Making money from spread betting
This is the first of a three part study commissioned by UK-Analyst on how to make money from financial spread-betting. It is aimed at beginners or those with no knowledge at all and also at intermediate investors who wish to improve their returns...and you'll find a free tip too!
Read on…
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History
Is spread betting as old as the City itself? Certainly not! The idea of spread betting was dreamt up by Stewart Wheeler, the founder of IG Group, in 1975 when he started to make a market to his friends on the price of gold. Every week, in those days, a select group of people met in New Court, at the offices of N.M. Rothschild, the merchant bankers, to ‘fix' the prices at which gold bullion would be bought or offered for sale by the firms that dealt in the metal. When they had agreed on the prices they announced the result to the market, and that became the basis on which gold would be traded until the next ‘fix'. Wheeler made a ‘buy' and a ‘sell' price on where he thought the next ‘fix' would be set.
Those who thought that the price would be above his placed a buy bet, those who thought the price would be below placed a ‘sell' bet. Such trading was a complete innovation in those days, but the amount of interest it generated in such a new market encouraged Wheeler to expand and widen the choice of instruments on which clients could bet. This was the birth of IG Index (International Gold), which was the forerunner of all the spread betting bookmakers today.
In 1985, Jonathon Spark and Michael Spencer went to Paris to watch the Prix de l'Arc de Triomphe at Longchamp, which is one of the premier horse races in France. Until that time, the only way that you could bet on the result of a horse race in the UK was to try to forecast and nominate a specific horse that would either win, or finish among the first three (occasionally four) horses past the post. Sometimes it was possible under certain circumstances to bet on the outcome of a stewards' enquiry (e.g. whether an objection would be upheld or dismissed), or the distance by which the winner beat the second (e.g. a short head, a head, a neck or half a length) in the days before cameras were installed at every racecourse. Messrs. Spark and Spencer had an argument, not about whether either of their selection would win the race, but about which of either horse that they fancied would beat the other, and by how many lengths. The concept of spread betting can best be illustrated by this different approach to backing your conviction. It works like this.
If you think that horse A will beat horse B at the end of the race, you ask the bookmaker (or the person who fancies horse B with equal conviction) for a price. Suppose he makes ‘a price of 2 lengths at 3 lengths'. Let us assume that you have great faith in your opinion that horse A is far superior and altogether a better horse and will finish the race considerably ahead of horse B, you would ‘buy' lengths. You would place a ‘buy' bet at a stake of – say - £100 per length. That means that for every whole length greater than 3 lengths that horse A beats horse B, you will receive £100 from whomsoever you placed the bet. Conversely, for every whole length greater than 2 lengths that horse B finishes in front of horse A, you will pay £100.
You think that Horse A will beat Horse B. The odds that are quoted for this are - 2 lengths, at 3 lengths. You place a ‘buy' bet at £100 per length.
The race result- Horse A sixth, Horse B eleventh i.e. 7 lengths between A and B.
YOU WIN 7 less 3 = 4 x £100 = £400
But if the race result had been- Horse A eighth, Horse B third i.e. 5 lengths between Horse B and Horse A, then
YOU LOSE 5 less 2 = 3 x £100 = £300
Thus it doesn't matter what horse wins the race, there is still a way for you to make winning bets on the outcome.
This concept opened up a whole new vista of betting opportunities and the dealers in the City of London as well as the sporting bookmaking fraternity recognised and welcomed the birth of a great big new market for punters to bet, and money to be made.
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What can you bet on?
The spread betting public has become spoiled for choice since the early days. There are now two main categories of bets:
• Financial
• Sport
The financial instruments that are available to use for spread betting are as follows:-
Daily Indices
Daily FTSE
Daily DOW
Daily FTSE Futures
Daily DOW Futures
Daily Dax 30 Futures
Daily CAC 40 Futures
Daily S&P 500 Futures
Daily NASDAQ 100 Futures
Individual/Weekly Shares
FTSE 350 Shares
Hundreds of other FTSE shares
EuroSTOXX 50 Shares
100's of US Stocks
DAX 30 Futures Indices
FTSE Futures
DOW Futures
FTSE/DOW Differential
DAX 30 Futures
DAX/FTSE Differential
CAC 40 Futures
IBEX 35 Futures
MIB 30 Futures
SOFFEX Futures
S&P 500 Futures
NASDAQ 100 Futures
Nikkei 225 Futures
Hang Seng Futures
EuroSTOXX Futures Sectoral Shares
Mining
Oil & Gas
Pharmaceuticals
Tobacco
Media
Transport
Banks & many others
Currencies
Interest Rates
Bonds
Options
Commodities
Indices
The most commonly chosen instrument on which to bet are market indices, particularly for the newcomer to spread betting. The indices are split into two groups, daily, and futures based. The most commonly chosen daily indices are:-
• Daily FTSE 100
• Daily Wall Street (Dow Jones)
• Daily Wall Street futures
• Daily S&P 500 futures
• Daily NASDAQ futures
These are daily bets which ‘die' at the end of the market hours that day, unless you have closed them out before that time. You can place the bet to 'open' the position, at any time after the market starts, up to just before it closes for the day. If you think that the stock market in London or New York is going to end the day at a higher level than either one is standing at a particular moment during the day, you place a ‘buy to open' bet on a ‘daily' index. If you think that a market will end the day at a lower level, you place a ‘sell to open' bet. You can close the bet any time from one minute afterwards, if you wish, or at any time up to the market close. If you do not close a daily bet, it will be ‘closed out' automatically at the level announced officially after the close of business. Bet based on financial futures.
