Shares digital

A new year brings with it new prospects and new investment opportunities, but where to start? Rachel Robson breaks down the fundamentals of investing and spells out the joy of shares

Will 2008 be the year that brings the chunky returns you have been longing for on your investments, or are you reading Shares for the first time, pondering which stocks to invest your money in and wondering where to start? The stock market can be a bit daunting, particularly if you are new to it. There are so many companies to look at, so many stocks to examine, so much news to read, and after last year’s turmoil, the first time investors may be feeling a tad confused. The stock market certainly isn’t a place to dive into half cocked, but if you have a fair idea of what you are doing, are prepared to take the rough with the smooth, and have lots of patience, it is possible to make the big bucks you are hoping for (well some of them anyway).

The ABCs

The idea of ‘shares’ dates back to the early 17th Century and the Dutch. Simply put, supporters of a company are given a share of the business by way of a thank you for their funding. Because investing in a company can be risky, shareholders of some successful companies are given part of the company’s profits in the form of dividends in return for taking the risk.

In the UK, the largest stock exchange is the London Stock Exchange (LSE). It was founded in 1801 and is one of the largest stock exchanges in the world. Situated in the heart of London, the LSE is divided into two parts, the main board and the Alternative Investment Market (Aim, or sometimes called the junior market). The main board carries more than 1,600 companies from 60 countries, including many of the world’s largest companies. Listed companies are required to follow a set of rules, which include issuing a profits warning if profits are likely to fall far below expectations, and issuing financial results twice a year within a given period.

The Alternative Investment Market meanwhile is reserved for smaller businesses and has a more flexible regulatory system than the main market, with lower fees. One requirement, however, is that Aim companies must have a nominated adviser, otherwise known as a nomad. The LSE must approve the nomad and if, for some reason, the company has a disagreement with the nomad and ends up without one, the group’s shares will be suspended. Ultimately, if no new nomad is found, the shares will be delisted. Aim companies are also obliged to inform shareholders of any changes in their financial state.

One of the big attractions to the junior market is that Aim securities are treated by HM Revenue & Customs (HMRC) in the same way as shares in unquoted companies. As a result, they have the benefit of enhanced taper relief, with a maximum of 75% relief after two years. In comparison, for shares in companies quoted on the main board, investors only get the maximum 40% relief after ten years, bringing them to 24%, or 12% for lower-rate taxpayers. However, recently there has been much talk about Alistair Darling’s plans to abolish taper relief and create a new starting rate for capital gains tax for both higher-rate and lower-rate tax payers (currently 40% and 20% respectively) at 18% – a move that is not being warmly welcomed by Aim investors.

It is also worth noting that some caution is needed when investing in Aim companies because smaller companies are often more vulnerable to financial problems and therefore can hold a greater element of risk.

Know your limits

So where do you start? Firstly, it is important to decide on how much money you are prepared to invest. The most important point to remember is that you should only invest money in shares that you truly believe you can afford to lose. Before you start anything, you need to ask yourself where the money you plan to use is coming from and if you end up losing that money, will you still be able to live comfortably and pay your bills, etc.

Many experts say £2,000 is good minimum amount for a single individual investment, but strictly speaking there is no minimum amount – if you play your cards right, you could see yourself making solid returns having only invested a couple of hundred pounds. What you do need to remember is that there are other costs involved. Nowadays the process of dealing in shares is much cheaper and easier thanks to the wonders of the internet, but still, you do need to take a note of what your additional costs are likely to be.

A lot of the cost of trading shares comes from the broker’s commission. Selecting a broker in itself can be a difficult task as there are so many out there, and costs can vary a fair bit. Dealing online is usually much cheaper than dealing over the phone. For example, TD Waterhouse will charge you £12.50 for a trade online, but at least £20 over the phone. I say at least, because the £20 minimum is dependent on the size of the trade – another point that investors should be aware of – as the size of the trade can ultimately decide the size of the commission fee. Investors should also keep an eye out for any hidden charges, including one that may be particularly surprising, a charge for simply being inactive.

