note on the ebook edition this ebook published in 2014 by...
TRANSCRIPT
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Note on the Ebook EditionFor an optimal readingexperience, please view largetables and figures in landscapemode.
This ebook published in 2014 by
Kogan Page Limited2nd Floor, 45 Gee StreetLondon EC1V 3RSUK
www.koganpage.com
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© Michael Becket, 2012, 2014
E-ISBN 978 0 7494 7239 9
Full imprint details
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Contents
Howthisbookcanhelp
Acknowledgements
01 What and why
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are shares?QuotedsharesReturnsStockmarkets
02 What arebonds andgilts?
BondsPreferenceshares
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ConvertiblesGilts
03 Thecomplicatedworld ofderivatives
PooledinvestmentsOtherderivatives
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04 Foreignshares
05 How to pick ashare
StrategyTheeconomyPickingshares
06 Tricks of the
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professionalsFundamentalanalysisTechnicalanalysis
07 Where to findadvice andinformation
AdviceInformationIndices
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OnlineCompanyaccountsUsingtheaccountsOtherinformation
fromcompaniesOthersourcesComplaints
08 What does ittake to dealin shares?
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InvestmentclubsCosts
09 How to tradein shares
Howtobuyandsellshares
UsingintermediariesTradingStockmarketsOthermarkets
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10 When to dealin shares
ChartsTechnicaltoolsSentimentindicatorsOtherindicatorsSelling
11 Consequencesof being a
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shareholderInformationAnnualgeneral
meetingExtraordinarygeneral
meetingConsultationDividendsScripissuesRightsissuesNomineeaccounts
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RegulatedmarketsCodesofconductTakeoversInsolvency
12 TaxDividendsCapitalprofitsEmployeeshare
schemesTaxincentivestorisk
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ISAsSIPPsTaxrates
GlossaryIndex
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M
How thisbook canhelp
akingmoneydemandseffort,whetherworking
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forasalaryorinvesting.Yougetnothingfornothing.Anyonewhotellsyouthestockmarketisanabsolutedoddle,andmoneyforoldrope,iseitheraconmanorafool.Andtheproofofthatbecameveryclearwiththestockmarketdepressionsstartingin2007.Butdoingabitofworkdoesnotnecessarilymeanheavy
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mathematicsandseveralhourseverydaywiththefinancialpress,theinternetandcompanyreports–thoughabitofallthoseisvital–butitdoesmeantakingthetroubletolearnthelanguage,doingabitofresearchandthinkingthroughwhatitisyoureallywantandwhatpriceyouarepreparedtopayforit.Attheveryleast
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thatlearningwillputtheinvestoronamoreevenfootingwiththepeopletryingtosell.
Ithasbeenhardenoughearningthemoney,sothisbookhelpswiththelittlebitextratomakesurethecashisnotwasted.
Therearefewgeneralrulesaboutinvestmentbutthemostimportantisvery
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simple:ifsomethingorsomebodyoffersasubstantiallyhigherprofitthanyoucangetelsewhere,thereisariskattached.Theworldofinvestmentisprettysophisticatedandprettyefficient(intheeconomists’sensethatparticipantscanbefairlywellinformed),soeverythinghasaprice.Andthepriceforhigherreturnsis
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higherrisk.Thereisnothingwronginthat–Chapter5setsouthowtodecidewhatyouracceptablelevelis–butthepointisithastobeaconsciousdecisiontoacceptthedangersratherthanmakeagreedygrabforwhatseemsabargain.
Scepticismisvitalbutitneedstobehelpedwithsomethingtojudge
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informationby,andthisbookprovidesthat.Intheendthough,thereisnobetterprotectionthancommonsense,askingoneselfwhatislikely,plausibleorpossible.Forinstance,whyshouldthismanbeofferingmeaninfalliblewayofmakingafortunewhenhecouldbeusingithimselfwithoutmyparticipation?Whyisthe
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sharepriceofthiscompanysoaringthroughtheroofwhenIcannotseeanyreasonablesubstancebehindit?WhatdoesthemarketknowaboutthatcompanythatIdonotwhichmakesitssharesseemtoprovidesuchahighreturn?Whatismyfeelingabouttheeconomythatwouldjustifythewaysharepricesingeneralare
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moving?Thestockmarketisof
coursenottheonlyavenueofinvestment.Peoplebuytheirownhomes,organizelifeassuranceandpensionpolicies,andhaverainy-daymoneyaccessibleinbanksandbuildingsocieties.Andindeedthosefoundationsshouldprobablyprecedegettingintothestockmarket,
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whichisgenerallymorevolatileandrisky.
Shareshavehadtheirlowmoments,forexampleatthedotcomcrashormorerecentlyduringthecreditcrisis,butoveranyreasonablymiddle-termviewthestockmarkethasprovidedabetterreturnthanmostotherformsofinvestment.That,however,isanaverageanda
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longishview,soyoustillhavetoknowwhatyouaredoing.Thatiswhythisbookstartswithsettingoutwhatthevariousfinancialinstrumentsare:sharesandotherthingsissuedbycompanies,bondsandgilts,andthenderivatives,whicharethecleverwaysofpackagingthoseprimaryinvestments.Eachhasitsown
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character,benefitsanddrawbacks.
Thathelpswiththedecisiononwheretoputyourmoney.Atleastasimportantisthetiming.Thatapplieswhetheryouareanin-and-outenergetictraderoralong-terminvestor,andChapter10willprovidehelp.
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I
Acknowledgements
wouldliketothankthegreathelpprovidedbytheWealth
ManagementAssociation(www.thewma.co.uk)inprovidingveryhelpfuladvice
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andup-to-dateinformationonthemarket,andforthecarefulhelpoftheLondonStockExchangeinvettingtheaccuracyofthetext.
IwouldalsoliketothankBarclaysCapitalforthechartsfromitspublication,BarclaysBankEquityGiltStudy.
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AndofcourseIremainconstantlygratefulforthehelp,patienceandencouragementofmywifeKay.
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Chapter OneWhat andwhy areshares?
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Businessesneedmoneytogetstarted,andeven
moretoexpandandgrow.Whensettingup,entrepreneursraisesomeofthisfromsavings,friendsandfamilies,andtherestfrombanksandventurecapitalists.Backersgetareceiptfortheirmoneywhichshowsthattheirinvestmentmakesthempart-ownersofthecompanyand
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sohaveashareofthebusiness(hencethename).Unlikebanks,whichprovideshort-termfinanceatspecifiedratesthathastoberepaid,theseinvestorsarenotlenders:theyaretheowners.Ifthereare100,000sharesissuedbythecompany,someonehaving10,000ofthemownsatenthofthebusiness.
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Thatmeansthemanagingdirectorandtherestoftheboardaretheshareholders’employeesjustasmuchastheshop-floorforemanorthecleaner.Beingashareholdercarriesallsortsofprivileges,includingtherighttoappointtheboardandtheauditors(seeChapter11).Inreturnforriskingtheirmoney,shareholdersofsuccessful
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companiesreceivedividends.Theamountvarieswithwhatthecompanycanaffordtopayout,whichinturndependsonprofits.
Atsomestagethebusinessmayneedmorethanthoseoriginalsourcescanprovide.Inaddition,therecomesatimewhensomeoftheoriginalinvestorswanttowithdrawtheirbacking,
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especiallyifitcanbeataprofit.Theonlywaytodothatwouldbebysellingtheshares,whichmeantfindinganinterestedbuyer,whichinitselfwouldbefarfromeasy,andthenhagglingabouttheprice,whichwouldbeawkward.Apublicmarketplacewasdevisedfortradingthem–astockexchange.Companies‘go
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public’whentheygettheirsharesquotedonthestockexchangetomakethingseasyforinvestors–aneatlittledeviceinventedbytheDutchrightatthestartofthe17thcentury.
Quoted shares
Onceacompanygetsitssharesquotedonthestock
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exchangethereisacontinuouslyupdatedandgenerallyknownmarketprice,whichisusuallyfarhigherthanthelevelatwhichtheoriginalinvestorsputtheirmoneyintothefledglingbusiness.Inaddition,thereisa‘liquid’market,meaningtherearelargenumbersofpotentialoractualtradersinthepaper,andsoholdersof
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theshareshaveafargreaterchanceoffindingbuyers,andpeoplewhowanttoputmoneyintothebusinesshavereadyaccess.
Blue chipsAllinvestmentcarriesarisk.Bankscanrunintotroubleandcompaniescangobust.Ithasanelementofgambling
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and,asyouwouldexpect,theoddsvarywithwhatoneinvestsin.Themajordifferenceisthattheonlywaytowinattruegamblingistoownthecasinoortobeabookmaker,whileintheworldofthestockmarketthechancesofatotallossarerelativelysmallandwithcarefulinvestmenttheprospectsareprettygood.
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‘Itisusuallyagreedthatcasinosshould,inthepublicinterest,beinaccessibleandexpensive.AndperhapsthesameistrueofStockExchanges’,wroteJohnMaynardKeynesin1935.Hehimselfmadeasmallfortuneontheexchangebutitissalutarytoberemindedoftheanalogyfromtimetotimeandthecomparablerisks;the
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term‘bluechip’isanexample.Thehighestvaluegamblingchipsinpokerweretraditionallyblue,andthestockswiththehighestprestigewerereckonedsimilar.Sothecompaniesdescribedasbeingbluechiparethelargest,safestbusinessesonthestockmarket.
Thecompaniesinthe
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FTSE100Index,beingthehundredbiggestcompaniesinthecountrybystockmarketvaluation,arebydefinitionallbluechips.Thatisreckonedtomakethemthesafestbetsaround.Thetheoryisnotunreasonable–largecompaniesaremorestablethansmallones;theycanhirethebestmanagersandfundthebiggestresearchbudgets;
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theyhavethefinancialmuscletofightoffcompetition;theirverysizeattractscustomers;andthelargeissuedsharecapitalgenerallyspeakingprovidesaliquidequitymarketwithmanysmallinvestorsandsomaintainsasteadierprice.Inpracticesomesmallercompanies,evenintheAlternativeInvestment
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Market,sometimescanalsoprovidethecomfortofaliquidmarketasaresultofbrisktradingintheshares.
Thecorollarytothatisthesharepricemovementsshouldbelessviolent,givingstability(butprovidingfewerchancesofshort-termprofitsthroughhoppinginandout),andtheyieldislikelytobelowerthanonriskier
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investments.Bluechipsharesare,inthetraditionalphrase,theinvestmentforwidowsandorphans.
Butnotinvariably:bluechipsaresaferthanacompanysetuplastyearbyacoupleofundergraduateswithabrilliantidea,buttheyarenevercompletelysafe.Theymaybeaboutthemostsolidthereisbuttheystill
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needtobewatched.Asanillustration,itisinstructivetolookbackattheIndexofthelargestcompaniesof,say,thepast30yearsandseehowfewremain.RememberthatcompanieslikeBritishLeyland,Rolls-RoyceandPollyPeckwereallintheIndexatonetime,andallwentbust–thoughwithgovernmenthelpRolls-Royce
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didre-emergeasasuccessful,quotedaero-enginemanufacturer.Hugebankswerehumbledacrosstheworldin2008asaresultoftheirfecklesslending,andevencompaniesthatdonotcompletelycollapsecanfalloutoffavour,haveincompetentmanagers,andshrinktorelativeinsignificance(suchasthe
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BritishcompanyGeneralElectric,whichshrankandthenbecametheprivatecompanyTelent).
Thereasonnoteveryoneseeksthesafetyofbluechipsharesistheirprice–sowellknownthattheyareprettyfairlyvalued,andsothechancesofbeatingthemarketarevanishinglyslim.Beinggenerallymultinational,they
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arealsoexposedtocurrencyfluctuations.
Thenextsetofcompaniesjustbelowtheminmarketvalue,theFTSE250,isgenerallymorerepresentativeoftheBritisheconomy,whichisclosertohomeandhencemoreeasilyunderstandable.
Finally,smallandnewentrepreneurialcompanies
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maybemoreriskybutthatmeanstheyhavethepotentialforfastergrowthandgreaterreturns–providedofcoursetheydonotgobust.ItisalsoworthrememberingthatevencompanieslikeMicrosoft,Tesco,ToyotaandSiemensweretinyonce.
So,notallsmallcompaniesaredangerousjustasnotallbigonesaresafe.
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Thisistrueevenofthemultinationaldarlingsthatwerereckoneddeepblue.JustconsiderthefateofthemajorAmericanairlines,insurancecompaniesorcarmakers.
Thatiswhytrackerfundshavebeensetup.Theybuymostofthesharesintheindextheyaretrackingandsofollowitstotality.Trackersreducethechancesofa
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disaster,mitigatethechancesofgreatcapitalgrowth,andshouldensureasteadydividendflow.
Returns
Shareholdersbenefittwiceoverwhenabusinessisdoingwell:theygetdividendsastheirpartofthecompany’sprofits,andthevalueofthe
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sharesgoesupsothatwhentheyselltheygetcapitalappreciationaswell.Thereturnonsharesoverthelongtermhasbeensubstantiallybetterthaninflationorthegrowthinpayandnotablybetterthanmostotherhomesforsavings.AccordingtodatafromCreditSuisse,GlobalFinancialDataandThomsonDatastream,thereturnonUS
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sharesbetween1904and2004wasverynearly10percentperannum,and8.5percentonUKshares.
Ifthecompanyfailstomakeaprofitshareholdersusuallygetnothing,thoughsomecompaniestrytokeepthemhappyandloyalbydippingintoreservestopayadividendevenatatimeofloss.Inanycase,ifthe
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companygoesbusttheyareatthebackofthequeueforgettingpaid.Ontheotherhand,oneofthereasonsabusinessisincorporated(ratherthanbeingapartnership,say)isthattheowners,theshareholders,cannotlosemoremoneythantheyusedtobuytheshares.Thatisinsharpcontrasttoapartnership,whereeach
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partnerhasunlimitedpersonalliability–theyareliableforthedebtsofthebusinessrightdowntotheirlastcuff-linksortotheirlastearrings.Soevenifanincorporatedcompanygoesspectacularlybrokeowingmillionsofpounds,thecreditorscannotcomeknockingontheshareholders’door.
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Stock markets
Thelanguageofinvestmentsometimesseemsdesignedtoconfusethenovice.Forinstance,sharesaretradedonthestockexchange,nottheshareexchange.Nobodyreallyknowswhyitcametobecalledthe‘stockexchange’.Onetheoryhasitthatitwasonthesiteofa
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meatandfishmarketintheCityandtheblocksonwhichthosetraderscutarecalledstocks.Analternativetheoryhasitthatstocksofthepillorykindusedtostandonthesite.IntheMiddleAgesthereceiptfortaxpaidwasatallystickwithappropriatenotches.Itwassplitinhalf,withthetaxpayergettingthestockandtheExchequer
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gettingthefoilorcounter-stock.Somehavesuggestedthemoneyfrominvestorswasusedtobuystocksforthebusiness.
Strictlyspeaking,inthepurists’definition,stocksarereallybonds–paperissuedwithafixedrateofinterest,asopposedtothedividendsonshares,whichvarywiththefortunesofthebusiness.
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However,inlooseconversation‘stocks’issometimesusedasasynonymfor‘shares’.Justtoconfusethingsfurther,Americanscallordinaryshares‘commonstock’.
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ChapterTwoWhat arebonds andgilts?
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TheingenuityofCityfinanciershasproduceda
widevarietyofpaperissuedbybusinesses,inadditiontoordinaryshares.
Bonds
Shareholdersareownersofacompanybyvirtueofputtingupthecashtorunit,butagoodbusinessbalancesthe
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sourcesoffinancewiththewayitisused,andsomeofitcancomefromborrowing.Apartoftheborrowingmaybeabankloanoroverdraft,buttopayformajorinvestmentsmostmanagersreckonitiswisertoborrowlongterm.Forsomeofthisthecompanyissuesadifferenttypeofpaper–ineffectacorporateIOU.Thegenericnamefor
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thissortofcorporateissueis‘bonds’.Theyaretradable,long-termdebtissueswithanundertakingtopayregularinterest(normallyataratefixedatthetimeofissue)andgenerallywithaspecifiedredemptiondatewhentheissuerwillbuythepaperback.Somehaveextrasecuritybybeingbackedbysomecorporateasset,and
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somearestraightunsecuredborrowings.Holdersofthesemustreceiveinterestpaymentswhetherthecompanyismakingaprofitornot.Thespecifieddividendrateonbondsissometimescalledthe‘coupon’,fromthedayswhentheycamewithalongsheetofdatedslipsthathadtobereturnedtothecompanytoreceivethe
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payment.Hereaselsewhereinthe
bookyouwillcomeacrosswordssuchas‘generally’,‘usually’,‘often’and‘normally’.ThisisnotacoverforignoranceorlackofresearchbutmerelyanacceptanceoftheCity’singenuity.Variantsofancientpracticesareconstantlybeinginvented,andnoveland
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cleverfinancialinstrumentscreatedtomeetindividualneeds.Whatisdescribedisthenorm,butinvestorsshouldbepreparedforoccasionaleccentricitiesorvariants.
Permanentinterest-bearingshares
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Theworldoffinancehasitsownlanguage,withtheproblemthatwordsaresometimesusedinwaysthatdonottallywiththeireverydayusage.Itisnotalwaysintendedtoconfusethelayperson–thoughitfrequentlyhasthateffect–butspecialistfunctionsneedspecialistdescriptionsandevenfinanciershaveonlythe
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languageweallusetodrawon.Oneexampleisthedifferencebetween‘permanent’and‘perpetual’.‘Permanentcapital’isusedasalabelforcorporatedebt.‘Perpetual’meansafinancialinstrumentthathasnodeclaredenddate.Soaperpetualcallabletier-onenotesoundslikeasortofdebtbutisinfactasortof
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preferenceshare.Ontheotherhand,apermanentinterest-bearingshareisnotashareatallbutforallpracticalpurposesabond.
Permanentinterest-bearingshares(Pibs)aresharesissuedbybuildingsocietiesthatbehavelikebonds(orsubordinateddebt).Pibsfromthedemutualizedbuildingsocieties,includingHalifax
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andCheltenham&Gloucester,areknownas‘perpetualsubbonds’.Likeotherbuildingsocietyinvestments(includingdeposits)theymakeholdersmembersofthebuildingsociety.
Theypayafixedrateandhavenostatedredemptiondate,thoughsomedohavearangeofdateswhentheissuer
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can(butneednot)buythemback,almostalwaysinthedistantfuture.Sometimes,insteadofbeingredeemedtheyareswitchedtoafloating-ratenote.
Theycannotbesoldbacktothesocietybutcanbetradedonthestockexchange.Nothavingacompulsoryredemptiondatemeansthepricefluctuatesinlinewith
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bothprevailinginterestratesandtheperceivedsoundnessoftheissuingorganization,whichmakesthemmorevolatilethanmostotherbonds.IfthelevelofinterestratesintheeconomyrisesthenthepriceofPibswillfall.Ifinterestratesrise,theirpricefalls,butifratesfall,capitalvaluesrise.Thereisgenerallynosetinvestment
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minimum,thoughdealerswilltradeonlythousandsofthematatime,andstockbrokers’dealingcostsmakeinvestmentsof,say,under£1,000to£1,500uneconomic.
Pibsprovidedyieldsacoupleofpercentagepointsaboveundatedgilts.Withdemutualizationandthesubsequentcollapseofsome
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buildingsocietiestheyieldhasbeenforcedhighertooffsettherisk.Theriskishighbecauseifcapitalratiosfallbelowspecifiedlevels,interestwillnotbepaidtoholdersandsinceinterestisnotcumulative,itislostforgood.AnotherproblemisthatholdersofPibsrankbelowmembersholdingshares(depositors)atatimeof
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collapse,and,astheyareclassedascapitalholders,arenotprotectedbytheFinancialServicesCompensationScheme,unlikedepositorswhoareprotectedforupto£85,000.However,buildingsocietiesaregenerallylowrisk.
Thegoodnewsisthereisnostampdutyonbuyingtheseinvestments;interestis
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paidgrossandthoughinterestistaxabletheycanbeshelteredinanISA(IndividualSavingsAccount);and,forthemoment,theyarenotsubjecttocapitalgainstax.Itisalsoworthbearinginmindthatbuildingsocieties,beforegreedcarriesthemawayintodemutualization,arerunconservatively,sotheirfunds
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comemainlyfromsaversratherthanthemuchmorevolatileandunpredictablesocietiescannotbedestabilizedbyhavingtheredictablewholesalemoneymarkets.Havingnoquotedshares,buildingsocietiescannotbedestabilizedbyhavingthesharepriceunderminedbyspecializedbeargamblerssellingshort
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(seeGlossary).
Loan stocks anddebenturesBondsthathavenospecifiedassettoactassecurityarecalled‘loanstocks’or‘notes’.Theseoffsetthegreaterriskbypayingahigherrateofinterestthandebentures,whicharesecured
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againstcompanyassets.InBritainthatiscommonlyafixedassetbutintheUnitedStatesitisoftenafloatingchargesecuredoncorporateassetsingeneral.
Interestpayments(dividends)onthesebondscomeregularly,irrespectiveofthestateofthecompany’sfortunes.Astherateofinterestisfixedatissue,the
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marketpriceofthepaperwillgoupwheninterestratesarecomingdownandviceversatoensuretheyieldfrominvestinginthepaperisinlinewiththereturnsobtainableelsewhereinthemoneymarkets.Inotherwords,theinvestmentreturnfrombuyingbondsatanyparticularmomentisgovernedmorebythe
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prevailinginterestratesthanbythestateofthebusinessissuingthem.
Thefurtheroffthematuritydatethegreaterthevolatilityinresponsetointerestratechangesbecausetheyarelessdominatedbytheprospectofredemptionreceipts.Ontheotherhandtheoscillationsareprobablymuchlessspectacularthan
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forequities,wherethepriceisgovernedbyamuchwiderrangeofeconomicfactors,notjustintheeconomybutinthesectorandthecompany.
Becausethereturnisfixedatissue,onceyouhaveboughtthemyouknowexactlyhowmuchtherevenuewillbeontheparticularbonds,assumingthecompanystayssolvent
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andthesecurityissound,rightuptothepointofredemptionwhentheoriginalcapitalisrepaid.Sincethereisstillthatlingeringworryaboutwhetheranyspecificcompanywillsurvive,thereturnisatouchhigherthanongilts(bondsissuedbythegovernment,page11),whicharereckonedtobetotallysafe.Soforaprivateinvestor
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thisrepresentsaprettyeasydecision:howconfidentamIthatthiscorporationwillsurvivelongenoughtogoonpayingtheinterestonthebonds,andisanylingeringdoubtoffsetbythereturnbeinghigherthanfromgilts?
Iftheissuerdefaultsontheguaranteedinterestpayments–whichisgenerallyonlywhenthebusinessisin
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seriousdangerofcollapse–debentureholderscanappointtheirownreceivertorealizetheassetsthatactastheirsecurityandsorepaythemthecapital.Unsecuredloanstockholdershavenosuchoptionbutstillrankaheadofshareholdersfortheremnantswhenthecompanygoesbust.
Therearevariantsonthetheme.A‘subordinated
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debenture’,asthenameimplies,comeslowerdownthepeckingorderandwillbepaidatliquidationonlyaftertheunsubordinateddebenture.Mostofthebonds,especiallytheonesissuedbyUScompanies,areratedbyMoody’s,Standard&Poor’sandotheragencieswithagradedsystemrangingfromAAAforcomfortinglysafe
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downtoDforbondsalreadyindefault.
WarrantsWarrantsareoftenissuedalongsidealoanstocktoprovidetherighttobuyordinaryshares,normallyoveraspecifiedperiodatapredeterminedprice,knownasthe‘exercise’or‘strike’
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price.Theyarealsoissuedbysomeinvestmenttrusts.Sincethepaperthereforehassomeeasilydefinablevalue,warrantsaretradedonthestockmarket,withthepricerelatedtotheunderlyingshares:thevalueisthemarketpriceoftheshareminusthestrikeprice.
Theycangearupaninvestment.Forinstance,if
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thesharestandsat100pandthecostofconvertingthewarrantsintoordinaryshareshasbeensetat80p,thesensiblepriceforthewarrantwouldbe20p.Ifthesharepricenowrisesto200p,therightpriceforthewarrantwouldbe120p(deductingthecostof80pforconvertingtoshares).Asaresult,whenthesharepricedoubledthe
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warrantpricejumpedsix-fold.
Thistypeofissueisinawaymoresuitedfordiscussionundertheheadingof‘derivatives’,alongsidefuturesandoptionsinChapter3.
Preference shares
Preferencesharescanbe
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consideredasortofhybrid.Theygiveholderssimilarrightsoveracompany’saffairsasordinaryshares(equities),butcommonlyholdersdonothaveavoteatmeetings;likebondstheygetspecifiedpaymentsatpredetermineddates.Thenamespellsouttheirprivilegedstatus,sinceholdersareentitledtoa
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dividendwhetherthereisaprofitornot,whichmakesthemattractivetoinvestorswhowantanincome.Inaddition,forsomethereisataxbenefittogettingadividendratherthananinterestpayment.Nodividendisallowedtobepaidonordinarysharesuntilthepreferenceholdershavehadtheirs.Theyrankbehind
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debentureholdersandcreditorsforpay-outsatliquidationandondividends.Ifthecompanyissohardupitcannotaffordtopayeventhepreferencedividend,theentitlementis‘rolledup’forissueswithcumulativerightsandpaidinfullwhenthegoodtimesreturn.Holdersofpreferenceshareswithoutthecumulativeentitlement
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usuallyhaverightstoimposesignificantrestrictionsonthecompanyiftheydonotgettheirmoney.Sometimeswhennodividendhasbeenpaidtheholdersgetsomevotingrights.
Likeordinarysharestheyaregenerallyirredeemable,sothereisnoguaranteedexitotherthanasale.Ifthecompanyfolds,holdersof
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preferencesharesrankbehindholdersofdebtbutaheadoftheownersofordinaryshares.
Therearecombinationsofvariousclassesofpaper,soforinstanceitisnotunknownforpreferencesharesalsotohaveconversionrightsattached,whichmeanstheycanbechangedintoordinaryshares.
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Convertibles
Somepreferencesharesandsomecorporatebondsareconvertible.Thismeansthatduringtheirspecifiedlivesaregulardividendincomeispaidtoholders,butthereisalsoafixeddatewhentheycanbetransformedintoordinaryshares–conversionisalwaysattheowner’s
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choiceandcannotbeforcedbytheissuer.
Beingbondsorpreferenceshareswithanembeddedcalloption(seeChapter3),thevalueisamixtureofthesharepriceandhencethecostofconversion,andtheincometheygenerate.
Gilts
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Thetermisanabbreviationof‘gilt-edgedsecurities’.Thesuggestionisthatofclass,distinctionanddependability.TheimplicationisthatthesebondsissuedbytheBritishgovernmentaresafeandreliable.Thereissomejustificationforthat:thegovernmentstartedborrowingfromtheCityofLondoninthe16thcentury,
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andithasneverdefaultedoneithertheinterestortheprincipalrepaymentsofanyofitsbonds.Althoughgiltsareaformofloanstocknotspecificallybackedbyanyasset,thecountryasawholeisassumedtostandbehindtheissueandthereforedefaultonfuturegiltsisprettyunlikelyaswell–theriskisreckonedtobeeffectively
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zero.Giltsexistbecause
politiciansmaythinktaxrevenuesaresufferingonlybecausetheeconomyisinabriefdipandtheywanttobridgethatshort-termdeficit,ortheydarenotcourtvoterdisapprovalbyraisingtaxestocoverstateexpenditure.Thedifferencebetweenrevenueandexpenditureis
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madeupbyborrowing–thisisthePublicSectorBorrowingRequirementorgovernmentdebt,muchdiscussedbypoliticiansandthefinancialpress.Ineffectitpassestheburdentofuturegenerationswhopayinterestonthepaperandeventuallyredeemit(buyitbackataspecifieddate).
Theissueshaveafixed
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rateofinterestandastatedredemptiondate(usuallyarangeofdatestogivethegovernmentabitofflexibility)whentheTreasurywillbuybackthepaper.Thenamesgiventogiltshavenosignificanceandaremerelytohelpdistinguishoneissuefromanother.
Theinterestratesetonissue(onceagaincalledthe
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‘coupon’)isdeterminedbyboththeprevailinginterestratesatthetimeandwhothespecificissueisaimedat.Thevastmajorityofthegiltsonissueareofthistype.Inadditiontherearesomeindex-linkedgiltsandacoupleofirredeemablesincludingthenotoriousWarLoan–peoplewhobackedthenationaleffortduringthe
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SecondWorldWarfoundthevalueoftheirsavingserodedtonegligiblevaluesbyinflation.Thisisstillonissueandthefinancialcrashof2008stoppeditbeingajokeasitgainednewlifeinthelow-interestenvironment.
Thereisalonglistofgiltsbeingtradedwithvariousdatesofredemption.Forcommonusetheseare
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groupedunderthelabelof‘shorts’foroneswithlivesofunderfiveyears,‘medium-dated’withbetweenfiveand15yearstogo,and‘longs’withover15yearstoredemption.Thegovernmenthasalsobeenissuingultra-longgiltswithupto50yearstoredemption.Onthewholetheseareprobablymoreaimedatandsuitablefor
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investorssuchaspensionfundsandinsurancecompanies,whichneedassetstomatchthelongerlivesofpensioners.
Innewspapertablestherearesometimestwocolumnsunder‘yield’.Oneistheso-called‘runningyield’,whichisthereturnyouwouldgetatthatquotedprice,andtheotheristhe‘redemption
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yield’,whichcalculatesnotjustthestreamofinterestpaymentsbutalsothevalueofholdingthemtoredemptionandgettingthemrepaid–alwaysat£100par(thefacevalueofasecurity).Ifthecurrentpriceofthegiltisbelowpartheredemptionyieldishigherthantherunningyield,butifthepriceisabovepar(whichgenerally
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suggestsitisahigh-intereststock)onewilllosesomevalueonredemptionsothereturnislower.
Sincethereturnisfixedatissue,whenthepriceofabondlikegiltsgoesup,theyield(theamountyoureceiveasapercentageoftheactualcashinvested)goesdown.Letusassumeyoubuyagiltwithanominalfacevalueof100p
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(yesthatis£1,butthestockmarketgenerallypreferstothinkinpennies),andwithaninterestrateof10percentsetatissue.Ifthecurrentpriceofthatspecificgiltis120p,youwouldgetayieldof8.3percent(10pasapercentageofthe120ppaid).Ifthepriceofthatissuethentumblesandyoubuyat80pyoucouldgetayieldof12.5percent(10p
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asapercentageof80p).Thereareotherpublic
bondsofhigherriskthanUKgilts.Theseincludebondsissuedbylocalauthoritiesandoverseasgovernments.Calculationsusedtobestraightforwardwhenmanydecadesofstabilitysuggestedneitherlocalauthoritiesnorforeigngovernmentwouldbecomeinsolvent.The2008
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crashandsubsequentfinancialturbulenceinmanycountrieswokeupthemarkettothefactnothingcanbetakenforgranted–notevensovereigndebtsarealwayssafe,especiallyfromcountrieswithlargedeficits.Ithasindeedhappenedbeforeasanycollectorofunredeemedbondswilltestify.Chinesegovernments,
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TsaristRussia,USstates,LatinAmericanenterprisesandsoonhaveallissuedbeautifullyengravedelaboratebondsthatarenowusedtomakelampshadesorframeddecorationsforthelavatory,becausetheywereneverredeemed.Onoverseasbondsthereisalsotheaddeduncertaintyfromcurrencymovements.
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Asalways,andthisisanimportantruletorememberforallinvestments,thehighertheriskthehigherthereturntocompensateforit.Soifsomethinglookstobereturningfabulouslyhighdividendsitmustbebecauseitis–oritisseentobe–afabulouslyhigh-riskinvestment.
Inthecaseofpublicbonds
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thehigherriskthanUKgiltsmeanslocalauthorityandforeigngovernmentbondsprovideahigheryield,varyingwiththeconfidenceinthecountries’financialstability,andcorporatebondssometimesslightlyhigherstill,dependingontheissuerandguarantor(oftenabigbank).Thedifferencesaregenerallymarginalforthe
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major,safeissuers,seldommuchmorethan0.3percent.
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ChapterThreeThecomplicatedworld ofderivatives
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Derivativesarefinancialinstrumentsthatdepend
onorderivefromanunderlyingsecuritythatalsodeterminesthepriceofthederivedinvestment.Inotherwords,thesearefinancialproductsderivedfromotherfinancialproducts.Strictlyspeakingthetermcouldcoverunitandinvestmenttrustsandexchangetradefunds,aswell
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asarangeofsophisticatedandcomplexcreations.Attheirsimplest,andnotnormallyallocatedtothisheading,theyarepooledinvestments.
Pooledinvestments
Themainbenefitofdevices
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suchasunitorinvestmenttrustsisthereductionofrisk:yougetaspreadofinvestmentsoveranumberofcompanies,whichcutsthedangerofanyoneofthecompaniesperformingbadlyorgoingunder.Anotheradvantageisadministrationbyamarketprofessionalwhomayhaveabetterfeelforwhatisagoodinvestment
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thantheaveragelayperson.
Investment trustsInvestmenttrustsaremerelycompanieslikeanyotherquotedonthestockexchange,buttheironlyfunctionistoinvestinothercompanies.Theyarecalled‘closed-endfunds’becausethenumberofsharesonissueisfixedand
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doesnotfluctuatenomatterhowpopularorotherwisethefundmaybe.
Asmallinvestorwithoutenoughsparecashtobuydozensofsharesasawayofspreadingriskcanbuyinvestmenttruststosubcontractthatwork.Atrustputsitsmoneyacrossdozens,possiblyhundreds,ofcompanies,soaproblemwith
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onecanbecompensatedbyboomatanother.Thatdoesnotmakethemfoolprooforcertainwinners:investmentmanagersafterallareonlyhumanandcanbewrong.
Therearealsopressuresonthemtowhichtheprivateinvestorisimmune.Forinstance,thereisacontinualmonitoringoftheirperformancesothereisno
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chancetoallowaninvestmentprospectthetimetomatureforanumberofyearsbeforereachingitsfullpotentialifthatmeansinthemeantimetheirfiguresaresubstantiallybelowthoseoftheirrivals.Aprivateinvestorontheotherhandcanaffordtobepatientandtakealong-termview.Similarly,itisonlybravemanagerswho
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decidetosticktheirnecksoutandtaketheirownmaverickcoursedifferentfromtheotherfunds.Theywillgetpraiseiftheyarerightandthesackifnot.Stickwiththesamesortofpoliciesasalltheothershowever,andthebonuseswillprobablykeeprollinginfornotbeingnotablyworsethantheindustryaverage.
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Somehavegivenupthechallengingandunrelentingtaskofoutperformingthemarketandcalledthemselves‘trackers’–theybuyalargecollectionofthebiggestcompanies’sharesandsomovewiththemarketasawhole.
Anotherdisadvantageofgoingforcollectiveinvestmentsisthecost.Since
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investmenttrustsarequotedonthestockexchangejustlikeanyothercompany,thesetofcostsisthesameaswithallsharedealings:thecostofthebroker(thoughthatcanbereducedthrougharegularsavingsschemewiththetrustmanagementcompany),thegovernmenttaxinstampduty,andthespreadbetweenthebuying
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andthesellingprice,whichinsmallertrustscanbeover10percent.Somecanbeboughtdirectlyfromthemanagementcompany.Thereareobviouslyadvantagesortheywouldnotstillbearound,muchlessinsuchlargenumbers.
Buyingintoinvestmenttrustsdoesnotentailabandoningallchoice.The
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investorhasanenormouslywiderangeofspecialiststopickfrom:therearetrustsspecializinginthehairierstockmarketslikeIstanbul,Budapest,Manila,MoscowandCaracas(someofthemdriftinandoutofvarious‘emergingmarkets’labelssuchastheBRICcountries(Brazil,Russia,IndiaandChina));therearesome
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investinginthecountriesofthePacificRimwithsomeofthoseconcentratingonjustJapan;somegoforsmallcompanies;somegambleon‘recovery’companies(whichtendtohaveafluctuatingsuccessrecord);somespecializeinEuropeortheUnitedStates;someinanareaoftechnology,andsoon.Managersofinvestmenttrusts
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tendonthewholetobemoreadventurousintheirinvestmentpoliciesthanunittrusts.
Somearesplitcapitaltrusts.Thesehaveafinitelifeduringwhichoneclassofsharesgetsalltheincome,andwhenitiswounduptheotherclassofsharesgetstheproceedsfromsellingofftheholdings.
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Asthetrusts’sharesarequoted,onecantellnotonlyhowthesharepriceisdoing,butcheckpreciselyhowtheyareviewed.Itispossibletocalculatethevalueofthequotedcompanysharesatrustowns,exceptofcoursefortheonesspecializinginprivatecompanies.Thenonecancompareassetvaluewiththetrust’sownshareprice,
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andthisispublished–seeChapter7.Quiteafewwillthenbeseentostandatadiscounttoassets(thevalueofatrust’sholdingspershareisgreaterthanthemarketisofferingforitsownshares),andsomeatapremium.
Onereasonmanyofthemarepricedlowerthantheirrealvalueisthatthemajorinvestinginstitutionstendto
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avoidthem.Ahugepensionfundorinsurancecompanydoesnothavetosubcontractthiswayofspreadinginvestments,nordoesithavetobuythemanagerialexpertise–itcangetthemin-house.Thisleavesinvestmenttrustsmainlytoprivateinvestorswhoaresteeredmoretowardsunittrustsbytheiraccountantsandbank
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managers.Fashionchanges,however,andfromtimetotimetheinvestmenttrustsectorbecomesmorepopular.Buyingintooneataheftydiscountcanprovideadecentreturn–solongasthediscountwasnotpromptedbysomemorefundamentalproblemwiththetrustoritsmanagement.
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Unit trustsUnittrustshavethesameadvantageofspreadingtheindividual’sriskoveralargenumberofcompaniestoreducethedangersofpickingaloser,andofhavingtheportfoliomanagedbyafull-timeprofessional.Aswithinvestmenttruststherearespecialistunittrustsinvesting
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inavarietyofsectorsortypesofcompany,soonecanpickhigh-income,highcapitalgrowth,PacificRim,high-technologyorotherspecializedareas.
Insteadoftheunitsbeingquotedonthestockmarket,asinvestmenttrustsare,investorsdealdirectlywiththemanagementcompany.Thepaperissuedhas
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thereforeonlyaverylimitedsecondarymarket–theinvestorcannotsellittoanyoneotherthanbacktotheunittrust.Themarketisviewedfromthemanagers’viewpoint:itsellsunitsatthe‘offer’priceandbuysthembackatthelower‘bid’price,togiveitaprofitfromthespreadaswellasfromthemanagementcharge.Manyof
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thepricesarealsopublishedinthebetternewspapers.
Asopposedtoinvestmenttrusts,thesearecalled‘open-endedfunds’becausetheyaremerelythepooledresourcesofalltheinvestors.Ifmorepeoplewanttogetintoaunittrust,itsimplyissuesmorepaperandinveststhemoney,andsogrowstoaccommodatethem.Unlike
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thepriceofinvestmenttrustsshares,whichissetbymarketdemandandcangetgrosslyoutoflinewiththeunderlyingvalue,thepriceofunitsissetstrictlybythevalueofthesharesthetrustowns.
TheEUandlegislationhaveinventedanewvocabulary.Unittrustsarenow‘collectiveinvestment
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schemes’(CIS)aspartofwhatthelawcallspooledschemesmanagedbyanindependentfundmanager.Theseareallowedtoinvestinquotedshares,bondsandgilts,butgenerallynotinunquotedsharesorproperty.Mostofthese‘openendedinvestmentcompanies’,unittrusts,andrecognizedoffshoreschemesare
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authorisedandregulatedbytheFinancialConductAuthority.
Theothersaresometimescallednon-mainstreampooledinvestments(NMPIs)becausetheyhaveunusual,riskyorcomplexassets,productstructures,orinvestmentstrategies.Theseareunregulatedcollectiveinvestmentschemes(UCIS);
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securitiesissuedbyspecialpurposevehicles(SPVs);unitsinqualifiedinvestorschemes(QIS);andtradedlifepolicyinvestments(TLPIs).Theseunregulatedschemesarenotbadorcrookedbutarereckonedgenerallytohavemoreriskyinvestmentportfoliosandsocannotbemarketedtoretailinvestorsormembersofthe
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generalpublic.Theycansellonlytopeoplewhohaveshowntheyknowwhattheyaredoing,suchaswealthyindividuals(incomeover£100,000and£250,000toinvest),sophisticatedinvestors,existinginvestorsinsuchschemesandfinancialinstitutions.UnregulatedschemesarenotsubjecttotheFCArulesoninvestment
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powers,howtheyarerun,whattypeofassetstheycaninvestin,ortheinformationtheymustdisclosetoinvestors.AndinvestorsdonothavethesafetynetoftheFinancialOmbudsmanServiceortheFinancialServicesCompensationScheme(FSCS)ifthingsgowrong.Theymayhowevercomplainaboutaregulated
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firmifitadvisedaninvestortoputmoneyintoanunregulatedscheme.
Tracker fundsLegendhasitthatblindfoldedstaffatoneUSbusinessmagazinethrewdartsatthepricespagesoftheWallStreetJournalandfoundtheirselectionbeateveryoneof
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themajorfundmanagers.Andindeedthetaskofhavingconsistentlytodobetterthanthemarketaverageoverlongperiodsoftimeissodauntingthatveryfewcanmanageit.
