Chapter 13 Stock Markets Hung Wan Kot University of Macau 1 FINC3003 Chapter 13 H.W. Kot FINC3003 Financial Markets Financial Institutions Money Market Mutual Fund Ind Bond Market Insurance Companies Stock Market Investment Banks Mortgage Market Venture Capital Firms Commercial Banks 2 FINC3003 Chapter 13 H.W. Kot Chapter Outline Investing in Stocks Computing the Price of Common Stock How the Market Sets Security Prices Errors in Valuation Stock Market Index ADRs Long-term performance of index revisions 3 FINC3003 Chapter 13 H.W. Kot Investing in Stocks Represents ownership in a firm Earn a return in two ways Price of the stock rises over time Dividends are paid to the stockholder Stockholders have claim on all assets Right to vote for directors and on certain issues Two types Common stock: Right to vote | Receive dividends Preferred stock: Receive a fixed dividend | Do not usually vote 4 FINC3003 Chapter 13 H.W. Kot 5 FINC3003 Chapter 13 H.W. Kot Sample Stock Certificate: Sapir Consolidated Airlines 6 FINC3003 Chapter 13 H.W. Kot Investing in Stocks: How Stocks are Sold Organized exchanges ─ ─ ─ ─ NYSE is best known, began trading in 1792. 24 brokers began trading a few stocks on Wall Street. “Organized” used to imply a specific trading location. But computer systems (ECNs) have replaced this idea. Others include the ASE (US), and Nikkei, LSE, DAX (international) Listing requirements exclude small firms NYSE merged Archipelago 2006 7 NYSE combined Euronext to NYSE Euronext 2007 NYSE Euronext acquired Amex 2009 FINC3003 Chapter 13 Intercontinental Ex purchased NYSE Euronext 2013 H.W. Kot 8 FINC3003 Chapter 13 H.W. Kot Circuit-breaker in U.S. https://news.cgtn.com/news/2020-03-28/What-are-stock-market-circuit-breakers-and-how-do-they-work--Pd2lBRmfza/index.html 9 FINC3003 Chapter 13 H.W. Kot March 2020 Warren Buffett said that he lived for 89 years old also have not seen this scene when March 8, the fist “circuit breaker” happens. 10 FINC3003 Chapter 13 H.W. Kot 11 FINC3003 Chapter 13 H.W. Kot Investing in Stocks: How Stocks are Sold Over-the-counter markets ─ ─ ─ ─ 12 Best example is NASDAQ Dealers stand ready to make a market Today, about 3,000 different securities are listed on NASDAQ. Important market for thinly-traded securities—securities that don’t trade very often. Without a dealer ready to make a market, the equity would be difficult to trade. FINC3003 Chapter 13 H.W. Kot Investing in Stocks: Organized vs. OTC Organized exchanges (e.g., NYSE) ─ ─ ─ Auction markets with floor specialists 25% of trades are filled directly by specialist Remaining trades are filled through SuperDOT Over-the-counter markets (e.g., NASDAQ) ─ ─ ─ 13 National Association of Securities Dealers Automated Quotation System Multiple market makers set bid and ask prices Multiple dealers for any given security FINC3003 Chapter 13 H.W. Kot Investing in Stocks: ATSs and MTFs Alternative trading systems (ATSs) Multilateral trading facilities (MTFs) ATSs and MTFs consist of Electronic Communications Networks (ECNs) ECNs allow brokers and traders to trade without the need of the middleman. They provide: • • • • 14 Transparency: everyone can see unfilled orders Cost reduction: smaller spreads Faster execution After-hours trading FINC3003 Chapter 13 H.W. Kot Investing in Stocks: ECNs However, ECNs are not without their drawbacks: Don’t work as well with thinly-traded stocks Many ECNs competing for volume, which can be confusing Major exchanges are fighting ECNs, with an uncertain outcome 15 FINC3003 Chapter 13 H.W. Kot Trading Exchanges • • • • • • 16 NYSE NASDAQ LSE HKEx SHSE … ATSs & MTFs • Dark pools (黑池) • ECNs • … FINC3003 Chapter 13 H.W. Kot Dark Pool A dark pool is a private financial forum or exchange for trading securities. dark pools are not accessible by the investing public. Non-exchange trading accounting for about 40% of