Introduction to Shares

Business is the art of extracting money from another man’s pocket without resorting to violence. - Max Amsterdam

 

Introduction to shares

Shares, stock, equity, whatever you call it; shares are an integral part of any investor’s portfolio. Most superannuation accounts are heavily geared toward stocks if you have balanced or growth options selected. A share gives you partial ownership of a company. When you own part of the company, you are generally entitled to part of the profits (dividends). Some stock have more voting rights than others (different classes) but for the most part, for each share you own, you have one vote on the outcome of where the company is headed. Easy.

So when you have majority ownership eg >50% of the shares, you effectively decide what goes on in the company. You can apply this to private companies, where there could be 2 shares, up to the biggest listed companies which have hundreds of millions of shares outstanding.

You can imagine that say a big bank like Westpac which has more than $100 billion market cap (the amount of shares on the market multiplied by the share price), even if you had $1 billion worth of Westpac shares (30.3 million by my estimations), you would only have 1% ownership of the company and its profits.

Most of the top 100 companies (ASX 100) are owned by investment companies and banks because, A – they have the money to splurge, but B – they are required to purchase these companies so that they mimic the performance of the top 20, 50, 100 etc companies overall. These are called indices, with the ASX 200 number and All Ordinaries (Top 500, making 98% of all market cap) the most common terms you always hear in the news. It is a number that reflects the overall movement of the top 200 / 500 companies – companies like BHP and CBA which make up a lot of the market cap for the top 200, contribute more to changes in the index than a smaller company.

Shares in Australia are listed either on the Australian Stock Exchange (ASX) or the Chi-X. ASX is by far the most popular and biggest exchange.

Why bother with shares? Aren’t they risky?

With risk comes reward. Think about it, why do companies need to pay higher interest to attract investors compared to government bonds? It all has to do with the higher perceived risk of companies vs a government.

Companies typically don’t pay out 100% of what they make to shareholders. Whatever they don't pay they use for working capital, paying down debt, but also it can increase the cash reserves that the company accumulates, much like savings that you and me do each week. So what’s left over is used by the company to grow and expand. If the company can grow the money faster than you can, it should be left inside the company to compound and make more profits. Companies are after all, designed to make profits. The biggest proponent of this is Warren Buffet. Other than the first time he paid dividends, (mind you, he regretted the decision ever since) he has always reinvested the profits within the company because he knows he can generate higher returns using the company than outside the company.

Performance of asset classes over the last 10 years to 2012

Since 1900, over a 20 year rolling term, there are only a handful of occasions where the returns on cash and bonds are higher than shares. If you look at 40 year periods since 1990, shares outperformed cash & bonds in every single period. Of course past performance is no indication of further performance, but with over 110 years worth of history, it is hard to ignore.

Ongoing stream of income

For as long as you hold the shares, you continue to enjoy the dividends and hopefully capital gains. Most large cap companies pay dividends twice a year, and so long as you hold the shares, you will continue to receive the dividends each time they are paid (assuming the company stays profitable and has profits to distribute).

Tax benefits – franking credits and capital gains tax (CGT) discounts

Franking Credits

The company tax rate is 30% and when businesses pay tax on profits, they then distribute profits to its shareholders via dividends. When individuals receive these dividends it would be unfair if they had to pay tax on these profits again seeing as how the business has already paid tax on these profits. This is the basis of franking credits.

At tax time, to account for the dividends, you include in the dividend income the amount of the dividend, but also the amount of the franking credit.

So my most recent Westpac dividend statement looked a bit like this:

Dividend per share: 98 cents

Participating shares: 200

Unfranked amount: $0

Franked amount: $196.00

Total Amount: $196.00

Franking Credit: $84.00

What I include in my tax return: $196.00 + $84.00 = $280.00.

Don’t worry. On your tax return there is an item called Franking Credit offset, which is equal to the sum of franking credits. Given the above example, it would be $84, assuming the above was the only dividend I receive during the financial year.

So if you had a marginal rate of tax of 30%, you would not pay tax on these dividends because the company tax rate is 30% and assuming this is fully franked dividends, it completely offsets the tax you would have had to pay.

If the marginal rate is <30%, then the investors are entitled to refunds from the ATO, if higher, say 45% marginal rate, then you would still benefit in that 45 – 30%, leaves 15% tax liability.

The above example has the total amount equalling the franked amount because there was no unfranked amount. Sometimes you may get a company which only has partial franking, eg 30% franked, as opposed to fully franked (100% franking credits). What determines the franking level of a company depends on the source of income and profits for the company and whether they paid enough tax to be entitled to pass on the franking credits to investors.

Also, we use the date that the dividend was paid to determine which financial year to include the income to.