Somemanagershavegivenuptheunequalstruggleoftryingtooutguessthevagariesofthestockmarketandcallthemselves‘trackerfunds’(or‘indexfunds’inthe
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UnitedStates).Thatmeanstheyinvestinallthebigshares(inpracticealargeenoughselectiontoberepresentative)andsomovewiththemainstockmarketindex–intheUnitedKingdomthatisusuallytakentobetheFTSE100.Thisgivesevengreatercomforttonervousinvestorsworriedaboutfallingbehindthe
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economy,andthepolicyprovidescorrespondinglylittleexcitement,soitishighlysuitableforpeoplelookingforahomefortheirsavingsthatinthemediumtermatleastisfairlyrisk-free–itisstillsubjecttothevagariesofthemarketasawholeintheshorttermbutonanyreasonabletimeframeshoulddoprettywell.
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Infacttherearevariouswaysofstructuringsuchafund.Fullreplicationinvolvesbuyingeveryshareintheindexorsectorinappropriateproportions.Stratifiedsamplingbuysthebiggestcompaniesinthesectorplusasampleoftherest,andoptimizationinvolvesstatisticalanalysisofthesharepricesinthesector.
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Justtocomplicatematters,thereisaverylargenumberofthingstotrack.EvenifyouwanttofollowtheUSeconomythereisthechoiceofanythingfromtheS&P500,throughtheRussell3000totheWilshire5000,whichcovers98percentofUS-basedsecurities.
Open-ended
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investmentcompaniesTheseareasortofhalf-wayhousebetweenunitandinvestmenttrusts.Likeinvestmenttruststheyareincorporatedcompaniesthatissueshares.Likeunittruststhenumberofsharesonissuedependsonhowmuchmoneyinvestorswanttoputintothe
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fund.Whentheytaketheirmoneyoutandsellthesharesback,thosesharesarecancelled.TheacronymOEICispronounced‘oik’byinvestmentprofessionals.
Thecompaniesusuallycontainanumberoffundssegmentedbyspecialism.Thisenablesinvestorstopickthesortofareatheypreferandtoswitchfromonefund
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toanotherwithaminimumofadministrationandcost.
Exchange tradedfundsVeryliketrackerfunds,ETFsarebasketsofsecuritiesgenerallytrackinganindex,amarketoranassetclass.Theyaredealtonthestockexchangeandhavenoentry
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orexitfees,but,astheytradelikeothershares,theyincurcommissionsontransactionsanddohaveannualfeesofusuallyunder0.5percent.Alsoliketrackerfundstheymaynotbuyeveryshareintheindextracked(called‘totalreplication’)butmayusesomesamplingtechniquethatcanleadto‘trackingerror’,ietheperformanceof
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thefunddoesnotfollowitstargetcompletelyandthiscanrangefromabout0.25percenttoabout4percent,whichcanoutweighfeesandpricechanges.
ThelowcostofETFshasrecentlyattractedabigriseininvestmentinterest,whichhasinturnbroughtinagreatervarietyofproducts.SomuchsothattheFinancial
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ConductAuthorityhasbeenmovedtopublishawarningaboutgrowingcomplexityintheproductsproducinghigherrisk.AnothersourceofproblemisthesloppyuseoftheETFlabel–sometimesitisnowappliedtoExchangeTradedCommoditiesandExchangeTradedNoteswhichareunsecuredassetsandhenceofsubstantially
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greaterrisk.
AdvantagesEverythinghasacost.Pooledinvestmentsaresaferforsmallinvestorsbecausetheyspreadrisksbut,conversely,theycannotsoarasaresultoffindingaspectacularperformer.Soyoupayforthelackofriskbylackof
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sparkle.Theyaremanagedbyprofessionalswhomustbepaid,sothefundschargeafee.
Optingforsafetydoesnotmeaninvestorscanavoidthought,careorresearch.Someinvestmentmanagersarenotawfullycleverandfailtobuysharesthatperformbetterthanaverage.Theycanbefoundintheleaguetables
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ofperformancesomenewspapersandmagazinesreproduce,ascanthefundswithstartlinglybetterperformancethanboththemarketandothertrusts.
Thosetableshavetobeusedwithcaution.Theperformancestatisticslookonlybackwardsandonecannotjustdrawastraightlineandexpectthatlevelof
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performancetocontinuesteadilyintothefuture.Onetrustmayhavedoneawfullywell,butitmayjustbetheflukeofhavingbeeninasectororareathatsuddenlybecamefashionable–retail,Japan,biotechnology,financials,emergingmarkets,etc.Thereisalsothefactorthatsomebodygoodatdealingwiththefinancial
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circumstancesof10yearsagomaynotbeasgoodatanalysingthemarketoftoday,muchlessoftomorrow.Ontopofthat,thechancesarethatwhoeverwasincharge10yearsagototakethefundtothetopoftheleaguetableswillhavebeenpoachedbyarivalcompany.
Theconverseholdsequallytrue.Afundmay
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havebeenhandicappedbybeingcommittedtoinvestmentinJapanatatimewhenJapanfelloutoffashionorhitaroughpatch,orininternetstockswhenthenetlostitsglister.Suchfactors,whetherpromptedbyeconomiccircumstanceorfashion,mayreversejustasquicklyandhavethefundatthetopofthetable.Itmay
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alsohavehadaclumsyinvestmentmanagerwhohassincebeenreplacedbyastarrecruitedfromthecompetition.
Asavehicleforrecurrentinvestments,orasanadditionalsafeguardagainstfluctuatingmarkets,manyoftheseorganizationshaveregularsavingsarrangements.Theinvestorputsinaset
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amountandthesizeoftheholdingboughtdependsontheprevailingpriceatthetime.Thisisanotherversionofwhatprofessionalscall‘poundcostaveraging’.Italsotendstoleveltheriskofbuyingallthesharesorunitswhenthepriceisatthetop.
OnewayofmitigatingmanagementchargesistogetintoaUSmutualfund,which
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ismuchthesamethingasaunittrustbuthaslowercharges.Theoffsettingfactoristheexposuretoexchangeraterisk.
Finally,thereistheoptionofsettingupyourownpooledinvestmentvehicle.Investmentclubs,hugelypopularintheUnitedStates,aregrowinguparoundtheUnitedKingdom.Agroupof
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peoplegettogethertopoolcashforputtingintothemarket.Theusualmethodistoputinasetamount,say£10amontheach,andjointlydecidewhatthebesthomeisforit.Thishastheadvantageofbeingabletospreadinvestments,toavoidmanagementcharges,tohavetheexcitementofdirectinvestment,toprovidean
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excuseforasocialoccasion,andfortheworkofresearchtobespreadamongthemembers.
Other derivatives
Whenpeopletalkofderivativestheyareusuallynotreferringtotherangeofcollectiveinvestmentsbutmeanhighly-gearedgambles
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requiringextensiveknowledge,continuousattentionanddeeppockets.Eventheprofessionalsgotitsospectacularlywrongthatthederivativesmirerockedthefoundationsoftheglobaleconomyinthe1990sandswallowedsomeoftheworld’slargestfinancehouses,banksandinsurancecompaniesbetween2007and
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2009.Ifthe‘expert’financierswhoarepaidmillionsayearcangetitsohugelywrongthattheybankruptedmultibillionpoundcompanies,asmallamateurisunlikelytosurvivelong.Theseshark-infestedwatersaretoodangerousforsmallorinexperiencedinvestors.
Thissectionthereforeis
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intendedasbackgroundratherthantemptation.Somereadersofthisbookmaybegamblers,richenoughtobetonlongodds,orgrowexperiencedenoughtoventureintosuchtreacherousareas.Thatisthespeculativeendofderivatives.Forothersitmayalsoactasasafetynetbyhedgingaperceivedrisk,orbyfixingthepriceat
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whichtotradewithinaspecifictime.Buteventhenoneneedsafeelforthemarket.
Thereisahugeselectionofevermorecomplicatedderivatives.Theyincludefutures,optionsandswapswithagrowingcollectionofincreasinglyexoticandcomplexinstruments.Thesederivativesarecontracts
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derivedfromorrelyingonsomeotherthingofvalue,anunderlyingassetorindicator,suchascommodities,equities,residentialmortgages,commercialproperty,loans,bondsorotherformsofcredit,interestrates,energyprices,exchangerates,stockmarketindices,ratesofinflation,weatherconditions,oryetmore
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derivatives.Theyarenothingnew.
ThalesofMiletusinthe6thcenturyBCwasmockedforbeingaphilosopher,anoccupationthatwouldkeephimpoor.Toprovethemwrongheusedhislittlecashtoreserveearlyalltheoilpressesforhisexclusiveuseatharvesttime.Hegotthemcheapbecausenobodyknew
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howmuchdemandtherewouldbewhentheharvestcamearound.AccordingtoAristotle,‘Whentheharvest-timecame,andmanyweresuddenlywantedallatonce,heletthemoutatanyratewhichhepleased,andmadeaquantityofmoney’,showingthinkerscouldberichiftheytriedbuttheirinterestlayelsewhere(PoliticsBk1
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Ch11).Thereissomedisputeastowhetherthiswasanoptionsorforwardcontractbuteitherwayitshowsderivativeshavealonghistory.
Derivativesaregenerallyanalogoustoaninsurancecontractsincetheprincipalfunctionisoffsettingsomeimpendingrisk(‘hedging’,asthefinancialworldcallsit)by
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onesideofthecontract,andtakingontheriskforafeeontheother.Inadditionthereisthestraightgambleoftakingapuntonthevalueofsomethingmovinginonedirection.
Hedgingcanentailusingafuturescontracttosellanassetataspecifiedpriceonastateddate(suchasacommodity,aparcelofbonds
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orshares,andsoon).Theindividualorinstitutionhasaccesstotheassetforaspecifiedamountoftime,andthencansellitinthefutureataspecifiedpriceaccordingtothefuturescontract.Thisallowstheindividualorinstitutionthebenefitofholdingtheassetwhilereducingtheriskthatthefuturesellingpricewill
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deviateunexpectedlyfromthemarket’scurrentassessmentofthefuturevalueoftheasset.
Derivativesallowinvestorstoearnlargereturnsfromsmallmovementsintheunderlyingasset’sprice,but,asisusual,bythesametokentheycouldloselargeamountsifthepricemovesagainstthemsignificantly,aswas
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shownbythe2009needtorecapitalizethegiantAmericanInternationalGroupwith$85billionofdebtprovidedbytheUSfederalgovernment.Ithadlostmorethan$18billionovertheprecedingthreequartersoncreditdefaultswaps(CDSs)withmorelossesinprospect.OrangeCountyinCaliforniawas
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bankruptedin1994throughlosingabout$1.6billioninderivativestrading.Buttheskyreallyfellinfrom2007onwardswhenitbecameclearthatmostofthemajorbankshadtradedincomplexderivativeswithouttheslightestunderstandingoftheorigin,riskandimplicationsofwhattheyweredoing.
Therearethreemaintypes
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ofderivatives:swaps,futures/forwards,andoptions,thoughtheycanalsobecombined.Forexample,theholderofa‘swaption’hastheright,butnottheobligation,toenterintoaswaponorbeforeaspecifiedfuturedate.
Futures/forwardsFutures/forwardsare
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contractstobuyorsellanassetonorbeforeadateatapricespecifiedtoday.Afuturesagreementisastandardizedcontractwrittenbyaclearinghouseandexchangewherethecontractcanbeboughtandsold;aforwardisnegotiatedforaspecificarrangementbythetwosidestothedeal.
Thefacility,aswithso
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manyderivatives,wasoriginallycreatedasawayof‘hedging’oroffloadingrisk.Forinstance,abusinessexportingtotheUnitedStatescanshielditselfagainstcurrencyfluctuationsbybuying‘forward’currency.Thatprovidestherighttohavedollarsataspecificdateataknownexchangeratesoitcanpredicttherevenue
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fromitsoverseascontract.Ifsomeshareshadtobesoldatsomeknowndate(saytosatisfyadebt)andtheinvestorwasnervousthatthemarketmightfallinthemeantime,itispossibletoagreeasellingpricenow.
Agamblerdecidestobuyafuturescontractof£1,000(italmostdoesnotmatterwhatliesbehindthe
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derivative–itcouldbegrain,shares,currencies,giltsorchromium).Itcostsonly10percent(calledthe‘margin’inthetrade),sointhiscase£100.Thatshowsthebusinessisgearedupenormously.Threemonthslaterthepriceisupto£1,500sotheluckypersoncansellata£500profit,whichisfivetimestheoriginalstake.It
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couldalsohappenthoughthatthepricedropsto£500andheorshedecidestogetoutbeforeitgetsworse.Onthesamereckoningthelossof£500isalsofivetimestheoriginalmoney.Thisshowsthat,unlikeinvestmentinsharesorwarrants,wherethemaximumlossistheamountofthepurchasemoney,thepossibledownsideofa
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futuresdealismanytimestheoriginalinvestment.
Futurescontractscanbesoldbeforethematuritydateandthepricewilldependonthepriceoftheunderlyingsecurity.Ifyoufailtoactintimeandsellacontract,thecontractcannowberolledoverintothenextperiodortheintermediaryarrangingthecontractwillcloseand
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remitprofitsordeductlosses.Thereisalsoan‘index
future’,whichisanoutrightbetsimilartobackingahorse,withthemoneybeingwonorlostdependingontheleveloftheindexatthetimethebetmatures.AFTSE100Indexfuturevaluesaone-pointdifferencebetweenthebetandtheIndexat£25.
Anextensionofthatis
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‘spreadtrading’,whichisjustoutandoutgamblingonsomeeventortrendvaguelyconnectedtothestockmarketorsomefinanciallyrelatedevent.ItcouldbeanythingfromtheleveloftheFTSE100Indextothesurvivalofamajorcompany’schiefexecutiveinhisorhertroubledjob.Ifthespreadbettingcompanyis
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quoting4,460to4,800orifthemarket-makersarequoting40to42daysforthechiefexecutiveandsomebodythoughtitwouldbelessthanamonth,itispossibleto‘sell’at40;whilesomebodyreckoningthechancesarebetterthanthatandtheexecutivecouldbethereformonthstocomewould‘buy’at42.Thenifthe
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personlasted47daysbeforegettingtheelbow,thebuyerswouldhavewonbyfivedaysandtheirwinningswoulddependonhowmuchtheystaked–at£1,000adaytheywouldhavecleared£5,000.Thesellers,however,wouldhavelostbysevendaysandonceagaintheirdebtwoulddependonhowmuchtheystaked.Themarket-maker
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makesaprofitonthespreadbetweenthetwo(ifrunninganevenbook),justasdomarket-makersinordinaryshares.
Thespreadbettingcompany,say,offersBrigantine&Fossbenderat361to371p.Ifyouthinktheshareswillrisesubstantiallyyoubuyat371inunitsof£10.Ifyouarerightandthe
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pricethengoesto390p,theshareshaveappreciatedby19paboveyourbettingprice(assumingoneunit)andtheproceedsaretherefore£190.Thatsoundsgooduntilyouconsiderthatiftheshareshadinsteaddroppedto340p,yourlosseswouldbe£210.Conversely,ifyouthinktheshareswillfall,you‘sell’at361pandthesame
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mathematicsappliestheotherway.Ifthepriceremainswithinthe361to371prangenobodywins.
Contract fordifferenceThisisacontractthatmirrorspreciselydealinginanasset,withoutanyofitactuallychanginghands.Iftheprice
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hasrisenbytheendofthestatedperiodthesellerpaysthebuyerthedifferenceinprice,andifthepricehasfallenthebuyerpaysthesellerthedifference.CFDsareavailableinunlistedorlistedmarketsintheUnitedKingdom,theNetherlands,Germany,Switzerland,Italy,Singapore,SouthAfrica,Australia,Canada,New
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Zealand,Sweden,France,Ireland,JapanandSpain,butnottheUnitedStateswheretheyarebanned,buttheydohavemargintrading.Theassetcanbeshares,index,commodity,currency,gold,bonds,etc.
Thetradesdonotconferownershipoftheunderlyingassetbutinvolvetakingapuntonthepricemovement,
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sothecontractsofferallthebenefitsoftradingshareswithouthavingtoownthem.Beingrisky,thecontractsareavailableonlytonon-private,intermediatecustomersasdefinedbytheFinancialConductAuthority.
InvestorsinCFDsarerequiredtomaintainamarginasdefinedbythebrokerageormarket-maker,usually
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from1to30percentofthenotionalvalueofleadingequities.Thatmeansinvestorsneedonlyasmallproportionofthevalueofapositiontotradeandhencetheyofferexposuretothemarketsatasmallpercentageofthecostofowningtheactualshare.Itoffersopportunitiesforlargegearingup–1:100when
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tradinganindex.Itallowstakinglongorshortpositions,andunlikefuturescontractsacontractfordifferencehasnofixedexpirydate,standardizedcontractorcontractsize.Asintheunderlyingmarket,takingalongpositionproducesaprofitifthecontractvalueincreases,andashortpositionbenefitsifthevaluefalls.
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Thereisadailyfinancingchargeforthelongsideofthecontracts,atanagreedratelinkedtoLIBOR(seeGlossary)orotherinterestrate,soadelayinclosingcanbeexpensive.Traditionally,CFDsaresubjecttoacommissionchargeonequitiesthatisapercentageofthesizeofthepositionforeachtrade.Alternatively,an
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investorcanopttotradewithamarket-maker,foregoingcommissionsattheexpenseofalargerbid/offerspreadontheinstrument.Thecontractscanhedgeagainstshort-termcorrectivemoves,butdonotincurthecostsandtaxesassociatedwiththeprematuresaleofanequityposition.Asnoequitieschangehands,thecontractsareexemptfrom
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stampduty.Likeallhighlygeared
deals,exposureisnotlimitedtotheinitialinvestment.Theriskcanbemitigatedthrough‘stoporders’(guaranteedstop-lossorderscostanadditionalone-pointpremiumonthepositionand/oraninflatedcommissiononthetrade).Astop-losscanbesettotriggeranexit,egbuyat
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300pwithastop-lossat260p.Oncethestop-lossistriggered,theCFDprovidersells.
Thedeviceisconvenientifusedunderaround10weeks–thepointwherefinancingexceedsthefinancingchargeforstocks–whilefuturesarepreferredbyprofessionalsforindexesandinterestratestrading.Itisalsofairlywell
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hidden–agroupofhedgefundslinkedtoBAESystemsacquiredmorethan15percentofAlvisthroughCFDswithouthavingtowarntheregulator.
Acquiring1,000Bloggins&Snooksplcsharesat350peachwouldneed£3,500.Usingcontractsfordifference,tradingona5percentmargin,youwouldneed
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onlyaninitialdepositof£175.Ifyouhad£175toinvest,andwantedtobuyBloggins&Snooksplcat350pandsellat370p,astandardtradewouldbe:
Althoughtheprofitafter
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gearingwasfargreater,lossesarecomparablymagnified.
OptionsOptionsgivetheright,butnottheobligation,tobuy(inthecaseofa‘calloption’)orsell(inthecaseofa‘putoption’)anasset.Thatishowtheydifferfromfutures,whichhaveanobligationtotrade.
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Thepriceatwhichthetradetakesplace,knownasthe‘strikeprice’,isspecifiedatthestart.InEuropeanoptions,theownerhastherighttorequirethesaletotakeplaceon(butnotbefore)thematuritydate;inUSoptions,theownercanrequirethesaletotakeplaceatanytimeuptothematuritydate.
If,duringthetimeaput
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optionisinforcethesharepricefallssignificantly,theinvestorcanmakeahandsomeprofitbybuyingthecheapersharesinthemarketandexercisingtheoptionbysellingthemattheagreedprice.Similarly,inreverse,acalloptionishandyifyouthinktheywillrisesubstantiallyintheinterim.Comethecontractedday,
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however,andthepricehasmovedthewrongway,onecanjustwalkawayandoptnottoexercisetheoption.Allthathasbeenlostisthemarginofoptionmoney,whichisalotlesspainfulthaniftheunderlyingsecurityhadbeenboughtandsold.
Thisisanotherwayofhedgingone’sposition.Saysomebodyknowsthatfor
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somereasontheywillhavetosellaparcelofsharesineightmonths’time–tofundthedown-paymentonahouse,forinstance.Butthereisaworrythemarketmayslumpinthemeantime:buyingaputoptionatroughlytoday’spriceprovidesawayofbuyingprotection.Ifitisoneofthe70orsocompanieswithoptionstradedinthe
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market,thereisalsothechancetoselltheoptionbeforeexpirysince,likemostderivatives,optionscanbetradedbeforematurity.
Acompanylanguishinginatroubledsectormaylooktoanastuteobservertobeabouttoturnitselfround,becomearecoverystock,andastonisheveryone.Butiftheobserverisalsoastuteenoughtohave
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misgivingsaboutsuchuniquelyprescientinsight,andworriesaboutcommittingtoomuchmoneytothehunch,thereisacheapwayin.Onesimplybuysanoptiontobuy.
SoifBathplug&Harbottlesharesarestandingat75p,itcancost,say,6ptoestablishtherighttobuysharesatthatpriceatanytimeoverthe
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nextthreemonths.Ifinthattimethesharesdoinfactfulfiltheforecastandjumpto120p,theastuteinvestorcanbuyandimmediatelysellthemataprofitof39pashare.Ifthemisgivingsprovejustifiedandthesharesfailtorespondorevenslumpfurther,only6pinsteadof75phasbeenlost.
Thewholethingworksthe
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otherwayaswell,sothesuspicionbutnottotalcertaintythatacompanyisabouttobeseriouslyhammeredbythemarketcouldpromptsomeonetobuyaputoption.Thatistherighttosellthesharesataspecifiedprice,withinanagreedsetofdates.
Theserightshaveavalueaswell,relatedtohowthe
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underlyingshareisperformingandhowlongtheyhavetorun,sotheycanbetraded,mostlyontheLondonInternationalFinancialFuturesandOptionsExchange(generallyabbreviatedtoLiffe,pronounced‘life’ratherthanliketheriverflowingthroughDublin).Thetradedoptionsmarketdealsinparcelsof
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optionsfor1,000sharesandatseveralexpirydates,withsomeaboveandsomebelowtheprevailingmarketpriceforabout70ofthelargestcompanies.
Whenonebuysasecurityordirectinvestment,forexample100sharesofSouthSeasat£5each,thecapitalresultislinear.Soifthepriceappreciatesto£7.50,wehave
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made£250,butifthepricedepreciatesto£2.50wehavelost£250.Buyingaone-monthcalloptiononSouthSeaswithastrikepriceof£5wouldgivetherightbutnottheobligationtobuySouthSeasat£5inonemonth’stime.Insteadofimmediatelypaying£500andreceivingthestock,itmightcost£70todayforthisright.IfSouth
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Seasgoesto£7.50inonemonth’stime,exercisingtheoptionbybuyingthesharesatthestrikepriceandsellingthemwouldproduceanetprofitof£180.Ifthesharepricehadgoneto£2.50,thelosswouldhavebeenrestrictedtothe£70premium.Ifduringtheperiodoftheoptionthesharessoarto£10theoptioncanbesoldfor
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£430.Anoptionprovidesflexibility.
WarrantsInnormalusagea‘warrant’isasortofguarantee,butinthestockmarketitisapieceofpaperentitlingonetobuyaspecifiedcompany’ssharesatafixedprice.Theseareequivalentsofshareoptions–
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thoughgenerallywiththelongerlifeofbetweenthreeand10years–andcanthereforebetraded.Ineffectitisacalloptionissuedbyacompanyonitsownstock.Thecompanyspecifiestheexercisepriceandmaturitydate.Thepricewillbesetbyacombinationoftheconversionpriceandtheprevailingpriceoftheactual
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sharesalreadybeingtraded.A‘coveredwarrant’is
different,andthe‘covered’bithaslongbeenabandoned.Itconveystherighttobuyorsellanasset(generallyashare)atafixedprice(calledthe‘exerciseprice’)uptoaspecifieddate(calledthe‘expirydate’).Itcanalsobebasedonawidevarietyofotherfinancialassetssuchas
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anindexliketheFTSE100,abasketofshares,acommoditysuchasgold,silver,currencyoroil,oreventheUKhousingmarket.Aswithotherderivatives,investorscanuseittogearuptheirspeculationoruseitasawayofhedgingagainstamarketfallorevenfortaxplanning.Unlike‘corporatewarrants’,whichareissued
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byacompanytoraisemoney,acoveredwarrantisissuedbyabankorotherfinancialinstitutionasapuretradinginstrument.CoveredwarrantscaneitherbeUSwarrants(exercisedanytimebeforeexpiry)orEuropean(exercisedonlyonthedatespecified)butmostaresimplyboughtandthensoldbacktotheissuerbefore
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expiry.Ifawarrantisheldtoexpiry,itisboughtbackforcashautomatically,withtheissuerpayingthedifferencebetweentheexercisepriceandthepriceoftheunderlyingsecurity.
Thereareanumberofissuersofferingover500warrantsandcertificatesonsinglesharesandindicesintheUnitedKingdomand
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aroundtheworld.Theytendtobemajorglobalinvestmentbanksthathave‘bid’(buy)and‘offer’(sell)pricesfortheirwarrantsduringnormalmarkethoursinexactlythesamewayasshares.Investorstradeinthemthroughastockbroker,bankorfinancialadviser,justaswithordinaryshares.Launchedin2002therearenowmorethan70
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brokerstrading.Germanylauncheditscoveredwarrantsmarketthreeyearsearlierin1989.
Acoveredwarrantcostslessthantheunderlyingsecurity;thisprovidesanelementof‘gearing’sowhenthepriceoftheunderlyingassetmoves,thewarrant’spricemovesproportionatelyfurther.Itisthereforeriskier
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thanbuyingtheunderlyingasset.Arelativelysmalloutlaycanproducealargeeconomicexposure,whichmakeswarrantsvolatile,andthatmeanstheycanproducealargereturnorlosethecompletecostofthewarrantprice(confusinglycalledthe‘premium’)iftheunderlyingsecurityfallsbelowthepurchaseprice(itis‘outof
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themoney’).Inaddition,warrantshavelimitedlivesandtheirvaluetendstoerodeastheexpirydateapproaches.
Coveredwarrantscanbeusedtomakebothupwardsanddownwardsbetsonanunderlyingasset.Buyinga‘call’isabetonanupwardmovement.Buyinga‘put’isabetonadownwardmovement.Withbothkinds
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ofbetthemostaninvestorcanloseisthecostofthewarrant.Coveredwarrantsarelikeoptionsbutarefreelytradedandlistedonastockexchange–theyaresecuritized.Asaresult,theyareeasyforordinaryprivateinvestorstobuyandsellthroughtheirusualstockbroker.
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SwapsSwapsarecontractstoexchangecashflowsonorbeforeaspecifiedfuturedatebasedontheunderlyingvalueofcurrencies/exchangerates,bonds/interestrates,commodities,stocksorotherassets.Interest-rateswapsaccountforthemajorityofbanks’swapactivity,withthe
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fixed-for-floating-ratebeingmostcommon.Inthatdealonesideagreestomakefixed-rateinterestpaymentsinreturnforfloating-rateinterestpaymentsfromtheother,withtheinterest-ratepaymentcalculationsbasedonahypotheticalamountofprincipalcalledthe‘notionalamount’.Swaps,forwardrateagreementsandexotic
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optionsarealmostalwaysagreedprivately,unlikeexchange-tradedderivatives.
AsreveredinvestorWarrenBuffettwarnedinhisBerkshireHathaway2002annualreport,‘Weviewthemastimebombsbothforthepartiesthatdealinthemandtheeconomicsystem…Inourview…derivativesarefinancialweaponsofmass
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destruction,carryingdangersthat,whilenowlatent,arepotentiallylethal.’
Theoriginalpurposeofinventingmostofthemwastoreducesomebody’srisk–asortofhedgingdevice.Itworksincommodities,forinstancewhenafarmertriestofindprotectionfromthepotentialhazardofahugeharvest(ofwheat,oranges,
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coffeeandsoon)withtheconsequentplummetingprices,byagreeingapriceearlierandbeforethesizeoftheharvestisknown.Ifthecropturnsouttohavebeenmeagreahugeprofitmayhavebeenforfeitedfromabigpricehike,butthefarmerwasprotectedfrompenuryifithadgonetheotherway.
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ChapterFourForeignshares
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Asubstantialnumberofforeigncompaniesare
quotedontheLondonStockExchange,especiallyfromEurope(egVolkswagen,BankofIreland,BayerandEricsson).InadditionthereareUScompanies(egGeneralElectricandAbbottLaboratories),Chinese(AirChina),Japanese(Honda,KawasakiandMitsubishi),
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Taiwanese(Acer),SouthAfrican(SABMiller),Chilean(Antofagasta)andRussian(Gazprom).MostofthemtradeinBritainaswellsoitispossibletogetsomeideaofthebusinessandseestockbrokeranalysisofthemanagementandfigures.TradingintheseisprettymuchlikeinvestinginamajorUKcompany.
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ThemergersofEuropeanstockmarketsmakeiteasiertogetaccesstomarketsinothermajorcountriesandtheirshares,especiallyasthereisalargenumberofrathergoodinternet-basedstockbrokersinGermany,FranceandHolland.
ItistheoreticallypossibletobuyoverseassharesthroughaUKbroker–in
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practiceonlysomeofferthisservicesocheckinadvancewhetherthebrokeryouwantdoes.However,globalmarketsanddifferentialeconomicperformancesareproducingmoreopportunities,andtheinternetandonlinebrokersmakeiteasy.ButdespitethegrowthofEuropeantradersmostofthereadilyavailabletradein
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overseassharesisforUSstocks.Thatlookstochangeasanever-growingnumberofcut-pricedealersfromGermanyandFrancesetupnetservicesinBritain.
Aswithallsuchinvestments,adegreeofresearchandhomeworkareessential.Thetroubleisthatthereareaddedlevelsofriskinoverseasshares.Thefirstis
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thestateoftheoverseaseconomy.Aninvestorneedstoknowwhetherinterestratesareonthevergeofchangeinthatcountrybecausethatmighthaveanimmediateeffectonshareprices,orwhethertheeconomyasawholeisabouttosoarawayorisheadingforaprecipice.
Second,awiseinvestorgetstoknowsomethingabout
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thestateofaparticularsector:oneneedstoknowwhichisabouttobeaffectedbyatradeagreement,areorganization,aspateofmergersandsoon.
Third,itisalittlehardertokeeptrackofthecompanies–Britishnewspaperstendnottowriteaboutthem,stockbrokersdonotanalysetheirfiguresandonecannot
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keepaneyeontheirproductsandservicesinthemarketplace.Therearealsolocalpeculiarities,forinstanceSwissshares,whicharecommonly£5,000each,withsomeatover£20,000forasingleshare.Thatmakesitharderforasmallinvestortogetarangeofthesestocks–thoughtobefairtherearewaysofbuyingpartofa
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share.Ontopofthatthereisthe
exchangeraterisk:acomfortableprofitfromtradinginthesharesmightbecompletelywipedoutbytherelativemovementofsterling.Finally,therearerisksinthewaythemarketitselfoperates.RegulationinmajorcountrieslikeAustraliaandtheUnitedStatesispretty
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comparablewithBritain,but‘emerging’marketscanrangefromthehaphazardtothecorrupt.Aspartofthattheremayalsobeerraticrecordingofdeals,ownershiprecordsmaybevariable,andcontrolswayward.
Therearepeoplewhocancopewithallthosedangers,andhavedoneverywellfromUSshares,andevenfrom
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investinginthebuddingmarketsofsmallercountries.Mostlytheyknowwhattheyaregettingintoandknowsomethingofthecircumstancestomanagetherisk.
Foranovicetothestockmarketsorsomeonewitharelativelysmallamountofmoneytoplaywith,itisprobablywisertobuy
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investmentorunittrustswiththesortofoverseasprofileyoufancy.Thereissuchavarietyonoffer,youcandecidewhethertooptforJapan,theUnitedStatesorGermany;forthePacificRim,westernEurope,ordevelopingcountries;andevenwhethertopickspecificindustrialsectorswithintheseregions.Thatnotonlyhands
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overthedecisiontoprofessionalsonwhicharethegoodshares,butalsospreadstherisk.AnotherchoiceistobuythesharesofaUKcompanythatdoesalotoftradeinthefavouredarea.Thosechoicesalsoeliminatetheforeignexchangeconsiderationsincethedealingsareinsterling.
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ChapterFiveHow to picka share
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A
I started withnothing. I still havemost of it.
JACKIE MASON, AMERICANRABBI AND COMEDIAN
nythingtodowithmoneyisamatterofdifficult
choices.Thesavingsandinvestmentpartalsodemandsalineofcarefuldecisions.Firstcomesthegradingof
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safetyandaccesstosparecash.Thereisthecurrentaccountforeverydayexpenses,followedbytheamountsaccumulatingforpredictablelargerspendingsuchasholidays,redecoratingthehome,replacingthecar,thechildren’seducation,andsoon.Thencomestheprovisionsforasafeoldage,lifeassurance,pensionand
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rainy-dayreserves.Onlywhenthesenecessitieshavebeentakencareofcomestheriskierareaofstockmarketinvestment.Itisnotcashyouwillneedtorealizeatshortnoticebutwillsupplementincomeforyouroldage,say.
Stockmarketinvestmentisforcashyoucanspareinthesensethatifitsvaluefallsitmaybedisappointingand
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inconvenientbutwillnotcauseserioushardship.Itisalsoforpeoplewhosenervescanstanduncertainty–forpeoplewhowillnotlieawakeatnightfrettingaboutthefluctuationsofsharepricesorgetulcersifthebusinessinvestedingoesofftheboil,orevendownthepan.Ifyoucanthinkofitinthesenseofanalternativetoaflutteron
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the3.30atSandown,orapuntataroulettewheel,andcanacceptreverseswithareasonablyphilosophicalshrug,thestockmarketmaybeforyou.
Thatisnotquiteafairpicture,sinceifthehorseyoubackfailstowin,allyourstakeisgone.Moneyinshareshasaprettyfairchanceofnotvanishingcompletely
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asmostcompaniesstayafloatandcontinuetopaydividendstoprovidesomereturnontheinvestment.Inanycase,unlessyouwerebeingforcedtosell,adropinsharepriceisonlyanotionallosswhiledividendscontinuetoarrive.Ontopofthat,notonlyaretheoddswayaheadofotherformsofgambling,butthereturnisbetterthanother
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formsofinvestment.Carefulresearch,monitoringandevaluationcanreducerisksonthestockmarket.Ifthehazardscouldcausealarm,itdoesnotmeanthestockmarketisclosedtoyou.Youcanstillbenefitfromthelong-termperformanceofsharesbythereduced-riskrouteofpooledinvestmentvehicles(seeChapter3).The
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moneyisstillinvestedinsharesbutthedangersofbiglossesarelessenedbyspreadingtherisk.
Butthatdoesnotendthedecisionmaking–onthecontrary,itjuststartsitonanewtack.Tosifttherightinvestmentfromthemanythousandsavailablethroughstockexchangestakesaseriesoftestsanddecisions.There
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arerisk/rewardcalculationsandapproachestodecide–otherpeoplecanhelpbyspellingouttheoptionsbutnottakethedecisionsforyou.Forinstance,somepeoplearepreparedtobetatoddsof14.5milliontooneagainstthem,whichwouldnormallyseeminsane,butbecausethecostoftakingpartintheNationalLotteryisonly£2
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andthewinningscanrunintomillions,lotsofpeoplearepreparedtotakeapunt.
Thatshowssomeofthecriteriafordecisions.Onewayofscreeningthethousandsofpotentialinvestmentsistosetyourowngoalsclearlyandexplicitly.Itisnotnearlyenoughtosaytheaimistomakemoneyoutofthestock
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exchange.Theprocessinvolves:
Decidingtheacceptableamountofrisk.Comparedwiththereturnonasafehomeforthecashlikegilt-edgedsecuritiesoradepositaccountatabuildingsociety,istheprofitfromsharesenoughto
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compensatefortherisks?HowmuchriskamIpreparedtoaccept,firstingeneral,forinvestinginsharesatall,thenintheparticularsortofsharestogofor–suchasacceptingthatsmallandnewcompaniesaremoreindangeroffailingbutdohavethepotentialfora
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largerpercentagegrowthinbothsharepriceanddividend;somecompaniesareseasonalormorereactivetoeconomicfluctuations;overseassharesincludeanelementofcurrencyrisk?Settingatimehorizonfortheinvestment.Whethertheinvestment
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istobeshort,mediumorlongterm:volatilityofsharepricecanbedisregardedforthelong-terminvestmentandsotheshorter-terminvestmentswouldbemorestablebusinesses.Choosingifitistogenerateanincomeorcapitalgrowth.Theformerwouldsendyou
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tocompanieswithahigheryield(thedividendasapercentageofthecashinvestedintheshares),thelatterforcompanieswithlowerdividendsbutthepotentialforhighercorporategrowth.Ahostofsubsidiarydecisions,possiblyincludingethical
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considerations,territorialpreferences,etc.Somepeoplemightbeaversetotobacco,armsmanufacturers,contraception,dealingwithdictators,alcohol,inadequateecologicalperformance,poorlabourrelationsandsoon.
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Thatprocessshouldhelpnarrowthefieldslightly.
Figure 5.1 Long-termstock market prices
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Anothercriterionmightbethesortofrewardyouwouldneedfortheadmittedrisksofinvestinginshares.Bothsidesofthatequationaresubjective–risksvarywiththetimescale,thechoiceofinvestmentsandtherangeofholdings;rewardsneedtobecomparedwiththereturnfromalternativeusesofthe
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moneysuchasputtingthecashondeposit,intogilts,orintootherinvestmentssuchasproperty,artandsoon.Returnsonequities(anothertermforshares)areusuallyseveralpercentagepointshigherthanongilts,whichinturnareseveralpointsabovedepositaccounts,butwhattherealreturnwillbeinthefutureisonlyanextrapolation
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–historyshowsthatbothabsoluteandrelativevalueschange.
Eventhatisnottheendofit,becausethereisnoreasontoinsistthatthewholeinvestmentpotisgovernedbyasinglestrategy.Or,toputitanotherway,theeffectofevenastronginitialstrategycanchangeastheamountandrangeoftheinvestments
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grows.Thefirstforaysintothestockmarketmightbeguidedbyalow-risklong-termincomedemand.Butastheportfolioextends,peoplearesometimespreparedtosaythat,thesafebasishavingbeenset,itisfairtotryforahigherreturnbytakingonariskierinvestment.Inaddition,astheygetmoreexperiencedand
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knowledgeable,somepeoplearetemptedtotryalittlemoreactivetradingtobenefitfromshorter-termfluctuationsinparticularcompaniesorsectors.
Strategy
RiskThereisnosuchthingasa
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risk-freeinvestment.Cometothatthereisnorisk-freelife.Ininvestmentthereiseconomiccyclerisk,companyrisk,exchangeraterisk,incomerisk,inflationrisk,marketrisk,sectororindustryrisk,andsoon.Inthiscontextthatusuallymeanscapitalrisk,iethedangerthatthesharepricefallsor,worsestill,thatthe
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companyfounders.Noonesharecanmatchallone’spreferences,sothepolicyhastobetobalancethespreadofsharestomatchriskneedsandthenassesseachnewinvestmenttomaintainthebalance.
Therearerisksconnectedwiththequalityofthecompany’smanagement,businessareaandsize.In
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additiontherearevulnerabilitiessuchasgreatrelianceonamanagingdirector(causingmajorproblemsifsuchakeypersondiesorleaves),orahighportionofbusinesswithafewcustomers(whichcanbenationalizedorgobust).Itcanalsobebecausethebusinesssectorisdoingbadlythroughachangeinfashion
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orcompetingproductsarriving,orhealthdangersassociatedwiththeproduct.Itcanalsobebecausethewholemarkethasfallenflatonitsface.Theresultscanbehitbyturmoilinthecurrencymarketsorinterestrates,orthestateoftheeconomy.Inaddition,somesharesreactmoreviolentlytomarketmovements.Thedegreeof
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thisresponsivenessisknowntoprofessionalsbytheGreekletterbeta,β(seeChapter6).
Companieswithriskfactorswillprobablyhavehigherthanaverageyields.Thisiscalledthe‘equityriskpremium’becauseitisgenerallyrecognized–notjustinthestockmarket–thatifyouhavetocarrygreaterriskyoushouldberewarded
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withmoremoney.Higher-riskcompanieswithgreateryieldsarefineforgamblers,orpeoplewithasufficientlydiversifiedportfoliotooffsettheriskbyspreadingacrossother,lessdangerouscompaniesandsectors.
Sometradeshavetraditionallybeenvolatileandprecarious,andsomewecantellfrominstinctare
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vulnerable.Theymaymovesharplywithfashions,seasonsortheeconomiccycle.
Anothergoodindicatoristhewaytherestoftheworldregardsthebusiness.Therearethreeusefulindicationsofthis:thebeta,theprice/earningsratioandtheyield,thelasttwoofwhichareavailableonthe
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newspapersharepricespages.Betaisameasureofthepricevolatility,measuredagainstthemarketasawhole,andisstronglycorrelatedwithrisk.TheP/Eisthepriceofthesharedividedbytheattributableearnings,soahighP/Esaysthemarketexpectsafasterthanaveragegrowth,andalowonemeansthegeneralfeelingisthatthe
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companywilllanguish.Ineffectthepricereflects,ordiscounts,theexpectedgrowthinthedividendsthecompanywillpayoverthenextfewyears.AverylowP/Eindicatesalackofmarketenthusiasm,probablybecauseitconsidersthebusinessrisky.
Theyieldwillshowasimilarpattern.Thereisa
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caveathere,though.SomeshareshavealowP/Eandahighyieldnotbecausetheyareintrinsicallydodgybutbecausetheyareunfashionable.Andthisiswheretheso-calledperfectmarketbreaksdownandashrewdinvestorcangetanedgeontheprofessionals.Forinstance,companieswithasmallmarketvaluewere
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avoidedforyearsfortwomainreasons:themajorinvestmentfundscouldnotfitthemintoapolicyofbuyinginbigchunksofmoneyyetendingupowningonlyasmallpercentageofacompany;andfewanalystsbothertolookatmostoftheshares.Thisneglectmeantitwaspossibleforthesmallinvestortofindrelatively
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highyieldsoninvestmentsbybuyingintothesecompanies.