all U.S. stock trades in 2014 (15% from Dark pools). They are mostly used by institutional investors for block trades involving a large number of securities. As of Feb 2020, there were >50 dark pools in the U.S. Dark pools explained https://www.youtube.com/watch?v=hq9waP7goSc http://www.investopedia.com/articles/markets/050614/introduction-dark-pools.asp 17 FINC3003 Chapter 13 H.W. Kot Types of Dark Pools Broker-dealer owned: These dark pools are set up by large broker-dealers for their clients. Agency broker or exchange-owned: These are dark pools that act as agents, not as principals. As prices are derived from exchanges Examples Goldman Sachs’ Sigma X, Citi’s Citi Match and Citi Cross, and Morgan Stanley’s MS Pool. Examples of agency broker dark pools include Instinet,, while exchange-owned dark pools include NYSE Euronext. Electronic market makers: These are dark pools offered by independent operators like Getco and Knight. 18 FINC3003 Chapter 13 H.W. Kot Dark Pools: Pros and Cons Reduced market impact/Avoidance of price devaluation Lower transaction costs Private trading HSBC: StockMax in 2013 19 Exchange prices may not reflect the real market Pool participatns may not get the best price Vulnerability to predatory trading by HFTs Small average trade size reduces need for dark pools (averaged 187 shares per trade) FINC3003 Chapter 13 H.W. Kot ECNs vs Dark Pool ECNs are a type of ATS that trade listed stocks and other exchange-traded products. Unlike dark pools, another type of ATS, ECNs display order in the consolidated quote stream. As ATSs, ECNs are required to register with the Commission as broker-dealers and are also members of FINRA. Examples of ECNs: Instinet, SelectNet, and NYSE Arca. https://www.sec.gov/answers/ecn.htm 20 FINC3003 Chapter 13 H.W. Kot orders orders Exchanges ECN (BATS) Dark Pools order 21 FINC3003 Chapter 13 H.W. Kot ECNs vs Dark Pool To place orders directly with an ECN, a person must be an ECN subscribers. Typically, only broker-dealers and certain institutional traders are permitted to become ECN subscribers. Individual investors must have an account with a broker-dealer subscriber to place an order on an ECN. https://www.sec.gov/answers/ecn.htm 22 FINC3003 Chapter 13 H.W. Kot ATSs vs Exchanges Although both exchanges and ATSs provide marketplaces for buyers and sellers to transact in securities, ATSs do not necessarily provide public information on the best prices available to traders within their system. They also do not set rules governing the conduct of subscribers and they perform no self-regulation, while exchanges perform all of these functions. Additionally, because ATSs are regulated as broker-dealers, they comply with a different set of regulations than traditional exchanges. https://www.sec.gov/marketstructure/research/alternative-trading-systems-march-2014.pdf 23 FINC3003 Chapter 13 H.W. Kot New Trading Strategies: Algorithmic Trading and HighFrequency Trading https://tradingsim.com/blog/how-has-algorithmic-trading-impacted-the-futures-markets/ 24 FINC3003 Chapter 13 H.W. Kot https://tradingsim.com/blog/how-has-algorithmic-trading-impacted-the-futures-markets/ 25 FINC3003 Chapter 13 H.W. Kot Chapter Outline Investing in Stocks Computing the Price of Common Stock How the Market Sets Security Prices Errors in Valuation Stock Market Index ADRs Long-term performance of index revisions 26 FINC3003 Chapter 13 H.W. Kot Computing the Price of Common Stock Valuing common stock is, in theory, no different from valuing debt securities: ─ ─ determine the cash flows discount them to the present We will review four different methods for valuing stock, each with its advantages and drawbacks. 