BUSINESS WORLD Understanding Capital Market Operations in Sierra Posted by Dr Mohamed Jalloh on Dec 24, 2008, 17:19

Given the growing concern to improve on the poor growth performance of African countries, development of the financial sector attracted considerable attention from policymakers across the continent. Since the mid-1980s, most African countries have experimented with policies of financial sector reforms partly motivated by the Structural Adjustment Programs (SAP) articulated by the World Bank and International Monetary Fund (IMF), as well as efforts to catch up with the pace at which other developing economies; particularly the East Asian Countries have been growing.

The focus of the reform agenda in most of these countries aims at accomplishing extensive liberalization of interest rates, deregulation of the financial sector, strengthening the banking system, introduction of new financial instruments, and development of securities markets, particularly the stock market. Emphasis has also been  placed on the establishment as well as the expansion of already existing stock markets in an effort to expedite domestic resource mobilization as well as attracting foreign capital so as to boost domestic investment  and hence growth. The securities segment of the capital market complement traditional lending institutions by providing risk capital (equity) and loan capital (debt). By means of these instruments, the market is able to mobilize long-term savings and provide capital to investors to finance long-term investments thereby broadening ownership of productive assets.

Dealers in the securities segment of the capital market include banking institutions, stockbrokers, investment and merchant bankers and venture capitalists that intermediate between the market and the public. In this article, the author will elaborate on Stocks /shares, which are major financial securities, traded on the floor of a Stock Exchange.  First, the author will provide a brief description on what stocks are all about. This article will also discuss the different types of stocks/shares so as to guide the investing public on the appropriate financial instrument to invest their resources in. 

What are Stock/Shares? 

When companies wanted to raise funds from the general public to finance investment projects, they normally issue some form of ownership rights to the general public in the form shares or Stocks. Unlike a corporate bond which is debt security issued by a company, a Stock or Share represents an ownership claim on the earnings and assets of a corporation. 

A shareholder of a corporation is an individual that invest in the shares/stocks of a corporation. Once an individual holds the shares of a corporation, that individual is entitled to receive a share/ proportion of the corporation’s profit in the form of dividend payments.  At the end of the financial year, companies normally meet with their shareholders to disclose pertinent information concerning their annual operations and financial positions vis-ŕ-vis their profits and loss accounts. During such annual general (AGM) meetings, the board of directors informs the shareholders on whether the company can afford to pay dividend to shareholders or not.  Shareholders can only receive dividend payments if the company generates some profit on their operations. 

In a situation whereby a company is not able to make profit, then shareholders are not entitled to receive dividend payment since such payments can only be made if the company earns some profit from their activities. Unlike the holder of a corporate bond who is entitled to receive interest payment whether or not the company is making profit, a shareholder can only receive a dividend payment if the company makes profit.

In some cases, the company’s management may decide not to pay any form of dividend even though the company is making some profit. For example, if the management decides to reinvest all the company’s profit in an effort to promote future growth of the company, then stockholders cannot compel the management to pay dividend. Even when the company’s management decides to pay dividend, it cannot afford to pay all the profit earned as dividend but only a proportion of that profit is normally payable to shareholders as dividend. This is because; the company may decide to use part of the profit to reinvest in an effort to expand operations. The proportion of the total profit of a company that is paid to shareholders as dividend is referred to as the pay out ratio.

Thus, if the company has a pay out ratio of 40%, it means that the company can only afford to pay 40% of the total profit earned as dividend, thereby retaining the remaining 60% to reinvest into the business. The only bone of contention here is that, many shareholders prefer companies that pay higher dividend to those that pay lower ones. Investors generally want to put their monies in corporations that pay them high returns than those that pay low returns. So, the question of dividend payment is a very critical issue in corporate management because, while corporations can only raise more financial resources by having many shareholders, giving out all their profits in the form of dividend payments to attract more shareholders can also be detrimental in terms of future growth of the company.

On the other hand, a company that is desirous of reinvesting a higher proportion of its profit to boost future growth by paying lower dividend may also face the problem of loosing its shareholders who are mostly interested in the quantum of dividend payments they receive. However, if shareholders are generally interested in seeing their corporation growing, then a low dividend payment resulting from higher reinvestment rates may not be a serious matter to worry about by the management.  What then determines the optimum level of dividend that corporations pay their shareholders is a whole research area. Subsequent versions of these series of articles will provide answers to this question. 

What are the Main Types of Stocks /Shares?

There are generally two types of Shares/Stocks issued by corporations – (i) Common Stocks, and (ii) Preferred Stocks.  Common Stocks are the most widely held corporation Stocks which represent a residual claim against the assets of the issuing company, entitling the owners to a share of the net earnings of the corporation after meeting all other liabilities. A unique characteristic of a common stock is the fact that holders of such stocks have limited liability. This means that, when the company goes bankrupt, the holder of a common stock can only loose his/her original investment in the stock. The assets of holders of common stock cannot be sold to settle down the liabilities of the company in case of bankruptcy.

