The Financial Times Guide to Investing Read online

  To two inspiring teachers of what is really valuable, Chris and Brenda Arnold, my parents

  Contents

  About the author

  Acknowledgements

  Publisher’s acknowledgements

  What’s new in the third edition

  Introduction

  part 1 Investment basics

  1 What is investment?

  Partnerships

  Limited liability

  Ordinary shares and extraordinary returns

  Shareholder rights

  A money-making machine

  Dividends and retained earnings

  What if I want to sell?

  Primary and secondary markets

  Bonds

  Capital structure

  Stocks and shares

  Rights issues

  Financial institutions

  Be proud to be a capitalist!

  A note of warning – investment and speculation

  2 The rewards of investment

  Becoming a millionaire

  Simple and compound interest

  How well have investors fared in the past?

  The importance of income

  International comparison

  Equities versus gilts

  What about risk?

  Closing comment

  Further reading

  3 Stock markets

  What is a stock market?

  Brokers and market makers

  Pricing – good old supply and demand

  A short history of the London Stock Exchange

  ‘Big Bang’

  The international scene

  Variety of securities traded

  LSE’s primary market

  The secondary market

  The Main Market (The Official List)

  The Alternative Investment Market

  techMARK and techMARK mediscience

  ICAP Securities & Derivatives Exchange (ISDX)

  Who owns UK shares?

  The role of stock exchanges

  Useful websites

  4 Buying and selling shares

  Stockbroker services

  Choosing a stockbroker

  Finding prices and other information

  Getting the most out of financial websites

  What happens when I buy or sell shares?

  An alternative mechanism

  A third trading system – SETSqx

  What happens after dealing?

  Ways of paying for your shares

  Internet dealing

  Direct market access

  Transferring shares without brokers

  Useful websites for further reading

  part 2 The investment spectrum

  5 Pooled investments

  Unit trusts

  Open-ended investment companies (OEICs)

  Exchange traded funds (ETFs)

  Investment trusts (investment companies)

  Investment platforms/supermarkets

  With-profits policies

  Insurance company bonds

  Stock-market-linked bonds

  Money markets

  Hedge funds

  Bringing home the significance of high fees

  6 Bonds

  Gilts

  Corporate bonds

  Credit rating

  High-yield (junk) bonds

  Convertible bonds

  Foreign bonds

  Eurobonds

  7 Unusual share investments

  Business angels (informal venture capitalists)

  Venture capital and other private equity

  Private equity categories

  Overseas shares

  Preference shares

  8 Options

  What is a derivative?

  What is an option?

  Share options

  Call option holders (call option buyers)

  Call option writers

  An example of an option writing strategy

  LIFFE share options

  Put options

  How to trade options

  Using share options to reduce risk: hedging

  Using options to reduce losses

  Index options

  Further reading

  Websites

  9 Futures

  Marking to market and margins

  Settlement

  Equity index futures

  Buying and selling futures

  10 Spread betting, contracts for difference and warrants

  Spread betting

  Contracts for difference

  Warrants

  Covered warrants

  Further reading

  Websites

  part 3 Company analysis

  11 Company accounts

  Oh no! Not numbers again!

  How to obtain reports

  The report and accounts

  Profit and loss account

  Balance sheet (statement of financial position)

  Cash flow statement

  Chairman’s statement

  Chief executive’s review

  Financial review

  Directors’ report and business review

  Auditors’ report

  Five-year summary

  Trading statements

  Further reading

  12 Key investment ratios and measures

  From the financial pages

  Performance ratios and measures

  Financial health ratios and measures

  Forward-looking measures

  Further reading

  13 Tricks of the accounting trade

  Goodwill

  Fair value

  What was our revenue again?

  Exceptional items

  Stock (inventory) valuation

  Depreciation

  Capitalisation

  Off-balance-sheet items

  Share (stock) options

  Missing the profits and assets in investee companies

  Other tricks

  Concluding comments

  Further reading

  14 Analysing industries

  The competitive floor

  The five competitive forces

  Threat of entry

  Intensity of rivalry of existing companies

  The threat from substitutes

  Buyer (customer) power

  Supplier power

  Industry evolution

  Concluding comments

  Further reading

  15 The competitive position of the firm

  The TRRACK system

  What makes resources extraordinary?

  Investment in resources

  Leveraging resources and over-exploiting them

  Concluding comments

  Further reading

  part 4 Managing your portfolio

  16 Companies issuing shares

  New issues

  Rights issues

  Other equity issues

  Scrip issues

  Share buy-backs and special dividends

  17 Taxation and investors

  Stamp duty

  Tax on dividends

  Capital gains tax

  Interest-bearing instruments

  Inheritance tax

  Individual savings accounts

  Personal pensions

  Enterprise Investment Scheme

  Venture capital trusts

  Tax-efficient charitable gifts

  18 Mergers and takeovers

  Merger motives

  Financing mergers

  The rules of the takeover game

  Who wins from mergers?

