Learn more about the main characteristics of the stock
market, just by clicking the terms below.
Shares or Stocks - parceling out a company
Shares, also known as stocks, are like pieces of a pie. Buying a company's shares is like owning slices of that company. Shareholders (or stockholders) - generally thousands of individuals and institutions - own part of the equity (ownership) of the company. Companies issue two basic types of shares: common?which have voting rights?and preferred, which have priority when dividends are distributed.
Companies that issue their shares for sale on the stock market are called " listed", "publicly-traded" or "public" companies, as opposed to "public sector" companies, which are owned by the government.
Publicly traded companies transfer part of the control over their stock to those investors who have acquired common shares. Investors who have acquired preferred shares will only have preference in the distribution of revenues, and do not take part in decision-making. In exchange, publicly-traded companies receive money for their securities and thereby obtain financing, which enables them to expand their business.
When they acquire shares, investors expect to receive dividends or interest on shareholders? equity, meaning they expect to receive part of the company?s profits. They also expect that the price of the stock will rise, making their investment profitable. However, as with any investment, when buying stock, investors have no performance guarantee: shares may gain or lose value.
Shareholders face the risk of their company failing to produce good financial results, or of the stock losing value. At worst, they can lose all of their investment, but only this, as shareholders are not liable for a company?s debts. In the long run, investing in stock has historically produced good results relative to other investment alternatives.
Common or ordinary shares, also known as ONs in Brazil, are securities representing a company?s capital, as do preferred shares, or PNs. The basic difference between ONs and PNs is that holders of common shares may vote at General Shareholder Meetings, thus playing a greater role in determining the company?s direction. The company?s controlling shareholders are those holding the majority of voting stock.
Preferred or preference shares, also known as PNs in Brazil, provide shareholders with preference in the payment of dividends. Holders of preferred shares are entitled to receive revenues before those who hold common shares. Furthermore, PN shareholders also have preference in the distribution of capital in the event of the winding up or dissolution of the company, in addition to their rights of preference concerning dividends. Under Brazilian Corporation Law, a maximum of 50% of a company?s stock may consist of shares with no voting rights, i.e., preferred stock.
Registered shares (or stock)
These are securities or stock certificates bearing the shareholder?s name. Transferring them to someone else requires delivery of the securities and the registration of the new shareholder in the appropriate records of the issuing company.
Book entry shares (or stock)
These are securities that are not represented by physical certificates, but are simply amounts which are debited or credited to shareholders.
Companies may also issue different classes of shares, such as A, B, C or some other letter, depending on their specific objectives. A company is free to create as many classes as it wishes. It can establish in its bylaws different values for the dividends or special payouts for each class of share. Classes may also indicate stock ownership limitations, such as a restriction on foreign investment.
The classes in Brazil are PNA (PN class A shares), or PNB (preferred class B shares), and generally go up to PNH (preferred class H shares). A company can continue issuing other share classes up to PNZ, although this is rare.
Blue Chip is a term originally employed in poker, where the "blue chips" are the most valuable. In financial terms, it refers to a commercial or industrial share of the highest class among investments. A blue-chip company must be well known, have a large paid-up capital, a good record of paying a rate of dividends in good times and bad, a highly skilled and progressive management, and must provide a safe investment. The list of companies classified as blue chips is not official and changes constantly.
The price of shares is established on the trading floor of a stock exchange, and is based on the dynamics of supply and demand for each type of security, which makes the price a reliable indicator of the value that the market ascribes to different shares. Greater or lower supply and demand for a given stock is directly related to the historical behavior of prices and, above all, to the future outlook of the issuing company and its dividends policy.
The value of stock may fluctuate at any time. It depends, for instance, on market conditions and investor perception of risk. When investors buy a company?s shares, they believe that the company will be profitable or that the value of its stock will rise.