• FTSE 100
• Wall Street futures
• S&P 500 futures
• NASDAQ 100 futures
• Nikkei 225 futures
• Hang Seng futures
Equities
Ordinary shares form the basis for most non-professional spread betters and there are thousands to choose from. In Part 3 of this survey which will be published on Thursday you will find pointers to help you choose the shares that are most likely to win, how to control your risk of loss, as well as some golden rules to increase your potential profits and limit the downside. It is true to say that the beginner should probably restrict his or her initial forays into financial spread betting on ordinary shares until the basic rudiments and disciplines have been really understood and the ability to read the ‘buy' and ‘sell' signs have become second nature, before venturing into the more volatile markets such as commodity futures in oil, cocoa, pork bellies or metals.
Bonds
The bonds most commonly chosen for spread betting are:-
• T Bond futures ( USA )
• Gilt futures ( UK )
• 10 year note futures ( USA )
Interest rates
The interest rates most commonly chosen for spread betting are:-
• Short Sterling (3 months)
• Eurodollar
Currencies
The list of currency/currency (e.g. the pound to the euro GBP/EUR) available for spread betting is extensive. The most commonly selected are:-
• GBP/USD (£/$ US)
• EUR/USD (euro/$US)
• EUR/GBP (euro/£)
Commodities
The list of commodities available for spread betting is extensive. The prices of some commodities can move very substantially and very fast. In this category are cocoa, coffee, crude oil, natural gas, sugar wheat and soya beans. It is very important that you learn as much as possible about one or two commodities, their markets and what factors influence supply and demand if you are to win consistently. You may not be able to impose guaranteed stop loss limits at an economical charge and this is a very good example of caveat emptor (let the buyer beware)!
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Why spread bet at all?
Everyone is attracted to the idea of making money out of backing their judgment, particularly when they see an anomalous situation which they think will be corrected, or when they spot a share price trend and want to cash in on it by riding the rise or fall so long as it lasts. Spread betting allows you to do this very efficiently without the need for access to large amounts of capital.
One of the most important aspects of financial spread betting, and one that is no longer available to the ordinary investor in stocks and shares, is that you can make money from a falling share or commodity price in just the same way that you can win from a rising one. Financial spread betters are just as happy operating in a falling market, when all conventional investors who hold equities or commodities in their portfolios are getting more and more depressed because they are watching the values of their investments diminishing all the time. If they have to liquidate any holdings, they will either get a smaller profit, or an outright loss.
However, the spread better will be able to take full advantage of falling prices and make as much money as they fall as they would when they rise. Furthermore, the spread better is able to make a whole lot more money out of the same share if the price turns and climbs back to where it was previously, whilst the holder of the same share can only watch the recovery, if it happens, and sigh with relief.
Essentially, financial spread betting is short term trading, as opposed to longer term investing, as well as being an adjunct to investing over a longer period. It can be used very effectively to protect profits that have been achieved in the core holdings of a portfolio, and this is described in more detail in Part 3 on Thursday.
There is another aspect to financial spread betting that has come about more or less by accident. The imposition of massive regulation upon stockbrokers and institutions which are licensed to deal in investments on a regulated investment exchange brings greatly increased costs which are passed on to the client.
Government stamp duty, dealing commissions both when you buy as well as when you sell which can vary in amount considerably between firms of stockbrokers and banks, and of course, the iniquitous capital gains tax, have all combined to make short term trading unattractive if you have to try to make money by buying and selling individual shares. None of these costs apply when you engage in financial spread betting. There is no capital gains tax to pay when you win. Of course the corollary applies; you cannot offset losses against gains, either from spread betting or any other investment activity. Nevertheless, by the judicial use of stop-loss limits, you should be able to ensure that your gains far outweigh any losses that might arise.
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How risky is it?
All investments carry a degree of risk, some greater than others. Financial spread betting is at the high end of the risk table in that, theoretically, your losses are unlimited, but there are several things that you can do to minimize the degree of risk, and at the same time control your exposure to actual loss. In fact you should not get involved in such financial short term trading activities unless you are prepared to follow the simple and obvious rules of common sense that govern such activities.
Firstly, you must always apply guaranteed stop-loss limits to your bets, regardless of the additional cost of provision of this safety factor. In certain circumstances, without such protection, the very real potential loss can be an infinite amount of money.
Secondly, you must really know as much as possible about the company or commodity upon which you are going to place your bet. You should become an expert in your chosen sector, and stick closely to what you know. Be persuaded to open or close a bet by your own judgment, rather than relying on a ‘tip in the pub'.
Thirdly, monitor your bets all the time that they are running – events that can have a dramatic effect on your open positions can happen very fast and without warning. Finally, you must be prepared to cut any losses without emotion getting involved. If you follow these rules you can reduce the degree of risk substantially.
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Is it for you?
Not everyone is suited temperamentally to financial spread betting. This is not so much the case for sports spread betting, probably because the potential amount of monetary loss is considerably smaller in most sports (other than cricket or rugby union perhaps) and such betting is generally regarded as somewhat more frivolous than as being a full time occupation.
