Investing in Stocks and Shares
Introduction
A STRATEGY FOR INVESTMENT ON THE UK STOCKMARKET
This book was compiled to demonstrate that it is possible to invest in the shares of UK-quoted companies in a sensible and logical manner that requires no special expertise; also, that the results will, in the long term, be better than those of more than half of the highly-paid professional fund managers.
It is directed at readers who may be considering investment on the Stockmarket as part of a balanced portfolio of investments. The early sections review features of the Stockmarket in a manner which is illustrative rather than definitive, showing the reasons underlying a ‘logical investment strategy’.
The first chapter provides an overview of the whole book, and should be read first. Subsequent chapters look more closely at the features of share investment and examine various strategies for investment on the Stockmarket with special emphasis on the ‘logical investment strategy’.
The closing chapters deal with additional areas for investment likely to appeal to the more experienced private investor, such as traded options, gilts and bonds.
It is hoped that this book will serve the reader not only as a general investment guide but also as a handy reference manual to be kept on the bookshelf. Numerous technical terms are explained at length and a substantial glossary has also been provided.
It is most important for the reader to remember one central tenet – past performance is no guide to future performance. That means that the logical investment strategy cannot be guaranteed to work in the future.
ABSOLUTE BEGINNERS
This book has been written on the assumption that the reader is familiar at least with the concept of trading in shares. If you have no previous experience at all of dealing in shares, then the London Stock Exchange (see Useful Addresses) provides some excellent beginner’s booklets at no charge.
SOURCES
Data used in the tables presented in this book have mostly been calculated from my private database. Long-term tables of inflation, building society interest rates and share price indices were obtained from the London firm Barclays Capital Ltd. Permission to use these tables and charts is gratefully acknowledged and the appropriate addresses are given at the end of this book. The Stock Transfer Form shown in Chapter 5 is reproduced by kind permission of the Solicitors’ Law Stationery Society Ltd.
ACKNOWLEDGEMENTS
Several investors, experienced and novice, read early and later drafts of this book. It is a pleasure to acknowledge particularly the valuable criticism, suggestions and contributions made by Ian Laurenson, former financial analyst at County NatWest. My wife laboured through many evenings to point out any areas which might need clarification for less experienced investors. Any errors which remain are my own.
DISCLAIMER
This is a book about one of several stockmarket investment strategies. In order to illustrate the reasons for creating the strategy, I have inevitably had to resort to using current charges, taxation levels, exemptions from tax and other variable figures. These were believed to be correct at the time of publication, but are certain to change in succeeding years.
The use of real companies to illustrate points made in the text should not be regarded as a recommendation to buy their shares. All of the companies illustrated in documents, such as share certificates, are fictitious and will not be found in the Financial Times.
Similarly, different investors have different objectives, priorities and financial standing. It is essential that they each seek qualified professional advice before making important financial decisions.
Why Buy Shares?
THE BENEFITS
The purchase of a company share gives the buyer a stake in the company and the entitlement to be paid a proportion of its profits known as the dividend. The value of shares in ordinary companies has, on aggregate, outperformed all other forms of investment over a reasonable period of time (say, most ten-year spans).
Figures given by the London stockbrokers, Barclays Capital Ltd (summarised by the author), show that in only six of the 75 consecutive rolling ten-year periods between 1920 and 2007 did the performance of government gilts (fixed interest bonds) exceed that of shares and most of these periods were in the dark days of the 1930s depression. Of 80 consecutive rolling five-year periods between 1920 and 2007, only 12 showed underperformance by shares, relative to gilts.
The following figures show relative performance between 1997 and 2007 and demonstrate that those who believe that houses are the best investment are very occasionally correct (this result has not been seen with any previous edition of this book)
Table 1. Relative performance between 1997 and 2007
% Growth
- Typical investment trust (with net dividends reinvested) + 98
- Typical house +189
- Building Society (Halifax Higher Rate: net interest reinvested) + 51
- Gilts (>15 years to expiry with, net interest reinvested) +126 Inflation index + 31
(Source: author’s data and Halifax Building Society. All figures given in this table are consistent with those published elsewhere.)
It must be recognised that the 1990s were an exceptional period of share price performance. However, the same factors which raised company profits, dividends and then share prices, also served to raise salaries and hence house prices. It has long been known that house prices are ultimately linked to family disposable income. Moreover, it is much easier to borrow money to invest in a house than it is to borrow to invest in shares.
This phenomenon, known as ‘gearing’, will be dealt with in Chapter 3. It is particularly important to realise that the house price rise does not take into account maintenance costs, including property taxes, which substantially reduce the real increase in value of the house. Standard financial advice for many years has been to buy as large a house as you need but not an inch bigger.
The availability of bonds linked to the inflation index and backed by the government has now provided investors with a clear target to beat. It is possible to buy index-linked bonds which additionally pay up to 2.5 per cent extra in interest. Since these bonds form one of the safest of all investments, it follows that any investment which is more risky must return a better yield than these bonds in the long run. The performance of shares has handsomely outperformed this target.
Figures 1 and 2 provide an illustration of the long-term outperformance of shares relative to gilts, building society funds and the Retail Price Index. The ‘Equity Index’ measures share price performance with the dividends received from the shares. Shares are often referred to as ‘the equity’ or as ‘equities’. Indices will be described more fully in the following chapter.
