Equities: Concepts and Legal Structures

Equities: Foundational Concepts and Legal Structures

• Equities' legal and structural features should be identified
• Equity market functions should be understood
• Risks unique to equity investing should be known
• Internalizing the fundamental nature of equity as a financial instrument is important

Defining Equity

• Ownership unit in a company
• Ownership grants economic and control rights over the company
• Owning a portion of a company's future is not lending money as with bonds

Legal Characteristics of Equity

• Organized by economic, membership, and structural/legal definitions

Economic Rights (Wealth-Linked)

• Dividend Rights: Share in residual profit (not guaranteed like a coupon)
• Liquidation Rights: Share of remaining assets if company is liquidated after all creditors
• Pre-Emptive Rights (PSR): Maintain the same percentage of ownership in future capital increases
• Transferability: Ability to sell/share, which may be limited by law or company statutes

Membership Rights (Control-Linked)

• Voting Rights: Right to vote in AGMs, elect board, and approve strategic decisions
• Right to Information: Access reports, question the board, and inspect governance
• Special Audit Right: Request special control investigation under certain cases
• Rights make shareholders participants in governance, unlike bondholders

Liability Limitation

• Shareholders' financial risk is limited to the invested amount
• Shareholders are not personally liable for corporate debts, unlike partners in a partnership

Nominal Value

• Accounting construct, not a market price
• In Switzerland, must be at least CHF 0.01
• Determines share in capital, not market valuation
• May differ between classes, like A shares (CHF 0.10) and B shares (CHF 1.00)

Economic Role

• Issuer (Company) provides long-term, non-repayable capital (no maturity date)
• Investor (Shareholder) gains ownership in growth, access to dividends, and capital appreciation
• Equities fund growth and risk-taking and offer potentially unlimited upside, but no guaranteed return

Types of Equity: Structural Classification

• Instrument classification moves from legal logic

By Registration Structure

• Bearer Shares: Anonymous ownership, where the holder is the owner
• Registered Shares: Name recorded in shareholder registry, must be accepted by the company
• Investors can register shares via banks using mandate and power of attorney in Switzerland to maintain anonymity

Hybrid or Special Types

• Participation Certificates: Come with nominal and economic rights, but no membership rights
• Profit-Sharing Certificates: Come with economic rights, but no nominal value or voting rights
• Voting Shares: Enhanced voting rights with a statutory limit of max 10x other shares

Preferred Shares (Preference Shares)

• Offer a fixed dividend (like bond)
• No voting rights, usually
• Dividend may be skipped without legal default
• Income-oriented, are a bond-equity hybrid

Restricted Shares

• Sold only to eligible investors (e.g., accredited or institutional)
• Common in private placements and employee stock plans
• Not registered with SEC, which limits resale (U.S. Rule 144)

Depositary Receipts (DRs)

• Certificates representing ownership of foreign shares
• ADR: American Depositary Receipt (listed in USD on NYSE/Nasdaq)
• EDR: European Depositary Receipt
• CDR: Chinese Depositary Receipt
• Issued by local depositary bank holding underlying shares
• Grants economic and voting rights
• Often used for cross-border listings

Chinese Share Classes (Example of Market Segmentation)

• A-Shares: China mainland market; Denominated in RMB; For domestic investors
• H-Shares: Hong Kong market; Denominated in HKD; For global investors
• B-Shares: Shanghai/Shenzhen market; Denominated in USD/HKD; For foreign investors
• N-Shares: NYSE/Nasdaq market; Denominated in USD; For global investors
• L-Shares: London market; Denominated in GBP; For global investors
• Red Chips: State-owned, listed in HK market; Denominated in HKD; For global investors
• Regulation, access, and currency define share classes

Strategic Thinking for Equity Structure Mastery

• Questions to consider from a wealth advisor's perspective:
  • Who holds the rights?
  • Are there restrictions on voting, transfer, or resale?
  • What income streams are available (dividends, fixed yield)?
  • What jurisdictions and legal rules apply (e.g., SEC rules, Swiss CO)?
• Questions to consider from an investor's perspective:
  • Is the share liquid?
  • What is the seniority in liquidation?
  • Do I get upside + governance rights?
  • Is the share tradable or blocked?

