The unlisted share market: beyond the pipe dream

While most investors think of the ASX when they think shares, there is also a thriving but lesser known share market that can offer quality investments at good prices. Peter Lavelle explains the workings of the unlisted share market.

While most investors think of the ASX when they think shares, there is also a thriving but lesser known share market that can offer quality investments at good prices. Peter Lavelle explains the workings of the unlisted share market.

Investors tend to automatically associate the buying and selling of shares with the Australian Stock Exchange (ASX). But while most shares in public companies are traded through the exchange, there is a small but thriving market in unlisted shares, traded via over-the-counter markets by specialist brokers.

Unlisted companies that trade their shares this way include building societies, pharmaceutical wholesalers, food and agriculture co-operatives, building products manufacturers, and unlisted property trusts.

While they don't have the liquidity of shares on the ASX, they trade at lower price to earnings ratios (PEs) than listed shares. Provided they pick the right company, investors can pick up quality stock at a better price than stock traded on the ASX.

According to David Perry, a director of Austock brokers, there are a variety of reasons why companies choose not to list but trade their shares privately.

They may not wish their share prices to be exposed to market volatility, which is a feature of listed small cap stocks in general - especially during a market downturn.

They may be too small or have too few shareholders to comply with ASX rules. Under these rules, a company must have a minimum of 500 shareholders and have assets of at least $2 million to list.

Or they may not be able to comply with other listing regulations. (For example, when the large pharmaceutical cooperative Sigma decided to become a public company, it wished to issue classes of shares; voting shares to be issued to its pharmacist members who wished to retain control of the company, and non-voting shares for other investors. Different classes of shares generally aren't allowed by the ASX, says David Perry. So the issue took place on Austock's alternative exempt market.)

If a small company doesn’t want to list on the ASX, but wants to trade its shares privately, it has several options.

In the case of smaller companies, the company itself may do the trading. The company secretary maintains a list of sellers - employee shareholders who have left the company, for example - and matches sellers with those potential buyers who make enquires to the company.

Once the register and the volume of turnover in the stock gets bigger, the system becomes an administrative burden, so an intermediary is needed — who in any case is usually more efficient at negotiating prices between buyers and sellers, says David Perry.

Most large brokers don't trade in unlisted stocks, as the volumes of trade in them is too thin compared to trade in ASX listed stocks to make it worth their while. So those brokers who do trade them are smaller brokers who tend to specialise in them, running what are known as 'exempt' markets - that is exempt from Corporations law requirements that require brokers to trade via the ASX. The best known is Melbourne-based Austock brokers.

Exempt markets are effectively over-the-counter markets, using paper-based settlement (although some are moving towards electronic trading facilities similar to the ASX's SEATS system).

The shares themselves are no different to those trading on the ASX. Unlisted companies can issue and trade ordinary or preference shares, undertake rights issues, and pay franked or unfranked dividends. Some unlisted companies have dividend reinvestment plans - there is even a market in options in some, says David Perry.

As far as the investor is concerned, the difference lies in the smaller volumes of trading taking place in these alternative markets, says stockbroker Richard Green, a broker at Cygnet Securities who also trades in unlisted stocks.

Because trading is less frequent and in smaller volumes, these shares have less liquidity than shares traded on the ASX. It may take months or even years to buy or dispose of them, he says.

This can be a drawback for some investors, but it can be an advantage, as the share price is not affected by a general market downturn, when small cap stocks tend to be sold down faster and further than larger stocks on the ASX.

It also means these shares tend to be traded at a discount to those of similar companies on the ASX.

For example, if a company is trading on the stockmarket at a PE ratio of 12 to 15 per cent (a typical range of PE ratios of small cap stocks), a similar unlisted company may be trading at a PE of 10 to 12 per cent, says Green.

"It gives investors a chance to buy in cheap", he says.

Some small companies see these markets as a stepping stone to a listing on the ASX at some stage in the future - at a time when their share register and their capitalisation do fit the ASX's requirements, says David Perry.

In this case the investor effectively gets a premium when the company does list.

One problem for investors however is the lack of information about the company - traditionally a problem with small cap stocks in general, but even more so in the case of unlisted stocks.

They are not subject to the reporting requirements of the ASX and so they receive much less coverage in the financial press (though Austock's markets are listed in the financial press and on their web site).

But generally speaking investors are reliant on brokers to monitor and keep them informed of the company's performance.

And, like small cap stocks in general, unlisted companies tend to retain profits to fund growth rather than paying them out as dividends. So the attraction for investors is usually the increase in share price and the capital gain on selling, rather than as a dividend income stream.

Richard Green believes investors who have most to gain from an investment in unlisted shares are those who are more experienced in share investing, are familiar with a particular company or industry, and who are prepared to stay in for the long haul - at least five to seven years.

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