How does the sharemarket work?

@wogitalia Thanks for taking the time to explain. I don't completely agree but I am on my phone. I won't try to respond in detail on this device. I might not be back on until tomorrow.

 

@wogitalia, I disagree with your suggestion that a company is at the whim of share holders:

If a company raises equity, there is nothing that would force them (at least that I am aware of) to "buy back the equity".

If a company raises $1 million to 10 shareholders (privately for simplicity sake, $100k per shareholder), then the company spends $800k of that capital on startup costs, keeping $200k for working capital. If 5 of those shareholders decide they want to sell their share of the business they can't then just expect the company to stump up $500k (which they no longer have anyway) to buy them out. They can sell their shares and get a higher or lower price for them, it has no impact on the companies capital/assets. Though increased demand for shares on the secondary market (and higher share price) can allow a company to raise additional capital at a higher valuation/with less dilution.

I agree that investing in established property can reduce Australia's productivity though. It's wasted capital pumping the same dollars through property at higher and higher prices, reduces drive for investors to put their capital into innovative enterprise, it drives up land & rents, increasing expenses for business and making Australian companies less competitive in the global market.

 

Excellent post @wogitalia and indeed I read your post differently to Guest in that I did not think you were inferring companies are at the whim of shareholders.

Much like property investing too!

 

Thanks Guest. Do you agree with @wogitalia's assertion that without the secondary market, companies would not be able to raise capital? I don't agree. I understand a company raising capital is more or less productive, examples like Dick Smith notwithstanding. However, I don't accept that equity can't exist without the secondary market. I also don't accept that speculative trading on the secondary market is particularly productive or that it has particular direct economic benefits.

The same arguments could be used about margin loans for speculative trading as for speculative real estate investment... that it soaks up all the capital so businesses can't borrow.

It's interesting that the same tax incentives and concessions are available to property investors as speculative share traders (except no first share buyers grant). However, property remains vastly more popular than the stock market in Australia. Restricted land supply, cheap credit and tax incentives simply do not adequately account for this.

 

I think you've misunderstood my point on this front. That "buy back the equity" is a hypothetical based on if a secondary market (aka the stock market) did not exist to allow owners to exit. Essentially if you removed the equity market then people would more than likely only be willing to "lend" money to companies on debt terms.

The point being if you removed the stock market the only alternatives would be that businesses would have to buy back equity when an owner wishes to leave or an owner would not be able to leave on their own terms and that if the business was forced to buy back it would remove their benefit of choosing equity in the first place (being the flexible "repayment" terms) and if you remove the ability to exit ownership that equity would become entirely unattractive to potential investors.

Agree with everything else you've said, even the point in rebuttal to what you've read what I said to mean, you're spot on that in the current structure and environment where large equity markets exist that there is nothing forcing companies to buy back equity.

Not actually my point mate, you only need to look at unlisted and private companies to see that businesses are able to raise capital, most private companies will never have a transfer of equity issue and removing the secondary market would not impact that at all.

The point is not so much the issue or raising capital as it is what would have to happen to that equity when ownership do wish to change, most private companies that are not between related parties will have complex shareholder agreements to deal with this very situation because of the incredible complexity it can create. The share market allows the largest and generally most productive businesses to have flexible ownership structures that allow the equity that has been invested in them to remain within them if and when ownership changes.

Any money invested in the share market is people investing directly in that company by allowing that equity to be maintained instead of repaid.

The difference is that the money being borrowed by the individual owner is being invested into a business by providing it as equity to that company. It's the same as the owner of a private company borrowing money in his own name and putting it into his private company for his business to use.

This is fundamentally not true.

Firstly a share trader is treated as a business, which means that any share trader is instantly excepted from the capital gains regime and the generous concessions it affords, you can't have negative gearing and the capital gains concessions together. Further to that you have the non-commercial loss provisions which disallow the loss being offset against other income unless the activity is substantial. Not to mention that record keeping requirements to qualify as a share trader and access the possible negative gearing is substantially higher than any other business.

If you have access to the capital gains concessions by being deemed a share investor then you do not have any access to negative gearing. Property is distinct in being allowed to have its cake and eat it too. In fairness the franking credits do make dividends an attractive income source for many investors, of course they work in the inverse of negative gearing where those with the highest incomes receive the biggest tax benefit.