However, if investors believe that the outlook is unfavorable and do not invest, or sell the shares that they already own, the stock price may fall. Stock price fluctuation is a natural market movement, and it depends on macroeconomic factors as well as the market?s perception of a given stock and its behavior related to these factors.
When the economy is sluggish, corporate earnings can drop quickly; however, when the economy recovers, earnings tend to move in tandem with rises in stock prices. These pricing oscillations are cyclical; they occur from time to time, depending on market movements. Fluctuation is normal, primarily because stocks are a long-term investment.
As previously mentioned, the profitability of shares is variable, and comes from two sources. The first results from selling the stock when there have been capital gains, or when the shareholder bought the shares at a given price and sold them when their price increased, thereby making a profit.
The second way to obtain earnings from stock is from the distribution of dividends, or participation in the results and benefits granted by the company to its shareholders. Keep reading to find out more.
At the end of every reporting period (generally at the end of the fiscal year year), publicly traded companies pay their shareholders their share of the net profit earned during the period. This payout is called a dividend. The distribution of dividends is proportional to the number of shares owned by the shareholder.
For instance, if company A announces an annual dividend of R$3 per share and you own 100 shares, you will receive R$300 that year, or half-yearly installments that amount to this figure. The dividend payment date is defined by the company?s directors, who also decide how much the company will distribute or whether it will indeed pay dividends. Generally speaking, only large companies pay dividends, as smaller ones need to reinvest their profits in order to continue growing.
Some people invest in stocks not only because they believe in their value gain potential, but also because a given company may be a good payer of dividends. These companies are known in the market jargon as "cash cows", because regardless of their stock rising or falling in value, their shareholders receive generous dividends from time to time.
Under Brazilian law, at least 25% of a company?s yearly net profits must be distributed to shareholders. Mandatory dividends do not fully apply to companies that are not publicly traded, which may distribute a lower percentage of their income, provided no shareholder present at the meeting convened to decide upon this issue objects to this. Furthermore, such dividends are not mandatory if they are not compatible with the company?s financial situation. The distribution of dividends is dealt with in Law 6404 [December 15, 1976].
Typically, dividends are paid in cash. However, companies may pay dividends in the form of stock, proportional to the number of shares owned by shareholders.
Interest on stockholders? equity
Interest on stockholders? equity Shareholders may also receive earnings from a company in the form of interest on stockholders? equity. Unlike dividends, this not paid according to the company?s performance during the period, but is instead based on profit reserves, or profits from previous years that were held back by the company.
The payment of interest on stockholders? equity is advantageous for companies. It is paid out in the form of financial expenses and, the greater a company?s expenses, the lower the profit. As income tax must be paid on the company?s profit, the company can reduce its tax liabilities.
Subscription rights enable shareholders to acquire a new issue of shares floated by the company, at a pre-set price and over a pre-determined period. The new issue will be proportional to the size investor?s current shareholding. Companies employ this strategy to increase their capital.
If shareholders do not wish to exercise their purchase option, they may transfer the subscription rights to a third party by selling the rights on the stock market. To know whether or not exercising the rights is advantageous, prospective investors should monitor the stock?s behavior in the market place.
This will allow shareholders to assess whether, at the time the option falls due, the price of the new shares and the price of the subscription rights will be lower than the stock?s price on that day. If they are not, investors could lose money.
Capital gains - making money on shares
Most people buy shares to make money through capital gains, or the profits from selling the shares at a higher price than what they cost. If 1000 shares of Company X are purchased for R$50 each, or R$50,000, and then sold for R$65 each, or R$65,000, the capital gain would be R$15 per share, or a total of R$15,000.
Profits from investments held for more than one year are regarded as long-term capital gains. However, not all the money made in this transaction will go to the investor, as it does not include taxes or brokerage commissions on the purchase and sale of the shares.
It is easy to talk about the secret to making money in stocks?meaning buying shares before other investors want to buy them and selling them before other investors want to get rid of them?but this is more easily said than done, as it is hard to foresee market movements.