27 FINC3003 Chapter 13 H.W. Kot Computing the Price of Common Stock: The One-Period Valuation Model Simplest model, just taking using the expected dividend and price over the next year. What is the price for a stock with an expected dividend and price next year of $0.16 and $60, respectively? Use a 12% discount rate. 28 FINC3003 Chapter 13 H.W. Kot Computing the Price of Common Stock: The Generalized Dividend Valuation Model Most general model, but the infinite sum may not converge. Rather than worry about computational problems, we use a simpler version, known as the Gordon growth model. 29 FINC3003 Chapter 13 H.W. Kot Estimating Dividends: Special Cases Constant dividend Constant dividend growth The firm will increase the dividend by a constant percent every period Supernormal growth 30 The firm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula Dividend growth is not consistent initially, but settles down to constant growth eventually FINC3003 Chapter 13 H.W. Kot 16000 Profit 14000 12000 Revenue 10000 8000 6000 4000 Dividend 2000 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 http://www.mtr.com.hk/chi/investrelation/financialinfo.php 31 FINC3003 Chapter 13 H.W. Kot Average Dividend growth 3% (2001-2007) Billion 700 Growth 60% Revenue 600 50% Profit 40% 500 30% 400 20% 300 Revenue 10% Profit Revenue growth Profit growth 2001-2008 22% 22% 2009-2014 6% 0% http://www.chinamobileltd.com/?lang=en 32 FINC3003 Chapter 13 H.W. Kot 2014 2013 2011 2011 2010 2009 2008 2002 2007 -20% 2006 0 2005 -10% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 100 2004 0% 2003 200 Generalized formula D1 + P1 D1 D2 P2 = + + (1 + r ) (1 + r ) (1 + r ) 2 (1 + r ) 2 D3 P3 D1 D2 = + + + (1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) 3 D3 D1 D2 D4 DT PT = + + + + ... + + (1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) 4 (1 + r )T (1 + r )T Po = T = t =1 Dt PT + (1 + r ) t (1 + r )T If T →∞ Dt Po = t ( 1 + r ) t =1 33 No matter how high the stock price is in the very distant future, its present value is essentially zero FINC3003 Chapter 13 H.W. Kot Remarks P0 is the ex-dividend price of the stock The stock price immediately after paying the current dividend! (This is also true for any Pt) The stock price does not depends on how long an investor is going to keep the stock. We implicitly assume that corporations will not go bankrupt in the future. Why are shares of stock in companies that currently pay no dividends traded at positive prices? For example, Alibaba and firms with loss. 34 FINC3003 Chapter 13 H.W. Kot 35 FINC3003 Chapter 13 H.W. Kot Currently Pays No Dividends The market value derives from The hope of future dividends Price won’t continue to increase forever. The company will eventually run out of productive ways to use its cash. E.g., Microsoft in 2003, Apple in 2012 Berkshire Hathaway? The expectation of a liquidating dividend 36 FINC3003 Chapter 13 H.W. Kot Constant Growth Assume that dividends will grow at a constant rate, g, forever D1 = D 0 (1 + g ) D 2 = D1 (1 + g ) = D 0 (1 + g ) 2 D 3 = D 2 (1 + g ) = D 0 (1 + g ) 3 D t = D t −1 (1 + g ) = D t − 2 (1 + g ) 2 = ... = D0 (1 + g ) t P0 = (1 + r) t =1 P0 = 37 Dt t = t =1 Do (1 + g ) D1 (1 + g ) t −1 D1 … = = . t (r - g) (r - g) (1 + r ) D1 r−g FINC3003 Chapter 13 H.W. Kot Computing the Price of Common Stock: The Gordon Growth Model Same as the previous model, but it assumes that dividend grow at a constant rate, g. That is, 38 FINC3003 Chapter 13 H.W. Kot Computing the Price of Common Stock: The Gordon Growth Model The model is useful, with the following assumptions: Dividends do, indeed, grow at a constant rate forever The growth rate of dividends, g, is less than the required return on the equity, ke. 39 FINC3003 Chapter 13 H.W. Kot Remarks How can g ever be assumed to be constant? lies in the competitive equilibrium. Firms will often attempt to manage their dividend policy so that there is a reasonably constant growth in dividends. Motor industry in US 九龍塘火車站收舊報紙 美國汽車品牌 40 FINC3003 Chapter 13 H.W. Kot Remarks How can we assume that r > g ? In short-run, g maybe greater than r. In equilibrium, high returns on investment will attract capital, which will ensure that in the succeeding periods, higher returns cannot be earned without taking greater risk. But taking greater risk will increase r, so g can not be increased without raising r. 