UNDERSTANDING THE THEORY OF MONEY

The time value of money

When lending (and borrowing) money, the timing of payments of interest and return of capital has a significant effect on the interest rate. For interest receipts it is called the AER (annual equivalent rate).

In the case of interest payments, such as for a mortgage, it is called the APR (annual percentage rate) but is effectively the same thing.

Figure 2 provides an example of the time value of money.

The effect of compound interest

Compound interest arises where interest is left in an investment and itself then earns interest. For example, doubling your money in such an investment takes:

• ten years at an interest rate of 5%
• seven years at 10%
• only five years at 15%.

Another example comes from pensions. To achieve a pension of £10,000 a year from the age of 65, a man needs to contribute:

• starting at age 30, £150 a month
• starting at 40, £300 a month
• starting at 50, £600 a month.

(For a woman it is 10% more in each case.)

Figure 3 shows how savings can grow in different investments.

The effect of inflation

’Real’ rates of interest are the rates in excess of inflation. Only these rates preserve the real value of the capital. Usually they are in the region of 3%, whatever the actual rate.

However, since all interest is taxable, high interest rates can result in negative real rates, so they are not necessarily a good thing for taxpayers.

Figure 4 shows the breakeven points for 22% and 40% taxpayers.

GRASPING THE LANGUAGE OF INVESTMENT

Fixed interest investments

These are investments where the income is a fixed amount, at least for the time being. Usually the capital value is also fixed, although in some cases it can change, too. However, either income or capital are fixed and in many cases both.

Equities

These are investments in ordinary shares of companies, where both the income and the capital can vary up or down.

They can be bought and sold on a stock exchange and they participate in profits (after any preference dividend is paid) and receive dividends, usually paid half-yearly.

Shares have a par value – usually £1 or 50p – but this bears no relationship to their market value and can be ignored.

Fixed interest versus equities

All statistics show that in the long run, due to capital growth, equities beat fixed interest by a big margin, whereas fixed interest may not even beat inflation (see Figure 5).

Here is another comparison. If you invested £1,000 in 1973, 20 years later, in 1993, it would have grown to:

• building society (average) . £43,000
• shares (FTSE 100) ..... £297,000

Even after allowing for inflation, the equity investment would have risen to £56,000, whereas the building society would not have kept pace with inflation and would have fallen to £8,700.

Although the income on equities is less than on fixed interest to start with, it catches up and passes it in the long run. Over the past 30 years or so, income from equities has on average doubled every seven years (see Figure 6).

But to achieve the best returns on equities it is necessary to have flexibility in the timing of both buying and selling and an ability to remain invested for the long term – say five years at least.

Active versus passive equity investing

Active investing is where you choose a manager or invest directly in equities (including pooled equity investments -See Chapter 4) in the expectation that you can beat the market index. Passive investing is where you invest in an index-tracking unit trust (See Chapter 4) so that you track the market.

Risk

The more you have invested and the longer you can leave it alone, the more risk you can afford to take with some of it to achieve a higher reward. The most important thing is to recognise the existence of risk and to take appropriate steps.

Spread your investments over a number of different categories, having perhaps more than one investment in each category. Consider pooled investments such as unit trusts (See Chapter 4).

In this connection, some advisers suggest that you should take into account your income from earnings (or from your pension if you are retired), which they capitalise and call your lifetime capital. The relative steadiness of this income can mean that you can take more risk with your investments.

Always look at the downside risk of each investment and decide whether you are happy with it. However, to achieve higher returns in the long run, you need to take some risk.

Shares have three opportunities/risks:

• the individual company,
• the market sector (such as stores, banks); and
• the overall market.

The volatility of individual shares has increased significantly in recent years and the potential to lose money is something like three times as great as 30-40 years ago. This applies in particular to shares in the FTSE 100 index (smaller companies are less volatile). In very recent times this increased volatility is due to the Internet-linked companies.

Events in the lifecycle of shares

New issues

New shares sometimes come to the market as a result of de-nationalisation and de-mutualisation but any company coming to the market for the first time is a new issue. Application forms are printed in newspapers and are available on request. You fill in the form and send it off with a cheque.

You may not get all the shares you ask for. Some people apply for more than they expect to get. Stags are people who aim for a quick profit, applying for a large number of shares with the intention of selling them as soon as they are received.

There is no commission or stamp duty payable on new issues and the full amount may be payable in instalments.

Rights issues

This is where a company raises further capital by offering existing shareholders the right to apply for more shares. The price is usually set below the current market price so that the rights themselves have a market value.

Shareholders can decide whether to take up their rights, so investing more money in the company, or to sell them. Those taking no action usually have the rights sold for them.

There is a third way, called tail swallowing, which is particularly appropriate if your investment is in a PEP or ISA. If you wish to take up the rights but have insufficient cash in the account, you can sell enough rights to bring your cash available up to the amount required for the remaining rights.

See Figure 7 for an example of how to calculate the value of rights.

