not talked about another function of the securities markets, which is to
raise new capital for corporations–and for the federal government and state
and local governments.
When you buy shares of stock on one of the exchanges, you are not
buying a “new issue”. In the case of an old established company, the stock
may have been issued decades ago, and the company has no direct interest in
your trade today, except to register the change in ownership on its books.
You have taken over the investment from another investor, and you know that
when you are ready to sell, another investor will buy it from you at some
price.
New issues are different. You have probably noticed the advertisements
in the newspaper financial pages for new issues of stocks or bonds–large
advertising which, because of the very tight restrictions on advertising
new issues, state virtually nothing except the name of the security, the
quantity being offered, and the names of the firms which are “underwriting”
the security or bringing it to market.
Sometimes there is only a single underwriter; more often, especially if
the offering is a large one, many firms participate in the underwriting
group. The underwriters plan and manage the offering. They negotiate with
the offering company to arrive at a price arrangement which will be high
enough to satisfy the company but low enough to bring in buyers. In the
case of untested companies, the underwriters may work for a prearranged
fee. In the case of established companies, the underwriters usually take on
a risk function by actually buying the securities from the company at a
certain price and reoffering them to the public at a slightly higher price;
the difference, which is usually between 1% and 7%, is the underwriters’
profit. Usually the underwriters have very carefully sounded out the demand
is disappointing–or if the general market takes a turn for the worse while
the offering is under way–the underwriters may be left with securities that
can’t be sold at the scheduled offering price. In this case the
underwriting “syndicate” is dissolved and the underwriters sell the
securities for whatever they can get, occasionally at a substantial loss.
The new issue process is critical for the economy. It’s important that
both old and new companies have the ability to raise additional capital to
meet expanding business needs. For you, the individual investor, the area
may be a dangerous one. If a privately owned company is “going public” for
the fist time by offering securities in the public market, it is usually
does so at a time when its earnings have been rising and everything looks
particularly rosy. The offering also may come at a time when the general
market is optimistic and prices are relatively high. Even experienced
investors can have great difficulty in assessing the real value of a new
offering under these conditions.
Also, it may be hard for your broker to give you impartial advice. If
the brokerage firm is in the underwriting group, or in the “selling group”
of dealers that supplements the underwriting group, it has a vested
interest in seeing the securities sold. Also, the commissions are likely to
be substantially higher than on an ordinary stock. On the other hand, if
the stock is a “hot issue” in great demand, it may be sold only through
small individual allocations to favored customers (who will benefit if the
stock then trades in the open market at a price well above the fixed
offering price)
If you are considering buying a new issue, one protective step you can
take is to read the prospectus The prospectus is a legal document
describing the company and offering the securities to the public. Unless
the offering is a very small one, it can't be made without passing through
a registration process with the SEC. The SEC can't vouch for the value of
the offering, but it does act to make sure that essential facts about the
company and the offering are disclosed in the prospectus.
This requirement of full disclosure was part of the securities laws of
the 1930s and has been a great boon to investors and to the securities
markets. It works because both the underwriters and the offering companies
know that if any material information is omitted or misstated in the
prospectus, the way is open to lawsuits from investors who have bought the
securities.
In a typical new offering, the final prospectus isn't ready until the
day the securities are offered. But before that date you can get a
"preliminary prospectus" or "red herring"—so named because it carries red
lettering warning that the prospectus hasn't yet been cleared by the SEC as
meeting disclosure requirements
The red herring will not contain the offering price or the final
underwriting arrangements But it will give you a description of the
company's business, and financial statements showing just what the
company's growth and profitability have been over the last several years It
will also tell you something about the management. If the management group
is taking the occasion to sell any large percentage of its stock to the
public, be particularly wary.
It is a very different case when an established public company is
selling additional stock to raise new capital. Here the company and the
stock have track records that you can study, and it's not so difficult to
make an estimate of what might be a reasonable price for the stock The
offering price has to be close to the current market price, and the
underwriters' profit margin will generally be smaller But you still need to
be careful. While the SEC has strict rules against promoting any new
offering, the securities industry often manages to create an aura of
enthusiasm about a company when an offering is on the way On the other
hand, the knowledge that a large offering is coming may depress the market
price of a stock, and there are times when the offering price turns out to
have been a bargain
New bond offerings are a different animal altogether. The bond markets
are highly professional, and there is nothing glamorous about a new bond
offering. Everyone knows that a new A-rated corporate
bond will be very similar to all the old A-rated bonds. In fact, to
sell the new issue effectively, it is usually priced at a slightly higher
"effective yield" than the current market for comparable older bonds—either
at a slightly higher interest rate, or a slightly lower dollar price, or
both. So for a bond buyer, new issues often offer a slight price advantage.
What is true of corporate bonds applies also to U.S. government and
municipal issues. When the Treasury comes to market with a new issue of
bonds or notes (a very frequent occurrence), the new issue is priced very
close to the market for outstanding (existing) Treasury securities, but the
new issue usually carries a slight price concession that makes it a good
buy. The same is true of bonds and notes brought to market by state and
local governments; if you are a buyer of municipals, these new offerings
may provide you with modest price concessions. If the quality is what you
want, there's no reason you shouldn't buy them—even if your broker makes a
little extra money on the deal.
8. MUTUAL FUNDS. A DIFFERENT APPROACH
Up until now, we have described the ways in which securities are bought
directly, and we have discussed how you can make such investments through a
brokerage account.
But a brokerage account is not the only way to invest. For many
investors, a brokerage has disadvantages–the difficulty of selecting an
individual broker, the commission costs (especially on small transactions),
and the need to be involved in decisions that many would prefer to leave to
professionals. For people who feel this way, there is an excellent
alternative available—mutual funds.
It isn't easy to manage a small investment account effectively. A
mutual fund gets around this problem by pooling the money of many investors
so that it can be managed efficiently and economically as a single large
unit. The best-known type of mutual fund is probably the money market fund,
where the pool is invested for complete safety in the shortest-term income-
producing investments. Another large group of mutual funds invest in common
stocks, and still others invest in long-term bonds, tax-exempt securities,
and more specialized types of investments.
The mutual fund principle has been so successful that the funds now
manage over $400 billion of investors' money—not including over $250
billion in the money market funds.
8.1 Advantages of Mutual Funds
Mutual funds have several advantages. The first is professional
management. Decisions as to which securities to buy, when to buy and when
to sell are made for you by professionals. The size of the pool makes it
possible to pay for the highest quality management, and many of the
individuals and organizations that manage mutual funds have acquired
reputations for being among the finest managers in the profession.
Another of the advantages of a mutual fund is diversification. Because
of the size of the fund, the managers can easily diversify its investments,
which means that they can reduce risk by spreading the total dollars in the
pool over many different securities. (In a common stock mutual fund, this
means holding different stocks representing many varied companies and
industries.)
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