Similarly,ifacoupleofmajorcompaniesinasector–retailing,computers,insuranceorwhatever–reportlowerprofits,leanermarginsandtoughtimesahead,allthesimilarcompanieswillbemarkeddown.Thereissomesenseinthat,sincethechancesare
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thatmostofthemwillbeaffectedinasimilarway.Ifonediscovers,however,thatbygoodluck,goodmanagement,orgoodproducts,onecompanyinthedisdainedsectoractuallyhascashinthebankandisachievingasubstantiallyhigherprofitmarginthanmostofitscompetitors(andthefiguresarereliableand
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notjustwindowdressing),thenitwillprovidearelativelycheapwayin,eitherforagoodincomeorforcapitalgrowthwhenmarketsentimentreassessesthewholeareaofbusiness.Inotherwords,thesignalsofhighriskweremisleadingormistaken.
Itisafoolhardyinvestor,however,whoreliesheavily
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onthissortofluckorimaginesheorsheknowsbetterthanthemarket.Ingeneralthemarketismoreoftenrightthanwrongandthefiguresreallyprovideaprettygoodindicationthatthereissomethingpotentiallydodgy.Itissometimespossibletofindgoldwhereothersseeonlydross,butdonotrelyonit.
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Withinvestments,aswiththerestoflife,therearenofreerides.Everythinghasaprice.Ifsomethinghasahigherrisk,itislikelytooffsetthatwithahigherreturn.WhatvictimsalwaysforgetwhentheygetcaughtinsomethingliketheBankofCredit&CommerceInternational’sorLloyd’sofLondonproblems,oraseries
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offraudsliketheNigerianscamortheprimebankpaper,isthatthecorollaryofthatrulealsoapplies:ifthereisahigherthanexpectedreturnthereisprobablyalsogreaterdanger.Onlyverysmallchildrenandpeoplewhosegreedovercomestheircommonsenseexpectsomethingfornothinginthisworld.
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Thereisamarketinrisk.Onecanhedgeagainstit–takefinancialmeasurestolimittheextentofrisk.Companieshedgetheircurrencyexchangeexposureonforeigntradingbybuyingcurrenciesforward,andothersuchdevices.Aninvestorcanlimitlossesonasharebybuyingoptions.
Thatinsummaryisthe
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passiveapproach,acceptingthemarket’sviewandmakingthebestofittosuityourpersonalcriteria.Assumingthatonariskcontinuumof1to10youarepreparedtobecautiouslybravebyoptingfor6doesnotmeaneverysharehastobescoredasa6.Itcanmeanarangeofreallysafe2withtheoccasionalrecklessflutteron
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somethinglikean8or9.Eachtimeabuying
opportunitycomesalong,itisworthatleastthinkingabouthowitfitsintotheoverallportfoliopictureandhowfaritwillmovetheoverallaverageriskprofile.Thiswillhavetobedonemorecarefullythelongeryouholdsharesbecause,asthepricesmove,thevariouscompanies
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willchangetheirpercentageoftheportfoliototalandtheireffectonthetotalriskbalancewillalsoalter.
Ifthelongandelaborateprocessofpickingsharesseemstoohard,ortherisk/rewardsystemseemsdauntinganditallrequiresmoreeffortthanyouhavetospare,youarenotalone.Someofthesharpest
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investmentmindsintheUnitedKingdomandtheUnitedStateshaveadmittedthechancesofbeingableconsistentlytopickwinnersareprettyslim.Andinanycase,itmaybeunrewardedeffort.Themarketasawhole,asrepresentedbytheFTSE100Index,doesprettywellthankyouonanyreasonabletimescale.Tracker
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fundsthatfollowthemainstockmarketindexcanbeananswer:theprivateinvestorcantakeastakeinoneofthose,orbealittlemoreadventurousandgoforaninvestmentorunittrustwithabroadbutselectiverangeofinvestments.
Defensive stocksSomecompaniesare
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reckonedagoodbetforvolatileorhazardoustimes.Theyoperateinareasthatarerelativelyimmunetoeconomiccyclesandincludecompaniesdealingintobacco,asthatisarelativelysteadymarket,andsupermarketsbecausepeoplegoonbuyingfood.Utilitycompaniesalsotendtobeindemandinbearmarkets,as
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peoplestillneed,regardlessofarecession,water,electricityandgas.
Emerging marketsThelabelisgenerallyappliedtostockexchangesincountrieswhicharebecomingindustrialized,becomingwealthyandwithagrowingnumberoflocalquotedcompanies.Itisvague
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enoughtoencompasstheBRICcountries(BrazilRussiaIndiaandChina)whichareprettybigandanextgenerationgroupwhichincludesMexico,Indonesia,SouthKoreaandTurkey.SomeincludeeasternEuropesuchasPoland,HungaryandtheCzechRepublic.Thesemarketscanbevolatile,performingspectacularlywell
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orplungingequallyspectacularly.Otherpotentialhazardsincludewaywardsupervision,lackofaccountancyrigour,andlessthanfulltransparency.
Long or short termAsallthenewspapers,magazinesandbookssay,overthelongtermthestock
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markethasproducedabetterreturnthanalmostanyalternative.Ontheotherhand,asLordKeynespointedout,inthelongtermwearealldead.
Overaperiodof30,50or100years,returnsfromsharesoutperformedmostotherinvestments.Theydobetterthanproperty,antiques,depositaccounts,finewines,
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buildingsocietysavings,andsoon.Since1918sharesinBritainhaveonaverageprovidedareturnof12.2percentayear,comparedwith,forexample,6.1percentproducedbythegilt-edgedsecuritiesissuedbygovernments.ThosefiguresaredespitetheUSmarketfalling87percentbetweenSeptember1929andJuly
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1932,theUKindexdropping55percentin1974,thesteepdropfollowingthehurricaneinOctober1987,ortheplungefrom2007,andtheFarEastmarketbatteringinthe1990s.
Cashinadepositaccountwouldhaveproducedevenlessthangovernmentbonds,probablysomethingunder5.5percent.Takingamore
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recentperiod,fromtheendoftheSecondWorldWar,equitieshaveonthewhole(takingintoaccountbothincomefromdividendsandcapitalappreciation)beatentheinflationratebyabout7percentormore.
Soonaverage–whichisalwaystheimportantwordofwarningtobearinmind–sharesprovideagoodlong-
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termhomeforsparecash.Thereturnonsharesisalmostalwayshigherthangilts,andcertainlysooverthelongterm.Thisistocompensateforthegreaterrisk:index-linkedgiltsareguaranteed,whilecompaniesaresubjecttothevagariesofeconomiccircumstances.Theresultingdifference–thegreaterreturnonequities–istherefore
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calledthe‘equity-riskpremium’.Ontheassumptionyouwillnothavetosellthesharestoraisecashatanyparticularmoment,youcanaffordtotakethelongviewoverwhichsharesperformbest.Becauseevennormallysensiblepeopleforgetthedangers,thegovernmenthasinsistedontheapparentlyobviouswealthwarningon
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alltheliteratureandadvertisingthatthepriceofsharescangodownaswellasup.
Anotheraspectofthedecisioniswhetheryouwantincomeorcapitalgrowth.Thesearenotcompletealternativessinceanycompanydoingsowellthatithandsoutgreatdollopsofcashindividendsisalmost
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certaintoseeitssharepriceboundahead.Butnotalways:evenacursoryglancedownthepricespageofanewspaperwillshowhugedisparitiesintheyieldfigures.Butifyouareaimingforcapitalappreciation,theshareswillbesoldtocrystallizetheprofit,whileincomeshareswillberetaineduntiltheystop
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producinganadequateflowofcash.
Experiencedinvestors,expertsandpeoplepreparedtodevotetimeandseriouseffortdeal.Itentailsbouncinginandouttotakeadvantageoftheshort-termoscillationsofthemarket.Youspotatakeovertrend,sayamongfoodcompanies,andgetinastheothercompaniesstart
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rising;oryoudetectagrowingfashionforatechnology–computers,internet,biotech,etc–andpileinastheboomstartstosweepthesharestounrealisticheights.Butthisalsomeansyouhavetowatchthemarketlikeahawkandseethesellsignalsintimetogetoutwithaprofit.Suchtacticsdemandmorespare
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money.Theproportionatelyhighercostsofspreads,broker’sfeesandgovernmenttaxmeanyouhavetodealinlargeramountsandachievebiggersharerisestomakeaprofit(seeChapter8).
Oneotherpoint–everytimeonepersonmanagestomakeabigprofit,somebodyelsemissesit.Theymaynotalwaysmakealossbutjust
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failtogettherealbenefit.Whatmakesyouthinkyouwillbethewinnereverytime,orspottherealsuccessesandavoidtheduffers?Somepeopledohaveatalentbutnotmany.
Atthemoreextremeendistherecentupsurgein‘day-trading’(buyingandsellingwithin24hours),whichcanbeachievedfairlyreadily
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overtheinternet.ThefiguresfromtheUnitedStates,wherethefashionstarted,suggestthatfewerthan5percentofthepeopledoingitmakemoney.
Ethical investingThegrowinginsistenceonresponsibleandmoralbehaviourbycompaniesboth
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towardspeopleandtheEarth,meanscompanieswithsoundethicalpoliciesaremorelikelytoprosper.Sosuchapolicyisgoodnotjustfortheconsciencebutthewallet.
Personalchoicedictateswheretodrawtheline.Companiesshunnedbysomeinvestorshaveincludedtobacco,armaments,makersofbabymilkforAfrica,oil,
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paperandtimber(deforestation),mining,pharmaceuticals(animaltesting),alcohol,andsoon,tosaynothingofspecificcompaniesbeingboycottedbecauseoftheirpoliciesonpollution,ozonedepletion,wastemanagement,personnel,etc.Butitcanproduceconfusionifpursuedtoofar.Beingopposedto
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gamblingwouldpresumablyruleouttheNationalLottery,whichcouldprecludealltheshopsandsupermarketsthatselltickets.Andhowaboutbuyinggiltsfromagovernmentthatencouragesarmsmanufacturers,trainssoldiersandprobablyfundsresearchcentresthatcarryoutanimalexperiments?
Theultimatepointisthat
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theinvestorshouldbeabletosleepatnight,notjustbecausethemoneyissafe,butbecausethereisnoneedtoworryoneissupportingacompanythatoppressesworkersorhelpstokillpeople.Ontheotherhand,itisthenonlylogicalthatonenotonlyavoidsmakingaprofitfromthecompany’ssuccessbutalsostopsbuying
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itsproducts.Ausefulsourceof
informationonthisistheEthicalInvestmentResearchService.Itwassetupin1983byseveralQuakerandMethodistcharitiesandresearchesover1,000companiesplusmostcollectivefunds,andkeepsalistoffundmanagersandstock-brokersconcentrating
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onethicalinvestments.AnotherisCantradeInvestments.
The economy
Decidingonashareorevenamarketsector–suchasretailers,propertydevelopers,engineeringmanufacturersorfinancialcompanies–involvesasecondlevelof
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investigation.Itmeanslookingattheeconomyasawholeandthenthewayitaffectstheconstituentparts.
Forecastingtheeconomycanbeamug’sgame.GovernmentsaresubstantiallyworseatforecastingthantheMetOffice.HaroldMacmillancomplainedwhenhewasprimeministerthatnational
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figuresweresooutofdateitwaslikedrivingacarlookingonlyintherear-viewmirror.Ithasgotlittlebettersince.Mostbigcompaniesdosomeforecasting,themajorfinancialinstitutionssuchasbankshavesubstantialeconomicdepartmentsfocusingonthat,andthereareanynumberofspecialisteconomicoreconometric
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organizations.Theprojectionsseldomagreeandifanyofthemisrightitismorebyluckthanbyjudgement.Fortunatelyhowever,theindividualinvestordoesnotneedtogetintothesortofcomplexdetailthoseinstitutionsattempt,andcommonsensetemperedbypersonalobservationwillusuallyhelp.
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Factorsthatcanaffectinvestmenttacticsinclude:
therateofinflation–boththeRetailPricesIndex(RPI)andtheConsumerPricesIndex(CPI);thegeneralhealthofeconomy–whetheritisrising,fallingorontheturn;
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theexchangevalueofthepound–againsttheeuro,dollar,yenortrade-weighted;industrytrends–eggrowthinretailspending,house-buildingandprices,engineeringconcernssufferingfromexchangeratemovements.
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Onmostoftheseonecangetaprettygoodfeelfromreadingthenewspapersandkeepinganeyeonwhatisgoingonatthelocalhighstreetestateagents,forexample.Onecangetitwrong,butthensocanthepunditsholdingforthfromparliamentorontelevision.Andthestockmarketitselfwillgiveaprettygood
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indicationofwhattherestoftheinvestmentworldthinks:ifitisfallingpeopleexpecttrouble,ifasectorisshunnedthereisareason(anditisworthinvestigatingifonlytoseewhetheryouagree),ifsharepricesarerisingoptimismabounds(andeventhenitisworthcheckingwhetheryouthinksucheuphoriaisjustified).
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Picking shares
Onceyouhavesetthegroundrules,youneedinvestmentstofitthem.Warning:almosteveryonewhohaseverhadanythingtodowiththestockmarkethasatheoryofhowtopickashare.Theyaresimilartoaddictedgamblersandtheirsure-firesystemsforwinningatrouletteorhorse
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racing.Thebookshopsarebulgingwithpetschemesandprivateformulae.Thosewinningmethodscomeinpredictablecategories.Therearethestrategicviews,whichrangefromin-and-outtradingallthetime,totheoppositeextremeofbuyandforget.Thereisthetacticaladvicecategorythatshowstheinfalliblewaytopickthebest
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bet.Itdoesnottakelongtodemonstratethefallacy–iftherewereacertainandpredictableschemeformakingmoneyeverybodywouldhavebeenusingitlongsince.
Thatisnotarecipefordespair.Althoughborrowedtacticswillnotproduceinfallibleopulence,therearesomecommonsensewaysof
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lookingatcompaniesandtheirsharesthatwillincreasethechancesofsuccess.Thisisseriousstuffhowever,andaninvestorwhohopestomakemoneyoutofthestockmarketwillhavetomakeaneffort.Everythinghasaprice,andthecostofmakingmoneyisusuallyhardgraft.ThefamouslysuccessfulWarrenBuffettdidnotgetrichby
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accidentorbyfollowingasecrettrick;hethinks,eats,breathesandsleepsthestockmarket.Hemaynotbetheworld’swittiestandmostwide-rangingconversationalist,butthenyouhavetoaskyourselfjusthowseriouslyyouwanttoberich,orevenslightlybetteroff.
Itcannotbesaidtoooften:
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bewareofalladvice.Donotrejectitoutofhand,butjustremembernobodygetsitrightallthetime(seeChapter7).Andeventhepeoplewhodogetitrightmoreoftenthannot,seldomknowhowtheydoit–theirexplanationsareusuallypost-hocrationalizationastheystruggletoexplainjustwhatinstinctdrovethemtobuy
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thatorselltheotheratjusttherighttime.Ifbysomemischancetheyreallycouldformulatethetrick,theywouldbeveryfoolishtosharethesecretwiththerestofusandsoqueerthepitchforthemselves.
Judgingbytheproliferationofsuchbooksthereisclearlymoremoneytobemadefrompublishing
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accountsofawonderfulnewwayofmakingafortuneonthestockmarketthanfromputtingtheprincipletoworkandbuyingshares.Whyotherwisewouldallthosepeoplebesodiligentlyoccupiedwritingandgettingpeopletocompetewiththeminsearchingfortheroutestofortune,whentheycouldberesearchingthemarketand
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dealing?Thepointforaninvestoris
toabsorballinformationavailable,buttoweighitcarefullyandalwaystotestitagainstcommonsense.Followingsomeoneelse’smethodslavishlywillprobablynotwork,butsomecombinationofthemethodsdescribedinthissectionshouldhelpmostpeople
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evolvetheirownwayofapproachingachallengingbutpersonaltask.Hereareafewexamplestoshowthediversityofmethodsandadviceavailable.
Onesetofinvestmentguidelineshassixrules:
1. Infundsorsectorsgofortheonesnearthebottomoftheleaguetables.The
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topperformersareusuallyoverpricedorarelastyear’sfashion.
2. Goforshareswithhighyields,butiftheysurvivethatlong,sellinayear.
3. Watchwhatdirectorsdowiththeirshares.
4. Buycompanieswhereatleast3percentofthesharesareownedbythe
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workforce.5. Companiesspending
over4percentofturnoveronresearchtendtodowell.
6. Buyafteraprofitwarningifthecompanyisfundamentallysoundbutgoingthroughanunluckypatch.
EvenWarrenBuffettclaims
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tohaveaformula(ifyoucancallitthat,sowonderfullysimpleisit),butitisnotveryobviouslyhelpfultothenoviceinvestor.Whenpressed,hisadvicewastobuygoodbusinessesandhangontothem.Whichisaboutashelpfulastheadviceforsuccessinbusiness:buycheapandselldear.ThebusinessmanRichardKoch
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elaborated:buycompanieswithagoodtradingrecord,specialize,watchprofittrends,sticktocompanieswithgoodbusinessreputations,pickcompaniesthatgeneratelotsofcashandproduceahighreturnoncapital,riskpartoftheportfolioonemergingmarkets,andsellanysharethathasdroppedbyatleast8
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percent.TRowePrice,wholaunchedafundinthe1950s,advisedconcentratingoncompanieswithlong-termearningsgrowthrecordsandthechancesofcontinuingthatway,whichhedefinedasreachinganewpeakatthetopofeachbusinesscycle.Theseareinanindustrywhereunitsalesandprofitsarerising,andhavegood
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patents,productsandmanagement.TheUSinvestorMichaelO’Higginsreckonsyoushouldselectthe10highest-yieldingsharesintheindex,andthenpickthefivewiththelowestshareprice.
MalcolmStacey,theauthorofaninvestmentguide,advisesspreadingthemoneyamongsectors,buying
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slowbutsteadyrisers,andstickingtoleaders(includingonesintheirsector).Healsohasasystemofsettingapricedifferentialatwhichdealingistriggered–ifthefilterweresetat10percenttheneverytimethesharefell10percentoffapeakoneshouldsellandstartbuyingagainwhenitcame10percentoffthebottom.
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Manyofthesepeopleadvocatingsystemshavethemselvesbeensuccessful,butnotehowvariedtheadviceis.Sobewareofformulae,butbeespeciallywaryoffashionableinvestmentgurus.
Inclearoppositiontoallthosewonderfulsystemsistheviewthatanyattempttooutperformtheaverageis
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doomedtofailure–itisjustnotpossible.The‘randomwalk’theorysaysmovementsofpricesareinherentlyunpredictableinbothsizeanddirection,andasaresultanywinsorlossesarepurelyamatterofchance.Inthelongrunyouwillendupeven,oratleastwillhavemovedwiththemarketaswhole.
Anotherhypothesisthat
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alsoassertsthattryingtooutperformthemarketisawasteoftimesaysthemarketisefficientintheeconomists’sense–itincorporatesinthesharepricealltheavailableknowledge.Thatmeanseverybodyhasaccesstoalltheinformationaboutthecompany,economicprospectsandthemarket,andtherearenopeoplewithenough
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financialclouttomovethemarket.Asaresult,thepriceofsharesalreadyreflectstheconcertedandprobablyrelativelyaccurateviewofthetotalityofinvestors,privateandinstitutional.Sinceshareshaveno‘correct’price,runsthishypothesis,andareworthonlywhatsomebodyispreparedtopayforthem,thegeneralconsensusviewisthe
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rightprice.Nicetheory,buteventhe
mostcursoryglancewillshowthestockmarkettobeanythingbutrandomandalongwayfrombeingrational.Thereareanomalies,andnoteveryonehasreactedyettotheinformationthatcanbegleaned.Informationmaybeavailablebutnoteverybodyhastakenitonboard.
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Inaddition,themarketdoesnotactinlinewiththeeconomists’depictionofoptimizingbehaviour.Theswingsseemtodemonstratefrequentoverreaction,amountingattimestohysteriaorblindherdstampedes,anditisclearsomepeopledohaveashrewderappreciationofwhatisgoingonthanothers.
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Ifitwereanefficientmarket,makingitthereforeimpossibleconsistentlytodobetterthantheaverage,howdoyouexplainpeoplewhohaveactuallymadethemselves–andsometimestheirclients–amajorfortune?Therearesomenotablenameswhohavesteadilymademoneyandsomefamousinvestment
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managerswhohaveoveralongtermperformedaboutfivetosixtimesbetterthanthemarketasawhole.
Aplainindicationthattheperfectmarketissomewayoffcanbegleanedfromeventhemostcursorylookattheviewsofstockbrokers’analystsoncompanyshares–thereislittlegeneralagreementaboutthe
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prospectiveperformanceofmanycompanies.Thepricecannothaveincorporatedalltheseviewsbecausetheycontradicteachother.Andastheoldsayinggoes,twoviewsmakeamarket.
Theacademicsarethereforemodifyingtheirviewsandconcedingtheremaybepocketsofinefficiencycontinuingto
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existthatcouldprovidethesharpanalystwithanopportunity.Marketpractitionershavealsopointedoutthatthissortofrigidacademicpicturedependsonthetimescale–intheveryshortterm,movementsinpricesmayseemrandomandirrationalbutthelongeryouextendtheperiodthemorelogicalit
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becomes.
FundamentalanalysisIndecidingwhatsharetobuyandwhen,thefirstthingtorememberisthatthereisnoabsoluteorcorrectprice.Thisisamarket,sothevalueiswhatpeoplearepreparedtopay.Butthatisatanyone
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time.Arealisticviewisthatthestockexchangeisquiteplainlyaverylongwayfromtheeconomists’perfectmarketwithperfectinformation.Butitisareasonablyefficientmarketsotheshrewdanalystcanspotcompaniesorsectorsthatareoutoffavourorhaveagreaterpotentialthanthemarketseemstorecognize,
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cananticipatepricemovementswhenthenewinformationspreads,andsomakeanabove-averageprofit.Thetacitassumptioncontradictstherandomwalktheoryaswellastrustinthecombinedwisdomofalltraders,andassertsitispossibletocalculatethevalueofabusiness,andthatthesharepricewilleventually
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tendtowardsthetruevalue.Thisistheprovinceof
fundamentalanalysis.Thisistheprocessthat:
evaluatesabusinessanditsproducts;examinesitspublishedaccounts,includingreturnoncapital;takesaguessatearnings,earningspotentialand
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dividendprospects;looksattheeconomicambience,suchastherateofinflation,thelevelofsterling,consumerdemandandinterestlevels;watchesthemarketthecompanyissellinginandwhatitscompetitorsareupto;judgesthecompany’s
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management.
Adiligentinvestorcantrytokeepaneyeonadvertisementsforhigh-poweredjobsincasetheyshowacompanyabouttomoveintoorenlarginganimportantnewarea(suchastheinternet),whichcouldbeaninsightnotavailabletomany.Allofthatresearch
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producesawayofdecidingwhetherthebusinessisfairlyvaluedbythemarket.
Butneverforgetthepriceissetbymarketreaction,soitispointlesstosayacompany’ssharesareundervalued.Ifthemarketcontinuestoundervaluethebusiness,theshareswillbecomenohigher.
Theassumptionbehind
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doingthisworkisthatthemarkethasdevelopedonlyatemporaryblindnessormisjudgementandwillinduecoursecometoappreciatetruevalue.Sooneisaimingtopickwinnersnotyetspottedbyothers.Assumingtheanalystisrightandwayaheadoftherestofthemarket,acorrectioncouldstilltakeyears,duringwhich
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timethecompanycouldbesoseriouslyhamperedbyitslowsharepricethatitsbusinessisovertakenbycompetitors.
Therearetwoadditionalfactorstotakeintoaccountbeforeactingonsuchanalysis.Oneisthebasisforthecurrentsharepriceandtheotherismarketfeel.
Sharepricesarebasedmoreonthefuturethanon
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thepast.Thatmeansapricemaybelowerthantheavailablefiguressuggestwouldbejust,becausethemarketexpectsthenextsetofresultstobepoor–andofcourseviceversa.Thatisoftenbasedonacombinationofwhatwasinthelastcorporateannouncementandwhatinfluentialstockbrokers’analystshavebeenprojecting
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forthefiguresandhavebeensayingaboutthestateofthecompany.Thatisthereason,incidentally,whysharessometimesactparadoxically:fallingonthepublicationofgoodtradingfiguresorrisingafteramediocreresult.Themarkethasalreadyfactoredthosenumbersintotheshareprice,andafterpublicationisreassessingthesharesinthe
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lightofthenextsetofresults.Ifyouthinkthemarkethasgotitsexpectationswrongitispossibletotradeinthehopeofasharpreactionwhenthetruefigurescomeout,iftheyareinlinewithyourprojections.Thisrequiresthatyouarenotonlyright,butthattherestofthemarketviewsthenewinformationinthewayyouhaveexpected.
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Forinstance,acompanymaybeproducingprettycomfortablelevelsofprofitandyetitssharesfailtorespondappropriately.Theremaybemanyreasonsforthat.Thecompanymaybetoosmallforthemajorinstitutionalinvestors,whichdominatethemarket.Oritmightbebecausethemarketreckonsthatfurtherdownthe
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roadthereistroublelooming,orbecausethepricehadalreadyreflectedjustthatlevelofprofit,orevenbecausethecompanymaybegoodbutthesectoriscurrentlyoutoffavour.
Thisiswheremarketfeelcomesin–theresultofallthatreadingofthefinancialpress,listeningtotheradio,etc,andjustgoodinstincts.
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Thisisnotaboutbeingmoreaccuratethanothersinthemarket,butbeingabletoanticipatethewaysotherswillseeandusenewinformation.Somepeoplejustfeeltherewillbeanimminentshiftinattitudestoaspecificcompany,anindustrialsector,oratypeofcompany,butthemoreyouknowandtheharderyou
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worktheluckieryouwillbe.Onewaytomakesuch
decisionseasieristosetthemdownatthetimeofpurchase.Youworkouthowmuchtheshareisundervalued–whatwouldbeitsrightmarketcapitalization,price/earningsratio,yield,orwhatever,consideringitssector,performanceandprospects?Whenitpassesthatlevelon
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thewayupyouwatchlikeahawkforsignsthemarketrealizesithasagainoverreacted,thistimeintheupwardsdirection,andthenyoumustsellatleastpartoftheholding.Neverbeafraidofmissingtheboat–itcouldjustbetheTitanic,asitwasfortheSouthSeabubbleinthe18thcentury,therailwaymaniainthe1830s,andthe
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dotcomlunacyin1999,amongothers.
In1998–99anybusinessthathadanewweb-basedideaorwhichproducedsoftwareforinternettrading,orinvestedinsuchenterprisessuddenlybecamethephilosopher’sstone.Sharepricesdoubledeverysixweeks,withonegoingfrom230pto£87inlessthana
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year;companiesunknownafewmonthsearlierweresuddenlyworthhundredsofmillions.Itwasheadystuffandmanypeoplegotcarriedaway.Theboomwasclearlyunsustainableandtriggeredanequallyexaggeratedreaction.Ittookoverayearformoresensibleapproachestoprevail:theinternetisevidentlyabigbusiness
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opportunitybutwillnotproducelimitlessprofitsovernight.Thesensibleinvestorsspottedtheopportunitiesearlyandtheverysensibleonesrealizedwhentheoptimismhadbeenoverdone,andeithersoldoratleasthugelyreducedtheirholdings.
Bearinmindalsothatyouarenotaloneinthisquest.
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Therearedrovesofanalystsbeingpaidludicrousamountsofmoneytohelpinstitutionsbeatthemarket,plusmillionsofprivateinvestorsonthehuntfortheendofthesamerainbow.Asaresult,thepricesinthemainreflectthesumoftheirexpectationsbothaboutthecompanyandthemarketinwhichitoperates.Inotherwords,they
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setthepricenotonwhatitisdoingnowbutwhatitislikelytobedoingoverthenextcoupleofyears–thepricehasdiscountedthefuture.
Nearlyallthesecalculationsaredonefrompublishedaccounts(seeChapter7).TheyarefiledatCompaniesHouse,butmostcompanieswillsendacopyto
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prospectiveinvestorsifaskednicely.Extractinginformationfromthemassofdataisapainstakingbusinessrequiringapplicationandexperience.Thereisnothingdifficultaboutit,butonehastolearnthelanguageofaccounting,haveaninklingaboutsomeofthedodgescompaniesuse,andunderstandthesignificanceof
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thenumbers.Theaccountsrevealnotjustwhattheformulaecalculate,butawealthofotherinformation.Elaboratefinancialengineering,suggestionsofskilfulburnishingofresults,orcarefulreallocationoffiguresareallsignsthatthebusinessisnotallitseemsorthatthemanagementisatouchflaky.Eitherway,these
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arecharacteristicstoavoid.Allthisresearchcanyield
dataofsuchvolumesitburiesinformation.Fortheprivateinvestortheansweristocreateasetofpersonalfilters.ThiscanbebystickingtocompanieswithaP/Eratioofnomorethanfiveorsix,orwithayieldatleast10percentabovetheaverage.Itcanbebylookingatneglected
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sectors;forexample,isitfairthatretailingshouldbeundersuchacloud;ismanufacturingstillgoingthroughthosetroublesthatmadeprofessionalinvestorsshunthem;arebreweriesreallyabetterbetthancateringcompanies?Inasenseitisbeingthecounter-cyclicalinvestor.
Somepeopleeven
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considershareholderperks.Thesearethebenefitsmanycompaniesprovideasaddedinducements:restaurantchainsandhousebuilders,clothingretailersandinsurancecompanies,palm-topcomputermakerstoferryoperators,givediscountstoshareholders.Thoseshouldbeabonusandnotareasonforbuying.
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Onethenselectsfromthatlonglistthecompaniesthatmayappealforotherreasons.Thebestapproachistocombineallofthatwiththeothercriteriaavailable,suchasalookatthecountry’seconomy(sometypesofcompanydobetteronanupturnandsomesurvivedownturnsbetter),theshopper’sview(seebelow)
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andtechnicalanalysis(seeChapter6).
TrackingAllthisdiscussionassumesaninvestoristryingtodobetterthanthemarketasawhole.Itisnottheonlystrategy.Manyindividualsandhordesofinvestmentfundsreckonthetaskistoo
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fraughtandoptforthesafercourseofjusttryingtokeeptheinvestmentsasgoodasthemarketasawhole.Sinceonalongertermthemarkettrendisgenerallyupwards,thisisasafeandlower-riskapproach.
Shell and recoverystocks
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Potentiallyspectacularchangesoffortunecouldcomefromshellandrecoverycompanies.Theyrequireaspecializedformofforecasting.‘Shell’companieshavelittleornoexistingbusinessbutareclingingtoacontinuedstockmarketlisting.Theirpurposeistoactasacheapwayforanothercompanytogeta
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stockmarketquotation.Somesharpmanagerscanmovein,raisemoneytoacquireothercompanies(possiblyprivate),oranotherbusinesscangetontotheexchangebya‘reversetakeover’–thequotedcompanyislegallybuyingtheunquotedbutisinrealitytakenoverbytheunquotedone’smanagersandbusiness.Bydefinitionitis
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almostimpossibletogetmuchinformationaboutsuchoutfitsortheirprospects.
A‘recovery’stockisofacompanythathassufferedapoorperiodandisonthemend,orhasacquiredadoctortohealitsills.Itcouldbringrapidreturns,buthistoryshowstheoddsareagainstyou.AsWarrenBuffettsaid,‘Whena
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companywithareputationforincompetencemeetsanewmanagementwithareputationforcompetence,itisthereputationofthecompanythatislikelytoremainintact.’
Thatisasoberingthoughtfromanacknowledgedwinner,butitisnotalwaystrue.Stumblingcompanieshavebeenrescuedfromthe
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edgeoftheabyssbycompanydoctorsorrevisedpolicies.Inaddition,thoughthestockmarketmayshowitsdislike,theprofitscouldbedownforsomeverygoodreason:thecompanyhasinvestedamassiveamountintoresearchanddevelopmentforaseriesofnewproductsthatwillcreatehugenewmarkets;ithasboughtanewbusiness
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thatwillextenditsownrange;ithasrestructuredthecompanytobemoreefficient(includingexpensiveredundancies);andsoon.Itisalwaysworthlookingbehindfactsforcauses.Theremaybetheseedsofhope,orBuffettcouldberightandtheloserwillsinkintooblivion.
Theconversedoesnotholdtrue,asrecentyears
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havedemonstratedalltooclearly.Winnersdonotholdtheirtopplaceforever.JSainsburyandMarks&Spencerwereforalongtimereveredastheretailerswiththemagictouch,anditseemedtheycoulddonowrong–untiltheyseemedintheeyesofthemarkettodoeverythingwrongandtheirsharestumbled.IBMwasat
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onestageprophesizedtoeliminateallothercomputermakers.
Bythesametokenthesoar-awaysuccessofyesterdayseldomlaststilltomorrow.Beforegettingtoomistyeyedatthesuccessofasharethathasdoubledinpriceinthepastthreemonths,juststopandextrapolate–ifitgoesonlikethatwillthe
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companybeabletobuythewholeofFranceandGermanyinfiveyears’time?Actually,evenwithoutbeingsilly,itisworthconsideringwhetheritisreasonableforthebusinesstobecomparablewithlong-establishedcompaniessuchasUnileverorShell.Thatcreatesasenseofperspectiveandmaypromptonetocreamoff
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profitsanddistributetheproceedstootherlikelysuccesses.
Bearingallthosefactorsinmind,onecanthenbegintosetthecriteriaforaninvestmentpolicythatrelieslessonhunchandhopeandalittlemoreonarealisticappraisalofpersonalneedsandmarketcircumstances.
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The shopper’s viewConsumersknowfrompersonalexperiencethattherearesomegoods,someshops,andsomeservicecompaniesthatreallyseemgoodvalueandhelpful,andtheykeepbuying.Othercustomersmaywellfeelthesameway,inwhichcaseitcouldbeagoodbusiness.Andofcoursethe
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oppositeisequallyawarning–ifyouhavestoppedbuyingsomegoodsorgoingtoachainofshopsbecausethegoodsareshoddyorthevalueispoor,soonerorlaterothersarelikelytospotthataswell.
Forinstance,ifshoppingatSainsburyhasbecomeexpensiveandapainandyouaregoingtoTescoinstead,orviceversa,asimilarview
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maystrikeothershoppers,andeventuallytheprofitsandsharepricewillreflectthat.Similarly,ifyouhavecomeacrossaproductorservicethatseemsoutstandingaswellasprovidinggoodvalue,andthecompanybehinditseemssoundandambitious,itmayinduecoursebecomeadarlingofthestockmarket.
Inawidercontext,onecan
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spotwhenamarkethasabandonedrealityandisstokeduponhopeandgreed.Exampleswerethedotcombubble,andthepropertyboominthe10yearsto2007whenmanysanepeoplecouldseethatGadareneswinewererushingheadlongtheyknewnotwhy,andcouldsensethatthingswouldendindisaster.Theshrewdoneslistenedto
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instinct,watchedsalesandprices,listenedtoearlyreportsofconcernandexitedwithprofits.
LosersThereisoneoutstandingcharacteristicshownbyprofessionalsthatseemscuriouslyabsentintheamateurinvestor:theability
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todroplosers.Small-timeinvestorsappeartohaveasentimentalattachmenttosharestheyhaveboughtnomatterhowbombedoutthecompany,orperhapstheyjusthatetoadmitmakingamistake,whichtakingalosswouldentail.Thesharepricefallsfrom850pto55pandtheysitandwaitforittocreepupagain,thoughany
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dispassionateviewwillshowittobeheadingtosomethingbetween20pandhell.
Someinvestorsevengoinfor‘averagingdown’–buyingmoresharesatthelowerpricetobringdowntheaveragecostofthestake.Thisisontheassumptionthatthesharesareabouttorecover.Buttodothissuccessfullyyoureallydo
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havetobeabsolutelycopper-bottomedcertainyouarerightandthemarketwillsoonshareyourview.
Itwouldprobablybemoresensibletoseeiftherearebetteropportunitieselsewhereinthemarket,andshedtheloser.Onewaythebigboyskeeptheirpolicyincheckandmakesuchdecisionseasierandmoreautomaticisby
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establishinganactionpoint–thestop-losssignalistriggeredbyafallof10to15percent.
PerksInadditiontotheusualbenefitsofowningshares,suchascapitalappreciationanddividendincome,manycompaniestrytokeep
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shareholdersloyalandenthusiasticbyprovidingperks–mostofthemaremerelydiscountsandthereforeentailadditionalspendingbyshareholders,whichhelpsprofits.Forsomethereisaminimumholdingbeforetheperkskickin.Somestockbrokersprovidelists.
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A
Chapter SixTricks of theprofessionals
ccordingtomarketpuriststherearetwobasicways
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ofassessingacompany:fundamentalandtechnicalanalysis.Inpracticetheformerisbestforshowingwhichsharesareworthbuyingandthelatterforwhentobuythem.
Fundamentalanalysisinvolvesevaluatingeverythingaboutacompany.Unfortunatelythereistoomuchtoknow.Ideallyyou
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wouldwanttoknownotonlythequalityoftheproduct/service,thestateofthecompany’scustomersandwhetherafewaccountedforalargeportionofsales,thecompetition,thecompetenceoftheboardandseniormanagement,theconditionoffinancesandthevulnerabilities,theextenttowhichthebusinesswas
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reliantonafewmarkets,theeconomiccycle,exchangeratesandlabourrelations,andsoon.
AfewofthebasicmeasuresandapproacheswerecoveredinChapter5,butmarketprofessionalshaveawiderangeoftoolsfordiggingdeeperintothecircumstancesandbackgroundofcompanies.
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Theyprovidetheprincipalbasisfordecidingwhattheunderlyingvalueofthecompanyshouldbe,andthenseeinghowfarthemarketdivergesfromthat.
Thereisnoonesimpleandobviouswayofdecidingwhatacompanyisworthnow,muchlesshowitsvalueislikelytomoveinthefuture.Allthecalculationsare
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helpfulsometimes,somemostofthetime,butnoneisconsistentlyandreliablyabletopaintadefinitivepictureofthebusiness.Asdifferentindustrieshavevaryingpaymentcustoms,stockturnovertimes,capitalneeds,amountsretainedforresearchandsoon,thebestwayistocheckwhatthenormisfortheindustryandseehowfar
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thecompanydivergesfromit.Thatinturnmaytakeafairamountofresearchfrompeoplelikestockbrokers,tradeassociationsandgovernment.
Anotherproblemistheshiftingopinionaboutwhichratioisthemostreliableindicator.Obviously,whenonefactorbecomesgenerallyappliedasthetruemeasureof
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acompanyitdistortsthepicture.Inotherwords,ifdividendcoveristakenasthetrueindicationofacompany’sworth,businessesarerankedbythatcriterionandasensibleinvestorwoulddobesttolookharderatotherfactorstoseeifthemarkethasgotitsevaluationright.
Manyratiosarequitedifficulttoworkoutandneed
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abitofdiggingtogetatthefigures.Mostofthesefiguresareextractedfromthecompany’sannualreportandaccounts,whichshouldbereadinconjunctionwiththeguidanceinChapter7onwhattolookforinthoseaccounts.
Theratiosmentionedherearethemostcommonandaregenerallyagreedtobe
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helpful.Expertshavearangeofothercalculations,indicatorsandratiostheyfinduseful.Thosecanbehandybutonlylongexperiencewillshowwhatindicatorsarepersonallyuseful,soitwillbethemoreexperiencedinvestorswhoshouldinvestigatetheserioustextbooksonhowtocalculateandusemoresophisticated
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modelsofstockmarketbehaviour.
Fundamentalanalysis
Chapter5discussedthereasonsforresearchingabusiness,itsbackgroundandcircumstances,andhowthiscanbenefitaninvestor.In
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additiontothegeneraloverallfeelandcursorytrawlthroughtheavailablefigures,therearetechniquesandcalculationsusedbymarketprofessionalsthatcanhelppinpointpreciselywhyacompanyisbetterorworsethangeneralsentimentsuggests.Theyarediscussedbelow,inalphabeticalorder.
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Acid testSometimescalledthe‘quickratio’,thiscanbeworkedoutfromthebalancesheet.Itcheckstoseejusthowsolventacompanyisbyhavingalookatitsliquidorreadily-realizableassetsthatcouldbeusedtomeetshort-termliabilities,andthencomparingthatwithits
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currentcreditorposition.Thismeansdividingthe
currentassetsminusstocks(ienetmonetaryassets)bythecurrentliabilities.Iftheresultislessthan1thebusinesscouldnotsettleallimmediatedebtsiftheywerecalledinandsuggestsaprecariousbalance,while2issafer.Itisalsoworthcheckingbackinprevious
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accountstoseeifthereismuchmovement.
Itisaslightlybetterversionofthenetcurrentassetandcurrentratio(seebelow)becauseitassumesthatnotallcurrentassetsareequallyavailabletobeturnedintocashifsuddenlyneeded.Forinstance,stockandworkinprogressneedtimetorealizeortheywillfetchvery
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lowprices,andinanycasefewcompanieswouldplantoliquidatealltheirstockjusttopayanoverduebill.Sotheacidtestisreckonedtobeamorerealisticmeasureofhoweasilyacompanycouldmeetitsobligations.
Altman Z-ScoreThiswasdevelopedin1968
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byNewYorkUniversityfinanceprofessorEdwardAltmantopredictthelikelihoodofacompanybecominginsolventwithinthenexttwoyears.Thescoreisabankruptcypredictioncalculationthatmeasurestheprobabilityofinsolvencythroughinabilitytopaydebtsastheybecomedue.Hestudied66manufacturers
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withassetsthenofover$1million,halfofwhichhadgonebust.Inonetestitpredicted72percentofcorporatebankruptciestwoyearsbeforetheyhappened.Z-scoresforfailingbusinessesshowaconsistentdownwardtrendastheyapproachinsolvency.