But it doesn’t end there. Further costs will come your way in the shape of stamp duty when you buy shares. Stamp duty is set at the rate of 0.5% and this tax will of course comfortably slide into the government’s pocket. However, stamp duty is only applicable when buying and you do not need to pay it when you sell shares. In addition, there is the cost of trading. With shares, you need to be aware that there is a difference between the price available for an immediate sale (bid price) and an immediate purchase (ask price). The difference between the two is called the spread and it varies with risk. Larger companies, such as British Airways (BAY), which have a large market value will have a fairly small spread of around 1 to 1.5% as people always want to deal in their shares. However, smaller companies which only have a few shareholders and therefore limited deals, will have a much wider spread, usually lurking around the 10% region.

Learning the ropes

Now that you have your finances sorted, you are almost ready to take the next step. But before you do, you need to ensure you are prepared to make mistakes. Mistakes do happen, whether you like it or not, and with them come losses. Don’t despair, this is an inevitable part of the process and is a great learning technique. However, if you are feeling a little uncertain, a good way to learn the basics is to dabble on the numerous shares games available online, in which you can buy and sell shares with imaginary money. This is a great way to get to grips with what you are doing and will help you to learn how to manage your money and investments. Gradually, as you start to feel more comfortable with the process, you can push the boat out and try out your luck on the real thing.

The next big question you have to face is which shares are you going to buy? One important point to take into account when choosing shares is not to put all your eggs into one basket. That is, don’t decide that because you like buying clothes you are going to invest all your money in clothes retailers, for example. If clothes sales plunge for some reason, you can say goodbye to a good chunk of your money in one go. It’s much more sensible to invest in a variety of stocks and mix it up a little, and in so doing, you will reduce some of the risk factor. However, it’s equally important not to go mad and have such a large portfolio that you can’t keep track of everything in it. Usually a portfolio of between eight and 15 stocks is advised.

It’s also important to make sure you research your stock. Have a look around and see which companies interest you, see what is going on in the market, or you might simply want to invest in a company whose products you use anyway and believe to be good value. Have a look on the company website and see what the company has been up to, what its last results were like and so on. Ultimately you need to decide whether you want to go for more of a safe bet with solid returns, or fancy taking a bit of a gamble on a riskier stock that has potential to give you higher returns if the business/technology takes off.

Alternatively you can be more analytical about it and acquaint yourself with the chartism. This relates solely to the movements of share prices in the recent past to forecast how they will move in the future. The idea is that everything revolves around the pattern of movements and so no attention is paid to how well the company is managed or other such factors. The share price is plotted in several different ways to see whether any pattern is developing, which could indicate more substantial movement. (See Shares’ own chartist pages.)

Keeping it up

Once you have picked your stocks you are ready to play and ready to make your fortune. However, again it’s not that simple. You need to ensure that you play the market right, and that means ensuring that you keep an eye out for any news and developments, and get a feel for when it is the right time to sell your stock. This is not necessarily straightforward. Believe it or not, emotions can easily play a part in your decision making. Sometimes they can get in the way of long-term gains, making you sell shares too early in a bid to make a quick small profit, but on the flip side, emotions can make you become too attached to a stock and hold on to a bad share for far too long. When it comes to losing money, it can often be difficult to remain hard headed and sell a share when it’s on a losing streak because there is always that niggling thought at the back of you head saying, ‘what if the stock shoots up the minute I sell?’ When it comes to it, simply selling a spiralling stock straight away is usually the best way to go.

One way to avoid this dilemma is to use stop losses, which will help to determine when it is time to sell up. Usually a good place to set your stop loss is about 20% below the price at which you bought your shares. So if you have bought a share for 100p, your stop loss would be at 80p. Once it hits that mark you simply sell, thus keeping your losses to a minimum. For larger companies, you might want to set a tighter stop loss of around 10%, or even 5% in some cases. Equally, you might want to widen the stop loss to 25-30% for certain smaller companies that are more volatile. Some investors also use trialing stop losses. This means that as the stock rises, the stop loss rises proportionately. If the stock falls, the stop loss remains the same. So if you have bought a share at 100p, with its 80p stop loss, and the stock then rises to 120p, you would have a new stop loss of 96p.