Thus, the holders of common stocks can only afford to loose the amount of money they invested in the purchase of the company’s shares in case it is liquidated. Holders of common stock also have the advantage of casting votes during the process of electing the board of directors of the corporation. Some corporations, however, issue two classes of common stock namely – class “A” stocks and class “B” stocks.  In such corporations, whilst holders of class “A” common stocks are granted the right to vote, those of class “B” common stocks are granted a prior claim on earnings but no voting power. That is, when it comes to voting, only holders of class “A” stocks can vote during elections. However, when it comes to dividend payment, holders of class “B” stocks are given priority in terms receiving payments first but they are not allowed to cast their votes during the process of electing board of directors. Thus, holders of class “B” stocks only benefit in terms of being given priority in the sharing of the company’s profit, but they can neither be voted for nor can they vote for any person for the corporation’s board directorship. In political terminology, a class “B” common stock holder has a defranchised political status within the corporation.  

A Preferred Stock is a stock which carries a stated annual dividend expressed as a percentage of the stock’s par value. Put in another way, a Preferred Stock defines a share of ownership in the business corporation that promises a stated annual dividend.   Unlike a common stockholder who receives a residual claim on the assets of the company, a Preferred Stockholder receives a predetermined return from the par value of the stock. For example, if a preferred stock carries Le 200.00 (two hundred leones) par value with a 10 percent dividend rate, then each preferred shareholder is entitled to 10% of Le 200.00  =  Le 20.00 (twenty leones )  per year on each share owned , provided the company declares a dividend.  That is, holders of preferred stocks are only entitle to dividend payment if they company decided to pay dividend.

In cases where the company decided not pay dividend at all, then holders of preferred stocks cannot compel the corporation to pay dividend at all cost. However, if the company declares dividend payments, holders of preferred stocks are the first set of stockholders that the company must pay before those holding common stocks.  Thus, as the name implies, holders of preferred stocks are given first preference in the payment of dividend before those holding common stocks.  Just like a class “B” common stockholder, a preferred stockholder has no right to vote or to be voted for during a corporation’s general elections for board directorship. The only commonality between a preferred stockholder and a common stockholder is that, they both represent an ownership stake in a corporation from which they receive some returns in the form of dividend payments. One other notable feature of preferred stocks is that they normally attract cumulative claims on payments that were not executed when they were due.

That is, if a company fails to pay dividend on preferred stock in some periods, holders of preferred stocks can make claims in the future to recoup past dividend payment which the company failed to honour.  Preferred stocks like some bonds do carry callable features. When a preferred stock carries a call provision, it means that the issuing company can redeem the stock by buying it back from the holder at a predetermined price that depends on the prevailing market value of the Stocks in question.

How are Stocks Traded?

Stocks are normally issued by corporations when they are in need of additional financial resources to undertake long-term investment projects.  When a company issues stocks to the general public for subscription for the first time, we call this an Initial Public Offering ( i.e. IPO) which is normally facilitated by an issuing house. Through the help of an issuing house, investors purchase stocks from the issuing company at given prices.

Normally, the issuing house may undertake to buy all the issued stocks/shares from the issuing company and then sells the issued stocks to the general public gradually. This is normally done to facilitate a quicker access to funds by the issuing company. That is, the issuing house may decide to underwrite the issue by paying in cash for the whole issue at a discount. In a country without a well established Stock Exchange, investors who wanted to sell their stocks have to take them to a Discount House which normally operates an over-the-counter (OTC) trading of securities.  The brokers or dealers in an OTC market buy and sell stocks/shares for private investors from which activities they get commissions.  In a country with a well established Stock Exchange, stocks /shares are traded on the floor of the Exchange by brokers who are the only individuals that have the authority to buy and sell securities on the floor of the Exchange.

Once an individual wants to buy or sell stocks/shares, he/she needs to have a broker who will do all the transactions pertaining to the buying or selling of securities on the floor of the Exchange. Just like any other commodity, the prices of stocks are determined by the market forces of demand and supply. If the supply for a particular stock is in excess of its demand, then the price of that stock is bound to fall. On the other hand, if the demand for the stocks is in excess of its supply, then the price will rise. So it is the relative forces of demand and supply that actually determine the price of stock at any point in time. Investors normally make returns from the buying and selling of stocks through the price appreciation of stocks over time. Once an investor buys stocks at low prices and later sell them when their prices appreciate, they are bound to make some capital gain. So most investors are interested in taking advantage of the price appreciation of stocks by buying when prices are low and selling when prices are high.