Financial spread betting does require a degree of nerve and courage, as well as the ability to accept losses without it affecting your judgment in the same way that players in high stakes poker games must remain aloof from emotional involvement when play goes against them. This state of mind is essential if you want to be able to continue to calculate dispassionately the odds against winning or losing as circumstances change at speed.
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How do you get started?
You need to open an account with a financial spread betting bookmaker. Generally the larger firms will offer facilities to place sporting bets also. All have to supply you with full details of their terms and conditions before they can accept any bets from you. They will want to know how much money you will want to stake normally, and they will ask for a deposit to be placed with them. This sum usually will be around £2,000 and they should pay interest to you whilst it is kept in their clients' account.
It will pay you to get to know an individual dealer with whom you transact your business because the relationship that you can build may be beneficial to you both. Trading with bookmakers tends to be rapid, since they have got a large number of clients and cannot afford to spend a lot of time discussing any particular bet. They are not there to give advice; you are supposed to understand the language and how it all works, but usually they will try to help those who tell them that they are beginners.
Remember that all telephone conversations with bookmakers are recorded, and this is very much to your advantage because if you dispute any verbal instruction that you may have given to the bookmaker, you are always able to demand to listen to the tape of the original telephone call. Make sure that you fully understand all the terms and conditions as well as settlement terms at the beginning of your relationship before you start to place your first bets.
Beginners Guide to PE Ratios
Quite simply the PE ratio is the current share price divided by the earnings per share of the company in question. When you see a PE ratio stated in a paper, the ratio in question is almost certainly the historic (or trailing) PE ratio, that is to say the current share price divided by last year's reported earnings per share. However most professional investors are more concerned with the forward or prospective price earnings ratio, that is to say the current share price divided by the current year's predicted earnings. Remember that the City always looks ahead - share prices are dictated by future, rather than past, profits.
Is a high PE ratio a bad sign?
If you look at today's paper you will see that certain stocks, such as the water companies, trade on an historic price earnings ratio of less than 10. But IT services companies such as Logica (LOG) often trade on historic price earnings ratios of 50 or more. So what does that tell us?
Investors, as a herd, will pay a higher multiple of earnings - a higher price in effect - for stocks that are expected to deliver superior earnings growth. Hence, utilities - which will do well to deliver any real earnings growth at all - command very low price earnings ratios while IT stocks - perceived as capable of delivering premium growth - command much higher ratings. Sectors such as housebuilding generally trade on a relatively low price earnings ratio because earnings per share in that industry can easily rocket for two years and then slump for three. In other words, a lack of consistency and visibility of earnings will also damage the PE rating a stock can achieve.
Buying into stocks on high PE ratios can be rewarding, if they deliver the goods. If ABC Plc trades at 100p and is forecast to deliver 2p of earnings this year, 3p next time, 4.5p, the year after and 6.75p the year after (i.e. 50% earnings growth per annum) you might be deterred from buying it initially because it traded on a forward price earnings ratio of 50. But if you look just three years out, earnings will have grown so fast that the stock would - at 100p - by then be trading on a forward PE of just 14.8 (100p divided by 6.75p). For a stock delivering earnings per share growth of 50% per annum such a PE would be ludicrous and hence the shares would - all things being equal - trade at a much higher price. In other words, buying into high PE stocks can pay off.
Equally you should not be lured into assuming that a stock on a low price earnings ratio is cheap. Often the price is telling you something.
But Caveat Emptor!
If a stock trading on a price earnings ratio of 10 issues a profits warning its stock may fall by 10 or 20% - on such a low rating, there was clearly some bad news "in the price" already. But if a stock on a glamour PE ratio issues a warning, prepare to lose a lot of money. Let's return to ABC Plc, which is still trading at 100p. Having achieved 2p of earnings in year one, it suddenly reveals that trading has weakened considerably and instead of earnings being set to rise by 50% per annum, 10% a year (or less) is now on the cards. Suddenly instead of owning a stock trading on a forward PE of under 30, investors own stock on a forward PE of 46. And what is worse is that instead of being a growth stock, ABC Plc's prospects are now starting to look very ordinary. If it is set to deliver only market-average earnings growth why should these shares trade on a PE ratio more than double the market average?
Of course, the next move is inevitable. Shares in ABC Plc are likely to slump to around 40p at which stage they will trade on an average sort of PE ratio. That is the risk in buying highly rated shares - there is no room for disappointment. One slip and you will lose heavily.
Beginners Guide to earnings per share
Any company can increase its reported profits simply by buying another company using its own shares as the currency. But is that necessarily good news for its own shareholders? Take for example Widget PLC which has 100 shares in issue and in calendar 2010 is predicted to make a pre-tax profit of £120.
Example A
At the start of 2001, Widget buys Crooks.com a company that is forecast to make a pre-tax profit of £12. This deal is likely to boost group profits by 10%. Widget funds its purchase by issuing new shares, to be precise 20 new shares to the owners of Crooks.com. Hence the effect of this deal is to reduce the share of group profits which is technically attributable to each shareholder from £1.20 to £1.10 (profits of £120 + £12 divided by the new number of shares in issue (120).
Example B
Had Widget bought Crooks.com by issuing only 5 new shares this deal would have been far more attractive to its existing shareholders as the profit attributable to each share in 2001 would have been £1.26.