The ‘Gilt Index’ similarly measures the performance of government gilts, also considering the interest which they pay to their owners. Figure 2 takes into account the effect of using the net (after-tax) income which shares and building societies provide, to buy more shares or to reinvest the money in the building society.
The ethicality of shares
The days when a wealthy enthusiast could back a good idea have now largely gone. Henry Ford started his car company between the two World Wars with capital borrowed from friends and made them millionaires, but that is no longer practical on a large scale.
The cost of installing a new blast furnace for British Steel would have made even Paul Getty blench. The only way to fund such costly developments is by the mobilisation of the savings of large numbers of ordinary people, by bank loans (using bank deposits) and by selling shares.
Current wisdom is that it is vitally important to put people’s savings into productive industry, rather than into unproductive housing. Unlike the inhabitants of Kipling’s island, the people of Britain cannot continue to eke out a precarious living by selling houses to each other.
Encouragement of the private investor
The decline in recent years in the number of private investors has caused unease among the boardrooms of British companies and among laissez-faire politicians, albeit for different reasons.
Private investors were traditionally loyal to the company management, while institutions have, with a few honourable exceptions, acquired a reputation for passing large blocks of a company’s shares around like so many sacks of potatoes. This has meant that managers now have to keep an eye on their share register for the sudden appearance of potential predators. This may be no bad thing in itself, if it concentrates their minds on improving the performance of their companies.
In recent years a number of British companies have taken positive steps to encourage the growth of private share ownership. Some now offer their products to shareholders at reduced prices. However, they have to be careful about the pricing of such goods or the Inland Revenue may tax the benefit. Typically a discount of up to 20 per cent is offered to shareholders in food, brewing, hotel and other service industries. A number of stockbrokers publish lists of shareholders’ perks.
Other companies encourage close contact with shareholders, while an increasing number now provide shareholders with a very cheap means of buying and selling their shares. For example, HBOS (Halifax) bank customers can buy and sell its shares at a discounted commission by sending a simple form, obtained from their branches, through the post to an approved broker.
Privatisations
The government has also recognised the value of promoting private share ownership. Tax concessions are now available to those who own shares in the company for which they work and Individual Savings Accounts (ISAs) have provided an increasingly valuable tax shelter for funds invested in British companies. All long-term investors should take out ISAs, and these are more fully described later in this book.
However, the main plank of the government’s determination to raise private share ownership was its privatisation programme. After the half-hearted, partial denationalisation of the oil company BP (in the late 1970s by Labour), the succeeding Conservative government sold off all the easily saleable nationalised industries such as British Telecom, British Aerospace and Amersham International. Some public utilities (water, gas, electricity) were also privatised, a step regarded in many quarters as being ethically dubious.
It soon became apparent that the shares of these companies were being sold cheaply and all later privatisation issues were massively over-subscribed by certain investors who sell shares immediately after purchase with a view to making a quick financial killing (‘stags’). As a result, it became impossible to acquire a worthwhile holding in any privatisation issue and the number of long-term investors remained low.
In addition, few of the new breed of privatisation investors went on to buy shares in other companies. The Central Statistics Office reported in 1994 that there were 7.5 million private investors in the UK (up from three million in 1979, before privatisations began in earnest), of which only one and a half million owned shares in more than four companies. The underlying trend of private share ownership was still down.
What is the effect of inflation?
Inflation is the name given to the creeping process by which the price of everything moves slowly upwards. It is widely believed to be due to the circulation of too much money. It erodes the value of savings, since they can purchase less and less, and most governments adhere to an avowed policy of reducing its rate of progress. Salaries and wages tend to be greatly influenced by inflation, in that inflation serves as the basis for the minimum demand for a wage increase.
Inflation is measured as an average percentage increase in the cost of everyday purchases and is estimated in the UK by the Retail Price Index (RPI), statistics compiled officially by the government. Every form of investment needs to grow at a rate at least equal to inflation, or the value of the investment is reduced.
Since most manufacturers try to improve their products, and thereby charge a higher price for the new item, there is an inbuilt element of inflation in ordinary technological progress.
Because shares provide a stake in a company they should, all other things being equal, prove to be comparatively immune to inflation. As inflation rises, so will the face value of the company’s assets – its land, factory and stocks – and so will the prices which it can charge for its finished products.
The same phenomenon is seen for all asset-backed commodities, whether soya beans, Rembrandt paintings – or land. Gold is discussed in Appendix 5.
British inflation was negligible during the periods 1200–1550 and 1700–1900AD.
WHY DO SHARES RISE IN VALUE?
Over any long period, shares in companies have always, hitherto, outperformed all other investments and the reasons are given below.
Inflation
As we have seen, a company can raise its prices and thereby its profits, in line with rising inflation, all other things being equal and provided there is no government intervention. However, it should be noted that this simple relationship breaks down in times of high inflation, when a government intervenes. The company has to pay high prices for its raw materials, but may be restrained by government edict (a ‘prices policy’) from raising its prices sufficiently to compensate.
The ability to raise dividends and capital values in line with inflation is not shared by bonds or gilts (unless index-linked), but is shared by property, paintings and related forms of investment. However, governments may impose periods of restraint on dividend growth as part of a general prices and incomes policy. This was last seen in the late 1970s under a Labour government.
