CHAPTER 2

INVESTING IN STOCKS

Learning Objectives

Identify the most important features of ordinary

shares, preference shares and the various types of
stocks in the market.

Describe the primary and secondary markets and

the processes involved in both markets.

Chapter Outline

What is a Share of Stock?

Why do Investors Invest in Shares?
Classes of Shares Ordinary and Preference
Shares
Privileges and Legal Rights of Ordinary
Shareholders
The Rights of Preference Shareholders
Category of Preference Shares
Types of Stocks

Chapter Outline

Primary Market
Initial Public Offering (IPO)
Why Companies Go Public?
Listing Methods - Public Offer for Sale and
Private Placement
The Cost of an IPO
Rights Issue

Chapter Outline

Secondary Market
Stock Exchanges
Listing Requirements
Bursa Malaysia
Over-the-Counter Market
Types of Orders
Buying Stock on Margin
Selling Short
Stock Market Indexes
FTSE Bursa Malaysia KLCI

What is a Share of Stock?

A share of stock is a financial security issued by

an incorporated company to raise long-term
capital for business growth and expansion
activities
A share of stock is actually the smallest unit of
ownership in a company.
Shares may be of different classes, carrying with
them different rights as to dividends, that is, as
to participation in the profits of the company,
return on capital on winding up, voting, etc.

Why do Investors Invest in

Shares?

Income from dividends - Dividends are a

distribution of profits. Companies pay dividend
either every six months (interim) or on a yearly
basis.
Capital gain from the appreciation of share
value Strategy of buy low and sell high.
The difference between the purchase price and
the selling price represents the capital gain or
the profits reaped by the investor

Classes of Shares
Two main classes
Ordinary Shares/Common Stock
Preference Shares/Preferred Stock

Ordinary Shares

Ordinary shares are issued to investors who are

interested to be the owners of a company.
A shareholder can be an individual or a
company that legally owns one or more shares of
stock in a company.
Ordinary shares are also known as equity
capital or equities for short.

Privileges and Legal Rights of

Ordinary Shareholders
Voting privileges.

1.

Right to vote for the BOD

Right to information.

2.

Right to minutes of meeting, list of shareholders,

audited financial statements, etc.

Pre-emptive rights.

3.

Right of existing s/h to purchase newly issued shares

before they are offered to public. Able to maintain
proportionate ownership if desired.

Privileges and Legal Rights of

Ordinary Shareholders
Rights to dividends.

1.

Right to earnings of the company.

Limited liability.

2.

Limits the liability of s/h to the capital owned in the

company plus unpaid portion if any.

Residual claim.

3.

In case of liquidation - right to claim the asset of the

company after all the creditors and preferred s/h. has
done so.

Preference Shares

Preference shares differ from ordinary shares in

that they typically do not carry voting rights but
are legally entitled to receive a fixed level of
dividend payments.
Preference dividends are not tax deductible in
computing the tax liability of the issuing
company and this may not be attractive for some
investors.

The Rights of Preference Shareholders

1.

2.

3.

Before a dividend can be declared on the

ordinary shares, any dividend obligation to the
preference shares must first be satisfied.
The dividend rights are often cumulative such
that if dividend is not paid, it accumulates from
year to year.
Preference shares may or may not have a fixed
liquidation value, or par value associated with
them.

The Rights of Preference

Shareholders (continuation)
4.

5.

Preference shares have a claim on liquidation

proceeds in the event of a company failure.
Preference shares have a negotiated fixed
dividend amount

Category of Preference Shares

Cumulative preference shares.

1.

Entitles for profit at stated yearly dividend. Arrears

are carried forward.

Non-cumulative preferences shares.

2.

If div. is not paid in any of the year, s/h will lose the
right for that div.

Participating preference shares.

3.

Have the right to further profit after ordinary s/h

received their stated div.

Category of Preference Shares

Redeemable preference shares.

1.

Redeemed by the company at a later date.

Convertible preference shares.

2.

Allows the holders to exchange for a pre-determined

number of the companys ordinary shares.

