note on the ebook edition this ebook published in 2014 by...
TRANSCRIPT
Note on the Ebook EditionFor an optimal readingexperience, please view largetables and figures in landscapemode.
This ebook published in 2014 by
Kogan Page Limited2nd Floor, 45 Gee StreetLondon EC1V 3RSUK
www.koganpage.com
© Michael Becket, 2012, 2014
E-ISBN 978 0 7494 7239 9
Full imprint details
Contents
Howthisbookcanhelp
Acknowledgements
01 What and why
are shares?QuotedsharesReturnsStockmarkets
02 What arebonds andgilts?
BondsPreferenceshares
ConvertiblesGilts
03 Thecomplicatedworld ofderivatives
PooledinvestmentsOtherderivatives
04 Foreignshares
05 How to pick ashare
StrategyTheeconomyPickingshares
06 Tricks of the
professionalsFundamentalanalysisTechnicalanalysis
07 Where to findadvice andinformation
AdviceInformationIndices
OnlineCompanyaccountsUsingtheaccountsOtherinformation
fromcompaniesOthersourcesComplaints
08 What does ittake to dealin shares?
InvestmentclubsCosts
09 How to tradein shares
Howtobuyandsellshares
UsingintermediariesTradingStockmarketsOthermarkets
10 When to dealin shares
ChartsTechnicaltoolsSentimentindicatorsOtherindicatorsSelling
11 Consequencesof being a
shareholderInformationAnnualgeneral
meetingExtraordinarygeneral
meetingConsultationDividendsScripissuesRightsissuesNomineeaccounts
RegulatedmarketsCodesofconductTakeoversInsolvency
12 TaxDividendsCapitalprofitsEmployeeshare
schemesTaxincentivestorisk
ISAsSIPPsTaxrates
GlossaryIndex
M
How thisbook canhelp
akingmoneydemandseffort,whetherworking
forasalaryorinvesting.Yougetnothingfornothing.Anyonewhotellsyouthestockmarketisanabsolutedoddle,andmoneyforoldrope,iseitheraconmanorafool.Andtheproofofthatbecameveryclearwiththestockmarketdepressionsstartingin2007.Butdoingabitofworkdoesnotnecessarilymeanheavy
mathematicsandseveralhourseverydaywiththefinancialpress,theinternetandcompanyreports–thoughabitofallthoseisvital–butitdoesmeantakingthetroubletolearnthelanguage,doingabitofresearchandthinkingthroughwhatitisyoureallywantandwhatpriceyouarepreparedtopayforit.Attheveryleast
thatlearningwillputtheinvestoronamoreevenfootingwiththepeopletryingtosell.
Ithasbeenhardenoughearningthemoney,sothisbookhelpswiththelittlebitextratomakesurethecashisnotwasted.
Therearefewgeneralrulesaboutinvestmentbutthemostimportantisvery
simple:ifsomethingorsomebodyoffersasubstantiallyhigherprofitthanyoucangetelsewhere,thereisariskattached.Theworldofinvestmentisprettysophisticatedandprettyefficient(intheeconomists’sensethatparticipantscanbefairlywellinformed),soeverythinghasaprice.Andthepriceforhigherreturnsis
higherrisk.Thereisnothingwronginthat–Chapter5setsouthowtodecidewhatyouracceptablelevelis–butthepointisithastobeaconsciousdecisiontoacceptthedangersratherthanmakeagreedygrabforwhatseemsabargain.
Scepticismisvitalbutitneedstobehelpedwithsomethingtojudge
informationby,andthisbookprovidesthat.Intheendthough,thereisnobetterprotectionthancommonsense,askingoneselfwhatislikely,plausibleorpossible.Forinstance,whyshouldthismanbeofferingmeaninfalliblewayofmakingafortunewhenhecouldbeusingithimselfwithoutmyparticipation?Whyisthe
sharepriceofthiscompanysoaringthroughtheroofwhenIcannotseeanyreasonablesubstancebehindit?WhatdoesthemarketknowaboutthatcompanythatIdonotwhichmakesitssharesseemtoprovidesuchahighreturn?Whatismyfeelingabouttheeconomythatwouldjustifythewaysharepricesingeneralare
moving?Thestockmarketisof
coursenottheonlyavenueofinvestment.Peoplebuytheirownhomes,organizelifeassuranceandpensionpolicies,andhaverainy-daymoneyaccessibleinbanksandbuildingsocieties.Andindeedthosefoundationsshouldprobablyprecedegettingintothestockmarket,
whichisgenerallymorevolatileandrisky.
Shareshavehadtheirlowmoments,forexampleatthedotcomcrashormorerecentlyduringthecreditcrisis,butoveranyreasonablymiddle-termviewthestockmarkethasprovidedabetterreturnthanmostotherformsofinvestment.That,however,isanaverageanda
longishview,soyoustillhavetoknowwhatyouaredoing.Thatiswhythisbookstartswithsettingoutwhatthevariousfinancialinstrumentsare:sharesandotherthingsissuedbycompanies,bondsandgilts,andthenderivatives,whicharethecleverwaysofpackagingthoseprimaryinvestments.Eachhasitsown
character,benefitsanddrawbacks.
Thathelpswiththedecisiononwheretoputyourmoney.Atleastasimportantisthetiming.Thatapplieswhetheryouareanin-and-outenergetictraderoralong-terminvestor,andChapter10willprovidehelp.
I
Acknowledgements
wouldliketothankthegreathelpprovidedbytheWealth
ManagementAssociation(www.thewma.co.uk)inprovidingveryhelpfuladvice
andup-to-dateinformationonthemarket,andforthecarefulhelpoftheLondonStockExchangeinvettingtheaccuracyofthetext.
IwouldalsoliketothankBarclaysCapitalforthechartsfromitspublication,BarclaysBankEquityGiltStudy.
AndofcourseIremainconstantlygratefulforthehelp,patienceandencouragementofmywifeKay.
Chapter OneWhat andwhy areshares?
Businessesneedmoneytogetstarted,andeven
moretoexpandandgrow.Whensettingup,entrepreneursraisesomeofthisfromsavings,friendsandfamilies,andtherestfrombanksandventurecapitalists.Backersgetareceiptfortheirmoneywhichshowsthattheirinvestmentmakesthempart-ownersofthecompanyand
sohaveashareofthebusiness(hencethename).Unlikebanks,whichprovideshort-termfinanceatspecifiedratesthathastoberepaid,theseinvestorsarenotlenders:theyaretheowners.Ifthereare100,000sharesissuedbythecompany,someonehaving10,000ofthemownsatenthofthebusiness.
Thatmeansthemanagingdirectorandtherestoftheboardaretheshareholders’employeesjustasmuchastheshop-floorforemanorthecleaner.Beingashareholdercarriesallsortsofprivileges,includingtherighttoappointtheboardandtheauditors(seeChapter11).Inreturnforriskingtheirmoney,shareholdersofsuccessful
companiesreceivedividends.Theamountvarieswithwhatthecompanycanaffordtopayout,whichinturndependsonprofits.
Atsomestagethebusinessmayneedmorethanthoseoriginalsourcescanprovide.Inaddition,therecomesatimewhensomeoftheoriginalinvestorswanttowithdrawtheirbacking,
especiallyifitcanbeataprofit.Theonlywaytodothatwouldbebysellingtheshares,whichmeantfindinganinterestedbuyer,whichinitselfwouldbefarfromeasy,andthenhagglingabouttheprice,whichwouldbeawkward.Apublicmarketplacewasdevisedfortradingthem–astockexchange.Companies‘go
public’whentheygettheirsharesquotedonthestockexchangetomakethingseasyforinvestors–aneatlittledeviceinventedbytheDutchrightatthestartofthe17thcentury.
Quoted shares
Onceacompanygetsitssharesquotedonthestock
exchangethereisacontinuouslyupdatedandgenerallyknownmarketprice,whichisusuallyfarhigherthanthelevelatwhichtheoriginalinvestorsputtheirmoneyintothefledglingbusiness.Inaddition,thereisa‘liquid’market,meaningtherearelargenumbersofpotentialoractualtradersinthepaper,andsoholdersof
theshareshaveafargreaterchanceoffindingbuyers,andpeoplewhowanttoputmoneyintothebusinesshavereadyaccess.
Blue chipsAllinvestmentcarriesarisk.Bankscanrunintotroubleandcompaniescangobust.Ithasanelementofgambling
and,asyouwouldexpect,theoddsvarywithwhatoneinvestsin.Themajordifferenceisthattheonlywaytowinattruegamblingistoownthecasinoortobeabookmaker,whileintheworldofthestockmarketthechancesofatotallossarerelativelysmallandwithcarefulinvestmenttheprospectsareprettygood.
‘Itisusuallyagreedthatcasinosshould,inthepublicinterest,beinaccessibleandexpensive.AndperhapsthesameistrueofStockExchanges’,wroteJohnMaynardKeynesin1935.Hehimselfmadeasmallfortuneontheexchangebutitissalutarytoberemindedoftheanalogyfromtimetotimeandthecomparablerisks;the
term‘bluechip’isanexample.Thehighestvaluegamblingchipsinpokerweretraditionallyblue,andthestockswiththehighestprestigewerereckonedsimilar.Sothecompaniesdescribedasbeingbluechiparethelargest,safestbusinessesonthestockmarket.
Thecompaniesinthe
FTSE100Index,beingthehundredbiggestcompaniesinthecountrybystockmarketvaluation,arebydefinitionallbluechips.Thatisreckonedtomakethemthesafestbetsaround.Thetheoryisnotunreasonable–largecompaniesaremorestablethansmallones;theycanhirethebestmanagersandfundthebiggestresearchbudgets;
theyhavethefinancialmuscletofightoffcompetition;theirverysizeattractscustomers;andthelargeissuedsharecapitalgenerallyspeakingprovidesaliquidequitymarketwithmanysmallinvestorsandsomaintainsasteadierprice.Inpracticesomesmallercompanies,evenintheAlternativeInvestment
Market,sometimescanalsoprovidethecomfortofaliquidmarketasaresultofbrisktradingintheshares.
Thecorollarytothatisthesharepricemovementsshouldbelessviolent,givingstability(butprovidingfewerchancesofshort-termprofitsthroughhoppinginandout),andtheyieldislikelytobelowerthanonriskier
investments.Bluechipsharesare,inthetraditionalphrase,theinvestmentforwidowsandorphans.
Butnotinvariably:bluechipsaresaferthanacompanysetuplastyearbyacoupleofundergraduateswithabrilliantidea,buttheyarenevercompletelysafe.Theymaybeaboutthemostsolidthereisbuttheystill
needtobewatched.Asanillustration,itisinstructivetolookbackattheIndexofthelargestcompaniesof,say,thepast30yearsandseehowfewremain.RememberthatcompanieslikeBritishLeyland,Rolls-RoyceandPollyPeckwereallintheIndexatonetime,andallwentbust–thoughwithgovernmenthelpRolls-Royce
didre-emergeasasuccessful,quotedaero-enginemanufacturer.Hugebankswerehumbledacrosstheworldin2008asaresultoftheirfecklesslending,andevencompaniesthatdonotcompletelycollapsecanfalloutoffavour,haveincompetentmanagers,andshrinktorelativeinsignificance(suchasthe
BritishcompanyGeneralElectric,whichshrankandthenbecametheprivatecompanyTelent).
Thereasonnoteveryoneseeksthesafetyofbluechipsharesistheirprice–sowellknownthattheyareprettyfairlyvalued,andsothechancesofbeatingthemarketarevanishinglyslim.Beinggenerallymultinational,they
arealsoexposedtocurrencyfluctuations.
Thenextsetofcompaniesjustbelowtheminmarketvalue,theFTSE250,isgenerallymorerepresentativeoftheBritisheconomy,whichisclosertohomeandhencemoreeasilyunderstandable.
Finally,smallandnewentrepreneurialcompanies
maybemoreriskybutthatmeanstheyhavethepotentialforfastergrowthandgreaterreturns–providedofcoursetheydonotgobust.ItisalsoworthrememberingthatevencompanieslikeMicrosoft,Tesco,ToyotaandSiemensweretinyonce.
So,notallsmallcompaniesaredangerousjustasnotallbigonesaresafe.
Thisistrueevenofthemultinationaldarlingsthatwerereckoneddeepblue.JustconsiderthefateofthemajorAmericanairlines,insurancecompaniesorcarmakers.
Thatiswhytrackerfundshavebeensetup.Theybuymostofthesharesintheindextheyaretrackingandsofollowitstotality.Trackersreducethechancesofa
disaster,mitigatethechancesofgreatcapitalgrowth,andshouldensureasteadydividendflow.
Returns
Shareholdersbenefittwiceoverwhenabusinessisdoingwell:theygetdividendsastheirpartofthecompany’sprofits,andthevalueofthe
sharesgoesupsothatwhentheyselltheygetcapitalappreciationaswell.Thereturnonsharesoverthelongtermhasbeensubstantiallybetterthaninflationorthegrowthinpayandnotablybetterthanmostotherhomesforsavings.AccordingtodatafromCreditSuisse,GlobalFinancialDataandThomsonDatastream,thereturnonUS
sharesbetween1904and2004wasverynearly10percentperannum,and8.5percentonUKshares.
Ifthecompanyfailstomakeaprofitshareholdersusuallygetnothing,thoughsomecompaniestrytokeepthemhappyandloyalbydippingintoreservestopayadividendevenatatimeofloss.Inanycase,ifthe
companygoesbusttheyareatthebackofthequeueforgettingpaid.Ontheotherhand,oneofthereasonsabusinessisincorporated(ratherthanbeingapartnership,say)isthattheowners,theshareholders,cannotlosemoremoneythantheyusedtobuytheshares.Thatisinsharpcontrasttoapartnership,whereeach
partnerhasunlimitedpersonalliability–theyareliableforthedebtsofthebusinessrightdowntotheirlastcuff-linksortotheirlastearrings.Soevenifanincorporatedcompanygoesspectacularlybrokeowingmillionsofpounds,thecreditorscannotcomeknockingontheshareholders’door.
Stock markets
Thelanguageofinvestmentsometimesseemsdesignedtoconfusethenovice.Forinstance,sharesaretradedonthestockexchange,nottheshareexchange.Nobodyreallyknowswhyitcametobecalledthe‘stockexchange’.Onetheoryhasitthatitwasonthesiteofa
meatandfishmarketintheCityandtheblocksonwhichthosetraderscutarecalledstocks.Analternativetheoryhasitthatstocksofthepillorykindusedtostandonthesite.IntheMiddleAgesthereceiptfortaxpaidwasatallystickwithappropriatenotches.Itwassplitinhalf,withthetaxpayergettingthestockandtheExchequer
gettingthefoilorcounter-stock.Somehavesuggestedthemoneyfrominvestorswasusedtobuystocksforthebusiness.
Strictlyspeaking,inthepurists’definition,stocksarereallybonds–paperissuedwithafixedrateofinterest,asopposedtothedividendsonshares,whichvarywiththefortunesofthebusiness.
However,inlooseconversation‘stocks’issometimesusedasasynonymfor‘shares’.Justtoconfusethingsfurther,Americanscallordinaryshares‘commonstock’.
ChapterTwoWhat arebonds andgilts?
TheingenuityofCityfinanciershasproduceda
widevarietyofpaperissuedbybusinesses,inadditiontoordinaryshares.
Bonds
Shareholdersareownersofacompanybyvirtueofputtingupthecashtorunit,butagoodbusinessbalancesthe
sourcesoffinancewiththewayitisused,andsomeofitcancomefromborrowing.Apartoftheborrowingmaybeabankloanoroverdraft,buttopayformajorinvestmentsmostmanagersreckonitiswisertoborrowlongterm.Forsomeofthisthecompanyissuesadifferenttypeofpaper–ineffectacorporateIOU.Thegenericnamefor
thissortofcorporateissueis‘bonds’.Theyaretradable,long-termdebtissueswithanundertakingtopayregularinterest(normallyataratefixedatthetimeofissue)andgenerallywithaspecifiedredemptiondatewhentheissuerwillbuythepaperback.Somehaveextrasecuritybybeingbackedbysomecorporateasset,and
somearestraightunsecuredborrowings.Holdersofthesemustreceiveinterestpaymentswhetherthecompanyismakingaprofitornot.Thespecifieddividendrateonbondsissometimescalledthe‘coupon’,fromthedayswhentheycamewithalongsheetofdatedslipsthathadtobereturnedtothecompanytoreceivethe
payment.Hereaselsewhereinthe
bookyouwillcomeacrosswordssuchas‘generally’,‘usually’,‘often’and‘normally’.ThisisnotacoverforignoranceorlackofresearchbutmerelyanacceptanceoftheCity’singenuity.Variantsofancientpracticesareconstantlybeinginvented,andnoveland
cleverfinancialinstrumentscreatedtomeetindividualneeds.Whatisdescribedisthenorm,butinvestorsshouldbepreparedforoccasionaleccentricitiesorvariants.
Permanentinterest-bearingshares
Theworldoffinancehasitsownlanguage,withtheproblemthatwordsaresometimesusedinwaysthatdonottallywiththeireverydayusage.Itisnotalwaysintendedtoconfusethelayperson–thoughitfrequentlyhasthateffect–butspecialistfunctionsneedspecialistdescriptionsandevenfinanciershaveonlythe
languageweallusetodrawon.Oneexampleisthedifferencebetween‘permanent’and‘perpetual’.‘Permanentcapital’isusedasalabelforcorporatedebt.‘Perpetual’meansafinancialinstrumentthathasnodeclaredenddate.Soaperpetualcallabletier-onenotesoundslikeasortofdebtbutisinfactasortof
preferenceshare.Ontheotherhand,apermanentinterest-bearingshareisnotashareatallbutforallpracticalpurposesabond.
Permanentinterest-bearingshares(Pibs)aresharesissuedbybuildingsocietiesthatbehavelikebonds(orsubordinateddebt).Pibsfromthedemutualizedbuildingsocieties,includingHalifax
andCheltenham&Gloucester,areknownas‘perpetualsubbonds’.Likeotherbuildingsocietyinvestments(includingdeposits)theymakeholdersmembersofthebuildingsociety.
Theypayafixedrateandhavenostatedredemptiondate,thoughsomedohavearangeofdateswhentheissuer
can(butneednot)buythemback,almostalwaysinthedistantfuture.Sometimes,insteadofbeingredeemedtheyareswitchedtoafloating-ratenote.
Theycannotbesoldbacktothesocietybutcanbetradedonthestockexchange.Nothavingacompulsoryredemptiondatemeansthepricefluctuatesinlinewith
bothprevailinginterestratesandtheperceivedsoundnessoftheissuingorganization,whichmakesthemmorevolatilethanmostotherbonds.IfthelevelofinterestratesintheeconomyrisesthenthepriceofPibswillfall.Ifinterestratesrise,theirpricefalls,butifratesfall,capitalvaluesrise.Thereisgenerallynosetinvestment
minimum,thoughdealerswilltradeonlythousandsofthematatime,andstockbrokers’dealingcostsmakeinvestmentsof,say,under£1,000to£1,500uneconomic.
Pibsprovidedyieldsacoupleofpercentagepointsaboveundatedgilts.Withdemutualizationandthesubsequentcollapseofsome
buildingsocietiestheyieldhasbeenforcedhighertooffsettherisk.Theriskishighbecauseifcapitalratiosfallbelowspecifiedlevels,interestwillnotbepaidtoholdersandsinceinterestisnotcumulative,itislostforgood.AnotherproblemisthatholdersofPibsrankbelowmembersholdingshares(depositors)atatimeof
collapse,and,astheyareclassedascapitalholders,arenotprotectedbytheFinancialServicesCompensationScheme,unlikedepositorswhoareprotectedforupto£85,000.However,buildingsocietiesaregenerallylowrisk.
Thegoodnewsisthereisnostampdutyonbuyingtheseinvestments;interestis
paidgrossandthoughinterestistaxabletheycanbeshelteredinanISA(IndividualSavingsAccount);and,forthemoment,theyarenotsubjecttocapitalgainstax.Itisalsoworthbearinginmindthatbuildingsocieties,beforegreedcarriesthemawayintodemutualization,arerunconservatively,sotheirfunds
comemainlyfromsaversratherthanthemuchmorevolatileandunpredictablesocietiescannotbedestabilizedbyhavingtheredictablewholesalemoneymarkets.Havingnoquotedshares,buildingsocietiescannotbedestabilizedbyhavingthesharepriceunderminedbyspecializedbeargamblerssellingshort
(seeGlossary).
Loan stocks anddebenturesBondsthathavenospecifiedassettoactassecurityarecalled‘loanstocks’or‘notes’.Theseoffsetthegreaterriskbypayingahigherrateofinterestthandebentures,whicharesecured
againstcompanyassets.InBritainthatiscommonlyafixedassetbutintheUnitedStatesitisoftenafloatingchargesecuredoncorporateassetsingeneral.
Interestpayments(dividends)onthesebondscomeregularly,irrespectiveofthestateofthecompany’sfortunes.Astherateofinterestisfixedatissue,the
marketpriceofthepaperwillgoupwheninterestratesarecomingdownandviceversatoensuretheyieldfrominvestinginthepaperisinlinewiththereturnsobtainableelsewhereinthemoneymarkets.Inotherwords,theinvestmentreturnfrombuyingbondsatanyparticularmomentisgovernedmorebythe
prevailinginterestratesthanbythestateofthebusinessissuingthem.
Thefurtheroffthematuritydatethegreaterthevolatilityinresponsetointerestratechangesbecausetheyarelessdominatedbytheprospectofredemptionreceipts.Ontheotherhandtheoscillationsareprobablymuchlessspectacularthan
forequities,wherethepriceisgovernedbyamuchwiderrangeofeconomicfactors,notjustintheeconomybutinthesectorandthecompany.
Becausethereturnisfixedatissue,onceyouhaveboughtthemyouknowexactlyhowmuchtherevenuewillbeontheparticularbonds,assumingthecompanystayssolvent
andthesecurityissound,rightuptothepointofredemptionwhentheoriginalcapitalisrepaid.Sincethereisstillthatlingeringworryaboutwhetheranyspecificcompanywillsurvive,thereturnisatouchhigherthanongilts(bondsissuedbythegovernment,page11),whicharereckonedtobetotallysafe.Soforaprivateinvestor
thisrepresentsaprettyeasydecision:howconfidentamIthatthiscorporationwillsurvivelongenoughtogoonpayingtheinterestonthebonds,andisanylingeringdoubtoffsetbythereturnbeinghigherthanfromgilts?
Iftheissuerdefaultsontheguaranteedinterestpayments–whichisgenerallyonlywhenthebusinessisin
seriousdangerofcollapse–debentureholderscanappointtheirownreceivertorealizetheassetsthatactastheirsecurityandsorepaythemthecapital.Unsecuredloanstockholdershavenosuchoptionbutstillrankaheadofshareholdersfortheremnantswhenthecompanygoesbust.
Therearevariantsonthetheme.A‘subordinated
debenture’,asthenameimplies,comeslowerdownthepeckingorderandwillbepaidatliquidationonlyaftertheunsubordinateddebenture.Mostofthebonds,especiallytheonesissuedbyUScompanies,areratedbyMoody’s,Standard&Poor’sandotheragencieswithagradedsystemrangingfromAAAforcomfortinglysafe
downtoDforbondsalreadyindefault.
WarrantsWarrantsareoftenissuedalongsidealoanstocktoprovidetherighttobuyordinaryshares,normallyoveraspecifiedperiodatapredeterminedprice,knownasthe‘exercise’or‘strike’
price.Theyarealsoissuedbysomeinvestmenttrusts.Sincethepaperthereforehassomeeasilydefinablevalue,warrantsaretradedonthestockmarket,withthepricerelatedtotheunderlyingshares:thevalueisthemarketpriceoftheshareminusthestrikeprice.
Theycangearupaninvestment.Forinstance,if
thesharestandsat100pandthecostofconvertingthewarrantsintoordinaryshareshasbeensetat80p,thesensiblepriceforthewarrantwouldbe20p.Ifthesharepricenowrisesto200p,therightpriceforthewarrantwouldbe120p(deductingthecostof80pforconvertingtoshares).Asaresult,whenthesharepricedoubledthe
warrantpricejumpedsix-fold.
Thistypeofissueisinawaymoresuitedfordiscussionundertheheadingof‘derivatives’,alongsidefuturesandoptionsinChapter3.
Preference shares
Preferencesharescanbe
consideredasortofhybrid.Theygiveholderssimilarrightsoveracompany’saffairsasordinaryshares(equities),butcommonlyholdersdonothaveavoteatmeetings;likebondstheygetspecifiedpaymentsatpredetermineddates.Thenamespellsouttheirprivilegedstatus,sinceholdersareentitledtoa
dividendwhetherthereisaprofitornot,whichmakesthemattractivetoinvestorswhowantanincome.Inaddition,forsomethereisataxbenefittogettingadividendratherthananinterestpayment.Nodividendisallowedtobepaidonordinarysharesuntilthepreferenceholdershavehadtheirs.Theyrankbehind
debentureholdersandcreditorsforpay-outsatliquidationandondividends.Ifthecompanyissohardupitcannotaffordtopayeventhepreferencedividend,theentitlementis‘rolledup’forissueswithcumulativerightsandpaidinfullwhenthegoodtimesreturn.Holdersofpreferenceshareswithoutthecumulativeentitlement
usuallyhaverightstoimposesignificantrestrictionsonthecompanyiftheydonotgettheirmoney.Sometimeswhennodividendhasbeenpaidtheholdersgetsomevotingrights.
Likeordinarysharestheyaregenerallyirredeemable,sothereisnoguaranteedexitotherthanasale.Ifthecompanyfolds,holdersof
preferencesharesrankbehindholdersofdebtbutaheadoftheownersofordinaryshares.
Therearecombinationsofvariousclassesofpaper,soforinstanceitisnotunknownforpreferencesharesalsotohaveconversionrightsattached,whichmeanstheycanbechangedintoordinaryshares.
Convertibles
Somepreferencesharesandsomecorporatebondsareconvertible.Thismeansthatduringtheirspecifiedlivesaregulardividendincomeispaidtoholders,butthereisalsoafixeddatewhentheycanbetransformedintoordinaryshares–conversionisalwaysattheowner’s
choiceandcannotbeforcedbytheissuer.
Beingbondsorpreferenceshareswithanembeddedcalloption(seeChapter3),thevalueisamixtureofthesharepriceandhencethecostofconversion,andtheincometheygenerate.
Gilts
Thetermisanabbreviationof‘gilt-edgedsecurities’.Thesuggestionisthatofclass,distinctionanddependability.TheimplicationisthatthesebondsissuedbytheBritishgovernmentaresafeandreliable.Thereissomejustificationforthat:thegovernmentstartedborrowingfromtheCityofLondoninthe16thcentury,
andithasneverdefaultedoneithertheinterestortheprincipalrepaymentsofanyofitsbonds.Althoughgiltsareaformofloanstocknotspecificallybackedbyanyasset,thecountryasawholeisassumedtostandbehindtheissueandthereforedefaultonfuturegiltsisprettyunlikelyaswell–theriskisreckonedtobeeffectively
zero.Giltsexistbecause
politiciansmaythinktaxrevenuesaresufferingonlybecausetheeconomyisinabriefdipandtheywanttobridgethatshort-termdeficit,ortheydarenotcourtvoterdisapprovalbyraisingtaxestocoverstateexpenditure.Thedifferencebetweenrevenueandexpenditureis
madeupbyborrowing–thisisthePublicSectorBorrowingRequirementorgovernmentdebt,muchdiscussedbypoliticiansandthefinancialpress.Ineffectitpassestheburdentofuturegenerationswhopayinterestonthepaperandeventuallyredeemit(buyitbackataspecifieddate).
Theissueshaveafixed
rateofinterestandastatedredemptiondate(usuallyarangeofdatestogivethegovernmentabitofflexibility)whentheTreasurywillbuybackthepaper.Thenamesgiventogiltshavenosignificanceandaremerelytohelpdistinguishoneissuefromanother.
Theinterestratesetonissue(onceagaincalledthe
‘coupon’)isdeterminedbyboththeprevailinginterestratesatthetimeandwhothespecificissueisaimedat.Thevastmajorityofthegiltsonissueareofthistype.Inadditiontherearesomeindex-linkedgiltsandacoupleofirredeemablesincludingthenotoriousWarLoan–peoplewhobackedthenationaleffortduringthe
SecondWorldWarfoundthevalueoftheirsavingserodedtonegligiblevaluesbyinflation.Thisisstillonissueandthefinancialcrashof2008stoppeditbeingajokeasitgainednewlifeinthelow-interestenvironment.
Thereisalonglistofgiltsbeingtradedwithvariousdatesofredemption.Forcommonusetheseare
groupedunderthelabelof‘shorts’foroneswithlivesofunderfiveyears,‘medium-dated’withbetweenfiveand15yearstogo,and‘longs’withover15yearstoredemption.Thegovernmenthasalsobeenissuingultra-longgiltswithupto50yearstoredemption.Onthewholetheseareprobablymoreaimedatandsuitablefor
investorssuchaspensionfundsandinsurancecompanies,whichneedassetstomatchthelongerlivesofpensioners.
Innewspapertablestherearesometimestwocolumnsunder‘yield’.Oneistheso-called‘runningyield’,whichisthereturnyouwouldgetatthatquotedprice,andtheotheristhe‘redemption
yield’,whichcalculatesnotjustthestreamofinterestpaymentsbutalsothevalueofholdingthemtoredemptionandgettingthemrepaid–alwaysat£100par(thefacevalueofasecurity).Ifthecurrentpriceofthegiltisbelowpartheredemptionyieldishigherthantherunningyield,butifthepriceisabovepar(whichgenerally
suggestsitisahigh-intereststock)onewilllosesomevalueonredemptionsothereturnislower.
Sincethereturnisfixedatissue,whenthepriceofabondlikegiltsgoesup,theyield(theamountyoureceiveasapercentageoftheactualcashinvested)goesdown.Letusassumeyoubuyagiltwithanominalfacevalueof100p
(yesthatis£1,butthestockmarketgenerallypreferstothinkinpennies),andwithaninterestrateof10percentsetatissue.Ifthecurrentpriceofthatspecificgiltis120p,youwouldgetayieldof8.3percent(10pasapercentageofthe120ppaid).Ifthepriceofthatissuethentumblesandyoubuyat80pyoucouldgetayieldof12.5percent(10p
asapercentageof80p).Thereareotherpublic
bondsofhigherriskthanUKgilts.Theseincludebondsissuedbylocalauthoritiesandoverseasgovernments.Calculationsusedtobestraightforwardwhenmanydecadesofstabilitysuggestedneitherlocalauthoritiesnorforeigngovernmentwouldbecomeinsolvent.The2008
crashandsubsequentfinancialturbulenceinmanycountrieswokeupthemarkettothefactnothingcanbetakenforgranted–notevensovereigndebtsarealwayssafe,especiallyfromcountrieswithlargedeficits.Ithasindeedhappenedbeforeasanycollectorofunredeemedbondswilltestify.Chinesegovernments,
TsaristRussia,USstates,LatinAmericanenterprisesandsoonhaveallissuedbeautifullyengravedelaboratebondsthatarenowusedtomakelampshadesorframeddecorationsforthelavatory,becausetheywereneverredeemed.Onoverseasbondsthereisalsotheaddeduncertaintyfromcurrencymovements.
Asalways,andthisisanimportantruletorememberforallinvestments,thehighertheriskthehigherthereturntocompensateforit.Soifsomethinglookstobereturningfabulouslyhighdividendsitmustbebecauseitis–oritisseentobe–afabulouslyhigh-riskinvestment.
Inthecaseofpublicbonds
thehigherriskthanUKgiltsmeanslocalauthorityandforeigngovernmentbondsprovideahigheryield,varyingwiththeconfidenceinthecountries’financialstability,andcorporatebondssometimesslightlyhigherstill,dependingontheissuerandguarantor(oftenabigbank).Thedifferencesaregenerallymarginalforthe
major,safeissuers,seldommuchmorethan0.3percent.
ChapterThreeThecomplicatedworld ofderivatives
Derivativesarefinancialinstrumentsthatdepend
onorderivefromanunderlyingsecuritythatalsodeterminesthepriceofthederivedinvestment.Inotherwords,thesearefinancialproductsderivedfromotherfinancialproducts.Strictlyspeakingthetermcouldcoverunitandinvestmenttrustsandexchangetradefunds,aswell
asarangeofsophisticatedandcomplexcreations.Attheirsimplest,andnotnormallyallocatedtothisheading,theyarepooledinvestments.
Pooledinvestments
Themainbenefitofdevices
suchasunitorinvestmenttrustsisthereductionofrisk:yougetaspreadofinvestmentsoveranumberofcompanies,whichcutsthedangerofanyoneofthecompaniesperformingbadlyorgoingunder.Anotheradvantageisadministrationbyamarketprofessionalwhomayhaveabetterfeelforwhatisagoodinvestment
thantheaveragelayperson.
Investment trustsInvestmenttrustsaremerelycompanieslikeanyotherquotedonthestockexchange,buttheironlyfunctionistoinvestinothercompanies.Theyarecalled‘closed-endfunds’becausethenumberofsharesonissueisfixedand
doesnotfluctuatenomatterhowpopularorotherwisethefundmaybe.
Asmallinvestorwithoutenoughsparecashtobuydozensofsharesasawayofspreadingriskcanbuyinvestmenttruststosubcontractthatwork.Atrustputsitsmoneyacrossdozens,possiblyhundreds,ofcompanies,soaproblemwith
onecanbecompensatedbyboomatanother.Thatdoesnotmakethemfoolprooforcertainwinners:investmentmanagersafterallareonlyhumanandcanbewrong.
Therearealsopressuresonthemtowhichtheprivateinvestorisimmune.Forinstance,thereisacontinualmonitoringoftheirperformancesothereisno
chancetoallowaninvestmentprospectthetimetomatureforanumberofyearsbeforereachingitsfullpotentialifthatmeansinthemeantimetheirfiguresaresubstantiallybelowthoseoftheirrivals.Aprivateinvestorontheotherhandcanaffordtobepatientandtakealong-termview.Similarly,itisonlybravemanagerswho
decidetosticktheirnecksoutandtaketheirownmaverickcoursedifferentfromtheotherfunds.Theywillgetpraiseiftheyarerightandthesackifnot.Stickwiththesamesortofpoliciesasalltheothershowever,andthebonuseswillprobablykeeprollinginfornotbeingnotablyworsethantheindustryaverage.
Somehavegivenupthechallengingandunrelentingtaskofoutperformingthemarketandcalledthemselves‘trackers’–theybuyalargecollectionofthebiggestcompanies’sharesandsomovewiththemarketasawhole.
Anotherdisadvantageofgoingforcollectiveinvestmentsisthecost.Since
investmenttrustsarequotedonthestockexchangejustlikeanyothercompany,thesetofcostsisthesameaswithallsharedealings:thecostofthebroker(thoughthatcanbereducedthrougharegularsavingsschemewiththetrustmanagementcompany),thegovernmenttaxinstampduty,andthespreadbetweenthebuying
andthesellingprice,whichinsmallertrustscanbeover10percent.Somecanbeboughtdirectlyfromthemanagementcompany.Thereareobviouslyadvantagesortheywouldnotstillbearound,muchlessinsuchlargenumbers.
Buyingintoinvestmenttrustsdoesnotentailabandoningallchoice.The
investorhasanenormouslywiderangeofspecialiststopickfrom:therearetrustsspecializinginthehairierstockmarketslikeIstanbul,Budapest,Manila,MoscowandCaracas(someofthemdriftinandoutofvarious‘emergingmarkets’labelssuchastheBRICcountries(Brazil,Russia,IndiaandChina));therearesome
investinginthecountriesofthePacificRimwithsomeofthoseconcentratingonjustJapan;somegoforsmallcompanies;somegambleon‘recovery’companies(whichtendtohaveafluctuatingsuccessrecord);somespecializeinEuropeortheUnitedStates;someinanareaoftechnology,andsoon.Managersofinvestmenttrusts
tendonthewholetobemoreadventurousintheirinvestmentpoliciesthanunittrusts.
Somearesplitcapitaltrusts.Thesehaveafinitelifeduringwhichoneclassofsharesgetsalltheincome,andwhenitiswounduptheotherclassofsharesgetstheproceedsfromsellingofftheholdings.
Asthetrusts’sharesarequoted,onecantellnotonlyhowthesharepriceisdoing,butcheckpreciselyhowtheyareviewed.Itispossibletocalculatethevalueofthequotedcompanysharesatrustowns,exceptofcoursefortheonesspecializinginprivatecompanies.Thenonecancompareassetvaluewiththetrust’sownshareprice,
andthisispublished–seeChapter7.Quiteafewwillthenbeseentostandatadiscounttoassets(thevalueofatrust’sholdingspershareisgreaterthanthemarketisofferingforitsownshares),andsomeatapremium.
Onereasonmanyofthemarepricedlowerthantheirrealvalueisthatthemajorinvestinginstitutionstendto
avoidthem.Ahugepensionfundorinsurancecompanydoesnothavetosubcontractthiswayofspreadinginvestments,nordoesithavetobuythemanagerialexpertise–itcangetthemin-house.Thisleavesinvestmenttrustsmainlytoprivateinvestorswhoaresteeredmoretowardsunittrustsbytheiraccountantsandbank
managers.Fashionchanges,however,andfromtimetotimetheinvestmenttrustsectorbecomesmorepopular.Buyingintooneataheftydiscountcanprovideadecentreturn–solongasthediscountwasnotpromptedbysomemorefundamentalproblemwiththetrustoritsmanagement.
Unit trustsUnittrustshavethesameadvantageofspreadingtheindividual’sriskoveralargenumberofcompaniestoreducethedangersofpickingaloser,andofhavingtheportfoliomanagedbyafull-timeprofessional.Aswithinvestmenttruststherearespecialistunittrustsinvesting
inavarietyofsectorsortypesofcompany,soonecanpickhigh-income,highcapitalgrowth,PacificRim,high-technologyorotherspecializedareas.
Insteadoftheunitsbeingquotedonthestockmarket,asinvestmenttrustsare,investorsdealdirectlywiththemanagementcompany.Thepaperissuedhas
thereforeonlyaverylimitedsecondarymarket–theinvestorcannotsellittoanyoneotherthanbacktotheunittrust.Themarketisviewedfromthemanagers’viewpoint:itsellsunitsatthe‘offer’priceandbuysthembackatthelower‘bid’price,togiveitaprofitfromthespreadaswellasfromthemanagementcharge.Manyof
thepricesarealsopublishedinthebetternewspapers.
Asopposedtoinvestmenttrusts,thesearecalled‘open-endedfunds’becausetheyaremerelythepooledresourcesofalltheinvestors.Ifmorepeoplewanttogetintoaunittrust,itsimplyissuesmorepaperandinveststhemoney,andsogrowstoaccommodatethem.Unlike
thepriceofinvestmenttrustsshares,whichissetbymarketdemandandcangetgrosslyoutoflinewiththeunderlyingvalue,thepriceofunitsissetstrictlybythevalueofthesharesthetrustowns.
TheEUandlegislationhaveinventedanewvocabulary.Unittrustsarenow‘collectiveinvestment
schemes’(CIS)aspartofwhatthelawcallspooledschemesmanagedbyanindependentfundmanager.Theseareallowedtoinvestinquotedshares,bondsandgilts,butgenerallynotinunquotedsharesorproperty.Mostofthese‘openendedinvestmentcompanies’,unittrusts,andrecognizedoffshoreschemesare
authorisedandregulatedbytheFinancialConductAuthority.
Theothersaresometimescallednon-mainstreampooledinvestments(NMPIs)becausetheyhaveunusual,riskyorcomplexassets,productstructures,orinvestmentstrategies.Theseareunregulatedcollectiveinvestmentschemes(UCIS);
securitiesissuedbyspecialpurposevehicles(SPVs);unitsinqualifiedinvestorschemes(QIS);andtradedlifepolicyinvestments(TLPIs).Theseunregulatedschemesarenotbadorcrookedbutarereckonedgenerallytohavemoreriskyinvestmentportfoliosandsocannotbemarketedtoretailinvestorsormembersofthe
generalpublic.Theycansellonlytopeoplewhohaveshowntheyknowwhattheyaredoing,suchaswealthyindividuals(incomeover£100,000and£250,000toinvest),sophisticatedinvestors,existinginvestorsinsuchschemesandfinancialinstitutions.UnregulatedschemesarenotsubjecttotheFCArulesoninvestment
powers,howtheyarerun,whattypeofassetstheycaninvestin,ortheinformationtheymustdisclosetoinvestors.AndinvestorsdonothavethesafetynetoftheFinancialOmbudsmanServiceortheFinancialServicesCompensationScheme(FSCS)ifthingsgowrong.Theymayhowevercomplainaboutaregulated
firmifitadvisedaninvestortoputmoneyintoanunregulatedscheme.
Tracker fundsLegendhasitthatblindfoldedstaffatoneUSbusinessmagazinethrewdartsatthepricespagesoftheWallStreetJournalandfoundtheirselectionbeateveryoneof
themajorfundmanagers.Andindeedthetaskofhavingconsistentlytodobetterthanthemarketaverageoverlongperiodsoftimeissodauntingthatveryfewcanmanageit.
Somemanagershavegivenuptheunequalstruggleoftryingtooutguessthevagariesofthestockmarketandcallthemselves‘trackerfunds’(or‘indexfunds’inthe
UnitedStates).Thatmeanstheyinvestinallthebigshares(inpracticealargeenoughselectiontoberepresentative)andsomovewiththemainstockmarketindex–intheUnitedKingdomthatisusuallytakentobetheFTSE100.Thisgivesevengreatercomforttonervousinvestorsworriedaboutfallingbehindthe
economy,andthepolicyprovidescorrespondinglylittleexcitement,soitishighlysuitableforpeoplelookingforahomefortheirsavingsthatinthemediumtermatleastisfairlyrisk-free–itisstillsubjecttothevagariesofthemarketasawholeintheshorttermbutonanyreasonabletimeframeshoulddoprettywell.
Infacttherearevariouswaysofstructuringsuchafund.Fullreplicationinvolvesbuyingeveryshareintheindexorsectorinappropriateproportions.Stratifiedsamplingbuysthebiggestcompaniesinthesectorplusasampleoftherest,andoptimizationinvolvesstatisticalanalysisofthesharepricesinthesector.
Justtocomplicatematters,thereisaverylargenumberofthingstotrack.EvenifyouwanttofollowtheUSeconomythereisthechoiceofanythingfromtheS&P500,throughtheRussell3000totheWilshire5000,whichcovers98percentofUS-basedsecurities.
