BUILDING UP AN EQUITY PORTFOLIO

It is not sensible to put all your money in one company. It is better to spread it over at least ten companies, which means having at least £10,000 to invest, as it is not economic to put less than, say, £1,000 in any one due to minimum dealing costs.

Consideration should also be given to share sectors. It is risky to have too much invested in one sector.

Many newspaper City pages recommend individual shares to buy or sell but this can push the price up or down before you can react. Information is also available on the Internet. Company reports can be obtained to provide more information.

There are also tip sheets, which recommend individual shares. They are expensive and one wonders whether the tipper keeps the best ideas to himself.

Word of mouth can be useful and it is a good idea to watch out for new ideas and successes, such as, for example, a shop which seems to be doing well or a product which you have bought or is recommended by a magazine or TV programme.

Smaller companies

There may be a narrow market in smaller companies’ shares, which can make them difficult to buy and (particularly) to sell. Also, smaller companies are more likely to go bust than are larger ones.

However, good smaller companies can be valuable investments as they tend to be cheaper than larger companies, have higher dividend yields and provide a greater potential for capital growth and dividend increase.

Fundamental analysis

This term is used to describe choosing shares by looking at the fundamentals – the financial results for recent years, including statistics such as profit and dividend trends, the annual and half-yearly reports, recent announcements by the company, share price history, share dealings by directors. In addition, there are the statistics for the sector in which the company’s shares sits.

Technical analysis

It is possible to carry out what is called technical analysis, which can be done on a computer using a proprietary system. Graphs of the price of each share can be drawn and you can superimpose on them the relative movement of an appropriate index, short- and/or long-term averages and stop/loss points.

There is a lot to be said for using both types of analysis rather than only one of them.

International shares

It has become easier to invest directly in shares outside the UK, following the introduction of Jiway, which is a recognised investment exchange under the jurisdiction of the Financial Services Agency. The cost to brokers is set in euros at an amount of less than £5, so their charge to you should not be astronomic.

When to buy and sell

Theoretically you should buy shares when the market starts going up and sell when it turns down but few of us can distinguish a blip from a trend. In any case, individual shares may not move with the market.

There is a great tendency to sell a share which has fallen in price, particularly if it goes below the purchase price, and to buy more of a share which has risen. This may be the right action but decisions should be based not on the past but on expectations of the future.

Cut losses, but let profits run. However, it can be sensible to sell part of your holding of shares which are showing a good profit, leaving in, say, the equivalent of your original investment, particularly if the shares are highly volatile.

Do not churn (continual dealing) as dealing costs can mount up.

Above all, do not panic when prices fall; take the long view – most big market falls (sometimes called corrections) are followed by a fairly quick recovery and what seems a catastrophe at the time later becomes only a small blip on a trend line.

Defensive stocks

Shares in some companies are recognised as defensive, which means they are worth holding in periods of uncertainty. Examples are:

• stores – people need to live and therefore will buy clothing, food and drink;
• utilities such as electricity, gas, oil and water – likewise, there has to be a continuing demand;
• transport such as bus/coach and rail (but perhaps not air) – demand for these will also hold up.

Value investing

This term describes the purchase of cheap, unpopular shares, as opposed to growth investing – sectors expected to have considerable growth. Together, the two approaches are called style investing.

Suitable shares for value investing are considered to be those with high cashflow, dividends and earnings yields, and high ratios of sales and book value to share price.

Over the very long run, value shares appear to outperform growth shares, possibly because of the greater volatility of the latter (the tortoise-and-hare phenomenon!)

Hedging

There are various ways of protecting your shares from an expected fall in the share price (or in the market as a whole) without actually selling them. They also have the advantage of locking in a profit but deferring a potential capital gain.

All use the techniques of ‘going short’ – selling something you have not got, which can be very risky on its own, but because you do hold the shares the high risk is removed.

For information on these techniques, see the section on CFD trading below, and on options and spread betting in Chapter 6.

DAY TRADING

A more risky way of investing in individual shares is day trading, where you buy and sell (or the reverse) the same day. You need to be able to monitor the market continually so that you can close (sell what you have bought or vice versa) as soon as you have achieved your objective.

The big advantage is that you do not put up the cash (except for any deposit your stockbroker requires), you just collect or pay the difference. Stamp duty as well as commission is still payable.

The same objective can be achieved by trading both ways within the settlement period, normally five or ten days but extendible to 20 or even 25 days at the cost of a wider spread.

OCO orders

This technique is designed to produce profits whether a share price goes up or down (it sounds like Utopia!). OCO stands for one cancels other; another name is stop entry.

It can be used for a share where you expect a movement (such as when a results announcement is imminent) but you do not know which way the price will go.

The OCO order ensures that the share is bought for you if the price goes up by a small amount and sold (i.e. sold short) if it goes down. If the price movement does not meet the minimum, then there is no transaction.

The argument for using the system is that once the share price starts moving it continues in the same direction, so you can make a quick profit. You are still left with a decision about the timing of the reverse transaction to close out your position.