Bonus issues

This is a misnomer – there is no bonus! A better term is scrip issues (or capitalisation issues) and it is where existing shares are subdivided into, say, two new shares, thus doubling the number of shares and halving their value.

No new money passes, the action being taken usually because the share price has risen to a level which is considered too high for an effective market.

Scrip dividends

This is where companies offer shareholders the opportunity to take new shares instead of a cash dividend. It is a cheap way to invest more money in a company but it complicates capital gains tax calculations.

Share buy-backs

A company sometimes buys back shares, usually because it has surplus cash which cannot be invested more profitably elsewhere. The effect should be an increase in the share price.

Take-over bids

From time to time one company will attempt to take over another by offering an attractive price for the shares. It is worth waiting for a competitive offer, even if the directors recommend acceptance. Newspapers and investment magazines will comment on the offer.

If the buying company is successful it can force the purchase against reluctant sellers.

Receivership and liquidation

If a company fails to pay debts a lender of money to it can appoint a receiver to manage its affairs (or have one appointed by the creditors) or the company can be put into liquidation. In either case, it is unlikely that the equity shareholders will get much, if anything – they are at the end of the queue.

HOW STOCK EXCHANGES WORK

The London Stock Exchange is a marketplace for buying and selling shares. There are two groups:

• Stockbrokers, who buy and sell for you. They arrange the deal and receive commission, which might be 1 % with a minimum amount of perhaps £15.
• Market makers, who buy from and sell to you. They get the difference between the buying and selling price -the spread (this is usually about 1%).

There is a new trading system, called order-driven trading (the old system is called quote-driven trading), operating for high value companies – SETS (Stock Exchange Electronic Trading System) – whereby buyers and sellers are automatically matched. However, deals are still set up by stockbrokers.

Some large companies have set up means to trade in their shares at lower costs than are charged direct by stockbrokers.

In addition to commission, stamp duty of 0.5% is payable on purchases.

Adding these together and you have to achieve a gain of about 2.5% to break even.

The animals

The Stock Exchange is full of nicknames. You have already met stags but there are two more important animals – bulls and bears. Bulls are optimistic and believe share prices will rise; bears take the opposite view.

To go with the meat there are chips! Blue chips are shares in big companies thought to be relatively sound, such as BP Amoco and Tesco. Then there are white chips -smaller, sound companies.

Share prices

Prices of popular shares are printed in most daily and evening papers and can be found on Ceefax/Teletext and on the Internet.

They are usually grouped into sectors, such as stores, electrical, engineering. Lists of share prices will include some or all of the following:

• Yesterday’s closing price – this being the middle market price, halfway between the buying and selling prices.
• Yesterday’s increase/decrease, shown as + or – the previous day’s price.
• Highest and lowest prices in the last 52 weeks.
• Market capitalisation – total number of shares times current price, a measure of company size.
• Gross yield – last full year’s dividend before tax as a percentage of the current price.
• P/E ratio – price divided by earnings (profit before tax) per share, i.e. how many years’ earnings to recover the share price (theoretically the higher the figure the better the potential growth).

Share price indices

Most people have heard of the ‘footsie’. It is the FT/SE (Financial Times/Stock Exchange) 100 index – the 100 being the largest 100 companies by market capitalisation.

The other main index is the all-share index comprising all the shares quoted on the main exchange. There is also the mid 250, being the next 250 after the top 100, and the recently introduced Techmark index for new technology stocks.

There are also indices for the main categories of shares on the London market and for foreign shares – Europe, the US, Japan, the Far East.

Settlement

Most transactions are now settled electronically through the Crest system, under which share ownership is registered in the name of a nominee.

The old system using transfer forms and share certificates is still available but may cost more.

Settlement of electronic deals is now made three working days after the transaction date. For certificated dealing it is still ten days.

Alternative investment market

In addition to the main market, there is also AIM – the alternative investment market – which deals in shares of companies which are relatively new and small. It is an intermediate step before the main market.

Stock exchange regulations are less onerous than for the main market, but this does not in itself mean more risk for the investor.

Shares quoted on AIM are more volatile, may be difficult to buy and sell due to restricted numbers and are certainly more risky due to the newness and small size of the companies. However, large profits can be made.

OFEX market

This is a market for trading in shares in unquoted companies, that is companies which are not quoted on the main or AIM markets and are therefore much more risky.

Stockbrokers

Some operate on an execution-only basis whereby they just deal in accordance with instructions. If advice is also needed, it will cost more. Deals are usually arranged by telephone or using the Internet.

The cheapest execution-only brokers have a minimum charge of not much over £10, with 1% thereafter.

A list of execution-only brokers can be obtained by ringing (020) 7247 7080.

CHOOSING AN INVESTMENT CATEGORY

The issues to consider are:

• Do you want protection against inflation? Remember that equities stand a better chance of achieving growth in the long run but index-linked products can be considered for fixed-interest investing.
• Do you want income? Income-producing equity investments can achieve growth as well but there is no point buying a product which must pay out income when you would rather it were left in.
• Can you afford to take risks?