CGT Discounts

Shares like many other assets are entitled to 50% discounts on the capital gains if you hold the shares for over 12 months. How this works is, for example you bought CBA and held them for 2 years. Hopefully you would have made a profit on these shares. Sold @ $75, bought at $55, profit of $20 each share times 100 shares is $2000 profit.

Gains that is reported in your tax return would be $2000 less the transaction costs x 50% discount, and that is your capital gains.

More liquid than property

Everyone knows how awesome property is as a wealth creating investment vehicle. You’ve heard it all the time about property prices exploding and how unaffordable it is. Well for property owners, this is just music to their ears. The only issue with property is that there is comparatively large transaction costs involved when buying and selling property. Stamp duty, legal fees, conveyancing fees, and so forth. Not to mention the time it takes to proceed with the trransactions, with settlement periods on average 6 weeks.

With shares? Every time you buy and sell you incur brokerage costs, about $19.95 for trades up to $10k usually. Shares trade under a settlement period of T + 3. What this means is that you need to fund the shares by 3 business days after the day you make the share transaction (or get the funds when you sell shares).

Won’t people think of the Shareholders!

If you can’t beat them, then join them. Whenever there is an interest rate move by the RBA, and the big banks don’t pass on the rate cut in full or even increase their rates independent of the RBA, their main excuse is that they have to balance the needs of their customers (their savers, mortgage holders and loan holders) and the needs of their shareholders who want the best return possible. So if you own part of the company, you own part of the record profits that banks always seem to enjoy, despite their “difficult trading conditions”. Hmm.

Difference between gambling?

Well with gambling, you’re either right or you’re wrong. If you’re wrong, you lose. Most of the time, you lose all of your bet. With shares, even if you’re wrong, you won’t lose everything. Sure it might go down, but if you’re confident in the company and its ability to generate profits, then it should recover in time.

You can also gamble with shares through speculating, but that is different from investing, as will be discussed below. Not a viable strategy in the long term in my opinion.

Basics

Buy (Long) and Selling (Short): Buying shares is also known as being LONG shares, where selling is known as SHORTING or being Short.  This is done either through a broker (middle man) or more commonly today – online trading (some options are listed at the end). You have 2 options when you are buying and selling. The market price, this would instruct your broker or online trading company to buy the shares at the current market price. You are guaranteed to have your order go through when you do the market price. Alternatively you can specify the exact price for the transaction to be done at.

A sale only occurs where the buyers and the sellers can agree on a price with which to do the trade. How the market is organised is that the Buyers of the shares will be prioritised first with the people willing to pay the highest will get priority. Then the sellers, the ones willing to offer to offload their shares for the lowest price will get priority as well. If you set the buy price too low or the sell price too high from what the current market price is, your trade may not go through.

Because of the fact that buying and selling incurs brokerage costs (generally $19.95 up to $10k worth of shares), i.e. a round trip would mean $40 down before you break even, it is important that your trades are big enough so that brokerage does not make up a large portion of the costs.

Let’s say you buy a parcel of NAB shares for $2000. Because of brokerage costs, the share price needs to be up 2% just to break even. Now if it were $10,000 worth of shares, then the shares need only advance 0.4% for you to break even.

Borrowing money to buy shares: Also known as buying on margin or using leverage. I wouldn't recommend doing it unless you really know what you’re doing and understand the full risks involved. Leverage will increase your profits during booms, but will exacerbate your losses if it should go down.

Dividends: With dividends, you can elect to receive it via cash to your bank account or via a dividend reinvestment plan (DRP). Cash is easy enough to understand, so I’ll skip straight to DRP. Most companies give you the option to reinvest the dividends through their DRP. You can elect to choose how many shares participate in the DRP (eg 50% of your shares, then 50% will be paid as cash), or full DRP plan. The price at which the DRP purchases the new shares is usually some weighted average price of the shares over a certain number of days chosen by the company. It is important to note the price as it forms your cost base for the dividends if you ever decide to sell them in the future.

Some advantages of the DRP is that it is an easy way for you to buy more shares in the company without brokerage costs. It will also buy more shares when the share price is lower, and less shares when the share price is higher.

A few companies even offer discounts to the market price as an incentive to choose DRP and stick it out with the stock.

For tax purposes, regardless of whether you take the cash or more shares, you treat it in your tax return the same. You treat it as if you received the cash, and do what was described above in the section for franking credits.

Dollar cost averaging: This technique involves buying shares regularly regardless of the share price. You don’t pretend to know when it is a good share price to buy at, so you will buy at both high prices and low prices, but keep at it long enough and you get to an average share price for a particular share.