The exceptionally high levels of inflation which British investors have to endure, much higher than those seen in the USA, Germany, Japan or other principal stockmarkets, mean that there is always a strong upwards pull on share prices. When inflation averages five per cent per annum, share prices have to rise five per cent just to stand still in real terms. This means that long-term investors in this country should always base their investment decisions on the premise that the stockmarket will rise in value.
It is possible to make a profit from a falling stockmarket by a variety of means. For example, buying ‘put options’ (see Chapter 7) or ‘selling stock short’, which means that you sell shares today in the expectation of buying them back cheaper at a later date. However, the upwards drag of inflation makes this a very risky pastime for any but the shortest of periods.
Figures 3 and 4 show the effects of inflation on the performance of shares, gilts and cash investments, and should be compared with corresponding Figures 1 and 2. Only shares have withstood the effect of inflation, while the performance of gilts (which do not in these tables include the index-linked types) has been disastrous in real terms.
Table 2. Net income paid per year on £100 invested
Date_______Building Society ( Higher Rate ) __ Alliance IT* Dividends
1/1/98______6.7________________________2.6
1/1/99______5.6________________________2.8
1/1/00______4.7________________________2.9
1/1/01______4.6________________________3.0
1/1/02______3.1________________________3.1
1/1/03______3.1________________________3.15
1/1/04______3.2________________________3.20
1/1/05______3.8________________________3.25
1/1/06______3.7________________________3.3
1/1/07______3.6________________________3.4
Capital: £100 £165
(Value of original capital on 1/1/07)
Table 3. Total returns (all net income reinvested) (Based to 1997=100)
Date_______Building Society ( Higher Rate ) __ Alliance IT* Dividends
1/1/98______107________________________116
1/1/99______113________________________135
1/1/00______118________________________157
1/1/01______123________________________153
1/1/02______127________________________141
1/1/03______131________________________115
1/1/04______135________________________137
1/1/05______140________________________142
1/1/06______145________________________180
1/1/07______151________________________198
Capital: £100 £165
(Value of original capital on 1/1/07)
(*Data from Alliance Investment Trust)
The employees care
The directors and workforce of a company have as much, or more, interest in the well-being of the company as the investor. They will strain every sinew to raise the profitability of their company (and thereby improve salaries and job security), thus working indirectly for the investors’ benefit. Strictly speaking, the directors are supposed to work directly for the investors’ benefit anyway, but it has been observed by industry analysts that many are more interested in empire building. However, manufacturing improvements, economies of scale and the like will all be working in the investors’ favour.
In the long term
In the long term, companies may reasonably be expected to pay increasing dividends to their shareholders and the share price should continue to rise to reflect this increase. Pension funds and insurance companies calculate their returns to policy holders on the basis that long-term benefits from shares will exceed increases in wages by at least two per cent. Also that long-term growth of the share value will be of the order of 6–8 per cent per year.
It is particularly instructive to compare the gains made from a building society higher-rate interest account and the growth in income from an ‘average company’ (actually an investment trust, see page 81). See Table 2. The income derived from the building society wanders up and down, depending on current interest rates, while the underlying capital remains the same if the income is spent. By contrast, the income from the ‘average share’ starts from a lower figure than the building society but soon exceeds the income from the safer investment. Moreover, the capital value of the share has increased in value.
Tables 3 and 4 also serve to emphasise the long-term gain which, hopefully, accrues from investment in an ‘average share’. Table 4 shows purely mathematical calculations. Table 5 shows recent inflation rates, which serve to devalue the performance shown in the earlier tables.
ARE SHARES RIGHT FOR YOU?
Table 4. Compound growth assuming fixed rates of increase.
Year ___________Dividend growth* (5% per year)
0 _____________4.0 (initial net dividend)
1 _____________4.2
2_____________ 4.4
3 _____________4.6
4 _____________4.9
5 ____________ 5.1
6 _____________5.4
7 _____________5.6
8 _____________5.9
9 _____________6.2
10 _____________6.5
(*Net dividend per £100 of stock)
Compound growth assuming £10,000 invested per year.
Growth rate (%)________ Total after 10 years*
0 ________100,000
5 ________125,778
10 ________159,374
15 ________203,037
20 ________259,586
(*excluding dividends)
Table 5. Average inflation rates (AIR)
(Rebased to 1997=100) Year _____AIR (%)_____ Cumulative
1/1/98_____ 3.6 _____103.6
1/1/99_____ 2.7 _____106.4
1/1/00_____ 1.9 _____108.4
1/1/01_____ 2.9 _____111.5
1/1/02_____ 0.7 _____112.3
1/1/03_____ 2.9 _____115.6
1/1/04_____ 2.8 _____118.8
1/1/05_____ 3.5 _____123.0
1/1/06_____ 2.2 _____125.7
1/1/07_____ 4.4 _____131.2
Buying shares means that the investor has taken a stake in the company. Companies can, unfortunately, go bankrupt, in which case the investor will lose all or part of the money he put into the shares. He will not, however, be personally liable for any part of the company’s debt, provided that it is either a ‘limited liability’ (Ltd) or a ‘Public Limited Company’ (plc).
This means that shares can be a comparatively risky form of investment. You do not expect to lose money placed in a building society or in most gilts, but you could lose part of any money invested in housing (as was discovered by the unfortunates who bought at the top of the housing market in 1988) or in paintings or other collectables.