Profits and earnings
Note that we have used the term profits so far and that is because all the figures referred to have been pre-tax numbers. Earnings per share (EPS) are defined as "the post-tax profits of a company divided by the average number of shares in issue during the period in question." Hence (if one assumes a normalised tax charge of 30%) pre Crooks deal, Widget was on track to generate earnings per share of 84p in 2001 (pre-tax profits of £120, become £84 after tax and there are 100 shares in issue). After buying Crooks.com on the terms of example A, predicted earnings per share are set to fall to 77p (pre-tax profit of £132 becomes a post-tax profit of £92.4 which is divided among 120 shares).
Under the terms agreed in example B, Widget's earnings per share for 2001 are likely to rise to 88p (post-tax profits of £92.4 divided by 105 shares). Hence while deal A is said to be "earnings dilutive," deal B is said to be "earnings enhancing." Had Widget funded this transaction by issuing 10 new shares it would be said to be "earnings neutral."
Of course not all deals are funded by issuing new shares. Widget could have funded this purchase by taking on extra debt. If the interest costs from doing so exceeded the extra operating profits generated by the deal, it would of course be deemed to be "earnings dilutive" in that the effect of doing the deal would be to reduce earnings per share.
The moral of this tale: issuing new shares is not necessarily bad news. If the money raised is invested well it can actually add to returns per share.
Why are earnings so important?
Because the EPS of a company represents the amount that will be returned to the owner of each share either directly (via a dividend) or indirectly as "retained earnings" which are reinvested in the company so adding to its net assets. Earnings = dividends + retained earnings.
Holy Grail
As investors we like to unearth companies that not only have a consistent record of growing their earnings historically but also that are likely to continue to do so for the foreseeable future. But be careful.
For a start, earnings growth is not everything. Is the company generating cash? How strong is its balance sheet? And are those earnings numbers distorted either by constant changes in the tax charge or by accounting policies that strike you as odd? If the company has a low tax charge currently, how long will it stay low?
And how visible (i.e. secure) are the earnings of a company going forward? Personally, I would bet that the forward earnings of Widget PLC (a dull metal-basher) are far more visible than those of Crooks.com (a B2C web-site). Finally, you must ask yourself if a company's earnings growth potential is not already discounted in the share price.
Beginners Guide to to Shorts and Shorting
Every fortnight Evil Knievil says at www.t1ps.com that he is "short of a stock" or is "shorting it." Quite simply that means that he has sold shares which he does not own in the hope that when he comes to buy them back they will have fallen in price. This is known as "running a short position." Someone who owns shares is said to be "long of stock" or running a "long position".
A more aggressive form of shorting is known as "bear raiding". Someone running a short position generally does so in a passive manner. That is to say, he or she will sell the stock and wit for it to fall before buying it back. A bear raider will not only take a short position but will then mount an aggressive campaign to drive that stock down. Evil is occasionally a bear raider.
In the early 1990s he bear-raided Maxwell Communications by sending out faxes to City analysts explaining why the company's accounts were not to be trusted. Evil has been known to order a company's shareholder register and to telephone shareholders individually explaining "certain facts". Within some restrictions on what can be said, this is a totally legal form of bear raiding.
Beginners Guide to Reverse Takeovers
Company X is quoted - that is to say it has shares that are traded on a recognised market. Company Y is private. However company Y is worth far more than Company X and wishes to buy it - it therefore engages in what is termed a reverse takeover. That is to say Company X launches an all-share bid for Company Y and issues so many shares in this transaction that Company Y ends up owning the majority of the enlarged share capital of Company X. Though Company X is the nominal purchaser it will be Company Y that runs the combined entity - hence the phrase reverse takeover.
For Company Y the attraction of such a deal is that it can make an acquisition without using cash and that - often as importantly - it can gain a quote for its shares without enduring the cost and regulatory argy-bargy of a formal flotation.
Obviously for shareholders in Company X there are two considerations:
1. They are trading in one management team for another - is this an upgrade?
2. They are exchanging 100% of the assets/earnings/dividends of one entity for less than 50% of the assets/earnings/dividends of another entity. If Company X had net assets of £100 and its shareholders were to end up owning 33.3% of the equity of the enlarged group (post the takeover of Company Y) that would look attractive if Company Y came with assets of £300 (£100 has become worth £133) but if company Y had net assets of just £140 then shareholders in X would be swapping 100% of £100 for 33.3% of £240 (i.e. £80) which is not such a good deal.
Reverse takeovers can be an effective way of injecting vibrant private companies into less than exciting quoted entities and thus restoring value for their shareholders. The most extreme examples of this would be when busted dotcom shells (true value: zippo) launched takeovers of profitable private companies. Shareholders in the dotcom shell may end up owning only 1% or less of the new group but 1% of something is worth more than 100% of nothing!
But with all deals you need to check out the exact terms and also to take a view on management.
Beginners Guide to to RNS (Regulatory News Service)
If a company has any announcement that may be deemed to be price sensitive (ie that might move its share price) it has to inform the market. It does this by sending an announcement to the Stock Exchange which will then issue an official notice via its own Regulatory News Service (RNS).
