Share Education

Introduction to Shares

Share EducationA share is simply part ownership of a business.

This category of financial instruments is, without a doubt, one of the greatest tools ever invented for building wealth. Shares are a part, if not the cornerstone, of nearly any investment portfolio. You need to have a solid understanding of shares and how they trade on the stock market.

Over the last few decades, the average person's interest in the stock market has grown exponentially. What was once a toy of the rich has now turned into the vehicle of choice for growing wealth. This demand coupled with advances in trading technology has opened up the markets so that nowadays nearly anybody can own shares.

Despite their popularity, however, most people don't fully understand shares. Much is learned from conversations around the water cooler with others who also don't know what they're talking about. Chances are you've already heard people say things like, "John's cousin made a killing in XYZ company, and now he's got another hot tip..." or "Watch out with shares--you can lose your shirt in a matter of days!" So much of this misinformation is based on a get-rich-quick mentality, which was especially prevalent during the amazing dotcom market in the late '90s. People thought that stocks were the magic answer to instant wealth with no risk. The ensuing dotcom crash proved that this is not the case. Stocks can (and do) create massive amounts of wealth, but they aren't without risks. The only solution to this is education. The key to protecting yourself in the stock market is to understand where you are putting your money.

A company can raise money to finance its business by 'going public' or in the finance industry known as an IPO (Initial Public Offering). Going public means being listed on a stock exchange and issuing shares to investors. By paying for the shares, each investor buys part ownership of the company's business and becomes a shareholder in the company.

The money that a company raises in this way is called equity capital. Unlike debt capital which is borrowed money, equity capital does not need to be repaid as it represents continuous ownership of the company. In return for investing in the company, shareholders can receive dividends and other benefits. Shares that have been issued to investors by a listed company can be sold to other investors on the stock market. In this way, shareholders can realise capital gains if the share price has risen - in other words, make a profit by selling their shares for more than they paid for them or lose capital if the share price has fallen and the loss is realised. 

What is a Stock/Share?

A share is simply part ownership of a business. A stock is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings. There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preferred stock generally does not have voting rights, but has a higher claim on assets and earnings than the common shares. For example, owners of preferred stock receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.


"Shares" or "Equity"

A holder of shares (a shareholder) has a claim to a part of the corporation's assets and earnings. In other words, a shareholder is an owner of a company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if company XYZ has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the company's assets. Stocks are the foundation of nearly every portfolio. Historically, they have outperformed most other investments over the long run.


The Definition of a Stock/Share

Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.

What are Stocks/Shares - Detailed Information

A security issued by a corporation that represents an ownership right in the assets of the corporation and a right to a proportionate share of profits after payment of corporate liabilities and obligations. Shares of stock are reflected in written instruments known as share certificates. Each share represents a standard unit of ownership in a corporation. Shares differs from consumer goods in that it is not used or consumed; it does not have any intrinsic value but merely represents a right in something else.

Nevertheless, a shareholder is a real owner of a corporation's property, which is held in the name of the corporation for the benefit of all its shareholders. An owner of shares generally has the right to participate in the management of the corporation, usually through regularly scheduled stockholders' (or shareholders') meetings. Shares differ from other securities such as notes and bonds, which are corporate obligations that do not represent an ownership interest in the corporation. The value of a share of stock depends upon the issuing corporation's value, profitability, and future prospects.

The market price reflects what purchasers are willing to pay based on their evaluation of the company's prospects. Two main categories of stock exist: common and preferred. An owner of common stock is typically entitled to participate and vote at shareholders' meetings. In addition to common shares, some corporate bylaws or charters allow for the issuance of preferred shares. If a corporation does not issue preferred shares, all of its shares is common shares, entitling all holders to an equal pro rata division of profits or net earnings, should the corporation choose to distribute the earnings as dividends. Preferred shareholders are usually entitled to priority over holders of common shares should a corporation liquidate.