Open-ended
investmentcompaniesTheseareasortofhalf-wayhousebetweenunitandinvestmenttrusts.Likeinvestmenttruststheyareincorporatedcompaniesthatissueshares.Likeunittruststhenumberofsharesonissuedependsonhowmuchmoneyinvestorswanttoputintothe
fund.Whentheytaketheirmoneyoutandsellthesharesback,thosesharesarecancelled.TheacronymOEICispronounced‘oik’byinvestmentprofessionals.
Thecompaniesusuallycontainanumberoffundssegmentedbyspecialism.Thisenablesinvestorstopickthesortofareatheypreferandtoswitchfromonefund
toanotherwithaminimumofadministrationandcost.
Exchange tradedfundsVeryliketrackerfunds,ETFsarebasketsofsecuritiesgenerallytrackinganindex,amarketoranassetclass.Theyaredealtonthestockexchangeandhavenoentry
orexitfees,but,astheytradelikeothershares,theyincurcommissionsontransactionsanddohaveannualfeesofusuallyunder0.5percent.Alsoliketrackerfundstheymaynotbuyeveryshareintheindextracked(called‘totalreplication’)butmayusesomesamplingtechniquethatcanleadto‘trackingerror’,ietheperformanceof
thefunddoesnotfollowitstargetcompletelyandthiscanrangefromabout0.25percenttoabout4percent,whichcanoutweighfeesandpricechanges.
ThelowcostofETFshasrecentlyattractedabigriseininvestmentinterest,whichhasinturnbroughtinagreatervarietyofproducts.SomuchsothattheFinancial
ConductAuthorityhasbeenmovedtopublishawarningaboutgrowingcomplexityintheproductsproducinghigherrisk.AnothersourceofproblemisthesloppyuseoftheETFlabel–sometimesitisnowappliedtoExchangeTradedCommoditiesandExchangeTradedNoteswhichareunsecuredassetsandhenceofsubstantially
greaterrisk.
AdvantagesEverythinghasacost.Pooledinvestmentsaresaferforsmallinvestorsbecausetheyspreadrisksbut,conversely,theycannotsoarasaresultoffindingaspectacularperformer.Soyoupayforthelackofriskbylackof
sparkle.Theyaremanagedbyprofessionalswhomustbepaid,sothefundschargeafee.
Optingforsafetydoesnotmeaninvestorscanavoidthought,careorresearch.Someinvestmentmanagersarenotawfullycleverandfailtobuysharesthatperformbetterthanaverage.Theycanbefoundintheleaguetables
ofperformancesomenewspapersandmagazinesreproduce,ascanthefundswithstartlinglybetterperformancethanboththemarketandothertrusts.
Thosetableshavetobeusedwithcaution.Theperformancestatisticslookonlybackwardsandonecannotjustdrawastraightlineandexpectthatlevelof
performancetocontinuesteadilyintothefuture.Onetrustmayhavedoneawfullywell,butitmayjustbetheflukeofhavingbeeninasectororareathatsuddenlybecamefashionable–retail,Japan,biotechnology,financials,emergingmarkets,etc.Thereisalsothefactorthatsomebodygoodatdealingwiththefinancial
circumstancesof10yearsagomaynotbeasgoodatanalysingthemarketoftoday,muchlessoftomorrow.Ontopofthat,thechancesarethatwhoeverwasincharge10yearsagototakethefundtothetopoftheleaguetableswillhavebeenpoachedbyarivalcompany.
Theconverseholdsequallytrue.Afundmay
havebeenhandicappedbybeingcommittedtoinvestmentinJapanatatimewhenJapanfelloutoffashionorhitaroughpatch,orininternetstockswhenthenetlostitsglister.Suchfactors,whetherpromptedbyeconomiccircumstanceorfashion,mayreversejustasquicklyandhavethefundatthetopofthetable.Itmay
alsohavehadaclumsyinvestmentmanagerwhohassincebeenreplacedbyastarrecruitedfromthecompetition.
Asavehicleforrecurrentinvestments,orasanadditionalsafeguardagainstfluctuatingmarkets,manyoftheseorganizationshaveregularsavingsarrangements.Theinvestorputsinaset
amountandthesizeoftheholdingboughtdependsontheprevailingpriceatthetime.Thisisanotherversionofwhatprofessionalscall‘poundcostaveraging’.Italsotendstoleveltheriskofbuyingallthesharesorunitswhenthepriceisatthetop.
OnewayofmitigatingmanagementchargesistogetintoaUSmutualfund,which
ismuchthesamethingasaunittrustbuthaslowercharges.Theoffsettingfactoristheexposuretoexchangeraterisk.
Finally,thereistheoptionofsettingupyourownpooledinvestmentvehicle.Investmentclubs,hugelypopularintheUnitedStates,aregrowinguparoundtheUnitedKingdom.Agroupof
peoplegettogethertopoolcashforputtingintothemarket.Theusualmethodistoputinasetamount,say£10amontheach,andjointlydecidewhatthebesthomeisforit.Thishastheadvantageofbeingabletospreadinvestments,toavoidmanagementcharges,tohavetheexcitementofdirectinvestment,toprovidean
excuseforasocialoccasion,andfortheworkofresearchtobespreadamongthemembers.
Other derivatives
Whenpeopletalkofderivativestheyareusuallynotreferringtotherangeofcollectiveinvestmentsbutmeanhighly-gearedgambles
requiringextensiveknowledge,continuousattentionanddeeppockets.Eventheprofessionalsgotitsospectacularlywrongthatthederivativesmirerockedthefoundationsoftheglobaleconomyinthe1990sandswallowedsomeoftheworld’slargestfinancehouses,banksandinsurancecompaniesbetween2007and
2009.Ifthe‘expert’financierswhoarepaidmillionsayearcangetitsohugelywrongthattheybankruptedmultibillionpoundcompanies,asmallamateurisunlikelytosurvivelong.Theseshark-infestedwatersaretoodangerousforsmallorinexperiencedinvestors.
Thissectionthereforeis
intendedasbackgroundratherthantemptation.Somereadersofthisbookmaybegamblers,richenoughtobetonlongodds,orgrowexperiencedenoughtoventureintosuchtreacherousareas.Thatisthespeculativeendofderivatives.Forothersitmayalsoactasasafetynetbyhedgingaperceivedrisk,orbyfixingthepriceat
whichtotradewithinaspecifictime.Buteventhenoneneedsafeelforthemarket.
Thereisahugeselectionofevermorecomplicatedderivatives.Theyincludefutures,optionsandswapswithagrowingcollectionofincreasinglyexoticandcomplexinstruments.Thesederivativesarecontracts
derivedfromorrelyingonsomeotherthingofvalue,anunderlyingassetorindicator,suchascommodities,equities,residentialmortgages,commercialproperty,loans,bondsorotherformsofcredit,interestrates,energyprices,exchangerates,stockmarketindices,ratesofinflation,weatherconditions,oryetmore
derivatives.Theyarenothingnew.
ThalesofMiletusinthe6thcenturyBCwasmockedforbeingaphilosopher,anoccupationthatwouldkeephimpoor.Toprovethemwrongheusedhislittlecashtoreserveearlyalltheoilpressesforhisexclusiveuseatharvesttime.Hegotthemcheapbecausenobodyknew
howmuchdemandtherewouldbewhentheharvestcamearound.AccordingtoAristotle,‘Whentheharvest-timecame,andmanyweresuddenlywantedallatonce,heletthemoutatanyratewhichhepleased,andmadeaquantityofmoney’,showingthinkerscouldberichiftheytriedbuttheirinterestlayelsewhere(PoliticsBk1
Ch11).Thereissomedisputeastowhetherthiswasanoptionsorforwardcontractbuteitherwayitshowsderivativeshavealonghistory.
Derivativesaregenerallyanalogoustoaninsurancecontractsincetheprincipalfunctionisoffsettingsomeimpendingrisk(‘hedging’,asthefinancialworldcallsit)by
onesideofthecontract,andtakingontheriskforafeeontheother.Inadditionthereisthestraightgambleoftakingapuntonthevalueofsomethingmovinginonedirection.
Hedgingcanentailusingafuturescontracttosellanassetataspecifiedpriceonastateddate(suchasacommodity,aparcelofbonds
orshares,andsoon).Theindividualorinstitutionhasaccesstotheassetforaspecifiedamountoftime,andthencansellitinthefutureataspecifiedpriceaccordingtothefuturescontract.Thisallowstheindividualorinstitutionthebenefitofholdingtheassetwhilereducingtheriskthatthefuturesellingpricewill
deviateunexpectedlyfromthemarket’scurrentassessmentofthefuturevalueoftheasset.
Derivativesallowinvestorstoearnlargereturnsfromsmallmovementsintheunderlyingasset’sprice,but,asisusual,bythesametokentheycouldloselargeamountsifthepricemovesagainstthemsignificantly,aswas
shownbythe2009needtorecapitalizethegiantAmericanInternationalGroupwith$85billionofdebtprovidedbytheUSfederalgovernment.Ithadlostmorethan$18billionovertheprecedingthreequartersoncreditdefaultswaps(CDSs)withmorelossesinprospect.OrangeCountyinCaliforniawas
bankruptedin1994throughlosingabout$1.6billioninderivativestrading.Buttheskyreallyfellinfrom2007onwardswhenitbecameclearthatmostofthemajorbankshadtradedincomplexderivativeswithouttheslightestunderstandingoftheorigin,riskandimplicationsofwhattheyweredoing.
Therearethreemaintypes
ofderivatives:swaps,futures/forwards,andoptions,thoughtheycanalsobecombined.Forexample,theholderofa‘swaption’hastheright,butnottheobligation,toenterintoaswaponorbeforeaspecifiedfuturedate.
Futures/forwardsFutures/forwardsare
contractstobuyorsellanassetonorbeforeadateatapricespecifiedtoday.Afuturesagreementisastandardizedcontractwrittenbyaclearinghouseandexchangewherethecontractcanbeboughtandsold;aforwardisnegotiatedforaspecificarrangementbythetwosidestothedeal.
Thefacility,aswithso
manyderivatives,wasoriginallycreatedasawayof‘hedging’oroffloadingrisk.Forinstance,abusinessexportingtotheUnitedStatescanshielditselfagainstcurrencyfluctuationsbybuying‘forward’currency.Thatprovidestherighttohavedollarsataspecificdateataknownexchangeratesoitcanpredicttherevenue
fromitsoverseascontract.Ifsomeshareshadtobesoldatsomeknowndate(saytosatisfyadebt)andtheinvestorwasnervousthatthemarketmightfallinthemeantime,itispossibletoagreeasellingpricenow.
Agamblerdecidestobuyafuturescontractof£1,000(italmostdoesnotmatterwhatliesbehindthe
derivative–itcouldbegrain,shares,currencies,giltsorchromium).Itcostsonly10percent(calledthe‘margin’inthetrade),sointhiscase£100.Thatshowsthebusinessisgearedupenormously.Threemonthslaterthepriceisupto£1,500sotheluckypersoncansellata£500profit,whichisfivetimestheoriginalstake.It
couldalsohappenthoughthatthepricedropsto£500andheorshedecidestogetoutbeforeitgetsworse.Onthesamereckoningthelossof£500isalsofivetimestheoriginalmoney.Thisshowsthat,unlikeinvestmentinsharesorwarrants,wherethemaximumlossistheamountofthepurchasemoney,thepossibledownsideofa
futuresdealismanytimestheoriginalinvestment.
Futurescontractscanbesoldbeforethematuritydateandthepricewilldependonthepriceoftheunderlyingsecurity.Ifyoufailtoactintimeandsellacontract,thecontractcannowberolledoverintothenextperiodortheintermediaryarrangingthecontractwillcloseand
remitprofitsordeductlosses.Thereisalsoan‘index
future’,whichisanoutrightbetsimilartobackingahorse,withthemoneybeingwonorlostdependingontheleveloftheindexatthetimethebetmatures.AFTSE100Indexfuturevaluesaone-pointdifferencebetweenthebetandtheIndexat£25.
Anextensionofthatis
‘spreadtrading’,whichisjustoutandoutgamblingonsomeeventortrendvaguelyconnectedtothestockmarketorsomefinanciallyrelatedevent.ItcouldbeanythingfromtheleveloftheFTSE100Indextothesurvivalofamajorcompany’schiefexecutiveinhisorhertroubledjob.Ifthespreadbettingcompanyis
quoting4,460to4,800orifthemarket-makersarequoting40to42daysforthechiefexecutiveandsomebodythoughtitwouldbelessthanamonth,itispossibleto‘sell’at40;whilesomebodyreckoningthechancesarebetterthanthatandtheexecutivecouldbethereformonthstocomewould‘buy’at42.Thenifthe
personlasted47daysbeforegettingtheelbow,thebuyerswouldhavewonbyfivedaysandtheirwinningswoulddependonhowmuchtheystaked–at£1,000adaytheywouldhavecleared£5,000.Thesellers,however,wouldhavelostbysevendaysandonceagaintheirdebtwoulddependonhowmuchtheystaked.Themarket-maker
makesaprofitonthespreadbetweenthetwo(ifrunninganevenbook),justasdomarket-makersinordinaryshares.
Thespreadbettingcompany,say,offersBrigantine&Fossbenderat361to371p.Ifyouthinktheshareswillrisesubstantiallyyoubuyat371inunitsof£10.Ifyouarerightandthe
pricethengoesto390p,theshareshaveappreciatedby19paboveyourbettingprice(assumingoneunit)andtheproceedsaretherefore£190.Thatsoundsgooduntilyouconsiderthatiftheshareshadinsteaddroppedto340p,yourlosseswouldbe£210.Conversely,ifyouthinktheshareswillfall,you‘sell’at361pandthesame
mathematicsappliestheotherway.Ifthepriceremainswithinthe361to371prangenobodywins.
Contract fordifferenceThisisacontractthatmirrorspreciselydealinginanasset,withoutanyofitactuallychanginghands.Iftheprice
hasrisenbytheendofthestatedperiodthesellerpaysthebuyerthedifferenceinprice,andifthepricehasfallenthebuyerpaysthesellerthedifference.CFDsareavailableinunlistedorlistedmarketsintheUnitedKingdom,theNetherlands,Germany,Switzerland,Italy,Singapore,SouthAfrica,Australia,Canada,New
Zealand,Sweden,France,Ireland,JapanandSpain,butnottheUnitedStateswheretheyarebanned,buttheydohavemargintrading.Theassetcanbeshares,index,commodity,currency,gold,bonds,etc.
Thetradesdonotconferownershipoftheunderlyingassetbutinvolvetakingapuntonthepricemovement,
sothecontractsofferallthebenefitsoftradingshareswithouthavingtoownthem.Beingrisky,thecontractsareavailableonlytonon-private,intermediatecustomersasdefinedbytheFinancialConductAuthority.
InvestorsinCFDsarerequiredtomaintainamarginasdefinedbythebrokerageormarket-maker,usually
from1to30percentofthenotionalvalueofleadingequities.Thatmeansinvestorsneedonlyasmallproportionofthevalueofapositiontotradeandhencetheyofferexposuretothemarketsatasmallpercentageofthecostofowningtheactualshare.Itoffersopportunitiesforlargegearingup–1:100when
tradinganindex.Itallowstakinglongorshortpositions,andunlikefuturescontractsacontractfordifferencehasnofixedexpirydate,standardizedcontractorcontractsize.Asintheunderlyingmarket,takingalongpositionproducesaprofitifthecontractvalueincreases,andashortpositionbenefitsifthevaluefalls.
Thereisadailyfinancingchargeforthelongsideofthecontracts,atanagreedratelinkedtoLIBOR(seeGlossary)orotherinterestrate,soadelayinclosingcanbeexpensive.Traditionally,CFDsaresubjecttoacommissionchargeonequitiesthatisapercentageofthesizeofthepositionforeachtrade.Alternatively,an
investorcanopttotradewithamarket-maker,foregoingcommissionsattheexpenseofalargerbid/offerspreadontheinstrument.Thecontractscanhedgeagainstshort-termcorrectivemoves,butdonotincurthecostsandtaxesassociatedwiththeprematuresaleofanequityposition.Asnoequitieschangehands,thecontractsareexemptfrom
stampduty.Likeallhighlygeared
deals,exposureisnotlimitedtotheinitialinvestment.Theriskcanbemitigatedthrough‘stoporders’(guaranteedstop-lossorderscostanadditionalone-pointpremiumonthepositionand/oraninflatedcommissiononthetrade).Astop-losscanbesettotriggeranexit,egbuyat
300pwithastop-lossat260p.Oncethestop-lossistriggered,theCFDprovidersells.
Thedeviceisconvenientifusedunderaround10weeks–thepointwherefinancingexceedsthefinancingchargeforstocks–whilefuturesarepreferredbyprofessionalsforindexesandinterestratestrading.Itisalsofairlywell
hidden–agroupofhedgefundslinkedtoBAESystemsacquiredmorethan15percentofAlvisthroughCFDswithouthavingtowarntheregulator.
Acquiring1,000Bloggins&Snooksplcsharesat350peachwouldneed£3,500.Usingcontractsfordifference,tradingona5percentmargin,youwouldneed
onlyaninitialdepositof£175.Ifyouhad£175toinvest,andwantedtobuyBloggins&Snooksplcat350pandsellat370p,astandardtradewouldbe:
Althoughtheprofitafter
gearingwasfargreater,lossesarecomparablymagnified.
OptionsOptionsgivetheright,butnottheobligation,tobuy(inthecaseofa‘calloption’)orsell(inthecaseofa‘putoption’)anasset.Thatishowtheydifferfromfutures,whichhaveanobligationtotrade.
Thepriceatwhichthetradetakesplace,knownasthe‘strikeprice’,isspecifiedatthestart.InEuropeanoptions,theownerhastherighttorequirethesaletotakeplaceon(butnotbefore)thematuritydate;inUSoptions,theownercanrequirethesaletotakeplaceatanytimeuptothematuritydate.
If,duringthetimeaput
optionisinforcethesharepricefallssignificantly,theinvestorcanmakeahandsomeprofitbybuyingthecheapersharesinthemarketandexercisingtheoptionbysellingthemattheagreedprice.Similarly,inreverse,acalloptionishandyifyouthinktheywillrisesubstantiallyintheinterim.Comethecontractedday,
however,andthepricehasmovedthewrongway,onecanjustwalkawayandoptnottoexercisetheoption.Allthathasbeenlostisthemarginofoptionmoney,whichisalotlesspainfulthaniftheunderlyingsecurityhadbeenboughtandsold.
Thisisanotherwayofhedgingone’sposition.Saysomebodyknowsthatfor
somereasontheywillhavetosellaparcelofsharesineightmonths’time–tofundthedown-paymentonahouse,forinstance.Butthereisaworrythemarketmayslumpinthemeantime:buyingaputoptionatroughlytoday’spriceprovidesawayofbuyingprotection.Ifitisoneofthe70orsocompanieswithoptionstradedinthe
market,thereisalsothechancetoselltheoptionbeforeexpirysince,likemostderivatives,optionscanbetradedbeforematurity.
Acompanylanguishinginatroubledsectormaylooktoanastuteobservertobeabouttoturnitselfround,becomearecoverystock,andastonisheveryone.Butiftheobserverisalsoastuteenoughtohave
misgivingsaboutsuchuniquelyprescientinsight,andworriesaboutcommittingtoomuchmoneytothehunch,thereisacheapwayin.Onesimplybuysanoptiontobuy.
SoifBathplug&Harbottlesharesarestandingat75p,itcancost,say,6ptoestablishtherighttobuysharesatthatpriceatanytimeoverthe
nextthreemonths.Ifinthattimethesharesdoinfactfulfiltheforecastandjumpto120p,theastuteinvestorcanbuyandimmediatelysellthemataprofitof39pashare.Ifthemisgivingsprovejustifiedandthesharesfailtorespondorevenslumpfurther,only6pinsteadof75phasbeenlost.
Thewholethingworksthe
otherwayaswell,sothesuspicionbutnottotalcertaintythatacompanyisabouttobeseriouslyhammeredbythemarketcouldpromptsomeonetobuyaputoption.Thatistherighttosellthesharesataspecifiedprice,withinanagreedsetofdates.
Theserightshaveavalueaswell,relatedtohowthe
underlyingshareisperformingandhowlongtheyhavetorun,sotheycanbetraded,mostlyontheLondonInternationalFinancialFuturesandOptionsExchange(generallyabbreviatedtoLiffe,pronounced‘life’ratherthanliketheriverflowingthroughDublin).Thetradedoptionsmarketdealsinparcelsof
optionsfor1,000sharesandatseveralexpirydates,withsomeaboveandsomebelowtheprevailingmarketpriceforabout70ofthelargestcompanies.
Whenonebuysasecurityordirectinvestment,forexample100sharesofSouthSeasat£5each,thecapitalresultislinear.Soifthepriceappreciatesto£7.50,wehave
made£250,butifthepricedepreciatesto£2.50wehavelost£250.Buyingaone-monthcalloptiononSouthSeaswithastrikepriceof£5wouldgivetherightbutnottheobligationtobuySouthSeasat£5inonemonth’stime.Insteadofimmediatelypaying£500andreceivingthestock,itmightcost£70todayforthisright.IfSouth
Seasgoesto£7.50inonemonth’stime,exercisingtheoptionbybuyingthesharesatthestrikepriceandsellingthemwouldproduceanetprofitof£180.Ifthesharepricehadgoneto£2.50,thelosswouldhavebeenrestrictedtothe£70premium.Ifduringtheperiodoftheoptionthesharessoarto£10theoptioncanbesoldfor
£430.Anoptionprovidesflexibility.
WarrantsInnormalusagea‘warrant’isasortofguarantee,butinthestockmarketitisapieceofpaperentitlingonetobuyaspecifiedcompany’ssharesatafixedprice.Theseareequivalentsofshareoptions–
thoughgenerallywiththelongerlifeofbetweenthreeand10years–andcanthereforebetraded.Ineffectitisacalloptionissuedbyacompanyonitsownstock.Thecompanyspecifiestheexercisepriceandmaturitydate.Thepricewillbesetbyacombinationoftheconversionpriceandtheprevailingpriceoftheactual
sharesalreadybeingtraded.A‘coveredwarrant’is
different,andthe‘covered’bithaslongbeenabandoned.Itconveystherighttobuyorsellanasset(generallyashare)atafixedprice(calledthe‘exerciseprice’)uptoaspecifieddate(calledthe‘expirydate’).Itcanalsobebasedonawidevarietyofotherfinancialassetssuchas
anindexliketheFTSE100,abasketofshares,acommoditysuchasgold,silver,currencyoroil,oreventheUKhousingmarket.Aswithotherderivatives,investorscanuseittogearuptheirspeculationoruseitasawayofhedgingagainstamarketfallorevenfortaxplanning.Unlike‘corporatewarrants’,whichareissued
byacompanytoraisemoney,acoveredwarrantisissuedbyabankorotherfinancialinstitutionasapuretradinginstrument.CoveredwarrantscaneitherbeUSwarrants(exercisedanytimebeforeexpiry)orEuropean(exercisedonlyonthedatespecified)butmostaresimplyboughtandthensoldbacktotheissuerbefore
expiry.Ifawarrantisheldtoexpiry,itisboughtbackforcashautomatically,withtheissuerpayingthedifferencebetweentheexercisepriceandthepriceoftheunderlyingsecurity.
Thereareanumberofissuersofferingover500warrantsandcertificatesonsinglesharesandindicesintheUnitedKingdomand
aroundtheworld.Theytendtobemajorglobalinvestmentbanksthathave‘bid’(buy)and‘offer’(sell)pricesfortheirwarrantsduringnormalmarkethoursinexactlythesamewayasshares.Investorstradeinthemthroughastockbroker,bankorfinancialadviser,justaswithordinaryshares.Launchedin2002therearenowmorethan70
brokerstrading.Germanylauncheditscoveredwarrantsmarketthreeyearsearlierin1989.
Acoveredwarrantcostslessthantheunderlyingsecurity;thisprovidesanelementof‘gearing’sowhenthepriceoftheunderlyingassetmoves,thewarrant’spricemovesproportionatelyfurther.Itisthereforeriskier
thanbuyingtheunderlyingasset.Arelativelysmalloutlaycanproducealargeeconomicexposure,whichmakeswarrantsvolatile,andthatmeanstheycanproducealargereturnorlosethecompletecostofthewarrantprice(confusinglycalledthe‘premium’)iftheunderlyingsecurityfallsbelowthepurchaseprice(itis‘outof
themoney’).Inaddition,warrantshavelimitedlivesandtheirvaluetendstoerodeastheexpirydateapproaches.
Coveredwarrantscanbeusedtomakebothupwardsanddownwardsbetsonanunderlyingasset.Buyinga‘call’isabetonanupwardmovement.Buyinga‘put’isabetonadownwardmovement.Withbothkinds
ofbetthemostaninvestorcanloseisthecostofthewarrant.Coveredwarrantsarelikeoptionsbutarefreelytradedandlistedonastockexchange–theyaresecuritized.Asaresult,theyareeasyforordinaryprivateinvestorstobuyandsellthroughtheirusualstockbroker.
SwapsSwapsarecontractstoexchangecashflowsonorbeforeaspecifiedfuturedatebasedontheunderlyingvalueofcurrencies/exchangerates,bonds/interestrates,commodities,stocksorotherassets.Interest-rateswapsaccountforthemajorityofbanks’swapactivity,withthe
fixed-for-floating-ratebeingmostcommon.Inthatdealonesideagreestomakefixed-rateinterestpaymentsinreturnforfloating-rateinterestpaymentsfromtheother,withtheinterest-ratepaymentcalculationsbasedonahypotheticalamountofprincipalcalledthe‘notionalamount’.Swaps,forwardrateagreementsandexotic
optionsarealmostalwaysagreedprivately,unlikeexchange-tradedderivatives.
AsreveredinvestorWarrenBuffettwarnedinhisBerkshireHathaway2002annualreport,‘Weviewthemastimebombsbothforthepartiesthatdealinthemandtheeconomicsystem…Inourview…derivativesarefinancialweaponsofmass
destruction,carryingdangersthat,whilenowlatent,arepotentiallylethal.’
Theoriginalpurposeofinventingmostofthemwastoreducesomebody’srisk–asortofhedgingdevice.Itworksincommodities,forinstancewhenafarmertriestofindprotectionfromthepotentialhazardofahugeharvest(ofwheat,oranges,
coffeeandsoon)withtheconsequentplummetingprices,byagreeingapriceearlierandbeforethesizeoftheharvestisknown.Ifthecropturnsouttohavebeenmeagreahugeprofitmayhavebeenforfeitedfromabigpricehike,butthefarmerwasprotectedfrompenuryifithadgonetheotherway.
ChapterFourForeignshares
Asubstantialnumberofforeigncompaniesare
quotedontheLondonStockExchange,especiallyfromEurope(egVolkswagen,BankofIreland,BayerandEricsson).InadditionthereareUScompanies(egGeneralElectricandAbbottLaboratories),Chinese(AirChina),Japanese(Honda,KawasakiandMitsubishi),
Taiwanese(Acer),SouthAfrican(SABMiller),Chilean(Antofagasta)andRussian(Gazprom).MostofthemtradeinBritainaswellsoitispossibletogetsomeideaofthebusinessandseestockbrokeranalysisofthemanagementandfigures.TradingintheseisprettymuchlikeinvestinginamajorUKcompany.
ThemergersofEuropeanstockmarketsmakeiteasiertogetaccesstomarketsinothermajorcountriesandtheirshares,especiallyasthereisalargenumberofrathergoodinternet-basedstockbrokersinGermany,FranceandHolland.
ItistheoreticallypossibletobuyoverseassharesthroughaUKbroker–in
practiceonlysomeofferthisservicesocheckinadvancewhetherthebrokeryouwantdoes.However,globalmarketsanddifferentialeconomicperformancesareproducingmoreopportunities,andtheinternetandonlinebrokersmakeiteasy.ButdespitethegrowthofEuropeantradersmostofthereadilyavailabletradein
overseassharesisforUSstocks.Thatlookstochangeasanever-growingnumberofcut-pricedealersfromGermanyandFrancesetupnetservicesinBritain.
Aswithallsuchinvestments,adegreeofresearchandhomeworkareessential.Thetroubleisthatthereareaddedlevelsofriskinoverseasshares.Thefirstis
thestateoftheoverseaseconomy.Aninvestorneedstoknowwhetherinterestratesareonthevergeofchangeinthatcountrybecausethatmighthaveanimmediateeffectonshareprices,orwhethertheeconomyasawholeisabouttosoarawayorisheadingforaprecipice.
Second,awiseinvestorgetstoknowsomethingabout
thestateofaparticularsector:oneneedstoknowwhichisabouttobeaffectedbyatradeagreement,areorganization,aspateofmergersandsoon.
Third,itisalittlehardertokeeptrackofthecompanies–Britishnewspaperstendnottowriteaboutthem,stockbrokersdonotanalysetheirfiguresandonecannot
keepaneyeontheirproductsandservicesinthemarketplace.Therearealsolocalpeculiarities,forinstanceSwissshares,whicharecommonly£5,000each,withsomeatover£20,000forasingleshare.Thatmakesitharderforasmallinvestortogetarangeofthesestocks–thoughtobefairtherearewaysofbuyingpartofa
share.Ontopofthatthereisthe
exchangeraterisk:acomfortableprofitfromtradinginthesharesmightbecompletelywipedoutbytherelativemovementofsterling.Finally,therearerisksinthewaythemarketitselfoperates.RegulationinmajorcountrieslikeAustraliaandtheUnitedStatesispretty
comparablewithBritain,but‘emerging’marketscanrangefromthehaphazardtothecorrupt.Aspartofthattheremayalsobeerraticrecordingofdeals,ownershiprecordsmaybevariable,andcontrolswayward.
Therearepeoplewhocancopewithallthosedangers,andhavedoneverywellfromUSshares,andevenfrom
investinginthebuddingmarketsofsmallercountries.Mostlytheyknowwhattheyaregettingintoandknowsomethingofthecircumstancestomanagetherisk.
Foranovicetothestockmarketsorsomeonewitharelativelysmallamountofmoneytoplaywith,itisprobablywisertobuy
investmentorunittrustswiththesortofoverseasprofileyoufancy.Thereissuchavarietyonoffer,youcandecidewhethertooptforJapan,theUnitedStatesorGermany;forthePacificRim,westernEurope,ordevelopingcountries;andevenwhethertopickspecificindustrialsectorswithintheseregions.Thatnotonlyhands
overthedecisiontoprofessionalsonwhicharethegoodshares,butalsospreadstherisk.AnotherchoiceistobuythesharesofaUKcompanythatdoesalotoftradeinthefavouredarea.Thosechoicesalsoeliminatetheforeignexchangeconsiderationsincethedealingsareinsterling.
ChapterFiveHow to picka share
A
I started withnothing. I still havemost of it.
JACKIE MASON, AMERICANRABBI AND COMEDIAN
nythingtodowithmoneyisamatterofdifficult
choices.Thesavingsandinvestmentpartalsodemandsalineofcarefuldecisions.Firstcomesthegradingof
safetyandaccesstosparecash.Thereisthecurrentaccountforeverydayexpenses,followedbytheamountsaccumulatingforpredictablelargerspendingsuchasholidays,redecoratingthehome,replacingthecar,thechildren’seducation,andsoon.Thencomestheprovisionsforasafeoldage,lifeassurance,pensionand
rainy-dayreserves.Onlywhenthesenecessitieshavebeentakencareofcomestheriskierareaofstockmarketinvestment.Itisnotcashyouwillneedtorealizeatshortnoticebutwillsupplementincomeforyouroldage,say.
Stockmarketinvestmentisforcashyoucanspareinthesensethatifitsvaluefallsitmaybedisappointingand
inconvenientbutwillnotcauseserioushardship.Itisalsoforpeoplewhosenervescanstanduncertainty–forpeoplewhowillnotlieawakeatnightfrettingaboutthefluctuationsofsharepricesorgetulcersifthebusinessinvestedingoesofftheboil,orevendownthepan.Ifyoucanthinkofitinthesenseofanalternativetoaflutteron
the3.30atSandown,orapuntataroulettewheel,andcanacceptreverseswithareasonablyphilosophicalshrug,thestockmarketmaybeforyou.
Thatisnotquiteafairpicture,sinceifthehorseyoubackfailstowin,allyourstakeisgone.Moneyinshareshasaprettyfairchanceofnotvanishingcompletely
asmostcompaniesstayafloatandcontinuetopaydividendstoprovidesomereturnontheinvestment.Inanycase,unlessyouwerebeingforcedtosell,adropinsharepriceisonlyanotionallosswhiledividendscontinuetoarrive.Ontopofthat,notonlyaretheoddswayaheadofotherformsofgambling,butthereturnisbetterthanother
formsofinvestment.Carefulresearch,monitoringandevaluationcanreducerisksonthestockmarket.Ifthehazardscouldcausealarm,itdoesnotmeanthestockmarketisclosedtoyou.Youcanstillbenefitfromthelong-termperformanceofsharesbythereduced-riskrouteofpooledinvestmentvehicles(seeChapter3).The
moneyisstillinvestedinsharesbutthedangersofbiglossesarelessenedbyspreadingtherisk.
Butthatdoesnotendthedecisionmaking–onthecontrary,itjuststartsitonanewtack.Tosifttherightinvestmentfromthemanythousandsavailablethroughstockexchangestakesaseriesoftestsanddecisions.There
arerisk/rewardcalculationsandapproachestodecide–otherpeoplecanhelpbyspellingouttheoptionsbutnottakethedecisionsforyou.Forinstance,somepeoplearepreparedtobetatoddsof14.5milliontooneagainstthem,whichwouldnormallyseeminsane,butbecausethecostoftakingpartintheNationalLotteryisonly£2
andthewinningscanrunintomillions,lotsofpeoplearepreparedtotakeapunt.
Thatshowssomeofthecriteriafordecisions.Onewayofscreeningthethousandsofpotentialinvestmentsistosetyourowngoalsclearlyandexplicitly.Itisnotnearlyenoughtosaytheaimistomakemoneyoutofthestock
exchange.Theprocessinvolves:
Decidingtheacceptableamountofrisk.Comparedwiththereturnonasafehomeforthecashlikegilt-edgedsecuritiesoradepositaccountatabuildingsociety,istheprofitfromsharesenoughto
compensatefortherisks?HowmuchriskamIpreparedtoaccept,firstingeneral,forinvestinginsharesatall,thenintheparticularsortofsharestogofor–suchasacceptingthatsmallandnewcompaniesaremoreindangeroffailingbutdohavethepotentialfora
largerpercentagegrowthinbothsharepriceanddividend;somecompaniesareseasonalormorereactivetoeconomicfluctuations;overseassharesincludeanelementofcurrencyrisk?Settingatimehorizonfortheinvestment.Whethertheinvestment
istobeshort,mediumorlongterm:volatilityofsharepricecanbedisregardedforthelong-terminvestmentandsotheshorter-terminvestmentswouldbemorestablebusinesses.Choosingifitistogenerateanincomeorcapitalgrowth.Theformerwouldsendyou
tocompanieswithahigheryield(thedividendasapercentageofthecashinvestedintheshares),thelatterforcompanieswithlowerdividendsbutthepotentialforhighercorporategrowth.Ahostofsubsidiarydecisions,possiblyincludingethical
considerations,territorialpreferences,etc.Somepeoplemightbeaversetotobacco,armsmanufacturers,contraception,dealingwithdictators,alcohol,inadequateecologicalperformance,poorlabourrelationsandsoon.
Thatprocessshouldhelpnarrowthefieldslightly.
Figure 5.1 Long-termstock market prices
Anothercriterionmightbethesortofrewardyouwouldneedfortheadmittedrisksofinvestinginshares.Bothsidesofthatequationaresubjective–risksvarywiththetimescale,thechoiceofinvestmentsandtherangeofholdings;rewardsneedtobecomparedwiththereturnfromalternativeusesofthe
moneysuchasputtingthecashondeposit,intogilts,orintootherinvestmentssuchasproperty,artandsoon.Returnsonequities(anothertermforshares)areusuallyseveralpercentagepointshigherthanongilts,whichinturnareseveralpointsabovedepositaccounts,butwhattherealreturnwillbeinthefutureisonlyanextrapolation
–historyshowsthatbothabsoluteandrelativevalueschange.
Eventhatisnottheendofit,becausethereisnoreasontoinsistthatthewholeinvestmentpotisgovernedbyasinglestrategy.Or,toputitanotherway,theeffectofevenastronginitialstrategycanchangeastheamountandrangeoftheinvestments
grows.Thefirstforaysintothestockmarketmightbeguidedbyalow-risklong-termincomedemand.Butastheportfolioextends,peoplearesometimespreparedtosaythat,thesafebasishavingbeenset,itisfairtotryforahigherreturnbytakingonariskierinvestment.Inaddition,astheygetmoreexperiencedand
knowledgeable,somepeoplearetemptedtotryalittlemoreactivetradingtobenefitfromshorter-termfluctuationsinparticularcompaniesorsectors.
Strategy
RiskThereisnosuchthingasa
risk-freeinvestment.Cometothatthereisnorisk-freelife.Ininvestmentthereiseconomiccyclerisk,companyrisk,exchangeraterisk,incomerisk,inflationrisk,marketrisk,sectororindustryrisk,andsoon.Inthiscontextthatusuallymeanscapitalrisk,iethedangerthatthesharepricefallsor,worsestill,thatthe
companyfounders.Noonesharecanmatchallone’spreferences,sothepolicyhastobetobalancethespreadofsharestomatchriskneedsandthenassesseachnewinvestmenttomaintainthebalance.
Therearerisksconnectedwiththequalityofthecompany’smanagement,businessareaandsize.In
additiontherearevulnerabilitiessuchasgreatrelianceonamanagingdirector(causingmajorproblemsifsuchakeypersondiesorleaves),orahighportionofbusinesswithafewcustomers(whichcanbenationalizedorgobust).Itcanalsobebecausethebusinesssectorisdoingbadlythroughachangeinfashion
orcompetingproductsarriving,orhealthdangersassociatedwiththeproduct.Itcanalsobebecausethewholemarkethasfallenflatonitsface.Theresultscanbehitbyturmoilinthecurrencymarketsorinterestrates,orthestateoftheeconomy.Inaddition,somesharesreactmoreviolentlytomarketmovements.Thedegreeof
thisresponsivenessisknowntoprofessionalsbytheGreekletterbeta,β(seeChapter6).
Companieswithriskfactorswillprobablyhavehigherthanaverageyields.Thisiscalledthe‘equityriskpremium’becauseitisgenerallyrecognized–notjustinthestockmarket–thatifyouhavetocarrygreaterriskyoushouldberewarded
withmoremoney.Higher-riskcompanieswithgreateryieldsarefineforgamblers,orpeoplewithasufficientlydiversifiedportfoliotooffsettheriskbyspreadingacrossother,lessdangerouscompaniesandsectors.
Sometradeshavetraditionallybeenvolatileandprecarious,andsomewecantellfrominstinctare
vulnerable.Theymaymovesharplywithfashions,seasonsortheeconomiccycle.
Anothergoodindicatoristhewaytherestoftheworldregardsthebusiness.Therearethreeusefulindicationsofthis:thebeta,theprice/earningsratioandtheyield,thelasttwoofwhichareavailableonthe
newspapersharepricespages.Betaisameasureofthepricevolatility,measuredagainstthemarketasawhole,andisstronglycorrelatedwithrisk.TheP/Eisthepriceofthesharedividedbytheattributableearnings,soahighP/Esaysthemarketexpectsafasterthanaveragegrowth,andalowonemeansthegeneralfeelingisthatthe
companywilllanguish.Ineffectthepricereflects,ordiscounts,theexpectedgrowthinthedividendsthecompanywillpayoverthenextfewyears.AverylowP/Eindicatesalackofmarketenthusiasm,probablybecauseitconsidersthebusinessrisky.
Theyieldwillshowasimilarpattern.Thereisa
caveathere,though.SomeshareshavealowP/Eandahighyieldnotbecausetheyareintrinsicallydodgybutbecausetheyareunfashionable.Andthisiswheretheso-calledperfectmarketbreaksdownandashrewdinvestorcangetanedgeontheprofessionals.Forinstance,companieswithasmallmarketvaluewere
avoidedforyearsfortwomainreasons:themajorinvestmentfundscouldnotfitthemintoapolicyofbuyinginbigchunksofmoneyyetendingupowningonlyasmallpercentageofacompany;andfewanalystsbothertolookatmostoftheshares.Thisneglectmeantitwaspossibleforthesmallinvestortofindrelatively
highyieldsoninvestmentsbybuyingintothesecompanies.
Similarly,ifacoupleofmajorcompaniesinasector–retailing,computers,insuranceorwhatever–reportlowerprofits,leanermarginsandtoughtimesahead,allthesimilarcompanieswillbemarkeddown.Thereissomesenseinthat,sincethechancesare
thatmostofthemwillbeaffectedinasimilarway.Ifonediscovers,however,thatbygoodluck,goodmanagement,orgoodproducts,onecompanyinthedisdainedsectoractuallyhascashinthebankandisachievingasubstantiallyhigherprofitmarginthanmostofitscompetitors(andthefiguresarereliableand
notjustwindowdressing),thenitwillprovidearelativelycheapwayin,eitherforagoodincomeorforcapitalgrowthwhenmarketsentimentreassessesthewholeareaofbusiness.Inotherwords,thesignalsofhighriskweremisleadingormistaken.
Itisafoolhardyinvestor,however,whoreliesheavily
onthissortofluckorimaginesheorsheknowsbetterthanthemarket.Ingeneralthemarketismoreoftenrightthanwrongandthefiguresreallyprovideaprettygoodindicationthatthereissomethingpotentiallydodgy.Itissometimespossibletofindgoldwhereothersseeonlydross,butdonotrelyonit.
Withinvestments,aswiththerestoflife,therearenofreerides.Everythinghasaprice.Ifsomethinghasahigherrisk,itislikelytooffsetthatwithahigherreturn.WhatvictimsalwaysforgetwhentheygetcaughtinsomethingliketheBankofCredit&CommerceInternational’sorLloyd’sofLondonproblems,oraseries
offraudsliketheNigerianscamortheprimebankpaper,isthatthecorollaryofthatrulealsoapplies:ifthereisahigherthanexpectedreturnthereisprobablyalsogreaterdanger.Onlyverysmallchildrenandpeoplewhosegreedovercomestheircommonsenseexpectsomethingfornothinginthisworld.
