Note on the Ebook Edition This ebook published in 2014 by...

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This ebook published in 2014 by

Kogan Page Limited2nd Floor, 45 Gee StreetLondon EC1V 3RSUK

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http://www.koganpage.com

© Michael Becket, 2012, 2014

E-ISBN 978 0 7494 7239 9

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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

http://www.thewma.co.uk

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

http://www.thewma.co.uk/private-investor-indices

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

http://www.hl.co.uk

subscription.Theadvantageisthatyoucandealimmediatelyontheinformationandattheprice.GoogleFinancealsoprovidesshareprices,chartsandcommentariesonmostcompaniesquotedinLondon.Inaddition,therearenewsservicessuchaswww.bloomberg.comandspecialistservicessuchas

http://www.bloomberg.com

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

http://www.thestreet.com

http://www.fmlx.com

http://www.hemscott.co.uk

http://www.news-review.co.uk

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

http://www.fool.co.uk

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]

http://[email protected]

08000234567;[email protected]

Figure 9.1 Roles of thebodies in the newregulatory architecture

http://[email protected]

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

http://http://www1.cityoflondon.gov.uk/CityPolice/Departments/ECD/Fraud/boilerroom.htm#sthash.cdL5LacD.dpuf

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

http://www.fca.org.uk/scams

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

http://www.europeaninvestor.com

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

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

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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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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