Key Equity Characteristics

• Equity = Ownership (property + membership rights)
• Types of equities vary by structure, rights, and legal origin
• Preferred shares = hybrid between bond and equity
• Depositary receipts = international equity access tool
• Chinese share classes show how regulation impacts equity markets
• Transferability, anonymity, and voting rights differ widely

Stock Market Capitalization

• Market Cap = Share Price × Shares Outstanding
• Represents the total market value of a company's equity
• Used to categorize companies as large-cap, mid-cap, or small-cap
• Reflects market sentiment (not book value)
• Serves as a proxy for scale, risk, liquidity, and analyst coverage

Free Float

• The proportion of shares not held by strategic, long-term holders
• Strategic, long-term holders excluded are founders, governments, cross-holdings, and insider holdings
• Free Float = Issued Shares – Strategic Holdings
• Used by index providers (e.g., MSCI, FTSE) to weight companies in indices
• Low Float = lower liquidity, higher volatility, potential price manipulation

Authorised Capital

• The maximum capital a board can issue without new shareholder approval
• Swiss companies' boards may increase capital by up to 50% of existing capital within 2 years
• Offers financing flexibility without convening a general meeting

Issued Capital

• Portion of authorized capital that is subscribed by shareholders
• Includes paid-up (fully paid by shareholders), called but unpaid (committed, not yet paid), and uncalled (not yet requested)
• Affects equity structure and shareholder obligations

Conditional Capital

• Capital becomes active only if a condition is met (e.g., conversion, exercise)
• Common triggers are convertible bonds, employee stock options, and warrants exercised
• Swiss rules allow up to 50% of ordinary capital, no time limit
• Enables deferred equity issuance for strategic flexibility

Shares Outstanding

• Shares Outstanding = Issued Shares - Treasury shares
• Used for market cap and EPS (earnings per share) calculations
• Declines with share buybacks and increases with new issuance

Share Repurchase on Own Account

• A company buys back its own shares
• Done to return capital to shareholders, support price, offset dilution, and boost EPS
• Can be done via market purchase, put options, or tender offer
• Often seen as a signal of undervaluation or strong cash flow

Ex Date vs Record Date

• Record Date: Date to determine eligible shareholders
• Ex Date: First day shares trade without entitlement
• If settlement is T+2, then Ex date = 2 days before the record date
• Needed because ownership settles after the trade, not on the trade date

Dilution

• Occurs during a capital increase
• Two effects: earnings dilution (EPS falls) and control dilution (reduced percentage of ownership and voting rights)
• Pre-emptive rights protect against dilution

Pre-emptive Subscription Right (PSR)

• Right to maintain percentage ownership during a capital increase
• Key features: one PSR per share held, allows subscription to new shares at a discount, tradable in secondary market (like a mini-option)
• Protects against value dilution (EPS) and control dilution (voting power)

Stock Split

• Divide each share into multiple shares, reducing nominal value
• Example: CHF 100 share → 2 × CHF 50 shares
• Shareholder wealth unchanged; increases liquidity
• Often done when price is too high for small investors

Reverse Stock Split

• Combine multiple shares into one, increasing nominal value
• Example: 10 × CHF 1 shares → 1 × CHF 10 share
• Done to raise price above minimum listing requirement or clean up penny-stock status
• Neutral in theory but often perceived negatively by the market

Dividend

• Portion of profits distributed to shareholders
• Forms: cash, stock, or optional (choose either)
• Ex date: Share trades without dividend
• Payment date: When funds are credited
• Subject to withholding tax, refundable under DTT (Double Tax Treaty)

Capital Gain/Loss on Sale

• Gain/Loss = Sale Price - Purchase Price
• Primary source of returns for growth investors
• Tax treatment depends on jurisdiction and holding period

Proceeds of Liquidation

• What remains after selling all company assets and paying debts
• Paid in order of: creditors, bondholders, preferred shareholders, common shareholders (last)
• Usually zero or near-zero for common equity holders in bankruptcy scenarios

Short Selling

• Selling securities not owned, hoping to buy them back cheaper later
• Mechanics: borrow stock, sell now, buy later at a lower price, and return stock to lender
• Used in hedging, speculation, and arbitrage
• Banned or restricted in many mandates, especially for fiduciaries

VWAP (Volume Weighted Average Price)

• Average price is calculated as: VWAP = Σ(Price × Volume) / ΣVolume
• Used for execution benchmarking, determining fair price over the day, and basis for algorithms and passive trading mandates
• A more accurate "average" than midpoint of high/low prices