Thereisamarketinrisk.Onecanhedgeagainstit–takefinancialmeasurestolimittheextentofrisk.Companieshedgetheircurrencyexchangeexposureonforeigntradingbybuyingcurrenciesforward,andothersuchdevices.Aninvestorcanlimitlossesonasharebybuyingoptions.
Thatinsummaryisthe
passiveapproach,acceptingthemarket’sviewandmakingthebestofittosuityourpersonalcriteria.Assumingthatonariskcontinuumof1to10youarepreparedtobecautiouslybravebyoptingfor6doesnotmeaneverysharehastobescoredasa6.Itcanmeanarangeofreallysafe2withtheoccasionalrecklessflutteron
somethinglikean8or9.Eachtimeabuying
opportunitycomesalong,itisworthatleastthinkingabouthowitfitsintotheoverallportfoliopictureandhowfaritwillmovetheoverallaverageriskprofile.Thiswillhavetobedonemorecarefullythelongeryouholdsharesbecause,asthepricesmove,thevariouscompanies
willchangetheirpercentageoftheportfoliototalandtheireffectonthetotalriskbalancewillalsoalter.
Ifthelongandelaborateprocessofpickingsharesseemstoohard,ortherisk/rewardsystemseemsdauntinganditallrequiresmoreeffortthanyouhavetospare,youarenotalone.Someofthesharpest
investmentmindsintheUnitedKingdomandtheUnitedStateshaveadmittedthechancesofbeingableconsistentlytopickwinnersareprettyslim.Andinanycase,itmaybeunrewardedeffort.Themarketasawhole,asrepresentedbytheFTSE100Index,doesprettywellthankyouonanyreasonabletimescale.Tracker
fundsthatfollowthemainstockmarketindexcanbeananswer:theprivateinvestorcantakeastakeinoneofthose,orbealittlemoreadventurousandgoforaninvestmentorunittrustwithabroadbutselectiverangeofinvestments.
Defensive stocksSomecompaniesare
reckonedagoodbetforvolatileorhazardoustimes.Theyoperateinareasthatarerelativelyimmunetoeconomiccyclesandincludecompaniesdealingintobacco,asthatisarelativelysteadymarket,andsupermarketsbecausepeoplegoonbuyingfood.Utilitycompaniesalsotendtobeindemandinbearmarkets,as
peoplestillneed,regardlessofarecession,water,electricityandgas.
Emerging marketsThelabelisgenerallyappliedtostockexchangesincountrieswhicharebecomingindustrialized,becomingwealthyandwithagrowingnumberoflocalquotedcompanies.Itisvague
enoughtoencompasstheBRICcountries(BrazilRussiaIndiaandChina)whichareprettybigandanextgenerationgroupwhichincludesMexico,Indonesia,SouthKoreaandTurkey.SomeincludeeasternEuropesuchasPoland,HungaryandtheCzechRepublic.Thesemarketscanbevolatile,performingspectacularlywell
orplungingequallyspectacularly.Otherpotentialhazardsincludewaywardsupervision,lackofaccountancyrigour,andlessthanfulltransparency.
Long or short termAsallthenewspapers,magazinesandbookssay,overthelongtermthestock
markethasproducedabetterreturnthanalmostanyalternative.Ontheotherhand,asLordKeynespointedout,inthelongtermwearealldead.
Overaperiodof30,50or100years,returnsfromsharesoutperformedmostotherinvestments.Theydobetterthanproperty,antiques,depositaccounts,finewines,
buildingsocietysavings,andsoon.Since1918sharesinBritainhaveonaverageprovidedareturnof12.2percentayear,comparedwith,forexample,6.1percentproducedbythegilt-edgedsecuritiesissuedbygovernments.ThosefiguresaredespitetheUSmarketfalling87percentbetweenSeptember1929andJuly
1932,theUKindexdropping55percentin1974,thesteepdropfollowingthehurricaneinOctober1987,ortheplungefrom2007,andtheFarEastmarketbatteringinthe1990s.
Cashinadepositaccountwouldhaveproducedevenlessthangovernmentbonds,probablysomethingunder5.5percent.Takingamore
recentperiod,fromtheendoftheSecondWorldWar,equitieshaveonthewhole(takingintoaccountbothincomefromdividendsandcapitalappreciation)beatentheinflationratebyabout7percentormore.
Soonaverage–whichisalwaystheimportantwordofwarningtobearinmind–sharesprovideagoodlong-
termhomeforsparecash.Thereturnonsharesisalmostalwayshigherthangilts,andcertainlysooverthelongterm.Thisistocompensateforthegreaterrisk:index-linkedgiltsareguaranteed,whilecompaniesaresubjecttothevagariesofeconomiccircumstances.Theresultingdifference–thegreaterreturnonequities–istherefore
calledthe‘equity-riskpremium’.Ontheassumptionyouwillnothavetosellthesharestoraisecashatanyparticularmoment,youcanaffordtotakethelongviewoverwhichsharesperformbest.Becauseevennormallysensiblepeopleforgetthedangers,thegovernmenthasinsistedontheapparentlyobviouswealthwarningon
alltheliteratureandadvertisingthatthepriceofsharescangodownaswellasup.
Anotheraspectofthedecisioniswhetheryouwantincomeorcapitalgrowth.Thesearenotcompletealternativessinceanycompanydoingsowellthatithandsoutgreatdollopsofcashindividendsisalmost
certaintoseeitssharepriceboundahead.Butnotalways:evenacursoryglancedownthepricespageofanewspaperwillshowhugedisparitiesintheyieldfigures.Butifyouareaimingforcapitalappreciation,theshareswillbesoldtocrystallizetheprofit,whileincomeshareswillberetaineduntiltheystop
producinganadequateflowofcash.
Experiencedinvestors,expertsandpeoplepreparedtodevotetimeandseriouseffortdeal.Itentailsbouncinginandouttotakeadvantageoftheshort-termoscillationsofthemarket.Youspotatakeovertrend,sayamongfoodcompanies,andgetinastheothercompaniesstart
rising;oryoudetectagrowingfashionforatechnology–computers,internet,biotech,etc–andpileinastheboomstartstosweepthesharestounrealisticheights.Butthisalsomeansyouhavetowatchthemarketlikeahawkandseethesellsignalsintimetogetoutwithaprofit.Suchtacticsdemandmorespare
money.Theproportionatelyhighercostsofspreads,broker’sfeesandgovernmenttaxmeanyouhavetodealinlargeramountsandachievebiggersharerisestomakeaprofit(seeChapter8).
Oneotherpoint–everytimeonepersonmanagestomakeabigprofit,somebodyelsemissesit.Theymaynotalwaysmakealossbutjust
failtogettherealbenefit.Whatmakesyouthinkyouwillbethewinnereverytime,orspottherealsuccessesandavoidtheduffers?Somepeopledohaveatalentbutnotmany.
Atthemoreextremeendistherecentupsurgein‘day-trading’(buyingandsellingwithin24hours),whichcanbeachievedfairlyreadily
overtheinternet.ThefiguresfromtheUnitedStates,wherethefashionstarted,suggestthatfewerthan5percentofthepeopledoingitmakemoney.
Ethical investingThegrowinginsistenceonresponsibleandmoralbehaviourbycompaniesboth
towardspeopleandtheEarth,meanscompanieswithsoundethicalpoliciesaremorelikelytoprosper.Sosuchapolicyisgoodnotjustfortheconsciencebutthewallet.
Personalchoicedictateswheretodrawtheline.Companiesshunnedbysomeinvestorshaveincludedtobacco,armaments,makersofbabymilkforAfrica,oil,
paperandtimber(deforestation),mining,pharmaceuticals(animaltesting),alcohol,andsoon,tosaynothingofspecificcompaniesbeingboycottedbecauseoftheirpoliciesonpollution,ozonedepletion,wastemanagement,personnel,etc.Butitcanproduceconfusionifpursuedtoofar.Beingopposedto
gamblingwouldpresumablyruleouttheNationalLottery,whichcouldprecludealltheshopsandsupermarketsthatselltickets.Andhowaboutbuyinggiltsfromagovernmentthatencouragesarmsmanufacturers,trainssoldiersandprobablyfundsresearchcentresthatcarryoutanimalexperiments?
Theultimatepointisthat
theinvestorshouldbeabletosleepatnight,notjustbecausethemoneyissafe,butbecausethereisnoneedtoworryoneissupportingacompanythatoppressesworkersorhelpstokillpeople.Ontheotherhand,itisthenonlylogicalthatonenotonlyavoidsmakingaprofitfromthecompany’ssuccessbutalsostopsbuying
itsproducts.Ausefulsourceof
informationonthisistheEthicalInvestmentResearchService.Itwassetupin1983byseveralQuakerandMethodistcharitiesandresearchesover1,000companiesplusmostcollectivefunds,andkeepsalistoffundmanagersandstock-brokersconcentrating
onethicalinvestments.AnotherisCantradeInvestments.
The economy
Decidingonashareorevenamarketsector–suchasretailers,propertydevelopers,engineeringmanufacturersorfinancialcompanies–involvesasecondlevelof
investigation.Itmeanslookingattheeconomyasawholeandthenthewayitaffectstheconstituentparts.
Forecastingtheeconomycanbeamug’sgame.GovernmentsaresubstantiallyworseatforecastingthantheMetOffice.HaroldMacmillancomplainedwhenhewasprimeministerthatnational
figuresweresooutofdateitwaslikedrivingacarlookingonlyintherear-viewmirror.Ithasgotlittlebettersince.Mostbigcompaniesdosomeforecasting,themajorfinancialinstitutionssuchasbankshavesubstantialeconomicdepartmentsfocusingonthat,andthereareanynumberofspecialisteconomicoreconometric
organizations.Theprojectionsseldomagreeandifanyofthemisrightitismorebyluckthanbyjudgement.Fortunatelyhowever,theindividualinvestordoesnotneedtogetintothesortofcomplexdetailthoseinstitutionsattempt,andcommonsensetemperedbypersonalobservationwillusuallyhelp.
Factorsthatcanaffectinvestmenttacticsinclude:
therateofinflation–boththeRetailPricesIndex(RPI)andtheConsumerPricesIndex(CPI);thegeneralhealthofeconomy–whetheritisrising,fallingorontheturn;
theexchangevalueofthepound–againsttheeuro,dollar,yenortrade-weighted;industrytrends–eggrowthinretailspending,house-buildingandprices,engineeringconcernssufferingfromexchangeratemovements.
Onmostoftheseonecangetaprettygoodfeelfromreadingthenewspapersandkeepinganeyeonwhatisgoingonatthelocalhighstreetestateagents,forexample.Onecangetitwrong,butthensocanthepunditsholdingforthfromparliamentorontelevision.Andthestockmarketitselfwillgiveaprettygood
indicationofwhattherestoftheinvestmentworldthinks:ifitisfallingpeopleexpecttrouble,ifasectorisshunnedthereisareason(anditisworthinvestigatingifonlytoseewhetheryouagree),ifsharepricesarerisingoptimismabounds(andeventhenitisworthcheckingwhetheryouthinksucheuphoriaisjustified).
Picking shares
Onceyouhavesetthegroundrules,youneedinvestmentstofitthem.Warning:almosteveryonewhohaseverhadanythingtodowiththestockmarkethasatheoryofhowtopickashare.Theyaresimilartoaddictedgamblersandtheirsure-firesystemsforwinningatrouletteorhorse
racing.Thebookshopsarebulgingwithpetschemesandprivateformulae.Thosewinningmethodscomeinpredictablecategories.Therearethestrategicviews,whichrangefromin-and-outtradingallthetime,totheoppositeextremeofbuyandforget.Thereisthetacticaladvicecategorythatshowstheinfalliblewaytopickthebest
bet.Itdoesnottakelongtodemonstratethefallacy–iftherewereacertainandpredictableschemeformakingmoneyeverybodywouldhavebeenusingitlongsince.
Thatisnotarecipefordespair.Althoughborrowedtacticswillnotproduceinfallibleopulence,therearesomecommonsensewaysof
lookingatcompaniesandtheirsharesthatwillincreasethechancesofsuccess.Thisisseriousstuffhowever,andaninvestorwhohopestomakemoneyoutofthestockmarketwillhavetomakeaneffort.Everythinghasaprice,andthecostofmakingmoneyisusuallyhardgraft.ThefamouslysuccessfulWarrenBuffettdidnotgetrichby
accidentorbyfollowingasecrettrick;hethinks,eats,breathesandsleepsthestockmarket.Hemaynotbetheworld’swittiestandmostwide-rangingconversationalist,butthenyouhavetoaskyourselfjusthowseriouslyyouwanttoberich,orevenslightlybetteroff.
Itcannotbesaidtoooften:
bewareofalladvice.Donotrejectitoutofhand,butjustremembernobodygetsitrightallthetime(seeChapter7).Andeventhepeoplewhodogetitrightmoreoftenthannot,seldomknowhowtheydoit–theirexplanationsareusuallypost-hocrationalizationastheystruggletoexplainjustwhatinstinctdrovethemtobuy
thatorselltheotheratjusttherighttime.Ifbysomemischancetheyreallycouldformulatethetrick,theywouldbeveryfoolishtosharethesecretwiththerestofusandsoqueerthepitchforthemselves.
Judgingbytheproliferationofsuchbooksthereisclearlymoremoneytobemadefrompublishing
accountsofawonderfulnewwayofmakingafortuneonthestockmarketthanfromputtingtheprincipletoworkandbuyingshares.Whyotherwisewouldallthosepeoplebesodiligentlyoccupiedwritingandgettingpeopletocompetewiththeminsearchingfortheroutestofortune,whentheycouldberesearchingthemarketand
dealing?Thepointforaninvestoris
toabsorballinformationavailable,buttoweighitcarefullyandalwaystotestitagainstcommonsense.Followingsomeoneelse’smethodslavishlywillprobablynotwork,butsomecombinationofthemethodsdescribedinthissectionshouldhelpmostpeople
evolvetheirownwayofapproachingachallengingbutpersonaltask.Hereareafewexamplestoshowthediversityofmethodsandadviceavailable.
Onesetofinvestmentguidelineshassixrules:
1. Infundsorsectorsgofortheonesnearthebottomoftheleaguetables.The
topperformersareusuallyoverpricedorarelastyear’sfashion.
2. Goforshareswithhighyields,butiftheysurvivethatlong,sellinayear.
3. Watchwhatdirectorsdowiththeirshares.
4. Buycompanieswhereatleast3percentofthesharesareownedbythe
workforce.5. Companiesspending
over4percentofturnoveronresearchtendtodowell.
6. Buyafteraprofitwarningifthecompanyisfundamentallysoundbutgoingthroughanunluckypatch.
EvenWarrenBuffettclaims
tohaveaformula(ifyoucancallitthat,sowonderfullysimpleisit),butitisnotveryobviouslyhelpfultothenoviceinvestor.Whenpressed,hisadvicewastobuygoodbusinessesandhangontothem.Whichisaboutashelpfulastheadviceforsuccessinbusiness:buycheapandselldear.ThebusinessmanRichardKoch
elaborated:buycompanieswithagoodtradingrecord,specialize,watchprofittrends,sticktocompanieswithgoodbusinessreputations,pickcompaniesthatgeneratelotsofcashandproduceahighreturnoncapital,riskpartoftheportfolioonemergingmarkets,andsellanysharethathasdroppedbyatleast8
percent.TRowePrice,wholaunchedafundinthe1950s,advisedconcentratingoncompanieswithlong-termearningsgrowthrecordsandthechancesofcontinuingthatway,whichhedefinedasreachinganewpeakatthetopofeachbusinesscycle.Theseareinanindustrywhereunitsalesandprofitsarerising,andhavegood
patents,productsandmanagement.TheUSinvestorMichaelO’Higginsreckonsyoushouldselectthe10highest-yieldingsharesintheindex,andthenpickthefivewiththelowestshareprice.
MalcolmStacey,theauthorofaninvestmentguide,advisesspreadingthemoneyamongsectors,buying
slowbutsteadyrisers,andstickingtoleaders(includingonesintheirsector).Healsohasasystemofsettingapricedifferentialatwhichdealingistriggered–ifthefilterweresetat10percenttheneverytimethesharefell10percentoffapeakoneshouldsellandstartbuyingagainwhenitcame10percentoffthebottom.
Manyofthesepeopleadvocatingsystemshavethemselvesbeensuccessful,butnotehowvariedtheadviceis.Sobewareofformulae,butbeespeciallywaryoffashionableinvestmentgurus.
Inclearoppositiontoallthosewonderfulsystemsistheviewthatanyattempttooutperformtheaverageis
doomedtofailure–itisjustnotpossible.The‘randomwalk’theorysaysmovementsofpricesareinherentlyunpredictableinbothsizeanddirection,andasaresultanywinsorlossesarepurelyamatterofchance.Inthelongrunyouwillendupeven,oratleastwillhavemovedwiththemarketaswhole.
Anotherhypothesisthat
alsoassertsthattryingtooutperformthemarketisawasteoftimesaysthemarketisefficientintheeconomists’sense–itincorporatesinthesharepricealltheavailableknowledge.Thatmeanseverybodyhasaccesstoalltheinformationaboutthecompany,economicprospectsandthemarket,andtherearenopeoplewithenough
financialclouttomovethemarket.Asaresult,thepriceofsharesalreadyreflectstheconcertedandprobablyrelativelyaccurateviewofthetotalityofinvestors,privateandinstitutional.Sinceshareshaveno‘correct’price,runsthishypothesis,andareworthonlywhatsomebodyispreparedtopayforthem,thegeneralconsensusviewisthe
rightprice.Nicetheory,buteventhe
mostcursoryglancewillshowthestockmarkettobeanythingbutrandomandalongwayfrombeingrational.Thereareanomalies,andnoteveryonehasreactedyettotheinformationthatcanbegleaned.Informationmaybeavailablebutnoteverybodyhastakenitonboard.
Inaddition,themarketdoesnotactinlinewiththeeconomists’depictionofoptimizingbehaviour.Theswingsseemtodemonstratefrequentoverreaction,amountingattimestohysteriaorblindherdstampedes,anditisclearsomepeopledohaveashrewderappreciationofwhatisgoingonthanothers.
Ifitwereanefficientmarket,makingitthereforeimpossibleconsistentlytodobetterthantheaverage,howdoyouexplainpeoplewhohaveactuallymadethemselves–andsometimestheirclients–amajorfortune?Therearesomenotablenameswhohavesteadilymademoneyandsomefamousinvestment
managerswhohaveoveralongtermperformedaboutfivetosixtimesbetterthanthemarketasawhole.
Aplainindicationthattheperfectmarketissomewayoffcanbegleanedfromeventhemostcursorylookattheviewsofstockbrokers’analystsoncompanyshares–thereislittlegeneralagreementaboutthe
prospectiveperformanceofmanycompanies.Thepricecannothaveincorporatedalltheseviewsbecausetheycontradicteachother.Andastheoldsayinggoes,twoviewsmakeamarket.
Theacademicsarethereforemodifyingtheirviewsandconcedingtheremaybepocketsofinefficiencycontinuingto
existthatcouldprovidethesharpanalystwithanopportunity.Marketpractitionershavealsopointedoutthatthissortofrigidacademicpicturedependsonthetimescale–intheveryshortterm,movementsinpricesmayseemrandomandirrationalbutthelongeryouextendtheperiodthemorelogicalit
becomes.
FundamentalanalysisIndecidingwhatsharetobuyandwhen,thefirstthingtorememberisthatthereisnoabsoluteorcorrectprice.Thisisamarket,sothevalueiswhatpeoplearepreparedtopay.Butthatisatanyone
time.Arealisticviewisthatthestockexchangeisquiteplainlyaverylongwayfromtheeconomists’perfectmarketwithperfectinformation.Butitisareasonablyefficientmarketsotheshrewdanalystcanspotcompaniesorsectorsthatareoutoffavourorhaveagreaterpotentialthanthemarketseemstorecognize,
cananticipatepricemovementswhenthenewinformationspreads,andsomakeanabove-averageprofit.Thetacitassumptioncontradictstherandomwalktheoryaswellastrustinthecombinedwisdomofalltraders,andassertsitispossibletocalculatethevalueofabusiness,andthatthesharepricewilleventually
tendtowardsthetruevalue.Thisistheprovinceof
fundamentalanalysis.Thisistheprocessthat:
evaluatesabusinessanditsproducts;examinesitspublishedaccounts,includingreturnoncapital;takesaguessatearnings,earningspotentialand
dividendprospects;looksattheeconomicambience,suchastherateofinflation,thelevelofsterling,consumerdemandandinterestlevels;watchesthemarketthecompanyissellinginandwhatitscompetitorsareupto;judgesthecompany’s
management.
Adiligentinvestorcantrytokeepaneyeonadvertisementsforhigh-poweredjobsincasetheyshowacompanyabouttomoveintoorenlarginganimportantnewarea(suchastheinternet),whichcouldbeaninsightnotavailabletomany.Allofthatresearch
producesawayofdecidingwhetherthebusinessisfairlyvaluedbythemarket.
Butneverforgetthepriceissetbymarketreaction,soitispointlesstosayacompany’ssharesareundervalued.Ifthemarketcontinuestoundervaluethebusiness,theshareswillbecomenohigher.
Theassumptionbehind
doingthisworkisthatthemarkethasdevelopedonlyatemporaryblindnessormisjudgementandwillinduecoursecometoappreciatetruevalue.Sooneisaimingtopickwinnersnotyetspottedbyothers.Assumingtheanalystisrightandwayaheadoftherestofthemarket,acorrectioncouldstilltakeyears,duringwhich
timethecompanycouldbesoseriouslyhamperedbyitslowsharepricethatitsbusinessisovertakenbycompetitors.
Therearetwoadditionalfactorstotakeintoaccountbeforeactingonsuchanalysis.Oneisthebasisforthecurrentsharepriceandtheotherismarketfeel.
Sharepricesarebasedmoreonthefuturethanon
thepast.Thatmeansapricemaybelowerthantheavailablefiguressuggestwouldbejust,becausethemarketexpectsthenextsetofresultstobepoor–andofcourseviceversa.Thatisoftenbasedonacombinationofwhatwasinthelastcorporateannouncementandwhatinfluentialstockbrokers’analystshavebeenprojecting
forthefiguresandhavebeensayingaboutthestateofthecompany.Thatisthereason,incidentally,whysharessometimesactparadoxically:fallingonthepublicationofgoodtradingfiguresorrisingafteramediocreresult.Themarkethasalreadyfactoredthosenumbersintotheshareprice,andafterpublicationisreassessingthesharesinthe
lightofthenextsetofresults.Ifyouthinkthemarkethasgotitsexpectationswrongitispossibletotradeinthehopeofasharpreactionwhenthetruefigurescomeout,iftheyareinlinewithyourprojections.Thisrequiresthatyouarenotonlyright,butthattherestofthemarketviewsthenewinformationinthewayyouhaveexpected.
Forinstance,acompanymaybeproducingprettycomfortablelevelsofprofitandyetitssharesfailtorespondappropriately.Theremaybemanyreasonsforthat.Thecompanymaybetoosmallforthemajorinstitutionalinvestors,whichdominatethemarket.Oritmightbebecausethemarketreckonsthatfurtherdownthe
roadthereistroublelooming,orbecausethepricehadalreadyreflectedjustthatlevelofprofit,orevenbecausethecompanymaybegoodbutthesectoriscurrentlyoutoffavour.
Thisiswheremarketfeelcomesin–theresultofallthatreadingofthefinancialpress,listeningtotheradio,etc,andjustgoodinstincts.
Thisisnotaboutbeingmoreaccuratethanothersinthemarket,butbeingabletoanticipatethewaysotherswillseeandusenewinformation.Somepeoplejustfeeltherewillbeanimminentshiftinattitudestoaspecificcompany,anindustrialsector,oratypeofcompany,butthemoreyouknowandtheharderyou
worktheluckieryouwillbe.Onewaytomakesuch
decisionseasieristosetthemdownatthetimeofpurchase.Youworkouthowmuchtheshareisundervalued–whatwouldbeitsrightmarketcapitalization,price/earningsratio,yield,orwhatever,consideringitssector,performanceandprospects?Whenitpassesthatlevelon
thewayupyouwatchlikeahawkforsignsthemarketrealizesithasagainoverreacted,thistimeintheupwardsdirection,andthenyoumustsellatleastpartoftheholding.Neverbeafraidofmissingtheboat–itcouldjustbetheTitanic,asitwasfortheSouthSeabubbleinthe18thcentury,therailwaymaniainthe1830s,andthe
dotcomlunacyin1999,amongothers.
In1998–99anybusinessthathadanewweb-basedideaorwhichproducedsoftwareforinternettrading,orinvestedinsuchenterprisessuddenlybecamethephilosopher’sstone.Sharepricesdoubledeverysixweeks,withonegoingfrom230pto£87inlessthana
year;companiesunknownafewmonthsearlierweresuddenlyworthhundredsofmillions.Itwasheadystuffandmanypeoplegotcarriedaway.Theboomwasclearlyunsustainableandtriggeredanequallyexaggeratedreaction.Ittookoverayearformoresensibleapproachestoprevail:theinternetisevidentlyabigbusiness
opportunitybutwillnotproducelimitlessprofitsovernight.Thesensibleinvestorsspottedtheopportunitiesearlyandtheverysensibleonesrealizedwhentheoptimismhadbeenoverdone,andeithersoldoratleasthugelyreducedtheirholdings.
Bearinmindalsothatyouarenotaloneinthisquest.
Therearedrovesofanalystsbeingpaidludicrousamountsofmoneytohelpinstitutionsbeatthemarket,plusmillionsofprivateinvestorsonthehuntfortheendofthesamerainbow.Asaresult,thepricesinthemainreflectthesumoftheirexpectationsbothaboutthecompanyandthemarketinwhichitoperates.Inotherwords,they
setthepricenotonwhatitisdoingnowbutwhatitislikelytobedoingoverthenextcoupleofyears–thepricehasdiscountedthefuture.
Nearlyallthesecalculationsaredonefrompublishedaccounts(seeChapter7).TheyarefiledatCompaniesHouse,butmostcompanieswillsendacopyto
prospectiveinvestorsifaskednicely.Extractinginformationfromthemassofdataisapainstakingbusinessrequiringapplicationandexperience.Thereisnothingdifficultaboutit,butonehastolearnthelanguageofaccounting,haveaninklingaboutsomeofthedodgescompaniesuse,andunderstandthesignificanceof
thenumbers.Theaccountsrevealnotjustwhattheformulaecalculate,butawealthofotherinformation.Elaboratefinancialengineering,suggestionsofskilfulburnishingofresults,orcarefulreallocationoffiguresareallsignsthatthebusinessisnotallitseemsorthatthemanagementisatouchflaky.Eitherway,these
arecharacteristicstoavoid.Allthisresearchcanyield
dataofsuchvolumesitburiesinformation.Fortheprivateinvestortheansweristocreateasetofpersonalfilters.ThiscanbebystickingtocompanieswithaP/Eratioofnomorethanfiveorsix,orwithayieldatleast10percentabovetheaverage.Itcanbebylookingatneglected
sectors;forexample,isitfairthatretailingshouldbeundersuchacloud;ismanufacturingstillgoingthroughthosetroublesthatmadeprofessionalinvestorsshunthem;arebreweriesreallyabetterbetthancateringcompanies?Inasenseitisbeingthecounter-cyclicalinvestor.
Somepeopleeven
considershareholderperks.Thesearethebenefitsmanycompaniesprovideasaddedinducements:restaurantchainsandhousebuilders,clothingretailersandinsurancecompanies,palm-topcomputermakerstoferryoperators,givediscountstoshareholders.Thoseshouldbeabonusandnotareasonforbuying.
Onethenselectsfromthatlonglistthecompaniesthatmayappealforotherreasons.Thebestapproachistocombineallofthatwiththeothercriteriaavailable,suchasalookatthecountry’seconomy(sometypesofcompanydobetteronanupturnandsomesurvivedownturnsbetter),theshopper’sview(seebelow)
andtechnicalanalysis(seeChapter6).
TrackingAllthisdiscussionassumesaninvestoristryingtodobetterthanthemarketasawhole.Itisnottheonlystrategy.Manyindividualsandhordesofinvestmentfundsreckonthetaskistoo
fraughtandoptforthesafercourseofjusttryingtokeeptheinvestmentsasgoodasthemarketasawhole.Sinceonalongertermthemarkettrendisgenerallyupwards,thisisasafeandlower-riskapproach.
Shell and recoverystocks
Potentiallyspectacularchangesoffortunecouldcomefromshellandrecoverycompanies.Theyrequireaspecializedformofforecasting.‘Shell’companieshavelittleornoexistingbusinessbutareclingingtoacontinuedstockmarketlisting.Theirpurposeistoactasacheapwayforanothercompanytogeta
stockmarketquotation.Somesharpmanagerscanmovein,raisemoneytoacquireothercompanies(possiblyprivate),oranotherbusinesscangetontotheexchangebya‘reversetakeover’–thequotedcompanyislegallybuyingtheunquotedbutisinrealitytakenoverbytheunquotedone’smanagersandbusiness.Bydefinitionitis
almostimpossibletogetmuchinformationaboutsuchoutfitsortheirprospects.
A‘recovery’stockisofacompanythathassufferedapoorperiodandisonthemend,orhasacquiredadoctortohealitsills.Itcouldbringrapidreturns,buthistoryshowstheoddsareagainstyou.AsWarrenBuffettsaid,‘Whena
companywithareputationforincompetencemeetsanewmanagementwithareputationforcompetence,itisthereputationofthecompanythatislikelytoremainintact.’
Thatisasoberingthoughtfromanacknowledgedwinner,butitisnotalwaystrue.Stumblingcompanieshavebeenrescuedfromthe
edgeoftheabyssbycompanydoctorsorrevisedpolicies.Inaddition,thoughthestockmarketmayshowitsdislike,theprofitscouldbedownforsomeverygoodreason:thecompanyhasinvestedamassiveamountintoresearchanddevelopmentforaseriesofnewproductsthatwillcreatehugenewmarkets;ithasboughtanewbusiness
thatwillextenditsownrange;ithasrestructuredthecompanytobemoreefficient(includingexpensiveredundancies);andsoon.Itisalwaysworthlookingbehindfactsforcauses.Theremaybetheseedsofhope,orBuffettcouldberightandtheloserwillsinkintooblivion.
Theconversedoesnotholdtrue,asrecentyears
havedemonstratedalltooclearly.Winnersdonotholdtheirtopplaceforever.JSainsburyandMarks&Spencerwereforalongtimereveredastheretailerswiththemagictouch,anditseemedtheycoulddonowrong–untiltheyseemedintheeyesofthemarkettodoeverythingwrongandtheirsharestumbled.IBMwasat
onestageprophesizedtoeliminateallothercomputermakers.
Bythesametokenthesoar-awaysuccessofyesterdayseldomlaststilltomorrow.Beforegettingtoomistyeyedatthesuccessofasharethathasdoubledinpriceinthepastthreemonths,juststopandextrapolate–ifitgoesonlikethatwillthe
companybeabletobuythewholeofFranceandGermanyinfiveyears’time?Actually,evenwithoutbeingsilly,itisworthconsideringwhetheritisreasonableforthebusinesstobecomparablewithlong-establishedcompaniessuchasUnileverorShell.Thatcreatesasenseofperspectiveandmaypromptonetocreamoff
profitsanddistributetheproceedstootherlikelysuccesses.
Bearingallthosefactorsinmind,onecanthenbegintosetthecriteriaforaninvestmentpolicythatrelieslessonhunchandhopeandalittlemoreonarealisticappraisalofpersonalneedsandmarketcircumstances.
The shopper’s viewConsumersknowfrompersonalexperiencethattherearesomegoods,someshops,andsomeservicecompaniesthatreallyseemgoodvalueandhelpful,andtheykeepbuying.Othercustomersmaywellfeelthesameway,inwhichcaseitcouldbeagoodbusiness.Andofcoursethe
oppositeisequallyawarning–ifyouhavestoppedbuyingsomegoodsorgoingtoachainofshopsbecausethegoodsareshoddyorthevalueispoor,soonerorlaterothersarelikelytospotthataswell.
Forinstance,ifshoppingatSainsburyhasbecomeexpensiveandapainandyouaregoingtoTescoinstead,orviceversa,asimilarview
maystrikeothershoppers,andeventuallytheprofitsandsharepricewillreflectthat.Similarly,ifyouhavecomeacrossaproductorservicethatseemsoutstandingaswellasprovidinggoodvalue,andthecompanybehinditseemssoundandambitious,itmayinduecoursebecomeadarlingofthestockmarket.
Inawidercontext,onecan
spotwhenamarkethasabandonedrealityandisstokeduponhopeandgreed.Exampleswerethedotcombubble,andthepropertyboominthe10yearsto2007whenmanysanepeoplecouldseethatGadareneswinewererushingheadlongtheyknewnotwhy,andcouldsensethatthingswouldendindisaster.Theshrewdoneslistenedto
instinct,watchedsalesandprices,listenedtoearlyreportsofconcernandexitedwithprofits.
LosersThereisoneoutstandingcharacteristicshownbyprofessionalsthatseemscuriouslyabsentintheamateurinvestor:theability
todroplosers.Small-timeinvestorsappeartohaveasentimentalattachmenttosharestheyhaveboughtnomatterhowbombedoutthecompany,orperhapstheyjusthatetoadmitmakingamistake,whichtakingalosswouldentail.Thesharepricefallsfrom850pto55pandtheysitandwaitforittocreepupagain,thoughany
dispassionateviewwillshowittobeheadingtosomethingbetween20pandhell.
Someinvestorsevengoinfor‘averagingdown’–buyingmoresharesatthelowerpricetobringdowntheaveragecostofthestake.Thisisontheassumptionthatthesharesareabouttorecover.Buttodothissuccessfullyyoureallydo
havetobeabsolutelycopper-bottomedcertainyouarerightandthemarketwillsoonshareyourview.
Itwouldprobablybemoresensibletoseeiftherearebetteropportunitieselsewhereinthemarket,andshedtheloser.Onewaythebigboyskeeptheirpolicyincheckandmakesuchdecisionseasierandmoreautomaticisby
establishinganactionpoint–thestop-losssignalistriggeredbyafallof10to15percent.
PerksInadditiontotheusualbenefitsofowningshares,suchascapitalappreciationanddividendincome,manycompaniestrytokeep
shareholdersloyalandenthusiasticbyprovidingperks–mostofthemaremerelydiscountsandthereforeentailadditionalspendingbyshareholders,whichhelpsprofits.Forsomethereisaminimumholdingbeforetheperkskickin.Somestockbrokersprovidelists.
A
Chapter SixTricks of theprofessionals
ccordingtomarketpuriststherearetwobasicways
ofassessingacompany:fundamentalandtechnicalanalysis.Inpracticetheformerisbestforshowingwhichsharesareworthbuyingandthelatterforwhentobuythem.
Fundamentalanalysisinvolvesevaluatingeverythingaboutacompany.Unfortunatelythereistoomuchtoknow.Ideallyyou
wouldwanttoknownotonlythequalityoftheproduct/service,thestateofthecompany’scustomersandwhetherafewaccountedforalargeportionofsales,thecompetition,thecompetenceoftheboardandseniormanagement,theconditionoffinancesandthevulnerabilities,theextenttowhichthebusinesswas
reliantonafewmarkets,theeconomiccycle,exchangeratesandlabourrelations,andsoon.
AfewofthebasicmeasuresandapproacheswerecoveredinChapter5,butmarketprofessionalshaveawiderangeoftoolsfordiggingdeeperintothecircumstancesandbackgroundofcompanies.
Theyprovidetheprincipalbasisfordecidingwhattheunderlyingvalueofthecompanyshouldbe,andthenseeinghowfarthemarketdivergesfromthat.
Thereisnoonesimpleandobviouswayofdecidingwhatacompanyisworthnow,muchlesshowitsvalueislikelytomoveinthefuture.Allthecalculationsare
helpfulsometimes,somemostofthetime,butnoneisconsistentlyandreliablyabletopaintadefinitivepictureofthebusiness.Asdifferentindustrieshavevaryingpaymentcustoms,stockturnovertimes,capitalneeds,amountsretainedforresearchandsoon,thebestwayistocheckwhatthenormisfortheindustryandseehowfar
thecompanydivergesfromit.Thatinturnmaytakeafairamountofresearchfrompeoplelikestockbrokers,tradeassociationsandgovernment.
Anotherproblemistheshiftingopinionaboutwhichratioisthemostreliableindicator.Obviously,whenonefactorbecomesgenerallyappliedasthetruemeasureof
acompanyitdistortsthepicture.Inotherwords,ifdividendcoveristakenasthetrueindicationofacompany’sworth,businessesarerankedbythatcriterionandasensibleinvestorwoulddobesttolookharderatotherfactorstoseeifthemarkethasgotitsevaluationright.
Manyratiosarequitedifficulttoworkoutandneed
abitofdiggingtogetatthefigures.Mostofthesefiguresareextractedfromthecompany’sannualreportandaccounts,whichshouldbereadinconjunctionwiththeguidanceinChapter7onwhattolookforinthoseaccounts.
Theratiosmentionedherearethemostcommonandaregenerallyagreedtobe
helpful.Expertshavearangeofothercalculations,indicatorsandratiostheyfinduseful.Thosecanbehandybutonlylongexperiencewillshowwhatindicatorsarepersonallyuseful,soitwillbethemoreexperiencedinvestorswhoshouldinvestigatetheserioustextbooksonhowtocalculateandusemoresophisticated
modelsofstockmarketbehaviour.
Fundamentalanalysis
Chapter5discussedthereasonsforresearchingabusiness,itsbackgroundandcircumstances,andhowthiscanbenefitaninvestor.In
additiontothegeneraloverallfeelandcursorytrawlthroughtheavailablefigures,therearetechniquesandcalculationsusedbymarketprofessionalsthatcanhelppinpointpreciselywhyacompanyisbetterorworsethangeneralsentimentsuggests.Theyarediscussedbelow,inalphabeticalorder.
Acid testSometimescalledthe‘quickratio’,thiscanbeworkedoutfromthebalancesheet.Itcheckstoseejusthowsolventacompanyisbyhavingalookatitsliquidorreadily-realizableassetsthatcouldbeusedtomeetshort-termliabilities,andthencomparingthatwithits
currentcreditorposition.Thismeansdividingthe
currentassetsminusstocks(ienetmonetaryassets)bythecurrentliabilities.Iftheresultislessthan1thebusinesscouldnotsettleallimmediatedebtsiftheywerecalledinandsuggestsaprecariousbalance,while2issafer.Itisalsoworthcheckingbackinprevious
accountstoseeifthereismuchmovement.
Itisaslightlybetterversionofthenetcurrentassetandcurrentratio(seebelow)becauseitassumesthatnotallcurrentassetsareequallyavailabletobeturnedintocashifsuddenlyneeded.Forinstance,stockandworkinprogressneedtimetorealizeortheywillfetchvery
lowprices,andinanycasefewcompanieswouldplantoliquidatealltheirstockjusttopayanoverduebill.Sotheacidtestisreckonedtobeamorerealisticmeasureofhoweasilyacompanycouldmeetitsobligations.
Altman Z-ScoreThiswasdevelopedin1968
byNewYorkUniversityfinanceprofessorEdwardAltmantopredictthelikelihoodofacompanybecominginsolventwithinthenexttwoyears.Thescoreisabankruptcypredictioncalculationthatmeasurestheprobabilityofinsolvencythroughinabilitytopaydebtsastheybecomedue.Hestudied66manufacturers
withassetsthenofover$1million,halfofwhichhadgonebust.Inonetestitpredicted72percentofcorporatebankruptciestwoyearsbeforetheyhappened.Z-scoresforfailingbusinessesshowaconsistentdownwardtrendastheyapproachinsolvency.
Altmanusedfiveratioswithvaryingweightings:
1. workingcapital(currentassets–currentliabilities)/totalassets×1.2
2. retainedearnings/totalassets×1.4
3. earningsbeforeinterestandtaxes/totalassets×3.3
4. marketcapitalization/totalliabilities×0.6
5. netsales/totalassets×0.999
Theresultswillbebetween–4and+8.AddedtheyproducetheZ-score.
Itcanalsobethoughtofasanequation:
Consistentlylowscoreseachyeararemoreofaconcernthanaone-offlowscore.
Asset backing
SeeNetassetvalue,below.
BetaThisisoneofthefewcalculationsinthischapternotderivedfromacompany’saccounts.Itisameasureofthesharepricevolatilityrelativetotherestofthestockmarket–whichisameasureofrisk,oratleastof
gettingone’smoneyoutwhenneeded.Betameasureshowfaranindividualsharemovescomparedwiththemarketasawhole.
Themarketistakentohaveabetaof1,soasharewithabetaof1movesexactlyinlinewiththemarketasawhole.Abetaof1.6wouldmove16percentwhenthemarketasawhole
moves10percent.Ahighpositivebetaindicatesthatasharecanbeexpectedtorisefasterthanaverageingoodtimesbutplungemoresteeplyinbad.Thatischaracteristicofsmallercompanies.
Conversely,asharewithabetaoflessthan1,suchas0.8,risesandfallslessthanthemarketasawhole.Asharewithanegativebeta
(prettyrare)shouldmoveintheoppositedirectiontotheothershares.
Behindthisapproachthereisasophisticatedmathematicalphilosophyaboutinvestorbehaviour,stemmingfromwhatiscalledthe‘capitalassetpricingmodel’.Thissuggeststhatinvestorscandecideontheriskofanindividualshare,or
decidetoreducethatriskbydiversifyingaportfolio.Noneofthatwillgetridofthemarketrisk–thesharesmovingasthewholeofthemarketrisesorfalls.Themeasureofthatriskismeasuredbythebeta,andaninvestorwould(orshould)seekahigherreturntocompensateforahigh-betashareorportfolio.
Thisapproachhasthebenefitofallowinginvestorstochoosetheirdegreeofriskandcheckthatthereturnisappropriatelyhighertocompensate,andconverselytospotmarketinefficienciesinsharesthathaveahigherreturnthanwouldbeindicatedbytheirbetariskrating.
CoverSeeDividendcover.
Current ratioAwayofassessingacompany’sabilitytopaybillsintheshorttermistolookatthecashithasandthethingsthatcanreadilybeturnedintocash.Itisarrivedatbythedivisionofcurrentassetsby
currentliabilities.Iftheresultis1thetwoareidenticalandthecompanyhasnosparemoney.Areassuringfigureismorelike1.5or2atleast.
