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CHAPTER 5 Investing in Shares
Investment Objectives • People invest for all sorts of reasons. Some do it as a way of accumulating money for major future purchases such as a car or deposit on a home, some as a way of supplementing their income (for example, through dividend or interest payments), and others as a way of saving enough money for their retirement.
Investment Objectives • Not all investing would normally be regarded as saving – it is usual to distinguish between investing as a form of savings and speculating. • Investing generally involves a medium- to long-term perspective and the investor generally seeks relatively stable and predictable returns. • Speculating is a riskier activity which occurs when returns are much more volatile and less predictable, and generally has a short-term perspective – the speculator is looking for a quick, high reward.
Investment Objectives • For a new investor with limited funds, it is usually advisable to stick to the basic investment choices — shares, bonds or managed funds (managed funds are covered in Chapter 7). • It is usually best to aim for reliable returns rather than spectacular ones. • Risk and return are closely related to each other. • A carefully selected combination of investments will usually provide a reasonable return with reduced risk.
Investment Objectives • Saving for Financial Goals • Some major financial goals: buying a car or house, paying for their children’s education, and having enough income for a comfortable retirement. • Typically the money for these goals doesn’t come from cash reserves, but instead must come from excess earning capacity. • Investing comes into the process of financial planning in the use of these excess funds.
Ways to Invest • Short-term investments • Short-term investments are normally classified as the money market. They comprise securities with maturities of one year or less and include cash, savings accounts, bank accepted bills (BABs), certificates of deposit (CDs), and Treasury notes issued by the Reserve Bank of Australia (RBA). • Short-term vehicles carry little or no risk and they are often used to warehouse funds.
Ways to Invest • They earn a return while suitable longer-term investments are found. • Conservative investors may have all or most of their money invested in them as their primary investment product. • Risk in lower interest rate environments lies in the chance of a negative return after tax and inflation.
Ways to Invest • Shares • Shares are equity investments that represent ownership in a corporation. • Each share represents a fractional ownership in the firm. • Next to short-term vehicles and investment properties, shares are the most popular form of investment for individual investors.
Ways to Invest • The return on share investments comes from either of two sources — dividends, which are periodic payments (often semi-annually) made by the corporation to its shareholders from its current and past earnings, and capital gains, which result from selling the share at a price above that for which it was originally purchased.
Ways to Invest • Fixed-income securities • A group of investment products that offer a fixed periodic return. • Some forms offer contractually guaranteed returns while others have specified, but not guaranteed, returns. Because of their fixed returns, fixed-income securities tend to be popular investments during periods of high interest rates when investors seek to lock in high returns.
Ways to Invest • The main forms of fixed income securities are: • bonds • preference shares, and • convertible securities
Ways to Invest • Bonds • Bonds are the long-term debt instruments (that is, IOUs) of corporations and governments. • A bondholder has a contractual right to receive a fixed interest return (known as the coupon rate) plus the return of the bond’s face value (the stated value given on the certificate) at maturity (typically three to 10 years). • Long-term debt instruments issued by corporations (the Corporate Bond Market) can be classified as debentures or unsecured notes.
Ways to Invest • Preference Shares • Like shares, preference shares represent an ownership interest in a corporation. • Unlike shares, preference shares have a stated dividend rate — payment of this dividend is given preference over other share dividends of the same firm. • Preference shares have no maturity date. • Investors typically purchase them for the dividends they pay, but preference shares may also provide capital gains.
Ways to Invest • Derivatives • Derivative securities derive their value from the value of an underlying security or asset (hence the name). They typically possess high levels of risk, because they usually have uncertain returns or volatile market values. • Because of the relatively high risk of investing in derivative securities, these investments also have high levels of expected return.
Ways to Invest • The main types of derivative securities are: • options, and • futures
Ways to Invest • Options • Options are securities which give the investor an opportunity to buy or sell another security (called the underlying security) at a specified price (called the exercise price) by a given date (called the expiration date, exercise date, or maturity). • If you can do this at any time up until the expiration date, the options are called American options. • If you can do this only on the expiration date, they are called European options.