Speaking the Language of Equities

• Understanding how ownership and dilution affect value is critical
• Knowing the timelines and mechanics of corporate actions is important
• Tracking how capital flows through dividends, buybacks, and splits is essential
• Think both like a trader (VWAP, float, repurchase timing) and a fundamentalist (EPS, capital structure)

Exam-Critical Takeaways for Equities

• Market cap = Price × Shares Outstanding
• Free float = tradable portion (excludes strategic holders)
• Ex date = first day without right to dividend
• Pre-emptive rights protect against dilution
• Stock split ≠ value change
• VWAP = trading benchmark
• Short selling = sell high, buy back low

Equity Classification by Market Participants

• Investors segment equities in ways that reflect different return dimensions and risk
• Cyclical vs. Defensive Equities: Characteristics determine volatility and example industries are noted
• Large Cap – Mid Cap – Small Cap: Market capitalization classification drives risk, liquidity, and return potential
• Growth vs. Value: A portfolio management style distinction that focuses on stock traits and risk profile

Cyclical vs Defensive Equities

• Defensive: Revenue/profits are stable across the economic cycle; include utilities, pharma, and consumer staples; low volatility
• Cyclical: Revenue/profits rise and fall with the economy; include construction, industrials, retail, and chemicals; high volatility
• Defensives are strategically used in downturns for stability
• Cyclicals are strategically used in booms for growth upside

Large Cap – Mid Cap – Small Cap

• Large Cap: Stable, established firms; Lower risk, High liquidity, Moderate return potential
• Mid Cap: Growth-oriented, scalable businesses; Medium risk, Medium liquidity, Higher return potential
• Small Cap: Emerging firms, under-covered; High risk, Low liquidity, and Very high (with risk) potential return
• Risk-adjusted returns favor mid-caps during expansion and large-caps during crisis periods

Growth vs Value

• Growth Style: Stocks that have high future potential with low dividends
• Focus: Price appreciation
• Risk Profile: higher volatility
• Value Style: Stocks that are undervalued relative to fundamentals
• Focus: Reversion to intrinsic value
• Risk Profile: less volatile (usually)
• Growth stocks equal tech startups
• Value stocks equal Banking, energy, industrials during recessions

Equity Listings

• Equities are listed in multiple currencies depending on their exchange
• Price moves in tick sizes → minimum increment based on price level
• What the buyer is willing to pay is the Bid Price
• What the seller demands is the Ask Price
• Spread = Ask − Bid → indicator of liquidity
• Tight spread equals liquid market
• Wide spread equals illiquid, volatile

Primary Market = First Issuance

• Primary Market is where companies raise capital by issuing new shares to investors
• Going Public = entering public market
• IPO = Initial Public Offering is the first equity issuance to the public
• Shares become tradeable only after IPO listing on an exchange

IPO Pricing Methods

• Fixed Price: Set by issuer; simple, rare; the company plus advisors set the price
• Book Building: Bank collects orders within a price range; most common; market participants set the price
• Auction: Bidders state quantity + price willing to pay; transparent but rare; market-driven

Primary Market Flow

1. Lead Manager (investment bank) receives funds
2. Deducts fees + commissions
3. Transfers net proceeds to issuing company
4. Shares distributed to investors (T+2 or T+3)

• No clearing house is involved; settlement is bilateral

Secondary Market = Trading After Issuance

• Secondary Market is where investors buy/sell shares that are already listed
• Platforms involved in trading are:
• Stock Exchange: Regulated, central venue (e.g., NYSE, SIX)
• OTC Market: Dealer-driven, bilateral negotiation (less regulated)
• MTF / ECN / ATS: Electronic alternatives, allow competition to traditional exchanges

Clearing & Settlement

• Central Counterparty (CCP) clears trades by netting obligations. This requires initial margin (upfront collateral for open trades) and variation margin (daily gains/losses on open positions)
• Trades settle via Delivery versus Payment (DvP) on T+2 (standard)
• CCP reduces counterparty risk by guaranteeing both sides of the trade

How Equity Classification is approached.