Altmanusedfiveratioswithvaryingweightings:
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1. workingcapital(currentassets–currentliabilities)/totalassets×1.2
2. retainedearnings/totalassets×1.4
3. earningsbeforeinterestandtaxes/totalassets×3.3
4. marketcapitalization/totalliabilities×0.6
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5. netsales/totalassets×0.999
Theresultswillbebetween–4and+8.AddedtheyproducetheZ-score.
Itcanalsobethoughtofasanequation:
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Consistentlylowscoreseachyeararemoreofaconcernthanaone-offlowscore.
Asset backing
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SeeNetassetvalue,below.
BetaThisisoneofthefewcalculationsinthischapternotderivedfromacompany’saccounts.Itisameasureofthesharepricevolatilityrelativetotherestofthestockmarket–whichisameasureofrisk,oratleastof
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gettingone’smoneyoutwhenneeded.Betameasureshowfaranindividualsharemovescomparedwiththemarketasawhole.
Themarketistakentohaveabetaof1,soasharewithabetaof1movesexactlyinlinewiththemarketasawhole.Abetaof1.6wouldmove16percentwhenthemarketasawhole
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moves10percent.Ahighpositivebetaindicatesthatasharecanbeexpectedtorisefasterthanaverageingoodtimesbutplungemoresteeplyinbad.Thatischaracteristicofsmallercompanies.
Conversely,asharewithabetaoflessthan1,suchas0.8,risesandfallslessthanthemarketasawhole.Asharewithanegativebeta
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(prettyrare)shouldmoveintheoppositedirectiontotheothershares.
Behindthisapproachthereisasophisticatedmathematicalphilosophyaboutinvestorbehaviour,stemmingfromwhatiscalledthe‘capitalassetpricingmodel’.Thissuggeststhatinvestorscandecideontheriskofanindividualshare,or
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decidetoreducethatriskbydiversifyingaportfolio.Noneofthatwillgetridofthemarketrisk–thesharesmovingasthewholeofthemarketrisesorfalls.Themeasureofthatriskismeasuredbythebeta,andaninvestorwould(orshould)seekahigherreturntocompensateforahigh-betashareorportfolio.
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Thisapproachhasthebenefitofallowinginvestorstochoosetheirdegreeofriskandcheckthatthereturnisappropriatelyhighertocompensate,andconverselytospotmarketinefficienciesinsharesthathaveahigherreturnthanwouldbeindicatedbytheirbetariskrating.
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CoverSeeDividendcover.
Current ratioAwayofassessingacompany’sabilitytopaybillsintheshorttermistolookatthecashithasandthethingsthatcanreadilybeturnedintocash.Itisarrivedatbythedivisionofcurrentassetsby
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currentliabilities.Iftheresultis1thetwoareidenticalandthecompanyhasnosparemoney.Areassuringfigureismorelike1.5or2atleast.
Ontheotherhand,ahighfiguresuggeststhecompanymayhaveanunusuallylargeamountofstocks,oritiskeepingitsassetsincash,whichmeansitearnsalargerreturnonlendingthanonthe
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businessitselforthatitcannotfindasuitablewayofgrowingitsrealactivity.Allarepotentiallyworryingandmightsuggestthecompanycouldmakeanattractivetakeovertargetforsomeoneinsearchofcheapcash.Itisworthcheckingifthefigureisrepresentativeoftheindustry,however.
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Debt collectionAllowingcustomerscreditisexpensivebecauseittiesupacompany’sowncapitaluntilthebillhasbeenpaid.Soitisamarkofgoodmanagementthatdebtsarecollectedpromptly.Onemethodistochecktheaveragecollectiontimeindays.Itiscalculatedbydividingthetradedebtors
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bytotalsalesandmultiplyingtheresultby365.
Debtorturnovermeasuresthenumberoftimesdebtorsareturnedoverintheyear,whichisprettygoodmeasureofhowefficientthecompanyisinshakingthemoneyoutofcustomers.Thecalculationisverysimple:justdividethefigureforsalesbytheend-yearfigureforamountof
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debt.
Debt/equity ratioSeeGearing.
Dividend coverThisshowswhatproportionofthecompany’searningsarebeingpaidtoshareholdersor,toputitanotherway,ameasureofthenumberof
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timesacompany’snetoftaxdividendiscoveredbyitsnetprofit.Iftheratiois3ormorethecompanyisbeingextremelyconservative;with2ormore(itcouldhavepaidatleastdoublethedividendifithadwantedto)itisreckonedprettysafe;butanythingbelow1.5islookingdodgy.At1alltheearningsaredistributedto
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shareholders,andiftheratiodropsbelow1thecompanyispayingoutretainedsurplusesfrompreviousyears.
So,ifWindowledgeplcpaidadividendof4pashareanditsearningspersharewere12p,itsdividendwouldbecoveredbyaverycautiousthreetimes.Lowlevelofcovercombinedwithhighyieldshowsthemarketis
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nervousaboutthecompany’sabilitytogoonpayingatthisrate.Differentindustrieshavedifferentneedsforcash,socomparisonsshouldbewithinthesector.
Dividend yieldThisistheamountofdividendpershare(usuallyquotednetoftax)asa
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percentageoftheshareprice.Itgivesthereturnontheinvestmentatthecurrentsharepriceandcurrentrateofpaymentsbythecompany.Aswithprice/earningsratios,thecalculationcanbedoneon‘historic’figures,whichwouldbebasedonthemostrecentdividendfigure;orprospective,whichwouldusetheforecastsofwhatthenext
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dividendislikelytobe.SoifWindowledgepaidadividendof4p,anditssharepriceis390p,theyieldisameagre1percent.
Thatisprettylowinabsoluteterms,butoneneedsalsotocompareitwiththeyieldsonothersharesinthesectortogetthefullflavour.Aswithprice/earningsratios(seebelow),comparisonwith
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competitorsgivesagoodindicationofthewayacompanyisregardedbythemarket.Yieldisdeterminedbyshareprice,soifacompanyisatthebottomendofthegenerallyavailableyieldsaround,itseemsinvestorsexpectquitealotofimprovementintheyearsaheadtobumpupthatfigure.
Conversely,ifayield
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seemstemptinglyhighthesharepriceislow,perhapsbecausethereisafeelingthatthecompanyisheadingintotroubleandmaywellcutitsdividend,attheveryleast.Onceagain,itwilltakefurtherdetectiveworktoseehowreasonablethoseexpectationsare.
Employee
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efficiencyThisiswagesdividedbysalestimes100,togetaproportionofsalespaidoutinemployeecosts.Thisfigureneedsverymuchtoberelatedtothesectorsinceitisobviouslynonsensetocomparecapital-intensivewithlabour-intensivebusinesses.
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GearingAlargeamountofshort-termborrowingleavesacompanyvulnerable,especiallyduringleanperiods.Ifinterestratesrisethebusinesscanfaceasuddenanddisastrousdrainonitsresources.Interesthastobepaidonborrowedmoneywhetherthecompanycanspareitornot,andifit
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cannot,creditorsfailingtogettheircashcouldcausethecompanytobebrokenup.Bankscancallinoverdraftsatwillandattimesofeconomicdownturngettwitchyenoughtodosoevenatthecostofkillingthebusiness.Loansmustatsomestageberepaid;sharesdonothavetheseproblems.Iftimesaretoughthecompanycan
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‘pass’(notpay)adividendpaymentwithimpunity.Itssharepricemaysufferbutatleastthebusinessdoesnotfold.
Someborrowingisprettywellinevitableandborrowingcanbeamoretax-efficientwayofraisingcapitalthanissuingshares.Thequestionisnothowmuchithasborrowedbuthowgreatthose
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loansareinrelationtothevalueofthebusiness.
Theratiobetweenacompany’sborrowedmoneyandthemoneythathasbeenputinbyshareholders(whichisalsocalled‘equity’)iscalled‘gearing’(‘leverage’intheUnitedStates).Soahighlevelofgearing–lotsofborrowinginrelationtotheequity–exposesacompany
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inadownturnandisthereforeahigh-riskstrategy.Correspondingly,shareholdersofhighlygearedcompaniesdoratherwellduringupturns.
Therearevariouswaysofworkingoutthefigures.Thesimplestisjusttotakethetotalborrowingsandcomparethatfigurewiththetotalamountofshareholders’
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funds.Thatisalsothecrudestwayofevaluatingthebusiness.Youcanrefinethecalculationofjusthowgreattheriskis(gearingisawayofmeasuringrisk)byleavingoutthelesssignificantcomponents.Forinstance,youcanexcludeshort-termdebtssincethesearejusttheday-to-daybusinessproceduresasopposedtothe
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underlyingindebtedness.Somepeopleprefertoleaveoutintangibleassets(suchastrademarks)asbeingdifficulttodisposeof,andsometimespreferencesharesareexcludedfromthetotalofshareholders’funds.
Net asset valueOnewayofjudginga
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companyisbythefail-safesystemofseeingwhatitwouldbeworthiftheworstcametotheworstanditwentbust.Theonlyrealwayistocheckwhatthevalueisofalltheassetsitowns.Inpracticeifthecompanydidgounderandhadtoselleverythingithad,theassetswouldprobablynotrealizethebookvaluebecausefiresales
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seldomgetbestprices.Thenetassetvaluefigure,
oftenabbreviatedtoNAV,canbecalculatedfromthebalancesheetbyaddingupthebookvalueofallacompany’sassets(includingbuildings,machinery,cashatthebank,investments,etc).Deductfromthatalltheliabilities(suchasunpaidbills,borrowings,etc)aswell
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asallcapitalchargessuchasdebentures,loanstocksandpreferenceshares.Theremainderistheshareholders’equityinthecompany,orthenetworthofthebusiness.Dividethisfigurebythenumberofordinarysharesonissuetogetthenetassetvaluepershare.
Theresultingnetassetvaluepershareprovidesa
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directmeasureofinvestmenttrustsbecauseitcanbecomparedpreciselywiththesharepricetoseewhetherthetruststandsatadiscountorpremium.Inanindustrialbusiness,allowingforthefactthatthebookvalueofassetsisnotalwayswhattheywouldfetchintheopenmarket,theresultisanindicationofjusthowmuch
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solidworthliesbehindeachshare.Itisnotsomuchwhatyouhaveaswhatyoudowithit,sothefigureisgenerallyonlyanotherfactortorememberratherthanaguideforinvestment.Acompanywithnetassets20percenthigherthanthesharepricewouldmakeatemptingtakeovertarget.Ifanofferdoescome,shareholderscan
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thenusethismeasureasonetestofhowfairtheofferpriceis.
Net current assetsThecalculationssofarhavebeenbasedontotalnetassets.Somepeopleuseanarrowermeasure–netcurrentassets–whichconcentratesoncash,thingsthatcanreadilybe
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turnedintocash,andmoneyowedthatislikelytobepaidinunderayear.Netcurrentassetspersharethatarewellabovethesharepriceintensifytheattractivenessofthebusinesstoatakeoverpredator.Thereisprofitwithaminimumconcernordoubtbecausetheportionsofthebusinesscanbesoldoffinbitswithoutworrying
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whetherlong-termassetsareworththeirbookvalue.Sothesharesareworthbuyingbecauseeithersomebodyisgoingtomaketheassetsworkharder–newmanagementoranoutsidebuyer–orthecompanywillgobust,inwhichcasetherewillbemorethanenoughtopayoffcreditorsandstillhavemoneyleftovertopayshareholders.
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Subtractingacompany’scurrentliabilities(itsdebtsandunpaidbills)fromthecurrentassets,bothofwhichfiguresareavailablefromtheaccounts,givesanideaofsolvencyintheshortrun.Ifthereisabigsurplusthecompanyhaslotsofsparecashornear-cashtopaydebtsinthecomingyearandcouldthereforegetquitealotof
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additionalcreditifneeded.Afigureclosetonothingor,worsestill,adeficit,iscauseforalarm.SeealsoCurrentratio,above.
Price/earningsratioProfitisagoodplacetostartwhenvaluingacompany.Theprofessionalsusuallystart
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withcomparingprofitstotheshareprice.Thisistheprice/earningsratio,oftenabbreviatedtoP/E,whichissowidelyaccepteditisevenprintedinnewspapersharepricecolumns.Itmeasureshowmanyyearsitwouldtakethecompanyatitscurrentlevelofearningstoequalthemarketvalue(totalpriceofallshares).Ineffect,thisisa
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measureofhowquicklythemarketthinksthecompanywillgrowoverthenextyearortwo.
Togetthefigure,dividethesharepricebythecompany’searningspershare.Forexample,ifWindowledgeHoldingsInternationalhasissued70millionsharesandmadeaprofitof£8.4million,its
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earningspersharewouldbe8,400,000/70,000,000,whichis12p(inpractice,calculationsmaybealittlemorecomplexsinceearningscanbedefinedindifferentways).Ifthesharepriceis390pthentheprice/earningsratiois390/12,whichmakesit32.5.Ineffectthatmeansitwouldtake32.5yearsofearningsatthecurrentlevel
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topayforthecurrentshareprice.ThatisthehistoricP/E,asitiscalculatedfromthelastprofitfigure;usingaforecastofprofitforthecurrentyearproducestheso-called‘forwardmultiple’.
That32.5yearsissuchalongaperiodthatthereisobviouslysomethingelsegoingon.Whatiscreatingsuchanapparentlyunrealistic
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figureistheexpectationbyinvestorsthatthecompanywillnotcontinuemakingthecurrentlevelofearningsbutislikelytogrowfairlyrapidly.Asaresult,thetimetakentocoverthecurrentsharepricewillprobably,inpractice,bealotlessthanthose32.5years.
ArelativelyhighP/Ethereforeindicatesthe
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presumptionoffastgrowth.Thepointtonoteistheword‘relatively’.Atonelevelitisacomparisonwiththemarketasawhole,andatanotherlevelitiswithothercompaniesinitssector.TogetthefullflavourofwhattheP/EindicatesonehastotakealookattheFTSEAllShareIndexP/E,aswellasthesameratioforthesector
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inwhichthecompanyoperates(suchasutilities,distributionorleisure).Thatindicateshowthecompanycompares,sincetheratioismostusefulasarelativeriskindicator.
TheP/Ethereforeindicateswhatthestockmarketaswholethinksoftheprospectsforthecompany.Theobviousnextstepisto
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discoverthecausesofthatsentiment.IftheP/Eishighrelativetoitssector,isthatbecausethecompanyisfashionable(journalistsallkeepsayinghowwonderfulthemanagersare),orisitbecauseitreallyisabouttogrowattwicetherateoftheothercomparablecompanies?Thefiguremaybepromptedbysomethingsimplelikethe
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rumourofanimpendingbidforthecompany.
AlowP/Eindicatespessimismorlackofinterestbyotherinvestors.Whetherthatgloomyviewisjustifiedandwhethersubsequenteventswillreverseitrequiresquitealotoffurtherthought.TheP/Ebeinghigherorlowerthanthesectoraveragemerelytellsyouwhatothers
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think,notwhethertheyarerightintheirforecasts.Sometimesitmaybenecessarytodisaggregateadisparategroupandvalueoperationsseparatelytoseeifthemarkethasratedthemfairly.Lifeassurersandpropertycompaniesareparticularlytrickytoevaluate.
AnotherpointtowatchiswhethertheP/Eishistoric
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(usesthelastsetofpublishedresults),whichiswhatthenewspaperpricesreproduce,orprospective(usesthegenerallyexpectedlevelforthecurrentfinancialyear),whichiswhatsomebrokers’andtipsters’circularsuse.
Profit marginTofindtheunderlying
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profitabilityofacompany’strading,taketradingoroperatingprofitasapercentageofturnover.Thisiscalledthe‘profitmargin’.Thefigureswillvaryenormouslybetweentradesandsectors.
Quick ratioSeeAcidtest.
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Return on capitalemployedThepointofacompanyistomakeasurplus,itsprofit.Thereasonitborrowsorsellssharesistoincreasethatprofit.Soanimportantgaugeofitssuccessistoseejusthowwellitdoesit.Thepointofreturnoncapitalemployedisthatitmeasuresthe
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efficiencywithwhichthecompanyisusingitslong-termcash.
Togetthismeasure,onedividesthetradingprofit(beforeexceptionalitems,interestandtax)bytheaveragecapitalemployedovertheperiod(shareholders’fundsplusborrowings)andmultipliestheresultby100.Areturnof10percentisthe
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bareminimumrequired;20percentisprettygood.Alowreturnoncapitalshowsinefficiencyinthewayitisusingthecash,eveniftheprofitmarginsarehigh.Thefirstcheckistoseewhetherthepercentageishigherthanthecostofborrowing.Itisinstructivetocomparethereturnoncashinthebusinesswithotherthingsthe
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company(orindeeditsinvestors)mighthavedonewithit.
Acommoncriterionistoseewhatitwouldhaveyieldedifputintosomethingreallysafe,likegilts.Ifthereturnfromthatsortofinvestmentisatleastasgreatasthecompany’s,thereissomethingwrong–thereshouldbea‘riskpremium’
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forputtingthemoneyintosomethingmorehazardoussuchasabusinessventure.Iftheyieldfromgiltsisatleast5percentlowerthanthereturnfromthecompany’suseofthemoney,theinvestmentisbeginningtoseemreasonable.Investorsprefersomethingbetterthan7or8percentabovethegiltyield.
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Return on salesThisisarevealingfigurebecauseitgivesanindicationofprofitmargins.Startwiththepre-taxprofitbeforeinterestandextraordinaryitems,thendividethatfigurebytotalsales,andmultiplytheresultby100.
Return per
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employeeThisisanothermeasureofhowefficientlyabusinessusesitsworkers.Itiscalculatedbydividingtheoperatingprofitbynumberofemployees.
Return toshareholders
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Thisisanothermeasurethatisnotderivedfromthepublishedaccounts.Itindicatesthetotalperformanceofanequityoveraperiodsuchasayear.Thefigurecomesfromaddingthechangeinshareprice(iethepriceattheendoftheperiodminusthepriceatthestart),plusthedividends,plustheinterest
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receivableonthedividends,andthentakenasapercentageofthepriceatthestartoftheperiodbeingexamined.
Forexample,asharestartedtheyearat520pandfinishedtheyearat670p.Duringtheyearthecompanypaida40pdividendastheinterimdividendand50pasthefinal.Theinterestratewas
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about6percent.Thatwouldmeanthesharepricebenefitwas£1.50andthetotaldividendwas90p.Interestearnedbyputtingtheinterimdividendmoneytoworkis1.2pandtheassumptionistherehasnotbeentimetoearninterestonthefinal.Sothegainequals£1.50+90p+1.2p=241.2p,whichdividedbythe520popeningpriceis
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0.46,sothereturnisslightlyover46percent.Notbad,butitisonlyanotionalprofitsinceitwouldentailsellingthesharestorealizeit,andtherewouldbeafeepaidfordoingthat,whichwouldreducethebenefit.
Stock turnoverDividethecostofsalesbythe
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stocklevelattheendoftheyear.
Value addedThisnotionwasdevelopedinthe1990stomeasurehowabusinesshasincreasedthevalueoftheshareholders’investment.
Yield
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SeeDividendyield.
Technical analysis
Thenormalcontrasttofundamentalanalysisis‘chartism’,whichisalsocalled‘technicalanalysis’.Thisisconcernedexclusivelywiththemovementsofsharepricesintherecentpasttoforecasthowtheywillmove
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infuture.Thereallydedicatedchartistdoesnoteveninquirewhetherthepricechartisforhouses,airlinetickets,goldbars,indicesliketheFTSE100,orthesharesofbanks,sinceallrelevantinformationisassumedtobeinthepatternofmovements.
Thisisincompletecontrastwithfundamentalanalysisinthatittotally
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ignorestheunderlyingworthofthebusiness.Technicalanalysisisconcernednotwithwhetherthecompanyisefficientlymanagedbutwithwhenthemarketpriceislikelytochange.Itcan,however,indicatewhichsharepricesaredueforaturn–ineitherdirection–andsoprovideastimulusforactivetraders.Thatmeansitdoes
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notsomuchindicatewhichsharetobuyaswhentodoso–andthisisexaminedindetailinChapter10.
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ChapterSevenWhere tofind adviceandinformation
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Anyone who thinksthere is safety innumbers hasn’t readthe stock marketpage.
IRENE PETER
After a long life Ihave come to theconclusion that
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when all theestablishment isunited it is alwayswrong.
HAROLD MACMILLAN, 1982
Advice
Whose advice canyou trust?
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Atthesimplestlevel,nobody’s.Takeeventhebroadestoutlineadvice.NathanRothschildsaid‘ThewaytomakemoneyontheExchangeistoselltoosoon.’Anothermemberofthesamebankingfamily,SolomonRothschildagreed:‘Onemustgetintothemarketasintoacoldbath–quickinandquickout.’TimothyBancroft
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ontheotherhandsaid‘Buygoodsecurities.Putthemaway.Forgetthem’,whichismuchthesameadviceastheSageofOmaha,WarrenBuffett.
AsChapter5pointedout,everybodywhocanfindapublisherproducesatheory,asystem,aformulaoranexplanation,andagoodmanybookshopshaveyardsof
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shelvingfilledwiththeirinfallibleadvice.Makingamajorfortuneisevidentlyadoddle.
Howaboutonindividualsharesthough?Thinkofitthisway–whatsortofphilanthropycoulditbethatpersuadessomenicepeopletomakeyourichinsteadofthemselves?Ifjournalistsreallyknewwhichshareto
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buyandwhen,wouldtheystillbehackingawayatthecomputerinsteadoflollingonsomeCaribbeanbeach?HowcantheauthorsofbookslikeMakeaKillingontheStockExchange,HowtoPicktheWinners,SelectingtheSoaringSharesandsoonaffordtospendallthosehourswritingwhentheyshouldbetoobusybecoming
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billionairesbytrading?Indeediftheyweregood,whywouldtheysharethesecretwhenyourbuyingmightinflatethesharestheywouldhavewantedtobuy?
Alladviceshouldbetreatedwithscepticism–eventhisone.ThereusedtobeanoldStockExchangemaxim:‘Wherethereisatipthereisatap.’Whatthat
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meantwasthatifsomebodyispersuadingyoutobuyasharethereisprobablysomeself-interestedmotivesuchashavinglargeamountsofthatcompany’ssharesontap.
Thisisnotadefeatistvieworinsistencethatalladviceshouldberejected,justarecognitionthatnobodyisalwaysright,thatsomepeopleareunreliable,andthat
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thedecisionlieswiththeinvestor.Noexcuses,nodefences,andnoattemptsatshufflingofftheblame:youchoose.
Scepticismshouldextendtofinancialadvisers.Stockbrokershaveanincentivetoencouragetradingbecausetheymakemoneyfromcommissionsondeals.Mostoftheiranalysts
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areclevergraduatesbutfewhaveevergottheirfingernailsdirtyinindustry,soalthoughtheyunderstandallthecorporateratios,meetthechairmenandfinancedirectors,andsometimesevenvisitfactories,theyhavelittlefeelforcommerce.Whattheydounderstandisthestockmarket,sotheyhaveabetterfeelthanthelay
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investorforhowtheCity,includinginstitutionalinvestors,willreacttoacompanyanditsperformance.Sincethosearethepeoplewhoinfluenceshareprices,thisinformationisvaluable.Itsvalueisaboutthemarket,butnotaboutanyindividualcompanyoraboutstrategy.
Stockbrokersplodthrough
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annualreportsandissuecircularsoncompanies,buttheaveragesmallinvestordoesnothaveaccesstothesecirculars,andwouldprobablyhavelittleuseforthemifheorshedid.Bythetimethecircularsareprintedtheprofessionalshavealreadyactedonanyinsightinthem,andthereislittleevidencethatstockbrokersare
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markedlybetterprophetsthantherestofus.Itisnotamatterofasking,ifyouaresocleverwhyareyounotrich(becausemanyofthemareprettycomfortablyoff),butonceagain,wouldtheystillbeworkingforwagesiftheycouldmakeamazingfortunesbymerelyinvesting?
Atleastthebetternewspapersandmagazines,
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unlikestockbrokers’analysts,assesstheperformanceoftheirsharetipsattheendoftheyear.Iftheydonot,youcanbeprettysureperformancehasbeendismal.Eventhatisnotaguidethough,becausepersonnelchange.
Thereareseveralreferencebooks,likeREFS,UKMajorCompaniesHandbookand
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UKSmallerCompaniesHandbookthatprovidestatisticsandfactsaboutbusinessandcompanies.TheseareontopoftheguidestotheStockExchangeandotherinvestments,plusotherexplanationsofthefinancialmarkets.
Insummary,thereislotsofadviceaboutbutlittleofitisdisinterestedandeventhat
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isnotalwaysright.Solistentoasmanyasyoucan,weighthemagainstcommonsenseandusethemasafactorbutnotasthefinalarbitersofaninvestmentdecision.Rememberthattheircriteriamaybedifferent.AsShawsaid,donotdountoothersasyouwouldhavethemdountoyou;theirtastesmaynotbethesame.
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NewspapersNewspapers,dailyandSunday,devotemanypagestobusinessinvestmentandfinance.Theyprovidenews,commentandadvice.Ontopofthattherearemanybusinessandinvestmentmagazines,rangingfromthevenerableInvestorsChronicletoawideandgrowingrange
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thatincludesYourMoney,MoneyManagement,WhatInvestment,Moneywise,PersonalFinance,BloombergMoney,Shares,MoneyWeekandMoneyObserver.TherearealsospecialistjournalssuchasYourPensionandWhichMortgageandgeneralbusinessjournalslikeFortune,ForbesandBusinessWeek.
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Seriousnewspaperscarrycompanynewsincludingreportsofresultsfromsmallerorlessinterestingcompanies,whichconcentrateonturnover,profitandexceptionalitemsplusdirectors’pay.Theyalsohavecolumnsthatconcentrateonanalysingcorporatefinancialresults–egQuestor,LexandTempus.Thesecolumnsdo
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notalwaysmakeexplicitrecommendationstobuyorsell,butthegeneralmessageoftheircommentsisusuallyobvious.
They,likemanyoftheSundaypapers,alsoreprintadvicefromstockbrokers.Inaddition,journalistsmeetpeople,sometimesincludingthemanagementofcompaniestheywriteabout,
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lookatresults,talktobrokersandtheiranalystsandtradeassociations,anddiscussbusinesswithindependentcommentators.Inthecourseofthistheymaycomeacrosscompaniesthatjustifyabetterratingandarecurrentlybeingignoredbythemarket.Theymaythereforealertinvestorstosharesthatareundervalued,andbydrawing
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attentiontothemmaypromptanupwardre-rating.
Tipslikethiscanmoveashare,especiallyifitisinatightmarket–therearenotmanyfreesharesonissue.Theriseisnotpurelybecauseofbuying,butalsobecausemarketprofessionalsreadnewspaperstooandsoanticipatedemandbymovinguptheprices.One
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consequenceisthatbythetimeyouhavereadthebuyrecommendation,thepriceatwhichitwassaidtohavebeenabargaincanbejustamemory.
Itmaystillbeworthactingonsuchrecommendationstobuy,butitisnotablethatnewspapersarelessgoodatspottingsharesthatareduetofall.Itmaybefearofthe
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fiercedefamationlaws,orthatjournalistsarejustmoregearedtofindingwinners,butinvestorsshouldnotrelyonnewspapersforwarningsofwhentosellashare,althoughitcanbejustasimportantapieceofadvice.Andnobodyismuchgoodatspottinginadvancewhenthemarketasawholeisabouttoturn.
Thefinancialpagesalso
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carrystoriesabouttakeoversandotherdramaticevents,andhaveinterviewswiththetopmanagers.Inaddition,theycarrydetailsofplans,newproducts,investments,changesoftactics,recruitmentofnewseniorstaff,changesatboardlevel,salesofsubsidiariesandahostofotherindicationsofhowacompanyis
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approachingitsbusiness.Inthecourseofthesearticlesjournalistsusuallygivestronghintsabouthowthemanagementandproductsofacompanyareregarded.Thatgivesanaddedlayerofinformationtotheinvestor.
Peoplehaveatendencytosaytheybelievenothingtheyreadinnewspapers,butthenactasifjournalistswere
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omniscientsupermen.Journalistsknowonlywhatsomebodyhastoldthem,andthoughthegoodonesdoconscientiouslydigbehindthefactsandtrytointerpretandtestwhattheyhear,theyarefallibleliketherestofus.Theydo,however,mixintheCityworld,talktoallthepeoplewhoaredirectlyandindirectlyinvolvedandkeep
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aneyeonwhatisgoingon.Anybodygettingintoinvestmentswouldbefoolishtoloseoutonthefloodofinformationthatisavailable.Thereisdailydetailonawidevarietyofcompaniesandsectors,discussingthemanagers,products,performance,dealsandprospects.Someofitmaybenothingbutgossiporaspace-
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filler,butinthereputablepressthereisoftenmoreandbetter-informedearlynewsaboutwhatishappeningthancomesoutofstockbrokers.Themoreauthoritativewritersdogetreadandasaresultmaymovepublicopinionaboutacompanyandhencetheshareprice.
Withsomanynewspaperpagesdevotedeverydayto
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financeandcompanies,andthelargenumberofmagazinesconcentratingoninvestmentadvice,itishardtoseewhatthetipsheetscanadd.
MagazinesSpecialistmagazinesprovidegreaterdepthofinformationonawiderangeof
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investments.TheInvestorsChronicle(publishedbyPearson,whichalsoownstheFinancialTimes)reportsawiderangeofstockmarketandeconomicinformationandhasaspeedysummingupofmajorcompanyresults.
Itschartistsectionrequiresextensiveknowledgeofthelanguageandmethodsoftechnicalanalysis;withoutit
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onecouldwellbelittlebetteroffforbeingtold‘thecurrentrallycouldconceivablytaketheindexthroughitsdailycloudandashighastheblackfallingtrend-linewhichwouldlikelyresultinoverboughtmomentum’,orreferencesto‘atime-cycleturning-date’.Butthepicturesmakeitclearer.
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Financial advisersAdvicefromnewspapers,magazines,radio,television,newslettersandmailshotsmaybereadilyavailable,andsomeofitfree,butinvestorsstillhavetocollectandsortitall,siftthematerialandtestittoseeifanyofitisworthactingon.Thisisnotonlyalongandtedioustaskbutthe
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testingistrickyforsomeoneinexperiencedinthestockmarket.Intheory,havingaprofessionaladvisercanimproveonthat.Thestockbrokeroradvisercantakeonboardtheinvestor’spreferencesandneedsandsoproducetailor-madeinvestmentrecommendations.Suchhand-holdingcanbevaluable,andthegood
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adviserscanproduceafarbetterportfoliothananindividualwhohasalivingtoearnandsocannotspendalldayevaluatingtheoptions.
Likeeverythingelseworthhaving,itcostsmoney,soitspricehastobecheckedagainstitsvalue.Inaddition,nosensibleinvestorhandsoverthefuturewithoutaskingquestionsandtestingthe
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answersagainstcommonsense.Justasanintelligentpatientasksthedoctorwhatiswrongandwhateffectsthemedicinewillhave,andacarefulclientasksthelawyershowthelawstandsandwhattheadviceisbasedon,soashrewdinvestorshouldaskfinancialadviserswhytheyadviseaparticularcourseandwhatassumptionsliebehind
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therecommendation.Itisatthatpointthatcommonsenseandpersonalexperiencere-enter.Ifyoudisagreewiththeadviser’sforecastsofthenextsixmonthsorfiveyears(andyourguessmaybeasgoodasanybody’s)itisimportanttosayso,sothattheportfoliocanbeadjustedtothesatisfactionofbothofyou.
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Figure 7.1 (left) andFigure 7.2 (right)Information in the InvestorsChronicle
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Suchadvisers/brokerschargeeithercommissionoraflatfee,oracommissionontrade(seeChapter8oncostsandvalue).
Information
Share pricesNewspapers’sharepricelists
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showcompaniesundermarketsectors.TheseareallocatedbytheStockExchangeandthecompanywillalsobeaconstituentofthatpartorheadingoftheFT-Actuariessectorindex.Itis,however,abitconfusingthatnotallthenewspaperslabelthesectorsinthesameway.Thechoiceofsectorisnotalwaysobviousandsome
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companiesfeeltheyareinthewronggroup–especiallywhenthatbecomesunfashionable–sooccasionallythereisachangeofallocationbytheStockExchangeauthorities,thoughthathappensmostlywhenthecompanyitselfhasalteredtheemphasisofitswork.
Thereareover2,500companiesquotedonthe
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LondonStockExchange,somewithseveraltypesofissues,plustheAlternativeInvestmentMarket(Aim),Techmark,ISDX,etc.Themajorityofcompaniesaretradedinfrequently,withthegreatestvolumeofinterestandtradebeinginthehundredlargestcompaniesbymarketvalue.ThosearethecomponentsoftheFTSE100
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ShareIndex(calledthe‘Footsie’),whichisthemainindicatorofstockmarkettrends.Themajorcompaniesinitmakethemimportantintheinvestmentstrategyofthelargefinancialinstitutions.Theconcentrationofinstitutionalinterestisshownmostclearlyatthetimeofthequarterlyreviewwhenthemarketvaluesofcompanies
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onaspecificdatearereviewedandthereisachangeinthecompositionoftheIndex.ThemomentacompanydropsoutoftheIndexitssharesmaytakeasuddenfall,sometimesbyasmuchas5percent,whilethenewmemberoftheelitesometimesseesasuddenadditionaljump.Sometrackerfundsandinvestors
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seethewaythingsaregoinganddealinthesharesbeforethecompanygainsorlosesitsstatusinaparticularindex,whichcanmeanthesharesdonotmovemuch.AnotherindexreviewworthwatchingistheMorganStanleyCapitalInternational(MSCI).Whilethefocusisglobal,UKcompaniesdoregularlymoveinoroutoftheIndex,which
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canleadtomovesinshareprices.
Belowthattoplevelisthesecondtier,madeupofthenext250companiesmeasuredonceagainbymarketcapitalization–thatis,inboththesecategoriesitisnotturnover,profit,assetvalueoranyothermeasurethatcounts,merelytheaggregatevalueofissuedshares.Allthe
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350largestcompaniesareinthelistsoftheseriousnewspapers’pricespages,whichalsocontainseveralhundredothercompanies.Butnoneofthepapershasthespacetoshowallthesecuritiesavailable.EventheFinancialTimes,whichdevotesmorepagesthantheotherstoshareprices,canshowonlypartofthelist
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actuallyquoted.Newspaperlistsarenotnecessarilyasignalofsignificance–mostofthecompaniespaytohavetheirshareslistedinthepricespages.
Newspapersdisplayarangeofinformationapartfromthelatestshareprice,includinghowthesharepricemovedfromtheclosingofthepreviousday,andsoon.
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Figure 7.3 Daily Telegraphprices page entry
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Figure7.3isanexampleofTheDailyTelegraphpricespage.Itshowsinthethirdcolumnthecompanyname,sometimesinabbreviated
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form,andiftheshareswerenotissuedinsterling,thecurrencyisalsogiven.Almostalwayswhatisquotedistheordinaryshare(called‘commonstock’intheUnitedStates),butsomecompaniesissueotherquotedpaper,suchasirredeemablepreferencestock,convertibles,warrantsandsoon,andthesearenormallylistedunderneath.
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Sometimesthereareadditionalsybols.Forinstance,intheFinancialTimes:
$,€,¥acurrencysymbolnexttothecompanynamesaysthesharesarenotpricedinsterling;
*highandlowsharepriceshavebeen
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adjustedforcapitalchanges;
†interimdividendincreasedorresumed;
‡interimdividendsincereduced,passedordeferred;
#dividendpriceatthetimethedealinginthesharewassuspended;
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ccentsdfairvaluenetasset
valueismorethan3%differentfromtheparvalueNAV;
qundatedPdividendadjustedfor
consolidationorsplitintheshares;
xdtherecently-declareddividendwillberetainedbythe
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currentholderoftheshare;
xrthesameforrightsissue–thebuyerwillnotbeentitledtosubscribetonewshares;
xRbuyerdoesnotgetthescripissue;
xaex-all–severalofthoserightsremainwiththecurrent
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holder;therenolongerseemstobeasymbolforthemosttradedstock.
TheDailyTelegraphsharepricecodesare:
boldtypeFTSE100indexshares;
FTSE250index
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shares;*ex-dividend;†ex-scrip;§ex-rights;‡ex-all;#sharedealingshave
beensuspended;Areportandaccountsare
notready.
Thefourthcolumngivesthepriceatwhichtheshares
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stoodatcloseoftradingthepreviousnightorthelasttradingday.Anybodywhohasboughtholidaymoneyknowsthepriceofbuyingisalwayshigherthanthepriceatwhichyoucansell,andthatdifferenceiscalledthe‘spread’.Thepublishedpriceistheaverageofthetwo,sonoinvestorcanhopetobuyatthepriceorsellatit,evenif
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themarkethadnotmovedbythetimethenewspaperarrivesthroughtheletterbox.Iftradingintheshareshasbeensuspended–saybecausethecompanyisbeingreorganized,ortherearequestionsaboutthefigures,orbecauseitissubjecttoatakeover–thepricelistedisthelastonebeforesuspension,with#nexttoit.
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Figure 7.4 Financial Timesprices page entry
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Withsharesthespreadwilldependonarangeoffactorsthataffectthedealer’srisk.Oneiswhatthemarketcalls‘liquidity’:howmanysharesthereareavailableandhowmanypeoplearepreparedtotradeinthem.Agoodmeasureasfarasthestockmarketisconcernedishowmuchthepricemoveswhen
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youtrytotrade.Trytobuysharesinacompanywithfewonissue,andmostofthoselockedupbyholdersnotpreparedtobetemptedoutbyasmallriseinthevalue,andthepricewillsuddenlybounce.
MassivecompanieslikeBritishTelecom,Vodafone,etchavemillionsofsharesonissueandthereisalways
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somebodyinthemarketwantingtodealinthem.Bycontrast,arelativelysmallbusinesswithamarketcapitalizationof£10million,ofwhichthemanagerandfamilyownhalfanddirectorsownanotherquarter,withmostoftherestheldbytheinitialinvestors,areverydifficulttotradein.Itssizemeansfewpeoplehaveheard
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aboutthebusiness,sonotmanywanttodealintheshares,andeveniftheydidwanttoitcouldbequitetrickytofindacounterparty.Sothefirstwillhavearelativelynarrowspreadbecausethemoretradethereisinasharethemoreconfidentthedealerisingettingshotofany,whilethelatterwillprobablyhavea
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frighteninglywidespread.Thewidthofthespreadalsodependsonthestateofthemarket.Inwildlyfluctuatingshares,market-makersareloathtosticktheirnecksoutandtheycarefullywidenthespread.Sothemiddlemarketpriceisjustanindicationoftheactualratetheshareswillfetchinarealdeal.
Peoplewhodealoverthe
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telephonecanaskthebroker,whowilllookattheStockExchangescreenshowingallthepeopledealinginthesharesandtheirprices.Thebrokercanspecifyexactlywhatthepriceisthenand,iftheagreementisswift,maybeabletodealatthatprice.Analternativeistogetaccesstothepricespagesviatheinternet,andchecktheprices
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foroneself.Thefifthcolumninthe
DailyTelegraphshowsthepricechangefromthepreviousday’sclosinglevel,alsoatthemid-marketprice.Thenexttwocolumnsshowthehighsandlowsthesharepricehasreachedoverthepreviousyearoverall.Thatwillindicatewhethertheshareisnearitsmaximumor
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minimum.Soifthesharepriceiscurrently127pandthehighandlowsare478pand123p,youcanimmediatelytellthatthepriceisverynearthebottomlevelithasreachedinthepastyear.
VolumeoftradeinthefinalcolumnoftheFinancialTimesshowshowmanythousandsofshareschangedhandsontheprevioustrading
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day.Thefigureisthetotalofequitiesboughtandsold–inotherwords,thereisdoublecounting.Thefigureshowsthelevelofinterestinthecompany’ssharesandisanindicationoftheliquidityinthemarket.Itissalutarytoseehowmanywerenotdealtinatall.Somenewspapersprintaseparatetableofthepreviousday’smosthighly-
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tradedshares.Yieldisthepercentage
returnyougetifinvestingatthesharepricelistedinthetableandatthecurrentrateofdividends.Theformulais:multiplytheannualgrossdividendby100,andthendividebytheshare’smarketprice.Soifthesharescost200pandthelatestyear’sdividendwas14p,theyieldis
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7percent.Thisisnormallyreportedgross,iebeforetaxhasbeendeducted,thoughalmosteverybodygetsthedividendchequesnetandthetaxisnotreclaimable.
TheDailyTelegraphpricespagesprinttheletter‘b’toindicatetheinterimdividendhasbeenraised;‘c’meanstheinterimdividendhasbeenreducedorithas
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beenomittedaltogether.TheP/Estandsfor
price/earningsratio,andisprobablythebestknownmethodofassessingequities.Itiscalculatedbycomparingthecurrentsharepricewiththelevelofearningspershare(foundinthecompany’saccounts).
Thecompany’saccountsmaysaysomethinglike,
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‘attributabletoordinaryshareholders£850,000’andatthebottomoftheprofitandlosstableitwillsaysomethinglike‘earningsoneachofthe10millionsharesonissue8½p’.TogettheP/Eratioyoudividethis8½intotheprevailingmarketpriceoftheshares.Ifthosestandat,say,170p,then170/8½=20.Ifthesharepricehalvesto
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85ptheP/Eratiowouldbe10,andifthesharesshotupto255ptheP/Ewouldbe30.
Onecantheninspecttheothercompaniesinthesameindustrysectorlistedinthenewspaperandseehowtheycompare.IfmostofthecompaniesareonaP/Eofbetween12and16andoneofthecompaniesison25,eitherthemarketknowsgreatthings
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areonthewayfromit,orthesharesaregrosslyoverpriced.Conversely,ifallthesectorisonaP/Eof18to20butoneofthecompaniesison4,eitherthemarketknowsthereissomenastynewsonthewayfromthemanagementortheyarewrongandthesharesaregrosslyunderpriced.