Preferred shares receive priority over common shares with respect to the payment of dividends. Holders of preferred share are entitled to receive dividends at a fixed annual rate before any dividend is paid to the holders of common share. If the earnings to pay a dividend are more than sufficient to meet the fixed annual dividend for preferred shares, then the remainder of the earnings will be distributed to holders of common shares. If the corporate earnings are insufficient, common shareholders will not receive a dividend.

In the alternative, a remainder may be distributed pro rata to both preferred and common classes of the shares. In such a case, the preferred share is said to "participate" with the common share. A preferred shares dividend may be cumulative or noncumulative. In the case of cumulative preferred shares, an unpaid dividend becomes a charge upon the profits of the next and succeeding years. These accumulated and unpaid dividends must be paid to preferred shareholders before common shareholders receive any dividends. Noncumulative preferred shares means that a corporation's failure to earn or pay a dividend in any given year extinguishes the obligation, and no debit is made against the succeeding years' surpluses. Par value is the face or stated value of a share of share. In the case of common shares, par value usually does not correspond to the market value of a stock, and a stated par value is of little significance.

Par is important with respect to preferred shares, however, because it often signifies the dollar value upon which dividends are figured. Shares without an assigned stated value are called no par. Some states have eliminated the concept of par value. Blue chip shares are shares traded on a securities exchange (listed shares) that have minimum risk due to the corporation's financial record. Listed shares means a company has filed an application and registration statement with both the Securities and Exchange Commission and a securities exchange.

The registration statement contains detailed information about the company to aid the public in evaluating the stock's potential. Floating shares is stock on the open market not yet purchased by the public. Growth shares is stock purchased for its perceived potential to appreciate in value, rather than for its dividend income. Penny stocks are highly speculative shares that usually cost under a dollar per share.


Owning Shares

Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim (albeit usually very small) to everything the company owns. A share is represented by a share certificate. This piece of paper is proof of your ownership. In today's computer age, you won't actually get to see this document because your brokerage keeps these records electronically. This is done to make the shares easier to trade. In the past, when a person wanted to sell his or her shares, that person physically took the certificates down to the brokerage. Now, trading with a click of the mouse or a phone call makes life easier for everybody.

Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. For instance, being a XYZ shareholder doesn't mean you can call up the Director and tell him how you think the company should be run. In the same line of thinking, being a shareholder of ABC doesn't mean you can walk into the factory and grab a free product ABC makes! The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed, at least in theory. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions. For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you don't want to have to work to make money, right? The importance of being a shareholder is that you are entitled to a portion of the company’s profits and have a claim on assets.

With shares it's possible for investors to create wealth in three different ways:

  • To receive an income from them in the form of dividends
  • To hopefully see a growth in their value and sell them at a profit
  • A combination of the above, known as balanced

Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get.

A share dividend is the payment an investor receives from the company he or she is currently investing in. The company pays the dividend from the profit it generates throughout its financial year. As a result, if the company fails to make a profit, dividends are not likely to be received by the investor. The dividend is normally paid in two parts, an interim and a final dividend. This means if an investor has shares in a company for a year, they will normally get paid two lump sums a year. To receive a dividend you must own the stock before the ex-dividend date. The dividend gets paid to the investor on the payment date set by each individual company, these dates can be found on a company’s investor relations section of their official website or on each company profile on Share Prices.

In case of liquidation, you'll receive what's left after all the creditors have been paid. This last point is worth repeating. The importance of share ownership is your claim on assets and earnings. Without this, the stock wouldn't be worth the paper it's printed on. Another extremely important feature of a share is its limited liability, which means that, as an owner of a share, you are not personally liable if the company is not able to pay its debts.


Different Types of Shares

There are two main types of stocks: common or ordinary shares and preferred shares. Common and preferred are the two main forms of shares; however, it's also possible for companies to customize different classes of shares in any way they want. The most common reason for this is the company wanting the voting power to remain with a certain group; therefore, different classes of shares are given different voting rights. For example, one class of shares would be held by a select group who are given ten votes per share while a second class would be issued to the majority of investors who are given one vote per share. When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. Berkshire Hathaway (ticker: BRK on the NYSE), has two classes of stock. The different forms are represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B".