• Portfolio Managers diversify across cap size, growth/value, and cyclical/defensive
• Traders focus on liquidity, spread, and volatility
• Wealth Advisors match client risk profile to equity types
• Investment Banks structure IPOs based on demand and market segment

Exam-Critical Takeaways

• Cyclical = economic sensitivity, defensive = stable demand
• Cap sizes drive risk, liquidity, and coverage
• Growth vs Value = style choice based on future vs intrinsic valuation
• IPO = primary market entry; book building = common pricing
• Bid-ask spread = liquidity gauge
• CCP reduces counterparty risk in secondary trades
• T+2 = standard settlement timeline

Cash Flow Components for the Investor

• Understanding equity investment = tracking what goes in, what comes out, and what affects it

Cash Outflows (What You Pay)

• Primary Market: Issue Price × No. of Shares for new shares directly from the company
• Secondary Market: (Purchase Price × Shares) + Transaction Tax + Execution Fees for buying existing shares from another investor
• Execution fees only apply if the bank acts as an agent

Cash Inflows (What You Get)

• Dividends: Cash (or sometimes shares) are paid from company profits
• Sale Proceeds: Calculated by subtracting Transaction Tax & Fees from (Sale Price x Shares)
• Pre-emptive Rights: Rights to buy discounted shares during capital increase
• Bonus Share Distributions: Free shares from retained earnings

Taxation & Friction Costs

• Transaction Tax: Stamp duty, FTT, etc.
• Dividend Withholding Tax: Country-specific; refundable under Double Taxation Treaties (DTT)
• Capital Gains Tax: May apply in the investor's or issuer's country
• Capital Loss Tax Credit: Offset against gains (jurisdiction-dependent)
• Some countries offer "relief at source"; others require long-form reclaim

Example Cash Flow Timeline

• T0 (Buy) equals the Outflow of amount you invested.
• T1 (Dividend) Inflow equals CHF gross – CHF withholding.
• Tn (Sell) Inflow equals CHF sale – CHF Fees.

Investment Risks in Equities

• Requires looking at both systematic and idiosyncratic factors, plus jurisdictional and structural complexities

Maximum Loss

• Long investor's loss equals the entire amount invested
• Short investor's loss is theoretically infinite as stock could rise without limit

Price Risk

Specific (Idiosyncratic) Risk

• Depends on sector, management, strategy, and competition
• Solution: diversification

Systematic (Market) Risk

• Affects all stocks due to interest rates, inflation, recession, and geopolitical shocks
• Beta (β) is the key metric

Meaning of Beta

• β=1 Moves like the index.
• β>1 More volatile than the market.
• β1

Credit Risk (Issuer Default)

• The company may become insolvent → equity holders are last in line
• Even if the firm is liquidated, residual value for shareholders may be zero
• No further liability beyond investment (unlike a partnership)

Tax Risk

• Tax treatment may change after investment (e.g., dividend is now taxed at a higher rate)
• Reclaiming withholding tax on dividends may be complex
• Use of double tax treaties and qualified intermediary (QI) structures is critical

Liquidity Risk

• Liquidity Risk is the risk that you can't sell, or only by accepting a large price cut
• Key divers are company size (small cap = lower liquidty) and market crisis (liquidity dries up)
• Regulatory constraints (e.g., restricted shares)

Foreign Exchange Risk

• Occurs when:
• Share is denominated in a non-reference currency
• Dividends or sale proceeds are paid in a foreign currency
• Currency volatility may wipe out gains or exacerbate losses

Country Risk

• These are jurisdictional risks, especially relevant for emerging market or foreign-listed stocks
• Nationalisation, where Government seizes assets
• Capital Controls, where Funds cannot be repatriated
• Accounting/Transparency Gaps, where there are Misleading financials
• Legal Uncertainty, where it is difficult asserting rights or enforcing contracts
• Economic Collapse, where there is Macro instability that disrupts firm operations
• All translates to higher required return (risk premium)

Investors

• The Role of Investors is to Buy price, dividend stream, tax efficiency, and exit value
• The Role of Portfolio Managers is Beta, risk exposure, and currency matching
• The Role of Tax Advisors is Whithholding, reclaim treaties, and CGT optimization
• The Role of Risk Officers is managing Exposure to default, illiquidity, and FX volatility

Equity Risks: Summary

• Primary cost = Price × Shares + Fees + Tax
• Cash inflows = Dividends (net), Sale Proceeds, Rights, Bonuses
• Max loss = 100% (long); unlimited (short)
• Specific risk = company-specific (diversified away)
• Systematic risk = market-wide (measured via β)
• FX, tax, and country risk are no-price risks that are critical
• Net cash flow depends on timing, fees, taxes, and foreign exposures