Getting this timing right means being attuned to a series of factors, such as the rate of growth of a company?s profits, the competitiveness of and existence of new markets for its products or services, strengths and weaknesses of the company?s executives and the historic economic environment in which the company operates.
How the stock market works
It is not difficult to buy and sell stock, but in order for it to work properly, the process has its own rules, a specific language and set of participants. Approximately one million Brazilians invest in stocks. Most of them buy and sell shares through a brokerage house, a stock exchange-accredited financial institution where buy and sell orders are carried out by operators licensed by the stock exchange. The execution of the buy and sell orders is as follows:
a) The client calls the stockbroker and, after talking to the operator, determines the transaction he wants to be carried out. This establishes the conditions for the buying or selling of shares.
b) The operator carries out the order by means of an electronic trading terminal or by relaying the order to the trading floor operator. However, the order may not necessarily be carried out immediately, as the market value of the shares may be fluctuating substantially.
c) The operator confirms the order execution to the client and records the transaction in his or her system.
d) Following that, the back office staff receives confirmation of the transaction and carries out the transaction?s physical settlement (stock transfer) and the financial settlement (payment or receipt of funds).
What is physical settlement?
This is when the brokerage firm representing the seller delivers the securities to the São Paulo Stock Exchange (Bovespa). Physical settlement takes place on the second working day after the deal has been closed. The shares only become available to the buyer after financial settlement of the transaction.
What is financial settlement?
This is payment for the total amount involved in the transaction by the buyer?s intermediating brokerage firm and receipt of payment by the seller. Financial settlement takes place on the third working day after the deal is closed.
This is the safeguarding and management of securities, including stocks, and is carried out by the stock exchanges themselves, or a registered custodian. The purpose is to record in whose name the assets were purchased, thereby guaranteeing their ownership.
Shares are generally purchased in multiples of 100, 1000, and so forth. In the market, these multiples are known are round lots.
Round-lot market vs. odd-lot market
The purchase of small or odd lots is generally more complicated and is carried out in the odd-lot market. This happens, for instance, when the investor does not wish to buy a round lot of 100 shares, but 150 shares. In this case, the round lot, or the 100 shares, will be traded on the round-lot market, whereas the other 50 shares will be traded on the odd-lot market.
How does a virtual brokerage firm work?
In a virtual brokerage firm, buy and sell orders are carried out via the internet, relying on a Home Broker service. Investors can check the price of the stock at that exact moment and specify under what conditions its purchase or sale should be executed.
Following that, the order is placed in an electronic system of the stock exchange (the Megabolsa or Megaexchange, in the case of the Bovespa), which tries to match the buy and sell orders. Upon the execution of the order, the investor receives a confirmation.
For instance: the investor checks the value of a company?s A shares via the internet. At that moment, these shares are being traded in the market at R$54. Following that, the investor decides to ask a minimum of R$53, for example, and can also specify for how long the order is valid for (only today, for instance).
Once the conditions for the transaction to be executed out are filled out on the screen, the investor confirms the order, which is automatically recorded in the stock exchange system (the Megabolsa).
After that, the stock exchange?s system will look for purchase orders for company A stock. If there is any order in the system, this information will be matched and the transaction carried out. Otherwise, the investor must wait for a subsequent company A buy order.
How can so much information be analyzed at once?
Up-to-date information on the market is like oxygen to an investor: prices, news, bulletins, corporate and economic analyses and warnings. They are vital for analyzing the right moment in which to buy or sell stock. But how is all this to be digested? Two ways traditionally chosen by investors for analyzing stocks and the stock market are fundamental analysis and technical analysis (also known as graphic analysis). Whereas the first of these focuses on defining the stock, the second kind analyzes the right time to buy.
This analytical tool is based on corporate fundamentals, by evaluating how the figures, the degree of indebtedness, the company?s background and the industry outlook can have an impact on the price of the stock. These indicators, in conjunction with the macroeconomic outlook and the stock?s market price, are used to define whether or not the shares of a given company are a good investment.