It follows, therefore, that the prudent investor should only buy shares with money that he, or she, can afford to lose. Diversification of risk is essential with money spread among many companies rather than concentrated in one or two. This means that outperformance of many shares will compensate for the occasional disaster when a company goes bankrupt (and this can happen to the most prudent investor, as the author can testify from personal experience). In short, the investor must be prepared for, or resigned to, the fact that part of his total investment – a small part, one hopes – is virtually certain to be lost in an investment career spanning several decades.
There is a widely held belief that only wealthy people can afford to own shares. Like many myths, this has some basis in fact. If it is necessary to invest only money which you can afford to lose (at any rate, lose in part) it follows that you must already have enough money for other commitments.
Commitments vary with age (especially) and with individual inclination. When one is younger, money is spent on rent, mortgage and/or children. But as the years unfold these commitments become less onerous. A 25-year mortgage would have seemed to require very high repayments when it was first taken out in 1992, but 15 years later they may only represent a small portion of the owner’s salary. Everyone requires an adequate financial cushion. Is your pension arrangement sufficient for your likely needs after retirement? Pensions are arranged with financial institutions and rely quite heavily on shares to provide long-term growth.
Indeed, insurance companies are now among the biggest owners of companies in the UK stockmarket, so virtually everybody who has, or is saving for, a pension is an indirect investor in the stockmarket.
Pensions are a complex subject in their own right and many employees will take out a stakeholder pension or else make additional voluntary contributions (AVCs) to top-up an existing company pension. Stakeholder pensions have been encouraged by the government, with tax incentives and a maximum 1% administration charge by the pensions company. Savers can also invest in Self Invested Personal Pensions (SIPPs), but these often require expensive administration by the provider even though the investor makes all the investment decisions. SIPPs are of most interest to those running their own businesses, when the business premises can, with tax advantage, be made part of the pension arrangement.
In all cases, insurance companies will normally offer a variety of schemes, of which most will be based, at least in part, on investment in shares in the stockmarkets of the world. Increasingly, the pension saver has the choice of deciding which investments to make.
Individual Savings Accounts (ISAs, mentioned earlier) provide a form of savings used extensively for pensions or mortgages, as well as for more personal investments. While a financial institution is usually involved in the selection of companies for an ISA for the above purposes, the private investor will sometimes be able to make his own decisions.
Do you have sufficient insurance? Everyone of working age requires life (term) insurance, house insurance and, probably, car insurance. Would your wife and children be able to carry on after your death? If not, an urgent demand for your money exists before you even consider buying shares.
Do you have ‘rainy day’ money? What will you do if the roof falls in, the house subsides, you need to buy a new car (or repair the old)? It is essential to have ‘safe’ money available in savings to meet unexpected contingencies. This money must be readily accessible and will normally be kept in a bank or building society. One of the fundamental axioms of investment in shares is that the investor must never allow himself to become a forced seller of shares, when it may become necessary to sell at an unfavourable price. It is necessary to maintain a contingency reserve sufficient to avoid enforced sales of shares.
If, after making provision for all the contingencies mentioned above, you still have enough residual cash, or income, then you have enough spare money to consider investment in shares.
Shares are part of a range of investments A holding of shares is only one of the many different types of investment and is one of the more risky.
Alternatives include investments in property (typically your own home), building society accounts, National Savings and fixed- interest bonds such as gilts (bonds guaranteed to pay a fixed rate of interest on the sum invested). The ‘fixed’ element may be relative to a moving index such as occurs with index-linked gilts, ‘granny bonds’ and the like. More arcane investments include the purchase of paintings, stamps or even toy soldiers.
Nevertheless, statistics show that over long periods an investment in shares outperforms all other investments, including property. It is very important to remember that investments in shares should form part of a balanced portfolio. What is meant by balanced? A portfolio is said to be balanced if it is spread across many different types of investment so that a fall in value of one part of the portfolio is balanced by a compensating rise in another part. Thus it is likely that a balanced portfolio will contain investments in a building society or on deposit with a bank (these investments are called ‘cash’) in addition to the contingency fund previously mentioned. Excessive economic growth (overheating) will cause share prices to surge. If the government takes corrective action by raising interest rates, then share prices are likely to fall but the amount of interest received on deposit will rise in compensation. Professional investors, such as pension institutions, seek to diversify risk among property, foreign shares and government bonds (gilts) as well as with shares and cash.
Table 6. Typical pension fund asset distribution in 2006
Asset
UK shares (equities) 50%
Overseas shares 32%
Property 2%
Bonds (UK and overseas) 9%
Index-linked bonds 0.5%
Cash 6.5%
Modern economic theory has provided much information about the management of risk and this is discussed in more detail later in this book. A professional (institutional) investor would add convertibles and traded options to his portfolio in order to get the right blend of long-term growth of capital and income with the desired degree of security. Private investors cannot so readily mimic the professionals’ practice, owing to the high cost of dealing in these so-called ‘derivative’ instruments.
It is axiomatic that high risk investments must carry higher rewards than low risk equivalents, or else no one would take the greater risk.