  Final comment: why do mergers fail?

  Further reading

  19 Investo
r protection

  Protecting investors from wayward financial services professionals

  Regulation of markets

  Regulation of companies

  Self-protection

  Scams

  20 Measuring performance: indices and risk

  Indices

  Risk

  Websites

  Further reading

  21 Investment clubs

  How to set up a club

  The unit valuation system

  Bank account

  Brokers

  Tax

  Further reading

  Glossary

  Index

  About the author

  Glen C. Arnold, PhD, has held positions of Professor of Investment and Professor of Corporate Finance, but came to the conclusion that academic life was not nearly as much fun as making money in the financial markets. As a wealthy investor in his early 50s, Glen now spends most of his time running his own equity portfolio (www.glen-arnold-investments.co.uk) and a property development company from his office in the heart of rural Leicestershire.

  Glen is happy to share his ideas with fellow enthusiasts in the City of London through seminar sessions. He also leads investing seminar days for private investors; see www.glen-arnold-investments.co.uk

  Glen is the author of the investing classics The Financial Times Guide to Value Investing, The Great Investors and Get Started in Shares.

  He wrote the market-leading university textbooks, Corporate Financial Management, Modern Financial Markets and Institutions and Essentials of Corporate Financial Management. He is also the author of three definitive books on finance: The Financial Times Guide to Banking, The Financial Times Handbook of Corporate Finance and The Financial Times Guide to the Financial Markets. All these books are available from Financial Times Publishing.

  Acknowledgements

  This book draws on the talents, knowledge and contributions of a great many people. I would especially like to thank the following.

  Warren Buffett who kindly assisted the illustration of key points by allowing the use of his elegant, insightful and witty prose.

  My personal assistant, Susan Henton, for her hard work, professionalism and enthusiastic support.

  Riccardo Landucci of stockbrokers Charles Stanley who took time to read Chapter 4 and made valuable suggestions for improvement.

  The team at Pearson Education (FT Publishing) who, at various stages, contributed to the production of the book: Chris Cudmore, Kat Habershon, Anna Campling, Lucy Carter, Linda Dhondy and Melanie Carter.

  Publisher’s acknowledgements

  We are grateful to the following for permission to reproduce copyright material:

  Figures

  Figure 3.3 from London Stock Exchange; Figures 4.1, 4.2, 4.3, 4.4, 4.5, 4.6, 4.7, 4.8, 4.9, 4.10, 4.11, 4.12, 4.13, 4.14, 4.15, 4.16 from www.advfn.com; Figure 4.17 from www.directorsholdings.com; Figure 5.1 from www.morningstar.co.uk; Figure 5.2 courtesy of Schroders plc; Figure 8.7 courtesy of Intercontinental Exchange, Inc.; Figure 14.1 reprinted with permission of The Free Press, a division of Simon & Schuster, Inc. from Competitive Strategy: Techniques for Analyzing Industries and Competitors by Michael E. Porter. Copyright © 1980, 1998 by The Free Press. All rights reserved. Figure in Box 20.3 reprinted with permission from Yahoo. © 2014 Yahoo.

  Articles

  Articles 3.1, 3.2, 3.3, 3.4, 3.5, 3.6, 3.7, 4.1, 4.2, 5.1, 5.2, 5.3, 5.4, 5.5, 5.6, 5.7, 5.9, 6.1, 10.1, 13.1, 13.2, 13.3, 13.4, 13.5, 13.6, 16.1, 16.2, 16.3, 17.1, 19.1, 19.2, 19.3 © The Financial Times Limited. All Rights Reserved; Article 5.8 from Warren Buffett’s letter to shareholders accompanying the 2005 Annual Report of Berkshire Hathaway, Inc., reproduced with kind permission of the author. Copyright remains with Warren Buffett; Article 8.1 courtesy of Neil Collins.

  Text

  Text on pages 439–40 from Warren Buffett’s letter to shareholders accompanying the 1993 Annual Report of Berkshire Hathaway, Inc., reproduced with kind permission of the author. Copyright remains with Warren Buffett.

  In some instances we have been unable to trace the owners of copyright material, and we would appreciate any information that would enable us to do so.

  What’s new in the third edition

  The financial markets have always been dynamic places, but the last few years have witnessed a particularly fast rate of change. Not only have we had to cope with the aftermath of the financial crisis – during which we all came to appreciate the importance of effective markets – but we have seen stock markets merge and change methods of operation, new financial instruments rise in popularity and new accounting/tax rules. Clearly, this new book is long overdue. Here are some of the ways it improves on the old one:

  Don’t be ripped off. Updated guide posts to avoid the loss of your nest egg to idiots and knaves.