Ways to Invest • There are two basic types of options — • puts and calls. • put options give the purchaser the right but not the obligation to sell the underlying security, whereas • call options give the purchaser the right but not the obligation to buy the underlying security. • With shares there is a type of option known as an equity warrant. • Put and call equity warrants are issued by banks and other approved institutions, and traded on the ASX. These warrants can be treated like ordinary options in most respects.
Ways to Invest • Futures • Futures are legally binding obligations stipulating that the sellers will make delivery and the buyers will take delivery of a specified commodity or financial instrument at some specific date in the future, at a price agreed on at the time the contract is sold. • There are some contracts that are actually cash-settled instead of delivery taking place (an example is the 10-year bond contract on the Sydney Futures Exchange (SFE)).
Ways to Invest • Managed Funds • An institution that raises money from investors and invests in and professionally manages a diversified portfolio of securities and/or real property is called a managed fund. • Investors in the fund own an interest in the fund’s portfolio but not in the underlying assets. • The fund invests pooled funds to yield returns in income and/or capital gain.
Ways to Invest • Managed funds include unit trusts, cash trusts, allocated pensions and annuities, and superannuation funds. Unit trusts provide a range of investment choices — trusts may invest in property, equities, mortgages and other investment products. Listed trusts (on the ASX) allow investors to sell their shares (units) at the time of their choice.
Ways to Invest • Property • The term real estate refers to assets such as residential homes, vacant land, and a variety of forms of income property, including warehouses and office and apartment buildings. • As a result of generally increasing values and favourable tax treatments since World War Two, real estate was a popular investment vehicle through the 1970s and much of the 1980s. • After another huge run in property prices the current property market is again depressed.
Ways to Invest • Tangibles • Tangibles are investment assets, other than real estate, that can be seen or touched. • They include gold and other precious metals, gemstones such as diamonds and sapphires, and collectibles such as coins, stamps, artworks, antiques and even wine.
Risk & Return • It is often said that risk and return are two sides of the same coin. • That is, if an investment has a high expected rate of return then it will have a high level of risk as well, and conversely if it has a low level of risk then it will usually have a low level of return. • This is sometimes called the risk-return trade-off.
Some Types of Investment Risk • Exchange rate risk • Business risk • Financial risk • Purchasing power risk • Interest rate risk • Marketability risk • The liquidity risk • Event risk
Components of Risk • The risk of an investment consists of two parts: diversifiable and non-diversifiable risk. • Diversifiable risk, also known as unsystematic risk, results from uncontrollable or random events, such as labour strikes, legal actions and regulatory actions. • Such risk affects various investment products differently. It is called diversifiable because it represents the portion of an investment’s risk that can be eliminated through diversification.
Components of Risk • On the other hand, non-diversifiable risk, also called systematic risk, is attributed to forces such as war, inflation and political events that affect all investments and thus are not unique to a particular investment • The sum of these two components of risk is called total risk: • Total risk = Non-diversifiable risk + diversifiable risk
Returns From Investments • The return from an investment can come from two sources — • current income, and • capital gains
Returns: The Holding Period Return (HPR) • The holding period return (HPR) is the total return earned from holding an investment for a specified period of time (the holding period). • This measure is usually used with holding periods of one year or less. For longer holding periods it is usual to use the yield or internal rate of return of the investment.
Returns: Yields • The yield or internal rate of return is the compounded annual rate of return earned by a long-term investment. It can also be viewed as the discount rate that produces a present value of benefits from the investment just equal to the cost of the investment.
Shares: The Appeal • There is no doubt that shares have become a popular form of investment for individual investors, both directly and through their holdings in superannuation or managed funds. • Much of this appeal can be attributed to the potential to earn tax-effective income.