The risks are obvious – the price change may not continue in the same direction. In particular, if it goes up after you have sold short, the potential losses are unlimited. So there is a need to monitor the share price throughout the day.

Not many brokers offer this service.

CFD TRADING

A way of gearing up your trading is CFD trading (contracts for differences – sometimes called margin trading), where there is a virtual share which can be as little as one-tenth of the actual value but you gain or lose the full value of the share price movement. It is therefore highly volatile and up to ten times as risky as ordinary investment in shares.

You can go ‘short’ – sell to buy back later – on any share.

Stamp duty is avoided but capital gains tax applies.

You trade at the cash price per share and pay a transaction charge (confusingly called the spread) calculated as a percentage of the value of the transaction. Also you put up between 10 and 25% of the underlying contract value.

During the period of investment your account is debited daily with interest charges (currently 8.5% per annum) and credited with any dividends which become due. (In the case of a short investment, the debits and credits are in reverse, but the interest rate is lower, currently 4%.)

You can trade under what is called controlled risk protection, which enables you to place a stop-loss level at which your position will be closed should the market move against you. There is a higher transaction charge for this.

You can also trade in share futures via CFD (See Chapter 6).

You do not deal through your stockbroker but directly with one of the specialist dealers.

Hedging

It is possible to use a short CFD position to avoid an expected fall in the share price without actually selling the shares. It can also be used to lock in a profit on an existing shareholding without realising a potentially taxable capital gain.

Similarly, if you expect to have money to invest at a later date, or you have to sell shares now to raise some urgently needed cash and you think the market is going to rise, you can buy CFD shares.

These techniques are called hedging and are the opposite of risky because there is more risk in not doing it.

However there are alternatives – See Chapter 6 under options and spread betting.

INVESTING IN EMPLOYEE SHARE INCENTIVE/OPTION SCHEMES

Under share incentive schemes employees are given shares or the right to buy shares.

In the case of share option schemes the employing company grants the employee an option to buy shares in the company at some date in the future at a price based on the current share price.

Hopefully the share price will increase during the intervening period, so that when the option is exercised a profit is made. However, if the reverse happens nothing is lost, as the option does not have to be exercised.

If the scheme is one permitted by the Inland Revenue, no income tax (or National Insurance contributions) are payable by the employee, except on any dividends paid on option shares after the option is exercised.

Capital gains tax is payable only if and when the shares are subsequently sold (not when an option is exercised) and the more favourable taper relief applies (See Chapter 10).

Shares arising from the first three types of scheme shown below can be transferred to an ISA within 90 days of exercising the option (without counting against the current year’s limits), thus ensuring longer tax-free ownership.

If your employer has a scheme which is approved by the Inland Revenue you should consider joining, as the tax-free benefits are significant.

The following schemes are approved by the Inland Revenue:

Savings-related schemes

These are linked to a save-as-you-earn contract (SAYE) and the total option value is limited to the maximum SAYE contract value, i.e. up to £250 a month plus the bonus after three years equal to 2 times the monthly contributions, or 6.2 times after five years.

The scheme must be open to all employees, with a qualifying period of service not exceeding five years.

The way it works is that at the commencement of the contract the employee starts an SAYE scheme with a bank or building society chosen by the employer and at the same time is offered an option to buy shares in three or five years’ time, at a price which can be up to 20% below the current market price.

Clearly if the shares go up in value over the period a profit is made. If the value of the shares goes down, all is not lost as the option does not have to be exercised and the SAYE savings scheme bonuses are worthwhile in themselves.

The bonus received at the end of the SAYE contract is tax-free. Contributions then cease (although you can start again) but in the case of a five-year contract, if the money is left in for a further two years instead of being used to buy options or withdrawn, a further bonus equal to 5.7 times the monthly contributions is received.

The bonuses are equivalent to 3.67% per annum after three years, 3.99% after five years and 4.07% after seven, tax-free. In the case of SAYE contracts terminated before the expiry of the contracted period, no bonus is paid but interest of 3% a year is paid instead.

CGT is calculated on the gain over the option price but taper relief starts from when the option is exercised.

All-employee share plans (AESOPs)

This new type of scheme began in the year 2000. As the name implies, AESOPs must be open to all employees, although a qualifying period of up to 18 months is allowed and the allocation amounts can be tied to length of service and/or hours worked. Allocations can also be based on performance.

There are three sections:

• free shares – employees can be given up to £3,000 of shares free of tax and NICs;
• partnership shares – employees can be allowed to buy shares out of pre-tax income up to an annual maximum of £1,500;
• matching shares – employers can match partnership shares by giving employees up to two free shares for each one bought.

Free and matching shares must remain in the scheme for at least three years; partnership shares can be taken out at any time. Income tax and NICs are payable on the initial value of the shares if they are taken out after three years but this is avoided if the shares are left in the scheme for five years.

Capital gains tax will be payable only on the increase in value after the shares are taken out. If left in the scheme till sold, no CGT will be payable.