Types of Stocks

Blue Chip (high priced stock because of their demand and

safety)
Penny (low priced, speculative stocks, risky)
Income (pay higher-than-average dividends)
Value (companies with good potential but selling at low
price)
Defensive (stocks whose prices stay stable when the
market declines)
Cyclical (fluctuating prices depending on
business/economic cycle)
Treasury (stock that has been bought back by companies
issuing it e.g. due to under-pricing of shares)

Initial Public Offering (IPO)

An IPO happens when a privately owned

company issues shares of stock to be sold to the
general public for the first time.
The money investors pay for the ordinary shares
in to become the stockholders of the company,
flows direct to the company that makes the
offering.
IPO is basically a way for a company to make
money based on expectations of future success
and profit but is highly risky.

Why Companies Go Public?

1.
2.
3.
4.
5.
6.

7.
8.

9.

10.

To obtain more capital to finance growth.

To source long-term capital.
To allow owners to realize their assets.
To make the shares more marketable.
To enable payment of managers by stock options.
To facilitate growth by acquisition.
To enhance the companys image.
To act as a catalyst for the participation of foreign
partners.
To establish good corporate governance practices.
To boost employee pride.

Listing Methods

There are two methods by which an unquoted

company can obtain a quotation on a stock
exchange.
Public Offer for Sale.
Private Placement.

Public Offer for Sale

When companies go public for the first time, a

large issue will probably take the form of an
offer for sale.
Shares can be offered to the public either at a
fixed price or by tender.
A prospectus will be drawn up and is intended to
provide investors with the information they need
to decide whether to invest in the company or
otherwise.

Private Placement

Shares are offered to clients or other contacts of

the investment bank leading the issue, rather than
to the general public.
Costs of advertising the shares and producing
documentation are reduced. This is attractive to
smaller companies.
Disadvantages include shares end up being held
by a smaller number of more powerful investors
and that often the discount on the issue is greater
than with public offers.

The Cost of an IPO

IPOs can vary greatly from one company to

another, and they require a long, expensive and
complicated process.
A company needs to consider the costs of
engaging underwriters, attorneys, accountants as
well as printing costs of prospectuses and the
listing fees imposed by the stock exchange.

Secondary Market

Once the the stocks are sold in the primary

market, they can be sold time and again in the
secondary market.
The secondary market is a market for existing
financial securities that are currently traded
among investors.
This ability to buy and sell stocks in the
secondary market is the reason why stock and
other securities are very popular among
investors.

Over-the-Counter Market

The over-the-counter (OTC) market is a network

of dealers who buy and sell the stocks of
companies that are not listed on a stock
exchange.
Over-the-counter trading unlike stock exchanges
is done directly between two parties with a
market maker (dealer) as the middleman.
An over-the-counter dealer who sit at a computer
terminal will match all the buy and sell orders for
that particular share of stock.

Stock Exchanges

A stock exchange is a corporation which

provides a place and facilities for the trading of
shares issued by companies, unit trusts, other
pooled investment products and debt securities
like debenture and bond.
A stock exchange can be considered as a
marketplace where traders and member brokers
who represent investors meet to buy and sell
stocks and other securities on behalf of their
clients.

Types of Stock Exchanges

Physical - physically located and transactions are

executed on a trading floor using a method
known as open outcry
Virtual - equipped with a network of computers
where trades are conducted electronically
through the actions of traders.

Bursa Malaysia

Bursa Malaysia is the only stock exchange approved by

the Minister of Finance under the provisions of the
Securities Industry Act 1983.
Bursa Malaysia is a self-regulatory organization with its
own memorandum and articles of association.
It is responsible for the surveillance of the marketplace
and for the enforcement of its listing requirements,
which spell out several criteria for listing, disclosure
requirements and standards to be maintained by listed
companies.

Listing Requirements of
Bursa Malaysia
Main Market
Profit Test
Uninterrupted profit after tax (PAT) of three to
five full financial years (FY), with aggregate of
at least RM20 million; and
PAT of at least RM6 million for the most recent
full financial year.

Listing Requirements

Listing requirements are the set of conditions

imposed by a stock exchange upon companies
that want to be quoted on that exchange.
Such conditions may include minimum number
of shares outstanding, minimum market
capitalization and minimum annual income.
Listing requirements vary by stock exchange.