When prices are high, fewer shares are bought. When prices are low, more shares are bought. You will then have ensured that you have not paid the highest price, but also not the lowest price either.

This also works if you buy some shares, and then it goes down. Nothing has changed for the company and you believe that it is still a worthwhile investment. You then purchase more shares at the lower price, thereby lowering your average purchase price of the shares.

Diversification: The idea around this is that you should look to have many different parcels of shares spanning many different industries so that if some industries go down, hopefully the others would have gone up (aka, not keeping all the eggs in the same basket). Should you suffer from big losses in one share, the hope is that the profits from your other shares will ease the pain.

Keeping records for tax time – Because of the tax implications and capital gains tax rules, it is important to keep accurate and up to date records of everything relating to shares. Keep a separate binder for all things share related. Some things to keep track of include:

·         date
·         price
·         which company
·         reason why you purchased it

Investing vs speculating

The first rule to remember is that don’t invest what you can’t afford to lose. Also, if you have a mortgage, owning shares could be an opportunity cost for you as it could otherwise be used to reduce interest on your mortgage. You will need to weigh up the benefits of diversification and expected returns to the cost of owning shares.

The second rule is that shares is a long term investment. Not as long term as houses, but generally you should be thinking a few years investment horizon. A really smart guy called Benjamin Graham, which incidentally happened to be Warren Buffett’s mentor in finance, once noted that during the short term, the sharemarket is a voting machine. In the long term it is a weighing machine.

In the short term, the sharemarket is very volatile. No escaping that. Prices seem to move independent of things that the company does or its earning potential. Some riots or uprising in Syria manages to bring the share price down. Some numbers for USA non-farm payroll come out better than expected. Share prices go up. Humans are invariably controlled by emotion and the emotion of fear has the potential to cause the sharemarkets to do crazy things.

This brings us to opportunities. If prices of sound, consistent, profitable companies get hammered for no fault of their own, then if you’re sure it will bounce back, perhaps it is a good time to get some of the action. In the long term, the market will go back to equilibrium, will reflect all available information, and share prices will reflect the value of the company and its future earnings capabilities.

One of my favourite quotes from Warren Buffett is:

“Be greedy when others are fearful and be fearful when others are greedy.”

Where do we start

I can't tell you what to buy, but can give you an idea of how to choose shares

Fundamental and value investing: Fundamentals pretty much implies what it means. We are looking at the insides of the company. The annual report, balance sheet, the income statement, etc.

Look at the various ratios, and the numbers, the economics of the business – does the business stack up? Good market position, hard for new entrants to get in? What about challenges that the business could face going forward. These are some of the questions that need to be looked at.

Evaluate shares as if you were evaluating a business. You are actually purchasing an ownership right of a miniscule part of the company.

Technical: involves looking at charts of the share prices and trying to extrapolate information from that. Don’t ask me how, I prefer looking at the fundamentals, but this is also something you can read up on if you are interested.

2 Books you can start with:

Peter Lynch – One up on Wall St.

(Beginner to intermediate)

Lynch proposes we look at investment opportunities closest to home. Look at successful businesses in your daily life for ideas. Huge lines at JB Hi Fi every time you go? Perhaps it is worth investigating further. Upon further investigation, JB Hi Fi looks undervalued – maybe now is the time to pull the trigger to buy. Is Myer always deserted? Maybe not wise to buy the stock

Alice Schroeder – Snowball

(Beginner level – biography on the life and investment habits of Warren Buffett, the world’s greatest investor, philanthropist and 3^rd richest person in the world)

3 Key messages:

•    Circle of competence – stick to companies that you can understand. Chances are if you don’t know what the heck a biometrics company does or how it earns its money, then it is unlikely you understand it well enough to have a good idea of investing or not
•      Business moat – does the business have something that gives it a competitive advantage, but also prevents other businesses from being able to compete.
•     Good value – Buffett is a huge proponent of getting value for his money and not paying more than necessary for a business. If a company has $50 million in cash reserves with no debt, and the whole market cap of the business is $48 million, then that could be something to look into. It could be that the business is facing some scandals, but that doesn't change the fact that it is being sold for less than the value of realisable cash!

Big players

All the big banks offer online trading for shares on the ASX. From time to time, they offer free brokerage up to $600 for a certain amount of trades for a certain amount of time.

Commsec (CBA) – the most popular and arguably the most user friendly. Their cash management account comes with a debit card making it convenient to spend your profits!
E-Trade (ANZ)

Westpac / St George

NAB

Disclaimer

Everything in this post is general information. I am not giving any recommendations of particular stocks nor have I taken your personal circumstances into account when typing this post. You should only use the information as a general guide and not rely solely on what I have posted, but make your own enquiries that are suitable to your needs.

Thanks!