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INTRODUCTION TO THE STOCK MARKET
Stock markets operate like an auction house where buyers and sellers can negotiate prices and trade on those prices. As of 2019, there were 91,000 publically listed shares in the world. The United States alone boasted more than 15,000 listed companies.
Equity markets are designed to confuse outsiders. Not only do they bring together the largest collection of badly dressed, gibberish hollering nutcases since Woodstock, but they also find exhilaration in the information that would send an accountant into a Rip van Winkle coma. In this section, we are going to take a dive into the stock market lexicon and what makes the market tick.
Primary vs. Secondary Markets
When companies are born, the moment they pop out of the womb and the umbilical cord is cut, they need to be fed. Drawing on my limited knowledge of the female anatomy, it is safe to say that women have two breasts. Breast one provides equity funding – this is the private capital invested by the founders. Breast two is the debt provided by lenders like banks. All this feeding takes place in private because female breasts are not supposed to be displayed and consumed in public. When breast number one no longer provides enough milk for life and godliness, the company needs to find a bigger boob – and there is no bigger boob than the public equity market.
Shares are “floated” in the primary market. This is where the brassiere is removed and all the privacy evaporates. The act of taking a company public is also known as an Initial Public Offering or IPO. Public companies need to open their kimonos and reveal everything. They come under extreme scrutiny. Instead of only having to answer to a handful of known shareholders, they are now accountable to any Tom, Dick, or Sally who buys their shares. They need to get off the couch, the Mars bars, the potato chips, and the daytime television and get onto a strict exercise regimen. The days of a sedentary life filled with smutty magazines, greasy takeaways, sweaty palms, and male pattern baldness are in the past. Every ounce of cellulite will now be publicly examined.
One of the biggest IPOs in history was Alibaba Group Holding Limited, the Chinese answer to Amazon. It went public on September 18, 2014, at a whopping $21.8 billion valuation. Four days later, underwriters exercised an option to sell more shares, bringing the total IPO to $25 billion. The IPO was priced at $69 and the lead bookrunner was Credit Suisse. The bookrunner is paid to list the company at a price favorable to both the investors and the company. Alibaba’s first steps as a public company were wobblier than the little house on the prairie during a tornado. In its first year, it went from $68 to $59 causing investors to drive voodoo needles into Credit Suisse effigies. The stock, however, found its feet and rallied 425 percent to its peak of $310 in October 2020.
After the IPO, the share moves from the primary market into the secondary market. We now exchange conservative corporate financiers for a bunch of crazy stockbrokers.
Crazy Men in Ugly Jackets Shouting and Screaming
Before the 1980s, all buying and selling of stocks was done in pits using a system of open outcry. This was a place were frothing at the mouth and uttering ungodly expletives was a normal day at the office. Monthly exorcisms were required during which demons were extracted and cast into herds of pigs which in turn were sacrificed to the gods.
Using a combination of shouting and hand signals, information was transmitted to the pit where trading took place. Palms facing out and hands away from the body indicated a sell order. Palms facing in and hands up indicated a buy order. Numbers one through five were signaled on one hand, and six through ten were gestured in the same way only held sideways at a 90-degree angle (index finger out sideways is six, two fingers are seven, and so on). The numbers gestured from the forehead were blocks of ten. Bids and offers were manually loaded up on the board for all to see.
In the 1980s, open outcry started to be replaced by electronic trading. Some traders did not make the transition. Human physicality dominated the trading pit. Five-foot tall traders with a voice pitched like a small field rodent did not last long. Former linebackers who weighed 300 pounds were perfect for life on the floor.
I knew many traders who only lasted a couple of years in the new world of electronic trading. They could not adapt to a world that instead of shouting orders and chalking up bids and offers on the big board, one needed to type these orders into a computer. The screaming was replaced with the almost silent whirring of computers and the hand gestures were replaced with keyboards and mouse clicks.
I recall one former colleague who incorrectly entered an order. Blood rapidly drained from his head. He sat motionless for a few seconds, thrust his chair back, and then lurched his 250-pound frame forward, diving under the desk to pull the PC power chord from the wall. He believed that his catlike reflexes and agility were faster to the speed of an electric current.
I started my trading career in South Africa on the Johannesburg Stock Exchange in 1997. I joined one year after open outcry had been abolished. Johannesburg was the fourth major exchange to move to electronic trading after the London Stock Exchange (1986), Borsa Italiana in Milan (1994) and the Bombay Stock Exchange in 1995. The New York Stock Exchange moved to electronic in 2007 although it does still execute a small percentage of its trades on the floor.
Private versus Public Stocks
As the name suggests, private equity is an equity investment in a private company and public equity is an equity investment in a public company. The words "private" and the "public" are thrown around the market indiscriminately. At times they are used to differentiate government (public) from non-government (private). This is not the case in equity markets where public means publically listed and private means unlisted.