Common or Ordinary Shares

Common shares is, well, common. When people talk about shares they are usually referring to this type. In fact, the majority of shares is issued is in this form. We basically went over features of common shares in the previous section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management. Over the long term, common shares, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common shares entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid.

Preferred or Preference Shares

Preferred shares represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common shares, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred shares may also be callable, meaning that the company has the option to purchase the shares from shareholders at any time for any reason (usually for a premium). Some people consider preferred shares to be more like debt than equity. A good way to think of these kinds of shares is to see them as being in between bonds and common shares. 


Why Stock/Share Prices Change

Over the last few decades, the average person's interest in the stock market has grown exponentially. What was once a toy of the rich has now turned into the vehicle of choice for growing wealth. This demand coupled with advances in trading technology has opened up the markets so that nowadays nearly anybody can own shares. Despite their popularity, however, most people don't fully understand shares. Much is learned from conversations around the water cooler with others who also don't know what they're talking about.

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall. Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative.

There are many answers to this problem and just about any investor you ask has their own ideas and strategies. That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don't equate a company's value with the share price. The value of a company is its market capitalization, which is the share price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million). To further complicate things, the price of a share doesn't only reflect a company's current value, it also reflects the growth that investors expect in the future. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Publicly listed companies are required to report their earnings four times a year (once each quarter).

The Financial world watches with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results surprise (are better than expected), the price jumps up. If a company's results disappoint (are worse than expected), then the price will fall. Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn, changes its price).

During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks.

Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Technical Oscillators or moving average convergence divergence. So, why do share prices change? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how share prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that shares are volatile and can change in price extremely rapidly.

The important things to grasp about this subject are the following:

  • At the most fundamental level, supply and demand in the market determines stock price.
  • Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.
  • Theoretically, earnings are what affect investors' valuation of a company, but there are other indicators that investors use to predict share price. Remember, it is investors' sentiments, attitudes and expectations that ultimately affect share prices.
  • There are many theories that try to explain the way share prices move the way they do. Unfortunately, there is no one theory that can explain everything.

How Stocks/Shares Trade

Most stocks/shares are traded on exchanges, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor. You've probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signalling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made electronically. The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. Just imagine how difficult it would be to sell shares if you had to call around the neighbourhood trying to find a buyer. Really, a stock market is nothing more than a super-sophisticated farmers' market linking buyers and sellers. Before we go on, we should distinguish between the primary market and the secondary market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company's stock does not directly involve that company.


The New York Stock Exchange

Share EducationThe most prestigious exchange in the world is the New York Stock Exchange (NYSE). The "Big Board" was founded over 200 years ago in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Currently the NYSE, with companies like General Electric, McDonald's, Citigroup, Coca-Cola, Gillette and Wal-Mart, is the market of choice for the largest companies in America.

The Trading Floor of the NYSE

The NYSE is the first type of exchange (as we referred to above), where much of the trading is done face-to-face on a trading floor. This is also referred to as a listed exchange. Orders come in through brokerage firms that are members of the exchange and flow down to floor brokers who go to a specific spot on the floor where the stock trades. At this location, known as the trading post, there is a specific person known as the specialist whose job is to match buyers and sellers. Prices are determined using an auction method: the current price is the highest amount any buyer is willing to pay and the lowest price at which someone is willing to sell. Once a trade has been made, the details are sent back to the brokerage firm, who then notifies the investor who placed the order. Although there is human contact in this process, don't think that the NYSE is still in the Stone Age: computers play a huge role in the process. 


The Nasdaq

The second type of exchange is the virtual sort called an over-the-counter (OTC) market, of which the NASDAQ is the most popular. These markets have no central location or floor brokers whatsoever. Trading is done through a computer and telecommunications network of dealers. It used to be that the largest companies were listed only on the NYSE while all other second tier stocks traded on the other exchanges. The tech boom of the late '90s changed all this; now the Nasdaq is home to several of not just the biggest technology companies but also biggest overall such as Apple, Microsoft, Cisco, Intel, and Facebook. This has resulted in the Nasdaq becoming a serious competitor to the NYSE.