Many investment banks and brokers have a team of analysts that monitor and analyze the many sectors of the economy, such as telecommunications, oil, steel and foods. Given the importance and size of certain companies, many analysts specialize in just a single company.
These professionals also rely on several sources of information to produce their reports: news, corporate financial results, and interviews with the principal executives, among others. The analyst?s end product is a full report in which the company?s chief figures are presented, as well as the assumptions used to estimate future results, plus an indication of whether the company?s shares should be bought, sold or held.
It is also possible to analyze a company through its balance sheet. However, the information contained in this document should be compared with other financial statements, in order to carry out a more complete analysis of the company.
All the data sent by listed companies to the São Paulo Stock Exchange (Bovespa), including the annual information on its balance sheets and trial balances, are available to investors for review at the Bovespa Information Center. Copies may also be purchased.
The Bovespa Information Center is located at Rua XV de Novembro, 275, 5th floor, in the city of São Paulo. It is open from 9:00 a.m. to 2:00 p.m. The Bovespa charges for this service, but corporate balance sheets can also be found on the Brazilian Securities Commission (CVM - Comissão de Valores Mobiliários) website.
As its name indicates, graphical analysis is based on graphs and charts that reflect the fluctuation in pricing of a given stock over a given period of time. These graphs also reflect market movements, thereby hopefully predicting high and low stock market cycles. By studying the behavior of the stock, technical analysts or graph specialists try to estimate possible future behavior and thus define the points at which the stock should be bought or sold. Graphical analysis is based on the principle that prices fluctuate as part of a trend. In other words, the behavior of a stock tends to repeat itself over time until there is a break in the pattern. Technical analysis can also identify this break.
Doing business on the cash market requires the intermediation of a brokerage firm authorized to carry out clients? buy or sell orders on the trading floor, through one of its operators.
In open outcry trading, the brokers? representatives shout out their offers, specifying the name of the company, the type and quantity of stock and the selling or buying price of the shares. Only stock with a high degree of liquidity is traded through the open outcry system. Many stock exchanges have eliminated this type of trading in recent years, although it still used at the Bovespa.
Electronic trading system
This system enables brokers to execute clients? orders directly from their offices, without offering them in open outcry on the stock exchange?s trading floor. Using an electronic trading system, the offer to buy or to sell is carried out through computer terminals. Computers automatically match the buyers with sellers entered in the system.
This is the electronic trading that takes place daily once the market has closed. After-hours trading typically involves only cash market transactions.
The daily open outcry sessions of the Bovespa take place from 10:00 a.m. to 4:45 p.m., with a break from 1:00 p.m. and 2:00 p.m.
The Bovespa electronic trading floor operates continuously from 10:00 a.m. to 5:00 p.m. for all companies with cash market listings. From 9:45 a.m. to 10:00 a.m. there is the pre-opening auction, when offers are inputted to establish theoretical opening prices. From 4:55 p.m. to 5:00 p.m. the electronic system carries out the Closing Call for all companies traded on the cash market, in open outcry and also for the stocks that are part of the Ibovespa Index.
The pre-opening of the after-hours market takes place from 5:30 p.m. to 5:45 p.m., during which time offers registered in the trading floor?s normal working period may be cancelled. Trading takes place from 5:45 p.m. to 7:00 p.m., when stock buying and selling transactions are carried out in accordance with the parameters established for this market segment.
A market order is an order to buy or sell a stock at the current market price. Unless investors specify otherwise, brokers will enter this order as a market order. The advantage of a market order is you are almost always guaranteed your order will be executed (as long as there are willing buyers and sellers).
A market order may also be less expensive than a limit order. The disadvantage is the price you pay when your order is executed may not be the price you obtained from a real-time quote service or were quoted by your broker. This may be especially true in fast-moving markets where stock prices are more volatile.
