Traditional Investments Part 1: Equities-Triple Crown of Finance: For MBA, CFA, CAIA, and FRM-PRM Professional Practitioners

Article 1.0: Traditional Investments Part 1 (Equities)

Following up on our previous article on the Investment Industry. In this article we are going to explore Traditional Investments, and we will follow up in upcoming articles with a break down and illustration of Alternative Investments and how they differ from traditional ones and how to classify them. So lets get started.

Traditional Investments refer to the most commonly known asset classes that were almost the main and major constitutions of almost the entire portfolios of investors for decades, they are also characterised by being almost Liquid which means they provide the ease and immediate ability to buy and sell them at any time at almost any quantity without having to sacrifice the current market price or wait for a long time to fulfill your order (in some cases some equities and bonds tend to be liquid under certain situations and circumstances; to be discussed later in another article on Market Structure and Investment Vehicles & Instruments). Now lets discuss Equities in a nutshell.

Equity Investments: Types of Stocks-Shares

Common Stocks/Shares

Liquid or Listed Equity which is commonly known as Common Stocks or Shares are partial ownership in a company relative to the percentage of the total shares outstanding in the market that an investor holds, and thus equities give the holder a direct claim on the issuing company’s assets and the right for dividends and voting rights as well (Common Shares ranks the lowest in seniority in case of liquidation after Preferred Shares, and Bonds which are the top ranking in terms of seniority in case of liquidation).

Common Stocks or Equities has no limits on the rate of return, profits can go to infinity theoretically, and the maximum risk is the price going to zero, and there are no fixed terms associated with the issuance of the shares or stocks.

Advantages of issuing shares

Advantages of a company issuing shares in an IPO (Initial Public Offering), while a company issuing shares has to meet certain criteria from the regulators and satisfy the sentiments and expectations of investors, raising equity does not put the issuing company in a situation where it has to worry about paying the raised equity back because there is no subsequent payments for servicing the equity or a due date, neither there is a need for pledging assets or offering guarantees to issue equity (which is the main case in Bonds or Secured Bonds with the exception of unsecured bonds which is not issued against any assets pledged and thus are more risky and have to provide higher interest payment or return to encourage the investors to take the higher risk). And hence equity doesn’t require a company to readjust its break even point because the company does not have to bear the burden of achieving financial performance benchmarks nor the concern of Insolvency Risk to fund the equity.

Preferred Stocks (Preference Shares)

Preferred Stocks or Preference Shares is another type of shares and its most likely to categorised among the fixed income securities as it holds more of the characteristics of a bond rather than a common share or stock (They hold mixed features of shares and bonds combined together with a more of a bond flavour). Preferred stocks or shares do not give the holder voting rights nor the right in all profits of the company, thus preferred stocks, rather they promise the holder fixed or adjustable rate of return in the form of dividends at fixed dates (an exception are Participating Preferred Stocks which under certain circumstances do entitle the holders to participate in earnings above the specified dividend rate), and sometimes have anti dilution rights (If the company issues more shares in the future in a seasoned public offering, holders of preferred shares maintains the same stake of equity, thus their holdings do not dilute).

Although if the company did miss a dividend payment to preferred stocks holders it may pay it accumulated on the next dividend payment date or they may not according to the issuance terms. In case of non payment the company is not forced to file for bankruptcy which is the case in Bonds, if a company defaults on paying the interest of a bond on the specified date of interest payment it can be forced to liquidation and filing for bankruptcy.

Preferred Stocks or shares are perpetual which means they never retire unlike a bond which has a maturity date where the principal amount has to be paid back. Preferred stocks can be called back (Callable; which is a fixed income security faeture) which means that the company may have the right according to the issuance terms to buy back the preferred stocks at prespecified price which is mostly higher than the market price at the time of the call, or they can be Convertible (Which is another feature of fixed income securities), meaning that they can be converted into common stock instead of calling them back, and the conversion rate is prespecified in the issuance term at how many common shares in exchange of the preferred ones.

Preferred Stocks or Preference Shares do have higher seniority to common shares and less seniority to bonds, so if a company files for bankruptcy or liquidates the first investors to be paid are bond or debt holders and if there is anything left then preferred stocks holders are paid next, and last in the queue are common shares holders.

While preferred shares are considered by financial markets and economists as a fixed income security, accountants to consider it equity and include it in the shareholders’ equity section on the balance sheet.

We will revisit preferred shares again in more details with their Tax Treatment in an upcoming article on Equity Valuation.

In the next article we will discuss Fixed Income Securities, till we meet again

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