A new way of sharing in the share market

The last few decades have seen a remarkable explosion in the different types of securities that are tradeable on the world’s financial markets.

These days you can buy shares on an instalment plan, buy and sell future shares in the present, and even sell shares that you don’t own, that belong to other people.

We can only wonder at the extraordinary ingenuity of the financial engineers who dreamed up these instruments. But these are the same geniuses who also gave us the CDOs - opaque, pooled streams of mortgage income that nearly wrecked the entire world financial system.

One of the things that all these instruments have in common is that none of them generate any more capital for the companies who ultimately produce all of the value that underpins them.

So what about developing a new type of security that would generate a continuous stream of capital for companies? At the moment, companies make an issue of new shares, and receive an influx of new capital on a once-only basis when they first sell these shares to the public. But once these shares enter the second-hand market, aka share market, companies no longer benefit from them being sold, even though they may be sold hundreds, or even thousands of times again, in some cases at 100 times their original value.

This is a little reminiscent of the art market, where artists benefit from selling their paintings to the first buyer, but have traditionally received nothing when the paintings are resold years later, perhaps for hundreds of thousands of dollars or more. If Van Gogh were still around, he would still be a pauper.

In Australia we have seen the obscene spectacle of Indigenous art being sold at these types of prices while the artists barely have enough food to eat.

It was for these reasons that many countries have now introduced resale royalties for art, in which a small surcharge on the resale price is returned to the artist, who, after all, is the original creator of all the value that everyone receives from the painting.

What about applying the same type of system to shares? Companies too are the creators of all the value, and also the added value, that accrues to shares. Shares only appreciate in value if the company is successful and the amount of profit per share increases. Consequently, shares are usually valued at a certain multiple of the earnings per share.

Why shouldn’t BHP Billiton or Westpac get, say, 1 per cent of the resale price of every BHP or Westpac share that is sold on the stock market? This would give them a tidy amount of extra capital to plough into expanding their operations, and therefore creating additional value. And the beauty of it is that they could obtain this extra capital at effectively no cost, and because they would not have to issue additional shares, they would not be diluting the returns that each shareholder can get in the short term (i.e. before the increased productivity flows through the pipeline).

On any given day, 15 million BHP shares might change hands on the Australian Stock Exchange, at say $30 per share (less at the depressed prices in the current downturn). At the rate of 1 per cent per share, this could generate $4.5 million in additional capital for BHP in one day’s trading.

Of course other companies have lower share prices, and would thus generate lower amounts of extra capital. I know of another mining company, Admiralty Resources, that has fallen on hard times and had to sell its most valuable asset (a salt lake rich in lithium) to survive, because it couldn’t raise the money to develop it.

If that company had been able to use repeating shares to generate extra capital at the time when its shares were still worth, say 24c, and it was turning over a similar number shares each day, it could have generated $37,500 per trading day. In only a hundred days of trading it would have been able to generate $3.75 million of new capital on this basis. In actual fact the company’s shares probably would have been worth a lot more, as the market would price in the fact that it would be able to raise the capital it needed to successfully complete the project.

The repeating shares could also have been a valuable recourse for the world’s banks in the period following the financial crisis, during which they needed to raise large slices of additional capital to maintain their lending ability and also satisfy the capital reserve requirements of regulators.

Of course, companies need to manage their capital wisely, and should not accumulate vast amounts of capital that they can’t use. For this reason, it would be necessary to add a small complication to the system, and ensure that companies could turn the repeating contribution on or off according to needs. They could give notice to the stock exchange that from such and such a date, the surcharge should be applied to all shares sold because they were in need of additional capital. And later they could notify the exchange that from such and such a date the surcharge should no longer be applied to transactions, as they did not need additional capital for the time being.

Alternatively, of course, the company could simply return the additional capital to shareholders. This would be a valuable source of additional return to shareholders.

These types of shares are likely to increase in value more than normal shares. The companies that issue them will have a free source of capital available to them whenever they need capital, without needing to dilute. Consequently, although the cost of acquisition will be 1 per cent higher than it otherwise would be, these shares could be highly sought after, as the companies will be better positioned to invest for long-term returns, and dilution would be less likely. This might create a perverse incentive however, as the shareholders might be less inclined to sell these shares, thus tending to limit the supply of additional capital.

Any change has differential effects on the various players in the market, and these would need to be modelled. On the face of it, we would expect the introduction of repeating shares to:

• favour sellers (who don’t pay the surcharge) over buyers (who do);
• favour buy and hold investors over day traders and other investors who conduct frequent transactions; and
• for the same reason favour non-profit funds over commercial funds that need to trade frequently to meet annual targets.

Clearly we would be transferring some of the cost of capital from companies to investors in used shares (as opposed to investors in new issues). And we would be reducing the overall return to investors, but not by much, especially for long-term investors who are after recurring dividends as well as capital gains. By definition, the capital gain on any investment would be reduced by the amount of the surcharge, but the total shareholder return would not be much reduced.

And, of course, there would be transaction costs. Brokers would have to deduct these before remitting the residual additional contribution back to the companies. But the transfers would be totally automated, and therefore the costs would be minimal, I would have thought.

So, what do you think? Do the benefits to the market overall outweigh the disadvantages?