I think you also vastly understate the impact of cheap credit or more importantly available credit, people can leverage and easily borrow to invest in property, it is actively advertised and encouraged by the government, banks and the multitude of real estate and property bodies who actively promote just how easy it is to borrow for property. There is a very good reason why APRA is targeting property loans and not share loans which are very hard to get. Whereas 90% LVR is readily available for property loans the general maximum LVR you will see on shares is 70% and even that will be severely restricted in what shares you will be allowed to buy and the total portion of your portfolio any share can makeup, basically to borrow for shares you need to give up a significant amount of control over your investment. It would be like if for a home loan you could nominate a suburb and the bank then got to pick the house and any research you did was irrelevant.

You only need to look at superannuation, where until recently borrowing was all but impossible to see this impact. SMSF's in Australia invest 31.7% of their assets in shares and only 15% in property. When you take borrowing out of the equation and investment is driven purely by available funds they are channeled towards business at a ratio of 2:1. I couldn't find the breakdown for the rest of investors who all have the borrowing ability discrepancy but I believe you in that more people invest more money in property than shares.

I will also add that mentality is a massive part of the equation, a mentality that has been fostered and created for decades now and is so fundamental to our entire economic position that it's not going anywhere and more importantly can't go anywhere. Housing has been engineered into the primary investment product for the average Australian. It is what it is, my original point was that this engineering helps make property the investment that it is, by having it feverishly protected by government intervention you get to have the cake and eat it, you've got government backing for your investment and can be pretty sure they will continue to do what they can to prop it up at the cost of everything else. My point was simply that this is unfortunate because property is fundamentally one of the worst asset classes for the economy as a whole, it's a selfish asset class that does little for the broader economy.

 

Sorry if I've missed your point @wogitalia, but the title of the thread was 'How does the sharemarket work?', so adding lots of hypothetical scenarios really dilutes the message you are trying to get across. For example where you say 'if you removed the stock market', what do you mean by this? Just remove the exchanges, because shares in companies could still change hands privately without a convenient way of pricing them...

Both the share market/investors and established property market/investors do serve a purpose. It's not feasible for everyone to own their own home, so this pool of investors holding a portion of stock serves a useful purpose to people and the economy. I would consider trying to prove which is more useful an impossible exercise as everyone will have a different idea on how to measure it.

Can you sum up your disagreement with @Perthguy in a single straightforward sentence or two without the wall of text? Perhaps it's the case I agree with what you're saying, but to be honest it's hard to tell with the posts in the thread so far.

 

An entire book could be written about this subject but the next para explains in a nutshell why the sharemarket is 'productive'.

The sharemarket is a vital cog in the financial the system. The role of the financial system is to facilitate (or enable) the reallocation of capital around the economy in the most efficient way possible. If there was no secondary trading, then while capital could still be reallocated via other measures, eg debt, mergers etc, it would NOT be AS EFFICIENT, because one option is gone, ie the equity market.

I Will use a company I hold as an example, Syrah Resources which is developing a resources project.

It needed capital to develop that project.

It needed to make a choice as to the most efficient way to raise that capital. Debt, mix of Debt and Equity or Equity. In the end it decided the most efficient (ie value adding) option was equity. If secondary trading did not exist, then this equity option, nor the debt/equity option, would be available.

 

That's it,most underestimate what is called investment courage and some risk takers are the side-product of media and their own delusions,then overconfidence ,then overoptimism,then underestimation of the final possible adverse outcomes,and regrettably some take it all too seriously,80-20 rules,greed vs fear,what you have to find within yourself is it's only a number on a page,put all the screens on,add some music,then make the phone call sit back and watch the number change..

 

Yeah, you've kind of jumped in the deep end, it's a thread dragged across from discussion in another topic. The hypothetical was purely to illustrate the purpose of the stock market and what it means to business. @Perthguy's original point was that the stockmarket, outside of IPOs and share raising, serves zero purpose in the economy and that it provides nothing to business to which I disagreed.

