The Challenge for Canada's Equity Market

MR. GORE:

What we call a Stock Exchange has been defined as "an organized market for dealings in negotiable securities issued by, and for the financing of governments, municipalities, public bodies, and business corporations, formed under the law of the countries in which they are incorporated".

In tracing the origin of this formal institution, we must go back several centuries to the informal setting of the coffee house of the day. There groups of men would meet to act as intermediaries between buyers and sellers--collecting a fee for their services.

As business grew, these middle-men formed associations, with rules governing their trading of stock, and these associations gradually evolved into the high complex stock exchange of today.

The Toronto Stock Exchange was established in 1852. At the start, twelve Toronto citizens met for half an hour each morning in the offices of one of their number. By 1861 it was possible to list 36 stocks for trading. Following Confederation in 1867, however, the Exchange expanded by leaps and bounds.

A glance at the stock listings in our daily newspapers reveals how tremendous that growth has been. Specifically, in the year 1967, the Toronto Stock Exchange handled over two million transactions, involving about 820 million shares. The value of shares traded was over three and a half billion dollars, an all-time high for the Toronto Stock Exchange. And, if you can stand one more statistic, you might be interested in the price of a seat on the Exchange. The seats are auctioned off and the price in 1967 ranged from $65,000 to $92,000.

The marketing of securities in Canada is the subject of a special York University study of the characteristics of the supply and demand for equities in Canada, which provides a look at the present structure of the capital market, particularly the stock market, and what the future may hold in this area.

The subject is one that has particular interest for our speaker today, Mr. John S. Deacon. It can be said, in fact, that a deep involvement in, and a comprehensive understanding of, the operations of the modern stock exchange, are the professional trade-marks of Mr. Deacon, who is Chairman of the Board of Governors of the Toronto Stock Exchange and President of the Brokerage Firm of F. H. Deacon & Company Limited.

A native of Toronto, Mr. Deacon graduated from the University of Toronto with a B.A. in 1934 and joined F. H. Deacon & Co. Ltd. that same year. He served over seas in the Second World War and retired in 1945 with the rank of major. He was elected to the Board of Governors of the Toronto Stock Exchange in 1960, became its Vice-Chairman in 1964, and its President in 1966.

In a concise booklet entitled The Function of a Modern Stock Exchange which was published in May of last year, Mr. Deacon revealed an authoritative grasp of his subject, befitting his prominence in the securities field. We can look forward to receiving the benefit of his specialized knowledge today as he speaks to us about "The Challenge for Canada's Equity Market".

Gentlemen--Mr. John S. Deacon.

MR. DEACON:

Until very recently, it has been the policy of the Toronto Stock Exchange Board of Governors to have the President do all the speaking on their behalf, and for them to avoid all public appearances themselves. I am here as a result of a change in policy which reflects a recognition by the Board of Governors of their responsibility, not only to the Members of the Exchange but to the investing public. If we are to continue to govern the Exchange, we must make ourselves known personally to this wider constituency and to report to them regularly concerning our activities.

I do not propose to bore you, today, with a repetition of what we have done to mend fences, put out fires, and to improve generally the operations of the Exchange, although we are justly proud of the leadership which our Exchange has shown in our industry. In the past ten years we have brought about a fairly thorough house-cleaning of our segment of the investment industry. The results have been felt right across Canada. Our efforts, together with the new Ontario Securities Act, have created for investors, an entirely new environment of integrity, disclosure, and competence.

We have now progressed to the point where we can afford to devote much more of our time to constructive planning and action, particularly in respect to the equity market in Canada. Our first move, and this has been under way for some time, was to improve the communications system for stock markets in Canada. Using our computer, we have moved vigorously into the field of communications and data processing. We have launched a completely new national communications system designed to meet the particular needs of the investment community in Canada. This is reflected in the publication in the press of our stock tables which daily are fed electronically and at high speed to the press and wire services across the country. Our dial quotation service, though still in its very early stages of development, is unique because of its low cost and availability any place in North America. Many other progressive steps are in the hands of our computer programming staff.