中國房地產 APPLE 41 FINC3003 Chapter 13 H.W. Kot Computing the Price of Common Stock: The Generalized Dividend Valuation Model The price earnings ratio (PE) is a widely watched measure of much the market is willing to pay for $1.00 of earnings from the firms. If the industry PE ratio for a firm is 16, what is the current stock price for a firm with earnings for $1.13 / share? Answer: Price = 16 $1.13 = $18.08 More on P/E ratio https://www.youtube.com/watch?v=_NAZxlIaf8U 42 FINC3003 Chapter 13 H.W. Kot P/E trap Current stock price Earnings per share Low P/E ratio is from: • Low current price => high future price • High current earnings => Low future earnings Tip: stocks paying stable (high) dividends 43 FINC3003 Chapter 13 H.W. Kot Chapter Outline Investing in Stocks Computing the Price of Common Stock How the Market Sets Security Prices Errors in Valuation Stock Market Index ADRs Long-term performance of index revisions 44 FINC3003 Chapter 13 H.W. Kot How the Market Sets Security Prices Generally speaking, prices are set in competitive markets as the price set by the buyer willing to pay the most for an item. The buyer willing to pay the most for an asset is usually the buyer who can make the best use of the asset. Superior information can play an important role. Short-term: Demand & Supply Long-term: Fundamental 45 FINC3003 Chapter 13 H.W. Kot How the Market Sets Security Prices Consider the following three valuations for a stock with certain dividends but different perceived risk: Bud, who perceives the lowest risk, is willing to pay the most and will determine the “market” price. 46 FINC3003 Chapter 13 H.W. Kot Errors in Valuation Although the pricing models are useful, market participants frequently encounter problems in using them. Any of these can have a significant impact on price in the Gordon model P=D/(r-g). • Problems with Estimating Growth • Problems with Estimating Risk • Problems with Forecasting Dividends 47 FINC3003 Chapter 13 H.W. Kot Errors in Valuation: Dividend growth rates Table 13.1 Stock Prices for a Security with D0 = $2.00, ke = 15%, and Constant Growth Rates as Listed 48 FINC3003 Chapter 13 H.W. Kot Errors in Valuation: Required returns 49 FINC3003 Chapter 13 H.W. Kot Errors in Valuation Security valuation is not an exact science! Considering different growth rates, required rates, etc., is important in determining if a stock is a good value as an investment. 在市場轉捩點附近,大多數人的感覺 永遠是錯誤的。 DJIA 如果你是瑞士口音,人们将会把你的 智商高估50分;如果是牛津剑桥口音, 可被高看25分;而可怜的老美,在这 里是入不了品的。 ——對沖基金風雲錄 50 FINC3003 Chapter 13 H.W. Kot Case: The 2007–2009 Financial Crisis and the Stock Market The financial crisis, which started in August 2007, was the start of one of the worst bear markets. The crisis lowered “g” in the Gordon Growth model - driving down prices. Also impacts ke - higher uncertainty increases this value, again lowering prices. The expectations were still optimistic at the start of the crisis. But, as the reality of the severity of the crisis was understood, prices plummeted. 51 FINC3003 Chapter 13 H.W. Kot Case: 9/11, Enron and the Market Both 9/11 and the Enron scandal were events in 2001. Both should lower “g” in the Gordon Growth model - driving down prices. Also impacts ke - higher uncertainty increases this value, again lowering prices. We did observe in both cases that prices in the market fell. And subsequently rebounded as confidence in US markets returned. 