On the Nasdaq brokerages act as market makers for various stocks. A market maker provides continuous bid and ask prices within a prescribed percentage spread for shares for which they are designated to make a market. They may match up buyers and sellers directly but usually they will maintain an inventory of shares to meet demands of investors. 


ASX or Australian Stock Exchange

The ASX Group's origins as a national exchange go back to 1987. The Australian Stock Exchange Limited was formed in 1987 after the Australian Parliament drafted legislation that enabled the amalgamation of six independent state-based stock exchanges. Each of those exchanges brought with it a history of share trading dating back to the 19th century.

In 2006 The Australian Stock Exchange merged with the Sydney Futures Exchange and originally operated under the name Australian Securities Exchange.

Later, however, ASX launched a new group structure to better position it in the contemporary financial market environment. From 1 August 2010 the Australian Securities Exchange has been known as the ASX Group. Today ASX is a world top-10 exchange group measured by market capitalisation.


Other Exchanges

The third largest exchange in the U.S. is the American Stock Exchange (AMEX). The AMEX used to be an alternative to the NYSE, but that role has since been filled by the Nasdaq. In fact, the National Association of Securities Dealers (NASD), which is the parent of Nasdaq, bought the AMEX in 1998. Almost all trading now on the AMEX is in small-cap stocks and derivatives. There are many stock exchanges located in just about every country around the world. American markets are undoubtedly the largest, but they still represent only a fraction of total investment around the globe.

The two other main financial hubs are London, home of the London Stock Exchange, and Hong Kong, home of the Hong Kong Stock Exchange. The last place worth mentioning is the over-the-counter bulletin board (OTCBB). The Nasdaq is an over-the-counter market, but the term commonly refers to small public companies that don't meet the listing requirements of any of the regulated markets, including the Nasdaq. The OTCBB is home to penny stocks because there is little to no regulation. This makes investing in an OTCBB stock very risky.


Buying Stocks

You've now learned what a stock/share is and a little bit about the principles behind the stock market, but how do you actually go about buying shares? Thankfully, you don't have to go down into the trading pit yelling and screaming your order. There are two main ways to purchase stock:

Using a Brokerage

The most common method to buy stocks is to use a brokerage. Brokerages come in two different forms. Full-service brokerages offer you expert advice and can manage your account but they also charge more. Discount brokerages (Online brokerages) offer little in the way of personal attention but are much cheaper. At one time, only the wealthy could afford a broker since only full-service brokers were available. With the internet came the explosion of online discount brokers. Thanks to them nearly anybody can now afford to invest in the market.

DRIPs & DIPs

Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are plans by which individual companies, for a minimal cost, allow shareholders to purchase stock directly from the company. Drips are a great way to invest small amounts of money at regular intervals.


Dividends

Franked Dividends

If you are an Australian resident for Tax purposes then you are able to take advantage of a tax arrangement designed to avoid the 'double taxation' of company profits where companies pay tax on their profits and Shareholders who receive the dividends must still pay income tax upon their receipts. To encourage domestic share ownership, the federal government introduced dividend imputation in 1987. Known as franking, this countered the issue of double taxation. Put simply, an Australian-based investor who holds Australian shares (or share funds) is entitled to a franking credit equal to the amount of the company tax paid. Franked dividends are those paid by a company that has paid company tax.

Example:

If a company pays out all of its earnings each year through dividends and achieved earnings before tax of $10.00 per share, it would pay tax of $3.00 per share and then distribute to shareholders the $7.00 as a dividend. With the introduction of franking credits, the company now also gives the share investors $3.00 in franking (or imputation) credits. Subsequently, when the shareholder submits their tax return, they add up the $7.00 dividend and $3.00 franking credit and declare $10.00 per share in pre-tax income. Then they apply whatever tax (from their personal tax bracket) is paid on this $10.00. So, investors on a 15% personal tax rate who would normally have to pay $1.50 of tax, however as $3.00 company tax has been paid by the company to the Australian Tax Office, the shareholder is 'owed' the difference of $1.50 by the ATO. Those on a rate of 48.5% rate would normally pay $4.85. However, as thirty percent tax has already been pre-paid by the company, they only pay the difference between the 48.5 % and 30% tax already paid.