Ontheotherhand,ahighfiguresuggeststhecompanymayhaveanunusuallylargeamountofstocks,oritiskeepingitsassetsincash,whichmeansitearnsalargerreturnonlendingthanonthe
businessitselforthatitcannotfindasuitablewayofgrowingitsrealactivity.Allarepotentiallyworryingandmightsuggestthecompanycouldmakeanattractivetakeovertargetforsomeoneinsearchofcheapcash.Itisworthcheckingifthefigureisrepresentativeoftheindustry,however.
Debt collectionAllowingcustomerscreditisexpensivebecauseittiesupacompany’sowncapitaluntilthebillhasbeenpaid.Soitisamarkofgoodmanagementthatdebtsarecollectedpromptly.Onemethodistochecktheaveragecollectiontimeindays.Itiscalculatedbydividingthetradedebtors
bytotalsalesandmultiplyingtheresultby365.
Debtorturnovermeasuresthenumberoftimesdebtorsareturnedoverintheyear,whichisprettygoodmeasureofhowefficientthecompanyisinshakingthemoneyoutofcustomers.Thecalculationisverysimple:justdividethefigureforsalesbytheend-yearfigureforamountof
debt.
Debt/equity ratioSeeGearing.
Dividend coverThisshowswhatproportionofthecompany’searningsarebeingpaidtoshareholdersor,toputitanotherway,ameasureofthenumberof
timesacompany’snetoftaxdividendiscoveredbyitsnetprofit.Iftheratiois3ormorethecompanyisbeingextremelyconservative;with2ormore(itcouldhavepaidatleastdoublethedividendifithadwantedto)itisreckonedprettysafe;butanythingbelow1.5islookingdodgy.At1alltheearningsaredistributedto
shareholders,andiftheratiodropsbelow1thecompanyispayingoutretainedsurplusesfrompreviousyears.
So,ifWindowledgeplcpaidadividendof4pashareanditsearningspersharewere12p,itsdividendwouldbecoveredbyaverycautiousthreetimes.Lowlevelofcovercombinedwithhighyieldshowsthemarketis
nervousaboutthecompany’sabilitytogoonpayingatthisrate.Differentindustrieshavedifferentneedsforcash,socomparisonsshouldbewithinthesector.
Dividend yieldThisistheamountofdividendpershare(usuallyquotednetoftax)asa
percentageoftheshareprice.Itgivesthereturnontheinvestmentatthecurrentsharepriceandcurrentrateofpaymentsbythecompany.Aswithprice/earningsratios,thecalculationcanbedoneon‘historic’figures,whichwouldbebasedonthemostrecentdividendfigure;orprospective,whichwouldusetheforecastsofwhatthenext
dividendislikelytobe.SoifWindowledgepaidadividendof4p,anditssharepriceis390p,theyieldisameagre1percent.
Thatisprettylowinabsoluteterms,butoneneedsalsotocompareitwiththeyieldsonothersharesinthesectortogetthefullflavour.Aswithprice/earningsratios(seebelow),comparisonwith
competitorsgivesagoodindicationofthewayacompanyisregardedbythemarket.Yieldisdeterminedbyshareprice,soifacompanyisatthebottomendofthegenerallyavailableyieldsaround,itseemsinvestorsexpectquitealotofimprovementintheyearsaheadtobumpupthatfigure.
Conversely,ifayield
seemstemptinglyhighthesharepriceislow,perhapsbecausethereisafeelingthatthecompanyisheadingintotroubleandmaywellcutitsdividend,attheveryleast.Onceagain,itwilltakefurtherdetectiveworktoseehowreasonablethoseexpectationsare.
Employee
efficiencyThisiswagesdividedbysalestimes100,togetaproportionofsalespaidoutinemployeecosts.Thisfigureneedsverymuchtoberelatedtothesectorsinceitisobviouslynonsensetocomparecapital-intensivewithlabour-intensivebusinesses.
GearingAlargeamountofshort-termborrowingleavesacompanyvulnerable,especiallyduringleanperiods.Ifinterestratesrisethebusinesscanfaceasuddenanddisastrousdrainonitsresources.Interesthastobepaidonborrowedmoneywhetherthecompanycanspareitornot,andifit
cannot,creditorsfailingtogettheircashcouldcausethecompanytobebrokenup.Bankscancallinoverdraftsatwillandattimesofeconomicdownturngettwitchyenoughtodosoevenatthecostofkillingthebusiness.Loansmustatsomestageberepaid;sharesdonothavetheseproblems.Iftimesaretoughthecompanycan
‘pass’(notpay)adividendpaymentwithimpunity.Itssharepricemaysufferbutatleastthebusinessdoesnotfold.
Someborrowingisprettywellinevitableandborrowingcanbeamoretax-efficientwayofraisingcapitalthanissuingshares.Thequestionisnothowmuchithasborrowedbuthowgreatthose
loansareinrelationtothevalueofthebusiness.
Theratiobetweenacompany’sborrowedmoneyandthemoneythathasbeenputinbyshareholders(whichisalsocalled‘equity’)iscalled‘gearing’(‘leverage’intheUnitedStates).Soahighlevelofgearing–lotsofborrowinginrelationtotheequity–exposesacompany
inadownturnandisthereforeahigh-riskstrategy.Correspondingly,shareholdersofhighlygearedcompaniesdoratherwellduringupturns.
Therearevariouswaysofworkingoutthefigures.Thesimplestisjusttotakethetotalborrowingsandcomparethatfigurewiththetotalamountofshareholders’
funds.Thatisalsothecrudestwayofevaluatingthebusiness.Youcanrefinethecalculationofjusthowgreattheriskis(gearingisawayofmeasuringrisk)byleavingoutthelesssignificantcomponents.Forinstance,youcanexcludeshort-termdebtssincethesearejusttheday-to-daybusinessproceduresasopposedtothe
underlyingindebtedness.Somepeopleprefertoleaveoutintangibleassets(suchastrademarks)asbeingdifficulttodisposeof,andsometimespreferencesharesareexcludedfromthetotalofshareholders’funds.
Net asset valueOnewayofjudginga
companyisbythefail-safesystemofseeingwhatitwouldbeworthiftheworstcametotheworstanditwentbust.Theonlyrealwayistocheckwhatthevalueisofalltheassetsitowns.Inpracticeifthecompanydidgounderandhadtoselleverythingithad,theassetswouldprobablynotrealizethebookvaluebecausefiresales
seldomgetbestprices.Thenetassetvaluefigure,
oftenabbreviatedtoNAV,canbecalculatedfromthebalancesheetbyaddingupthebookvalueofallacompany’sassets(includingbuildings,machinery,cashatthebank,investments,etc).Deductfromthatalltheliabilities(suchasunpaidbills,borrowings,etc)aswell
asallcapitalchargessuchasdebentures,loanstocksandpreferenceshares.Theremainderistheshareholders’equityinthecompany,orthenetworthofthebusiness.Dividethisfigurebythenumberofordinarysharesonissuetogetthenetassetvaluepershare.
Theresultingnetassetvaluepershareprovidesa
directmeasureofinvestmenttrustsbecauseitcanbecomparedpreciselywiththesharepricetoseewhetherthetruststandsatadiscountorpremium.Inanindustrialbusiness,allowingforthefactthatthebookvalueofassetsisnotalwayswhattheywouldfetchintheopenmarket,theresultisanindicationofjusthowmuch
solidworthliesbehindeachshare.Itisnotsomuchwhatyouhaveaswhatyoudowithit,sothefigureisgenerallyonlyanotherfactortorememberratherthanaguideforinvestment.Acompanywithnetassets20percenthigherthanthesharepricewouldmakeatemptingtakeovertarget.Ifanofferdoescome,shareholderscan
thenusethismeasureasonetestofhowfairtheofferpriceis.
Net current assetsThecalculationssofarhavebeenbasedontotalnetassets.Somepeopleuseanarrowermeasure–netcurrentassets–whichconcentratesoncash,thingsthatcanreadilybe
turnedintocash,andmoneyowedthatislikelytobepaidinunderayear.Netcurrentassetspersharethatarewellabovethesharepriceintensifytheattractivenessofthebusinesstoatakeoverpredator.Thereisprofitwithaminimumconcernordoubtbecausetheportionsofthebusinesscanbesoldoffinbitswithoutworrying
whetherlong-termassetsareworththeirbookvalue.Sothesharesareworthbuyingbecauseeithersomebodyisgoingtomaketheassetsworkharder–newmanagementoranoutsidebuyer–orthecompanywillgobust,inwhichcasetherewillbemorethanenoughtopayoffcreditorsandstillhavemoneyleftovertopayshareholders.
Subtractingacompany’scurrentliabilities(itsdebtsandunpaidbills)fromthecurrentassets,bothofwhichfiguresareavailablefromtheaccounts,givesanideaofsolvencyintheshortrun.Ifthereisabigsurplusthecompanyhaslotsofsparecashornear-cashtopaydebtsinthecomingyearandcouldthereforegetquitealotof
additionalcreditifneeded.Afigureclosetonothingor,worsestill,adeficit,iscauseforalarm.SeealsoCurrentratio,above.
Price/earningsratioProfitisagoodplacetostartwhenvaluingacompany.Theprofessionalsusuallystart
withcomparingprofitstotheshareprice.Thisistheprice/earningsratio,oftenabbreviatedtoP/E,whichissowidelyaccepteditisevenprintedinnewspapersharepricecolumns.Itmeasureshowmanyyearsitwouldtakethecompanyatitscurrentlevelofearningstoequalthemarketvalue(totalpriceofallshares).Ineffect,thisisa
measureofhowquicklythemarketthinksthecompanywillgrowoverthenextyearortwo.
Togetthefigure,dividethesharepricebythecompany’searningspershare.Forexample,ifWindowledgeHoldingsInternationalhasissued70millionsharesandmadeaprofitof£8.4million,its
earningspersharewouldbe8,400,000/70,000,000,whichis12p(inpractice,calculationsmaybealittlemorecomplexsinceearningscanbedefinedindifferentways).Ifthesharepriceis390pthentheprice/earningsratiois390/12,whichmakesit32.5.Ineffectthatmeansitwouldtake32.5yearsofearningsatthecurrentlevel
topayforthecurrentshareprice.ThatisthehistoricP/E,asitiscalculatedfromthelastprofitfigure;usingaforecastofprofitforthecurrentyearproducestheso-called‘forwardmultiple’.
That32.5yearsissuchalongaperiodthatthereisobviouslysomethingelsegoingon.Whatiscreatingsuchanapparentlyunrealistic
figureistheexpectationbyinvestorsthatthecompanywillnotcontinuemakingthecurrentlevelofearningsbutislikelytogrowfairlyrapidly.Asaresult,thetimetakentocoverthecurrentsharepricewillprobably,inpractice,bealotlessthanthose32.5years.
ArelativelyhighP/Ethereforeindicatesthe
presumptionoffastgrowth.Thepointtonoteistheword‘relatively’.Atonelevelitisacomparisonwiththemarketasawhole,andatanotherlevelitiswithothercompaniesinitssector.TogetthefullflavourofwhattheP/EindicatesonehastotakealookattheFTSEAllShareIndexP/E,aswellasthesameratioforthesector
inwhichthecompanyoperates(suchasutilities,distributionorleisure).Thatindicateshowthecompanycompares,sincetheratioismostusefulasarelativeriskindicator.
TheP/Ethereforeindicateswhatthestockmarketaswholethinksoftheprospectsforthecompany.Theobviousnextstepisto
discoverthecausesofthatsentiment.IftheP/Eishighrelativetoitssector,isthatbecausethecompanyisfashionable(journalistsallkeepsayinghowwonderfulthemanagersare),orisitbecauseitreallyisabouttogrowattwicetherateoftheothercomparablecompanies?Thefiguremaybepromptedbysomethingsimplelikethe
rumourofanimpendingbidforthecompany.
AlowP/Eindicatespessimismorlackofinterestbyotherinvestors.Whetherthatgloomyviewisjustifiedandwhethersubsequenteventswillreverseitrequiresquitealotoffurtherthought.TheP/Ebeinghigherorlowerthanthesectoraveragemerelytellsyouwhatothers
think,notwhethertheyarerightintheirforecasts.Sometimesitmaybenecessarytodisaggregateadisparategroupandvalueoperationsseparatelytoseeifthemarkethasratedthemfairly.Lifeassurersandpropertycompaniesareparticularlytrickytoevaluate.
AnotherpointtowatchiswhethertheP/Eishistoric
(usesthelastsetofpublishedresults),whichiswhatthenewspaperpricesreproduce,orprospective(usesthegenerallyexpectedlevelforthecurrentfinancialyear),whichiswhatsomebrokers’andtipsters’circularsuse.
Profit marginTofindtheunderlying
profitabilityofacompany’strading,taketradingoroperatingprofitasapercentageofturnover.Thisiscalledthe‘profitmargin’.Thefigureswillvaryenormouslybetweentradesandsectors.
Quick ratioSeeAcidtest.
Return on capitalemployedThepointofacompanyistomakeasurplus,itsprofit.Thereasonitborrowsorsellssharesistoincreasethatprofit.Soanimportantgaugeofitssuccessistoseejusthowwellitdoesit.Thepointofreturnoncapitalemployedisthatitmeasuresthe
efficiencywithwhichthecompanyisusingitslong-termcash.
Togetthismeasure,onedividesthetradingprofit(beforeexceptionalitems,interestandtax)bytheaveragecapitalemployedovertheperiod(shareholders’fundsplusborrowings)andmultipliestheresultby100.Areturnof10percentisthe
bareminimumrequired;20percentisprettygood.Alowreturnoncapitalshowsinefficiencyinthewayitisusingthecash,eveniftheprofitmarginsarehigh.Thefirstcheckistoseewhetherthepercentageishigherthanthecostofborrowing.Itisinstructivetocomparethereturnoncashinthebusinesswithotherthingsthe
company(orindeeditsinvestors)mighthavedonewithit.
Acommoncriterionistoseewhatitwouldhaveyieldedifputintosomethingreallysafe,likegilts.Ifthereturnfromthatsortofinvestmentisatleastasgreatasthecompany’s,thereissomethingwrong–thereshouldbea‘riskpremium’
forputtingthemoneyintosomethingmorehazardoussuchasabusinessventure.Iftheyieldfromgiltsisatleast5percentlowerthanthereturnfromthecompany’suseofthemoney,theinvestmentisbeginningtoseemreasonable.Investorsprefersomethingbetterthan7or8percentabovethegiltyield.
Return on salesThisisarevealingfigurebecauseitgivesanindicationofprofitmargins.Startwiththepre-taxprofitbeforeinterestandextraordinaryitems,thendividethatfigurebytotalsales,andmultiplytheresultby100.
Return per
employeeThisisanothermeasureofhowefficientlyabusinessusesitsworkers.Itiscalculatedbydividingtheoperatingprofitbynumberofemployees.
Return toshareholders
Thisisanothermeasurethatisnotderivedfromthepublishedaccounts.Itindicatesthetotalperformanceofanequityoveraperiodsuchasayear.Thefigurecomesfromaddingthechangeinshareprice(iethepriceattheendoftheperiodminusthepriceatthestart),plusthedividends,plustheinterest
receivableonthedividends,andthentakenasapercentageofthepriceatthestartoftheperiodbeingexamined.
Forexample,asharestartedtheyearat520pandfinishedtheyearat670p.Duringtheyearthecompanypaida40pdividendastheinterimdividendand50pasthefinal.Theinterestratewas
about6percent.Thatwouldmeanthesharepricebenefitwas£1.50andthetotaldividendwas90p.Interestearnedbyputtingtheinterimdividendmoneytoworkis1.2pandtheassumptionistherehasnotbeentimetoearninterestonthefinal.Sothegainequals£1.50+90p+1.2p=241.2p,whichdividedbythe520popeningpriceis
0.46,sothereturnisslightlyover46percent.Notbad,butitisonlyanotionalprofitsinceitwouldentailsellingthesharestorealizeit,andtherewouldbeafeepaidfordoingthat,whichwouldreducethebenefit.
Stock turnoverDividethecostofsalesbythe
stocklevelattheendoftheyear.
Value addedThisnotionwasdevelopedinthe1990stomeasurehowabusinesshasincreasedthevalueoftheshareholders’investment.
Yield
SeeDividendyield.
Technical analysis
Thenormalcontrasttofundamentalanalysisis‘chartism’,whichisalsocalled‘technicalanalysis’.Thisisconcernedexclusivelywiththemovementsofsharepricesintherecentpasttoforecasthowtheywillmove
infuture.Thereallydedicatedchartistdoesnoteveninquirewhetherthepricechartisforhouses,airlinetickets,goldbars,indicesliketheFTSE100,orthesharesofbanks,sinceallrelevantinformationisassumedtobeinthepatternofmovements.
Thisisincompletecontrastwithfundamentalanalysisinthatittotally
ignorestheunderlyingworthofthebusiness.Technicalanalysisisconcernednotwithwhetherthecompanyisefficientlymanagedbutwithwhenthemarketpriceislikelytochange.Itcan,however,indicatewhichsharepricesaredueforaturn–ineitherdirection–andsoprovideastimulusforactivetraders.Thatmeansitdoes
notsomuchindicatewhichsharetobuyaswhentodoso–andthisisexaminedindetailinChapter10.
ChapterSevenWhere tofind adviceandinformation
Anyone who thinksthere is safety innumbers hasn’t readthe stock marketpage.
IRENE PETER
After a long life Ihave come to theconclusion that
when all theestablishment isunited it is alwayswrong.
HAROLD MACMILLAN, 1982
Advice
Whose advice canyou trust?
Atthesimplestlevel,nobody’s.Takeeventhebroadestoutlineadvice.NathanRothschildsaid‘ThewaytomakemoneyontheExchangeistoselltoosoon.’Anothermemberofthesamebankingfamily,SolomonRothschildagreed:‘Onemustgetintothemarketasintoacoldbath–quickinandquickout.’TimothyBancroft
ontheotherhandsaid‘Buygoodsecurities.Putthemaway.Forgetthem’,whichismuchthesameadviceastheSageofOmaha,WarrenBuffett.
AsChapter5pointedout,everybodywhocanfindapublisherproducesatheory,asystem,aformulaoranexplanation,andagoodmanybookshopshaveyardsof
shelvingfilledwiththeirinfallibleadvice.Makingamajorfortuneisevidentlyadoddle.
Howaboutonindividualsharesthough?Thinkofitthisway–whatsortofphilanthropycoulditbethatpersuadessomenicepeopletomakeyourichinsteadofthemselves?Ifjournalistsreallyknewwhichshareto
buyandwhen,wouldtheystillbehackingawayatthecomputerinsteadoflollingonsomeCaribbeanbeach?HowcantheauthorsofbookslikeMakeaKillingontheStockExchange,HowtoPicktheWinners,SelectingtheSoaringSharesandsoonaffordtospendallthosehourswritingwhentheyshouldbetoobusybecoming
billionairesbytrading?Indeediftheyweregood,whywouldtheysharethesecretwhenyourbuyingmightinflatethesharestheywouldhavewantedtobuy?
Alladviceshouldbetreatedwithscepticism–eventhisone.ThereusedtobeanoldStockExchangemaxim:‘Wherethereisatipthereisatap.’Whatthat
meantwasthatifsomebodyispersuadingyoutobuyasharethereisprobablysomeself-interestedmotivesuchashavinglargeamountsofthatcompany’ssharesontap.
Thisisnotadefeatistvieworinsistencethatalladviceshouldberejected,justarecognitionthatnobodyisalwaysright,thatsomepeopleareunreliable,andthat
thedecisionlieswiththeinvestor.Noexcuses,nodefences,andnoattemptsatshufflingofftheblame:youchoose.
Scepticismshouldextendtofinancialadvisers.Stockbrokershaveanincentivetoencouragetradingbecausetheymakemoneyfromcommissionsondeals.Mostoftheiranalysts
areclevergraduatesbutfewhaveevergottheirfingernailsdirtyinindustry,soalthoughtheyunderstandallthecorporateratios,meetthechairmenandfinancedirectors,andsometimesevenvisitfactories,theyhavelittlefeelforcommerce.Whattheydounderstandisthestockmarket,sotheyhaveabetterfeelthanthelay
investorforhowtheCity,includinginstitutionalinvestors,willreacttoacompanyanditsperformance.Sincethosearethepeoplewhoinfluenceshareprices,thisinformationisvaluable.Itsvalueisaboutthemarket,butnotaboutanyindividualcompanyoraboutstrategy.
Stockbrokersplodthrough
annualreportsandissuecircularsoncompanies,buttheaveragesmallinvestordoesnothaveaccesstothesecirculars,andwouldprobablyhavelittleuseforthemifheorshedid.Bythetimethecircularsareprintedtheprofessionalshavealreadyactedonanyinsightinthem,andthereislittleevidencethatstockbrokersare
markedlybetterprophetsthantherestofus.Itisnotamatterofasking,ifyouaresocleverwhyareyounotrich(becausemanyofthemareprettycomfortablyoff),butonceagain,wouldtheystillbeworkingforwagesiftheycouldmakeamazingfortunesbymerelyinvesting?
Atleastthebetternewspapersandmagazines,
unlikestockbrokers’analysts,assesstheperformanceoftheirsharetipsattheendoftheyear.Iftheydonot,youcanbeprettysureperformancehasbeendismal.Eventhatisnotaguidethough,becausepersonnelchange.
Thereareseveralreferencebooks,likeREFS,UKMajorCompaniesHandbookand
UKSmallerCompaniesHandbookthatprovidestatisticsandfactsaboutbusinessandcompanies.TheseareontopoftheguidestotheStockExchangeandotherinvestments,plusotherexplanationsofthefinancialmarkets.
Insummary,thereislotsofadviceaboutbutlittleofitisdisinterestedandeventhat
isnotalwaysright.Solistentoasmanyasyoucan,weighthemagainstcommonsenseandusethemasafactorbutnotasthefinalarbitersofaninvestmentdecision.Rememberthattheircriteriamaybedifferent.AsShawsaid,donotdountoothersasyouwouldhavethemdountoyou;theirtastesmaynotbethesame.
NewspapersNewspapers,dailyandSunday,devotemanypagestobusinessinvestmentandfinance.Theyprovidenews,commentandadvice.Ontopofthattherearemanybusinessandinvestmentmagazines,rangingfromthevenerableInvestorsChronicletoawideandgrowingrange
thatincludesYourMoney,MoneyManagement,WhatInvestment,Moneywise,PersonalFinance,BloombergMoney,Shares,MoneyWeekandMoneyObserver.TherearealsospecialistjournalssuchasYourPensionandWhichMortgageandgeneralbusinessjournalslikeFortune,ForbesandBusinessWeek.
Seriousnewspaperscarrycompanynewsincludingreportsofresultsfromsmallerorlessinterestingcompanies,whichconcentrateonturnover,profitandexceptionalitemsplusdirectors’pay.Theyalsohavecolumnsthatconcentrateonanalysingcorporatefinancialresults–egQuestor,LexandTempus.Thesecolumnsdo
notalwaysmakeexplicitrecommendationstobuyorsell,butthegeneralmessageoftheircommentsisusuallyobvious.
They,likemanyoftheSundaypapers,alsoreprintadvicefromstockbrokers.Inaddition,journalistsmeetpeople,sometimesincludingthemanagementofcompaniestheywriteabout,
lookatresults,talktobrokersandtheiranalystsandtradeassociations,anddiscussbusinesswithindependentcommentators.Inthecourseofthistheymaycomeacrosscompaniesthatjustifyabetterratingandarecurrentlybeingignoredbythemarket.Theymaythereforealertinvestorstosharesthatareundervalued,andbydrawing
attentiontothemmaypromptanupwardre-rating.
Tipslikethiscanmoveashare,especiallyifitisinatightmarket–therearenotmanyfreesharesonissue.Theriseisnotpurelybecauseofbuying,butalsobecausemarketprofessionalsreadnewspaperstooandsoanticipatedemandbymovinguptheprices.One
consequenceisthatbythetimeyouhavereadthebuyrecommendation,thepriceatwhichitwassaidtohavebeenabargaincanbejustamemory.
Itmaystillbeworthactingonsuchrecommendationstobuy,butitisnotablethatnewspapersarelessgoodatspottingsharesthatareduetofall.Itmaybefearofthe
fiercedefamationlaws,orthatjournalistsarejustmoregearedtofindingwinners,butinvestorsshouldnotrelyonnewspapersforwarningsofwhentosellashare,althoughitcanbejustasimportantapieceofadvice.Andnobodyismuchgoodatspottinginadvancewhenthemarketasawholeisabouttoturn.
Thefinancialpagesalso
carrystoriesabouttakeoversandotherdramaticevents,andhaveinterviewswiththetopmanagers.Inaddition,theycarrydetailsofplans,newproducts,investments,changesoftactics,recruitmentofnewseniorstaff,changesatboardlevel,salesofsubsidiariesandahostofotherindicationsofhowacompanyis
approachingitsbusiness.Inthecourseofthesearticlesjournalistsusuallygivestronghintsabouthowthemanagementandproductsofacompanyareregarded.Thatgivesanaddedlayerofinformationtotheinvestor.
Peoplehaveatendencytosaytheybelievenothingtheyreadinnewspapers,butthenactasifjournalistswere
omniscientsupermen.Journalistsknowonlywhatsomebodyhastoldthem,andthoughthegoodonesdoconscientiouslydigbehindthefactsandtrytointerpretandtestwhattheyhear,theyarefallibleliketherestofus.Theydo,however,mixintheCityworld,talktoallthepeoplewhoaredirectlyandindirectlyinvolvedandkeep
aneyeonwhatisgoingon.Anybodygettingintoinvestmentswouldbefoolishtoloseoutonthefloodofinformationthatisavailable.Thereisdailydetailonawidevarietyofcompaniesandsectors,discussingthemanagers,products,performance,dealsandprospects.Someofitmaybenothingbutgossiporaspace-
filler,butinthereputablepressthereisoftenmoreandbetter-informedearlynewsaboutwhatishappeningthancomesoutofstockbrokers.Themoreauthoritativewritersdogetreadandasaresultmaymovepublicopinionaboutacompanyandhencetheshareprice.
Withsomanynewspaperpagesdevotedeverydayto
financeandcompanies,andthelargenumberofmagazinesconcentratingoninvestmentadvice,itishardtoseewhatthetipsheetscanadd.
MagazinesSpecialistmagazinesprovidegreaterdepthofinformationonawiderangeof
investments.TheInvestorsChronicle(publishedbyPearson,whichalsoownstheFinancialTimes)reportsawiderangeofstockmarketandeconomicinformationandhasaspeedysummingupofmajorcompanyresults.
Itschartistsectionrequiresextensiveknowledgeofthelanguageandmethodsoftechnicalanalysis;withoutit
onecouldwellbelittlebetteroffforbeingtold‘thecurrentrallycouldconceivablytaketheindexthroughitsdailycloudandashighastheblackfallingtrend-linewhichwouldlikelyresultinoverboughtmomentum’,orreferencesto‘atime-cycleturning-date’.Butthepicturesmakeitclearer.
Financial advisersAdvicefromnewspapers,magazines,radio,television,newslettersandmailshotsmaybereadilyavailable,andsomeofitfree,butinvestorsstillhavetocollectandsortitall,siftthematerialandtestittoseeifanyofitisworthactingon.Thisisnotonlyalongandtedioustaskbutthe
testingistrickyforsomeoneinexperiencedinthestockmarket.Intheory,havingaprofessionaladvisercanimproveonthat.Thestockbrokeroradvisercantakeonboardtheinvestor’spreferencesandneedsandsoproducetailor-madeinvestmentrecommendations.Suchhand-holdingcanbevaluable,andthegood
adviserscanproduceafarbetterportfoliothananindividualwhohasalivingtoearnandsocannotspendalldayevaluatingtheoptions.
Likeeverythingelseworthhaving,itcostsmoney,soitspricehastobecheckedagainstitsvalue.Inaddition,nosensibleinvestorhandsoverthefuturewithoutaskingquestionsandtestingthe
answersagainstcommonsense.Justasanintelligentpatientasksthedoctorwhatiswrongandwhateffectsthemedicinewillhave,andacarefulclientasksthelawyershowthelawstandsandwhattheadviceisbasedon,soashrewdinvestorshouldaskfinancialadviserswhytheyadviseaparticularcourseandwhatassumptionsliebehind
therecommendation.Itisatthatpointthatcommonsenseandpersonalexperiencere-enter.Ifyoudisagreewiththeadviser’sforecastsofthenextsixmonthsorfiveyears(andyourguessmaybeasgoodasanybody’s)itisimportanttosayso,sothattheportfoliocanbeadjustedtothesatisfactionofbothofyou.
Figure 7.1 (left) andFigure 7.2 (right)Information in the InvestorsChronicle
Suchadvisers/brokerschargeeithercommissionoraflatfee,oracommissionontrade(seeChapter8oncostsandvalue).
Information
Share pricesNewspapers’sharepricelists
showcompaniesundermarketsectors.TheseareallocatedbytheStockExchangeandthecompanywillalsobeaconstituentofthatpartorheadingoftheFT-Actuariessectorindex.Itis,however,abitconfusingthatnotallthenewspaperslabelthesectorsinthesameway.Thechoiceofsectorisnotalwaysobviousandsome
companiesfeeltheyareinthewronggroup–especiallywhenthatbecomesunfashionable–sooccasionallythereisachangeofallocationbytheStockExchangeauthorities,thoughthathappensmostlywhenthecompanyitselfhasalteredtheemphasisofitswork.
Thereareover2,500companiesquotedonthe
LondonStockExchange,somewithseveraltypesofissues,plustheAlternativeInvestmentMarket(Aim),Techmark,ISDX,etc.Themajorityofcompaniesaretradedinfrequently,withthegreatestvolumeofinterestandtradebeinginthehundredlargestcompaniesbymarketvalue.ThosearethecomponentsoftheFTSE100
ShareIndex(calledthe‘Footsie’),whichisthemainindicatorofstockmarkettrends.Themajorcompaniesinitmakethemimportantintheinvestmentstrategyofthelargefinancialinstitutions.Theconcentrationofinstitutionalinterestisshownmostclearlyatthetimeofthequarterlyreviewwhenthemarketvaluesofcompanies
onaspecificdatearereviewedandthereisachangeinthecompositionoftheIndex.ThemomentacompanydropsoutoftheIndexitssharesmaytakeasuddenfall,sometimesbyasmuchas5percent,whilethenewmemberoftheelitesometimesseesasuddenadditionaljump.Sometrackerfundsandinvestors
seethewaythingsaregoinganddealinthesharesbeforethecompanygainsorlosesitsstatusinaparticularindex,whichcanmeanthesharesdonotmovemuch.AnotherindexreviewworthwatchingistheMorganStanleyCapitalInternational(MSCI).Whilethefocusisglobal,UKcompaniesdoregularlymoveinoroutoftheIndex,which
canleadtomovesinshareprices.
Belowthattoplevelisthesecondtier,madeupofthenext250companiesmeasuredonceagainbymarketcapitalization–thatis,inboththesecategoriesitisnotturnover,profit,assetvalueoranyothermeasurethatcounts,merelytheaggregatevalueofissuedshares.Allthe
350largestcompaniesareinthelistsoftheseriousnewspapers’pricespages,whichalsocontainseveralhundredothercompanies.Butnoneofthepapershasthespacetoshowallthesecuritiesavailable.EventheFinancialTimes,whichdevotesmorepagesthantheotherstoshareprices,canshowonlypartofthelist
actuallyquoted.Newspaperlistsarenotnecessarilyasignalofsignificance–mostofthecompaniespaytohavetheirshareslistedinthepricespages.
Newspapersdisplayarangeofinformationapartfromthelatestshareprice,includinghowthesharepricemovedfromtheclosingofthepreviousday,andsoon.
Figure 7.3 Daily Telegraphprices page entry
Figure7.3isanexampleofTheDailyTelegraphpricespage.Itshowsinthethirdcolumnthecompanyname,sometimesinabbreviated
form,andiftheshareswerenotissuedinsterling,thecurrencyisalsogiven.Almostalwayswhatisquotedistheordinaryshare(called‘commonstock’intheUnitedStates),butsomecompaniesissueotherquotedpaper,suchasirredeemablepreferencestock,convertibles,warrantsandsoon,andthesearenormallylistedunderneath.
Sometimesthereareadditionalsybols.Forinstance,intheFinancialTimes:
$,€,¥acurrencysymbolnexttothecompanynamesaysthesharesarenotpricedinsterling;
*highandlowsharepriceshavebeen
adjustedforcapitalchanges;
†interimdividendincreasedorresumed;
‡interimdividendsincereduced,passedordeferred;
#dividendpriceatthetimethedealinginthesharewassuspended;
ccentsdfairvaluenetasset
valueismorethan3%differentfromtheparvalueNAV;
qundatedPdividendadjustedfor
consolidationorsplitintheshares;
xdtherecently-declareddividendwillberetainedbythe
currentholderoftheshare;
xrthesameforrightsissue–thebuyerwillnotbeentitledtosubscribetonewshares;
xRbuyerdoesnotgetthescripissue;
xaex-all–severalofthoserightsremainwiththecurrent
holder;therenolongerseemstobeasymbolforthemosttradedstock.
TheDailyTelegraphsharepricecodesare:
boldtypeFTSE100indexshares;
FTSE250index
shares;*ex-dividend;†ex-scrip;§ex-rights;‡ex-all;#sharedealingshave
beensuspended;Areportandaccountsare
notready.
Thefourthcolumngivesthepriceatwhichtheshares
stoodatcloseoftradingthepreviousnightorthelasttradingday.Anybodywhohasboughtholidaymoneyknowsthepriceofbuyingisalwayshigherthanthepriceatwhichyoucansell,andthatdifferenceiscalledthe‘spread’.Thepublishedpriceistheaverageofthetwo,sonoinvestorcanhopetobuyatthepriceorsellatit,evenif
themarkethadnotmovedbythetimethenewspaperarrivesthroughtheletterbox.Iftradingintheshareshasbeensuspended–saybecausethecompanyisbeingreorganized,ortherearequestionsaboutthefigures,orbecauseitissubjecttoatakeover–thepricelistedisthelastonebeforesuspension,with#nexttoit.
Figure 7.4 Financial Timesprices page entry
Withsharesthespreadwilldependonarangeoffactorsthataffectthedealer’srisk.Oneiswhatthemarketcalls‘liquidity’:howmanysharesthereareavailableandhowmanypeoplearepreparedtotradeinthem.Agoodmeasureasfarasthestockmarketisconcernedishowmuchthepricemoveswhen
youtrytotrade.Trytobuysharesinacompanywithfewonissue,andmostofthoselockedupbyholdersnotpreparedtobetemptedoutbyasmallriseinthevalue,andthepricewillsuddenlybounce.
MassivecompanieslikeBritishTelecom,Vodafone,etchavemillionsofsharesonissueandthereisalways
somebodyinthemarketwantingtodealinthem.Bycontrast,arelativelysmallbusinesswithamarketcapitalizationof£10million,ofwhichthemanagerandfamilyownhalfanddirectorsownanotherquarter,withmostoftherestheldbytheinitialinvestors,areverydifficulttotradein.Itssizemeansfewpeoplehaveheard
aboutthebusiness,sonotmanywanttodealintheshares,andeveniftheydidwanttoitcouldbequitetrickytofindacounterparty.Sothefirstwillhavearelativelynarrowspreadbecausethemoretradethereisinasharethemoreconfidentthedealerisingettingshotofany,whilethelatterwillprobablyhavea
frighteninglywidespread.Thewidthofthespreadalsodependsonthestateofthemarket.Inwildlyfluctuatingshares,market-makersareloathtosticktheirnecksoutandtheycarefullywidenthespread.Sothemiddlemarketpriceisjustanindicationoftheactualratetheshareswillfetchinarealdeal.
Peoplewhodealoverthe
telephonecanaskthebroker,whowilllookattheStockExchangescreenshowingallthepeopledealinginthesharesandtheirprices.Thebrokercanspecifyexactlywhatthepriceisthenand,iftheagreementisswift,maybeabletodealatthatprice.Analternativeistogetaccesstothepricespagesviatheinternet,andchecktheprices
foroneself.Thefifthcolumninthe
DailyTelegraphshowsthepricechangefromthepreviousday’sclosinglevel,alsoatthemid-marketprice.Thenexttwocolumnsshowthehighsandlowsthesharepricehasreachedoverthepreviousyearoverall.Thatwillindicatewhethertheshareisnearitsmaximumor
minimum.Soifthesharepriceiscurrently127pandthehighandlowsare478pand123p,youcanimmediatelytellthatthepriceisverynearthebottomlevelithasreachedinthepastyear.
VolumeoftradeinthefinalcolumnoftheFinancialTimesshowshowmanythousandsofshareschangedhandsontheprevioustrading
day.Thefigureisthetotalofequitiesboughtandsold–inotherwords,thereisdoublecounting.Thefigureshowsthelevelofinterestinthecompany’ssharesandisanindicationoftheliquidityinthemarket.Itissalutarytoseehowmanywerenotdealtinatall.Somenewspapersprintaseparatetableofthepreviousday’smosthighly-
tradedshares.Yieldisthepercentage
returnyougetifinvestingatthesharepricelistedinthetableandatthecurrentrateofdividends.Theformulais:multiplytheannualgrossdividendby100,andthendividebytheshare’smarketprice.Soifthesharescost200pandthelatestyear’sdividendwas14p,theyieldis
7percent.Thisisnormallyreportedgross,iebeforetaxhasbeendeducted,thoughalmosteverybodygetsthedividendchequesnetandthetaxisnotreclaimable.
TheDailyTelegraphpricespagesprinttheletter‘b’toindicatetheinterimdividendhasbeenraised;‘c’meanstheinterimdividendhasbeenreducedorithas
beenomittedaltogether.TheP/Estandsfor
price/earningsratio,andisprobablythebestknownmethodofassessingequities.Itiscalculatedbycomparingthecurrentsharepricewiththelevelofearningspershare(foundinthecompany’saccounts).
Thecompany’saccountsmaysaysomethinglike,
‘attributabletoordinaryshareholders£850,000’andatthebottomoftheprofitandlosstableitwillsaysomethinglike‘earningsoneachofthe10millionsharesonissue8½p’.TogettheP/Eratioyoudividethis8½intotheprevailingmarketpriceoftheshares.Ifthosestandat,say,170p,then170/8½=20.Ifthesharepricehalvesto
85ptheP/Eratiowouldbe10,andifthesharesshotupto255ptheP/Ewouldbe30.
Onecantheninspecttheothercompaniesinthesameindustrysectorlistedinthenewspaperandseehowtheycompare.IfmostofthecompaniesareonaP/Eofbetween12and16andoneofthecompaniesison25,eitherthemarketknowsgreatthings
areonthewayfromit,orthesharesaregrosslyoverpriced.Conversely,ifallthesectorisonaP/Eof18to20butoneofthecompaniesison4,eitherthemarketknowsthereissomenastynewsonthewayfromthemanagementortheyarewrongandthesharesaregrosslyunderpriced.
TheWealthManagementAssociationalsoproduces
indices–seewww.thewma.co.uk/private-investor-indices.
Investment trustsInsteadofprice/earningsratios,thecolumnforinvestmenttrustsshows‘NAV’,whichstandsfornetassetvalue.Thatisacalculationoftheinvestmenttrust’sholdingsasavalueper
share.Liketheshareprice,itisquotedinpence.TheFinancialTimesalsohasacolumnshowing‘DisorPm(–)’.Thatisacalculationofthedifferencebetweenthenetassetvalueandtheactualpriceoftheshare–‘Dis’meansthesharesareatadiscountasthepriceisbelowtheassetvalue;‘Pm’meansthesharesareatapremiumto
theunderlyingvalueoftheinvestments.Perverselyandconfusingly,adiscountisshownasapositivefigure,whileapremiumisshownwithaminussign.
TheAssociationofInvestmentCompaniesproducesamonthlybookletonthepricesanddetailedotherfiguresofitsmembers.
GiltsTherearealsopricetablesforgilts–government-issuedsecurities.Theseareusuallysplitintoshort,mediumandlong-dated.Therearealsothetwoundatedones,andindex-linkedstocks.ForeigngovernmentsalsoissuebondsthatareobtainableinBritainandarequotedsometimeswithaloweryieldthannative
varieties.(Seepage73fortheDailyTelegraphpricespage.)
Unit trustsTheheadingofthepricespagesisactually‘UnitTrustsandOpen-EndedInvestmentCompaniesPrices’.Thevariousunitsaregroupedunderthemanagementcompany,suchasAberdeen,M&Gandsoon,withthe
addressesandtelephonenumbers(fortrading,information,prices,etc)soonecancallforapplicationformsandinformation–investorsdonothavetogothroughstockbrokerstobuythembutcangodirecttothecompany.Someofthesecompanieshaveregularsavingsplans.Alongwiththename,someofthemhavea
numberinfigures,eg(1200)F,whichmeansthepricesweresetatnoon(usingthe24-hourclock)andthecompanyusesforwardpricing–ordersaretakenfrominvestorsandthepriceisdeterminedfromthenextvaluation.
Figure 7.5 Unit trust pricespage entry, Daily
Telegraph – as that showsOIECS are listed only withbid prices
Noonisthemostcommontimeforsettingprices.Aninvestortelephoninganorderat11amwouldbebuyingatapricesetanhourlater,butanotheronecallingat1pmwouldhavetowaituntilthenextdayfortheprice.
The52-weekhighsandlowsaresimilartothoseforshares,butforunittruststhe
papersprintabuyingandsellingpriceandachangeinthemid-marketpricefromthepreviousones.Somealsoprovideacolumntoshowyieldgrossasapercentageoftheofferprice(atwhichtheinvestorbuys).
MondaysOnMondays,withnonewsonthetradingfront(readers
willpresumablyhavegottheweek’sclosingpricesfromtheSaturdaynewspaper,ifnotoffthenet),thenewspapershavethechancetoprintdifferentoradditionalmaterial.
Marketcapitalizationisthetotalvalueofthecompanyonthestockmarketatthecurrentshareprice.SoifConsolidatedAlaskan
CoconutPlantationshasissued50millionsharesandtheyarecurrentlybeingtradedat85p,thecompanyisvaluedat£42.5millionatthemomentandthatishowmuchitwouldcosttobuyallitsshares.Thisisofnohelpindecidingwhetheritisagoodbuyornot,butnewspapershavealwaysprintedsuchfiguresandtheydoatleast
givesomeindicationofitsstanding.
IfitisintheFTSE100thenitisoneofthelargestcompaniesinthecountry,andyoucangaugethemarketratingbycombinationsofprice/earningsratio,yieldandmarketcapitalization.Donotbefooledbythesizethough–PollyPeckwasahugecompanyintheFTSE100
IndexjustbeforeitimplodedwhenthemanwhoranitjumpedbailtofleetonorthernCyprus.