  Which website for what topic? Websites are important sources of information, but we need guidance on what each website is useful for. Where a website will help you keep up to date, find data or provide a useful tool, it is referenced in the relevant chapter (over 140 websites are listed).

  Unit trust and other collective investing is explained in more detail – with even more warnings against overpaying.

  Tax, etc. Updating of tax avoidance moves you can make, tax rates, changes in cash/share ISAs, changes to capital gains tax and various ways of saving tax.

  New section on dividend payments and what to watch out for.

  Jargon-busting. The extensive glossary has been enlarged even more, so you can look up a range of words, phrases and concepts.

  Tapping into the Financial Times. Extensive use of recent Financial Times articles and FT tables to illustrate and expand upon the material in the chapters.

  Up-to-date statistics. A very wide array of statistics ranging from investor returns on shares and bonds to amounts raised by companies on the stock market.

  Introduction

  There are some myths about investment, many of which are perpetuated by finance industry insiders. Myth one is that financial assets and markets are hideously complicated and confusing. Myth two is that you have to pay large sums to ‘experts’ who will then make far greater returns on your money than you could achieve on your own.

  In truth the most important things you need to know about investing are simple. They are based on common sense and can be understood by anyone with a modicum of intelligence. It is just that the jargon and the detail obscure the view of outsiders peering through trying to see what it is all about. This book, in a step-by-step way, first explains the simple essence of investment and the functioning of the financial markets. It allows you to focus on what is really valuable, discarding grand-sounding but unimportant layers of mumbo-jumbo. It then goes on to explain the practicalities of investing, such as where to find a broker and how to go about buying shares. It explains the variety of financial securities you can place money into, from bonds and unit trusts to traded options and exchange-traded funds. It also has a key section providing tools allowing you to analyse companies.

  As for the argument that you need to employ an ‘expert’ to run your investments – well, this is complete nonsense. For a start, the majority of professional fund managers underperform the stock market. This has been observed year after year. You haven’t heard about this? Well, of course you haven’t. It is not the sort of thing that fund managers publicise. Some researchers even asked various fund managers to pit their wits against an ape in the selection of share portfolios. The subsequent portfolio performance was noted most carefully. You’ve guessed who won! Even on a random basis we should find that 50 per cent of professional fund managers beat the market and 50 per cent do worse, but they don’t even manage that.

  Don’t misunderstand me: some professionals, in some circumstances, have their uses. But to imagine that the private investor is generally at a disadvantage to the professional and should always defer to their superior insight is just plain wrong. Sure, you need some basic knowledge (which this book will he
lp with), and you need some dedication to the task, but please don’t be browbeaten into believing that the pinstriped suits have a competitive advantage over you, with your down-to-earth focus on what really matters and some sound investment tools. Share investment is about businesses – when you buy a share you buy a portion of the ownership of a business. Let me emphasise that a share is not a gambling counter in a short-term random game of chance; it represents ownership of something that will probably outlive you, and its value depends on what will happen to that company years from now. It is not too difficult for you to become more knowledgeable about that business than a fund manager stuck in London who has a portfolio of shares in 200 different companies.

  Once you have a grounding in the principles of investment you will free yourself from the assumption that the professionals know best and that you could not achieve a good return without them. You will be aware of a range of alternatives to simply handing your money to, say, an ISA manager. Sometimes the financial service house can do things better and cheaper than you could on your own. But, quite often, you end up paying huge fees for atrocious performance. This book will help you decide when to manage your money yourself and when to employ others.

  A third myth is that only wealthy people can afford shares and other financial assets. In reality people of relatively modest means invest in the stock market. It is possible to start with only £20 per month. In Chapter 2 there is an example of a woman who stretched herself to put £100 per month into shares over a 20-year period. The sacrifice was worth it: by the time she retired the fund had grown to be worth many millions of pounds – all for £100 per month. And this was achieved by gaining the same annual returns as the UK stock market as a whole – it wasn’t that she bought all the best shares on the market and with perfect foresight ignored what turned out to be the worst ones.

  Read on: investing can be profitable and fun!

  part 1

  Investment basics

  1

  * * *

  What is investment?

  To appreciate fully what it means to be an investor, I ask you to imagine that you do not live in the twenty-first century, with its vast range of financial instruments. You live in a simpler time. You are a member of the Victorian middle class, and life has been good to you. A substantial nest-egg has been built up over the years, but you are dissatisfied with the 2 per cent annual return you are getting on it in the local bank.