Market Mechanisms

By Gary Pearson (Stocks and Commodities Magazine)

The basic purpose of a stock exchange is to create a facility where shares of companies are freely available for trading. Thus a quoted company is a company, the shares of which are available for trading on a stock exchange. The other very important reason for the existence of stock exchanges is that is a facility whereby companies can raise capital and thus provide for their expansion and for the growth of employment and investment, which will be beneficial for the whole economy of the country concerned.

Companies raise money, by using either debt or equity. Debt would normally imply borrowing money from banks or other financial institutions, equity by the issue of shares. In other words, if a company feels that it requires one million rands of capital to finance its business, it will either borrow that sum and then pay, say 19-20% interest, or else it will take the equity route and issue shares from the company, either to the founders or to the public (usually through the stock exchange).

Should one use the equity route, the issued share capital of a million-rand company could be:

R 1 000 000 divided into 1 000 000 shares of one hundred cents each. The company could raise money from the public by issuing, for example, a further five hundred thousand shares at one hundred cents each, or whatever price they decided upon.

There is a distribution of a share of the companies profits to its shareholders. This takes place through dividends. A company would need to pay approximately two hundred thousand rands of interest annually on a loan of one million rands, but would probably only pay thirty to forty thousand rands to shareholders, provided that the company appeared to have good prospects for making increased future profits.

Therefore equity sometimes allows the company to obtain capital at a cheaper rate than a loan from a bank. Their shareholders should benefit because of their share in present and future profits. Increased profits normally lead to increased share prices and therefore there is a second prospect of gain.

Factors governing share prices

Now let us examine the factors that govern the price. The biggest single factor is a simple one. Supply and demand. Should demand exceed supply the price of the share will rise and alternatively, it will decline should supply exceed demand. However, the question is, what causes one or the other to be dominant?

Many factors cause supply. For example, with the winding up of a large estate, there may be very few buyers in the market and the sellers might have to accept a lower price.

The main factor causing a rise in demand is usually the weight of available money. In this country the pension funds, insurance companies, etc., need to find a home for the ever increasing monthly premium income.

While there can be little doubt that "supply and demand" ultimately governs the price of shares, the most important economic factor is that of interest rates. Should rates rise, investors would require a larger income and therefore shares would fall, while if interest rates fell the opposite would prevail. Thus while interest rates are rising, shares fall quickly in a bear market and when interest rates ease, we have a rising or bull market.

Other very important factors

1. What is the present state of the South African economy?

2. The state and prospects of the world economy, as South Africa is both an exporter of primary commodities and manufactured goods, and

3. What is the state of the South African political scene and that of the world generally?

For self evident reasons, political factors play a much greater part locally than in other country's. However, in the UK for example, the likelihood of a Labour victory at the polls would normally result in a decline in the market, as would the prospects of a Democratic administration in the US. The reason is that big business usually perceives these parties as a threat.

All world stock markets influence each other, but the most important are Wall Street in the US, the London stock market and Japan's Nikkei Dow. However, there are very important markets in almost all the country's of Europe, while the most dynamic markets are mostly in the country's of the Pacific rim, such as South Korea, Taiwan, Hong Kong, Thailand, Singapore and in Central and South America, such as Mexico.

Mining shares

Most stock markets consist mainly of industrial shares. The South African market and to a slightly lesser extent Canada and Australia have very developed mining markets. At one time, South Africa was almost exclusively a mining market. Although the same factors govern the price of mining shares, they are obviously heavily dependent upon the price of the particular metal, such as gold and platinum, which is again dependent upon supply and demand, interest rates and (especially) the state of world inflation.

Factors that come into play when one considers the price of gold shares include:

1. The grade of ore mined,

2. The cost per ton milled,

3. The cost per ounce produced and

4. The mines expected life.

For several years costs have been increasing annually at more than the inflation rate. However, in the past few years or so there has been better control and this has not been the case.

When the price of gold rises strongly, mines tend to concentrate on lower grade ore, to lengthen the life of the mine. At times such as those prevailing at present, mines concentrate on higher quality ore to cut costs and maximize profits. Unfortunately that shortens the life of mines.

Thus it may often benefit investors to buy mining finance houses, which normally have large holdings of gold, platinum and other mining shares, plus in many cases, large industrial holdings. Unless one is an expert, this is normally a safer option.

Many of these companies also hold rights to ground, which have mining rights. Exploitation of these rights will then take place at some stage. If that company then finds a profitable source of metals in that ground, the public will perceive the share price to be under its true value and an upward price correction will most likely take place. A further attraction is that these shares more often than not trade at a discount to the value of the underlying holdings.

Industrial shares

When speculators analyze industrial shares, the most important factors to consider are what the earnings and dividends of those shares are? One would generally buy shares that have rising earnings and the best prospects would be those which would show an annual increase in earnings of 20% or more over a long period of years.

After deciding which shares to buy, one would consider when to buy. The right time is normally when the price/earnings ratio of a share is at a relatively low level. The price/earnings ratio is the relationship between the price of the companies' shares, say one hundred cents and the earnings, say ten cents. In that case the price-earning ratio would be ten. The Indicators and Terminology section will cover this later in the Shares chapter.

The sophisticated stock exchange investor uses different tools to assist him or her with decisions. You can find information about the earnings and dividends and all other relevant facts about companies, from various financial journals and newspapers. This is an aspect of Fundamental Analysis.

In modern times a further very important mechanism has come into use. An alternative is Technical Analysis and involves the use of sophisticated charting systems. Nowadays, the use of both fundamental and technical analysis is the ideal approach.

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