Thereisalsoinformationlikethepercentagechangeofpriceduringtheweek,thelastdividend(usuallyshownnetoftax),whenitwaslastquotedxd(ex-dividend);†intheFinancialTimesindicatesanincreaseintheinterim
dividendinthecurrentfinancialyearand‡showsadecrease;dividendcovershowsthenumberoftimesthatlevelofdividendcouldhavebeenpaidoutofthelatestprofits.Thereisoftenaseparatetableforthemostrecentissues.
Indices
Togetaflavouroftheeconomiccircumstancesandtojudgethetenorofthemarketasawhole,awiderangeofindicesspecifysectormovementsinmostofthemarketsintheworld.InBritainthemostcommonlyusedistheFTSE100.Itcontainsthelargesthundredcompaniesbymarketcapitalization–theirworthby
thetotalvalueoftheirissuedshares.Thatinevitablymeanstheconstitutionoftheindexchangesassomecorporationsfallfromgraceorgettakenover,andothersgroworbecomepopular.Andsureenough,theStockExchangedoesindeedcontinuouslyupdatetheconstituentsoftheFTSE100.
Alittlefurtherdownthe
peckingorderisthenextcropoflargecompanies,theFTSE250,andthosetwoaresometimescombinedintotheFTSE350.Widerstillisthe650AllShare(whichdoesnotinfactincludeallshares).TheFinancialTimesproducesafulllistoftheFTSEindicescompiledandcalculatedunderformulaedevelopedbyactuaries.
Newspaperssometimesprintfiguresforthemovementofindicesforindustrialsectorssuchasengineeringandmachinery,orconstructionandbuildingmaterials–whicharethenaggregatedtoformwiderindustrialindicessuchasBasicIndustries,GeneralIndustrials–andsomedescribethetypeofcompany,suchas‘smallcap’
(smalltotalmarketvalueoftheshares).
Everystockmarketaroundtheworldhasitsindicestoindicatemarketmovementasawhole,buttheonesreproducedinBritainaregenerallyconfinedtothelocalequivalentsoftheFTSE100.SomeofthebetterknownandmorecommonlyusedonesaretheDowJones
(actuallytheDowJonesIndustrialAverage),Nasdaq100,NYSEComposite,andStandard&Poor’sfortheUnitedStates,thoughtherearelargercoverageindicesaswellsuchastheRussell2000andtheWilshire5000;Toronto300forCanada;Nikkei225forJapan;HangSengforHongKong;DaxforGermany;CAC40forFrance;
AEXforAmsterdam;BEL20forBrussels;IBrXforthehundredlargestBraziliancompanies;andEurotop100forthehundredlargestmarketcapitalizationcompaniesonEuropeanexchanges.ThereisalsotheMSCIworldindex.
InTheDailyTelegraphtherearetwotablesofindicesonthepricespage.Oneisfor
the12largestforeignstockmarketsexceptingNewYorkandToronto,whichareintheKeyMarketstableonthefacingpage(thenewspaperownerisCanadian),thoughTokyo’sNikkeiindexappearsonbothpages.TheothertableshowsthemajorBritishshareindicesincludingtheFTSE100and250(plusthe350,whichisjustthosetwo
together)andthe30,whichwastheFTSE100’spredecessor.ThereisalsotheTechmark,whichistheStockExchange’sattempttoshowbackingforthenewcomersandhigh-technologycompaniesbyseparatingthemintoago-goindex,whichhasturnedintoabitofago-stop-go.Thereisalsoatableofthehighestvolumes
oftrade.
Online
Theinternetmeanswearenolongerdependentonlyonthemorningpaperforinformation,thoughthereareelectronicversionsofnewspapersandsomemagazines,oftencarryingstoriesthatwillappearinthe
nextmorning’sprintedversion.Thearchivescanalsoshowwhattheypreviouslysaidaboutacompanyorthestateoftheeconomy.
Otherinformationaboutinvestmentsandcompanies(includingfromtheirownwebsites),andsomecommentisalsoavailable.Aswithallinternetadviceandcommenthowever,trustonlythose
withreliableprovenance,knownrecordandevidentindependence.
Therearemanyonlinebrokers,suchasHargreavesLansdown(www.hl.co.uk),someofwhichoffercommentaries,aswellas‘realtime’prices(theonesbeingquotedatthatmomentontheExchangecomputers),occasionallyforanadditional
subscription.Theadvantageisthatyoucandealimmediatelyontheinformationandattheprice.GoogleFinancealsoprovidesshareprices,chartsandcommentariesonmostcompaniesquotedinLondon.Inaddition,therearenewsservicessuchaswww.bloomberg.comandspecialistservicessuchas
www.thestreet.com.Otheronlinesitesworth
exploringareHome&Finance(www.fmlx.com)forinvestmenttools;thepublishersoftheCompanyGuideandREFS(www.hemscott.co.uk);Moneyworldforshareprices,indices,newissues,news,etc;andwww.news-review.co.ukforasummary
ofusefulnewsandinformation.
Company accounts
Muchoftheanalysisofsuitableinvestmentsforbothprofessionalsandprivateinvestorsstartswiththecompany’sannualreportandaccounts,andmostoftheratiosarecalculatedfrom
figurestakenfromtheannualreport.MostcompanieswillbehappytoforwardacopyonrequestandlargenumbersofthemareavailableontheinternetfromCompanyAnnualReportsOn-Line(CAROL).Quiteoften,companiesputtheiraccountsontheirwebsites,andtheycanusuallybefoundontheinvestorhomepage.
Annualreportsandaccountsareformidabledocumentsapparentlydesignedtowardoffinsomniainallbutthemostdedicated.Butyoudon’tgetowtfornowt–investingyourtimebeforeinvestingyourmoneyreducesthechancesofdoingsomethingspectacularlysilly.Soitisworthlearningalittleofthe
meaningsbehindthefigures,andtheconventionsusedtopreparethem.Foratrueunderstandingofabusinessandhowthecompanyfaresonereallyneedstotalktoproductionforemen,salesstaff,vandrivers,internalauditors,purchasingmanagersandthefinancedirectortosupplementthepicturefromthepublished
figures.Unhappilythisisnotopentoinvestors,thoughitwouldbeforstockbrokers’analystsiftheybotheredtoavailthemselvesofit.
Thefirstruletorememberisnottobetakeninbythespuriousaccuracyofhavingitallsetdowninprecise-lookingnumbers.Everythingintheannualreportistheresultofapproximation,
estimation,interpretationorguess.Accountingstandardsmaylimittherangeofflexibilitybutthecompanystillhasscopeforaprettyfairrangeofsubjectiveassessment.Thatisinpartbecausetherulesthemselveshavetoapplytoawiderangeoftypesandsizeofbusinessandanenormousrangeofcircumstances.Aseventhe
AccountingStandardsBoardconcededmanyyearsago,corporateaccountscanberelevantorcomparable,butnotboth.Ithasinthemaingoneforrelevance(thefiguresaretailoredmoretoproduceafairpictureofthebusiness)attheexpenseofproducingreadilycomparableaccounts,whichmeansinvestorsgetabetterpicture
ofthebusinessitselfbutmustputinsomeextraworktotryandmeasureonebusinessagainstanother.
Thesecondruleisthatthepurposeofaccountsistodemonstratethatthebusinessisbeingrunhonestlyandtheinvestors’cashisnotbeingembezzled.Thereisnointentiontodemonstratecompetence,muchless
efficiency,thoughthatiswhatinvestorsneed.Intheabsenceofdirecthintsabouthowcleverthemanagersare,investorsneedtodigintotheannualreporttodeduceitfromtheavailableinformation.
Itispartlytohelpthatprocessthattheaccountingprofessionhasfordecadesgonewaybeyondthe
demandsoftheCompaniesActsintheamountofdisclosure.Thetheoryisthatifallpossibleinformationisthere,crooksandfoolswillhavenowheretohide.Ontheotherhand,BritainisapproachingtheUnitedStatesinthesizeofcorporatedocumentsandfewcansiftrelevancefromthemountainoffigures.Someofitis
unquestionablyhelpfulingettingdowntothedetailsofhowthenumbersrelate,butthatusuallyactsasasubstituteforfindingjustwhatmakesabusinesstick.
Acompany’sannualreportandaccountsmayhaveplentyofmaterialforthecarefulcalculationsofstockbrokers’analystsbutmuchofitwillbe
incomprehensible,boringorirrelevanttomostinvestors.Neverthelessthedocumentdoescontaintheoccasionalgemsthatindicatewherethecompanyisgoingandwhetheritisheadedforrichesortheknackers’yard.
Relyingontheauditorstooheavilyisamistake.Theyareaccountants,nominallyappointedbyshareholdersbut
inpracticebydirectors,whoaresupposedtotakeanoutsider’sdispassionateviewofthefiguresandtoseethattheyhavesomerelationtoreality.Theirmaincriteriaaresupposedtobederivedfromtherequirementthattheaccountsrepresentatrueandfairview,butincreasinglytheypreferthelesscontentiousapproachof
sayingthefigureshavebeencompiledinlinewiththerules.Evenwhentheyareconscientious,independentandrigorous,auditorsaregovernedbythesameuncertaintiesinthefiguresasthecompanyitself,andinanycasetheycannotpossiblycheckeverything.Astheythemselveskeepsaying,theyareguard-dogs,not
bloodhounds–inotherwordstheyaretheretocheckthefiguresaddupandthestocksreallyareinthewarehousebutdonotseetheirjobashuntingthroughthebusinessforsignsoffraudorevenincompetence.Thatiswhyauditorsclearlysayattheendofthereportitwasthedirectorswhopreparedtheaccountsandwhomusttake
responsibilityforthem.Suchstatementsarealso
anattemptatapre-emptivedefenceagainstlitigation.Whencompaniesgounderorarefoundtohavebeensubjecttomassivefraud,creditorssueauditorsbecausetheyhavelargeprofessionalindemnityinsurance,ratherthandirectorswhomayhavecarefullysaltedmoneyaway
inoverseastrustsortheirspouses’namesandthereforeseemtobepeopleofnosubstance.Directorsare,however,responsiblebothinlawandinfactforrunningthecompany,andshareholdersshouldresistpressurestoreducetheirliabilitynomatterhowworthythecauseappearstobe.
Anotherthingtorememberisthataccountsrepresentthepast.Theywillnotthereforenecessarilygiveanaccuratepictureofwherethecompanyisnow,muchlesswhereitwillbeinthefuture,especiallyinfast-movingtradesorchangingeconomies.Accountsarepreparedona‘going-concern’basis,whichmeans,
amongotherthings,thatassetsarevaluednotbyhowmuchtheywouldfetchinabreak-upbutattheirworthtothebusiness.
Noneofthisisintendedtosuggestthataccountsareuselessormisleading,merelythattheyneedinterpretation,areimpreciseandrepresentthepast.Thatmeansalittlemoreworkintryingto
evaluatejustwhattheyreallydosuggest.
First,someconventions.Likethegovernment,companiesgenerallydonotsticktothecalendaryear.Financialyearsstartatanytime,sometimesnotevenatthebeginningofamonth.Theremaybenothingsinisterinthis.Financialyearsstartwhenthecompanywas
originallyregisteredanditcouldbethatithasjuststuckwithit.Somebusinessesreckontheirsalesareseasonalandsetthefinancialyearsothesecondhalfgetsthebenefitoftheupturn.
Anynumberinparenthesesisanegative.So,attheprofitleveloftheaccounts,£12.8millionindicatesaprofitbut
(£385,000)showsaloss.Thenumbersinthemainpagesoftheaccountsaremostlysumsofvariousgroupsofnumbersthatarethenshowningreaterdetailinthenotes–thereisnormallyalittlenumbernexttoeachlinetoshowwhichnoterelatestoit.Itisalsoworthrememberingthatmanyofthenumbersinthereportareabitbarrenontheir
ownandhaveafargreatersignificancewhenrelatedtoothernumbersintheaccounts,setagainstpreviousyearsorbycomparisonwithotherbusinesses.
Themainitemsinthedocumentarethedirectors’report,theprofitandlossaccount,andthebalancesheet.Inadditiontherearetheextensivenotes,whichare
supposedtoamplifyorexplainthefigures;thesourceandapplicationoffunds,whichshowwherethecompanygotitscashandhowthemoneywasused;andtheauditors’report.
Chairman’s anddirectors’ reportRightatthefrontisabrief
wordfromthechairmanandthedirectors’report.Theseshouldsaywhatthecompanydoesandsumupsignificanthighlightsoftheyearjustcompleted,possiblywithsomecommentsontheperformanceandhowthefiguresshouldbeinterpreted.Thereisoftenawordaboutprospects,whichisonlyfairconsideringmostreportsare
producedseveralmonthsintothenextfinancialyear,butseldomgivemorethanacursorysuggestion.Theusualformulaissomethinglike,‘Despitethedifficultfinancialcircumstanceswehopetocontinuedevelopingthecompanyandhopeforfurtherimprovementintheresultsforthecurrentyear.’Iftheresultsturnoutworse,
shareholderscannotsueformisrepresentationevenonthatsmallscaleand,tobefair,eventhreemonthsintoayearmaygiveamisleadingpictureoftheresultsforthewhole12months.Onehasthereforetolearntoreadbetweenthelinesandseewhatthephrasesindicateandwhatthereportishintingat.Somedotrytobeasexplicit
ascircumstancespermit,andsocanofferaveiledmessage.
AccountingpoliciesMostofthisisextremelyboringandcansafelybeignoredasroutineprescribedbythelawsandaccountingstandards.Justoccasionally,however,acompanyreckons
thestandardruleswouldproducenonsenseand,ratherthanmislead,itintendstodepartfromthenormalpresentation.Thereportthenshouldexplainwhatstandardisbeingbreachedandwhy.Theexplanationofthismaynotalwaysbethemostlucidproseandisnotprimarilyaimedatthelayperson,butabitofcarefulattentionwill
usuallyunravelit.Iftheauditorsreckonitisabitofflummeryorspeciousexcusetheywillcommentonitintheirreport.
Profit and lossaccountTurnoverTheprofitandlossaccountstartsbyshowingthe
company’stradingoverthepreviousfinancialyear.Thatshowsturnover,whichjustmeanssalesandsometimesisactuallylabelledso.Drinkscompaniessometimesthentakeoffexcisetaxestoshownetsalesvalue.Onecanthenseehowthislatestyearcomparedwiththepreviousone.Evenifitlookshealthyitisprobablywisetofliptothe
noteassociatedwiththefigureandseeiftherearebreakdowns.Somecompaniesshowthesalesbyproduct,bygeographicalarea,bymarketsectorandsoon.Thiswillshowwhetherthereareanypeculiarities,likeoneproductsupportingthesaggingrestoronegeographicalareaturningdistinctlydodgy.Ifthereis
anythinglikethat,turntothechairman’sanddirectors’reportstoseeifthereisanyexplanation.Theanswermaybesomethingsimplelikeanacquisitionoradisposal.Ifthereisnoexplanation,suchdistortionsoroddfiguresshouldpromptquestionsandtriggercaution.
Operating profit
Nextaretheoperatingcostsofrunningthecompanyincludingeverythingfromstationerytowages,whichareoftenbrokendownintomajorcomponentssuchascostofmanufacturing,distribution,administration,andresearchanddevelopment.Thesecansometimessuggestquestions,suchas:whyis
administrationsoexpensive,orwhyhasthecompanybeencuttingbackonresearchforseveralyears?Whenthecostofsalesisdeductedfromthetotalturnoverfigure,theresultistheoperatingprofit.
Other incomesInlargercompaniesyouthengetavarietyofotherincomessuchasmoneypaidtothe
parentcompanybysubsidiaries,oroccasionallytheotherway,andsomeexceptionalitemsthatarenotthenormalpartofthecompany’stradingoperations.Abusinesshastopayinterestonmoneyithasborrowed.Anysharpmovementininterestoutorinthatisoutoflinewithprevailinginterestrates
shouldpromptsearchesinthenotesandstatementsforexplanations.Itcouldbeborrowingsforacquisitionsorforalargeredundancyprogramme.
Pre-tax profitWhentheoperatingcostsandotherincomeshavebeenaccountedfor,whatisleftisthepre-taxprofit,whichis
thefigurenormallyusedinnewspaperaccountsofresults.TakingoffCorporationTaxanddividendpaymentsleavesretainedprofit,whichthebusinessisplanningtoreinvest.
Accountingstandardssayexceptionalitemssuchasprofitfromthesaleofanofficebuildingorthecostofamajorreorganizationand
redundancyofmanyemployees,havetobeseparatedout.
Other itemsTheotheritemsarefairlystraightforward.Theprofitandlosstableshowstheamountbeingpaidtoshareholdersindividends,sometimeswithpreferencesharesseparatedout.
Anythingleftafterthatistransferredtoreserves.Thisdoesnotmeanitgoesintothecompanycoffers,andthetermisconfusing,sosomecompanieshaveoptedinsteadtocalltheamount‘retainedprofits’or,tobeevenmoreexplanatory,somethinglike‘profitsretainedinthebusiness’.Thisisthemoneythatbuildsthecompany.It
goesintobuyingmachinery,factoriesorrawmaterials,orfinancingworkinprogress.Somecompanieshavestarvedthemselvesofthisvitalreinvestmentbecauseinstitutionalshareholdersdemandagrowingdividendchequeeveryyearevenifthatmeansdeprivingtheenterpriseofcash–ifthebusinesssufferstheywilljust
ditchthesharesandmoveontoanothercompany.
Thereisnothingintheaccountsthatwouldsuggest,forinstance,agoodstarttotheyearbutthewholebusinessfallingoutofbedinitslastthreemonthswithplungingsalesandprofits.Allofthatshouldbementionedinthereportsfromchairmananddirectorswith
explanationsastowhyithappenedandwhattheyaredoingaboutit.
Aclichéistotalkaboutthebottomline,whichisreckonedtocomefromtheaccounts.Infactthebottomlineoftheprofitandlossaccount,aftertheretainedprofitsfigure,isusuallytheearningspershare.Dividingthesharepricebythisfigure
providestheP/Eratio,ortobeprecisethehistoricP/E.
Balance sheetWhileprofitandlossaccountsshowanaccumulationoftransactionsoverthewholefinancialyear,thebalancesheetisthepicture(traditionallycalleda‘snapshot’toemphasizehow
brieflyrelevantitis)ofthefinancialpositionandassetsonthelastdayofacompany’sfinancialyear.Everythingitownsorisowedonthatdayisshownunderarangeofheadings.Bythetimeshareholdersseethetotals,thefiguresarelargelyirrelevantbecauseintheinterveningmonthseverythingcouldhave
changed.Thefiguresare,aswith
muchelseintheaccounts,opentoadegreeofflexibility.Forinstance,valuationsofassetsarefairlysubjectiveanddependonthepurposeforwhichthefigureisbeingprepared.Amachinetoolmaybevitalforthecompanybutwouldfetchlittleiftheliquidatorhadto
breakuptheassets.Settingapriceonpatents,trademarksorbrandnamesisevendodgierandtherehavebeenyearsofargumentsaboutthetruevaluationofsuchintangibleassets.Thephysicalassetsandstocksareoftenshownatcost,butinflationwillhaveerodedthatevenifotherfactorshavenotalteredthevaluation.
Similarly,landvaluescanmovesharplywiththevagariesoftheeconomyandthepropertymarket.
Whattheaccountswillshowisthedepreciationreducingtheworthofassets.Thenotesandaccountingpoliciesusuallyelaborateonthis,butitisnormalformachinerytobewrittendownbyafixedamounteachyear–
straight-linedepreciation.Clearlythatleavesampleroomforabitofanudgeorwindow-dressingbyadjustingvaluationsorbringingforwardsomeitemsanddelayingothers,togivethetotalfigurethecompanywantstoproject.Thesnapshotmaythereforebewhollyatypicalofthestateofitsfinancesonanyotherday
oftheyear.Despitethat,itgivesahintofthefinancialhealthofthebusiness,allthemoresosincetherangeofmanipulations–shortofoutrightfraud–islimitedforanumberofreasonsincludingaccountingstandardsandtheneedtobereasonablyconsistentwiththepreviousyears.
Inthelistofthingsthe
companyownsthefirstheadingisfixedassets.Thiscomprisesthingsthathavebeenandarelikelytocontinueaslong-terminvestments.Soitincludesthingslikefactoriesandequipment,officeblocksandthelike.Lorriesarealsoincludedunderthisheading,probablyforwantofabetterplacetoputthem.Thevalue
isnormallyinthereatcostorwhattheywouldsellfor,orsomeformula.
Thencomeinvestmentsinothercompanies.Thentherearecurrentassets,whichcoversthemoremobile,changingthingslikestocksofrawmaterialsandfinishedproductsinthewarehouse,moneyowedbycustomers,andmoneyinthebank.
Afterthatcomesalistofthecompany’sdebts.Firsttherearecurrentliabilities,orcreditorsexpectingtobepaidinunderayear.Thisincludestradecreditors(suppliersofgoodsandserviceswhohavenotyetbeenpaid),moneyborrowedshortterm,themoneysetasidefortheproposeddividend,andtheCorporationTaxtobepaidon
theprofits.Thetotalisthendeductedfromthecurrentassetstoshowthenetfigure.Thisissometimescalled‘workingcapital’.
Longer-termdebtincludesthingslikeaterm-loanfromthebankandprovisionsforknownspendingsuchasrestructuringthebusiness,movingthefactoryorthefearedoutcomeofalegal
case.Takingtheshort-andlong-termliabilitiesfromtheassetsproducesthenetassetfigure.
Onceagain,thereshouldbecomparisonnotonlywiththepreviousyear,whichmostcompaniesprovide,butalsowiththepreviousfiveyears.Combiningthecurrentfigurewithpreviousyears’andknowingsomethingaboutthe
normsinthatindustryshouldprovideaprettygoodmeasureofthecompany’sfinancialhealth.
Cash-flowstatementCashflow,orflowoffunds,orsourceandapplicationoffundsstatementsare,asthenamessuggest,a
supplementaryindicationofhowthemoneyflowsinfromprofitsandinvestments,andgoesoutagainfortax,dividendsandthelike.Inadditionitgivesthefiguresforrepaymentofcapital–redeemingadebenture,forinstance–orfinanceinfromraisingfurthercapital.Thereislittlepointinmakingaprofitifthebusinessjustruns
outofcash,andthisiswherethewarningshouldshow.
Thefinalfigureofthestatementshowsthegrowthordecreaseinthecompany’sfundsduringtheyear.Thatisafairlygoodindicationofhowsuccessfullyithasbeenmanaged.
Auditors’ report
Theauditors’reportisnormallyaprettyroutineaffair,sayingthecompanyhasabidedbytheaccountingstandards,CompaniesActsrequirementsandotherrules;thatthedirectorsareresponsiblefortheaccountsandtheauditorsmerelytakesamplesandtestsasrequiredbytheAuditingPracticesBoard;andthatasfarasthey
cantelltheaccountsrepresentatrueandfairaccountofthestateofplay.Justoccasionallyitisaqualifiedreport.
Inessencetherearetwosortsofqualification,asaresultofuncertaintyorfromdisagreementwiththewaydirectorstreatsomeitem.Theeffectmaybemuchthesamebutthemessageissignalled
indifferentways.Iftheuncertaintyisbig
enoughtomentionbutnotfundamentaltothebusiness,theauditorsnormallysaythat,subjecttothespecificdoubts,whichtheywillnormallyspellout,theaccountsareallright.Thatmayjustbeawaitingtheoutcomeofacourtactionandhenceareinherently
uncertain,butitcouldalsosaytheauditorscouldnottellifproperaccountshadbeenkeptinonepartofthebusiness.
Sometimesitisastraightdisagreementaboutthetreatmentofanitem.Onceagain,ifitisabiggishnumberinthecontextoftheaccountsbutnotseriousenoughtounderminethe
survivaloftheorganization,theauditorsnormallysayitisalltrueandfairexceptforthespecifieditem.Theauditorsmay,forinstance,sayadebtinthebalancesheetisnotrecoverabledespiteallthedirectors’optimism.
Onafewrareoccasionsthesplitbetweentheboardandtheauditorsissoserious,ortheauditorshavestumbled
onsomethingsocrucialtothecompany’sviability,thatamoreseriouswarningisinsertedintotheaccounts.Ifthedoubtsaboutrecord-keepingorthereliabilityofinformationgenerallyissogreatthattheauditorshaveseriousdoubtsaboutthewholething,theywillsaytheycouldnotdiscoverwhetherthestocksarepresent
orthesalesareasstated;theymaysaythebooksandfigureswerenotavailable;sometestsofthebookswerefrustrated;ortheyhadsomedeepproblemaboutverifyingwhatwasgoingonandsoon,andasaresulttheycangivenoopiniononwhethertheaccountsaretrueandfair.
Sometimesthereisjustafundamentaldisagreement
betweenthedirectorsandauditorsaboutwhatthingsareworthorhowtheyshouldbetreated.Ifthesearesuchmajoritemsthattheyarefundamentaltothestateofthebusiness,theauditorsnormallysetouttheproblem–saythevaluationofmajorlong-termcontracts–andstatethattheaccountsareasaresultmisleading.They
normallyaddthathadtheaccountingtreatmentbeenastheysuggested,theprofitswouldhavebeensomanymillionslower.
Suchmajorrowsarerarebecausetheboardandtheauditorsargueaboutsuchitemsatenormouslength,andauditorsbendoverbackwardstoavoidsuchopenconflicts,ifonlybecauseitisalmost
alwaysthepreludetoachangeofauditor,sotheaccountantswillloseasourceofrevenue.
Anotherworryingcommentfromtheauditorsisthattheaccountshavebeenpreparedonagoing-concernbasis,whichisawarningthatthefigureswouldbeunjustifiedifthebusinesswentbust.Clearlythatsortof
pointisnotgoingtobemadeaboutabusinesswithaboomingpresentandaflourishingfuture.
NotesBehindallthesearethenotes,frequentlyrunningtodozensofpages.Itisafrighteningandlongsetoftechnical-lookingstatistics.Infactthis
iswheretherealmeatisgenerallyburied.
AseriesofreportsoncorporategovernancehasproducedtheCombinedCode,whichtheStockExchangebacks,thatinstructscompaniestoincludementionintheirannualreportsofhowfartheycompliedwiththerequirements.Inaddition,
somecompaniesprovideunauditedsupplementsgivingbreakdownsbyproductareaandcountryofsales,sometimesbycountryofmanufactureandotherdetails.
Thisisthesectionwhereyouwillfindhowmuchdirectorsearnedandwhatsortofincentiveandshare-optionpackagestheyhave.Itwill
alsoshowhowmanyemployeesthereareandhowthattotalchangedduringtheyear.
Alsoatthebackbutnotusuallyaformalpartofthenotesisatableshowingpreviousyears’performance,goingbackatleastfiveandsometimes10years.Thatmeansonecancheckwhethersaleshaverisenfasterthan
therateofinflationandwhetherthetrendhasbeenasteadyoneorerratic.Italsotendstoshowthestepchangewhentheboosttoprofitandturnovercamenotfromorganicgrowthbutanacquisition.
Using the accounts
Thisthenisthestart:now
thesebarefiguresmustberelatedtosomethingtoextractsomemeaningfromthem.Forinstance,thefigureofthetradecreditorsasapercentageofturnover:thehigherthepercentagethelongercustomersaretakingtopay.Thismeansnotonlythatthecompanymustfindexpensivefinancetobridgethatgap,butthatitscashand
creditcontrolarenotverygood.
Anothersignificantfigureistherelationshipbetweenborrowingsandsharecapital.Borrowedmoneyhastoberepaidandtheinterestisduewhetherthecompanyismakingaprofitornot.Equity–sharecapital–isneverlikelytoberepaidanddividendsarepaidonlywhen
thecompanycanaffordthem.Iftheprofitabilityisgreaterthanthecostofdebt,theprofitattributablewillbegearedupsubstantially.Allthesame,therearelimitstohowmuchacompanymayborrow,andborrowingmakesabusinessvulnerable.Theratiobetweenthoseborrowingsandtheequitymoneyiscalled‘gearing’
(‘leverage’intheUnitedStates),andacompanywithshareholders’fundsof£150millionandborrowingsof£75millionwouldbecalled50percentgeared.Itvariesabitdependingonexternalcircumstancesandtheindustrysector,butifitwenttoover60percentthecompanywouldbecalled‘highlygeared’.Analysisof
suchratioscanbefoundinChapter6.
Oneaspectthatiseasytostudyisthetrendsovertime.Allaccountsprovidethepreviousyear’sfiguresandmanyprovidesummarytablesforthepreviousfiveyears.Thesewillshow,forinstance,whetherturnoverhasrisenfasterthantherateofinflation,andwhetherprofits
haverisenevenfasterthroughincreasedefficiency,concentrationonhigh-marginproductsandsoon.
Other informationfrom companies
Interim reportsInbetweentheannualreports
companiesalsoproducetheresultsoftradinginthefirsthalfoftheirfinancialyear.Thesearegenerallyprettyshortdocumentsgivingabriefstatementofthevolumeoftradeandprofit,plusanabbreviatedbalancesheetminusthecopiousnotes.Somecompaniesgivesomesegmentalinformationaswell.Thefiguresarenot
audited.
Prospectuses andlisting particularsCompaniesfirstcomingtothestockmarketmustprovideextensivedetailsnotjustaboutthebusinessbutthepeoplerunningit.ThelistingrulesoftheStockExchangerequireallsortsof
informationaboutassets,depreciation,governmentgrants,abriefhistory,auditors,bankers,financialadvisers,stockbrokers,solicitors,acompletedescriptionofthebusiness,detailsofmanagement(directorshaveaskedthegovernmenttobeexcusedfromputtinginhomeaddressesinfuture),staffand
premises,whatwillbedonewiththemoneyraised,expectationsoftheimmediatefuture,andsoon.Sotheprospectusisthemostcomprehensiveinformationaboutitselfthatacompanyeverpublishes.
TheAlternativeInvestmentMarkethasslightlylessonerousdemandsfordetails,buttheyarestill
prettyextensive.
Circulars ondisposals andacquisitionsShareholdersmustbetoldofanysubstantialacquisitionwithdetailsoftheoffer,whyitisbeingmadeandhowitistobepaidfor.Inmostcasestheshareholderswillhaveto
ratifytheboard’sdecisiontopurchase.
Somebidsarecalled‘hostile’,thoughitisthebusinessonthereceivingendofanunwelcomeofferthatisbelligerent.Insuchnon-agreedtakeoverbattlesthetargetcompanywillsendshareholdersdocumentsdefendingitsmanagementandtradingrecord,and
emphasizingitsglowingfutureaswellastheneedforcontinuedindependence.Thesetendtobeaccompaniedbyextensivedisclosures,accountsandforecasts,rivallingtheannualreportinscope.Sometimesahigherofferseemstoconquersuchemphaticmisgivings.
Newsletters
Shareholderloyaltyhasgrowninimportanceinrecentyears,socompaniestrytokeeptheirinvestorshappybysendingthemnewsletters.Evenmorecommonly,therearemagazinesandnewssheetsdistributedtoemployees,whosometimesalsogetashortenedversionoftheannualaccounts.Carelesscompanies
sometimestelladifferentstoryinhousemagazinesandshareholderreports.
Other sources
Share buy-backsAcompanybuyingbackitsownsharesshouldsuggestquestions.Isitbecausethebusinesshassurpluscashand
canfindnowayofgrowingthebusiness?Isitafailureofmanagementinfindingnothinginthebusinessinwhichtoinvest?Isitjustanattempttomakeitsfigureslookbetterbyboostingtheearningspershare,andincreasingitsshareprice?Orisitasignthatthebusinessthinksthismoresensiblethanbuyingoverpricedassets
throughabusinesstakeover?Thesharesboughtback
canbecancelledbythecompanyorkeptin‘treasury’forreleaseatalaterdate.
Directors’ dealingsCompaniesareobligedtotelltheStockExchangeauthoritiesaboutdealingsintheirsharesbydirectors.This
goesoutontheStockExchange’snewssystemandisoccasionallypickedupbyanincreasingnumberofnewspapers.
Directorsmayprovideveryplausiblereasonsforselling,butitisbestallthesametobewaryandcheckwhatisgoingon.Thedirectormayreallyneedthemoneyforthechildren’seducation,
topaydeathduties,tobuyasmallchateauintheDordogne,ortofundacontentiousandexpensivedivorce.Buteventhen,whydidthatdirectorsellthosesharestofindthemoney?Withoutconvincingexplanations,onereallydoeswonderwhatthemanagersofabusinessknowthatothershareholdersdonotwhen
theystartsellingthesharesinsubstantialquantities.
Conversely,thefactthatseveralboardmembersseemanxioustoincreasetheirholdingsdoesseemprettyencouragingeveniftheyarenotactingoninsiderinformation.Directorsareallowedtotradeinsharesonlywhentheyarenotina‘closedperiod’ofsittingon
sensitiveinformation,suchasthecompany’slatestsetofresultsornewsofacontractwon.
FashionFadsovertaketheworldofinvestmentwithevengreatervirulencethanwomen’sclothing,andareequallyevanescent.Theinternet
bubbleisanexample,butatleastthatwasrelatedtosomeunderlyingbusinessopportunity.Itreallywastruethatthesystemwaschangingthewaypeopledobusiness,butnobodyknewhowmuchorhowquickly,muchlesswhowasgoingtowinduringthetradingrevolution.Asaresulttherewasnoobviouswayofvaluinganinternet
company.Valuationwasmadeadditionallydifficultbythevarietyofsoftwareproducers,internetserviceproviders,retailers,etc.P/Eratiosbecameinsaneorirrelevant(therewerenoearningsyet)andeveryoneknewthebusinesseswereovervalued,butthereseemednowayofstoppingtheboom–untilitstopped.
Unliketheinternetfashion,whichatleastderivedfromsomeconfusedperceptionofwhatreallywasgoingon,somefashionsseembasedonnothingbutvaporousunrealistichope.Thepointhereistwofold:itisnotwrongtoinvestinapromisingsectorsuchastheinternetsolongasyoucanseerealvalueinthebusiness,
butitisfollytogetcaughtinthehysteria;anditisvitaltoseparatetheboomsthatarebasedonrealbusinessopportunitiesfromtheonesthatarenothingbutpassingfadsapparentlycreatedbysomesortofmarketramp.
Sometimesabigtakeoverinasector–banking,insurance,pharmaceuticals,retailingandsoon–prompts
speculationthatotherswillfollow,andmostofthesharesinsimilarbusinessessuddenlyrompahead.Whetherthereisasheep-likementalityinbusiness,whetherfinancialadvisersthenseethechanceofincomeandurgetheirclientstograbashareofwhatisleft,orwhethermanagementsreallydofearbeingleftbehind,the
speculationquiteoftenbecomesfact.Ithappenedwiththedemutualizationofbuildingsocietiesandinsurancecompanies.Whenoneofthosebecameapubliccompany,ownersoftheotherscouldnotresistthelureofshort-termprofitsandforcedaflurryofdemutualizations.
Whenthereisageneral
realignmentintheindustryofthistype,thepeoplewhospotitatthestartandbuyintothecompanieslikelytobecometakeovertargetsseehealthyrisesintheshares.Similarly,carpetbaggersgettingintothebuildingsocietiesintimeemergewithafewthousandpoundsofsharesthattheycanswiftlyextract.
Anotherfashionisfor
sectors.Suddenlybiotechnologyisseenasthesaviourofmankindwithuntoldrichestobederivedfromnewdrugs;softwarecompaniesareseenastheuniversaltraders;theinternetisthoughttobeaguaranteedmeansofsellingtohundredsofmillionsofpeopleatnocostatall;oraminingsectorisreckonedtobecertainto
makeafortunefromthespurtofdemandforitsmetals.Voguesofthistypeseldomlastmorethanayear,soittakesnimblemindstospotthetrends,buttheresultscanbespectacular.Itispossibletoincreasethevalueoftheholdingbyanythingfromfive-foldto20-foldinamatterofmonths.Thepointistogetoutbeforethesky
fallsin.Conversely,itisdangerous
toclimbaboardabandwagonifitseemstohavenorealengine.Ifyoudonotunderstandwhatacompanydoesorwhyitisvaluedashighlyasitseemstobe,avoidit.
Stockbrokers/investmentadvisers
Ifyouhaveastockbrokerwhoisprovidingmorethanjustadealingservice,oraninvestmentadviser,therewillbeampleadviceandinformationontap.Itmaybeverygoodadvice,butintelligentinvestorsarenotwhollyinert,preparedtoaccepteverythingtheyaretold.Yougetbetteradviceifyouareinformedenoughto
beabletodiscussthemarketandyourneedsinanintelligentmanner.Theinvestorneedstobecontinuouslykeepinguptodateandtohavehisorherprioritiesclear.Thisisnotjustausefulantidotetobeingbaffledbypretentiousjargon:italsohelpsestablishwhetherone’sideasareright.
Peoplewithoutaregular
financialadviserandthosewhodistrusttheadvicetheygethavetohuntaroundforothersources.Stockbrokers’circularsarestillgenerallyavailabletothemeitherdirectlyorthroughthepress,butusuallyafterfavouredclientshavebeentoldtheconclusionsandhavehadtimetoactonthem.Thisisusefulinformationbecauseit
givesalotofbackgroundaboutabusiness,thecalculationsandfeelingsofaprofessional,andanindicationofhowtheCitymayviewtheshares.Youcanthencheckwhatyoufeel,whatthesharepriceisdoingandsoon,andusetheadditionalinsightasanextraaidindecisionmaking.
Ifyoudonothaveaccess
toabroker’sadvice,donotdespair.Stockbrokersareaslikelyasanybodytobewrong.AclassiccasewasthecarmakerBritishLeyland.Forabouttwoyearspriortoitsdemise,investorsweregettingmoreandmorenervousabouttheunrulyunions,theshoddyworkmanship,theshort-sightedmanagementandthe
increasingsignsthatthecompanycouldnotmakethecarsthemarketwantedandwasill-preparedtomaketheprofoundchangesneeded.Soitsshareslidsteadily.Nevertheless,stockbrokersqueuedupthroughoutthatinexorabletumbleintoinsolvencytorecommendthesharesasagoodbuy.
Complaints
Ifsomethinghasgonewrong–inappropriateadvice,theinvestorbeingbadlytreated,orinstructionsnotbeingfollowed–thefirstandmostobviousstepistotakeitupwiththecompanyconcerned.Brokersandadvisersallnowhaveacomplianceofficerwhosejobistoensurethat
therulesarefollowedandtotakeactionwhentheyhavenotbeen.
Ifthatfails,thenextstepistotaketheproblemtotheombudsmanand/ortheregulatoryauthority.Thisshowstheimportanceofensuringfromtheoutsetthatoneisdealingwithaproperlyrecognizedandauthorizedfirm.
ChapterEightWhat does ittake to dealin shares?
Mostadvisersreckon£2,000isthesmallest
sensibleamountforasingleinvestment,thoughmanyrecommend£3,000.Itispossibletodealinsmalleramountsatonetimebutitputsupanextrabarriertomakingareturn:stockbrokerssetaminimumpriceontransactionsandthedealingcostscanoverwhelmthe
profitfromthetransaction.Ifyouaredealinginasmallcompany’ssharesthathaveawidepricespread(thedifferencebetweenthebuyingandsellingprice)thethresholdforpotentialprofitisraisedstillfurther.Andthereisalsoagovernmenttaxondealing(seepage102).
Forexample,ifthedealingcostis£20fora£500parcel,
thesharehastorisebymorethan8percentjusttobreakeven,bearinginmindthelikelydealingspread.Thatmeansasharestandingat220pwouldhavetorisebyover18pbeforetheinvestorsawanybenefit.Itcanhappen,butitisjuststackingtheoddsagainstyourself.However,competitionamongstockbrokersisincreasing
withthenumbersofsitesontheinternetgrowingdaily,sothecostcouldstartcomingdownandwithittheminimumeconomicinvestment.
MarkTwainsaidtherewasnothingwrongwithputtingallyoureggsinonebasket,butwatchthatbasket.Thatisunlikelytoworkforthestockmarket.Scrutinizeacompany
withalltheattentionpossible,analyseitsfiguresandreadallthereportsavailableand,despiteallthefavourableindications,itcanstilldecline,togeneralsurprise.Suddenexternalchangescanoverwhelmsoundbusinesses,andineptmanagerscansofailtokeeptrackofwhatishappeningundertheirnosesthatnobodyoutsidenotices
eitheruntilprofitwarningsshowthedepthoftheproblems,ortakeoverpredatorsortheliquidatormovein.
Forsafety,therefore,oneneedstospreadtherisksoveranumberofcompanies.Adecentportfolioevenforarelativelysmallinvestorwouldcontainatleast10companies.Thatisthe
eventualsafehavenhowever,anditdoesnotmeaneveryonemuststartwithatleast£20,000goingspareforittobewortheventhinkingaboutthestockmarket–itjustmeansthesearethesensiblerequirementstoreducethemuch-publicizedrisks.Rememberthemainaimofinvestingistogetadecentreturnforan
acceptablerisk.Withonesharetheriskisgreater,butthemorecompanies’sharesyouownthelesschancethereisofyourentirestockmarketholdingsuddenlycollapsingtonothing.Itispossibletobuildarangeofsharesovertheyears;indeedmostadvisersreckonitisagoodideatokeepalittlefloatofavailablecashtotake
advantageofopportunities.Areallyrichinvestorcan
putmoneyintoproperty,fineart,venturecapital,currencyfunds,etc,andspreadequityinvestmentallroundthesectorsandtheworld.Thatwayallrisksarehedged.Formostofus,offsettingoneortwoofthedangersisthebestwecanhopefor.Thetwomostobviousrisksarethat
themoneywillbeerodedbyinflation,andthatallofitwilldisappearthroughcorporateincompetence.