52 FINC3003 Chapter 13 H.W. Kot Chapter Outline Investing in Stocks Computing the Price of Common Stock How the Market Sets Security Prices Errors in Valuation Stock Market Index ADRs Long-term performance of index revisions 53 FINC3003 Chapter 13 H.W. Kot 54 FINC3003 Chapter 13 H.W. Kot Stock Market Indexes Stock market indexes are frequently used to monitor the behavior of a groups of stocks. Major indexes include the Dow Jones Industrial Average, the S&P 500, and the NASDAQ composite. https://www.youtube.com/watch?v=f0vdMBsC6fM 55 FINC3003 Chapter 13 H.W. Kot The Thirty Companies That Make Up the Dow Jones Industrial Average 3M, American Express, Amgen, Apple, Boeing, Caterpillar, Chevron, Cisco Systems, Coca-Cola, Disney, Dow, Goldman Sachs, Home Depot, Honeywell, IBM, Intel, Johnson & Johnson, JP Morgan Chase, McDonald’s, Merck, Microsoft, Nike, Procter & Gamble, Salesforce, Travelers, UnitedHealth,Visa, Walgreens, and Walmart. The highest close for the DJIA since 1896 (when it was first introduced) is 36,799.65 on January 4, 2022. http://money.cnn.com/data/dow30/ 56 FINC3003 Chapter 13 H.W. Kot Stock Market Indexes $1.00 invested in the DJIA back in 1980 (DJIA was around 800) would have grown to about $16.40 in 2012 (Dow closed year at 13,104). This represented an annual growth rate around 8.8%. What’s annual growth rate if Down closed in year 2022 at 33147? 800*[(1+g)^43]=33147 G=9.05% 57 FINC3003 Chapter 13 H.W. Kot 58 FINC3003 Chapter 13 H.W. Kot Buying Foreign Stocks Buying foreign stocks is useful from a diversification perspective. However, the purchase may be complicated if the shares are not traded in the U.S or your home country. American depository receipts (ADRs) allow foreign firms to trade on U.S. exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue receipts against the shares in U.S. markets. 59 FINC3003 Chapter 13 H.W. Kot Designing a Strategy to Source Equity Globally (refer to Citibank ADR guide) Depositary receipts (depositary shares) are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank. American depository receipts (ADRs) are certificates traded in the United States and denominated in US dollars. ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share. (China Mobile, 1 ADR=5 shares) 60 FINC3003 Chapter 13 H.W. Kot Mechanics of American Depositary Receipts (ADRs) 61 FINC3003 Chapter 13 H.W. Kot Designing a Strategy to Source Equity Globally ADRs can be exchanged for the underlying foreign shares, or vice versa, so arbitrage keeps foreign and US prices of any given share the same after adjusting for transfer costs. While ADRs are quoted only in US dollars and traded only in the US, Global Registered Shares (GRSs) can be traded on equity exchanges around the globe in a variety of currencies. May not list on home market, like Baidu, Alibaba. 62 FINC3003 Chapter 13 H.W. Kot China Mobile listed on HKEx and NYSE 63 FINC3003 Chapter 13 H.W. Kot China Mobile listed on HKEx and Shanghai A-share market March 22, 2022 64 FINC3003 Chapter 13 H.W. Kot 65 FINC3003 Chapter 13 H.W. Kot 66 FINC3003 Chapter 13 H.W. Kot Panel A: Pure domestic listing 1800 1600 1400 1200 1000 800 600 400 200 Developed 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 0 Emerging Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture. 67 FINC3003 Chapter 13 H.W. Kot Panel B: Cross-listings 250 200 150 100 50 Developed Emerging Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture. 68 FINC3003 Chapter 13 H.W. Kot 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 0 Panel A: Proceeds from local portion and global portion 300000 250000 Million USD 200000 150000 100000 50000 Local Proceeds Global Proceeds Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture. 69 FINC3003 Chapter 13 H.W. Kot 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 0 120,000 60% 100,000 50% 80,000 40% 60,000 30% 40,000 20% 20,000 10% Total Proceeds from Cross-listing IPOs 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 0% 1990 - Proceeds of cross-listing/Total porceeds Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture. 70 FINC3003 Chapter 13 H.W. Kot Croll-listing/Total proceeds Million USD Panel B: Cross-listing IPOs Benefits for a DR program for issuers Access capital outside the issuer’s home market Build company visibility in the U.S. and internationally Broaden and diversify shareholder base Expand opportunity to increase local share price as a result of global demand/trading Enlarge the market for the company’s shares, potentially increasing liquidity Adjust share price levels to those of peers through DR ratio Facilitate merger and acquisition activity through use as acquisition currency Develop stock option plans and stock purchases plans for U.S. employees 71 FINC3003 Chapter 13 H.W. Kot Benefits of a DR program for investors Facilitating diversification into Non-U.S. securities Trading, clearing and settling in accordance with practices of the investor’s home market Eliminating cross border custody safekeeping charges Providing enhanced accessibility of research, and of price and trading information Allowing easy comparison to securities of similar companies trading in the investor’s home market Permitting dividend payments in US$ and corporate action notifications in English Allowing for lower dividend tax rates for exchanged-listed ADRs 72 FINC3003 Chapter 13 H.W. Kot My related articles in the HK newspapers 明報 • 5國企退美市 不足為奇(2022.8.17) • 中概股回港上市高股價之謎(2021.6.18) • 跨境上市 貴在「承諾」——中國三大電訊商被 美退市的啟示(2021.1.13) 香港經濟日報 • 中資股來港第二上市續增 有何啟示(2020.9.14) • 阿里回港上市 衣錦還鄉抑另有所求? (2019.11.20) • 澳交所倘成立 吸4類企業跨境上市(2019.11.7) • 阿里巴巴不來 港人焉知非福(2013.12.24) 73 FINC3003 Chapter 13 H.W. Kot Regulation of the Stock Market The primary mission of the SEC of HK is “…to protect investors and maintain the integrity of the securities markets.” The SEC brings around 500 actions against individuals and firms each year toward this effort. This is accomplished through the joint efforts of four divisions. 74 FINC3003 Chapter 13 H.W. Kot Regulation of the Stock Market: Divisions of the SEC Division Duty Corporate Finance responsible for collecting, reviewing, and making available all of the documents corporations and individuals are required to file Market Regulation establishes and maintains rules for orderly and efficient markets Investment Management Enforcement 75 oversees and regulates the investment management industry investigates violations of the rules and regulations established by the other divisions FINC3003 Chapter 13 H.W. Kot https://podcast.rthk.hk/podcast/item.php?pid=911&lang=zh-CN 76 FINC3003 Chapter 13 H.W. Kot Chapter Outline Investing in Stocks Computing the Price of Common Stock How the Market Sets Security Prices Errors in Valuation Stock Market Index ADRs Long-term performance of index revisions 77 S&P 500 Index Hang Seng Index CSI 300 Index FINC3003 Chapter 13 H.W. Kot 78 FINC3003 Chapter 13 H.W. Kot A comprehensive long term analysis of S&P 500 Index additions and deletions Kalok Chan, Hung Wan Kot, & Gordon Y.N. Tang Journal of Banking & Finance, 2013 (37), 2920-2930 79 FINC3003 Chapter 13 H.W. Kot 80 FINC3003 Chapter 13 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 Number of Constituent Stock Changes 70 60 50 40 30 20 10 0 H.W. Kot Motivations Lack of study on long-run performance after stocks added to or deleted from an index. Changes of an index constituent stocks is an important event. The fraction of index funds among mutual funds increased significantly. 