Shares: Categories • Shares are commonly divided into a variety of categories — we will look at nine categories of shares. • They are: • blue-chip shares • value shares • growth shares • speculative shares • cyclical shares • defensive shares • large-cap shares • mid-cap shares, and • small-cap shares
Shares: Investment Strategies • Buy-and-hold: • This strategy involves looking for solid companies which will be around over the long term and then investing in them and holding on to this investment for the medium to long term (say 7–20 years). This will usually give a solid combination of current income (through dividends) and long-term capital growth (through the growth in the share price over time).
Shares: Investment Strategies • Generally you would diversify your investments by selecting several stocks (and probably some bonds) to reduce risk yet retain good returns. • However, even with a buy-and-hold strategy, the share portfolio has to be well managed if it is to perform well over time.
Shares: Measures of Performance • There are several measures available to the astute investor who wants to measure the performance of shares. • One of these is the dividend yield.
Shares: Measures of Performance • Six of the most commonly used measures are: • book value • net profit margin • return on equity • earnings per share • price/earnings ratio, and • beta
Shares: Measures of Value • Dividend Valuation Models • One example, the constant dividend model, assumes that the dividends paid do not change over time. • Making this assumption is a little unrealistic as a shareholder would normally expect the dividends paid to increase with the share price (keeping a reasonably constant dividend yield). • However, it is a simple model to use since we do not have to estimate how much the dividends will change over time.
Shares: Measures of Value • Fundamental analysis • Fundamental analysis of shares measures value, taking into account the economic fundamentals, to obtain estimates of value. • Technical analysis • In contrast, technical analysis (or charting) uses graphs of the price history of an asset over a particular time period to look for patterns which will indicate what will happen to the asset’s price in the future. • Chartists look for recurring patterns in the history of price movements and have created a bewildering array of terms to describe these so-called patterns.
Markets and Exchanges • Money Market • Short-term securities; one year or less • Capital Markets • Medium/long term; equities, debt, foreign exchange, derivatives • Primary Markets • New securities are sold to investors; RBA tenders, IPOs (‘floats’), seasoned offerings such as rights issues, public and private placements • Secondary Markets • Existing ‘second hand’ securities are traded between investors; organised securities exchanges and OTC
Markets and Exchanges • Organised securities exchanges • ASX • Sydney Futures Exchange • New York Stock Exchange • NASDAQ
Regulation • ASIC • Corporations Act • ACCC • Trade Practices Act • ASX • Business Rules • Surveillance Department • National Guarantee Fund
Regulation • Insider Trading • The use of private information to make profitable securities transactions • — Unethical • — Illegal
Brokers and Trading • Roles of stockbrokers • Transactions • Research • Advice • Types of stockbrokers • Full service (advisory) • Discount (non-advisory) • — Telephone orders • — Internet
Executing Trades • Order to sell buy is made to broker and entered to SEATS • — At market (best available price) • — Limit (at a particular price or better) • — Stop Loss (sell if a specified price is reached) • Orders matched and trades executed by SEATS • Contract notes sent • Buyers pay broker within 3 days (T+3) • Share ownership transfers on CHESS • Funds transfer from buying to selling brokers through CHESS • Sellers paid at T+3
Margin lending • Borrowing to magnify losses and gains (gearing or leverage) • Security for margin loans is the investment itself • A deposit or extra security is required to establish a margin (buffer) between the loan value and the investment value • The margin must be maintained; if investment values fall, extra security or cash may be called for (margin calls) • If calls are not met, the investments will be sold • If a shortfall remains after investments are sold, the borrower is liable for it and must pay from other resources
Information and Indices • Useful information for investors • Economic developments • Current events • News of industries and individual companies • Prices of shares, commodities and currencies • Sources • Media; Aust Fin Review, Wall Street Journal, Economist etc • Government publications; ABS, RBA • Publications and websites of the ASX, companies, brokers, ratings agencies
Information and Indices Indices allow comparisons over time of average performance across market segments or entire markets
Summary • This chapter has covered • The objectives of investment • The risks involved • Risk/Return tradeoffs • Returns on investment • Types of shares and strategies • Measurement of performance and value • Markets, exchanges and regulation • Brokers and trading • Margin lending • Information sources and indices