In assessing our capital market generally, we have taken note of some significant trends that have been occurring. The interest of Canadian investors in U.S. stocks has prompted a considerable number of our Toronto Stock Exchange members to join the Mid-West Stock Exchange in Chicago. Recently, the New York Stock Exchange has decided to allow Canadian firms to join that Exchange subject to the approval of the Securities Exchange Commission. There is some likelihood that the American Stock Exchange will do likewise. If all of the major Canadian brokerage firms were to join the New York or American Stock Exchanges, it would mean that the market for our more seasoned stocks might shift to New York. What control this will give the Securities Exchange Commission over our Canadian firms remains to be determined. These developments might not be in the best interests of Canada.

The growing importance of institutional investors in the market-place is reflected in their seeking to become members of stock exchanges in order to secure reduced commissions. The Pacific Coast Stock Exchange has admitted several mutual funds as members of that Exchange. Included among them is American Growth Fund, which is operated by a Canadian broker.

In Canada reduced commissions are available on large block transactions which do not take place on the trading floors of the Exchange and in which the general public have no chance to participate. The effect has been to reduce the liquidity of our Exchange markets. Within the next few years, the Toronto and Montreal Exchanges will be introducing new procedures in a effort to bring this business onto the Exchanges and thereby increase the breadth and depth of our equity market, to the benefit of both private and institutional investors.

Marked competition is emerging between various types of institutional investors. Banks and trust companies have launched their own investment funds. Insurance com panies are now making strong drives into the retailing of what are the equivalent of investment funds. Such organizations as banks, trust companies and insurance companies have sizable sales forces and branch offices to mount a strong selling effort in this direction. Forbes Magazine recently remarked that it seems possible that the investment business in a few years may be dominated by giant institutions giving it an effect quite different from today.

To spur local development or to save public companies whose demise would create serious local depressions, governments have become joint shareholders with the public in various ventures. These trends plus government pension funds and the emergence of the proposed Canadian Development Corporation and its provincial equivalents are resulting in large amounts of money being accumulated by, or allocated to, government agencies. The funding and investing activities of these agencies will greatly affect the structure of the equity market in Canada.

Many of us older members of the Board of Governors in our so-called wisdom, express opinions concerning what is best for the future of the stock market in Canada. Fortunately, some of our younger Governors whom I like to refer to as "rebels" insist on facts and figures rather than opinions. It became quite apparent last year how limited was our background information about the stock market in Canada. Accordingly, discussions were begun with York University School of Business towards the launching of a study. We were gratified to find that not only was the University prepared and equipped to undertake such a task but that we would likely receive some considerable co-operation from various Federal Government departments towards developing statistics for such a study. In effect, the Study became a joint effort between our own statistical department, various Federal Government departments, and York University. The Study also involved directly and indirectly in varying degrees many financial institutions and other corporations in Canada whose unstinting co-operation helped us immeasurably. Some financial institutions in particular have expressed intense interest in certain of the sections of the Study, and we have hope that the results will be useful to these institutions.

My comments, today, are based on a very early draft of the Study which is entitled "Supply of and Demand for Canadian Stocks". It will be some considerable time be fore its text and statistics can be made available to those interested in the subject. It should be emphasized that the Study is not an exhaustive and final document. The Study is very much a preliminary examination of the equity marked, a pilot study which may likely point up vital areas that require more intensive studies.

As the Study began in 1967, it might have been appropriate to refer to it as our "Centennial Project". However, it seemed too selfish in its approach to deserve such a title. Perhaps now, through a more general use of its findings, it may become apparent that the Study has some real value for Canadians generally.

Because The Toronto Stock Exchange handles about 70% of the total dollar volume of trading in listed stocks in Canada, we realized it was our responsibility to work towards adding more depth, more breadth and greater liquidity to the market. By increasing the supply and demand for stocks, and hence the volume of trading, liquidity is increased. Liquidity is measured by the ease with which investors may buy or sell sizable amounts of securities without influencing the price unduly.

In order to plan the steps necessary to attain this latter important objective, it was essential to have a better understanding of the structure and trends of our Canadian stock market. This is the purpose of the York University Study, and I will now tell you about some of its more intriguing and interesting preliminary findings.

The Study indicates that between now and 1975, the additional demand for stocks by Canadian financial institutions and individuals will be about double the present annual increase in the supply of listed Canadian stocks. On the supply side, the Study estimates that the new equity financing of all listed Canadian companies averaged over $500 million a year over the four years 1963 to 1966.