81 WSJ 2012.2.20 2001 2011 Index fund ETF Asset(100 million US$) 278 119 3,470 336 1148 12,400 Index fund/Stock fund (asset) 16% 33% FINC3003 Chapter 13 H.W. Kot Questions What’s the long-run stock performance of addition stocks and deletion stocks? What are the driving forces? Long-run operating performance Information environment Institutional ownership Analyst coverage, dispersion of forecasts Liquidity Investor awareness/shadow costs Insider trading 82 FINC3003 Chapter 13 H.W. Kot Market Adjusted Buy-and-hold Returns (Table 2) Post Event Months 83 [0, 36] [1, 36] [1, 60] Raw returns (additions) 0.44 0.40 0.75 Raw (additions) - CRSP 0.09** 0.06 0.11** T-value 2.22 1.59 2.17 Raw returns (deletions) 0.61 0.68 1.07 Raw (deletions) - CRSP 0.32*** 0.41*** 0.54*** T-value 3.83 4.40 4.92 Raw Ret (Deletions) – Raw Ret (Additions) 0.17* 0.28*** 0.32*** T-value 1.90 3.22 2.62 FINC3003 Chapter 13 H.W. Kot Institutional Ownership IH_NO is the number of institutions holding the stock; IH_RATIO is the proportion of stock held by institutions the total number of shares held by institutions divided the number of shares outstanding. Sample stocks: 1985-2003 84 FINC3003 Chapter 13 H.W. Kot Changes in Institutional Ownership (from Table 4) 0.7 300 0.65 250 0.6 200 0.55 150 0.5 100 0.45 50 0.4 t-5 t-4 t-3 t-2 t-1 IH_Ratio (Addition) 85 t t+1 t+2 t+3 t+4 t+5 IH_Ratio (Deletion) 0 t-5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5 IH_No (Addition) IH_No (Deletion) FINC3003 Chapter 13 H.W. Kot Analysts COVERAGE is defined as the number of analysts following a stock; DISPERSION is the standard deviation of analysts’ annual earnings per share forecasts for a fiscal year divided by the average of their earnings per share (EPS) forecasts. Sample stocks: 1979-2003 86 FINC3003 Chapter 13 H.W. Kot Changes in Analyst Coverage (Figure 2) 18 16 14 12 10 8 6 4 2 -60-55-50-45-40-35-30-25-20-15-10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60 Coverage-Addition 87 Coverage-Deletion FINC3003 Chapter 13 H.W. Kot Changes in Dispersion of Forecasts (Figure 2) 0.1100 0.1000 0.0900 0.0800 0.0700 0.0600 0.0500 0.0400 0.0300 0.0200 -60-55-50-45-40-35-30-25-20-15-10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60 Dispersion-Addition 88 Dispersion-Deletion FINC3003 Chapter 13 H.W. Kot Shadow Costs (×109) Re sidualS tan dardDevt FirmSize0 ShadowCost t = S&P500MarketCap 0 NumberofSh areholderst 89 FirmSize0 (the market value of equity) S&P500MarketCap0 are measured on the announcement dates of the index changes. ResidualStandardDevt is the standard deviation of the difference between the firm’s return and the S&P 500 total return over a 252-day period from year t-5 to year t before the index change announcement for the pre-period, or after the effective day for the post period. FINC3003 Chapter 13 H.W. Kot Changes of Shadow Costs (Table 6) 3 2.5 2 1.5 1.2 1 0.5 0.23 0.14 0 -5 -4 -3 -2 -1 Addition 90 0 1 2 3 4 5 Deletion FINC3003 Chapter 13 H.W. Kot Operating Performance Profit Margin is defined as net income divided by sales. ROA is defined as net income over total assets. OIBD/Assets is operating income divided by total assets, where operating income is defined as operating income before depreciation, amortization, and taxes, plus interest income. (CE+RD)/Assets is capital and R&D expenditures as a proportion of total assets. M/B is the firm’s market-to-book ratio. All ratios are adjusted by related industry average. 91 FINC3003 Chapter 13 H.W. Kot Industry-Adjusted Operating Performance Comparison (Addition stocks, from Table 8) 0.045 0.04 0.035 0.03 OIBD/Assets 0.025 CE+RD/Assets Profit Margin 0.02 ROA Market/Book*20 0.015 0.01 0.005 0 -5 92 -4 -3 -2 -1 0 1 2 3 4 5 FINC3003 Chapter 13 H.W. Kot Industry-Adjusted Operating Performance Comparison (Deletion stocks, from Table 8) 0.002 0 -5 -4 -3 -2 -1 0 1 2 3 4 5 -0.002 -0.004 OIBD/Assets -0.006 CE+RD/Assets -0.008 Profit Margin ROA -0.01 Market/Book*20 -0.012 -0.014 -0.016 -0.018 93 FINC3003 Chapter 13 H.W. Kot The long-term performance of index additions and deletions: Evidence from the Hang Seng Index Hung Wan Kot, Harry Leung, & Gordon Tang International Review of Financial Analysis 42 (2015) 407-420 94 FINC3003 Chapter 13 H.W. Kot