I felt the easiest way to illustrate what it does is to show the options left if it is removed from the equation and what this would mean for business and investors.

On the last point this again ignores PG's position that the secondary exchange of shares provides absolutely nothing to a company. Yes that would absolutely exist even without the exchanges but the original point was that anyone who buys existing equity in a business provides nothing to the economy or business they buy in, hence removing the stock market (not just exchanges) to show what is left without it from the business perspective.

That wasn't really ever the argument for what it's worth. Yes I believe that investment in business and innovation provides more to the economy than investment in property (like nearly all economists do) but we were never actually arguing that aspect.

The argument was from PG that investing in business via the provision of equity did not do anything for business, essentially that buying shares in a company provided no benefit to the economy at all.

At it's most basic level...

Me - The share market provides a vital service and investment in good businesses provides more to the economy than property.

PG - The share market is worthless beyond IPOs and share issues and that any money invested via it provides zero to the economy and that as such property is a far better asset class for the economy as a whole than business and enterprise.

 

No wonder we are arguing. You appear to have no idea of what I am saying. I no way or nowhere have I ever claimed the stockmarket (outside of IPOs and share raising) serves zero purpose in the economy.

Not my position.

Incorrect. Not my argument.

Not even close. Quite hilarious though. Thanks for that one.

In case anyone has followed this far, I really don't think property investing is a better asset class for the economy as a whole than business and enterprise.

Guest, it's a lot more simple than that. Here are the claims that @wogitalia, using his words and not my loose interpretation of them:

I don't agree. I don't think that investing in property is incredibly unproductive. The obvious alternative to investing in property is investing in shares. My point is that I don't see trading shares as particularly productive. And then we get to this:

This is simply not true. Borrowing money to trade shares on the secondary market does not increase the amount of equity available to a business. It is not the same as the owner of a private company borrowing money in his own name and putting it into his private company for his business to use.

If I borrowed money to buy shares on the primary market, that would be same as the owner of a private company borrowing money to invest in his business. Borrowing money to trade on the secondary market is not nearly the same thing.

 

Guest A simple version is if you classify property investing into active (property developers, renovators), which could be considered the primary market, and passive (buy, hold, rent), which could be considered the secondary market.

The sharemarket is divided into the primary market (to raise capital) and the secondary market (where shares are traded).

Even @wogitalia agrees that the primary property investing market is productive and I agree the primary share market is productive. It is the secondary markets that are disputed.

@wogitalia's view is the secondary real estate market is incredibly unproductive and provides no direct economic benefits. I accept that the secondary real estate market is not particularly productive but I argue that it provides some direct economic benefits.

My view of the secondary share market is that it is not particularly productive and that it does not provide direct economic benefits or direct benefits to the companies whos shares are being traded. @wogitalia's view is that secondary trading of shares provides direct economic benefits and increases the amount of equity available to a business.

 

Because it has been an emotional, not factual/rational argument so far, I don't even know how much money we are really arguing about. In Australia very roughly, residential real estate averages around at 70% owner occupier, 30% investor split. We know that not all investors are passive investors, so passive investors would make up less than 30% of the overall market. I would like to see a number put on the estimated investment in passive property investment. Considering the claim that housing is the primary investment product for the average Australian, does this stack up in terms of numbers against the value of super?

The most recent number I can find is that the total value of investor loans stands at more than $500 billion. If this is right, then residential property investment pales into insignificance when compared to superannuation, at an estimated $1.5 trillion.

Banks understated value of investor loans by $50b: RBA

Super has been engineered to be the primary investment product for the average Australian.

 

These are your exact quotes:

"If I buy BHP shares today, sit on them for 10 years and sell them for a profit, how does that benefit the company, the economy, society or anyone else except me. I see that as more "unproductive" than property."

"If you had taken any care to read my comment, you would have seen that I specifically referred to purchasingexisting shares. These comments do not apply to IPOs or capital raising by issuing new shares. These are different. They do represent an investment in a company and could be argued to be productive. If you think that buying a company share from a private shareholder, sitting on it and later reselling it for a profit to another private shareholder benefits a company, it just indicates a fundamental lack of understanding of economics at its most basic level."

