Actuarial Investments

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Actuarial Investments

• Shane Whelan
• L527

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Description of Key Markets

• - THE EQUITY MARKETS
• I of II

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Size of Global Equity Market - World Indices

• For example, the FTSE Global Equity Index Series
  (www.ftse.com)
• The series covers over 7,000 securities in 48
  different countries and captures 98 of the
  world's investable market capitalisation.
• Note that 2,700 stocks captures 90-95 of the
  investible market capitalisation.
• It shows the world equity market at the current
  time as

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World Index
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Plenty more to choose from

• Global Equity Indices  
•     FTSE Global Equity Index Series 
•     FTSE All-World Index Series  
•     FTSE Global Small Cap Indices 
•     FTSE Global Islamic Index Series  
•     FTSE Global Sector Index Series 
•     FTSE Global Style Index Series 
•     FTSE4Good Index Series 
•     FTSE Multinationals Index Series  
•     FTSE Gold Mines Index Series  
•     FTSE/ISS Corporate Governance Indices 
• UK Indices 
•     FTSE UK Index Series 
• inc. FTSE 100 and FTSE All-Share Index 
•     FTSE techMARK Index Series 
•     FTSE APCIMS Private Investor Index Series 

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Equity Markets

• Equity or ordinary share part ownership of the
  company with a right to vote on management of
  company, to participate in distributable profits
  of company and residual value on wind-up.
• So term of investment as long as company often
  assumed to last in perpetuity.
• Quoted shares those listed and traded on a
  recognised exchange. Unquoted share means the
  opposite not listed.
• Quoted companies must comply with the regulations
  of the stock exchange as well as company law.
• Income from equities dividends of uncertain
  amount and of indefinite term.
• Expected to keep pace with inflation
• Real economic growth?
• Hence investors content with low running yieldas
  they expect income to grow in the future.

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Security of Income from Equities

• Key issues
• Stability of future (post-tax) profits
• The dividend cover Payout Ratio
• Dividend Cover profits for Ordinary Shares/
  (Total Cost of Dividends)
• Payout ratio 1/Dividend Cover
• Stability
• Industry type e.g., cyclical or defensive
  industry
• Operational gearing co.s with high fixed costs
  and low marginal costs are said to have high
  operational gearing. Hence operating profits very
  sensitive to turnover.
• Maturity of industry young or well established
• Size of company as indication of diversity of
  product range.
• Financial leaverage or gearing a company with
  high ratio of fixed borrowings to equity. Hence
  profit very sensitive to turnover.

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Security of Income from Equities

• Other factors affecting dividend stability
• Outlook for company industry
• Management capability, vision, acumen,

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Capital Values

• Volatile
• Changing expectation of future dividends
• With new information news.
• Supply/demand conditions change
• Interest rate to value income stream changes
• Some equities are more volatile than others

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Other Features of Equities

• Marketability varies very considerably so must
  look at, say,..
• Whether listed or not.
• Volumes traded.
• In particular, the normal market size (NMS) the
  amount up to which a (UK) market-maker is
  prepared to deal at his quoted price.
  Approximately equal to average daily turnover of
  the share.
• The average bid/offer spread of market makers.
  Also the touch the highest bid and lowest
  offer amongst all the market makers.
• The no. of market makers.
• Irish Stock Exchange trades on a matched
  bargain basis (e.g. no market makers).
• How would you gauge the marketability of a given
  share in this market?

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Other Features of Equities

• Dealing Costs
• Market Impact the effect your deal has on the
  price.
• The bid/ask spread on market and/or commission
• Stamp duty or other taxes
• Costs of maintaining records custodian, etc.
• Mid-price is average of market offer bid and
  this is the price generally quoted in financial
  press.

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Trading Costs in US Non-US Equity Markets
Active Passive Mandates
Source The Relevance of Index Funds for Pension
Investment in Equities, Shah Fernandes, World
Bank, 2000 . (with turnover figures
made more conservative).
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Quoted Shares

• To gain a listing on a stock exchange the company
  must comply with the listing rules which are
  generally more onerous than company law in the
  country.
• This is to give investors greater protection.
• Listed shares are generally more marketable than
  unlisted ones and hence
• easier to value in holders accounts (investment
  performance, etc.)
• Dealing costs generally lower
• Maybe tax differences

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Dealing Systems

• Stock Exchanges employ to types of dealing system
• Quote-driven system market makers quote two-way
  prices in stocks in which they are prepared to
  deal up to certain limits (the Normal Market Size
  or NMS), e.g. NYSE, LSE (since 1997 in parallel
  with an order-driven system).
• Order-driven system buyers and sellers list the
  price and quantity they wish to deal and they are
  electronically matched, e.g., NASDAQ.
• What are the risks in buying or selling in an
  order-driven system? Compare liquidity under
  both.
• Price limits may be imposed on markets so the
  market closes for a cooling-off period (maybe an
  hour or maybe until next trading day) if index of
  market rises above/falls below a given of
  previous days close. Market can close limit-up
  (price hits upper bound) or limit-down.

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Description of Key Markets

• - THE EQUITY MARKETS
• II of II

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Review of Last Lecture

• Equity markets
• Ownership
• Brought for future dividend stream
• Expected to keep pace with inflation
• Income from equities stability
• Course of profits dividend cover
• Industry type, maturity of industry
• Operational financial gearing
• Market capitalisation, etc.
• Markets Trading
• Marketability of shares
• Dealing costs
• Dealing systems

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Equity Categorisation

• Categorisation by industry
• An important classification key as price
  movements between shares in same industry tend to
  be correlated.
• This is obvious as such companies share similar
  resources, markets, and often financial
  structure.
• Also equity analysts tend to be specialised by
  industry and hence research reports tend to rank
  companies within an industry.