Greater Reward = Greater Risk
Where to buy and sell shares
Shares are traditionally traded through a stockbroker, who may offer a simple dealing service, advice or portfolio management. Charges will vary according to the amount of service provided. Banks also offer dealing facilities. The ‘touch-screen’ operation of National Westminster Bank, whereby transactions are handled at a computer screen in the bank branch, provides an especially convenient service. It seems likely that retail outlets, such as bank and building society branches, will provide increasing competition for the more traditional methods of dealing and this development is being encouraged by the government.
The various share trading options are discussed in much greater detail later in this book.
Independent advisers
How often have you seen the phrase ‘Consult your Independent Financial Adviser’? In recent years, the role of the so-called ‘financial adviser’ has become closely defined. All advisers must be members of one or other of the regulatory authorities and must state whether they are entitled to sell all financial products (independent adviser), products from a short-list of companies (multi-tied), or only those of one company (tied adviser).
Independent advisers live mostly off the commission which they earn by selling financial products. Although required by the Financial Services Act to give ‘best advice’, in practice some of them may advise the purchase of those products which provide the highest commission. There have been many complaints from financial professionals that some ‘independent’ advisers invest in one way for themselves and in another (more profitable in terms of their commissions) for their clients.
The levels of commission can be surprisingly high. For instance, arranging a typical pension will earn the independent adviser something like a thousand pounds.
The alternative is to use a fee-based adviser. He or she will charge perhaps £100 per hour, so that a typical consultation for a pension will cost you £400. The fee-based adviser ought also to return any commission he receives from the insurance company whose pension he recommends. However, the returned commission should not be subject to income tax for retail customers (check with the adviser).
A good stockbroker should provide an excellent source of information about shares at no charge to the investor, although the broker’s commission structure for share dealing with advice is likely to be higher than that of a ‘dealing only’ service. The addresses of local stockbrokers and financial advisers, of all types, can be found in your telephone book. Unfortunately, crooked, or fraudulent, advisers do still exist and a number of their ploys are described later in this book.
A HISTORY OF SHARES
Ancient history
The ability of individuals to take stakes in companies has long been known. The Romans used to fund expeditions to India for silks. Indeed, there were contemporary fears that the export of solid silver in exchange for perishable silks would ultimately bankrupt the Empire, a prediction not fulfilled. Many merchants became rich as a result of this trade while the Empire exacted a tax on it. Nevertheless, many of the aristocracy were debarred from taking part in commercial ventures, while the real mark of wealth was to own land. The larger the estate the better and this would provide the primary source of income for the ‘old rich’. As a result, the Romans never really sorted out the principles of modern lending (banking), accountancy (they lacked the security of double entry systems) or companies with multiple shareholders who could trade their holdings.
After the collapse of the western Roman Empire in 476 AD, there was a long period of stagnation in Europe. European financiers in medieval times, particularly those of the maritime trading cities such as Venice, invented and developed many of the modern accounting systems that today we take for granted. For example, paper money and transactions between distant banks, and double accounting and the use of black and red inks for positive and negative value entries. However, the Reformation and the spread of British sea power created a new class of entrepreneurs who sought their fortunes in overseas goods.
In the sixteenth to eighteenth centuries a typical method of trading was to create a company by borrowing from wealthy backers. The money would be used to buy a ship and finance an expedition to one of the colonies or further afield. When, or if, the ship returned, the cargo would be sold, the crew paid off, the ship sold and the money so obtained divided between the original backers. Profits had to be very high to compensate for the risk that the ship might not return.
The first record of such early companies was ‘The Mysterie and Companie of the Merchant Adventurers for the Discoverie of Regions, Dominions, Islands and Places Unknowen’ (1553), which subsequently became known as the ‘Muscovy Company’ for rather obvious reasons! Other famous companies which began in this way included the East India Company, trading primarily with the new ‘jewel in the crown’ of India, and the Hudson’s Bay Company.
Developments
By now it had become recognised that to create and disband companies after every venture was inefficient. Instead, it was much better for everyone if the company could continue. This was achieved by issuing ‘shares’ in the company. Instead of breaking up the company at the conclusion of its original purpose, a new venture (typically a new journey overseas) was arranged. The original investors could retain their ‘shares’ or they could sell them on to someone else who wanted to take a stake in the company.
From here it was but a short step to creating a ‘market’ in which investors would meet to buy and sell their shares. The Royal Exchange in London was an important venue for banking. Trading of shares continued informally here until the disturbance was such that the traders were ejected. The surrounding coffee houses (coffee being a new imported luxury), especially those in Threadneedle Street, subsequently became popular as meeting places for the exchange of shares. In 1773, the coffee shop ‘New Jonathan’s’ became known as the world’s first ‘Stock Exchange’.
The trading of commodities was already much better established than the trading of shares and the trading empires of the continent had already experienced spectacular ups and downs. Holland had been importing tulips from Turkey since the 1560s and had created a strong local demand. This demand became so high that by 1634 there was a huge market dealing in the supply of tulip bulbs as speculative items.
Demand outstripped supply and the price of bulbs rose to fantastic heights with whole estates changing hands for a single bulb! In 1636 the authorities advised against further purchases of tulips, a panic set in, no one would buy the bulbs and by 1637 the market was almost dead with many people still clutching the now worthless tulip bulbs.
A similar period of crazed speculation led to the ‘South Sea Bubble’. In 1711 the Chancellor of the Exchequer persuaded many of the government’s creditors to accept shares in a new company rather than take interest payments raised through taxation. The new company was called ‘The Governor and Company of Merchants of Great Britain Trading to the South Seas and Other Parts of America’ and was granted a monopoly of trade to Spanish America (principally South America).