TheWealthManagementAssociationalsoproduces
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indices–seewww.thewma.co.uk/private-investor-indices.
Investment trustsInsteadofprice/earningsratios,thecolumnforinvestmenttrustsshows‘NAV’,whichstandsfornetassetvalue.Thatisacalculationoftheinvestmenttrust’sholdingsasavalueper
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share.Liketheshareprice,itisquotedinpence.TheFinancialTimesalsohasacolumnshowing‘DisorPm(–)’.Thatisacalculationofthedifferencebetweenthenetassetvalueandtheactualpriceoftheshare–‘Dis’meansthesharesareatadiscountasthepriceisbelowtheassetvalue;‘Pm’meansthesharesareatapremiumto
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theunderlyingvalueoftheinvestments.Perverselyandconfusingly,adiscountisshownasapositivefigure,whileapremiumisshownwithaminussign.
TheAssociationofInvestmentCompaniesproducesamonthlybookletonthepricesanddetailedotherfiguresofitsmembers.
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GiltsTherearealsopricetablesforgilts–government-issuedsecurities.Theseareusuallysplitintoshort,mediumandlong-dated.Therearealsothetwoundatedones,andindex-linkedstocks.ForeigngovernmentsalsoissuebondsthatareobtainableinBritainandarequotedsometimeswithaloweryieldthannative
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varieties.(Seepage73fortheDailyTelegraphpricespage.)
Unit trustsTheheadingofthepricespagesisactually‘UnitTrustsandOpen-EndedInvestmentCompaniesPrices’.Thevariousunitsaregroupedunderthemanagementcompany,suchasAberdeen,M&Gandsoon,withthe
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addressesandtelephonenumbers(fortrading,information,prices,etc)soonecancallforapplicationformsandinformation–investorsdonothavetogothroughstockbrokerstobuythembutcangodirecttothecompany.Someofthesecompanieshaveregularsavingsplans.Alongwiththename,someofthemhavea
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numberinfigures,eg(1200)F,whichmeansthepricesweresetatnoon(usingthe24-hourclock)andthecompanyusesforwardpricing–ordersaretakenfrominvestorsandthepriceisdeterminedfromthenextvaluation.
Figure 7.5 Unit trust pricespage entry, Daily
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Telegraph – as that showsOIECS are listed only withbid prices
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Noonisthemostcommontimeforsettingprices.Aninvestortelephoninganorderat11amwouldbebuyingatapricesetanhourlater,butanotheronecallingat1pmwouldhavetowaituntilthenextdayfortheprice.
The52-weekhighsandlowsaresimilartothoseforshares,butforunittruststhe
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papersprintabuyingandsellingpriceandachangeinthemid-marketpricefromthepreviousones.Somealsoprovideacolumntoshowyieldgrossasapercentageoftheofferprice(atwhichtheinvestorbuys).
MondaysOnMondays,withnonewsonthetradingfront(readers
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willpresumablyhavegottheweek’sclosingpricesfromtheSaturdaynewspaper,ifnotoffthenet),thenewspapershavethechancetoprintdifferentoradditionalmaterial.
Marketcapitalizationisthetotalvalueofthecompanyonthestockmarketatthecurrentshareprice.SoifConsolidatedAlaskan
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CoconutPlantationshasissued50millionsharesandtheyarecurrentlybeingtradedat85p,thecompanyisvaluedat£42.5millionatthemomentandthatishowmuchitwouldcosttobuyallitsshares.Thisisofnohelpindecidingwhetheritisagoodbuyornot,butnewspapershavealwaysprintedsuchfiguresandtheydoatleast
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givesomeindicationofitsstanding.
IfitisintheFTSE100thenitisoneofthelargestcompaniesinthecountry,andyoucangaugethemarketratingbycombinationsofprice/earningsratio,yieldandmarketcapitalization.Donotbefooledbythesizethough–PollyPeckwasahugecompanyintheFTSE100
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IndexjustbeforeitimplodedwhenthemanwhoranitjumpedbailtofleetonorthernCyprus.
Thereisalsoinformationlikethepercentagechangeofpriceduringtheweek,thelastdividend(usuallyshownnetoftax),whenitwaslastquotedxd(ex-dividend);†intheFinancialTimesindicatesanincreaseintheinterim
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dividendinthecurrentfinancialyearand‡showsadecrease;dividendcovershowsthenumberoftimesthatlevelofdividendcouldhavebeenpaidoutofthelatestprofits.Thereisoftenaseparatetableforthemostrecentissues.
Indices
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Togetaflavouroftheeconomiccircumstancesandtojudgethetenorofthemarketasawhole,awiderangeofindicesspecifysectormovementsinmostofthemarketsintheworld.InBritainthemostcommonlyusedistheFTSE100.Itcontainsthelargesthundredcompaniesbymarketcapitalization–theirworthby
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thetotalvalueoftheirissuedshares.Thatinevitablymeanstheconstitutionoftheindexchangesassomecorporationsfallfromgraceorgettakenover,andothersgroworbecomepopular.Andsureenough,theStockExchangedoesindeedcontinuouslyupdatetheconstituentsoftheFTSE100.
Alittlefurtherdownthe
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peckingorderisthenextcropoflargecompanies,theFTSE250,andthosetwoaresometimescombinedintotheFTSE350.Widerstillisthe650AllShare(whichdoesnotinfactincludeallshares).TheFinancialTimesproducesafulllistoftheFTSEindicescompiledandcalculatedunderformulaedevelopedbyactuaries.
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Newspaperssometimesprintfiguresforthemovementofindicesforindustrialsectorssuchasengineeringandmachinery,orconstructionandbuildingmaterials–whicharethenaggregatedtoformwiderindustrialindicessuchasBasicIndustries,GeneralIndustrials–andsomedescribethetypeofcompany,suchas‘smallcap’
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(smalltotalmarketvalueoftheshares).
Everystockmarketaroundtheworldhasitsindicestoindicatemarketmovementasawhole,buttheonesreproducedinBritainaregenerallyconfinedtothelocalequivalentsoftheFTSE100.SomeofthebetterknownandmorecommonlyusedonesaretheDowJones
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(actuallytheDowJonesIndustrialAverage),Nasdaq100,NYSEComposite,andStandard&Poor’sfortheUnitedStates,thoughtherearelargercoverageindicesaswellsuchastheRussell2000andtheWilshire5000;Toronto300forCanada;Nikkei225forJapan;HangSengforHongKong;DaxforGermany;CAC40forFrance;
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AEXforAmsterdam;BEL20forBrussels;IBrXforthehundredlargestBraziliancompanies;andEurotop100forthehundredlargestmarketcapitalizationcompaniesonEuropeanexchanges.ThereisalsotheMSCIworldindex.
InTheDailyTelegraphtherearetwotablesofindicesonthepricespage.Oneisfor
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the12largestforeignstockmarketsexceptingNewYorkandToronto,whichareintheKeyMarketstableonthefacingpage(thenewspaperownerisCanadian),thoughTokyo’sNikkeiindexappearsonbothpages.TheothertableshowsthemajorBritishshareindicesincludingtheFTSE100and250(plusthe350,whichisjustthosetwo
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together)andthe30,whichwastheFTSE100’spredecessor.ThereisalsotheTechmark,whichistheStockExchange’sattempttoshowbackingforthenewcomersandhigh-technologycompaniesbyseparatingthemintoago-goindex,whichhasturnedintoabitofago-stop-go.Thereisalsoatableofthehighestvolumes
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oftrade.
Online
Theinternetmeanswearenolongerdependentonlyonthemorningpaperforinformation,thoughthereareelectronicversionsofnewspapersandsomemagazines,oftencarryingstoriesthatwillappearinthe
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nextmorning’sprintedversion.Thearchivescanalsoshowwhattheypreviouslysaidaboutacompanyorthestateoftheeconomy.
Otherinformationaboutinvestmentsandcompanies(includingfromtheirownwebsites),andsomecommentisalsoavailable.Aswithallinternetadviceandcommenthowever,trustonlythose
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withreliableprovenance,knownrecordandevidentindependence.
Therearemanyonlinebrokers,suchasHargreavesLansdown(www.hl.co.uk),someofwhichoffercommentaries,aswellas‘realtime’prices(theonesbeingquotedatthatmomentontheExchangecomputers),occasionallyforanadditional
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subscription.Theadvantageisthatyoucandealimmediatelyontheinformationandattheprice.GoogleFinancealsoprovidesshareprices,chartsandcommentariesonmostcompaniesquotedinLondon.Inaddition,therearenewsservicessuchaswww.bloomberg.comandspecialistservicessuchas
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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
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ofusefulnewsandinformation.
Company accounts
Muchoftheanalysisofsuitableinvestmentsforbothprofessionalsandprivateinvestorsstartswiththecompany’sannualreportandaccounts,andmostoftheratiosarecalculatedfrom
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figurestakenfromtheannualreport.MostcompanieswillbehappytoforwardacopyonrequestandlargenumbersofthemareavailableontheinternetfromCompanyAnnualReportsOn-Line(CAROL).Quiteoften,companiesputtheiraccountsontheirwebsites,andtheycanusuallybefoundontheinvestorhomepage.
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Annualreportsandaccountsareformidabledocumentsapparentlydesignedtowardoffinsomniainallbutthemostdedicated.Butyoudon’tgetowtfornowt–investingyourtimebeforeinvestingyourmoneyreducesthechancesofdoingsomethingspectacularlysilly.Soitisworthlearningalittleofthe
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meaningsbehindthefigures,andtheconventionsusedtopreparethem.Foratrueunderstandingofabusinessandhowthecompanyfaresonereallyneedstotalktoproductionforemen,salesstaff,vandrivers,internalauditors,purchasingmanagersandthefinancedirectortosupplementthepicturefromthepublished
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figures.Unhappilythisisnotopentoinvestors,thoughitwouldbeforstockbrokers’analystsiftheybotheredtoavailthemselvesofit.
Thefirstruletorememberisnottobetakeninbythespuriousaccuracyofhavingitallsetdowninprecise-lookingnumbers.Everythingintheannualreportistheresultofapproximation,
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estimation,interpretationorguess.Accountingstandardsmaylimittherangeofflexibilitybutthecompanystillhasscopeforaprettyfairrangeofsubjectiveassessment.Thatisinpartbecausetherulesthemselveshavetoapplytoawiderangeoftypesandsizeofbusinessandanenormousrangeofcircumstances.Aseventhe
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AccountingStandardsBoardconcededmanyyearsago,corporateaccountscanberelevantorcomparable,butnotboth.Ithasinthemaingoneforrelevance(thefiguresaretailoredmoretoproduceafairpictureofthebusiness)attheexpenseofproducingreadilycomparableaccounts,whichmeansinvestorsgetabetterpicture
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ofthebusinessitselfbutmustputinsomeextraworktotryandmeasureonebusinessagainstanother.
Thesecondruleisthatthepurposeofaccountsistodemonstratethatthebusinessisbeingrunhonestlyandtheinvestors’cashisnotbeingembezzled.Thereisnointentiontodemonstratecompetence,muchless
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efficiency,thoughthatiswhatinvestorsneed.Intheabsenceofdirecthintsabouthowcleverthemanagersare,investorsneedtodigintotheannualreporttodeduceitfromtheavailableinformation.
Itispartlytohelpthatprocessthattheaccountingprofessionhasfordecadesgonewaybeyondthe
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demandsoftheCompaniesActsintheamountofdisclosure.Thetheoryisthatifallpossibleinformationisthere,crooksandfoolswillhavenowheretohide.Ontheotherhand,BritainisapproachingtheUnitedStatesinthesizeofcorporatedocumentsandfewcansiftrelevancefromthemountainoffigures.Someofitis
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unquestionablyhelpfulingettingdowntothedetailsofhowthenumbersrelate,butthatusuallyactsasasubstituteforfindingjustwhatmakesabusinesstick.
Acompany’sannualreportandaccountsmayhaveplentyofmaterialforthecarefulcalculationsofstockbrokers’analystsbutmuchofitwillbe
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incomprehensible,boringorirrelevanttomostinvestors.Neverthelessthedocumentdoescontaintheoccasionalgemsthatindicatewherethecompanyisgoingandwhetheritisheadedforrichesortheknackers’yard.
Relyingontheauditorstooheavilyisamistake.Theyareaccountants,nominallyappointedbyshareholdersbut
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inpracticebydirectors,whoaresupposedtotakeanoutsider’sdispassionateviewofthefiguresandtoseethattheyhavesomerelationtoreality.Theirmaincriteriaaresupposedtobederivedfromtherequirementthattheaccountsrepresentatrueandfairview,butincreasinglytheypreferthelesscontentiousapproachof
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sayingthefigureshavebeencompiledinlinewiththerules.Evenwhentheyareconscientious,independentandrigorous,auditorsaregovernedbythesameuncertaintiesinthefiguresasthecompanyitself,andinanycasetheycannotpossiblycheckeverything.Astheythemselveskeepsaying,theyareguard-dogs,not
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bloodhounds–inotherwordstheyaretheretocheckthefiguresaddupandthestocksreallyareinthewarehousebutdonotseetheirjobashuntingthroughthebusinessforsignsoffraudorevenincompetence.Thatiswhyauditorsclearlysayattheendofthereportitwasthedirectorswhopreparedtheaccountsandwhomusttake
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responsibilityforthem.Suchstatementsarealso
anattemptatapre-emptivedefenceagainstlitigation.Whencompaniesgounderorarefoundtohavebeensubjecttomassivefraud,creditorssueauditorsbecausetheyhavelargeprofessionalindemnityinsurance,ratherthandirectorswhomayhavecarefullysaltedmoneyaway
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inoverseastrustsortheirspouses’namesandthereforeseemtobepeopleofnosubstance.Directorsare,however,responsiblebothinlawandinfactforrunningthecompany,andshareholdersshouldresistpressurestoreducetheirliabilitynomatterhowworthythecauseappearstobe.
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Anotherthingtorememberisthataccountsrepresentthepast.Theywillnotthereforenecessarilygiveanaccuratepictureofwherethecompanyisnow,muchlesswhereitwillbeinthefuture,especiallyinfast-movingtradesorchangingeconomies.Accountsarepreparedona‘going-concern’basis,whichmeans,
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amongotherthings,thatassetsarevaluednotbyhowmuchtheywouldfetchinabreak-upbutattheirworthtothebusiness.
Noneofthisisintendedtosuggestthataccountsareuselessormisleading,merelythattheyneedinterpretation,areimpreciseandrepresentthepast.Thatmeansalittlemoreworkintryingto
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evaluatejustwhattheyreallydosuggest.
First,someconventions.Likethegovernment,companiesgenerallydonotsticktothecalendaryear.Financialyearsstartatanytime,sometimesnotevenatthebeginningofamonth.Theremaybenothingsinisterinthis.Financialyearsstartwhenthecompanywas
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originallyregisteredanditcouldbethatithasjuststuckwithit.Somebusinessesreckontheirsalesareseasonalandsetthefinancialyearsothesecondhalfgetsthebenefitoftheupturn.
Anynumberinparenthesesisanegative.So,attheprofitleveloftheaccounts,£12.8millionindicatesaprofitbut
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(£385,000)showsaloss.Thenumbersinthemainpagesoftheaccountsaremostlysumsofvariousgroupsofnumbersthatarethenshowningreaterdetailinthenotes–thereisnormallyalittlenumbernexttoeachlinetoshowwhichnoterelatestoit.Itisalsoworthrememberingthatmanyofthenumbersinthereportareabitbarrenontheir
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ownandhaveafargreatersignificancewhenrelatedtoothernumbersintheaccounts,setagainstpreviousyearsorbycomparisonwithotherbusinesses.
Themainitemsinthedocumentarethedirectors’report,theprofitandlossaccount,andthebalancesheet.Inadditiontherearetheextensivenotes,whichare
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supposedtoamplifyorexplainthefigures;thesourceandapplicationoffunds,whichshowwherethecompanygotitscashandhowthemoneywasused;andtheauditors’report.
Chairman’s anddirectors’ reportRightatthefrontisabrief
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wordfromthechairmanandthedirectors’report.Theseshouldsaywhatthecompanydoesandsumupsignificanthighlightsoftheyearjustcompleted,possiblywithsomecommentsontheperformanceandhowthefiguresshouldbeinterpreted.Thereisoftenawordaboutprospects,whichisonlyfairconsideringmostreportsare
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producedseveralmonthsintothenextfinancialyear,butseldomgivemorethanacursorysuggestion.Theusualformulaissomethinglike,‘Despitethedifficultfinancialcircumstanceswehopetocontinuedevelopingthecompanyandhopeforfurtherimprovementintheresultsforthecurrentyear.’Iftheresultsturnoutworse,
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shareholderscannotsueformisrepresentationevenonthatsmallscaleand,tobefair,eventhreemonthsintoayearmaygiveamisleadingpictureoftheresultsforthewhole12months.Onehasthereforetolearntoreadbetweenthelinesandseewhatthephrasesindicateandwhatthereportishintingat.Somedotrytobeasexplicit
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ascircumstancespermit,andsocanofferaveiledmessage.
AccountingpoliciesMostofthisisextremelyboringandcansafelybeignoredasroutineprescribedbythelawsandaccountingstandards.Justoccasionally,however,acompanyreckons
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thestandardruleswouldproducenonsenseand,ratherthanmislead,itintendstodepartfromthenormalpresentation.Thereportthenshouldexplainwhatstandardisbeingbreachedandwhy.Theexplanationofthismaynotalwaysbethemostlucidproseandisnotprimarilyaimedatthelayperson,butabitofcarefulattentionwill
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usuallyunravelit.Iftheauditorsreckonitisabitofflummeryorspeciousexcusetheywillcommentonitintheirreport.
Profit and lossaccountTurnoverTheprofitandlossaccountstartsbyshowingthe
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company’stradingoverthepreviousfinancialyear.Thatshowsturnover,whichjustmeanssalesandsometimesisactuallylabelledso.Drinkscompaniessometimesthentakeoffexcisetaxestoshownetsalesvalue.Onecanthenseehowthislatestyearcomparedwiththepreviousone.Evenifitlookshealthyitisprobablywisetofliptothe
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noteassociatedwiththefigureandseeiftherearebreakdowns.Somecompaniesshowthesalesbyproduct,bygeographicalarea,bymarketsectorandsoon.Thiswillshowwhetherthereareanypeculiarities,likeoneproductsupportingthesaggingrestoronegeographicalareaturningdistinctlydodgy.Ifthereis
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anythinglikethat,turntothechairman’sanddirectors’reportstoseeifthereisanyexplanation.Theanswermaybesomethingsimplelikeanacquisitionoradisposal.Ifthereisnoexplanation,suchdistortionsoroddfiguresshouldpromptquestionsandtriggercaution.
Operating profit
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Nextaretheoperatingcostsofrunningthecompanyincludingeverythingfromstationerytowages,whichareoftenbrokendownintomajorcomponentssuchascostofmanufacturing,distribution,administration,andresearchanddevelopment.Thesecansometimessuggestquestions,suchas:whyis
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administrationsoexpensive,orwhyhasthecompanybeencuttingbackonresearchforseveralyears?Whenthecostofsalesisdeductedfromthetotalturnoverfigure,theresultistheoperatingprofit.
Other incomesInlargercompaniesyouthengetavarietyofotherincomessuchasmoneypaidtothe
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parentcompanybysubsidiaries,oroccasionallytheotherway,andsomeexceptionalitemsthatarenotthenormalpartofthecompany’stradingoperations.Abusinesshastopayinterestonmoneyithasborrowed.Anysharpmovementininterestoutorinthatisoutoflinewithprevailinginterestrates
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shouldpromptsearchesinthenotesandstatementsforexplanations.Itcouldbeborrowingsforacquisitionsorforalargeredundancyprogramme.
Pre-tax profitWhentheoperatingcostsandotherincomeshavebeenaccountedfor,whatisleftisthepre-taxprofit,whichis
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thefigurenormallyusedinnewspaperaccountsofresults.TakingoffCorporationTaxanddividendpaymentsleavesretainedprofit,whichthebusinessisplanningtoreinvest.
Accountingstandardssayexceptionalitemssuchasprofitfromthesaleofanofficebuildingorthecostofamajorreorganizationand
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redundancyofmanyemployees,havetobeseparatedout.
Other itemsTheotheritemsarefairlystraightforward.Theprofitandlosstableshowstheamountbeingpaidtoshareholdersindividends,sometimeswithpreferencesharesseparatedout.
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Anythingleftafterthatistransferredtoreserves.Thisdoesnotmeanitgoesintothecompanycoffers,andthetermisconfusing,sosomecompanieshaveoptedinsteadtocalltheamount‘retainedprofits’or,tobeevenmoreexplanatory,somethinglike‘profitsretainedinthebusiness’.Thisisthemoneythatbuildsthecompany.It
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goesintobuyingmachinery,factoriesorrawmaterials,orfinancingworkinprogress.Somecompanieshavestarvedthemselvesofthisvitalreinvestmentbecauseinstitutionalshareholdersdemandagrowingdividendchequeeveryyearevenifthatmeansdeprivingtheenterpriseofcash–ifthebusinesssufferstheywilljust
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ditchthesharesandmoveontoanothercompany.
Thereisnothingintheaccountsthatwouldsuggest,forinstance,agoodstarttotheyearbutthewholebusinessfallingoutofbedinitslastthreemonthswithplungingsalesandprofits.Allofthatshouldbementionedinthereportsfromchairmananddirectorswith
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explanationsastowhyithappenedandwhattheyaredoingaboutit.
Aclichéistotalkaboutthebottomline,whichisreckonedtocomefromtheaccounts.Infactthebottomlineoftheprofitandlossaccount,aftertheretainedprofitsfigure,isusuallytheearningspershare.Dividingthesharepricebythisfigure
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providestheP/Eratio,ortobeprecisethehistoricP/E.
Balance sheetWhileprofitandlossaccountsshowanaccumulationoftransactionsoverthewholefinancialyear,thebalancesheetisthepicture(traditionallycalleda‘snapshot’toemphasizehow
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brieflyrelevantitis)ofthefinancialpositionandassetsonthelastdayofacompany’sfinancialyear.Everythingitownsorisowedonthatdayisshownunderarangeofheadings.Bythetimeshareholdersseethetotals,thefiguresarelargelyirrelevantbecauseintheinterveningmonthseverythingcouldhave
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changed.Thefiguresare,aswith
muchelseintheaccounts,opentoadegreeofflexibility.Forinstance,valuationsofassetsarefairlysubjectiveanddependonthepurposeforwhichthefigureisbeingprepared.Amachinetoolmaybevitalforthecompanybutwouldfetchlittleiftheliquidatorhadto
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breakuptheassets.Settingapriceonpatents,trademarksorbrandnamesisevendodgierandtherehavebeenyearsofargumentsaboutthetruevaluationofsuchintangibleassets.Thephysicalassetsandstocksareoftenshownatcost,butinflationwillhaveerodedthatevenifotherfactorshavenotalteredthevaluation.
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Similarly,landvaluescanmovesharplywiththevagariesoftheeconomyandthepropertymarket.
Whattheaccountswillshowisthedepreciationreducingtheworthofassets.Thenotesandaccountingpoliciesusuallyelaborateonthis,butitisnormalformachinerytobewrittendownbyafixedamounteachyear–
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straight-linedepreciation.Clearlythatleavesampleroomforabitofanudgeorwindow-dressingbyadjustingvaluationsorbringingforwardsomeitemsanddelayingothers,togivethetotalfigurethecompanywantstoproject.Thesnapshotmaythereforebewhollyatypicalofthestateofitsfinancesonanyotherday
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oftheyear.Despitethat,itgivesahintofthefinancialhealthofthebusiness,allthemoresosincetherangeofmanipulations–shortofoutrightfraud–islimitedforanumberofreasonsincludingaccountingstandardsandtheneedtobereasonablyconsistentwiththepreviousyears.
Inthelistofthingsthe
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companyownsthefirstheadingisfixedassets.Thiscomprisesthingsthathavebeenandarelikelytocontinueaslong-terminvestments.Soitincludesthingslikefactoriesandequipment,officeblocksandthelike.Lorriesarealsoincludedunderthisheading,probablyforwantofabetterplacetoputthem.Thevalue
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isnormallyinthereatcostorwhattheywouldsellfor,orsomeformula.
Thencomeinvestmentsinothercompanies.Thentherearecurrentassets,whichcoversthemoremobile,changingthingslikestocksofrawmaterialsandfinishedproductsinthewarehouse,moneyowedbycustomers,andmoneyinthebank.
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Afterthatcomesalistofthecompany’sdebts.Firsttherearecurrentliabilities,orcreditorsexpectingtobepaidinunderayear.Thisincludestradecreditors(suppliersofgoodsandserviceswhohavenotyetbeenpaid),moneyborrowedshortterm,themoneysetasidefortheproposeddividend,andtheCorporationTaxtobepaidon
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theprofits.Thetotalisthendeductedfromthecurrentassetstoshowthenetfigure.Thisissometimescalled‘workingcapital’.
Longer-termdebtincludesthingslikeaterm-loanfromthebankandprovisionsforknownspendingsuchasrestructuringthebusiness,movingthefactoryorthefearedoutcomeofalegal
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case.Takingtheshort-andlong-termliabilitiesfromtheassetsproducesthenetassetfigure.
Onceagain,thereshouldbecomparisonnotonlywiththepreviousyear,whichmostcompaniesprovide,butalsowiththepreviousfiveyears.Combiningthecurrentfigurewithpreviousyears’andknowingsomethingaboutthe
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normsinthatindustryshouldprovideaprettygoodmeasureofthecompany’sfinancialhealth.
Cash-flowstatementCashflow,orflowoffunds,orsourceandapplicationoffundsstatementsare,asthenamessuggest,a
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supplementaryindicationofhowthemoneyflowsinfromprofitsandinvestments,andgoesoutagainfortax,dividendsandthelike.Inadditionitgivesthefiguresforrepaymentofcapital–redeemingadebenture,forinstance–orfinanceinfromraisingfurthercapital.Thereislittlepointinmakingaprofitifthebusinessjustruns
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outofcash,andthisiswherethewarningshouldshow.
Thefinalfigureofthestatementshowsthegrowthordecreaseinthecompany’sfundsduringtheyear.Thatisafairlygoodindicationofhowsuccessfullyithasbeenmanaged.
Auditors’ report
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Theauditors’reportisnormallyaprettyroutineaffair,sayingthecompanyhasabidedbytheaccountingstandards,CompaniesActsrequirementsandotherrules;thatthedirectorsareresponsiblefortheaccountsandtheauditorsmerelytakesamplesandtestsasrequiredbytheAuditingPracticesBoard;andthatasfarasthey
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cantelltheaccountsrepresentatrueandfairaccountofthestateofplay.Justoccasionallyitisaqualifiedreport.
Inessencetherearetwosortsofqualification,asaresultofuncertaintyorfromdisagreementwiththewaydirectorstreatsomeitem.Theeffectmaybemuchthesamebutthemessageissignalled
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indifferentways.Iftheuncertaintyisbig
enoughtomentionbutnotfundamentaltothebusiness,theauditorsnormallysaythat,subjecttothespecificdoubts,whichtheywillnormallyspellout,theaccountsareallright.Thatmayjustbeawaitingtheoutcomeofacourtactionandhenceareinherently
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uncertain,butitcouldalsosaytheauditorscouldnottellifproperaccountshadbeenkeptinonepartofthebusiness.
Sometimesitisastraightdisagreementaboutthetreatmentofanitem.Onceagain,ifitisabiggishnumberinthecontextoftheaccountsbutnotseriousenoughtounderminethe
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survivaloftheorganization,theauditorsnormallysayitisalltrueandfairexceptforthespecifieditem.Theauditorsmay,forinstance,sayadebtinthebalancesheetisnotrecoverabledespiteallthedirectors’optimism.
Onafewrareoccasionsthesplitbetweentheboardandtheauditorsissoserious,ortheauditorshavestumbled
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onsomethingsocrucialtothecompany’sviability,thatamoreseriouswarningisinsertedintotheaccounts.Ifthedoubtsaboutrecord-keepingorthereliabilityofinformationgenerallyissogreatthattheauditorshaveseriousdoubtsaboutthewholething,theywillsaytheycouldnotdiscoverwhetherthestocksarepresent
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orthesalesareasstated;theymaysaythebooksandfigureswerenotavailable;sometestsofthebookswerefrustrated;ortheyhadsomedeepproblemaboutverifyingwhatwasgoingonandsoon,andasaresulttheycangivenoopiniononwhethertheaccountsaretrueandfair.
Sometimesthereisjustafundamentaldisagreement
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betweenthedirectorsandauditorsaboutwhatthingsareworthorhowtheyshouldbetreated.Ifthesearesuchmajoritemsthattheyarefundamentaltothestateofthebusiness,theauditorsnormallysetouttheproblem–saythevaluationofmajorlong-termcontracts–andstatethattheaccountsareasaresultmisleading.They
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normallyaddthathadtheaccountingtreatmentbeenastheysuggested,theprofitswouldhavebeensomanymillionslower.
Suchmajorrowsarerarebecausetheboardandtheauditorsargueaboutsuchitemsatenormouslength,andauditorsbendoverbackwardstoavoidsuchopenconflicts,ifonlybecauseitisalmost
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alwaysthepreludetoachangeofauditor,sotheaccountantswillloseasourceofrevenue.
Anotherworryingcommentfromtheauditorsisthattheaccountshavebeenpreparedonagoing-concernbasis,whichisawarningthatthefigureswouldbeunjustifiedifthebusinesswentbust.Clearlythatsortof
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pointisnotgoingtobemadeaboutabusinesswithaboomingpresentandaflourishingfuture.
NotesBehindallthesearethenotes,frequentlyrunningtodozensofpages.Itisafrighteningandlongsetoftechnical-lookingstatistics.Infactthis
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iswheretherealmeatisgenerallyburied.
AseriesofreportsoncorporategovernancehasproducedtheCombinedCode,whichtheStockExchangebacks,thatinstructscompaniestoincludementionintheirannualreportsofhowfartheycompliedwiththerequirements.Inaddition,
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somecompaniesprovideunauditedsupplementsgivingbreakdownsbyproductareaandcountryofsales,sometimesbycountryofmanufactureandotherdetails.
Thisisthesectionwhereyouwillfindhowmuchdirectorsearnedandwhatsortofincentiveandshare-optionpackagestheyhave.Itwill
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alsoshowhowmanyemployeesthereareandhowthattotalchangedduringtheyear.
Alsoatthebackbutnotusuallyaformalpartofthenotesisatableshowingpreviousyears’performance,goingbackatleastfiveandsometimes10years.Thatmeansonecancheckwhethersaleshaverisenfasterthan
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therateofinflationandwhetherthetrendhasbeenasteadyoneorerratic.Italsotendstoshowthestepchangewhentheboosttoprofitandturnovercamenotfromorganicgrowthbutanacquisition.
Using the accounts
Thisthenisthestart:now
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thesebarefiguresmustberelatedtosomethingtoextractsomemeaningfromthem.Forinstance,thefigureofthetradecreditorsasapercentageofturnover:thehigherthepercentagethelongercustomersaretakingtopay.Thismeansnotonlythatthecompanymustfindexpensivefinancetobridgethatgap,butthatitscashand
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creditcontrolarenotverygood.
Anothersignificantfigureistherelationshipbetweenborrowingsandsharecapital.Borrowedmoneyhastoberepaidandtheinterestisduewhetherthecompanyismakingaprofitornot.Equity–sharecapital–isneverlikelytoberepaidanddividendsarepaidonlywhen
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thecompanycanaffordthem.Iftheprofitabilityisgreaterthanthecostofdebt,theprofitattributablewillbegearedupsubstantially.Allthesame,therearelimitstohowmuchacompanymayborrow,andborrowingmakesabusinessvulnerable.Theratiobetweenthoseborrowingsandtheequitymoneyiscalled‘gearing’
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(‘leverage’intheUnitedStates),andacompanywithshareholders’fundsof£150millionandborrowingsof£75millionwouldbecalled50percentgeared.Itvariesabitdependingonexternalcircumstancesandtheindustrysector,butifitwenttoover60percentthecompanywouldbecalled‘highlygeared’.Analysisof
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suchratioscanbefoundinChapter6.
Oneaspectthatiseasytostudyisthetrendsovertime.Allaccountsprovidethepreviousyear’sfiguresandmanyprovidesummarytablesforthepreviousfiveyears.Thesewillshow,forinstance,whetherturnoverhasrisenfasterthantherateofinflation,andwhetherprofits
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haverisenevenfasterthroughincreasedefficiency,concentrationonhigh-marginproductsandsoon.
Other informationfrom companies
Interim reportsInbetweentheannualreports
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companiesalsoproducetheresultsoftradinginthefirsthalfoftheirfinancialyear.Thesearegenerallyprettyshortdocumentsgivingabriefstatementofthevolumeoftradeandprofit,plusanabbreviatedbalancesheetminusthecopiousnotes.Somecompaniesgivesomesegmentalinformationaswell.Thefiguresarenot
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audited.
Prospectuses andlisting particularsCompaniesfirstcomingtothestockmarketmustprovideextensivedetailsnotjustaboutthebusinessbutthepeoplerunningit.ThelistingrulesoftheStockExchangerequireallsortsof
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informationaboutassets,depreciation,governmentgrants,abriefhistory,auditors,bankers,financialadvisers,stockbrokers,solicitors,acompletedescriptionofthebusiness,detailsofmanagement(directorshaveaskedthegovernmenttobeexcusedfromputtinginhomeaddressesinfuture),staffand
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premises,whatwillbedonewiththemoneyraised,expectationsoftheimmediatefuture,andsoon.Sotheprospectusisthemostcomprehensiveinformationaboutitselfthatacompanyeverpublishes.
TheAlternativeInvestmentMarkethasslightlylessonerousdemandsfordetails,buttheyarestill
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prettyextensive.
Circulars ondisposals andacquisitionsShareholdersmustbetoldofanysubstantialacquisitionwithdetailsoftheoffer,whyitisbeingmadeandhowitistobepaidfor.Inmostcasestheshareholderswillhaveto
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ratifytheboard’sdecisiontopurchase.
Somebidsarecalled‘hostile’,thoughitisthebusinessonthereceivingendofanunwelcomeofferthatisbelligerent.Insuchnon-agreedtakeoverbattlesthetargetcompanywillsendshareholdersdocumentsdefendingitsmanagementandtradingrecord,and
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emphasizingitsglowingfutureaswellastheneedforcontinuedindependence.Thesetendtobeaccompaniedbyextensivedisclosures,accountsandforecasts,rivallingtheannualreportinscope.Sometimesahigherofferseemstoconquersuchemphaticmisgivings.
Newsletters
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Shareholderloyaltyhasgrowninimportanceinrecentyears,socompaniestrytokeeptheirinvestorshappybysendingthemnewsletters.Evenmorecommonly,therearemagazinesandnewssheetsdistributedtoemployees,whosometimesalsogetashortenedversionoftheannualaccounts.Carelesscompanies
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sometimestelladifferentstoryinhousemagazinesandshareholderreports.
Other sources
Share buy-backsAcompanybuyingbackitsownsharesshouldsuggestquestions.Isitbecausethebusinesshassurpluscashand
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canfindnowayofgrowingthebusiness?Isitafailureofmanagementinfindingnothinginthebusinessinwhichtoinvest?Isitjustanattempttomakeitsfigureslookbetterbyboostingtheearningspershare,andincreasingitsshareprice?Orisitasignthatthebusinessthinksthismoresensiblethanbuyingoverpricedassets
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throughabusinesstakeover?Thesharesboughtback
canbecancelledbythecompanyorkeptin‘treasury’forreleaseatalaterdate.
Directors’ dealingsCompaniesareobligedtotelltheStockExchangeauthoritiesaboutdealingsintheirsharesbydirectors.This
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goesoutontheStockExchange’snewssystemandisoccasionallypickedupbyanincreasingnumberofnewspapers.
Directorsmayprovideveryplausiblereasonsforselling,butitisbestallthesametobewaryandcheckwhatisgoingon.Thedirectormayreallyneedthemoneyforthechildren’seducation,
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topaydeathduties,tobuyasmallchateauintheDordogne,ortofundacontentiousandexpensivedivorce.Buteventhen,whydidthatdirectorsellthosesharestofindthemoney?Withoutconvincingexplanations,onereallydoeswonderwhatthemanagersofabusinessknowthatothershareholdersdonotwhen
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theystartsellingthesharesinsubstantialquantities.
Conversely,thefactthatseveralboardmembersseemanxioustoincreasetheirholdingsdoesseemprettyencouragingeveniftheyarenotactingoninsiderinformation.Directorsareallowedtotradeinsharesonlywhentheyarenotina‘closedperiod’ofsittingon
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sensitiveinformation,suchasthecompany’slatestsetofresultsornewsofacontractwon.
FashionFadsovertaketheworldofinvestmentwithevengreatervirulencethanwomen’sclothing,andareequallyevanescent.Theinternet
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bubbleisanexample,butatleastthatwasrelatedtosomeunderlyingbusinessopportunity.Itreallywastruethatthesystemwaschangingthewaypeopledobusiness,butnobodyknewhowmuchorhowquickly,muchlesswhowasgoingtowinduringthetradingrevolution.Asaresulttherewasnoobviouswayofvaluinganinternet
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company.Valuationwasmadeadditionallydifficultbythevarietyofsoftwareproducers,internetserviceproviders,retailers,etc.P/Eratiosbecameinsaneorirrelevant(therewerenoearningsyet)andeveryoneknewthebusinesseswereovervalued,butthereseemednowayofstoppingtheboom–untilitstopped.
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Unliketheinternetfashion,whichatleastderivedfromsomeconfusedperceptionofwhatreallywasgoingon,somefashionsseembasedonnothingbutvaporousunrealistichope.Thepointhereistwofold:itisnotwrongtoinvestinapromisingsectorsuchastheinternetsolongasyoucanseerealvalueinthebusiness,
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butitisfollytogetcaughtinthehysteria;anditisvitaltoseparatetheboomsthatarebasedonrealbusinessopportunitiesfromtheonesthatarenothingbutpassingfadsapparentlycreatedbysomesortofmarketramp.
Sometimesabigtakeoverinasector–banking,insurance,pharmaceuticals,retailingandsoon–prompts
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speculationthatotherswillfollow,andmostofthesharesinsimilarbusinessessuddenlyrompahead.Whetherthereisasheep-likementalityinbusiness,whetherfinancialadvisersthenseethechanceofincomeandurgetheirclientstograbashareofwhatisleft,orwhethermanagementsreallydofearbeingleftbehind,the
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speculationquiteoftenbecomesfact.Ithappenedwiththedemutualizationofbuildingsocietiesandinsurancecompanies.Whenoneofthosebecameapubliccompany,ownersoftheotherscouldnotresistthelureofshort-termprofitsandforcedaflurryofdemutualizations.
Whenthereisageneral
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realignmentintheindustryofthistype,thepeoplewhospotitatthestartandbuyintothecompanieslikelytobecometakeovertargetsseehealthyrisesintheshares.Similarly,carpetbaggersgettingintothebuildingsocietiesintimeemergewithafewthousandpoundsofsharesthattheycanswiftlyextract.
Anotherfashionisfor
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sectors.Suddenlybiotechnologyisseenasthesaviourofmankindwithuntoldrichestobederivedfromnewdrugs;softwarecompaniesareseenastheuniversaltraders;theinternetisthoughttobeaguaranteedmeansofsellingtohundredsofmillionsofpeopleatnocostatall;oraminingsectorisreckonedtobecertainto
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makeafortunefromthespurtofdemandforitsmetals.Voguesofthistypeseldomlastmorethanayear,soittakesnimblemindstospotthetrends,buttheresultscanbespectacular.Itispossibletoincreasethevalueoftheholdingbyanythingfromfive-foldto20-foldinamatterofmonths.Thepointistogetoutbeforethesky
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fallsin.Conversely,itisdangerous
toclimbaboardabandwagonifitseemstohavenorealengine.Ifyoudonotunderstandwhatacompanydoesorwhyitisvaluedashighlyasitseemstobe,avoidit.
Stockbrokers/investmentadvisers
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Ifyouhaveastockbrokerwhoisprovidingmorethanjustadealingservice,oraninvestmentadviser,therewillbeampleadviceandinformationontap.Itmaybeverygoodadvice,butintelligentinvestorsarenotwhollyinert,preparedtoaccepteverythingtheyaretold.Yougetbetteradviceifyouareinformedenoughto
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beabletodiscussthemarketandyourneedsinanintelligentmanner.Theinvestorneedstobecontinuouslykeepinguptodateandtohavehisorherprioritiesclear.Thisisnotjustausefulantidotetobeingbaffledbypretentiousjargon:italsohelpsestablishwhetherone’sideasareright.
Peoplewithoutaregular
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financialadviserandthosewhodistrusttheadvicetheygethavetohuntaroundforothersources.Stockbrokers’circularsarestillgenerallyavailabletothemeitherdirectlyorthroughthepress,butusuallyafterfavouredclientshavebeentoldtheconclusionsandhavehadtimetoactonthem.Thisisusefulinformationbecauseit
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givesalotofbackgroundaboutabusiness,thecalculationsandfeelingsofaprofessional,andanindicationofhowtheCitymayviewtheshares.Youcanthencheckwhatyoufeel,whatthesharepriceisdoingandsoon,andusetheadditionalinsightasanextraaidindecisionmaking.
Ifyoudonothaveaccess
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toabroker’sadvice,donotdespair.Stockbrokersareaslikelyasanybodytobewrong.AclassiccasewasthecarmakerBritishLeyland.Forabouttwoyearspriortoitsdemise,investorsweregettingmoreandmorenervousabouttheunrulyunions,theshoddyworkmanship,theshort-sightedmanagementandthe
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increasingsignsthatthecompanycouldnotmakethecarsthemarketwantedandwasill-preparedtomaketheprofoundchangesneeded.Soitsshareslidsteadily.Nevertheless,stockbrokersqueuedupthroughoutthatinexorabletumbleintoinsolvencytorecommendthesharesasagoodbuy.