Listing Requirements of
Bursa Malaysia
For listing requirements on the ACE (Access,
Certainty and Efficiency) Market, please refer
to Table 2.2 in the text.

Stock Market Indexes

Stock market indexes track the movements of

securities prices in a market or a section of a
market.
Each of the indexes tracks the performance of a
specific basket of stocks considered to
represent a particular market or sector of the
economy.

Types of Stock Market Indexes

1.

2.

3.

4.

Broad-base index - represents the performance of a

whole stock market and by proxy reflects investor
sentiment on the state of the economy.
Price-weighted index - an index in which each stock
influences the index in proportion to its price per
share.
Market-value weighted or capitalization-weighted
index an index whose individual components are
weighted according to their market capitalization, so
that larger components carry a larger percentage
weighting.
Market-share weighted index - price is weighted
relative to the number of shares, rather than their total
value.

FTSE Bursa Malaysia KLCI

Used to be known as the Kuala Lumpur Composite

Index (KLCI) and is the main stock market index in
Malaysia.
In July 2009, Bursa Malaysia together with FTSE, its
index partner, integrated the KLCI with internationally
accepted index calculation methodology to provide a
more investable, tradable and transparent managed
index - FTSE Bursa Malaysia KLCI (FBM KLCI).
FBM KLCI is a market capitalization weighted index
with 30 component stocks.
To ensure that the component stocks do not over-present
or under-present certain sectors, the number of
component stocks selected for different economic
activities is also constantly correlated with the sectoral
contribution to gross domestic product.

Types of Orders
Market order - a request to buy or sell shares of a stock
at the best price available when the order reaches the
marketplace.
Limit order - a request to buy or sell shares at a
specified price (the limit) or better.

A limit order to buy therefore states the highest price the

investor is willing to pay for a purchase. E.g. a limit order to
buy a stock for RM10. The shares will not be purchased until
the price drops to RM10 or lower.
A limit order to sell ensures the investor sells at the best
possible price, but not below a specified value set by the
investor. (the lowest price the investor is willing to accept.
E.g. a limit order to sell a share for RM15. The shares will
not be sold until the price rises to RM15 a share or higher.

Types of Orders

Stop loss order - an order to sell a particular stock at the

next available opportunity after the price of the stock
reaches a specified amount. This is frequently used to
protect an investor against a sharp drop in price and
therefore reduce the amount of loss on a stock
investment. E.g. If an investor owns a stock that is
declining in price, he might want to place a stop order
loss. This will instruct the broker to sell if the price falls
to a certain level, in order to prevent further losses.

Rights Issue

A company already listed on the stock exchange

wishing to issue additional new shares can do so
by offering a rights issue
A rights issue provides a way of raising new share
capital for the company by means of an offer to
existing shareholders, inviting them to subscribe
cash for new shares in proportion to their existing
holdings.
A rights issue must be low enough to secure the
acceptance of shareholders who are asked to
provide extra funds, but not too low, so as to avoid
excessive dilution of the earnings per share.

Rights Issue (continuation)

An existing shareholder therefore has the
following options with a rights issue:

Take up his rights by buying the specified

proportion at the price offered.
Renounce his rights and sell them in the market.
Renounce part of his rights and take up the
remainder.
Do nothing.

(Study example: En Malik)

Rights Issue - Example

Encik Malik holds 2,000 shares of Boustead

Berhad. The market price of the shares currently
stands at RM1 per share. The company
announces a one-for-four rights issue. The
subscription price for the new shares is fixed at
RM0.80 a share.
Show the changes to En Maliks wealth if he
decides to:

Take up the rights

Renounce his rights and sell them in the market
Renounce part of his rights and take up the remainder.
Do nothing.

Rights Issue - Take up his rights by buying the

specified proportion at the price offered.

The value of holding before the rights issue:

= 2,000 shares x RM1 = RM2,000.
cum rights price

En. Malik will have to purchase 500 new shares at a price

of RM0.80. Therefore he has to pay RM400 to the company
(500 shares x RM0.80)
After a few weeks from the initial announcement , the
shares go ex-rights (investors has no longer the rights to
buy the new shares). The share price, known as the
theoretical ex-rights price will be:
Total value of investment = RM2,000 + RM400 = RM0.96
Total number of shares held
2,000 + 500

Rights Issue - Take up his rights

Current value

Theoretical value after rights issue (2,500 x RM0.96) = RM2,400

Less: Purchase price (500 x RM0.80)
= RM 400
Net wealth
= RM2,000
Hence, the overall wealth is unchanged.