In this case they only have to pay tax of $1.85.To be eligible, the company has to be registered for franking and that the holder of the relevant shares upon which the dividend has been paid has held the shares for 45 days (or 90 days in the case of preference shares). If not, the tax benefit of the franking credits will be denied. Additionally, this rule will not apply to individual shareholders who receive less than $2,000 in franking credits per annum on all shareholdings. Importantly, a company is not required to pass on all credits to shareholders. The degree of passing-on is the percentage of franking, eg a 75%-franked dividend is one upon which only 75% of the maximum possible attachable credits have in fact been attached to that dividend.

Dividend Payout Ratio

This is a means of measuring the sustainability of dividend payments. By calculating the proportion of company profits that are paid out as dividends (dividends per share divided by earnings per share). Therefore if a company is earning $5 per share, and pays a dividend of $4 per share, the payout ratio is 80 per cent.

Risk

It must be emphasized that there are no guarantees when it comes to companies listed on the market. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those publicly listed companies that have traditionally given them. Without dividends, an investor can make money on a share only through its appreciation in the open market. On the downside, any company may go bankrupt, in which case your investment is worth nothing. Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts.


Debt vs. Equity

Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise capital. To do this, companies can either borrow it from a financial institution or raise it by selling part of the company, which is known as issuing shares. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing shares is called equity financing.

Issuing shares is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a shares, which is issued by the private company itself, is called the initial public offering (IPO). It is important that you understand the distinction between a company financing through debt and financing through equity.

When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful. 


Equities - The Science of Valuation

As an investor (or a trader) you will have a specific interest in valuing a stock to help ascertain the growth potential. For example, is XYZ bank better 'value' than its peers? Investors are traditionally willing to pay a premium price for companies consistently posting above-average growth and the ability to identify stocks that are undervalued would allow you to buy at a time that would maximise your gains. There are a number of standard valuation tools that can be used to assist you in reaching a decision. Assuming that all calculations are standardised for all peer group comparisons, these valuation tools can provide credible indications of investment or trading opportunities. They are all based around comparing the current share price to other numbers that can normally be found in the corporate accounts; Earnings, dividend, assets and sales.

The Price/Earnings (P/E) Ratio

Also referred to as the earnings multiple of the company. This is probably the best-known, and most quoted measure of valuation. Calculated as the price per share divided by the amount of earnings per share (net profit after tax) over the preceding 12 months, it is the number of years it will take to recover the purchase price from earnings at the current rate. The accepted theory is that if you can buy a company for 5 times its earnings, it has a better chance of increasing in value than where you pay 15 times its earnings. As always there are exceptions such as a company that has good growth prospects. It can therefore justify a higher ratio due to the earnings growing quickly (this can be verified by using the other valuation tools below). However, the 'tech wreck' period showed us that the PE ratio for a growth company can also be too high with expected growth already factored into the price with little leeway for error.

The Price/Assets Ratio

This tool is typically used when investors are seeking value stocks. Value stocks are those that typically sell with relatively low price/assets ratios which imply that their market value is close to their asset value and that their intangible assets (Structure, staff, management, goodwill etc) are valued at a low level. One would expect that the intangible assets could provide an increase in value; e.g. the appointment of a CEO with a successful track record.

The Price/Sales Ratio

A tool that can assist in measuring a company’s potential, particularly useful when trying to value companies that currently do not have earnings or are experiencing operating difficulties and are reporting depressed earnings.


Bulls and Bears

On the stock market, the Bulls and Bears are in a constant struggle. If you haven't heard of these terms already, you undoubtedly will as you begin to invest.

The Bulls

A Bull Market is when everything in the economy is great, people are finding jobs, gross domestic market (GDP) is growing, and stocks are rising. Things are just plain rosy! Picking stocks during a bull market is easier because everything is going up. Bull markets cannot last forever though, and sometimes they can lead to dangerous situations if stocks become overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a "bullish outlook".