To avoid buying or selling a stock at a price higher or lower than you wanted, you need to place a limit order rather than a market order. A limit order is an order to buy or sell a security at a specific price. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.
The individual or legal entity that manages the securities portfolio or a representative of more than one client establishes the conditions under which the order is to be executed.
The investor defines the sell order of a security or buying right of another, choosing which transaction is to be carried out first. The transactions will only be closed if both orders are executed.
The investor specifies a buy or sell order for a security or right in a given stock exchange and, at the same time, the selling or buying of the same security or right in the same exchange or at another one, with a different settlement date.
This is an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the specified price is reached, the stop order becomes a market order. Investors typically use a buy stop order when buying stock to limit a loss or protect a profit on short sales. The order is entered at a price that is always above the current market price. A sell stop order helps investors to avoid further losses or to protect a profit that exists if a stock price continues to drop.
The following fees apply to cash market transactions in Brazil: a fee for brokerage services, calculated by ranges of total financial turnover (purchases plus sales) of the orders executed on behalf of investors by a given brokerage firm in the same trading session, as well as fees and the Stock Trading Notice fees (ANA - Aviso de Negociações com Ações), charged for each trading session in which investors had orders executed, regardless of the number of transactions carried out on their behalf.
Why should a company go public and float its stock?
A company is a limited liability concern, privately held. In other words, it is limited to its partners. In this case, when the company needs to make new investments in order to grow and modernize itself, it can resort to certain sources of funds, such as obtaining capital transfers from its controlling shareholders, increasing its borrowings from financial institutions?which will grant the necessary loans?or raising capital by obtaining new stockholders.
It may not always be advantageous for the controlling shareholders to bring further capital into the company. Furthermore, besides the fact that they do not normally have all the funds required to implement new projects, the investment of further capital by the same partners increases the risk level of their investment in the company, given that there is no investment diversification and that the funds are entirely invested in a single concern. Additionally, this is a very expensive procedure.
Increasing borrowings above a certain level from financial institutions is generally also a not very good alternative as the debt can escalate to where it becomes difficult to settle, even in the long-term. Given this situation, the last alternative-a capital increase through new shareholders-has been the one most often chosen by large and mid-size companies. They ideally wait to increase capital when interest rates are low, which will tend to increase the price of shares traded on the stock market.
How to go public and/or issue shares?
When a company goes public and therefore becomes a corporation (in Brazil, a Sociedade Anônima or S.A.), its stock is listed on stock exchanges and traded in the marketplace. However, a publicly traded company may issue not only stock, but also any type of security, such as debentures, bonds, subscription rights and promissory notes for public distribution.
For a company to go public, it must meet certain requirements, such as:
- implementing, if necessary, a corporate restructuring, through splits, consolidations, mergers or the establishment of new companies. A common case is to create a holding company that holds stakes in the group?s companies, so that the said holding company goes public.
- transforming the company from a limited liability company into a corporation.
- setting up bylaws that include provisions making it easier to manage the company as a publicly traded company.
- revaluating assets, should they be undervalued.
- creating a Board of Directors and electing its members.
- hiring independent auditors to examine the company?s financial statements.
- appointing an Investor or Market Relations director.
Going public, step by step
This procedure normally includes the following steps:
1- The company shows interest in going public.
2- The team in charge goes into action and analyses the operation.
3- If the evaluation is favorable, the area in charge of issuing stock (underwriting) prepares a document called a mandate.
4- If the company accepts the mandate, the underwriting area structures the operation, including volume, price, documentation for the Securities Commission (CVM - Comissão de Valores Mobiliários), contracts, road-shows and syndication.
5- During the structuring of the operation, the strategy for distributing the shares in the market is defined. The pre-sale of stock, through private placement or seed stock, is announced in the financial media. These advertisements are generally known as tombstones because of their shape.
6- Finally, the stock is offered to the public.
Road show: a presentation in which information on the company is presented to investors, including pension and mutual fund managers, and private bankers.