The company proved to be extremely popular with speculators, notwithstanding the fact that there was a war continuing with Spain. The directors of the company felt able to sell more and more of the government’s debts to eager investors, using the money the investors handed over to pay fat initial dividends to those investors. The whole merry-go-round collapsed in 1720 when no new investors could be found to purchase further stocks. Variants of this confidence trick (using the investors’ own money to pay them their dividends, until the money runs out or the company folds) are still with us today. By the end of the eighteenth century most companies comprised partnerships with unlimited financial liability for the partners in the event that their companies went bankrupt. This promoted extreme care in trading by the partners.
At the beginning of the nineteenth century, it became recognised that further progress of the Industrial Revolution required the raising of capital on a grand scale. This led to a number of more-orless unrelated developments, some legislated by Parliament.
In 1802, the Stock Exchange was formally constituted with 550 subscribers and 100 clerks. Other regional exchanges opened throughout the century. Finally there were over 30 exchanges, the seven regional survivors of which were incorporated into the London Stock Exchange as recently as 1973.
Subsequent legislation created the concept of ‘limited liability’ (Ltd). It meant that the owners of a limited company were not liable for its debts, beyond the money which they had already sunk into the venture. This greatly reduced the risk to the investor of buying shares in a company, and thus had the effect of encouraging investment. Another very important development was the separation of ownership and management. The owners of a company could appoint managers to run the business while the owners stayed in the background.
The unregulated stock markets of the nineteenth century saw investment on a huge scale at home and abroad, and in all the corners of the British Empire. A particular favourite was investment in the new railroads, which first appeared in Britain but which subsequently spread their tentacles all over the USA and then Latin America.
The 1822–1825 bond bubble exploited the stocks of Latin American governments. The bubble burst when several countries defaulted on interest payments.
The great difficulty was in knowing where to invest since communications were, by modern standards, poor and fraud was rife. Wealthy individuals could make many investments and thereby spread their risk, but this option was not open to the smaller investor.
The first investment trust, ‘Foreign and Colonial ’, was created in 1868. Its stated objective was ‘to give the investor of moderate means the same advantage as the large capitalist, in diminishing the risk of investing in foreign and colonial government stocks, by spreading the investment over a number of different stocks’.
The early investment trusts were immensely popular. They were set up as real trusts, but a court decision (subsequently overturned) declared that they were not legally trusts. Consequently the first trusts were turned into limited liability companies. By 1900 over one hundred investment trusts had been formed.
The First World War began in August 1914. The Stock Exchange closed its doors on the first day of the war, fearing a massive wave of selling, and no trading was permitted for the remainder of the year. Post-war saw the merging of several British companies into forms which are still recognisable today, for example Imperial Chemical Industries (ICI) formed in 1926. The oil companies began their rise to prominence and shares began to move into favour with institutional investors.
Up until the First World War, inflation in Britain had been negligible and rates of interest were low. This was the period of the government bonds known as ‘Consols’, which paid either a 2.5 per cent or 4 per cent interest per annum. Consols were ‘safe’, while shares were more risky and therefore gave a higher yield to their owners. Advice given to Harley Street doctors of this era was to ‘put your first £100,000 into Consols, then buy shares’. However, the aftermath of the war saw a surge in inflation (still low by today’s standards) which made shares, with their asset backing, more attractive.
The value of shares rose steeply in the 1920s, led by the USA. This led to the same speculative excesses seen in earlier times. The Great Crash came in 1929 and the depression followed.
The Great Crash is vividly associated in the public’s mind with financiers throwing themselves out of the windows of skyscrapers. The reason was that so many investors had borrowed heavily to fund share purchases. When the market collapsed their holdings became worthless and they could not afford to repay the borrowings. In some cases, bank staff had ‘borrowed’ illicitly from their banks to buy shares. They were certain to lose their jobs and receive jail sentences when they could not repay their unauthorised loans. Others had mortgaged their homes or estates.
But what of those who bought shares with their own money? In the popular TV series Upstairs, Downstairs, the servant girl Rose is advised at the height of the 1929 boom to put her inherited money into an investment trust – a wise scheme, even if the timing was wrong. The story ends with the market crash, the adviser dead by suicide (he had borrowed heavily) and Rose penniless – but is she? She still has the holding in her investment trust and owes no one any money. In years to come, Rose would find that her share certificate would refund all her money and more.
The rise and fall of stockmarkets is a cyclical phenomenon, with the markets rising and falling in cycles of several years. Periodically investors forget that shares are tied to underlying companies, the ‘tulip phenomenon’ sets in until the market crashes and investors are taught a sharp lesson. Economic processes also play their part in causing the values of shares to rise and fall, usually with a cycle of roughly four to five years in the UK (see Figure 1). Some commentators have claimed to see a very slow underlying cycle, or wave, with a time span of around fifty years. This presupposes that nothing changes in human or economic terms over several cycles, each of nearly two generations.
Fraud was an increasing problem during the boom years of the 1920s, and the Stock Exchange became known as the ‘thieves’ kitchen’. Some financial magazines had acquired a reputation for touting worthless shares, particularly in new issues, and this and other abuses needed to be cleaned up. The authorities imposed restrictions in 1930 on new issues of shares.