Itisageneralrulethatthelowertherisk,thelowerthereturn–whichgeneratesitsownobviouswarningthatifsomebodyisofferingmouth-wateringreturnsorevenaprofitthatseemsmarkedlyabovecomparable
destinationsforyourcash,youmayrelyonit:thereisacatch.Theconversealsoholdstrue:thehighertherisk,thehigherthepotentialreward.Investinasingleshareandifyoustruckitluckytheinvestmentcanmultiplymanytimesinasingleyear,andforsomepeoplewithanappetitefordangerthatoffsetstherisk
thatthecompanycouldfold,takingeverypennyoftheinvestor’smoneywithit.Ingeneralthisistodramatizewhatreallyhappens–inpracticeitisfarmorecommonfortheshareyouownneithertoburstthroughtheroofnorcrashthroughthecellarbuttopootlealonginthedoldrumsformonthsorevenyears,producinglittle
movementintheprice.That£20,000maylooka
formidablesum–especiallyifonethinksaboutitastheminimumsafelevelofholding–butsetitagainstlifetimeearningsofover£1millionforevenarelativelylowly-paidhouseholdanditbeginstoseemalittlemoredoable.Ontheotherhand,ifthetotalcostslistedhereand
theamountneededtoprovideareasonablysafeincomeseemoutofreach,therearelessdauntingalternatives,thoughstillwithalinktothebenefitsofthestockexchange,suchasinvestmentorunittrusts(seeChapter3).
Investment clubs
Analternativetomanaged,
pooledvehicleslookedafterbyaprofessionalisaninvestmentclub.Thisisagroupofprivateinvestorswhopooltheircashandjointlydecidehowitshouldbeinvested.Thishastheadvantageofspreadingholdingsoveralargernumberofinvestmentsthananysinglemembercouldmanage,withouthavingtopaythefees
ofaunitorinvestmenttrustorotherprofessionalmanagementcompany.Youforfeittheexpertiseoftheunitandinvestmenttrustpeoplebuthavethefunofpickingyourownshares(oranysortofinvestment)andgetasocialoccasionthrowninasabonus.Theattractionsarebecomingmorewellknown:in1997therewere
about350clubs,buttheLondonStockExchangeestimatestherewere5,000by2009.
Theidealnumberofmembersforaclubissomewherebetweenthreeand20.Withmorethan20memberstheclubwillbecalledacorporationbytheRevenueandyouwillhavetostartpayingCorporationTax.
ThespecialistcharityProSharepublishesahandbookwithsomeusefuladviceonhowtogoaboutstartingaclub;mostexpertsrecommendmembersreadotherguidanceaswelltogetabroadrangeofexpertise.Itisnotvitalanymemberreallyknowsabouttheintricaciesofthestockmarket,butitishandytohavearangeof
knowledgeamongmembersabout,say,engineering,brewing,retailingandsoon.
Itisvitaltogettheorganizationsetuponaformalbasisortherecouldbesomeverypainfulsurprisesandargumentslater.Therearemodelrulesandconstitutionsavailable,whicheveryonehastosign.Thesesetout,amongotherthings,
howpeoplemayjoinandleave,aunitvaluationsystemandhowdecisionsaremade.Awiderangeofotherissuesneedtobeagreed:thelevelofmonthlysubscriptions;whenandwherethemembersmeet;howdecisionsaremade;appointingachair,treasurer,andsecretary;anddecidingonbankers,stockbrokersandaccountants.Youhavealsoto
decidewhethertheclubwillcontinuetoaccumulateaportfolioorwhetheritistohaveafinitelifeof,say,fiveyears,afterwhichtheproceedsaresharedoutamongthemembers.Somehavespecifiedthattherebenorecriminationsifaninvestmentgoeswrong.Also,someformalmechanismhastobesetupfortheholdings.
Theycanbeheldbyonememberonbehalfoftherest(usuallythetreasurer),orbyanomineecompanysetupforthepurpose,orevenbyabank.Severalstockbrokershavepackagesforinvestmentclubs.
Youmightbeinvitedtojoinanexistingclub,inwhichcaseitiswisetocheckthatallthesedecisionshave
alreadybeenmadeandareinaccordwiththesortofthingthatfeelscomfortable.Alsocheckthatthemonthlycontributionisinlinewithwhatyoucanaffordorwouldwanttoputin.
Ifthisroutesoundsfun,therearestillsomebasicconsiderationstopreventtearslater.First,onlygettogetherwithpeopleyoulike
andtrust,andwhoseobjectivesandpreferencesaresimilartoyourown.Ifyoufancytakingapuntonthelatesthigh-technologystart-uporgoingforriskyrecoverystocks,itwouldbeamistaketojoinaclubwhosemembersreckonbuyingintoVodafoneisprettyracy.
Thecriteriaforchoosinginvestmentsvarywidely
amongtheclubsbutmanyoptfortheriskierendofthemarketbecausetheclubparticipationisadditionaltotheinvestmentsmembershavealreadymadeontheirownbehalf.So,theyaregenerallyfairlyreadytogoforAim,technologystocksandthelike.Someevenextendbeyondthestockmarketandinvestinproperty,
directlyorindirectly.Themainadviceoftheexpertsisnottoinvestinanythingyoudonotunderstandandmostprofessionalsstronglysuggestavoidingthecomplexandriskyendofthemarket,likederivatives.
Second,itisnotafreeridewhereyoucanrelaxonthecoat-tailsofmoreexpertandhardworkingmembers.Most
clubsshareouttheworkandmakeitcleartheyexpectpeopletoparticipatebeyondjustputtinginthemonthlymoney,evenfiningthemiftheyturnuplateformeetings.
Mostclubsinvestwellunder£100amonth–acommonfigureisabout£20to£40–sothisisnottheprerogativeofthewealthy.Conversely,itisunlikelythe
proceedswillallowanyonetoretireat30orbuyaCaribbeanisland.Butyouneverknow–theHampshirevillageofWhiteparishhasaclubthatmanageda49percentreturnonitsinvestments(andwontheprizeforbeingthebest),andevensomechildren’sclubshavemanagedreturnsprettyclosetothat.Severalhavebuilt
portfoliosworth£500,000.Onlyafewhavedonesobadlythatmembershavelosttheircash.
Costs
Aswithsomanyotherthings,itismoreexpensiveinBritaintotradeinsharesthaninmanyotherindustrializedcountries.International
comparisonshaveshowncheaperdealingoverseasandfewercomplaintsaboutspeedandinformation.SomeUSbrokersalsoallowsmallinvestorsachancetogetinonthegroundfloorbyparticipatinginaflotation–whattheycalltherean‘initialpublicoffering’,orIPO.
NotthattheUSbrokersthemselvesareuniversally
regardedaskindlyphilanthropists.ThereisanoldclassicbookaboutWallStreet,reprintedregularlyoverthepast40years,whichcommentsonthewealthofbrokers–itiscalledWhereAretheCustomers’Yachts?Competitionandtechnologymaybechangingallthat.
ForalltheloudproclamationsbytheStock
Exchange,smallindividualholdersarestillconsideredanuisance.Smallinvestorsdealinsmallamounts,whichcostjustasmuchtotransactaslargedeals,andtheshareholdersneedelaborateprotectionfromsharksandtheirownfollybecausetheymightsueorgeneratesnidestoriesinthenewspapers,andMPsarelikelytokickupa
self-interestedfuss.However,themarketneedsthesmallinvestorasacounterweighttotheunimaginativeshort-termismofthemajorinstitutionalholders.Privateinvestorsgenerallyalsoprovideamarketforsmallercompaniesthatarenotpracticalinvestmentsformajorfinancehouses.
Brokers’commissionThemaincostofdealingcomesfromthebroker’scommission.Itvariesdependingonthetypeofbroker,theamountofworkbeingdone,andthesizeofthedeal.
Somechargeaslittleas£5minimumfordealing,but
mostbrokerschargearound£12to£15minimumpertransaction,thoughtherearebrokersgoingashighas£20to£25,withacommissiononaslidingscaleabovetheminimum,dependingonthevalueofthetransaction.Anorderof£2,500mightcost1.5percent,withtheratefallingto0.75percentorsometimesevenloweron
majordeals.Theremayalsobeaone-offchargeofatleast£10forjoiningCrest,theStockExchange’selectronicregistryofshareholdings.
Asiteontheinternetcalledwww.fool.co.ukprovidesaguidetochargesofnetandtelephonebrokers.Itisnotcomprehensiveandsometimesmissesanewserviceorspecialoffersfrom
someoftheparticipants.Itisnotunusualforanewentranttobuyabitofmarketsharebyenticinginthepassinginvestorthroughhavinganintroductoryperiodfreeofcharges.Otheronlinecomparisonsitessuggestotheroptionsbutallfurtherinformationneedsexamination.
The spreadThereisalsothecostoftrading.Asanyonewhohasevertriedtosellasecond-handcarknows,thepriceofsomethingisverydifferentdependingonwhetheryouarebuyingorselling.Soitiswithshares,whichisfairenoughbecausethetraderneedstoeataswell.Tomake
surethedealerdoesnotstarve,this‘spread’varieswiththerisk.SoFTSE100companieslikeVodafone,BarclaysBank,BritishAirways,etc,whichhavehugemarketcapitalizations,thousandsofshareholdersandaregularflockofdealseveryday,wouldhavearelativelynarrowspreadofunder1percent,andsomemaydropas
lowas0.03percent;bycontrastatinycompanywithfewshareholdersandlittletradecouldhaveaspreadofaround10percent.
Thismakessmallcompaniesandtheirshareholdersunhappybecauseitcreatesaviciouscircle.Itismuchhardertomakeaprofitfromsmall-companysharesbecausethe
pricehastorisefarmoretooffsetthewidespread.Thatdetersallbutthehardiestoptimists,whichthereforemeansfewertradesintheshares,soreinforcingthewidespread.
Advice andportfoliomanagement
Ifyouuseafinancialadvisertohelppickinvestments,thereisobviouslyachargefortheresearchandfortheexpertiseinsiftingtheresultstoprovidetheadvice.
Somepeoplegetarealbuzzfromorganizingtheirinvestments.Thecombinationofgambler’shunch,rationalanalysis,theprospectofprofit,achancetooutsmart
thehighlypaidprofessionals,andthearcanelanguageoffinancecombinetoproduceafascinatingpursuitforsomepeople.Thatislovelybecauseitcreatesthebestsortofhobby–thesortthatmakesmoney.
Withoutthatconfidence,enthusiasmandtime,onecanstilllookaftertheinvestmentsbutonamore
intermittentbasis.ThesearethepeoplewhoreadtheCitypagesofthenewspapersandkeepuptodatewiththeeconomictrends;theyrevaluetheirinvestmentsreasonablyregularlyandthendecidewhatthebestcoursemightbe.
Aswithadvice,anotheroptionistosubcontractthatworkandgetprofessional
help,notjustwithbuildingbutalsowithmanagingaportfolio.Thoughsomeindependentfinancialadvisersandassetmanagementcompanieswilltakeonportfoliosfrom£25,000upwards,manyofthecompaniesarereluctanttolookatyouwithlessthan£50,000toplaywith.Thefeestructuremeansitwould
probablynotbeworthitiftheydid–andmanymanagersprefermorethan£100,000.Thiscanbedonethroughaformalscheme.Thatbringsadviceandcommentfromthestockbrokerbutstillleavesthefinaldecisiononbuyingandsellingandtheamountstobeputintotheinvestor.
Anotheralternativeis
‘discretionary’management,whichpassesonthepreferencesandcriteria(seeChapters5and6onhowtosortthoseout)tothebroker/manager,whothentakesonthejobofpickingboththestocksandthetiming.Allthiscostsmoneyofcourse–eitheraflatfeeof,say,£1,000ayear,orapercentageoftheportfolio
managed,whichcanbe0.5to1percentdependingonsize.Itgoeswithoutsayingthatyouonlygivethissortofpoweroveryourpersonalfinancestosomeoneyoutrust,buteventhenkeepaneyeonthem:somestockbrokershavebeendisciplinedfor‘churning’–continuouslybuyingandsellingtogenerate
commissionforthemselves.Itisuptotheindividualto
decidewhethertheadvice,informationandmanagementareworththecost.Formostnovicesitmaywellbe,butastheygetmoreexperienced,learnhowtoferretoutfinancialdata,andgetusedtothewayitispresentedinnewspapersandmagazines,manydecidetostrikeout
alone.Eitherway,ifafinancialadviserislookingafterstrategyorportfoliomanagement,docheckfromtimetotimewhethertheinvestmentperformancehasbeenbetterthanaverage,asthatcouldeasilyhavebeenachievedbyinvestinginatrackerfundorexchangetradedfund.Evenifitisbetter,asecondcalculation
shouldshowthattheperformancewassufficientlybettertomorethanoffsetthemanagementfees.
TaxAfterthemarket-makers,stockbrokersandadvisershavetakentheirfees,thegovernmenttakesitsadditionalcutfromour
savingsthroughataxcalledstampdutyreservetaxattherateof0.5percentonthevalueofeverypurchaseinUKequitiesofover£1,000(forUKcompanies,foreigncompanieswithaBritishshareregister,rightsandoptions),eventhoughitwasmadeusingincomethathadalreadybeentaxed.Formoreontaxation,seeChapter12.
ChapterNineHow totrade inshares
Investors shouldunderstand thatwhat is good for thecroupier is not goodfor the customer. Ahyperactive stockmarket is thepickpocket ofenterprise.
WARREN BUFFETT,CHAIRMAN, BERKSHIRE
THATHAWAY
hestockmarketisnotinitsfundamentalsgreatly
differentfromthenewCoventGarden,SmithfieldorBillingsgatemarkets.Whetheryouaredealinginturnips,porkorhaddock,orthesharesofMarks&Spencer,itisjustamatterofbuyers,sellers,anagreed
price,andusuallyamiddleman.Andjustasthefoodmarketsdonotencouragepeopletoambleinandaskforhalfapoundofcarrots,sotheStockExchangeisnervousaboutprivateinvestorspokingintoitselectronicsandthereforerequiresanintermediarytofeedtheinvestor’sinstructionsintothe
computer.InBritainthefirst
recordedjoint-stockcompany(astheywerethencalled)wasfoundedin1553tofinanceanexpeditiontotheOrientviaanorth-eastpassage.TwooftheshipsshelteredfromstormsinnorthernScandinaviaandalltheofficersandcrewfrozetodeath.Thethirdmanagedto
reachArchangelandthenwentoverlandtoMoscow–whichwasasneartotheOrientastheygot–wheretheTsar,IvantheTerrible,agreedatradinglink.Thatseemedgoodenough:thelinkcreatedbusinessconfidence,soothersfollowedthetechniqueforraisingmoney.
Withthegrowingnumberofjoint-stockcompanies
beingcreated,asecondarybusinessarosetotradeholdings.AswithsomanyofLondon’sfinancialinstitutions(Lloyd’sofLondon,theinsurancemarketandtheBalticExchangeareotherexamples),itgrewoutofacoffeehouse,inthiscaseNewJonathan’s.Asbusinessgrew,thetradersmovedintoasuccessionoftheirown
premisesandin1773acquiredthenameofStockExchange.
Ithasnotbeenanuntroubledhistory.OneofthemostnotoriousdisastersistheSouthSeaBubble.Itwasnotuniqueeitherintheshadybackgroundortheunhappyconsequences.
Thereusedtobe20otherexchangesaroundthecountry
buttheywereamalgamatedintotheoneinLondon.Innormaldiscussion,itisthemainmarketorofficiallistofmajorcompaniesthatisbeingconsidered.Thisisdividedupintogroupingsbytrade.Thereisasectionfordistribution,oneforbanks,anotherforbreweries,andthereisthetechnologysector.Inaddition,thereisthe
AlternativeInvestmentMarket,whichisforyoungcompanieswhich,bytheirnature,donothavethetradingrecorddemandedforafulllisting,orforsmallercompanies.ThereisalsotheProfessionalSecuritiesMarketforspecialistsecuritiessuchasconvertibles,debtordepositaryreceipts.Itis
aimedatmarketprofessionalratherthanprivateinvestorsandtheinstrumentsaredenominatedatleastat€50,000.TheSpecialistFundMarketisalsosuggestedbythenameandisforfundsaimedatinstitutional,professionalorknowledgeableinvestors.
How to buy andsell shares
Oneimportantdifferencefromtheworldofmeatandvegisthatinstockmarketsoneisatseveralstagesremovedfromtherealworld.Itisnotjustthatthesharesrepresentaninterestinacompanythatmaybemilesawayorevenoverseas,but
increasinglythereisnotevenascrapofpapertoshowtheownershipofthatinterest,merelyacomputerrecordsomewhere.Andasthetradingbecomesmoreelectronic,withtradingfromone’sdesktopcomputerandwiththepaymentbeingjustanotherelectronicinstructiontotransferfunds,itisincreasinglybecomingmore
ofacomputergame.
Usingintermediaries
Justaswithotherwholesalemarkets,thesmalluserneedsaprofessionaldealertocarryouttheinvestmentorsellorders.Thereisarangeofcompetingfirmsoffering
services,andwhichoneyouusedependsonthetypeofserviceneeded,thoughthelinesbetweenthemareincreasinglyblurred.Mostofthemhavebothtelephoneandonlinetrading,thoughforsometrades–suchasoverseasshares–someinsistontelephonecontactonly.
Itisalwaystrickyfindingtherightprofessionalfirm,
whetherarchitect,dentist,solicitorordoctor,andthatappliestoinvestmentintermediariesaswell.Itisnotjustamatteroffinancialcompetence,butalsooftechnicalefficiency.Therearebig,highstreetfinancialinstitutionssuchasbanksandbuildingsocietieswithbranchesroundthecountryandadvertisementsallover
theplace.Therearealsogoodlocalfirmsexperiencedintheneedsofsmallinvestorsthatcanproduceperformanceequaltoanyofthebiggestnamesinthecountry.Andtherearehostsofcomputer-andtelephone-basedintermediarieswithvaryingspecialisms,costsandservices.Thebestwaytopickthecompanyisthrough
recommendation,preferablyfromsatisfiedcustomers,orasasecondbestfromwrite-upsinnewspapersandmagazines.Withoutseeingthepeople,thebuildings,theorganizationandsoon,itishardtogetafeelforhowreputableorefficientthebrokeris,soaninvestorisdrivenfarmoretorelyingonreputation,recommendation
andnewspaperopinion.Makesurethatthebroker
orintermediaryusedisauthorizedandhencesupervisedbytheCityauthorities.Notonlydoesitprovidereassuranceofsomequalitymonitoring,butprovidesawaytocomplainandseekcompensation.
Warning
‘Phishing’messagesande-mailstryingtoextractpersonalinformationforfraudandidentitythefthavebecomecommonandquitesophisticated–theyoftenlookconvincinglyauthentic.Butaswiththeonespurportingtocomefrombanks,e-mailsfromtheFinancialConductAuthority,theBankofEngland,orthe
Ombudsmanaskingforpersonalinformationormoneyarefakes.Sometimestheyevencreatefalsetelephoneswitchboards.Donotrespondanddonotaccessanyofthelinks.DeletethemandtelephonetheFCAon08001116768orsendane-mail:[email protected]
08000234567;[email protected]
Figure 9.1 Roles of thebodies in the newregulatory architecture
Anuninvitedphonecallfrompeopleyoudonotknowtryingtosellsharesislikely
tobeascam.Theyarefrom‘boilerrooms’–bogusstockbrokers,usuallybasedoverseas(sometimeswithaUKfreepostforwardingaddress).Youwillalmostcertainlyloseallthemoney.Itisnotjustnoviceinvestorswhoaredupedthisway.Mostofthevictimsareexperiencedinvestors,with41percentofvictimshavingbeeninvesting
forover11years.Theaveragelossis£20,000withthebiggestindividuallossrecordedbytheCityofLondonPolicebeing£1.2million.Thescamsnetbetween£200millionand£500millionintheUKeveryyear.Theysometimespromisetorecovermoneylosttotheoriginalboilerroom,ortopurchasethose
worthlessshares(onceanup-frontfeehasbeenpaid).Someoffertobuysharesyouown,usuallyatahigherpricethantheirmarketvalue,andaskforpaymentupfront,asaformofsecurity,whichtheysaywillbereturnedifthesaledoesnotgothrough.Theysometimesdemandsigningaformtopreventdisclosureoftheofferdetails.Some
investorsareencouragedtosellpreviouslyhighlyregardedcompanyshares,suchasbanksandfinancialinstitutionsandtoinvestingreenornewtechnologyshares,oreventotakeoutloanstofundnewinvestments.Thesefraudstersareusuallywellspokenandknowledgeable.Theycanbeverypersistent,phoning
manytimesandevensendingdocumentsorformstocomplete.Itisanadvancefeescam–theytakethemoneyandyouneverhearfromthemagain.Theymayclaimyouhavealreadyenteredintoacontracttobuythesharesandareunderanobligationtopay.ThisisnottrueandsuchcontractsareunenforceableunderUKlaw.Fraudsters
occasionallyhavethegalltothreateninvestorswithpoliceactioniftheyrefusetogoaheadwithaninitiallyagreedtransaction.Thepolicesaythey‘donotandwouldnotactasadebtcollectionagency’.IftheytrythatonetellyourlocalpoliceforceorCityofLondonPolice.–Seehttp://www1.cityoflondon.gov.uk/CityPolice/Departments/ECD/Fraud/boilerroom.htm#sthash.cdL5LacD.dpuf
Generallyitisagainstthe
lawto‘coldcall’tryingtosellinvestments,soauthorizedfirmsdonotcontactyououtoftheblueofferingtobuyorsellshares,buttherehasbeenadramaticincreaseinthefakeuseofnames,registrationnumbersandaddressesofpeopleauthorizedbytheFCA.Theyevencopythewebsitesofauthorizedfirms,making
subtlechangessuchasusingdifferentphonenumbers.CheckontheFCAwebsiteifafirmisauthorized.
Thereisnorecourse,righttocomplainortocompensationintheUK,asboilerroomsarebasedoverseasandsonotauthorizedbytheFCA.Ifyouhavenotinvitedthecall,justhangup.
Seealsowww.fca.org.uk/scams.
Ifyouhavebeencontactedbyanunauthorizedoverseasfirmorsuspectascam,forwardtheinformationtotheFCAorthepoliceastheyaretryingtopursuethecrooks,eventhroughgovernments.Theinitialcontactshouldbeactionfraud.police.ukorby
phone03001232040.Thenthereistheconstant
fearthatonlinetransactionscanbeeavesdroppedbyshadycharacterswhomightuseyourparticularstodealfortheirownprofit,orhackintoyouroryourbroker’scomputerandtamperwithdata.Thereisalwaysthedangerofcomputerfailurestoo.Computersseemtohave
reachedaboutthelevelofdevelopmentandreliabilityofcarsinthelate1920swhendrivershadtoknowaboutmagnetos,drivebeltsanddistributorstocopewiththecontinuousbreakdowns.Thatmeans,justwhenyouneedtodeal,oneofthemachinesmaybehavingitswicktrimmedoritselasticbeingchanged.Also,onlinetrading
doesnotgeneratesharecertificates.Thesharesarestillregisteredtothenewowner,butitisallcomputerizedandgenerallythebrokerwillholdthetitletothemina‘nominee’account,whichisadministrativelytidybutcouldmeantheinvestorcannoteasilychangeallegiancetoanotherbroker.
Aninvestorcanrequestapapercertificate.
Anotherdangeristheseductiveworldofcomputing.Sittingatahomescreenwithaccesstoallthatinformation,itiseasytobelulledintothinkingthedataarecomprehensiveandreliable,andalsointomakingasnapdecision.Italmostfeelslikeagameusing
Monopolymoney,sooneisdrawnintomakinginvestmentsattheclickofamousethatcouldwipeoutthefamily’ssavings.
Tojoinoneofthegrowingbandofonlinestockbrokers,oneneedstogetonthewebsiteandfollowtheinstructionsforregistering.Manyofthemdemandacashaccountfromwhichpayments
canbemade,withalmostallofthemrequiringafloatofcashdepositedwiththebrokerage.Thereisinterestonthis,butgenerallybelowwhatitcouldearnelsewhere.Thesigning-onprocedureasksyoutosetapasswordtopreventotherslookingat,muchlesstamperingwithyourinvestments,andexplainstheminimumlevel
ofsoftwarecapabilityneededtogetintothesystem.
Technicalcompetenceandinfrastructureshowinthespeedandeffectivenessofreactionstotelephonecallsoronlinecontacts.Timingcanbecrucialinatradeandtherehavebeencomplaintsaboutthespeedofreactionandindeedtheabilitytogetanythingdone.In1999a
Jersey-basedinvestorwhohadhiscomputerscreendisplayingsharepricescontactedhistelephonebrokerandsawthevalueofhisholdingshalvewhilethestockbrokerlefthimhangingonlisteningtoarecordedmessagetellinghimallcustomerserviceoperativeswerebusyandhewouldbeconnectedassoonasonewas
free.Hewaskeptonholduntilsomebodycouldbefoundtotalktohim.Sogreatwerehisirritationandfrustrationatwatchingthecontinuingplungeofhisinvestmentsandhisinabilitytosellthathehadafatalheartattack.
Whenpickingabroker,therefore,itisusefultogetrecommendationsfrom
experience,butafewquestionsarestillinorder,suchasservicequality,termsandconditions,includingredresswhenthingsdonotgoaccordingtoplan.
Stockbrokersactforindividualinvestorsbyexecutingtheirordersinthemarket,sothepuntertelephonesthebrokerwhoholdstheagreedaccountor
morecommonlycontactsthefirmontheinternet–andgivestheordertobuyorsell.
Onlineintermediariesusuallydemandinvestorsdepositafloatbigenoughtocoverthedealandifitislargerthantheimmediatepurchasetheydopayinterestonituntilthemoneyisactuallyinvested.Peopleareunderstandablyreluctantto
getinvolvedinanarearifewithunseendangers.Butitischangingrapidly.Customershappytoseeawaiterdisappearwiththeircreditcardfor20minuteswithoutworryingwhetherhewasnippinguptheroadforashoppingspreewerealsopreparedtoreadtheircardnumberouttosomeunknownpersonattheotherendofthe
telephoneforanorder.Thesepeoplearenowincreasinglybuyingbooks,CDs,holidayticketsandthelikeonthenetandrelativelyfewhavebeenrippedoff.
Fromtimetotimetherearetalesofpimplyschoolboysextractingcreditcardnumbersfromonlinetrades,butfewpeoplehavelostmoneyasaconsequence
anditisalotrarerthanhavingyourcarstolenoryourhouseburgled.Thedangerofsomehackergettingintoyourcomputerordealingatyourexpenseisprettyremote.Virusesareahazardbutcanbeavoidedbyhavingacontinuouslyupdatedviruschecker,whichappliestoanyonewhogoesontothenet.
TherearemillionsofonlinestockbrokingaccountsinEuropeandthenumberisgrowing.Manyofthesepeoplehavelittleloyaltytoanybrokerormarket,butwilltradewhereitissafe,cheapandconvenient.
Themoreadventurous,whowanttobuyaUSshare,maywanttogothroughaUSbrokerintheUnitedStates.It
isliabletobecheaperthantheBritishstockbrokers,andcheapereventhantheEuropeanoffshootsoftheUSbrokers.Asitethatcomparestheperformanceofseveralonlinebrokersoncosts,speedofserviceandotherbenefitsincludinghelpingsmallinvestorstogetasubscriptionatthetimeofthefirstlisting,is
www.europeaninvestor.com.Oneofthebigthrillsinthe
UnitedStatesisdaytrading.Thisrequiresspottingthesmallfluctuationsandgettinginandoutofshareswithinoneday.Forallthefashionsandthehype,anddespitethemanybooksexplaininghowtomakeafortunefromthepractice,itlooksasifhardlyanyprivateinvestorhasmade
anymoneyonthesystem.Manyloseheavily.
Allthiscanbeaccessedandorganizedfromanywhere,viatelephonesandcomputers,andsomebrokersarealsointroducingvoice-recognitionsystemstoprovidesharepricesoverthetelephone.Whetherthetradingintermediaryisastockbrokerorindependent
financialadviser,therearethreebasicwaystheserviceisprovided–discretionary,advisoryorexecution-only.
DiscretionaryIneffecttheinvestorishandingovercontroltotheadviser.Itwillstillmeansettingouttheoverallplanorstrategyatthestart,as
discussedinChapter5:thedegreeofrisk,thetimehorizon,thepreferenceforcapitalgrowthorincome,andsoon.Thatmeansaprolongedpreliminarydiscussionsettingoutthoseprioritiesandaims.Oncethebrokerknowswhatyouaretryingtoachievewithyourmoney,theadvicecanbemoresensibleandhelpful.
Afterthat,however,itisalluptotheprofessionaltodecidewhatandwhentobuyandsell.Ithadthereforebetterbesomeonewhoseintegrity,judgementandeffectivenessyoutrust.
Thisapproachhastheadvantageofusinganexperiencedmarketoperatorwithaccesstomoreinformationonacontinuous
basisthanisavailabletoalayinvestor.Italsohasthebenefitofswiftreaction–theadviser/stockbrokercanreactimmediatelytoamarketmovementandnothavetowaituntiltheinvestorhasspotteditorgivesapproval.Needlesstosaythereisaprice:onehastopayforexpertise.
Discretionaryservice
demandsareasonableminimumamountofinitialcashorholdings–thelowestisabout£10,000but£50,000or£100,000ismorecommon,andthemanagementfeeisabout0.5to2percentofthesizeoftheportfolio.Theinvestorhandsovertheportfolioandgivesthebrokertherighttomanageasbestheorshecan,buyingandselling
asseemsright.Onegetsaregularreportofwhattheinvestmentsareandhowmuchtheyareworth,plusnotificationofanydealings.Somebrokerswillalsotakeintothisservicemanagementofbankaccounts,pensionsandeveninsurance.
Independentorrestrictedadvisorsdonotofferdiscretionaryservice.Some
brokermembersoftheWealthManagementAssociationdounderstringentUKandEUregulations.
AdvisoryInvestorswhowanttoretaincontrolovertheportfoliobutwouldstillliketohavetheprofessional’sadvicecanopt
forreceivingsuggestions.Thisworksontheassumptionthatnoteverysuggestionwillleadtoatrade,oritmightbeeasiertohandthewholethingoverandlettheadvisergetonwithit.Atleastitallowsthenovicetolearnthewaymarketparticipantsthinkandthesortofstimulusthatpromptsaction,aswellasgettinginformedopinion.It
couldbeatypeoftuitionprocessontheroadtotakingovertotalcontrolofone’sinvestments.
Anyfirmsuchasastockbrokerofferingadvicehastomeetsuitabilityrulesonthingssuchasriskandcoverageoftheclient.
Thereisobviouslyafeeforthisserviceaswell,thoughitislowerthanforthe
completediscretionaryoperation.
Execution-onlyInvestorswiththeconfidencethattheyknowwhattheywantandhowtofindit,withenoughinformationandtimetowatchthemarkets,cansavethemselvesmoneybygoingitalone.Allthatis
neededthenistogoonthewebsiteorthetelephoneandgiveinstructionsonwhatistobedone.Someofthebrokers/advisersprovidefreeservicestohelp,suchaselementarychartsandportfoliovaluations,aswellassomehighlightsfromstockbrokers’circulars.
Transaction-onlybrokersareavailablewidely,mostly
online.Informationonlow-costbrokersisavailablethroughtablespublishedinmanyofthemoreseriousnewspapersandinvestmentmagazines.
Trading
Normallywhentheinstructionisgiventodeal,thebrokerwilltransact‘at
best’–buyatthelowestavailablepriceandsellatthehighest.Anotheroptionistosetthebrokeralimit–setthemaximumatwhichyouarepreparedtobuyoraminimumpricebelowwhichyouarenotpreparedtosell.Usuallysuchlimitslastforonly24hours,thoughsomebrokersmaybepreparedtoacceptlongerinstructionsof
thissort.Oncethetransactionis
completethebrokersendsacontractnotedetailingthedealandhowmuchmoneyistochangehands.Itmaytakealittletimetoreceivethesharecertificatebutthatisincidentalsinceitisyourpresenceontheshareregisterthatreallydeterminesownershipoftheholding.The
inconveniencescanbecircumventedbyhavingthebrokerkeeptheholdingsina‘nominee’account(seepage139)orbyhavingthemregisteredinCrest,theStockExchange’selectronicregistryofshareholdings.
Stock markets
Wherestockmarketsusedto
haveaphysicalpresencewherepeoplemetandhaggledaboutdeals,electronicshasliberatedthemsothedisseminatedmarketiseverywhereandnowhere.Thisispresentingtheauthoritieswithanincreasinglydifficulttaskinmonitoring,andpresentstheinvestorwithagrowingchallengetomakesurethe
dealisauthentic,thepriceisrightandthesecuritiesreallyarebeingtransferred.
TheLondonmarketoperatesasoftwarecalledSeaqforthesmallestcompanytrades.Forthemajorityofdealingsthemarketusestheretailserviceproviderwhichaccountsfor94%ofretailtrades,therestgoingontoSets(theStock
ExchangeElectronicTradingSystem)usedbyinstitutions.Thisisanorder-matchingsystem,sobuyersandsellersposttheirrequirementsandifpossiblethecomputermatchesthem.Sincethesescreensshownoteventhebroker,muchlesstheinvestor,onlythetwosidestothedealknowtheidentityoftheultimatebuyerandseller.
ThereisalsoSETsqforthelessliquid(ielesstraded)securities.
CompanieshavebeenmovingtoSetsMM,anelectronicsystemthatinvolvesmarket-makers(hencetheMM)divulgingtheirbidandofferprices.TheStockExchangesaysthiscutsspreadsandincreasesthevalueofsharestraded.The
completeddealispassedtoyetanothercomputertoorganizesettlement.TheCrestsystemistryingtoeliminatetheblizzardofpaperbyreplacingsharecertificateswithanelectronicrecordinmuchthesamewaythatone’shoardofgoldandcashhasbeentransformedintoaniteminabank’scomputermemory.Forthe
mistrustfulandLudditeinvestors,sharecertificatesarestillavailable.
Manyoftheexecution-onlybrokerstrytosimplifylifebyputtingtheirinvestors’holdingsintoa‘nomineeaccount’.ThatmeansthesharesareregisteredtoonebrokeraccountintheCrestandthecompanies’shareregisters,whichmakethe
dealsquickerandcheaper.
Other markets
Inadditiontothetraditionalmajorstockexchanges,manyofwhichareamalgamatingacrossboundaries,anewbreedofsmallerexchangeshassprungup,someaffiliatedtothebigones.Retailusersgenerallygetaccesstosome
ofthesemarketsviatheirstockbrokerswhousethemasnecessaryforatrade.
AlternativeInvestment MarketUsuallyknownbyitsinitialsAim,thisisactuallymerelyapartofthestockmarketreservedforsmallerbusinesses.Theideaisthat
eventuallytheymature,growandgraduateontothemainmarket,soitissometimescalledthe‘cadetbranch’ofthestockmarket.Thismeansthatyoungercompanieswithaless-solidorshorterrecordofprofitsareallowedtojoin.ButthecostsforthebusinessofgettingontoAimarealmostashighasforthefulllisting,sothemainattraction
isthelowerhurdleandaccesstothemarketpublicity.AnotherproblemisthatAimshares,likesmallerquotedcompaniesonthemainexchange,goinandoutoffashionwithinstitutionalinvestors.
Thatprovidesanopportunityforthesmallinvestor.Shrewdopportunistswhospottedinternetstocksas
havingagoodfuturewhentheyfirstappearedontheAimmarketmadeamassiveamountofmoney,sincesomesharesrosetenfoldinamatterofdays.Itisnoguaranteethough,becausetheself-sameshareslaterplummetedandsomeofthemuch-toutedbusinessescollapsedaltogether.Butthensmallercompaniesaregenerallymore
vulnerabletoproblems.Companiesquotedonthis‘juniormarket’canalsosufferfromexaggeratedsharepricemovesastheyareoftenentrepreneurialbusinesses,inwhichthefoundersretainalargechunkoftheshares.
Sincethemarketwassetuptoprovideaccesstoyoungandsmallcompanies–importantforadvanced
technologybusinesses–theaimwasforalightersystemofregulation.Butthishasbroughtcriticism,especiallyfromrivaloverseasmarkets,thatAimcompaniesaretoolightlyregulatedandhencelesssafe.
TechmarkWiththegrowingpopularity
ofhigh-techcompanies,theLondonStockExchangelaunchedanindexinitsmarketcalledtechMARK.
Oneaimwastoattractsuchcompanieswhichhadthepotentialofrapidgrowthbutwithoutthetradingrecordtobeeligibleforanormalquotation.Astheliteraturepointsout,buyingsharesinthisareaisconsiderablymore
risky,sincemanyoftheso-calledbusinessesarelittlemorethanabrightidea,andmanyofthemhaveneverseenprofits.
Thecompaniesarealsogroupedintotheusualindustrysectors,whichnowcontainawiderange,includingcomputersandtelecoms.Theiruseforinvestorsistomeasuretheir
exposuretotechnologycompaniesinthesamewaythattheycanusesectorclassificationstomeasureexposuretobanking,engineeringorretailers.
High growthToattractmediumandlargecompanieswiththepromiseoffastglobalgrowth,an
easierroutetothemarkethasbeendevisedfortheoneswhichmaynotmeetthenormaleligibilitytestsforafullmarketquote.TheymustbeintheEuropeanEconomicArea,tradingandwitharecordofgoodgrowth.
EuronextThisistheshareand
derivativesmarketcreatedfromtheamalgamationoftheexchangesinAmsterdam,Brussels,LisbonandParisplustheLondonInternationalFinancialFuturesandOptionsExchange.ItthereforebecamethesecondlargestinEurope,behindLondon.
Eurex
TheGermanDeutscheTerminbörseandtheSwissSoffexcombinedtobecomeEurex,Europe’slargestderivativesexchange.
ISDXAsmallLondon-basedstockmarketwhichboughtanotherofthesmallerstockexchanges,PlusMarket.
TradepointAmidgetrivaltotheLondonStockExchange,Tradepointisacompletelyautomatedelectronicorderbookmarketstartedin1995,whichcuriouslyenoughisitselfquotedontheAimpartofthemainStockExchange.Thebusinessis54percentownedbyaconsortiumofbanks
includingtheUSmerchantbanksGoldmanSachsandMorganStanleyDeanWitter.IthasformedanalliancewiththeSwissexchangeSWXtocreateanewexchangecalledVirt-X,regulatedbytheLondonauthorities,inwhichtheSwisshavea38percentstake.
InadditiontotradinginthenormalUKquotedstocks
(thoughithasonlyabout1percentofthetotaltrade),ithassetupclearanceandregistrysystemstoallowtradinginEurotop,the300largestcompaniesinEurope.
NasdaqNasdaqistheacronymfortheNationalAssociationofSecuritiesDealersAutomated
Quotationsystem.ItissecondonlytotheNewYorkStockExchange(oftencalledtheBigBoard)asthelargeststockmarketintheUnitedStatesandisoneofthefourbigonesintheworld.Asithaskeptcostsofentryandadministrativedemandscomparativelylow,manyyoungcompanies,especiallyintechnology,haveoptedto
bequotedthere,includinginternetcompaniesliketheAmazonbookshop.Some,likeMicrosoft,DellandIntel,stayedtheredespitetheirsubsequentgrowth.
Ithascounteredthethreatoftheinternet-basedsharetradingsystemsbyforgingallianceswithsomeofthem.Thereisagrowingnumberofsuchschemes,includingones
runbyBloomberg,ReutersandMarketXT.Thecomputer-basedsystemscanpostquotesandexecutetradesonNasdaqIntermarket,includinginsharesquotedontheNewYorkStockExchange.
TheoperationhasopenedaTokyomarket,hasaLondonofficeandisorganizingapan-European
operation,whichshouldmakeitaglobalexchangewithapermanentandcontinuoustradingsystem.
Nasdaq OMXEuropeEasdaqhasusedtheprinciplesandthesoftwarefromNasdaqtostartaParis-basedoperationbutwith
markedlylesssuccess.
Chi-XChi-XstartedoperatinginMarch2007,backedbyJapaneseinvestmentbankNomura.Theventureclaimstoofferasystem10timesquickerand10timescheaperthanexistingtradingsystemsandallowsinvestorstodeal
inEuropeanstocks.
BATS EuropeThiswasfoundedoutoftheUnitedStates-basedtradingsystemBATS,markingitsmoveintotheEuropeanequitiesmarket.Itwentliveinlate2008.
NYSE Arca Europe
Thisisanotherpan-Europeantradingfacility,whichisfullyintegratedintotheNYSEEuronextsystems.ItisregulatedbytheDutchregulatorAutoriteitFinanciëleMarkten.
Other routesElectronictradingexchangesmayemerge.Theinternetis
continuouslyprovidingnewopportunities.TwomarketfacilitiesalreadyrunningarecalledPositandInstinet,whichareprincipallyforinstitutionalinvestors,butothersarepromisedorattrialstages.
Thereisalsotalkofdisintermediation(cuttingoutthemiddleman)bycompaniesraisingcapital.Raising
moneybyapublicissueofsharesisacostlybusinessforacompany,notleastintheenormousfeestoaccountants,lawyers,stockbrokersandmerchantbanks.Itwouldbeattractiveifallthiscouldbebypassedbymakingthesharesavailableoverthenet.Smallinvestorsfortheirpartseldomgettheirhandsonnewissuesbecausetheyare
snappedupbeforetheygetthere,ormoreoftencompaniesoptforthecheaperrouteofplacingtheissuewithinstitutions.Itcouldbedodgyforthesmallerinvestor,however,sincetherewillbelessassurancethattheprofessionalshavecrawledoverthebusinesstocheckitsfigures,managersandpromises,anditisdifficultto
tellfromthepuffappearingonthescreenwhetheracompanyevenexistsasdescribed,muchlesswhetheritsmanagersarecompetentandhonest.
Chapter TenWhen todeal inshares
Never be afraid ofmissing the boat – itmay turn out to bethe Titanic.
ELLIOT JANEWAY
The early birdcatches the worm,but the secondmouse gets the
cheese.STOCK MARKET ADAGE
A businessman issomeone who buysat ten and is happyto get out at twelve.The other kind ofman buys at ten,sees it rise to
eighteen and doesnothing. He iswaiting for it to riseto twenty. When itdrops to two hewaits for it to getback to ten.
V S NAIPAUL, A BEND INTHE RIVER
heobviousansweron‘when’
Tquestionsistobuywhentheyarecheapandsell
whentheyaredear.Predictably,thereareproblemsinvolved,includingdecidinghowyoudefinecheap,findingthestockthatischeapanddecidingwhetheritischeaporjustapoorbet.Soimportantisthisaspectthatexperiencedinvestorswilltellyouitis
moreimportanttojudgewhentobuythanwhattobuy.