Normally, public is big and private is small. There are, however, some monstrous private companies. The largest private company in the U.S. by revenue, according to Forbes, was Cargill as per financial information from 2018. The company boasted $114.7 billion in revenue and 155,000 employees. This agribusiness juggernaut has topped Forbes' annual list of America's largest private companies for 28 of the last 30 years.
Founded in 1865, Cargill processes, trades, and exports agricultural products. It is owned by descendants of founder William Cargill and his son-in-law John MacMillan. The average Joe is not able to buy shares in Cargill. To date, roughly 100 members of the Cargill and MacMillan families control 90 percent of the shares in the company. The other 10 percent are owned by employees.
That does not mean that private equity is out of bounds to all investors. Two of the largest private equity funds in the world are listed. The Carlyle Group and the Blackstone Group both manage large private equity portfolios. Blackstone, in particular, has delivered spectacular returns over the past ten years.
The stock has outperformed the Standard and Poor’s 500 Index delivering total returns of 815 percent to shareholders in the 10 years ending September 2021. In comparison, the S&P 500 delivered an “anemic” 285 percent.
Brokerage Houses – Once a Ticket to a Life of Debauchery
To buy and sell equities, you need a registered broker. The rules of global stock markets have been written in such a way that the average man on the street cannot go directly to the New York Stock Exchange and buy IBM stock. You need to go through an intermediary or a stockbroker.
Not surprisingly, these rules were written by the stockbrokers themselves. It is a thing of beauty when the monopolists start an exclusive club and then make it almost impossible for outsiders to enter.
Twenty years ago stockbroking was the ticket to a life of sex, drugs and rock 'n roll. It was one of the best-paid professions in finance and in the world. The life of a stockbroker was not far removed from a 1980s cigarette commercial.
You wake up to a liberal serving of French croissants, Brazilian coffee, and Catherine Zeta-Jones. You make your way over to the office in your private helicopter with a song in your heart and a Mont Blanc pen in your Hugo Boss breast pocket. Making use of your keen intellect and Sherlock Holmesian deductive reasoning, you would go about your day moving money from one bank account to another.
For this back-breaking work, you were paid obscene amounts of money. I started in a brokerage house in 1997 when the markets were roaring. Lavish parties, expense accounts, five-star travel and Verve Cliquot brut – and all before 10am. My first job was in a building next to the Johannesburg Stock Exchange. We were on the 11th floor and the offices for Playboy magazine were on the 13th floor. I found some interesting creatures in the elevator.
In the 1990s, brokerage commissions were obese. We would charge 2 percent for retail investors and 1 percent for institutions. The reason we could charge these kinds of fees is that we were a full-service broker. We offered high-quality research from top-rated analysts and best execution. Large institutions would allocate a fixed portion of their business to us as a reward for our research and execution.
This business model suffered a fatal body blow when it was revealed that research recommendations could be compromised. Analysts were sometimes recommending the purchase of shares because they were being "pressurized" by that very same company in return for corporate finance business. Let's take a peek into this dirty little secret.
To list your company on the stock exchange, you need to use a respectable broker that has good standing and connections in the market. They will prepare the documentation and make all the necessary filings to the exchange. They will also act as bookrunners. They go out onto the streets, in the non-prostitute sense although critics argue that the professions are not that different, and convince investors to buy the stock.
Now, this is where it gets a little tricky. The corporate financiers will call up the analyst who covers the sector in which the new company operates. Let's assume that it is a construction company. They will ask the analyst to analyze the company and publish a research report. In theory, there exists a Chinese wall between the two departments. It is one of those paper walls that you find in...well...China. In theory, the analyst will write an objective report.
But what happens when the analyst concludes the company is worth 10 but the banker wants to list it at 25? The analyst believes the company is uglier than my hairy aunt Mavis after a heavy night of booze and bingo with the girls. The bankers now require the analyst to turn hairy aunt Mavis into a bulimic underwear model in a wonderbra and a pair of red pumps.
This creates a conundrum. How can a banker go and roadshow a stock at 25 when his analyst believes its worth 10? The corporate financier needs to get the analyst "in line with the program". This could involve a trip down to the woodshed with a baseball bat and a water board. Nine times out of ten the analyst was able to "find" that 25 handle.
When the world cottoned onto this reality, the days of the full-service broker were numbered. Some investment clients started to turn a blind eye to the recommendation and only focused on the content of the research while they built their own in-house research teams.
Other clients separated trading from research altogether. They bought research from independent firms that started to surface and executed their trades through discount execution-only brokers.
Commissions were shaved to the bone and the days of wild Christmas parties, padded expense accounts and client trips to Vegas to watch Elton John were over. Change sucks but what can you do?
The lowering of commissions has helped to democratize equity markets. The advent of discount and online brokers has made it possible for anyone with a computer and a hundred dollar roll to open an account.
This is inordinately positive for rebel financiers because it means there is more dumb money to pick off the carcass.