The scope of what sort of news merits an RNS statement is a little blurred. Some items such as: results notification; dividend payment and ex-div dates; directors dealings; results; trading statements; AGM statements; certain dealings in shares by anyone owning over 3% of a company or takeover news are pretty clear cut: the company must issue a statement in order to maintain an "orderly market". And that requirement sometimes also prompts a company to issue an RNS announcement saying that it is "unaware of any reason for a movement in its share price".
But other announcements are less clear cut. If a company agrees a new distribution agreement, signs a joint venture or wins a new order it may or may not put out an announcement. The decision whether to do so rests upon whether the news is likely to move the share price. If a large company wins a new contract worth £1 million it might seem like big money to you or me but actually, spread over a couple of years it might only boost revenues by a fraction of a percent per annum. Hence there is little point announcing it. If a microcap stock signed such a contract that might account for 15% or more of this year's projected revenues and so that company would make a statement.
Be warned: some companies are so desperate to drive their shares higher that they will RNS announce more or less anything!
Beginners Guide to MBOs (management buy-outs)/MBIs (management buy-ins)
An MBO is when a company's current executive directors wish to buy that company. If that company is quoted they must make an offer just like any other predator. But it would be unfair on the company's other shareholders if the executive directors could make an offer and then - as a board - approve it. It would be very hard for shareholders to recommend such a "recommended offer" although when Alan Sugar tried to take Amstrad private some years ago the shareholders did indeed reject his kind proposal, arguing (correctly as it emerged) that the bid was far too low.
Hence an MBO proposal will only be considered by those directors not involved in the deal, usually the non-executive directors. They in turn will take advice from the company's broker. It is presumed that the broker will be independent and - to be fair - it is unlikely that the broker would wish to damage its reputation by supporting a bid that was palpably too low. Assuming that the MBO bid is supported by the non-execs it should proceed as per a normal bid.
An MBI is slightly different in that the predator is an external management team that wishes to take control of the company.
The Common Feature
Most bids that we see are by one quoted company for another. In essence you will be asked to swap your paper in company A for shares in company B, for cash or for a combination of cash and shares. An MBI or MBO team have no paper to offer and hence they must raise the cash for a bid themselves. This is usually done partly with bank debt, partly with money put up by the MBI or MBO team themselves but also with cash provided by a venture capitalist such as 3i.
Whereas the banks lend money to an MBO team secured against assets, venture capitalists lend money in return for an equity stake. If the MBO or MBI goes bust, the banks will probably get most if not all of their cash back but even if it flies their upside is limited to the interest they receive. The venture capitalists (VCs) will lose everything if the company goes bust but the upside is that they receive a substantial stake in the business in return for their cash. The management team will also own a good portion of the business - in return for far less money than the VCs inject. But in order to ensure that the MBO team is really motivated, VCs will usually demand that the MBO team put in enough cash that it will really hurt the managers if the enterprise fails.
A variant
A variant on this theme is a Leveraged Buy Out (LBO). In this case the buy-out is largely funded by debt or junk-bonds. The deal is leveraged because if the enterprise is successful (because it is so highly geared) the returns for those holding the small amount of equity are phenomenal. But if it fails to fly, an LBO can quickly drown in its own debts.
Beginners Guide to dawn raids
As soon as any shareholder in any quoted company owns more than 3% of that company, he, she or it must declare that interest in an official statement released through the Regulatory News Service (RNS) run by the Stock Exchange. And if the investor subsequently increases his stake such that his interest passes through another full percentage point of ownership (i.e. 4%, 5% etc) he must make another announcement. Incidentally if the investor is selling down a stake the same rules apply.
These rules mean that if a potential predator is looking to build a stake as a platform to launching a full bid it is very hard to do it incrementally as the market will be notified of your intentions by those RNS releases and will mark the price up accordingly. Hence potential predators tend to build their stake in one large go via a "dawn raid".
A predator's broker can stage a dawn raid by contacting a large number of institutional investors (usually first thing in the morning) and simply bidding them for stock that they own. Because companies' shareholder lists can easily be ordered the broker will know exactly which fund manager to talk to.
But a simpler way of staging a raid is to buy out two or three large investors - such a move would have to be carried out as a result of several days of negotiation. Of course, one advantage of owning a large stake before launching a formal bid is that it acts as a deterrent to a second bidder entering the contest. And if a second bidder does come in and gazump you, at least you will share in the upside that a higher offer brings!
Beginners Guide to bid & offer & mid price & spreads
How much does a share cost? It sounds like a silly question. Just look in a newspaper or on teletext and you will see that, for instance, Marks & Spencer (MKS) shares cost, say, 400p . But of course if you want to buy or sell shares in Marks you will not trade at 400p. Confused?
Bid & Offer
When a broker goes into the market to trade stock for you from a market-maker he will be quoted two prices. The lower of these two prices is the price at which the market maker will bid your broker for stock (i.e. buy it from him) - this is termed the "bid-price." The higher of the two prices is the price at which the market-maker will offer your broker stock for you (i.e. will sell it to him) - that is termed the offer.
So when you are wishing to buy stock, the price in which you are interested is "the offer", and when you want to sell you are interested in "the bid." The gap between the bid and the offer is known as the spread. And it is via the spread that a market-maker takes his turn.
Mid-Price
The price that you will see quoted in the paper (and which we use on t1ps.com) is the mid-price. The mid-price is simply the average of the bid and offer price.
