Forward Diary

How to Invest in Stocks and Shares

So you’re ready to start investing, but what should you look out for? Here are some golden rules and pointers to start you on your exciting stockmarket journey Let’s assume you have now opened an account with a stockbroker – whether it’s a bang up-to-date online account with all the bells and whistles or a traditional account that involves dealing in person over the telephone.  Chances are your thoughts will now turn to UK shares, looking at some of the companies that figure regularly in the business news as well as smaller ones that rarely make the headlines. You are now about to start on the great stock market adventure. This may be not without a certain amount of trepidation. After all, events in the financial markets over the last three years have hardly been comforting. But even in the most testing financial environment for 80 years, it has proved possible to make money and there is no reason not to make your money work for you now. GOLDEN RULES 
Before we look closer at the stock market, here are ten golden rules for investors. 1. Set your targets It’s very easy for newcomers to the markets to be bewildered by the wide variety of investments available. By narrowing down what you are really interested in, you can drastically reduce the amount of research you need to do, both before you do a deal and on a continuing basis. There are investors who only ever buy or sell shares in one major blue-chip company – a bit extreme and not recommended as a strategy, but at least they really get to know everything there is to know about that company! Before you buy a share, ask yourself why you think the investment will do well and write a note of the reasons. At the same time, think about your time horizon. Generally, Shares magazine advocates long-term investing under- pinned by dividend reinvestment, but when the potential rewards far outweigh the risks a shorter-term approach is reasonable too. Shares believes a 7% annual return is a realistic target for those investing over 30 years. Markets can be volatile and there will be periods when assets fall in price. Your attitude to these periods, such as we saw in 2008 to early 2009, will determine your appetite for risk and whether you are prepared to stay the course to benefit from the rebound. 2. Be a tortoise, not a hare Later on in this guide, we discuss ‘trading’ – frequent dealing to secure short-term profits – as opposed to longer-term investment. Trading has its merits and can generate excellent returns if risk is controlled and the right investments and tools are selected. However, for steady long-term profits from shares, the investor camp is preferable. There are three main reasons for this view: Long-term investors accrue dividend payments. Since it was established in 1962, the FTSE All-Share has paid an average annual yield of 3.8%
– providing more than half the 7% annual return targeted above. Dividend reinvestment is key to superior returns (see table, overleaf ). Had you harnessed the FTSE All-Share’s 7.2% average annual capital return since 1962, £10,000 would have become more than £81,000 over 30 years – but your investment would have grown to over £231,000 by reinvesting the dividends. Long-term investors will incur fewer dealing charges and lose less through indirect costs such as bid/offer spreads, which can chip away at a portfolio’s returns for more regular traders. The savvy investor can also invest via wrappers such as an ISA (Individual Savings Account) and SIPP (Self-Invested Personal Pension) – see chapter 13 – helping to protect the portfolio’s income and capital gains from the attentions of the tax man. All this is not an argument for never, ever selling. The US investment guru Warren Buffett, who is often quoted as a champion of the ‘buy-and-hold’ strategy, has amassed a fortune by ignoring the short term; he is sometimes quoted as asking ‘Why would anyone want to sell a share?’ But we are not all Warren Buffetts. Selling a stock bought for a long-term portfolio may seem like an admission that we got it wrong, but so what? Not everything works out as planned and sometimes you have to cut your losses and move on. A poorly-performing investment can then make way for a better idea. 3. Monitor your portfolio Once a portfolio has been built and cash sensibly spread across a variety of sectors, further care is still required. Your portfolio will never be static as the market price of nearly all of your investments will change during every single trading session. Regular reviews of the winners and losers, taking profits in the former and weeding out the latter, will ensure no one selection takes up too much of the portfolio and will avoid exposure to undue risk. Careful checks of your performance will show how your profits or losses are stacking up against the expected performance and whether you need to make any changes. Maintaining a proper balance should be relatively straightforward, trimming here, reinvesting dividends there and hopefully watching the long- term returns trickle in. A useful technique to ensure you do not hold on to a share for too long is to draw up a list of five reasons why you expect an asset to rise in value. Once three have happened, start to trim back, and sell if all five come to pass. A valuable tool for both investors and traders is the stop loss. Here you simply decide that any holding which falls a certain amount – say, 20% – is automatically sold. Instructions can be left with your broker to do this. 4. Balance risk with reward You should always consider what could go wrong with an