The boom period of the 1920s created a demand for monitoring the performance of shares. Hitherto, individual stockbrokers or magazines had attempted to monitor selections of shares, and the ‘old’ Financial Times started an index in 1926. On 1 July 1935, the Financial News – which was subsequently to acquire the Financial Times and change its own name to the ‘new’ Financial Times – created the celebrated FT-30 share index, measuring the performance of thirty of the top publicly-quoted companies in Britain. 1931 saw the launch of the first true public trust. Municipal & General (M&G), still one of the most respected names in the field, created its first ‘unit trust’ with trustees to watch over the fund. Unlike the investment trusts, which were real companies owned by shareholders, the unit trusts were severely restricted in their range of investments. Purchase of ‘units’ gave the investor a stake in a wide range of companies. In 1936 control of unit trusts was transferred from the Stock Exchange to the Board of Trade.
The outbreak of the Second World War in September 1939 reversed what had been a steadily rising stock market into a slow decline. This steepened rapidly in 1940 when it was feared that the Germans would invade Britain. By 1941 the market was rising again. Inflation became a serious anxiety in Britain throughout the Second World War.
Modern times
In 1950 it was still possible to buy shares with borrowed money, repaying the interest from dividend income. This situation rapidly changed as inflation took hold in the post-war years. It became apparent that asset-backed shares could survive inflation much better than low-interest gilts. This resulted in a reversal of gilt and share yields. Previously gilts, such as Consols, paid a lower yield than shares to reflect the latter’s greater risk. Now prices of shares rose, causing a lower percentage dividend yield from the shares, in recognition of their ability to show long-term growth and to withstand inflation.
Social factors created another major change. With the increasing role of the State in an individual’s affairs, the number of private investors began to decline. There were two principal reasons for this:
. The provision of State health care, social security and pensions reduced the need for individuals to save.
. The increased burden of taxation required to finance the benefits of the Welfare State reduced the ability of individuals to save.
In the place of the private investor came a whole series of financial institutions, such as life funds, insurance companies and unit trusts.
Their faceless managers handled the pooled savings of large sections of the population and charged heavily for the service.
Changes in taxation by successive governments favoured the channelling of savings into tax-sheltered institutions, quickening the transfer of share ownership from private investors. A number of scandals rocked the investment trust industry. The old investment trusts found that their original base of private investors was falling and the institutions took their place on the trusts’ share registers. But then the institutions assembled their own share management teams and sold out of the investment trusts, whose share prices fell heavily. Many investment trusts were swallowed up by predators, others entered specialist areas in which the institutions as yet lacked expertise. It is only in recent years that investment trusts have managed to encourage the private investor back again.
The process of transfer of shares from private investors to institutions was greatly accelerated by the terrible market crash of 1973–1974. This was caused by high inflation, a quadrupling of the oil price, ruinous taxation of inflation-induced gains and a subsequent dividend freeze imposed by the Labour government. Nearly 70 per cent of the peak market value (of 1972) was lost. The market largely recovered in 1975 and 1976, but the shock had been even more severe to investors in this country than that of 1929. In 1979 a new Conservative government was elected to power with the avowed intention of rolling back state intervention. A rocky start in 1980, brought about by a recession induced in an attempt to lower inflation, caused share prices to fall, but they rose steadily thereafter all through the 1980s.
London was by now the largest stockmarket in the world, in terms of shares traded. The Office of Fair Trading criticised the Stock Exchange’s cosy cartel which kept commissions high. In order to protect the Exchange’s position and its ‘invisible earnings’ for the country, a number of changes were announced to be brought into simultaneous operation on one day in October 1986. That day came to be known as ‘Big Bang’. The Big Bang meant primarily that fixed commissions for handling shares would go and outside (mostly foreign) competitors would be allowed in. Another innovation was the amalgamation of brokers (who acted for investors as agents) and jobbers (who made the markets at the Stock Exchange) into one function – the ‘market maker’.
These changes had a variety of effects, some probably unintended. Commissions fell steeply for the large institutions (from around 1.5 per cent to 0.2 per cent), but were raised for private clients who had previously been subsidised by the institutions’ fees. The introduction of competition meant that the new market makers had to become bigger to survive. There were numerous mergers of the old stockbrokers with outside firms. City salaries rose steeply. Another difficulty was that of the abuse of ‘inside information’, which had newly been made illegal. The new market makers were not allowed to use privileged information (for example, that they had just been wrong-footed into buying a load of expensive rubbish) in order to gain an advantage (for example, to dump the rubbish onto their private clients as a ‘good long-term investment’). Socalled ‘Chinese Walls’ were supposed to prevent the passage of privileged information from one department of the market maker to another. Several subsequent prosecutions showed that the Chinese Walls were as flimsy as the paper originals.
In 1987, a Conservative government having just been re-elected, share prices exploded upwards out of control again. In October, coincidentally after two days of the fiercest storms of the century which caused widespread damage around Britain, markets plunged in panic, losing a third of their value in just three days. The fastest crash in history. It is, however, noteworthy that the UK stockmarket indices ended the year still slightly higher than when they began. As usual, recovery occurred and a new stockmarket peak was reached in 1990.