Must the bid be lower than the offer? You would have thought so but this is not always the case. Sometimes (usually when a stock is plunging) share prices move so fast that one market maker gets left behind and thus you can actually find yourself in a situation where it is theoretically possible to buy stock from one market maker cheaper than you can sell it on to another. This situation - which is rare and will last only temporarily - is known as backwardation.
Why are some spreads wider than others?
Marks & Spencer is a fairly liquid stock. A market maker would not mind running a reasonable position (either long or short) because he knows that he can close that position down relatively quickly. Hence he is quite happy to encourage business. And since there are a number of competing market makers, that tends to produce a narrow spread (0.2%).
But that is not always the case. Take a small cap company whose spread could be 10% or more. In this case there are perhaps only two or three market-makers and if one of them gets lumbered with a position of even 50,000 shares (long or short) and the share price moves quickly against them it would be hard to close out without taking a really quite painful nip. There is simply not that much trade in many small cap shares. Hence in order to deter people from executing large orders and hence to protect a neutral book, the market makers are happy to run with a wide spread. A wide spread is thus indicative of illiquidity.
Beginners Guide to share consolidation or share splitting
In a share consolidation, quite simply a company announces that it will in effect be cancelling a certain percentage of the shares outstanding. Hence if it is planning a one for ten consolidation then 90% of its shares in issue will - at a given date - be cancelled. So if you owned 100 shares prior to that date you will suddenly find yourself owning just 10.
Is the company worth any more?
The company has the same assets/profits and liabilities both before an after the consolidation so there is no logical reason why a consolidation should alter its market capitalisation. If its market capitalisation was £200 million and it had 200 million shares in issue each share would trade at £1. If it announced a 10 for 1 consolidation it would have 20 million shares in issue, each trading at £10. Someone owning 100 shares before the consolidation would swap an investment worth £100 (100 times £1) for one worth £100 (10 times £10).
Can a consolidation be reversed?
Of course it can. Sometimes companies will announce a "bonus" or scrip issue of shares - in effect a share split. A 9 for one bonus issue would thus serve to increase the number of shares in issue tenfold. As above the theoretical effect on the company's market capitalisation is nil.
So why consolidate?
There are a number of reasons why companies may wish to consolidate their shares.
1. Not to be classified as a penny stock. Some institutions regard shares trading at sub 10p as the sort of shares that should be "left to private investors." Equally some private investors will - for reasons that may be hard to understand - only buy penny shares. By losing a long tail of small investors and bringing on board some institutions the company is likely both to be re-rated and to cut the - not insignificant - costs of sending interim and annual reports to all its investors.
2. To improve the spread. If a share has a mid price of 1.5p the chances are that the spread will be (at best) 1.25p-1.75p, i.e. 33%. Were that stock to announce a 100 for 1 consolidation the mid price should be 150p and the spread is unlikely to be worse than 140-160p - i.e. 13%. The process of consolidation thus slashes the spread making this stock far more attractive to buy.
3. In the US, the listing rules for Nasdaq state that if your stock price falls below $1 for 30 days you will be de-listed unless you can produce a plan to correct the de-rating. One obvious plan is a share consolidation. It is artificial but it works.
And why split?
Again, there are a number of explanations:
1. In the US it is quite normal for a stock to trade at $100 or more. In the UK investor psychology is such that we prefer to buy lots of lowly priced stocks rather than one high priced investment. Of course that psychology also suggests that a pound of feathers is lighter than a pound of lead. However, whether investors are misguided or not, companies will sometimes split their shares to make them appear "less expensive" and thus more desirable.
2. Some companies have a relatively small free float of shares. That is to say that most of their stock is tightly held by long-term investors or managers. If such investors are unwilling to sell, the price movements of that stock can be incredibly volatile simply because it is so illiquid. For such companies it may make sense to engineer a stock split simply to create a larger number of "loose" shares so making the stock more liquid and tradable.
Conclusion: The Mirrors Can Work!
The process of consolidation or splitting does not alter the fundamental value of a company and hence, logically, it should not alter the company's market capitalisation. But as we have seen above there are good reasons why a company may wish to alter its shareholder structure and why that process can trigger a modest re-rating of its shares.
Beginners Guide to demergers
A demerger is quite simply when a company splits itself in two. As a shareholder in a company that is about to demerge you will own a certain percentage of the equity in that company. Post demerger you will, all things being equal, own the same percentage of the two (or possibly more) demerged companies. Hence if you owned 1% of ICI (ICI) back in 1990, when it spun off its pharmaceuticals arm Zeneca - now AstraZeneca (AZN) - you would have found yourself owning 1% of ongoing ICI and 1% of Zeneca.
Normally, if a company demerging is quoted then it will ensure that both of the demerging companies are also quoted. As a shareholder you need do nothing but alter your records.
Why do companies de-merge?
In short: because they think that the distinct parts will be valued more highly than the combined group. You might think that this is nonsense because surely the City can always do a sum-of-the-parts valuation and see through any demerger benefits. And of course the cost of running two separate companies with two separate stockmarket quotes will be higher, so eating into profits. In theory (assuming no change in PE ratings) that would force down share prices.