This can be an extremely effective way of controlling your trades. You will still need some will-power if you are going to use stop losses and you also need to be prepared for the fact that it may not all go your way. You may find you sell at your stop loss, only to see the share price shoot up a few months later. Alternatively, something like a profit warning could see shares plummet well below your stop loss and you could lose a lot more money than you had initially envisaged. However, it still prevents you from vacillating about when to sell your stock and can prove very beneficial.

Practice makes perfect

Overall, a lot of trading on the stock market simply comes down to practice and patience. The more you dabble, the more you will learn and the better you will become. Last year brought a lot of ups and downs for the stock market, highlighting the fact that trading in shares is a risky and volatile business. But that doesn’t mean you should be put off. With a fresh year ahead of us, now could be a good time to take the plunge and have a go at building up a solid portfolio of stocks. If you do your research properly, are prepared for the highs and lows, and have your finances in check, you could find yourself with a very handsome portfolio that could well be worth your while.

BREAKING THE JARGON CODE

Earnings per share (EPS)

This is calculated by dividing a company’s final 12-month earnings (once all outgoings and taxes have been taken into account) by the number of shares in the market. Basically it gives you an idea of how much profit each share has earned that year and will give you an indication of a company’s growth.

Price/earnings ratio (PE)

The PE is most commonly used to assess how much confidence investors have in a company. It measures the value of a company’s shares and is calculated by dividing the company’s share price by its EPS figure. By comparing PE ratios in different companies, it can help you to establish which stocks are undervalued. Generally speaking, a high PE suggests that investors are confident about the future outlook for the company and are expecting higher earnings growth, while a low PE suggests that investors are less optimistic about the outlook. However, there are other factors to consider such as a company with a high PE may be overvalued by the market. It is also important to note that different sectors can have very different PE ratios. Usually high growth companies such as technology firms have high PE ratios, while low growth companies such as utility firms have low PE ratios.

PEG ratio

The PEG ratio compares a company’s PE ratio with its expected EPS growth rate and is calculated simply by dividing the PE by the company’s EPS growth rate. It was devised by successful investor Jim Slater. As a rule of thumb, a stock is usually regarded as undervalued if its PEG is below 1, while a stock with a PEG much above 1 is considered to be overpriced. However, the PEG ratio is a relatively short-term measure, with many analysts only making forecasts for up to two years.

Market capitalisation

This is the total value of a company on the stock market at the current share price. It doesn’t help you to pick a good ‘buy’ necessarily but it gives you an idea of how big the company is. It is calculated by multiplying the company’s current share price by the number of shares in issue.

Dividend yield

The dividend yield is the annual rate of return on an investment which is expressed as a percentage. To calculate this, the annual gross dividend is divided by the current share price and multiplied by 100. For example, if the dividend was 10p and the current share price is 250p, the yield would be 4%.

WHAT MAKES SHARES MOVE?

There are many reasons for share price movement but sometimes it’s not always easy to tell what they are. Listed below are some of the main factors influencing share price movement:

Company news and results

Positive results or an encouraging trading statement can help to push prices up, while disappointing results or a profit warning can lead to share prices plunging. However, sometimes you may find that a company produces good results and yet its share price falls on the day of the results. This is often because shares have already risen on rumours that profits are good and once the results have been released, investors choose to take profits, causing the share price to fall. Takeovers or rumours of takeovers can also have an impact on share prices because investors expect the bidder to pay a premium to shareholders.