= RM2,000

Rights Issue - Renounce his rights and sell them in the

market

Since rights have a value, they can be sold on the stock

market in the period between:
The rights being announced and issued to existing
shareholders, and
The new issue actually takes place
Value of a right = RM0.96 RM0.80 = RM0.16
By selling 500 rights, he will get 500 x RM0.16 = RM80
Therefore, change of wealth:
Current value
=RM2,000
Theoretical ex-rights price (2,000 x RM0.96) = RM1,920
+ Sale of rights
= RM 80
Net wealth
= RM2,000
(unchanged)

Rights Issue - Renounce part of his rights and

take up the remainder.

En Malik decides to sell 420 of his rights and buys 80

shares.
By selling 420 rights, he will get 420 x RM0.16 = RM67.
By buying 80 shares, he has to pay 80 x RM0.80 = RM64
Therefore, change of wealth:
Current value
=RM2,000
Theoretical ex-rights price (2,080 x RM0.96) = RM1,997
Less: Purchase price of 80 shares
= RM 64
RM1,933
+ Sale of rights
= RM 67
Net wealth
= RM2,000
(unchanged)

Rights Issue - Renounce half of his

rights and take up the remainder.

No. of rights sold, 250 rights

Value of rights sold: 250 * 0.16 = RM40
Exercise, 250 rights to get 250 shares,

Value of investment = 250 *0.80 = RM200

En. Malik wealth

2250 shares * RM0.96
Income from rights sold
Cost of investment
NEW WEALTH
% owned (2250 * 0.96)/2500

=
=
=
=
=

2160
40
(200)
2000
86%

Rights Issue Do nothing

Therefore, change of wealth:

Current value
=RM2,000
Theoretical ex-rights price (2,000 x RM0.96) = RM1,920
(Net wealth)
Therefore, loss of RM80

Buying Stock on Margin

Buying on margin lets investors borrow some of

the money needed to buy stocks by setting up a
margin account with a broker.
The margin requirement is set by the authorities
regulating the stock exchange and is designed to
protect the broker against a fall in the value of
securities to the point they no longer cover the
loan
Investors who buy on margin will need to pay
interest on the borrowings made from the broker.

Buying Stock on Margin

(continuation)

Investors buy on margin because the financial leverage

provided by borrowing money can increase the return on
investment.
To illustrate, let us say Mr. A wants to buy 400 shares of a
stock at a current price of RM20 a share. The total cost
would be RM8,000. If he decides to buy on margin, he will
need to deposit RM4,000 into the margin account and
borrow the remaining RM4,000 from the broker. In a
situation where the share market price of the stock rises to
RM40 and he decides to sell, the proceeds from the sale will
be RM16,000. He will then repay the broker RM4,000 for
the amount borrowed and pocket the remaining RM12,000
himself (minus interest and commissions). The profit made
is almost 200% on the RM4,000 original investment.

Buying Stock on Margin

(continuation)

Buying on margin can be risky in a declining

market. E.g. if the market price of the 400
shares owned by Mr. A drops so much that
selling them would not raise enough money
to repay the loan from his broker. Mr. A will
then receive a margin call from his broker.
This additional margin is intended to cover
the potential fall in the value of the position
on the following day.

EXAMPLE
DAY

VARIATION GAINS

Investment Value: 400 shares X RM20 = RM8000

Initial Margins requirements (50%) : RM4000
Amount borrowed from broker: RM4000

4000

Share price rise to RM30

Gains: (30 20) X 400 = RM4000

8000

Share prices drop to RM20

Loss (20 30) X 400 = 4000

4000

Share prices drop to 15

Loss: (15 -20) X 400 = 2000

2000

Assume maintenance margin: RM3000

Investor will receive a margin call and will have to top
up his account by RM2000 to initial margin

4000

1
2
3

Share prices rise to RM45

Gain: (45 15 ) X 400 = RM12000

BALANCE (RM)

16000

Buying Stock on Margin

(continuation)

E.g. It is agreed between the two parties that the

broker will issue a margin call if the value of Mr. As
investment falls below 75% of his original value.
Lets say the value of the shares purchased for
RM8,000, has now reduced to RM5,600.This value
is less than 75% of the initial investment. To meet
the margin requirement of RM6,000 (75% x
RM8,000), Mr. A would have to deposit RM400 into
the margin account to bring it back to an
acceptable limit.