The scarcity of quality Canadian stocks is due partly to the form in which foreign capital has entered Canada. Large blocks of capital have come into Canada as direct investment. By direct investment I mean advances to or investments in foreign controlled Canadian companies. About half of the largest corporations in Canada do not have any outstanding shares that are listed on a stock exchange. A number of these companies are controlled by Canadians, but most of them are subsidiaries of nonresident companies; non-resident companies that themselves are publicly traded in a foreign jurisdiction.

It is estimated that at the end of 1966 the pension funds, mutual funds and insurance companies held over $4 billion of stocks, $3 billion of this amount being in Canadian stocks. As fiduciaries, these institutions are reluctant to concentrate their investment in any particular company. Moreover by law, there are certain restraints against such concentration. Canadian institutional holdings have in the aggregate, already reached major proportions. At the end of 1965 they held over 20% of the outstanding common shares of eleven of the 101 largest listed Canadian companies, and between ten and twenty percent of an additional 25 of these largest companies.

The portfolio concentration of these institutional investors is also evident if one looks at the proportion of their total stock portfolio that is invested in relatively few companies. The pension funds and life insurance companies have about 93% of their Canadian stock portfolio in the 101 largest listed Canadian companies, while the mutual funds have 80% in these companies. Half of the total stock portfolio of all these institutions is invested in only 18 companies.

As the Study points out, it appears that if the institutions wish to continue to invest primarily in large wellestablished companies, their ability to greatly expand their Canadian stock portfolio is quite limited. More stock issues by established companies would be required. Otherwise, a substantial flow of funds will be directed into foreign securities.

On the demand side, the Study finds that if recent rates of growth continue and if the proportion of their total assets invested in stocks increase, as appears likely, pension funds, life insurance companies and mutual funds will be wanting to invest between now and 1975 almost $12 billion of new money in stocks. However, the Study points out that the rapid growth of the assets of these institutions in recent years may slow down and the increase in the relative size of the stock portfolios might not be so rapid. It should be noted that money presently invested in equities by individual Canadians might be moved into mutual funds. Even though this generates more money for mutual funds, it does not represent new money in the equity market.

If even three-quarters of the projected demand from institutions materializes, it means that between now and 1975 there would be about $1 billion a year of new money available for equities, or an aggregate amount of approximately $8 billion. This estimate of potential demand excludes any net purchases by Canadian individuals and Canadian financial institutions other than pension funds, mutual funds, and insurance companies. It also excludes any consideration of net changes in the portfolio position of non-resident, direct or indirect investors.

If the growth of stock holdings of Canadian individuals were to increase at a rate equal to half that of the gross national product, and if the growth of equity holdings by financial institutions other than mutual funds, pension funds, and insurance companies, parallels the growth of gross national product: then according to the Study, Canadian individuals and these other financial institutions would add an average of $300 million a year to their stock portfolios in the eight years to 1975. This in aggregate would amount to $2.4 billion in the eight years. Therefore, taking into account all major domestic demands for stocks in Canada, Canadians could have an average of $1.3 billion a year to add to their stock portfolio in each of the next eight years. This would work out to an aggregate potential demand of over $10 billion.

Mutual funds have shown the most rapid growth over recent years according to the Study. But, as they have increased substantially the proportion of their portfolio going into foreign stocks until their foreign stock holdings are now equal to their holdings of Canadian stocks, the impact of this growth has been somewhat muted. The growth of pension funds has exceeded 10% a year and can be expected to continue. More important, the porportion of their assets invested in stocks has more than doubled in the past five years and could well double again. Thus, pension plans could be an extremely important source of buying in the Canadian stock market, particularly if their purchases are not directed towards the foreign markets.

Undoubtedly, the most significant implication of the Study is the enormous potential demand for equities that will be generated by Canadian financial institutions and Canadian individuals in the immediate years ahead. The Study suggests that regardless of where these stocks will be bought, whether in Canada or the United States, Canadian individuals and institutional investors will be seeking to purchase between now and 1975 over $10 billion in equities. This figure could be conservative if, as seems quite likely, some of the major financial institutions will decide or will be allowed by law, to further increase the percentage of equities in their investment portfolio.