investment decision and coolly assess whether you feel comfortable with the balance of risk and reward. There is some ‘risk’ attached to even the safest investments – if you buy a Premium Bond, for example, your capital is 100% safe but the rate of return will not protect you from inflation. If you are happy to take a guaranteed small loss rather than expose yourself to the higher risk and potential reward involved in stock market investment, then stick to Premium Bonds. But a share portfolio, as well as property and gold, can be a good long-term hedge against inflation and is more likely to achieve our benchmark 7% annual return. In his book An Investor's Guide to Analysing Companies and Valuing Shares, experienced analyst Michael Cahill explains how to look at risk and return. He says a good benchmark for a relatively risk-free return is the ten-year UK government bond or gilt, which at the time of writing was yielding 4.05% per annum. The key is to use this as a reference point for the lowest risk (and therefore lowest return) asset and assess what gains you would then like to make from alternative arenas. Remember that returns can come from both yield (via dividend income) and capital appreciation. Technology stocks – particularly growth companies focused on research and development – tend not to be at the dividend-paying stage yet, so any return will have to come from appreciation of the shares’ value. If you feel like buying a biotechnology share but believe there is less than 20% upside in the stock, maybe you should think again as the return is insufficient given the risk. Investors also need to be aware of other major risks they face, including currency changes and market volatility, and review those risks frequently to take account of changing personal circumstances.   5. Diversify This golden rule can be simplified by saying ‘Never put all of your eggs in one basket’. No matter how keen you are on a particular investment, putting everything you have into it is courting disaster. How many times do we read of some apparently intelligent individual who has done just that and been wiped out? Regardless of how well thought out and well researched an investment is, something could still go wrong due to an unforeseen event such as a natural disaster, terrorist attack or market crash. Such events can see markets lurch down suddenly and inflict serious pain on the investor. Think of Jarvis, the contractor which collapsed this year, having never recovered from the Potters Bar train crash of 2002. A well-balanced portfolio with exposure across several asset classes should be able to withstand any such blow. Ideally these should be uncorrelated – that is to say, likely to react in different ways to a specific event. Following a hurricane, for example, insurance shares may fall but the price of a commodity such as oil and oil company shares could rise if the affected area is a key production site. The same applies to asset classes and is an argument for spreading your money across more than one. A stock market crash will see a jump in risk- aversion and a move by investors to more stable assets such as bonds. An inflation spike will likely see bonds and cash do badly but shares, commodities and property do well. Many commentators remain convinced that inflation, rather than deflation, will be the biggest issue in 2010 and 2011. If this proves correct, gold should prove a useful part of any portfolio. If offers no yield but could shoot up in value if the cost of living soars, given its traditional role as a store of value during times of strife. Investors can trade the yellow metal easily via an exchange-traded fund or get indirect exposure through shares in gold-mining companies. 6. Everything has its price Knowing how to value a potential investment is vital in deciding when to buy and sell. There are several key valuation techniques but the one you are most likely to come across is the price/earnings ratio, or PE. This is calculated by dividing a company’s share price by its earnings per share and is used as guide to both the ‘value’ of the share and the company’s future growth prospects. Share price’ and ‘valuation’ are, of course, not the same thing. Warren Buffett drew this distinction clearly when he said, ‘Price is what you pay, but value is what you get’. To take an example: at the time of writing, based on 2010 earnings per share forecasts, drug company GlaxoSmithKline was trading on a price/earnings (PE) ratio of 10.3 times against its big rival AstraZeneca’s 7.9, even though its share price was lower. In other words, the more lowly priced share was in fact rated more highly by the market, attributed by some analysts to a better strategy and superior earnings growth. Valuation does need a catalyst, however. Just because a stock with a high PE appears expensive, it does not have to be a ‘sell’, nor because it is cheap does it have to be a ‘buy’. Cheap stocks can stay cheap unless a catalyst such as a bid approach, change of management or restructuring programme comes along to help unlock that value. Investors may take a view on the prospects of such a catalyst happening and decide whether a share is overvalued, undervalued or correctly valued by the market. Shares tipsters often base their arguments on a belief that the market has got it wrong. Dividend yield is another key tool used to evaluate a prospective investment. Here you will need to consider whether the company is likely to at least continue paying the current dividend and ideally increase it in future. Dividend cover is used as a measure of the ability of a company to maintain its payout if profits drop – the higher the cover, the better. It is calculated by dividing earnings per share by dividend per share. A ratio of 2 or higher is generally considered safe while anything below 1.5 is risky. Other key valuation tools that you can explore as you learn more about the stock market include: •Discounted cashflow (DCF) 