What type of stock should be floated?
Depending on the rights and advantages that they offer their holders, a corporation?s stock may consist of common shares or preferred shares. The first group provides their holders with voting rights and enables them to take part in the company?s results. On the other hand, preferred shares guarantee their holders priority in the distribution of dividends and in the refunding of capital, should the company be wound up. The stock may be in the form of book entry shares or registered shares. Brazilian corporations may issue up to 50% of their stock in the form of preferred shares.
How does subscription work?
The company may decide to carry out private or public subscriptions. The first type is only open to the company?s shareholders. The second type is open to new shareholders. In this case, the issue must first be submitted for registration with the Securities Commission (CVM - Comissão de Valores Mobiliários) and must have the intermediation of a financial institution.
The work carried out to float a corporate stock issue comprises coordination (the services of setting up and structuring the operation), guarantee or underwriting (ensuring that the securities will be fully placed in the market) and placement (distribution of the stock to investors in the market).
American Depositary Receipts (ADRs)
ADRs are receipts that represent shares of a foreign issuer. These shares are deposited with and under the custody of a given bank in the country of origin. The receipts are issued by a US bank and are traded in the United States. ADRs are also traded in London and Brazil, but only through a US trading system, such as Instinet.
ADRs are the natural path for a foreign company (such as a Brazilian one) to make itself known in the US market. A new stock issue would be more difficult to carry out, given that the market might not be aware of the company and that the share issue might therefore be a failure.
Normally, companies choose to enter a foreign market by issuing Level 1 ADRs, because they do not involve floating new shares, and the laws concerning corporate responsibilities are a little more flexible. The company?s financial statements, for instance, should be presented in accordance with US accounting standards and should be published in major US newspapers.
Level 2 ADRs are an upgrade from Level 1. They include listing the securities on a US stock exchange, which gives rise to new costs and obligations, such as releasing periodic financial statements and the payment of listing fees to the stock exchange.
Level 3 ADRs are only used when the company wishes to raise funds by issuing new securities, which involves fairly complex laws and much higher costs. This option used much less frequently by foreign companies.
ADRs may be traded on US stock exchanges (such as the New York Stock Exchange and the electronic NASDAQ exchange). However, this trading is very different from the way in which securities are traded in Brazil, in the following respects:
In Brazil, the only way to maintain a short position in the stock market is through the futures index or through options. In the ADRs market investors may maintain a short position in a given stock, which makes many strategies easier to implement. To this end, investors need a stock loan, which is a common practice in the US market, and requires a margin account with a US institution.
A margin account is a broker?s account that enables the broker?s clients to acquire securities with funds loaned by the brokers. If the value of the securities or commodity rises, any profit goes to the original buyer; but if the value falls, the broker may demand from the buyer another cash payment towards the value of the purchase, known as a margin call. The stock market crash of 1929 was due in part to too many shares being bought on margin, and too few buyers being able to meet the margin calls issued by their brokers when prices started to drop.
The holder of a put option has the right to sell a security to a buyer at a fixed price and date.
The secondary market is where an investor purchases a security from another investor rather than the issuer, subsequent to the original issuance in the primary market.
In the United States, this is characterized by any type of trading executed outside a stock exchange, but involving a security listed with an exchange. This typically means the over-the-counter trading of listed securities among institutional investors and broker-dealers for their own accounts, rather than as agents for investors.
Proprietary trading systems
Some US brokers supply their own electronic trading software and equipment. These proprietary systems are often used for the trading of ADRs that are not listed with US stock exchanges.
The over-the-counter market involves any type of stock trading outside US stock exchanges. Although Nasdaq represented the first transparent dealings in the over-the-counter market, nowadays it operates much more as a stock exchange. One type of over-the-counter transaction is an interdealer transaction, involving two brokers trading a security directly, without the participation of any stock exchange. A brokerage firm specializing in intermediating transactions, particularly over-the-counter, is known as a broker-dealer.
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