But the City does not always think through sum-of-the-parts valuations. Let us return to ICI. Within the old ICI, the pharmaceuticals arm was very much the junior partner. At that time chemicals stocks traded on PE ratios in the low teens, drug stocks in the high twenties: ICI as a whole was valued at a slight premium to the rest of the chemicals sector (because of the drugs excitement) but not a great premium. When the companies split, ongoing ICI was marginally de-rated: it traded in line with other chemicals plays. But Zeneca shares were fairly soon valued on a pharmaceuticals sector rating - i.e. the PE ratio for that part of the business soared. That created added value for shareholders.
Zeneca demonstrates another point about demergers: they can put part of a company in play as a takeover target. Zeneca merged with Astra of Sweden in the mid-nineties - a deal that again added real value for shareholders. But Astra would never have tried to do a deal with the combined old ICI group. Sure, it would have acquired a nice drugs business but it would also have bought - and had to go through the hassle of selling - a mammoth bulk chemicals business.
And there is a third reason to split. Back to Zeneca. Its management always felt that the ICI group was a cumbersome bureaucratic giant which stifled its entrepreneurial spirit and did not really understand its business. Sometimes smaller businesses need to be set free to realise their potential.
Do demergers always add value?
There are perhaps four reasons why a de-merger might not create value.
1. Timescale. A demerger will not take effect as soon as it is announced. Hence a stock may run up after the announcement but before the demerger. When the actual split takes place, that good news may be discounted and hence profits taking may set in.
2. The wider market (or sector) may start to tumble as a demerger takes effect. Thus good company news is offset by wider economic forces.
3. Trading fundamentals for one of the demerged businesses may be deteriorating and this might prompt it to be de-rated (i.e. moved to a lower PE) post the split.
4. There may be an institutional re-allocation of assets. Take as an example when property giant Burford (BUO) spun-off (that is to say demerged a far smaller entity) publisher Columbus into a separately quoted company by handing out free shares in Columbus to Burford's shareholders. The net result was that a number of managers running specialist funds that only invested in larger property companies suddenly found themselves owning a significant slug of a small publisher. It was quite inevitable that those funds would dump those shares. Not only were they not interested in publishing but also their holdings while forming a significant part of Columbus' shareholder list were very small relative to the size of the funds. Hence that created a large technical overhang in Columbus that depressed its share price post-demerger.
1 and 4 are short-term technical issues. If there is industrial logic behind a demerger and if trading fundamentals remain unchanged, then as a shareholder you should normally welcome such a proposal.
Beginners Guide to Broker Terminology
Buy, Strong Buy, Recommended List, European Focus List, Weak Buy, Strong Hold, 1, 2, 3M, 3L, Outperform - the list of possible broker recommendations is endless - but does it mean anything?
Context
Remember that institutional research is written for institutional clients whose performance is judged in relative, not absolute terms. In other words a fund manager is a star if he outperforms the FTSE All-Share not if he simply records gains: a 10% gain in a market up 20% is worse than a 10% loss in a market down 20%.
Hence when a broker is positive about a stock it is not saying that it will go up merely that it will outperform its peer group index.
Recommendations
Different brokers use different scoring systems. However, broadly they can be categorized into 7 distinct categories.
1. Buy (sometimes referred to as 1 by those brokers that use a numeric system). This means that on a 12-month view the broker expects the stock to outperform its peer group index by 10% or more.
2. Outperform, Add, Accumulate, 2, market outperformer. This means that the broker expects the stock to outperform but by less than 10%.
3. Trading Buy. This is something of a "cop-out." Essentially the broker is saying that this is poor quality stock but that its shares have fallen so far that the bad news is more than discounted. This is not a strategy followed by great investors such as Warren Buffett, who famously said: "if you don't want to own a stock for ten years, you shouldn't own it for ten seconds."
4. Strong Buy, European Focus List, Recommended List. Member of "Model Portfolio". Around 1999 when brokers realised that they rated most stocks as a buy, a few brokers decided to introduce various categories of "super-buys" - their overall favoured stocks.
5. Hold, Neutral, 3, Market Performer. Such a stock is expected to trade broadly in line with index performance over the following 12 months.
6. Underperform, Market Underperformer, Reduce, 4. Such a stock is expected to underperform the market by between 0 and 10% over the next 12 months.
7. Sell, 5. Such a stock is expected to underperform by 10% or more over the following year.
Simple? Perhaps not...
Given that we have been trading in a fairly tough market for the past two years, you would have thought that bearish research would balance bullish reports. Er... think again. A very small proportion of broker research suggests that clients should sell. At least two thirds of broker reports suggest that clients at least "add" to their holdings. Rather like University degrees their has clearly been quite a lot of "stance inflation" in recent years - hence the introduction of Recommended Lists, etc. There are four reasons why brokers say "buy" when they don't really mean it.
1. If a broker publishes a sell note on a company the most commission business that he can drum up is if the entire institutional shareholder base does indeed sell their stock through him - as such his research is likely to be of interest to a very small universe of institutional clients - pen a "buy" note and potentially every institutional client is a purchaser of stock and will thus be interested. For the same amount of work, one route clearly offers more potential commission business than another.
2. If you publish a sell note, current institutional holders will probably not sell but since the share price will be moved they will see the value of their holdings reduced. At an individual level that means that the performance of an individual fund manager will suffer and - over time - that can affect the level of his pay or bonus. Next time that fund manager has a large block of shares to buy or sell is he likely to give that commission earning business to the broker that has made him look like a schmuck or to one that has helped massage his portfolio with soothing "buy" notes?