The 1987 crash was initiated by the selling of unit trusts in the USA (known there as ‘mutual funds’). The situation was exacerbated by ‘program trading’, the programming of idiot computers by human idiots to force-sell shares at any price once a certain fall in share prices had occurred. There was subsequently a widespread outcry against program trading, and so-called ‘circuitbreakers’ are now in operation in the USA designed to break the vicious circle of selling causing further programmed selling of shares.
A new Labour government, appropriately entitled ‘New Labour’, was elected in May 1997, the first in 18 years. Its first budgets contained some major tax changes for private investors, the significance of which were perhaps not properly appreciated at the time.
Tax credits on dividends could no longer be reclaimed by those who paid no tax; thus those on low incomes, charities and, especially, pension funds immediately lost 20 per cent of their income from shares. For private investors, the tax credit was maintained for five years (until year 2004) at the reduced level of ten per cent; however, the government promised that changes in personal taxation rates would ensure that neither higher- nor lower-rate taxpayers would pay more income tax in consequence, before or after 2004. However, the critical link between the standard income tax rate and the dividend tax rate has been broken with unpredictable long-term consequences.
Advance Corporation Tax (ACT), whereby companies paid tax at the same time as their dividends as an advance against their year-end tax bills, was subsequently abolished from April 1999. It was this tax pre-payment that had provided the dividend tax credit to the recipient of the dividend in the first place. Foreign Income Dividends (FIDs), derived from companies that did not have to pay ACT on large overseas earnings, were also abolished from April 1999.
These changes to dividend payments have had the long-term effect that many companies are now more willing to return excess capital to their shareholders and to buy back their own shares for cancellation than was hitherto the case. Although such changes give rise to capital gains tax (CGT), pension funds and many other large institutions are exempt from CGT. Ironically, the new Chancellor had attacked ‘short-termism’ in the holding of company shares by predominantly these institutions, yet he now proceeded to make changes to CGT, in the name of encouraging long-term share holding, that would affect only non-institutional shareholders, such as private individuals.
Previously CGT had been based on capital gains made after the initial acquisition costs of an asset had been indexed for inflation. The new ‘tapering’ tax system for individuals ended indexation, but reduced capital gains on a sliding scale according to how long the asset had been held. The same Budget ended the practice of ‘bedand- breakfasting’ – the sale and repurchase of the same shares so as to establish a capital gain on the sale date and to rebase the cost to the new purchase date. Finally, the new Labour government ended the ten-year-old Personal Equity Plan (PEP) and TESSA schemes and introduced an inferior replacement called ‘Individual Savings Accounts’ (ISAs).
The new government had assumed as a matter of belief that payment of dividends was a Bad Thing, taking money out of businesses which should have been re-invested. Instead, capital gains (rise in share price) were to be the investors’ reward. This strategy worked briefly, but by early 2000 the stockmarket had temporarily peaked with the TMT (technology, media, telephones) boom. Share valuations had completely exceeded reality, and with the widespread failure of the so-called ‘Dot-coms’ (companies created to make money from the Internet) it was now downhill all the way. Accounting scandals in the USA also left their mark on British companies, although they were not directly implicated, and the market had declined by almost 50% in value by the low point.
As usual shares recovered sharply from their low point of March 2003 and had largely returned to their high point by the end of 2006 (although many dot.com stocks would never recover), bolstered by a strong recovery in company profits. Another characteristic of this period of recovery was that governments around the world had greatly reduced global interest rates in order to stimulate the recovery, leading to the availability of huge sums of cheap money. Many privately financed companies took advantage of this to make opportunistic bids for under-priced large public companies. In the UK alone, numerous household names, including ABP (Associated British Ports), BAA (British Airports Authority), several utilities and P&O (the famous shipping line) were swallowed up.
The same cheap money in Britain led to easy finance for mortgages for houses, leading to the present, certainly unsustainable, house prices boom. The three-year decline caused severe financial stress to many pension funds. Some commentators observed that the amount taken out of dividends by the abolition of the tax credit (£5 billion per annum for five years) closely matched the new shortfalls in the pension funds (£27 billion in 2002). By the end of 2002, threequarters of the popular Final Salary Pension schemes had closed to new entrants. Those individuals seduced into taking up first the replacement Personal Pensions and later the Stakeholder Pension found their pensions savings greatly reduced. These fiascos occurred despite the government’s avowed aim of inducing individuals to save more for their retirement.
All these new changes are explained within this book, mostly in the Appendices. But the complication for private investors of holding shares personally in individual companies has increased under the new rules. Many readers will prefer to invest through collective savings vehicles, such as investment trusts, rather than have to deal with the new tax rules directly.
THE DIFFICULTY OF SELECTING SHARES
Someone once asked me, ‘How do you select the shares which you buy?’ This simple question at first mystified me. I purchase shares which I have long been wanting to buy, but for which I have only just acquired the money by saving out of income.
This response, however, only serves to set the question one remove back. How did I decide which shares I wanted to buy? It occurred to me that this is a matter of no small significance to the private investor without access to expert information, and may explain the perennial popularity of tip sheets. However, as a former Chancellor of the Exchequer once drily observed, ‘In rising markets, all tips are good. In falling markets, all tips are bad.’
This book will describe ‘The Logical Investment Strategy’, one of the many possible strategies for buying shares. It is the strategy which I use myself. But first it will be necessary to examine the background of investments in shares available to the person with a few thousand pounds to spare.