Why Hang Seng Index? S&P 500 Index: survivorship bias Chan, Kot, and Tang (2013): Added vs deleted stocks (788 vs 244) Chen, Noronha, and Singal (2004): ¾ of S&P 500 deletions occur due to M&A, bankruptcies etc. Hang Seng Index Most deleted stocks are still listing on exchange 95 FINC3003 Chapter 13 H.W. Kot Hang Seng Index Start from July 31, 1964; 33 constituent stocks Quarterly review, 2 stages 1st : Fulfill 4 objective criteria (including no foreign firms) 2nd: 1. market cap, turnover ranking; 2. better reflect the subsectors in the market; 3. financial performance After September 11, 2006 No. of constituent stocks could increased to a max of 50 Mainland China firms are eligible Further study→ 96 FINC3003 Chapter 13 H.W. Kot Hang Seng Index vs S&P500 Index S&P 500 Index Hang Seng Index Most changes are initiated by deletions The majority of changes are because they can not represent the market Changes do not occur on a regular basis Quarterly review 22 additions/deletions per year 2.1 additions/deletions per year Announce the changes before the Announce one month before the effective dates: from 1 day to 1 month effective date One deletion match with one addition Not a one-to-one basis 97 FINC3003 Chapter 13 H.W. Kot Sample All of the additions to and deletions from the HSI from June 1986 to October 2008. Final sample comprises 44 added stocks and 35 deleted stocks. 98 FINC3003 Chapter 13 H.W. Kot Market adjusted buy-and hold returns (Table 2) Post Event Months [1, 12] [1, 60] Raw returns 0.0747 0.663 Raw-Hang Seng Index 0.0358 0.0055 0.46 0.03 Raw returns 0.0828 1.6636 Raw-Hang Seng Index 0.0455 0.9499*** 0.69 3.66 -0.0098 -0.9444*** -0.09 -2.93 Panel A: Additions T-value Panel B: Deletions T-value Panel C: Difference Raw-Hang Seng Index (A-B) T-value 99 FINC3003 Chapter 13 H.W. Kot Red-chips, H-shares & Family-owned firms Additions Others Red-chips & Hshares Deletions Familyowned firms Diff is significant Others Diff is insignificant 100 FINC3003 Chapter 13 H.W. Kot Operating performance profit margin return on assets (ROA) OIBD/assets (operating income before depreciation) (CE+RD)/assets (capital and R&D expenditures) M/B adjusted according to the industry average 101 FINC3003 Chapter 13 H.W. Kot Operating performance (Added stocks, normalized at t-5) 3.5 3 2.5 2 1.5 1 0.5 0 -5 -4 Profit Margin 102 -3 -2 -1 OIBD/Assets 0 1 2 CE+RD/Assets 3 ROA FINC3003 Chapter 13 4 5 M/B H.W. Kot Operating performance (Deleted stocks, normalized at t-5) 3 2.5 2 1.5 1 0.5 0 -5 -4 -3 Profit Margin 103 -2 -1 OIBD/Assets 0 1 CE+RD/Assets 2 3 ROA FINC3003 Chapter 13 4 5 M/B H.W. Kot Changes in analyst coverage (Table 5) 25 23 21 19 17 15 Additions 13 Deletions 11 9 7 5 -5 104 -4 -3 -2 -1 0 1 2 3 4 5 FINC3003 Chapter 13 H.W. Kot Beta RETitA / D − R ft = i + i (MKTt − R ft ) + it RETit is stock i’s return on month t, where A/D refers to whether it belongs to the addition or the deletion set. Rf is again the risk-free rate, and MKT is the monthly return of the HSI. We compute the betas using monthly data per year from years t-5 to t+5. 105 FINC3003 Chapter 13 H.W. Kot Beta changes (Table 7) 1.6 1.4 1.2 Additions 1 Deletions 0.8 0.6 0.4 -5 -4 -3 -2 -1 0 1 2 Additions 3 4 5 Deletions Panel B:Significance of difference (t-value) 106 t-5 vs. t 2.59** -0.14 t vs. t+5 -2.38** 0.88 FINC3003 Chapter 13 H.W. Kot CSI 300 additions and deletions Price performance of firms added to or deleted from the CSI 300. Added and deleted stocks both have abnormal returns over four-year holding period. Deleted stocks outperform added stocks Firm risk, manager overconfidence, and state ownership new identified factors Long-term impacts of index reconstitutions: Evidence from the CSI 300 additions and deletions, Gang Chu, John W. Goodell, Xiao Li, Yongjie Zhang, 2021, Pacific-Basin Finance Journal 69, 101651. 107 FINC3003 Chapter 13 H.W. Kot