Oneproblemwiththestockmarketistheherdinstinctthatdrivesithitherandyononsuperstition,greed,fashionanduncertainty.Sowhenthemarketisrisingeverybodypilesinbecausetheyfearbeingleftoutwhenthereare
profitstobemade.Theyareconvincedthattrendswillcontinue,sonomatterwhathashappenedsofar,sharesarecheapbecausetheywillprobablygofarhigher.Inthereversephase,investorsprivateandinstitutionalsellshareswhich,onmostcriteria,wouldbereckonedcheap,becausetheyexpectthemtogoonplunging
further.In1710to1720aseriesof
‘bubble’companiesburstontothestockmarket,ofwhichtheSouthSeaCompany(actuallythefullandsplendidlyrollingnameoftheenterprisewasTheGovernorandCompanyofMerchantsofGreatBritainTradingtotheSouthSeasandOtherPartsofAmericaand
forEncouragingFishery)wasmerelythemostnotorious.Itsshareswereissuedat£100andstarted1720at£12810s0d.ByAugusttheyhadreached£1,050butfinishedtheyearbackat£124beforethecompanycollapsed.Theboomwasgeneratedbymadenthusiasmoveracompanythattookoverthenationaldebtinreturnforhavinga
monopolyoftradeinthePacific.Thenpeoplerealizedthecompanywasmorepreoccupiedwithrampingitssharesandprovidingdirectorswithagoodlifethanwithanybusiness.Thatcausedthebubbleandthecompanytoburstandtheshockwavessentotherstoppling,asbanks,shopsandindividualswentbustasaresult.
Inthe1830sitwasrailwaymania,withanycompanyevenvaguelyconnectedwithtrainsbeingrelentlesslypursuedbyinvestorswantingtoputyetmoremoneyintoit.Morerecentlywehavehadotherenthusiasms.Atonetimebeingincomputerswasalltherageandanythingtodowithelectronicssawitssharesknocktheroofoff.The
internetgrabbedtheimaginationtoproduceeye-wateringsharepricerises.Latertheenthusiasmmovedontobiotechnologywhenmiracledrugs,‘silverbullets’andpanaceaswerereckonedimminent.
Youcanrecognizeabullmarketreachingitspeakbytheunanimityofopinionthathappydaysarehereagain.
Eventhetabloidsstarttalkingaboutthestockmarket;therearepictureseverywhereofchampagne-swillingyoungdealers;seriouseconomistssayingthistimeitisdifferent;peoplewhowouldnotnormallyknowabalancesheetfromabedsheetstartbuyingshares;andthesharesthemselvesareonabsurdlyhighprice/earningsratiosand
lowyields.Asignthemarketisprettywellatthebottomiswhensharepriceshavebeendiscountedfordoomsday–priceshaveallowedformoremassiveslumpsthanitisrationaltoexpect.Infactthesharepriceshaveanticipatedsomuchbadnewsthattheynolongerreacttoitwhenitcomes.Ontheotherhand,thepricedoesstarttostirandrise
abitwheneventheslightestglimmerofgoodnewscomesalong.Thatisthetimetostarthuntingforgoodvalue.
Theturnhappensinoneoftwoways.Thereiseitherasuddentriggerlikeahugeandswifthikeinthepriceofoil,bankssuddenlyrealizingtheyhavebeenlendingmoneyonfresh-airsecurity,orjustalassitudewhennothingseems
quiteright.Thesharesfailtorespondtogoodnews,butrelapseateverysignofadversenews.Thatiswhentostopbuying,attheveryleast.Similarlyatdownturnsinstitutionsandprivateinvestorspreparefortheendofcapitalismasweknowit.Thebottomisnighwheneverybodyagreestheeconomyisslidingandwill
staylowforatleasttwoyears.
Tobefairthereisalsoinpartarationalreasonforallthis:duringboomspeoplehavehigherdisposableincomebothfordirectinvestmentandforpensionsandinsurance(withthosecompaniesthenchannellingpartofthecashintothemarket),whileduringa
recessionthereisunemployment,negativeequityinone’shomeandanabsenceofpayrises.
Whenthemarkethasbeenslidingforsometimethecarefulinvestorwillstarttocheckwhetherthebottomcanbeinsight.Youhavetofacethefactthatyouareveryunlikelytobuyattheabsolutebottomortosellatthevery
top.Ifyoumanageeither,nevermindboth,admitittobeapurefluke.Sotherearetwopossibletimings:whenit(themarket,thesector,theindividualshare)isstillheadingdownbutonehasareasonablefeelingtherecannotbemuchfurthertogo;andwhenpriceshavejusttentativelystartedcomingoffthebottom.Getthetiming
wronginadownturnandthepriceswillcontinuetotumble,andittakesahardysoulwithagambler’sinstincttogoinfor‘poundcostaveraging’–puttingthesameamountinagainasthepricefallstogetevenmoreshares.
Thatsortofthinkingappliestothemarketasawholeandalsotoindividualshares.Averysuccessful
largecompanyintowhicheveryonehasputtheirpensionmoneyforyears,suddenlystumbles.Itmakesafewmistakes,losessomeorders,miscalculatesthemarketorwhatever,andissuesaprofitwarning.Thedisillusionhitstheprofessionalssobadlythattheyabandonthefallenstarindroves.Thoughsmall
companiesdieindozensandtheoccasionalmiddle-rankcompanysuccumbs,itisfairlyrareforamajorcommercialundertakingtogobellyup.TherehavebeentheLeylands,PollyPecksandthelikeovertheyears,butthatisstillprettyunusual,andmassivecollapsessuchasthe2008foldingofLehmanBrothers,oneofWallStreet’s
largestbanks,arethankfullyrarerstill.Butasthatshockwave-causingfallshowed,theycanstillhappen.Eveniftheboardcannotimmediatelyretrieveitsmistakes,bringinnewmanagersorjustgetbackonitsoldtrack,thereisagoodchancesomebodywillbewaitingtosnapupthebusinessinatakeover.
Atthesimplestlevel,muchoftheinvestor’saimcanbeachievedbybeingjustcounter-cyclical:seewhichwaytheherdgoesandheadtheotherway.Ontheotherhand,ittakesstrongnervestobuyinabearmarketwhengloomanddespondencysuggestshareswillplungefurtherandcompanieswilltoppleoverbythescore.It
alsotakessternself-disciplinetotakeprofitsinaroaringbullmarketknowingsharesmaywellrisefurtherandoneisthereforeforgoingsomeoftheextraprofit.Thereis,however,anoldstockmarketadageforsuchdealing:alwaysleavesomeprofitfortheotherfellow.
Likeallothercontrarianviewsittakescautionand
care.Thepeoplewhospecializeinthissortofinvestmentnormallywaituntilthefirstandsecondtumbleshaveworkedthroughthemarketandthesharepriceisbumpingalongasteadylow,beforestartingtobuy.
Therearetwosetsoftimingstoconsider.Oneconcernsthemarketasawhole,andthesecondisfor
theindividualsharethathasalreadybeenidentified(bythedecisionsdiscussedinChapter5).Amongthefactorsaffectingthemarketasawholeare:
thegeneraleconomiccycle(andthatcouldbeanythingfromarecoverytoaslowinginanticipationofa
recession);thelevelofinflation;interestrates,sincetheyaffectconsumerdemandaswellasthecostsofbusinessandhenceitsprofitability;taxlevelsandthechanges;therelativestrengthofthecurrency,sincethataffectsthecostsof
importsandthecompetitivenessofexporters;thepoliticalsituation,includingtheproximityofelectionsandwhoislikelytowin.
Thereareotherinfluencesaswell.Forinstance,theLondonstockmarketreactsinsympathywithUSstock
markets.Thisprovidesthebackgroundforlookingatandtryingtoextractinformationfromrecentpricemovements,andsetsthecontextforexaminingindividualcompanies.
Attheendofthe19thcenturyCharlesHDow,whohelpedstarttheDowJonesIndexfortheWallStreetStockExchangeaswellas
foundtheWallStreetJournal,detectedapatterninsharepricemovements.Hereckonedthesefollowedaregularenoughprogressiontobeabletoforecastwherethepricewillgonext.
TheDowTheorysaystherearegreatlong-termpatterns,called‘primarytrends’,whichcreatethebullorbearmarketsthatcan
dominateaneconomyforseveralyears.Withinthatthereareshorter-termfluctuationsthatgoagainsttheoveralltrend,reinforceit,orpredictitsturn,andthesehecalled‘secondaryreactions’.Finally,therearethedailyoscillationsthatarecalled,predictablyenough,‘tertiarypatterns’.
TheaccountantRalph
Elliottworkedonagranderscale.Hetalkedof‘supercycles’lasting150to200yearswithinwhichthereareshorterfluctuations.Therearemanybooksonsuchtopics,buttheyareprobablyatouchspecializedforanamateurinvestor.
Withinthesegrandeconomiccyclesarepricemovementsofthemarketand
ofindividualshares,andifthetrendorpatterncanbespottedintimethereisanopportunityforprofit.Thisistheprovinceofthetechnicalanalystwhoreliesprincipallyonchartsofmarketchanges.Atthemostbloodthirstythesepeopleassertitisnotnecessarytoknoweventhenameoftheunderlyinginstrument,whetheritisa
share,acurrencyoracommodity,becauseeverythingisintheprice.Moreparticularly,thepriceissetbymarketpsychologyand,sincehumanbehaviourisfairlyconstant,thepatterncanbeextrapolated.Thetrickisthereforetodetectpatternsintimeandthenactonthem.Thatrequirescharts,usuallyofpricemovements.
Chartsrepresentoneofthetwomainwaysofassessingashare.Theotherisfundamentalanalysis–thestudyofthecompanyanditsaccounts,themarketsinwhichitoperates,andthequalityofitsmanagement(seeChapter6).
Theaimofalltheseistoreinforceothercriteriaforchoosingashareoratimefor
buying,andnottousetheminisolation.Thatappliesalsotodifferenttypesofchart.Checkingtoseehowthepriceofacompany’ssharemovesinrelationtothemarketasawholeissometimesanindicationtohelpwiththedecisions.Shareswithawildlyfluctuatingrelativestrengtharelikelytobeunpredictableperformersand
soamoreriskyinvestment.Ontheotherhand,ifthecompanyhasforsometimebeensagging,withthesharesconsistentlyunderperformingthemarketasawhole,anditsrelativestrengthstartsimproving,thismightunderlinethedecisiontobuythatwaspromptedbyothersignals.Thesemaybebetteratgivingaddedinformation
aboutindividualsharesthanaboutthemarketasawhole.
WilliamDGann,amathematicianandsuccessfultraderinsharesandcommodities,producedavariantofthis,concentratingmoreonsupportandresistancelevelsandthespeedofpricechange,buttheexplanationiswellnighincomprehensibletoanyone
withlessmathematicalexpertise.ItslinktoChinesehoroscopeshasprovokedsometradersintodismissingitasmumbo-jumbo.
Thepatternsinsharepricescanbeexplainedbypsychologicaldescriptionsofthewaypeoplebehave,andtheseseemquiteplausible,butnottotheacademicswhohaveusedmathematical
analysistoproducethe‘randomwalk’theory.Thissaysthepricesmovetotallyunpredictablyandchartingthetossingofacoinwouldproducesimilarpatterns.Inaddition,theefficientmarkethypothesissaysinformationissoswiftlyanduniformlydisseminatedthatnobodycangetanadvantagetooutperformthemarket.That,
however,ignoresthetimefactor,andtheobviousfactthatsomepeopledoverynicelyindeed,thankyou.
Itisnotquiteasstraightforwardasabriefexplanationmakesitsound.Eveniftherandomwalktheoryandefficientmarkethypothesisaredismissedasbeingnotuniversallyapplicable,thereareproblems
withcharts.Forastarttheyrequireexpertinterpretationofshapesthatareseldomassimpleandobviousastheillustrationsinbooks.Justwhendoesafluctuationindicateaturnandwhenisitmerelyatemporarycorrection?Evenwithotherfinancialknowledgetotesttheplausibilityofanindicator,andevenwith
extensiveexperienceinterpretingcharts,thechancesofmakingamistakearehigh.Thatmeansmakingafalliblesubjectivejudgementaboutadevelopingpattern,andsomepeoplearebetteratthisthanothers.Falsesignalsandeasilymisinterpretedpatternscouldleadaninvestorintopenury.
Forinstance,onetaskisto
assesswhetherthecurrenttrendislikelytocontinue–ifyouareinaboommarket,willtheeuphoriacontinuelongenoughtobuythesharesandreapthebenefits,andifitisasoggybearmarket,canyoupredictwhenitislikelytoturnupagain?Thisismadealltheharderbytheshort-termfluctuationswithinthelonger-termmovements
or,asthedistinguishedeconomistSirAlecCairncrossputit:
Atrend(tousethelanguageofGertrudeStein)isatrendisatrend.Butthequestionis:willitbend?Willitalteritscourse,Throughsomeunforeseenforce,Andcometoaprematureend?
Thesecondproblemisthatifchartswerereallyhelpfuland
accessible,theywouldgetwidelyadopted,otherinvestorswouldrelyonthedevelopingpatternandtheself-fulfillingprophecieswouldrunawaybeforetheamateurcouldgetinvolved.Therewouldalsoberepeatedattemptstospotthedirectionofdevelopmentbeforeitwascomplete,whichwoulddistorttheshapesandcause
confusion.Professionalsdonotrely
onchartsasthetriggerorguidance,butusethemasanadjuncttootherinvestmentcriteria.Whatthisallboilsdowntoistryingtogetadditionalhelpontiming.Thatmeanstimingnotjustfortheindividualcompanybutforthesectorandthemarketasawhole.That
applieswithequalforceonwhentobuyorsell.Ameasureofhowwell-pricedthesharesareistheyieldgap.Thatisthedifferencebetweentheyieldonordinarysharesandthereturntomaturityofgilts.
Charts
Chartsareausefuladjunctfor
theprivateinvestorbecauseforoncethereisparitywiththeprofessionals.Bothhaveaccesstothesameinformationanditistheskillininterpretingthedatathatmakesthedifference.Butjustasthereareswarmsofpeoplewiththeirownpettheoriesonhowtopickthewinners,sotherearefanaticalchartistslookingforthephilosopher’s
stone.Theirgreatestvalueistofocusthemindonthefactthatinamarketthecorrectpriceiswhatsomebodyispreparedtopay,sochartsdoprovideabitofdisciplineforprivateinvestorsbymakingthemconcentrateonsupplyanddemand,priceandtiming.
Lines
Forsuccessfulpredictionsyouhavetobeabletorecognizethepatternsthatanyoftheselinesfollow;seeFigure10.1.Therearetheoveralltrendsforinstance–up,downorsideways–detectablebyjoiningthepeaksandtroughs(orbartips)ofthefluctuatinglinesofprices.Inasidewaysmarket,whentheprice
oscillatesbetweentwohorizontallines,awisechartistwaitsfora‘breakout’signalwhenthepricefinallyshowswhichwaythemarketisnowgoingtogo.
Figure 10.1 Lines
Oneanswerisnottoworryiftheshareistakingafavourablelong-termpath.Forinstance,takeacompanywithsharesthatarenotoriouslyvolatile–itmaylooklikeasidewaysmovementbutthetwotrendlinesarealongwayapart.Thepricebouncesupanddownonrumourandgloom,
orprofit-takingandbargain-hunting,withoutanyobviouslong-termdirection.Foranalertinvestor,thatcanprovideanicelittleearner.Justexaminewhenandbyhowmuchittendstooscillateandkeephoppinginatthebottomandoutatthetop.Thisissaferinlargishcompanies,whichalsomeansthegainswillnotbe
enormous,sothedealshavetobelargeenoughtooffsetdealingcosts.
Thechartpatternshavegraphicnamestohelp.A‘supportarea’canbedetectedbythepricedroppingtobutconstantlyreboundingfromaspecificpricelevel,andthereisanupwardequivalentcalleda‘resistancelevel’.Ifthemarketbreaksthroughthe
establishedresistancelevel,chartistsreckonthepricewillrisesubstantiallytoanewhigh,andsimilarlyinreverseforbreakingthroughasupportlevel.
Therearealso‘doubletops’,whichasyouwouldexpecthavetwinpeaksandindicateanimminentdrop,witha‘doublebottom’beingtheupside-downequivalent,
A‘headandshoulders’isapeakflankedbytwosmallerpeaksandindicatesthereversalofanupwardtrend,signallinganimminentfall.Understandably,a‘reversedheadandshoulders’isthesamethingupsidedown,forecastingarise.
‘Flags’areparallelogramswithamastdownatleastonesidewhenasharpchangeis
followedbyasidewaysfluctuationwithinanarrowrange.Iftheflagisprecededbyariseitisusuallyfollowedbyanotherrise,andafallisfollowedbyafurtherfall.
‘Triangles’areprettyself-explanatory.Thesharepriceoscillatesthroughasteadilysmallerrange.Whenitfinallybreaksoutofthepattern,thedirectionissaidtobean
indicatorofthewayitwillmoveforatime.
Ifasharehasbeenwobblingalongforalongtimebetweentwoconstantlimits,itissaidtobeina‘channel’andonceagain,breakingoutofitisnormallyanindicationofthenewdirectionthepriceisnowlikelytotake.
Whenashortmoving
average,suchasarollingaverageof20dayscrossesalongermovingaverageof,say,50daysupwards,itiscalleda‘goldencross’.Itpromisesabigpriceriseandisanevenstrongerindicationifthetwomovingaverageshavebeenmovinginparallel,asitindicatesareappraisalbythemarket.Ifthelinecrossesdownwardsitiscalleda
‘deadcross’andpresagesagloomyoutlook.
Awealthofotherpatternscanbedetectedbythepractisedandimaginativechartistandtheyallprovidesomesignalaboutthefuturedirectionofprices.
Bar chartsBarchartshaveverticallines
withthetopindicatingthehighestpricetradedatduringtheday,andthebottomrepresentingthelowestprice;seeFigures10.2and10.3.Theclosingpriceisshownbyashorthorizontalledgeontheright,andtheopeningpriceontheleft.Iftheleftopeningpriceislowerthantheclose,theverticalbarisblack(sometimesblue).Ared
barsignalsthestockhasgonedown.
Figure 10.2 Bar chart
Figure 10.3 Bar chart
Point and figurePointandfigurecharts,asshowninFigures10.4to10.6,selectanappropriateamountofpricechangethatisworthrecording,say5p.
Figure 10.4 Point andfigure chart
Figure 10.5 Point andfigure chart
Figure 10.6 Point andfigure chart
Ifthesharerisesbythat,thechartshowsanx;anotherriseofthatamountandanotherxisstackedabovethefirstandsoonuntilthepricechangesdirection.Thenthechartistmovestothenextcolumnandonesquaredownfromthelineofcrossesputsano.Ifitdropsanother5ptherewillbeanothero
beneaththatandsoon.Areversalstartsanewlineonesquareupwithanx.Thechartignorestime,thoughchartistsusuallyputthenumberofthemonthofanewstackatthetopandbottom–1forJanuary,2forFebruary,etc–andusuallystartanewyearwithanewstack.
CandlesticksAnothertypeofchartthathasgainedinterestinrecentyearsisthe‘candlestick’(previouslyknownasthemorestraightforward‘barchart’).ItismucholderthanDow’stheories,havingbeenusedbyJapanesericetradersforcenturies,butworksonthesameassumptions:price
changesmoveinpatternsthatrecurandhencearepredictable.Despiteasmallbutdevotedfollowingamongsomeprofessionals,includingcurrencytraders,thisiswidelyignoredbypeoplediscussinginvestment.
Figure 10.7 Candlestickchart
Figure 10.8 Candlestickchart
Figure 10.9 Candlestickchart
Thechartshowsforeachdaytheopeningandclosingprices,aswellasthehighestandlowestpricesreachedduringtheday(seeFigures10.7to10.9).JustastheOccidentalchartshavenamesforregularorsignificantpatterns,sodoesthis,butwithanOrientaltwist.Therearethingscalled‘threeblack
crows’and‘threeadvancingsoldiers’,‘shootingstars’,‘morningstars’and‘eveningstars’,‘hangingman’,‘hammers’,andsoon.Thesechartsshowhowtradingwent.So,forinstance,ifthereisalotofwickabovethecandletheremusthavebeenarallyduringthedaythatfailedtoholdandwillhavediscouragedtraders.
Converselyalengthofwickdanglingoutofthebottom(calledthe‘hammer’)showsthatanabundanceofsellersthreatenedtopushthemarketdownbutthereweremorethanenoughbuyerstooffsetthem,sothemarketbouncedoffthebottom,whichgivespromiseoffurtherrises.
Thewickofeachcandlerunsfromthelowtothehigh
thatwasreached.Thewiderbodyofthecandleisbetweentheopeningandclosingprices–iftheclosingpriceislowerthantheopeningthecandleisblack;ifhigheritiswhite(theoriginalJapaneseversionusedredforthese).
Technical tools
Noneofthesechartsneedsbe
usedonitsown.Awealthofadditionalinformationonthechartwilladdalevelofperspectiveorevenexplanation.Forinstance,addingthemovementofanindex–whethertheFTSE100,theAllShareorthesectorofthatcompany–canshowwhetheritismovingwiththemarket.Ifitisnot,thatmayprompt
furtherresearch.Itisalsopossibletoseetherateofchangeofapriceovertheselectedtimespan.
Transformingthechartlinetoamovingaveragecansmoothoutthedailyfluctuations.Makingitaweightedaveragegivesgreaterweighttomorerecentpricemovements,andmakingitanexponentialweighting
addsgreatersophistication.Thatsortoftoolhelpsspotatrendorachangeinone.
Ifyoucanfindawebsitethatalsoprovidesannotationstothecharts,thatwouldgiveyetanotherinsightintowhatishappeningandwhy.Themostusualtypeofnotesincludedealingsinthecompany’ssharesbyitsowndirectors,andnewspaperor
stockbrokercommentsonthecompany.
Therelativestrengthindexmeasuresthelevelofasharepricerelativetoitselfanditsrecenthistory.Itiscalculatedastheaverageofpricesfordayswhenthepricerose,dividedbytheaverageofthepricesfordayswhenthepricefell.Theindexrangesbetween0and100.
MomentumRecentpricechangesshowthesentimentofthemarket,sotheassumption–justifiedbysomeresearch–isthatwhatevercausedthemtomoveinonedirectionwillcontinuetodosoforatleastalittlelonger.Itisnotinvariablyasoundinvestmentpolicy,notjustbecausethe
marketisnotoriouslyfickle,butbecauseitrequirescontinuouslyactivetradingatalevelwhereanyprofitsmaybeunderminedbycostsandtax.
Forthoseinterestedinthesuggestion,astochasticoscillatorcanbeusedthatshowsthelocationofthelatestclosingpricerelativetothehigh/lowpricerangeover
asetnumberofperiods.Itismadeupoftwolinesthatoscillatebetweenaverticalscaleof0to100:oneisthemainlineandtheotherisitsmovingaverage.Faststochasticistheaverageofthelastthreevalues,andslowstochastichasaspecifiedperiod.
Sentimentindicators
Technicalanalysisisnotjustaboutcharts.Therearehostsofotherindicatorsprovidingadditionaloralternativepointerstomarketmovementsandhencetipsonwhentotrade.Someofthemworkonindicationsofgeneralsentimentinthe
market.Oneofthedifficultieswithanyoftheseguides,ofcourse,isthatassoonastheybecomegenerallyknowntheyfailtoprovidereliablesignals.
Anexampleisthe‘small-lotindicator’(smalltradesinshares)asausefulcounter-indicatorintheUnitedStates.Thisworksontheassumptionthatsmallinvestorsare
almostinvariablywrong.Theybuyatthetopandsellatthebottom,sotheyprovideagoodcounter-indicator.Thishasbeengraduallyextendedasitbecameclearitwasnotjusttheamateurswhogotcarriedawaybytheprevailingorfashionableeconomicview:itbecameslightlytransformedtothefeelingthatauniversally
bearishattitudeinthecountryasawholeisasignofanupturnandrampantbullishnessisasigntosell.Somecompanieseventabulatethenumberofinvestmentadvisersthatarebullishorbearishasasigntogotheotherwaywhenunanimityseemsimminent.Inotherwords,whenthesmallbuyersstartpilinginit
istimetosell,andviceversa.Wordgotaroundandsomanypeoplestartedactingonthetheorythatitbecameaself-defeatingprophecyandconfusionseemstohaveburiedit.
Theflowoffundsindicatorsshowdemandforsecuritiesandwherepeopleareheadingtoputtheircash.Sometimestheintensityof
feelingaboutacompanycanbegaugedbythevolumeofsharestraded,especiallyifachartcanshowwhetherthetotalisup,downorunchanged.Thecombinationofpriceandvolumemovementsgivesaprettygoodindicationofoverallattitudes:
ifpricesandtheamounts
ofsharestradedarebothrisingitisanindicationthatthemarketfortheshareissettorise;arisingpricebutadecliningvolumeofsharestradedisaworryingtrendindicatingthepriceriseisrunningoutofsteam,andastheupwardmovementslowstoa
haltthedirectionislikelytoreverseandthepricewillsoonstarttofall;afallingpricecoupledwithrisingvolumeshowsinvestorsheadingfortheexitingrowingnumbers,whichcanonlyreinforceandacceleratethefallingprice;thepriceandvolumeof
sharestradedbothfallingshowsinvestorsbeginningtohavesecondthoughtsaboutsellingandthedownwardpressureisthereforeeasing;soonitwillbottomoutandstartupwards.
Other indicators
Therearemanyothersystemsattemptingtopredictmarketmovements.Likeanyotheractivityinareasdominatedbyluckandtheunpredictable,likefishingandactingforinstance,thereisquitelotofsuperstitioninvolved.Peoplearereadytograspatanyapparentcorrelation,nomatterhowdubious.
Sothereisonetheorythat
sunnyweatherproducesoptimisminpeoplegenerallythatisreflectedinprices,andanotherviewhasitthatthemarketindexmovesupanddownwithskirthemlines.Anotheroldadagewas‘sellinMayandgoawayuntilStLeger’sDay’ontheassumptionthateverybodywentawayforthesummerandreturnedforthepopular
horseracethatmarkedtheendofthesummerlull–henceintheabsenceoftrade,activitywaslistlessandrandom.Infactanyinvestigationshowsthesayingtohavebeenunjustifiedwhencoinedandbecominglessreliablesince.
Finally,bewaryofbuyingonatiporrumour.Itismostunlikelyyouwillbethefirst
tohearit,evenifitistrue,andthereisaverygoodchanceitisunjustifiedgossipora‘ramp’–somebodystartingastorytoshoveupthepriceofsharesheorshewantstosell.Ontheotherhand,ifitreallyistrueandtheinformationcomesfromsomeoneontheinside,actingonitcouldlandyouinjailforinsidertrading.
Oneviewholdsthatshareselectionisforthelongterm,sothereislittlepointinreactingtoeverywhimofstockmarketfashion.Youboughtforthelongterm,soholdontotheshares–anapparentlysensibleapproachthatcanprovideausefuloverallguidebutignorestherealitiesoflife.Forinstance,theassumptionthatdictated
theoriginaldecisionmaynolongerapply–thecompany,theeconomyortheportfoliomayhavechanged.Soitisworthreviewingthedecisionfromtimetotime.
Someoftheguidestoinvestmentwillsayfatuousthingslike‘sellyourworstsharesearly’.Butifitwereeasytotellwhichtheworstshareswere,onewouldnot
bereadingabook–justbecauseasharehasdroppedandanotherrisendoesnotmeantheywillcontinueinthesamedirection,aslotsofpricechartswillclearlyshow.Someoldmarkethandsarealwaysagainstbuyingaplungingshareinthehopeofrecovery–‘themarketistryingtotellyousomething’theysay.Butif,forinstance,
asharegoesfrom23pto£12.40inthespaceof18monthsandthendropsbackto60pinthenextsixmonths,whendidthemarketgetitright?
Sotherearenoobviousanswers.Anybodyclaimingtohaveasimpleexplanationisafooloraliar.Ifitwerethateasyeverybodywouldhavedoneitlongago.
Therearesophisticatedmathematicalmodellingtheoriesaboutwhatyoushoulddo.Theyareinteresting,somehavebeenprogrammedintocomputers,butnoneofthemcanbejustifiedonanylogicalbasis.Onesuggestssellingsharesaftertheyhavefallen8percent;anothersayssellwhentheyhavedropped7percent
belowthetoppricereached.
Selling
Itisneverwrongtotakeaprofitisoneoftheancientrulesofstockmarketinvestment.Yes,thesharepricemaygoonzoomingupstillfurther,butyourprofitissafe.Onealternativewhenwinningistohedgeyourbets
bysellingpartoftheholdingtorecovertheoriginalinvestmentplusabitofprofit,andlettherestridejustincasethereisfurthergrowthleft.Anotherofthehallowedsayingsofthemarketcomestomuchthesamething:‘Leavesomeprofitfortheotherchap.’Thisisdeeplyreassuringstuff,anditeasestheirritationofsellingwhen
thesharecontinuestorise–butjustconsidertheoddsagainstbeingabletobuyatthebottomandsellatthetop.
Bysomecuriouschancemostoftheadvicefromprofessionalsisabouthowtosecureyourprofit.Theassumptionisthatnobodyeverbuysadud.Thereislesshelpfuladviceaboutwhentojointheothersleekrats
headingfortheshore.Infallingmarketsprivate
shareholdersfallintotwoopposingcamps.ThereistheoneNaipauldescribed,whohangsontothemostobviousrubbishinthehopeitwilleventuallyrecover.Thenthereisthesortwhopanicatanyseriousdropandbailoutintheexpectationthatoncethepriceisheading
downwards,thelawofgravitywillcontinuetooperate.Bothareprobablywrong.
Thepointaboutprivateinvestmentisthatitisgenerallyforthelongishterm,sothebuyershouldhavedonesomeprettycarefulresearchonthebusinessbeforebuyingitsshares.Thecorollaryisthatifitcontinues
tomeetthosecriteria(goodmanagement,reasonablemargins,innovation,goodfinancialcontrol,etc),thenitmaywellbeagoodideatohangonandjustgooncollectingdividends.Ontheotherhand,thatalsomeanstheinvestormustcontinuewiththework,toseeifthecompanyisstilluptosnuffandthereforeworthbacking.
Ifnot,sell.Somuchforcashingin
profitsorpreventingfurtherhaemorrhageforafailure;thatassumesthemarketasawholeisstillhealthy.Theproblemisspottingwhenthemarketissickandlikelytogetworse,andknowingwhetheritisabliporthemarketontheturn.
Forinstance,thereisthe
timewhenaroaringbullmarketsuddenlyfalters.Thiscouldbetheresultofsomeexternaltriggerlikeatradewaroranapparentlyunconnectedevent–whythehurricanethatroaredacrosssouthernEnglandinOctober1987shouldhavetriggeredaplungeinpricesstillleavesmarketanalystsbaffled.Anothercausecanbea
generallossofimpetus.Insomecuriousandindefinablewaytheenthusiasmthathadbuoyedupeverybodyandhadseemedreadytocontinueforeversuddenlydrainsaway.Nothingseemsreallysatisfying.Evengoodnewsfailstoliftprices,thoughunhappynewsknocksthemback.Thesearesignalsofamarketontheturnand
indicatethatitistimetostartsellingbeforetheroutstarts.
Oncethebearmarketistrulyunderway,sellingonthewaydownistrickier.Professionalinvestorsareruthlessaboutgettingoutifthesignslookbad,andmanyinstitutionsnowhavecomputerprogramsthatautomaticallystartsellingwhenacertainpercentage
declinehasbeennoted.ThisisoneofthereasonstheNewYorkstockexchangescansometimesregisteracceleratingfallsinashareoreventhemarketasawhole,ascomputersareautomaticallytriggeredtosavewhatcanbesalvaged.Privateshareholders,however,arealwaysslowtosell.Itisreckonedtobea
mixtureofignorance(theyhavenotbeenfollowingtheshare’sperformance),sentimentalattachmenttoacarefullychosenshare,andasortofinertiathatsuggestshangingonforjustanotherdayorsoincaseitbouncesback.
Thejudgementisbetweencuttingyourlossesandnotmissingoutonarecovery.
Therearesomewarningsignalsthatmaysuggestadiscreetexit;forinstance,therecouldbeconflictingindicatorsandrumoursaboutthecompanywhosesharesyouhold.Anothergoodtestistoaskyourselfwhethertheshareshavebecomesolowandtheindicationsofgoodprofitssoconvincingthatthesharesseemanirresistible
bargain–ifnot,itisprobablyagoodideatosell.Evenifyouareconvincedthemarkethasgotitwrongandthebusinesswillbounceback,itcanbeshrewdtosell.Then,ifthepricecontinuestofallandtheindicationsarecomingthroughthatthecompanyhasturnedthecorner,youcanalwaysgetbackin.
ChapterElevenConsequencesof being ashareholder
Shareholdersarethetrueownersofthecompany,
sotheyhavelotsofrights.Forastart,intheorytheyappointboththeboardofdirectorsandtheauditors.Inpracticethedirectorsdobothandshareholdershavealltoooftensupinelyagreedtoeverythingdoneintheirname.Evengreatinstitutionalholderswhoknowthelaw
andaccountingprinciplesandaresophisticatedinvestorshavebeenlaxinexertingtheirpowerandhavegenerallymoreoftensoldthesharesthanspokenupordoneanythingforthebusiness.Thishasbeenchanging:someinstitutionsareusingtheirinfluenceanditisbecominglesseasyfortheboardtodismissawkwardquestionsat
theannualmeeting,butstilltoomanyprivateindividualsconsideranyquestioningoftheboardasanunseemlydelayoftheirfreedrinks.
Asowners,shareholdersareentitledtobegivenawiderangeofinformation,andtoparticipateinthecompany’ssuccess.
Information
Theinformationtheownersmusthaveincludesregularfinancialfacts.Everyyearthecompanymustproduceanaccountofitsfinances(thephrasinginlawisalittlemorecomplicatedbutthatiswhattherulesamountto)andthismustbesenttoallregisteredshareholders.(See
Chapter7forwhattheusefulinformationisinthoseannualreportsandaccountsandhowtoextractit.)Shareholdersmustalsohavenoticeofimportanteventsaffectingthebusiness.Thatincludesdetailsofmajoracquisitionsanddisposals,demergersandreorganizations.
Annual generalmeeting
Theannualgeneralmeetingisalegalobligationandshareholdersmustbenotifiedinadvance.Thereis,however,nolegalinsistencethatthemeetingisheldinaconvenientspot,soifthedirectorsarefeelingbloody-mindedtheycouldholditin
theupstairsroomofapubonStornoway.Curioustimesandinconvenientplacesformeetings,pluscompanyannouncementsonChristmasEve,aregoodsignstoshareholdersthatallisnotwellwiththebusiness.
Atthemeetingtheyarecalledontoapprovetheaccountsbyvoting,canaskquestionsandhaveavoteon
anumberofotherresolutionsincludingthereappointmentofauditorsanddirectors.Mostshareholdersneglectthisprivilege,eitherthrowingawaythevotingcardaltogetherorjustsendingbacktheenclosedproxyformgivingthechairmancarteblanchetovoteontheirbehalf.
Extraordinarygeneral meeting
Shareholdersrepresentingatleast10percentoftheequitymaydemandtheconveningofanextraordinarygeneralmeeting.
Consultation
Thereisalegalobligationtoconsultshareholdersonmattersthataffectthecompany’sfuture.Theyhavetherighttovoteonmajordecisions,includingactionsthatmaydilutetheirholdingssuchasrightsissuesandemployeeshareoptionsschemes.Iftheycanmuster5percentofthecompany’sequityor100shareholdersto
backthem,theycanevenintroducetheirownresolutionsatthemeeting.
Dividends
Shareholdersareentitledtotakepartinthecompany’ssuccessandprofits.Normallyshareholdersparticipateinthecompany’sprofitsbywayofdividends,whichareusually
paidtwiceayear,butthisisnotalegalrightsinceacompanymaydecidetoreinvestitsprofitsinthebusinessforfastergrowth.Inpracticefewhavethecouragetorefrainfrompayingaltogether.Thecheque,ornotificationofpaymentintoanaccount,showsthesizeofholdingandrateofdividend.Preferencesharesare
normallyentitledtoadividend,andifthecompanycannotforatimeaffordtopay,thatentitlementisnormallyonlydeferredandhastobepaidlaterwhenthemoneyisavailable.
Scrip issues
Thislookslikeaburstofspontaneousgenerosityby
companiesthatgiveinvestorssomeextrasharesfornothing.Sometimestheyareinplaceofcashdividendsandsometimesasasupplementtothem.Infactitisasimplebookkeepingexercisethatshouldhavenoeffectonthesharepriceorthevalueofthecompany–someoftheretainedearningsarecapitalizedandshiftedfrom
onelineinthebookstoanother.Thatisalsothereasontheyarecalled‘capitalizationissues’.Sometimesissuingscripiscalleda‘bonusissue’andsurprisinglyenough,contrarytologic,thesharepricesometimesrisesatthetime.Shareholdersmaythenfindithardtocalculatethecostoftheholdingforcapitalgains
taxwhentheysell.
Rights issues
Companieswantingtoraiseadditionalcapitalsometimesturntoexistingshareholdersfirst.Thereareseveralreasonsforthis.Thefirstisobvious:shareholdersbydefinitionmustlikethecompany,soifitsaysitcan
seeopportunitiesforusefulinvestmenttoallowittogrowbutneedsadditionalcash,theyaremorelikelytotakeafriendlyview.Second,itisonlyfairtoallowexistingholderstotakeactionagainsthavingtheirholdingsdilutedbytheissueoffurthershares.Third,theinstitutionsthatownmostofthesharesonissueinBritainareespecially
insistentonbeinggiventhechancetomaintainthepercentageofthecompanytheyhavedecidedwasrightforthatportfolio–thisiscalledtheir‘pre-emptionright’.
Itisalongandexpensivebusinessforacompanysinceitmustprintextensiveliteratureandpostittoallholders,andthemerchant
banksandaccountantscostafortuneinfees.Aplacing–ringingroundfundsknowntobeinterestedandaskingiftheywouldliketobuyextrashares–worksoutalotcheaperandcanbeveryquick.
Theopportunitytobuythenewsharesisallocatedasaratioofexistingsharesowned.Itissomethinglike
therighttobuythreenewsharesforevery11alreadyheld,orsomesuchformuladependingonhowmuchthecompanyistryingtoraiseandhowdeepadiscountitisoffering.Theissuewilldilutethevalueoftheexistingsharesbecauseprofitsanddividendswillbedistributedoveralargernumberofshares.
Rightsissuesarenormallyofferedatadiscounttotheprevailingsharepricetogivepeopletheillusionthattheyaregettingabargain.Soifthesharesstandat200p,thecompanymightofferonenewshareforeveryfouralreadyheldatapriceof150p.Soforeveryfourshares,worth£8,theycanbuyanotherfor£1.50.Ifinvestorsdobuy
theyhaveaholdingworth£9.50(assumingthepricedoesnotmove)andthefourcontinuingshareswouldbeworth£7.60(four-fifthsof£9.50),butonthatcalculationtherightwouldbeworth40p,sotheywouldbebacktotheoriginal£8holding.Onecomplicationisthatthemoneyreceivedfortherightsmaybetaxable,andanother
isthatthemarketpricewillreacttotheannouncement.
Shareholdersfacedwitharightsissuecantakeitupinfullandpayforthenewissueofshares.Theycansellthenil-paidrights,whichhaveavalueonthestockmarket.Ortheycancompromisebysellingenoughnil-paidrightstomaintainthevalueoftheportfoliobyusingthe
proceedstobuynewshares.Thenil-paidpriceisthedifferencebetweenthediscountedrightsissuesharepriceandtheex-rightsprice.
Nominee accounts
Manypeopleholdtheirsharesinnomineeaccounts–forSIPPsandISAstheyhaveto.Theseareheldina
numberofplacesandareaconveniencetopreventshufflingofpapersortospeeduptheprocessesofbuyingandselling.Forinstance,thedealingstockbrokermayholdanaccountforaninvestor,whodoesnotthereforehavetowaitforsharecertificatestoarrivebeforebeingabletosellthem,anddoesnothave
tostoreandfindthenecessarypapers.Somebrokersoffertheservicefreeasawayofreducingtheirownadministration;somechargeaflatfeeoronebasedonthevalueoftheshares;yetotherschargepertransaction;andsomelargecompanieshaveinstitutedtheirownsystems.
Regulated markets
Inadditiontotheirrightsinrelationtothecompanyofwhichtheyownapiece,investorshavearightnottoberippedoffbythefinancialcommunity.Thisisthepartthatismainlywatchedoverbytheregulatoryauthority.ItregulatesBritishbrokersanddealers,whethertheyareina
Cityofficeordealingviatheinternet,butnobodyregulatestheinternet.Inevitably,thenethasbeenahappyplaygroundforsomeshadyoperators,rangingfromvarioustypesoffraudsterstopeopleoperatingpyramidschemes.Somehavesetupboguswebsitestolooklikethepagesoperatedbyrealinvestmentcompanies,inthe
hopeofgettingunsuspectingpeopletopartwiththeirmoney.Inaddition,thenetisawashwithrumours,manyofthemcarefullyplacedtodrivethepriceupordownsotheinstigatorcansellorbuyasneedsbeandmakeakilling.Theauthoritiesinthemoreresponsiblecountriespursuethesepeople,butthenetistoovasttobewatched.
TheLondonStockExchangealsoregulatesitsownmarket.TheExchange’scomputerhasasophisticatedprogramtryingtospotunusualpatterns,andifthereareuntowardmovementsinadvanceofanofficialannouncement(egasharprisejustbeforeabidisdisclosed),theExchangeauthoritiesinvestigate.
Despitesomeapparentlysuspiciouscircumstances,however,theyhardlyeverfindanythinguntoward.Prosecutionsforinsidertradingarerare,andconvictionsevenrarer.
Relyingonsomebodyelsetopickupthepiecesandfightthebattlesforfecklessorfoolishinvestingisamistake.Alittleelementarycarecan
preventalotofmistakesandsavemuchefforttryingtoassertone’srightslater.Forinstance,youshoulduseonlyauthorizedbusinessestoactonyourbehalf,andthatiseasytocheckontheregisteroftheregulatoryauthority.Beforestartinganytransactions,checkthecostsandfees.Thefirstruleis,ifthereisanythingyoudonot
understand–goonaskingforanexplanationuntilitiscrystalclear.Itismuchbettertoseemfoolishbyaskingquestionsthantobefoolishbynothavingtheanswers.