3. The really big money for brokers is made not from buying or selling shares but from acting as a corporate broker to a company. That means handling any disposals, acquisitions, share buy-backs or fund raisings. This is mega-bucks territory. Rule 1 of corporate broking is that you do not annoy corporate clients by writing bearish research. At the very worst a company's corporate broker will rate a stock as a "hold" - more normally it is a buy. Hence for a "corporate hold" – you might well read "sell" and a corporate "buy" note is arguably not worth the paper it is written on.
4. A corporate brokership is not for life! Not only does the incumbent broker have to suck up to its clients but other brokers will also try to suck up to them with expensive meals and by penning flattering research. It only costs £100,000 in analyst time, printing and distribution costs to pen a medium-sized report and send it out to institutions. If such flattery helps you win a corporate mandate you could easily earn a tenfold return on that investment.
So Beware!
Of course when a company puts out glowing research on a duff company it does so to win that corporate mandate. The last thing it wants is its best institutional clients actually buying the shares and losing money as a result. So brokers will often quite happily communicate one message verbally to their favoured institutional clients while publishing another for the benefit of corporate readers.
But research has its uses. No analyst will publish forecasts without running them by the company for "guidance" and so broker notes can be a helpful source of financial forecasts. When well written (a rarity), it can also be a useful way of putting your own ideas about a company into context or a more rational order.
In addition, City analysts are paid an awful lot to cover one particular industry or sector in enormous detail. And so on their specialised subject they are - on the whole - pretty knowledgeable. If you can tap into that knowledge do so but just take their recommendations with a pinch of salt.
Beginners Guide to Stags & Stagging
A "stag" is someone who buys into a new issue ahead of the flotation with the sole intention of selling out as soon as the stock makes its market debut, hopefully making a quick profit. The process of doing this is known as "stagging" while the practice of selling the shares very quickly is sometimes referred to as "flipping."
Like Duran Duran and Larry Hagman, stagging was big in the 1980s when - for political reasons - a large number of highly accessible share offerings (the privatisations) were priced at levels at which they were bound to make decent gains after flotation. Anyone could be a stag back then.
The decline in stagging is partly due to changes in the listing rules which mean that private investors get access to far fewer new issues now than used to be the case. These days the choice new issues are saved for favoured clients of institutional brokers while ordinary investors are usually only offered rubbish or over-hyped stocks which are never going to fly.
And of course any stag would find it hard to operate in a bear market when there are very few new issues and no guarantee of a liquid and buoyant secondary market for those that do manage to make it off the starting blocks. As a general rule those stocks that debut at a level below their flotation price rarely make it back to that level.
Beginners Guide to why shares fall after a rights issue
Why is it that shares fall immediately after a rights issue is announced?
There is a simple answer and - on some occasions - a deeper issue. Perhaps the first question is: "what is a rights issue?"
Companies wishing to raise more money can do so in a number of ways. One option is to borrow more money from the banks. If the amount that it wishes to raise is small, and as long as it has obtained at a prior AGM broad shareholder approval to issue more shares, it can simply place (or sell) a small number of shares with new investors. There is a statutory limit on the size of such "placings".
If the company wishes to raise more money it can undertake a "rights issue." That it is to say it issues new shares and existing investors have an automatic right to buy those shares. If ABC Plc announces a one-for-four rights issue, that means that its current investors will have the right to buy one new share (at a stated price) for every four they currently hold. Normally such fund raisings are underwritten by stockbrokers who - in return for a small fee - agree to buy any stock at the rights price which current investors choose not to take up.
So why should shares fall on such news?
In order to persuade existing shareholders to buy more shares the new shares have to be priced at a discount to the current price. If the stock in question is a bit of a basket case and the fund raising is in effect a "rescue rights issue" then the discount is likely to be "deeply discounted." But having announced the level of the discount in all cases, a process of arbitrage begins. Let's take a hypothetical example.
Prior to the announcement of a 1 for 1 rights issue at 60p, shares in jokecompany.com traded at 70p. But if you purchased one share in jokecompany.com at 70p you would gain the right to buy another at 60p meaning that having exercised your rights you would own two shares bought at an average cost of 65p.
Sounds like a bargain? Well perhaps up to a point.
Because in any situation it is likely that some investors will either not want, or not be able, to take on board fresh stock, any rights issue is bound to create some stock overhang. You just know that some of the owners of these shares bought at 60p will be keen to flip them for a quick turn. And that - in all cases tends to drag the pre-rights price lower. And because the market assumes that this will be the case that markdown tends to occur not when the actually flipping occurs (because by that stage it is already discounted) but when the issue is first announced.
Short term-pain...long term...er?
So there is almost always a short term markdown associated with any rights issue. What happens thereafter depends very much on the underlying story. If the cash is merely being raised to rescue a bad management or a duff company there is no compelling reason why the de-rating should not continue. But if the company concerned can show that every 100p raised in the rights issue will be used to create well in excess of 100p of added shareholder value then the shares should subsequently increase in price. In such circumstances it can be worth buying into a stock once an issue has been announced - and its shares have fallen back slightly - but before it goes ex-rights.
For once a stock has gone ex-rights then any purchaser of that stock buys only the underlying share not the right to buy the newly issued shares. That right remains with the owner of the share immediately before it went ex-rights.