Questions to ask about any investment

• Capital – does it remain unchanged or can it go up and down?
• Income – is it fixed or variable? – is it paid out, kept in or reinvested?
• Tax – is income tax-free, taxable or taxed? – are capital gains taxable?
• Guarantees of income or capital – are there any?
• Period of investment – is it fixed or variable?
• Risks to capital or income – what are they?
• Commission – is any payable and to whom?
• Management fees – how much, if any, initial and/or annual?
• Past performance – what is it, remembering that it may not be maintained?
• Future performance – what could affect it?

Warnings

• Beware of the hard sell.
• Beware of apparent bargains.
• Beware of fashions.
• Read the small print, especially if there are guarantees.
• Consider the implications of long-term commitment, especially for regular contributions.

INTERPRETING COMPANY REPORTS

If you invest directly in shares, you should receive copies of company reports unless the shares are held by a nominee. If you are thinking of investing in a company and would like to see the annual report, you can arrange to have it sent to you (ring the company secretary).

If you do not receive company reports because your shares are held by a nominee, you can arrange to get them. To avoid additional cost, a useful source is the Financial Times, which has a free service – see the notes on the share price pages.

Annual report and accounts

This is usually a glossy affair which the company uses for publicity and marketing. It is also long and wordy because parts are required by law.

To find out what really matters without reading it all, consider the following:

Summary

Read this first. It will be at or near the beginning and may be called ‘Financial Highlights’. Compare this year’s figures with last year’s. Look especially at earnings per share (EPS) as this is the most valuable statistic. EPS is profit for the period divided by the number of shares in issue.

Chairman’s statement

This summarises the results but it is not a legal document so it will be slanted favourably. The most important paragraph is prospects, usually near the end.

Directors’ report

See if there are any changes in accounting practice, which must be reported here. If there are any, have the previous year’s figures been adjusted for comparison?

Auditors’ report

Is it ‘clean’ – in other words have they not said there is anything wrong?

Profit and loss account

You will have already seen the important figures in the summary but in the profit and loss account you will find a useful analysis of profit between ongoing businesses and (if any) new or discontinued businesses.

Balance sheet

Look at the group balance sheet if there is one. Compare each item with last year and think about any wide deviations, looking at the relevant notes. Look particularly at net current assets and borrowings.

Cash flow

Is there a net inflow or outflow? In the latter case try to work out why, in case it is a warning. (Fast-growing companies can be highly profitable but still run out of cash.)

Notes on the accounts

Read the note relating to directors’ pay – always of interest!

List of directors

Does the company have non-executive directors and if so do they seem powerful enough to stand up to the executives?

Interim report

This is usually quite brief. It shows figures for the first half of the current year compared with the same period last year and the last full year.

The figures will not have been audited and there may not be a balance sheet or cash flow statement. Watch out for any accounting changes which affect the comparison.

There will probably be a short chairman’s statement, including a comment on prospects.

MONITORING YOUR INVESTMENTS

It is essential to keep records of your investments – date of purchase or sale, quantity, price and value.

It is also a good idea to record successive prices of equity investments, where appropriate, so you can spot a trend.

If you have a computer, there are a number of programs for keeping records and share prices can be downloaded and graphs drawn as an aid to investment decisions, including prospective purchases.

You can set a stop-loss price for each share held, say 10 or 20% below the purchase price (computer programs are good at this). You do not have to sell when the price falls below it, especially if the whole market is down, but it is a signal to review. A good test is whether you would buy at the current price if you did not already have the shares.

Another vital record is a diary of future events, such as the date any National Savings certificates expire.

CASE SCENARIOS

Amanda decides her investment objectives

Amanda doesn’t need to invest for income and as she is young can invest long term, so she decides that her objective should be growth. Bearing in mind that equities perform better than fixed-interest in the long run, she thinks most of her investments should be in equities.

Jean knows about stockbrokers

Jean’s elder brother James, who has been successful, boasts of his investment prowess, but indicates he uses his bank for stock exchange transactions.

Jean has heard on Woman’s Hour that there may be cheaper stockbrokers and suggests he gets a list of execution-only brokers from APCIMS.

James scoffs a bit, but rings later to thank her, because he has found there are cheaper alternatives. He picks out the cheapest and registers in advance with a view to trying them next time.

Gwen and Hugh need income in retirement

Gwen and Hugh reckon any investments they make should be slanted in the direction of income rather than growth.

Also, since retirement is near, they consider that fixed-interest should form a large part of their investment portfolio.

POINTS TO CONSIDER FURTHER

• 1.The P/E ratio measures share price as a multiple of last year’s earnings. Comparatively high figures are said to show a greater potential for share price growth. Why is that? What should an individual P/E ratio be compared with?
• 2.What do you consider are the three most important items of information in a company’s annual report? Some people say cash flow is more important than profit – why do you think that is?
• 3.How do you feel about passive as opposed to active investing? Which is the safer route? How far are you prepared to take a risk with your money?