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Complaints
Ifsomethinghasgonewrong–inappropriateadvice,theinvestorbeingbadlytreated,orinstructionsnotbeingfollowed–thefirstandmostobviousstepistotakeitupwiththecompanyconcerned.Brokersandadvisersallnowhaveacomplianceofficerwhosejobistoensurethat
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therulesarefollowedandtotakeactionwhentheyhavenotbeen.
Ifthatfails,thenextstepistotaketheproblemtotheombudsmanand/ortheregulatoryauthority.Thisshowstheimportanceofensuringfromtheoutsetthatoneisdealingwithaproperlyrecognizedandauthorizedfirm.
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ChapterEightWhat does ittake to dealin shares?
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Mostadvisersreckon£2,000isthesmallest
sensibleamountforasingleinvestment,thoughmanyrecommend£3,000.Itispossibletodealinsmalleramountsatonetimebutitputsupanextrabarriertomakingareturn:stockbrokerssetaminimumpriceontransactionsandthedealingcostscanoverwhelmthe
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profitfromthetransaction.Ifyouaredealinginasmallcompany’ssharesthathaveawidepricespread(thedifferencebetweenthebuyingandsellingprice)thethresholdforpotentialprofitisraisedstillfurther.Andthereisalsoagovernmenttaxondealing(seepage102).
Forexample,ifthedealingcostis£20fora£500parcel,
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thesharehastorisebymorethan8percentjusttobreakeven,bearinginmindthelikelydealingspread.Thatmeansasharestandingat220pwouldhavetorisebyover18pbeforetheinvestorsawanybenefit.Itcanhappen,butitisjuststackingtheoddsagainstyourself.However,competitionamongstockbrokersisincreasing
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withthenumbersofsitesontheinternetgrowingdaily,sothecostcouldstartcomingdownandwithittheminimumeconomicinvestment.
MarkTwainsaidtherewasnothingwrongwithputtingallyoureggsinonebasket,butwatchthatbasket.Thatisunlikelytoworkforthestockmarket.Scrutinizeacompany
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withalltheattentionpossible,analyseitsfiguresandreadallthereportsavailableand,despiteallthefavourableindications,itcanstilldecline,togeneralsurprise.Suddenexternalchangescanoverwhelmsoundbusinesses,andineptmanagerscansofailtokeeptrackofwhatishappeningundertheirnosesthatnobodyoutsidenotices
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eitheruntilprofitwarningsshowthedepthoftheproblems,ortakeoverpredatorsortheliquidatormovein.
Forsafety,therefore,oneneedstospreadtherisksoveranumberofcompanies.Adecentportfolioevenforarelativelysmallinvestorwouldcontainatleast10companies.Thatisthe
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eventualsafehavenhowever,anditdoesnotmeaneveryonemuststartwithatleast£20,000goingspareforittobewortheventhinkingaboutthestockmarket–itjustmeansthesearethesensiblerequirementstoreducethemuch-publicizedrisks.Rememberthemainaimofinvestingistogetadecentreturnforan
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acceptablerisk.Withonesharetheriskisgreater,butthemorecompanies’sharesyouownthelesschancethereisofyourentirestockmarketholdingsuddenlycollapsingtonothing.Itispossibletobuildarangeofsharesovertheyears;indeedmostadvisersreckonitisagoodideatokeepalittlefloatofavailablecashtotake
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advantageofopportunities.Areallyrichinvestorcan
putmoneyintoproperty,fineart,venturecapital,currencyfunds,etc,andspreadequityinvestmentallroundthesectorsandtheworld.Thatwayallrisksarehedged.Formostofus,offsettingoneortwoofthedangersisthebestwecanhopefor.Thetwomostobviousrisksarethat
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themoneywillbeerodedbyinflation,andthatallofitwilldisappearthroughcorporateincompetence.
Itisageneralrulethatthelowertherisk,thelowerthereturn–whichgeneratesitsownobviouswarningthatifsomebodyisofferingmouth-wateringreturnsorevenaprofitthatseemsmarkedlyabovecomparable
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destinationsforyourcash,youmayrelyonit:thereisacatch.Theconversealsoholdstrue:thehighertherisk,thehigherthepotentialreward.Investinasingleshareandifyoustruckitluckytheinvestmentcanmultiplymanytimesinasingleyear,andforsomepeoplewithanappetitefordangerthatoffsetstherisk
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thatthecompanycouldfold,takingeverypennyoftheinvestor’smoneywithit.Ingeneralthisistodramatizewhatreallyhappens–inpracticeitisfarmorecommonfortheshareyouownneithertoburstthroughtheroofnorcrashthroughthecellarbuttopootlealonginthedoldrumsformonthsorevenyears,producinglittle
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movementintheprice.That£20,000maylooka
formidablesum–especiallyifonethinksaboutitastheminimumsafelevelofholding–butsetitagainstlifetimeearningsofover£1millionforevenarelativelylowly-paidhouseholdanditbeginstoseemalittlemoredoable.Ontheotherhand,ifthetotalcostslistedhereand
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theamountneededtoprovideareasonablysafeincomeseemoutofreach,therearelessdauntingalternatives,thoughstillwithalinktothebenefitsofthestockexchange,suchasinvestmentorunittrusts(seeChapter3).
Investment clubs
Analternativetomanaged,
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pooledvehicleslookedafterbyaprofessionalisaninvestmentclub.Thisisagroupofprivateinvestorswhopooltheircashandjointlydecidehowitshouldbeinvested.Thishastheadvantageofspreadingholdingsoveralargernumberofinvestmentsthananysinglemembercouldmanage,withouthavingtopaythefees
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ofaunitorinvestmenttrustorotherprofessionalmanagementcompany.Youforfeittheexpertiseoftheunitandinvestmenttrustpeoplebuthavethefunofpickingyourownshares(oranysortofinvestment)andgetasocialoccasionthrowninasabonus.Theattractionsarebecomingmorewellknown:in1997therewere
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about350clubs,buttheLondonStockExchangeestimatestherewere5,000by2009.
Theidealnumberofmembersforaclubissomewherebetweenthreeand20.Withmorethan20memberstheclubwillbecalledacorporationbytheRevenueandyouwillhavetostartpayingCorporationTax.
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ThespecialistcharityProSharepublishesahandbookwithsomeusefuladviceonhowtogoaboutstartingaclub;mostexpertsrecommendmembersreadotherguidanceaswelltogetabroadrangeofexpertise.Itisnotvitalanymemberreallyknowsabouttheintricaciesofthestockmarket,butitishandytohavearangeof
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knowledgeamongmembersabout,say,engineering,brewing,retailingandsoon.
Itisvitaltogettheorganizationsetuponaformalbasisortherecouldbesomeverypainfulsurprisesandargumentslater.Therearemodelrulesandconstitutionsavailable,whicheveryonehastosign.Thesesetout,amongotherthings,
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howpeoplemayjoinandleave,aunitvaluationsystemandhowdecisionsaremade.Awiderangeofotherissuesneedtobeagreed:thelevelofmonthlysubscriptions;whenandwherethemembersmeet;howdecisionsaremade;appointingachair,treasurer,andsecretary;anddecidingonbankers,stockbrokersandaccountants.Youhavealsoto
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decidewhethertheclubwillcontinuetoaccumulateaportfolioorwhetheritistohaveafinitelifeof,say,fiveyears,afterwhichtheproceedsaresharedoutamongthemembers.Somehavespecifiedthattherebenorecriminationsifaninvestmentgoeswrong.Also,someformalmechanismhastobesetupfortheholdings.
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Theycanbeheldbyonememberonbehalfoftherest(usuallythetreasurer),orbyanomineecompanysetupforthepurpose,orevenbyabank.Severalstockbrokershavepackagesforinvestmentclubs.
Youmightbeinvitedtojoinanexistingclub,inwhichcaseitiswisetocheckthatallthesedecisionshave
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alreadybeenmadeandareinaccordwiththesortofthingthatfeelscomfortable.Alsocheckthatthemonthlycontributionisinlinewithwhatyoucanaffordorwouldwanttoputin.
Ifthisroutesoundsfun,therearestillsomebasicconsiderationstopreventtearslater.First,onlygettogetherwithpeopleyoulike
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andtrust,andwhoseobjectivesandpreferencesaresimilartoyourown.Ifyoufancytakingapuntonthelatesthigh-technologystart-uporgoingforriskyrecoverystocks,itwouldbeamistaketojoinaclubwhosemembersreckonbuyingintoVodafoneisprettyracy.
Thecriteriaforchoosinginvestmentsvarywidely
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amongtheclubsbutmanyoptfortheriskierendofthemarketbecausetheclubparticipationisadditionaltotheinvestmentsmembershavealreadymadeontheirownbehalf.So,theyaregenerallyfairlyreadytogoforAim,technologystocksandthelike.Someevenextendbeyondthestockmarketandinvestinproperty,
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directlyorindirectly.Themainadviceoftheexpertsisnottoinvestinanythingyoudonotunderstandandmostprofessionalsstronglysuggestavoidingthecomplexandriskyendofthemarket,likederivatives.
Second,itisnotafreeridewhereyoucanrelaxonthecoat-tailsofmoreexpertandhardworkingmembers.Most
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clubsshareouttheworkandmakeitcleartheyexpectpeopletoparticipatebeyondjustputtinginthemonthlymoney,evenfiningthemiftheyturnuplateformeetings.
Mostclubsinvestwellunder£100amonth–acommonfigureisabout£20to£40–sothisisnottheprerogativeofthewealthy.Conversely,itisunlikelythe
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proceedswillallowanyonetoretireat30orbuyaCaribbeanisland.Butyouneverknow–theHampshirevillageofWhiteparishhasaclubthatmanageda49percentreturnonitsinvestments(andwontheprizeforbeingthebest),andevensomechildren’sclubshavemanagedreturnsprettyclosetothat.Severalhavebuilt
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portfoliosworth£500,000.Onlyafewhavedonesobadlythatmembershavelosttheircash.
Costs
Aswithsomanyotherthings,itismoreexpensiveinBritaintotradeinsharesthaninmanyotherindustrializedcountries.International
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comparisonshaveshowncheaperdealingoverseasandfewercomplaintsaboutspeedandinformation.SomeUSbrokersalsoallowsmallinvestorsachancetogetinonthegroundfloorbyparticipatinginaflotation–whattheycalltherean‘initialpublicoffering’,orIPO.
NotthattheUSbrokersthemselvesareuniversally
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regardedaskindlyphilanthropists.ThereisanoldclassicbookaboutWallStreet,reprintedregularlyoverthepast40years,whichcommentsonthewealthofbrokers–itiscalledWhereAretheCustomers’Yachts?Competitionandtechnologymaybechangingallthat.
ForalltheloudproclamationsbytheStock
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Exchange,smallindividualholdersarestillconsideredanuisance.Smallinvestorsdealinsmallamounts,whichcostjustasmuchtotransactaslargedeals,andtheshareholdersneedelaborateprotectionfromsharksandtheirownfollybecausetheymightsueorgeneratesnidestoriesinthenewspapers,andMPsarelikelytokickupa
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self-interestedfuss.However,themarketneedsthesmallinvestorasacounterweighttotheunimaginativeshort-termismofthemajorinstitutionalholders.Privateinvestorsgenerallyalsoprovideamarketforsmallercompaniesthatarenotpracticalinvestmentsformajorfinancehouses.
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Brokers’commissionThemaincostofdealingcomesfromthebroker’scommission.Itvariesdependingonthetypeofbroker,theamountofworkbeingdone,andthesizeofthedeal.
Somechargeaslittleas£5minimumfordealing,but
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mostbrokerschargearound£12to£15minimumpertransaction,thoughtherearebrokersgoingashighas£20to£25,withacommissiononaslidingscaleabovetheminimum,dependingonthevalueofthetransaction.Anorderof£2,500mightcost1.5percent,withtheratefallingto0.75percentorsometimesevenloweron
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majordeals.Theremayalsobeaone-offchargeofatleast£10forjoiningCrest,theStockExchange’selectronicregistryofshareholdings.
Asiteontheinternetcalledwww.fool.co.ukprovidesaguidetochargesofnetandtelephonebrokers.Itisnotcomprehensiveandsometimesmissesanewserviceorspecialoffersfrom
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someoftheparticipants.Itisnotunusualforanewentranttobuyabitofmarketsharebyenticinginthepassinginvestorthroughhavinganintroductoryperiodfreeofcharges.Otheronlinecomparisonsitessuggestotheroptionsbutallfurtherinformationneedsexamination.
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The spreadThereisalsothecostoftrading.Asanyonewhohasevertriedtosellasecond-handcarknows,thepriceofsomethingisverydifferentdependingonwhetheryouarebuyingorselling.Soitiswithshares,whichisfairenoughbecausethetraderneedstoeataswell.Tomake
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surethedealerdoesnotstarve,this‘spread’varieswiththerisk.SoFTSE100companieslikeVodafone,BarclaysBank,BritishAirways,etc,whichhavehugemarketcapitalizations,thousandsofshareholdersandaregularflockofdealseveryday,wouldhavearelativelynarrowspreadofunder1percent,andsomemaydropas
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lowas0.03percent;bycontrastatinycompanywithfewshareholdersandlittletradecouldhaveaspreadofaround10percent.
Thismakessmallcompaniesandtheirshareholdersunhappybecauseitcreatesaviciouscircle.Itismuchhardertomakeaprofitfromsmall-companysharesbecausethe
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pricehastorisefarmoretooffsetthewidespread.Thatdetersallbutthehardiestoptimists,whichthereforemeansfewertradesintheshares,soreinforcingthewidespread.
Advice andportfoliomanagement
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Ifyouuseafinancialadvisertohelppickinvestments,thereisobviouslyachargefortheresearchandfortheexpertiseinsiftingtheresultstoprovidetheadvice.
Somepeoplegetarealbuzzfromorganizingtheirinvestments.Thecombinationofgambler’shunch,rationalanalysis,theprospectofprofit,achancetooutsmart
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thehighlypaidprofessionals,andthearcanelanguageoffinancecombinetoproduceafascinatingpursuitforsomepeople.Thatislovelybecauseitcreatesthebestsortofhobby–thesortthatmakesmoney.
Withoutthatconfidence,enthusiasmandtime,onecanstilllookaftertheinvestmentsbutonamore
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intermittentbasis.ThesearethepeoplewhoreadtheCitypagesofthenewspapersandkeepuptodatewiththeeconomictrends;theyrevaluetheirinvestmentsreasonablyregularlyandthendecidewhatthebestcoursemightbe.
Aswithadvice,anotheroptionistosubcontractthatworkandgetprofessional
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help,notjustwithbuildingbutalsowithmanagingaportfolio.Thoughsomeindependentfinancialadvisersandassetmanagementcompanieswilltakeonportfoliosfrom£25,000upwards,manyofthecompaniesarereluctanttolookatyouwithlessthan£50,000toplaywith.Thefeestructuremeansitwould
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probablynotbeworthitiftheydid–andmanymanagersprefermorethan£100,000.Thiscanbedonethroughaformalscheme.Thatbringsadviceandcommentfromthestockbrokerbutstillleavesthefinaldecisiononbuyingandsellingandtheamountstobeputintotheinvestor.
Anotheralternativeis
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‘discretionary’management,whichpassesonthepreferencesandcriteria(seeChapters5and6onhowtosortthoseout)tothebroker/manager,whothentakesonthejobofpickingboththestocksandthetiming.Allthiscostsmoneyofcourse–eitheraflatfeeof,say,£1,000ayear,orapercentageoftheportfolio
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managed,whichcanbe0.5to1percentdependingonsize.Itgoeswithoutsayingthatyouonlygivethissortofpoweroveryourpersonalfinancestosomeoneyoutrust,buteventhenkeepaneyeonthem:somestockbrokershavebeendisciplinedfor‘churning’–continuouslybuyingandsellingtogenerate
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commissionforthemselves.Itisuptotheindividualto
decidewhethertheadvice,informationandmanagementareworththecost.Formostnovicesitmaywellbe,butastheygetmoreexperienced,learnhowtoferretoutfinancialdata,andgetusedtothewayitispresentedinnewspapersandmagazines,manydecidetostrikeout
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alone.Eitherway,ifafinancialadviserislookingafterstrategyorportfoliomanagement,docheckfromtimetotimewhethertheinvestmentperformancehasbeenbetterthanaverage,asthatcouldeasilyhavebeenachievedbyinvestinginatrackerfundorexchangetradedfund.Evenifitisbetter,asecondcalculation
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shouldshowthattheperformancewassufficientlybettertomorethanoffsetthemanagementfees.
TaxAfterthemarket-makers,stockbrokersandadvisershavetakentheirfees,thegovernmenttakesitsadditionalcutfromour
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savingsthroughataxcalledstampdutyreservetaxattherateof0.5percentonthevalueofeverypurchaseinUKequitiesofover£1,000(forUKcompanies,foreigncompanieswithaBritishshareregister,rightsandoptions),eventhoughitwasmadeusingincomethathadalreadybeentaxed.Formoreontaxation,seeChapter12.
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ChapterNineHow totrade inshares
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Investors shouldunderstand thatwhat is good for thecroupier is not goodfor the customer. Ahyperactive stockmarket is thepickpocket ofenterprise.
WARREN BUFFETT,CHAIRMAN, BERKSHIRE
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THATHAWAY
hestockmarketisnotinitsfundamentalsgreatly
differentfromthenewCoventGarden,SmithfieldorBillingsgatemarkets.Whetheryouaredealinginturnips,porkorhaddock,orthesharesofMarks&Spencer,itisjustamatterofbuyers,sellers,anagreed
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price,andusuallyamiddleman.Andjustasthefoodmarketsdonotencouragepeopletoambleinandaskforhalfapoundofcarrots,sotheStockExchangeisnervousaboutprivateinvestorspokingintoitselectronicsandthereforerequiresanintermediarytofeedtheinvestor’sinstructionsintothe
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computer.InBritainthefirst
recordedjoint-stockcompany(astheywerethencalled)wasfoundedin1553tofinanceanexpeditiontotheOrientviaanorth-eastpassage.TwooftheshipsshelteredfromstormsinnorthernScandinaviaandalltheofficersandcrewfrozetodeath.Thethirdmanagedto
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reachArchangelandthenwentoverlandtoMoscow–whichwasasneartotheOrientastheygot–wheretheTsar,IvantheTerrible,agreedatradinglink.Thatseemedgoodenough:thelinkcreatedbusinessconfidence,soothersfollowedthetechniqueforraisingmoney.
Withthegrowingnumberofjoint-stockcompanies
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beingcreated,asecondarybusinessarosetotradeholdings.AswithsomanyofLondon’sfinancialinstitutions(Lloyd’sofLondon,theinsurancemarketandtheBalticExchangeareotherexamples),itgrewoutofacoffeehouse,inthiscaseNewJonathan’s.Asbusinessgrew,thetradersmovedintoasuccessionoftheirown
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premisesandin1773acquiredthenameofStockExchange.
Ithasnotbeenanuntroubledhistory.OneofthemostnotoriousdisastersistheSouthSeaBubble.Itwasnotuniqueeitherintheshadybackgroundortheunhappyconsequences.
Thereusedtobe20otherexchangesaroundthecountry
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buttheywereamalgamatedintotheoneinLondon.Innormaldiscussion,itisthemainmarketorofficiallistofmajorcompaniesthatisbeingconsidered.Thisisdividedupintogroupingsbytrade.Thereisasectionfordistribution,oneforbanks,anotherforbreweries,andthereisthetechnologysector.Inaddition,thereisthe
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AlternativeInvestmentMarket,whichisforyoungcompanieswhich,bytheirnature,donothavethetradingrecorddemandedforafulllisting,orforsmallercompanies.ThereisalsotheProfessionalSecuritiesMarketforspecialistsecuritiessuchasconvertibles,debtordepositaryreceipts.Itis
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aimedatmarketprofessionalratherthanprivateinvestorsandtheinstrumentsaredenominatedatleastat€50,000.TheSpecialistFundMarketisalsosuggestedbythenameandisforfundsaimedatinstitutional,professionalorknowledgeableinvestors.
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How to buy andsell shares
Oneimportantdifferencefromtheworldofmeatandvegisthatinstockmarketsoneisatseveralstagesremovedfromtherealworld.Itisnotjustthatthesharesrepresentaninterestinacompanythatmaybemilesawayorevenoverseas,but
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increasinglythereisnotevenascrapofpapertoshowtheownershipofthatinterest,merelyacomputerrecordsomewhere.Andasthetradingbecomesmoreelectronic,withtradingfromone’sdesktopcomputerandwiththepaymentbeingjustanotherelectronicinstructiontotransferfunds,itisincreasinglybecomingmore
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ofacomputergame.
Usingintermediaries
Justaswithotherwholesalemarkets,thesmalluserneedsaprofessionaldealertocarryouttheinvestmentorsellorders.Thereisarangeofcompetingfirmsoffering
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services,andwhichoneyouusedependsonthetypeofserviceneeded,thoughthelinesbetweenthemareincreasinglyblurred.Mostofthemhavebothtelephoneandonlinetrading,thoughforsometrades–suchasoverseasshares–someinsistontelephonecontactonly.
Itisalwaystrickyfindingtherightprofessionalfirm,
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whetherarchitect,dentist,solicitorordoctor,andthatappliestoinvestmentintermediariesaswell.Itisnotjustamatteroffinancialcompetence,butalsooftechnicalefficiency.Therearebig,highstreetfinancialinstitutionssuchasbanksandbuildingsocietieswithbranchesroundthecountryandadvertisementsallover
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theplace.Therearealsogoodlocalfirmsexperiencedintheneedsofsmallinvestorsthatcanproduceperformanceequaltoanyofthebiggestnamesinthecountry.Andtherearehostsofcomputer-andtelephone-basedintermediarieswithvaryingspecialisms,costsandservices.Thebestwaytopickthecompanyisthrough
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recommendation,preferablyfromsatisfiedcustomers,orasasecondbestfromwrite-upsinnewspapersandmagazines.Withoutseeingthepeople,thebuildings,theorganizationandsoon,itishardtogetafeelforhowreputableorefficientthebrokeris,soaninvestorisdrivenfarmoretorelyingonreputation,recommendation
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andnewspaperopinion.Makesurethatthebroker
orintermediaryusedisauthorizedandhencesupervisedbytheCityauthorities.Notonlydoesitprovidereassuranceofsomequalitymonitoring,butprovidesawaytocomplainandseekcompensation.
Warning
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‘Phishing’messagesande-mailstryingtoextractpersonalinformationforfraudandidentitythefthavebecomecommonandquitesophisticated–theyoftenlookconvincinglyauthentic.Butaswiththeonespurportingtocomefrombanks,e-mailsfromtheFinancialConductAuthority,theBankofEngland,orthe
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Ombudsmanaskingforpersonalinformationormoneyarefakes.Sometimestheyevencreatefalsetelephoneswitchboards.Donotrespondanddonotaccessanyofthelinks.DeletethemandtelephonetheFCAon08001116768orsendane-mail:[email protected]
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Anuninvitedphonecallfrompeopleyoudonotknowtryingtosellsharesislikely
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tobeascam.Theyarefrom‘boilerrooms’–bogusstockbrokers,usuallybasedoverseas(sometimeswithaUKfreepostforwardingaddress).Youwillalmostcertainlyloseallthemoney.Itisnotjustnoviceinvestorswhoaredupedthisway.Mostofthevictimsareexperiencedinvestors,with41percentofvictimshavingbeeninvesting
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forover11years.Theaveragelossis£20,000withthebiggestindividuallossrecordedbytheCityofLondonPolicebeing£1.2million.Thescamsnetbetween£200millionand£500millionintheUKeveryyear.Theysometimespromisetorecovermoneylosttotheoriginalboilerroom,ortopurchasethose
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worthlessshares(onceanup-frontfeehasbeenpaid).Someoffertobuysharesyouown,usuallyatahigherpricethantheirmarketvalue,andaskforpaymentupfront,asaformofsecurity,whichtheysaywillbereturnedifthesaledoesnotgothrough.Theysometimesdemandsigningaformtopreventdisclosureoftheofferdetails.Some
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investorsareencouragedtosellpreviouslyhighlyregardedcompanyshares,suchasbanksandfinancialinstitutionsandtoinvestingreenornewtechnologyshares,oreventotakeoutloanstofundnewinvestments.Thesefraudstersareusuallywellspokenandknowledgeable.Theycanbeverypersistent,phoning
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manytimesandevensendingdocumentsorformstocomplete.Itisanadvancefeescam–theytakethemoneyandyouneverhearfromthemagain.Theymayclaimyouhavealreadyenteredintoacontracttobuythesharesandareunderanobligationtopay.ThisisnottrueandsuchcontractsareunenforceableunderUKlaw.Fraudsters
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occasionallyhavethegalltothreateninvestorswithpoliceactioniftheyrefusetogoaheadwithaninitiallyagreedtransaction.Thepolicesaythey‘donotandwouldnotactasadebtcollectionagency’.IftheytrythatonetellyourlocalpoliceforceorCityofLondonPolice.–Seehttp://www1.cityoflondon.gov.uk/CityPolice/Departments/ECD/Fraud/boilerroom.htm#sthash.cdL5LacD.dpuf
Generallyitisagainstthe
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lawto‘coldcall’tryingtosellinvestments,soauthorizedfirmsdonotcontactyououtoftheblueofferingtobuyorsellshares,buttherehasbeenadramaticincreaseinthefakeuseofnames,registrationnumbersandaddressesofpeopleauthorizedbytheFCA.Theyevencopythewebsitesofauthorizedfirms,making
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subtlechangessuchasusingdifferentphonenumbers.CheckontheFCAwebsiteifafirmisauthorized.
Thereisnorecourse,righttocomplainortocompensationintheUK,asboilerroomsarebasedoverseasandsonotauthorizedbytheFCA.Ifyouhavenotinvitedthecall,justhangup.
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Seealsowww.fca.org.uk/scams.
Ifyouhavebeencontactedbyanunauthorizedoverseasfirmorsuspectascam,forwardtheinformationtotheFCAorthepoliceastheyaretryingtopursuethecrooks,eventhroughgovernments.Theinitialcontactshouldbeactionfraud.police.ukorby
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phone03001232040.Thenthereistheconstant
fearthatonlinetransactionscanbeeavesdroppedbyshadycharacterswhomightuseyourparticularstodealfortheirownprofit,orhackintoyouroryourbroker’scomputerandtamperwithdata.Thereisalwaysthedangerofcomputerfailurestoo.Computersseemtohave
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reachedaboutthelevelofdevelopmentandreliabilityofcarsinthelate1920swhendrivershadtoknowaboutmagnetos,drivebeltsanddistributorstocopewiththecontinuousbreakdowns.Thatmeans,justwhenyouneedtodeal,oneofthemachinesmaybehavingitswicktrimmedoritselasticbeingchanged.Also,onlinetrading
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doesnotgeneratesharecertificates.Thesharesarestillregisteredtothenewowner,butitisallcomputerizedandgenerallythebrokerwillholdthetitletothemina‘nominee’account,whichisadministrativelytidybutcouldmeantheinvestorcannoteasilychangeallegiancetoanotherbroker.
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Aninvestorcanrequestapapercertificate.
Anotherdangeristheseductiveworldofcomputing.Sittingatahomescreenwithaccesstoallthatinformation,itiseasytobelulledintothinkingthedataarecomprehensiveandreliable,andalsointomakingasnapdecision.Italmostfeelslikeagameusing
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Monopolymoney,sooneisdrawnintomakinginvestmentsattheclickofamousethatcouldwipeoutthefamily’ssavings.
Tojoinoneofthegrowingbandofonlinestockbrokers,oneneedstogetonthewebsiteandfollowtheinstructionsforregistering.Manyofthemdemandacashaccountfromwhichpayments
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canbemade,withalmostallofthemrequiringafloatofcashdepositedwiththebrokerage.Thereisinterestonthis,butgenerallybelowwhatitcouldearnelsewhere.Thesigning-onprocedureasksyoutosetapasswordtopreventotherslookingat,muchlesstamperingwithyourinvestments,andexplainstheminimumlevel
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ofsoftwarecapabilityneededtogetintothesystem.
Technicalcompetenceandinfrastructureshowinthespeedandeffectivenessofreactionstotelephonecallsoronlinecontacts.Timingcanbecrucialinatradeandtherehavebeencomplaintsaboutthespeedofreactionandindeedtheabilitytogetanythingdone.In1999a
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Jersey-basedinvestorwhohadhiscomputerscreendisplayingsharepricescontactedhistelephonebrokerandsawthevalueofhisholdingshalvewhilethestockbrokerlefthimhangingonlisteningtoarecordedmessagetellinghimallcustomerserviceoperativeswerebusyandhewouldbeconnectedassoonasonewas
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free.Hewaskeptonholduntilsomebodycouldbefoundtotalktohim.Sogreatwerehisirritationandfrustrationatwatchingthecontinuingplungeofhisinvestmentsandhisinabilitytosellthathehadafatalheartattack.
Whenpickingabroker,therefore,itisusefultogetrecommendationsfrom
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experience,butafewquestionsarestillinorder,suchasservicequality,termsandconditions,includingredresswhenthingsdonotgoaccordingtoplan.
Stockbrokersactforindividualinvestorsbyexecutingtheirordersinthemarket,sothepuntertelephonesthebrokerwhoholdstheagreedaccountor
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morecommonlycontactsthefirmontheinternet–andgivestheordertobuyorsell.
Onlineintermediariesusuallydemandinvestorsdepositafloatbigenoughtocoverthedealandifitislargerthantheimmediatepurchasetheydopayinterestonituntilthemoneyisactuallyinvested.Peopleareunderstandablyreluctantto
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getinvolvedinanarearifewithunseendangers.Butitischangingrapidly.Customershappytoseeawaiterdisappearwiththeircreditcardfor20minuteswithoutworryingwhetherhewasnippinguptheroadforashoppingspreewerealsopreparedtoreadtheircardnumberouttosomeunknownpersonattheotherendofthe
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telephoneforanorder.Thesepeoplearenowincreasinglybuyingbooks,CDs,holidayticketsandthelikeonthenetandrelativelyfewhavebeenrippedoff.
Fromtimetotimetherearetalesofpimplyschoolboysextractingcreditcardnumbersfromonlinetrades,butfewpeoplehavelostmoneyasaconsequence
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anditisalotrarerthanhavingyourcarstolenoryourhouseburgled.Thedangerofsomehackergettingintoyourcomputerordealingatyourexpenseisprettyremote.Virusesareahazardbutcanbeavoidedbyhavingacontinuouslyupdatedviruschecker,whichappliestoanyonewhogoesontothenet.
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TherearemillionsofonlinestockbrokingaccountsinEuropeandthenumberisgrowing.Manyofthesepeoplehavelittleloyaltytoanybrokerormarket,butwilltradewhereitissafe,cheapandconvenient.
Themoreadventurous,whowanttobuyaUSshare,maywanttogothroughaUSbrokerintheUnitedStates.It
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isliabletobecheaperthantheBritishstockbrokers,andcheapereventhantheEuropeanoffshootsoftheUSbrokers.Asitethatcomparestheperformanceofseveralonlinebrokersoncosts,speedofserviceandotherbenefitsincludinghelpingsmallinvestorstogetasubscriptionatthetimeofthefirstlisting,is
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www.europeaninvestor.com.Oneofthebigthrillsinthe
UnitedStatesisdaytrading.Thisrequiresspottingthesmallfluctuationsandgettinginandoutofshareswithinoneday.Forallthefashionsandthehype,anddespitethemanybooksexplaininghowtomakeafortunefromthepractice,itlooksasifhardlyanyprivateinvestorhasmade
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anymoneyonthesystem.Manyloseheavily.
Allthiscanbeaccessedandorganizedfromanywhere,viatelephonesandcomputers,andsomebrokersarealsointroducingvoice-recognitionsystemstoprovidesharepricesoverthetelephone.Whetherthetradingintermediaryisastockbrokerorindependent
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financialadviser,therearethreebasicwaystheserviceisprovided–discretionary,advisoryorexecution-only.
DiscretionaryIneffecttheinvestorishandingovercontroltotheadviser.Itwillstillmeansettingouttheoverallplanorstrategyatthestart,as
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discussedinChapter5:thedegreeofrisk,thetimehorizon,thepreferenceforcapitalgrowthorincome,andsoon.Thatmeansaprolongedpreliminarydiscussionsettingoutthoseprioritiesandaims.Oncethebrokerknowswhatyouaretryingtoachievewithyourmoney,theadvicecanbemoresensibleandhelpful.
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Afterthat,however,itisalluptotheprofessionaltodecidewhatandwhentobuyandsell.Ithadthereforebetterbesomeonewhoseintegrity,judgementandeffectivenessyoutrust.
Thisapproachhastheadvantageofusinganexperiencedmarketoperatorwithaccesstomoreinformationonacontinuous
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basisthanisavailabletoalayinvestor.Italsohasthebenefitofswiftreaction–theadviser/stockbrokercanreactimmediatelytoamarketmovementandnothavetowaituntiltheinvestorhasspotteditorgivesapproval.Needlesstosaythereisaprice:onehastopayforexpertise.
Discretionaryservice
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demandsareasonableminimumamountofinitialcashorholdings–thelowestisabout£10,000but£50,000or£100,000ismorecommon,andthemanagementfeeisabout0.5to2percentofthesizeoftheportfolio.Theinvestorhandsovertheportfolioandgivesthebrokertherighttomanageasbestheorshecan,buyingandselling
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asseemsright.Onegetsaregularreportofwhattheinvestmentsareandhowmuchtheyareworth,plusnotificationofanydealings.Somebrokerswillalsotakeintothisservicemanagementofbankaccounts,pensionsandeveninsurance.
Independentorrestrictedadvisorsdonotofferdiscretionaryservice.Some
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brokermembersoftheWealthManagementAssociationdounderstringentUKandEUregulations.
AdvisoryInvestorswhowanttoretaincontrolovertheportfoliobutwouldstillliketohavetheprofessional’sadvicecanopt
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forreceivingsuggestions.Thisworksontheassumptionthatnoteverysuggestionwillleadtoatrade,oritmightbeeasiertohandthewholethingoverandlettheadvisergetonwithit.Atleastitallowsthenovicetolearnthewaymarketparticipantsthinkandthesortofstimulusthatpromptsaction,aswellasgettinginformedopinion.It
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couldbeatypeoftuitionprocessontheroadtotakingovertotalcontrolofone’sinvestments.
Anyfirmsuchasastockbrokerofferingadvicehastomeetsuitabilityrulesonthingssuchasriskandcoverageoftheclient.
Thereisobviouslyafeeforthisserviceaswell,thoughitislowerthanforthe
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completediscretionaryoperation.
Execution-onlyInvestorswiththeconfidencethattheyknowwhattheywantandhowtofindit,withenoughinformationandtimetowatchthemarkets,cansavethemselvesmoneybygoingitalone.Allthatis
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neededthenistogoonthewebsiteorthetelephoneandgiveinstructionsonwhatistobedone.Someofthebrokers/advisersprovidefreeservicestohelp,suchaselementarychartsandportfoliovaluations,aswellassomehighlightsfromstockbrokers’circulars.
Transaction-onlybrokersareavailablewidely,mostly
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online.Informationonlow-costbrokersisavailablethroughtablespublishedinmanyofthemoreseriousnewspapersandinvestmentmagazines.
Trading
Normallywhentheinstructionisgiventodeal,thebrokerwilltransact‘at
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best’–buyatthelowestavailablepriceandsellatthehighest.Anotheroptionistosetthebrokeralimit–setthemaximumatwhichyouarepreparedtobuyoraminimumpricebelowwhichyouarenotpreparedtosell.Usuallysuchlimitslastforonly24hours,thoughsomebrokersmaybepreparedtoacceptlongerinstructionsof
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thissort.Oncethetransactionis
completethebrokersendsacontractnotedetailingthedealandhowmuchmoneyistochangehands.Itmaytakealittletimetoreceivethesharecertificatebutthatisincidentalsinceitisyourpresenceontheshareregisterthatreallydeterminesownershipoftheholding.The
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inconveniencescanbecircumventedbyhavingthebrokerkeeptheholdingsina‘nominee’account(seepage139)orbyhavingthemregisteredinCrest,theStockExchange’selectronicregistryofshareholdings.
Stock markets
Wherestockmarketsusedto
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haveaphysicalpresencewherepeoplemetandhaggledaboutdeals,electronicshasliberatedthemsothedisseminatedmarketiseverywhereandnowhere.Thisispresentingtheauthoritieswithanincreasinglydifficulttaskinmonitoring,andpresentstheinvestorwithagrowingchallengetomakesurethe
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dealisauthentic,thepriceisrightandthesecuritiesreallyarebeingtransferred.
TheLondonmarketoperatesasoftwarecalledSeaqforthesmallestcompanytrades.Forthemajorityofdealingsthemarketusestheretailserviceproviderwhichaccountsfor94%ofretailtrades,therestgoingontoSets(theStock
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ExchangeElectronicTradingSystem)usedbyinstitutions.Thisisanorder-matchingsystem,sobuyersandsellersposttheirrequirementsandifpossiblethecomputermatchesthem.Sincethesescreensshownoteventhebroker,muchlesstheinvestor,onlythetwosidestothedealknowtheidentityoftheultimatebuyerandseller.
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ThereisalsoSETsqforthelessliquid(ielesstraded)securities.
CompanieshavebeenmovingtoSetsMM,anelectronicsystemthatinvolvesmarket-makers(hencetheMM)divulgingtheirbidandofferprices.TheStockExchangesaysthiscutsspreadsandincreasesthevalueofsharestraded.The
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completeddealispassedtoyetanothercomputertoorganizesettlement.TheCrestsystemistryingtoeliminatetheblizzardofpaperbyreplacingsharecertificateswithanelectronicrecordinmuchthesamewaythatone’shoardofgoldandcashhasbeentransformedintoaniteminabank’scomputermemory.Forthe
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mistrustfulandLudditeinvestors,sharecertificatesarestillavailable.
Manyoftheexecution-onlybrokerstrytosimplifylifebyputtingtheirinvestors’holdingsintoa‘nomineeaccount’.ThatmeansthesharesareregisteredtoonebrokeraccountintheCrestandthecompanies’shareregisters,whichmakethe
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dealsquickerandcheaper.
Other markets
Inadditiontothetraditionalmajorstockexchanges,manyofwhichareamalgamatingacrossboundaries,anewbreedofsmallerexchangeshassprungup,someaffiliatedtothebigones.Retailusersgenerallygetaccesstosome
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ofthesemarketsviatheirstockbrokerswhousethemasnecessaryforatrade.
AlternativeInvestment MarketUsuallyknownbyitsinitialsAim,thisisactuallymerelyapartofthestockmarketreservedforsmallerbusinesses.Theideaisthat
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eventuallytheymature,growandgraduateontothemainmarket,soitissometimescalledthe‘cadetbranch’ofthestockmarket.Thismeansthatyoungercompanieswithaless-solidorshorterrecordofprofitsareallowedtojoin.ButthecostsforthebusinessofgettingontoAimarealmostashighasforthefulllisting,sothemainattraction
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isthelowerhurdleandaccesstothemarketpublicity.AnotherproblemisthatAimshares,likesmallerquotedcompaniesonthemainexchange,goinandoutoffashionwithinstitutionalinvestors.
Thatprovidesanopportunityforthesmallinvestor.Shrewdopportunistswhospottedinternetstocksas
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havingagoodfuturewhentheyfirstappearedontheAimmarketmadeamassiveamountofmoney,sincesomesharesrosetenfoldinamatterofdays.Itisnoguaranteethough,becausetheself-sameshareslaterplummetedandsomeofthemuch-toutedbusinessescollapsedaltogether.Butthensmallercompaniesaregenerallymore
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vulnerabletoproblems.Companiesquotedonthis‘juniormarket’canalsosufferfromexaggeratedsharepricemovesastheyareoftenentrepreneurialbusinesses,inwhichthefoundersretainalargechunkoftheshares.
Sincethemarketwassetuptoprovideaccesstoyoungandsmallcompanies–importantforadvanced
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technologybusinesses–theaimwasforalightersystemofregulation.Butthishasbroughtcriticism,especiallyfromrivaloverseasmarkets,thatAimcompaniesaretoolightlyregulatedandhencelesssafe.
TechmarkWiththegrowingpopularity
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ofhigh-techcompanies,theLondonStockExchangelaunchedanindexinitsmarketcalledtechMARK.
Oneaimwastoattractsuchcompanieswhichhadthepotentialofrapidgrowthbutwithoutthetradingrecordtobeeligibleforanormalquotation.Astheliteraturepointsout,buyingsharesinthisareaisconsiderablymore
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risky,sincemanyoftheso-calledbusinessesarelittlemorethanabrightidea,andmanyofthemhaveneverseenprofits.
Thecompaniesarealsogroupedintotheusualindustrysectors,whichnowcontainawiderange,includingcomputersandtelecoms.Theiruseforinvestorsistomeasuretheir
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exposuretotechnologycompaniesinthesamewaythattheycanusesectorclassificationstomeasureexposuretobanking,engineeringorretailers.
High growthToattractmediumandlargecompanieswiththepromiseoffastglobalgrowth,an
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easierroutetothemarkethasbeendevisedfortheoneswhichmaynotmeetthenormaleligibilitytestsforafullmarketquote.TheymustbeintheEuropeanEconomicArea,tradingandwitharecordofgoodgrowth.
EuronextThisistheshareand
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derivativesmarketcreatedfromtheamalgamationoftheexchangesinAmsterdam,Brussels,LisbonandParisplustheLondonInternationalFinancialFuturesandOptionsExchange.ItthereforebecamethesecondlargestinEurope,behindLondon.
Eurex
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TheGermanDeutscheTerminbörseandtheSwissSoffexcombinedtobecomeEurex,Europe’slargestderivativesexchange.