•Price to earnings growth (PEG) 
•Price to net asset value (P/NAV) •Enterprise value multiples such as EV/sales and EV/EBITDA   7. Cash is king Investment legend Benjamin Graham argued: ‘In the short run, the stock market is a voting machine but in the long run it is a weighing machine’. By this he meant that share prices can be easily driven by fashion in the short term, but in the long term cashflow and earnings must be delivered to justify the valuations attributed to stocks. A company’s cashflow indicates the movement of cash in or out of the business. Cash is vital for any business – it may survive for a while without sales or profits, but not without cash. Companies with plenty of cash on hand are able to invest it back into the business in order to generate more cash and profit. Longer-term investors will naturally lean toward cash-generative firms as they are the ones most likely to pay out fat dividends. Information on cashflow is one of the things to watch out for in a company’s final and interim results statements. Graham would never have put money into the early-stage oil exploration and mining stocks which dominated the new flotation list through 2006 to 2008. He would have asked where the profits and cashflows were to justify lofty valuations. He would have missed some profits on the way up but would have not been caught cold on the way down when those cashflows failed to materialise on time. Nor would he have fallen for the charms of certain tech and telecoms firms which were all apparently generating good profits and growing, yet consistently failing to produce cash while doing so and whose share prices eventually collapsed.       8. Investing is like a beauty parade Stock market investment is not just about the analysis of a company but about understanding the market’s attitude to that company’s shares. It is invaluable to be able to gauge market psychology and judge what events will make others want to buy or sell a stock. It’s all a bit of a beauty parade. Markets are not always right or efficient – they often become over- heated and even confused – but price movements may be telling you there is something you missed. Banking stocks began to underperform the broader UK equity market in summer 2006, nine months before the first sub-prime debt losses were reported by US and European banks and nearly two years before the financial crisis claimed Northern Rock and drove Bradford & Bingley, Alliance & Leicester and HBOS into the arms of a rival. Markets are forward-looking. Assets will be valued and priced according to the market’s perception of the future, not reality – until reality intervenes in the form of a trading update, set of results, piece of macro-economic news or some other item and changes the market’s view of the future. Then valuations and prices will be reset by buyers and sellers as the new information is swiftly digested.   9. It’s never different this time Markets always swing back from extremes. That means you should never pay a high price for shares on the basis that returns will remain above average for longer than normal. Equally, once commentators start to argue that there will never be a recovery or return to past peak profits because of some new structural fault, it is often a buy signal. Investment guru John Templeton once observed, ‘The four most dangerous words in investing are: ‘This time it’s different’. Reasons spouted to defend stratospheric valuations and share prices during the technology, media and telecoms boom of 1998 to 2000 proved to be non- sense – leading to a near ten-year bear market in those sectors as overhyped earnings expectations became impossible to attain. It looked like a brave new world, but in the end it was just another bubble. 10. Know when to go against the herd The best performing assets between 2000 and 2009 were Russian equities and gold. Russian stocks rose 708% and gold 305%, even though both had been well and truly out of favour at the end of 1999. Russia had defaulted on its debt in 1998 and its currency and stock market had both subsequently collapsed. Gold had fallen by 29.7% in the 1990s to just $291 a ounce, adding to
the 21.4% decline seen in the prior decade.
Their very unpopularity at the start of the decade helped make Russia and gold compelling investments. Prices and
valuations had already col-
lapsed and hope had been abandoned. This was the perfect
scenario for a comeback, as it would take precious little for sentiment to turn since things could hardly get any worse and there was no-one left to sell. Spotting these opportunities is not easy and requires patience. But looking at areas where the financial press is not bullish, which brokers and independent financial advisers are not touting, and which are laughed at when you even mention them is often a good start.   This ‘How to’ guide is produced by Shares Magazine and is only for general information and use, and is not intended to address particular requirements. The value of investments and the income derived from them can go down as well as up. Past performance is not necessarily a guide to future performance. You should get professional financial advice before making any investment decisions.

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