time, anyway !).

Thanks for the contribution.


musicwhiz said...

Hi Financialfreedom,

Yep your point is somewhat similar to what Patrick Ho has mentioned, a place for people to transact !


musicwhiz said...

Hi Alisa,

In those olden days, shares of companies were literally just pieces of paper stating ownership of X shares in ABC Company, and buyers and sellers had to be privately sought (similar to trying to sell your provision shop to someone else) to facilitate a transaction. I would say there are pros and cons to such an arrangement, as it makes people more inclined to understand the business before buying a piece of it. Those were the days before crowd psychology and technical analysis.


musicwhiz said...

Hi Anonymous,

Well, if you have the capability to do that, I am sure there are interested buyers out there who would want a piece of your company, letting you enjoy the retirement you desire ! Work hard at it ! Good luck !