ISDXAsmallLondon-basedstockmarketwhichboughtanotherofthesmallerstockexchanges,PlusMarket.
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TradepointAmidgetrivaltotheLondonStockExchange,Tradepointisacompletelyautomatedelectronicorderbookmarketstartedin1995,whichcuriouslyenoughisitselfquotedontheAimpartofthemainStockExchange.Thebusinessis54percentownedbyaconsortiumofbanks
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includingtheUSmerchantbanksGoldmanSachsandMorganStanleyDeanWitter.IthasformedanalliancewiththeSwissexchangeSWXtocreateanewexchangecalledVirt-X,regulatedbytheLondonauthorities,inwhichtheSwisshavea38percentstake.
InadditiontotradinginthenormalUKquotedstocks
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(thoughithasonlyabout1percentofthetotaltrade),ithassetupclearanceandregistrysystemstoallowtradinginEurotop,the300largestcompaniesinEurope.
NasdaqNasdaqistheacronymfortheNationalAssociationofSecuritiesDealersAutomated
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Quotationsystem.ItissecondonlytotheNewYorkStockExchange(oftencalledtheBigBoard)asthelargeststockmarketintheUnitedStatesandisoneofthefourbigonesintheworld.Asithaskeptcostsofentryandadministrativedemandscomparativelylow,manyyoungcompanies,especiallyintechnology,haveoptedto
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bequotedthere,includinginternetcompaniesliketheAmazonbookshop.Some,likeMicrosoft,DellandIntel,stayedtheredespitetheirsubsequentgrowth.
Ithascounteredthethreatoftheinternet-basedsharetradingsystemsbyforgingallianceswithsomeofthem.Thereisagrowingnumberofsuchschemes,includingones
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runbyBloomberg,ReutersandMarketXT.Thecomputer-basedsystemscanpostquotesandexecutetradesonNasdaqIntermarket,includinginsharesquotedontheNewYorkStockExchange.
TheoperationhasopenedaTokyomarket,hasaLondonofficeandisorganizingapan-European
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operation,whichshouldmakeitaglobalexchangewithapermanentandcontinuoustradingsystem.
Nasdaq OMXEuropeEasdaqhasusedtheprinciplesandthesoftwarefromNasdaqtostartaParis-basedoperationbutwith
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markedlylesssuccess.
Chi-XChi-XstartedoperatinginMarch2007,backedbyJapaneseinvestmentbankNomura.Theventureclaimstoofferasystem10timesquickerand10timescheaperthanexistingtradingsystemsandallowsinvestorstodeal
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inEuropeanstocks.
BATS EuropeThiswasfoundedoutoftheUnitedStates-basedtradingsystemBATS,markingitsmoveintotheEuropeanequitiesmarket.Itwentliveinlate2008.
NYSE Arca Europe
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Thisisanotherpan-Europeantradingfacility,whichisfullyintegratedintotheNYSEEuronextsystems.ItisregulatedbytheDutchregulatorAutoriteitFinanciëleMarkten.
Other routesElectronictradingexchangesmayemerge.Theinternetis
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continuouslyprovidingnewopportunities.TwomarketfacilitiesalreadyrunningarecalledPositandInstinet,whichareprincipallyforinstitutionalinvestors,butothersarepromisedorattrialstages.
Thereisalsotalkofdisintermediation(cuttingoutthemiddleman)bycompaniesraisingcapital.Raising
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moneybyapublicissueofsharesisacostlybusinessforacompany,notleastintheenormousfeestoaccountants,lawyers,stockbrokersandmerchantbanks.Itwouldbeattractiveifallthiscouldbebypassedbymakingthesharesavailableoverthenet.Smallinvestorsfortheirpartseldomgettheirhandsonnewissuesbecausetheyare
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snappedupbeforetheygetthere,ormoreoftencompaniesoptforthecheaperrouteofplacingtheissuewithinstitutions.Itcouldbedodgyforthesmallerinvestor,however,sincetherewillbelessassurancethattheprofessionalshavecrawledoverthebusinesstocheckitsfigures,managersandpromises,anditisdifficultto
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tellfromthepuffappearingonthescreenwhetheracompanyevenexistsasdescribed,muchlesswhetheritsmanagersarecompetentandhonest.
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Chapter TenWhen todeal inshares
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Never be afraid ofmissing the boat – itmay turn out to bethe Titanic.
ELLIOT JANEWAY
The early birdcatches the worm,but the secondmouse gets the
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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
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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’
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Tquestionsistobuywhentheyarecheapandsell
whentheyaredear.Predictably,thereareproblemsinvolved,includingdecidinghowyoudefinecheap,findingthestockthatischeapanddecidingwhetheritischeaporjustapoorbet.Soimportantisthisaspectthatexperiencedinvestorswilltellyouitis
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moreimportanttojudgewhentobuythanwhattobuy.
Oneproblemwiththestockmarketistheherdinstinctthatdrivesithitherandyononsuperstition,greed,fashionanduncertainty.Sowhenthemarketisrisingeverybodypilesinbecausetheyfearbeingleftoutwhenthereare
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profitstobemade.Theyareconvincedthattrendswillcontinue,sonomatterwhathashappenedsofar,sharesarecheapbecausetheywillprobablygofarhigher.Inthereversephase,investorsprivateandinstitutionalsellshareswhich,onmostcriteria,wouldbereckonedcheap,becausetheyexpectthemtogoonplunging
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further.In1710to1720aseriesof
‘bubble’companiesburstontothestockmarket,ofwhichtheSouthSeaCompany(actuallythefullandsplendidlyrollingnameoftheenterprisewasTheGovernorandCompanyofMerchantsofGreatBritainTradingtotheSouthSeasandOtherPartsofAmericaand
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forEncouragingFishery)wasmerelythemostnotorious.Itsshareswereissuedat£100andstarted1720at£12810s0d.ByAugusttheyhadreached£1,050butfinishedtheyearbackat£124beforethecompanycollapsed.Theboomwasgeneratedbymadenthusiasmoveracompanythattookoverthenationaldebtinreturnforhavinga
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monopolyoftradeinthePacific.Thenpeoplerealizedthecompanywasmorepreoccupiedwithrampingitssharesandprovidingdirectorswithagoodlifethanwithanybusiness.Thatcausedthebubbleandthecompanytoburstandtheshockwavessentotherstoppling,asbanks,shopsandindividualswentbustasaresult.
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Inthe1830sitwasrailwaymania,withanycompanyevenvaguelyconnectedwithtrainsbeingrelentlesslypursuedbyinvestorswantingtoputyetmoremoneyintoit.Morerecentlywehavehadotherenthusiasms.Atonetimebeingincomputerswasalltherageandanythingtodowithelectronicssawitssharesknocktheroofoff.The
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internetgrabbedtheimaginationtoproduceeye-wateringsharepricerises.Latertheenthusiasmmovedontobiotechnologywhenmiracledrugs,‘silverbullets’andpanaceaswerereckonedimminent.
Youcanrecognizeabullmarketreachingitspeakbytheunanimityofopinionthathappydaysarehereagain.
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Eventhetabloidsstarttalkingaboutthestockmarket;therearepictureseverywhereofchampagne-swillingyoungdealers;seriouseconomistssayingthistimeitisdifferent;peoplewhowouldnotnormallyknowabalancesheetfromabedsheetstartbuyingshares;andthesharesthemselvesareonabsurdlyhighprice/earningsratiosand
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lowyields.Asignthemarketisprettywellatthebottomiswhensharepriceshavebeendiscountedfordoomsday–priceshaveallowedformoremassiveslumpsthanitisrationaltoexpect.Infactthesharepriceshaveanticipatedsomuchbadnewsthattheynolongerreacttoitwhenitcomes.Ontheotherhand,thepricedoesstarttostirandrise
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abitwheneventheslightestglimmerofgoodnewscomesalong.Thatisthetimetostarthuntingforgoodvalue.
Theturnhappensinoneoftwoways.Thereiseitherasuddentriggerlikeahugeandswifthikeinthepriceofoil,bankssuddenlyrealizingtheyhavebeenlendingmoneyonfresh-airsecurity,orjustalassitudewhennothingseems
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quiteright.Thesharesfailtorespondtogoodnews,butrelapseateverysignofadversenews.Thatiswhentostopbuying,attheveryleast.Similarlyatdownturnsinstitutionsandprivateinvestorspreparefortheendofcapitalismasweknowit.Thebottomisnighwheneverybodyagreestheeconomyisslidingandwill
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staylowforatleasttwoyears.
Tobefairthereisalsoinpartarationalreasonforallthis:duringboomspeoplehavehigherdisposableincomebothfordirectinvestmentandforpensionsandinsurance(withthosecompaniesthenchannellingpartofthecashintothemarket),whileduringa
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recessionthereisunemployment,negativeequityinone’shomeandanabsenceofpayrises.
Whenthemarkethasbeenslidingforsometimethecarefulinvestorwillstarttocheckwhetherthebottomcanbeinsight.Youhavetofacethefactthatyouareveryunlikelytobuyattheabsolutebottomortosellatthevery
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top.Ifyoumanageeither,nevermindboth,admitittobeapurefluke.Sotherearetwopossibletimings:whenit(themarket,thesector,theindividualshare)isstillheadingdownbutonehasareasonablefeelingtherecannotbemuchfurthertogo;andwhenpriceshavejusttentativelystartedcomingoffthebottom.Getthetiming
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wronginadownturnandthepriceswillcontinuetotumble,andittakesahardysoulwithagambler’sinstincttogoinfor‘poundcostaveraging’–puttingthesameamountinagainasthepricefallstogetevenmoreshares.
Thatsortofthinkingappliestothemarketasawholeandalsotoindividualshares.Averysuccessful
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largecompanyintowhicheveryonehasputtheirpensionmoneyforyears,suddenlystumbles.Itmakesafewmistakes,losessomeorders,miscalculatesthemarketorwhatever,andissuesaprofitwarning.Thedisillusionhitstheprofessionalssobadlythattheyabandonthefallenstarindroves.Thoughsmall
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companiesdieindozensandtheoccasionalmiddle-rankcompanysuccumbs,itisfairlyrareforamajorcommercialundertakingtogobellyup.TherehavebeentheLeylands,PollyPecksandthelikeovertheyears,butthatisstillprettyunusual,andmassivecollapsessuchasthe2008foldingofLehmanBrothers,oneofWallStreet’s
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largestbanks,arethankfullyrarerstill.Butasthatshockwave-causingfallshowed,theycanstillhappen.Eveniftheboardcannotimmediatelyretrieveitsmistakes,bringinnewmanagersorjustgetbackonitsoldtrack,thereisagoodchancesomebodywillbewaitingtosnapupthebusinessinatakeover.
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Atthesimplestlevel,muchoftheinvestor’saimcanbeachievedbybeingjustcounter-cyclical:seewhichwaytheherdgoesandheadtheotherway.Ontheotherhand,ittakesstrongnervestobuyinabearmarketwhengloomanddespondencysuggestshareswillplungefurtherandcompanieswilltoppleoverbythescore.It
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alsotakessternself-disciplinetotakeprofitsinaroaringbullmarketknowingsharesmaywellrisefurtherandoneisthereforeforgoingsomeoftheextraprofit.Thereis,however,anoldstockmarketadageforsuchdealing:alwaysleavesomeprofitfortheotherfellow.
Likeallothercontrarianviewsittakescautionand
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care.Thepeoplewhospecializeinthissortofinvestmentnormallywaituntilthefirstandsecondtumbleshaveworkedthroughthemarketandthesharepriceisbumpingalongasteadylow,beforestartingtobuy.
Therearetwosetsoftimingstoconsider.Oneconcernsthemarketasawhole,andthesecondisfor
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theindividualsharethathasalreadybeenidentified(bythedecisionsdiscussedinChapter5).Amongthefactorsaffectingthemarketasawholeare:
thegeneraleconomiccycle(andthatcouldbeanythingfromarecoverytoaslowinginanticipationofa
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recession);thelevelofinflation;interestrates,sincetheyaffectconsumerdemandaswellasthecostsofbusinessandhenceitsprofitability;taxlevelsandthechanges;therelativestrengthofthecurrency,sincethataffectsthecostsof
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importsandthecompetitivenessofexporters;thepoliticalsituation,includingtheproximityofelectionsandwhoislikelytowin.
Thereareotherinfluencesaswell.Forinstance,theLondonstockmarketreactsinsympathywithUSstock
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markets.Thisprovidesthebackgroundforlookingatandtryingtoextractinformationfromrecentpricemovements,andsetsthecontextforexaminingindividualcompanies.
Attheendofthe19thcenturyCharlesHDow,whohelpedstarttheDowJonesIndexfortheWallStreetStockExchangeaswellas
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foundtheWallStreetJournal,detectedapatterninsharepricemovements.Hereckonedthesefollowedaregularenoughprogressiontobeabletoforecastwherethepricewillgonext.
TheDowTheorysaystherearegreatlong-termpatterns,called‘primarytrends’,whichcreatethebullorbearmarketsthatcan
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dominateaneconomyforseveralyears.Withinthatthereareshorter-termfluctuationsthatgoagainsttheoveralltrend,reinforceit,orpredictitsturn,andthesehecalled‘secondaryreactions’.Finally,therearethedailyoscillationsthatarecalled,predictablyenough,‘tertiarypatterns’.
TheaccountantRalph
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Elliottworkedonagranderscale.Hetalkedof‘supercycles’lasting150to200yearswithinwhichthereareshorterfluctuations.Therearemanybooksonsuchtopics,buttheyareprobablyatouchspecializedforanamateurinvestor.
Withinthesegrandeconomiccyclesarepricemovementsofthemarketand
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ofindividualshares,andifthetrendorpatterncanbespottedintimethereisanopportunityforprofit.Thisistheprovinceofthetechnicalanalystwhoreliesprincipallyonchartsofmarketchanges.Atthemostbloodthirstythesepeopleassertitisnotnecessarytoknoweventhenameoftheunderlyinginstrument,whetheritisa
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share,acurrencyoracommodity,becauseeverythingisintheprice.Moreparticularly,thepriceissetbymarketpsychologyand,sincehumanbehaviourisfairlyconstant,thepatterncanbeextrapolated.Thetrickisthereforetodetectpatternsintimeandthenactonthem.Thatrequirescharts,usuallyofpricemovements.
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Chartsrepresentoneofthetwomainwaysofassessingashare.Theotherisfundamentalanalysis–thestudyofthecompanyanditsaccounts,themarketsinwhichitoperates,andthequalityofitsmanagement(seeChapter6).
Theaimofalltheseistoreinforceothercriteriaforchoosingashareoratimefor
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buying,andnottousetheminisolation.Thatappliesalsotodifferenttypesofchart.Checkingtoseehowthepriceofacompany’ssharemovesinrelationtothemarketasawholeissometimesanindicationtohelpwiththedecisions.Shareswithawildlyfluctuatingrelativestrengtharelikelytobeunpredictableperformersand
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soamoreriskyinvestment.Ontheotherhand,ifthecompanyhasforsometimebeensagging,withthesharesconsistentlyunderperformingthemarketasawhole,anditsrelativestrengthstartsimproving,thismightunderlinethedecisiontobuythatwaspromptedbyothersignals.Thesemaybebetteratgivingaddedinformation
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aboutindividualsharesthanaboutthemarketasawhole.
WilliamDGann,amathematicianandsuccessfultraderinsharesandcommodities,producedavariantofthis,concentratingmoreonsupportandresistancelevelsandthespeedofpricechange,buttheexplanationiswellnighincomprehensibletoanyone
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withlessmathematicalexpertise.ItslinktoChinesehoroscopeshasprovokedsometradersintodismissingitasmumbo-jumbo.
Thepatternsinsharepricescanbeexplainedbypsychologicaldescriptionsofthewaypeoplebehave,andtheseseemquiteplausible,butnottotheacademicswhohaveusedmathematical
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analysistoproducethe‘randomwalk’theory.Thissaysthepricesmovetotallyunpredictablyandchartingthetossingofacoinwouldproducesimilarpatterns.Inaddition,theefficientmarkethypothesissaysinformationissoswiftlyanduniformlydisseminatedthatnobodycangetanadvantagetooutperformthemarket.That,
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however,ignoresthetimefactor,andtheobviousfactthatsomepeopledoverynicelyindeed,thankyou.
Itisnotquiteasstraightforwardasabriefexplanationmakesitsound.Eveniftherandomwalktheoryandefficientmarkethypothesisaredismissedasbeingnotuniversallyapplicable,thereareproblems
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withcharts.Forastarttheyrequireexpertinterpretationofshapesthatareseldomassimpleandobviousastheillustrationsinbooks.Justwhendoesafluctuationindicateaturnandwhenisitmerelyatemporarycorrection?Evenwithotherfinancialknowledgetotesttheplausibilityofanindicator,andevenwith
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extensiveexperienceinterpretingcharts,thechancesofmakingamistakearehigh.Thatmeansmakingafalliblesubjectivejudgementaboutadevelopingpattern,andsomepeoplearebetteratthisthanothers.Falsesignalsandeasilymisinterpretedpatternscouldleadaninvestorintopenury.
Forinstance,onetaskisto
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assesswhetherthecurrenttrendislikelytocontinue–ifyouareinaboommarket,willtheeuphoriacontinuelongenoughtobuythesharesandreapthebenefits,andifitisasoggybearmarket,canyoupredictwhenitislikelytoturnupagain?Thisismadealltheharderbytheshort-termfluctuationswithinthelonger-termmovements
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or,asthedistinguishedeconomistSirAlecCairncrossputit:
Atrend(tousethelanguageofGertrudeStein)isatrendisatrend.Butthequestionis:willitbend?Willitalteritscourse,Throughsomeunforeseenforce,Andcometoaprematureend?
Thesecondproblemisthatifchartswerereallyhelpfuland
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accessible,theywouldgetwidelyadopted,otherinvestorswouldrelyonthedevelopingpatternandtheself-fulfillingprophecieswouldrunawaybeforetheamateurcouldgetinvolved.Therewouldalsoberepeatedattemptstospotthedirectionofdevelopmentbeforeitwascomplete,whichwoulddistorttheshapesandcause
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confusion.Professionalsdonotrely
onchartsasthetriggerorguidance,butusethemasanadjuncttootherinvestmentcriteria.Whatthisallboilsdowntoistryingtogetadditionalhelpontiming.Thatmeanstimingnotjustfortheindividualcompanybutforthesectorandthemarketasawhole.That
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applieswithequalforceonwhentobuyorsell.Ameasureofhowwell-pricedthesharesareistheyieldgap.Thatisthedifferencebetweentheyieldonordinarysharesandthereturntomaturityofgilts.
Charts
Chartsareausefuladjunctfor
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theprivateinvestorbecauseforoncethereisparitywiththeprofessionals.Bothhaveaccesstothesameinformationanditistheskillininterpretingthedatathatmakesthedifference.Butjustasthereareswarmsofpeoplewiththeirownpettheoriesonhowtopickthewinners,sotherearefanaticalchartistslookingforthephilosopher’s
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stone.Theirgreatestvalueistofocusthemindonthefactthatinamarketthecorrectpriceiswhatsomebodyispreparedtopay,sochartsdoprovideabitofdisciplineforprivateinvestorsbymakingthemconcentrateonsupplyanddemand,priceandtiming.
Lines
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Forsuccessfulpredictionsyouhavetobeabletorecognizethepatternsthatanyoftheselinesfollow;seeFigure10.1.Therearetheoveralltrendsforinstance–up,downorsideways–detectablebyjoiningthepeaksandtroughs(orbartips)ofthefluctuatinglinesofprices.Inasidewaysmarket,whentheprice
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oscillatesbetweentwohorizontallines,awisechartistwaitsfora‘breakout’signalwhenthepricefinallyshowswhichwaythemarketisnowgoingtogo.
Figure 10.1 Lines
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Oneanswerisnottoworryiftheshareistakingafavourablelong-termpath.Forinstance,takeacompanywithsharesthatarenotoriouslyvolatile–itmaylooklikeasidewaysmovementbutthetwotrendlinesarealongwayapart.Thepricebouncesupanddownonrumourandgloom,
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orprofit-takingandbargain-hunting,withoutanyobviouslong-termdirection.Foranalertinvestor,thatcanprovideanicelittleearner.Justexaminewhenandbyhowmuchittendstooscillateandkeephoppinginatthebottomandoutatthetop.Thisissaferinlargishcompanies,whichalsomeansthegainswillnotbe
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enormous,sothedealshavetobelargeenoughtooffsetdealingcosts.
Thechartpatternshavegraphicnamestohelp.A‘supportarea’canbedetectedbythepricedroppingtobutconstantlyreboundingfromaspecificpricelevel,andthereisanupwardequivalentcalleda‘resistancelevel’.Ifthemarketbreaksthroughthe
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establishedresistancelevel,chartistsreckonthepricewillrisesubstantiallytoanewhigh,andsimilarlyinreverseforbreakingthroughasupportlevel.
Therearealso‘doubletops’,whichasyouwouldexpecthavetwinpeaksandindicateanimminentdrop,witha‘doublebottom’beingtheupside-downequivalent,
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A‘headandshoulders’isapeakflankedbytwosmallerpeaksandindicatesthereversalofanupwardtrend,signallinganimminentfall.Understandably,a‘reversedheadandshoulders’isthesamethingupsidedown,forecastingarise.
‘Flags’areparallelogramswithamastdownatleastonesidewhenasharpchangeis
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followedbyasidewaysfluctuationwithinanarrowrange.Iftheflagisprecededbyariseitisusuallyfollowedbyanotherrise,andafallisfollowedbyafurtherfall.
‘Triangles’areprettyself-explanatory.Thesharepriceoscillatesthroughasteadilysmallerrange.Whenitfinallybreaksoutofthepattern,thedirectionissaidtobean
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indicatorofthewayitwillmoveforatime.
Ifasharehasbeenwobblingalongforalongtimebetweentwoconstantlimits,itissaidtobeina‘channel’andonceagain,breakingoutofitisnormallyanindicationofthenewdirectionthepriceisnowlikelytotake.
Whenashortmoving
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average,suchasarollingaverageof20dayscrossesalongermovingaverageof,say,50daysupwards,itiscalleda‘goldencross’.Itpromisesabigpriceriseandisanevenstrongerindicationifthetwomovingaverageshavebeenmovinginparallel,asitindicatesareappraisalbythemarket.Ifthelinecrossesdownwardsitiscalleda
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‘deadcross’andpresagesagloomyoutlook.
Awealthofotherpatternscanbedetectedbythepractisedandimaginativechartistandtheyallprovidesomesignalaboutthefuturedirectionofprices.
Bar chartsBarchartshaveverticallines
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withthetopindicatingthehighestpricetradedatduringtheday,andthebottomrepresentingthelowestprice;seeFigures10.2and10.3.Theclosingpriceisshownbyashorthorizontalledgeontheright,andtheopeningpriceontheleft.Iftheleftopeningpriceislowerthantheclose,theverticalbarisblack(sometimesblue).Ared
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barsignalsthestockhasgonedown.
Figure 10.2 Bar chart
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Figure 10.3 Bar chart
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Point and figurePointandfigurecharts,asshowninFigures10.4to10.6,selectanappropriateamountofpricechangethatisworthrecording,say5p.
Figure 10.4 Point andfigure chart
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Figure 10.5 Point andfigure chart
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Figure 10.6 Point andfigure chart
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Ifthesharerisesbythat,thechartshowsanx;anotherriseofthatamountandanotherxisstackedabovethefirstandsoonuntilthepricechangesdirection.Thenthechartistmovestothenextcolumnandonesquaredownfromthelineofcrossesputsano.Ifitdropsanother5ptherewillbeanothero
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beneaththatandsoon.Areversalstartsanewlineonesquareupwithanx.Thechartignorestime,thoughchartistsusuallyputthenumberofthemonthofanewstackatthetopandbottom–1forJanuary,2forFebruary,etc–andusuallystartanewyearwithanewstack.
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CandlesticksAnothertypeofchartthathasgainedinterestinrecentyearsisthe‘candlestick’(previouslyknownasthemorestraightforward‘barchart’).ItismucholderthanDow’stheories,havingbeenusedbyJapanesericetradersforcenturies,butworksonthesameassumptions:price
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changesmoveinpatternsthatrecurandhencearepredictable.Despiteasmallbutdevotedfollowingamongsomeprofessionals,includingcurrencytraders,thisiswidelyignoredbypeoplediscussinginvestment.
Figure 10.7 Candlestickchart
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Figure 10.8 Candlestickchart
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Figure 10.9 Candlestickchart
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Thechartshowsforeachdaytheopeningandclosingprices,aswellasthehighestandlowestpricesreachedduringtheday(seeFigures10.7to10.9).JustastheOccidentalchartshavenamesforregularorsignificantpatterns,sodoesthis,butwithanOrientaltwist.Therearethingscalled‘threeblack
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crows’and‘threeadvancingsoldiers’,‘shootingstars’,‘morningstars’and‘eveningstars’,‘hangingman’,‘hammers’,andsoon.Thesechartsshowhowtradingwent.So,forinstance,ifthereisalotofwickabovethecandletheremusthavebeenarallyduringthedaythatfailedtoholdandwillhavediscouragedtraders.
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Converselyalengthofwickdanglingoutofthebottom(calledthe‘hammer’)showsthatanabundanceofsellersthreatenedtopushthemarketdownbutthereweremorethanenoughbuyerstooffsetthem,sothemarketbouncedoffthebottom,whichgivespromiseoffurtherrises.
Thewickofeachcandlerunsfromthelowtothehigh
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thatwasreached.Thewiderbodyofthecandleisbetweentheopeningandclosingprices–iftheclosingpriceislowerthantheopeningthecandleisblack;ifhigheritiswhite(theoriginalJapaneseversionusedredforthese).
Technical tools
Noneofthesechartsneedsbe
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usedonitsown.Awealthofadditionalinformationonthechartwilladdalevelofperspectiveorevenexplanation.Forinstance,addingthemovementofanindex–whethertheFTSE100,theAllShareorthesectorofthatcompany–canshowwhetheritismovingwiththemarket.Ifitisnot,thatmayprompt
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furtherresearch.Itisalsopossibletoseetherateofchangeofapriceovertheselectedtimespan.
Transformingthechartlinetoamovingaveragecansmoothoutthedailyfluctuations.Makingitaweightedaveragegivesgreaterweighttomorerecentpricemovements,andmakingitanexponentialweighting
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addsgreatersophistication.Thatsortoftoolhelpsspotatrendorachangeinone.
Ifyoucanfindawebsitethatalsoprovidesannotationstothecharts,thatwouldgiveyetanotherinsightintowhatishappeningandwhy.Themostusualtypeofnotesincludedealingsinthecompany’ssharesbyitsowndirectors,andnewspaperor
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stockbrokercommentsonthecompany.
Therelativestrengthindexmeasuresthelevelofasharepricerelativetoitselfanditsrecenthistory.Itiscalculatedastheaverageofpricesfordayswhenthepricerose,dividedbytheaverageofthepricesfordayswhenthepricefell.Theindexrangesbetween0and100.
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MomentumRecentpricechangesshowthesentimentofthemarket,sotheassumption–justifiedbysomeresearch–isthatwhatevercausedthemtomoveinonedirectionwillcontinuetodosoforatleastalittlelonger.Itisnotinvariablyasoundinvestmentpolicy,notjustbecausethe
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marketisnotoriouslyfickle,butbecauseitrequirescontinuouslyactivetradingatalevelwhereanyprofitsmaybeunderminedbycostsandtax.
Forthoseinterestedinthesuggestion,astochasticoscillatorcanbeusedthatshowsthelocationofthelatestclosingpricerelativetothehigh/lowpricerangeover
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asetnumberofperiods.Itismadeupoftwolinesthatoscillatebetweenaverticalscaleof0to100:oneisthemainlineandtheotherisitsmovingaverage.Faststochasticistheaverageofthelastthreevalues,andslowstochastichasaspecifiedperiod.
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Sentimentindicators
Technicalanalysisisnotjustaboutcharts.Therearehostsofotherindicatorsprovidingadditionaloralternativepointerstomarketmovementsandhencetipsonwhentotrade.Someofthemworkonindicationsofgeneralsentimentinthe
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market.Oneofthedifficultieswithanyoftheseguides,ofcourse,isthatassoonastheybecomegenerallyknowntheyfailtoprovidereliablesignals.
Anexampleisthe‘small-lotindicator’(smalltradesinshares)asausefulcounter-indicatorintheUnitedStates.Thisworksontheassumptionthatsmallinvestorsare
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almostinvariablywrong.Theybuyatthetopandsellatthebottom,sotheyprovideagoodcounter-indicator.Thishasbeengraduallyextendedasitbecameclearitwasnotjusttheamateurswhogotcarriedawaybytheprevailingorfashionableeconomicview:itbecameslightlytransformedtothefeelingthatauniversally
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bearishattitudeinthecountryasawholeisasignofanupturnandrampantbullishnessisasigntosell.Somecompanieseventabulatethenumberofinvestmentadvisersthatarebullishorbearishasasigntogotheotherwaywhenunanimityseemsimminent.Inotherwords,whenthesmallbuyersstartpilinginit
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istimetosell,andviceversa.Wordgotaroundandsomanypeoplestartedactingonthetheorythatitbecameaself-defeatingprophecyandconfusionseemstohaveburiedit.
Theflowoffundsindicatorsshowdemandforsecuritiesandwherepeopleareheadingtoputtheircash.Sometimestheintensityof
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feelingaboutacompanycanbegaugedbythevolumeofsharestraded,especiallyifachartcanshowwhetherthetotalisup,downorunchanged.Thecombinationofpriceandvolumemovementsgivesaprettygoodindicationofoverallattitudes:
ifpricesandtheamounts
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ofsharestradedarebothrisingitisanindicationthatthemarketfortheshareissettorise;arisingpricebutadecliningvolumeofsharestradedisaworryingtrendindicatingthepriceriseisrunningoutofsteam,andastheupwardmovementslowstoa
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haltthedirectionislikelytoreverseandthepricewillsoonstarttofall;afallingpricecoupledwithrisingvolumeshowsinvestorsheadingfortheexitingrowingnumbers,whichcanonlyreinforceandacceleratethefallingprice;thepriceandvolumeof
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sharestradedbothfallingshowsinvestorsbeginningtohavesecondthoughtsaboutsellingandthedownwardpressureisthereforeeasing;soonitwillbottomoutandstartupwards.
Other indicators
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Therearemanyothersystemsattemptingtopredictmarketmovements.Likeanyotheractivityinareasdominatedbyluckandtheunpredictable,likefishingandactingforinstance,thereisquitelotofsuperstitioninvolved.Peoplearereadytograspatanyapparentcorrelation,nomatterhowdubious.
Sothereisonetheorythat
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sunnyweatherproducesoptimisminpeoplegenerallythatisreflectedinprices,andanotherviewhasitthatthemarketindexmovesupanddownwithskirthemlines.Anotheroldadagewas‘sellinMayandgoawayuntilStLeger’sDay’ontheassumptionthateverybodywentawayforthesummerandreturnedforthepopular
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horseracethatmarkedtheendofthesummerlull–henceintheabsenceoftrade,activitywaslistlessandrandom.Infactanyinvestigationshowsthesayingtohavebeenunjustifiedwhencoinedandbecominglessreliablesince.
Finally,bewaryofbuyingonatiporrumour.Itismostunlikelyyouwillbethefirst
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tohearit,evenifitistrue,andthereisaverygoodchanceitisunjustifiedgossipora‘ramp’–somebodystartingastorytoshoveupthepriceofsharesheorshewantstosell.Ontheotherhand,ifitreallyistrueandtheinformationcomesfromsomeoneontheinside,actingonitcouldlandyouinjailforinsidertrading.
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Oneviewholdsthatshareselectionisforthelongterm,sothereislittlepointinreactingtoeverywhimofstockmarketfashion.Youboughtforthelongterm,soholdontotheshares–anapparentlysensibleapproachthatcanprovideausefuloverallguidebutignorestherealitiesoflife.Forinstance,theassumptionthatdictated
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theoriginaldecisionmaynolongerapply–thecompany,theeconomyortheportfoliomayhavechanged.Soitisworthreviewingthedecisionfromtimetotime.
Someoftheguidestoinvestmentwillsayfatuousthingslike‘sellyourworstsharesearly’.Butifitwereeasytotellwhichtheworstshareswere,onewouldnot
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bereadingabook–justbecauseasharehasdroppedandanotherrisendoesnotmeantheywillcontinueinthesamedirection,aslotsofpricechartswillclearlyshow.Someoldmarkethandsarealwaysagainstbuyingaplungingshareinthehopeofrecovery–‘themarketistryingtotellyousomething’theysay.Butif,forinstance,
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asharegoesfrom23pto£12.40inthespaceof18monthsandthendropsbackto60pinthenextsixmonths,whendidthemarketgetitright?
Sotherearenoobviousanswers.Anybodyclaimingtohaveasimpleexplanationisafooloraliar.Ifitwerethateasyeverybodywouldhavedoneitlongago.
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Therearesophisticatedmathematicalmodellingtheoriesaboutwhatyoushoulddo.Theyareinteresting,somehavebeenprogrammedintocomputers,butnoneofthemcanbejustifiedonanylogicalbasis.Onesuggestssellingsharesaftertheyhavefallen8percent;anothersayssellwhentheyhavedropped7percent
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belowthetoppricereached.
Selling
Itisneverwrongtotakeaprofitisoneoftheancientrulesofstockmarketinvestment.Yes,thesharepricemaygoonzoomingupstillfurther,butyourprofitissafe.Onealternativewhenwinningistohedgeyourbets
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bysellingpartoftheholdingtorecovertheoriginalinvestmentplusabitofprofit,andlettherestridejustincasethereisfurthergrowthleft.Anotherofthehallowedsayingsofthemarketcomestomuchthesamething:‘Leavesomeprofitfortheotherchap.’Thisisdeeplyreassuringstuff,anditeasestheirritationofsellingwhen
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thesharecontinuestorise–butjustconsidertheoddsagainstbeingabletobuyatthebottomandsellatthetop.
Bysomecuriouschancemostoftheadvicefromprofessionalsisabouthowtosecureyourprofit.Theassumptionisthatnobodyeverbuysadud.Thereislesshelpfuladviceaboutwhentojointheothersleekrats
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headingfortheshore.Infallingmarketsprivate
shareholdersfallintotwoopposingcamps.ThereistheoneNaipauldescribed,whohangsontothemostobviousrubbishinthehopeitwilleventuallyrecover.Thenthereisthesortwhopanicatanyseriousdropandbailoutintheexpectationthatoncethepriceisheading
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downwards,thelawofgravitywillcontinuetooperate.Bothareprobablywrong.
Thepointaboutprivateinvestmentisthatitisgenerallyforthelongishterm,sothebuyershouldhavedonesomeprettycarefulresearchonthebusinessbeforebuyingitsshares.Thecorollaryisthatifitcontinues
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tomeetthosecriteria(goodmanagement,reasonablemargins,innovation,goodfinancialcontrol,etc),thenitmaywellbeagoodideatohangonandjustgooncollectingdividends.Ontheotherhand,thatalsomeanstheinvestormustcontinuewiththework,toseeifthecompanyisstilluptosnuffandthereforeworthbacking.
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Ifnot,sell.Somuchforcashingin
profitsorpreventingfurtherhaemorrhageforafailure;thatassumesthemarketasawholeisstillhealthy.Theproblemisspottingwhenthemarketissickandlikelytogetworse,andknowingwhetheritisabliporthemarketontheturn.
Forinstance,thereisthe
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timewhenaroaringbullmarketsuddenlyfalters.Thiscouldbetheresultofsomeexternaltriggerlikeatradewaroranapparentlyunconnectedevent–whythehurricanethatroaredacrosssouthernEnglandinOctober1987shouldhavetriggeredaplungeinpricesstillleavesmarketanalystsbaffled.Anothercausecanbea
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generallossofimpetus.Insomecuriousandindefinablewaytheenthusiasmthathadbuoyedupeverybodyandhadseemedreadytocontinueforeversuddenlydrainsaway.Nothingseemsreallysatisfying.Evengoodnewsfailstoliftprices,thoughunhappynewsknocksthemback.Thesearesignalsofamarketontheturnand
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indicatethatitistimetostartsellingbeforetheroutstarts.
Oncethebearmarketistrulyunderway,sellingonthewaydownistrickier.Professionalinvestorsareruthlessaboutgettingoutifthesignslookbad,andmanyinstitutionsnowhavecomputerprogramsthatautomaticallystartsellingwhenacertainpercentage
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declinehasbeennoted.ThisisoneofthereasonstheNewYorkstockexchangescansometimesregisteracceleratingfallsinashareoreventhemarketasawhole,ascomputersareautomaticallytriggeredtosavewhatcanbesalvaged.Privateshareholders,however,arealwaysslowtosell.Itisreckonedtobea
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mixtureofignorance(theyhavenotbeenfollowingtheshare’sperformance),sentimentalattachmenttoacarefullychosenshare,andasortofinertiathatsuggestshangingonforjustanotherdayorsoincaseitbouncesback.
Thejudgementisbetweencuttingyourlossesandnotmissingoutonarecovery.
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Therearesomewarningsignalsthatmaysuggestadiscreetexit;forinstance,therecouldbeconflictingindicatorsandrumoursaboutthecompanywhosesharesyouhold.Anothergoodtestistoaskyourselfwhethertheshareshavebecomesolowandtheindicationsofgoodprofitssoconvincingthatthesharesseemanirresistible
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bargain–ifnot,itisprobablyagoodideatosell.Evenifyouareconvincedthemarkethasgotitwrongandthebusinesswillbounceback,itcanbeshrewdtosell.Then,ifthepricecontinuestofallandtheindicationsarecomingthroughthatthecompanyhasturnedthecorner,youcanalwaysgetbackin.
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ChapterElevenConsequencesof being ashareholder
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Shareholdersarethetrueownersofthecompany,
sotheyhavelotsofrights.Forastart,intheorytheyappointboththeboardofdirectorsandtheauditors.Inpracticethedirectorsdobothandshareholdershavealltoooftensupinelyagreedtoeverythingdoneintheirname.Evengreatinstitutionalholderswhoknowthelaw
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andaccountingprinciplesandaresophisticatedinvestorshavebeenlaxinexertingtheirpowerandhavegenerallymoreoftensoldthesharesthanspokenupordoneanythingforthebusiness.Thishasbeenchanging:someinstitutionsareusingtheirinfluenceanditisbecominglesseasyfortheboardtodismissawkwardquestionsat
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theannualmeeting,butstilltoomanyprivateindividualsconsideranyquestioningoftheboardasanunseemlydelayoftheirfreedrinks.
Asowners,shareholdersareentitledtobegivenawiderangeofinformation,andtoparticipateinthecompany’ssuccess.
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Information
Theinformationtheownersmusthaveincludesregularfinancialfacts.Everyyearthecompanymustproduceanaccountofitsfinances(thephrasinginlawisalittlemorecomplicatedbutthatiswhattherulesamountto)andthismustbesenttoallregisteredshareholders.(See
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Chapter7forwhattheusefulinformationisinthoseannualreportsandaccountsandhowtoextractit.)Shareholdersmustalsohavenoticeofimportanteventsaffectingthebusiness.Thatincludesdetailsofmajoracquisitionsanddisposals,demergersandreorganizations.
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Annual generalmeeting
Theannualgeneralmeetingisalegalobligationandshareholdersmustbenotifiedinadvance.Thereis,however,nolegalinsistencethatthemeetingisheldinaconvenientspot,soifthedirectorsarefeelingbloody-mindedtheycouldholditin
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theupstairsroomofapubonStornoway.Curioustimesandinconvenientplacesformeetings,pluscompanyannouncementsonChristmasEve,aregoodsignstoshareholdersthatallisnotwellwiththebusiness.
Atthemeetingtheyarecalledontoapprovetheaccountsbyvoting,canaskquestionsandhaveavoteon
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anumberofotherresolutionsincludingthereappointmentofauditorsanddirectors.Mostshareholdersneglectthisprivilege,eitherthrowingawaythevotingcardaltogetherorjustsendingbacktheenclosedproxyformgivingthechairmancarteblanchetovoteontheirbehalf.
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Extraordinarygeneral meeting
Shareholdersrepresentingatleast10percentoftheequitymaydemandtheconveningofanextraordinarygeneralmeeting.
Consultation
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Thereisalegalobligationtoconsultshareholdersonmattersthataffectthecompany’sfuture.Theyhavetherighttovoteonmajordecisions,includingactionsthatmaydilutetheirholdingssuchasrightsissuesandemployeeshareoptionsschemes.Iftheycanmuster5percentofthecompany’sequityor100shareholdersto
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backthem,theycanevenintroducetheirownresolutionsatthemeeting.
Dividends
Shareholdersareentitledtotakepartinthecompany’ssuccessandprofits.Normallyshareholdersparticipateinthecompany’sprofitsbywayofdividends,whichareusually
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paidtwiceayear,butthisisnotalegalrightsinceacompanymaydecidetoreinvestitsprofitsinthebusinessforfastergrowth.Inpracticefewhavethecouragetorefrainfrompayingaltogether.Thecheque,ornotificationofpaymentintoanaccount,showsthesizeofholdingandrateofdividend.Preferencesharesare
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normallyentitledtoadividend,andifthecompanycannotforatimeaffordtopay,thatentitlementisnormallyonlydeferredandhastobepaidlaterwhenthemoneyisavailable.
Scrip issues
Thislookslikeaburstofspontaneousgenerosityby
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companiesthatgiveinvestorssomeextrasharesfornothing.Sometimestheyareinplaceofcashdividendsandsometimesasasupplementtothem.Infactitisasimplebookkeepingexercisethatshouldhavenoeffectonthesharepriceorthevalueofthecompany–someoftheretainedearningsarecapitalizedandshiftedfrom
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onelineinthebookstoanother.Thatisalsothereasontheyarecalled‘capitalizationissues’.Sometimesissuingscripiscalleda‘bonusissue’andsurprisinglyenough,contrarytologic,thesharepricesometimesrisesatthetime.Shareholdersmaythenfindithardtocalculatethecostoftheholdingforcapitalgains
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taxwhentheysell.