The Bears

A Bear Market is when the economy is bad, recession is looming and stock prices are falling. Bear markets make it tough for investors to pick profitable stocks. One solution to this is to make money when stocks are falling using a technique called short selling (we will get to this in the next section). Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going to drop, he or she is called a "bear" and said to have a "bearish outlook". While it's true that you should never invest in something over which you lose sleep, you are also guaranteed never to see any return if you avoid the market completely and never take any risk.

What Type of Investor Will You Be?

There are plenty of different investment styles and strategies out there. Even though the bulls and bears are constantly at odds, they can both make money with the changing cycles in the market. 


Short Selling Shares

Share EducationShort selling is a valuable tool in any trader's armoury: not only can you take advantage of a Bearish market via Exchange traded options, CFDs or warrants, but you can also Short Sell shares. Clarification; Let us clarify the terminology used. To avoid confusion (and subsequent monetary loss), instead of talking about buy and sell, your broker would prefer to talk in terms of Long (buying shares and holding them) and Short (selling shares that you do not own).

When would you short a stock?

When you have a view that the value of those securities are likely to fall, i.e. either a bear market or bear trend.

Can all shares be short sold?

No, they have to be on an Approved List of securities of the ASX and you should consult your broker as to this prior to placing an order to short sell. Some brokers will not short sell due to the increased risk.

What are the restrictions?

Your broker will ensure that your transaction does not bring the total of short selling volume for that particular stock to more than 10% of the listed securities (min; 50 million) available for that company. The company must also have a minimum market capitalisation of $100m and be approved by the ASX for short selling. Additionally, you are not able to short sell at a price lower than the last trade price, this prevents short sellers forcing the market down but can make timing of short selling awkward in a falling market.

How is this done?

Through certain full service brokers, they will; borrow the stock from another shareholder on your behalf through a custodian, these will then be sold onto somebody else. At a later stage you will have to buy those shares back and return the ownership to the original shareholder.

What is the cost?

Typically this is negotiated between yourself and the broker, but be mindful that you will be; Liable for any dividends and their franking credits to the buyer over the period. Interest costs that may be charged by the broker for the duration. Initial and Subsequent Margin requirements to your broker. As the process is more complicated the brokerage may be more.

Example:

You choose to short sell 1,000 XYZ shares @ $10.00 giving a total value of $10,000.00. You will be required to provide an initial margin cover of 20% of this with your broker, i.e. 20% of $10,000.00. This can be in the form of cash or listed securities.


Share Buy Back

Every week there are announcements of company share buy-backs. Why do companies buy-back shares?

Some of the main reason are:

  • To distribute excess profits back to shareholders. Allow shareholders of small companies that are seldom traded on the ASX an opportunity to sell their shares
  • Cut the administrative costs associated with having lots of small shareholders

Companies have several options in how they can perform a buy-back, they include:

  • An On-market buy back - where the company will buy directly from the ASX, they announce the period that they will conduct the buy-back (i.e. Sept - Nov) and the maximum price they will pay
  • An equal access scheme - when the company offers to buy back the same proportion of each shareholder's shares
  • A selective buy-back - when the company offers to buy back shares from only one or some of its shareholders. Occasionally shareholders may be required to approve the share buy-back. Each shareholder, whose shares the company wants to buy back, will receive an offer. Each shareholder must then decide whether they want to sell their shares

The question is why would you sell your shares if, on the face of it, the remuneration was less than the market value of the shares?

The answer is the taxation treatment of the buy-back. Under normal circumstances Capital Gains Tax is payable on any profit when you sell shares. However, the ATO may agree to different treatment depending upon the way the buy-back is conducted. The dividend is fully-franked so superannuation funds and charities that pay no tax or 15 per cent get a refund cheque from the Tax Office. Additionally, individuals who pay less than 30 per cent tax also benefited greatly. So how does a trader/investor profit from the buy-back? Assuming that your tax situation allows you to benefit from the discounted offer price and the franking credits there is reason to participate. In practical terms, the buy-back can also place a floor under the share price, giving stability to the share price. On occasion, investors who participate in the buy-backs reinvest their profits into the company as the company share price increases thanks to the underlying support initiated by the buy back.


