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Securities as an Investments

An amazing diversity of securities has developed over time. People have been very creative in developing securities, and there are many variations on the general type described here. The pace of innovation has increased in recent years with the development of quantitative analysis and investment models. New types of securities are being created, and old types modified, at an unprecedented pace. Financial engineering, which it the design of new and often very complex instruments and strategies, has emerged as a separate new discipline. The standard forms of securities predominate, however, and are typically classified according to various common characteristics into equity, fixed income, derivatives, and money market securities. There are also some investment instruments that have security characteristics, but are less readily traded. While investors need not live in constant fear, it is not advisable to invest without complete understanding of the nature of the security involved.

Equity Securities

Equity securities are simply evidence of a partial share in the ownership of an enterprise. Thus, individual common stocks are referred to as "shares." Sale of shares is more attractive to the firm than direct investment. Since many shares can be issued for the same enterprise, the firm has access to a much wider pool of capital. This enables the firm to raise larger amounts and so consider larger projects.

Sale of shares is also attractive to management, at least in part, because it has more control over the firm due to the diffusion of ownership. The holder of a share does not have a direct voice in the management of the enterprise, but has an indirect control through the election of the members of the board of directors, who in turn choose the management of the firm. Voting for directors may be through simple majority voting or through cumulative voting. In the majority system, each investor may cast one vote per position for each share held, and the director receiving more than 50% of the votes wins. Under majority voting, a group holding more than 50% of the voting stock could lock out minority groups. In the cumulative system, each investor receives one vote per position for each share held, but may "cumulate" the votes received by casting them all for one candidate. Under cumulative voting fewer shares are required to guarantee election of a director, so that excluding minority stockholder groups is more difficult.

Managements of firms that are takeover targets or are facing challenges from stockholders prefer to be under majority voting. Even under cumulative voting mounting a successful dissident drive faces formidable hurdles, however, since management may dominate the board of directors and controls the assets of the firm. If there is a disagreement with management the conventional wisdom of Wall Street has been to sell the stock rather than mount a challenge. This conventional wisdom has changed somewhat in recent times because of a willingness of stockholders to take on the role of activists. Also, large positions held by institutions such as mutual fund or pension funds make challenges to management easier to pursue.

The cash flows to an equity investor are not specified in advance. They depend on the success of the enterprise, are uncertain or risky, and are properly described in terms of probability distributions. As part owner of the firm, the owner shares in the success or failure of the firm in two ways. The first way is through returns from capital gains and capital losses, increases or decreases in the value of the stock. The second way is through cash flows arising from the distribution of earnings in the form of dividends. The distribution of earnings through dividends is not automatic. Dividends are not obligation, but instead are "declared" at the discretion of the board of directors. In practice, dividends are usually not just a function of earnings. Dividends are thought to be a signal to investors as to firm performance. Management prefers to present positive signals, "smoothing" dividends by avoiding decreases and increasing dividends only if it is likely that the higher level can be maintained. In some cases, firms have raised funds in the capital markets so as to maintain the dividend. An exception is the extraordinary dividend, so labeled by management as a sign that the increase is not permanent.

In case of bankruptcy, common stock has limited liability. Legally, the firm is considered to be an individual, able to assume its own liabilities separately from the shareholders. As a result, liability is separated from ownership. The investor is not liable for the debts of the firm, and should the firm fail the investor's loss will be limited to no more than the amount invested. In bankruptcy the various claims on the firm follow a well-defined priority, with common stockholders assigned the lowest priority. It is for this reason that the common stockholders are sometimes called the residual owners of the firm. Limited liability is very important to investors, and is considered a major factor in the development of the corporate form of business.

There are other characteristics of equity that are less universal, and there are other exceptions to these general properties of equity securities. Some firms have multiple classes of stock with different voting power and/or share of dividends. Other stock may be restricted as to trading. Common stocks are traded in several exchanges and over the counter. The size of the underlying firm, and the trading volume of the stock vary widely. Consequently, the liquidity and the amount of information available on a stock also vary widely.

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