Rights issues
Companieswantingtoraiseadditionalcapitalsometimesturntoexistingshareholdersfirst.Thereareseveralreasonsforthis.Thefirstisobvious:shareholdersbydefinitionmustlikethecompany,soifitsaysitcan
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seeopportunitiesforusefulinvestmenttoallowittogrowbutneedsadditionalcash,theyaremorelikelytotakeafriendlyview.Second,itisonlyfairtoallowexistingholderstotakeactionagainsthavingtheirholdingsdilutedbytheissueoffurthershares.Third,theinstitutionsthatownmostofthesharesonissueinBritainareespecially
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insistentonbeinggiventhechancetomaintainthepercentageofthecompanytheyhavedecidedwasrightforthatportfolio–thisiscalledtheir‘pre-emptionright’.
Itisalongandexpensivebusinessforacompanysinceitmustprintextensiveliteratureandpostittoallholders,andthemerchant
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banksandaccountantscostafortuneinfees.Aplacing–ringingroundfundsknowntobeinterestedandaskingiftheywouldliketobuyextrashares–worksoutalotcheaperandcanbeveryquick.
Theopportunitytobuythenewsharesisallocatedasaratioofexistingsharesowned.Itissomethinglike
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therighttobuythreenewsharesforevery11alreadyheld,orsomesuchformuladependingonhowmuchthecompanyistryingtoraiseandhowdeepadiscountitisoffering.Theissuewilldilutethevalueoftheexistingsharesbecauseprofitsanddividendswillbedistributedoveralargernumberofshares.
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Rightsissuesarenormallyofferedatadiscounttotheprevailingsharepricetogivepeopletheillusionthattheyaregettingabargain.Soifthesharesstandat200p,thecompanymightofferonenewshareforeveryfouralreadyheldatapriceof150p.Soforeveryfourshares,worth£8,theycanbuyanotherfor£1.50.Ifinvestorsdobuy
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theyhaveaholdingworth£9.50(assumingthepricedoesnotmove)andthefourcontinuingshareswouldbeworth£7.60(four-fifthsof£9.50),butonthatcalculationtherightwouldbeworth40p,sotheywouldbebacktotheoriginal£8holding.Onecomplicationisthatthemoneyreceivedfortherightsmaybetaxable,andanother
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isthatthemarketpricewillreacttotheannouncement.
Shareholdersfacedwitharightsissuecantakeitupinfullandpayforthenewissueofshares.Theycansellthenil-paidrights,whichhaveavalueonthestockmarket.Ortheycancompromisebysellingenoughnil-paidrightstomaintainthevalueoftheportfoliobyusingthe
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proceedstobuynewshares.Thenil-paidpriceisthedifferencebetweenthediscountedrightsissuesharepriceandtheex-rightsprice.
Nominee accounts
Manypeopleholdtheirsharesinnomineeaccounts–forSIPPsandISAstheyhaveto.Theseareheldina
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numberofplacesandareaconveniencetopreventshufflingofpapersortospeeduptheprocessesofbuyingandselling.Forinstance,thedealingstockbrokermayholdanaccountforaninvestor,whodoesnotthereforehavetowaitforsharecertificatestoarrivebeforebeingabletosellthem,anddoesnothave
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tostoreandfindthenecessarypapers.Somebrokersoffertheservicefreeasawayofreducingtheirownadministration;somechargeaflatfeeoronebasedonthevalueoftheshares;yetotherschargepertransaction;andsomelargecompanieshaveinstitutedtheirownsystems.
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Regulated markets
Inadditiontotheirrightsinrelationtothecompanyofwhichtheyownapiece,investorshavearightnottoberippedoffbythefinancialcommunity.Thisisthepartthatismainlywatchedoverbytheregulatoryauthority.ItregulatesBritishbrokersanddealers,whethertheyareina
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Cityofficeordealingviatheinternet,butnobodyregulatestheinternet.Inevitably,thenethasbeenahappyplaygroundforsomeshadyoperators,rangingfromvarioustypesoffraudsterstopeopleoperatingpyramidschemes.Somehavesetupboguswebsitestolooklikethepagesoperatedbyrealinvestmentcompanies,inthe
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hopeofgettingunsuspectingpeopletopartwiththeirmoney.Inaddition,thenetisawashwithrumours,manyofthemcarefullyplacedtodrivethepriceupordownsotheinstigatorcansellorbuyasneedsbeandmakeakilling.Theauthoritiesinthemoreresponsiblecountriespursuethesepeople,butthenetistoovasttobewatched.
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TheLondonStockExchangealsoregulatesitsownmarket.TheExchange’scomputerhasasophisticatedprogramtryingtospotunusualpatterns,andifthereareuntowardmovementsinadvanceofanofficialannouncement(egasharprisejustbeforeabidisdisclosed),theExchangeauthoritiesinvestigate.
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Despitesomeapparentlysuspiciouscircumstances,however,theyhardlyeverfindanythinguntoward.Prosecutionsforinsidertradingarerare,andconvictionsevenrarer.
Relyingonsomebodyelsetopickupthepiecesandfightthebattlesforfecklessorfoolishinvestingisamistake.Alittleelementarycarecan
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preventalotofmistakesandsavemuchefforttryingtoassertone’srightslater.Forinstance,youshoulduseonlyauthorizedbusinessestoactonyourbehalf,andthatiseasytocheckontheregisteroftheregulatoryauthority.Beforestartinganytransactions,checkthecostsandfees.Thefirstruleis,ifthereisanythingyoudonot
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understand–goonaskingforanexplanationuntilitiscrystalclear.Itismuchbettertoseemfoolishbyaskingquestionsthantobefoolishbynothavingtheanswers.
Codes of conduct
Theapathyofmostshareholdershasallowedcompanyboardssomuch
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latitudethattheyseemedbeyondreasonablecontrol.TofillthisvacuumtheCityhasproducedaseriesofcodesofconducttoguidedirectorsonbestpractice.Thelatestofthose,theHampelReport(followingtheCadburyandGreenburyReports),whichisbackedbytheStockExchange,suggestedforinstance,that:
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thetaskofchairingtheboardandtheworkofchiefexecutiveshouldbeseparate;directorsshouldstandforre-electioneverythreeyears;boardmembersshouldnothaveaservicecontractofmorethantwoyears;athirdoftheboard
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shouldbenon-executiveswhoshouldbeindependentofthecompany;shareholdersshouldbetoldatleast20daysinadvanceofanannualgeneralmeeting;whenraisingnewcapitalthecompanyshouldgiveexistinginvestorsfirstrefusal;
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anyquestionsnotansweredattheannualgeneralmeetingshouldgetwrittenanswerssoonafterwards.
Takeovers
Usually,yousaythankyouverymuch.Bidsforcompaniesarealmostinvariablywellabovethe
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priceofthesharesjustbeforethebid,soshareholdersbenefit.Ontheotherhand,whatmaywellhavetemptedapredatorispreciselythatthepricewasstandingwaybelowanyrationalbasisofvaluation,forinstancethenetassetvalue,soitwouldbeworthbuyingabusinessjusttoselloffitsassetsataprofit.Inthatcaseitisworth
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resisting,ifonlytogetabetterprice.
Sometimestheofferisresistedfiercelybythetargetcompany,andtheschemeforsomeinvertedreasonisthencalleda‘hostiletakeover’.Thedefenceusuallysaysthebidisunwelcomeandopportunisticasitundervaluesthecompany’sprospects,andthecompany
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couldperformfarbetteronitsown,giventhechance.Theprivateshareholdercannottellwhetherthisoppositionismotivatedbyadesireforindependence,afearofdirectors’losingtheirjobs,anattempttogetthebiddertoincreasetheprice,oragenuinefeelingthatshareholderswoulddobetterwiththeexistingregime.Itis,
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however,worthrememberingthatthedirectors’legaldutyistoactinthebestinterestsofshareholders.
Thedecisionismadeevenmorecomplicatediftheofferiswhollyorinpartintheformofthebidder’sshares.Thechoiceisthenclutteredwithotherconsiderationssuchaswhetheronewantsthoseshares,whetherthe
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valuationofthebuyer’sequityisfairorrealistic,andwhethersellingmightcrystallizeanunwelcomecapitalgainstaxliability.
ThetakeoverprocessismonitoredbytheCityTakeoverPanel,whichhasnopower,legalorotherwise,butmanagestohaveitswaybecausealltheCitypeoplesupportit.Soanybodywho
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triestofloutitsrulingswouldbeostracized,andoncefrozenoutofthefinancialcommunitydoingbusinesswouldbeimpossible.Beingnon-statutoryalsogivesthepanelthesignaladvantageofbeingabletoactquickly.Moreover,itcantellparticipantsitdoesnotlikethewaytheyareacting–ithasbeenknowntoreprimand
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peoplenotforfailingtofollowtheletteroftheCityCodebutforneglectingitsspirit.InadditionitcantakeinstantactiontochangetheCodewhenaloopholehasbeendiscovered.
Thepanelchargesofferdocumentsandrelatedpapersofover£1millionbetween0.2%and11%.Italsochargessaverstosupervise
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companiesat£1onsharedealsofover£10,000whichiscollectedforthepanelbystockbrokers.
Itcanbealmostasgoodtoownsharesinacompanythatisinthesamesectorasahighlypublicizedacquisition.Assoonasoneestateagent,retailer,computerassembler,brewerorwhateverhasbeenbought,themarketusually
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assumesarippleofparallelacquisitionactivitywillovertakeitscompetitors.Theirsharesjumpasaresult.Sincetheflurryofcopycatactivityrarelymaterializes,especiallyoncethetargetshavebecomeexpensive,itmaythenbeagoodtimetosell.
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Insolvency
Investinginsharesisrisky.Thereisnowayofgettingawayfromthis.Oneofthereasonsthestockmarketproducesahigheraveragereturnthan,say,puttingthemoneyintoabuildingsocietyorabanksavingsaccount,istooffsetthisdangerbycompensatinginvestors.But
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notetheword‘average’.Somesharesaremoreriskythanothersand,shortofbuyingintohundredsofcompanies,theinvestorwillbeinvolvedinsharesthatareamixture:someareasuccess–iflucky,someofthosespectacularlyso;someareprettyho-humperformers;andsome,rarely,arecompletecollapses.
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Occasionallycollapsesaresignalledwellahead.Thesharesshowasteepandprettycontinuousslide,andthestatementsfromthecompanymixprofitwarningswithpromisesofrestructuring,refinancing,searchingforalliances,appointingnewexecutivesandnewpoliciesontheway.Thisusuallyendsina
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suspensionofdealingsintheshares,amovethatiscommonlysaidtobetohelpshareholders.Purebunkum:itisacompletedisasterforshareholderswhocannotthereforesellsharesatanypricetorescueevenatinyportionoftheirinvestmentmoney.Thepeopleithelpsarethestockmarkettraderswhoarefearfulofdealing
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withoutadequateinformationandcannotfacebeingswampedbypeoplestampedingoutofthecompany.
Companiesseldomreturnfromthatsortofsuspension.Thereareotherreasonsforsuspension,suchasduringthefinalstagesofamajoracquisition,butthosereallyarebenignandaretoprevent
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totalmarketchaoswhenthereisnotenoughknownaboutthedealdetailstosetafairprice.Butbeingsuspendedbecausethecompanyhasrunoutofmoneyoffersfewroadsback.
Bythetimethesharesaresuspendedtheyareseldomworthmorethanafewpenceinanycase.Butnotallcollapsesaresowell
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signposted.Arethereanymorecovertsignsofimpendingdoomthatcannyshareholdersmaybeabletospot?Manypeoplehavetrieddrawingupsigns,includingBritain’stopliquidatorinthe1960s,BillMackie.Thespecificsofhiswarningsignals,includingflamboyantheadquartersandprofligatetopmanagement,maynow
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seemdated,buttheunderlyingprinciplesarestillsound.Wemaynolongerhaveflagpolesandtanksoftropicalfishbutthereareplentyofotherloudsignalsthattheorganizationthinksappearancemoreimportantthanefficiency.
Investorsshouldbemonitoringthebusinessandhowitismanaged.Profit
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marginsareagoodsign,sooneshouldcheckwhethertheyareashighastheywereandatleastasgreatasthoseatothersimilarcompanies,andwhetherthebusinessisgeneratingsufficientcashforitsneedsandambitions.Whenexternalmoneyisbeingraisedthroughloans,rightsissuesandthelike,itshouldbeforexpansion
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ratherthanbalingoutthecurrentproblems.Accountsbeinglateorfudged,lackofinformationonauditors’qualifications,suggestionsofwindow-dressingintheaccountsandextremelysophisticatedfinancialdealingsarecausesforconcern.Withsmallbusinesses,mostofthatdoesnotapplyandyouhavelittle
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recoursebuttojudgebythemanagers.Thepointaboutsmallbusinessesisthattheprofitcanbespectacularbutthecollapsessudden.
Whenacompany’ssharedealingsaresuspended,thatiscommonlyasignthatthecompany’smanagers,bankersandsetofinsolvencyaccountantsaregoingintoconfab.Onerouteisforthe
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companytotryforavoluntaryarrangementunderwhichitscreditorsholdoffknockingbitsoffthecorporatestructuretosellasawayofrecoveringtheirmoneyandallowittotrytradingoutofitsproblems.Courtscanappointanadministratorwhoalsocontinuestotradeandholdsoffcreditors.
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Anotherrouteistakenbysecuredcreditors,normallythebanks,whichhaverunoutofpatiencewiththecompany’sexcusesandareworriedtheirloanscouldsoonbecomeirrecoverable.Theyappointareceiverwiththesoletaskofkeepingthebusinessgoingjustlongenoughtorecoverthebanks’money.Taxauthoritieshave
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alsobeenprettyactiveinthisroutetomakesuretheirmoneyispaid.Occasionallythedirectorsaskfortheappointmentbecausetheycanseeadefaultondebtsloomingorbecausetheyareindangerof‘overtrading’,whichisthecriminaloffenceofcontinuinginbusinessoncethecompanyisinsolvent.Aspecialist
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accountantisthenappointedandmovesintorunthebusinessbrieflytoextractsomemoneyorsellassetsforpayingthedebt.Intheorytheadministratorthenmovesoutandthecompanyrevertstobusinessasusual.Thatseldomhappensinpracticebecausethereceiver’staskentailssellingofftheassetsagainstwhichthemoneywas
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lent,ortradinglongenoughtogeneratethecashtopayofftheloan.Thatusuallydoesnotleavemuch,andthecompanyisoftenpassedtoaliquidator.
Asthatnameimplies,theliquidator’sjobistoturnanythingsaleableintosomethingmoreliquidlikecash.Firesaleslikethatseldomproduceanythinglike
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thebookvalueofassets.Inalloftheseprocedures
thereisahierarchyofcreditors,andtheholderofordinarysharesstandsatthebackofthequeue.Thegovernmenttakesitstaxesoffthetop,andisfollowedbysecuredlenderswithaclaimonthepropertyandemployees,andthebankswithotherguarantees.Then
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therearebondholdersandownersofpreferenceshares.Onceallthesepeoplehavehadtheirtakethereisseldomanythingleftfortheholdersofordinaryshares.
Theonecomfortingthoughtisthatrelativelyfewquotedcompaniesdoactuallygobust.Andifyourinvestmenthappenstobeoneofthem,tryandlookforthe
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silverlining:youcancashinsomereallyprofitableinvestmentsandsetoffthecapitalgainsagainstthelossesonthecrashedcompany.
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I
ChapterTwelveTax
tisgallingthatthegovernmenttakesanother
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sliceondividendsandcapitalgainsafterithasalreadychargedadditionaltaxoninvestingtaxedincome.Butreconcileyourselfwiththethoughtthatatleastyouhaveprofitstobetaxed.
Taxisalwayscomplicated,andhugemanualshavebeenwrittenonhowtocopeorgetthebestdealpossibletofrustratetheeffortsofHM
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Revenue&Customs(HMRC).Thischapterrepresentsthemerestskimmingofthesurfaceandisgeneralizedasthesethingschangecontinually.
Governmentshavetriedtosteerustowardssomeinvestmentvehiclesbytaxincentivesbecausetheythinktheywouldbegoodforusorforthecountry.Itwouldbe
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foolishnottotakeadvantageofanyextrabenefitsprovidedbythetaxoffice,butitwouldbejustassillytoinvestpurelyforthetaxbreak.Thisisespeciallysoasthemanagementfeesforsomeschemesneedcarefulscrutinytotestwhetherthedealisstillworthitaftertheprofessionalshavehadtheirshareofthecream.Soweigh
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thealternativesandgofortheonethatisbest,judgedbyyourpersonalcriteria,andonlygoforthesavingsintaxiftheinvestmentwouldhavemadesensewithoutthem.
Governmentsarerathergoodattakingmoneyoffus.Thereisnotonlytaxongettingintoshares–called‘stampduty’–butalsoonthebenefitsfrommostkindsof
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investment,bothontheincomeandthecapitalappreciation.Dividends,includingscripissues(seeChapter11)andbonusshares,countasincomeandthereforearesubjecttoIncomeTax.Mostcompaniespaydividendsnetoftax.
HMRCpublishessomeusefulbookletsontax,includingoneoncapitalgains
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tax(CGT),availablefromalltaxoffices.
Dividends
Dividendsonsharesarealmostinvariablypaidnetoftaxandthevoucherthatcomeswiththepaymentnotificationcontainsdetailsofataxcredit.PeoplewhodonotnormallypayIncomeTax
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cannotreclaimthetaxalreadypaidonthedividend.Thosewhopaytaxatthebasicrateneedpaynofurthertaxontheincome.Butpeoplepayingtaxatthehigherratehavetopayat32.5percentofthegross,thoughthecreditdetailedintheslipissetoffagainstthis.Thismeansthatthehigher-ratetaxpayerwill,ineffect,paytoprateoftax
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onthegrossdividendpaidbythecompany.Thiscomplicatedwayofhandlingthingsmeansthataboutaquarterofthenetdividendisdueintaxforhigher-ratepayers.
So,forinstance,someoneowning400sharesinQuilp&HeepIntercontinental,whichpaysa15pdividend,wouldgetachequefor£60.Since
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thetaxcreditis10percent,thisrepresents90percentofthegrossdividend,whichwouldhavethereforebeen£66.66(60/90×100).Asaresult,thetaxcreditnotifiedwiththechequewouldbe£6.66.Payersonthestandardrateoftaxarethenallsquare,butpayersatthehigherrate,obligedtopay32.5percentofthegross,mustnow
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calculate66.66×32.5/100,whichworksoutto£21.66.Settingoffthe£6.66alreadypaidleavesaliabilityof£15tobesenttoHMRC.
Scripissuesofsharesinlieuofdividend(seeChapter11)aretreatedinaprettysimilarfashion.Thereisnoadditionaltaxdueforpeopleonthestandardrate,andthosepayingthehigherrate
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areassumedtohavehada10percenttaxcredit.
Ifthecompanybuysbackshares,themoneyreceivedistreatedasadividend–coveredbyIncomeTax,notCGT.
Capital profits
Aprofitonthesaleofsharesisliabletotaxforprofits
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abovethebasictax-freeallowance.Thisisaprettyhandsomechunkasfarasmostsmallinvestorsareconcerned.CGTisaproblemonlyforpeopledealinginlargishamountsorwhohavereallystruckitluckywithoneoftheirstocks.Inotherwords,iftheprofitissogreatthatCGTisdue,youhavedonesowellthatabitforthe
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exchequerseemslesspainful.Windfallsharesreceivedfromdemutualizedbuildingsocietiesorinsurancecompaniesarecountedashavingcostnothingandanythingmadefromtheirsaleiscountedasacapitalgain–unlesstheyhavebeenputintoatax-shelteredschemesuchasaSIPPorISA.
Thereisataperedtax
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relief,however,soholdingsharesforalongtimewillreducethetaxliability.IftheshareswereboughtbeforeApril1998thepricerisecanbeadjustedforinflationbeforetaxispayable.Dealingcostsinbuyingandsellingareallowableagainstthetotalgain,andthereisanallowanceforpart-paidshares.Giftsbetweenspouses
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aretax-free,sotheportfoliocanbeadjustedtobenefitfromthemaximumallowance.
Unquotedsharesareaproblemsincethereisnopubliclyavailableunequivocalpricefordealing.ForthesedealsyouwilljusthavetohagglewiththelocalHMRCoffice.
Asisonlyfair,losses
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madefromsellingsharesinthesametaxyearcanbesetoffagainsttheprofit.Andifanyofthecompaniesactuallygobust,thesharesarereckonedtohavebeensoldatthatdatefornothingandthecapitallossfromthepurchasepricecanalsobesetoffagainstgains.
Allthismayhelpwithdecisionsbetweenalternative
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coursesofbuyingandselling,thoughonceagainbeingguidedpurelybytaxdifferencesisusuallyamistake.Agoodaccountantcanadviseonsuchthingsatarelativelylowcost.
Employee shareschemes
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ReceivingsharesfromanemployercountsaspayandsoissubjecttoIncomeTax.Iftheemployees(andthatincludesdirectors)buythesharesatadiscounttothemarketprice,thediscountportionisthepartonwhichtaxispaid.
Underapprovedprofit-sharingschemesthecompanycanallocatetax-freesharesto
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workers,thoughasyouwouldexpect,thereisaraftofrulesaboutthedetails.Shareoptionschemesthatmeetallthechancellor’srequirementshavefewadvantages.
Tax incentives torisk
Thegovernmentwantsnew
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ideastobefinanced,high-technologytogetstarted,andinnovationstobegivenachance.Investmentinstitutionssuchasventurecapitalistswillnottouchthem,sothetaxincentivesaredirectedatprivateinvestors.Theseareriskyventuresandthoughrewardscanbehighforasuccess,thechanceoffailureisalsopretty
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high.Evenwiththetaxcome-onsthisisanareaforpeoplewithasteadybaseofsafeinvestmentwhoalsohaveafewhundredthousandtogamblewith.
Venture capitaltrustsThesearereallyjustacollectiveversionofthe
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EnterpriseInvestmentSchemeitreplaced.Thetaxbreaksaresimilarbuttheinvestmentisintoaquotedfinancialvehicle,whichinturnputsthecashintoarangeofentrepreneurialbusinesses,sotheriskisreduced,aswithinvestmentandunittrusts,byspreadingthemoneyoveranumberofventures.
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ISAs
Individualsavingsaccountsarepartofthegovernment’saimtopersuadeustosavemoreofourincomebyprovidingtaxincentives.Theamountswhichcanbeinvestedineachtaxyear,ofwhichallisinvestedinshares–includingAIMshares–andaproportionmayremainin
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cash,changeswiththeBudgetannouncements.Agoodstockbrokerhasthecurrentrates.
SIPPs
Self-InvestedPersonalPensions(SIPPs)offerthefreedomtochooseandmanageinvestments(fromthelistapprovedbythe
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Revenue)andunliketraditionalpensionsinwhichtheproviderownstheinvestments,theprospectivepensionerownstheassets.Theythereforeofferflexibilityinchoosinginvestmentsandtakingretirementbenefitssolongastheyarearrangedbyasuitableprovidertopassstringentcriteriafortax.
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SIPPs,incommonwithpersonalpensionschemes,aretax‘wrappers’,allowingtaxrebatesoncontributionsinexchangeforlimitsonaccessibility.
Amongtheassetsnotsubjecttoataxchargeareunlistedshares,shareslistedonarecognizedexchange,futuresandoptionstradedonrecognizedfuturesexchanges,
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authorizedUKunittrusts,OEICsandotherUCITS(seeGlossary),unauthorizedunittruststhatdonotinvestinresidentialproperty,investmenttrustssubjecttoFCAregulation.
ContributionstoSIPPsaretreatedasothertypesofpersonalpensiononlimits.Higherratetaxpayersclaimataxrefundthroughthetax
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return.Employercontributionsareusuallyallowableagainstcorporationorincometax.Afundvalueatretirementabovethelifetimeallowance(theamountfluctuateswithBudgets),istaxedat55%.
ASIPPholderreachingearlyretirementageof55maytakeuptoaquarterofthefundastax-freelump
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sum,andtherestmusteitherbemovedintogeneratinganincomefrom‘drawdown’(whereitremainsinvested)orusedtobuyanannuity.ThedrawdownincomeistobeinlinewithwhattheGovernmentActuary’sDepartmentreckonsanannuitywouldgenerate.Thisisreviewedeverythreeyearsuntilage75andthen
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annually.Thislimitdoesnotapplytoplanholderswhocanshowthattheyhavearrangementsinplacetoprovideaminimumguaranteedincomefromothersourcesandwhoarenolongercontributingtoapension.Pensionincomeistaxedasincomeattheowner’shighestmarginalrate.
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Tax rates
Chancellorshavetobeseentobeearningtheirkeep,soeachyear’sbudgetproducessometinkeringwithtaxrates,allowancesandincentives.Recentlytherehasbeenaspateoflastyear’sincentivessuddenlybeingrelabelled‘viciousavoidanceloopholes’thatneedtobewithdrawn.
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Sometimesimpendingelectionsorotherpoliticalexigenciesproduceaneedforotherpublicreactionsaswell.Asaresult,thepicturecontinuouslyshiftsindetail.Thatiswhythissectionhasgivenageneralpictureandtheoverallpoliciesbutcarefullyomittednumbers.Togetthelatestlevelsoftaxrates,allowancesand
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benefits,telephoneanyofthe10largestaccountancyfirms,allofwhichwillalmostcertainlyhaveafreeleafletsummarizingthecurrentposition.
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Glossary
acidtest:acheckinthecompany’sbalancesheettoseeifithasenoughliquidassetstomeetitscurrentdebts.
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AlternativeInvestmentMarket:thepartoftheLondonStockExchangeforsmallcompaniesoronestooyoungtomeettherequirementsforfullquotation;oftenabbreviatedtoAim.
assets:inacompany’sbalancesheetthesearethethingsitownsorareowedtoit;netassetsinthe
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balancesheetaredefinedascapitalplusreserves,ortotalassetsminuscurrentliabilities,anddeductingthelong-termcreditors.
authorizedsharecapital:everycompanyhasamemorandumandarticlesofassociationandtheseshowhowmanysharesitmayissue.Itisnotcompelledtoissueallof
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themandmanycompanieskeepsomeinreserveforrightsissues,employeeincentivesandthelike(seealsoissuedsharecapital).
bearmarket:atimeofgenerallyfallingshareprices.
bid:thepriceatwhichthemanagersofunittrustswillbuybacktheunits
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frominvestors,comparedwiththeofferatwhichtheysellunits;alsolooselyusedfortheofferinatakeover.
bluechip:atop-qualitycompanyanditsshares,derivedfromthetop-valuegamingchipsusedincasinosandpoker.
bond:anIOUissuedbyaborrowertothelenderto
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acknowledgethedebt;itnormallycarriesafixedrateofinterestandcanbetraded(eggilts,debentures).
bonusissue:anothernameforascripissue;thedistributionofsharestoexistingholdersatnocosttothem.
broker:seestockbroker.bullmarket:aperiodof
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risingshareprices.
calloption:therighttobuyashareatasetpricewithintheperiodoftheagreement.
capitalizationissue:seescripissue.
commonstock:USnameforordinaryshares.
consumerpriceindex:aweightedindexofa
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collectionofgoodschosenbythegovernmenttomeasurethechangeinaveragepricesandsoindicatetherateofinflation.KnowncommonlyastheCPI,itisanalternativetotheretailpricesindex(RPI).
convertible:aclassofpaperissuedbycompanies(suchasloanstockorpreference
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shares)thatcanbeconvertedintoordinarysharesatapre-setprice,andusuallyonasetdate.
coupon:theinterestrateonacorporatebond;itcomesfromthepracticeinthepastofattachingtothecertificateaseriesofcouponsthatonehadtoclipoffandsendtothecompanytocollectthe
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interest.Crest:anelectronicshare
registryandtransfersystemoperatedbytheLondonStockExchange,whichgetsridoftheneedforpapercertificates.
cumdividend:theshareissoldwiththeentitlementtothenewlydeclareddividend.
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dead-catbounce:asmallshort-termrecoveryinafallingstockmarket,derivedfromarathersickmetaphor:evenadeadcatwillbounceslightlyifdroppedfromhighenough,butthatdoesnotmeanithascomebacktolife.
debenture:atypeofcorporatebond.
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depositoryreceipt:anegotiablecertificaterepresentingaforeigncompany’spubliclytradedsecuritiesmakingiteasiertobuysharesinforeigncompaniesbecausetheydonothavetoleavethehomestate;italsogetsroundrestrictionsonforeignersowningshares.
derivative:agenerictermto
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coversomethingatsomestageremovedfromthedirectinvestmentbutdependentonit,soitincludesoptions,warrants,futures,swaps,indices,structureddebtobligationsanddeposits,caps,floors,collars,forwardsandcombinationsofthese;standardizedversionsofsome(egfuturesand
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options)aretradedonexchanges.
disintermediation:cuttingoutthemiddleman.
dividend:itisstatedassomuchpershare,soacompanydeclaringadividendof12ppaysthatamounttotheholderforeveryshareonissue.Theownerof1,000shareswouldget£12,minustax.
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dividendcover:showswhatproportionofthecompany’searningsarebeingpaidtoshareholdersor,toputitanotherway,ameasureofthenumberoftimesacompany’snetoftaxdividendiscoveredbyitsnetprofit.
dividendyield:theamountofdividendpershare(usuallyquotednetoftax)
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asapercentageoftheshareprice.
equities:anothernameforordinaryshares.
exceptionalitems:profitsorlossesinthecompanyaccountsfromdealingsthatarenotpartofthecompany’smaintradingactivities,suchasthesaleofafactory.
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ex-dividend:asharebeingsoldsoonafteradividendhasbeendeclared,withthesellerstillgettingthepayment.
flotation:bringingacompanytothestockmarkettogetitssharespubliclytraded.
FTSE100:stockmarketindexcoveringthe100
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companieswiththelargestmarketcapitalization.Sincecompaniesgroworshrink,becomefashionableoraresuddenlyshunned,theconstituentsoftheindexchangecontinually.Asaresultitisanindicationofthetemperofthemarketasawholeratherthanshowingtheperformance
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ofanyspecificsetofcompanies.
FTSEAll-Share:theaggregationoftheFTSE100,FTSE250andFTSESmallCapindices;itdoesnotcoverallsharesonthemarket.
fundamentalanalysis:lookingatthecompanybehindtheshare,itinvolvescalculatingnet
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assetvalueandprobablefuturedividends,whichmayinvolveeconomicpredictionsaswell;itisincontrasttotechnicalanalysis,whichlooksonlyatthechangesinshareprices.
gearing:inbalancesheets,aratioofacompany’sborrowingstoitsequity.
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gilts:shortforgilt-edged,theusualnameforgovernment-issuedbonds.
hedging:protectingagainstapotentialliability.
independentfinancialadviser:providerofunbiasedadviceonfinancialinstrumentsincludinglifepolicies,
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units,stakeholderandpersonalpensions,investmenttrustsandtheirsavingsschemes,andpackagedderivatives,butnotnecessarilysharesandbonds(seerestricted).
insider:somebodywithprivilegedaccesstoinformationaboutacompany,suchasadirector;itisillegalto
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tradeinsharesonsuchknowledge.
IPO:initialpublicoffering;UStermforflotation.
issuedsharecapital:thesearethesharesthecompanyhasactuallysoldasopposedtotheauthorizedsharecapitalthatitisallowedtosell.
leverage:USnamefor
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gearing.liquidation:thesaleofan
insolventcompany’sassetstopaycreditors.
liquidity:onemeaningisameasureofthemarket:howeasyitistobuyorselltheshares,whichisafunctionofhowmanysharesareavailable,howmanypeopletradeinthemandhowgreatthevolume
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ofdealingsis;anothermeaningisameasureofhowreadilyanassetcanbeturnedintocash:themorereadily,themoreliquiditis.
LIBOR:LondonInter-BankOfferedRate,theinterestchargedbymoststablebankslendingtoeachother.
long:owninganinvestment
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inanticipationofthepricerising;oppositeofgoingshort.
marketcapitalization:thevalueofaquotedcompanyonthestockmarket:asimpleproceduremultiplyingthevalueofeachsharebythenumberofsharesonissue;soifacompanyhasissued5
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millionsharesandtheyarenowtradingat125p,thecompany’smarketcapitalizationis£6,250,000.
marketcorrection:afallinshareprices.
members:theshareholdersofacompany.
MSCIworldindex:astockmarketindexofsharestradedonseveralmarkets
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aroundtheworld.ItismaintainedbyMSCI,formerlyknownasMorganStanleyCapitalInternational.
Nasdaq:NationalAssociationofSecuritiesDealersAutomatedQuotationsystem;NewYork-basedelectronicstockmarketwithaheavy
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emphasisoncompaniesusingadvancedtechnology.
NasdaqOMXEurope:London-basedtradingfacilityforapproximately800Europeanblue-chipshares.
netassetvalue:alltheassetsofacompanyminusallitsliabilitiesandcapitalcharges.
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NeuerMarkt:Frankfurt-basedmarketforsharesofsmaller,youngercompaniesthanarenormallyadmittedtothemainstockexchange.
noisetrader:someonedealingforthewrongreasons,caughtupbythe‘noise’inthemarketandseducedintotradesbygossip,fashionandphoney
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analysis.nomineeaccount:shares
heldbyaninstitutionorcompanyonbehalfofindividualshareholders.
offer:thepriceatwhichmanagersofunittrustsselltheunitstothepublic;itishigherthanthebidpriceatwhichtheyarepreparedtobuythemback,andthe
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differenceisthespread.open-ended:aninvestment
vehiclethatissuespaperinratiototheamountofinvestmentitreceivesfromthepublic;unittrusts(calledmutualfundsintheUnitedStates);thereisnosecondarymarketinthepaper,sobuyingandsellingisonlywiththemanagementcompany.
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PlusMarkets:UK-basedstockexchangethatevolvedfromOFEXtorivaltheLondonStockExchange’sjuniormarket,Aim.
poundcostaveraging:accumulatingaholdingbyinvestingthesameamountofpoundsinthesecuritiesatintervals;yougetmoresharesforthemoneywhen
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thepriceisfallingandthatreducestheaveragecostpershare.
preferredstock:USnameforpreferenceshares.
price/earningsratio:thiscomparesthecurrentpriceofthesharewiththeattributableearningspershare.Itisthewaythemarketcomparesexpectedgrowthinacompany’s
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dividendwiththerequiredrateofreturnofaninvestor.Theformulasaysthecorrectpriceequalstheexpectedcurrentdividend,dividedbytherequiredreturnandexpectedgrowthinthecompany’sdividends.Soifthedividendnowis10ppershareandthisisexpectedtogrowby5percenta
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year,butthecurrentdemandisforareturnof8percent,thecalculationis10/(0.08–0.05),whichwouldmaketherightshareprice333p.
putoption:therighttosellashareatasetpricewithintheperiodoftheagreement.
registrar:theorganization
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thatmaintainstherecordofacompany’ssharesandtheirownership;runbyspecialistregistrarcompanies,mostofthemownedbymajorbanks.
re-rating:achangeofopinionbythestockmarket:asurgeofgoodnews,aseriesofanalysts’reports,thepromiseofnewproductsandthelike
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maymakeinvestorsfeelthecompany’sprospectsarebetterthanthepricerises,withacorrespondingriseintheprice/earningsratioandfallintheyield,andconverselytheotherway.
reserves:thenon-distributedprofitsofacompany,plusprofitsfromrevaluingassets,plusanyshare
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premium;thisisnotmoneyinthebankbutisusedinthebusiness,thoughitremainspartoftheshareholders’funds.
restricted:afinancialadviserwhodoesnotcovertherangedemandedofanindependentandwhomustdesignatebeingrestrictedandexplaintoclientstherestrictionbyproductor
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provider.retailpricesindex:a
measureofpricesinasetbasketofdomesticretailgoodsandservices.KnownastheRPI,itisgenerallyconsideredtogiveamoreaccuratepictureofthecostoflivingthanthealternative,theconsumerpriceindex(CPI).
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returnoncapital:measurestheefficiencywithwhichthecompanyisusingitslong-termfundsbydividingtradingprofit(beforeexceptionalitems,interestandtax)bytheaveragecapitalemployedovertheperiod(shareholders’fundsplusborrowings)andmultipliestheresultby100.
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returnoninvestments:seeyield.
rightsissue:onewayacompanyraisesmoneyisbysellingmoreshares,andsometimesitdoesthisbygivingthepeoplewhoalreadyownitssharestherightoffirstrefusalinproportiontothesharestheyalreadyown.
ruleof20:awayofjudging
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theeuphoriaorgloomofthemarketasawhole;itsaystheprice/earningsratioplustheinflationrateshouldequal20.
scripissue:freeissueofsharestoexistingholdersconvertingcorporatereservesintoequities–anaccountingexercise.
SEATSPlus:atrading
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systemusedforAimstocksandforothershareswithoutenoughmarket-makerstocreateacompetitivemarket;thecomputerscreenshowsanymarket-makers’pricesplusordersfrombuyersandsellersseekingacounter-party.
sellshort:sellingsharesonedoesnotowninthehope
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ofbuyingthemcheaperinafallingmarketbeforedeliveryisdue.
sharepremium:ifthenominalvalueofacompany’sshareis20pbutitissuesthemat50p,the30pdifferenceisinthebooksasthesharepremiumaccount.
shareholders’funds:theassetsofacompanyminus
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itsliabilities;sincetheshareholdersownthebusinesswhatisleftultimatelybelongstothem.
short:goingshortmeansadealeriscommittedtodeliveringsharesheorshedoesnotown;itisdoneinanticipationofafallingprice.
spread:thedifference
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betweenthebuyingandsellingpriceofashareorotherasset.
stockbroker:aprofessionaldealerinsecuritieswhoactsasanagentforinvestors.
straddle:buyingsimultaneouslyabuyandaputoptioninasharewiththesameexercisepriceandexpirydate;a
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techniqueinoptionstradingusedbyinvestorswhoexpectvolatilityinthepriceoftheunderlyingshares,itwidensthebreak-evenpointbutmeanstheycanmakemoneyifthereisasubstantialmovementineitherdirection.
structurednotes:debtsecuritiesnotbackedby
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mortgages,withcashflowdependentonanindexorindicesand/orwithembeddedforwardsoroptions.
support:inchartismitisthelevelatwhichfallingpricesstoporbouncebecausebuyersarebeingtemptedback.
technicalanalysis:in
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practiceanothernameforthechartistwayoflookingatthemarket;itusesnotjusttheconventionalmethodofhavingalinetodepictpricemovements,butalso‘pointandfigure’charts.
TheUndertakingsforCollectiveInvestmentinTransferableSecurities(UCITS):allowcollective
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investmentschemestooperatethroughouttheEUifauthorizedbyonememberstate.Thefundscaninvestinawiderangeoffinancialinstruments(includingderivatives),whicharesubjecttothesameregulationineverymemberstate.InpracticemanyEUmembersimposedextrarulesto
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protectlocalassetmanagers.
Tradepoint:acompany(itselftradedontheAlternativeInvestmentMarket)providinganelectronicmarketinshares.
unittrusts:anopen-endedinvestmentvehicle(seeabove).
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volatility:theamountoffluctuationinashareprice;themoreitmovesthegreatertherisk.
warrants:atypeofinvestmentallowingtheholdertobuypaperfromtheissueratafixedpricesometimeinthefuture;mostarelistedonthestockexchangeandcanbe
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tradedlikeanyotherinvestment,priortotheirexpirydate.
with-profitspolicy:aninsurancecoverthatguaranteesapaymentattheendofthesettermorondeath,butwhichalsoaddsanannualandaterminalbonus,thesizeofwhichdependsonthecompany’sprofit;thatin
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turnisaffectedmainlybyitsinvestmentinshares.
yield:calculatedbytakingtheamountofadividendasapercentageofthecurrentshareprice.Ifthesharesstandat120p(irrespectiveofwhatthenominalpricemightbe)adividendof12prepresentsayieldof10percent.If
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thesharesthendropto100p,theyieldwillhavecorrespondinglyrisento12percent.Itislistedinthenewspapersasyieldandcomparesdirectlywithwhatcanbehadinabankorbuildingsocietyforthemoney,butshouldbehigher.
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Index
accountingpolicies(i)AccountingStandardsBoard(i)accountsseereportsandaccountsacidtest(i),(ii)acquisitions(i),(ii)advice(i),(ii)advisory(i)AEX(i)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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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)
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Wilshire5000(i),(ii)
yieldseedividendyieldyield,redemption(i)yield,running(i)
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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
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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
Apart from any fair dealing for thepurposes of research or privatestudy, or criticism or review, as
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permitted under the Copyright,Designs and Patents Act 1988, thispublication may only be reproduced,stored or transmitted, in any form orby any means, with the priorpermission in writing of thepublishers, or in the case ofreprographic reproduction inaccordance with the terms andlicences issued by the CLA.Enquiries concerning reproductionoutside these terms should be sentto the publishers at theundermentioned addresses:
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© Michael Becket, 2002, 2004© Michael Becket and YvetteEssen, 2010© Michael Becket, 2012, 2014
The right of Michael Becket to beidentified as the author of this workhas been asserted by him inaccordance with the Copyright,Designs and Patents Act 1988.
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ISBN 978 0 7494 7238 2EISBN 978 0 7494 7239 9
British Library Cataloguing inPublication Data
A CIP record for this book isavailable from the British Library.
Library of Congress Cataloging-in-Publication Data
Becket, Michael (Michael Ivan H.) How the stock market works : abeginner’s guide to investment /Michael Becket. – Fifth edition.
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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
2014025415
Typeset and eBook by GraphicraftLimited, Hong KongPrint production managed byJellyfishPrinted and bound by CPI Group
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(UK) Ltd, Croydon, CR0 4YY