Reporting Season

What is all the fuss about?

Reporting season is always a busy time for everybody concerned with the stock market. It is the time when companies open up their books and we see the good, the bad and the ugly of the past six months of work. Companies can bask in the glory of their profits and present their thoughts on the future, or explain away the disappointment of missing past promised targets and promise to do better next time.

Under Corporate Governance regulations companies have to report their earnings for the periods ending June 30 and December 31. Traditionally companies report over a period of a few weeks in August and February (The Banks, apart from CBA, are the exception), but in reality the market, and in particular the analysts, have been under pressure to predict the figures ahead of time. There is plenty of money to be made from going long on a company that will exceed expectations or shorting a stock that disappoints the market. Reporting season is often characterised by high volatility.

The derivatives market (e.g. Options and CFDs) for any one share is affected as investors and speculators jockeying for position, covering existing stock positions and reacting to the buying or selling opportunities presented as markets over-react to short-term news. The market normally reacts by comparing the results with analysts' forecasts and expectations. Therefore it is not uncommon for a company that registers a 40% increase in profits to experience a sharp fall in share price if the market was expecting 50% increase in profits. Conversely a share price rise may be seen for a company that has lost less money than predicted

Reporting Season and Short Term Trading

Please see the CFD and Options lessons sections for more information on what they are, how they work and how they apply to Short Term Trading.

Technical analysts who study the charts over many reporting seasons see something quite startling: the chances of an individual stock selection moving in line with the short-term technical indicators is at best, uncertain. The fact is that the risk-reward scenario of holding a CFD or option overnight when the company is about to report is unfavourable.

From experience, more short-term CFD and option traders get hurt during earnings season than at any other time of the year. Why? There are several mechanics at work during an earnings release.

Firstly, there are the raw numbers themselves. Did they actually beat the estimates? Sometimes it appears as they though they have, but how did they do it? If they did it on falling revenues, then they accomplished the feat by cost cutting or playing the currency spreads. None of them are indicative of great growth.

Then we have the issue of just how much did they beat the estimates by? Quite often beating the estimates can be more a matter of creative accounting than a real estimate of business growth.

Moreover, the short-term technical analysis generally supports the jawboning of the analysts and their estimates. The CFD or Option trader sees the stock price moving with the expectations of the analysts, encouraging the trader to enter the trade. The next morning the company announces their earnings and the share price gaps down of falls quickly, despite the fact that they beat the numbers.

Secondly, there is the all-important guidance. The earnings released is already old news as they represent the half-year that has already past. Fund managers and analysts are very interested in what the company is doing now and what they think they will do in the future. If the guidance is less than encouraging, the stock may well take a knock. As we roll through the earnings season, the best solution for the CFD and Option trader is trade in the direction of the prevailing tend and exit the trade prior to the day before the company reports. The trader may miss some of the ones that explode higher, however on the flip side, they will have avoided the trades that implode. Holding the CFD or option trade on hope would have proved regrettable.


Conclusion

  • Shares means ownership, as an owner, you have a claim on the assets and earnings of a company as well as voting rights with your shares
  • Shares is equity, bonds are debt. Bondholders are guaranteed a return on their investment and have a higher claim than shareholders. This is generally why shares are considered riskier investments and require a higher rate of return
  • You can lose all of your investment with shares. The flip-side of this is you can make a lot of money if you invest in the right company
  • The two main types of stocks/shares are common (ordinary) and preferred. It is also possible for a company to create different classes of stock/shares
  • Stock markets are places where buyers and sellers of stock meet to trade. The NYSE and the Nasdaq are the most important exchanges in the United States and the ASX the most important exchange in Australia
  • Stock prices change according to supply and demand. There are many factors influencing prices, the most important of which is earnings
  • There is no consensus as to why stock prices move the way they do
  • To buy stocks/shares you can either use a brokerage or a dividend reinvestment plan (DRIP)

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