Equity securities come in various forms, each with unique characteristics. Common stock grants ownership and voting rights, while preferred stock offers priority in dividends. Understanding these differences is crucial for investors navigating the stock market.

The structure of equity markets plays a vital role in how stocks are traded. Primary markets handle new issues, while secondary markets facilitate trading of existing shares. Efficient market theory suggests prices reflect all available information, impacting investment strategies and valuation methods.

Common vs Preferred Stock

Ownership Rights and Key Characteristics

• Common stock represents an ownership stake in a company, granting stockholders voting rights and the potential for capital appreciation and dividends
• Preferred stock typically does not carry voting rights but offers priority in receiving dividends and in the event of liquidation
• In the event of liquidation, preferred stockholders have a higher claim on company assets than common stockholders but rank below bondholders

Dividends and Callable/Convertible Features

• Common stockholders are entitled to a proportionate share of a company's profits through dividends, which are paid at the discretion of the board of directors
  • Dividends for common stockholders are variable and depend on the company's financial performance and board decisions
• Preferred stockholders generally receive fixed dividends that must be paid before any dividends are paid to common stockholders
  • Preferred dividends are typically expressed as a percentage of the preferred stock's par value (e.g., 5% of $100 par value)
• Preferred stock may have a callable feature, allowing the issuing company to repurchase the shares at a predetermined price after a specified date
  • This feature gives the company flexibility to retire the preferred stock if market conditions change or if the company no longer needs the capital
• Preferred stock can be convertible, allowing holders to convert their shares into a specified number of common shares under certain conditions
  • Conversion ratios and trigger events (e.g., stock price reaching a certain level) are set at the time of issuance

Equity Markets: Primary & Secondary

Primary Market and Investment Banks

• The primary market is where new securities are issued and sold to investors, typically through an initial public offering (IPO) or a private placement
  • IPOs involve a company selling shares to the public for the first time, while private placements involve selling shares to a select group of investors
• Investment banks play a crucial role in the primary market by underwriting securities, which involves purchasing shares from the issuing company and reselling them to investors
  • Underwriters assume the risk of the offering and help determine the initial price of the shares
• Investment banks also provide advisory services, such as assisting with IPO pricing and allocation
  • They help the issuing company navigate the regulatory requirements and market conditions to ensure a successful offering

Secondary Market and Stock Exchanges

• The secondary market is where previously issued securities are bought and sold among investors
  • This market provides liquidity for investors and allows for price discovery based on supply and demand
• Stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq, facilitate the trading of equity securities in the secondary market by providing a platform for buyers and sellers to trade shares
  • Exchanges match buy and sell orders, execute trades, and disseminate price and volume information
• Stock exchanges ensure fair and orderly trading by enforcing rules and regulations, such as listing requirements and disclosure standards, and by providing transparency in pricing and trading volume
  • Listed companies must meet certain criteria (e.g., minimum market capitalization, financial reporting) to maintain their listing on the exchange
• Over-the-counter (OTC) markets, such as the OTC Bulletin Board and Pink Sheets, provide a platform for trading securities that are not listed on a major stock exchange, typically involving smaller and less liquid companies
  • OTC markets have fewer regulatory requirements and less transparency compared to major exchanges

Market Efficiency & Implications

Efficient Market Hypothesis (EMH)

• Market efficiency refers to the degree to which stock prices reflect all available information
• The efficient market hypothesis (EMH) suggests that, in an efficient market, stock prices quickly adjust to new information, making it difficult for investors to consistently outperform the market
• The EMH has three forms: weak, semi-strong, and strong
  • The weak form suggests that stock prices reflect all historical price and volume data
  • The semi-strong form suggests that prices also reflect all publicly available information (e.g., financial statements, news)
  • The strong form suggests that prices reflect all information, including insider information

Implications for Valuation and Investment Strategies

• In an efficient market, equity valuation techniques based on fundamental analysis, such as discounted cash flow (DCF) models and price-to-earnings (P/E) ratios, may have limited effectiveness in identifying mispriced securities
  • If prices already reflect all available information, there may be fewer opportunities to find undervalued or overvalued stocks
• Market efficiency has implications for investment strategies, such as the debate between active and passive management
  • In an efficient market, passive strategies that aim to match market returns, such as index investing, may be more effective than active strategies that attempt to outperform the market through stock selection and market timing
  • However, some investors believe that market inefficiencies exist and can be exploited through active management
• Behavioral finance challenges the assumptions of market efficiency by highlighting the role of investor psychology and biases in driving stock prices, potentially creating opportunities for investors to exploit market inefficiencies
  • Examples of behavioral biases include overconfidence, herding, and loss aversion, which can lead to mispricing of securities

Factors Influencing Stock Prices

Short-term Factors

• In the short-term, stock prices are influenced by market sentiment, which reflects investors' collective emotions, opinions, and expectations about a company or the overall market
  • Positive sentiment can drive prices higher, while negative sentiment can lead to price declines
  • Sentiment can be influenced by factors such as media coverage, social media buzz, and investor psychology
• Short-term price movements can also be affected by news events, such as earnings announcements, mergers and acquisitions, changes in management, and macroeconomic data releases
  • Positive news (e.g., better-than-expected earnings) can lead to price increases, while negative news (e.g., a major scandal) can cause price drops
• Technical factors, such as trading volume, chart patterns, and support and resistance levels, can influence short-term price movements as investors make trading decisions based on these indicators
  • High trading volume can indicate strong interest in a stock, while low volume may suggest a lack of enthusiasm
  • Chart patterns (e.g., head and shoulders, cup and handle) and support/resistance levels are used by technical analysts to identify potential entry and exit points

Long-term Factors

• In the long-term, stock prices are primarily driven by a company's fundamentals, such as revenue growth, profitability, cash flow, and competitive advantage
  • Companies with strong fundamentals and growth prospects tend to experience price appreciation over time
  • Investors analyze financial statements, management quality, and industry trends to assess a company's long-term potential
• Macroeconomic factors, such as interest rates, inflation, economic growth, and government policies, can also influence stock prices in the long-term by affecting companies' operating environments and future cash flows
  • Higher interest rates can make borrowing more expensive and reduce the present value of future cash flows, potentially leading to lower stock prices
  • Economic growth can boost corporate profits and stock prices, while recessions can have the opposite effect
• Industry-specific factors, such as technological advancements, regulatory changes, and shifts in consumer preferences, can impact the long-term performance of stocks within a particular sector
  • Disruptive technologies (e.g., smartphones) can create winners and losers within an industry
  • Changes in regulations (e.g., environmental laws) can affect the profitability and growth prospects of companies in certain sectors
• Demographic trends, such as population growth and aging, can influence long-term stock prices by shaping consumer demand and the labor market
  • An aging population may increase demand for healthcare and financial services, benefiting companies in those sectors
  • Population growth can drive demand for housing, consumer goods, and infrastructure, supporting companies in related industries