The economy

As 2007 proved, the economy has a major impact on share prices. Generally, if the economy is doing well, company profits will improve and shares will rise. However, if the economy weakens, company profits will decline and shares will fall. And it’s not just the UK economy that will impact UK company share prices – again as 2007 proved. Other major economies, particularly those of the US and Europe, will also play their part in driving UK shares up or down, as ultimately what affects their economies will affect the UK’s. Certain sectors, are of course, more likely to be impacted than others. Companies which are more closely linked with the economy are called cyclical stocks, while those that are less affected are called defensive stocks.

Directors’ dealings

If a company director buys shares in the firm, it could indicate that the company’s outlook is promising and as a result, more stock might be bought than usual, affecting the share price. Alternatively, if a director sells a lot of shares, it could be an indication of bad news and more shares might be sold.

Tips

If a magazine, such as Shares, or a newspaper tips a company, the share price will often rise.

Broker notes

Similarly, if a broker slaps a ‘buy’ recommendation on a particular stock, the company’s share price will often rise. On the flip-side, if the stock is downgraded to a ‘sell’, the share price is likely to fall.

Market makers

Market makers can also have an effect on share prices. If they do not own enough shares to balance their books, they will buy more. Also, if the market is looking flat, market makers will reduce prices to try and entice buyers.

TOP TIPS FROM THE BEST

A great way of developing your own stock picking strategy is to base it on somebody else’s successful technique. This feature lists eight great investors whose investment philosophies can be used as a foundation for your stock market ventures.

Benjamin Graham is widely regarded as the grandfather of value investing. His books, Security Analysis and The Intelligent Investor, marked him out as a pioneer of the concept of making money through undervalued shares. Co-authored with David Dodd and published in 1934, Security Analysis is an epic tome, describing in detail how to analyse a company’s financial statements. However, The Intelligent Investor is the book Graham is most well known for and in spite of being written over 50 years ago (it was penned in 1949), it remarkably remains as relevant today as it was then.

You could say Philip Fisher was the stock market’s first technology investor. Originally published in 1958, his book, Common Stocks and Uncommon Profits broke new ground in explaining how investors could judge fast growing, innovative companies. Fisher famously used his techniques to pinpoint the likes of Motorola (MOT:NYSE) and Texas Instruments (TXN:NYSE) as far back as the 1950s, two stocks that registered substantial gains over the following decades.

Arguably the greatest investor ever, Warren Buffett has earned a $30 billion fortune making him one of the world’s richest men. Buffett’s reputation ha been enhanced over the years by his annual letters to shareholders, writing to the investors in his investment vehicle, Berkshire Hathaway (BRK.A:NYSE). Freely available to all, the shareholder letters outline the investment strategy that has served him well for over 30 years, as well as making entertaining reading.

Some professional fund managers suffer from a poor reputation but a few stand out and Peter Lynch is certainly one that does. Lynch ran the Fidelity Magellan Fund between 1977 and 1990 with startling success. Anybody putting in £1,000 when Lynch took control would have seen the investment balloon to £28,000 by the time he retired. The techniques that helped Lynch record the near 30% per annum return are encapsulated in his three books, the best of which is probably One Up On Wall Street.

Jim Slater is probably the UK’s most well known private investor. Published in 1992, his book The Zulu Principle was the first that presented British investors with a specific stock market strategy. Alongside refinements published in the follow-up, Beyond The Zulu Principle, Slater also helped create REFS (Really Essential Financial Statistics), a system designed to for stock picking.

Legendary stock picker Sir John Templeton was first to spot the potential of ‘emerging markets’.

Having seen it all, done it all, investors will always find solace with Sir John’s open-minded and contrarian beliefs. Although Sir John’s efforts are now largely devoted to philanthropy and the funding of various scientific studies and theological pursuits, his record and thoughts have survived the test of time. Anybody who had invested $10,000 in the Templeton Growth fund at

its inception in 1954 would have seen it turn into $4 million by 1992.

All books mentioned above are available through the MoneyAM bookshop

Tel: 01730 233870

Web: www.global-investor.com/moneyam