Selling Short

Selling short is a way for investors to make money in a

declining stock market by borrowing rather than buying
stocks. (refer to next slide for illustration).
The biggest risk about short selling is how well you can
forecast the market direction. If you correctly predict
that a stock will decrease in value, you will profit from
selling short. If you predict incorrectly and the value of
the stock increases, then you will pay more to cover
your short position than you made from selling the stock
resulting in a big loss from your investment.

Selling Short (continuation)

To illustrate, assume the current market price of Short Berhad is

quoted at RM40 a share. Due to some economic forecasts, you
predict the stock market will decline and the share price of the
company will decrease in value over the next three months. In
order to profit from this situation, you decide to short sell and you
contact your broker to borrow 10,000 shares of Short Berhad. The
broker then sells the 10,000 shares on your behalf at the current
price of RM40 a share.
Let us assume that after two months, your prediction is correct,
the market is in a shamble and the share price of the company
actually falls to RM20 a share. You then instruct your broker to
buy 10,000 shares of the company at the current RM20 a share.
The 10,000 newly purchased shares are then returned to the
broker to replace the shares that you have borrowed two months
ago. From the short selling, you have actually made RM200,000
(RM400,000 selling price RM200,000 purchase price =
RM200,000 profit) minus the commissions for buying and selling
of the stock to the broker.

Investors Monitoring

Management serve as agents for shareholders by controlling

and making decisions to maximize stocks price.

But, the separation of ownership (shareholders) &

control(management) resulting to agency problem.

Managers tend to fulfill theirs interest rather than align with

shareholders interests.

Shareholders can monitor managers performance by

monitoring the stocks price - when price decline/ not to
the level expected, shareholders may blame weak
performance on the managers.

Investors Monitoring (continuation)

1)

By monitoring share prices

-when price decline/ not to the level
expected, shareholders may blame weak
performance on the managers.

2)

Accounting irregularities
- management tend to manipulate financial
statements. However, investors monitoring of
some firms are limited because the auditors
not properly audit & the audit committee not
oversee the audit properly.

Investors Monitoring (continuation)

3)

Sarbanes Oxley Act (U.S)

4)

Shareholder Activism
i) communication with the firm (informal)
- communicate with other investors to
put pressure to the company
- e.g. power of institutional investors
ii) Proxy contest (formal)
- to change board composition

Investors Monitoring (continuation)

5)

Shareholder Lawsuits
- investors sue the companys board if they
believe the directors not fulfilling their
responsibilities to shareholders.
- this action intended to force the board make
decisions that aligned with shareholders
interests.

- e.g. to prevent merger, takeovers, acquisition

etc.

Corporate Monitoring
1)

Stock repurchases
- asymmetric information managers
have information about the firms future
prospects that known by investors.
- if management believe companys share
price is undervalue, they use the excess cash
to purchase the shares.
- generally, study found that share prices
respond favorably to this signal.

Corporate Monitoring (continuation)

2)

Market for Corporate Control

- if a firms share price is relatively low
because of the poor performance of the
management, it may become an attractive
target for takeover.
- therefore, market for corporate control can
encourage managers to make decisions that
maximize the share value to avoid takeovers.

Corporate Monitoring (continuation)

Barriers :
1)
Antitakeover amendments
- e.g. need 2/3 shareholders vote to approve takeover
2)
Poison Pills
- special rights awarded to shareholders or specific
managers on the occurrence of specified events.
- e.g. shareholders get the rights to be allocated an additional 30%
of shares without cost whenever a potential acquirer attempts
to acquire the firm
3)
Golden Parachutes
- specifies compensation to managers in the event they lose their
jobs or there is a change in the control of the firm.
- e.g. all managers might have the right to receive 100,000 shares
whenever the firm is acquired.