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Attribution of Individual Stock Price Variation
from Kings study US Market, 1927-60
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Equity Categorisation

• Index providers give an equity categorisation
  system.
• SP (Standard Poors), MSCI (Morgan Stanley
  Capital International), Dow Jones, FTSE, as well
  as local (single market) providers
• Classification classes change with time
• FTSE system prior to 2000 used be
• Mineral Extraction e.g. mining, oil exploration
• General Industrials e.g. construction,
  engineering
• Consumer Goods e.g. breweries, household goods
• Services e.g. hotels, food retailers, transport
• Utilities electricity, gas, water
• Financials banks, life insures
• Investment trusts

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The FTSE Classification System

• Resources
• Basic industries
• General Industries
• Consumer Goods
• Cyclical Consumer Goods
• Non-Cyclical Consumer Goods
• Services
• Cyclical Services
• Non-Cyclical Services
• Utilities
• Financials
• Information Technology

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Resources

• These companies are involved in the extraction
  and supply of primary products used throughout
  the global economy.
• Oil is most important but other mining included.
  Integrated Oil is largest sub-category, e.g.,
  BP,Shell, etc.
• Share prices highly positively correlated with
  commodity price movements. Currency-link is to .
• Global market for product so world economy
  conditions matter not local.
• Generally very large companies by market cap.

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Basic Industries/General Industries

•  
• General industrial companies are involved in the
  various stages in the supply and production of
  goods. Many of the goods tend to be capital
  items, i.e. aircraft, ships, machinery,
  electronic and electrical equipment.
• This group also includes building construction,
  engineering, printing, textiles, diversified
  industrials
• Dependent on level of capital formation in
  economy
• Cyclical, with profits high in early phase of
  economic growth cycle. Volatile profits.
• Generally low level of financial gearing
• Dependent on Government spending (on
  infrastructure)
• High profits when conditions favourable
• Servicing a mix of global and local markets

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Consumer Goods

• Companies that manufacture consumer durables and
  non-durables breweries spirits food
  manufacturers, pharmaceuticals, tobacco.
• Capital intensive
• Brand names important
• Increasingly international
• Moderate to high financial gearing (due to
  relative stability of demand for non-durables)
• Low profit margins

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Services

• Included here media, leisure hotels,
  transport and food general retailers,
  distributors.
• Local market important.
• Labour intensive (also maybe property costs)
• If more defensive then high gearing

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Utilities

• Electricity, Telecommunications, Water, Gas
• Very stable demand and hence low growth prospects
• Huge sunk costs (infrastructure) and capital
  maintenance bills.
• Natural monopolies hence regulated (most
  originally set up by Gov.)
• Vulnerable to political risk
• Largely national/regional in characterbut
  evolving.

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Financials

• Clearing banks, investment banks, general
  insurance, life insurance
• Both capital intensive and labour intensive
• Banks highly geared and have cyclical profits.
• Life low gearing and stable profits.
• General low gearing and cyclical profits.
• Reinsurance and investment banking international,
  otherwise national.

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Information Technology

• Comprises companies involved in information and
  communications technology hardware, software and
  the provision of computer services. Many
  companies in this group have yet to make profits
  or pay dividends so traditional valuation
  measures not applicable. Dividend yield in this
  sector is therefore low, and their assets can be
  largely intangible.

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Sundry matters on equities

• Convertible securities
• Preference shares
• Rights issues
• Underwriting
• Scrip (or bonus) issues
• Scrip dividends
• Terminology
• Xd, cum div.

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Principal Economic Influences on Equity Markets
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The Obvious Point

• General price level in market set by supply
  demand
• Shift in supply or demand higher/lowers level of
  market (yield, ex ante return expectations)
• Demand for capital assets is very price elastic
  as many close substitutes
• In general think of supply and demand factors
  when justifying current levels and anticipating
  future price changes.
• Note that demand in the market can generally
  change faster than supply.

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Level of the Equity Market

• Demand for equities is highly dependent on
  expectations the expectations of future
  corporate profitability and
• Expectations of real interest rates as the lower
  they are the better for equities as higher
  value and stimulus to economic activity.
• Perceptions of risk the equity risk premium
• Real growth of economy the tide that raises all
  boats.
• Inflation as creates uncertainty and, often,
  higher taxes (the tax wedge).
• Currency a factor that works in many directions
  but a weak domestic currency is generally a good
  for equity market.

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Level of the Equity Market

• Other influences
• Supply privatisations, share buybacks, rights
  issues
• Demand tax incentives to save, institutional
  flow of funds
• Political climate stability preferred
• Overseas equity markets especially the US as
  increasingly one world
• Alternative investments
• ALSO SEE LATER HOW ONE VALUES INDIVIDUAL SHARES

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Changes to Sector Distribution of World Equity
Markets in Market Crash of 2000-2001

• Feb. 2000 Sept 2001
• Resources 5 8
• Basic industries 4 4
• General Industrials 8 8
• Cyclical Consumer Goods 3 3
• Non-Cyclical Consumer Goods 12 20
• Cyclical Services 11 11
• Non-Cyclical Services 13 9
• Utilities 3 4
• Financials 17 23
• Information Technology 24 11

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Historical Statistics on Irish Equity Returns
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Questions

• Dollar collapses how does it affect your
  portfolio?
• An unantipicated recession, you believe, is fast
  approaching. What main sectors do you overweight?
  What do you underweight?
• Minister for Finance decreases PRSI on workers in
  budget. How does this effect your portfolio?
• You are told by a friend in the Department of
  Finance that the Government will shortly announce
  the privatisation of a large state business. What
  should you do in your portfolio?

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Actuarial Investments

• Shane Whelan
• L527