Up to £1,500 a year of dividends paid on the shares will be tax-free if used to buy more shares in the company.

Profit-sharing schemes

Companies can allocate a proportion of profits to the acquisition of shares in the company for the benefit of eligible employees. The maximum value per employee in any tax year is £3,000 or 10% of salary, whichever is the greater, subject to a maximum of £8,000.

The shares must be held by trustees for at least two years. Once they are transferred to employees they can be sold but income tax and National Insurance contributions are payable on the initial market value if the shares are sold within four years of the original allocation, the rate reducing to 75% of the applicable income tax rate if sold between four and five years. Thereafter they are only subject to capital gains tax.

Dividends are taxed in the normal way, whether the shares are held by the trustees or the employee.

Schemes must be open to all employees but a qualifying period of service up to five years is permitted.

Schemes must be merged into an all-employee scheme after April 2002.

Company share option plans (formerly executive schemes)

Unlike the other schemes, company plans may be selective in membership.

There is an upper limit to the market value of shares when options are taken up, of £30,000 and a three-year minimum period before options can be exercised. There may also be a requirement for minimum productivity improvement before options can be exercised.

Discounts are not permitted in this case – options must be offered at the full current market price.

Cash will be required to buy the shares when the option is exercised and usually there is an arrangement with a stockbroker for immediate sale of some at least of the shares, to raise all or part of the cash, with a temporary loan to cover the period between sale and receipt of proceeds.

The usual tax reliefs apply.

Enterprise management incentives

This further new scheme also began in the year 2000. It is for key people in smaller companies, i.e. independent trading companies with gross assets not exceeding £15 million.

Any number of employees can each be granted options within a total for the company of up to £3 million in value of shares.

The usual tax reliefs apply.

Unapproved share option schemes

Although there are no tax reliefs on unapproved schemes (apart from the more favourable capital gains tax taper relief because the shares are in the employing company), it can still be worthwhile joining in, as the potential gain from an increase in value over the option period, even after paying additional income tax and National Insurance contributions, may well be worth having.

BUYING SHARES IN YOUR EMPLOYING COMPANY

Any shares you hold in your employing company, whether through share option schemes or direct, are treated as business assets for the purpose of CGT taper relief and are therefore more tax-efficient than other equity investments.

The only thing to watch is the risk of having too many of your investments tied up in the company which employs you.

INVESTING THROUGH AN INVESTMENT CLUB

Investment clubs are organisations which arrange cooperative investing. Funds are built up by contributions from individual club members, who meet regularly to review their existing portfolio and select further investments, which are made by the club on behalf of the members.

The advantage is the saving in cost from bulk buying and the spreading of risk over more individual shares than you could buy on your own with the same amount you put in. The disadvantage is that you have to go along with the majority decision, whether you like it or not.

The Association of Investment Clubs will provide details of any club in your area and tell you how to start one. Information can be obtained by ringing ProShare on (020) 7220 1730.

GETTING SHAREHOLDERS’ PERKS

Some companies offer perks to shareholders, usually in the form of a discount on goods or services they supply. There is usually a minimum shareholding to qualify. Experts warn not to invest in a company merely to get the perk; the share should be worth buying for its intrinsic value.

A guide (priced £3 but possibly free) can be obtained from Hargreaves Lansdown (tel: (0117) 988 9880) or from Barclays Stockbrokers (tel: 0845 7777 100).

CASE SCENARIOS

Amanda starts investing in equities

Amanda decides to build up a portfolio of individual shares by using technical analysis. She sets up on her computer price charts for a number of shares. For each share, as well as the graph line showing the movement over the last two years, she adds lines comparing the prices with the all-share index and short-term and long-term moving averages. Finally, she inserts a 10% stop-loss line.

She picks out ten shares which look likely to grow in value, based on past performance. Then she thinks about sectors and studies the last annual reports to see whether she still thinks she has made the right choice.

Then it is time to contact a stockbroker.

Jean joins the company share scheme

The company Jean works for has a share scheme. As a part-timer she has not been interested, but having read about the tax advantages of share schemes, she decides to join.

There is an SAYE scheme, which she can join immediately, and she goes for the maximum SAYE investment of £250 a month. The grapevine says there will be one of the new all-employee schemes later in the year, which she may also join.

Hugh buys shares in his employing company

His employer is a very successful company and Hugh has every reason to think this will continue. So although he is nearing retirement, he decides he will invest some of his lump sum in that company’s shares, but not too much because his pension comes from a company scheme and he doesn’t want too many eggs in one basket.

POINTS TO CONSIDER FURTHER

• 1.You have decided to start investing in equities. How do you decide which shares to buy?
• 2.How do you feel about investing in your employing company? Do you think it is too risky, because you might lose your job as well as your savings? What is the advantage over other shares?
• 3.If you have bought a share but the price has since fallen, should you cut your losses? Does it make any difference if the whole market has suffered a set-back? What is the most important factor in making your decision?