In my opinion, the findings of the Study, lay to rest, the old myth that had plagued us for years that there is a lack of capital in Canada for investment in equities. Not too long ago, it was clearly demonstrated to us that Canada's capital market has greatly matured. Recently, Canadians oversubscribed one single issue of $100 million of Canadian Pacific Investments Limited Preferred. It is my conviction that the capital is available if suitable vehicles for investment are offered.

To meet the projected demand for equities, the rate of new issues would have to more than double. Otherwise, it can be expected that the acquisition of foreign stocks by Canadians will increase dramatically. For example, the York Study points out that if the pension funds, life insurance companies, and mutual funds were to find it necessary to invest half of their total stock portfolio in foreign stocks, by 1975 they could well be holding $8 billion in foreign stocks. Thus, a substantial portion of the savings of Canadians would be invested in non-Canadian industries a development that might be acceptable, but one which at least must be recognized and assessed.

There are some startling inconsistencies in our market. We have an economy that requires massive amounts of capital. There are available unique investment opportuni ties. U.S. investors have taken advantage of these opportunities to invest in Canada by the end of 1966 a total of 27.3 billion. In 1966 alone, almost $1.1 billion came from U.S. investors in the form of direct investments while an additional $539 million was added to retained earnings of U.S. subsidiaries in Canada. While these large amounts of money are coming into Canada, Canadians are busily moving millions of dollars into U.S. equities. In 1967, the value of trading in U.S. stocks by Canadians exceeded the total value of the securities traded on the Toronto Stock Exchange. The Canadian equity market, if it were fulfilling its function, would provide the proper vehicle for directing Canadian investments into Canadian enterprises rather than U.S. equities. This it has failed to do.

Grave fears have been expressed as to the effect on the growth of the Canadian economy of the recently announced intention of the United States Government to enforce by legislation various formal restraints on the movement of U.S. capital. Little attention is paid to the growing imports of capital from other countries such as Japan, South Africa, Germany, Belgium and France. More important is the growing investment in equities by Canadians themselves. The study shows that in the 101 largest listed Canadian companies, Canadian ownership, has since 1962, increased in about 80% of these companies. If major U.S. based companies in Canada are to stagnate or even retrench because of United States Government edicts, then surely, this is an opportunity for us and others to take advantage of the vacuum.

In conclusion, I would like to enumerate the various points which have been mentioned. Many important changes are presently occurring in our industry. More and more savings are being channelled into securities through financial institutions. The decisions of relatively few people are now involved in the investment in securities of larger and larger sums of money. Competition between institutions for the management of such savings is intensifying. There will be changes in the characteristics of brokerage and investment firms; there will be changes in the types of firms that are permitted to become members or associated members of stock exchanges; and, there will be changes in the extent of participation by Canadian brokers or investment dealers in the U.S. stock exchanges.

The role of the government through pension funds, holding companies and economic development bodies, will become increasingly significant in the capital market. At the same time the Canadian Government may move towards encouraging a greater direct investment by Canadians in some of our crown corporations. There will have to be more investment opportunities of such a character as to attract both individuals and financial institutions.

The most important implication of the York Study is that there will be substantial supplies of Canadian capital available for investment in equities. Our industry, the financial institutions and our Canadian corporations must provide the necessary investment vehicles so that our equity market can properly allocate Canadian savings to sound Canadian investment opportunities where the capital will be used in the most efficient manner. This does not mean that we must buy back everything already owned by foreign investors in Canada. It might well be that the best investment opportunities for Canadians in Canada would be in providing the additional capital which will be required to finance the continued growth of our economy.

Our objectives of developing a more mature equity market in Canada are not purely selfish. A sound capital market is essential for the development of the economy of the country. The Toronto Stock Exchange acknowledges its responsibility in respect of the future development of our market, but the public and our major financial institutions also have some responsibility. Money going out of Canada into foreign countries does not further the development of our own capital market and our economy. There are, and will be, outstanding investment opportunities in Canada. It is for the public, financial institutions, corporate manager, and the Exchange community to identify these opportunities and devise the vehicles for channelling Canadian savings into them. For those Canadian corporations which have shown enterprise and expertise in their fields of endeavour Canadians have been quick to make capital available. Such companies can be the vehicles through which future Canadian investors can invest their money--all $10 billion of it--in the future of Canada.

Thanks of the meeting were expressed by J. G. K. Strathy.