I'm sorry if I've misunderstood them but they pretty clearly say to me that your opinion is that providing equity to a company via the share market "does not provide benefit to the company, economy, society or anyone else" and that your position specifically excludes "IPOs or capital raisings" which are "different" in your words.

If I've misunderstood those points, I apologise.

 

Super is a vehicle or structure rather than an asset class. You put money into Super and then use it to invest in specific asset class (generally shares, cash and property are the main 3).

 

Since you both have different view points because you both have misunderstood each other, it's a draw.
0-0.

 

Since we don't seem share any common ground, there is probably no value in arguing this any further. I will leave you something to think about though. You claim that:

But that's not true, is it?

I quoted before that the value of loans for resi property is estimated to be around $500 bn. The value of superannuation is estimated at around $2 trillion. With an estimated 60% of Australian superannuation funds invested in shares, that would put the value of shares at over $1 trillion.

If that is true, then through compulsory super, shares have been engineered into the primary investment product for the average Australian. I don't know if my numbers are accurate but I know this, a lot of people got a huge shock during GFC when they had a huge chunk of their super wiped out when the share market crashed.

Australian share market’s plunge wipes out billions of dollars in superannuation gains​

http://www.news.com.au/finance/supe...rannuation-gains/story-e6frfmdi-1226111378034​

For an investor who feels they are too exposed to shares (through compulsory super), what investment asset class are they going to turn to?

This comment is in the context of this:

So you remove residential property as an asset class. My super is invested predominantly in shares, than am I to leverage to invest in shares outside of super? What will happen, as I near retirement, if a GFC style crash wipes out a significant portion of my savings? I could also be forced to sell some shares at a loss to meet a margin call. This actually happened to people I know during GFC. It resulted in delayed retirement for some of them. Instead of retiring, they had to keep working for years after they planned to retire.

I would rather have super diversified in shares and other non-residential asset classes. For my investments outside of super, I will diversify my portfolio and mitigate some of the risks by investing in residential property.

Personally, I think your notion of removing residential property as an investment asset class is ridiculous for the reasons I have outlined above. Whatever. It is a property investment forum after all, so if you don't like people investing in property I guess don't expect a good reaction when you complain?

 

Perthguy, the initial shares in BHP or any other publicly listed company starts off through an IPO. Funds raised in that initial IPO went directly into the company coffers to fund its expansion, etc.

That is, all share holders own a % of the company through their equity/share holding - and like any asset, it can be sold on to someone else....who then holds the same privileges as the original owner of the shares.

The company benefited from the original IPO and those benefits are shared amongst its equity/share holders.

I sorry. I may be missing something, but currently, I don't understand your argument.

 

The argument is that investing in residential rental properties is unproductive and trading on existing shares on the stockmarket is productive. My argument is that a company does not directly finacially benefit when their shares are traded on the secondary market. There are also few direct economic benefits that flow on from people trading shares on the secondary market.

In some ways, investing in residential rental properties is more productive than trading shares on the secondary market.

 

But don't you see that without a stock market, many companies wouldn't exist. The world economy as you know it wouldn't exist.

Imagine if you tried to lock people into holding onto stocks they bought through IPOs for any company, I would suggest that the majority wouldn't invest if they could never sell. The world economy runs on the stock market.

It is as productive as owning an IP.......probably more so.

 

Correct, but no one is calling for the stock market to be abolished. The argument is about the relative direct economic benefits of the primary and secondary markets. We understand the primary market is productive. Next question is, could the primary market exist without the secondary market?

No one is suggesting that people owning stocks could never sell. Just that they could not be actively traded (sold to any person at any time). Would people still invest in companies offering a return on their investment? Would people invest in an asset that is less liquid than an existing share. The argument was that Australian's won't invest in illiquid assets. The concurrent claim is residential rental properties are Australian's biggest asset class. Last time I checked, residential rental properties are considered an illiquid asset. Something isn't adding up here. Can you see my problem with this argument?

You are making the same argument that has been made before. You are guessing that companies would not exist without the secondary market and therefore trading shares on the secondary market is more productive than investing in residential rental properties. I don't agree. That argument only works if you restrict people from ever selling shares and no one is suggesting that.