Codes of conduct
Theapathyofmostshareholdershasallowedcompanyboardssomuch
latitudethattheyseemedbeyondreasonablecontrol.TofillthisvacuumtheCityhasproducedaseriesofcodesofconducttoguidedirectorsonbestpractice.Thelatestofthose,theHampelReport(followingtheCadburyandGreenburyReports),whichisbackedbytheStockExchange,suggestedforinstance,that:
thetaskofchairingtheboardandtheworkofchiefexecutiveshouldbeseparate;directorsshouldstandforre-electioneverythreeyears;boardmembersshouldnothaveaservicecontractofmorethantwoyears;athirdoftheboard
shouldbenon-executiveswhoshouldbeindependentofthecompany;shareholdersshouldbetoldatleast20daysinadvanceofanannualgeneralmeeting;whenraisingnewcapitalthecompanyshouldgiveexistinginvestorsfirstrefusal;
anyquestionsnotansweredattheannualgeneralmeetingshouldgetwrittenanswerssoonafterwards.
Takeovers
Usually,yousaythankyouverymuch.Bidsforcompaniesarealmostinvariablywellabovethe
priceofthesharesjustbeforethebid,soshareholdersbenefit.Ontheotherhand,whatmaywellhavetemptedapredatorispreciselythatthepricewasstandingwaybelowanyrationalbasisofvaluation,forinstancethenetassetvalue,soitwouldbeworthbuyingabusinessjusttoselloffitsassetsataprofit.Inthatcaseitisworth
resisting,ifonlytogetabetterprice.
Sometimestheofferisresistedfiercelybythetargetcompany,andtheschemeforsomeinvertedreasonisthencalleda‘hostiletakeover’.Thedefenceusuallysaysthebidisunwelcomeandopportunisticasitundervaluesthecompany’sprospects,andthecompany
couldperformfarbetteronitsown,giventhechance.Theprivateshareholdercannottellwhetherthisoppositionismotivatedbyadesireforindependence,afearofdirectors’losingtheirjobs,anattempttogetthebiddertoincreasetheprice,oragenuinefeelingthatshareholderswoulddobetterwiththeexistingregime.Itis,
however,worthrememberingthatthedirectors’legaldutyistoactinthebestinterestsofshareholders.
Thedecisionismadeevenmorecomplicatediftheofferiswhollyorinpartintheformofthebidder’sshares.Thechoiceisthenclutteredwithotherconsiderationssuchaswhetheronewantsthoseshares,whetherthe
valuationofthebuyer’sequityisfairorrealistic,andwhethersellingmightcrystallizeanunwelcomecapitalgainstaxliability.
ThetakeoverprocessismonitoredbytheCityTakeoverPanel,whichhasnopower,legalorotherwise,butmanagestohaveitswaybecausealltheCitypeoplesupportit.Soanybodywho
triestofloutitsrulingswouldbeostracized,andoncefrozenoutofthefinancialcommunitydoingbusinesswouldbeimpossible.Beingnon-statutoryalsogivesthepanelthesignaladvantageofbeingabletoactquickly.Moreover,itcantellparticipantsitdoesnotlikethewaytheyareacting–ithasbeenknowntoreprimand
peoplenotforfailingtofollowtheletteroftheCityCodebutforneglectingitsspirit.InadditionitcantakeinstantactiontochangetheCodewhenaloopholehasbeendiscovered.
Thepanelchargesofferdocumentsandrelatedpapersofover£1millionbetween0.2%and11%.Italsochargessaverstosupervise
companiesat£1onsharedealsofover£10,000whichiscollectedforthepanelbystockbrokers.
Itcanbealmostasgoodtoownsharesinacompanythatisinthesamesectorasahighlypublicizedacquisition.Assoonasoneestateagent,retailer,computerassembler,brewerorwhateverhasbeenbought,themarketusually
assumesarippleofparallelacquisitionactivitywillovertakeitscompetitors.Theirsharesjumpasaresult.Sincetheflurryofcopycatactivityrarelymaterializes,especiallyoncethetargetshavebecomeexpensive,itmaythenbeagoodtimetosell.
Insolvency
Investinginsharesisrisky.Thereisnowayofgettingawayfromthis.Oneofthereasonsthestockmarketproducesahigheraveragereturnthan,say,puttingthemoneyintoabuildingsocietyorabanksavingsaccount,istooffsetthisdangerbycompensatinginvestors.But
notetheword‘average’.Somesharesaremoreriskythanothersand,shortofbuyingintohundredsofcompanies,theinvestorwillbeinvolvedinsharesthatareamixture:someareasuccess–iflucky,someofthosespectacularlyso;someareprettyho-humperformers;andsome,rarely,arecompletecollapses.
Occasionallycollapsesaresignalledwellahead.Thesharesshowasteepandprettycontinuousslide,andthestatementsfromthecompanymixprofitwarningswithpromisesofrestructuring,refinancing,searchingforalliances,appointingnewexecutivesandnewpoliciesontheway.Thisusuallyendsina
suspensionofdealingsintheshares,amovethatiscommonlysaidtobetohelpshareholders.Purebunkum:itisacompletedisasterforshareholderswhocannotthereforesellsharesatanypricetorescueevenatinyportionoftheirinvestmentmoney.Thepeopleithelpsarethestockmarkettraderswhoarefearfulofdealing
withoutadequateinformationandcannotfacebeingswampedbypeoplestampedingoutofthecompany.
Companiesseldomreturnfromthatsortofsuspension.Thereareotherreasonsforsuspension,suchasduringthefinalstagesofamajoracquisition,butthosereallyarebenignandaretoprevent
totalmarketchaoswhenthereisnotenoughknownaboutthedealdetailstosetafairprice.Butbeingsuspendedbecausethecompanyhasrunoutofmoneyoffersfewroadsback.
Bythetimethesharesaresuspendedtheyareseldomworthmorethanafewpenceinanycase.Butnotallcollapsesaresowell
signposted.Arethereanymorecovertsignsofimpendingdoomthatcannyshareholdersmaybeabletospot?Manypeoplehavetrieddrawingupsigns,includingBritain’stopliquidatorinthe1960s,BillMackie.Thespecificsofhiswarningsignals,includingflamboyantheadquartersandprofligatetopmanagement,maynow
seemdated,buttheunderlyingprinciplesarestillsound.Wemaynolongerhaveflagpolesandtanksoftropicalfishbutthereareplentyofotherloudsignalsthattheorganizationthinksappearancemoreimportantthanefficiency.
Investorsshouldbemonitoringthebusinessandhowitismanaged.Profit
marginsareagoodsign,sooneshouldcheckwhethertheyareashighastheywereandatleastasgreatasthoseatothersimilarcompanies,andwhetherthebusinessisgeneratingsufficientcashforitsneedsandambitions.Whenexternalmoneyisbeingraisedthroughloans,rightsissuesandthelike,itshouldbeforexpansion
ratherthanbalingoutthecurrentproblems.Accountsbeinglateorfudged,lackofinformationonauditors’qualifications,suggestionsofwindow-dressingintheaccountsandextremelysophisticatedfinancialdealingsarecausesforconcern.Withsmallbusinesses,mostofthatdoesnotapplyandyouhavelittle
recoursebuttojudgebythemanagers.Thepointaboutsmallbusinessesisthattheprofitcanbespectacularbutthecollapsessudden.
Whenacompany’ssharedealingsaresuspended,thatiscommonlyasignthatthecompany’smanagers,bankersandsetofinsolvencyaccountantsaregoingintoconfab.Onerouteisforthe
companytotryforavoluntaryarrangementunderwhichitscreditorsholdoffknockingbitsoffthecorporatestructuretosellasawayofrecoveringtheirmoneyandallowittotrytradingoutofitsproblems.Courtscanappointanadministratorwhoalsocontinuestotradeandholdsoffcreditors.
Anotherrouteistakenbysecuredcreditors,normallythebanks,whichhaverunoutofpatiencewiththecompany’sexcusesandareworriedtheirloanscouldsoonbecomeirrecoverable.Theyappointareceiverwiththesoletaskofkeepingthebusinessgoingjustlongenoughtorecoverthebanks’money.Taxauthoritieshave
alsobeenprettyactiveinthisroutetomakesuretheirmoneyispaid.Occasionallythedirectorsaskfortheappointmentbecausetheycanseeadefaultondebtsloomingorbecausetheyareindangerof‘overtrading’,whichisthecriminaloffenceofcontinuinginbusinessoncethecompanyisinsolvent.Aspecialist
accountantisthenappointedandmovesintorunthebusinessbrieflytoextractsomemoneyorsellassetsforpayingthedebt.Intheorytheadministratorthenmovesoutandthecompanyrevertstobusinessasusual.Thatseldomhappensinpracticebecausethereceiver’staskentailssellingofftheassetsagainstwhichthemoneywas
lent,ortradinglongenoughtogeneratethecashtopayofftheloan.Thatusuallydoesnotleavemuch,andthecompanyisoftenpassedtoaliquidator.
Asthatnameimplies,theliquidator’sjobistoturnanythingsaleableintosomethingmoreliquidlikecash.Firesaleslikethatseldomproduceanythinglike
thebookvalueofassets.Inalloftheseprocedures
thereisahierarchyofcreditors,andtheholderofordinarysharesstandsatthebackofthequeue.Thegovernmenttakesitstaxesoffthetop,andisfollowedbysecuredlenderswithaclaimonthepropertyandemployees,andthebankswithotherguarantees.Then
therearebondholdersandownersofpreferenceshares.Onceallthesepeoplehavehadtheirtakethereisseldomanythingleftfortheholdersofordinaryshares.
Theonecomfortingthoughtisthatrelativelyfewquotedcompaniesdoactuallygobust.Andifyourinvestmenthappenstobeoneofthem,tryandlookforthe
silverlining:youcancashinsomereallyprofitableinvestmentsandsetoffthecapitalgainsagainstthelossesonthecrashedcompany.
I
ChapterTwelveTax
tisgallingthatthegovernmenttakesanother
sliceondividendsandcapitalgainsafterithasalreadychargedadditionaltaxoninvestingtaxedincome.Butreconcileyourselfwiththethoughtthatatleastyouhaveprofitstobetaxed.
Taxisalwayscomplicated,andhugemanualshavebeenwrittenonhowtocopeorgetthebestdealpossibletofrustratetheeffortsofHM
Revenue&Customs(HMRC).Thischapterrepresentsthemerestskimmingofthesurfaceandisgeneralizedasthesethingschangecontinually.
Governmentshavetriedtosteerustowardssomeinvestmentvehiclesbytaxincentivesbecausetheythinktheywouldbegoodforusorforthecountry.Itwouldbe
foolishnottotakeadvantageofanyextrabenefitsprovidedbythetaxoffice,butitwouldbejustassillytoinvestpurelyforthetaxbreak.Thisisespeciallysoasthemanagementfeesforsomeschemesneedcarefulscrutinytotestwhetherthedealisstillworthitaftertheprofessionalshavehadtheirshareofthecream.Soweigh
thealternativesandgofortheonethatisbest,judgedbyyourpersonalcriteria,andonlygoforthesavingsintaxiftheinvestmentwouldhavemadesensewithoutthem.
Governmentsarerathergoodattakingmoneyoffus.Thereisnotonlytaxongettingintoshares–called‘stampduty’–butalsoonthebenefitsfrommostkindsof
investment,bothontheincomeandthecapitalappreciation.Dividends,includingscripissues(seeChapter11)andbonusshares,countasincomeandthereforearesubjecttoIncomeTax.Mostcompaniespaydividendsnetoftax.
HMRCpublishessomeusefulbookletsontax,includingoneoncapitalgains
tax(CGT),availablefromalltaxoffices.
Dividends
Dividendsonsharesarealmostinvariablypaidnetoftaxandthevoucherthatcomeswiththepaymentnotificationcontainsdetailsofataxcredit.PeoplewhodonotnormallypayIncomeTax
cannotreclaimthetaxalreadypaidonthedividend.Thosewhopaytaxatthebasicrateneedpaynofurthertaxontheincome.Butpeoplepayingtaxatthehigherratehavetopayat32.5percentofthegross,thoughthecreditdetailedintheslipissetoffagainstthis.Thismeansthatthehigher-ratetaxpayerwill,ineffect,paytoprateoftax
onthegrossdividendpaidbythecompany.Thiscomplicatedwayofhandlingthingsmeansthataboutaquarterofthenetdividendisdueintaxforhigher-ratepayers.
So,forinstance,someoneowning400sharesinQuilp&HeepIntercontinental,whichpaysa15pdividend,wouldgetachequefor£60.Since
thetaxcreditis10percent,thisrepresents90percentofthegrossdividend,whichwouldhavethereforebeen£66.66(60/90×100).Asaresult,thetaxcreditnotifiedwiththechequewouldbe£6.66.Payersonthestandardrateoftaxarethenallsquare,butpayersatthehigherrate,obligedtopay32.5percentofthegross,mustnow
calculate66.66×32.5/100,whichworksoutto£21.66.Settingoffthe£6.66alreadypaidleavesaliabilityof£15tobesenttoHMRC.
Scripissuesofsharesinlieuofdividend(seeChapter11)aretreatedinaprettysimilarfashion.Thereisnoadditionaltaxdueforpeopleonthestandardrate,andthosepayingthehigherrate
areassumedtohavehada10percenttaxcredit.
Ifthecompanybuysbackshares,themoneyreceivedistreatedasadividend–coveredbyIncomeTax,notCGT.
Capital profits
Aprofitonthesaleofsharesisliabletotaxforprofits
abovethebasictax-freeallowance.Thisisaprettyhandsomechunkasfarasmostsmallinvestorsareconcerned.CGTisaproblemonlyforpeopledealinginlargishamountsorwhohavereallystruckitluckywithoneoftheirstocks.Inotherwords,iftheprofitissogreatthatCGTisdue,youhavedonesowellthatabitforthe
exchequerseemslesspainful.Windfallsharesreceivedfromdemutualizedbuildingsocietiesorinsurancecompaniesarecountedashavingcostnothingandanythingmadefromtheirsaleiscountedasacapitalgain–unlesstheyhavebeenputintoatax-shelteredschemesuchasaSIPPorISA.
Thereisataperedtax
relief,however,soholdingsharesforalongtimewillreducethetaxliability.IftheshareswereboughtbeforeApril1998thepricerisecanbeadjustedforinflationbeforetaxispayable.Dealingcostsinbuyingandsellingareallowableagainstthetotalgain,andthereisanallowanceforpart-paidshares.Giftsbetweenspouses
aretax-free,sotheportfoliocanbeadjustedtobenefitfromthemaximumallowance.
Unquotedsharesareaproblemsincethereisnopubliclyavailableunequivocalpricefordealing.ForthesedealsyouwilljusthavetohagglewiththelocalHMRCoffice.
Asisonlyfair,losses
madefromsellingsharesinthesametaxyearcanbesetoffagainsttheprofit.Andifanyofthecompaniesactuallygobust,thesharesarereckonedtohavebeensoldatthatdatefornothingandthecapitallossfromthepurchasepricecanalsobesetoffagainstgains.
Allthismayhelpwithdecisionsbetweenalternative
coursesofbuyingandselling,thoughonceagainbeingguidedpurelybytaxdifferencesisusuallyamistake.Agoodaccountantcanadviseonsuchthingsatarelativelylowcost.
Employee shareschemes
ReceivingsharesfromanemployercountsaspayandsoissubjecttoIncomeTax.Iftheemployees(andthatincludesdirectors)buythesharesatadiscounttothemarketprice,thediscountportionisthepartonwhichtaxispaid.
Underapprovedprofit-sharingschemesthecompanycanallocatetax-freesharesto
workers,thoughasyouwouldexpect,thereisaraftofrulesaboutthedetails.Shareoptionschemesthatmeetallthechancellor’srequirementshavefewadvantages.
Tax incentives torisk
Thegovernmentwantsnew
ideastobefinanced,high-technologytogetstarted,andinnovationstobegivenachance.Investmentinstitutionssuchasventurecapitalistswillnottouchthem,sothetaxincentivesaredirectedatprivateinvestors.Theseareriskyventuresandthoughrewardscanbehighforasuccess,thechanceoffailureisalsopretty
high.Evenwiththetaxcome-onsthisisanareaforpeoplewithasteadybaseofsafeinvestmentwhoalsohaveafewhundredthousandtogamblewith.
Venture capitaltrustsThesearereallyjustacollectiveversionofthe
EnterpriseInvestmentSchemeitreplaced.Thetaxbreaksaresimilarbuttheinvestmentisintoaquotedfinancialvehicle,whichinturnputsthecashintoarangeofentrepreneurialbusinesses,sotheriskisreduced,aswithinvestmentandunittrusts,byspreadingthemoneyoveranumberofventures.
ISAs
Individualsavingsaccountsarepartofthegovernment’saimtopersuadeustosavemoreofourincomebyprovidingtaxincentives.Theamountswhichcanbeinvestedineachtaxyear,ofwhichallisinvestedinshares–includingAIMshares–andaproportionmayremainin
cash,changeswiththeBudgetannouncements.Agoodstockbrokerhasthecurrentrates.
SIPPs
Self-InvestedPersonalPensions(SIPPs)offerthefreedomtochooseandmanageinvestments(fromthelistapprovedbythe
Revenue)andunliketraditionalpensionsinwhichtheproviderownstheinvestments,theprospectivepensionerownstheassets.Theythereforeofferflexibilityinchoosinginvestmentsandtakingretirementbenefitssolongastheyarearrangedbyasuitableprovidertopassstringentcriteriafortax.
SIPPs,incommonwithpersonalpensionschemes,aretax‘wrappers’,allowingtaxrebatesoncontributionsinexchangeforlimitsonaccessibility.
Amongtheassetsnotsubjecttoataxchargeareunlistedshares,shareslistedonarecognizedexchange,futuresandoptionstradedonrecognizedfuturesexchanges,
authorizedUKunittrusts,OEICsandotherUCITS(seeGlossary),unauthorizedunittruststhatdonotinvestinresidentialproperty,investmenttrustssubjecttoFCAregulation.
ContributionstoSIPPsaretreatedasothertypesofpersonalpensiononlimits.Higherratetaxpayersclaimataxrefundthroughthetax
return.Employercontributionsareusuallyallowableagainstcorporationorincometax.Afundvalueatretirementabovethelifetimeallowance(theamountfluctuateswithBudgets),istaxedat55%.
ASIPPholderreachingearlyretirementageof55maytakeuptoaquarterofthefundastax-freelump
sum,andtherestmusteitherbemovedintogeneratinganincomefrom‘drawdown’(whereitremainsinvested)orusedtobuyanannuity.ThedrawdownincomeistobeinlinewithwhattheGovernmentActuary’sDepartmentreckonsanannuitywouldgenerate.Thisisreviewedeverythreeyearsuntilage75andthen
annually.Thislimitdoesnotapplytoplanholderswhocanshowthattheyhavearrangementsinplacetoprovideaminimumguaranteedincomefromothersourcesandwhoarenolongercontributingtoapension.Pensionincomeistaxedasincomeattheowner’shighestmarginalrate.
Tax rates
Chancellorshavetobeseentobeearningtheirkeep,soeachyear’sbudgetproducessometinkeringwithtaxrates,allowancesandincentives.Recentlytherehasbeenaspateoflastyear’sincentivessuddenlybeingrelabelled‘viciousavoidanceloopholes’thatneedtobewithdrawn.
Sometimesimpendingelectionsorotherpoliticalexigenciesproduceaneedforotherpublicreactionsaswell.Asaresult,thepicturecontinuouslyshiftsindetail.Thatiswhythissectionhasgivenageneralpictureandtheoverallpoliciesbutcarefullyomittednumbers.Togetthelatestlevelsoftaxrates,allowancesand
benefits,telephoneanyofthe10largestaccountancyfirms,allofwhichwillalmostcertainlyhaveafreeleafletsummarizingthecurrentposition.
Glossary
acidtest:acheckinthecompany’sbalancesheettoseeifithasenoughliquidassetstomeetitscurrentdebts.
AlternativeInvestmentMarket:thepartoftheLondonStockExchangeforsmallcompaniesoronestooyoungtomeettherequirementsforfullquotation;oftenabbreviatedtoAim.
assets:inacompany’sbalancesheetthesearethethingsitownsorareowedtoit;netassetsinthe
balancesheetaredefinedascapitalplusreserves,ortotalassetsminuscurrentliabilities,anddeductingthelong-termcreditors.
authorizedsharecapital:everycompanyhasamemorandumandarticlesofassociationandtheseshowhowmanysharesitmayissue.Itisnotcompelledtoissueallof
themandmanycompanieskeepsomeinreserveforrightsissues,employeeincentivesandthelike(seealsoissuedsharecapital).
bearmarket:atimeofgenerallyfallingshareprices.
bid:thepriceatwhichthemanagersofunittrustswillbuybacktheunits
frominvestors,comparedwiththeofferatwhichtheysellunits;alsolooselyusedfortheofferinatakeover.
bluechip:atop-qualitycompanyanditsshares,derivedfromthetop-valuegamingchipsusedincasinosandpoker.
bond:anIOUissuedbyaborrowertothelenderto
acknowledgethedebt;itnormallycarriesafixedrateofinterestandcanbetraded(eggilts,debentures).
bonusissue:anothernameforascripissue;thedistributionofsharestoexistingholdersatnocosttothem.
broker:seestockbroker.bullmarket:aperiodof
risingshareprices.
calloption:therighttobuyashareatasetpricewithintheperiodoftheagreement.
capitalizationissue:seescripissue.
commonstock:USnameforordinaryshares.
consumerpriceindex:aweightedindexofa
collectionofgoodschosenbythegovernmenttomeasurethechangeinaveragepricesandsoindicatetherateofinflation.KnowncommonlyastheCPI,itisanalternativetotheretailpricesindex(RPI).
convertible:aclassofpaperissuedbycompanies(suchasloanstockorpreference
shares)thatcanbeconvertedintoordinarysharesatapre-setprice,andusuallyonasetdate.
coupon:theinterestrateonacorporatebond;itcomesfromthepracticeinthepastofattachingtothecertificateaseriesofcouponsthatonehadtoclipoffandsendtothecompanytocollectthe
interest.Crest:anelectronicshare
registryandtransfersystemoperatedbytheLondonStockExchange,whichgetsridoftheneedforpapercertificates.
cumdividend:theshareissoldwiththeentitlementtothenewlydeclareddividend.
dead-catbounce:asmallshort-termrecoveryinafallingstockmarket,derivedfromarathersickmetaphor:evenadeadcatwillbounceslightlyifdroppedfromhighenough,butthatdoesnotmeanithascomebacktolife.
debenture:atypeofcorporatebond.
depositoryreceipt:anegotiablecertificaterepresentingaforeigncompany’spubliclytradedsecuritiesmakingiteasiertobuysharesinforeigncompaniesbecausetheydonothavetoleavethehomestate;italsogetsroundrestrictionsonforeignersowningshares.
derivative:agenerictermto
coversomethingatsomestageremovedfromthedirectinvestmentbutdependentonit,soitincludesoptions,warrants,futures,swaps,indices,structureddebtobligationsanddeposits,caps,floors,collars,forwardsandcombinationsofthese;standardizedversionsofsome(egfuturesand
options)aretradedonexchanges.
disintermediation:cuttingoutthemiddleman.
dividend:itisstatedassomuchpershare,soacompanydeclaringadividendof12ppaysthatamounttotheholderforeveryshareonissue.Theownerof1,000shareswouldget£12,minustax.
dividendcover:showswhatproportionofthecompany’searningsarebeingpaidtoshareholdersor,toputitanotherway,ameasureofthenumberoftimesacompany’snetoftaxdividendiscoveredbyitsnetprofit.
dividendyield:theamountofdividendpershare(usuallyquotednetoftax)
asapercentageoftheshareprice.
equities:anothernameforordinaryshares.
exceptionalitems:profitsorlossesinthecompanyaccountsfromdealingsthatarenotpartofthecompany’smaintradingactivities,suchasthesaleofafactory.
ex-dividend:asharebeingsoldsoonafteradividendhasbeendeclared,withthesellerstillgettingthepayment.
flotation:bringingacompanytothestockmarkettogetitssharespubliclytraded.
FTSE100:stockmarketindexcoveringthe100
companieswiththelargestmarketcapitalization.Sincecompaniesgroworshrink,becomefashionableoraresuddenlyshunned,theconstituentsoftheindexchangecontinually.Asaresultitisanindicationofthetemperofthemarketasawholeratherthanshowingtheperformance
ofanyspecificsetofcompanies.
FTSEAll-Share:theaggregationoftheFTSE100,FTSE250andFTSESmallCapindices;itdoesnotcoverallsharesonthemarket.
fundamentalanalysis:lookingatthecompanybehindtheshare,itinvolvescalculatingnet
assetvalueandprobablefuturedividends,whichmayinvolveeconomicpredictionsaswell;itisincontrasttotechnicalanalysis,whichlooksonlyatthechangesinshareprices.
gearing:inbalancesheets,aratioofacompany’sborrowingstoitsequity.
gilts:shortforgilt-edged,theusualnameforgovernment-issuedbonds.
hedging:protectingagainstapotentialliability.
independentfinancialadviser:providerofunbiasedadviceonfinancialinstrumentsincludinglifepolicies,
units,stakeholderandpersonalpensions,investmenttrustsandtheirsavingsschemes,andpackagedderivatives,butnotnecessarilysharesandbonds(seerestricted).
insider:somebodywithprivilegedaccesstoinformationaboutacompany,suchasadirector;itisillegalto
tradeinsharesonsuchknowledge.
IPO:initialpublicoffering;UStermforflotation.
issuedsharecapital:thesearethesharesthecompanyhasactuallysoldasopposedtotheauthorizedsharecapitalthatitisallowedtosell.
leverage:USnamefor
gearing.liquidation:thesaleofan
insolventcompany’sassetstopaycreditors.
liquidity:onemeaningisameasureofthemarket:howeasyitistobuyorselltheshares,whichisafunctionofhowmanysharesareavailable,howmanypeopletradeinthemandhowgreatthevolume
ofdealingsis;anothermeaningisameasureofhowreadilyanassetcanbeturnedintocash:themorereadily,themoreliquiditis.
LIBOR:LondonInter-BankOfferedRate,theinterestchargedbymoststablebankslendingtoeachother.
long:owninganinvestment
inanticipationofthepricerising;oppositeofgoingshort.
marketcapitalization:thevalueofaquotedcompanyonthestockmarket:asimpleproceduremultiplyingthevalueofeachsharebythenumberofsharesonissue;soifacompanyhasissued5
millionsharesandtheyarenowtradingat125p,thecompany’smarketcapitalizationis£6,250,000.
marketcorrection:afallinshareprices.
members:theshareholdersofacompany.
MSCIworldindex:astockmarketindexofsharestradedonseveralmarkets
aroundtheworld.ItismaintainedbyMSCI,formerlyknownasMorganStanleyCapitalInternational.
Nasdaq:NationalAssociationofSecuritiesDealersAutomatedQuotationsystem;NewYork-basedelectronicstockmarketwithaheavy
emphasisoncompaniesusingadvancedtechnology.
NasdaqOMXEurope:London-basedtradingfacilityforapproximately800Europeanblue-chipshares.
netassetvalue:alltheassetsofacompanyminusallitsliabilitiesandcapitalcharges.
NeuerMarkt:Frankfurt-basedmarketforsharesofsmaller,youngercompaniesthanarenormallyadmittedtothemainstockexchange.
noisetrader:someonedealingforthewrongreasons,caughtupbythe‘noise’inthemarketandseducedintotradesbygossip,fashionandphoney
analysis.nomineeaccount:shares
heldbyaninstitutionorcompanyonbehalfofindividualshareholders.
offer:thepriceatwhichmanagersofunittrustsselltheunitstothepublic;itishigherthanthebidpriceatwhichtheyarepreparedtobuythemback,andthe
differenceisthespread.open-ended:aninvestment
vehiclethatissuespaperinratiototheamountofinvestmentitreceivesfromthepublic;unittrusts(calledmutualfundsintheUnitedStates);thereisnosecondarymarketinthepaper,sobuyingandsellingisonlywiththemanagementcompany.
PlusMarkets:UK-basedstockexchangethatevolvedfromOFEXtorivaltheLondonStockExchange’sjuniormarket,Aim.
poundcostaveraging:accumulatingaholdingbyinvestingthesameamountofpoundsinthesecuritiesatintervals;yougetmoresharesforthemoneywhen
thepriceisfallingandthatreducestheaveragecostpershare.
preferredstock:USnameforpreferenceshares.
price/earningsratio:thiscomparesthecurrentpriceofthesharewiththeattributableearningspershare.Itisthewaythemarketcomparesexpectedgrowthinacompany’s
dividendwiththerequiredrateofreturnofaninvestor.Theformulasaysthecorrectpriceequalstheexpectedcurrentdividend,dividedbytherequiredreturnandexpectedgrowthinthecompany’sdividends.Soifthedividendnowis10ppershareandthisisexpectedtogrowby5percenta
year,butthecurrentdemandisforareturnof8percent,thecalculationis10/(0.08–0.05),whichwouldmaketherightshareprice333p.
putoption:therighttosellashareatasetpricewithintheperiodoftheagreement.
registrar:theorganization
thatmaintainstherecordofacompany’ssharesandtheirownership;runbyspecialistregistrarcompanies,mostofthemownedbymajorbanks.
re-rating:achangeofopinionbythestockmarket:asurgeofgoodnews,aseriesofanalysts’reports,thepromiseofnewproductsandthelike
maymakeinvestorsfeelthecompany’sprospectsarebetterthanthepricerises,withacorrespondingriseintheprice/earningsratioandfallintheyield,andconverselytheotherway.
reserves:thenon-distributedprofitsofacompany,plusprofitsfromrevaluingassets,plusanyshare
premium;thisisnotmoneyinthebankbutisusedinthebusiness,thoughitremainspartoftheshareholders’funds.
restricted:afinancialadviserwhodoesnotcovertherangedemandedofanindependentandwhomustdesignatebeingrestrictedandexplaintoclientstherestrictionbyproductor
provider.retailpricesindex:a
measureofpricesinasetbasketofdomesticretailgoodsandservices.KnownastheRPI,itisgenerallyconsideredtogiveamoreaccuratepictureofthecostoflivingthanthealternative,theconsumerpriceindex(CPI).
returnoncapital:measurestheefficiencywithwhichthecompanyisusingitslong-termfundsbydividingtradingprofit(beforeexceptionalitems,interestandtax)bytheaveragecapitalemployedovertheperiod(shareholders’fundsplusborrowings)andmultipliestheresultby100.
returnoninvestments:seeyield.
rightsissue:onewayacompanyraisesmoneyisbysellingmoreshares,andsometimesitdoesthisbygivingthepeoplewhoalreadyownitssharestherightoffirstrefusalinproportiontothesharestheyalreadyown.
ruleof20:awayofjudging
theeuphoriaorgloomofthemarketasawhole;itsaystheprice/earningsratioplustheinflationrateshouldequal20.
scripissue:freeissueofsharestoexistingholdersconvertingcorporatereservesintoequities–anaccountingexercise.
SEATSPlus:atrading
systemusedforAimstocksandforothershareswithoutenoughmarket-makerstocreateacompetitivemarket;thecomputerscreenshowsanymarket-makers’pricesplusordersfrombuyersandsellersseekingacounter-party.
sellshort:sellingsharesonedoesnotowninthehope
ofbuyingthemcheaperinafallingmarketbeforedeliveryisdue.
sharepremium:ifthenominalvalueofacompany’sshareis20pbutitissuesthemat50p,the30pdifferenceisinthebooksasthesharepremiumaccount.
shareholders’funds:theassetsofacompanyminus
itsliabilities;sincetheshareholdersownthebusinesswhatisleftultimatelybelongstothem.
short:goingshortmeansadealeriscommittedtodeliveringsharesheorshedoesnotown;itisdoneinanticipationofafallingprice.
spread:thedifference
betweenthebuyingandsellingpriceofashareorotherasset.
stockbroker:aprofessionaldealerinsecuritieswhoactsasanagentforinvestors.
straddle:buyingsimultaneouslyabuyandaputoptioninasharewiththesameexercisepriceandexpirydate;a
techniqueinoptionstradingusedbyinvestorswhoexpectvolatilityinthepriceoftheunderlyingshares,itwidensthebreak-evenpointbutmeanstheycanmakemoneyifthereisasubstantialmovementineitherdirection.
structurednotes:debtsecuritiesnotbackedby
mortgages,withcashflowdependentonanindexorindicesand/orwithembeddedforwardsoroptions.
support:inchartismitisthelevelatwhichfallingpricesstoporbouncebecausebuyersarebeingtemptedback.
technicalanalysis:in
practiceanothernameforthechartistwayoflookingatthemarket;itusesnotjusttheconventionalmethodofhavingalinetodepictpricemovements,butalso‘pointandfigure’charts.
TheUndertakingsforCollectiveInvestmentinTransferableSecurities(UCITS):allowcollective
investmentschemestooperatethroughouttheEUifauthorizedbyonememberstate.Thefundscaninvestinawiderangeoffinancialinstruments(includingderivatives),whicharesubjecttothesameregulationineverymemberstate.InpracticemanyEUmembersimposedextrarulesto
protectlocalassetmanagers.
Tradepoint:acompany(itselftradedontheAlternativeInvestmentMarket)providinganelectronicmarketinshares.
unittrusts:anopen-endedinvestmentvehicle(seeabove).
volatility:theamountoffluctuationinashareprice;themoreitmovesthegreatertherisk.
warrants:atypeofinvestmentallowingtheholdertobuypaperfromtheissueratafixedpricesometimeinthefuture;mostarelistedonthestockexchangeandcanbe
tradedlikeanyotherinvestment,priortotheirexpirydate.
with-profitspolicy:aninsurancecoverthatguaranteesapaymentattheendofthesettermorondeath,butwhichalsoaddsanannualandaterminalbonus,thesizeofwhichdependsonthecompany’sprofit;thatin
turnisaffectedmainlybyitsinvestmentinshares.
yield:calculatedbytakingtheamountofadividendasapercentageofthecurrentshareprice.Ifthesharesstandat120p(irrespectiveofwhatthenominalpricemightbe)adividendof12prepresentsayieldof10percent.If
thesharesthendropto100p,theyieldwillhavecorrespondinglyrisento12percent.Itislistedinthenewspapersasyieldandcomparesdirectlywithwhatcanbehadinabankorbuildingsocietyforthemoney,butshouldbehigher.
Index
accountingpolicies(i)AccountingStandardsBoard(i)accountsseereportsandaccountsacidtest(i),(ii)acquisitions(i),(ii)advice(i),(ii)advisory(i)AEX(i)
AllShareIndex(i)AlternativeInvestmentMarket(i),(ii),
(iii),(iv),(v)AltmanZscore(i)AmericanInternationalGroup(i)annualgeneralmeeting(i)Aristotle(i)assetbackingseenetassetvalueAuditingPracticesBoard(i)auditors(i)auditors’report(i)
balancesheet(i)Bancroft,Timothy(i)BankofCredit&Commerce
International(i)BATSEurope(i)
BEL20(i)Beta(i)Bloomberg(i)bluechips(i)bonds(i),(ii)borrowing(i)broker’scommission(i)Buffett,Warren(i),(ii),(iii),(iv),(v),
(vi)
CAC40(i)Cairncross,SirAlec(i)capitalassetpricingmodel(i)capitalprofits(i)capitalgainstax(i),(ii),(iii),(iv)capitalizationissueseescripissuecash-flowstatement(i)
chairmananddirector’sreport(i)charts(i)bar(i)candlestick(i)line(i)pointandfigure(i)Chi-X(i)churning(i)circulars(i)closed-endfunds(i)codesofconduct(i)CombinedCode(i)commodities(i)commonstock(i),(ii)CompaniesActs(i)CompaniesHouse(i)companyaccounts(i)
CompanyAnnualReportsOn-Line(i)complaints(i)consultation(i)contractfordifference(i)convertibles(i)costs(i)coupon(i),(ii),(iii)coverseedividendcovercoveredwarrant(i),(ii)CreditSuisse(i)Crest(i),(ii)currentassets(i),(ii)currentliabilities(i),(ii),(iii)currentratio(i)
DailyTelegraph(i),(ii),(iii),Dax(i)
day-trading(i)debentures(i)debtcollection(i)debt/equityratioseegearingdefensivestocks(i)derivatives(i)directors’dealings(i)directors’report(i)discretionaryservice(i)dividends(i),(ii)dividendcover(i),(ii)dividendyield(i)Dow,CharlesH(i)DowJonesIndustrialAverage(i)
economy(i)efficientmarket(i),(ii)
Elliott,Ralph(i)emergingmarkets(i),(ii),(iii)employeeefficiency(i)employeeshareschemes(i)energyprices(i)equityriskpremium(i)ethicalinvesting(i)Eurex(i)Euronext(i)Eurotop(i)(ii)exchangerates(i)exchangetradedfunds(i)extraordinarygeneralmeeting(i)
fashion(i)financialadvisers(i)FinancialOmbudsman(i),(ii)
FinancialConductAuthority(i),(ii),(iii)
FinancialTimes(i),(ii),(iii),(iv),(v),(vi)
flowoffundsseecash-flowforecasting(i)forwardcontractsseefuturesFTSE100(i),(ii),(iii),(iv),(v),(vi),
(vii),(viii),(ix),(x),(xi),(xii)FTSE250(i),(ii),(iv)fundamentalanalysis(i),(ii),(iii)futures(i)
Gann,WilliamD(i)gearing(i),(ii)gilts(i),(ii),(iii)GlobalFinancialData(i)
goingconcernbasis(i)GoldmanSachs(i)
HangSeng(i)HargreavesLansdown(i)hedging(i),(ii)highgrowth(i)HMRevenue&Customs(HMRC)(i)Home&Finance(i)
IBrX(i)indexfunds(i)indices(i)inflation(i),(ii),(iii)information(i),(ii)insolvency(i)Instinet(i)
institutionalshareholders(i)interestrates(i),(ii),(iii),(iv)interimreports(i)intermediaries(i)internet(i),(ii),(iii),(iv),(v),(vi),(vii),
(viii),(ix)investmentadviser(i)investmentclubs(i)investmenttrusts(i),(ii)InvestorsChronicle(i),(ii),(iii)ISA(i)ISDX(i)
Janeway,Elliot(i)
Keynes,LordJM(i),(ii)Koch,Richard(i)
LehmanBrothers(i)leverageseegearingLIBOR(i),(ii)LIFFE(i)linecharts(i)liquidator(i),(ii)liquidity(i),(ii)listingseequotationloanstocks(i)losers(i)
Mackie,Bill(i)Macmillan,Harold(i),(ii)magazines(i)margin(i)marketcapitalization(i),(ii),(iii)MarketXT(i)
Marks&Spencer(i)Mason,Jackie(i)momentum(i)Mondays(i)Moody’s(i)MorganStanleyCapitalInternational
(i),(ii)MorganStanleyDeanWitter(i)mutualfunds(i)
Naipaul,VS(i)Nasdaq(i)NasdaqOMXEurope(i)Nasdaq(i)(ii)netassetvalue(i)netcurrentassets(i)newsletters(i)
newspapers(i)Nikkei225(i)nomineeaccounts(i)Nomura(i)NYSEArcaEurope(i)
O’Higgins,Michael(i)onlineseeinternetopen-endedinvestmentcompanies(i),
(ii)operatingprofit(i)options(i)OrangeCounty(i)otherincomes(i)otheritems(i)othermarkets(i)overtrading(i)
P/Eseeprice/earningsperfectmarketseeefficientmarketperks(i)permanentinterest-bearingshares(i)Peter,Irene(i)pickingshares(i)PlusMarkets(i)police(i)pooledinvestments(i)portfoliomanagement(i)poundcostaveraging(i),(ii)preferenceshares(i),(ii),(iii)pre-taxprofit(i)price/earningsratio(i),(ii)profitandlossaccount(i)profitmargin(i)ProShare(i)
prospectuses(i)
quickratioseeacidtestquotation(i),(ii)quotedshares(i)
‘randomwalk’theory(i),(ii)receiver(i)recoverystocks(i)redemptionyield(i)REFS(i),(ii)regulatedmarkets(i)research(i)returnoncapitalemployed(i)returnonsales(i)returnperemployee(i)returntoshareholders(i)
returns(i)Reuters(i)reversetakeover(i)rightsissues(i)riskviii,(i),(ii),(iii)Rothschild,Nathan(i)Rothschild,Solomon(i)runningyield(i)Russell3000(i)
JSainsbury(i)scepticismviii,(i)scripissues(i)Seaq(i)selling(i)sentimentindicators(i)sharebuy-backs(i)
shareprices(i)Shaw,GB(i)Shell(i)shoppers(i)SIPP(i)small-lot(i)SouthSeaCompany(i)spread(i)spreadtrading(i)Stacey,Malcolm(i)Standard&Poor’s(i),(ii)StockExchangeElectronicTrading
System(i)Stockmarkets(i),(ii)stockturnover(i)stockbrokers(i)stoporders(i)
strategy(i)strikeprice(i)subordinateddebenture(i)swaps(i)
takeovers(i)tax(i),(ii)rates(i)TechMark(i),(ii),(iii)technicalanalysis(i),(ii)technicaltools(i)ThalesofMiletus(i)ThomsonDatastream(i)timing(i),(ii),(iii)Toronto300(ii)trackerfunds(i),(ii),(iii)tracking(i)
Tradepoint(i),(ii)trading(i)TRowePrice(i)turnover(i)Twain,Mark(i)
UKMajorCompaniesHandbook(i)UKSmallerCompaniesHandbook(i)Unilever(i)unittrusts(i),(ii),(iii)
valueadded(i)venturecapitaltrusts(i)voluntaryarrangement(i)
WallStreetJournal(i),(ii)warrants(i),(ii),(iii)
Wilshire5000(i),(ii)
yieldseedividendyieldyield,redemption(i)yield,running(i)
If you speculate on the stockmarket, you do so at your own
risk.
Publisher’s noteEvery possible effort has beenmade to ensure that theinformation contained in thisbook is accurate at the time ofgoing to press, and thepublishers and author cannotaccept responsibility for anyerrors or omissions, howevercaused. No responsibility for
loss or damage occasioned toany person acting, or refrainingfrom action, as a result of thematerial in this publication canbe accepted by the editor, thepublisher or the author.
First published in 2002Second edition, 2004Third edition, 2010Fourth edition, 2012Fifth edition, 2014
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ISBN 978 0 7494 7238 2EISBN 978 0 7494 7239 9
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Becket, Michael (Michael Ivan H.) How the stock market works : abeginner’s guide to investment /Michael Becket. – Fifth edition.
pages cm ISBN 978-0-7494-7238-2(paperback) – ISBN 978-0-7494-7239-9 (ebook) 1. Portfoliomanagement. 2. Investmentanalysis. 3. Stock exchanges. I.Title. HG4529.5.B43 2014 332.64’2–dc23
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